A

RESEARCH REPORT
ON

“STUDY ON DYNAMICS OF FOREIGN EXCHANGE

MARKET IN INDIA”

SUBMITTED TO
SAVITRIBAI PHULE PUNE UNIVERSITY
IN PARTIAL FULFILLMENT OF TWO YEARS FULL TIME COURSE OF
MASTERS IN BUSINESS ADMINISTRATION (MBA)

SUBMITTED BY
PRASHANT SUDHAKAR AGARKAR
(FINANCE)

UNDER THE GUIDANCE OF

PROF. SANJAY GAIKWAD

PIMPRI CHINCHWAD EDUCATION TRUST’S

PIMPRI CHINCHWAD COLLEGE OF ENGINEERING
DEPARTMENT OF BUSINESS ADMINISTATION
NIGDI - PUNE- 411044

BATCH –2019-21
 DECLARATION OF STUDENT

I Prashant Sudhakar Agarkar, student of SY MBA (Finance), hereby declare that the
research work titled “Study on Foreign Exchange Market and It’s Risk Management”
which has been submitted to Savitribai Phule Pune University is an original work of the
undersigned and has not been reproduced from any other sources and has not been submitted to
any university.

Signature of student

PRASHANT S. AGARKAR

Date:

Place: AKURDI, PUNE

 ACKNOWLEDGEMENT

Every person who touches heights, reaches that level with the grand support, blessings of his /her
loved ones, guides, teachers, elders.He can’t deny the fact that they are the people behind his success.
I am very thankful to the people who provided me their help and support.

I owe my special thanks to Dr. Santosh Shinde (HOD, MBA Department) for her grand support,
guidance, and for being a helping hand in every possible way in this project.

I am very thankful to Prof. Sanjay Gaikwad (Lecturer, MBA Department) for devoting his precious
time and for leaving no stone unturned for the completion of this project.

I would also like to extend my thanks to my supporting faculty of

MBA Department,

Pimpri Chinchvad College of Engeneering, Pune.

THANK YOU ALL!

Chapter 1- Introduction
 INTRODUCTION

The foreign exchange market is the generic term for the worldwide institutions that exist to exchange
or trade currencies. Foreign exchange is often referred to as “forex” or “FX.” The foreign exchange
market is an over-the-counter (OTC) market, which means that there is no central exchange and
clearinghouse where orders are matched. FX dealers and market makers around the world are linked
to each other around the clock via telephone, internet links, and fax, creating one cohesive market.

The foreign exchange market is the largest and highly liquid financial market in the world with
worldwide average daily trading volume over $6 trillion, this is more than two thousend times of the
daily trading on the National Stock Exchange (NSE) which is around $3 billion . Foreign exchange
forms the basis of dealings for trade and other monetary transactions between economies of the
world. Foreign exchange market operates with heterogeneous participants such as central banks,
commercial banks, companies, brokers, fund managers, speculators and individuals. Central banks
regulate the market for smooth and orderly operations with a broader objective of economic and
financial development. On the other hand, other participants try to minimise the potential risk with
the best possible way and try to maximise the profit. Presences of high volatility make the exposure
management challenge since the global capital is highly volatile and purely depends on the
performances in the economic fundamentals. Moreover, country-specific and market-specific
investors sentiments also influence the same. This volatile pattern in the foreign exchange market is
extremely crucial for a country like India which has unfavourable trade balance and facing stiff
competition in the global market.

Foreign exchange market is the largest financial market having trading centres across the globe on
which the sun never sets and operate in a virtual platform. It operates like other financial markets
where the price of the currency is measured as the value of a foreign currency relative to domestic
currency or vice-versa. A foreign exchange contract typically states the currency pair, the amount of
the contract, the agreed rate of exchange. Highly dynamic nature of exchange rate necessitates the
behaviour for minimising the potential exposure. Understanding the foreign exchange rate
movements is not only crucial for exporters and importers but also other active market participants
such as commercial banks, brokers, central banks, traders, speculators, tourists and investors.

For understanding the movements in the foreign exchange market, much emphasis is given on
fundamental, behavioural, technical analysis along with central bank’s actions for currency
management. Fundamental analysis involves the study of economic fundamentals of a country such
as Gross Domestic Product (GDP), Balance of Payment (BOP) Position, Political Stability, Inflation,
Interest Rates and Rating by major Global Credit Rating Agencies etc. Nonfundamental factors play
an unavoidable role as the market not always concerns with fundamental, but it has strong relations
with sensitive factors. Behavioural factor like bandwagon effects, peers/social and rumours influence
the participant's decision. Similarly, technical analysis uses exchange rate forecasting techniques
based on historical movements in the market. Impact of fundamental and non-fundamental factors on
the foreign exchange market has become a widely studied topic in academic literature. One side of
this literature focuses on the impact of fundamental and non-fundamental factors, while the other on
the role, efficiency and use of technical analysis by foreign exchange traders in generating trading
signals. Some studies have reported from their survey of foreign exchange traders that
non-fundamental factors such as bandwagon effects, over-reaction to news, technical trading, and
excessive speculation determines short-run exchange rate and the role of fundamental factors is
relevant in the long run. Previous literature on technical analysis provides that technical analysis is
an important and widely used method of analysis in the foreign exchange market and that applying
certain technical trading rules over a sustained period may lead to significant positive excess returns.
Most of these studies have however been limited to major developed countries and some developing
countries excluding India. These results might differ between the countries as it depends on the
specific country’s market regulations, ‘maturity’ and the economy itself.

Motives for central bank interventions in the foreign exchange market are clearly available and
supported by the academic literature. But the impact of central bank interventions on foreign
exchange volatility and its relationship with technical rules is still unclear. Some studies on a survey
of foreign exchange dealers have reported that central bank intervenes with the objective to bring
stability in the market, whereas other studies have reported from their survey evidence that central
bank interventions increase volatility in the market. This contradiction need to be addressed has
aroused the necessity to identify the existent impact of central bank interventions on foreign
exchange volatility so that behaviour of the market to intervention practices can be understood
clearly at indian context.

This study primarily investigates the dynamic characteristics of Indian foreign exchange market
including perception and attitude of the market participants to forecasting the exchange rate with an
artificial neural network technique. It specifically examines the relative importance of fundamental
as well non-fundamental that influence foreign exchange rate predictions and their time-varying
behaviour in the market. Similarly, it explores the significance of fundamental and non-fundamental
factors in the trading decision of foreign exchange traders. Further study assesses the impact of
central bank interventions by measuring the extent of the volatility of the Indian foreign exchange
market due to Central Bank interventions. Finally, study recommend measures for policy makers,
investors and corporate on the basis of the findings from the present study.
Chapter 2- Liteature Review
 LITERATURE REVIEW

Collier and Davis (1985) in their study about the organisation and practice of currency risk

management by U.K. multi-national companies. The findings revealed that there is a degree of

centralised control of group currency risk management and that formal exposure management

policies existed. There was active management of currency transactions risk. The preference was for

risk-averse policies, in that automatic policies of closeout were applied.

Batten, Metlor and Wan (1992) focussed on foreign exchange risk management practice and
product

usage of large Australia-based firms. The results indicated that, of the 72 firms covered by the

Study, 70% of the firms traded their foreign exchange exposures, acting as foreign exchange

risk bearers, in an attempt to optimise company returns. Transaction exposure emerged as the most

relevant exposure.

Jesswein et al, (1993) in their study on use of derivatives by U.S. corporations, categorises

foreign exchange risk management products under three generations: Forward contracts belonging to

the First Generation; Futures, Options, FuturesOptions, Warranties and Swaps belonging to the

Second Generation; and Range, Compound Options, Synthetic Products and Foreign Exchange

Agreements belonging to the Third Generation. The findings of the Study showed that the use of

the third generation products was generally less than that of the second-generation products, which

was, in turn, less than the use of the first generation products. The use of these risk management
products was generally not significantly related to the size of the company, but was significantly

related to the company’s degree of international involvement.

Phillips (1995) in his study focused on derivative securities and derivative contracts found that

organisations of all sizes faced financial risk exposures, indicating a valuable opportunity for

using risk management tools. The treasury professionals exhibited selectivity in their use of

derivatives for risk management.

Howton and Perfect (1998) in their study examines the pattern of use of derivatives by a large
number of U.S. firms and indicated that 60% of firms used some type of derivatives contract and
only 36% of the randomly selected firms used derivatives. In both samples, over 90% of the interest
rate contracts were swaps, while futures and forward contracts comprised over 80% of currency

contracts.

Hentschel and Kothari (2000) identify firms that use derivatives. They compare the risk

exposure of derivative users to that of nonusers. They find economically small differences in equity

return volatility between derivative users and nonusers. They also find that currency hedging has

little effect on the currency exposure of firms' equity, even though derivatives use ranges from

0.6% to 64.2% of the firm's assets. Our findings are very important since no previous work has

examined the FERM practice in Indian context. This study will be a pioneering attempt in Indian

scenario and first of its kind to survey the Indian companies and their risk management practices

Sen Gupta, Abhijit and Rajeshwari Sengupta (2013): “Management of Capital Flows in India”,
ADB South Asia Working Paper Series, No. 17, March.
Ouyang, Alice Y. and Ramkishen S Rajan (2008): “Reserve Stockpiling and Managing its

Monetary Consequences: the Indian Experience”, Macroeconomics and Finance in Emerging Market

Economies, February.

Bank for International Settlements (2013): “Market volatility and foreign exchange intervention in
EMEs: what has changed?”, BIS Papers No. 73, October.

Ljubaj, Igor and Ana Martinis and Marko Mrkalj (2010), “Capital Inflows and Efficiency of
Sterilisation – Estimation of Sterilisation and Offset Coefficients”, Croatian National Bank Working
Paper No. 24, April.

Patnaik, Ila (2004): “India’s Experience with a Pegged Exchange Rate”, India Policy Forum, 2004,
Vol 1, Issue 1.

Pattanaik, Sitikantha (1997): “Targets and Instruments for the External Sector with an Open
Capital Account”, Economic and Political Weekly, October 4.

Reserve Bank of India (2004): Report on Currency and Finance, 2002-03.

Theoretical studies like Copeland and Copeland (1999) are usually supported by the findings from
developed countries (the USA, Canada, the UK). Therefore, the application of such studies might be
complicated in developing markets. Researchers that analyze the foreign exposure management in
companies often use large samples and questionnaires to evaluate the derivate use, and are successful
in describing countries with well-developed markets.
.

Chapter 3- Objective
 OBJECTIVES OF THE STUDY

1. To study and understand Foreign Exchange Market in India.

2. To study the role of RBI in Foreign Exchange Market in India.

3. To study technique of risk management in Foreign Exchange Market.

Chapter 4- Research Methedology
 RESEARCH METHEDOLOGY

3.1 Introduction

The purpose of this chapter is to explain in detail the research methods and the methodology
implemented for this study. The chapter will explain first of all the choice of research approach, then
the research design, as well as the advantages and disadvantages of the research tools chosen. . The
chapter then goes on to discuss the scope of study. It concludes with a brief discussion on the
problems encountered during the research.

3.2 Research Approach

This dissertation makes use of Descriptive Research Approach. Descriptive research is defined as a
research method that describes the characteristics of the population or phenomenon studied. This
methodology focuses more on the “what” of the research subject than the “why” of the research
subject. The descriptive research method primarily focuses on describing the nature of a
demographic segment, without focusing on “why” a particular phenomenon occurs. In other words, it
“describes” the subject of the research, without covering “why” it happens.

For example, A researcher wants to understand reaction among forex market player’s on central
banks interventions in Forex market will conduct a survey among players, gather population data and
then conduct descriptive research on this sector. The study will then uncover details on “what is the
cource of action of forex players,” but not cover any investigative information about “why” the type
of actions exist.

3.3 Research Design

For this research I made use of descriptive research strategy. A descriptive research strategy is
particularly applicable for the purposes of this research, where the collection and presentation of data
has to be done. The data for research is collected from the secondary data sources. The research
makes use of various secondary data sources like data available on internet, data published by
government and non government agencies, commercial information sources etc. In this study, for
obtaining a broader view of the impact of the various factors like RBI interventions, rules &
regulations on the Foreign Exchange Market in india.

The validity and the advantages and disadvantages of the data collection tools used to implement the
research strategy will be discussed next.

3.4 Data Collection Methods

For the purposes of this research, I decided to use a combination of two classic secondary data
collection methods- 1.Data available on Internet 2.Data published by government and
non-government agencies.

A) Data available on Internet

The data available on internet is the vary popular source of collecting secondary data. There is huge amount of
data available on various sites. For this study the data is extracteed from various diverse sites available on
internet.

B) Data Published by government & non-government agencies

The data published by government & non-government agencies, central banks is also vary important and
reliable source of secondary data collection. For this study the data source is various reports published by RBI,
and reports published by diffrent rating agencies in india.

3.5 Scope of Study

The scope of a study explains the extent to which the research area will be explored in the work and
specifies the parameters within the study will be operating. Basically, this means that you will have
to define what the study is going to cover and what it is focusing on.

The purpous of study is to gain knowledge about the indian foreign exchange market and risk
management techniques in foreign exchange market. he study mainly focuses on foreign exchange
market market of india also touch upon some basics terminologies of foreign exchange market in
general. The duration of study is of two months.

This study is about knowing the basics of foreign exchange market and also studying the foreign
exchange market of india. The study is to synthesize about the the various factors affecting exchange
rates, rules and regulations of indian foreign exchange market. The study then talks about the role of
RBI at indian foreign exchange market. Further more the study goes on the techniques of risk
management in foreign exchange market.

3.6 Problems and Limitations

1. While collecting secondary data sometimes it gets difficult to get appropriate data for fulfilling
our study objectives

2. Since the information or data available is collected by someone else with respect to their needs it
gets hard to match with our study objectives.

3. The issue of unreliability occured when the data is collected from unofficial data sources.

4. Sometimes it is possible that the data collected may not be current or fresh data which may
reuslt in wrong data presentation.
Chapter 5 - Conceptual Background
 CONCEPTUAL BACKGROUND

FOREIGN EXCHANGE MARKET

The foreign exchange market is a global marketplace where the currencies of various countries are
bought and sold against each other. The rate at which the currency is trading is known as the value of
that currrency against it is treaded. At foreign exchange market few commodities like Gold(XAU),
silver(AUG) are also treaded against currencies of various countries. The foreign exchange rates are
accepted by all countries for the purpous of exchanging currencies.

OVERVIEW OF FOREIGN EXCHANGE MARKET

Foreign exchange , forex or just Forex are all terms used to describe the trading of the world's many
currencies. The forex market is the largest market in the world, with trades amounting to more than
$6 trillion every day. This is more than two thousend times the daily trading on the National Stock
Exchange (NSE) which is around $3 billion. Most forex trading is speculative, with only a few
percent of market activity representing fundamental currency conversion needs.

Unlike trading on the stock market, the forex market is not carried out by a central exchange, but on
the “interbank” market , which is thought of as an OTC (over the counter ) market. Trading takes
place directly between the two counterparts necessary to make a trade, whether over the telephone or
on electronic networks all over the world. The main centres for trading are Sydney, Tokyo, London,
Frankfurt and New York. This worldwide distribution of trading centres means that the forex market
is a 24-hour market.

TRADING AT FOREX MARKET

A currency trade is the simultaneous buying of one currency and selling of another one. The
currency combination used in the trade is called a cross (for example, the Euro/US Dollar, or the GB
Pound/Japanese Yen.). The most commonly traded currencies are the so-called “majors” – EURUSD,
USDJPY, USDCHF and GBPUSD.The most important forex market is the spot market as it has the
largest volume.

The market is called the spot market because trades are settled “immediately” or on the spot. In
practice this means within two banking days.

❖ Forward Outrights

For forward outrights, settlement on the value date selected in the trade means that even though the
trade itself is carried out immediately, there is a small interest rate calculation left. This is because if
you trade e.g. NOKJPY, you get almost 7% (annual) interest in Norway and close to 0% in Japan. So,
if you borrow money in Japan, to finance the trade as you must have one currency with which to buy
or another, and place it in Norway you have a positive interest rate differential.

This differential has to be calculated and added to your account. You can have both a positive and a
negative interest rate differential, so it may work for or against you when you make a trade. The
interest rate differential doesn't usually affect trade considerations unless you plan on holding a
position with a large differential for a long period of time. The interest rate differential varies
according to the cross you are trading.

❖ Trading on Margin

Trading on margin means that you can buy and sell assets that represent more value than the capital
in your account. Forex trading is usually done with relatively little margin since currency exchange
rate fluctuations tend to be less than one or two percent on any given day. To take an example, a
margin of 2.0% means you can trade up to $500,000 even though you only have $10,000 in your
account. In terms of leverage this corresponds to 50:1, because 50 times $10,000 is $500,000, or put
another way, $10,000 is 2.0% of $500.000. Using this much leverage gives you the possibility to
make profits very quickly, but there is also a greater risk of incurring large losses and even being
completely wiped out.Therefore, it is inadvisable to maximize your leveraging as the risks can be
very high.
 ❖ Forex Futures

Forex futures are standardized futures contracts to buy or sell currency at a set date, time, and
contract size. These contracts are traded at one of the numerous futures exchanges around the world.
Unlike their forwards counter-parts, futures contracts are publicly traded, non-customizable
(standardized in their specified contract size and settlement procedures) and guaranteed against credit
losses by an intermediary known as a clearing house. The clearing house provides this guarantee
through a process in which gains and losses accrued on a daily basis are converted into actual cash
losses and credited or debited to the account holder. This process, known as mark-to-market, uses the
average of the final few trades of the day to calculate a settlement price. This settlement price is then
used to determine whether a gain or loss has been incurred in a futures account. In the time span
between the previous day’s settlement and the current’s, the gains and losses are based on the last
settlement value.

❖ Futures Margins

Futures clearing houses require a deposit from participants known as a margin. Unlike margin in the
stock market, which is a loan from a broker to the client based on the value of their current portfolio,
margin in the futures sense refers to the initial amount of money deposited to meet a minimum
requirement. There is no borrowing involved, and this initial margin acts as a form of good-faith to
ensure both parties involved in a trade will fulfill their side of the obligation. Furthermore, the
futures initial margin requirement is typically lower than the margin required in a stock market. In
fact, futures margins tend to be less than 10 percent or so of the futures price.

Should an account take on losses after daily mark-to-market, the holders of futures positions must
ensure that they maintain their margin levels above a predesignated amount known as
the maintenance margin. If accrued losses lower the balance of the account to below the maintenance
margin requirement, the trader will be given a margin call (no relation to the movie) and must
deposit the funds to bring the margin back up to the initial amount.
 USES OF FOREX MARKET

❖ Hedging

Forex futures are used extensively for both hedging and speculating activity. Let's briefly examine an
example of using FX futures to mitigate currency risk.

An American company doing business in Europe is expecting to receive a payment of €1,000,000 for
services rendered, in five months’ time. For the sake of the example, imagine that the prevailing spot
EUR/USD rate is currently at $1.04. Fearing further deterioration of the euro against the dollar, the
company can hedge this upcoming payment by selling 8 euro futures contracts, each containing
€125,000, expiring in five months at $1.06 dollars per euro. Over the course of the next five months,
as the euro depreciates further against the dollar, the company’s account is credited daily by the
clearinghouse. After the time has elapsed and the euro has fallen to $1.03, the fund has realized gains
of $3750 per shorted contract, calculated by 300 ticks (at a minimum price move per tick at $.0001)
and a multiplier of $12.50 per contract. With 8 contracts sold, the firm realizes total gains of $30,000,
before accounting for clearing fees and commissions.

If the American company in the example had not entered this trade and received euros at the spot rate,
they would have had a loss of $10,000: $1.04 EUR/USD spot five months prior to futures expiry, and
$1.03 spot at futures expiry translates to a loss of $10,000 per €1,000,000.

❖ Trading and Speculating

As with the equities market, the types of trading method is dependent upon the unique preferences of
the individual when it comes to both techniques and time frames.

Day traders generally never hold positions overnight and can be in and out of a trade within a matter
of minutes seeking to jump on an intraday swing. A day trader’s M.O. is centered around price and
volume action with a heavy emphasis on technical analysis as opposed to fundamental factors. A
forex futures day trader primarily employs the main technical indicators prevalent in the sport
markets, such as, Fibonacci patterns, Bollinger Bands, MACD, oscillators, moving averages, trend
lines chart patterns, and support and resistance areas.

Many, if not all the aspects of technical analysis for equities can be interchangeable with the futures
market, and thus, trading between the two asset classes can be an easy transition for day traders.
Swing traders are traders who hold positions overnight, for up to a month in length. They generally
employ technical analysis spanning a longer time frame (hourly to daily charts), as well as short-term
macroeconomic factors.

Finally, there are the position traders who hold onto a position for multiple weeks to multiple years.
For these individuals, technical analysis may take a back seat to macroeconomic factors. Position
traders are not concerned with the day-to-day fluctuations on the contract prices, but are interested in
the picture as a whole. As such, they may employ wider stop-losses and differing risk management
principles than the swing or day trader.

Note however, these are generalized definitions and the differentiating characteristics of traders are
not black and white. At times, day traders may employ fundamental analysis, such as when Federal
Open Market Committee data is released. By the same token, position traders may employ technical
analysis tools to set up entries, exits, and trailing stop losses. Furthermore, the time-frames utilized
by traders are also quite subjective, and a day trader may hold a position overnight, while a swing
trader may hold a position for many months at a time. Much like in the equities markets, the type of
trading style is entirely subjective and varies from individual to individual.

POPULAR FOREX FUTURES EXCHANGES

Forex futures are traded at exchanges around the world, with the most popular being the Chicago
Mercantile Exchange (CME) group, which features the highest volume of outstanding futures
contracts. Forex, much like most futures contracts, can be traded in an open out-cry system via live
traders on a pit floor or entirely through electronic means with a computer and access to the
Internet. Currently, open-outcry is being phased out in Europe and replaced with electronic trading.
As mentioned earlier, in terms of the sheer number of derivatives contracts traded, the CME group
leads the pack with 3.16 billion contracts in total for 2013. The Intercontinental Exchange and Eurex
follow behind at 2nd and 3rd places, respectively, at 2807.97 and 2190.55 billion contracts traded. The
bulk of the FOREX futures contracts are traded through the CME group and its intermediaries.
 FOREX MARKET IN INDIA

The foreign exchange market in India has been around for about 40 years now. The market
started operating in 1978 after the government's decree. After its establishment, the forex market has
seen significant growth over the years. The market is regulated by the central government and all
aspects of the trade are defined by national laws. There are many things about this market that make
it distinct from other markets in the world. To start with, its structure is slightly unique and defined
by different market dynamics. In order to understand the forex market in India, you need to study its
structure and what makes it different.

◼ Structure Of The Forex Market In India:

Like other forex markets in the world, the forex in India consists of several stakeholders. The main
stakeholders in this market are:

1. Individual Traders
2. Commercial Banks
3. Authorized dealers/ brokers
4. Corporates
5. The Reserve Bank of India

The five actors mentioned above play different roles in the trade. Traders are generally all
individuals in the public who are also corporate customers of the banks. These customers use the
banks as authorized dealers to access the forex market. There are traders of different kinds but all of
them are able to access the market only through dealers. This is much like elsewhere in the world
where brokers are the intermediaries between the forex and ordinary traders.

The banks, on the other hand, are the legally authorized institutions to handle currency. In India,
banks exist in different tiers and there are clear laws that determine which institution is categorized
as a financial institution. From these legal institutions, all those who want to trade can create
accounts, access the market and choose products that they would like to trade in. The trading
landscape has changed a lot over the years especially since the 1990's when the Indian regulatory
authorities liberalized this market.
As trading the Forex markets with overseas Forex brokers is considered to be an illegal activity in
india , indians are only allowd to tread with SEBI regulated Forex brokers or any Authorised dealers.
SEBI Forex brokers have the option of offering Forex trading products as part of its services
portfolio, but these brokers are required to follow all guidelines issued by the SEBI and the official
authorities governing the FEMA act. Failure to stick to the rules and guidelines will result in all
SEBI regulated brokers to face severe consequences, which can also ultimately result in drastic legal
concerns. SEBI also imposes restrictions on the maximum available leverage, types of trading, and
the rules governing exotic currency pairs. In reality, SEBI Forex brokers are only allowed to offer
INR based currency pair options for USD, EUR, GBP, and JPY. Almost all other currency pairs are
barred from FX trading unless authorized by the Government authorities.

Lastly, the Reserve Bank of India (RBI) is the central financial institution which is responsible for
the monetary policy in India. This institution has been instrumental in shaping the trading landscape
in India. Before 1993, the Indian Rupee had a fixed value which was determined by the RBI. This
meant that the currency only attracted a certain exchange rate even though the market dynamics were
changing. In 1993, though, the RBI repealed the prevailing law at the time to allow for an exchange
rate determined by the market itself. Since then, the Rupee's value has changed a lot in relation to
different currencies.

❖ Status Of The Forex Market In India

The forex market in India is quite vibrant. Even though it is not the market with the most daily
volume, it is among the top ten markets in the world. As of 2020, in terms of highest Foreign
currency Reserves asset, India is at 8th place with $473.3 billion of Foreign currency Reserves asset.
The top asset in this market is the United States as represented by US institutional bonds and
government bonds. The Indian forex reserves are also held in terms of gold. Indeed, India is the first
nation in the world in terms of gold consumption.

Statistically, the Indian forex market has changed a lot. The avrage daily turnover of the indian forex
market is now around $3 billion from couple of millions when it was started. The Indian forex
market has several forex players that facilitate the exchange of currency. The markets in these
exchanges have several listed brokers and authorized institutions. There are several non-bank
financial institutions that are legally authorized to facilitate trade in the Indian market. These
institutions are regulated by the FEDAI and they use the USP for better rates of exchange. The
market is open 24 hours every day and it is linked to the rest of the world markets.
Chapter 6: Data Collection
 DATA COLLECTION

UNDERSTANDING THE FOREIGN EXCHANGE MARKET

It is a fact that the currencies of different countries have different values that is based upon their
actual economic and monetary strength. It is from this difference that the genesis of foreign exchange
occurs.

Foreign exchange can be termed as the act of matching the different values of the goods and services
that is involved in the international business transaction process in order to attain the exact value that
is to be transferred between the parties of an international trading transaction in monetary terms.

Foreign exchange as an activity had started the day civilization and independent principalities got
established in the world. But in those days it was a case of exchanging value in the form of transfer
of goods and services of identical value that is commonly identified with barter system. Moreover
the transactions were done on a one-to-one basis, and the terms and conditions were determined by
the parties entering into such transactions. There was no universal system or rule that determined
these transactions. In that way foreign exchange and international monetary system is a modern day
trend that gained an institutional form in the first half of the twentieth century and has been
developing since then.

❖ Foreign Exchange:

According to International Monetary Fund (IMF), Foreign Exchange is defined as different forms of
financial instruments like foreign currency notes, deposits held in foreign banks, debt obligations of
foreign banks and foreign governments, monetary gold and Special Drawing Rights (SDR) that are
resorted to make payments in lieu of business transactions that is done by two business entities or
otherwise, of nations that have currencies having different inherent monetary value (www.imf.org).

Leading economist Lipsey Richard G.,1993 has mentioned that the foreign exchange transactions are
basically a form of negotiable instrument that are resorted to deliver the cost of goods and services
that form a part of trading transactions and otherwise, between business and public entities of nations
of the global economy.

Sarno, Taylor and Frankel, 2003 gives the definition of foreign exchange as denoting the act of
purchase and sale of currencies of different economies that is performed over the counter for various
purposes that includes international payments and deliverance of cost of various business
transactions, where the value is usually measured by tallying the value of the currencies involved in
the foreign exchange transaction with that of the value of U.S. Dollar.

According to Clark and Ghosh 2004, Foreign Exchange denotes transactions in international
currency i.e. currencies of different economies. In such transactions the value of a currency of one
country is tallied and exchanged with similar value of the currency of the country in order to
exchange the cost of a business transaction or public monetary transfer that is taking place between
two entities of these economies.

❖ Foreign Exchange Transactions:

Transactions in foreign exchange are done through various types and various modes between
different countries of the world.

According to information mentioned in the Reuter’s Financial Training Series, 1999,’TOD’

Transactions, ‘TOM’ Transactions, Swap Rates, Spot Rates, Forward Rates, Margin Trading and
Buy / Sell on Fixed Rates foreign exchange transaction methods are some of the commonly used
methods that are widely used by global managers for their foreign exchange transaction activities.

A. TOD Operations:

TOD Operations are foreign exchange transaction methods where the trader uses the exchange rate
of the day on which the foreign exchange transaction order is to be executed. In other words TOP
operations are commonly used in intra-day foreign exchange transactions. As a result they are
commonly resorted to by speculators in foreign exchange transactions and those who general
speculate on the rates of different foreign exchange markets of the globe.

B. TOM Operations:
In this type of transactions the transaction process carried forward to the next day instead of it being
an intra-day trading. TOM transactions rate is fixed on the day the transaction is signed, but the rate
of exchange is agreed upon to be that of the next day.

C. SPOT Transactions:

SPOT Transactions can be compared with TOM transactions because here also the exchange rate is
fixed at a value that prevails over the exchange rate of intra-day trading of shares. But SPOT
transactions have been separated as a different category because unlike TOM transactions, SPOT
transactions’ contracts are executed on the third day after the signing of agreement between the Bank
and the client.

D. Forward Contract:

Forward contracts are those exchange rate contracts where the currency conversion exchange rate
agreement is decided at a certain rate at a time that is well before the date of execution of the
exchange contract. In that way they are similar to TOM transactions. The only differ from them in
the fact that these transactions are made for a long term i.e. generally for one year, and the parties
involved in making this foreign exchange transaction deposit five percent of the contract value with
the bank involved in facilitating the transaction at the time of executing the contract which is then
returned to the client after execution of the exchange transaction. The need for depositing this
amount is to secure the transaction against any loss due to market fluctuations.

E. SWAP:

The greatest advantage of SWAP transactions is that the clients involved in the foreign exchange get
prior information about the exchange rate of the currencies that are part of the transaction. In this
type of transaction the bank first buys the amount of transaction form the client and resells it to the
client after a few days after disclosing the exchange rate of the currencies involved in the transaction
process. SWAP transactions are much sought after by traders because here they get to know
beforehand the exchange rate of the currencies involved in the transaction process that helps them in
avoiding fluctuations in market rate and gives them the advantage of determining the prices of goods,
the nature of the currency market notwithstanding. .
 F. MarginTrading:

The key element of Margin trading is that any trader can opt for SPOT trading round the clock by
going through the margin trading mode. The other key element of margin trading is that the traders
can make deals with a minimal spread for a huge amount of funds by projecting fraction of the
needed amount. In that way it is a unique form of global financial transaction where the threshold
value that can be transacted through the margin trading mode is $ 100000 with bigger deals being
multiples of $ 100000. But in order to deal in margin trading the trader has to make a security deposit
of five recent of the contract value that has to be replenished from time to time in order to maintain
the amount from which the probable losses from margin trading transactions are accommodated.

G. Buying/Selling on Fixed Rate Order:

This is a mutual agreement between the buyer and seller of foreign exchange. Neither its rate nor its
other terms and conditions are based upon actual conditions. Rather the deal is based keeping the
mutual profitability of the buyer and seller intact where both of them get their desired amount.

❖ Global Foreign Exchange Market:

According to the table depicting the ‘Triennial Bank Survey of Foreign Exchange and Derivatives
Market Activity’ done by Bank for International Settlements (BIS), as shown below the global
foreign exchange market has an average daily turnover of over $ 5 trillion. This rise in foreign
exchange transactions it is observed has been due to rise in the volume of trading in ‘Spot’ and
‘Forward’ markets. This is indicative towards increase in volatility of foreign exchange markets
around the world. (www.bis.org).

As observed by Jacque Laurent L.1996, Studies in foreign exchange point to the fact that the volume
involved in foreign exchange transactions in the total markets around the globe has the potential to
affect the overall functioning of the global financial system due to the systematic risks that are part
and parcel of the foreign exchange transaction system. Most of the transactions occur in the major
markets of the world with the London Exchange followed by New York and Tokyo Stock Exchange
accounting for over sixty percent of the foreign exchange transactions done around the globe.
Among these transactions the largest share is carried out by banks and financial institutions followed
by other business transactions i.e. exchange of value for goods and services as well as dealers
involved in securities and financial market transactions. According to the studies by Levi Maurice D.,
2005, in foreign exchange transactions most of the transactions happen in the spot market in the
realm of OTC derivative contracts. This is followed by hedging and forward contracts that are done
in large numbers. The central banks of different countries of the world and the financial institutions
operating in multiple markets are the main players that operate in the foreign exchange market and
provide the risk exchange control mechanism to the players of the exchange market and the system
where around $ 3 trillion amount of money is transacted in 300000 exchanges located around the
globe. The largest amount of transactions takes place in the spot rate and that too in the liquidity
market. The quotation on price in these markets sometimes reaches to around two thousand times in
a single day with the maximum quotations being done in Dollar and Deutschemark with the rates
fluctuating every two to three minutes with the volume of transaction for a dealer in foreign
exchange i.e. both individual and companies going to the range of $ 500 million in normal times. In
recent years the derivative market is also gaining popularity in OTC dealings with regards to the
foreign exchange market.

❖ Global Foreign Exchange Market Management Risks:

According to the researcher Kim S. H., 2005, Foreign exchange transactions are identified by their
connection with some financial transactions occurring in some overseas market or markets. But this
interconnectivity does not affect the inherent value of the currency of the country which is
determined by the economic strength of that country. This means that the inherent value of each
currency of the world is different and unequal. So when the need arises to exchange the value of
some goods or service between countries engaged in such activity it becomes imperative to exchange
the exact value of goods and services. Considering the complexity and volume of such trading and
exchange activity occurring in the global market between countries it is but natural that the
currencies of individual countries is subject to continual readjustment of value with the currency with
which its value has to be exchanged. This gives rise to the importance of foreign exchange
transactions as a separate area of study and thereby needs much focus for its understanding (Frenkel ,
Hommel and Rudolf , 2005).

In addition to this it is to be realized that with the growing pace globalization and integration of
global economic order there has been a tremendous increase in international business transactions
and closer integration of economic systems of countries around the world especially between the
members of WTO, that has led to the increase in economic transactions and consequent activity in
international foreign currency exchange system (Adams, Mathieson and Schinasi, 1998). Added to
this is the fact that the exchange value of currencies in the transactions is not determined by the
respective countries but by the interplay of value of the currencies engaged in an international
foreign exchange transaction and the overall value of each currency in the transaction prevailing at
that time. In fact each country in the global economic order would want to determine the value of its
currency to its maximum advantage, which was possible a few years ago in when the countries used
to determine the value of their currency according to the existing value of their economy.

The individual countries till the early nineties used to follow a policy of total or partial control over
the exchange value of their currency in the global market. At the same time there also were a group
of countries that followed the policy or system in determining the exchange value of their currency
i.e. left it to the interplay of global economic activity where the value was determined by its
economic performance. The currencies of countries that provide full or partial amount of control in
the international exchange value of its currency are known to follow a ‘Fixed Rate’ whereas the
currencies of countries that allow its currency to seek its inherent value through its performance in
the global economic system are termed as following the ‘Floating Rate’ of foreign exchange
conversion mechanism. Though logically both the type of mechanism of foreign exchange face the
effect of exchange rate fluctuations and consequent volatility in rate it is the currencies having a
floating rate that are continually affected by the fluctuations in exchange rate in the global market
when in the case of currencies with a fixed rate it is more of a controlled and regulated affair
(Chorafas Dimitris N., 1992).

❖ Foreign Exchange Risks Prevailing in the Global Market:

Risks related to the exchange rate of a currency in the global market as has been mentioned, occurs
due to the interplay of inherent value of each currency of the respective countries that are part of the
global financial mechanism. Risks related to foreign exchange come into picture and are also
inevitable in this world marching towards increased interaction due to globalization. The risks will
occur due to business interaction and consequent exchange of value for goods and services.

According to Kodres LauraE., 1996, the risks related to foreign exchange occur when there is
increased interaction between the currency of a country with that of other countries in the
international market and that too if the currency has a floating exchange rate. In that case the value of
the currency is continually affected by its business and financial performance. This relation with
other currencies in the market affects it during the time when the need arises to exchange it with
another currency for settlement of financial transaction in some business or financial purposes and
gives rise to various types of risks. The prominent risks associated during this situation are Herstatt
Risk, and Liquidity Risk.

1. Herstatt Risk:

Herstatt risk is a risk that is named after a German Bank that got liquidated by the German
Government in the seventies of the last century and made to return all; the claims accruing to its
customers. This is because its creditworthiness was affected and it could not pay the settlement
claims to its customers and also on behalf of its customers to their clients. It is basically connected to
the time aspect of foreign exchange value claim settlements in which the foreign exchange
transactions do not get realized as the bank loses its ability to honour the transaction in the
intervening period due to some causes. In the particular case the German bank failed to honour the
financial settlement claims of its clients to their counter parties that were to be paid in values of U.S
Dollars. The main issues that arose were regarding quantifying the amount to be delivered and the
time of the transaction process due to the two countries’ financial systems being located and working
according to different or separate time zones. This case has established a phenomenon in foreign
exchange market where there may erupt situations in which the working hours of banks located in
different time zones may never match with each other leading to foreign exchange settlement
transactions getting affected during the mismatch of the two banks closing and opening time. In fact
the Alsopp Report that studied this phenomenon in detail said that though the foreign exchange
transactions are made in pen and paper on a single day the actual transfer of value takes place within
three to four days. And with the exchange value of currencies operating in the international market
always remaining in a state of flux they either get jacked up or devalued. In either case it affects the
clause of transactions that was decided on an intra-day rate, as the value of both the currencies in the
international market has changed during these days.

2. Risks related to Liquidity:

There can crop up different problems related to the banking systems’ operations and dynamics i.e. in
both technical and management systems as well as inability in terms of volume of available liquidity
strength or in mismatch in tallying of time etc; that can affect the capacity of banks to honour foreign
exchange transactions in terms of transfer of liquidity. These types of risks are being commonly
witnessed in newly emerging economies that are being unable to cope with the sudden surge in
volume of global business transactions thereby leading to exchange rate settlement and payment
delays, outstanding payments and dishonouring of financial commitments in the exchange rate
transaction market.

3. Repercussions:

According to the Studies in foreign exchange related risks by Dumas and Solnik, 1995 aver that risk
related to transactions in foreign exchange have increased with globalization and the rise of global
economic integration process with the countries getting affected in relation to the volume of their
transactions in the global financial and business marketplace. This is because the market is now more
oriented towards market value driven convertibility of currencies that is influenced by the global
financial movements and transactions, and any independent transaction especially of transnational
and multinational companies; will automatically affect other transactions happening in the global
financial marketplace (Klopfenstein G.,1997).

However, according to another study by Gallati Reto R., 2003, these multinational and transnational
companies are simultaneously being affected by the fluctuations in exchange rate of different
currencies of the global market that is exposing their business operations in different global markets
to exchange rate related risks especially due to difference in ‘Spot’ and ‘Forward’ rates and the
inevitable fluctuations (Choi , 2003) that give rise to foreign exchange settlement related problems.

4. Remedies to Foreign Exchange Settlement Risks:

As there risks that have cropped up in foreign exchange transactions due to increase in volume and
frequency of transactions mainly as a result of globalization so, also there have come up remedies to
minimize the risk related to adverse conditions in foreign exchange transactions.

The Bank for International Settlements (BIS) in one of its studies in 1999 has said that settlement of
claims is the most predominant risk that is related to foreign exchange transactions, especially the
speed with which these transactions are materialized and the roadblocks that they may face in the
process due to tremendous increase in volume of foreign exchange transactions that cannot be
cleared in expected times. The solution to these risks according to the study is to simultaneously
clear transactions on either side i.e. for both the parties’ side so that they simultaneously give and
receive payments at the agreed rate of exchange. This would solve the problem of extended time of
actual payment when the rate of exchange fluctuates, thereby creating problems for both the parties.
This arrangement is related to deals being processed simultaneously, which requires the concurrence
and common cause of both the parties. This is because the party that is expecting a hike in value of
its currency may not agree to such a proposal. In that case there should be some law or arrangement
that would make it mandatory for both the parties to settle their intra-day payments on that day itself
so that there is no scope left for speculation by them. According to the study, such arrangements
have been made in USA and Europe where systems like ‘Fedwire’ and ‘Trans- European Automated
Real-Time Gross Settlement Express Transfer (TARGET)’ have been established. ‘Fedwire’
facilitates payments in foreign exchange transactions under the mode of ‘Real Time Gross
Settlements (RTGS)’and ‘TARGET’ facilitates intra-day transfer of foreign exchange between
parties of member countries of Europe on the same day itself.

But, for simultaneous release of funds by both the parties and the intra-day settlement of claims to
succeed it is imperative that the member countries of the global economic system should come
together have concurrence on these issues. This is because all said and done the foreign exchange
transaction related rules and laws are still governed by the respective countries. And most of these
countries are reluctant to make any headway in linking their currency system to the global currency
system for speedy disposal of foreign exchange transactions for fear that such a move would expose
their currency end financial system to the baneful effects of risks and volatility of global foreign
exchange system (Hagelin and Pramborg, 2004).

At the level of international trading corporations there has been initiated some steps whereby they
have formed a private arrangement known as ‘Group of Twenty’. They are a group of twenty
internationally acclaimed global clearing banks who have formed an system called the ‘Global
Clearing Bank’ that acts as a connection between the payment systems of different countries and
verifies international foreign exchange transactions in order to simultaneously satisfy both the parties
regarding authenticity of the process of transaction. The thing is that this system puts a high amount
of strain on the financial and foreign exchange system as well as reserves of individual countries
along with requiring them to bring about some amount of commonality between the financial rules
and regulations of individual countries which is easier said than done. All the same the establishment
of ‘Bilateral Netting System’ and ‘Multilateral Netting Systems’ as well as of ‘Exchange Clearing
House (ECHO)’ are trying to facilitate foreign exchange transactions and minimize the inherent risks
involved (McDonough ,1996).
 INDIAN FOREIGN EXCHANGE SYSTEM:

Exchange Rate Management in India

Foreign exchange market is the market in which foreign currencies are bought and sold. Being a
member of IMF, India followed the par value system of pegged exchange rate system. But when
the Breton Woods system collapsed in 1971, the rupee was pegged to pound sterling for four
years after which it was initially linked to the basket of 14 currencies but later reduced to 5
currencies of India’s major trading partners. Currently India has adopted the managed exchange
rate system.

Exchange rate is simply value of a currency in terms of another currency. The buyers and sellers
of foreign currency includes the, brokers, students,, commercial banks, central banks, individual
firms, foreign exchange brokers etc. The system of exchange rate works through the facility
provided by the key players of the markets. The major functions of the foreign exchange include:

I. Transferring currency from one market to other where it is needed in the transactions.

II. Providing short-term credit to the importers, and thereby facilitating the smooth flow of goods
and services between the countries.

III. Stabilizing the foreign exchange rate through spot and forward market.

Historical Background

Since Independence, the exchange rate system in India has transited from a fixed exchange rate
regime where the Indian rupee was pegged to the pound sterling on account of historic links with
Britain to a basket-peg during the 1970s and 1980s and eventually to the present form of
market-determined exchange rate regime since March 1993. The evolution of exchange
management is discussed below:

Par Value System (1947-1971): After gaining Independence, India followed the par value
system of the IMF whereby the rupee's external par value was fixed at 4.15 grains of fine gold.

Pegged Regime (1971-1992): India pegged its currency to the US dollar (from August 1971 to
December 1991) and to the pound sterling (from December 1971 to September 1975).
The Period Since 1991: A two-step downward adjustment of 18-19 per cent in the exchange rate
of the Indian rupee was made on July 1 and 3, 1991.

Liberalised Exchange Rate Management System: The Finance Minister announced the
liberalised exchange rate management system (LERMS) in the Budget for 1992- 93. This system
introduced partial convertibility of rupee. Under this system, a dual exchange rate was fixed under
which 40 per cent of foreign exchange earnings were to be surrendered at the official exchange
rate while the remaining 60 per cent were to be converted at a market-determined rate.

Kinds of foreign Exchange Market in India:

1. Spot market: It refers to a market in which the sale and purchase of foreign currency are
settled within two days of the deal. The spot sale and purchase of foreign exchange make the spot
market. The rate at which the foreign currency is bought and sold is called spot exchange rate. For
all practical purposes, spot rate is treated as the current exchange rate.

2. Forward Market: It refers to that market, which deals in the sale and purchase of foreign
currency at some future date at a presettled exchange rate. When buyers and sellers enter an
agreement to buy and sell a foreign currency after 90 days of the deal, it is called forward
transaction. The exchange rate settled between buyer and seller for forward sale and purchase of
currency is called forward exchange rate.

Types of exchange rate management

A. Fixed Exchange Rate

B. Flexible Exchange Rate

A. The Fixed Exchange Rate

When the exchange rate between the domestic and foreign currencies is fixed by the monetary
authority of a country and is not allowed to fluctuate beyond a limit, it is called fixed exchange
rate. Under the IMF system, the monetary authority of a member nation fixes the official value of
its currency in terms of a reserve currency (usually the US dollar) or a basket of 'key currencies.'
The exchange rate so determined is known as currency's par value. It is also called 'pegged'
exchange rate. However, flexibility is allowed within the upper and lower limits prescribed by the
IMF, usually 1% up and down, under the normal conditions.
The basic purpose of adopting fixed exchange rate system is to ensure stability in foreign trade
and capital movements. Under fixed exchange rate system, the government assumes the
responsibility of ensuring stability of exchange rate. To this end, the government undertakes to
buy and sell the foreign currency-buy when it becomes weaker and sell when it gets stronger.
Private sale and purchase of foreign currency is suspended. Any change in the official exchange
rate is made by the monetary authority of the country in-consultation with the IMF. In practice,
however, most countries adopt a dual system: a fixed exchange rate for all official transactions
and a market rate for private transactions.

Arguments in Favour of Fixed Exchange Rate:

First, it provides stability in the markets, certainty about the future course of actions in the
Foreign Exchange Market, and it eliminates the risk caused by the uncertainty.

Second, it creates a system for a smooth flow of foreign capital between the nations, as it gives
assurance of fixed return on investment.

Third, It removes the possibility of speculative transactions in foreign exchange markets.

Lastly, it reduces the possibility of competitive exchange depreciation or devaluation of

currencies.

B. Flexible Exchange Rate

When the exchange rate is decided by the market force (demand and supply of currency), it is
called the flexible exchange rate.

The advocates of flexible exchange rate have put forward equally convincing arguments in its
favour. They have challenged all the arguments against the flexible exchange rate. It is often
argued that flexible exchange rate causes destabilization, uncertainty, risk and speculation. The
proponents of the flexible exchange rate have not only rebutted these charges but also have put
forward strong arguments in favour of flexible exchange rate.

Arguments in favour of Flexible Exchange Rate:

First, flexible exchange rate provides a good deal of autonomy in respect of domestic policies as
it does not require any obligatory constraints. This advantage is of great significance in the
formulation of domestic economic policies.
Second, flexible exchange rate is self-adjusting and therefore it does not devolve on the
government to maintain an adequate foreign exchange reserves to stabilize the exchange rate.

Third, since flexible exchange rate is based on a theory, it has a great advantage of predictability
and has the merit of automatic adjustment.

Fourth, flexible exchange rate serves as a barometer of actual purchasing power of a currency in
the foreign exchange market.

Finally, some economists argue that the most serious charge against the flexible exchange rate,
that is, uncertainty, is not tenable because speculative tendency under this system itself creates
conditions for certainty and stability. They argue that the degree of uncertainty under flexible
exchange rate system, if any, is not greater than one under the fixed exchange rate
 RBI’S INTERVENTIONS ON FOREIGN EXCHANGE MARKET

IN INDIA

The Reserve Bank of India’s policy on the exchange rate of the rupee has been to allow it to be
determined by market forces. It intervenes only to maintain orderly market conditions by containing
excessive volatility in the exchange rate, without reference to any pre-determined level or band. In
the absence of any intervention by the Reserve Bank in the foreign exchange market, surges and
sudden stops in capital flows and the associated disorderly movements in the exchange rate can often
have a deleterious impact on trade and investment, besides endangering overall macroeconomic and
financial stability. Intervention in the foreign exchange market through purchase or sale of US
dollars, however, could pose other challenges by altering domestic liquidity conditions; while
purchases lead to injection, sales result in withdrawal of primary rupee liquidity from the system.1
This requires proactive management of liquidity consistent with the stance of monetary policy.

If liquidity injected due to forex operations is more than the requirement of a growing economy,
excess liquidity may have to be neutralised or sterilised, i.e., specific liquidity management measures
may have to be undertaken to withdraw the excess surplus liquidity from the system, in consonance
with the objectives of monetary policy. The need for pro-active liquidity management that takes into
account the liquidity impact of interventions is best corroborated by the well-known “impossible
trinity”, according to which an independent conduct of monetary policy, a fixed exchange rate (or a
managed exchange rate through interventions) and free cross border capital flows are simultaneously
incompatible. This challenge for monetary policy becomes unavoidable irrespective of whether the
central bank sterilises the liquidity impact of forex interventions. For example, if the excess liquidity
injected through forex purchases is not sterilised (i.e., non-sterilised interventions), then excess
liquidity could drag down the operating target of monetary policy and other money market interest
rates below the policy interest rate. Non-sterilised interventions, thus, could lead to a loss of control
over interest rate, thereby undermining the effectiveness of monetary policy. By contrast, if surplus
liquidity is sterilised, depending on the choice of instrument for absorption of liquidity, market
interest rates may vary significantly from the desired levels that could be consistent with the stance
of monetary policy. This results in greater capital flows, thus defeating the very objective of
sterilisation. For example, when a central bank undertakes open market sale of government securities
to absorb the surplus liquidity as a part of the sterilised intervention strategy, it could harden
sovereign yields, which, in turn, could attract further debt inflows driven by higher interest rate
differentials. Thus, sterilisation could amplify the original problem,thereby rendering sterilised
interventions ineffective. Moreover, this risk intensifies as the magnitude of sterilisation increases. In
this context, capital flows management measures (CFMs) could enhance the effectiveness of
sterilised interventions to some extent. For instance, if portfolio investments in both government
securities and corporate bonds are capped (as in India), additional portfolio inflows would not
materialise even when sterilised intervention widens the yield differential. This paper presents in
detail as to how the RBI’s forex market interventions have impacted domestic liquidity conditions,
and how they have been managed. The study is organised into five sections. Section II sets out the
mechanics of forex market intervention, its consequences, and cross-country practices in managing
the liquidity impact of such intervention through alternative instruments. Recent episodes of capital
flows and their attendant challenges in the Indian context are discussed in Section III, while the
effectiveness of sterilised intervention is empirically assessed in Section IV. Concluding
observations are presented in Section V.

 Capital Flows and Forex Market Interventions in India

Since the onset of external sector reforms in the early 1990s and with the progressive deregulation of
the capital account, India has experienced episodes of surges in capital inflows and sporadic sudden
stops/reversals. Theoretically, while capital inflows are required to finance a sustainable current
account deficit in an ex ante sense, capital inflows, however, have often exceeded the financing
requirement, driven by favourable interest rate differentials and/ or more promising growth outlook,
leading to an overall surplus position in the balance of payments in most years (Chart 1). Given the
objective of avoiding disruptive excess volatility in the exchange rate of the rupee, RBI’s
intervention through purchases led to an accretion in foreign exchange reserves. In an integrated
global financial system, capital inflows pose multiple challenges for overall macroeconomic
management. While there are several available tools – ranging from (i) forex market intervention; (ii)
fiscal/monetary policy measures; (iii) macro-prudential regulations; and (iv) imposition of capital
controls – to moderate the impact of such inflows, the moot issue is about managing the trade-offs
while deploying these instruments either individually or in some optimal mix. This paper, however,
solely focusses on forex market intervention and its impact on domestic liquidity conditions.
When a central bank purchases foreign currency, its net foreign assets (NFA) increase, resulting in
expansion of primary liquidity or reserve money (RM) (Table 1). In this context, it is important to
assess whether the increase in RM resulting from an increase in NFA is: (a) consistent with the
required increase in RM during the year, in which case no sterilisation may be necessary; (b) higher
than the required increase in RM, thereby necessitating sterilisation; and (c) less than the required
increase in RM in which case the central bank may have to inject liquidity over and above what is
already injected through intervention.

Unsterilised intervention on a continuous basis can lead to a surfeit of liquidity with attendant
implications for inflation, which, in turn, could result in hikes in the policy interest rate. Such hikes
may, however, widen the interest rate differential, thereby triggering further inflows. Thus,
unsterilised interventions often defeat the very objective of intervention; hence, central banks
generally conduct sterilisation operations to neutralise the monetary impact of its operations in the
foreign exchange market. Sterilised intervention through open market purchase of securities,
however, also keeps interest rates elevated in the economy, as alluded to earlier. There are also limits
to intervention operations as central banks may be constrained by the availability of government
securities for sterilisation. As a result, several other instruments have been used by most central
banks with varying degree of effectiveness (Table 2).

 Forex Operations and Liquidity Management in India – Recent Episodes

As emphasised by the Report of the Expert Committee to Revise and Strengthen the Monetary Policy
Framework (Chairman: Dr. Urjit R. Patel), the desirable evolution of the base money path (without
rigid adherence to any base money rule) is a key component of the liquidity management strategy
[Pillar II as distinct from Pillar I, which is about day to day liquidity management under the liquidity
adjustment facility (LAF)]. For instance, increase in NFA in 2014-15 was higher than the actual
increase in RM (consistent with the annual increase in nominal GDP), necessitating open market
operations (OMO) (sales) to absorb excess durable surplus liquidity (Table 3). In contrast, in
2013-14 and 2015-16, the actual increase in RM was significantly higher than the increase in NFA,
which necessitated OMO (purchases) by the Reserve Bank for injecting durable liquidity. The year
2016-17 was an exceptional year as the problem of large surplus liquidity post-demonetisation was
exacerbated by the increase in NFA. In 2017-18, while the liquidity overhang from demonetisation
moderated gradually with increasing remonetisation thus taking the system level liquidity closer to
neutrality, primary durable liquidity increased due to forex inflows which was partly offset through
OMO (sales), consistent with the Pillar II approach mentioned above.
It is pertinent to note that forward purchases of foreign exchange that are due to mature over the next
few months can lead to injection of durable liquidity, unless rolled over. Thus, while forward forex
market interventions/rollovers could relax the liquidity management challenges, such an approach
carries the risk of distorting forward rates (with forward rates being also influenced by
demand-supply conditions at the margin, besides interest rate differentials).

Forex interventions change significantly the composition of the RBI’s balance sheet (in terms of the
sources of expansion in reserve money), which also poses challenges. A high share of NFA at any
point in time and the resultant decline in net domestic assets (NDA) can pose collateral constraints to
the Reserve Bank’s market-based liquidity absorption operations, particularly open market sales and
reverse repo auctions to absorb surplus liquidity. Under conditions of persistently large surplus
liquidity, this constraint could become binding. For instance, the sharp rise in the share of foreign
assets in total assets in the RBI’s balance sheet between 2001 and 2003 (Chart 2) necessitated the
introduction of Market Stabilisation Scheme (MSS) in April 2004.2 Thereafter, the share of foreign
assets kept increasing, reaching almost 89 per cent in 2006 and 2008; however, the Reserve Bank
was able to effectively sterilise surplus liquidity by issuing securities under the MSS along with the
cash reserve ratio (CRR) and OMO sales. This ensured that the burden of sterilisation was shared by
all stakeholders, i.e., (i) the Government (interest cost on MSS); (ii) the Reserve Bank (interest cost
on reverse repos); and (iii) the banking sector (unremunerated reserve requirements). Capital
outflows in the wake of the global financial crisis and large scale OMO purchases to meet the normal
expansion in RM in the following years (up to 2012-13) led to some moderation in the share of
foreign assets in the total assets of the Reserve Bank; however, this ratio has started rising in recent
years. The Standing Deposit Facility (SDF), which has been announced in the Union Budget 2018-
19, once operationalised, will significantly enhance the sterilisation capacity by removing the
collateral constraint that the Reserve Bank occasionally faced in the past.

 Estimating the Effectiveness of Sterilised Interventions

As noted earlier, central banks that intervene in the foreign exchange market typically calibrate the
extent of sterilisation to modulate base money expansion in sync with the normal requirements of a
growing economy and its monetary policy stance. In the Indian context also, forex market
intervention is offset to the extent required through changes in net domestic assets so as to ensure
that the base money expansion remains consistent with the growth in nominal GDP.

The extent and effectiveness of sterilisation operations undertaken by a central bank are empirically
measured by computing sterilisation and offset coefficients, both varying between 0 and -1. The
sterilisation coefficient measures the extent by which the NDA of a central bank change in response
to a change in NFA. Typically, while a value of -1 represents complete sterilisation, i.e., no impact of
surplus capital inflows on the monetary base, a value of 0 implies that forex intervention is not
sterilised at all by the central bank.

As discussed earlier, sterilisation operations undertaken by a central bank can widen the interest rate
differential if such operations are undertaken through open market sale of securities, which, in turn,
could result in higher capital inflows, thereby leading to an adverse feedback loop. If interest
sensitive capital flows are large (or the sensitivity of capital flows to widening interest rate
differentials is high), and if open market sales, as the key instrument of sterilisation, harden yields,
then the sterilisation effort could become ineffective. The offset coefficient captures this combined
effect, i.e., the extent to which a decrease in NDA due to open market sales is offset by an increase in
net foreign assets driven by sterilisationinduced higher yields. If sterilisation operations result in a
widening of interest rate differential, the change in net domestic assets can be fully offset through a
change in net foreign assets. In this scenario, a value of -1 for the offset coefficient represents the
complete ineffectiveness of the central bank in sterilising capital flows, i.e., complete attenuation of
monetary control. Thus, an offset coefficient of -1 would tantamount to perfect capital mobility,
while a value of 0 would imply no capital mobility, which is also consistent with the impossible
trinity, according to which fixed exchange rate, perfect capital mobility and independent monetary
policy are mutually incompatible.

In the Indian context, several studies have estimated the “sterilisation coefficient”, but there are very
few studies that have estimated the “offset coefficient”, notable exceptions being Pattanaik (1997)
and Ouyang and Rajan (2008). While the former found the offset coefficient to be in the range of
-0.31 and -0.33, the latter estimated it to be between -0.79 and -0.84. These findings indicate that the
offset coefficient has increased in India over time given that the exposure of the economy to
short-term portfolio debt flows has increased gradually through successive increases in FPI limits on
Government securities, state development loans (SDLs) and corporate bonds reflecting increasing
openness of the capital account. Moreover, the yield differential has remained significantly
favourable for India in the post global crisis period because of the persistently low interest rates in
advanced economies. Using monthly data for over a 20-year period from July 1997 to October 2017,
the sterilisation and offset coefficients are estimated by a modified money demand function and a
modified equation on capital flows using the two-stage least squares (2SLS) method (Annex). The
estimated sterilisation coefficient is -1.03 while the offset coefficient is -0.83, which are consistent
with the findings of Ouyang and Rajan, op. cit, (Table 4).
 FOREIGN EXCHANGE RISK MANAGEMENT

The Indian economy saw a sea change in the year 1999 whereby it ceased to be a
closed and protected economy, and adopted the globalisation route, to become a part
of the world economy. In the pre-liberalisation era, marked by Statedominated, tightly
regulated foreign exchange regime, the only risk management tool available for

corporate enterprises was, ‘lobbying for government intervention’. With the advent of

LERMS (Liberalised Exchange Rate Mechanism System) in India, in 1992, the market
forces started to present a regime with steady price volatility as against the earlier
trend of long periods of constant prices followed by sudden, large price movements.

The unified exchange rate phase has witnessed improvement in informational and
operational efficiency of the foreign exchange market, though at a halting pace.

In the corporate finance literature, research on risk management has focused on the
question of why firms should hedge a given risk. The literature makes the important
point that measuring risk exposures is an essential component of a firm's risk

management strategy. Without knowledge of the primitive risk exposures of a firm, it

is not possible to test whether firms are altering their exposures in a manner consistent
with theory. Recent product innovations in the financial markets and the use of these
products by the corporate sector are also examined. In addition to the traditional
"physical" products, such as spot and forward exchange rates, the new "synthetic" or
derivative products, including options, futures and swaps, and their use by the
corporate sector are considered. These synthetic products have their market value
determined by the value of a specific, underlying, physical product.
The spurts in foreign investments in India have led to substantial increase in the
quantum of inflows and outflows in different currencies, with varying maturities.
Corporate enterprises have had to face the challenges of the shift from low risk to
highrisk operations involving foreign exchange. There was increasing awareness of
the need for introduction of financial derivatives in order to enable hedging against
market risk in a cost effective way. Earlier, the Indian companies had been entering
into forward contracts with banks, which were the Authorised Dealers (AD) in foreign

exchange. But many firms preferred to keep their risk exposures un-hedged as they
found the forward contracts to be very costly. In the current formative phase of the
development of the foreign exchange market, it will be worthwhile to take stock of the
initiatives taken by corporate enterprises in identifying and managing foreign
exchange risk.

India had earlier followed a tightly regulated foreign exchange regime. The liberalisation of the

Indian economy started in 1991. The 1992-93 Budget provided for partial convertibility of Indian

Rupee in current accounts and, in March 1993, the Rupee was made fully convertible in current

account. Demand and supply conditions now govern the exchange rates in our foreign exchange

market. A fast developing economy has to cope with a multitude of changes, ranging from

individual and institutional preferences to changes in technology, in economic policies, in regulations

etc. Besides, there are changes arising from external trade and capital account interactions. These
generate a variety of risks, which have to be managed.

There has been a sharp increase in foreign investment in India. Multi-national and transnational
corporations are playing increasingly important roles in Indian business. Indian corporate units are
also engaging in a much wider range of cross border transactions with different countries and
products. Indian firms have also been more active in raising financial resources abroad. All these
developments combine to give a boost to cross-currency cash flows, involving different currencies
and different countries.

The corporate enterprises in India are increasingly alive to the need for organised fund management

and for the application of innovative hedging techniques for protecting themselves against attendant
risks. Derivatives are the tools that facilitate trading in risk. The foreign exchange market is still
evolving and corporate enterprises are going through the movements in transition from a passive to
an active role in risk management. There is no organised information available on how the corporate

enterprises in India are facing this challenge. It is in this context that a review of the perceptions and

concerns of the corporates, in relation to derivatives and of their initiatives in tuning the
organisational set up to acquire and adopt the requisite skills in risk management, assumes

significance. Appropriate policy and other measures can then be taken to accelerate the process of
further development of foreign exchange market and also upgrade foreign exchange risk
management (FERM) with higher professionalism and increased effectiveness.

FOREIGN EXCHANGE RISKS

Whenever a company is running overseas business, the company is exposed to different categories of
risk including commercial risk, financial risk, country risk and foreign exchange risk (Oxelheim
1984).

1. Country Risk
2. Foreign Exchange Risk
3. Financial Risk
4. Commercial Risk

Foreign exchange risk is commonly defined as the additional variability experienced by a

multinational corporation in its worldwide consolidated earnings that results from unexpected
currency fluctuations. It is generally understood that this considerable earnings variability can be
eliminated-partially or fully-at a cost, the cost of Foreign Exchange Risk Management. (Jacques,
1981). According to Shapiro (2006), foreign exchange rate exposure can be defined as … a measure
of the potential changes in a firm’s profitability, net cash flow and market value because of a change
in exchange rates.

THE CLASSIFICATIONS OF FOREIGN EXCHANGE RISKS

In the recent literature of foreign exchange exposure management, the types of exposures are usually
summarized and simplified into three categories, translation, transaction, and economic. It is
conventionally stated that the exposure to currency risk is categorized into three factors.

1.Transaction Exposure

The transaction exposure concept concentrates on contractual commitments which involve the actual
conversion of currencies. A firm’s transaction exposure thus consists of its foreign currency accounts
receivables and payables, its longer-term foreign currency investments and debt, as well as those of
its foreign currency cash positions which are to be exchanged into other currencies. Until these
positions are settled, their home currency value may be impaired by unfavorable parity changes.

There exist four possibilities by which transaction exposure may arise (Eiteman 2007):

• When prices are stated in foreign currencies and the firm decides to purchase or sell goods or
services.
• When borrowing or lending funds while contractual agreements on repayment are to be make
in a foreign currency.
• When becoming a party to an unimplemented foreign exchange forward contract.
• When incurring liabilities or acquiring assets which are denominated in foreign currencies.

2.Economic Exposure

The economic exposure, also called the operating exposure, measures any change in the present
value of a company resulting from changes in future operating cash flows caused by unexpected
changes in currency exchange rates. The analysis of economic exposure assesses the result of
changing exchange rates on a company’s own operations over coming months and years and on its
competitive position in comparison with other companies.
By measuring the effects on future cash flows related to economic exposure, the goal is to identify
strategic moves or operating techniques that a company might wish to adopt in order to enhance its
value in the face of unexpected exchange rate changes.

Loderer and Pichler (2002) assert that firms often manage economic exposure by lending and
borrowing in foreign currencies. He cites the following reasons for not hedging economic exposure:
firms are unable to measure the size and the currency of future expected cash flows with much
confidence, firms already hedge transaction exposure, firms consider that in the long term currency
fluctuations offset each others. Surprisingly, the cost of hedging economic exposure is not an
obstacle.

3.Translation exposure

By consolidating its financial statements, a parent company with foreign operations must translate
the assets and liabilities of its foreign subsidiaries, which are stated in a foreign currency, into the
reporting currency of the parent firm. Basically, foreign subsidiaries must restate their local currency
into the main reporting currency so the foreign values can be added to the parent’s reporting currency
denominated balance sheet and income statement. The translation is usually used for measuring a
subsidiary’s performance(McInnes, 1971), providing accurate information for decision makers and
investors (Ross, 1992; Bartov, 1995), and for both internal and external users (Sercu and Uppal,
1995). The common reason for translation from a foreign currency into the home currency is to meet
the requirements of accounting regulations of home countries.

FOREIGN EXCHANGE RISK MANAGEMENT

1. Identification and quantification of exposure

Business cycle of the company is analyzed to identify where foreign exchange risk exists. Future
cash flow which are confirm to arise out of contracts already entered and future foreign currency
cash flows which are not confirm over the time period are forecasted and measured to get the foreign
exchange exposure. After measuring the level of exposure of the company, decision is to be made
regarding what magnitude of risk is to be hedged and how much risk is to be covered.

2. Policy formulation
Effective FERM requires well-framed policies, clear objectives and parameters within which the
strategy is to be controlled. These policies should clearly mention the principles which is to be
followed and extent of hedging (risk coverage) which are needed. Objectives should set standard for
bank’s exposure to foreign exchange risk; and personnel are appointed who have the authority to
trade in foreign exchange on behalf of company; and should mention the different currencies, which
have been approved for transaction within the company. There should be some stop loss
arrangements to prevent the firm from abnormal losses if the forecasts turn out wrong. There should
be monitoring systems to detect critical levels in the foreign exchange rates where appropriate
measure is required.

3. Hedging

After formulating policies, the firms then decides about an appropriate hedging strategies keeping in
mind the principles and objectives and extent of exposure coverage. There are various financial
instruments available for the firm to mitigate its risk- futures, forwards, options and swaps and issue
of foreign debt. Hedging strategies and instruments are explained later.

4. Reporting and Review

Risk management policies are periodically reviewed based on periodic reports prepared. These
periodic reports measure the effectiveness of hedging strategy adopted by the company to mitigate its
foreign exchange exposure. The review of risk management policies are done to judge the validity of
benchmarks set; whether they are effective in controlling the exposures; what the market trends are
and whether the overall strategy is enough or change is required in it
 HEDGING TOOLS AND TECHNIQUES

A firm may choose any one or any set of combinations of the following techniques (Figure- 1) to
manage foreign exchange rate risks.

❖ Internal hedging methods

For the reason that external hedging techniques with derivatives to manage foreign exchange
exposure are often costly, many multinational firms would rather turn to consider using internal
hedging devices such as Michael (2006):

1. Matching:-

Cash inflows in one of the pairing currencies can be offset against cash flows in the others. A firm
can balance its receivables and payables in the same currency. Firms may also deliberately influence
the balance by arranging short or long term loans or deposits.

2. Multi-lateral Netting:-
The netting can be done between inflows and outflows of different currencies arising from
cross-border transactions of the different entities in the group. This, of course, requires a
comprehensive information system concerning foreign exchange dealings of the group companies.

3. Leads and Lags:-

Within the boundaries of the terms of the trading contracts or in keeping with prevailing commercial
practices and within the existing regulations, payments to trading partners or foreign subsidiaries, in
currencies whose values are expected to appreciate or depreciate, can be accelerated or delayed.

4. Invoicing and Currency Clauses:-

Trading companies may, sometimes, have options to invoice their cross-border sales or purchases, in

domestic currency, so that the other party absorbs exchange rate risk. Similar choices of invoicing in

third country currencies may also be negotiated with trading partners. There are instances of
invoicing in terms of currency baskets, comprising a composite index of different national currencies

that have been allotted predetermined weights. Judiciously employed, this can help in reducing the

impact of volatility of exchange rates.

5. Money Market Hedging:-

Companies that have need to raise medium term foreign currency loans should explore the possibility
of reducing currency risk by raising them in currencies in which they have medium term exposure in
terms of receivables and assets in these currencies.

❖ External Hedging Methods

As it is shown, the exposure to currency risk may involve current business transactions, future
business transactions as well as financial statement translations. However, as there are factors or risk,
so are there strategies for dealing with them. For companies, there are a number of external methods
to use for the management of currency risk, namely the use of financial derivatives.
The name derivative arises from the fact that the value of these instruments is derived from an
underlying asset like a stock or a currency. By using these instruments it is possible to reduce the
risks associated with the management of corporate cash flow, a method known as hedging.

1. Forward Currency Transactions:-

A foreign exchange forward is an agreement to buy or sell one currency at a certain future date for a
certain price with a specific amount. It is the most common instrument used to hedge currency risk.
The predetermined exchange rate is the forward exchange rate. The amount of the transaction, the
transaction date, and the exchange rate are all determined in advance where the exchange rate is
fixed on the day of the contract but the actual exchange takes place on a pre-determined date in the
future. In major currencies, forward contracts can be available daily with maturities of up to 30, 90 or
180 days (Bodie & Marcus 2008).

A survey by Belk and Glaum (1990) indicates that the most common method used to hedge exchange
rate risk is the forward contract. An empirical study of Pramborg (2002), also demonstrates that
firms can be fully hedged with forward contracts.

2. Currency Futures:-

In principle, a futures contract can be arranged for any product or commodity, including financial
instruments and currencies. A currency futures contract is a commitment to deliver a specific amount
of a specified currency at a specified date for an agreed price incorporated in the contract. The
futures perform a similar function to a forward contract, but it has some major differences.
The specific characteristics of currency futures include:

1. They are marketable instruments traded on organized futures markets.

2. Futures can be completed (liquidated) before the contracted date, whereas a forward
contract has to run to maturity.
3. They are relatively inflexible, being available for only a limited range of currencies and for
standardized maturity dates.
4. The dealings occur in standard lot sizes, or contracts.
5. They require a down-payment of margin of about 5 percent of the contract value, whereas
forward contracts involve a single payment at maturity.
6. Futures are usually cheaper than forwards contracts, requiring a small commission payment
rather than a buy / sell spread.

3. Currency Options:-

A foreign exchange option which is different from currency forward contracts and currency futures is
to give the holder of the contract the right to buy or sell a certain amount of a certain currency at a
predetermined price (also called strike or exercise price) until or on a specified date, but he is not
obliged to do so. The seller of a currency option has obligation to perform the contract. The right to
buy is a call; the right to sell, a put.

There is option premium needed to pay by those who obtain such a right. The holder of a call option
can benefit from a price increases (profit is the difference between the market price and the strike
price plus the premium), while can choose not to excise when the price decreases (locked in loss of
the option premium).

Vice versa is for the holder of a put option. For the advantages of simplicity, flexibility, lower cost
than the forward, and the predicted maximum losswhich is the premium, the currency option has
become increasing popular as a hedging devise to protect firms against the exchange movements.
Whenever there is uncertainty in the size of cash flows and the timing of cash flows, currency option
contracts would be superior to traditional hedging instruments such as forward contracts and futures
contracts. Grant and Marshall (1997) examined the extent of derivative use and the reasons for their
use by carried out surveys in 250 large UK companies, found that a widespread use of both forwards
and options(respectively 96% and 59%). The pointed that comparing to the primary reasons for the
use of forwards were company policy, commercial reasons and risk aversion, a good understanding
of instrument, and price were prominent while the primary reasons to use option for company
management.

4. Currency Swaps:-

Currency swaps are a hedging instrument for which two parties agree to swap a debt denominated in
one currency for that in another currency. For example, an agreement between two firms to swap
their debts of which one is denominated in Euro and that in US dollar (Leger and Fortin, 1994).

In order to explain the use of currency of swaps, a Japanese firm that has exports to Australia is
given as an example. The Japanese firm wants to protect its Australian-dollar receivables by using
currency swap to match inflows in one currency with outflows in a foreign currency (natural
hedging). Assuming the Japanese firm is not well recognized in the US financial markets, it may
obtain funds from a domestic bank to swap with another firm that has dollar-denominated debt. This
process is carried out by the swap dealers (usually banks) as an intermediary.

The common objective of this type of transaction is that firms want to alter various future currency
cash flows in its schedules into a particular currency for which its future revenues will be generated
(Eiteman et.al 1998). The preference of particular currency is caused by several factors, such as,
capital market segmentation, differences in regulation governing investment by institutional
investors and asymmetry in the tax treatment of interest income and capital gains/losses
(Jacque1996).

Although there are other types of swaps involving foreign currencies, such as, foreign currency
forward swaps, plain vanilla, and a three-way back-to-back currency swap, they are designated
primarily for hedging interest rate exposure.

❖ Fundamental Philosophy behind Hedging

We have presented that authors embrace hedging as insurance, and hedging as a value-enhancing
tool. We believe the common view of hedging can be summarized as follows:

Hedging is one of the three most fundamental reasons for the existence of the financial market,
alongside speculative and arbitrage activities (Jüttner, 2000).

The hedging industry is evolving just like the rest of the business world. In fact, there is no definite
set of tools or technique that can define hedging. As the world changes, new hedging mechanisms
are derived; and as time passes, these mechanisms are refined and evolve into something new that
can be better applied to the contemporary commercial marketplace (Batten et al, 1993; Faff and Chan,
1998; Alster, 2003;). Hedging is not a way of making money, but to assist management in better
managing corporate revenue through reducing the corporate exposure to volatility in the foreign
currency markets.

When used prudently, hedging can be effective insurance as well as a value-enhancing exercise for
corporations. Effective hedging programs have been proven to allow corporations to minimize or
transfer their foreign currency exposure. The diminished exposure to foreign currency fluctuations
allows more stable and predictable cash-flows, notably in terms of revenue. As a result, firms are
then capable of making more comprehensive financial plans, including more reliable estimations on
tax, income after tax and dividends payable to shareholders. It is believed that a dividend payout is
often of significant appeal to long-term, current or prospective shareholders (Nguyen and Faff, 2002,
2003b; Alster, 2003; Anac and Gozen, 2003; De Roon et al., 2003; and Dinwoodie and Morris,
2003).
The three main questions surrounding hedging: when, what and how to hedge are shown in Figure
below as a decision tree.

Fig. Generic Hedging Decision Tree

The question to hedge or not to hedge is a complex and controversial one in financial risk
management. Natural hedges carry no explicit out of pocket cost and intrinsically form a better offset
to economic exposures and so generally are preferred to synthetic hedges. Synthetic hedging can be
likened to insurance, where the company incurs an explicit cost to reduce the risk or volatility
inherent in its business results. The cost must be weighed against the risk-reducing benefits of the
transactions, taking into account their precision and effectiveness. The real drivers of any hedging
decision are-

1) what is the risk tolerance of the company; and

2) what cost is acceptable for entering into transactions to reduce or eliminate the risk.

Some managers feel strongly that hedging either should always be done or never done, and their
approaches vary tremendously. Indeed, there is an academic perspective that hedging is never
appropriate since risks like FX exposure represent diversifiable risks from the shareholder
perspective, and thus, the cost is wasted effort for shareholders. Some managers share this view, but
most multinational businesses of significant size engage in some financial hedging transactions.
Major arguments for and against hedging are displayed in Table 2.2
Chapter 7: Findings
 FINDINGS

Fallowing are the findings of the research-

1. Foreign exchange risk management plays an important role in profitability of the every

firm operating in multiple countries.

2. Foreign exchange rate fluctuation risk management is vary crucial to every business.

3. In the indian context RBI plays an important role in balancing thr exchange rates.

4. RBI has introduced various policies for foreign exchange rate management and also takes
various regulatory actions to prevent any of the mal-practices in Indian foreign exchange
market.

5. There are various effective techniques available through which we a business can reduse or
mittigate the currency rate fluctuations risk. Most popular techniques are Forward contracts,
future contracts , option contracts and currency swaps.
Chapter 8: Conclusion
 CONCLUSION

Based on the above study and findings here I conclude that, Sterilised intervention in India has not
only ensured that the reserve money growth remains consistent with the requirements of the growing
economy but also that money market rates remain aligned with the operating target of the monetary
policy, no matter how significant and persistent the liquidity impact of forex interventions may be.
The estimated large offset coefficient, however, suggests that the impossible trinity poses a challenge
to the effective conduct of monetary policy. Forex market intervention requires a continuous
assessment of exchange market conditions (in terms of intervention preventing volatility), liquidity
conditions (arising out of forex operations) relative to system wide demand for liquidity, G-sec
market conditions (in terms of sensitivity of yields to OMOs) and forward market conditions (in
terms of forward premia getting influenced by forward purchases/sales).

Many EMEs have successfully managed the impossibility trinity by adopting country and
time-specific suitable mix of sterilisation, exchange rate flexibility and CFMs. In the foreseeable
future, India may have to persevere with the past strategy which has stood the test of time, even
while further strengthening the arsenal for sterilisation.

The advent of Globalisation has witnessed a rapid rise in the quantum of cross border flows
involving different currencies, posing challenges of shift from low-risk to high-risk operations in
foreign exchange transactions. The Study covers a sample of 501 corporate falling in 18 different
categories. 53% of the respondents are using derivatives. The non-users of derivatives have cited
Confused Perceptions of derivatives use, Technical and Administrative Constraints, and Fear of High
Costs of derivatives as reasons for not using derivatives. Even the users of derivatives have concerns
arising from Confused Perceptions regarding investor expectations, Pricing and Hedging; they have
Policy and Legal issues to be sorted out; Monetary considerations involving transaction costs and
liquidity problems also pose some anxiety. Quite a few do not have adequate knowledge of the use of
derivatives.

Reduction in the volatility of cash flows is the main reason for hedging. Hedging is mostly with

reference to Currency risk, next in importance being Interest Rate risk and, marginally, Equity risk.
The greatest preference is for simple Forward Contracts. Swaps, and Cross Currency Options are
moderately used. 40% of respondents consider the treasury department as a ‘Service Centre’, 28% as
a ‘Cost Centre’, and 20% as a ‘Profit Centre’. There is a noticeable preference for outsourcing advice
for managing currency risk exposure. In most cases, Banks provide the necessary expertise and
advice. A majority of the respondents have in use, a working system of performance review. They
employ tools such as Value-at-Risk, Stress or Scenario Test, etc., for evaluating risk associated

with usage of specific derivatives. The Currency Risk Management practices in India are evolving at

a slow pace. At the Policy, Reporting, and Operational levels, there is need for a greater sense of
urgency in developing foreign exchange market fully and using the hedging instruments effectively.

The framework developed in this research is based on a mental model of a medium-to-large

manufacturing company producing industrial components, as perceived by the researcher. The

complex nature of the relationship between the ‘risk elements’ and ‘decision variables’ may often

be beyond human comprehension without the aid of special diagnostic and analytical tools.
Decisions and actions in the area of FERM may have impact on other segments and activities in the
enterprise. A larger interactive model capable of embracing all facets of enterprise-wide risk
management needs to be developed. This is an area of further inquiry.
Chapter 9: References
 REFRENCES

Fallowing are the references from where the data is collected-

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