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FOREIGN EXCHANGE MARKET

INTRODUCTION:

FOREIGN EXCHANGE MARKET AN OVERVIEW:

In today’s world no economy is self sfficient! so t"ere is need for e#c"an$e of $oods and

ser%ices amon$st t"e different contries& 'o in t"is $lo(al %illa$e! nli)e in t"e ancient

a$e t"e e#c"an$e of $oods and ser%ices is no lon$er carried ot on (arter (asis& E%ery

so%erei$n contry in t"e world "as a crrency t"at is le$al tender in its territory and t"is

crrency does not act as money otside its (ondaries& 'o w"ene%er a contry (ys or

sells $oods and ser%ices from or to anot"er contry! t"e residents of two contries "a%e to

e#c"an$e crrencies& 'o we can ima$ine t"at if all contries "a%e t"e same crrency t"en

t"ere is no need for forei$n e#c"an$e&

T"e Forei$n Tradin$ Mar)et is re$arded as t"e (i$$est financial mar)et& It is t"is mar)et

t"at is res*onsi(le for t"e tradin$ of crrencies& +ery lar$e amonts of crrency are

traded (y lar$e or$ani,ations sc" as financial instittions! mltinational cor*orations!

crrency s*eclators! central (an)s and $o%ernment& T"e forei$n e#c"an$e mar)et is

re$arded as t"e most sita(le mar)et for t"is trade and s*erior to t"e New -or) 'toc)

E#c"an$e .N-'E/& 0' 1 2 trillion is "andled eac" day (y t"e forei$n e#c"an$e mar)et&

T"e New -or) 'toc) E#c"an$e "andles 0' 1 34 (illion eac" day& As soon as one )ind of

crrency is traded for anot"er )ind t"en it re$arded as forei$n e#c"an$e mar)et& T"is

mar)et allows for t"e tradin$ of any )ind of crrency&

T"ere are crrencies as different from one anot"er as t"e 0' dollar and t"e 'wiss franc

and t"e 5a*anese yen& T"e forei$n e#c"an$e mar)et does not cater only to t"e needs oft"e (i$$est instittions as was t"e case in *re%ios years& Nowadays! smaller enter*rises

also ta)e ad%anta$e of t"e forei$n e#c"an$e mar)et& In fact t"ere are many *eo*le w"o

se t"is mar)et (ecase it "as t"e *otential to yield $ood *rofits&&

6



T"e forei$n e#c"an$e mar)et one t"at is ni7e& T"is is a mar)et t"at "as an enormos

di%ersity of traders sitated arond t"e $lo(e&

T"e forei$n e#c"an$e mar)et is ni7e (ecase of followin$8

• tradin$ %olme reslts in mar)et li7idity

• $eo$ra*"ical dis*ersion

• continos o*eration8 29 "ors a day e#ce*t wee)ends! i&e& tradin$ from 24863

0TC on 'nday ntil 22844 0TC Friday

• t"e %ariety of factors t"at affect e#c"an$e rate

• t"e low mar$ins of relati%e *rofit com*ared wit" ot"er mar)ets of fi#ed income

• t"e se of le%era$e to en"ance *rofit mar$ins wit" res*ect to accont si,e

NEED FOR FOREIGN EXCHANGE:

:et s consider a case8

;"ere Indian com*any e#*orts cotton fa(rics to 0'A and in%oices t"e $oods in 0'

dollar& T"e American im*orter will *ay t"e amont in 0' dollar! as t"e same is "is "ome

crrency&

2

Indian

E#*orts Cotton

0'A

0' 1

E#*orter Im*orter



Howe%er t"e Indian e#*orter re7ires r*ees means "is "ome crrency for *rocrin$ raw

materials and for *ayment to t"e la(or c"ar$es etc& T"s "e wold need e#c"an$in$ 0'

dollar for r*ee&

If t"e Indian e#*orters in%oice t"eir $oods in r*ees! t"en im*orter in 0'A will $et "is

dollar con%erted in r*ee and *ay t"e e#*orter&

From t"e a(o%e e#am*le we can infer t"at in case $oods are (o$"t or sold otside t"e

contry! e#c"an$e of crrency is necessary& 'ometimes it also "a**ens t"at t"e

transactions (etween two contries will (e settled in t"e crrency of t"ird contry& In t"at

case (ot" t"e contries t"at are transactin$ will re7ire con%ertin$ t"eir res*ecti%e

crrencies in t"e crrency of t"ird contry& For t"at also t"e forei$n e#c"an$e is re7ired&

<

Indian Co&

0'A Rs&

E#*orts 1 con%ert

E# orter is aid in Rs&



OVER-THE-COUNTER TRADING:

Forei$n e#c"an$e mar)et t"ere is no for mar)et *lace called t"e forei$n e#c"an$e mar)et&

It is mec"anism t"ro$" w"ic" one contry’s crrency can (e e#c"an$e i&e& (o$"t or

sold for t"e crrency of anot"er contry& T"e forei$n e#c"an$e mar)et does not "a%e any

$eo$ra*"ic location&

Forei$n e#c"an$e mar)et is descri(ed as an OTC .o%er t"e conter/ mar)et as t"ere is no

*"ysical *lace w"ere t"e *artici*ants meet to e#ecte t"e deals! as we see in t"e case of

stoc) e#c"an$e& T"e lar$est forei$n e#c"an$e mar)et is in :ondon! followed (y t"e New

-or)! To)yo! =ric" and Fran)frt& T"e mar)et is sitated t"ro$"ot t"e different time

,one of t"e $lo(e in sc" a way t"at one mar)et is closin$ t"e ot"er is (e$innin$ its

o*eration& T"erefore it is stated t"at forei$n e#c"an$e mar)et is fnctionin$ t"ro$"ot

29 "ors a day& In most mar)et 0' dollar is t"e %e"icle crrency! %i,&! t"e crrency sed

to dominate international transaction&

9



Why Hold Forex Reserves

Tec"nically! it is *ossi(le to consider t"ree moti%es i.e., transaction! s*eclati%e and

*recationary moti%es for "oldin$ reser%es& International trade $i%es rise to crrency

flows! w"ic" are assmed to (e "andled (y *ri%ate (an)s dri%en (y t"e transaction

moti%e& 'imilarly! s*eclati%e moti%e is left to indi%idal or cor*orate& Central (an)

reser%es! "owe%er! are c"aracteri,ed *rimarily as a last resort stoc) of forei$n crrency

for n*redicta(le flows! w"ic" is consistent wit" *recationary moti%e for "oldin$

forei$n assets& >recationary moti%e for "oldin$ forei$n crrency! li)e t"e demand for

money! can (e *ositi%ely related to wealt" and t"e cost of co%erin$ n*lanned deficit! and

ne$ati%ely related to t"e retrn from alternati%e assets&

From a *olicy *ers*ecti%e! it is clear t"at t"e contry (enefits t"ro$" economies of scale

(y *oolin$ t"e transaction reser%es! w"ile s( ser%in$ t"e *recationary moti%e of

OTC

?ERI+ATI+E'

INTERE'T

RATE

?ERI+ATI+E'

FOREIGN

C0RRENC-

?ERI+ATI+E'

FOR;AR?

RATE

AGREEMENT

INTERE'T

RATE

';A>'

FOREIGN

EXCHANGE

FOR;AR?'

CRO''

C0RRENC-

FOR;AR?'

FOREIGN

C0RRENC-

R0>EE

';A>'

CRO''

C0RRENC-

O>TION'

FOREIGN

C0RRENC-

R0>EE

O>TION'

OTC >RO?0CT >ERMITTE? IN IN?IA

3



)ee*in$ official reser%es as a @war c"est’& Frt"ermore! fore# reser%es are instrments to

maintain or mana$e t"e e#c"an$e rate! w"ile ena(lin$ orderly a(sor*tion of international

money and ca*ital flows& In (rief! official reser%es are "eld for *recationary and

transaction moti%es )ee*in$ in %iew t"e a$$re$ate of national interests! to ac"ie%e

(alance (etween demand for and s**ly of forei$n crrencies! for inter%ention! and to

*reser%e confidence in t"e contry’s a(ility to carry ot e#ternal transactions&

Reser%e assets cold (e defined wit" res*ect to assets of monetary at"ority as t"e

cstodian! or of so%erei$n Go%ernment as t"e *rinci*al& For t"e monetary at"ority! t"e

moti%es for "oldin$ reser%es may not de%iate from t"e monetary *olicy o(ecti%es! w"ile

for Go%ernmentB t"e o(ecti%es of "oldin$ reser%es may $o (eyond t"at of t"e monetary

at"orities& In ot"er words! t"e final e#*ression of t"e o(ecti%e of "oldin$ reser%e assets

wold (e inflenced (y t"e reconciliation of o(ecti%es of t"e monetary at"ority as t"e

cstodian and t"e Go%ernment as *rinci*al& T"ere are cases! "owe%er! w"en reser%es are

sed as a con%enient mec"anism for Go%ernment *rc"ases of $oods and ser%ices!

ser%icin$ forei$n crrency de(t of Go%ernment! insrance a$ainst emer$encies! and in

res*ect of a few! as a sorce of income&

FACTOR! AFFECTING FOREIGN EXCHANGE MARKET

RATE

Alt"o$" e#c"an$e rates are affected (y many factors! in t"e end! crrency *rices are a

reslt of s**ly and demand forces& '**ly and demand for any $i%en crrency! and t"s

its %ale! are not inflenced (y any sin$le element! (t rat"er (y se%eral& T"ese elements

$enerally fall into t"ree cate$ories8 economic factors! *olitical conditions and mar)et

*syc"olo$y&

"# E$o%o&'$ ()$*ors



Go%ernment (d$et deficits or sr*lses8 T"e mar)et sally reacts ne$ati%ely to

widenin$ $o%ernment (d$et deficits! and *ositi%ely to narrowin$ (d$et deficits& T"e

im*act is reflected in t"e %ale of a contryDs crrency&

• alance of trade le%els and trends8 T"e trade flow (etween contries illstrates

t"e demand for $oods and ser%ices! w"ic" in trn indicates demand for a contryDs

crrency to condct trade& 'r*lses and deficits in trade of $oods and ser%ices

reflect t"e com*etiti%eness of a nationDs economy& For e#am*le! trade deficits may

"a%e a ne$ati%e im*act on a nationDs crrency&

• Inflation le%els and trends8 Ty*ically! a crrency will lose %ale if t"ere is a "i$"

le%el of inflation in t"e contry or if inflation le%els are *ercei%ed to (e risin$&

T"is is (ecase inflation erodes *rc"asin$ *ower! t"s demand! for t"at

*articlar crrency&

• Economic $rowt" and "ealt"8 Re*orts sc" as $ross domestic *rodct .G?>/!

em*loyment le%els! retail sales! ca*acity tili,ation and ot"ers! detail t"e le%els of

a contryDs economic $rowt" and "ealt"& Generally! t"e more "ealt"y and ro(st a

contryDs economy! t"e (etter its crrency will *erform! and t"e more demand for

it t"ere will (e& Internal! re$ional! and international *olitical conditions and e%ents

can "a%e a *rofond effect on crrency mar)ets&

+# ,ol'*'$)l $o%d'*'o%s:

All e#c"an$e rates are ssce*ti(le to *olitical insta(ility and antici*ations a(ot t"e new

$o%ernment& For e#am*le! *olitical or financial insta(ility in Rssia is also a fla$ for t"e

R*ee to 0' R*ee e#c"an$e (ecase of t"e s(stantial amont of German in%estments

directed to Rssia&

# M)r.e* /sy$holo0y )%d *r)der /er$e/*'o%s

T"ey inflence t"e forei$n e#c"an$e mar)et in a %ariety of ways

Fli$"ts to 7ality8 0nsettlin$ international e%ents can lead to a fli$"t to 7ality! wit"



in%estors see)in$ a safe "a%en& T"ere will (e a $reater demand! t"s a "i$"er *rice! for

crrencies *ercei%ed as stron$er o%er t"eir relati%ely wea)er conter*arts&

Ho1 *o /red'$* &)r.e* &ove&e%*s

T"ere are two ty*es of analysis w"ic" are $enerally sed to )ee* a trac) of t"e E#c"an$e

mar)ets& T"ese are8

F2%d)&e%*)l A%)lys's

Fndamental analysis incldes a detailed stdy of t"e (asic and *rimary elements w"ic""a%e and can *otentially mani*late t"e financial system of a certain t"in$& T"is ty*e of

tec"ni7e is often sed to stdy and forecast t"e %arios trends li)e *rice action and

mar)et trends& T"ese *redictions are done mainly t"ro$" e%alatin$ t"e followin$

indicators8

6& Acti%ity Indicators relatin$ to G?>! >rodction! 'ales! Income! '*endin$!

Hosin$&

2& Inflation Indicators com*risin$ of C>I! ;>I etc&

<& E#ternal 'ector Indicators w"ic" inclde Trade alance! Crrent accont (alance&

3 Te$h%'$)l A%)lys's

Tec"nical analysis is a met"od of e%alatin$ crrencies (y analy,in$ statistics $enerated

(y mar)et acti%ity! sc" as *ast *rices and %olme& It attem*ts not to measre a secrityDs

intrinsic %ale! (t instead ses c"arts and ot"er tools to identify *atterns t"at can s$$est

ftre acti%ity&

'ome of t"e tec"ni7es sed are8

6& Candlestic) C"arts



2& Mo%in$ A%era$es .'im*le and E#*onential/

<& ollin$er ands

9& Relati%e 'tren$t" Indicator

3& Oscillators

Wh)* 's ) hed0e

Hed$e is an in%estment *osition ta)en in order to *rotect oneself from t"e ris) of an

nfa%ora(le *rice mo%e in a crrency&

Why o%e &2s* hed0e h's Fore'0% $2rre%$y R's.

"# To &'*'0)*e Ex$h)%0e r)*e r's.:

• Flctations in t"e e#c"an$e rate of crrencies $i%e rise to e#c"an$e rate ris)&

• As t"e time $a* (etween finali,in$ an e#*ortJim*ort order and recei%in$Jma)in$

*ayment a$ainst it widens! t"e *ossi(ility of flctation of e#c"an$e rate rises& A

"ed$e "el*s in *rotectin$ (sinesses from nfa%ora(le flctations&

+# To )v)'l *he (ollo1'%0 4e%e('*s:

6& It (rin$s certainty in (siness yo wold )now t"e *recise e#c"an$e rate at

w"ic" yor recei%a(lesJ *aya(les will (e con%erted&

2& Hel*s in estimatin$ recei*ts and *aymentsonce yo are aware of one side on t"e

>J: yo can *lan t"e ot"er&

L



<& siness is immne to any frt"er mo%ement in crrency mar)ets! t"s relie%in$

itself of t"e e#ercise of trac)in$ crrency mar)ets&

Hed0'%0 ,rod2$*s

"5 For1)rds8

It is a forei$n crrency contract to (y or sell a forei$n crrency at a fi#ed rate for

deli%ery on a s*ecified ftre date or *eriod&

Forwards contract is sed as a forei$n crrency "ed$e w"en a *ersonJ(siness "as an

o(li$ation to eit"er ma)e or ta)e a forei$n crrency *ayment at some *oint in t"e ftre&

If t"e date of t"e forei$n crrency *ayment and t"e last tradin$ date of t"e forei$n

crrency Forwards contract are matc"ed *! t"e in%estor "as in effect loc)ed in t"e

e#c"an$e rate *ayment amont&

Adv)%*)0es:

6& Hel*s in "ed$in$ t"e e#c"an$e rate ris)&

2& rin$s t"e certainty of con%ertin$ forei$n e#c"an$e at a fi#ed rate&

<& >ro%ides for early or *art settlement&

D's)dv)%*)0es:

6& Creates an o(li$ation to settle t"e contract and does not allow t"e (yer to ma)e

se of (etter mar)et rates! if a%aila(le&

"5 Wh)* 's &)*2r'*y d)*e

T"e date on w"ic" t"e forward contract e#*ires&

+5 Wh)* 's ) s*r'.e /r'$e

64



T"is is also called E#ercise >rice& T"is is t"e rate (oo)ed (y an e#*orter or im*orter on

t"e date of t"e contract&

For E#am*le8 On <6 Marc"! 244! an e#*orter (ys and Forward contract! matrity date

for <4 'e*tem(er 244

0'?JINR rate on <6 Marc"! 244 <L&34

Forward rate (oo)ed (y t"e e#*orter 94&44 'tri)e *rice J'tri)e Rate

+ O/*'o%s:

It is a financial Forei$n crrency contract $i%in$ t"e (yer t"e ri$"t! (t not t"e

o(li$ation! to *rc"ase or sell a s*ecific forei$n crrency contract .t"e nderlyin$/ at a

s*ecific *rice .t"e stri)e *rice/ on or (efore a s*ecific date .t"e e#*iration date/& T"e

amont *aid for t"e contract is called *remim&

In ot"er words! (y *ayin$ a *remim t"e (yer can stay *rotected from nfa%ora(le

mar)et mo%ements and at t"e same time ma)e se of (etter mar)et rates w"en a%aila(le&

Adv)%*)0es:

6& 0nli)e a forwards contract! it does not create an o(li$ation to settle! t"e (yer can

ma)e se of (etter mar)et rates w"en a%aila(le&

66



2& >ro%ides *rotection a$ainst lossB "owe%er t"e o*tion to ma)e se of fa%ora(le

mar)et rate e#ists&

<& >ro%ides t"e fle#i(ility of c"oosin$ t"e stri)e *rice and matrity *eriod!

accordin$ly t"e o*tion *rice can (e arri%ed to sit t"e (yers’ needs&

9& Ta# enefit>remim *aid can (e claimed nder e#*enses for ta# (enefit as *er

Income Ta# Act .India/! 6L6&

O/*'o%s (or '&/or*ers:

Im*orters "a%e to *ay in forei$n crrency for t"eir im*orts& As sc" im*orters (y

forei$n crrency and sell r*ees& Hence! Im*orters can (oo) an O*tions contract and

(oo) t"e rate at w"ic" t"ey will (y forei$n crrency& On t"e matrity date! im*orters

can (y forei$n crrency at t"e rate (oo)ed or t"e mar)et rates w"ic"e%er is lower& T"is

is also )nown as a call o*tion contract&

For e.g. an importer books an Options contract on 31 March, 2008, maturity date 30

September 2008 at the rate of 3.00.

O/*'o%s (or ex/or*ers:

E#*orters recei%e *ayment in forei$n crrency& As sc" e#*orters sell forei$n crrency

and (y r*ees& Hence an e#*orter can (oo) an O*tions contract and (oo) a rate at w"ic"

t"ey will sell forei$n crrency& On t"e matrity date! e#*orters can sell forei$n crrency

at t"e rate (oo)ed or t"e mar)et rates w"ic"e%er is lower& T"is is also )nown as a *t

o*tion contract&

For e.g. an e!porter books an Options contract on 31 March, 2008, maturity date 30

September 2008 at the rate of "0.00.

Fore'0% Ex$h)%0e M)r.e* '% I%d')6 I%d')% E$o%o&y

62



As in t"e rest of t"e world! in India too! forei$n e#c"an$e mar)et is t"e lar$est financial

mar)et in e#istence& T"e *"enomenon t"at "as dramatically c"an$ed India’s forei$n

e#c"an$e mar)et was li(erali,ation of economy started drin$ early L4’s& In 6LL<! central

$o%ernment re*laced t"e *re%ailin$ fi#ed e#c"an$e rate system wit" a less re$lated

mar)et dri%en arran$ement& E%en t"o$" t"is cannot (e called as a flly floatin$

e#c"an$e rate system li)e t"e 0&'&! in t"e Indian scenario it is wor)in$ well& In t"e

crrent system! t"e Reser%e an) of India and its affiliates inter%ene in t"e mar)et

w"ene%er t"ey decide it is necessary&

T"e maor *artici*ants in Indian FX mar)et are t"e (yers! sellers! mar)et mediators and

t"e at"orities& esides t"e contry’s commercial ca*ital Mm(ai! centers for forei$n

e#c"an$e transactions in India inclde Kol)ata! New ?el"i! C"ennai! an$alore!>ondic"erry and Coc"in&

T"e FX mar)et in India is re$lated (y T"e Forei$n E#c"an$e Mana$ement Act! 6LLL or

FEMA! w"ic" re*laced t"e old Forei$n E#c"an$e Re$lation Act! 6L9& Now! t"e

re$lators "a%e introdced se%eral inno%ations to *romote t"e $rowt" of FX mar)et in

India& T"e introdction of crrency ftres in India in 244L was sc" as ste*& T"is "as

$i%en t"e FX mar)et *artici*ants in India a new )ind of financial instrment! w"ic" is

a%aila(le in de%elo*ed mar)ets&

Alt"o$" no one e#*ects t"e transformation of India to a flly mar)et dri%en floatin$

forei$n e#c"an$e system any time soon! t"ere are many *ossi(ilities for frt"er loosenin$

of controls& T"e *ermission for t"e introdction of new FX deri%ati%es followin$ t"e *at"

of crrency ftres is also e#*ected&

Forei$n E#c"an$e Mar)et in India is controlled (y t"e Forei$n E#c"an$e Mana$ement

Act! 6LLL and is ra*idly im*ro%in$& Forei$n E#c"an$e Mar)et in India wor)s nder t"e

central $o%ernment in India and e#ectes wide *owers to control transactions in Forei$n

6<



E#c"an$e&

T"e Forei$n E#c"an$e Mana$ement Act! 6LLL or FEMA re$lates t"e w"ole Forei$n

E#c"an$e Mar)et in India& efore t"is act was introdced! t"e Forei$n E#c"an$e was

re$lated (y t"e reser%e (an) of India t"ro$" t"e E#c"an$e Control ?e*artment! (y t"e

FERA or Forei$n E#c"an$e Re$lation Act! 6L9& After inde*endence! FERA was

introdced as a tem*orary measre to re$late t"e inflow of t"e forei$n ca*ital& t wit"

t"e economic and indstrial de%elo*ment! t"e need for conser%ation of forei$n crrency

was r$ently felt and on t"e recommendation of t"e >(lic Acconts Committee! t"e

Indian $o%ernment *assed t"e Forei$n E#c"an$e Re$lation Act! 6L< and $radally!

t"is act (ecame famos as FEMA&

Forei$n E#c"an$e Mar)et in India! Indian Economy 0ntil 6LL2 all forei$n in%estments in

India and t"e re*atriation of forei$n ca*ital re7ired *re%ios a**ro%al of t"e

$o%ernment& T"e Forei$n E#c"an$e Re$lation Act rarely allowed forei$n maority

"oldin$s for forei$n in India& Howe%er! a new forei$n in%estment *olicy annonced in

5ly 6LL6! declared atomatic a**ro%al for forei$n e#c"an$e in India for t"irtyfor

indstries& T"ese indstries were desi$nated wit" "i$" *riority! * to an e7i%alent limit

of 36 *ercent& T"e Forei$n E#c"an$e Mar)et in India is re$lated (y t"e reser%e (an) of

India t"ro$" t"e e#c"an$e Control ?e*artment&

Initially t"e $o%ernment re7ired t"at a com*any’s rotine a**ro%al mst rely on

identical e#*orts and di%idend re*atriation! (t in May 6LL2 t"is re7irement of Forei$n

E#c"an$e in India was lifted! wit" an e#ce*tion to low*riority sectors& In 6LL9 a forei$n

d nonresident Indian in%estors were *ermitted to re*atriate not only t"eir *rofits (t also

t"eir ca*ital for Forei$n E#c"an$e in India&

Indian e#*orters are enoyin$ t"e freedom to se t"eir e#*ort earnin$s as t"ey find it

sita(le& Howe%er! transfer of ca*ital a(road (y Indian nationals is only allowed in

*articlar circmstances! sc" as emi$ration Indian at"orities are a(le to mana$e t"e

e#c"an$e rate easily! only (ecase forei$n e#c"an$e transactions in India are so secrely

69



controlled& From 6L3 to 6LL2 t"e r*ee was co*led to a tradewei$"ted (as)et of

crrencies& In Fe(rary 6LL2! t"e Indian $o%ernment started to ma)e t"e r*ee

con%erti(le! and in Marc" 6LL< a sin$le floatin$ e#c"an$e rate in t"e Mar)et of Forei$n

E#c"an$e in India was im*lemented& In 5ly 6LL3! Rs <6&6 was wort" 0'16! as

com*ared to Rs & in 6L4! Rs 62&< in 6L3! and Rs6&34 in 6LL4& 'ince t"e onset of

li(erali,ation! Forei$n E#c"an$e Mar)et in India "a%e witnessed e#*losi%e $rowt" in

tradin$ ca*acity& T"e im*ortance of t"e e#c"an$e rate of Forei$n E#c"an$e in India for

t"e Indian economy "as also (een far $reater t"an e%er (efore& ;"ile t"e Indian

$o%ernment "as clearly ado*ted a fle#i(le e#c"an$e rate re$ime! in *ractice t"e r*ee is

one of most resorcefl trac)ers of t"e 0' dollar&

,)r*'$'/)%*s '% (ore'0% ex$h)%0e

6& CU!TOMER!8

63



T"e cstomers w"o are en$a$ed in forei$n trade *artici*ate in % forei$n e#c"an$e

Mar)et (y a%ailin$ of t"e ser%ices of (an)s& E#*orters re7ire con%ertin$ t"e dollars

in to r*ee and im*orters re7ire con%ertin$ r*ee in to t"e dollars! as t"ey "a%e to

*ay in dollars for t"e $oodsJser%ices t"ey "a%e im*orted&

2& COMMERCIA7 8ANK:

T"ey are most acti%e *layers in t"e fore# Mar)et& Commercial (an) dealin$ wit"

international transaction offer ser%ices for con%ersion of one crrency in to anot"er&

T"ey "a%e wide networ) of (ranc"es& Ty*ically (an)s (y forei$n e#c"an$e from

e#*orters and sells forei$n e#c"an$e to t"e im*orters of $oods& As e%ery time t"e

forei$n e#c"an$e (o$"t or o%ersold *osition& T"e (alance amont is sold or (o$"t

from t"e Mar)et&

To/ "9 $2rre%$y *r)ders of o%erall %olme! May 2464 Ran) Name Mar)et '"are

Germany ?etsc"e an) 6&4P

'wit,erland 0' AG 66&<4P

0nited Kin$dom arclays Ca*ital 66&4P

0nited 'tates Citi &LP

0nited Kin$dom Royal an) of

'cotland

&34P

0nited 'tates 5>Mor$an &<3P

0nited Kin$dom H'C 9&33P

'wit,erland Credit 'isse 9&99P

0nited 'tates Goldman 'ac"s 9&2P

6



<& CENTRA7 8ANK :

In all contries Central (an) "a%e (een c"ar$ed wit" t"e res*onsi(ility of maintainin$

t"e e#ternal %ale of t"e domestic crrency& Generally t"is is ac"ie%ed (y t"e

inter%ention of t"e (an)&

# Ex$h)%0e 8ROKER!

Fore# (ro)ers *lay %ery im*ortant role in t"e forei$n e#c"an$e Mar)et& Howe%er t"e

e#tent to w"ic" ser%ices of forei$n (ro)ers are tili,ed de*ends on t"e tradition and

*ractice *re%ailin$ at a *articlar fore# Mar)et center& In India as *er FE?AI $ideline

t"e Ads are free to deal directly amon$ t"emsel%es wit"ot $oin$ t"ro$" (ro)ers& T"e

(ro)ers are not amon$ to allowed to deal in t"eir own accont allo%er t"e world and also

in India&

9& OVER!EA! FOREX :

Mar)et Today t"e daily $lo(al trno%er is estimated to (e more t"an 0' 1 6&3 trillion a

day& T"e international trade "owe%er constittes "ardly 3 to P of t"is total trno%er&

T"e rest of tradin$ in world fore# Mar)et is constitted of financial transaction and

s*eclation&

3& !,ECU7ATOR!:

T"e s*eclators are t"e maor *layers in t"e fore# Mar)et an) dealin$ are t"e maor

s*eclators in t"e fore#¬& Mar)et wit" a %iew to ma)e *rofit on accont of fa%ora(le

mo%ement in e#c"an$e rate! ta)e *osition i&e& if t"ey feel t"at rate of *articlar crrency

is li)ely to $o * in s"ort term& T"ey (y t"at crrency and sell it as Cor*oration’s

*articlarly¬soon as t"ey are a(le to ma)e 7ic) *rofit& Mltinational Cor*oration and

6



transnational cor*oration "a%in$ (siness o*eration (eyond t"eir national frontiers and on

accont of t"eir cas" flows (ein$ lar$e and in mlti crrencies $et in to forei$n e#c"an$e

e#*osres&

;it" a %iew to ma)e ad%anta$e of e#c"an$e rate mo%ement in t"eir fa%or t"ey eit"er

delay co%erin$ e#*osres or do Indi%idal li)e s"are dealin$¬not co%er ntil cas" flow

materiali,e& Also nderta)e t"e acti%ity of (yin$ and sellin$ of forei$n e#c"an$e for

(oo)in$ s"ort term *rofits& T"ey also (y crrency forei$n stoc)s! (onds and ot"er assets

wit"ot co%erin$ t"e forei$n e#c"an$e e#*osre ris)& T"ese also reslt in s*eclations&

I%ves*&e%* &)%)0e&e%* ('r&s

In%estment mana$ement firms .w"o ty*ically mana$e lar$e acconts on (e"alf of

cstomers sc" as *ension fnds and endowments/ se t"e forei$n e#c"an$e Mar)et to

facilitate transactions in forei$n secrities& For e#am*le! an in%estment mana$er (earin$

an international e7ity *ortfolio needs to *rc"ase and sell se%eral *airs of forei$n

crrencies to *ay for forei$n secrities *rc"ases&

'ome in%estment mana$ement firms also "a%e more s*eclati%e s*ecialist crrency

o%erlay o*erations! w"ic" mana$e clientsD crrency e#*osres wit" t"e aim of $eneratin$ *rofits as well as limitin$ ris)& ;"ilst t"e nm(er of t"is ty*e of s*ecialist firms is 7ite

small! many "a%e a lar$e %ale of assets nder mana$ement .A0M/! and "ence can

$enerate lar$e trades&

6



Evol2*'o% o( Reserve M)%)0e&e%* ,ol'$y '% I%d')

India’s a**roac" to reser%e mana$ement! ntil t"e (alance of *ayments crisis of 6LL6 was

essentially (ased on t"e traditional a**roac"! i.e., to maintain an a**ro*riate le%el of

im*ort co%er defined in terms of nm(er of mont"s of im*orts e7i%alent to reser%es& For

e#am*le! t"e Reser%e an)’s Annal Re*ort 6LL4L6 stated t"at t"e im*ort co%er of

reser%es s"ran) to < wee)s of im*orts (y t"e end of ?ecem(er 6LL4! and t"e em*"asis on

im*ort co%er constitted t"e *rimary concern say! till 6LL<L9& T"e a**roac" to reser%emana$ement! as *art of e#c"an$e rate mana$ement! and indeed e#ternal sector *olicy

nderwent a *aradi$m s"ift wit" t"e ado*tion of t"e recommendations of t"e Hi$" :e%el

Committee on alance of >ayments .C"airman8 ?r& C& Ran$araan/& T"e Re*ort! of

w"ic" I "ad t"e *ri%ile$e of (ein$ Mem(er'ecretary! articlated an inte$rated %iew of

t"e isses and made s*ecific recommendations on forei$n crrency reser%es& T"e rele%ant

e#tracts are8

It "as traditionally (een t"e *ractice to %iew t"e le%el of desira(le reser%es as a

*ercenta$e of t"e annal im*orts say reser%es to meet t"ree mont"s im*orts or for

mont"s im*orts& Howe%er! t"is a**roac" wold (e inade7ate w"en a lar$e nm(er of

transactions and *ayment lia(ilities arise in areas ot"er t"an im*ort of commodities&

T"s! lia(ilities may arise eit"er for disc"ar$in$ s"ortterm de(t o(li$ations or ser%icin$

of medimterm de(t! (ot" interest and *rinci*al& T"e Committee recommends t"at w"ile

determinin$ t"e tar$et le%el of reser%e! de attention s"old (e *aid to t"e *ayment

o(li$ations in addition to t"e le%el of im*orts&

In t"e %iew of t"e Committee! t"e factors t"at are to (e ta)en into consideration in

determinin$ t"e desira(le le%el of reser%es are8 t"e need to ensre a reasona(le le%el of

confidence in t"e international financial and tradin$ commnities a(ot t"e ca*acity of

6L



t"e contry to "onor its o(li$ations and maintain trade and financial flowsB t"e need to

ta)e care of t"e seasonal factors in any (alance of *ayments transaction wit" reference to

t"e *ossi(le ncertainties in t"e monsoon conditions of IndiaB t"e amont of forei$n

crrency reser%es re7ired to conter s*eclati%e tendencies or antici*atory actions

amon$st *layers in t"e forei$n e#c"an$e Mar)etB and t"e ca*acity to maintain t"e

reser%es so t"at t"e cost of carryin$ li7idity is minimal&

;it" t"e introdction of Mar)et determined e#c"an$e rate as mentioned in t"e Reser%e

an)’s Annal Re*ort! 6LL3L a c"an$e in t"e a**roac" to reser%e mana$ement was

warranted and t"e em*"asis on im*ort co%er "ad to (e s**lemented wit" t"e o(ecti%e of

smoot"enin$ ot t"e %olatility in t"e e#c"an$e rate! w"ic" "as (een reflecti%e of t"e

nderlyin$ Mar)et condition&

Wh)* 's *he A//ro/r')*e 7evel o( Forex Reserves

asic moti%es for "oldin$ reser%es do reslt in alternati%e framewor)s for determinin$

a**ro*riate le%el of forei$n reser%es& Efforts "a%e (een made (y economists to *resent an

o*timi,in$ framewor) for maintainin$ a**ro*riate le%el of forei$n reser%es and one

%iew*oint s$$ests t"at o*timal reser%es *ertain to t"e le%el at w"ic" mar$inal social cost

e7als mar$inal social (enefit& O*timal le%el of reser%es "as also (een indicated as t"e

le%el w"ere mar$inal *rodcti%ity of reser%es *ls interest earned on reser%e assets e7als

t"e mar$inal *rodcti%ity of real resorces and t"is framewor) encom*asses e#c"an$e

rate sta(ility as t"e *redominant o(ecti%e of reser%e mana$ement& 'ince t"e nderlyin$

costs and (enefits of reser%es can (e measred in se%eral ways! t"ese a**roac"es to

o*timal le%el *ro%ide am*le sco*e for de%elo*in$ a "ost of indicators of a**ro*riate le%el

of reser%es&

It is *ossi(le to identify for sets of indicators to assess ade7acy of reser%es! and eac" of

t"em do *ro%ide an insi$"t into ade7acy t"o$" none of t"em may (y itself flly e#*lain

ade7acy& First! t"e money (ased indicators incldin$ reser%e to (road money or reser%es

to (ase money w"ic" *ro%ide a measre of *otential for resident (ased ca*ital fli$"t from

crrency& An nsta(le demand for money or t"e *resence of a wea) (an)in$ system may

indicate $reater *ro(a(ility of sc" ca*ital fli$"ts& Money (ased indicators! "owe%er!

24



sffer from se%eral draw(ac)s& In contries! w"ere money demands is sta(le and

confidence in domestic crrency "i$"! domestic money demand tends to (e lar$er and

reser%es o%er money ratios! relati%ely small&

T"erefore! w"ile a si,a(le money stoc) in relation to reser%es! prima facie! s$$ests a

lar$e *otential for ca*ital fli$"t ot of money! it is not necessarily a $ood *redictor of

actal ca*ital fli$"t& Money (ased indicators also do not ca*tre com*re"ensi%ely t"e

*otential for domestic ca*ital fli$"t& Moreo%er! em*irical stdies find a wea) relations"i*

(etween money (ased indicator and occrrence and de*t" of international crises&

'econdly! trade (ased indicatorsB sally t"e im*ort(ased indicators defined in terms of

reser%es in mont"s of im*orts *ro%ide a sim*le way of scalin$ t"e le%el of reser%es (y t"e

si,e and o*enness of t"e economy& It "as a strai$"tforward inter*retation a nm(er of

mont"s a contry can contine to s**ort its crrent le%el of im*orts if all ot"er inflows

and otflows cease& As t"e measre focses on crrent accont! it is rele%ant for small

economies! w"ic" "a%e limited access and %lnera(ilities to ca*ital mar)ets& For

s(stantially o*en economies wit" a si,a(le ca*ital accont! t"e im*ort co%er measre

may not (e a**ro*riate&

T"irdly! de(t (ased indicators are of recent ori$inB t"ey a**eared wit" e*isodes of

international crises! as se%eral stdies confirmed t"at reser%es to s"ort term de(t (y

remainin$ matrity is a (etter indicator of identifyin$ financial crises& ?e(t(ased

indicators are sefl for $a$in$ ris)s associated wit" ad%erse de%elo*ments in

international ca*ital mar)ets& 'ince s"ortterm de(t (y remainin$ matrity *ro%ides a

measre of all de(t re*ayments to nonresidents o%er t"e comin$ year! it constittes a

sefl measre of "ow 7ic)ly a contry wold (e forced to adst in t"e face of ca*ital

Mar)et distortion& 'tdies "a%e s"own t"at it cold (e t"e sin$le most im*ortant indicator

of reser%e ade7acy in contries wit" si$nificant (t ncertain access to ca*ital mar)ets&

26



M)%)0e&e%* o( Forex Reserves '% I%d')

In India! le$al *ro%isions $o%ernin$ mana$ement of fore# reser%es are set ot in t"e RI

Act and forei$n e#c"an$e Mana$ement Act! 6LLL and t"ey also $o%ern t"e o*en Mar)et

o*erations for ensrin$ orderly conditions in t"e fore# mar)ets! t"e e#ercise of *owers as

a monetary at"ority and t"e cstodian in re$ard to mana$ement of forei$n e#c"an$e

assets&

In *ractice! "oldin$s of $old "a%e (een %irtally nc"an$ed ot"er t"an occasional sales of

$old (y t"e Go%ernment to t"e Reser%e an)& T"e $old reser%es are mana$ed *assi%ely&

Crrently! accretion to forei$n crrency reser%es arises mainly ot of *rc"ases (y t"e

Reser%e an) from t"e At"ori,ed ?ealers .i.e. o*en Mar)et o*erations/! and to some

e#tent income from de*loyment of fore# assets "eld in t"e *ortfolio of t"e Reser%e an)

.i.e. reser%es! w"ic" are in%ested in a**ro*riate instrments of select crrencies/& T"e

RI Act sti*lates t"e in%estment cate$ories in w"ic" t"e Reser%e an) is *ermitted to

de*loy its reser%es& T"e aid recei*ts on Go%ernment accont also flow into reser%es& T"e

otflow arises mainly on accont of sale of forei$n crrency to At"ori,ed ?ealers .i.e.

for o*en Mar)et o*erations/& T"ere are occasions w"en fore# is made a%aila(le from

reser%es for identified sers! as *art of strate$y of meetin$ lm*y demands on fore#

mar)ets! *articlarly drin$ *eriods of ncertainty& T"e net effect of *rc"ases and sale

of forei$n crrency is t"e most determinin$ one for t"e le%el of fore# reser%es! and t"ese

inclde sc" sale or *rc"ase in forward mar)ets .w"ic" incidentally is %ery small in

ma$nitde/&

T"e essence of *ortfolio mana$ement of reser%es (y t"e Reser%e an) is to ensre safety!

li7idity and o*timi,ation of retrns& T"e reser%e mana$ement strate$ies are continosly

re%iewed (y t"e Reser%e an) in consltation wit" Go%ernment& In de*loyin$ reser%es!

22



attention is *aid to t"e crrency com*osition! dration and instrments& All of t"e forei$n

crrency assets are in%ested in assets of to* 7ality w"ile a $ood *ro*ortion s"old (e

con%erti(le into cas" at s"ort notice& T"e conter*arties wit" w"om deals are condcted

are also s(ect to a ri$oros selection *rocess& In assessin$ t"e retrns from de*loyment!

t"e total retrn .(ot" interest and ca*ital $ains/ is ta)en into consideration& Circmstances

sc" as lm*y demand and s**ly in reser%e accretion are contered t"ro$" a**ro*riate

immni,ation strate$ies in de*loyment& One crcial area in t"e *rocess of in%estment of

t"e forei$n crrency assets in t"e o%erseas mar)ets! relates to t"e ris) in%ol%ed in t"e

*rocess #i$. credit ris)! Mar)et ris) and o*erational ris)& ;"ile t"ere is no set formla to

meet all sitations! t"e Reser%e an) tili,es t"e acce*ted *ortfolio mana$ement

*rinci*les for ris) mana$ement&

2<



REVIEW OF ARTIC7E! ON FOREIGN EXCHANGE

MARKET:

I%d')% Forex - Where does I%d') s*)%d '% Glo4)l Forex M)r.e*

India 'atrday 64 A*ril 2464 T"e daily trno%er of t"e Glo(al Fore# mar)et is *resently

estimated at 0'1 < trillion& >resently t"e Indian Fore# mar)et is t"e 6t" lar$est Fore#

mar)et in t"e world in terms of daily trno%er as t"e I' Triennial 'r%ey re*ort& As *er

t"is re*ort t"e daily trno%er of t"e Indian Fore# mar)et is 0'1 <9 (illion in t"e year244& esides t"e OTC deri%ati%e se$ment of t"e Indian Fore# mar)et "as also increased

si$nificantly since its commencement in t"e year 244& ?rin$ t"e year 2444 t"e daily

trno%er of t"e deri%ati%e se$ment in t"e Indian Fore# mar)et stands at 0'1 9 (illion&

T"e $rowt" of t"e Indian Fore# mar)et owes to t"e tremendos $rowt" of t"e Indian

economy in t"e last few years& Today India "olds a si$nificant *osition in t"e Glo(al

economic scenario and it is considered to (e one of t"e emer$in$ economies in t"e

;orld& T"e steady $rowt" of t"e Indian economy and di%ersification of t"e indstrial

sectors in India "as contri(ted si$nificantly to t"e ra*id $rowt" of t"e Indian Fore#

mar)et& :et s ta)e a watc" on t"e Indian Fore# tradin$ scenario since t"e early days&

T"e Fore# tradin$ "istory of India dates (ac) to 6L! w"en Reser%e an) of India too) a

ste* towards allowin$ t"e (an)s to nderta)e intraday tradin$ in Forei$n e#c"an$e& It is

drin$ t"e *eriod of 6L36LL2 w"en Reser%e an) of India! officially determined t"e

e#c"an$e rate of r*ee accordin$ to t"e wei$"ed (as)et of crrencies wit" t"e si$nificant

(siness *artners of India& t it needs to (e mentioned t"at t"ere are too many

restrictions on t"ese (an)s drin$ t"is *eriod for tradin$ in t"e Fore# mar)et&

29

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T"e introdction of t"e o*en mar)et *olicy in t"e year 6LL6 and im*lementation of t"e

new economic *olicy (y t"e Go%t& of India (ro$"t a com*re"ensi%e c"an$e in t"e Fore#

mar)et of India&

It is drin$ t"e mont" of 5ly 6LL6! t"at t"e r*ee nder$one a two fold downward

adstment and t"is was in line wit" inflation differential to ensre com*etiti%eness in

e#*orts& T"en as *er t"e recommendation of a "i$" le%el committee set * to re%iew t"e

alance of >ayment *osition! t"e :i(erali,ed E#c"an$e Rate Mana$ement 'ystem or t"e

:ERM' was introdced in 6LL2& T"e met"od of dal e#c"an$e rate mec"anism t"at was

*art of t"e :ERM' also came into effect 6LL<& It is drin$ t"is time t"at niform

e#c"an$e rate came into effect and t"at started demand and s**ly controlled e#c"an$e

rate re$ime in Indian& T"is ltimately *ro$ressed towards t"e crrent accontcon%erti(ility t"at was a *art of t"e Articles of A$reement wit" t"e International

Monetary Fnd&

23

foreign exchange market nnn

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