Ultimate Guide : How bank participates in forex market...!

1. WHY WE NEED FOREIGN EXCHANGE

Almost every nation has its own national currency or monetary unit its dollar, its peso, its rupees used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for “foreign exchange” transactions exchanges of one currency for another.

2. PAYMENT AND SETTLEMENT SYSTEMS

Just as each nation has its own national currency, so also does each nation have its own payment and settlement system that is, its own set of institutions and legally acceptable arrangements for making payments and executing financial transactions within that country,using its national currency. “Payment” is the transmission of an instruction to transfer value that results from a transaction in the economy, and “settlement” is the final and unconditional transfer of the value specified in a payment instruction. Thus, if a customer pays a department store bill by check, “payment” occurs when the check is placed in the hands of the department store, and “settlement” occurs when the check clears and the department store’s bank account is credited. If the customer pays the bill with cash,payment and settlement are simultaneous.

When two traders enter a deal and agree to undertake a foreign exchange transaction, they are agreeing on the terms of a currency exchange and committing the resources of their respective institutions to that agreement. But the execution of that exchange the settlement does not take place until later.

3.PAYMENTS VIA FEDWIRE AND CHIPS

When a payment is executed over Fedwire, a regional Federal Reserve Bank debits on its books the account of the sending bank and credits the account of the receiving bank, so that there is an immediate transfer from the sending bank and delivery to the receiving bank of “central bank money” (i.e., a deposit claim on that Federal Reserve Bank).A Fedwire payment is “settled”when the receiving bank has its deposit account at the Fed credited with the funds or is notified of the payment. Fedwire is a “realtime gross settlements” (or RTGS) system To control risk on Fedwire, the Federal Reserve imposes charges on participants for intra-day (daylight) overdrafts beyond a permissible allowance. 

In contrast to Fedwire, payments processed over CHIPS are finally “settled,” not individually during the course of the day, but collectively at the end of the business day, after the net debit or credit position of each  CHIPS participant (against all other CHIPS participants) has been determined. Final settlement of CHIPS obligations occurs by Fedwire transfer (delivery of “central bank money”). Settlement is initiated when those CHIPS participants in a net debit position for the day’s CHIPS activity pay their day’s obligations. If a commercial bank that is scheduled to receive CHIPS payments makes funds available to its customers before CHIPS settlement occurs at the end of the day, that commercial bank is exposed to some risk of loss if CHIPS settlement cannot occur.To ensure that settlement does, in fact, occur, the New York Clearing House has put in place a system of net debit caps and a loss sharing arrangement backed up by collateral as a risk control mechanism.

4. CENTRAL BANKS

All central banks participate in their nations’foreign exchange markets to some degree, and their operations can be of great importance to role of the Federal Reserve in the foreign exchange market is discussed more in previous articles. Intervention operations designed to influence foreign exchange market conditions or the exchange rate represent a critically important aspect of central banks’ foreign exchange transactions. However, the intervention practices of individual central banks differ greatly with respect to objectives, approaches, amounts, and tactics.

Unlike the days of the Bretton Woods par value system, nations are now free, within broad rules of the IMF, to choose the exchange rate regime they feel best suits their needs. The United States and many other developed and developing nations have chosen an varied in many ways—whether and when to intervene, in which currencies and geographic markets, in what amounts, aggressively or less so, openly or discreetly, and in concert with other central banks or not. The resolution of these and other issues depends on an assessment of market conditions and the objectives of the intervention.United States, operating under the same broad policy guideline over a number of years, has experienced both periods of relatively heavy intervention and periods of minimal activity. 

Foreign exchange market intervention is not the only reason central banks buy and sell foreign currencies.Many central banks serve as their government’s principal international banker, and handle most, and in some cases all, foreign exchange transactions for the government as well as for other public sector enterprises, such as the post office, electric power utilities, and nationalized airline or railroad. Consequently, even without its own intervention operations, a central bank may be operating in the foreign exchange market in those markets. But central banks differ, not only in the extent of their participation, but also in the manner and purposes of their involvement.

The“independently floating” regime, providing for a considerable degree of flexibility in their exchange rates. But a large number of countries continue to peg their currencies, either to the U.S. dollar or some other currency, or to a currency basket or a currency composite, or have chosen some other regime to limit or manage flexibility of the home currency. 

The choice of exchange rate regime determines the basic framework within which each central bank carries out its intervention activities. The techniques employed by a central bank to maintain an exchange rate that is pegged or closely tied to another currency are straightforward and have limited room for maneuver or change. But for the United States and others with more flexible regimes, the approach to intervention can be order to acquire or dispose of foreign currencies for some government procurement or investment purpose. A central bank also may seek to accumulate, reallocate among currencies, or reduce its foreign exchange reserve balances. It may be in the market as agent for another central bank, using that other central bank’s resources to assist it in influencing that nation’s exchange rate. Alternatively, it might be assisting another central bank in acquiring foreign currencies needed for the other central bank’s activities or business expenditures.

Thus, for example, the Foreign Exchange Desk of the Federal Reserve Bank of New York engages in intervention operations only occasionally. But it usually is in the market every day, buying and selling foreign currencies, often in modest amounts, for its “customers” (i.e., other central banks, some U.S. agencies, and international institutions). This “customer”business provides a useful service to other central banks or agencies,while also enabling the Desk to stay in close touchwith the market for the currencies being traded

5. LINKAGES BETWEEN MAIN FOREIGN EXCHANGE INSTRUMENTS IN BOTH OTC AND EXCHANGE-TRADED MARKETS

=> SPOT (settled two days after deal date, or T+2) = 

Benchmark price of a unit of the base currency expressed in a variable amount of the terms currency.

=> PRE-SPOT: 

VALUE TOMORROW (settled one day after deal date, or T+1) = Price based on spot rate adjusted for the value for one day of the interest rate differential between the two currencies. (Higher interest rate currency trades at a premium from spot.)

=> PRO-SPOT: 

CASH (settled on deal date, or T+0) = Price based on spot rate adjusted for the value for two days of the interest rate differential between the two currencies. (Higher interest rate currency trades at a premium from spot.)

=> OUTRIGHT FORWARD = 

Price based on spot rate adjusted for the value of the interest rate differential between the two currencies for the number of days of the forward. (Higher interest rate currency trades at a forward discount from spot.)

=> FX SWAP = 

One spot transaction plus one outright forward transaction for a given amount of the base currency, going in opposite directions, or else two outright forward transactions for a given amount of the
base currency, with different maturity dates, going in opposite directions.

=> CURRENCY FUTURES = 

Conceptually, a series of outright forwards, one covering each period from one day’s marking to market and cash settlement to the next.

=> CURRENCY SWAP = 

An exchange of principal in two different currencies at the beginning of the contract (sometimes omitted) and a reexchange of same amount at the end; plus an exchange of two streams of interest payments covering each interest payment period, which is conceptually a series of outright forwards, one covering each interest payment period.

=> CURRENCY OPTION = 

A one-way bet on the forward rate, at a price (premium) reflecting the market’s forecast of the volatility of that rate. A synthetic forward position can be produced from a combination of options, and a package of options can be replicated by taking apart a forward.