INTERNATIONAL FINANCE

Unit II
FOREIGN EXCHANGE MANAGEMENT

DR. ARIFA BEGUM

AURORA’S PG COLLEGE
 FOREIGN EXCHANGE MANAGEMENT
• Meaning Of Foreign Exchange
• According to Hartley Withers, “ Foreign exchange is the
art and science of international monetary exchange”
• 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.
• The main currency used for Forex trading is the US
dollar.
• The term Foreign exchange implies two things:
a)foreign currency and b) exchange rate
• Foreign exchange generally refers to foreign
currency, e.g. for India it is dollar, euro, yen, etc…
& the other part of foreign exchange is exchange
rate which is the price of one currency in terms of
the other currency. Forex is the international
market for the free trade of currencies. Traders
place orders to buy one currency with another
currency.
• Definition and Organization of the Foreign Exchange Markets
• Foreign exchange markets are markets on which individuals,
firms and banks buy and sell foreign currencies: – foreign
exchange trading occurs with the help of the
telecommunication net between buyers and sellers of foreign
exchange that are located all over the world
– a single international foreign exchange market for every
single currency
– foreign exchange trading takes place at least in some of the
world financial centers in every moment.
• Need of Forex Market
• All international trade (export/import) transactions are
essentially of two types: (1) The transfer of merchandise,
services and portfolio products, and (2) The exchange of
currencies.
• When buying goods from one country, you have to pay for it
in that country’s currency.
• Therefore they must exchange the domestic (home) currency
for an appropriate value of the other country’s currency & as
such the issue for a rate at which the conversion takes place
arises, thus known as the Foreign Exchange Rate.
Features of Forex Market
• 24-hour trading, 5 days a week with continuous access to global dealers
• Increase in international trade.
• An enormous liquid market making it easy to exchange most currencies.
• Volatile markets offering profit opportunities for speculators and
opportunities for hedgers.
• Recognized instruments (Forwards, Futures, Options and Interest Rate
Derivatives) for controlling risk exposure.
• The ability to make profit in rising or falling markets.
• Bigger role for BRIC economies and the other emerging markets in the
global trade.
• The market share of the 23 emerging market currencies increased to
14.0% in April 2010 from 12.3% in April, 2009.
 MARKET PARTICIPANTS
• Commercial banks
• Bank clients
• Brokers
• Central bank
• Arbitrageurs
• Traders
• Hedgers
• Speculators
• Corporates
• Financial intermediaries
Bank clients:
• Individuals, firms, non- banking financial
institutions need foreign currency in doing
their commercial or investment business.
Commercial banks
• They buy & sell foreign currencies for their
clients and trade for themselves.
Brokers:
• Agents that connects dealers interested in
buying and selling foreign exchange, but does
not become an active client in the transaction
• They provide their client, the bank, with the
information about the exchange rates at which
banks are willing to buy or sell a particular
currency
• central banks:
• Foreign exchange market interventions are
meant to influence the exchange rate of the
domestic currency in a way that is beneficial
for the domestic economy and, consequently,
for the country
• It does not necessarily have a profit, it can also
have a loss
• Arbitragers:
• They want to earn a profit without taking any kind
of risk (usually commercial banks
• Try to profit from simultaneous exchange rate
differences in different markets
• Making use of the interest rate differences that
exist in national financial markets of two countries
along with transactions on spot and forward foreign
exchange market at the same time (covered interest
parity)
• Hedgers and Speculators:
• Hedgers do not want to take risk while participating in the
market, they want to insure themselves against the
exchange rate changes
• Speculators think they know what the future exchange rate
of a particular currency will be, and they are willing to
accept exchange rate risk with the goal of making profit
• Every foreign exchange market participant can behave
either as a hedger or as a speculator in the context of a
particular transaction
• Participants in the Foreign Exchange Market
Participants at 2 Levels
• Wholesale Level (95%) - major banks
• Retail Level (business customers)
• Two Types of Currency Markets
• Spot Market: - Immediate transaction - Recorded by
2nd business day
• Forward Market: - Transactions take place at a
specified future date
• OVER- THE- COUNTER
• CLEARING CORPORATION
 Foreign Exchange Market in India
• Foreign Exchange Market in India
• The changing contours were mirrored in a rapid expansion of
foreign exchange market in terms of participants, transaction
volumes, decline in transaction costs and more efficient
mechanisms of risk transfer.
• The origin of the foreign exchange market in India could be
traced to the year 1978 when banks in India were permitted
traced to the year 1978 when banks in India were permitted to
undertake intra-day trade in foreign exchange.
• However, it was in the 1990s that the Indian foreign exchange
market witnessed far reaching changes along with the shifts in
the currency regime in India.
S
AUTHORISED PERSONS
• Authorized dealers:
 Commercial banks, state banks
• Financial institutions
 Factoring agencies
• Full fledge money transfers
 UCBs(Urban cooperative banks)
 FFMCs(full fledge money changers)
• The foreign exchange market in India consists of 3
segments or tires. The first consists of transactions between
the RBI and the authorized dealers (AD). The latter are
mostly commercial banks. The second segment is the
interbank market in which the AD’s deal with each other.
And the third segment consists of transactions between
AD’s and their corporate customers. As in any market
essentially the demand and supply for a particular currency
at any specific point in time determines its price (exchange
rate) at that point. Prior to 1990s fixed Exchange rate of the
rupee was officially determined by RBI.
• During the early years of liberalization, the
Rangarajan committee recommended that
India’s exchange rate be flexible. India moved
from a fixed exchange rate regime to “market
determined” exchange rate system in 1993.
This is explained as under..
• A country’s currency exchange rate is typically affected by the
supply and demand for the country’s currency in the
international foreign exchange market. Let’s take the example of
Rupee Dollar exchange. The rupee/dollar rate is a two-way rate
which means that the price of 1 dollar is quoted in terms of how
much rupees it takes to buy one dollar. The value of one currency
against another is based on the demand of the currency. If the
demand for dollar increases, the value of dollar would
appreciate. As the quotation for Rs/$ is a two way quote, an
appreciation in the value of dollar would automatically mean the
depreciation in Indian rupee and vice-versa. Besides the primary
powers of demand and supply, the Indian exchange rate is
affected by following factors:
• RBI Intervention: When there is too much volatility in the rupee-dollar rates,
the RBI prevents rates going out of control to protect the domestic economy.
The RBI does this by buying dollars when the rupee appreciates too much and
by selling dollars when the rupee depreciates way too much.
• Inflation: When inflation increases there will be less demand of domestic
goods and more demand of foreign goods i.e. increases demand for foreign
currency), thus value of foreign currency increases and home currency
depreciates thus negatively affecting exchange rate of home currency.
• Imports and Exports: Importing foreign goods requires us to make payment in
foreign currency thus strengthening the foreign currency’s demand. Increase in
demand increases the value of foreign currency and exports do the reverse.
• Interest rates: The interest rates on Government bonds in emerging
countries such as India attract foreign capital to India.
If the rates are high enough to cover foreign market risk, money would
start pouring in India and thus would provide a push to rupee demand
thus appreciating rupee value for exchange.
• Operations: The major sources of supply of foreign exchange in the
Indian foreign exchange market are receipts on account of exports and
invisibles in the current account, drafts, travellers cheque and inflows in
the capital account such as foreign direct investment (FDI), portfolio
investment, external commercial borrowings (ECB) and non-resident
deposits. On the other hand, the demand for foreign exchange rises from
imports and invisible payments in the current account, amortisation of
ECB (including short-term trade credits) and external aid, redemption of
NRI deposits and outflows on account of direct and portfolio investment.
• In India, banks exist in different tiers and there
are clear laws that determine which institution is
categorized as a financial institution. From these
legal institutions, all those who want to trade can
create accounts, access the market and choose
products that they would like to trade in. The
trading landscape has changed a lot over the
years especially since the 1990's when the Indian
regulatory authorities liberalized this market.
• F.E.D.A.I Foreign Exchange Dealer's Association of India
(FEDAI) was set up in 1958 as an Association of banks dealing in
foreign exchange in India (typically called Authorized foreign
exchange in India (typically called Authorized Dealers - ADs) as
a self regulatory body and is incorporated under Section 25 of
The Companies Act, 1956. It's major activities include framing of
rules governing the conduct of inter-bank foreign exchange
business among conduct of inter bank foreign exchange business
among banks vis-à-vis public and liaison with RBI for reforms
and development of Forex market.
• Public and private sector banks • Foreign banks • Co-operative
banks • Financial institutions such as EXIM bank, I.D.B.I.,I.F.C.I.
and S I D B I
 FUNCTIONS OF FEDAI
• Announcement of daily and periodical rates to
member banks
• Prescribing margin for calculating exchange
rates for various merchant transactions.
• Formulating code of conduct for dealers
working in banks exchange brokers for dealing
between each other
• UCBs & FFMC(Full fledge money changers)
• Sale and purchase of foreign exchange for
private and business visits abroad.
 Exchange rate mechanism
• An exchange rate mechanism (ERM) is a device
used to manage a country's currency exchange rate
relative to other currencies.
• It is part of an economy's monetary policy and is
put to use by central banks.
• Such a mechanism can be employed if a country
utilizes either a fixed exchange rate or one with
floating exchange rate that is bounded around its
peg (known as an adjustable peg or crawling peg).
• Most new currencies started as a fixed exchange
mechanism that tracked gold or a widely traded
commodity.
• It is loosely based on fixed exchange rate margins,
whereby exchange rates fluctuate within certain
margins.
• An upper and lower bound interval allows a currency to
experience some variability without sacrificing liquidity
or drawing additional economic risks. • The concept of
currency exchange rate mechanisms is also referred to
as a semi-pegged currency system.
• The most notable exchange rate mechanism happened in Europe
during the late 1970s. The European Economic Community
introduced the ERM in 1979, as part of the European Monetary
System to reduce exchange rate variability and achieve stability
before member countries moved to a single currency. It was
designed to normalize exchange rates between countries before
they were integrated in order to avoid any problems with price
discovery.
• The exchange rate mechanisms came to a head in 1992 when
Britain, a member of the European ERM, withdrew from the
treaty. The British government initially entered the agreement to
prevent the British pound and other member currencies from
deviating by more than 6%.
 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. say: US $ 1 = Rs. 69.48
• Types of Exchange Rates
• Fixed Exchange Rate
• Floating/Flexible Exchange Rate
• Managed Float
• Fixed exchange rate: This is where a Government maintains a
given exchange rate over a period of time. This could be for a
few months or even years. In order to maintain the exchange
rate at the stated level government uses fiscal and monetary
policies to control aggregate demand.
• Floating exchange rate : A floating exchange rate is where
the rate of exchange is determined purely by the demand
and supply of that currency on the foreign exchange market.
• Managed Float : This is where the currency is broadly
managed by the forces of demand and supply but the
government takes action to influence the rate of change in
the exchange rate
 SPOT RATE
• Spot Exchange Rate : A spot exchange rate is the price to
exchange one currency for another for immediate delivery.
• The spot rates represent the prices buyers pay in one currency
to purchase a second currency.
• Although the spot exchange rate is for delivery on the earliest
value date, the standard settlement date for most spot
transactions is two business days after the transaction date.
• The spot exchange rate is the price paid to sell one currency for
another for delivery on the earliest possible value date
• The spot exchange rate is the amount one currency will trade
for another today.
• In other words, it’s the price a person would have to pay in one
currency to buy another currency today. You could also think of
it as today’s rate that one currency can be traded with another.
• Spot Market : The foreign exchange spot market can be very
volatile; in the short term, rates are often driven by rumor,
speculation and technical trading. In the long term, rates are
generally driven by a combination of economic growth and
interest rate differentials. Central banks sometimes intervene
to smooth the market, either by buying or selling the local
currency or by adjusting interest rates
 FORWARD RATE
• Forward Exchange Rate : The forward exchange
rate (also referred to as forward rate or forward
price) is the exchange rate at which a bank agrees
to exchange one currency for another at a future
date when it enters into a forward contract with
an investor.
• Multinational corporations, banks, and other
financial institutions enter into forward contracts
to take advantage of the forward rate for hedging
purposes
• A forward rate is a rate applicable to a financial
transaction that will take place in the future.
• Forward rates are based on the spot rate,
adjusted for the cost of carry and refer to the
rate that will be used to deliver a currency,
bond or commodity at some future time.
• It may also refer to the rate fixed for a future
financial obligation, such as the interest rate on
a loan payment.
• Foreign Exchange Quotations & Rates
• American quotations and the European quotations
• The European quotations are quotes given as “number of units
of a currency per us dollar.“ • Example : JPY I25.65/ USD,
INR 69.57/ USD. – The American quotations are quotes given
as “number of US dollars per unit of a currency”. • Example :
USD 0.8775 / EUR, USD 0.014 / INR etc.
• Direct quotes :In a country, direct quotes are those
that give units of the home currency per unit of a
foreign currency,
• For example : INR 73.56/USD is a direct quote in
India . USD 0.6385/CANADIAN$ is a direct quote in
USA
• Indirect quotes : stated as number of units of a
foreign currency per unit of home currency.
• USD 0.04132/INR is a indirect quote in India
• JPY 0.243/USD is an indirect quote in America
• If the price of a basket of goods in
• Cross rates : Given the exchange rates of two countries,
the exchange rate for a third country can also be found
out.
• USD 0.02339/ GBP , USD 0.02536 / INR.
• TT buying rate : The banks quote a variety of exchange
rates. One of them is the TT buying rate (TT stands for
telegraphic transfer).
• TT rates are applicable for clean inward or outward
remittances where the banks undertake only the job of
money transfer and do not have to perform any other
function, such as handling documents.
• Bill buying rate : Exporters frequently draw bills of
exchange on their foreign customers. Then they sell
these bills to an authorized dealer in foreign
currency. The authorised dealer buys the bill and
then collects the payment from the importer.
• Exchange margin : The banks have to transmit or
transit the cheques or bills it has received, in which,
considerable amount of time and some money is
spent. In order to recover this along with profit the
bank or ad charges exchange margin.
• Bill selling rate : When an importer requests
the bank to make payment to a foreign
supplier, against a bill drawn on an importer,
the bank has to handle documents related to
the transaction. • For this, the bank loads
another margin on the base rate to arrive at
the bill selling rate. • Hence bill selling rate =
base rate + exchange margin.
• Bid rate and Ask rate:
• Bid and Ask The bank’s quote of Bid and Ask is
from the banker’s perspective.
• Bid = Buy Ask = Sell
• Eg. USD/INR = 64.50-64.55 If the Bid rate for
USD is 64.50 it means that the bank is ready to
buy 1$ for 64.50 If the ask rate is for USD is
64.55, it means that the bank is (asking if
someone will buy) selling 1$ for 64.55.
• Spread ASK MINUS BID = SPREAD Eg. 64-65 SPREAD = 64 - 65 = 1
Factors:
• a) Stability of the exchange rate
• Depth of the market - Volume of transaction High volume (deep
market) - narrow spread Low volume (thin market) - wider spread
• Spread = ask price –bid price/ask price *100
• A dollar has been quoted @ INR.35.0000-35.0050.CALCULATE
SPREAD.

• % SPREAD= 35.0050-35.0000/35.0000*100
• =0.0143
 Triangular arbitrage
• A triangular arbitrage opportunity is a trading strategy that
exploits the arbitrage opportunities that exist among three
currencies in a foreign currency exchange. The arbitrage is
executed through the consecutive exchange of one currency
to another when there are discrepancies in the quoted prices
for the given currencies.
• A triangular arbitrage opportunity occurs when the exchange
rate of a currency does not match the cross-exchange rate.
The price discrepancies generally arise from situations when
one market is overvalued while another is undervalued.
•
• If the price of the product in Paris is FFR 60.00
& the same product cost $ 22.00 in US, then
what should be the spot exchange rate for
FFR/$, If spot rate (ffr/$)= 2.3. explain
arbitrage.
• Price of the product in Paris = FFR60
• Price of the product in US=$22
• Spot exchange rate= FFR/$
• =60/22=2.73
 From following 3 quotes, examine if any
arbitrage gains are possible and if yes, calculate
the same for USD 1 million.
• 0.5591 UK Pound per USD (UK£/US$)
• 1.4521 Euro per UK Pound
• 0.8128 Euro per USD
• From following 3 quotes, examine if any
arbitrage gains are possible and if yes,
calculate the same for SGD 1 million.
• 64.85 JPY per SGD(Singapor $)
• 0.0113 CHF(Swiss franc) per JPY
• 0.7345 CHF per SGD
• The exchange rates of three currencies are
$1.19/€, $1.37/£ &€1.167/£ &. What are the
steps to conduct triangular arbitrage if you
start with $1000000?
• In New Delhi 1US$ is INR.46.010-48.000 & in
Paris 1US$ = 5.1025FFR-5.1050 FFR. Explain
arbitrage.
 Derivatives
• Derivatives
• Derivatives are derived values. A derivative is a
financial instrument or contract whose value is derived
from some other asset or economic variable called as
underlying assets.
• Derivatives are instruments which include – Security
derived from a debt instrument share, loan, risk
instrument or contract for differences of any other
form of security and , – a contract that derives its value
from the price/index of prices of underlying securities.
• A financial instrument whose characteristics and value
depend upon the characteristics and value of an
underlying assets, typically a commodity, bond, equity
or currency,
• Examples of derivatives include futures and options. •
Advanced investors sometimes purchase or sell
derivatives to manage the risk associated with the
underlying security, to protect against fluctuations in
value, or to profit from periods of inactivity or decline. •
These techniques can be quite complicated and quite
risky.
• Definition:
• Securities contract (regulation ) act, 1956, defines
derivatives as under
1. Security derived from a debt instrument, share,
loan whether secured or unsecured, risk
instrument or contract for differences or any
other form of security.
2. A contract which derives its value from the
prices or index of prices of underlying securities.
• Derivatives contract is between two parties to
buy and sell an asset at a certain price at a
specified quantity and at a specified future
time and place.
• They are two types of markets:
• Customized contract: over-the-counter
• Standardized contract: exchange trade
• Advantages of Derivative Market
• Diversion of speculative instinct form the cash market to the
derivatives.
• Increased hedge for investors in cash market.
• Reduced risk of holding underlying assets.
• Lower transactions costs.
• Enhance price discovery process.
• Increase liquidity for investors and growth of savings flowing into
these markets.
• It increase the volume of transactions.
• Evolution of derivatives
• 1997
• Odyssey of Indian derivative market.
• There are two types of derivatives 1. Financial
derivatives – Financial Derivatives the
underlying instruments is stock, bond, foreign
exchange. 2. Commodity Derivatives –
Commodity derivatives the underlying
instruments are a commodity which may be
sugar, cotton, copper, gold, silver.
• Forward contract • A forward is a contract in which one party
commits to buy and the other party commits to sell a specified
quantity of an agreed upon asset for a pre-determined price at a
specific date in the future. • It is a customized contract, in the
sense that the terms of the contract are agreed upon by the
individual parties. • A bilateral contract • Hence, it is traded OTC. •
Generally closing with delivery of base asset • Not need any initial
payment when signing the contract
• A forward contract is an agreement to buy or sell an asset on a
specified date for a specified price. • One of the parties to the
contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date, for a certain specified price
• Future contract:
• Future contracts are special type of forward
contracts.
• They are standardized and are traded on
exchanges (clearing corporations).
• The term like quantity, quality, delivery time,
place & value etc., are regulated by these
exchanges where they trade.
• Options:
• An option is a contract that gives one party (the option
holder) the right but not the obligation to perform a
specified transaction with another party(the option
seller).
Definition :
An option is an instrument or contract which gives one
party ( the option holder) the right but not the obligation,
to perform a specified transaction with another
party( the option writer) according to specified terms.
• Types of options
• Call option gives the buyer the right but not the
obligation to buy a given quantity of the underlying
assets, at a given price on or before a given future date.
• If assets price is higher than the strike price – Option is
in the money.
• If assets price is exactly at the strike price – Option is at
the money.
• If assets price is below the strike price – Option is out
of the money.
• Put gives the buyer the right but not obligation to sell a
given quantity of the underlying asset at a given price on
or before a given date.
• If asset price is lower than the strike price – Option is in
the money.
• If asset price is exactly at the strike price – Option is at the
money.
• If asset price is higher than the strike price – Option is out
of the money.
• Swaps are private agreement between two parties to
exchange cash flows in the future according to pre arranged
formula. They can be regarded as portfolio’s of forward
contract.
• The two commonly used swaps are:
• Interest rate swaps: This entail swapping only the interest
related cash flows between the parties in the same currency.
• Currency swaps: This entail swapping both principal and
interest between the parties with the cash flows in one
direction being in a different currency than those in the
opposite direction.
• Market participants
• Hedge is the position taken in derivative exchange/markets for
the purpose of reducing risk. A person who takes such position
is called hedger.
• A hedger uses the derivatives market to reduce risk caused by
movement in prices of shares/securities, commodities,
exchange rates, interest rate, indices, etc.
• The position taken by hedger is opposite to the risk he is
exposed.
• Taking an opposite position to the risk exposure is called
hedging strategy.
• A speculator may be defined as a investor who
is willing to take a risk by taking derivatives
position with the expectation to earn profits.
• The speculator forecasts the future economic
conditions and decides which position (long or
short) to be taken will yield a profit if his
forecast is correct.
• An arbitrageur is an intelligent trader who
attempts to make profits in a derivatives market
by simultaneously entering into two transaction
at a time in two different markets and takes
advantage of the difference in pricing.
• The arbitrage opportunities available in two
markets usually do not last long because of
heavy transaction by arbitrageur when such
opportunity arises.
• Market maker:
• Market maker is a trader who competes with a
number of participants by quoting both and
offer price simultaneously with a motive to
ensure that the public will receive a market
determinant price for their traders.
• The Foreign Exchange Regulation Act (FERA) of 1973 enacted in 1973 .
• In the backdrop of acute shortage of foreign exchange in the country
FERA had a controversial 27 year stint during which many bosses of the
Indian corporate world found themselves at the mercy of the
Enforcement Directorate (E.D).
• The FEMA (1999) or in short FEMA has been introduced as a
replacement for earlier Foreign Exchange Regulation Act (FERA)
• FEMA came into act on the 1st day of June,2000
• 49 sections in the Act.
• To consolidate & amend the law relating to foreign exchange. To
facilitating external trade & payments. To remove imbalance of
payment. To make strong & developed foreign exchange market.
Regulation of employment business & investment of non-residents.
• 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 residents of 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 MA 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.
 Types of foreign exchange market
• Spot Market
• The spot market is a market in which quick
transactions regarding currency exchange takes
place. Here buying and selling of currencies is done
for immediate delivery. Immediate payment at the
current exchange rate is provided to buyers and
sellers in the spot market. The Trade-in spot market
takes one or two days for settlement of transactions
and allows traders to open to the volatility of the
currency market.
• Forward contract
• It is a market in which transactions are done
for doing trade at some future date. Here both
payment and delivery are done at future date at
agreed exchange rate also termed as the
forward exchange rate. The contract is made
between buyers and sellers for sale and
purchase of currency after 90 days. Forward
contracts are non-standardized contracts.
• Future Market
• Future market is also similar to the forward market. In future
market, contract are made between buyers and sellers to do
trade in future. All payments and delivery in this market are
done at decided exchange rate which is also termed as future
rate. Whereas future contracts are standardized contracts and
cannot be customized. These contracts are standardized in
terms of their date, features, size, and cannot be negotiated.
Trading on future market is centralized on stock exchanges
like BSE, NSE, and KOSPI.
• Swaps Market
• Swap market is one where transactions for
simultaneous lending and borrowing of two
different currencies are done between investors. It
is a contract between two or more parties for
exchanging cash flows on the basis of a
predetermined notional principal amount. In the
swap market, there two types of swap transactions
done that are currency swap and interest swap.
• Option market:
• The options market is one where transactions are done for
exchanging one currency with at agreed rate and on a
specified date. Under the option contract, it is an option for an
investor to convert the currency but not under any obligation
to do so. The buyer of the option has the right but not an
obligation to sell or purchase the underlying currency in the
contract at future date and at agreed rate. Options are of two
types that is call option and put option. A put option gives the
right to sell and call option gives the right to buy.
 Bop payments
• Balance of payments (BOP) accounts are an accounting
record of all monetary transactions between a country and
the rest of the world. These transactions include payments
for the country's exports and imports of goods & services,
financial capital, and financial transfers.
• A country has to deal with other countries in respect of 3
items:- Visible items which include all types of physical goods
exported and imported. Invisible items which include all
those services whose export and import are not visible. e.g.
transport services, medical services etc. Capital transfers
which are concerned with capital receipts and capital
payment
• According to Kindle Berger, "The balance of
payments of a country is a systematic record
of all economic transactions between the
residents of the reporting country and
residents of foreign countries during a given
period of time".
 Importance of BOP
1. BOP records all the transactions that create demand for and
supply of a currency.
2. Judge economic and financial status of a country in the short-
term
3. BOP may confirm trend in economy’s international trade and
exchange rate of the currency. This may also indicate change or
reversal in the trend.
4. This may indicate policy shift of the monetary authority (RBI) of
the country.
5. BOP may confirm trend in economy’s international trade and
exchange rate of the currency. This may also indicate change or
reversal in the trend.
 Components of BOP
1.CURRENT ACCOUNT BOP
• BOP on current account is a statement of actual receipts and
payments in short period.
• It includes the value of export and imports of both visible and
invisible goods. There can be either surplus or deficit in current
account.
• The current account includes:- export & import of services,
interests, profits, dividends and unilateral receipts/payments
from/to abroad.
• BOP on current account refers to the inclusion of three balances of
namely – Merchandise balance, Services balance and Unilateral
Transfer balance
• Types of balances:
• Trade Balance
• Merchandise: exports - imports of goods Services:
exports - imports of services
• Income Balance
Net investment income: net income receipts from assets
Net international compensation to employees: net
compensation of Employees
Net Unilateral Transfers
Gifts from foreign countries minus gifts to foreign countries
• CAPITAL ACCOUNT:
• The capital account records all international transactions that
involve a resident of the country concerned changing either his
assets with or his liabilities to a resident of another country.
Transactions in the capital account reflect a change in a stock –
either assets or liabilities.
• It is difference between the receipts and payments on account
of capital account. It refers to all financial transactions.
• The capital account involves inflows and outflows relating to
investments, short term borrowings/lending, and medium
term to long term borrowing/lending.
• The reserve account balance:
• Three accounts: IMF, SDR, & Reserve and Monetary
Gold are collectively called as The Reserve Account.
• The IMF account contains purchases (credits) and re-
purchase (debits) from International Monetary Fund.
• Special Drawing Rights (SDRs) are a reserve asset
created by IMF and allocated from time to time to
member countries. It can be used to settle
international payments between monetary
authorities of two different countries.
• Errors and omissions:
• The entries under this head relate mainly to
leads and lags in reporting of transactions
• It is of a balancing entry and is needed to
offset the overstated or understated
components.
 Recent trends in BOP
• Key Features of India’s BoP 2019-20
• India’s Current Account Deficit (CAD) at US$ 6.3 billion (0.9 per cent of GDP) in of 2019-20
narrowed from US$ 19.0 billion (2.9 per cent of GDP) in Q2 of 2018-19 and US$ 14.2 billion (2.0
per cent of GDP) in the preceding quarter.
• The contraction in the CAD was primarily on account of a lower trade deficit at US$ 38.1 billion
as compared with US$ 50.0 billion a year ago.
• Net services receipts increased by 0.9 per cent on a y-o-y basis, on the back of a rise in net
earnings from computer, travel and financial services.
• Private transfer receipts, mainly representing remittances by Indians employed overseas, rose to
US$ 21.9 billion, increasing by 5.2 per cent from their level a year ago.
• In the financial account, net foreign direct investment was US$ 7.4 billion, almost same level as
in Q2 of 2018-19.
• Foreign portfolio investment recorded net inflow of US$ 2.5 billion – as against an outflow of
US$ 1.6 billion in Q2 of 2018-19 – on account of net purchases in the debt market.
• Net inflow on account of external commercial borrowings to India was US$ 3.2 billion as
compared with US$ 2.0 billion in Q2 of 2018-19.
• There was an accretion of US$ 5.1 billion to the foreign exchange reserves (on BoP basis) as
against a depletion of US$ 1.9 billion in Q2 of 2018-19
 CURRENT ACCOUNT CONVERTIBILITY
• CONVERTIBILITY OF CURRENT ACCOUNT
• Free convertibility of currency means that the currency
can be exchanged for any other convertible currency
without any restriction at the market determined
exchange rates.
• Convertibility of rupee means that the rupee can be
freely converted in to dollar, yen, pound, euro etc. and
vice versa at market determined exchange rates.
• India adopted 100% convertibility of Indian rupee in
1994.
 CAPITAL ACCOUNT CONVERTIBILITY
• RBI defined Capital Account Convertibility
(CAC) as the freedom to convert local financial
assets into foreign financial assets and vice
versa at market determined rates of exchange.
It is associated with changes of ownership in
foreign/ domestic financial assets and
liabilities and embodies the creation and
liquidation of claims on or by the rest of the
world
 TARAPORE COMMITTEE REPORT
• Jumping into capital account convertibility game without
considering the downside of the step can harm the
economy. The Committee on Capital Account Convertibility
(CAC) or Tarapore Committee was constituted by the
Reserve Bank of India for suggesting a roadmap on full
convertibility of Rupee on Capital Account.
• The committee submitted its report in May 1997. The
committee observed that there is no clear definition of CAC.
The CAC as per the standards, refers to the freedom to
convert the local financial assets into foreign financial assets
or vice versa at the market determined rates of exchange.
The CAC Committee recommended the implementation of Capital Account
Convertibility for a 3 year period viz. 1997-98, 1998-99 and 1999-2000. But
this committee had laid down some pre conditions as follows:
• Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5
per cent in 1997-98 to 3.5% in 1999-2000.
• A consolidated sinking fund has to be set up to meet government’s debt
repayment needs; to be financed by increased in RBI’s profit transfer to the
govt. and disinvestment proceeds.
• Inflation rate should remain between an average 3-5 per cent for the 3-year
period 1997-2000.
• Gross NPAs of the public sector banking system needs to be brought down
from the present 13.7% to 5% by 2000. At the same time, average effective
CRR needs to be brought down from the current 9.3% to 3%
• RBI should have a Monitoring Exchange Rate Band of plus
minus 5% around a neutral Real Effective Exchange Rate
RBI should be transparent about the changes in REER
• External sector policies should be designed to increase
current receipts to GDP ratio and bring down the debt
servicing ratio from 25% to 20%
• Four indicators should be used for evaluating adequacy of
foreign exchange reserves to safeguard against any
contingency. Plus, a minimum net foreign asset to currency
ratio of 40 per cent should be prescribed by law in the RBI
Act.