Black book pooja (1)

FOREIGN EXCHANGE MANAGEMENT

EXECUTIVE SUMMARY

A Foreign exchange market is worldwide network of banks,

brokers, Multinationals corporations and central banks, all of who

buys and sells currencies. These markets participants are linked

by communications system that allow instant knowledge of factors

that affect the market and of rates as they are quoted around the

world. The market functions practically on 24-hour basis and is not

restricted to the opening and closing hours in one particular center.

The foreign exchange market is centered around the interbank

market- a large group of international commercial bank whose

transactions form the major part of the daily turnover. Central

banks occupy a key place in the market as they implement the

foreign exchange policies of the government.

Major issues confronting the market are:

Could new system satisfactorily replace floating?

Should the market remain basically unregulated or should

central bank exert more control?

Will the trend towards free trade and unrestricted capital flows

continue?

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OBJECTIVE OF THE STUDY

MAIN OBJECTIVE

This project attempt to study the intricacies of the foreign

exchange market. The main purpose of this study is to get a better

idea and the comprehensive details of foreign exchange risk

management.

SUB OBJECTIVES

To know about the various concept and technicalities in

foreign exchange.

To know the various functions of forex market.

To get the knowledge about the hedging tools used in foreign

exchange.

LIMITATIONS OF THE STUDY

Time constraint.

Resource constraint.

DATA COLLECTION

The data was collected from books, newspapers, other

publications and internet.

DATA ANALYSIS

The data analysis was done on the basis of the information

available from various sources and brainstorming.

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INTRODUCTION

Taking cue from the rise in popularity of forex trading the world

over, the Indian foreign exchange market is also growing in leaps

and bounds. At present, the annual turnover of foreign exchange

trading in India exceeds a whopping $400 billion. The volumes

included inter banking trading as well as futures and forward

trading in foreign exchange. Transactions are also made on the

basis of swapping currencies and interest rates as well.

Mumbai

The principal place where forex is transacted in big volumes is

Mumbai. The market involves intermediaries, buyers, sellers and

the monetary authority of India. Apart from Mumbai, the other

centers where forex is also traded are Kolkata, Chennai, New

Delhi, Cochin, Pondicherry and Bangalore. Even though the

markets are not linked as they are in other parts of the world, they

do perform collectively.

Authorized dealers

The Reserve Bank of India or India’s central bank regulates the

market using the help of the exchange control department of the

bank. Only the authorized dealers in foreign exchange are allowed

to participate in trading which also included accredited brokers as

well. The entire transactions are governed by FEMA or the Foreign

Exchange Management Act of 1999, which is an updated version

of the Foreign Exchange Regulation Act or FERA.

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NEED FOR FOREIGN EXCHANGE

Let us consider a case where Indian company exports cotton

fabrics to USA and invoices the goods in US dollar. The American

importer will pay the amount in US dollar, as the same is his home

currency. However the Indian exporter requires rupees means his

home currency for procuring raw materials and for payment to the

labor charges etc. Thus he would need exchanging US dollar for

rupee. If the Indian exporters invoice their goods in rupees, then

importer in USA will get his dollar converted in rupee and pay the

exporter.

From the above example we can infer that in case goods are

bought or sold outside the country, exchange of currency is

necessary.

Sometimes it also happens that the transactions between two

countries will be settled in the currency of third country. In that

case both the countries that are transacting will require converting

their respective currencies in the currency of third country. For that

also the foreign exchange is required.

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ABOUT FOREIGN EXCHANGE MARKET.

Particularly for foreign exchange market there is no market place

called the foreign exchange market. It is mechanism through which

one country’s currency can be exchange i.e. bought or sold for the

currency of another country. The foreign exchange market does

not have any geographic location.

Foreign exchange market is described as an OTC (over the

counter) market as there is no physical place where the participant

meets to execute the deals, as we see in the case of stock

exchange. The largest foreign exchange market is in London,

followed by the New York, Tokyo, Zurich and Frankfurt. The

market is situated throughout the different time zone of the globe in

such a way that one market is closing the other is beginning its

operation. Therefore it is stated that foreign exchange market is

functioning throughout 24 hours a day.

In most market US dollar is the vehicle currency, viz., the currency

sued to dominate international transaction. In India, foreign

exchange has been given a statutory definition. Section 2 (b) of

foreign exchange regulation ACT, 1973 states

Foreign exchange means foreign currency and includes:

All deposits, credits and balance payable in any foreign

currency and any draft, traveler’s cheques, letter of credit

and bills of exchange. Expressed or drawn in India currency

but payable in any foreign currency.

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Any instrument payable, at the option of drawee or holder

thereof or any other party thereto, either in Indian currency or

in foreign currency or partly in one and partly in the other.

In order to provide facilities to members of the public and

foreigners visiting India, for exchange of foreign currency into

Indian currency and vice-versa. RBI has granted to various firms

and individuals, license to undertake money-changing business at

seas/airport and tourism place of tourist interest in India. Besides

certain authorized dealers in foreign exchange (banks) have also

been permitted to open exchange bureaus.

Following are the major bifurcations:

Full fledge moneychangers – they are the firms and

individuals who have been authorized to take both, purchase and

sale transaction with the public.

Restricted moneychanger – they are shops, emporia and

hotels etc. that have been authorized only to purchase foreign

currency towards cost of goods supplied or services rendered by

them or for conversion into rupees.

Authorized dealers – they are one who can undertake all types

of foreign exchange transaction. Bank are only the authorized

dealers. The only exceptions are Thomas cook, western union,

UAE exchange which though, and not a bank is an AD.

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Even among the banks RBI has categorized them as follows’:

Branch A – They are the branches that have nostro and vostro

account.

Branch B – The branch that can deal in all other transaction but

do not maintain nostro and vostro a/c’s fall under this category.

Nostro a/c:-

Bank in India is permitted to open foreign currency accounts with

banks abroad. Indian overseas bank’s account with Chase

Manhattan Bank, New York is a nostro a/c. It is “our account with

u”. When an Indian bank issues a foreign currency draft payable

abroad drawn on a correspondent bank, the nostro account of the

bank maintained with the correspondent id debited and the amount

is paid beneficiary. When an export bill is sent for realization

abroad, the realized exporter bill proceeds is credited to the nostro

account.

Vostro account:

It is the account in India in Indian rupee maintained by an overseas

bank. If Chase Manhattan Bank, New York opens an account with

Indian overseas bank in India, it is a vostro account .it is “your

account with us. Any draft, issued by overseas correspondents in

Indian rupees is paid in India, to the debit of vostro account.

Loro account:

This terminology is used when one bank refers to the ‘nostro’

account of another bank. If Indian Overseas bank and state bank

of India maintain nostro account with Chase Manhattan Bank, New

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York, IOB refers SBI account with Chase Manhattan Bank as loro

account. It is ‘their account with you’.

Mirror account:

The banks in India maintain the replica of the Nostro account they

have with the foreign banks and these accounts are called as

mirror accounts. The mirror account mainly helps in reconciliation

of the statement of account sent by the foreign bank.

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FOREIGN EXCHANGE MARKET:

There are three types of market:

Merchant market: it is the retail market, which involves the

transaction of customers with authorized dealers.

Inter-bank market : it is the market where transaction takes

place between authorized dealers.

International market : it is the market where transaction

takes place between banks in different countries.

The base for all these types/layers of market is the need for

squaring up the position of Ads. Ads are permitted to retain

exchange only up to a certain level that means any purchase of

foreign exchange has to be disposed of and sale of foreign

exchange has to be covered by purchase.

Any AD will try to match the position. If it is not possible to match,

it has to go to another AD for purchase and sale of foreign

exchange and the market is the inter-bank market.

ADs in India move to forex markets and do the purchase / sale

transaction. This market is called as international market.

For Indian we can conclude that foreign exchange refers to foreign

money, which includes notes, cheques, bills of exchange, bank

balance and deposits in foreign currencies.

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PARTICIPANTS IN FOREIGN EXCHANGE MARKET

The main players in foreign exchange market are as follows:

1. Customers

The customers who are engaged in foreign trade participate in

foreign exchange market by availing of the services of banks.

Exporters require converting the dollars in to rupee and imporeters

require converting rupee in to the dollars, as they have to pay in

dollars for the goods/services they have imported.

2. COMMERCIAL BANK

They are most active players in the forex market. Commercial

bank dealing with international transaction offer services for

conversion of one currency in to another. They have wide network

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PARTICIPANTS

CUSTOMERS

COMMERCIAL BANK

CENTRAL BANK

EXCHANGE BROKERS

OVERSEAS FOREX

MARKET

SPECULATORS


of branches. Typically banks buy foreign exchange from exporters

and sells foreign exchange to the importers of goods. As every

time the foreign exchange bought or oversold position. The

balance amount is sold or bought from the market.

3. CENTRAL BANK

In all countries Central bank have been charged with the

responsibility of maintaining the external value of the domestic

currency. Generally this is achieved by the intervention of the

bank. Here the Reserve Bank of India (RBI) plays a vital role in

foreign exchange management. It has laid down some rules and

regulations to carry out foreign exchange.

4. EXCHANGE BROKERS

Forex brokers play very important role in the foreign exchange

market. However the extent to which services of foreign brokers

are utilized depends on the tradition and practice prevailing at a

particular forex market center. In India as per FEDAI guideline the

Ads are free to deal directly among themselves without going

through brokers. The brokers are not among to allowed to deal in

their own account all over the world and also in India.

5. OVERSEAS FOREX MARKET

Today the daily global turnover is estimated to be more than US

$ 1.5 trillion a day. The international trade however constitutes

hardly 5 to 7 % of this total turnover. The rest of trading in world

forex market is constituted of financial transaction and speculation.

As we know that the forex market is 24-hour market, the day

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begins with Tokyo and thereafter Singapore opens, thereafter

India, followed by Bahrain, Frankfurt, Paris, London, New York,

Sydney, and back to Tokyo.

6. SPECULATORS

The speculators are the major players in the forex market.

Bank dealing are the major speculators in the forex market with

a view to make profit on account of favorable movement in

exchange rate, take position i.e. if they feel that rate of particular

currency is likely to go up in short term. They buy that currency

and sell it as soon as they are able to make quick profit.

Corporation’s particularly multinational corporation and

transnational corporation having business operation beyond their

national frontiers and on account of their cash flows being large

and in multi currencies get in to foreign exchange exposures. With

a view to make advantage of exchange rate movement in their

favor they either delay covering exposures or do not cover until

cash flow materialize.

Individual like share dealing also undertake the activity of

buying and selling of foreign exchange for booking short term

profits. They also buy foreign currency stocks, bonds and other

assets without covering the foreign exchange exposure risk. This

also results in speculations.

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TYPES OF TRANSACTIONS

There are different types of transaction under each market.

Merchant Market

SPOT FORWARD

Rates quoted for the

transaction on the same

day.

Rates quoted for

transaction at a future

date.

Spot transaction in the merchant market is one where the rates are

being quoted and the transactions are being routed on the same

day. In forward transactions the rate are being quoted today for

future transactions.

INTER BANK MARKET & INTERNATIONAL MARKET

CASH VALUE

TOMORROW

SPOT FORWARD

Rate today

&

Settlement

on the

same

day/working

day

Rate today &

settlement on

the first

succeeding

working day.

Rate

Today &

settlement

on second

succeeding

working

day.

Rate today &

settlement

from third

succeeding

working day.

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Permitted currency :

It is the foreign currency which is freely convertible to major

currencies like USD (us dollar), GDP (Great Britain pounds) etc.

and for which a fairly active market exists.

Authorized dealers may open and maintain balance and

position in any permitted currency and in euro of the European

currency area.

Authorized dealer may open and maintains freely accounts with

their branches and correspondents abroad in any permitted

currency. Opening of such accounts should be reported to RBI

in the “R” return.

EURO : the single currencies of the European Union were born

In the name of ‘EURO’ with effect from 1-1-1999. 11 out of the

15 members’ countries accepted the single currency. four

countries that were unable to fulfill the set of conditions (U.K,

SWEDEN, DENMARK AND GREECE) were not participating.

Currency notes and coins in the participating countries continue

to be the legal tender for an interim period up to 30-6-2002.

Notes and coins in euro started circulating from 1-1-2002 and

the participating currency ceased to be legal tender 6 months

later. All the transaction between the member countries will be

done at the fixed exchange rates or at ‘’EURO’ until it replaces

the national currencies as the legal tender. The no of

participating countries have gone up.

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EXCHANGE RATE SYSTEM :

Countries of the world have been exchanging goods and services

amongst themselves. This has been going on from time

immemorial. The world has come a long way from the days of

barter trade. With the invention of money the figures and problems

of barter trade have disappeared. The barter trade has given way

to exchanged of goods and services for currencies instead of

goods and services.

The rupee was historically linked with pound sterling. India was a

founder member of the IMF. During the existence of the fixed

exchange rate system, the intervention currency of the Reserve

Bank of India (RBI) was the British pound, the RBI ensured

maintenance of the exchange rate by selling and buying pound

against rupees at fixed rates. The interbank rate therefore ruled

the RBI band. During the fixed exchange rate era, there was only

one major change in the parity of the rupee- devaluation in June

1966.

Different countries have adopted different exchange rate system at

different time. The following are some of the exchange rate system

followed by various countries.

THE GOLD STANDARD

Many countries have adopted gold standard as their monetary

system during the last two decades of the 19th century. This

system was in vogue till the outbreak of world war 1. under this

system the parties of currencies were fixed in term of gold. There

were two main types of gold standard:

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1.Gold piece standard

Gold was recognized as means of international settlement for

receipts and payments amongst countries. Gold coins were an

accepted mode of payment and medium of exchange in domestic

market also. A country was stated to be on gold standard if the

following condition were satisfied:

Monetary authority, generally the central bank of the country,

guaranteed to buy and sell gold in unrestricted amounts at the

fixed price.

Melting gold including gold coins, and putting it to different uses

was freely allowed.

Import and export of gold was freely allowed.

The total money supply in the country was determined by the

quantum of gold available for monetary purpose.

2.Gold Bullion Standard

Under this system, the money in circulation was either partly of

entirely paper and gold served as reserve asset for the money

supply.. However, paper money could be exchanged for gold at

any time. The exchange rate varied depending upon the gold

content of currencies. This was also known as “Mint Parity

Theory“ of exchange rates.

The gold bullion standard prevailed from about 1870 until 1914,

and intermittently thereafter until 1944. World War I brought an end

to the gold standard.

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BRETTON WOODS SYSTEM

During the world wars, economies of almost all the countries

suffered. In order to correct the balance of payments

disequilibrium, many countries devalued their currencies.

Consequently, the international trade suffered a deathblow. In

1944, following World War II, the United States and most of its

allies ratified the Bretton Woods Agreement, which set up an

adjustable parity exchange-rate system under which exchange

rates were fixed (Pegged) within narrow intervention limits (pegs)

by the United States and foreign central banks buying and selling

foreign currencies. This agreement, fostered by a new spirit of

international cooperation, was in response to financial chaos that

had reigned before and during the war.

In addition to setting up fixed exchange parities (par values) of

currencies in relationship to gold, the agreement established the

International Monetary Fund (IMF) to act as the “custodian” of the

system.

Under this system there were uncontrollable capital flows, which

lead to major countries suspending their obligation to intervene in

the market and the Bretton Wood System, with its fixed parities,

was effectively buried. Thus, the world economy has been living

through an era of floating exchange rates since the early 1970.

FLOATING RATE SYSTEM

In a truly floating exchange rate regime, the relative prices of

currencies are decided entirely by the market forces of demand

and supply. There is no attempt by the authorities to influence

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exchange rate. Where government interferes’ directly or through

various monetary and fiscal measures in determining the

exchange rate, it is known as managed of dirty float.

PURCHASING POWER PARITY (PPP)

Professor Gustav Cassel, a Swedish economist, introduced this

system. The theory, to put in simple terms states that currencies

are valued for what they can buy and the currencies have no

intrinsic value attached to it. Therefore, under this theory the

exchange rate was to be determined and the sole criterion being

the purchasing power of the countries. As per this theory if there

were no trade controls, then the balance of payments equilibrium

would always be maintained. Thus if 150 INR buy a fountain pen

and the seamen fountain pen can be bought for USD 2, it can be

inferred that since 2 USD or 150 INR can buy the same fountain

pen, therefore USD 2 = INR 150.

For example India has a higher rate of inflation as compared to

country US then goods produced in India would become costlier as

compared to goods produced in US. This would induce imports in

India and also the goods produced in India being costlier would

lose in international competition to goods produced in US. This

decrease in exports of India as compared to exports from US

would lead to demand for the currency of US and excess supply of

currency of India. This in turn, cause currency of India to

depreciate in comparison of currency of us that is having relatively

more exports.

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EXCHANGE RATE MECHANISM

In international transaction, if we export goods to other countries,

our exporter in India would like to be paid in Indian rupees where

as the foreign buyers would like to pay in his home currency.

If the buyer is in United States, he will pay only in US Dollars. Thus

it becomes necessary to convert this US Dollars into Indian rupees

and the rate at which this conversion is done is called “Exchange

Rate.”

Exchange Rates are quoted in two methods:

1. Direct method.

2. Indirect method.

DIRECT QUOTATIONS

While quoting the exchange rate for a currency if the foreign

currency is kept constant and its value is expressed in terms of

home currency it is known as direct quotation. In this case, the

units of home currency will b varying for every unit of foreign

currency.

Example;

USD 1 = RS 45.7500

GBP 1=RS 67.8500

Effective from august 6, 1993 we have changed our system of

quoting exchange rates to direct quotation. By adopting this

system we have fallen in line with the international practice. It has

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become more transparent for the dealing public and it will be

easier for them to follow up the movement of exchange rates.

INDIRECT QUOTATIONS:

When we keep the unit of home currency constant and the value of

foreign currency is expressed in variable units then this method of

quoting exchange rate is called indirect quotation.

Prior to august 1993 we were following this system for quoting

exchange rates.

Example:

RS 100/- = USD 2.1200

RS 100/- = GBP 1.4200

TWO WAY QUOTATION:

In any other commercial transaction whenever we enquire the rate

of the commodity the seller will immediately quote the selling price.

If we enquire the rate for fruits with the fruit seller he will quote his

selling price.

But in foreign exchange market always both the rates will be

quoted that is one rate for buying and the other for selling.

Example: if the bank X calls for the rates from bank Y for USD/INR

bank will quote:

RS 45.7200/50

It means that the Bank Y is prepared to buy USD at RS 45.7200

and sell at 45.7250. This method of quoting both buying and

selling rates is known as “TWO WAY QUOTATIONS.”

For all practical purposes if we treat foreign exchange as a

commodity the logic and application of this two –way quotations

can be understood easily that is a trader will always be willing to

buy a commodity at a lesser price and sell at a higher price.

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The principle or maxim involved in this method of quotations is:

“BUY LOW – SELL HIGH “ (under DIECT QUOTATION)

The advantage of two–way quote is as under

The market continuously makes available price for buyers or

sellers

Two way prices limit the profit margin of the quoting bank and

comparison of one quote with another quote can be done

instantaneously.

As it is not necessary any player in the market to indicate

whether he intends to buy or sale foreign currency, this ensures

that the quoting bank cannot take advantage by manipulating

the prices.

It automatically insures that alignment of rates with market

rates.

Two way quotes lend depth and liquidity to the market, which is

so very essential for efficient market.

In two way quotes the first rate is the rate for buying and another

for selling. We should understand here that, in India the banks,

which are authorized dealer, always quote rates. So the rates

quoted- buying and selling is for banks point of view only. It means

that if exporters want to sell the dollars then the bank will buy the

dollars from him so while calculation the first rate will be used

which is buying rate, as the bank is buying the dollars from

exporter. The same case will happen inversely with importer as he

will buy dollars from the bank and bank will sell dollars to importer.

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DIFFERENT TYPES OF TRANSACTION

We have different types of transactions in foreign exchange:

It may be remittance Representing payment of subscription to

a foreign journal.

It can be an import payment relating to retirement of an import

bill.

It may be an inward remittance received by a resident/non-

resident Indian.

It may be an export bill, which will be presented to the

overseas buyer for payment.

Depending upon the nature and involvement of labour different

exchange rate are quoted for different transaction.

DIFFERENT TRANSACTION AND RELEVANT EXCHANGE

RATE

On an outward remittance does not involve any labour. Bank will

be recovering the rupee equivalent from the customer and issue a

draft in foreign currency drawn on their correspondent as per their

drawing arrangements. If it is a remittance relating to an import bill,

as a banker, bank will verify the documents entering them in their

register, presenting the bill to the importer for the payments and

also check whether all the conditions stipulated by the

correspondent bank are complied with. For this the labour bank is

eligible for some compensation. This compensation will be loaded

or adjusted while quoting the exchange rate for this import

transaction. In other words, the exchange rate for import

transaction will be costlier to the customers when compared to the

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exchange rate for clean outward remittance. The different rates

quoted for these two transactions are TT (Telegraphic transfer)

and bill selling.

Likewise bank will quote different buying rates for export bills and

for other clean inward remittance.

Following are the different rates, which are quoted to the

customers depending upon the nature of transaction.

BUYING RATES SELLING RATES

TT BUYING BILLS BUYING TT SELLING BILLS

SELLING

(A.1) (A.2) (B.1) (B.2)

A. BUYING RATES

A.1. TT BUYING RATE (nature of transaction)

Clean inward remittance for which cover has already been

provided in ADs Nostro account abroad.

Conversation of proceeds of instruments sent on collection

basis [ when collection are credited to Nostro account].

Cancellation of outward TT, DD,PO etc

Cancellation of forward sale contract.

Undrawn portion of an export bill realized.

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A.2. BILL BUYING RATE (nature of transaction)

Purchase/ negotiations/discounting of export bills.( and other

instruments).

B. SELLING RATE

B.1. TT SELLING RATE (nature of transaction)

Outward remittance in foreign currency.

Cancellation of purchase that is;

a. Bill purchased earlier is returned unpaid.

b. Bill purchased earlier is transferred to collection account

c. Inward remittance received earlier (converted into rupees) is

refunded to the remitting bank.

Forward purchase contract is cancelled.

Remittances relating to payment of import bills which are

directly received by the importer.

Crystallization of overdue export bills.

NOTE:

If the remittance that is no documents is to be handled by the

banks TT selling rate will be applied.

B.2. BILL SELLING RATE (nature of transaction)

Transaction involving remittance of proceeds of import bill.

Even if the proceeds of the import bills are to be remitted in

foreign currency by the way of DD, TT rate to be applied will be

bill selling rate

Crystallization of overdue import bills.

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Apart from the above, separate rates will be quoted for

selling and buying of travelers Cheques and foreign currency

notes.

CROSS RATES:

If a person wants to purchase Swiss Francs (CHF) since this

currency is not normally quoted in India, ADs will procure US

Dollars

From interbank market and will contact any of the overseas market

to get CHF by selling the US Dollars in the overseas market.

Example: a customer’s wants to retire an import bill for CHF 50000

and the Inter Bank rate for USD/INR is at 45.75/78 and the

overseas market for USD/CHF is 1.7084/94. In order to arrive at

the CHF/INR rate bank will be applying Chain rule method.

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FACTOR AFFECTINGN EXCHANGE RATES

In free market, it is the demand and supply of the currency which

should determine the exchange rates but demand and supply is

the dependent on many factors, which are ultimately the cause of

the exchange rate fluctuation, sometimes wild.

The volatility of exchange rates cannot be traced to the single

reason and consequently, it becomes difficult to precisely define

the factors that affect exchange rates. However, the more

important among them are as follows:

STRENGTH OF ECONOMY

Economic factors affecting exchange rates include hedging

activities, interest rates, inflationary pressures, trade imbalance,

and euro market activities. Irving fisher, an American economist,

developed a theory relating exchange rates to interest rates. This

proposition, known as the fisher effect, states that interest rate

differentials tend to reflect exchange rate expectation.

On the other hand, the purchasing- power parity theory relates

exchange rates to inflationary pressures. In its absolute version,

this theory states that the equilibrium exchange rate equals the

ratio of domestic to foreign prices. The relative version of the

theory relates changes in the exchange rate to changes in price

ratios.

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POLITICAL FACTOR

The political factor influencing exchange rates include the

established monetary policy along with government action on

items such as the money supply, inflation, taxes, and deficit

financing. Active government intervention or manipulations, such

as central bank activity in the foreign currency market, also have

an impact. Other political factors influencing exchange rates

include the political stability of a country and its relative economic

exposure (the perceived need for certain levels and types of

imports). Finally, there is also the influence of the international

monetary fund.

EXPACTATION OF THE FOREIGN EXCHANGE MARKET

Psychological factors also influence exchange rates. These factors

include market anticipation, speculative pressures, and future

expectations.

A few financial experts are of the opinion that in today’s

environment, the only ‘trustworthy’ method of predicting exchange

rates by gut feel. Bob Eveling, vice president of financial markets

at SG, is corporate finance’s top foreign exchange forecaster for

1999. eveling’s gut feeling has, defined convention, and his

method proved uncannily accurate in foreign exchange forecasting

in 1998.SG ended the corporate finance forecasting year with a

2.66% error overall, the most accurate among 19 banks. The

secret to eveling’s intuition on any currency is keeping abreast of

world events. Any event, from a declaration of war to a fainting

political leader, can take its toll on a currency’s value. Today,

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instead of formal modals, most forecasters rely on an amalgam

that is part economic fundamentals, part model and part judgment.

Fiscal policy

Interest rates

Monetary policy

Balance of payment

Exchange control

Central bank intervention

Speculation.

Technical.

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HYPOTHETICAL SITUATION

Consider a hypothetical situation in which ABC trading co. has to

import a raw material for manufacturing goods. But this raw

material is required only after three months. However, in three

months the price of raw material may go up or go down due to

foreign exchange fluctuations and at this point of time it cannot be

predicted whether the price would go up or come down. Thus he is

exposed to risks with fluctuations in forex rate. If he buys the

goods in advance then he will incur heavy interest and storage

charges. However, the availability of derivatives solves the

problem of importer. He can buy currency derivatives. Now any

loss due to rise in raw material price would be offset by profits on

the futures contract and vice versa. Hence, the derivatives are the

hedging tools that are available to companies to cover the foreign

exchange exposure faced by them.

Definition of Derivatives

Derivatives are financial contracts of predetermined fixed duration,

whose values are derived from the value of an underlying primary

financial instrument, commodity or index, such as: interest rate,

exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to

reduce exposure to changes in foreign exchange rates, interest

rates, or stock indexes or commonly known as risk hedging.

Hedging is the most important aspect of derivatives and also its

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basic economic purpose. There has to be counter party to hedgers

and they are speculators.

Derivatives have come into existence because of the prevalence of

risk in every business. This risk could be physical, operating,

investment and credit risk.

Derivatives provide a means of managing such a risk. The need to

manage external risk is thus one pillar of the derivative market.

Parties wishing to manage their risk are called hedgers.

The common derivative products are forwards, options, swaps and

futures.

1. Forward Contracts

Forward exchange contract is a firm and binding contract,

entered into by the bank and its customers, for purchase of

specified amount of foreign currency at an agreed rate of

exchange for delivery and payment at a future date or period

agreed upon at the time of entering into forward deal.

The bank on its part will cover itself either in the interbank

market or by matching a contract to sell with a contract to buy. The

contract between customer and bank is essentially written

agreement and bank generally stands to make a loss if the

customer defaults in fulfilling his commitment to sell foreign

currency.

A foreign exchange forward contract is a contract under which

the bank agrees to sell or buy a fixed amount of currency to or

from the company on an agreed future date in exchange for a fixed

30


amount of another currency. No money is exchanged until the

future date.

A company will usually enter into forward contract when it knows

there will be a need to buy or sell for a currency on a certain date

in the future. It may believe that today’s forward rate will prove to

be more favorable than the spot rate prevailing on that future date.

Alternatively, the company may just want to eliminate the

uncertainty associated with foreign exchange rate movements.

The forward contract commits both parties to carrying out the

exchange of currencies at the agreed rate, irrespective of whatever

happens to the exchange rate.

The rate quoted for a forward contract is not an estimate of what

the exchange rate will be on the agreed future date. It reflects the

interest rate differential between the two currencies involved. The

forward rate may be higher or lower than the market exchange rate

on the day the contract is entered into.

Forward rate has two components .

Spot rate

Forward points

Forward points, also called as forward differentials, reflect the

interest differential between the pair of currencies provided capital

flow are freely allowed. This is not true in case of US $ / rupee rate

as there is exchange control regulations prohibiting free movement

of capital from / into India. In case of US $ / rupee it is pure

demand and supply which determines forward differential.

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Forward rates are quoted by indicating spot rate and premium /

discount.

In direct rate,

Forward rate = spot rate + premium / - discount.

Various options available in forward contracts :

A forward contract once booked can be cancelled, rolled over,

extended and even early delivery can be made.

ROLL OVER FORWARD CONTRACTS

Rollover forward contracts are one where forward exchange

contract is initially booked for the total amount of loan etc. to be re-

paid. As and when installment falls due, the same is paid by the

customer at the exchange rate fixed in forward exchange contract.

The balance amount of the contract rolled over till the date for the

next installment. The process of extension continues till the loan

amount has been re-paid. But the extension is available subject to

the cost being paid by the customer. Thus, under the mechanism

of roll over contracts, the exchange rate protection is provided for

the entire period of the contract and the customer has to bear the

roll over charges. The cost of extension (rollover) is dependent

upon the forward differentials prevailing on the date of extension.

Thus, the customer effectively protects himself against the adverse

spot exchange rates but he takes a risk on the forward

32


differentials. (i.e. premium/discount). Although spot exchange rates

and forward differentials are prone to fluctuations, yet the spot

exchange rates being more volatile the customer gets the

protection against the adverse movements of the exchange rates.

A corporate can book with the Authorised Dealer a forward cover

on roll-over basis as necessitated by the maturity dates of the

underlying transactions, market conditions and the need to reduce

the cost to the customer.

A corporate can freely cancel a forward contract booked if desired

by it. It can again cover the exposure with the same or other

Authorised Dealer. However contracts relating to non-trade

transaction\imports with one leg in Indian rupees once cancelled

could not be rebooked till now. This regulation was imposed to

stem bolatility in the foreign exchange market, which was driving

down the rupee. Thus the whole objective behind this was to stall

speculation in the currency.

But now the RBI has lifted the 4-year-old ban on companies re-

booking the forward transactions for imports and non-traded

transactions. It has been decided to extend the freedom of re-

booking the import forward contract up to 100% of un-hedged

exposures falling due within one year, subject to a capital of $ 100

Millions in a financial year per corporate.

The removal of this ban would give freedom to corporate

Treasurers who should be in opposition to reduce their foreign

exchange risks by canceling their existing forward transactions and

33


re-booking them at better rates. Thus this in not liberalization, but it

is restoration of the status quotient.

Also the Details of cancelled forward contracts are no more

required to be reported to the RBI.

The following are the guidelines that have to be followed in case of

cancellation of a forward contract

In case of cancellation of a contract by the client (the request

should be made on or before the maturity date) the Authorised

Dealer shall recover/pay the, as the case may be, the difference

between the contracted rate and the rate at which the

cancellation is effected. The recovery/payment of exchange

difference on canceling the contract may be up front or back –

ended in the discretion of banks.

Rate at which the cancellation is to be effected :

Purchase contracts shall be cancelled at the contracting

Authorised Dealers spot T.T. selling rate current on the date

of cancellation.

Sale contract shall be cancelled at the contracting Authorised

Dealers spot T.T. selling rate current on the date of

cancellation.

Where the contract is cancelled before maturity, the

appropriate forward T.T. rate shall be applied.

Exchange difference not exceeding Rs. 100 is being ignored by

the contracting Bank.

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In the absence of any instructions from the client, the contracts,

which have matured, shall be automatically cancelled on 15th

day falls on a Saturday or holiday, the contract shall be

cancelled on the next succeeding working day.

In case of cancellation of the contract:

Swap, cost if any shall be paid by the client under advice to him

When the contract is cancelled after the due date, the client is

not entitled to the exchange difference, if any in his favor, since

the contract is cancelled on account of his default. He shall

however, be liable to pay the exchange difference, against him.

Substitution of Orders

The substitution of forward contracts is allowed. In case shipment

under a particular import or export order in respect of which

forward cover has been booked does not take place, the corporate

can be permitted to substitute another order under the same

forward contract, provided that the proof of the genuineness of the

transaction is given.

OPTIONS

An option is a Contractual agreement that gives the option buyer

the right, but not the obligation, to purchase (in the case of a call

option) or to sell (in the case of put option) a specified instrument

at a specified price at any time of the option buyer’s choosing by or

before a fixed date in the future. Upon exercise of the right by the

option holder, and option seller is obliged to deliver the specified

instrument at a specified price.

35


The option is sold by the seller (writer)

To the buyer (holder)

In return for a payment (premium)

Option lasts for a certain period of time – the right expires at its

maturity

Options are of two kinds

Put Options

Call Options

PUT OPTIONS

The buyer (holder) has the right, but not an obligation, to sell the

underlying asset to the seller (writer) of the option.

CALL OPTIONS

The buyer (holder) has the right, but not the obligation to buy the

underlying asset from the seller (writer) of the option.

STRIKE PRICE

Strike price is the price at which calls & puts are to be exercised

(or walked away from)

AMERICAN & EUROPEAN OPTIONS

American Options

The buyer has the right (but no obligation) to exercise the option at

any time between purchase of the option and its maturity.

European Options

36


The buyer has the right (but no obligations) to exercise the option

at maturity only.

UNDERLYING ASSETS :

Physical commodities, agriculture products like wheat, plus

metal, oil.

Currencies.

Stock (Equities)

CURRENCY OPTIONS

A currency option is a contract that gives the holder the right (but

not the obligation) to buy or sell a fixed amount of a currency at a

given rate on or before a certain date. The agreed exchange rate

is known as the strike rate or exercise rate.

An option is usually purchased for an up front payment known as a

premium. The option then gives the company the flexibility to buy

or sell at the rate agreed in the contract, or to buy or sell at market

rates if they are more favorable, i.e. not to exercise the option.

How are Currency Options are different from Forward Contracts ?

A Forward Contract is a legal commitment to buy or sell a fixed

amount of a currency at a fixed rate on a given future date.

A Currency Option, on the other hand, offers protection against

unfavorable changes in exchange raters without sacrificing the

chance of benefiting from more favorable rates.

37


TYPES OF OPTIONS :

A Call Option is an option to buy a fixed amount of currency.

A Put Option is an option to sell a fixed amount of currency.

Both types of options are available in two styles :

The American style option is an option that can be exercised

at any time before its expiry date.

The European style option is an option that can only be

exercised at the specific expiry date of the option.

OPTION PREMIUMS :

By buying an option, a company acquires greater flexibility and at

the same time receives protection against unfavorable changes in

exchange rates. The protection is paid for in the form of a

premium.

SPOT RATE AND FORWARD RATES

We have some background about exchange rate as, it is the price

at which one currency can be bought or sold for an of other

currency.

The data on which currencies are exchanged can be any date from

the date starting from the date of transaction. Transaction may be

either Spot or forward depending upon the delivery of the foreign

exchange.

Under spot we have CASH-SPOT, TOM-SPOT. If the exchange of

currencies takes place on the same day of transaction it is known

as CASH DEAL. If the exchange of currencies take place on the

38


next working day that is tomorrow, it is known as deal as TOM-

DEAL.

If the exchange of currencies takes place on the second working

day after the date of transaction it is known as SPOT DEAL.

Normally exchange rate are quoted on spot basis that is the

settlement will take place on the second working day after the date

of transaction. Wherever foreign exchange will be delivered after

SPOT date it is known as Forward transactions.

Going back to the above import transaction, if the importer gets the

information that his shipment will be reaching India only after 3

months it is possible that due to exchange fluctuations he may

have to pay more in rupees term. If he feels that the exchange rate

on the month at the time if retirement of import bill will not be

favorable to him, he may like to fix an assured rate for his future

transaction. This type of fixing the exchange rate for the future

transaction, at a favorable time earlier to the date of actual

transaction is known as forward contracts.

39


PREMIUM/DISCOUNT ON DIRECT QUOTATIONS

If we are familiar with the commodity or share Market it would be

known that spot rate and forward rates are different and they need

not be the same. This is so because the anticipated demand and

supply and the cost situations at the forward date may not

necessarily be identical with that of the existing at present. The

commodity/share could be quoted at a higher (premium) or lower

(discount) rate for future deliveries.

We shall illustrate this with the example:

Spot interbank rate of USD 1 =Rs.45.75

3 months forward USD 1 =Rs.45.95

If one has to buy Dollar three months forward against rupees, he

has to pay 20 paisa more for the same dollar, i.e. 3 months dollar

will be costlier by 20 paisa compared to spot rate. Therefore US

Dollar is at premium in forwards vis-à-vis Rupee. In direct

quotations premium is always added to both the buying and selling

spot rates.

In another situation:

Spot interbank rate of USD 1 =Rs.45.75

3 months forward USD 1 =Rs.45.45

From the above illustration it will be seen that the dollar fot three

month forward is available for lesser money as compared to spot.

In other words USD is cheaper by 30 paisa in forward as

compared to spot.

40


I.e. USD is at discount in forwards vis-à-vis Rupee in direct

quotations. Discount factor is always deducted from the buying

and selling spot rate.

From the above it is now clear that if we compare spot and forward

rates we are able to arrive at the following three possibilities

If the spot rate and forward rate are the same they are at par

In direct quotation if forward rate is more than the spot rate the

base currency is said to be at premium

In direct quotation if forward rate is less than the spot rate the

base currency is said to be at discount rate.

Quoting forward rates:

Forward differentials are always quoted in two figures like 15/20

and 15/10. It will be either at ascending or descending order. If the

first figure is less than the second figure then the base currency is

said to be at premium.

In direct quotations premium is always is always added to both the

buying and selling rates .if it is a buying transaction for the bank,

the quoting bank will add lesser of the two premium figure so as to

give minimum Rupees. Likewise if it is a selling transaction, the

quoting bank, will add higher of the two premium figures so as to

take the maximum amount in rupees for selling a foreign currency.

Example:

Interbank market rates:

Spot USD 1 =Rs 45.70/90

41


1 month forward =14/16

We have a export bill buying transaction.

Since the forward differentials are in ascending order the base

currency USD is at premium. Hence it should be added with the

spot rate to arrive at forward rate. Out of the two premium

figures (14/16) since bank will be given Indian rupees, they will

give minimum amount in rupees.

Step 1

Spot buying rate USD 1 = Rs 45.70

Step 2

To arrive at the forward rate:

Since the base currency is at premium and the bank has to give

rupees, add the minimum premium that is adding 14 paisa to the

spot rate.


Add premium = Rs 00.14

Rs 45.84

Hence the forward rate for this export transaction will be 45.84

In an import transaction, while recovering rupees from importer

customer, for one –month forward rate, bank will add t6he

maximum premium that is 16 paisa and the forward rate for the

bank’s selling transaction would be:


Add premium = Rs 00.16

Rs 46.06

42


If the forward differentials are on the descending order that is

25/20, the base currency is said to be at a discount.

In direct quotations, if the base currency is at a discount, discount

factor is always deducted from the spot rate. When two discount

figures are quoted if it is buying transaction in which bank will be

giving rupees, they will be deducting the higher of the two figures

and give minimum Rupees.

Example:

Interbank market spot USD 1 = Rs 45.70/90

I month forward = 25/20 (paisa)

To arrive at the 1 month forward rates:

Buying Selling

Interbank Spot 45.70 45.90

Deduct the discount (0.25) (0.20)

1 month forward rate 45.45 45.70

From the above examples, in direct quotations, in selling

transactions lesser amount of discount is deducted so as to take

maximum Rupees for every Dollar.

43


FERA TO FEMA

In India, all transactions that include foreign exchange were

regulated by Foreign Exchange Regulations Act (FERA), 1973.

Due to the policy leaning toward nationalized economy the main

objective of FERA was conservation and proper utilization of the

foreign exchange resources of the country. It also sought to control

certain aspects of the conduct of business outside the country by

Indian companies and in India by foreign companies.

Over the years as the economy opened up with steady pace of

reforms a need was felt for more, liberalized foreign exchange

controls and restrictions on foreign investment. FERA was

replaced by a new Act called the Foreign Exchange Management

Act (FEMA), 1999.

The Act applies to all branches, offices and agencies outside India,

owned or controlled by a person resident in India. FEMA is now a

purely a civil legislation in the sense that its violation implies only

payment of monetary penalties and fines. However, under it, a

person will be liable to civil imprisonment only if he does not pay

the prescribed fine within 90 days from the date of notice but that

too happens after formalities of show cause notice and personal

hearing. FEMA also provides for a two year sunset clause for

offences committed under FERA which may be taken as the

transition period granted for moving from one 'harsh' law to the

other 'industry friendly' legislation.

44


FEMA has been formulated with clear cut objective to:

to facilitate external trade and payments; and

to promote the orderly development and maintenance of foreign

exchange market.

The Act has assigned an important role to the Reserve Bank of

India (RBI) in the administration of FEMA. The rules, regulations

and norms pertaining to several sections of the Act are laid down

by the Reserve Bank of India, in consultation with the Central

Government. The Act requires the Central Government to appoint

as many officers of the Central Government as Adjudicating

Authorities for holding inquiries pertaining to contravention of the

Act. There is also a provision for appointing one or more Special

Directors (Appeals) to hear appeals against the order of the

Adjudicating authorities. The Central Government also establishes

an Appellate Tribunal for Foreign Exchange to hear appeals

against the orders of the Adjudicating Authorities and the Special

Director (Appeals). The FEMA provides for the establishment, by

the Central Government, of a Director of Enforcement with a

Director and such other officers or class of officers as it thinks fit

for taking up for investigation of the contraventions under this act.

FEMA permits only authorized person to deal in foreign exchange

or foreign security. Such an authorized person, under the Act,

means authorized dealer, money changer, off-shore banking unit

or any other person for the time being authorized by Reserve

Bank.

45


When a business enterprise imports goods from other countries,

exports its products to them or makes investments abroad, it deals

in foreign exchange. Foreign exchange means 'foreign currency'

and includes: -

deposits, credits and balances payable in any foreign currency;

drafts, travelers’ cheques, letters of credit or bills of exchange,

expressed or drawn in Indian currency but payable in any

foreign currency; and (iii) drafts, travellers' cheques, letters of

credit or bills of exchange drawn by banks, institution’s or

persons outside India, but payable in Indian Currency.

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 acquires, hold, own, possess or transfer any foreign

exchange, foreign security or any immovable property situated

outside India.

The Act deals with two types of foreign exchange transactions.

The basis of foreign exchange management is:

46


FEMA 1999- act passed by government of India.

Foreign exchange management rules 2000 – notifications by

government of India.

Foreign exchange management regulations 2000 – notifications

by RBI.

47


ROLE OF RESERVE BANK OF INDIA

RESERVE BANK OF INDIA is a central bank for india. All

commercials and cooperative bank comes under the RBI.

Therefore it is known as Apex bank.

Authorized person shall comply with general are specific directions

or orders of RBI while dealing in foreign exchange. Failure to do so

will attract revocation of such authorization.

RBI plays a vital role in the control and the management of

forex in India.

RBI is entrusted with the task of regulating and managing

foreign exchange.

Exchange control department of RBI is the sanctioning and

administrative authority under FEMA1 999. Now this

department is known as foreign exchange department by RBI.

The instructions/guidelines of RBI operative through the

authorized person in foreign exchange.

RBI has been vested with the powers to regulate investments,

trading and commercial activities in india of foreign companies

and individuals.

Holding of immovable property abroad and the trading,

commercial and the industrial activities abroad by residents of

India have been brought under the FEMA 1999 and hence

under the purview of RBI

The Directorate of enforcement is the investigating authority

under the FEMA1999.

48


ROLE OF FOREIGN EXCHANGE DEALERS

ASSOCIATION OF INDIA(FEDEAI)

It is a company registered under section 25 of the companies

act 1956.

It was established in 1958.

It is an association of all ADs in forex who undertake to abide

by the terms and conditions prescribed by FEDEAI for forex

business/ transactions.

The basic objective is to bring a uniformity bon forex transaction

and to regulate the dealings among ADs.

To regulate the dealings of ADs with the public, brokers, RBI

and other bodies.

To promote sound forex policy in Co-operation and consultation

with RBI.

The affairs of FEDEAI are managed by a managing committee,

which is empowered to frame rules with prior RBI permission.

FEDEAI is having its office at Mumbai. Local chapters at

various places give the advisory services to all.

The first edition of FEDEAI rules was effective from 1.6.1991.

The second edition of rule as on 31.03.1999 replaced the first

edition and it covers the following

Rule1- hours of business.

Rule2- export transaction.

Rule 3- import transaction.

Rule 4-machinating trade.

Rule5-claen instruments.

Rule6-gurantees.

49


Rule 7-exchange contracts.

Rule8-early delivery, extensions, cancellation of forward

contract.

The rules of FEDEAI are reviewed periodically and changes if

any are informed to AD by way of circulation.

The service chargers governing Forex transaction are left to the

ADs.

Balance of trade

It refers to the net difference between the value of exports and

imports or visible trade.

Balance of payment

It includes not only the visible trade but also the invisible items like

shipping, banking, tourism etc.if the inflow of forex is more, the

balance of payment if favorable and it is to be unfavorable or

adverse when the outflow is more.

Capital account:

As pre FEMA1999 capital accounts transaction , which alters the

asset and liabilities , including contingent liabilities outside India of

persons resident outside India.

Example:

Any borrowing or lending in rupee between a person resident in

India and person resident outside India. Deposits between persons

resident in India and person outside India. Any borrowing or

lending in foreign exchange etc.

50


Current account:

Current account transaction means a transaction other than a

capital account transaction and includes:

Payments due in connection with foreign tradew, other current

business, services and short term banking and credit facilities in

the ordinary course of business.

Payments due as interest on loans and as net income from

investments.

Remittance for living expenses of parents, spouse and children

residing abroad and

Expenses in connection with foreign travel, education and

medical care of parents, spouse and children etc.

51


SODHANI COMMITTEE RECOMMENDATIONS

The committee headed by shri O.P.Sodhani, the executive director

of RBI has recommended sweeping changes to free forex control

and to open up healthy speculation.

RECOMMENDATIONS:

Corporate are to be allowed to hedge genuine exposures on

declaration.

ADs to fix overnight position and aggregate Gap limit in tune with

forex operations and risk taking capacity.

ADs can initiate position abroad ( after satisfying capital

adequency norms) within limits fixed by the management and

approved by RBI.

ADs are allowed to lend and borrow up to six months at market

rates overseas upto specified limits.

Increasing the number of players in forex market by removing the

restrictions for institutions like IDBI, IFCI, and ICICI & FOREIGN

TRADE bank who have larger forex commitments.

ADs to be freed to fix interest rate, maturity period for FCNR

deposit.

Prospole for exemption of CRR/SLR on inter-bank deposits.

Proposal to set up a forex clearing house at Mumbai.

Proposal to retain 100% forex earnings of exporters in EEFC

accounts

Selective intervention by RBI and a separate swap window open to

control forward rates in interbank market.

52


CONCLUSION

Now a days foreign exchange market has expanded unbelievably.

Earlier only Bombay stock exchange and national stock exchange

were seen trading in forex but now there are many private

organizations working in these sector.

Derivative use for hedging is only to increase due to the increased

global linkages and volatile exchange rates. Firms need to look at

instituting a sound risk management system and also need to

formulate their hedging strategy that suits their specific firm

characteristics and exposures.

In India, regulation has been steadily eased and turnover and

liquidity in the foreign currency derivative markets has increased,

although the use is mainly in shorter maturity contracts of one year

or less. Forward and option contracts are the more popular

instruments. Regulators had initially only allowed certain banks to

deal in this market however now corporate can also write option

contracts. There are many variants of these derivatives which

investment banks across the world specialize in, and as the

awareness and demand for these variants increases, RBI would

have to revise regulations.

53


BIBLOGRAPHY:

BOOKS REFFERD:

Foreign exchange management and

Foreign Exchange Management Act (FEMA)

By-ICFAI UNIVERSITY

Banking transaction and finance

By-WELINGKAR INSTITUTE

INTERNET SOURCE:

www.fema.rbi.org.in

www.eximguru.com/exim/reserve-bank/fema.aspx

www.femaonline.com/fema-act-regulation.php?id=20

www.kesdee.com/pdf/foreignexchangemanagement

54

http://www.eximguru.com/exim/reserve-bank/fema.aspx

http://www.fema.rbi.org.in/

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