Local Foreign Exchange Market

1
Local Foreign Exchange Market

• By
• Muhammad ARIF
• Senior Joint Director
• FSCD

2
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

3
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.

4
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, travelers cheques, letters of credit and
  bills of exchange, expressed or drawn in Pakistan
  currency but payable in any foreign currency

5
Financial Markets

• Financial market is a place where Resources/funds
  are transferred from those having surplus/excess
  to those having a deficit/shortage.

6
Foreign Exchange Markets

• 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

8

• 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.

9
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

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FOREIGN EXCHANGE REGIMES

• FIXED
• PEGGED
• COMPOSITE
• MANAGED FLOAT
• FREE FLOATING

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• Components of a Standard
• FX Transaction
• Base Currency (USD/PKR)
• Dealt or Variable Currency
• Exchange Rate
• Amount
• Deal Date
• Value Date
• Settlement Instructions

12
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
• 4) Forward Transaction Settlement at some future
  date ahead of the spot.

13

• 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.

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• 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.

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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.

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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.

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• FORWARD TRANSACTIONS
• Out right sale/purchase of a currency against the
  other for settlement at a future date at the
  predetermined exchange rate.
• Forward rates are quoted as premium or discount
  over spot rate.
• Forward rates depend upon interest rate
  differential between the two currencies.
• Currency with higher interest rates is at
  discount wrt currency having lower interest rate.
• Currency with lower interest rates is at premium
  wrt currency having higher interest rate.

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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 .06181/365)/(1.0125181/360)
59.87
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• 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.
• SWIFT (Society for Worldwide Interbank Financial
  Telecommunications)

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• Deals are done over Telephone, REUTERS dealing
  system etc
• R E U T E R S
• Dealing Terminal
• Industry Standard for FX trading.
• Security guaranteed by Reuters Int.
• Password Protected.
• Maintains record of all transactions.
• SBPK (SBPs 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.

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• 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, education,
  medical treatment etc.

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• 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.
• Elaborate system of reporting by ADs to SBP.

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• 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.
• Forward cover for FC loans also transferred to
  banks (under certain rules and regulations).

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• 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 customers buying and
  selling rate and gave a 1 band to the market,
  quoting its buying and selling rates for ADs.
• The target was to put the currency on free float.

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• 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

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• 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 remained there till July 2000. when
  it was finally done away with.

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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.

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• 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.

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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.

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• Foreign Exchange Risk
• Exposure to exchange rate movement.
• Any sale or purchase of foreign currency entails
  foreign exchange risk.
• Foreign exchange transaction affects the net
  asset or net liability position of the
  buyer/seller.
• Carrying net assets or net liability position in
  any currency gives rise to exchange risk.

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• 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.

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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
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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.
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Foreign Exchange Markets Role of SBP and
linkages with economy
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SBPs 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.

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SBPs 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.

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• TREASURY OPERATIONS AT SBP
• 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.

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• 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.

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• 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.

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• Front Office Challenges
• Small Market Size
• Lumpy payments
• Leads and Lags.
• Historical trend of keeping long positions.
• The issue of entries in transit.

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• 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

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• OTHER FX RELATED FUNCTIONS
• OFFSITE MONITORING
• DAILY RATES FOR MARKET
• THIRD CURRENCY ACTIVITY FOR GoP PAYMENTS
• RESERVE MANAGEMENT

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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

• Rate

• Deal Date

• Type of Deal

• Maturity Date

• Mode of Deal

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Off Site monitoring of banks by SBP

• Reports from CRS

• Exposure Report

• FE - 25 balances other deposits

• Nostro Balances

• Un-reconciled interbank deals

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Off Site monitoring of banks by SBP

• Reports from CRS Contd

Reports for research statistical purposes

• Types of transactions/customers/currency

• Business volume - banks/customers/currency

• Broker wise market volume report

• History of exchange rates - trend analysis

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How does SBP manages exchange rate in the
interbank market?

• Non-Quantitative Tools
• Quantitative Tools

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• Non-Quantitative Tools
• Moral suasion
• facilitating large commercial outflows
• Relaxation in FEEL

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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
  its 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.

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• 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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Thank You