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FOREIGN EXCHANGE RATE MANAGEMENT

The main objective of India's exchange rate policy is to ensure that economic fundamentals are reflected in the external value of the rupee.
The three dominant views that shaped exchange rate policy in India since 1997 were:(a) exchange rates should be flexible and not fixed or pegged; (b) countries should be able to intervene or manage exchange rates; (c) reserves should at least be sufficient to take care of fluctuations in capital flows and liquidity at risk.

Subject to the above predominant objective, the conduct of exchange rate policy is guided by three major purposes as follow :-

First, to reduce excess volatility in exchange rates, while ensuring that the market correction of overvalued or undervalued exchange rate is orderly and calibrated. Second, to help maintain an adequate level of foreign exchange reserves.
Third, to help eliminate market constraints with a view to the development of a healthy foreign exchange market.

FEMA ACT 1999 Defines Foreign Exchange as Foreign Exchange means & includes as follow:-

a) All deposits, credits and balances payable in foreign currency, and any drafts, traveler's cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency and payable in any foreign currency.
b) Any instrument payable at the option of the drawee or holder, thereof or any other party thereto, either in Indian currency or in foreign currency, or partly in one and partly in the other.

What is Exchange Rate ? Exchange Rate is a rate at which one currency can be exchanged into another currency. In other words it is value one currency in terms of other. Ex: US $ 1 = Rs.54.36 This rate is the conversion rate of every US $ 1 to Rs. 54.36

Method I One Orange = Rs 2 One Apple = Rs 2.50


Price

Method II Rs. 10 = 5 Oranges Rs. 10 = 4 Apples

under both the methods is the same though expressed differently.

Method - I DIRECT(FC fixed) USD 1 = Rs 54.36 Pound1 = Rs.82.59 EUR 1 = Rs 71.12

Method - II INDIRECT( HC fixed) Rs 100 = USD 1.83 Rs 100 = GBP 0.83 Rs 100 = EUR 0.71

BENEFICIARIES
Governments, banks, businesses, traders, individual investors and vacationers all participate in the forex market. Governments use the forex market to ensure competitive trade. Banks use the forex market to invest. Businesses use the forex market to protect themselves against exchange rate risk. Traders and individual investors try to profit in the forex market. Vacationers use the forex market to convert their currencies.

FACTORS INFLUENCING FOREIGN EXCHANGE RATE.

Strength of the Economy :The strength of the economy affects the demand and supply of foreign currency. Political and Psychological Factors: Political or psychological factors are believed to have an influence on exchange rates. Economic Expectations :Exchange rates move on economic expectations. Since such expectations affect the external value of the rupee, all economic data the balance of payments, export growth, inflation rates and the likes are analyzed and its likely effect on exchange rates is examined. Capital Movements : Capital movements are one of the most important reasons for changes in exchange rates. Capital movements of foreign currency are usually more than connected with international trade. This occurs due to a variety of reasons both positive and negative.

Capital Movements : Capital movements are one of the most important reasons for changes in exchange rates. Capital movements of foreign currency are usually more than connected with international trade. This occurs due to a variety of reasons both positive and negative. Interest Rates : An important factor for movement in exchange rates in recent years is interest rates, i.e. interest differential between major currencies. Inflation Rates : It is widely held that exchange rates move in the direction required to compensate for relative inflation rates. Tariffs and Quotas : Tariffs and quotas exist to protect a countrys foreign exchange by reducing demand. Till before liberalization, India followed a policy of tariffs and restrictions on imports. Very few items were permitted to be freely imported.

Balance of Payments : As mentioned earlier, a net inflow of foreign currency tends to strengthen the home currency vis--vis other currencies. This is because the supply of the foreign currency will be in excess of demand. A good way of ascertaining this would be to check the balance of payments. If the balance of payments is positive and foreign exchange reserves are increasing, the home currency will become stronger.

HEDGING STRATEGY
Hedging is a transaction designed to limit what is called exchange rate risk. A business or individual is exposed to exchange rate risk when they conduct business in a country that uses a different currency.

A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to maintain their currency value constant against one another. The fixed exchange rate system was carried out in the earlier 90s. Under this, currencies of different countries were tied to gold. Thus, the exchange rate of different countries got automatically fixed. The flexible exchange rate system is one in which the value of currency of one country is expressed in terms of that of the other.

DEFINITION OF 'CURRENCY PEG'


A country or government's exchange-rate policy of pegging the central bank's rate of exchange to another country's currency. Currency has sometimes also been pegged to the price of gold. Also known as a "fixed exchange rate" or "pegged exchange rate."

THE PEGGED EXCHANGE RATE


A pegged, or fixed system, is one in which the exchange rate is set and artificially maintained by the government. The rate will be pegged to some other country's dollar, usually the U.S. dollar. The rate will not fluctuate from day to day Countries that have immature, potentially unstable economies usually use a pegged system. Developing nations can use this system to prevent out-of control-inflation. The system can backfire, however, if the real world market value of the currency is not reflected by the pegged rate. In that case, a black market may spring up, where the currency will be traded at its market value, disregarding the government's peg.

CURRENCY BASKET
A portfolio of several currencies with different weightings. For example, one may construct a currency basket with 40% euros, 35% U.S. dollars, and 25% British pounds; the percentages determine the basket's value. Using a currency basket is a common way to peg a currency without overexposing it to the fluctuations of a single currency. For example, Kuwait shifted the peg of the Kuwaiti dinar to a currency basket from the U.S. dollar in 2007 because the dollar was weak at the time, resulting in high inflation.

At present in both India and USA, there is floating exchange regime. Therefore the value of currency of each country in terms of the other depends upon the demand and supply of their currency. We shall take a case between the $ and the Indian Rupee: Indians sell Rupees for US $; People holding US $ will sell dollars in exchange for Rupees; It is the demand and supply of foreign exchange that will determine the rate between the two.

Price of R dollar [rupee s as R per dollar R (assu med)]

Excess Supply

Rs 46 Rs 45.5 Rs 44

Excess Demand

Quantity of dollars

SHAPE OF THE DEMAND CURVE


When there is a fall in the price of a $ in terms of rupees, that is when $ depreciates, fewer rupees than before would be required to buy a $ now. This implies, that goods worth in $s are now cheaper in terms of Indian rupees and also an increased demand of USA made goods in India. This implies to an increased demand for dollars which will again increase the price of the dollar. In the end this means that lower the price of a $, greater is the quantity of goods demanded for imports and higher the price of a dollar, smaller the quantity of imports demanded from the USA by the Indians. This causes the demand curve to slope downwards.

REASONS FOR DEMAND OF THE US $ [FOREIGN CURRENCY]


Indian individuals or firms that import goods from USA to India, need US $s; Indians traveling or living in USA would need $s to meet their demand; Indians that invest in shares and bonds of companies in USA would require $s; Indians that directly invest in houses, shops, etc. in the USA would need $s.

SHAPE OF THE SUPPLY CURVE


According to the current exchange rate between US $s and Indian rupees; Indian goods of worth Rs100 would be relatively cheaper in terms of dollars.[Suppose Rs48=$1] This will increase demand for Indian goods in the USA, and boost exports from India to USA at a higher price of the dollar and thus ensure more supply of $s in the foreign exchange market. This implies that increased supply of $s will reduce its value in terms of rupees and it also implies that the Indian goods will now be more expensive in terms of $s. This will reduce the demand for Indian goods, and hence reduce the supply of $s in the foreign exchange market. This shows, that when the rate of exchange is high, the supply increases, and vice versa.

REASONS FOR SUPPLY OF US $S


When USA exports goods and charges revenue in $s. Citizens of USA who invest $s in India. Those who make loans to Indians. American tourists who spend $s in India. Indians living in the USA send $s to their relatives in India [remittances].

THE EQUILIBRIUM EXCHANGE RATE


If equilibrium price of $ in terms of rupees is Rs.45.5 at which demand and supply curve intersect. At Rs46 [higher price of $] qty supplied exceeds qty demanded. Excess supply will reduce the exchange rate of $ and the price will fall back to Rs45.5. When the rate of $ in terms of rupees is Rs44, there will be excess demand. This will increase the price again to Rs45.5.

Pri Y Excess Supply ce D of dol R Rs 46 lar [ru Rs 45.5 R E pe es Rs 44 as R per Excess Demand dol lar] s O Q Quantity of dollars

There are factors other than the rater of a currency in terms of another currency that affects the demand and supply of the currency. This hence affects the equilibrium exchange rate. For e.g. if there is an increase in the income of the US economy, due to conditions of BOOM. This will increase imports in the US including goods from India. This implies that there will be an increase in the supply of $s in the foreign exchange market. This will cause a rightward shift in the supply curve, and hence affect the equilibrium price. This also shows that the value of the $ will depreciate and the value of the rupee will appreciate.

Purchase power parity[relative price levels]: To understand this, we must first assume that there are no restrictions in trade between countries, and transport cost is nil. Then the exchange rate between two countries will show the difference between the price levels in the two countries. The exchange rate can now be fixed, by the proportionate difference between the price levels prevailing in the country. For instance, a TV costs much higher in India that in the US. This will pay businessmen to buy TVs from the US and sell it in India.

CONTINUED..
This will decrease the supply of TVs in the US, and increase it in India. Hence the price of the same TV will now be high in the US and low in India. This process will continue till the price of the TV is same in both the countries. This concludes, that price levels in different countries affects the exchange rate of the currency. It must be noted that, it is only in the long run that with no trade restrictions, that this may be possible.

RATE OF INFLATION AND EXCHANGE RATE


High rate of inflation in a country will affect the exchange rate of that country. Suppose, India has a relatively high rate of inflation that USA. This means that the cost of production in India is higher than USA. This prompts the Indian consumer to import more goods from USA. This results in an increased demand for US $s.

The interest rate in a country relative to interest rate of other countries with which it trades its goods is an important factor affecting foreign exchange rate. This means that businessmen of the home country will invest in a the bonds of a foreign country if the latters interest rates are lower. As a result, there will be a flight of capital from the foreign country or Capital Inflows into the home country.

By convertibility of a currency, we mean that the currency of a country can be freely converted into currency of foreign country at market determined rate of exchange, ie. the rate determined by demand & supply. Here, there are authorized dealers of foreign exchange such as banks, which constitute Foreign Exchange market. The exporters who receive other currencies can go to these dealers and get their convertibility. Importers who require foreign exchange, can go to these dealers and get their home currency converted into foreign currency.

TYPES OF CONVERTIBILITY
Current Account Convertibility Currency convertibility means the freedom to convert one currency into other internationally accepted currencies, wherein the exporters and importers where allowed a free conversion of rupee. But still none was allowed to purchase any assets abroad. Capital Account Convertibility Capital Account Convertibility means that one currency can now be freely convertible into any foreign currencies for acquisition of assets like shares, properties and assets abroad. Further, the banks can accept deposits in any currency.

Daily foreign exchange market turnover in billions of US dollars

0.025 0.02 0.015 0.01 0.005 0 2002 2003 2004 2005 2006

INR / EUR

INR / EUR

2007

2008

2009

2010

2011

2012

INR / USD
0.03 0.025 0.02 0.015 0.01 0.005 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
INR / USD

A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally. The date of settlement is referred to as the value date. A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Both purchase and sale are conducted with the same counterparty.

An outright forward transaction (usually called just forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.

Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.

The foreign exchange market consists of two tiers: the interbank or wholesale market (multiples of $1M US or equivalent in transaction size), and the client or retail market (specific, smaller amounts). Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms, central banks and foreign exchange brokers.

UNDERSTANDING THE FOREX QUOTES


Working at any forex quote you note is that all currencies are quoted in pairs such as EUR/USD (Euro US dollar pair or) USD/JPY (US dollar yen pair) GBP/USD USD/CHF AUD/USD USD/CAD NZD/USD

A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.

Foreign currency dealers provide two quotes: Bid Price: Price at which the dealer is willing to buy foreign currency from you. Ask Price: Price at which the dealer is willing to sell foreign currency to you.

It is always the case that the Ask Price > Bid Price. The difference is the Bid-Ask spread.

Banks act as market makers and realise their profits from the spread: Bid-Ask Spread = (Ask-Bid)/Ask

Consider the quote example,

1.4484 1.4482 % spread 100 1.38%


1.4484

Many currency pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency. For example, an Australian importer needs Danish currency to pay for purchases in Copenhagen. The Australian dollar (symbol A$) is not widely quoted against the Danish kroner (symbol DKr). However, both currencies are quoted against the U.S. dollar. Assume the following quotes: Australian dollar A$1.5431/US$ Danish kroner DKr7.0575/US$

The Australian importer can buy one U.S. dollar for A$1.5431 and with that dollar buy DKr7.0575. The cross-rate calculation would be:

Australian dollar/U.S. dollar A$1.5431/US$ 0.2186 A$/DKr Danish kroner/U.S . dollar DKr7.0575/ US$

The Australian dollar be quoted at A$1.8445/US$ on Aug 19, 2012, while on March 2, 2012 it was quoted at A$1.335/US$.
Thus, the appreciation/depreciation of the US$, relative to the A$ from t-1 to t is:

Rt 1,t

St St 1 A$1.335/$ A$1.8445 /$ 27.6% St 1 A$1.8445 /$


Thus, the U.S.$ has depreciated relative to the A$ by 27.6%

A transferable futures contract that specifies the price at which a specified currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk.

Currency futures trading was started in Mumbai August 29, 2008. With over 300 trading members including 11 banks registered in this segment, the first day saw a very lively counter, with nearly 70,000 contracts being traded. The first trade on the NSE was by East India Securities Ltd Amongst the banks, HDFC Bank carried out the first trade. The largest trade was by Standard Chartered Bank constituting 15,000 contracts. Banks contributed 40 percent of the total gross volume.

Currency futures can be traded between Indian rupees and US dollar (US$ -- INR) The trading of Indian currency futures can be done between 9 am to 5 pm The minimum size of currency futures is US$ 1000 periodically the value of the contract can be changed by RBI and SEBI The currency future can have maximum validity of 12 months The currency futures contract can be settled in cash

There are 3 trade exchange that trades in currency futures 1. National Stock Exchange (NSE)
2. Bombay Stock Exchange (BSE)

3. Multi-Commodity Exchange (MCX)

According to market analysts, introduction of currency futures in the Indian market will give companies greater flexibility in hedging their underlying currency exposure and will bring in more liquidity into the market as currency future or forex derivative contract will enable a person, a bank or an institution to buy or sell a particular currency against the other on a specified future date, and at a price specified in the contract.

EXCHANGE RATE MANAGEMENT IN INDIA


India was under fixed exchange rate regime till March 1992. The exchange rate of the Rupee was determined and adjusted by the Central Bank (Reserve Bank of India). The Rupee was adjusted to a basket of currencies, comprising of currencies of important trade partners of India like US, Britain, Japan etc. Through the system of fixed/pegged exchange rate and exchange controls, the governments objective was to attain exchange rate stability to encourage traders and discourage speculators.

LIBERALIZED EXCHANGE RATE MANAGEMENT (POST 1991)


In March 1992, following the policies of liberalization and structural adjustment program, the Rupee was made partially convertible on the current account. When the Rupee began depreciating sharply at the end of 1995, the RBI intervened by selling the foreign exchange in the market to check further fall of the Rupee.

CURRENT SCENARIO
India went ahead with full convertibility of Rupee on the current account, but rightly adopted a very cautious, phased out approach towards Capital account convertibility. The country was in no way economically strong enough for Capital account convertibility. A strong economy would mean an appreciation of the Rupee. At the same time RBI has raised policy rates to check inflationary pressure. This would encourage more portfolio investment, leading to appreciation of the rupee. The RBI has thus stepped in to check the rupee from appreciating, following a managed float; allowing the exchange rate to be determined by market forces, while also intervening when required by buying and selling foreign exchange, to protect the economy from the dangers of volatile foreign capital and sudden depletion of reserves.

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