Research Paper

on

Forex Market in India

Submitted By:
Amit Wadhwa
Roll No. 60
PGDMFinance
8th September, 2009.

Under the Guidance of

Prof. K.S. Ranjini

In partial fulfillment of the requirement of Trimester IV of the course

Post Graduate Diploma in Management

K.J. Somaiya Institute of Management Studies and Research

Batch: 2008-2010
Index
Introduction.......................................................................................................................................................................... 3

Statement of need ............................................................................................................................................................... 3

What is special about the forex market ............................................................................................................................ 5

Where does India stand in global forex market?.............................................................................................................. 6

Foreign exchange markets in India..................................................................................................................................... 6

Foreign Exchange Regulatory Regimes in India ................................................................................................................ 7

Determinants of exchange rate in india ............................................................................................................................ 8

Integration between foreign exchange and capital markets in India........................................................................... 10

Relationship Between Exchange Rate and Stock Prices in India................................................................................... 12

Forex derivatives in India.................................................................................................................................................. 13

Value at Risk in forex market............................................................................................................................................ 14

The Way Ahead .................................................................................................................................................................. 15

References .......................................................................................................................................................................... 16

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

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

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

India being one of the fastest growing economies of the world and its ambition to become a
developed economy by 2020, it needs a developed forex market to back its economy. This
research report will help us understand the existing scenario of the Indian forex market and what
changes will help it to become a developed forex market.

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The research paper will include:

 Evolution of the Indian forex Market.

 Structure of the Indian Foreign Exchange Market.

 Integration between foreign exchange and capital markets in India.

 Current scenario in the world forex market.

 Suggestions that will help Improve the Indian forex market.

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WHAT IS SPECIAL ABOUT THE FOREX MARKET?

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

The forex market differs from other financial markets in a number of respects. First, it is by far
the world‟s largest financial market in terms of transaction volume. The daily transaction volume
in all currencies is estimated to amount to $3.98 trillion a day. This is gigantic even in
comparison to a very active equity market like the New York Stock Exchange, which reaches an
average daily volume of approximately US$ 296 billion a day.

Secondly, the forex market is also a market with extraordinarily low transaction costs. A
common measure to express transaction costs is to calculate quoted spreads as the price
difference between a buy (ask) and a sell ( bid) order for a currency rate relative to the mid-price.
Such quoted spreads in the forex inter-bank market can become as low as 0.5 to 1.5 basis points
(a basis point is 1% of 1%, i.e. 0.0001) for the most liquid currency pairs. Quoted spreads in
equity markets tend to be 50 times larger even for the most liquid stocks. These are some of the
reasons why the forex market is known as the fairest market of the world.

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WHERE DOES INDIA STAND IN GLOBAL FOREX MARKET?

As per the BIS Triennial Survey on the global foreign exchange and derivatives market activity
(2007), the foreign exchange market in India has grown into the 16th largest market in the world
in terms of total daily turnover which was US$34 billion in 2007. The OTC derivatives segment
of the foreign exchange market has also increased significantly to register a daily average
turnover of USD 24 billion, which is 17th largest among all countries. The daily turnover has
increased to US$48 billion in 2007-08.

There is no ready template available internationally that India could draw upon since most of the
countries that have active currency futures markets are those which are relatively more
convertible on the capital.

The introduction of currency futures last year has provided further depth and breadth to the
market and fulfill the intended objective as an effective risk-management instrument. This is
leading to an urge in all the market participants to leverage this significant milestone for skill
development within as well as at a broader industry level.

FOREIGN EXCHANGE MARKETS IN INDIA

Since the onset of liberalization, foreign exchange markets have witnessed explosive growth in
trading volume. The importance of the exchange rate to the Indian economy has also been
greater than ever before. While the government has explicitly adopted a flexible exchange rate
regime, in practice the rupee is one of most efficient “trackers” of the US dollar. Apprehensions
of capital flow-driven currency crisis have held India back from capital account convertibility
though the debate continues. The rupee‟s deviations from Covered Interest Parity (with respect to
the dollar) exhibit relatively long-lived swings. An inevitable side-effect of the Indian exchange
rate policy has been the ballooning of foreign exchange reserves to well over a hundred billion
dollars. In an unprecedented move, the government is considering using part of these reserves to
finance infrastructure investments in the country.
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FOREIGN EXCHANGE REGULATORY REGIMES IN INDIA:

Soon after independence, a complex web of controls were imposed for all external transactions
through a legislation i.e. Foreign Exchange Regulation Act (FERA), 1947. These were put into
more rigorous framework of controls through FERA, 1973. Severe restrictions on current
account transactions had continued till mid-1990‟s when relaxations were made in the operations
of FERA, 1973. The control framework was essentially transaction based in terms of which all
transaction in foreign exchange including those between residents and non residents were
prohibited, unless specifically permitted.

A sequence of events started in the subsequent years generally followed by the recommendations
made by different committees such as the high level committee on Balance of Payments under
chairman Dr. C. Rangarajan, 1993. In 1993, exchange rate of rupee was made market
determined. In 1994 India accepted article VIII of the Articles of Agreement of the International
Monetary Fund in August 1994 and adopted current account convertibility.

In June 2000 a legal framework , with implementation of FEMA, has also has also being put into
effect to ensure convertibility on the current account. This consistent approach has lent
credibility to the liberalization process of both current and capital account transactions.

As evident from various economic indicators , the liberalization process has been underway for
some time created a more competitive environment for Indian Industry vis-a-vis what existed
earlier. Consequently the Indian companies have upgraded their technology and expanded to
more efficient scales of production and refocused their activities to areas of competence.
Increasingly, Indian companies are looking to become global players. Reform measures is
external sectors , including dismantling of exchange control have been a contributor to this
development.

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DETERMINANTS OF EXCHANGE RATE IN INDIA

In a floating exchange rate mechanism, foreign exchange rate is determined much in the same
way as the price of any commodity in a free market economy. Appreciation or depreciation of
the domestic currency thus depends on the supply of foreign exchange reserves, liquidity
conditions in the economy as determined by money supply, central bank‟s policy intentions and
differences in the interest yield on dated securities of the concerned economies.

Literature on similar studies for various economies, especially developed economies, is an

inspiration for the present work. At the same time, there is a need to understand the determinants
of foreign exchange rate under the shifting exchange rate policy in case of Indian economy. The
determinants of exchange rate are discussed as follows:

The Bank Rate:

Changes in the bank rate indicate the monetary policy intentions of the RBI. If such a change is
unanticipated, economic agents alter their expectations regarding the future monetary policy.
Thus, an increase in the bank rate indicates a tight monetary policy, and is counter-reacted with
an expectation that the bank rate will decline in future. This results in a depreciation of the
domestic currency. On the contrary, the increase in bank rate may also result in further tightening
of the monetary policy by the RBI, which is necessary for lowering the inflation in the domestic
economy as against the foreign economy.

A future appreciation of domestic currency is anticipated here, causing an appreciation of the

current exchange rate. To incorporate this effect, data on bank rate are included. Simultaneously,
the impact of the differences between the cost of long-term and short-term liquidity are also
included by introducing the difference between inter-bank call money rate and the bank rate.
Five-period lag values point out any lag effect of the same on the exchange rate.

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Interest Yield Differentials:

The relation between short-term and long-term interest yield differentials and exchange rate is
complex. An increase in the interest differential between domestic securities and foreign
securities indicates a rise in the gain from capital inflows into the economy. This is expected to
result in a depreciation of the domestic currency. The nominal interest differential reflects both
the real interest differential and the inflation differential. The inverse relation between the
exchange rate and nominal interest differential is due to the inflation differential. Thus, if
inflation in India exceeds the inflation in the US, the nominal interest differential is positive,
making a positive gain on capital in India possible.

Liquidity

The growth rates of broad money and foreign exchange reserves indicate increased liquidity in
the economy. Such an increase in the liquidity is expected to cause depreciation in the exchange
rate. An anticipation of inflation due to increased liquidity and increase in the aggregate demand
are two major causes behind such depreciation. However, an increase in the foreign exchange
reserves also implies an increase in the supply of foreign currency, which often results in
appreciation of the domestic currency.

External Shocks:

The concept of external shock affecting the exchange market can be explained by two real life
examples. The first such shock relates to the month of December 1997. In spite of strong
economic fundamentals, market sentiment weakened sharply during September 1997 to January
1998. Profit taking by FIIs on the stock exchanges added to the pressure on the rupee in
November. The market was driven by downside expectations created largely in the backwash of
the currency turmoil in South- East Asia and political developments within the country. Excess
demand conditions reflected in the intensified spot merchant transactions too. The volatility in
the exchange market and the swing in the market sentiments were reflected in the significant
spurt in inter-bank and merchant turnover by November and December 1997 in relation to April-
June 1997 levels. Over the quarter October-December 1997, there was a nominal depreciation of

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the spot exchange rate by about 7.6 per cent, and the value of rupee eroded by more than 5.3 per
cent in the month of December alone.

Another major shock was felt in April 2007, when the rupee appreciated by almost 4.3 per cent.
This was mainly due to strong domestic economic growth vis-à-vis moderating of the US
economy during the previous two years, robust growth in the euro area and narrowing interest
differentials. Large capital inflows due to increasing investor interest, dampening crude oil prices
in the world market and depreciation in dollar against other currencies further added to
appreciation of the rupee.

INTEGRATION BETWEEN FOREIGN EXCHANGE AND CAPITAL

MARKETS IN INDIA

There have been several reasons that the need for well-developed, efficient and integrated
financial markets is being increasingly being stressed. In finance theory, this refers to a market
condition that reduces arbitrage opportunities and also helps investors to diversify their portfolio
across different markets (and hence reduce risk exposures). An economist considers one such
development as a facilitator of savings, investment and consequent economic growth. Moreover,
under such development, as impulses in one market get reflected quickly in other markets,
transmission mechanism of monetary policy becomes smooth and speedy and thus policy
intervention becomes more effective in bringing fruits in desired direction within specified time
horizon. The development of deep and integrated financial markets, therefore, has been
emphasized by monetary policy makers in modern days. In fact, this has been a precondition for
„inflation targeting approach‟, a new paradigm of monetary policy, to function credibly and
effectively.

Prior to 1990s, Indian financial system was full of substantial structural rigidities and was under
sever administrative control. Administered interest rate structure, thin foreign exchange market
and prevailing fixed exchange rate mechanism, under-developed secondary markets for
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government securities, lack of adequate depth of money and capital markets, and also inadequate
institutional arrangements/framework are a few characteristics of the financial sector, which had
resulted into substantial amount of segmentation of financial markets during those years. One of
the major objectives of the economic reforms that have been initiated in India since 1991,
therefore, has been development of financial markets into an integrated one. Accordingly,
several policy measures have been taken, in phases, towards innovations of new financial
instruments, improving market depth/conditions, strengthening institutional and regulatory
framework and so on. Now, it is believed that Indian financial system has achieved the
international standard in its market practices.

Some of the specific developments that have taken place during the reforms process and might
have impacted on the extent of financial markets integration are:

 Dismantling of various price and non-price controls in financial markets; like other Asian
emerging economies, Indian equity market has continued to grow and has seen the
relaxation of foreign investment restrictions primarily through country deregulation.

 The issuance of American Depository Receipts (ADR‟s) or General Depository Receipts

(GDR‟s) has facilitated the trade of foreign securities on the NYSE, NASDAQ or on non-
American exchanges.

 Allowing Indian Rupee to be determined by market forces (though at times market

intervention by Reserve Bank of India, the concerned authority, took place). Gradual move
towards full convertibility of Indian Rupee has had an impact in the Indian capital market as
international investors have invested substantial amount (about US $15 billion) in Indian
capital market.

 The two-way fungibility of ADRs/GDRs allowed by RBI has also possibly strengthened the
linkages between the stock and foreign exchange markets in India.

In view of above, the extent of financial markets integration in the liberalization era needs to be
scrutinized empirically. Though some recent studies have investigated related issues, further
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research on the subject is needed primarily because the Indian economy is still passing through a
transition phase and impact of reform measures initiated in different phases during the
liberalization era might have not yet reflected fully in the economy. Thus, the extent of markets
integration is perhaps changing over time – indicating the possibility of getting different
conclusion on market integration for the period, which was not covered in previous studies.

RELATIONSHIP BETWEEN EXCHANGE RATE AND STOCK PRICES IN

INDIA:

The dynamic linkage between exchange rate and stock prices has been subjected to extensive
research for over a decade and attracted considerable attention from researchers worldwide
during the Asian crisis of 1997-98. The issue is also important from the viewpoint of recent large
cross-border movement of funds. In India the issue is also gaining importance in the
liberalization era. The causal link is generally absent though in recent years there has been strong
causal influence from stock market return to forex market return. The results, however, are
tentative and we need further in-depth research to identify the causes and consequences of the
findings.

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FOREX DERIVATIVES IN INDIA
In respect of forex derivatives involving rupee, residents have access to foreign exchange
forward contracts, foreign currency-rupee swap instruments and currency options - both cross
currency as well as foreign currency-rupee. In the case of derivatives involving only foreign
currency, a range of products such as IRS, FRAs, option are allowed. While these products can
be used for a variety of purposes, the fundamental requirement is the existence of an underlying
exposure to foreign exchange risk whether on current or capital account.
During the first year of the launch of exchange traded currency futures reveals growing interest
in the market. However, these markets have not been able to evince the kind of activity that OTC
markets are witnessing. Many corporate using currency derivatives for hedging their foreign
currency exposure find requirement of margin and settlement of daily mark - to – market
differences cumbersome especially since there is no such requirement for OTC trades. It would
perhaps take some time for them to realize the concomitant benefits of these risk containment
measures. There is a perceive resistance to change or switch over from OTC to Exchange traded
framework with the grip and comfortability level in the OTC markets.
In conclusion, considering the nascent stage of development of these markets in the country, the
cautious approach of the regulators is understandable. One hopes to see further developments in
exchange traded currency markets over time. There is no doubting that this is a market which
will eventually establish its niche and would be an area of activity to watch and gain from for all
market participants in the near future.

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VALUE AT RISK IN FOREX MARKET
Value at Risk (VaR) models plays a core role in the risk management of today‟s financial
institutions. A VaR model measures market risk by determining how much the value of a
portfolio could decline over a given period of time with a given probability due to the change in
the market price of an asset. A number of VaR models are used with all having the same aim to
measure the size of potential future losses at a given confidence level. The way the losses are
estimated can vary. Models differ in fact in the way they calculate the density function of future
profits and losses of current positions, as well as the assumptions they rely on. The VaR analysis
originated with the variance-covariance model introduced by JP Morgan, RiskMetrics (1993).

The two most important components of VaR models are the length of time over which market
risk is to be measured and the confidence level at which the market risk is measured. These
choices affect the nature of VaR modelsThere are four major categories of financial risk, viz.,
credit risk, operational risk, liquidity risk and market risk.

Credit risk generally relates to the potential loss due to the default on the part of the counterparty
to meet its obligations at designated time. It has three basic components: credit exposure,
probability of default and loss in the event of default. Operational risk takes into account the
errors that can be made in instructing payments or settling transactions, and includes the risk of
fraud and regulatory risks. Liquidity risk is caused by an unexpected large and stressful negative
cash flow over a short period. If a firm has highly illiquid assets and suddenly needs some
liquidity, it may be compelled to sell some of its assets at a discount. Finally, market risk
estimates the loss of an investment portfolio due to the changes in prices of financial assets and
liabilities (market conditions).
Value-at-Risk (VaR) has been widely promoted by the Bank for International Settlement (BIS)
as well as central banks of all countries as a way of monitoring and managing market risk and as
a basis for setting regulatory minimum capital standards

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THE WAY AHEAD
With the passage of time, India‟s exchange rate policies will continue to evolve. The policy of
managing the Rupee-US Dollar exchange rate is likely to continue for some time to come.
However, over time as the Euro gains in importance, it will probably be become a key ingredient
in setting the “target” value of the currency. Trading in currency and its derivatives is likely to
increase and the involvement of foreign banks is expected to go up. The introduction and popular
trading of currency futures on the rupee may bring about greater informational efficiency in
currency trading markets at the risk, however, of making the markets more speculative.

The philosophy of cautious liberalization is likely to continue among Indian policymakers.

Financial stability and avoidance of Asian Crisis-type catastrophes are likely to remain
paramount in the exchange rate management system. However, if the accumulation of US dollar
reserves continues to progress uninhibited or if the economy experiences external shocks like an
oil shock, it may trigger some rethink of the exchange rate policy. Of course a lot depends on the
nature – both size and composition – of cross-border investment flows. The UPA government‟s
decision to tax interest on the nonresident Indians‟ deposit shows the country‟s heavy
dependence of such flows is a thing of the past. If China is any indication, India should be able to
attract several times the global investment it presently does.

In barely a decade and a half since the beginning of liberalization, India‟s external finances have
undergone a complete transformation. From a foreign exchange-starved, control-ridden
economy, India has moved on to a position of $250 billion plus in international reserves with a
firm rupee and with far less forex control. In 1999 the notorious FERA (Foreign Exchange
Regulation Act) gave way to the much milder FEMA (Foreign Exchange Management Act). The
role of policy makers, however, is no less important today than before. With the added freedom
and ease of transaction comes the risk of exposure to the vagaries of world financial markets.
Prudent policy and careful monitoring are necessary to reap the benefits of external sector
liberalization without taking inordinate amount of risks.

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References
 „Indian Rupee Market‟, by Vikram Murarka

 „Foreign Exchange Market‟ by Dun and Bradstreet

 „Development of forex market in India‟ by K.J. Udeshi

 „Where does India stand in global forex market?‟ by Commodity Online

 „What is special about the forex market?‟, by Harald Hau, William Killeen and Michael
Moore

 „Foreign Exchange Regulatory Regimes in India: From Control to Management‟ by:

Shyamala Gopinath

 ICFAI Journals, „Forex Markets‟ by GRK Murthy

 „Why canonize exchange rate?‟ by: N.A. Majumdar

 „Exchange rate sense and nonsense‟ by: S.S. Tarapore

 „Relationship Between Exchange Rate and Stock Prices in India‟ by Golaka C Nath and
G P Samanta

 „Foreign Exchange Markets in India‟ by: Rajesh Chakrabarti

 „Determinants Of Exchange Rate In India‟ by Dr. Mita H. Suthar

 „Integration Between Foreign Exchange and Capital Markets in India‟ by Golaka C. Nath
and G. P. Samanta

 „Value at Risk: Issues and implementation in Forex Market in India‟ by Golaka C Nath
and Dr. Y V Reddy

 „Forex derivative markets in India: developments thus far and road ahead‟, by Anuradha
Guru
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 „Analysis of Indo-US Forex Market‟, by Rohit Vishal Kumar

 „What Drives Forward Premia in Indian Forex Market?‟, by Anil Kumar Sharma and
Anujit Mitra

 „Foreign Exchange Exposure Management Practices of Indian Firms‟, by Madhu Vij

 „The Indian Foreign Exchange Market and the Equilibrium Real Exchange Rate of the
Rupee‟, by Ila Patnaik and Peter Pauly.

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