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RAHEJA COLLEGE OF ARTS & COMMERCE JUHU ROAD, SANTACRUZ (WEST), MUMBAI 400054
DECLARATION
I, KOMAL TANDEL of L.S. RAHEJA COLLEGE, T.Y.BBI (Semester V) hereby declares that I have completed this project on RESERVE BANK OF INDIA in the academic year 2010-2011. The information submitted is true and original to the best of my knowledge.
L.S. RAHEJA COLLEGE OF ARTS AND COMMERCE JUHU ROAD, SANTACRUZ (W), MUMBAI-400 054.
CERTIFICATE I, Mr. Harshad hereby certify that KOMAL TANDEL student of L.S. College of Arts & Commerce of T.Y. BBI (Semester V) has completed this project on INDIAN FOREIGN EXCHANGE MARKET in the academic year 2010-2011. The information in this project is true and to the best of my knowledge.
Signature
Project Coordinator
Internal Guide
External Guide
ACKNOWLEDGEMENT
I KOMAL TANDEL, the student of L.S.Raheja College pursuing my third year of Bachelors of Banking & Insurance (T.Y.B.B.I), is very grateful to a lot of people for guiding and helping me in the right direction throughout my project.
First of all, I would like to specially thank Mr. Kannan, for introducing me to such a wonderful and challenging topic because of which I learnt about the world and especially about the various frauds that take place in detail and for being my guide in the true sense of the word and for guiding, correcting and motivating me at each and every moment during my project.
I would also like to thank Mr. Harshad, our coordinator to whom we shall forever remain in debt for setting the foundation for this course and for assisting in the project whenever help was required.
INDEX
of buying and selling foreign exchange is handled by the foreign exchange departments of RBI and authorized branches of commercial banks in India.
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.
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 and Exim bank are also permitted conditionally to hold foreign currency. The whole foreign 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. After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the economic and industrial development, the need for conservation of foreign currency was felt and on the recommendation of the Public Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act became famous as FEMA.
cancellations) has more 3 than tripled, growing at a compounded annual rate exceeding 25%. The growth of foreign exchange trading in India between 1999 and 2006. The inter-bank forex trading volume has continued to account for the dominant share (over 77%) of total trading over this period, though there is an unmistakable downward trend in that proportion. (Part of this dominance, though, result s from double-counting since purchase and sales are added separately, and a single interbank transaction leads to a purchase as well as a sales entry.) This is in keeping with global patterns.
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: Import of goods and services Dividend, interest and profit to foreign firms. Unilateral payments. Capital outflow in the form of investments abroad, short / long term lending, etc.
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. Receipts on account of export of goods and services. Receipt of dividend, interests and profit by firms. Unilateral receipts. Capital inflow in the form of foreign investments in India, 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.
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.
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.
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.
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%)
considerably to US $ 23 billion during 2006-07 (up to February 2007) with the daily turnover crossing US $ 35 billion on certain days during October and November 2006. The inter-bank to merchant turnover ratio has halved from 5.2 during 1997-98 to 2.6 during 2005-06, reflecting the growing participant in the merchant segment of the foreign exchange market. Turnover in the foreign exchange market was 6.6 times of the size of Indias balance of payments during 2005-06 as compared with 5.4 times in 2000-01. The bank group-wise distribution of the turnover (as a proportion of the total turnover for the respective year) reveals that foreign banks accounts for the largest share in total turnover, though their share declined from 59 percent in 1996-97 to 42 percent during 2005-06
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.
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.
In 1978, the RBI allowed banks to undertake intra-day trading in foreign exchange and as a consequence, the stipulation of maintaining `square' or `near square' position was to be complied with only at the close of business hours each day. This perhaps marks the beginning of forex market in India. As opportunities to make profits began to emerge, the major banks started quoting two-way prices against the rupee as well as in cross currencies and gradually, trading volumes began to increase. During the period, 1975-92 the exchange rate regime in India was characterized by daily announcement by the RBI of its buying and selling rates to Authorised Dealers (ADs) for merchant transactions. Given the then prevalent RBIs obligation to buy and sell unlimited amounts of the intervention currency arising from the banks merchant purchases, its quotes for buying/selling effectively became the fulcrum around which the market was operated. The RBI performed a market-clearing role on a day-to-day basis, which naturally introduced some variability in the size of reserves. Incidentally, certain categories of current and capital account transactions on behalf of the Government were directly routed through the reserves account.
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 inter-bank 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 market-makers, 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 inter-bank) 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. Further, banks were allowed to grant foreign currency loans out of FCNR (B) liabilities and this too facilitated integration as such foreign currency demarcated loans did not have any use restriction. The integration is also achieved through banks
swapping/unswapping FCNR (B) deposits. If the liquidity is considerable and call rates are easy, banks consider deployment either in forex, government or money/repo market. This decision also affects the premia. Gradually, with the opening up of the capital account, the forward premia is getting aligned with the interest rate differential. However, the fact remains that free movement in capital account is only a necessary condition for full development of forward and other forex derivatives market. The sufficient condition is provided by a deep and liquid money market with a well-defined yield curve in place. Developing a well integrated, consistent and meaningful yield curve requires considerable market development in terms of both volume and liquidity in various time and market segments. No doubt, the integration between the domestic market and the overseas market operates more often through the forward market. This integration is facilitated now by allowing ADs to borrow from their overseas offices/correspondents and invest funds in overseas money market up to the same amount.
Data on Forex Markets The RBI publishes daily data on exchange rates, forward premia, foreign exchange turnover etc. in the Weekly Statistical Supplement (WSS) of the RBI Bulletin with a lag of one week. The movement in foreign exchange reserves of the RBI on a weekly basis are furnished in the same publication. The RBI also publishes data on Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER), RBI's purchases and sales in the foreign exchange market along with outstanding forward liabilities on reserves etc. in the monthly RBI Bulletin with a time lag of one month. Since July 1998, the Reserve Bank of India started publishing the 5-country trade based NEER and REER in addition to 36country NEER and REER in the RBI Bulletin. Way ahead of many developing and industrial country central banks, the RBI has been publishing the size of its gross intervention (purchase and sale) each month and its net forward liability position.
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. When corporates borrow in foreign currency, there is an inflow into the market but there may be hedging by corporates. When banks swap into rupees and lend, there
is an impact on forex markets but forward premia and lending rates in rupees are critical. Thus, tracking the use of FCNR (B) deposits is essential in appreciating forex markets.
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 nondisruptive way to the benefit of both the PSE concerned and functioning of forex market in India.
Off-shore Banking Units The setting up of Off-shore banking units at this advanced stage of financial liberalisation in our country is considered by many to be unnecessary and that the time for an offshore banking unit has gone. In a country of our size, the issue of linkages between off-shore sector and the domestic sector is undoubtedly an important one. We need to make a clear distinction between the financial issues and the non-financial issues on the subject. From the central bank's perspective, designing appropriate regulatory framework is important and the most important issue is ensuring of a firewall between the off-shore transactions and domestic transactions. Physical location is not relevant, especially when deposit taking and
cash transactions are not permitted in off-shore business. In fact, we do not have a good model of real off-shore centre in a country with capital controls. Confederation of Indian Industry (CII) with assistance from the Government of Maharashtra is engaged in a detailed study of the various issues to make recommendations to the RBI and the Government of 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.
Role of FEDAI In a regime where exchange rates were fixed and there were restrictions on outflow of foreign exchange, the RBI encouraged the banks to constitute a self
regulatory body and lay down rules for the conduct of forex business. In order to ensure that all the banks participated in the arrangement, the RBI placed a condition while issuing foreign exchange licence that every licensee agree to be bound by the rules laid down by the bankers body the FEDAI. FEDAI also accredited brokers through whom the banks put through deals. There is increasing emphasis now on competition, and fixing or advising charges by professional bodies is being viewed with disfavour and often treated as a restrictive trading practice. It is currently argued by some that with the growth in volumes and giant strides in telecommunication, banks may no longer need to deal through brokers when efficient match making arrangements exist. As in some other markets, the deals are concluded on the basis of voice broking and it is sometimes held that this often results in conclusion of deals which are less than transparent, evidenced by instances where deals have been called off on payment of differences. Under the circumstances, there is perhaps a need to review several aspects, viz., compatibility of advising or prescribing fees with pro-competition policy; role of brokers; electronic dealing vis--vis voice broking; and relationship between the RBI, FEDAI and authorised dealers.
In foreign exchange market, two types of exchange rate operations take place, spot exchange rate and forward exchange rate.
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 may either be at a premium or discount in relation to the spot exchange rate: If the forward exchange rate is above the present spot rate, it is said to be at a premium. If the forward exchange rate is below the present spot rate, it is said to be at a discount The quotation foe forward exchange rate can be done as follows: It is expressed in terms of the amount of local currency at which the dealer will buy or sell a unit of foreign currency. This is termed as the outright rate. It can also be expressed in terms of points (called the forward points). These points are 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: Balance of payments position Inflation rate. Interest rate. Degree of speculation in foreign exchange market. Economic situation in the country. Political situation in the country. Government policies, etc.
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.
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.
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.
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.
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.
INDIAN ECONOMY
Foreign Exchange Market in India operates under the Central Government of India and executes wide powers to control transactions in foreign exchange. The Foreign Exchange Management Act, 1999 or FEMA regulates the whole Foreign Exchange Market in India. Before the introduction of this act, the foreign exchange market in India was regulated by the Reserve Bank of India through the Exchange Control Department, by the Foreign Exchange Regulation Act or FERA, 1947.
After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the Economic and Industrial development, the need for conservation of foreign currency was urgently felt and on the recommendation of the Public Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act became famous as FEMA. Early Years of Foreign Exchange Market Until 1992, all Foreign Investments in India and the repatriation of Foreign Capital required previous approval of the government. The Foreign Exchange Regulation Act rarely allowed foreign majority holdings for Foreign Exchange in India. However, a new Foreign Investment Policy announced in July 1991, declared automatic approval for Foreign Exchange in India for thirty-four industries. These industries were designated with high priority, up to an equivalent limit of 51 percent. The foreign exchange market in India is regulated by the Reserve Bank of India through the Exchange Control Department. Initially, the Government required that a company`s routine approval must rely on identical exports and dividend repatriation, but in May 1992, this requirement of Foreign Exchange in India was lifted, with an exception to lowpriority sectors. In 1994, foreign nationals and non-resident Indian investors were permitted to repatriate not only their profits but also their capital for Foreign Exchange in India. Indian exporters enjoyed the freedom to use their export earnings as they found it suitable. However, transfer of capital abroad by Indian nationals is only allowed in particular circumstances, such as emigration. Foreign Exchange in India is automatically made accessible for imports for which import licenses are widely issued.
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.
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
RBI Regulations
These contracts were allowed with the following conditions:
These currency options can be used as 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. Such contracts are allowed to be freely re-booked and cancelled. Any premier payable on account of such transactions does not require RBI approval. Cost reduction strategies like range forwards can be used as long as there is no net inflow of premier to the customer. Banks can also purchase call or put options to hedge their cross currency proprietary trading positions. But banks are also required to fulfill the condition that no stand alone transactions are initiated. If a hedge becomes naked in 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.
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.
Best time to trade The Indian forex traders have also come to realize that a small ripple felt in a far corner of the globe can affect markets in India. We are more interconnected and no country can remain unaffected from the changes happening in the world these days. If you are planning to invest in forex trading in India, this could be the best opportunity as things have kick started and would be on a roll soon. Currencies are also interlinked and any changes in a major currency price can affect other weaker currencies of the world. Forex trading takes benefit from the rise and falls in prices of currencies.
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.
other central banks, international commercial banks, and the Bank for International Settlement following a multicurrency and multi-markets approach. As at endMarch, 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.
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
(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 co-operative 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.