kinjal mehta_final report

8/7/2019 KINJAL MEHTA_FINAL REPORT

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FOREX MARKETS IN INDIAN L DALMIA INSTITUTE OF MANAGE MENT STUDIES AND

RESEARCH

A REPORT ON

FOREX MARKES IN INDIA

SUBMITTED IN PARTIAL FULFILLMENT FOR THE AWARD OF

POST GRADUATE DIPLOMA IN BUSINESS MANAGEMENT

UNDER THE GUIDANCE OF

MR. HARESH DESAI

DIRECTOR

A. V. RAJWADE AND COMPANY

SUBMITTED BY

KINJAL MEHTA

PGDM- FINANCE

SESSION 2008-2010

N.L.DALMIA INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

MIRA ROAD (E), MUMBAI-401104

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ACKNOWLEDGEMENT

Two months of summer training at A. V. Rajwade & Co. has been a great value addition to

my career that would not have been possible without continuous guidance and administration

of certain key people. I would like to place on record, my sincere gratitude to each of them.

I am grateful to Prof. P. L. Arya, Director, N L Dalmia Institute of Management Studies andResearch for giving me this opportunity.

I would like to express my appreciation towardsMr. Haresh Desai (Director A V Rajwade

& Co) for giving me the opportunity to work on this project. I express my gratitude and

indebtedness to him for guiding me in every aspect for making this effort a great success.

I sincerely thank Prof. V. S. Date, N L Dalmia Institute of Management Studies and

Research for the valuable guidance extended by them during my entire course in the

preparation of this dissertation and for letting me their valuable time when ever I was in need.

KINJAL YASHWANT MEHTA

N. L. Dalmia Institute of Management Studies and Research

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Executive Summary

This project gives an in-depth analysis and understanding of Foreign Exchange Markets in

India. It helps to understand the History and the evolution of the foreign market in India.

It gives an overview of the conditions existing in the current global economy. It gives an

overview of the Foreign exchange market.

It talks about the foreign exchange management act applicable and also gives details about

the participants in the forex markets. It gives an insight about the foreign exchange rate

indices like NEER, REER, etc.

It also talks about what are the sources of demand and supply of foreign exchange in the

market all over the world.

The report also talks about the Foreign Exchange trading platform and how the efficiency and

the transparency is maintained.

The report focuses on corporate hedging for foreign exchange risk in India. The report

contains details about some companies Foreign Exposure and how they have maintained it.

It also talks about the determinants to be taken care of while taking corporate hedging

decisions. It gives insights about the Regulatory guidelines for the use of Foreign Exchange

derivatives, Development of Derivatives markets in India and also the Hedging instruments

for Indian firms.

The report gives an in-depth analysis of the currency risk management by talking about what

currency risk is, the types of currency risk Transaction risk ,Translation risk and Economic

risk. It also contains details about the companies in the index sensex and nifty showing their

transaction is foreign currency like the imports, exports, Loans, Interst payments and the

other expenses. It then shows the sensitivity analysis of how the currency rates impact the

gains/ profits of the company.

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TABLE OF CONTENTS:

Sr.No. Topic Page No

1 Overview: Investors ponder depth and duration of global downturn 4

2 Foreign Exchange Market Overview 9

3 Forex Market: A Historical Perspective 14

4 Foreign Exchange Management Act, 1999 19

5 Participants in foreign exchange market 20

6 Exchange rate System 23

7 Foreign Exchange Market Structure 26

8 Fundamentals in Exchange Rate 28

9 Exchange Rate Indices 31

10 Sources of Supply and Demand in the Foreign exchange 39

11 Foreign Exchange Market Trading Platform 44

12 Corporate Hedging for Foreign Exchange Risk in India 46

13 Determinants of Hedging Decisions 58

14 An Overview of Corporate Hedging in India 61

15 Currency Risk Management 68

16 Core Principles of Managing Currency Risk 77

Overview: Investors ponder depth and duration of global

downturn

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Uncertainty about the depth and duration of the economic contraction continued to roil

financial markets over the period between end-November 2008 and 20 February 2009. Credit

markets generally remained under pressure from weak economic data and earnings reports

and the resulting expectations of rising defaults. Pressures were particularly evident in therenewed widening of non-investment grade spreads. Cyclical deterioration also drove the

worsening of equity prices, particularly in Japan. At the same time, policy measures aimed at

stabilizing markets appeared to gain traction over the period. In money markets, central bank

actions and government guarantees helped to calm interbank markets and spreads between

Libor and overnight index swaps (OIS) continued to decline gradually.

Facilities that included outright purchases of agency mortgage- and other asset-backed

securities contributed to signs of normalization in mortgage markets, while funding facilities

and government guarantees of financial sector issues provided a helping hand to primary debt

markets, where activity surged to record levels in January. To be sure, policy measures

backstopping debt claims on banks were generally not perceived as positive for financial

shares, and financial sector concerns continued to lead overall equity market losses in the

United States and Europe. Meanwhile, the lack of detail on key support packages, among

other factors, contributed to elevated levels of implied volatility as well as to price/earnings

ratios which were extremely low by the standards of the past two decades.

Uncertainties about the severity of the financial crisis and the economic downturn exerted

further downward pressure on government bond yields, though mounting concerns over

increased issuance limited overall declines in yield during the period under review. At the

same time, segments of the bond market were still showing clear signs of being affected by

factors other than expectations about economic fundamentals and policy actions. Although

emerging markets generally had little direct exposure to the distressed asset problem plaguing

major industrial economies and managed to weather the most acute phase of the financial

crisis in late 2008 relatively well, they were much less immune to the deepening recession in

the advanced industrial world. Plunging exports and GDP growth bore clear evidence of the

severity and synchronicity of the global economic downturn, which was reflected in

declining asset prices, particularly in emerging Europe.

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Rupee Dolla

January 20

45

50

55

Rupee/PounJanuary 20

80

85

90

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Rupee/Japanese Y

January 2

50

55

60

Rupee/Euro

January 20

62

64

66

68

70

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Managing Currency Risk The Investor: Currency Exposure

within the Investment Decision

Investors and corporations face similar types of risk on foreign currency exposure. For

instance, investors face transaction riskwhen they invest abroad. They also face translation

riskon assets and liabilities if they spread their operations overseas. For its part, the corporate

sector clearly seems to have moved to a view that currency risk is an unavoidable issue that

has to be managed independently from the underlying business.

On the face of it, this chapter may seem targeted at only those who manage currency risk on

an active basis. This is not the case. Rather, it is aimed at any institutional investor who faces

in the course of their underlying business exposure to a foreign currency, whether or not

they are in fact allowed to carry out some of the ideas and strategies presented herein. Let us

start then with two core principles on the issue of currency risk:

1. Investing in a country is not the same as investing in that countrys currency

2. Currency is not the same as cash; the incentive for currency investment is primarily capital

gain rather than income.

The dynamics that drive a currency are not the same as those that drive asset markets

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Foreign Exchange Market Overview

Globally, operations in the foreign exchange market started in a major way after the

breakdown of the Bretton Woods system in 1971, which also marked the beginning of

floating exchange rate regimes in several countries. Over the years, the foreign exchange

market has emerged as the largest market in the world. The decade of the 1990s witnessed a

perceptible policy shift in many emerging markets towards reorientation of their financial

markets in terms of new products and instruments, development of institutional and market

infrastructure and realignment of regulatory structure consistent with the liberalized

operational framework. The changing contours were mirrored in a rapid expansion of foreignexchange market in terms of participants, transaction volumes, decline in transaction costs

and more efficient mechanisms of risk transfer.

The origin of the foreign exchange market in India could be traced to the year 1978 when

banks in India were permitted to undertake intra-day trade in foreign exchange. However, it

was in the 1990s that the Indian foreign exchange market witnessed far reaching changes

along with the shifts in the currency regime in India. The exchange rate of the rupee, that was

pegged earlier was floated partially in March 1992 and fully in March 1993 following the

recommendations of the Report of the High Level Committee on Balance of Payments

(Chairman: Dr.C. Rangarajan). The unification of the exchange rate was instrumental in

developing a market-determined exchange rate of the rupee and an important step in the

progress towards current account convertibility, which was achieved in August 1994. 6.3 A

further impetus to the development of the foreign exchange market in India was provided

with the setting up of an Expert Group on Foreign Exchange Markets in India (Chairman:

Shri O.P. Sodhani), which submitted its report in June 1995. The Group made several

recommendations for deepening and widening of the Indian foreign exchange market.

Consequently, beginning from January 1996, wide-ranging reforms have been undertaken in

the Indian foreign exchange market. After almost a decade, an Internal Technical Group on

the Foreign Exchange Market (2005) was constituted to undertake a comprehensive review of

the measures initiated by the Reserve Bank and identify areas for further liberalization or

relaxation of restrictions in a medium-term framework.

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The momentous developments over the past few years are reflected in the enhanced risk-

bearing capacity of banks along with rising foreign exchange trading volumes and finer

margins. The foreign exchange market has acquired depth (Reddy, 2005). The conditions in

the foreign exchange market have also generally remained orderly (Reddy, 2006c). While itis not possible for any country to remain completely unaffected by developments in

international markets, India was able to keep the spillover effect of the Asian crisis to a

minimum through constant monitoring and timely action, including recourse to strong

monetary measures, when necessary, to prevent emergence of self fulfilling speculative

activities

In todays world no economy is self sufficient, so there is need for exchange of goods and

services amongst the different countries. So in this global village, unlike in the primitive age

the exchange of goods and services is no longer carried out on barter basis. Every sovereign

country in the world has a currency that is legal tender in its territory and this currency does

not act as money outside its boundaries. So whenever a country buys or sells goods and

services from or to another country, the residents of two countries have to exchange

currencies. So we can imagine that if all countries have the same currency then there is no

need for foreign exchange.

Need for Foreign Exchange:

Let us consider a case where Indian company exports cotton fabrics to USA and invoices the

goods in US dollar. The American importer will pay the amount in US dollar, as the same is

his home currency. However the Indian exporter requires rupees means his home currency

for procuring raw materials and for payment to the labor charges etc. Thus he would need

exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then

importer in USA will get his dollar converted in rupee and pay the exporter. From the above

example we can infer that in case goods are bought or sold outside the country, exchange of

currency is necessary. Sometimes it also happens that the transactions between two countries

will be settled in the currency of third country. In that case both the countries that are

transacting will require converting their respective currencies in the currency of third

country. For that also the foreign exchange is required.

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About foreign exchange market:

Particularly for foreign exchange market there is no market place called the foreign exchange

market. It is mechanism through which one countrys currency can be exchange i.e. bought

or sold for the currency of another country. The foreign exchange market does not have anygeographic location. Foreign exchange market is described as an OTC (over the counter)

market as there is no physical place where the participant meets to execute the deals, as we

see in the case of stock exchange. The largest foreign exchange market is in London,

followed by the New York, Tokyo, Zurich and Frankfurt. The markets are situated

throughout the different time zone of the globe in such a way that one market is closing the

other is beginning its operation. Therefore it is stated that foreign exchange market is

functioning throughout 24 hours a day. In most market US dollar is the vehicle currency, viz.,

the currency sued to dominate international transaction. In India, foreign exchange has been

given a statutory definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states:

Foreign exchange means foreign currency and includes:

All deposits, credits and balance payable in any foreign currency and any draft,

travelers cheques, letter of credit and bills of exchange. Expressed or drawn in India

currency but payable in any foreign currency.

Any instrument payable, at the option of drawee or holder thereof or any other party thereto,

either in Indian currency or in foreign currency or partly in one and partly in the other. In

order to provide facilities to members of the public and foreigners visiting India, for

exchange of foreign currency into Indian currency and vice-versa RBI has granted to various

firms and individuals, license to undertake money-changing business at seas/airport and

tourism place of tourist interest in India. Besides certain authorized dealers in foreign

exchange (banks) have also been permitted to open exchange bureaus. Following are the

major bifurcations:

Full fledge moneychangers they are the firms and individuals who have been authorized

to take both, purchase and sale transaction with the public.

Restricted moneychanger they are shops, emporia and hotels etc. that have been

authorized only to purchase foreign currency towards cost of goods supplied or services

rendered by them or for conversion into rupees.

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Authorized dealers they are one who can undertake all types of foreign exchange

transaction. Banks are only the authorized dealers. The only exceptions are Thomas cook,

western union, UAE exchange which though, and not a bank is an AD. Even among the

banks RBI has categorized them as follows:

Branch A They are the branches that have Nostro and Vostro account.

Branch B The branch that can deal in all other transaction but do not maintain Nostro and

Vostro a/cs fall under this category. For Indian we can conclude that foreign exchange refers

to foreign money, which includes notes, cheques, bills of exchange, bank balance and

deposits in foreign currencies.

Foreign Exchange Market: An Assessment

The continuous improvement in market infrastructure has had its impact in terms of enhanced

depth, liquidity and efficiency of the foreign exchange market. The turnover in the Indian

foreign exchange market has grown significantly in both the spot and derivatives segments in

the recent past. Along with the increase in onshore turnover, activity in the offshore market

has also assumed importance. With the gradual opening up of the capital account, the process

of price discovery in the Indian foreign exchange market has improved as reflected in the

bid-ask spread and forward premia behaviour.

Foreign Exchange Market Turnover

As per the Triennial Central Bank Survey by the Bank for International Settlements (BIS) on

Foreign Exchange and Derivatives Market Activity, global foreign exchange market

activity rose markedly between 2001 and 2004 (Table 6.4). The strong growth in turnover

may be attributed to two related factors. First, the presence of clear trends and higher

volatility in foreign exchange markets between 2001 and 2004 led to trading momentum,

where investors took large positions in currencies that followed persistent appreciating

trends. Second, positive interest rate differentials encouraged the so-called carry trading,

i.e., investments in high interest rate currencies financed by positions in low interest rate

currencies. The growth in outright forwards between 2001 and 2004 reflects heightened

interest in hedging. Within the EM countries, traditional foreign exchange trading in Asian

currencies generally recorded much faster growth than the global total between 2001 and

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2004. Growth rates in turnover for Chinese renminbi, Indian rupee, Indonesian rupiah,

Korean won and new Taiwanese dollar exceeded 100 per cent between April 2001 and April

2004 (Table 6.5). Despite significant growth in the foreign exchange market turnover, the

share of most of the EMEs in total global turnover, however, continued to remain low.

The Indian foreign exchange market has grown manifold over the last several years. The

daily average turnover impressed a substantial pick up from about US $ 5 billion during

1997-98 to US $ 18 billion during 2005-06. The turnover has risen 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

participation in the merchant segment of the foreign exchange market (Table 6.6 and Chart

VI.2). Mumbai alone accounts for almost 80 per cent of the foreign exchange turnover.

6.60 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 (Table 6.7). With the

deepening of the foreign exchange market and increased turnover, income of commercial

banks through treasury operations has increased considerably. Profit from foreign exchange

transactions accounted for more than 20 per cent of total profits of the scheduled commercial

banks during 2004-05 and 2005-06

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Forex Market: A Historical Perspective

Early Stages: 1947-1977

The evolution of Indias foreign exchange market may be viewed in line with the shifts in

Indias exchange rate policies over the last few decades from a par value system to a basket-

peg and further to a managed float exchange rate system. During the period from 1947 to

1971, India followed the par value system of exchange rate. Initially the rupees external par

value was fixed at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the

rupee within the permitted margin of 1 per cent using pound sterling as the intervention

currency. Since the sterling-dollar exchange rate was kept stable by the US monetary

authority, the exchange rates of rupee in terms of gold as well as the dollar and other

currencies were indirectly kept stable. The devaluation of rupee in September 1949 and June

1966 in terms of gold resulted in the reduction of the par value of rupee in terms of gold to

2.88 and 1.83 grains of fine gold, respectively. The exchange rate of the rupee remained

unchanged between 1966 and 1971 (Chart VI.1).

Given the fixed exchange regime during this period, the foreign exchange market for all

practical purposes was defunct. Banks were required to undertake only cover operations and

maintain a square or near square position at all times. The objective of exchange controls

was primarily to regulate the demand for foreign exchange for various purposes, within the

limit set by the available supply. The Foreign Exchange Regulation Act initially enacted in

1947 was placed on a permanent basisin 1957. In terms of the provisions of the Act, the

Reserve Bank, and in certain cases, the Central Government controlled and regulated the

dealings in foreign exchange payments outside India, export and import of currency notesand bullion, transfers of securities between residents and non-residents, acquisition of foreign

securities, etc3 .

With the breakdown of the Bretton Woods System in 1971 and the floatation of major

currencies, the conduct of exchange rate policy posed a serious challenge to all central banks

world wide as currency fluctuations opened up tremendous opportunities for market players

to trade in currencies in a borderless market. In December 1971, the rupee was linked with

pound sterling. Since sterling was fixed in terms of US dollar under the Smithsonian

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Agreement of 1971, the rupee also remained stable against dollar. In order to overcome the

weaknesses associated with a single currency peg and to ensure stability of the exchange rate,

the rupee, with effect from September 1975, was pegged to a basket of currencies. The

currency selection and weights assigned were left to the discretion of the Reserve Bank. Thecurrencies included in the basket as well as their relative weights were kept confidential in

order to discourage speculation. It was around this time that banks in India became interested

in trading in foreign exchange

Formative Period: 1978-1992

The impetus to trading in the foreign exchange market in India came in 1978 when banks in

India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange

and were required to comply with the stipulation of maintaining square or near square

position only at the close of business hours each day. The extent of position which could be

left uncovered overnight (the open position) as well as the limits up to which dealers could

trade during the day were to be decided by the management of banks. The exchange rate of

the rupee during this period was officially determined by the Reserve Bank in terms of a

weighted basket of currencies of Indias major trading partners and the exchange rate regime

was characterised by daily announcement by the Reserve Bank of its buying and selling rates

to the Authorised Dealers (ADs) for undertaking merchant transactions. The spread between

the buying and the selling rates was 0.5 per cent and the market began to trade actively within

this range. ADs were also permitted to trade in cross currencies (one convertible foreign

currency versus another). However, no position in this regard could originate in overseas

markets.

As opportunities to make profits began to emerge, major banks in India started quoting two

way prices against the rupee as well as in cross currencies and, gradually, trading volumes

began to increase. This led to the adoption of widely different practices (some of them being

irregular) and the need was felt for a comprehensive set of guidelines for operation of banks

engaged in foreign exchange business. Accordingly, the Guidelines for Internal Control over

Foreign Exchange Business, were framed for adoption by the banks in 1981. The foreign

exchange market in India till the early 1990s, however, remained highly regulated with

restrictions on external transactions, barriers to entry, low liquidity and high transaction

costs. The exchange rate during this period was managed mainly for facilitating Indias

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imports. The strict control on foreign exchange transactions through the Foreign Exchange

Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets

for foreign exchange in the world, i.e., the hawala (unofficial) market.

By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and

structural factors had contributed to balance of payments difficulties. Devaluations by Indias

competitors had aggravated the situation. Although exports had recorded a higher growth

during the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8

per cent of GDP in 1990-91), trade imbalances persisted at around 3 percent of GDP. This

combined with a precipitous fall in invisible receipts in the form of private remittances, travel

and tourism earnings in the year 1990-91 led to further widening of current account deficit.

The weaknesses in the external sector were accentuated by the Gulf crisis of 1990-91. As a

result, the current account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital

flows also dried up necessitating the adoption of exceptional corrective steps. It was against

this backdrop that India embarked on stabilisation and structural reforms in the early 1990s.

Post-Reform Period: 1992 onwards

This phase was marked by wide ranging reform measures aimed at widening and deepening

the foreign exchange market and liberalisation of exchange control regimes. A credible

macroeconomic, structural and stabilization programme encompassing trade, industry,

foreign investment, exchange rate, public finance and the financial sector was put in place

creating an environment conducive for the expansion of trade and investment. It was

recognised that trade policies, exchange rate policies and industrial policies should form part

of an integrated policy framework to improve the overall productivity, competitiveness and

efficiency of the economic system, in general, and the external sector, in particular. As a

stabilsation measure, a two step downward exchange rate adjustment by 9 per cent and 11 per

cent between July 1 and 3, 1991 was resorted to counter the massive drawdown in the foreign

exchange reserves, to instill confidence among investors and to improve domestic

competitiveness. A two-step adjustment of exchange rate in July 1991 effectively brought to

close the regime of a pegged exchange rate. After the Gulf crisis in 1990-91, the broad

framework for reforms in the external sector was laid out in the Report of the High Level

Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). Following the

recommendations of the Committee to move towards the market-determined exchange rate,

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the Liberalised Exchange Rate Management System (LERMS) was put in place in March

1992 initially involving a dual exchange rate system. Under the LERMS, all foreign

exchange receipts on current account transactions (exports, remittances, etc.) were required to

be surrendered to the Authorised Dealers (ADs) in full. The rate of exchange for conversionof 60 per cent of the proceeds of these transactions was the market rate quoted by the ADs,

while the remaining 40 percent of the proceeds were converted at the Reserve Banks official

rate. The ADs, in turn, were required to surrender these 40 per cent of their purchase of

foreign currencies to the Reserve Bank. They were free to retain the balance 60 per cent of

foreign exchange for selling in the free market for permissible transactions. The LERMS was

essentially a transitional mechanism and a downward adjustment in the official exchange rate

took place in early December 1992 and ultimate convergence of the dual rates was made

effective from March 1, 1993, leading to the introduction of a market-determined exchange

rate regime.

The dual exchange rate system was replaced by a unified exchange rate system in March

1993, whereby all foreign exchange receipts could be converted at market determined

exchange rates. On unification of the exchange rates, the nominal exchange rate of the rupee

against both the US dollar as also against a basket of currencies got adjusted lower, which

almost nullified the impact of the previous inflation differential. The restrictions on a number

of other current account transactions were relaxed. The unification of the exchange rate of the

Indian rupee was an important step towards current account convertibility, which was finally

achieved in August 1994, when India accepted obligations under Article VIII of the Articles

of Agreement of the IMF.

With the rupee becoming fully convertible on all current account transactions, the risk-

bearing capacity of banks increased and foreign exchange trading volumes started rising.

This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in

conjunction with the Government to remove market distortions and deepen the foreign

exchange market. The process has been marked by gradualism with measures being

undertaken after extensive consultations with experts and market participants. The reform

phase began with the Sodhani Committee (1994) which in its report submitted in 1995 made

several recommendations to relax the regulations with a view to vitalising the foreign

exchange market.

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In addition, several initiatives aimed at dismantling controls and providing an enabling

environment to all entities engaged in foreign exchange transactions have been undertaken

since the mid-1990s. The focus has been on developing the institutional framework and

increasing the instruments for effective functioning, enhancing transparency and liberalisingthe conduct of foreign exchange business so as to move away from micro management of

foreign exchange transactions to macro management of foreign exchange flows (Box VI.3).

An Internal Technical Group on the Foreign Exchange Markets (2005) set up by the Reserve

Bank made various recommendations for further liberalisation of the extant regulations.

Some of the recommendations such as freedom to cancel and rebook forward contracts of any

tenor, delegation of powers to ADs for grant of permission to corporates to hedge their

exposure to commodity price risk in the international commodity exchanges/markets and

extension of the trading hours of the inter-bank foreign exchange market have since been

implemented.

Along with these specific measures aimed at developing the foreign exchange market,

measures towards liberalising the capital account were also implemented during the last

decade, guided to a large extent since 1997 by the Report of the Committee on Capital

Account Convertibility (Chairman: Shri S.S. Tarapore). Various reform measures since the

early 1990s have had a profound effect on the market structure, depth, liquidity and

efficiency of the Indian foreign exchange market.

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Foreign Exchange Management Act, 1999

The change in the entire approach towards exchange control regulation has been the result of

the replacement of the Foreign Exchange Regulation Act, 1973, by the Foreign Exchange

Management Act, 1999. The latter came into effect from June 1, 2000. The change in the

preamble itself signifies the dramatic change in approach -- from "for the conservation of the

foreign exchange resources" in FERA 1973, to "facilitate external trade and payments"

under FEMA 1999. Any FEMA violations are civil, not criminal, offences, attracting

monetary penalties, and not arrests or imprisonment.

The scheme of FEMA and the notifications issued thereunder take into the account theconvertibility of the rupee for all current account transactions. Indeed, there is now general

freedom to authorised dealers to sell currency for most current account transactions. One old

limitation continues. All transactions in foreign exchange have to be with authorised dealers,

i.e. banks authorised to act as dealers in foreign exchange by the Reserve Bank. The original

rules, regulations, notifications, etc., under FEMA are contained in the A.D. (M.A. series)

Circular No. 11 of May 16, 2000. Subsequent circulars have been issued under the A.P. (DIR

series) nomenclature. It is obviously impossible to incorporate all the current regulations in a

book of this type, particularly since the regulations keep changing. An outline of the basic

framework of exchange control under FEMA is in Annexure 5.3. But its contents should not

be considered as either definitive or current and those interested need to keep up with the

various circulars and other communications on the subject.

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Participants in foreign exchange market

Market Players

Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in

foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers

individuals, corporates, who need foreign exchange for their transactions. Though

customers are major players in the foreign exchange market, for all practical purposes they

depend upon ADs and brokers. In the spot foreign exchange market, foreign exchange

transactions were earlier dominated by brokers. Nevertheless, the situation has changed with

the evolving market conditions, as now the transactions are dominated by ADs. Brokers

continue to dominate the derivatives market.

The Reserve Bank intervenes in the market essentially to ensure orderly market conditions.

The Reserve Bank undertakes sales/purchases of foreign currency in periods of excess

demand/supply in the market. Foreign Exchange Dealers Association of India (FEDAI)

plays a special role in the foreign exchange market for ensuring smooth and speedy growth of

the foreign exchange market in all its aspects. All ADs are required to become members of

the FEDAI and execute an undertaking to the effect that they would abide by the terms andcondition stipulated by the FEDAI for transacting foreign exchange business. The FEDAI is

also the accrediting authority for the foreign exchange brokers in the interbank foreign

exchange market.

The licences for ADs are issued to banks and other institutions, on their request, under

Section 10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided into

different categories. All scheduled 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. Select 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 five are co-operative banks (Table 6.3). 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 utilise

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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 encouraged to participate in the market making.

The number of participants who can give two-way quotes also needs to be increased.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.

The main players in foreign exchange market are as follows:

1. Customers:

The customers who are engaged in foreign trade participate in foreign exchange market by

availing of the services of banks. Exporters require converting the dollars in to rupee and

importers require converting rupee in to the dollars, as they have to pay in dollars for the

goods/services they have imported.

2. Commercial Bank:

They are most active players in the forex market. Commercial bank dealings with

international transaction offer services for conversion of one currency in to another. They

have wide network of branches. Typically banks buy foreign exchange from exporters and

sells foreign exchange to the importers of goods. As every time the foreign exchange bought

or oversold position. The balance amount is sold or bought from the market.

3. Central Bank:

In all countries Central bank have been charged with the responsibility of maintaining the

external value of the domestic currency. Generally this is achieved by the intervention of the

bank.

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4. Exchange Brokers:

Forex brokers play very important role in the foreign exchange market. However the extent

to which services of foreign brokers are utilized depends on the tradition and practice

prevailing at a particular forex market center. In India as per FEDAI guideline the Ads arefree to deal directly among themselves without going through brokers. The brokers are not

among to allowed to deal in their own account allover the world and also in India.

5. Overseas Forex Market:

Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The

international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of

trading in world forex market is constituted of financial transaction and speculation. As we

know that the forex market is 24-hour market, the day begins with Tokyo and thereafter

Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York,

Sydney, and back to Tokyo.

6. Speculators:

The speculators are the major players in the forex market. Bank dealing are the major

speculators in the forex market with a view to make profit on account of favorable movement

in exchange rate, take position i.e. if they feel that rate of particular currency is likely to go

up in short term. They buy that currency and sell it as soon as they are able to make quick

profit.

Corporations particularly multinational corporation and transnational corporation having

business operation beyond their national frontiers and on account of their cash flows being

large and in multi currencies get in to foreign exchange exposures. With a view to make

advantage of exchange rate movement in their favor they either delay covering exposures or

do not cover until cash flow materialize.

Individual like share dealing also undertake the activity of buying and selling of foreign

exchange for booking short term profits. They also buy foreign currency stocks, bonds and

other assets without covering the foreign exchange exposure risk. This also results in

speculations.

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Exchange rate System

Countries of the world have been exchanging goods and services amongst themselves. This

has been going on from time immemorial. The world has come a long way from the days of

barter trade. With the invention of money the figures and problems of barter trade have

disappeared. The barter trade has given way ton exchanged of goods and services for

currencies instead of goods and services. The rupee was historically linked with pound

sterling. India was a founder member of the IMF. During the existence of the fixed exchange

rate system, the intervention currency of the Reserve Bank of India (RBI) was the British

pound, the RBI ensured maintenance of the exchange rate by selling and buying pound

against rupees at fixed rates. The inter bank rate therefore ruled the RBI band. During thefixed exchange rate era, there was only one major change in the parity of the rupee-

devaluation in June 1966. Different countries have adopted different exchange rate system at

different time.

The following are some of the exchange rate system followed by various countries.

The Gold StandardMany countries have adopted gold standard as their monetary system during the last two

decades of the 19he century. This system was in vogue till the outbreak of World War 1.

Under this system the parties of currencies were fixed in term of gold. There were two main

types of gold standard:

1) Gold specie standard

Gold was recognized as means of international settlement for receipts and payments amongst

countries. Gold coins were an accepted mode of payment and medium of exchange in

domestic market also. A country was stated to be on gold standard if the following condition

were satisfied:

Monetary authority, generally the central bank of the country, guaranteed to buy and

sell gold in unrestricted amounts at the fixed price.

Melting gold including gold coins, and putting it to different uses was freely allowed.

Import and export of gold was freely allowed.

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The total money supply in the country was determined by the quantum of gold available for

monetary purpose.

2) Gold Bullion Standard:Under this system, the money in circulation was either partly of entirely paper and gold

served as reserve asset for the money supply. However, paper money could be exchanged for

gold at any time. The exchange rate varied depending upon the gold content of currencies.

This was also known as Mint Parity Theory of exchange rates. The gold bullion standard

prevailed from about 1870 until 1914, and intermittently thereafter until 1944. World War I

brought an end to the gold standard.

Bretton Woods System

During the world wars, economies of almost all the countries suffered. In order to correct the

balance of payments disequilibrium, many countries devalued their currencies. Consequently,

the international trade suffered a deathblow. In 1944, following World War II, the United

States and most of its allies ratified the Bretton Woods Agreement, which set up an

adjustable parity exchange-rate system under which exchange rates were fixed (Pegged)

within narrow intervention limits (pegs) by the United States and foreign central banks

buying and selling foreign currencies. This agreement, fostered by a new spirit of

international cooperation, was in response to financial chaos that had reigned before and

during the war. In addition to setting up fixed exchange parities (par values) of currencies in

relationship to gold, the agreement established the International Monetary Fund (IMF) to act

as the custodian of the system. Under this system there were uncontrollable capital flows,

which lead to major countries suspending their obligation to intervene in the market and the

Bretton Wood System, with its fixed parities, was effectively buried. Thus, the world

economy has been living through an era of floating exchange rates since the early 1970.

Floating Rate System

In a truly floating exchange rate regime, the relative prices of currencies are decided entirely

by the market forces of demand and supply. There is no attempt by the authorities to

influence exchange rate. Where government interferes directly or through various monetary

and fiscal measures in determining the exchange rate, it is known as managed of dirty float.

PURCHASING POWER PARITY (PPP) Professor Gustav Cassel, a Swedish economist,

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introduced this system. The theory, to put in simple terms states that currencies are valued for

what they can buy and the currencies have no intrinsic value attached to it. Therefore, under

this theory the exchange rate was to be determined and the sole criterion being the purchasing

power of the countries. As per this theory if there were no trade controls, then the balance ofpayments equilibrium would always be maintained. Thus if 150 INR buy a fountain pen and

the same fountain pen can be bought for USD 2, it can be inferred that since 2 USD or 150

INR can buy the same fountain pen, therefore USD 2 = INR 150.For example India has a

higher rate of inflation as compared to country US then goods produced in India would

become costlier as compared to goods produced in US. This would induce imports in India

and also the goods produced in India being costlier would lose in international competition to

goods produced in US. This decrease in exports of India as compared to exports from US

would lead to demand for the currency of US and excess supply of currency of India. This in

turn, cause currency of India to depreciate in comparison of currency of US that is having

relatively more exports.

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Foreign Exchange Market Structure

Market Segments

Foreign exchange market activity in most EMEs takes place onshore with many countries

prohibiting onshore entities from undertaking the operations in offshore markets for their

currencies. Spot market is the predominant form of foreign exchange market segment in

developing and emerging market countries. A common feature is the tendency of

importers/exporters and other end-users to look at exchange rate movements as a source of

return without adopting appropriate risk management practices. This, at times, creates uneven

supplydem and conditions, often based on news and views. Though most of the emerging

market countries allow operations in the forward segment of the market, it is still

underdeveloped in most of these economies. The lack of forward market development

reflects many factors, including limited exchange rate flexibility, the de facto exchange rate

insurance provided by the central bank through interventions, absence of a yield curve on

which to base the forward prices and shallow money markets, in which market-making banks

can hedge the maturity risks implicit in forward positions (Canales-Kriljenko, 2004).

Most foreign exchange markets in developing countries are either pure dealer markets or acombination of dealer and auction markets. In the dealer markets, some dealers become

market makers and play a central role in the determination of exchange rates in flexible

exchange rate regimes. Market makers set two-way exchange rates at which they are willing

to deal with other dealers. The bidoffer spread reflects many factors, including the level of

competition among market makers. In most of the EMEs, a code of conduct establishes the

principles that guide the operations of the dealers in the foreign exchange markets. It is the

central bank, or professional dealers association, which normally issues the code of conduct

(Canales-Kriljenko, 2004). In auction markets, an auctioneer or auction mechanism allocates

foreign exchange by matching supply and demand orders. In pure auction markets, order

imbalances are cleared only by exchange rate adjustments. Pure auction market structures

are, however, now rare and they generally prevail in combination with dealer markets.

The Indian foreign exchange market is a decentralised multiple dealership market comprising

two segments the spot and the derivatives market. In the spot market, currencies are traded

at the prevailing rates and the settlement or value date is two business days ahead. The two-

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day period gives adequate time for the parties to send instructions to debit and credit the

appropriate bank accounts at home and abroad. The derivatives market encompasses

forwards, swaps and options. Though forward contracts exist for maturities up to one year,

majority of forward contracts are for one month, three months, or six months. Forwardcontracts for longer periods are not as common because of the uncertainties involved and

related pricing issues. A swap transaction in the foreign exchange market is a combination of

a spot and a forward in the opposite direction. As in the case of other EMEs, the spot market

is the dominant segment of the Indian foreign exchange market. The derivative segment of

the foreign exchange market is assuming significance and the activity in this segment is

gradually rising.

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Fundamentals in Exchange Rate

Exchange rate is a rate at which one currency can be exchange in to another currency, say

USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice

versa.

Methods of Quoting Rate

There are two methods of quoting exchange rates.

1) Direct method:

Foreign currency is kept constant and home currency is kept variable. In direct quotation, the

principle adopted by bank is to buy at a lower price and sell at higher price.

2) Indirect method:

Home currency is kept constant and foreign currency is kept variable. Here the strategy used

by bank is to buy high and sell low. In India with effect from august 2, 1993, all the exchange

rates are quoted in direct method. It is customary in foreign exchange market to always quote

two rates means one for buying and another rate for selling. This helps in eliminating the risk

of being given bad rates i.e. if a party comes to know what the other party intends to do i.e.

buy or sell, the former can take the letter for a ride. There are two parties in an exchange deal

of currencies. To initiate the deal one party asks for quote from another party and other party

quotes a rate. The party asking for a quote is known as asking party and the party giving a

quotes is known as quoting party. The advantage of twoway quote is as under

The market continuously makes available price for buyers or sellers

Two way prices limit the profit margin of the quoting bank and comparison of

one quote with another quote can be done instantaneously.

As it is not necessary any player in the market to indicate whether he intends

to buy or sale foreign currency, this ensures that the quoting bank cannot take

advantage by manipulating the prices.

It automatically insures that alignment of rates with market rates.

Two way quotes lend depth and liquidity to the market, which is so very

essential for efficient market. In two way quotes the first rate is the rate for

buying and another for selling.

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We should understand here that, in India the banks, which are authorized dealer, always,

quote rates. So the rates quoted- buying and selling is for banks point of view only. It means

that if exporters want to sell the dollars then the bank will buy the dollars from him so while

calculation the first rate will be used which is buying rate, as the bank is buying the dollarsfrom exporter. The same case will happen inversely with importer as he will buy dollars from

the bank and bank will sell dollars to importer.

Factors Affecting Exchange Rates

In free market, it is the demand and supply of the currency which should determine the

exchange rates but demand and supply is the dependent on many factors, which are

ultimately the cause of the exchange rate fluctuation, some times wild. The volatility ofexchange rates cannot be traced to the single reason and consequently, it becomes difficult to

precisely define the factors that affect exchange rates. However, the more important among

them are as follows:

Strength of Economy

Economic factors affecting exchange rates include hedging activities, interest rates,

inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an American

economist, developed a theory relating exchange rates to interest rates. This proposition,

known as the fisher effect, states that interest rate differentials tend to reflect exchange rate

expectation. On the other hand, the purchasing- power parity theory relates exchange rates to

inflationary pressures. In its absolute version, this theory states that the equilibrium exchange

rate equals the ratio of domestic to foreign prices. The relative version of the theory relates

changes in the exchange rate to changes in price ratios.

Political Factor

The political factor influencing exchange rates include the established monetary policy along

with government action on items such as the money supply, inflation, taxes, and deficit

financing. Active government intervention or manipulations, such as central bank activity in

the foreign currency market, also have an impact. Other political factors influencing

exchange rates include the political stability of a country and its relative economic exposure

(the perceived need for certain levels and types of imports). Finally, there is also the

influence of the international monetary fund.

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Expectation of the Foreign Exchange Market

Psychological factors also influence exchange rates. These factors include market

anticipation, speculative pressures, and future expectations. A few financial experts are of the

opinion that in todays environment, the only trustworthy method of predicting exchangerates by gut feel. Bob Eveling, vice president of financial markets at SG, is corporate

finances top foreign exchange forecaster for 1999. evelings gut feeling has, defined

convention, and his method proved uncannily accurate in foreign exchange forecasting in

1998.SG ended the corporate finance forecasting year with a 2.66% error overall, the most

accurate among 19 banks. The secret to evelings intuition on any currency is keeping abreast

of world events. Any event, from a declaration of war to a fainting political leader, can take

its toll on a currencys value. Today, instead of formal modals, most forecasters rely on an

amalgam that is part economic fundamentals, part model and part judgment.

Fiscal policy

Interest rates

Monetary policy

Balance of payment

Exchange control

Central bank intervention

Speculation

Technical factors

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Exchange Rate Indices

Since the dawn of the floating exchange rate era, the terms "devaluation" or "upvaluation" of

a currency have lost much of their significance or meaning: a currency may depreciate

against some while simultaneously appreciating against others, that too by varying

percentages. It is, therefore, necessary to devise some measure, or index, to determine the ap-

preciation or depreciation of a currency from a base date, against foreign currencies as a

whole, i.e., the effective exchange rate of the currency in question. Various indices are in use

for the purpose. Some of the more important ones are described in subsequent paragraphs.

Nominal Effective Exchange Rate Index

The nominal effective exchange rate (NEER) index is based on "nominal", i.e., actual,

unadjusted exchange rates, existing during the base period (or date) and the comparison

period. Weights are given to each currency in such a way that the total of the weights is 1 (in

other words, the index is 1 in the base period/date), and the index is calculated by applying

the weights to the ratio of the exchange rates ruling during the comparison and base periods.

If arithmetic sum is to be used, the formula can be developed as follows. Let

n = the number of currencies against which the effective

rate is to be calculated;

Cib = nominal exchange rate with the ith currency in the

base period;

Cic = nominal exchange rate with the ith currency in the

comparison period; and

Wi = weight given to the ith currency.

In that case,

W1 + W2 + W3........ + Wn = 1

Then, NEER = ((C1c/C1b)*W1) + ((C2c/C2b)*W2) + ..... + ((Cnc/Cnb) * (Wn)

And, NEER (Base Period) =1

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Note:

A. The base and the comparison periods could be specific dates. If periods are used, the

average rate for the period is considered; if dates, the closing rate on that date.

B. If direct rates (i.e. the value of one unit of foreign currency in domestic currency) are

used, an increase in the index denotes depreciation of the home currency, and vice versa for

indirect rates (i.e. the number of units of foreign currency equal to one unit of domestic

currency).

C. Again, if direct rates are used, the effective weight of the appreciating currency goes

up; under indirect rates, that of the depreciating currency goes up.

Thus the indices based on direct and indirect rates are not the inverse of each other. To

illustrate the arithmetic, let us work out the NEER index of the rupee with the following

assumed rate structure:

n = 3

C1b 1.00 = Rs.20 (direct), or C1b 5.00 = Rs. 100 (indirect)



C1c 1.00 = Rs.25 (direct), or C1c 4.00 = Rs. 100 (indirect)



W1 = .30, W2 = .60, W3 = .10.

It will be noticed that, between the base and the comparison periods, the rupee has

depreciated against currencies C1 and C2, but has appreciated against currency C3.

Therefore, NEER index using direct rates

= ((25/20) x .30) + ((12/10) x .60) + ((4/5) x .10)

= 0.375 + 0.72 + 0.08 = 1. 175

NEER index using indirect rates

= ((4/5) x .30) + ((8.33/10) x .60) + ((25/20) x .10)

= 0.24 + 0.4998 + 0.125 = 0.8648

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Note that 1.175 is not equal to 1/0.8648.

Also consider how the effective weights have changed

Currency C1 C2 C3

Original % 30 60 10NEER direct % 31.9 61.3 6.8

NEER indirect % 27.8 57.8 14.4

To avoid the distortion in weights, it is common to use weighted geometric means, rather

than weighted (arithmetic) averages. In that case, the formula becomes

NEER = ((C1c/C1b)^W1) x ... x ((Cnc/Cnb)^Wn)

Let us calculate the geometric mean using the same data.

A. Direct rates

NEER Index = ((25/20)^0.3) x ((12/10)^0.6) x ((4/5)^0.1)

= 1.0692 x 1.1156 x 0.9779 = 1.1665

B. Indirect rates

NEER Index = ((4/5)^0.3) x ((8.33/10)^0.6) x ((25/20)^0.1)

= 0.9352 x 0.8962 x 1.0225 = 0.8570

And, 1.1665 is equal to 1/0.8570

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Trade Weighted Exchange Rate Index

We now turn to discussing the weights to be used. The most common and simple basis is

trade (hence, trade-weighted exchange rate, or TWER, index). Thus, the weight to be given

to say the dollar in the rupee TWER index would reflect the proportion of our trade with

United States as compared to our total trade. If our trade with the United States is say

Rs.70,000 crores a year, and our total trade is Rs.280,000 crores, the dollar's weight will be

25%. Again, as a rule, the currencies of all the countries we trade with may not be used in

calculating the index. For instance, we may choose to ignore currencies of countries whose

trade with us is less than say 1% of our total trade. In that case, the weights will need to be

reworked on the basis of the trade with countries included in the index calculation. For ex-

ample, in the illustration cited above, if trade with countries not to be included is say

Rs.20,000 crores, the dollar weight will be (70/260 x 100)% or 26.92%.

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It is also useful to calculate separately the export TWER and import TWER indices, using

weights based on exports and imports. Some analysts use direct rates and arithmetic means to

calculate the import index, and indirect rates and arithmetic means for the export index. The

composite index then becomes((Exp Index) x (Exp volume)) + ((Imp Index) x (Imp volume))

Total trade (Exports + Imports)

It is customary to use 100, instead of 1, as the base (the calculations remain the same as

above except that the result is multiplied by 100), and to indicate depreciation through

lowering of the index (i.e., if direct rates are used, inverse the result before multiplying by

100).

So calculated, the nominal TWER index is an indicator of the appreciation, or depreciation,

of the home currency against the currencies of our trading partners taken together. However,

as a measure of competitiveness of our exports or imports, it suffers from two major

disabilities:

A. It does not give due weightage to the exchange rates of our competitors in third

countries; and

B. The difference in inflation rates is ignored.

To illustrate the first point, let us consider that our exports to, say, Sri Lanka are negligible

and therefore that country's currency is not included in our export TWER index. However,

Sri Lankan tea exports compete with our tea exports in world markets. If the Sri Lankan cur-

rency has depreciated more than the Indian rupee, Sri Lanka gets a competitive edge over us,

which is not reflected in our export TWER index.

To make the index a better indicator of price competitiveness, the International Monetary

Fund has developed a weighting model known as the Multilateral Exchange Rate Model

(MERM). This is a highly complex model and has not so far been used in India.

Real Effective Exchange Rate

The second weakness of the NEER index as an indicator of international price

competitiveness is that it does not take account of inflation. The classical purchasing power

parity theory of exchange rates (PPP) postulates that exchange rates must move to

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compensate for inflation differentials, if international price competitiveness is to be

maintained. In other words, if our inflation rate is 20%a year, and that in the United States

10%, the rupee should depreciate by 10% against the dollar to compensate for the higher

domestic costs.

The real effective exchange rate index (REER) therefore uses "real" exchange rates, i.e.,

nominal rates adjusted for relative inflation, to calculate the index. For example, if a dollar

was worth Rs.40.00 at the base date and is worth Rs.50.00 now, in nominal terms the dollar

has appreciated by 25%, (or the rupee has depreciated by 20%). Therefore, our goods should

be more cost competitive in the United States. However, if our costs have gone up by 40%

(in rupee terms) during the period, and the prices in United States by only 10% in dollars, in

"real" terms we have become less competitive.

Using the algebraic notation adopted earlier, let:

p be the ratio of price index in India on comparison date to that on the base date; and

Pi be the same ratio for the country of the ith currency.

Then, using indirect rates and geometric mean, and 100 as

base,

REER = 100 x (((C1c/C1b) * (p/pi))^W1) x (((C2c/C2b) * (p/p2))^W2) x . . . . . . x

(((Cnc/Cnb) * (p/pn))^Wn)

Let us calculate the REER using the earlier data and assuming price index on base date in

India and the other three countries as 100. The price index on comparison date was say:

India 125

C1 110

C2 105

C3 115

Therefore, REER Index = 100 x (((4/5)x(125/110))^0.3) x (((8.33/10)x(125/105))^0.6) x

(((25/20)x(125/115))^0. 1)

= 100 * 0.9718 * 0.9950 * 1.0311

= 99.70

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Thus, while the NEER shows a rupee depreciation of 16.65%, the REER has hardly declined.

The nominal rupee depreciation has just about compensated for our higher inflation, and

given no competitive advantage in reality.

Fundamental Equilibrium Exchange Rate

There is one other index which needs a mention. This is the so-called FundamentalEquilibrium Exchange Rate (FEER) index.

The concept of the FEER starts with the macro-economic saving: investment balance. As is

well known, if domestic savings are insufficient to finance domestic investment, capital will

have to be imported. In other words, the economy will need to incur a current account deficit

to the extent of the gap.

The FEER is that rate of exchange which will ensure that the desired deficit on current

account results. To elaborate, if domestic savings are in excess of domestic investments, a

current account surplus will result and will require an undervalued exchange rate. In the

opposite scenario, as in the United States presently, an overvalued currency results in a

deficit on the current account which, in turn, is financed by foreign capital (investments or

borrowings).

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Published Indices

Most central banks publish the NEER and REER indices for the domestic currency. Some,

like the Bank of England, publish indices for other currencies as well. The following table

shows the Real Effective Exchange Rate (REER) and the Nominal Effective Exchange Rate(NEER) of the rupee (5 country bilateral trade-based weights; Base: 1993-94 = 100)

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Sources of Supply and Demand in the Foreign exchange

Exchange Market

The major sources of supply of foreign exchange in the Indian foreign exchange market are

receipts on account of exports and invisibles in the current account and inflows in the capital

account such as foreign direct investment (FDI), portfolio investment, external commercial

borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign

exchange emanates from imports and invisible payments in the current account, amortization

of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and

outflows on account of direct and portfolio investment. In India, the Government has no

foreign currency account, and thus the external aid received by the Government comes

directly to the reserves and the Reserve Bank releases the required rupee funds. Hence, this

particular source of supply of foreign exchange is not routed through the market and as such

does not impact the exchange rate.

During last five years, sources of supply and demand have changed significantly, with large

transactions emanating from the capital account, unlike in the 1980s and the 1990s when

current account transactions dominated the foreign exchange market. The behavior as well asthe incentive structure of the participants who use the market for current account transactions

differs significantly from those who use the foreign exchange market for capital account

transactions. Besides, the change in these traditional determinants has also reflected itself in

enhanced volatility in currency markets. It now appears that expectations and even

momentary reactions to the news are often more important in determining fluctuations in

capital flows and hence it serves to amplify exchange rate volatility (Mohan, 2006a). On

many occasions, the pressure on exchange rate through increase in demand emanates from

expectations based on certain news. Sometimes, such expectations are destabilizing and

often give rise to self-fulfilling speculative activities. Recognizing this, increased emphasis is

being placed on the management of capital account through management of foreign direct

investment, portfolio investment, external commercial borrowings, nonresident deposits and

capital outflows. However, there are occasions when large capital inflows as also large

lumpiness in demand do take place, in spite of adhering to all the tools of management of

capital account. The role of the Reserve Bank comes into focus during such times when it has

to prevent the emergence of such destabilising expectations. In such cases, recourse is

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undertaken to direct purchase and sale of foreign currencies, sterilisation through open

market operations, management of liquidity under liquidity adjustment facility (LAF),

changes in reserve requirements and signaling through interest rate changes. In the last few

years, despite large capital inflows, the rupee has shown two - way movements. Besides, thedemand/supply situation is also affected by hedging activities through various instruments

that have been made available to market participants to hedge their risks.

Derivative Market Instruments

Derivatives play a crucial role in developing the foreign exchange market as they enable

market players to hedge against underlying exposures and shape the overall risk profile of

participants in the market. Banks in India have been increasingly using derivatives for

managing risks and have also been offering these products to corporates. In India, various

informal forms of derivatives contracts have existed for a long time though the formal

introduction of a variety of instruments in the foreign exchange derivatives market started

only in the post-reform period, especially since the mid-1990s. Cross-currency derivatives

with the rupee as one leg were introduced with some restrictions in April 1997. Rupee-

foreign exchange options were allowed in July 2003. The foreign exchange derivative

products that are now available in Indian financial markets can be grouped into three broad

segments, viz., forwards, options (foreign currency rupee options and cross currency options)

and currency swaps (foreign currency rupee swaps and cross currency swaps)

Available data indicate that the most widely used derivative instruments are the forwards and

foreign exchange swaps (rupee-dollar). Options have also been in use in the market for the

last four years. However, their volumes are not significant and bid offer spreads are quite

wide, indicating that the market is relatively illiquid. Another major factor hindering the

development of the options market is that corporates are not permitted to write/sell options. If

corporates with underlying exposures are permitted to write/sell covered options, this would

lead to increase in market volume and liquidity. Further, very few banks are market makers

in this product and many deals are done on a back to back basis. For the product to reachthe

farther segment of corporates such as small and medium enterprises (SME) sector, it is

imperative that public sector banks develop the necessary infrastructure and expertise to

transact in options. In view of the growing complexity, diversity and volume of derivatives

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used by banks, an Internal Group was constituted by the Reserve Bank to review the existing

guidelines on derivatives and formulate comprehensive guidelines on derivatives for banks

With regard to forward contracts and swaps, which are relatively more popular instruments inthe Indian derivatives market, cancellation and rebooking of forward contracts and swaps in

India have beenregulated. Gradually, however, the Reserve Bank has been taking measures

towards eliminating such regulations. The objective has been to ensure that excessive

cancellation and rebooking do not add to the volatility of the rupee. At present, exposures

arising on account of swaps, enabling a corporate to move from rupee to foreign currency

liability (derived exposures), are not permitted to be hedged. While the market participants

have preferred such a hedging facility, it is generally believed that equating derivedexposure

in foreign currency with actual borrowing in foreign currency would tantamount to violation

of the basic premise for accessing the forward foreign exchange market in India, i.e., having

an underlying foreign exchange exposure.

This feature (i.e., the role of an underlying transaction in the booking of a forward contract)

is unique to the Indian derivatives market. The insistence on this requirement of underlying

exposure has to be viewed against the backdrop of the then prevailing conditions when it was

imposed. Corporates in India have been permitted increasing access to foreign currency funds

since 1992. They were also accorded greater freedom to undertake active hedging.

However, recognising the relatively nascent stage of the foreign exchange market initially

with the lack of capabilities to handle massive speculation, the underlying exposure

criterion was imposed as a prerequisite. Exporters and importers were permitted to book

forward contracts on the basis of a declaration of an exposure and on the basis of past

performance.

Eligible limits were gradually raised to enable corporates greater flexibility. The limits are

computed separately for export and import contracts. Documents are required to be furnished

at the time of maturity of the contract. Contracts booked in excess of 25 per cent of the

eligible limit had to be on a deliverable basis and could not be cancelled. This relaxation has

proved very useful to exporters of software and other services since their projects are

executed on the basis of master agreements with overseas buyers, which usually do not

indicate the volumes and tenor of the exports (Report of Internal Group on Foreign Exchange

Markets, 2005). In order to provide greater flexibility to exporters and importers, as

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announced in the Mid-term review of the Annual Policy 2006-07, this limit has been

enhanced to 50 per cent.

Notwithstanding the initiatives that have been taken to enhance the flexibility for thecorporates, the need is felt to review the underlying exposure criteria for booking a forward

contract. The underlying exposure criteria enable corporates to hedge only a part of their

exposures that arise on the basis of the physical volume of goods (exports/imports) to be

delivered4. With the Indian economy getting increasingly globalised, corporates are also

exposed to a variety of economic exposures associated with the types of foreign

exchange/commodity risks/ exposures arising out of exchange rate fluctuations.

At present, the domestic prices of commodities such as ferrous and non-ferrous metals, basic

chemicals, petro-chemicals, etc. are observed to exhibit world import parity. Given the two-

way movement of the rupee against the US dollar and other currencies in recent years, it is

necessary for the producer/ consumer of such products to hedge their economic exposures to

exchange rate fluctuation. Besides, price-fix hedges are also available for traders globally.

They enable importers/exporters to lock into a future price for a commodity that they plan to

import/export without actually having a crystallised physical exposure to the commodity.

Traders may also be affected not only because of changes in rupee-dollar exchange rates but

also because of changes in cross currency exchange rates. The requirement of underlying

criteria is also often cited as one of the reasons for the lack of liquidity in some of the

derivative products in India. Hence, a fixation on the underlying criteria as India globalises

may hinder the full development of the forward market. The requirement of past

performance/underlying exposures should be eliminated in a phased manner. This has also

been the recommendation of both the committees on capital account convertibility. It is cited

that this pre-requisite has been one of the factors contributing to the shift over time towards

the non deliverable forward (NDF) market at offshore locations to hedge such exposures

since such requirement is not stipulated while booking a NDF contract. An attempt has been

made recently provide importers the facility to partly hedge their economic exposure by

permitting them to book forward contracts for their customs duty component.

The Annual Policy Statement for 2007-08, released on April 24, 2007 announced a host of

measures to expand the range of hedging tools available to market participants as also

facilitate dynamic hedging by residents. To hedge economic exposures, it has been proposed

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that ADs (Category- I) may permit (a) domestic producers/users to hedge their price risk on

aluminium, copper, lead, nickel and zinc in international commodity exchanges, based on

their underlying economic exposures; and (b) actual users of aviation turbine fuel (ATF) to

hedge their economic exposures in the international commodity exchanges based on theirdomestic purchases. Authorised dealer banks may approach the Reserve Bank for permission

on behalf of customers who are exposed to systemic international price risk, not covered

otherwise. In order to facilitate dynamic hedging of foreign exchange exposures of exporters

and importers of goods and services, it has been proposed that forward contracts booked in

excess of 75 per cent of the eligible limits have to be on a deliverable basis and cannot be

cancelled as against the existing limit of 50 per cent. With a view to giving greater flexibility

to corporates with overseas direct investments, the forward contracts entered into for hedging

overseas direct investments have been allowed to be cancelled and rebooked. In order to

enable small and medium enterprises to hedge their foreign exchange exposures, it has been

proposed to permit them to book forward contracts without underlying exposures or past

records of exports and imports. Such contracts may be booked through ADs with whom the

SMEs have credit facilities. They have also been allowed to freely cancel and rebook these

contracts. In order to enable resident individuals to manage/hedge their foreign exchange

exposures, it has been proposed to permit resident individuals to book forward contracts

without production of underlying documents up to an annual limit of US $ 100,000, which

can be freely cancelled and rebooked.

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Foreign Exchange Market Trading Platform

A variety of trading platforms are used by dealers in the EMEs for communicating and

trading with one another on a bilateral basis. They conduct bilateral trades through telephones

that are later confirmed by fax or telex. Some dealers also trade on electronic trading

platforms that allow for bilateral conversations and dealing such as