If you buy a Binny Silk Saree for your wife (or girl friend!) at T.Nagar Chennai Nalli Silks, you will naturally want to pay for it with Indian Rupees and the Nalli Silks will want to be paid in Rupees because he pays all his bills with Rupees.
Likewise, if a Korean resident wants to buy Korean Silk garment, he purchases at nearby leading brand shop and pays for it in Korean Won. The leading brand shop is happy because he meets his expenses in Won.
However, if an Indian developed a taste for Korean silk and wished to buy directly from this leading brand shop in Korea, the transaction would become somewhat complicated. He would like to pay in Rupees but the Korean shop would want Won. Somehow the Indian would have to acquire Won if he wished to indulge in his craving for Korean silk.
In the world today there are millions of such transactions between citizens of different countries. A system of exchange rates has been evolved to facilitate such trade. Exchange rates are nothing more than the price of a foreign currency in terms of one’s own currency.
Since it would be extremely difficult for someone who needed Korean won to search out an individual who has them for sale, the foreign exchange market has developed as a medium through which buyers and sellers can readily get in touch with each other.
Historically banks have handled this service. Through their correspondent relationships with banks in various countries, they have easy access to foreign currency.
Naturally, there is not a physical transfer of, let us say Korean Won for Indian Rupees. It is simply a book keeping entry whereby the bank in Korea and the bank in India credit each other’s account for the currency. The Korean bank keeps an account with a bank in India and vice versa. They then exchange a won balance in Korea for a Rupee balance in India.
At any rate, any bank dealing in foreign currency can, in a very short time, provide any customer with an exchange rate for any currency.
The exchange rates are quoted in two methods – direct and indirect.
Under the direct method, the foreign currency units will be fixed and the equivalent home currency will be fluctuating. Under the indirect, the home currency unit will be fixed and the foreign currency equivalent fluctuating.
Again, the exchange rates are furnished for both purchase and sale transactions. As is the practice in any commodity market, to make profit, one has to buy low and sell high in foreign exchange market too.
The person at the bank who quotes rates to the customers and clinches the deal is nicknamed as FOREX Dealer and if he is active in quoting two way quotes as above, he will also be called a MARKET MAKER.
After clinching the deal with the customer, our dealer will square (or cover!) his position in the foreign exchange market, by going in for a matching opposite transaction.
The foreign exchange market, an Over The Counter market has the other players – central banks who are keen to maintain a certain level for their currencies, other bankers, multinational companies, corporate dealing and trading in currencies, etc. As in any other market, we do have BROKERS also in Forex markets to facilitate the trades and traders!
Foreign Exchange Markets function 24 hours a day, the world over.
As per Bank for International Settlement statistics, the daily turnover in foreign exchange markets add upto something of the order USD – a mind boggling figure indeed! Of this amount, the trade related customer transactions form just 1-3 per cent! The rest is on account of trading positions undertaken by the players in the market.
One may wonder what this ‘trading’ represent in FX markets. Foreign exchange rates, in simple terms, mean, the value of one currency in terms of another currency under exchange. Movement of currencies across their countries’ borders depend on the level of exchange control regulations in force.
The rates of exchange are guided by the demand and supply, interest rat differential, inflation rate differential, balance of payment/balance of trade, etc. Because of this, one can see fluctuations in exchange rates in foreign exchange markets.
On an average, rates change every four second (of course, in an orderly equilibrium market). A Forex dealer to take advantage of such volatility in exchange rates, will enter into trading positions – purely buying and selling – to maximize profits.
Foreign exchange transactions are entered into with specific value dates – cash (today), tomorrow, spot (second business working day after the date of entering into transaction) and forward (beyond spot value) – for settlement. Depending upon the interest rate differential of the currencies, exchange rates will be different for different values
Foreign exchange transactions can be outright transactions – purchase or sale – either for spot or forward value. In foreign exchange markets, swap transactions are also popular. A swap transaction in a foreign exchange market represents a simultaneous purchase and sale or sale and purchase of currencies of one value against another. For example, spot vs forward or forward vs forward.
Market maker, as seen earlier, will quote two way price (bid-offer) for any particular currency and normally, such quotes are for market lots only, unless otherwise specially asked for. Banks dealing with each other in foreign exchange markets will go by market practices and the conversation could go something like this:
BANK A Hi Hi Frds
Bank A here. Spot USD/INR please++
BANK B Hi there
54.75/78++
BANK A Ok at 75 yours two++
BANK B Agreed
I buy USD Two Mio at 54.75 Val Spot
My USD at my account with Citi NY
Where Your INR plse++
BANK A My INR to my account with SBI Mumbai
Thanks Bi Bi Frd++
BANK B Tks for the call Bi Bi Frd++
In this example, BANK B, the market maker (read market maker as the person being asked to quote a price) is willing to deal in USD/INR at 54.75/78 value spot (bid/offer). After receiving the price, BANK A has three options
– Hit the bid
– Take the offer
– Decline the quote
But BANK A will have to answer immediately. Otherwise BANK B cannot be held to its price. It is considered ‘unprofessional’ not to respond a quote within about 2 or 3 seconds unless BANK A requests confirmation of the price by asking ‘any change?’
Usually, the bank requesting a price (in this example, BANK A) will know at what levels they wish to transact before calling another bank (in this example, BANK B) for a price, so immediate response is a must and usual.
Foreign Exchange market being Over The Counter market, are made up of many different types of players, each with its own set up rules, practices and trader disciplines. Nevertheless, the market operates on a very professional basis and this professionalism is held together by the integrity of the dealers.
It may not be out of context to mention here that the recent episodes during LIBOR fixing involving unprofessional behaviour and extreme greediness exhibited by the players have been severely reprimanded and criticized and the concerned banks have been heavily fined by the regulators. In addition, the banks’ reputation was also severely affected.
Foreign exchange market functions on the basis of banks making prices to one another on a reciprocal basis. Occasionally, banks active in the market may withdraw temporarily, from making markets. There is a good reason for doing so but sometimes hilarious excuses are made to avoid making a quote when requested by another bank.
In a lighter vein, some of the standard ‘excuses’ often offered by such banks are:
– Dealer at lunch (even though it is only 10 AM!)
– No interest at mom (although you will get my name through broker!)
– Computer has crashed (but it will be working again, after your call!)
– Staff meeting (the meeting finishes immediately as soon as you disconnect!)
– Only quoting customers in that currency (everybody, except you, is a customer!)
Due to complex nature of foreign exchange markets and the volatile nature of exchange rate movements, a sharp focus on risks associated with foreign exchange dealing operations and their management is insisted upon.
Some of the major risks associated with foreign exchange dealing operations are:
– Credit risk – is the risk of loss due to inability or unwillingness of the counterparty to meet its obligations. Sometimes, this is also referred to as settlement risks – pre-settlement and post-settlement. In the case of pre-settlement risk, the actual risk is the price risk arising on account of price fluctuations. In post-settlement risk, the actual risk is the entire amount that has been settled by one of the parties to the transaction with the counterparty not settling his obligations
– Liquidity risk – is the risk that a party to foreign exchange dealing will be unable to meet its funding requirements or execute a transaction at a reasonable price.
– Market risk – is the risk that a party to foreign exchange dealing unable to exit or offset positions quickly at a reasonable price
– GAP Risk / Interest Rate Risk – is the risk owing to adverse movements in implied interest rates or actual interest rate differentials
A comprehensive and accurate risk measurement procedure covering both trading and non trading activities may enable the bank managements to assess exposures on a consolidated basis.
Foreign exchange is a highly specialised function and has to be performed by well trained, qualified personnel.
Typically a dealing room may consist of dealers and middle and back office staff who are responsible for the follow up of deals made by the dealers.
The need for effective control over the dealing operations is of great importance as possibilities exist for manipulation of exchange rates, dealing positions, mismatches, etc.
One may have seen in recent times, how the dealers / traders affected the banks they were working for, by taking up huge positions and incurring massive losses in addition to affecting the very reputation of their banks. We will cover their actions/inactions in separate posts.
The supreme principle of operational procedures in the area of trading activities is the clear functional separation of front office, middle office and back office functions, accounting, reporting and reconciliation.
Heavy responsibility rests upon the dealers as the manner of handling foreign exchange business can make all the difference.
As the foreign exchange market is an Over The Counter market and also as most of the deals are done over the phone, dealing systems, highest level of professionalism is expected of the dealers.
Dealers have to obey certain code of conduct. We will try to cover them in separate posts.
Foreign exchange dealers have also an association – Forex Association ( affiliated to Association of Cambiste Internationale, Paris a National Organisation whose members are Treasury Managers, Foreign Exchange Dealers and Foreign Exchange Brokers who are actively involved in Foreign Exchange Trading and Foreign Exchange Risk Management )