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INTRODUCTION

A forex market is a market that facilitates exchange of currencies. The world is emerging as a global
economy because of flow of goods, services and capital. For each transaction of goods and services
there is a corresponding currency transaction, which forms a part of an international network of
payments. This increase in world trade and the lowering of capital controls have led to tremendous
growth in the foreign exchange market over the years. It offers unparalleled personal and financial
freedom to make money as well as lose it in no time. It is described as the fairest market on earth for it
is so large that no one player, not even government can completely control its directions.

The Indian forex market is in its evolving stage, the market is described as thin with few players and
low volumes unlike the global scenario. The main reason for low volumes is the non-convertibility of
rupee on capital account. This research will give insight about the evolution of the Indian forex
market and the importance of forex market in a developing economy like India.

The foreign exchange market has gained a lot of importance in recent years and has become an
essential part of every economy, but there are very few developed foreign exchange markets today.
London is the forex capital of the world today and other are mostly centered around organized
markets like New York, Tokyo, Zurich, honk Kong, Singapore, etc.

India being one of the fastest growing economies of world and its ambition to become a developed
economy by 2020, it needs a developed forex market to back its economy.

No Physical Existence

The stock markets and bond markets of the world have a physical existence. If you wanted to visit the
New York Stock Exchange or the London Stock Exchange, there would be a historic building that you
would end up visiting. However, this is not the case with Forex Markets. Forex Markets do not have
any physical existence. This means that there is no building anywhere in the world where Forex
dealers are located and have designated the place to be the Forex Market.

Instead, the Forex market is made up of money changers all over the world. The market is
interconnected via means of information. Earlier, the information was transmitted manually, now the
information is transmitted via electronic means. Therefore, the currency dealer in your neighborhood
as well as in a far-off place like Mexico City together all constitute the Forex Market. The Forex
market therefore constitutes an interconnected network of buyers and sellers.

Largest Market in the World

The Forex market is by far the largest market in the world. The daily transaction volume in the Forex
market is over $4 trillion. This massive amount of money does not change hands even if we consider
the imports and exports of the entire world for an entire year!

The trading volume in the Forex markets dwarfs the trading volume in all the stock markets of the
world by a huge extent. Also, the trading volume is greater than some of the oldest and most advanced
bond markets in the world. The Forex market is also the oldest financial market in the world which
helps in making it the largest!

24 by 7 Market
The Forex market is the only 24 by 7 market in the world. This means that the market is operational
all the time. This can be contrasted with stock and bond markets which operate for only a few hours
every weekday. In case you want to buy or sell Forex there is always someone somewhere on the
planet that is willing to sell it. If you are trying to sell in the middle of the night in the United States,
maybe a buyer in China is willing to buy! If you are trying to sell your currency on a Sunday, buyers
in the Middle East are transacting because they work on Sundays and have their week offs on Friday!
Therefore, the convenience and flexibility provided by the Forex markets is unparalleled.

Liquidity

The fact that the Forex markets are open 24 by 7 and have the largest trading volume in the entire
world makes it the most liquid financial market. Anyone who wishes to buy or sell their currency
holdings can do so in a matter of seconds with a mouse click and with minimum loss of value. Forex
prices are readily quoted on a real time basis by various individuals and organizations in the world.
Also, since there are so many intermediaries around the world that deal in these currency markets, the
transaction costs for such trades is very low. These trades are carried out on a global scale and are not
restricted by any geography. As such, there is minimal taxation on these trades!

Transparency

Forex markets provide a benchmark for transparency that can be followed by other financial markets.
The trades that happen in these markets are diffused all over the world and are conducted during
different time zones. Yet, the information systems are so well developed that all the information is
available instantly at the click of a button, any time of the day! The data is collated and presented to
the investor to enable them to make informed decisions. Also, since so many individuals and
organizations operate in the Forex market, foul play is nearly impossible. There are government
organizations like Central Banks of various nations which operate in this market and hence one can be
sure that this market works efficiently.

Special about forex market:-


The forex market is special in a number of ways. We cannot designate any physical location where
forex traders get together to exchange currencies. Rather, traders are located in offices of major
commercial banks around the world and communicate using computer terminals, telephones and other
information channels. The international scope of the forex market implies the absence of any central
regulatory authority. Instead the forex market provides an example of private regulation, where
market participants agree on a common set of rules governing transactions and their settlement.
Hence, the forex market is certainly not a chaotic realm of lawlessness. In fact, ethical and
professional standards are essential in an economic environment in which a single verbal agreement
on a telephone can commit millions of dollars or euros.

The forex market differs from other financial markets in a number of respects. First, it is by far the
world’s largest financial market in terms of transaction volume.

The daily transaction volume in all currencies is estimated to amount to $3.98 trillion a day. This is
gigantic even in comparison to a very active equity market like the New York Stock Exchange, which
reaches an average daily volume of approximately US$296 billion a day.
Secondly, the forex market is also a market with extraordinarily low transaction costs. A common
measure to express transaction costs is to calculate quoted spreads as the price difference between a
buy (ask) and a sell (bid) order for a currency rate relative to the mid-price. Such quoted spreads in
the forex inter-bank market can become as low as 0.5 to 1.5 basis points(a basis point is 1% of 1%,
i.e. 0.0001) for the most liquid currency pairs. Quoted spreads inequity markets tend to be 50 times
larger even for the most liquid stocks. These are some of the reasons why the forex market is known
as the fairest market of the world.
Participants in Forex Market:
The participants in the foreign exchange market comprise;

Forex Dealers

Forex dealers are amongst the biggest participants in the Forex market. They are also known as broker
dealers. Most Forex dealers in the world are banks. It is for this reason that the market in which
dealers interact with one another is also known as the interbank market. However, there are some
notable non-bank financial institutions also that deal in foreign exchange.

These dealers participate in the Forex markets by providing bid-ask quotes for currency pairs at all
times. All brokers do not participate in all currency pairs. Rather, they may specialize in a specific
currency pair. Alternatively, a lot of dealers also use their own capital to conduct proprietary trading
operations. When both these operations are combined, Forex dealers have a significant participation in
the Forex market.

Corporates:

The business houses, international investors, and multinational corporations may operate in the
market to meet their genuine trade or investment requirements. They may also buy or sell currencies
with a view to speculate or trade in currencies to the extent permitted by the exchange control
regulations. They operate by placing orders with the commercial banks. The deals between banks and
their clients form the retail segment of foreign exchange market.

In India the foreign Exchange Management (Possession and Retention of Foreign Currency)
Regulations, 2000 permits retention, by resident, of foreign currency up to USD 2,000. Foreign
Currency Management (Realisation, Repatriation and Surrender of Foreign Exchange) Regulations,
2000 requires a resident in India who receives foreign exchange to surrender it to an authorized
dealer:

(a) Within seven days of receipt in case of receipt by way of remuneration, settlement of lawful
obligations, income on assets held abroad, inheritance, settlement or gift: and

(b) Within ninety days in all other cases.

Any person who acquires foreign exchange but could not use it for the purpose or for any other
permitted purpose is required to surrender the unutilized foreign exchange to authorized dealers
within sixty days from the date of acquisition. In case the foreign exchange was acquired for travel
abroad, the unspent foreign exchange should be surrendered within ninety days from the date of return
to India when the foreign exchange is in the form of foreign currency notes and coins and within 180
days in case of travellers cheques.

Similarly, if a resident required foreign exchange for an approved purpose, he should obtain from and
authorized dealer.

Commercial Banks

Commercial Banks are the major players in the market. They buy and sell currencies for their clients.
They may also operate on their own. When a bank enters a market to correct excess or sale or
purchase position in a foreign currency arising from its various deals with its customers, it is said to
do a cover operation. Such transactions constitute hardly 5% of the total transactions done by a large
bank. A major portion of the volume is accounted buy trading in currencies indulged by the bank to
gain from exchange movements. For transactions involving large volumes, banks may deal directly
among themselves. For smaller transactions, the intermediation of foreign exchange brokers may be
sought.

Exchange brokers

Exchange brokers facilitate deal between banks. In the absence of exchange brokers, banks have to
contact each other for quotes. If there are 150 banks at a centre, for obtaining the best quote for a
single currency, a dealer may have to contact 149 banks. Exchange brokers ensure that the most
favorable quotation is obtained and at low cost in terms of time and money. The bank may leave with
the broker the limit up to which and the rate at which it wishes to buy or sell the foreign currency
concerned. From the intends from other banks, the broker will be able to match the requirements of
both. The names of the counter parities are revealed to the banks only when the deal is acceptable to
them. Till then anonymity is maintained.

Exchange brokers tend to specialize in certain exotic currencies, but they also handle all major
currencies. In India, banks may deal directly or through recognized exchange brokers. Accredited
exchange brokers are permitted to contract exchange business on behalf of authorized dealers in
foreign exchange only upon the understanding that they will conform to the rates, rules and conditions
laid down by the FEDAI. All contracts must bear the clause ―subject to the Rules and Regulations of
the Foreign Exchanges Dealers ‗Association of India‘.

Central Bank

Central bank may intervene in the market to influence the exchange rate and change it from that
would result only from private supplies and demands. The central bank may transact in the market on
its own for the above purpose. Or, it may do so on behalf of the government when it buys or sell
bonds and settles other transactions which may involve foreign exchange payments and receipts. In
India, authorized dealers have recourse to Reserve Bank to sell/buy US dollars to the extent the latter
is prepared to transact in the currency at the given point of time. Reserve Bank will not ordinarily
buy/sell any other currency from/to authorized dealers. The contract can be entered into on any
working day of the dealing room of Reserve Bank. No transaction is entered into on Saturdays. The
value date for spot as well as forward delivery should be in conformity with the national and
international practice in this regard. Reserve Bank of India does not enter into the market in the
ordinary course, where the exchages rates are moving in a detrimental way due to speculative forces,
the Reserve Bank may intervene in the market either directly or through the State Bank of India.

Governments

Governments have requirements for foreign currency, such as paying staff salaries and local bills for
embassies abroad, or for arraigning a foreign currency credit line, most often in dollars, for industrial
or agricultural development in the third world, interest on which ,as well as the capital sum, must
periodically be paid. Foreign exchange rates concern governments because changes affect the value of
product and financial instruments, whichaffects the health of a nation’s markets and financial systems.
Banks: There are different types of banks, all of which engage in the foreign exchange market to
greater or lesser extent. Some work to signal desired movement in the market without causing overt
change, while some aggressively manage their reserves by making speculative risks. The vast
majority, however, use their knowledge and expertise is assessing market trends for speculative gain
for their clients

Brokering Houses

These exist primarily to bring buyer and seller together at a mutually agreed price. The broker is not
allowed to take a position and must act purely as a liaison. Brokers receive a commission from both
sides of the transaction, which varies according to currency handled. The use of human brokers has
decreased due mostly to the rise of the interbank electronic brokerage systems

International Monetary Market

The International Monetary Market (IMM) in Chicago trades currencies for relatively small contract
amounts for only four specific maturities a year. Originally designed for the small investor, the IMM
has grown since the early 1970s, and the major banks, who once dismissed the IMM, have found that
it pays to keep in touch with its developments, as it is often a market leader

Money Managers

These tend to be large New York commission houses that are often very aggressive players in the
foreign exchange market. While they act on behalf of their clients, they also deal on their own account
and are not limited to one time zone, but deal around the world through their agents.6. Corporations:
Corporations are the actual end-users of the foreign exchange market. With the exception only of the
central banks, corporate players are the ones who affect supply and demand. Since the corporations
come to the market to offset currency exposure they permanently change the liquidity of the
currencies being dealt with.

Retail Clients

This includes smaller companies, hedge funds, companies specializing in investment services linked
by foreign currency funds or equities, fixed income brokers, the financing of aid programs by
registered worldwide charities and private individuals. Retail investors trade foreign exchange using
highly leveraged margin accounts. The amount of their trading in total volume and in individual trade
amounts is dwarfed by the corporations andinter bank markets. Central Bank External value
of the domestic currency is controlled and assigned by central bank of everycounty. Each country
has a central or apex bank. For example In India Reserve Bank of Indiais the central Bank

Hedgers

There are many businesses which end up creating an asset or a liability priced in foreign currency in
the regular course of their business. For instance, importers and exporters engaged in foreign trade
may have open positions in several foreign currencies. They may therefore be impacted if there is a
fluctuation in the value of foreign currency. As a result, to protect themselves against these losses,
hedgers take opposite positions in the market. Therefore if there is an unfavorable movement in their
original position, it is offset by an opposite movement in their hedged positions. Their profits and
losses and therefore nullified and they get stability in the operations of their business.

Speculators

Speculators are a class of traders that have no genuine requirement for foreign currency. They only
buy and sell these currencies with the hope of making a profit from it. The number of speculators
increases a lot when the market sentiment is high and everyone seems to be making money in the
Forex markets. Speculators usually do not maintain open positions in any currency for a very long
time. Their positions are transient and are only meant to make a short term profit.

Arbitrageurs

Arbitrageurs are traders that take advantage of the price discrepancy in different markets to make a
profit. Arbitrageurs serve an important function in the foreign exchange market. It is their operations
that ensure that a market as large, as decentralized and as diffused as the Forex market functions
efficiently and provides uniform price quotations all over the world. Whenever arbitrageurs find a
price discrepancy in the market, they start buying in one place and selling in another till the
discrepancy disappears.

Other financial institutions involved in the foreign exchange market include:

Stock brokers Commodity

Firms Insurance

Companies Charities

Private Institutions

Private Individual
Functions of foreign exchange market
The foreign exchange market is commonly known as FOREX, a worldwide network, that enables the
exchanges around the globe. The following are the main functions of foreign exchange market,
which are actually the outcome of its working:

Transfer Function: The basic and the most visible function of foreign exchange market is the
transfer of funds (foreign currency) from one country to another for the settlement of payments. It
basically includes the conversion of one currency to another, wherein the role of FOREX is to transfer
the purchasing power from one country to another.

For example, If the exporter of India import goods from the USA and the payment is to be made in
dollars, then the conversion of the rupee to the dollar will be facilitated by FOREX. The transfer
function is performed through a use of credit instruments, such as bank drafts, bills of foreign
exchange, and telephone transfers.

Credit Function: FOREX provides a short-term credit to the importers so as to facilitate the smooth
flow of goods and services from country to country. An importer can use credit to finance the foreign
purchases. Such as an Indian company wants to purchase the machinery from the USA, can pay for
the purchase by issuing a bill of exchange in the foreign exchange market, essentially with a three-
month maturity.

Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange
risks. The parties to the foreign exchange are often afraid of the fluctuations in the exchange rates,
i.e., the price of one currency in terms of another. The change in the exchange rate may result in a
gain or loss to the party concerned.

Thus, due to this reason the FOREX provides the services for hedging the anticipated or actual
claims/liabilities in exchange for the forward contracts. A forward contract is usually a three month
contract to buy or sell the foreign exchange for another currency at a fixed date in the future at a price
agreed upon today. Thus, no money is exchanged at the time of the contract.

There are several dealers in the foreign exchange markets, the most important amongst them are the
banks. The banks have their branches in different countries through which the foreign exchange is
facilitated, such service of a bank are called as Exchange Banks.
Types of Foreign Exchange Rates
 Floating Rates
Floating rates is one of the primary reasons for fluctuation of currency in foreign
exchangemarket. This is one of the most important commonly and main type of exchange
rate. Under this market force all the economies of developed countries allow there currency to
flowfreely. When the value of the currency becomes low it makes the imports more and
theexports are cheaper, so the countries domestic goods and services are demanded more
inforeign buyers. The country can withstand the fluctuation only if the economy is strong.
When the country’s economy is able to meet the demand then it can adjust between the
foreign trade and domestic trade automatically.
 Fixed Rates
Fixed exchange rates are used to attract the foreign investments and to promote foreign
trade.This type of rates is used only by small developed countries. By Fixed exchange rates
thecountry assures the investors for the stable and constant value of investment in the country.
Amonetary policy of the country becomes ineffective. In this type the exchange rates
theimports become expensive. The exchange value of the currency does not move. This
normally reduces the country’s currency against foreign currencies.
 Pegged Rates
This rate is between the floating rate and the fixed rate. Pegged rates appropriate more for
developed country. A country allows its currency to fluctuation to some extend for a
adjustedcentral value. Pegged allow some adjustments and stability. No artificial rates are
found infixed and floating exchange rates. Pegged can fix the economic problem by itself and
provide growth opportunity also. When a fixed value is not maintains by the country it can’t
follow the fixed exchange rate.
Major Currency Pairs in Forex
Market
The Importance of Major Pairs
The Forex market is a place where trading happens in all currencies. However, the volume of trade
that is conducted in different currencies is very different. Hence, even though there are hundreds of
currencies in the world, about two thirds of the massive $4 trillion dollar Forex volume is
transacted in just 4 currency pairs! These 4 pairs are referred to as the major currencies. The
movement in these pairs is the most watched metric in the Forex market and is considered to be the
overall barometer of the market. Therefore when currency experts talk about the Forex market rising
or falling in general, it is these pairs that are being referred to. In this article, we will have a closer
look at the 4 major currency pairs.

The Big 4:

EUR/USD:
The EUR/USD currency pair is the most actively traded currency pair in the world. Almost all the
leading banks in the world have dedicated traders who trade exclusively in EUR/USD. Even though
Euro has only been recently introduced as a currency, it has rose to immense prominence and has
become a part of the most traded currency pair in the world.

It is important to understand that in the EUR/USD pair, Euro is the base currency. This means that all
the contracts pertaining to EUR/USD are denominated in Euros. This can be contrasted with the fact
that the movements in prices as well as the profit and loss calculations are denominated in terms of
the United States Dollar.

Also, since the United States dollar is the more widely accepted and liquid currency amongst the two,
all the margin payments are usually required to be made in terms of USD!

Trading this currency pair has several advantages. One of these advantages is the fact that the spreads
are lowest on this pair. This means that there are minimum transaction costs if you trade the
EUR/USD pair. This lower spread can be attributed to the fact that the EUR/USD pair is the most
liquid currency pair in the world and there are several traders and market makers that are always
offering quotes for this pair.

USD/CHF:
The Swiss Franc is considered to be the safe haven of currencies. The USD/CHF pair therefore falls in
value when the world considers the United States Dollar to be a safe investment. However, when the
dollar appears to be in danger, investors are keen on investing in the Swiss Franc. It must however be
noted that the value of this pair is largely dependent on the capital flows in the Swiss banking system
which is known worldwide for its secrecy! Also, the reputation of Switzerland as a stable country with
sound economic fundamentals adds to the reputation of the Swiss Franc for being a safe haven
amongst currencies.

USD/JPY:
The Japanese Yen, after the United States Dollar and the Euro, is the third most actively traded
currency in the world. As such, the USD/JPY pair is of extreme importance. According to some
estimates, trading in this currency pair single handedly accounts for about 20% of the Forex trade in
the world. Also, one must understand that USD/JPY is an extremely volatile currency pair. It is
notorious for being range bound for a long period of time and then showing sudden fluctuations as it
moves to a new homeostasis at a different price level. This currency pair shows the maximum
sensitivity to changes in the United States interest rate. This is because the Japanese government holds
massive amount of United States debt and any changes in the yield severely affect the cash flow of the
Japanese government.

In this case, the United States Dollar is the base currency. Therefore all contracts pertaining to
USD/JPY are denominated in United States dollar. However, the movements of prices as well as the
profit and loss calculations are denominated in the Japanese Yen.

Once again, since the United States Dollar has unmatched liquidity, margin payments are always
collected in terms of USD.

GBP/USD:
The British economy is amongst the most important economies in the world and the trade
relationships between the Great Britain Pound and the United States Dollar is of prime importance.
This pair is one of the oldest currency pairs that is traded in the market. As such, it has a nickname
and is referred to as the “Sterling”

The Sterling has a massive trading volume and the GBP/USD pair account for about 8% of the trading
volume in the Forex markets. This currency pair is extremely sensitive to news regarding the United
States dollar. Also, it is important to note that this pair has a positive correlation with the EUR/USD
pair. If the EUR/USD pair moves 5% in a certain direction, then the GBP/USD pair will move 8% in
the same direction. At the same time, there is a negative correlation between the GBP/USD pair and
the USD/CHF pair.

These 4 currency pairs also have strong correlations with many other currencies. Therefore if
there is a movement in these currency pairs, it is likely to affect the entire Forex market and
therefore the entire world.
How Are Exchange Rates Determined
?
The Foreign exchange market is far more complicated as compared to stock or bond markets. Predicting the
foreign exchange rate includes predicting the performance of entire economies. There are a multitude of
factors which come into play when exchange rates are being determined. This article lists down and
explains some of the important factors which have a major influence on the exchange rates.

Pricing In The Future Expectations


Foreign Exchange markets are also financial markets. The price reflected in any financial market does not
reflect the price of today. Rather, it reflects the expectations about the future based on the information that we
have on hand today. Therefore, the foremost and important determinant of Forex rates between any two
countries is expectations about the future.

The term “expectations about the future” sounds like a vague and generic term. The next question arises,
“expectations about what?” The remainder of this article will explain the various factors that influence the
exchange rates.

Comparison of Monetary Policy


Exchange rates are basically a comparison between the policies of two countries. It is essential to understand
that exchange rates are not absolute rather they are relative. The following factors are considered amidst many
others while comparing the monetary policies of any two countries.

 Inflation: Exchange rate is basically a ratio between the expected number of units of one currency and
the expected number of units of other currency in the market. Inflation increases the number of
currency units. Therefore, if one currency is facing inflation at the rate of 6% whereas the other is only
facing inflation at the rate of 2%, then the ratio between the two is bound to change. Hence, inflation
rates are a major factor while determining exchange rates. However, the official inflation rates often do
not tell the true picture. Therefore, participants of the market use their own estimates of inflation rate
and come up with their own valuations for currency pairs.
 Interest Rates: When investors hold a certain currency, they get a yield in terms of the interest rate
that is applicable on that currency. Therefore if investors were to hold a currency with a 6% yield as
opposed to a 3% yield, they would end up profiting more! Therefore, the interest rate yields are also
priced into the Forex rates that are quoted in the market. The currency valuations are extremely
subjective to interest rate changes. A small change in this rate brings about a big reaction from the
market participants.

Therefore, Central Banks become extremely important participants in the Forex market since they control the
monetary policy which is one of the biggest determinants of the value of the currency.

Comparison of Fiscal Policy


While monetary policy is controlled by the Central Bank of the country, the fiscal policy is controlled by the
government. This too has important implications because it signals the forthcoming changes in the monetary
policy.

 Public Debt: A large amount of public debt means that the government of a country will have to make
huge interest payments. Investors will analyze whether these payments can be collected from the tax
i.e. from existing money supply. If not, then this signals that the country will monetize its debt i.e. print
more currency and pay off the debt. Since a huge public debt today is a signal of problems coming up
in the future, the Forex market prices this too in the value that is quoted.

However, it needs to be understood that once again there is a relative comparison between the public
debts of the two countries in question. Absolute amounts may not matter as much!

 Budget Deficit: Another major factor which influences the Forex rates is the budget deficit. This is
because a budget deficit is a precursor to public debt. Governments spend more money than they have
and as a result run up a budget deficit. This deficit then has to be financed by debt. The problems
pertaining to public debt and how it impacts the Forex rate have already been discussed in the above
point.

Political Stability
Political stability of the country in question is also of prime importance for Forex rates. This is because modern
monetary system is a system of Fiat money. This means that money is nothing except the promise of the
government. Therefore, if there is a danger to the government, there is a danger that the promise itself may be
worthless once a new government takes over. It is possible that the new government may want to issue a new
currency of its own! Therefore, whenever a country faces a geopolitical turmoil, its currency usually takes a
beating in the Forex markets.

Speculation and Market Sentiment


Lastly, the Forex market is extremely speculative in nature. This is because Forex provides the leverage for
investors to amplify their trade several times using borrowed money and then invest in the markets. Therefore,
sentiments take over the Forex market more than they take over other asset markets because of the availability
of easy money.

Hence, just like all other markets, Forex markets are prone to irrational exuberance and they too can distort
exchange rates in the short term creating long term investment opportunities.

Many other factors like the price of commodities such as gold and oil also play a vital role in the
determination of Forex rates. However, that will be discussed in a later article in this module.
Foreign Exchange Market In India

The foreign exchange market India is growing very rapidly. The annual turnover of the market is
more than $400 billion. This transaction does not include the inter-bank transactions. According to the
record of transactions released by RBI, the average monthly turnover in the merchant segment was
$40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the same period.

The foreign exchange market India is growing very rapidly. The annual turnover of the market is
more than $400 billion. This transaction does not include the inter-bank transactions. According to the
record of transactions released by RBI, the average monthly turnover in the merchant segment was
$40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the same period.

.The average total monthly turnover was about $174.7 billion for the same period. The transactions
are made on spot and also on forward basis, which include currency swaps and interest rate swaps.
The Indian foreign exchange market consists of the buyers, sellers ,market intermediaries and the
monetary authority of India. The main center of foreign exchange transactions in India is Mumbai, the
commercial capital of the country. There are several other centers for foreign exchange transactions in
the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin.

The foreign exchange market India is regulated by the reserve bank of India through the Exchange
Control Department. At the same time, Foreign Exchange Dealers Association(voluntary association)
also provides some help in regulating the market. The

Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate in
the foreign Exchange market in India. When the foreign exchange trade is going on between
Authorized Dealers and RBI or between the Authorized Dealers and the Overseas banks, the brokers
have no role to play.

Apart from the Authorized Dealers and brokers, there are some others who are provided with there
stricted rights to accept the foreign currency or travelers cheque. Among these, there are the
authorized money changers, travel agents, certain hotels and government shops. The IDBI and Exim
bank are also permitted conditionally to hold foreign currency.

The whole foreign exchange market in India is regulated by the Foreign Exchange Management Act,
1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign
Exchange Regulation Act ,1947. After independence, FERA was introduced as a temporary measure
to regulate the inflow of the foreign capital. But with the economic and industrial development, the
need for conservation of foreign currency was felt and on there commendation of the Public Accounts
Committee, the Indian government passed the Foreign Exchange Regulation Act,1973 and gradually,
this act became famous as FEMA
Project Report on the Origin of Foreign Exchange
Market in India:

The foreign exchange market in India started in earliest less than three decades ago when in 1978 the

government allowed banks to trade foreign exchange with one another. Today, over 70% of the

trading in foreign exchange continues to take place in the interbank market.

The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among

themselves and come out “square” or without exposure at the end of the trading day. Trading is

regulated by the Foreign Exchange Dealers’ Association of India (FEDAI), a self-regulatory

association of dealers.

Since 2001, clearing and settlement functions in the foreign exchange market are largely carried out

by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3.5

billion US dollars a day, about 80% of the total transactions.

The movement towards market-determined exchange rates in India began with the official devaluation

of the rupee in July 1991. In March 1992, a dual exchange rate system was introduced in the form of

the Liberalised Exchange Rate Management System (LERMS).

Under this system, all foreign exchange receipts on current account transactions were required to be

submitted to the Authorised dealers of foreign exchange in full, who in turn would surrender to RBI

40% of their purchases of foreign currencies at the official exchange rate announced by RBI. The

balance 60% could be retained for sale in the free market.

As the exchange rate aligned itself with market forces, the Re/$ rate depreciated steadily from 25.83

in March 1992 to 32.65 in February 1993. The LERMS as a system in transition performed well in

terms of creating the conditions for transferring an augmented volume of foreign exchange

transactions onto the market. Consequently, in March 1993, India moved from the earlier dual

exchange rate regime to a single, market determined exchange rate system.


The dual exchange rate system was replaced by a unified exchange rate system in March 1993,

whereby all foreign exchange receipts could be converted at market-determined exchange rates. On

unification of the exchange rates, the nominal exchange rate of the rupee against both the US dollar as

also against a basket of currencies got adjusted lower, which almost nullified the impact of the

previous inflation differential.

The restrictions on a number of other current account transactions were relaxed. The unification of the

exchange rate of the Indian rupee was an important step towards current account convertibility, which

was finally achieved in August 1994, when India accepted obligations under Article VIII of the

Articles of Agreement of the IMF.


Foreign Exchange Dealers’ Association of India (FEDAI)

Foreign Exchange Dealers’ Association of India (FEDAI) was set up in 1958 as an association of

banks dealing in foreign exchange in India (typically called Authorised Dealers – ADs) as a self-

regulatory body and is incorporated under Section 25 of The Companies Act, 1956.

Its major activities include framing of rules governing the conduct of interbank foreign exchange

business among banks vis-a-vis public and liaison with RBI for reforms and development of forex

market.

Major functions of FEDAI include:

1. Guidelines and Rules for Forex Business.

2. Training of Bank Personnel in the areas of Foreign Exchange Business.

3. Accreditation of Forex Brokers.

4. Advising/Assisting member banks in settling issues/matters in their dealings.

5. Represent member banks on Government/Reserve Bank of India/Other Bodies.

6. Announcement of daily and periodical rates to member banks.

Due to continuing integration of the global financial markets and increased pace of deregulation, the

role of self-regulatory organisations like FEDAI plays a catalytic role for smooth functioning of the

markets through closer coordination with the RBI, other organisations like FIMMDA, the Forex

Association of India and various market participants.

FEDAI also maximizes the benefits derived from synergies of member banks through innovation in

areas like new customised products, benchmarking against international standards on accounting,

market practices, risk management systems, etc.


During 2003-04, the average monthly turnover in the Indian foreign exchange market touched about

175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars

for all cash, derivatives and debt instruments put together in the country, and the sheer size of the

foreign exchange market becomes evident.

Since then, the foreign exchange market activity has more than doubled with the average monthly

turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay

Stock Exchange. As in the rest of the world, in India too, foreign exchange constitutes the largest

financial market by far.

Liberalisation has radically changed India’s foreign exchange sector. Indeed, the liberalisation process

itself was sparked by a severe Balance of Payments and foreign exchange crisis. Since 1991, the rigid,

four-decade old, fixed exchange rate system replete with severe import and foreign exchange controls

and a thriving black market is being replaced with a less regulated, “market-driven” arrangement.

While the rupee is still far from being “fully floating” (many studies indicate that the effective

pegging is no less marked after the reforms than before), the nature of intervention and range of

independence tolerated have both undergone significant changes.

With an overabundance of foreign exchange reserves, imports are no longer viewed with fear and

skepticism. The Reserve Bank of India and its allies now intervene occasionally in the foreign

exchange markets not always to support the rupee but often to avoid an appreciation in its value. Full

convertibility of the rupee is clearly visible in the horizon.

The effects of these developments are palpable in the explosive growth in the foreign exchange

market in India.

Liberalisation and Indian Forex Market:

The liberalisation process has significantly boosted the foreign exchange market in the country by

allowing both banks and corporations greater flexibility in holding and trading foreign currencies. The

Sodhani Committee set up in 1994 recommended greater freedom to participating banks, allowing
them to fix their own trading limits, interest rates on FCNR deposits and the use of derivative

products.

The growth of the foreign exchange market in the last few years has been nothing less than

momentous. In the last 5 years, from 2000-01 to 2005-06, trading volume in the foreign exchange

market (including swaps, forwards and forward cancellations) has more than tripled, growing at a

compounded annual rate exceeding 25%.

The interbank forex trading volume has continued to account for the dominant share (over 77%) of

total trading over this period, though there is an unmistakable downward trend in that proportion.

(Part of this dominance, though, result s from double-counting since purchase and sales are added

separately, and a single interbank transaction leads to a purchase as well as a sales entry.) This is in

keeping with global patterns.

In March 2006, about half (48%) of the transactions were spot trades, while swap transactions

(essentially repurchase agreements with a one-way transaction – spot or forward – combined with a

longer-horizon forward transaction in the reverse direction) accounted for 34% and forwards and

forward cancellations made up 11% and 7% respectively. About two-thirds of all transactions had the

rupee on one side.

In 2004, according to the triennial central bank survey of foreign exchange and derivative markets

conducted by the Bank for International Settlements (BIS (2005a), the Indian Rupee featured in the

20th position among all currencies in terms of being on one side of all foreign transactions around the

globe and its share had tripled since 1998.

As a host of foreign exchange trading activity, India ranked 23rd among all countries covered by the

BIS survey in 2004 accounting for 0.3% of the world turnover. Trading is relatively moderately

concentrated in India with 11 banks accounting for over 75% of the trades covered by the BIS 2004

survey.

Liberalisation has transformed India’s external sector and a direct beneficiary of this has been the

foreign exchange market in India. From a foreign exchange-starved, control-ridden economy, India
has moved on to a position of $150 billion plus in international reserves with a confident rupee and

drastically reduced foreign exchange control.

As foreign trade and cross-border capital flows continue to grow, and the country moves towards

capital account convertibility, the foreign exchange market is poised to play an even greater role in the

economy, but is unlikely to be completely free of RBI interventions any time soon.
Foreign exchange Management Act (FEMA)
The Government of India formulated FEMA or Foreign Exchange Management
Act to encourage the external payments and across the border trades in India. It was
formulated in the year 1999 while it replaced FERA (Foreign Exchange Regulation
Act). This was meant to close all the loopholes and drawback of FERA and hence
major economic reforms were introduced under this act. It was primarily formulated
to de-regularize and have liberal Indian economy.

Objectives of FEMA:
The main objective of FEMA was to help facilitate external trade and payments in
India. It was also meant to help orderly development and maintenance of foreign
exchange market in India. It defines the procedures, formalities, dealings of all
foreignexchange transactions in India. These transactions are mainly classified under
two categories -- Current Account Transactions and Capital Account Transactions.
FEMA is applicable to all parts of India and was primarily formulated to utilize the
foreign exchange resources in efficient manner. It is also equally applicable to the
offices and agencies which are located outside India however is managed or owned
by an Indian Citizen. FEMA head office is known as Enforcement Directorate and is
situated in heart of city of Delhi.

Applicability of FEMA Act:


 exports of any foods and services from India to outside, foreign currency, that is
any currency other than Indian currency,
 foreign exchange,
 foreign security,
 Imports of goods and services from outside India to India,
 securities as defined in Public Debt Act 1994,
 banking, financial and insurance services,
 sale, purchase and exchange of any kind (i.e. Transfer),
 any overseas company that is owned 60% or more by an NRI (Non Resident
Indian) and
 any citizen of India, residing in the country or outside (NRI)

Major Provisions of FEMA Act 1999:


Here are major provisions that are part of FEMA (1999) –
 Free transactions on current account subject to reasonable restrictions that may be
imposed.
 RBI controls over capital account transactions.
 Control over realization of export proceeds.
 Dealing in foreign exchange through authorized persons like authorized dealer or
money changer etc.
 Appeal provision including Special Director (Appeals)
 Directorate of enforcement
 Any person can sell or withdraw foreign exchange, without any prior permission
from RBI and then can inform RBI later.
 Enforcement Directorate will be more investigative in nature
 FEMA recognized the possibility of Capital Account convertibility.
 The violation of FEMA is a civil offence.
 FEMA is more concerned with the management rather than regulations or control.
 FEMA is regulatory mechanism that enables RBI and Central Government to pass
regulations and rules relating to foreign exchange in tune with foreign trade policy
of India.

Following are the main features of Foreign Exchange


Management Act, 1999:
1. FEMA gives power to the central government for imposing restriction on activities
like making payments to a person situated outside of the country or receiving money
through them. Apart from this, foreign exchange as well as foreign security deals is
also restricted by FEMA.

2. Transactions revolving around foreign security or foreign exchange as well as


payments made from any foreign country to India cannot be made without specific or
general permission of FEMA. All transactions must be carried out via an individual
who has received authorization for the same.

3. The central government can restrict an authorized individual to carry out foreign
exchange deals within the current account, on the basis of general interest of the
public.

4. Even though drawing or selling of foreign exchange is carried out via an authorized
individual, the FEMA actempowers the Reserve Bank of India to place a number of
restrictions on the transactions of the capital account.

5. Under the act, the Indian residents have the permission to conduct foreign
exchange and foreign security transactions or the right to hold or own immovable
property in a foreign country in case the security, property or currency was acquired
or owned when the individual was based outside of the country, or when they inherit
the property from another individual staying outside the country.

6. The act is not applicable on the resident (of an Indian citizen) based outside the
country.
Conclusion:
As per Section 3 of FEMA, all the current account transactions are free; however
central government at any time could impose reasonable instructions by issuing
special rules. As per Section 6 of FEMA, Capital Account Transactions are permitted
only to the extent as specified by RBI in its issued regulations. As per Section 10 of
FEMA, RBI have controlling role in its management however RBI cannot directly
handle foreign exchange transaction and must authorize a person to deal with it as
per directions set by RBI. FEMA also have provisions of various enforcement,
penalties, adjudication and appeals in this area.
Transactions in the foreign Exchange Market
A very brief account of certain important types of transactions conducted in the foreign exchange
market is given below Spot and Forward Exchanges

Spot Market The term spot exchange refers to the class of foreign exchange transaction which
requires the immediate delivery or exchange of currencies on the spot. In practice the settlement takes
place within two days in most markets. The rate of exchange effective for the spot transaction is
known as the spot rate and the market for such transactions is known as the spot market.

Forward Market The forward transactions is an agreement between two parties, requiring the delivery
at some specified future date of a specified amount of foreign currency by one of the parties, against
payment in domestic currency be the other party, at the price agreed upon in the contract. The rate of
exchange applicable to the forward contract is called the forward exchange rate and the market for
forward transactions is known as the forward market.

The foreign exchange regulations of various countries generally regulate the forward exchange
transactions with a view to curbing speculation in the foreign exchanges market. In India, for
example, commercial banks are permitted to offer forward cover only with respect to genuine export
and import transactions.

Forward exchange facilities, obviously, are of immense help to exporters and importers as they can
cover the risks arising out of exchange rate fluctuations be entering into an appropriate forward
exchange contract. With reference to its relationship with spot rate, the forward rate may be at par,
discount or premium.
If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making the
contract the forward exchange rate is said to be at par.
The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot rate
when one dollar buys more units of another currency,say rupee, in the forward than in the spot rate on
a per annum basis.
The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate
when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually
expressed as a percentage deviation from the spot rate on a per annum basis.
The forward exchange rate is determined mostly be the demand for and supply of forward exchange.
Naturally when the demand for forward exchange exceeds its supply, the forward rate will be quoted
at a premium and conversely, when the supply of forward exchange exceeds the demand for it, the
rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange,
the forward rate will tend to be at par.

Futures

While a focus contract is similar to a forward contract, there are several differences between them.
While a forward contract is tailor made for the client be his international bank, a future contract has
standardized features the contract size and maturity dates are standardized. Futures cab traded only on
an organized exchange and they are traded competitively. Margins are not required in respect of a
forward contract but margins are required of all participants in the futures market an initial margin
must be deposited into a collateral account to establish a futures position.

Options
While the forward or futures contract protects the purchaser of the contract from the adverse exchange
rate movements, it eliminates the possibility of gaining a windfall profit from favorable exchange rate
movement.

An option is a contract or financial instrument that gives holder the right, but not the obligation, to sell
or buy a given quantity of an asset as a specified price at a specified future date. An option to buy the
underlying asset is known as a call option and an option to sell the underlying asset is known as a put
option. Buying or selling the underlying asset via the option is known as exercising the option. The
stated price paid (or received) is known as the exercise or striking price. The buyer of an option is
known as the long and the seller of an option is known as the writer of the option, or the short. The
price for the option is known as premium.

Types of options: With reference to their exercise characteristics, there are two types of options,
American and European. A European option cab is exercised only at the maturity or expiration date of
the contract, whereas an American option can be exercised at any time during the contract.

Swap operation

Commercial banks who conduct forward exchange business may resort to a swap operation to adjust
their fund position. The term swap means simultaneous sale of spot currency for the forward purchase
of the same currency or the purchase of spot for the forward sale of the same currency. The spot is
swapped against forward. Operations consisting of a simultaneous sale or purchase of spot currency
accompanies by a purchase or sale, respectively of the same currency for forward delivery are
technically known as swaps or double deals as the spot currency is swapped against forward.

Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with intention of making profits
from the difference between the exchange rate prevailing at the same time in different markets

Forward Contract
Forward contracts are typical OTC derivatives. As the name itself suggests, forward are transactions
involving delivery of an asset or a financial instrument at a future date. One of the first modern to
arrive contracts as forward contracts ere known was agreed at Chicago Boar of Trade in March 1851
for maize corn to be delivered in June of that year.

Characteristics of forward contracts

The main characteristics of forward contracts are given below;

They are OTC contracts

Both the buyer and seller are committed to the contract. In other words, they have to take deliver and
deliver respectively, the underlying asset on which the forward contract was entered into. As such,
they do not have the discretion as regards completion of the contract.

Forwards are price fixing in nature. Both the buyer and seller of a forward contract are fixed to the
price decided upfront.

Due to the above two reasons, the pay off profiles of the borrower and seller, in a forward contract,
are linear to the price of the underlying.
The presence of credit risk in forward contracts makes parties wary of each other. Consequently
forward contracts are entered into between parties who have good credit standing. Hence forward
contracts are not available to the common man.

Determining Forward Prices

In principle, the forward price for an asset would be equal to the spot or the case price at the time of
the transaction and the cost of carry. The cost of carry includes all the costs to be incurred for carrying
the asset forward in time.
Depending upon the type of asset or commodity, the cost of carry takes into account the payments and
receipts for storage, transport costs, interest payments, dividend receipts, capital appreciation etc.
Thus
Forward price = Spot or the Cash Price + Cost of Carry

Merchant Rate

The foreign exchange dealing of a bank with its customer is known as ‘merchant business’ and the
exchange rate at which the transaction takes place is the merchant rate. The merchant business in
which the contract with the customer to buy or sell foreign exchange is agreed to and executed on the
same day is known as ready transaction or cash transaction. As in the case of interbank transactions a
value next day contract is deliverable on the next business day and a ‘spot contract’ is deliverable on
the second succeeding business day following the date of the contract. Most of the transactions with
customers are on ready basis. In practice, the term ‘ready’ and ‘spot’ are used synonymously to refer
to transactions concluded and executed on the same day.

Foreign Exchange Transactions

Foreign exchange dealing is a business in which foreign currency is the commodity. It was seen
earlier that foreign currency is not a legal tender. The US dollar cannot be used for settlement of debts
in India; nevertheless, it has value. The value of US dollar is like the value of any other commodity.
Therefore, the foreign currency can be considered as the commodity in foreign exchange dealings.

Purchase and Sale transactions

Any trading has two aspects Purchase and sale. A trader has to purchase goods from his suppliers
which he sells to his customers. Likewise the bank (which is authorized to deal in foreign exchange)
purchases as well as sells its commodity the foreign currency.
Two points need be constantly kept in mind while talking of a foreign exchange transaction:

The transaction is always talked of from the banks point of view

The item referred to is the foreign currency.

Therefore when we say a purchase we implied that

the bank has purchased

it has purchased foreign currency

Similarly, when we sale a sale, we imply that

the bank has sold


it has sold foreign currency.

In a purchase transaction the bank acquired foreign currency and parts with home currency.
In a sale transaction the bank parts with foreign currency and acquires home currency.

Exchange Quotations

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

direct quotation

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 Rs.48 may be quoted at Rs 46 or Rs.49 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.
Factors affecting Movement of Exchange Rates
Aside from factors such as interest rates and inflation ,exchange rate is one of the most important
determinants of a country's relative level of economic health. Exchange rates play a vital role in a
country's level of trade, which is critical to every free market economy in the world. For this reason,
exchange rates are among the most watched ,analyzed and governmentally manipulated economic
measures. But exchange rates matter on a smaller scale as well: they impact the real return of an
investor's portfolio. Here we look at some of the major forces behind exchange rate movements.
Before we look at these forces, we should sketch out how exchange rate movements affect a nation's
trading relationships with other nations. A higher currency makes a country's exports more expensive
and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its
imports more expensive in foreign markets. A higher exchange rate can be expected to lower the
country's balance of trade, while a lower exchange rate would increase it. Numerous factors determine
exchange rates, and all are related to the trading relationship between two countries. Remember,
exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The
following are some of the principal determinants of the exchange rate between two countries. Note
that these factors are in no particular order; like many aspects of economics ,the relative importance of
these factors is subject to much debate.

Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as
its purchasing power increases relative to other currencies. During the last half of the twentieth
century, the countries with low inflation included Japan ,Germany and Switzerland, while the U.S.
and Canada achieved low inflation only later. Those countries with higher inflation typically see
depreciation in their currency in relation to the currencies of their trading partners. This is also usually
accompanied by higher interest rates. .

Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates,
central banks exert influence over both inflation and exchange rates, and changing interest rates
impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the
country is much higher than in others, or if additional factors serve to drive the currency down. The
opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease
exchange rates.

Current-Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all
payments between countries for goods, services, interest and dividends. A deficit in the current
account shows the country is spending more on foreign trade than it is earning, and that it is
borrowing capital from foreign sources to make up the deficit. In other words, the country requires
more foreign currency than it receives through sales of exports, and it supplies more of its own
currency than foreigners demand for its products. The excess demand for foreign currency lowers the
country's exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector project sand
governmental funding. While such activity stimulates the domestic economy ,nations with large
public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages
inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real
dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but increasing
the money supply inevitably causes inflation. Moreover, if a government is not able to service its
deficit through domestic means (selling domestic bonds, increasing the money supply), then it must
increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large
debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations.
Foreigners will be less willing to own securities denominated in that currency if the risk of default is
great. For this reason, the country's debt rating (as determined by Moody's or Standard& Poor's, for
example) is a crucial determinant of its exchange rate

Terms of Trade

Trade of goods and services between countries is the major reason for the demand and supply of
foreign currencies. A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports rises by a greater rate
than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows
greater demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If the
price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners. This is a typical case for underdeveloped countries which rely on
imports for development needs. The current account balance(deficit or surplus) thus reflects the
strength and weakness of the domestic currency. 6. Fundamental Factors viz. Political Stability and
Economic Performance Fundamental factors include all such events that affect the basic economic
and fiscal policies of the concerned government. These factors normally affect the long-term
exchange rates of any currency. On short-term basis on many occasions, these factors are found to be
rather inactive unless the market attention has turned to fundamentals. However, in the long run
exchange rates of all the currencies are linked to fundamental causes. The fundamental factors are
basic economic policies followed by the government in relation to inflation, balance of payment
position, unemployment ,capacity utilization, trends in import and export, etc. Normally, other things
remaining constant the currencies of the countries that follow the sound economic policies will always
be stronger. Similar for the countries which are having balance of payment surplus, the exchange rate
will always be favourable. Conversely, for countries facing balance of payment deficit, the exchange
rate will be adverse. Continuous and ever growing deficit in balance of payment indicates over
valuation of the currency concerned and the dis-equilibrium created can be remedied through
devaluation. Foreign investors inevitably seek out stable countries with strong economic performance
in which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil, for
example, can cause a loss of confidence in a currency and a movement of capital to the currencies of
more stable countries.

Political and Psychological factors

Political and psychological factors are believed to have an influence on exchange rates.Many
currencies have a tradition of behaving in a particular way for e.g. Swiss Franc asa refuge currency.
The US Dollar is also considered a safer haven currency whenever there is a political crisis anywhere
in the world.

Speculation

Speculation or the anticipation of the market participants many a times is the prime reason for
exchange rate movements. The total foreign exchange turnover worldwide is many times the actual
goods and services related turnover indicating the grip of speculators over the market. Those
speculators anticipate the events even before the actual data is out and position themselves
accordingly in order to take advantage when the actual data confirms the anticipations. The initial
positioning and final profit taking make exchange rates volatile. These speculators many times
concentrate only on one factor affecting the exchange rate and as a result the market psychology tends
to concentrate only on that factor neglecting all other factors that have equal bearing on the exchange
rate movement. Under these circumstances even when all other factors may indicate negative impact
on the exchange rate of the currency if the one factor that the market is concentrating comes out
positive the currency strengthens.

Capital Movement

The phenomenon of capital movement affecting the exchange rate has a very recent origin. Huge
surplus of petroleum exporting countries due to sudden spurt in the oil prices could not be utilized by
these countries for home consumption entirely and needed to be invested elsewhere productively.
Movement of these petro dollars, started affecting the exchange rates of various currencies. Capital
tended to move from lower yielding to higher yielding currencies and as a result the exchange rates
moved. International investments in the form of Foreign direct investment (FDI) and Foreign
institutional investments (FII) have become the most important factors affecting the exchange rate in
today’s open world economy. Countries which attract large capital inflows through foreign
investments, will witness an appreciation in its domestic currency as its demand rises. Outflow of
capital would mean a depreciation of domestic currency.

Intervention

Exchange rates are also influenced in no small measure by expectation of changes in regulation
relating to exchange markets and official intervention. Official intervention can smoothen an
otherwise disorderly market but it is also the experience that if the authorities attempt halfheartedly to
counter the market sentiments through intervention in the market, ultimately more steep and sudden
exchange rate swings can occur. In the second quarter of 1985 the movement of exchange rates of
major currencies reflected the change in the US policy in favour of coordinated exchange market
intervention as a measure to bring down the value of dollar.

Stock Exchange Operations

Stock exchange operations in foreign securities, debentures, stocks and shares, influence the demand
and supply of related currencies, thus influencing their exchange rate.
Political Factors

Political scenario of the country ultimately decides the strength of the country. Stable efficient
government at the centre will encourage positive development in the country, creating successful
investor confidence and a good image in the international market. An economy with a strong, positive
image will obviously have a strong domestic currency. This is the reason why speculations rise
considerably during the parliament elections, with various predictions of the future government and
its policies. In 1998,the Indian rupee depreciated against the dollar due to the American sanctions
after India conducted the Pokharan nuclear test

Others

The turnover of the market is not entirely trade related and hence the funds placed at the disposal of
foreign exchange dealers by various banks, the amount which the dealers can raise in various ways,
banks' attitude towards keeping open position during the course of a day, at the end of the day, on the
eve of weekends and holidays ,window dressing operations as at the end of the half year to year, end
of the month considerations to cover operations for the returns that the banks have to submit the
central monetary authorities etc. - all affect the exchange rate movement of the currencies. Value of a
currency is thus not a simple result of its demand and supply, but a complex mix of multiple factors
influencing the demand and supply.

It’s a tight rope walk for any country to maintain a strong, stable currency, with policies taking care of
conflicting demands like inflation and export promotion, welcoming foreign investments and avoiding
an appreciation of the domestic currency, all at the same time.
Risk Management and Settlement of Transactions in the Foreign Exchange Market

 The foreign exchange market is characterized by constant changesand rapid innovations


in trading methods and products. While theinnovative products and ways of trading create
new possibilities for profit, they also pose various kinds of risks to the market. Central banks
all over the world, therefore, have become increasinglyconcerned of the scale of foreign
exchange settlement risk and theimportance of risk mitigation measures. Behind
this growingawareness are several events in the past in which foreign exchangesettlement risk
might have resulted in systemic risk in globalfinancial markets, including the failure
of Bankhaus Herstatt in1974 and the closure of BCCI SA in 1991.
 The foreign exchange settlement risk arises because the delivery of the two currencies
involved in a trade usually occurs in twodifferent countries, which, in many cases are located
in differenttime zones. This risk is of particular concern to the central banksgiven the large
values involved in settling foreign exchangetransactions and the resulting potential
for systemic risk. Most of the banks in the EMEs use some form of methodology
for measuring the foreign exchange settlement exposure. Many of these banks use the single
day method, in which the exposure ismeasured as being equal to all foreign exchange receipts
that aredue on the day. Some institutions use a multiple day approach for measuring risk. Most of the banks in
EMEs use some form of individual counterparty limit to manage their exposures. Theselimits are
often applied to the global operations of the institution.These limits are sometimes monitored
by banks on a regular basis.In certain cases, there are separate limits for foreign
exchangesettlement exposures, while in other cases, limits for aggregatesettlement exposures
are created through a range of instruments.Bilateral obligation netting, in jurisdictions where
it is legallycertain, is an important way for trade counterparties to mitigate theforeign
exchange settlement risk. This process allows tradecounterparties to offset their gross
settlement obligations to each other in the currencies they have traded and settle these
obligationswith the payment of a single net amount in each currency.

 Several emerging markets in recent years have implementeddomestic real time gross settlement
(RTGS) systems for thesettlement of high value and time critical payments to settle thedomestic
leg of foreign exchange transactions. Apart from risk reduction, these initiatives enable
participants to actively managethe time at which they irrevocably pay way when selling
thedomestic currency, and reconcile final receipt when purchasing thedomestic currency.
Participants, therefore, are able to reduce theduration of the foreign exchange settlement risk.

 Recognizing the systemic impact of foreign exchange settlementrisk, an important element


in the infrastructure for the efficientfunctioning of the Indian foreign exchange market has
been theclearing and settlement of inter-bank USD-INR transactions. In pursuance of
the recommendations of the Sodhani Committee, theReserve Bank had set up the Clearing
Corporation of India Ltd.(CCIL) in 2001 to mitigate risks in the Indian financial markets.The
CCIL commenced settlement of foreign exchange operationsfor inter-bank USD-INR spot
and forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom trades
fromFebruary 5, 2004. The CCIL undertakes settlement of foreignexchange trades on a multilateral net
basis through a process of notation and all spot, cash and tom transactions are guaranteed
for settlement from the trade date. Every eligible foreign exchangecontract entered between
members gets notated or replaced by twonew contracts – between the CCIL and each of
the two parties,respectively. Following the multilateral netting procedure, the netamount
payable to, or receivable from, the CCIL in each currencyis arrived at, member-wise. The
Rupee leg is settled through themembers’ current accounts with the Reserve Bank and the USD leg
through CCIL’s account with the settlement bank at New York. TheCCIL sets limits for each member
bank on the basis of certain parameters such as member’s credit rating, net worth,
asset valueand management quality. The CCIL settled over 900,000 deals for a gross volume of US
$ 1,180 billion in 2005-06. The CCIL hasconsistently endeavoured the entire gamut of foreign
exchangetransactions under its purview. Intermediation, by the CCIL thus, provides its members the
benefits of risk mitigation, improvedefficiency, lower operational cost and easier
reconciliation of accounts with correspondents.

 An issue related to the guaranteed settlement of transactions by theCCIL has been the
extension of this facility to all forward trades aswell. Member banks currently encounter
problems in terms of hugeoutstanding foreign exchange exposures in their books and
thiscomes in the way of their doing more trades in the market. Riskson such huge outstanding
trades were found to be very high and sowere the capital requirements for supporting such
trades. Hence,many member banks have expressed their desire in several forathat the CCIL
should extend its guarantee to these forward tradesfrom the trade date itself which could
lead to significant increase inthe liquidity and depth in the forward market. The risks that
bankstoday carry in their books on account of large outstanding forward positions will also
be significantly reduced (Gopinath, 2005). Thishas also been one of the recommendations of
the Committee onFuller Capital Account Convertibility.

 Apart from managing the foreign exchange settlement risk, participants also need to manage
market risk, liquidity risk, creditrisk and operational risk efficiently to avoid future losses. As
per the guidelines framed by the Reserve Bank for banks to aligns andexposure in derivative
markets as market makers, the boards of directors of ADs (category-I) are required to frame
an appropriate policy and fix suitable limits for operations in the foreign exchangemarket.
The net overnight open exchange position and theaggregate gap limits need to be approved by
the Reserve Bank. Theopen position is generally measured separately for
each foreigncurrency consisting of the net spot position, the net forward position, and the net
options position. Various limits for exposure,viz., overnight, daylight, stop loss, gap limit, credit
limit, value atrisk (VaR), etc., for foreign exchange transactions by banks arefixed. Within the contour of these
limits, front office of the treasuryof ADs transacts in the foreign exchange market for customers
andown proprietary requirements. These exposures are accounted,confirmed and settled
by back office, while mid-office evaluatesthe profit and monitors adherence to risk limits on
a continuous basis. In the case of market risk, most banks use a combination of measurement
techniques including and managed by most banks onan aggregate counter-party basis so as
to include all exposures inthe underlying spot and derivative markets. Some banks
alsomonitor country risk through cross-border country risk exposurelimits. Liquidity risk is
generally estimated by monitoring assetliability profile in various currencies in various
buckets andmonitoring currency-wise gaps in various buckets. Banks also track balances to
be maintained on a daily basis in Nostro accounts,remittances and committed foreign
currency term loans whilemonitoring liquidity risk.

 To sum up, the foreign exchange market structure in India hasundergone substantial
transformation from the early 1990s. Themarket participants have become diversified and
there are severalinstruments available to manage their risks. Sources of supply anddemand in
the foreign exchange market have also changed in linewith the shifts in the relative
importance in balance of paymentsfrom current to capital account. There has also
been considerableimprovement in the market infrastructure in terms of trading platforms and
settlement mechanisms. Trading in Indian foreignexchange market is largely concentrated in
the spot segment evenas volumes in the derivatives segment are on the rise. Some of theissues
that need attention to further improve the activity in thederivatives segment include flexibility
in the use of variousinstruments, enhancing the knowledge and understanding thenature of
risk involved in transacting the derivative products,reviewing the role of underlying in
booking forward contracts andguaranteed settlements of forwards. Besides, market players
wouldneed to acquire the necessary expertise to use different kinds of instruments and
manage the risks involved.