WELINGKAR INSTITUTE OF MANAGEMENT DEVELOPMENT & RESEARCH

SUMMER PROJECT

ON

GROWTH AND SCOPE OF FOREX AND LINKAGES WITH OTHER MARKET

BY

Siddharth Kheria

Masters In Management Studies

SPECIALISATION:

FINANCE

ACKNOWLEDGEMENTS
I am grateful to Mr A.D.M Chavali, General Manager-Treasury, Bank of Baroda, Treasury
Branch, Mumbai for allowing me to undertake my project work in treasury Division.

I would like to acknowledge a deep sense of gratitude to my Project Guide Mr Sanjay

Grover, chief dealer forex department, for imparting me with knowledge of the forex markets
and the art of analyzing them along with the market dynamics, for mentoring me and without
whose help this project would not have taken its current shape.

I am also thankful to Mr. Narendra Kumar, Mr. Ashish Gupta and Mr. Pranav Murari, for
providing me valuable inputs and guidance throughout the project.

Finally I would like to thank my alma mater WELINGKAR for providing me this platform to
grow in my career.

CONTENTS
# Topic Page #
1 PREFACE 4
2 TRESURY MANAGEMENT 5
3 FOREX MARKETS 7
A.FOREX FUNDAMENTALS 7
B. FOREX TERMINOLOGY 7
C.THEORIES OF EXCHANGE RATE DETERMINATION 12
D.FACTORS AFFECTING FOREX RATES 16
4 FOREIGN EXCHANGE GLOBAL MARKET 19
A.EVENTS IN THE GLOBAL FOREX MARKETS 19
B.MAJOR CURRENCIES 22
C.CURRENCY TURNOVER 22
5 FOREIGN EXCHANGE MARKET DEVELOPMENT IN 25
INDIA
A.EVENTS IN THE INDIAN FOREX MARKETS 25
B.REGULATORY FRAMEWORK 26
C.COMMITTEE RECOMMENDATIONS 28
6 FOREX DEREVATIVES 30
A.FORWARD 30
B.SWAPS 31
C.OPTIONS 33
D.FUTURES 33
E.DEREVATIVES MARKET IN INDIA 35
7 INTERRELATIO OF FOREX MARKETS WITH OTHER 36
MARKET SEGMENTS
A.FOREX V/S EQUITY 39
B.FOREX V/S MONEY MARKET 40
C.FOREX V/S DEBT MARKET 41
D.FOREX V/S COMMODITY MARKETS 43
8 CORRELATION AND MOVEMENTS 44
A.USD/INR 44
 B.USD/MAJOR TRADED CURRENCIES 44
C.USD/INR V/S OTHER CURRENCY PAIR 45
D.USD/INR V/S CRUDE 47
E.USD/INR V/S GOLD 48
9 FOREX RISK MANAGEMENT 49
10 FUTURE OUTLOOK 52
11 REFORMS IN THE FOREX MARKETS 54

Organization Profile

Bank of Baroda is fifth largest public sector banks in India. It has total assets of Rs. 2.27 lakh
crores and a network of over 2800 branches and offices, and about 1100+ ATMs. Bank of
Baroda offers a wide range of banking products and financial services to corporate and retail
customers through a variety of delivery channels and through its specialised subsidiaries and
affiliates in the areas of investment banking, credit cards and asset management.

It has significant international presence and countries beginning from America to Zambia, in

the alphabetical order have been enjoying the services of Bank of Baroda (first
overseas venture in 1953 in Kenya). It has overseas network of 74 offices in 25 countries, the
details are:

Bank’s Overseas Branches  # 48

Bank’s Representative Offices # 03

Branches of Bank’s Overseas Subsidiaries  # 23

In addition to the above, the Bank’s associate in Zambia has nine branches. Among Bank of
Baroda's 46 overseas branches are ones in the world’s major financial centers i.e. New York,
London, Dubai, Hongkong, Brussels and Singapore, as well as a number in other countries.

Bank of Baroda was one of the earliest nationalized banks to tap the capital market in the
mid-90s to shore up its capital base to be in alignment with Basel-I norms & with Basel-II by
disclosing ICAAP policy and also the first nationalized bank to return part of the capital to
Government of India.

For the current financial year (2008-2009) Bank has booked it’s Net profit Rs. 2227 Crores,
with Net NPA declining to 0.31%. (*All data as of 31st Mar’2009)

Treasury Management

Treasury is called heart of any banking and financial organization. It is the window through
which the Bank raises funds from or places funds in markets. Treasury management may be
defined as “management of the liquidity of a business to ensure that the right amount of funds
are available in the right currency at the right time at the right place”.

In a commercial bank, treasury refers to the funds and revenues at the disposal of the bank
and day-to-day management of the same. The treasury unit acts as the custodian of cash and
other liquid assets.

Functions of the treasurer revolve around two concepts:

 Basic cash management: Management of collections and payments, liquidity monitoring

in banking operations, short-term treasury forecasts, the management of banking
balances on value date and negotiation with financial organizations

 Advanced cash management: Includes the management of the financing of treasury

deficits, the management of the positioning of treasury peaks and the management of
financial risks.

Objectives:

○ To maintain CRR and SLR as stipulated by the regulator

○ To deploy the surplus fund for profitability by optimising return to risk ratio
 ○ To fund of balance-sheet at the lowest possible cost

○ Participation in the G-sec market bidding and help in creating secondary market
for that

○ To effectively manage foreign currency assets and liabilities

○ Maintenance of liquidity for the bank

○ To earn profit by taking the advantage of arbitrage and trading opportunity

Function:

○ Maintainance CRR(Cash Reserve Ratio) and SLR(Statutory Liquidity Ratio) at

the required level

○ Deploying surplus money in short term or long term depending on the maturity
profile of resources and market opportunities

○ Drawals of refinance from RBI

○ Maximise Returns through trading and retailing securities

Source of Profit:

○ Investment: Bank tries to maximise the return by putting the money where the
yield is above the hurdle rate. “Yield > Hurdle Rate”

○ Spread: It is difference between funding of assets and borrowing cost of liability.

Rate of Return > Cost of Fund

○ Arbitrage: Taking an opportunity of difference of two situation (either market or

instrument) for risk less profit

○ Relative Value: Bank uses this opportunity when same rated instrument
(eg.AAA) issued by two different corporates have differnet price.

○ Proprietary Trading: Entirely short-term as opposed to investment. Aim is to earn

trading profits from inter-day or intra-day movements in security and forex
prices.

○ Portfolio Mgmt. Services: Offer such services to non-bank corporate clients.

Customises the product as per the corportes requi rement.

○ Investment Banking: Treasuries cover trade execution on behalf of the Bank’s

clients in the cash or derivatives markets.

Functional Area of Treasury:

Following graph represents Main function of the treasury:

Introduction

Forex market also known as foreign exchange is a new concept for India. It is a place where
various currencies are traded. Foreign exchange or forex means a market place where one
currency is traded for another. The major players of this market are banks, financial
institution, large companies, financial brokers and individuals. In the recent years forex
trading has gained tremendous popularity. These are unique by its large volume, extreme
liquidity, 24 hour trading availability and various types of options available.

FOREX MARKET DEVELOPMENT

Forex Fundamentals

Forex is derived from the words Foreign Exchange and is also occasionally referred to as
‘Spot FX’ or simply ‘FX’. Forex can be defined as “trading and exchange of currencies at
varying exchange rates, which result in profit (or loss) for those who participate as traders.”
Forex market is renowned for its flexibility and liquidity. The major players of this market
are banks, financial institution, large companies, financial brokers and individuals. Forex is
flexible in the sense that it has no central trading location or exchange. Most of the trading is
conducted via a global ETS (electronic trading system) that operate 24hrs a day.
Concurrently, liquidity is a powerful attraction to any investor as it suggests the freedom to
enter or exit the market at point of time. Forex markets are dynamic in nature and are of
round the clock and updated in seconds. Due to the different time zones of the participating
countries the quotes are available continuously all along the time. It starts from Australia &
Japan and before ending at New York & Los Angles and restarts from Australia & Japan.

AM PM

1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12

MUMBAI

NEW YORK

SYDNEY

TOKYO

LONDON
Time Table: As per Indian Standard Time
Trade between the two countries (current account as well capital account) requires conversion
of currency from one’s foreign currency to another’s local currency and vice-versa and that is
the prime objective for which Forex market was developed & established.

Global forex market development started only after the Second World War. In 1944 after
Breton Woods Accord and IMF, the US dollar become reserve currency for all capitalist
countries of the world and the rest of the currencies, gold and crude oil were compared
against it.

Forex market and India

Indian forex market is small when compared with other developed countries but with the
multinationals coming up and new government policies the path of expansion is on its new
heights. The Indian government has now open up new ways to trade and regulated this
market as well. India has shown great rise in its forex turnover in last three years. People now
feel comfortable to trade in and exit from the market.

India’s share in world forex market has shown growth of 0.9% last year and will grow
further. It is the fastest growth of any country. The growth rates of developed countries is
much lower compared with developing countries.UK and US have shown the lowest change
in contribution of foreign exchange. In India people are now more aware of the kinds of
trading like derivative markets, options, swapping, hedging etc. The most important
characteristic of forex is the impact on various currencies by the change in one currency rates.
Any economic activity in world affects the forex market immediately.

Need for Foreign Exchange

In today’s world no country is self sufficient, consequently there is a need for exchange of
goods & services amongst different countries. Every sovereign country in the world has a
currency which is a legal tender in its territory & this currency does not act as money outside
its boundaries. Therefore whenever a country buys or sells goods and services from one
country to another, the residents of two countries have to exchange currencies.

Hence, Forex markets acts as a facilitating mechanism through which one country’s currency
can be exchanged i.e. bought or sold for the currency of another company.

Features of the market:

liquidity: the market operates the enormous money supply and gives absolute freedom in
opening or closing a position in the current market quotation. High liquidity is a powerful
magnet for any investor, because it gives him or her the freedom to open or to close a
position of any size whatever.

promptness: with a 24-hour work schedule, participants in the FOREX market need not wait
to respond to any given event, as is the case in many markets.
availability: a possibility to trade round-the-clock; a market participant need not wait to
respond to any given event;

flexible regulation of the trade arrangement system: a position may be opened for a pre-
determined period of time in the FOREX market, at the investor’s discretion, which enables
to plan the timing of one’s future activity in advance;

value: the Forex market has traditionally incurred no service charges, except for the natural
bid/ask market spread between the supply and the demand price;

one-valued quotations: with high market liquidity, most sales may be carried out at the
uniform market price, thus enabling to avoid the instability problem existing with futures and
other forex investments where limited quantities of currency only can be sold concurrently
and at a specified price;

market trend: currency moves in a quite specific direction that can be tracked for rather a
long period of time. Each particular currency demonstrates its own typical temporary
changes, which presents investment managers with the opportunities to manipulate in the
FOREX market;

margin: the credit “leverage” (margin) in the FOREX market is only determined by an
agreement between a customer and the bank or the brokerage house that pushes it to the
market and is normally equal to 1:100. That means that, upon making a $1,000 pledge, a
customer can enter into transactions for an amount equivalent to $100,000. It is such
extensive credit “leverages”, in conjunction with highly variable currency quotations, which
makes this market highly profitable but also highly risky.

Forex Terminology:

There are certain terminologies, which are frequently used and practiced in Indian forex
market. Some of them are:

Direct Quote: Quoting the rate in variable currency (Domestic currency) keeping the base
currency (Foreign Currency) constant. Eg. 1 USD = INR 49.8525. Direct quote is used in
practice these days for quoting any kind of rate in Indian market. The notion for such quote is
“Buy low Sell High”.

Indirect Quote: Quoting the rate in base currency (Foreign currency) keeping the variable
currency (Domestic Currency) constant. Eg. 100 INR = USD 2.0060. Earlier in India indirect
method of quotation was used.

Bid and Ask: Bid is the highest price that the seller is offering for the particular currency at
the moment; Ask is the lowest price acceptable to the buyer. Together, the two prices
constitute a quotation; the difference between the two is the spread, that is, the difference
between the price offered by a dealer willing to sell something and the price he’s willing to
pay to buy it back. In a trading situation consider the figure $/Y115.05/10. What this figure
means is that the trading platform would be able to offer you yen at .05 but is willing to buy it
back at 10. As a trader, the spread is inherently important to know because your desire to
obtain or liquidate your position on the market will be effected by the spread.
Intervention Currency: The Foreign currency in which rates are quoted against the
domestic currency. In India the intervention currency is USD.

Cross Currency Rates: Foreign currency rate are not quoted directly (i.e in USD terms) and
parity between them (the two variable currency) is obtained through intervention currency
(USD).

1. Eg. 1 USD = INR 49.8525/8725: and 1 Euro = USD 1.3680/3685

Then the rate for buying/selling EURO in INR would be:

Buying Rate for 1 EURO = 49.8525*1.3680 = INR 68.1982
Selling Rate for I EURO = 49.8725*1.3685 = INR 68.2505

2. Eg USD/INR=40.50/51 and USD/JPY= 99.25/75; then the JPY/INR rate would be;

Formulae; for Bid: Buy (domestic)/sell (foreign) and for ask: sell (domestic) /buy(foreign)
So, Bid price= 40.50/99.75 and selling Ask price would be = 40.51/99.25

Pips & Big figure: The smallest denominated unit of the quoted price against the base price.

Currency Quote Overview

USD/CAD = 1.2232/37

Base Currency USD Currency to the left

Quote/Counter
CAD Currency to the right
Currency

Price for which the market maker

Bid Price 1.2232 will buy the base currency. Bid is
always smaller than ask.

Price for which the market maker

Ask Price 1.2237
will sell the base currency.

One point move, in USD/CAD it is .

The pip/point is the smallest
Pip 0001 and 1 point change would be
movement a price can make.
from 1.2231 to 1.2232

Difference between bid and ask

Spread Spread in this case is 5 pips/points;
price (1.2237-1.2232).
Market Maker: Market makers are those authorized dealers who give two-way quotes i.e.
for both buying and selling. Eg. USD/INR= 49.8525/8725. Once they quote the rate they
have to buy or sale on that quoted rate.

Market Taker: Market takers are those participant who takes any side of two way quote
given by market maker either to buy or sell the currencies.

Two Way Quote Quoting rate, which shows both buying as well as the selling rate of the
currencies. Eg. USD/INR = 49.8525/8725.

The left side rate is called BID rate i.e. the rate on which Banks are ready to buy the currency
and the rates on the right side are called OFFER rate i.e. the rate on which bank sells the
currencies.

Base Currency: The first currency in currency pair is normally the base currency. It is
generally more valuable of the two quoted currencies. The rates are quoted in per unit of base
currency.

Eg. In EUR/USD Euro is more valuable so it is base currency and it’s quoted rate would be
1Euro= USD 1.3245

Variable Currency: The second currency in the pair, which is normally less valuable than
the other pair currency, is known as variable currency. The rates are quoted in variable
currencies. Like in the above example the USD is the variable currency as it is less valuable
and rates are quoted in USD terms.

Value date: The date on which cash flow (settlement) take place. Most common and
acceptable form of value date is SPOT (which is T+2 day). Apart, value date may be ‘Value
today’ or ‘Value tomorrow’ or any forward date.

TT Selling Rate: TT selling rate doesn’t involve any delay in realization i.e. Nostro account
is debited immediately. This rate is applied for all clean outward remittance in foreign
currency i.e., for selling foreign currency to its customer by the bank such as by issuance of
bank drafts, mail/telegraphic transfers etc.

TT selling rate: (spot selling rate + margin); Generally for importer, where bank sell forex

TT Buying Rate: TT buying rate also doesn’t involve any delay in realization from the bank
i.e. Nostro account is credit immediately. This rate is applied for clean inward remittance in
foreign currency i.e. purchase of foreign currency by banks where cover is already obtained
by banks in India. Thus all foreign inward remittances which are made payable in India are
converted by applying this rate.

TT buying rate = (spot buying price – Margin); Generally for exporter, where bank buy forex

Bill Selling Rate: This rate is applied for all foreign outwards remittances as proceeds of
import bills payable in India. This rate is a little worse than TT selling rate because of the
inherent risk and time involved. In bill payment it has to be scrutinized on receipt, follow-up
to be done regarding payment and finally store the papers properly that increases the work
involved. So rates are worse.

Bill selling rate= spot rate + forward point + exchange margin (bank sell Forex to Importer)

Bill Buying Rate: This rate is applied for purchase/discounting of sight export bills or other
instrument, which will result in foreign inward remittance to India after realization. This rate
is worsen than TT buying rate and, in addition, the bank will also recover interest for the
period for which the bank is out of funds.

Bill buying rate: spot rate + forward point – exchange margin (Bank buy Forex from
exporter)

Cover Operation: Bank offer forex service to exporter and importer to buy or sell the forex.
As and when the customer executed the order the bank is left with a position and in such
position the sale may be more than purchase or vise versa. The outstanding position is called
open position and in order to avoid risk on account of exchange rate movement the dealer
covers its position in the market.

Overbought position: If banks buy position is more than sold then it is called overbought
and in that condition to cover the market bank sell the forex.

Oversold position: If bank sells more forex than it buys then it is called oversold position
and in such situation bank buys from the market to cover its position.

Forex Forwards Rate: Forward rate for any commodity are different from the spot price and
it all depends upon the anticipated demand and supply of that commodity. In the currency
also the same logic applies, the forward rates may be on premium or on discount. Currency in
excess supply would tend to be cheaper (discount) while scare one gets costlier (premium).
Generally it is the difference of the interest rate between the two quoted currencies.

Forex Outright: It is a combination of forex spot with forex forward deal. It helps investor
in managing risk inherent in currency market by predetermining the rate and date on which
they want to transact. Eg. Buying USD/INR from the spot market and selling it in 3 month
USD/INR forward market.

Forward Value Date: Forward value dates are valid for forward contracts, which are
generally quoted for months. So, we can say the Forward Value Date = Forward Month
+Spot day (2 day). Eg. If a three-month forward deal is made on 25th April 2009 then the
value date will be three month hence plus Spot i.e. 27th July 2009.

Dealing Room: Dealing room is a professionally managed placed in bank where dealer can
deal with any bank at any center by making two way quotes to deploy or to borrow fund
during the business hours to manage the bank’s fund under the authorized limit.

Swap: Swap is an agreement under which the future cash flow of one stream is exchanged
with another stream of future cash flow. Swaps can be used as an instrument for hedging
purpose and is traded over the counter (OTC) only.
Currency Swap: Commitment between two parties to exchange streams of interest payment
in different currencies for an agreed period of time and exchange principal at the pre agreed
exchange rate at maturity.

Foreign exchange Swap: In forex swap equal amount of currency for two different value
dates are purchased and sold at the same time. Since the amount is same and buy/sell deals
are simultaneous there is no exchange rate risk but due to different value date mis-match is
there.

Eg. Buying USD 1million spot and selling USD 1 million one month forward.

Selling USD 1 Million spot and buying USD 1 Million two month forward.

Such situation arises when suppose bank has entered in forward contract with an importer say
for 31st may for selling USD 1 million. If the importer gets the import invoice suppose on 30th
April then he request bank to remit forex on 30th April instead of 31st May as per the original
forward contract. In such case bank will buy forex in swap inter-bank market by buying USD
1 million for 30 April and selling the same forward for 31st May.

Spot price: Spot price is the prevailing market price at which the assets or currency trades.

Future price: price at which future contract trades in future market.

Forward Rate Agreement (FRA): FRA is an agreement between two parties today to
exchange interest payment on the notionally borrowed (principal) amount in future at an
agreed rate of interest. Eg. 2x5 FRA means an agreement to borrow or lend the notional
amount for three (3) month period beginning from two (2) month hence (time=0).

In case of exporter if the spot rate (at the end of 2nd month) increases the buyer of FRA
makes profit and if spot rate (2 month hence) decreases the FRA seller makes the profit.

Options: Options are a non-linear product where the buyer of the option gets the right but not
the obligation to buy or sell the given quantity of the currency or assets in future at the agreed
price decided upfront.

Strike Price: Strike price is the agreed price between option buyer and seller on which the
option buyer can exercise the option if he wants but on or before the expiration date of
option.

Call: Buyer of the call option gets the right but not the obligation to buy the given underlying
asset s at specified time in future at the price agreed upfront.

Put: Buyer of the put option gets the right but not the obligation to sell the given underlying
assets at specified time in future at the price agreed upfront.

In the Money: It is a profit-making situation in the option contract.

Strike Price (K) < Market Price (M) = for Call Option i.e. M – K= Gain

Strike Price (K) > Market Price (M) = for Put Option i.e. K – M = Gain
Out the Money: It is a loss-making situation in the option contract.

Strike Price (K) > Market Price (M) = for Call Option i.e. K-M = Loss

Strike Price (K) < Market Price (M) = for Put Option i.e. M-K = Loss

At the Money: In this situation it is neither profit nor loss.

Strike Price (K) = Market Price (M) = for Call Option and Put Option both

i.e. K=M = no profit no Loss

Intrinsic Value: Intrinsic value is only for those options, which are ‘in the money’. It is the
difference between market price (M) and the strike price (K) for call option and vise-versa for
put option. Options, which are ‘at the money’ or ‘out the money’, have no intrinsic value.

Intrinsic Value of call option: Max [0,M-K]

Intrinsic Value of put option: Max [0,K-M]

Market Value: Current prevailing market price of the underlying assets at which buyer and
seller agree to exchange the commodity.

Time Value: It is the difference between the option premium and intrinsic value of the option
at point of time prior to the expiration of the option.

Mark to Market: calculate the value of assets on the current prevailing market price to show
the gain or loss on the position.

Nostro account: It is the account maintained by any Indian Bank abroad in foreign currency.
The Latin meaning of NOSTRO is “Our account our money with you”.

Vostro account: This is the account which foreign bank maintains in India in Indian Rupee.
Latin meaning of VOSTRO is “your account your money with us”.

Mirror account: As clear from the name itself it is the mirror of the nostro account
maintained in foreign currency and rupee also for the reconciliation purpose.

Loro account: It is an account where third party account is maintained. The Latin meaning
of LORO account is “there account with you”.

Transaction Risk: Risk arises due to unexpected change in exchange rates.

Economic Risk: risk arises due to impact of exchange rate change on firm’s discounted value
of future cash flows, which represents the market value of assets and liabilities.

Non-Deliverable Forward Market: In addition to the onshore spot and derivatives market,
there is another segment, which is offshore and is known as non-deliverable forward (NDF)
market. NDF contract is a forward contract where there is no actual exchange of currencies
takes place. Instead, net payment is made by one party to another, based on the contracted
rate and market rate on the day of settlement. These markets are in operation in Singapore -
deals are settled and difference amount is paid based on the contracted forward price and spot
price of rupee.

These are synthetic foreign currency forward contracts on non-convertible or restricted

currencies traded over the counter outside the direct jurisdiction of the respective national
authorities of restricted currencies. The demand for NDFs arises due to regulatory and
liquidity constraint issues of the underlying currencies. These derivatives allow multinational
corporations, portfolio investors, hedge funds and investment banks to hedge or take
speculative positions in local currencies. Indian banks are not allowed to participate in such
market but foreign bank offer such product.

Indian Forex Market-Structure:

Types of Transactions & Market:

The dealer deals in Forex market and the sub markets are:
• Cash market: Value date  T+0
• Tom market: Value date:  T+1
• Spot market: Value date  T+2 (sale & purchase of currency for immediate delivery;
settlement within 2 days).
• Forward market:  T+n (settled on future specified date – decided upfront; Over the
Counter market)
• Future market:  T+n (settled on future specified date-decided upfront; Mark to
Market, exchange traded)
 • Options market:  T is decided by option buyer based on or up to the maturity at the
strike price.
• Swaps market:  T+n decided upfront and exchange of cash flow in two different
currencies.
• Packing Credit Foreign Currency (PCFC)/Foreign Currency Non-Resident (Bank)
FCNR(B) and External Commercial Borrowing (ECB) loans.
• Money market operations: the surplus foreign currency fund as well as rupee swapped
into foreign currency is placed in money market to earn interest.
• Cross Currency Market: apart from USD/INR other currencies are quoted, traded and
rates are given as being the market maker.

Resources and Deployment of Funds:

Resources of Fund (Deposit) Deployment of Fund (Loan)
Foreign Currency Non Resident Deposit Foreign Currency Non Resident Loan
Exchange Earner Foreign Currency Packing Credit Foreign Currency Loan
Resident Foreign Currency Placements
Borrowings Swaps
Swaps
Basically dealers’ deals with following type of market:
1. Inter-bank Forex Market – only among the authorized dealers, also called as
wholesale market. Generally a few market makers and many market takers would be
there. Market maker announces two way quotes i.e for buy & sell, but market taker
can choose the side they want. The different rate quoted by different AD depends
upon their position, need and view about the market. Inter-bank market is most liquid
market, hence works as benchmark rate for other (merchant) markets – these rates are
called as “base rates”.
2. Overseas Transactions: Generally this is the part of Inter-bank market. When banks
in India do forex transaction in overseas market (Bank) it is called overseas
transaction. Banks can maintain their positions, which may arise from the following
forex market transactions:
• Position Initiating
• Position Squaring off
• Merchant Covering
1. Merchant Market (rates): Authorized dealer serves the requirement of exporters and
importers for Forex through several authorized branches. Rates quoted to merchants
are in tune of inter bank rate (which is considered as benchmark rate) +/- margin. The
 quoted rate for the merchant can be used only for genuine transaction not for any kind
of speculation.
2. Transaction between banks and Reserve Bank of India: RBI has the right to
intervene in the market as and when it feels necessary by buying or selling forex to
influence the market. RBI also intervenes in spot, forward and swaps market.
3. Brokers: Broker acts as a middleman between two market makers and provides
information about the currency to the prospective buyer or seller. Some time bank use
broker service to acquire information about the general state of the market. Certain
broker specializes themselves by their constant contact with the market maker and
they posses more information than the dealer itself.
The main economic theories found in the foreign exchange deal with parity conditions. A
parity condition is an economic explanation of the price at which two currencies should be
exchanged, based on factors such as inflation and interest rates. The economic theories
suggest that when the parity condition does not hold, an arbitrage opportunity exists for
market participants. However, arbitrage opportunities, as in many other markets, are quickly
discovered and eliminated before even giving the individual investor an opportunity to
capitalize on them. Other theories are based on economic factors such as trade, capital flows
and the way a country runs its operations. We review each of them briefly below.

Major Theories:
• Purchasing Power Parity
Purchasing Power Parity (PPP) is the economic theory that price levels between two
countries should be equivalent to one another after exchange-rate adjustment. The basis of
this theory is the law of one price, where the cost of an identical good should be the same
around the world. Based on the theory, if there is a large difference in price between two
countries for the same product after exchange rate adjustment, an arbitrage opportunity is
created, because the product can be obtained from the country that sells it for the lowest
price.

The relative version of PPP is as follows:

Where 'e' represents the rate of change in the exchange rate and 'π 1' and 'π2'represent the rates
of inflation for country 1 and country 2, respectively.

For example, if the inflation rate for country XYZ is 10% and the inflation for country ABC
is 5%, then ABC's currency should appreciate 4.76% against that of XYZ.

• Interest Rate Parity

The concept of Interest Rate Parity (IRP) is similar to PPP, in that it suggests that for there to
be no arbitrage opportunities, two assets in two different countries should have similar
interest rates, as long as the risk for each is the same. The basis for this parity is also the law
of one price, in that the purchase of one investment asset in one country should yield the
same return as the exact same asset in another country; otherwise exchange rates would have
to adjust to make up for the difference.

The formula for determining IRP can be found by:

Where 'F' represents the forward exchange rate; 'S' represents the spot exchange rate; 'i1'
represents the interest rate in country 1; and 'i2' represents the interest rate in country 2.

International Fisher Effect

The International Fisher Effect (IFE) theory suggests that the exchange rate between two
countries should change by an amount similar to the difference between their nominal interest
rates. If the nominal rate in one country is lower than another, the currency of the country
with the lower nominal rate should appreciate against the higher rate country by the same
amount.

The formula for IFE is as follows:

Where 'e' represents the rate of change in the exchange rate and 'i 1' and 'i2'represent the rates
of inflation for country 1 and country 2, respectively.

Balance of Payments Theory

A country's balance of payments is comprised of two segments - the current account and the
capital account - which measure the inflows and outflows of goods and capital for a country.
The balance of payments theory looks at the current account, which is the account dealing
with trade of tangible goods, to get an idea of exchange-rate directions.

If a country is running a large current account surplus or deficit, it is a sign that a country's
exchange rate is out of equilibrium. To bring the current account back into equilibrium, the
exchange rate will need to adjust over time. If a country is running a large deficit (more
imports than exports), the domestic currency will depreciate. On the other hand, a surplus
would lead to currency appreciation. The balance of payments identity is found by:

Where BCA represents the current account balance; BKA represents the capital account
balance; and BRA represents the reserves account balance.

Real Interest Rate Differentiation Model

The Real Interest Rate Differential Model simply suggests that countries with higher real
interest rates will see their currencies appreciate against countries with lower interest rates.
The reason for this is that investors around the world will move their money to countries with
higher real rates to earn higher returns, which bids up the price of the higher real rate
currency.
Asset Market Model
The Asset Market Model looks at the inflow of money into a country by foreign investors for
the purpose of purchasing assets such as stocks, bonds and other financial instruments. If a
country is seeing large inflows by foreign investors, the price of its currency is expected to
increase, as the domestic currency needs to be purchased by these foreign investors. This
theory considers the capital account of the balance of trade compared to the current account
in the prior theory. This model has gained more acceptance as the capital accounts of
countries are starting to greatly outpace the current account as international money flow
increases.

Monetary Model
The Monetary Model focuses on a country's monetary policy to help determine the exchange
rate. A country's monetary policy deals with the money supply of that country, which is
determined by both the interest rate set by central banks and the amount of money printed by
the treasury. Countries that adopt a monetary policy that rapidly grows its monetary supply
will see inflationary pressure due to the increased amount of money in circulation. This leads
to a devaluation of the currency.

These economic theories, which are based on assumptions and perfect situations, help to
illustrate the basic fundamentals of currencies and how they are impacted by economic
factors. However, the fact that there are so many conflicting theories indicates the difficulty
in any one of them being 100% accurate in predicting currency fluctuations. Their importance
will likely vary by the different market environment, but it is still important to know the
fundamental basis behind each of the theories.

Factors affecting Forex Rates:

There are various factors with affect the forex market and its exchange rate. Right from the
government intervention to demand and supply to investor’s appetite, attitude and analysis all
these factors plays an important role in deciding forex market operation and particularly on
exchange rate determination.

Price determination

The law of supply and demand essentially governs the Forex market like any other market.
The law of supply states, as prices rises for a given commodity or currency, the quantity of
the item that is supplied will increase; conversely, as the price falls, the quantity provided
will fall.
The law of demand states that as the price for an item rises, the quantity demanded will fall.
As the price for an item falls, the quantity demanded will rise.
In the case of currency, it is the demand and supply of both domestic and foreign currency
that is considered for price determination. It is the interaction of these basic forces that results
in the movement of currency prices in the Forex market.

Broadly we can divide these factors in two categories:

[A] FUNDAMENTAL FACTORS AND [B] TECHNICAL FACTORS

A. Fundamental Factor:
Fundamental factor shows future price movements of a financial instrument based on
economic, political, environmental and other relevant factors, as well as data that will affect
the basic supply and demand of forex market. Some of the major fundamental factors are:

Factors responsible for exchange rate determination:

• Balance of payment: If the exports to other countries are more than import then the
exchange rate will be stronger as there will be inflow of foreign currency. More relies
on imports, weaker will be the exchange rate because there will be outflow of
domestic currency. A favorable balance of payment on current account indicates
greater demand of goods & services of that country abroad. As due to export the
supply of foreign currency is greater than the demand of foreign currency at home, so
the home currency is likely to appreciate with respect to foreign currency.
• Exchange rate policy and regime: Fixing an exchange rate is policy matter but in India
it is largely dismantled as market force determines the exchange rates with certain
exchange control regulations (in capital account).

• Monetary policy & fiscal policy: If a government runs into deficit, it has to borrow
money (by selling bonds). If it can't borrow from its own citizens, it must borrow
from foreign investors. That means selling more of its currency, increasing the supply
and thus driving the prices down.

• Domestic Financial Market: Strong domestic financial markets will also lead to the
strengthening of domestic currency, as investors will be less worried about their
investments and foreign investor will also will be attracted.

• Central bank intervention in Forex market: By open market operation or by increasing

/ decreasing key rates or by purchasing and selling the forex, central bank directly or
indirectly affects the forex market operation.

• Capital account liberalization: Till now convertibility of capital account is not fully
permitted by government. Convertibility of capital account means freedom to convert
local financial assets to foreign financial assets and vice versa. So. We can foresee the
situation that if market becomes fully open on capital account issue then lots of inflow
and outflow will take place on account of capital assets, which may have great impact
of exchange rate determination.

• Interest rate differentials: If there are higher interest rates in home country then it will
attract investments from abroad in the form of FII, FDI and increased borrowings.
This will lead to increased supply of foreign currency. On the other hand, if the
interest rates are higher in the other country, investments will flow out leading to
decreased supply of foreign currency.

• Inflation differentials: If inflation rates are high in one country then the other then the
country which is having low inflation rate will be in position to maintain the price
level of commodity in such a manner that will lead to improve the demand of its
goods and hence its currency. So, due to higher inflation rate country’s currency
depreciates (as it purchasing power decreases) till the differential of the other base
currency.

• Stock Market: Stock market has direct relationship with forex market. In the surging
market the foreign investor wants to invest in the stock and get the benefit. In this
 case they bring more foreign currency (Dollar) in Indian market and sell for investing
in equity. So, the price of dollar comes down and ultimately rupee appreciates.

• Prices of non-tradable goods relative to tradable goods: Price of non-tradable good are
having indirect impact in exchange rate determination as many of the tradable good
are directly dependent on such non-tradable good and prices of that tradable good are
having direct impact on the forex. As the price of the non-tradable goods goes up the
inflation increase which have adverse impact on exchange rate and it continues to
depreciates.

• Productivity differentials: Demand of goods produced in a country explains the

demand of the particular currency. So, economic data such as labor reports (payrolls,
unemployment rate and average hourly earnings), Consumer Price Indices (CPI),
Gross Domestic Product (GDP), International Trade, Productivity, Industrial
Production, Consumer Confidence etc, also affect fluctuations in currency exchange
rates.

• Business Environment: Positive indications (in terms of government policy,

competitive advantages, market size, etc.) increase the demand for currency, as more
and more enterprises want to invest there. Any positive indications abroad will lead to
strengthening of foreign currency.

• GDP growth and phases of business cycle: If the domestic economy is strong then
there will be lots of investments from abroad which will lead to increased supply of
foreign currency, ultimately leading to strengthening of domestic currency. And if
there were weaker domestic economy it would lead to outflow of funds from a
country. Also the phase of business cycle plays an important role as different phase of
business have different feature. For maximum in flow of foreign fund the country’s
business cycle should be in growth phase, which ultimately results in appreciating the
home currency.

• Global economic situation and financial crisis: Global scenario of the world acts an
indicator of the forex market. If there is no financial crisis and economy is doing well
then forex market is also suppose to do well as it’s revealed from the forex triennial
survey done by Bank of International settlement. In situation of crisis the interest rates
may go down which results in devaluation of that particular currency. As we have
seen during 2007-2008 financial crisis that due to economic slow down, sub prime
loan default and lowering interest rate USD keep dwindling (depreciating) against all
the major currencies the market became so volatile that no market maker was ready to
 give competitive quotes. USD was all time low for the EURO and GBP. Indian forex
market was under pressure because of the reversal of the capital flow as part of global
de-leveraging process. Also corporates were converting the Rupee liability into
Foreign currency liability to meet external obligations, which ultimately put pressure
on the rupee.

• Political factors: All exchange rates are susceptible to political instability and
anticipations about the new government. All the market players get worried about the
policies and may start unwinding their positions thereby affecting the demand and
supply.

• Sovereign risk rating: Sovereign is the country health indicator on various parameter.
It tells the risk involved in a particular country based on the parameter like political
and financial indicator. If a country has got high rating that means the country is
politically sound and is able to meets its foreign obligation with any difficulty. Higher
the rating of county more likely to appreciate the host country currency.

• Rumors: Any rumor in the markets also leads to fluctuation in the values. Any
favourable news will lead to strengthening of domestic currency and any negative
rumor will lead to weakening of the currency.

B Technical Factors:
Technical factors predicts price movements and future market trends by studying what has
occurred in the past using various charts. Technical factor is built on three essential
principles:

1. Market (price) action discounts everything: This means that the actual price is a
reflection of everything that is known to the market that could affect it,

2. Prices move in trends: used to identify patterns of market behavior,

3. 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. Since patterns have worked
well in the past, it is assumed that they will continue to work well into the future.

Foreign Exchange Global Market

The currency trading (FOREX) market is the biggest and the fastest growing market on earth.
Its daily turnover is more than 3.98 trillion dollars (according to Bank for International
Settlement), which is 100 times greater than the NASDAQ daily turnover. For the foreign
exchange, currency is required because the currency provides:
 ○ A standard of value

○ A medium of exchange

○ A unit of measure for economic transactions

4.1 Events in Global Forex Market

Evolution of Money

Over time, with the introduction of metals and coins, it became a medium of exchange,
having a value much greater than its intrinsic value. It was no longer used for consumption,
but for acquiring other commodities for consumption. This was the evolution of ‘money’.
The use of coins facilitated exchange, as it was easy to determine the value of a unit, and was
easily divisible and acceptable to all. Two metals, gold and silver were favoured because of
their intrinsic value.

Gold Standard

Under the gold standard, the exchange rate of two currencies was based on the intrinsic value
of gold in the unit of each currency. This also came to be known as the mint parity theory of
exchange rates. Under the gold standard exchange rates could only fluctuate within a narrow
band known as the upper and lower gold points.

A country, which had a balance of payments deficit had to part with some of its gold and
transfer it to the other country. The transfer of gold would reduce the volume of money in the
deficit country and lead to deflation while the inflow of gold in the surplus country would
have an inflationary impact on that economy. The country, which was in deficit, would then
be able to export more and restrict its imports as a result of the fall in domestic prices and
reduce its BOP deficits.

The main types of gold standard were:

○ The Gold Specie Standard.

○ The Gold Bullion standard.

○ The Gold Exchange standard

Gold Bullion

The Gold Specie Standard (1880-1914)

Under the gold specie standard, gold was recognized as a means of settling domestic as well
as international payments. Import and export of gold was freely allowed and Central Banks
guaranteed the issue or purchase of gold at a fixed price, on demand. The price of gold varied
according to the supply of the metal in the market and the value of gold coins was based on
their intrinsic value.

Gold Bullion Standard (1922 – 1936)

Due to the First World War the gold standard was exposed and its weakness to fund the
expenditure of war was a major concern. So, it was decided at an international conference in
Brussels in 1922 to reintroduce the gold standard but in a modified form. Under the gold
bullion standard, paper money was the main form of exchange. It could however be
exchanged for gold at any time. As it was unlikely that there would be a great demand for
converting currency notes to gold at any given time, the banks could issue currency notes in
excess of the value of gold they were holding.

The gold bullion standard too could not last long as many major currencies were highly over
or under valued leading to a distortion in balance of payment positions.

In 1925, the sterling was over valued against the dollar by nearly 44% and necessitated
devaluation. This devaluation had an impact on other currencies too and led to an exchange
rate war. England withdrew from the gold standard in 1931, America in 1933 and Italy,
France, Belgium, Switzerland and Holland remained. It finally collapsed in 1936 with the
devaluation of the French franc and the Swiss franc.

The Gold Exchange Standard (1944- 1970)

During the Second World War, international trade suffered with runaway inflation and
devaluation of currencies. Anew monetary system was started in 1943 by Britain and the US
and finally in July 1944 the American proposal was accepted at the Bretton Woods
conference.

The International Monetary Fund (IMF) was set up in 1946 under the Bretton Woods
agreement and the new exchange rate system came that is known as the Bretton Woods
system. Under the Bretton Woods system, member countries were required to fix parities of
their currencies to gold or the US dollar and ensure that rates did not fluctuate beyond 1% of
the level fixed. It was also agreed that no country would effect a change in the parity without
the prior approval of the IMF.

Post Bretton Wood Scenario:

The Bretton Woods agreement (established in 1944) resulted in a system of fixed exchange
rates that partly reinstated the gold standard and set the dollar at a rate of USD 35 per ounce
of gold and fixing the other main currencies to the dollar - and was intended to be permanent.
The Bretton Woods system came under increasing pressure as national economies moved in
different directions during the sixties and eventually Bretton Woods collapsed in the early
seventies following president Nixon's suspension of the gold convertibility in August 1971.
The dollar was no longer suitable as the sole international currency.

Then the EEC (European Economic Community) introduced a new system of fixed exchange
rates in 1979 and continued till 1992-93 when due to economic pressure there was a forced
devaluation in number of weak European currencies and subsequently many of them were
replaced by EURO in 2001.

In 1997 South East Asian currencies were devaluated against USD, which shows the lack of
sustainability in fixed foreign exchange. Now most of the countries follow a free-floating
exchange rate system.

India's approach can be characterized as intermediate since it follows a system between a

freely floating and fully managed system. This type of system is known as Managed Float
System, exchange rates are allowed to float freely, but RBI intervenes when it feels
necessary. For e.g. in order to curb appreciation of INR it may buy USD from the market or it
may increase the interest rates.

4.2 Major Currencies

Some of the major common currency & symbols used in the Forex:

Symbol Country Currency Nickname

USD United States Dollar Buck
EUR Euro members Euro Fiber
JPY Japan Yen Yen
GBP Great Britain Pound Cable
CHF Switzerland Franc Swissy
CAD Canada Dollar Loonie
AUD Australia Dollar Aussie
NZD New Zealand Dollar Kiwi
The following is the list of approved foreign currencies for the Bank Of Baroda:

• US Dollar

• British Pound

• Euro + Legacy currencies till December 2001

• Swiss Franc

• Japanese Yen

• Singapore Dollar

• HongKong Dollar

• Nepali Rupee

• Saudi Riyal

• Canadian Dollar

• Australian Dollar

• Swedish Kroner

• Norwegian Kroner

• New Zealand Dollar

• Danish Kroner

• Kenyan Schilling

• All currencies of the countries where the bank has its presence.

Minimum trading size for most deals is usually 1 million units (1,000,000) of intervention
currency (USD), which is a standard "lot".

Currency Turnover

Global Turnover in traditional forex market (spot, outright forward & swap transaction) was
phenomenon. As compared to last survey i.e. 2004 to 2007 there was a growth of 69%. The
growth over the period of last one decade can be observed from the following bar chart,
which is more than 600%.
Average daily turnover in global market is $3.98 trillion. Trading in the world's main
financial markets accounted for $3.21 trillion of the total. This approximately $3.21 trillion in
main foreign exchange market turnover was broken down as follows:

• $1.005 trillion in spot transactions

• $362 billion in outright forward

• $1.714 trillion in forex swaps

• $129 billion estimated gaps in reporting

The main trading center is London, but New York, Hong Kong and Singapore are all
important centers. Of the $3.98 trillion daily global turnover, trading in London accounted for
around $1.36 trillion (34.1%)l, making London the global center for foreign exchange. For
second and third places respectively, trading in New York accounted for 0.67 trillion
(16.6%), and Tokyo accounted for 0.24 trillion (6.0%). In addition to "traditional" turnover,
$2.1 trillion was traded in derivatives.

Top 10 Currency Traders (% of overall volume)

These ten most active traders account for almost 80% of trading volume, according to the
2008 Euromoney FX survey.

Rank Name Volume

1 Deutsche Bank 21.70%
2 UBS AG 15.80%
3 Barclays Capital 9.12%
4 Citi Bank 7.49%
5 Royal Bank of Scotland 7.30%
6 J P Morgan 4.19%
7 HSBC 4.10%
8 Lehman Brothers** 3.58%
9 Goldman Sachs 3.47%
10 Morgan Stanley 2.86%
Source: Bank for international settlement – Triennial survey’ 2007

Most Traded Currencies world wide in forex market:

Rank Currency Code (Symbol) % Daily Share

1 United States Dollar USD ($) 86.3%
2 Euro EUR (€) 37.0%
3 Japanese Yen JPY (¥) 17.0%
4 Pound Sterling GBP (£) 15.0%
5 Swiss Franc CHF (Fr) 6.8%
6 Australian Dollar AUD ($) 6.7%
7 Canadian Dollar CAD ($) 4.2%
8-9 Swedish Krona SEK (kr) 2.8%
8-9 HongKong Dollar HKD ($) 2.8%
10 Norwegian Krone NOK (kr) 2.2%
 11 New Zealand Dollar NZD ($) 1.9%
12 Mexican Peso MXN ($) 1.3%
13 Singapore Dollar SGD ($) 1.2%
14 South Korean WON KRW (₩) 1.1%
…
19 Indian Rupee INR (Rs) 0.7%
Others 13.8%

Total 200%

Note: Total percentage is 200% as two currencies are involved in exchange.

On the spot market, according to the BIS study, the most heavily traded products were:

• EUR/USD: 27%

• USD/JPY: 13%

• GBP/USD: 12%

Global foreign exchange market turnover

Daily averages in April, in billions of US dollars
1992 1995 1998 2001 2004 2007

Spot transactions 394 494 568 387 631 1,005

Outright forwards 58 97 128 131 209 362

Up to 7 days … 50 65 51 92 154

Over 7 days … 46 62 80 116 208

Foreign exchange swaps 324 546 734 656 954 1,714

Up to 7 days … 382 528 451 700 1,329

Over 7 days … 162 202 204 252 382

Estimated gaps in reporting 44 53 60 26 106 129

Total “traditional” turnover 820 1190 1490 1200 1900 3,210

Memo: Turnover at April 2007 880 1150 1650 1420 1970 3210
exchange rates3
Indinan Forex Market Turnover Scenario:

As far as indian scenario is concerned the forex average daily turnover was contributing
0.23% of total gobal turnover in 2001 which increased to 0.34% in 2004, and in 2007 it just
became double and reached to 0.69% which shows the rapid growth of forex market in India.
The break-up of the transactions are as follows (as per 2007 BIS survey):

○ 42.6% transactions are on spot market,

○ 27.5% in outright forward market and

○ 29.8% under the forex swap market.

Currency wise growth in the traditional foreign exchange market in India for last couple of
year was significant. As per the Bank for International Settlement survey the details are:

In the major currency category there was a noteworthy growth in Pound Sterling by
whooping 93% over last three year while in the minor category Chinese currency and
Indonesian currency transaction has grown up by more than 500% and 280% respectively.

Inter-Bank Vs Merchant:
In India Forex Market was largely dominated by Inter-bank participants (nearly 60%) as it is
clear from the following graph but in last 2-3 there was significant growth in merchant
market turnover and the ratio of these two has come from 5:1 in 1997 to 2:1 in 2006.

Source: BIS Survey

Source: Reserve Bank of India

Types of Transaction in Indian Forex Market:

Total turnover in the Indian forex has seen more than 400% growth in the last nine years. Out
of that 52% was spot transaction, 30% swap and only 18% are of forward in nature.
Forex Income of Public Sector Bank:

Income of Public Sector Banks (Forex)

(Rs. crore)

2005-06 2006-07 2007-08

1 Allahabad Bank 58.88 32.49 53.78

2 Andhra Bank 27.71 32.27 33.41

3 Bank of Baroda 178.19 239.28 278.79

4 Bank of India 182.31 224.08 306.58

5 Bank of Maharashtra 28.66 16.16 22.25

6 Canara Bank 154.78 173.1 153.64

7 Central Bank of India 26.09 43.1 48.42

8 Corporation Bank 32.94 45.96 41.23

9 Dena Bank 25.26 30.76 42.03

10 Indian Bank 68.06 75.77 99.96

11 Indian Overseas Bank 65.75 85.64 110.17

12 Oriental Bank of Commerce 74.86 61.87 68.8

13 Punjab & Sind Bank 21.04 23.49 30.01

14 Punjab National Bank 122.1 176.72 211.39

15 Syndicate Bank 43.4 45.26 67.26

16 UCO Bank 31.68 33.36 49.99

17 Union Bank of India 149.77 198.39 261.2

18 United Bank of India 6.2 12.95 28.27

19 Vijaya Bank 23.52 31.16 41.1

State Bank Group

1 State Bank of India 1,001.27 331.47 692.7

2 State Bank of Bikaner & 15.47 20.34 23.57

Jaipur

3 State Bank of Hyderabad 61.27 68.39 68.41

4 State Bank of Indore 27.15 20.11 18.83

5 State Bank of Mysore 21.58 27.73 28.66

6 State Bank of Patiala 40.84 32.73 33.15

7 State Bank of Saurashtra 9.53 10.2 13.74

8 State Bank of Travancore 29.51 15.04 53.28

Other Public Sector Banks

1 IDBI Bank Ltd. 59.02 45.73 87.17

Source: Reserve Bank of India

In 2005-06 Bank of Baroda profit was 827 Cr. So forex contribution in profit was 21.5%

In 2006-07 Bank of Baroda profit was 1027 cr. so, forex contribution in profit was 23.5%

In 2007-08 Bank of Baroda profit was 1436 Cr. So forex contribution in profit was 19.4%

Forex Market Development in India:

Every nation has its own currency. For international financial transactions most of the
country involve in an exchange of one’s currency to another. The rate (conversion of one
currency to another) of one currency in terms of another is known as exchange rate. In India
the rates are quoted in USD/INR terms, where USD is termed as base currency and INR is
known as variable currency. In practice the rates are quoted by direct method. In India USD
is used as intervention currency for quoting the rates. For getting the rates of other currency
we use the cross currency method to determine their price. The majority of all foreign
exchange trades involve the US dollar against another currency due to the fact that the US
economy is the largest in the world and being global leader it is used for benchmarking.
Average daily trading volume of Indian Forex market is nearly $34 billion as per Bank for
International settlement survey.

The origin of the forex market development in India could be traced back to 1978 when
banks were permitted to undertake intra-day trades. However, the market witnessed major
activities only after 1990’s with the floating of the currency in March 1993, following the
recommendations of Rangarajan committee.

Forex in India

The daily turnover of the Global Forex market is presently estimated at US$ 3 trillion.
Presently the Indian Forex market is the 16th largest Forex market in the world in terms of
daily turnover as the BIS Triennial Survey report. As per this report the daily turnover of the
Indian Forex market is US$ 34 billion in the year 2007. Besides the OTC derivative segment
of the Indian Forex market has also increased significantly since its commencement in the
year 2007. During the year 2007-08 the daily turnover of the derivative segment in the Indian
Forex market stands at US$ 48 billion.

The growth of the Indian Forex market owes to the tremendous growth of the Indian
economy in the last few years. Today India holds a significant position in the Global
economic scenario and it is considered to be one of the emerging economies in the World.
The steady growth of the Indian economy and diversification of the industrial sectors in India
has contributed significantly to the rapid growth of the Indian Forex market. Let us take a
watch on the Indian Forex trading scenario since the early days.

The Forex trading history of India dates back to 1978, when Reserve Bank of India took a
step towards allowing the banks to undertake intra-day trading in Foreign exchange. It is
during the period of 1975-1992 when Reserve Bank of India, officially determined the
exchange rate of rupee according to the weighed basket of currencies with the significant
business partners of India. But it needs to be mentioned that there are too many restrictions
on these banks during this period for trading in the Forex market.

The introduction of the open market policy in the year 1991 and implementation of the new
economic policy by the Govt. of India brought a comprehensive change in the Forex market
of India. It is during the month of July 1991, that the rupee undergone a two fold downward
adjustment and this was in line with inflation differential to ensure competitiveness in
exports. Then as per the recommendation of a high level committee set up to review the
Balance of Payment position, the Liberalized Exchange Rate Management System or the
LERMS was introduced in 1992. The method of dual exchange rate mechanism that was part
of the LERMS also came into effect 1993. It is during this time that uniform exchange rate
came into effect and that started demand and supply controlled exchange rate regime in
Indian. This ultimately progressed towards the current account convertibility that was a part
of the Articles of Agreement with the International Monetary Fund.

It was the report and recommendations of the Expert Group on Foreign Exchange, formed to
judge the Forex market in India that actually helped to widen the Forex trading practices in
the country. As per the recommendations of the expert committee, Reserve bank of India and
the Government took so many significant steps that ultimately gave freedom to the banks in
many ways. Apart from the banks corporate bodies were also given certain relaxation that
also played an instrumental role in spread of Forex trading in India.

It is during the year 2008 that Indian Forex market has seen a great advancement that took the
Indian Forex trading at par with the global Forex markets. It is the introduction of future
derivative segment in Forex trading through the largest stock exchange in country – National
Stock Exchange or NSE. This step not only increased the Indian Forex market volume too
many folds also gave the individual and retail investor a chance to trade at the Forex market,
that was till this time remained a forte of the banks and large corporate.

Indian Forex market got yet another boost recently when the SEBI and Reserve Bank of India
permitted the trade of derivative contract at the leading stock exchanges NSE and MCX for
three new currency pairs. In its recent circulars Reserve Bank of India accepting the proposal
of SEBI, permitted the trade of INRGBP (Indian Rupee and Great Britain Pound), INREUR
(Indian Rupee and Euro) and INRYEN (Indian Rupee and Japanese Yen). This was in
addition with the existing pair of currencies that is US$ and INR. From inclusion of these
three currency pairs in the Indian Forex circuit the Indian Forex scene is expected to boost
even further as these are some of the most widely traded currency pairs in the world.

Events in Indian Forex Market Development:

Suspension of convertibility of USD into gold and increase in oil price resulted into floating
and fluctuating rate era. During this period (1971-1975) the rupee was linked to Pound
Sterling except for the period between August’ 1971 to December’ 1971 where it was linked
to USD. It was 25th September’ 1975 when Rupee was de-linked from the Pound Sterling
and linked with a basket of currencies. The value of rupee was determined by the value of
currencies that constituted the basket and its relative weight. It (Currency & its weight) was
kept secret but the Pound Sterling continued to be the intervention currency. The very much
purpose behind the linking the rupee to the basket of currencies was to do moderate
fluctuation in the exchange rate and moderate depreciation of Indian Rupee.

In 1978 Reserve Bank of India (RBI) allowed banks to undertake intra-day trading in foreign
exchange. During the period 1975-1992, the exchange rate of rupee was officially determined
by the RBI in terms of a weighted basket of currencies of India’s major trading partners and
there were significant restrictions on the current account transactions. This exchange rate
regime was characterized by daily announcement by the Reserve Bank of its buying and
selling rates to the Authorized Dealers (ADs) for undertaking merchant transactions. In 1992
when US dollar was adopted as the intervention currency in place of Pound sterling the rupee
became partially floated. The system is known as Liberalized Exchange Rate Management
System (LERMS). The basic feature of LERMS was:

➢ 40% of all inward remittance (excluding capital account) was converted at official
rate and rest 60% could be sold to the authorized dealer at the market prevailing rate,
which was basically on the basis of demand and supply.

➢ All import remittances were to be made at market rates (other than govt. import).

The Modified version of Liberalized Exchange Rate Management System (LERMS) was
implemented from March’1993 when the Rupee became fully floating i.e. official rate was
abolished and market forces determined the exchange rate of Rupee or value of rupee. Now-
a-days even RBI rates are market rates.

As far as convertibility (convertibility: conversion of currency by its holder into any currency
of its choice at market determined rates) of rupee is concerned, it is fully convertible on
Current account and moving towards making rupee fully convertible on Capital account.
Since, rupee is partially convertible its exchange rate can be managed (by central bank’s
intervention) more effectively than fully convertible currency. Some of the important
measures taken by Government of India and RBI to reinforce Forex market:

• Foreign Exchange Regulation Act (FERA) 1973 replaced by Foreign Exchange

Management Act (FEMA) 1999

• Clearing Corporation of India Limited (CCIL) was established in 2001

• Cross currency and various derivatives product were allowed

• Authorized Dealers (Ads) were allowed trading position

 • Banks to fix their overnight and day limit (approval by RBI)

• Banks have been allowed to use currency derivatives for ALM

• Foreign Institutional Investor (FII) and Non Resident Indian (NRI) have been
permitted to trade in exchange derivatives

• Bank is allowed to decide interest rates on Foreign Currency Non-Resident Account-

Bank [FCNR –B] – (subject to max. ceiling)

• Introduction of exchange traded currency future

Regulatory Framework in Forex Market:

As far as regulatory part is concerned in India two different ministries are involved for
controlling different aspect of the Forex monetary system. The two ministries are;

• Ministry of commerce: Ministries of commerce looks after about the goods, what is
exportable/ importable or what is not by formulating product code and customer code
and in this matter Directorate General of Foreign Trade (DGFT) help them. We can
say that trade angle of the Forex transaction is looked after by ministry of commerce.
• Ministry of finance: Ministry of finance looks after the transactional/ operational
mode and method of the Forex market instead of trade angle. Finance Ministry act
through the following agencies;
○ Reserve Bank of India (RBI)
○ Custom
○ Enforcement directives

Reserve Bank of India (RBI) is the reporting authority of the Authorised person and RBI has
delegated the power to Authorised person for receiving the Forex in India and to remit the
Forex from India (Under Foreign exchange Management act FEMA). RBI communicates
through the AP (DIR) circulars called Authorised person directives. RBI only gives the
direction and the rules are given by Foreign Exchange Dealers Association of India (FEDAI)
a advisory body to RBI. FEDAI is a limited company by the constitution and formed with the
approval of RBI to undertake certain function in Forex market. At present 87 banks are
member of FEDAI and the major function of FEDAI include:

○ Framing of rules for smooth and efficient function of Forex market

○ Preparation of Rule book of FEDAI i.e. Amending Rules (ARSeries)

○ Advisory body to Reserve Bank of India on Forex market

 ○ Allied activities for member bank

○ Providing education to the bank official

For regulating foreign exchange market government in 1973 made an act called Foreign
Exchange Regulation Act (FERA), which stricter and not relay helping in promoting Forex
market. So, FERA was replaced in 1999 by a new act called Foreign Exchange Management
Act (FEMA) and it was implemented from 01st June 2000. The main difference between
FERA and FEMA is:

Foreign Exchange Regulation Act Foreign Exchange Management Act

(FERA) (FEMA)
FERA is basically a disabling act, it’ rules FEMA is enabling act. It was made with the
and regulation discourages people form aim to promote Forex market and make it
being involved in Forex market. deeper.
Objective of FERA was conservation of Objective of FEMA was to manage the
Forex market Forex market.
The law was made with the objective to deal This law was made to deal the problem of
with problem of scarcity of Forex. plenty of Forex.
Offences were treated at par with criminal Offences are of civilian in nature and there
case hence it was punishable. for compoundable, value wise i.e. one can
pay the penalty and get rid off from accuse.
In FERA the burden of proof was always on In FEMA the burden of proof is on the
the accused. executor (prosecutor).

So, we can say that in Indian context, the RBI Act and the Foreign Exchange Management
Act, 1999 set the legal provisions for governing the foreign exchange reserves. RBI acts as
the chief monetary authority and the custodian of foreign exchange assets. RBI accumulates
foreign currency reserves by purchasing from authorized dealers in the open market
operations. Another source of Foreign exchange for RBI is deployment of foreign exchange
reserves in appropriate instruments of select currencies. The type of instruments in which
RBI can invest is stipulated in the RBI Act. The aid received by the government also
becomes a part of the reserves. The outflow of funds results from the sale of foreign currency
to the authorized dealers through open market operations. The resultant effect of the sale and
purchase of foreign currency determines the level of foreign exchange reserves in a country.
Committee Recommendations:
Rangarajan Committee

After the initiation of economic reforms Dr. C. Rangarajan committee recommended dual
exchange rate mechanism keeping in view the competitiveness edge of the exporters.
Subsequently, the recommendations of the High Level Committee on Balance of Payments
(Chairman: Dr C. Rangarajan) the Liberalized Exchange Rate Management System
(LERMS) involving dual exchange rate mechanism was instituted in March 1992.

The ultimate convergence of the dual rates became effective from March 1, 1993(known as
modified LERMS). The unification of the exchange rate of the rupee marks the beginning of
the era of market-determined exchange rate, based on demand and supply in the forex market.
It is also an important step in the progress towards current account convertibility, which was
finally achieved in August 1994.

Sodhani Committee:

Expert Group on Foreign Exchange under the chairmanship of Mr. Sodhani was constituted
in November 1994 for suggesting development measure in forex market in India. The Group
studied the market in great detail and came up with recommendations to develop, deepen and
widen the forex market. In the process of development of forex markets, banks have been
given significant freedom to operate in the market. Some of them are:

○ Banks were allowed freedom to fix their trading limits

○ Permitted to borrow and invest funds in the overseas markets up to specified limits

○ Freedom to determine interest rates on FCNR deposits within ceilings

○ Allowed to use derivative products for asset-liability management purposes

○ Corporates were given flexibility to book forward cover based on past turnover

○ Allowed to use a variety of instruments like interest rates and currency swaps,
caps/collars and forward rate agreements in the international forex market

○ Rupee-foreign currency swap market for hedging longer -term exposure

Tarapore Committee:
The Tarapore committee is a committee setup by the Reserve Bank of India under the
chairmanship of former RBI deputy governor S S Tarapore in 1997 to "lay the road map" to
capital account convertibility. Capital account convertability refers to the freedom to convert
local financial assets into foreign and vice versa at the market detremined exchange rate. It is
also the change in ownership of the domestic or foreign financial assets. It has a great impact
on forex market as current account was already made convertible (open) way back in 1993.
The committee recommended a three-year timeframe for complete capital convertibility by
1999-2000. The salient feature of the committee recommendations are:

○ Exchange rate policy: Reserve Bank should have a monitoring exchange rate band of
+/- 5% around the neutral real effective exchange rate (REER).

○ Transparent exchange rate policy: The neutral Real Effective Exchange Rate should
be announced. REER monitoring band should be declared on weekly basis.

○ Balance of Payments: Ask government to ensure rising trend of Current Receipt (CR)
and Gross Domestic Product (GDP) and reduce the Debt Service Coverage Ratio.

○ Adequacy of Reserve: In order to move towards capital account convertibility (CAC)

the committee has recommended four indicator,

1. Reserve should not be less than six month import,

2. Reserve should not be less than 3 month import+ 50% debt service + 1 month
import & export

3. Short term debt and portfolio stock should be lowered to 60% of reserve

4. Forex Assets to Currency ratio should not less than 40%

Participants of Market:
The active participants in the Indian forex market are:

Banks

Customers can deal in foreign exchange through authorized dealers or through the exchange
only. For international transaction one has to buy and sell the foreign currency and for that it
is essential to comply with Foreign exchange regulations, which are known as FEMA. FEMA
regulates the Forex market with regulatory authority RBI under the instruction of Ministry of
Finance and as per the guidance of advisory body FEDAI. Only Authorized Dealers (AD)
licensed by RBI can participate directly in Forex market. Apart, there are institutions, which
have been granted restrictive AD license, which permits them to undertake FX activities. For
Forex business RBI has passed the power to:

1. Authorized Dealer – Commercial Bank (#87)

a. Category I: All Scheduled commercial Banks

b. Category II: RRBs, Cooperative Banks, FFMCs

c. Category III: Institutional Dealers, Nabard, Exim etc

2. Authorized Money changer

a. Restricted money changer (RMC)

b. Full Fledged money changer (FFMC)

3. Overseas Banking Unit (OBU)

Commercial companies

Companies who involved in export or import are one of the active key players in forex
market. They do transaction (trade in nature) but of fairly small amount and participate in
forex derivative markets to hedge their risk arises due to exchange rate fluctuation.

Central banks

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. They use their foreign reserve to influence (stabilise) the forex market
and maintains the parity.

Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions are speculative and in most of the
case the hedge funds tries to take the opportunity for the profit generation which arises due to
fluctuation of price of a particular currency. They don’t intend either to take or give delivery
of the currency.

Currency Derivatives:
The origins of the Indian foreign exchange market can be traced to 1978 when banks were
permitted to undertake intra-day trading in foreign exchange. However, the market started
growing only after the liberalisation process picked up in 1992. The continuous improvement
in market infrastructure has had its impact in terms of the enhanced depth, liquidity and
efficiency of the foreign exchange market. The turnover in the Indian foreign exchange
market has grown significantly in both the spot and derivatives segments in the recent past.
The daily average turnover saw a substantial pick up from about $5 billion during 1997-98 to
$18 billion during 2005-06. The turnover has risen further to $49 billion during 2007-08.56.
In June 2009, the size of India’s forex market was estimated to have a turnover of $34 billion
per day: of this, the OTC forex market was estimated to have a daily turnover of $33 billion
while the exchange-traded currency futures market stood at $1 billion.58 Within the OTC
segment, the spot market has remained the most important one, accounting for 50 per cent of
the total turnover in 2007-08.59 Foreign exchange swaps are the dominant form of OTC
derivatives accounting for over 30 per cent of the total turnover, followed by forwards (12 per
cent of the total turnover) in 2007-08 .

Rupee-foreign exchange options, which were allowed in July 2003, have remained
insignificant despite being in existence for more than six years.

It is important to note that foreign institutional investors (FIIs) are able to do transactions on
the currency derivatives market but only “hedging” of the currency risk exposure on their
Indian investment is permitted.

Below is the graph showing variation in USD-INR Exchange rate for more than last 2
years

Source: Tradingeconomics.com

Foreign Exchange rates, like any other asset class move depending on many factors, like
demand supply, interest rate parity, trade and capital flows, speculators taking positions,
client hedging risk arising from their trade and capital flows etc.

Currency Futures
India’s total foreign trade has quadrupled in just seven years, from USD 95 billion in 2000-01
to USD 414 billion in 2007-08; volatility in Indian forex markets has increased. The
availability of over-the-counter (OTC) currency derivatives contracts has inherent limitations.
The OTC markets could not address the need of micro small and medium scale enterprises
(MSME) for mitigating currency risk; bid-ask spread for currency forward quotes for the
MSME sector is usually wide due to smaller lot size of their import/export exposure. Many
corporates had also exposed themselves needlessly to currency risk in OTC derivatives
markets, especially in the non-USDINR exotic derivatives such as knock-in and knock-out
option contracts, Constant Maturity Spread (CMS) Range Accruals, etc. This resulted in
losses for corporates in excess of Rs 25,000 crore in 2007-08. This had accelerated the need
for introducing a simple yet effective instrument in the form of USDINR futures.

Currency futures are standardised foreign exchange contracts traded on approved stock
exchanges to buy or sell one currency against another on a specified date in the future at a
specified price (exchange rate). The price is fixed on the purchase date. This price can be
different from the price that is quoted in the spot foreign exchange markets. This will help
investors to hedge against foreign exchange risk arising due to price fluctuations in the
particular currency in a future date.

Say, an investor is expecting a cash flow denominated in foreign currency on a future date, he
can lock in the current exchange rate by entering into an offsetting currency future position,
which expires on the date of the cash flow. Futures contracts are exchange traded and the
clearing house guarantee the transactions (principle of novation). This drastically lowers the
probability of default to almost nil. INR-USD Currency Futures started on 29th August 2008
at National Stock Exchange (NSE). Trades done at NSE are cleared, settled and risk managed
by National Securities Clearing Corporation (NSCCL). NSCCL is set up as a separate and
independent entity whose practices and principles followed are globally benchmarked.

Some details of Currency Futures contract

1. Contract Size – USD 1000

2. Tick Size – 0.25 paise

3. Contract traded and settled in INR

4. There will be 12 monthly contracts starting with the current month onwards

5. Near month contract will trade till 12 noon on the second day prior to the last business day
in the month
6. The final settlement will be on the last business day of the month and shall be based on the
RBI’s reference rate on the last trading day of the month

7. The daily trading hours for the contract will be from 9 am to 5 pm.

8. The trade in the currency futures will co-exist with the prevalent OTC (over the counter)
market for forwards.

No of Contracts Volume-wise on MCX-SX (Single Side)

Source:MCX-SX Site

Turnover Value of futures contracts Traded on MCX-SX

Source: MCX-SX Site

However there are few factors are impeding liquidity in this segment:

1. There is a limit of USD 100 million on the open interest applicable to trading members
who are banks and the USD 25 million limits for other trading members.

So, larger exporters and importers might continue to deal in the OTC market, where there is
no limit on the hedges.

2. The management of margin and settlement of daily mark – to – market differences could
be cumbersome for some corporate customers.

3. Absence of FIIs could also reduce liquidity, whereas FIIs are already active in DGCX
(Dubai Gold and Commodity Exchange), that was opened a year ago. Closing the door to
them will reduce liquidity/ opportunity and business for domestic exchanges and
intermediaries.

After the success of USD-INR currency futures, in March 2010, 3 non-USDINR currency
pairs such as EURINR, INRJPY, and GBPINR were launched to significantly reduce
currency risk for market participants having exposure to these currencies.

Currency Forward:
In Currency Forward Contract, one party agrees to exchange a certain amount of one
currency for a certain amount of another currency at a future date. This type of forward
contract in practice will specify an exchange rate at which one party can buy a fixed amount
of the currency underlying the contract. If we need to exchange 10 crores rupees for U.S.
dollars in 60 days in future, the company might receive a quote of USD 47.68. The forward
contract specifies that the long will purchase USD 47.48 lakhs for 10 crores rupees at the
settlement. Currency forwards contract can be deliverable or settled in cash. The cash
settlement amount is the amount necessary to compensate the party who would be
disadvantaged by the actual change in market rates as of the settlement date.

The Rupee-Dollar Forward Market (R-D FM) This market is both onshore and offshore,
though the offshore market is not as large as the onshore. In the onshore market,
approximately 120,000 forward transactions came to CCIL for settlement in 2008-09, with
notional values of a little over $1 trillion. After reaching a peak average daily volume of $7.6
trillion in March 2008, the market has slowed down considerably and the average daily
volume has fallen to $4.5 trillion in March 2009 and to less than $3 trillion at the end of
November 2009. This partly reflected the strengthening of prudential regulations effected by
the RBI on off-balance sheet exposure (three-fourth of which is accounted for by forward
exchange contracts) of the SCBs.

The R-D FM accounts for about 30 per cent of the total forex market in 2008-09.The market
is dominated by foreign banks, which have strong experience in forex business and use more
advanced technology for the purpose. There are three remarkable features about the Indian
currency forward market.

a. Even though trading is negotiated off-exchange, there is netting by novation at CCIL to

eliminate credit risk.

b. Even though it is an OTC market, it trades standardised contracts that expire on the last
business day of each month.

c. Ordinarily, currency forward markets have pricing that is controlled by the covered interest
parity (CIP). However, the system of capital controls involves considerable barriers on CIP
arbitrage. Hence, the forward rate often strays away from the fair value.

The CCIL has started guaranteed settlement of foreign exchange forward trades (with a
residual maturity of up to 13 months) from December 1, 2009. The proposed settlement
process has been approved by RBI. Once CCIL starts guaranteed settlement of forwards from
the trade date, banks will not have any counterparty exposure for these trades and, as a result,
will have significant benefit in terms of a reduction in their inter-bank counterparty
exposures. They will also have significant savings from capital requirements to support such
trade.

The Offshore Non-Deliverable Forwards (NDF) Market In addition to the onshore R-D
FM, there is active trading in cash-settled rupee-dollar forwards on what are termed non-
deliverable forwards (NDF). The NDF markets in the Indian rupee (INR NDFs) have grown
in volume and depth over time. While these are largely concentrated in Singapore, they also
exist in London and New York. NDF turnover is estimated at $0.5 to $0.75 billion a day,
compared with $1.5 billion a day for the onshore R-D FM. The typical quote depth on both
markets is $5 million. The spread on the onshore market is roughly 0.5 to 1.0 paisa, while the
offshore NDF market has a spread between 0.5 and 2.0 paisa. These derivatives allow
multinational corporations, portfolio investors, hedge funds and proprietary foreign exchange
accounts of commercial and investment banks to hedge or to take speculative positions in
local currencies. The demand for NDFs arises principally out of regulatory and liquidity
issues of the underlying currencies. The requirements that transactions in the onshore market
must only be for the purpose of hedging has made the NDF market interesting to entities that
are prevented from making transactions in onshore market.

Currency Options:
The Reserve Bank of India (RBI) allowed trading in rupee options from July 7th, 2003. The
timing could not have been more appropriate with the government having a comfortable
forex reserves position and markets mature enough to be able to exploit the opportunity.

A currency option is the one in which the underlying asset is foreign exchange. In options the
buyer of option has the right but no obligation to enter into a contract with the seller.
Therefore the buyer of a currency option has the right, to his advantage, to enter into the
specified contract. In every currency transaction, one currency is bought and another sold.
For example an option to buy US dollars (USD) for Indian rupees (INR) is an USD call and
an INR put. Conversely, an option to sell USD for INR is an USD put and an INR call. The
other basics which should be specified to enter into an options contract are strike price,
expiration period, American style or European style.

Quotation of a currency option can be done in two ways: American or direct terms, in which
a currency is quoted in terms of the Indian Rupees per unit of foreign currency; and European
or inverse terms, in which the Rupee is quoted in terms of units of foreign currency per rupee.
The same applies to situations where the Indian Rupee is not one of the currencies. Before the
introduction of currency options the Indian corporates had only two alternatives: either to
enter into a forward contract or leave the exposure open. The problem with forwards is that
they are price fixing agreements and deny any gains of favourable movement in the market.
Leaving the exposure open subjects them to the mercy of the market.

Option Pricing

The premium quoted for a particular option at a particular time represents a consensus of the
option's current value which is comprised of two elements: intrinsic value and time value.
Intrinsic value is simply the difference between the spot price and the strike price. A put
option will have intrinsic value only when the spot price is below the strike price. A call
option will have intrinsic value only when the spot price is above the strike price. Options,
which have positive intrinsic value, are said to be "in-the-money".

When the price of a call or put option is greater than its intrinsic value, it is because of its
time value. Time value is determined by five variables: the spot or underlying price, the
expected volatility of the underlying currency, the exercise price, time to expiration, and the
difference in the "risk-free" rate of interest that can be earned by the two currencies. Time
value falls toward zero as the expiration date approaches. An option is said to be "out-of-the-
money" if its price is comprised only of time value. A variety of complex option pricing
models such as Black-Scholes and Cox-Rubinstein have been developed to determine option
pricing. Another commonly used model for currency option valuation is the Garmen-
Kohlhagen model.

Interest rate differentials between nations and temporary supply/demand imbalances can also
have an effect on option premiums. In the final analysis, option prices (premiums) must be
low enough to induce potential buyers to buy and high enough to induce potential option
writers to sell.

Types of Options

Apart from the normal call and put the following are a few basic types of currency options. In
real life most of the options are combinations of these basic types.

Call Spread

An options strategy that involves purchasing a call option at a specific strike price while also
selling the same number of calls of the same asset and expiration date but at a higher strike. A
call spread is used when a moderate rise in the price of the underlying asset is expected. The
maximum profit in this strategy is the difference between the strike prices of the long and
short options, less the net cost of options.

Put Spread

A type of options strategy that involves purchasing one put option while simultaneously
selling another put option with a higher strike price. It is used when the investor expects a
moderate rise in the price of the underlying asset. The Profit is realized when the price of the
underlying stays above the higher strike price, which causes the short option to expire
worthless, resulting in the trader keeping the premium.

Range Spread

A Type of options strategy that involves purchasing one Put option while simultaneously
selling a call option at different strike price. In this strategy the investor will be paying
premium for pull option while receiving premium for the call option.

Knock-Out Options
These are like standard options except that they extinguish or cease to exist if the underlying
market reaches a pre-determined level during the life of the option. The knockout component
generally makes them cheaper than a standard Call or Put.

Knock-in Options

These options are the reverse of knockout options because they don't come into existence
until the underlying market reaches a certain pre-determined level, at this time a Call or Put
option comes into life and takes on all the usual characteristics.

Calendar Spread

An options or futures spread established by simultaneously entering a long and short position
on the same underlying asset but with different delivery months.

Seagull Option

A three Legged Options Strategy which is structured through the purchase of a call spread
and a sale of a Put Option or vice Versa.

Though there are many more structured products available for trading in Currency options,
But because of complexity in these structured products generally only three types of products
are used Call Spread, Put Spread Range Spread.

Currency Swap:
A currency swap is a contract which commits two counter parties to an exchange, agreed
period, two streams of payments in different currencies; each calculated using a different
interest rate, and an exchange, at the end of the period, of the corresponding principal
amounts, at an exchange rate agreed at the start of the contract.

In Currency swap not only exchange of interest happens, but also an exchange of principal
amount. Unlike interest rate swaps, currency swaps are not off balance sheet instruments
since they involve exchange of principal at the start and at the end of the period. The interest
payments at various intervals are calculated either at a fixed interest rate or a floating rate
index as agreed between the parties. Currency swaps can also use two fixed interest rates for
the two different currencies – different from the interest rate swaps. The agreed exchange rate
need not be related to the market.

Below is the mechanism for the Swap which involves an Indian Bank and the counterparty is
the U.S. Bank. Swap starts with the exchange of the principal between the two banks at the
agreed exchange rate, follows by the periodic interest payments, and the exchange of the
principal during the termination of the Swap.
Swap Initiation

Indian Bank U.S. Bank wants

INR
· wants USD Swaps
INR for USD Swaps USD for
Swap Interest Payments

Indian pays USD U.S. Pays INR

Interest interest

Swap Termination

Indian Bank U.S. firm returns

returns USD INR borrowed

Cross-currency basis swap involve payments attached to a floating rate index for both the
currencies. In other words, floating-against-floating cross-currency basis swaps while cross
currency coupon swaps are fixed against floating swaps.

In India, the Reserve Bank of India has permitted banks to arrange currency swaps with one
currency leg being Indian Rupee. However, the USD/INR forward foreign exchange markets
are illiquid beyond one year. Since currency swaps involve the forward foreign exchange
markets also, there are limitations to entering the Indian Rupee currency swaps beyond
twelve months. Moreover, banks are also not allowed to take risk /run open swap books i.e.,
they have to locate counter parties with matching requirements; e.g. one desiring to swap a
dollar liabilities into rupee liabilities and the other wishing to exchange rupee debt servicing
obligation for dollar obligations. However, some aggressive banks do provide quotes for
currency swaps for three to five years out for reasonable size transactions.

Corporate who have huge rupee liabilities and want have foreign currency loans in their
books, both as a diversification as well as a cost reduction exercise could achieve their
objective by swapping their rupee loans into foreign currency loans through the dollar/rupee
swap route. However, the company is assuming currency risk in the process and unless
carefully managed, might end up increasing the cost of the loan instead of reducing it. In
India, it is more the norm for corporates to swap their foreign currency loans into rupee
liabilities rather than the other way round.

Example:
A corporate has a loan of USD 10 million outstanding with remaining maturity of 2 years,
interest on which is payable every six months linked to 6-month Libor + 150 basis points.
This dollar loan can be effectively converted into a fixed rate rupee loan through a currency
swap.

If the corporate wants to enter into a currency swap to convert his loan interest payments and
principal into INR, he can find a banker with whom he can exchange the USD interest
payments for INR interest payments and a notional amount of principal at the end of the swap
period. The banker quotes a rate of say 10.75% for a USD/INR swap. The total cost for the
corporate would now work out to 12.25%. If the spot rate on the date of transaction is 44.65,
the rupee liability gets fixed at Rs. 446.50 million. At the end of the swap, the bank delivers
USD 10 million to the corporate for an exchange of INR 446.50 million, which is used by the
corporate to repay his USD loan. The corporate is able to switch from foreign currency.

Derivatives market in India:

The economic liberalization in the early nineties provided the economic rationale for the
introduction of FX derivatives. Contribution of derivatives in forex market in India is nearly
50% of the total turn over in the over the counter forex market. Out of this derivative product,
swaps are the favoured transactions over forward and options. But as far as growth is
concerned swap market has registered a growth of 300% from 2001 to 2007 while forward
market growth has registered a growth of 600% over same corresponding year. The Indian
forex derivatives market is still in a nascent stage of development but offers tremendous
growth potential. Although global trade in currency derivatives has been substantial, forex
derivatives in India are still dominated by INR/USD forward contracts.
In recent past Forex derivatives contract mainly taken by corporate to hedge their foreign
exchange risk arising from overseas operation they suffered huge losses. For the exporter
one/two years back when Rupee was strengthening they took exposure in derivative and tried
to hedge their loss on appreciation of rupee to minimize the loss. Now the situation is adverse
form then, as the rupee has depreciated more than their expectation of appreciation and they
have started feeling the heat of depreciating rupee which, is resulting in huge loss for them. I
would like to mention that these losses are not on account of cost benefit but on the mark to
market basis. These losses they have to show in their books as per the valuation of foreign
currency on the closing day of financial year.

Forex vs Other Markets:

Relationship between Forex Market and other markets:

Forex versus Other Financial Markets

The Forex (or currency) market is one of four financial markets. These markets include the
stock, bond, commodity, and currency markets. Each market has its own special
characteristics that attract banks and financial institutions to trade its products. Individuals
have only recently been permitted to trade in the currency markets. Previously, the Forex
market was traded primarily by banks, large financial institutions, and governments.
Individuals have been trading in the other financial markets for many years. Let’s take a look
at a few basic characteristics of the other markets and their major differences with the Forex
market.

The Stock Market

The stock market is a system that permits the buying and selling (or trading) of a company’s
shares and derivatives. There are stock markets around the world. The worldwide stock
market is valued at $51 trillion.

Key differences from the Forex Market

• The stock market has lower liquidity.

• The stock market has lower leverage and risk (2:1 vs. 100:1 in Forex).

• The stock market has more regulation, control, and remedies.

The Bond Market

The bond market is a loosely connected system in which buyers and sellers trade fixed
income assets and securities. Bond and other fixed income assets are traded informally in the
over-the-counter market. The worldwide bond market is valued at $45 trillion.

Key differences from Forex Market

• The bond market has the world’s largest investment sector.

• The bond market has lower volatility and risk.

• The bond market has limited trading hours.

• The bond market is a decentralized market without a common exchange.

The Commodities Market

The commodities market is an exchange where raw goods or products are traded. Like the
stock market, there are commodities markets around the world. Commodities from apples to
zinc are sold in commodities exchanges.

Key differences from Commodities Market

• The commodities market has lower leverage (10:1 vs. 100:1 in Forex).

• The commodities market has lower liquidity.

• The commodities market tends to have longer trends.

• The commodities market has limited trading hours.

• The commodities market has more errors and slippage (misquoted prices).

These four markets are operating simultaneously. Each has its own advantages and
challenges. Many Forex traders will study how these markets work together, which is called
Intermarket Analysis.
Other markets Forex markets
Available trading hours are dictated by The forex market is open 24 hours a day,
the trading schedule of the exchange- 5.5 days a week. Because of the
floor and the local time-zone. This limits decentralized clearing of trades and
market open times. overlap of major financial markets
throughout the world, the forex market
remains open, thus creating trading
volume throughout the day and overnight.

Liquidity can be greatly diminished after
market hours, or when many market
participants limit their trading or move to
markets that are more popular.
Forex is the most liquid market in the
world, eclipsing all others in comparison.
Because currency is the basis of all world
commerce, exchange activities are
constant. Liquidity — particularly in the
majors — often does not dry up during
"slow times."

Traders are charged multiple fees, such
as commissions, clearing fees, exchange
fees and government fees as well as
platform and charting fees.
All you pay is the spread, which is built
into the buy and sell prices — although
market makers like GFT are compensated
by revenues from their activities as a
currency dealer.

Trading restricted by large minimum
capital requirements — sometimes as
high as $50,000 — and high margin
rates.
One consistent margin rate 24 hours a day
allows forex traders to leverage their
capital, as much as 100:1. In fact, GFT
green accounts allow traders to begin with
as little as $200 and 100:1 leverage. It is
important to know that without
appropriate use of risk management, a
high degree of leverage can lead to large
losses as well as gains.
Margin requirements can be as much as
50 percent of your capital in order to take
a position.
Restrictions on short selling and stop
orders.
No restrictions on short-selling (placing a
sell order when you think the market will
trend down), because you are
simultaneously buying one currency while
selling another.
GFT offers multiple order types, including
stop orders and trailing stop orders to help
you manage your trading equity, which
you can use even when short selling.

Correlation & Movements

Correlation, is the statistical measure of the relationship between two variables in forex
market we say two different currency set. The correlation coefficient ranges between -1 and
+1. A correlation of +1 implies that the two currency pairs will move in the same direction
100% of the time. A correlation of -1 implies the two currency pairs will move in the
opposite direction 100% of the time. In any currency pair there are two currencies and any
factor affecting any currency XXX will affect both currency pair XXX/YYY and cross
currency pair XXX/ZZZ. This causes positive/ negative currency correlation between
XXX/YYY and XXX/ZZZ.

1. USD/INR movement
1995-96 depreciation of rupee

During 1993-94 India saw relatively large inflows on account of portfolio investments, which
were regularly picked up by the reserve bank of India, keeping the rupee steady at around 31
levels.

Over September 1995-96 the govt debt and int. Repayments worth about $4 billion hit the
market which, coupled with increased covering of capital liabilities by corporate and a
dramatic slowdown in foreign portfolio investment, led to around 22% fall in the rupee, from
31 levels to 38 levels.

1996-97 stagnant

Trade, which had grew at a rate in excess of 20 % over 1994-96 , stagnant in financial year
1996-97 due to both, credit squeeze induced slowdown in domestic growth as well as a
downturn in India’s major export markets.

1997-98 to 2000-01 depreciation of rupee

In 1997-98 the rupee depreciated by 9.1%, in 1998-99 by 6.9%, and again it continued to
depreciate by 6.5 % in 2000-01. The main reasons for depreciation in the rate of rupee are
increase in the rate of inflation and increase in the prices of crude oil, petroleum products.

2001-04 rupee appreciation

India recorded a current account surplus since financial year 2001-02, also liberalization
encouraged and attracted large inflows on its capital account. This pressure on the rupee lead
to its appreciation.

2006-07 rupee appreciation

The trend of steady month on month appreciation began in September 2006. The Indian rupee
had appreciated by nearly 10% since late 2006, posing an acute dilemma for Indian
policymakers. The average Rupee US dollar rate in November 2007 was the lowest since
1999/2000.

It suggests that the country’s attractiveness to foreign investors had been increasing and
signals optimism about the Indian economy more generally.

2007-08

In the first five months of 2007/08, the value of exports rose by 19% in US dollar terms and
by 6% in Indian rupees. In the period up to November 2007, export growth more-or-less
followed the same pattern of growth in US dollars at 22% and 8% in Indian rupees. The rate
of growth in the April-Aug period was the same for non-petroleum products (18%) and non-
POL, non-gems & jewellery (17%) in US dollar terms, and 5% and 4% respectively in Indian
rupees.

2008-09 The Fall of the Indian Rupee

The INR recently breached the psychological mark of Rs50 per US$. The currency has lost
its values substantially, both in nominal and real terms, notably against the USD and the JPY.
Only about one year back, the INR-greenback exchange rate was Rs39.26 per US$.

In recent months, fluctuations in low interest rate currencies such as the JPY and high interest
rate currencies such as the AUD have been heavily subjected to carry trade. In the case of the
INR, the evidence is less sanguine.

The unexpected strength in the USD relative to a basket of six major currencies, known as the
USD index, outflow of foreign institutional investments (FIIs) from the Indian market, the
country’s widening trade deficit, and the significantly lower flow in external commercial
borrowings (ECBs) by Indian corporate houses, inter alia, have caused the depreciation of
the INR.

The USD index has strengthened 17 percent over the past quarter. As the financial crisis
spreads to the emerging markets, the money is moving to the United States in search of a safe
haven, despite mounting credit and other economic malaise in the world’s largest economy.

Moreover, there is an inverse relation between oil prices and the USD. As the developed
world is in a recession and most emerging markets prioritise inflation check over growth,
there is a big fall in oil and other commodity prices.

The Indian equity market has witnessed a rapid withdrawal of portfolio investments in the
last few months that instigated, among others, the free fall of the Indian stock markets. The
Reserve Bank of India (RBI) reports that, during the first quarter of 2008-09, there were
portfolio investment outflows by FIIs in the order of US$5.2 billion, compared to a net inflow
of US$7.1 billion during April-June 2007. According to data from the Securities and
Exchange Board of India, international investors sold a record US$13.5 billion in Indian
equities this year as at 24 November 2008. The net ECB was only US$1.6 billion during
April-June 2008, as against US$6.9 billion a year ago.

However, foreign direct investment (FDI) statistics show a different trend. India received
US$19.3 billion in FDI as at September 2008. Inflows under the American depository
receipts, global depository receipts and non-resident Indians deposits were higher during
April-June 2008 than the corresponding period last year.

Although exports of both primary and manufacturing products recorded a higher growth in
the current year than in the previous year, the trade data for the first quarter of 2008-09
showed a widening merchandise trade deficit, as the growth of imports (33.3 percent)
outpaced that of exports (22.2 percent). Higher commodity prices, notably oil, have widened
the export-import gap. Merchandise trade deficit widened to US$31.6 billion during the first
quarter of 2008-09. However, the gross invisible receipts recorded US$37.7 billion, a year-
on-year increase of 29.7 percent. Nevertheless, the current account deficit amounted to
US$10.7 billion in the first quarter of 2008-09, according to the RBI.

The dynamics in the current and capital accounts resulted in a decline in India’s foreign
exchange reserve – it stood at US$245.8 billion as at 21 November 2008. The reserve reached
more than US$313 billion at the end of April 2008. Moreover, the RBI had to intervene in the
foreign exchange market by selling the USD and buying the INR to curb the rapid fall in the
INR.

All these factors placed huge pressures on the INR, and the currency depreciated by 18.9
percent vis-à-vis the USD, 19.1 percent against the JPY, and 0.4 percent against the Euro in
nominal terms during the current fiscal year (as at 22 October 2008).

2009-10 appreciation of rupee

Performance of Indian rupee against dollar has improved significantly in the year 2009-2010.
The rupee has shown tremendous strength against the US$ as the rupee US$ exchange rate
appreciated to Rs. 46.64 per dollar on January 1, 2010, which was Rs. 50.95 per dollar in
end-March 2009. Overall the rupee has appreciated by 9.2 per cent over its March 31, 2009
level, according to Economic Survey 2009-10. The main reasons behind the appreciation of
rupee against dollar is significant change in FII inflows, continued inflows under FDI and
NRI deposits, better economic performance of the Indian economy and weakening of the US$
in international markets which has facilitated the appreciation of rupee.

USD/INR Vs other currency pair

Currencies Correlation
USD/GBP Vs USD/INR -0.833686878
USD/ Euro Vs USD/INR -0.307030235
USD/JPY Vs USD/INR -0.511929451

In India the major currencies used for the Forex purpose are U.S Dollar, EURO, GBP and
YEN. We have tried to find out the relationship between these currencies and how that moves
against each other. In the last couple of years, the rupee-dollar exchange rates are
increasingly getting linked to exchange rate of some of the currencies such as Japanese yen
vis-à-vis US dollar.

The correlation between USD/YEN and USD/INR is significantly negative. For the last five
years (2004- 2010) correlation is -0.511929451. Which means that when USD/YEN gains
there are 51% chances are there that USD/INR will move in opposite direction and if YEN is
getting stronger then rupee will become weaker.

Correlation between another important currency pair USD/ GBP and USD/INR is highly
negative for last five years (2004 to 2010) i.e. -0.833686878. The implicit meaning of such a
highly negative correlation is that both these pair move in opposite direction with it tandem.
The relation tell that if GBP gets strong or weaker there are 83% chance that INR will go
down or up against the dollar.

Another important currency pair is USD/EURO whose correlation with USD/INR for the last
five years is -0.307030235. This correlation implies that if USD/EURO goes on rallies or
decline there are 30% chances that USD/INR will increase.

USD/CRUDE OIL Vs USD/INR

USD/CRUDE OIL Vs USD/INR -0.362220959

We have tried to find out relationship between the movements of USD/INR Vs Crude oil as it
is one of the major factors in the international market to influence the Forex exchange rate.
Since most of the country spend substantial amount of their currency to buy crude oil, it has
direct impact on exchange rate.

If we see the graph we can easily say that there is negative correlation between these two
commodities. We have tried to establish correlation for year 2004 to 2010 and the same was
-0.362220959. We can observe that during the last one year crude price is decreasing like
anything and just opposite is happening for Rupee as it depreciating continuously. Negatively
correlated means one increases other tend to decreases by that much value.

USD Vs Gold

USD/GOLD Vs USD/INR 0.211068833

Gold is an important commodity in the international market and is generally considered
liquid cash. It has historic importance in determining exchange price as it is globally accepted
and one of the most valuable commodity for getting Forex. As far as correlation between
USD/INR Vs Gold markets is considered it has negative correlation (0.211068833) that
means the value of Dollar increases then the value of gold will increase. So we can draw the
inference that Gold and USD has inverse relationship in the Forex market.

USD/Equity:

USD/Equity -0.351174213

Equity (Sensex) and forex markets are most vibrant market in financial sector and it has been
established that there is strong correlation between these two sectors. We have tried to find
out correlation between these two and it was very high. Correlation between equity and
USD/INR was -0.351174213 for the last five year (2004 to Mar2010).

The inference we can draw is USD/INR had strongly inversely proportional to Sensex i.e.
whenever sensex gains the USD will depreciate so, the value of rupee will appreciate. From
the chart it is quite clear that during 2007-08 when there was huge inflow in the forex market
due to booming sensex the USD has depreciated most i.e. rupee has appreciated most but
reverse happened in the very next year when stock market crashed, then USD became strong
and rupee depreciated at record level.

FOREX RISK MANAGEMENT

Forex market is one the most consistently volatile financial market. At the one side there is
enormous scope of making profit on the other side on the coin same amount of risk for loss is
associated. The various kind of risk linked to the Forex markets are:

MARKET RISK

• Exchange risk: This risk relates to appreciation or depreciation of currencies. The risk
can arise due to mismatch of amounts of assets and liabilities as well as from the
mismatch of maturity dates of assets or liabilities. The opposite view (appreciation/
depreciation) of the dealer and the borrower leads to the transaction, and in that case
both are exposing to risk, but the beneficiary is who in whose favour rate moves.

• Open position Risk: The main source of Forex risk is open position in individual
currencies. It is completely un-hedged exposure in a particular currency. It can be
mitigated by doing complete cover operations, immediately in the same currency by
taking opposite position. On the other hand daylight limit and overnight positions are
 given during the course of trading day, which are exposed to risk due to depreciation /
appreciation in currency.

• Gap Risk: Period mismatch in the currency pair result in interest rate risk. Eg bank
has long position in USD/INR for three months while short in USD/INR for six
months for the same amount, so this creates exchange / interest rate risk (IRR) or gap
risk. Interest rate risk may be of:

• Basis Risk: Imperfect correlation between the indices of underlying assets and
liabilities

• Yield curve risk: Different rate shock for different bucket

• Re-pricing risk: Due to mismatch in asset & liability duration

• Settlement Risk: Such risk arises from time differences between trading zones i.e
debit and credit are not synchronized. These risks can’t be mitigated fully but can be
reduced by fixing exposure limit to each individual counter party.

• Country Risk: This is also called sovereignty risk. This arises when the exposed
country will not be able to honour obligation due to shortage of foreign exchange or
political risk. It can be mitigated, by developing internal rating, or setting limits as per
the classification of country risk used by ECGC (seven categories).

OPERATIONAL RISK

This covers the entire gamut of Forex transaction. It (operational risk) may be divided into
those arising from:

• Risk arose through work and document flow

• Non-compliance of guidelines & procedure specified for dealing & settlement

• Fraudulent attempt or practices

• Technology enabled risk (Hardware & software)

• Legal Risk is a risk where the transaction is not valid and enforceable, under the
applicable (relevant local and other international) law.

• Event Risk: unexpected/ sudden happening like 26/11 terror attack in Mumbai

All these risk can be minimized by taking precautionary measure, like making proper
documented policy, setting prudential limits, stop loss limit, no deviation from approved
work, delegation of power judiciously, prescribed settlement system, backup system for
computer etc.

CREDIT RISK
This risk arises from the possibility of a counter-party making default in payment either
interest or principal or both. Credit risk also includes nonperformance of obligation even for
the off-balance sheet contracts. It can be reduced by fixing the limits (either by tenure wise or
product wise or both) of operations per clients, based on the creditworthiness of the client by
doing the rating of counter-party.

Mitigation can be done by better credit appraisal, careful analysis of cash flow of the counter-
party business, etc. Asking for more margins, setting the exposure limit of the counter-party,
collateralized transaction, investments in rated instrument etc are the other measure to curtail
the risk.

Nostro a/c settlement: The foreign exchange deals struck by SITB are settled through
NOSTRO accounts maintained by SITB. The SITB maintains NOSTRO accounts in
different currencies and settles its inter-bank and inter-branch transactions through debits and
credits to the relevant NOSTRO accounts. The settlement of rupee transactions of the SITB
is carried out through CCIL (Clearing Corporation of India Limited) and RTGS (Real Time
Gross settlement System).

Assets & Liability Management (ALM):

In forex market the assets and liability management has great importance particularly in the
current volatile market. The importance of ALM is not only due to volatility but also due to
volatile interest rate, squeeze in spreads and proactive regulatory environment. The core
objective of ALM policy is to ensure planned and profitable growth in business through
management of liquidity risk, interest rate risk and currency risk. In the forex market context
the basic task for ALM is:

Identify the possible shock on the open position and net open position

To identify the drives of such shock (change in exchange rate, interest rate etc.)

Measure the liquidity gap and economic value of equity (Forex exposure outstanding)

Manage and mitigate the potential risk

• Yield Curve Risk: This risk refers to non-parallel shift of yield curve on assets &
liabilities of different maturities i.e. “different rate shock for different maturities”.
Example 1 year assets is financed by 6-month deposit; and change in rate of interest
for 1year is different from the change of rate of 6 month. So it has impact on the
forward premium and present value of open position of portfolio.

• Basis risk: Basis risk refers to those risks where two different benchmarking indices at
attached with assets and liability. Example: assets are LIBOR linked while Liability is
MIFOR liked and change in rate of interest of any of the two may not see the
proportionate change in the others benchmark indices. It is not guaranteed that change
of 1% in LIBOR will imply 1% change in MIFOR.
Through the above discussed various kind of risk we can identify the adverse market rate
movement and accordingly the present value of the open position of portfolio.

The last decade of this millennium has witnessed huge and profound changes in the
foreign exchange market, which involves nearly every bank in the world and every
company with overseas business.

Although the market has grown more than 30 percent over the past three years, the number of
players and providers has shrunk as the banking industry continues to consolidate. The
Future of the Foreign Exchange Markets provides a comprehensive study of the key issues
affecting the market including the dramatic developments taking place in trading technology,
the impact of the EMU and the opportunities and threats posed by emerging markets. The
Future of the Foreign Exchange Markets discusses the new foreign exchange clearing
bank, the CLSS and considers its implications for the future structure of the global foreign
exchange market, specifically the reduction of settlement risk. It reviews the emergence of
Contracts for Differences (CFDs) which avoid the need for any settlement. The expected
effects of EMU on the size and structure of the market are analysed, with issues such as the
likely size and distribution of activity in the euro being specifically addressed.

Structure and Scope

The Future of the Foreign Exchange Markets addresses the critical issues including:

• Developments in the foreign exchange markets including the spot market, the forwards
market and foreign exchange options and derivatives market.

• Trading Technology - in particular the development of electronic matching systems and

their new dominance of trading in the market.

• Netting and Settlement systems, with particular reference to the new foreign exchange
clearing bank, CLSS. The rise of CFDs will also be considered.

• EMU - a discussion on the size and structure of the market, both during the first year of its
implementation and once stage three of monetary union is completed.

• Emerging Markets - considering the growing proportion of forex trading devoted to

emerging markets’ currencies and whether this growth and development will continue in the
face of the turmoil in Asia and Russia.

Key Benefits

As a result of this report you will be able to:

• Assess where the the market is today and put into perspective where it is going tomorrow.

• Review forcasts on the future of emerging markets currency trading and assess which
currencies are most likely to be extensively traded and why.

• Evaluate the planned global foreign exchange clearing service, CLSS and assess how it will
decrease worldwide settlement risk.
• Identify how EMU is changing the foreign exchange market and evaluate how much
impact it will ultimately have.

• Access the thoughts of prominent bank foreign exchange executives on the directions the
market is taking and what they are doing to prepare.

• Assess whether the proportion of trading conducted over electronic matching systems has a
natural limit and whether it will prove as successful in the forward and options markets as it
has in the spot markets.

In the near future the change in Forex market should revolve around following key areas:

○ Capital account convertibility: We can expect lots of liberalization towards capital

account during the next 3-5 years as the new stable government has formed which is
committed to economic liberalization. Here government may take some cautious
approach because once capital market is open it is very difficult to control the price of
rupee due to large amount and volume involved.

○ Exchange traded derivatives: As over the counter Forex market doesn’t have much
transparency and trading is not allowed we can expect more exchange traded product
will be launched after the initial success of currency futures, which was launched last
year. Due to lots of restriction on OTC derivatives in Indian market the entities
outside finds it difficult to hedge their direct or indirect exposure in Indian rupee
market and these exchange-traded derivatives may help in hedging. These products
not only brings transparency but also eliminate counter party risk, brings mark to
market concept and provides access to all type of market participants.

○ Role of Reserve Bank of India: Role of reserve Bank will be changed from regulatory,
monitoring & controlling authority to regulatory & monitoring authority as it does not
have to come frequently in market to sell or buy Forex to influence the rupee rate.

○ Customized and exotic product: we have recently seen that the many corporates has
suffered huge loss on Forex derivatives exposure due depreciation of rupee on
account of USD. These losses lead to credit risk for the banks who has offered the
derivative product. In such scenario we can expect more customized product as per
the requirement of customer in the market.