Foreign exchange is such a sensitive commodity and subject to wide fluctuations in price that the bank which deals in it would like to keep the balance always near zero. The bank would endeavor to find a suitable buyer whenever it purchases so as to dispose of the foreign exchange acquired and be free from exchange risk.
Likewise, whenever it sells it tries to cover its position by a corresponding purchase. But, in practice, it is not possible to match purchase and sale for each transaction. So the bank tries in such a way that for the total of day’s transaction sales are near equal to purchases. If the amount of sales and purchases of a particular foreign currency are equal, the position of the bank in that currency is said to be ‘square’. If the purchases exceed sales, then the bank is said to be in an ‘over-bought’ or ‘long’ position.
If the sales exceed purchases, then the bank is said to be in an ‘over-sold’ or ‘short’ position. The bank’s endeavor would be to keep its position square. If it is in over-bought or over-sold position, it is exposing itself to exchange risks. The bank works out its position in each foreign currency separately. There are two aspects of maintenance of exchange positions. One is the total purchase or sale or commitment of the bank to purchase or sell. This is known as the exchange position or dealing position. The other is the actual balance in the bank’s account with its correspondent bank abroad. This is known as the cash position.
Dealing Position or Exchange Position
This is the overall position of the bank in a particular currency. All purchases and sales whether spot or forward are included here. In the case of forward contracts, they will enter into the exchange position on the date the contract with the customer is concluded. The actual date of delivery is not considered here. All purchases add to the balance and sales reduce the balance. The exchange position is worked out every day so as to ascertain the position of the bank in that particular currency and wherever remedial measures are needed they may be taken. For example, if the bank finds that it is over-sold to the extent of US $ 25,000 it may arrange to buy this amount from the inter-bank market.
Examples of sources for the bank for purchase of foreign currency are:
1. Payment of DD, MT, TT, Traveler cheques, etc.
2. Purchase of bills.
3. Forward purchase contract with export customers. (Entered in the position on the date of purchase.)
4. Realization of bills sent for collection.
Examples of avenues of sales are:
1. Issue of DD, MT, TT, Traveler cheques, etc.
2. Payment of bills drawn on customers.
3. Forward sale contract with importer-customers. (Entered in the position on the date of contract.)
The stock of foreign currency is held by the bank in the form of balances with correspondent bank in the foreign center concerned. For example, an Indian bank will have an account with Bank of America in New York. All the transactions of the bank in US.dollars will be routed through this account. If the bank is required to issue a demand draft in US dollars it will issue it on Bank of America, New York.
On presentation at New York the bank’s account with Bank of America will be debited. Likewise, when the bank purchases bills in US dollars they will be sent to another bank in the USA with instructions to remit proceeds to the credit of bank’s account with Bank of America. Thus, purchase of foreign exchange by the bank in India increases the balance and sale of foreign exchange reduces the balance in the bank’s account with its correspondent bank abroad. Cash position is the balance outstanding in the bank’s overseas account. If the balance is in debit it indicates oversold position; if it is in credit it indicates overbought position.
The exchange position and cash position may now be compared. The exchange position is concerned with the overall position of the bank with respect to a particular foreign currency. Transactions enter into the exchange position on the date of purchase/sale or on the date the bank commits itself to purchase or sell. The cash position is concerned with the exact date on which the bank’s overseas account is debited/credited.
For example, a bill purchased by the bank will enter into the exchange position on the date of purchase, but will be taken into account in the cash position only on the date it is realized and credited by the correspondent bank. Likewise, a forward sale contract enters into the exchange position on the date of contract itself, but will find a place in the cash position only on the date it is debited by the correspondent bank.
While the exchange position enables the bank to remain square and avoid exchange risk, the cash position enables it to keep just adequate funds at the foreign center to meet its commitments as and when they arise without running into deficits or keeping excess funds unnecessarily and suffering consequent loss.