Exchange rates, Quatations and Determinations

CURRENCY RATE/CURRENCY QUOTATION

When the rate of exchange is quoted a fixed number of units of the home currency
in terms of a varying number of units of a foreign currency, it is called the currency
or certain or indirect rate of exchange,
Currency Quotation:
An exchange rate quotation expressed as a fixed number of home currency units in
terms of a varying number of foreign currency units is called a foreign currency or
indirect quotation, e.g.,
Rs.lOO = £ 1.2437
Or Rs.lOO = $ 2.450
Here, the amount in rupees (home currency) price quotation is fixed, while the
amount in pound sterling and dollar (foreign currency) varies.
In India the usual practice is to quote the rate of exchange in the
currency/certain/indirect method in terms of Rs.lOO.

RATE/DIRECT QUOTATION
A rate of exchange quoted as a fixed number of foreign currency units in terms of a
varying number of home currency units is direct rate of exchange, and a quotation
so expressed is a home currency or direct quotation. For instance, if the Rupee-
Dollar rate is quoted at USD = Rs. 44.35, i.e. , in terms of so many (i.e., a varying
number of) Rupees to a Dollar, it is a direct rate.
At present all nationalised banks follow this method in quoting its rate of exchange.

BUYING AND SELLING RATES

(a) As noted earlier, a foreign exchange transaction is either a purchase or a sale
transaction, i.e., a transaction which involves either buying or selling of a foreign
currency.
For the buying and selling of foreign currencies, there are different rates. The price
in terms of the home currency at which a banker is willing to buy a foreign currency
is the buying rate, and the price. also in terms of the home currency, at which the
banker will sell a foreign currency is the selling rate, between the two currencies.

(b) Two-Way Quotation:

The buying and selling rates of a currency in terms of another currency vary, and
the two are quoted together as under:
Rs.l00 = £ 1.2437-1.1821
& £ 1 = $1.64-1.6316
In the above quotations the rates
Rs.lOO = £ 1.2437 and £1 = $ 1.64 Are the buying rates, and the rates
Rs.I00 = £ 1.1827 and £1 = $ 1.63 are the selling rates. A quotation with a pair of
rates, i.e. , the buying and selling rates, is known as a two-way price or quotation.

CROSS RATES
A cross rate is a rate of exchange derived from the quotations of any two currencies
in terms of a third, or of more than two currencies in terms of another. For instance,
if London quotes:
£ 1 = $1.60
£ 1 = Rs.55.70
then the rupee-dollar quotation, i.e., the cross rate, may be found by the Chain Rule
method as under:
or
£ 1.60 x 100
55.70
Rs. 100
= 2.874
= $2.87
FACTORS INFLUENCING EXCHANGE RATES
Commercial Transactions:
If imports exceed exports, the demand for foreign currencies rises, that is to say the
value of the home currency is depreciated in terms of the concerned foreign
currencies.
If exports exceed imports, there is a greater demand for the home currency, forcing
its price up in terms of the concerned foreign currencies.
This may also be called balance of payments factor influencing the rate of
exchange.

(b) Investments:
Investments in this country will cause an increased demand for the home currency
and push up its value.
(c) Government Loans and Grants:
When the loan is repaid or when interest on the loan is paid, such payment tends to
strengthen the currency of the lender country.
(d) Transactions with International lnstitutiolls:
When a country subscribes its contribution to the IMF or the International Bank for
Reconstruction and Development (IBRD) or to any of its associates, and that
currency is lent out to another member country, such lending tends to weaken the
exchange rate of the subscriber country's currency.
(e) Arbitrage:
Arbitrage in foreign exchange consists in simultaneous buying and selling of one or
more currencies in different exchange markets so as to make a profit out of the
differences, in the exchange rates of the currencies at different centres. Arbitrage
operations may be classified as under:
Two-Point Arbitrage:
When the arbitrageur finds a spread in the price of the currency of his own country
in two markets, generally his own and one 'abroad, that is, when the transaction is
confined to two markets, it is a single or direct or two-point arbitrage. For example,
if the rates of exchange are -
£1=$2
£ 1 = 500 francs
$ 1 = 125 francs
and the dollar-franc rate moves to $1=1000 francs, then the arbitrageur may buy
1,000 francs in London and sell them in New York, making a profit of $ 1 .

Three-Point Arbitrage or Cross Arbitrage:

When the buying and selling involves 3 markets - for instance, purchasing francs
against dollars in New York, then selling the francs for pounds in London and then
selling the pounds against dollars in New York - we have what is known as a three-
point arbitrage.

Arbitrage in Space
 Refers to transactions in foreign exchange to take advantage of discrepancies
between rates quoted at the same moment at different markets.
Arbitrage in Time refers to transaction to take advantage of discrepancies between
forward margins for different maturities.

Interest Arbitrage
Refers to the movement of funds from a low interest to a high-interest centre,
provided that a profit is likely even after allowing for the cost of forward cover, and
that the centre to which funds are moved is regarded as politically and economically
stable .

Arbitrage transactions
have the effect of leveling down discrepancies in the rates of exchange obtaining in
different centres, thereby making two or more centers, though physically separate, a
single market where only one price exists for the same commodity. This is
sometimes referred to as

Interest Differential factor influencing the rate of exchange.

if) Short-Term Capital Movements:
Short-term capital is attracted to a centre with a comparative high rate of interest,
causing an increased demand for the currency of that country and hence a rise in its
rate of exchange.
(g) Confidence in the Currency:
High rate of interest, no doubt, attracts foreign capital. But there would be no
movement of capital into a country unless there is, generally speaking, confidence
in that country's currency.
Leads and lags:
If it is feared that the currency of a country may be devalued, then the importers in
the country, who have payments to make in foreign currency,
(Il) Technical Factors
The technical factors influencing the rate of exchange include keeping open
positions at weekends, window-dressing operations at the year-end, cover
operations for the returns that banks have to submit to the authorities, etc.
OTHER EXCHANGE RATES SYSTEMS
(a) Unitary Exchange Rates System:
When there is only one official rate of exchange in a country for all types of
transactions, a unitary exchange rates system is deemed to be in operation. A unitary
exchange rates system is one of the objectives of the IMF, and many leading
members of the Fund, including India, have adopted this system.
(b) Multiple Exchange Rates System:
This is an arrangement under which different rates are permitted for a country's
currency for different types of transactions. The IMF is opposed to multiple
currency practices.
(c)Two-Tier Exchange Rates:
A country having a system of multiple exchange rates may have a controlled rate of
exchange for its currency for certain transaction and a free market rate for other
transactions. Or it may have one rate for exports and a lower rate for imports, or one
rate for mercantile transactions and a lower rate for transactions of a capital nature
to prevent any outflow of capital. When this happens the rates are known as two-tier
exchange rates.
Nominal Exchange rates
The number of units of the domestic that are needed to purchase a unit of a given
foreign currency.
For example, if the value of the Euro in terms of the dollar is 1.37, this means that
the nominal exchange rate between the Euro and the dollar is 1.37. We need to give
1.37 dollars to buy one Euro.
It’s called nominal, because it takes into account only the numerical value of the
currencies.

Real Exchange Rate

The real exchange rate (RER) compares the relative price of two countries’ the rate
at which the currency of one country would be changed for another if differences in
prices and wages between the two countries are taken into account.
Real exchange rates are used to compare the values of currencies over time when
considering the different rates of inflation in different countries:
RER = (Nominal exchange rate x Price of the foreign basket) / (Price of the
domestic basket).

Real Effective Exchange Rate (REER)

The real effective exchange rate (REER) is the weighted average of a country's
currency in relation to an index or basket of other major currencies. The weights are
determined by comparing the relative trade balance of a country's currency against
each country within the index. This exchange rate is used to determine an individual
country's currency value relative to the other major currencies in the index.

Equilibrium Rates of Exchange:

When the value of a currency in terms of another currency reflects its purchasing
power parity -and the country maintains equilibrium in its balance of payments, the
rate of exchange between the two currencies is said to be the equilibrium rate of
exchange.

Flexible Rate:

Under a flexible exchange rates system, the rate of exchange is allowed to fluctuate
in response to the market conditions of demand and supply.

INTERMEDIARY ARRANGEMENTS
Between the fixed and the freely flexible rates of exchange, there may be at least
four
Intermediary arrangements –
the flexible exchange rate with government intervention;
the wide band;
the adjustable peg; and
the sliding or crawling peg.
(a)Flexible Rate with Government Intervention:
In a business cycle, the government should spend reserves or draw on the IMF
during a deficit period, and restock or repay during a surplus one. They further
suggest that the government should allow the rate to move in response to other
influences such as changes in demand and supply. But the flexible exchange rate
advocates oppose intervention on the ground that the governments are no better at
distinguishing temporary from far reaching effects than private speculators.

(b) The Wide Band:

The movements of the exchange rates within the band should not be so wide as to
discourage trade and investment, and not too limited to promote adjustment. The
wide and proposal lies between fixity and flexibility of the exchange, and
contemplates plus or minus 10 per cent of parity instead of 2114% permissible
under the IMF Agreement.

(c)The Adjustable Peg:

The adjustable peg is a fixed rate of exchange which is changed from time to time.
The adjustable peg is said to stimulate destabilising speculation by providing
speculators a one-way option. When a currency is in trouble, there is no chance of
its going up but a considerable chance of its going down. It may then be safe to
speculate against it.
(d) The Crawling Peg:

The crawling or sliding peg is a more subtle scheme which has been devised to
contain fluctuations in the rates of exchange. Under this scheme, the exchange rates
are not pegged at one point, but are free to move, though to a limited extent, in each
period. The crawling/ sliding peg system has not been taken up by business or
government circles.
(e) International Clearing: When goods are exported from one country, say India,
to another country, say the USA, the exporter in India acquires a claim upon the
importer in the USA, and the importer in the USA has payment to make to the
exporter in India. Now, even if the goods and the relative credit instruments, i.e.,
bills of exchange, etc., move across the border, the payment is made by the importer
and received by the exporter in their respective domestic currencies, viz., dollar and
rupee.

(f) Providing Credit for Foreign Trade: Credit for foreign trade may be required by
an exporter during the period of manufacture of the goods and/or for the period of
transit of the goods from one country to another.

(g) Hedging:
Hedging means covering exchange risks, i.e., the risks of fluctuations in the
exchange rates which may adversely affect the home currency realisations of
exports and the home currency cost of imports invoiced in a foreign currency.
Such risks are inherent in forward transactions, since there is always a likelihood of
an adverse movement in the rate of exchange. Hedging is done through banks.
It may be done through the spot market if the trader has sufficient cash or credit
facilities; but it is usually done through a forward contract.

Spot and Forward Market:

The buying and selling of foreign currencies for spot or ready delivery against
domestic currency collectively represent the spot market, while the buying and the
selling of foreign currencies under forward contracts for delivery at a future date at
a rate fixed now represents the forward market.

RATE OF EXCHANGE
Foreign exchange accrues out of foreign exchange transactions involving
conversion of one currency into another.

SYSTEMS OF EXCHANGE RATES

There are various systems of calculating and expressing the rate of exchange, such
as the Fixed Rate, Floating Rate, Flexible Rate, etc.

FIXED RATE OF EXCHANGE

(a) Mint Par: Countries like the U.K. the USA, etc., while on gold standard, a
monetary system which was abandoned in 1931, based the value of their respective
currencies on a specified quality of fine gold, making their currencies freely
convertible into gold at the rate so fixed. This fixed relationship of the currencies
with a common denominator, that is, gold, led to fixed parities between
them, known as the mint par of exchange.
Ex:dolalr 1=25/5=Rs.5
Rs 1=5/25=1/5 or 20 cent
In thisRs 1=5gms gold and 1dollar=25 gms gold

It was held that under this arrangement the exchange rate between two currencies
would vary, if at all; only slightly from the mint par of exchange, since any
movement away from the mint par would make it profitable to convert the currency
into gold, export the gold to a foreign centre and then convert it into a foreign
currency.

(b) Specie Points: Under gold standard, gold could be exported or imported freely.
But the export or import of gold involved a certain amount of expenditure in
shipping and insuring it, and the expenditure so incurred set a margin on either side
of the mint par of exchange, called the specie points, to the extent of which the rate
of exchange might vary before there was any movement of gold. When,
however, the exported gold was sold in a foreign currency, there naturally, was a
larger demand for then concerned foreign currency raising its value above the mint
par, while when the sale process were sold there were larger offers of that currency,
reducing its value back towards the mint par. In a reverse process, gold would be
imported. But the import of gold would necessitate the purchase of foreign currency
with which to obtain the gold, and this would cause the value of that currency to
appreciate back towards the mint par.

FIXED RATE OF EXCHANGE

(a) Mint Par: Countries like the U.K. the USA, etc., while on gold standard, a
monetary system
which was abandoned in 1931, based the value of their respective currencies on a
specified quality of
fine gold, making their currencies freely convertible into gold at the rate so fixed.
This fixed
relationship of the currencies with a common denominator, that is, gold, led to fixed
parities between
them, known as the mint par of exchange. It was held that under this arrangement
the exchange rate
between two currencies would vary, if at all; only slightly from the mint par of
exchange, since any
movement away from the mint par would make it profitable to convert the currency
into gold, export
the gold to a foreign centre and then convert it into a foreign currency.
(b) Specie Points: Under gold standard, gold could be exported or imported freely.
But the export
or import of gold involved a certain amount of expenditure in shipping and insuring
it, and the
expenditure so incurred set a margin on either side of the mint par of exchange,
called the specie points,
to the extent of which the rate of exchange might vary before there was any
movement of gold. When,
however, the exported gold was sold in a foreign currency, there naturally, was a
larger demand for the
concerned foreign currency raising its value above the mint par, while when the sale
process were sold
there were larger offers of that currency, reducing its value back towards the mint
par.
In a reverse process, gold would be imported. But the import of gold would
necessitate the
purchase of foreign currency with which to obtain the gold, and this would cause
the value of that
currency to appreciate back towards the mint par.

FLOATING/FLEXIBLE RATES OF EXCHANGE

(a) Floating Rate: Under a floating exchange rates system there are no fixed
parities, and the
rates of exchange are allowed to float, i.e., fluctuate freely without official
intervention. It has been
argued in favour of floating rates that the fixing of parities with gold or otherwise is,
after all,
arbitrary, and that under a fixed exchange rates system the currency may be
overvalued or
undervalued, leading to a persistent 'adverse or favourable balance of payments,
whereas by allowing
the rate to float in accordance with the demand for and supply of the currency, it
may be fixed by
market operations at the level of the true international value of the currency, leading
to growth in
international trade.
A floating exchange rates system implies a complete suspension of parities or any
attempt at
pegging the rates, i.e., artificially confining through official intervention the
movement of the rates of
exchange within certain predetermined limits. In practice, however, the necessity of
occasional
official intervention to correct too erratic fluctuations in the rate cannot be
altogether ruled out.

(b) Flexible Rate: Under a flexible exchange rates system, the rate of exchange is
allowed to
fluctuate in response to the market conditions of demand and supply.
Floating and flexible exchange rates are more or less alike. However, a distinction is
attempted
by some. According to them, a floating exchange rate implies a complete absence of
official
intervention or of any attempt at pegging the rate, whereas a flexible exchange rate
may be subject to
relatively frequent changes in the exchange parities or may be subject to the
pegging of the rate.
~. 8.12 INTERMEDIARY ARRANGEMENTS
Between the fixed and the freely flexible rates of exchange, there may be at least
four
intermediary arrangements - the flexible exchange rate with government
intervention; the wide
band; the adjustable peg; and the sliding or crawling peg.
(a) Flexible Rate with Government Intervention: The flexible exchange rate with
government
intervention presupposes that the government can recognise transitory influences
which should not be
allowed to move the exchange rate or set in motion factors which would lead to
resource reallocation.
The advocates of government intervention suggest that, in a business cycle, the
government should
spend reserves or draw on the IMP during a deficit period, and restock or repay
during a surplus one.
They further suggest that the government should allow the rate to move in response
to other
influences such as changes in demand and supply. But the flexible exchange rate
advocates oppose
intervention on the ground that the governments are no better at distinguishing
temporary from farreaching
effects than private speculators.
(b) The Wide Band: The wide band proposal was put forward by Keynes, the
famous British
economist. The proposal envisaged freely ' fluctuating exchange rates within a band
wide enough to
have effects on resource allocation, but not so wide as to discourage, because of
risk, international
economic intercourse. In other words the movements of the exchange rates within
the band should
not be so wide as to discourage trade and investment, and not too limited to
promote adjustment. The
wide and proposal lies between fixity and flexibility of the exchange, and
contemplates plus or minus
10 per cent of parity instead of 2114% permissible under the IMF Agreement.
(c) The Adjustable Peg: The adjustable peg is a fixed rate of exchange which is
changed from
time to time. This position was virtually adopted by the IMF Agreement at Bretton
Woods in 1944,
when it was agreed that small movements in the exchange rate were permissible· at
any time and
larger movements, in the event of fundamental disequilibrium. The adjustable peg is
said to stimulate
destabilising speculation by providing speculators a one-way option. When a
currency is in trouble,
there is no chance of its going up but a considerable chance of its going down. It
may then be safe to
speculate against it. Moreover, small changes made successively in the rate of
exchange may lead to
bigger changes and thus a national crisis of adjustments may ensue, calling for
international
arrangement to avert the crisis, as in the case of the Basel Agreement in 1961.
(d) The Crawling Peg: The crawling or sliding peg is a more subtle scheme which
has been
devised to contain fluctuations in the rates of exchange. Under this scheme, the
exchange rates are not
pegged at one point, but are free to move, though to a limited extent, in each period.
The implication
is that successive movements in the same direction for successive periods would
result in a discrete
change, but the change in anyone period is not large enough to encourage
speculation. The crawling
I sliding peg is srud to effect integration through confidence in international values,
while limiting
destabilising speculation. However, like all proposals for exchange rate flexibility,
the crawling/
sliding peg system has not been taken up by business or government circles.
 Foreign exchange market
 It is the market for buying and selling foreign currencies.
 The foreign exchange market is the international market in which buyers and
sellers of currencies "meet".
 It is largely decentralized. The participants (classified as market makers,
brokers and customers) are physically separated from one another, they
communicate via telephone/internet-mail. Trading volume is large.
 Most of this large trading was between book market makers.

Make a market in one or more currencies by providing bid and ask prices upon
demand. A broker arranges trades by keeping a book of market makers' limit orders
Market Makers
Market makers may trade for their own account - that is, they may maintain a long
or short position in a foreign currency - and require significant capitalization for
that purpose.
Brokers
Brokers do not contract customers and do not deal on their own account; instead
they profit by charging a fee for the service of bringing foreign market makers
together.

(b) Operations:
The foreign exchange market has three-tierdealings:
(i) Dealing between banks and customers;
(ii) Dealing between local banks including the Reserve Bank and
(iii) Dealing between domestic banks and banks abroad.

(c) Contracts:
Transactions in the foreign exchange market are made through contracts between
the dealer and the banker, known as the 'broker's contracts.' Such contracts in India
contain, inter alia, a, clause: Subject to the Rules and Regulations of the Foreign
Exchange Dealers Association of India (FEDAI).
The contracts may be:
(i) Cash or Ready,
under which the delivery is to be made immediately, or Ready contracts
between banks will be deliverable within two business days after the date of
contract, while those between banks and their customers will be deliverable
on the same day.
(ii) Forward,
under which the delivery is to take place at a future date and the option to
take delivery lies with the purchasing bank or customer. All contracts should
be understood to read "to be delivered or paid for at the bank."
(d) Functions:
By the very nature of its operations, the foreign exchange market is international
and performs three functions, namely:
(i) Effecting transfer of purchasing power through a clearing process from one
country to another;
(ii) Providing credit for foreign trade; and
(iii) Furnishing facilities for hedging foreign exchange risks.
(c) Contracts: Transactions in the foreign exchange market are made through
contracts between
the dealer and the banker, known as the 'broker's contracts.' Such contracts in India
contain, inter
alia, a ,clause: Subject to the Rules and Regulations of the Foreign Exchange
Dealers Association of
India (FEDAI).
The contracts may be: (i) Cash or Ready, under which the delivery is to be made
immediately, or
(ii) Forward, under which the delivery is to take place at a future date and the option
to take delivery
lies with the purchasing bank or customer. All contracts should be understood to
read "to be delivered
or paid for at the bank." Ready contracts between banks will be deliverable within
two business days
after the date of contract, while those between banks and their customers will be
deliverable on the
same day.
(d) Functions: By the very nature of its operations, the foreign exchange market is
international
and performs three functions, namely:
(i) Effecting transfer of purchasing power through a clearing process from one
country to
another;
(ii) Providing credit for foreign trade; and
(iii) Furnishing facilities for hedging foreign exchange risks.
(e) International Clearing: When goods are exported from one country, say India,
to another
country, say the USA, the exporter in India acquires a claim upon the importer in
the USA, and the
importer in the USA has payment to make to the exporter in India. Now, even if the
goods and the
relative credit instruments, i.e., bills of exchange, etc., move across the border, the
payment is made
by the importer and received by the exporter in their respective domestic currencies,
viz., dollar and
rupee. The linking of the receiving and the making of payment is done by banks;
and in the U.K., and
the USA, this is also done through the bill market, which is a constituent of the
foreign exchange
market. In India, there is no bill market as such.
(f) Providing Credit for
DEFINITION
Foreign exchange, vide Section 2 (n) of the Foreign Exchange Management Act,
1999 is foreign currency and includes: Deposits, credits and balances payable in any
foreign currency, and any drafts, traveller's cheques, letters of credit and bills of
exchange, expressed or drawn in Indian currency but payable in any foreign
currency; and
~ 8.2 FOREIGN EXCHANGE TRANSACTIONS
A foreign exchange transaction is a purchase or sale of one national currency
against another. The purchase or sale of currency arises out of import or export of
goods and services, lending and borrowing, transfer of funds, etc., between two or
more countries. In other words, a foreign exchange transaction implies a transfer of
purchasing power, that is, the acquisition of, or parting with, the right to wealth in
another country.
~ 8.3 SALE/PURCHASE TRANSACTIONS
. (a) Foreign exchange transactions are either sale or purchase transactions.

For instance, when a

bank in Kolkata collects an import bill received from its branch in London, or issues
a draft on its correspondent in New York, the collection of the bill or the issue of the
draft is called a sale transaction. In these transactions, the payment against the bill
or the draft is received from the drawee or the purchaser in rupees, while the
London branch receives the payment for the bill in pound sterling, and the
beneficiary of the draft receives payment against it in dollars from the New York
bank.
SALE/PURCHASE TRANSACTIONS
. (a) Foreign exchange transactions are either sale or purchase transactions. a
foreign exchange transaction which involves conversion of the home currency into
a foreign currency, is a sale transaction. Sale transactions entail the spending of
foreign currency. Other sale transactions include - opening of letters of credit, issue
of ITs, MTs, traveller's cheques, circular letters of credit on foreign branches or
correspondents, collection of rupee cheques, drafts etc., on behalf of an overseas
branch or correspondent.

(b) On the other hand, when a bank in Mumbai purchases an export bill drawn in
dollars and sends it to its correspondent in New York for collection, or pays a IT
drawn on it by its branch in London, the purchase of the bill or the payment of the
IT is a purchase transaction.
In the case of the bill, the drawer in India receives the proceeds in rupees, while the
New York correspondent receives payment against it in dollars; and in the case of
the IT, the funds are deposited in London in pound sterling, while the payee
receives payment in India in rupees. Thus, a foreign exchange transaction which
involves the conversion of a foreign currency, such as U.S. dollar, pound sterling,
etc.,

into the
home currency, that is, rupees, is a purchase transaction. As a result of purchase
transactions, foreign exchange is earned. Other purchase transactions include
payment of DDs, MTs, circular letters of credit, etc., issued by foreign branches or
correspondents, negotiation of export bills drawn under letters of credit opened by
foreign branches or correspondents, collection or discounting of export bills,
sending foreign cheques, drafts, etc., to overseas branches or correspondents for
collection, etc.
~ 8.4 SPOT/FORWARD TRANSACTIONS
(a) Spot:
A transaction which involves an immediate conversion of currency and the
delivery or receipt of the currency sold or bought immediately with the offer
of sale or after the purchase is a spot transaction. Under it settlement takes
place on the second working day.
(b) Forward:
When the conversion between two · currencies, and consequently, the receipt
or delivery of the currency bought or sold, are to take place at a future date at
a rate of exchange agreed upon now, such a transaction is forward transaction.
Forward transactions are usually made in order to avoid exchange risks, or for
the purpose of squaring up the exchange position of a bank. Delivery of funds
takes place on any day after spot date.
~ 8.5 FOREIGN EXCHANGE MARKET
(a) Definition:
The foreign exchange market is the market for buying and selling foreign
currencies. There is in India no particular place, like a Stock Exchange, for
transactions in foreign exchange. The exchange market may be said to be composed
of the two principal operators in it, namely, the dealers and the brokers. The
operations, i.e., buying and selling of foreign exchange, are done over the telephone
or by personal contact between the brokers and the dealers. The brokers.are the
intermediaries acting on commission between the dealers, while the dealers, i.e., the
exchange banks, the State Bank of India and the 19 nationalized banks, etc,
authorised to deal in foreign exchange, act as principals buying and selling on their
own account. The customers as well as the foreign banks with whom the banks in
India enter into forward contracts for purchase or sale of foreign exchange may also
be treated as components of the foreign exchange to and from banks at rates fixed
by it, is at the apex, controlling the exchange market in India.

The foreign exchange market is the international market in which buyers and sellers
of currencies "meet".
It is largely decentralised. the participants (classified as market makers, brokers and
customers) are physically separated from one another, they communicate via
telephone/i nternetle-mail. Trading volume is large. Most of this large trading was
between book market makers. The market is dominated by the market makers at
commercial and investment banks. who trade currencies with each other both
directly and through foreign exchangc brokers. Market-makers. make a market in
one or
..... more currencies by providing bid and ask prices upon demand. A broker
arranges trades by keeping a book of
•••••.• market makers' limit orders - that is orders to buy (alternatively to sell) a
specified quality of foreign currency
•• ~.~ ~~;t:~~~~e:r~{~~:s bo:~o:e ~:~~~h:; C~~I~~~~:~r~~~r~i~n:;~de
~~~e~~~~~:~~hne:~;~~~~'p~:t: ~ne~~:~a~~~t :~~
the customers of the market making banks, who generally use the market to
complete transaction in international
trade and central banks, who may enter the market to move exchange rates or
simply to complete their own
international transactions. Market makers may trade for their own account - that is,
they may maintain a long or
short position in a foreign currency - and require significant capitalisation for that
purpose. Brokers do not
contract customers and do not deal on their own account; instead they profit by
charging a fee for the service of
bringing foreign market makers together.
As the bankers' bank, the Reserve Bank is interested in developing the foreign
exchange
business of the banks in India as much as in developing an orderly, competitive and
active inter-bank
market in foreign currencies in order that banks may quote as fine rates as possible
to their customers
in the metropolitan as well as other centres in the country. And in discharge of its
function to maintain
the external value of the rupee it has directed the banks in India -
(i) to maintain a square or near-square 'position' in each foreign currency at the
close of
business on each day;
(ii) to secure a reasonable matching of the maturities of various transactions
entering the
position;
(iii) to maintain cash balances with their overseas branches/correspondents at levels
commensurate with the normal needs of business and to repatriate surpluses to
India;
(iv) to restrict their cover operations as far as practicable to the Indian inter-bank
exchange
market, and only when unavoidable, to have recourse to London and other
international
exchange markets; and
(v) to keep surveillance over the rupee balances maintained in their non-resident
rupee
accounts, particularly over the funding and repatriation operations, with a view to
checking
hot money flows and speculative transactions.
For the same purpose the Reserve Bank has advised the banks not to quote
preferential rates for
their rupee transactions with overseas branches/correspondents so that the exchange
value of the
rupee might not be depressed to levels not warranted by its external value as
determined by the multicurrency
basket. It has also imposed restrictions on the bank's granting or obtaining loans or
advances
to or from their overseas brancheslcorrespondents beyond certain limits or for
purposes other than
meeting the normal needs of business.
As for buying or selling foreign currencies from or to the banks, the Reserve Bank
purchases the
major foreign currencies, e.g., pound sterling, U.S. dollars, yen and euro both spot
and forward in
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which exports are generally invoiced. Forward purchases of pound sterling are
made by the Reserve
Bank at rates determined by it from time to time. The Reserve Bank's spot buying
rates for U.S.
dollar, and yen are normally based on the corresponding cross rates quoted in the
international
markets coupled with its buying rate for sterling, and the Bank's forward buying
rates for these
currencies are based on the corresponding cross rates and the premium/discount for
the currencies
quoted in the international markets coupled with its buying rates for pound sterling
for corresponding
months. The Reserve Bank sells these currencies only spot.
(b) Operations: The foreign exchange market has three-tier dealings:
(i) Dealing between banks and customers;
(ii) Dealing between local banks including the Reserve Bank and
(iii) Dealing between domestic banks and banks abroad.
(c) Contracts: Transactions in the foreign exchange market are made through
contracts between
the dealer and the banker, known as the 'broker's contracts.' Such contracts in India
contain, inter
alia, a ,clause: Subject to the Rules and Regulations of the Foreign Exchange
Dealers Association of
India (FEDAI).
The contracts may be: (i) Cash or Ready, under which the delivery is to be made
immediately, or
(ii) Forward, under which the delivery is to take place at a future date and the option
to take delivery
lies with the purchasing bank or customer. All contracts should be understood to
read "to be delivered
or paid for at the bank." Ready contracts between banks will be deliverable within
two business days
after the date of contract, while those between banks and their customers will be
deliverable on the
same day.
(d) Functions: By the very nature of its operations, the foreign exchange market is
international
and performs three functions, namely:
(i) Effecting transfer of purchasing power through a clearing process from one
country to
another;
(ii) Providing credit for foreign trade; and
(iii) Furnishing facilities for hedging foreign exchange risks.
(e) International Clearing: When goods are exported from one country, say India,
to another
country, say the USA, the exporter in India acquires a claim upon the importer in
the USA, and the
importer in the USA has payment to make to the exporter in India. Now, even if the
goods and the
relative credit instruments, i.e., bills of exchange, etc., move across the border, the
payment is made
by the importer and received by the exporter in their respective domestic currencies,
viz., dollar and
rupee. The linking of the receiving and the making of payment is done by banks;
and in the U.K., and
the USA, this is also done through the bill market, which is a constituent of the
foreign exchange
market. In India, there is no bill market as such.
(f) Providing Credit for Foreign Trade: Credit for foreign trade may be required by
an exporter
during the period of manufacture of the goods and/or for the period of transit of the
goods from one
country to another. Credit I-or imports may be needed by the importer for the period
between the
payment for the goods and his receipt of payment after selling them in their original
form or in a
processed form. In the former case, credit is provided by a bank by allowing
packing credit to the
exporter and/or by negotiating/purchasing/discounting his export bills, and in the
latter case, by
Agarwal, O. P.. International Financial Management, Himalaya Publishing House,
2009. ProQuest Ebook Central,
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Copyright © 2009. Himalaya Publishing House. All rights reserved.
opening letters of credit on his behalf and advancing money to him against import
bills if and when
he fails to honour such bills on presentation.
(g) Hedging: Hedging means covering exchange risks, i.e., the risks of fluctuations
in the
exchange rates which may adversely affect the home currency realisations of
exports and the home
currency cost of imports invoiced in a foreign cun·ency. Such risks are inherent in
forward
transactions, since there is always a likelihood of an adverse movement in the rate
of exchange. The
exchange risks involved in a forward sale transaction are covered by a forward
purchase and those in
a forward purchase transaction by a forward sale. In other words. the risks are
covered by taking
speculative risk in order to offset a bigger speculative risk in the opposite sense. An
importer, having
to pay foreign currency abroad in the future, runs the risk that the price of the
currency may rise
between the time the obligation arises and the time it must be discharged. To cover
himself against
this risk, that is, to hedge the risk, he can deposit abroad funds equal to the
prospective debt or he can
buy forward foreign exchange. Similarly, an exporter with funds falling due in
foreign exchange at
some future date runs the risk that the rate of exchange may fall between the time
he makes the
contract and the payment date. For cover, he can borrow abroad and use the
proceeds of his exports,
when received, to payoff the debt, or he can sell his expected foreign currency
forward.
Hedging is done through banks. It may be done through the spot market if the trader
has
sufficient cash or credit facilities; but it is usually done through a forward contract.
(h) Spot and Forward Market: The buying and selling of foreign currencies for spot
or ready
delivery against domestic currency collectively represent the spot market, while the
buying and the
selling of foreign cUlTencies under forward contracts for delivery at a future date at
a rate fixed now
represents the forward market.