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JNANA VARDHINI SIBSTC MONTHLY NEWSLETTER -COVERING CONTEMPORARY BANKING RELATED TOPICS 8th Issue MARCH- 2011 SOUTHERN INDIA BANKS’ STAFF TRAINING COLLEGE No.531, Faiz Avenue, 11th Main, 32nd Cross IV Block, Jayanagar, BANGALORE-560 011 1 CURRENCY FUTURES What Does Currency Futures Mean? A transferable futures contract that specifies the price at which a currency can be bought or sold at a future date. Currency future contracts facilitate hedging of currency exposures and these are traded at the floor of organized exchanges. In future contracts the quantum of currency, the price and the delivery date all get pre-determined. Currency Futures- Need and advantages Any transaction denominated in a currency other than the home currency is a foreign exchange transaction and hence it is subject to exchange risk and to hedge this risk several hedging instruments are now available in the market. Amongst the various derivative products available, currency futures are now being increasingly used by Corporates and Financial Institutions to hedge their underlying currency exposures in foreign exchange transactions. Currency Futures have emerged as the preferred tool in view of the following advantages 1. Currency futures contracts are marked-to-market daily. Investors can exit their obligation to buy or sell the currency prior to the contract's delivery date. This is done by closing out the position. 2. In currency futures, the price is pre-determined when the contract is signed, just in the case of forward contracts. Depending on the views taken and the market trends, the hedger can minimize the loss by closing the position even well before the due date as the contracts are tradable in nature. 3. However, most participants in the futures markets are speculators who usually close out their positions before the date of settlement, so most contracts do not tend to last until the date of delivery 4. The counter party risk is nil in respect of Currency Futures as these products are at the floors of organized future exchanges which are well regulated and settlement process well monitored by clearing houses. Comparison between Currency Futures and Forward Contracts are: Characteristics Size of the contract Maturity Location Currency Futures Standardized as per exchange guidelines Fixed and longest being one year At the floor of an organized exchange 2 Forward Contracts Any size acceptable Any maturity and normally up to one year OTC product normally at the counters of a Bank Pricing Margin/Collateral Settlement Trading hours Counter party Liquidity Outcry process exchange floor on the Prices determined by market forces based on bid and offer quotes Initial margin as per No explicit margin. But an exchange guidelines and agreement and customerdifferentials collected on Bank relationship shall be marked to market basis essential Rarely delivered upon. Normally delivery takes Settlement normally by place or offsetting is also cash or by offsetting the possible subject to payment position of differentials During exchange hours Through Banks network or through common monitors/screens like Reuters Unknown to each other due Counter party risk prevails to auction type trading. But counter party risk nil as regulated well by exchanges Highly liquid and large Liquid and relatively higher volumes are now traded volumes are transacted Developments in India In India though liberalization under FEMA triggered a quantum jump in the volume of business in foreign exchange markets, extensive fluctuations in exchange rates also started taking place causing a concern to those who have genuine exposures in foreign exchange as volatility in exchange rates started creating dents in profits. This situation resulted in attracting the attention of policy makers, investors, importers, exporters and borrowers. The following developments led to an orderly growth of markets for currency futures in India. The Reserve Bank of India issued a set of directions and guidelines for the launch of the much-awaited currency futures trading in India. Following are the guidelines issued under the Reserve Bank of India Act, 1934 that have come into force with effect from August 6, 2008. Definitions Currency Futures means a standardised foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another 3 on a specified future date, at a price specified on the date of contract, but does not include a forward contract. Currency Futures market means the market in which currency futures are traded. Permission (i) Currency futures are permitted in US Dollar - Indian Rupee or any other currency pairs, as may be approved by the Reserve Bank from time to time. (ii) Only ‘persons resident in India’ may purchase or sell currency futures to hedge an exposure to foreign exchange rate risk or otherwise. Features of Currency Futures Standardized currency futures shall have the following features: a. Only USD-INR contracts are allowed to be traded. b. The size of each contract shall be USD 1000. c. The contracts shall be quoted and settled in Indian Rupees. d. The maturity of the contracts shall not exceed 12 months. e. The settlement price shall be the Reserve Bank’s Reference Rate on the last trading day. Participants (i) No person other than 'a person resident in India' as defined in section 2(v) of the Foreign Exchange Management Act, 1999 (Act 42 of 1999) shall participate in the currency futures market. (ii) Notwithstanding sub-paragraph (i), no scheduled bank or such other agency falling under the regulatory purview of the Reserve Bank under the Reserve Bank of India Act, 1934, the Banking Regulation Act, 1949 or any other Act or instrument having the force of law shall participate in the currency futures market without the permission from the respective regulatory Departments of the Reserve Bank. (iii) Similarly, for participation by other regulated entities, concurrence from their respective regulators should be obtained. Membership The membership of the currency futures market of a recognised stock exchange shall be separate from the membership of the equity derivative segment or the 4 cash segment. Membership for both trading and clearing, in the currency futures market shall be subject to the guidelines issued by the SEBI. Banks authorized by the Reserve Bank of India under section 10 of the Foreign Exchange Management Act, 1999 as ‘AD Category - I bank’ are permitted to become trading and clearing members of the currency futures market of the recognized stock exchanges, on their own account and on behalf of their clients, subject to fulfilling the following minimum prudential requirements: a) Minimum net worth of Rs. 500 crores. b) Minimum CAR of 10 per cent c) Net NPA should not exceed 3 per cent. d) Made net profit continuously for last 3 years. The AD Category - I banks which fulfil the prudential requirements should lay down detailed guidelines with the approval of their Boards for trading and clearing of currency futures contracts and management of risks. AD Category - I banks which do not meet the above minimum prudential requirements and AD Category - I banks which are Urban Co-operative banks or State Co-operative banks can participate in the currency futures market only as clients, subject to approval therefor from the respective regulatory Departments of the Reserve Bank. Position Limits The position limits for various classes of participants in the currency futures market shall be subject to the guidelines issued by the SEBI. The AD Category - I banks, shall operate within prudential limits, such as Net Open Position (NOP) and Aggregate Gap (AG) limits. The exposure of the banks, on their own account, in the currency futures market shall form part of their NOP and AG limits. Risk Management Measures The trading of currency futures shall be subject to maintaining initial, extreme loss and calendar spread margins and the Clearing Corporations / Clearing Houses of the exchanges should ensure maintenance of such margins by the participants on the basis of the guidelines issued by the SEBI from time to time. 5 Surveillance and Disclosures The surveillance and disclosures of transactions in the currency futures market shall be carried out in accordance with the guidelines issued by the SEBI. Authorisation to Currency Futures Exchanges / Clearing Corporations Recognized stock exchanges and their respective Clearing Corporations / Clearing Houses shall not deal in or otherwise undertake the business relating to currency futures unless they hold an authorization issued by the Reserve Bank under section 10 (1) of the Foreign Exchange Management Act, 1999. Powers of Reserve Bank The Reserve Bank may from time to time modify the eligibility criteria for the participants, modify participant-wise position limits, prescribe margins and / or impose specific margins for identified participants, fix or modify any other prudential limits, or take such other actions as deemed necessary in public interest, in the interest of financial stability and orderly development and maintenance of foreign exchange market in India. Terminology used in Futures markets Long Position- Go on buying a currency at future dates Short Position- Go on selling at future dates Maturity dates- The contracts due dates for delivery usually 3rd Wednesday of January, March, April, June July, September, October and December Last trading day- Contracts can be traded up to the second business day prior to the maturity date. Therefore unless holidays interfere, trading can be up to the Monday preceding the maturity date Margin- The purchaser should deposit the initial margin or collateral. It can be by way of cash or a letter of credit from a bank Marked to market- The value of the contracts will be valued on day to basis using the closing price of the day and differential margin collected. This differential margin is also called variation margin. Settlement- Only 5% of future contracts are normally settled through physical delivery process. The seller delivers to the buyer and gets cash and the buyer gets securities and parts with cash. Mostly buyers and sellers offset their original position by taking an opposite position. The person who is long will go short for the same delivery date 6 Round Turn- The complete buy/sell or sell/buy as above is called “round turn’ Counter Party- The other person to the deal is called the counter party. But in Future Contracts, the counter party risk is nil as the highly regulated exchange itself ensures the settlement process. Open- The rate at which a currency gets quoted as the trading day opens High- The rate at which the currency was quoted for the highest value during a trading day Low- The rate at which the currency was quoted for the lowest value Settle- The closing rate for valuation purposes Change- Indicates the change in the settle price from the previous day’s closing rate Open Interest- Indicates the number of contracts outstanding Now after over a year of introduction of exchange-traded currency futures in the USDINR pair on the stock exchanges in the country, the market regulators have now permitted trading of Euro-INR, Japanese Yen-INR and Pound Sterling-INR on the exchange platform. This is a move that the market had been demanding for a long time. The currency derivatives segment on the NSE and MCX has witnessed consistent growth both in traded value and open interest since its inception. Current trends The currency futures have gained momentum in both MCX-SX and NSE exchanges in India and the situation as on 05-04-2011 (from BL dtd 06-04-2011) furnished here below for ready reference. Contracts Open High Low Close Volume USDINR-Apr 11 May11 June 11 44.58 44.82 45.15 44.65 44.92 45.17 44.51 44.79 45.09 44.62 44.89 45.16 2082225 117262 21681 Open Interest (OI) 908760 136740 56234 EURINR-Apr 11 GBPINR-Apr 11 JPYINR-Apr11 63.41 72.48 53.14 63.42 72.50 53.14 63.18 71.55 52.71 63.22 72.40 52.95 50573 20269 24837 45385 7321 10060 7 Conclusion The market participants in Futures Markets may include NRIs and FIIs also at a later date which may still cause an upward swing in the volumes Potential arbitrage opportunities between OTC products and futures could again increase the volume of business in future markets The Government, as a part of economic and financial reforms, kick started the much needed revival of financial sector reforms by introducing currency futures for all the leading global currencies versus Indian Rupee Further pace of liberalization like permitting Non Resident Indians and Foreign Institutional Investors also in futures markets may add further momentum to the galloping futures markets in India Banks being the predominant players in futures markets too for hedging their open positions and the clientele exposures, a complete knowledge of the working of futures markets will enable rendering value added services to the customers in the present day competitive environment. LIBOR (London Inter -Bank Offered Rate) -Origin and Developments For investments or borrowings made in an international currency like US$, the interest rates are now linked to a bench mark rate LIBOR or LIBID and let us try to understand briefly about the origin and the developments. What is LIBOR? An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year LIBOR-How it shot to prominence? The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. Countries that rely on the LIBOR for a reference rate earlier included the United States, Canada, Switzerland and the U.K and in India also all the international borrowings and investments and borrowings, investments at home denominated in a foreign currency, the 8 interest rates are now linked to bench mark rate like LIBOR or LIBID What is the difference between LIBID and LIBOR? Both LIBID and LIBOR are rates primarily used by banks in the London interbank market. The London interbank market is a wholesale money market in London where banks exchange currencies either directly or through electronic trading platforms. The acronym LIBID stands for London Interbank Bid Rate. It is the bid rate that banks are willing to pay for euro currency deposits in the London interbank market. Eurocurrency deposits refer to money in the form of bank deposits of a currency outside the country that issued the currency. However euro currency deposits may be of any currency in any country. The most common currency deposited as euro currency is the US dollar. For example, if US dollars are deposited in a European bank or any bank outside the U.S, then the deposit is referred to as a euro currency. What Does London Interbank Mean Rate - LIMEAN Mean? The mid-market rate in the London Interbank market, which is calculated by averaging the offer rate (LIBOR) and the bid rate (LIBID). The LIBOR is the rate at which funds are sold in the market, while the LIBID is the rate at which the funds are purchased in the market. The LIMEAN rate can be used by institutions borrowing and lending money in the interbank market, instead of using the LIBID or LIBOR rates, in any lending agreements. It can also be used to gain insight into the average rate at which money is being borrowed and lent in the interbank market What Does Euro Interbank Offer Rate - EURIBOR Mean? The rate of interest at which panel banks borrow funds from other panel banks, in marketable size, in the EU interbank market. In other words, this is the rate at which participant banks within the European Union money market will lend to another participant bank in the EU money market. Because banks involved with EURIBOR are the largest participants in the EU money market, this rate has become the benchmark for short-term interest rates. 9 EXCHANGE RATE SYSTEMS- EVOLUTION AND THE DYNAMICS Introduction: Every sovereign nation has a distinct national currency and hence international trade and financial transactions necessitated exchange of currencies. Different countries adopted different exchange rate systems at different times. The following are some of the exchange rate systems adopted by various countries. The Gold Standard Many countries had adopted Gold Standard as their monetary system during the last two decades of the nineteenth century. This system was in vogue till the outbreak of World War I. Under this system, the parities of currencies were fixed in terms of gold. Purchasing power parity After abandonment of Gold standard, the exchange rates were determined on the basis of purchasing power parity (PPP) theory which was propounded by a Swedish economist Professor Gustav Cassel. The theory in simpler terms stated that the currencies are valued based on what they can buy. For an example if 135 Japanese Yen can buy a pen and the same pen can be bought for one US Dollar, then exchange rate becomes USD1=JPY 135. Under this theory the sole criterion to determine the exchange rate of two currencies was their purchasing power. The Breton Woods System During the World Wars the economies were badly ruined and in order to correct their Balance of Payments disequilibrium, many countries resorted to devaluation of their currencies. As the race for devaluation started to boost the exports, there were violent fluctuations in exchange rates and hence the international trade suffered a blow. The bitter experience of war years forced the countries to create a free and stable multilateral monetary system which would help restoration of international trade. In accordance with an agreement reached in Breton Woods conference held in July 1944, with the main objective of restoring free multilateral Trade and stable exchange rates, the International Monetary Fund (IMF) was established in 1946. Under the Articles of IMF, an exchange rate system, popularly known as Breton Woods System, was evolved and this was followed by member banks till 1971. The Breton Woods System required the member banks to fix the parities of their currencies in terms of US Dollar or Gold. The objective of stable exchange rate was achieved as the countries were asked to keep the fluctuations within +1% of their declared parity. Under this system the central bank of the respective member country had to intervene effectively in the market for keeping the exchange rate within the declared 10 parity. This situation created a pressure for the central banks for maintaining sufficient reserves and whenever required they could draw from IMF through SDR (Special Drawing Rights) and other facilities extended by IMF. This resulted in huge demand for US Dollars and there was a virtual run on the American currency. The Breton Woods System finally collapsed as United States announced on August 1971 that it would no longer convert US Dollars into Gold at the fixed rate committed to IMF. Floating rate system With the exit of fixed parities system, different countries experimented with various exchange rate systems. Almost all the industrialized countries adopted some form of “managed float”. If the value of a currency is not determined solely on demand and supply but is managed by the Central Bank of the country through continuous intervention, the same is known as ‘Dirty Float”. Exchange rate of Rupee The Indian Rupee was historically linked to the Pound Sterling as most of India’s international trade transactions were denominated in Pound Sterling. Under the Breton Wood’s System, as member of IMF, India declared its par value of Rupee in terms of Gold and RBI maintained the par value of Rupee within the permitted band using Pound Sterling as the intervention currency. When the Bretton Wood System broke down in 1971 and the major currencies started floating, Rupee was pegged to US$. On September 25,1975 rupee was delinked from a single currency and was linked to a basket of currencies and the currencies included in the basket and their relative weights were kept as a guarded secret so that the speculators do not get a wind of the direction in the movement of exchange rate of rupee. With the liberalization process sweeping through the financial sectors globally, it was felt that the forces of demand and supply should determine the exchange rates. Developments in India Liberalisation in India started in the year 1991 and in March 1992 dual exchange rate system was put in place. This was known as LERMS (Liberalised Exchange Rates Management System). Two exchange rates were prevailing during that period, one determined by RBI and the other determined by the market forces. Under this system 40% of current account receipts were converted at OR (Official Rate) and 60% at MR (Market Rate). Later on an unified Exchange Rate System came into effect from 01-031993.Under this system Exchange rates were allowed to float fully and freely at market determined rates. However RBI has the right to intervene in the market as and when necessary to restore equilibrium in the market. All foreign Exchange transactions routed through Authorised Dealers are to be at market based exchange rates. RBI also announces its rates (which act as reference rates) based on market rates. Any person desiring to buy or sell foreign Exchange can do so only through an AD and only for permissible transactions. 11 Current Account, Capital Account transactions: India, being a member Bank of IMF having subscribed to Article VI of IMF, declared that Indian Rupee will be fully convertible for all Current Account transactions with effect from 01-03-1993. This resulted in removal of several trade restrictions and extending relaxations in exchange control especially under Current Account Transactions so that the full benefits of integrating the Indian economy with the world economy is reaped by Indian Exporters and Importers. Current account transactions relate to conversion of rupee to foreign exchange or vice versa for all trade related and personal related purposes like tour, study, medical treatment, training/seminar etc. Capital account convertibility refers to freedom to convert local financial assets into foreign currency financial assets and vice versa at market determined rates of exchange. Market rates Exchange rates express the value of one currency in terms of the other. They involve: Base Currency - Usually one unit of fixed amount of Currency Terms Currency - Variable amount of local Currency Example 1 USD= INR 43.9125 1 GBP= USD 1.4250 In an exchange rate 1USD= INR 43.9125, USD is the base currency and the Indian Rupee is the terms/variable currency. Foreign Exchange transactions take place at the exchange rates agreed to between the two parties. Purchase transactions- Where Foreign Currency is purchased by the AD from the Customer. Example- Export Bill denominated in USD tendered by a Customer is purchased by the Bank Sale transactions –Where Foreign Exchange is sold to a Customer by the Bank. Example- An Importer buying USD from an AD for retiring an Import bill denominated in USD. Here Bank is selling Foreign Exchange to an Importer. Direct Quotations In this method the home currency is the variable currency and the Foreign Currency is the fixed (base) unit Example : 1USD=INR 43.9125/43.9225 12 Indirect Quotations In this method, the home currency is the fixed /constant unit and the Foreign Currency is the variable unit. Example: INR 100=USD2.1850/2.1900 Here the cost of Foreign Currency is obtained by way of an arithmetical calculation and not straight in the case of a Direct Quotation. In India we have switched over to Direct Quotations from 02-08-1993. Banks quote rates against one unit of Foreign Currency except for certain currencies for which rates are quoted against 100 units of Foreign Currency Example JPY 100= INR 39.4725 At present the currencies for which 100 units are taken as the base are Indonesian Rupiah Japanese Yen, Kenyan Shilling and Spanish Peseta. How exchange rates are quoted Whenever a Bank quotes a rate of exchange it quotes in two way price Example 1USD=INR 43.9175/43.9275 USD is the Base Currency INR is the variable Currency The first rate 43.9175 is the rate at which the quoting Bank is prepared to buy one unit of USD. This is the BID (buying) rate. The second rate 43.9275 is the rate at which the quoting Bank is prepared to sell one unit of the Base Currency. This is the OFFER (Selling) rate. The difference of .01(1 paisa) between the BID and OFFER rate is the SPREAD and the profit margin for the quoting bank Now in India exchange rates are purely market driven (based on demand/supply) but with very purposeful intervention/monitoring by RBI Cross Rates The exchange rate which is derived from two other exchange rates is called a cross rate. We can work out a cross rate by applying the chain rule mentioned below: 13 How a inter bank deal is done? Example: ABC bank quotes in the market as USD1= INR 43.9125/43.9225 in a Reuters screen. Here the quoting Bank’s buying rate for USD is 43.9125(BID rate) and selling rate for USD is 43.9225(Offer Rate) They always adopt the Dictum “BUY LOW SELL HIGH” If this quote is acceptable for the counter party Bank and if they want to buy USD they will be able to buy from the quoting Bank at 43.9225 (Quoting Bank’s Selling rate) and if they want to sell USD to the quoting Bank they can do so at the rate 43.9125 (quoting Bank’s buying rate). The quoting Bank can change its quote before the deal is confirmed. Merchant Rates: The rates quoted by the Banks to its Customers (Exporters, Importers, Remitters etc) for various types of transactions are called Merchant Rates. The exchange rates for merchant transactions can be broadly classified as under: TT Buying Rate Bill Buying Rate TC Buying rate FC Buying rate TT Selling Rate Bill Selling Rate TC Selling rate FC Selling rate 1. Clean Inward remittances for which cover funds already received in NOSTRO a/c 2. Collection proceeds of Export Bills/Cheques/Travellers cheques/Currencies realized and credited to NOSTRO a/c 3. Cancellation of a forward Sale Contract 4. for discounting Foreign Currency cheques payable abroad 5. For conversion of FCNR/RFC/EEFC balance to Indian Rupee Purchase/discount/negotiation of Export Bills For purchase of Travellers Cheques tendered for encashment For purchase of permitted foreign currencies tendered for encashment 1. For all clean outward remittances by way of DD/TT 2. Remittances towards direct import bills 3. recovery of export bills returned unpaid 4. for recovery of foreign Bank charges 5. Cancellation of Forward Purchase contract 6. Crystallisation /Delinking of overdue export bills/cheques purchased by the AD 1. Remittances towards Import bills received on collection/under LC opened 2. Delinking of Import bills (under LC issued by the bank) For selling Travellers cheques For selling Foreign Currencies 14 The merchant rates are calculated/quoted based on on-going market rates and the base rate to be fixed by the respective Bank after giving due consideration to the market trend, volatility, existing position etc as it may not be possible to cover the transaction immediately . Cover rate and Base rate The rate at which the Bank can cover a merchant transaction in the inter bank Market at no loss no profit is called COVER rate. Example: The rate at which a Bank can cover an Import transaction in USD by buying USD from the market at Market’s selling price is the COVER Rate for that Import transaction. The base rate is arrived from the cover rate after allowing some cushion for any possible adverse movements in rates before the cover deal is done. In practice there are instances where the Cover rate and the Base Rate are the same. Member banks are allowed to load margins in their discretion on the cover/base rate subject to compliance of maximum spreads. Computation of Exchange Rates (examples) TT Buying Rate Assume Inter Bank rate as USD1=INR42.4525-42.4625 Base rate becomes 42.4525(rate at which the market Buys) Less Exchange Margin (say 3 paise) 0.03 TT Buying Rate 42.4225 Bill Buying (sight Bill) Assume Inter Bank Rate USD 1=INR42.4525-42.4625 Base Rate becomes Less Exchange Margin 42.4525 0.06 Bill Buying rate (sight Bill) 42.3925 TC Buying Rate Take one month forward Buying rate (say) 42.5125 Less commission (not exceeding 1%) 0.43 TC Buying rate becomes 42.10 (rounded to nearest 5 paise) FC Buying Rate 15 Deduct .50% form TC buying rate 0.21 FC Buying rate becomes 41.90((rounded to nearest 5 paise) TT Selling rate Assume Inter Bank rates as USD1= INR 42.4525-42.4625 Base rate becomes 42.4625(rate at which market sells) Add exchange Margin (say) 00.04 TT Selling Rate 42.5025 Bill Selling rate Base rate 42.4625 Add exchange margin (say) 00.09 Bill Selling rate 42.5525 It is to be noted that all merchant quotes as above are based on on-going interbank exchange rates which are not static and the volatility is subject to market situations that may prevail at that point of time and nobody can precisely predict the movement of exchange rates. RBI POLICY RATES SLR CRR Bank Rate Repo Reverse Repo 24% 6% 6% 6.75% 5.75% 16