You are on page 1of 28

The IMF is an intergovernmental institution established by

an international treaty in 1945 to create a framework for

international economic cooperation focusing on balance of
payment problems and the stability of currencies.
IMF headquarters is in Washington D.C , U.S.A

Three main problems are :
Economic order and piece.
Reconstruction of economies
Stable world piece

Objectives Of IMF
1) To Promote International Monetary Cooperation
2) To Establishment a System of Multilateral Payments
3) To Maintain Stability in the Rate of Exchange
4) To Provide Aid to Members during


5) To reduce Disequilibrium in Balance of Payments

6) To promote balanced economic development

1) The funds provide a mechanism for improving shortterm BOP Position
2) Fund provides a machinery for international

3) Technical Assistance
4) Imparts Training
5) Facilities during emergency
6) It serves as a short-term credit institutions
7) Determining Exchange Rate for every Country

There are two types of members of the Fund
1) ORIGINAL MEMBERS- All those countries whose representatives took part in
Bretton Woods Conference and who agreed to be the member of the fund prior
to 31st December,1945, are called Ordinary Members
2) ORDINARY MEMBERS- All those countries who became its member
subsequently are called Ordinary Members. Any country can cease to be its
member after giving a notice in writing to that effect . Fund can terminate the
membership of such a country which does not observe its rules.
1) International Monetary Cooperation
2) Reconstruction of European Countries
3) Multilateral System of Foreign Payments
4) Increase in International Liquidity
5) Increase in International Trade
6) Special Aid to Developing Countries
7) Providing Statistical Information
8) Helpful in Times of Difficulties

1) Lack of Stability in Exchange Rate
2) Lack of Stability in the Price of Gold
3) Inability to Remove Restrictions on Foreign Trade
4) Rich Nations Club
5) No help for development projects
6) No Solution of International Liquidity
7) Interference in Domestic Economies
8) Inability to tackle the Monetary Crisis of August 1971
9) Less Aid for Developing Countries
10) High Rate of Interest


1) Facility of Foreign Exchange
2) Freedom from British Pound
3) Membership of the World Bank
4) Importance of India in International Sector
5) Economic Consultation
6) Help during Emergency
7) Financial help for five Year Plans
8) Special Drawing Rights
9) Help in Foreign Exchange Crisis
10) Profit from Sale of Gold

Q.1 : Define Foreign Exchange and Explain the Functions of Foreign

Exchange Market. (M.2011)


Foreign Exchange refers to foreign currencies possessed by a country
for making payments to other countries. It may be defined as exchange of money or credit in
one country for money or credit in another. It covers methods of payment, rules and
regulations of payment and the institutions facilitating such payments.
A foreign exchange market refers to buying foreign currencies with domestic
currencies and selling foreign currencies for domestic currencies. Thus it is a market in which
the claims to foreign moneys are bought and sold for domestic currency. Exporters sell
foreign currencies for domestic currencies and importers buy foreign currencies with
domestic currencies.
According to Ellsworth, "A Foreign Exchange Market comprises of all those
institutions and individuals who buy and sell foreign exchange which may be defined as
foreign money or any liquid claim on foreign money". Foreign Exchange transactions result
in inflow & outflow of foreign exchange.
Foreign exchange is also referred to as forex market. Participants are
importers, exporters, tourists and investors, traders and speculators, commercial banks,
brokers and central banks.
Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc.
are the important foreign exchange instruments used in foreign exchange market to carry out
its functions.
The Foreign Exchange Market performs the following functions.

Transfer Of Purchasing Power I Clearing Function

The basic function of the foreign exchange market is to facilitate the
conversion of one currency into another i.e. payment between exporters and importers. For
eg. Indian rupee is converted into U.S. dollar and vice-versa. In performing the transfer
function variety of credit instruments are used such as telegraphic transfers, bank drafts and
foreign bills. Telegraphic transfer is the quickest method of transferring the purchasing

Credit Function
The foreign exchange market also provides credit to both national and
international, to promote foreign trade. It is necessary as sometimes, the international
payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are
used in international payments, a credit for about 3 months, till their maturity, is required.
For eg. Mr. A can get his bill discounted with a foreign exchange bank in New
York and this bank will transfer the bill to its correspondent in India for collection of money
from Mr. B after the stipulated time.

Hedging Function

A third function of foreign exchange market is to hedge foreign exchange risks. By

hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange
rates. Under this function the foreign exchange market tries to protect the interest of the
persons dealing in the market from any unforseen changes in exchange rate. The exchange
rates under free market can go up and down, this can either bring gains or losses to concerned
parties. Hedging guards the interest of both exporters as well as importers, against any
changes in exchange rate.
Hedging can be done either by means of a spot exchange market or a forward exchange
market involving a forward contract.
Q. 2 : Explain the dealers or participants in foreign exchange market. (M.2011)
Foreign exchange market needs dealers to facilitate foreign exchange
transactions. Bulk of foreign exchange transaction are dealt by Commercial banks & financial
institutions. RBI has also allowed private authorised dealers to deal with foreign exchange
transactions i.e buying & selling foreign currency. The main participants in foreign exchange
markets are
1. Retail Clients
Retail Clients deal through commercial banks and authorised agents. They
comprise people, international investors, multinational corporations and others who need
foreign exchange.
2. Commercial Banks
Commercial banks carry out buy and sell orders from their retail clients and of
their own account. They deal with other commercial banks and also through foreign exchange
3. Foreign Exchange Brokers
Each foreign exchange market centre has some authorised brokers. Brokers act
as intermediaries between buyers and sellers, mainly banks. Commercial banks prefer

Central Banks
Under floating exchange rate central bank does not interfere in exchange
market. Since 1973, most of the central banks intervened to buy and sell their currencies to
influence the rate at which currencies are traded.
From the above sources demand and supply generate which in turn helps to
determine the foreign exchange rate.


Foreign Exchange Market is of two types retail and wholesale market.

Retail Market
The retail market is a secondary price maker. Here travellers, tourists and
people who are in need of foreign exchange for permitted small transactions, exchange one
currency for another.

2. Wholesale Market
The wholesale market is also called interbank market. The size of transactions in this
market is very large. Dealers are highly professionals and are primary price makers. The main
participants are Commercial banks, Business corporations and Central banks. Multinational
banks are mainly responsible for determining exchange rate.

Other Participants
Brokers have more information and better knowledge of market. They provide
information to banks about the prices at which there are buyers and sellers of a pair of
currencies. They act as middlemen between the price makers.

Price Takers
Price takers are those who buy foreign exchange which they require and sell
what they earn at the price determined by primary price makers.


Indian Foreign Exchange Market

It is made up of three tiers
i. Here dealings take place between RBI and Authorised dealers (ADs) (mainly
commercial banks).
ii. Here dealings take place between ADs
iii. Here ADs deal with their corporate customers.

Q. 3 : Define I Explain I Write note on spot and forward exchange rates.

Transactions in exchange market are carried out at what are termed as
exchange rates. In foreign exchange market two types of exchange rate operations take place.
They are spot exchange rate and forward exchange rate.

Spot Exchange Rate :When foreign exchange is bought and sold for immediate delivery, it is called
spot exchange. It refers to a day or two in which two currencies are involved. The basic
principle of spot exchange rate is that it can be analysed like any other price with the help of
demand and supply forces.
The exchange rate of dollar is determined by intersection of demand for and
supply of dollars in foreign exchange. The Remand for dollar is derived from countrys
demand for imports which are paid in dollars and supply is derived from countrys exports
which are sold in dollars.
The exchange rate determined by market forces would change as these forces
change in market. The primary price makers buy (Bid) or sell (ask) the currencies in the
market and the rates continuously change in a free market depending on demand and supply.
The primary dealer (bank) quotes two-way rates i.e., buy and sell rate.
(Bid) Buy Rate 1 US $ = ` 45.50
(Ask) Sell Rate 1 US $ = ` 45.75
The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The
difference of Rs.0.25 is the profit margin of dealer.


Forward Exchange Rate

Here foreign exchange is bought or sold for future delivery i.e., for the period
of 30, 60 or 90 days: There are transactions for 180 and 360 days also. Thus, forward market
deals in contract for future delivery. The price for such transactions is fixed at the time of
contract, it is called a forward rate.
Forward exchange rate differs from spot exchange rate as the former may
either be at a premium or discount. If the forward rate is above the present spot rate, the
foreign exchange rate is said to be at a premium. If the forward rate is below the present spot
rate, the foreign exchange rate is said to be at a discount. Thus foreign exchange rate may be
at forward premium or at forward discount.
For Eg. an Indian importer may enter into an agreement to purchase US $
10,000 sixty days from today at 1 US $ = Rs. 48. No amount is paid at the time of agreement,
except for usual security margin money of about 10% of the total amount. 60 days form
today, the importer will get 10,000 US $ in exchange for Rs. 4,80,000 irrespective of the Spot
exchange rate prevailing on that date.

Factors Influencing Forward Exchange Rate

Interest rates.
Degree of speculation in foreign exchange market.
Inflation rate.
Foreign investors confidence in domestic country.
Economic situation in the country.
Political situation in the country.
Balance of payments position etc.
Need For Forward Exchange Rate Contracts
To overcome the possible risk of loss due to fluctuations in exchange rate,
exporters, importers and investors in other countries may enter in forward exchange rate
In floating or flexible exchange rate system the possibility of wide
fluctuation in exchange is more. Thus, both exporters and importers safeguard their
position through a forward arrangement. By entering into such an arrangement both
parties minimize their loss.
Q. 4 : Write note on Arbitrage.


Write note on Interest rate and Arbitrage.

Arbitrage is the act of simultaneously buying a currency in one market
and selling it in another to make a profit by taking advantage of exchange rate differences in
two markets. If the arbitrages are confined to two markets only it is said two-point
arbitrage. If they extend to three or more markets they are known as three-point or multipoint arbitrage. Those who deal with arbitrage are called arbitrageurs.
A Spot sale of a currency when combined with a forward repurchase in a
single transaction is called Currency Swap". The Swap rate is the difference between spot
and forward exchange rates in currency swap.

Arbitrage opportunities may exist in a foreign exchange market.. Suppose the

rate of exchange is 1 US $ = `. 50 in US market and 1 US $ = `. 55 in Indian Markets, then an
arbitrageur can buy dollars in US market and sell it in Indian market and get a profit of `. 5
per dollar..
In todays modern well connected and advanced markets, arbitrageurs (which
are mainly banks) can spot it quickly and exploit the opportunity. Such opportunities vanish
over a period of time and equilibrium is again maintained.
For Eg.
Bank A

` / $ = 50.50 / 50.55

Bank B

` / $ = 50.40 / 50.45

The above rates are very close. The arbitrageur may take advantage and he can
purchase $ 1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A at `. 50.50, thus
making a profit of 0.05. The total profit would be (1,00,000 x 0.05) = `. 5,000. The profit is
earned without any risk and blocking of capital.
Interest arbitrage refers to differences in interest rates in domestic market and
in overseas markets. If interest rates are higher in overseas market than in domestic market,
an investor may invest in overseas market to take the advantage of interest differential.
Interest arbitrage may be covered and uncovered.

Uncovered Arbitrage
In this system, arbitrageurs would take a risk to earn profit by investing in a

high interest bearing risk free securities in a foreign market. His earnings would be according
to his calculations if the currency of foreign market where he invested does not depreciate. If
depreciation is equal to the difference in interest rate, the investor would not incur loss.
However, if depreciation is more than interest rate, then the arbitrageur will incur loss.
For Eg. In New York interest rate on 6 month Treasury Bill is 6% and in Spain
it is 8%. An US investor may convert US dollars in EURO and invest in Spain, thereby taking
an advantage of +2% interest rate. Now when bill matures, US investor will convert EURO
into dollars. However, by that time EURO may have depreciated the US investor will get less
dollars per EURO. If EURO depreciates by 1%, US investor will gain only +1% (+2 1%).
If EURO depreciates by 2% or more, US investor will not gain anything or incur loss. If
EURO appreciates, US investor will gain, +2% and interest rate differential


Covered Arbitrage
International investors would like to avoid the foreign exchange risk, thus interest

arbitrage is usually covered. The investor converts the domestic currency for foreign currency

at the current spot rate for the purpose of investment. At the same time, investor sells forward
the amount of foreign currency which he is investing plus the interest that he will earn so as
to coincide with maturity of foreign investment.
The covered interest arbitrage refers to spot purchase of foreign currency to make
investment and offsetting simultaneous forward sale of foreign currency to cover foreign
exchange risk. When treasury bills mature, the investor will get the domestic currency
equivalent of foreign investment plus interest without a foreign exchange risk.

Q 1: What is Money Market? What are the important functions performed by it?
Ans. A.MEANING OF MONEY MARKET:A money market is a market for borrowing and lending of short-term funds. It deals in
funds and financial instruments having a maturity period of one day to one year. It is a
mechanism through which short-term funds are loaned or borrowed and through which a
large part of financial transactions of a particular country or of the world are cleared.
It is different from stock market. It is not a single market but a collection of markets for
several instruments like call money market, Commercial bill market etc. The Reserve Bank of
India is the most important constituent of Indian money market. Thus RBI describes money
market as the centre for dealings, mainly of a short-term character, in monetary assets, it
meets the short-term requirements of borrowers and provides liquidity or cash to lenders.
II. PLAYERS OF MONEY MARKET :In money market transactions of large amount and high volume take place. It is
dominated by small number of large players. In money market the players are :-Government,
RBI, DFHI (Discount and finance House of India) Banks, Mutual Funds, Corporate Investors,
Provident Funds, PSUs (Public Sector Undertakings), NBFCs (Non-Banking Finance
Companies) etc.
The role andlevel of participation by each type of player differs from that of others.
III. FUNCTIONS OF MONEY MARKET :1) It caters to the short-term financial needs of the economy.
2) It helps the RBI in effective implementation of monetary policy.
3) It provides mechanism to achieve equilibrium between demand and supply of short-term
4) It helps in allocation of short term funds through inter-bank transactions and money market
5) It also provides funds in non-inflationary way to the government to meet its deficits.
6) It facilitates economic development.

Q.2: Explain the structure or components of Indian Money Market. (Mar.11)

What are the principal constituents of Indian Money Market?


Indian money market is characterised by its dichotomy i.e. there are two sectors of
money market. Theorganised sector and unorganised sector. The organised sector is within
the direct purview of RBI regulations. The unorganisedsector consist of indigenous bankers,
money lenders, non-banking financial institutions etc.


Organised Sector
Unorganised Sector
Call and Notice Money Market
Indigenous Bankers
Treasury Bill Market
Money Lenders
Commercial Bills
Certificate of Deposits
Commercial Papers
Money Market Mutual Funds
The REPO Market
I. Organised Sector Of Money Market :Organised Money Market is not a single market, it consist of number of markets. The
most important feature of money market instrument is that it is liquid. It is characterised by
high degree of safety of principal. Following are the instruments which are traded in money
1) Call And Notice Money Market :The market for extremely short-period is referred as call money market. Under call
money market, funds are transacted on overnight basis. The participants are mostly banks.
Therefore it is also called Inter-Bank Money Market. Under notice money market funds are
transacted for 2 days and 14 days period. The lender issues a notice to the borrower 2 to 3
days before the funds are to be paid. On receipt of notice, borrower have to repay the funds.
In this market the rate at which funds are borrowed and lent is called the call money rate.
The call money rate is determined by demand and supply of short term funds. In call money
market the main participants are commercial banks, co-operative banks and primary dealers.
They participate as borrowers and lenders. Discount and Finance House of India (DFHI),
Non-banking financial institutions like LIC, GIC, UTI, NABARD etc. are allowed to
participate in call money market as lenders.
Call money markets are located in big commercial centres like Mumbai, Kolkata,
Chennai, Delhi etc. Call money market is the indicator of liquidity position of money market.
RBI intervenes in call money market as there is close link between the call money market and
other segments of money market.
2) Treasury Bill Market (T - Bills) :This market deals in Treasury Bills of short term duration issued by RBI on behalf of
Government of India. At present three types of treasury bills are issued through auctions,
namely 91 day, 182 day and364day treasury bills. State government does not issue any
treasury bills. Interest is determined by market forces. Treasury bills are available for a
minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Periodic auctions are held for
their Issue.
T-bills are highly liquid, readily available; there is absence of risk of default. In India Tbills have narrow market and are undeveloped. Commercial Banks, Primary Dealers, Mutual
Funds, Corporates, Financial Institutions, Provident or Pension Funds and Insurance
Companies can participate in T-bills market.


Commercial Bills :Commercial bills are short term, negotiable and self liquidating money market
instruments with low risk. A bill of exchange is drawn by a seller on the buyer to make
payment within a certain period of time. Generally, the maturity period is of three months.
Commercial bill can be resold a number of times during the usance period of bill. The
commercial bills are purchased and discounted by commercial banks and are rediscounted by
financial institutions like EXIM banks, SIDBI, IDBI etc.
In India, the commercial bill market is very much underdeveloped. RBI is trying to
develop the bill market in our country. RBI have introduced an innovative instrument known
as Derivative .Usance Promissory Notes, with a view to eliminate movement of papers and
to facilitate multiple rediscounting.

Certificate Of Deposits (CDs) :CDs are issued by Commercial banks and development financial institutions. CDs are
unsecured, negotiable promissory notes issued at a discount to the face value. The scheme of
CDs was introduced in 1989 by RBI. The main purpose was to enable the commercial banks
to raise funds from market. At present, the maturity period of CDs ranges from 3 months to 1
year. They are issued in multiples of Rs. 25 lakh subject to a minimum size of Rs. 1 crore.
CDs can be issued at discount to face value. They are freely transferable but only after the
lock-in-period of 45 days after the date of issue.
In India the size of CDs market is quite small.
In 1992, RBI allowed four financial institutions ICICI, IDBI, IFCI and IRBI to issue
CDs with a maturity period of. one year to three years.

Commercial Papers (CP) :. Commercial Papers wereintroduced in January 1990. The Commercial Papers can be
issued by listed company which have working capital of not less than Rs. 5 crores. They
could be issued in multiple of Rs. 25 lakhs. The minimum size of issue being Rs. 1 crore. At
present the maturity period of CPs ranges between 7 days to 1 year. CPs are issued at a
discount to its face value and redeemed at its face value.

Money Market Mutual Funds (MMMFs) :A Scheme of MMMFs was introduced by RBI in 1992. The goal was to provide an
additional short-term avenue to individual investors. In November 1995 RBI made the
scheme more flexible. The existing guidelines allow banks, public financial institutions and
also private sector institutions to set up MMMFs. The ceiling of Rs. 50 crores on the size of
MMMFs stipulated earlier, has been withdrawn. MMMFs are allowed to issue units to
corporate enterprises and others on par with other mutual funds. Resources mobilised by
MMMFs are now required to be invested in call money, CD, CPs, Commercial Bills arising
out of genuine trade transactions, treasury bills and government dated securities having an
unexpired maturity upto one year. Since March 7, 2000 MMMFs have been brought under the
purview of SEBI regulations. At present there are 3 MMMFs in operation.

The Repo Market ;Repo was introduced in December 1992. Repo is a repurchase agreement. It means
selling a security under an agreement to repurchase it at a predetermined date and rate. Repo

transactions are affected between banks and financial institutions and among bank
themselves, RBI also undertake Repo.
In November 1996, RBI introduced Reverse Repo. It means buying a security on a spot
basis with a commitment to resell on a forward basis. Reverse Repo transactions are affected
with scheduled commercial banks and primary dealers.
In March 2003, to broaden the Repo market, RBI allowed NBFCs, Mutual Funds,
Housing Finance and Companies and Insurance Companies to undertake REPO transactions.

Discount And Finance House Of India (DFHI)

In 1988, DFHI was set up by RBI. It is jointly owned by RBI, public sector banks and
all India financial institutions which have contributed to its paid up capital.It is playing an
important role in developing an active secondary market in Money Market Instruments. In
February 1996, it was accredited as a Primary Dealer (PD). The DFHI deals in treasury bills,
commercial bills, CDs, CPs, short term deposits, call money market and government
II. Unorganised Sector Of Money Market :The economy on one hand performs through organised sector and on other hand in rural
areas there is continuance of unorganised, informal and indigenous sector. The unorganised
money market mostly finances short-term financial needs of farmers and small businessmen.
The main constituents of unorganised money market are:1) Indigenous Bankers (IBs)
Indigenous bankers are individuals or private firms who receive deposits and give loans
and thereby operate as banks. IBs accept deposits as well as lend money. They mostly operate
in urban areas, especially in western and southern regions of the country. The volume of their
credit operations is however not known. Further their lending operations are completely
unsupervised and unregulated. Over the years, the significance of IBs has declined due to
growing organised banking sector.
2) Money Lenders (MLs)
They are those whose primary business is money lending. Money lending in India is
very popular both in urban and rural areas. Interest rates are generally high. Large amount of
loans are given for unproductive purposes. The operations of money lenders are prompt,
informal and flexible. The borrowers are mostly poor farmers, artisans, petty traders and
manual workers. Over the years the role of money lenders has declined due to the growing
importance of organised banking sector.
3) Non - Banking Financial Companies (NBFCs)
They consist of :1. Chit Funds
Chit funds are savings institutions. It has regular members who make periodic
subscriptions to the fund. The beneficiary may be selected by drawing of lots. Chit fund is
more popular in Kerala and Tamilnadu. Rbi has no control over the lending activities of chit
2. Nidhis :Nidhis operate as a kind of mutual benefit for their members only. The loans are given to
members at a reasonable rate of interest. Nidhis operate particularly in South India.
3. Loan Or Finance Companies
Loan companies are found in all parts of the country. Their total capital consists of
borrowings, deposits and owned funds. They give loans to retailers, wholesalers, artisans and
self employed persons. They offer a high rate of interest along with other incentives to attract
deposits. They charge high rate of interest varying from 36% to 48% p.a.


Finance Brokers
They are found in all major urban markets specially in cloth, grain and commodity
markets. They act as middlemen between lenders and borrowers. They charge commission for
their services.

Q. 3:Explain the main features of Indian Money Market.


State the drawbacks I defects of Indian Money Market?








Indian money market is relatively underdeveloped when compared with advanced
markets like New York and London Money Markets. Its' main features / defects are as
Dichotomy:A major feature of Indian Money Market is the existence of dichotomy i.e. existence of
two markets: -Organised Money Market and Unorganised Money Market. Organised Sector
consist of RBI, Commercial Banks, Financial Institutions etc. The Unorganised Sector consist
of IBs, MLs, Chit Funds, Nidhis etc. It is difficult for RBI to integrate the Organised and
Unorganised Money Markets. Several segments are loosely connected with each other. Thus
there is dichotomy in Indian Money Market.
Lack Of Co-ordination And Integration :It is difficult for RBI to integrate the organised and unorganised sector of money
market. RBT is fully effective in organised sector but unorganised market is out of RBIs
control. Thus there is lack of integration between various sub-markets as well as various
institutions and agencies. There is less co-ordination between co-operative and commercial
banks as well as State and Foreign banks. The indigenous bankers have their own ways of
doing business.
Diversity In Interest Rates :There are different rates of interest existing in different segments of money market. In
rural unorganised sectors the rate of interest are high and they differ with the purpose and
borrower. There are differences in the interest rates within the organised sector also. Although
wide differences have been narrowed down, yet the existing differences do hamper the
efficiency of money market.
Seasonality Of Money Market :Indian agriculture is busy during the period November to June resulting in heavy
demand for funds. During this period money market suffers from Monetary Shortage
resulting in high rate of interest. During slack season rate of interest falls &s there are plenty
offunds available. RBI has taken steps to reduce the seasonal fluctuations, but still the
variations exist.
Shortage Of Funds :In Indian Money Market demand for funds exceeds the supply. There is shortage of
funds in Indian Money Market an account of various factors like inadequate banking
facilities, low savings, lack of banking habits, existence of parallel economy etc. There is also
vast amount of black money in the country which have caused shortage of funds. However, in
recent years development of banking has improved the mobilisation of funds to some extent.
Absence Of Organised Bill Market :-

A bill market refers to a mechanism where bills of exchange are purchased and
discounted by banks in India. A bill market provides short term funds to businessmen. The
bill market in India is not popular due to overdependence of cash transactions, high
discounting rates, problem of dishonour of bills etc.
7. Inadequate Banking Facilities :Though the commercial banks, have been opened on a large scale, yet banking facilities
are inadequate in our country. The rural areas are not covered due to poverty. Their savings
are very small and mobilisation of small savings is difficult. The involvement of banking
system in different scams and the failure of RBI to prevent these abuses of banking system
shows that Indian banking system is not yet a well organised sector.
8. Inefficient And Corrupt Management :One of the major problem of Indian Money Market is its inefficient and corrupt
management. Inefficiency is due to faulty selection, lack of training, poor performance
appraisal, faulty promotions etc. For the growth and success of money market, there is need
for well trained and dedicated workforce in banks. However, in India some of the bank
officials are inefficient and corrupt.
Q. 4: Explain the reforms introduced by RBI to strengthen the money market in India.
Discuss the measures to strengthen the Indian Money Market?





Ans. A) REFORMS I MEASURES TO STRENGTHEN THE INDIAN MONEYMARKET:On the recommendations of S. Chakravarty Committee and Narasimhan Committee,
the RBI has initiated a number of reforms.
Deregulation Of Interest Rates :RBI has deregulated interest rates. Banks have been advised to ensure that the interest
rates changed remained within reasonable limits. From May 1989, the ceiling on interest rates
on call money, inter-bank short-term deposits, bills rediscounting and inter-bank participation
was removed and rates were permitted to be determined by market forces.
Reforms In Call And Term Monev Market :To provide more liquidity RBI liberalized entry in to call money market. At present
Banks and primary dealers operate as both lenders and borrowers. Lenders other than UTI
and LIC are also allowed to participate in call money market operations. RBI has taken
several steps in recent years to remove constraints in term money market. In October 1998,
RBI announced that there should be no participation of non-banking institutions in call / term
money market operations and it should be purely an interbank market.
Introducing New Money Market Instruments:In order to widen and diversify the Indian Money Market, RBI has introduced many
new money market instruments like 182 days Treasury bills, 364 days Treasury bills, CD3
and CPs. Through these instruments, the government, commercial banks, financial
institutions and corporates can raise funds through money market. They also provide
investors additional instruments for investments.
Repo :Repos were introduced in 1992 to do away. With short term fluctuations in liquidity of
money market. In 1996 reverse repos were introduced. RBI has been using Repo and Reverse
repo operations to influence the volume of liquidity and to stabilise short term rate of interest
or call rate. Repo rate was 6.75% in March 2011 and reverse repo rate, was 5.75%.

5. Refinance By RBI :The RBI uses refinance facilities to various sectors to meet liquidity shortages and
control the credit conditions. At present two schemes of refinancing are in operations :Export credit refinance and general refinance.
RBI has kept the refinance rate linked to bank rate.
6. MMMFs:Money Market Mutual Funds were introduced in 1992. The objective of the scheme
was to provide an additional short-term avenue to the individual investors. In 1995, RBI
modified the scheme to allow private sector organisation to set up MMMFs. So far, three
MMMFs have been set up one each by IDBI, UTI and one in private sector.
7. DFHI:The Discount and Finance House of India was set up on 25th April 1988. It buys bills
and other short term paper from banks and financial institutions. Bank can sell their short
term securities to DFHI and obtain funds in case they need them, without disturbing their
8. The Clearing Corporation Of India Limited (CCIL) :CCIL was registered in 2001 under the Companies Act, 1956 with the State Bank of
India as Chief Promoter. CCIL clears all transaction in government securities and repos
reported on NDS (Negotiated Dealing System) of RBI and also Rupee / US $ foreign
exchange spot and forward deals.
9. Regulation Of NBFCs:In 1997, RBI Act was amended and it provided a comprehensive regulation for non
bank financial companies (NBFCs) sector. According to amendment, no NBFC can carry on
any business of a financial institution including acceptance of public deposit, without
obtaining a Certificate of Registration from RBI. They are required to submit periodic returns
to RBI.
10. Recovery Of Debts:In 1993 for speedy recovery of debts, RBI has set up special Recovery Tribunals. The
Special Recovery Tribunals provides legal assistance to banks to recover dues.

Advantages and Disadvantages of Options

An investor can gain leverage in a stock without committing to a trade.
Option premiums are significantly cheaper on a per-share basis than
the full price of the underlying stock.
Risk is limited to the option premium (except when writing options for a
security that is not already owned).
Options allow investors to protect their positions against price
The costs of trading options (including both commissions and the bid/ask
spread) is significantly higher on a percentage basis than trading the
underlying stock, and these costs can drastically eat into any profits.
Options are verycomplex and require a great deal of observation
and maintenance.
The time-sensitive nature of options leads to the result that most
options expire worthless . Making money by trading options is extremely
difficult, and the average investor will fail.
Some option positions, such as writing uncovered options, are
accompanied by unlimited risk.

Underlying asset
Call vs. put
Strike price
Expiration date
American vs. European

Underlying asset
Option is a derivative security, a contract giving the owner (buyer) of the option the right (but
not the obligation) to buy or sell a defined quantity of a defined asset. This asset is called
underlying asset or underlying security or just underlying.
The use and popularity of options has been expanding rapidly in the last decades and there is
a wide range of underlying assets for which options exist today. Perhaps the best known
underlyings are single stocks (shares in companies traded in the stock market).
There are also options on various indices like the S&P500 or the VIX (volatility index). You
can also trade options on futures, bonds, interest rates, currencies, ETFs, and many other
kinds of assets or economic variables.

Call option vs. put option

There are two basic types of options, call options and put options. A call option gives its
owner a right to buy the underlying asset, while a put option gives its owner a right to sell
the underlying asset.

Strike price
Strike price is the price for which the options owner can buy or sell the underlying security,
if he decides to exercise the option.
An options strike price is fixed and does not change during the whole life of the option. For
one underlying and one type of options (calls or puts) there are usually at least several
different strike prices available. For example for a stock which currently trades at 57 you can
trade call options with strike prices of 50, 55, 60, 65 etc. and put options with strikes of 50,
55, 60, 65 etc. But of course every single option always has only one strike price defined and
once you own it you cant change its strike its fixed.

Expiration date
Options have limited life. Every option has a defined expiration date that is also fixed during
its whole life and nothing can change or move it. If an option is not exercised before or on its
expiration date, it becomes worthless (it expires) after that date.

American vs. European

The distinction between American and European options is about when an options owner can
exercise the option. An American option can be exercised during its whole life, this means
from the moment you buy it till the moment it expires (its expiration date). On the contrary, a
European option can be exercised only at one single moment the moment it is expiring.

General Framework
for Interest Rate Risk Management
I. Sound interest rate risk management practices
16.Sound interest rate risk management involves the application of four
basic elements in the management of assets, liabilities and OBS
1. Appropriate board and senior management oversight;
2. Adequate risk management policies and procedures;
3. Appropriate risk measurement,monitoring, and control functions; and
4. Comprehensive internal controls and independent audits.
5. Banking corporations should monitor the interest rate risk on a
consolidated basis.
6. The duties of the individuals involved in the risk measurement,
monitoring and control functions must be sufficiently separate and as
relevant, independent from the business decision makers and position
takers to ensure the avoidance of conflicts of interests.
7. The specific manner in which a banking corporation applies these
elements in managing its interest rate risk will depend on the complexity
and nature of its holdings and activities, as well as on the level of interest
rate risk exposure.

II. Board and senior management oversight of interest rate risk

Effective oversight by the board of directors and senior management is
critical to a sound interest rate risk management process.
Interest rate risk measurement techniques

Maturity/repricing scheduleinterest-sensitive assets, liabilities and

OBS positions can be distributed into time bands according to their
maturity (if fixed-rate) or time remaining to their next repricing (if
imulation techniquesdetailed assessments of the potential effects of
changes in interest rates on earnings and economic value by simulating the
future path of interest rates and their impact on cash flows. In static
simulations, the cash flows arising solely from the banking corporations
current on- and off-balance sheet positions are assessed

Short-Term Measures
Short-term measurement techniques quantify the potential reduction in earnings
that might result from changing interest rates over a 12- to 24-month time
horizon. The two most common short-term measures for community banks are
static gap reports and earnings-at-risk (EaR) analysis
Static Gap
Static gap reports attempt to highlight potential "gaps" in the near future
(typically over the next 12 months), where changes to interest rates on assets
such as loans and bonds, or liabilities such as deposits, do not occur

Balance of Payments
Nations continually carry out economic, commercial and
financial transactions between residents of one nation and
rest of world in the form of :

-- goods and services for money etc.

BOP statistics are published monthly by RBI in India. These

are analysed by bankers, businessmen, economists foreign
exchange traders etc. to know international economic
performance of the country.

-- and payments made by residents* for

goods imported and
services received in addition to capital
transferred to
non-residents and foreigners.

* Official Settlement accounts

* Balance Of Payment on Current Account

-- It includes value of exports and imports of visible items
and receipts and payments on invisibles i.e. services like
banking, insurance, travel, tourism, transportation etc.
-- Balance of Payment on current account is added to
determine nations Gross Domestic Product (GDP).

* Balance of Payment on Capital Account

-- It comprises of
i) Private capital (both long and short-term) :
Long- term with maturity period of more than one year
and short-term with maturity of one year or less.
-- Long-term private capital includes Foreign
Investments ( both Direct and Portfolio), long term loans,
foreign currency deposits and unclassified
capital account
receipts of foreign currency, SDRs etc.

* Unilateral Transfers Account

It comprises of uni-directional transactions like giving of

gifts. Disaster relief, foreign aids, govt. grants, pension paid to
and received by Indian citizens for services rendered abroad.

* Official Settlements Account

It represents official sales of foreign currencies and other
reserves to foreign countries or official purchase of foreign
currencies or other reserves from foreign countries.

Disequilibrium in BOP are caused by :

* Economic factors
* Political factors and
* Sociological factors.

* Economic Factors may cause

1) Development Disequilibrium
2) Cyclical Disequilibrium
3) Secular disequilibrium and
4) Structural Disequilibrium

* Political Factors
-- Political uncertainties, instability, internal disturbances,
external wars etc. create threatening situation for local industry
and investments. In such cases domestic production declines
leading to increase in imports and outflow of capital

-- It results in deficit in BOP as it happened in Sri Lanka,

Pakistan etc.

* Social Factors
-- Changes in culture, taste, preference, fashion etc. bring
about changes in nature of import of consumer items first,
followed by capital goods leading to deficit in BOP.

Correction of BOP Disequilibrium

1. Automatic Correction of BOP Disequilibrium
2. Deliberate Measures
A. Monetary Measures
* Interest Rate Adjustment :
* Devaluation
* Exchange Control
B. Trade Measures
* Export Promotion Measures
* Import Control Measures
C. Miscellaneous Measures
a) Attracting Foreign Investments both FDI and FPI
b) Attracting NRI deposits
c) Promoting tourism
d) Negotiating Foreign currency loans etc.

Structure of Indias BOP Statement


Debit Net

A. Current Account
I. Merchandise
i) Private
ii) Govt.
II. Invisibles
1. Non-monetary gold
2. Travel
3. Transportation
4. Insurance
5. Investment Income
6. Govt. not included anywhere
7. Miscellaneous
8. Transfers Receipts / Payments
i) Official
ii) Private
Total Current Account ( I + II )

Credit Debit Net

B. Capital Account
1. Private
i) Long-term
ii) Short-term
2. Banking
3. Official
i) Loans
ii) Amortisation
iii) Miscellaneous
Total Capital account (1 + 2 + 3 )
S.D.R. Allocation
Capital Account, I.M.F. & S.D.R.

Indias BOP Account

Credit Debit Net
Total Current Account,
Capital Account,I.M.F.
& S.D.R. Allocation
G. Errors & Omissions
H. Reserves and Monetary Gold

Factors That Influence Exchange Rates :

1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing
interest rates impact inflation and currency values.

3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest and dividends.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with
large public deficits and debts are less attractive to foreign investors.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a greater
rate than that of its imports, its terms of trade have favorably improved.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment
funds away from other countries perceived to have more political and economic risk.