Foreign Exchange Market: Unit 2

Unit 2
Foreign Exchange Market

2.1 Foreign Exchange Market
2.2 Participants in Foreign Exchange Market
2.3 Forecasting Exchange Rate
2.4 Foreign Exchange Management Act (FEMA), 1999
2.5 Foreign Exchange Rate
2.6 Parity Relations
2.7 Foreign Exchange Risk
2.8 Speculation in Foreign Exchange Market
2.9 Currency Arbitrage
2.10 Convertibility of Indian Rupee
Introduction
 The market for foreign exchange involves the purchase and sale of national currencies.
 A foreign exchange market exists because economies employ national currencies. If the
world economy used a single currency there would be no need for foreign exchange
markets. In Europe 11 economies have chosen to trade their individual currencies for a
common currency.
 But the euro will still trade against other world currencies. For now, the foreign
exchange market is a fact of life. The foreign exchange market is extremely active.
 It is primarily an over the counter market, the exchanges trade futures and option (more
below) but most transactions are OTC.
 It is difficult to assess the actual size of the foreign exchange market because it is traded
in many markets.
Foreign Exchange:
After liberalisation, globalisation gathered momentum in India in 1991, Foreign Exchange
Market have assumed greater significance in India. The Indian economy which was closed and
regulated, got converted into an open economy. With the opening of the economy, various types
of transactions started taking place among international and Indian parties with minimum
intervention from RBI or Government of India.
A) Meaning :
By ‘Foreign Exchange’ we mean broadly, a vast array of foreign currencies such as Pound
Sterling, US Dollars, French Francs, Deutsch Marks, Yens etc. apart from currency, near
money assets denominated in foreign exchange are also included in foreign exchange.
B) Definition :
1) Foreign Exchange Management Act 1999 :
“All deposits, credits, balances payable in any foreign currency and any drafts, travellers
cheques, letters of credit, bills of exchange expressed or drawn in Indian currency but
payable in any foreign currency”.
Foreign Exchange Market:

A) Meaning :
Foreign Exchange Market is a part of money market. It is a place where foreign money is
bought and sold. It is a market for national currency anywhere in the world. The trading in
Foreign Exchange Market is done 24 hours a day by telephone, telex and fax machine,
display monitor, satellite communication, SWIFT (Society for Worldwide Interbank
Financial Telecommunication) .
B) Features of Foreign Exchange Market :

The features of foreign exchange market are given below:
Size of the 24 Hours Currencies

Location
Market Market Traded
Physical Settlement of
Participants
Markets Transactions

1) Location :
Foreign exchange market is described as an over the counter (OTC) market. There is no
physical place where the participants meet to execute the deals. It is more an informal
arrangement among the banks and brokers.
2) Size of the Market :
Foreign exchange market is the largest financial market. These markets were primarily
developed to facilitate settlement of debts arising out of international trade. There is
steady increase in the volume of foreign trade in India which is evidenced from foreign
exchange markets in India.
3) 24 Hours Market :
The foreign exchange markets are situated throughout the different zones of the world.
They are situated in such a way that when one market is closing the other is beginning its
operations. Thus, at any point of time one market or the other is open.
4) Currencies Traded :
In most markets, US dollar is the vehicle currency. The currencies like Euro and Yen are
also gaining a larger share.

5) Physical Markets :
In the centres like Paris and Brussels, foreign exchange business takes place at a fixed
place. At these centres, the banks meet and in the presence of the central bank, fix rates
for a number of major currencies. This practice is called fixing.
6) Participants :
There are four major participants in the foreign exchange market. They are as follows :
 Corporate
 Commercial Banks
 Exchange Brokers, and
 Central Banks.
7) Settlement of Transactions :
Foreign exchange markets make extensive use of the latest developments in
telecommunications for transmitting as well as settling foreign exchange transactions.

C) Functions of Foreign Exchange Market:
Its main purpose is to assist transfer of purchasing power denominated in one currency into
another.
Intermediary between Buyers and Sellers of

Foreign Exchange
Transfer of Purchasing Power
Provision of Credit
Provision of Hedging Facilities

C) Functions of Foreign Exchange Market:
1) Intermediary between Buyers and Sellers of Foreign Exchange:
Since the foreign exchange markets provide a convenient way of converting the
currencies earned from international trade and other sources, they act as intermediary
between buyers and sellers of foreign exchange.
2) Transfer of Purchasing Power:
The primary function of a foreign exchange market is the transfer of purchasing power
from one country to another and from one currency to another. The international clearing
function performed by foreign exchange markets plays a very important role in
facilitating international trade and capital movements.
3) Provision of Credit:
The credit function performed by foreign exchange markets also plays a very important
role in the growth of foreign trade, for international trade depends to a great extent on
credit facilities.
4) Provision of Hedging Facilities:
The other important function of the foreign exchange market is to provide hedging
facilities. Hedging refers to covering of foreign trade risks, and it provides a mechanism
to exporters and importers to guard themselves against losses arising from fluctuations in
exchange rates.

D) Factors Affecting/ Determinants of Foreign Exchange Rates:
Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries.
Differentials
in Inflation
Political
Differentials
Stability and
in Interest
Economic
Rates
Performance
Current-
Terms of
Account
Trade
Deficits
Public Debt

D) Factors Affecting/ Determinants Foreign Exchange Rates:
1) Differentials in Inflation:
As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies. During the
last half of the 20th century, the countries with low inflation included Japan, Germany and
Switzerland, while the U.S.
2) Differentials in Interest Rates:

Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values.
3) Current-Account Deficits:
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest and dividends.

D) Factors Affecting/ Determinants Foreign Exchange Rates:
4) Public Debt:
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations
with large public deficits and debts are less attractive to foreign investors as a large debt
encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid
off with cheaper real dollars in the future.
5) 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.
6) Political Stability and Economic Performance:

Foreign investors inevitably seek out stable countries with strong economic performance
in which to invest their capital. A country with such positive attributes will draw
investment funds away from other countries perceived to have more political and
economic risk.
The foreign exchange market in India is relatively very small. The major players in that market
are the RBI, banks and business enterprises. Indian foreign exchange market is controlled and
regulated by the RBI.
A) Various Participants in Foreign Exchange Market:

For exchange of currencies of different countries in foreign exchange market services of
following participants are needed: Traders
Speculato
Banks
r
Overseas
Forex Brokers
Markets

1) Traders :
Exporters and Importers participate in foreign exchange market through availing services
of banks. An exporter gets his foreign exchange receipts converted into domestic
currency through a bank and an importer gets his currency converted into foreign
currency by paying for the goods imported.
2) Banks :
Commercial banks deal in international transactions by converting one currency into the
other currency with the help of their network of branches and correspondent banks in
different countries.
3) Brokers :
Brokers in foreign exchange play a vital role. Dealing in interbank market in India takes
place through forex brokers. They cannot deal on their own account. They charge
commission as a brokerage.
4) Overseas Forex Markets :
A significant development of foreign exchange markets took place during last 20 years.
Apart from London many other centres of trading operate for 24 hours in different time
zones.

5) Speculator :
Speculators in the foreign exchange markets are :
 Banks
 Government
 Multinational Corporations and Transportation Corporations
 Individuals who purchase foreign currency bonds and other assets
 Corporate entities.
All these speculators experience profit or loss on account of fluctuations in the rate of
exchange.
B) Role Played by Various Participants Customers

of Foreign/ Exchange Market:
Traders or
These participants play a variety of roles in foreign exchange market as follows:
Corporate and
Corporate and
Individuals
Foreign Commercial
Travellers Banks
International
Financial Central Bank
Institutions
Authorised
Speculators
Dealers
Foreign
Exchange
Markets
abroad
B) Role Played by Various Participants of Foreign Exchange Market:

1) Customers / Traders or Corporate and Individuals :
For thousands of years, international traders have dominated the foreign exchange market
in terms of barter goods, gold, silver or foreign currencies. A variety of goods change
hands internationally and supplies have to be paid in acceptable currencies.
2) Commercial Banks :
In every country, the Central Bank cannot handle all foreign exchange business of the
country by itself. It therefore appoints ‘Authorised Dealers’ for facilitating international
trade and commerce.
Because of the financial strength and expertise, commercial banks now deal in foreign
exchange business for following reasons:
a) Customer Service :
Suppliers and buyers of goods in international trade choose the most suitable bank for
their business and use that bank for their foreign exchange operations.
b) Exchange Rate Risk Management :
Banks are experts in gauging the depth and direction of foreign exchange rates. They
are therefore well placed, to manage the risks involved because of fluctuations in
exchange rates.

2) Commercial Banks :
c) Treasury Management :
Commercial banks have now added temporary foreign exchange holdings as one of
the current assets in their business. With expertise and experience, banks manage their
integrated treasuries in a better and more efficient manner.
3) Central Bank (RBI in Case of India) :
In every country, generally the Central Bank is the authorised custodian of foreign
exchange. Maintenance of the value and stability of the local currency in international
markets is very important for every economy.
The Central Banks main functions can be summarized as follows :
a) Maintaining the External Value of the Currency :
The Central Bank has to intervene in the affairs of foreign exchange business, if it
finds that the local currency is likely to go down or up, substantially affecting the
economic stability of the country.
b) Exchange Rate Risk Management :
Different currencies behave in different ways in international market. Depending on
the need of exports and imports, the Central Bank may adopt different approaches for
adjustment of exchange rates with respect to different countries.

3) Central Bank (RBI in Case of India) :
c) Foreign Exchange Reserves Management :
The most important function of the management is to manage reserves of the foreign
exchange of a country. Changes in the holdings of different currencies by Central
Bank affect the foreign exchange rates with respect to these countries directly.
4) Authorised Dealers :
In most countries, the Central Bank authorises some banks to act as Authorised Dealers
in foreign exchange. Apart from banks, Central Bank may authorise certain individuals,
institutions as Authorised Dealers depending on its discretion.
5) Foreign Exchange Markets abroad :
In recent times because of globalisation, some major international foreign exchange
markets have made their presence felt. Among them, most important markets are
London, New York, Tokyo, Singapore, Hong Kong, Dubai, Frankfurt, Paris, Bahrain etc.
6) Speculators :
Because of forward quotations for commodities, forward quotes for different currencies
there is a huge speculative international market. Futures of commodities like oil, gold,
silver and currencies like US $, Euro, Pound etc.

7) International Financial Institutions :
Organisations like World Bank, IMF, ADB etc. which deal with infrastructural, industrial
and agricultural developments across many countries of the globe, sanction millions of
dollars for different projects.
8) Foreign Travellers :
In a globalised world, a large number of people move from one country to another for
jobs, corporate work, international trade or tourism. Every country has a different
currency. Though currencies like US - Dollar, British - Pound, Kuwaiti - Dinar, Hong
Kong- Dollar are hard currencies which can get converted to local currency anywhere,
currency such as Indian- Rupee, Malaysia- Ringet, Kenya- Shilling etc. are not
convertible.
Corporates need to do the exchange rate forecasting for taking decisions regarding hedging,
short-term financing, short-term investment, capital budgeting, earnings assessments and long-
term financing etc.
A) Need of Exchange Rate Forecasting:

An exchange rate forecast is necessary for following reasons:
Spot Speculation
and Uncovered Spot-forward Option Hedging
Interest Arbitrage Speculation Speculation
Investment and
Financing
Capital Budgeting Pricing Decisions Strategic Planning
Decisions
Decisions
Macroeconomic Central Bank

Conditions Intervention

1) Spot Speculation and Uncovered Interest Arbitrage:
A spot speculator buys (goes long on) a currency if a forecast indicates that it will
appreciate and sells (or short sells) a currency if the forecast indicates impending
depreciation. In both cases profit will be made if the expectation or forecast turns out to
be accurate.
2) Spot-forward Speculation:
If a forecast indicates that the spot exchange rate will be higher than the forward rate on
the maturity date of the forward contract, a speculator will buy forward and sell spot
upon delivery.
3) Option Speculation:
A long call or a short put position will be taken if the underlying currency is expected to
appreciate, whereas a short call or a long put position will be taken if the currency is
expected to depreciate.
4) Hedging:
The decision whether or not to hedge exposure to foreign exchange risk resulting from
payables or receivables depends on the spot exchange rate expected to prevail when
payables or receivables are due.

5) Investment and Capital Budgeting Decisions:
The choice of currency for short term investment depends on the rate of return on assets
denominated in that currency and whether or not it is expected to appreciate over the
investment horizon.
6) Financing Decisions:
A currency will be chosen for financing purposes if it is expected to depreciate. A long-
term financing decision involves the choice of the currency to serve as the denomination
of a bond issue.
7) Pricing Decisions:
Exchange rate forecasting is important for international business firms selling their
products in foreign countries. The foreign currency price of a product could be anything
in relation to the corresponding domestic currency price, depending on the level of the
exchange rate.
8) Strategic Planning:
Exchange rate forecasting is also important for strategic planning, such as the choice of
production location and the foreign markets in which to sell the products.

9) Macroeconomic Conditions:
Exchange rate forecasting may be useful not only for its own sake but also because of its
by-products. The forecasting process provides an extensive discussion of macroeconomic
conditions in each country.
10) Central Bank Intervention:
Business firms need exchange rate forecasting and so do central banks and economic
decision-making authorities. For example, the central bank intervenes in the foreign
exchange market in order to make the expected path of the exchange rate converge on the
desired path. Identifying the expected path requires exchange rate forecasting.
B) Techniques of Exchange Rate Forecasting:

The numerous methods available for forecasting exchange rates can be categorized into four
genera] groups:
Fundament
Technical
al
Forecasting
Forecasting
Market
Mixed
Based
Forecasting
Forecasting
1) Technical Forecasting:
Technical forecasting involves the use of historical exchange rate data to predict future
values; There may be a trend of successive daily exchange rate adjustments in the same
direction, which could lead to a continuation of that trend.
B) Techniques of Exchange Rate Forecasting:

2) Fundamental Forecasting:
Fundamental forecasting is based on fundamental relationships between economic
variables and exchange rates. Given current values of these variables along with their
historical impact on a currency’s value, a corporation can develop exchange rate
projections.
3) Market Based Forecasting:

Market based forecasting generally assumes that current speculation will reflect the
actuality of future conditions. Relying on market indicators, proponents of this method
use spot rates or forward rates to determine the movement of currencies.
4) Mixed Forecasting:
Mixed forecasting is the natural result of the lack of a single and superior method of
predicting rates of exchange. Essentially, mixed forecasting assigns weighted values to
the results derived from other valuation techniques.
C) Forecasting Models:
There are two exchange rate forecasting models. These are as follows:
Reduced-form
Model
Forecast may be
Conditional
Single-equation Estimated from

Models Historical Data
Econometric
Forecasting Models
Multi-equation
Forecasting Measurement
Econometric
Models Errors
Models
Time Series
Forecasting Models
Variables are
Qualitative in
Nature
1) Econometric Forecasting Models :
Econometric models, as the term is used, are models that are specified on the basis of
some economic theory and estimated by an econometric method.
a) Single-equation Models:
In the case of single-equation models (also called reduced form models), the exchange
rate (or its rate of change) is to depend on one or more variables.
In general, a single-equation model may be specified as
tS   (X X
1,t X )
2,t ..... n ,t
1) Reduced-form Model:
A single-equation econometric model is called a reduced-form model because it
explains the value of the exchange rate in terms of other variables without telling
us how these explanatory variables are determined.
2) Forecast may be Conditional:
Second, the forecast may be conditional on the future values of the explanatory
variables. If this is the case, our forecast of the exchange rate depends on the
accuracy of the forecasts of the explanatory variables.
1) Econometric Forecasting Models :
a) Single-equation Models:
3) Estimated from Historical Data:
The underlying assumption is that the equation as estimated from historical data
will remain valid over the forecasting horizon, which implies that the estimated
coefficients are constant.
4) Measurement Errors:
There are measurement errors in some explanatory variables. For example, the
balance of payments position is measured with a significant errors and omissions
item.
5) Variables are Qualitative in Nature:
A bigger problem arises when some of the explanatory variables are qualitative in
nature, such as market sentiment.
b) Multi-equation Econometric Models:
The first problem associated with single-equation econometric models can be dealt
with by specifying a structural multi-equation model. This can be done by specifying
equations to explain the explanatory variables X1,, ..., Xn.
2) Time Series Forecasting Models:
What distinguishes time series models from what we call econometric models is that the
former are based entirely on the past history of the exchange rate. The level of the
exchange rate is postulated to depend on its past levels, in this case the model is written
as:
St   (St 1,t X t  2..... X t  n )
In India, all transactions that include foreign exchange are regulated by the Foreign Exchange
Management Act (FEMA), 1999. It repealed the Foreign Exchange Regulations Act (FERA),
1973. FEMA has been enacted to facilitate external trade and payments and to promote the
orderly development and maintenance of foreign exchange market.
A) Meaning of Foreign Exchange:

According to the Act, the term 'foreign exchange' means "foreign currency and includes:-
 deposits, credits and balances payable in any foreign currency;
 drafts, travellers cheques, letters of credit or bills of exchange, expressed or drawn in
Indian currency but payable in any foreign currency;
 drafts, travelers cheques, letters of credit or bills of exchange drawn by banks,
institutions or persons outside India, but payable in Indian currency".
B) Provisions of the Act:

The Reserve Bank of India (RBI) has been assigned the function of administering the
various provisions of FEMA.
The main provisions of the Act are:-
1) It permits only authorised person to deal in foreign exchange or foreign security. Such an
authorised person, under the Act, means authorised dealer, money changer, off-shore
banking unit or any other person for the time being authorised by Reserve Bank. The Act
thus prohibits any person who:-
 Deal in or transfer any foreign exchange or foreign security to any person not being an
authorized person;
 Make any payment to or for the credit of any person resident outside India in any
manner;
 Receive otherwise through an authorized person, any payment by order or on behalf of
any person resident outside India in any manner;
 Enter into any financial transaction in India as consideration for or in association with
acquisition or creation or transfer of a right to acquire, any asset outside India by any
person;
 Is resident in India which acquire, hold, own, possess or transfer any foreign exchange,
foreign security or any immovable property situated outside India.
B) Provisions of the Act:

The Reserve Bank of India (RBI) has been assigned the function of administering the
various provisions of FEMA.
The main provisions of the Act are:-
2) The Act regulates two types of foreign exchange transactions, namely 'Capital Account
Transactions' and 'Current Account Transactions'.
a) According to the Act, 'Capital account transaction' means a transaction which alters
the assets or liabilities, including contingent liabilities, outside India of persons
resident in India or assets or liabilities in India of persons resident outside India.
b) It also defines the term 'current account transaction' as a transaction other than a
capital account transaction and without prejudice to the generality of the foregoing.
3) The Act has empowered the Reserve Bank of India (RBI) to specify, in consultation with
the Central Government, the permissible capital account transactions and the limits upto
which foreign exchange may be drawn for such transactions.
4) Any person may sale or draw foreign exchange if such sale or drawal is a current account
transaction. Under the Act, Central Government may, in public interest and in
consultation with the Reserve Bank, impose such reasonable restrictions for current
account transactions as may be prescribed.
C) Role of RBI in Management of Foreign Exchange:

The Reserve Bank oversees the foreign exchange market in India. It supervises and regulates
it through the provisions of the Foreign Exchange Management Act, 1999.
Gives Permission to
Provided the
Issues Licences hold Foreign
Exchange Facility
Currency
Indian Investment External Commercial

Foreign Investment
Abroad Borrowings
Liberalised Indian Depository

Currency Futures
Remittance Scheme Receipts (IDRs)

1) Issues Licences:
The Reserve Bank issues licences to banks and other institutions to act as Authorised
Dealers in the foreign exchange market. In keeping with the move towards liberalisation,
the Reserve Bank has undertaken substantial elimination of licensing, quantitative
restrictions and other regulatory and discretionary controls.
2) Provided the Exchange Facility:
Apart from easing restrictions on foreign exchange transactions in terms of processes and
procedure, the Reserve Bank has also provided the exchange facility for liberalised travel
abroad for purposes.
3) Gives Permission to hold Foreign Currency:
Moreover, the Reserve Bank has permitted residents to hold foreign currency up to a
maximum of USD 2,000 or its equivalent. Residents can now also open foreign currency
accounts in India and credit specified foreign exchange receipts into it.
4) Foreign Investment:
Foreign investment comes into India in various forms. Following the reforms path, the
Reserve Bank has liberalised the provisions relating to such investments.

5) Indian Investment Abroad:
RBI allows any Indian entity to make investment in an overseas joint venture or in a
wholly-owned subsidiary, up to 400% of its net-worth.
6) External Commercial Borrowings:
Indian companies are allowed to raise external commercial borrowings including
commercial-bank loans, buyers’ credit, suppliers’ credit, and securitised instruments etc.
7) Liberalised Remittance Scheme:
As a step towards further simplification and liberalisation of the foreign exchange
facilities available to the residents, the Reserve Bank has permitted resident individuals
to freely remit abroad up to USD 200,000 per financial year for any permissible
purposes.
8) Currency Futures:
In a recent development, regulators have permitted exchange-traded currency futures in
India. Such trading facilities are currently being offered by the National Stock Exchange,
the Bombay Stock Exchange and the MCX-Stock Exchange.

9) Indian Depository Receipts (IDRs):
Under another reform measure, authorities in India have allowed eligible companies
resident outside India to issue Indian Depository Receipts (IDRs) through a domestic
depository. Such issuances are subject to approval of the sectoral regulators.
10) Exchange Rate Policy:
The Reserve Bank’s exchange rate policy focuses on ensuring orderly conditions in the
foreign exchange market. For the purpose, it closely monitors the developments in the
financial markets at home and abroad.
11) Facilitate Derivative Instruments in the Foreign Exchange Market:
In addition to the traditional instruments like forward and swap contracts, the Reserve
Bank has facilitated increased availability of derivative instruments in the foreign
exchange market.
In the foreign exchange market, at a particular time, there exists, not one unique exchange rate,
but a variety of rates, depending upon the credit instruments used in the transfer function.
A) Major Types of Exchange Rate:

Major types of exchange rates are as follows:
1) Spot Rates:
In finance, a spot contract, spot transaction, or simply "spot," is a contract of buying or
selling a commodity, security, or currency for settlement (payment and delivery) on the
spot date, which is normally two business days after the trade date. The settlement price
(or rate) is called a "spot price" or "spot rate."
2) Forward Rates:
A spot contract is in contract with a forward contract where contract terms are agreed
now but delivery and payment will occur at a future date. The settlement price of a
forward contract is called a "forward price" or "forward rate. "
3) Cross Rates:
A cross rate is the currency exchange rate between two currencies, both of which are
not the official currencies of the country in which the exchange rate quote is given in.
B) Exchange Rate –Regime/System:

Exchange rates are determined by demand and supply. But governments can influence those
exchange rates in various ways.
Following are the new exchange rate system:
Fixed Exchange Rate System
Floating/ Flexible Rate System
Currency Pegging
1) Fixed Exchange Rate System:

A fixed exchange rate system is an exchange rate regime in which the government of a
country is committed to maintaining a fixed exchange rate for its domestic currency.
B) Exchange Rate –Regime/System:

2) Floating/ Flexible Rate System:
During the Bretton Woods era, exchange rates were more or less fixed or pegged.
However, many leading economists argued that they should be allowed to float.
3) Currency Pegging:
Currency pegging is the idea of fixing the exchange rate of a currency by matching its
value to the another single currency or to a basket of other currencies, or to another
measure of value, such as gold or silver.
2.6 Parity Relations
The international parity relationships are the basis of analysis of exchange rate behaviour. In the
absence of barriers to international capital movements, there is a relationship between spot
exchange rates, forward rates, interest rates and inflation rates.
Purchasing Interest Rate

Power Parity Parity
1) Purchasing Power Parity:
Purchasing power parity expresses the idea that a bundle of goods in one country should
cost the same in another country after exchange rates are taken into account. Suppose that
with existing relative prices and exchange rates, a basket of goods can be purchased for
fewer U.S. dollars in Canada than in the United States.
2) Interest Rate Parity:
Interest rate parity has to do with the idea that money should (after adjusting for risk) earn
an equal rate of return. Suppose that an investor can earn 6% interest with a dollar deposit in
a United States bank, or can earn 4% interest with a British pound deposit in a London bank.
Foreign exchange risk is the risk of an investment’s value changing due to changes in currency
exchange rates. It is the risk that an investor will have to close out a long or short position in a
foreign currency at a loss due to an adverse movement in exchange rates.
A) Types of Risks :
There are various types of risks involved in foreign exchange markets. They are discussed
below:
Exchange Rate Risk or Position Risk
Operational Risk
Country Risk
Legal Risk
Counter Party Risk or Credit Risk

A) Types of Risks :
1) Exchange Rate Risk or Position Risk :
This type of risk refers to the risk of change in exchange rates affecting the overbought or
oversold position in foreign currency held by a bank. If the amount of currency
purchased by a bank is more than the amount of currency sold to the foreign exchange
dealer the bank is said to have “over purchase” or “long or plus position” on the other
hand, if the amount of currency purchased by the bank is less than the amount of
currency sold to the foreign dealer, the bank is said to have “Over sold” or “Short or
Minus Position”.
2) Operational Risk :
Human mistakes, faults in working procedures may create operational risk in case of
exchange transactions. Banks should take precautions about these risks and try to take
proper action in time.
3) Country Risk :
Country risk is also known as sovereign risk or transfer risk. This risk relates to the
ability and willingness of a country to service its external liabilities. It refers to the
possibility that the Government as well as other borrowers of a particular country may be
unable to fulfill their obligations under foreign exchange transactions due to reasons
which are beyond the usual credit risks.
A) Types of Risks :
4) Legal Risk :
This risk is created due to events happening in one country or events happening in the
country of origin in case of the currencies in which banks have exchange transactions.
This risk may be created in a country in which a bank as a counter party makes exchange
transactions.
5) Counter Party Risk or Credit Risk :
Counter party risk is related to risk of loss which may be created in case of outstanding
contracts where a counter party fails to fulfill obligations. Owing to lack of ability to
repay or due to unwillingness on the part of a borrower he is not able to repay the loans,
there will be a Credit Risk.
B) Tools and Techniques of Foreign Exchange Risk Management:

The most frequently used financial instruments by companies in India and abroad for
hedging the exchange risk are discussed below.
Currency Currency
Forward Futures
Contracts Contracts
Currenc
Currenc
y Option
y Swap
Contract
1) Currency Forward Contracts:

A forward contract is one where counterparty agrees to exchange a specified currency at
an agreed price for delivery on a fixed maturity date. Forward contracts are one of` the
most common means of hedging transactions in foreign currencies.
B) Tools and Techniques of Foreign Exchange Risk Management:

2) Currency Futures Contracts:
Futures are the same as a forward contract except that it is standardized in terms of
contract size is traded on Future exchanges and is settled daily. In practice, futures differ
from forwards in 3 important ways.
3) Currency Option Contract:

An option contract is one where the customer has the right but not the obligation to
contract on maturity date. Options have an advantage as compared to Forward contracts
as the customer has no obligation to exercise the option in case it is not in his favour.
4) Currency Swap:
A currency swap is defined as an agreement where two parties exchange a series of cash
flows in one currency for a series of cash flows in another currency at agreed intervals
over an agreed period.
C) Hedging Techniques of Foreign Exchange Risk:

There is a wide range of methods available to minimise foreign exchange risk. External
techniques use contractual means to insure against potential foreign exchange losses.
Hedging Techniques
Internal Techniques of Hedging External Techniques of Hedging


A) Internal Techniques of Hedging:
Internal techniques embrace netting, matching, leading and lagging, pricing policies and
asset/liability management. External techniques include forward contracts, borrowing
short term, discounting, factoring, government exchange risk guarantees and currency
options.
a) Netting :
Netting involves associated companies which trade with each other. The technique is
simple. Group companies merely settle inter-affiliate indebtedness for the net amount
owing. Gross intra-group trade receivables and payable are netted out.
b) Matching :
Although netting and matching are terms which are frequently used interchangeably,
there are distinctions. Strictly speaking, netting is a term applied to potential flows
within a group of companies whereas matching can be applied to both intra-group and
third-party balancing.
c) Leading and Lagging :
Leading and lagging refer to the adjustment of credit terms between companies. They
are most usually applied with respect to payments between associate companies
within a group.

B) External Techniques of Hedging:
a) Forward Contract Hedge :
Forward contract has been most widely used form of hedging exchange rate risk. In a
forward contract, the company arranges for disposing the foreign currency or acquires
the foreign currency at a future date, when it is likely to be received or paid by it, at a
predetermined exchange rate.
b) Money Market Hedge :
This is also known as spot market hedge. Under this method, the company which has
an exposure in a foreign currency, covers it by borrowing or investing the concerned
currency in the money market and square its position on the due date.
c) Hedging with Options :
Option gives the buyer a right, but not an obligation to buy or sell a specified amount
of foreign currency on a specified future date.
d) Hedging with Futures :
Due to intense competition in the futures market, currency futures are available with
this margin. They may prove to be a good tool for hedging where large exposure is
involved and is expected to mature near the due date of the futures contracts.
2.8 Speculation in Foreign Exchange Market
Speculation means raking a foreign exchange risk in the hope of making profit. Speculation is
based on the expectations about the future rate of a foreign currency.
A) Speculation in Different Market of Foreign Exchange:

Currency speculation exists whenever someone buys a foreign currency, not because he
needs to pay for an import or is investing in a foreign business, but because he hopes to sell
the currency at a higher rate in the future (in technical language the currency "appreciates").
1) Speculation in the Spot Market:
Speculation in the spot market occurs when the speculator anticipates a change in the
value of a currency. Suppose the exchange rate today is Rs. 40/US $. The speculator
anticipates this rate to become Rs. 41/US $ within the coming three months.
2) Speculation In Forward Market:
In addition to the arbitrageur or the hedger, speculators are also very active in forward
market operations. Their purpose is not to reduce the risk but to reap profits from the
changes in the exchange rates.
2.9 Currency Arbitrage
Buying currency in one market and selling the same in another market is called ‘currency
arbitrage'. With the increasing amount of currency trade taking place not with U.S. dollar, but
with non-U.S. dollars, it provides an opportunity to foreign exchange dealers to benefit from
differences in exchange rates prevailing in many financial centers of the world.
Uncovered Interest Covered Interest

Arbitrage Arbitrage
1) Uncovered Interest Arbitrage:
Consider an international investor who can purchase assets either at home or abroad.
Assume the foreign interest rate is higher than the domestic interest rate, for similar
instruments.
2) Covered Interest Arbitrage:
Uncovered investment in a foreign security involves exposure to exchange risk. Most
foreign portfolio investment is covered; investors hedge by selling foreign currency forward.
The return on the foreign investment is therefore the interest plus the cost of the forward
market hedge.
The Indian rupee has a market determined exchange rate. However, the RBI trades actively in
the USD/INR currency market to impact effective exchange rates. Thus, the currency regime in
place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate.
However, unlike China, successive administrations have not followed a policy of pegging the
INR to a specific foreign currency at exchange rate.
A) Current Account Convertibility:

 The rupee was made convertible on the current account of the balance of payments in
August 1994. Current account transactions refer to transactions in goods and services.
There has been further relaxation of restrictions on current transactions in 1995-96 and
1996-97.
 Indian exporters exporting to Asian Cleaning Union (ACU) countries and receiving the
export proceeds in rupees or in Asian Monetary Units (AMU), or in the currency of the
participating country, were permitted to receive payments in any permitted currency
through banking channels provided it is offered by the overseas buyer in the ACU country.
 Authorised Dealers (ADs) were empowered to release exchange without prior approval of
the Reserve Bank in certain types of foreign travel even in excess of the indicative limits
provided that they are satisfied about the bonafides of the applicant and the need to release
exchange in excess of the prescribed scale.
A) Current Account Convertibility:

 Interest income on Non-resident Non-repatriable (NRNR) Rupee deposits which were not
eligible for renewal could be renewed along with principle for deposit accounts opened on
or after October 1, 1994.
 ADs were empowered to allow remittances by a family unit of residential Indian nationals
to their families for renewals could be renewed along with the principle for deposit
accounts opened on or after October 1,1994.
 ADs were empowered to allow remittances by a family unit of residential Indian nationals
to their close relatives residing abroad for their maintenance expenses up to US $ 5,000 in
a calendar year per beneficiary subject to certain conditions.
 ADs were permitted to allow Exchange Earners’ Foreign Currency (EEFC) account
holders to utilise funds held in such accounts for making remittances in foreign exchange
connected with their trade and business related transactions which are of a current account
nature.
 ADs were permitted to export their surplus stocks of foreign currency notes and coins for
realisation of proceeds of private money changes abroad, in addition to their overseas
branches or correspondents.
B) Capital Account Convertibility:

 Capital account convertibility implies the right to transact in financial assets with foreign
countries without restrictions. Although the rupee is not fully convertible on the capital
account, convertibility exists in respect of certain constituent elements of the capital
account,
 Capital account convertibility exists for foreign investors and Non-Resident Indians
(NRIs) for undertaking direct and portfolio investment in India.
 Indian investment abroad up to US $ 4 million is eligible for automatic approval by the
RBI subject to certain conditions.
 In September 1995, the RBI appointed a special committee to process all applications
involving Indian direct foreign investment abroad beyond US $ 4 million or those not
qualifying for fast track clearance.

Foreign Exchange Market: Unit 2

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Foreign Exchange Market: Unit 2

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Unit 2

Foreign Exchange Market

Foreign Exchange Market:

B) Features of Foreign Exchange Market :

Size of the 24 Hours Currencies

Foreign Exchange Market:

Foreign Exchange Market:

Foreign Exchange Market:

Intermediary between Buyers and Sellers of

Transfer of Purchasing Power

Provision of Hedging Facilities

Foreign Exchange Market:

Foreign Exchange Market:

2) Differentials in Interest Rates:

Foreign Exchange Market:

6) Political Stability and Economic Performance:

A) Various Participants in Foreign Exchange Market:

A) Various Participants in Foreign Exchange Market:

A) Various Participants in Foreign Exchange Market:

B) Role Played by Various Participants Customers

B) Role Played by Various Participants of Foreign Exchange Market:

B) Role Played by Various Participants of Foreign Exchange Market:

B) Role Played by Various Participants of Foreign Exchange Market:

B) Role Played by Various Participants of Foreign Exchange Market:

A) Need of Exchange Rate Forecasting:

Macroeconomic Central Bank

A) Need of Exchange Rate Forecasting:

A) Need of Exchange Rate Forecasting:

A) Need of Exchange Rate Forecasting:

B) Techniques of Exchange Rate Forecasting:

B) Techniques of Exchange Rate Forecasting:

3) Market Based Forecasting:

Single-equation Estimated from

A) Meaning of Foreign Exchange:

B) Provisions of the Act:

B) Provisions of the Act:

C) Role of RBI in Management of Foreign Exchange:

Indian Investment External Commercial

Liberalised Indian Depository

C) Role of RBI in Management of Foreign Exchange:

C) Role of RBI in Management of Foreign Exchange:

C) Role of RBI in Management of Foreign Exchange:

A) Major Types of Exchange Rate:

B) Exchange Rate –Regime/System:

Floating/ Flexible Rate System

1) Fixed Exchange Rate System:

B) Exchange Rate –Regime/System:

Purchasing Interest Rate

Counter Party Risk or Credit Risk

B) Tools and Techniques of Foreign Exchange Risk Management:

1) Currency Forward Contracts:

B) Tools and Techniques of Foreign Exchange Risk Management:

3) Currency Option Contract:

C) Hedging Techniques of Foreign Exchange Risk:

Internal Techniques of Hedging External Techniques of Hedging

C) Hedging Techniques of Foreign Exchange Risk:

C) Hedging Techniques of Foreign Exchange Risk:

A) Speculation in Different Market of Foreign Exchange:

Uncovered Interest Covered Interest

A) Current Account Convertibility:

A) Current Account Convertibility:

B) Capital Account Convertibility: