Chapter : I Volatile Nature of the Indian Rupee

Volatile exchange rates are the main cause of the instability in the international economy -Peter Bofinger Volatility in the exchange rates refers to the dispersion of returns. In the financial world, volatility is an important contributor to risks. The exchange rates could display higher volatility because of several factors such as deviation from fundamentals, excessive speculative activities, macroeconomic shocks, or other global and domestic news. Excessive fluctuations in exchange rates could spillover to other segments of financial markets, can blur the monetary policy signals and lead to financial stability problems. Excessive exchange rate fluctuations also have a detrimental impact on foreign trade and at times even on genuine investments. Investments could then be potentially guided by a view or a bet on exchange rate movements rather than by underlying returns, especially if the umbilical cord between the cash-futures arbitrage is snapped. The solution to this problem is in the form of using appropriate derivative tools to hedge the currency exposures. In fact the whole research material stated in the introductory part revolves around studying the impact of volatile nature in the parity of rupee with other currencies and effective use of derivative tools by identifying problems faced by Indian corporates through the process of exploration. Accordingly, this chapter initially looks at the basic nature of the foreign exchange market and its growth over a period, briefly covers the exchange rate risk and then talks about the rupee exchange rate volatility by calculating coefficient of variance and standard deviation and plotting graphs against that data and looks into the reasons behind that volatility. The foreign exchange market is a market where financial paper with a relatively short maturity is traded, and those financial papers are denominated in different currency. (Riehl, Rodriguez, 1977)

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Each nation decides to keep its sovereign right to have and control its own currency. Foreign exchange market is a virtual place, where one currency gets exchanged with other currency. There is neither a particular place (physical market) nor there is an organized exchange as such where traders meet and exchange currencies. Its the largest market in the world. The foreign exchange market is unique because of: Its trading volumes; The extreme liquidity of the market, The large number of and variety of traders in the market, The geographical dispersion, Its long trading hours; 24 hours a day (except weekends) Variety of factors affecting exchange rates.

Bank for International Settlements Survey Results: According to the data compiled by Switzerland-based Bank for International Settlement in April 2007, shows a rise in the daily turnover in the traditional FX market to $ 3.2 trillion in April 2007 as compared to $ 1.8 trillion in 2004, which was further broken to as follows: $ 1005 bn in spot transaction. $ 362 bn in outright forwards. $ 1714 bn in Swaps. $ 129 bn estimated gaps in reporting.

In case of geographical distribution of the foreign exchange trading, the United Kingdom continued to be the most active trading centre in 2007, capturing 34.1% share of the total turnover in 2007 from 31.3% in 2004. US, the second largest market, saw a slowdown in its share growth to 16.6% in 2007 from 19.2% in 2004. Japan, third largest market, also saw its market share easing to 6% from 8.3% three years ago. On the other hand Singapore, Hong Kong, Australia, and Switzerland gained their shares in the traditional foreign exchange market. Among emerging markets, the growth of Indian foreign exchange market was noteworthy

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When expectations about any of these variables change, there is an immediate effect on the expected returns and thereby on the exchange rate. No country is self-sufficient and cannot produce all goods and services due to scarcity of resources, skills, technology, etc. All nations can simultaneously gain from exploiting their comparative advantage, as well as, from the larger scale of production and broader choice of products that is made possible by international trade.5 And this very basic fact led to rise in the cross-border trade and exploration to the various types of risks in the international market. Under these circumstances avoiding the exchange rate risk is not possible at all; rather learning to mange this risk is the better option for companies, who are into international business. While understanding the use of currency derivative tools in managing the exchange rate risk, the volatility of the exchange rate should be viewed as a source of risk. Professor Peter Bofinger of the Wurzburg University argues that the, volatile exchange rates are the main cause of the instability in the international economy (Bofinger, 2003). Exchange rate risk has risen far more than the amount of foreign trade and due to ever rising overseas investments; exchange rates have become increasingly volatile. Unexpected changes in exchange rates can have important impacts on sales, prices and profits of both exporters and importers. And this situation has created a need for the risk management techniques. A study by the National Bureau of Economic Research in the United States, published in early 2002, came to the conclusion that reduced exchange rate volatility significantly increases trade and that sharing a common currency has an even more positive effect. The study concludes that nations with the same currency trade three times as much with each other as they would with different currencies. Robert Mundell (the father of the Euro), has argued that the only people to benefit from volatile exchange rates are currency speculators. Mundell has for long been arguing in favour of the single world currency, with monetary policy
For more details on the Principal of Comparative Advantage please refer Maurice D. Levi, (1996), International Finance, McGraw-Hill, Inc.
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controlled by a world central bank. Mundells dream of the single world currency has a long way to go, but before that the volatile exchange rates needs to be managed with the various risk management techniques (Mundell, 2002).

Indian Scenario: the two way movements of the rupee against major currencies after liberalization.

It was Keynes who once remarked that knowing nothing about the past makes a man as primitive as knowing nothing about the future. In other words, one cannot live in the present alone. Although in the financial markets, future need not have a link to the past, nevertheless, it is important to know a bit of the past to make informed predictions about the future (V. Kamesam, 2001). The purpose of this section, therefore, is to take a birds eye-view of the past, reflect on the present scenario of the Indian foreign exchange market. The Foreign exchange market in India till late 1990s remained highly regulated, i.e., restrictions on external transactions, barriers to entry, low liquidity and high transaction cost, etc. The exchange rate was managed mainly for facilitating Indias imports (RBI Report, 2007). These strict controls on the foreign exchange transactions through FERA has created parallel and the most efficient, but unofficial foreign exchange market in the world, called, Hawala market. But this regulatory atmosphere could not be sustained for long, as Indias trade activities were increasing at a faster rate. In 1991-92 the Indian economy experienced a paradigm shift with the external sector being the centre stage of reforms. The rupee was made convertible on current account, partially in 1992 and fully in 1993 under the Liberalized Exchange Rate Management System6. This was the beginning in the direction of freeing external transactions from the administrative controls. Freedom to cancel and rebook forward contracts
For more information on LERMS, please see, H.R. Machiraju, (1998), Indian Financial System, Vikas Publishing House Pvt. Ltd. Pg. No. 14.5
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