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Description

Overview On FOREX Management

A PROJECT REPORT Submitted by Chirag Shah Batch 2009-2011 in partial fulfillment for the award of the degree

POST GRADUATE DIPLOMA IN MANAGEMENT

Under the Guidance of

Prof Aditi Mahajan THAKUR INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH KANDIVILI MUMBAI

Thakur Institute Of Management Studies And Research

ACKNOWLEDGEMENT Two months of summer training at Anugrah Stock & Broking Pvt Ltd

has been a great value addition to my career that would not have been possible without continuous guidance and administration of certain key people

I would like to place on record,

my sincere gratitude to each of them

I am grateful to Dr

Mrinalini Kohojkar,

Director,

Thakur Institute Of Management Studies and Research for giving me this opportunity

I would like to express my appreciation towards Mr

Balkishan Sharma for giving me the opportunity to work on this project

I express my gratitude and indebtedness to him for guiding me in every aspect for making this effort a great success

I sincerely thank Prof

Aditi Mahajan,

Thakur Institute Of Management Studies and Research for the valuable guidance extended by them during my entire course in the preparation of this dissertation and for letting me their valuable time when ever I was in need

Thakur Institute Of Management Studies And Research

Executive Summary This project gives an in-depth analysis and understanding of Foreign Exchange Markets in India

It helps to understand the History and the evolution of the foreign market in India

It gives an overview of the conditions existing in the current global economy

It gives an overview of the Foreign exchange market

It talks about the foreign exchange management act applicable and also gives details about the participants in the forex markets

It also talks about what are the sources of demand and supply of foreign exchange in the market all over the world

The report also talks about the Foreign Exchange trading platform and how the efficiency and the transparency is maintained

The report focuses on corporate hedging for foreign exchange risk in India

The report contains details about some companies Foreign Exposure and how they have maintained it

It also talks about the determinants to be taken care of while taking corporate hedging decisions

It gives insights about the Regulatory guidelines for the use of Foreign Exchange derivatives,

Development of Derivatives markets in India and also the Hedging instruments for Indian firms

The report gives an in-depth analysis of the currency risk management by talking about what currency risk is,

the types of currency risk – Transaction risk ,Translation risk and Economic risk

It also contains details about the companies in the index sensex and nifty showing their transaction is foreign currency like the imports,

Interst payments and the other expenses

It then shows the sensitivity analysis of how the currency rates impact the gains/ profits of the company

Thakur Institute Of Management Studies And Research

Contents

1 Contents

Thakur Institute Of Management Studies And Research

Foreign Exchange Market Overview Globally,

operations in the foreign exchange market started in a major way after the breakdown of the Bretton Woods system in 1971,

which also marked the beginning of floating exchange rate regimes in several countries

Over the years,

the foreign exchange market has emerged as the largest market in the world

The decade of the 1990s witnessed a perceptible policy shift in many emerging markets towards reorientation of their financial markets in terms of new products and instruments,

development of institutional and market infrastructure and realignment of regulatory structure consistent with the liberalized operational framework

The changing contours were mirrored in a rapid expansion of foreign exchange market in terms of participants,

decline in transaction costs and more efficient mechanisms of risk transfer

The origin of the foreign exchange market in India could be traced to the year 1978 when banks in India were permitted to undertake intra-day trade in foreign exchange

However,

it was in the 1990s that the Indian foreign exchange market witnessed far reaching changes along with the shifts in the currency regime in India

The exchange rate of the rupee,

that was pegged earlier was floated partially in March 1992 and fully in March 1993 following the recommendations of the Report of the High Level Committee on Balance of Payments (Chairman: Dr

Rangarajan)

The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility,

which was achieved in August 1994

Sodhani),

which submitted its report in June 1995

The Group made several recommendations for deepening and widening of the Indian foreign exchange market

Consequently,

wide-ranging reforms have been undertaken in the Indian foreign exchange market

After almost a decade,

an Internal Technical Group on the Foreign Exchange Market (2005) was constituted to undertake a comprehensive review of the measures initiated by the Reserve Bank and identify areas for further liberalization or relaxation of restrictions in a medium-term framework

The momentous developments over the past few years are reflected in the enhanced risk-bearing capacity of banks along with rising foreign exchange trading volumes and finer margins

The foreign exchange market has acquired depth (Reddy,

The conditions in the foreign exchange market have also generally remained orderly (Reddy,

While it is not possible for any country to remain completely unaffected by developments in international markets,

India was able to keep the spillover effect of the Asian crisis to a minimum through constant monitoring and timely action,

including recourse to strong monetary measures,

to prevent emergence of self fulfilling speculative activities Thakur Institute Of Management Studies And Research

In today’s world no economy is self sufficient,

so there is need for exchange of goods and services amongst the different countries

So in this global village,

unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis

Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries

So whenever a country buys or sells goods and services from or to another country,

the residents of two countries have to exchange currencies

So we can imagine that if all countries have the same currency then there is no need for foreign exchange

Need for Foreign Exchange: Let us consider a case where Indian company exports cotton fabrics to USA and invoices the goods in US dollar

The American importer will pay the amount in US dollar,

as the same is his home currency

However the Indian exporter requires rupees means his home currency for procuring raw materials and for payment to the labor charges etc

Thus he would need exchanging US dollar for rupee

If the Indian exporters invoice their goods in rupees,

then importer in USA will get his dollar converted in rupee and pay the exporter

From the above example we can infer that in case goods are bought or sold outside the country,

exchange of currency is necessary

Sometimes it also happens that the transactions between two countries will be settled in the currency of third country

In that case both the countries that are transacting will require converting their respective currencies in the currency of third country

For that also the foreign exchange is required

About foreign exchange market: Particularly for foreign exchange market there is no market place called the foreign exchange market

It is mechanism through which one country’s currency can be exchange i

bought or sold for the currency of another country

The foreign exchange market does not have any geographic location

Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participant meets to execute the deals,

as we see in the case of stock exchange

The largest foreign exchange market is in London,

Zurich and Frankfurt

The markets are situated throughout the different time zone of the globe in such a way that one market is closing the other is beginning its operation

Therefore it is stated that foreign exchange market is functioning throughout 24 hours a day

In most market US dollar is the vehicle currency,

the currency sued to dominate international transaction

In India,

foreign exchange has been given a statutory definition

Section 2 (b) of foreign exchange regulation ACT,

credits and balance payable in any foreign currency and any draft,

letter of credit and bills of exchange

Expressed or drawn in India currency but payable in any foreign currency

Any instrument payable,

at the option of drawee or holder thereof or any other party thereto,

either in Indian currency or in foreign currency or partly in one and partly in the other

In order to provide facilities to members of the public and foreigners visiting India,

for exchange of foreign Thakur Institute Of Management Studies And Research

currency into Indian currency and vice-versa RBI has granted to various firms and individuals,

license to undertake money-changing business at seas/airport and tourism place of tourist interest in India

Besides certain authorized dealers in foreign exchange (banks) have also been permitted to open exchange bureaus

Following are the major bifurcations: Full fledge moneychangers – they are the firms and individuals who have been authorized to take both,

purchase and sale transaction with the public

Restricted moneychanger – they are shops,

that have been authorized only to purchase foreign currency towards cost of goods supplied or services rendered by them or for conversion into rupees

Authorized dealers – they are one who can undertake all types of foreign exchange transaction

Banks are only the authorized dealers

The only exceptions are Thomas cook,

UAE exchange which though,

Even among the banks RBI has categorized them as follows: Branch A – They are the branches that have Nostro and Vostro account

Branch B – The branch that can deal in all other transaction but do not maintain Nostro and Vostro a/c’s fall under this category

For Indian we can conclude that foreign exchange refers to foreign money,

bank balance and deposits in foreign currencies

Foreign Exchange Market: An Assessment The continuous improvement in market infrastructure has had its impact in terms of enhanced depth,

liquidity and efficiency of the foreign exchange market

The turnover in the Indian foreign exchange market has grown significantly in both the spot and derivatives segments in the recent past

Along with the increase in onshore turnover,

activity in the offshore market has also assumed importance

With the gradual opening up of the capital account,

the process of price discovery in the Indian foreign exchange market has improved as reflected in the bid-ask spread and forward premia behaviour

Foreign Exchange Market Turnover As per the Triennial Central Bank Survey by the Bank for International Settlements (BIS) on “Foreign Exchange and Derivatives Market Activity”,

global foreign exchange market activity rose markedly between 2001 and 2004 (Table 6

The strong growth in turnover may be attributed to two related factors

the presence of clear trends and higher volatility in foreign exchange markets between 2001 and 2004 led to trading momentum,

where investors took large positions in currencies that followed persistent appreciating trends

Second,

positive interest rate differentials encouraged the so-called “carry trading”,

investments in high interest rate currencies financed by positions in low interest rate currencies

The growth in outright forwards between 2001 and 2004 reflects heightened interest in hedging

Within the EM countries,

traditional foreign exchange Thakur Institute Of Management Studies And Research

trading in Asian currencies generally recorded much faster growth than the global total between 2001 and 2004

Growth rates in turnover for Chinese renminbi,

Indian rupee,

Indonesian rupiah,

Korean won and new Taiwanese dollar exceeded 100 per cent between April 2001 and April 2004 (Table 6

Despite significant growth in the foreign exchange market turnover,

the share of most of the EMEs in total global turnover,

The Indian foreign exchange market has grown manifold over the last several years

The daily average turnover impressed a substantial pick up from about US $ 5 billion during 1997-98 to US $ 18 billion during 2005-06

The turnover has risen considerably to US $ 23 billion during 2006-07 (up to February 2007) with the daily turnover crossing US $ 35 billion on certain days during October and November 2006

The inter-bank to merchant turnover ratio has halved from 5

reflecting the growing participation in the merchant segment of the foreign exchange market (Table 6

Mumbai alone accounts for almost 80 per cent of the foreign exchange turnover

With the deepening of the foreign exchange market and increased turnover,

income of commercial banks through treasury operations has increased considerably

Profit from foreign exchange transactions accounted for more than 20 per cent of total profits of the scheduled commercial banks during 2004-05 and 2005-06

Forex Market: A Historical Perspective Early Stages: 1947-1977 The evolution of India’s foreign exchange market may be viewed in line with the shifts in India’s exchange rate policies over the last few decades from a par value system to a basket-peg and further to a managed float exchange rate system

During the period from 1947 to 1971,

India Thakur Institute Of Management Studies And Research

followed the par value system of exchange rate

Initially the rupee’s external par value was fixed at 4

The Reserve Bank maintained the par value of the rupee within the permitted margin of ±1 per cent using pound sterling as the intervention currency

Since the sterling-dollar exchange rate was kept stable by the US monetary authority,

the exchange rates of rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable

The devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction of the par value of rupee in terms of gold to 2

88 and 1

The exchange rate of the rupee remained unchanged between 1966 and 1971 (Chart VI

Given the fixed exchange regime during this period,

the foreign exchange market for all practical purposes was defunct

Banks were required to undertake only cover operations and maintain a ‘square’ or ‘near square’ position at all times

The objective of exchange controls was primarily to regulate the demand for foreign exchange for various purposes,

within the limit set by the available supply

The Foreign Exchange Regulation Act initially enacted in 1947 was placed on a permanent basisin 1957

In terms of the provisions of the Act,

the Central Government controlled and regulated the dealings in foreign exchange payments outside India,

export and import of currency notes and bullion,

transfers of securities between residents and non-residents,

acquisition of foreign securities,

With the breakdown of the Bretton Woods System in 1971 and the floatation of major currencies,

the conduct of exchange rate policy posed a serious challenge to all central banks world wide as currency fluctuations opened up tremendous opportunities for market players to trade in currencies in a borderless market

In December 1971,

the rupee was linked with pound sterling

Since sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971,

the rupee also remained stable against dollar

In order to overcome the weaknesses associated with a single currency peg and to ensure stability of the exchange rate,

with effect from September 1975,

was pegged to a basket of currencies

The currency selection and weights assigned were left to the discretion of the Reserve Bank

The currencies included in the basket as well as their relative weights were kept confidential in order to discourage speculation

It was around this time that banks in India became interested in trading in foreign exchange Formative Period: 1978-1992 The impetus to trading in the foreign exchange market in India came in 1978 when banks in India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and were required to comply with the stipulation of maintaining ‘square’ or ‘near square’ position only at the close of business hours each day

The extent of position which could be left uncovered overnight (the open position) as well as the limits up to which dealers could trade during the day were to be decided by the management of banks

The exchange rate of the rupee during this period was officially determined by the Reserve Bank in terms of a weighted basket of currencies of India’s major trading partners and the exchange rate regime was characterised by daily announcement by the Reserve Bank of its buying and selling rates to the Authorised Dealers (ADs) Thakur Institute Of Management Studies And Research

for undertaking merchant transactions

The spread between the buying and the selling rates was 0

ADs were also permitted to trade in cross currencies (one convertible foreign currency versus another)

However,

no ‘position’ in this regard could originate in overseas markets

As opportunities to make profits began to emerge,

major banks in India started quoting two way prices against the rupee as well as in cross currencies and,

trading volumes began to increase

This led to the adoption of widely different practices (some of them being irregular) and the need was felt for a comprehensive set of guidelines for operation of banks engaged in foreign exchange business

Accordingly,

the ‘Guidelines for Internal Control over Foreign Exchange Business’,

were framed for adoption by the banks in 1981

The foreign exchange market in India till the early 1990s,

remained highly regulated with restrictions on external transactions,

low liquidity and high transaction costs

The exchange rate during this period was managed mainly for facilitating India’s imports

The strict control on foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets for foreign exchange in the world,

the hawala (unofficial) market

By the late 1980s and the early 1990s,

it was recognized that both macroeconomic policy and structural factors had contributed to balance of payments difficulties

Devaluations by India’s competitors had aggravated the situation

Although exports had recorded a higher growth during the second half of the 1980s (from about 4

trade imbalances persisted at around 3 percent of GDP

This combined with a precipitous fall in invisible receipts in the form of private remittances,

travel and tourism earnings in the year 1990-91 led to further widening of current account deficit

The weaknesses in the external sector were accentuated by the Gulf crisis of 1990-91

As a result,

the current account deficit widened to 3

It was against this backdrop that India embarked on stabilisation and structural reforms in the early 1990s

Post-Reform Period: 1992 onwards This phase was marked by wide ranging reform measures aimed at widening and deepening the foreign exchange market and liberalisation of exchange control regimes

A credible macroeconomic,

structural and stabilization programme encompassing trade,

public finance and the financial sector was put in place creating an environment conducive for the expansion of trade and investment

It was recognised that trade policies,

exchange rate policies and industrial policies should form part of an integrated policy framework to improve the overall productivity,

competitiveness and efficiency of the economic system,

As a stabilsation measure,

a two step downward exchange rate adjustment by 9 per cent and 11 per cent between July 1 and 3,

to instill confidence Thakur Institute Of Management Studies And Research

Page 10

among investors and to improve domestic competitiveness

A two-step adjustment of exchange rate in July 1991 effectively brought to close the regime of a pegged exchange rate

After the Gulf crisis in 1990-91,

the broad framework for reforms in the external sector was laid out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr

Rangarajan)

Following the recommendations of the Committee to move towards the market-determined exchange rate,

the Liberalised Exchange Rate Management System (LERMS) was put in place in March 1992 initially involving a dual exchange rate system

Under the LERMS,

all foreign exchange receipts on current account transactions (exports,

) were required to be surrendered to the Authorised Dealers (ADs) in full

The rate of exchange for conversion of 60 per cent of the proceeds of these transactions was the market rate quoted by the ADs,

while the remaining 40 percent of the proceeds were converted at the Reserve Bank’s official rate

The ADs,

were required to surrender these 40 per cent of their purchase of foreign currencies to the Reserve Bank

They were free to retain the balance 60 per cent of foreign exchange for selling in the free market for permissible transactions

The LERMS was essentially a transitional mechanism and a downward adjustment in the official exchange rate took place in early December 1992 and ultimate convergence of the dual rates was made effective from March 1,

leading to the introduction of a market-determined exchange rate regime

The dual exchange rate system was replaced by a unified exchange rate system in March 1993,

whereby all foreign exchange receipts could be converted at market determined exchange rates

On unification of the exchange rates,

the nominal exchange rate of the rupee against both the US dollar as also against a basket of currencies got adjusted lower,

which almost nullified the impact of the previous inflation differential

The restrictions on a number of other current account transactions were relaxed

The unification of the exchange rate of the Indian rupee was an important step towards current account convertibility,

which was finally achieved in August 1994,

when India accepted obligations under Article VIII of the Articles of Agreement of the IMF

With the rupee becoming fully convertible on all current account transactions,

the risk-bearing capacity of banks increased and foreign exchange trading volumes started rising

This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with the Government to remove market distortions and deepen the foreign exchange market

The process has been marked by ‘gradualism’ with measures being undertaken after extensive consultations with experts and market participants

The reform phase began with the Sodhani Committee (1994) which in its report submitted in 1995 made several recommendations to relax the regulations with a view to vitalising the foreign exchange market

In addition,

several initiatives aimed at dismantling controls and providing an enabling environment to all entities engaged in foreign exchange transactions have been undertaken since the mid-1990s

The focus has been on developing the institutional framework and increasing the instruments for effective functioning,

enhancing transparency and liberalising the conduct of Thakur Institute Of Management Studies And Research

Page 11

foreign exchange business so as to move away from micro management of foreign exchange transactions to macro management of foreign exchange flows (Box VI

An Internal Technical Group on the Foreign Exchange Markets (2005) set up by the Reserve Bank made various recommendations for further liberalisation of the extant regulations

Some of the recommendations such as freedom to cancel and rebook forward contracts of any tenor,

delegation of powers to ADs for grant of permission to corporates to hedge their exposure to commodity price risk in the international commodity exchanges/markets and extension of the trading hours of the inter-bank foreign exchange market have since been implemented

Along with these specific measures aimed at developing the foreign exchange market,

measures towards liberalising the capital account were also implemented during the last decade,

guided to a large extent since 1997 by the Report of the Committee on Capital Account Convertibility (Chairman: Shri S

Tarapore)

Various reform measures since the early 1990s have had a profound effect on the market structure,

liquidity and efficiency of the Indian foreign exchange market

Basic Concepts in Forex Trading :

Bid and Ask Rate: The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask",

or "offer") and the price at which a market taker will buy ("bid") from a wholesale or retail customer

The customer will buy from the market-maker at the higher "ask" price,

and will sell at the lower "bid" price,

thus giving up the "spread" as the cost of completing the trade

Margin Trading: Thakur Institute Of Management Studies And Research

Page 12

Foreign exchange is normally traded on margin

A relatively small deposit can control much larger positions in the market

For trading the main currencies,

Saxo Bank requires a 1% margin deposit

This means that in order to trade one million dollars,

you need to place just USD 10,000 by way of security

In other words,

you will have obtained a gearing of up to 100 times

This means that a change of,

in the underlying value of your trade will result in a 200% profit or loss on your deposit

Stop-loss discipline: There are significant opportunities and risks in foreign exchange markets

Aggressive traders might experience profit/loss swings of 20-30% daily

This calls for strict stop-loss policies in positions that are moving against you

Fortunately,

there are no daily limits on foreign exchange trading and no restrictions on trading hours other than the weekend

This means that there will nearly always be an opportunity to react to moves in the main currency markets and a low risk of getting caught without the opportunity of getting out

Of course,

the market can move very fast and a stop-loss order is by no means a guarantee of getting out at the desired level

For speculative trading,

it is recommended to place protective stop-loss orders

Spot and forward trading: When you trade foreign exchange you are normally quoted a spot price

This means that if you take no further steps,

your trade will be settled after two business days

This ensures that your trades are undertaken subject to supervision by regulatory authorities for your own protection and security

If you are a commercial customer,

you may need to convert the currencies for international payments

If you are an investor,

you will normally want to swap your trade forward to a later date

This can be undertaken on a daily basis or for a longer period at a time

Often investors will swap their trades forward anywhere from a week or two up to several months depending on the time frame of the investment

Although a forward trade is for a future date,

the position can be closed out at any time

Thakur Institute Of Management Studies And Research

Page 13

Currency Traded Across Globe & India The FOUR major currency pairs  EUR/USD  USD/JPY  USD/CHF  GBP/USD Currency Crosses  EUR/CHF  EUR/JPY  GBP/JPY  EUR/GBP Currencies traded in India:  USD/INR 

EUR/INR

GBP/INR

JPY/INR

Currency Exchanges in India: 1

MCX Stock Exchange (MCX – SX)

Thakur Institute Of Management Studies And Research

Page 14

National Stock Exchange (NSE) 3

United Stock Exchange (USE)

The daily turnover of NSE and MCX – SX together is around 30,000 cr

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Thakur Institute Of Management Studies And Research

Page 15

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Thakur Institute Of Management Studies And Research

Page 16

Factors Affecting Foreign Exchange There are various factors affecting the exchange rate of a currency

They can be classified as fundamental factors,

political factors and speculative factors

Fundamental factors: The fundamental factors are basic economic policies followed by the government in relation to inflation,

Normally,

other things remaining constant the currencies of the countries that follow sound economic policies will always be stronger

Similarly,

countries having balance of payment surplus will enjoy a favorable exchange rate

Conversely,

for countries facing balance of payment deficit,

the exchange rate will be adverse

Technical factors: Interest rates: Rising interest rates in a country may lead to inflow of hot money in the country,

thereby raising demand for the domestic currency

This in turn causes appreciation in the value of the domestic currency

Inflation rate: High inflation rate in a country reduces the relative competitiveness of the export sector of that country

Lower exports result in a reduction in demand of the domestic currency and therefore the currency depreciates

Exchange rate policy and Central Bank interventions: Exchange rate policy of the country is the most important factor influencing determination of exchange rates

For example,

a country may decide to follow a fixed or flexible exchange rate regime,

exchange rate movements may be less/more frequent

Further,

governments sometimes participate in foreign exchange market through its Central bank in order to control the demand or supply of domestic currency

Political factors: Political stability also influences the exchange rates

Exchange rates are susceptible to political instability and can be very volatile during times of political crises

Speculation: Speculative activities by traders worldwide also affect exchange rate movements

For example,

if speculators think that the currency of a country is overvalued and will devalue in near future,

they will pull out their money from that country resulting in reduced demand for that currency and depreciating its value

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Foreign Exchange Management Act,

by the Foreign Exchange Management Act,

The latter came into effect from June 1,

The change in the preamble itself signifies the dramatic change in approach

to "facilitate external trade and payments" under FEMA 1999

Any FEMA violations are civil,

attracting monetary penalties,

and not arrests or imprisonment

The scheme of FEMA and the notifications issued thereunder take into the account the convertibility of the rupee for all current account transactions

Indeed,

there is now general freedom to authorised dealers to sell currency for most current account transactions

One old limitation continues

All transactions in foreign exchange have to be with authorised dealers,

banks authorised to act as dealers in foreign exchange by the Reserve Bank

The original rules,

under FEMA are contained in the A

Subsequent circulars have been issued under the A

It is obviously impossible to incorporate all the current regulations in a book of this type,

particularly since the regulations keep changing

An outline of the basic framework of exchange control under FEMA is in Annexure 5

But its contents should not be considered as either definitive or current and those interested need to keep up with the various circulars and other communications on the subject

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Participants in foreign exchange market Market Players Players in the Indian market include (a) ADs,

mostly banks who are authorised to deal in foreign exchange,

(b) foreign exchange brokers who act as intermediaries,

and (c) customers – individuals,

who need foreign exchange for their transactions

Though customers are major players in the foreign exchange market,

for all practical purposes they depend upon ADs and brokers

In the spot foreign exchange market,

foreign exchange transactions were earlier dominated by brokers

Nevertheless,

the situation has changed with the evolving market conditions,

as now the transactions are dominated by ADs

Brokers continue to dominate the derivatives market

The Reserve Bank intervenes in the market essentially to ensure orderly market conditions

The Reserve Bank undertakes sales/purchases of foreign currency in periods of excess demand/supply in the market

Foreign Exchange Dealers’ Association of India (FEDAI) plays a special role in the foreign exchange market for ensuring smooth and speedy growth of the foreign exchange market in all its aspects

All ADs are required to become members of the FEDAI and execute an undertaking to the effect that they would abide by the terms and condition stipulated by the FEDAI for transacting foreign exchange business

The FEDAI is also the accrediting authority for the foreign exchange brokers in the interbank foreign exchange market

The licences for ADs are issued to banks and other institutions,

under Section 10(1) of the Foreign Exchange Management Act,

ADs have been divided into different categories

All scheduled commercial banks,

which include public sector banks,

private sector banks and foreign banks operating in India,

All upgraded full fledged money changers (FFMCs) and select regional rural banks (RRBs) and co-operative banks belong to category II of ADs

Select financial institutions such as EXIM Bank belong to category III of ADs

Currently,

there are 86 (Category I) Ads operating in India out of which five are co-operative banks (Table 6

All merchant transactions in the foreign exchange market have to be necessarily undertaken directly through ADs

However,

to provide depth and liquidity to the inter-bank segment,

Ads have been permitted to utilise the services of brokers for better price discovery in their inter-bank transactions

In order to further increase the size of the foreign exchange market and enable it to handle large flows,

it is generally felt that more ADs should be encouraged to participate in the market making

The number of participants who can give two-way quotes also needs to be increased

The customer segment of the foreign exchange market comprises major public sector units,

corporates and business entities with foreign exchange exposure

It is generally dominated by select large public sector units such as Indian Oil Corporation,

Maruti Udyog and also the Government of India (for defence and civil debt service) as also big private sector corporates like Reliance Group,

Tata Group and Larsen and Toubro,

In recent

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foreign institutional investors (FIIs) have emerged as major players in the foreign exchange market

The main players in foreign exchange market are as follows: 1

Customers: The customers who are engaged in foreign trade participate in foreign exchange market by availing of the services of banks

Exporters require converting the dollars in to rupee and importers require converting rupee in to the dollars,

as they have to pay in dollars for the goods/services they have imported

Commercial Bank: They are most active players in the forex market

Commercial bank dealings with international transaction offer services for conversion of one currency in to another

They have wide network of branches

Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of goods

As every time the foreign exchange bought or oversold position

The balance amount is sold or bought from the market

Central Bank: In all countries Central bank have been charged with the responsibility of maintaining the external value of the domestic currency

Generally this is achieved by the intervention of the bank

Exchange Brokers: Forex brokers play very important role in the foreign exchange market

However the extent to which services of foreign brokers are utilized depends on the tradition and practice prevailing at a particular forex market center

In India as per FEDAI guideline the Ads are free to deal directly among themselves without going through brokers

The brokers are not among to allowed to deal in their own account allover the world and also in India

Overseas Forex Market: Today the daily global turnover is estimated to be more than US $ 1

The international trade however constitutes hardly 5 to 7 % of this total turnover

The rest of trading in world forex market is constituted of financial transaction and speculation

As we know that the forex market is 24-hour market,

the day begins with Tokyo and thereafter Singapore opens,

Frankfurt,

London,

New York,

Sydney,

Speculators: Thakur Institute Of Management Studies And Research

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The speculators are the major players in the forex market

Bank dealing are the major speculators in the forex market with a view to make profit on account of favorable movement in exchange rate,

if they feel that rate of particular currency is likely to go up in short term

They buy that currency and sell it as soon as they are able to make quick profit

Corporation’s particularly multinational corporation and transnational corporation having business operation beyond their national frontiers and on account of their cash flows being large and in multi currencies get in to foreign exchange exposures

With a view to make advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize

Individual like share dealing also undertake the activity of buying and selling of foreign exchange for booking short term profits

They also buy foreign currency stocks,

bonds and other assets without covering the foreign exchange exposure risk

This also results in speculations

Exchange rate System Thakur Institute Of Management Studies And Research

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Countries of the world have been exchanging goods and services amongst themselves

This has been going on from time immemorial

The world has come a long way from the days of barter trade

With the invention of money the figures and problems of barter trade have disappeared

The barter trade has given way ton exchanged of goods and services for currencies instead of goods and services

The rupee was historically linked with pound sterling

India was a founder member of the IMF

During the existence of the fixed exchange rate system,

the intervention currency of the Reserve Bank of India (RBI) was the British pound,

the RBI ensured maintenance of the exchange rate by selling and buying pound against rupees at fixed rates

The inter bank rate therefore ruled the RBI band

During the fixed exchange rate era,

there was only one major change in the parity of the rupee- devaluation in June 1966

Different countries have adopted different exchange rate system at different time

The following are some of the exchange rate system followed by various countries

The Gold Standard Many countries have adopted gold standard as their monetary system during the last two decades of the 19he century

This system was in vogue till the outbreak of World War 1

Under this system the parties of currencies were fixed in term of gold

There were two main types of gold standard: 1) Gold specie standard Gold was recognized as means of international settlement for receipts and payments amongst countries

Gold coins were an accepted mode of payment and medium of exchange in domestic market also

A country was stated to be on gold standard if the following condition were satisfied: • Monetary authority,

generally the central bank of the country,

guaranteed to buy and sell gold in unrestricted amounts at the fixed price

• Melting gold including gold coins,

and putting it to different uses was freely allowed

• Import and export of gold was freely allowed

The total money supply in the country was determined by the quantum of gold available for monetary purpose

the money in circulation was either partly of entirely paper and gold served as reserve asset for the money supply

However,

paper money could be exchanged for gold at any time

The exchange rate varied depending upon the gold content of currencies

This was also known as “ Mint Parity Theory “ of exchange rates

The gold bullion standard prevailed from about 1870 until 1914,

and intermittently thereafter until 1944

World War I brought an end to the gold standard

Bretton Woods System Thakur Institute Of Management Studies And Research

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During the world wars,

economies of almost all the countries suffered

In order to correct the balance of payments disequilibrium,

many countries devalued their currencies

Consequently,

the international trade suffered a deathblow

In 1944,

the United States and most of its allies ratified the Bretton Woods Agreement,

which set up an adjustable parity exchange-rate system under which exchange rates were fixed (Pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies

This agreement,

fostered by a new spirit of international cooperation,

was in response to financial chaos that had reigned before and during the war

In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold,

the agreement established the International Monetary Fund (IMF) to act as the “custodian” of the system

Under this system there were uncontrollable capital flows,

which lead to major countries suspending their obligation to intervene in the market and the Bretton Wood System,

the world economy has been living through an era of floating exchange rates since the early 1970

Floating Rate System In a truly floating exchange rate regime,

the relative prices of currencies are decided entirely by the market forces of demand and supply

There is no attempt by the authorities to influence exchange rate

Where government interferes’ directly or through various monetary and fiscal measures in determining the exchange rate,

it is known as managed of dirty float

PURCHASING POWER PARITY (PPP) Professor Gustav Cassel,

The theory,

to put in simple terms states that currencies are valued for what they can buy and the currencies have no intrinsic value attached to it

Therefore,

under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries

As per this theory if there were no trade controls,

then the balance of payments equilibrium would always be maintained

Thus if 150 INR buy a fountain pen and the same fountain pen can be bought for USD 2,

it can be inferred that since 2 USD or 150 INR can buy the same fountain pen,

For example India has a higher rate of inflation as compared to country US then goods produced in India would become costlier as compared to goods produced in US

This would induce imports in India and also the goods produced in India being costlier would lose in international competition to goods produced in US

This decrease in exports of India as compared to exports from US would lead to demand for the currency of US and excess supply of currency of India

This in turn,

cause currency of India to depreciate in comparison of currency of US that is having relatively more exports

Foreign Exchange Market Structure Market Segments Foreign exchange market activity in most EMEs takes place onshore with many countries prohibiting onshore entities from undertaking the operations in offshore markets for their currencies

Spot market is the predominant form of foreign exchange market segment in Thakur Institute Of Management Studies And Research

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developing and emerging market countries

A common feature is the tendency of importers/exporters and other end-users to look at exchange rate movements as a source of return without adopting appropriate risk management practices

creates uneven supplydem and conditions,

often based on ‘‘news and views’’

The lack of forward market development reflects many factors,

including limited exchange rate flexibility,

the de facto exchange rate insurance provided by the central bank through interventions,

absence of a yield curve on which to base the forward prices and shallow money markets,

in which market-making banks can hedge the maturity risks implicit in forward positions (Canales-Kriljenko,

Most foreign exchange markets in developing countries are either pure dealer markets or a combination of dealer and auction markets

In the dealer markets,

some dealers become market makers and play a central role in the determination of exchange rates in flexible exchange rate regimes

The bidoffer spread reflects many factors,

including the level of competition among market makers

In most of the EMEs,

a code of conduct establishes the principles that guide the operations of the dealers in the foreign exchange markets

It is the central bank,

or professional dealers association,

which normally issues the code of conduct (Canales-Kriljenko,

In auction markets,

an auctioneer or auction mechanism allocates foreign exchange by matching supply and demand orders

In pure auction markets,

order imbalances are cleared only by exchange rate adjustments

Pure auction market structures are,

now rare and they generally prevail in combination with dealer markets

The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments – the spot and the derivatives market

In the spot market,

currencies are traded at the prevailing rates and the settlement or value date is two business days ahead

The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad

The derivatives market encompasses forwards,

Though forward contracts exist for maturities up to one year,

majority of forward contracts are for one month,

Forward contracts for longer periods are not as common because of the uncertainties involved and related pricing issues

A swap transaction in the foreign exchange market is a combination of a spot and a forward in the opposite direction

As in the case of other EMEs,

the spot market is the dominant segment of the Indian foreign exchange market

The derivative segment of the foreign exchange market is assuming significance and the activity in this segment is gradually rising

Fundamentals in Exchange Rate Exchange rate is a rate at which one currency can be exchange in to another currency,

This rate is the rate of conversion of US dollar in to Indian rupee and vice versa

Methods of Quoting Rate Thakur Institute Of Management Studies And Research

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There are two methods of quoting exchange rates

In direct quotation,

the principle adopted by bank is to buy at a lower price and sell at higher price

Here the strategy used by bank is to buy high and sell low

In India with effect from august 2,

all the exchange rates are quoted in direct method

It is customary in foreign exchange market to always quote two rates means one for buying and another rate for selling

This helps in eliminating the risk of being given bad rates i

if a party comes to know what the other party intends to do i

the former can take the letter for a ride

There are two parties in an exchange deal of currencies

To initiate the deal one party asks for quote from another party and other party quotes a rate

The party asking for a quote is known as’ asking party and the party giving a quotes is known as quoting party

The advantage of two–way quote is as under • The market continuously makes available price for buyers or sellers • Two way prices limit the profit margin of the quoting bank and comparison of one quote with another quote can be done instantaneously

• As it is not necessary any player in the market to indicate whether he intends to buy or sale foreign currency,

this ensures that the quoting bank cannot take advantage by manipulating the prices

• It automatically insures that alignment of rates with market rates

• Two way quotes lend depth and liquidity to the market,

which is so very essential for efficient market

In two way quotes the first rate is the rate for buying and another for selling

We should understand here that,

So the rates quoted- buying and selling is for banks point of view only

It means that if exporters want to sell the dollars then the bank will buy the dollars from him so while calculation the first rate will be used which is buying rate,

as the bank is buying the dollars from exporter

The same case will happen inversely with importer as he will buy dollars from the bank and bank will sell dollars to importer

Factors Affecting Exchange Rates In free market,

it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors,

which are ultimately the cause of the exchange rate fluctuation,

The volatility of exchange rates cannot be traced to the single reason and consequently,

it becomes difficult to precisely define the factors that affect exchange rates

However,

the more important among them are as follows: Thakur Institute Of Management Studies And Research

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• Strength of Economy Economic factors affecting exchange rates include hedging activities,

Irving fisher,

developed a theory relating exchange rates to interest rates

This proposition,

states that interest rate differentials tend to reflect exchange rate expectation

On the other hand,

the purchasing- power parity theory relates exchange rates to inflationary pressures

In its absolute version,

this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices

The relative version of the theory relates changes in the exchange rate to changes in price ratios

• Political Factor The political factor influencing exchange rates include the established monetary policy along with government action on items such as the money supply,

Active government intervention or manipulations,

such as central bank activity in the foreign currency market,

Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports)

Finally,

there is also the influence of the international monetary fund

• Expectation of the Foreign Exchange Market Psychological factors also influence exchange rates

These factors include market anticipation,

A few financial experts are of the opinion that in today’s environment,

the only ‘trustworthy’ method of predicting exchange rates by gut feel

Bob Eveling,

vice president of financial markets at SG,

is corporate finance’s top foreign exchange forecaster for 1999

and his method proved uncannily accurate in foreign exchange forecasting in 1998

SG ended the corporate finance forecasting year with a 2

the most accurate among 19 banks

The secret to eveling’s intuition on any currency is keeping abreast of world events

Any event,

from a declaration of war to a fainting political leader,

can take its toll on a currency’s value

most forecasters rely on an amalgam that is part economic fundamentals,

Fiscal policy Interest rates Monetary policy Balance of payment Exchange control Central bank intervention Thakur Institute Of Management Studies And Research

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Speculation Technical factors

Sources of Supply and Demand in the Foreign exchange Exchange Market The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and invisibles in the current account and inflows in the capital account such as foreign direct investment (FDI),

external commercial borrowings (ECB) and non-resident deposits

On the other hand,

the demand for foreign exchange Thakur Institute Of Management Studies And Research

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emanates from impor