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3PS OF FOREIGN EXCHANGE IN INDIA
(PAST,PRESENT&PROSPECT)
DISSERTATIONREPORT
Submitted by
Dimpal Goyal
Under the supervision
PROF.SATISH THUKRAL
AJAY KUMAR GARG INSTITUTE OF MANAGEMENT
GHAZIABAD
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Table of Contents
Certificate
Acknowledgement
Preface
Chapter-1 Conceptual Framework of Foreign Exchange
Market
1.1 What is Foreign Exchange
1.2 FOREX Market
1.3 Indian Foreign Exchange Market
Chapter 2 Research Methodology2.1 Objectives of The Study
2.2 Tools for Data Collection
2.3 Limitation of The Study
Chapter 3 Organization and Regulation of FOREX Market
3.1 Organization of FOREX Market
3.2 Exchange Regulation in India
3.3 Exchange Rate Mechanism in India3.4 Management of Exchange Risk
Chapter 4 Analysis of FOREX Market in India
4.1 Short Term Factors
a) Commercial Factors
b) Financial Factors
4.2 Long Term Factors
a) Currency and Credit Conditionsb) Political and Economic Conditions
Chapter 5 Conclusion, Recommendations and Future
Prospects of FOREX Market
Bibliography
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To Whom it May Concern
This is to certify that Ms. Dimpal Goyal student of AJAY
KUMAR GARG INSTITUTE OF MANAGEMENT,
GHAZIABAD has complete dissertation entitled 3PS OF
FOREIGN EXCHANGE IN INDIA Under my supervision.
To the best of my knowledge and belief the work is based on the
investigations made, data collected and analyzed by her and it
has not been submitted in any other university or institution for
the awards of any degree or diploma.
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Acknowledgement
Effort is work and no work is accomplished on its own.
It is the achievement of entire human effort and trademark. So I
would like to acknowledge all those who made this work
possible.
First, I would like to express my most sincere and
profound gratitude to Prof. Satish Thukral, AJAY KUMAR
GARG INSTITUTE OF MANAGEMENT ,GHAZIABAD
for his continuous guidance, creative thoughts and perspective
comments at various stages under whose able supervision this
work has been completed.
And I would like to thank all those who have helped me directly
or indirectly in the completion of this projectDimpal Goyal
PGDM-08/017
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Preface
The foreign exchange market is the market where one currency is traded for
another. This market is somewhat similar to the over the counter market in securities.The trading in currencies is usually accomplished over the telephone or through the
telex. With direct dialing telephone service anywhere in the word, foreign exchange
markets have become truly global in the sense that currency transactions now require
only a single telephone call and take place twenty four hours per day. The different
monetary centers are connected by a telephone network and video screens and are in
constant contact with one another, thus forming a single international foreign
exchange market. However, the currencies and the extent of the participation of each
currency in this market depend on local regulations, which vary form country to
country.
Chapter 1 deals with the introduction and conceptual framework of foreign
exchange market in India. It also deals with the structure of Indian Forex Market.
Chapter 2 deals with the methodology adopted in the research process
outlining the objectives of the study, research methodology and limitations faced
while conducting the study.
Chapter 3 deals with organization and regulation of forex market as well as
management of exchange risk, exchange rate mechanism.
Chapter 4 deals with the analysis of the foreign exchange market in India. It
covers the long term and short term factors which account to the problems.
Chapter 5 deals with the conclusion, recommendations and future prospects of
forex market in India.
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Chapter1
Conceptual Framework of forex Market
1.1 Theory of Foreign exchange
The term foreign exchange is normally used to denote foreign currency
surrendered or asked for in any of its current forms, i.e. a currency note or a
negotiable instrument or transfer of funds through cable or mail transfer or a letter of
credit transaction requiring sale and purchase of foreign exchange or conversion of
one currency into another, either at the local center or an overseas center. The banks,
dealing in for exchange and providing facilities for conversion of one currency into
another or vice versa are known as Authorized Dealers or Dealers in Foreign
Exchange. A bank is said to buy or sell foreign exchange when it handles the claims
drawn in foreign currency or the actual legal tender money, i.e., foreign currency
notes and coins of other countries.
The theory of Foreign exchange covers different means and methods by which
the claims expressed in terms of one currency are converted into another currency and
specifically deal with the rates at which such conversion takes place.
With partial or complete exchange control, as exercised by countries since
World War II exchange markets are no longer free. Exchange rates today are notentirely determined by market forces but are officially fixed and maintained by
Central Monetary Authorities. Fluctuations in exchange rates are permitted by
authorities only within narrow limits,. And official rates often very different to what
they would be if natural forces were allowed to operate.
1.2 Forex Markets
The foreign exchange market, like the market for any other commodity,
comprises of buyers and sellers of foreign currencies. The operations in the foreignexchange market originate in the requirements of customers for making remittances to
and receiving them from other countries. But the bulk of transactions take place
among banks dealing in foreign exchange for their own requirements as they do
cover operations. Banks undertake large and frequent deals with other banks through
the agency of Exchange Brokers, and it is these deals which give the market its
significance. In addition, there are other transactions which take place in the foreign
exchange market. All transactions of the exchange market may be divided into five
categories:
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(i) Transactions between banks and their customers.
(ii) Transactions between different banks in the same center.
(iii) Dealings between banks in a country and their correspondents, and
overseas branches.
(iv) The purchase and sale of currencies between the central bank of a country
and the commercial banks.
(v) The transactions of the central banks of one country, with central banks of
other countries.
There is not much difference between one market and another as far as the
international transaction between markets at different centers is concerned. But local
dealings, among members of the same market are organized in two different forms.
One of them is the pattern adopted in Great Britain, U.S. A. and some other countries,
where foreign exchange dealers never meet each other but transact business through a
network of telephone lines linking the banks, with exchange brokers who act as
intermediaries. In India also the foreign exchange market is organized on these lines.
The other type is the markets in countries of Western Europe, where the dealers in
Foreign exchange meet on every working day at a meeting place for business
proposals-They fix the exchange rates for certain kind of business particularly with-
customers. The foreign exchange markets in these countries are like commodity
exchange or stock exchange. However, the global important of these markets, is
comparatively small.
1.3 Indian Foreign Exchange Market
The Indian foreign exchange market, broadly concentrated in big cities, is a
three-tier market. The first tier covers the transactions between the Reserve Bank
and Authorized Dealers (Ads). As per the Foreign Regulation Act, the responsibility
and authority of foreign exchange administration is vested with the RBI. It is the apex
body in this area and for its own convenience, has delegated its responsibility of
foreign exchange transaction functions to Ads, primarily the scheduled commercial
banks. They have formed the Foreign Exchange Dealers Association of India which
framers rules regarding the conduct of business, coordinates with the RBI in the
proper administration of foreign exchange control and acts as a clearing house for
information among Ads. Besides the commercial banks, there are money- changers
operating on the periphery. They are well-established firms and hotels doing this
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business under license from the RBI. In the first tier of the market, the RBI buys and
sells foreign currency from and to Ads according to the exchange control regulations
in force from time to time. Prior to the introduction of the Liberalized Exchange
Management System, Ads had to sell foreign currency acquired by them from the
primary market at rates administered by the RBI. The latter too sold pounds sterling
or US dollars, spot as well as forward, to Ads to cover the latters primary market
requirements. But with the unified exchange rate system, the RBI now intervenes in
the market to stabilize the value of the rupee.
The second of the market is the inter-bank market where Ads transaction
business among themselves. They normally do their business within the country, but
they can transact business also with overseas bank in order to cover their own
position. Through they can do it independently, they do it normally through a
recognized broker. The brokers are not allowed to execute any deals on their own
account or for the purpose of jobbing. Within the country, the inter-bank transactions
can be both sport and forwards. These may be swap transactions. Any permitted
currency can be sued. But while dealing with the overseas Ads, because the Indian
market lacks depth in other currencies; the Indian banks can deal mainly in two
currencies, viz, the US branches must cover only genuine transactions relating to a
customer in India or for the purpose of adjusting or squaring the banks own position.
Forward trading with overseas banks is also allowed if it is done for the above two
purpose, that is for covering genuine transactions or for squaring the currency
position, and does not exceed a period of six months. In case the import is made on
deferred payment terms and the period exceeds six months, permission has to be
obtained from the RBI.
Cancellation of forward contracts is allowed in India, although it has to be
referred to the RBI. Previously, the banks used to get the forward transactions covered
with the RBI, but since 1994-95 the RBI has stopped giving this cover and has
permitted the banks to trade freely in the forward market. Cancellation of a forward
contract involves entering into a reverse transaction at the going rate. Suppose US
$1,000 was bough forward on 1 February for three months at Rs. 40/US $. On 1
March, it is cancelled involving selling the US dollar at the rate prevalent on this
day. If the exchange rate on 1 March is Rs. 39.50/US $ there will be a loss of Rs.
500 (the dollar sold for Rs. 39.5 minus dollar bought at Rs. 40.00). The loss is
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borne by the customer. If the value of the US dollar is greater on the cancellation day,
the customer shall reap the profit.
The third tier of the foreign exchange market is represented by the primary
market where Ads transact in foreign currency with the customers. The very
existence of this tier is the outcome of the legal provision that all foreign exchange
transactions of the Indian residents must take place through Ads. The tourists
exchange currency, exporters and importers exchange currency, and all these
transactions come under the primary market.
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Chapter 2
Objectives of the Study
To study the evolution and growth of Forex market in India.
To study the problems faced by the Foreign Exchange market in India.
To evaluate the future trends and prospects of Foreign Exchange market in
India.
RESEARCH METHODOLOGY
Every research work in supported by number of information and relevant data
for analyzing the work done. The information has taken from secondary sources.
To complete this research, I have heavily relied on the secondary data as the
topic needs a number of published information regarding forex market, recent
developments in it etc. So keeping in view the requirement of the information for this
topic, I have relied on a number of magazines, journals, newspapers, books etc.
A part from secondary data, I have also collected a number of relevant
information from different persons who are associated with the derivative segments of
Indian forex market.
LIMITATIONS
(i) Not much primary data could be collected on account of the fact that the
persons who could provide the relevant data were busy & it was difficult
to seek an appointment form them.
(ii) Due to paucity of time, it was difficult to gather sufficient data on such a
vast area.
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Chapter 3
Organization And Regulation of Forex Market
The Foreign Exchange department, which is also being called as the
International Banking Division, is one of the important departments of the banks
operating in international market. In India also all scheduled commercial banks, both
in the nationalized or non-nationalized sectors, do have Foreign Exchange
departments, both at their principal offices as well as offices, in metropolitan centers.
This department functions independently under the overall change of some senior
executive or a senior officer well-versed in foreign exchange operations as well as in
the rules and regulations in force from time to time pertaining to foreign exchange
transactions advised by various government agencies.
The principal function of a Foreign exchange department is to handle
foreign inward remittances as well as outward remittances; buying and selling of
foreign currencies, handling and forwarding of import and export documents
and giving the consultancy services to the exporters and importers. Besides this,
the department also gives the financial assistance in relation to the foreign trade, i.e.,
it gives assistance to the exporters by way of financing the exports and imports bygiving them the financial assistance to clear the consignments or open a letter of
credit. The department issues letters of credit for their importer clients and handles
letters of credit received from overseas correspondents in favor of exporters from
India. Issuance of Performance and the Bid Bond guarantees and tender document is
also one of the important functions of the banks that are dealing I foreign exchange.
In India, the banks doing foreign exchange business are issued a license to this
effect by the Reserve Bank of India under Foreign Exchange Regulation Act, 1973.
No bank, not having such license to deal in foreign exchange, can handle foreign
exchange operations. Besides Authorized Dealers, licenses are also issued to the
Dealers with limited powers to change foreign currency notes, coins and travelers
cheques. Such licensees are known as Authorized Money Changers.
3.1 Organization of a Foreign Exchange Department
The foreign exchange department of a medium or large sized-bank can be
divided into various department and sections such department are locked after by a
senior person not lower than the category of a branch manager having both
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administrative and operational know-how as well as discretionary powers for
advances required from time to time by the clients. The in charge of the department
functions independently within the overall framework laid down by the Management
of the bank. The in charge is assisted in hid day-to-day work by a team of officers,
and workmen. One of the important functions of the Foreign exchange department,
beside banking operations, is to maintain liaison and correspondence relations with
overseas banks who may be their correspondents.
SECTION OF THE FOREIGN EXCHANGE DEPARTMENT
The Foreign exchange department is divided into number of sections, each one
equally important and looked after by one officer or a department head. A particular
section can be sub-divided into sub-section with specific duties allotted. The sections
in Foreign exchange department can be broadly stated as under:
1. Dealers Section
This section is the nerve of the foreign exchange department as the exchange
rates are computed and advised by this section. The exchange rates are the on a
foreign exchange and so any incorrect fixation of rates (price) will turn the profits of
the bank into losses and instead of earning from the foreign exchange transactions, the
bank may keep on losing. This section is headed by an officer who is called a Dealer.
In the morning, before the banking hours begin, the exchange rates of various
currencies are computed. The rates are computed on the basis of certain fixed
principles which may by either market quotations or any such approved channel. In
India, the Dealer works out the exchange rates on cross rate method based on the
sterling rate schedule fixed and advised by FEDAI vis--vis the previous days
closing rates in London market. This department calculates and advised both the
ready rates as well as forward rates as and when requested. Besides rate computation,
it also looks after the foreign currency accounts of the bank and supervises the
balancing position in foreign currency accounts maintained abroad. It also controls the
exchange position of the department and reconciles the various entries put forth by
other sections both for buying as well as selling of foreign exchange. In addition, the
section also calculates and tabulates the statistical data required by the principal office
of the bank concerned, as well as the Exchange Control Department of the Reserve
Bank of India. Such statistics prepared by the bank are to be reported to the authorities
on the prescribed forms at the prescribed intervals. This data is very essential and of
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prime important as the Balance of Trade and Balance of Payments position is arrived
at only from the statistics provided by the banks. From the data available from the
banks even the import policy is formed and other fiscal fiscal measure adopted by the
monetary authorities from time to time depend.
This section can be further sub-divided into following subsections:
(i) Rate calculation and advising
(ii) Forward Exchange contracts
(iii) Foreign currency Accounts
(iv) Exchange position and control, and
(v) Reconciliation of Foreign Currency Accounts.
2. Foreign Remittances Section
This section deals with the inward and outward remittances received in the
country and sent outside, both on behalf of the transactions taken up by residents and
non-residents. Foreign remittances are carried out in the form of cable transfers, mail
transfers, demand drafts, travelers cheques and payment instructions by letters. All
these forms are widely used both for inward remittances as well as outward
remittances. The officer of this particular department has to be quite well-versed with
various regulations in force from time to time and the amendments thereto as strict
exchange control regulations are prevailing specially in case of outward remittances
in developing and underdeveloped countries, due to the adverse balance of payments
position, depleting foreign exchange reserves, and available resources required to
meet with development programmes and national exigencies. This department also
keeps Test Key arrangements used for transmitting the instructions by cable, as in
cable transfers no signature of the remitting bank is possible. So messages are
computed with a particular number known as code or cipher. This code or cipher is
recomputed at the other centre on the basis of the test arrangements exchanged
between the two banks.
In foreign exchange, whatever the reason may be irrespective of the amount,
the entire gamut is focused around the inward and outward remittances and so this
section is of prime importance. The remittances are converted into local currency in
case of inward remittances and in foreign currency in case of outward remittances at
the prevailing rate of exchange on the date of each transaction or a forward exchange
rate if exchange rate if exchange is already booked earlier. So, the remittance
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department has to keep a close contact with Dealers section, both for getting the rates
and also advising them the funds position which changes from time to time due to
the remittances flowing in either direction.
3. Import SectionImport section can be sub-divided into import letters of credit both opening
and payment thereof, issue of Bid guarantees, performance guarantees and guarantees
to Government agencies for release of import consignment, import documents
received on collection basis and imports on consignment basis. Import section has to
keep in touch with latest developments in international markets as well as the rules
and regulations in force in various centers to take up the import business at right
earnest without violating the rules and regulations. Both in developing and developed
countries, there are Import and Export Trade Control Regulations and such
regulations are enforced through a licensing procedure. Hence the Import section has
to take care of the Import Trade Control Regulations as well as Exchange Control
Regulations before allowing import transactions to be put through.
4. Export Section
The section deals with various exchange operations arising out of export
trade. The principal functions of this sub-section are:
(a) Advising and confirming letters of credit received from abroad:
(b) Extending financial assistance to exporters as and when required.
(c) Acting as an agent for collection on behalf of the clients;
(d) Negotiation of export bills drawn under letters of Credit whereby the
dealer acts as an agent of overseas bank and facilitates smooth function/operation
of international trade; and
(e) Acting as an authorized channel appointed by Central Banking
Authority to receive the export proceeds.
5. Statistics Section
This section collects the sales and purchase figures from various
departments along with necessary exchange control forms, tabulates then and submits
a periodical report by way of statements and returns to the Exchange Control
Department of the Reserve Bank of India under whose authority it operates. This
reports is also being submitted from time to time in one form or the other to the head
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office of the concerned bank to enable it to compile the overall position of the foreign
exchange preferably of the bank as a whole.
3.2 Exchange Regulation in India
Exchange Control Regulations were first introduced in our country on 3rd
September, 1939 at the outbreak of World War II. The control was introduced
under the guidelines of Bank of England and also as a measure under the Defense of
India rules to conserve and augment the foreign exchange resources of India to meet
the defense requirements for Britishers. It primary objective was to conserve the
foreign exchange resources, which needed to be diversified due to changed
circumstances.
It was initially introduced as a temporary device to meet the
emergency situation arisen due to Second World War. In May, 1944 the Defense of
India Rules were lifted and all emergency provisions promulgated during the Defense
of India Rules were ineffective. But the Government of India was not in a position to
lift the Exchange Control Regulations due to the strain on the sterling balances; The
Exchange Control Regulations were kept alive under a new law named as Emergency
Provisions Continuance Act of 1994. The Exchange Control was put on a permanent
Statute and the First Foreign Exchange Regulations Act came into existence on 25 th
March, 1947 as a full fledged foreign Exchange Regulations Act.
The system of control adopted in 1947 was structurally identical to provisions
laid down in 1939 at the inception of the control, but important changes in detail were
introduced in FERA 1947 to meet the specific requirements of the situation and to
protect the interests of independent India.
The Foreign Exchange Regulations Act (FERA) of 1947 has now been
replaced by the FERA, 1973. Basic structure of the Exchange Control Regulations is
till not very much divergent that the earlier ones, but keeping in view the economic
conditions and balance of payments positions, certain new provisions have been
included and the control has been made more comprehensive. Under the Act of 1973,
the Authorized Dealers have been given wider powers for releasing foreign exchange
to the residents in India and a strict view has been taken of the non-resident interests.
I) BROAD FEATURES OF EXCHANGE CONTROL
There is an elaborate machinery to enforce Exchange Control Regulations in our
country. The machinery comprises of the controller of the Exchange Control
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department of the Reserve Bank of India at the helm of affairs, which in turn has
empowered the Banks dealing in foreign exchange to deal with general public for
their foreign exchange requirements. This authority enforces the provisions of the
Foreign Exchange Regulations Act and has the powers to deal with any infringement
or violation of the provisions of the Act.
II) THE FERA AND THE EXCHANGE CONTROL MANUAL
All the provisions of the FERA have been transcribed in the banking
terminology by the Reserve Bank of India to facilitate the day to day transactions
between Reserve Bank, between the various dealers and the general public.
Exchange control in India is administered by the Reserve Bank of India in
accordance with the general policy laid down by the Union Government in
consultation with the Reserve Bank. The Bank has an Exchange Control Department
which is entrusted with this functions. Under the system, the Reserve Bank is
authorized to license export of gold, silver, currency notes, securities, and a variety of
other transactions involving the sue of foreign exchange.
For foreign exchange transactions, which the general public conducts with the
authorized dealers in foreign exchange, the Reserve Bank of India has laid down
general instructions for the guidance of the latter. The directions cover all transactions
relating to imports and exports, foreign travel payments, family maintenance
remittances by foreign nationals, transfers of investment income, capital transfers by
foreign and Indian Nationals and other invisible items. Some of these transactions
particularly those pertaining to capital transfers, have to be referred by the authorized
dealers to the Reserve Bank for its prior approval. Some remittances may, however,
be made by the authorized dealers without prior approval of the Reserve Bank, such
as those for foreign Nationals seeking to remit a part of their, earnings for the
maintenance of their families abroad, provided the amounts are within limits specified
by the Reserve Bank.
The institutional framework of the exchange control system also compromised
of a special machinery for enforcement and for dealing with any infringements of the
provisions of the Act. The function is entrusted to the Directorate of Enforcement
attached to the Union Ministry of Finance. The directorate deals with offenders who
violate the control provisions and is authorized to take punitive action. It is also
empowered to adjudicate in certain cases of infringement.
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III) Purchases and Sales by Authorized Dealers
Authorized dealers purchase and sell foreign currencies in accordance with the
regulations.
Purchase: They purchase T.Ts., M.Ts., drafts, bill etc., freely from banks and thegeneral public. The receipt of remittances from any country is free and banks are,
therefore allowed to purchase freely.
Purchase of foreign currencies is also done from their overseas branches and
correspondents for the purpose of making rupee payments into non-resident accounts
in India and also for making payments to residents.
The authorized dealers and authorized money changers purchase foreign
currency notes, coins, and travelers, cheques from travelers coming from abroad. The
amounts purchased are endorsed on the reverse of the customs stamped currency
declaration forms of the travelers. Foreign currency notes and coins are also
purchased from other authorized dealers and money changers.
Sales; Sales of foreign currency are made by authorized dealers subject to control
regulations. No remittances may be made to countries advised from time to time and
no transactions may be carried out with persons, firms or banks residents in those
countries.
For the purpose of sales persons, firms, and banks residents in Nepal are
treated as non- residents.
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3.3 Exchange Rate Mechanism in India
India is a founder member of the IMF. It followed the fixed parity system till
the early 1970s as a result which the value of the rupee in terms of gold was originally
fixed as the equivalent of 0.268601 gram of fine gold. In view of Indias longeconomic and political relations with England and membership of the sterling area
from September 1939 to June 1972, the rupee was pegged to the pound sterling. The
exchange rate was thus remained unchanged but the gold content of the rupee fell to
0.186621 gram. Again, with the devaluation of the Indian rupee in June 1996 the gold
content fell further to 0.118489 gram. The following year, the pound was also
devalued. This devaluation did have an impact on the rupee pound link, but the rupee
was kept stable in terms of the pound. The latter continued as an intervention
currency.
In August 1971 when the system of fixed parity was under a cloud, the rupee
was briefly pegged to the US dollar at Rs. 7.50/US $ and this continued till December
1971. The peg to the dollar was not very effective as the pound sterling remained to
continue as the intervention currency. In December 1971, the rupee returned to the
sterling peg at a parity of Rs. 18.9677/ with of course , a margin of 2.2 S percent.
After the Smithsonian arrangement had failed and the pound had began to
float, the rupee tended to depreciate. The reserve Bank then had to delink it from the
pound sterling in September 1975 and link it with a basket of five currencies; but the
pound sterling was retained as the intervention currency for fixing the external value
of the rupee. The weight of different currencies forming the basket remained
confidential and the exchange rate continued to be administered. The administered
rate did not keep pace with the growing rate of inflation and this resulted in a
widening gap between the real and the nominal exchange rates that was more evident
during the late 1980s and early 1990s. Thus, when economic reforms were initiated
in the country, the rupee was depreciated by around 20 percent in two successive
installments in the first weeks of July 1991. In absolute terms, depreciation occurred
from Rs. 21.201/US $ to Rs. 25.80 /US $
From March 1992 a dual exchange rate system was introduced, in terms of
which 40 percent of export earnings were to be converted at the official exchange rate
prescribed by the Reserve Bank and the remaining 60 percent were to be converted at
market determined rates. The US dollar was he intervention currency. From March
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1993 the receipts on merchandise trade account and some of the items of invisible
trade account came to be convertible entirely at the market determined rates on all
items of current account.
The adoption of the unified exchange rate system form March 1993 means
adoption of a floating-rate regime, but it is a managed floating and the reserve Bank
of India intervenes in the foreign exchange market in order to influence the value of
the rupee. In the first two years, the value of the rupee remained stable but the
onward, it has been depreciating despite RBIs intervention.
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3.4 Management of Exchange Risk
Risk Hedging tools in Forex Market
In recent years financial markets have developed many new products whose
popularity has become phenomenal. Measured in terms of trading volume, the growth
of these products principally futures and options has confused traditional investors.
Although active markets in futures and options contracts for physicals commodities
have only recently attracted Internet.
Multinational Companies normally use the spot and forward markets for
international transactions. They also use currency futures, currency options,
and currency futures options for various corporates functions. While speculators
trade currencies in these three markets for profit, multilingual companies use them tocover open positions in foreign currencies.
3.4 (a) Forward contract
Forward Exchange
Forward exchange is a device to protect traders against risk arising out of
fluctuations in exchange rates. A trader, who has to make or receive payment in
foreign currency at the end of a given period, may find at the time of payment or
receipt that the foreign currency has appreciated or depreciated. Ifthe currency moves
down or gets depreciated the trader will be att a loss as he will get lesser units of
home currency for a given amount of foreign currency, which he was holding.
Similarly, an importer, who was contracted to make payment of a given
amount in pound sterling at the end of a given period, may find that at the time of
payment, the rupee sterling rate is higher. He would then have to pay more in rupees
than what it would have been at the time when the contract was made.
To protect traders against such risks of appreciation and getting lesser amountof home currency, there is a device in exchange market of booking forward exchange
contracts. The emergence of forward exchange contracts has been due to the rate
fluctuations and possible losses that the traders might have to suffer in their foreign
exchange business. The forward exchange transaction is an umbrella which gives
protection to the dealers against the adverse movement of exchange rates. The
forward exchange market in fact came into existence when the exchange rates were
highly unstable following the abandonment of the gold standard by most of the
countries at the end of first and Second World Wars. There are other means of taking
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care of the risks of the adverse effects of the exchange rate fluctuations such as
including the Escalation Clause in the sale and purchase contracts entered between the
buyers and sellers or fixing a parity rate between the home currency and foreign
currency and any variation in the fixed parity entered into between the importers and
exporters, the exchange risks will be passed on as per the terms of the contract.
Escalation clause is more adaptable in contracts amounting to a very large volume,.
especially in contracts entered into on deferred payment terms.
Forward Exchange Contracts
Under option forward exchange contracts, the customers has an option to
receive or deliver the contract amount of foreign exchange on spot basis on any day
during the month the where in the option falls. This option period is one calendar
month and the customer has an option to call for or deliver the forward exchange on
any day during 1st and the last day of the month for which the contract is booked. In
option forward exchange, the delivery is not fixed but is adjusted to mature on any of
the two dates or in between. Option forward contracts are very much in vogue due to
uncertainty prevailing in the delivery schedules in the international market.
Option forward contracts in inter-bank markets are also booked for split
delivery and the contracts are booked for delivery in first half or second half of the
month. This means delivery of forward exchange will be made from 1 st day of the
month to the 15th day of the month and second half means that the delivery will be
effected from 6th day of the month to the last day of the month, as requested.
The ordinary forward transaction requiring delivery on a specified date is
often fixed forward, to the distinguish it from the forward option.
When the banker has to quote to a customer rates for a forward contract, he
bases his quotation on the fixed forward rates. In an option contract the customer may
demand completion of the contract on any day during the option period. For fixed
forward contracts different rates will apply to different days of the period. For the
option it will be the same rate for the whole period, and obviously it will be the rate
which is most favourable the banker.
As an illustration, let us suppose the current quotation for
dollar sterling in New York is:
Spot 1 U.S. $ 216-2118
1 month forward 3-2 c. discount
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2 months forward 5-4 c. descent
3 months forward 8-6 c. discount
The outright quotations for fixed forward deals will be as follows:
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Buying Selling
Spot 216 218
1 1month forward fixed 213 216
2 months forward fixed 211 2143 months forward fixed 210 212
Now, if a customer wants to buy forward sterling at its option during the
following month, the banker undertakes to deliver him the dame at the agreed rate at
any time during the month. Hence , the customer can pick up delivery of the dollars
on the first or last day of the month or any intervening day. The banker is aware that
he may have to deliver the sterling at the earliest, on the first day, and at the latest, at
the end of the month, and these are the extremes of the option allowed to the
customer, and the rates applicable to these dates will be considered by the banker in
deciding what rate to quote for the transaction. The banker will quote the rate which is
favorable to him.
On the basis of the rates given above , the bankers selling rate for spot will be
$ 218 if the customer wants delivery ready, and $ 216 will be 1 month fixed forward
rate, if delivery is demanded at the end of one month. For an option over the month
the banker will quote the rate, which is more favorable to him, i.e., 218. If the optionallowed is for the period over the second month, the rate quoted will be 216, the one
month fixed forward rate, i.e., the rate applicable for delivery on the fisrt day of the
second month. For option over the third month the rate will be that applicable for
delivery on the first day of the third month, i.e. 214. On the same principle, if a
customer, who wants to sell sterling to the bank, wants an option over the first
month, the rate quoted will be chosen from the bankers buying rates applicable to the
first and the last day of the month, viz., $ 216 and 213. It will obviously be the one
wherein the banker has to apart with less dollars per , i.e., $ 213. Similarly, for a two
month option over the second month, the rate will be the one applicable to the last day
of the second month viz. 211. For a three month forward option or for option over the
second and third months or for option only over the third month, the rate quoted will
be the one applicable to the last day of the third months, viz., $ 210.
If sterling is at a premium the same principle will apply. Thus, if the market
rates on a particular day are spot $ 216-218 and forward 1 month 2-3 c., 2 months 4-5
c., and 3 months 6-8 c. premium, the rates quoted on the day will be as under:
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Buying Selling
Spot 216 218
1 1month forward fixed 213 221
2 months forward fixed 220 2233 months forward fixed 222 226
Forward Rates & Forward Margin
Factors responsible for premium and discount
Forward Rates at a
Premium Discount
Over the spot Rates Over the spot rates
Forward rates Dearer Forward Rates Cheaper
Than the spot rates than the spot rates
Factors Responsible for
Premium Discount
i) Excess demand of forward
currency
ii) Higher Rate of Interest in
home centre
iii) Likely Appreciation of Spot
Rates
i) Excess supply of forward
currency
ii) Higher Rate of Interest in
Foreign centre
iii) Likely depreciation of Spot
Rates
3.4 (b) Future Contract
Introduction
Besides spot and forward markets, foreign currencies are traded in the market for
currency futures and he marked for currency option. These two are known as
derivatives because such contracts derive their value of a price time series. The
market for currency futures and options is known as the market for derivatives
because the prices in these markets are driven by the spot market price.
Hedging in Currency Futures Market
Tenders make use of the market for currency futures in order to hedge their foreign
exchange risk. For instance suppose a French importer importing goods from
Germany for DM 1.0 million needs this amount for making payment to the exporter .
It will purchase DM at a future settlement date. By holding a futures contact, the
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importer does not have to worry about any change in the spot rate of the DM over
time. On the other hand, if the French exported exports goods to a German firm and
has to receive DM for the exports, the exporter would sell a DM futures contract. This
way the exporter will be locking in the price of the export to be received in terms of
DM. It will protect itself form the loss that may occur in case of depreciation of the
DM over time.
Speculation With Currency Futures
Speculators make use of the currency futures for reaping profits. When they
expect that the spot rate of a particular currency will move up beyond those
mentioned in the currency futures contract, they buy currency futures denominated in
that particular currency. At maturity, if their expectations come true, the difference
in the sport rate and the rate mentioned in the futures contract will be the profit to be
reaped by them. Suppose, the futures rate is US & 1.75/and the spot rate on maturity
is expected to be US$ 1.76. If the speculator purchases 62,500at the rate of US1.75
(under the futures contract) and the expectation comes true and so sells that pound at
the rate of US $1.76 in the spot market, the profit will be US $ (1.76-1.75)* 62,500 =
US $625. In other words, the speculators buy currency futures in a currency when the
future rate of that currency is expected to be greater than the currency futures rate. On
the other hand, if the sport rate of a particular currency is expected to depreciate
below the rate mentioned in the currency. For example, if the value of the pound is
expected to drop to US $ 1.74 on the maturity date, the speculator will strike a
currency futures deal to sell pounds. On the maturity date, it will sell 62,500 at US $
1.75 and with the sale proceeds to be obtained in US dollars, it will buy pounds at the
spot rate. This way, it will make profits equal to US $ (1.75-1.740* 62,500 or US $
625. It may be noted here that these transactions involve cost that is to be deducted
from the gain. The transaction cost is very nominal for the locals, but is significant for
the speculators.
Intra-currency Spread
Speculators can buy or sell futures of the same currency for two delivery dates
if the rates for those two dates differ. This is known as intra currency spread. Suppose,
sport rate is US$ 1.795/: the June-delivery rate is US$ 1.79/ and the September
delivery rate is US $ 1.775/. If the speculator expects that the pound will depreciate
more rapidly than exhibited by the futures rates, he will buy two futures in pounds for
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the above two dates. Prior to maturity, he will reverse the two contracts respectively,
say, at US $ 1.78 and US $ 1.76. Now in the original contract, the price difference in
the two different maturity contracts is US $ 1.79-1.775 = 0.015 while in the reverse
contracts, the difference amounts to US $ 0.02. Since the difference in the price of the
reverse contracts is greater than the difference in the price of the original contracts,
the speculator makes profit amounting to US $ (0.020-0.015)* 62,500 = 312.5.
Inter-currency Spread
Besides the intra-currency spread, inter-currency spread is also used by the
speculators. Such spread occurs when the deal involves purchase and sale of future
contracts with the same delivery date but with two different underlying currencies.
Suppose the speculator expects an appreciation of Canadian dollar relative to the
British pound. HE WILL BUY Canadian dollar futures and sell pound futures. Before
maturity, he will reverse the two contracts. If the price difference of the two reverse
contracts is less than the price difference of the original contracts, the speculator will
make a profit.
3.4 (c) OPTION CONTRACT
Privilege of Non-execution of Contract
Foreign currencies are traded in the market for currency options as well. The
purpose is either the hedging of foreign exchange exposure or making of profits
through speculation. As in currency forward and futures contracts the buyer of
currency options possesses the right to buy or sell foreign currency after the lapse of
specified period at a rate, determined on the day the contract is made. The currency
options contract has a distinctive feature that is not found in a forward or futures
contract. It is that the buyer of currency options has the freedom to exercise the option
if the agreed-upon rate terms in his favor. If the rate does not turn in his favor, he can
let the options expire. Thus the exercising of options in the buyers right but not his
obligation. For this privilege, the buyer has to pay a premium to the option-seller.
Suppose a person decides to acquire call options to buy Swiss francs at a price of US
$ 0.70 along with a premium for US$ 0.02. On the maturity date, if spot rate of the
Swiss franc is lower than the agreed upon rate, he will let the option expire because he
will be able to buy it in the sport market at a cheaper rate. But if the sport rate is US $
0.75 he will exercise the option because his cost of buying Swiss francs under the
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options contract (inclusive of premium) will be US $ 0.72, whereas he can sell his
currency in the spot market at a higher rate and can thereby earn a profit.
Type of Options
Broadly speaking, there are two types of options. In a call option, the buyer ofthe option agrees to buy the underlying currency, while in a put option contract, the
buyer of the option agrees to sell the underlying currency.
The call and put options are also of two types. One, known as the European
option, is exercised only on maturity. The other, the American option, may be
exercised even before maturity. It is normally in the buyers interest to exercise the
option before maturity and so American options command higher prices than
European options.
In recent years, some more variants of options have become available. The
first is, for example, known as a forward reversing option. In this case, a call option
premium is paid only when the spot rate is below a specified level. The premium is
quoted by the seller who charges the premium only when the options are not
exercised. This way the buyer gets liberal terms. Secondly, there are preference
options in which the buyer gets an additional privilege to designate the option either
as a call option or as a put option. Though this privilege is exercised only after the
lapse of a specified period. In the case of average rate options, it is the arithmetic
average of the sport rate during the like of the option that is taken into account at
maturity instead of the spot rate. This type of option enables the buyer to hedge a
series of daily cash inflows over a given period in one single contract. If the average
rate on maturity is lower than the strike price, the buyer gets the difference between
the two. If the average rate is higher than the strike rate, the buyer lets the option
expire.
A look-back option gives the holder the right to purchase or sell foreign
currency at the most favorable exchange rate realized over the life of the option. For
example, the buyer of a call has the right to buy the underlying currency at the lowest
exchange rate realized between the creation of the call and the expiry date. The buyer
of a put option has the right to sell the underlying currency at the highest exchange
rate during the life of the option. All this means that the strike rate in a look-back
option is not known until the expiry date. Naturally, because of this specialty, the
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premium of a look-back option is normally higher than the premium of the traditional
option.
In a cylinder or tunnel option, two strike rates exist. When the spot rate is
lower than the lower strike rate, the buyer has to pay the lower strike rate. He pays the
higher strike rate if the spot rate is higher than the higher strike rate. If the sport rate is
between the two strike rates, the buyer pays the spot rate.
There are also barrier options. In the case of down-and-out option, the option
expires automatically if the spot rate reaches a level mention ed in the contract. In a
down-and-in option, option is activated only when the sport rate reaches a specified
barrier within the expiry date. The basket option caters to buyers who are confronted
with foreign exchange risk in respect of many currencies.
Hedging With Currency Options
(a) Hedging through purchase of option
In order to hedge their foreign exchange risks, if it is a direct quote, the
importers buy a call option and the exporters buy a put option. We first take the case
of an importer. Suppose and Indian firm is importing goods for 62,500 and the
amount is to be paid after two months. If an appreciation in the pound is expected, the
importer will buy a call option on it with maturity coinciding with the date of
payment. If the strike price is Rs. 60.00/, the premium is Rs. 0.05 per pound and the
spot price at maturity is Rs. 60.20/, the importer will exercise the option. It will have
to pay Rs. 60.00*62,500+3,125 = 3,753,123. If the importer had not opted for an
option, it would have had to pay Rs. 62,500*60.20 = 3,762,500. Buying of the call
option reduces the importers obligation by Rs.3,762,500-3,753,125 =9375. If on the
other hand, the pound falls to Rs.59.80, the importer will not exercise the option since
his obligation will be lower even after paying the premium. Buying of currency option
is preferred only when strong volatility in exchange rate is expected and volatility is
only marginal, forward market hedging is preferred. Suppose, in the earlier example,
the pound appreciates to only Rs. 60.04 or depreciates to only Rs. 59.97, the amount
of premium paid by the importer will be more than the benefit form hedging through
purchase of options. There will then be net positive cost of hedging through buying of
option.
The exporter buys a put option. Suppose an Indian exporter exports goods
for 62,500. It fears a depreciation of pound within two months when payments
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are to be received. In order to avoid the risk, it will buy a put option for selling
he pound for a two-month maturity. Suppose the strike rate is Rs. 60.00 the
premium is Rs. 0.05 and the spot rate at maturity is Rs. 59.80. In case of the
hedge, it will receive Rs. 62,500*60.00-3,125 = 3,746,875. In the absence of a
hedge, it will receive only Rs. 3,737,500. This means buying of a put option helps
increase the exporters earnings, or reduces its exposure, by Rs. 3,746,875
3,737,500 = 9,375.
(b) Hedging through Selling of Options
Hedging through selling of options is advised when volatility in exchange rate
is expected to be only marginal. The importer sells a put option and the exporter sells
a call option. Let us first take the case of importers. Suppose an Indian importer
imports for 62,500. It fears an appreciation in the pound and so it sells a put option
on the pound at a strike price of Rs. 60.00/ and at a premium of Rs. 0.15 per pound.
If the spot price at maturity goes up to Rs. 60.05 the buyer of the option will not
exercise the option. The importer as a seller of the put option will receive the
premium of Rs. 9,375 which it would not have received if it had not bought the
option. If the spot price at maturity falls to Rs. 59.95 the buyer of the option will
exercise the option. But in that case, the importer will have to pay to the buyer Rs.
3,750,000-9,375=3,740,625. When there is no hedging through selling of a put option,
the importer, will gave to pay Rs 3,746,875. Thus the importer reduces its risk
through the sale of put options.
The exporter sell the call option. If an Indian exporter exports for 62,500
and fears that pound will depreciate and sells a call option on the pound at a strike
price of Rs. 60.00 at a premium of Rs.0.15 per pound. If the spot rate at maturity
really falls to Rs. 59.95, the buyer of the option will not exercise the option. The
exporter being the seller of the call option will get Rs. 93,95 as the premium. Its total
receipt will be Rs. 62,500*59.95 =9,375 = 3,756,250. In the case of no sale of a call
option, the total receipt 9from the importer) will be only Rs. 3,746,875.
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CHAPTER 4
ANALYSIS OF FOREX MARKET IN INDIA
Problems of Fluctuations in Forex Market
The exchange value of a currency, or the rate of exchange, fluctuates with
changes in demand and supply. The factors which affect the demand for and the
supply of a currency are many and varied. There are some factors which operate in the
short period and have influence on day-to-day- fluctuations in rates of exchange. The
commercial and financial relationship between trading countries is now extensive and
payments on various accounts fall, due for early settlement. These payments on
various accounts fall, due for early settlement. These payments constitute the short-
term demand and supply in regard to currencies. There are, however, changes in
currency and credit conditions and political and industrial conditions which have their
influence on exchange rates only in the long period.
The factors affecting exchange rates may be summarized thus:
1. Short-term factors: (a) Commercial
(b) Financial
2. Long-term factors: (a) Currency and credit conditions
(b) Political and economic conditions
4.1 SHORT TERM FACTORS
(a) Commercial factors
One of the important factors influencing the demand for and supply of
currencies is trade in merchandise, i.e., imports and exports of goods. The demand for
the currency of a country arises from exports of goods by the country B. An increase
in a countrys imports due to an increase in demand, a reduction of tariffs, or an
export-promotion drive by exporting countries raises the demand for and exchange
value of currencies of exporting countries in the exchange market of the importing
country.
In other words, the exchange value of the currency of the exporting country
falls. An increase in exports has the reverse effect.
There are, in addition, many invisible items of payment which create debts
and, therefore, need for settlements through purchase and sale of exchange. The
residents of a country have to pay and receive from foreigners for services of variouskinds, such as transport, banking, insurance, etc. Premium, brokerage, commission
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and other risks of payments are made, or received by trading countries. Exports of
equipment, enterprise and technical skill by advanced countries to underdeveloped
countries has assumed considerable importance during recent years for which the
exporting countries receive payments in the form of profits, dividends, foreign
royalties and other charges.
The effects of lactations in exchange rates are either favorable or adverse and
healthy or unhealthy, depending upon the ultimate result and influence of the
fluctuations on the balance of trade and payments position between the trading
partners directly or indirectly. To avoid the adverse effects of rate of fluctuations and
ultimate losses or gains to either of the trading partners, some of the countries,
especially East European countries, have opted to enter into Bilateral Trade
Agreements wherein the payments are settled through exchange of goods and services
instead of making the payments in currencies of either of the countries. Such
agreements avoid monetary transactions and the countries with lesser foreign
exchange reserves can make the use of these scarce commodities to trade with other
direct payment procedure countries.
Summing up we can say that the demand for currency on trade account arises
on account of the following factors:
(i) The residents of the country have exported goods to other nations for
which they have to receive payments.
(ii) The shipping, banking and insurance companies of the country render
services to other countries for which they receive remuneration.
(iii) Entrepreneurs setting up business abroad, and supply technical personnel
and managers receive profits and salaries.
(iv) Tourists and students coming from abroad spend money in the country.
(v) Besides the regular tourist traffic going from country to country only for
tourist interests, here are certain groups traveling on cultural and exchange
programmers under various government-sponsored delegations and private
visits to fiends and relatives staying in other countries also lead to the need
of foreign exchange. In recent years, movement of individuals and groups
on these accounts are on higher side, and the overall contribution of the
exchanges effecting on these accounts are figuring remarkably in overall
balance of payments position under the heading of private transfers.
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Similarly factors which are responsible for supply of currency against a demand for
foreign currencies are:
(1) Imports from other countries.
(2) Use of services by foreign shipping, banking, insurance and other
services, for which payments are to be made.
(3) Payments made as salaries and profits to foreigners not staying in the
same country.
(4) Residents of the country going as tourists abroad and for higher
education in foreign universities and institutions spend money there.
(b) Financial Short-term Factors
International financial operations had important influence on exchange rates
when movements of foreign capital and speculative dealings in foreign exchange are
not controlled. The influence of short-term factors is much-less in present-day
conditions.
Financial operations include, among other transactions, short period
movement of funds between two or more countries. If rates of interest are higher at
one center than at another, the tendency would be for banks and other institutions at
the place where the rates are low to use some of the funds for investment in bills the
other center. In rates of interest in a country rise due to a rise in the central bank or
some other reasons, there is a flow of short-term funds to the country and the demand
for its currency and the exchange value of the currency rises in the exchange markets
of other countries. The reverse happens if there is a fall in interest rates. Funds are
also exported for short-term investment in other countries when the exchange value of
the currency is expected to fall. This is purely a speculative operation.
Stock exchange transactions do play an important part in influencing exchange
rates when imports and exports of capital are permitted. Residents of country
sometimes buy a foreign currency in order to purchase securities on the stock
exchanges of that country. These purchases may be for genuine investment or may be
for speculative purposes. This is likely to happen when industrial prospects in the
country of investment are bright and the prices of securities are expected to rise. In the
event of poor economic and industrial outlook investments in that country are
repatriated and the demand for its currency falls.
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Another financial factor is movement of funds from one center to another by
banks. Banks maintain balances at different centers and the volume of maintaining the
balances at a center depends on the economic and industrial state of the country.
When the outlook in this regard is bright, remittances to the country increases and the
banks acquires larger balances in that country. To pay for the foreign currency with
increased demand, the value the currency changes the event of a poor outlook, banks
shift their holdings to centers where the outlook is favorable and in such
circumstances the exchange value of the currency depreciates.
In recent years movement of funds from one country to another has been
taking place on government account due to external assistance, aid and line of credits.
Untied States particularly has been giving large financial assistance to other courtiers.
This has increased the supply of funds in the aid-receiving countries.
An exchange rate is sometimes affected by the disbursements and repatriation
between countries for their debt settlements. When the economic outlook for a
country has a stronger position in relation to others, and foreigners who have to make
remittances to the country do so before the value of the currency rises higher. The
demand for the currency rises further and its exchange value becomes more country is
poor, the currency shows a downward trend in exchange markets. There is a tendency
for the residents of the country to transfer their funds abroad and for foreigners to
withdraw their funds. The currency, therefore, weakens further.
Financial, operations also arise form what are known as Arbitrage
Operations. Arbitrage means the simultaneous buying and selling of any commodity
at two or more centers, used by a discrepancy in the price differentiation at different
places. Arbitrage in stocks or money or exchange on a international scale has an
important influence n exchange rates. For example, taking price and exchange rates
into account, an international operator may find that the price of a particular security
which is bought on stock exchange at two centers in different countries differs. He,
therefore, enters in a purchase deal at the center where the price is low and
simultaneously enters into a sale deal at the one where the price is high. This
necessitates remittance from the latter center to the former, causing the exchange rate
to change in favor of the former and against the latter.
4.2 LONG TERM FACTORS
(a) Currency and Credit Conditions
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Any economic condition which causes the internal purchasing power of a
currency to rise or fall eventually affects its exchange value. Such effects are
frequently aggravated by the speculators in the exchange markets. Sometimes these
operations curtail or diminish the effects of the economic factors.
An expansion of currency circulation in a country raises the level of internal
prices, or in other words, reduces the purchasing power of the currency and in the
country. This has an adverse effect on export trade of the country and the demand for
its currency in the exchange market tends to fall, causing fall in the exchange value of
the currency. The speculators then sell the currency with the intention of buying it
back when its price has gone down. This has a further lowering effect on the exchange
value. This trend prevails till the effect of the internal rise in prices on exports is
offset by the fall in the exchange value of the currency. A revival of a trade activity or
an improvement in the investment climate in a country increases the demand for the
countrys exports from rising further.
A currency may be in demand as it may be used as reserve by central banks or
is used for making internal payments. This is usually a currency which is easily
convertible into other currencies. U.S. dollar is one such currency and its value could
be maintained in spite of large supplies of dollars in the world market. British sterling
has been convertible into other Sterling Area currencies and has been in use for
payments between countries of that area. Since 1958, the sterling has been made
initially convertible into other currencies also and its demand has increased. This,
therefore, been able to maintain its value in spite of payments deficits.
(b) Political and Economic Conditions
Political conditions in a country have an effect on the exchange market. A
stable government and healthy economic and political conditions are factors which
entourage foreign capital to flow into the country. The demand for the countrys
currency strengthens its exchange value. Political unrest, on the other hand, causes
and outflow of capital, weakening the currency externally.
The current position and future outlook in the industrial field, the budgetary
position of the government, and an overall economic situation have also important
influences in the exchange market. The existence of industrial peace, stable level of
wages and prices and high level of efficiency in production have a strengthening
effect on the exchange value of the currency in the long period. S similar is the effect
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of a balanced budged. Conversely, industrial unrest, high cost of production and
prolonged deficit financing having an adverse effect on the exchange value of the
currency.
The effects of economic and political factors on exchange rates are further
accentuated by speculation. Speculation creates considerable uncertainty and
disturbance in the exchange market.
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CHAPTER 5
CONCLUDING REMARKS, RECOMMENDATIONS AND
FUTURE PROSPECTS OF FOREX MARKET IN INDIA
With the passage of time and with the advent of globalization, the Indian forex
market has experienced sea changes. The adoption of the unified exchange rate
system from March 1993 means adoption of a floating-rate regime, but it is a
managed floating and the Reserve Bank of India intervenes in the foreign exchange
market in order to influence the value of the rupee. In the first two years, the value of
the rupee remained stable but then onward, it has been depreciating despite RBIs
intervention. The foreign exchange market again came under pressure in August
1998, reflecting the adverse sentiment on account of the deepening of financial crisis
in Russia and fears of the Chinese renminbi devaluation, resulting in a depreciation of
the rupee to Rs. 43.42 on August 19, 1998.
Authorized dealers in foreign exchange do a small volume of business with
travelers going or coming from other countries of selling and buying foreign currency
notes and coins. Besides the authorized dealers, there are also money changers
specially authorized to deal in foreign currencies.
The Indian foreign exchange market, broadly concentrated in big cities, is athree-tier market. The first tier covers the transactions between the Reserve Bank and
the authorized dealers (Ads). As per the Foreign Exchange Regulation Act, the
responsibility and authority of foreign exchange is vested with the RBI. It is the apex
body in this area and for its own convenience, has delegated its responsibility of
foreign exchange transaction functions to Ads, primarily the scheduled commercial
banks. They formed the Foreign Exchange Dealers Association of India which frames
rules regarding the conduct of business, coordinates with the RBI in the proper
administration of foreign exchange control and acts as a clearing house for
information among Ads.
The exchange value of a currency, or the rate of exchange, fluctuates with
changes in demand and supply. The factors which affect the demand for and the
supply of a currency are many and varied. There are some factors which operate in the
short period and have influence on day-to-day fluctuations in rates of exchange. The
commercial and financial relationship between trading countries is now extensive and
payments on various accounts fall, due for early settlement. These payments
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constitute the short-term demand and supply in regard to currencies. There are,
however, changes in currency and credit conditions and political and industrial
conditions which have their influence on exchange rates only in the long period.
In recent years financial markets have developed many new products whose
popularity has become phenomenal. Measured in terms of trading volume, the growth
of these products-principally futures and options contracts for physicals commodities
have only recently attracted internet. Traders make use of the market for currency
futures in order to hedge their foreign exchange risk. Speculators make use of the
currency futures for reaping profits. When they expect that the sport rate of a
particular currency will move up beyond those mentioned in the currency futures
contract, they buy currency futures denominated in that particular currency. At
maturity, if their expectations come true, the difference in the sport rate and the rate
mentioned in the futures contract will be the profit to be reaped by them. Foreign
currencies are traded in the market for currency options as well. The purpose is either
the hedging of foreign exchange exposure or making of profits through speculation.
Broadly speaking, there are two types of options. In a call option, the buyer of
the option agrees to buy the underlying currency, while in a put option contract the
buyer of the option agrees to sell the underlying currency.
The need of the hour is to have a complete control of market by the RBI and
Govt. of India regarding the convertibility of rupee so that the story of currency of the
South-East Asia could not be repeated and the stability of rupee could also be
maintained to give boost and confidence to our international trade.
Recommendations
1) To avoid the adverse effects of rate of fluctuations and ultimate losses or
gains to either of the trading partners, India should enter into Bilateral
Trade Agreements wherein the payments are settled through exchange of
goods and services instead of making the payments in currencies of either
of the countries.
2) Shares purchased by foreign citizens should be controlled and checked
because this is more for speculative purposes.
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3) As the prices of currency differ in different markets, it promotes arbitrage
operations of the currency so focus should be paid on maintaining similar
rates around the world.
4) Circulation of the currency in the country should be limited as it decreases
the purchasing power of the currency and which has a adverse effect on
exports of the country.
5) In India industrial unrest, high cost of production and prolonged deficit
financing are causing adverse effect on exchange value of the currency
which needs to be removed.
6) Incremental CRR of 10% of NRER and NR accounts should be reduced to
segment supply of foreign exchange in the country.
FUTURE PROSPECTS OF FOREX MARKET IN INDIA
The exchange rate remained stable in the period that followed the institution of
a market-based exchange rate mechanism in March 1993, even though liberalization
of transactions during this period helped in a quick transition to currency account
convertibility. During 1992-93 or 1994-95, stability in the currency market was
supported by the Reserve Banks policy of absorbing the excess supply resulting from
strong capital inflows. As a result, all segments of financial market witnessed easy
liquidity conditions as a result. The Reserve Bank divested net domestic assets
(essentially through open market, including repo operations) to maintain monetary
stability, while modulation interest rates in the money market. The domestic currency
came under minor pressure during November 1994 and in mid March1995, but
stability was quickly restored. The latter half of the nineties, however, witnessed
some episodes of volatility in the money and the foreign exchange market which
underscored the gradual integration of the domestic money market and the foreign
exchange market. Asset prices responded to deregulation of interest rates, two-way
capital movements, changes in macroeconomic conditions and general sentiments that
were impacted by economic and non-economic factors. The South-East Asian crises
necessitated twin-pronged policy action. The Reserve Bank attempted to mitigate
excess demand conditions in the foreign exchange market. In also moved to siphon
off excess liquidity from the system in order to reduce the scope for arbitrage between
the easy money market and the volatile foreign exchange market. This helped contain
the impact of contagion. Foreign currency sales in the third quarter of1997-98 (which
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resulted in a decline of Ks. 7,150 crore in the RBIs NFA-adjusted for revaluation)
were undertaken to curb the volatility in the exchange rate. Measures, such as removal
of incremental CRR of10.0 per cent on NRER and NR (NR) deposits defective
December 6, 1997, were also undertaken to segment supply of foreign currency. With
a view to containing demand, the interest rate on post-shipment export credit in rupees
beyond 90 days and up to six months was raised from 13.0 percent to15.0 percent and
an interest rate surcharge was introduced on import finance as leads and lags in import
payments and export realizations widened.
The restoration of stability in the Indian currency market was primarily the
result of a credible stance to arrest volatility caused by speculation and keep rupee
stable and the gradual moderation of pressures in the East Asian currency markets in
end-January 1998. As the rupee adjusted downwards smoothly in the months that
followed aided by a turnaround in capital inflows, the Reserve Bank eased some of
the monetary measures clamed earlier in the face of volatility. Export credit refinance
limits were restored in April 1998.
The foreign exchange market saw the return of excess demand conditions in
mid May 1998, in reaction to the Impending sanctions, resulting in the exchange rate
weakening from Rs. 39.73 per US dollar at the beginning of May to Rs. 42.38 by June
11, 1998. The Reserve Bank sold foreign currency in response to excess demand in
the foreign exchange market, depleting its NFA by Rs. 6,597 crore (adjusted for
revaluation). Net merchant forward sales jumped to US $ 5,498 million, resulting in a
sharp increase in the one-month forward premium to 9.59 percent in June 1998 from
3.67 percent in April 1998. The Reserve Bank announced a package of policy
measures on June 11, 1998 to contain volatility in the foreign exchange market. These
included:
(i) Announcement of the Reserve Banks readiness to sell foreign exchange to
meet demand-supply mismatches.
(ii) Advising importers as well as banks to monitor their credit utilization so as
to meet only genuine foreign exchange demand and discourage any undue
buildup of inventory.
(iii) Allowing banks/Ads acting on behalf of FIIs to approach the Reserve
Bank for direct purchase of foreign exchange and
(iv) Advising banks to charge a spread of not more than 1.5 percentage points
above the LIBOR on export credit in foreign currency as against the earlier
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norm of 2.0-2.5 percentage points. Stability returned briefly but pressures
renewed by the end of the month. The rupee touched Rs. 42.92 per US
dollar on June 23, 1998 but firmed up at end-June 1998 to Rs. 42.47 per
US as stability was restored with the sentiment improving in response to
the Reserve Banks policy response and favorable politician developments.
The foreign exchange market again came under pressure in August 1998, reflecting
the adverse sentiment on account of the deepening of financial crisis in Russia and the
fears of the Chinese renminbi devaluation, resulting in a depreciation of the rupee of
Rs,. 43.42 on August 19,1998. This was reflected in net spot and forward merchant
sales in the foreign exchange market of US $ 1255 million and US $ 2,225 million.
The one-month forward premia, which had softened to 5.84 percent in July firmed
back to 9.58 percent in August 1998. The Reserve Bank announced a second package
of measures in order to prevent speculative pressures on the foreign exchange market,
which, inter alia, included:
(i) A hike in the CRR from 10 percent to 11 percent.
(ii) Increase in repo rate from 5 per cent to 8 percent, and
(iii) Withdrawal of the facility of rebooking of the cancelled contracts for
Imports and splitting forward and spot legs for a commitment. A
significant contribution in this phase was made by the mobilization of US
$4.2 billion through Resurgent India Bonds (RIBs) that helped in an
accretion of US $ 3.7 billion to the foreign exchange reserves. The rupee
strengthened to Rs. 42.55 per US dollar by end-August and further to Rs.
42.59 per US dollar by end-September. The one-month forward premia
declined to 7.42 percent in September and to 4.96 percent by December
1998.
Liquidity conditions tightened with the return of excess demand conditions in
the foreign exchange market during May-June 1998 but eased after the Reserve Bank
announced its intention to limit the impact of the large Government borrowing
programm by accepting private placement of Government securities when bids were
unreasonably high and releasing them to the foreign exchange market as and when
liquidity conditions improved. RBIs also helped in reviving the market interest in the
Government paper.
March 1999 saw the revival in capital inflows with the Reserve Banks NFA
recording an accretion of Rs. 8008 crore 9adjusted for revaluation). With the return of
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orderly conditions in the foreign exchange market/the Reserve Bank announced the
reduction in the Bank Rate by one percentage point to 8 percent and the repo rate by 2
percentage point to 6 percent effective March 2, 1999 and lowered the reserve
requirements (by 50 basis points each effective March 13, 1999 and May 8, 1999.
The foreign exchange market witnessed a degree of volatility during end-May-
June 1999 and August 1999. Effects of policy pronouncements backed by sale of
foreign exchange of Rs. 2242 crore (adjusted for revaluation were able to restore
stability in the foreign exchange market. The Reserve Bank reiterated its policy of
meeting temporary mismatches in the foreign exchange market, after the rupee
depreciated to Rs. 43.39 per US dollar by June 25, 1999 in order to restore orderly
conditions in the foreign exchange market as the demand supply gap widened in end-
August 1999 the Reserve Bank indicated its readiness to meet fully/partly foreign
exchange requirements on account of crude oil imports.
The exchange rate of the rupee against the US dollar continued to be broadly
market determined. During 1999-2000, the exchange rate market displayed reasonable
stability, with the rupee depreciating by about 2.9 per cent from the annual average of
Rs. 42.07 per US dollar in 1998-99 to Rs. 43.33 in 1999-2000. In contrast the year
2000-2001 witnessed significant downward pressures on the rupee-dollar rate from
mid-May 2000. The forex markets were affected by considerable uncertainly with the
rupee depreciating by 6.7 percent between end-April and end-October 2000 from Rs.
43.665 per US dollar to Rs. 46.775. Since November 2000, the situation has shown
large improvement and the forex market have been relatively stable. At the end of
January 2001, the exchange rate of the rupee was Rs. 46.415 per US dollar showing a
depreciation of 6.1 percent, compared with the rate of Rs. 43.605 at the end of March
2000.
The exchange rate remained stable in the period that followed the institution of
a market-based exchange rate mechanism in March 1993, even though liberalization
of transactions during this period helped in a quick transition to current account
convertibility. During 1992-93 to 1994-95, stability in the currency market was
supported by the Reserve Banks policy of absorbing the excess supply resulting from
strong capital inflows. As a result, all segments of financial market witnessed easy
liquidity condition as a result. The Reverse Bank divested net domestic assets
(essentially through open market, including repo operations) to maintain monetary
stability, while modulating interest rates in the money market. The domestic currency
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came under minor pressure during November 1994 and in mid-March 1995, but
stability was quickly restored. The latter half of the nineties, however, witnessed some
episodes of volatility in the money and the foreign exchange market which
underscored the gradual integration of the domestic money market and the foreign
exchange market. Asset prices responded to deregulation of interest rates, two-way
capital movements, changes in macroeconomic conditions and general sentiments that
were impacted by economic and non-economic factors. The foreign exchange
reserves of the country consist of foreign currency assets held by the RBI, gold
holding of the RBI and SDRs. Foreign currency assets at the end of March 2000
amounted to US $ 35.06 billion, showing an increase of US % 5.54billion during
1999-2000. During the first seven months of 2000-01, these assets had declined by
about US $ 2.96 billion to US $ 32.09 billion at the end of October 2000, reflecting
steps (sale of foreign exchange) taken by the RBI to meet part of the excess demand
in the foreign exchange market created by the surge in Indias oil import bill because
of the near tripling of international oil prices within a year so. An essential component
of strategy by to meet the challenge of this extraordinary increase in oil imp