SEBI Grade A 2020: ECONOMICS: FOREIGN EXCHANGE MARKET · The foreign exchange market, also called...

SEBI Grade A 2020: ECONOMICS: FOREIGN EXCHANGE MARKET

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Table of Contents FOREIGN EXCHANGE MARKET ......................................................................................... 3

What is ‘Foreign Exchange Market’? ................................................................................................................. 3

Forex Leverage ............................................................................................................................................... 3

Benefits of Using the Forex Market................................................................................................................ 4

Participants in the Foreign Exchange Market ..................................................................................................... 4

Characteristics of Foreign Exchange Market ...................................................................................................... 5

Transactions in Foreign Exchange Markets ........................................................................................................ 6

Spot Market Transactions ............................................................................................................................... 6

Futures Market Transactions........................................................................................................................... 6

Forward Market Transactions ......................................................................................................................... 6

Functions of Foreign Exchange Market .............................................................................................................. 7

Advantages of Foreign Exchange Market........................................................................................................... 7

Disadvantages of Foreign Exchange Market ...................................................................................................... 8

Factors Affecting Foreign Exchange Rates ........................................................................................................ 8

Inflation Rates ................................................................................................................................................. 9

Interest Rates ................................................................................................................................................. 10

Country’s Current Account / Balance of Payments ...................................................................................... 10

Government Debt .......................................................................................................................................... 10

Terms of Trade .............................................................................................................................................. 10

Political Stability & Performance ................................................................................................................. 10

Recession ...................................................................................................................................................... 10

Speculation .................................................................................................................................................... 10

Exchange control in India ................................................................................................................................. 11

Objectives of exchange control in India ....................................................................................................... 11

Exchange Quotations ........................................................................................................................................ 11

Methods of Exchange Quotation .................................................................................................................. 12

Transactions under Direct and Indirect Quotations ...................................................................................... 13

Two Way Quotations .................................................................................................................................... 13

Foreign Exchange Management Act (FEMA) .................................................................................................. 14

Objectives of FEMA ..................................................................................................................................... 14

Applicability of FEMA Act .......................................................................................................................... 14

Prohibition on Drawal of Foreign Exchange ................................................................................................ 15

The Main Features of the FEMA .................................................................................................................. 15

Foreign exchange operations in commercial banks .......................................................................................... 16



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FOREIGN EXCHANGE MARKET

What is ‘Foreign Exchange Market’? The foreign exchange market, also called FOREX (FX), is an Over-the-Counter(OTC) marketplace where

various national currencies are traded, and FX participants can buy, sell, exchange and speculate on

currencies. It also facilitates currency conversion for international trade and investments. It determines the

exchange rate for currencies around the world.

• Foreign exchange markets are made up of banks, commercial companies, central banks,

investment management firms, hedge funds, and retail forex brokers and investors.

• FX is the largest financial market in the world.

• The foreign exchange market in India started operating in 1978 and grown significantly over the years.

The market is regulated by the Reserve Bank of India on behalf of central government, under

Foreign Exchange Management Act, 1999.

• In FOREX, currencies are always traded in pairs, so the "value" of one of the currencies in that pair is

relative to the value of the other. This determines how much of country A's currency country B can buy,

and vice versa.

• Establishing this relationship (price) for the global markets is the main function of the foreign

exchange market. This also greatly enhances liquidity in all other financial markets, which is key to

overall stability.

• The value of a country's currency depends on whether it is a "free float" or "fixed float".

• Free floating currencies are those whose relative value is determined by free market forces, such as

supply / demand relationships.

• A fixed float is where a country's governing body sets its currency's relative value to other currencies,

often by pegging it to some standard.

• Free floating currencies include the U.S. Dollar, Japanese Yen and British Pound, while examples of fixed

floating currencies include the Chinese Yuan and the Indian Rupee.

• One of the most unique features of the forex market is that it is comprised of a global network of financial

centers that transact 24 hours a day, closing only on the weekends. As one major forex hub closes,

another hub in a different part of the world remains open for business. This increases the liquidity

available in currency markets, which adds to its appeal as the largest asset class available to investors.

• The most liquid trading pairs are, in descending order of liquidity:

EUR/USD

USD/JPY

GBP/USD

Forex Leverage

• The leverage available in FX markets is one of the highest that traders and investors can find anywhere.

Leverage is a loan given to an investor by their broker. With this loan, investors are able to increase

their trade size, which could translate to greater profitability. A word of caution, though: losses are also

amplified.



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• For example, investors who have a $1,000 forex market account can trade $100,000 worth of currency

with a margin of 1 percent. This is referred to as having a 100:1 leverage. Their profit or loss will be

based on the $100,000 notional amount.

Benefits of Using the Forex Market

There are some key factors that differentiate the forex market from others, like the stock market.

• There are fewer rules, which means investors aren't held to the strict standards or regulations found in

other markets.

• There are no clearing houses and no central bodies that oversee the forex market.

• Most investors won't have to pay the traditional fees or commissions that you would on another market.

• Because the market is open 24 hours a day, you can trade at any time of day, which means there's no

cut-off time to be able to participate in the market.

• Finally, if you're worried about risk and reward, you can get in and out whenever you want and you can

buy as much currency as you can afford.

Participants in the Foreign Exchange Market • The participants here refers to the people involved in the exchange or trade of foreign currency. These

can be the buyers, sellers or the intermediaries. The participants in a forex market include the following

five parties:

1. Central Bank: The central bank

regulates the exchange rates of the

currency of their respective country

to ensure fluctuations within the

desired limit and keep control over

the money supply in the market. In

India, RBI regulates FOREX.

2. Commercial Banks: The

commercial banks are the medium of

forex transactions, facilitating

international trade and exchange to

its customers along with other forex

functions like making foreign

investments.

3. Traditional Users: The traditional

users involve foreign tourists,

companies carrying

out business operations across the

globe, patients taking treatment in

other country’s hospitals and students studying abroad.

4. Traders and Speculators: The traders and speculators are the opportunity seekers and look forward

to making a profit through trading on short-term market trends.Brokers: They are considered to be

financial experts who act as an intermediary between the dealers and the investors by providing the

best quotations.



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Characteristics of Foreign Exchange Market To understand what a forex market is, we must first go through its essential features. Discussed below are

the various characteristics of the foreign exchange market which differentiates it from other financial

markets:

• Market Transparency: It is effortless to monitor the fluctuations in the value of currencies of different

countries in a forex market easily through account tracking and real-time portfolio, without the

involvement of brokers.

• Dollar is Extensively Traded Currency: The USD, which is paired with almost every country’s

currency and listed on the forex, is the most widely traded currency in the world.

• Most Dynamic Market: The value of the currencies in the forex market keeps on changing every second

and function twenty-four hours a day. This makes it one of the most active markets in the world.

• International Network of Dealers: The foreign exchange market establishes a medium among the

dealers and also with the customers. There are dealer’s institutions located globally to carry out the

exchange and trading activities.

• “Over-The-Counter” Market: In different countries, the forex market is the highly unregulated market

initiating over the counter trade by the banks through telex and telephone.



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• High Liquidity: The currency is considered to be the most widely traded financial instrument across the

globe, making the forex market highly liquid.

• Twenty-Four Hour Market: The foreign exchange market is operational for twenty-four hours of the

day, initiating the active trade and exchange of currencies at any time.

Transactions in Foreign Exchange Markets A forex market performs three significant operations which are explained in detail below:

Spot Market Transactions

The forex transactions which are executed immediately, or usually within two days, is known as the spot

transaction. Such a forex market is termed as a spot market, and the rate of exchange is called a spot

rate.

Futures Market Transactions

The market in which the exchange of currencies involve a future delivery and payment and the rate of

exchange for the same is pre-determined is called a futures forex market. Such exchange rate is known

as a future rate. It protects the buyer from the risk of a rise in the value of the currency.

Forward Market Transactions

A forward forex market is however very similar to the futures market, but here, the terms of the contract

are negotiable and can be amended by any of the parties involved.

• Options: In an options contract, the holder is not bound to but have the right to buy or sell the

specified asset quantity at the pre-determined price on the specific future.

• Futures: In a future contract, the quantity of an asset, date of execution and price of the contract is

fixed and standardized.

• Swap: Usually, commercial banks adopt swap contracts if they perform forward exchange business

operations. Here, they sell off a particular currency in the spot market to buy that same currency in

the forward market.

• Arbitrage: The rigorous buying and selling of different currencies in the forex market to fetch gains

out of such transactions are called arbitrage.



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Functions of Foreign Exchange Market A foreign exchange market is the largest global financial market which performs some crucial functions. The

three of the primary functions of a forex market are as follows:

Hedging Function: The globally trading business entities can hedge the risk of currency fluctuations by

adopting means like a letter of credit or forward contract. Here, the goods are to be delivered on a pre-

determined future date and at a mutually agreed price.

Transfer Function: The forex market majorly functions to exchange the currency of one country into that

of other, to facilitate international trade activities.

Credit Function: Providing the credit facility at the time of making overseas payments through foreign

bill of exchange to its maturity or execution, is another significant function of the forex market.

Advantages of Foreign Exchange Market As we know that ‘trade makes everyone better-off’ and so goes for the exchange or trade of currencies.

Let us now discuss the various benefits of the foreign exchange market:

High Leverage: A forex investor can avail the facility of

leverage or loan of up to 20 or 30 times of his/her

capacity, for trading in the forex market.

International Trade: Every country has its currency and

therefore, to facilitate trade activities between two

countries, the forex market is essential.

Trading Option: For the speculators or traders, foreign

exchange market is just like other financial markets where

they can make money on short term fluctuations in the

currencies.

Flexibility: We know that the forex market is a twenty-

four-seven market, and there is no minimum or maximum

limit of the exchange amount. It provides the flexibility

of investment or exchange to the traders.



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Hedging Risk: The forex market provides for hedging the risk of loss on currency fluctuations while

carrying global business operations and trading in foreign currency.

Low Transaction Costs: Since brokers are not very much entertained in the forex market, the

transaction cost (called as ‘spread’) charged by the dealers is reasonably low if compared to other

financial markets.

Inflation Control: To maintain the economic stability in the country and control situations like inflation,

the central bank maintains a forex reserve which consists of currencies of different countries around the

world.

It adopts other means too, like decreasing bank lending rates and selling out domestic currency for foreign

currency.

Disadvantages of Foreign Exchange Market A forex market is not always favorable and involves various kinds of risks. These can be seen as its

drawbacks and are elaborated below:

Leverage Risks: Leverage refers to loan in other

terms. Forex market initiates the leverage of up to 20

to 30 times the investment capacity of the traders or

speculators, which may even lead the loss of the

entire amount of the investor.

Counterparty Risks: The forex is highly unregulated

with no central authority for currency exchange or

trading risk mitigation. Thus, it may encounter the

risk of non-fulfilment of the obligations by any of the

parties involved in such a contract.

Operational Risks: Since forex is a twenty-four

hours market, it is difficult to manage its operations

by humans. As a result, the traders and MNCs rely on

the algorithms, and trading desks spread,

respectively, to safeguard their investment in their

absence.

Factors Affecting Foreign Exchange

Rates • Foreign Exchange rate (ForEx rate) is one of the most important means through which a country’s

relative level of economic health is determined. A country's foreign exchange rate provides a window

to its economic stability, which is why it is constantly watched and analyzed.

• The exchange rate is defined as "the rate at which one country's currency may be converted into

another." It may fluctuate daily with the changing market forces of supply and demand of currencies

from one country to another.



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• Here we will discuss some of the leading factors that influence the variations and fluctuations in

exchange rates and explains the reasons behind their volatility.

Inflation Rates

Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation

rate than another's will see an appreciation in the value of its currency. The prices of goods and services

increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate

exhibits a rising currency value while a country with higher inflation typically sees depreciation in its

currency and is usually accompanied by higher interest rates.



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Interest Rates

Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and

inflation are all correlated. Increases in interest rates cause a country's currency to appreciate because

higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes

a rise in exchange rates

Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total

number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending

more of its currency on importing products than it is earning through sale of exports causes depreciation.

Balance of payments fluctuates exchange rate of its domestic currency.

Government Debt

Government debt is public debt or national debt owned by the central government. A country with more

government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their

bonds in the open market if the market predicts government debt within a certain country. As a result, a

decrease in the value of its exchange rate will follow.

Terms of Trade

Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to

import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports

prices. This results in higher revenue, which causes a higher demand for the country's currency and an

increase in its currency's value. This results in an appreciation of exchange rate.

Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country with less

risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from

other countries with more political and economic instability. Increase in foreign capital, in turn, leads to an

appreciation in the value of its domestic currency. A country with sound financial and trade policy does not

give any room for uncertainty in value of its currency. But, a country prone to political confusions may see

a depreciation in exchange rates.

Recession

When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire

foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering

the exchange rate.

Speculation

If a country's currency value is expected to rise, investors will demand more of that currency in order to

make a profit in the near future. As a result, the value of the currency will rise due to the increase in

demand. With this increase in currency value comes a rise in the exchange rate as well.



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Exchange control in India • Exchange controls are maintained in the belief that they help to protect a country's currency and its

foreign-exchange reserves. The controls may restrict investments by residents overseas and non-

residents' investments and participation in the local market. Big international currency movements tend

not to obey such controls. Regulations are thus made at government level of money-flows in and out of

a country.

• Sometimes individuals are limited in the amount of currency they may take abroad for holidays. The UK

abandoned exchange controls in 1979. In Australia, exchange controls which had persisted in one form

or another since 1939 were virtually abolished in December 1983 when the $A was floated.

• Types of controls that governments put in place to ban or restrict the amount of foreign currency or local

currency that is allowed to be traded or purchased.

• Common exchange controls include banning the use of foreign currency and restricting the amount of

domestic currency that can be exchanged within the country.

Objectives of exchange control in India

Some of the Key Objectives of exchange control in India are as follows:

Protection of Balance of Payments

• One of the important objectives of exchange control is protection of balance of payments.

• When the balance of payments deficit of a nation becomes large and chronic and its automatic correction

is not possible, certain active measures have to be adopted.

Reducing Burden of Foreign Debt

• The exchange value of a currency is sometimes fixed and maintained at higher level to lighten the burden

of foreign debts contracted in terms of foreign currencies.

• By overvaluing currency, the foreign exchange earnings of the country from exports are increased in

cases where the demand is inelastic and the prices in terms of the home currency to be paid for essential

imports get reduced

Raising the Level of Prices

• Sometimes the currency is undervalued to help in raising certain conditions in thought desirable to

stabilize the exchange rate at what can be called the equilibrium level, i.e., the level determined by

market forces.

• Short-term fluctuations are eliminated by deliberate action of authorities.

Economic Planning

• Exchange control is an important part of economic policy in any planned economy. Planning involves a

very careful use of foreign exchange resources of the country so that only those goods are imported

which are essential for the implementation of the plans.

• Exchange controls are resorted to regular the exports and imports in the light of plans.

Prevention of Export of Capital

• When the country suffers from exceptionally heavy outflow of capital caused by loss of confidence on

the part of nationals of the country or foreigners in the economy of the country or its currency, certain

exchange controls over remittances from and the country are necessary

Elimination of Short-term Fluctuations in Exchange Rate

• Exchange regulation in certain conditions is thought desirable to stabilize the exchange rate at what can

be called the equilibrium level, i.e., the level determined by market forces.

• Short-term fluctuations are eliminated by deliberate action of authorities

Exchange Quotations • We have seen that exchange rates can be quoted in either of the two ways;

1. Direct quotation



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2. Indirect quotation

• The quotation in which exchange rate is expressed as the price per unit of foreign currency in terms of

the home currency is k known as Home currency quotation or Direct quotation. It may be noted

that under direct quotation the number of units of foreign currency is kept constant and any change in

the exchange rate will be made by changing the value in term of rupees. For instance, US dollar quoted

at INR 70 may be quoted at INR 68 or INR 71 as may be warranted.

• The quotation in which the unit of home currency is kept constant and the exchange rate is expressed

as so many unit of foreign currency is known as Foreign Currency quotation or Indirect quotation

or simply Currency Quotation. Under indirect quotation, any change in exchange rate will be effected

by changing the number of units of foreign currency.

Methods of Exchange Quotation

• The exchange rate may be quoted in two ways:

1. Direct quotation or home currency quotation and

2. Indirect quotation or foreign currency quotation

• For instance, a fruit vendor may express the price of apples in either of the following two ways:

Method I: One apple costs INR 10

Method II: For INR 100, 10 apples

• In both the case the value of apple or the rupee is the same though expressed differently. In method I,

the price per apple is quoted in rupees. In method II, the unit of rupees kept constant at 100, and the

quantity of fruits is varied to reflect their prices.

• The same is also true for foreign currency. In foreign exchange also the rate of exchange can be quoted

in two ways:

Method I: USD 1=INR 70.20

Method II: INR 100 = USD 1.4245

• The quotation under Method I, in which exchange rate is expressed as the price per unit of one US dollar

in terms of the home currency is known as “Home Currency Quotation” or “Direct Quotation‘. It may be

noted that under direct quotation the number of units of foreign currency is kept constant and any

change in the US dollar quoted at under different values of rupees.

• Under Method II, the unit of home currency is kept constant and the exchange rate is expressed as so

many units of foreign currency for a fixed unit of home currency is known as “Foreign Currency

Quotation” or “Indirect Quotation”. Under indirect quotation, any change in exchange rate will be effected

by changing the number of units of foreign currency. For instance, the rate INR/.100=USD 1.4245 may

become in due course USD 1.4100 or USD 1.4300, and so on.

• The indirect quotation is used in London foreign exchange market. In New York and other foreign

exchange markets mostly the direct method is in vogue.

• In India, earlier we had used indirect method. However, from August 2, 1993, India has switched over

to direct method of quotation. The change has been introduced in order to simplify and establish

transparency in exchange rates in India.



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Transactions under Direct and Indirect Quotations

• Under direct quotation the bank buys the foreign currency at lower price and selling it to a customer

at a higher price. For instance a bank may buy US dollar at Rs.46 and sell at 46.20 and thus book a

profit. Therefore, under direct quotation the maxim is buy low; Sell high.

• In the case of indirect quotations, while buying, the bank would acquire more units of foreign currency

for a fixed unit of home currency and while selling part with lesser units of foreign currency for more

units of home currency. Therefore, the maxim under indirect quotation is buy high and sell low.

Two Way Quotations

• The first area of mystique in foreign exchange quotations arises from the fact that there are two ways

of quoting rates; the direct quote and the indirect quote that we already discussed. The former gives

the quotation in terms of the number of units of home currency necessary to buy one unit of foreign

currency. The latter gives the quotation in terms of the number of units of foreign currency bought with

one unit of home currency.

• Foreign exchange dealers quote two prices, one for selling and the other for buying. Therefore, in the

foreign exchange market; quotations are always for both buying and selling. For instance a bank may

quote its rate for dollars as follows:

• One US dollar=INR 70.57- 70.75 or INR 100=USD 1.4134- 1.4170. While in the case of One US

dollar=INR 70.57- 70.75 the first INR 70.57 is the buying rate, the second 70.75 is the selling rate.

On the other hand in the case of INR 100= USD 1.4134- 1.4170, the bank agrees to sell at the rate

of USD 1.4134 for INR 100, the bank is willing to buy at USD 1.4170 for INR 100. The buying rate is

known as the bid rate and the selling rate is known as offer rate.

• Continental European dealers normally quote via the direct method. In London dealers use the indirect

method. In the US, both quotation methods are used. When a bank is dealing with a customer within

the US direct quotation is given but when dealing with other banks in Europe (except the UK) the indirect

quotation is used. Foreign exchange dealers quote two prices: the rate at which they are prepared to

sell a currency and that at which they are prepared to buy. The difference between the bid rate and the

offer is the dealer‘s spread which is one of the potential sources of profit for dealers. Whether using the

direct quotation method or the indirect quote, the smaller rate is always termed the bid rate and the

higher is called the offer or ask rate.

The size of the bid/offer spread varies according to the depth of the market and its stability at any particular

time. Depth of a market refers to the volume of transactions in a particular currency. Deep markets have

many deals, shallow markets have a few. High percentage spreads are associated with high uncertainty and

low volume s of transactions in a currency. Lower spreads are associated with stable, high volume markets.

Deep markets usually have narrower spreads than shallow one.



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Foreign Exchange Management Act (FEMA) • The Reserve Bank of India sets India’s exchange-control policy and administers foreign exchange

regulations in consultation with the Government of India. India's foreign exchange control regime is

governed by the Foreign Exchange Management Act (FEMA), 1999.

• The Foreign Exchange Management Act, 1999 (FEMA) is an Act of the Parliament of India "to consolidate

and amend the law relating to foreign exchange with the objective of facilitating external trade and

payments and for promoting the orderly development and maintenance of foreign exchange market in

India".

• It was passed in the winter session of Parliament in 1999, replacing

the Foreign Exchange Regulation Act (FERA).

• This act makes offences related to foreign exchange civil offenses. It

extends to the whole of India, replacing FERA, which had become

incompatible with the pro-liberalization policies of the Government of

India.

• It enabled a new foreign exchange management regime consistent

with the emerging framework of the World Trade Organization (WTO).

• It also paved the way for the introduction of the Prevention of Money

Laundering Act, 2002, which came into effect from 1 July 2005.

Objectives of FEMA

The main objective for which FEMA was introduced in Indian was to

facilitate external trade and payments. In addition to this, FEMA was also

formulated to assist orderly development and maintenance of the Indian forex market. FEMA outlines the

formalities and procedures for the dealings of all foreign exchange transactions in India. These foreign

exchange transactions have been classified into two categories — Capital Account Transactions and Current

Account Transactions.

Under the FEMA Act, the balance of payment is the record of dealings between the citizen of different

countries in goods, services and assets. It is mainly divided into two categories, i.e. Capital Account and

Current Account. Capital Account comprises all capital transactions whereas Current Account comprises

trade of merchandise.

Current Account transactions are those transactions which involve inflow and outflow of money to and from

the country/countries during a year, due to the trading/rendering of commodity, service, and income. The

current account is an indicator of an economy’s status.

As mentioned above the balance of payment comprises current and capital accounts, the remainder of the

Balance of Payment is Capital Account, which consists the movement of capital in the economy due to capital

receipts and expenditure. Capital account recognises domestic investment in foreign assets and foreign

investment in domestic.

Applicability of FEMA Act

FEMA (Foreign Exchange Management Act) is applicable to the whole of India and equally applicable to the

agencies and offices located outside India (which are owned or managed by an Indian Citizen). The head

office of FEMA is situated at New Delhi and known as Enforcement Directorate.

FEMA is applicable to:

• Foreign exchange

• Foreign security

• Exportation of any commodity and/or service from India to a country outside India

• Importation of any commodity and/or services from outside India

• Securities as defined under Public Debt Act 1994



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• Purchase, sale and exchange of any kind (i.e. Transfer)

• Banking, financial and insurance services

• Any overseas company owned by an NRI (Non-Resident Indian) and the owner is 60% or more

• Any citizen of India, residing in the country or outside (NRI)

The Current Account transactions under the FEMA Act has been categorized into three parts which, namely-

(i) Transactions prohibited by FEMA,

(ii) The transaction requires Central Government’s permission,

(iii) The transaction requires RBI’s permission.

Prohibition on Drawal of Foreign Exchange

• Any kind of remittance out of winning the lottery

• Any kind of remittance from the income on racing/riding etc,

• Any remittance for buying of a lottery ticket, football pools, sweepstakes, banned/prescribed magazines

etc.

• Commission payment on exports towards equity investment of Indian Companies in Joint

ventures/wholly owned subsidiaries abroad.

• Remittance of dividend by any company. However, this clause is applicable only if the requirement of

dividend balancing is applicable.

• Commission payment on exportation under Rupees State Credit Routes except commission up to 10%

of invoice value of export of tea and tobacco,

• Payment regarding “ Call back Services” of telephones

• A travel to Bhutan and/or Nepal

• Remittance of interest income on funds held in NRSR Account i.e. Non-resident Special Rupees Scheme

account

• A transaction with a resident of Bhutan or Nepal.

The Main Features of the FEMA

The following are some of the important features of Foreign Exchange Management Act:

1. It is consistent with full current account convertibility and contains provisions for progressive

liberalisation of capital account transactions.

2. It is more transparent in its application as it lays down the areas requiring specific permissions of the

Reserve Bank/Government of India on acquisition/holding of foreign exchange.

3. It has classified the foreign exchange transactions in two categories, viz. capital account and current

account transactions.

4. It provides power to the Reserve Bank for specifying, in , consultation with the central government, the

classes of capital account transactions and limits to which exchange is admissible for such transactions.

5. It gives full freedom to a person resident in India, who was earlier resident outside India, to

hold/own/transfer any foreign security/immovable property situated outside India and acquired when

s/he was resident.

6. This act is a civil law and the contraventions of the Act provide for arrest only in exceptional cases.

7. FEMA does not apply to Indian citizen’s resident outside India.



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Foreign exchange operations in commercial banks Commercial banks are crucial to international trade. When trading partners are on the other side of the

world or in a country where business contracts are difficult to enforce, banks lessen the risks of doing

business overseas with financial products.

Exports:

• With regards to exports, below are the operations which commercial banks undertake as part of its

Foreign exchange operations:

1. Pre-shipment Advances: Pre-shipment is also referred as “packing credit”. It is working capital finance

provided by commercial banks (such as export-import bank or trade development bank) to the exporter

prior to shipment of goods. The finance required to meet various expenses before shipment of goods is

called pre-shipment finance or packing credit.

2. Post-shipment Advances: Also referred as Post shipment credit, is extended to exporters by commercial

banks (such as export-import bank or trade development bank) with low interest rate till realization of

their export proceeds. Post shipment loan helps exporters to get finance without waiting amount of sales

from their overseas buyers.

3. Advising/Confirming Letter of Credit: When a Letter of Credit (LC) is issued, the LC Issuing Bank sends

the LC either to its branch office or correspondent bank, which is normally located in the seller’s

(beneficiary) country. The commercial banks that receives the LC is known as the Advising Bank

authenticate the LC to ensure that the LC comes from a genuine source there by providing its

confirmation on the LC.

4. Facilitating project exports: Commercial bank (EXIM Bank) support existing or new projects, plants or

processes that require additional assistance in processes such as international competitive bidding:

including multilaterally funded projects in India. EXIM Bank has extended funded and non-funded

facilities to export of projects and services categorized as:

Civil Engineering and Construction Projects

Turnkey Projects

Technical and Consultancy Service Contracts

Supplies

Few other operations undertaken by commercial banks are Bills for collection etc.

Imports:

• With regards to imports, below are the operations which commercial banks undertake as part of its

Foreign exchange operations.

Opening letters of credit:

• Commercial banks aid in opening letter of credit. Letters of credit are the most common financial service

that commercial banks provide for international businesses. They are typically used for exporting goods

to countries where there can be difficulty enforcing contracts or when trading with countries that present

a considerable risk.

• A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received

on time and for the correct amount. In the event that the buyer is unable to make payment on the

purchase, the bank will be required to cover the full or remaining amount of the purchase.

• Due to the nature of international dealings, including factors such as distance, differing laws in each

country, and difficulty in knowing each party personally, the use of letters of credit has become a very

important aspect of international trade.



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• Banks may levy a service charge that is a percentage of the amount of the letter of credit requested.

The service charge often reflects the amount of risk the bank assumes.

Few other operations undertaken by commercial banks are Import loans and guarantees, Advance bills etc.

Exchange Dealings

With regards to exchange dealings, below are the operations which commercial banks undertake as part of

its Foreign exchange operations.

1. Rate computation

2. Maintaining Nostro/Vostro Accounts

3. Forward Contracts

4. Nostro and Vostro (Middle Italian, from Latin, noster and voster; English, ours and yours) are accounting

terms used to distinguish an account you hold for another entity from an account another entity holds

for you. The entities in question are almost always, but need not be, banks.

5. Nostro: An account at foreign bank where a domestic bank keeps reserves of a foreign currency. A bank

keeps a nostro account so that it does not have to make a currency conversion (which brings with it

foreign exchange risk) should an account holder make a depositor a withdrawal in that foreign currency

6. Vostro: An account that a bank holds on behalf of another bank in another country.



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SEBI Grade A 2020: ECONOMICS: FOREIGN EXCHANGE MARKET · The foreign exchange market, also called...

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