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Objectives of the study1) To overview the mechanism of foreign exchanges market.

2) To understand determination and participants in forex market.

) To understand features and importance of forex market.

!) To study recent deve"opments in forex market.

#) To know the various functions of forex market.




Time constraintsThe time stipu"ated for the project is "ess and thus there are chances that some information might have been "eft out& however due care is taken to inc"ude a"" information needed.


'xecutive summery(ndia is now a we""-integrated with the wor"d economy and moves in tandem with g"oba" deve"opments& both on the economic front as we"" on the currency front. The far-reaching changes in the (ndian economy since "ibera"i)ation in the ear"y 1**+s have had a deep impact on the (ndian financia" sector. The deve"opment in the (ndian foreign exchange ,-.) derivatives market shou"d be seen a"ong with the steps taken to gradua""y reform the (ndian financia" markets.

The resu"tant spurts in foreign investments "ed to substantia" increase in the /uantum of inf"ows and outf"ows in different currencies& with varying maturities. The reforms provided the economic rationa"e for the introduction of foreign exchange ,-.) derivatives and risk management since then has under gone a paradigm shift. -oreign exchange future market refers to a type of financia" derivative in which two parties enter into a contract to buy0se"" a particu"ar currency at a pre-determined price on a specific future date. 1 foreign exchange future market provides an opportunity to hedge risk and specu"ate against the exchange rate f"uctuations.



The foreign exchange market ,forex or -. for short) is one of the most exciting& fast-paced markets around. 2nti" recent"y& forex trading in the currency market had been the domain of "arge financia" institutions& corporations& centra" banks& hedge funds and extreme"y wea"thy individua"s. The emergence of the internet has changed a"" of this& and now it is possib"e for average investors to buy and se"" currencies easi"y with the c"ick of a mouse through on"ine brokerage accounts. 3ai"y currency f"uctuations are usua""y very sma"". 4ost currency pairs move "ess than one cent per day& representing a "ess than 15 change in the va"ue of the currency. This makes foreign exchange one of the "east vo"ati"e financia" markets around. Therefore& many currency specu"ators re"y on the avai"abi"ity of enormous "everage to increase the va"ue of potentia" movements. (n the retai" forex market& "everage can be as much

as 2#+61. 7igher "everage can be extreme"y risky& but because of roundthe-c"ock trading and deep "i/uidity& foreign exchange brokers have been ab"e to make high "everage an industry standard in order to make the movements meaningfu" for currency traders. 'xtreme "i/uidity and the avai"abi"ity of high "everage have he"ped to spur the market8s rapid growth and made it the idea" p"ace for many traders. 9ositions can be opened and c"osed within minutes or can be he"d for months. :urrency prices are based on objective considerations of supp"y and demand and cannot be manipu"ated easi"y because the si)e of the market does not a""ow even the "argest p"ayers& such as centra" banks& to move prices at wi"". There are severa" avenues for retai" customers to make investments. (ndividua"s can use investments instruments in financia" markets by using "ong term goa"s or short term trading i.e. shares& options& derivatives& swaps& commodity& rea" estate& go"d& si"ver& bonds etc.& some of these instruments give an opportunity for peop"e to make money. (ndian financia" market is sti"" on"y 2; decades o"d and re/uires "ot of maturity. <ecent"y some of trading instruments are avai"ab"e in the market because of the on"ine faci"ity and many fo"ks are using the techno"ogy to make additiona" money by trading in futures or cash market a"ong with commodity. There are bound to be many changes going to happen in the coming years because of the stake taken in =>' and ?>' by foreign exchanges and substantia" deve"opments are going to happen w.r.t techno"ogy and access to retai" investors. There are many new products wi"" be "aunched in the financia" market& which provides easy access for retai" investors to benefit from the same. One such trading activity is -O<'.& which is now accessib"e for many retai" investors. 4ost of the fo"ks are not aware of how to use this trading avenue to make additiona" money and the beauty of this product is that you can trade 2!hrs which provides opportunity for fo"ks who can do some bit of trading during "ater hours or after work or ear"y in the morning. 1s we a"" know that -O<'. trading is the biggest market g"oba""y and there are so many combinations individua"s can hedge. The project study is an attempt to de"ve into detai"s of different strategies used in -O<'. trading and app"y some of the common"y used strategies to profit from these new instruments which is rapid"y catching up in (ndia.


Definition of 'Foreign Exchange'The exchange of one currency for another or the conversion of one currency into another currency. -oreign exchange a"so refers to the g"oba" market where currencies are traded virtua""y around-the-c"ock. The term foreign exchange is usua""y abbreviated as @forex@ and occasiona""y as @-..@ -oreign exchange transactions encompass everything from the conversion of currencies by a trave"er at an airport kiosk to bi""ion-do""ar payments made by corporate giants and governments for goods and services purchased overseas. (ncreasing g"oba"i)ation has "ed to a massive increase in the number of foreign exchange transactions in recent decades. The g"oba" foreign exchange market is by far the "argest financia" market& with average dai"y vo"umes in the tri""ions of do""ars.



Key Features of Forex Market

There are severa" features of (ndian forex market which& are brief"y stated as under. 1) 9articipants The foreign exchange market in (ndia comprises of customers& 1uthorised 3ea"ers ,13s) in foreign exchange and <eserve =ank of (ndia. The 13s are essentia""y banks authorised by <=( to do foreign exchange business. 4ajor pub"ic sector units& corporates and other business entities with foreign exchange exposure& access the foreign exchange market through the intermediation of 13s. The foreign exchange market operates from major centres - 4umbai& 3e"hi& :a"cutta& :hennai& =anga"ore& Aochi and 1hmedabad& with 4umbai accounting for the major portion of the transactions. -oreign 'xchange 3ea"ers 1ssociation of (ndia ,-'31() p"ays an important ro"e in the forex market as it sets the ground ru"es for fixation of commissions and other charges and a"so invo"ves itse"f in matters of mutua" interest of the 1uthorised 3ea"ers. The customer segment is dominated by (ndian Oi" :orporation and certain other "arge pub"ic sector units "ike Oi" and ?atura" Bas :ommission& =harat 7eavy '"ectrica"s %imited& >tee" 1uthority of (ndia %imited& 4aruti 2dyog and a"so Bovernment of (ndia ,for defence and civi" debt service) on the one hand and "arge private sector corporates "ike <e"iance Broup& Tata Broup& %arsen and Tubro& etc.& on the other. Of "ate& the -oreign (nstitutiona" (nvestors ,-((s) have emerged as a major component in the foreign exchange market and they do account for noticeab"e activity in the market. 2) >egments The foreign exchange market can be c"assified into two segments. The merchant segment consists of the transactions put through by customers to meet their transaction needs of ac/uiring0off"oading foreign exchange&

and inter-bank segment encompassing transactions between banks. 1t present& there are over 1++ 13s operating in the foreign exchange market. The banks dea" among themse"ves direct"y or through foreign exchange brokers. The inter-bank segment of the forex market is dominated by few "arge (ndian banks with >tate =ank of (ndia ,>=() accounting for a "arge portion of turnover& and a few foreign banks with benefit of significant internationa" experience. ) 4arket 4akers (n the inter-bank market& >=( a"ong with a few other banks may be considered as the market-makers& i.e.& banks which are a"ways ready to /uote 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 "i/uidity of a market are often gauged in terms of bid-offer spreads. Cide spreads are an indication of an i""i/uid market or a one way market or a nervous condition in the market. (n (ndia& the norma" spot market /uote has a spread of +.# to one paisa& whi"e the swap /uotes are avai"ab"e at 2 to ! paise spread. 1t times of vo"ati"ity& the spread widens to # to 1+ paise. !) Turnover The turnover in the (ndian forex market has been increasing over the years. The average dai"y gross turnover in the do""ar-rupee segment of the (ndian forex market ,merchant p"us inter-bank) was in the vicinity of 2> D .+ bi""ion during 1**E-**. The dai"y turnover in the merchant segment of the do""ar-rupee segment of foreign exchange market was 2> D +.F bi""ion& whi"e turnover in the inter-bank segment was 2> D 2. bi""ion. %ooking at the data from the ang"e of spot and forward market& the data revea"s that the average dai"y turnover in the spot market was around 2> D 1.2 bi""ion and in the forward and swap market the dai"y turnover was 2>D 1.E bi""ion during 1**E-**. #) -orward 4arket The forward market in our country is active up to six months where two way /uotes are avai"ab"e. 1s a resu"t of the initiatives of the <=(& the maturity profi"e has since recent"y e"ongated and there are /uotes avai"ab"e up to one year. (n (ndia& the "ink between the forward premia and interest rate differentia" seems to work "arge"y through "eads and "ags. (mporters and exporters do inf"uence the forward markets through avai"ment of0grant of credit to overseas parties. (mporters can move between sight payment and 1E+ days usance and wi"" do so depending on

the overseas interest rate& "oca" interest rate and views on the future spot rate. >imi"ar"y& importers can move between rupee credit and foreign currency credit. 1"so& the decision& to hedge or not to hedge exposure depending on expectations and forward premia& itse"f affects the forward premia as a"so the spot rate. 'xporters can a"so de"ay payments or receive funds ear"ier& subject to conditions on repatriation and surrender& depending upon the interest on rupee credit& the premia and interest rate overseas. >imi"ar"y& decision to draw bi""s on sight0usance basis is inf"uenced by spot market expectations and domestic interest rates. The freedom to avai" of pre0post-shipment credit in forex and switch between rupee and foreign currency credit has a"so integrated the money and forex markets. -urther& banks were a""owed to grant foreign currency "oans out of -:?< ,=) "iabi"ities and this too faci"itated integration as such foreign currency demarcated "oans did not have any use restriction. The integration is a"so achieved through banks swapping0unswapping -:?< ,=) deposits. (f the "i/uidity is considerab"e and ca"" rates are easy& banks consider dep"oyment either in forex& government or money0repo market. This decision a"so affects the premia. Bradua""y& with the opening up of the capita" account& the forward premia is getting a"igned with the interest rate differentia". 7owever& the fact remains that free movement in capita" account is on"y a necessary condition for fu"" deve"opment of forward and other forex derivatives market. The sufficient condition is provided by a deep and "i/uid money market with a we""-defined yie"d curve in p"ace. 3eve"oping a we"" integrated& consistent and meaningfu" yie"d curve re/uires considerab"e market deve"opment in terms of both vo"ume and "i/uidity in various time and market segments. ?o doubt& the integration between the domestic market and the overseas market operates more often through the forward market. This integration is faci"itated now by a""owing 13s to borrow from their overseas offices0correspondents and invest funds in overseas money market up to the same amount. $) 3ata on -orex 4arkets The <=( pub"ishes dai"y data on exchange rates& forward premia& foreign exchange turnover etc. in the Ceek"y >tatistica" >upp"ement ,C>>) of the <=( =u""etin with a "ag of one week. The movement in foreign exchange reserves of the <=( on a week"y basis are furnished in the same pub"ication. The <=( a"so pub"ishes data on ?omina" 'ffective 'xchange <ate ,?''<) and <ea" 'ffective 'xchange <ate ,<''<)& <=(Gs purchases and sa"es in the foreign exchange market a"ong with outstanding forward "iabi"ities on reserves etc. in the month"y <=( =u""etin with a time "ag of one month. >ince Hu"y 1**E& the <eserve =ank of (ndia started pub"ishing the #-country trade based ?''< and <''< in

addition to $-country ?''< and <''< in the <=( =u""etin. Cay ahead of many deve"oping and industria" country centra" banks& the <=( has been pub"ishing the si)e of its gross intervention ,purchase and sa"e) each month and its net forward "iabi"ity position. F) %inkages among 4arkets and 9o"icy <esponses >ince the introduction of the reform measures& broad segments of the market& vi).& money market& Bovernment securities market& capita" market& and foreign exchange market& have exhibited some degree of integration. The markets have become inter-"inked to the extent participants can move free"y from one market to another. The "inkages between the forex market and domestic markets essentia""y depend on the foreign currency "iabi"ities and assets banks can maintain and the extent and degree to which they are swapped into rupees and vice versa. Thus& on the "iabi"ities side& we have foreign currency borrowings from overseas offices0correspondents& borrowings for "ending to exporters& -:?<-= deposits and ''-:0<-: deposits. These funds can be used either for raising rupee resources through swaps or for "ending in foreign currency. 1 significant step was taken by the <=( when it a""owed banks to "end in foreign currency to companies in (ndia for any productive purpose without "inking to exports or import financing. This effective"y meant that companies had the choice to borrow either in foreign currency or rupees depending on the cost& taking into account both exchange risk and interest cost. Thus& companies can substitute rupee credit for foreign credit free"y. >imi"ar"y& exporters a"so have the abi"ity to substitute rupee credit for foreign currency credit. The integration of foreign exchange market with other markets "ike money market and government securities market meant c"oser coordination of monetary and exchange rate po"icy. -or instance& in Hanuary 1**E& when the foreign exchange market came under severe pressure& <eserve =ank of (ndia undertook strong monetary po"icy measures "eading to sharp withdrawa" of "i/uidity and increase in short-term interest rates. The impact of monetary management was such that by -ebruary 1**E order"y conditions were restored in the forex market and norma"cy was attained in money market. 1t times of high"y specu"ative exchange rate movements& simu"taneous intervention in foreign exchange and domestic market is ca""ed for to have an immediate strong effect on both the exchange rate and money market conditions. Thus& to maximise the effectiveness of the foreign exchange market intervention as a signa"ing device& it is a"so carefu""y co-ordinated with monetary management. These co-ordinated intervention strategies re/uire c"ose

day-to-day monitoring of the supp"y of banking system "i/uidity and an active use of open market operations to adjust "i/uidity conditions. 7owever& driving a wedge between money and forex markets at times& becomes necessary when it is fe"t that "i/uidity conditions may put pressure on the forex market& whi"e tightening "i/uidity cou"d hurt the rea" sector. The recent initiatives of <=( to usher in the rupee interest rate derivatives shou"d faci"itate the deve"opment of rupee term money market and define the rupee yie"d curve across maturities. =esides bringing about greater integration of the money and forex markets& the move has set the stage for the take-off of rupee-foreign currency derivatives.


Unique Features of Indian Forex Market

1) Bo"d 9o"icy %ibera"isation of go"d po"icy had an indirect but& significant impact on the forex market. The "ogic behind the changes in the go"d po"icy was exp"ained in my ear"ier speeches on the subjects of capita" f"ight and go"d. The major thrust of the "ibera"isation process in go"d po"icy centred around opening up of additiona" channe"s of import& a "ogica" conse/uence of which was the reduction in differentia" between the internationa" and domestic price of go"d. The price differentia" of go"d was as high as $F per cent in 1**2 when the structura" reform process was initiatedI it fe"" to $ per cent by the end of 1**E. The unofficia" market in foreign exchange which drew its sustenance from the i""ega" trade in go"d went out of existence as an immediate fa"" out. (n essence& the import of go"d which was "arge"y on unofficia" account in ear"ier years& was officia"ised& and corresponding"y the foreign exchange used to finance such unofficia" imports was a"so officia"ised& main"y through enhanced f"ow under invisib"es account.

2) ?<( 3eposits Jarious deposit schemes have been designed from time to time to suit the re/uirements of non-resident (ndians ,?<(s). :urrent"y& we have three ?<( deposit schemes& vi).& ?on <esident 'xterna" ,?<') account which is denominated in rupees& ?on <esident ?on <epatriab"e ,?<?<) account& which is non-repatriab"e rupee account except for the interest component which is repatriab"e& and the -oreign :urrency ?on <esident ,=ank) ,-:?<-=) account which is a foreign currency account. =anks have a"so been a""owed considerab"e freedom in dep"oyment of these funds. Of interest to forex markets is the operation of -:?<-= scheme& because banks have to bear exchange risk. =anks either ho"d these deposits in foreign currency investing them abroad or "end in foreign currency to corporates in (ndia or swap into rupees and "end to (ndian corporates in rupees. Chen corporates borrow in foreign currency& there is an inf"ow into the market but there may be hedging by corporates. Chen banks swap into rupees and "end& there is an impact on forex

markets but forward premia and "ending rates in rupees are critica". Thus& tracking the use of -:?< ,=) deposits is essentia" in appreciating forex markets. ) 9ub"ic 'nterprises Operations of "arge pub"ic sector undertakings have a significant impact especia""y on spot market& and their procedures for purchase or sa"e of foreign currency a"so impact on market sentiments. To this end& and in order to enab"e 9ub"ic >ector 'nterprises ,9>'s) to e/uip themse"ves in formu"ating an approach to management of foreign currency exposure re"ated risks& the Bovernment of (ndia had set up a :ommittee in Hanuary 1**E. The <eport of the :ommittee exp"icit"y brings out the approach that is appropriate for risk management with reference to the foreign currency exposure of 9>'s. 9>'s with "arge vo"ume of foreign exchange exposure were a"so advised by the :ommittee to consider setting up 3ea"ing <oom for undertaking treasury functions both for rupee and foreign exchange which inc"ude management of rupee resources& foreign exchange transactions and risk management. 1doption of approaches recommended wou"d enab"e the 9>'s to spread their demand and supp"y in forex market& in a non-disruptive way to the benefit of both the 9>' concerned and functioning of forex market in (ndia. !) Off-shore =anking 2nits The setting up of Off-shore banking units at this advanced stage of financia" "ibera"isation in our country is considered by many to be unnecessary and that the time for an offshore banking unit has gone. (n a country of our si)e& the issue of "inkages between off-shore sector and the domestic sector is undoubted"y an important one. Ce need to make a c"ear distinction between the financia" issues and the non-financia" issues on the subject. -rom the centra" bankGs perspective& designing appropriate regu"atory framework is important and the most important issue is ensuring of a firewa"" between the off-shore transactions and domestic transactions. 9hysica" "ocation is not re"evant& especia""y when deposit taking and cash transactions are not permitted in off-shore business. (n fact& we do not have a good mode" of rea" off-shore centre in a country with capita" contro"s. :onfederation of (ndian (ndustry ,:(() with assistance from the Bovernment of 4aharashtra is engaged in a detai"ed study of the various issues to make recommendations to the <=( and the Bovernment of (ndia.


#) :"earing 7ouse The idea of estab"ishing a -oreign 'xchange :"earing 7ouse ,-.:7) in (ndia was mooted in 1**!. The 'xpert Broup on -oreign 'xchange 4arkets in (ndia a"so recommended introduction of foreign exchange c"earing and making netting "ega""y enforceab"e. The >cheme was conceived as mu"ti"atera" netting arrangement of inter-bank forex transactions in 2> do""ar. The membership wou"d be open to a"" 13s in foreign exchange participating in the inter-bank foreign exchange market. <=( wi"" a"so be a participating member. The net position of each bank arrived at the end of the trading day wou"d be sett"ed through a :"earing 1ccount to be maintained by <=(. (t was recognised that a substantia" reduction in number of ?ostro account transactions of the participating banks wou"d "ead to economy in sett"ement cost and efficiency in sett"ement. Other benefits inc"ude easing the process of reconci"iation of ?ostro accounts ba"ances by banks& reduction in si)e of credit and "i/uidity exposure of participating banks and hence systemic risk& etc. The "ong-term objective is to estab"ish c"earing house as a separate "ega" entity with risk and "i/uidity management features& infrastructure and operationa" efficiency akin to other "eading c"earing systems. 7owever& to start with& we may aim at commencing the operation with such minimum modification to the scheme as may be necessary. -or the present& the focus areas are "ega"& risk and "i/uidity aspects and operationa" infrastructure& and a"" these issues are under examination in the <=(.

$) <o"e of -'31( (n a regime where exchange rates were fixed and there were restrictions on outf"ow of foreign exchange& the <=( encouraged the banks to constitute a se"f regu"atory body and "ay down ru"es for the conduct of forex business. (n order to ensure that a"" the banks participated in the arrangement& the <=( p"aced a condition whi"e issuing foreign exchange "icence that every "icensee agree to be bound by the ru"es "aid down by the banker8s body K the -'31(. -'31( a"so accredited brokers through whom the banks put through dea"s. There is increasing emphasis now on competition& and fixing or advising charges by professiona" bodies is being viewed with disfavour and often treated as a restrictive trading practice. (t is current"y argued by some that with the growth in vo"umes and giant strides in te"ecommunication& banks may no "onger need to dea" through brokers when efficient match making arrangements exist. 1s in

some other markets& the dea"s are conc"uded on the basis of voice broking and it is sometimes he"d that this often resu"ts in conc"usion of dea"s which are "ess than transparent& evidenced by instances where dea"s have been ca""ed off on payment of differences. 2nder the circumstances& there is perhaps a need to review severa" aspects& vi).& compatibi"ity of advising or prescribing fees with pro-competition po"icyI ro"e of brokersI e"ectronic dea"ing vis-L-vis voice brokingI and re"ationship between the <=(& -'31( and authori)ed dea"ers.


Functions of foreign exchange market

-oreign exchange is a"so referred to as forex market. 9articipants are importers& exporters& tourists and investors& traders and specu"ators& commercia" banks& brokers and centra" banks. -oreign bi"" of exchange& te"egraphic transfer& bank draft& "etter of credit etc. are the important foreign exchange instruments used in foreign exchange market to carry out its functions. The -oreign 'xchange 4arket performs the fo""owing functions.

1 !ransfer "f #urchasing #o$er I %&earing Function The basic function of the foreign exchange market is to faci"itate the conversion of one currency into another i.e. payment between exporters and importers. -or eg. (ndian rupee is converted into 2.>. do""ar and vice-versa. (n performing the transfer function variety of credit instruments are used such as te"egraphic transfers& bank drafts and foreign bi""s. Te"egraphic transfer is the /uickest method of transferring the purchasing power. ' %redit Function The foreign exchange market a"so provides credit to both nationa" and internationa"& to promote foreign trade. (t is necessary as sometimes& the internationa" payments get de"ayed for $+ days or *+ days. Obvious"y& when foreign bi""s of exchange are used in internationa" payments& a credit for about months& ti"" their maturity& is re/uired. -or eg. 4r. 1 can get his bi"" discounted with a foreign exchange bank in ?ew Mork and this bank wi"" transfer the bi"" to its correspondent in (ndia for co""ection of money from 4r. = after the stipu"ated time.


)edging Function

1 third function of foreign exchange market is to hedge foreign exchange risks. =y hedging& we mean covering of a foreign exchange risk arising out of the changes in exchange rates. 2nder this function the foreign exchange market tries to protect the interest of the persons dea"ing in the market from any unforseen changes in exchange rate. The exchange rates under free market can go up and down& this can either bring gains or "osses to concerned parties. 7edging guards the interest of both exporters as we"" as importers& against any changes in exchange rate. 7edging can be done either by means of a spot exchange market or a forward exchange market invo"ving a forward contract.


#artici*ants + dea&ers in foreign exchange market

-oreign exchange market needs dea"ers to faci"itate foreign exchange transactions. =u"k of foreign exchange transaction is dea"t by :ommercia" banks N financia" institutions. <=( has a"so a""owed private authori)ed dea"ers to dea" with foreign exchange transactions i.e. buying N se""ing foreign currency. The main participants in foreign exchange markets are

,etai& %&ients

<etai" :"ients dea" through commercia" banks and authori)ed agents. They comprise peop"e& internationa" investors& mu"tinationa" corporations and others who need foreign exchange.

%ommercia& -anks

:ommercia" banks carry out buy and se"" orders from their retai" c"ients and of their own account. They dea" with other commercia" banks and a"so through foreign exchange brokers.

Foreign Exchange -rokers

'ach foreign exchange market centre has some authorised brokers. =rokers act as intermediaries between buyers and se""ers& main"y banks. :ommercia" banks prefer brokers.

%entra& -anks

2nder f"oating exchange rate centra" bank does not interfere in exchange market. >ince 1*F & most of the centra" banks intervened to buy and se"" their currencies to inf"uence the rate at which currencies are traded.

-rom the above sources demand and supp"y generate which in turn he"ps to determine the foreign exchange rate.

/ a0

"ther #artici*ants -rokers

=rokers have more information and better know"edge of market. They provide information to banks about the prices at which there are buyers and se""ers of a pair of currencies. They act as midd"emen between the price makers.


#rice !akers

9rice takers are those who buy foreign exchange which they re/uire and se"" what they earn at the price determined by primary price makers.


#ros and cons of foreign exchange market

The foreign exchange ,forex) market is the interbank market where institutions trade currencies. (t is a"so accessib"e to retai" investors through on"ine dea"ers or brokers. The forex market has severa" pros and cons that investors and traders shou"d be aware of. Anowing whatGs invo"ved with participating in the forex market wi"" increase your chances of success.

The foreign exchange marketGs si)e gives it severa" advantages. The "arge number of participants provides "i/uidity& meaning currencies are easi"y bought or so"d& and orders are typica""y fi""ed right away. The si)e of the market a"so prevents any sing"e entity from exercising too much contro" over the market. %arge participants& such as centra" banks& may inf"uence the market& but on"y for a short amount of time.

The forex market is open 2! hours a day& five days a week. >ome brokers are even open on weekends. This a""ows for f"exibi"ity to trade when you want. =rokers re/uire "ow opening deposits& offer "ow transaction costs and typica""y charge on"y the bid-ask spread per trade& which is the difference between the buying and se""ing price. Traders can a"so use "everage to trade a "arger amount of money than they have in their account.

!rading 2ty&es
The forex market accommodates different trading sty"es. (nvestors can buy "ong or se"" short in the foreign exchange market without restrictions. (nvestors can participate in the forex market using futures& exchangetraded funds or options& or direct"y through a broker in the spot market. This caters to different investment objectives.


5oose ,egu&ations
The forex market is an over-the-counter market with no centra" exchange. (t is "ess regu"ated than other markets. Traders typica""y p"ace trades direct"y with their broker& who takes the other side of the trade. The "ack of a centra" exchange resu"ts in a "ack of information on certain market statistics& such as trading vo"ume& and creates a greater risk of mispricing.

-roker ,isk
The "oose regu"ation of on"ine brokers increases the potentia" for fraud. Traders must research a broker carefu""y before opening an account. -unds deposited with a forex broker are typica""y not protected if the broker goes bankrupt. 1ny outages in a brokerGs trading system cou"d "eave a trader unab"e to manage open trades.

,isk of 5oss
There is the potentia" to "ose a"" of your money. 2sing "everage to trade more money than is in your account magnifies the potentia" "oss if the market moves against you. Mou may be responsib"e for "osses greater than the funds in your account. =ecause currency prices are inf"uenced by many factors& the amount of fundamenta" information to ana"y)e is daunting


!y*es of foreign exchange market

>pot 4arketThese are the /uickest transactions invo"ving currency in foreign markets. These transactions invo"ve immediate payment at the current exchange rate& which is a"so ca""ed the spot rate. The -edera" <eserve says the spot market accounts for one-third of a"" currency exchange& and trades usua""y take p"ace within two days of the agreement. This does "eave the traders open to the vo"ati"ity of the currency market& which can raise or "ower the price between the agreement and the trade.

-utures 4arket1s the name imp"ies& these transactions invo"ve future payment and future de"ivery at an agreed exchange rate& a"so ca""ed the future rate. These contracts are standardi)ed& which means the e"ements of the agreement are set and non-negotiab"e. (t a"so takes the vo"ati"ity of the currency market& specifica""y the spot market& out of the e/uation. These are popu"ar among traders who make "arge currency transactions and are seeking a steady return on their investments.

-orward 4arketThese transactions are identica" to the -utures 4arket except for one important difference---the terms are negotiab"e between the two parties. This way& the terms can be negotiated and tai"ored to the needs of the participants. (t a""ows for more f"exibi"ity. (n many instances& this type of market invo"ves a currency swap& where two entities swap currency for an agreed-upon amount of time& and then return the currency at the end of the contract.



Chere economic theory wi"" affect the -orex market on a "ong-term basis& the affect of changes in economic data is much more immediate. Oftentimes& the biggest companies in the exchange market are the various countries that participate in market activities and there currency is "ikened to shares in that country. (t fo""ows then that the countryGs economic data is ana"ogous to the earnings data of a company or business entity. ?ews and information regarding a countryGs economy can have a direct impact on the direction that the countryGs currency is heading in much the same way that current events and financia" news affect stock prices& hence the importance of economic factors. The fo""owing eight economic factors wi"" direct"y affect a currencyGs movements in the -orex market. Factor 1 - Em*&oyment Data ?on-farm payro""s is the name given to the data that pertains to the number of peop"e who are emp"oyed within the 2> economy& and it is re"eased the first -riday of every month by the =ureau of %abor >tatistics. >trong decreases in emp"oyment indicate a contracting economy& whi"e strong increases are perceived indicators of a prosperous economy. Factor ' - Interest ,ates This is a"ways a major focus in the forex market. >ince the centra" banks mandate monetary po"icy and supp"y& they are the prime focus of investors and the various market participants. Factor ( - Inf&ation This is the measure of increases or decreases in pricing "eve"s over a period of time. 3ue to the immense number of goods and services avai"ab"e in a country& usua""y a grouping of these goods and services are used to measure changes in the pricing. (ncreases in pricing indicate an increase in the inf"ation rate which in turn can deva"ue that countryGs

currency. Factor . - 6ross Domestic #roduct This is the measurement for goods and services that were finished over a period of time. The B39 is broken down into ! categories6 1. business spending 2. government spending . private consumption !. tota" net exports Factor / - ,etai& 2a&es The measurement of sa"es recorded by retai"ers over a period of time is a ref"ection of either increased or decreased consumer spending& depending on whether sa"es are up or down for the comparative period a year ago. This indicator gives market participants an idea as to how strong or weak the economy is. Factor 7 - Dura1&e 6oods Boods that have a "ifespan of three or more years are considered durab"e goods and they are measured in /uantities that are ordered& shipped& or unfi""ed over a period of time. These are a"so an indicator of economic spending or the "ack of it. Factor 8 - !rade and %a*ita& F&o$s :urrency va"ues can be significant"y impacted by monetary f"ows that resu"t from certain interactions between countries. Chen imports exceed exports& there is a tendency for the currency va"ue to dec"ine. (ncreased investments in a country can "ead to the opposite resu"t. Factor 9 - Macroeconomic and 6eo*o&itica& E:ents '"ections& financia" crises& monetary po"icy changes& and wars can inf"uence the biggest changes in the -orex market. These events can either change and0or "ead to reshaping of a countryGs economy.



,ecent ;o&ati&ity !rends Jo"ati"ity is typica""y measured in one of two ways. 7istorica" vo"ati"ity is a measure of how much an exchange rateOor any assetOhas varied& on average& over a specified period& say one month. 1s its name suggests& historica" vo"ati"ity is backward "ooking. 1n a"ternative measure& imp"ied vo"ati"ity& is extracted from options prices. This measure has the advantage of te""ing us something about expected vo"ati"ity over the tenor of the contract. (t therefore has a forward-"ooking component. -or this discussion& Ce wi"" focus on one-month at-the-money forward imp"ied vo"ati"ity. Over "ong periods& these two measures of vo"ati"ity genera""y move together& though at times they can& and have& diverged. ?ote that these measures are independent of trends in the under"ying spot rate. 1n exchange rate might have a substantia" cumu"ative move that is steady and gradua" over the course of a year& but shorter term rea"i)ed and option-imp"ied vo"ati"ity may sti"" remain "ow. :ontrast that behavior with an exchange rate that ended the year where it began& but in the interim fre/uent"y moved with sudden swings in both directions. 3espite ending the year where it began& the shorter term measures of historica" and option-imp"ied vo"ati"ity are high. Cith that introduction in p"ace& "et me turn to the facts. (n the major exchange rate pairs& both historica" and imp"ied vo"ati"ity have been dec"ining in recent years. 3uring the 1**+s& dai"y /uotations of onemonth at-the-money imp"ied vo"ati"ity of the do""ar0deutsche mark common"y traded in the doub"e digits. 7owever& that average does not convey the swings in imp"ied vo"ati"ity that were observed& for examp"e& during the '<4 crisis. 9ut different"y& if somewhat awkward"y& the vo"ati"ity of imp"ied vo"ati"ity was high. Cith the transition in 'urope to the sing"e currency& imp"ied vo"ati"ity in the euro0do""ar initia""y "ooked simi"ar to that of the do""ar0deutsche mark exchange rate. (n 2+++& imp"ied vo"ati"ity of the euro0do""ar averaged about 1 percent& before beginning a steady dec"ine over subse/uent years. (n 2++#& one-month imp"ied vo"ati"ity in the euro0do""ar averaged

about E.F percent. (n 2++$& it has been just above E.+ percent. 1gain& "ooking at average imp"ied vo"ati"ity does not convey the fu"" story. ?ot on"y is imp"ied vo"ati"ity "ow on average& it has a"so been persistent"y "ow. Chereas spikes were common in the 1**+s& they have been few and far between more recent"y. 'ven dramatic events such as the terrorist attacks in 2++1 bare"y nudged the vo" meter& and vo"ati"ity is nowhere near the peaks reached in the mid-1**+s and 1**E. (n short& average imp"ied vo"ati"ity is "ow and the vo"ati"ity of imp"ied vo"ati"ity is much "ower than it used to be. Ce observe the same phenomenon in the do""ar0yen currency pair. Onemonth imp"ied vo"ati"ity averaged a"most 1$ percent in 1**E& with spikes into the high 2+s. This average fe"" to 11. percent in 2+++ and to E.! percent by 2++#. 1"though the "ast coup"e of weeks have seen imp"ied vo"ati"ity tick higher& overa"" average imp"ied vo"ati"ity thus far in 2++$ remains just be"ow * percent. Ce find this "onger term phenomenon in many emerging market currencies as we""& inc"uding some that experienced currency crises in the recent past. The vo"ati"ities of currencies from 4exico& =ra)i"& >outh Aorea& Taiwan& Turkey and <ussia moderated from 2++ through 2++#O a"though some of these vo"ati"ities have picked up in recent weeks. The dec"ine in vo"ati"ity is not iso"ated to foreign exchange. Other financia" assets exhibit some of the same broad patterns. -ixed-income vo"ati"ity and e/uity market vo"ati"ity as measured& respective"y& by indices such as 4OJ' and J(. are at near-record "ows. On"y commodity prices are bucking that "ow vo" trend.

Market Factors (n addition to broad macroeconomic factors& structura" market forces may be at work. Two that Ce wi"" comment on are increased transparency and participation& and heightened activity in the options market. Ce mentioned techno"ogyGs importance to the market. =esides simp"ifying transactions& techno"ogy has enab"ed greater price transparency and a wider range of agents to participate in the marketp"ace. ?ewer p"ayers inc"ude sma""er fund managers& individua"s and so-ca""ed a"gorithmic tradersOa"" of whom participate most"y or exc"usive"y through e-trading systems& particu"ar"y in the spot market. 1

"arger number of participants trading more active"y resu"ts in higher turnover& narrower bid-offer spreads and continuous pricing. >ome of these newer participants may be more wi""ing to provide "i/uidity at Ps"owerQ times of the day. Cith more participants supp"ying prices& the probabi"ity of price gaps in the spot market may be reduced& thereby "owering rea"i)ed and option-imp"ied vo"ati"ity. 1s more p"ayers have entered the spot market& more have become invo"ved in the options market. The expertise of pricing options has become more diffuse in recent years& as traders have moved from marketmaking banks to hedge funds and brought with them the pricing and risk management expertise that on"y a few firms had at one time. One theory is that this diffusion of expertise has "ed to a decrease in imp"ied vo"ati"ity Owhich fre/uent"y was higher than historica" vo"ati"ityOas the newer participants so"d what they knew were PexpensiveQ options that they knew how to hedge. 1 "ess benign exp"anation for the "ow "eve" of imp"ied vo"ati"ity is that market participants are se""ing options to generate premiums. 2nder this theory& the supp"y0demand dynamic may have driven down the price of the options and the imp"ied vo"ati"ity. (f option protection is so"d too cheap"y& the se""er may not be compensated ade/uate"y for the risk assumed. 5ooking 4head 1s my remarks suggest& foreign exchange markets have been unusua""y stab"e in recent years. Ce donGt know why they have been so stab"e. Optimists point to structura" changes in how the g"oba" economy operates. Breater macroeconomic stabi"ity across countries& coup"ed with increased exchange rate f"exibi"ity among many countries& has a""owed for gradua" exchange rate adjustments. The optimists argue that these factors have reduced risk premia and thus a reduction of vo"ati"ity is justified by these benign conditions. 9essimists counter that fundamenta"s have not changed. <ather& investors are now wi""ing to take on "arge risks for "itt"e extra compensation. The pessimists be"ieve that the current environment is one with huge uncertainties associated with geopo"itica" risks& energy prices and productivity that markets are mispricing. Ce cannot determine which of these two scenarios is correctOor whether a third one might exist. Cith profits in the financia" sector strong& it is

seductive to assume the current benign period wi"" persist. The danger is that this current period may not persist if& for examp"e& the economic backdrop changes. There have after a"" been other times when "ow vo"ati"ities have been fo""owed by an increase in risk aversion& a sudden widening of risk spreads and a spike in vo"ati"ity. Ce donGt know the direction of exchange rates or the speed at which they wi"" move in the future. =ut firms shou"d not be "u""ed into comp"acency by the recent period and assume that market vo"ati"itiesOand risksOare permanent"y "ower. <isk managers shou"d be conscious of how the inc"usion of the most recent data is affecting their risk mode"s. >tatistica" risk measures& such as va"ue at risk& may not capture the fu"" extent of soca""ed Ptai" events&Q even during periods of norma" vo"ati"ity. These measures are even more "ike"y to paint too rosy a picture of risk when market vo"ati"ities are "ow. 1s a resu"t& managing and si)ing tai" eventsO through stress testing and other risk containment too"sOis particu"ar"y important in the present market environment. 4ore broad"y& the stress testing of positions and exposures is an especia""y important too" for si)ing -. risks& because corre"ations between the foreign exchange market and other markets are famous"y unstab"e. -or this reason& we shou"d be extreme"y skeptica" of risk measures based on the status /uo assumption that vo"ati"ity wi"" remain "ow. This is precise"y because the events that we shou"d be most concerned about are those that have the abi"ity to turn the status /uo on its head.


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The forex market has seen profound changes since the ear"y 1*F+s& not on"y in its si)e but a"so in the way in which it operates& as a resu"t of structura" shifts in the wor"d economy and in the internationa" financia" system. >ome of the main changes which have occurred in the wor"dGs financia" environment inc"ude6 1. 1 fundamenta" change in the internationa" monetary system from the fixed exchange rates arising out of the =retton Coods agreement to a much more f"exib"e system in which countries can f"oat their exchange rates or fo""ow other exchange rate practices of their own choosing. 2. 4ajor financia" deregu"ation across the g"obe inc"uding the e"imination of government contro"s and restrictions in a"most every country& which has resu"ted in far greater freedom in nationa" and internationa" financia" transactions and huge"y increased competition among financia" institutions. . 1 fundamenta" change in savings and investment& with funds managers and investment institutions around the wor"d diversifying their investments across internationa" borders and into mu"tip"e currencies. !. 4ajor changes in& and "ibera"i)ation of& internationa" trade as a resu"t of a series of trade agreements inc"uding the Tokyo and the 2ruguay <ounds of the Benera" 1greement on Tariffs and Trade& the ?orth 1merican -ree Trade 1greement& and 2> bi"atera" trade initiatives with the 'uropean 2nion& :hina and Hapan. #. Techno"ogica" advances which have made it possib"e to achieve the rea"-time transmission of huge amounts of market information wor"dwide and to ana"y)e that information rapid"y so that market opportunities can be identified and exp"oited. (n addition& financia" transactions can now be executed /uick"y and safe"y& with a "eve" of efficiency which a""ows costs to be kept at "eve" we"" be"ow those which were possib"e previous"y. $. ?ew thinking in terms of both the theory and practice of finance which have resu"ted in the deve"opment of many new financia" instruments and derivative products. 1dvances in thinking have a"so served to change our understanding of the internationa" financia" system and the techni/ues we

need to use to operate within it. 1s markets have grown and deve"oped since the 1*F+s in a c"imate of much greater freedom and competition& the ro"e of the markets themse"ves has changed and we have deve"oped the too"s and techni/ues to a""ow us to exp"oit these growing markets to the fu"". One major beneficiary of these changes has been the forex trader who has an investment vehic"e avai"ab"e today which was undreamt of a few years ago and which wi"" continue to provide the sma"" investor with an exce""ent trading opportunity for many years to come.




-irst& there are some "imits on freedom accorded to banks& such as ones on borrowing and investing overseasI cei"ings on interest rates and maturities of non-resident foreign currency depositsI and these cou"d be reviewed at appropriate time& with a view to "ibera"ising them prudent"y.

>econd& the medium-term objective of reducing cash reserve re/uirements to the minimum prescribed in the statute and the "onger term objective of proposing amendments to the statute to make a"" the reserve re/uirements f"exib"e wi"" be pursued& consistent with deve"opments in fisca" and monetary conditions.

Third& the restoration of freedom to corporates to hedge anticipated exposures is continuous"y under review. 7owever& the issue of restoration of faci"ity to rebook cance""ed contracts needs to be reviewed with caution.

-ourth& the extension of faci"ity of forward cover to -((s is a"so under continuous review& though faci"ities avai"ab"e now are yet to be fu""y uti"ised by -((s.


-ifth& trading in derivatives is a desirab"e objective& but a number of preconditions are to be satisfied in the matter of institutiona" as we"" as regu"atory arrangements. This is a comp"ex task& but certain"y is on the agenda of reform.

>ixth& setting up a forex c"earing house is on the agenda and it is essentia" to design it on par with other "eading c"earing systems in the wor"d.

>eventh& a number of recommendations of Tarapore :ommittee have been accepted& and others are a"so reviewed from time to time. 1 view wi"" have to be taken on each one of them on"y in the context of overa"" "ibera"isation of capita" account& which in turn& depends on& among other things& progress of our financia" sector reforms and evo"ving internationa" financia" architecture.

'ighth& deve"opment of deep and "i/uid money market with a we""defined yie"d curve in p"ace is an accepted objective of <=(. The actions taken and those contemp"ated to perform this hard task have a"ready been articu"ated in my ear"ier speeches on money and debt markets& and the recent 4onetary and :redit 9o"icy >tatement of 1pri" 1*** has provided evidence of <=(Gs approach in this regard.

?inth& imp"ementation of the recommendations of the <eport on 9ub"ic >ector 'nterprises wi"" faci"itate the efficient management of their foreign currency risks and a"so even out "umpy demand and supp"y situations in the forex market.


Tenth& whi"e there is a dominant view that setting up 4umbai as an off-shore financia" centre is no "onger a necessity& the views of :((& which is posing the issue& may have to be awaited and considered serious"y.

'"eventh& in any effort to deve"op markets& ro"e of se"f regu"atory bodies is critica". The ro"e of -'31( in achieving greater competition& efficiency and transparency in the forex markets needs to be reviewed on a continuous basis& so as to keep pace with deve"opments in techno"ogy and financia" sector reforms.

Twe"fth& a number of "egis"ative changes are under contemp"ation& and of these the ones re"ating to -oreign 'xchange 4anagement and 4oney %aundering are critica" to deve"opment of forex markets. 7armonisation between existing institutions& regu"ations and practices& inc"uding transition path to new "egis"ative framework wou"d be a significant task in the context of forex market deve"opment.

Thirteenth& severa" representations have been received by <egu"ations <eview 1uthority to simp"ify& stream"ine and rationa"ise some of the regu"atory and reporting re/uirements pertinent to foreign exchange. The <<1 shou"d be taking a fina" view in the matter& on the basis of expected report of group of 1micus :uriae& within a few weeks.

-ourteenth& in the area of techno"ogy& on-"ine connectivity has been initiated in respect of data transmission by market to the <=(. Once this system is fu""y estab"ished& it wi"" "ead to a very prompt and effective on-"ine monitoring by <=( as we"" as reduction in mu"tip"icity of reporting statements. >imi"ar"y& initiatives are underway to expedite back office "inkage between banks

themse"ves and with <=( for sett"ement& which wi"" fructify once the J>1T is fu""y operationa".


To conc"ude& the medium-term objective of deve"oping an efficient and vibrant forex market continues to be an important priority within the overa"" framework of deve"opment of financia" markets. ?atura""y& the pace and se/uencing have to be determined by both the domestic and internationa" deve"opments. (n particu"ar& the uni/ue features of (ndian forex markets& "ega"& institutiona" and techno"ogica" factors& and deve"opments re"ated to macro-economic po"icies wou"d govern the path of moving towards the medium-term objective& without sacrificing freedom in tactica" measures to respond to unforeseen circumstances in the very short-term.

=esides& with the (ndian economy moving towards further capita" account "ibera"isation& the deve"opment of a we""-integrated foreign exchange market a"so becomes important as it is through this market that crossborder financia" inf"ows and outf"ows are channe"ed to other markets. 3eve"opment of the foreign exchange market a"so needs to be coordinated with the capita" account "ibera"isation. <eforms in the financia" markets is a dynamic process and need to be harmonised with the evo"ving macroeconomic deve"opments and the "eve" of maturity of participating financia" institutions and other segments of the financia" market.