Company Secretaryship Training

Project Report

Project Topic: Forex Management

Submitted By:

AKRITI PATHAK
Regd. No.: 240084711/03/2013
E-mail ID: akriti_pathak22@yahoo.com
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CONTENTS
PART PARTICULARi PAGE No.

Abbreviations 4

Acknowledgment 5

I. Introduction 6

a) What is Forex? 6

b) When did it start? 7

c) Development in India 7-8

d) Who trades in the Forex Market? 9

e) Forex Management 9

II. Features of Foreign Exchange Market 9-10

When Foreign Exchange/ Currency

Ill. Conversion required? 10-11

IV. Factor affecting Foreign exchange rates 12

1) Interest rate 12

2) Employment outlook 13

3) Economic Growth Expectation 13

4) Trade Balance 13

5) Central Bank Association 14

6) Political Conditions 14

V. Foreign Exchange in India 14-15

1) Authorized Money Changers 14

15
2) Authorised Dealers in Foreign Exchange

VI. Determination of Exchange Rate 15-22

1) Balance of Payment 16

2) Demand and Supply 16-19

3) Purchase Power Parity (PPP) 20

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4) Interest rate 21

VII. Foreign Exchange Risk 22

VIII. Types of Risk 22-24

1) Translation Exposure 23-24

2) Transaction Exposure 24

3) Economic Exposure 24

IX. FEMA 1999 25

1) Preamble of the act 25

2) Switch from FERA 25

3) Need for its management 26

4) Main features of FEMA 26-27

X. Types of foreign exchange transactions 27-29

1) Current account transactions 27

2) Capital account transactions 28-29

XI. Role of RBI in FOREX Market 29

XII. Conclusion 30

ABBREVIATIONS

US United States

OTC Over the Counter

GDP Gross Domestic Product

IMF International Monetary Fund

BIS Bank for International Settlement

CKD Completely Knocked Down

USA United States of America

PPP Purchasing Power Parity

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RBI Reserve Bank of India

TNC Transnational Corporations

WTO World Trade Organisation

NFP Non-Form Payroll

FERA Foreign Exchange Regulation Act

FEMA Foreign Exchange Management Act

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ACKNOWLEDGEMENT

The project is about emerging scope of the professionals in the field of Forex
Management. Forex Management is intended as a surreptitious way of managing
the funds the Country. India is an emerging economy where opportunities for the
investment are too wide or the route from where the funds must be entered in to the
economy mainly the approval route. So, we as professionals are the guide for those
foreigners who are interested to make investment. Various laws are applicable on
Foreign Direct Investment (FDI) where we can practice or advice for foreign direct
investment.

This project is a culmination of the constant endeavor to learn while

pursuing a professional course such as the Company Secretaryship Course. At the
outset I would like to express my sincere acknowledgements to my parents who
have always encouraged me to pursue the Company Secretaryship Course as well
as all my other family members. Further, I would also like to thank my Trainers Mr.
Vipul Seth and Mr. Ayush Sinha who has always trained me with great enthusiasm
and sincerity.

Further, I would also like to express my gratitude to my professional

colleagues at work who have always helped me while I was pursuing my
apprenticeship training and last but not least to the Almighty, who has given me the
strength, courage, perseverance and the power to grasp knowledge which are all
essential attributes to pursue a professional course such as the Company
Secretaryship Course.

-- Akriti Pathak
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1. INTRODUCTION

Forex, an acronym for Foreign exchange, is the largest financial market in the world
with an estimated $ 1.5 trillion in currencies traded daily, Forex provide income to
millions of traders and large bank worldwide.

Forex, unlike other financial markets, is not tied to an actual stock exchange.
Currencies are traded directly through network of banks and brokers by an electronic
network or the telephone. The Foreign Exchange market is therefore also referred to
have an “interbank” or “over the counter (OTC)” market.

Historically, Forex have been dominated by inter-world investment and commercial

banks, money portfolio managers, money brokers, large corporations and very few
private traders.

When the term Foreign Exchange Market come in between questions we get asked
all the time are :-

a. What is Forex trading?

b. When did it start?

c. Development in India?

d. Who are the major players?

Here are the answers to all your questions!

a. What is Forex?

Forex is the international market for the free trade of currencies. Traders place
orders to buy one currency with another currency. For example, a trader may want to
buy Indian Rupees with US dollars, and will use the Forex market to do this.

The Forex market is the world's largest financial market. Over $4 trillion dollars’
worth of currency are traded each day. The amount of money traded in a week is
bigger than the entire annual GDP of the United States.
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The Forex Market is a global, worldwide - decentralized financial market for trading
currencies. Financial centres around the world function as anchors of trading
between a wide range of different types of buyers and sellers around the clock, with
the exception of weekends. The foreign exchange market determines the relative
values of different currencies.

The main currency used for Forex trading is the US dollar.

b. When did Forex start?

As the world continued to tear itself apart in the Second World War, there was an
urgent need for financial stability. International negotiators from 29 countries met in
Bretton Woods and agreed to a new economic system where, amongst other things,
exchange rates would be fixed.

The International Monetary Fund (IMF) was established under the Bretton Woods
agreement, and started to operate in 1949. All exchange rates changes above 1%
had to be approved by the IMF, which had the effect of freezing these rates.

By the late 1960's the fixed exchange rate system started to break down, due to a
number of international political and economic factors. Finally, in 1971, President
Nixon stopped the US dollar being converted directly to gold, as part of a set of
measures designed to stem the collapse of the US economy. This was known as the
Nixon shock, and lead to floating rate currency markets being established in early
1973. By 1976, all major currencies had floating exchange rates.

With floating rates, currencies could be traded freely, and the price changed based
on market forces. The modern Forex market was born.

c. Development in India

The development in Forex management in India is undergoing rapid transformation.

It is increasingly getting integrated within the broad ambit of financial market. Over
the last 15 years, momentous changes have happened in the financial sectors. The
global foreign exchange market has grown manifold in the recent years. The latest
BIS Triennial Central Bank Survey on Forex and derivatives markets 2004 indicates
our substantial rise in activity in foreign exchange market across the world average
daily turnover at US $ 1.9 trillion in April 2004 showed an increase of 57 % and 36 %
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at current and constant exchange rates respectively compare to April 2001,

reversing the fall in global trading volumes between 1998 and 2001. Both global
factors such as search for yield and a secular depending in Asian financial markets
contributed to the strong growth. In this context, it is important to note that the share
of trading between banks and financial customers rose significantly from 28 % in
2001 to 33% in 2004.

However, the currency composition of turnover has not change significantly the US $
was on one side of 89% of all transaction followed by the Euro (37%), the Yen (20%)
of global turnover, followed by US $/Yen with 17% and US $/pound stealing with
14%. The percentage share of the Indian rupee, though miniscule in comparison,
has almost trebled to constitute 0.3% of the total daily turnover.

The Indian Forex market has widened and deepened since the 1990 on account of
implementation of various majors recommended by the high level committee on
balance of payment in 1993 (Chairman Dr. C Rangrajan), the expert group of foreign
exchange market in India in 1995 (Chaiman Shri O.P. Sodhani) and the committee
on capital accounting convertibility in 1997 (Chairman Shri S.S. Tarapore). With the
transition to a market – determined exchange rate system in March 1993 and the
subsequent gradual liberalization of restrictions on various external transactions,
ensuring orderly conditions in the Forex market in India has become one of the key
objectives. The RBI has undertaken various majors towards development of spot as
well as forward segment o foreign exchange market. As a result, the average gross
daily turnover increased to US $ 12.1 Billion in 2004-05 (April to March) from US $
3.7 billion in 1996 to 1997. The top 30 banks in India account for approximately 90%
of the overall turnover in the market.

India’s share in worldwide foreign exchange market turnover has grown to 0.9% in
2007, marking a three-fold jump from 0.3% in 2004.

This is the fastest increase in market share for any country in the world, according to
data compiled by Switzerland-based Bank for International Settlement (BIS).

The growth of India among the emerging nations was notable and reflects the efforts
of Indian authorities in recent times to ease control on capital movements.
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d. Who trades on the Forex market?

There are many different players in the Forex market. Some trade to make profits,
others trade to hedge their risks and others simply need foreign currency to pay for
goods and services. The participants include the following:

 Government central banks

 Commercial banks

 Investment banks

 Brokers and dealers

 Pension funds

 Insurance companies

 International corporations

 Individuals and Corporate

e. Forex Management

Forex Management may be defined as the science of management of:

1. generation,
2. use and

3. storage

Of foreign currencies in the process of exchange of one currency in to other is called

Foreign exchange.

The meaning of management in simple terms is to manage the man. Likewise,

foreign exchange markets must be managed by the regulators.

So, all the functions like generation, use and storage of the foreign currency must be
managed by the regulators.

II. FEATURES OF FOREIGN EXCHANGE MARKET

The foreign exchange market is unique because of the following reasons:-

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1. Its huge trading volume representing the largest asset class in the world
leading to high liquidity;

2. Its geographical dispersion;

3. Its continuous operation i.e., 24 hours a day except weekends, i.e. trading
from 20:15 GMT on Sunday until 22:00 GMT Friday;

4. The variety of factors that affect exchange rates;

5. The low margins of relative profit compared with other markets of fixed
income; and

6. The use of leverage to enhance profit and loss margins and with respect to
account size.

III. WHEN FOREIGN EXCHANGE OR CURRENCY CONVERSION REQUIRED?

Fundamentally, currency conversion involves a transfer of purchasing power.This is

necessary because international trade and capital transactions usually involve
parties living in different countries with different national currencies. Countries either
transfer power to or from their home currency in order to be active in the global
economy. Following are the conditions in which a company or an individual needs
Currency conversion or Foreign Exchange:-

A. When a company is importing goods from another country, it will usually give up
its domestic currency in the foreign exchange market to get the foreign currency
needed to pay for the import. Resulting, demand for the foreign currency
increases, supply in the foreign exchange market of the home currency
increases.
B. Companies receiving payment in foreign currencies need to convert these
payments to their home currency. For Example, A Japanese components
manufacturer receives payment in US$ from their US customer; the
manufacturer may want to convert it so it can be spent in Japan.

C. Companies paying foreign businesses for goods or services. For Example, A US

Company must obtainJapanese yen to pay for an order they received because
the contract specified “payment in yen.”

D. Companies investing spare cash for short terms in money market accounts. For
Example, US Company has dollars that they want to invest short term, but the
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interest rate is only 2% in US but 12% in South Korea. So the company changes
dollars into won and invests in the money market of South Korea. Rate of return
will depend on the interest rate and the value of the Korean won at the time they
exchange the won back into dollars and bring back their money to the U.S.

E. Companies taking advantage of changing exchange rates (Speculation = short

term moment of funds from one currency to another, seeking to profit from
changes in exchange rates)U.S. company has $10 million to invest. The
company thinks that the dollar is too strong against the yen (it is overvalued),
and that it will lose its value over time (depreciate).Assume exchange rate is $1
= Yen 120 and the Company changes money and receives1.2 billion Yen ($10
million x 120 yen). Over next three months value of the dollar drops, so that one
dollar buys less yen and now the exchange rate is $1 = Yen 100.Now the
company exchanges the 1.2 billion Yen back into dollars and because of the
new exchange rate receives $12 million.

F. A citizen of India travels abroad on a business visit and purchases foreign

currency from an authorized dealer.

G. An Indian citizen goes to USA for a period of 3 years under an employment

contract. He periodically remits US $ to his bank account in India.

H. An Indian student subscribe to a British scientific magazine and pays for it

through an international credit card held by him.

I. An Indian industrialist imports raw material from Malaysia for his plant under a
letter of credit arrangement provided by his Bank.

J. A sports goods manufacturer of India exports his consignment to Europe and

gets paid for it in foreign currency received through banking channels.

K. The World Bank disburses aid to an Indian state under infrastructure

development project.

Forex management being involved in all the trade and non-trade transactions
involving Forex, it is essential to have a broad idea of international banking and
trading practices. Since the transactions are taking place among counter parties
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from different countries, a standardized format of the documentation is used to

minimize errors.

From the above illustrations, we can see that all individuals and corporate firm are
required to deal with the Foreign exchange. So, the scope is so much wide.

IV. FACTORS AFFECTING FOREIGN EXCHANGE RATES

Currency changes affect you, whether you are actively trading in the foreign
exchange market, planning your next vacation, shopping online for goods from
another country—or just buying food and staples imported from abroad.

Like any commodity, the value of a currency rises and falls in response to the forces
of supply and demand. Everyone needs to spend, and consumer spending directly
affects the money supply (and vice versa). The supply and demand of a country’s
money is reflected in its foreign exchange rate.

When a country’s economy falters, consumer spending declines and trading

sentiment for its currency turns sour, leading to a decline in that country’s currency
against other currencies with stronger economies. On the other hand, a booming
economy will lift the value of its currency, if there is no government intervention to
restrain it.

Consumer spending is influenced by a number of factors: the price of goods and

services (inflation), employment, interest rates, government initiatives, and so on.
Here are some economic factors you can follow to identify economic trends and their
effect on currencies.

1. Interest Rates

"Benchmark" interest rates from central banks influence the retail rates financial
institutions charge customers to borrow money. For instance, if the economy is
under-performing, central banks may lower interest rates to make it cheaper to
borrow; this often boosts consumer spending, which may help expand the economy.
To slow the rate of inflation in an overheated economy, central banks raise the
benchmark so borrowing is more expensive.
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Interest rates are of particular concern to investors seeking a balance between yield
returns and safety of funds. When interest rates go up, so do yields for assets
denominated in that currency; this leads to increased demand by investors and
causes an increase in the value of the currency in question. If interest rates go
down, this may lead to a flight from that currency to another.

The interest rate is the cost associated with borrowing money; that is, the price of
credit. In a loan transaction, the lender gives up the immediate use of funds to the
borrower. In return, the lender receives compensation (interest), in addition to the
eventual full repayment of the loan amount. Interest is expressed as a percentage of
the loan amount. Setting interest rates is the primary monetary policy tool available
to central banks to manage open market economies.

2. Employment Outlook

Employment levels have an immediate impact on economic growth. As

unemployment increases, consumer spending falls because jobless workers have
less money to spend on non-essentials. Those still employed worry for the future
and also tend to reduce spending and save more of their income.

An increase in unemployment signals a slowdown in the economy and possible

devaluation of a country's currency because of declining confidence and lower
demand. If demand continues to decline, the currency supply builds and further
exchange rate depreciation is likely. One of the most anticipated employment reports
is the U.S. Non-Farm Payroll (NFP), a reliable indicator of U.S. employment issued
the first Friday of every month.

3. Economic Growth Expectations

To meet the needs of a growing population, an economy must expand. However, if

growth occurs too rapidly, price increases will outpace wage advances so that even
if workers earn more on average, their actual buying power decreases. Most
countries target economic growth at a rate of about 2% per year. With higher growth
comes higher inflation, and in this situation central banks typically raise interest rates
to increase the cost of borrowing in an attempt to slow spending within the economy.
A change in interest rates may signal a change in currency rates.

Deflation is the opposite of inflation; it occurs during times of recession and is a sign
of economic stagnation. Central banks often lower interest rates to boost consumer
spending in hopes of reversing this trend.
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4. Trade Balance

A country's balance of trade is the total value of its exports, minus the total value of
its imports. If this number is positive, the country is said to have a favourable
balance of trade. If the difference is negative, the country has a trade gap, or trade
deficit.

Trade balance impacts supply and demand for a currency. When a country has a
trade surplus, demand for its currency increases because foreign buyers must
exchange more of their home currency in order to buy its goods. A trade deficit, on
the other hand, increases the supply of a country’s currency and could lead to
devaluation if supply greatly exceeds demand.

5. Central Bank Actions

With interest rates in several major economies already very low (and set to stay that
way for the time being), central bank and government officials are now resorting to
other, less commonly used measures to directly intervene in the market and
influence economic growth.

For example, quantitative easing is being used to increase the money supply within
an economy. It involves the purchase of government bonds and other assets from
financial institutions to provide the banking system with additional liquidity.
Quantitative easing is considered a last resort when the more typical response—
lowering interest rates—fails to boost the economy. It comes with some risk:
increasing the supply of a currency could result in a devaluation of the currency.

6. Political conditions

Internal, regional, and international political conditions and events can have a
profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the
new ruling party. Political upheaval and instability can have a negative impact on a
nation's economy. For example, destabilization of coalition governments in Pakistan
and Thailand can negatively affect the value of their currencies. Similarly, in a
country experiencing financial difficulties, the rise of a political faction that is
perceived to be fiscally responsible can have the opposite effect. Also, events in one
country in a region may spur positive/negative interest in a neighbouring country
and, in the process, affect its currency.
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V. FOREIGN EXCHANGE IN INDIA

As we have discussed earlier that the Forex market in India is regulated by Reserve
Bank of India. Key participants in this market are Authorized money changers and
dealers.

1. Authorized money changers

Tourism sector plays an important role in India. Lots of tourists come to India and
vice versa. So, for their convenience the Reserve Bank has granted licenses to
certain established firms, hotel and other organization permitting them to deal in
foreign currency notes, coins and travelers Cheques subject to the directions issued
to them time to time. These firms and organizations are generally known as
“Authorized Money Changers”. These may be categorized in to two:

a. Full Fledged money changers who are authorized to undertake both

purchase and sell transaction with the public.
b. Restricted money changers who are authorized to purchase currency
notes, coins and travelers Cheques, subject to the conditions that all such
collections are surrendered by them in turn to an authorized dealer in
foreign exchange.

2. Authorized Dealers in Foreign exchange

Reserve Bank of India has the authority to issue the license to the banks which are
well equipped to undertake foreign exchange transaction in India. Such authorization
or license can be issued to the certain financial institutions for the same task as
issued to the Banks.

Turnover in Foreign Exchange market has two components,

a. Merchant transactions are the transaction undertaken by importers and
exporters
b. Interbank transactions.

VI. DETERMINATION OF EXCHANGE RATES

Various economists have evolved various theories or model by which the Exchange
rates of a currency rates can be determined. But, there is no universal accepted
theory or model to determine the exchange rates. However, certain approaches
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which provide a general frame-work for analysis of exchange rates which are as
discussed below:-
1. Balance of payments
2. Demand and Supply
3. Purchasing power parity (PPP)
4. Interest rate

1. Balance of Payment

Export and import are very vital transactions carried between two countries. Where a
country pays foreign exchange for the imports made by them similarly, when the
country make any export then receipts of foreign currency will take in to accounts
then two possibilities may be arise i.e.,
a. If foreign exchange payments exceed receipts and there is a deficit, then it
puts the home currency of the country under downward pressure against
foreign currencies. It means the home currency tends to depreciate.
b. If foreign exchange receipts exceed payment and there is a surplus, then it
puts the home currency of the country upward pressure against foreign
currencies. It means it tends to appreciate.

2. Demand and Supply

At the most basic level, exchange rates are determined by the demand and supply
of one currency relative to the demand and supply of another. The demand and
supply of currencies is fuelled by the supply and demand of goods and services. The
spot exchange rate depends on supply and demand of a foreign currency throughout
the day. This is in response to the changes in the supply and demand for goods and
services. Differences in spot rates reflect differences in supply and demand for
currencies. These differences will affect the value of the currency.

For example: If spot demand for US dollars is high and US dollars are in short
supply but the spot demand for British pounds is low and the supply of British
pounds is plentiful, the dollar will most likely appreciate against the pound. This
reflects the supply and demand for US and British goods.
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When can affect the demand and supply of goods and services:

For Example: Change in income due to increased employment, more workers in the
workforce, period of economic growth etc., give resident of a country more
expandable income. An increase in domestic income of a country will usually
encourage the residents o spend a portion of their additional income on imports.
When the income of a nation grows rapidly, imports tend to rise rapidly. Which
resulted in to more domestic currency is traded for more foreign currency and at the
domestic currency will usually depreciate.

If income in both trading partner are increasing, the country with the faster growing
income will increase demand for imports relatively more. This may lead to
depreciation in currency of the more rapidly growing national economy.

We will through some charts and an example to show how these forces work, from a
theatrical point of view:

Figure No.1 – Demand Curve

Figure 1 shows that the demand for British pounds in the United states. The curve is
a normal downward sloping demand curve, indicating that as the pound depreciates
relative to the dollar, the quantity of pounds demanded by Americans increases.
Note that we are measuring the price of the pound-the exchange rate-on the vertical
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axis. Since it is dollar per pound ($/£), it is the price of a pound in terms of dollars
and an increase in the exchange rate, R, is a decline in the value of the dollar. In
other words, movement up the vertical axis represent an increase in price of the
pound, which is equivalent to a fall in the price of the dollar. Similarly, movement
down the vertical axis represent a decrease in the price of the pound.

Figure No. 2 Supply Curve

Figure 2 shows the supply side of the picture. The supply curve slopes up because
British firms and consumers are willing to buy a greater quantity of American goods
as the dollar becomes cheaper (i.e., they receive more dollars per pound). Before
British customers can buy Americans goods, however, they must convert pounds
into dollars, so the increase in the American goods demanded is simultaneously an
increase in the quantity of foreign curency supplied to the US.

Figure No.3 Equilibrium Price

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Suppliers and consumers meet at a particular quantity and price at which they are
both satisfied. Figure 3 combines the supply and demand curves. The intersection
determines the market exchange rate and the quantity of dollars supplied to US. At
the exchange rate R1 the demand and supply of British Pounds to the US is equal
which is Q1 at point E.

3. Purchasing power parity/ Law of One Price:

In theory, the exchange rate should be the medium of transfer and equalize
purchasing power from one currency to another. To understand the relationship
between prices and exchage rates, we must examine two theories:
A. Law of One Price
B. Purchasing Power Parity

Law of One Price

a. Basic premise: If an identical product or service can be sold in two
different markets, and no restrictions exist on the sale or transportation
costs of moving the product between markets, the product’s price
should be the same in both markets.
b. Therefore, Price Currency A = Price Currency B X Exchange Rate.
c. How would this come about: This is the result of the occurrence of
arbitrage and markets seeking equilibrium. Prices that are different will
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tend to equalize in market free of transportation costs and trade

barriers.
d. For Example: US $/ British Pound Exchange Rate i.e., $1.50/ £1 jacket
selling for US $75 in New York should sell for £50 in London ($75/1.50).
If jackets in London sell for £40, demand would increase, and price
would go up in London while extra supply would lower the price in New
York.
e. Net Result in theory, prices will tend to equalize.

Purchasing Power Parity

a. In theory, the ideal is that the Exchange Rate should represent

equivalence of purchasing power between two currencies.
b. Basic Premise: If the Law of One price were true for all goods and
services, the PPP could be found from any individual set of prices,
assuming the market is efficient.

c. Thus Exchange Rate = P$ / P£

d. By Extension, in relatively efficient markets (few impediments to trade

and investment) then a ‘basket of goods’ should be roughly equivalent in
such country.

Extension of PPP/Law of One Price

It is applicable to a basket of goods and their prices. If relative prices change in a

basket of goods, the exchange rates should change to reflect the difference in
purchasing power for a given currency PPP.

For Example: On Jan 1, a basket of goods cost US $ 200 and Japan ¥ 20,000
and On Dec 1, the same basket of goods costs US $ 200 and Japan ¥ 22,000.

Result: It takes 10% more yen to buy the same basket of goods (22,000/
20,000) so the value of the yen is depreciating by 10%. The Dollar is
appreciating and will buy 10% more.

4. Interest Rate
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When we take interest rate as a determinants of Exchange rates then two

questions arise to understand the concepts i.e.,

A. What about the relationship of inflation and interest rates?

B. What is the impact on FOREX rates?

Theory says that nominal interest rates reflect expectations about future
inflation rates.

Fisher Effects (i = r + I) i.e., Nominal rates are equal to the real rate of return
plus compensation for expected inflation. For example, if the real interest rate
in a country is 5% and annual inflation is expected to be 10%, the nominal rate
will be 15%.

i – Normal interest rate

r – Real rate of return
I – Expected inflation

In the global market, differences in interest rates can exist. Investors will trade
in their home currency to obtain currency of the country offering the higher rate
so that they can purchase higher yield assets. Initially this will cause more
demand for the currency in the country with the higher rate and thus cause an
appreciation of that currency.

For Example: Japan has higher interest rate than the US. So, US investors
trade in their dollars for Yen in order to buy higher yield assets. This increased
demand for Yen causes the Yen to appreciate initially.

As investors transfer capital freely between countries and take advantage of

interestrate differences, eventually arbitrage will equalize them.

Example: Over time, the lower interest rate in the U.S. will attract more
borrowers and the demand for money in the U.S. will raise the interest rates
there. The increase in supply of money in Japan would begin to lower interest
rates there. This would continue until both sets of real interest rates are
equalized.
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PPP theory predicts that changes in relative prices will result in a change in
exchange rates; exchange rates are affected by inflation.From Fisher Effect,
we know that interest rates reflect expectations about inflation. Interest rates
tell us about inflation can cause exchange rates to change. Therefore, theory
says that interest rates reflect expectations about future exchange rates.

VII. FOREIGN EXCHANGE RISK

The risk that arises from changes in exchange rates: the likelihood that
unpredictable or unexpected changes in exchange rates will have an impact
(positive or negative) on the value of various activities of a company’s business.
Foreign exchange transaction affects the net asset or net liability position of the
buyer/seller. Carrying net assets or net liability position in any currency gives rise to
exchange risk.

For Examples:

1. An unexpected change in exchange rates will change the home currency value
of foreign currency cash payment that is expected from a foreign source;

2. An unexpected change in exchange rates will change the amount of home

currency needed to make a payment or service a debt that requires payment in
a foreign currency.

VIII. TYPES OF FOREIGN EXCHANGE RISK

Foreign exchange transactions are effected by various Kinds of risks. These are:

1. Translation exposure
2. Transaction exposure
3. Economic exposure

1. Translation exposure

The risk, faced by companies involved in international trade, that currency exchange
rate will change after the companies have already entered into financial obligations.
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Such exposure to fluctuating exchange rates can lead to major losses for firms.

All financial statements of a foreign subsidiary have to be translated into the home
currency for the purpose of finalizing the accounts for any given period.

Translation exposure is the degree to which a firm’s foreign currency denominated

financial statements is affected by the exchange rate changes. The changes in the
asset valuation due to fluctuations in the exchange rate will affect the group’s assets,
capital structure ratios, profitability ratios, solvency ratios etc.

Following procedure is to be followed:

a. Assets & Liabilities are to be translated at the current rate, i.e. the rate prevailing
at the time of preparation of consolidated statements.

b. All revenues & expenses are to be translated at the actual exchange rates
prevailing on the date of transactions.

c. Translation adjustments (gains or losses) are not be charged to the net income
of the reporting company. (They are accumulated & reported in a separate
account).

For example:

a. Currant Current exchange rate: $ 1 = Rs 47.10

Assets Liabilities

Rs. 20000000 Rs. 20000000

$ 424628 $ 424628
In the next period, exchange rate fluctuates to $ 1 = Rs. 47.50

Assets Liabilities

Rs. 20000000 Rs. 20000000

$ 421052 $ 421052

Decrease in the Book Value of the assets is $ 3575.

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Translation exposure = (Exposed assets – Exposed liabilities) * (Change in

exchange in exchange rates)

2. Transaction exposure

The risk of an investment value changing due to changes in currency exchange

rates. The risk that an investor will have to close out a long or short position
in a foreign currency at a loss due to an adverse movement in exchange rates also
known as "currency risk" or "exchange-rate risk".

This exposure refers to the extent to which the future value of firm’s domestic cash
flow is affected by exchange rate fluctuations. It arises from the possibility of
incurring exchange rate gains or losses on transaction already entered into and
denominated in a foreign currency.

“More the transactions, more the risk”

All transactions gains and losses should be accounted for and included in the
equity’s net income for the reporting period.

The exposure could be interpreted either from the standpoint of the affiliate or the
parent company.

3. Economic Exposure:- It refers to the degree to which a firm’s present value of

future cash flows can be influenced by exchange rate fluctuations.

It is a more managerial concept than an accounting concept.

The risk is that a variation in the rate will affect the company’s competitive position in
the market and hence its profits.

It cannot be hedged.

IX. THE FOREIGN EXCHANGE MANAGEMENT ACT, 1999

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Preamble of the Act: “An Act to consolidate and amend the law relating to foreign
exchange with the objective of facilitating external trade and payments and for
promoting the orderly development and maintenance of foreign exchange market in
India”.

As we can see that the whole act has been enacted only for the purpose to regulate,
promote, facilitate and manage foreign exchange, so how much this is important for
the Country.

The Foreign Exchange Management Act (FEMA) was an act passed in the winter
session of Parliament in 1999 which replaced Foreign Exchange Regulation Act. This
act seeks to make offenses related to foreign exchange civil offenses in place of
criminal offences. It extends to the whole of India.

FEMA, which replaced Foreign Exchange Regulation Act (FERA), had become the
need of the hour since FERA had become incompatible with the pro-liberalization
policies of the Government of India. FEMA has brought a new management regime
of Foreign Exchange consistent with the emerging framework of the World Trade
Organization (WTO). It is another matter that the enactment of FEMA also brought
with it the Prevention of Money Laundering Act 2002, which came into effect from 1
July 2005.

Unlike other laws where everything is permitted unless specifically prohibited, under
this act everything was prohibited unless specifically permitted. Hence the tenor and
tone of the Act was very drastic. It required imprisonment even for minor offences.
Under FERA a person was presumed guilty unless he proved himself innocent,
whereas under other laws a person is presumed innocent unless he is proven guilty.

1. Switch from FERA:

The introduction of Foreign Exchange Regulation Act was done in 1974, a period
when India’s foreign exchange reserve position wasn’t at its best. A new control in
place to improve this position was the need of the hour. FERA did not succeed in
restricting activities, especially the expansion of TNCs (Transnational Corporations).
The concessions made to FERA in 1991-1993 showed that FERA was on the verge
of becoming redundant. After the amendment of FERA in 1993, it was decided that
the act would become the FEMA. This was done in order to relax the controls on
foreign exchange in India, as a result of economic liberalization. FEMA served to
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make transactions for external trade (exports and imports) easier – transactions
involving current account for external trade no longer required RBI’s permission. The
deals in Foreign Exchange were to be ‘managed’ instead of ‘regulated’. The switch to
FEMA shows the change on the part of the government in terms of foreign capital.

2 Need for its management

The buying and selling of foreign currency and other debt instruments by businesses,
individuals and governments happens in the foreign exchange market. Apart from
being very competitive, this market is also the largest and most liquid market in the
world as well as in India. It constantly undergoes changes and innovations, which
can either be beneficial to a country or expose them to greater risks. The
management of foreign exchange market becomes necessary in order to mitigate
and avoid the risks. Central banks would work towards an orderly functioning of the
transactions which can also develop their foreign exchange market.

Whether under FERA or FEMA’s control, the need for the management of foreign
exchange is important. It is necessary to keep adequate amount of foreign exchange
reserves, especially when India has to go in for imports of certain goods. By
maintaining sufficient reserves, India’s foreign exchange policy marked a shift from
Import Substitution to Export Promotion.

3 Main Features
 Activities such as payments made to any person outside India or receipts
from them, along with the deals in foreign exchange and foreign security
is restricted. It is FEMA that gives the central government the power to
impose the restrictions.

 Restrictions are imposed on people living in India who carry out

transactions in foreign exchange, foreign security or who own or hold
immovable property abroad.

 Without general or specific permission of the Reserve Bank of India,

FEMA restricts the transactions involving foreign exchange or foreign
security and payments from outside the country to India – the
transactions should be made only through an authorized person.
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 Deals in foreign exchange under the current account by an authorized

person can be restricted by the Central Government, based on public
interest.

 Although selling or drawing of foreign exchange is done through an

authorized person, the RBI is empowered by this Act to subject the capital
account transactions to a number of restrictions.

 People living in India will be permitted to carry out transactions in foreign

exchange, foreign security or to own or hold immovable property abroad if
the currency, security or property was owned or acquired when he/she was
living outside India, or when it was inherited to him/her by someone living
outside India.

 Exporters are needed to furnish their export details to RBI. To ensure that
the transactions are carried out properly, RBI may ask the exporters to
comply with its necessary requirements.

X. Types of Transactions

A. Current Account Transactions

Current Account Transactions as defined in Section 2 (j) of FEMA, means a

transaction other than capital account transactions and without prejudice to the
generality of the other provisions shall include:

 Payments due in connection with foreign trade, other account current

business, services and short term banking and credit facilities in the
ordinary course of business.;
 Payments due as interest on loans and as net income from the
investments;

 Remittances for living expenses of parents, spouse and children

residing aboard;

 Expenses in connection with foreign travel, education and medical care

of parents, spouse and children.

B. Capital Account Transactions

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Capital account transactions of a person may be classified under the following

heads, namely:-

 Transactions, specified in Schedule I, of a person resident in India;

 Transactions specified in Schedule II, of person resident outside India.

Classes of capital account transactions of a person resident in India

 Investment by a person resident in India in foreign securities

 Foreign currency loans raised in India and abroad by a person resident in
India

 Transfer of immovable property outside India by a person resident in India

 Guarantees issued by a person resident in India in favors of a person

resident outside India

 Export, import and holding of currency/currency notes

 Loans and overdrafts (borrowings) by a person resident in India from a

person resident in India

 Maintenance of foreign currency accounts in India and outside India by a

person resident in India

 Taking out of insurance policy by a person resident in India from an

insurance company outside India

 Loans and overdrafts by a person resident in India to a person resident

outside India

 Remittance outside India of capital assets of a person resident in India

 Sale and purchase of foreign exchange derivatives in India and abroad

and commodity derivatives in India and abroad and commodity
derivatives abroad by a person resident in India.
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Classes of capital account transactions of a person resident in India

 Investment in India by a person resident outside India, that is to say,

 Issue of security by a body corporate or an entity in India and investment
therein by a person resident outside India; and

 Investment by way of contribution by a person resident outside India to the

capital of a firm or a proprietorship concern or an association of persons in
India.

 Acquisition and transfer of immovable property in India by a person resident

outside India.

 Guarantee by a person resident outside India in favors of, or on behalf of, a

person resident in India.

 Import and export of currency/currency notes into/from India by a person

resident outside India.

 Deposits between a person resident in India and a person resident outside

India.

 Foreign currency accounts in India of a person resident outside India.

 Remittance outside India of capital assets in India of a person resident

.outside India.

XI.RBI’s Role in the Forex Market

 To manage the exchange rate mechanism.

 Regulate inter-bank Forex transactions and monitor the foreign exchange risk
of the banks.

 Keep the exchange rate stable.

 Manage and maintain country's foreign exchange reserves.

 RBI has imposed foreign exchange exposure limits on banks (FE 12 of 1999).

 The limits are tied with the Paid up capital of the bank.
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 Previously banks had NOP limit, which was based on foreign exchange
volume handled by the bank.

XII. CONCLUSION

As per the report, Foreign Exchange market is one of the emerging areas of
opportunities for the corporate. Foreign exchange can be considered as an
instrument of money market where corporate can invest huge funds and make profits
in short term. For corporate which have foreign investment or foreign subsidiary or
companies mainly engaged in the export or import of goods and services requires to
keep a close view on the Foreign Exchange rates of various currencies in which the
Companies are mainly in to dealings with the other countries.

In the Indian perspective FOREX may be considered as a vital tool in managing the
debt of economy and its subsequent waiver or valuation. The concept of PPP also
plays a vital role in managing the burden of economy and bringing to fore t disparities
in earnings’ and expenditures of the nation in a judicious and wise manner so as to
enhance its presence as a key player in the global arena.

The role of RBI as a regulator of foreign exchange of the nation and its judicious and
wise policies including the re-fabrication of FERA to FEMA in due course has helped
INDIA to attain a safe and stale position in the great economic turmoil which has
seen almost all major economies of the world melting in its crucible. The judicious
step taken by RBI in purchasing gold worth 200 billion to prevent the currency and its
precise timing just before recession hit the world has also been seen as a vital step
by many economists round the globe as a celebrated step in insulating its currency
from the fluctuations of world market at large.
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Hence, an efficient regulatory authority and a mechanism to do so as RBI in INDIAN

context have become mandatory for a nation.Thus by and large one can conclude
that an efficient management of foreign exchange reserves of the nation especially
its dependence on dollar bullion (used as a global currency today) if done efficiently
aids a lot in the management of resources and repute of a nation in world market.
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