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Transcript of 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)
C2b 1.00 = Rs.10 (direct), or C2b 10.00 = Rs. 100 (indirect)
C3b 1.00 = Rs.5 (direct), or C3b 20.00 = Rs. 100 (indirect)
C1c 1.00 = Rs.25 (direct), or C1c 4.00 = Rs. 100 (indirect)
C2c 1.00 = Rs.12 (direct), or C2c 8.33 = Rs. 100 (indirect)
C3c 1.00 = Rs.4 (direct), or C3c 25.00 = 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