Evolution and Future of Forex

1.
Executive Summary
The Project is titled Foreign Exchange Markets Evolution and Future. The objective behind the project is to study and understand the global foreign exchange market and Indian foreign exchange market in particular. The project begins with an understanding of the basics of the Foreign Exchange markets and then moves on to understand how the exchange rates among different currencies are determined. An overview of the global foreign exchange market and the major currencies that have a significant contribution to the turnover of the global foreign exchange market is provided. In order to get an in-depth understanding of the Indian foreign exchange markets, the evolution, structure and functioning of the market is studied. Subsequently the various rules and regulations that guide the operation of the market are studied. The project looks into and analyzes various events that have occurred over the past few years and how they have impacted the foreign exchange markets as a whole and more specifically the USD/INR exchange rate movement. The various risks involved in Foreign Exchange Dealings and the current status of Capital Account Convertibility in India along with the pros and cons of full capital account convertibility are explained. Finally the project analyses the future of the Indian Forex market for the corporates as well as financial institutions.
FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE
2. Research Design 2.1 Objective of the Study:

To study and understand the global foreign exchange market and Indian foreign exchange market in particular. To understand how the exchange rates among different currencies are determined. To study and understand the evolution, structure and functioning of the market & the various rules and regulations that guide the operation of the market. To analyze various events that have occurred over the past few years and how they have impacted the foreign exchange markets as a whole and more specifically the USD/INR exchange rate movement. To study and understand the risks involved in Foreign Exchange Dealings and the current status of Capital Account Convertibility in India along with the pros and cons of full capital account convertibility. To analyze the future of the Indian Forex market for the corporate as well as financial institutions.
2.2 Scope of the study:

In this project I have studied evolution and future of foreign exchange market. I have tried to explain the nitty-grittys of foreign exchange market in general; containing foreign exchange basics, global foreign exchange markets, foreign exchange market in India, risk involved in foreign exchange etc. Further my emphasis was on to explain in particular USD/INR movement and its correlation with other factors. I have also mentioned outlook for the future which focused on scope for fuller capital account convertibility, currency future-the South African experience and Indian perspective.
2.3 Research Methodology:

Primary Data: Secondary Data: For this project secondary data has been collected from various reports, journals, Policy documents etc. Apart from this other sources of information include Internet, various books, magazines & some leading financial dailies.
3. Introduction to Foreign Exchange

Foreign Exchange Foreign exchange simply means foreign money. It is the value of one currency expressed in terms of another. It involves the simultaneous sell and purchase of one currency for another. Foreign exchange commonly referred to as Forex or FX, gives us an idea of how well an economy is doing as compared to another. Need for Foreign Exchange In todays world no country is self-sufficient; consequently there is need for exchange of goods and services amongst different countries. However unlike the primitive age, the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries. Therefore whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. Hence, Forex markets acts as a facilitating mechanism through which one countrys currency can be exchanged i.e. bought or sold for the currency of another country. Features of Foreign Exchange Market The foreign exchange market is unique because of:
Its trading volume (Average daily turnover of around $ 3.98trillion )

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The extreme liquidity of the market The large number and variety of traders in the market Its geographical dispersion Its trading hours - 24 hours a day (except on weekends) The variety of factors that affect exchange rates
4. Foreign Exchange Basics

The foreign exchange market is a global network of buyers and sellers of currencies.
4.1 Understanding Foreign Exchange Terminology

Reading a Quote USD/INR = 53.83 This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The quote indicates the number of units of quoted currency that can be bought for 1 unit of base currency. The quote means that US$1 = 53.83 Indian Rupees. In other words, US$1 can buy 53.83 Indian Rupees. Direct Quote vs. Indirect Quote There are two ways to quote a currency pair, either directly or indirectly. A direct quote is simply a currency pair in which the domestic currency is the base currency; E.g. 100 INR = 1.86 USD (where INR is the domestic currency) An indirect quote is a currency pair where the domestic currency is the quoted currency. E.g. 1 USD = 53.83 INR (where INR is the domestic currency) In the forex spot market, the U.S. dollar is frequently the base currency in the currency pair. However, not all currencies have the U.S. dollar as the base. The Queens currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro, which
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is relatively new, is quoted the same way as well. Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places. Cross Currency A cross-rate is the rate of exchange between two currencies that do not involve the domestic currency. In the international market, cross rates have come to mean rates that do not involve the American dollar. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. Bid and Ask As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency. The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency. The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the ask price. Whichever currency is quoted first (the base currency) is always the one in which the transaction is being conducted. You either buy or sell the base currency Lets look at an example: USD/CAD = 1.2000/05 Bid = 1.2000 Ask= 1.2005
If you intend to buy the base currency, you will look at the ask price to see how much (in Canadian dollars) the market will charge for U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars. However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency, you would look at the bid price. It tells you that the market will buy US$1 base currency (you will be selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars, which is the quoted currency. Spreads and Pips The difference between the bid price and the ask price is called a spread. If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points. The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places.
Currency Quote Overview USD/CAD = 1.2232/37 Base Currency Quote/Counter Currency USD CAD Currency to the left Currency to the right Price for which the market Bid Price 1.2232 maker will buy the base currency. Bid is always smaller than ask. Price for which the market Ask Price 1.2237 maker will sell the base currency. One point move, in USD/CAD it Pip is .0001 and 1 point change would be from 1.2231 to 1.2232 Spread 5 pips/points; The pip/point is the smallest movement a price can make. Difference between bid and ask price (1.2237-1.2232).
4.2Types of Transaction
A foreign exchange transaction is a contract to exchange one currency for another currency at an agreed rate on an agreed date. Cash: Where the transaction and the settlement take place on the same day of the date of the transaction itself, then such transaction is said to have taken place on Cash or Today value basis. TOM: It refers to the transaction wherein the settlement takes place one working day after the date of the transaction. The term TOM stands for Value Tomorrow. Spot: Spot transaction refers to the transaction wherein the settlement takes place two working days after the date of transaction. This is the standard basis on which majority of FX transactions are concluded. Forward: Any transaction in respect of which the settlement takes place beyond the spot date is a Forward transaction. The Forward Market requires a more complicated calculation - a forward rate is based on the prevailing spot rate plus (or minus) a premium (or discount), which are determined by the interest rate differential between the two currencies involved. The important thing to remember is that a forward rate is not a guess as to what the spot rate is going to be in the future; it is purely a mathematically driven calculation. A forward rate will protect you against unfavorable movements, but will not allow gains to be made should the exchange rate move in your favor in the period between entering the contract and final settlement of the currency. Outright transaction: An Outright transaction is one in which a particular currency is bought against another currency that is being sold for a given value date at a mutually agreed exchange rate. Swap: Swap transaction refers to purchase and sale of a given pair of currencies against each other for different maturity/ value dates. In effect, it is a combination of two outright deals of varying maturity dates.
Future: Futures are the market-traded counterparts of currency forwards. With standardized contract size and maturity dates, they make for a liquid hedging instrument and aid price discovery in the currency market.
Models of Exchange Rate Determination The movements of exchange rates are indeed fascinating, thus it is very important that one understands the factors influencing exchange rates. Along with the factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country's relative level of income Purchasing Power Parity The Purchasing Power Parity (PPP) theory states that exchange rates are determined by the relative prices of similar baskets of goods. Changes in inflation rates are expected to be offset by equal but opposite changes in the exchange rate. For example, if a bottle of Coke costs $2 in America and 1 in England, then, according to PPP, the pounddollar exchange rate must be 2 dollars per 1 British pound. If the prevailing market exchange rate is $1.7 per British pound, then the pound is said to be undervalued and the dollar overvalued. The theory then assumes that the two currencies will eventually move towards the 2:1 relation. PPPs major weakness is that it assumes goods are easily tradable, with no costs to trade such as tariffs, quotas or taxes. Interest Rate Parity This states that an appreciation or depreciation of one currency against another currency must be neutralized by a change in the interest rate differential. For example, if American interest rates exceed Japanese interest rates, then the American dollar should depreciate against the Japanese yen by an amount that prevents riskless arbitrage. Balance Of Payments Model This model holds that a foreign exchange rate must be at its equilibrium level, i.e. the rate that produces a stable current account balance. For example, a nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nations exports more affordable in the global marketplace while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.
Asset Market Model Economic variables such as growth, inflation and productivity are no longer the only drivers of foreign exchange movements. The proportion of foreign exchange transactions stemming from cross-border trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services. The asset market approach views currencies as asset prices traded in an efficient financial market. As a result, currencies are increasingly demonstrating a strong correlation with asset markets, particularly equities.
Monetary Model The Monetary Model focuses on a country's monetary policy to help determine the exchange rate. A country's monetary policy deals with the money supply of that country, which is determined by both the interest rate set by central banks and the amount of money printed by the treasury. Countries that adopt a monetary policy that rapidly grows its monetary supply will see inflationary pressure due to the increased amount of money in circulation. This leads to a devaluation of the currency.
Factors affecting Foreign Exchange Rates The movements of exchange rates are indeed fascinating, thus it is very important that one understands the factors influencing exchange rates. Apart from factors such as interest rates and inflation, the 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 most 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. 1. Supply and Demand in the foreign exchange market The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and invisibles in the current account and inflows in the capital account such as: Foreign direct investment (FDI) Portfolio investment
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External commercial borrowings (ECB) and Non-resident deposits
On the other hand, the demand for foreign exchange emanates from imports and invisible payments in: Current account, Amortization of ECB (including short-term trade credits) and external aid, Redemption of NRI deposits and Outflows on account of direct and portfolio investment.
2. Inflation Rate differentials: As a rule of thumb, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. 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. 3. Interest Rate Differentials: 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 4. Current-account deficits: 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. 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.
Trade Deficit
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5. Public debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding, etc. Nations with large public deficits and debts are less attractive to foreign investors since large debt encourages inflation. 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. 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 (for example as determined by Moody's or Standard & Poor's,) is a crucial determinant of its exchange rate. 6. Terms of trade: 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. An increase in 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. 7. Balance of Payments Indias current account turned negative in fiscal 2004-05 and has remained so ever since. This has been offset by capital account surpluses with the exception of fiscal 2008-09 during which the balance of payments (BOP) actually turned negative (Table 6). Even though the BOP has once again turned positive, the global financial crisis has exposed vulnerabilities in Indias foreign currency position and prospects for future growth. A positive balance of payments indicates an accumulation of forex to the existing forex reserves and aide the RBI to maintain the exchange rate at desired levels. 8. Political stability and economic performance: Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A
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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.
5. Global Foreign Exchange Markets 5.1 History of events in Global Foreign Exchange Markets
The Evolution of money Primitive societies used various commodities as a medium of exchange. The marketability of a commodity determined its acceptance and use as a means of exchange. Marketability of a commodity was determined by the familiarity with the commodity and its quality, divisibility, uniformity and ease of transportation and storage.Over time, with the introduction of metals and coins, another important quality of the commodity emerged. It became a medium of exchange, having a value much greater than its intrinsic value. It was no longer used for consumption, but for acquiring other commodities for consumption. This was the evolution of money. The Gold Standard Under the gold standard,a currency would be backed by gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first standardized means of currency exchange in history. This also came to be known as the mint parity theory of exchange rates. The main types of gold standard were: 1. The Gold Specie Standard 2. The Gold Bullion Standard 3. The Gold Exchange Standard
The Gold Specie Standard 1880 1914 Under the Gold Specie Standard, gold was recognized as a means of settling domestic as well as international payments. Import and export of gold was freely allowed and Central Banks guaranteed
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the issue or purchase of gold at a fixed price, on demand. The price of gold varied according to the supply of the metal in the market and the value of gold coins was based on their intrinsic value. The Gold Bullion Standard- 1922 - 1936 The Gold Bullion Standard started after the First World War, as increased expenditures to fund the war effort exposed the weaknesses of the gold standard. Under the gold bullion standard, paper money was the main form of exchange. It could however be exchanged for gold at any time. The gold bullion standard too could not last long as many major currencies were highly over or under valued leading to a distortion in balance of payment positions.
The Gold Exchange Standard- 1944- 1970 During the Second World War, international trade suffered with runaway inflation and devaluation of currencies. A need was felt to bring out a new monetary system that would be stable and conducive to international trade. The new system aimed to bring about convertibility of all currencies, eliminate exchange controls and establish an international monetary system with stable exchange rates.
5.2 Summary of events since 1944
Year
Event
1944
Bretton Wood Accord is established to help stabilize the global economy after Wolr War II Smithsonian Agreement established to allow for greater fluctuations band for currencies European Joint Float established as the European community tried to move away from its dependency on the US dollar Smithsonian Agreement and European Joint failed and signified the official switch to a freefloeating system Free floating system officially mandated by the IMF European Monetary System fails making way for a world-wide free floating system
1971
1972
1973
1978
1993
Figure 3: Summary of events in global foreign exchange markets since 1944
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Bretton Wood System The IMF was set up in 1946 under the Bretton Woods agreement and the new exchange rate system also came to be known as the Bretton Woods system. Under the Bretton Woods system, member countries were required to fix parities of their currencies to gold or the US dollar and ensure that rates did not fluctuate beyond 1% of the level fixed. It was also agreed that no country would effect a change in the parity without the prior approval of the IMF.
Stated purposes and goals: The main terms of this agreement were: Formation of the International Monetary Fund and the International Bank for Reconstruction and Development (presently part of the World Bank). Adjustable peg Foreign exchange market rates system: The exchange rates were fixed, with the provision of changing them if necessary. Currencies were required to be convertible for trade related and other current account transactions. The governments, however, had the power to regulate capital flows. As it was possible that exchange rates thus established might not be favourable to a country's Balance of payments position, the governments had the power to revise them by up to 10%. All member countries were required to subscribe to the International Monetary Fund's capital. Encouraging open markets The seminal idea behind the Bretton Woods Conference was the notion of open markets. The establishment of the International Monetary Fund and the World Bank marked the end of economic nationalism. This meant that countries would maintain their national interest, but trade blocks and economic spheres of influence would no longer be their means. Another idea behind the Bretton Woods Conference was joint management of the Western politicaleconomic order. Meaning that the foremost industrial democratic nations must lower barriers to trade and the movement of capital, in addition to their responsibility to govern the system.
5.3 Turnover
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5.4 Timing
Forex is the only 24-hour market It starts from Sunday 5pm EST through Friday 4pm EST. Forex trading begins each day in New Zealand, Sydney (Australia,) and moves around the globe as the business day begins in each financial center, to Tokyo (Asia), the Middle East, London (Europe), and New York (America). Foreign exchange market is in fact misnomer as there is no market place as such which can be called as foreign exchange market. It is a facilitating mechanism through which one countrys currency can be exchanged i.e. bought or sold for the currency of another country.
5.5 Major Currencies

EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD and USD/CADare the most liquid and widely traded currency pairs in the world. Trades involving them make up about 90% of total Forex trading. GBP/USD is the only currency pair with its own name. It is known as Cable.
6. Foreign Exchange Market in India 6.1 History of Events shaping the Foreign Exchange markets in India
The exchange rate regime in India has undergone significant changes since independence and particularly during the beginning of 1990. The following provides a bird's eye view of major changes.
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Year
Type of Change
1966
The rupee was devalued by 57.5% against the sterling on June 6th. Rupee-sterling parity changed as a result of devaluation of sterling Bretton woods system broke down in August. Rupee briefly pegged to the US dollar at rupee 7.5 before repegging to sterling at Rs.18.967 with a 2.25 % margin on either side. Sterling was floated on June 23rd. Rupee sterling parity revalued at Rs.18.95 and then in October to Rs.18.80 Rupee pegged to an undisclosed currency basket with margins of 2.25% on either side. Intervention currency was sterling with a central rate of Rs 18.3084 Margins around basket parity widened to 5% on each side in January Rupee devaluead by 22% between July 1st and July 3rd. Rupee-Dollar rate depreciated from Rs.21.20 to Rs 25.80 LERMS(Liberalised Exchange Rate Management System) introduced with 4060 dual rate for converting export proceeds, market determined rate for all specified imports and market rate for approved capital transaction Unified market determined exchange rate introduced for all transactions. RBI would buy spot US dollar and sell US dollars for specified purposes. It will not buy or sell forward, though it will enter into dollar swaps
1967
!971
!972
1975
1979
1991
1992
1993
Figure 5: History of Events shaping the Foreign Exchange markets in India
6.2 Development of Foreign Exchange Markets

Market players in forex became active in the seventies, consequent upon the collapse of Bretton Woods Agreement. However, India was somewhat insulated since stringent exchange controls prevailed and banks were required to undertake only cover operations and maintain a square or near square position at all times. In 1978, the RBI allowed banks to undertake intra-day trading in foreign exchange and as a consequence, the stipulation of maintaining `square' or `near square' position was to be complied with only at the close of business hours each day. This perhaps marks the beginning of forex market in India.
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As opportunities to make profits began to emerge, the major banks started quoting two-way prices against the rupee as well as in cross currencies and gradually, trading volumes began to increase. During the period, 1975-92 the exchange rate regime in India was characterised by daily announcement by the RBI of its buying and selling rates to Authorized Dealers (ADs) for merchant transactions. Given the then prevalent RBIs obligation to buy and sell unlimited amounts of the intervention currency arising from the banks merchant purchases, its quotes for buying/selling effectively became the fulcrum around which the market was operated. The RBI performed a market-clearing role on a day-to-day basis, which naturally introduced some variability in the size of reserves. Incidentally, certain categories of current and capital account transactions on behalf of the Government were directly routed through the reserves account. FERA Soon after independence, complex webs of controls were imposed for all external transactions through legislation, i.e., Foreign Exchange Regulation Act (FERA), 1947. These were put into a more rigorous framework of controls through FERA, 1973. The Foreign Exchange Regulation Act, 1973, (hereinafter referred to as FERA) was drafted with the object of introducing the changes felt necessary for the effective implementation of the Government policy and removing the difficulties faced in the working of the previous enactment. The control framework was essentially transaction based in terms of which all transactions in foreign exchange including those between residents and non-residents were prohibited, unless specifically permitted. The prevailing mood then was one of preserving and consolidating the freedom and not to permit once again any type of foreign domination, political or economic. Initial approach on foreign capital was negative to a not-interested attitude.Any offence under FERA was a criminal offence liable for imprisonment.
From Regulation to Management (FERA to FEMA) As the country came to be endowed with sizeable reserves of foreign exchange, the basic aim of foreign exchange policy shifted from one of control and conservation to that of effective management, to facilitate external trade/payment and promote the orderly development and maintenance of the forex market in India.
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FERA had become incompatible with the pro-liberalization policies of the Government of India. In order to remove the special restrictions in respect of companies registered in India and to simplify the regulations in regard to foreign investment, to attract better flow of foreign capital and investment a change in the policy was necessary. Hence Foreign Exchange Regulation Act of 1973 (FERA) in India was repealed and was replaced by the Foreign Exchange Management Act (FEMA) 1979. The new legislation reflected the economic realities and was far more pragmatic in its approach. The objective of the earlier Act (FERA) as contained in its preamble was the conservation of foreign exchange and its utilization for economic development of the country whereas the objective of the new Act (FEMA) is "facilitating external trade" and "promoting the orderly development and maintenance of foreign exchange market in India". The most significant feature of the new Act is that it provides legal basis to the current account convertibility.
Foreign Exchange Management Act, 1979 (FEMA) The Act was thoroughly revised and replaced by the by the Foreign Exchange Management Act, 1999. The latter has dropped many of the stringent provisions of the older Act, in the area of transactions involving foreign exchange. The FEMA 1999 took effect from June 1, 2000. This Act extends to the whole of India and also applies to all branches, offices and agencies outside India owned or controlled by a person resident in India. It is also be applicable to any contravention committed outside India by any person to whom this Act is applicable. Objectives and Extent of FEMA The object of the 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. Broad Scheme of the Foreign Exchange Management Act, 1999 Prohibits dealings in foreign exchange except through an authorized person. Restrains any person resident in India from acquiring, holding, owning, possessing or transferring any foreign exchange, foreign security or any immovable property situated outside India except as specifically provided in the Act.
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Allows a person to draw or sell foreign exchange from or to an authorized person for a capital account transaction. RBI in consultation with Central Govt. has issued various regulations on capital account transactions.
Every exporter is required to furnish to the RBI or any other authority, a declaration etc. regarding full export value. Establishment of Directorate of Enforcement and the powers to investigate the violation of any provisions of Act, rule, regulation, notifications, directions or order issued in exercise of the powers under this Act.
6.3 Recommendations of various Committees

LERMS After the Gulf crisis in 1990-91 and the official devaluation of the rupee in July 1991, the broad framework for reforms in the external sector was laid out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). Following the recommendations of the Committee to move towards the market-determined exchange rate, the Liberalized Exchange Rate Management System (LERMS) was introduced in March 1992 initially involving a dual exchange rate system. Under this system all foreign exchange receipts on current account transactions were required to be submitted to the Authorized 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. Consequently, in March 1993, India moved from the earlier dual exchange rate regime to a single, market determined exchange rate system. 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. Sodhani Committee: The Report is widely regarded as an enlightened blue-print for the development of the Indian Foreign Exchange Market.Summary of Major Recommendations aimed at developing the Foreign Exchange Market:
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Recommendation Open positions limits to be decided by banks subject to their earmarking capital to the extent of 5% of Open Exposure Limit. Cap of Rs 15 Crores on open exchange position may be withdrawn Banks should be permitted to fix their own Gap limits based on capital, risk bearing capacity etc
Implication
Acceptance
Banks decide their own Overnight Open Accepted Position limits according to the capital base, volume of merchant transactions, dealing expertise and infrastructure. Banks earmark their capital to the extent of 5% of the open position limit to cover market risk. Limits are approved by RBI Ceiling of Rs 15 Crores was removed on 1st Jan, 1996. Banks are permitted to fix their own Gap Accepted. limits, subject to a daily ceiling of $ 100 million or 6 times the net owned funds of a bank.
Banks may, on application to RBI, be permitted to initiate Cross Currency positions overseas Market intervention by RBI should be selective rather than continuous. Forex swaps may be used as a tool by RBI to control the forward margins Banks should have the freedom to determine the interest rates and maturity period of FCNR (B) deposits subject to a cap being put in place by RBI.
Permissions
granted
on
basis
of Accepted.
infrastructural capabilities and dealing expertise and experience.
The RBI no longer quotes two way Accepted prices on a daily basis. RBI intervenes in both Spot and Forward markets.
Interest rates on FCNR (B) deposits are Accepted fixed by RBI and are uniform across all part banks.
in
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Exporters should, subject to liquidation of
Exporters are allowed to retain 50% of Not accepted their export earnings in foreign currency as accounts (EEFC Accounts - Exchange Earners Foreign Currency Accounts). However,exporters can lend upto $ 3 million abroad out of their EEFC accounts. Another move towards Capital Account Convertibility. yet
outstanding advances, be permitted to retain 100% of export earnings in
foreign currency in India.
The
proposed House
Forex CCIL was set up in 2001. As a clearing agency Accepted in for transactions improved the stability in the
Clearing
Bombay may be set up market by mitigating the settlement risk. early considering the
substantial benefits this could offer to banks.
Tarapore Committee: Tarapore-I committee report on Capital Account Convertibility (CAC), which came out in May 1997, wanted CAC to be phased in over three years. Some of the parameters recommended by the Tarapore Committee on CAC such as Reduction in the combined fiscal deficit Inflation between 3 and 5 percent Further reduction in the gross NPAs of the banking sector
were to be achieved for creating an enabling environment for further liberalization in the forex markets.
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Tarapore-II noted that two of the three milestones the inflation rate and a reduction in nonperforming assets (NPA) had been substantially reached. Observations The perspective on CAC has, however, undergone some change following the experiences of emerging market economies (EMEs) in Asia and Latin America which went through currency and banking crises in the 1990s. A few countries backtracked and re-imposed some capital controls as part of crisis resolution. It was argued that extensive presence of capital controls, when an economy opens up the current account, creates distortions, making them either ineffective or unsustainable. The link between capital account liberalisation and growth is yet to be firmly established by empirical research.
Meaning of Account Convertibility Current account convertibility refers to freedom in respect of payments and transfers for current international transactions. Capital account convertibility (CAC) would mean freedom of currency conversion in relation to capital transactions in terms of inflows and outflows. The cross-country experience with capital account liberalization suggests that countries, including those which have an open capital account, do retain some regulations influencing inward and outward capital flows. Thus the Committee recommended the definition of CAC to be as follows: CAC refers to the freedom to convert local financial assets into foreign financial assets and vice versa. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC can be, and is, coexistent with restrictions other than on external payments.
6.4 Participants of Market

Following are the major participants of the foreign exchange market: 1. Banks
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The interbank market caters to both the majority of commercial turnover and large amounts of speculative trading every day. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Only Authorized Dealers (ADs) licensed by the RBI can participate directly in the FX market. Customers approach ADs to get the best value for their FX requirements. Factors like customer relationship, execution capability and post trade service quality also has a bearing on which AD gets the deal. The competitiveness of the quote offered by the AD to the customer depends on how active that AD is in the inter-bank FX market. An exporter would sell foreign currency to an AD while an importer would purchase foreign currency. Apart from trade transactions there are remittances which could be inward remittances, involving the sale of foreign currency to an AD, and outward remittances involving purchase of foreign currency. Customer's requirements for purchase or sale of foreign currency also arise from capital account transactions such as Foreign Currency Borrowings or their repayment, issue of ADRs/GDRs, acquisition of domestic companies by an overseas entity or vice-versa etc. Apart from merchant transactions ADs also take proprietary positions i.e. positions on their own account. These positions are subject to daylight and overnight limits. The net overnight position which is termed as the Net Overnight Open Position Limit (NOOPL) is approved by the RBI for each AD after the latter's Board of Directors has approved the same. 2. Commercial companies Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. 3. Central banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial
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target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. 4. Hedge funds Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor. 5. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreign equities. Since the forex transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profit-maximization. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades. 6. Retail forex brokers They provide the currency conversion or credit-depositary processes between the foreign currency purchaser and seller. Forex brokers don't charge a commission, difference between the price at which a currency can be purchased and the price at which it can be sold at any given point in time is how they make money. Forex brokers are usually tied to large banks or lending institutions because of the large amounts of capital required. 7. Other
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Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as Foreign Exchange Brokers but are distinct from Forex Brokers as they do not offer speculative trading but currency exchange with payments. i.e. there is usually a physical delivery of currency to a bank account.
6.5 Institutional Framework

Foreign Exchange Market is governed under Foreign Exchange Market Act 1999 1. Foreign Exchange Dealers Association of India (FEDAI): FEDAI frames rules governing the conduct of inter-bank foreign exchange business among banks vis--vis public and liaison with RBI for reforms and development of forex market.Some of the current functions of FEDAI are as follows:

Guidelines and Rules for Forex Business Training of Bank Personnel in the areas of Foreign Exchange Business Accreditation of Forex Brokers Advising/Assisting member banks in settling issues/matters in their dealings Represent member banks on Government/Reserve Bank of India/Other Bodies Announcement of daily and periodical rates to member banks
FEDAI plays a catalytic role for smooth functioning of the markets through closer coordination with the RBI, other organizations 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 customized products, bench marking against international standards on accounting, market practices, risk management systems, etc. 2. Clearing Corporation of India Limited (CCIL):It was set up in 2001 in pursuance of the Sodhani Committees recommendations. CCIL as a clearing agency for transactions has improved the stability in the market by mitigating the settlement risk. CCIL is the first institution in India to offer centralized clearing and settlement services to players in the financial services sector. The Corporation has been promoted by the country's major banks and financial institutions and conducts its operations via modern computer and telecommunication systems, leading to efficiency in operations, lower cost, and mitigation of risks, particularly the systemic risk. CCIL's intermediation has gone a long way towards
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facilitating the deepening of India's debt markets by bringing in all classes of investors wholesale, semi-wholesale and retail. 3. Reserve Bank of India (RBI) : The RBI is the constant monitoring authority of Indian financial markets. The RBIs primary aim when it comes to foreign exchange management is to ensure safety and liquidity, with higher returns figuring lower in the hierarchy of preferences. RBIs parking of reserves is consistent with the best practices laid down for central banks by the International Monetary Fund (IMF). This includes parking part of the reserves as cash deposits with foreign central banks and multilateral agencies such as IMF and the Bank for International Settlements (BIS). It also invests in the deposits of foreign commercial banks and bonds, generally the highest-rated sovereign bonds of leading economies and occasionally in top rated corporate bonds. Indias foreign exchange reserves are spread across a variety of currencies including the dollar, euro and yen. But, the precise currency composition of reserves is generally not released by most countries including India, going by global practice.
6.6 Foreign Exchange Derivative Instruments in India

1. Foreign Exchange Forwards Authorised Dealers (ADs) (Category-I) are permitted to issue forward contracts to persons resident in India with crystallized foreign currency/foreign interest rate exposure and based on past performance/actual import-export turnover, as permitted by the Reserve Bank and to persons resident outside India with genuine currency exposure to the rupee, as permitted by theReserve Bank. The residents in India generally hedge crystallized foreign currency/foreign interest rate exposure or transform exposure from one currency to another permitted currency. Residents outside India enter into such contracts to hedge or transform permitted foreign currency exposure to the rupee, as permitted by the Reserve Bank. 2. Foreign Currency Rupee Swap A person resident in India who has a long-term foreign currency or rupee liability is permitted to enter into such a swap transaction with ADs (Category-I) to hedge or transform exposure in foreign currency/foreign interest rate to rupee/rupee interest rate. A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to
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give back the original amounts swapped.Currency swaps can be negotiated for a variety of maturities up to 30 years. 3. Foreign Currency Rupee Options ADs (Category-I) approved by the Reserve Bank and ADs (Category-I) who are not market makers are allowed to sell foreign currency rupee options to their customers on a back-toback basis, provided they have a capital to risk weighted assets ratio (CRAR) of 9 per cent or above. These options are used by customers who have genuine foreign currency exposures, as permitted by the Reserve Bank and by ADs (Category-I) for the purpose of hedging trading books and balance sheet exposures. 4. Cross-Currency Options ADs (Category-I) are permitted to issue cross-currency options to a person resident in India with crystallized foreign currency exposure, as permitted by the Reserve Bank. The clients use this instrument to hedge or transform foreign currency exposure arising out of current account transactions. ADs use this instrument to cover the risks arising out of market-making in foreign currency rupee options as well as cross currency options, as permitted by the Reserve Bank. 5. Cross-Currency Swaps Entities with borrowings in foreign currency under external commercial borrowing (ECB) are permitted to use cross currency swaps for transformation of and/or hedging foreign currency and interest rate risks. Use of this product in a structured product not conforming to the specific purposes is not permitted.
6.7 Foreign Exchange Derivative Guidelines

The Reserve Bank has issued comprehensive guidelines on derivatives laying down broad generic principles for undertaking all derivative transactions, management of risks and sound corporate governance requirements as adoption of suitability and appropriateness policy. Banks and their clients, who scrupulously follow the extant guidelines, including the Regulations framed under the FEMA, would be well equipped to meet any potential consequences. However, there are four main modifications to the instructions contained in the extant guidelines issued by Foreign Exchange Department, RBI with regard to the above instruments, viz;
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Users, such as importers and exporters having crystallized (evidenced by firm order, opening of LC or actual shipment), un-hedged foreign exchange receivables and payables in respect of current account transactions may write covered call and put options in both foreign currency/ rupee and cross currency and receive premia.
Market-makers may write cross currency options. Market-makers may offer plain vanilla American foreign currency-rupee options. A person resident in India, who has a foreign exchange or rupee liability, is permitted to enter into a foreign currency rupee swap for hedging long-term exposure. For purposes of clarity, the term long-term exposure may be defined to mean exposure with residual maturity of three years or more.
In respect of foreign exchange derivatives, market participants may be guided by the instructions issued by Foreign Exchange Department, RBI from time to time to the extent indicated in the guidelines.
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7 Foreign Exchange Risks

Each company has a different approach to foreign exchange based on industry, trade volumes, markets, etc. To develop a strategy its important to know whether the company is risk-averse, the levels of risk for the currencies one deals with, and how well one understands financial services. Credit risk/exposure: The risk that counterparty will not settle an obligation for full value, either when due or at any time thereafter. This risk can be effectively managed through fixing of counter party limits, appropriate measurement of exposures, ongoing credit evaluation and monitoring and following sound operating procedures.
Replacement risk/replacement cost risk: The risk that counterparty to an outstanding transaction for completion at a future date will fail to perform on the settlement date. This failure may leave the solvent party with an unhedged or open market position or deny the solvent party unrealized gains on the position. The resulting exposure is the cost of replacing, at current market prices, the original transaction.
Systemic risk: The risk that the failure of one participant in a transfer system, or in financial markets generally, to meet its required obligations when due will cause other participants or financial institutions to be unable to meet their obligations (including settlement obligations in a transfer system) when due. Such a failure may cause significant liquidity or credit problems and, as a result, might threaten the stability of financial markets and confidence in the market.
Legal risk: The risk that counterparty will incur damage because laws or regulations are inconsistent with the rules of the settlement system, settlement arrangements or other interests entrusted to the settlement system. Legal risk is also created by unclear or unsystematic application of laws and regulations. To avoid this risk one should insist on internationally accepted Master Agreements between the two parties to be supported by other relevant documents.
Liquidity risk: The risk that a counterparty (or participant in a settlement system) will not settle an obligation for full value when due. Liquidity risk does not imply that a counterparty
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or participant is insolvent since it may be able to settle the required debit obligations at some time thereafter. The following limits are fixed for managing the above risk:
Individual Gap Limits (IGL) Aggregate Gap Limits (AGL) Total Aggregate Gap Limits (TAGL)
Market risk:The risk that an institution or other trader will experience a loss on a trade owing to an unfavorable exchange rate movement.
Foreign exchange settlement exposure:The amount at risk when a foreign exchange transaction is settled. This equals the full amount of the currency purchased and lasts from the time that a payment instruction for the currency sold can no longer be cancelled unilaterally until the time the currency purchased is received with finality.
Operational risk: The risk of incurring interest charges or other penalties for misdirecting or otherwise failing to make settlement payments on time owing to an error or technical failure.
Foreign exchange settlement risk: The risk that one party to a foreign exchange transaction will pay the currency it sold but not receive the currency it bought. This is also called crosscurrency settlement risk or principal risk.
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8.USD/INR movement and its correlation with other factors 8.1 Explaining USD/INR movement
Figure 7: USD/INR movement
1995-96 - Depreciation of Rupee During 1993-94, India saw relatively large inflows on account of portfolio investments, which were regularly picked up by the Reserve Bank of India, keeping the Rupee steady at around 31 levels (or else the currency would have appreciated in nominal terms). The Indian Rupee depreciated sharply against the Dollar, from Rs 31.40 to the USD in June '95 to approximately 38 levels in February '96 (down 22.1%), regained to 34.20 by March 1996 before falling again to 35.70 by June-July 1996. Over September 1995 to February 1996, the Government's net foreign debt and interest repayments worth about $ 4 billion hit the market which, coupled with increased covering of capital liabilities by corporates and a dramatic slowdown in foreign portfolio investments, led to around 22% fall in the Rupee, from 31 levels to 38 levels. 1996 97 - Stagnant Thereafter the currency had been steady in a broad range of 35.60 to 36.00. After currency falling in 1995-96, FII and FDI flows picked up in 1996-97, making up for sizeable debt repayments.
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Trade, which had grew at a rate in excess of 20% over 1994-96, stagnated in Financial Year 1996-97(April to March), due to both, credit squeeze induced slowdown in domestic growth as well as a downturn in India's major export markets.
Capital inflows during 1996-97 roughly matched capital outflows and, together with subdued imports and trade, led to a relatively stable Rupee.
1997-98 to 2000-01 - Depreciation of Rupee In 1997-98 the rupee depreciated by 9.1 per cent, in 1998-99 by 6.9 per cent, and again it continued to depreciate by 6.5 per cent in 2000-01. The increase in prices of crude oil internationally which impacted on Indias trade and it had an effect on the exchange rate. Since 1998, increase in the prices of imported oil had been high. This resulted in increase in import bill substantially. The other point was the higher rate of inflation on the value of the rupee. The major reason for increase in the rate of inflation during that period in India was the increase in the prices of petroleum products, including mineral oils, etc. 2001-04 - Rupee Appreciation India recorded a current account surplus since financial year 2001-02, also liberalization encouraged and attracted large inflows on its capital account. This pressure on the rupee lead to its appreciation. The principal sources of current account inflows have been buoyant remittance flows and inflows under the ''software services'' head. Inflows on account of software services rose from $5.75 billion in 2000-01 to $6.88 billion in 2001-02, $8.86 billion in 2002-03 and $9.09 billion over the first nine months of 2003-04, while private transfers (mainly remittances) were $12.8 billion and $12.13 billion in 2000-01 and 2001-02 respectively, and it touched $14.81 billion in 2002-03 and $14.49 billion during April-December 2003.In an intensification of this trend, during the first nine months of the financial year 2003-04, net inflows on account of invisibles stood at around $18 billion, well above the $15 billion deficit on the trade account. Even while India's current account was relatively healthy on account of the foreign exchange largesse from Indian workers abroad, the country's liberalized capital markets have attracted large inflows of capital amounting to a net sum of $10.57 billion in 2001-02, $12.11 billion in 2002-03 and a at around massive $18 billion during the first nine months of 2003-04.
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2006 2010 - Rupee Appreciation The trend of steady month-on-month appreciation began in September 2006. The Indian rupee had appreciated by nearly 10% since late 2006, posing an acute dilemma for Indian policymakers. The average rupee-US dollar rate in November 2007 was the lowest since 1999/2000. It suggests that the country's attractiveness to foreign investors had been increasing and signals optimism about the Indian economy more generally. Performance of Indian rupee against dollar has improved significantly in the year 2009-2010. The rupee has shown tremendous strength against the US$ as the rupee US$ exchange rate appreciated to Rs. 46.64 per dollar on January 1, 2010, which was Rs. 50.95 per dollar in end-March 2009. Overall the rupee has appreciated by 9.2 per cent over its March 31, 2009 level, according to Economic Survey 2009-10. Explaining the rupee's appreciation The main reason for the rupee's appreciation since late 2006 has been a flood of foreign-exchange inflows which was primarily due to the strong fundamentals of the economy which includes: High GDP growth Rate - (GDP grew by more than 9 % since FY06) Demographic dividend Low Inflation Reasonable interest rates Strong Corporate earnings Change in FII inflows, continued inflows under FDI and NRI deposits Weakening of the US$ in international markets
The main factors responsible for Rupee appreciation are as follows: FDI - India's stellar economic growth had created a large domestic market that offered promising opportunities for foreign companies. In the current year FDI equity inflows during the financial year 2009-2010 (from April 2009 to November, 2009) are US $ 19,379 million (Rs. 93,354 core) compared to US $ 19,791 million (Rs. 85,700 corer) during the corresponding period in 2008-09. This represents a decrease of 2% in dollar terms and an increase of 9% in rupee terms. The cumulative amount of FDI equity inflows from April
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2000 to October 2010 stood at US$ 122.68 billion, according to the data released by the Department of Industrial Policy and Promotion (DIPP)
Foreign portfolio inflows - India's booming stock market embodied the confidence of investors in the country's corporate sector. Foreign portfolio inflows had played a key role in fuelling this boom. In dollar terms the net equity inflow in 2010 totaled $29.36 billion, compared to an inflow of $17.45 billion in 2009. The annual inflow in 2010 was at record level.
External commercial borrowings (ECBs) - Indian companies had borrowed enormous amounts of money overseas to finance investments and acquisitions at home and abroad.
ADR and GDRs: Another major source of portfolio capital inflows had been overseas equity issues of Indian companies via global depositary receipts (GDRs) and American depositary receipts (ADRs The inflows under ADRs/ GDR increased to US $ 2.7 billion in AprilSeptember 2010 (US $ 1.1 billion in April-September 2009).
Investments and remittances - Indians settled in other countries have also been a major source of capital inflows, with many non-resident Indians (NRIs) investing large amounts in special bank accounts. The attractive interest rates offered on such deposits provided a powerful incentive.
Impact of Rupee Appreciation on Companies The RBI's deputy governor, Rakesh Mohan, referred to the effects of the rupee's appreciation as a case of "Dutch disease". The term refers to episodes where large inflows of foreign exchange usually as a result of the discovery of natural resources or massive foreign investment leads to appreciation of the currency, undermining a country's traditional export industries. Positive Impact of Rupee Appreciation The appreciation of the INR helped in bringing down the countrys import bill particularly that of oil imports which easily accounts for more than a third of all imports. This in turn helped the country in bringing down the trade deficit. Major Indian stock indices were able to scale new peaks because of appreciation in the INR. This resulted in wealth creation for the investors. INR appreciation helped control inflation.
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Sectors that gained from the currency appreciation were auto, engineering, telecom, aviation companies to name a few: Auto: The biggest gainers in the auto sector are Hero Honda, Maruti, Tata Motors and Ashok Leyland as the imported price of their raw materials cost less. Engineering: Engineering companies like Suzlon also gained on raw material cost savings. Aviation: Airlines like Jet were gainer on account of its aviation fuel costs. Companies with foreign currency loans: Companies with foreign currency loans or FCCBs like Reliance Communications, Bharat Forge, Sun Pharma and Ranbaxy are also gained due to rupee appreciation due to lower debt servicing costs. Telecom: The telecom companies capital expenditure (capex) mainly goes into equipment imports for their expansion plans. The rupee appreciation resulted in foreign exchange gains as the companies were paying in dollars. The two major companies Bharti Airtel and Reliance Communications were the major Gainers
Negative Impact of Rupee Appreciation Sectors that lost due the currency appreciation were apparel, IT, BPO, Textile companies to name a few. The continued appreciation of the rupee by had made it difficult for the manufacturing exporter, who had to further offer his quotations to match the competitive range of suppliers from other countries. Apparel:In the apparel sectorone of India's major export industries--the strong currency led to a decline of 3.5% year on year in January-April 2010. During the same period, apparel exports to the US by China, India's most important competitor, rose by 57%. Moreover, for India the decline marked the reversal of a positive trendapparel exports to the US were rising at an average rate of 21% a year after import quotas were phased out at the beginning of 2005. IT: Software companies lost on the back of the appreciating rupee as their exports are priced in foreign currency. Infosys had in the fourth quarter seen an impact of 100 bps on their operating margins because of the movement of the rupee.
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BPO: The rise of the rupee against the dollar impacted the Indian outsourcing companies, as two-thirds of their business comes from the U.S.A. The rising rupee had pushed down exporters' rupee revenues, even as their costs locally (staff salaries etc) went up. Textile: Textile growth from a healthy export growth rate of 21% in 2005-06 plummeted to a mere 4.6% during the 11 months of 2009-10. This had also resulted in a lot of job cuts. Others: Other sectors like leather and handicrafts, which provide huge
employment, actually registered a negative growth. These sectors seldom use import for their production and are mainly depending on export for revenue generation. Hence the appreciating rupee did not cause any savings in raw material purchases for leather and handicraft companies on the contrary it resulted in severe pressure on margins. Policy dilemma Given the limited extent to which the RBI can intervene in the foreign-exchange market in the face of large and sustained capital inflows, policymakers can only stem rupee appreciation substantially by easing limits on domestic firms' overseas investments or restricting inflows, for instance, through further controls on ECBs RBI had stopped aggressive intervention in the currency market because of the adverse effects noticed as a result of its injection of liquidity by sale of rupees in exchange for forex. The supply of excess domestic currency leads to inflationary pressures unless offset by sterilisation, which means the central bank would have to sell debt paper of Government to the banks to suck out the additional rupees. Unfortunately, sterilisation has its costs. It increases the supply of debt paper leading to a fall in their price, which is the inverse of interest rate. The net result of successful intervention and sterilisation is rise of interest rates, which, in turn, leads to further capital inflows,a vicious cycle. Rise of the rupee: Way out Following are some of the ways of dealing with the rising rupee: Japan faced its problem of appreciation of the yen in the 1990s from nearly 230 yen to a dollar to around 130. To overcome this appreciation Japan improved its productivity and introduced product innovations. To emulate Japan, India, perhaps, needs to import low end
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goods from other developing countries and concentrate on value-added products. This is possible as, with the appreciation of the Rupee, newer technologies become economical and accessible to Indian manufacturing. This is, of course, a challenge that requires a host of other enabling factors. Infrastructure, for instance, is an important bottleneck. As India is home to one-sixth of humanity Indian businesses can ill afford to ignore their own home markets? They should focus partly on the domestic markets which will provide and automatic hedge to rising rupee
9. Outlook for the Future
9.2 Currency Futures Outlook for India

Currently several stipulations apply to the derivative instruments available in India. In an effort to ensure that forwards are used only for hedging purposes, resident individuals/firms and FIIs can book contract in the forward market only against their underlying. Therefore entities outside India even if having direct or indirect exposures on INR cannot hedge themselves. An important consequence of these restrictions has been the development of a vibrant offshore market in Non-Deliverable Forwards (NDF) on the Indian rupee. Based primarily in Singapore and in operation since the mid-1990s, this is a market where deals are settled by paying in dollars the difference between the contracted forward price and the resulting spot price of the rupee on the settlement date. Thus no rupee transaction actually takes place, but the instrument serves as a betting device on the value of the rupee. In recent times, the NDF market has witnessed explosive growth with average transaction volumes reportedly exceeding $750 million a day in 2007, from about $100 million a day only three years ago. Most major foreign banks offer NDFs, but Indian banks are barred from doing so. The NDF market serves currency hedge funds and other offshore entities interested in speculating on India. Multinationals and foreign portfolio investors who use the P-Note route to Indian assets also use this hedging device. Arbitrageurs, including Indian exporters, with access to both onshore and offshore forward markets help keep the rates close to one another. The first exchange-traded currency derivative on the rupee was recently launched in Dubai.
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The success of rupee futures in Dubai, without explicit RBI approval, points to two things: that it were regulations that held back the growth of exchange-traded currency derivatives in India, and that in todays globalised financial environment, domestic strictures merely shift the trading overseas. In order to provide the entities that are exposed to currency risk with more hedging instruments the Indian government is planning to introduce exchange traded currency futures. Once these futures are introduced the NDF markets in INR will cease to exist.International experiences, albeit of select countries like South Africa and South Korea, suggest that currency futures could coexist with the OTC currency markets as well as capital controls. A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument on a certain date in the future, at a specified price. Traditionally, the futures market meets the needs of the three distinct sets of market users those who wish to discover price information those who wish to speculate and those who wish to hedge
Forward vs. Future The pros and cons of Future contracts as compared to forward contracts are as follows: Advantages of Futures The exchange traded currency futures offer different advantages over OTC market. The advantages are: Transparency and efficient price discovery. Elimination of counterparty credit risk. Access to all types of market participants. Standardized products. Transparent trading platform.
Disadvantages of Futures
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The futures are also disadvantageous in a few areas when compared to OTC market. The major disadvantages are: Standardization it is not possible to obtain a perfect hedge in terms of amount and timing. Cost forwards have no upfront cost, while margining requirements may effectively drive the cost of hedging in futures up. Small lots- not possible to hedge small exposures generally.
Risks of possible Dollarization of the economy Dollarization refers to broad use of foreign currency as a substitute for domestic currency for transaction or other purposes. Currency futures, however, entail some potential risk of permeating through the capital controls in place causing dollarization of the economy, as its consequence or otherwise. Given a choice, many residents might prefer to hold assets denominated in foreign currencies (US dollar or any other hard currency) in the interest of preserving the value of their holdings. Such a preference of the economic agents could potentially lead to dollarization of an economy. The serious risk emanating from the process of dollarization is that it makes it very difficult for the domestic monetary authority to conduct an independent monetary policy. It could be extremely damaging to the domestic economy if, for instance, the domestic demand shock warrants a monetary policy compression in the domestic economy at a time when the external monetary authority is pursuing an expansionary monetary policy on the basis of its own macroeconomic situation, or vice-versa. The gains likely from the introduction of currency futures in the Indian context could be set out as below: Provide an additional tool for hedging currency risk. Further development of domestic foreign exchange market. Permit trades other than hedges with a view to moving gradually towards fuller capital account convertibility.
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Provide a platform to retail segment of the market to ensure broad based participation based on equal treatment.
Efficient method of credit risk transfer through the Exchange. Create a market to facilitate large volume transactions to go through on an anonymous basis without distorting the levels. While theoretically futures prices should reflect similar interest rate expectations, the real effect on prices remains to be seen.
Framework for Introduction of Currency Futures Initially only USD-INR currency futures contract may be introduced at the outset The Internal Working Group of RBI recommends that a single contract of notional value USD 1,000 may be introduced. The Group recommends the following: Initially, the tenors of the contract may largely replicate the tenors of the currency forwards and to this end, the currency futures maturing in the first 12 calendar months may be offered. The futures settlement cycle may be co-terminus with the settlement of month end forward contracts. No quantitative restrictions may be imposed on residents to trade in currency futures. This is likely to ensure greater liquidity and wider participation and would be in line with usual policy where liberalization is done first for residents. Participation
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In the interest of financial stability, at the inception, the participation in the futures market may be restricted to residents alone. This will help in evaluating the robustness of various systems such as surveillance, monitoring, reporting, etc. Role of Reserve Bank The introduction of currency futures will not alter the role of Reserve Bank in the domain of exchange rate management. The Reserve Bank will continue to retain the right to stipulate or modify the participants and / or fixing participant-wise position limits or any other prudential limits in the interest of financial stability. Currency Futures Market: Surveillance and Reporting A key prerequisite for smooth functioning of the currency futures market at exchanges is to put in place a state-of-the- art surveillance system and an adequate reporting mechanism. Ideally, the surveillance system should have the following features: It should be based on the on-line trading system It should have the capability of generating real time data, if required. It may also provide exception reporting at a fairly short interval of say every half-an-hour. Be capable of providing warning mechanisms through alerts at the earliest possible. It should also be able to treat distinctly hedge, arbitrage, and speculative trades.
The surveillance system is of a critical importance, especially in respect of the generation of key reports on market manipulation. The primary task of the Surveillance Committee should be to ensure that day-to-day monitoring by the exchange ensures compliance with the best of the surveillance abilities.
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9.3 Exchange traded Currency Options

Once the currency futures are implemented and the currency future market stabilizes, the government can go ahead with the implementation of exchange traded currency options. Transactions can be cleared through the clearinghouses of the exchanges on which currency futures will be traded. The option buyer who has no further financial obligation after having paid the premium may not be required to make margin payments. The option writerwho would have all of the financial risk may be required to put up initial margin and to make additional (maintenance) margin payments if the market price moves adversely to his position. Options on foreign currencies presently are traded on the Philadelphia Stock Exchange(PHLX) and the Chicago Mercantile Exchange (CME). Advantages of Currency Options: Exchange-traded options have many benefits including: flexibility
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leverage limited risk for buyers employing these strategies, and Contract performance guaranteed by the clearing house. An option allows one to participate in price movements without committing a large amount of funds. Options can also be used to hedge a position, to acquire or sell at a purchase price more favorable than the current market price, or, in the case of writing (selling) options, to earn premium income.
9.4 Exotic options

Options being over the counter products can be tailored to the requirements of the clients. More sophisticated hedging strategies call for the use of complex derivative products, which go beyond plain vanilla options. These products are currently discontinued due to the recent forex derivative losses posted by corporates. These products could be introduced again once the dust over the forex derivative issuessettleand upon RBIs comfort with competencies and Risk Management Systems of market participants. Some of these probable products are mentioned below: Simple structures involving vanilla European calls and puts such as range-forwards, bull and bear spreads, strips, straps, straddles, strangles, butterflies, risk reversals, etc.
Simple exotic options such as barrier options, Asian options, Lookback options and also American options.
More complex range of exotics including binary options, barrier and range digital options, forward-start options, etc
Some innovative products may be introduced which satisfy specific customer requirements. These are designed from the cash and derivative market instruments and offer complex payoffs depending on the movement of various underlying factors.
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1.

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

2. Research Design 2.1 Objective of the Study:

2.2 Scope of the study:

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

2.3 Research Methodology:

3. Introduction to Foreign Exchange

Its trading volume (Average daily turnover of around $ 3.98trillion )

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

4. Foreign Exchange Basics

4.1 Understanding Foreign Exchange Terminology

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

External commercial borrowings (ECB) and Non-resident deposits

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

5.2 Summary of events since 1944

Figure 3: Summary of events in global foreign exchange markets since 1944

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

5.5 Major Currencies

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

Figure 5: History of Events shaping the Foreign Exchange markets in India

6.2 Development of Foreign Exchange Markets

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

6.3 Recommendations of various Committees

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

infrastructural capabilities and dealing expertise and experience.

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

Exporters should, subject to liquidation of

outstanding advances, be permitted to retain 100% of export earnings in

foreign currency in India.

substantial benefits this could offer to banks.

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

6.4 Participants of Market

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

6.5 Institutional Framework

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

6.6 Foreign Exchange Derivative Instruments in India

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

6.7 Foreign Exchange Derivative Guidelines

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

7 Foreign Exchange Risks

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

Figure 7: USD/INR movement

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

9. Outlook for the Future

9.2 Currency Futures Outlook for India