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The market where the commodity traded is Currency.

Price of each currency is determined in term of other currencies.

Purpose: to help international trade and investment

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WHAT IS A FOREIGN EXCHANGE MARKET?

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

This 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.

As in the rest of the world, in India too, foreign exchange constitutes the largest financial market by far.

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ORIGIN

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ORIGIN

In India the foreign exchange market originated in 1978

It was in the 1990’s that the Indian foreign exchange market witnessed far reaching changes along with the shifts in the currency regime.

Following the recommendations of the “Rangarajan Committee” on Balance of Payments, the exchange rate of the rupee (which was earlier pegged) was floated partially in March 1992 and fully in March 1993.

The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and was an effort towards current account convertibility, which was achieved in August 1994.

A further impetus to its’ development was provided with the setting up of an Expert Group on Foreign Exchange Markets in India (Chairman: Mr O.P. Sodhani), which submitted its report in June 1995.

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

Consequently, beginning from January 1996, wide-ranging reforms have been undertaken in the Indian foreign exchange market.

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ORIGIN

In 2005, an Internal Technical Group was constituted to undertake a comprehensive review of the measures initiated by the RBI and identify areas for further liberalisation. or relaxation of restrictions

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Enhanced risk-bearing capacity of banks along with rising foreign exchange trading volumes and finer margins.

The foreign exchange market has acquired depth

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

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,

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CONSEQUENCES

The exchange rate of the rupee was officially determined by the RBI in terms of a weighted basket of currencies of India’s major trading partners

The foreign exchange market in India till the early 1990s, remained highly regulated with restrictions on external transactions, barriers to entry, low liquidity and high transaction costs

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, i.e., the hawala (unofficial) market

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FOREX MARKET DEVELOPMENT

Fixed ERM, with occasional devaluations.

Reserve Bank of India (RBI) to fix its buying & selling rates for Authorized Dealers and their rates for customers.

Residents not allowed to hold foreign exchange.

Only ADs (Banks), allowed to deal in Forex.

Forex available only for current account transactions. (goods & services) and some other personal transactions viz. travel, education, medical treatment etc. 9

PRE REFORMS ERA

Reserve Bank of India (RBI) to buy and sell forex from and to ADs, at its buying and selling rates for Authorized Dealers.

Reserve Bank of India (RBI) to provide forward cover to ADs for importers and exporters as well as foreign currency loans mobilized by corporates from abroad.

Exporters of goods and services, were bound to sell forex to an AD at rates prescribed by Reserve Bank of India (RBI).

Elaborate system of reporting by ADs to Reserve Bank of India (RBI).

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PRE REFORMS ERA

FERA was introduced at a time when Forex reserves were low

Was based on the presumption that all foreign exchange earned by Indians rightfully belonged to the Government, so should be surrendered to the RBI.

It also regulated all transactions with non-residents

Primarily prohibited all Forex transactions except those permitted by the RBI

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FERA - 1973

Basic purpose of FERA was to:

Help RBI to maintain exchange rate stability

Conserve precious foreign exchange

Prevent/ regulate foreign business in India

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FERA - 1973

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POST REFORMS ERA

Following the recommendations “O.P.Sodhani Expert Committee,” since 1996, wide-ranging reforms have been undertaken for deepening and widening of the Indian foreign exchange market.

Recommendations implemented by RBI include:

For Banks, freedom to:-

Fix overnight position or gap limit

Initiate trading position in overseas markets

Borrow or invest funds in the overseas markets (within

limits)

Determine interest rates and maturity period of FCNR

deposits

Use derivative products for asset liability management

Exemption of inter-bank borrowings from statutory

requirements

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POST REFORMS ERA

For corporates:-

Permission to hedge anticipated exposures Freedom to cancel and rebook forward contractsSome freedom in managing exposures and access to lower cost option strategies

For improvements in internal controls:-

Framing risk management guidelines for banks

FEMA was the required since FERA was incompatible with the pro-liberalization policies of the GOI.

FEMA sought to make foreign exchange offences Civil offences, as opposed to Criminal offences under FERA

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FEMA - 1999

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RUPEE IN THE POST REFORMS ERA

During 1994-95 there was upward pressure on the rupee because of foreign portfolio capital inflow that was now allowed to enter India.

However, the rupee was not allowed to appreciate but was kept constant by the RBI.

This was due to the conflict between the objectives of export promotion and the free movement of the rupee.

The market was not freely allowed to determine the exchange rate of the rupee. If it had, the rupee would have appreciated.

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RUPEE IN THE POST REFORMS ERA

In 1995 the initial surge was over and buying pressure from FII’s reduced.

As the rupee continued to be overvalued the current account deficit started mounting.

There was downward pressure on the rupee.

A depreciation in the rupee was welcome as the appreciation in the real exchange rate had made exports uncompetitive.

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RUPEE IN THE POST REFORMS ERA

In the following year, the appreciation of the US dollar against other major currencies put upward pressure on the rupee.

In 1997-88 and 1998-99 the RBI allowed the rupee to be more or less determined by the market.

In this period there has been little pressure on the nominal rate to appreciate and whenever political, economic or other reasons have introduced volatility in the foreign exchange market the RBI has intervened.

The stated objective of the RBI’s exchange rate policy is to reduce volatility and speculation in the foreign exchange market and to keep the rate in line with economic fundamentals

The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments – – Spot market– 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 derivatives market encompasses forwards, futures, swaps and options

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STRUCTURE

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

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

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

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STRUCTURE

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PARTICIPANTS IN THE FOREX MARKET

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SOURCES OF SUPPLY OF FOREX

SUPPLY

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SOURCES OF DEMAND FOR FOREX

DEMAND

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FOREX DERIVATIVE INSTRUMENTS IN INDIA

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COMPONENTS OF A STANDARD FOREX TRANSACTION

Base Currency (USD/INR)

‘Dealt’ or ‘Variable’ Currency

Exchange Rate

Amount

Settlement Instructions

In the Forex market rates are always quoted ‘two way’.

Two way quote gives both ‘Bid’ and ‘Offer’.

e.g.

USD/INR= 48.50 / 50 Bid / Offer

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FOREX RATE QUOTATION

The bank quoting the price is ‘price maker’ or ‘market maker’.

The bank asking for the price or ‘quote’ is the ‘price taker’ or ‘user’.

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PRICE TAKER v/s PRICE MAKER

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NOSTRO & VOSTRO ACCOUNTS

Foreign exchange transactions are settled Foreign exchange transactions are settled through Nostro and Vostro accounts.through Nostro and Vostro accounts.

Nostro : our account with banks abroad. Nostro : our account with banks abroad. Reserve Bank of India (RBI) maintains various Reserve Bank of India (RBI) maintains various Nostro accounts in a number of countries.Nostro accounts in a number of countries.

Vostro : their account with us. Many multilateral Vostro : their account with us. Many multilateral agencies (e.g. IMF, World Bank) maintain their agencies (e.g. IMF, World Bank) maintain their Nostro accounts at Reserve Bank of India (RBI). Nostro accounts at Reserve Bank of India (RBI).

Exposure to exchange rate movement:-

• Any sale or purchase of foreign currency entails foreign exchange risk.

• Foreign exchange transaction affects the net asset or net liability position of the buyer/seller.

• Carrying net assets or net liability position in any currency gives rise to exchange risk.

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Foreign Exchange Risk

• NOP is the Net Asset/Net Liability position in all FCs together

• Net Asset Position is also called “LONG” or “Overbought “ position.

• Net liability Position is also called “SHORT” or “Oversold “ position.

• NOP is a single statistic that provides a fairly good idea about exchange risk assumed by the bank.

• Its major flaw is that FX exposures in third currencies remain hidden.

–

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NET OPEN POSITION- (NOP)NET OPEN POSITION- (NOP)

EXAMPLE (NOP)EXAMPLE (NOP) (USD in Mill)

Opening Position $ 0.00

Ready Purchases from Exporter $ 1.00

Fwd Purchases from Corporate (1.00 Euro) $ 0.90

Ready Sell to importer ( 60 Mill Yen) - $ 0.50

Fwd Sell to Corporate - $ 0.40

NET OPEN POSITION $ 1.00

Foreign Exchange Exposure

FX Exposure is the higher of the long and short positions in FCs.

EXAMPLE

Currency-wise NOP in equivalent INR

CURRENCY SHORT LONG

Dollar -10Yen 10Euro -10Pound 10

Total -20 20

Net Open Position is 0 while exposure is 20.

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Introduction to Inter-bank FX activitiesIntroduction to Inter-bank FX activities

• In pursuance of the recommendations of the Sodhani Committee, the RBI had set up the Clearing Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets.

• The CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR spot and forward trades from November 8, 2002 and for inter-bank USD-INR cash trades from February 5, 2004.

• The CCIL undertakes settlement of foreign exchange trades and all spot and cash transactions are guaranteed for settlement from the trade date.

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RISK MANAGEMENT

• 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, thereby increasing market efficiency.

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ASSESSMENT

• The efficiency/liquidity of the foreign exchange market is often gauged in terms of bid-ask spread.

• The low and stable bid-ask spread in the foreign exchange market indicates that market is efficient with underlying low volatility, high liquidity and less of information asymmetry.

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ASSESSMENT

• Turnover in the foreign exchange market was 6.6 times of the size of India’s balance of payments during 2005-06 as compared with 5.4 times in 2000-01.

• With the deepening of the foreign exchange market and increased turnover, income of commercial banks through treasury operations has increased considerably.

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ASSESSMENT

INR vs USD

INR vs USD• From 1991-92 to 1995:

– Rupee corrected as it was highly overvalued vis-à-vis other currencies.– From Rs. 18/$ (1991-92) to Rs. 35/$ (1995).

• From 1995 to 2001:– The partially convertible rupee has depreciated from 30 in 1995 to

49.90 in 2001 against the US dollar on greenback’s strength globally.

– The US dollar index posted a high of 121 during 2001 from low of 80.00 posted during 1995.

• From 2002 to 2007:– the rupee has been appreciating or the USD has been falling to post a

low of 39.00, as the US dollar slid against the major currencies.

• From 2008 onwards:– The Indian rupee started losing against the US dollar from 2008

onwards on global economic recession and as US Dollar attracted some buying interest as a safe heaven investment.

– The USDINR rose to a high of 52.13 following short supply in the market. Among all asset classes, the US dollar performed during the period as safe heaven instrument despite its own structural problems.

– The period marked with massive FII outflow from India following redemption pressure of funds in their home countries.

INR vs JPY

INR vs JPY• 1995 JPY appreciation:– From 1991-92 to 1995 Rupee corrected as it was highly overvalued

vis-à-vis other currencies.– From Rs. 18/$ (1991-92) to Rs. 35/$ (1995).

This is reflected v/s JPY.

• 1997 JPY depreciation:– Asian crisis of 1997 hit Japan harder than India. Hence, depreciation.

• 2001 JPY depreciation:  – This transition is due to dot com bubble burst

• 2007 JPY depreciation:– Financial crisis, recession. JPY suffered.– Rupee relatively insulated. Hence fall for JPY.

• 2010 JPY appreciation:– Capital and current a/c surplus – Japan– Heavy investments by China into JPY bonds.

INR vs CNY

INR vs CNY• Steep decline in 1994:

- 1990-2006: Waves of public protests, particularly in rural areas against Chinese Government

• Slowdown in 1996:

- 1995: Overheating of the economy: 17% Inflation rate,

- 1995, Oct.: Earthquake in Yunnan (6.5 at Richter scale). 50 people die and 6,000 are injured. 170,000 people homeless.

• Slowdown Post 1998:

- 1998-1999: Slow-down of the Chinese economy - partly due to Asian Financial Crisis

- 1998: Worst flooding in years - 230 million people affected and 3,656 dead

- 1998, April: One of the most devastating sandstorm in decades is raging in Beijing for two days, blocking sunlight

• Peak at 2002:

- 2001, Nov.: China becomes a member of the World Trade Organization

- 2002 Feb: A series of riots in India

INR vs CNY• Decline post 2002: - 2001, June: Growing tension across the Taiwan Strait• Appreciation from 2007-09: - Rapid Economic growth in China ( GDP in 2007 – 10.6%) - International Balance of Payment surplus and large Forex Reserves - Rising Interest Rates• Decline in 2010: - Earthquake of magnitude 7.1 on Richter scale hit southern Qinghai

province in China - The European debt crisis - Major Oil Spill in China

• The Indian Foreign Exchange Market and the Equilibrium Real Exchange Rate of the Rupee - Ila Patnaik and Peter Pauly

• www. rbi.com

• www.tradingeconomics.com

• www.economictimes.com

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REFERENCES

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