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KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES
INTERNATIONAL TRADE FINANCE
UNIT III FOREX MANAGEMENT
Foreign Exchange Markets – Spot Prices and Forward Prices – Factors
influencing
Exchange rates – The effects of Exchange rates in Foreign Trade – Tools for hedging
against Exchange rate variations – Forward, Futures and Currency options – FEMA –
Determination of Foreign Exchange rate and Forecasting.
Contents
3.1 INTRODUCTION ................................................................................................................................. 3
3.2 FOREIGN EXCHANGE MARKETS - MEANING ..................................................................................... 3
3.3 NATURE OF FOREIGN EXCHANGE MARKET ...................................................................................... 3
3.4 PARTICIPANTS of FOREX MARKET ..................................................................................................... 5
3.5 SETTLEMENTS.................................................................................................................................... 7
3.5.1 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET ............................................................ 7
3.6 FACTORS AFFECTING EXCHANGE RATE............................................................................................. 8
3.7 FOREIGN EXCHANGE RISK ............................................................................................................... 11
3.7.1 Types of Risk/Exposure ............................................................................................................ 12
3.7.1.1 Transaction Exposure ........................................................................................................ 12
3.7.1.2 Economic Exposure ........................................................................................................... 12
3.7.1.3 Translation Exposure......................................................................................................... 13
3.8 HEDGING TECHNIQUES ................................................................................................................... 13
3.8.1 Definition of 'Spread' ............................................................................................................... 13
3.8.2 Strike Price ............................................................................................................................... 14
3.8.3 Hedging Techniques Types....................................................................................................... 15
3.8.3.1 INTERNAL TECHNIQUES .................................................................................................... 15
3.8.3.2 EXTERNAL TECHNIQUES .................................................................................................... 17
3.8.4 DIFFERENCE BETWEEN FORWARD AND FUTURE MARKET ...................................................... 21
Option Contract Specifications ......................................................................................................... 21
Option Class .................................................................................................................................. 21
Strike Price .................................................................................................................................... 22
Premium........................................................................................................................................ 22
Expiration Date ............................................................................................................................. 22
Option Style................................................................................................................................... 22
Underlying Asset ........................................................................................................................... 22
Contract Multiplier........................................................................................................................ 22
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3.9 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA), 1999 ............................................................... 22
3.9.1 Objectives of FEMA .................................................................................................................. 23
3.9.2 Scope of FEMA ......................................................................................................................... 23
3.9.3 Highlights of FEMA ................................................................................................................... 23
3.9.4 Applicability of FEMA ............................................................................................................... 24
3.9.5 Authorities responsible for various aspect of FEMA............................................................ 26
3.9.6 Distinguish between FERA and FEMA. ..................................................................................... 26
3.10 DETERMINANTS OF EXCHANGE RATE ........................................................................................... 27
3.11 FORECASTING FOREIGN-EXCHANGE RATES .................................................................................. 40
3.11.1 Forecasting exchange rates ................................................................................................... 40
3.11.2 Exchange Rate Forecasting in Practice .................................................................................. 42
3.11.3 Forecasting in Practice ........................................................................................................... 42
3.12 IMPACT AND EFFECTS OF EXCHANGE RATE.................................................................................. 43
3.13 ROLE OF RBI IN FOREIGN EXCHANGE MARKET ............................................................................. 46
3.14 Expected Questions – 16 marks .................................................................................................... 48
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3.1 INTRODUCTION
The Foreign Exchange Market (FOREX, FX, or currency market) is a global
decentralized market for the trading of currencies. The main participants in this market are
the larger international banks. The foreign exchange market works through financial
institutions, and it operates on several levels. The foreign exchange market assists
international trade and investment by enabling currency conversion. For example, it permits a
business in the United States to import goods from the European Union member states,
especially Eurozone members, and pay euros, even though its income is in United States
dollars. It also supports direct speculation in the value of currencies, and the carry trade,
speculation based on the interest rate differential between two currencies.
3.2 FOREIGN EXCHANGE MARKETS - MEANING
Foreign exchange market is a market in which foreign currencies are bought and sold.
Foreign exchange market is a system facilitating mechanism through which one country
currencies can be exchanged for the currencies of another country.”
3.3 NATURE OF FOREIGN EXCHANGE MARKET
 Foreign exchange market refers to the market in which participants are able to buy,
sell, exchange and speculate on currencies.
 Foreign exchange markets are made up of banks, commercial companies, central
banks, investment management firms, hedge funds, and retail foreign exchange
brokers and investors.
 The foreign exchange market is considered to be the largest financial market in the
world.
 The foreign exchange market is a global, worldwide-decentralized financial market
for trading currencies.
 Financial centers around the world function as anchors of trading between a wide
range of different types of buyers and sellers around the clock, with the exception of
weekends.
 The foreign exchange market determines the relative values of different currencies.
The foreign exchange market assists international trade and investment by enabling
currency conversion. For example, it permits a business in the United States to import
goods from the European Union member states especially Euro zone members and
pay Euros, even though its income is in United States dollars.
 The foreign exchange market determines the relative values of different
currencies.
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 The foreign exchange market assists international trade and investment by enabling
currency conversion.
 For example, it permits a business in the United States to import goods from the
European Union member states especially Euro zone members and pay Euros, even
though its income is in United States dollars.
Foreign Exchange Market: Global market
 Over the counter market
 Around the clock market
 Banks are involved in 95% cases.
 1-2% transactions are for actual transaction rest for speculation.
 Money and near money instruments are denominated in foreign currency is
foreign exchange.
 There is no physical transfer of money it is online.
 A party can never be a demander of one currency without being simultaneously a
supplier of another.
 Volatile, affected by hedger, arbitrager, speculator.
 Affected by demand and supply.
 Affected by rate of interest.
 Affected by balance of payment surplus and deficit.
 Affected inflation rate.
 Spot and forward rates are different.
 Affected by the economic stability of the country.
 Affected by the fiscal policy of the government.
 Affected by the political condition of the country.
 It can be quoted directly or indirectly
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3.4 PARTICIPANTS of FOREX MARKET
Exchange
companies
and
individuals
Traveller
s and
Tourists
All
Scheduled
Commerci
al Banks
Central
Banks
Participants
of FOREX
market
FOREX
Brokers
Hedgers
Arbitra
gers









Speculat
ors
MNC’s
All Scheduled Commercial Banks
Reserve Bank of India (RBI). - Central Banks
Speculators
FOREX Brokers
MNC’s
Arbitragers
Hedgers
Travellers and Tourists
Exchange companies and individuals
Speculators
Speculators seek to profit from changes in foreign exchange rates based upon their
expectations. This class of participants, actively expose themselves to currency risk by
buying and selling currencies in the forward market to profit from exchange rate fluctuations.
Arbitrators
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This class of participants seeks to earn risk-free profits by seeking advantage of
differences in the prices of currencies, in interest rates among various countries. they use
forward contract to hedge risk.
Hedgers:Many MNCs engage themselves in forward contract to protect the home currency
values of F.C. denominated assets and liabilities on their balance sheet that are not to be
realized over the life of contract. They also hedge receivables and payables.
Risk Quantum
Speculator
Arbitrator
Hedger
• High risk
• No risk
• Low risk
Structure of Foreign Exchange Market
Exchange rate market has three segments: Transactions between R.B.I. and Authorized dealers (Commercial banks).
 Transactions among authorized dealers.
 Transaction among authorized dealers and customers (Retail segment).
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3.5 SETTLEMENTS
Cash/Ready
• Settlement made on The same day.
Tom
• On the next working day (tomorrow).
Spot
• When the exchange of currencies takes
place on the second day, working day after
the date of deal is called spot rate.
3.5.1 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
Two Types of Currency Markets
Spot
Market
Forward
Market
• When the exchange of currencies takes
place on the second day, working day after
the date of deal is called spot rate.
• Settlement made at some
future date
Spot Prices / Spot Market
The spot market refers to that segment of the foreign exchange market in which sale
and purchase transactions are settled within two days of the deal.
i.e. when buyers and sellers of a currency settle their transaction within two days
of the deal is called as spot transaction.
Forward Market
The forward exchange market refers to the foreign exchange deals for sale and
purchase of foreign currency at some future date, normally after 90 days of the deal.
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INTERNATIONAL TRADE FINANCE
When buyers and sellers enter an agreement to buy and sell a foreign currency after
90 days of the deal at the agreed rate of exchange, it is called forward transaction.
3.6 FACTORS AFFECTING EXCHANGE RATE
Introduction:
Every country has its own currency that has its own individual value. Whether you are
an active trader in the foreign exchange market, planning your vacation abroad or shopping
an exotic product online, understanding of exchange rate is essential. The value of currency
across the world differs as the Kuwaiti dinar varies from the US dollar.
The fact that a country‘s financial healthiness is judged by its exchange rate, makes
evident its significance. Other than factors like interest rate and inflation, exchange rate is
deemed to play a pivotal role in the country’s trade activities with it being one of the most
valued factors.
A higher currency makes a country's exports more expensive and imports cheaper in
foreign markets; a lower currency makes a country's exports cheaper and its imports more
expensive in foreign markets. A higher exchange rate can be expected to lower the
country's balance of trade, while a lower exchange rate would increase it.
Exchange Rate: Understanding the Term
Exchange rates are determined by supply and demand. For example, if there was
greater demand for American goods then there would tend to be an appreciation (increase in
value) of the dollar. If markets were worried about the future of the US economy, they would
tend to sell dollars, leading to a fall in the value of the dollar.
The exchange rate is the rate at which one country’s currency may convert into
another currency.
Note:
Appreciation = increase in value of exchange rate
Depreciation / devaluation = decrease in value of exchange rate.
A country with a stronger currency will lose as its exports will be more expensive and
imports will be cheaper in the foreign market. On the contrary, a country with a weaker
currency will benefit from as imports will be expensive and exports cheaper.
Depreciation and Appreciation of currency
 A decline in a currency’s value is referred to as depreciation and an increase in
currency’s value is called appreciation.
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 If currency A can buy you more units of foreign currency, currency A has appreciated
and foreign currency depreciated
 If currency A can buy you less units of foreign currency, currency A has depreciated
and foreign currency appreciated
Factors Influencing Exchange Rate – Diagrammatic Representation
Political
factors
International
Trade
Stock
Exchange
operations
Economic
Expectations
Balance of
payment
Facto
rs
Capital
movements
Exchange rate
policy &
Interventions
strength of
the
economy
Government
Policies &
measures
Inflation
Speculation
Sentiment
s
International Trade
Trade of goods and services between countries is the major reason for the demand and
supply of foreign currencies. The value or strength or weakness of a country’s currency in
terms of other currencies depends on its trade with those countries. If a country’s import is
higher, the demand for foreign currency will be high. Higher demand for foreign currency
means high value of foreign currency and low value of domestic currency. The current
account balance (deficit or surplus) thus reflects the strength and weakness of the domestic
currency.
Strength of the Economy:
The strength of the economy affects the demand and supply of foreign currency. If an
economy is growing fast and is strong it will attract foreign currency thereby
strengthening its own. On the other hand, weaknesses result in an outflow of foreign
exchange. If a country is a net exporter (as were Japan and Germany), the inflow of foreign
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INTERNATIONAL TRADE FINANCE
currency far outstrips the outflow of their own currency. The result is usually a strengthening
in its value.
Balance of Payment:
It is the total number of transactions including its exports, imports, debt, etc. that a
country deals with, in comparison to other countries determining the amount it has to pay or
receive. A country that is in a position to receive more than pay will have a higher value for
its currency and vice versa.
Government policies and measures:
A country prone to political turmoil and continuous clashes will deter the investor’s
confidence lowering the value of the currency. However, a country with sound financial and
trade policies without giving room for uncertainties will witness a positive influence on the
value of a currency directly and indirectly, as it will influence every aspect of trade including
tariffs, exports and imports, etc.
Sentiment:
The way, market perceives our economy as an investment destination, is essential. If
it confides in our policies and believes that we are on the right track, paving way for an
unprecedented growth, it will express its interest by investing with the expectation of
receiving lucrative returns. Hence, sentiment of the market tends to be a major determinant of
a country’s exchange rate.
Inflation:
A country with lower inflation will have an upper-hand in the market and have a
higher currency value. On the other hand, countries with high inflation will consequently
witness depreciation in their currency in comparison to the currencies of their global
counterparts.
Interest Rates:
When interest rate for a particular currency rises, it will have a consequent effect on
the yields for the assets denominated in that particular currency, nudging way for an increase
in demand by investors and hence, increase the value of currency. Investors generally try to
seek a balance between yield returns and safety of funds.
Capital Movements:
Capital movements are one of the most important reasons for changes in exchange
rates. Capital movements of foreign currency are usually more than connected with
international trade. This occurs due to a variety of reasons – both positive and negative.
When India began its economic liberalisation and invited Foreign Institutional Investors
(FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the
country strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out
of the country weakening the currency. These were capital outflows. One of the reasons
popularly believed for the rupee not depreciating in the manner other South-east Asian
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currencies did in 1997-98 was because the rupee was not convertible on the “capital
account”.
Speculation:
Speculation in a currency raises or lowers the exchange rate. For instance, the foreign
exchange market in India is very shallow. If a speculator enters and buys US $1 million, it
will raise the value of the US dollar significantly. If a few others do so too, the price of the
US dollar will rise even further against the Indian rupees.
Exchange Rate Policy and Intervention:
Exchange rates are also influenced, in no small measure, by expectation of change in
regulations relating to exchange markets and official intervention. Official intervention can
smoothen an otherwise disorderly market. As explained before, intervention is the buying or
selling of foreign currency to increase or decrease its supply. Central banks often intervene to
maintain stability. It has also been experienced that if the authorities attempt to half-heartedly
counter the market sentiments through intervention in the market, ultimately more steep and
sudden exchange rate swings can occur.
Economic Expectations:
Exchange rates move on economic expectations. After the 1999 budget in India there
was an expectation that the rupee would fall by 7% to 9%. Since such expectations affect the
external value of the rupee, all economic data – the balance of payments, export growth,
inflation rates and the likes – are analysed and its likely effect on exchange rates is examined.
If the economic downturn is not as bad as anticipated the rate can even appreciate
Stock exchange operations
Stock exchange operations in foreign securities, debentures, stocks and shares
influence the demand and supply of related currencies, thus influencing their exchange rate.
Political factors
Political scenario of the country ultimately decides the strength of the country. Stable
efficient government at the centre will encourage positive development in the country,
creating investor confidence and a good image in the international market. An economy with
a strong, positive image will obviously have a strong domestic currency.
3.7 FOREIGN EXCHANGE RISK
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Foreign exchange risk (also known as exchange rate risk or currency risk) is
a financial risk posed by an exposure to unanticipated changes in the exchange
rate between two currencies.
Investors and multinational businesses exporting or importing goods and
services or making foreign investments throughout the global economy are faced with an
exchange rate risk which can have severe financial consequences if not managed
appropriately.
3.7.1 Types of Risk/Exposure
Transaction
exposure
Operating
exposure
Accounting
exposure
3.7.1.1 Transaction Exposure
Transaction exposure is the effect of an exchange rate change on outstanding
obligations, such as imports and exports.
Transaction exposure involves actual cash outflows.
A firm has transaction exposure whenever it has contractual cash flows (receivables
and payables) whose values are subject to unanticipated changes in exchange rates due to a
contract being denominated in a foreign currency.
3.7.1.2 Economic Exposure
A firm has economic exposure (also known as operating exposure) to the degree that
its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate
adjustments can severely affect the firm's market share|position with regards to its
competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure
can affect the present value of future cash flows. Any transaction that exposes the firm to
foreign exchange risk also exposes the firm economically, but economic exposure can be
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caused by other business activities and investments which may not be mere international
transactions, such as future cash flows from fixed assets.
A shift in exchange rates that influences the demand for a good in some country
would also be an economic exposure for a firm that sells that good.
3.7.1.3 Translation Exposure
Accounting or translation exposure is the effect of an exchange rate change on
financial statement items.
Translation exposure does not involve actual cash flows.
A firm's translation exposure is the extent to which its financial reporting is affected
by exchange rate movements. As all firms generally must prepare consolidated financial
statements for reporting purposes, the consolidation process for multinationals entails
translating foreign asset]s and liabilities or the financial statements of foreign subsidiary
/subsidiaries from foreign to domestic currency. While translation exposure may not affect a
firm's cash flows, it could have a significant impact on a firm's reported earnings and
therefore its stock price. Translation exposure is distinguished from transaction risk as a
result of income and losses from various types of risk having different accounting treatments.
3.8 HEDGING TECHNIQUES
In simple language, a hedge is a technique used to reduce any substantial losses/gains
suffered by an individual or an organization.
A hedge is an investment position intended to offset potential losses/gains that may
be incurred by a companion investment.
A hedge can be constructed from many types of financial instruments,
including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many
types of over-the-counter and derivative products, and futures contracts.
A risk
management
strategy
used
in
limiting
or
offsetting probability of loss from fluctuations in
the prices of commodities, currencies,
or securities. In effect, hedging is a transfer of risk without buying insurance policies.
3.8.1 Definition of 'Spread'
The difference between the bid and the ask price of a security or asset.
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The spread for an asset is influenced by a number of factors:
a) Supply or "float" (the total number of shares outstanding that are available to trade)
b) Demand or interest in a stock
c) Total trading activity of the stock
Therefore, currencies are quoted in terms of their price in another currency.
In order to express this information easily, currencies are always quoted in pairs (e.g.
USD/CAD). The first currency is called the base currency and the second currency is called
the counter or quote currency (base/quote). For example, if it took C$1.20 to buy US$1, the
expression USD/CAD would equal 1.2/1 or 1.2. The USD would be the base currency and the
CAD would be the quote or counter currency.
Now that we know how currencies are quoted in the marketplace, let's look at how we
can calculate their spread. Forex quotes are always provided with bid and ask prices, similar
to what you see in the equity markets. The bid represents the price at which the forex market
maker is willing to buy the base currency (USD in our example) in exchange for the counter
currency (CAD). Conversely, the ask price is the price at which the forex market maker is
willing to sell the base currency in exchange for the counter currency. Forex prices are
always quoted using five numbers; so, for this example, let's say we had a USD/CAD bid
price of 120.00 and an ask of 120.05. Thus, the spread would be equal to 0.05, or $0.0005.
3.8.2 Strike Price
The price at which a specific derivative contract can be exercised is called as Strike
price. Strike price is mostly used to describe stock and index options, in which strike prices
are fixed in the contract. For call options, the strike price is where the security can be bought
(up to the expiration date), while for put options the strike price is the price at which shares
can be sold.
The difference between the underlying security's current market price and the option's
strike price represents the amount of profit per share gained upon the exercise or the sale of
the option. This is true for options that are in the money; the maximum amount that can be
lost is the premium paid. finance, the strike price (or exercise price) of an option is the fixed
price at which the owner of the option can buy (in the case of a call), or sell (in the case of
a put), the underlying security or commodity.
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3.8.3 Hedging Techniques Types
Two types of Hedging techniques are
1. Internal Techniques
2. External techniques
HEDGING TECHNIQUES
External Techniques
Internal Techniques
1.
2.
3.
4.
5.
1. Pricing Policy
2. Netting:
3. Leading and
lagging
4. Shifting the
manufacturing
base
5. Swaps
6. Centre for
re-invoicing.
Forward Market
Future Market
Currency Options
Swaps
Foreign debt
3.8.3.1 INTERNAL TECHNIQUES
Sometimes known as commercial or natural, these techniques are within the internal
management control of the company.
Pricing:
Pricing of the product should be done in the currency in which the majority of the
costs are incurred i.e. n the domestic currency of the main competitors, so that comparative
prices are less affected by exchange rate variations.
In order to manage foreign exchange risk exposure, there are two types of pricing
tactics: price variation and currency of invoicing policy. One way for companies to protect
themselves against exchange risk is to increase selling prices to offset the adverse effects of
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exchange rate fluctuations. Selling price requires the analysis of Competitive situation,
Customer credibility, Price controls and Internal delays.
Matching:

Setting up an equal and opposite commercial transaction when the original exposure is
created—for example, using the currency receivable to buy a commodity used by the
business.

Borrow in the same currency as that needed to complete the asset purchase.
The netting is typically used only for inter company flows arising out of groups receipts
and
payments. As such, it is applicable only to the operations of a multinational company
rather than exporters or importers. In contrast, matching applies to both third parties as well
inter-company cash flows. It can be used by the exporter/importer as well as the multinational
company. It refers to the process in which a company matches its currency inflows with its
currency outflows with respect to amount and timing. Receipts generated in a particular
currency are used to make payments in that currency and hence, it reduces the need to hedge
foreign exchange risk exposure. Hedging is required for unmatched portion of foreign
currency cash flows. The aggressive company may decide to take forward cover on its
currency payables and leave the currency receivables exposed to exchange risk; if forward
rate looks cheaper than the expected spot rate.
In matching operation, the basic requirement is a two-way cash flow in the same foreign
currency. This kind of operation is referred to as natural matching. Parallel matching is
another possibility. In parallel matching, gains in one foreign currency are expected to be
offset by losses in another, if the movements in two currencies are parallel. In parallel
matching, there is always the risk that if the exchange rates move in opposite direction to
expectations, both sides of the parallel match leads to exchange losses or gains.
Netting:
A partial alternative to matching—a net amount is still left exposed, but the overall
risk is reduced.
Netting implies offsetting exposures in one currency with exposure in the same or
another currency, where exchange rates are expected to move high in such a way that losses
or gains on the first exposed position should be offset by gains or losses on the second
currency exposure. It is of two types bilateral netting & multilateral netting. In bilateral
netting, each pair of subsidiaries nets out their own positions with each other. Flows are
reduced by the lower of each company’s purchases from or sales to its netting partner.
Leading and lagging:
Simply, either delaying payment, or settling early, in anticipation of falling or
rising exchange rates. Safe, and simple to manage, but there is a reliance on the accuracy of a
forecast.
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It refers to the adjustment of intercompany credit terms, leading means a prepayment of a
trade obligation and lagging means a delayed payment. It is basically intercompany
technique whereas netting and matching are purely defensive measures. Intercompany
leading and lagging is a part of risk-minimizing strategy or an aggressive strategy that
maximizes expected exchange gains. Leading and lagging requires a lot of discipline on the
part of participating subsidiaries. Multinational companies which make extensive use of
leading and lagging may either evaluate subsidiary performance in a pre-interest basis or
include interest charges and credits to overcome evaluation problem.
Another important complicating factor in leading & lagging is the existence of local
minority interests. If there are powerful local shareholders in the ‘losing’ subsidiary, there
will be strong objections because of the added interest cost and lower profitability which
results from the consequent local borrowing Government by implementing credit and
exchange controls may restrict such operations.
Intercompany payment discipline:

Intercompany payables and receivables are real exposure and should be ranked equally for
settlement with external liabilities.
There is no canceling gain or loss situation within a group. When the transaction interacts
with the market there will be a gain or a loss—and it will be real.
3.8.3.2 EXTERNAL TECHNIQUES
External techniques involve the use of external contracts. Companies purchase or sell
forward contracts, options, swaps, futures, etc. in order to protect themselves against the
exchange rate risk. External techniques insure against the possibility of exchange losses
which will occur from an exposed position which internal measures have not been able to
eliminate.
Forwards:A forward is a made-to-measure agreement between two parties to buy/sell a specified
amount of a currency at a specified rate on a particular date in the future. The Depreciation of
the receivable currency is hedged against by selling a currency forward. If the risk is that of a
currency appreciation (if the firm has to buy that currency in future say for import), it can
hedge by buying the currency forward.
Futures:A futures contract is similar to the forward contract but is more liquid because it is
traded in an organized exchange i.e. the futures market.
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Depreciation of a currency can be hedged by selling futures and appreciation can be
hedged by buying futures.
Advantages of futures are that there is a central market for futures which eliminates
the problem of double coincidence
Options:A currency Option is a contract giving the right, not the obligation, to buy or sell a
specific quantity of one foreign currency in exchange for another at a fixed price; called the
Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty
of exchange rate changes and limits the losses of open currency positions. Options are
particularly suited as a hedging tool for contingent cash flows, as is the case in bidding
processes. Call Options are used if the risk is an upward trend in price (of the currency),
while Put Options are used if the risk is a downward trend
An option is the right, but not the obligation, to exchange a fixed amount of one
currency for a fixed amount of another within, or at the end of, a predetermined period. In
effect, it is a forward contract that can be walked away from, where you lose only the cost of
the option, which could be 3–5% of the contract value. It therefore has the advantage of
limiting the downside, as the maximum cost is known at the beginning, while leaving
unlimited profit potential. These options are ideally suited to translations, where the size or
existence of the exposure is uncertain, for example tender-to-contract or price list exposures.
Illustration: A quantity of a commodity (or currency to pay for it) is needed in three months’
time. A dealer is willing to accept US$100 per ton to supply a predetermined quantity at
US$2,000 per ton. If the price of this commodity in three months’ time is US$1,700 per ton,
then the option would be thrown away, the product bought in the spot market, and the cost to
the company would be US$1,800 per ton. The tender-to-contract or price list item would have
been safeguarded, and the price could even be reduced by US$200 per ton if competitive
conditions demanded. If the price of the commodity rose, the cost to the company would be
contained. The option could be sold at a profit if the product was not needed, or the loss
would in any event be limited to US$100 per ton.
There are two types of option:
 Calls—giving the right to buy a currency;
 Puts—giving the right to sell a currency.
Currency Options
The exchange rate (known as the strike price) and the expiry date of the option are
chosen by the customer at the outset. The cost (known as the premium) of the option is
calculated based on these decisions and the volatility of the currency involved. Options can
be exchange-traded where they exist in standardized form, or bought over the counter, where
they are written to fit a customer’s particular circumstances.
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There are two styles of option:

American option. The buyer can exercise the option (make the exchange of currencies) at
any time up to the expiry date.

European option. This can be exercised on the expiry date only, and is slightly cheaper
because of its lack of flexibility.
Options may have a resale value, determined by the same criteria as the original cost.
When the exercise price of an option is better than the current spot exchange rate, it is called
“in the money”; when it is the other way round, it is “out of the money.”
Swaps:
A swap is a foreign currency contract whereby the buyer and seller exchange
equal initial principal amounts of two different currencies at the spot rate. The buyer and
seller exchange fixed or floating rate interest payments in their respective swapped currencies
over the term of the contract. At maturity, the principal amount is effectively re-swapped at a
predetermined exchange rate so that the parties end up with their original currencies.
 Swap is essentially an exchange of two – transactions. It is an important instrument
for hedging for foreign exchange transactions in which two streams of payments are
exchanged.
Example:
Deposit US $ 1 million
Spot rate of DM 1.4/US$
American Company
Bank
Variable Interest rate
Borrow 1.4 million
American Company
Bank
Fixed rate of interest
Will be re-exchanged for the principal amount
DM 1.4 Million
American Company
Bank
$ 1 million
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Instruments
Description
Pros
Cons
Forwards
An almost custom-made contract to
buy or sell foreign-exchange in the
future, at a presently specified price.
Maturity and size of
contract can be determined
individually to almost
exactly hedge the desired
position.
Use up bank credit lines
even when two forward
contracts exactly offset
each other.
Futures
A ready-made contract to buy or sell
foreign exchange in the future, at a
presently specified price. Unlike
forwards, futures have a few
maturity dates per year. The most
common contracts have maturity
dates in March, June, September, or
December. But, these contracts are
almost continuously traded on
organised exchanges. Contracts sizes
are fixed.
No credit lines required.
Easy access for small
accounts. Fairly low margin
requirements. Contract’s
liquidity guaranteed by the
exchange on which it is
traded.
Margin requirements
cause cash-flow
uncertainty and use
managerial resources.
Options
A contract that offers the right but
not the obligation to buy or sell
foreign exchange in the future, at a
presently specified price. Unlike
forwards and futures, options do not
have to be exercised. Available on
an almost custom-made basis from
banks or in ready-made form on
exchanges.
Allow hedging of
contingent exposures and
taking positions while
limiting downside risk and
retaining upside potential
for profit. Also permit
trade-offs other than risk
versus expected return.
Since an option is like
insurance coupled with
an investment
opportunity, its benefits
are not readily
observable, leading
some to conclude that it
is “too expensive”
Swaps
An agreement to exchange one
currency for another at specific dates
and prices. Essentially, a swap is a
series of forward contracts.
Versatile, allowing easy
hedging of complex
exposures.
Documentation
requirement might be
extensive.
Foreign Debt:-Foreign debt can be used to hedge foreign exchange exposure by taking
advantage of the International Fischer Effect relationship.
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3.8.4 DIFFERENCE BETWEEN FORWARD AND FUTURE MARKET
Forward contracts, on the other hand, do not have such mechanisms in place. Since
forwards are only settled at the time of delivery, the profit or loss on a forward contract is
only realized at the time of settlement, so the credit exposure can keep increasing. Hence, a
loss resulting from a default is much greater for participants in a forward contract.
Futures market
Exchange traded Market and Futures
contracts are highly standardized
Futures contracts have clearing
houses that guarantee the transactions,
which drastically lowers the probability
of default to almost never
Futures contracts are marked-tomarket daily, which means that daily
changes are settled day by day until the
end of the contract.
Settlement for futures contracts can
occur over a range of dates.
Forward Market
Private agreements between two parties and
are not as rigid in their stated terms and
conditions.
Forward contracts are private agreements,
there is always a chance that a party
may default on its side of the agreement.
Forward contracts, settlement of the
contract occurs at the end of the contract.
Forward contracts, on the other hand, only
possess one settlement date or at the time of
delivery, so the profit or loss on a forward
contract is only realized at the time of
settlement.
Guarantee deposit
Contract with Clearing House
Quotation on market
Commission or brokerage
Frequently employed by speculators,
who bet on the direction in which an
asset's price will move, they are usually
closed out prior to maturity and delivery
usually never happens.
No guarantee deposit
Contract with a bank
Quotation by a bank
Quoted rate (spread between buying and
selling rates)
Hedgers
that
want
to
eliminate
the volatility of an asset's price, and delivery
of the asset or cash settlement will usually
take place.
Option Contract Specifications
The following terms are specified in an option contract.
Option Class
The two classes of stock options are puts and calls. Call options confers the buyer the right
to buy the underlying stock while put options give him the rights to sell them.
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Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the
option is exercised. It's relation to the market value of the underlying asset affects
the moneyness of the option and is a major determinant of the option's premium.
Premium
In exchange for the rights conferred by the option, the option buyer have to pay the option
seller a premium for carrying on the risk that comes with the obligation. The option
premium depends on the strike price, volatility of the underlying, as well as the time
remaining to expiration.
Expiration Date
Option contracts are wasting assets and all options expire after a period of time. Once the
stock option expires, the right to exercise no longer exists and the stock option becomes
worthless. The expiration month is specified for each option contract. The specific date on
which expiration occurs depends on the type of option. For instance, stock options listed in
the United States expire on the third Friday of the expiration month.
Option Style
An option contract can be either american style or european style. The manner in which
options can be exercised also depends on the style of the option. American style options can
be exercised anytime before expiration while european style options can only be exercise on
expiration date itself. All of the stock options currently traded in the marketplaces are
american-style options.
Underlying Asset
The underlying asset is the security which the option seller has the obligation to deliver to or
purchase from the option holder in the event the option is exercised. In the case of stock
options, the underlying asset refers to the shares of a specific company. Options are also
available for other types of securities such as currencies, indices and commodities.
Contract Multiplier
The contract multiplier states the quantity of the underlying asset that needs to be delivered in
the event the option is exercised. For stock options, each contract covers 100 shares.
3.9 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA), 1999
The Foreign Exchange Management Act (FEMA), 1999 replaced the Foreign
Exchange Regulation Act (FERA), 1973 which regulated the foreign exchange transactions in
India and which sought to control certain aspects of the conduct of business outside the
country by Indian companies and in India by foreign companies.
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The FEMA, which came into effect from 1st January, 2000 extends to the whole of
India and also applies to all branches, offices, and agencies outside India, owned or
controlled by a person resident in India.
Foreign Exchange Management Act or in short (FEMA) is an act that provides
guidelines for the free flow of foreign exchange in India. It has brought a new management
regime of foreign exchange consistent with the emerging frame work of the World Trade
Organisation (WTO). Foreign Exchange Management Act was earlier known as FERA
(Foreign Exchange Regulation Act), which has been found to be unsuccessful with the
proliberalisation policies of the Government of India.
FEMA is applicable in all over India and even branches, offices and agencies located
outside India, if it belongs to a person who is a resident of India.
3.9.1 Objectives of FEMA
1. To facilitate external trade and payments.
2. To promote the orderly development and maintenance of foreign exchange market.
3.9.2 Scope of FEMA
FEMA provides
1. Free transactions on current account subject to reasonable restrictions that may be
imposed.
2. RBI controls over capital account transactions.
3. Control over realization of export proceeds.
4. Dealing in foreign exchange through authorized persons like authorized dealer/money
changer / off shore banking unit.
3.9.3 Highlights of FEMA

It prohibits foreign exchange dealing undertaken other than an authorised person;

It also makes it clear that if any person residing in India, received any Forex payment
(without there being a corresponding inward remittance from abroad) the concerned
person shall be deemed to have received they payment from a nonauthorised person.
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

There are 7 types of current account transactions, which are totally prohibited, and
therefore no transaction can be undertaken relating to them. These include transaction
relating to lotteries, football pools, banned magazines and a few others.
FEMA and the related rules give full freedom to Resident of India (ROI) to hold or
own or transfer any foreign security or immovable property situated outside India.

Similar freedom is also given to a resident who inherits such security or immovable
property from an ROI.

An ROI is permitted to hold shares, securities and properties acquired by him while
he was a Resident or inherited such properties from a Resident.

The exchange drawn can also be used for purpose other than for which it is drawn
provided drawl of exchange is otherwise permitted for such purpose.

Certain prescribed limits have been substantially enhanced. For instance, residence
now going abroad for business purpose or for participating in conferences seminars
will not need the RBI's permission to avail foreign exchange up to US$. 25,000 per
trip irrespective of the period of stay, basic travel quota has been increased from the
existing US$ 3,000 to US$ 5,000 per calendar year.
FEMA regulations have an immense impact in international trade transactions and
different modes of payments.RBI release regular notifications and circulars, outlining its
clarifications and modifications related to various sections of FEMA.
3.9.4 Applicability of FEMA
The Foreign Exchange Management Act, 1999 was enacted to consolidate and amend
the law relating to foreign exchange with the objective of facilitating external trade and for
promoting the orderly development and maintenance of foreign exchange market in India.
 FEMA extends to the whole of India.
 The Act also applies to all branches, offices and agencies outside India owned or
controlled by a person resident in India, and also to any contravention committed
there under outside India by any person to whom this Act is applies.
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Overall Structure
The overall structure of Foreign Exchange Management Act, 1999 is covered by
legislations rules and regulations. These legislations, rules and regulations relating to Foreign
Exchange Management Act, 1999 can be divided in to the following.
1. FEMA contains 7 chapters divided into 49 sections (Supreme Legislation)
2. 5 sets of Rules made by Ministry under section 46 of FEMA. (Delegated legislations)
3. 23 sets of regulations made by RBI under section 47 of FEMA (Subordinate
Legislations).
4. Master circular issued by RBI every year.
5. Foreign Direct Investment (FDI) policy issued by Department of Industrial policy and
Promotion (DIPP) time to time.
6. Notifications and circulars issued by RBI.
7. Enforcement Directorate.
FEMA contains 7 chapters divided into 49 sections of which 12 sections cover
operational part and the rest 37 sections deal with contraventions, penalties, adjudication,
appeals, enforcement directions, etc.
 FEMA makes provisions for dealings in foreign exchanges.
 The capital account transactions will be regulated by RBI/Central Government for
which necessary circulars/notifications will have to be issued under FFEMA.
 All chapters of FEMA divided into 49 sections. Besides the FEMA, there are 5 rules
and 23 regulations under the Act which help in implementation of the act are
classified here:
Chapter I: Preliminary (Section 1&2)
Chapter II: Regulation and Management of Foreign Exchange (Section 3-9)
Chapter III: Authorized Person (Section 10-12)
Chapter IV: Contraventions and Penalties (Section 13-15)
Chapter V: Adjudication and Appeal (Section 16-35)
Chapter VI: Directorate of Enforcement (Section 36-38)
Chapter VII: Miscellaneous (Section 39-49)
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3.9.5 Authorities responsible for various aspect of FEMA
1. Enforcement Directorate:
They are responsible to investigate provisions of the Act, the Central Government,
have established the Directorate of Enforcement with Directors and other officers as officers
of the Enforcement.
2. Adjudicating Authorities
The Adjudicating Authorities will issue a notice to the person who has contravened
the provisions of the Foreign Exchange Management Act, Rules, Regulations, Notificatons or
any directions issued by the RBI.
3. Special Director (Appeals)
Any person aggrieved by an order made by the Adjudicating authority, being an
Assistant Director of Enforcement or a Deputy Director of Enforcement can prefer an appeal
to the special Director (Appeals).
4. Appellate Tribunal
Any person aggrieved by an order made by the adjudicating Authority, or the special
director (appeals) can prefer an appeal to the Appellate Tribunal.
3.9.6 Distinguish between FERA and FEMA.
FERA
1. FERA means Foreign Exchange
Regulation Act.
FEMA
FEMA means Foreign Exchange
Management Act.
2. RBI’s permission was necessary in
RBI’s permission is necessary only for
Section 3.
respect of most of the regulations.
3. Any person who contravenes
Any person who contravenes is liable to
penalty but not imprisonment.
Dealings with Non-residents have been
substantially diluted.
FERA is subject to penalty and
imprisonment.
4. All transactions with Non-residents
were prohibited.
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3.10 DETERMINANTS OF EXCHANGE RATE
The rate of exchange in the foreign exchange market will be determined by the
interaction between the demand for foreign exchange and the supply of foreign exchange.
Exchange Rate Equilibrium
 Forces of demand and supply together determine the exchange rate
 Demand for foreign currency
 Supply of foreign currency
Changes in Exchange Rates

Exchange rates (e) are a function of the supply and demand for currency.

An increase in the supply of a currency (US$) will decrease the exchange rate
of a currency ((US$).

A decrease in supply of a currency will increase the exchange rate of a
currency.

An increase in demand for a currency will increase the exchange rate of a
currency.

A decrease in demand for a currency will decrease the exchange rate of a
currency.
Supply of Dollars (The Demand for Rupees )
1. Firms, households, or governments that import Indian goods into the United States or
want to buy British-made goods and services.
2. U.S. citizens traveling in India.
3. Holders of dollars who want to buy Indian stocks, bonds, or other financial
instruments.
4. U.S. companies that want to invest in India.
5. Speculators who anticipate a decline in the value of the dollar relative to the Indian
Rupee.
The Demand for Dollars (Supply of Rupees)
1. Firms, households, or governments that import U.S. goods into India or want to buy U.S.made goods and services
2. Indian citizens traveling in the United States
3. Holders of Rupees who want to buy stocks, bonds, or other financial instruments in the
United States
4. Indian companies that want to invest in the United States
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5. Speculators who anticipate a rise in the value of the dollar relative to the Indian Rupee.
The Equilibrium Exchange Rate
When exchange rates are allowed to float, they are determined by the forces of supply
and demand.
 An excess demand for rupees will cause the rupee to appreciate against the dollar.
 An excess supply of rupees will lead to a depreciate rupees against the dollar.
3.10.1 EXCHANGE RATE DETERMINANTS:
•
Exchange rate changes
•
Reactions of traders in the foreign-exchange market to changes in
 Relative price levels
 Relative productivity levels
 Consumer preferences for domestic or foreign goods
 Trade barriers
Relative
price
levels
Trade
barriers
Determin
ants of
Exchang
e rate
Relative
productivity
levels
Consumer
preferences for
domestic or
foreign goods
Determinants of the dollar’s exchange rate in the long term
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•
Increase in the U.S. price level relative to price levels in other countries
•
Increase in the demand for foreign currency.
•
Decrease in the supply of foreign currency
•
Depreciation of the dollar
Market fundamentals that affect the dollar’s exchange rate in the long term (a)
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In the long term, the exchange rate between the dollar and the pound reflects relative price
levels, relative productivity levels, preferences for domestic or foreign goods, and trade
barriers.
•
U.S. productivity growth is faster than that of other countries
•
•
•
Increase in the supply of foreign currency
Decrease in the demand for foreign currency
Appreciation of the dollar
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Market fundamentals that affect the dollar’s exchange rate in the long term (b)
In the long term, the exchange rate between the dollar and the pound reflects relative price
levels, relative productivity levels, preferences for domestic or foreign goods, and trade
barriers.
Determining Long-Term Exchange Rates
•
An increased demand for U.S. exports
• Appreciation of the dollar
• An increased demand for U.S. imports
• Depreciation of the dollar
• U.S. imposes trade barriers
• Appreciation of the dollar
Market fundamentals that affect the dollar’s exchange rate in the long term (c)
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In the long term, the exchange rate between the dollar and the pound reflects relative price
levels, relative productivity levels, preferences for domestic or foreign goods, and trade
barriers.
Market fundamentals that affect the dollar’s exchange rate in the long term (d)
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In the long term, the exchange rate between the dollar and the pound reflects relative
price levels, relative productivity levels, preferences for domestic or foreign goods, and trade
barriers.
Purchasing Power Parity: The Law of One Price
The higher price level in India makes imports relatively less expensive.
Indian citizens are likely to increase their spending on imports from US, shifting the demand
for US Dollar to the right, from D0 to D1.
At the same time, the U.S. people see Indian goods getting more expensive and reduce their
demand for Indian goods stop imports from India.
The supply of US $ Dollar shifts to the left, from S0 to S1. The result is an increase in the
price of Dollar. The dollar appreciates, and the Indian rupee is worth less.
Price of Rupee/US Dollar
S1
S0
Rs.68/$
Rs.60/$
D1
D0
0
INR
Quantity of US Dollar
Relative Interest Rates
If U.S. interest rates rise relative to British interest rates, British citizens holding pounds may
be attracted into the U.S. securities market. To buy bonds in the United States, British buyers
must exchange pounds for dollars.
The supply of pounds shifts to the right, from S0 to S1. However, U.S. citizens are less likely
to be interested in British securities because interest rates are higher at home. The demand
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for pounds shifts to the left, from D0 to D1. The result is a depreciated pound and a stronger
dollar.
•
•
•
If interest rates in U.S. > interest rates abroad
•
Increase in the demand for dollars
•
Dollar appreciation
If interest rates in U.S. < interest rates abroad
•
Decrease in the demand for dollars
•
Dollar depreciation
Real interest rate
•
Nominal interest rate minus the inflation rate
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In the short term, the exchange rate between the dollar and the pound reflects relative interest
rates and expected changes in the exchange rate.
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3.10.2 Determining Short-Term Exchange Rates:
The Asset-Market Approach
•
Expected change in the exchange rate
•
Future expectations of an appreciation of the dollar can be self-fulfilling for today’s
value of the dollar
Factors affecting the dollar’s exchange rate in the short term (b)
In the short term, the exchange rate between the dollar and the pound reflects relative interest
rates and expected changes in the exchange rate.
Other factors affecting investment flows among economies
•
Size of the stock of assets denominated in a particular currency in investor
portfolios
•
Significant safe-haven effect behind some investment flows
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3.10.3 The Ups and Downs of the Dollar
•
•
•
•
•
•
The 1980s, appreciation and then depreciation
• 1979, dollar appreciation
• Sharp tightening of monetary policy
• Reagan administration - sizable tax cuts along with increased
government spending
• Peak in1985
The 1980s, appreciation and then depreciation
• Second half of the 1980s, dollar depreciation
• Speculators – expected dollar depreciation
• Sizable currency interventions aimed at weakening an overvalued
dollar
• Expansionary monetary policy
• Fiscal policy - to reduce the size of budget deficits
The 1990s
• Weakening economy, recession in 1991
• Expansionary monetary policy
• Fiscal policy - increased government spending and dampened tax
receipts
• Dollar depreciation
The 1990s
• Mid-1990s, the U.S. economy was growing rapidly
• Sharp increase in the pace of investment spending by business
• Market acceleration in productivity growth
• Strong consumer demand
• Deregulation; Trade liberalization; Computer era
• Declining rate of inflation
• Dollar appreciation
First decade of the 2000s
• 2002-2004, depreciation of the dollar
• Weakening of the demand for dollar-denominated assets
• Recession in the U.S. in 2001
• Declining stock market
• Uncertainty about corporate accounting practices
• Steady decline in interest rates
• Uncertainty due to the ongoing war on terrorism and the war with Iraq
First decade of the 2000s
• By 2005, dollar appreciation
• Current and prospective strong performance of the U.S. economy
• Restrictive monetary policy – higher interest rates
• 2006–2007, weakening dollar
• Slackening of private investment flows
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•
•
By 2008, stronger dollar
• U.S. - safe haven; economic crisis of 2007–2008
2009, weakening dollar
3.10.4 THE DETERMINANTS OF FOREIGN EXCHANGE RATES - THEORIES
Purchasing Power Parity Approach
•
PPP is the oldest and most widely followed of the exchange rate theories
•
PPP is embedded within most theories of exchange rate determination
•
PPP calculations and forecasts have structural differences across countries and significant
data challenges in estimation
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Balance of Payments (Flows) Approach
•
Essentially BOP approach says equilibrium exchange rate is achieved when current account
inflows match current account outflows
•
BOP transactions are widely appealing, captured, and reported
•
Criticism of the BOP approach is that it focuses on flows rather than stocks of money or
financial assets
•
Relative stocks of money or financial assets do not play a role in the theory
•
Practitioners use BOP but academics largely dismiss it
Monetary Approaches
•
Changes in supply and demand for money largely determine inflation which in turn alter
exchange rates
•
Prices are flexible in both the short and long-run thus, the transmission impact is immediate
•
Real economic activity influences exchange rates through any alterations in demand for
money
•
Omits a number of important factors for exchange rate determination including:
•
–
The failure of PPP to hold in the short to medium term
–
Money demand appears to be relatively unstable over time
–
The level of economic activity and the money supply do not appear to be independent
Do to these significant omissions the authors choose to ignore this approach
Asset Market Approach
•
AKA relative price of bonds or portfolio balance approach
•
argues that exchange rates are determined by supply and demand for a wide variety of assets
–
Shifts in supply and demand alter exchange rates
–
Changes in monetary and fiscal policy alter expectations and thus exchange rates
–
Theories of currency substitution follow the same basis premises of portfolio
rebalance framework
•
The Asset market approach assumes that whether foreigners are willing to hold claims in
monetary form depends on an extensive set of investment considerations or drivers (as per the
previous exhibit)
•
In highly developed countries, foreign investors are willing to hold securities and undertake
foreign direct investment based primarily on relative real interest rates and the outlook for
economic growth and profitability
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3.11 FORECASTING FOREIGN-EXCHANGE RATES
3.11.1 Forecasting exchange rates
•
•
Is very tricky, especially in the short term
Necessary for exporters, importers, investors, bankers, and foreign-exchange
dealers and Consulting firms
Exchange-rate forecasters
•
•
Judgmental forecasts
• Subjective or common sense models.
• Require
• Wide array of political and economic data
• Interpretation of these data in terms of the timing, direction, and
magnitude of exchange-rate changes
• Projections based on a thorough examination of individual nations
• Economic indicators; Political factors
• Technical factors; Psychological factors
Technical forecasts
• Technical analysis
• Use of historical exchange-rate data to estimate future values
• Ignoring economic and political determinants of exchange-rate movements
• “History repeats itself”
Technical analysis of the Yen’s exchange value
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When forecasting exchange rates, technical analysts watch for new highs and lows,
broken trend lines, and patterns that are thought to predict price targets and movement.
• Fundamental analysis
• The opposite of technical analysis
• Considerations of economic variables that are likely to affect the supply and
demand of a currency
• Computer-based econometric models
• For individual nations
• Attempt to incorporate the fundamental variables that underlie
exchange-rate movements
• Interest rates, balance of trade, productivity, inflation rates
• Limitations of econometric models used to forecast exchange rates
• Rely on predictions of key economic variables
• Factors affecting exchange rates that cannot easily be quantified
• Precise timing of a factor’s effect on a currency’s exchange rate may be
unclear
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3.11.2 Exchange Rate Forecasting in Practice
3.11.3 Forecasting in Practice
•
•
•
Decades of theoretical and empirical studies show that exchange rates do adhere to
the fundamental principles and theories outlined in the previous sections –
fundamentals do apply in the long term
Therefore, there is something of a fundamental equilibrium path for a currency’s
value
In the short term, a variety of random events, institutional frictions, and technical
factors may cause currency values to deviate significantly from their long term
fundamental path – this is sometimes referred to as noise
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3.12 IMPACT AND EFFECTS OF EXCHANGE RATE
Exchange rate means how much one currency is worth in terms of another currency.
If we can buy $ 1 with Rs. 46, the exchange rate of the two currencies
would be $1 = Rs. 46.
There are two types of exchange rate: Fixed and Floating. Some countries have
fixed exchange rate systems while some have floating. As the name suggests, the fixed
exchange rate doesn’t fluctuate because of government intervention. The floating exchange
rate on the other hand keeps on changing continuously just like the stock market. Thus the
government intervention is almost negligible.
In India, we have a Managed Floating Exchange Rate System. This means that the
Indian government intervenes only if the exchange rate seems to go out of hand by increasing
or reducing the money supply as the situation demands.
Rupee Appreciation & Rupee Depreciation (instead of using the word ‘currency’
we are using ‘rupee’ for the Indian context and explain the fluctuation with respect to
dollar). When rupee is said to be appreciating it means that our currency is gaining
strength and its value is increasing with respect to dollar. However, when rupee depreciates
it means our currency is getting weaker & its value is falling with respect to dollar. You
can understand it with the following example:
Suppose, currently, the exchange rate is Rs. 45 = $1,
10 months later, either of the following two cases can happen
Case1: The exchange rate is say Rs. 40 = $1. This means rupee has appreciated or gotten
stronger by approx 11% and you would be paying less to for a dollar
Case2: The exchange rate is at Rs. 50 = $1. This means rupee has depreciated or gotten
weaker by approx 11% and you end up paying more for a dollar.
Rupee’s appreciation or depreciation against the dollar depends on the change in demand and
supply for both the currencies. If the demand for rupee is comparatively high, rupee
appreciates; if low, it depreciates.
What factors drive the demand for a currency?’ They are:
o
Interest Rate: A demand for a currency is hugely dependent on the interest rate
differential between two countries. A country like India where int. rate is around 7-8%
experiences greater capital inflow as investors get better return than what they might get in
US. (with Interest rates of 2-3%). This results into rupee appreciation.
o
Inflation Rate: The demand for a country’s goods & services by the foreign buyers would be
more if the inflation rate is lower in that country compared to other countries. Higher demand
for goods & services would mean higher demand for that currency resulting in the
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appreciation of that currency. For instance if India’s inflation rate is lower than that of
Zimbabwe then the demand for our goods, services and currency would be higher than that
for Zimbabwe’s.
o
Export-Import: If a country is exporting more than its imports from other countries, then
this would mean higher demand for that currency, causing appreciation of that currency
against others.
o
Trading in currencies in the Forex market: The exchange rate fluctuates minute by minute
because of speculative trading in the Forex market.
Though trading in Forex market causes fluctuations in the exchange rate, over a period the
change is backed by the fundamental factors like the growth potential in the economy,
interest rate differential and the inflation rate existing in different countries.
In a manage floating exchange rate system like India the government purchases rupee in
exchange for the foreign currency to increase money supply in the economy which leads to
depreciation of the home currency. Conversely, it purchases foreign currency in exchange for
rupee to reduce the money supply in the economy leading to appreciation of the home
currency.
Impact on economy: Exchange rate fluctuation has a significant impact on the overall
economy of a country. Rupee appreciation against US dollar is an indication of the
strengthening of Indian economy with respect to US economy.
Impact on foreign investors: If a foreign investor invests in Indian stock market and even if
its value doesn’t change in 1 year, he’ll earn profit if rupee appreciates and make a loss if it
depreciates. You can understand this with an example:
Suppose an FII Invests Re. 1 Cr. in the Indian stock market and at an exchange rate of $1 =
Rs. 50. So, the amount invested is $200,000.
Suppose, after 1 year, even if the value of investment doesn’t appreciate the foreign investor
can earn a profit if the exchange rate has changed to $1 = Rs. 40 (Rupee appreciation)
If the investor sells his investment and converts the currency, he would get $ 250,000. So, he
would earn $ 50,000 as a profit thanks to a change in the exchange rate i.e. rupee appreciation
So, a continuously appreciating rupee would lead to greater investment by the FIIs.
Impact on industry/companies:
Appreciation of the rupee makes imports cheaper
and exports expensive.
So, it can spell good news for companies who rely on import of goods like heavy
machinery, technology, micro chips etc. According to reports by Associated Chambers of
Commerce and Industry of India (ASSOCHAM) sectors like Petro & Petro Products,
Drugs & Pharma and Engineering Goods which have import inputs of as much as 77%,
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19% and 21% respectively would stand to gain the most if rupee appreciates.They would
have to pay less for the imported raw materials which would increase their profit margins.
Similarly, a depreciating rupee makes
EXPORTS CHEAPER AND IMPORTS EXPENSIVE
So, it is welcome news for sectors like IT, Textiles, Hotel & Tourism etc. which
generates revenue mainly from exporting their products or services. Rupee depreciation
makes Indian goods & services cheaper for the foreign buyers thus leading to increase in
demand and higher revenue generation. The foreign tourist would find it cheaper to come to
India thus increasing the business of hotel, tours & travel companies.
Indian IT sector is dependent on foreign clients, especially US, for more than 70% of its
revenue. When an IT company gets a project from a client it pre-decides on the length of the
contract and the cost of the project. The contracts with US clients are usually quoted in
dollars term. So, the fluctuation in the exchange rate can bring a considerable difference in
the performance of a company.
Take the example of Infosys results between 2007 and 2008 to understand the impact that
the fluctuation in exchange rate can have on the performance of a company. The income of
Infosys, in 2008, increased by 34.1% to $ 3912 million but because of rupee appreciation of
11.2%, from Rs. 45.06 to Rs. 40, in rupee terms, its income increased only by 19%.
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“Every 1% movement in the Rupee against the US Dollar has an impact of approximately
50 basis points on operating margins” – Infosys Annual Report
However the IT sector does not just sit idle and let exchange rate play the spoil sport. It
undertakes various measures like hedging exchange risks using forward and future contracts.
This helps them in mitigating some of the loss due to exchange rate fluctuation but none the
less the impact is substantial.
Exchange rate is thus an important tool that can be used to analyze many key
industries like IT, Textiles etc. Fluctuating exchange rate has a significant impact on the
economy, industries, companies, foreign investors etc. Rupee appreciation is beneficial for
industries which rely heavily on imported inputs while depreciation of rupee is good news for
industries which are exporting majority of their production.
RBI’s INTERVENTION AND EXCHANGE RATE MANAGEMENT:In 1939, the Exchange Control Department of RBI was set up. In order to conserve
the scarce foreign exchange reserves, the Foreign Exchange Regulation Act (FERA) was
passed in 1947.
India adopted fixed exchange rate of IMF upto 1971, whereby the Indian Rupee
external par value was fixed. In 1973, FERA was amended and it came in force on January
1st, 1974. It gave wide powers to RBI to administer exchange control mechanism properly.
In 1992, RBI introduced LERMS (Liberalised Exchange Rate Management System)
Under LERMS a dual exchange rate was fixed. The 1993-94 Budget made Indian Rupee fully
convertible on trade account. LERMS was withdrawn. Developing countries allowed market
forces to determine the exchange rate. Under flexible exchange rate system, if demand for
foreign currency is more than that of its supply, foreign currency appreciates and domestic
currency depreciates and vice versa. To minimise the disadvantages of flexible exchange rate,
most of the developing countries including India have adopted the concept of managed
Flexible Exchange Rate (MFER).
Under MFER, the Central bank intervenes to bring stability in exchange rate. RBI’s
intervention involves purchase of foreign currency from market or release (sale) of foreign
currency in the market, to bring stability in exchange rates.
3.13 ROLE OF RBI IN FOREIGN EXCHANGE MARKET
The role of RBI in the foreign exchange market is revealed by the provisions of
FERA (1973).
Administrative Authority
The RBI is the administrative authority for exchange control in India. The RBI has
been given powers to issue licences to those who are involved in foreign exchange
transactions.
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Authorised Dealers
The RBI has appointed a number of authorised dealers. They are permitted to carry out ail
transactions involving foreign exchange. The above provision is laid down in Section 3 of
FERA.
Issue Of Directions
The 'Exchange Control Manual' contains all directions and procedures given by RBI to
authorised dealers from time to time.
Fixation Of Exchange Rates :The RBI has the responsibility of fixing the exchange value of home currency in
terms of other currencies. This rate is known as official rate of exchange. All authorised
dealers and money lenders are required to follow this rate strictly in all their foreign exchange
transactions.
Foreign Investments:Non-residents can make investments in India only after obtaining the necessary
permission from Central Government or RBI. Great investment opportunities are provided to
non-resident Indians.
Foreign Travel :Indian residents can get foreign exchange released from RBI upto a specified amount
for travelling abroad through proper application.
Import Trade
The RBI regulates import trade. Imports are permitted only against proper licenses.
The items of imports that can be imported freely are specified under Open General Licence.
Export Trade
The RBI controls export trade. Export of gold and jewellery are allowed only with
special permission from RBI.
Gold. Silver. Currency Notes Etc.
In recent years, the limits fixed for bringing gold, silver, currency notes etc. has
been relaxed considerably.
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Submission of Returns
All foreign exchange transactions made by authorised dealers must be reported to
RBI. This enables the RBI to have a close watch on foreign exchange dealings in India.
Thus, from above points we can say that RBI is the apex bank that intervens,
supervises, controls the foreign exchange markets in order to create an stable and active
exchange market.
3.14 Expected Questions – 16 marks
1.
2.
3.
4.
5.
Explain how Foreign Exchange rates are determined.
Explain and Illustrate the Purchasing Power Parity Theory.
Explain Forward, Futures and currency options and its uses.
Illustrate the impact and effects of exchange rates in the foreign trade.
Briefly explain the FEMA Act.
6. Explain RBI’s intervention in exchange rate management in India. (M.2011)
OR
“RBI is the apex body that intervenes and control foreign exchange in India”. Discuss. OR
How does RBI intervene in the foreign exchange market.
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http://study-material4u.blogspot.in/2012/07/chapter-19-rbis-intervention-and.html RBI
INTERNVNETION
http://stockshastra.moneyworks4me.com/basics-of-investing/exchange-rate-fluctuation-rupeeappreciation-impact-on-stock-markets/ - impact of exchange rate
http://study-material4u.blogspot.in/2012/07/chapter-19-rbis-intervention-and.html
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