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Role of RBI in FOREX Market

Summary

Introduction
The Indian FOREX market owes its origin to the important step that RBI took in 1978 to allow banks to undertake intraday trading in foreign exchange. As a consequence, the stipulation of maintaining Square or near square position was to be complied with only at the close of business each day. During the period 1975-1992, the exchange rate of rupee was officially determined by the RBI in terms of a weighted basket of currencies of Indias major trading partners and there were significant restrictions on the current account transactions. The initiation of economic reforms in July 1991 saw significant two-step downward adjustment in the exchange rate of the rupee on July 1 and 3, 1991 with a view to placing it at an appropriate level in line with the inflation differential to maintain the competitiveness of exports. Subsequently, following the recommendations of the High Level Committee on Balance of Payments (Chairman:Dr C. Rangarajan) the Liberalised Exchange Rate Management System(LERMS) involving dual exchange rate mechanism was instituted in March 1992 which was followed by the ultimate convergence of the dual rates effective from March 1, 1993(christened modified LERMS). The unification of the exchange rate of the rupee marks the beginning of the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It is also an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

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. 48.50 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.

Types Of Exchange Rates


There are 4 types of Exchange rates: 1. Ready 2. Value Tom 3. Spot Transaction 4. Forward Transaction

1) Ready: Settlement of funds on the same day (date of the deal). 2) Value Tom: Settlement of funds takes place on the next working day of the date of the deal. 3) Spot Transaction: Settlement of funds takes place on the second working day following the date of the deal. 4) Forward Transaction: Delivery takes place on any day after the date of the deal.

What Does Price Maker Mean?


A monopoly or a firm within monopolistic competition that has the power to influence the price it charges as the good it produces does not have perfect substitutes.

Investopedia explains Price Maker A monopoly is a price maker as it holds a large amount of power over the price it charges. A price maker that is a firm within monopolistic competition produces goods that are differentiated in some way from its competitors' products. This kind of price maker is also a profit-maximizer as it will increase output only as long as its marginal revenue is greater than its marginal cost, in other words, as long as it's producing a profit.

What Does Price-Taker Mean?


1. An investor whos buying or selling transactions are assumed to have no effect on the market. 2. A firm that can alter its rate of production and sales without significantly affecting the market price of its product.

Investopedia explains Price-Taker 1. In the context of the stock market, individual investors are price-takers. 2. Suppose you sell water, which of course is supplied by millions of other places, including the sky. If you decide to set the price of a gallon of your water at $10, you will likely sell nothing because this commodity is readily available elsewhere for a much cheaper price. The main purpose of the foreign currency exchange market is to make money but it is different from other equity markets. There are various technical terminologies and strategies a trader must know to deal with currency exchange. In the Currency Exchange market the commodity that is traded is the foreign currency. These foreign currencies are always priced in pairs. The value of one unit of a foreign currency is always expressed in terms of another foreign currency. Thus all trades incorporate the purchase and sale of two foreign currencies at the same time. You have to buy a currency only when you expect the value of that currency to increase in the future. They are always quoted in pairs as USD/JPY. The first currency is the base currency and the second one is the quote currency. The quote value depends on the currency conversion rates between the two currencies under consideration. Mostly the USD will be used as based currency but sometimes euro, pound sterling is also used. The profit of the broker depends on the bid and the ask price. The bid is the price the broker is ready to pay to buy base currency for exchanging the quote currency. The ask is the price the broker is ready to sell the base currency for exchanging the quote currency. The difference between these two prices is called the spread which determines the profit or loss of the trade.

RATE QUOTATION CONVENTIONS:


An exchange system quotation is given by stating the number of units of "term currency" (or "price currency" or "quote currency") that can be bought in terms of 1 "unit currency" (also called "base currency"). For example, in a quotation that says the EURUSD exchange rate is 1.4320 (1.4320 USD per EUR), the term currency is USD and the base currency is EUR. There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR GBP AUD NZD USD others. Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the Euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which the base currency is where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies. Quotes using a country's home currency as the price currency (e.g., EUR 0.63 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective) [1] and are used by most countries. Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.58 in the euro zone) are known as indirect

quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the Euro zone.

1. DIRECT QUOTATION: Direct quotation: 1 foreign currency unit = x home currency units
Price of one Unit of Domestic Currency in terms of Foreign Currency Five Currencies are quoted in Direct Terms

) Pound Sterling 2) Euro 3) Australian Dollar 4) New Zealand Dollar 5) Irish Punt

2. IN-DIRECT QUOTATION:
Price of one Unit of Foreign Currency in terms of Domestic Currency Indirect quotation: 1 home currency unit = x foreign currency units In the international market, almost all currencies are quoted indirectly. Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions

and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip.") An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places. In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this. Risk Management and Settlement of Transactions in the Foreign Exchange Market The foreign exchange market is characterized by constant changes and rapid innovations in trading methods and products. While the innovative products and ways of trading create new possibilities for profit, they also pose various kinds of risks to the market. Central banks all over the world, therefore, have become increasingly concerned of the scale of foreign exchange settlement risk and the importance of risk mitigation measures. Behind this growing awareness are several events in the past in which foreign exchange settlement risk might have resulted in systemic risk in global financial markets, including the failure of Bankhaus Herstatt in 1974 and the closure of BCCI SA in 1991.

The foreign exchange settlement risk arises because the delivery of the two currencies involved in a trade usually occurs in two different countries, which, in many cases are located in different time zones. This risk is of particular concern to the central banks given the large values involved in settling foreign exchange transactions and the resulting potential for systemic risk. Most of the banks in the EMEs use some form of methodology for measuring the foreign exchange settlement exposure. Many of these banks use the single day method, in which the exposure is measured as being equal to all foreign exchange receipts that are due on the day. Some institutions use a multiple day approach for measuring risk. Most of the banks in EMEs use some form of individual counterparty limit to manage their exposures. These limits are often applied to the global operations of the institution. These limits are sometimes monitored by banks on a regular basis. In certain cases, there are separate limits for foreign exchange settlement exposures, while in other cases, limits for aggregate settlement exposures are created through a range of instruments. Bilateral obligation netting, in jurisdictions where it is legally certain, is an important way for trade counterparties to mitigate the foreign exchange settlement risk. This process allows trade counterparties to offset their gross settlement obligations to each other in the currencies they have traded and settle these obligations with the payment of a single net amount in each currency. Several emerging markets in recent years have implemented domestic real time gross settlement (RTGS) systems for the settlement of high value and time critical payments to settle the domestic leg of foreign exchange transactions. Apart from risk reduction, these initiatives enable participants to actively manage the time at which they irrevocably pay way when selling the domestic currency, and reconcile final receipt when purchasing the

domestic currency. Participants, therefore, are able to reduce the duration of the foreign exchange settlement risk. Recognizing the systemic impact of foreign exchange settlement risk, an important element in the infrastructure for the efficient functioning of the Indian foreign exchange market has been the clearing and settlement of inter-bank USD-INR transactions. In pursuance of the recommendations of the Sodhani Committee, the Reserve Bank had set up the Clearing Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets. The CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR spot and forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom trades from February 5, 2004. The CCIL undertakes settlement of foreign exchange trades on a multilateral net basis through a process of notation and all spot, cash and tom transactions are guaranteed for settlement from the trade date. Every eligible foreign exchange contract entered between members gets notated or replaced by two new contracts between the CCIL and each of the two parties, respectively. Following the multilateral netting procedure, the net amount payable to, or receivable from, the CCIL in each currency is arrived at, member-wise. The Rupee leg is settled through the members current accounts with the Reserve Bank and the USD leg through CCILs account with the settlement bank at New York. The CCIL sets limits for each member bank on the basis of certain parameters such as members credit rating, net worth, asset value and management quality. The CCIL settled over 900,000 deals for a gross volume of US $ 1,180 billion in 2005-06. The CCIL has consistently endeavoured the entire gamut of foreign exchange transactions under its purview. Intermediation, by the CCIL thus, provides its members the benefits of risk mitigation, improved efficiency, lower operational cost and easier reconciliation of accounts with correspondents.

An issue related to the guaranteed settlement of transactions by the CCIL has been the extension of this facility to all forward trades as well. Member banks currently encounter problems in terms of huge outstanding foreign exchange exposures in their books and this comes in the way of their doing more trades in the market. Risks on such huge outstanding trades were found to be very high and so were the capital requirements for supporting such trades. Hence, many member banks have expressed their desire in several fora that the CCIL should extend its guarantee to these forward trades from the trade date itself which could lead to significant increase in the liquidity and depth in the forward market. The risks that banks today carry in their books on account of large outstanding forward positions will also be significantly reduced (Gopinath, 2005). This has also been one of the recommendations of the Committee on Fuller Capital Account Convertibility. Apart from managing the foreign exchange settlement risk, participants also need to manage market risk, liquidity risk, credit risk and operational risk efficiently to avoid future losses. As per the guidelines framed by the Reserve Bank for banks to aligns and exposure in derivative markets as market makers, the boards of directors of ADs (category-I) are required to frame an appropriate policy and fix suitable limits for operations in the foreign exchange market. The net overnight open exchange position and the aggregate gap limits need to be approved by the Reserve Bank. The open position is generally measured separately for each foreign currency consisting of the net spot position, the net forward position, and the net options position. Various limits for exposure, viz., overnight, daylight, stop loss, gap limit, credit limit, value at risk (VaR), etc., for foreign exchange transactions by banks are fixed. Within the contour of these limits, front office of the treasury of ADs transacts in the foreign exchange market for customers and

own proprietary requirements. These exposures are accounted, confirmed and settled by back office, while mid-office evaluates the profit and monitors adherence to risk limits on a continuous basis. In the case of market risk, most banks use a combination of measurement techniques including and managed by most banks on an aggregate counter-party basis so as to include all exposures in the underlying spot and derivative markets. Some banks also monitor country risk through cross-border country risk exposure limits. Liquidity risk is generally estimated by monitoring asset liability profile in various currencies in various buckets and monitoring currency-wise gaps in various buckets. Banks also track balances to be maintained on a daily basis in Nostro accounts, remittances and committed foreign currency term loans while monitoring liquidity risk. To sum up, the foreign exchange market structure in India has undergone substantial transformation from the early 1990s. The market participants have become diversified and there are several instruments available to manage their risks. Sources of supply and demand in the foreign exchange market have also changed in line with the shifts in the relative importance in balance of payments from current to capital account. There has also been considerable improvement in the market infrastructure in terms of trading platforms and settlement mechanisms. Trading in Indian foreign exchange market is largely concentrated in the spot segment even as volumes in the derivatives segment are on the rise. Some of the issues that need attention to further improve the activity in the derivatives segment include flexibility in the use of various instruments, enhancing the knowledge and understanding the nature of risk involved in transacting the derivative products, reviewing the role of underlying in booking forward contracts and guaranteed settlements of forwards. Besides, market players would

need to acquire the necessary expertise to use different kinds of instruments and manage the risks involved.