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.

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 BASIC
CONCEPTS/TERMINOLOGIES
AsForeign
per Foreign Exchange
Currency Act, (Section
v/s Foreign Exchange2),
1947.
(c) "ForeignCurrency" 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
 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
 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 12
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 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.
 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.

o Currency with lower interest rates is at

premium wrt currency having higher
 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+
.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.
 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)
 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

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.
 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.
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. All Central Banks have treasuries to
implement policy objectives vis a vis
EXCHANGE RATE & INTEREST RATES
4. Dealing room catered to the FX market
only
5. Money market was being looked after by
the Securities department
6. 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
7. 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

 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 Rate Deal Date
Type of Deal 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

• 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
Thank You