significance of foreign exchange reserves

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SIGNIFICANCE OF FOREIGN EXCHANGE RESERVES

Page 1

A

PROJECT REPORT

On

SIGNIFICANCE OF FOREIGN

EXCHANGE RESERVES

SUBMITTED BY

RESHMA VISHNU MALI

ROLL NO31

M.COM BANKING AND FINANCE

SEMESTER

III (2013-2014)

UNDER THE GUIDANCE OF

Prof. Ajit Karandikar

SUBMITTED TO

S.K SOMAIYA DEGREE COLLEGE OF ARTS, SCIENCE AND

COMMERCE,

VIDHYAVIHAR (E), MUMBAI-400077 AFFILIATED TO

UNIVERSITY OF MUMBAI.


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(SOMAIYA VIDYAVIHAR)

(S. K. SOMAIYA DEGREE COLLEGE OF ARTS, SCIENCE AND

COMMERCE VIDYAVIHAR)

CERTIFICATE

This is to certify that (Reshma Mali) of M.Com Banking &Finance

Semester III (2013-14) has successfully

Completed the project on (Significance Of Foreign Exchange Reserves)

guidance of Mr. Ajit Karandikar.

Course Co-ordinator Principal

Project guide/Internal Examiner

External Examiner


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DECLARATION

I (Reshma Mali) a student of M.com Banking & Finance Semester III

(2013-14) hereby declare that I have Completed the project on

(Significance of Foreign Exchange Reserve).

The information submitted is true and original to the best of my

knowledge.

Signature

(Reshma Mali)


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ACKNOWLEGEMENT

I would sincerely like to give my heartfelt acknowledgement and thanks

to my parents. Any amount of thanks given to them will never be

sufficient.

I would sincerely like to thank our Principal Dr.Sangeeta Kohli. I

would also like to thank my project guide for his valuable support and

guidance whenever needed.

I also feel heartiest sense of obligation my library staff members &

seniors who helped in collection of Data and materials and also in this

processing as well as in drafting manuscript.

Last, but not the least, I would like to thank my friends & colleagues for

always being there.

(Reshma Mali)


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Foreign Exchange Reserves

Sr.

No.

Index Page

No.

1

2

3

4

5

6

7

8

9

1011

Introduction

History of forex market

Foreign Exchange Restrictions

Factors affecting the exchange rate of

Indian rupee

Different types of transactions in the

Foreign exchange market

Foreign Exchange risk

Major participates in Forex market

Purpose of holding Foreign exchange

reserves

Indias forex reserves 4th largest in the

worlds

Conclusion

Bibliography

6

10

15

20

25

29

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38

40

4243


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MEANING

Foreign-exchange reserves (also called forex reserves orFX

reserves) in a strict sense are 'only' the foreign currency deposits and bonds

held by central banks and monetary authorities. However, the term in

popular usage commonly includes foreign exchange and gold, special

drawing rights (SDRs), and International Monetary Fund (IMF) reserve

positions. This broader figure is more readily available, but it is more

accurately termed official international reserves orinternational reserves.

These are assets of the central bank held in different reserve currencies,

mostly the United States dollar, and to a lesser extent the euro, the United

Kingdom pound sterling, and the Japanese yen, and used to back

its liabilities, e.g., the local currency issued, and the various bank

reserves deposited with the central bank, by the government orfinancialinstitutions.

Definition
http://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Gold_reservehttp://en.wikipedia.org/wiki/Special_drawing_rightshttp://en.wikipedia.org/wiki/Special_drawing_rightshttp://en.wikipedia.org/wiki/International_Monetary_Fundhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Reserve_currencyhttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Eurohttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/Pound_sterlinghttp://en.wikipedia.org/wiki/Japanese_yenhttp://en.wikipedia.org/wiki/Liability_(accounting)http://en.wikipedia.org/wiki/Bank_reserveshttp://en.wikipedia.org/wiki/Bank_reserveshttp://en.wikipedia.org/wiki/Deposit_accounthttp://en.wikipedia.org/wiki/Governmenthttp://en.wikipedia.org/wiki/Financial_institutionshttp://en.wikipedia.org/wiki/Financial_institutionshttp://en.wikipedia.org/wiki/Financial_institutionshttp://en.wikipedia.org/wiki/Financial_institutionshttp://en.wikipedia.org/wiki/Governmenthttp://en.wikipedia.org/wiki/Deposit_accounthttp://en.wikipedia.org/wiki/Bank_reserveshttp://en.wikipedia.org/wiki/Bank_reserveshttp://en.wikipedia.org/wiki/Liability_(accounting)http://en.wikipedia.org/wiki/Japanese_yenhttp://en.wikipedia.org/wiki/Pound_sterlinghttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/Eurohttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Reserve_currencyhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/International_Monetary_Fundhttp://en.wikipedia.org/wiki/Special_drawing_rightshttp://en.wikipedia.org/wiki/Special_drawing_rightshttp://en.wikipedia.org/wiki/Gold_reservehttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Currency


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According to the International Monetary Fund, foreign exchange

reserves are defined in the Balance of Payments manual (5thedition) as

Those external assets that are readily available to and controlled by

monetary authorities for direct financing of payments imbalances, for

indirectly regulating the magnitudes of imbalances through

intervention in exchange markets to affect the currency exchange rate,

and/or for other purposes

Changes in reserves

The quantity of foreign exchange reserves can change as a central bank

implements monetary policy A central bank that implements a fixed

exchange rate policy may face a situation where supply and demand would

tend to push the value of the currency lower or higher (an increase in

demand for the currency would tend to push its value higher, and a decrease

low. In a flexible exchange rate regime, these operations occur

automatically, with the central bank clearing any excess demand or supply

by purchasing or selling the foreign currency. Mixed exchange rate regimes

('dirty floats', target bands or similar variations) may require the use of

foreign exchange operations (sterilizedor unsterilized[to maintain the

targeted exchange rate within the prescribed limits .

Foreign exchange operations that are unsterilized will cause an expansion or

contraction in the amount of domestic currency in circulation, and hence

directly affect monetary policy and inflation: An exchange rate target cannot
http://en.wikipedia.org/wiki/Managed_floathttp://en.wikipedia.org/wiki/Managed_floathttp://en.wikipedia.org/wiki/Managed_floathttp://en.wikipedia.org/wiki/Sterilization_(economics)http://en.wikipedia.org/wiki/Sterilization_(economics)http://en.wikipedia.org/wiki/Sterilization_(economics)http://en.wikipedia.org/wiki/Sterilization_(economics)http://en.wikipedia.org/wiki/Managed_float


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be independent of an inflation target. Countries that do not target a specific

exchange rate are said to have afloating exchange rate, and allow the market

to set the exchange rate; for countries with floating exchange rates, other

instruments of monetary policy are generally preferred and they may limit

the type and amount of foreign exchange interventions. Even those central

banks that strictly limit foreign exchange interventions, however, often

recognize that currency markets can be volatile and may intervene to counter

disruptive short-term movements.

To maintain the same exchange rate if there is increased demand, the central

bank can issue more of the domestic currency and purchase the foreign

currency, which will increase the sum of foreign reserves. In this case, the

currency's value is being held down; since (if there is no sterilization) the

domestic money supply is increasing (money is being 'printed'), this may

provoke domestic inflation (the value of the domestic currency falls relative

to the value of goods and services).

Since the amount of foreign reserves available to defend a weak currency (a

currency in low demand) is limited, a foreign exchange crisis

ordevaluationcould be the end result. For a currency in very high and rising

demand, foreign exchange reserves can theoretically be continuously

accumulated, although eventually the increased domestic money supply will

result in inflation and reduce the demand for the domestic currency (as its

value relative to goods and services falls). In practice, some central banks,

through open market operations aimed at preventing their currency from

appreciating, can at the same time build substantial reserves.
http://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Devaluationhttp://en.wikipedia.org/wiki/Devaluationhttp://en.wikipedia.org/wiki/Devaluationhttp://en.wikipedia.org/wiki/Devaluationhttp://en.wikipedia.org/wiki/Floating_exchange_rate


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In practice, few central banks or currency regimes operate on such a

simplistic level, and numerous other factors (domestic demand, production

and productivity, imports and exports, relative prices of goods and services,

etc.) will affect the eventual outcome. As certain impacts (such as inflation)

can take many months or even years to become evident, changes in foreign

reserves and currency values in the short term may be quite large as different

markets react to imperfect data.


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History of Forex Market in India

The modern exchange market as tied to the prices of gold began during

1880. Of this year the countries significant by size of reserves were Austria,

Belgium, Canada, Denmark, Finland, Germany and Sweden.

Official international reserves, the means of official international payments,

formerly consisted only of gold, and occasionally silver. But under

theBretton Woods system, the US dollar functioned as a reserve currency,so it too became part of a nation's official international reserve assets. From

19441968, the US dollar was convertible into gold through the Federal

Reserve System, but after 1968 only central banks could convert dollars into

gold from official gold reserves, and after 1973 no individual or institution

could convert US dollars into gold from official gold reserves. Since 1973,

no major currencies have been convertible into gold from official gold

reserves. Individuals and institutions must now buy gold in private markets,

just like other commodities. Even though US dollars and other currencies are

no longer convertible into gold from official gold reserves, they still can

function as official international reserves.

Until the early seventies, given the fixed rate regime, theforeign exchangemarketwas perceived as a mechanism merely to put through merchant

transactions. With the collapse of the Breton Woods agreement and the

floatation of major currencies, the conduct of exchange rate policy posed a

great challenge to central banks as currency fluctuations opened up
http://en.wikipedia.org/wiki/Bretton_Woods_systemhttp://en.wikipedia.org/wiki/Bretton_Woods_systemhttp://en.wikipedia.org/wiki/Bretton_Woods_systemhttp://www.mbaknol.com/investment-management/forex-market-or-foreign-exchange-market/http://www.mbaknol.com/investment-management/forex-market-or-foreign-exchange-market/http://www.mbaknol.com/investment-management/forex-market-or-foreign-exchange-market/http://www.mbaknol.com/investment-management/forex-market-or-foreign-exchange-market/http://www.mbaknol.com/investment-management/forex-market-or-foreign-exchange-market/http://www.mbaknol.com/investment-management/forex-market-or-foreign-exchange-market/http://en.wikipedia.org/wiki/Bretton_Woods_system


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tremendous opportunities for market players to trade in currency volatilities

in a borderless market.

he market in Indian, however, remained insulated as exchange rate controls

inhibited capital movements and the banks were required to undertake cover

operations and maintain a square position at all times.

Slowly a demand began to build up that banks in India be permitted to trade

in FOREX. In response to this demand the RBI, as a first step, permitted

banks to undertake intra-day trade inFOREXin 1978. As a consequence,

the stipulation of maintaining square or near square position was to be

complied with only at close of business each day. The extent of position

which conduct be left uncovered overnight (the open position) as well as the

limit up to which dealers conduct trade during the day was to be decided by

the management of the banks.

As opportunities to make profit began to emerge, the major banks started

quoting two-way prices against the Rupee as well as in cross-currencies

(Non-rupee) and gradually, trading volumes began to increase. This wasenabled by a major change in the exchange rate regime in 1975 whereby the

Rupee was delinked from the Pound Sterling and under a managed floating

arrangement; the external value of the rupee was determined by the RBI in

terms of a weighted basket of currencies of Indias major trading partners.

Given the RBIs obligation to buy and sell unlimited amounts of Pound

Sterling (the intervention currency), arising from the banks merchant trades,

its quotes for buying/selling effectively became the fulcrum around which

the market moved.

As volumes increased, the appetite for profits was found to lead to the

observance of widely different practices (some of which were irregular)
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dictated largely by the size of the players, their location, expertise of the

dealing staff, and availability of communications facilities, it was thought

necessary to draw up a comprehensive set of guidelines covering the entire

gamut of dealing operations to be observed by banks engaged in FOREX

business. Accordingly, in 1981 the Guidelines for Internal Control over

Foreign Exchange Business was framed for adoption by banks.

During the eighties, deterioration in the macro-economic situation set in,

ultimately warranting a structural change in the exchange rate regime, which

in turn had an impact on the FOREX market. Large and persistent external

imbalances were reflected in rising level of internal indebtedness. The

graduated depreciation of the rupee could not compensate for the widening

inflation differentials between India and the rest of the world and the

exchange rate of the Rupee was getting increasingly overvalued. The Gulf

problems of August 1990, given the fragile state of the economy, triggered

off an unprecedented crisis of liquidity and confidence. This unprecedented

crisis called for the adoption of exceptional corrective steps. The countrysimultaneously embarked upon measures of adjustment to stabilize the

economy and got in motion structural reforms to generate renewed impetus

for stable growth.

As a first step in this direction, the RBI effected a two-step downward

adjustment of the Rupee in July 1991. Simultaneously, in order to provide a

closer alignment between exports and imports, the EXIM scrip scheme was

introduced. The scheme provide a boost to exports and with the experience

gained in the working of the scheme, it was thought prudent to

institutionalize the incentive component and convey it through the price

mechanism, while simultaneously insulating essential imports from currency


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fluctuations. Therefore, with effect from March 1, 1992, RBI instituted a

system of dual exchange rates under the Liberalised Exchange Rate

Management System (LERMS). Under this, 40% of the exchange earnings

had to be surrendered at a rate determined by the RBI and the RBI was

obliged to sell foreign exchange only for imports of essential commodities

such as oil, fertilizers, life saving drugs etc., besides the governments debt

servicing. The balance 60% could be converted at rates determined by the

market. The scheme worked satisfactorily preparing the market for its

emerging role and the Rupee remained fairly stable with the spread between

the official and market rate hovering around 17%.

Even through the dual exchange rate system worked well, it however,

implied an implicit tax on exporters and remittances. Moreover it distorted

the efficient allocation of resources. The LERMS was essentially a

transitional mechanism and in March 1993, the two legs of the exchange

rates were unified and christened Modified LERMS. It stipulated that form

March 2nd 1993, all FOREX receipt could be converted at marketdetermined rates of exchange. Over the next eighteen months restrictions on

a number of other current account transactions were relaxed and on August

20th 1994, the Rupee was made fully convertible for all current account

transactions and the country formally accepted obligations under Article

VIII of the IMFs Article of Agreement.

1966 The Rupee was devalued by 57.5% against on June 6 1967 Rupee-Sterling parity change as a result of devaluation of the sterling 1971 Bretton Woods system broke down in August. Rupee briefly pegged to

the USD @ Rs 7.50 before reneging to Sterling at Rs. 18.8672 with a 2.25%

margin on either side


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1972 Sterling floated on June 23. Rupee sterling parity revalued to Rs 18.95and the in October to Rs 18.80

1975 Rupee pegged to an undisclosed basket with a margin of 2.25%oneither side. Sterling the intervention currency with a central bank rate of Rs

18.3084

1979 Margins around basket parity widened to 5% on each side in January 1991 Rupee devalued by 22% July 1st and 3rd. Rupee dollar rate

depreciated from 21.20 to 25.80. A version of dual exchange rate introduced

through EXIM scrip scheme, given exporters freely tradable import

entitlements equivalent to 30-40% of export earnings. 1992 LERMS introduced with a 40-60 dual rate converting export proceeds,

market determined rate for all but specified imports and market rate for

approved capital transaction. US Dollar became the intervention currency

from March 4th. EXIM scrip scheme abolished.

1993 Unified market determined exchange rate introduced for alltransactions. RBI would buy/sell US Dollars for specified purposes. It will

not buy or sell forward Dollars though it will enter into Dollar swaps.

1994 Rupee made fully convertible on current account from August 20th. 1998 Foreign Exchange Management Act FEM Bill 1998, which was

placed in the Parliament to replace FERA

1999 Implication of FEma start.

Foreign Exchange Restrictions


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Althoughthe direct intervention methodsreferred to haveinfluenced many

exchange rates, they do not fully serve the needs of countries with a

continuous shortage of foreign exchange. To supplement the direct measures

many countries adopted a number offoreign exchange restrictions. Most

countries have employed foreign exchange restrictions from time to time.

Developing countries especially have found restrictions necessary to secure

compliance with their development plans.

An exchange restriction plan implies that the government restricts the uses to

which the available supply of exchange shall be put. Foreign exchange may

be allocated specially for the payment of import bills, interest on foreign

loans, and on other specific purposes. Sometimes the restrictions prevent the

use of exchange for trade with a given (unfriendly) country. In the latter case

the purpose may be political, but the basic reason for most exchange

restrictions is the shortage of foreign exchange sufficient to meet freely all

of the requirements of international marketing and finance. More

specifically, exchange restrictions are designed:

1. To provide the exchange necessary for the financing of essential imports andto discourage specific imports that are considered to be luxuries or that may

be available from local producers.

2. To allocate or limit exchange for the servicing of external debts andinvestments.

3. To prevent the flight of capital.4. To limit speculation.5. To encourage lagging exports.6. To encourage tourist travel.
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In addition to these objectives, all of which are primarily related to a

shortage of exchange, exchange restrictions also contribute to influencing

ordetermining of foreign exchange rates. When a government limits and

prescribes the uses of all or most of the available exchange, it fixes

thenations official exchange rates. The exchange rates fixing power of

some governments further enhanced by import quotas, licensing plans, and

other foreign trade control measures. This ability of agovernment to

manipulate the rate of its exchangecan thus become an important instrument

in the foreign commercial and even political, policy of a country.

Administration of Exchange Restrictions

In Indiaexchange restrictions are administered through Reserve Bank of

India.Exporters are required to receive paymentsin foreign currency and

turn over to the RBI all or such portion of their exchange as the current

regulations require atan official buying rate. Importers and others requiring

foreign exchange then purchase it, so far as the restrictions permit, at an

official selling rate.

In some countries there is also a free exchange market in which exchange

derived from certain exports or from other authorized services may be

obtained, usually at higher cost to the buyer. Thus, in a single country, there

may be one or morepegged exchange ratesfor official exchange and also a

free market rate. This is known as a system of multiple exchange rates.

Multiple exchange rates are most likely to be used by developing countries

when a nation faces a shortage of foreign exchange.

Marketers are interested in these rates because the rate affects the price of,

their products. Multiple rates are established to inhibit the importation of

specific products. The least favorable rates are set for luxury goods such as
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automobiles, especially if these are also produced locally. As the economy

develops, the items might be shifted from one category to another.

Other types of exchange restriction systems of interest to marketers include

those in which a country requires that a license be obtained in order to

import certain products. These import licenses are allocated by the exchange

control authority in accordance with priorities set by the government.

Countries also have levied import surcharges and have provided export

subsidies to local producers. They have required that importers pay an

advance deposit for desired exchange, thereby tying up the importers capital

and increasing the cost of importing. In addition, various measures have

been used to affectcapital movements.

Effects of Exchange Restrictions

Exchange restrictions, although intended to accomplish the internal

objectives of the country enforcing them, have necessarily affected the

international trading of the other trading nations throughout the entire world.As they are imposed primarily because certain countries are faced with a

shortage of foreign exchange, international trading as a whole has not

always been curtailed. But it is clear that exchange restrictions have:

1. affected the importation of some classes of goods more adversely thanothers, the essential character of imports being considered in the allocation

of exchange;

2. affected the trade of some exporting countries more seriously than that ofothers;

3. tended, particularly in connection with certain international agreements, tochannelize trade bilaterally;
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4.been used by some countries for bargaining purposes;5.been utilized by some countries for the purpose of subsidizing particular

exports;

6. influenced domestic prices in some countries so as to handicap exports; and7. Complicated the routine work of importers and exporters.

Exchange restriction measures, however, also have certain desirable features

under conditions of serious and more than seasonal or strictly temporary

exchange shortages. Exchange restrictions have:

1. stabilized exchange rates for both importers and exporters;2. aided various needy countries in obtaining a larger supply of the

commodities considered most necessary by their governments; and

3. enable debtor nations to safeguard their currency,control exchange ratesinthe national interest, protect their economy to some extent against

unfavorable commodity price changes,regulate interestand other financial

payments, and otherwise protect themselves against threatening

disturbances.

In general it is clear that marketing opportunities and efforts for specific

firms have been altered as a result of governmental Intervention in the

exchange process. No marketing programme is complete until it has taken

into account the potential effect of anticipated changes in governmental

policies and rates of exchange.
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Factors affecting the exchange rate of Indian Rupee

As we know thatForex marketfor Indian currency is highly volatile where

one cannot forecast exchange rate easily, there is a mechanism which works

behind the determination of exchange rate. One of the most important

factors, which affect exchange rate, is demand and supply of domestic and

foreign currency. There are some other factors also, which are having major


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impact on the exchange rate determination. After studying research reports

on relationship between Rupee and Dollar of last four years we identified

some factors, which have been segregated under four heads. These are:

1. Market Situations.2. Economic Factors.3. Political Factors.4. Special Factors.

1. Market Situations:

India follows the floating rate system fordetermining exchange rate. In

this system market situation also is pivot for determining exchange rate.

As we know that 90% of the Forex market is between the inter-bank

transactions. So how the banks are taking the decision for settling out their

different exposure in the domestic or foreign currency that is impacting to

the exchange rate. Apart from the banks, transactions of exporters and

importers are having impact on this market. So in the day-to-day Forex

market, on the basis of the bank and traders transactions the demand and

supply of the currencies increase or decrease and that is deciding the

exchange rate. On the basis of this study we found out the different types ofthe decisions, which is affecting to market. These are as follows:

In India, there are big Public Sectors Units (PSUs) like ONGC, GAIL, IOCetc. all the foreign related transactions of these PSUs are settled through the

State Bank of India. E.g. India is importing Petroleum from the other
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countries so payment is made through State Bank of India in the foreign

currency. When State Bank of India (SBI) sells and buys the foreign

currency then there will be noticeable movement in the rupee. If the SBI is

going for purchasing the Dollar then Rupee will be depreciated against

Dollar and vice versa.

Foreign Institutional Investors (FIIs) inflow and outflow of the currency ishaving the major impact on the currency. E.g. U.S. based company is

investing their money through the Stock markets BSE or NSE so her inflows

of the Dollars is increasing and when it is selling out their investments

through these Stock markets then outflows of the Dollars are increasing.

However if the FIIs inflowing the capital in the country then there will be

the supply of the foreign currency increases and Demand for the Rupee will

increases and that will resulted appreciation in the rupee and vice versa.

Importer and Exporters trading is also affecting to the rupee. Like if anIndian exported material to U.S. so he will get his payments in Dollars and

that will increase the supply of Dollars and increase of demand of rupee and

that will appreciate the rupee and vice versa.

Banks can be confronted different positions like oversold or over boughtposition in the foreign currency. So bank will try to eradicate these positions

by selling or purchasing the foreign currency. So this will be increased or

decreased demand and supply of the currency. And that will cause to

appreciation or depreciation in the currency.

As we know that in India there is a floating rate system. In India CentralBank (RBI) is always intervene in the trade for smoothen the market. And

this RBI can achieve by selling foreign exchange and buying domestic


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currency. Thus, demand for domestic currency which, coupled with supply

of foreign exchange, will maintain the price foreign currency at the desired

level. Interventions can be defined as buying or selling of foreign currency

by the central bank of a country with a view to maintaining the price of a

given currency against another currency. US Dollar is the currency of

intervention in India.

2. Economic Factors:

In the Forex Market Economic factors of the country is playing the pivot

role. Every country is depending on its prospect economy. If there will be

change in any economy factors, which will directly or indirectly affected to

Forex market. Here there are two types of economic factors. These are as

follows:

1. Internal Factors.2. External Factors.

Internal Factors includes:

Industrial Deficit of the country. Fiscal Deficit of the country. GDP and GNP of the country.

Foreign Exchange Reserves. Inflation Rate of the Country. Agricultural growth and production.


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Different types of policies like EXIM Policy, Credit Policy of the country aswell reforms undertaken in the yearly Budget.

Infrastructure of the CountryExternal Factors includes:

Export trade and Import trade with the foreign country. Loan sanction by World Bank and IMF Relationship with the foreign country.

Internationally OIL Price and Gold Price.

Foreign Direct Investment, Portfolio Investment by the country.

3. Political Factors:

In India election held every five years mean thereby one party has rule for

the five years. But from the 1996 India was facing political instability and

this type of political instability has created hefty problem in the different

market especially in Forex market, which is highly volatile. In fact in the

year 1999 due to political uncertainty in the BJP Government the rupee has

depreciated by 30 paise in the month of April. So we can say that political

can become important factor to determine foreign exchange in India.

Due to political instability there can be possibility of de possibility delaying

implementation of all policies and sanction of budget. So that will create

also major impact on trade.

4. Special Factors:


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Till now we have seen the general factors, which will affect the Forexmarket in daily business. And on that factors the different players in the

market have taken the decision. But some times some event happened in

such a way that it will really change the whole scenario of the market so we

can called that event special factors. However traders have to really consider

those things and take the decisions. We will see these types of factors in

detailed:

In the year 1998, when Government of India has done Pokhran NuclearTest at that time rupee has been depreciated around 85 paise in day and 125

paise in seven days. Her main fear was that U.S., Australia and other

countries have stop to sanctions the loans So this type of event will have

major impact on the market. And due to this the decision procedure of the

trader also varies.

In the year 2000,India has faced Kargil war, which is also affected to themarket. By this war the defense expenditures are raised and due to that there

will be increase in the fiscal deficit. And become obstacle in the growth of

the economy. So this type of event has impact on the Forex market.

Different types of transactions in the Foreign Exchange Market

A very brief account of certain important types of transactions conducted in

theforeign exchange marketis given below

Spot and Forward Exchanges


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Spot Market:

The term spot exchange refers to the class of foreign exchange transaction

which requires the immediate delivery or exchange of currencies on the spot.

In practice the settlement takes place within two days in most markets. The

rate of exchange effective for the spot transaction is known as the spot rate

and the market for such transactions is known as the spot market.

Forward Market:

The forward transactions is an agreement between two parties, requiring the

delivery at some specified future date of a specified amount of foreign

currency by one of the parties, against payment in domestic currency be theother party, at the price agreed upon in the contract. The rate of exchange

applicable to the forward contract is called the forward exchange rate and

the market for forward transactions is known as the forward market. The

foreign exchange regulations of various countries generally regulate the

forward exchange transactions with a view to curbing speculation in the

foreign exchanges market. In India, for example, commercial banks are

permitted to offer forward cover only with respect to genuine export and

import transactions. Forward exchange facilities, obviously, are of immense

help to exporters and importers as they can cover the risks arising out of

exchange rate fluctuations be entering into an appropriate forward exchange

contract. With reference to its relationship with spot rate, the forward rate

may be at par, discount or premium. If the forward exchange rate quoted is

exact equivalent to the spot rate at the time of making the contract the

forward exchange rate is said to be at par.

The forward rate for a currency, say the dollar, is said to be at

premium with respect to the spot rate when one dollar buys more units of


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another currency, say rupee, in the forward than in the spot rate on a per

annum basis.

The forward rate for a currency, say the dollar, is said to be at discount with

respect to the spot rate when one dollar buys fewer rupees in the forward

than in the spot market. The discount is also usually expressed as a

percentage deviation from the spot rate on a per annum basis.

The forward exchange rate is determined mostly be the demand for and

supply of forward exchange. Naturally when the demand for forward

exchange exceeds its supply, the forward rate will be quoted at a premium

and conversely, when the supply of forward exchange exceeds the demandfor it, the rate will be quoted at discount. When the supply is equivalent to

the demand for forward exchange, the forward rate will tend to be at par.

Futures

While a focus contract is similar to a forward contract, there are several

differences between them. While a forward contract is tailor made for the

client be his international bank, a future contract has standardized featuresthe contract size and maturity dates are standardized. Futures cab traded only

on an organized exchange and they are traded competitively. Margins are

not required in respect of a forward contract but margins are required of all

participants in the futures market an initial margin must be deposited into a

collateral account to establish a futures position.

Options

While the forward or futures contract protects the purchaser of the contract

fro m the adverse exchange rate movements, it eliminates the possibility of

gaining a windfall profit from favorable exchange rate movement. An option

is a contract or financial instrument that gives holder the right, but not the


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obligation, to sell or buy a given quantity of an asset as a specified price at a

specified future date. An option to buy the underlying asset is known as a

call option and an option to sell the underlying asset is known as a put

option. Buying or selling the underlying asset via the option is known as

exercising the option. The stated price paid (or received) is known as the

exercise or striking price. The buyer of an option is known as the long and

the seller of an option is known as the writer of the option, or the short. The

price for the option is known as premium.

Types of options: With reference to their exercise characteristics, there are

two types of options, American and European. A European option cab is

exercised only at the maturity or expiration date of the contract, whereas an

American option can be exercised at any time during the contract.

Swap operation

Commercial banks who conduct forward exchange business may resort to a

swap operation to adjust their fund position. The term swap means

simultaneous sale of spot currency for the forward purchase of the samecurrency or the purchase of spot for the forward sale of the same currency.

The spot is swapped against forward. Operations consisting of a

simultaneous sale or purchase of spot currency accompanies by a purchase

or sale, respectively of the same currency for forward delivery are

technically known as swaps or double deals as the spot currency is swapped

against forward.

Arbitrage

Arbitrage is the simultaneous buying and selling of foreign currencies with

intention of making profits from the difference between the exchange rate

prevailing at the same time in different markets


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Foreign Exchange Risk

The identifiedrisks in the foreign exchange marketare: (a) rates; (b) credit;

(c) mismatched maturities; (d) country; and (e) business.

Rate Risk : Rate risk is normally assumed when a dealer quotes a price

against another currency and does not cover it immediately. He is running
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the risk of the currency going against him. The rate risk is assumed by

corporate treasurer who has invoiced his exports or imports in foreign

currency at a predetermined Indian rupee rate and does not cover his foreign

exchange by entering into a forward contract with a bank, For example, if an

exporter invoices his goods in US dollar US $ l = INR 17.50, and exports the

goods and when he receives the payment if the exchange rate has moved

against him he may receive only INR 17.25 resulting in a loss of 25 paise

per dollar. Although in the present scenario of depreciating rupee this is

unlikely to happen, one can imagine the risk to which an exporter will be

exposed to in conditions of an appreciating rupee.

Credit Risk: Credit risk is assumed on counter parties with whom an

exchange transaction is concluded. If a spot contract is concluded between a

bank and a customer, the bank is taking a risk on the customer, in the sense

that if the bank delivers the foreign currency, let us say in Tokyo, in an

important transaction, because of the time zone differences, the bank will be

able to debit the customers account only after an interval of 4-5 hours and

is, therefore, exposed to full amount of the contract concluded. However,

with regard to forward contracts which can be liquidated in the market, the

risk assumed is between 1 0 per cent and 20 per cent of the contracted

amount.

Risk of Mismatched Maturities: The risk of mismatched maturities arises

due to the mismatch of inflows and outflows of foreign currencies.

Technical, if one were to receive US$ 1 million and also remit US$ 1 million

today, one does not carry any exchange risk except the loss of the spread to

the bank, However, in real life, situations are not so ideal and, therefore,


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corporate treasurers are exposed to risks of mismatched maturities that is, a

time lag between receipt and payment of foreign currency, even if they are

both exporters and importers.

Country Risk: Country risk has assumed serious proportions in view of the

economic and political instability prevailing in many countries, such as in

Latin America, and Africa. It is advisable for a corporate treasurer to check

the country risk aspect before he concludes a deal with problem countries, as

he may not receive the foreign exchange against his goods due to exchange

control restrictions. The recent Middle-East war has ravaged the economiesof Iraq and Iran and, therefore, all transactions with these countries must be

carefully handled to ensure that goods or funds are not blocked.

Business Risk: Business risk is common to all types of businesses, such as

hearing a wrong rate, communicating the wrong amount, etc; however, in

the foreign exchange business, it can be disastrous as exchange rates move

very quickly and errors could be difficult to rectify without a loss. The

corporate treasurers are, therefore, advised to communicate all the details in

writing with the banks to avoid any misunderstandings.

Management of Foreign Exchange Risks

Generally, the corporate treasurers fall into one of the three categories:

(a) Those who cover every exposure;

(b) Those who do not cover all; and

(c) Those who cover judiciously.


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The first category belongs to corporate which are extremely conservative

and, therefore, cover every exposure immediately by entering into a forward

exchange contract with a bank their contention is that they should best

concentrate on the line of their business rather than dabble in the speculative

world of foreign exchange. If the corporate cover every exposure, obviously

they eliminate the foreign exchange risk altogether. The second category

belongs to corporate which believe in the do nothing approach and cover

their exposure on a spot basis at whatever rate is offered on the date of

remittance. This category of corporate, therefore, believes in keeping

exposures open and, pays for the risk they assume. Although in some casesthey might benefit by favorable movements of exchange rates, they do not

crystallize their liabilities and will never know their rupee liabilities until the

date of remittance. The third category belongs to corporate which cover their

exposure judiciously by talking to corporate dealers of the respective banks

and deciding whether to book exposure or not, depending upon short term

/ long-term trends of currencies, the rate of depreciation of the rupee against

foreign currency, and the level of premier and discounts prevailing in the

inter-bank market.

It is, therefore, obvious that a corporate treasurer may belong to any one of

the three categories and depending upon circumstances, decide his policy on

foreign exchange objective may be stated to curtail losses on account of

exchange risk fluctuations to the extent of I per cent of the cost of goods or

projected cost during the period I January to 31 December 1990. Within

these broad objectives, the operative staff can be given authority to book

exposure within 1/4 per cent or 1/2 per cent of costs involved so that they do

not have to revert to the senior management every time an exposure decision


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needs to be taken. The operating staff could then work in close co-ordination

with the corporate dealers of banks and efficiently cover the exchange risk

on an on-going basis.

Major participants in Forex Market

Participants in Forex Market

The participants in theforeign exchange marketcomprise;


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Corporates Commercial banks Exchange brokers Central banks

Corporates: The business houses, international investors, and multinational

corporations may operate in the market to meet their genuine trade or

investment requirements. They may also buy or sell currencies with a view

to speculate or trade in currencies to the extent permitted by the exchange

control regulations. They operate by placing orders with the commercial

banks. The deals between banks and their clients form the retail segment of

foreign exchange market.

In India the Foreign Exchange Management (Possession and Retention of

Foreign Currency) Regulations, 2000 permits retention, by resident, of

foreign currency up to USD 2,000. Foreign Currency Management

(Realisation, Repatriation and Surrender of Foreign Exchange) Regulations,

2000 requires a resident in India who receives foreign exchange to surrender

it to an authorized dealer:

Within seven days of receipt in case of receipt by way of remuneration,settlement of lawful obligations, income on assets held abroad, inheritance,

settlement or gift: and

Within ninety days in all other cases.Any person who acquires foreign exchange but could not use it for the

purpose or for any other permitted purpose is required to surrender the


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unutilized foreign exchange to authorized dealers within sixty days from the

date of acquisition. In case the foreign exchange was acquired for travel

abroad, the unspent foreign exchange should be surrendered within ninety

days from the date of return to India when the foreign exchange is in the

form of foreign currency notes and coins and within 180 days in case of

travellers cheques. Similarly, if a resident required foreign exchange for an

approved purpose, he should obtain from and authorized dealer.

Commercial Banks are the major players in the Forex market. They buy

and sell currencies for their clients. They may also operate on their own.

When a bank enters a market to correct excess or sale or purchase position in

a foreign currency arising from its various deals with its customers, it is said

to do a cover operation. Such transactions constitute hardly 5% of the total

transactions done by a large bank. A major portion of the volume is

accounted buy trading in currencies indulged by the bank to gain from

exchange movements. For transactions involving large volumes, banks maydeal directly among themselves. For smaller transactions, the intermediation

of foreign exchange brokers may be sought.

Exchange brokers facilitate deal between banks. In the absence of

exchange brokers, banks have to contact each other for quotes. If there are

150 banks at a centre, for obtaining the best quote for a single currency, a

dealer may have to contact 149 banks. Exchange brokers ensure that the

most favourable quotation is obtained and at low cost in terms of time and

money. The bank may leave with the broker the limit up to which and the

rate at which it wishes to buy or sell the foreign currency concerned. From


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the intends from other banks, the broker will be able to match the

requirements of both. The names of the counter parties are revealed to the

banks only when the deal is acceptable to them. Till then anonymity is

maintained. Exchange brokers tend to specialize in certain exotic currencies,

but they also handle all major currencies.

In India, banks may deal directly or through recognized exchange brokers.

Accredited exchange brokers are permitted to contract exchange business on

behalf of authorized dealers in foreign exchange only upon the

understanding that they will conform to the rates, rules and conditions laid

down by the FEDAI. All contracts must bear the clause subject to the Rulesand Regulations of the Foreign Exchanges Dealers Association of India.

Central Bankmay intervene in the market to influence the exchange rate

and change it from that would result only from private supplies and

demands. The central bank may transact in the market on its own for the

above purpose. Or, it may do so on behalf of the government when it buys orsell bonds and settles other transactions which may involve foreign

exchange payments and receipts. In India, authorized dealers have recourse

to Reserve Bank to sell/buy US dollars to the extent the latter is prepared to

transact in the currency at the given point of time. Reserve Bank will not

ordinarily buy/sell any other currency from/to authorized dealers. The

contract can be entered into on any working day of the dealing room of

Reserve Bank. No transaction is entered into on Saturdays. The value date

for spot as well as forward delivery should be in conformity with the

national and international practice in this regard.Reserve Bank of Indiadoes

not enter into the market in the ordinary course, where the exchages rates are
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moving in a detrimental way due to speculative forces, the Reserve Bank

may intervene in the market either directly or through the State Bank of

India.


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Purposes for Holding Official Foreign Reserves

1. To fulfill the monetary and exchange rate policies

2. To store of nations wealth

3. To give credibility to foreign investors

4. To back the banknotes in use

In order to achieve all the aforementioned objectives, The Bank of

Thailand manages the official reserves according to the following 3 guiding

principles as follows

1. Securitypreservation of reserves values


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2. Liquidity- able to meet the objectives of exchange rate

and monetary policies

3. Returns- to maximize the returns within the given

guidelines

Sources of Official Foreign Reserves

1. Balance of payment Surplus: The Balance of Payments consists

of the current account and the capital account. Under the managed

floating exchange rate, surpluses will lead to increases in foreign

exchange holdings when the central bank intervenes by buying the

foreign currency.

2. Returns from management of official reserves: Returns from interest

payments and the change in principal values of asset.

What are the Two Main Types of Foreign Exchange Market?

There are two foreign exchange markets: (a) the retail market and (b) the

interbank market.

1.Retail Market:

In the retail foreign exchange market, the individual and firms who require

foreign currency can buy it and those who have acquired foreign currency

can sell it. The commercial banks dealing in foreign exchange serve their


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customers by purchasing foreign exchange from some and selling foreign

exchange to other.

Thus, each bank acts as a clearing house where purchases of exchange can

be offset by sales of foreign exchange.

2.Interbank Market:

Interbank foreign exchange market serves to smoothen the excessive

purchases or sales made by individual banks. At times, the quantity of

foreign exchange supplied exceeds the quantity demanded, or vice versa.

When such an imbalance occurs, the exchange rate changes. If the foreign

exchange is in excess supply, the exchange rate falls; if the foreign exchange

is in excess demand, the exchange rate rises, the movement in the exchange

rate helps to correct the situation by encouraging or discouraging additional

buyers and sellers into or from the market.

India's forex reserves 4th largest in world: Survey

The Economic Survey said India has the fourth largest foreign exchange

reserves, which helped the nation to tide over global financial crisis.

India's foreign exchange reserves touched USD 297.3 billion in December,

2010 from USD 279.1 billion in March.

"It needs to be acknowledged that foreign exchange reserves have helped

insulate India from the worst impact of the crisis," it said.


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Unlike many Western nations, India was relatively less affected by the

global financial meltdown in 2008-09 that had pushed many advanced

economies into recession.

India had the fourth largest foreign exchange reserves at USD 297.3 billion

at the end of December 2010, it said.

At the same time, the foreign exchange reserves of Japan and Russia stood at

USD 1.12 trillion and USD 479.4 billion, respectively.

Neighbouring China's foreign exchange reserves was at USD 2.45 trillion in

June, 2010.

According to the Survey, the country's reserves mainly comprise portfolio

investment (FII), "which are more vulnerable to sudden stops and reversals

and borrowings from abroad".

India's foreign exchange reserves have increased over the years from just

USD 5.8 billion in March, 1991.

"The reserves reached a peak at USD 314.6 billion at May-end, 2008 before

declining to USD 252 billion at the end of March 2009.

"The decline in reserves in 2008-09 was inter alia a fallout of the global

crisis and strengthening of US dollar vis-a-vis other international

currencies," the Survey said.


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Conclusion

The increasing size and concentration of official foreign exchange reserves

after years of continued expansion, especially since the Asian crisis, have led

to renewed interest in the way reserve management decisions are taken and

in their possible impact on financial markets. Reserve management practices

have evolved substantially over the past decade or so, reflecting changes in

both the economic and the broader institutional environment. While some of


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these changes have been remarked upon, others have attracted less attention.

This paper documents some of the main changes in foreign exchange reserve

management practices, considers the main drivers behind them, and explores

some of the challenges ahead. We focus, in particular, on those challenges

that could have a more significant impact on financial markets. These

include the choice of an appropriate balance between risk and return, of the

numeraire currency and of the degree of public disclosure, from which some

conclusions are drawn concerning the future of the US dollar as a reserve

currency and volatility in financial markets. The discussion relies

extensively on a survey of central banks and monetary authoritiesrepresenting in total about 80% of global foreign exchange reserves at end-

2006.

Bibliography

RBI.COM

INVETOPEDIA. COM

BUISNESS ISSUE.COM

SCRIBED.COM


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significance of foreign exchange reserves

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