Kinjal Mehta - Final Report

FOREX MARKETS IN INDIA
N L DALMIA INSTITUTE OF MANAGE MENT STUDIES AND

RESEARCH
A REPORT ON
“FOREX MARKE”S IN INDIA”
SUBMITTED IN PARTIAL FULFILLMENT FOR THE AWARD OF

“POST GRADUATE DIPLOMA IN BUSINESS MANAGEMENT”
UNDER THE GUIDANCE OF

MR. HARESH DESAI
DIRECTOR
A. V. RAJWADE AND COMPANY
SUBMITTED BY
KINJAL MEHTA
PGDM- FINANCE
SESSION 2008-2010
N.L.DALMIA INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

MIRA ROAD (E), MUMBAI-401104
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ACKNOWLEDGEMENT
Two months of summer training at A. V. Rajwade & Co. has been a great value addition to
my career that would not have been possible without continuous guidance and administration
of certain key people. I would like to place on record, my sincere gratitude to each of them.
I am grateful to Prof. P. L. Arya, Director, N L Dalmia Institute of Management Studies and

Research for giving me this opportunity.
I would like to express my appreciation towards Mr. Haresh Desai (Director – A V Rajwade
& Co) for giving me the opportunity to work on this project. I express my gratitude and
indebtedness to him for guiding me in every aspect for making this effort a great success.
I sincerely thank Prof. V. S. Date, N L Dalmia Institute of Management Studies and

Research for the valuable guidance extended by them during my entire course in the
preparation of this dissertation and for letting me their valuable time when ever I was in need.
KINJAL YASHWANT MEHTA

N. L. Dalmia Institute of Management Studies and Research
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Executive Summary
This project gives an in-depth analysis and understanding of Foreign Exchange Markets in
India. It helps to understand the History and the evolution of the foreign market in India.
It gives an overview of the conditions existing in the current global economy. It gives an
overview of the Foreign exchange market.
It talks about the foreign exchange management act applicable and also gives details about
the participants in the forex markets. It gives an insight about the foreign exchange rate
indices like NEER, REER, etc.
It also talks about what are the sources of demand and supply of foreign exchange in the
market all over the world.
The report also talks about the Foreign Exchange trading platform and how the efficiency and
the transparency is maintained.
The report focuses on corporate hedging for foreign exchange risk in India. The report
contains details about some companies Foreign Exposure and how they have maintained it.
It also talks about the determinants to be taken care of while taking corporate hedging
decisions. It gives insights about the Regulatory guidelines for the use of Foreign Exchange
derivatives, Development of Derivatives markets in India and also the Hedging instruments
for Indian firms.
The report gives an in-depth analysis of the currency risk management by talking about what
currency risk is, the types of currency risk – Transaction risk ,Translation risk and Economic
risk. It also contains details about the companies in the index sensex and nifty showing their
transaction is foreign currency like the imports, exports, Loans, Interst payments and the
other expenses. It then shows the sensitivity analysis of how the currency rates impact the
gains/ profits of the company.
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TABLE OF CONTENTS:
Sr.
No. Topic Page No
1 Overview: Investors ponder depth and duration of global downturn 4
2 Foreign Exchange Market Overview 9
3 Forex Market: A Historical Perspective 14
4 Foreign Exchange Management Act, 1999 19
5 Participants in foreign exchange market 20
6 Exchange rate System 23
7 Foreign Exchange Market Structure 26
8 Fundamentals in Exchange Rate 28
9 Exchange Rate Indices 31
10 Sources of Supply and Demand in the Foreign exchange 39
11 Foreign Exchange Market Trading Platform 44
12 Corporate Hedging for Foreign Exchange Risk in India 46
13 Determinants of Hedging Decisions 58
14 An Overview of Corporate Hedging in India 61
15 Currency Risk Management 68
16 Core Principles of Managing Currency Risk 77
Overview: Investors ponder depth and duration of global

downturn
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Uncertainty about the depth and duration of the economic contraction continued to roil
financial markets over the period between end-November 2008 and 20 February 2009. Credit
markets generally remained under pressure from weak economic data and earnings reports
and the resulting expectations of rising defaults. Pressures were particularly evident in the
renewed widening of non-investment grade spreads. Cyclical deterioration also drove the
worsening of equity prices, particularly in Japan. At the same time, policy measures aimed at
stabilizing markets appeared to gain traction over the period. In money markets, central bank
actions and government guarantees helped to calm interbank markets and spreads between
Libor and overnight index swaps (OIS) continued to decline gradually.
Facilities that included outright purchases of agency mortgage- and other asset-backed
securities contributed to signs of normalization in mortgage markets, while funding facilities
and government guarantees of financial sector issues provided a helping hand to primary debt
markets, where activity surged to record levels in January. To be sure, policy measures
backstopping debt claims on banks were generally not perceived as positive for financial
shares, and financial sector concerns continued to lead overall equity market losses in the
United States and Europe. Meanwhile, the lack of detail on key support packages, among
other factors, contributed to elevated levels of implied volatility as well as to price/earnings
ratios which were extremely low by the standards of the past two decades.
Uncertainties about the severity of the financial crisis and the economic downturn exerted
further downward pressure on government bond yields, though mounting concerns over
increased issuance limited overall declines in yield during the period under review. At the
same time, segments of the bond market were still showing clear signs of being affected by
factors other than expectations about economic fundamentals and policy actions. Although
emerging markets generally had little direct exposure to the distressed asset problem plaguing
major industrial economies and managed to weather the most acute phase of the financial
crisis in late 2008 relatively well, they were much less immune to the deepening recession in
the advanced industrial world. Plunging exports and GDP growth bore clear evidence of the
severity and synchronicity of the global economic downturn, which was reflected in
declining asset prices, particularly in emerging Europe.
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Rupee Dollar Exchange

January 2004 to July 20
55
50
45
40
Rupee/Pound Exchange
35
90
30
85
Apr-04
Oct-04
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Jan-05
Jul-05
Jan-04
Jul-04
Jan-06
Jul-06
Jan-07
80
75
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Rupee/Japanese Yen (100) Exch

60
55
50
45
Rupee/Euro Exchange R
40
70
35
68
66
30
64
Apr-04
Oct-04
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Jan-05
Jul-05
Jan-04
Jul-04
Jan-06
Jul-06
Jan-07
62
60
58
56
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Managing Currency Risk – The Investor: Currency Exposure

within the Investment Decision
Investors and corporations face similar types of risk on foreign currency exposure. For
instance, investors face transaction risk when they invest abroad. They also face translation
risk on assets and liabilities if they spread their operations overseas. For its part, the corporate
sector clearly seems to have moved to a view that currency risk is an unavoidable issue that
has to be managed independently from the underlying business.
On the face of it, this chapter may seem targeted at only those who manage currency risk on
an active basis. This is not the case. Rather, it is aimed at any institutional investor who faces
in the course of their “underlying business” exposure to a foreign currency, whether or not
they are in fact allowed to carry out some of the ideas and strategies presented herein. Let us
start then with two core principles on the issue of currency risk:
1. Investing in a country is not the same as investing in that country’s currency
2. Currency is not the same as cash; the incentive for currency investment is primarily capital
gain rather than income.
The dynamics that drive a currency are not the same as those that drive asset markets
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Foreign Exchange Market Overview
Globally, operations in the foreign exchange market started in a major way after the
breakdown of the Bretton Woods system in 1971, which also marked the beginning of
floating exchange rate regimes in several countries. Over the years, the foreign exchange
market has emerged as the largest market in the world. The decade of the 1990s witnessed a
perceptible policy shift in many emerging markets towards reorientation of their financial
markets in terms of new products and instruments, development of institutional and market
infrastructure and realignment of regulatory structure consistent with the liberalized
operational framework. The changing contours were mirrored in a rapid expansion of foreign
exchange market in terms of participants, transaction volumes, decline in transaction costs
and more efficient mechanisms of risk transfer.
The origin of the foreign exchange market in India could be traced to the year 1978 when
banks in India were permitted to undertake intra-day trade in foreign exchange. However, it
was in the 1990s that the Indian foreign exchange market witnessed far reaching changes
along with the shifts in the currency regime in India. The exchange rate of the rupee, that was
pegged earlier was floated partially in March 1992 and fully in March 1993 following the
recommendations of the Report of the High Level Committee on Balance of Payments
(Chairman: Dr.C. Rangarajan). The unification of the exchange rate was instrumental in
developing a market-determined exchange rate of the rupee and an important step in the
progress towards current account convertibility, which was achieved in August 1994. 6.3 A
further impetus to the development of the foreign exchange market in India was provided
with the setting up of an Expert Group on Foreign Exchange Markets in India (Chairman:
Shri O.P. Sodhani), which submitted its report in June 1995. The Group made several
recommendations for deepening and widening of the Indian foreign exchange market.
Consequently, beginning from January 1996, wide-ranging reforms have been undertaken in
the Indian foreign exchange market. After almost a decade, an Internal Technical Group on
the Foreign Exchange Market (2005) was constituted to undertake a comprehensive review of
the measures initiated by the Reserve Bank and identify areas for further liberalization or
relaxation of restrictions in a medium-term framework.
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The momentous developments over the past few years are reflected in the enhanced risk-
bearing capacity of banks along with rising foreign exchange trading volumes and finer
margins. The foreign exchange market has acquired depth (Reddy, 2005). The conditions in
the foreign exchange market have also generally remained orderly (Reddy, 2006c). While it
is not possible for any country to remain completely unaffected by developments in
international markets, India was able to keep the spillover effect of the Asian crisis to a
minimum through constant monitoring and timely action, including recourse to strong
monetary measures, when necessary, to prevent emergence of self fulfilling speculative
activities
In today’s world no economy is self sufficient, so there is need for exchange of goods and
services amongst the different countries. So in this global village, unlike in the primitive age
the exchange of goods and services is no longer carried out on barter basis. Every sovereign
country in the world has a currency that is legal tender in its territory and this currency does
not act as money outside its boundaries. So whenever a country buys or sells goods and
services from or to another country, the residents of two countries have to exchange
currencies. So we can imagine that if all countries have the same currency then there is no
need for foreign exchange.
Need for Foreign Exchange:

Let us consider a case where Indian company exports cotton fabrics to USA and invoices the
goods in US dollar. The American importer will pay the amount in US dollar, as the same is
his home currency. However the Indian exporter requires rupees means his home currency
for procuring raw materials and for payment to the labor charges etc. Thus he would need
exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then
importer in USA will get his dollar converted in rupee and pay the exporter. From the above
example we can infer that in case goods are bought or sold outside the country, exchange of
currency is necessary. Sometimes it also happens that the transactions between two countries
will be settled in the currency of third country. In that case both the countries that are
transacting will require converting their respective currencies in the currency of third
country. For that also the foreign exchange is required.
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About foreign exchange market:

Particularly for foreign exchange market there is no market place called the foreign exchange
market. It is mechanism through which one country’s currency can be exchange i.e. bought
or sold for the currency of another country. The foreign exchange market does not have any
geographic location. Foreign exchange market is described as an OTC (over the counter)
market as there is no physical place where the participant meets to execute the deals, as we
see in the case of stock exchange. The largest foreign exchange market is in London,
followed by the New York, Tokyo, Zurich and Frankfurt. The markets are situated
throughout the different time zone of the globe in such a way that one market is closing the
other is beginning its operation. Therefore it is stated that foreign exchange market is
functioning throughout 24 hours a day. In most market US dollar is the vehicle currency, viz.,
the currency sued to dominate international transaction. In India, foreign exchange has been
given a statutory definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states:
Foreign exchange means foreign currency and includes:
All deposits, credits and balance payable in any foreign currency and any draft,
traveler’s cheques, letter of credit and bills of exchange. Expressed or drawn in India
currency but payable in any foreign currency.
Any instrument payable, at the option of drawee or holder thereof or any other party thereto,
either in Indian currency or in foreign currency or partly in one and partly in the other. In
order to provide facilities to members of the public and foreigners visiting India, for
exchange of foreign currency into Indian currency and vice-versa RBI has granted to various
firms and individuals, license to undertake money-changing business at seas/airport and
tourism place of tourist interest in India. Besides certain authorized dealers in foreign
exchange (banks) have also been permitted to open exchange bureaus. Following are the
major bifurcations:
Full fledge moneychangers – they are the firms and individuals who have been authorized
to take both, purchase and sale transaction with the public.
Restricted moneychanger – they are shops, emporia and hotels etc. that have been
authorized only to purchase foreign currency towards cost of goods supplied or services
rendered by them or for conversion into rupees.
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Authorized dealers – they are one who can undertake all types of foreign exchange
transaction. Banks are only the authorized dealers. The only exceptions are Thomas cook,
western union, UAE exchange which though, and not a bank is an AD. Even among the
banks RBI has categorized them as follows:
Branch A – They are the branches that have Nostro and Vostro account.
Branch B – The branch that can deal in all other transaction but do not maintain Nostro and
Vostro a/c’s fall under this category. For Indian we can conclude that foreign exchange refers
to foreign money, which includes notes, cheques, bills of exchange, bank balance and
deposits in foreign currencies.
Foreign Exchange Market: An Assessment

The continuous improvement in market infrastructure has had its impact in terms of enhanced
depth, liquidity and efficiency of the foreign exchange market. The turnover in the Indian
foreign exchange market has grown significantly in both the spot and derivatives segments in
the recent past. Along with the increase in onshore turnover, activity in the offshore market
has also assumed importance. With the gradual opening up of the capital account, the process
of price discovery in the Indian foreign exchange market has improved as reflected in the
bid-ask spread and forward premia behaviour.
Foreign Exchange Market Turnover

As per the Triennial Central Bank Survey by the Bank for International Settlements (BIS) on
“Foreign Exchange and Derivatives Market Activity”, global foreign exchange market
activity rose markedly between 2001 and 2004 (Table 6.4). The strong growth in turnover
may be attributed to two related factors. First, the presence of clear trends and higher
volatility in foreign exchange markets between 2001 and 2004 led to trading momentum,
where investors took large positions in currencies that followed persistent appreciating
trends. Second, positive interest rate differentials encouraged the so-called “carry trading”,
i.e., investments in high interest rate currencies financed by positions in low interest rate
currencies. The growth in outright forwards between 2001 and 2004 reflects heightened
interest in hedging. Within the EM countries, traditional foreign exchange trading in Asian
currencies generally recorded much faster growth than the global total between 2001 and
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2004. Growth rates in turnover for Chinese renminbi, Indian rupee, Indonesian rupiah,
Korean won and new Taiwanese dollar exceeded 100 per cent between April 2001 and April
2004 (Table 6.5). Despite significant growth in the foreign exchange market turnover, the
share of most of the EMEs in total global turnover, however, continued to remain low.
The Indian foreign exchange market has grown manifold over the last several years. The
daily average turnover impressed a substantial pick up from about US $ 5 billion during
1997-98 to US $ 18 billion during 2005-06. The turnover has risen considerably to US $ 23
billion during 2006-07 (up to February 2007) with the daily turnover crossing US $ 35 billion
on certain days during October and November 2006. The inter-bank to merchant turnover
ratio has halved from 5.2 during 1997-98 to 2.6 during 2005-06, reflecting the growing
participation in the merchant segment of the foreign exchange market (Table 6.6 and Chart
VI.2). Mumbai alone accounts for almost 80 per cent of the foreign exchange turnover.
6.60 Turnover in the foreign exchange market was 6.6 times of the size of India’s balance of
payments during 2005-06 as compared with 5.4 times in 2000-01 (Table 6.7). With the
deepening of the foreign exchange market and increased turnover, income of commercial
banks through treasury operations has increased considerably. Profit from foreign exchange
transactions accounted for more than 20 per cent of total profits of the scheduled commercial
banks during 2004-05 and 2005-06
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Forex Market: A Historical Perspective
Early Stages: 1947-1977

The evolution of India’s foreign exchange market may be viewed in line with the shifts in
India’s exchange rate policies over the last few decades from a par value system to a basket-
peg and further to a managed float exchange rate system. During the period from 1947 to
1971, India followed the par value system of exchange rate. Initially the rupee’s external par
value was fixed at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the
rupee within the permitted margin of ±1 per cent using pound sterling as the intervention
currency. Since the sterling-dollar exchange rate was kept stable by the US monetary
authority, the exchange rates of rupee in terms of gold as well as the dollar and other
currencies were indirectly kept stable. The devaluation of rupee in September 1949 and June
1966 in terms of gold resulted in the reduction of the par value of rupee in terms of gold to
2.88 and 1.83 grains of fine gold, respectively. The exchange rate of the rupee remained
unchanged between 1966 and 1971 (Chart VI.1).
Given the fixed exchange regime during this period, the foreign exchange market for all
practical purposes was defunct. Banks were required to undertake only cover operations and
maintain a ‘square’ or ‘near square’ position at all times. The objective of exchange controls
was primarily to regulate the demand for foreign exchange for various purposes, within the
limit set by the available supply. The Foreign Exchange Regulation Act initially enacted in
1947 was placed on a permanent basisin 1957. In terms of the provisions of the Act, the
Reserve Bank, and in certain cases, the Central Government controlled and regulated the
dealings in foreign exchange payments outside India, export and import of currency notes
and bullion, transfers of securities between residents and non-residents, acquisition of foreign
securities, etc3 .
With the breakdown of the Bretton Woods System in 1971 and the floatation of major
currencies, the conduct of exchange rate policy posed a serious challenge to all central banks
world wide as currency fluctuations opened up tremendous opportunities for market players
to trade in currencies in a borderless market. In December 1971, the rupee was linked with
pound sterling. Since sterling was fixed in terms of US dollar under the Smithsonian
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Agreement of 1971, the rupee also remained stable against dollar. In order to overcome the
weaknesses associated with a single currency peg and to ensure stability of the exchange rate,
the rupee, with effect from September 1975, was pegged to a basket of currencies. The
currency selection and weights assigned were left to the discretion of the Reserve Bank. The
currencies included in the basket as well as their relative weights were kept confidential in
order to discourage speculation. It was around this time that banks in India became interested
in trading in foreign exchange
Formative Period: 1978-1992

The impetus to trading in the foreign exchange market in India came in 1978 when banks in
India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange
and were required to comply with the stipulation of maintaining ‘square’ or ‘near square’
position only at the close of business hours each day. The extent of position which could be
left uncovered overnight (the open position) as well as the limits up to which dealers could
trade during the day were to be decided by the management of banks. The exchange rate of
the rupee during this period was officially determined by the Reserve Bank in terms of a
weighted basket of currencies of India’s major trading partners and the exchange rate regime
was characterised by daily announcement by the Reserve Bank of its buying and selling rates
to the Authorised Dealers (ADs) for undertaking merchant transactions. The spread between
the buying and the selling rates was 0.5 per cent and the market began to trade actively within
this range. ADs were also permitted to trade in cross currencies (one convertible foreign
currency versus another). However, no ‘position’ in this regard could originate in overseas
markets.
As opportunities to make profits began to emerge, major banks in India started quoting two
way prices against the rupee as well as in cross currencies and, gradually, trading volumes
began to increase. This led to the adoption of widely different practices (some of them being
irregular) and the need was felt for a comprehensive set of guidelines for operation of banks
engaged in foreign exchange business. Accordingly, the ‘Guidelines for Internal Control over
Foreign Exchange Business’, were framed for adoption by the banks in 1981. The foreign
exchange market in India till the early 1990s, however, remained highly regulated with
restrictions on external transactions, barriers to entry, low liquidity and high transaction
costs. The exchange rate during this period was managed mainly for facilitating India’s
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imports. The strict control on foreign exchange transactions through the Foreign Exchange
Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets
for foreign exchange in the world, i.e., the hawala (unofficial) market.
By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and
structural factors had contributed to balance of payments difficulties. Devaluations by India’s
competitors had aggravated the situation. Although exports had recorded a higher growth
during the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8
per cent of GDP in 1990-91), trade imbalances persisted at around 3 percent of GDP. This
combined with a precipitous fall in invisible receipts in the form of private remittances, travel
and tourism earnings in the year 1990-91 led to further widening of current account deficit.
The weaknesses in the external sector were accentuated by the Gulf crisis of 1990-91. As a
result, the current account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital
flows also dried up necessitating the adoption of exceptional corrective steps. It was against
this backdrop that India embarked on stabilisation and structural reforms in the early 1990s.
Post-Reform Period: 1992 onwards

This phase was marked by wide ranging reform measures aimed at widening and deepening
the foreign exchange market and liberalisation of exchange control regimes. A credible
macroeconomic, structural and stabilization programme encompassing trade, industry,
foreign investment, exchange rate, public finance and the financial sector was put in place
creating an environment conducive for the expansion of trade and investment. It was
recognised that trade policies, exchange rate policies and industrial policies should form part
of an integrated policy framework to improve the overall productivity, competitiveness and
efficiency of the economic system, in general, and the external sector, in particular. As a
stabilsation measure, a two step downward exchange rate adjustment by 9 per cent and 11 per
cent between July 1 and 3, 1991 was resorted to counter the massive drawdown in the foreign
exchange reserves, to instill confidence among investors and to improve domestic
competitiveness. A two-step adjustment of exchange rate in July 1991 effectively brought to
close the regime of a pegged exchange rate. After the Gulf crisis in 1990-91, the broad
framework for reforms in the external sector was laid out in the Report of the High Level
Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). Following the
recommendations of the Committee to move towards the market-determined exchange rate,
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the Liberalised Exchange Rate Management System (LERMS) was put in place in March
1992 initially involving a dual exchange rate system. Under the LERMS, all foreign
exchange receipts on current account transactions (exports, remittances, etc.) were required to
be surrendered to the Authorised Dealers (ADs) in full. The rate of exchange for conversion
of 60 per cent of the proceeds of these transactions was the market rate quoted by the ADs,
while the remaining 40 percent of the proceeds were converted at the Reserve Bank’s official
rate. The ADs, in turn, were required to surrender these 40 per cent of their purchase of
foreign currencies to the Reserve Bank. They were free to retain the balance 60 per cent of
foreign exchange for selling in the free market for permissible transactions. The LERMS was
essentially a transitional mechanism and a downward adjustment in the official exchange rate
took place in early December 1992 and ultimate convergence of the dual rates was made
effective from March 1, 1993, leading to the introduction of a market-determined exchange
rate regime.
The dual exchange rate system was replaced by a unified exchange rate system in March
1993, whereby all foreign exchange receipts could be converted at market determined
exchange rates. On unification of the exchange rates, the nominal exchange rate of the rupee
against both the US dollar as also against a basket of currencies got adjusted lower, which
almost nullified the impact of the previous inflation differential. The restrictions on a number
of other current account transactions were relaxed. The unification of the exchange rate of the
Indian rupee was an important step towards current account convertibility, which was finally
achieved in August 1994, when India accepted obligations under Article VIII of the Articles
of Agreement of the IMF.
With the rupee becoming fully convertible on all current account transactions, the risk-
bearing capacity of banks increased and foreign exchange trading volumes started rising.
This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in
conjunction with the Government to remove market distortions and deepen the foreign
exchange market. The process has been marked by ‘gradualism’ with measures being
undertaken after extensive consultations with experts and market participants. The reform
phase began with the Sodhani Committee (1994) which in its report submitted in 1995 made
several recommendations to relax the regulations with a view to vitalising the foreign
exchange market.
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In addition, several initiatives aimed at dismantling controls and providing an enabling

environment to all entities engaged in foreign exchange transactions have been undertaken
since the mid-1990s. The focus has been on developing the institutional framework and
increasing the instruments for effective functioning, enhancing transparency and liberalising
the conduct of foreign exchange business so as to move away from micro management of
foreign exchange transactions to macro management of foreign exchange flows (Box VI.3).
An Internal Technical Group on the Foreign Exchange Markets (2005) set up by the Reserve
Bank made various recommendations for further liberalisation of the extant regulations.
Some of the recommendations such as freedom to cancel and rebook forward contracts of any
tenor, delegation of powers to ADs for grant of permission to corporates to hedge their
exposure to commodity price risk in the international commodity exchanges/markets and
extension of the trading hours of the inter-bank foreign exchange market have since been
implemented.
Along with these specific measures aimed at developing the foreign exchange market,
measures towards liberalising the capital account were also implemented during the last
decade, guided to a large extent since 1997 by the Report of the Committee on Capital
Account Convertibility (Chairman: Shri S.S. Tarapore). Various reform measures since the
early 1990s have had a profound effect on the market structure, depth, liquidity and
efficiency of the Indian foreign exchange market.
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Foreign Exchange Management Act, 1999
The change in the entire approach towards exchange control regulation has been the result of
the replacement of the Foreign Exchange Regulation Act, 1973, by the Foreign Exchange
Management Act, 1999. The latter came into effect from June 1, 2000. The change in the
preamble itself signifies the dramatic change in approach -- from "for the conservation of the
foreign exchange resources" in FERA 1973, to "facilitate external trade and payments"
under FEMA 1999. Any FEMA violations are civil, not criminal, offences, attracting
monetary penalties, and not arrests or imprisonment.
The scheme of FEMA and the notifications issued thereunder take into the account the
convertibility of the rupee for all current account transactions. Indeed, there is now general
freedom to authorised dealers to sell currency for most current account transactions. One old
limitation continues. All transactions in foreign exchange have to be with authorised dealers,
i.e. banks authorised to act as dealers in foreign exchange by the Reserve Bank. The original
rules, regulations, notifications, etc., under FEMA are contained in the A.D. (M.A. series)
Circular No. 11 of May 16, 2000. Subsequent circulars have been issued under the A.P. (DIR
series) nomenclature. It is obviously impossible to incorporate all the current regulations in a
book of this type, particularly since the regulations keep changing. An outline of the basic
framework of exchange control under FEMA is in Annexure 5.3. But its contents should not
be considered as either definitive or current and those interested need to keep up with the
various circulars and other communications on the subject.
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Participants in foreign exchange market
Market Players
Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in
foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers
– individuals, corporates, who need foreign exchange for their transactions. Though
customers are major players in the foreign exchange market, for all practical purposes they
depend upon ADs and brokers. In the spot foreign exchange market, foreign exchange
transactions were earlier dominated by brokers. Nevertheless, the situation has changed with
the evolving market conditions, as now the transactions are dominated by ADs. Brokers
continue to dominate the derivatives market.
The Reserve Bank intervenes in the market essentially to ensure orderly market conditions.
The Reserve Bank undertakes sales/purchases of foreign currency in periods of excess
demand/supply in the market. Foreign Exchange Dealers’ Association of India (FEDAI)
plays a special role in the foreign exchange market for ensuring smooth and speedy growth of
the foreign exchange market in all its aspects. All ADs are required to become members of
the FEDAI and execute an undertaking to the effect that they would abide by the terms and
condition stipulated by the FEDAI for transacting foreign exchange business. The FEDAI is
also the accrediting authority for the foreign exchange brokers in the interbank foreign
exchange market.
The licences for ADs are issued to banks and other institutions, on their request, under
Section 10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided into
different categories. All scheduled commercial banks, which include public sector banks,
private sector banks and foreign banks operating in India, belong to category I of ADs. All
upgraded full fledged money changers (FFMCs) and select regional rural banks (RRBs) and
co-operative banks belong to category II of ADs. Select financial institutions such as EXIM
Bank belong to category III of ADs. Currently, there are 86 (Category I) Ads operating in
India out of which five are co-operative banks (Table 6.3). All merchant transactions in the
foreign exchange market have to be necessarily undertaken directly through ADs. However,
to provide depth and liquidity to the inter-bank segment, Ads have been permitted to utilise
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the services of brokers for better price discovery in their inter-bank transactions. In order to
further increase the size of the foreign exchange market and enable it to handle large flows, it
is generally felt that more ADs should be encouraged to participate in the market making.
The number of participants who can give two-way quotes also needs to be increased.
The customer segment of the foreign exchange market comprises major public sector units,
corporates and business entities with foreign exchange exposure. It is generally dominated by
select large public sector units such as Indian Oil Corporation, ONGC, BHEL, SAIL, Maruti
Udyog and also the Government of India (for defence and civil debt service) as also big
private sector corporates like Reliance Group, Tata Group and Larsen and Toubro, among
others. In recent years, foreign institutional investors (FIIs) have emerged as major players in
the foreign exchange market.
The main players in foreign exchange market are as follows:
1. Customers:
The customers who are engaged in foreign trade participate in foreign exchange market by
availing of the services of banks. Exporters require converting the dollars in to rupee and
importers require converting rupee in to the dollars, as they have to pay in dollars for the
goods/services they have imported.
2. Commercial Bank:
They are most active players in the forex market. Commercial bank dealings with
international transaction offer services for conversion of one currency in to another. They
have wide network of branches. Typically banks buy foreign exchange from exporters and
sells foreign exchange to the importers of goods. As every time the foreign exchange bought
or oversold position. The balance amount is sold or bought from the market.
3. Central Bank:
In all countries Central bank have been charged with the responsibility of maintaining the
external value of the domestic currency. Generally this is achieved by the intervention of the
bank.
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4. Exchange Brokers:
Forex brokers play very important role in the foreign exchange market. However the extent
to which services of foreign brokers are utilized depends on the tradition and practice
prevailing at a particular forex market center. In India as per FEDAI guideline the Ads are
free to deal directly among themselves without going through brokers. The brokers are not
among to allowed to deal in their own account allover the world and also in India.
5. Overseas Forex Market:

Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The
international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of
trading in world forex market is constituted of financial transaction and speculation. As we
know that the forex market is 24-hour market, the day begins with Tokyo and thereafter
Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York,
Sydney, and back to Tokyo.
6. Speculators:
The speculators are the major players in the forex market. Bank dealing are the major
speculators in the forex market with a view to make profit on account of favorable movement
in exchange rate, take position i.e. if they feel that rate of particular currency is likely to go
up in short term. They buy that currency and sell it as soon as they are able to make quick
profit.
Corporation’s particularly multinational corporation and transnational corporation having

business operation beyond their national frontiers and on account of their cash flows being
large and in multi currencies get in to foreign exchange exposures. With a view to make
advantage of exchange rate movement in their favor they either delay covering exposures or
do not cover until cash flow materialize.
Individual like share dealing also undertake the activity of buying and selling of foreign
exchange for booking short term profits. They also buy foreign currency stocks, bonds and
other assets without covering the foreign exchange exposure risk. This also results in
speculations.
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Exchange rate System
Countries of the world have been exchanging goods and services amongst themselves. This
has been going on from time immemorial. The world has come a long way from the days of
barter trade. With the invention of money the figures and problems of barter trade have
disappeared. The barter trade has given way ton exchanged of goods and services for
currencies instead of goods and services. The rupee was historically linked with pound
sterling. India was a founder member of the IMF. During the existence of the fixed exchange
rate system, the intervention currency of the Reserve Bank of India (RBI) was the British
pound, the RBI ensured maintenance of the exchange rate by selling and buying pound
against rupees at fixed rates. The inter bank rate therefore ruled the RBI band. During the
fixed exchange rate era, there was only one major change in the parity of the rupee-
devaluation in June 1966. Different countries have adopted different exchange rate system at
different time.
The following are some of the exchange rate system followed by various countries.
The Gold Standard

Many countries have adopted gold standard as their monetary system during the last two
decades of the 19he century. This system was in vogue till the outbreak of World War 1.
Under this system the parties of currencies were fixed in term of gold. There were two main
types of gold standard:
1) Gold specie standard

Gold was recognized as means of international settlement for receipts and payments amongst
countries. Gold coins were an accepted mode of payment and medium of exchange in
domestic market also. A country was stated to be on gold standard if the following condition
were satisfied:
• Monetary authority, generally the central bank of the country, guaranteed to buy and
sell gold in unrestricted amounts at the fixed price.
• Melting gold including gold coins, and putting it to different uses was freely allowed.
• Import and export of gold was freely allowed.
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The total money supply in the country was determined by the quantum of gold available for
monetary purpose.
2) Gold Bullion Standard:

Under this system, the money in circulation was either partly of entirely paper and gold
served as reserve asset for the money supply. However, paper money could be exchanged for
gold at any time. The exchange rate varied depending upon the gold content of currencies.
This was also known as “ Mint Parity Theory “ of exchange rates. The gold bullion standard
prevailed from about 1870 until 1914, and intermittently thereafter until 1944. World War I
brought an end to the gold standard.
Bretton Woods System

During the world wars, economies of almost all the countries suffered. In order to correct the
balance of payments disequilibrium, many countries devalued their currencies. Consequently,
the international trade suffered a deathblow. In 1944, following World War II, the United
States and most of its allies ratified the Bretton Woods Agreement, which set up an
adjustable parity exchange-rate system under which exchange rates were fixed (Pegged)
within narrow intervention limits (pegs) by the United States and foreign central banks
buying and selling foreign currencies. This agreement, fostered by a new spirit of
international cooperation, was in response to financial chaos that had reigned before and
during the war. In addition to setting up fixed exchange parities (par values) of currencies in
relationship to gold, the agreement established the International Monetary Fund (IMF) to act
as the “custodian” of the system. Under this system there were uncontrollable capital flows,
which lead to major countries suspending their obligation to intervene in the market and the
Bretton Wood System, with its fixed parities, was effectively buried. Thus, the world
economy has been living through an era of floating exchange rates since the early 1970.
Floating Rate System

In a truly floating exchange rate regime, the relative prices of currencies are decided entirely
by the market forces of demand and supply. There is no attempt by the authorities to
influence exchange rate. Where government interferes’ directly or through various monetary
and fiscal measures in determining the exchange rate, it is known as managed of dirty float.
PURCHASING POWER PARITY (PPP) Professor Gustav Cassel, a Swedish economist,
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introduced this system. The theory, to put in simple terms states that currencies are valued for
what they can buy and the currencies have no intrinsic value attached to it. Therefore, under
this theory the exchange rate was to be determined and the sole criterion being the purchasing
power of the countries. As per this theory if there were no trade controls, then the balance of
payments equilibrium would always be maintained. Thus if 150 INR buy a fountain pen and
the same fountain pen can be bought for USD 2, it can be inferred that since 2 USD or 150
INR can buy the same fountain pen, therefore USD 2 = INR 150.For example India has a
higher rate of inflation as compared to country US then goods produced in India would
become costlier as compared to goods produced in US. This would induce imports in India
and also the goods produced in India being costlier would lose in international competition to
goods produced in US. This decrease in exports of India as compared to exports from US
would lead to demand for the currency of US and excess supply of currency of India. This in
turn, cause currency of India to depreciate in comparison of currency of US that is having
relatively more exports.
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Foreign Exchange Market Structure
Market Segments
Foreign exchange market activity in most EMEs takes place onshore with many countries
prohibiting onshore entities from undertaking the operations in offshore markets for their
currencies. Spot market is the predominant form of foreign exchange market segment in
developing and emerging market countries. A common feature is the tendency of
importers/exporters and other end-users to look at exchange rate movements as a source of
return without adopting appropriate risk management practices. This, at times, creates uneven
supplydem and conditions, often based on ‘‘news and views’’. Though most of the emerging
market countries allow operations in the forward segment of the market, it is still
underdeveloped in most of these economies. The lack of forward market development
reflects many factors, including limited exchange rate flexibility, the de facto exchange rate
insurance provided by the central bank through interventions, absence of a yield curve on
which to base the forward prices and shallow money markets, in which market-making banks
can hedge the maturity risks implicit in forward positions (Canales-Kriljenko, 2004).
Most foreign exchange markets in developing countries are either pure dealer markets or a
combination of dealer and auction markets. In the dealer markets, some dealers become
market makers and play a central role in the determination of exchange rates in flexible
exchange rate regimes. Market makers set two-way exchange rates at which they are willing
to deal with other dealers. The bidoffer spread reflects many factors, including the level of
competition among market makers. In most of the EMEs, a code of conduct establishes the
principles that guide the operations of the dealers in the foreign exchange markets. It is the
central bank, or professional dealers association, which normally issues the code of conduct
(Canales-Kriljenko, 2004). In auction markets, an auctioneer or auction mechanism allocates
foreign exchange by matching supply and demand orders. In pure auction markets, order
imbalances are cleared only by exchange rate adjustments. Pure auction market structures
are, however, now rare and they generally prevail in combination with dealer markets.
The Indian foreign exchange market is a decentralised multiple dealership market comprising
two segments – the spot and the derivatives market. In the spot market, currencies are traded
at the prevailing rates and the settlement or value date is two business days ahead. The two-
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day period gives adequate time for the parties to send instructions to debit and credit the
appropriate bank accounts at home and abroad. The derivatives market encompasses
forwards, swaps and options. Though forward contracts exist for maturities up to one year,
majority of forward contracts are for one month, three months, or six months. Forward
contracts for longer periods are not as common because of the uncertainties involved and
related pricing issues. A swap transaction in the foreign exchange market is a combination of
a spot and a forward in the opposite direction. As in the case of other EMEs, the spot market
is the dominant segment of the Indian foreign exchange market. The derivative segment of
the foreign exchange market is assuming significance and the activity in this segment is
gradually rising.
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Fundamentals in Exchange Rate
Exchange rate is a rate at which one currency can be exchange in to another currency, say
USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice
versa.
Methods of Quoting Rate

There are two methods of quoting exchange rates.
1) Direct method:
Foreign currency is kept constant and home currency is kept variable. In direct quotation, the
principle adopted by bank is to buy at a lower price and sell at higher price.
2) Indirect method:
Home currency is kept constant and foreign currency is kept variable. Here the strategy used
by bank is to buy high and sell low. In India with effect from august 2, 1993, all the exchange
rates are quoted in direct method. It is customary in foreign exchange market to always quote
two rates means one for buying and another rate for selling. This helps in eliminating the risk
of being given bad rates i.e. if a party comes to know what the other party intends to do i.e.
buy or sell, the former can take the letter for a ride. There are two parties in an exchange deal
of currencies. To initiate the deal one party asks for quote from another party and other party
quotes a rate. The party asking for a quote is known as’ asking party and the party giving a
quotes is known as quoting party. The advantage of two–way quote is as under
• The market continuously makes available price for buyers or sellers
• Two way prices limit the profit margin of the quoting bank and comparison of
one quote with another quote can be done instantaneously.
• As it is not necessary any player in the market to indicate whether he intends
to buy or sale foreign currency, this ensures that the quoting bank cannot take
advantage by manipulating the prices.
• It automatically insures that alignment of rates with market rates.
• Two way quotes lend depth and liquidity to the market, which is so very
essential for efficient market. In two way quotes the first rate is the rate for
buying and another for selling.
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We should understand here that, in India the banks, which are authorized dealer, always,
quote rates. So the rates quoted- buying and selling is for banks point of view only. It means
that if exporters want to sell the dollars then the bank will buy the dollars from him so while
calculation the first rate will be used which is buying rate, as the bank is buying the dollars
from exporter. The same case will happen inversely with importer as he will buy dollars from
the bank and bank will sell dollars to importer.
Factors Affecting Exchange Rates

In free market, it is the demand and supply of the currency which should determine the
exchange rates but demand and supply is the dependent on many factors, which are
ultimately the cause of the exchange rate fluctuation, some times wild. The volatility of
exchange rates cannot be traced to the single reason and consequently, it becomes difficult to
precisely define the factors that affect exchange rates. However, the more important among
them are as follows:
• Strength of Economy
Economic factors affecting exchange rates include hedging activities, interest rates,
inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an American
economist, developed a theory relating exchange rates to interest rates. This proposition,
known as the fisher effect, states that interest rate differentials tend to reflect exchange rate
expectation. On the other hand, the purchasing- power parity theory relates exchange rates to
inflationary pressures. In its absolute version, this theory states that the equilibrium exchange
rate equals the ratio of domestic to foreign prices. The relative version of the theory relates
changes in the exchange rate to changes in price ratios.
• Political Factor
The political factor influencing exchange rates include the established monetary policy along
with government action on items such as the money supply, inflation, taxes, and deficit
financing. Active government intervention or manipulations, such as central bank activity in
the foreign currency market, also have an impact. Other political factors influencing
exchange rates include the political stability of a country and its relative economic exposure
(the perceived need for certain levels and types of imports). Finally, there is also the
influence of the international monetary fund.
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• Expectation of the Foreign Exchange Market

Psychological factors also influence exchange rates. These factors include market
anticipation, speculative pressures, and future expectations. A few financial experts are of the
opinion that in today’s environment, the only ‘trustworthy’ method of predicting exchange
rates by gut feel. Bob Eveling, vice president of financial markets at SG, is corporate
finance’s top foreign exchange forecaster for 1999. eveling’s gut feeling has, defined
convention, and his method proved uncannily accurate in foreign exchange forecasting in
1998.SG ended the corporate finance forecasting year with a 2.66% error overall, the most
accurate among 19 banks. The secret to eveling’s intuition on any currency is keeping abreast
of world events. Any event, from a declaration of war to a fainting political leader, can take
its toll on a currency’s value. Today, instead of formal modals, most forecasters rely on an
amalgam that is part economic fundamentals, part model and part judgment.
Fiscal policy
Interest rates
Monetary policy
Balance of payment
Exchange control
Central bank intervention
Speculation
Technical factors
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Exchange Rate Indices
Since the dawn of the floating exchange rate era, the terms "devaluation" or "upvaluation" of
a currency have lost much of their significance or meaning: a currency may depreciate
against some while simultaneously appreciating against others, that too by varying
percentages. It is, therefore, necessary to devise some measure, or index, to determine the ap-
preciation or depreciation of a currency from a base date, against foreign currencies as a
whole, i.e., the effective exchange rate of the currency in question. Various indices are in use
for the purpose. Some of the more important ones are described in subsequent paragraphs.
Nominal Effective Exchange Rate Index

The nominal effective exchange rate (NEER) index is based on "nominal", i.e., actual,
unadjusted exchange rates, existing during the base period (or date) and the comparison
period. Weights are given to each currency in such a way that the total of the weights is 1 (in
other words, the index is 1 in the base period/date), and the index is calculated by applying
the weights to the ratio of the exchange rates ruling during the comparison and base periods.
If arithmetic sum is to be used, the formula can be developed as follows. Let

n = the number of currencies against which the effective
rate is to be calculated;
Cib = nominal exchange rate with the i’th currency in the
base period;
Cic = nominal exchange rate with the i’th currency in the
comparison period; and
Wi = weight given to the i’th currency.
In that case,
W1 + W2 + W3........ + Wn = 1
Then, NEER = ((C1c/C1b)*W1) + ((C2c/C2b)*W2) + ..... + ((Cnc/Cnb) * (Wn)

And, NEER (Base Period) =1
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Note:
A. The base and the comparison periods could be specific dates. If periods are used, the
average rate for the period is considered; if dates, the closing rate on that date.
B. If direct rates (i.e. the value of one unit of foreign currency in domestic currency) are
used, an increase in the index denotes depreciation of the home currency, and vice versa for
indirect rates (i.e. the number of units of foreign currency equal to one unit of domestic
currency).
C. Again, if direct rates are used, the effective weight of the appreciating currency goes
up; under indirect rates, that of the depreciating currency goes up.
Thus the indices based on direct and indirect rates are not the inverse of each other. To
illustrate the arithmetic, let us work out the NEER index of the rupee with the following
assumed rate structure:
n=3
C1b 1.00 = Rs.20 (direct), or C1b 5.00 = Rs. 100 (indirect)
C1c 1.00 = Rs.25 (direct), or C1c 4.00 = Rs. 100 (indirect)
W1 = .30, W2 = .60, W3 = .10.

It will be noticed that, between the base and the comparison periods, the rupee has
depreciated against currencies C1 and C2, but has appreciated against currency C3.
Therefore, NEER index using direct rates

= ((25/20) x .30) + ((12/10) x .60) + ((4/5) x .10)
= 0.375 + 0.72 + 0.08 = 1. 175
NEER index using indirect rates
= ((4/5) x .30) + ((8.33/10) x .60) + ((25/20) x .10)
= 0.24 + 0.4998 + 0.125 = 0.8648
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Note that 1.175 is not equal to 1/0.8648.

Also consider how the effective weights have changed
Currency C1 C2 C3
Original % 30 60 10
NEER direct % 31.9 61.3 6.8
NEER indirect % 27.8 57.8 14.4
To avoid the distortion in weights, it is common to use weighted geometric means, rather
than weighted (arithmetic) averages. In that case, the formula becomes
NEER = ((C1c/C1b)^W1) x ... x ((Cnc/Cnb)^Wn)
Let us calculate the geometric mean using the same data.
A. Direct rates
NEER Index = ((25/20)^0.3) x ((12/10)^0.6) x ((4/5)^0.1)
= 1.0692 x 1.1156 x 0.9779 = 1.1665
B. Indirect rates
NEER Index = ((4/5)^0.3) x ((8.33/10)^0.6) x ((25/20)^0.1)
= 0.9352 x 0.8962 x 1.0225 = 0.8570
And, 1.1665 is equal to 1/0.8570
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Trade Weighted Exchange Rate Index

We now turn to discussing the weights to be used. The most common and simple basis is
trade (hence, trade-weighted exchange rate, or TWER, index). Thus, the weight to be given
to say the dollar in the rupee TWER index would reflect the proportion of our trade with
United States as compared to our total trade. If our trade with the United States is say
Rs.70,000 crores a year, and our total trade is Rs.280,000 crores, the dollar's weight will be
25%. Again, as a rule, the currencies of all the countries we trade with may not be used in
calculating the index. For instance, we may choose to ignore currencies of countries whose
trade with us is less than say 1% of our total trade. In that case, the weights will need to be
reworked on the basis of the trade with countries included in the index calculation. For ex-
ample, in the illustration cited above, if trade with countries not to be included is say
Rs.20,000 crores, the dollar weight will be (70/260 x 100)% or 26.92%.
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It is also useful to calculate separately the export TWER and import TWER indices, using
weights based on exports and imports. Some analysts use direct rates and arithmetic means to
calculate the import index, and indirect rates and arithmetic means for the export index. The
composite index then becomes
((Exp Index) x (Exp volume)) + ((Imp Index) x (Imp volume))
Total trade (Exports + Imports)
It is customary to use 100, instead of 1, as the base (the calculations remain the same as
above except that the result is multiplied by 100), and to indicate depreciation through
lowering of the index (i.e., if direct rates are used, inverse the result before multiplying by
100).
So calculated, the nominal TWER index is an indicator of the appreciation, or depreciation,

of the home currency against the currencies of our trading partners taken together. However,
as a measure of competitiveness of our exports or imports, it suffers from two major
disabilities:
A. It does not give due weightage to the exchange rates of our competitors in third
countries; and
B. The difference in inflation rates is ignored.
To illustrate the first point, let us consider that our exports to, say, Sri Lanka are negligible
and therefore that country's currency is not included in our export TWER index. However,
Sri Lankan tea exports compete with our tea exports in world markets. If the Sri Lankan cur-
rency has depreciated more than the Indian rupee, Sri Lanka gets a competitive edge over us,
which is not reflected in our export TWER index.
To make the index a better indicator of price competitiveness, the International Monetary
Fund has developed a weighting model known as the Multilateral Exchange Rate Model
(MERM). This is a highly complex model and has not so far been used in India.
Real Effective Exchange Rate

The second weakness of the NEER index as an indicator of international price
competitiveness is that it does not take account of inflation. The classical purchasing power
parity theory of exchange rates (PPP) postulates that exchange rates must move to
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compensate for inflation differentials, if international price competitiveness is to be

maintained. In other words, if our inflation rate is 20%a year, and that in the United States
10%, the rupee should depreciate by 10% against the dollar to compensate for the higher
domestic costs.
The real effective exchange rate index (REER) therefore uses "real" exchange rates, i.e.,
nominal rates adjusted for relative inflation, to calculate the index. For example, if a dollar
was worth Rs.40.00 at the base date and is worth Rs.50.00 now, in nominal terms the dollar
has appreciated by 25%, (or the rupee has depreciated by 20%). Therefore, our goods should
be more cost competitive in the United States. However, if our costs have gone up by 40%
(in rupee terms) during the period, and the prices in United States by only 10% in dollars, in
"real" terms we have become less competitive.
Using the algebraic notation adopted earlier, let:

‘p’ be the ratio of price index in India on comparison date to that on the base date; and
‘Pi’ be the same ratio for the country of the i’th currency.
Then, using indirect rates and geometric mean, and 100 as

base,
REER = 100 x (((C1c/C1b) * (p/pi))^W1) x (((C2c/C2b) * (p/p2))^W2) x . . . . . . x
(((Cnc/Cnb) * (p/pn))^Wn)
Let us calculate the REER using the earlier data and assuming price index on base date in
India and the other three countries as 100. The price index on comparison date was say:
India 125
C1 110
C2 105
C3 115
Therefore, REER Index = 100 x (((4/5)x(125/110))^0.3) x (((8.33/10)x(125/105))^0.6) x

(((25/20)x(125/115))^0. 1)
= 100 * 0.9718 * 0.9950 * 1.0311
= 99.70
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Thus, while the NEER shows a rupee depreciation of 16.65%, the REER has hardly declined.
The nominal rupee depreciation has just about compensated for our higher inflation, and
given no competitive advantage in reality.
Fundamental Equilibrium Exchange Rate

There is one other index which needs a mention. This is the so-called Fundamental
Equilibrium Exchange Rate (FEER) index.
The concept of the FEER starts with the macro-economic saving: investment balance. As is
well known, if domestic savings are insufficient to finance domestic investment, capital will
have to be imported. In other words, the economy will need to incur a current account deficit
to the extent of the gap.
The FEER is that rate of exchange which will ensure that the desired deficit on current
account results. To elaborate, if domestic savings are in excess of domestic investments, a
current account surplus will result and will require an undervalued exchange rate. In the
opposite scenario, as in the United States presently, an overvalued currency results in a
deficit on the current account which, in turn, is financed by foreign capital (investments or
borrowings).
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Published Indices
Most central banks publish the NEER and REER indices for the domestic currency. Some,
like the Bank of England, publish indices for other currencies as well. The following table
shows the Real Effective Exchange Rate (REER) and the Nominal Effective Exchange Rate
(NEER) of the rupee (5 country bilateral trade-based weights; Base: 1993-94 = 100)
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Sources of Supply and Demand in the Foreign exchange
Exchange Market
The major sources of supply of foreign exchange in the Indian foreign exchange market are
receipts on account of exports and invisibles in the current account and inflows in the capital
account such as foreign direct investment (FDI), portfolio investment, external commercial
borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign
exchange emanates from imports and invisible payments in the current account, amortization
of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and
outflows on account of direct and portfolio investment. In India, the Government has no
foreign currency account, and thus the external aid received by the Government comes
directly to the reserves and the Reserve Bank releases the required rupee funds. Hence, this
particular source of supply of foreign exchange is not routed through the market and as such
does not impact the exchange rate.
During last five years, sources of supply and demand have changed significantly, with large
transactions emanating from the capital account, unlike in the 1980s and the 1990s when
current account transactions dominated the foreign exchange market. The behavior as well as
the incentive structure of the participants who use the market for current account transactions
differs significantly from those who use the foreign exchange market for capital account
transactions. Besides, the change in these traditional determinants has also reflected itself in
enhanced volatility in currency markets. It now appears that expectations and even
momentary reactions to the news are often more important in determining fluctuations in
capital flows and hence it serves to amplify exchange rate volatility (Mohan, 2006a). On
many occasions, the pressure on exchange rate through increase in demand emanates from
“expectations based on certain news”. Sometimes, such expectations are destabilizing and
often give rise to self-fulfilling speculative activities. Recognizing this, increased emphasis is
being placed on the management of capital account through management of foreign direct
investment, portfolio investment, external commercial borrowings, nonresident deposits and
capital outflows. However, there are occasions when large capital inflows as also large
lumpiness in demand do take place, in spite of adhering to all the tools of management of
capital account. The role of the Reserve Bank comes into focus during such times when it has
to prevent the emergence of such destabilising expectations. In such cases, recourse is
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undertaken to direct purchase and sale of foreign currencies, sterilisation through open
market operations, management of liquidity under liquidity adjustment facility (LAF),
changes in reserve requirements and signaling through interest rate changes. In the last few
years, despite large capital inflows, the rupee has shown two - way movements. Besides, the
demand/supply situation is also affected by hedging activities through various instruments
that have been made available to market participants to hedge their risks.
Derivative Market Instruments

Derivatives play a crucial role in developing the foreign exchange market as they enable
market players to hedge against underlying exposures and shape the overall risk profile of
participants in the market. Banks in India have been increasingly using derivatives for
managing risks and have also been offering these products to corporates. In India, various
informal forms of derivatives contracts have existed for a long time though the formal
introduction of a variety of instruments in the foreign exchange derivatives market started
only in the post-reform period, especially since the mid-1990s. Cross-currency derivatives
with the rupee as one leg were introduced with some restrictions in April 1997. Rupee-
foreign exchange options were allowed in July 2003. The foreign exchange derivative
products that are now available in Indian financial markets can be grouped into three broad
segments, viz., forwards, options (foreign currency rupee options and cross currency options)
and currency swaps (foreign currency rupee swaps and cross currency swaps)
Available data indicate that the most widely used derivative instruments are the forwards and
foreign exchange swaps (rupee-dollar). Options have also been in use in the market for the
last four years. However, their volumes are not significant and bid offer spreads are quite
wide, indicating that the market is relatively illiquid. Another major factor hindering the
development of the options market is that corporates are not permitted to write/sell options. If
corporates with underlying exposures are permitted to write/sell covered options, this would
lead to increase in market volume and liquidity. Further, very few banks are market makers
in this product and many deals are done on a back to back basis. For the product to reachthe
farther segment of corporates such as small and medium enterprises (SME) sector, it is
imperative that public sector banks develop the necessary infrastructure and expertise to
transact in options. In view of the growing complexity, diversity and volume of derivatives
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used by banks, an Internal Group was constituted by the Reserve Bank to review the existing
guidelines on derivatives and formulate comprehensive guidelines on derivatives for banks
With regard to forward contracts and swaps, which are relatively more popular instruments in
the Indian derivatives market, cancellation and rebooking of forward contracts and swaps in
India have beenregulated. Gradually, however, the Reserve Bank has been taking measures
towards eliminating such regulations. The objective has been to ensure that excessive
cancellation and rebooking do not add to the volatility of the rupee. At present, exposures
arising on account of swaps, enabling a corporate to move from rupee to foreign currency
liability (derived exposures), are not permitted to be hedged. While the market participants
have preferred such a hedging facility, it is generally believed that equating derivedexposure
in foreign currency with actual borrowing in foreign currency would tantamount to violation
of the basic premise for accessing the forward foreign exchange market in India, i.e., having
an underlying foreign exchange exposure.
This feature (i.e., ‘the role of an underlying transaction in the booking of a forward contract’)
is unique to the Indian derivatives market. The insistence on this requirement of underlying
exposure has to be viewed against the backdrop of the then prevailing conditions when it was
imposed. Corporates in India have been permitted increasing access to foreign currency funds
since 1992. They were also accorded greater freedom to undertake active hedging.
However, recognising the relatively nascent stage of the foreign exchange market initially
with the lack of capabilities to handle massive speculation, the ‘underlying exposure’
criterion was imposed as a prerequisite. Exporters and importers were permitted to book
forward contracts on the basis of a declaration of an exposure and on the basis of past
performance.
Eligible limits were gradually raised to enable corporates greater flexibility. The limits are
computed separately for export and import contracts. Documents are required to be furnished
at the time of maturity of the contract. Contracts booked in excess of 25 per cent of the
eligible limit had to be on a deliverable basis and could not be cancelled. This relaxation has
proved very useful to exporters of software and other services since their projects are
executed on the basis of master agreements with overseas buyers, which usually do not
indicate the volumes and tenor of the exports (Report of Internal Group on Foreign Exchange
Markets, 2005). In order to provide greater flexibility to exporters and importers, as
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announced in the Mid-term review of the Annual Policy 2006-07, this limit has been
enhanced to 50 per cent.
Notwithstanding the initiatives that have been taken to enhance the flexibility for the
corporates, the need is felt to review the underlying exposure criteria for booking a forward
contract. The underlying exposure criteria enable corporates to hedge only a part of their
exposures that arise on the basis of the physical volume of goods (exports/imports) to be
delivered4. With the Indian economy getting increasingly globalised, corporates are also
exposed to a variety of ‘economic exposures’ associated with the types of foreign
exchange/commodity risks/ exposures arising out of exchange rate fluctuations.
At present, the domestic prices of commodities such as ferrous and non-ferrous metals, basic
chemicals, petro-chemicals, etc. are observed to exhibit world import parity. Given the two-
way movement of the rupee against the US dollar and other currencies in recent years, it is
necessary for the producer/ consumer of such products to hedge their economic exposures to
exchange rate fluctuation. Besides, price-fix hedges are also available for traders globally.
They enable importers/exporters to lock into a future price for a commodity that they plan to
import/export without actually having a crystallised physical exposure to the commodity.
Traders may also be affected not only because of changes in rupee-dollar exchange rates but
also because of changes in cross currency exchange rates. The requirement of ‘underlying
criteria’ is also often cited as one of the reasons for the lack of liquidity in some of the
derivative products in India. Hence, a fixation on the ‘underlying criteria’ as India globalises
may hinder the full development of the forward market. The requirement of past
performance/underlying exposures should be eliminated in a phased manner. This has also
been the recommendation of both the committees on capital account convertibility. It is cited
that this pre-requisite has been one of the factors contributing to the shift over time towards
the non deliverable forward (NDF) market at offshore locations to hedge such exposures
since such requirement is not stipulated while booking a NDF contract. An attempt has been
made recently provide importers the facility to partly hedge their economic exposure by
permitting them to book forward contracts for their customs duty component.
The Annual Policy Statement for 2007-08, released on April 24, 2007 announced a host of
measures to expand the range of hedging tools available to market participants as also
facilitate dynamic hedging by residents. To hedge economic exposures, it has been proposed
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that ADs (Category- I) may permit (a) domestic producers/users to hedge their price risk on
aluminium, copper, lead, nickel and zinc in international commodity exchanges, based on
their underlying economic exposures; and (b) actual users of aviation turbine fuel (ATF) to
hedge their economic exposures in the international commodity exchanges based on their
domestic purchases. Authorised dealer banks may approach the Reserve Bank for permission
on behalf of customers who are exposed to systemic international price risk, not covered
otherwise. In order to facilitate dynamic hedging of foreign exchange exposures of exporters
and importers of goods and services, it has been proposed that forward contracts booked in
excess of 75 per cent of the eligible limits have to be on a deliverable basis and cannot be
cancelled as against the existing limit of 50 per cent. With a view to giving greater flexibility
to corporates with overseas direct investments, the forward contracts entered into for hedging
overseas direct investments have been allowed to be cancelled and rebooked. In order to
enable small and medium enterprises to hedge their foreign exchange exposures, it has been
proposed to permit them to book forward contracts without underlying exposures or past
records of exports and imports. Such contracts may be booked through ADs with whom the
SMEs have credit facilities. They have also been allowed to freely cancel and rebook these
contracts. In order to enable resident individuals to manage/hedge their foreign exchange
exposures, it has been proposed to permit resident individuals to book forward contracts
without production of underlying documents up to an annual limit of US $ 100,000, which
can be freely cancelled and rebooked.
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Foreign Exchange Market Trading Platform
A variety of trading platforms are used by dealers in the EMEs for communicating and
trading with one another on a bilateral basis. They conduct bilateral trades through telephones
that are later confirmed by fax or telex. Some dealers also trade on electronic trading
platforms that allow for bilateral conversations and dealing such as the Reuters Dealing
2000-1 and Dealing 3000 Spot systems. Bilateral conversations may also take place over
networks provided by central banks and over private sector networks (Brazil, Chile,
Colombia, Korea and the Philippines). Reuters’ Dealing System has been the most popular
trading platform in EMEs.
In the Indian foreign exchange market, spot trading takes place on four platforms, viz., FX
CLEAR of the CCIL set up in August 2003, FX Direct that is a foreign exchange trading
platform launched by IBS Forex (P) Ltd. in 2002 in collaboration with Financial
Technologies (India) Ltd., and two other platforms by the Reuters - D2 platform and the
Reuters Market Data System (RMDS) trading platform that have a minimum trading amount
limit of US $ 1 million. FXCLEAR and FX Direct offer both real time order matching and
negotiation modes for dealing. The Real Time Matching system enables real time matching
of currency pairs for immediate and auto execution in both the spot and forward segments. In
the Negotiated Dealing System, on the other hand, participant is free to choose and negotiate
with his counter-party on all aspects of the transaction, thereby offering him flexibility to
select the underlying currency as well as the terms of trade. These trading platforms cover the
US dollar-Indian Rupee (USDINR) transactions and transactions in major cross currencies
(EUR/USD, USD/JPY, GBP/USD etc.), though USD-INR constitutes the most of the foreign
exchange transactions in terms of value. It is the FX CLEAR of the CCIL that remains the
most widely used trading platform in India. This platform has been given to members free of
cost. The main advantage of this platform is its offer of straight-through processing (STP)
capabilities as it is linked to CCIL’s settlement platform.
In the forward segment of the Indian foreign exchange market, trading takes place both over
the counter (OTC) and in an exchange traded market with brokers playing an important role.
The trading platforms available include FX CLEAR of the CCIL, RMDS from Reuters and
FX Direct of the IBS.
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In order to enhance the efficiency and transparency of the foreign exchange market and make
it comparable with the markets of other EMEs, the Committee on Fuller Capital Account
Convertibility (FCAC, 2006) has proposed the introduction of an electronic trading platform
for the conduct of all foreign exchange transactions. Under such an arrangement, an
authorised dealer will fix certain limits for its clients for trading in foreign exchange, based
on a credit assessment of each client or deposit funds or designated securities as collateral. A
number of small foreign exchange brokers could also be given access to the foreign exchange
trading screen by the authorised dealers. In the case of electronic transaction, the buy/sell
order for foreign exchange of an authorised dealer’s client first flows from the client’s
terminal to that of the authorised dealers’ dealing system. If the client’s order is within the
exposure limit, the dealing system will automatically route the order to the central matching
system. After the order gets matched, the relevant details of the matched order would be
routed to the client’s terminal through the trading system of the authorised dealer. Such a
system would also have the advantage of the customer having the choice of trading with the
bank quoting the best price and the Reserve Bank’s intervention in the foreign exchange
market could remain anonymous. For very large trades, a screen negotiated deal system has
been proposed by the Committee on Fuller Capital Account Convertibility.
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Corporate Hedging for Foreign Exchange Risk in India
Introduction
In 1971, the Bretton Woods system of administering fixed foreign exchange rates was
abolished in favour of market-determination of foreign exchange rates; a regime of
fluctuating exchange rates was introduced. Besides market-determined fluctuations, there
was a lot of volatility in other markets around the world owing to increased inflation and the
oil shock. Corporates struggled to cope with the uncertainty in profits, cash flows and future
costs. It was then that financial derivatives – foreign currency, interest rate, and commodity
derivatives emerged as means of managing risks facing corporations.
In India, exchange rates were deregulated and were allowed to be determined by markets in
1993. The economic liberalization of the early nineties facilitated the introduction of
derivatives based on interest rates and foreign exchange. However derivative use is still a
highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps
and options are available in India and the use of foreign currency derivatives is permitted for
hedging purposes only.
The aim is to provide a perspective on managing the risk that firm’s face due to fluctuating
exchange rates. It investigates the prudence in investing resources towards the purpose of
hedging and then introduces the tools for risk management. These are then applied in the
Indian context. The motivation of this study came from the recent rise in volatility in the
money markets of the world and particularly in the US Dollar, due to which Indian exports
are fast gaining a cost disadvantage. Hedging with derivative instruments is a feasible
solution to this situation.
This report is organised in 6 sections. The next section presents the necessity of foreign
exchange risk management and outlines the process of managing this risk. Section 3
discusses the various determinants of hedging decisions by firms, followed by an overview of
corporate hedging in India in Section 4. Evidence from major Indian firms from different
sectors is summarized here and Section 5 concludes.
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Foreign Exchange Risk Management: Process & Necessity

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of
sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure
is defined as a contracted, projected or contingent cash flow whose magnitude is not certain
at the moment and depends on the value of the foreign exchange rates. The process of
identifying risks faced by the firm and implementing the process of protection from these
risks by financial or operational hedging is defined as foreign exchange risk management.
This paper limits its scope to hedging only the foreign exchange risks faced by firms.
Kinds of Foreign Exchange Exposure

Risk management techniques vary with the type of exposure (accounting or economic) and
term of exposure. Accounting exposure, also called translation exposure, results from the
need to restate foreign subsidiaries’ financial statements into the parent’s reporting currency
and is the sensitivity of net income to the variation in the exchange rate between a foreign
subsidiary and its parent. Economic exposure is the extent to which a firm's market value, in
any particular currency, is sensitive to unexpected changes in foreign currency. Currency
fluctuations affect the value of the firm’s operating cash flows, income statement, and
competitive position, hence market share and stock price. Currency fluctuations also affect a
firm's balance sheet by changing the value of the firm's assets and liabilities, accounts
payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in
foreign banks; this type of economic exposure is called balance sheet exposure. Transaction
Exposure is a form of short term economic exposure due to fixed price contracting in an
atmosphere of exchange-rate volatility. The most common definition of the measure of
exchange-rate exposure is the sensitivity of the value of the firm, proxied by the firm’s stock
return, to an unanticipated change in an exchange rate. This is calculated by using the partial
derivative function where the dependant variable is the firm’s value and the independent
variable is the exchange rate (Adler and Dumas, 1984).
Necessity of managing foreign exchange risk

A key assumption in the concept of foreign exchange risk is that exchange rate changes are
not predictable and that this is determined by how efficient the markets for foreign exchange
are. Research in the area of efficiency of foreign exchange markets has thus far been able to
establish only a weak form of the efficient market hypothesis conclusively which implies that
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successive changes in exchange rates cannot be predicted by analyzing the historical

sequence of exchange rates.(Soenen, 1979). However, when the efficient markets theory is
applied to the foreign exchange market under floating exchange rates there is some evidence
to suggest that the present prices properly reflect all available information.(Giddy and Dufey,
1992). This implies that exchange rates react to new information in an immediate and
unbiased fashion, so that no one party can make a profit by this information and in any case,
information on direction of the rates arrives randomly so exchange rates also fluctuate
randomly. It implies that foreign exchange risk management cannot be done away with by
employing resources to predict exchange rate changes.
Hedging as a tool to manage foreign exchange risk:

There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel
hedging techniques are speculative or do not fall in their area of expertise and hence do not
venture into hedging practices. Other firms are unaware of being exposed to foreign
exchange risks. There are a set of firms who only hedge some of their risks, while others are
aware of the various risks they face, but are unaware of the methods to guard the firm against
the risk. There is yet another set of companies who believe shareholder value cannot be
increased by hedging the firm’s foreign exchange risks as shareholders can themselves
individually hedge themselves against the same using instruments like forward contracts
available in the market or diversify such risks out by manipulating their portfolio. (Giddy and
Dufey, 1992).
There are some explanations backed by theory about the irrelevance of managing the risk of
change in exchange rates. For example, the International Fisher effect states that exchange
rates changes are balanced out by interest rate changes, the Purchasing Power Parity theory
suggests that exchange rate changes will be offset by changes in relative price
indices/inflation since the Law of One Price should hold. Both these theories suggest that
exchange rate changes are evened out in some form or the other.
Also, the Unbiased Forward Rate theory suggests that locking in the forward exchange rate
offers the same expected return and is an unbiased indicator of the future spot rate. But these
theories are perfectly played out in perfect markets under homogeneous tax regimes. Also,
exchange rate-linked changes in factors like inflation and interest rates take time to adjust and
in the meanwhile firms stand to lose out on adverse movements in the exchange rates.
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The existence of different kinds of market imperfections, such as incomplete financial

markets, positive transaction and information costs, probability of financial distress and
agency costs and restrictions on free trade make foreign exchange management an
appropriate concern for corporate management. (Giddy and Dufey, 1992) It has also been
argued that a hedged firm, being less risky can secure debt more easily and this enjoy a tax
advantage (interest is excluded from tax while dividends are taxed). This would negate the
Modigliani-Miller proposition as shareholders cannot duplicate such tax advantages. The
MM argument that shareholders can hedge on their own is also not valid on account of high
transaction costs and lack of knowledge about financial manipulations on the part of
shareholders.
There is also a vast pool of research that proves the efficacy of managing foreign exchange
risks and a significant amount of evidence showing the reduction of exposure with the use of
tools for managing these exposures. In one of the more recent studies, Allayanis and Ofek
(2001) use a multivariate analysis on a sample of S&P 500 non-financial firms and calculate
a firms exchange-rate exposure using the ratio of foreign sales to total sales as a proxy and
isolate the impact of use of foreign currency derivatives (part of foreign exchange risk
management) on a firm’s foreign exchange exposures. They find a statistically significant
association between the absolute value of the exposures and the (absolute value) of the
percentage use of foreign currency derivatives and prove that the use of derivatives in fact
reduce exposure.
Risk Management and Settlement of Transactions in the Foreign Exchange

Market
The foreign exchange market is characterized by constant changes and rapid innovations in
trading methods and products. While the innovative products and ways of trading create new
possibilities for profit, they also pose various kinds of risks to the market. Central banks all
over the world, therefore, have become increasingly concerned of the scale of foreign
exchange settlement risk and the importance of risk mitigation measures. Behind this
growing awareness are several events in the past in which foreign exchange settlement risk
might have resulted in systemic risk in global financial markets, including the failure of
Bankhaus Herstatt in 1974 and the closure of BCCI SA in 1991.
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The foreign exchange settlement risk arises because the delivery of the two currencies
involved in a trade usually occurs in two different countries, which, in many cases are located
in different time zones. This risk is of particular concern to the central banks given the large
values involved in settling foreign exchange transactions and the resulting potential for
systemic risk. Most of the banks in the EMEs use some form of methodology for measuring
the foreign exchange settlement exposure. Many of these banks use the single day method, in
which the exposure is measured as being equal to all foreign exchange receipts that are due
on the day. Some institutions use a multiple day approach for measuring risk. Most of the
banks in EMEs use some form of individual counterparty limit to manage their exposures.
These limits are often applied to the global operations of the institution. These limits are
sometimes monitored by banks on a regular basis. In certain cases, there are separate limits
for foreign exchange settlement exposures, while in other cases, limits for aggregate
settlement exposures are created through a range of instruments. Bilateral obligation netting,
in jurisdictions where it is legally certain, is an important way for trade counterparties to
mitigate the foreign exchange settlement risk. This process allows trade counterparties to
offset their gross settlement obligations to each other in the currencies they have traded and
settle these obligations with the payment of a single net amount in each currency.
Several emerging markets in recent years have implemented domestic real time gross
settlement (RTGS) systems for the settlement of high value and time critical payments to
settle the domestic leg of foreign exchange transactions. Apart from risk reduction, these
initiatives enable participants to actively manage the time at which they irrevocably pay away
when selling the domestic currency, and reconcile final receipt when purchasing the domestic
currency. Participants, therefore, are able to reduce the duration of the foreign exchange
settlement risk.
Recognising the systemic impact of foreign exchange settlement risk, an important element
in the infrastructure for the efficient functioning of the Indian foreign exchange market has
been the clearing and settlement of inter-bank USD-INR transactions. In pursuance of the
recommendations of the Sodhani Committee, the Reserve Bank had set up the Clearing
Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets.
The CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR
spot and forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom
trades from February 5, 2004. The CCIL undertakes settlement of foreign exchange trades on
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a multilateral net basis through a process of novation and all spot, cash and tom transactions
are guaranteed for settlement from the trade date.
Every eligible foreign exchange contract entered between members gets novated or replaced
by two new contracts – between the CCIL and each of the two parties, respectively.
Following the multilateral netting procedure, the net amount payable to, or receivable from,
the CCIL in each currency is arrived at, member-wise. The Rupee leg is settled through the
members’ current accounts with the Reserve Bank and the USD leg through CCIL’s account
with the settlement bank at New York. The CCIL sets limits for each member bank on the
basis of certain parameters such as member’s credit rating, net worth, asset value and
management quality. The CCIL settled over 900,000 deals for a gross volume of US $ 1,180
billion in 2005-06. The CCIL has consistently endeavoured to add value to the services and
has gradually brought the entire gamut of foreign exchange transactions under its purview.
Intermediation, by the CCIL thus, provides its members the benefits of risk mitigation,
improved efficiency, lower operational cost and easier reconciliation of accounts with
correspondents.
An issue related to the guaranteed settlement of transactions by the CCIL has been the
extension of this facility to all forward trades as well. Member banks currently encounter
problems in terms of huge outstanding foreign exchange exposures in their books and this
comes in the way of their doing more trades in the market. Risks on such huge outstanding
trades were found to be very high and so were the capital requirements for supporting such
trades. Hence, many member banks have expressed their desire in several fora that the CCIL
should extend its guarantee to these forward trades from the trade date itself which could lead
to significant increase in the liquidity and depth in the forward market. The risks that banks
today carry in their books on account of large outstanding forward positions will also be
significantly reduced (Gopinath, 2005). This has also been one of the recommendations of
the Committee on Fuller Capital Account Convertibility. 6.55 Apart from managing the
foreign exchange settlement risk, participants also need to manage market risk, liquidity risk,
credit risk and operational risk efficiently to avoid future losses. As per the guidelines framed
by the Reserve Bank for banks to manage risk in the inter-bank foreign exchange dealings
and exposure in derivative markets as market makers, the boards of directors of ADs
(category-I) are required to frame an appropriate policy and fix suitable limits for operations
in the foreign exchange market. The net overnight open exchange position and the aggregate
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gap limits need to be approved by the Reserve Bank. The open position is generally measured
separately for each foreign currency consisting of the net spot position, the net forward
position, and the net options position. Various limits for exposure, viz., overnight, daylight,
stop loss, gap limit, credit limit, value at risk (VaR), etc., for foreign exchange transactions
by banks are fixed. Within the contour of these limits, front office of the treasury of ADs
transacts in the foreign exchange market for customers and own proprietary requirements.
These exposures are accounted, confirmed and settled by back office, while mid-office
evaluates the profit and monitors adherence to risk limits on a continuous basis. In the case of
market risk, most banks use a combination of measurement techniques including VaR
models. The credit risk is generally measured and managed by most banks on an aggregate
counter-party basis so as to include all exposures in the underlying spot and derivative
markets. Some banks also monitor country risk through cross-border country risk exposure
limits. Liquidity risk is generally estimated by monitoring asset liability profile in various
currencies in various buckets and monitoring currency-wise gaps in various buckets. Banks
also track balances to be maintained on a daily basis in Nostro accounts, remittances and
committed foreign currency term loans while monitoring liquidity risk.
To sum up, the foreign exchange market structure in India has undergone substantial
transformation from the early 1990s. The market participants have become diversified and
there are several instruments available to manage their risks. Sources of supply and demand
in the foreign exchange market have also changed in line with the shifts in the relative
importance in balance of payments from current to capital account. There has also been
considerable improvement in the market infrastructure in terms of trading platforms and
settlement mechanisms. Trading in Indian foreign exchange market is largely concentrated in
the spot segment even as volumes in the derivatives segment are on the rise. Some of the
issues that need attention to further improve the activity in the derivatives segment include
flexibility in the use of various instruments, enhancing the knowledge and understanding the
nature of risk involved in transacting the derivative products, reviewing the role of
underlying in booking forward contracts and guaranteed settlements of forwards. Besides,
market players would need to acquire the necessary expertise to use different kinds of
instruments and manage the risks involved.
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Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A
heuristic for firms to manage this risk effectively is presented below which can be modified
to suit firm-specific needs i.e. some or all the following tools could be used.
• Forecasts: After determining its exposure, the first step for a firm is to develop a forecast
on the market trends and what the main direction/trend is going to be on the foreign
exchange rates. The period for forecasts is typically 6 months. It is important to base the
forecasts on valid assumptions. Along with identifying trends, a probability should be
estimated for the forecast coming true as well as how much the change would be.
• Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit
or loss for a move in rates according to the forecast) and the probability of this risk
should be ascertained. The risk that a transaction would fail due to market-specific
problems4 should be taken into account. Finally, the Systems Risk that can arise due to
inadequacies such as reporting gaps and implementation gaps in the firms’ exposure
management system should be estimated.
• Benchmarking: Given the exposures and the risk estimates, the firm has to set its limit
for handling foreign exchange exposure. The firm also has to decide whether to manage
its exposures on a cost centre or profit centre basis. A cost centre approach is a defensive
one and the main aim is ensure that cash flows of a firm are not adversely affected
beyond a point. A profit centre approach on the other hand is a more aggressive approach
where the firm decides to generate a net profit on its exposure over time.
• Hedging: Based on the limits a firm set for itself to manage exposure, the firms then
decides an appropriate hedging strategy. There are various financial instruments available
for the firm to choose from: futures, forwards, options and swaps and issue of foreign
debt. Hedging strategies and instruments are explored in a section.
• Stop Loss: The firms risk management decisions are based on forecasts which are but
estimates of reasonably unpredictable trends. It is imperative to have stop loss
arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there
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should be certain monitoring systems in place to detect critical levels in the foreign
exchange rates for appropriate measure to be taken.
• Reporting and Review: Risk management policies are typically subjected to review
based on periodic reporting. The reports mainly include profit/ loss status on open
contracts after marking to market, the actual exchange/ interest rate achieved on each
exposure, and profitability vis-à-vis the benchmark and the expected changes in overall
exposure due to forecasted exchange/ interest rate movements. The review analyses
whether the benchmarks set are valid and effective in controlling the exposures, what the
market trends are and finally whether the overall strategy is working or needs change.
Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of some other
financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or
even an index of prices. The main role of derivatives is that they reallocate risk among
financial market participants, help to make financial markets more complete. This section
outlines the hedging strategies using derivatives with foreign exchange being the only risk
assumed.
• Forwards: A forward is a made-to-measure agreement between two parties to

buy/sell a specified amount of a currency at a specified rate on a particular date in the
future. The depreciation of the receivable currency is hedged against by selling a currency
forward. If the risk is that of a currency appreciation (if the firm has to buy that currency
in future say for import), it can hedge by buying the currency forward. E.g if RIL wants
to buy crude oil in US dollars six months hence, it can enter into a forward contract to
pay INR and buy USD and lock in a fixed exchange rate for INR-USD to be paid after 6
months regardless of the actual INR-Dollar rate at the time. In this example the downside
is an appreciation of Dollar which is protected by a fixed forward contract. The main
advantage of a forward is that it can be tailored to the specific needs of the firm and an
exact hedge can be obtained. On the downside, these contracts are not marketable, they
can’t be sold to another party when they are no longer required and are binding.
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• Futures: A futures contract is similar to the forward contract but is more liquid
because it is traded in an organized exchange i.e. the futures market. Depreciation of a
currency can be hedged by selling futures and appreciation can be hedged by buying
futures. Advantages of futures are that there is a central market for futures which
eliminates the problem of double coincidence. Futures require a small initial outlay (a
proportion of the value of the future) with which significant amounts of money can be
gained or lost with the actual forwards price fluctuations. This provides a sort of leverage.
The previous example for a forward contract for RIL applies here also just that RIL will
have to go to a USD futures exchange to purchase standardised dollar futures equal to the
amount to be hedged as the risk is that of appreciation of the dollar. As mentioned earlier,
the tailorability of the futures contract is limited i.e. only standard denominations of
money can be bought instead of the exact amounts that are bought in forward contracts.
• Options: A currency Option is a contract giving the right, not the obligation, to buy or
sell a specific quantity of one foreign currency in exchange for another at a fixed price;
called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces
the uncertainty of exchange rate changes and limits the losses of open currency positions.
Options are particularly suited as a hedging tool for contingent cash flows, as is the case
in bidding processes. Call Options are used if the risk is an upward trend in price (of the
currency), while Put Options are used if the risk is a downward trend. Again taking the
example of RIL which needs to purchase crude oil in USD in 6 months, if RIL buys a
Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a specified
amount of dollars at a fixed rate on a specified date, there are two scenarios. If the
exchange rate movement is favourable i.e the dollar depreciates, then RIL can buy them
at the spot rate as they have become cheaper. In the other case, if the dollar appreciates
compared to today’s spot rate, RIL can exercise the option to purchase it at the agreed
strike price. In either case RIL benefits by paying the lower price to purchase the dollar
• Swaps: A swap is a foreign currency contract whereby the buyer and seller exchange
equal initial principal amounts of two different currencies at the spot rate. The buyer and
seller exchange fixed or floating rate interest payments in their respective swapped
currencies over the term of the contract. At maturity, the principal amount is effectively
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re-swapped at a predetermined exchange rate so that the parties end up with their original
currencies. The advantages of swaps are that firms with limited appetite for exchange rate
risk may move to a partially or completely hedged position through the mechanism of
foreign currency swaps, while leaving the underlying borrowing intact. Apart from
covering the exchange rate risk, swaps also allow firms to hedge the floating interest rate
risk. Consider an export oriented company that has entered into a swap for a notional
principal of USD 1 mn at an exchange rate of 42/dollar.
The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6
months on 1st January & 1st July, till 5 years. Such a company would have earnings in
Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather
than in Rupee) thus hedging its exposures.
• Foreign Debt: Foreign debt can be used to hedge foreign exchange exposure by taking
advantage of the International Fischer Effect relationship. This is demonstrated with the
example of an exporter who has to receive a fixed amount of dollars in a few months
from present. The exporter stands to lose if the domestic currency appreciates against that
currency in the meanwhile so, to hedge this, he could take a loan in the foreign currency
for the same time period and convert the same into domestic currency at the current
exchange rate. The theory assures that the gain realised by investing the proceeds from
the loan would match the interest rate payment (in the foreign currency) for the loan.
Choice of hedging instruments

The literature on the choice of hedging instruments is very scant. Among the available
studies, Géczy et al. (1997) argues that currency swaps are more cost-effective for hedging
foreign debt risk, while forward contracts are more cost-effective for hedging foreign
operations risk. This is because foreign currency debt payments are long-term and
predictable, which fits the long-term nature of currency swap contracts. Foreign currency
revenues, on the other hand, are short-term and unpredictable, in line with the short-term
nature of forward contracts. A survey done by Marshall (2000) also points out that currency
swaps are better for hedging against translation risk, while forwards are better for hedging
against transaction risk. This study also provides anecdotal evidence that pricing policy is the
most popular means of hedging economic exposures.
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These results however can differ for different currencies depending in the sensitivity of that
currency to various market factors. Regulation in the foreign exchange markets of various
countries may also skew such results.
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Determinants of Hedging Decisions
The management of foreign exchange risk, as has been established so far, is a fairly
complicated process. A firm, exposed to foreign exchange risk, needs to formulate a strategy
to manage it, choosing from multiple alternatives. This section explores what factors firms
take into consideration when formulating these strategies.
Production and Trade vs. Hedging Decisions

An important issue for multinational firms is the allocation of capital among different
countries production and sales and at the same time hedging their exposure to the varying
exchange rates. Research in this area suggests that the elements of exchange rate uncertainty
and the attitude toward risk are irrelevant to the multinational firm's sales and production
decisions (Broll,1993). Only the revenue function and cost of production are to be assessed,
and, the production and trade decisions in multiple countries are independent of the hedging
decision.
The implication of this independence is that the presence of markets for hedging instruments
greatly reduces the complexity involved in a firm’s decision making as it can separate
production and sales functions from the finance function. The firm avoids the need to form
expectations about future exchange rates and formulation of risk preferences which entails
high information costs.
Cost of Hedging
Hedging can be done through the derivatives market or through money markets (foreign
debt). In either case the cost of hedging should be the difference between value received from
a hedged position and the value received if the firm did not hedge. In the presence of efficient
markets, the cost of hedging in the forward market is the difference between the future spot
rate and current forward rate plus any transactions cost associated with the forward contract.
Similarly, the expected costs of hedging in the money market are the transactions cost plus
the difference between the interest rate differential and the expected value of the difference
between the current and future spot rates. In efficient markets, both types of hedging should
produce similar results at the same costs, because interest rates and forward and spot
exchange rates are determined simultaneously. The costs of hedging, assuming efficiency in
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foreign exchange markets result in pure transaction costs. The three main elements of these
transaction costs are brokerage or service fees charged by dealers, information costs such as
subscription to Reuter reports and news channels and administrative costs of exposure
management.
Factors affecting the decision to hedge foreign currency risk

Research in the area of determinants of hedging separates the decision of a firm to hedge
from that of how much to hedge. There is conclusive evidence to suggest that firms with
larger size, R&D expenditure and exposure to exchange rates through foreign sales and
foreign trade are more likely to use derivatives. (Allayanis and Ofek, 2001) First, the
following section describes the factors that affect the decision to hedge and then the factors
affecting the degree of hedging are considered.
• Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale. Risk
management involves fixed costs of setting up of computer systems and training/hiring of
personnel in foreign exchange management. Moreover, large firms might be considered
as more creditworthy counterparties for forward or swap transactions, thus further
reducing their cost of hedging. The book value of assets is used as a measure of firm size.
• Leverage: According to the risk management literature, firms with high leverage have
greater incentive to engage in hedging because doing so reduces the probability, and thus
the expected cost of financial distress. Highly levered firms avoid foreign debt as a means
to hedge and use derivatives.
• Liquidity and profitability: Firms with highly liquid assets or high profitability have
less incentive to engage in hedging because they are exposed to a lower probability of
financial distress. Liquidity is measured by the quick ratio, i.e. quick assets divided by
current liabilities). Profitability is measured as EBIT divided by book assets.
• Sales growth: Sales growth is a factor determining decision to hedge as opportunities are
more likely to be affected by the underinvestment problem. For these firms, hedging will
reduce the probability of having to rely on external financing, which is costly for
information asymmetry reasons, and thus enable them to enjoy uninterrupted high
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growth. The measure of sales growth is obtained using the 3-year geometric average of
yearly sales growth rates.
As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole
determinants of the degree of hedging are exposure factors (foreign sales and trade). In other
words, given that a firm decides to hedge, the decision of how much to hedge is affected
solely by its exposure to foreign currency movements.
This discussion highlights how risk management systems have to be altered according to
characteristics of the firm, hedging costs, nature of operations, tax considerations, regulatory
requirements etc. The next section discusses these issues in the Indian context and regulatory
environment.
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An Overview of Corporate Hedging in India
The move from a fixed exchange rate system to a market determined one as well as the
development of derivatives markets in India have followed with the liberalization of the
economy since 1992. In this context, the market for hedging instruments is still in its
developing stages. In order to understand the alternative hedging strategies that Indian firms
can adopt, it is important to understand the regulatory framework for the use of derivatives
here.
Development of Derivative Markets in India

The economic liberalization of the early nineties facilitated the introduction of derivatives
based on interest rates and foreign exchange. Exchange rates were deregulated and market
determined in 1993. By 1994, the rupee was made fully convertible on current account. The
ban on futures trading of many commodities was lifted starting in the early 2000s. As of
October 2007, even corporates have been allowed to write options in the atmosphere of high
volatility.9 Derivatives on stock indexes and individual stocks have grown rapidly since
inception. In particular, single stock futures have become hugely popular. Institutional
investors prefer to trade in the Over-The-Counter(OTC) markets to interest rate futures,
where instruments such as interest rate swaps and forward rate agreements are thriving.
Foreign exchange derivatives are less active than interest rate derivatives in
\ India, even though they have been around for longer. OTC instruments in currency forwards
and swaps are the most popular. Importers, exporters and banks use the rupee forward market
to hedge their foreign currency exposure. Turnover and liquidity in this market has been
increasing, although trading is mainly in shorter maturity contracts of one year or less. The
typical forward contract is for one month, three months, or six months, with three months
being the most common. The Indian rupee, which is being traded on the Dubai Gold and
Commodities Exchange (DGCX), crossed a turnover of $23.24 million in June 2007.
Regulatory Guidelines for the use of Foreign Exchange Derivatives

With respect to foreign exchange derivatives involving rupee, residents have access to
foreign exchange forward contracts, foreign currency-rupee swap instruments and currency
options – both cross currency as well as foreign currency-rupee. In the case of derivatives
involving only foreign currency, a range of products such as Interest Rate Swaps, Forward
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Contracts and Options are allowed. While these products can be used for a variety of
purposes, the fundamental requirement is the existence of an underlying exposure to foreign
exchange risk i.e. derivatives can be used for hedging purposes only.
The RBI has also formulated guidelines to simplify procedural/documentation requirements

for Small and Medium Enterprises (SME) sector. In order to ensure that SMEs understand
the risks of these products, only banks with which they have credit relationship are allowed to
offer such facilities. These facilities should also have some relationship with the turnover of
the entity. Similarly, individuals have been permitted to hedge upto USD 100,000 on self
declaration basis. Authorised Dealer(AD) banks may also enter into forward contracts with
residents in respect of transactions denominated in foreign currency but settled in Indian
Rupees including hedging the currency indexed exposure of importers in respect of customs
duty payable on imports and price risks on commodities with a few exceptions. Domestic
producers/users are allowed to hedge their price risk on aluminium, copper, lead, nickel and
zinc as well as aviation turbine fuel in international commodity exchanges based on their
underlying economic exposures. Authorised dealers are permitted to use innovative products
like cross-currency options; interest rate swaps (IRS) and currency swaps, caps/collars and
forward rate agreements (FRAs) in the international foreign exchange market. Foreign
Institutional Investors (FII), persons resident outside India having Foreign Direct Investment
(FDI) in India and Nonresident Indians (NRI) are allowed access to the forwards market to
the extent of their exposure in the cash market.
Hedging Instruments for Indian Firms

The recent period has witnessed amplified volatility in the INR-US exchange rates in the
backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock
markets. In this context, the paper has attempted to study the choice of instruments adopted
by prominent firms to stem their foreign exchange exposures. All the data for this has been
compiled from the 2006-2007 Annual Reports of the respective companies. A summary of
the foreign exchange risk hedging behaviour of select Indian firms is given in the table.
Instruments Currency(mn) Rs (Cr) Nature of exposure

Reliance Industries Earnings in all businesses are linked to USD.
Currency Swaps 1064.49 The key input, crude oil is purchased in USD.
Options Contracts 2939.76 All export revenues are in foreign currency and
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local prices are based on import parity prices as

Forward Contracts 5764.1 well
Maruti Udyog .
Forward Contracts 6411 (INR- Import/Royalty payable in Yen and
JPY)
70 ($-INR) Exports Receivables in dollars.
Currency swaps 124.70(USD Interest rate and forex risk.
-INR)
.
Mahindra and
Mahindra
Forward Contracts 350 (INR- Trade payables in Yen and Euro and
JPY)
2(INR-EUR) export receivables in dollars.
27.3($-INR)
Currency Swaps 5390 (JPY- Interest rate and foreign exchange risk.
INR)
Arvind Mills
Forward Contracts 152.98 ($- 703.67
INR)
2.25 (GBP-
INR)
5 (INR-$) 21.88 Most of the revenue is either in dollars
or linked to dollars due to export.
Option Contracts 1 2 2.5 ($- 547.16
INR)
Infosys
Forward Contracts 119 ($-INR) 529
Options Contracts 4 ($-INR) 18 Revenues denominated in these
8 (INR-$) 36 currencies.
Range barrier options 2 ($-INR) 971
3 (Eur-INR)
TCS
Forward Contracts 15 (Eur-INR) 265.75 Revenues largely denominated in
21 (GBP- foreign currency, predominantly US$,
INR)
GBP, and Euro. Other currencie include
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Options Contracts 8 3 0 ($-INR) 4057 Australian $, Canadian $, South African

47.5 (Eur-
INR) Rand, and Swiss Franc
76.5 (GBP-
INR)
Ranbaxy
2894.58
Forward Contracts 9 Exposed on accounts receivable and
loans payable. Exposure in USD and
Jap Yen
Dr. Reddy’s Labs

Forward Contracts 398 ($-INR) Foreign currency earnings through
11(Eur $) export, currency requirements for
settlement of liability for import of
Options Contracts 30 (EUR-$) goods.
Discussion on Hedging by Indian Firms

From the Table above, it can be seen that earnings of all the firms are linked to either US
dollar, Euro or Pound as firms transact primarily in these foreign currencies globally.
Forward contracts are commonly used and among these firms, Ranbaxy and RIL depend
heavily on these contracts for their hedging requirements. As discussed earlier, forwards
contracts can be tailored to the exact needs of the firm and this could be the reason for their
popularity. The tailor ability is a consideration as it enables the firms to match their
exposures in an exact manner compared to exchange traded derivatives like futures that are
standardized where exact matching is difficult. RIL, Maruti Udyog and Mahindra and
Mahindra are the only firms using currency swaps. Swap usage is a long term strategy for
hedging and suggests that the planning horizons for these companies are longer than those of
other firms. These businesses, by nature involve longer gestation periods and higher initial
capital outlays and this could explain their long planning horizons.
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Another observation is that TCS prefers to hedge its exposure to the US Dollar through
options rather than forwards. This strategy has been observed among many firms recently in
India11. This has been adopted due to the marked high volatility of the US Dollar against the
Rupee. Options are more profitable instruments in volatile conditions as they offer unlimited
upside profitability while hedging the downside risk whereas there is a risk with forwards if
the expectation of the exchange rate (the guess) is wrong as firms lose out on some profit.
The use of Range barrier options by Infosys also suggests a strategy to tackle the high
volatility of the dollar exchange rates. Software firms have a limited domestic market and
rely on exports for the major part of their revenues and hence require additional flexibility in
hedging when the volatility is high. Another implication of this is that their planning horizons
are shorter compared to capital intensive firms.
It is evident that most Indian firms use forwards and options to hedge their foreign currency
exposure. This implies that these firms chose short-term measures to hedge as opposed to
foreign debt. This preference is possibly a consequence of their costs being in Rupees, the
absence of a Rupee futures exchange in India and curbs on foreign debt. It also follows that
most of these firms behave like Net Exporters and are adversely affected by appreciation of
the local currency. There are a few firms which have import liabilities which would be
adversely affected by Rupee depreciation.
However it must be pointed out that the data set considered for this study does not indicate
how the use of foreign debt by these firms hedges their exposures to foreign exchange risk
and whether such a strategy is used as a substitute or complement to hedging with
derivatives.
Conclusion
Derivative use for hedging is only to increase due to the increased global linkages and
volatile exchange rates. Firms need to look at instituting a sound risk management system
and also need to formulate their hedging strategy that suits their specific firm characteristics
and exposures.
In India, regulation has been steadily eased and turnover and liquidity in the foreign currency
derivative markets has increased, although the use is mainly in shorter maturity contracts of
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one year or less. Forward and option contracts are the more popular instruments. Regulators
had initially only allowed certain banks to deal in this market however now corporates can
also write option contracts. There are many variants of these derivatives which investment
banks across the world specialize in, and as the awareness and demand for these variants
increases, RBI would have to revise regulations.
For now, Indian companies are actively hedging their foreign exchanges risks with forwards,
currency and interest rate swaps and different types of options such as call, put, cross
currency and range-barrier options. The high use of forward contracts by Indian firms also
highlights the absence of a rupee futures exchange in India.
However, the Dubai Gold and Commodities Exchange in June, 2007 introduced Rupee-
Dollar futures that could be traded on its exchanges and had provided another route for firms
to hedge on a transparent basis. There are fears that RBI’s ability to control the partially
convertible currency will be subdued by this introduction but this issue is beyond the scope
of this study. The partial convertibility of the Rupee will be difficult to control if many
exchanges offer such instruments and that will be factor to consider for the RBI.
The Committee on Fuller Capital Account Convertibility had recommended that currency
futures may be introduced subject to risks being contained through proper trading
mechanism, structure of contracts and regulatory environment. Accordingly, Reserve Bank of
India in the Annual Policy Statement for the Year 2007-08 proposed to set up a Working
Group on Currency Futures to study the international experience and suggest a suitable
framework to implement the proposal, in line with the current legal and regulatory
framework.
The limitation of this study is that only one type of risk is assumed i.e the foreign exchange
risk. Also applicability of conclusion is limited as only very few firms were reviewed over
just one time period. However the results from this exploratory study are encouraging and
interesting, leading us to conclude that there is scope for more rigorous study along these
lines.
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Currency Risk Management

Introduction
The management of currency risk by corporations has come a longway in the last three
decades. Before the break-up of BrettonWoods currency riskwas not a major consideration
for corporate executives, nor did it have to be. Exchange rates were allowed to fluctuate, but
only within reasonably tight bands, while the US dollar itselfwas pegged to that most solid of
commodities, gold. The responsibility for managing currency risk, or rather maintaining
currency stability, was largely that of governments. Needless to say, that burden, that
responsibility has now passed from the public to the private sector.
The way the corporation has dealt with currency risk has changed substantially over time.
Corporations, many of which were reluctant to touch anything but the most vanilla of
hedging structures, have now greatly increased the sophistication of their currency risk
management and hedging strategies, particularly over the last decade. In this regard, two
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developments have helped greatly – the centralizing of Treasury operations, particularly

within large multinationals, and the focus put on hiring specifically experienced and qualified
personnel to manage the day-to-day operations of risk management.
Currency Risk
So, what precisely is currency risk? There is no point in focusing on an issue if one cannot
first define it. Although definitions vary within the academic community, a practical
description of currency risk would be:
The impact that unexpected exchange rate changes have on the value of the corporation
Currency risk is very important to a corporation as it can have a major impact on its cash
flows, assets and liabilities, net profit and ultimately its stock market value. Assuming the
corporation has accepted that currency risk needs to be managed specifically and separately,
it has three initial priorities:
1. Define what kinds of currency risk the corporation is exposed to
2. Define a corporate Treasury strategy to deal with these currency risks
3. Define what financial instruments it allows itself to use for this purpose
Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible
gain or loss resulting from an exchange rate move. It can affect the value of a corporation
directly as a result of an unhedged exposure or more indirectly.
Different types of currency risk can also offset each other. For instance, take a US citizen
who owns stock in a German auto manufacturer and exporter to the US. If the Euro falls
against the US dollar, the US dollar value of the Euro-denominated stock falls and therefore
on the face of it the individual sees the US dollar value of their holding decline. However, the
German auto exporter should in fact benefit from a weaker Euro as this makes the company’s
exports to
the US cheaper, allowing them the choice of either maintaining US prices to maintain margin
or cutting them further to boost market share. Sooner or later, the stock market will realize
this and mark up the stock price of the auto exporter. Thus, the stock owner may lose on the
currency translation, but gain on the higher stock price. This is of course a very simple
example and life unfortunately is rarely that simple. For just as a weaker Euro makes exports
from the Euro-zone cheaper, so it makes imports more expensive. Thus, an exporter may not
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in fact feel the benefit of the currency translation through to market share because higher
import prices force it to raise export prices from where they would otherwise would be
according to the exchange rate.
The first step in successfully managing currency risk is to acknowledge that such risk
actually exists and that it has to be managed in the general interest of the corporation and the
corporation’s shareholders. For some, this is of itself a difficult hurdle as there is still major
reluctance within corporate management to undertake what they see as straying from their
core, underlying business into the speculative world of currency markets. The truth however
is that the corporation is a participant in the currency market whether it likes it or not; if it has
foreign currency-denominated exposure, that exposure should be managed. To do anything
else is irresponsible. The general trend within the corporate world has however been in
favour of recognizing the existence of and the need to manage currency risk. That recognition
does not of itself entail speculation. Indeed, at its best, prudent currency hedging can be
defined as the elimination of speculation:
The real speculation is in fact not managing currency risk
The next step, however, is slightly more complex and that is to identify the nature and extent
of the currency risk or exposure. It should be noted that the emphasis here is for the most part
on non-financial corporations, on manufacturers and service providers rather than on banks
or other types of financial institutions. Non-financial corporations generally have only a
small amount of their total assets in the form of receivables and other types of transaction.
Most of their assets are made up of inventory, buildings, equipment and other forms of
tangible “real” assets. In order to measure the effect of exchange rate moves on a corporation,
one first has to define the type and then the amount of risk involved, or the “value at risk”
(VaR). There are three main types of currency risk that a multinational corporation is
exposed to and has to manage.
Types of Currency Risk
1. Transaction risk (receivables, dividends, etc.)

2. Translation risk (balance sheet)
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3. Economic risk (present value of future operating cash flows)
Transaction Risk
Transaction currency risk is essentially cash flow risk and relates to any transaction, such as
receivables, payables or dividends. The most common type of transaction risk relates to
export or import contracts. When there is an exchange rate move involving the currencies of
such a contract, this represents a direct transactional currency risk to the corporation. This is
the most basic type of currency risk that a corporation faces.
Translation Risk
Translation risk is slightly more complex and is the result of the consolidation of parent
company and foreign subsidiary financial statements. This consolidation means that
exchange rate impact on the balance sheet of the foreign subsidiaries is transmitted or
translated to the parent company’s balance. Translation risk is thus balance sheet currency
risk. While most large multinational corporations actively manage their transaction currency
risk, many are less aware of the potential dangers of translation risk.
The actual translation process in consolidating financial statements is done either at the
average exchange rate of the period or at the exchange rate at the period end, depending on
the specific accounting regulations affecting the parent company. As a direct result, the
consolidated results will vary as either the average or the end-of-period exchange rate varies.
Thus, all foreign currency-denominated profit is exposed to translation currency risk as
exchange rates vary. In addition, the foreign currency value of foreign subsidiaries is also
consolidated on the parent company’s balance sheet, and that value will vary accordingly.
Translation risk for a foreign subsidiary is usually measured by the net assets (assets less
liabilities) that are exposed to potential exchange rate moves.
Problems can occur with regard to translation risk if a corporation has subsidiaries whose
accounting books are local currency-denominated. For consolidation purposes, these books
must of course be translated into the currency of the parent company, but at what exchange
rate? Income statements are usually translated at the average exchange rate over the period.
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However, deciding at what exchange rate to translate the balance sheet is slightly trickier.
There are generally three methods used by major multinational corporations for translating
balance sheet risk, varying in how they separate assets and liabilities between those that need
to be translated at the “current” exchange rate at the time of consolidation and those that are
translated at the historical exchange rate:
_ The all current (closing rate) method
_ The monetary/non-monetary method
_ The temporal method
As the name might suggest, the all current (closing rate) method translates all foreign
currency exposures at the closing exchange rate of the period concerned. Under this method,
translation risk relates to net assets or shareholder funds. This has become the most popular
method of translating balance exposure of foreign subsidiaries, both in the US and worldwide
On the other hand, the monetary/non-monetary method translates monetary items such as
assets, liabilities and capital at the closing rate and non-monetary items at the historical rate.
Finally, the temporal method breaks balance sheet items down in terms of whether they are
firstly stated at replacement cost, realizable value, market value or expected future value, or
secondly stated at historic cost. For the first group, these are translated at the closing
exchange rate of the period concerned, for the second, at the historical exchange rate.
The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. Under
FAS 52, the translation of foreign currency revenues and costs is made at the average
exchange rate of the period. FAS 52 generally uses the all current method for translation
purposes, though it does have several important provisions, notably regarding the treatment
of currency hedging contracts. Under SSAP 20, the corporation can use either the current or
average rate. Generally, there has been a shift among multinational corporations towards
using the average rather than the closing rate because this is seen as a truer reflection of the
translation risk faced by the corporation during the period. Translation risk is a crucial issue
for corporations. Later in this chapter, we will look at methods of hedging it. For now, it is
important to get an idea of how it can affect the company’s overall value.
Example
Take an example of a Euro-based manufacturer, which has bought a factory in Poland.

Needless to say, the cost base in Poland is substantially below that of the parent company,
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one of several major reasons why the acquisition was made in the first place. From 1999 to
2001, the Euro was on a major downtrend, not just against its major currency counterparts
but also against most currencies of the Central and East European area, such as the Polish
zloty. Thus we get the following simple model:
EUR–USD ↓= EUR–PLN ↓
where:
EUR–USD = The Euro–US dollar exchange rate
EUR–PLN = The Euro–Polish zloty exchange rate
This is an over-simplification to be sure. For one thing, the Polish zloty was pegged to a
basket of Euro (55%) and US dollar (45%) with a crawl and trading bands up until 2000, and
thus was unable to appreciate despite the ongoing decline in the value of the Euro across the
board. For another, it does not take account of EUR–PLN volatility. That said, general Euro
weakness has clearly been an important factor in the depreciation of the Euro–zloty exchange
rate. Note however that as the Euro–zloty exchange rate has depreciated for this and other
reasons so the value of the original investment in the Polish factory has increased in Euro
terms. Thus:
EUR–PLN ↓= EURtranslation value of Polish subsidiary ↑
Whatever our Euro-based manufacturer may think of Euro weakness, it is entirely beneficial
for the manufacturer’s translation value of the Polish factory/subsidiary when the financial
statements are consolidated at the end of the accounting period. The translation benefit to the
balance sheet will depend on the accounting method of translation. Conversely, were the
Euro ever to rally on a sustained basis, this might cause the Euro–zloty exchange rate to rally,
thus in turn reducing the translation value of the corporation’s Polish subsidiary. The
consolidation of financial statements would mean that this not only has an impact on the Euro
value of the Polish subsidiary but also on the balance sheet of the parent, Euro-based
manufacturer. The risk of a sudden balance sheet deterioration of this kind is not negligible
where corporations have a broad range of foreign subsidiaries, with accompanying
transactional and translational currency risk.
Economic Risk
The translation of foreign subsidiaries concerns the consolidated group balance sheet.
However, this does not affect the real “economic” value or exposure of the subsidiary.
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Economic risk focuses on how exchange rate moves change the real economic value of the
corporation, focusing on the present value of future operating cash flows and how this
changes in line with exchange rate changes. More specifically, the economic risk of a
corporation reflects the effect of exchange rate changes on items such as export and domestic
sales, and the cost of domestic and imported inputs. As with translation risk, calculating
economic risk is complex, but clearly necessary to be able to assess how exchange rate
changes can affect the present value of foreign subsidiaries. Economic risk is usually applied
to the present value of future operating cash flows of a corporation’s foreign subsidiaries.
However, it can also be applied to the parent company’s operations and how the present
value of those change in line with exchange rate changes.
Summarizing this part, transaction risk deals with the effect of exchange rate moves on
transactional exposure such as accounts receivable/payable or dividends. Translation risk
focuses on how exchange rate moves can affect foreign subsidiary valuation and therefore the
valuation of the consolidated group balance sheet. Finally, economic risk deals with the
effect of exchange rate changes to the present value of future operating cash flows, focusing
on the “currency of determination” of revenues and operating expenses. Here it is important
to differentiate between the currency in which cash flows are denominated and the currency
that may determine the nature and size of those cash flows. The two are not necessarily the
same. To complicate the issue further, there is the small matter of the parent company’s
currency, which is used to consolidate the financial statements. If a parent company has
foreign currency-denominated debt, this is recorded in the parent company’s currency, but
the value of its legal obligation remains in the currency denomination of the debt. In sum,
transaction risk is just the tip of the iceberg!
Of necessity, the reality of currency risk is very case-specific. That said, there has been an
attempt by the academic and economic communities to apply the traditional exchange rate
models to the corporate world for the purpose of demonstrating how exchange rates impact a
corporation.
PPP (or the law of one price) suggests that price differentials of the same good in different
countries require an exchange rate adjustment to offset them. The international Fisher effect
suggests that the expected change in the exchange rate is equal to the interest rate differential.
The unbiased forward rate theory suggests that the forward exchange rate is equal to the
expected exchange rate.
74 | P a g e
RESEARCH
Generally, these theories are grounded in the efficient market hypothesis and therefore
flawed at best. Over the long term, these traditional “rules” of exchange rate theory suggest
that competition and arbitrage should neutralize the effect of exchange rate changes on
returns and on the valuation of the corporation. Equally, locking into the forward rate should,
according to the unbiased forward rate theory, offer the same return as remaining exposed to
currency risk, as this theory suggests that the distribution of probability should be equal on
either side of the forward rate.
The unfortunate thing about such models, however worthy the attempt, is that they do not and
cannot deal with the practical realities of managing currency risk. What academics regard as
“temporary deviations” from where the model suggests the exchange rate should be can be
sufficient and substantial enough to cause painful and intolerable deterioration to both the
P&L and the balance sheet?
To conclude this part, a corporation should define and seek to quantify the types of currency
risk to which it is exposed in order then to be able to go about creating a strategy for
managing that currency risk.
Sensex 30 Companies
Forex Other
Company Exports Imports Loans Interest Expenses
Name Industry Rupees Rupees Rupees Rupees Rupees
Reliance Diversified 75,974.22 94988.8 11,918.44 1,192.06
ICICI Banks - Private Sector 40854.2386 0.00 65141.3245 21657.2802 0
HDFC Finance - Housing 17.66 0 516.33 115.4794614 8.2005041
Infosys Computers - Software 14468 304 0 0 6484
Larsen Diversified 5636.02 2507.13 0 0 2023.8
ITC Cigarettes 1574.56 1051.1 0 0 107.8
HDFC Bank Banks - Private Sector 0 0 3591.86 263.06 0
SBI Banks - Public Sector 28169.6714 0 42989.2021 3026.385
Oil Drilling And
ONGC Exploration 3615.939 4659.189 36.942 1.224 5392.504
TCS Computers - Software 16756.93 272.81 0 0 6421.96
Telecommunications –
Bharti Airtel Service 1546.2027 4867.8095 0 0 1568.072
Sterlite Ind Metals – Non Ferrous 7093.97 11818.03 159.05 114.1 205.08
TATA Steel Steel – Large 2123.41 103.15 12237.21 502.95 180.82
BHEL Engineering - Heavy 2364.68 3394.62 0 0 209.04
Telecommunications –
Reliance Comm Service 1296.15 4410.81 13261.43 377.07 569.56
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RESEARCH
Wipro Computers - Software 0 0 1468.3 22.2655 0

Power -
NTPC Generation/Distribution 31 1229.5 7887.4 490.4 0.5
Mahindra and
Mahindra Auto - Cars & Jeeps 844.66 279.01 1523.18 46.65 106.77
Hindalco Aluminium 6434.261 931.248 232.1 49.145 28.4
Power -
Reliance Infra Generation/Distribution 0 448.79 0 0 276.41
Jaiprakash Construction &
Association Contracting - Civil 15.6585876 669.6720451 3099.11 117.865995 73.834567
Maruti Suzuki Auto - Cars & Jeeps 741.3 2261.1 500.2 42.5 490.5
Power -
Tata Power Generation/Distribution 4.65 1484.57 524.17 41.08 9.45
Grasim Diversified 377.81 1395.02 1616.83 14.55 25.11
SunPharma Pharmaceuticals 806.45 268.08 79.64 4.58 100.85
Tata Motars Auto - LCVs/HCVs 2754.05 2420.83 3862.17 131.08 457.98
Construction &
DLF Contracting - Real Estate 120.3073 43.1275 0 0 109.2291
Ranbaxy Labs Pharmaceuticals 26469.74 5407.99 17344.8 547.36 5232.38
ACC Cement Major 0.18 377.91 0 0 61.23
HUL Personal Care 1264.6545 808.4928 0 0 146.0903
Notes:
65141.3245 '--- Borrowings outside india
40854.2386 '--- Deposits in branches outside India
23484.2423 '--- Total Interest Payment

21657.2802 1826.9621 '--- Interest to RBI
As no clear details about foreign currency interest mentioned the amount of other
263.06 interest is taken
15.6585876 Deemed Exports included
73.834567 Foreign Exchange fluctuations included
28169.6714 Deposits from outside india brances
Since no classification given about the interest, the figure under "other interest"
3026.385 taken as foreign currency interest
76 | P a g e
RESEARCH
Core Principles for Managing Currency Risk
1. Determine the types of currency risk to which the corporation is exposed – Break
these down into transaction, translation and economic risk, making specific reference to what
currencies are related to each type of currency risk.
2. Establish a strategic currency risk management policy – Once currency risk types have
been agreed on, corporate Treasury should establish and document a strategic currency risk
`management policy to deal with these types of risks. This policy should include the
corporation’s general approach to currency risk, whether it wants to hedge or trade that risk
and its core hedging objectives.
3. Create a mission statement for Treasury – It is crucial to create a set of values and
principles which embody the specific approach taken by the Treasury towards managing
currency risk, agreed upon by senior management at the time of establishing and
documenting the risk management policy.
4. Detail currency hedging approach – Having established the overall currency risk
management policy, the corporation should detail how that policy is to be executed in
practice, including the types of financial instruments that could be used for hedging, the
process by which currency hedging would be executed and monitored and procedures for
monitoring and reviewing existing currency hedges.
5. Centralizing Treasury operations as a single centre of excellence – Treasury operations

can be more effectively and efficiently managed if they are centralized. This makes it easier
to ensure all personnel are clear about the Treasury’s mission statement and hedging
77 | P a g e
RESEARCH
approach. Thus, the Treasury can be run as a single centre of excellence within the
corporation, ensuring the quality of individual members. Large multinational corporations
should consider creating a position of chief dealer to manage the dealing team, as the
demands of a Treasurer often exceed the ability to manage all positions and exposures on a
real-time basis. The currency dealing team must have the same level of expertise as their
counterparty banks.
6. Adopt uniform standards for accounting for currency risk – In line with the
centralizing of Treasury operations, uniform accounting procedures with regard to currency
risk should be adopted, creating and ensuring transparency of risk. Create benchmarks for
measuring the performance of currency hedging.
7. Have in-house modelling and forecasting capacity – Currency forecasting is as

important as execution. While Treasury may rely on its core banks for forecasting exchange
rates relative to its needs, it should also have its own forecasting ability, linked in with its
operational observations which are frequently more real time than any bank is capable of.
Treasury should also be able to model all its hedging positions using VaR and other
sophisticated modelling systems.
8. Create a risk oversight committee – In addition to the safeguard of a chief dealer

position for larger multinational corporations, a risk oversight committee should be
established to approve position taking above established thresholds and review the risk
management policy on a regular basis.
78 | P a g e
RESEARCH
BIBLIOGRAPHY
• www.rbi.gov.in
• www.google.co.in
• CURRENCY STRATEGY: BY CALLUM HENDERSON
• BANK FOR INTERNATIONAL SETTLEMENT(BIS) MARCH 2009
• FOREX MARKETS IN INDIA
79 | P a g e

Kinjal Mehta - Final Report

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FOREX MARKETS IN INDIA

N L DALMIA INSTITUTE OF MANAGE MENT STUDIES AND

“FOREX MARKE”S IN INDIA”

SUBMITTED IN PARTIAL FULFILLMENT FOR THE AWARD OF

UNDER THE GUIDANCE OF

N.L.DALMIA INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

I am grateful to Prof. P. L. Arya, Director, N L Dalmia Institute of Management Studies and

I sincerely thank Prof. V. S. Date, N L Dalmia Institute of Management Studies and

KINJAL YASHWANT MEHTA

1 Overview: Investors ponder depth and duration of global downturn 4

2 Foreign Exchange Market Overview 9

3 Forex Market: A Historical Perspective 14

4 Foreign Exchange Management Act, 1999 19

5 Participants in foreign exchange market 20

6 Exchange rate System 23

7 Foreign Exchange Market Structure 26

8 Fundamentals in Exchange Rate 28

9 Exchange Rate Indices 31

10 Sources of Supply and Demand in the Foreign exchange 39

11 Foreign Exchange Market Trading Platform 44

12 Corporate Hedging for Foreign Exchange Risk in India 46

13 Determinants of Hedging Decisions 58

14 An Overview of Corporate Hedging in India 61

15 Currency Risk Management 68

16 Core Principles of Managing Currency Risk 77

Overview: Investors ponder depth and duration of global

Rupee Dollar Exchange

Rupee/Japanese Yen (100) Exch

Managing Currency Risk – The Investor: Currency Exposure

Foreign Exchange Market Overview

Need for Foreign Exchange:

About foreign exchange market:

Foreign Exchange Market: An Assessment

Foreign Exchange Market Turnover

Forex Market: A Historical Perspective

Early Stages: 1947-1977

Formative Period: 1978-1992

Post-Reform Period: 1992 onwards

In addition, several initiatives aimed at dismantling controls and providing an enabling

Foreign Exchange Management Act, 1999

Participants in foreign exchange market

The main players in foreign exchange market are as follows:

5. Overseas Forex Market:

Corporation’s particularly multinational corporation and transnational corporation having

Exchange rate System

The Gold Standard

1) Gold specie standard

2) Gold Bullion Standard:

Bretton Woods System

Floating Rate System

Foreign Exchange Market Structure

Fundamentals in Exchange Rate

Methods of Quoting Rate

Factors Affecting Exchange Rates

• Expectation of the Foreign Exchange Market

Exchange Rate Indices

Nominal Effective Exchange Rate Index

If arithmetic sum is to be used, the formula can be developed as follows. Let

Then, NEER = ((C1c/C1b)*W1) + ((C2c/C2b)*W2) + ..... + ((Cnc/Cnb) * (Wn)

W1 = .30, W2 = .60, W3 = .10.

Therefore, NEER index using direct rates

Note that 1.175 is not equal to 1/0.8648.

Then, NEER = ((C1c/C1b)W1) + ((C2c/C2b)W2) + ..... + ((Cnc/Cnb) * (Wn)