A REPORT

ON

ANALYTICAL STUDY OF THE DYNAMICS OF THE INDIAN FOREIGN EXCHANGE DERIVATIVE MARKET

SUBMITTED BYNEHA JAIN PUNJAB NATIONAL BANK

A REPORT

ON

ANALYTICAL STUDY OF THE DYNAMICS OF THE INDIAN FOREIGN EXCHANGE DERIVATIVE MARKET

SUBMITTED TOPROF A.K.MITRA

SUBMITTED BYNEHA JAIN IBS, KOLKATA 08BS0001906

ACKNOWLEDGEMENT
Bernard Shaw once remarked: "If you teach a man anything, he will never learn." Learning is an active process. We learn by doing. So, if one desires to master the principles he is studying, he has to do something about them. Apply these rules at every opportunity. If he doesnt, he will forget them quickly. Only knowledge that is used sticks in ones mind. Working on this project has been a great learning experience for me. I am thankful to Punjab National Bank for providing me this opportunity. I would like to thank Prof.A.KMitra for his encouragement and guidance as faculty guide. I would like to express my utmost and sincere thanks to Mr. Rakesh Grover ,Chief Manager, Overseas Operations, IBD for his support over the last three months. I would also like to extend my gratitude to Ms. Vibha Aren, Senior Manager, Treasury, Mr.Chinmay Gopal, Manager Treasury, Mr. Ashok Gandhi, Senior Manager, FEO and many others in Mid Office, Back Office and Research Desk in the treasury division. Finally I would like to thank Mrs.Suman Aggrawal, Senior Manager ,Punjab National Bank without whose guidance I would never have started this voyage of discovery.

Neha Jain

TABLE OF CONTENTS
INTRODUCTION PURPOSE SOPE LIMITATION METHODOLOGY OVERVIEW FOREIGN EXCHANGE MARKET FOREIGN EXCHANGE DERIVATIVE INSTRUMENTS PARTICIPANTS TYPES RISKS CRITICISM FOREIGN EXCHANGE MARKET NEED MEANING CHARACTERISTICS RISKS HOW DERIVATIVES DEVELOPED USERS FOREIGN EXCHANGE DERIVATIVE INSTRUMENTS FORWARDS TYPES FUTURES SWAPS TYPES OPTIONS TYPES OTHER EXOTIC PRODUCTS FACTORS INFLENCING EXCHANGE RATES FACTORS INFLUENCING CURRENCY FORECASTING FORECASTING MODELS FINANCIAL CRISIS-INDIAN CONTEXT REFERENCES ANNEXURE ABOUT PUNJAB NATIONAL BANK MAJOR CURRENCIES QUESTIONNAIRE

INTRODUCTION PURPOSE To find out the characteristics of the foreign exchange derivative market. Study of the foreign exchange derivative products. To find the relationship between exchange rates and different factors influencing it. Constructing the forecasting models for exchange rates. Models- Time series model Econometric model To find out what went wrong in the Indian context-the financial crisis

SCOPE Better understanding of the trends and products of the market dealt with. An insight of the requirements of the corporate towards the market. Help in making a view towards the USD/INR exchange rate which plays a vital role in taking any decision.

LIMITATIONS Time constraint. Updated statistical data not available. Unwillingness among respondents to give accurate and complete data. Opinion oriented interpretation of the statistical data used for constructing the forecasting models.

METHODOLOGY The research methodology to be used in the report is as follows: The report has broadly four parts. Part a. undertakes the literature survey that will help in understanding the different theoretical concepts of the derivative products and their structures. It also involves studying the Indian market in the same context. Part b. involves analysis that helps in describing the major factors influencing the transactions Part c. involves construction of forecasting models for USD/INR exchange rates. Part d. involves the description of the current financial crisis in the Indian context. A questionnaire has also been prepared and sent to all Indian companies listed in NIFTY and BSE A group. Measurement technique A simple method Multiple Choice Question of selecting the most appropriate option(s) from those listed has been used. The Likert Scale Method has been used. Likert Scales sometimes referred to as Summated Scales; require a respondent to indicate the degree of agreement or disagreement with each of a series of statements related to the object attitude. Descriptive study of the questionnaire could not be done as only few people responded to the questionnaires which was not enough to do a statistical study.

OVERVIEW FOREIGN EXCHANGE MARKET The FOREX market is one of the largest and most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Traditional daily turnover was reported to be over US$ 3.2 trillion in April 2007 by the Bank for International Settlements. Since then, the market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between 2007 and 2008. The purpose of FOREX market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar, Pound Sterling, etc. and the need for trading in such currencies. FOEIGN EXCHANGE DERIVATIVE INSTRUMENTS A Foreign Exchange Derivative is a financial instrument where the underlying is a particular currency and/or its exchange rates. The foreign exchange market is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. Participants

 Types The derivative instruments can be categorized in different ways On basis of place a. Exchange traded instruments b. Over the counter traded instruments On basis of structure a. Forward b. Future c. Swap d. Option Risks involved Exchange risk Interest risk Credit risk Replacement risk Settlement risk Dictatorship risk

Derivatives are often subject to the following criticisms: Possible large losses The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as: The need to recapitalize insurer American AIG with $85 billion of debt provided by the US federal government. An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written. It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarter. The loss of $7.2bn by Societe Generalein January 2008 through misuse of futures contracts. .

Counter-party risk Derivatives (especially swaps) expose investors to counter-party risk. For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate. Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis. Unsuitably high risk for small/inexperienced investors Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it. Large notional value Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffet. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. Leverage of an economy's debt Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression

FOREIGN EXCHANGE MARKET In a universe with a single currency, there would be no foreign exchange market, no foreign exchange rates, no foreign exchange. But in our world of mainly national currencies, the foreign exchange market plays the indispensable role of providing the essential machinery for making payments across borders, transferring funds and purchasing power from one currency to another, and determining that singularly important price, the exchange rate. Over the past twenty-five years, the way the market has performed those tasks has changed enormously. WHY WE NEED FOREIGN EXCHANGE Almost every nation has its own national currency or monetary unitits dollar, its peso, its rupeeused for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for foreign exchange transactions exchanges of one currency for another. WHAT FOREIGN EXCHANGE MEANS Foreign exchange refers to money denominated in the currency of another nation or group of nations. Any person who exchanges money denominated in his own nations currency for money denominated in another nations currency acquires foreign exchange. That holds true whether the amount of the transaction is equal to a few dollars or to billions of dollars; whether the person involved is a tourist cashing a travelers check in a restaurant abroad or an investor exchanging hundreds of millions of dollars for the acquisition of a foreign company; and whether the form of money being acquired is foreign currency notes, foreign currency denominated bank deposits, or other short term claims denominated in foreign currency. A foreign exchange transaction is still a shift of funds, or short-term financial claims, from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian rupee is, broadly speaking, foreign exchange. Foreign exchange can be cash, funds available on credit cards and debit cards, travelers checks, bank deposits, or other short-term claims. It is still foreign exchange if it is a short-term negotiable financial claim denominated in a currency other than the Indian rupee. But, in the foreign exchange market the international network of major foreign exchange dealers engaged in high-volume trading around the worldforeign exchange transactions almost always take the form of an exchange of bank deposits of different national currency denominations. If one bank agrees to sell dollars for Deutsche marks to another bank, there will be an exchange between the two parties of a dollar bank deposit for a DEM bank deposit. CHARACTERISTICS

It Is The Worlds Largest Market The foreign exchange market is by far the largest and most liquid market in the world. The estimated worldwide turnover of reporting dealers, at around $1 trillion a day, is several times the level of turnover in the U.S. Government securities market, the worlds second largest market. Turnover is equivalent to more than $200 in foreign exchange market transactions, every business day of the year, for every man, woman, and child on earth! The breadth, depth, and liquidity of the market are truly impressive. Individual trades of $200 million to $500 million are not uncommon. Quoted prices change as often as 20 times a minute. It has been estimated that the worlds most active exchange rates can change up to 18,000 times during a single day. Large trades can be made, yet econometric studies indicate that prices tend to move in relatively small increments, a sign of a smoothly functioning and liquid market. While turnover of around $1 trillion per day is a good indication of the level of activity and liquidity in the global foreign exchange market, it is not necessarily a useful measure of other forces in the world economy. Almost two-thirds of the total represents transactions among the reporting dealers themselveswith only one third accounted for by their transactions with financial and non-financial customers. It is important to realize that an initial dealer transaction with a customer in the foreign exchange market often leads to multiple further transactions, sometimes over an extended period, as the dealer institutions readjust their own positions to hedge, manage, or offset the risks involved. The result is that the amount of trading with customers of a large dealer institution active in the interbank market often accounts for a very small share of that institutions total foreign exchange activity. Among the various financial centers around the world, the largest amount of foreign exchange trading takes place in the United Kingdom, even though that nations currencythe pound sterlingis less widely traded in the market than several others.

It Is A Twenty-Four Hour Market

During the past quarter century, the concept of a twenty-four hour market has become a reality. Somewhere on the planet, financial centers are open for business, and banks and other institutions are trading the dollar and other currencies, every hour of the day and night, aside from possible minor gaps on weekends. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade. The foreign exchange market follows the sun around the earth. The International Date Line is located in the western Pacific, and each business day arrives first in the Asia-Pacific financial centers first Wellington, New Zealand, then Sydney, Australia, followed by Tokyo, Hong Kong, and Singapore. A few hours later, while markets remain active in those Asian centers, trading begins in Bahrain and elsewhere in the Middle East. Later still, when it is late in the business day in Tokyo, markets in Europe open for business.

Subsequently, when it is early afternoon in Europe, trading in New York and other U.S. centers starts .Finally, completing the circle, when it is mid or late afternoon in the United States, the next day has arrived in the Asia-Pacific area, the first markets there have opened, and the process begins again. The twenty-four hour market means that exchange rates and market conditions can change at any time in response to developments that can take place at any time. It also means that traders and other market participants must be alert to the possibility that a sharp move in an exchange rate can occur during an off hour, elsewhere in the world. The large dealing institutions have adapted to these conditions, and have introduced various arrangements for monitoring markets and trading on a twenty-four hour basis. Some keep their New York or other trading desks open twenty-four hours a day, others pass the torch from one office to the next, and still others follow different approaches. However, foreign exchange activity does not flow evenly. Over the course of a day, there is a cycle characterized by periods of very heavy activity and other periods of relatively light activity. Most of the trading takes place when the largest number of potential counterparties is available or accessible on a global basis. Market liquidity is of great importance to participants. Sellers want to sell when they have access to the maximum number of potential buyers, and buyers want to buy when they have access to the maximum number of potential sellers. Business is heavy when both the U.S. markets and the major European markets are openthat is, when it is morning in New York and afternoon in London. In the New York market, nearly two thirds of the days activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid- to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have opened. Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day, and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the twenty-four hour market does provide a continuous real-time market assessment of the ebb and flow of influences and attitudes with respect to the traded currencies, and an opportunity for a quick judgment of unexpected events. With many traders carrying pocket monitors, it has become relatively easy to stay in touch with market developments at

all timesindeed, too easy, some harassed traders might say. The foreign exchange market provides a kind of never-ending beauty contest or horse race, where market participants can continuously adjust their bets to reflect their changing views.

The Market Is Made Up Of An International Network Of Dealers The market consists of a limited number of major dealer institutions that are particularly active in foreign exchange, trading with customers and (more often) with each other. Most, but not all, are commercial banks and investment banks. These dealer institutions are geographically dispersed, located in numerous financial centers around the world. Wherever located, these institutions are linked to, and in close communication with, each other through telephones, computers, and other electronic means. There are around 2,000 dealer institutions whose foreign exchange activities are covered by the Bank for International Settlements central bank survey, and who, essentially, make up the global foreign exchange market. A much smaller subset of those institutions account for the bulk of trading and market making activity .It is estimated that there are more than 100200 market-making banks worldwide; major players are fewer than that. At a time when there is much talk about an integrated world economy and the global village, the foreign exchange market comes closest to functioning in a truly global fashion, linking the various foreign exchange trading centers from around the world into a single, unified, cohesive, worldwide market. Foreign exchange trading takes place among dealers and other market professionals in a large number of individual financial centers New York, Chicago, Los Angeles, London, Tokyo, Singapore, Frankfurt, Paris, Zurich, Milan, and many, many others. But no matter in which financial center a trade occurs, the same currencies, or rather, bank deposits denominated in the same currencies, are being bought and sold. A foreign exchange dealer buying dollars in one of those markets actually is buying a dollar-denominated deposit in a bank located in the United States, or a claim of a bank abroad on a dollar deposit in a bank located in the United States. This holds true regardless of the location of the financial center at which the dollar deposit is purchased. Similarly, a dealer buying Deutsche marks, no matter where the purchase is made, actually is buying a mark deposit in a bank in Germany or a claim on a mark deposit in a bank in Germany. And so on for other currencies. Each nations market has its own infrastructure. For foreign exchange market operations as well as for other matters, each country enforces its own laws, banking regulations, accounting rules, and tax code, and, as noted above, it operates its own payment and settlement systems. Thus, even in a global foreign exchange market with currencies traded on essentially the same terms simultaneously in many financial centers, there are different national financial systems and infrastructures through which transactions are executed, and within which currencies are held. With access to all of the foreign exchange markets generally open to participants from all countries, and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross border foreign exchange trading among dealers as well as between dealers and their customers. At any moment, the exchange rates of major currencies tend to be virtually identical in all of the financial centers where there is active trading. Rarely are there

such substantial price differences among major centers as to provide major opportunities for arbitrage. In pricing, the various financial centers that are open for business and active at any one time are effectively integrated into a single market. Accordingly, a bank in the United States is likely to trade foreign exchange at least as frequently with banks in London, Frankfurt, and other open foreign centers as with other banks in the United States. Surveys indicate that when major dealing institutions in the United States trade with other dealers, 58 percent of the transactions are with dealers located outside the United States. The United States is not unique in that respect. Dealer institutions in other major countries also report that more than half of their trades are with dealers that are across borders; dealers also use brokers located both domestically and abroad.

It is an over-the-counter market with an exchange-traded segment Until the 1970s, all foreign exchange trading in the United States (and elsewhere) was handled over-the-counter, (OTC) by banks in different locations making deals via telephone and telex. In the United States, the OTC market was then, and is now, largely unregulated as a market. Buying and selling foreign currencies is considered the exercise of an express banking power. Thus, a commercial bank in the United States does not need any special authorization to trade or deal in foreign exchange. Similarly, securities firms and brokerage firms do not need permission from the Securities and Exchange Commission (SEC) or any other body to engage in foreign exchange activity. Transactions can be carried out on whatever terms and with whatever provisions are permitted by law and acceptable to the two counterparties, subject to the standard commercial law governing business transactions in the United States. There are no official rules or restrictions in the United States governing the hours or conditions of trading. The trading conventions have been developed mostly by market participants. There is no official code prescribing what constitutes good market practice. Although the OTC market is not regulated as a market in the way that the organized exchanges are regulated, regulatory authorities examine the foreign exchange market activities of banks and certain other institutions participating in the OTC market. As with other business activities in which these institutions are engaged, examiners look at trading systems, activities, and exposure, focusing on the safety and soundness of the institution and its activities. Examinations deal with such matters as capital adequacy, control systems, disclosure, sound banking practice, legal compliance, and other factors relating to the safety and soundness of the institution. The OTC market accounts for well over 90 percent of total foreign exchange market activity. On the organized exchanges, foreign exchange products traded are currency futures and certain currency options. Trading practices on the organized exchanges, and the regulatory arrangements covering the exchanges, are markedly different from those in the OTC market. In the exchanges, trading takes place publicly in a centralized location. Hours, trading practices, and other matters are regulated by the particular exchange; products are standardized. There are margin payments, daily marking to market, and cash settlements through a central clearinghouse.

Steps are being taken internationally to help improve the risk management practices of dealers in the foreign exchange market, and to encourage greater transparency and disclosure. With respect to the internationally active banks, there has been a move under the auspices of the Basle Committee on Banking Supervision of the BIS to introduce greater consistency internationally to risk-based capital adequacy requirements. Over the past decade, the regulators of a number of nations have accepted common rules proposed by the Basle Committee with respect to capital adequacy requirements for credit risk, covering exposures of internationally active banks in all activities, including foreign exchange. Further proposals of the Basle Committee for risk-based capital requirements for market risk have been adopted more recently. With respect to investment firms and other financial institutions, international discussions have not yet produced agreements on common capital adequacy standards.

RISKS EXCHANGE RATE RISK. Exchange rate risk is the effect of the continuous shift in the worldwide market supply and demand balance on an outstanding foreign exchange position. For the period it is outstanding, the position will be subject to all the price changes. The most popular measures to cut losses short and ride profitable positions that losses should be kept within manageable limits are the position limit and the loss limit. By the position limitation a maximum amount of a certain currency a trader is allowed to carry at any single time during the regular trading hours is to be established. The loss limit is a measure designed to avoid unsustainable losses made by traders by means of stop-loss levels setting. INTEREST RATE RISK. Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. This risk is pertinent to currency swaps; forward outright, futures, and options (See below). To minimize interest rate risk, one sets limits on the total size of mismatches. A common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. All the transactions are entered in computerized systems in order to calculate the positions for all the dates of the delivery, gains and losses. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps. CREDIT RISK. Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counter party. In these cases, trading occurs on regulated exchanges, such as the clearinghouse of Chicago. The following forms of credit risk are known: Replacement risk occurs when counterparties of the failed bank find their books are subjected to the danger not to get refunds from the bank, where appropriate accounts became unbalanced. Settlement risk occurs because of the time zones on different continents. Consequently, currencies may be traded at the different price at different times during the trading day. Australian and New Zealand dollars are credited first, then Japanese yen, followed by the European currencies and ending with the U.S. dollar. Therefore, payment may be made to a party that will declare insolvency (or be declared insolvent) immediately after, but prior to executing its own payments. Therefore in assessing the credit risk, end users must consider not only the market value of their currency portfolios, but also the potential exposure of these portfolios. The potential exposure may be determined through probability analysis over the time to maturity of the outstanding position. The computerized systems currently available are very useful in implementing credit risk policies. Credit lines are easily monitored. In

addition, the matching systems introduced in foreign exchange since April 1993 are used by traders for credit policy implementation as well. Traders input the total line of credit for a specific counterparty. During the trading session, the line of credit is automatically adjusted. If the line is fully used, the system will prevent the trader from further dealing with that counterparty. After maturity, the credit line reverts to its original level. DICTATORSHIP RISK. Dictatorship (sovereign) risk refers to the government's interference in the Forex activity. Although theoretically present in all foreign exchange instruments, currency futures are, for all practical purposes, excepted from country risk, because the major currency futures markets are located in the USA. Hence, traders have to realize that kind of the risk and be in state to account possible administrative restrictions.

HOW DERIVATIVES DEVELOPED Foreign exchange history can be traced back to times of bartering when goods were traded for other good. At that time metals (bronze, silver, gold) were traded in the form of coin sizes. Later on, paper became a mean of exchange with which trading was carried out, which was followed by the introduction of the gold standard system The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. Bretton Woods Agreement was an agreement that was established in 1944 and is known as the first Foreign Exchange system. Representatives from 45 countries attended this conference and discussed the foreign exchange system. At the end of this conference the formation of the International Monetary Fund (IMF) was established. According to which the US dollars value was pegged (to peg means to connect the value of a certain currency to gold) at $35 per ounce. Other currencies were to be compared to the values of the U.S. dollar. The idea behind this system was to stabilize world economy. And indeed for a certain amount of time, it was able to do exactly that. The system of fixed prices came under stress from the 1970s onwards. Inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. This meant that the US dollar was no longer convertible to gold and that the economic system was much more free-floating from that point onward. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. In 1973 two additional agreements failed, completing the transition to a free-floating system. These agreements were the Smithsonian Agreement, which allowed greater fluctuation band for currencies, and the European Joint Float, which allowed a greater fluctuation range in currency values. Both failed and resulted in the emergence of new markets along with new financial instruments, market deregulation, market systems and trade liberalization. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk.

USERS OF FOREIGN EXCHANGE DERIVATIVE INSTRUMENTS Banks The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. Central banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades. Retail foreign exchange brokers There are two types of retail brokers offering the opportunity for speculative trading:

a. Retail foreign exchange brokers b. Market makers Non-bank Foreign Exchange Companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. i.e., there is usually a physical delivery of currency to a bank account. Money Transfer/Remittance Companies Money transfer/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally.

FOEIGN EXCHANGE DERIVATIVE INSTRUMENTS A Foreign Exchange Derivative is a financial instrument where the underlying is a particular currency and/or its exchange rates. The foreign exchange market is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. FORWARDS A forward exchange contract, commonly known as FEC or forward cover, may be defined as a contract between a bank and its customer whereby a rate of exchange is fixed immediately for the purchase (or sale) of one currency for another, or for delivery at an agreed future date. Forward exchange contract rates are based on interest differentials between the countries concerned, and are not predictions of what the rates of exchange will be in the future. TYPES OF FORWARD CONTRACTS On basis of delivery date Fixed contract A specific delivery date is agreed upon. The delivery of the foreign currency at the rate fixed in the FEC will be made on the exact date (fixed date) specified in the contract. Window Forward Similar to a traditional forward, but allows you to select up to a 30-day time frame during which the forward can settle at the contract rate. Partially optional contract This contract is fixed during the first period (from opening to option start date) and then fully optional from option start date to due/maturity date. The delivery of the foreign currency at the forward contract rate can take place at any time during the optional period. Fully optional contract The delivery of the foreign currency can take place at the forward contract rate at any time throughout the entire existence of the FEC.

Other contracts Non-deliverable Forwards Allows a company to hedge foreign currency risk where no traditional forward market exists. It is a synthetic hedge that is net settled in U.S. dollars. No delivery of foreign currency will occur under this contract. The net U.S. dollar difference offsets the change in market pricing of the currency hedged.

Ideal for companies who need to protect exposures in countries that do not have a freely traded forward market. Examples include: China, India and Brazil. This type of hedge is often used as an overlay on a U.S. dollar-based cash flow to protect margins. Range forward contract Similar to a forward contract, it provides 100% protection against unfavorable currency fluctuations while allowing limited participation in favorable currency rate market movements. Average rate range forward An average rate forward allows the buyer the ability to create a hedge rate for a future exposure by locking in forward points and a spot rate today. At some point in the future, there is an averaging period of daily spot observations to determine an average rate which, when compared to the hedge rate, will set the payout. Unlike options, this hedge tool is a forward contract and has no premium cost associated with it. If the receivable currency is weaker during the averaging period compared to the hedge rate, the forward seller will make a payment to the forward buyer. Conversely, if the receivable currency appreciates during the averaging period, the forward buyer must make a payment to the forward seller. These structures are cash settled.

Participating forward contract A participating forward contract provides 100% protection against an unfavorable currency fluctuation while allowing unlimited participation in favorable currency rate market movements. Break forward contract A forward contract that permits the holder to profit if the price of foreign exchange rises, but puts a floor on losses if it falls. This payoff profile can be obtained using both FX options and forward contracts. Also known as cancelable forward FX contract.

FUTURES Future contracts are similar to forward contracts. The only difference between a forward contract and a futures contract is that, in a futures contract, a transaction can be agreed to be carried out at a time, which is not more than 3 months from the current date. There is a time boundary within which the transaction must be closed. The size and the time period of the transaction are fixed in a futures contract unlike a forward contract. Also these are exchange traded instruments. Currency Future This is a futures contract where the parties of a contract agree to exchange their currencies at a specified future date for a price. On that particular date, the exchange takes place irrespective of the Forex rate that prevails on that date. Due to the unpredictability of the Forex rates, either a loss or a profit might arise out of a currency future transaction.

 SWAPS FOREX Swaps In the FOREX market, most inter-bank trading of forwards is done through the trade of FOREX swaps. A FOREX swap is simply two transactions entered into simultaneously; an agreement is made to exchange currencies now at the prevailing spot rate and also to exchange the currencies back in the future at the prevailing forward rate. For example, when a swap trader enters a swap she may agree to give DM and receive $US now (with amounts determined by the current spot) and also agree to give $US and get DM in one year (amounts determined by the prevailing one year forward rate). A FOREX swap is just a spot trade and a forward trade rolled into one. Because FOREX swaps are actually far more common than regular forward transactions in the FOREX market, regular forward contracts are generally referred to as outright forwards. A swap trader is really trading in the difference between the spot rate and the forward rate. This is why forward rates are normally quoted in terms of forward points, the annualized difference between spot and forward. Interest Rate Swaps Interest rate swaps (including currency swaps to be discussed later) are basically the exchange (between two firms, with a bank as an intermediary) of one type of debt for another type of debt. The simplest type of swap is a plain vanilla interest rate swap. In a plain vanilla swap, one party agrees to pay the other party cash flows equal to a fixed rate of interest on some notional principal. In return, they get cash flows equal to a floating rate of interest on that same notional principal. The notional principal is simply the amount used to determine the size of the payments. There is no actual exchange of principals. A bank will act as the middle-man in these swaps and collects part of the profits.

Example: Two firms want to borrow $10 million. Company B has a better credit rating and can therefore get better rates. Company Company A Company B Fixed Rate 11% 10% Floating Rate LIBOR + 1% LIBOR + 0.5%

Note that the difference between the rates available to each firm is smaller for floating rates than for fixed rates. In other words, for some reason the market for fixed rate loans values Bs creditworthiness more than does the market for floating rate loans. This implies a type of inefficiency in the debt markets and swaps are designed to take advantage of this.

Because of the inefficiency in debt markets, A has a comparative advantage in borrowing floating rate funds (its floating rate is not as much above Bs as is its fixed rate). Similarly, B has a comparative advantage in the fixed rate market. Assume, however, that B wants to borrow at a floating rate and A at a fixed rate. Each firm should borrow where it has the comparative advantage and then go to the bank to arrange a swap. Company A goes to bank and agrees to make payments equal to 9.8% and receive payments from the bank of LIBOR (on a notional principal of $10 million). This is As swap. Company B goes to the bank and agrees to make payments equal to LIBOR and receive payments equal to 9.7%. This is Bs swap. The situation ends up looking like this:

LIBOR + 1%

9.8%

Bank

9.7%

10%

LIBOR

LIBOR

You can now look at the net payments that each firm is making: Company A: Pays Receives Pays Total

LIBOR + 1% LIBOR 9.8% 10.8%

(for loan) (from swap with bank) (from swap with bank)

Company is effectively paying a fixed rate of 10.8%. Less than it could have gotten on a fixed rate loan itself. Company B: Pays Receives Pays Total

10% 9.7% LIBOR LIBOR + 0.3%

(for loan) (from swap with bank) (from swap with bank)

Company B pays less than if it had borrowed at a floating rate itself. Bank: Pays Receives Pays

LIBOR LIBOR 9.7%

Receives Total

9.8% -0.1%

The bank is making a profit of 0.1% per year on a $10 million notional principal. Therefore, everybody wins. The total gain to all parties involved is: A saves 0.2% over its own fixed rate. B saves 0.2% over its own floating rate. Bank makes 0.1% 0.5% total gain. This amount of total gain is determined by the degree of inefficiency in the bond market: (As fixed - Bs fixed) = 11% - 10% = (As floating - Bs floating) = (LIBOR+1%) - (LIBOR+0.5%) = Difference 0.5% 1% 0.5%

Note that, in reality, both parties to a swap do not make payments to each other each year. Rather, the difference in value of the payments going each way is calculated and the party owing more sends a difference cheque to the other. Also, the above example is simplified (obviously). The bank will not actually match up two firms who each want to take opposite sides of a swap. Instead, the bank will enter many swaps with firms wanting to make fixed rate payments, and enter many swaps with firms wanting to make floating rate payments. Net, all of the banks swaps taken together should cancel out, leaving a profit for the bank. If all of the swaps entered into with customers do not cancel each other out, the bank can simply go to the swap market to obtain the necessary offsetting swaps. The swap market is, in effect, a market in which banks and other large institutions enter swaps between themselves. Swaps are actually a form of derivative security. Plain vanilla swaps may be used to obtain cheaper financing, but they are actually a bet on the direction of interest rates. Because of this, banks and other large investors will often enter swaps for speculative purposes. They do this simply by entering a swap without having an offsetting initial loan. For instance, suppose you enter a plain vanilla swap where you make fixed rate payments and receive floating rate payments. If, subsequently, interest rates rise, then the payments you are making stay the same, but the payments you are receiving go up. You win. If you want, you can offset that swap with by entering a new swap where you pay floating and get fixed and effectively pocket your profits.

Currency Swaps A currency swap involves the exchange of interest payments on debt which is denominated in different currencies. Fixed-for-fixed currency swap.

Party A makes periodic interest payments to Party B in one currency and receives payments in another currency. Principals for the loans are also exchanged at the end of the swap. Both sets of payments are based on fixed interest rates. Example: Firm A has borrowed $1,000,000 Can. at 10% for five years. Firm B has borrowed 100,000,000 at 5% for five years. However, A wants to borrow , and B wants to borrow $Can. Assume no intermediary for convenience (i.e. the firms can set up a swap between themselves). Current spot rate = 100 /$Can. Enter a swap agreement: Each year, A gives B 100,000,000(0.05) = 5,000,000 B gives A 1,000,000(0.10) = $100,000 Can. At the fifth year, principals are also exchanged, A gives B 100,000,000 B gives a $1,000,000 Can. Note that the swap does not have to include trading the principals now, since Firm A could simply take the $Can it borrowed and buy the that it needs on the spot market. Note also that at a current spot rate of 100 /$Can, swapping $1,000,000 Can in debt for 100,000,000 in debt is a fair deal.

5,000,000 100,000,000 (105) t . (105) 5 . t 1 PV of what A gives =

= 100,000,000

100,000 1,000,000 . t (11) 5 . PV of what A gets = t 1 (11)

= $1,000,000 Can. Therefore, at the current spot rate, this is a fair deal in that NPV=0.

Basically, the advantage of a currency swap is that a firm can borrow in the currency where it has a comparative advantage and then swap into the currency that it actually needs. Fixed-for-floating currency swap The most common type of currency swap is actually a fixed-for-floating currency swap, wherein payments in one currency at a floating rate are swapped for payments in another currency at a fixed rate. In the swap markets, swaps are generally quoted as floating $US payments at LIBOR versus a fixed rate in another currency. Because currency swaps are

always fixed-for-floating, in order to get a fixed-for-fixed swap you would have to enter both a fixed-for-floating currency swap and a plain vanilla interest rate swap. Hence, fixed-forfixed swaps are generally referred to as circus swaps (combined interest rate and currency swaps). Example: Again assume no intermediary for simplicity. A German firm wishes to borrow DM 2,000,000 at a floating rate. A U.S. firm wishes to borrow $1,000,000 US at a fixed rate. Rates available to German Firm: fixed 8% 7% floating LIBOR+2% LIBOR+1%

$US DM Rates available to U.S. firm:

$US DM

fixed 9% 8%

floating LIBOR+1% LIBOR

Current spot rate is 2 DM/$US. German firm borrows $1,000,000 US at a fixed rate. U.S. firm borrows DM 2,000,000 at a floating rate. They then enter a swap with one another. First, they use the borrowed funds to purchase the currency that they actually need on the spot market. The payments between the firms look like:

$US @ 8%

German Firm

DM @ LIBOR

US Firm

DM @ LIBOR

$US @ 8%

Net, the German firm is paying LIBOR in DM and the U.S. firm is paying 8% in $US. These rates are better than either firm could have done on its own. At the end of the swap (in five years), the principals amounts are also exchanged. Note that the German firm borrows $US but is not exposed top any exchange rate risk as the swap provides exactly enough $US to meet its needs. There are many other types of currency swaps (the types of swaps are only limited by your imagination) such as floating-for-floating swaps and off-market swaps. Basic motivation for swaps include: Market inefficiencies (just as with interest rate swaps). The market for a firms debt in a particular currency may be saturated. Tax Arbitrage

Swaptions

A swaption is an option to get into a swap. The customer pays the bank an upfront premium to get the right to enter a swap with the bank at a pre-determined interest rate if the customer wants to in the future. A swaption call gives the holder the right to enter a swap where they receive a fixed rate and pay a floating rate. A swaption put gives the holder the right to enter s swap where they receive a floating rate and pay a fixed rate. Swaptions allow firms to pre-arrange swaps that they can use if the rates of interest they find in the market turn out to not be what they want. Swaptions can also allow a firm to get out of a swap if they want to. For instance, say you enter swap where you make floating rate payments. At the same time you buy a swaption put. If interest rates rise in the future then the payments you are making through the original swap increase. In order to get out of the swap you can use the swaption to enter a new swap where you receive floating rate payments. The two swaps then cancel each other out.

Options

Cross currency options The Reserve Bank of India has permitted authorised dealers to offer cross currency options to the corporate clients and other interbank counter parties to hedge their foreign currency exposures. Before the introduction of these options the corporates were permitted to hedge their foreign currency exposures only through forwards and swaps route. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. Currency options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium. Rupee currency options Corporates in India can use instruments such as forwards, swaps and options for hedging cross-currency exposures. However, for hedging the USD-INR risk, corporates are restricted to the use of forwards and USDINR swaps. Introduction of USD-INR options would enable Indian forex market participants manage their exposures better by hedging the dollar-rupee risk. The advantages of currency options in dollar rupee would be as follows: Hedge for currency exposures to protect the downside while retaining the upside, by paying a premium upfront. This would be a big advantage for importers, exporters (of both goods and services) as well as businesses with exposures to international prices. Currency options would enable Indian industry and businesses to compete better in the international markets by hedging currency risk. Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures. e.g. If an Indian company is bidding for an international assignment where the bid quote would be in dollars but the costs would be in rupees, then the company runs a risk till the contract is awarded. Using forwards or currency swaps would create the reverse positions if the company is not allotted the contract,

but the use of an option contract in this case would freeze the liability only to the option premium paid upfront. The nature of the instrument again makes its use possible as a hedge against uncertainty of the cash flows. Option structures can be used to hedge the volatility along with the non-linear nature of payoffs. Attract further forex investments due to the availability of another mechanism for hedging forex risk. Hence, introduction of USD-INR options would complete the spectrum of derivative products available to hedge INR currency risk.

Exotic options Options being over the counter products can be tailored to the requirements of the clients. More sophisticated hedging strategies call for the use of complex derivative products, which go beyond plain vanilla options. These products could be introduced at the inception of the Rupee vanilla options or in phases, depending on the speed of development of the market as well as comfort with competencies and Risk Management Systems of market participants. Some of these products are mentioned below: Simple structures involving vanilla European calls and puts such as range-forwards, bull and bear spreads, strips, straps, straddles, strangles, butterflies, risk reversals, etc. Simple exotic options such as barrier options, Asian options, Look-back options and also American options More complex range of exotics including binary options, barrier and range digital options, forward-start options, etc Some of the above-mentioned products especially the structure involvingsimple European calls and puts may even be introduced alongwith the options itself.

FOREIGN EXCHANGE OPTIONS GALORE The array of foreign exchange options available in the OTC market to dealers and the broader market of customers is almost endless, and new forms are being created all the time. Naturally, the following list is not comprehensive. Multi-currency options give the right to exchange one currency, say dollars, for one of a number of foreign currencies at specified rates of exchange. to obtain the foreign currency if the exchange rate moves in favor of the option. Split fee options enable the purchaser to pay a premium up front, and a back fee in the future Contingent options involve a payoff that depends, not only on the exchange rate, but also on such conditions as whether the firm buying the option obtains the contract for which it is tendering, and for which the option was needed. There are a large number of options with reduced or zero cash outlay up frontwhich is made possible by combinations (buying one or more options and selling others) that result in a small or zero net initial outlay. One example is the range forward or cylinder option, which gives the buyer assurance that not more than an agreed maximum rate will be paid for needed foreign currency, but requires that the buyer agree he will pay no less than a stipulated (lower) minimum rate. Another example is the conditional forward, in which the premium is paid in the future but only if the exchange rate, is below a specified level. A third example is the participating forward, in which the buyer is fully protected against a rise in the exchange rate, but pays a proportion of any decrease in the exchange rate. Such options and there are any number of varietiesare popular since the buyer pays for his option by providing another option, rather than by paying cash, giving the appearance (which can be misleading) of cost-free protection, or the proverbial free lunch. There is the all-or-nothing, or binary, option, where, if the exchange rate is beyond the strike price at expiration, there is a fixed payout, and the amount is not affected by the magnitude of the difference between the underlying and the strike price. There are various forms of path dependent options, in which the options value is determined, not simply by the exchange rate at the expiration of the option, but partly or exclusively by the path that the exchange rate took in arriving there. There are barrier options, in which, for example, the option expires worthless if the exchange rate hits some pre-agreed level, or, alternatively, in which the option pays off only if some pre-specified exchange rate is reached prior to expiration. There are Bermuda options (somewhere between American and European options) in which rights are exercisable on certain specified dates. There are Asian, or average rate, options, which pay off at maturity on the difference between the strike price and the average exchange rate over the life of the contract. There are look back options, or no regrets options, which give the holder the retroactive right to buy (sell) the underlying at its minimum (maximum) within the look back period. There are downand-out options, knock-out options, and kick-out options, that expire if the market

price of the underlying drops below a predetermined (out strike) price, and down-andin options etc., that take effect only if the underlying drops to a predetermined (in strike) price. Compound options are options on options, and chooser options allow the holder to select before a certain date whether the option will be a put or a call. There are non-deliverable currency options (as there are non-deliverable forwards) which do not provide for physical delivery of the underlying currency when the option is exercised. If exercised, the option seller pays the holder the in the money amount on the settlement date in dollars or other agreed settlement currency. Other permutations include models developed in-house by the major dealers to meet individual customers needs, and any number of customized arrangements that attach or embed options as part of more complex transactions.

FACTORS INFLUENCING EXCHANGE RATES Inflation If inflation in the UK is lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for s. Also foreign goods will be less competitive and so UK citizens will supply less s. Therefore the rate of will increase from say 1=$1.4 to $1.5 Interest Rates If UK interest rates rise relative to elsewhere it will become more attractive to deposit money in the UK, Therefore demand for Sterling will rise. This is known as hot money flows. Therefore the value of sterling will appreciate Speculation If speculators believe the sterling will rise in the future They will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets Change in competitiveness If British goods become more attractive and competitive this will also cause the value of the ER to rise Relative strength of other currencies Between 1999 and 2001 the appreciated because the Euro was seen as a weak currency Balance of Payments A large deficit on the current account means that the value of imports is greater than the value of exports. If this is financed by a suplus on the financial/ capital account then this is OK. But a country who struggles to attract enough capital inflows will see a depreciation in the currency. (For example current account deficit in US of 7% of GDP is one reason for depreciation of dollar in 2006)

FACTORS AFFECTING CURRENCY FORECASTING The most important and most complicated component of currency dealing is the ability to analyze tendencies of market changes and, respectively, forecast what factors and how will influence currency rates. Price behavior includes both opportunities of quick gain of profit and possibilities of quick and considerable loss. Thats why correct forecasting of market movements, assessment of events, as well as the understanding of rumors and expectations, is a required component of brokers or dealers work and is a guarantee of his successful activity. There are many factors that influence both, the whole currency market in general and some currencies, in particular. There are two main analysis methods of the market situation: fundamental analysis and technical analysis. The first one assesses the situation from the point of view of political, economic, financial and credit policy. The second one is based on methods of graphic research and analysis based on mathematical principles. Fundamental analysis implies the study of various messages about financial events in the world, about the activity in the political and economic life in both specific countries and in the world community, in general, that can influence the development of the foreign exchange market. Some analysis is done to understand what changes in the currency rates they can cause. Information about the functioning of stock exchanges and of big companies of the type of market-makers, the discount rates of the central banks, the economic and administration policies, the possible changes in the political life of the country, as well as various signs and expectations are found to be important here. Fundamental factors are assessed from two positions, as a rule: From the point of view of their influence on the official discount rate; From the point of view of the condition of the national economy of the country. Fundamental factors that influence the FOREX market. Fundamental analysis distinguishes four groups of factors that influence the market directly: economic; political; signs and expectations; force majeure.

Classification of news according to the degree of their expectancy: accidental and unexpected usually some news of political and natural origin, more rare economic news (political instability in the country, wars, natural disasters, etc.); planned and expected usually news of economic character, more rare political news. The economic group of factors and their influence on the market are based on the axiom that any currency is a derivative of the economic development of the country and its cost may be regulated with the help of certain economic measures. The economic group of the factors influencing the market can be divided into the following components: information about the economic development of the country trade negotiations meetings of the central banks any changes in the monetary and credit policy meetings of G-7, economic unions or commercial alliances

speeches of the heads of central banks, heads of governments, distinguished economists concerning the situation of the foreign exchange market, changes in the economic policy,economic situation in the country or their forecasts interventions neighbouring markets speculation

Fundamental analysis is one of the most complicated parts, and, at the same time, one of the key types of work on the foreign exchange market. It is much more difficult to make fundamental analysis than any other analysis, as the same factors influence the market differently in various conditions or, being decisive, may become utterly insignificant. It is necessary to know the interrelation and mutual influence of two different currencies that reflect the ties between various states, the history of development of currencies, to determine the cumulative result of some economic measures and to establish connection between events that may originally seem to have no connection at all. In addition to some basic and very formal rules, it is required to have considerable work experience at the foreign exchange market.

Technical analysis Technical analysis is a method of predicting price movements and future market trends by studying charts of past market action. Technical analysis is concerned with what has actually happened in the market, rather than what should happen and takes into account the price of instruments and the volume of trading, and creates charts from that data to use as the primary tool. One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments simultaneously. Technical analysis is built on three essential principles: Market action discounts everything! This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. However, the pure technical analyst is only concerned with price movements, not with the reasons for any changes. Prices move in trends Technical analysis is used to identify patterns of market behavior that have long been recognized as significant. For many given patterns there is a high probability that they will produce the expected results. Also, there are recognized patterns that repeat themselves on a consistent basis. History repeats itself Forex chart patterns have been recognized and categorized for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little over time.

Forex charts are based on market action involving price. There are five categories in Forex technical analysis theory: Indicators (oscillators, e.g.: Relative Strength Index (RSI) Number theory (Fibonacci numbers, Gann numbers) Waves (Elliott wave theory) Gaps (high-low, open-closing) Trends (following moving average).

Some major technical analysis tools are described below:

Relative Strength Index (RSI): The RSI measures the ratio of up-moves to down-moves and normalizes the calculation so that the index is expressed in a range of 0-100. If the RSI is 70 or greater, then the instrument is assumed to be overbought (a situation in which prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation in which prices have fallen more than the market expectations). Stochastic oscillator: This is used to indicate overbought/oversold conditions on a scale of 0-100%. The indicator is based on the observation that in a strong up trend, period closing prices tend to concentrate in the higher part of the period's range. Conversely, as prices fall in a strong down trend, closing prices tend to be near to the extreme low of the period range. Stochastic calculations produce two lines, %K and %D that are used to indicate overbought/oversold areas of a chart. Divergence between the stochastic lines and the price action of the underlying instrument gives a powerful trading signal. Moving Average Convergence Divergence (MACD): This indicator involves plotting two momentum lines. The MACD line is the difference between two exponential moving averages and the signal or trigger line, which is an exponential moving average of the difference. If the MACD and trigger lines cross, then this is taken as a signal that a change in the trend is likely. Number theory: Fibonacci numbers: The Fibonacci number sequence (1,1,2,3,5,8,13,21,34...) is constructed by adding the first two numbers to arrive at the third. The ratio of any number to the next larger number is 62%, which is a popular Fibonacci retracement number. The inverse of 62%, which is 38%, is also used as a Fibonacci retracement number. Gann numbers: W.D. Gann was a stock and a commodity trader working in the '50s who reputedly made over $50 million in the markets. He made his fortune using methods that he developed for trading instruments based on relationships between price movement and time, known as time/price equivalents. There is no easy explanation for Gann's methods, but in essence he used angles in charts to determine support and resistance areas and predict the times of future trend changes. He also used lines in charts to predict support and resistance areas. Waves Elliott wave theory: The Elliott wave theory is an approach to market analysis that is based on repetitive wave patterns and the Fibonacci number sequence. An ideal Elliott wave patterns shows a five-wave advance followed by a three-wave decline. Gaps Gaps are spaces left on the bar chart where no trading has taken place. An up gap is formed when the lowest price on a trading day is higher than the highest high of the previous day. A down gap is formed when the highest price of the day is lower than the lowest price of the prior day. An up gap is usually a sign of market strength, while a down gap is a sign of market weakness. A breakaway gap is a price gap that forms on the completion of an important price pattern. It usually signals the beginning of an important price move. A runaway gap is a price gap that usually occurs around the mid-point of an important market trend. For that reason, it is also called a measuring gap. An exhaustion gap is a price gap that occurs at the end of an important trend and signals that the trend is ending. Trends A trend refers to the direction of prices. Rising peaks and troughs constitute an up trend;

falling peaks and troughs constitute a downtrend that determines the steepness of the current trend. The breaking of a trend line usually signals a trend reversal. Horizontal peaks and troughs characterize a trading range. Moving averages are used to smooth price information in order to confirm trends and support and resistance levels. They are also useful in deciding on a trading strategy, particularly in futures trading or a market with a strong up or down trend. The most common technical tools: Coppock Curve is an investment tool used in technical analysis for predicting bear market lows. DMI (Directional Movement Indicator) is a popular technical indicator used to determine whether or not a currency pair is trending.

Unlike the fundamental analyst, the technical analyst is not much concerned with any of the "bigger picture" factors affecting the market, but concentrates on the activity of that instrument's market.

FINANCIAL CRISIS-INDIAN CONTEXT

A simplistic explanation of the logic of high leverage derivatives (HLD) USD/INR has depreciated from INR 46.50/USD to INR 40/USD. If a majority of a companys revenues are from exports, it translates into an 11% drop in gross margins, assuming the rest of the P&L is in INR. To restore the margins, an export hedging structure has to be constructed that gives a benefit of 11% over-and-above a risk neutral hedge. The only way to get this benefit is to leverage the position and enter into a high-leverage derivative (HLD) . Cost (HLD) = Cost (Hedge) - Cost (Payout) Assuming that the bank makes no money on the transaction, cost (HLD) = 0 Then, Cost (hedge) = Cost (payout) Cost of a hedge is proportional to the benefit one can realise from the hedge and the probability that the hedge will be live at the time of exercise, hence: Benefit (hedge) x Probability (hedge) = Amount (payout) x Probability (payout) Let us say, a company wants to sell USD 1 mn @ INR 46.50 every month for five years and the average forward price is INR 41.50. Benefit (hedge) = INR 5/USD x 1 mn USD x 60 months = INR 300 mn. Given that the hedge is not contingent on any market parameter, probability (hedge) = 1. Now, let's say the payout is to happen only if USD/CHF goes below 1.10. In July 2007,with USD/CHF the lowest it has ever been in the last 20 years (1.11), made the payout situation a 3-sigma event with a probability of less than 4.5%. Doing the math: INR 300 mn x 1 = Amount (payout) x 4.5% Amount (payout) = INR 6.66 bn.

In the above example, the company would be actually risking INR 6.66 bn (which it does not realize in the beginning) in order to save/earn INR 300 mn. MTM losses (due to exotic derivatives) could be ~USD 4-5 bn. Given the prominence of foreign banks in these products, roughly two-third of this exposure is likely to be with foreign banks, and the remaining with Indian banks. Large corporate houses, with the ability to feed MTM margin calls, are likely to account for ~70-80% of these losses; the small and medium enterprises (SMEs) will incur the remaining. Given that very few of these companies have any transaction in JPY or CHF, why have these exotic option structures found such favor with the otherwise astute finance teams? The answer is: The same exotic options exploding today had been boosting bottom lines for these companies consistently in the previous quarters. Trading in these options has become a popular tool for profit management in these companies treasuries. The exotic options entered into require a strong understanding of highly correlated international macro-economics. Understanding the possible blowout risks is difficult and in many cases, difficult to quantify. This gives rise to the undesirable position where the best case profit is known, while the worst case loss is unknown, possibly even to the market maker.

Mark-to-market positions on the exotic structures can only be estimated through mark-to-model approaches. This creates a problem, as the companies cannot track their own positions on a daily basis. Complicating the situation further is the fact that the payoffs being non-linear, it is impossible to predict the loss probabilities at various currency levels at the beginning of the transaction. The levels at which the blowout barriers were placed were beyond historical precedent. USD/CHF had not traded below 1.10 in over 20 years and USD/JPY had remained strong at ~110 consistently. Possibly, the worst case scenarios were difficult to envision upfront and quantify. To begin to appreciate the structures entered, we need to delve into the motivations of the companies to take up these positions in the first place. Genesis High interest rates and an appreciating INR were looking to severely impact earnings Indian companies were faced with a two-pronged problem over the past years that were looking to adversely affect their financials: Unprecedented appreciation of INR against USD Increase in domestic interest rates These two factors, though distinct in their effect, are closely tied in their causes. With USD tending to depreciate against most Asian currencies, INR was no exception. However, to maintain the strong focus that India has on promoting exports, the Reserve Bank of India (RBI) worked to support the USD/INR pair, whenever it looked to depreciate. With the gargantuan inflows India received over 2005-2007 by way of FDI, ECB and FII inflows, this proved to be expensive. Every time a USD/INR down move was supported, RBI bought dollars from the market by paying with INR, which dramatically increased the monetary liquidity in the system. This increased liquidity started to lead towards runaway inflation that threatened the economy at large. In response, RBI consistently prodded the interest rates in the market higher over the later part of 2006-07. By beginning 2007, on an average, corporates were paying 3.5% higher on their borrowing programs than in 2005. All through this, offshore dollars relentlessly flowed into the Indian market. With the interest rates having already increased sharply and the sword of inflation still hanging over their heads, there was little option left for the regulators to support the dollar. USD went into a free fall against the rupee and started hurting those companies, dependant on good forex rates for their INR top line. To counter the losses being suffered on the above market situations, four breeds of products were developed in the market: ECBs denominated in JPY, to be hedged with barrier options (to access lower JPY interest rates). Cross currency swaps from INR loans into CHF, again hedged with barrier options (to access lower CHF interest rates). USD/INR export hedging strips to allow the corporate to sell their export receivables at rates significantly higher than market. These were in some cases, financed by the companies selling back high-value USD/CHF & USD/JPY blowout risk options with a perceived low probability of getting exercised. Purely speculative products that allowed various payout strategies, depending on short-term calls on the international currency markets. A large part of these were breakout or mean reverting strategies encouraged by the low volatilities prevalent in the international currency markets earlier this year.

The yen ECB - The interest rate on a partially hedged ECB was as low as 6%, as against 12% on a similar INR borrowing A company will raise funds through an ECB with an average tenor of three years at a cost of LIBOR +3%. The choice of currency is left to the company with a strong justification given for denominating the loan in JPY. The underlying risk on the loan is that, since the borrowing is in JPY, the loan has to be repaid in JPY for which the company will have to pay INR to buy JPY at the then prevalent rate. Table 1: Interest rate differentials in INR and JPY/CHF created cost saving opportunities

Base cost of funds(3year average tenor) Risk premium Final interest rate Open risks

INR loan 9% (FD interest rate used as a surrogate for cost of funds). 3% 12% None

USD ECB 5% (3-year USD IRS)

JPY ECB 1.5% (3-year JPY IRS)

3% 8% Repayment in USD.USD/INR conversion risk unhedged.

3% 4.5% Repayment in JPY.USD/JPY conversion risk unhedged.

If one purchases hedges for the open risks through forward covers (fully hedged), the realized interest rates work out at par. i.e. cost of a JPY/INR 3-year average tenor forward cover is 7.5%. With a depreciating USD/INR and a possible natural hedge through export receivables, most companies preferred to leave the USD/INR leg open. Cost of a USD/JPY forward cover by the same logic is 3.5%. However, if this leg is hedged with an option costing only 1.5% (to arrive at target loan cost of 6%), there are two benefits illustrated to the company: Participation (full or partial) in favorable movements in USD/JPY. Protection such that USD/JPY risk is hedged as long as USD/JPY does not depreciate to a much lower knockout level (says USD/JPY = 100). Various combinations of the two benefits are packaged to suit the company's appetite and a loan of 6% cost is designed with only one predominant risk - USD/JPY must not go to the knockout level during the loan tenor.

The CHF Swap - A benefit of ~2.75% could be realized by swapping INR loans into CHF loans A company with an existing INR loan could re-denominate the loan into CHF and receive the 'carry' (part of the differential between the CHF LIBOR and INR MIFOR). These swaps were typically of a tenor of 1-2 years and completely off-balance sheet. Again, the underlying risk on the swap was that now a payment had to be made in CHF, for which, the company will have to pay INR to buy CHF at the then prevalent rate. This risk is partially hedged with an embedded option with two benefits illustrated to the company:

 Participation (full or partial) in favorable movements in USD/CHF. Protection such that USD/CHF risk is hedged as long as USD/CHF does not touch a knockout level (says USD/CHF = 1.10). This structure was primarily resting on the premise that USD/CHF had not traded at 1.10 in 20 years, and hence, was a level for significant global option congestion. Again barring the blowout risk of USD/CHF defying history, the structure was sound. USD/INR strips - Long forward premiums were averaged to yield better export realizations and once these proved insufficient, additional value was derived by selling blowout options. As the USD/INR spot slipped from INR 46+ levels down to INR 42, a lot of companies found that their benchmark realization rates were being busted. To maintain the realization, some companies entered into forward strips where they contracted to sell a fixed number of dollars every month for the next five years at a higher rate than spot (say INR 44). This was possible by averaging out the forward premiums i.e. subsidizing the closer forwards by the higher longer forwards. For instance, if 5-year forward premium was INR 5 per USD, then one can have an average higher realization of INR 2.5. The risk on this structure is that if USD/INR appreciates to above INR 44, the company would have to convert its USD at INR 44 instead of a higher spot rate. The blowout risk on the structure devolves if USD/INR goes above INR 50 in the next five years. This was an acceptable risk for most companies and the market was flooded with such deals. As a result, the forward premiums contracted such that these 'par' forward structures started yielding only ~INR 42.50, making it unviable. At this stage, companies had to resort to complex structures to raise the levels higher. The companies sold options in CHF and JPY to finance these higher realizations for their receivables. Once again, the structures would be protected as long as USD/CHF does not trade below 1.10 consistently or USD/JPY below 105 or so. Truly speculative - Short-term structures were entered into with high payoffs and high blowouts in the belief that the market was predictable in the short term. A segment of the market entered into complex exotics with a life span of 1 year or less. These had no direct correlation to their books, except that underlying exposures existed, albeit in a different currency. The payoff was received as single barrier knockouts, monthly accruals, or in extreme cases as geometrically increasing monthly realizations. Most of these structures relied on the currencies remaining within stable ranges or at worst, not breaching historical extremes definitively. The logic of these structures were simple, get in, make money, and get out before the markets move. With low volatilities in the currency market holding sway, the predictability was perceived high in the extreme short term and the speculative plays relied on a low likelihood of sudden dramatic movements. What has gone wrong? - The currency movements that are hurting the companies Over the past few years, companies have aggressively entered into derivative contracts to generate lower interest costs. These have given annual benefits of upwards of 2% in interest cost reductions and created an impression of a strong understanding of the currency markets. USD/JPY at 110 and USD/CHF at 1.10 became sacred cows, which the entire market was willing to bet over.

USD/CHF in the last month broke below 1.10, USD/JPY broke below 110, and EUR/USD and GBP/USD have been making historical highs every second day. The embedded protections in a lot of the cases have collapsed, and some sold options have exploded; however the options are still live and will not expire for the next six months on an average. Only if this level hold till expiry or worsens, will the companies have much to worry about, everything is notional, right? Wrong. Because the currency movements are killing them softly by way of MTM margin calls.

SELECTION OF FORECASTING MODEL Simple Linear Regression

The USD/INR exchange rate is forecasted using the simple liner regression with exchange rate as dependent variable and interest rate differential as independent variable. The model is analyzed for its application. The regression equation obtained is: E = -0.245 + 1.06 * I Where E exchange rate I interest rate differential Model Analysis While analyzing the regression model, the first criteria to justify the model is the residual analysis of the model as shown below. a) It can be seen that the residual are not following a normal probability distribution. Even it can be justified from the box which shows Anderson-Darling Normality Test Statistics(A2) is around 8.409 and the p-value is less than 0.005.Both of these values are indicating that the residuals are not following a normal distribution. N AD P-Value 60 8.409 <0.005

REGRESSION OUTPUT Predictor Constant I S = 0.246713 Hence, Coef. -0.2451 1.06124 SE Coef 0.1513 0.02561 T -1.62 41.43 0.107 0.000 P

R-Sq = 90.7% R-Sq = 90.6% E = -0.245+1.06*I

ANALYSIS OF VARIANCE Source Regression Residual Error Total DF 1 176 177 SS 104.49 10.71 115.20 MS 104.49 0.06 F 1716.65 P 0.000

Durbin-Watson statistic (d value) = 0.0794856

ANALYSIS Analyzing the t-value and the p-value i.e. the probability of obtaining a test statistic that is at least as extreme as the actual calculated value, if the null hypothesis is true i.e. the p-value represents the probability of making a Type I error, or rejecting the null hypothesis when it is actually true. The smaller the p-value, the smaller the probability is that you would be making a mistake by rejecting the null hypothesis. As in this case as the p-value is even less than so the null hypothesis is rejected. Hence the model is rejected. As the value of R-Sq is quite high so from this perspective the model is justified. While analyzing the ANOVA table as p is less than so the null hypothesis is again rejected i.e. all j are equal. Now the most important thing to notice the Durbin-Watson Statistic that is equal to 0.0794856 shows the autocorrelation is present in the residuals. As we know that For n=60, k (no. of independent variables) = 1; dL (lower limit of DW statistic) = 1.65 dU (upper limit of DW statistic) = 1.69 and 0.0794856 is less than the lower limit so positive autocorrelation exists.

Hence the model is not appropriate for forecasting. Quadratic Regression Model

As shown above in the Linear Regression Model is not fit for forecasting so a Quadratic Model which is the most common form of non-linear relationships (i.e. quadratic relationship between two variables) is applied to the time series and is analyzed for its applicability. The regression equation obtained after applying the model is E = 4.40 0.595*I+0.145I2 Where E exchange rate I interest rate differential

Model Analysis a) It can be again seen that the residual are not following a normal probability distribution. Even it can be justified from the box which shows Anderson-Darling Normality Test Statistics(A2) is around 5.353 and the p-value is less than 0.005.Both of these values are indicating that the residuals are not following a normal distribution. N AD P-Value 60 5.353 <0.005 REGRESSION OUTPUT

Predictor Constant I I2

Coef. 4.396 -0.5950 0.14528

SE Coef 1.564 0.5563 0.04874

T 2.81 -1.07 2.98

P 0.006 0.286 0.003

VIF 492.8 492.8

S = 0.241367 R-Sq = 91.2% R-Sq = 91.0% Hence, E = 4.40 0.595*I + 0.145*I2 ANALYSIS OF VARIANCE Source Regression Residual Error Total DF 2 175 177 SS 105.005 10.195 115.201 MS 52.503 0.058 F 901.21 P 0.000

Durbin-Watson statistic (d value) = 0.0916674 ANALYSIS t-value and p-value from the table shows that the null hypothesis is violated for constant and I2. As per ANOVA, the null hypothesis is rejected as again p is less than . Now the final and the most important thing to notice is the Durbin-Watson Statistic which is equal to 0.0916674 shows that autocorrelation is present in the residuals.As we know that For n=60, k (no. of independent variables) = 2; dL (lower limit of DW statistic) = 1.63 dU (upper limit of DW statistic) = 1.72 and 0.0916674 is less than the lower limit so positive autocorrelation exists. Hence the model is not appropriate for forecasting. Now it can be implied from the above results that neither Simple Regression nor Quadratic Regression are appropriate tools for forecasting of exchange rates.

UNIVARIATE ARIMA Model In the time series analysis, there is a fundamental distinction between the terms process and realization. The actual values in the observed time series are the realization of some underlying process (stochastic generating process) that generated those values. In the time series analysis, the relation between the realization (i.e. the observed sample values) and the process (i.e. the underlying stochastic process) is analogous to the relationship between the sample and the population as studied in statistical hypothesis testing. The purpose of the time series analysis is to use the realization of a process to identify a model of ARIMA process that generated the series. The procedures to build models are broadly referred to as Box-Jenkins or ARIMA model building methods. It is |empirically driven methodology of systematically identifying, estimating, diagnosing and forecasting time series.

ARIMA Notation (p,d,q) p = order of auto-regression d = order of integration q = order of moving average Auto-regressive Process-ARIMA(1,0,0) Auto-regression is an extension of simple linear regression. An ARIMA(1.0,0) model, commonly called an AR(1) model is Yt = 0 + 1Yt-1 + et where 0 , 1 coefficients chosen to minimize the sum of squared errors. For this model, the absolute value of coefficient 1 is normally constrained to be less than 1.This constraint is called a bound of stationarity: Bound of Stationarity | 1| <1 If the bound is exceeded then the series is not autoregressive, it is either drifting or trending, and differences should be used to model the time series.

Moving Average Process-ARIMA(0,0,1) ARIMA moving averages are similar to the exponential smoothing.An ARIMA(0,0,1) model commonly called an MA(1) model is Yt = - 1et-1 + et Where 1 is an estimated coefficient and Yt is only correlated with the previous forecast error, et-1. In this model, absolute value of 1 for a moving average model is constrained to be less than 1. This constraint is called the Bound of invertibility, a concept related to stationarity. Bound of invertibility | 1| <1 If this bound is exceeded, the model is not stationary. Integrated Process-ARIMA(0,1,0) Integrated processes are level-nonstationary series. It(i.e. summed series) include random walks and trends(because their means or levels are not constant. The means either randomly changes as the series randomly walks or consistently increases/decreases). For a random walk series, the previous actual value is a best predictor of all future values. So the model is Yt = Yt-1 + et

These three models are the basic models in the ARIMA model building processes. APPLYING THE UNIVARIATE ARIMA MODEL TO EXCHANGE RATES TIME SERIES AND MODEL SELECTION ARIMA(1,1,0) 1 The descriptive statistics for ARIMA (1,1,0) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared 5 59 55 0.050 0.980

RMSE MAPE MAE Normalized BIC Statistic Ljung Box Q DF Statistic Significance

0.104 1.193 0.070 -4.478 18.194171 17 0.377

Stationary R-Squared is a measure that compares the stationary part of the model to a simple mean model. This measure is preferable to ordinary R-squared when there is a trend or seasonal pattern. Stationary R-Squared can be negative with a range of negative infinity to 1. Negative values mean that the model under consideration is worse than the baseline model. Positive values mean that the model under consideration is better than the baseline model. R-Squared is an estimate of the proportion of the total variation in the series that is explained by the model. This measure is most useful when the series is stationary. R-Squared can be negative with a range of negative infinity to 1. Negative values mean that the model under consideration is worse than the baseline model. Positive values mean that the model under consideration is better than the baseline model. RMSE(Root Mean Square Error) is a measure of how much a dependent series varies from its model-predicted level, expressed in the same units as the dependent series. MAPE(Mean Absolute Square Error) is a measure of how much a dependent series varies from its model-predicted level. It is independent of the units used and can therefore be used to compare series with different units. MAE(Mean Absolute Error) measures how much the series varies from its model-predicted level. MAE is reported in the original series units.

Normalized BIC(Normalized Bayesian Information Criterion) is a general measure of the overall fit of a model that attempts to account for model complexity. It is a score based upon the mean square error and includes a penalty for the number of parameters in the model and the length of the series. The penalty removes the advantage of models with more parametes, making the statistic easy to compare across different models for the same series.

Constant AR,1

Estimate 0.008 0.223

SE 0.010 0.074

T 0.806 3.032

Significance 0.421 0.003

So the model equation for ARIMA (1,1,0) 1 becomes Yt = Yt-1 + *(Yt-1 Yt-2 ) + 0

i.e. Yt = Yt-1 + 0.223*(Yt-1 Yt-2 ) + 0.008 ARIMA(1,1,1) 1 Now while applying ARIMA(1,1,1) 1 The descriptive statistics for ARIMA (1,1,1) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared RMSE MAPE MAE Normalized BIC Statistic Ljung Box Q DF Statistic Significance Estimate 0.008 0.212 -0.012 15 59 54 0.050 0.980 0.104 1.194 0.070 -4.443 18.154 16 0.315 SE 0.010 0.332 0.340 T 0.806 0.0637 -0.036 Significance 0.422 0.525 0.971

Constant AR,1 MA,12

While comparing the two models i.e. ARIMA(1,1,0) 1 and ARIMA(1,1,1) 1 , the best fit model decided on the criteria of Normalized BIC is ARIMA(1,1,0) 1 as it has the smaller BIC coefficient. (-4.478 < -4.443) Secondly the number of iterations in ARIMA(1,1,0) 1 is much less than ARIMA(1,1,1) 1 (5 < 15). So ARIMA(1,1,0) 1 is preferred. But still the value of Stationary R-Squared and the R-Square is quite low which shows that there is still some kind of variance non-stationarity which can be removed by taking the first difference of log of the natural time series. ARIMA(1,1,0)1,1 Now by applying the ARIMA(1,1,0)1,1 model The descriptive statistics for ARIMA (1,1,0) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared 5 59 55 0.061 0.980

RMSE MAPE MAE Normalized BIC Statistic Ljung Box Q DF Statistic Significance Estimate 0.001 0.245

0.104 1.198 0.070 -4.477 19.354 17 0.309 SE 0.002 0.073 T 0.757 3.343 Significance 0.450 0.001

Constant AR,1

So the model equation for ARIMA (1,1,0) 1,1 becomes LnYt =Ln Yt-1 + *(LnYt-1 LnYt-2 ) + 0 i.e. LnYt = LnYt-1 + 0.245*(LnYt-1 Ln Yt-2 ) + 0.001 Now the next forecasted value will be for ARIMA(1,1,0)1,1 Forecasted Value No. Forecasted Value UCL LCL ARIMA(1,1,1)1,1 Now applying the ARIMA(1,1,1)1,1 model so as to see whether it fits the forecasted model better or not. The descriptive statistics for ARIMA (1,1,1) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared RMSE MAPE MAE Normalized BIC Statistic Ljung Box Q DF Statistic Significance Estimate 0.001 0.309 8 59 54 0.061 0.980 0.104 1.197 0.070 -4.441 19.455 16 0.246 SE 0.002 0.293 T 0.743 1.055 Significance 0.459 0.293 60 50.4577 51.4657 50.2333

Constant AR,1

MA,12

0.068

0.308

0.222

0.0825

So the model equation for ARIMA(1,1,1)1,1 becomes Ln Yt = Ln Yt-1+ 1*(Ln Yt-1 - Ln Yt-2) +12*( Ln Yt-1 - Ln Yt-2) + 0 i.e. Ln Yt = Ln Yt-1+ 0.309*(Ln Yt-1 - Ln Yt-2) +0.068*( Ln Yt-1 - Ln Yt-2) + 0.001 Now the next forecasted value will be for ARIMA(1,1,1)1,1 Forecasted Value No. Forecasted Value UCL LCL 60 51.3487 52.6690 50.1145

While comparing the two models i.e. ARIMA(1,1,0) 1,1 and ARIMA(1,1,1) 1,1 , the best fit model decided on the criteria of Normalized BIC is ARIMA(1,1,0) 1,1 as it has the smaller BIC coefficient. (-4.477 < -4.441) Secondly the number of iterations in ARIMA(1,1,0) 1,1 is much less than ARIMA(1,1,1) 1,1 (5 < 15). So ARIMA(1,1,0) 1,1 is preferred. Hence the bst fit model is ARIMA(1,1,0)1,1 to forecast the exchange rates and the forecasting equation is LnYt = LnYt-1 + 0.245*(LnYt-1 Ln Yt-2 ) + 0.001

VALIDATION OF FORECASTING MODEL Now to test the validity of the forecasting model stated above, monthly exchange rates for last 8 months were taken. month september,2008 october,2008 november,2008 december,2008 january,2009 february,2009 march,2009 april,2009 exchange rate 45.4264 48.6196 48.7905 48.4804 48.7326 49.1914 51.2062 50.3333 predicted exchange rate 45.2712 48.7849 48.9703 48.8286 48.9432 48.8968 50.9564 50.4577 difference 0.1552 -0.1653 -0.1798 -0.3482 -0.2106 0.2946 0.2498 -0.1244

Now after observing the difference and the graph plotted between actual and predicted exchange rates confirms the validity of the forecasting model.

ECONOMETRIC MODEL Econometric model has its own significance among all the forecasting models. It takes into consideration all the macro economic factors and thus is more reliable. Broadly the economic model is built considering the simultaneous equilibrium of exchange, money and goods market. Therefore the joint behavior of bilateral exchange rates, interest rate differential and growth rate differential are taken into account. The foreign exchange market The foreign exchange market is primarily influenced by the following macro economic variables. Consumer price index Real price of oil Export to import ratio Interest rate differential Thus exchange rates depends on the above mentioned factors. The Money Market Factors influencing the money market are GDP Real money supply Thus interest rate differential depends on the above mentioned factors. The Goods Market Factors influencing the goods market are Interest rate differential Consumer price index Real oil prices Export to import ratio Thus growth rate differential depend on the above mentioned factors. Let Xt denotes the exchange rate at a time t thus, Xt= f(RRL,Y,Q) Where RRL=g(MG,Y) Q = h(LTNT,LTOT,ROIL,RRL) Y = k(RRL,LTNT,LTOT,ROIL) RRL Q Y MG Interest rate differential Real exchange rate Annual growth rate Real money supply

LTNT LTOT ROIL Descriptive study of the variable utilized Equation RRL Q Y MG LTNT LTOT ROIL Skewness 0.3350 0.4480 0.9320 0.8770 0.8750 0.0010 0.3260

Consumer price index Export to import ratio Real oil prices

Kurtosis 0.3050 0.2910 0.0120 0.0100 0.0310 0.3190 0.4780

Skewness+kurtosis 0.3710 0.4300 0.0420 0.0370 0.0970 0.0030 0.4800

Rank Test Number of lags considered - 3 H0: Rank <= r r=0 r=1 r=2 r=3 r=4 r=5 r=6 Test Statistic 233.54 172.55 119.50 75.40 45.75 23.72 6.81 P value 0.0000 0.0004 0.0128 0.1467 0.3316 0.5055 0.7677 95% 181.86 144.61 111.39 82.20 57.06 35.75 18.08 99% 193.72 155.28 120.86 90.49 64.18 41.66 22.70

Equilibrium dynamics- real exchange rates Variable LTNT LTOT ROIL RRL Coefficient -2.1057 0.6540 0.1318 -4.7978 Standard error 0.2281 0.1178 0.0367 0.2989 t-value -9.2315 5.5518 3.5913 -16.015

Equilibrium dynamics-interest rate differential Variable Y MG Coefficient 6.0033 -8.5467 Standard error 0.5337 0.5620 t-value 11.2485 -15.2077

Equilibrium dynamics-growth rate differential Variable Coefficient Standard error t-value

LTNT LTOT ROIL RRL

1.5180 -0.4262 0.1370 4.1181

0.1942 0.1037 0.0319 0.2546

7.8167 -4.1099 4.2947 16.1748

Graph-Actual v/s Forecasted Values

REFERENCES 1. Hull John C.-Options, Futures and Other Derivatives, Fifth Edition Pearson Education Inc,2003,Prentice Hall Finance Series 2. NCFM Module-Derivatives 3. Master Circulars by RBI 4. ICFAI Journal of Derivatives LIST OF WEBSITES: www.rbi.org www.nseindia.org www.google.com www.realtimeforex.com www.fxstreet.com www.ecnomagic.com www.rbi.org www.bis.org

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With its presence virtually in all the important cities of the country, Punjab National Bank offers a wide variety of banking services which include corporate and personal banking, industrial finance, agricultural finance, financing of trade and international banking. Among the clients of the bank are Indian conglomerates, medium and small industrial units, exporters, non-resident Indians and multinational companies. The large presence and vast resource base have helped the bank to build strong links with trade and industry. Punjab National Bank is serving over 3.5 Crore customers through 4589 branches and 322 extension counters- largest among Nationalized banks. The bank was recently ranked 21st amongst top 500 companies by the leading financial daily, The Economic Times. The banks attempt at providing best customer service has earned it 9th place among Indias Most

Trusted top 50 service brands in Economic Times-A.C.Nelson Survey.PNB is also ranked 255 amongst the top 1000 banjs in the world according to The Banker London. At the same time the bank has been conscious of its social responsibilities by financing agriculture and allied activities and small scale industries(SSI). Considering the importance of the small scale industries, bank has established 31 specialized branches to finance exclusively such industries. Strong correspondent banking relationship which Punjab National Bank maintains with over 200 leading international banks all over the world enhances its capabilities to handle transaction world-wide. Besides, bank has Rupee Drawing Arrangements with 15 exchange companies in the Gulf and one in Singapore. Bank is a member of the SWIFT and over 150 exchange branches of the bank are connected through its computer based terminal at Mumbai. With its state-of-art dealing rooms and well-trained dealers, the bank offers efficient foreign exchange dealing operations in India. Backed by strong domestic performance, the bank is planning to realize its global aspirations. In order to increase its international presence, the bank has already set up representative offices at Almaty (Kazakhstan), Dubai (UAE) & Shanghai (China) ; a branch at Kabul (Afghanistan) and a subsidiary at London (UK) and a branch at Hongkong. Work on assessing potential at other international centers is progressing. The bank also has a joint venture with Everest Bank Ltd. (EBL), Nepal, with 20 per cent equity participation. With PNBs management, EBL has become one of the leading banks in Nepal. PNB has always looked at technology as a key facilitator to provide better customer service and ensured that its IT strategy follows the Business strategy so as to arrive at Best Fit. The bank has made rapid strides in this direction and achieved 100% branch computerisation. A pioneering effort of the bank in the use of IT is the implementation of Core Banking Solution (CBS) which facilitates any time, any where banking. PNB has implemented CBS in 3503 service outlets at around centers to facilitate "anytime, anywhere" banking to its clients. The bank has also been offering Internet banking services to the customers of CBS branches like booking of tickets, payment of bills of utilities, purchase of airline tickets etc. Towards developing a cost effective alternative channels of delivery, the bank has installed more than 1516 ATMs and entered into ATM sharing arrangement with other banks & IDRBT, making available a pool of additional 21,500 ATMs throughout the country to its customers.

Organization Structure: Bank has its corporate office at New Delhi. The delegation of powers is decentralized up to the branch level to facilitate quick decision making.

Head Office

Circle Office(58)

Branches(4267)

ANNEXURE 2 MAJOR CURRENCIES Kinds of major currencies and exchange systems The U.S. Dollar. The United States dollar is the world's main currency an universal measure to evaluate any other currency traded on Forex. All currencies are generally quoted in U.S. dollar terms. Under conditions of international economic and political unrest, the U.S. dollar is the main safe-haven currency, which was proven particularly well during the Southeast Asian crisis of 1997-1998 As it was indicated, the U.S. dollar became the leading currency toward the end of the Second World War along the Breton Woods Accord, as the other currencies were virtually pegged against it. The introduction of the euro in 1999 reduced the dollar's importance only marginally. The other major currencies traded against the U.S. dollar are the euro, Japanese yen, British pound, and Swiss franc. The Euro. The euro was designed to become the premier currency in trading by simply being quoted in American terms. Like the U.S. dollar, the euro has a strong international presence stemming from members of the European Monetary Union. The currency remains plagued by unequal growth, high unemployment, and government resistance to structural changes. The pair was also weighed in 1999 and 2000 by outflows from foreign investors, particularly Japanese, who were forced to liquidate their losing investments in euro-denominated assets. Moreover, European money managers rebalanced their portfolios and reduced their euro exposure as their needs for hedging currency risk in Europe declined. The Japanese Yen. The Japanese yen is the third most traded currency in the world; it has a much smaller international presence than the U.S. dollar or the euro. The yen is very liquid around the world, practically around the clock. The natural demand to trade the yen concentrated mostly among the Japanese keiretsu, the economic and financial conglomerates. The yen is much more sensitive to the fortunes of the Nikkei index, the Japanese stock market, and the real estate market. The British Pound. Until the end of World War II, the pound was the currency of reference. The currency is heavily traded against the euro and the U.S. dollar, but has a spotty presence against other currencies. Prior to the introduction of the euro, both the pound benefited from any doubts about the currency convergence. After the introduction of the euro, Bank of England is attempting to bring the high U.K. rates closer to the lower rates in the euro zone. The pound could join the euro in the early 2000s, provided that the U.K. referendum is positive. The Swiss Franc.

The Swiss franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. Although the Swiss economy is relatively small, the Swiss franc is one of the four major currencies, closely resembling the strength and quality of the Swiss economy and finance. Switzerland has a very close economic relationship with Germany, and thus to the euro zone. Therefore, in terms of political uncertainty in the East, the Swiss franc is favored generally over the euro. Typically, it is believed that the Swiss franc is a stable currency. Actually, from a foreign exchange point of view, the Swiss franc closely resembles the patterns of the euro, but lacks its liquidity. As the demand for it exceeds supply, the Swiss franc can be more volatile than the euro.

ANNEXURE 3
QUESTIONNAIRE

QUESTIONNAIRE SURVEY ON FOREIGN EXCHANGE DERIVATIVES

NAME DESIGNATION ORGANISATIONS NAME . . .

1. Companies can manage financial risk more efficiently through derivatives.

Strongly disagree Somewhat disagree Neither agree or disagree Somewhat agree

Strongly agree

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2. Derivative is used as
Risk managing instrument Profit making instrument Both of them None of them

3. The most important factor kept in mind before finalizing any contract
Fundamental analysis Technical analysis

Bankers opinion

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4. Stop loss/take profit limit is set at the time of finalizing the contract

Yes No

The limit is not considered important

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5. If the limit is set, then it is religiously followed

Yes No

Limit can be reset depending on market

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6. The approximate range of exposure towards hedging(in INR)

0-20 crores 20-30 crores 30-40 crores 40 crores and above

7. The approximate range of losses incurred (in INR) in the financial year 2008-09
No losses 0-10 crores 10-15 crores 15-20 crores

20 crores and above

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8. The reason for companies incurring huge losses can be

Inability to predict currency movement Opinion of bankers went otherwise Personal judgment /forecast Optimism that trend reversal will happen

9. Rank (on a scale of 1-4)the following in order of volumes of trade done

Forward

Future Swaps Option

10. Based on the past experience do you still continue to have an exposure in this market
Yes No Yes but the volume has decreased

11. Derivatives have created a new type of risk

Strongly disagree Somewhat disagree Neither agree nor disagree Somewhat agree Strongly agree

12. Impact of derivatives on the global financial system is beneficial

Strongly disagree Somewhat disagree Neither agree nor disagree Somewhat agree Strongly agree

13. Contribution by derivative to the stability of the global financial system

It stabilizes the system It destabilizes the system Any of them-depends on the way it is used

14. The most important benefit that derivatives offer is

Flexibility in customizing risk profile

Inexpensive risk management tool Both of them None of them

15. The area that will be benefitted most from the innovations in the next 5 years is
Credit risk Financial services International and emerging markets