FOREIGN EXCHANGE Introduction

Foreign Exchange, simply stated, means foreign money. Thus, foreign exchange and near money instruments denominated in foreign currency, are called foreign Exchange. In other words, all claims to foreign currency payable abroad, whether consisting of funds held abroad in foreign currency or bill or cheques in foreign currency etc., fall in the category of foreign exchange. In India, foreign exchange has been given a statutory definition: Def: Sec 2(b) of Foreign Exchange Regulation Act, 1973 states: Foreign Exchange means foreign currency and includes: 1. All deposits, credits and balances payable in any foreign currency and any drafts, travelers cheques, letter of credit and bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency 2. Any instruments 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.

The need for Foreign Exchange

An example in this aspect would be apt to understand the need of Foreign Exchange. A Japanese company exports electronic goods to USA and invoices the goods in US Dollars. The American importer will pay the amount in US dollars, as the same is his home currency. However, the Japanese exporter requires Yen i.e. his home currency for procuring raw material locally and making payments for the labour charges incurred for the purpose etc. Thus, he would need exchanging US dollars for Yen. If the Japanese exporter invoices his goods in Yen, then importer in USA will get his dollars converted in Yen and pay the exporter. And therefore, it can be inferred that in case goods are bought or sold outside the country, exchange of currencies becomes necessary.

Foreign Exchange Market

Foreign Exchange market is in fact misnomer or misleading in as much as there is no market place as such which can be called foreign exchange market. However, it is a facilitating mechanism through which one countrys currency can be exchanged i.e. bought or sold for the currency of another country. It does not have any geographic location. The foreign exchange market comprises of all the foreign exchange traders who are connected to each other throughout the world through telecommunication network. They deal with each other through telephones, telexes, and electronic systems. With advent of advanced technology like Reuters Money 2000-2, it is possible to access any trader in any corner of the world within a few seconds. In fact now deal can be done through electronic dealing systems that allow bid and offer rates to be matched automatically through central computers and thus transaction take place in jiffy.

Factors that contribute to the growth of Indian Forex Markets

Global Forex market has taken quantum jump and the Indian market has followed suit. Better communication network like telephones, telexes, SWIFT, Reuters/Telerate system etc., have been made available to the forex dealers and these have contributed to the speed and efficiency of the market. Thus, they are able to generate larger turnover. Rigid and tight exchange controls have been relaxed and the banks are completely free to deal in the inter bank market as also, to some extent, in the overseas market. With opening up of the banking sector to private sector more players have been added to the market. Also, many more foreign banks have set up shops in India and those, which were already operating, have established more branches. This has contributed to higher foreign exchange turnover. Banks have been allowed to have, albeit to a small extent, an access to the foreign currency assets and liabilities. With limited integration of Indian and overseas forex markets, banks have access to the inter bank markets for conversion of forex funds into Indian rupees and re-conversion of the same on a continuous basis has given the fillip in the market. The Liberalised Exchange Rate Management System and freedom given to the corporates to book re-book and cancel forward contracts so long they have the genuine exposure, have also contributed to the increased inter-bank dealings and consequently increase in the trading volume in the foreign exchange markets.

Four Steps in Risk Management

1. Understand the nature of various risks.

2. Define a risk management policy for the organization and quantifying maximum risk that organization is willing to take if quantifiable. 3. Measure the risks if quantifiable and enumerate otherwise. 4. Build internal control mechanism to control and monitor all the risks. Step 1 Understanding Risks Risks can be classified into five categories: 1. Price or Market Risk 2. Counter party or Credit Risk 3. Dealing Risk 4. Settlement Risk 5. Operating Risks 1. Price Risks or Market Risk This is the risk of loss due to change in market prices. Price risk can increase further due to Market Liquidity Risk, which arises when large positions in individual instruments or exposures reach more than a certain percentage of the market, instrument or issue. Such a large position could be potentially illiquid and not be capable of being replaced or hedged out at the current market value and as a result may be assumed to carry extra risk. 2. Counter party Risk or Credit Risk This is the risk of loss due to a default of the Counterpart in honouring its commitment in a transaction (Credit Risk). If the Counterparty is situated in another country, this also involves Country Risk, which is the risk of the Counter party not honouring its commitment because of the restrictions imposed by the government though counter party itself is capable to do so. 3. Dealing Risk Dealing Risk is the sum total of all unsettled transactions due for all dates in future. If the Counter party goes bankrupt on any day, all unsettled transactions would have to be redone in the market at the current rates. The loss would be the difference between the original contract rate and the current rates. Dealing risk is therefore limited to only the movement in the prices and is measured as a percentage of the total exposure. 4. Settlement Risk Settlement risk is the risk of Counterparty defaulting on the day of the settlement. The risk in this case would be 100% of the exposure if the corporate gives value before receiving

value from the Counterparty. In addition the transaction would have to be redone at the current market rates. 5. Operating Risks Operational risk is the risk that the organization may be exposed to financial loss either through human error, misjudgment, negligence and malfeasance, or through uncertainty, misunderstanding and confusion as to responsibility and authority. Further operating risks could be classified as under:

Legal Regulatory Errors & Omissions Frauds Custodial Systems

Legal Legal risk is the risk that the organisation will suffer financial loss either because contracts or individual provisions thereof are unenforceable or inadequately documented, or because the precise relationship with the counter party is unclear. Regulatory Regulatory risk is the risk of doing a transaction, which is not as per the prevailing rules and laws of the country. Errors & Omissions Errors and omissions are not uncommon in financial operations. These may relate to price, amount, value date, currency, and buy/sell side or settlement instructions.

Frauds Some examples of frauds are:

Front running Circular trading Undisclosed Personal trading Insider trading Routing deals to select brokers

Custodial Custodial risk is the loss of prime documents due to theft, fire, water, termites etc. This risk is enhanced when the documents are in transit. Systems Systems risk is due to significant deficiencies in the design or operation of supporting systems; or inability of systems to develop quickly enough to meet rapidly evolving user requirements; or establishment of a great many diverse, incompatible system configurations, which cannot be effectively linked by the automated transmission of data and which require considerable manual intervention. Step 2 - Define Risk Policy Decide the basic risk policy that the organisation wants to have. This may vary from taking no risk (cover all) to taking high risks (open all). Most organisations would fall somewhere in between the two extremes. Risk and reward go hand in hand. Cost Center Vs. Profit Center A cost center approach looks at exposure management as insurance against adverse movements. One is not looking for optimisation of cost or realisation but meeting certain budgeted or targeted rates. In a profit center approach, the business is taking deliberate risks to make money out of price movements. Step 3- Risk Measurement There are a number of different measures of price or market risk which are mainly based on historical and current market values Examples are Value at Risk (VAR), Revaluation, Modeling, Simulation, Stress Testing, Back Testing, etc.

Step 4- Risk Control Control of Price Risk

Position limits are established to control the level of price or market risk taken by the organization. Diversification is used to reduce systematic risk in a given portfolio. Control of Credit Risk Credit limits are established for each counter party for both Dealing Risk and Settlement Risk separately depending upon the risk perception of the counter party. Control of Operating Risk Establishment of an effective and efficient internal control structure over the trading and settlement activities, as well as implementing a timely and accurate Management Information System (MIS). Tools to control operating risks

Comprehensive Systems and Operations Manuals Proper Organizations structure and adequate personnel Separation of trading function from settlement, accounting and risk control functions. Strict enforcement of authority and limits Written confirmation of all verbal dealings Voice recording Legally binding agreements with counter parties ensuring proposed transactions are not ultra vires. Contingency Planning Internal Audits Daily reconciliations Ethical standards and codes of conduct Dealing discipline

Objectives and Extent of FEMA

The Intent of this Act is 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. FEMA extends to the whole of India. It applies to all branches, offices and agencies outside India owned or controlled by a person who is a resident of India and also to any contravention there under committed outside India by any person to whom this Act applies. Except with the general or special permission of the Reserve Bank of India, no person can :

deal in or transfer any foreign exchange or foreign security to any person not being an authorized person; make any payment to or for the credit of any person resident outside India in any manner; receive otherwise through an authorized person, any payment by order or on behalf of any person resident outside India in any manner; reasonable restrictions for current account transactions as may be prescribed.

Any person may sell or draw foreign exchange to or from an authorized person for a capital account transaction. The Reserve Bank may, in consultation with the Central Government, specify :

any class or classes of capital account transactions which are permissible; the limit up to which foreign exchange shall be admissible for such transactions

However, the Reserve Bank cannot impose any restriction on the drawing of foreign exchange for payments due on account of amortization of loans or for depreciation of direct investments in the ordinary course of business. The Reserve Bank can, by regulations, prohibit, restrict or regulate the following :

transfer or issue of any foreign security by a person resident in India; transfer or issue of any security by a person resident outside India; transfer or issue of any security or foreign security by any branch, office or agency in India of a person resident outside India; any borrowing or lending in foreign exchange in whatever form or by whatever name called; any borrowing or tending in rupees in whatever form or by whatever name called between a person resident in India and a person resident outside India; deposits between persons resident in India and persons resident outside India; export, import or holding of currency or currency notes; transfer of immovable property outside India, other than a lease not exceeding five years, by a person resident in India; acquisition or transfer of immovable property in India, other than a lease not exceeding five years, by a person resident outside India;

giving of a guarantee or surety in respect of any debt, obligation or other liability incurred o (i) by a person resident in India and owed to a person resident outside India or o (ii) by a person resident outside India.

A person, resident in India may hold, own, transfer or invest in foreign currency, foreign security or any immovable property situated outside India if such currency, security or property was acquired, held or owned by such person when he was resident outside India or inherited from a person who was resident outside India. A person resident outside India may hold, own, transfer or invest in Indian currency, security or any immovable property situated in India if such currency, security or property was acquired, held or owned by such person when he was resident in India or inherited from a person who was resident in India. The Reserve Bank may, by regulation, prohibit, restrict, or regulate establishment in India of a branch, office or other place of business by a person resident outside India, for carrying on any activity relating to such branch, office or other place of business. Every exporter of goods and services must :

furnish to the Reserve Bank or to such other authority a declaration in such form and in such manner as may be specified, containing true and correct material particulars, including the amount representing the full export value or, if the full export value of the goods is not ascertainable at the time of export, the value which the exporter, having regard to the prevailing market conditions, expects to receive on the sale of the goods in a market outside India; furnish to the Reserve Bank such other information as may be required by the Reserve Bank for the purpose of ensuring the realization of the export proceeds by such exporter.

The Reserve Bank may, for the purpose of ensuring that the full export value of the goods or such reduced value of the goods as the Reserve Bank determines, having regard to the prevailing market-conditions, is received without any delay, direct any exporter to comply with such requirements as it deems fit. Where any amount of foreign exchange is due or has accrued to any person resident in India, such person shall take all reasonable steps to realize and repatriate to India such foreign exchange within such period and in such manner as may be specified by the Reserve Bank. Section 3: Except as provided in the FEMA Act, rules and RBI permission, no person shall: Deal in/ transfer any forex to any person not being an authorized person Make any payment to or for the credit of any non resident Receive otherwise through an authorized person, any payment by order or on behalf of any non resident Enter into any financial transaction in India as consideration for or in association with acquisition or creation or transfer of a right to acquire, any asset outside India by any person

STATUTORY BASIS : Exchange control was introduced in India with the outbreak of second World War on September 3, 1939. This was done by virtual of the emergency powers derived under the financial provisions of the Defence of India Rules. The main purpose was to conserve the non-sterling area currencies and utilise them for essential purposes. India was a part of British Empire, hence, it was basically introduced to boost up the war-efforts of the United Kingdom's Government, When India became independent, she was having large foreign exchange balances held in her favour in London. The UK Government was impovertsheda s a result of the war and freeze the balances. India was in dire need for foreign exchange to meet the developmental requirements of the country, India's sources of foteig11 exchange were limited to exports of a few traditional items oily, such as tea, jute, gunny, etc. The income from exports, even when supplemented by large borrowings from abroad, fell far short of the total requirement. This resulted in huge deficits in her balance of payments. Hence, it became essential to conserve the country's scarce foreign exchange resources. Thus, the foreign exchange control became essential to make the most prudent use of the foreign exchange resources, It wag, therefore, decided to place the control on a statutory basis and the Foreign Exchange Regulation Act of 1947 was enacted. The act, which came into force on March 25, 1947, was valid initially for five years only. In 1952, its life was extended till the end of 1957 and it was finally placed on a permanent basis in 1957. The act empowered the Reserve Bank and in certain cases the Central Government to control and regulate dealings in foreign exchange. This includes payments outside India export and import of currency notes and bullion, transfer of securities between residents and non-residents, acquisition of foreign securities, etc. The act was later replaced by a more comprehensive legislation. The new Foreign Exchange Regulation ct, 1973, came into force on January 1, 1974, while the basic structure of the 1973 act 1s the same as that of 1947 act, certain new provisions have been introduced besides amendment to some of the provisions of the earlier act, The bank has now been vested with additional powers to regulate the exchange process. This includes the investments and the trading, commercial and industrial activities in India of foreign companies (other than banking companies), foreign nationals and non resident individuals; commercial property abroad and the non resident individuals. Commercial and industrial activities abroad by residents have also been brought under the control. Further the FERA 1973 has been substantially, amended by the Foreign Exchange Regulation (Amendment) Act, 1993. It has been again amended by the Finance Act, 1995