Foreign Exchange Market

Foreign
Foreign Exchange
Exchange Market
Market
BASIC CONCEPTS/TERMINOLOGIES
Foreign Currency v/s Foreign Exchange
As per Foreign Exchange Act, (Section 2), 1947.
(c)"Foreign Currency" means any currency other than
Pakistan currency;
(d) "Foreign Exchange" means includes any instrument
drawn, accepted, made or issued under clause (8) of section
17 of the State Bank of Pakistan Act, 1956, all deposits,
credits and balance payable in any foreign currency, and any
drafts, traveler’s cheques, letters of credit and bills of
exchange, expressed or drawn in Pakistan currency but
payable in any foreign currency;
Financial Markets
 Financial market is a place where
Resources/funds are transferred from those
having surplus/excess to those having a
deficit/shortage.
3
Foreign Exchange Markets
 The market where the commodity traded is
Currencies.
 Price of each currency is determined in term of
other currencies.
4
What is an Exchange Rate ?
Exchange Rate is the price of one country's currency
expressed in another country's currency. In other
words, the rate at which one currency can be
exchanged for another.
e.g. Rs. 59.50 per one USD
Major currencies of the World

USD
EURO
YEN
POUND STERLING
What is a Foreign Exchange Transaction ?
 Any financial transaction that involves more than one
currency is a foreign exchange transaction.
 Most important characteristic of a foreign exchange
transaction is that it involves Foreign Exchange Risk.
PARTICIPANTS IN THE FOREIGN
EXCHANGE MARKET
 All Commercial Banks
(Authorized Dealers only).
 State Bank of Pakistan.
 Corporate Treasuries.
 Public Sector/Government.
 Inter Bank Brokerage Houses.
 Resident Pakistanis
 Non Residents
 Exchange Companies
 Money Changers
FOREIGN EXCHANGE REGIMES
 FIXED
 PEGGED
 COMPOSITE
 MANAGED FLOAT
 FREE FLOATING
Components of a Standard
FX Transaction
 Base Currency (USD/PKR)
 ‘Dealt’ or ‘Variable’ Currency
 Exchange Rate
 Amount
 Deal Date
 Value Date
 Settlement Instructions
Value Date Conventions
Currencies are traded both in Ready and forward value
dates.
1) Ready: Settlement on the deal date. e.g. Pakistan
2) Value Tom : Settlement on next day. e.g. Canada
3) Spot Transaction : settlement usually in two working days.
In international FX transactions, Spot is the Standard value date.
Why Spot Date ?
 Time Zone Difference
 Herstat Risk
The risk that a foreign exchange trade will not settle. For example, a buyer may not receive delivery of the currency he/she bought by the
settlement date, or the seller may not receive payment. This may occur because of the negligence or deliberate withholding by one
party or the other. If a party does not receive the securities or payment, he/she is not obligated fulfill his/her end of the bargain until
delivery or payment is made, but this can render him/her unable to conduct other activities that would advance his/her investment
goals. Herstatt risk takes its name from the Herstatt bank, which notoriously failed to settle currency transactions and went into
bankruptcy in 1974.
4) Forward Transaction: Settlement at some future date ahead of

the spot.
10
FX Rate Quotation:
In the forex market rates are always quoted ‘two way’.
Two way quote gives both ‘Bid’ and ‘Offer’.
e.g.
USD/PKR= 58.55 / 60
Bid / Offer
‘Big Figure’: Term referring to the first digits of an exchange rate. These figures are rarely change in
normal market fluctuations and are usually omitted in dealer quotes.
‘Pips (or Point): The smallest incremental move an exchange rate can make.
‘Base Currency’ Vs. ‘Dealt Currency’
Number of variable or dealt currency unit in one unit of base currency.

In international quotes base currency comes first.
e.g. BC/VC
USD/PKR= 58.55/60
Price maker Vs. Price Taker
The bank quoting the price is ‘price maker’ or

‘market maker’.
The bank asking for the price or ‘quote’ is the

‘price taker’ or ‘user’.
RATE QUOTATION CONVENTIONS
IN-DIRECT QUOTATION:
“Price of one Unit of Foreign Currency in terms of
Domestic Currency”
e.g. USD/PKR = 59.45/50
Buy One USD at 59.45
Sell One USD at 59.50
Spread 00.05
In the international market, almost all currencies
are quoted indirectly.
13
RATE QUOTATION CONVENTIONS
DIRECT QUOTATION:
“Price of one Unit of Domestic Currency in terms of Foreign Currency”
e.g. EURO= 1.2805/12
Buy One Euro at 1.2805
Sell One Euro at 1.2812
Spread 0.0007
Five Currencies are quoted in Direct Terms

1) Pound Sterling
2) Euro
3) Australian Dollar
4) New Zealand Dollar
5) Irish Punt
14
In the international market, almost all the
currencies are quoted in terms of USD.
e.g.
JPY= 105.78/82
A visit to REUTERS ‘EFX=’ Page.
FORWARD TRANSACTIONS
1. Out right sale/purchase of a currency against the other

for settlement at a future date at the predetermined
exchange rate.
2. Forward rates are quoted as premium or discount over
spot rate.
3. Forward rates depend upon interest rate differential

between the two currencies.
4. Currency with higher interest rates is at discount wrt

currency having lower interest rate.
5. Currency with lower interest rates is at premium wrt

currency having higher interest rate.
Calculating Forward Rate
Interest rate of USD = 1.25%

Interest rate of PKR = 6%
Spot Rate = 58.50
DB for PKR = Actual/365
DB for USD = Actual/360
Six month Forward Rate =

spot rate x (1+ .06*181/365)/(1+.0125*181/360)
=59.87
FX SWAP Transaction
“An FX swap is a contract to buy an amount of

currency for one value date at an agreed rate,
and to simultaneously resell the same amount of
currency for a later value date, also at an agreed
rate, to the same counter party”.
FX swap is essentially a ‘funding’ or ‘Money

Market’ transaction and does not involve
exchange risk.
 Foreign exchange transactions are settled through Nostro and
Vostro accounts.
 Nostro: our account with banks abroad. SBP maintains

various Nostro accounts in a number of countries.
 Vostro: their account with us. Many multilateral agencies
(e.g. IMF, World Bank) maintain their Nostro accounts at
SBP.
 SWIFT (Society for Worldwide Interbank Financial

Telecommunications)
Deals are done over Telephone, REUTERS
dealing system etc
REUTERS
Dealing Terminal
 Industry Standard for FX trading.
 Security guaranteed by Reuters Int.
 Password Protected.
 Maintains record of all transactions.
 SBPK (SBP’s REUTERS address)
News Terminal
 Domestic Market Data/ news available on line.
 Real Time Exchange Rate quotes of all major Currencies.
 Data about Interest Rates (e.g. LIBOR)
 Various SBP pages on REUTERS.
Forex Transactions
The Demand Side of inter-bank market
 importers – buying foreign exchange to finance
their imports.
 A host of regulations governing imports into
Pakistan.
 Out ward remittances for debt servicing.
 Out ward remittances for services.
 PTEQ and BTQ, Medical treatment etc.

Forex Transactions
The Demand Side of inter-bank market

 Remittances on account of education abroad.
 Remittances on account medical treatment.
 Repatriation of profit of foreign controlled

companies and ‘freight collection’ etc.
 Disinvestment through SCRA.
 A host of other invisible payments.

Forex Transactions
The Supply Side of inter-bank market
 Exports – regulations governing export receipts.
 Home remittances.
 Foreign Direct Investment.
 Capital account receipts.
 Investment through SCRA.
 A host of other invisible receipts.

Foreign Exchange Risk
Exposure to exchange rate movement.
1. Any sale or purchase of foreign currency
entails foreign exchange risk.
2. Foreign exchange transaction affects the net
asset or net liability position of the
buyer/seller.
3. Carrying net assets or net liability position in
any currency gives rise to exchange risk.
NET OPEN POSITION- (NOP)
A measure of foreign exchange risk
• NOP is the Net Asset/Net Liability position in all

FCs together (Both B/S & Off B/S).
• Net Asset Position is also called “LONG” or
“Overbought “ position.
• Net liability Position is also called “SHORT” or
“Oversold “ position.
• NOP is a single statistic that provides a fairly good
idea about exchange risk assumed by the bank.
• Its major flaw is that FX exposures in third
currencies remain hidden.
EXAMPLE (NOP) (USD in Mio)
Opening Position $ 0.00
Ready Purchases from Exporter $ 1.00
Fwd Purchases from Corporate (1.00 Euro) \ $ 0.90
Ready Sell to importer ( 60 Mio Yen) - $ 0.50
Fwd Sell to Corporate - $ 0.40
NET OPEN POSITION $ 1.00

Introduction to Inter-bank FX activities
Foreign Exchange Exposure

FX Exposure is the higher of the long and short positions in FCs.
EXAMPLE
Currency-wise NOP in equivalent PKR
CURRENCY SHORT LONG
Dollar -10
Yen 10
Euro -10
Pound 10
Total -20 20
Net Open Position is 0 while exposure is 20.
Foreign Exchange Markets
Role of SBP and linkages with

economy
SBP’s Role in the Forex Market
 To manage the exchange rate mechanism.

 Regulate inter-bank forex transactions and monitor
the foreign exchange risk of the banks.
 Keep the exchange rate stable.
 Manage and maintain country's foreign exchange
reserves.
SBP’s Role in the Forex Market
• SBP has imposed foreign exchange exposure

limits on banks (FE 12 of 1999).
• The limits are tied with the Paid up capital of
the bank.
• Previously banks had NOP limit, which was
based on foreign exchange volume handled by
the bank.
TREASURY OPERATIONS AT SBP
1. All Central Banks have treasuries to implement policy
objectives vis a vis EXCHANGE RATE &
INTEREST RATES
2. Dealing room catered to the FX market only
3. Money market was being looked after by the
Securities department
4. It soon became apparent that the two cannot work in
isolation with each other as the linkage between the
money market & exchange market became
pronounced
5. Finally the dealing room and securities department
were merged to form EDMD to from first ever
Treasury of SBP.
Functions of DMMD
Market Monitoring
 Pro active monitoring of interbank MM & FX
market by Front Office.
 Prepare demand/supply forecast.
 Gather data from various Sources.
 Real time feedbck to management.
 Real time remedial measures to remove

distortions in the market.
A day in the Front Office
 NOP report.
 FX inflow/outflow statements.
 Oil payments,
 Forward transactions.
 Market monitoring – Market Flows and their impact
on exchange rate.
 Money Market liquidity
 Forward rates
 Market activity – if required
 Rates Preparation – M 2 M, Wtd Avg, FCA
Conversion.
Front Office Challenges
 Small Market Size
 Lumpy payments
 ‘Leads’ and ‘Lags’.
 Historical trend of keeping long positions.
 The issue of ‘entries in transit’.

INTERVENTION
 To keep exchange rate in line with macro
objectives SBP has to intervene from time
to time
 Intervention is a process where FX is sold
or purchased to keep the right amount of
liquidity available in the FX market so that
demand / supply equilibrium is maintained
 Intervention can be in READY or
FORWARD
OTHER FX RELATED FUNCTIONS
 OFFSITE MONITORING
 DAILY RATES FOR MARKET
 THIRD CURRENCY ACTIVITY FOR GoP
PAYMENTS
 RESERVE MANAGEMENT
How does SBP manages exchange
rate in the interbank market?
• Non-Quantitative Tools
• Quantitative Tools
Non-Quantitative Tools
• Moral suasion
• facilitating large commercial outflows
• Relaxation in FEEL
How does SBP manages exchange
rate in the interbank market?
Quantitative Measures
Foreign Exchange Exposure Limit (FEEL)
 Basically restricts the banks to keep a net asset (long) or net
liability (short) position in foreign currencies.
 Presently FEEL for each bank is set at 15 % of it’s paid up
capital.
 In the presence of FEEL, banks’ net purchases or net sales in
foreign exchange on a given day have to be within their
FEEL.
Physical intervention
• Direct selling or buying of foreign exchange by State
Bank in the interbank market.
• Such sale/purchase can be in spot or forward value
• It can have two objectives
To provide support to the market for
lumpy payments
To manage the Rs/$ parity
• Intervention may be direct or indirect. Currently SBP

only indirectly intervenes in the market.
• RESERVE BUILDING
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Foreign Exchange Market

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Foreign

Major currencies of the World

4) Forward Transaction: Settlement at some future date ahead of

‘Base Currency’ Vs. ‘Dealt Currency’

Number of variable or dealt currency unit in one unit of base currency.

The bank quoting the price is ‘price maker’ or

The bank asking for the price or ‘quote’ is the

Five Currencies are quoted in Direct Terms

1. Out right sale/purchase of a currency against the other

3. Forward rates depend upon interest rate differential

4. Currency with higher interest rates is at discount wrt

5. Currency with lower interest rates is at premium wrt

Interest rate of USD = 1.25%

Six month Forward Rate =

“An FX swap is a contract to buy an amount of

FX swap is essentially a ‘funding’ or ‘Money

 Nostro: our account with banks abroad. SBP maintains

 SWIFT (Society for Worldwide Interbank Financial

 Out ward remittances for services.

 PTEQ and BTQ, Medical treatment etc.

The Demand Side of inter-bank market

 Remittances on account medical treatment.

 Repatriation of profit of foreign controlled

 A host of other invisible payments.

 Foreign Direct Investment.

 Capital account receipts.

 Investment through SCRA.

 A host of other invisible receipts.

• NOP is the Net Asset/Net Liability position in all

Opening Position $ 0.00

Ready Purchases from Exporter $ 1.00

Fwd Purchases from Corporate (1.00 Euro) \ $ 0.90

Ready Sell to importer ( 60 Mio Yen) - $ 0.50

Fwd Sell to Corporate - $ 0.40

NET OPEN POSITION $ 1.00

Foreign Exchange Exposure

Role of SBP and linkages with

 To manage the exchange rate mechanism.

• SBP has imposed foreign exchange exposure

 Gather data from various Sources.

 Real time feedbck to management.

 Real time remedial measures to remove

 ‘Leads’ and ‘Lags’.

 Historical trend of keeping long positions.

 The issue of ‘entries in transit’.

• Intervention may be direct or indirect. Currently SBP

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