Foreign Exchange Market

Local Foreign Exchange Market By Muhammad ARIF Senior Joint Director FSCD

A Comment “There is no sphere of human influence in which it is easier to show superficial cleverness and the appearance of superior wisdom as in matters of currency and exchange” Winston Churchill House of Commons 1946

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Structure of the Presentation Basic Concepts, Terminologies, Instruments & Mechanism.  Exchange Rate Regimes  Historical perspective  Foreign Exchange Trading & rate quotations  Role of SBP in the FX Market. 3

BASIC CONCEPTS/TERMINOLOGIES Currency v/s Foreign Exchange AsForeign 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.

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Foreign Exchange Markets 

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The market where the commodity traded is Currencies. Price of each currency is determined in term of other currencies.

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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 

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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

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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 Sell One USD at Spread

59.45 59.50 00.05

In the international market, almost all currencies are quoted indirectly. 15

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

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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 •

Out right sale/purchase of a currency against the other for settlement at a future date at the predetermined exchange rate.

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Forward rates are quoted as premium or discount over spot rate.

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Forward rates depend upon interest rate differential between the two currencies.

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Currency with higher interest rates is at discount wrt currency having lower interest rate.

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Currency with lower interest rates is at premium wrt currency having higher

Calculating Forward Rate Interest rate of USD Interest rate of PKR Spot Rate = DB for PKR = DB for USD =

= 1.25% = 6% 58.50 Actual/365 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.

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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. 

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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.

Pre-Reform era till early 90s ( The fixed ERM & Exchange Control Regime) Fixed ERM, with occasional devaluations.  SBP to fix its buying & selling rates for Authorized Dealers and their rates for customers.  Residents not allowed to hold foreign exchange.  Only ADs (Banks), allowed to deal in Fx.  Fx available only for current account transactions. (goods & services) and some other personal transactions viz. travel, 

Pre-Reform era till early 90s (The fixed ERM & Exchange Control Regime)

SBP to buy and sell forex from and to ADs, at its buying and selling rates for Authorized Dealers.  SBP to provide forward cover to ADs for importers and exporters as well as foreign currency loans mobilized by corporates from abroad.  Exporters of goods and services, were bound to sell forex to an AD at rates prescribed by SBP. 

Market liberalization. The decade of 90s Early nineties marked an era of liberalization of foreign exchange market.  FCAs Scheme was launched for Resident Pakistanis. Banks were required to surrender their FC deposits against purchase of forward cover from SBP.  Money Changers were authorized to Deal in foreign exchange (Notes and TCs only).  Forward cover for imports and exports shifted to banks. 

Post detonation crisis (May ’98) and move towards market based ERM.  In early 98, Pakistan was making gradual moves towards market based ERM.  Third currency rates to be quoted by banks.  SBP also stopped giving customer’s buying and selling rate and gave a 1% band to the market, quoting its buying and

Post detonation crisis (May ’98) and move towards market based ERM. Detonation of May 98 changed the way things were moving.  Despite low reserves, SBP made the decision of going ahead with fx market reforms.  Phased approach was adopted for transition to free float.  As a first step Two-Tier ERM was introduced in July 21, 1998.  Except for essential items (e.g. wheat l/cs) , the rest of the trade transactions were settled through interbank market.  Initially 50/50 , 80/20, FINALLY 95/05 

Post detonation crisis (May ’98) and move towards market based ERM.  Two-tier

was finally abolished in May

1999.  Currency was freely floated.  Regulations pertaining to current account transactions remained more or less unchanged. However all transactions were to be done at interbank rate and every bank was to offer its own rate to customers.  However, an unofficial narrow band was imposed on banks, which

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. 

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. 3. Any sale or purchase of foreign currency entails foreign exchange risk. 4. Foreign exchange transaction affects the net asset or net liability position of the buyer/seller. 5. 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

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Fwd Sell to Corporate

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.

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Regulate inter-bank forex transactions and monitor the foreign exchange risk of the banks.

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Keep the exchange rate stable. Manage and maintain country's foreign exchange reserves.

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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 3.

4. 5. 6.

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All Central Banks have treasuries to implement policy objectives vis a vis EXCHANGE RATE & INTEREST RATES Dealing room catered to the FX market only Money market was being looked after by the Securities department 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 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   

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OFFSITE MONITORING DAILY RATES FOR MARKET THIRD CURRENCY ACTIVITY FOR GoP PAYMENTS RESERVE MANAGEMENT

Off Site monitoring of banks by SBP Inputs of Computerized Reporting System

(CRS) All individual foreign exchange transactions reported by each bank on daily basis on a floppy diskette Amount Currency Posting date Counter Party Type of Deal

Rate Deal Date Maturity Date Mode of Deal

Off Site monitoring of banks by SBP Reports from CRS Exposure Report FE - 25 balances & other deposits Nostro Balances Un-reconciled interbank deals

Off Site monitoring of banks by SBP Reports from CRS Cont’d

Reports for research & statistical purposes

Types of transactions/customers/currency Business volume - banks/customers/curren Broker wise market volume report History of exchange rates - trend analysis

How does SBP manages exchange rate in the interbank market? • Non-Quantitative Tools • Quantitative Tools

Non-Quantitative Tools

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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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