Different Foreign Exchange Regimes: ...........................................................................................13Determinants of FX rates ...............................................................................................................15Economic factors ...........................................................................................................................16
Political conditions .........................................................................................................................17Market psychology .................................................................................................................17Role of Bangladesh Bank: .............................................................................................................18Foreign Exchange Regulations: .....................................................................................................22Limits of Foreign Exchange Trading: ............................................................................................26
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The foreign exchange market (forex, FX, or currency market) is a worldwide decentralizedover-the-counter financial market for the trading of currencies. Financial centers around theworld function as anchors of trading between a wide range of different types of buyers andsellers around the clock, with the exception of weekends. The foreign exchange marketdetermines the relative values of different currencies.
The primary purpose of the foreign exchange is to assist international trade and investment, byallowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is inUS dollars. It also supports speculation, and facilitates the carry trade, in which investors borrowlow-yielding currencies and lend (invest in) high-yielding currencies, and which (it has beenclaimed) may lead to loss of competitiveness in some countries.
In a typical foreign exchange transaction, a party purchases a quantity of one currency by payinga quantity of another currency. The modern foreign exchange market began forming during the1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of
• its huge trading volume, leading to high liquidity;• its geographical dispersion;• its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT
on Sunday until 22:00 GMT Friday;• the variety of factors that affect exchange rates;• the low margins of relative profit compared with other markets of fixed income; and• the use of leverage to enhance profit margins with respect to account size.
As such, it has been referred to as the market closest to the ideal of perfect competition,notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets isestimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volumeas of April 2007.
The $3.98 trillion break-down is as follows:
• $1.490 trillion in spot transactions• $475 billion in outright forwards• $1.765 trillion in foreign exchange swaps• $43 billion currency swaps• $207 billion in options and other products
The foreign exchange market is one of the most important financial markets. The $3.98 Trillion
(April 2010)-per-day foreign exchange (FX) market surpasses stocks and bonds as the largestmarket in the world. Foreign exchange markets are critical for setting exchange rates betweencountries. It affects the relative price of goods between countries and so can affect trade. Itmeans that it affects the price of imports and so affects a country’s price level (inflation rate). Italso affects the international investment and financing decision. In this project, we will try tofind why exchange rate would give many risks to a company and how a company can hedgeitself.
Purpose of the Assignment:
The purpose of the project is to fulfill partial requirement of the Course of Theory andPractice of International Business of University of Dhaka, Evening MBA program,
Department of International Business.
Objective of the Assignment:
Objective of this report is to give an overview of the Foreign Exchange Market. Towards that, anattempt has been made to describe the nature of the market, to explain how the market works,identify the traders and factors, and give an idea about the size of the market and the volume of trading.
Methodology:
This report has been primarily based on secondary research – various publications of BangladeshBank and other banks, notably HSBC, Standard Chartered Bank and Al-Arafah Islami Bank Limited, newspaper reports, web-sites on the internet, some informal discussions with bank officials and different lecture delivered by Dr. Khondoker Bazlul Hoque, course teacher of Theory and Practice of International Business, Department of International Business, Evening
MBA program, University of Dhaka were the main sources for the information. Scope and Limitations:
A true assessment regarding the aspects covered in the report would have be more rigorous andis beyond the scope of this report. Essentially, direct access to the information available to themembers of Bangladesh Foreign Exchange Dealers Association (BAFEDA) BAFEDA would berequired which was not available for the preparation of the report. However this report may beused as the basis for further research.
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Foreign exchange is a commodity that consists of currencies issued by countries other than one’sown. Like the prices of other commodities, the price of foreign exchange i.e. exchange rate
between domestic currency foreign currency is set by demand and supply in the market place. Asfor example, the demand for Japanese yen is derived from foreigners demand for Japanese yen.
In simplest language, foreign exchange is the system of exchanging the money of one currencyfor that of another country.
Meaning of Exchange Rate:
Exchange rate is simply the rate at which one currency is converted into another.
Meaning of Foreign Exchange Market:
Foreign exchange market is a market for converting the currency of one country into that of another country. The foreign exchange market has two major: Over the counter market (O.T.C)and the exchange-traded market. The OTC market is composed of banks, both commercial banksand other financial institutions, and it is where the most of the foreign exchange activity takes place. The exchange-traded market is composed of securities exchanges, (such as ChicagoMercentile Exchages, Philadelphia Stock Exchange) where certain types foreign exchangeinstruments such as exchange-traded futures, and options are traded.
A Short History of the Foreign Exchange Trading Market :
Arbitrage
The simultaneous sale (or purchase) of a financial instrument and the taking of an equal andopposite position in a similar instrument to provide a profit. That is, exploiting pricingdifferences (anomalies) across markets. True arbitrage is risk free.
Margin in the context of FX & CFDs
A cash deposit provided by clients as collateral to cover losses (if any) that may result from the
client's trading activities.
"Pegged" Currency
A currency is pegged or fixed when its country's Central Bank decides to tie its value to astronger currency, in an effort to stabilize its own currency. Currencies such as the Hong KongDollar have historically pegged to the US Dollar.
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A sophisticated individual who trades with significant leverage, taking on above average risk inhopes of above average returns.
Foreign exchange markets originally developed to facilitate cross border trade conducted in
different currencies by governments, companies and individuals. While these markets primarilyexisted to provide for the international movement of money and capital, even the earliest marketshad speculators.
Today, an enormous proportion of FX market activity is being driven by speculation, arbitrageand professional dealing, in which currencies are traded like any other commodity.
Traditionally, retail investors' only means of gaining access to the foreign exchange market wasthrough banks that transacted in large amounts of currencies for commercial and investment purposes. Trading volume has increased rapidly over time, especially after exchange rates wereallowed to float freely in 1971.
From 1944 until 1971, most of the world's major currencies were pegged to the US dollar under an arrangement called the Bretton Woods Agreement. Participating countries agreed to try andmaintain the value of their currency with a narrow margin against the US dollar and acorresponding rate of gold, as needed. These countries were prohibited from devaluing their currencies to gain a foreign trade advantage. Consequently, the foreign exchange market wasrelatively static.
Foreign Exchange Instrument:
Several different types of foreign exchange instruments are traded in the foreign exchangemarket but the traditional foreign exchange instruments that composed the bulk of foreignexchange trading are:
1. Spot2. Outsight forward3. Fx Swap
Others are
4. Currency Swap5. Options6. Futures
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A spot transaction is a two-day delivery transaction (except in the case of trades between the USDollar, Canadian Dollar, Turkish Lira, EURO and Russian Ruble, which settle the next businessday), as opposed to the futures contracts, which are usually three months. This trade represents a
“direct exchange” between two currencies, has the shortest time frame, involves cash rather thana contract; and interest is not included in the agreed-upon transaction.
Outsight Forward
One way to deal with the foreign exchange risk is to engage in a forward transaction. In thistransaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on thatdate, regardless of what the market rates are then. The duration of the trade can be one day, a fewdays, months or years. Usually the date is decided by both parties. Then the forward contract isnegotiated and agreed upon by both parties.
Fx Swap
The most common type of forward transaction is the FX swap. In an FX swap, two partiesexchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.
Currency Swap
Currency swaps deal more with interest bearing financial instruments (such as a bond) and theyinvolve the exchange of pricipal and interest payment.
Option
A foreign exchange option (commonly shortened to just FX option) is a derivative where theowner has the right but not the obligation to exchange money denominated in one currency intoanother currency at a pre-agreed exchange rate on a specified date. The FX options market is thedeepest, largest and most liquid market for options of any kind in the world.
Future
Foreign currency futures are exchange traded forward transactions with standard contract sizes
and maturity dates — for example, $1000 for next November at an agreed rate. Futures arestandardized and are usually traded on an exchange created for this purpose. The averagecontract length is roughly 3 months. Futures contracts are usually inclusive of any interestamounts.
Foreign Exchange Market allows currencies to be exchanged to facilitate international trade andfinancial transactions.
Foreign Evolution of the market in Bangladesh is closely linked with the exchange rate regime of the country. It had virtually no foreign exchange market up to 1993. Bangladesh Bank, as agentof the government, was the sole purveyor of foreign currency among users. It tried to equilibratethe demand for and supply of foreign exchange at an officially determined exchange rate, which,however, ceased to exist with introduction of current account convertibility. Therefore, the major functions of foreign exchange market are:
Currency Conversion:i. To convert all the receipts into home country’s currencyii. To pay a foreign company for its products or services in its country’s currency
iii. To invest the spare cash for short term in money marketsiv. Currency speculation
Insuring against foreign exchange risks:
i. Spot exchange ratesii. Forward exchange ratesiii. Currency swaps
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Main foreign exchange market turnover, 1988–2007, measured in billions of USD.
The foreign exchange market is the largest and most liquid financial market in the world. Tradersinclude large banks, central banks, institutional investors, currency speculators, corporations,governments, other financial institutions, and retail investors. The average daily turnover in theglobal foreign exchange and related markets is continuously growing. The daily Trade Volume – $1.9 Trillion (April 2004) 50 times the turnover of NYSE stocks, 10 times U.S. daily GDP.According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).Of this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion wastraded in outright forwards, FX swaps and other currency derivatives.
The $3.98 trillion break-down is as follows:
• $1.490 trillion in spot transactions• $475 billion in outright forwards• $1.765 trillion in foreign exchange swaps• $43 billion currency swaps• $207 billion in options and other products
Trading in London accounted for 36.7% of the total, making London by far the most importantglobal center for foreign exchange trading. In second and third places respectively, trading in New York City accounted for 17.9%, and Tokyo accounted for 6.2%.
Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recentyears, reaching $166 billion in April 2010 (double the turnover recorded in April 2007).Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. FXfutures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are activelytraded relative to most other futures contracts.
Most developed countries permit the trading of FX derivative products (like currency futures andoptions on currency futures) on their exchanges. All these developed countries already have fully
convertible capital accounts. A number of emerging countries do not permit FX derivative products on their exchanges in view of controls on the capital accounts. The use of foreignexchange derivatives is growing in many emerging economies. Countries such as Korea, SouthAfrica, and India have established currency futures exchanges, despite having some controls onthe capital account.
Foreign exchange trading increased by 20% between April 2007 and April 2010 and hasmore than doubled since 2004. The increase isturnover is due to a number of factors: thegrowing importance of foreign exchange as anasset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment.
The growth of electronic execution methodsand the diverse selection of execution venueshave lowered transaction costs, increasedmarket liquidity, and attracted greater participation from many customer types. In
particular, electronic trading via online portals has made it easier for retail traders to trade in theforeign exchange market. By 2010, retail trading is estimated to account for up to 10% of spotFX turnover, or $150 billion per day.
Because foreign exchange is an OTC market where brokers/dealers negotiate directly with oneanother, there is no central exchange or clearing house. The biggest geographic trading centre is
the UK, primarily London, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Dueto London's dominance in the market, a particular currency's quoted price is usually the Londonmarket price. For instance, when the IMF calculates the value of its SDRs every day, they use theLondon market prices at noon that day.
Market participants :
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top isthe inter-bank market, which is made up of the largest commercial banks and securities dealers.Within the inter-bank market, spreads, which are the difference between the bid and ask prices,are razor sharp and usually unavailable, and not known to players outside the inner circle. Thedifference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currenciessuch as the EUR). This is due to volume. If a trader can guarantee large numbers of transactionsfor large amounts, they can demand a smaller difference between the bid and ask price, which isreferred to as a better spread. The levels of access that make up the foreign exchange market aredetermined by the size of the "line" (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller banks, followed by large multi-national corporations (which need to hedge risk and pay
employees in different countries), large hedge funds, and even some of the retail FX-metalmarket makers. According to Galati and Melvin, “Pension funds, insurance companies, mutualfunds, and other institutional investors have played an increasingly important role in financialmarkets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, henotes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number
and overall size” Central banks also participate in the foreign exchange market to aligncurrencies to their economic needs.
Banks :
The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of thistrading is undertaken on behalf of customers, but much is conducted by proprietary desks,trading for the bank's own account. Until recently, foreign exchange brokers did large amountsof business, facilitating interbank trading and matching anonymous counterparts for large fees.Today, however, much of this business has moved on to more efficient electronic systems. The
broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial companies :
An important part of this market comes from the financial activities of companies seekingforeign exchange to pay for goods or services. Commercial companies often trade fairly smallamounts compared to those of banks or speculators, and their trades often have little short termimpact on market rates. Nevertheless, trade flows are an important factor in the long-termdirection of a currency's exchange rate. Some multinational companies can have an unpredictableimpact when very large positions are covered due to exposures that are not widely known by
other market participants.
Central banks :
National central banks play an important role in the foreign exchange markets. They try tocontrol the money supply, inflation, and/or interest rates and often have official or unofficialtarget rates for their currencies. They can use their often substantial foreign exchange reserves tostabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" isdoubtful because central banks do not go bankrupt if they make large losses, like other traderswould, and there is no convincing evidence that they do make a profit trading.
Forex Fixing :
Forex fixing is the daily monetary exchange rate fixed by the national bank of each country. Theidea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the forex market. Banks,dealers and online foreign exchange traders use fixing rates as a trend indicator.
The mere expectation or rumor of central bank intervention might be enough to stabilize acurrency, but aggressive intervention might be used several times each year in countries with adirty float currency regime. Central banks do not always achieve their objectives. The combinedresources of the market can easily overwhelm any central bank. Several scenarios of this naturewere seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.
Hedge funds as speculators :
About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of thecurrency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996.They control billions of dollars of equity and may borrow billions more, and thus mayoverwhelm intervention by central banks to support almost any currency, if the economicfundamentals are in the hedge funds' favor.
Investment management firms :
Investment management firms (who typically manage large accounts on behalf of customerssuch as pension funds and endowments) use the foreign exchange market to facilitatetransactions in foreign securities. For example, an investment manager bearing an internationalequity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreignsecurities purchases.
Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as wellas limiting risk. Whilst the number of this type of specialist firms is quite small, many have a
large value of assets under management (AUM), and hence can generate large trades.
Retail foreign exchange brokers :
Retail traders (individuals) constitute a growing segment of this market, both in size andimportance. Currently, they participate indirectly through brokers or banks. Retail brokers, whilelargely controlled and regulated in the USA by the CFTC and NFA have in the past beensubjected to periodic foreign exchange scams. To deal with the issue, the NFA and CFTC began(as of 2009) imposing stricter requirements, particularly in relation to the amount of NetCapitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone.
There are two main types of retail FX brokers offering the opportunity for speculative currencytrading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the priceobtained in the market. Dealers or market makers, by contrast, typically act as principal in thetransaction versus the retail customer, and quote a price they are willing to deal at—the customer has the choice whether or not to trade at that price.
In assessing the suitability of an FX trading service, the customer should consider theramifications of whether the service provider is acting as principal or agent. When the service provider acts as agent, the customer is generally assured of a known cost above the best inter-dealer FX rate. When the service provider acts as principal, no commission is paid, but the priceoffered may not be the best available in the market—since the service provider is taking the other
side of the transaction, a conflict of interest may occur.
Non-bank foreign exchange companies :
Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but aredistinct in that they do not offer speculative trading but currency exchange with payments. I.e.,there is usually a physical delivery of currency to a bank account. Send Money Home offers anin-depth comparison into the services offered by all the major non-bank foreign exchangecompanies.
It is estimated that in the UK, 14% of currency transfers/payments are made via ForeignExchange Companies. These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ fromMoney Transfer/Remittance Companies in that they generally offer higher-value services.
Money transfer/remittance companies :
Money transfer companies/remittance companies perform high-volume low-value transfersgenerally by economic migrants back to their home country. In 2007, the Aite Group estimatedthat there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange
& Financial Services Ltd.
Different Foreign Exchange Regimes:
Immediately after liberation, the Bangladesh currency taka was pegged with pound sterling butwas brought at par with the Indian rupee. Within a short time, the value of taka experienced arapid decline against foreign currencies and in May 1975, it was substantially devalued. In 1976,Bangladesh adopted a regime of managed float, which continued up to August 1979, when acurrency-weighted basket method of exchange rate was introduced. The exchange ratemanagement policy was again replaced in 1983 by the trade-weighted basket method and US the
dollar was chosen as intervention currency. By this time a secondary exchange market (SEM)was allowed to grow parallel to the official exchange rate. This gave rise to a ‘kerb’ market.
Up to 1990, multiple exchange rates were allowed under different names of export benefitschemes such as, Export Bonus Scheme, XPL, XPB, EFAS, IECS, and Home RemittancesScheme. This led to a wide divergence between the official rate and the SEM rate. The situationalso gradually gave rise to a number of conflicting regulations, poor risk management, andvarious types of implicit or explicit government guarantees to the users of foreign exchange. This
resulted in a number of macro-economic imbalances prompting the government to adjust theofficial rate in phases and to liquidate its difference with the rate at SEM. The two rates werefinally unified in January 1992. The first step towards currency convertibility was taken on 17July 1993 and this marked the beginning of a relatively open foreign exchange market in thecountry. Until then the Bangladesh Bank used to declare mid-rate along with the buying and
selling rates for dollar applicable to authorized dealers. Initially the spread was Tk 0.10, whichwas gradually widened to Tk 0.30.
Until late in 2003, Bangladesh followed an exchange rate policy of occasionally adjusting therate with an eye on maintaining export competitiveness, mainly with reference to the trend of Real Effective Exchange Rate Index based on a trade weighted basket of currencies acted as asort of benchmark for the banks to set their own rates.
From May 31, 2003, the exchange rates for the Bangladesh Bank’s spot purchase and saletransactions of US dollars with authorized dealers were to be decided without reference to any pre-announced band and the Taka essentially became a floating currency of major trade partners.
The Bangladesh Bank had a preannounce one Taka wide band within which it would, at itsdiscretion, undertake US Dollar purchase and sale transactions with banks. The banks were freeto set their own rates for their interbank and customer transactions. Those rates generally tendedto be outside the announced rate band for transactions between the Bangladesh Bank andauthorized dealers.
Exchange Rate:
Bangladesh Bank limits its market interventions to countering disorderly movements and to building a more comfortable reserves position consistent with the macroeconomic programagreed with the International Monetary Fund. A managed floating exchange rate system in forcesince May 2003 has served the economy well, enabling it to adjust relatively smoothly to thechanging external environment, especially in absorbing the oil price shock, supporting exportgrowth, and protecting reserves.
The exchange rates of Taka for inter-bank and customer transactions are set by the dealer banksthemselves, based on demand-supply interaction. The Bangladesh Bank is not present in themarket on a day-to-day basis and undertakes purchase or sale transactions with the dealer banksonly as needed to maintain orderly market conditions. The exchange rates are used as referencerates to purchase or sale transactions for Bangladesh Bank with Government or differentInternational Organization. But USD/BDT buying and selling rates represent previous day inter- bank market's highest and lowest exchange rates.
Forecast of USD-BDT Movement for the Year 2010:
Month Taka per USDJan-10 69.25Feb-10 69.30Mar-10 69.26Apr-10 69.25
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(b) Balance of payments model: This model, however, focuses largely on tradable goodsand services, ignoring the increasing role of global capital flows. It failed to provide anyexplanation for continuous appreciation of dollar during 1980s and most part of 1990s in faceof soaring US current account deficit.(c) Asset market model: views currencies as an important asset class for constructing
investment portfolios. Assets prices are influenced mostly by people’s willingness to hold theexisting quantities of assets, which in turn depends on their expectations on the future worthof these assets. The asset market model of exchange rate determination states that “theexchange rate between two currencies represents the price that just balances the relativesupplies of, and demand for, assets denominated in those currencies.”
None of the models developed so far succeed to explain FX rates levels and volatility in thelonger time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have madeconsistent profits from it. It is understood from above models that many macroeconomic factorsaffect the exchange rates and in the end currency prices are a result of dual forces of demand and
supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the priceof one currency in relation to another shifts accordingly. No other market encompasses (anddistills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any singleelement, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.
Economic factors
These include: (a) economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.
• Economic policy comprises government fiscal policy (budget/spending practices) andmonetary policy (the means by which a government's central bank influences the supplyand "cost" of money, which is reflected by the level of interest rates).
• Government budget deficits or surpluses: The market usually reacts negatively towidening government budget deficits, and positively to narrowing budget deficits. Theimpact is reflected in the value of a country's currency.
• Balance of trade levels and trends: The trade flow between countries illustrates the
demand for goods and services, which in turn indicates demand for a country's currencyto conduct trade. Surpluses and deficits in trade of goods and services reflect thecompetitiveness of a nation's economy. For example, trade deficits may have a negativeimpact on a nation's currency.
• Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is becauseinflation erodes purchasing power , thus demand, for that particular currency. However, a
currency may sometimes strengthen when inflation rises because of expectations that thecentral bank will raise short-term interest rates to combat rising inflation.
• Economic growth and health: Reports such as GDP, employment levels, retail sales,capacity utilization and others, detail the levels of a country's economic growth andhealth. Generally, the more healthy and robust a country's economy, the better its
currency will perform, and the more demand for it there will be.• Productivity of an economy: Increasing productivity in an economy should positively
influence the value of its currency. Its effects are more prominent if the increase is in thetraded sector.
Political conditions
Internal, regional, and international political conditions and events can have a profound effect oncurrency markets.
All exchange rates are susceptible to political instability and anticipations about the new ruling
party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affectthe value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also,events in one country in a region may spur positive/negative interest in a neighboring countryand, in the process, affect its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
• Flights to quality: Unsettling international events can lead to a "flight to quality," withinvestors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar ,Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.• Long-term trends: Currency markets often move in visible long-term trends. Althoughcurrencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that mayrise from economic or political trends.• "Buy the rumor, sell the fact": This market truism can apply to many currency situations.
It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the oppositedirection. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the cognitive bias known asanchoring, when investors focus too much on the relevance of outside events to currency prices.• Economic numbers: While economic numbers can certainly reflect economic policy,some reports and numbers take on a talisman-like effect: the number itself becomes
important to market psychology and may have an immediate impact on short-term marketmoves. "What to watch" can change over time. In recent years, for example, money supply,employment, trade balance figures and inflation numbers have all taken turns in thespotlight.• Technical trading considerations: As in other markets, the accumulated price movements
in a currency pair such as EUR/USD can form apparent patterns that traders may attempt touse. Many traders study price charts in order to identify such patterns.
Role of Bangladesh Bank :
At present, the system of exchange rate management in Bangladesh is to monitor the movementof the exchange rate of taka against a basket of currencies through a mechanism of real effectiveexchange rate (RFER) intended to be kept close to the equilibrium rate. The players in theforeign exchange market of Bangladesh are the Bangladesh Bank, authorized dealers, andcustomers. The Bangladesh Bank is empowered by the Foreign Exchange Regulation Act of 1947 to regulate the foreign exchange regime. It, however, does not operate directly and instead,
regularly watches activities in the market and intervenes, if necessary, through commercial banks. From time to time it issues guidelines for market participants in the light of the country'smonetary policy stance, foreign exchange reserve position, balance of payments, and overallmacro-economic situation. Guidelines are issued through a regularly updated Exchange ControlManual published by the Bangladesh Bank.
According to Bangladesh Bank “banks and authorized dealers are free to set their own rates of foreign exchange against Bangladesh Taka for their inter-bank and customer transactions. Theexchange rate is being determined in the market on the basis of market demand and supply forcesof the respective currencies. However, to avoid any unusual volatility in the exchange rate, BBoccasionally engages itself to intervene in the market through purchase and sale US Dollar as
and when it deems necessary to maintain stability in the foreign exchange market. BangladeshTaka is fully convertible for current international transactions.” However, only authorizeddealers are allowed to participate in trading with license from Bangladesh Bank, and license may be revoked due to irregularities or if the Bangladesh Bank regulations are not followed.
The exchange rates of Bangladesh Taka were left on the market forces after the floatation whereany intervention in the foreign exchange market by the Bangladesh Bank is not enviable. Theexchange rates of Bangladesh Taka against major international currencies witnessed somewhatstability since then, which did not warrant any intervention in the foreign exchange market by theBangladesh Bank. In view of keeping foreign exchange reserve at a comfortable level, however,the Bangladesh Bank had to participate in the market. Data as shown at the table below indicate
that the Bangladesh Bank did not sell any foreign currency during the last two fiscal years.
Purchases and Sales of Foreign Exchange by the Bangladesh Bank (Million US$)
Source: Bangladesh Bank Annual Reports 2002- 2007The Bangladesh Bank only purchased US $ 503.9 million and US $ 314.0 million during 2003and 2004 respectively. Overall trends in both the sales and purchases of foreign currency by theBangladesh Bank show declining trends during 2002-2004 indicating gradually less necessity for intervention by the Bangladesh Bank.
Because of relatively faster growth in import payments than export receipts, the demand for foreign exchange than that of supply was much stronger during the last half of 2005 generatingsome depreciating pressure on the Taka-Dollar exchange rate. With a view to mitigating themismatch between the supply and demand for foreign exchange, the Bangladesh Bank intervened by selling a sizeable of amount of foreign currency in the foreign exchange market.The Bangladesh Bank sold USD 459.5 million as against the purchase of USD 70.1 million in2005. Bangladesh Bank's intervention helped stabilize the exchange rate to Taka 63.70 duringfourth quarter of 2005, although pressure on forex market continued, reflecting widening currentaccount deficit.
Source: Bangladesh Bank
Bangladesh Bank also allowed limited overdraft facility on foreign currency clearing accountwith the Bangladesh Bank to NCBs and some private sector banks facing temporary mismatch inliquidity and relaxed restrictions on swap and forward operations in order to give banks someflexibility to manage their liquidity.
Pressure in the foreign exchange market continued due to price hike of oil and petroleum products and major import commodities coupled with higher growth in lending to the privatesector, which led to rapid growth in imports demand in the face of slowdown in export earningsin the first half of 2006. But due to adoption of contractionary monetary policy together withsubstantial inflow of foreign exchange from export earnings and remittances, the situations easedlater on. To increase the supply of foreign currencies in the market, BB sold USD 413.0 millionas against the purchase of USD 77.0 million in 2006. Overall trend in purchases of foreigncurrency by the BB, were showing declining trends during 2004 to 2006 indicating gradually lessnecessity for intervention by the Bangladesh Bank.
According Bangladesh bank annual report, in 2007, to absorb excess liquidity from the foreignexchange market, Bangladesh Bank purchased USD 649.50 million from banks and had no sales.However, an HSBC report (Bangladesh Review & Outlook) quoting newspapers mentioned thatBangladesh Bank sold USD 220.0 million near the end of 2007 to support the market for commodity import payments.
Authorized Dealers of Foreign Exchange in Bangladesh:
The authorized dealers are the only resident entities in the foreign exchange market to transactand hold foreign exchange both at home and abroad. Bangladesh Bank issues licenses of authorized dealership in foreign currencies only to scheduled banks. The amount of foreignexchange holdings by the authorized dealers are subject to open position limits prescribed byBangladesh Bank, which itself purchases and sells dollars from and to the dealers on spot basis.
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The size of each such transaction with Bangladesh Bank is required to be in multiples of $10,000, subject to a minimum of $50,000. In addition to authorized dealers, there are registeredmoneychangers to buy foreign currencies from tourists and sell them to outgoing Bangladeshitravelers as per entitlement. Their excess holdings beyond the permitted balance are required to be retained with authorized dealers. Some service institutions like hotels and shops have also
obtained limited money changing licenses to accept foreign currencies the foreign tourists, butthose are to be sold to authorized dealers. Transactions by customers take place mainly to satisfycustomer demand for individual needs and to facilitate export, import, and remittances.
The phenomenal growth of inter-bank transactions was due mainly to relaxation of exchangecontrol regulations and expansion of the activities of the Bangladesh Foreign Exchange DealersAssociation (BAFEDA) formed on 12 August 1993. The association was incorporated as a non- profit organization under the Companies Act (Act.XVIII) of 1994 on March 30, 1998. At present, 44 banks operating in Bangladesh are member of the association.
Objectives of BAFEDA :
According to the Constitution of Bangladesh Foreign Exchange Dealers' Association, theobjectives of the Association are:i. To create and promote inter-bank foreign exchange dealings and develop good fellowship thatare indispensable in foreign exchange dealings and relations;ii. To function in the best interest of the members and also to do all such other things as may benecessary or desirable in furtherance of the objectives of the Association;iii. To arrange that the foreign exchange dealers of member banks keep one another informedand they render assistance to one another without prejudice to the interests of their respectiveinstitutions;iv. To do all that is necessary in the power of the Association and the members, collectively andindividually, and also to uphold high standards of ethics by rendering quality service in foreignexchange dealings.For smooth functioning of the inter-bank foreign exchange market, a “Code of Conduct” for Bangladesh Inter-Bank Foreign Exchange and Treasury Operations and also “BAFEDA Rules”were formulated earlier, with the approval of Bangladesh Bank.2.4.4 Members of BAFEDAThe association may have two classes of members Committees-Primary Members: This remains open to all scheduled banks in Bangladesh, who are authorizeddealers and actively engaged in dealing in foreign exchange. The members are represented by theChief Executives. However, after giving a due notice, a member may withdraw from theAssociation.Associate Member: This includes those who are authorized in sale and purchase of foreigncurrencies and also active in financing import and export activities in Bangladesh. Associatemembership is subject to approval of the Executive Committee. Associate members have novoting rights.
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Transactions volume in the inter-bank foreign exchange market was USD 56.0 billion in 2001,and USD 98.4 billion in 2002. Forward transactions had a 4.7 fold increase from USD 7.19 billion of 2001 to USD 33.7 billion in 2002. This ballooning of forward transactions volume wasnot a balanced growth however; forward sales of dealers were covered mostly by spot purchasesrather than by matching forward purchases from exporters and other non-bank foreign exchangeearners. Soon after, Bangladesh Bank put up a series of restrictions, at the same time paving theway for floating the currency as was done on May 31, 2003.
The interbank foreign exchange transaction volume in 2003 was USD 91.08 billion less than the previous years, mainly because of the restriction imposed on building up forward sales covered by spot rather than forward purchases. Due to further restrictions imposed on building upforward sales covered by spot rather than forward purchases, the interbank foreign exchangetransaction volume in 2004 stood at USD 56.39 billion, and spot transactions at USD 40.8 billion.
In 2005, all authorized dealer banks were instructed not to undertake any non-real cross currencyforward and swap transactions, and consequently the interbank foreign exchange transactionsvolume in 2005 stood at USD 19.9 billion and volume of forward transactions came down toUSD 0.3 billion in 2005
As authorized dealer banks were instructed not to undertake any non-real cross currency forwardand swap transactions, volume of inter-bank forward transactions was almost nil in 2006, and thevolume of inter-bank foreign exchange transactions in 2006 stood at USD 20.3 billion. This trendcontinued in 2007, and the volume inter-bank foreign exchange transactions stood at USD 19.2 billion
Nature of Trading:
The-inter bank foreign exchange market of Bangladesh is still at its rudimentary stage. Themarket is an oligopolistic one and is dominated by a few relatively large banks, which haveremained only as dealers instead of developing themselves into buyers or sellers. The mostwidely used practice is spot transaction; this covers 95% of the total transactions. Only forwardtransactions offer protection against foreign exchange risks. Deals in foreign exchange marketare usually confirmed over telephone, followed by a written advice. Confirmed deals may becancelled on payment of necessary costs.
There also exists a ‘kerb’ market, where currency racketeers transact foreign currencies through
a chain of middlemen. This market emerged in the restricted regime of foreign exchangetransaction but continues to be active. This market operates in the alleys or lanes and by-lanes of Dhaka city around the foreign exchange branches of authorized banks. Dealers of hundi alsoform part of this market. A sizeable amount of foreign currencies is channeled through thismarket every year.
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Of major note is, of course, that of May 31, 2003 to have a managed float of BDT, whereby
Bangladesh Bank will have a minimum interaction with the market except as in stabilizing role.Also of not are those of 2005 and 2006 restricting swaps and forwards.
Some major changes in regulations are given below.Year 2002
Bangladesh continued in 2002 with the policy of leaving the banks authorized to deal in foreignexchange, free to set their spot and forward exchange rates for customer transactions andinterbank transactions, with the Bangladesh Bank announcing a one-Taka wide band withinwhich it will buy and sell US dollars from and to the Authorized Dealer banks on a spot basis.This band was revised once in 2002, on 6 January 2002, to Taka 57.40--58.40 per US dollar from
the previous Taka 56.50 to 57.50, involving depreciation by 1.6 percent.
Year 2003
Effective from 31st May 2003, Bangladesh stepped into fully market based exchange rate for theTaka, with BB notifying that it no longer had a pre-announced rate band for transactions with banks and that it would intervene in the market only as and when needed to ensure orderlymarket conditions. The BB took elaborate preparation prior to this changeover to equip itself with the necessary instruments to maintain the stability of the market exchange rate and interestrates. Monitoring of key market variables and forecasting of liquidity were strengthened;monitoring of open exchange positions of the banks and of the capital controls were paid specialattention. Repo and reverse repo with banks by the BB were introduced to enable a firm grip on
market liquidity.
The major changes in foreign exchange regulations in 2003 were:
a) With a view to ensuring balanced buildup of forward purchase and sale commitments,authorized dealers were instructed to cover their forward sales of foreign exchange with forwardrather than spot purchases.
b) The foreign exchange retention quota for exporters was enhanced from 40 percent to 50 percent for merchandise exports and software/IT exports. The retention quota for exports withhigh import content was increased from 7.5 to 10 percent.
c) Exemption from declaration to the customs authorities of foreign exchange brought intoBangladesh by an incoming passenger was lowered to USD 3,000 from USD 5,000.
Year 2004
The major changes in foreign exchange regulations in 2004 were as under:
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a) In order to avoid risk/gain associated with transactions other than real transactions, theauthorized dealers instructed to establish contract of new cross currency forward and swaptransactions only against customer requirements without renewal of earlier non-realcontracts of forward and swap transactions at their maturity.
b) To boost up the garments industries, cash incentives payment systems on fob export value of local garments in lieu of bonded warehouse or duty draw back facilities have been revised.
c) Validity period for export of Crust Leather has been extended up to 30 June 2004.
d) To increase the export of agricultural goods and to encourage the exporter of such goods, cashincentive has been increased from 15 percent to 25 percent in case of export of fresh vegetablesand agro-based products. It has also been extended from 20 percent to 25 percent in case of fruitsexport.
e) A facility of 5 percent cash incentive has been declared in 2004 against the export of jutegoods produced by government and non- government jute mills.
f) With a view to diversifying and expanding export of agricultural products 10% cash incentiveintroduced for export of tobacco and 15% for export of potato.
g) The ceiling of foreign currency to be brought into Bangladesh without declaration to thecustoms authority was refixed at USD 5,000 from USD 3,000.
h) For convenience of the incoming and outgoing tourists/travelers and to eliminate the illegalactivities in foreign exchange, Bangladesh Bank issued 636 money changers (MCs) licenses tillSeptember 26, 1999. Subsequently, 376 licenses were cancelled upon detection of irregularitiescommitted by the MCs leaving 260 in operation. On-site and Offsite supervision on the activitiesof money changers has been further strengthened to ensure disciplined operations in this area.
Year 2005
The major changes in foreign exchange regulations in 2005 were as under:
a) The compulsion of covering forward sales by forward purchases with the same amountwere relaxed. Under the new arrangement Authorized Dealers (AD) were required to cover atleast 50 percent of their forward sales by forward purchases. The remaining portion may becovered by inter-bank forward purchase and spot purchase of export bills. Besides, forward salesassociated with swap transactions were not required to be covered by forward purchases.However, outstanding swap transactions would have to be limited up to the open position limitdesignated for the transacting AD. Banks were advised to undertake swap transactions in linewith counter party limit in accordance with core risk management guidelines issued by BankingRegulation and Policy Department of Bangladesh Bank on October 7, 2003.
b) ADs were instructed to prepare and submit currency-wise daily foreign exchange position as per revised format of exchange position statement.
c) Cash incentives for export of agriculture and agricultural products (fresh vegetables/fruits/agro-processing produces) would be 30 percent instead of 25 percent effective from July 1, 2004.
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d) Non-packer exporters would get cash incentives at 10 percent in case of export of frozenshrimp and other fish for retail packing.
e) Cash incentives or subsidy for export of jute and jute goods by Government and Private sector jute mills at 7.5 percent effective from July 1, 2004 to June 30, 2005.
f) To prevent the irregularities regarding non-entering of imported goods and non-tracing of theimporters against imports and import payments, all banks were advised to make themselvesconfirmed about the authenticity of importers, importers present and permanent addresses, their business, their good will, their previous transactions, eligibility etc. before opening of letter of credit. However banks have also been advised to make sure about entering of imported goodsagainst import payments.g) Restriction of advance payment against imports without the permission of Bangladesh Bank were withdrawn subject to availability of bank guarantee issued by internationally recognizedand renowned foreign banks on behalf of the foreign beneficiaries/suppliers.
h) To encourage more foreign investment in Bangladesh and to create scope for local
commercial banks to profitably invest their funds, local banks were given authorization to provide working capital loan facilities to B and C type industries in EPZs.
i) To ensure about entering of imported goods against import payments, commercial banks wereadvised not to open new LCs on behalf of the importers against outstanding/nonsubmitted bill of entries.
Year 2006
The major changes in foreign exchange regulations in FY06 were as under:
a) In order to attract more investment "The US Dollar Premium Bond Rules 2002” and “The USDollar Investment Bond Rules 2002” have been revised with effect from 3 July 2005. Accordingto the revised US Dollar Premium Bond Rules and Investment Bond Rules, non-resident accountholder means an individual of Bangladesh or foreign national residing abroad and holding a non-resident foreign currency account in a bank branch in Bangladesh with Authorized Dealership inforeign exchange.
b) It has been decided that prior Bangladesh Bank approval will, however, not be required for Taka advances by way of purchase of cheques in freely convertible currencies drawn by foreignembassies/international organizations/foreign nationals employed therein on their bank accountsabroad, provided that(i) the Authorized Dealer is fully satisfied about collectibility of cheque proceeds in foreigncurrency within four weeks of purchase,
(ii) the expected collection period is fully factored in while deciding the purchase price in Taka,and(iii) the purchases are with recourse to drawers of the cheques for any difficulty in collection.
c) It has been clarified that balance in the Nonresident Investors Taka Account (NITA) held for investment in Bangladeshi shares and securities may be transferred to the Foreign CurrencyAccount (FCA) of the same person with the respective AD without prior approval of BangladeshBank. Similarly, balance in the FCA may also be transferred to NITA without prior approval of
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Bangladesh Bank. However, in both the cases a written request of the account holder will berequired.
d) To attract investment in agro-based industry in Ishwardi EPZ it has been decided that subsidyfacility would be given for the export of liquid glucose produced in this EPZ and the rate of subsidy will be 20 percent of net repatriated fob value. This facility will be applicable for liquidglucose shipped during July 1, 2005 to June 30, 2006.
e) A decision has been taken by the government of Bangladesh that subsidy facility will be givenagainst export of light engineering products (Carbon Rod for battery, UM-1/R-20/D size battery,UM-3/R-06/AA size battery and locally manufactured glassware, manufacturing machinery,moulds and parts) produced within the country. This facility will be applicable for the export products where shipment will be made during 1 July 2005 to 30 June 2006. If these productshave value addition of more than 50 percent, then subsidy will be given at the rate of 10 percentof repatriated of net export value under prescribed conditions. In this connection, someguidelines have been issued to the ADs for compliance.
f) Authorized Dealers are instructed that besides bills of lading and Air Way Bills issued by theconcerned carriers, negotiation of export bills may also take place against Forwarders' CargoReceipts (FCRs) and House Air Way Bills (HAWBs) issued by freight forwarders provided thati) the export letter of credit and the export sale contract specifically provide for negotiation of export bill against FCR/HAWB (as the case may be ) issued by a freight forwarder, andii) the freight forwarder issuing the FCR/HAWB is operating in Bangladesh with authorizationfrom the Bangladesh Bank under Section 18A of the FER Act 1947.
g) Under Export Development Fund (EDF) preshipment credit facility in US Dollar was initiallyintroduced for import of raw materials, accessories, spare parts and packing materials againstexport letter of credits on sight basis. Now it has also been extended for import of the same itemson sight basis against export contract, provided that if any export proceeds becomes overdue for
not being repatriated within four months after the shipment, the concerned exporter and/or business entity is not allowed to avail further facility under Export Development Fund. A single borrower exposure limit is fixed up to a maximum of USD 1.00 million.
Year 2007
The major changes in foreign exchange regulations in 2007 were as under:a) Export subsidy for export of Halal meat will be given at 20 percent during 2007.
b) Cash incentives for export of selected items during 2007 is as follows; 5 percent for exportoriented local textile sector, 10 percent for frozen shrimp and fishes, 15 percent for leather products, 15 percent and 20 percent (depend on using local material) for products made byhoogla, straw, coir of sugar cane, 10 percent for tobacco, 10 percent for potato, 15 percent for bicycle and crust bone, 7.5 percent for jute products, 15 percent for hatching eggs and dayoldchicken of poultry industries, 10 percent for light engineering products and 20 percent for agroand agro processing products.
c) To attract investment in agro-based industry in Ishwardi EPZ it has been decided that subsidyfacility would be given for the export of liquid glucose produced in this EPZ and the rate of
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subsidy will be 20 percent of net repatriated fob value. This facility will be applicable for liquidglucose shipped during 1 July 2005 to 30 June 2008.
d) On August 2006, it was decided that term loans in Taka for capacity expansion/BMRE of foreign owned/controlled industrial firms may henceforth be extended/renewed by banks without prior approval of Bangladesh Bank provided that: 1) the term loan in Taka does not exceed, as percentage of total term borrowing, the percentage of equity of the firm/company held byBangladeshi nationals and firms/ companies not owned or controlled by foreigners, and 2) totaldebt of the firm/company does not exceed the 50:50 debt equity ratio. Besides, if requested,Bangladesh Bank may give consent to term borrowing proposals not confirming with thestipulations stated above.
e) For implementation of Uniform Customs and Practices for Documentary Credits (UCPDC-600), 2007 Revision, the Authorized Dealers (ADs) are advised to explicitly mention thatUCPDC-600 shall apply for all Letters of Credit (LCs) to be opened from 1 July 2007. Similarly,in case of exports from Bangladesh against LCs are in conformity with the rule of UCPDC- 600.If otherwise, ADs shall get the LCs amended accordingly.
Source: BAFEDA
Limits of Foreign Exchange Trading:
The foreign exchange market of the country is confined to the city of Dhaka. The 32 scheduled banks operating as authorized dealers in the inter-bank foreign exchange market are not permitted to run a position beyond certain limits. In the event of speculation on an appreciationof the value, an authorized dealer may buy more foreign currencies than it needs, but at the end
of the day it must maintain its limit by selling excess currencies either in the inter-bank market or to customers. Authorized dealers maintain clearing accounts with the Bangladesh Bank in dollar, pound sterling, mark and yen to settle their mutual claims. If there any excess foreign exchangeholdings exist after these transactions, it is obligatory for them to sell it to the Bangladesh Bank.In case of shortfall of the limit, authorized dealers have to cover it either through purchase fromthe market or from the Bangladesh Bank.
References
1.2. Bangladesh Review & Outlook - 2007, HSBC3. Bangladesh Bank, Annual Reports 2002, 2003, 2004, 2005, 2006, 2007 & 2009
4. Weekly Currency roundup, Standard Chartered Bank 5. Bangladesh Bank Quarterly Report Oct-Dec, 20076. The Social Organization of Remittances: Channelling Remittances from East and
Southeast Asia to Bangladesh by Md Mizanur Rahman and Brenda S.A. Yeoh7. http://www.bangladesh-bank.org8. http://www.bafeda.com/9. http://www.cpd-bangladesh.org
