Research Paper

on

Forex Market in India
Submitted By:
Amit Wadhwa Roll No. 60 PGDMFinance 8th September, 2009.

Under the Guidance of Prof. K.S. Ranjini In partial fulfillment of the requirement of Trimester IV of the course

Post Graduate Diploma in Management K.J. Somaiya Institute of Management Studies and Research

Batch: 2008-2010

.................................................................................................................................................................................................................................................................................................................................................................................................................................................... 8 Integration between foreign exchange and capital markets in India.................................................................................... 13 Value at Risk in forex market............................................................................................... 15 References .................................................................................................................... 14 The Way Ahead .................................................................................................................................................................................................................................................................... 3 Statement of need ........................................................................................................................................................................................ 6 Foreign Exchange Regulatory Regimes in India ........................................... 5 Where does India stand in global forex market?.................... 16 Page | 2 ........................................................................................ 6 Foreign exchange markets in India................................................ 3 What is special about the forex market ............................................................................................................................. 10 Relationship Between Exchange Rate and Stock Prices in India..........Index Introduction.................................................................................. 7 Determinants of exchange rate in india ...................................................................................................... 12 Forex derivatives in India................

but there are very few developed foreign exchange markets today. Honk Kong.Introduction: A forex market is a market that facilitates exchange of currencies. which forms a part of an international network of payments. The main reason for low volumes is the non convertibility of rupee on capital account. The Indian forex market is in its evolving stage. the market is described as thin with few players and low volumes unlike the global scenario. not even large government can completely control its directions. For each transaction of goods and services there is a corresponding currency transaction. It offers unparalleled personal and financial freedom to make money as well as lose it in no time. London is the forex capital of the world today and others are mostly centered around organized markets like New York. Zurich. India being one of the fastest growing economies of the world and its ambition to become a developed economy by 2020. Page | 3 . Statement of Need The foreign exchange market has gained a lot of importance in recent years and has become an essential part of every economy. The world is emerging as a global economy because of flow of goods. The increase in world trade and the lowering of capital controls have led to tremendous growth in the foreign exchange market over the years. Singapore etc. This research report will give insight about the evolution of the Indian forex market and the importance of forex market in a developing economy like India . This research report will help us understand the existing scenario of the Indian forex market and what changes will help it to become a developed forex market. it needs a developed forex market to back its economy. Tokyo. It is described as the „fairest market on earth‟ for it is so large that no one player. services and capital.

 Integration between foreign exchange and capital markets in India.  Structure of the Indian Foreign Exchange Market.  Suggestions that will help Improve the Indian forex market.The research paper will include:  Evolution of the Indian forex Market. Page | 4 .  Current scenario in the world forex market.

e. A common measure to express transaction costs is to calculate quoted spreads as the price difference between a buy (ask) and a sell ( bid) order for a currency rate relative to the mid-price. traders are located in offices of major commercial banks around the world and communicate using computer terminals. telephones and other information channels. We cannot designate any physical location where forex traders get together to exchange currencies. the forex market is certainly not a chaotic realm of lawlessness. Such quoted spreads in the forex inter-bank market can become as low as 0. Hence. Page | 5 . In fact ethical and professional standards are essential in an economic environment in which a single verbal agreement on a telephone can commit millions of dollars or euros.5 to 1. it is by far the world‟s largest financial market in terms of transaction volume. which reaches an average daily volume of approximately US$ 296 billion a day. First. Instead the forex market provides an example of private regulation. 0. Secondly.98 trillion a day. This is gigantic even in comparison to a very active equity market like the New York Stock Exchange. The international scope of the forex market implies the absence of any central regulatory authority. i. Rather.5 basis points (a basis point is 1% of 1%. These are some of the reasons why the forex market is known as the fairest market of the world. The forex market differs from other financial markets in a number of respects. The daily transaction volume in all currencies is estimated to amount to $3. Quoted spreads in equity markets tend to be 50 times larger even for the most liquid stocks. the forex market is also a market with extraordinarily low transaction costs.WHAT IS SPECIAL ABOUT THE FOREX MARKET? The forex market is special in a number of ways.0001) for the most liquid currency pairs. where market participants agree on a common set of rules governing transactions and their settlement.

WHERE DOES INDIA STAND IN GLOBAL FOREX MARKET? As per the BIS Triennial Survey on the global foreign exchange and derivatives market activity (2007). The importance of the exchange rate to the Indian economy has also been greater than ever before. foreign exchange markets have witnessed explosive growth in trading volume. in practice the rupee is one of most efficient “trackers” of the US dollar. the government is considering using part of these reserves to finance infrastructure investments in the country. There is no ready template available internationally that India could draw upon since most of the countries that have active currency futures markets are those which are relatively more convertible on the capital. While the government has explicitly adopted a flexible exchange rate regime. The rupee‟s deviations from Covered Interest Parity (with respect to the dollar) exhibit relatively long-lived swings. The OTC derivatives segment of the foreign exchange market has also increased significantly to register a daily average turnover of USD 24 billion. The introduction of currency futures last year has provided further depth and breadth to the market and fulfill the intended objective as an effective risk-management instrument. Apprehensions of capital flow-driven currency crisis have held India back from capital account convertibility though the debate continues. An inevitable side-effect of the Indian exchange rate policy has been the ballooning of foreign exchange reserves to well over a hundred billion dollars. Page | 6 . In an unprecedented move. the foreign exchange market in India has grown into the 16th largest market in the world in terms of total daily turnover which was US$34 billion in 2007. which is 17th largest among all countries. This is leading to an urge in all the market participants to leverage this significant milestone for skill development within as well as at a broader industry level. The daily turnover has increased to US$48 billion in 2007-08. FOREIGN EXCHANGE MARKETS IN INDIA Since the onset of liberalization.

1973. The control framework was essentially transaction based in terms of which all transaction in foreign exchange including those between residents and non residents were prohibited. Indian companies are looking to become global players. Foreign Exchange Regulation Act (FERA). 1947. Reform measures is external sectors . has also has also being put into effect to ensure convertibility on the current account. 1993. exchange rate of rupee was made market determined. with implementation of FEMA. the liberalization process has been underway for some time created a more competitive environment for Indian Industry vis-a-vis what existed earlier. These were put into more rigorous framework of controls through FERA. As evident from various economic indicators . A sequence of events started in the subsequent years generally followed by the recommendations made by different committees such as the high level committee on Balance of Payments under chairman Dr. a complex web of controls were imposed for all external transactions through a legislation i. 1973. Increasingly. This consistent approach has lent credibility to the liberalization process of both current and capital account transactions.FOREIGN EXCHANGE REGULATORY REGIMES IN INDIA: Soon after independence. Consequently the Indian companies have upgraded their technology and expanded to more efficient scales of production and refocused their activities to areas of competence. C. including dismantling of exchange control have been a contributor to this development. In 1994 India accepted article VIII of the Articles of Agreement of the International Monetary Fund in August 1994 and adopted current account convertibility.e. Page | 7 . In June 2000 a legal framework . In 1993. Severe restrictions on current account transactions had continued till mid-1990‟s when relaxations were made in the operations of FERA. unless specifically permitted. Rangarajan.

the impact of the differences between the cost of long-term and short-term liquidity are also included by introducing the difference between inter-bank call money rate and the bank rate. The determinants of exchange rate are discussed as follows: The Bank Rate: Changes in the bank rate indicate the monetary policy intentions of the RBI.DETERMINANTS OF EXCHANGE RATE IN INDIA In a floating exchange rate mechanism. an increase in the bank rate indicates a tight monetary policy. Five-period lag values point out any lag effect of the same on the exchange rate. Simultaneously. Page | 8 . there is a need to understand the determinants of foreign exchange rate under the shifting exchange rate policy in case of Indian economy. foreign exchange rate is determined much in the same way as the price of any commodity in a free market economy. Literature on similar studies for various economies. is an inspiration for the present work. Appreciation or depreciation of the domestic currency thus depends on the supply of foreign exchange reserves. especially developed economies. If such a change is unanticipated. data on bank rate are included. the increase in bank rate may also result in further tightening of the monetary policy by the RBI. A future appreciation of domestic currency is anticipated here. At the same time. which is necessary for lowering the inflation in the domestic economy as against the foreign economy. economic agents alter their expectations regarding the future monetary policy. central bank‟s policy intentions and differences in the interest yield on dated securities of the concerned economies. and is counter-reacted with an expectation that the bank rate will decline in future. This results in a depreciation of the domestic currency. To incorporate this effect. liquidity conditions in the economy as determined by money supply. On the contrary. causing an appreciation of the current exchange rate. Thus.

making a positive gain on capital in India possible. This is expected to result in a depreciation of the domestic currency. External Shocks: The concept of external shock affecting the exchange market can be explained by two real life examples. In spite of strong economic fundamentals. Liquidity The growth rates of broad money and foreign exchange reserves indicate increased liquidity in the economy. The first such shock relates to the month of December 1997. An anticipation of inflation due to increased liquidity and increase in the aggregate demand are two major causes behind such depreciation. there was a nominal depreciation of Page | 9 .Interest Yield Differentials: The relation between short-term and long-term interest yield differentials and exchange rate is complex. The market was driven by downside expectations created largely in the backwash of the currency turmoil in South. market sentiment weakened sharply during September 1997 to January 1998. The volatility in the exchange market and the swing in the market sentiments were reflected in the significant spurt in inter-bank and merchant turnover by November and December 1997 in relation to AprilJune 1997 levels. Such an increase in the liquidity is expected to cause depreciation in the exchange rate. Excess demand conditions reflected in the intensified spot merchant transactions too. An increase in the interest differential between domestic securities and foreign securities indicates a rise in the gain from capital inflows into the economy. Profit taking by FIIs on the stock exchanges added to the pressure on the rupee in November. if inflation in India exceeds the inflation in the US. Over the quarter October-December 1997.East Asia and political developments within the country. The nominal interest differential reflects both the real interest differential and the inflation differential. The inverse relation between the exchange rate and nominal interest differential is due to the inflation differential. However. Thus. which often results in appreciation of the domestic currency. an increase in the foreign exchange reserves also implies an increase in the supply of foreign currency. the nominal interest differential is positive.

under-developed secondary markets for Page | 10 . as impulses in one market get reflected quickly in other markets. In fact.the spot exchange rate by about 7. this has been a precondition for „inflation targeting approach‟. efficient and integrated financial markets is being increasingly being stressed. The development of deep and integrated financial markets. Prior to 1990s. Another major shock was felt in April 2007. when the rupee appreciated by almost 4.3 per cent in the month of December alone. Indian financial system was full of substantial structural rigidities and was under sever administrative control. therefore.3 per cent. This was mainly due to strong domestic economic growth vis-à-vis moderating of the US economy during the previous two years. robust growth in the euro area and narrowing interest differentials. this refers to a market condition that reduces arbitrage opportunities and also helps investors to diversify their portfolio across different markets (and hence reduce risk exposures). transmission mechanism of monetary policy becomes smooth and speedy and thus policy intervention becomes more effective in bringing fruits in desired direction within specified time horizon. has been emphasized by monetary policy makers in modern days. thin foreign exchange market and prevailing fixed exchange rate mechanism. An economist considers one such development as a facilitator of savings.6 per cent. Large capital inflows due to increasing investor interest. investment and consequent economic growth. to function credibly and effectively. under such development. a new paradigm of monetary policy. In finance theory. dampening crude oil prices in the world market and depreciation in dollar against other currencies further added to appreciation of the rupee. Moreover. and the value of rupee eroded by more than 5. INTEGRATION BETWEEN FOREIGN EXCHANGE AND CAPITAL MARKETS IN INDIA There have been several reasons that the need for well-developed. Administered interest rate structure.

In view of above. lack of adequate depth of money and capital markets. Though some recent studies have investigated related issues. improving market depth/conditions. Gradual move towards full convertibility of Indian Rupee has had an impact in the Indian capital market as international investors have invested substantial amount (about US $15 billion) in Indian capital market. strengthening institutional and regulatory framework and so on. and also inadequate institutional arrangements/framework are a few characteristics of the financial sector. the concerned authority. took place).  Allowing Indian Rupee to be determined by market forces (though at times market intervention by Reserve Bank of India. One of the major objectives of the economic reforms that have been initiated in India since 1991. Accordingly. Indian equity market has continued to grow and has seen the relaxation of foreign investment restrictions primarily through country deregulation. in phases. therefore.  The two-way fungibility of ADRs/GDRs allowed by RBI has also possibly strengthened the linkages between the stock and foreign exchange markets in India. has been development of financial markets into an integrated one. towards innovations of new financial instruments. like other Asian emerging economies. it is believed that Indian financial system has achieved the international standard in its market practices. which had resulted into substantial amount of segmentation of financial markets during those years. NASDAQ or on nonAmerican exchanges.  The issuance of American Depository Receipts (ADR‟s) or General Depository Receipts (GDR‟s) has facilitated the trade of foreign securities on the NYSE. several policy measures have been taken. the extent of financial markets integration in the liberalization era needs to be scrutinized empirically. Some of the specific developments that have taken place during the reforms process and might have impacted on the extent of financial markets integration are:  Dismantling of various price and non-price controls in financial markets.government securities. Now. further Page | 11 .

however.research on the subject is needed primarily because the Indian economy is still passing through a transition phase and impact of reform measures initiated in different phases during the liberalization era might have not yet reflected fully in the economy. The results. Thus. RELATIONSHIP BETWEEN EXCHANGE RATE AND STOCK PRICES IN INDIA: The dynamic linkage between exchange rate and stock prices has been subjected to extensive research for over a decade and attracted considerable attention from researchers worldwide during the Asian crisis of 1997-98. The causal link is generally absent though in recent years there has been strong causal influence from stock market return to forex market return. Page | 12 . The issue is also important from the viewpoint of recent large cross-border movement of funds. In India the issue is also gaining importance in the liberalization era. the extent of markets integration is perhaps changing over time – indicating the possibility of getting different conclusion on market integration for the period. which was not covered in previous studies. are tentative and we need further in-depth research to identify the causes and consequences of the findings.

the fundamental requirement is the existence of an underlying exposure to foreign exchange risk whether on current or capital account. One hopes to see further developments in exchange traded currency markets over time. Many corporate using currency derivatives for hedging their foreign currency exposure find requirement of margin and settlement of daily mark . considering the nascent stage of development of these markets in the country. a range of products such as IRS. There is no doubting that this is a market which will eventually establish its niche and would be an area of activity to watch and gain from for all market participants in the near future. During the first year of the launch of exchange traded currency futures reveals growing interest in the market. There is a perceive resistance to change or switch over from OTC to Exchange traded framework with the grip and comfortability level in the OTC markets. residents have access to foreign exchange forward contracts.both cross currency as well as foreign currency-rupee. these markets have not been able to evince the kind of activity that OTC markets are witnessing. While these products can be used for a variety of purposes. In conclusion.FOREX DERIVATIVES IN INDIA In respect of forex derivatives involving rupee. FRAs. option are allowed. the cautious approach of the regulators is understandable. In the case of derivatives involving only foreign currency.to – market differences cumbersome especially since there is no such requirement for OTC trades. Page | 13 . It would perhaps take some time for them to realize the concomitant benefits of these risk containment measures. However. foreign currency-rupee swap instruments and currency options .

If a firm has highly illiquid assets and suddenly needs some liquidity. Operational risk takes into account the errors that can be made in instructing payments or settling transactions. It has three basic components: credit exposure. RiskMetrics (1993). The way the losses are estimated can vary. Credit risk generally relates to the potential loss due to the default on the part of the counterparty to meet its obligations at designated time. A number of VaR models are used with all having the same aim to measure the size of potential future losses at a given confidence level.VALUE AT RISK IN FOREX MARKET Value at Risk (VaR) models plays a core role in the risk management of today‟s financial institutions. Models differ in fact in the way they calculate the density function of future profits and losses of current positions. The two most important components of VaR models are the length of time over which market risk is to be measured and the confidence level at which the market risk is measured. viz. credit risk. The VaR analysis originated with the variance-covariance model introduced by JP Morgan. These choices affect the nature of VaR modelsThere are four major categories of financial risk. operational risk.. Finally. market risk estimates the loss of an investment portfolio due to the changes in prices of financial assets and liabilities (market conditions). as well as the assumptions they rely on. liquidity risk and market risk. it may be compelled to sell some of its assets at a discount. and includes the risk of fraud and regulatory risks. A VaR model measures market risk by determining how much the value of a portfolio could decline over a given period of time with a given probability due to the change in the market price of an asset. Liquidity risk is caused by an unexpected large and stressful negative cash flow over a short period. Value-at-Risk (VaR) has been widely promoted by the Bank for International Settlement (BIS) as well as central banks of all countries as a way of monitoring and managing market risk and as a basis for setting regulatory minimum capital standards Page | 14 . probability of default and loss in the event of default.

However. The introduction and popular trading of currency futures on the rupee may bring about greater informational efficiency in currency trading markets at the risk. is no less important today than before. If China is any indication. However. of making the markets more speculative. In 1999 the notorious FERA (Foreign Exchange Regulation Act) gave way to the much milder FEMA (Foreign Exchange Management Act). however. Financial stability and avoidance of Asian Crisis-type catastrophes are likely to remain paramount in the exchange rate management system. however. India has moved on to a position of $250 billion plus in international reserves with a firm rupee and with far less forex control. India‟s exchange rate policies will continue to evolve. Prudent policy and careful monitoring are necessary to reap the benefits of external sector liberalization without taking inordinate amount of risks. The policy of managing the Rupee-US Dollar exchange rate is likely to continue for some time to come. The UPA government‟s decision to tax interest on the nonresident Indians‟ deposit shows the country‟s heavy dependence of such flows is a thing of the past. India‟s external finances have undergone a complete transformation. The role of policy makers. it may trigger some rethink of the exchange rate policy. India should be able to attract several times the global investment it presently does. The philosophy of cautious liberalization is likely to continue among Indian policymakers. over time as the Euro gains in importance. it will probably be become a key ingredient in setting the “target” value of the currency.THE WAY AHEAD With the passage of time. From a foreign exchange-starved. control-ridden economy. if the accumulation of US dollar reserves continues to progress uninhibited or if the economy experiences external shocks like an oil shock. In barely a decade and a half since the beginning of liberalization. With the added freedom and ease of transaction comes the risk of exposure to the vagaries of world financial markets. Page | 15 . Of course a lot depends on the nature – both size and composition – of cross-border investment flows. Trading in currency and its derivatives is likely to increase and the involvement of foreign banks is expected to go up.

by Harald Hau. P.J. by Anuradha Guru Page | 16 .A. by Vikram Murarka  „Foreign Exchange Market‟ by Dun and Bradstreet  „Development of forex market in India‟ by K. Samanta  „Value at Risk: Issues and implementation in Forex Market in India‟ by Golaka C Nath and Dr.References  „Indian Rupee Market‟. Tarapore  „Relationship Between Exchange Rate and Stock Prices in India‟ by Golaka C Nath and G P Samanta  „Foreign Exchange Markets in India‟ by: Rajesh Chakrabarti  „Determinants Of Exchange Rate In India‟ by Dr. Majumdar  „Exchange rate sense and nonsense‟ by: S. Suthar  „Integration Between Foreign Exchange and Capital Markets in India‟ by Golaka C. Y V Reddy  „Forex derivative markets in India: developments thus far and road ahead‟.S. Udeshi  „Where does India stand in global forex market?‟ by Commodity Online  „What is special about the forex market?‟. William Killeen and Michael Moore  „Foreign Exchange Regulatory Regimes in India: From Control to Management‟ by: Shyamala Gopinath  ICFAI Journals. Nath and G. „Forex Markets‟ by GRK Murthy  „Why canonize exchange rate?‟ by: N. Mita H.

by Madhu Vij  „The Indian Foreign Exchange Market and the Equilibrium Real Exchange Rate of the Rupee‟. Page | 17 . „Analysis of Indo-US Forex Market‟. by Anil Kumar Sharma and Anujit Mitra  „Foreign Exchange Exposure Management Practices of Indian Firms‟. by Ila Patnaik and Peter Pauly. by Rohit Vishal Kumar  „What Drives Forward Premia in Indian Forex Market?‟.

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