Unique Source of Forex

Covered Interest Arbitrage

2009-11-18T09:13:00.001-08:00

i = one-year interest rate on (Eurocurrency ) deposits denominated
i* = one-year interest rate on (Eurocurrency) deposits denominated in the foreign currency
e = spot price of the home currency in terms of the foreign currency
f = one-year forward price of the home currency in terms of the foreign currency

Historical Background

2009-11-17T09:22:00.001-08:00

The Eurodollar market arose in the 1950s. The Soviet Union had large amounts of dollars from their oil sales. They did not want to hold them in the United States because of fears that the US would freeze them.
They found European banks that would accept their dollars as deposits. It is said that one was a French bank with the cable address eurobank, hence the name. Thus, there arose a large pool of dollars outside the United States and outside the control of US authorities.
In 1958 the British government introduced a restrictions on capital flows. British banks tried to get around these regulations by issuing loans dollar loans.
Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the late 1980s onwards, US companies began to borrow and hold money offshore. British banks found it attractive to make loans in dollars.
London is the most important centre.

Eurocurrency Markets

2009-11-16T09:11:00.000-08:00

Eurocurrency refers to deposits in a commercial bank which are denominated in a currency other than the currency issued by the country the bank is resident in. For example, a bank deposit denominated in dollars in a bank located in London is a Eurodollar deposit. It does not matter whether the bank is Barclays or an American bank.

The Timing of the Contract

2009-11-15T09:47:00.000-08:00

At time zero: All of the details of the contract were worked out
At time zero plus two months and two days: The exchange is carried out.

Example of a Forward Contract

2009-11-14T10:08:00.001-08:00

Frank Dollar, the foreign exchange manager at the Big American Automobile Company was informed that the BAAC is importing parts from Japan at a cost of 600 million yen, to be paid upon delivery in two months time. To protect the BAAC from exchange rate fluctuations, Frank Dollar arranged to purchase 600 million yen forward from Mega Bank. The two-month forward price was 120.00 yen/dollar. In two months and two days, Dollar paid 5 million dollars and received 600 million yen.

Types of Contracts

2009-11-13T09:22:00.000-08:00

Spot contracts -- a price and quantity are agreed upon. The two currencies are typically exchanged two business days later.
Forward contracts -- a fixed price contract made today for delivery of a certain amount of a currency at a specified future date. The specified date is the settlement date and the agreed price is the forward rate. More precisely, the two currencies are exchanged on an agreed upon date which is a certain number of days or months after the spot date. Thus, a three-month forward contract is conventionally settled in three months plus two days. Typically, no money changes hands at the time the contract is written

We can find cross rates with spreads

2009-11-12T08:53:00.001-08:00

In European form: The Swiss franc is 1.5020 – 1.5088 and the Swedish krona is 10.0025 – 10.0075. Find the kronar/franc cross rates.
The dealer will buy 1 Swiss franc for 1/1.5088 dollars. He will buy 1/1.5020 dollars for 10.0025/1.5088 = 6.6294 kronar. So, he will buy 1 Swiss franc for 6.6294 kronar.
The dealer will sell one Swiss franc for 1/1.5020 dollars. He will sell 1/1.5020 dollars for 10.0075/1.5020 =6.6628 kronar.
The kronar/franc cross rates are 6.6294 – 6.6628.

The Spread

2009-11-11T09:19:00.001-08:00

Foreign exchange dealers quote two rates: the rate at which they will buy the currency and the rate at which they will sell the currency.
Example: A newspaper may report that the Swiss franc had a central rate of 1.5024 francs /$ and a bid/offer spread of 020 – 028.
This means that the two exchange rates were 1.5020 and 1.5028. The dealer would buy dollars (sell Swiss francs) for 1.5020 Swiss francs per dollar. He would sell dollars (buy Swiss francs) for 1.5028 Swiss francs per dollar.
When expressed as units of currency per dollar, the smaller rate is the bid rate: the rate at which the dealer will buy (bid for) dollars. The higher rate is the offer rate: the rate at which the dealer will sell (offer) dollars.

Learn how to compute cross rates

2009-11-10T10:03:00.001-08:00

Suppose you are given exchange rates for currencies A and B in terms of currency C and that you are told to find the price of currency B in terms of currency A (or equivalently, units of currency A / currency B).
First, find the exchange rates for A and B in the form: units of A / units of C and units of B / units of C.
Then: units of A / units B = (units of A/units of C) / (units of B/units of C)

Another example:

2009-11-08T09:35:00.001-08:00

The Bhutan ngultrum is trading at 39.3020 Ngultrums per dollar.
The Mauritania ouguiya is trading at 251.620.
The cross rate is ngultrums / ouguiya = (ngultrums /$) / (ouguiya /$) = 39.3020/ 251.620 = .156196.

To find what the cross rate must be:

2009-11-07T09:23:00.000-08:00

Suppose the pound is quoted at 2.0000 dollars per pound.
Suppose that the euro is quoted at 1.3000 euros per dollar
Then, euros / pound = (euros /dollar) / (pounds/dollar) = 1.3000/.5000 = 2.6000

Example of Triangular Arbitrage

2009-11-06T09:30:00.000-08:00

Suppose the pound is quoted at 2.0000 dollars per pound.
Suppose that the euro is quoted at 1.3000 euros per dollar
Suppose that the pound is quoted at 2.5000 euros per pound
Trade 1 dollar for 1.3 euros. Trade 1.3 euros for 1.3/2.5 = .52 pounds. Trade for more than 1 dollar and make a profit.

Triangular Arbitrage

2009-11-05T09:23:00.000-08:00

Opportunities for triangular arbitrage arise when direct quotations (exchange rates in terms of the dollar - this is another sense of this word) and cross-rate quotations (two other currencies against each other) allow for profit making.
This entails using one currency to buy a second, a second currency to buy a third, and a third currency to buy the first.

Def. An exchange rate is the price of one currency in terms of another.

2009-11-04T09:30:00.000-08:00

A complication is that there are two ways to express any exchange rate.

Direct quote: the number of units of home currency necessary to buy one unit of foreign currency - the home currency price of foreign currency

Indirect quote: the number of units of foreign currency necessary to buy one unit of home currency - the foreign currency price of home currency

In terms of the dollar we have

American terms: dollars per other currency unit

European terms: other currency units per dollar

For example, suppose that the pound is trading at 2.0000 dollars per pound. We could also express the exchange rate at .5000 pounds per dollar.

Direct quote: the number of units of home currency necessary to buy one unit of foreign currency - the home currency price of foreign currency : .5000

Indirect quote: the number of units of foreign currency necessary to buy one unit of home currency - the foreign currency price of home currency: 2.0000

In terms of the dollar we have

American terms: dollars per other currency unit: 2.0000

European terms: other currency units per dollar: .5000

The dollar is the most important currency

2009-11-03T08:49:00.000-08:00

Many central banks hold the bulk of their reserves in the form of dollars; many central banks conduct much of their intervention in dollars; many international transactions are done using dollars; many contracts are invoiced in dollars.
The dollar is the major “vehicle” currency: if a dealer wants to trade Swiss francs for Mexican pesos, he will probably trade the francs for dollars and the dollars for pesos.

Central Banks

2009-11-02T09:45:00.001-08:00

Central Banks intervene in the foreign exchange market to influence the value of their currency.
Many central banks serve as the primary banker for their government and for other public enterprises.
Some central banks (for example, the Federal Reserve Bank of New York) act as agent for other central banks.
Some central banks actively manage their foreign exchange reserves.

Market Makers

2009-11-01T09:29:00.000-08:00

A market maker for a currency is a dealer who regularly quotes the rates at which he is willing to buy and to sell that currency.
During normal hours, he creates a two-sided market for its customers. He is willing (within reason) to both buy and sell at the rates he quotes.
He makes a profit from the spread; that is the difference between the selling and buying rates.

Foreign Exchange Dealers

2009-10-31T10:11:00.000-07:00

The market is made up of 2000 foreign exchange dealers. These are mostly commercial banks and investment banks. They trade with customers and with each other.
They are linked through telephones, computers and other electronic means.
There are about 100 – 200 market-making banks that account for the bulk of the trading.
The dealers don’t trade physical currency; they trade bank accounts denominated in different currencies.

London is the largest market

2009-10-30T10:40:00.001-07:00

London’s size as a financial centre is partially due to its historical importance and it relative lack of regulation.
London benefits from its proximity to major Eurocurrency markets.
London benefits from its time zone: London’s morning overlaps with late trading in the Far East and London’s afternoon overlaps with New York.
Most of the trading in London is done by foreign-owned institutions.

It is a 24-hour market

2009-10-29T09:44:00.001-07:00

The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore.
A few hours later, trading begins in Bahrain.
Late in the Tokyo day, markets open in Europe.
In the early afternoon in Europe, markets open in the United States.
In the mid to late afternoon in New York, markets open in the Asia-Pacific area.
Most of the activity takes place when European markets are open.

Reasons for the Changes

2009-10-28T10:05:00.000-07:00

The fall in 2001 was due to: the introduction of the euro, consolidation in the banking sector, mergers in the corporate sector.
The recent rise is more difficult to explain in terms of fundamentals.

From a 1998 publication by the NY Fed:

2009-10-27T11:38:00.000-07:00

Individual trades of $200 – 500 million are not uncommon.
Quoted prices change as often as 20 times a minute.
It is estimated that the world’s most active exchange rates can change 18,000 times a day.

The Foreign Exchange Market

2009-10-26T11:20:00.001-07:00

The foreign exchange market is by far the largest and most liquid financial market in the world.
It is many times larger than the next largest market: the US government securities market.
Despite its size and importance of the foreign exchange market, it is largely unregulated. No international organization supervises it; no international institution sets rules.

Theory #4: Expectations theory of forward rates

2009-10-25T10:02:00.000-07:00

Main idea:
The forward rate equals expected spot exchange rate

With risk, the forward rate may not equal the spot rate

If Group 1 predominates, then E(s€/$) < f€/$
If Group 2 predominates, then E(s€/$) > f€/$

Example of capital market equilibrium

2009-10-24T10:48:00.001-07:00

Fisher condition in U.S. and France:
(1 + r$(Real)) = (1 + r$) / (1 + i$)
(1 + r€(Real)) = (1 + r€) / (1 + i€)

If real rates are equal, then the Fisher condition implies:

The difference in interest rates is equal to the expected difference in inflation rates

Theory #3: The Fisher condition

2009-10-23T10:25:00.000-07:00

Main idea: Market forces tend to allocate resources to their most productive uses

So all countries should have equal real rates of interest

Relation between real and nominal interest rates:

(1 + rNominal) = (1 + rReal)(1 + i )

(1 + rReal) = (1 + rNominal) / (1 + i )

Evidence on interest rate parity

2009-10-22T10:45:00.000-07:00

Does interest rate parity hold?
Which way will funds flow?
How will this affect exchange rates?

Evidence on interest rate parity

Generally, it holds
Why would interest rate parity hold better than PPP?
Lower transactions costs in moving currencies than real goods
Financial markets are more efficient than real goods markets

Interest rate parity

2009-10-21T10:11:00.001-07:00

Main idea: Either strategy gets you the 100,000€ when you need it.
This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates

Example of a forward market transaction

2009-10-20T10:31:00.000-07:00

Suppose you will need 100,000€ in one year

Through a forward contract, you can commit to lock in the exchange rate

f$/€ : forward rate of exchange
Currently, f$/€ = 1.19854 Þ 1 € buys $1.19854
Þ 1 $ buys 0.83435 €

At this forward rate, you need to provide $119,854 in 12 months.

Theory #2: Interest rate parity

2009-10-19T10:20:00.001-07:00

Main idea: There is no fundamental advantage to borrowing or lending in one currency over another

This establishes a relation between interest rates, spot exchange rates, and forward exchange rates

Forward market: Transaction occurs at some point in future
BUY: Agree to purchase the underlying currency at a predetermined exchange rate at a specific time in the future
SELL: Agree to deliver the underlying currency at a predetermined exchange rate at a specific time in the future

What is the evidence?

2009-10-18T09:43:00.000-07:00

The Law of One Price frequently does not hold.
Absolute PPP does not hold, at least in the short run.
See The Economist’s Big McCurrencies
The data largely are consistent with Relative PPP, at least over longer periods.

Relative PPP

2009-10-17T10:09:00.000-07:00

Absolute PPP:

For PPP to hold in one year:

P€ (1 + i€) = E(s€/$) · P$ (1 + i$),

or: P€ (1 + i€) = s€/$ [E(s€/$)/s€/$ )] · P$ (1 + i$)

Using absolute PPP to cancel terms and rearranging:

Relative PPP:
Relative PPP
Main idea – The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates:

Absolute PPP

2009-10-16T10:04:00.000-07:00

If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:
May 21 : s€/$ = P€ / PUS
= 1235.75 € / $1482.07 = 0.8338 €/$

May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$

Absolute PPP

2009-10-15T12:39:00.001-07:00

Extension of law of one price to a basket of goods
Absolute PPP examines price levels
Apply the law of one price to a basket of goods with price P€ and PUS (use upper-case P for the price of the basket):

where P€ = Si (wFR,i · p€,i )
PUS = Si (wUS,i · pUS,i )

The Law of One Price

2009-10-14T10:17:00.001-07:00

Example:
Price of wheat in France per bushel (p€) = 3.45 €
Price of wheat in U.S. per bushel (p$) = $4.15
S€/$ = 0.83215 (s$/€ = 1.2017)

Dollar equivalent price
of wheat in France = s$/€ x p€
= 1.2017 $/€ x 3.45 € = $4.15

Þ When law of one price does not hold, supply and demand forces help restore the equality

Theory #1: Purchasing power parity

2009-10-10T15:11:00.000-07:00

The Law of One Price

A commodity will have the same price in terms of common currency in every country
In the absence of frictions (e.g. shipping costs, tariffs,..)

Example
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P$
S€/$ = spot exchange rate

The Foreign Exchange Market - Four theories

2009-10-08T09:37:00.000-07:00

Theory #1: Purchasing power parity

Theory #2: Interest rate parity

Theory #3: The Fisher condition

Theory #4: Expectations theory of forward rates

The Foreign Exchange Market - Definitions

2009-10-07T10:31:00.001-07:00

r$ : dollar rate of interest (r¥, rHK$,…)
i$ : expected dollar inflation rate
f€/$ : forward rate of exchange
s€/$ : spot rate of exchange
“Indirect quote”:
s€/$ = 0.83215 Þ 1 $ buys 0.83215 €
“Direct quote”:
s$/€ = 1.2017 Þ 1 € buys $1.2017

The Foreign Exchange Market...

2009-10-05T19:23:00.001-07:00

Some basic questions

Why aren’t FX rates all equal to one?

Why do FX rates change over time?

Why don’t all FX rates change in the same
direction?

What drives forward rates – the rates at
which you can trade currencies at some future
date?

The Foreign Exchange Market

2009-10-04T11:57:00.000-07:00

Some currency rates as of May 21, 2004:

Per U.S. dollar:
Brazil (Real) 3.1939
Mexico (Peso) 11.5754
Japan (Yen) 112.2839
Indonesia (Rupiah) 89066
South Africa (Rand) 6.7295
United Kingdom (Pound) 0.5593

Foreign Exchange Markets

2009-10-01T20:00:00.000-07:00

The foreign exchange (FX) market

Basic questions and definitions

Four theories

- Purchasing Power Parity

- Interest Rate Parity

- Fisher condition for capital market equilibrium

- Expectations theory of forward rates

FX Quant Advisors - Tactical Asset Allocation Fund

2009-10-01T00:35:00.001-07:00

Managed Accounts Program

Tactical Asset Allocation Fund - Five-year proven track record (average over 50% per year)

True diversification – non-correlated to traditional asset classes (stocks, bonds,
real estate). Alternative asset class yields higher risk-adjusted rate of return (MPT)

Managed account funds held at JP MorganChase – only clients can access account funds

Trading execution on an institutional (Currenex) trading platform – no dealing desk intervention

Transparency – clients can monitor account online 24/7

Liquidity – no restrictions on client withdrawals

Fees – primarily performance-based – FXQA makes money when you make money*

*FXQA also charges a spread mark-up

Trading Strategy and Money Management Principals

2009-10-01T00:34:00.000-07:00

Trading Advisor utilizes technical analysis of the Forex markets as the primary determinant of its trading strategy. Technical analysis operates on the theory that market prices at any given point in time reflect all known factors affecting supply and demand for a particular market.

Technical analysis is of particular concern in the timing of entry and exit positions, in ascertaining the development of trends, and in evaluating the extent to which the market price reflects the underlying value.

The inherent structure of most investment (mutual) funds is reliant on a directional market (on the long side only) – whereas the Advisor is indifferent to market direction (long or short). The focus is on precision of market entry/timing signals and favorable risk/reward algorithms.

The overall trading program is not only diversified by its use of multiple systems, but also by markets and timeframes. These layers of diversification are intended to expand the range of opportunities, reduce overall program risk, and provide a high degree of non-correlation between the returns of the GMF Managed Account program and global stock and bond markets.

The focus is on risk reduction, capital preservation, anticipation of significant technical levels, efficient trade entry and exit points, and continual evaluation and adjustment of portfolio exposure.

Attempt to eliminate large losses and show profit day in and day out through ANY market condition.

The Trading Advisor

2009-10-01T00:33:00.002-07:00

The Trading Advisor for the Tactical Asset Allocation Fund is FX Quant Advisors (“FXQA”) – FXQA is a subsidiary of Protrade Capital Group, LLC., a California limited liability company. FXQA provides FX advisory and asset management services to institutional and high net-worth clients. The Managing Director and Trading Advisor of FXQA is Mr. Mark Shawzin.

Mr. Shawzin has over twenty-five years experience in the stock and futures and Forex markets in varying capacities as an analyst, broker, trader and portfolio manager. Since 1979, Mr. Shawzin has traded for his personal account and has managed discretionary accounts for individuals and institutional accounts , including Commodity Corp. (a division of Goldman Sachs), Itafin, GIC Management Co. and the Laurentian Bank of Canada, based on his proprietary trading methods and analysis.

During his trading and brokerage career, Mr. Shawzin was a senior broker and officer with Merrill Lynch, EF Hutton, Drexel, Burnham & Lambert, and Oppenheimer & Co. and a senior portfolio manager with Bridgewater U.S.A. and Global Futures Exchange & Trading Co.

Mr. Shawzin has spent thousands of hours developing his proprietary trading methodology and has worked extensively in the areas of portfolio optimization, risk management and trading strategy development.

In 1979 Mr. Shawzin graduated from USC Business School with a degree in Finance and Management.

FX Quant Advisors - Managed Account Features & Benefits

2009-10-01T00:33:00.001-07:00

Professional management
Leverage and low investment requirements
Optimal "per trade" risk management
Broad Diversification
Access to International markets
Non-correlated to traditional equity and fixed income markets
Potential profits in both rising and falling markets
Liquidity – month-to-month
Transparency – monitor/view account 24/7 in “real-time”
No commingling of accounts

Why Managed Forex

2009-10-01T00:32:00.000-07:00

Forex markets have many important advantages over other investment alternatives:

Forex markets are highly liquid and trade 24 hours a day around the world.

Forex markets offer leverage without interest expense. An equivalent amount of money can control significantly more value than futures or stocks.

Forex markets are traded globally, which makes it possible to spread risk and participate in potential profit opportunities around the world.

Forex can be traded in both rising and falling markets. Because there is no prohibition against short sales in Forex markets, it is just as easy to establish a short position with the objective of profiting from declining prices, as it is to establish a long position with the objective of profiting from rising prices.

Because managed Forex accounts have a low to negative correlation to stocks and bonds, adding them to the traditional portfolio mix enhances risk-adjusted returns.

SAFETY OF FUNDS: Your money remains deposited with a large and reputable FX dealing firm (FXDD) – client deposits are held at JPMorgan Chase bank.). FXQA cannot and will not accept custody of your funds or securities.

TRANSPARENCY – clients can view/monitor their account balances/positions in real-time 24/7

Managed Forex is suitable for your IRA, 401(k), Roth IRA, & SEP

FOREX = Controlled Risk

2009-10-01T00:31:00.000-07:00

Perception = Higher leverage capability implies Forex most “risky” investment vehicle
Reality = no other trading market (stocks, futures) offers the ability to CONTROL
RISK as well as FOREX market:

FOREX Trades 24hrs/day/6days/week – means no price gaps, stop-loss orders ALWAYS working
LIQUID - $1.5 – 4 trillion/day turnover – INSTANT EXECUTION on large $ orders
NO SLIPPAGE on stop orders (even in fast market) – HUGE advantage
No fixed unit size – FLEXI-LEVERAGE – select trade unit size ($10,000 mini or $100,000 standard lot) to meet individual/customized risk/reward parameters
Electronic platform “kicks-out” positions before go negative – NO DEBIT BALANCES, NO MARGIN CALLS
Limit your risk to an amount you choose: System software offers clients ability to automatically close out positions and cease trading at a specified risk tolerance level

Forex vs. Stocks

2009-10-01T00:26:00.000-07:00

Forex
- Open 24 Hours, 6 Days a Week
- Superior Market Liquidity
- Profit Potential in both
rising and falling markets
- No commission fees
- Increased leverage

Stocks
- Open Limited Hours
- Limited Liquidity
- Profit in rising markets
- Commission fees
- Limited leverage

FX Market - Overview

2009-10-01T00:25:00.000-07:00

FX market more than 40x US stock market
FX market has no physical location or central
Exchange
Operates through an electronic network
of banks, corporations, institutional
investors and individuals
Trades filled in seconds
Forex market operates on a 24-hour basis,
spanning from one zone to another across
the major global financial centers

Features and Advantages of the FOREX market

2009-10-01T00:24:00.000-07:00

LARGEST and most LIQUID investment market in the world ($1.5 - 4 trillion per day – 50x larger than US stock market)
LIQUIDITY – trades 24 hours/day and 5.5 days/week
LEVERAGE –100:1 on invested $ - $1,000 controls $100,000
FASTER LEARNING CURVE – 15-20 currency pairs vs. 40,000 stocks
CONTROLLED RISK – 24 hour market means no price gaps – no slippage on stops - clients set a $ stop-loss limit on their account
INSTANT EXECUTION – FX market is all electronic – no delays in order fills
NON-CORRELATED to traditional asset classes (stocks, bonds, real estate) – true DIVERSIFICATION
TRENDING MARKETS – Forex markets tend to trend for days, weeks, months and years
NO UPTICK RULE - ability to go long and short with equal ease
NO MARGIN CALLS – trading software will not let an account go deficit - can’t lose more than you invest!
NO FINANCIAL DISCLOSURE – clearing firm does not report financial gains

FX Quant Advisors - The Current Investment Environment

2009-10-01T00:23:00.000-07:00

U.S. stock market – high-volatility, non-trending market environment makes trading success difficult for S-T AND L-T investors/traders. Recession likelihood & mid-low single-digit returns makes L-T risk/reward unfavorable for this asset class.

Inflation soaring – unofficial estimates now over 10%/year!

Mutual Fund investor return - paltry 3.5% over twenty-year period.

Rising L-T interest rates constraining returns for “traditional assets” - stocks, bonds & real-estate.

Money-market yield at 2.0%; 10-year government treasury bond yield 3.8%.

Real estate investors prisoner of “credit crunch”.

Twin deficits (trade/budget) and “demographic bubble” - long-term overhang over economy and inhibiting investment returns.

FXQA believes we have positioned our portfolios to take advantage of these trends. What are you doing to protect and/or enhance your portfolio?

FX Quant Advisors - Philosophy

2009-10-01T00:22:00.000-07:00

IT IS ABSOLUTELY NECESSARY TO HAVE AN EDGE...
"You can't win without an edge, even with the world's
greatest discipline and money management skills.
If you could, then it would be possible to win at
roulette (over the long run) using perfect discipline
and risk control. Of course, that is an impossible
task because of the laws of probability. If you don't
have an edge, all the money management and discipline
will do for you is to guarantee that you will gradually
bleed to death.”

Incidentally, if you don't know what your edge is,
you don't have one.

FX Quant Advisors

2009-10-01T00:21:00.000-07:00

The Current Investment Environment

About the FOREX market – Features & Advantages

Trading Styles & Methodologies

Managed Account Program – Features & Benefits

About FX Quant Advisors

How to Open An Account

Conclusions and Concerns (4)Main Concerns

2009-09-28T20:42:00.001-07:00

Delay in bankruptcy proceedings and credit dispute resolution
Time taken for winding up proceedings is highest in the world
Improvement in effective enforcement of creditor rights required
Faster resolution of stressed assets of financial intermediaries
Regulation of financial conglomerates and holding companies
Role of SROs
Regulatory co-operation – particularly cross border
Management of capital account
Deficiency in retail payment systems

Conclusions and Concerns (3)Main Concerns

2009-09-28T20:40:00.000-07:00

Financial Markets –
Risk of contagion
Development of an appropriate risk free yield curve
Corporate bond markets
Issues relating to derivatives – knowledge concentration and capacity building
Transparency –
Some issues in fiscal transparency; Need to strengthen data collection agencies

Conclusions and Concerns (2)Main Concerns

2009-09-28T20:39:00.000-07:00

Macro economy –
Fiscal Deficit
Agricultural Growth
Susceptibility to international commodity price movements
Institutions –
Emerging liquidity concerns
Corporate governance in co-operative sector
Health of rural co-operatives
Funding constraints for NBFCs
Lack of timely data to gauge household indebtedness
Stress Testing
Lack of database, techniques and capacity to conduct appropriate systemic stress tests taking into account sectoral interlinkages as also contagion risk

Conclusions and Concerns (1)Summary of Assessment

2009-09-28T20:38:00.000-07:00

Financial Sector – Has expanded; acquired greater depth and vibrancy
Macro economy – Short-term - Uncertainty; Medium-term - high growth sustainable
Banks – Healthy and Robust
Financial Markets – Resilient and fairly liquid
Financial Infrastructure – Robust
Transparency – Significant improvements

CFSA and Advisory Panels – Some Differences

2009-09-28T20:37:00.002-07:00

Regulatory Independence
Panel view : Issues regarding independence of SEBI and IRDA
CFSA view: Regulatory independence adequate
Review of Legislation
Panel view : Review of RBI Act needed
CFSA view : Requires to be viewed in a more comprehensive manner
Role of HLCCFM
Panel view : Further formalisation and institutionalisation
CFSA view: Not consistent with regulators’ autonomy
Prompt Corrective Action
Panel view : Appropriate time-frame required
CFSA view: Any rigidity in timeline unduly restrictive

Accounting and Auditing

2009-09-28T20:37:00.001-07:00

Ian Mackintosh
Exercise caution while developing country specific and sector specific accounting standards
Important to give functional independence to AASB
N.P. Sarda
Determining the role of the Quality Review Board to review and improve the quality of audit service is required

Peer Reviewers’ Comments (3)

2009-09-28T20:36:00.000-07:00

Bankruptcy Laws
Thomas Baxter
Indian insolvency regime remains an enigma
Special Insolvency regime for banks complement access to credit facilities of central bank and deposit insurance
Fiscal Transparency
Vito Tanzi
Better classification of expenditure central to fiscal policy
Relevant fiscal target should be GFD and not revenue deficit
Relatively few countries have made a transition to accrual based accounting

Peer Reviewers’ Comments (2)

2009-09-28T20:35:00.000-07:00

Assessment of BCP
Eric Rosengren
Urgent need to improve co-ordination between regulatory agencies
LoLR should have the ability to assess solvency and liquidity risks facing institutions
Report should elaborate on aspects relating to Central Government’s role in operation of PSBs – whether it interferes with the regulatory role of RBI
Corporate Governance and
Transparency in Monetary Policy
Sir Andrew Large
Higher corporate governance standards for the unlisted sector
Mechanism to enable central bank to be adequately informed to handle liquidity related events
Improvements in transparency would enhance central bank independence

Financial Stability Assessment and Stress Testing

2009-09-28T20:33:00.000-07:00

V. Sundararajan
Plausible shocks and vulnerabilities arising out of domestic macroeconomic and external sectors should be systemically linked to stress scenarios
Growing use of purchased funds need analysis of second round contagion effects
Andrew Sheng
Creation of secondary mortgage market
Setting up of Government sponsored secondary mortgage vehicles
On-site examination process should be supplemented by a forensic “follow the evolution of the product” approach.

Transparency and Development Issues (4) Making Financial Inclusion Work

2009-09-28T20:32:00.000-07:00

Rangarajan Committee on financial inclusion
Exploit synergies between local and national level financial institutions
Finance consumption and household expenditure
Scale-up IT initiatives
Biometric smart cards in rural areas
Development of mobile banking
Incentivise BCs
Urban poor
Dilute KYC norms

Transparency and Development Issues (3) Assessment of Data Dissemination Standards

2009-09-28T20:31:00.000-07:00

Major Gaps:
Need for proper legal and institutional support for CSO
IIP data - need to adjust basket of commodities and weights assigned
Multiple agencies in collection of labour data
WPI – outdated weights

Transparency and Development Issues (2) Assessment of Fiscal Transparency

2009-09-28T20:30:00.002-07:00

Significant improvement following FRBM Act and Fiscal Responsibility Legislations
Major Gaps/Issues:
Functional overlap by Central Government on issues relating to State Government like health and agriculture
Mode of calculating FD does not capture off-budget items separately –augmented FD required
Need for accrual-based accounting – guarded approach

Transparency and Development Issues (1)Assessment of Transparency in Monetary and Financial Policies

2009-09-28T20:30:00.001-07:00

Major Gaps/Issues:
Need for review of legislations- overhaul of legislations not required
Operational independence of RBI
Strengthening TACMP – requires ongoing review
Separation of debt management from monetary management – Chairman’s
dissent
Price index for measuring inflation – WPI/CPI debate

Financial Infrastructure (7)Depositor Protection

2009-09-28T20:29:00.000-07:00

Independence of Deposit Insurance and Credit Guarantee Corporation (DICGC) (recommended by Advisory Panel)
Increase flat-rate premium
Involvement of DICGC in resolution process- delink settlement of DICGC claims from liquidation process

Financial Infrastructure (6)Assessment of Bankruptcy Law Principles

2009-09-28T20:28:00.002-07:00

Major Gaps:
Implementation of bankruptcy laws – poor- average 10 years to complete liquidation proceedings – ‘Doing Business Report’- World Bank
Amendment to the Companies Act still pending – Setting up of NCLT
Issues relating to Competition Amendment Act, 2007
Lack of a Central Registry for recording security interests

Financial Infrastructure (5)Business Continuity Management

2009-09-28T20:28:00.001-07:00

Ease of operations during crises
Areas for strengthening
Human Resources management
Business continuity processes of vendors
Outsourcing risk
Succession planning

Financial Infrastructure (4)Payment and Settlement

2009-09-28T20:26:00.000-07:00

Payment & Settlement Act of 2007 fills a major gap

Sub-optimal utilisation of electronic payment infrastructure

Delays in collection of outstation cheques

Financial resources with CCIL need strengthening

Financial Infrastructure (3)Accounting and Auditing

2009-09-28T20:25:00.002-07:00

More autonomy for Accounting Standards Board

Need to develop sector-specific guidance

Issues in auditing about convergence with ISAs

Need to give functional independence to AASB

Financial Infrastructure (2)Markets and Liquidity

2009-09-28T20:25:00.001-07:00

Large capital movements
Volatility in overnight rates
Strengthen government cash management
Asset liability management of banks
Issues related to market integrity—participatory notes
Term liquidity facility not required at this stage

Financial Infrastructure (1)Regulatory Infrastructure

2009-09-28T20:24:00.000-07:00

Multiple roles of regulators
Consistent with financial development
Needs effective coordination
Principles vs. Rules-based: complementary
Develop supervision of financial conglomerates
Legislation, a new Act?
Develop Self -Regulatory Organisations?
Regulatory independence
Panels have raised some issues
But CFSA considered adequate

Financial Markets (8) Compliance With IOSCO

2009-09-28T20:22:00.000-07:00

Despite high compliance, some gaps remain
Equities Market: Responsibilities and operational independence of regulator; inspection and surveillance powers; capital and prudential requirements for market intermediaries
Foreign Exchange Market: Operational independence and accountability of regulator; co-operation and detection of manipulation and unfair trading practices
G-Sec markets: Operational independence and accountability of regulator; home-host co-operation; disclosure of financial results
Money markets: Operational independence; regulatory co-operation with foreign regulator

Financial Markets (6)Other Market Segments

2009-09-28T20:20:00.000-07:00

Need to develop corporate bond market

Develop credit risk transfer mechanism

But with appropriate checks and balances

Capacity building in financial institutions with

regard to securitisation and credit derivatives

Financial Markets (5)Money Market

2009-09-28T20:19:00.000-07:00

Liquid market
Increased share of repo and CBLO
Need for active interest rate futures market
Being re-introduced
Development of term money market
Development of short-end yield curve necessary
Under examination in TAC Group
Development of the repo market

Financial Markets (4)Equity Market

2009-09-28T20:18:00.002-07:00

Significant improvement in market and settlement infrastructure
Functions in robust regulatory environment
Very high compliance with IOSCO Principles
Risk management by market participants
Strengthening of inter-exchange surveillance
Need to improve IPO processes
Setting up of Central Integrated Platform

Financial Markets (3)Sovereign Debt Market

2009-09-28T20:18:00.001-07:00

Significant growth in volume and liquidity
Further diversification of investor base needed
Foreign investor participation: proceed with care
Increase in tradable assets desirable
Large proportion parked in HTM category

Financial Markets (2)Foreign Exchange Market

2009-09-28T20:17:00.000-07:00

Fastest growing market globally
Total annual turnover increased from USD 1.3 trillion
during 1997-98 to USD 12.3 trillion during 2007-08
Derivatives:
High growth in forward market
Forex futures introduced in 2008
Need for monitoring and regulation
Customer appropriateness and product suitability

E. Financial Markets

2009-09-28T20:16:00.002-07:00

Financial Markets (1)Regulation and Supervision

Systemic stability
Importance of markets other than equity market
IOSCO Principles extended to:
G-Sec markets; Forex Markets; Money Markets
Results: Generally satisfactory

Financial Institutions (10)An Assessment of Insurance

2009-09-28T20:16:00.001-07:00

Significant growth in size, penetration and diversified products
Comfortable solvency and capital adequacy
But gaps/issues remain
Increase supervisory powers of IRDA
Group-wide supervision – effective policy to be put in place
Risk Management
Further requirement of skilled professionals – actuaries, treasury managers

Financial Institutions (9)An Assessment of Insurance

2009-09-28T20:13:00.002-07:00

The level of compliance of the Insurance Sector to IAIS Core Principles

Assessment
Observed
Number of Principles - 5
Largely Observed
Number of Principles - 13
Partly Observed
Number of Principles - 10
Not Observed
Number of Principles - 10

Financial Institutions (8)Non-Bank Financial Services

2009-09-28T20:13:00.001-07:00

NBFCs are key players in financial markets
Corporate bond market development would ease funding constraints
Development of regulatory structure for financial conglomerates
Prudential regulations of NBFCs strengthened – some way to go
Housing finance: growing and important segment
National Housing Price Index, Housing Starts Index a priority
Regulation of HFCs should be entrusted to RBI – Government’s stance – status quo

Financial Institutions (7) Risk Management and Governance

2009-09-28T20:11:00.000-07:00

Conservative risk management matters
Counter-cyclical prudential measures by RBI
Off-balance sheet items: Better accounting, disclosure
Capital charge if reliance on purchased liquidity beyond a threshold

Consolidation
Encourage market-based consolidation

Co-operative and rural banks need better governance
Dual control: improve corporate governance
Regulation and supervision of rural financial sector: role for RBI and NABARD

Financial Institutions (6) New Competition Act: Some Issues

2009-09-28T20:10:00.000-07:00

Power of Competition Commission to regulate combination
Any combination required to be notified to Commission
Maximum period of wait 210 days
RBI may be able to give sanction only after getting order of Commission or wait for 210 days
Delays the process
Possibility of regulatory conflict as order of any statutory authority not binding on Commission
Could lead to regulatory overlap and conflict
Central Government could give necessary exemption under Section 54 of the Competition (Amendment) Act 2007

Financial Institutions (5)Banking For The 21st Century

2009-09-28T20:09:00.000-07:00

Capacity Building:
Training
Succession Planning
Lateral Recruitment
Improved remuneration – but discourage excessive risk taking
Corporate Governance:
Improve governance in PSBs
Roadmap for foreign banks –
A well-considered approach within the WTO norms

Financial Institutions (4)Commercial Banks Oversight

2009-09-28T20:08:00.000-07:00

Government ownership poses dilemmas
Possibility of conflicts of interest minimized through even-handed regulation
Newer instruments
Through selective dilution of government equity

Capital augmentation of PSBs is a challenge,
but could be managed through a variety of ways
Amalgamation where commercial synergies exist

Financial Institutions (3)Basel Core Principles: A Compliance Summary

2009-09-28T20:07:00.001-07:00

Major Gaps:
All Institutions: Risk management (for commercial banks the level of compliance is comparatively lower in respect of banking groups); home-host country regulation
Commercial Banks: Exposure to related parties; non-compliance in respect to interest rate risk in banking book for which guidelines have since been issued
Rural & Co-operative Banks: Dual Control; internal control; corporate governance
NBFCs: Major acquisitions, transfer of significant ownership, internal control
HFCs: Permissible activities; internal control

Financial Institutions (1)Regulation and Supervision

2009-09-28T20:06:00.000-07:00

Inherent linkages across institutions
Inter-bank
Bank and non-banks
Basel Core Principles not applicable to:
Co-operative Sector; Regional Rural Banks;
NBFCs; HFCs
But, Assessment done for health check
Results: Generally satisfactory

Stability Assessment and Stress Testing (9)The Way Forward

2009-09-28T20:05:00.000-07:00

In Sum:
Commercial Banking System – Broadly Sound
Can withstand significant shocks from large potential changes
Possible Next Steps:
Need to strengthen liquidity management
Stress Testing by individual banks
Periodic scenario testing by RBI
Setting up of a Financial Stability Unit

Stability Assessment and Stress Testing (8)Liquidity Risk Management

2009-09-28T20:04:00.000-07:00

Gradual, growing dependence on purchased liquidity

Increase in illiquid parts of banks’ balance sheets

Greater reliance on volatile liabilities for asset growth

Stability Assessment and Stress Testing (6)Interest rate risk

2009-09-28T20:03:00.002-07:00

Calculates the erosion in accounting capital due to unit
increase in interest rate

Higher the DoE (duration of equity), greater the sensitivity
of banks capital to interest rate shocks
The annualised yield volatility is estimated at 244 bps

Given a DoE of 8.1 years, a 244 bps shock implies
an erosion of 20 per cent of capital and reserves.

=> Better management of interest rate risk by
commercial banks over time

Stability Assessment and Stress Testing (5)Credit Risk

2009-09-28T20:03:00.001-07:00

Concerns about credit risk remain
muted at present

Need for close monitoring of such risks
in the current scenario

Stability Assessment and Stress Testing (4) Stress Testing

2009-09-28T20:00:00.000-07:00

What is Stress Testing
Techniques to assess vulnerability of the financial system in the face of shocks;
identifies how portfolios respond to changes in key economic variables: e.g., interest rates, credit quality
Coverage of stress tests
Credit risk
Market/interest rate risk
Liquidity risk
Open positions in foreign exchange much below regulatory limits – Exchange rate tests not undertaken

C. Stability Assessment and Stress Testing

2009-09-28T19:58:00.002-07:00

Stability Assessment and Stress Testing (1)
Main Findings

Financial Institutions
Commercial Banks: financially robust
NBFCs and HFCs: healthy financial indicators
Some financing concerns
UCBs and RRBs: improvements in financials
governance concerns
Rural Co-operative Sector
significant weaknesses

Macroeconomic Outlook and Vulnerabilities (2)Pressing Challenges

2009-09-28T19:58:00.001-07:00

Need for revival of growth in agriculture
Address restoration of the fiscal reform path
Continuation of financial sector consolidation and development
Address the infrastructure deficit
Complement bank financing with bond market development
Insurance and pension reforms
FCAC desirable, but with concomitant macroeconomic and market developments

Macroeconomic Outlook and Vulnerabilities

2009-09-28T19:56:00.000-07:00

Macroeconomic Outlook and Vulnerabilities (1)
The Growth Story

Growth in recent period contributed by several factors

High domestic demand

Productivity

Credit growth

High levels of savings and investment

Current global financial crisis: shift from
benign outlook to one of uncertainty
8 %+ growth sustainable in the medium-term due to
high demand; deceleration in the short-term

Background and Timing (3)The Process

2009-09-28T19:55:00.000-07:00

Benefits
Composition of CFSA: ownership and commitment
Regulatory cooperation: GoI, RBI, SEBI, IRDA, other agencies
Involvement of experts: advisory panels
Peer reviews: Impartiality
Learning and capacity-building: involvement of professionals
Execution
Complex issues – approach with humility
Broad directions instead of specifics in the current context
Focus on Transparent Reporting : Differing opinions of CFSA and
Panels covered in the report

Background and Timing (2)Overview of Self-Assessment

2009-09-28T19:54:00.000-07:00

Approach and Methodology

Pillar I Macro-prudential surveillance and financial stability analysis

Pillar II Legal and institutional frameworks review

Pillar III International financial standards and codes:
assessment and status of implementation

The FSAP and Self-Assessment

2009-09-28T19:53:00.000-07:00

A. Background and Timing

Background and Timing (1)
The Story So Far

IMF-WB FSAP in 2001, self-assessment of international
standards and codes in 2002, reviewed again in 2005

Set up CFSA in 2006

India among the first country to undertake
comprehensive and holistic self-assessment
of financial sector

Post-crisis, emphasis by the G-20