dimpal goyal desertation (1)

8/7/2019 dimpal goyal desertation (1)

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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


37/43

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


41/43

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


42/43

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

Documents

dimpal goyal desertation (1)