CONTENTS OF 2ND UNIT

2.

Foreign Exchange Market and International Parity Relationships.........................5

2.1. FOREIGN EXCHANGE MARKET...................................................................5
2.1.1.

MEANING OF FOREIGN EXCHANGE..........................................................5

2.1.2.

MEANING AND DEFINITION OF FOREIGN EXCHANGE MARKET.................5

2.1.3.

CHARACTERISTICS OF FOREIGN EXCHANGE MARKET..............................6

2.1.4.

FUNCTIONS OF FOREIGN EXCHANGE MARKET.........................................7

2.1.5.

PARTICIPANTS IN FOREIGN EXCHANGE MARKET.......................................7

2.1.6.

STRUCTURE OF FOREIGN EXCHANGE MARKET IN INDIA..........................9

2.1.7.

FACTORS INFLUENCING FOREIGN EXCHANGE MARKET..........................11

2.1.8.

CLASSIFICATION OF FOREIGN EXCHANGE MARKET................................13

2.1.9.

SPOT MARKET:....................................................................................... 14

2.1.9.1. Features of Spot Markets:..........................................................14

2.1.9.2. Types of Spot Market:.................................................................14
2.1.9.3. Quotes in Spot Market:...............................................................15
2.1.9.4. Currency Arbitrage in Spot Market:..........................................16
2.1.9.5. Hedging in Spot Market:.............................................................16
2.1.9.6. Speculation in Spot Market:.......................................................17
2.1.10. FORWARD MARKET:............................................................................... 17
2.1.10.1.Features of Forward Exchange Contract:................................17
2.1.10.2.Types of Forward Exchange Contracts:....................................19
2.1.10.3.Forward Rate Agreements (FRA):.............................................20
2.1.10.3.1...................................................................Characteristics of FRAs:
22
2.1.10.3.2....................................................................Pay-off Formula in FRA:
22
2.1.10.3.3............................................................................. Functions of FRA:
23
2.1.10.3.4................................................................................ Benefits of FRA:
24
2.1.10.3.5...........................................................................Limitations of FRA:
24
2.1.10.4.Quotes in Forward Market:.........................................................25
2.1.10.5.Arbitrage in Forward Market:....................................................28
2.1.10.6.Hedging in Forward Market:......................................................28
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2.1.10.7.Speculation in Forward Market:................................................29

2.2. EXCHANGE RATES..................................................................................... 29
2.2.1.

MEANING OF EXCHANGE RATES:............................................................29

2.2.2.

EXCHANGE RATE QUOTATIONS:.............................................................30

2.2.2.1. Bid and Ask Prices:......................................................................30

2.2.2.2. Direct Quote:................................................................................32
2.2.2.3. Indirect Quotes:...........................................................................33
2.2.2.4. Spot Rate/Quote:.........................................................................33
2.2.2.5. Forward Rate/Quote:...................................................................33
2.2.2.6. Cross Rates:..................................................................................33
2.2.2.7. % Spread/Cost of Transaction:...................................................34
2.2.2.8. Spread:.......................................................................................... 35
2.2.3.

EFFECTIVE EXCHANGE RATE:.................................................................35

2.2.3.1. Nominal Effective Exchange Rate (NEER):...............................36

2.2.3.2. Real Effective Exchange Rate (REER).......................................37
2.2.3.3. Nominal Effective Exchange Rate Vs Real Effective Exchange
Rate
38
2.3. CURRENCY DERIVATIVES.........................................................................38
2.3.1.

MEANING OF CURRENCY DERIVATIVE:...................................................38

2.3.2.

TYPES OF CURRENCY DERIVATIVES:.......................................................40

2.3.3.

CURRENCY FORWARD:...........................................................................40

2.3.3.1. Feature of Currency Forward:....................................................40

2.3.3.2. Trading Process of Currency Forward:.....................................41
2.3.3.3. Hedging in Currency Forward:...................................................42
2.3.3.4. Speculation in Currency Forward:.............................................43
2.3.4.

CURRENCY FUTURES:............................................................................ 45

2.3.4.1. Features of Currency Futures....................................................45

2.3.4.2. Trading Process of Currency Futures:......................................46
2.3.4.3. Hedging in Currency Futures:....................................................47
2.3.4.4. Speculation in Currency Futures:..............................................47
2.3.5.

CURRENCY OPTIONS:............................................................................. 47

2.3.5.1. Features of Currency Options:...................................................48

2.3.5.2. Determinants of Currency Options:..........................................48
2.3.5.3. Hedging in Currency Options:....................................................50
2.3.5.4. Speculation in Currency Options...............................................51
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2.3.6.

CURRENCY SWAPS................................................................................. 51

2.3.6.1. Features of Currency Swaps......................................................52

2.3.6.2. Steps Involved in Currency Swaps............................................52
2.3.6.3. Hedging in Currency Swap.........................................................53
2.3.6.4. Speculation in Currency Swap...................................................53
2.3.7.

CURRENCY ARBITRAGE..........................................................................53

2.3.7.1. Spatial Arbitrage (Without Cost of Transaction)....................54

2.3.7.2. Spatial Arbitrage (With Cost of Transaction)..........................54
2.3.7.2.1.Locational Arbitrage......................................................................54
2.3.7.2.2.Triangular Arbitrage......................................................................55
2.3.7.3. Interest Rate Arbitrage...............................................................57
2.4. FOREIGN EXCHANGE MANAGEMENT ACT(FEMA), 1999......................59
2.4.1.

INTRODUCTION...................................................................................... 59

2.4.2.

OBJECTIVES OF FEMA............................................................................. 59

2.4.3.

FEATURES OF FEMA...............................................................................59

2.4.4.

SCOPE OF FEMA..................................................................................... 60

2.4.5.

PROVISIONS OF FEMA............................................................................61

2.5. BALANCE OF PAYMENTS:-........................................................................62

2.5.1.

INTRODUCTION...................................................................................... 62

2.5.2.

COMPONENTS OF BOP...........................................................................63

2.5.3.

STRUCTURE OF BOP ACCOUNTING........................................................66

2.5.4.

FACTORS AFFECTING BOP......................................................................68

2.5.5.

IMPORTANCE OF BOP.............................................................................69

2.5.6.

BOP TRENDS IN INDIA............................................................................69

2.5.7.

CURRENT ACCOUNT DEFICIT.................................................................72

2.5.7.1. Components of a Current Account Deficit...............................72

2.5.7.2. Implications of Current Account Deficit on Exchange Rate. .73
2.5.7.3. Disequilibrium in Current Account Deficit...............................73
2.5.7.4. Measures of Current Account Deficit........................................74
2.6. CURRENCY CONVERTIBILITY...................................................................76
2.6.1.

MEANING OF CURRENCY CONVERTIBILITY.............................................76

2.6.2.

PRE-CONDITIONS FOR CURRENCY CONVERTIBILITY...............................77

2.6.3.

CONVERTIBILITY OF INDIAN RUPEE........................................................77

2.6.4.

CURRENT ACCOUNT CONVERTIBILITY....................................................78

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2.6.5.

CAPITAL ACCOUNT CONVERTIBILITY......................................................79

2.6.5.1. Features and Implications of CAC.............................................80

2.6.5.2. Impact of Capital Account Convertibility.................................81
2.6.5.3. Tarapore Committee Report.......................................................81
2.6.5.4. Reasons for Capital Account Convertibility.............................83
2.6.5.5. Advantages of Capital Account Convertibility........................84
2.6.5.6. Disadvantages of Capital Account Convertibility...................84
2.7. INTERNATIONAL PARITY CONDITIONS...................................................85
2.7.1.

INTRODUCTION...................................................................................... 85

2.7.2.

PURCHASING POWER PARITY (PPP)........................................................85

2.7.2.1. Two Versions of PPP Theory.......................................................86

2.7.2.2. Monetary Approach.....................................................................87
2.7.2.3. Criticisms of Purchasing Power Parity.....................................88
2.7.3.

INTEREST RATE PARITY (IRP) THEORY....................................................90

2.7.3.1. Two Versions of IRP Theory........................................................92

2.7.3.2. Implications of Interest Rate Parity..........................................96
2.7.3.3. Covered Interest Parity Arbitrage.............................................97
2.7.3.4. Relationship Between Forward and Future Spot Rate.........101
2.7.4.

FISHER EFFECT/FISHER PARITY............................................................103

2.7.5.

INTERNATIONAL FISHER EFFECT (IFE)..................................................104

2.7.6.

UNBIASED FORWARD RATE THEORY....................................................106

2.7.7.

PARITY CONDITIONS AND MANAGERIAL IMPLICATIONS........................107

2.8. INTERNATIONAL DEBT CRISIS...............................................................108

2.8.1.

INTRODUCTION.................................................................................... 108

2.8.2.

GREEK DEBT CRISIS.............................................................................109

2.9. CURRENCY CRISIS................................................................................... 110

2.9.1.

INTRODUCTION.................................................................................... 110

2.9.2.

SOURCES OF CURRENCY CRISIS..........................................................111

2.9.3.

ASIAN CURRENCY CRISIS.....................................................................113

2. Foreign Exchange Market and

International Parity Relationships
2.1.
FOREIGN EXCHANGE MARKET
2.1.1. MEANING OF FOREIGN EXCHANGE
Foreign exchange is currency other than the local currency which is used in settling international
transactions, also called foreign currency. It is system of trading in and converting the currency
of one country into that of another. Foreign exchange is the system or process of converting one
national currency into another and of transferring the ownership of money from one country to
another country.
Foreign exchange as defined Section 2 of FEMA, 1999:
1) Foreign currency means any currency other than Indian currency.
2) Foreign exchange means foreign currency and includes
i).
Deposits, credits, and balances payable in any foreign currency.
ii).
Drafts, travelers cheques, letters of credit or bills of exchange, expressed or
iii).

drawn in Indian currency but payable in any foreign currency.

Drafts, travelers cheques, letters of credit or bills of exchange drawn by banks,
institutions or persons outside India, but payable in India currency.

2.1.2. MEANING AND DEFINITION OF FOREIGN

EXCHANGE MARKET
The foreign exchange (currency or FOREX or FX) market refers to the market for currencies.
Transactions in this market typically involve one party purchasing a quantity of one currency in
exchange for paying a quantity of another. The FX market is the largest and most liquid financial
market in the world, and includes trading between large banks, central banks, currency
speculators, corporations, governments, and other institutions.
According to kindle Berger, Foreign exchange market is a place where foreign moneys are
bought and sold. Foreign exchange market is an institutional arrangement for buying and selling
of currencies. Exporters sell the foreign currencies and importers buy them.
Foreign exchange market is merely a part of the money in the financial centers. It is a place
where foreign moneys are bought and sold. The buyers and sellers of claim on foreign money
5

and the intermediaries together constitute a foreign exchange market. It is not restricted to any
given country or a geographical area.
Thus, the foreign exchange market is the market for a national currency (foreign money)
anywhere in the world, as the financial centres of the world are united in a single market.

2.1.3. CHARACTERISTICS OF FOREIGN EXCHANGE

MARKET
Some of the important characteristics of a foreign exchange market as follows:
1) Electronic Market: Foreign exchange market does not have a physical place. It is a
market whereby trading in foreign currencies takes place through the electronically
linked network of banks, foreign exchange brokers and dealers whose function is to bring
together buyers and sellers of foreign exchange.
2) Geographical Dispersal: A redeeming feature of the foreign exchange market is that it is
not to be found in one place. The market is vastly dispersed throughout the leading
financial centers of the world such as London, New York, Paris, Zurich, Amsterdam,
Tokyo, Hong Kong, Toronto, Frankfurt, Milan and other cities.
3) Transfer of Purchasing Power: Foreign exchange market aims at permitting the transfer
of purchasing power denominated in one currency to another whereby one currency is
traded for another currency. For example, an Indian exporter sells software to a U.S. firm
for dollars and a U.S. dollars. It is the foreign exchange market, which facilitates such a
settlement between countries in their respective currency units.
4) Intermediary: Foreign exchange market provides a convenient way of converting the
currencies earned into currencies wanted of their respective countries. For this purpose,
the market acts as an intermediary between buyers and sellers of foreign exchange.
5) Volume: A special feature of the foreign exchange market is that out of the total trading
transactions that take place in the foreign exchange market, around 95 per cent takes the
form of cross-border purchase and sale of assets, i.e., international capital flows. Only
around 5 per cent relates to the export and import activities.
6) Provision of Credit: A foreign exchange market provides credit through specialized
instruments such as bankers acceptances and letters of credit. The credit, thus, provided
is of much help to the traders and businessmen in the international market.
7) Minimizing Risks: The foreign exchange market helps the importer and exporter in the
foreign trade to minimize their risks of trade. This is being done through the provision of
6

Hedging facilities. This enables traders to transact business in the international market
with a view to earning a normal business profit without exposure to an expected change
in anticipated profit. This is because exchange rates suddenly change.

2.1.4. FUNCTIONS OF FOREIGN EXCHANGE

MARKET
A foreign exchange market preforms three important functions:
1) Transfer of Purchasing Power: The primary function of a foreign exchange market is to
transfer of purchasing power from one country to another and from one currency to
another. The international cleaning function performed by foreign exchange market plays
a very important role in facilitating international trade and capital movements.
2) Provision of Credit: The credit function performed by foreign exchange market also
plays a very important role in the growth of foreign trade, for international trade depends
to a great extent on credit facilities. Exporters may get pre-shipment and post-shipment
credit. Credit facilities are available also for importers. The Euro-dollar market has
emerged as a major international credit market.
3) Provision of Hedging Facilities: The other important function of the foreign exchange
market is to provide hedging facilities. Hedging refers to covering of export risks, and it
provides a mechanism to exporters and importers to guard themselves against losses
arising from fluctuations in exchange rates.

2.1.5. PARTICIPANTS IN FOREIGN EXCHANGE

MARKET
The major participants in foreign exchange market is shown in figure below:
1) Retail Clients: These are made up of businesses, international investors, multinational
corporations and the like who need foreign exchange for the purposes of operating their
businesses. Normally, they do not directly purchase or sell foreign currencies themselves;
rather they operate by placing buy sell order with commercial banks.
2) Commercial Banks: The commercial banks carry out buy/sell orders from their retail
clients and buy/sell currencies on their own account (known proprietary trading) so as to
alter the structure of their assets and liabilities in different currencies. The banks deal
either directly with other banks of through foreign exchange broker. In addition to the
commercial banks other financial institutions such as merchant banks are engaged in
7

buying and selling of currencies both for proprietary purposes and on behalf of their
customers in finance-related transactions.

Participants in Foreign Exchange Market

Commercial Banks
Retail Clients
Hedger, Speculators and Arbitrageurs
Foreign Exchange Brokers
Central Banks

3) Foreign Exchange Brokers: Often banks do not trade directly with one, another, rather
they offer to buy and sell currencies via foreign exchange brokers. Operating through
such brokers is advantageous because they collect buy and sell quotations for most
currencies from many banks, so that the most favorable quotations is obtained quickly
and at very low cost. One disadvantage of dealing though a broker is that a small
brokerage fee is payable, which neither is nor incurred in a straight bank-to-bank deal.
Each financial centre normally has just a handful of authorized brokers through which
commercial banks conduct their exchanges.
4) Hedger, Speculators and Arbitrageurs: Traders buying and selling foreign exchange
can take the role of hedgers, or speculators or arbitrageurs. Hedgers are traders who
undertake forex trading because they have domestic currency to buy foreign currency, he
is termed as a hedger. The importer has a foreign currency has asset denominated in
foreign currency. A MNC entering into a foreign currency forward contract so that it can
repatriate its earning to parent company. An Indian company swapping its foreign
currency interest payment obligations to INR interest obligation. All these are examples
of hedging. Hedgers use the foreign currency market to hedge the risk associated with
volatility in foreign exchange market.
Speculators are traders who essentially buy and sell foreign currency to make profit from
the expected futures movement of the currency. These traders do not have any genuine

requirement for trading foreign currency. They do not hole any cash positions in the
currency.
Arbitrageurs buy and sell the same currency at two different markets whenever there is
price discrepancy. The principle of law of one price governs the arbitrage principle.
Arbitrageurs ensure that market prices move to rational or normal levels. With the
proliferation on internet, cross currency, cross currency arbitrage possibility has increased
significantly.
5) Central Banks: Normally the monetary authorities of a country are not indifferent to
changes in the external value of their currency, and even though exchange rates of the
major industrialized nations have been left to fluctuate freely since 1973, central banks
frequently intervene to buy and sell their currencies in a bid to influence the rate at which
their currency is traded. Under a fixed exchange-rate system the authorities are obliged to
purchase their currencies when there excess supply and sell the currency when there is
excess demand.

2.1.6. STRUCTURE OF FOREIGN EXCHANGE

MARKET IN INDIA
The structure of foreign exchange market in India is shown in figure below:
1) Retail Market: The exchange of bank notes, bank drafts, currency, ordinary, and
travelers cheques between private customers, tourists, and banks takes place in the retail
market. The RBI has granted two types of money changers licenses to certain established
firms, hotels, shops, and other organizations to de in currency notes, coins, and travelers
cheques to a limited extent. While the full-fledged morn changers can undertake both
purchase and sale transactions with the public, restricted money changer can only
purchase foreign currency from the foreign tourists.
2) Wholesale Market: The wholesale market is primarily an inter-bank market in which
major banks trade in currencies held in different currency-dominated bank accounts, i.e.,
they transfer bank deposits from sellers to buyers accounts. This market is far larger than
the bank notes market. Only the head offices and regional offices of the major
commercial banks are the market makers (entities which deal with assets on their own
accounts) in the wholesale market. Most of the small banks and the local offices of even
9

the major banks do not deal directly in the inter-bank market. They usually have a credit
line with large banks or with their head offices and they serve their customers through the
latter. Through correspondent relationship with banks in other countries, major banks
have ready access to foreign currencies.

Structure of Foreign Exchange Market in India

Retail Market

Wholesale Market

anks and Money Changes (Currencies, bank notes, cheques)

Inter-bank (Bank accounts or deposits)

i).

Central Bank

Inter-Bank Market: The inter-bank market can, thus, be said to have two parts:
a)

Direct Market: In the direct market, banks quote buying and selling

prices directly to each other and all participating banks are market makers. It
has been sometimes characterized as a decentralized, continuous, open-bid,
double auction market.
b)

Indirect Market: In the indirect market, the banks put orders with brokers

who put them on books, and try to match purchases and sales orders for
different currencies. They charge commission to both the buyers and sellers.
This market is characterized as quasi-centralized, continuous, limit-book,
single auction market.
ii).

Central Banks: Normally the monetary authorities of a country are not indifferent to
changes in the external value of their currency, and even though exchange rates of the
major industrialized nations have been left to fluctuate freely since 1973, central
banks frequently intervene to buy and sell their currencies in a bid to influence the
rate at which their currency is traded. Under a fixed exchange-rate system the

10

authorities are obliged to purchase their currencies when there is excess supply and
sell the currency when there is excess demand.

2.1.7. FACTORS INFLUENCING FOREIGN

EXCHANGE MARKET
Factors influencing foreign exchange market are as follows:
1) Economic Factors: These include economic policy, disseminated by government
agencies and central banks, economic conditions, generally revealed through economic
reports, and other economic indicators. Economic policy comprises government fiscal
policy (budget/spending practices) and monetary policy (the means by which a
governments central bank influences the supply and cost of money, which is reflected by
the level of interest rates).
i).

Government Budget Deficits or Surpluses: The market usually reacts negatively to

widening government budget deficits, and positively to narrowing budget deficits.
The impact is reflected in the value of a countrys currency.

ii).

Balance of Trade Levels and Trends: The trade flow between countries illustrates
the demand for goods and services, which in turn indicates demand for a countrys
currency to conduct trade. Surpluses and deficits in trade of goods and services
reflect the competitiveness of a nations economy. For example, trade deficits may
have a negative impact on a nations currency.

iii).

Inflation Levels and Trends: Typically, a currency will lose value if there is a high
level of inflation in the country or if inflation levels are perceived to be rising. This
is because inflation erodes purchasing power, thus demand, for that particular
currency. However, a currency may sometimes strengthen when inflation rises
because of expectations that the central bank will raise short-term interest rates to
combat rising inflation.

iv).

Economic Growth and Health: Reports such as gross domestic product (GDP),
employment levels, retail sales, capacity utilization and others, detail the levels of a
countrys economic growth and health. Generally, the more healthy and robust a
countrys economy, the better its currency will perform, and the more demand for it
there will be.

2) Political Conditions: Internal, regional, and international political conditions and events
11

can have a profound effect on currency markets. For example, political upheaval and
instability can have a negative impact on a nations economy. The rise of a political
faction that is perceived to be fiscally responsible can have the opposite effect. Also,
events in one country in a region may spur positive or negative interest in a neighboring
country and, in the process, affect its currency.
3) Market Psychology: Market psychology and trader perceptions influence the foreign
exchange market in a variety of ways:
i).

Flights to Quality: Unsettling international events can lead to a flight to quality,

with investors seeking a safe haven. There will be a greater demand, thus a higher
price, for currencies perceived as stronger over their relatively weaker counterparts.
The Swiss Franc has been a traditional safe haven during times of political or
economic uncertainty.

ii).

Long-Term Trends: Currency markets often move in visible long-term trends.

Although currencies do not have an annual growing season like physical
commodities, business cycles do make themselves felt. Cycle analysis looks at
longer-term price trends that may rise from economic or political trends.

iii).

Buy the Rumor, Sell the Fact: This market truism can apply to many currency
situations. It is the tendency for the price of a currency to reflect the impact of a
particular action before it occurs and, when the anticipated event comes to pass, react
in exactly the opposite direction. This may also be referred to as a market being
oversold or overbought. To buy the rumor or sell the fact can also be an example
of the cognitive bias known as anchoring, when investors focus too much on the
relevance of outside events to currency prices.

iv).

Economic Numbers: While economic numbers can certainly reflect economic

policy, some reports and numbers take on a talisman-like effect; the number it
becomes important to market psychology and may have an immediate impact on
short-term market moves. What to watch can change over time. In recent years,
e.g., money supply, employment, trade balance figures, and inflation numbers have
all taken turns in the spotlight.

v).

Technical Trading Considerations: As in other markets, the accumulated price

movements in a currency pair such as EUR/USD can form apparent patterns that
12

traders may attempt to use. Many traders study price charts in order to identify such
patterns.
vi).

Balance of Payment: Balance of payments of a country will cause the exchange rate
of its domestic currency to fluctuate. The balance of payments is a summary of all
economic and financial transactions between the country and the rest of the world. It
reflects the countrys international economic standing and influences its
macroeconomic and microeconomic operations. The balance of payments can affect
the supply and demand for foreign currencies as well as their exchange rates.

vii).

Interest Rates: When a countrys key interest rate rises higher or falls lower than
that of another country, the currency of the nation with lower interest rate will be
sold and the other currency will be bought so as to achieve higher returns. Given this
increase in demand for the currency with higher interest rate, the value of that
currency will rise against other currencies.

viii).

Speculation: Speculation by major market operators is another crucial factor that

influences exchange rates. In the forex market, the proportion of transactions that are
directly related to international trade activities is relatively low. Most of the
transactions are actually speculative tradings which cause currency movement and
influence exchange rates. When the market predicts that a certain currency will rise
in value, it may spark a buying frenzy that pushes the currency up and fulfill the
prediction. Conversely, if the market expects a drop in value of a certain currency,
people will start selling it away and the currency will depreciate.

2.1.8. CLASSIFICATION OF FOREIGN EXCHANGE

MARKET
The foreign exchange market is classified on the basis of the nature of transactions in two
categories:

13

Classification of Foreign Exchange Market

Spot Market

2.1.9.

Forward Market

SPOT MARKET:

The spot market refers to that segment of the foreign exchange market in which sale and
purchase transactions are settled within two days of the deal. The spot and purchase foreign
exchange makes the spot market. The rate at which foreign currency is bought and sold in the
spot market is called the spot exchange rate. For all practical purposes, the spot rate is the
prevailing exchange rate.

2.1.9.1.

Features of Spot Markets:

The features of spot markets are as follows:

1) The spot market is a buying strategy in which the buyer makes an immediate payment
that is equal to the current market price for commodities and other types of securities.
2) Upon the receipt of the payment, the seller relinquishes all claims to the property and
bestows ownership upon the buyer.
3) One of the characteristics that set the spot market apart from a futures market is this
immediate satisfaction and transfer of ownership. With a cash market, the investor
immediately assumes ownership and is free to do with the commodity or security as he or
she wishes.
4) Spot markets tend to be somewhat fast paced, since the turnaround time on a transaction
is so short. Many investors may purchase a commodity on the cash market this morning,
see a rise in the value by this afternoon, and sell before closing and make a significant
profit.

2.1.9.2.

Types of Spot Market:

The spot market can be of two types:

14

1) Organized Market, an Exchange: An exchange (or bourse) is a highly organized

market where (especially) tradable securities, commodities, foreign exchange are sold
and bought.
2) Over-the-Counter (OTC): Over-the-Counter or off-exchange trading is to trade
financial instruments such as stocks, bonds, commodities, or derivatives directly between
two parties. It is contrasted with exchange trading, which occurs via facilities constructed
for the purpose of trading.

2.1.9.3.

Quotes in Spot Market:

Spot quote (spot exchange rate) is that exchange rate which applies to those sale/purchase
transactions in foreign exchange for which payments and receipts are to be effected on the spot
(in practice, it normally means a specified short period, say two working days or so).
The most common way of stating a foreign exchange quotation is in terms of the number of
units of foreign currency needed to buy one unit of home currency. Thus, India quotes its
exchange rates in terms of the amount of rupees that can be exchanged for one unit of foreign
currency. For example, if the Indian rupee is the home currency and the foreign currency is the
French franc (FF) then the exchange rate between the rupee and the French franc might be
stated as,
FF 0.1462 / T1 reads 0.1462 French franc per rupee. This means that for one Indian rupee
one can buy 0.1462 French francs.
Example 1: The market quotes:
GBP/USD Spot - 1.8680
USD/JPY Spot - 105.70
USD/INR Spot-43.80
Please calculate spot:
1) JPY/INR
2) GBP/INR
3) GBP/JPY
Solution:
15

1) 1 USD = 105.70 JPY as well as 1 USD = 43.80 INR

Therefore 105.70JPY = 43.80 INR
Therefore 1 JPY = 43.80/105.70 INR =0.4144 INR
2) 1 GBP = 1.8680 USD and 1 USD = 43.80 INR
Therefore 1 GBP =1.8680x43.80=81.82 INR
3) 1 GBP = 1.8680 USD and 1 USD = 105.70 JPY
Therefore 1 GBP = 1.8680 x 105.70 = 197.45 JPY

2.1.9.4.

Currency Arbitrage in Spot Market:

With fast development in the telecommunication system, rates are expected to be uniform in
different foreign exchange markets. Nevertheless, inconsistency exists at times. The arbitrageurs
take advantage of the inconsistency and garner profits by buying and selling of currencies. They
buy a particular currency at cheaper rate in one market and sell it at a higher rate in the other.
This process is known as currency arbitrage.
For example,
1) In New York: $1.9800 - 10/; and
2) In London: $ 1.9700 - 10/
The arbitrageurs will sell pound in New York and buy pound in London making a profit of
$1.9810 - 1.9700 = $0.0110 per pound sterling.

2.1.9.5.

Hedging in Spot Market:

Hedging in spot market can be seen with the help of following example. The importer borrow
1,00,000 at the present spot rate of SR = $1/1 and leave this sum on deposit in a bank (to earn
interest) for three months, when payment is due. By so doing, the importer avoids the risk that
the spot rate in three months will be higher than todays spot rate and that he or she would have
to pay more than $1,00,000 for the imports. The cost of insuring against the foreign exchange
risk in this way is the positive difference between the interest rate the importer has to pay on the
loan of 1,00,000 and the lower interest rate he or she earns on the deposit of 1,00,000.
Similarly, the exporter could borrow 1,00,000 today, exchange this sum for $1,00,000 at todays
16

spot rate of SR = $1/1 and deposit the $100,000 in a bank to earn interest. After three months,
the exporter would repay the loan of 1,00,000 with the payment of 1,00,000 he or she receives.
The cost of avoiding the foreign exchange risk in this manner is, once again, equal to the positive
difference between the borrowing and deposit rates of interest.
Covering the foreign exchange risk in the spot market has a very serious disadvantage.

2.1.9.6.

Speculation in Spot Market:

If a speculator believes that the spot rate of a particular foreign currency will rise, he or she can
purchase the currency now and hold it on deposit in a bank for resale later. If the speculator is
correct and the spot rate does indeed rise, he or she earns a profit on each unit of the foreign
currency equal to the spread between the previous lower spot rate at which he or she purchased
the foreign currency and the higher subsequent spot rate at which he or she resells it. If the
speculator is wrong and the spot rate falls instead, he or she incurs a loss because the foreign
currency must be resold at a price lower than the purchase price.
Speculation in the spot market occurs when the speculator anticipates a change in the value of a
currency. For example, the exchange rate today is 40/US$. The speculator anticipates this rate
to become 41/US$ within the coming three months. Under these circumstances, he will buy
US$ 1,000 for 40,000 and hold this amount for three months, although he is not committed to
this particular time horizon. When the target exchange rate is reached, he will sell US$ 1,000 at
the new exchange rate, that is at 41 per dollar and earn a profit of 41,000 - 40,000 =
1,000.

2.1.10. FORWARD MARKET:

The forward exchange market refers to foreign exchange deals for sale and purchase of foreign
currency at some future date, normally after 90 days of the deal. When buyers and sellers enter
an agreement to buy and sell a foreign currency after 90 days of the deal at the agreed rate of
exchange, it is called forward transaction. The forward transactions in foreign exchange make the
forward market. The exchange rate settled between the buyers and sellers for forward sale and
purchase of currencies is called forward exchange rate.

17

2.1.10.1. Features of Forward Exchange

Contract:
The basic features of a forward exchange contract are explained below:
1) Bilateral Contracts: Forward contracts are bilateral contracts and hence, they are
exposed to counterparties risk. There is risk of non-performance of obligation either of
the parties, so these are riskier than to futures contracts.
2) Customized Contract: Each contract is custom designed and hence, is unique in terms
of contract size, expiration date, the asset type, quality, etc.
3) Long and Short Position: In forward contract, one of the parties takes a long position by
agreeing to buy the asset at a certain specified future date. The other party assumes a
short position by agreeing to sell the same asset at the same date for the same specified
price. A party with no obligation offsetting the forward contract is said to have an open
position. A party with a closed position is, sometimes, called a hedger.
4) Delivery Price: The specified price in a forward contract is referred to as the delivery
price. The forward price for a particular forward contract at a particular time is the
delivery price that would apply if the contract were entered into at that time. It is
important to differentiate between the forward price and the delivery price. Both are
equal at the time the contract is entered into. However, as time passes, the forward price
is likely to change whereas the delivery price remains the same.
5) Synthetic Assets: In the forward contract, derivative assets can often be contracted from
the combination of underlying assets, such assets are often known as synthetic assets in
the forward market.
6) Settlement by Delivery on Expiration Date: In the forward market, the contract has to
be settled by delivery of the asset on expiration date. In case the party wishes to reverse
the contract, it has to compulsory go to the same counter-party, which may dominate and
command the price it wants as being in a monopoly situation.
7) Covered Parity: In the forward contract, covered parity or cr ^-of-carry relations are
relation between the prices of forward and underlying assets. Such relations further assist
in determining the arbitrage-based forward asset prices.
8) Popular Contracts: Forward contracts are very popular in foreign exchange market as
18

well as interest rate bearing instruments. Most of the large and international banks quote
the forward rate through their forward desk lying within their foreign exchange trading
room. Forward foreign exchange quotes by these banks are displayed with the spot rates.

As per the Indian Forward Contract Act, 1952, different kinds of forward contracts can be done
like hedge contracts, Transferable Specific Delivery (TSD) contracts and Non-Transferable
Specify Delivery (NTSD) contracts. Hedge contracts are freely transferable and do not specific,
any particular lot, consignment or variety for delivery. Transferable specific delivery contracts
are though freely transferable from one party to another, but are concerned with a specific and
predetermined consignment. Delivery is mandatory. Non-transferable specific delivery contracts,
as the name indicates, are not transferable at all and as such, they are highly specific.

2.1.10.2. Types of Forward Exchange

Contracts:
Forwards contracts in India are broadly governed by the Forward Contracts (Regulation) Act,
1952. According to this act, forward contracts are of the following three major categories:
1) Fixed Term and Optional Term Forward Contract: Both buying and selling forward
exchange contracts may be either fixed or optional term contracts.
i).

Fixed Term Contracts: Fixed Term Contracts allow the customer to specify the
date when the deliver) of the overseas currency will occur. Earlier delivery is
usually an option however a marginal adjustment to the Forward Contract Rate
may be required.

ii).

Optional Term Contracts: Optional Term Contracts allow the customer to enter in
to an agreement for specific period, where the customer declares a certain period
within which they would like the delivery be made (this normally occurs for
periods shorter than one month), e.g., a customer may enter a contract 1 a six
month period while having the option of receiving a delivery anytime during the
final week.

2) Hedge Contracts: These are freely transferable contracts which do not require
specification of a particular lot size, quality or delivery standards for the underlying
assets. Most of these are necessary to be settled through delivery of underlying
19

assets.
3) Transferable Specific Delivery Forward Contracts: Apart from being freely transferable
between par concerned, these forward contracts refer to a specific and predetermined lot
size and variety of the underlying asset. It is compulsory for delivery of the underlying
assets to take place at expiration of contract.
4) Non-Transferable Specific Delivery Forward Contracts: These contracts are normally
exempted from the provision of regulation under Forward Contract Act, 1932 but the
Central Government reserves the right to bring them back under the act when it feels
necessary. These are contracts which cannot be transferred to another party. The
contracts, the consignment lot size and quality of underlying asset are required to be
settled at expiration through delivery of the assets.
5) Other Forward Contracts: It includes:
i).

Forward Rate Agreements (FRA): Forward contracts are commonly arranged on

domestic interest rate bearing instruments as well as on foreign currencies. In
forward rate agreement, no actual lending or borrowing is affected. Only it fixes
the rate of interest for a futures transaction.

ii).

Range Forwards: These instruments are very much popular in foreign exchange
markets. Under the instrument, instead of quoting a single forward rate, a
quotation is given in terms of a range, i.e., range may be quoted for Indian rupee
against US dollar at 47 to 49. It means there is no sing forward rate rather a
series of rate ranging from 47 to 49 has been quoted. This is also known
flexible forward contracts.

2.1.10.3.

Forward Rate Agreements (FRA):

A Forward Rate Agreement (FRA) is an interest rate forward purchase or sale contract. Under a
FRA, the interest differential between the FRA contract rate and the market interest rate on the
settlement date on 1 notional principal is paid or received.
In addition to the contract, FRA rate valuation model requires the Future Rate (i.e., the futures
interest rate from the settlement date to the final maturity date) and the Risk Free Interest Rate
(i.e., the zero coupon government bond rate for the period from the valuation date to the final
maturity date). A forward rate agreement is contract between the two parties, (usually one being
20

the banker and other a bankers customer c independent party), in which one party (the banker)
has given the other party (customer) a guarantee future rate of interest to cover a specified sum
of money over a specified period of time in the future.
FRAs are Over-the-Counter (OTC) instruments which are typically issued by investment banks
to end-users and are not traded on exchanges. Thus, the terms of the FRA can be set according to
the end-users requirements but they tend to be illiquid as they can only be sold back to the
issuing investment bank.
The assumption underlying the contract is that the borrowing or lending would normally be done
at LIBOR.
Consider a forward rate agreement where company X is agreeing to lend money to company Y
for the period time between Ti and T2.
Where,
RK: The rate of interest agreed to in the FRA (Forward Rate Agreement)
RF: The forward LIBOR interest rate for the period between times T1 and T2, calculated today.
RM: The actual LIBOR interest rate observed in the market at time T 1 for the period between
times T1 and T2
L: The principal underlying the contract
The extra interest rate leads to a cash flow to company X at time T2 of
L(RK-RM)(T2-T1)
Similarly, there is a cash flow to company Y at time T2 of
L(RM-RK)(T2-T,)
For example, X, the pay-off at time Tj is,
L(RK-RM)(T2-T1)
I+RM (T2 T1)
And, for company Y, the pay-off at time T1 is,
L(RM-RK)(T2-Tt)
I+RM (T2 T1)

For example, Suppose that a company enters into an FRA that specifies it, will receive a fixed

21

rate of 4% on a principal of $100 million for a 3-month period starting in 3 years. If 3-month
LIBOR provides to be 4.5% for the 3-month period the cash flow to the lender will be,
1, 00,000,000 x (0.04-0.045) x 0.25 =-$125,000
at the 3.25-year point. This is equivalent to a cash flow of
1,25,000
=$ 123,609
1+0.0450.25
at the 3-year point. The cash flow to the party on the opposite side of the transaction will be +
$125,000 at the 3.25-year point or +$123,609 at the 3-year point.
Note: (All interest rates in this example are expressed with quarterly compounding.)

2.1.10.3.1.

Characteristics of FRAs:

A FRA is an off-balance sheet instrument.

1) The structure is the same for all currencies. The structure is as follows: The short party or
dealer and the long party or end-user will agree on an interest rate, a time interval and a
hypothetical contract amount. The end-user benefits if rates increase (she has locked-in
a lower rate with the dealer). Because the end-user is long, the dealer must be short the
interest rate and will benefit if rates decrease.
2) FRAs mature in a certain number of days and are based on a rate that applies to an
instrument maturing in a certain number of days, measured from the maturity of the
FRA.
3) The contract covers a notional amount but only interest rate payments on that amount are
considered.
4) It is important to note that even though the FRA may settle in fewer days than the
underlying rate (i.e., the number of days to maturity in the underlying instrument), the
rate that the dealer quotes has to be evaluated in relation to the underlying rate.
5) Because there are two-day figures in the quotes, participants have come-up with a system
of quotes such as 3 x 9, which means the contract expires in three months and in six
months, or the nine months from the formation of the contract, interest will be paid on
the underlying Eurodollar time deposit upon which the contracts rate is based.
22

6) Other examples include 1x3 with the contract expiring in one month based on a 60 days
LIBOR, or 6 x 12, which means the contract expires in six months based on the
underlying rate of a 180 day LIBOR.
7) Usually, based on exact months such as 30 days LIBOR or 60 days LIBOR not 37 days
and 134 days LIBOR. If a client wants to tailor an FRA, it is likely that a dealer will do it
for the client. When this occurs, it is considered to bean off-the-run contract.

2.1.10.3.2.

Pay-off Formula in FRA:

The net payment made at the effective date is:

Payment=National Amount (

( Reference rate rate )

)
1+ Reference rate

1) The Fixed Rate is the rate at which the contract is agreed.

2) The Reference Rate is typically Euribor or LIBOR.
3) A is the day count fraction, i.e., the portion of a year over which the rates are calculated,
using the day count convention used in the money markets in the underlying currency.
For EUR and USD this is generally the number of days divided by 360, for GBP it is the
number of days divided by 365 days.
4) The Fixed Rate and Reference Rate are rates that should accrue over a period starting on
the effective date and then paid at the end of the period (termination date). However, as
the payment is already known at the beginning of the period, it is also paid at the
beginning. This is why the discount factor is used in the denominator.

2.1.10.3.3.

Functions of FRA:

FRAs work as follows:

1) A customer enters into an agreement with his bank to either buy or sell an FRA. The FRA
defines an intent rate for a principal of a deposit or a loan for a defined interest period
that will start at a future date. The interest rate on which they agree also known as
FRA rate is the price of the FRA as it is quoted by the market
2) By doing so, the bank has not committed itself to lend or take money at this rate. Instead,
23

the customer and the bank agree to compare the fixed FRA rate to a reference interest
rate (e.g., LIBOR) two (exception: GBP) before the defined interest period (fixing date).
The reference rate is defined on fixing date; it is also called settlement rate.
3) Who receives or pays the due amount depends on whether the customer or the bank
Fixed Rate
LIBOR

FRA Intermediary

Company

bought or sold the FRA and whether the FRA rate is higher or lower than the reference
rate at settlement date.

A large company wishes to fix the interest rate for a loan of U.S.D 20 Mio for 3 months,
beginning in two months. The company might buy an FRA from a bank that is trading such
instruments. The bank quotes an FR rate. This FRA rate is applied to the principal (U.S.D 20
Mio), but not to the three month loan itself. Thereto the FRA rate serves as the fixed rate the
company wanted to secure for the three month term of interest (from the end of the 2nd until the
end of the 5th month). This fixed rate is known to both of the counterparties o trading day, but
they do not know the future level of the reference rate.
Usually, two days before the settlement date, the FRA rate is compared to the agreed reference
rate (LIBOR). ] the reference rate is higher than the defined FRA rate, the due amount is paid to
the customer. This is compensation for the higher interest payments for his (more expensive) re
financing.
If the reference rate happens to be lower than the FRA rate, the customer must settle the
balance. This effect in turn is balanced by lower interest expenses. In this process, there is no
exchange of principal; only the interest rate gaps are balanced. With the settlement payment, the
interest rate for the future re-financing has been fixed at the FRA rate.

2.1.10.3.4.

Benefits of FRA:

The benefits of FRA are as follows:

24

1) Customized dates and amounts.

2) Very liquid market so small Bid/Offer spreads.
3) No premiums or payments upfront.
4) Can be reversed at any time at the then prevailing rate.

2.1.10.3.5.

Limitations of FRA:

The limitations of FRA are as follows:

1) Only cover short-term interest rates.
2) The FRA market is not very liquid.
3) It is more expensive for clients to trade small amounts.
4) If an FRA is to be adapted to a client s underlying asset, which often does not coincide
with the stand periods of three or six months, this will add to the clients costs.

2.1.10.4.

Quotes in Forward Market:

A forward quote (or forward exchange rate) is the one which applies to a foreign exchange
transaction t effected on a specified future date. Both the buyer and seller of exchange in the
forward market agree that forward rate will sell a stated amount of the foreign currency at an
agreed exchange rate to the buyer specified future date (e.g., three months hence) irrespective of
the actual exchange rate that may prevail o said future date. The deal also involves a
corresponding payment, in (normally) domestic currency by the 1 of foreign currency to the
seller of it. Forward rates can be calculated from spot rates and interest rates.
The formula for calculating forward rate is as follows:
Spot x (1+ Domestic Interest Rate)/(1 + Foreign Interest Rate)
Where, the Spot is expressed as a direct rate (i.e., as the number of domestic currency units one
unit of the foreign currency can buy).
In other words, if S is the spot rate and F the forward rate, and rr and rd are foreign currency
interest rates and domestic currency interest rates respectively, then:
F=S

1+r d
1+r f
25

For example, if the spot CAD/USD rate is 1.1239 and the three month interest rates on CAD
and USD are 0.75% and 0.4% annually respectively, by calculate the 3 month CAD/USD
forward rate. Then the forward rate will be:
90
360
1.1239=
=1.1249
90
1+0.4
360
1+0.75

Another formula for calculating forward rate is:

Forward rates can be calculated over later years as well. The general formula is:
1+r dn

1+r n1

n1

F n=
Where, Fn= Forward rate over the nth year
rn = n-year spot rate
rn-1 = Spot rate for n - 1 years
Example 2: the following set of rates:
Year

Spot Rate

5%

6%

7%

6%

What are the forward rates over each of the four years?
Solution: The forward rate over the first year is, by definition, equal to the one-year spot rate.
Thus, we do not generally speak of the forward rate over the first year. The forward rates over
26

the later years are:

1.06

F2 =
1.07

F2 =
1.06

F2 =
With reference to its relationship with the spot rate, the forward rate may be at par, at a discount
or at a premium.
i).

At Par: If the forward exchange rate quoted is exactly equivalent to the spot rate at the
time of making contract, forward exchange rate is said to be at par.

ii).

At Premium: The forward rate for a currency, say, the US dollar, is said to be at a
premium with respect the spot rate when one dollar buys more units of another currency,
say, the rupee, in the forward rather in the spot market. The premium is usually expressed
as a percentage deviation from the spot rate on annum basis.
For example, if the spot rate is $1 = 1 and the three-month forward rate is $1.01 = 1,
the euro is said at a forward premium of 1 cent or 1 per cent for three months or 4 per
cent per year.

iii).

At Discount: The forward rate for a currency, for example, the US dollar, is said to be at
a discount with respect to the spot rate when one dollar buys fewer rupees in tile forward
than in the spot market. The discount, too, is usually expressed as a percentage deviation
front die spot rate on a per annum basis. For example, if the spot rate is $1 = 1 and the
27

three-month forward rate is $0.99 = 1, the euro is said to be at three-month forward

discount of I cent or I per cent (or at a 4 per cent forward discount per year) with respect*
to the dollar.
Forward Discounts (FD) or Premiums (FP) are usually expressed as percentages per year
from the corresponding spot rate and can be calculated formally with the following
formula:
A forward contract without an accompanying spot transaction is called an outright forward
contract.
Calculation of forward rate using forward premium and discount method
Forwarard / premium=

forward PriceSpot Price

Spot Price

Example 3: Using the following data, calculate the 30-day, 90-day, and 180-day forward
premiums for the British pound.
Spot:

1 =$1.4487

30-day forward:

1 =$1.4498

90-day forward:

1 =$1.4511

18-day forward

1 =$1.4529

Solution: Here are the relevant calculations for the pound:

The 30-day forward premium is:
[($ 1.4498 - $ 1.4487)/$ 1.4487] 12 = 0.91 %
The 90-day forward premium is:
[($1.4511 -$1.4487)/$1.4487] 4 = 0.66%
The 180-day forward premium is:
[($ 1.4529 - $ 1.4487)/$ 1.4487] 2 = 0.58%
The small forward premiums at these maturities indicate that British and U.S. interest rates are
very close.
28

Calculation of forward rate using annualised forward margin

The annualised rate can be calculated by using the following formula:
Annualised Forward Premium

Forward PriceSpot Price

12

100
Spot Price
No. of Months

So in the case listed above, the premium would be calculated as:

Annualised Forward Premium
= ((109.50-109.38) 109.38) (123) 100% = 0.04%

2.1.10.5.

Arbitrage in Forward Market:

The forward differential is approximately equal to the interest rate differential. Sometimes there
may be marked deviation between these two differentials. In such cases, covered interest
arbitrage begins and continues till the two differentials become equal. This is arbitrage in a
forward market.

2.1.10.6.

Hedging in Forward Market:

The forward market is used not only by the arbitrageurs but by the hedgers too. Changes in the
exchange rate are a usual phenomenon. Such changes entail some foreign exchange risk in terms
of loss or gain to the traders and other participants in the foreign exchange market. The risk is
reduced or hedged through forward market transactions.
Under the process of hedging, currencies are bought and sold forward. Forward buying and
selling depends upon whether the hedger finds himself in a long, or a short, position. An export
billed in foreign currency creates a long position for the exporter.
On the contrary, an import billed in foreign currency leads to a short position for the importer.
Hedging in a forward market, whether it concerns a long position or a short position, is a doubleedged sword and if the trend in the exchange rate movement is not according to expectations, it
can result in a loss.

2.1.10.7.

Speculation in Forward Market:

In addition to the arbitrageur or the hedger, speculators are also very active in forward market
29

operations. Their purpose is not to reduce the risk but to reap profits from the changes in the
exchange rates.
The source of profit to them being the difference between the forward rate and the future spot
rate, they are not very concerned with the direction of the exchange rate change.
For example, a speculator sells US$ 1,000 three-month forward at the rate of 40.50/US$. If, on
maturity, the US dollar depreciates to 40, the speculator will get 40,500 under the forward
contract. At the same time, he will exchange 40,500 at the then future spot rate of 40/US$ and
will get US$ 1,012.50. Both these activities - the selling and the purchasing of US dollars will be
simultaneous. Thus, without making any investment, the speculator will make a profit of US$
12.50 through the forward market deal. This is an example of speculation in the forward market.

2.2.1.

2.2.
EXCHANGE RATES
MEANING OF EXCHANGE RATES:

Exchange rates (also known as the foreign exchange rate, forex rate or FX rate) between any two
currencies are the rates at which they are exchanged or sold against each other. Transactions in
the foreign exchange market are carried out at what are termed as foreign exchange rates.
In other words, the rate at which the currencies of two nations are exchanged for each other is
called the foreign exchange rate. It is nothing but the value or price of a countrys currency
expressed in terms of a foreign currency. For example, if 1 U.S. dollar is exchanged for 10 then
foreign exchange rate is. 1 U.S. $ = 10.
For example, an exchange rate of 102 Japanese yen (JPY, ) to the United States dollar (USD, $)
means that JPY 102 is worth the same as USD 1. The foreign exchange market is one of the
largest markets in the world.
Exchange rates can influence the sourcing of funds for businesses, investment in foreign
countries as well as the reporting of financial results. The determination of exchange rates is a
complex process that has significant economic impact on imports and exports and in turn job
growth.

30

The foreign exchange market plays an important role in the determination of the exchange rates.
Individuals can use exchange rates not only for investment decisions, but also for lifestyle
choices like tourism, relocation, and buying consumer products.

2.2.2.

EXCHANGE RATE QUOTATIONS:

Foreign exchange quotations can be confusing because currencies are quoted in terms of other
currencies. It means exchange rate is a relative price. In other words, foreign exchange quotation
is the amount of currency that is exchanged for a unit of another currency. For example, the
exchange rates of rupees () in India may be quoted in terms of dollar ($), e.g., /$ = 44/$. It
means that $1 is worth 44.
A change in price of one currency implies, therefore, a change in price of the other currency
that appears in the quote. For example, if the price of against the $ moves from 44/$ to
43.5/$, one can say that has appreciated relative to $ by 0.50. This is the same as saying
that $ has depreciated relative to the rupee.
Types of Exchange Rate Quotations:
Following are the types of foreign exchange quotations as shown in figure below:

2.2.2.1.

Bid and Ask Prices:

A quotation is the amount of a currency necessary to buy or sell a unit of another currency.
When it is expressed in currency terms it is called outright rate, e.g., S ( /$) = 35.980 is an
outright rate between rupees and dollar.

31

Types of Exchange Rate Quotations

Direct Quote
Bid and Ask Prices
Spot Rate/Quote
Indirect Quote
Cross Rates
Forward Rate/Quote
Spread
%Spread/Cost of Transaction

The quotes are usually made in the form of buy and sell or bid and ask rates.
The buy quote is the price at which the exchange dealer is ready is ready to buy a currency for
which the quote is made and sell quote indicates the price at which the dealer is ready to sell the
currency. The bid and ask' are the alternative terms for the above two quotes. Sometimes ask
is also referred as other price.
If an investor looks at a computer screen for a quote on the stock of say XYZ Ltd., it might look
something like this:
Here, on the left-hand

Bid (Buy Side)

Ask (Sell Side)

Price
Quantity
(50.35
)
2000

hand side we find the

1000
500

Price ()
50.25
50.10

prices. The best Buy

550

50.05

1000
1500

order with the highest

2500

50.00

sits on the first line of

1300

49.85

quantity

shares

and

price,

50.25).

order is the order with

Quantity

5850

side after

the Bid

whereas on the right

50.40

Ask

50.50

(Bid) order is

3000

50.55

price

1450
8950

50.65

the Bid side (1000

quantity
and

and
the

therefore

The best Sell (Ask)

the lowest sell price

(2000 shares @ 50.35). The difference in the price of the best bid and ask is called as the BidAsk spread and often is an indicator of liquidity in a stock. The narrower the difference the more
liquid or highly traded is the stock.
An example of bid and |ask* price is:

"
32

Currency Notes:
Buying: 35.10/$
Setting: 36.35/$
For example, if a bank quotes bid rate at spot for dollars as S ( /bid S) it simultaneously
sells rupees for dollar. In particular, if S (/bid $) 35.50/$ which is the bid price for dollar
but at the same time it is the ask price for rupees in terms of dollars. The inverse of this ask
rate of rupees would again be equal to the bid rate of dollar. In other words:
S(/bid$)=1/s($/ask) and S($/ask)= 1/(S(/bid$)
This can well be seen from the above quote; Bid rate for dollar is :35.50/$= ask price of rupees
indirect quotes. And the direct quote would be S ($/ask ) = $ (1/35.5)/= 0.0282/ Now if we
invert this rate we find that this equals the rate with which we started.
In general items we can write:
S(x/bid y) = 1/ S(y/ask x) and S(x/ask y) = l/S(y/bid x)
Where, x and y are currencies of two countries.
The above equations define the relationship between bid and ask rate of direct and indirect
quotes.

2.2.2.2.

Direct Quote:

In the case of direct quote, a unit of foreign currency is quoted in terms of domestic currency.
Direct Quote: Bid rate < Ask rate
1. Bid Rate: It is the rate at which an AD buyer is ready to buy the currency that is constant
(currency F).
2. Ask Rate: It is the rate at which an AD seller is ready to sell the currency that is constant
(currency F).
For example, at New York foreign exchange market the Deutsche mark (DM) is quoted as:
Spot (bid) = $2.4000/DM,
Spot (Ask) = $2.4017/DM
Or, at New Delhi the dollar is quoted as:
Spot (bid) = 35.90/$
Spot (Ask) = 36.00/$

33

These quotes are direct quotes, because in the first case a unit of foreign currency (DM) is
expressed in terms of domestic currency ($) and in the second quotes also a unit of foreign
currency ($) is quoted in terms of domestic currency ().

2.2.2.3.

Indirect Quotes:

An indirect rate quote is the price of one unit of home currency in terms of a foreign currency.
Indirect Quote: Bid rate > Ask rate
1. Bid Rate: It is the rate at which an AD buyer is ready to buy the currency that is constant
(currency H).
2. Ask Rate: It is the rate at which an AD seller is ready to sell the currency that is constant
(currency H).
For example, at London foreign exchange market the quotation are made as:
Spot (bid) = S3.0201/BP,
Spot (ask) = S3.0180/BP
Where, BP = British pound
These quotes are indirect because here a unit of domestic currency is expressed in terms of
foreign currency. A BP is the domestic currency in England. European quotes are indirect quotes.
Sometimes the quotes s against 100 units of a currency instead of a unit of the currency.

2.2.2.4.

Spot Rate/Quote:

Refer to Spot Market

2.2.2.5.

Forward Rate/Quote:

Refer to Forward Market

2.2.2.6.

Cross Rates:

It is the exchange rate between two inactively traded currencies usually involves the use of a
third widely traded currency, the U.S. dollar.
Sometimes the value of a currency in terms of another one is not known directly. In such cases,
one currency is sold for a common currency; and again, the common currency is exchanged for
the desired currency. This is known as cross rate trading and the rate established between the two
currencies is known as the cross rate. Suppose, a newspaper quotes 35.00-35.20/U.S.$; and at
34

the same time, it quotes Canadian $0.76-0.78/U.S.$ but does not quote the exchange rate
between the rupee and the Canadian dollar. Thus the rate of exchange between the rupee and the
Canadian dollar will be found through the common currency, the U.S. dollar. The technique is
similar for both spot and forward cross rates.
For example, we have
Japanese yen: U106.2000/$
Mexican peso: Ps10.9680$
And the required exchange rate is U/Ps. The cross rate calculation would be:
Exchange rate U = $ = U106.20000 = $ = U9.6827 = Ps.
Exchange rate Ps=$ Ps10.9680 = $
For example, we have
So (CHF/USD) = CHF 2.0000
So (JPY/USD) = JPY 120.000
The number of Japanese yen for Swiss francs or the number of francs for yen can easily be
found. If you had yen and wanted francs, you could pay JPY 120 and get USD 1. Then you could
sell the dollar and buy CHF 2. For each franc you would have paid JPY 120/CHF 2 = JPY 60.
Conversely, if you had Swiss francs and wanted yen, you could sell CHF 2 and receive USD1,
then you could sell the dollar and buy JPY 120. For each yen you would have paid CHF 2/JPY
120 = CHF 0.0167.

2.2.2.7.

% Spread/Cost of Transaction:

%Spread is also known as cost of transaction. The %spread/cost of transaction at any point in
time is represented by the percentage of spread and is given by:
1)[(Ask - Bid)/Ask] * 100 when the quotes are direct
= (0.0403/35.8024) x 100
2)[(Bid - Ask)/Bid] * 100 when the quotes are indirect
= (0.0025/1.590) x 100

35

Percentage Spread=

Ask priceBid price

100
Ask price

Example 4: An Indian Banker gives the following quotes for USD as INR 50.1125/50.4560.
Calculate percentage spread.
Solution: INR/USD: 50.1125/50.4560
Percentage Spread=

2.2.2.8.

Ask priceBid price

50.456050.1125
100=
100=0.6807
Ask price
50.4560

Spread:

The Bid-Ask Spread, also known as the Bid-Offer Spread, is the quote of the price at which
participants in A Market are willing to buy or sell a good or security.
Ask and bid differential is called the spread.

'

When quotes are direct:

Spread = Ask Bid
However, when the quotes are indirect the spread is given as:
Spread - Bid - Ask
Following example explains the calculation of spread:
Spread bid price of dollar at spot S(/bid $) = 35.7621 and the ask price is S(/ask $) = 35.8024,
therefore the spread is:
Ask - Bid = 35.8024 - 35.7621 - f 0.0403
When the quotes are indirect, i.e. the quotes at Frankfurt for dollar are:
Bid price for dollar is S ($/bid DM) = $ 1.5900/DM and the ask price is S ($/ask DM) = $
1.5875/DM in this case the spread is Bid - Ask = 1.5900 - 1.5875 = $ 0.0025.

2.2.3.

EFFECTIVE EXCHANGE RATE:

The bilateral exchange rates between the domestic currency and other currencies may not be of
much use in determining the international competitiveness of a country when it has trade
relations with some countries only. The bilateral movements of a currency may not indicate the
overall change in the home currency value against the currencies of the countrys trading
partners. Therefore, an overall measure of the movement of the home currency against the
countrys major trading partners currencies is of great significance. It is in this context that the
36

concept of effective exchange rate has come into prominence.

The effective exchange rate, also called multilateral exchange rate, is a weighted average rate
that is calculated by weighing the exchange rates between the home currency, and other major
currencies; using the different countries shares in the home countrys foreign trade as weights.
Thus the effective exchange rate is a measure of the overall value of one currency against a
basket of currencies. As trade weights are used in the computation, the effective exchange rate is
also called trade-weighted exchange rate.
The effective exchange rate can be a Nominal Effective Exchange Rate (NEER) or a Real
Effective Exchange (REER).

2.2.3.1.
Nominal Effective Exchange Rate
(NEER):
The exchange rate, which is a weighted average of nominal exchange rates of a national currency
excluding tendencies for change in prices of a country under consideration with respect to prices
in countries-partners in trading, is called a Nominal Effective Exchange Rate (NEER). The
NEER does not reflect the price changes in the observed country relatively to price changes in
the trading partners.
The nominal effective exchange rate allows to define the extent by which the exchange rate of
the national currency changed relatively to exchange rates of the trading countries compared to a
base year. However, the change in the nominal effective exchange rate does not reflect changes
in the purchasing power of the currency, nor to what extent the competitiveness of goods
produced in this country and showing an export potential changed during a specific period of
time. In order to define the extent by which the purchasing power of the currency changed
during some period of time, a Real Effective Exchange Rate (REER) is calculated.
The Reserve Bank of India calculates the NEER of the Indian rupee in the following way:
The NEER is the weighted geometric average of the bilateral nominal exchange rates of the
home currency in terms of foreign currencies.
n

NEER=
i=1

e
ei

Wi

()

37

Here,
e = Exchange rate of INR against SDR in indexed form.
ei = Exchange rate of currency i against SDR (i.e., SD per currency i) in indexed form.
e/ei = Exchange rate of INR against currency i in indexed form L
wi = Weight attached to country i in the index.
n = Number of countries/currencies in the index other than India

2.2.3.2.
(REER)

Real Effective Exchange Rate

The real effective exchange rate is a weighted average of the value of a country relative to a
basket of other major currencies, adjusted for differences in inflation. The real effective
exchange rate often is used as a measure of the competitiveness of a countrys exports. The real
effective exchange rate is best understood by examining how it is different from other kinds of
exchange rates. The real exchange rate is equal to the nominal foreign exchange rate adjusted for
the difference in inflation between the two counties involved. This is determined by multiplying
the foreign exchange rate by the ration of the domestic price to the foreign price level. The real
exchange rate takes into account changes in the purchasing power of each currency because of
inflation.
The Reserve Bank of India calculates the REER of the Indian rupee in the following way:
The REER is the weighted average of the NEER, adjusted by the ratio of domestic prices to
foreign prices.
n

REER=
i=1

e p

ei pi

Wi

Here,
e = Exchange rate of INR against SDR in indexed form.
ei = Exchange rate of currency i against SDR (i.e., SD per currency i) in indexed
form,
e/ei = Exchange rate of INR against currency i in indexed form.
P = Indias wholesale price index.
38

Pi = Consumer price index of country i.

Wi = Weight attached to country i in the index.
n = Number of countries/currencies in the index other than India.

2.2.3.3.
Nominal Effective Exchange Rate
Vs Real Effective Exchange Rate
The NEER is obtained by sing nominal exchange rates, while the REER is derived by adjusted
the nominal effective exchange rate for price differences between a country, and its trading
partners. According to the IMF, the REER is computed as the weighted geometric average of the
prices of the domestic country relative to the prices of its trade partners.
There are different methods followed in the computation of the REER. The Reserve Bank of
India calculates the NEER and the REER of the Indian rupee in the following way:
1. The NEER is the weighted geometric average of the bilateral nominal exchange rates of
the home currency in terms of foreign currencies.
n

NEER=
i=1

e
ei

Wi

()

2. The REER is the weighted average of the NEER, adjusted by the ration of domestic
prices to foreign prices.
n

REER=
i=1

e p

ei pi

Wi

Here,
e = Exchange rate of INR against SDR in indexed form.
ei = Exchange rate of currency i against SDR (i.e., SD per currency i) in indexed
form,
e/ei = Exchange rate of INR against currency i in indexed form.
P = Indias wholesale price index.
Pi = Consumer price index of country i.
Wi = Weight attached to country i in the index.
n = Number of countries/currencies in the index other than India.

39

2.3.1.

2.3.
CURRENCY DERIVATIVES
MEANING OF CURRENCY DERIVATIVE:

The complexities of derivatives are manageable to anyone comfortable with the concept of
parallel markets Derivatives are the contracts in the various foreign exchange markets forwards, futures, options, and swaps The markets for these instruments all closely parallel
die spot currency market. A currency derivative is defined as follows:
1) A contract or financial agreement to exchange two currencies at a pre-determined rate, or
2) A contract or financial agreement whose value is derived from the rate of exchange of two
currencies at spot.
In either case, the exchange of currency may be actual or implied.
Currency derivatives trade in markets that parallel the spot market, so spot (cash) market
exposures can be hedged with currency derivatives. The spot rate is the price of the
underlying currency. One advantage of derivative hedging is the number of markets
available, all moving parallel to the underlying currency.
Currency derivatives represent contracts covering foreign currency obligations or claims. 1
he pay-off is decided based on the price of the currency. The important types of currency
derivatives are currency futures, currency options, currency swaps, etc. Currency derivatives
are a type of financial agreement that is based around the relationship between two foreign
currencies.
The agreement usually involves two traders making a deal to exchange currencies at u fixed
rate on a future date. The difference between this rate, and the actual market rate on this date
will determine who comes-off better from the agreement. Either party can sell his position in
the agreement to a third party before the agreed completion date, thus making the agreement
itself a financial asset.
There are several reasons traders engage in currency derivatives. One is simply as a form of
financial speculation. Another is to hedge against other financial investments, to take a position
that will pay-off under circumstances that mean other investments have gone badly, thus

40

mitigating the losses. Some businesses also use currency derivatives to provide more certainty.
For example, a business exporting goods at the present time but receiving payment in a
foreign currency at a later date might set-up a forex swap, so it can guarantee getting a set
amount in its domestic currency.

2.3.2.

TYPES OF CURRENCY DERIVATIVES:

Following are the types of currency derivatives:

Types of Currency Derivatives
Currency Future
Currency Forward
Currency swaps
Currency Options

2.3.3.

CURRENCY FORWARD:

An agreement between two parties to exchange a certain amount in currencies at a certain rate at
a certain time is called currency forward. When a forward contract of any sort is made, terms are
negotiated directly between the parties, unlike a futures contract, which trades on an exchange
partly because there is little secondary market for forward contract, determining the forward
price is a zero-sum game - one party will gain on the contract at one will lose. Thus, in a
currency forward, each party believes that the prevailing exchange rate will move in a direction
favorable to him/her by the expiry of the contract.

2.3.3.1.

Feature of Currency Forward:

Currency forward contracts are entered into when a party has an open position in a foreign
currency that either received or paid at a known future time. Thus, the important features of a
forward contract are:
1) The party entering into a currency forward contract should have an exposure to that
currency.
2) The amount of exposure should be known with certainty.
3) The time at which the exposure will develop should be known with certainty.
These conditions should be satisfied before the party can enter into a forward transaction with a
bank. The pm regulations require that the bank verifies these details before the contract is entered
41

into. The regulations a provide for the cancellation and re-negotiation of the forward contract.

2.3.3.2.
Trading Process of Currency
Forward:
Currency forward contracts are usually provided by banks. If an Indian exporter needs to enter
into a U.S. dollar forward sell contract, they will approach a bank authorised to deal in the
foreign exchange for the same. The bank will quote the forward rate, and the contract will be
finalised.
Banks take a risk by entering into a forward contract. For the exporter, there is no risk, because
they have an open position in a foreign currency that they are covering with the forward contract.
An open position means that the exporter is exposed to foreign exchange risk. This exposure to
foreign exchange risk arises because the exporter will be receiving U.S. dollars after 90 days and
they need to convert the received U.S. dollars into Indian rupees at that time. When a person has
an open position in the underlying asset, they are exposed to the risk of changes in the prices of
the underlying asset and they need to hedge this risk of exposure. The exporter, therefore, uses
the forward contract in the foreign currency to hedge this exposure. By entering into a forward
transaction, the hedger is able to cover his exposure so that his new position is zero. This is
explained as follows:
At the current time, the exporter has an open position in U.S. dollars to the tune of U.S. $1
million, which will be received after 90 days. They cover their position by entering into the
forward sale of U.S. $! million after 90 days. The net position is therefore zero.

However, for a bank, this forward contract creates an open position. For example, assume that
the bank has entered into a forward contract to buy U.S. $1,000,000 after three months at the
exchange rate of U.S. $1 = 49.09. This means that the bank will receive U.S. $1,000,000 which
was bought with 49.09 million, after three months. After three months, the bank will have an
open position in U.S. dollars to the value of U.S. $1,000,000. This is an open position subject to
exchange rate risk. To eliminate this risk, the bank will have to develop strategies. This can be
done by entering into an off-setting forward contract with another party or by entering into
currency futures or currency options contracts.

42

Currency forward contracts are used by parties that develop exposure to a foreign currency at a
future time. The exposure can result from the following reasons:
1) Export of goods and services with the invoice denominated in a foreign currency.
2) Import of goods and services from a foreign country with the invoice
denominated in the foreign currency.
3) Investments in foreign securities, which pay interest or dividends in foreign
currency at known future time periods.
4) Borrowing from a foreign entity, which requires payment of interest in foreign
currency at known future intervals.

2.3.3.3.

Hedging in Currency Forward:

An importer or exporter may face considerable foreign exchange risk due to exchange rate
fluctuations when his trade is invoiced in a foreign currency.' An importer is generally not
required to make the payment immediately. He gets some credit period.
However, his account payable is exposed to foreign exchange risk because the payment has to be
made in a foreign currency. The amount of rupees required to meet his payment would depend on
the spot exchange rate prevailing at the due date for making the payment. This exposure can be
hedged through a currency forward deal.
For example, an Indian company has imported some goods worth $ 100,000 from the U S.A. and
that the payment is due in three months. There is uncertainty about the amount of rupees that
would be required to buy 5,00.000 at the due date because of exchange rate fluctuations. The
company can hedge this risk by buying U.S. $100,000 forward for delivery on the due date of
payment of the import bill.
let us suppose that the company concludes such a forward deal at a forward rate of 43.85 per
U.S. dollar. By entering into such a forward deal, the company eliminates the uncertainty
regarding the rupee cost of his imports whatever be the actual spot rate at the time of settlement,
the importing company can buy the dollars at 43.85.
An exporter faces a similar foreign exchange risk on his account receivable when the trade is
invoiced in a foreign currency. The amount due on account of the export trade is likely to be
received only alter a delay of a few months.
The amount of rupees that he will realise by converting the foreign currency into Indian rupees
when it is received would depend upon the spot rate at that time.
43

The exporter can hedge this risk by selling forward the foreign currency expected to be received
later. I le can thus eliminate the possibility of loss on conversion of the forward currency. Such a
currency forward deal is outlined in below table while some exchange rate quotes are given in
table 2.2.
Currency Forward Deal
Export Contract Data
Exporter

Indian company

Importer

American Company

Currency of Invoice

U.S. Dollar

Invoice Date

1 July

Credit Period

3 Months

Due Date of Receipt

1 October

Table 2.2: Exchange Rate Quotes on July 1,2008 (7/U.S. $)

Spot
Forward
July
August
September
October

43.30

43.73

43.47
43.62
43.74
43.87

43.91
44.06
44.19
44.32

Forward Deal Transactions

1 July

Indian exporting company sells $200,000 three month forward at 43.87 per
U.S. dollar.

1 October
Indian exporting company receives. $200,000 from the American company.
1 October
Indian company delivers $200,00 to the foreign exchange dealer and receives
87,74,000 at the rate of 43.87 per U.S. dollar.

2.3.3.4.

Speculation in Currency Forward:

Speculators are basically profit seekers. Exchange rate fluctuations provide opportunities to
speculators for making speculative profits. Currency forwards are also used by speculators to
44

make speculative gains.

Forward exchange rates are quoted at a premium or discount to the current exchange rate or spot
rate. The future spot rate, i.e., the spot rate prevailing at the maturity of the forward contract, is
generally expected to be equal to the forward rate. But, it may also diverge from the forward rate.
Such divergence is often utilised by speculators to make short-term gains.
For example, the dollar-rupee spot exchange rate is 720/U.S $ and the three-month forward
exchange rate is 41/U.S. $. The forward exchange quotation is an indication that the dollar is
expected to appreciate in the short-term and move upto 41/U.S. $ in three months from now.
Depending on his view on the future spot rate, he would enter into a forward contract. If he
thinks that the future spot rate would be above the speculator buys U.S $
In the same situation, had the speculator taken a view that the future spot rate would be below
the forward rate he would have entered into a forward contract to sell U.S. dollars. Let us assume
that the speculator sells U.S, $20,000 three-month forward at 41/U.S. $ and on maturity the
spot rate is 40.75/U.S. $. Through the forward deal, the speculator would receive 8,20,000 in
exchange for U.S. $20,000. He would simultaneously buy U.S. dollars at the prevailing spot rate
of 40.75/U.S. $ and receive U.S. $20,122.70. He thus makes a speculative profit of U.S.
$122.70 through the forward deal.
Forward rates for different maturity periods normally differ. Speculators may exploit such
differences for seeking short-term gains. For example, let us suppose that a speculator has bought
U.S. $10,000 three-month forward at the forward rate of 41.50/U.S. $ when the dollar-rupee
spot exchange rate is 41.10/U.S. $. Altera lapse of one month, he finds that the two-month
forward exchange rate at the time is 41,60/U.S. $; it would 1 advantageous to him to enter into
an offsetting forward contract to sell U.S. $10,000 two-month forward at 41.60/U.S. $. At the
end of the next two months, both the contracts would mature. He would receive U.S, $10,000 in
exchange for 4,15,000 as per the three-month forward contract. At the same time, he would
receive 4,16,000 in exchange for U.S. $10,000 as per the two-month forward contract. In
effect, he makes a speculative profit of 1,000 without any investment as the forward deals
mature simultaneously.

45

The above-mentioned examples show that currency forwards can be used for speculative activity
as well, in addition to hedging the risk in foreign exchange transactions. But, it may be noted
that, while using currency forwards for speculation, the speculator may suffer a loss if the
exchange rate moves in a direction opposite to his expectations.

2.3.4.

CURRENCY FUTURES:

A currency futures contract provides a simultaneous right and obligation to buy and sell a
particular currency at a specified future date, a specified price and a standard quantity. In other
words, in currency futures market, the different currencies are sold and purchased at the specified
future date, at predetermined price and of specified quantity on a particular recognized exchange.
It is similar to other futures contracts like commodities, interest, rates, metals, etc. The foreign
currency futures were started in the year 1972 at the International Money Market (IMM), a
division of Chicago Mercantile Exchange at Chicago.

2.3.4.1.

Features of Currency Futures

A currency futures contract is a commitment to deliver a specified quantity of a specified

currency at a specified future date and at a specified price-The principal features, in general, of
the contract are as follows:
1) Organized Exchanges: The currency futures contracts are negotiated only on
recognized/organized exchanges with a designated physical location where such trading take
place. These exchanges provide

ready, liquid market in which futures-can be bought and

sold at any time.

2) Standardization: Like other futures contracts, the currency futures contract are also
standardized by the respective organized exchanges on which trading are initiated.
3) Minimum Variation (Tick Size): In each futures market, there is minimum price variation,
also called as tick, which is standardized for every contract. It may vary exchange to
exchange. Generally it is 0.01 percent or 0.0001 dollar per unit of currency.
4) Clearing Mouse: After a futures contract is agreed between the two parties at the trading
Hour, dien the agreement between A and B immediately replaced by to contracts one
between A and clearing house, and other, between B and the clearing house. The clearing
house is responsible for keeping the

accounts margin

payments, settlement of deliveries and

others like information and data collection. The clearing house plays a vital role between the
46

two parties and eliminates the need for A and B to investigate each other's creditworthiness
and guarantees the financial integrity of the market. Further, the clearing house gives the
guarantee for execution and delivery of the contracts held till their maturity.
5) Marking-to-Market: At the end of the trading session, all the outstanding contracts arc repriced at the settlement price of that session. It means that all the futures contracts arc daily
settled, and profit and loss is determined on each transaction. This procedure, called
marking-to-market, requires that funds change every day. The funds are added or subtracted
from a mandatory margin (initial margin) that traders are required to maintain the balance in
the account. Due to this adjustment, futures contract is also called as daily reconnected
forwards.
6) Margins: For the smooth functioning and execution of futures contracts at the exchanges, the
exchange requires a performance bond in the form of a margin which must be deposited with
the clearing house. If will be treated as security against each partys market position. The
margin payment is a good faith deposit which provides evidence of partys ability to settle
the contract. The margin account is designed to be sufficient to meet the largest possible
days loss. So, the size of this initial deposit varies with the volatility of the currency.
Normally, it varies between 2.5 to

10

per cent of the value of the contract. The deposit in the

margin account by the member can be in the form of cash or securities, such as treasury bills,
and in some cases, even banks letter of credit.

2.3.4.2.
Trading Process of Currency
Futures:
Like other futures trading, the futures currency is also traded at the organized exchanges.

47

Trader (Buyer)

Trader (Seller)
Sale order

Purchase order
Member (Broker)

Member (Broker)

Transaction on the floor (Exchange)

Informs

Clearing House

The following figure 2.1 the common flow diagram of how operations take place on currency
futures market. It describes the mechanism of the flow of transactions which arc taken place at
the recognized exchanges. When the market is open, the transactions take place at the floor of the
exchange. Beyond the opening hours, negotiations may take place through an electronic system,
called GLOBEX which connects the markets of Chicago, Paris, London and others from 2:30
p.m. until 7:05 a.m. the following morning. The GLOBEX system matches purchase and sale
orders for each type of currency futures contract. Orders are confirmed electronically and the
traders are informed about the quantity and price of the negotiations. This information is then
sent to the clearing houses which further make the adjustments in the buyers and sellers margin
accounts.

2.3.4.3.

Hedging in Currency Futures:

Traders make use of the market for currency futures in order to hedge their foreign exchange
risk. For example, a French importer importing goods from USA for $1.0 million needs this
amount for making payments to the exporter. It will purchase US dollar futures contract which
would lock in the price to be paid f the exporter in terms of US dollar at a future settlement date.
By holding a futures contract, the importer do not have to worry about any change in the spot
rate of the US dollar over time. On the other hand, if the French exporter exports goods to a US
firm and has to receive US dollar for the exports, the exporter would sell a 1 dollar futures
contract. This way the exporter will be locking in the price of the export to be received in terms

48

US dollar. It will protect itself from the loss that may occur in case of depreciation of the US
dollar over time

2.3.4.4.

Speculation in Currency Futures:

Speculators make use of the currency futures for reaping profits. When they expect that the spot
rate of a particular currency will move up beyond those mentioned in the currency futures
contract, they buy currency futures denominated in that particular currency.
On the other hand, if the spot rate of a particular currency is expected to depreciate below the
rate mentioned in the currency futures contract, the speculators will sell currency futures in that
currency. It may be noted here that these transactions involve cost that is to be deducted from the
gain. The transaction cost is very nominal f0r the locals, but is significant for the speculators.

2.3.5.

CURRENCY OPTIONS:

A currency option confers on its buyer the right either to buy or to sell a specified amount of
currency at a set price known as the strike price. An option that gives the right to buy is known as
a call while one that gives the right to sell is known as a put. Depending on the contract terms,
an option may be exercisable on any date during a specified period or it may be exercisable only
on the final or expiration date of the period covered by the option contract.
In return for guaranteeing the exercise of an option at its strike price, the option seller or writer,
charges a premium which the buyer usually pays upfront. Under favorable circumstances, the
buyer may choose to exercise it. Alternatively, the buyer may be allowed to sell it.

2.3.5.1.

Features of Currency Options:

The features of currency options are as follows:

1) The spot price of the underlying currency (e.g., the price of dollar per yen),
2) The strike price of the option,
3) The volatility of the underlying currency, and
4) The interest rates in both countries (e.g., in the U.S. and Japan when the option price on
yen is determined),

2.3.5.2.

Determinants of Currency Options:

Knowledge about the factors to which the value of an option is sensitive is very important for the
49

hedgers and speculators who trade in the options. These factors or sensitivities are:
1) Changes in Forward Rates: The current spot rate and at-the-money position the interest rate
differential form the basis of option pricing as well as the forward rate. This is why option
rates are close to the forward rates. In other words, forward rates are central to option pricing
and so, changes in the forward rates influence the pricing of an option.
2) Changes in Spot Rates: Changes in the spot rates influence the option prices. At an at-themoney position, the intrinsic value is zero and the entire premium is represented by the time
value. At the out-of- the-money position, the intrinsic value is zero but it cannot be negative
because in that case, the option will not be exercised. But as the spot rate moves to in-themoney position, intrinsic value will emerge and the premium will be made up partly of the
intrinsic value and partly of the time value. Again, with the spot rate moving into the in-themoney position, both the intrinsic value and the time value will change and as a result, and
so will the premium. The extent of change in the premium due to change in the spot rate is
represented by delta This means:
Delta () = Change in premium/Change in spot rate
3) Time to Maturity: The longer the time to maturity, the greater is the options value. The
impact of change in time to maturity on the option value is represented by theta. In other
words,
Theta () = Change in premium/Change in time
Theta represents an exponential, and not a linear, relationship between time to maturity and
the value of an option. The option price shrinks fast as maturity approaches. A trader buying
options for shorter maturity has to pay proportionately less. A six-month options value is
approximately 2.5 times more expensive the that of a one-month option, but a 12-month
option is only 3.5 times costlier than a one-month option.
4) Volatility in exchange rate: Volatility is expressed as the standard deviation of daily
percentage changes in the sport rate of the underlying currency. It is started as per annum
percentage. If the annual volatility is 10.0 per cent, a single day volatility can be found as:
10.0
10.0
=
=0.523
365 19.105
The large the volatility, the larger is the chance for the spot rate moving into the in-the
50

money zone and greater is the value of the option.

The impact of volatility on the options value is expressed by Vega In other words,
Vega = Change in premium/ Change in volatility
5) Sensitivity to Varying Interest Rate Differential: It is evident from the theory of option
pricing that an option value is either equal to the difference between the strike price and the
forward rate, or it may be higher. The impact of changes in domestic interest rate on the
options value is expressed by rho and the impact of change in the foreign interest rate on the
options value is expressed by phi. If foreign interest rate increases, forward rate of the
foreign currency will be at a discount and the value of the option denominated in this
currency will fall. But if the domestic interest rate rises, the value of this option will
improve.
6) Changing Strike Price: Any change in the strike price leads to a change in the intrinsic value
and thereby in the value of an option. In a call option, if the strike price falls with the spot
rate being constant, the intrinsic value will be larger and the options price will be higher.
But in a put option, the lowering of strike price with the spot price being constant will lower
the intrinsic value. The value of the option will fall.

2.3.5.3.

Hedging in Currency Options:

The hedging with currency options are as follows:

1) Hedging through Purchase of Options: In order to hedge their foreign exchange risks, if
it is a direct quote, the importers buy a call option and the exporters buy a put option, lake
first the case of an importer. For example, an Indian firm is importing goods for 62,500
and (lie amount is to be paid aller two months. If an appreciation in the pound is
expected, the importer will buy a call option on it with maturity coinciding with the date
of payment. If the strike price is 83.00/, the premium is 0.05 per pound and the spot
price at maturity is 83.20, the importer will exercise the option. He will have to pay
83.00 x 62,500 + 3,125 = 51,90,625. If the importer had not opted for an option, he
would have had to pay 62,500 x 83.20 = 52, 00,000. Buying of the call option reduces
the importers obligation by 52,00,000 51,90,625 = 9,375. If, on the other hand, the
pound falls to 82.80, the importer will not exercise the option since his obligation will
be lower even after paying the premium.
The exporter buys a put option. For example, Indian exporter exports goods for 62,500.
51

Me fears a depreciation of pound within two months when payments are to be received.
In order to avoid the risk, he will buy a put option for selling the pound for a two-month
maturity. Suppose the strike rate is ^83.00, the premium is ^0.05 and the spot rate at
maturity is 82.80. In case of the hedge, he will receive 62,500 x 83.00 - 3,125 =
51,84,375. In the absence of a hedge, he will receive only 51,75,000. This means,
buying of a put option helps increase the exporters earnings, or reduces his exposure, by
51,84,375 - 51,75,000 = ^9,375.
2) Hedging through Selling of Options: Hedging through selling of options is advised when
volatility in exchange rate is expected to be only marginal. The importer sells a put option
and the exporter sells a call option. Let take the case of importers. For example, an Indian
Importer imports for 62,500. He fears an appreciation in the pound and so it sells a put
option on the pound at a strike price of 83.00/ and at a premium of 0.15 per pound. If
the spot price at maturity goes up to 83.05, the buyer of the option will not exercise the
option. The importer as a seller of the put option will receive the premium of 9,375
which if would not have received if he had not sold the option. If the spot price at
maturity falls to 82.95, the buy of the option will exercise the option. But in that case,
the importer received premium of 9,375. The net gain to the importer will be 9,375
3,125 = 6,250.
The exporters sell the call option. If an Indian exporter exports for 62,500 and fears that
the pound w depreciate and sells a call option on the pound at a strike price of 83.00 at a
premium of 0.15 per pour If the spot rate at maturity really falls to 82.95, the buyer of
the call option will not exercise the optic The exporter being the seller of the call option
will get 9,375 as the premium.

2.3.5.4.

Speculation in Currency Options

Speculation with currency options includes the following headings:

1) Purchase of Options: Speculators make profit out of purchase of currency options. They
normally buy call options when they expect upward movement in the value of the
underlying currency. On the expiry date, they buy the currency at the agreed-upon rate
and sell it in the open market at a higher rate and thereby reap profits. On the contrary,
they buy put options when they expect depreciation of the underlying currency. They sell
the underlying currency at an agreed-upon rate that is higher than the spot rate. This way
52

they get more of the other currency than they could get in the open market. Besides these
simple operations, they often go in for complicated deals mixing either two calls or two
puts or one call and the other put.
2) Spreads: In a spread, speculators combine either two calls or two puts. In case of two
calls or puts, one is sold and the other is purchased. If the expiry of the two is the same
but the strike prices differ, it is known as a vertical spread. When the strike price is the
same but the expiry differs, it is known as a horizontal spread. When the strike price and
the expiry date both differ between the two calls, it is known as a diagonal spread.
Similar features are marked with two puts.
3) Combination of Calls and Puts: As a practice, different from spreads, the speculators
combine calls with puts and such combinations are of two types. One is known as
straddles where the two options have the same strike price and the same expiry date. The
other, called strangles is when the strike price and maturity differ in case of the two
options of the combination.

2.3.6.

CURRENCY SWAPS

Currency swaps are derivative products that help to manage exchange rate and interest rate
exposure on long-term liabilities. A currency swap involves exchange of interest payments
denominated in two different currencies for a specified term, along with exchange of principals.
The rate of interest in each leg could either be a fixed rate, or a floating rate indexed to some
reference rate, like the LIBOR.
In atypical currency swap, counterparties will perform the following:
1) Exchange equal initial principal amounts of two currencies at the spot exchange rate,
2) Exchange a stream of fixed or floating interest rate payments in their swapped currencies
for the agreed period of the swap, and then,
3) Re-exchange the principal amount at maturity at the initial spot exchange rate.
The currency swap provides a mechanism for shifting a loan from one currency to another, or
shifting the currency of an asset. It can be used, for example, to enable a company to borrow in a
currency different from the currency it needs for its operations, and to receive protection from
exchange rate changes with respect to the loan.

53

2.3.6.1.

Features of Currency Swaps

The features of currency swaps are as follows:

1) It reduces uncertainty associated with future cashflows as it enables companies to modify
their debt conditions.
2) It reduces costs and risks associated with currency exchange.
3) Currency swaps are an essential financial instrument utilized by banks, multinational
corporations and institutional investors.
4) The currency swap market is the oldest and most creative sector of the swap market.

2.3.6.2.

Steps Involved in Currency Swaps

Currency swaps involves three steps:

1) Initial Exchange of Principal Amount: In the first step, the counterparties exchange the
principal amounts of the swap at an agreed exchange rate. This rate is generally based on
the spot exchange rate however, a forward rate set in advance of the swap
commencement date may also be used. The principal amounts may be exchanged on
physical or notional, without any physical change, basis.
2) Exchange of Interest: It is the second key step for a currency swap. The counterparties
exchange interest payments on agreed dates based on outstanding principal amounts at
the fixed interest rates agreed at the beginning of transaction.
3) Re-exchange of Principal Maturity: This step involves re-exchange of the principal sum
at the maturity date by the counterparts. In order to determine the actual sums involved
generally the original spot rate is used.

2.3.6.3.

Hedging in Currency Swap

Although using swaps as vehicles for hedging and funding primary operations is a relatively
new phenomenon, foreign exchange traders have been employing the principle for years. When
a foreign exchange dealer receives an order to sell foreign exchange forward, he covers himself
by borrowing in domestic currency, purchasing foreign currency spot, and lending the foreign
currency. In this operation, he effectively swaps a liability in foreign currency for a liability in
domestic currency. The current swap market is an extension of the foreign exchange trader's
basic technique to a wide range of financial instruments.
54

2.3.6.4.

Speculation in Currency Swap

Currency or Foreign Exchange (FX) swaps have been employed to raise foreign currencies, both
for financial institutions and their customers, including exporters and importers, as well as
institutional investors who wish to hedge their positions. They are also frequently used for
speculative trading, typically by combining two offsetting positions with different original
maturities. FX swaps are most liquid at terms shorter than one year, but transactions with longer
maturities have been increasing in recent years.

2.3.7.

CURRENCY ARBITRAGE

Arbitrage is the act of simultaneously buying a currency in one market and selling it in another
to make a profit by taking advantage of price or exchange rate differences in the two markets. If
the arbitrage operations are confined to two markets only, they will be known as two-point
arbitrage. If they extend to three or more markets, they are known as three-point or multipoint arbitrage.
In other words, arbitrage refers to the purchase of a currency in that financial center where it is
cheaper for immediate resale in another center where it is relatively expensive so its to make a
profit out of this two-step deal.
International arbitrage revolves around taking advantages of price differences between goods
and securities in different countries. While this is a common practice among many types of
investors, arbitrage separates itself because the buying and selling happen nearly simultaneously.
When the broker is purchasing an item in one market, they are selling that same item in a
different market. International arbitrage is widely seen as a little to no-risk investment, as the
initial purchase doesnt take place unless the profit is available right then.
Types of Currency Arbitrage
The types of currency arbitrage are as follows:

55

Types of Currency Arbitrage

Interest Rate Arbitrage

Spatial Arbitrage (With and Without Cost of Transaction)

Covered Interest Rate Arbitrage

Uncovered Interest Rate Arbitrage

2.3.7.1.
Spatial Arbitrage (Without Cost of
Transaction)
When discrepancy between the price quotations of a currency at two disjoint markets exists,
the arbitrage possibilities exist. The rule to earn profit is buy cheap and sell dear, i.e., buy
from markets where the currency is selling cheap and sell the currency where it has a higher
price. The two transactions are simultaneously conducted. Since the quotes are either direct
or indirect therefore the discrepancy can be judged by inverse or cross product of exchange
rates.

2.3.7.2.
Spatial Arbitrage (With Cost of
Transaction)
Spatial Arbitrage (With Cost of Transaction) are categorized into two types:
1) Locational arbitrage, and
2) Triangular arbitrage

2.3.7.2.1.

Locational Arbitrage

Commercial banks providing foreign exchange services will normally quote about the
same rates on currencies therefore shopping around for better quotes may not result in an
advantage. If demand and supply conditions for different banks for a particular currency
differ, in that case the banks may quote different prices for the same currency and market
forces will force realignment of the prices so that the price offered by banks for the *
currency become equal.
Suppose the two banks are offering the following price for $:
Bank ABC

Bank XYZ
56

Bid
/35.60/$

Ask
35.65/S

Bid
35.67/$

Ask
35.70/$

It is clear from the above quotes that one can buy $ from bank ABC and sell this to bank XYZ.
Thus as a matter of rule: If ask price of one quote is less than the bid price of another quote then
the spatial arbitrage is possible.

2.3.7.2.2.

Triangular Arbitrage

Occasionally, prices of one currency can vary from one market to another. A currency may be
cheaper in New York than it is in London. If such a situation arises, it provides an opportunity
for market participants to buy the currency in New York and sell it in London. This activity is
known as triangular arbitrage, or inter-market arbitrage. Whether such arbitrage is possible is
indicated by comparing a currencys actual price in one market and its price in another market,
using cross-rate quotations. There are several steps an arbitrageur must take to profit from such
an opportunity. For example, assume that the following exchange rates are quoted in the
interbank market:
New York: /US$ = 1.8300
/US$ = 1.2700
Paris: / = 1.42
The euro and the pound sterling are quoted against the U.S. dollar in New York and against each
other in Paris, but one can also compute the exchange rate of the euro against the pound in the
New York market through the mechanism of cross rates:

57

Step 3: Sells euros for U.S. dollars in New York

Step1: Buys British pounds in New York

Triangular Arbitrage
Step 2: Sells British pounds for euros in Paris

58

It is evident that the two rates for pounds in terms of euros in New York and Paris are not the
same. It would be profitable, therefore, to buy pounds in New York and sell them in Paris. Thus,
a U.S. arbitrageur c 183,000 in the New York market for U.S.$100,000 and then sell these in
Paris for 128,873. The euros can then are sold in the New York market and bring U.S.$
101,474.99. The arbitrageur can make a clean p U.S.$1,474.99 without incurring any risk.
Example 5: Assume the following information:
QuotedPrice
Value of Canadian dollar in U.S. dollars

$.90

Value of New Zealand dollar in U.S. dollars

$.30

Value of Canadian dollar in New Zealand dollars

NZ$3.02

Given this information, is triangular arbitrage possible If so, explain the steps that would
reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to
use. What market forces would occur to eliminate any further possibilities of triangular arbitrage

Solution: Yes. The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand
dollars.
Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than what
it should be.
One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for New Zealand
dollars and then exchange New Zealand dollars for U.S. dollars. With $1,000,000, this strategy
would generate $1,006,667 thereby representing a profit of $6,667.
[$l,000,000/$.90 = C$1,111,111 x 3.02 = NZ$3,355,556 x $.30 = $1,006,667]
The value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the
Canadian dollar with respect to the New Zealand dollar would decline. The value of the New
Zealand dollar with respect to the U.S. dollar would fall.
Example 6: Bank is willing to buy or sell British pounds for $1.98. The bank is willing to buy or
sell Mexican pesos at an exchange rate of 10 pesos per dollar. The bank is willing to purchase

59

British pounds at an exchange rate of 1 peso = .05 British pounds. Show how you can make a
profit from triangular arbitrage and what your profit would be if you had $100,000.
Solution: 1 pound = 20 pesos
$1,00,000/1.98 = 50,505 pounds
50,505 pounds x 20= 1,010,100 pesos = $1,01,010'
Profit is $1,010

2.3.7.3.

Interest Rate Arbitrage

Interest arbitrage refers to the international flow of short-term liquid capital to earn a higher
return abroad. It means migration of short term capital across international financial centers in
search of better safety and returns. As in the case of exchange rate arbitrage, interest arbitrage
also has the effect of reducing and wiping out interest differential. This is because the movement
of funds from a low-interest to a higher interest centre means that the supply of funds in the
higher interest centre increases and leads to a decline in interest rate, while just the opposite
happens in the centre where interest rate is low. This can also be seen in another way. The funds
flowing into the high-interest centre are invested in various financial instruments like treasury
bills, short term bonds, and deposits, etc. This increases their price which is the same thing as a
decline of interest earned on them. Correspondingly, the supply of funds declines in the centre
from where they are moving out. This reduces the demand for financial instruments in which
they were invested causing a decline in their prices (which means higher rates of earnings from
them). This process continues till the interest rate differential is wiped out.
Types of Interest Rate Arbitrage
Interest arbitrage has two variants:
1) Uncovered Interest Rate Arbitrage: The transfer of funds abroad to take advantage of
higher interest rates in foreign monetary centers usually involves the conversion of the
domestic currency to the foreign currency, to make the investment. At the time of
maturity, the funds (plus the interest) are reconverted from the foreign currency to the
domestic currency. During the period of investment, a foreign exchange risk is involved
due to the possible depreciation of the foreign currency. I& such a foreign exchange risk
is covered, we have covered interest arbitrage; otherwise we have uncovered interest
60

arbitrage.
2) Covered Interest Rate Arbitrage: Interest arbitrage is usually covered as investors of
short term funds abroad generally want to avoid the foreign exchange risk. To do this, the
investor exchanges the domestic currency for the foreign currency at the current spot rate
so as to purchase the foreign treasury bills and at the same time he sells forward the
amount of the foreign currency he is investing plus the interest he will earn so as to
coincide with the maturity of his foreign investment. Thus, covered interest arbitrage
refers to the spot purchase of the foreign currency to make the investment and offsetting
the simultaneous forward sale (swap of the foreign currency) to cover the foreign
exchange risk.
Example 7: The one-year U.S. interest rate is 4%, while the one-year interest rate in Argentina is
17%. The spot rate of the Argentine peso (AP) is $.44. The one-year forward rate of the AP
exhibits a 14% discount. Determine the yield (percentage retrun on investment) to an investor
from Argentina who engages in covered interest arbitrage.
Solution:
Forward rate of Argentine peso $.44 x (1 .14) = $.3784.
Assume Argentine investors invest API,00,000. [You can start with any assumed amount.]
AP

1,00,000

euros

$.44

$44,000

Invest in U.S.: $44,000 x (] .04) =$45,760

Convert back to AP: $45,760/.3784 = AP
1,20,930.
Yield = (AP 1,20,930 - AP 1,00,000)/AP 1,00,000 = 20.930%.

2.4.
2.4.1.

FOREIGN EXCHANGE MANAGEMENT

ACT(FEMA), 1999
INTRODUCTION

The foreign exchange Management Act (FEMA), 1999, replaced the Foreign Exchange
Regulation Act (FERA), 1973, which regulated the foreign exchange transactions in India and
which sought to control certain aspects of the conduct of business outside the country by Indian
companies and in India by foreign companies.
The FEMA, which came in to effect from January, 1, 2000, extends to the whole of India and
also applies to all branches, offices, and agencies outside India, owned or controlled by a person
61

resident in India.

2.4.2.

OBJECTIVES OF FEMA

The objectives of FEMA are as follows:

1) To facilitate external trade and payments.
2) To promote the orderly development and maintenance of foreign exchange market.

2.4.3.

FEATURES OF FEMA

Following are the salient features of FEMA:

1) The FEMA empowers the Central Government to impose restrictions on dealings in
foreign exchange and foreign security and payments to and receipts from any person
outside India.
2) The Act imposes restrictions on persons residing in India on acquiring, holding or owning
foreign exchange, foreign security and immovable property abroad and on transfer of
foreign exchange or security abroad.
3) The FEMA lays-down that all dealings in foreign exchange or foreign security and all
payments from outside the country to India shall be made only through authorised
persons, except with the general or special permission of the Reserve Bank. The Act also
prohibits any payment outside India except with the general or special permission of the
Reserve Bank.
4) The FEMA permits dealings in foreign exchange through authorised persons for current
account transactions. However, the Central Government can impose reasonable
restrictions in public interest.
5) Any person may sell or draw foreign exchange to or from an authorised person for u
capital account transaction permitted by the Reserve Bank. However, the Act empowers
the RBI to impose a number of restrictions on capital account transactions.
6) The FEMA permits a person residing in India to hold, own, transfer or invest in foreign
currency, foreign security or any immovable property situated outside India if such
currency, security or properly was acquired, held or owned by such person when an
individual was resident outside India or inherited from a person who was resident outside
India. Also, a person resident outside India may hold, own, transfer or invest in Indian
currency, security or any immovable property situated in India if such currency, security
62

or property was acquired, held or owned by such person when he was resident in India or
inherited from a person who was resident in India.
7) The Reserve Bank is empowered by this Act to prohibit, restrict, or regulate
establishment in India of a branch, office or other place of business by a person residing
outside India, for carrying-on any activity relating to such branch, office or other place of
business. However, the RBI shall not impose any restriction on the drawal of foreign
exchange for payments due on account of amortisation of loans or for depreciation of
direct investments in the ordinary course of business.
8) The Act requires the exporters to furnish to the Reserve Bank or to such other authority
certain details regarding the exports.
9) For the purpose of ensuring that export value of the goods is received without any delay,
the Reserve Bank may direct any exporter to comply with such requirements as it deems
fit.
10) Where any amount of foreign exchange is due or has accrued to any person, a person
shall take all reasonable steps to realise and repatriate it to India with in the time and in
the manner prescribed by the RBI. Several exemptions are, however, granted to this
clause.

2.4.4.

SCOPE OF FEMA

FEMA provides:
1) Free transactions on current account subject to reasonable restrictions that may be
imposed.
2) RBI controls over capital account transactions.
3) Control over realization of export proceeds.
4) Dealing in foreign exchange through authorized persons like authorized dealer/money
changer/off shore banking unit.
5) Adjudication of Offences.
6) Appeal provision including Special Director (Appeals) and Appellate Tribunal.
7) Directorate of Enforcement.

2.4.5.

PROVISIONS OF FEMA

The provisions of FEMA are as follows:

63

1) Dealing in Foreign Exchange [Section 3]: Section 3 of FEMA imposes restrictions on

dealings in foreign exchange and foreign security and payment td and receipts from any
person outside India. Accordingly, except as provided in terms of the ACT, or with the
general or special permission of the Reserve Bank, no person shall:
i).

Deal in any foreign exchange or foreign security with any person other than an
authorized person;

ii).

Make any payment to or for the credit of any person resident outside India in any
manner;

iii).

Receive otherwise through an authorized person, any payment by order or on

behalf of any person resident outside India in any manner;

iv).

Enter in to any financial transaction in India as a consideration for or in

association with acquisition or transfer of a right to acquire, any asset outside
India by any person.
Further , save as otherwise provided in this Act, no person resident in India shall
acquire, hold, own, possess or transfer any foreign exchange, foreign security or any
immovable property situated outside India.

2) Holding of Foreign Exchange [Section 4]: No person, resident in India, shall acquire,
hold, own, possess or transfer any foreign exchange, foreign security or any immovable
property situated outside India, without permission from the reserve bank.
3) Current Account Transactions [Section 5]: Any person may sell or draw foreign exchange
to or from an authorized person if such sale or drawl is a current account transaction.
4) Capital Account Transaction [Section 6]: Any person may sell or draw foreign exchange
to or from an authorized person for a capital account transaction. The Reserve Bank may,
in consultation with the Central Government, specify any class or classes of capital
account transactions which are permissible and limit upto which foreign exchange shall
be admissible for such transaction.
5) Export of Goods and Services [Section 7]: Every exporter of goods or services shall
furnish to the reserve bank details regarding the export value of such goods or services.
6) Realization and Repatriation of Foreign Exchange [Section 8]: Where any amount of
foreign exchange is due or accrued to any person resident in India, such a person shall
64

take steps to realize and repatriate to India, such foreign exchange within a specified
period of time.

2.5.1.

2.5.
BALANCE OF PAYMENTS:INTRODUCTION

Balance of payment is a broader term and it includes balance of trade. It is more comprehensive
than the balance of trade. Balance of trade refers to the merchandise account of exports and
imports only.
Balance of payment refers to the net results that are drawn recording all the visible and
invisible items that are imported and exported from the country. Balance of payment, such as,
provides a comprehensive statement over the net results of foreign trade and gives a true picture
as to where the country stands in the international trade. Balance of payment clearly exposes
the economic viability, strength, and capability by correctly measuring its imports and exports,
competency in goods and services as well as technical knowhow. By services we mean the
services of shipping lines, insurance companies banking concerns, and others. Balance of
payment also includes the foreign loan that is either provided by it or accepted from other
country or countries.
According to Kindleberger, Balance of payment 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.
In other words, the balance of payments is a comprehensive record of economic transactions of
the residents of a country with the rest of the world during a given period of time. The aim is to
present an account of all receipts and payments on account of goods exported services rendered
and capital by resident of a country and goods imported, services received and capital
transferred by residents of the country.
The balance of payments is an accounting statement that summarises all the economic
transactions between residents of the home country and residents of all other countries. It is a
measure of all transactions between domestic country and international countries.

2.5.2.

COMPONENTS OF BOP

The accounting contents or components of balance of payments are:

65

Components of BOP

Capital Account
Current Account
Other Items in the Balance of Payments

Official Reserve Account

1) Current Account: Current account is typically, divided into three sub-categories; the
merchandise trat balance, the services balance and the balance on unilateral transfer^ Entries
in this account are current value as they do not give rise to future claims. A surplus in the
current account represents an inflow funds while a deficit represents an outflow of funds.
The capital account can be divided into three categories:
i).

Merchandise: Balance of merchandise trade refers to the balance between

exports and imports of tangible goods such as automobiles, computers, machinery
and so on. A favourable balance of merchandise trade (surplus) occurs when
exports are greater in value than imports. An unfavourable balance of
merchandise trade (deficit) occurs when imports exceed exports. Merchandise
exports and imports are the largest single component of total international
payments for most countries.

ii).

Invisibles: Services represent the second category of the current account.

Services include interest payments, shipping and insurance fees, tourism,
dividends and military expenditures. These trades in services are sometimes called
invisible trade.

iii).

Unilateral Transfers: Unilateral transfers are gifts and grants by both private
parties and governments. Private gifts and grants include personal gifts of all
kinds and also relief organization shipments. For example, money sent by
immigration workers to their families in their native country represents private
transfer. Government transfers include money, goods and services sent as aid to
other countries.

2) Capital Account: The capital account is an accounting measure of the total domestic
currency value of financial transactions between domestic residents and the rest of the world
over a period of time. This account consists of loans, investments, and other transfers of
66

financial assets and the creation of liabilities. It includes financial transactions associated
with international trade as well as flows associated with portfolio shifts involving the
purchase of foreign stocks, bonds and bank deposits.
The capital account can be divided into three categories: direct investment, portfolio
investment and other capital flows.
i).

Direct Investment: Direct investment occurs when the investor acquires equity
such as purchases of stocks, the acquisition of entire firms, or the establishment of
new subsidiaries. Foreign direct investment (FDI) generally takes place when
firms tend to take advantage of various market imperfections. Firms also
undertake foreign direct investments when the expected returns from foreign
investment exceed the cost of capital, allowing for foreign exchange and political
risks. The expected returns from foreign profits can be higher than those from
domestic projects due to lower material and labour costs, subsidised financing,
investment tax allowances, exclusive access to local markets, etc.

ii).

Portfolio Investment: Portfolio investments represent sales and purchases of

foreign financial assets such as stocks and bonds that do not involve a transfer of
management control. A desire for return, safety and liquidity in investments is the
same for international and domestic portfolio investors. International portfolio
investments have specifically boomed in recent years due to investors desire to
diversify risk globally. Investors generally feel that they can reduce risk more
effectively if they diversify their portfolio holdings internationally rather than
purely domestically. In addition, investor.' may also benefit from higher expected
returns from some foreign markets.

iii).

Capital Flows: Capital flows represent the third category of capital account and
represent claims with maturity of less than one year. Such claims include bank
deposits, short-term loans, short-term securities, money market investments and
so forth. These investments are quite sensitive to changes in relative interest rates
between countries and the anticipated change in the exchange rate. F< example, if
the interest rates rise in India, with other variables remaining constant, India w
experience capital inflows as investors would like to deposit or invest in India to
67

take advantage of t higher interest rate. But if the higher interest rate is
accompanied by an expected depreciation of 1 Indian rupee, capital inflows to
India may not materialise.
3) Official reserve account: Official reserves are government owned assets. The official
reserve account represents only purchases and sales by the central bank of the country (for
example, the reserve bank of India). The changes in official reserves are necessary to
account for the deficit or surplus in the balance of payments. For example, if a country has a
BOP deficit, the central bank will have to either run down its official reserve assets such as
gold, foreign exchange and SDRs or borrow fresh from foreign central banks. However, if a
country has a BOP surplus, its central bank will either acquire additional reserve assets from
foreigners or retire some of its foreign debts.
4) Other Items in^ the Balance of Payments: The remaining items that cannot be categorised
into the preceding categories constitute the other items in the balance of payments. They are
included since the full balance of payments account must balance. These items are as
follows:
i).

Errors and Omissions: These are to take into account the difficulty of accurately
recording all the wide variety of transactions that take place in the accounting
period. They may arise due to the present of sampling of transactions rather than
recording each individual transaction (e.g., instead of recording each of a
thousand exports of lemons, they may multiply an average lemon export figure by
thousand) due to dishonesty, i.e., businessmen underreporting sales abroad to
avoid taxes, or when smuggling occurs, etc.

ii).

Official Reserve Transactions: All transactions except those in this category

may be termed as autonomous transactions. They are so called because they are
entered into with some independent motive, i.e., not with a view to bring their
consequences on the balance of payments or on the exchange rate. In contrast to
this, official reserve transactions are carried-out by the government and the central
banks in pursuit of some international economic policy objective; while keeping
an eye on the effect of such transactions on the BOP and the exchange rate. As a
result such transactions are not autonomous. The first of these items is the change
in the domestic countrys official reserve assets. These reserves of a country are
68

held in the form of foreign currency or foreign currency securities, gold and
Special Drawing Rights (SDR) with the IMF. SDR allows a country to avail of
foreign exchange in proportion to the quantum of the countrys deposit of its
currency with the IMF under the SDR scheme. The changes in the countrys
reserves must reflect the net value of all other items in the BOP. Reduction in
these assets will be used to finance expenditures abroad. Reductions appear as a
credit item in the BOP (because their sale causes foreign exchange inflow into the
country). An increase in these reserves will appear as a debit because of
purchasing assets.

2.5.3.

STRUCTURE OF BOP ACCOUNTING

The balance of payment statement records all types of international transactions that a
country consummates over a certain period of time. The BOP statement is usually divided
into three major groups of accounts. It is shown in table 2.3:
Table 2.3
Credit
A). Current Account
1. Merchandise
i). Exports (on f.o.b. basis)
ii). Imports (on c.i.f. basis)
2. Invisibles (i + ii + iii)
i). Services
a) Travel
b) Transportation
c) Insurance
d) Miscellaneous
ii). Transfers
a) Official
b) Private
iii). Investment Income
Total Current Account (1+2)
B). Capital Account
1) Foreign Investment (i + ii)
i). In India
a) Direct
b) Portfolio
ii). Abroad

69

Debit

Net

2) Loans (i + ii+ iii)

i). External Assistance
a) By India
b) To India
ii). Commercial Borrowings (MT and LT)
a) By India
b) To India
iii). Short-term To India
3) Banking Capital (i + ii)
i). Commercial Banks
a) Assets
b) Liabilities
c) Non-Resident Deposits
4) Others
5) Rupee Debt Service
6) Other Capital
Total Capital Account (1 + 2 + 3+ 4 +5)
C). Errors and Omissions
D). Overall Balance (A + B + C)
E). Monetary Movements (i + ii)
1) I.M.F.
2) Foreign Exchange Reserves (Increase
-/Decrease +)

Since the balance of payments statement is drawn up in terms of debits and credits based on a
system of double entry book-keeping, if all entries are made correctly, the total debits must equal
total credits.
This is because two aspects (debits and credits) of each transaction recorded are equal in amount
and appear on the opposite sides of the balance of payments account. In the accounting sense,
balance of payments of a country must always balance.
In other words, debit or payment side of the balance of payments accounts of a country
represents the total of all the uses made out of the total foreign exchange acquired by a country
during the given period, while the credit or the receipt side represents the sources from which
this foreign exchange was acquired by this country in the same period. The sides as such
necessarily balance.

70

2.5.4.

FACTORS AFFECTING BOP

Following factors affect the balance of payments of the country:

Factors Affecting BOP
Cost of Production

Demand and Supply

Cost of Availability

Exchange Rate Movements

Domestic Business

Trade Agreement

External Pressures

Price

1) Cost of Production: The cost of production (land, labour, capital, taxes, incentives,
etc.) in the exporting economy vis-a-vis those in the importing economy
2) Demand and Supply: The demand and supply trend defines the cost of domestic
products to be sold in the international market.
3) Cost and Availability: The cost and availability of raw materials, intermediate goods
and other inputs.
4) Exchange Rate Movements: For nations with low exchange rate values, balance of
trade tends to remaind unfavourable.
5) Domestic Business: Sound, domestic policies are required to boost production and
international trade some countries like the U.S. provide subsidies to local
manufacturers for exported goods and services.
6) Trade Agreements: Bilateral agreements govern international trade and define the
products and their prices in the global context.
7) External Pressures: Many countries export items that face heavy competition in
international market. This results in market segmentation and low pricing. Countries
that are mostly oil exporters or IT hubs tend to generate favourable trade balance due
to less competition in the international market. External pressures also work in the
form of trade bans. These bans are enforced by either individual countries or
international organisations such as the WTO or IMF.
71

8) Price: Prices of goods manufactured at home (influenced by the responsiveness of

supply).

2.5.5.

IMPORTANCE OF BOP

BOP data may be important for any of the following reasons:

1) Forecasting: The BOP helps forecast a countrys market potential, especially in the short
run. A country experiencing a serious BOP deficit is not likely to import as much as it
would if it were running a surplus.
2) Indicator of Pressure: The BOP is an important indicator of pressure on a countrys
foreign exchange rate, and thus on the potential of a firm trading with or investing in that
country to experience foreign exchange gains or losses. Changes in the BOP may presage
the impositions (or removal) of foreign exchange controls.
3) Signal of Imposition: Changes in a countrys BOP may also signal the imposition (or
removal) of controls over payment of dividends and interest, license fees, royalty fees, or
other cash disbursements to foreign firms or investors.
4) Judging the Stability: Judging the stability of a floating exchange rate system is easier
with BOP as the record of exchanges that take place between nations help to track the
accumulation of currencies, in the hands of those individuals more willing to hold on to
them and judging the stability of a fixed exchange rate system is also easier with the same
record of international exchange. These exchanges again show the extent to which a
currency is accumulating in foreign hands, raising questions about the ease of defending
the fixed exchange rate in a future crisis.

2.5.6.

BOP TRENDS IN INDIA

India presently has a deficit in its current account of BOP, which has increased substantially after
reforms in 1991. In 1991-92, current account deficit was $1,178 million, which rose to $17,403
million in 2007-08, and accounted for $36,469 million for the last three quarters of 2008. After
the reforms in 1991, Indias position of merchandise trade (exports and imports of goods) kept on
deteriorating, but its position on invisibles (services, current transfers, etc.) improved during the
period. However, one of the major factors for increasing current account deficit in the last few
years has been a rising oil import bill. Some countries like Japan and Germany have current
72

account surpluses, while the U.S.A. and U.K. have deficits.

Indias Balance of Payments - Current Account Deficit Shrinks to 0.2% of GDP iu 2013-14Q4
1) Current Account Deficit Dips to 20-Quarter Low in Q4 of 2013-14: A sharp moderation
in merchandise trade deficit, especially a decline in import of gold and a moderate
increase in services helped to bring the current account deficit to SI.2 billion in the fourth
quarter of FY2013-14 from $18.1 billion in the corresponding quart in the previous year.
For the financial year 2013-14, CAD stood at $32.4 billion over 60% lower than the
$87 billion of CAD observed at the end of FY2012-13. The ratio of current account
deficit to GDP dropped meager 0.2% in the final quarter against 0.9% a quarter before
and 3.6% a year before.
2) Overall Balance of Payments (BOP) Improved Significantly Y-O-Y: The BOP sharply
jumped to $' billion in the fourth quarter of 2013-14 from $2.7 billion in the
corresponding quarter previous y primarily on account of drastic decline in the CAD.
However, on a quarter-on-quarter basis, it massively shrunk from $19.1 billion in the Q3
of FY2013-14 due to decrease in financial account. For entire financial year, BOP stood
at $15.5 billion 300% up from the previous years tally of $3.8 billion.
3) Merchandise Trade Deficit: Declined further to $30.7 billion from $50.5 billion during
the Q1 of FY2013-14 and from $45.6 billion from year ago. Various measures taken by
the RBI to curb import of gold has been the primary reason behind the sharp fall in the
overall imports. For the entire financial 3 merchandise trade deficit declined sharply from
$195.7 billion (FY2012-13) to $147.6 billion (FY2013-14).
4) Services Increased Moderately: Net services posted a moderate growth of about 8% on QO-Q basis and a healthy growth of about 15.6% on Y-o-Y basis to reach $19.6 billion in
Q4 of 2013-14.
5) Capital Account Turns into Deficit Mode in Q4 of 2013-14: After improving marginally
to $0.1 billion in the third quarter of FY2013-14, the capital account turned into deficit at
$0.2 in the final quarter due to net outflows under the capital transfers section.

73

6) Financial Account Surplus Depicted in Q4 of 2013-14: Net financial account comprising

portfolio, direct and other investments registered a dramatic fall of about 88% Y-o-Y basis
to reach about $2.2 billion in the fourth quarter of 2013-14 due to a significant decline in
direct investment, portfolio investment and heavy outflows under other investment
category.
The Indias Balance-of-Payments (BOP) position improved dramatically in 2013-14, particularly
in the last three quarters. This owed in large part to measures taken by the government and the
Reserve Bank of India (RBI) and in some part to the overall macroeconomic slowdown that fed
into the external sector. Current Account Deficit (CAD) declined sharply from a record high of
US$ 88.2 billion (4.7 per cent of gross domestic i product [GDP]) in 2012-13 to US$ 32.4 billion
(1.7 per cent of GDP) in 2013-14. After staying at perilously unsustainable levels of well over
4.0 per cent of GDP in 2011-12 and 2012-13, the improvement in BOP I position is a welcome
relief, and there is need to sustain the position going forward. This is because even as I CAD
came down, net capital flows moderated sharply from US$92.0 billion in 2012-13 to US$ 47.9
billion in 2013-14, that too after a special swap window of the RBI under the Non-Resident
Indian (NR1) scheme/overseas borrowings of banks alone yielded US$34.0 billion. This led to
some increase in the level of external debt, but it has remained at manageable levels. The large
depreciation of the rupee during the course of the year, notwithstanding sizeable accretion to
reserves in 2013-14, could partly be attributed to frictional forces I and partly to the role of
expectations in the forex market. The rupee has stabilized recently, reflecting an overall sense of
confidence in the forex market as in other financial markets of a change for better economic
prospects.
There is a need to nurture and build upon this optimism through creation of an enabling
environment for l investment inflows so as to sustain the external position in an as yet uncertain
global milieu.
Trends in Balance of Payments (USD Billion)
SI. No. Item
1)
Current Account: i) Exports
ii) Imports
74

2009-10 2010-11

2011-12

2012-13 2013-14

182442
300644

309774
499533

306581
502237

256159
383481

318607
466216

iii) Trade balance

iv) Invisibles (Net)
a) Services
b) Transfer
c) Income
Current account balance

-118202
80022
36016
52045
-8038
-38180

-127322
79269
44081
53140
-17952
-48053

- 189759
111604
64098
63494
-15988
-78155

-195656
107493
64915
64034
-21455
-88163

-147609
115212
72965
65276
-23028
-32397

4941
12160
12034
4962
3238
42127
11834
30293
-12484
63740
61104
-2636
13050
-13050

2296
10344
6668
16226
11918
39231
22061
17170
-7008
67755
65323
-2432
-12831
12831

982
8485
21657
16570
14842
46711
19819
26891
. -5105
89300
91989
2689
3826
-3826

1032
11777
-5044
25449
38892
26386
21564
4822
-10813
48787
47905
-882
15508
-15508

2)
Capital Account: i) External assistance
2890
ii) External commercial borrowings
2000
iii) Short-term debt
7558
iv) Banking capital of which
2083
Non-resident deposits
2922
v) Foreign investment
50362
a) FDI
17966
b) Portfolio investment
32396
vi) Other flows
-13259
Capital Account Balance
51634
Capital Account (including errors & 51622
Errors
& Omissions
-12
omissions)
Overall Balance
13441
Reserves Change
-13441
(-indicates increase, + indicates decrease!

2.5.7.

CURRENT ACCOUNT DEFICIT

A current account deficit is when a countrys government, businesses and individuals imports
more goods services ] and capital than it exports. That is because the current account measures
trade, as well as international income direct transfers of capital, and investment income made
on assets. When those within the country rely on foreigners for the capital to invest and spend,
that creates a current account deficit. Depending on why the country is running the deficit, it
could be a positive sign of growth, or it could be a negative sign that the country is a credit
risk.

2.5.7.1.
Deficit

Components of a Current Account

The components of a current account deficit are as follows:

1) Trade Deficit: The largest component of a deficit usually a trade deficit. This simply
means the country imports more goods and services than it exports.

75

2) Net Income: The second largest component is usually a deficit in the net income. This
occurs when the country exports dividends on stocks, interest payments made on
financial assets, and wages paid to foreigners working in the country. If all payments
made to foreigners are greater than the interest, dividends and wages made by
foreigners to the countrys residents, the deficit will rise.
3) Direct Transfers: The last component of the deficit is the smallest. These are direct
transfers, which includes government grants to foreigners. It also includes any money
sent back to their home countries by foreigners.

2.5.7.2.
Implications of Current Account
Deficit on Exchange Rate
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for its products. The
excess demand for foreign currency lowers the countrys exchange rate until domestic goods and
services are cheap enough for foreigners, and foreign assets are too expensive to generate sales
for domestic interests.

2.5.7.3.
Deficit

Disequilibrium in Current Account

Disequilibrium in current account deficit are as follows:

1) A large current account deficit may be an indication that the economy is too much
geared towards spending (e.g. spending on imports) and too little on exports.
2) A current account deficit may also be a sign of underlying inflationary pressures. As
domestic goods increase in price, people buy imports instead.
3) It may also be an indication the country is losing competitiveness. This is especially
important in a fixed exchange rate.
4) It is also a reflection, saving is less than investment and investment is being financed by
capital inflows.
76

2.5.7.4.
Deficit

Measures of Current Account

Main methods to measure current account deficit are as follows:

1) Currency Depreciation: Balance of trade is basically records the net exports of a
nation (exports-imports). A worsening or a deficit of the balance of trade means that the
value of imports exceeds those of exports. A worsening of the terms of trade, the index
of the price of a countrys in terms of its imports, could be caused by expenditurereducing measures such as deflationary monetary or fiscal policy. Prices would drop
and would be relatively more expensive. Assuming the elasticity of and do not play a
big role in these phenomena. However, it may be unnecessarily costly in terms of lost
domestic employment and output.
Basically when a countrys terms of trade worsens, become more expensive relative to
the price of exports. Assuming the quantity of and were the same, there would be a
balance of trade deficit when are more expensive than exports. However, that may not
necessarily be the case. The outcome of the balance of trade will largely depend on the
Price Elasticity of Demand (PED) of both, and exports. (PED is defined as the change
in quantity demanded of a good to a change in its price.)
2) J-Curve Theory: J-curve effect states that a decline in currency value will initially
worsen the deficit before improvement. The J-curve is a graphic of a frequency
distribution that visualizes change process, growth, or achievement.

Net change in trade balance

Trade balance impro

Currency depreciation

Tim

Trade balance initially deteriorates

This is an expression utilized in various fields that refers different types of unrelated
77

diagrams drawn in J shaped where the curve falls at the initial stage but goes high
compared to the initial point. When one talk about the different currencies and the trade
balance of a country, J-curve theory declares that a trade deficit of the country will
deteriorate at the initial stage where the depreciation of the currency as high costs on
overseas imports will be much more compared to the reduced cost of imports.
3) U.S. Deficit and the Demand for U.S Assets: The U.S. merchandise trade deficit is a
part of the overall U.S. balance of payments. It is observed-that grown concerned over
the magnitude of the U.S. merchandise trade deficit and the associated increase in U.S
dollar-denominated assets owned by foreigners. The recent slowdown in global
economic activity has reduced global trade flows and, consequently, reduced the size of
the U.S. trade deficit. The inflow of capital from abroad supplements domestic sources
of capital and likely allows the United States to maintain its current level of economic
activity at interest rates that are below the level they likely would be without the capital
inflows. Foreign official and private acquisitions of dollar-denominated assets likely
will generate a stream of returns to overseas investors that would have stayed in the
U.S. economy and supplemented other domestic sources of capital had the assets not
been acquired by foreign investors.
The most practical indicator of sustainability revolves around the demand for U.S.
assets. Issues such as the investment income riddle, the net international investment
position enigma, and the dark matter debate are reflective of data that are either
seriously flawed, or atleast questionable, in one way or another, rendering unhelpful the
use of the standard sustainability measures. The more reliable test is foreigners
willingness to go on holding U.S. dollar claims. The issues relevant to the U.S. external
deficit and its sustainability from this particular perspective are:
i).

The implications of a continued reduction in home bias.

ii).

The substantial build-up of international reserves and official holdings of dollars

by foreign government agencies.

iii).

The financial innovations that have linked capital inflows into the United States
with household sector financing and the housing market.

iv).

This last issue is to what extent the Euro may offer competition to the U.S.
78

dollar as an international currency and repository for international reserve

holdings.
4) Protectionism: Protectionism is the generic term used to describe a number of
mercantilist policies designed to keep foreign goods out of a country and to support the
export of domestically produced goods to other countries. These policies include:
i).

Quotas: Two types of quotas are common:

a)

Import Quotas: This unilaterally specifies the quantity of a

particular product that can be imported from abroad.

b)

Export Quotas: This result from negotiated agreements between

producers and consumers and restrict the flow of products, (e.g., shoes
or sugar) from the former to the latter.
An Orderly Market Arrangement (OMA) is a formal agreement in which a
country agrees to limit the export of products that might impair workers in the
importing country, often under specific rules designed to monitor and manage
tradeflows. Exporting countries are willing to accept such restrictions in
exchange for concessions on other fronts from the importing countries. The
Multi-Fiber Arrangement (MFA) is an example of an elaborate OMA that
restricts exports of textiles and apparel.
ii).

Tariffs: Instead of using quotas, governments can limit imports by placing a tax
on foreign goods. The tax may be a fixed amount imposed on each unit of an
item being imported, or it may be based on some percentage of the value of
each unit. Under what is known as strategic trade policy, governments
sometimes provide subsidies to a particular industry in order to make its goods
more competitive abroad. Two protectionist responses to this practice are
countervailing duties, the imposition of tariffs to offset alleged subsidies by
foreign producers, and antidumping duties imposed to counter the alleged sale
of products at below the cost of production.

2.6.
CURRENCY CONVERTIBILITY
2.6.1. MEANING OF CURRENCY CONVERTIBILITY
Currency convertibility refers to the freedom to convert the domestic currency into other
79

internationally accepted currencies and vice versa. The Report on Fuller Capital Account
Convertibility (FCAC) defines convertibility as, The freedom to convert local financial assets
into foreign financial assets and vice versa. 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. CAC can be, and is, co-existent with restrictions other
than on external payments.
Convertible currencies are defined as currencies that are readily bought, sold, and converted
without the need for permission from a Central Bank or government entity. Most major
currencies are fully convertible; i.e., they can be traded freely without restriction and with no
permission required. The easy convertibility of currency is a relatively recent development and is
in part attributable to the growth of the international trading markets and the Forex markets in
particular. Historically, movement away from the gold exchange standard once in common usage
has led to more and more convertible currencies becoming available on the market. Because the
value of currencies is established in comparison to each other, rather than measured against a real
commodity like gold or silver, the ready trade of currencies can offer investors and opportunity
for profit.

2.6.2. PRE-CONDITIONS FOR CURRENCY

CONVERTIBILITY
For introducing convertibility and for making it effective, the following preconditions need to be
met:
1) The ER must be realistic.
2) The country should enjoy low inflation rate and internal financial stability.
3) Foreign exchange reserves should be large in practice.
4) Te trading partners should open-up their trade and payments systems.
5) Debt levels, particularly external debt level, should be low.
6) Fiscal and monetary austerity, produce, consolidation, and drastic reduction in fiscal
deficit should be achieved.
7) Labour market reforms, including unemployment assurance, job retraining, job
retraining, and wage discipline should be achieved.
80

2.6.3.

CONVERTIBILITY OF INDIAN RUPEE

Rupee convertibility means the system where any amount of Rupee can be converted into any
other currency without any question asked about the purpose for which the foreign exchange is
to be used. Though impressionistic reports suggest that the Rupee is already convertible in the
unofficial markets, this is a fact not the case free convertibility refers to officially sanctioned
market mechanism for currency conversion.
Non-convertibility can generally be defined with reference to transaction for which foreign
exchange cannot be legally purchased (e.g., import of consumer goods, etc) or transactions
which are controlled and approved on a case-by-case basis (like regulated imports, etc). A move
towards free convertibility implies a reduction in the number/volume of the above types of
transaction.
The need to convert domestic currency into foreign currency or to convert foreign currency into
domestic currency arises for two reasons:
1) For transactions arising due to exports, imports, tourism, medical expenses,
education, currency gifted overseas (or received from overseas). These transactions
are called Current Account Transactions.
2) For transactions arising due to Foreign Direct Investment (FDI) into a country or
outside the country, to borrow overseas, and to lend overseas. These transactions are
called Capital Account Transactions.
The IMF considers currency convertibility to imply the absence of restrictions on foreign
exchange transactions. Article VIII of the IMF states that, A member cannot impose restrictions
on making of payments and transfers on currency transactions. Thus it defines convertibility
only on the current account. But Article VI (3) allows members to exercise such controls as are
necessary to regulate international capital movements.

2.6.4.

CURRENT ACCOUNT CONVERTIBILITY

This refers to freedom in respect of payments and transfers for current international transactions.
In other words, if Indians are allowed to buy only foreign goods and services but restrictions
remain on the purchase of assets abroad, it is only current account convertibility. As of now,
convertibility of the Rupee into foreign currencies is almost wholly free for current account, i.e.,
in case of transactions such as trade, travel and tourism, education abroad, etc.
81

The government introduced a system of Current Account Convertibility (Partial Rupee

Convertibility) on February 29, 1992 as part of the Fiscal Budget for 1992-93. PRC is designed
to provide a powerful boost to export as well as to achieve as efficient import substitution. It is
designed to reduce the scope for bureaucratic controls which contribute to delays and
inefficiency. Government liberalized the flow of foreign exchange to include terms like amount
of foreign currency that can be procured for purpose like travel abroad, studying abroad,
engaging the service of foreign consultants, etc. What it means that people are allowed to have
assess to foreign currency for buying a whole range of consumables products and services. These
relaxations coincided with the liberalization on the industry and commerce front which is why
there are Honda City cars, Mars chocolate, and Bacardi in India.
The objective of the entire trade policy reforms go far beyond mere balancing of imports and
exports or a favourable Balance of Trade (BOT). There is growing interdependence among
technology, investment, and production. Trade policy, therefore, becomes the spearhead for
better technology, greater investment, and more efficient production.
Considerable evidence has accumulated over the years that for most countries, deregulation of
foreign trade transactions must precede deregulation of international capital account flows. For
an economy in transition from a controlled to a market based one, international capital
movements can be highly destabilizing and disruptive. It is essential that capital flows be
regulated under a separate controlled regime during the initial movement towards convertibility.
The system introduced to combine the advantage of relatively suitable managed float and the
BOP balancing property of a freely floating rate. This involves creation of two exchange rate
channels:
1) A market channel in which the exchange fate is determined by market forces of supply
and demand of foreign exchange where access if free for all transactions, (other than
those specified as not free)
2) An official channel where the exchange rate continues to be determined by RBI on the
base of the value of Rupee in relation to the basket of currencies and fixed but access to
the market is restricted.
With view to giving effect to the Current Account Convertibility (PRC), RBI introduced a
system called the Liberalized Exchange Rate Management System (LERMS) effective from 1st
March 1992.
82

2.6.5.

CAPITAL ACCOUNT CONVERTIBILITY

Capital Account Convertibility (Full Convertibility) in its entirety would mean that any
individual, be it Indian or foreigner, will be allowed to bring in any amount of foreign currency
into the country. Full convertibility also known as Floating Rupee means the removal of all
controls on the cross-border movement of capital, out of India to anywhere else or vice versa.
Capital Account Convertibility or CAC refers to the freedom to convert local financial assets into
foreign financial assets or vice versa at market-determined rates of interest. If CAC is introduced
alongwith current account convertibility, it would mean full convertibility.
Complete convertibility would mean no restrictions and no questions. In general, restrictions on
foreign currency movements are placed by developing countries which have faced foreign
exchange problems in the past are to avoid sudden erosion of their foreign exchange reserves
which are essential to maintain stability of trade balance and stability in their economy. With
Indias Forex reserves increasing steadily, it has slowly and steadily removed restrictions on
movement of capital on many counts.
The last few steps, as and when they happen, will allow an Indian individual to invest in
Microsoft or Intel shares that are traded on NASDAQ, or buy a beach resort on Bahamas, or sell
home or small industry to Mr. James Bond and invest the proceeds abroad without any
restrictions.
Capital account convertibility is a monetary policy that centers around the ability to conduct
transactions of local financial assets into foreign financial assets freely and at market-determined
exchange rates. It is sometimes referred to as Capital Asset Liberation.
It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency
at low rates. This is so local merchants can easily conduct transnational business without needing
foreign currency exchanges to handle small transactions. CAC is mostly a guideline to changes
of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and
extends the framework of the creation and liquidation of claims on, 6r by the rest of the world,
on local asset and currency markets.
Normally, the convertibility of capital account is introduced only after the lapse of a certain
period of time after the introduction of current account convertibility.
CAC was first coined as a theory by the Reserve Bank of India in 1997 by the Tarapore
Committee, in an effort to find fiscal and economic policies that would enable developing third
83

world countries transactions to globalized market economies.

2.6.5.1.

Features and Implications of CAC

The features and implications of CAC are as follows:

1) Implies progressive integration of the domestic financial system with international
financial flows.
2) Regarded as one of the hallmarks of a developed economy. Signals openness of the
economy.
3) Comfort factor for overseas investors. Encourages global capital flows into the
country.
4) Indian businesses access to cheaper external credit (Global rates + Country risk)
without having to ask permission of the RBI.
5) High Risk High Gain Good Times - Chance of huge inflows of foreign
capital; Bad times Chance of an enormous outflow of capital.
6) 'Chance of export of domestic savings - for capital scarce developing countries this
could curb domestic investment.
7) Exposes an economy to extreme volatility on account of hot money flows.

2.6.5.2.
Impact of Capital Account
Convertibility
After full convertibility is adopted by India, it will lead to acceptance of Indian Rupee currency
all over the world. In case of two convertible currencies, forward exchange rates reflect interest
rate differentials between these two currencies. Thus, it can be said that the forward exchange
rate for the higher interest rate currency would depreciate so as to neutralize the interest rate
difference. However, sometimes there can be opportunities when forward rates do not fully
neutralize interest rate differentials. In such situations, arbitrageurs get into the act and forward
exchange rates quickly adjust to eliminate the possibility of risk-less profits.
Capital account convertibility is likely to bring depth and large volumes in long-term INR
currency swap markets. Thus for a better market determination of INR exchange rates, the INR
should be convertible.

2.6.5.3.

Tarapore Committee Report

This report (also known as the Tarapore Report) set-out a roadmap and identified a set of
84

essential preconditions for successfully making the transition to capital account convertibility.
They were:
1) A stable macro-economic environment,
2) Reigning in fiscal deficit,
3) A stable rupee,
4) Adequate foreign exchange reserves,
5) A strong financial sector,
6) A banking system with high capital adequacy norms and low non-performing assets,
7) Continuous and effective supervision of the financial sector, and
8) Stringent risk management and prudential norms.
The report made 40 recommendations (mainly with respect to residents of India), of which
19 recommendations were fully implemented by the RBI and 15 were partly implemented.
This report specified three stages for introduction of capital account convertibility in
India. It stated that these stages should be preceded by financial sector reform; namely
interest rate deregulation, insistence on capital adequacy, and a reduction in nonperforming assets in the banking sector. The committee was concerned with the level of
preparedness of the Indian financial sector and the Indian economy, and recommended
that full convertibility should be undertaken only when certain conditions were fulfilled
(table 2.4):
1) Gross fiscal deficit, as a percentage of GDP, should be reduced in a time-bound
manner by 1999-2000 to 3 % in 1999-2000.
2) The three-year average inflation between 1997 and 2000 should range between 3%
and 5%.
3) Gross non-performing assets of public sector banks should be reduced in a timebound manner by 1999- 2000, so as to come-down to 5% in 1999-2000.
4) The RBI should have a monitoring exchange rate band of plus or minus 5% around
a neutral REER (Real Effective Exchange Rate).
5) The RBI should be transparent about changes in the REER.
6) |6) External policies should be designed to increase the current receipts to GDP
ratio, and bring-down the debt service ratio to 20%.

7) A consolidated sinking fund should be set-up to meet the governments debt

85

repayment needs. It should be financed by an increase in the RBIs profit transfer

to the government and from disinvestment proceeds.
8) A minimum net foreign asset to currency ratio of 40% should be prescribed by law
in the RBI Act. Four indicators should be used to evaluate adequacy of foreign
exchange reserves so as to safeguard against any contingency.
Prerequisites for CAC (Tarapore Committee Report, 1997)

Parameter

Target

Gross fiscal deficit as a percentage of GDP

1997 - 98:4.5%
1998 - 99:4% .
1999 - 00: 3%
Gross NPAs of public sector banks
1997 - 98: 12%
1998 99: 9%
1999 - 00: 5%
Inflation range during 1997-00

Since, the RBI accepted only 34 of the 40 recommendations made by the report; some
restrictions on convertibility still remained. Even in the case of residents, the implementation of
recommendations by the RBI lead to greater freedom to resident corporates, and less to resident
individuals. These were addressed in the IFCAC Report, 2006.

2.6.5.4.
Reasons for Capital Account
Convertibility
CAC, it is argued, is a process, not an event, such that a currency attains convertibility over a
period of time. This is the method being followed in India, and a number of policy changes have
been announced from time to time. Proponents of CAC, advocate it on several grounds:
1) It is considered a pre-condition to financial integration.
2) CAC implies financial openness, and is a hallmark of the financial systems of many
industrial countries.
86

3) FDI and portfolio flows register an increase because CAC acts as a pull factor in
attracting these flows.
When a country announces its decision to go in for CAC, it is interpreted as a signal that
future policies regarding i corporate taxation, repatriation of profits, transfer payments, and
exchange rates are going to be overseas investor friendly. Foreign investors are attracted by
convertibility because it enables easy entry and exit.
Capital account convertibility imposes control on the monetary and fiscal policies of a
country so that the balance of payments position is not adversely affected, and inflation is
kept in check. Fiscal deficits and current account deficits are held-down and this has a
beneficial impact on interest rates and money supply. Since, the Exchange rate is
determined by market expectations; there is no parallel market (black market) in foreign
^exchange. Financial institutions learn to hedge foreign exchange risks since inadequate
risk management practices can lead to their collapse. In many countries including India,
financial systems are bank based, and are dominated by the banking sector. CAC exposes
and exacerbates financial fragility. The FCAC Report, 2006 explained some of the reasons
for currency crises:
1) Prolonged, overvalued exchange rates leading to unsustainable current account
deficits.
2) Large, unsustainable levels of external debt, domestic debt, and short-term debt.
3) Weak and ineffectively supervised domestic financial institutions and inadequate
risk management.

2.6.5.5.
Advantages of Capital Account
Convertibility
The advantages of capital account convertibility are as follows:
1) Increases competition and reduces inefficiency; aids price discovery.
2) Allows access to funds at global rates (plus country risk).
3) Disciplines domestic policy and exchange rate monitoring.
4) Integrates economy to global trade and capital flows.
5) Capital controls ineffective with open trade, human movement.
87

6) Natural direction of evolution for developing economies (globalisation).

2.6.5.6.
Disadvantages of Capital Account
Convertibility
The disadvantages of capital account convertibility are as follows:
1) No evidence linking improved growth to CAC.
2) Increases vulnerability to herd behaviour, contagion, sentiment,
3) Downside exceeds upside - High Risk, High/Moderate Gain.
4) Reduces monetary, exchange rate autonomy for a nation.

2.7.
2.7.1.

INTERNATIONAL PARITY CONDITIONS

INTRODUCTION

Based on a few traditional assumptions, including the premises that both goods and financial
markets are perfect and that there is an absence of transactional costs and barriers to trade, the
law of one price implies that homogeneous goods or assets are expected to trade at the same
exchange-adjusted price in any two countries. Thus, international parity holds if expected
asset returns claimed by investors are equal regardless of whether investments occur in
domestic or foreign market.
This law of one price is enforced by international arbitrageurs who buy low and sell high and
prevent all deviations from equality. The theoretical economic relationships emerge from
arbitrage economic activity. These are as follows:

88

r effect; interest rate differential equals expected exchange rate change

Purchasing power parity; Inflation differential offset by excha

Unbiased forward rate theory; forward rate differs percentage equal to ex

Interest rate parity; forward sport rate by a percentage equal to interest rate differential

Fisher effect; Interest rate equals real rate plus expected in

89

2.7.2.

PURCHASING POWER PARITY (PPP)

Purchasing power parity is a theory about exchange rate determination based on a idea that
the two currencies involved in the calculation of the exchange rate have the same purchasing
power for the same good sold in the two countries.
Simply, it is the law of one good, one price.
In international finance, PPP means that the same goods or basket of goods should sell at the
same price in different countries when measured in a common currency, in absence of
transactions costs.

2.7.2.1.

Two Versions of PPP Theory

The PPP theory has two versions, namely, the absolute or positive version and the comparative
or relative version.
1) Absolute or Positive Version: According to the absolute version of the Purchasing Power
Parity (PPP) theory, the exchange rates between two currencies should reflect the relation
between the international purchasing powers of various currencies. In simple words, the
exchange rate would be determined, at the point where the internal purchasing power of the
respective currencies gets equalised.
For example, suppose particular basket of goods cost 1,000 in India and $100 in the
U.S.A. That means the exchange rate would be 10 = $ 1.
The exchange rate can be determined with the following equation:
R n=

Pb Q0
Pa Q0

Where, R = Exchange rate,

Pb = Prices in nation b,

Pa Prices in nation a
Qo = Corresponding weights

Criticism of Absolute or Positive Version

i).

Firstly, though the absolute version appears to be very elegant arid simple it is
totally useless because it measures the absolute levels of internal prices. And one
know that the value (or purchasing power) of money cannot be measured in
absolute terms.

ii).

Secondly, the goods produced and demanded in two different countries are not of

90

the same kind and quality. Therefore, the equalization of goods prices, internal
purchasing power of two-currencies cannot be easily envisaged.
iii).

As a matter of fact, the relative price structure between two-countries cannot be

identical on account of differences in qualities and characteristics of goods and
services, differences in demand patterns, differences in technology, influence of
transport costs, differences in tariff policies, differences in tax structure, market
imperfections of different degrees, different degrees of government intervention
and, control, and such other complex forces.

2) Relative or Comparative Version: The relative version was put forward by Cassel in order
to find the strength of the changes in the equilibrium exchange rate. Any departure from the
equilibrium will lead to the disequilibrium. It can take place due to changes in the internal
purchasing power of a particular currency. The changes in the purchasing power are
measured with the help of domestic price indices of the respective nation. Assume the any
past rate of exchange as a Base Exchange rate in order to know the percentage change in the
exchange rate. By comparing the price indices in the past, i.e., base period with that of the
present period, the new equilibrium exchange rate could be found out.
The exchange rate can be determined with the following equation
Rn=R n1

Pb / Pb
Pa / Pa
1

Where,
Rn = New equilibrium exchange rate
Rn1 = Base period exchange rate
Pb

= Price index of nation b in current period

Pb

= Price index of nation b in base period

Pa = Price index of nation a in current period

1

Pa

= Price index of nation a in base period

Thus, according to the equation when the price level in concerned nation changes, automatically
the internal purchasing power of the currency of that nation goes on changing. This change leads
91

to the change in the equilibrium exchange rate. Thus, under this theory Gustav Cassel has tried to
link the purchasing power of two currencies in determining the equilibrium exchange rate.

2.7.2.2.

Monetary Approach

Although PPP itself can be viewed as a theory of exchange rate determination, it also serves as a
foundation for a more complete theory, namely, the monetary approach. The monetary approach
is based on two basic tenets purchasing power parity and the quantity theory of money.
From the quantity theory of money, we obtain the following identity that must hold in each
country:
P$ = M$V$/Y$
P = MV/Y
Where, M denotes the money supply, V the velocity of money, measuring the speed at which
money is being circulated in the economy, y the national aggregate output, and P the general
price level; the subscripts denote countries. According to the monetary approach, what matters in
the exchange rate determination are:
1) The relative money supplies,
2) The relative velocities of money, and
3) The relative national outputs.
All else equal, an increase in the U.S. money supply will result in a proportionate depreciation of
the dollar against the pound. So will an increase in the velocity of the dollar, which has the same
effect as an increased supply of dollars. But an increase in U.S. output will result in a
proportionate appreciation of the dollar.
The monetary approach, which is based on PPP, can be viewed as a long-run theory, not a shortrun theory, of exchange rate determination. This is so because the monetary approach does not
allow for price rigidities. It assumes that prices adjust fully and completely, which is unrealistic
in the short-run. Prices of many commodities and services are often fixed over a certain period of
time. A good example of short-term price rigidity is the wage rate set by a labour contract.
Despite this apparent shortcoming, the monetary approach remains an influential theory and
serves as a benchmark in modern exchange rate economics.
92

2.7.2.3.
Parity

Criticisms of Purchasing Power

Following are the criticism of purchasing power parity:

1) Difficult to Measure Accurate Purchasing Power: The rate of exchange between two
countries, according to this theory, is determined by the purchasing power parity. The
purchasing powers of the currency units of the two counties are determined by the priceindex numbers. According to the critics, there are three main defects in these price-index
numbers:
i).

These index numbers are connected with the past prices. They do not deal with
the present prices in the two countries. As such, they lose their importance in
practical life.

ii).

These price index numbers include the prices of even those commodities which
are not internationally traded or which do not enter into international trade. In
fact, the prices of only those commodities should be included in the index
number, which enter into international trade.

iii).

The third defect of these index numbers is that they do not include the same
commodities in both the countries. In other words, the index numbers include
different types of commodities in the two countries. As such, it becomes difficult
to establish equality between the purchasing powers of the two currencies.

2) Neglects the Cost of Transportation: This theory has neglected the costs incurred on
the transportation of goods from one country to another.
3) Neglects the Quality of Goods: This theory does not take into account the quality of
those goods the prices of which are compared between the twp countries.
4) Ignore Other Elements of Balance of Payments: This theory furnishes no explanation
of other elements which affect the rate of exchange by influencing the balance of
payments between the two countries. This theory, as it is, studies only those elements
which influence the internal price-levels of the two countries. In fact, there are several
elements which produce no effect on the internal price-level, but do influence the balance
of payments^ f a country, and as such its rate of exchange with the other country.
5) Changes in the Rate of Exchange Influence the Price-Level: According to this theory,
the changes in the internal price-level of the two countries influence the rate of exchange.
93

But, according to the critics, the changes in the rate of exchange between the two
countries also influence their internal price-levels.
6) Contrary to General Experience: There is hardly any example, according to the critics,
where the rate of exchange between the two countries has been fixed on the basis of the
purchasing power parity of their currencies. Since this theory is contrary t general
experience, it has little importance in practical life.
7) Theory does not Explain the Demand for Foreign Currencies: This theory does not
offer a complete explanation^ the manner in which the rate of exchange between the two
countries is determined in actual practice. Iff fact, the rate of exchange is determined in
the same manner as the price of a commodity. Just as the internal value of a currency is
determined by its demand and supply, in the same manner, the external value of that
currency (or, its rate of exchange) in the foreign exchange market is also determined by
its demand and supply.
8) Assumes a Given Rate of Exchange: A serious defect of this theory is that it starts with
a given rate of exchange. How that rate of exchange is arrived at, is not explained by this
theory. As already explained, this theory before establishing the parity between the
purchasing powers of the two countries assumes a certain rate of exchange as the given
rate. The reason is that without assuming a given rate of exchange, it is not possible to
establish the parity between the purchasing powers of the currencies of the two countries.
Thus, this theory hells us how with a given rate of exchange, the changes in the
purchasing powers of the two countries affect the exchange situation.
9) Based on a Wrong Conception of Elasticity of Demand: This theory is based on the
wrong assumption, that the elasticity of the foreigners demand for the goods of the
country is equal to unity. In other words, the foreigners demand for the goods declines in
the same proportion in which their prices rise, or vice versa the foreigners demand for
the goods increases in the same proportion in which their prices decline. But, this
assumption is not true. In fact, the demand for goods in foreign countries does not vary in
proportion to the changes in prices. In other words, the elasticity of demand can either be
more less than unity.
10) Offers only a Long-term Explanation of the Rate of Exchange: Unfortunately, this
theory does not explain how the rate of exchange between the countries is determined
94

in the short period. Actually, the rate of exchange between two countries is influenced
by a large variety of factors during the short period, but this theory unfortunately omits
to take such elements into account. From this point of view, the theory cannot be
looked upon as a satisfactory one.

2.7.3.

INTEREST RATE PARITY (IRP) THEORY

The determined of exchange rate in a forward market finds an important place in the theory of
Interest Rate Parity (IRP). The IRP theory states that equilibrium is achieved when the forward
rate differential is approximately equal to the interest rate differential.
In other words, the forward rate differs from the spot rate by an amount that represents the
interest rate differential. In this process, the currency of a country with a lower interest rate
should be at a forward premium in relation to the currency of a country with a higher interest
rate.
Equating forward rate differential with interest rate differential, we find:
A

nday FS 1+r A
=
1
S
1+r B

On the basis of the IRP theory, the forward exchange rate can easily determined. One has
simply to find out the value of the forward rate (F) in above equation. The equation shall be
rewritten as:
F=

S 1+r A
1 + S
A 1+r B

For example, interest rate in India and the United State of America is, respectively, 10 per cent
and 7 percent. The spot rate is 40 U.S.$ the 90-day forward rate can be calculated as follows:
F=

Or

40 1.10
1 + 40
4 1.07
F = 40.28/US$.

95

This means that a higher interest rate in India will push down the forward value of the rupee
from 40a dollar to 40.28 a dollar.
Example 8:
Spot $1

= 45.50

Interest Rate($)

= 8% p.a.

Interest Rate()

= 12% p.a.

1) Estimate three months forward rate as per IRP theory.

2) Calculate rate of discount/premium of dollar on the basis of forward and spot rates.
3) Calculate rate of discount/premium of dollars on the basis of interest rates.
Solution:
Spot Rate:

= 45.50

Three months forward ate (basis on IRP theory):

$1(1.02)

= 45.50(1.03)

$1.02

= 46.8650

$1

= 45.9461

Rate of Premium of $(Three months)

45.946145.50
100=0.98
45.50

0.030.02
Rate of Premium of $ (Three months) 45.501+ 0.02 100=0.98

2.7.3.1.

Two Versions of IRP Theory

The two versions IRP theory are as follows:

1) Covered Interest Rate Parity (CIRP): If forward rate differential is not equal to interest rate
differential covered interest arbitrage will begin and it will continue till the two differentials
96

"become equal. In other words, a positive interest rate differential in a country is offset by
annualized forward discount. Negative, interest rate differential is offset by annualized forward
premium. Finally, the two differentials will be equal. In fact, this is the point where forward rate
is determined.
The process of covered interest arbitrage may be explained with the help of an example. For
example, the spot rate is 40/US$ and three-month forward rate is 40.28/U-S$ involving a
forward differential of 2-8 percent. Interest rate is 18 percent in India and it is 12 percent in the
United States of America, involving an interest rate differential of 5.37 per cent. Since the two
differentials are not equal, covered interest arbitrage will begin.
The successive steps shall be as follows:
i).

Borrowing in the United States of America, e.g., US $1,000 at 12 per cent interest rate.

ii).

Converting the US dollar into rupees at spot rate to get 40,000/. ill) Investing
^40,000 in India at 1 8 percent interest rate.

iii).

Selling the rupee 90-day forward at 40.28/US$,

iv).

After three months, liquidating 40,000 investment, which would fetch 41,800.

v).

Selling 41,800 for US dollars at the rate of 40.2.8/US $ to get US $1,038.

vi).

Repaying loan in the United States of America, this amounts to US $1,030.

vii).

Reaping profit: US $1,038-1,030 =US $8.

The covered interest rate parity exists if:

97

Interest Rate Parity

= Premium forward discount

S = Present or Chang
S = applicable to open interest rate parity

98


$
[(1+ r )/ (1+ r )] < (F/S), i.e., when foreign market is an investment market for

$
[(1+ r )/ (1+ r )] > (F/S), i.e., when foreign market is an investment market for

Thus the no arbitrage condition is:

$
[(1+ r )/(1+ r )] = (F-S)/S.(1)

Subtracting oe from each side and simplifying we have:

$
[(1+ r )/(1+ r )] = (F-S)/S(1(a))

$
[(1+ r )/(1 r +)] = premium/discount for a unit period

As a limiting case, if we assume that foreign interest rates are small as compared to unity then

$
the denominator (1+ r ) in the limit tends to 1 (1+ r ) 1) and the above inequality

becomes:
r r $ = Premium/Discount for a unit period.(2)
i.e., the forward premium and discount are to be equal to interest rate differential
between the domestic and foreign interest rates for no interest arbitrage situation.
If we want to be more precise, for no arbitrage situation we can use equality Equation
and write it as;

$
(1+ r ) = (F/S) (1+ r )]

On simplify we get:
r - (F/S) r $

= (F-S) -1

r - (F/S) r $

= (F/S)/S

r - (F/S) r $

= premium/Discount for unit a period

This states that for no interest arbitrage situation the forward premium and discounts have to be
equal to-the adjusted interest rate differential. Interest rate parity can be explained
diagrammatically as shown above figure.
2) Uncovered Interest Rate Parity (UIP): UIP states that there is a relationship between the
expected changes in the spot exchange rate differentiate between the two countries and the
expected change in spot exchange rate is equal to the two countries interest rate differential.
99

For example, a risk-neutral investor deciding whether to invest in assets denominated m currency
a currency B, he will be guided by expected returns after allowing for exchange rate changes. In
a perfect capital mobility the following condition, known as uncovered Interest Parity UTP must
hold:
S en
A B=

( BA )S ( BA )
S(

B
)
A

Here, S is the spot rate expected to rule n-years from now, and i A and iB are interest rates on A
and B assets. It is to be noted that as in the case of covered interest parity, the UIP condition is
not a causal relationship. It is a capital market equilibrium condition under perfect capital
mobility. It only says that in equilibrium, returns on the two assets and expected exchange rate
change must obey a certain relation, neither is the cause of the other.
Now, Combine the UIP condition with the relative PPP condition. For this purpose, relative PPP
must be cast in an ex-ante form, that is, it must be viewed as a relationship between expected
change in exchange rate and the expected inflation differential. Let S e denote the expected
proportionate change in the exchange rate. Then relative PPP can be written as:
e

S = A B

The famous Fisher equation is a relationship between the nominal interest rate i, the real interest
rate r, and the expected rate of inflation ne in any economy:
i=r + c
Now take the Fisher equation for each of the two countries A and B and the UIP with n = 1. Then
i Ai B = ^Se =r A r B +eA eB
Using the relative PPP, this implies
r A r B
i.e., perfect capital mobility will equalize real rates of interest across countries. This is sometimes
called the Fisher Open Relation

100

The UIP condition together with the covered interest parity condition implies that the forward
rate is an unbiased predictor of the future spot rate.
Coming back to the UIP condition with n = 1, let us re-write it as:
S c (A / B)
S ( A /B)=
1+(i A i B)
This says that the current spot rate is determined by the expected future spot rate and the interest
rate differential. Can this help us predict how the spot rate will respond to changes in interest
rates?
For example, the European Central Bank (ECB) hikes the discount rate; can we say that this will
lead to appreciation of the Euro against the US dollar? The answer is that it depends upon what
happens to SC (A/B). If the market interprets the ECB action as a sign of monetary tightening
which will lead to slower inflation in the Eurozone, the expectations effect will reinforce the
interest rate hike and the Euro will appreciate. However, if the increase in i B is interpreted as a
signal of faster inflation to come, S e (A/B) may rise and negate the interest rate effect; currency
B, Euro, may in fact depreciate. There are at least four reasons why perfect capital mobility
cannot hold and hence the UIP condition would be violated.
1. First, investors are risk averse and therefore would not be guided only by expected returns.
Since exchange rate changes are uncertain, they would be willing to sacrifice some return in
order to reduce risk. Thus, for example, dollar assets pay 4% p.a. while pound assets pay 8%.
The expected appreciation of the dollar against the pound is 6% p.a. Risk neutral investors
would put all their wealth in dollar assets and even borrow pounds to invest in dollars;
however risk adverse investors would diversify their portfolios.
Second, even if all investors are risk neutral, they could have differing views about future
exchange rate movements. In the above example, there might be a group of risk neutral investors
who expect the dollar to appreciate by more than 4%, while another group might expect the
appreciation to be less than 4%. The former would shift their entire wealth to dollar assets while
the latter would shift to pounds. UIP would not be required to achieve equilibrium.
Third, transaction costs and liquidity needs would force people to hold some of their wealth in
the currency of their operating habitat even though the expected return on a foreign currency is
higher.
101

Finally, Exchange controls may prohibit portfolio shifts between currencies and interfere with
realization of UIP.

2.7.3.2.

Implications of Interest Rate Parity

The implications of interest rate parity are as follows:

1) If domestic interest rates are less than foreign interest rates, foreign currency must
trade at a forward discount to offset any benefit of higher interest rates in foreign
country to prevent arbitrage.
2) If foreign currency does not trade at a forward discount or if the forward discount is
not large enough to offset the interest rate advantage of foreign country, arbitrage
opportunity exists for domestic investors. Domestic investors can benefit by
investing in the foreign market.
3) If domestic interest rates are more than foreign interest rates, foreign currency must
trade at a forward premium to offset any benefit of higher interest rates in domestic
country to prevent arbitrage.
4) If foreign currency does not trade at a forward premium or if the forward premium
if not large enough to offset the interest rate advantage of domestic country,
arbitrage opportunity exists for foreign investors. Foreign investors can benefit by
investing in the domestic market.

2.7.3.3.

Covered Interest Parity Arbitrage

Covered Interest Parity (CBP) is also called covered interest rate parity. Under the
assumption of free capital flow, it states that the forward premium of a foreign currency
should be equal to the interest rate | differential between a domestic asset and a
substitutable foreign asset.
Covered interest arbitrage is the transfer of liquid funds from one monetary centre to
another to take I advantage of higher rates of return or interest, while covering the
transaction with a forward currency hedge.
For example, the 3-month T-bill rate in the U.S. is 12%, higher than the 3-month T-bill
rate of 8% in I Canada. Attracted by the higher interest rate, investors would tend to
change their Canadian dollar into U.S.
I dollar and invest their funds in the U.S. Simultaneously; they buy contracts to sell dollars

102

in 3 months in the forward market. If the spot exchange rate is 1.00CAD/USD at present,
and the 3-month forward exchange rate is 0.99CAD/USD at present, then the investors
losses in exchange conversion will be 1%. From the interest rate differential, they will earn
1% in 3 months (since annually they earn (12% 8%) = 4% by | investing in U.S. rather
than in Canada). This profit is just offset by the loss. However, if the interest rate in I U.S.
is higher, making the earning in interest rate differential much larger in absolute value than
the loss in [ foreign exchange, this arbitrage process will continue. Then, large amount of
funds flow from Canada into I U.S., putting pressures for U.S. to lower its interest rate and
for Canada to raise its interest rate. In addition, I the increasing demand of U.S. dollar in
the current market tends to raise the spot rate for U.S. dollar. The increasing demand of
Canada dollar in the forward market tends to decrease the future rate for U.S. dollar. The
process continues until returns from investing in the two countries reach the same level.
Then the CIP I conditions will be satisfied again.
Steps for Covered Interest Arbitrage
One would achieve arbitrage through the following steps:
Step 1: Identify whether the Forward Contract is Over-Priced or Under-Priced: A forward
contract is I over-priced relative to the current spot rate if the actual forward rate is more than the
theoretical forward rate, and a forward contract is under-priced relative to the current spot rate if
the actual rate is less than the theoretical forward rate.
Step 2: Take a Long Position in an Under-Priced Security and a Short Position in an
Over-Priced I Security: If the actual forward rate is higher than the theoretical forward rate, the
forward is over-priced and the current spot contract is under-priced. This means that the
arbitrager will buy the foreign currency at the spot market rate and sell it through a forward
contract. This requires the arbitrager to:
1) Borrow money in the home currency;
2) Use this money to buy the foreign currency;
3) Invest the foreign currency amount in the foreign country at the foreign
interest rate;
4) Convert the proceeds of the investment into the home currency; and j
5) Pay the borrowed funds with interest in the home country.
This process will result in a profit.
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If the actual forward rate is less than the theoretical forward rate, the forward is under-priced and
the current spot contract is over-priced. This means that the arbitrager will sell the foreign
currency at the spot market rate and buy them through a forward contract. This requires the
arbitrager to:
1) Borrow money in the foreign currency;
2) Sell the borrowed funds to buy the home currency;
3) Invest the home currency amount at the home interest rate of foreign currency
4) Convert the proceeds of the investment in-the home country at the forward
and
5) Pay the borrowed funds with interest in the foreign country.
This process will result in a profit.
The actions of arbitragers will bring the mispriced forward rate to its theoretical value.
Example 9: Arjun is an NRI investor who has an opportunity to invest in India as well as in the
S.A. In the U.S.A., the investment can be made at 4% per annum, while the interest rate in
India is 10% per annum. Since the interest rate in India is higher, the NRI investor from the
U.S.A. decides to invest USD 100,000 in India for 90 days. Assume that the current exchange
rate is USD 1 = INR 40 and the 90-day forward rate is USD 1 = INR 40.6752.
1) Calculate the 90-day theoretical forward rate.
2) Identity' whether there is any arbitrage opportunity.
3) It there is an arbitrage opportunity, calculate the arbitrage profit for USD
100,000.
Solution:
1) To calculate the theoretical forward rate:
Step 1: Calculate the 90-Day Interest Rate in India and in the U.S.A.
90-day interest rate in India = 10% 90/365 = 2.4658%
90-day interest rate in U.S.A. = 4% 90/365 = 0.9863%
Step 2: Calculate the Theoretical Forward Rate

104

f 0=e 0

1+ R INR
1+ RUSD

The 90-day forward rate =

40

1+0.0024658
=INR 40.5860
1.009863

2) In order to identify whether an arbitrage opportunity exists, compare the actual forward ate with
the theoretical forward rate. The theoretical forward rate is USD 1=INR 40.586, and the actual
forward rate is USD 1=INR 40.6752. Thus, the actual forward rate is higher than the theoretical
value and hence there exists an arbitrage opportunity. The forward contract is priced at a higher
value and hence the arbitrage requires selling the U.S. dollar at the forward rate and buying it at
the spot rate.
3) To calculate the arbitrage profit for USD 100,000:
Step 1: Borrow Money in the Home Currency
Since the arbitrager needs USD 100,000 and the spot exchange rate is USD 1 = INR 40, the
amount to be borrowed is 40 100,000 =INR 4,000,000.
Step 2: Use the Borrowed Funds to Buy Foreign Currency: Amount in U.S. dollars that would be
bought at the exchange rate of USD 1 = INR 40 is USD 100,000.
Step 3: Invest the Foreign Currency Amount in the Foreign Country at the Foreign Interest Rate:
Invest USD 100,000 at 4% for 90 days. The amount at eh end of 90 days would be:

100,000 1+ 4

90
=USD 100,986.30
365

Step 4: Convert the Proceeds of the Investment in the Foreign Country at the Forward Rate into
the Home Currency: Amount in Indian rupees upon converting USD 100,986.30 at the forward
rate of USD 1 = INR 40.6752 is INR 4,107,638.
Step 5: Pay the Borrowed Funds Alongwith Interest in the Home Country: Amount to be repaid
for borrowed funds of INR 4,000,000 at 10% for 90 days = 4,000,000 (1+10% 90/365)
= INR 4,098,630.

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Step 6: Calculate the arbitrage profit as the difference between the home currency received from
foreign investment and the payment of the borrowed funds in the home country.
Arbitrage Profit = INR 4,107,638 INR 4,098,630 = INR 9,008.
Use of Covered Interest Parity Theory in Borrowing and Investment Decisions
Covered Interest Parity (CIP) is the theory that positive returns cannot be earned by borrowing
the home or base currency to invest the commensurate amount in a foreign currency on a covered
basis.
An example to illustrate covered interest rate parity in borrowing and investment decisions.
The interest rate for borrowing funds for a one-year period in Country A is 3% per annum, and
that the on-year deposit rate in Country B is 5%. Further, assume that the currencies of the two
countries are trading at par in the spot market (i.e., Currency A = Currency B)
An investor:
Borrows in Currency A at 3%.
Converts the borrowed amount into Currency B at the spot rate.
Invests these proceeds in a deposit denominated in Currency B and paying 5% per annum.
The investor use the one-year forward rate to eliminate the exchange risk implicit in this
transaction, which arises because the investor is holding Currency B, and has to repay the funds
borrowed in Currency A.
Under covered interest rate parity, the one-year forward rate should be approximately equal to
1.0194 (i.e., Currency A = 1.0194 Currency B), according to the formula discussed above.
What if the one-year forward rate is also at parity (i.e., Currency A = Currency B)? In this case,
the investor in the above scenario could reap riskless profits of 2%.
Solution: Assume the investor:
Borrows 1, 00,000 of Currency A at 3% for a one-year period.
Immediately converts the borrowed proceeds to Currency B at the spot rate.
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Places the entire amount in a one-year deposit at 5%.

Simultaneously enters into a one-year forward contract for the purchase of 1, 03,000 Currency A.
After one year, the investor receives 1,05,000 of Currency B, of which 1,03,000 is used to
purchase Currency A under the forward contract and repay the borrowed amount, leaving the
investor to pocket the balance 2,000 of Currency B. This transaction is known as covered
interest rate arbitrage.
Market forces ensure that forward exchange rates are based on the interest rate differential
between two currencies, otherwise arbitrageurs would step in to take advantage of the
opportunity for arbitrage profits. In the above example, the one-year forward rate would
therefore necessarily be close to 1.0194.

2.7.3.4.
Relationship Between Forward and
Future Spot Rate
Because of a widespread belief that foreign exchange markets are efficient, the forward
currency rate should reflect the expected future spot rate on the date of settlement of the forward
contract. This theory is often called the expectations theory of exchange rates.
Example 10: If the 90-day forward rate is DM 1 = $0.456, arbitrage should that the market
expects the spot value of DM in 90 days to be about $0.456.
An unbiased predictor intuitively implies that the distribution of possible future actual spot
rates is centred on the forward rate. This, however, does not mean the future spot rate will
actually be equal to what the future rate predicts. It merely means that the forward rate will, on
average, under an over- estimate the actual future spot rates in equal frequency and degree. As
a matter of fact, the forward rate may never actually equal the future spot rate.
The relationship between these two rates can be rested as follows:
The forward differential (premium or discount) equals the expected change in the spot exchange
rate.

107

Difference between Forward and Spot Rate

Equals Expected Change in Spot Rate

Algebraically,
With indirect quotes:
SpotForward Begining RateEnding Rate
=
Spot
Ending Rate
With direct quotes:
Forward Spot Ending RateBegining Rate
=
forward
Begining Rate

108

-3

-2

-1

-4

-2

-5

-1

xpected change in home currency value of foreign currency (%)

J

-5

-4

-3

Forward premium (+) or discount (-) on foreign currency (%)

Parity line

109
1

2.7.4.

FISHER EFFECT/FISHER PARITY

Fisher effect is also known as Fisher Closed Theorem. It is concerned with the relationship
between the real interest rate, the nominal interest rate, and inflation in a domestic economic
setting. The interest rates that are quoted in the financial press are nominal rates. That is, they
are expressed as the rate of exchange between current and future dollars. For example, a
nominal interest rate of 8% on a one-year loan means that $1.08 must be repaid in one year
for $1.00 loaned today. But what really matters to both parties to a loan agreement is the real
interest rate, the rate at which current goods are being converted into future goods. Looked at
one way, the real rate of interest is the net increase in wealth that people expect to achieve
when they save and invest their current income. Alternatively, it can be viewed as the added
future consumption promised by a corporate borrower to a lender in return for the latter's
deferring current consumption. From the company's standpoint, this exchange is worthwhile
as long as it can find suitably productive investments. However, because virtually all-financial
contracts are stated in nominal terms, the real interest rate must be adjusted to reflect expected
inflation. The Fisher effect states that the nominal interest rate r is made up of two
components:
1) A real required rate of returns a and
2) An inflation premium equals to the expected amount of inflation i.
Formally, the Fisher effect is 1 + Nominal rate = (1 + Real rate) (1 + Expected inflation rate),
1+r = (1+a) (1+i) or r = a + i + ai

2.7.5.

INTERNATIONAL FISHER EFFECT (IFE)

The Fisher Open Theorem is also known as International Fisher Effect or the generalized
form of Fisher Effect. The IFE uses interest rates rather than inflation rate differential to
explain the changes in exchange rates overtime. IFE is closely related to the PPP because
interest rates are significantly correlated with inflation rates. The relationship between the
percentage change in the spot exchange rate over time and the differential between
comparable interest rates in different national capital markets is known as the International
Fisher Effect.
The IFE suggests that given two countries, the currency in the country with the higher interest
110

rate will depreciate by the amount of the interest rate differential. That is, within a country, the
nominal interest rate tends to approximately equal the real interest rate plus the expected
inflation rate.
The international Fisher effect suggests that the nominal interest rate differential reflects the
expected change in the spot rate. A rise in the inflation rate in a country will be associated with
a rise in the interest rate in the country and a fall in the country's currency value. This implies
that the expected return on domestic investment should be equal to the expected return on
foreign investment.
1+ K h 1+i h
=
1+ K f 1+i f
1+ K h E(S t )
=
..(1)
1+ K f
S0

Or,

Where,
Kh, = Nominal home currency interest rate
K f= Nominal foreign currency interest rate
ih = Expected inflation rate in home country
if = Expected inflation rate in foreign country
So = Spot exchange rate
E(St) Expected spot rate at time t
This explains the expected spot rate in terms of relative nominal interest rates.
By subtracting 1 from both sides of equation 1:
K h+ K f E ( S t ) S 0
=
1+K f
S0
Let us understand the international Fisher effect with the help of an example. Suppose that the
real required rate of return in the United States is 4 per cent and the rate of inflation over the year
is expected to be 3 per cent. In this situation, the purchasing power of the U.S. dollar will
become USD (1/1.03), or USD 0.9708. At the end of the year, the U.S. dollar can purchase only
97.08 per cent of what it can purchase today. If the investor requires his real purchasing power to
be 4 per cent higher at the end of the year than today, then his nominal interest rate should be:
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0.9708(1+K) = 1.04
Or,

K = 0.0713 = 7.13 per cent

Comparison of IRP, PPP and EFE Theories

Theory
Interest

Key Variables of Theory

Rate Forward rate Interest

Party (IRP)

premium

Summary of Theory
The forward rate of one currency

(or differential

discount)

with respect to another will contain a

premium that is determined by' the
differential id interest rates between
the two countries. As a result, covered
interest arbitrage will provide a
return that is no higher than a

Purchasing
Power

Percentage

domestic return.
Inflation rate The spot rate of one currency with

AX change in spot differential

Parity (PPP)

exchange rate

respect to another will change in

reaction to the differential in inflation
rates

between

the

two

countries.

Consequently, the purchasing power for

consumer** when purchasing goods in
their own country will be similar to their
purchasing
International
Fisher
(IFE)

Percentage

Interest

power

when

importing

goods from the foreign country. |

rate The spot fate of one currency With

Effect change in spot differential

exchange rate

respect to another will change in

accordance with the differential in
interest rates between die two countries.
Consequently, the return on uncovered
foreign money market securities will, on
an average, be no higher than the return
on domestic money market securities
from the perspective of investors in the
home country.

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2.7.6.

UNBIASED FORWARD RATE THEORY

The Unbiased Forward Rate Theory asserts that the forward exchange rate is th e best estimate
of the expected future spot rate. While it is consistent with the efficient market theory that asserts
that all relevant information is reflected in prices, including forwards and futures, market
efficiency allows the existence of factors that can introduce a bias in the forward price of
foreign exchange. However, in the absence of such factors, it is difficult to claim that systematic
and regular biases exist that would not be taken advantage of by professional market participants,
and thus eliminated. Indeed, the best empirical evidence of ex post data demonstrates that risk
premiums exist, but they are time-variant, exhibiting a largely random pattern.
For risk management, therefore, there is little choice but to act as if ex ante, the forward is an
unbiased; predictor of the expected future spot-rate in all those currencies where there are no
factors such as exchange controls, excess external indebtedness, or other identifiable reasons that
would rationalize a reasonably systematic risk premium. In the absence of such influences, the
unbiased forward rate theory can be stated simply:
Expected exchange rate = Forward exchange rate
Now we can summarize the impact of unexpected exchange rate changes on the internationally
involved firm by drawing. On these parity conditions. Given sufficient tiling, competitive forces,
and arbitrage will neutralize the impact of exchange rate changes on the Returns to assets; due to
the relationship between rates of devaluation and inflation differentials. These factors will also
neutralize the impact of the changes on the value of the firm. This is simply the principle of
purchasing power parity and the law of one price operating at the level of the firm.' On the
liability side, the cost-of-debt tends to adjust as debt is re-priced at the end of the contractual
period, reflecting (revised) expected exchange rate changes. And return on equity will also
reflect required rates of return; in a competitive market, these will be influenced by expected
exchange rate changes. Finally, the unbiased forward rate theory suggests that locking in the
forward exchange rate offers the same expected return as remaining exposed to the ups and
downs of the currency - On average, it can be expected to err as much above as below the
forward rate. In the long ran, it would seem that a firm operating in this setting will not
experience net exchange losses or gains. However, because of contractual or, more importantly,
strategic commitments, these equilibrium condition rarely hold in the short and medium term.
Moreover, the preceding equilibrium conditions refer to economic relationships across all
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markets in the entire economy, which does not necessary mean that they hold for the individual
firm that operates in a specific segment of the market. Therefore, the Essence of foreign
exchange exposure and, significantly, its management, are made relevant by these deviations,
which may be temporary or structural.
This theory relies on the efficient markets theory, which states that a broadly traded market,
accessible to all participants, unmanipulated, and equally available to competitive forces, will
produce a value that is truly the composite of all factors affecting its price. The UFR asserts that
if a forward exchange rate is produced in an unbiased efficient market, then it should equal the
expected future spot exchange rate.
In actual practice, the spot exchange rate has an equal probability of being above or below the
forward rate at the delivery date of the foreign market. Therefore, the greatest value of UFR may
be in determining the impact of unexpected exchange rate changes due to international events.
The UFR may not be particularly useful in determining the most important position to establish
in the market, but it does teach us a very important lesson that an exchange rate determined in an
efficient market will be the result of the composite opinion of all participants, and thus a composite
of all factors governing the market at that moment in time.

2.7.7. PARITY CONDITIONS AND MANAGERIAL

IMPLICATIONS
a) Provide guidelines for financial strategic decisions suggested by each side of parity
condition.
b) The parity conditions define international financial break-even points encompassing
attractive strategies yielding identical financial outcomes suggested by each side of
parity condition.
c) Parity conditions help to make optimal (beneficial) financial decisions regarding the
choice of currency for borrowing, location of plants in different countries, measuring
currency risk exposure.

2.8.
INTERNATIONAL DEBT CRISIS
2.8.1. INTRODUCTION
International debt crisis arises when the sum of a borrower nations cross-border repayment
114

obligations cannot be met without radically altering expenditure levels or renegotiating

repayment terms. Because both parties to cross- border debt contracts are not covered by a
common contract law, lenders expect that borrowers national governments bear residual
repayment responsibility. Cross-border debt also typically involves exchange risk. If the debt
contract is denominated in the lenders currency, then the borrower takes on exchange risk, and
vice versa.
The debt crisis of the 1980s affected all the countries. The international financial markets were
severally affected when a number of developing countries found that they were unable to meet
the payments amounting to several hundred billion dollars to major banks around the world. As
countries trade with each other, economies are integrated. The stagnant economies in Europe and
the United States had an adverse effect on many Less Developed Countries (LDC) economies.
These countrys were highly dependent on their exports business on these two economies. In
addition, due to the oil glut at that time, the oil exporting LDCs were also generating less
revenue.
The strengthening of the dollar during the early 1980s adversely affected the debt problems of
the LDCs as most of the loans provided to LDCs were denominated in U.S. dollars.
The interest rates in 1981 were also at their peak, exceeding 20% in 1981. Infact, the increased
market interest rates, alongwith the strengthening of the U.S. dollar, resulted in the effective
interest rates on previous loans to be 30% or more.
Thus, the international debt crisis reflected a combination of external shocks including
deterioration of terms of trade and a sharp rise in U.S. dollar interest rates and domestic
imbalances such as large fiscal deficit and currency overvaluation.
In August 1982, Mexico announced that is was unable to pay its debt to international creditors.
Brazil and Argentina also found themselves in a similar situation. By the spring of 1983, several
LDC governments simultaneously announced their inability to re-pay loans and entered into loan
re-scheduling negotiations with the creditor banks. The negotiating power of LDCs was
enhanced because they had announced as a group, their inability to re-pay the loans. This forced
the authorities to search for long-term economic rescue plans that would ultimately help in
recovery of the loan.

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Negotiations between the commercial banks, LDCs and the IMF were held in 1983. In
November 1983, the IMF funding bill was passed to provide additional funding to those LDCs
that could meet specified economic goals.

2.8.2.

GREEK DEBT CRISIS

Historically, financial crisis have been followed by a wave of governments defaulting on their
debt obligations financial crisis tend to lead to, or exacerbate, sharp economic downturns, low
government revenues, widening government deficits, and high levels of debt, pushing many
governments into default. As recovery from the global financial crisis begins, but the global
recession endures, some point to the threat of a second wave of the crisis sovereign debt crises.
Greece is currently facing such a sovereign debt crisis. On 2 nd May 2010, the Eurozone members
and International Monetary fund (IMF) endorsed a historic 110 billion (about $145 billion)
financial package for Greece in an effort to avoid a Greek default and to stem contagion of
Greeces crisis to other European countries, particularly Portugal, Span, Ireland, and Italy. On 9 th
May 2010, the European Union (EU) announced an additional 500 billion (about 636 billion)
in financial assistance that could be made available to assist vulnerable European countries.
Greeces debt crisis has raised a host of questions about the merits of the euro, and the prospects
for future European monetary integration, with some calling for more integration, and others
less. Of heated debate, in particular, is the viability of an economic union that has a common
monetary policy but diverse national fiscal policies. Some economists have suggested that
Greece could benefit from abandoning the euro, and issuing a new national currency, although
doing so would raise the real value of Greeces external debt, and possibly trigger runs on Greek
banks and contagion of the crisis more broadly within the Eurozone.
The United States and the EU have strong economic ties, and a crisis in Greece that threatens to
spill-over to other Southern European countries could impact U.S. economic relations with the
EU and the general economic recovery from the financial crisis. Additionally, the exposure of
U.S. banks is estimated at $16.6 billion. The Obama Administration was reportedly supportive of
the EU and IMFs decision to offer financial support to Greece, and other vulnerable Euro-zone
economies. Indeed, atleast one press report indicates that administration officials began urging
their European counterparts to take decisive action to prevent the possibility of Greek default asearly-as February. President Obama is reported to have called German Chancellor Angela Merkel
and French President Nicolas Sarkozy on 9 th May 2010, to encourage them to structure a broader
116

package of financial assistance in an effort to stem possible contagion of the Greek crisis to other
Eurozone Members. On 10th May 2010, the U.S. Federal Reserved re-opened credit swap-lines
with the European Central Bank (ECB), among other major central banks, to help ease economic
pressures resulting from the crisis in Europe.
In this case, congressional interest in Greeces debt crisis is high. Greeces economic situation
was a major focus of discussion during Greek Prime Minister George Papandreous meetings
with congressional leaders in a visit to Washington, DC in March 2010. Numerous congressional
hearings in 2010 have referenced Greeces economic situation, and the house committee on
financial services held a hearing on 29th April 2010, on the implications of Greeces debt crisis
for credit default swaps. Given the large financial commitment of the United States to the IMF,
there is also strong congressional interest in the IMFs role in providing financial assistance to
Greece.

2.9.1.

2.9.
CURRENCY CRISIS
INTRODUCTION

A currency crisis is a specific form of a financial crisis for a currency. It occurs when the
exchange rate can no longer be maintained and has to adjust abruptly to a new equilibrium.
A shortcoming of the international monetary system is that major currency crisis have been a
common occurrence in recent years. A currency crisis, also called a speculative attack, is a
situation in which a weak currency experiences heavy selling pressure. There are several possible
indications of selling pressure. One is sizable losses in the foreign reserves held by a countrys
central bank. Another is depreciating exchange rate in the forward market, where buyers and
sellers promise to exchange currency at some future date rather than immediately. Finally, in
extreme cases where inflation is running rampant, selling pressure consists of widespread flight
out of domestic currency or into goods that people think will retain value, such as gold or real
estate. Experience shoes that currency crisis can decrease the growth of the countrys gross
domestic product by six percent, or more. That is like losing one or two years of economic
growth in most countries.
A currency crisis ends when selling pressure stops. One way to end pressure is to devalue. i.e.,
establish a new exchange rate at a sufficiently depreciated level. For example, Mexicos cerntal
117

bank might stop exchange pesos for dollars at the previous rate of 10 pesos per dollar and set a
new level of 20 pesos per dollar. Another way to end selling pressure is to adopt a floating
exchange rate. Floating permits the exchange rate to find its own level, which is almost always
depreciated compared to the previous pegged rate. Devaluation and allowing depreciating make
foreign currency, and foreign goods more costly in terms of domestic currency, which tends to
decrease demand for foreign currency, ending the imbalance that triggered selling pressure.
Round of devaluation occur.
Currency crisis that end in devaluations or accelerated depreciations are sometimes called
currency crashes. Not all crisis end in crashes. A way of trying to end the selling pressure of a
crisis without suffering a crash is to impose restrictions on the ability of people to buy and sell
foreign currency. These controls, however, create profit opportunities for people who discover
how to evade them, so over time controls lose effectiveness unless enforced by an intrusive
bureaucracy. Another way to end selling pressure is to obtain a loan to bolster the foreign
reserves of the monetary authority. Countries that wish to bolster their foreign reserves often ask
the IMF for loans. Althought the loan can help temporarily, it may just delay rather than end
selling pressure. The final way to end selling pressure is to restore confidence in the existing
exchange rate, such as by announcing appropriate, and credible changes in monetary policy.

2.9.2.

SOURCES OF CURRENCY CRISIS

1) Budget Deficits: One source for a currency crisis is budget deficits financed by inflation.
If the government cannot easily finance its budget deficits by raising taxes or borrowing,
it may pressure the central bank to finance them by creating money can increase the
supply of money faster than demand is growing, thus causing inflation. Budget deficits
financed by inflation seemed to capture the essential of many currency crisis up thought
the 1980s. By the 1990s, however, this explanation appeared to be lacking. During the
currency crisis in Europe in 192-193, budget deficits in most adversely affected countries
were small and sustainable. Moreover, most East Asian countries affected by the currency
crisis o 1997-1998 were running budget surpluses, and realizing strong economic growth
Economists have thus looked for other explanations of currency crisis
2) Weak Financial Systems: Currency crisis may also be caused by weak financial
systems. Weak banks can trigger speculative attacks if people think the central bank will
rescue the banks even at the cost of spending much of its foreign reserves to do so. The
118

explicit or implicit promise to rescue the banks is a form of moral hazard a situation in
which people do not pay the full cost of their own mistakes. A people become
apprehensive about eh future value of the local currency, they sell it to obtain more stable
foreign currencies.
Some of the major currency crises of the last 20 years have occurred in countries that had
recently deregulated their financial systems. Many governments formerly used financial
regulations to channel investment into politically favored outlets. In return, they restricted
competition among banks, life insurance companies, and the like. Profits from restricted
competition subsidized unprofitable government directed investments. Deregulation
altered the picture by reducing government direction of investments, and allowing more
competition among institutions. However, governments failed to ensure that in the new
environment of greater freedom to reap the rewards of success, financial institution also
bore greater responsibility for failure. Therefore, financial institutions made mistakes in
the unfamiliar environment of deregulation, failed, and were rescued at public expense.
This resulted in public fears about the future value of local currency and the selling of
local currency to obtain more stable foreign currencies.
A weak economy can trigger a currency crisis by creating doubt about the determination
of the government and the central bank to continue with the current monetary policy if
weakness continues. A weak economy is characterized by falling GDP growth per person,
a rising unemployment rate, a falling stock market, and falling export growth. If the
public expects the central bank to increase the money supply to stimulate the economy. It
may become apprehensive about eh future value of the local currency and begin selling it
on currency markets.
3) Political Factors: political factors can also cause currency crisis. Developing countries
have historically been more prone to currency crisis than developed countries because
they tend to have a weaker rule of law, governments more prone to being over-thrown by
force, central banks that are not politically independent, and other characteristics that
create political uncertainty about monetary policy.

2.9.3.

ASIAN CURRENCY CRISIS

With globalization, there has been a consistent rise in cross-border investment and increased
interdependency among the various economies in the world. A crisis in one part, however
small, is sure to have serious repercussions on other parts of the globe. The Asian financial
119

crisis began in July 1997 as a result of an exchange rate crisis in Thailand and spread almost
immediately to Malaysia, Indonesia, Philippines, and Korea. The crisis adversely affected
these countries and produced severe downturns in real economic activity. In fact, the SouthEast Asian economies were nire acutely affected by the crisis than the other countries in the
region such as Hong Kong, China, Singapore, and Taiwan (i.e., South Asian regions). The
South Asian countries experienced only a mild impact, i.e., a slower economic growth and
only a limited adverse effect from reduced international competitiveness.
The South-East Asian economies experienced currency and stock market depreciation and
the world capital flows also reduced as investors in the developed nations stayed away from
the disturbance in South-East Asia. For example, capital inflow into the South-East Asian
region was U.S. $35 billion in the first half of 1997 which reduced dramatically in the second
half of 1997 to a capital outflow of U.S. $50 billion.
Causes of the Asian Currency Crisis
It is important to find out why the crisis hit Asia in order for us to come-up with any cure for
the illness. There seem to be several factors causing and worsening the crisis in Asia. These
factors are as follows:
1) Currency Factors: There are obviously some currency factors. It is early to blame
currency speculators for a market-induced devaluation. However, it became clear already
by the end of 1996 that all of the Southeast Asian currencies were over-valued, as they
were pegged to the rapidly appreciating U.S. dollar against the Japanese yen and the
Chinese Yuan in 1995-96. In particular, the Thai baht which was first hit by speculation in
the current crisis had been almost completely pegged to the dollar for more than 10 years.
So, it was time for its devaluation anyway.
2) Financial Factors: These factors can explain why those Asian governments kept the
pegged exchange-rate regime so long and also why the markets reacted so drastically over-reacted in some cases. In the last several years, many of the Asian countries have
been trying to attract short-term capital money from abroad to finance growing credit
demand at home. This is the main reason why the governments were so reluctant to
devalue their currencies for the benefit of foreign investors, and were so willing to
liberalize their financial system without implementing reasonable rules and regulations
on financial institutions. As a result, their financial system as a whole became so
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vulnerable, and once it was attacked by speculators, there was a massive outflow of shortterm capital from the system, leading to the market over-reaction.
3) Macroeconomic, Fundamental Factors: With overly ambitious development targets
pursued by the governments, many of the Asian economies were over-heating with high
inflation rates and large trade deficits, contributing to heavy external borrowing and
currency over-valuation. Their stock and real estate values were inflated too much, and
ready to collapse at any moment. In any event, their growth expectations were too high,
and had to be adjusted to a sustainable level.
4) Political and Structural Factors: In the process of economic development in Asia,
many of the political leaders became de facto dictators, based on their antiquated
political systems with special privileges for their inner circle, and widespread corruption
in key government sectors. All this amounted to inflexibility in adjusting growth targets,
and in dealing with crisis situations; leading to the loss of market confidence in the whole
system. Therefore, new political leaders should emerge as a step towards necessary
structural reforms in Asia.
5) IMF Factor: Finally, one might add the IMF factor. While the IMF has extended its
assistance in an attempt to help ease the Asian crisis, and to restore some confidence in
the markets, there is much criticism of the IMFs remedies for the crisis. Especially, many
government officials in Asia alongwith some Western economists are critical of the
restrictive rules, and conditions attached to the IMFs aid packages; tight fiscal and
monetary policies, together with structural reforms, forced by the IMF, might well make
the already depressed economy even worse. Others insist that the IMF-led rescue
packages have bailed-out many investors and thereby prompted more risk-taking
behavior, leading to the worsening of the financial crisis in Asia.

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