THE FOREX AND RISK MANAGEMENT

Executive Summary
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The foreign exchange market does not have a physical market place called the foreign exchange market. It is a mechanism through which one country's currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange market does not have any geographic location. The market comprises of all foreign exchange traders who are connected to each other through out the world. They deal with each other through telephones, telexes and electronic systems. The foreign exchange market operates twenty four hours a day during the business week; the only time it is silent is after the New York market closes on Friday afternoon and before the Sydney market opens on Monday morning (which would be Sunday evening New York time). In the aftermath of the Asian crisis, which curbed and restricted offshore trading in regional currencies, most derivatives markets in Asia are still in their infancy. Financial institutions trying to introduce or transplant products from mature markets to those that are lesser developed are meeting with limited success. The RBI has ushered rupee derivatives trading into the country: it has formally allowed banks and corporate to hedge against interest rate risks through the use of interest rate swaps (IRS) and forward rate agreement (FRA). According to the guidelines issued by RBI there will be no restriction on the tenure and size of the IRS and FRA entered into by banks. The IRS will also allow corporate to hedge their interest rate risks and also to provide an opportunity to swap their old high cost loans with cheaper ones. With the new guidelines in place, commercial banks, primary institutions and financial institutions can now undertake IRS and FRA as a product of their own balance sheet management and market making purposes. Initially, there was a lot of enthusiasm shown over swaps by corporates and financial institutions but now it seems to have waned. Not many deals have been reported for long. Market participants now realize that one can strike a couple of deals for the sake of

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publicity, but one cannot have a sustainable interest rate market based on a single benchmark that too when it is as short as an overnight call money market. The issues of concern being the lack of a term market and domestic interest rates, particularly the overnight rate being hostage to the fortunes of the rupee in the Forex market. The swap market is expected to grow with growth in the money and forex markets.

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Objective
The main idea was to know what is foreign exchange market and what are Derivatives and how corporate use these Derivatives to manage the risk that they would have faced if there were no derivatives. And how these Derivatives helps corporate to minimize the risk and survive in world.

Research Methodology
The data for the project report was collected from diverse sources like books, Internet. The details of the books and sites visited have been mentioned in reference and bibliography. This report is a collection of secondary data.

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FOREIGN EXCHANGE
INTRODUCTION
Foreign exchange is the process of conversion of one currency into another currency. For a country its currency becomes money and legal tender. For a foreign country it becomes the value as a commodity. This commodity character can be understood when we study about Exchange Rate mechanism. Since the commodity has a value its relation with the other currency determines the exchange value of one currency with the other. For example, the US dollar in USA is the currency in USA but for India it is just like a commodity, which has a value which varies according to demand and supply. Foreign exchange is that section of economic activity, which deals with the means, and methods by which rights to wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of the current of another country. It involves the investigation of the method, which exchanges the currency of one country for that of another. Foreign exchange can also be defined as the means of payment in which currencies are converted into each other and by which international transfers are made; also the activity of transacting business in further means.

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Authorised Dealers In Foreign Exchange

The Reserve Bank of India (RBI) has granted licenses to certain established firms, hotels and other organizations permitting them to deal in foreign currency notes, coins and travellers cheques subject to directions issued to them from time to time. Except for transactions involving purchase or sale of foreign currency between any person and an authorized money changer, no person, firm or company, other than an authorized dealer, is permitted to enter into transactions involving the buying, acquiring or borrowing from, or selling, transferring or lending to, or exchanging with a person not being an authorized dealer, any foreign exchange except with the general or special permission of the RBI.

Authorised Money Changer

In order to provide facilities for encashment of foreign currency to visitors from abroad, especially foreign tourists, Reserve Bank has granted licenses to certain established firms, hotels and other organizations permitting them to deal in foreign currency notes, coins and travellers cheques subject to directions issued top them from time to time. The firms and organizations generally known as authorized moneychangers fall into two categories, namely Full-fledged money-changers who are authorized to undertake both purchase and sale transactions with the public and Restricted money-changers who are authorized only to purchase foreign currency notes, coins and travellers cheques, subject to the collections are surrendered by them in turn to an authorized dealer in foreign exchange/full-fledged moneychanger.

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FOREIGN EXCHANGE MARKET

Foreign exchange markets allow market participants to exchange one currency for another. One counterparty buys a specified currency from the other counterparty in exchange for another currency. The relative amount of the two currencies is determined by the foreign exchange rate between those two countries. The date on which the two currencies are exchanged is known as settlement date or value date. Foreign exchange market is the single largest market in the world. More than USD 1.44 trillion is traded in the FX market each day, according to the Bank for International Settlements, which monitors the FX market activity. To put this figure in perspective, the sum total of global trade in physical goods in one year accounts for the same amount of trade as a few days in the foreign exchange market. Hence the FX market is much, much bigger than all other markets put together.

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Exchange Rate
Countries of the world have been exchanging goods and services amongst themselves from time immemorial. With the invention of money, the rigors and problems of barter trade have disappeared. The barter trade has given way to exchange of goods and services for currencies instead of exchange for goods and services. As every sovereign nation has a distinct national currency, international trade has necessitated exchange of currencies and this exchange of currencies had necessitated exchange rate. Like any other commodity, the price of one unit of foreign currency can be stated in terms of domestic currency. Thus, the rate of exchange means the price of one currency in terms of another countrys currency. For instance, the price of US Dollar can be expressed in terms of Indian Rupees. If US Dollar 1 = INR 48.50(as on august 282002), it means the exchange rate of US Dollar and Indian Rupees is 1:48.50. Exchange rates are normally quoted in terms of a buying rate, a flat rate, and a selling rate. The buying rate in that which a bank will pay for foreign currency. The selling rate is the rate a bank will charge for currency, and the flat is an average of the buying and selling rates. In other words, the exchange rate is said to be the rate at which a number of units of one currency can be exchanged for a number of another currency.

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Exchange Determination and Forecasting

INTRODUCTION: EXCHANGE RATE AN OVERVIEW

What is Exchange rate?

Countries of the world have been exchanging goods and services amongst themselves from time immemorial. With the invention of money, the rigors and problems of barter trade have disappeared. The barter trade has given way to exchange of goods and services for currencies instead of exchange for goods and services. As every sovereign nation has a distinct national currency, international trade has necessitated exchange of currencies and this exchange of currencies necessitated exchange rate. Like any other commodity, the price of one unit of foreign currency can be stated in terms of domestic company. Thus, the rate of exchange means the price of one currency in terms of another country. For instance, the price of US Dollar can be expressed in terms of Indian Rupees. If US Dollar 1 = INR 48.50(as on August 28, 2002), it means the exchange rate of US Dollars and Indian Rupees is 1: 48.50. Exchange rates are normally quoted in terms of a buying rate, a flat rate, and a selling rate. The buying rate is that which a bank will pay for a foreign currency. The selling rate is the rate a bank will charge for the currency, and the flat rate is an average of the buying and the selling rates. In other words, the exchange rate is said to be the rate at which a number of units of one currency can be exchanged for a number of units of another currency.

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Some Important Terms

1. Fixed Exchange Rate System
In a fixed exchange rate system foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of dollars.

2. Intervention
Intervention is the buying or selling of foreign exchange by the central bank. Foreign exchange market intervention occurs when a government buys and sells foreign exchange in an attempt to influence the exchange rate.
3.

Flexible Exchange Rate System

In a flexible exchange rate system, the central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency. The terms flexible and floating rates are used interchangeably. In a system of Clean Floating Rate, Central Banks stand aside completely and allow exchange rates to be freely determined in the foreign exchange markets. Under a Managed or a Dirty floating rate, Central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates.

4. Devaluation
Devaluation takes place when the price of foreign currencies under a fixed rate regime is increased by official action. The outfall of this is that the foreigners pay less for the devalued currency and the residents of the devaluing currency pay more for foreign currencies.

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5. Depreciation
A change in price of foreign exchange under flexible exchange rates is referred to as currency depreciation or appreciation. A currency depreciates when, under floating rates, it becomes less expensive in terms of foreign currencies. The reverse results in appreciation. If the exchange rate falls, the domestic currency is worth more; it costs fewer domestic currencies to buy a unit of foreign currency.

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Fixed Rate To Flexible Exchange Rate System

Different countries have adopted different exchange rate systems at different times. The following are some of such systems in brief Gold Bullion In modern times, the operative system of exchange rates has evolved from a gold bullion standard to a system of floating exchange rates with several alternative systems used in between. The gold bullion standard prevailed from about 1870 until 1914, and intermittently thereafter until 1944. Under this system, central governments defined their currencies in terms of a specific amount of gold bullion and agreed to redeem their currencies at the set rates (mint parities). However, as a commodity, the international market price of a currency (the exchange rate) would fluctuate above or below parity based on the supply and demand of that currency relative to others. If excessive demand forced the market price of a currency above the parity band, external debtors found it cheaper to pay their debts in gold. Conversely, if insufficient demand for a currency lowered its market price below the parity band, external creditors demanded payments in gold. Under this system, unless a country maintained a reasonable trade balance over time, continuing trade deficits would drain its gold reserves. The lower level of gold reserves would, in turn, result in shrinkage of that country's money supply and a lower internal price level. Lower domestic prices would eventually make the country's products more competitive in the international marketplace. As exports increased, the demand for the country's currency would also increase resulting in an inflow of gold reserves. With a self-balancing system such as this, the governments' role was a passive one in which they would merely permit the free flow of gold to stabilize economies and exchange rates. Thus, the gold bullion standard acted as an automatic stabilizer, at least in theory.

THE FOREX AND RISK MANAGEMENT The Gold Standard Many countries had accepted the Gold Standard as their monetary system during the last two decades of the nineteenth century. Under this system, the parities of currencies were fixed in terms of gold. The currencies of the countries, which were on gold standards, could be exchanged freely and the rate varied depending upon the gold content of the currencies. This was also known as the Mint Parity Theory of exchange rates. Gold Standard helped in maintaining the stability in exchange rates and correcting the disequilibria in their balance of payments on an automatic basis. This system was in vogue till the outbreak of World War I. Several efforts went futile in reviving this system and the era of Gold Standard came to an end by late 1930s. Bretton Woods System During the world wars, economies of almost all the countries suffered. In order to correct the balance of payments disequilibrium, many countries devalued their currencies. Consequently, the international trade suffered a deathblow. In 1944, following World War II, the United States and most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity exchange-rate system under which exchange rates were fixed (pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in response to the financial chaos that had reigned before and during the war. In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund (IMF) to act as the "custodian" of the system.

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Under this system,

a. Member governments were obligated to defend the exchange rates within a narrow band of about 1 percent above or below parity (the official exchange rate). b. The revaluation or devaluation of a currency was called for only in the case of "fundamental disequilibria" (chronic surpluses or deficits in a nation's balance of payments). c. Incase of insufficiency of the reserve amount available with a member country, the Monetary Fund could draw from their quota through Special drawing Rights (SDRs) with the IMF. Despite the fact that the IMF expressed currencies in terms of gold, in practice currencies were expressed in terms of dollars, and the Bretton Woods Agreement became a rigid dollar standard. This situation arose because the United States was the only country that agreed to redeem its currency for gold. Naturally, the dollar could not serve as both a national and an international currency, since under these conditions international liquidity (total trade financing potential) could be expanded only through larger balance-of-payments deficits on the part of the United States. The ensuing massive United States balance-of-payments deficits led to an erosion of confidence in the dollar as a store of wealth, the cancellation of the gold convertibility of the dollar in August 1971 by the United States, and the signing of the Smithsonian Agreement in December 1971 by the major trading nations, referred to as The Group of Ten. This was an attempt to restore monetary order by devaluing the dollar and establishing a wider parity band (plus or minus 2.25 percent). The Smithsonian agreement was reached wherein USA agreed to devalue its currency provided Germany and Japan revalued their currencies. Despite this effort, the United States continued to experience balance-of-payments deficits. In early 1973, an additional 1 percent devaluation of the dollar, along with agreement of

THE FOREX AND RISK MANAGEMENT several European Economic Community (EEC) member nations to let their currencies float against the dollar, dealt the death knell to the Bretton Woods and Smithsonian Agreements. Allowing exchange rates to float in the midst of financial chaos was like setting a boat adrift in the middle of a storm--smooth sailing was next to impossible. To make matters worse, the tripling of oil prices by the Organization of Petroleum Exporting Countries (OPEC) during 1973 hit the foreign exchange markets like a hurricane, causing global inflation to raise with the tide. However, the circumstances under which floating exchange rates were introduced are by no means the only problem with the system. The lack of an official common denominator and the diminished authority of the IMF have not helped matters. Money has become a commodity that is bought and sold at market prices. In the international economic sense, money has become a circular concept--defined only in terms of the price that each currency will bring in other currencies. In addition, three important trends developed that contributed to the problem. 1. There was a persistent increase in liquid resources available to the private sector relative to the monetary reserves held by the central banks. (The money supply was no longer tied to a country's gold reserves and the multiplier effect allowed for this growth.) 2. There were constantly improving techniques permitting market participants to shift large amounts of capital rapidly from one currency to another. 3. There were improving communication methods making information available instantaneously to a growing number of analysts throughout the world Thus with the uncontrollable capital flows, major countries suspended their obligation to intervene in the market and the Bretton Wood System, with its fixed parities, was effectively buried.

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Floating Rate System

With the exit of fixed parities system, different countries experimented with exchange rate systems. The breakdown of Bretton Woods System and the subsequent adoption of generalized floating by major industrialized countries, the option was left open to the developing countries to choose their own exchange rate regime in line with national preferences. Today, exchange rate regimes and practices vary considerably across countries. The widespread adoption of flexible exchange rate system has made major contributions by offering many countries the easier use of an effective means of adjustment and by reducing the political biases against adjustments, which existed under the par value system.

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Exchange Rate Systems In Different Countries

The member countries generally accept the IMF classification of exchange rate regime, which is based on the degree of exchange rate flexibility that a particular regime reflects. However, it has been generally observed that there exists no strict relationship between a particular regime and the degree of exchange rate flexibility it faces, either at the nominal or real exchange rate levels. The exchange rate arrangements adopted by the developing countries cover a broad spectrum, which are as follows:

a) Single Currency Peg

The country pegs to a major currency, usually the U. S. Dollar or the French franc (ExFrench colonies) with infrequent adjustment of the parity. Many of the developing countries have single currency pegs.

b) Composite Currency Peg

A currency composite is formed by taking into account the currencies of major trading partners. The objective is to make the home currency more stable than if a single peg was used. Currency weights are generally based on trade in goods exports, imports, or total trade. About one fourth of the developing countries have composite currency pegs.

c) Flexible Limited vis--vis Single Currency

The value of the home currency is maintained within margins of the peg. Some of the Middle Eastern countries have adopted this system.

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d) Adjusted to indicators
The currency is adjusted more or less automatically to changes in selected macroeconomic indicators. A common indicator is the real effective exchange rate (REER) that reflects inflation adjusted change in the home currency vis--vis major trading partners.

e) Managed floating
The Central Bank sets the exchange rate, but adjusts it frequently according to certain pre-determined indicators such as the balance of payments position, foreign exchange reserves or parallel market spreads and adjustments are not automatic.

f) Independently floating
Free market forces determine exchange rates. The system actually operates with different levels of intervention in foreign exchange markets by the central bank. It is important to note that these classifications do conceal several features of the developing country exchange rate regimes. A particular regime may be compatible with dual or multiple rates, separate exchange rates for capital and current account transactions, a combination of fixed-floating arrangement and tax-subsidy schemes for export import trade.

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The Evolution Of Indias Exchange Rate Regime

Market in India
The Rupee was historically linked with Pound Sterling. India was a founder member of the IMF. During the existence of the fixed exchange rate system, the intervention currency of the Reserve Bank of India (RBI) was the British Pound; the RBI ensured maintenance of the exchange rate by selling and buying pounds against rupees at fixed rates. The inter-bank rate therefore ruled the RBI band. During the fixed exchange rate era, there was only one major change in the parity of the rupee- devaluation in June 1966. According to John E. Rule, it is the views of participants in the foreign-exchange markets that result in the daily buying and selling pressures on currencies. The views of these participants, such as traders, bankers, and businessmen, are in turn influenced by political, economic and psychological factors. Political Factors The political factors influencing exchange rates include the established monetary policy along with government action or inaction on items such as the money supply, inflation, taxes, and deficit financing. Active government intervention or manipulations, such as central bank activity in the foreign currency markets, also have an impact. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Finally, there is also the influence of the International Monetary Fund.

Economic Factors Economic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalances, and EuroMarket activities. Irving Fisher, an

THE FOREX AND RISK MANAGEMENT American economist, developed a theory relating exchange rates to interest rates. This proposition, known as the Fisher Effect, states that interest rate differentials tend to reflect exchange rate expectations. On the other hand, the purchasing-power-parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios. Other economic factors influencing exchange rates are included in a theory proposed by Dombush, who presented both a long-run view and a short-run view of exchange rate determinants. According to Dombush, the long-run determinants of exchange rates are the nominal quantities of monies, the real money demands and the relative price structure. Among the factors that exert an influence on real money demand are interest rates, expected inflation, and real income growth. In the short run, Dombush theorizes, exchange rates are determined by interest arbitrage together with speculation about future spot rates.

Psychological Factors Psychological factors also influence exchange rates. These factors include market anticipation, speculative pressures, and future expectations. A few financial experts are of the opinion that in todays environment, the only trustworthy method of predicting exchange rates is by gut feel. Bob Eveling, vicepresident of financial markets at SG, is Corporate Finance's top foreign exchange forecaster for 1999. Eveling's gut feeling has, defied convention, and his method proved uncannily accurate in foreign exchange forecasting in 1998. SG ended the Corporate Finance forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to Eveling's intuition on any currency is keeping abreast of world events. Any event, from a declaration of war to a fainting political leader, can take its toll on a currency's value. Today, instead of formal models, most

THE FOREX AND RISK MANAGEMENT forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment.

Factors Influencing Fx Rates

The government to control its foreign exchange rates uses the interest rates. The three key factors affecting interest rates are: The supply and demand for money The rate of inflation Government interventions

There are a number of other factors which have both long and short term influences on exchange rates which also need to be considered for a complete picture. These influences can be grouped broadly as shown in the following diagram:

Economic

Political

Influences on Exchange rate

People

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Economic Factors
In this category there are four factors to be considered: Relative interest rates Purchasing power parity (PPP) Economic conditions Supply and demand for capital Relative Interest Rates Large investors can easily switch investments between different currencies so it is important for them to compare the returns from investments in different currencies to make sure they obtain the best investment performances. If an investor can receive a higher interest rate by lending money in a foreign currency than he can by lending money in his domestic currency, it makes sense for that investor to lend in the foreign currency.

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Comparing interest rates in different currencies in this way is called comparing relative interest rates. However, as the FX rate may vary over the tenor of the loan, the investor is exposed to the risk that the foreign currency may be depreciate against the domestic currency by more than the difference between the two interest rates. In this case, the investor will make a loss by lending in foreign currency. In fact, currencies with higher interest rates tend to appreciate against other currencies because more investors buy the high interest currency in order to chase the higher returns.

Purchasing Power Parity (PPP)

Purchasing power parity is the measure of the relative purchasing power of different currencies. It is measured by the price of the same goods in different countries, translated by the FX rate of that countrys currency against a base currency, usually the dollar. The concept behind purchasing power parity is that if goods are cheap in one country it pays to export them to another country where they are more expensive. If the equivalent amount of currency purchases exactly the same amount of goods in every country then international trade is no longer profitable. That is, every currency is in purchasing power parity.

Economic Conditions
FX exchange rates are affected in the long-term by a countrys economic conditions and trends such as: Balance of payments Economic growth

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Rate of inflation Money supply Unemployment figures Rates of taxation

Supply and demand for capital

Capital flows to a country where investors see opportunities. Some countries need capital and offer appropriate interest rates others have a surplus of money and so have lower interest rates. However, investors do no always invest purely for high interest rate returns. For example, Japanese car and electronic manufacturers have invested in manufacturing operations in the USA and Europe to overcome tariff and quota problem. In short-term normal business activities affect the supply and demand for capital.

Political Factors
Foreign exchange rates can be affected in the long and short term by political factors such as: The type of economic policies pursued by the government

THE FOREX AND RISK MANAGEMENT The amount of uncertainty in the political situation The regulatory policies followed by central banks and/or other regulatory bodies Central bank intervention in the FX market to strengthen or weaken its currency

Market Sentiment
Short term changes in FX rates are often a result of what market participants call market sentiment. This is the perception traders have of the short term prospects for the movement in the currency.

Market sentiment is usually said to be positive or negative. A currency will normally strengthen relative to other currencies on positive sentiment and weaken relative on other currencies on negative sentiment. Traders act as news about a given economy. Often, traders will anticipate a news report or significant government announcement by buying and selling the currency before the news is actually reported. Sentiment affects how the currency moves when the news really breaks. For example, if the market sentiment is positive ahead of the Governments announcements of GDP figures, the currency will probably rise in anticipation of the figures being announced. If the governments GDP figure is less than the market was expecting, the currency will fall, even if the GDP figure is still good news for the economy.

Technical Analysis

THE FOREX AND RISK MANAGEMENT Many market participants trade on the basis of past price movements. This is because they believe past market moves, rather than economic fundamentals or news, predict future market moves. This practice is called technical analysis. Technical analysis highlights the trends in the market based on the assumption that market participants will react in the same way today as they did in the past.

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INTEREST RATE SWAPS

An IRS can be defined as an exchange between two parties of interest rate obligations (payments of interest) or receipts (investment income) in the same currency on an agreed amount of notional principal for an agreed period of time. The most common type of interest rate swaps are the "plain vanilla" IRS. Currently, these are the only kind of swaps that are allowed by the RBI in India. Dealing in `Exotics' or advanced interest rate swaps have not been permitted by the RBI. In a plain vanilla swap, one party agrees to pay to the other party cash flows equal to the interest at a predetermined fixed rate on a notional principal for a number of years. In exchange, the party receiving the fixed rate agrees to pay the other party cash flows equal to interest at a floating rate on the same notional principal for the same period of time. Moreover, only the difference in the interest payments is paid/received; the principal is used only to calculate the interest amounts and is never exchanged. An example will help understand this better: Consider a swap agreement between two parties, A and B. The swap was initiated on July 1, 2001. Here, A agrees to pay the 3 month NSE-MIBOR rate on a notional principal of Rs. 100 million, while B pays a fixed 12.15% rate on the same principal, for a tenure of 1 year. We assume that payments are to be exchanged every three months and the 12.15% interest rate is to be compounded quarterly. This swap can be depicted diagrammatically as shown below:

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MIBOR (3m)

Party A
12.5%

Party B

An interest rate swap is entered to transform the nature of an existing liability or an asset. A swap can be used to transform a floating rate loan into a fixed rate loan, or vice versa.

BENEFITS FROM SWAPPING

a) Swap for a comparative advantage Comparative advantages between two firms arise out of differences in credit rating, market preferences and exposure. Example: Say, Firm A with high credit rating can borrow at a fixed rate of 12% and at a floating rate of MIBOR + 20 bps. Another firm B with a lower credit rating can borrow at a fixed rate of 14 % and a floating rate of MIBOR + 150 bps. Party A B Fixed Rate Loan 12% 14% Floating Rate Loan MIBOR + 0.20% MIBOR + 1.50%

Firm A has an absolute advantage over firm B in both fixed and floating rates. Firm B pays 200 bps more than firm A in the fixed rate borrowing and only 120 bps more than A in the floating rate borrowing. So, firm B has a comparative advantage in borrowing floating rate funds. Now, Firm A wishes to borrow at floating rates and becomes the floating rate payer in the swap arrangement. However, A actually borrows fixed rate funds in the cash market. It is the

THE FOREX AND RISK MANAGEMENT interest rate obligations on this fixed rate funds, which are swapped. At the same time, B wishes to borrow at a fixed rate, and thus will actually borrow from the market at the floating rate. Then, both the parties will exchange their underlying interest rate exposures with each other to gain from the swap. The calculation of the gain from the swap is shown below: The gain to firm A, because it borrows in the fixed rate segment is: 14% - 12% = 200 bps. And, the loss because firm B borrows in the floating rate segment is: (MIBOR + 20 bps) (MIBOR + 120 bps) = 130 bps. Thus, the net gain in the swap = 200 120 = 70 bps. The firms can divide this gain equally. Firm B can pay fixed at 12.15% to firm A and receive a floating rate of MIBOR as illustrated below:

MIBOR (3m)

Party A
12.5%

Party B

12%

MIBOR + 150 bps

Effective cost for firm A = 12% + (MIBOR 12.15) = MIBOR - 15 bps

THE FOREX AND RISK MANAGEMENT This results into a net gain of ((MIBOR + 20) - (MIBOR - 15)) i.e., a gain of 35 bps. Effective cost for firm B = (MIBOR + 150) + (12.15% - MIBOR) = 13.65% This results into a gain of (14% - 13.65%) i.e., a gain of 35 bps. Thus, both the parties gain from entering into a swap agreement. b) Swap for Reducing Cost of Borrowing With the introduction of rupee derivatives, the Indian corporates can attempt to reduce their cost of borrowing and thereby add value. A typical Indian case would be a corporate with a high fixed rate obligation. MIPL, an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of 18.5%. Today a 364-day T-bill is yielding 10.25%, as the interest rates have come down. The 3-month MIBOR is quoting at 10%. Fixed to floating 1 year swaps are trading at 50 bps over the 364 day T- bill vs. 6-month MIBOR. The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next one year. The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364-day treasury yield i.e. 10.25 + 0.50 = 10.75 %.

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10.75% MIBOR

18.5% MIPL
MIBOR (3m)

Party B

The effective cost for MIPL= 18.50 + MIBOR - 10.75 = 7.75 + MIBOR At the present 3m MIBOR is 10%, the effective cost is = 10 + 7.75 = 17.75% The gain for the firm is (18.5 - 17.75) = 0.75 % The risks involved for the firm are: Default/credit risk of party B: Since the counterparty is a bank, this risk is much lower than would arise in the normal case of lending to corporates. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments. The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond 10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firm hold a well-suggested view that MIBOR shall remain below 10.75%. This will require continuous monitoring.

How does the bank benefit out of this transaction?

The bank either goes for another swap to offset this obligation and in the process earn a spread. The bank may also use this swap as an opportunity to hedge its own floating liability. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%.

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CURRENCY SWAP TRANSACTION PROCESS

It may be noted that transaction-taking place in currency swaps are done in exactly the same manner as in the case of Interest Rate Swaps. The only difference is that in Interest Rate Swaps the underlying asset is interest rate while in case of Currency Swaps the underlying asset is that specified currency. Thus, here we need not see the swapping process all over again. It may be referred to in the Fixed Income Derivatives part of the project.

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BENEFITS OF CURRENCY SWAPS

To mange the exchange rate risk To lower financing cost To access restricted markets The international trade implies returns and payments in a variety of currencies whose relative values may fluctuate it involves taking foreign exchange risk. All the players, namely, FIs, banks, exchange dealers, etc are facing the risk. A key question facing the players then is whether these exchange risks are so large as to affect their business. A related question is what special strategies should be followed to reduce the impact of foreign exchange risk. One way to minimize the long-term risk of one currency being worth more or less in the future is to offset the particular cash flow stream with an opposite flow in the same currency. The currency swap helps to achieve this without raising new funds; instead it changes existing cash flows.

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THE FX DEAL
A foreign exchange deal may be defined as:
Its a contract wherein one party (country,fiis,fdis) Exchange with other party in the global market. Foreign Exchange Markets are OTC operating worldwide, with trading hours overlapping to make a 24 hour global market. The principal components of a deal are: Trade date Counterparty Currencies Exchange rate Amounts Value date Payment instructions

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THE FX MARKETS AT WORK

The Dealing Arena
The range of products available in the FX market has increased dramatically over the last 30 years. Dealers at banks provide these products for their clients to allow them to invest, speculate or hedge. The complex nature of these products , combined with huge volumes of money that are being traded, mean banks must have three important functions set up in order to record and monitor effectively their trades.

Front Office/Dealing Room

This is where OTC trading in financial markets takes place

Middle Office
This provides the dealers with specialist facilities, support, advice and guidance from risk managers, economists, technical analysis, legal advisers etc.

Back Office
This is where the processing, confirmation, settlement, query handling and cash management functions are carried out. It is important to remember that dealers cannot trade without back office.

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WORKING OF FOREIGN EXCHANGE MARKET

Banks will generally lend their customers money in any currency they demand. Thus, banks regularly have to participate in the foreign exchange market to buy and sell the currencies they are lending or receiving. In order that banks may deal quickly and efficiently in the FX market, there is an inter bank market, in which banks may buy and sell currencies in wholesale amounts. However, the bulk of FX trading is not directly related to international trade or investment. Most FX trading is carried out inter bank and is for profit. The main methods of trading FX are via: Direct inter bank Voice brokers Electronic broking system Most FX dealers specialize in one or a small group of closely related currencies. A liquidly in major currency is good but some of more exotic currencies can be thinly traded. The US dollar remains the major currency in FX terms with over 90% of world trade being settled in USD. In 1995 the USD was involved in 86% of FX transactions world-wide. Foreign exchange rates and interest rates are closely linked and affect one another, and in turn both can make an impact on a countrys domestic economy.

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The FX rate also affects a countrys balance of payments the net amount of inflows and outflows of money from a country in relation to trade payments. A strong domestic currency makes imports cheaper and tends to stimulate demand for imports, resulting in a balance of payments deficit. Conversely, a weak currency makes imports expensive and dampens demand for imports, resulting in a balance of payments surplus.

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The Participants In Foreign Exchange Markets

CUSTOMERS
The customers who are engaged in foreign trade participate in foreign exchange markets by availing of the services of banks. For example, Exporters require converting the dollars in to rupee and importers require converting rupee in to the dollars, as they have to pay in dollars for the goods/services they have imported. COMMERCIAL BANKS They are most active players in the Forex market. Commercial banks dealing with international transactions offer services for conversion of one currency in to another. They have wide network of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of the goods. As every time the foreign exchange bought and sold may not be equal banks are left with the overbought or oversold position. The balance amount is sold or bought from the market. Nowadays, in international foreign exchange markets, the international trade turnover accounts for a fraction of huge amounts dealt, i.e. bought and sold. The balance amount is accounted for either by financial transactions or speculation. Banks have enough financial strength and wide experience to speculate the market and banks does so. Which is popularly known as the trading in the Forex market. Commercial banks have following objectives for being active in the foreign exchange markets.

They render better service by offering competitive rates to their customers engaged in international trade;

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They are in a better position to manage risks arising out of exchange rate fluctuations; Foreign exchange business is a profitable activity and thus such banks are in a position to generate more profits for themselves; They can manage their integrated treasury in a more efficient manner. In India Reserve Bank of India has given license to the commercial banks to deal in foreign exchange under section 6 Foreign Exchange Regulation Act, 1973, who are called the Authorized Dealers (A Ds).

CENTRAL BANK
In all countries central banks have been charged with the responsibility of maintaining the external value of the domestic currency. Generally this is achieved by the intervention of the bank. Apart from this central banks deal in the foreign exchange market for the following purposes:

Exchange rate management: It is achieved by the intervention though sometimes banks have to maintain external rate of the domestic currency at a level or in a band so fixed.

Reserve management: Central bank of the country is mainly concerned with the investment of countries foreign exchange reserve in a stable proportions in range of currencies and in a range of assets in each currency. For this bank has to involve certain amount of switching between currencies.

EXCHANGE BROKERS
Forex brokers play a very important role in the foreign exchange markets. However the extent to which services of Forex brokers are utilized depends on the tradition and practice prevailing at a particular Forex market center. In India as per FEDAI guidelines the ADs are free to deal directly among themselves without going through

THE FOREX AND RISK MANAGEMENT brokers. The Forex brokers are not allowed to deal on their own account all over the world and also in India.

HOW EXCHANGE BROKERS WORK?

Banks seeking to trade display their bid and offer rates on their respective pages of Reuters's screen, but these prices are indicative only. On inquiry from brokers they quote firm prices on telephone. In this way, the brokers can locate the most competitive buying and selling prices, and these prices are immediately broadcast to a large number of banks by means of hotlines / loudspeakers in the banks dealing room / contacts many dealing banks through calling assistants employed by the broking firm. If any bank wants to respond to these prices thus made available, this is done by counterparty bank by clinching the deal. Brokers do not disclose counterparty bank's name until the buying and selling banks have concluded the deal. Once the deal is struck the broker exchange the names of the bank who has bought and who has sold. The brokers charge commission for the services rendered. In India broker's commission bas been fixed by FEDAI.

OVERSEAS FOREX MARKETS

Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading in world Forex markets is constituted of financial transactions and speculation. As we know that the Forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York, Sydney, and back to Tokyo.

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SPECULATORS The speculators are the major speculators in the Forex market.

Banks dealing are the major speculators in the Forex markets with a view to make profit on account of favorable movement in exchange rate, take position i.e. if they feel that rate of particular currency is likely to go up in short term. They buy that currency and sell it as soon as they are able to make quick profit.

Corporations' particularly Multinational Corporation and transnational corporations having business operations beyond their national frontiers and on account of their cash flows being large and in multi currencies get in to foreign exchange exposures. With a view to make advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize. Sometimes they take positions so as to take advantage of the exchange rate movement in their favor and for undertaking this activity, they have state of the art dealing rooms. In India, some of the big corporate are as the exchange control have been loosened, booking, and canceling forward contracts, and at times the same borders on speculative activity.

Governments borrow or invest in foreign securities and delay coverage of the exposure on account of such deals. Individuals like share dealings also undertake the activity of buying and selling of foreign exchange for booking short-term profits. They also buy foreign currency stocks, bonds and other assets without covering the foreign exchange exposure risk. This also results in speculations.

Corporate entities take positions in commodities whose price are expressed in foreign currency. This also adds to speculative activity.

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FOREIGN EXCHANGE EXPOSURE

Foreign exchange risk is related to the variability of the domestic currency values of assets, liabilities or operating income due to unanticipated changes in exchange rates, whereas foreign exchange exposure is what is at risk. Foreign currency exposures and the attendant risk arises whenever a business has an income or expenditure or an asset or liability in a currency other than that of the balance-sheet currency. Indeed exposures can arise even for companies with no income, expenditure, asset or liability in a currency different from the balance-sheet currency. When there is a condition prevalent where the exchange rates become extremely volatile the exchange rate movements destabilize the cash flows of a business significantly. Such destabilization of cash flows that affects the profitability of the business, is the risk from foreign currency exposures.

TYPES OF EXPOSURES
Financial economists distinguish between three types of currency exposures - transaction exposures, translation exposures, and economic exposures. All three affect the bottom- line of the business.

TRANSACTION EXPOSURE
Suppose that a company is exporting deutsche mark and while costing the transaction had reckoned on getting say Rs 24 per mark. By the time the exchange transaction materializes i.e. the export is effected and the mark sold for rupees, the exchange rate moved to say Rs 20 per mark. The profitability of the export transaction can be completely wiped out by the movement in the exchange rate. Such transaction exposures arise whenever a business has foreign currency denominated receipt and payment. The risk is an adverse movement of the

THE FOREX AND RISK MANAGEMENT exchange rate from the time the transaction is budgeted till the time the exposure is extinguished by sale or purchase of the foreign currency against the domestic currency.

TRANSLATION EXPOSURE
Translation exposure arises from the need to "translate" foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. A typical example of translation exposure is the treatment of foreign currency borrowings. Consider that a company has borrowed dollars to finance the import of capital goods worth Rs 10000. When the import materialized the exchange rate was say Rs 30 per dollar. The imported fixed asset was therefore capitalized in the books of the company for Rs 300000. In the ordinary course and assuming no change in the exchange rate the company would have provided depreciation on the asset valued at Rs 300000 for finalizing its accounts for the year in which the asset was purchased. If at the time of finalization of the accounts the exchange rate has moved to say Rs 35 per dollar, the dollar loan has to be translated involving translation loss of Rs50000. The book value of the asset thus becomes 350000 and consequently higher depreciation has to be provided thus reducing the net profit.

ECONOMIC EXPOSURE
An economic exposure is more a managerial concept than a accounting concept. A company can have an economic exposure to say Yen: Rupee rates even if it does not have any transaction or translation exposure in the Japanese currency. This would be the case for example, when the company's competitors are using Japanese imports. If the Yen weekends the company loses its competitiveness (vice-versa is also possible). The company's competitor uses the cheap imports and can have competitive edge over the company in terms of his cost cutting. Therefore the company's exposed to Japanese Yen in an indirect way.

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In simple words, economic exposure to an exchange rate is the risk that a change in the rate affects the company's competitive position in the market and hence, indirectly the bottom-line. Broadly speaking, economic exposure affects the profitability over a longer time span than transaction and even translation exposure. Under the Indian exchange control, while translation and transaction exposures can be hedged, economic exposure cannot be hedged.

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Models And Theories Of Exchange Rate

Purchasing Power Parity Theory(PPP) Purchasing Power Parity Theory was pronounced by Prof. Gustav Cassel. The theory argues that exchange rate movements primarily reflect differences in inflation rates between countries. It advocated that currencies are valued for what they can buy and the currencies had no intrinsic value attached to it. Therefore, under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. As per this theory if there were no trade controls, then the balance of payments equilibrium would always be maintained. Examining the real exchange rate, ePf /P, the theory maintains the following When Pf and /or P changes, e changes in such a way as to maintain ePf /P constant. Where, P is the domestic price, Pf is the foreign price level and e is the exchange rate. PPP is a plausible description of the trend behaviour of exchange rates, especially when inflation differentials between the countries are large. This theory does hold in the case of an increase in the money stock. However, in this theory some factors like the methods of production, the consumer preferences, transportation costs and the existence of trade controls was overlooked Influence of non-monetary disturbances affecting exchange rates was totally ignored.

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The Mundell Fleming Model: Perfect Capital Mobility Robert Mundell and Marcus Fleming, extended the standard IS-LM model to the open economy under perfect capital mobility. It is advocated that under fixed exchange rates and perfect capital mobility, a country cannot pursue an independent monetary policy. Interest rates cannot move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and a need to intervene until interest rates are back in line with those in the world market. Under perfect capital mobility the slightest interest differential provokes infinite capital flows. It follows that with perfect capital mobility, central banks cannot conduct an independent monetary policy under fixed exchange rate system. It tightens the monetary policy, and interest rates rise resulting in portfolio changes. As a result of huge capital inflow, the balance of payments shows huge surplus. The foreigners tend to buy domestic assets, appreciating the exchange rate and forcing the central bank to intervene to hold the exchange rate constant. This intervention results in increase in home currency stocks. As a result, the initial monetary contraction is reversed and the process ends when home interest rates have been pushed back to the initial level. The following is represented by Figure 1 below.

Figure 1: Monetary Expansion Under Fixed Rates And Perfect Capital Mobility Extending this model to flexible exchange rate system, the absence of central bank intervention implies a zero balance of payments. Any current account deficit must be

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financed by private capital inflows: a current account surplus is balanced by capital outflows. Adjustments in the exchange rate ensure that the sum of the current and capital accounts is zero.

Dornbush Theory on Monetary Expansion: Short and Long term effects With given prices a monetary expansion under flexible rates and perfect mobility leads to depreciation and increased income. However when adjustments in prices are taken into consideration, the output increase is transitory. In the long un a monetary expansion leads to an exchange depreciation and to higher prices with no change in competitiveness. The important feature of the adjustment process is that exchange rate and prices do not move at the same rate. When a monetary expansion pushes interest rates down, the exchange rate adjusts immediately but prices adjust only gradually. Monetary expansion therefore leads in the short run to an immediate and abrupt change in relative prices and competitiveness. Table 2: Effects of Monetary Expansion Exchange Rate Price ePf /P Short run + 0 + Long run + + 0 Output + 0

The exchange rate overshoots its new equilibrium level when, in response to a disturbance, it first moves beyond the equilibrium it ultimately will reach and then gradually returns to the long-run equilibrium position. Here, overshooting means that changes in monetary policy produce large changes in exchange rates. An application of the above-described models in the real life has been discussed below based on a model developed by some experts.

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RBIs Intervention in Foreign Exchange Market

An Econometric Analysis
By 1. Sumon Kumar Bhaumik 2. Hiranya Mukhopadhyay The objective of this study was to Derive a reduces form specification that will allow us to link a central banks direct interventions in the foreign exchange market with changes in the countrys exchange rate We would test this relationship with the Indian data to see whether indeed the magnitude of an offset is significant. The model owes its origin to the Keynes-Mundell-Fleming (KMF) model. The endogenous variables of the model are Y, r and e. The extent of any change in the value of foreign exchange reserves with the central bank is perfectly correlated with the amount of dollars that the bank buys and sells in the foreign exchange market. Once the central bank purchases dollars from the foreign exchange market, the exchange rate depreciates. As e depreciates, ceteris paribus, trade balances improve and hence there is an increase in the effective demand facing the economy. Moreover, a rise in income leads to higher imports, and the initial improvement in trade balance is dampened. At the same time, the inflow of dollars from foreign investors too tends to rise, dampening the initial downward pressure on account of depreciation of the exchange rate.

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To relate to the Indian context, monthly data on net purchase of foreign exchange by RBI, expressed in dollars, and monthly exchange rates of US Dollars (e), expressed as rupees per dollar.36 data points have been considered. The conclusion derived is that in response to an appreciation of the rupee vis--vis other currencies, if there is an increase in the net purchase of dollars by the RBI, change in e will decrease, indicating that the rupee will appreciate further. In other words, the effect of the RBIs direct intervention in the foreign intervention in the foreign exchange market is more than offset by the impact of the intervention on the macro-economic variables, which, in turn, influence capital flows and nominal exchange rates. Annexure 2 gives the data regarding the RBI intervention in Indian markets. ARIMA 0.37715 0.01002

MAPE Thiels U

Simple Moving Avg MSE MAPE

Double

Single

Browns Method

Holts Method 3.258937 1.528195

Winters Method 408.8397 22.32619

Moving Avg Exponen Smoothen 3.566822 1.702292

4.327164 4.513591 1.882539 1.950541

2.912831 0.015037

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Forecasting
NET EFFECTIVE EXCHANGE RATE (NEER) Performance over the past five years
NEER is a good indicator of the exchange rate of the country. It is a multi-lateral measurement of the exchange rate of the Rupee, which depends on the trade based weights of five countries. Trends in the movement of NEER from 1993 April to February 1999 are illustrated in Table 2 on the next page. This is in effect the performance of the NEER after the implementation of the Modified Liberalized Exchange Rate Management System (Modified LERMS) with effect from 1st March 1993.

The performance of the NEER makes a good study of the effect of the policies on the exchange rate after April 1993.

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Foreign Exchange Rate Forecasting

Forecasting foreign exchange rates is important for treasury and forex managers as it reduces the uncertainties associated with commitments to accept or to make payments in foreign currencies with short-term and long-term investment decisions, with financing decisions and with income earned in foreign currencies. It is also important for a forex manager to understand the intricacies and the limitations of forecasting foreign exchange rates as it helps them to utilize the alternate avenues to manage exchange rate risk. Though an intra-day forecast of the exchange rate is not possible, but the direction and magnitude of change in longer term can be forecasted with a fair degree of accuracy. Exchange rate forecasts also help to: Analyze attractiveness of foreign borrowings; Plan investments in foreign countries; Plan long-term export-import strategy; Manage exchange rate risks and plan hedging strategies. Now, the exchange rate between two currencies could be either fluctuating or fixed. Logically, forecast for fluctuating exchange rates only would be required by treasury manager, as fixed rates are more or less kept within a narrow band by intervention of the two governments.

Techniques of forecasting Exchange rate

There are several techniques available to forecast future rates. These can be classified under following categories: 1. 2. 3. Forward rates as short-term forecasters. Technical Analysis Economic Models.

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Forward Rates as Short-term forecasters. Forward rates are

sometimes used to predict future spot rates. Banks act as clearing houses for both forward and spot contracts. Firms generally anticipate future spot rate: The evaluation of any forecasts can be done based on two criteria. 1. Accurate Forecast Indicator: If the future values are forecasted accurately every time with minor forecast errors, then it is an accurate forecast indicator. 2. Unbiased Forecast Indicator: An unbiased estimator is one, which can overestimate the value as much with the same probability as it can underestimate which implies that positive errors are as much probable as negative errors. If the forecasts are done accurately on an average they are called unbiased forecasts.

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Foreign Exchange Rate Forecasting with Technical Analysis

Forecasting future exchange rates with the use of past exchange rate movements is called technical analysis. The forecasters are called technicians. Economic factors such as inflation rates, interest rates, balance of payments and political stability are ignored by pure technicians. The pure technicians believe that clues in the past movements lead them to the future. A technician believes that exchange rate movements are mechanistic and are not caused by economic and political changes. Technicians develop their own forecasts about future currency values and each technician has his individual method. There are many methods used by technicians such as sophisticated statistical models, charts of past exchange rate movements etc. Some technicians use historical data from primary analysis and then recommend the client in an informal fashion by keeping in view the economic and political factors.

Evaluation of technical Forecasts

Economists do not like technical analysis, as it does not obey the principles of economics. The logical explanation given by economists in support of their view is that according to efficient market hypothesis, prices reflect all available information. In an efficient forex market, the impact of available information is already reflected in the present rates, therefore, forecasts based on historical data do not help develop accurate forecasts. Economic research indicates that forex movements follow a pattern of random walk, which implies that a specific present change is unrelated to past changes and therefore a forecast is not possible. The explanation given by economists is that current exchange rates change with the unforeseeable events. The unforeseeable events occur in random fashion and hence exchange rate changes follow a random pattern. Technical analysts assert that their approach works and it is very difficult to disapprove their assertions. The evaluation of technical forecasts is difficult because it works at times. To

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prove the efficiency of technical forecasts, it is necessary to prove them to be superior to other methods over a period of time. This is not possible as at a given time, the technical analysis has proved to be superior. Technical forecasts arte often used in conjunction with economic model based forecasts, but technical forecasts are widely used by speculators in the forex markets to book quick profits since technical forecasts emphasize on short-term exchange rates. We have made a forecast of the NEER, which was shown in the previous chapter, using various time-series techniques. These time-series techniques are technical forecasts and their accuracy can be studied by sing MAPE, MSE and Thiels statistic. In the tables given below, the different techniques and their respective MAPE, MSE and Thiels statistics are given.

ARIMA MAPE 0.37715 Thiels U 0.01002

Simple Moving Avg MSE MAPE

Double

Single

Browns Method

Holts Method 3.258937 1.528195

Winters Method 408.8397 22.32619

Moving Avg Exponen Smoothen 3.566822 1.702292

4.327164 4.513591 1.882539 1.950541

2.912831 0.015037

THE FOREX AND RISK MANAGEMENT Exchange rate forecasting with Economic Models The difference between technical analysis and economic forecasting is that economic forecasting is based on established and verified economic relationships such as BoP, inflation, interest rates, etc. The approach adopted is cause and effect approach. For example, in case of inflation rate, we know that inflation rates affect future exchange rates. Future exchange rates can be forecasted by forecasting inflation rate. The statistical models work by establishing a relationship between future exchange rates and the variables that affect future exchange rates. Usually, as it involves more than two variables, a multiple regression analysis based on statistical models is done. In any forecasting model, the future exchange rate is a dependent variable as it depends on various economic indicators. These indicators such as BOP, inflation, and interest rates are independent variables. The accuracy of the predicted changes in the independent variables and the gathering of accurate historical data on the variables such as inflation, GNP is difficult. In case of three or four variables gathering historical information for a specific period for all the variables is also difficult. There is a difference of opinion in inclusion and exclusion of variables. Any statistical model does not give fruitful results unless political factors and impact of news are quantified. It also requires for a good forecast to predict the future direction and extent of government intervention. The superiority of a forecasting model depends on its accuracy over market forecast. If some forecasts are superior to others its advantage is quickly eliminated by the market forces as they act favorably towards the forecasts and brings the price to the forecasted level if it is an efficient market. If a firm develops a superior forecast it is not sufficient to gain from it. A firm should have enough capital to materialize the gains out of its forecast. So, it will be advantageous to firms to keep abreast of the latest information regarding economic indicators such as BOP, inflation rates, interest rates etc.

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