UNIT-IIIFOREIGN EXCHANGE MARKET:

Introduction:Within India the rupee can be used to buy all types of goods and services. But it cannot

be used to buy goods from foreign countries for the very simple reasons that the people in foreign countries do not like to be paid in any other currency except in their own. However, an Indian who wants to buy foreign goods, say, from England, can easily do so by first buying the pound sterling with the help of the rupee and using the sterling to buy anything he requires in England. The rupee, therefore, can buy goods in a foreign country not directly but indirectly, through the help of the foreign currency.

What do you mean by rate of exchange?The rate at which one currency buys or exchanges for another currency is known as the

rate of exchange. In other words, the foreign exchange rate or exchange rate is the rate at which one currency is exchanged for another.

It is the price of one currency in terms of another currency.The rate of exchanges of a currency simply expresses its external value or its external

purchasing power. The rate of exchange is a price – the price of one currency in terms of another. Like any other price, the rate of exchange depends upon demand and supply of the local currency in terms of the foreign currency.

The exchange rate between the dollar and the rupee refers to the number of dollar required to purchase rupee. Thus, the exchange rate between the dollar and the rupee from the U.S point is expressed as &1 = Rs.52.

Concepts / transactions / kinds of foreign exchange: Spot rate and forward rate:

The spot rate of exchange refers to the rate at which foreign currency is made available on the spot. In other words, spot exchange refers to the class of foreign exchange transaction which required the immediate delivery or exchange of currencies on the spot. In practice, the settlement takes place with in two days in most markets.

The forward rate is the rate at which a future contract for foreign currency is bought and sold the forward rate is quoted at a premium or discount over the spot rate. In other words, it is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract.Fixed, flexible and floating exchange rates:

Fixed exchange rate refers to the system under which the rate of exchange of a currency is fixed or pegged in terms of gold or in terms of another currency. In other words, countries following the fixed change rate (also known as stable exchange rate and pegged exchange rate) system agree to keep their currencies at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so.

Under flexible exchange rate system, exchange rate is freely determined in an open market primarily by private dealings, and they, like other market prices, vary from day – to day.

Floating rate of exchange comes into existence when the currency unit of a country is free to fluctuate and find its own level, according to conditions of demand and supply in the foreign exchange market.Multiple rates:

If a country adopts more than one rate of exchange for its currency, it is said to follow a system of multiple exchange rates. It may have one rate for exports and another for imports; or it may have one rate of exchange (viz. controlled rate) with some countries, and another rate (viz. free exchange rates) with others.Two tire exchange rate system:

A form of multiple exchange rates is known as the two-tier exchange rate system under which the government maintains two rates – a higher rate for commercial transactions and lower rate for capital transactions. Since 1971, France and Italy have adopted this system.

Arbitrage:Arbitrage is the act of simultaneously buying a currency in one market and selling it in

another market to make a profit by taking advantage of price or exchange rate differences in the two markets. If the arbitrage operations are confined to two markets only, they will be known as ‘two point arbitrage’. If they extend to three to more markets they are known as ‘three point’ or ‘multi point’ arbitrage.

For illustration, assume that the rate of exchange in London is 1 pound sterling = 2 dollars, while in New York 1 pound sterling = 2.10 dollar. This presents a situation wherein one can purchase one pound sterling in London for two dollars and earn a profit of 0.10 by selling the pound sterling in New York for 2.10.

Swap operation:Commercial banks who conduct forward exchange business may resort to a swap

operation to adjust their fund position. The term swap means simultaneous sale of spot currency for the forward purchase of the same currency or purchase of spot for the forward sale of the same currency. The spot is swapped against forward. Operations consisting of a simultaneous sale or purchase of spot currency accompanied by a purchase or sale respectively, of the same currency for forward delivery, are technically known as swaps or double deals, as the spot currency is swapped against forward.

What do you mean by foreign exchange market? What are its functions?The foreign exchange market consists of a number of banks, brokers and dealers engaged

in buying and selling foreign exchange and also the central bank of the country and the treasury authorities. The last two may intervene in the market occasionally. However, in India, where there was strict exchange control system, there was no foreign exchange market as such. All exporters who secured foreign currency had to surrender it within a period of three months to the RBI and get rupee from the RBI by supplying rupees. But in London and New York and other international markets, there are dealers, brokers and bankers who deal in foreign exchange.

The following are the important functions performed by foreign exchange market.Transfer functions:

The principle function of the foreign exchange market is to transfer purchasing power between countries. In the transfer of foreign exchange, the bill of exchange is the instrument normally used. The instrument most in use in foreign payment these days is the Telegraphic

Transfer (TT). It is an instrument from one bank to its correspondent bank in a foreign country to pay a specific amount of foreign currency to a particular person or firm.Credit functions:

The bill of exchange is an instrument used in the foreign exchange market with the maturity period of 3 months to meet the credit requirements of the traders. The three month period is allowed so that the importer maybe able to take possession of the goods, sell them and secure the amount to pay off the bill.Hedging function:

The hedging function is performed by the foreign exchange market whenever there is exchange risk. When exchange rates are fixed and exchange controls are imposed, there is no risk involved in foreign exchange dealings. If on the other hand, the rupee sterling rate is subject to alteration, then the Indian firm which has to receive or make payment in pound sterling will have to take exchange risks. Suppose that an Indian firm expects 10,000 pound sterling in the near future which it has earned when the rate of exchange was Rs. 55 to a pound. If the rate of exchange fluctuates, the firm will either get a profit or incur a loss depending upon the rupee sterling exchange rate. When a firm has large net claim or net liabilities in a foreign currency, it is taking an exchange risk. The exchange market provides facilities for hedging anticipated or actual claims or liabilities. This is the work of the forward or future market in foreign exchange.

SYSTEM OF EXCHANGE RATE:Fixed and flexible exchange rates:Fixed exchange rates:

The maintenance of stable rate of exchange has been the major monetary objective of all countries at all times. The International Monetary Fund (IMF) was established with the objective of stabilizing the rates of exchanges. Under fixed or pegged exchange rates all exchange transactions take place at an exchange rate that is determined by the monetary authority. The system of fixed change came to be known as pegged exchange rates or par values.

Fixed exchange rate refers to the system under which the rate of exchange of a currency is fixed or pegged in terms of gold or in terms of another currency. In other words, countries following the fixed change rate (also known as stable exchange rate and pegged exchange rate) system agree to keep their currencies at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so.Case for fixed exchange rates:Smooth flow of international trade:

International trade will flow more quickly and more easily when there is confidence all round that the existing rate will continue in future.Facilitate international investment:

International investment will be promoted through a system of stable exchange rates. Unless the exchange rate is stable, the lender and the investor will not be prepared to lend long – term investment.Necessary for a currency area:

A stable rate of exchange is more suited to a world of currency areas, such as the sterling area, where as a free or flexible exchange rate for the common currency might be a bone of contention within the area.Remove speculation:

Stable exchange rate will remove the dangerous possibilities of speculation. For, past experience with fluctuating exchange rates has shown that movements in the rate of exchange are significantly affected b y large transfer of capital.Less inflationary:

It leads to greater monetary discipline and so to less inflationary pressure.

Case against fixed change rate:The following arguments are advanced against a system of fixed change rates.

Sacrifice of objectives:The principle deficit in the operation of a system of fixed change rates is the sacrifice of

the objectives of full employment and stable price at the alter of stable exchange rates. For example, balance of payment adjustment under fixed change rates of a surplus country can take place through a rise in prices. This is bound to impose large social costs within the country.Heavy burden:

Under it, large reserves of foreign currencies are required to be maintained. Countries with balance of payment deficit must have large reserves if they want to avoid devaluation. If countries wish to remain on the fixed exchange rate system, they must hold large reserves of foreign currencies. This also imposes a heavy burden on the monetary authority for managing foreign exchange reserves.Malallocation of resources:

This system requires complicated exchange control measures which lead to malallocation of the economy’s resources.Dependence n international institutions:

Under this system, a country mostly depends upon international institutions for borrowing and lending foreign currencies.Balance of payment disequilibrium persists:

This system fails to solve the problem of balance of payment disequilibrium. It can be tackled only temporarily because its permanent solution lies in monetary, fiscal and other measures.

Flexible exchange rates:Under flexible exchange rate system, exchange rate is freely determined in an open

market primarily by private dealings, and they, like other market prices, vary from day – to day.Floating rate of exchange comes into existence when the currency unit of a country is

free to fluctuate and find its own level, according to conditions of demand and supply in the foreign exchange market.Case for flexible exchange rates:Promoted of international trade:

So long as traders have confidence in the existing exchange rates and in the ability of the government to maintain them, there will no difficult and the flow of international trade will be smooth. Under this system, the importer or exporter need not be afraid of fluctuating exchange rates because he can always protect himself through the system of forward exchange rates.Promotion of International investment:

Under this system, neither the borrower nor the lender can surely expect that the exchange rate in which he is interested will remain stable for decades. Therefore, the long term

loan floated for development purposes will be favorably influenced by the system of fixed exchange rates, but adversely influenced by flexible exchange rates is not valid.Currency area:

It is pointed out that sable exchange rates are not really necessary for any system of currency areas. Certain economic, political and social forces have bound the various countries to form the sterling block and these forces would not be weakened if the sterling is allowed to have flexible exchange, after consultation among member-countries of the block.Prevent speculation:

The chief defect of the stable exchange rates is that it encourages currency speculation, which will definitely destroy and make devaluation of the currency inevitable. A second disability of a stable exchange rate is that too often the rate does not reflect the existing and true cost –price relationship between two countries. No need to borrow and lend shor6t term funds:

As a corollary to the above, when foreign exchange rates move freely, there is no need to have international institutional arrangements like the IMF for borrowing and lending short term funds to remove disequilibrium in the balance of payments.

Case against flexible exchange rates:Mal allocation of resources:

Critics of flexible exchange rates point out that market mechanism may fail to bring about an appropriate exchange rate. The equilibrium exchange rate in the foreign exchange market at a point of time may not give correct signals to concerned parties in the country. This may lead to wrong decisions and mal allocation of resources with the country.No justification:

As a corollary, there is no justification for a government to leave the determination of exchange rates to international market forces when price, rents, wages, interest rates etc., are often controlled by the government.Encouragement to inflation:

This system has inflationary bias. Critics argue that under a system of flexible exchange rates, a depreciation of the exchange rate leads to a vicious circle of inflation. Depreciation leads to a rise in import prices thereby making import goods more expensive. This lead to cost push inflation.Breaks the world market:

This system breaks up the world market. There is no one’s money which serves as a medium of exchange, unit of account, store of value and a standard of deferred payment. Under it, the world market for goods and capital would be divided. Resources allocation would be vastly sub-optimal. In fact, such a system clearly would not last long according to Kindleberger.Fails to solve balance of payment deficit of LDCs:

Under developed countries are faced with the perpetual problem of deficit in their balance of payments because they import raw materials, machinery, capital equipments, etc., for their development. But their exports are limited to primary and other products which fetch low prices in world markets. This balance of payments deficit can be removed in a system of flexible exchange rates if there is continuous depreciation of the country’s currency.

DETERMINATION OF RATE OF EXCHANGE:Under gold standard:

This theory is associated with the working of the international gold standard. Under this system, the currency in use was made of gold or was convertible into gold at a fixed rate. If two countries are on gold standard and if their currencies are expressed in terms of a weight of gold, the rate of exchange is determined simply by reference to the gold contents of the two currencies.

Let us suppose England and United States are on the gold standard. If the official British price of gold was 6 pounds per ounce and US price of gold is 36 dollar per ounce, they were the mint price of gold in the respective countries. The exchange rate between the dollar and the pound would be fixed at &36 / 6 = &6. This rate was called the mint party or mint par of exchange because it was based on the mint prices of gold. Thus under the gold standard, the normal or basic rate of exchange was equal to the ration of their mint par values.

But the actual rate of exchange could vary above and below the mint parity by the cost of shipping gold between the two countries.

Under free paper currency – Purchasing power parity theory:This theory is associated with the name of the Swedish Economist, Gustav Cassel in 1920

to determine the exchange rate between countries on inconvertible paper currencies. The theory states that equiliburium exchange rate between two inconvertible paper currencies is determined by the equality of the relative change in relative prices in two counties. In other words, the rate of exchange between two counties is determined by their relative price level.

In simple terms, this theory states that the purchasing power of one currency will be equal to that of another currency and the rate of exchange will reflect the equality or the parity of the purchasing powers of the two currencies. The rate of exchange of the rupee and the dollar will be determined by or will be equal to their respective purchasing powers.

Let us take a simple example to illustrate this theory. Suppose India and England are on inconvertible paper standard and by spending Rs. 60, the same bundle of goods can be purchased in India as can be bought by spending 1 in England. Thus according to the purchasing power parity theory, the rate of exchange will be Rs. 60 = 1.

According to this theory, the exchange rate between two countries is determined at a point which expresses the equality between the respective purchasing powers of the two currencies. Thus, with every change in price level, the exchange rate also changes. To calculate the equiliburium exchange rate, the following formula is used.

R = domestic price of a foreign currency * domestic price index / foreign price index.

According to Cassel, the purchasing power parity is determined by the quotients of the purchasing powers of the different currencies. This is what the formula does. Let us explain it in terms of our above example. Before the change in the price level, the exchange rate was RS. 60 = 1. Suppose the domestic (India) price index rises to 300 and the foreign (England) price index rises to 200, thus the new equiliburium exchange rate will be.

R = 1 * 300/200 = 1.5 or RS. 60 = 1.5 pound sterling.

Demand and supply theory of foreign exchange: The demand for and supply of foreign exchange theory is also known as balance of

payment theory or the general equilibrium theory of exchange rate, holds that the foreign exchange rate, under free market conditions, is determined by the conditions of demand and

supply in the foreign exchange market. Thus, according to this theory, the price of a currency, i.e., the exchange rate is determined just like the price of any commodity is determined by the free play of the forces of demand and supply.

The value of a currency appreciate when the demand for its increases and depreciate when the demand falls, in relation to its supply in the foreign exchange market.

The extent of the demand for and supply of a country’s currency in the foreign exchange market depends on its balance of payment s position. When the balance of payments is in equilibrium, the supply of and demand for the currency are equal. But when there is a deficit in the balance of payments, supply of the currency exceeds its demand and causes a fall in the external value of the currency, where there is a surplus, demand exceeds supply and causes a rise in the external value of the currency.

The demand for foreign exchange arises from demand for foreign goods, services, financial assets etc., and the supply of foreign exchange comes from the foreign demand for the home country’s goods, services, financial assets etc.DIAGRAM:

In the above diagram, D represents the demand for foreign exchange and S for the supply of foreign exchange. At point E the supply and demand are equal and, therefore, E represents the equilibrium rate of exchange. If the demand shifts to D1, the exchange rate will increase to R3 and if the demand falls to D2, the rate will fall to R4. The other diagram shows the effect of changes in the supply on the exchange rate.Evaluation:

The balance of payment theory provides a fairly satisfactory explanation of the determination of the rate of exchange. This theory has the following merits.

Unlike the purchasing power parity theory, the balance of payments theory recognizes the importance of all the items in the balance of payments, in determining the exchange rate.

This demand and supply theory is in conformity with the general theory of value – like the price of any commodity in a free market; the rate of exchange is determined by the forces of demand and supply.

This theory brings the determination of the rate of exchange within the purview of the general equilibrium theory. That is why this theory is also called the general equilibrium theory of exchange rate determination.

It also indicates that balance of payments disequilibrium can be corrected by adjustments in the exchange rate (i.e., by devaluation or revaluation) rather than by internal deflation or inflation.The main defect of the theory is that is does not recognize the fact that the rate of

exchange may influence the balance of payments.

Why does the rate of exchange fluctuate?The rate of exchange does not fluctuate under the gold standard, as it is fixed by

reference to the gold contents of the two currency units. On the other hand, the rate of exchange under free paper currency will fluctuate according to demand and supply forces.

The factors which affect or influence or responsible for fluctuations in the rate of exchange are given below.

The course of international trade Monetary policy Capital movement and

Speculative activities Change in price Change in rate of interest Stock exchange influences Political conditions Type of economy Policies of the government.

The course of international trade:Basically, foreign exchange is demanded to pay for imports. If India exports to and

imports from America are exactly equal, there will be no net demand for the rupee or the dollar. But suppose India’s demand for American goods is greater than the American demand for Indian goods. This leads to greater demand for the dollar by the Indian to meet the excess of imports from America. Consequently, the price of the dollar in terms of the rupee will rise; the dollar tends to appreciate in value. Thus, whenever there is disequiliburium in the balance of trade, there will be a pressure on the rate o exchange pushing up or down the value of one currency in terms of another.Monetary policy:

Suppose India follows an inflationary policy (say, through deficit financing), the price level in India is rising and the purchasing power of the rupee is falling. The price level in America may remain the same. Indian will like to buy more from America while the Americans will like to buy less from India. As a result, Indian exports from America will tend to exceed Indian exports to America. This will also lead to a pressure on the rate of exchange in favor of the dollar. On the other hand, if India raises the bank rate, there will also be a rise in the rates of interest by commercial banks in India. Foreign funds may be attracted into India leading to a greater demand for the rupee and hence the rate of exchange will rise in favor of the rupee.Capital movement:

Capital movement between countries may be for short periods generally to secure high interest rates or for long periods for genuine investment. Suppose a large amount of capital is shifted from America to India. In the first instance, it leads to demand for Indian currency and thus pushes up the value of the rupee in terms of the dollar. But when capital gets back to America, the effect on the exchange rate will be just the oppose- appreciation of the America currency and depreciation of the Indian currency.Speculative activities:

Speculation in foreign exchange plays an important part in the fluctuation of the exchange rate. If speculators imagine nor that the some reason for the other the dollar will appreciate in value in the near future, they will buy it from now on to sell it later at the higher price. But the current buying of the dollar will raise its value from now on. In the same way if speculators in foreign exchange anticipate an appreciation of the rupee in the future, they will buy the rupee now, as a result of which the rate of exchange will go up even now in favor of the rupee.Change in prices:

It is the changes in the relative price levels that cause change in the exchange rte. Suppose the rice level in Britian rise relative to the US price level. This will lead to the rise in the price of British goods in terms of pound sterling. British goods will become dearer in the US. This will lead to reduction in British exports to the US. So, the supply of dollar to British will diminish. On the other hand, the American goods become cheaper in Britian and their

imports into Britian increase. So the demand for dollars will increase. Thus, the supply curve for dollars will shift to the left so that the change rate is established at a higher level from the point of view of the US. It implies appreciation of the value of the dollar and depreciation of the value of the pound.Change in the interest rate:

Changes in the interest rates also lead to changes in the exchange rate. If interest rates rise in the home country, there is a large inflow of capital from foreign counties. As a result, the exchange rate of the domestic currency will appreciate relative to the foreign currency. The opposite will be case, if interest rate falls in the home country.Stock market influences:

Stock market operation in foreign securities, debentures, stock and shares, etc., exert significant influence on the exchange rate. If the stock exchanges help in the sale of securities, debentures, shares, etc., to foreigners, the demand for the domestic currency will rise on the part of the foreigners and the exchange rate also tends to rise. The opposite will be the case if the foreigners purchase securities, debentures, shares etc., through the domestic stock exchanges.Political conditions:

Stable political and industrial conditions and peace and security in the country have a significant influence on the exchange rate. If there is political stability and the government is stable, strong and efficient, foreigners will have tendency to invest their funds into the country. With the inflow of capital, the demand for domestic currency will rise and the exchange rate will move in favour of the country. On the contrary, if the government is weak, inefficient and dishonest and there is no safety to life and property, capital will flow out of the country and the exchange rate will move against the country.Type of economy:

If a country is developing, it needs to import large quantities of raw materials and capital goods for its development along with capital. But its capacity to export is low. Therefore, its demand for foreign exchange is more which leads to the depreciation of its exchange rate vis –a –vis a developed country whose exchange rate appreciates.Policies of the government:

Policies of exchange control and protection discourage imports and lead to fall in the demand for foreign currency. As a result, the exchange rate of the home country appreciates in relation to the foreign country.

CURRENCY EXCHANGE RISK AND MANAGEMENT:One of the important problems of firm with international business may encounter is the

currency exchange rate risk.Fluctuations in exchange rates may cause a loss or profit to a firm. Suppose an Indian

exporter has invoiced the exports in dollar and gets payed three months after the date. If the dollar appreciates during this period, the rupee equivalent of his receipts increase i.e., his profit goes up. For illustration, assume that the exchange rate between the dollar changes from $1 = Rs. 48 to Rs. 50. If the export value was $1million, now the exporter can get Rs. 50 million instead of RS. 48 million. A depreciation of the dollar will have the opposite effect. Appreciation of the foreign currency will adversely affect the importer.

Type of foreign exchange risks:

There are two types of foreign exchange risks or exposures. The term exposure refers to the degree to which a company is affected by exchange rate changes.

Economic exposure: Accounting exposure (translation exposure)

Economic exposure:Economic exposure refers to the risks arising from economic factors through economic

transactions and other economic activities.The economic exposure focuses on the impact of an exchange rate change on future cash

flows. The economic exposure may be divided into two component parts, transaction exposure and real operating exposure.Transaction exposure:

Transaction exposure arises out of the various types of transactions (such as information technology, borrowing and lending in foreign currencies and the local purchasing and sales activities of foreign subsidiaries) that requires settlement in a foreign currency.Operating exposure:

Operating exposure arises because currency fluctuations can alter a company’s future revenue and costs – that is, its operating cash flows, consequently, measuring a firm’s operating exposure requires a longer term perspective, viewing the firm as an on going concern with operation whose cost and price competitiveness could be affected by exchange rate changes.

Accounting exposure:Accounting exposure arises from the need, for purposes of reporting and consolidation, to

convert the financial statements of foreign operations from the local currencies (LC) involved to the home currency (HC).

There are four methods of foreign currency translation.Current / non current method:

According to the current / non current method, assts and liabilities are translated based on their maturity. Current assets and liabilities are converted at the current exchange rate and non current assets and liabilities are translated at the historical exchange rate i.e., rate in effect at the time the asset or liabilities are first recorded on the books.Monetary / non monetary method:

Under the monetary / non- monetary method, all monetary balance sheet items ( such as cash, marketable securities, accounts payment and receivable, and long term debt) of a foreign subsidiary are translated at the current exchange rate and all the non- monetary balance sheet items ( such as inventory, fixed asses and long term investments) are translated at the historical exchange rate.Temporal method:

Under the temporal method, monetary items are translated at the current exchange rate. Other balance sheet items are translated at the current rate if they are carried on the books at a current value; if they are carried at historical cost, they are translated at the rate of exchange on the data the item was placed on the books.Current rate method:

Under the current rate method, all balance sheet accounts are translated at the current exchange rate, except for stockholders equity. This is the simplest methods to apply. The common stock account and any additional paid in capital.

Strategies for management:There are several measures to eliminate / minimize risks of exchange rate fluctuations.

Exchange risk avoidance:Exchange risk avoidance is the elimination of exchange risk by doing business locally.

The adverse effect of a devaluation of the domestic currency can be mitigated by procuring the items domestically if devaluation has made the domestic goods cheaper than the foreign goods.Change / diversify sourcing:

Another strategy is to change the source of purchasing. For e.g., if the US goods become costlier because of dollar appreciation, change the source of purchase from the US to the countries where the product is cheaper, either because of deprecation of their currencies or other reasons. A number of companies have diversified the countries of sourcing to spread and minimize the risk of exchange rate fluctuations.Currency diversification:

Currency diversification is the spreading of financial assets across several or more currencies so that exchange rate movements of different currencies may be evened out. This may be applicable to large MNCs that have an ongoing need for these currencies; however, it is not very feasible in respect of small firms whose international operations are not widely spread.Hedging:

Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to guard themselves against losses arising from fluctuations in exchange rates. In other words, hedging a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge.Money market hedge:

Money market hedge is a technique by which transaction exposure may be hedged by borrowing and lending in the domestic and foreign money market. A firm may borrow (lend) in foreign currency to hedge its foreign currency receivables. For e.g., an American firm which has receivables in Pounds may borrow the required amount in Pound for a period which equals the maturity of the receivables, convert them in to dollars and invest them. The Pound loan can be paid off when the pound receivables are realized.Hedging by lead and lag:

Hedging and lagging the foreign currency receipts and payments is another technique for reducing the transaction exposure. To lead to pay or collect early and to lag means the opposite. A firm may lead soft currency (i.e., relatively week currency prone to depreciate) payment and lag hard currency (strong currency which is likely to appreciate) receivables to avoid the loss from deprecation of the soft currency and to gain from the appreciation of the hard currency.Exposure netting:

Exposure netting involves offsetting exposure in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses ( gains ) on the first exposed position should be offset by gain ( losses ) on the second currency exposure.

FEMA, 1999:Foreign exchange transactions were regulated by India by the FERA, 1973. This act also

sought to regulate certain aspects of the conduct of business outside the country by Indian companies and in India by foreign companies.

The main objective of FERA, framed against the background of severe foreign exchange problem and conservation and proper utilization of the foreign exchange resource of the country.

There was a lot of demand for a substantial modification of FERA in the light of the ongoing economic liberalization and improving foreign exchange reserve position. Accordingly, a new act, the FEMA, 1999 replace the FERA.

The FEMA, which came into effect from January, 1, 2000, extends to the whole of Indian and also applies to all branches, offices and agencies outside India, owned or controlled by a person resident in India.

Objectives:The objectives of FEMA are;

To facilitate external trade and payments. To promote the orderly development and maintenance of foreign exchange market.

Section 3 of FEMA imposes restriction on dealing in foreign exchange and foreign security and payments to and receipts from any person outside India. Accordingly, except as provided in term of the act, or with the general or specific permission of the RBI, no person shall-

Deal in any foreign exchange or foreign security with any person other than an authorized person.

Make any payment to or for the credit of any person resident outside India in any manners.

Receive otherwise through an authorized person, any payment by order or on behalf of any person resident outside India in any manner; and

Enter into any financial transaction in India as a consideration for or in association with acquisition or creation or transfer of a right to acquire, any asset outside India by any person.

Comparison between FERA and FEMA:Important differences between FERA and FEMA have been summed up as follows.

In FEMA, only the specified acts relating to foreign exchange are regulated. While in FERA, anything and everything that has to do with foreign exchange was

controlled. The aim of FEMA is facilitating trade as against that of FERA, which was to prevent

misuse. FEMA is a much smaller enactment. Only 49 section as against 81 section of FERA. In the process of simplification, many of the ‘laid down of the erstwhile FERA have been

withdrawn. Many provisions of FERA like the ones relating to blocked accounts, Indians taking up

employment abroad, employment of foreign technicians in India. Contracts in evasion of the act, vexatious search, culpable mental state etc., have no appearance in FEMA.