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The Foreign Exchange Market

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The foreign exchange market is the market where one currency is traded for another. This market is somewhat similar to the over the counter market in securities. The trading in currencies is usually accomplished over the telephone or through the telex. With direct dialing telephone service anywhere in the word, foreign exchange markets have become truly global in the sense that currency transactions now require only a single telephone call and take place twenty four hours per day. The different monetary centers are connected by a telephone network and video screens and are in constant contact with one another, thus forming a single international foreign exchange market. However, the currencies and the extent of the participation of each currency in this market depend on local regulations, which vary form country to country.

Chapter 1 deals with the introduction and conceptual framework of foreign exchange market in India. It also deals with the structure of Indian Forex Market.

Chapter 2 deals with the literature review of organization and regulation of forex market as well as management of exchange risk, exchange rate mechanism.

Chapter 3 deals with the methodology adopted in the research process outlining the objectives of the study, methods of data collection and limitations faced while conducting the study.

Chapter 4 deals with the data analysis of the foreign exchange market in India. It covers the long term and short term factors which account to the problems.

Chapter 5 deals with the conclusion, recommendations and future prospects of forex market in India.

Chapter1

Conceptual Framework of forex Market

  • Theory of Foreign exchange

The term foreign exchange is normally used to denote foreign currency surrendered or asked for in any of its current forms, i.e. a currency note or a negotiable instrument or transfer of funds through cable or mail transfer or a letter of credit transaction requiring sale and purchase of foreign exchange or conversion of one currency into another, either at the local center or an overseas center. The banks, dealing in for exchange and providing facilities for conversion of one currency into another or vice versa are known as Authorized Dealers or Dealers in Foreign Exchange. A bank is said to buy or sell foreign exchange when it handles the claims drawn in foreign currency or the actual legal tender money, i.e., foreign currency notes and coins of other countries.

The theory of Foreign exchange covers different means and methods by which the claims expressed in terms of one currency are converted into another currency and specifically deal with the rates at which such conversion takes place.

With partial or complete exchange control, as exercised by countries since World War II exchange markets are no longer free. Exchange rates today are not entirely determined by market forces but are officially fixed and maintained by Central Monetary Authorities. Fluctuations in exchange rates are permitted by authorities only within narrow limits,. And official rates often very different to what they would be if natural forces were allowed to operate.

  • Forex Markets

The foreign exchange market, like the market for any other commodity, comprises of buyers and sellers of foreign currencies. The operations in the foreign exchange market originate in the requirements of customers for making remittances to and receiving them from other countries. But the bulk of transactions take place among banks dealing in foreign exchange for their own requirements as they do cover operations. Banks undertake large and frequent deals with other banks through the agency of Exchange Brokers, and it is these deals which give the market its significance. In addition, there are other transactions which take place in the foreign exchange market. All transactions of the exchange market may be divided into five categories:

  • Transactions between banks and their customers.
  • Transactions between different banks in the same centre.
  • Dealings between banks in a country and their correspondents, and overseas branches.
  • The purchase and sale of currencies between the central bank of a country and the commercial banks.
  • The transactions of the central banks of one country, with central banks of other countries.

There is not much difference between one market and another as far as the international transaction between markets at different centres is concerned. But local dealings, among members of the same market are organized in two different forms. One of them is the pattern adopted in Great Britain, U.S. A. and some other countries, where foreign exchange dealers never meet each other but transact business through a network of telephone lines linking the banks, with exchange brokers who act as intermediaries. In India also the foreign exchange market is organized on these lines. The other type is the markets in countries of Western Europe, where the dealers in Foreign exchange meet on every working day at a meeting place for business proposals-They fix the exchange rates for certain kind of business particularly with-customers. The foreign exchange markets in these countries are like commodity exchange or stock exchange. However, the global important of these markets, is comparatively small.

  • Indian Foreign Exchange Market

The Indian foreign exchange market, broadly concentrated in big cities, is a three-tier market. The first tier covers the transactions between the Reserve Bank and Authorized Dealers (Ads). As per the Foreign Regulation Act, the responsibility and authority of foreign exchange administration is vested with the RBI. It is the apex body in this area and for its own convenience, has delegated its responsibility of foreign exchange transaction functions to Ads, primarily the scheduled commercial banks. They have formed the Foreign Exchange Dealers' Association of India which framers rules regarding the conduct of business, coordinates with the RBI in the proper administration of foreign exchange control and acts as a clearing house for information among Ads. Besides the commercial banks, there are money- changers operating on the periphery. They are well-established firms and hotels doing this business under license from the RBI. In the first tier of the market, the RBI buys and sells foreign currency from and to Ads according to the exchange control regulations in force from time to time. Prior to the introduction of the Liberalized Exchange Management System, Ads had to sell foreign currency acquired by them from the primary market at rates administered by the RBI. The latter too sold pounds sterling or US dollars, spot as well as forward, to Ads to cover the latter's primary market requirements. But with the unified exchange rate system, the RBI now intervenes in the market to stabilize the value of the rupee.

The second of the market is the inter-bank market where Ads transaction business among themselves. They normally do their business within the country, but they can transact business also with overseas bank in order to cover their own position. Through they can do it independently, they do it normally through a recognized broker. The brokers are not allowed to execute any deals on their own account or for the purpose of jobbing. Within the country, the inter-bank transactions can be both sport and forwards. These may be swap transactions. Any permitted currency can be sued. But while dealing with the overseas Ads, because the Indian market lacks depth in other currencies; the Indian banks can deal mainly in two currencies, viz, the US branches must cover only genuine transactions relating to a customer in India or for the purpose of adjusting or squaring the bank's own position. Forward trading with overseas banks is also allowed if it is done for the above two purpose, that is for covering genuine transactions or for squaring the currency position, and does not exceed a period of six months. In case the import is made on deferred payment terms and the period exceeds six months, permission has to be obtained from the RBI.

Cancellation of forward contracts is allowed in India, although it has to be referred to the RBI. Previously, the banks used to get the forward transactions covered with the RBI, but since 1994-95 the RBI has stopped giving this cover and has permitted the banks to trade freely in the forward market. Cancellation of a forward contract involves entering into a reverse transaction at the going rate. Suppose US $1,000 was bough forward on 1 February for three months at Rs. 40/US $. On 1 March, it is cancelled involving selling the US dollar at the rate prevalent on this day. If the exchange rate on 1 March is Rs. 39.50/US $ there will be a loss of Rs. 500 (the dollar sold for Rs. 39.5 minus dollar bought at Rs. 40.00). The loss is borne by the customer. If the value of the US dollar is greater on the cancellation day, the customer shall reap the profit.

The third tier of the foreign exchange market is represented by the primary market where Ads transact in foreign currency with the customers. The very existence of this tier is the outcome of the legal provision that all foreign exchange transactions of the Indian residents must take place through Ads. The tourists exchange currency, exporters and importers exchange currency, and all these transactions come under the primary market Chapter 2

LITERATURE REVIEW

Organization And Regulation of Forex Market

The Foreign Exchange department, which is also being called as the International Banking Division, is one of the important departments of the banks operating in international market. In India also all scheduled commercial banks, both in the nationalized or non-nationalized sectors, do have Foreign Exchange departments, both at their principal offices as well as offices, in metropolitan centers. This department functions independently under the overall change of some senior executive or a senior officer well-versed in foreign exchange operations as well as in the rules and regulations in force from time to time pertaining to foreign exchange transactions advised by various government agencies.

The principal function of a Foreign exchange department is to handle foreign inward remittances as well as outward remittances; buying and selling of foreign currencies, handling and forwarding of import and export documents and giving the consultancy services to the exporters and importers. Besides this, the department also gives the financial assistance in relation to the foreign trade, i.e., it gives assistance to the exporters by way of financing the exports and imports by giving them the financial assistance to clear the consignments or open a letter of credit. The department issues letters of credit for their importer clients and handles letters of credit received from overseas correspondents in favour of exporters from India. Issuance of Performance and the Bid Bond guarantees and tender document is also one of the important functions of the banks that are dealing I foreign exchange.

In India, the banks doing foreign exchange business are issued a license to this effect by the Reserve Bank of India under Foreign Exchange Regulation Act, 1973. No bank, not having such license to deal in foreign exchange, can handle foreign exchange operations. Besides Authorized Dealers, licenses are also issued to the Dealers with limited powers to change foreign currency notes, coins and travellers' cheques. Such licensees are known as Authorized Money Changers.

2.1 Organisation of A Foreign Exchange Department

The foreign exchange department of a medium or large sized-bank can be divided into various department and sections such department are locked after by a senior person not lower than the category of a branch manager having both administrative and operational know-how as well as discretionary powers for advances required from time to time by the clients. The in charge of the department functions independently within the overall framework laid down by the Management of the bank. The in charge is assisted in hid day-to-day work by a team of officers, and workmen. One of the important functions of the Foreign exchange department, beside banking operations, is to maintain liaison and correspondence relations with overseas banks who may be their correspondents.

SECTION OF THE FOREIGN EXCHANGE DEPARTMENT

The Foreign exchange department is divided into number of sections, each one equally important and looked after by one officer or a department head. A particular section can be sub-divided into sub-section with specific duties allotted. The sections in Foreign exchange department can be broadly stated as under:

1. Dealers' Section

This section is the nerve of the foreign exchange department as the exchange rates are computed and advised by this section. The exchange rates are the on a foreign exchange and so any incorrect fixation of rates (price) will turn the profits of the bank into losses and instead of earning from the foreign exchange transactions, the bank may keep on losing. This section is headed by an officer who is called a Dealer. In the morning, before the banking hours begin, the exchange rates of various currencies are computed. The rates are computed on the basis of certain fixed principles which may by either market quotations or any such approved channel. In India, the Dealer works out the exchange rates on cross rate method based on the sterling rate schedule fixed and advised by FEDAI vis-à-vis the previous day's closing rates in London market. This department calculates and advised both the ready rates as well as forward rates as and when requested. Besides rate computation, it also looks after the foreign currency accounts of the bank and supervises the balancing position in foreign currency accounts maintained abroad. It also controls the exchange position of the department and reconciles the various entries put forth by other sections both for buying as well as selling of foreign exchange. In addition, the section also calculates and tabulates the statistical data required by the principal office of the bank concerned, as well as the Exchange Control Department of the Reserve Bank of India. Such statistics prepared by the bank are to be reported to the authorities on the prescribed forms at the prescribed intervals. This data is very essential and of prime important as the Balance of Trade and Balance of Payments position is arrived at only from the statistics provided by the banks. From the data available from the banks even the import policy is formed and other fiscal measure adopted by the monetary authorities from time to time depend.

This section can be further sub-divided into following subsections:

  • Rate calculation and advising
  • Forward Exchange contracts
  • Foreign currency Accounts
  • Exchange position and control, and
  • Reconciliation of Foreign Currency Accounts.

2. Foreign Remittances Section

This section deals with the inward and outward remittances received in the country and sent outside, both on behalf of the transactions taken up by residents and non-residents. Foreign remittances are carried out in the form of cable transfers, mail transfers, demand drafts, travelers cheques and payment instructions by letters. All these forms are widely used both for inward remittances as well as outward remittances. The officer of this particular department has to be quite well-versed with various regulations in force from time to time and the amendments thereto as strict exchange control regulations are prevailing specially in case of outward remittances in developing and underdeveloped countries, due to the adverse balance of payments position, depleting foreign exchange reserves, and available resources required to meet with development programmes and national exigencies. This department also keeps Test Key arrangements used for transmitting the instructions by cable, as in cable transfers no signature of the remitting bank is possible. So messages are computed with a particular number known as code or cipher. This code or cipher is recomputed at the other centre on the basis of the test arrangements exchanged between the two banks.

In foreign exchange, whatever the reason may be irrespective of the amount, the entire gamut is focused around the inward and outward remittances and so this section is of prime importance. The remittances are converted into local currency in case of inward remittances and in foreign currency in case of outward remittances at the prevailing rate of exchange on the date of each transaction or a forward exchange rate if exchange rate if exchange is already booked earlier. So, the remittance department has to keep a close contact with Dealer's section, both for getting the rates and also advising them the funds position which changes from time to time due to the remittances flowing in either direction.

3. Import Section

Import section can be sub-divided into import letters of credit both opening and payment thereof, issue of Bid guarantees, performance guarantees and guarantees to Government agencies for release of import consignment, import documents received on collection basis and imports on consignment basis. Import section has to keep in touch with latest developments in international markets as well as the rules and regulations in force in various centres to take up the import business at right earnest without violating the rules and regulations. Both in developing and developed countries, there are Import and Export Trade Control Regulations and such regulations are enforced through a licensing procedure. Hence the Import section has to take care of the Import Trade Control Regulations as well as Exchange Control Regulations before allowing import transactions to be put through.

4. Export Section

The section deals with various exchange operations arising out of export trade. The principal functions of this sub-section are:

  • Advising and confirming letters of credit received from abroad:
  • Extending financial assistance to exporters as and when required.
  • Acting as an agent for collection on behalf of the clients;
  • Negotiation of export bills drawn under letters of Credit whereby the dealer acts as an agent of overseas bank and facilitates smooth function/operation of international trade; and
  • Acting as an authorized channel appointed by Central Banking Authority to receive the export proceeds.

5. Statistics Section

This section collects the sales and purchase figures from various departments along with necessary exchange control forms, tabulates then and submits a periodical report by way of statements and returns to the Exchange Control Department of the Reserve Bank of India under whose authority it operates. This reports is also being submitted from time to time in one form or the other to the head office of the concerned bank to enable it to compile the overall position of the foreign exchange preferably of the bank as a whole.

2.2 Exchange Regulation in India

Exchange Control Regulations were first introduced in our country on 3rd September, 1939 at the outbreak of World War II. The control was introduced under the guidelines of Bank of England and also as a measure under the Defence of India rules to conserve and augment the foreign exchange resources of India to meet the defence requirements for Britishers. It primary objective was to conserve the foreign exchange resources, which needed to be diversified due to changed circumstances.

It was initially introduced as a temporary device to meet the emergency situation arisen due to Second World War. In May, 1944 the Defence of India Rules were lifted and all emergency provisions promulgated during the Defence of India Rules were ineffective. But the Government of India was not in a position to lift the Exchange Control Regulations due to the strain on the sterling balances; The Exchange Control Regulations were kept alive under a new law named as Emergency Provisions Continuance Act of 1994. The Exchange Control was put on a permanent Statute and the First Foreign Exchange Regulations Act came into existence on 25th March, 1947 as a full fledged foreign Exchange Regulations Act.

The system of control adopted in 1947 was structurally identical to provisions laid down in 1939 at the inception of the control, but important changes in detail were introduced in FERA 1947 to meet the specific requirements of the situation and to protect the interests of independent India.

The Foreign Exchange Regulations Act (FERA) of 1947 has now been replaced by the FERA, 1973. Basic structure of the Exchange Control Regulations is till not very much divergent that the earlier ones, but keeping in view the economic conditions and balance of payments positions, certain new provisions have been included and the control has been made more comprehensive. Under the Act of 1973, the Authorized Dealers have been given wider powers for releasing foreign exchange to the residents in India and a strict view has been taken of the non-resident interests.

I) BROAD FEATURES OF EXCHANGE CONTROL

There is an elaborate machinery to enforce Exchange Control Regulations in our country. The machinery comprises of the controller of the Exchange Control department of the Reserve Bank of India at the helm of affairs, which in turn has empowered the Banks dealing in foreign exchange to deal with general public for their foreign exchange requirements. This authority enforces the provisions of the Foreign Exchange Regulations Act and has the powers to deal with any infringement or violation of the provisions of the Act.

II) THE FERA AND THE EXCHANGE CONTROL MANUAL

All the provisions of the FERA have been transcribed in the banking terminology by the Reserve Bank of India to facilitate the day to day transactions between Reserve Bank, between the various dealers and the general public.

Exchange control in India is administered by the Reserve Bank of India in accordance with the general policy laid down by the Union Government in consultation with the Reserve Bank. The Bank has an Exchange Control Department which is entrusted with this functions. Under the system, the Reserve Bank is authorized to license export of gold, silver, currency notes, securities, and a variety of other transactions involving the sue of foreign exchange.

For foreign exchange transactions, which the general public conducts with the authorized dealers in foreign exchange, the Reserve Bank of India has laid down general instructions for the guidance of the latter. The directions cover all transactions relating to imports and exports, foreign travel payments, family maintenance remittances by foreign nationals, transfers of investment income, capital transfers by foreign and Indian Nationals and other invisible items. Some of these transactions particularly those pertaining to capital transfers, have to be referred by the authorized dealers to the Reserve Bank for its prior approval. Some remittances may, however, be made by the authorized dealers without prior approval of the Reserve Bank, such as those for foreign Nationals seeking to remit a part of their, earnings for the maintenance of their families abroad, provided the amounts are within limits specified by the Reserve Bank.

The institutional framework of the exchange control system also compromised of a special machinery for enforcement and for dealing with any infringements of the provisions of the Act. The function is entrusted to the Directorate of Enforcement attached to the Union Ministry of Finance. The directorate deals with offenders who violate the control provisions and is authorized to take punitive action. It is also empowered to adjudicate in certain cases of infringement.

III) Purchases and Sales by Authorized Dealers

Authorized dealers purchase and sell foreign currencies in accordance with the regulations.

Purchase: They purchase T.Ts., M.Ts., drafts, bill etc., freely from banks and the general public. The receipt of remittances from any country is free and banks are, therefore allowed to purchase freely.

Purchase of foreign currencies is also done from their overseas branches and correspondents for the purpose of making rupee payments into non-resident accounts in India and also for making payments to residents.

The authorized dealers and authorized moneychangers purchase foreign currency notes, coins, and travellers, cheques from travellers coming from abroad. The amounts purchased are endorsed on the reverse of the customs stamped currency declaration forms of the travellers. Foreign currency notes and coins are also purchased from other authorized dealers and money changers.

Sales; Sales of foreign currency are made by authorized dealers subject to control regulations. No remittances may be made to countries advised from time to time and no transactions may be carried out with persons, firms or banks residents in those countries.

For the purpose of sales persons, firms, and banks residents in Nepal are treated as non- residents.

2.3 Exchange Rate Mechanism in India

India is a founder member of the IMF. It followed the fixed parity system till the early 1970s as a result which the value of the rupee in terms of gold was originally fixed as the equivalent of 0.268601 gram of fine gold. In view of India's long economic and political relations with England and membership of the sterling area from September 1939 to June 1972, the rupee was pegged to the pound sterling. The exchange rate was thus remained unchanged but the gold content of the rupee fell to 0.186621 gram. Again, with the devaluation of the Indian rupee in June 1996 the gold content fell further to 0.118489 gram. The following year, the pound was also devalued. This devaluation did have an impact on the rupee pound link, but the rupee was kept stable in terms of the pound. The latter continued as an intervention currency.

In August 1971 when the system of fixed parity was under a cloud, the rupee was briefly pegged to the US dollar at Rs. 7.50/US $ and this continued till December 1971. The peg to the dollar was not very effective as the pound sterling remained to continue as the intervention currency. In December 1971, the rupee returned to the sterling peg at a parity of Rs. 18.9677/£ with of course , a margin of ±2.2 S percent.

After the Smithsonian arrangement had failed and the pound had began to float, the rupee tended to depreciate. The reserve Bank then had to delink it from the pound sterling in September 1975 and link it with a basket of five currencies; but the pound sterling was retained as the intervention currency for fixing the external value of the rupee. The weight of different currencies forming the basket remained confidential and the exchange rate continued to be administered. The administered rate did not keep pace with the growing rate of inflation and this resulted in a widening gap between the real and the nominal exchange rates that was more evident during the late 1980s and early 1990s. Thus, when economic reforms were initiated in the country, the rupee was depreciated by around 20 percent in two successive instalments in the first weeks of July 1991. In absolute terms, depreciation occurred from Rs. 21.201/US $ to Rs. 25.80 /US $

From March 1992 a dual exchange rate system was introduced, in terms of which 40 percent of export earnings were to be converted at the official exchange rate prescribed by the Reserve Bank and the remaining 60 percent were to be converted at market determined rates. The US dollar was he intervention currency. From March 1993 the receipts on merchandise trade account and some of the items of invisible trade account came to be convertible entirely at the market determined rates on all items of current account.

The adoption of the unified exchange rate system form March 1993 means adoption of a floating-rate regime, but it is a managed floating and the reserve Bank of India intervenes in the foreign exchange market in order to influence the value of the rupee. In the first two years, the value of the rupee remained stable but the onward, it has been depreciating despite RBI's intervention.

2.4 Management of Exchange Risk

Risk Hedging tools in Forex Market

In recent year's financial markets have developed many new products whose popularity has become phenomenal. Measured in terms of trading volume, the growth of these products principally futures and options has confused traditional investors. Although active markets in futures and options contracts for physicals commodities have only recently attracted Internet.

Multinational Companies normally use the spot and forward markets for international transactions. They also use currency futures, currency options, and currency futures options for various corporate functions. While speculators trade currencies in these three markets for profit, multilingual companies use them to cover open positions in foreign currencies.

2.4 (a) Forward contract

Forward Exchange

Forward exchange is a device to protect traders against risk arising out of fluctuations in exchange rates. A trader, who has to make or receive payment in foreign currency at the end of a given period, may find at the time of payment or receipt that the foreign currency has appreciated or depreciated. Ifthe currency moves down or gets depreciated the trader will be att a loss as he will get lesser units of home currency for a given amount of foreign currency, which he was holding.

Similarly, an importer, who was contracted to make payment of a given amount in pound sterling at the end of a given period, may find that at the time of payment, the rupee sterling rate is higher. He would then have to pay more in rupees than what it would have been at the time when the contract was made.

To protect traders against such risks of appreciation and getting lesser amount of home currency, there is a device in exchange market of booking forward exchange contracts. The emergence of forward exchange contracts has been due to the rate fluctuations and possible losses that the traders might have to suffer in their foreign exchange business. The forward exchange transaction is an umbrella which gives protection to the dealers against the adverse movement of exchange rates. The forward exchange market in fact came into existence when the exchange rates were highly unstable following the abandonment of the gold standard by most of the countries at the end of first and Second World Wars. There are other means of taking care of the risks of the adverse effects of the exchange rate fluctuations such as including the Escalation Clause in the sale and purchase contracts entered between the buyers and sellers or fixing a parity rate between the home currency and foreign currency and any variation in the fixed parity entered into between the importers and exporters, the exchange risks will be passed on as per the terms of the contract. Escalation clause is more adaptable in contracts amounting to a very large volume,. especially in contracts entered into on deferred payment terms.

Forward Exchange Contracts

Under option forward exchange contracts, the customers has an option to receive or deliver the contract amount of foreign exchange on spot basis on any day during the month the where in the option falls. This option period is one calendar month and the customer has an option to call for or deliver the forward exchange on any day during 1st and the last day of the month for which the contract is booked. In option forward exchange, the delivery is not fixed but is adjusted to mature on any of the two dates or in between. Option forward contracts are very much in vogue due to uncertainty prevailing in the delivery schedules in the international market.

Option forward contracts in inter-bank markets are also booked for split delivery and the contracts are booked for delivery in first half or second half of the month. This means delivery of forward exchange will be made from 1st day of the month to the 15th day of the month and second half means that the delivery will be effected from 6th day of the month to the last day of the month, as requested.

The ordinary forward transaction requiring delivery on a specified date is often “fixed forward”, to the distinguish it from the forward option.

When the banker has to quote to a customer rates for a forward contract, he bases his quotation on the fixed forward rates. In an option contract the customer may demand completion of the contract on any day during the option period. For fixed forward contracts different rates will apply to different days of the period. For the option it will be the same rate for the whole period, and obviously it will be the rate which is most favourable the banker.

As an illustration, let us suppose the current quotation for dollar sterling in New York is:

Spot £ 1 U.S. $ 216-2118

1 month forward 3-2 c. discount

2 months forward 5-4 c. descent

3 months forward 8-6 c. discount

The outright quotations for fixed forward deals will be as follows:

Buying

Selling

Spot

216

218

1 1month forward fixed

213

216

2 months forward fixed

211

214

3 months forward fixed

210

212

Now, if a customer wants to buy forward sterling at its option during the following month, the banker undertakes to deliver him the dame at the agreed rate at any time during the month. Hence , the customer can pick up delivery of the dollars on the first or last day of the month or any intervening day. The banker is aware that he may have to deliver the sterling at the earliest, on the first day, and at the latest, at the end of the month, and these are the extremes of the option allowed to the customer, and the rates applicable to these dates will be considered by the banker in deciding what rate to quote for the transaction. The banker will quote the rate which is favorable to him.

On the basis of the rates given above , the bankers selling rate for spot will be $ 218 if the customer wants delivery ready, and $ 216 will be 1 month fixed forward rate, if delivery is demanded at the end of one month. For an option over the month the banker will quote the rate, which is more favorable to him, i.e., 218. If the option allowed is for the period over the second month, the rate quoted will be 216, the one month fixed forward rate, i.e., the rate applicable for delivery on the fisrt day of the second month. For option over the third month the rate will be that applicable for delivery on the first day of the third month, i.e. 214. On the same principle, if a customer, who wants to sell sterling to the bank, wants an option over the first month, the rate quoted will be chosen from the bankers buying rates applicable to the first and the last day of the month, viz., $ 216 and 213. It will obviously be the one wherein the banker has to apart with less dollars per £, i.e., $ 213. Similarly, for a two month option over the second month, the rate will be the one applicable to the last day of the second month viz. 211. For a three month forward option or for option over the second and third months or for option only over the third month, the rate quoted will be the one applicable to the last day of the third months, viz., $ 210.

If sterling is at a premium the same principle will apply. Thus, if the market rates on a particular day are spot $ 216-218 and forward 1 month 2-3 c., 2 months 4-5 c., and 3 months 6-8 c. premium, the rates quoted on the day will be as under:

Buying

Selling

Spot

216

218

1 1month forward fixed

213

221

2 months forward fixed

220

223

3 months forward fixed

222

226

Forward Rates & Forward Margin

Factors responsible for premium and discount

Forward Rates at a

Premium Discount

Over the spot Rates Over the spot rates

Forward rates DearerForward Rates Cheaper

Than the spot rates than the spot rates

Factors Responsible for

Premium

Discount

  • Excess demand of forward currency
  • Higher Rate of Interest in home centre
  • Likely Appreciation of Spot Rates
  • Excess supply of forward currency
  • Higher Rate of Interest in Foreign centre
  • Likely depreciation of Spot Rates

2.4 (b) Future Contract

Introduction

Besides spot and forward markets, foreign currencies are traded in the market for currency futures and he marked for currency option. These two are known as derivatives because such contracts derive their value of a price time series. The market for currency futures and options is known as the market for derivatives because the prices in these markets are driven by the spot market price.

Hedging in Currency Futures Market

Tenders make use of the market for currency futures in order to hedge their foreign exchange risk. For instance suppose a French importer importing goods from Germany for DM 1.0 million needs this amount for making payment to the exporter . It will purchase DM at a future settlement date. By holding a futures contact, the importer does not have to worry about any change in the spot rate of the DM over time. On the other hand, if the French exported exports goods to a German firm and has to receive DM for the exports, the exporter would sell a DM futures contract. This way the exporter will be locking in the price of the export to be received in terms of DM. It will protect itself form the loss that may occur in case of depreciation of the DM over time.

Speculation With Currency Futures

Speculators make use of the currency futures for reaping profits. When they expect that the spot rate of a particular currency will move up beyond those mentioned in the currency futures contract, they buy currency futures denominated in £ that particular currency. At maturity, if their expectations come true, the difference in the sport rate and the rate mentioned in the futures contract will be the profit to be reaped by them. Suppose, the futures rate is US & 1.75/£and the spot rate on maturity is expected to be US$ 1.76£. If the speculator purchases£ 62,500at the rate of US1.75 (under the futures contract) and the expectation comes true and so sells that pound at the rate of US $1.76 in the spot market, the profit will be US $ (1.76-1.75)* 62,500 = US $625. In other words, the speculators buy currency futures in a currency when the future rate of that currency is expected to be greater than the currency futures rate. On the other hand, if the sport rate of a particular currency is expected to depreciate below the rate mentioned in the currency. For example, if the value of the pound is expected to drop to US $ 1.74 on the maturity date, the speculator will strike a currency futures deal to sell pounds. On the maturity date, it will sell £ 62,500 at US $ 1.75 and with the sale proceeds to be obtained in US dollars, it will buy pounds at the spot rate. This way, it will make profits equal to US $ (1.75-1.740* 62,500 or US $ 625. It may be noted here that these transactions involve cost that is to be deducted from the gain. The transaction cost is very nominal for the locals, but is significant for the speculators.

Intra-currency Spread

Speculators can buy or sell futures of the same currency for two delivery dates if the rates for those two dates differ. This is known as intra currency spread. Suppose, sport rate is US$ 1.795/£: the June-delivery rate is US$ 1.79/£ and the September -delivery rate is US $ 1.775/£. If the speculator expects that the pound will depreciate more rapidly than exhibited by the futures rates, he will buy two futures in pounds for the above two dates. Prior to maturity, he will reverse the two contracts respectively, say, at US $ 1.78 and US $ 1.76. Now in the original contract, the price difference in the two different maturity contracts is US $ 1.79-1.775 = 0.015 while in the reverse contracts, the difference amounts to US $ 0.02. Since the difference in the price of the reverse contracts is greater than the difference in the price of the original contracts, the speculator makes profit amounting to US $ (0.020-0.015)* 62,500 = 312.5.

Inter-currency Spread

Besides the intra-currency spread, inter-currency spread is also used by the speculators. Such spread occurs when the deal involves purchase and sale of future contracts with the same delivery date but with two different underlying currencies. Suppose the speculator expects an appreciation of Canadian dollar relative to the British pound. HE WILL BUY Canadian dollar futures and sell pound futures. Before maturity, he will reverse the two contracts. If the price difference of the two reverse contracts is less than the price difference of the original contracts, the speculator will make a profit.

2.4 (c)OPTION CONTRACT

Privilege of Non-execution of Contract

Foreign currencies are traded in the market for currency options as well. The purpose is either the hedging of foreign exchange exposure or making of profits through speculation. As in currency forward and futures contracts the buyer of currency options possesses the right to buy or sell foreign currency after the lapse of specified period at a rate, determined on the day the contract is made. The currency options contract has a distinctive feature that is not found in a forward or futures contract. It is that the buyer of currency options has the freedom to exercise the option if the agreed-upon rate terms in his favour. If the rate does not turn in his favour, he can let the options expire. Thus the exercising of options in the buyer's right but not his obligation. For this privilege, the buyer has to pay a premium to the option-seller. Suppose a person decides to acquire call options to buy Swiss francs at a price of US $ 0.70 along with a premium for US$ 0.02. On the maturity date, if spot rate of the Swiss franc is lower than the agreed upon rate, he will let the option expire because he will be able to buy it in the sport market at a cheaper rate. But if the sport rate is US $ 0.75 he will exercise the option because his cost of buying Swiss francs under the options contract (inclusive of premium) will be US $ 0.72, whereas he can sell his currency in the spot market at a higher rate and can thereby earn a profit.

Type of Options

Broadly speaking, there are two types of options. In a call option, the buyer of the option agrees to buy the underlying currency, while in a put option contract, the buyer of the option agrees to sell the underlying currency.

The call and put options are also of two types. One, known as the European option, is exercised only on maturity. The other, the American option, may be exercised even before maturity. It is normally in the buyer's interest to exercise the option before maturity and so American options command higher prices than European options.

In recent years, some more variants of options have become available. The first is, for example, known as a forward reversing option. In this case, a call option premium is paid only when the spot rate is below a specified level. The premium is quoted by the seller who charges the premium only when the options are not exercised. This way the buyer gets liberal terms. Secondly, there are preference options in which the buyer gets an additional privilege to designate the option either as a call option or as a put option. Though this privilege is exercised only after the lapse of a specified period. In the case of average rate options, it is the arithmetic average of the sport rate during the like of the option that is taken into account at maturity instead of the spot rate. This type of option enables the buyer to hedge a series of daily cash inflows over a given period in one single contract. If the average rate on maturity is lower than the strike price, the buyer gets the difference between the two. If the average rate is higher than the strike rate, the buyer lets the option expire.

A look-back option gives the holder the right to purchase or sell foreign currency at the most favourable exchange rate realized over the life of the option. For example, the buyer of a call has the right to buy the underlying currency at the lowest exchange rate realized between the creation of the call and the expiry date. The buyer of a put option has the right to sell the underlying currency at the highest exchange rate during the life of the option. All this means that the strike rate in a look-back option is not known until the expiry date. Naturally, because of this specialty, the premium of a look-back option is normally higher than the premium of the traditional option.

In a cylinder or tunnel option, two strike rates exist. When the spot rate is lower than the lower strike rate, the buyer has to pay the lower strike rate. He pays the higher strike rate if the spot rate is higher than the higher strike rate. If the sport rate is between the two strike rates, the buyer pays the spot rate.

There are also barrier options. In the case of down-and-out option, the option expires automatically if the spot rate reaches a level mention ed in the contract. In a down-and-in option, option is activated only when the sport rate reaches a specified barrier within the expiry date. The basket option caters to buyers who are confronted with foreign exchange risk in respect of many currencies.

Hedging With Currency Options

(a) Hedging through purchase of option

In order to hedge their foreign exchange risks, if it is a direct quote, the importers buy a call option and the exporters buy a put option. We first take the case of an importer. Suppose and Indian firm is importing goods for £ 62,500 and the amount is to be paid after two months. If an appreciation in the pound is expected, the importer will buy a call option on it with maturity coinciding with the date of payment. If the strike price is Rs. 60.00/£, the premium is Rs. 0.05 per pound and the spot price at maturity is Rs. 60.20/£, the importer will exercise the option. It will have to pay Rs. 60.00*62,500+3,125 = 3,753,123. If the importer had not opted for an option, it would have had to pay Rs. 62,500*60.20 = 3,762,500. Buying of the call option reduces the importer's obligation by Rs.3,762,500-3,753,125 =9375. If on the other hand, the pound falls to Rs.59.80, the importer will not exercise the option since his obligation will be lower even after paying the premium. Buying of currency option is preferred only when strong volatility in exchange rate is expected and volatility is only marginal, forward market hedging is preferred. Suppose, in the earlier example, the pound appreciates to only Rs. 60.04 or depreciates to only Rs. 59.97, the amount of premium paid by the importer will be more than the benefit form hedging through purchase of options. There will then be net positive cost of hedging through buying of option.

The exporter buys a put option. Suppose an Indian exporter exports goods for £ 62,500. It fears a depreciation of pound within two months when payments are to be received. In order to avoid the risk, it will buy a put option for selling he pound for a two-month maturity. Suppose the strike rate is Rs. 60.00 the premium is Rs. 0.05 and the spot rate at maturity is Rs. 59.80. In case of the hedge, it will receive Rs. 62,500*60.00-3,125 = 3,746,875. In the absence of a hedge, it will receive only Rs. 3,737,500. This means buying of a put option helps increase the exporter's earnings, or reduces its exposure, by Rs. 3,746,875 - 3,737,500 = 9,375.

(b) Hedging through Selling of Options

Hedging through selling of options is advised when volatility in exchange rate is expected to be only marginal. The importer sells a put option and the exporter sells a call option. Let us first take the case of importers. Suppose an Indian importer imports for £ 62,500. It fears an appreciation in the pound and so it sells a put option on the pound at a strike price of Rs. 60.00/£ and at a premium of Rs. 0.15 per pound. If the spot price at maturity goes up to Rs. 60.05 ‘the buyer of the option will not exercise the option. The importer as a seller of the put option will receive the premium of Rs. 9,375 which it would not have received if it had not bought the option. If the spot price at maturity falls to Rs. 59.95 the buyer of the option will exercise the option. But in that case, the importer will have to pay to the buyer Rs. 3,750,000-9,375=3,740,625. When there is no hedging through selling of a put option, the importer, will gave to pay Rs 3,746,875. Thus the importer reduces its risk through the sale of put options.

The exporter sell the call option. If an Indian exporter exports for £ 62,500 and fears that pound will depreciate and sells a call option on the pound at a strike price of Rs. 60.00 at a premium of Rs.0.15 per pound. If the spot rate at maturity really falls to Rs. 59.95, the buyer of the option will not exercise the option. The exporter being the seller of the call option will get Rs. 93,95 as the premium. Its total receipt will be Rs. 62,500*59.95 =9,375 = 3,756,250. In the case of no sale of a call option, the total receipt 9from the importer) will be only Rs. 3,746,875.

Chapter 3

RESEARCH METHODOLOGY

Objectives of the Study

  • To study the evolution and growth of Forex market in India.
  • To study the problems faced by the Foreign Exchange market in India.
  • To evaluate the future trends and prospects of Foreign Exchange market in India.

TOOLS FOR DATA COLLECTION

Every research work in supported by number of information and relevant data for analysing the work done. The information may be from primary or secondary sources.

To complete this project, I have heavily relied on the secondary data as the topic needs a number of published information regarding forex market, recent developments in it etc. So keeping in view the requirement of the information for this topic, I have relied on a number of magazines, journals, newspapers, books etc.

A part from secondary data, I have also collected a number of relevant information from different persons who are associated with the derivative segments of Indian forex market.

LIMITATIONS

  • Not much primary data could be collected on account of the fact that the persons who could provide the relevant data were busy & it was difficult to seek an appointment form them.
  • Due to paucity of time, it was difficult to gather sufficient data on such a vast area.

CHAPTER 4

DATA ANALYSIS

Problems of Fluctuations in Forex Market

The exchange value of a currency, or the rate of exchange, fluctuates with changes in demand and supply. The factors which affect the demand for and the supply of a currency are many and varied. There are some factors which operate in the short period and have influence on day-to-day- fluctuations in rates of exchange. The commercial and financial relationship between trading countries is now extensive and payments on various accounts fall, due for early settlement. These payments on various accounts fall, due for early settlement. These payments constitute the short-term demand and supply in regard to currencies. There are, however, changes in currency and credit conditions and political and industrial conditions which have their influence on exchange rates only in the long period.

The factors affecting exchange rates may be summarized thus:

1.Short-term factors:(a) Commercial

(b) Financial

2.Long-term factors:(a) Currency and credit conditions

(b) Political and economic conditions

4.1SHORT TERM FACTORS

(a) Commercial factors

One of the important factors influencing the demand for and supply of currencies is trade in merchandise, i.e., imports and exports of goods. The demand for the currency of a country arises from exports of goods by the country B. An increase in a country's imports due to an increase in demand, a reduction of tariffs, or an export-promotion drive by exporting countries raises the demand for and exchange value of currencies of exporting countries in the exchange market of the importing country.

In other words, the exchange value of the currency of the exporting country falls. An increase in exports has the reverse effect.

There are, in addition, many invisible items of payment which create debts and, therefore, need for settlements through purchase and sale of exchange. The residents of a country have to pay and receive from foreigners for services of various kinds, such as transport, banking, insurance, etc. Premium, brokerage, commission and other risks of payments are made, or received by trading countries. Exports of equipment, enterprise and technical skill by advanced countries to underdeveloped countries has assumed considerable importance during recent years for which the exporting countries receive payments in the form of profits, dividends, foreign royalties and other charges.

The effects of lactations in exchange rates are either favourable or adverse and healthy or unhealthy, depending upon the ultimate result and influence of the fluctuations on the balance of trade and payments position between the trading partners directly or indirectly. To avoid the adverse effects of rate of fluctuations and ultimate losses or gains to either of the trading partners, some of the countries, especially East European countries, have opted to enter into Bilateral Trade Agreements wherein the payments are settled through exchange of goods and services instead of making the payments in currencies of either of the countries. Such agreements avoid monetary transactions and the countries with lesser foreign exchange reserves can make the use of these scarce commodities to trade with other direct payment procedure countries.

Summing up we can say that the demand for currency on trade account arises on account of the following factors:

  • The residents of the country have exported goods to other nations for which they have to receive payments.
  • The shipping, banking and insurance companies of the country render services to other countries for which they receive remuneration.
  • Entrepreneurs setting up business abroad, and supply technical personnel and managers receive profits and salaries.
  • Tourists and students coming from abroad spend money in the country.
  • Besides the regular tourist traffic going from country to country only for tourist interests, here are certain groups travelling on cultural and exchange programmers under various government-sponsored delegations and private visits to fiends and relatives staying in other countries also lead to the need of foreign exchange. In recent years, movement of individuals and groups on these accounts are on higher side, and the overall contribution of the exchanges effecting on these accounts are figuring remarkably in overall balance of payments position under the heading of private transfers.

Similarly factors which are responsible for supply of currency against a demand for foreign currencies are:

  • Imports from other countries.
  • Use of services by foreign shipping, banking, insurance and other services, for which payments are to be made.
  • Payments made as salaries and profits to foreigners not staying in the same country.
  • Residents of the country going as tourists abroad and for higher education in foreign universities and institutions spend money there.

(b) Financial Short-term Factors

International financial operations had important influence on exchange rates when movements of foreign capital and speculative dealings in foreign exchange are not controlled. The influence of short-term factors is much-less in present-day conditions.

Financial operations include, among other transactions, short period movement of funds between two or more countries. If rates of interest are higher at one centre than at another, the tendency would be for banks and other institutions at the place where the rates are low to use some of the funds for investment in bills the other centre. In rates of interest in a country rise due to a rise in the central bank or some other reasons, there is a flow of short-term funds to the country and the demand for its currency and the exchange value of the currency rises in the exchange markets of other countries. The reverse happens if there is a fall in interest rates. Funds are also exported for short-term investment in other countries when the exchange value of the currency is expected to fall. This is purely a speculative operation.

Stock exchange transactions do play an important part in influencing exchange rates when imports and exports of capital are permitted. Residents of country sometimes buy a foreign currency in order to purchase securities on the stock exchanges of that country. These purchases may be for genuine investment or may be for speculative purposes. This is likely to happen when industrial prospects in the country of investment are bright and the prices of securities are expected to rise. In the event of poor economic and industrial outlook investments in that country are repatriated and the demand for its currency falls.

Another financial factor is movement of funds from one centre to another by banks. Banks maintain balances at different centres and the volume of maintaining the balances at a centre depends on the economic and industrial state of the country. When the outlook in this regard is bright, remittances to the country increases and the banks acquires larger balances in that country. To pay for the foreign currency with increased demand, the value the currency changes the event of a poor outlook, banks shift their holdings to centres where the outlook is favourable and in such circumstances the exchange value of the currency depreciates.

In recent years movement of funds from one country to another has been taking place on government account due to external assistance, aid and line of credits. Untied States particularly has been giving large financial assistance to other courtiers. This has increased the supply of funds in the aid-receiving countries.

An exchange rate is sometimes affected by the disbursements and repatriation between countries for their debt settlements. When the economic outlook for a country has a stronger position in relation to others, and foreigners who have to make remittances to the country do so before the value of the currency rises higher. The demand for the currency rises further and its exchange value becomes more country is poor, the currency shows a downward trend in exchange markets. There is a tendency for the residents of the country to transfer their funds abroad and for foreigners to withdraw their funds. The currency, therefore, weakens further.

Financial, operations also arise form what are known as “Arbitrage Operations”. Arbitrage means the simultaneous buying and selling of any commodity at two or more centers, used by a discrepancy in the price differentiation at different places. Arbitrage in stocks or money or exchange on a international scale has an important influence n exchange rates. For example, taking price and exchange rates into account, an international operator may find that the price of a particular security which is bought on stock exchange at two centers in different countries differs. He, therefore, enters in a purchase deal at the center where the price is low and simultaneously enters into a sale deal at the one where the price is high. This necessitates remittance from the latter center to the former, causing the exchange rate to change in favor of the former and against the latter.

4.2LONG TERM FACTORS

(a)Currency and Credit Conditions

Any economic condition which causes the internal purchasing power of a currency to rise or fall eventually affects its exchange value. Such effects are frequently aggravated by the speculators in the exchange markets. Sometimes these operations curtail or diminish the effects of the economic factors.

An expansion of currency circulation in a country raises the level of internal prices, or in other words,


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