A lesson on Forex Treasury operations in Banks

In India, over 90% of Treasury operations, in the forex (foreign exchange) market are between the banks. The inter-bank foreign currency operations are taking place for two purposes namely (i). Buying and selling foreign currency on behalf of their customers as an intermediary. (ii). Proprietary trading (buying and selling currencies on its own account) with an intention to make money on the movement of the exchange rate.     

What is Exchange Rate?

The exchange rate is the rate at which one currency is converted into another currency. It means the price of a currency is in terms of another currency like the price of any product in the market. For example, the cost of one toothbrush is Rs.50.00 likewise the cost of one USD is Rs. 89.00 in the foreign exchange market.

How Exchange rate is determined?

The exchange rate of a currency is determined by the demand for and supply of each currency. Let us take an example of the price of USD in the Indian Market. If there is less demand for US Dollars and at the same time there is an abundant supply of US dollars available in India, then dollars would be sold in India at a cheaper rate. So we pay fewer Rupees to buy a US dollar, we call it “Rupee become stronger vis-à-vis US Dollar. If demand for US Dollar is outstripping their supply for any reason like our import (outflow of the dollar) is more than our export (inflow of dollars) or FIIs (Foreign Institutional Investors) pulling out their investments from the Indian market. In such a situation, the price of the dollar goes up, and we call it “ Rupee becomes weak against Dollar”.

How Exchange rates are quoted?

There are two methods of quoting the exchange rate. i. The direct method of rate quotation. ii. The indirect method of rate quotation. In India, we follow the direct method of rate quotation with effect from 01.081993. Till 31.07.1993 India was following the indirect method of rate quotation.

What is the direct method of rate quotation?

The direct method of rate quotation is called a direct quote or home currency quotation. In this quote, the home currency is quoted per unit of foreign currency. In other words, it is a quote where a home currency is a variable unit.

For example, I USD = 82.5850

What is the buying rate?

The buying rate is the purchase rate quoted by Authorized Dealer, at which rate he is ready to buy foreign currency from the public (customer).

What is the selling rate?

The selling rate is the rate quoted by the Authorized Dealer, at which rate the bank (AD) is ready to sell the foreign currency to the public Customer).

The maxim ‘Buy low and sell high’  is coined from the point of view of the Authorized Dealer (AD). For the authorized dealer, the foreign currency is a commodity and he makes a profit by trading foreign currency, i.e.  Buying and selling rates are not the same. AD is buying foreign currency at a lower rate per unit and selling the same currency at a higher rate per unit.  Therefore” buy low and sell high” maxim is coined from the point of view of AD. It means the customer gets less local money when he sells a unit of foreign currency and he has to pay more local currency to AD when he buys a foreign currency. ( Please note in an indirect quote the maxim is the opposite i.e. ‘buy high and sell low”.)

When TT buying rates are applied?

TT buying rates are applied by Authorized Dealer (AD) when clean inward remittance where the cover funds are already credited to the NOSTRO account of the AD.  For the following items, banks apply the TT buying rate.

a)    Realization of instruments sent for collection

b)    Cancellation of DD/MT/TT issued earlier.

c)    Cancellation of Forward Sale contracts.

When TT selling rates are applied by AD?

1. When banks (AD) issue DD/MT/TT in foreign currencies.
2. Cancellation of bills purchased/discounted/negotiated if returned unpaid.
3. Recovery/refund of Inward remittance credited to the customer’s account.
4. Cancellation of the forward purchase contract.

When Bill buying rates are applied by AD?

1. Purchase or discount or negotiation of bills
2. Where drawing bank at one center remits cover for credit to a different center.

When Bill selling rate is applied?

Bill selling rate is applied while making payment of import bill.

For Traveller’s cheque/currency notes: Different rates are applied for selling and buying Travelers Cheque and when Currency notes are purchased or sold by the AD. The rates quoted by AD for these items are not attractive compared to other types of instruments.

What is a two-way quote?

In earlier days, banks in India used to trade foreign currency through a closed electronic system. Like in the Stock market, the bank dealer used to quote two rates conveying that he would purchase a currency at one rate and sell at another rate. The method of quoting both the buying and selling rate is called a two-way quote.  For example, if the interbank buy/sell rate quoted by the banker is 82.5850 (Bid)/82.5950 (Ask),  it means he is ready to purchase 1Dollar at 82.5850 and would sell 1 USD at 82.5950. This method of dealer quoting a price of a ‘currency pair’ is called a two-way quote.

How merchant rate is arrived by AD?

The Authorized Dealer would load profit and exchange margin on the interbank rate as per their bank’s policy. Such a rate is called the merchant rate.

Value dates in foreign exchange rates:

Cash transactions:  Rate Today and Settlement the same day.

Tom: Rate Today and Settlement on the first succeeding working day.

Spot: Rate Today and settlement on the second succeeding working day.

Forward: Rate today and settlement from the third succeeding working day.

Forward rate quoted at premium or discount:

In the indirect method of quoting, the forward rate at premium means, the foreign currency will be dearer (costlier) at a future date compared to the spot rate. The AD would add a premium on the spot rate on buying as well as the selling side to arrive at the forward rate. If the forward rate is at a discount, that means the foreign currency will be available at a cheaper at a future date, compared to the spot rate. The discount is deducted from the spot rate on buying as well as the selling rate to arrive at the forward discount rate.

Derivative

The derivative is a financial product, it is used to hedge exchange risk, interest rate risk, etc. As the value is derived out of the underlying, it is called a derivative. Examples of the derivative are

1. Forward contract
2. Options
3. Forward rate agreement
4. Interest rate swaps

Derivatives are traded in exchange houses or over the counter (OTC). Most of the derivatives are marked to the market and there is a market risk of loss. However, derivatives divert risks from investors who are risk-averse to those who are ready to take risks for earning more profit. 

Forward contract

The exchange agreement between two parties to deliver one currency in exchange for another currency at a forward or future date.

Futures contract: 

A futures contract is an agreement to buy or sell a particular commodity, currency, or security on a fixed future date, at a fixed price. Unlike options, in future contracts, the buyer and seller must complete the deal as agreed in the future contract.

Exchange Contract?

An exchange contract is a Verbal, or written agreement, between two parties, to deliver one currency in exchange for another currency, for a specific value, date, or as in the case of an option contract, for a specific period.

What are the options?

Options are two types. 1. Call option.   2. Put option.

Call option: The call option is the option of the buyer buying an asset at a specified price and time.

Put option: Put option is the right of a seller to sell an asset at a specified price and time.

The obligation of a buyer or seller under an option contract:

There is no obligation on the part of the buyer or seller to buy or sell the asset at an ‘exercise price’ under the option contract. They will do so if the deal is profitable to them. In the case of a lapse of option, only option money or premium, which is the initial purchase money of the option, is lost. The agents of trade and industry normally hedge, by way of options, against the risk of wide fluctuations in prices. The option also allows dealers and speculators to gamble for large profits with limited liability. The maximum option period allowed is one calendar month. If the delivery date or the last date of the option happens to be a holiday, the delivery has to be effected on the preceding working day. To know about integrated treasury operations read the following post.

Originally posted on August 21, 2013, edited and reposted on March 1, 2023

Now that treasury management system integration is possible, corporate treasurers can look forward to solutions that can enhance their performance, make them more efficient, and reduce risk.

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