Interbank deals refer to purchase and sale of foreign exchange between the banks. In other words it refers to the foreign exchange dealings of a bank in the interbank market. The main features of interbank deals are given in this section.
Cover Deals
Purchase and sale of foreign currency in the market undertaken to acquire or dispose of foreign exchange required or acquired as a consequence of the dealings with its customers is known as the ‘cover deal’. The purpose of cover deal is to insure the bank against my fluctuation in the exchange rates.
Since the foreign currency is a peculiar commodity with wide fluctuations in price, the bank would like to sell immediately whatever it purchases and whenever it sells it goes to the market and makes an immediate purchase to meet its commitment. In other words, the bank would like to keep its stock of foreign exchange near zero. The main reason for this is that the bank wants to reduce the exchange risk it faces to the minimum. Otherwise, any adverse change in the rates would affect its profits.
Trading
Trading refers to purchase and sale of foreign exchange in the market other than to cover bank‘s transactions with the customers. The purpose may be to gain on the expected changes in exchange rates.
Funding of Nostro Account
Funding of nostro account of the bank is done by realization of foreign exchange in the relevant currency purchased by the bank. If sales exceed purchase to avoid overdraft in the nostro account, the bank would purchase the requisite foreign exchange in the interbank market and arrange for its credit to the nostro account
Some of the foreign banks who maintain nostro accounts with the bank may fund the account by arranging remittance through some other bank. Or the foreign bank concerned may request the Indian Bank to credit its rupee account and in compensation credit the account of the Indian bank with it. When required to quote a rate for this transaction, the bank in India, would quote the rate at which it could dispose of the foreign exchange in India, viz., the market buying rate. Exchange margin may not be taken for such transactions.
Swap Deals
A ‘swap deal’ is a transaction in which the bank buys and sells the specified foreign currency simultaneously for different maturities. Thus a swap deal may involve:
- Simultaneously purchase of spot and sage of forward or vice versa; or
- Simultaneously purchase and sale, both forward but for different maturities, For Instance, the bank may buy one month forward and sell two months forward. Such a deal is known as ‘forward to forward swap’.
To be precise, a deal should fulfil the following conditions to be called a swap deal:
- There should be simultaneous buying and selling of the same foreign currency of same value for different maturities; and
- The deal should have been concluded with the distinct understanding between the banks that it is a swap deal.
A swap deal is done in the market at a difference from the ordinary deals. In the ordinary deals, the following factors enter into the rates;
- The difference between the buying and selling rates; and
- The forward margin. i.e., the premium or discount.
In a swap deal, the first factor is ignored and both buying and selling are done at the snow rate. Only the forward margin enters into the deal same as the swap difference.
Arbitrage Operations
If perfect conditions prevail in the market, the exchange rate for a currency should be the same in all centres. For example, if US dollar is quoted at Rs.49,4000 in Mumbai, it should be quoted at the same rate of Rs. 49,4000 at New York. But under imperfect conditions prevailing, the rates in different centres may be different. Thus at New York Indian rupees may be quoted at Rs.49,4800 per dollar. In such a case, it would be advantageous for a bank in Mumbai to buy US dollars locally and arranged to sell them in New York. Assuming the operations to involve Rs.10 lakhs the profit made by the bank would be:
At Mumbai US dollars purchased for Rs.10,00,000 at Rs.49,4000 would be (10,00,000 ÷ 49,4000) USD 20,242.9). Amount in rupees realized on selling USD 20,242.91 at New York at Rs.49.4800 would be Rs.10,0,.619. Therefore, the gross profit made by the bank on the transactions is Rs.1,619. The new profit would be after deducting cable charges, etc., incurred for the transactions. The purchase and sale of a foreign currency in different centres to take advantage of the rate differential is known as ‘arbitrage operations’. When the arbitrage operations involves only two currencies, it is known as ‘simple’ or ‘direct’ arbitrage.