FOREIGN EXCHANGE MARKET Meaning

Foreign exchange market is a market for the purchase and sale of foreign currencies. The need for a foreign exchange market arises because of the presence of the multiple currencies such as US Dollar, UK Pound, Sterling. Euro, Franc, Yen etc. The purpose of foreign exchange market is to facilitate international trade and investments. The foreign exchange is converted at a price called the exchange rate. Free operations in the exchange markets are not possible. The exchange rate is determined by the supply and demand for foreign exchange. Foreign exchange markets differ from country to country.

TYPES OF FOREIGN EXCHANGE MARKET:

The foreign exchange market is broadly divided into two categories: ^ Retail Market ^ Wholesale market. RETAIL MARKET: The retail foreign exchange market is a secondary price marker wherein travellers, tourist and people who are in need of foreign currency carry out small permitted transactions. WHOLESALE MARKET: The wholesale foreign exchange market is also called the interbank market wherein large transactions of foreign exchange are carried out. The dealers in this market are highly professional and are the primary price makers.

INDIAN FOREIGN EXCHANGE MARKETS

Introduction During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash, derivatives and debt instruments put together in the country. and the sheer size of the foreign exchange market becomes evident. Since then, the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD In 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too, foreign exchange constitutes the largest financial market by far. Liberalization has radically changed Indias foreign exchange sector. Indeed the liberalization process itself was sparked by a severe Balance of Payments and foreign exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe import and foreign exchange controls and a thriving black market is being

replaced with a less regulated, market driven arrangement. While the rupee is still far from being fully floating (many studies indicate that the effective pegging is no less marked after the reforms than before), the nature of intervention and range of independence tolerated have both undergone significant changes. With an overabundance of foreign exchange reserves, imports are no longer viewed with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in the foreign exchange markets not always to support the rupee but often to avoid an appreciation in its value. Full convertibility of the rupee is clearly visible in the horizon. The effects of these development s are palpable in the explosive growth in the foreign exchange market in India..

Foreign Exchange Market in India

The Indian foreign exchange market consists of the buyers, sellers, market intermediaries and the monetary authority of India. The main center of foreign exchange transactions in India is Mumbai, the commercial capital of the country. There are several other centers for foreign exchange transactions in the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin. In past, due to lack of communication facilities all these markets were not linked. But with the development of technologies, all the foreign exchange markets of India are working collectively. The foreign exchange market India is regulated by the reserve bank of India through the Exchange Control Department. At the same time, Foreign Exchange Dealers Association (voluntary association) also provides some help in regulating the market. The Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate in the foreign Exchange market in India. When the foreign exchange trade is going on between Authorized Dealers and RBI or between the Authorized Dealers and the overseas banks, the brokers have no role to play.Apart from the Authorized Dealers and brokers, there are some others who are provided with the restricted rights to accept the

foreign currency or travelers cheque. Among these, there are the authorized money changers, travel agents, certain hotels and government shops. The IDBI exchange market in India is regulated by the Foreign Exchange Management Act, 1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign Exchange Regulation Act, 1947.

FUNCTIONS:
The main functions of the foreign exchange market are 1. TRANSFER OF PURCHASING POWER: International trade involves different currencies. The residents of one country require the currency of another country to make payments in respect of the following transactions:

. This involves transfer of purchasing power from the prayers country to the receivers country. Similarly, the residents of the other country receive the foreign currency in respect of the following transaction.

al receipts. ndia, NRI deposits, borrowings, etc. Thus foreign exchange market helps transfer purchasing power between people of different countries.

2) PROVISION OF CREDIT INSTUMENTS AND CREDIT: The foreign exchange market facilitates provision of credit for foreign trade through credit instruments like telegraphic transfer, letters of credit, bill of exchange, drafts, etc. Moreover, instruments with time period (eg. Bill of foreign exchange of 90 days or more) can be discounted with commercial banks or authorised agents before due date. 3) COVERGE OF RISK: Exports and imports may cover the risk due to future change in exchange rate through forward exchange market whereby currencies are exchanged (at a fixed rate) at some specified date.

NATURE IN INDIAN FOREIGN EXCHANGE MARKET

Every country has its foreign exchange market. These markets differ from country to country. In a developing country like India free operations in exchange markets are not possible because exchange controls are necessary. These markets have to operate under a variety of constraints. Exchange markets developing countries are expected to provide more of service to the import5 and export trade, rather than opportunities for pure exchange trading. Financial transactions not directly related to trade flows have steadily increased in all the countries. It was estimated that trading turnover in foreign exchange market in the world averaged around US dollar 150 million per day while the world exports were only about US dollar 7 billion per day during the mid 1980s. In other words, barely 5% of the foreign exchange transactions reflected international trade, while the balance of 95% of the exchange transactions were accounted for by the capital transfers, arbitrage and speculation. In India, the foreign exchange dealings have been expanded since 1980s. The foreign exchange market in India is free to operate within prescribed bands of the RBI rate. The authorized banks are free to deal among themselves in any currency in both spot and forward maturities against either the rupee or any other foreign currency. The authorized dealers are expected to buy from or sell

currencies to the RBI only after exhausting all avenues for meeting their needs and unloading currencies on the domestic market. The foreign exchange market in Mumbai, Kolkata, Chennai, and New Delhi are very active. The objective of RBI in respect of forward market is that it should became a useful tool for covering all exchange risks by the importers and exporters in respect of their firm commitments in the foreign exchange. The main objective of the exchange control is to regulate the demand for foreign exchange for various purposes within the limits set by the available limited supply. Some of the important features of the foreign exchange market in India as follows: (1) Geographical Dispersal: The foreign exchange market in India is widely dispersed throughout the leading financial centers. It is not to be found at one place. (2) Electronic Market: Foreign exchange market in India is connected electronically. Trading in foreign currencies takes place through the electronically linked network of banks, foreign exchange brokers and dealers. They bring together various buyers and seller in the foreign exchange. (3) Transfer of Purchasing Power: Foreign exchange market aims at permitting the transfer of purchasing power denominated in one currency to another. Firms of respective countries would like to have their payments settled in their currencies. (4) Intermediary: Foreign exchange market acts as an intermediary between buyers and sellers of foreign exchange. It provides a convenient way of converting the currencies earned into currencies wanted to their respective countries. (5) Provision of credit: The foreign exchange market provides credit through specialized instruments like bankers acceptances and letters of credit. This credit is much helpful to the traders in the international market.

(6) Minimizing Risks: Foreign exchange market helps the importers and exporters in the foreign trade and minimizes their risks in international trade. This is done through the provisions of Hedging facilities. This enables traders to transact business in the international market with a view to earn a normal profit without exposure to an expected change in anticipated profit.

GROWTH OF FOREIGN EXCHANGE MARKET IN INDIA

The Foreign Exchange Market in India is growing very rapidly, since the annual turnover of the market is more than $400 billion. This Foreign Exchange transaction in India does not include the Inter-Bank transactions. According to the record of Foreign Exchange in India, Reserve Bank of India released these transactions. The average monthly turnover in the merchant segment was $40.5 billion in 2003-04 and the Inter-Bank transaction was $134.2 for the same period. The average total monthly turnover in the sector of Foreign Exchange in India was about $174.7 billion for the same period. The transactions are made on spot and also on forward basis, which include currency swaps and interest rate swaps. The Indian Foreign Exchange Market is made up of the buyers, sellers, market mediators and the Monetary Authority of India. The main centre of Foreign Exchange in India is Mumbai, the commercial capital of the country. There are several other centers for Foreign Exchange Transactions in India including the major cities of Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin. With the development of technologies, all the Foreign Exchange Markets of India work collectively and in much easier process. Foreign Exchange Dealers Association is a voluntary association that also provides some help in regulating the market. The Authorized Dealers and the attributed brokers are qualified to participate in the Foreign Exchange Markets of India. When the Foreign Exchange Trade is going on between Authorized Dealers and Reserve Bank of India or between the Authorized Dealers and the Overseas Banks, the brokers usually do not have any role to play. Besides the

Authorized Dealers and Brokers, there are some others who are provided with the limited rights to accept the Foreign Currency or Travellers` Cheque; they are the Authorized Moneychangers, Travel Agents, certain Hotels and Government Shops. The IDBI and Exim Bank are also permitted at specific times to hold Foreign Currency.

ROLE OF RBI IN INDIAN FOREIGN EXCHANGE MARKET

The Indian FOREX market owes its origin to the important step that RBI took in 1978 to allow banks to undertake intraday trading in foreign exchange. As a consequence, the stipulation of maintaining Square or near square position was to be complied with only at the close of business each day. During the period 1975-1992, the exchange rate of rupee was officially determined by the RBI in terms of a weighted basket of currencies of Indias major trading partners and there were significant restrictions on the current account transactions. The initiation of economic reforms in July 1991 saw significant two-step downward adjustment in the exchange rate of the rupee on July 1 and 3, 1991 with a view to placing it at an appropriate level in line with the inflation differential to maintain the competitiveness of exports. Subsequently, following the recommendations of the High Level Committee on Balance of Payments (Chairman:Dr C. Rangarajan) the Liberalized Exchange Rate Management System(LERMS) involving dual exchange rate mechanism was instituted in March 1992 which was followed by the ultimate convergence of the dual rates effective from March 1, 1993(christened modified LERMS). The unification of the exchange rate of the rupee marks the beginning of the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It is also an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

GLOBAL AND INDIAN FOREIGN EXCHANGE MARKET ACTIVITY

The 2007 BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity shows that turnover in traditional foreign exchange markets significantly to $3.2 trillion in April 2007. The growth since April 2004, the previous survey date, was an unprecedented 71% at current exchange rates and 65% at constant exchange rates. Although this growth was broadly based across traditionally foreign exchange instruments, the pickup in the growth of foreign exchange swaps was particularly strong, increasing to 82% from 44% ever the previous three years. Trends in the growth of turnover by different types of counterparty have shown the increase in trading between reporting dealers, typically commercial and, to a lesser extent, investment banks, and other financial institutions, including hedge funds and pension funds, were particularly notable: the share of this trade in total turnover increased from 33% to 40%. The share of trading between reporting dealers and non-financial customers also rose, reaching 17%, recovering to the level it held in 1992-98. Correspondingly, the share of interbank trading continued to fall. In April 2007, trading between reporting dealers captured 43% of the total market, compared to 53% in 2004 and 64% in 1998. This trend is present across instruments. The turnover involving emerging market currencies grew significantly faster than aggregate turnover. As a result, emerging market currencies are estimated to be on at least one side of almost 20% of all transactions, compared to less than 15% in April 2004 and less than 17% in April 2001. The largest growth rates in turnover for emerging market currencies were in transactions between banks and non-financial customers (157%), a segment generally identified more closely with economic growth and trade, and financial customers (144%)

EXCHANGE RATES
There are different types of exchange rates used in the Indian Foreign Exchange Market. These are given below: (1) Merchant Rate: The rate at which the foreign exchange dealing takes place between a bank and the merchant business in known as the Merchant Rate. Cash transaction or spot transaction is the contract for buying or selling foreign exchange, which is agreed and executed on the same day (2) Inter Bank Rate: The rate quoted between the banks is known as inter-bank rate or base rate. Two types of rates are quoted in India. One is Telegraphic Transfer Buying Rate and the other is Bill Buying Rate. Telegraphic transfer simply implies that a bank without any delay receives the foreign exchange proceeds. It is between 0.025% and 0.08%. The rate applied on the purchase of foreign bills is known as bill buying rate (3) Nominal Exchange Rate: The price of one currency in terms of other currency is called nominal exchange rate. It is the rate that prevails at a given time. For example, the rate between Indian Rupee and U.S. dollar is as say Rs. 45. It means one U.S. dollar is equal to Rs. 45. The nominal rate is presented in an index from. A rise or fall in nominal rate does not necessarily imply that the country has become more competitive or less competitive in the international markets. (4) Real Exchange Rate: The rate that measures the purchasing power of the currency and gives an idea whether the exchange rate is competitive in international markets is called as Real Exchange Rate. It is obtained by adjusting the nominal exchange rate for relative prices between the two countries. (5) Effective Exchange Rate: Effective exchange rate is a measure of appreciation or depreciation of a currency against the weighted basket of currencies with whom the country trades. Real Effective Exchange Rate Changes without any change in exchange rate. It can

appreciate due to the reduction of non-tariff barriers that make imports cheaper. On the other hand, this rate can depreciate due to import liberalization which has the effect of removing the difficulties in the availability of imported inputs.

INDIA: Exchange rate regime and recent trends

The movement towards market determined exchange rates in India began with the official devaluation of the rupee in July 1991. In March 1992 a dual exchange rate system was introduced in the form of the Liberalized Exchange Rate Management System (LERMS). Under this system all foreign exchange receipts on current account transactions were required to be submitted to the Authorized dealers of foreign exchange in full, who in turn would surrender to RBI 40% of their purchases of foreign currencies at the official exchange rate announced by RBI. The balance 60% could be retained for sale in the free market. As the exchange rate aligned itself with market forces, the Re/$ rate depreciated steadily from 25.83 in March 1992 to 32.65 in February 1993. The LERMS as a system in transition performed well in terms of creating the conditions for transferring an augmented volume of foreign exchange transactions onto the market. Consequently, in March 1993, India moved from the earlier dual exchange rate regime to a single, market determined exchange rate system. The deepening of the foreign exchange market has been aided by the implementation of some of the recommendations of the Sodhani Committee on Foreign Exchange Markets (1995) and the Tara pore Committee on Capital Account Convertibility (1997). The Sodhani Committee (1995) made recommendations to develop, deepen and widen the forex market. A number of its recommendations regarding introduction of various products and removal of restrictions in foreign exchange markets to improve efficiency and increase integration of domestic foreign exchange markets with foreign markets have been implemented. Liberalisation measures undertaken on the capital account

relate to foreign direct investment, portfolio investment, investment in joint ventures/wholly owned subsidiaries abroad, project exports, opening of Indian corporate offices abroad, and raising of Exchange Earners Foreign Currency entitlement.

INDIAN FOREX MARKET

During the early 1990s, India embarked on a series of structural reforms in the foreign exchange market. The exchange rate regime that was pegged earlier was floated partially in March 1992 and fully in March 1993. The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility, which was achieved in August 1994. Banks are now permitted to approve proposals for commodity hedging in international exchanges from their corporate customers. Cancellation and rebooking of all eligible forward contracts booked by residents, irrespective of tenor, has been allowed. The closing time for inter-bank foreign exchange market in India has been extended by one hour up to 5.00 p.m. The foreign exchange market in India has acquired a distinct vibrancy as evident from the range of products, participation, liquidity and turnover. From 2001 to 2007, forex trading in India has been growing at a Compounded Annual Growth Rate (CAGR) of approx. 37%. This was in line with the increase in foreign exchange transactions. According to BIS survey, the average daily turnover in the Indian foreign exchange market in 2007 stood at around US $34.085 billion. The same was around US$23.07 billion in 2006 and US$14 billion in 2005. In India, spot market transactions hold the majority 42% share of the total forex turnover, followed by 39% share in foreign exchange swaps, while the rest is contributed by outright forward transactions. The Reserve Bank of India (RBI) has the overall responsibility of managing the affairs relating to foreign exchange and exchange rate, and also the mandate of maintaining monetary and financial stability. The preamble to the RBI Act provides the objective for the

establishment of the Bank to regulate the issue of Bank notes and keeping reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. The preamble makes it clear that operation of the currency and credit system falls within the regulatory ambit of the Bank. Furthermore, promoting orderly development and maintenance of forex markets is one of the main functions of the RBI.

FEATURES OF INDIAN FOREX MARKET

There are several features of Indian forex market which, are briefly stated as under. Participants The foreign exchange market in India comprises of customers, Authorised Dealers (ADs) in foreign exchange and Reserve Bank of India. The ADs are essentially banks authorised by RBI to do foreign exchange business. Major public sector units, corporates and other business entities with foreign exchange exposure, access the foreign exchange market through the intermediation of ADs. The foreign exchange market operates from major centers - Mumbai, Delhi, Calcutta, Chennai, Bangalore, Kochi and Ahmadabad, with Mumbai accounting for the major portion of the transactions. Foreign Exchange Dealers Association of India (FEDAI) plays an important role in the forex market as it sets the ground rules for fixation of commissions and other charges and also involves itself in matters of

mutual interest of the Authorised Dealers. The customer segment is dominated by Indian Oil Corporation and certain other large public sector units like Oil and Natural Gas Commission, Bharat Heavy Electricals Limited, Steel Authority of India Limited, Maruti Udyog and also Government of India (for defence and civil debt service) on the one hand and large private sector corporates like Reliance Group, Tata Group, Larsen and Tubro, etc., on the other. Of late, the Foreign Institutional Investors (FIIs) have emerged as a major component in the foreign exchange market and they do account for noticeable activity in the market. Segments The foreign exchange market can be classified into two segments. The merchant segment consists of the transactions put through by customers to meet their transaction needs of acquiring/offloading foreign exchange, and inter-bank segment encompassing transactions between banks. At present, there are over 100 ADs operating in the foreign exchange market. The banks deal among themselves directly or through foreign exchange brokers. The interbank segment of the forex market is dominated by few large Indian banks with State Bank of India (SBI) accounting for a large portion of turnover, and a few foreign banks with benefit of significant international experience. Market Makers In the inter-bank market, SBI along with a few other banks may be considered as the marketmakers, i.e., banks which are always ready to quote two-way prices both in the spot and swap segments. The market makers are expected to make a good price with narrow spreads both in the spot and the swap segments. The efficiency and liquidity of a market are often gauged in terms of bid-offer spreads. Wide spreads are an indication of an illiquid market or a one way market or a nervous condition in the market. In India, the normal spot market quote has a spread of 0.5 to one paisa, while the swap quotes are available at 2 to 4 paise spread. At times of volatility, the spread widens to 5 to 10 paise.

Turnover The turnover in the Indian forex market has been increasing over the years. The average daily gross turnover in the dollar-rupee segment of the Indian forex market (merchant plus interbank) was in the vicinity of US $ 3.0 billion during 1998-99. The daily turnover in the merchant segment of the dollar-rupee segment of foreign exchange market was US $ 0.7 billion, while turnover in the inter-bank segment was US $ 2.3 billion. Looking at the data from the angle of spot and forward market, the data reveals that the average daily turnover in the spot market was around US $ 1.2 billion and in the forward and swap market the daily turnover was US$ 1.8 billion during 1998-99. Forward Market The forward market in our country is active up to six months where two way quotes are available. As a result of the initiatives of the RBI, the maturity profile has since recently elongated and there are quotes available up to one year. In India, the link between the forward premia and interest rate differential seems to work largely through leads and lags. Importers and exporters do influence the forward markets through availment of/grant of credit to overseas parties. Importers can move between sight payment and 180 days usance and will do so depending on the overseas interest rate, local interest rate and views on the future spot rate. Similarly, importers can move between rupee credit and foreign currency credit. Also, the decision, to hedge or not to hedge exposure depending on expectations and forward premia, itself affects the forward premia as also the spot rate. Exporters can also delay payments or receive funds earlier, subject to conditions on repatriation and surrender, depending upon the interest on rupee credit, the premia and interest rate overseas. Similarly, decision to draw bills on sight/usance basis is influenced by spot market expectations and domestic interest rates. The freedom to avail of pre/post-shipment credit in forex and switch between rupee and foreign currency credit has also integrated the money and forex markets.

UNIQUE FEATURES OF INDIAN FOREIGN EXCHANGE MARKET

Gold Policy Liberalisation of gold policy had an indirect but, significant impact on the forex market. The logic behind the changes in the gold policy was explained in my earlier speeches on the subjects of capital flight and gold. The major thrust of the liberalization process in gold policy centred around opening up of additional channels of import, a logical consequence of which was the reduction in differential between the international and domestic price of gold. The price differential of gold was as high as 67 per cent in 1992 when the structural reform process was initiated; it fell to 6 per cent by the end of 1998. The unofficial market in foreign exchange which drew its sustenance from the illegal trade in gold went out of existence as an immediate fall out. In essence, the import of gold which was largely on unofficial account in earlier years, was officialised, and correspondingly the foreign exchange used to finance such unofficial imports was also officialised, mainly through enhanced flow under invisibles account. NRI Deposits Various deposit schemes have been designed from time to time to suit the requirements of non-resident Indians (NRIs). Currently, we have three NRI deposit schemes, viz., Non Resident External (NRE) account which is denominated in rupees, Non Resident Non Repatriable (NRNR) account, which is non-repatriable rupee account except for the interest component which is repatriable, and the Foreign Currency Non Resident (Bank) (FCNR-B) account which is a foreign currency account. Banks have also been allowed considerable freedom in deployment of these funds. Of interest to forex markets is the operation of FCNRB scheme, because banks have to bear exchange risk. Banks either hold these deposits in foreign currency investing them abroad or lend in foreign currency to corporates in India or swap into rupees and lend to Indian corporates in rupees.

Public Enterprises Operations of large public sector undertakings have a significant impact especially on spot market, and their procedures for purchase or sale of foreign currency also impact on market sentiments. To this end, and in order to enable Public Sector Enterprises (PSEs) to equip themselves in formulating an approach to management of foreign currency exposure related risks, the Government of India had set up a Committee in January 1998. The Report of the Committee explicitly brings out the approach that is appropriate for risk management with reference to the foreign currency exposure of PSEs. PSEs with large volume of foreign exchange exposure were also advised by the Committee to consider setting up Dealing Room for undertaking treasury functions both for rupee and foreign exchange which include management of rupee resources, foreign exchange transactions and risk management. Adoption of approaches recommended would enable the PSEs to spread their demand and supply in forex market, in a non-disruptive way to the benefit of both the PSE concerned and functioning of forex market in India. Clearing House The idea of establishing a Foreign Exchange Clearing House (FXCH) in India was mooted in 1994. The Expert Group on Foreign Exchange Markets in India also recommended introduction of foreign exchange clearing and making netting legally enforceable. The Scheme was conceived as multilateral netting arrangement of inter-bank forex transactions in US dollar. The membership would be open to all ADs in foreign exchange participating in the inter-bank foreign exchange market. RBI will also be a participating member. The net position of each bank arrived at the end of the trading day would be settled through a Clearing Account to be maintained by RBI. It was recognised that a substantial reduction in number of Nostro account transactions of the participating banks would lead to economy in settlement cost and efficiency in settlement. Other benefits include easing the process of

reconciliation of Nostro accounts balances by banks, reduction in size of credit and liquidity exposure of participating banks and hence systemic risk, etc. The long-term objective is to establish clearing house as a separate legal entity with risk and liquidity management features, infrastructure and operational efficiency akin to other leading clearing systems. However, to start with, we may aim at commencing the operation with such minimum modification to the scheme as may be necessary. For the present, the focus areas are legal, risk and liquidity aspects and operational infrastructure, and all these issues are under examination in the RBI.

SPOT AND FORWARD EXCHANGE RATE

Foreign exchange market is a medium through which individuals, business, governments and banks buy and self foreign currencies. Foreign exchange market is a worldwide market that operates round the clock. In fact, it is the largest and the most liquid market in the world. In foreign exchange market, two types of exchange rate operations take place, spot exchange rate and forward exchange rate. Spot exchange rate Spot exchange rate is the current exchange rate. It is determined by market forces (demand for and supply of foreign exchange ) At the spot rate, immediate delivery of foreign exchange has to be made. However, in practice, there is a two day time lag between the transaction and actual delivery for paper work, verification and clearing of payments. Since the spot exchange rate is determined by market forces, any change in the demand or supply will change the exchange rate. The primary price makers in the foreign exchange market continuously bid or ask the currencies, hence the exchange rate also changes continuously in a free market. Since the

primary dealers quote two-way prices and are ready to deal on either side (i.e. to buy and sell) the rate is quoted in the following manner: INR /USD 48.50 bid / 48.75 ask Spot transaction Spot transactions account for two-thirds of the total business transacted in the international foreign exchange market. The spot dealings between an individual like a tourist and banks are settled on the spot by exchanging the currencies immediately. Forward exchange rate In the foreign exchange forwards market, the purchase/sale of foreign exchange is done currently for delivery and payment at a fixed date in future at a specified exchange rate. This is known as the foreign exchange rate. These contracts usually have maturities of 30, 60 or 90 days. Some transactions also have maturities of 180 0r 360days. Forward exchange rate may either be at a premium or discount in relation to the spot exchange rate: it is said to be at a premium.

The quotation foe forward exchange rate can be done as follows: at which the dealer will buy or sell a unit of foreign currency. This is termed as the outright rate.

added to the spot rate if the foreign currency is traded at a premium. These points are deducted from the spot rate if the currency is traded at a discount.

Factors influencing foreign exchange rate:

Forward exchange rate is influenced by various factors that may prevail at a future date. These include:

Thus, in a fully floating exchange rate system, the forward exchange rate is left to the speculation of dealers, whereas in a managed float, the role of the central bank also influences the forward rate.

DEVALUATION AND DEPRECIATION

Indian Rupee was devalued about 3o%in 1949. The value of Rupee at that time was reduced from 0.268601 grams to 0.186621 grams in terms of gold and from Rs. 3.3082 to Rs. 47619 in terms of the US dollar. Further, it was devalued by about 36.5 percent in June, 1966 when its value was reduced from 0.186620 to 0.118489 grams in terms of gold and from Rs. 47.619 to Rs. 7.58 in terms of Us dollar. India has the exchange rate system of managed flexibility under the IMF arrangements. During the period 1971 and 1991, the value of rupee declined substantially against major international currencies. Therefore, Indian Rupee was again devalued in July, 1991. It was in response to the Balance of payment crisis which became particularly acute in the year, 1991. The conditions regarding exports, imports, balance of trade, earnings on the invisible account,

current account balance, foreign exchange reserves capital flows and credit worthiness of the country had been deteriorating over the past many years. (a) Devaluation: When a country of official exchange rate relative to gold to another currency is lowered it is called devaluation of currency. It is a conscious reduction in the official exchange rate. It is relevant in under the managed and pegged exchange rate system. (b) Depreciation: When the price of a given currency fails relative to a foreign currency, it is called depreciation of domestic currency; Depreciation is an automatic decline in the external value of the currency in the foreign exchange market. It is opposite of devaluation. It is also known as revaluation. It is relevant under the free of floating exchange rate system (c) Exchange Rate Adjustment: The exchange rate adjustment is a broader term and if may encompass both devaluation and depreciation. Given the type of exchange rate arrangements which have existed in India, it can be said that the rupee has been devalued a number of times during 1949 to 199. Under the system of currency basket, the rupee exchange rate is normally fixed officially only in terms of the intervention currency, it is unnecessary to insist on the distinction between depreciation and devaluation of the rupee.

CURRENCY AND CONVERTIBILITY

The freedom to convert into other internationally accepted currencies is known as currency convertibility. There are two types of convertibility. One is current account convertibility and the other is capital account convertibility. Convertibility for current international transaction is known as current account convertibility. The convertibility of capital movements is known as capital account convertibility implies the absence of restriction on foreign exchange transactions or exchange controls. It is compatible with other forms of transaction an international transaction in goods and services India has made the rupee convertible on current account on August, 9, 1994. The Indian rupee became partially convertible. Under the current account convertibility, there is freedom to buy or sell foreign exchange for the following purposes. (1) The international transactions consisting of payments due in connection with foreign trade, other account businesses include services ad nominal short-term banking and credit facilities. (2) Payment due as interest on loans and as not income from other investments. (3) Payment of moderate amount of amortization of loans for depreciation of direct investments. (4) Moderate remittance for family living expenses.

FUNCTION OF FOREIGN EXCHANGE MARKET

The foreign exchange market is the mechanism by which a person of firm transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, and minimizes exposure to foreign exchange risk. Transfer of Purchasing Power: Transfer of purchasing power is necessary because international transactions normally involve parties in countries with different national currencies. Each party usually wants to deal in its own currency, but the transaction can be invoiced in only one currency. Provision of Credit: Because the movement of goods between countries takes time, inventory in transit must be financed. Minimizing Foreign Exchange Risk: The foreign exchange market provides "hedging" facilities for transferring foreign exchange risk to someone else. Market Participants The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market. Individual transactions in the interbank market usually involve large sums that are multiples of a million USD or the equivalent value in other currencies. By contrast, contracts between a bank and its client are usually for specific amounts, sometimes down to the last penny. FOREIGN EXCHANGE DEALERS Banks, and a few nonbank foreign exchange dealers, operate in both the interbank and client markets. They profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price. Worldwide competitions among dealers narrows the spread between bid and ask and so contributes to making the foreign exchange market efficient in the same sense as

securities markets. Dealers in the foreign exchange departments of large international banks often function as market makers. They stand willing to buy and sell those currencies in which they specialize by maintaining an inventory position in those currencies. Participants in Commercial and Investment Transactions: Importers and exporters, international portfolio investors, multinational firms, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions. Some of these participants use the foreign exchange market to hedge foreign exchange risk. Central Banks and Treasuries: Central banks and treasuries use the market to acquire or spend their country's foreign exchange reserves as well as to influence the price at which their own currency is traded. In many instances they do best when they willingly take a loss on their foreign exchange transactions. As willing loss takers, central banks and treasuries differ in motive and behavior form all other market participants. Foreign Exchange Brokers: Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction. For this service, they charge a small commission, and maintain access to hundreds of dealers worldwide via open telephone lines. It is a broker's business to know at any moment exactly which dealers want to buy or sell any currency. This knowledge enables the broker to find a counterpart for a client quickly without revealing the identity of either party until after an agreement has been reached.

FEATURES OF THE FORWARD PREMIUM ON THE INDIAN RUPEE

The Indian rupee has had an active forward market for some time now. The Forward premium or discount on the rupee (vis--vis the US dollar, for instance) reflects the markets beliefs about future changes in its value. The strength of the relationship of this

forward premium with the interest rate differential between India and the US the Covered Interest Parity (CIP) condition gives us a measure of Indias integration with global markets. The CIP is a no-arbitrage relationship that ensures that one cannot borrow in a country, convert to and lend in another currency, insure the returns in the original currency by selling his anticipated proceeds in the forward market and make profits without risk through this process. During the period the average difference between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was about 4.5% for 3-months and 3.5% for the 6-months period. With these two figures in the same ballpark (particularly given that bank deposit rates and inter-bank rates are not strictly comparable), annual averages of interest rate differences and the forward exchange premium also indicate a moderate degree of co-movement between the two variables. The interest rate differential explains about 20% of the total variation in the forward discount. This would indicate arbitrage opportunities and market imperfections provided we could be sure of the comparability of the interest rates considered. Therefore, while the behavior of the forward premium on the Indian rupee is broadly in lines with the CIP, more careful empirical analysis involving directly comparable interest rates is necessary to measure the strength of the covered interest parity condition and the efficiency of the foreign exchange market. Uplift the quality management of balance of payments of the country.

FOREIGN EXCHANGE RATE POLICY IN INDIA

Indian authorities are able to manage the Exchange Rate easily, only because Foreign Exchange Transactions in India are so securely controlled. From 1975 to 1992 the Rupee was coupled to a trade-weighted basket of currencies. In February 1992, the Indian Government started to make the Rupee convertible, and in March 1993 a single floating Exchange Rate in the market of Foreign Exchange in India was implemented. In July 1995, Rs 31.81 was worth

US$1, as compared to Rs 7.86 in 1980, Rs 12.37 in 1985, Rs 17.50 in 1990, Rs 44.942 in 2000 and Rs 44.195 in the year 2011. Since the onset of liberalization, Foreign Exchange Markets in India have witnessed explosive growth in trading capacity. The importance of the Exchange Rate of Foreign Exchange in India for the Indian Economy has also been far greater than ever before. While the Indian Government has clearly adopted a flexible exchange rate regime, in practice the Rupee is one of most resourceful trackers of the US dollar. Predictions of capital flow-driven currency crisis have held India back from Capital Account Convertibility, as stated by experts. The Rupee`s deviations from Covered Interest Parity, as compared to the Dollar, display relatively long-lived swings. An inevitable side effect of the Foreign Exchange Rate Policy in India has been the ballooning of Foreign Exchange Reserves to over a hundred Billion Dollars. In an unparalleled move, the Government is considering to use part of these reserves to sponsor infrastructure investments in the country.

FOREIGN EXCHANGE DERIVATIVES MARKET IN INDIAStatus and Prospects Introduction The gradual liberalization of Indian economy has resulted in substantial inflow of foreign capital into India. Simultaneously dismantling of trade barriers has also facilitated the integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures.

The global market for derivatives has grown substantially in the recent past. The Foreign Exchange and Derivatives Market Activity survey conducted by Bank for International Settlements (BIS) points to this increased activity. The total estimated notional amount of outstanding OTC contracts increasing to $111 trillion at end-December 2001 from $94 trillion at end-June 2000. This growth in the derivatives segment is even more substantial when viewed in the light of declining activity in the spot foreign exchange markets. The turnover in traditional foreign exchange markets declined substantially between 1998 and 2001. In April 2001, average daily turnover was $1,200 billion, compared to $1,490 billion in April 1998, a 14 percent decline when volumes are measured at constant exchange rates. Whereas the global daily turnover during the same period in foreign exchange and interest rate derivative contracts, including what are considered to be traditional foreign exchange derivative instruments, increased by an estimated 10 percent to $1.4 trillion

Evolution of the forex derivatives market in India

This tremendous growth in global derivative markets can be attributed to a number of factors. They reallocate risk among financial market participants, help to make financial markets more complete, and provide valuable information to investors about economic fundamentals. Derivatives also provide an important function of efficient price discovery and make unbundling of risk easier. In India, the economic liberalization in the early nineties provided the economic rationale for the introduction of FX derivatives. Business houses started actively approaching foreign markets not only with their products but also as a source of capital and direct investment opportunities. With limited convertibility on the trade account being introduced in 1993, the environment became even more conducive for the introduction of these hedge products. Hence, the development in the Indian forex derivatives market should be seen along with the steps taken to gradually reform the Indian financial markets. As

these steps were largely instrumental in the integration of the Indian financial markets with the global markets. Derivatives Markets in India: 2003 In 1992 foreign institutional investors were allowed to invest in Indian equity & debt markets and the following year foreign brokerage firms were also allowed to operate in India. Non Resident Indians (NRIs) and Overseas Corporate Bodies (OCBs) were allowed to hold together about 24 percent of the paid up capital of Indian companies which was further raised to 40 percent in 1998. In 1992, Indian companies were also encouraged to issue ADRs/GDRs to raise foreign equity, subject to rules for repatriation and end use of funds. These rules were further relaxed in 1996 after being tightened in 1995 following a spurt in such issues. Presently, the raising of ADRs/GDRs/FCCBs is allowed through the automatic route without any restrictions. FDI norms have been liberalized and more and more sectors have been opened up for foreign investment. Initially, investments up to 51 percent were allowed through the automatic route in 35 priority sectors. The approval criteria for FDI in other sectors was also relaxed and broadened. In 1997, the list of sectors in which FDI could be permitted was expanded further with foreign investments allowed up to 74 percent in nine sectors. Ever since 1991, the areas covered under the automatic route have been expanding. This can be seen from the fact that while till 1992 inflows through the automatic route accounted for only 7 percent of total inflows; this proportion has increased steadily with investments under the automatic route accounting for about 25 percent of total investment in India in 2001. In 1991, there were also modifications to the limits for raising ECBs to avoid excessive dependence on borrowings that was instrumental for 1991 Bop crises. In March 1997, the list of sectors allowed to raise ECBs was expanded; limits for individual borrowers were raised while interest rate limits were relaxed and restrictions on the end-use of the borrowings largely eliminated.

RBI Regulations
These contracts were allowed with the following conditions: a hedge for foreign currency loans provided that the option does not involve rupee and the face value does not exceed the outstanding amount of the loan, and the maturity of the contract does not exceed the un-expired maturity of the underlying loan. uch contracts are allowed to be freely re-booked and cancelled. Any premier payable on account of such transactions does not require RBI approval.

of premier to the customer.

trading positions. But banks are also required to fulfill the condition that no stand alone transactions are initiated. part or full owing to shrinking of the portfolio, it may be allowed to continue till the original maturity and should be marked to market at regular intervals.

CORPORATE HEDGING FOR FOREIGN EXCHANGE RISK IN INDIA

Introduction In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favour of market-determination of foreign exchange rates; a regime of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world owing to increased inflation and the oil shock. Corporates struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that financial derivative foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations.

In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. However derivative use is still a highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps and options are available in India and the use of foreign currency derivatives is permitted for hedging purposes only. This study aims to provide a perspective on managing the risk that firms face due to fluctuating exchange rates. It investigates the prudence in investing resources towards the purpose of hedging and then introduces the tools for risk management. These are then applied in the Indian context. The motivation of this study came from the recent rise in volatility in the money markets of the world and particularly in the US Dollar, due to which Indian exports are fast gaining a cost disadvantage. Hedging with derivative instruments is a feasible solution to this situation. This report is organized in 6 sections. The next section presents the necessity of Foreign exchange risk management and outlines the process of managing this risk. Section 3 discusses the various determinants of hedging decisions by firms, followed by an overview of corporate hedging in India in Section 4. Evidence from major Indian firms from different sectors is summarized here and Section 5 concludes. Authorized dealers The Reserve Bank of India or Indias central bank regulates the market using the help of the exchange control department of the bank. Only the authorized dealers in foreign exchange are allowed to participate in trading which also included accredited brokers as well. The entire transactions are governed by FEMA or the Foreign Exchange Management Act of 1999, which is an updated version of the Foreign Exchange Regulation Act or FERA.

Regulations changed Apart from the usual authorized dealers and brokers, designated hotels, government shops, authorized money changers are also allowed to accept foreign currency. If you are thinking of the systems in operation in other parts of the world, India is slightly lagging behind. On certain conditions, the IDBI or the Industrial Development Bank of India and the Exim Bank are also allowed to hold foreign currency. The set-in-stone policy in foreign exchange holdings and trading has been relaxed in keeping with the changing scenario the world over. India bracing up Initially, FERA was bright in to regulate the inflow of foreign capital, but in later decades as the economy opened up, some changes were brought in. At a later stage, the government felt the need to conserve foreign money, and hence, the changes in the act were brought about. Moreover, with the opening up of the economy, there came an urgency to change with the times. With the economy getting more global in recent years, India wanted to brace up to the challenges ahead and went in for more interaction in the financial markets the world over. Hedging and swapping Initially, Indian investors were also not aware of different types of trading in forex like futures and derivates that could lead to more sustained profits in the long run. They are now hedging, swapping and going for options trading these days. Forex can also be traded online these days and investors are also finding out the benefits in currency trading. Earlier, they had very few options to make money from speculative trades with commodities and stocks being the only available options.

Market Players in the Indian Foreign Exchange Market The market is skewed with a handful of public-sector banks accounting for the major share of the merchant transactions and the private and foreign banks having a greater share of inter-

bank business. It is conducive for healthy market development to have much larger number of players active in the market with enhanced volumes of business. The presence of increased number of players and larger volumes alone lend certainly greater depth to the forex market leading to a more efficient functioning. How Are The Foreign Exchange Reserves Managed In India The Reserve Bank of India in consultation with the Government of India currently manages FER. As the objectives of reserve management are liquidity and safety, attention is paid to the currency composition and duration of investment, so that a significant proportion can be converted into cash at short notice. The essential framework for investment is conservative and is provided by the RBI Act,1934, which requires that investments be made in foreign government securities (with maturity not exceeding 10 years), and the deposits be placed with other central banks, international commercial banks, and the Bank for International Settlement following a multicurrency and multi-markets approach. As at end- March, 2007, out of the total foreign currency assets of US$ 191.9 billion, US$ 53.0 billion was invested in securities, US $ 92.2 billion was deposited with other central banks, BIS & IMF and US$ 46.8 billion was in the form of deposits with foreign commercial banks. During the year 2005-06 the return on foreign currency assets and gold, after accounting for depreciation, increased to 3.9 percent from 3.1 percent during 2004-05, mainly because of hardening of global short term interest rates. The conservative strategy adopted in the management of FER has implication for the rate of return on investment. The direct financial return on holdings of foreign currency assets is low, given the low interest rates prevailing in the international markets. However, the low returns on foreign investment have to be compared with the costs involved in reviving international confidence once eroded, and with the benefits of retaining confidence of the domestic and international markets, including that of the credit agencies.

Are FER excessively high in India at present? The following norms indicate that they are excessive. The appropriate level of the ratio of foreign currency assets to domestic currency is regarded to be 60 percent, while this ratio in India was 105% in 2002. It means that the net foreign currency assets (FCAs) with the RBI are more than the total cash with the public in India at present. According to the High Level Committee on BOP, which was appointed by the Government with C Rangarajan as its Chairman, the level of reserves should be able to buy imports of three months. If so, present level of FERs are excessive. Even if we accept the other norm for optimum reserves namely, six months of imports as suggested by some economist, the present FER in India can be regarded to be excessive. The third type of norm is based on the thinking that FER should meet not only imports requirements but also should take into account the volume of short- term debt, servicing of medium term debt, interest and principle payments on debt. As per this, thinking, the level of FER that can meet one years imports and capital flow requirements is good or desirable. This is known as Guidotti rule . Indias FER at present are excessive even in terms of this very liberal norm.

DOMESTIC AND FOREIGN INTEREST RATE AND THE EXCHANGE RATE

The RBI and banks and other participate in both the spot and forward markets. The market is characterized sometimes by the excess demand for foreign exchange in merchant and interbank segments which haderns the forward premia and it also makes the RBI to sell the currency in the forward market. It is natural that the RBI intervention is in the opposite direction to the excess demand or supply in the market, and then only it can help to stabilize the market. One of the ways in which the efficiency of the foreign exchange management is assessed is to study the co-movement of domestic and foreign interest rate and the exchange rate. Two

theories or conditions which we used for this purpose are covered interest parity condition and the uncovered interest parity condition. The CIP states that the forward premium or forward discount i.e. forward exchange rate reflects the differential between the domestic and foreign interest rates. UIP states that the expected change in the exchange rate reflects the interest rate differential mentioned above. The CIP and UIP imply the forward premia or discounts are an unbiased predictor of the future spot exchange rate. Several channels have resulted in growing integration of money and forex markets. Importers and exporters influence the forward markets through getting/giving credit to overseas parties. Similarly, decisions to draw bills is influenced by spot market expectations and domestic interest rates. The freedom to avail pre/post-shipment credit in forex and switch between rupee and foreign currency credit has also helped to increase integration between money and forex markets. Further, when banks are allowed to grant foreign currency loans out of FCNR liabilities, integration is enhanced. Similarly, when banks swap/unswap FCNR deposits, greater integration is achieved. The introduction of rupee interest rates derivatives also will help greater market integration. Allowing ADs to borrow from their overseas offices/correspondents, and to invest funds in overseas money market also has induced integration. Further, the step by the RBI to allow banks to lend in forex to companies in India without linking to import or export financing has also helped integration. As a result of this step, companies, exporters can substitute rupee credit for forex credit depending on the cost and exchange risk

PLAYERS IN THE FOREIGN EXCHANGE MARKET IN INDIA

Players in the Indian market include (a) ADs, mostly banks who are authorized to deal in foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers individuals, corporates, who need foreign exchange for their transactions Though customers are major players in the foreign exchange market, for all practical purposes they depend upon ADs and brokers. In the spot foreign exchange market, foreign exchange transactions were earlier dominated by brokers. Nevertheless, the situation has changed with the evolving market conditions, as now the transactions are dominated by ADs. Brokers continue to dominate the derivatives market. ADs have been divided into different categories. All schedule commercial banks, which include public sector banks, private sector banks and foreign banks operating in India, belong to category I of ADs. All upgraded Full Fledged Money Changers (FFMCs) and select Regional Rural Banks (RRBs) and cooperative banks belong to category II of ADs. Selected financial institutions such as EXIM Bank belong to category III of ADs. Currently, there are 86 (category I) ADs operating in India out of which are five co-operative banks. All merchant transactions in the foreign exchange market have to be necessarily undertaken directly through ADs. However, to provide depth and liquidity to the inter-bank segment, ADs have been permitted to utilize the services of brokers for better price discovery in their inter-bank transactions. In order to further increase the size of the foreign exchange market and enable it to handle large flows, it is generally felt that more ADs should be encourage to participate in the market making. The customer segment of the foreign exchange market comprises major public sector units, corporates and business entities with foreign exchange exposure. It is generally dominated by select large public sector units such as Indian Oil Corporation, ONGC, BHEL, SAIL, Maruti

Udyog and also the Government of India (for defence and civil debt service) as also big private sector corporates like Reliance Group, Tata Group and Larsen and Toubro, among others. In recent years, foreign institutional investors (FIIs) have emerged as major players in the foreign exchange market.

CONCLUSION
In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporate can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross currency and range-barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. However, the Dubai Gold and Commodities Exchange in June, 2007 introduced Rupee- Dollar futures that could be traded on its exchanges and had provided another route for firms to hedge on a transparent basis. There are fears that RBIs ability to control the partially convertible currency will be subdued by this introduction but this issue is beyond the scope of this study. The partial convertibility of the Rupee will be difficult to control if many exchanges offer such instruments and that will be factor to consider for the RBI. The Committee on Fuller Capital Account Convertibility had recommended that currency futures may be introduced subject to risks being contained through proper trading mechanism, structure of contracts and regulatory environment. Accordingly, Reserve Bank of

India in the Annual Policy Statement for the Year 2007-08 proposed to set up a Working Group on Currency Futures to study the international experience and suggest a suitable framework to implement the proposal, in line with the current legal and regulatory framework. The limitation of this study is that only one type of risk is assumed i.e. the foreign exchange risk. Also applicability of conclusion is limited as only very few firms were reviewed over just one time period. However the results from this exploratory study\ are encouraging and interesting, leading us to conclude that there is scope for more rigorous study along these lines.