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Indian Currency Market

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Critical examination of Indian Currency Market & its Future by Abhishek Gupta (4713) Modak Sarda (4719) Nitesh Goyal (4735) Rachit Makker (4716) Under the guidance of Mr. Kumar Bijoy Shaheed Sukhdev College Of Business Studies New Delhi – 110092 25 August, 2009 Critical Examination of Indian Currency Market & its Future || 1 Executive Summary The Economy of India is the twelfth largest economy in the world by market exchange rates and the fourth largest by purchasing power parity (PPP) basis. India’s large service industry accounts for 54% of the country’s GDP while the industrial and agricultural sector contribute 29% and 17% respectively.

Economic development in India depends on the various sectors that constitute the Indian economy – these are primarily the agriculture, services and manufacturing industries. Post 1991, Globalization in India has allowed companies to increase their base of operations, expand their workforce with minimal investments, and provide new services to a broad range of consumers. India uses Wholesale Price Index (WPI) to calculate its inflation. In 2009, India saw negative inflation for the first time since 1977-78.

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Therefore, the Union Budget 2009 aims towards an Inclusive Development.

Its main objective is to provide basic amenities and opportunities for livelihood to vulnerable sections. Planning is very important for the smooth functioning of the economy. In India, The Planning Commission is entrusted with the responsibility of the creation, development and execution of the Five Year Plans. Given the rapid growth of the Indian economy, it can assume a significant role in growth of Indian Currency markets. With fast increasing global presence, India is emerging as top destination for Foreign Direct Investments (FDI).

India has strengths in information technology, auto components, chemicals, apparels, pharmaceuticals, textile and diamond cutting. Despite a surge in foreign investments, rigid FDI policies resulted in a significant hindrance. The Currency Market or Forex Market is a place where banks and other authorized establishments trade the currencies of various nations. The purpose of the foreign exchange market is to help international trade and investment. Floating Exchange System is used these days by almost all the countries. The Indian Currency Market is highly dynamic and volatile.

Bygone are the days of fixed exchange rate system, India now follows Liberalised Exchange Rate Management System (LERMS). This system was implemented post 1991 when India was on the spree of globalization. Comprehensive analysis of the major factors influencing the Indian Currency Market is also undertaken. The key elements of forex market are ? Market Size and Liquidity ? Market Participants ? Determinants of FX rates ? Trading and Analysis in Foreign Exchange ? Financial Instruments involved ? Working of the Forex Market ?

Benefits and drawbacks of Forex Market Currency futures trading started in India on August 29, 2008 on National Stock Exchange. Currency futures are standardised foreign exchange contracts traded on approved stock exchanges to buy or sell one currency against another on a specified date in the future at a specified price (exchange rate). . The BSE has failed to generate enough interest in this segment and the volumes remain abysmally low on the exchange. Although volatility has ensured that volumes surged after the launch, trading has been Critical Examination of Indian Currency Market & its Future || 2 oncentrated on front-month contracts as majority of users are traders, small exporters and brokers/banks. Capital Account Convertibility is freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions. It offers numerous advantages like it helps in attracting foreign investment and offers foreign investors a lot of comfort as they can re-convert local currency into foreign currency anytime they want to and take their money away.

At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets. But at the same time, India should be overcautious while implementing CAC as it results in arbitrage operations, exchange rate appreciation and India is not in acute need of CAC (because of high voluntary savings in India). To implement CAC, the Tarapore committee, setup by the Reserve Bank of India under the chairmanship of former RBI deputy governor S S Tarapore to “lay the road map” to capital account convertibility, was formed.

The five-member committee recommended a three-year timeframe for complete convertibility by 1999-2000. The timing of the report was spectacularly bad, since the Asian crisis ensued only a year later. Therefore, the report was divided in three phases to be implemented by 2011. Critical Examination of Indian Currency Market & its Future || 3 Acknowledgement We owe thanks to Mr. Kumar Bijoy and also extend our sincere gratitude for the excellent guidance and tremendous support provided by him to accomplish our project successfully.

The classroom teachings provided by him and the project specific discussions were extremely beneficial and guided us on how to go about our project. The knowledge about the various sectors of economy have enabled us to analyze in the right prospective. The teachings through this project will be a lifetime investment and it has surely provided us with an insight into the Currency Market. Abhishek Gupta Modak Sarda Nitesh Goyal Rachit Makker Shaheed Sukhdev College Of Business Studies Delhi Critical Examination of Indian Currency Market & its Future || 4 Table of Contents . Overview……………………………………………………………………………………………………………………. 9 1. 1. Indian Economy Overview ………………………………………………………………………………………….. 9 1. 2. Indian Economic Development ……………………………………………………………………………………. 9 1. 3. Globalization in India ……………………………………………………………………………………………….. 10 1. 4.

Inflation in India ……………………………………………………………………………………………………….. 10 1. 5. Indian Budget …………………………………………………………………………………………………………… 11 1. 6. Foreign Direct Investment …………………………………………………………………………………………. 12 1. 7. Five Year Plans ………………………………………………………………………………………………………… 12 2.

Literature Review ……………………………………………………………………………………………………… 13 2. 1. Currency Market, Forex Market…………………………………………………………………………………. 13 2. 2. Market size and liquidity …………………………………………………………………………………………… 14 2. 3. Market participants……………………………………………………………………………………………………. 14 2. 4. Determinants of FX Rates ………………………………………………………………………………………… 16 2. 5. Algorithmic trading in foreign exchange …………………………………………………………………….. 17 2. 6. Fundamental trading in foreign exchange …………………………………………………………………… 18 2. 7. Technical Analysis in foreign exchange ……………………………………………………………………… 18 2. 8. Financial instruments ………………………………………………………………………………………………… 8 2. 9. Speculation ………………………………………………………………………………………………………………. 19 3. Theory ……………………………………………………………………………………………………………………… 20 3. 1. How the Forex market works …………………………………………………………………………………….. 20 3. 2. Working of the Indian Currency Market …………………………………………………………………….. 20 3. 3.

Benefits of the Forex Market……………………………………………………………………………………… 21 Critical Examination of Indian Currency Market & its Future || 5 3. 4. Drawbacks of Forex Market ………………………………………………………………………………………. 21 4. Currency Market – India ……………………………………………………………………………………………. 23 4. 1. Factors influencing Indian Currency Market ………………………………………………………………. 23 4. 2. How India Inc.

Handles risk associated with Currency market …………………………………….. 26 5. Currency Futures ………………………………………………………………………………………………………. 29 5. 1. Introduction ……………………………………………………………………………………………………………… 29 5. 2. Currency Futures – Indian Context …………………………………………………………………………….. 29 5. 3. Growing opportunities for traders in currency futures market ………………………………………. 0 5. 4. The Road Ahead ……………………………………………………………………………………………………….. 31 5. 5. FDI and FII ………………………………………………………………………………………………………………. 32 6. Capital Account Convertibility ………………………………………………………………………………….. 34 6. 1. The Tarapore Committee …………………………………………………………………………………………… 36 7. 8.

Analysis …………………………………………………………………………………………………………………… 37 Appendices ………………………………………………………………………………………………………………. 40 Appendix I ………………………………………………………………………………………………………………………… 40 Appendix II ……………………………………………………………………………………………………………………….. 0 Appendix III ……………………………………………………………………………………………………………………… 40 9. Bibliography …………………………………………………………………………………………………………….. 46 Critical Examination of Indian Currency Market & its Future || 6 List of Figures & Tables Figure 1: Main foreign exchange market turnover, 1988 – 2007, measured in billions of USD……13 Figure 2: Exchange Rate Fluctuation……………………………………………………………………………………….. 6 Figure 2: Turnover in currency figures on NSE and MCX ………………………………………………………… 30 Figure 3: Foreign Capital Inflows ……………………………………………………………………………………………. 34 Figure 4: External Borrowing by India …………………………………………………………………………………….. 35 Figure 5: Daily NSE and MCX turnover and open interest ……………………………………………………….. 8 Figure 6: Share of Top investing Countries FDI inflows …………………………………………………………… 44 Figure 7: Sectors attracting highest FDI inflows ………………………………………………………………………. 44 Figure 8: Year wise FDI inflows……………………………………………………………………………………………… 45 Table 1: Top 10 currency traders % of overall volume, may 2008……………………………………………. 43 Critical Examination of Indian Currency Market & its Future || 7 List of Appendices No.

Description Bretton Woods System, Floating Exchange Rate, Fear of Float, Exchange rate Regime Derivative Foreign Direct Investment Page I II III Critical Examination of Indian Currency Market & its Future || 8 1. Overview 1. 1. Indian Economy Overview India has been one of the best performers in the world economy in recent years, but rapidly rising inflation and the complexities of running the world’s biggest democracy are proving challenging. India’s Economy has grown by more than 9% for three years running, and has seen a decade of 7%+ growth. This has reduced poverty by 10%, but with 60% of India’s 1. billion population living off agriculture and with droughts and floods increasing, poverty alleviation is still a major challenge. The structural transformation that has been adopted by the national government in recent times has reduced growth constraints and contributed greatly to the overall growth and prosperity of the country. However there are still major issues around federal vs state bureaucracy, corruption and tariffs that require addressing. India’s public debt is 58% of GDP according to the CIA World Fact book, and this represents another challenge.

During this period of stable growth, the performance of the Indian service sector has been particularly significant. The growth rate of the service sector was 11. 18% in 2007 and now contributes 53% of GDP. The industrial sector grew 10. 63% in the same period and is now 29% of GDP. Agriculture is 17% of the Indian economy. Additional factors that have contributed to this robust environment are sustained in investment and high savings rates. As far as the percentage of gross capital formation in GDP is concerned, there has been a significant rise from 22. % in the fiscal year 2001, to 35. 9% in the fiscal year 2006. Further, the gross rate of savings as a proportion to GDP registered solid growth from 23. 5% to 34. 8% for the same period. Despite robust economic growth, India continues to face several major problems. The recent economic development has widened the economic inequality across the country. Despite sustained high economic growth rate, approximately 80% of its population lives on less than $2 a day (Nominal), more than double the same poverty rate in China.

Even though the arrival of Green Revolution brought end to famines in India, 40% of children under the age of three are underweight and a third of all men and women suffer from chronic energy deficiency. 1. 2. Indian Economic Development Economic development in India depends on the various sectors that constitute the Indian economy – these are primarily the agriculture, services and manufacturing industries. India is rated as one of the top economies in the world in terms of the purchasing power parity of the gross domestic product by leading financial entities of the world such as the International Monetary Fund, the World Bank, and the CIA.

As far as agriculture is concerned, India is in the second largest in volume of output. Certain connected sectors of the agricultural sector have played a major role in the development of the Indian economy by providing employment to a number of people in the forestry, fishing and logging industries. In the industrial arena, India is 14th in volume of factory output. Economic developmental roles are Critical Examination of Indian Currency Market & its Future || 9 also being played in the areas of gas, mining, electricity and quarrying. All these sectors contribute significantly to the GDP, and provide jobs to India’s citizens.

India is regarded as the 15th best economy in terms of work production by the services sector. A sizeable amount of the Indian workforce is also employed by the service sector. In the ten-year period between 1990 and 2000, the rate of growth has been 7. 5%, which is more than the 4. 5% rate during the 30-year period from 1951 to 1980. 1. 3. Globalization in India The process of globalization has been an integral part of the recent economic progress made by India. One of the major forces of globalization in India has been in the growth of outsourced IT and business process outsourcing BPO) services. The last few years have seen an increase in the number of skilled professionals in India employed by both local and foreign companies to service customers in the US and Europe in particular. Taking advantage of India’s lower cost but educated and English-speaking work force, and utilizing global communications technologies such as voice-over IP (VOIP), email and the internet, international enterprises have been able to lower their cost base by establishing outsourced knowledge-worker operations in India.

Globalization in India has been advantageous for companies that have ventured in the Indian market. By simply increasing their base of operations, expanding their workforce with minimal investments, and providing services to a broad range of consumers, large companies entering the Indian market have opened up many profitable opportunities. Indian companies are rapidly gaining confidence and are themselves now major players in globalization through international expansion. From steel to Bollywood, from cars to IT, Indian companies are setting themselves up as powerhouses of tomorrow’s global economy. . 4. Inflation in India In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. Most developed countries use the Consumer Price Index (CPI) to calculate inflation. But, India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy. Wholesale Price Index WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks.

The Indian government has taken WPI as an indicator of the rate of inflation in the economy. Critical Examination of Indian Currency Market & its Future || 10 Consumer Price Index CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. In 2009, Negative inflation or Deflation has been recorded in India for the first time since 1977-78. Inflation for week ended June 6 was at -1. 1% in the 12 months to June 6, compared with the previous week’s annual rise of 0. 13 percent. The annual inflation rate was 11. 66 percent during the corresponding week of the previous year. Experts say that this is due to the high statistical base and effect will keep the WPI inflation in the negative zone for at least three months. They expect that going forward inflationary risks are already in sight. 1. 5. Indian Budget The Indian Budget is a schematic plan of India’s financial and operational goals. It is an action plan that facilitates allocation of resources in India.

The Government of India Budget, also known as the Union Budget, is primarily made up of the Revenue Budget and Capital Budget. ? Revenue Budget: The revenue budget primarily comprises Government revenue receipts like tax and expenditure met from the revenue. The tax revenues principally constitute yields of taxes and other duties imposed by the Government of India. Capital Budget: The capital budget primarily comprises capital receipts and payments. The primary components of capital receipts include loans brought up by Government of India from public, termed as market loans.

The primary components of capital payments include capital expenditure on acquisition of assets like equipment, machinery, land and buildings. ? During 2008-09, the growth rate of GDP of India fell from an average of over 9 % in the previous three fiscal years to 6. 7 %. The wholesale price index of India also witnessed large fluctuations between 13% in August 2008 to 0% in March 2009. The fiscal deficit of Indian government had gone up to 6. 1% in March 2009. The budget was preceded by an interim budget by Pranab Mukherjee on 16 Feb 2009.

The total estimated expenditure for 2009-10 was Rs. 10,20,838 crore, of which Rs. 6,95,689 crore was towards Non Plan and Rs. 3,25,149 crore towards Plan expenditure. Total estimated revenue was Rs 6,19,842 crore, including revenue receipts of Rs 6,14,497 and capital receipts of Rs 5345 crores, excluding borrowings. The resulting fiscal deficit was Rs 4,00,996 crore while revenue deficit was Rs 2,82,735 crore. The gross tax receipts were budgeted at Rs. 6,41,079 crore and non tax revenue receipts at Rs. 1,40,279. Critical Examination of Indian Currency Market & its Future | 11 1. 6. Foreign Direct Investment FDI has helped the Indian economy grow, and the government continues to encourage more investments. Foreign direct investment (FDI) in India has played an important role in the development of the Indian economy. FDI in India has – in a lot of ways – enabled India to achieve a certain degree of financial stability, growth and development. This money has allowed India to focus on the areas that may have needed economic attention, and address the various problems that continue to challenge the country.

FDI investments are permitted through financial collaborations, through private equity or preferential allotments, by way of capital markets through Euro issues, and in joint ventures. FDI is not permitted in the arms, nuclear, railway, coal & lignite or mining industries. Federal democracy is perversely an impediment for India. Local authorities are not part of the approvals process and have their own rights, and this often leads to projects getting bogged down in red tape and bureaucracy. India actually receives less than half the FDI that the federal government approves. . 7. Five Year Plans The economy of India is based in part on planning through its five-year plans, developed, executed and monitored by the Planning Commission. With the Prime Minister as the ex officio Chairman, the commission has a nominated Deputy Chairman, who has rank of a Cabinet minister. Income & Poverty ? Accelerate GDP growth from 8% to 10% and then maintain at 10% in the 12th Plan in order to double per capita income by 2016-17 ? Increase agricultural GDP growth rate to 4% per year to ensure a broader spread of benefits. Education ?

Reduce dropout rates of children from elementary school from 52. 2% in 2003-04 to 20% by 2011-12 ? Develop minimum standards of educational attainment in elementary school, and by regular testing monitor effectiveness of education to ensure quality Health ? Reduce infant mortality rate to 28 and maternal mortality ratio to 1 per 1000 live births Women and Children ? Raise the sex ratio for age group 0-6 to 935 by 2011-12 and to 950 by 2016-17 ? Ensure that at least 33 percent of the direct and indirect beneficiaries of all government schemes are women and girl children Infrastructure ?

Ensure electricity connection to all villages and BPL households by 2009 and round-the-clock Critical Examination of Indian Currency Market & its Future || 12 2. Literature Review 2. 1. Currency Market, Forex Market The currency market or forex market is a place where banks and other authorized establishments trade the currencies of various nations. This market is unique in the sense that it allows trading 24-hour a day, 5. 5 days in a week. The currency market is highly liquid and is the world’s largest financial market, with more than $3 trillion being traded on a daily basis.

According to the Triennial Central Bank survey conducted end-2007, the daily trade in the forex market can be broken down into: ? ? ? ? Spot transactions – $1. 005 trillion. Forward contracts – $362 billion. Foreign exchange swaps – $1. 714 trillion. Estimated Gaps in reporting – $ 129 Billion The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U. S. business to import European goods and pay Euros, even though the business’s income is in U. S. dollars.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. (Appendix 1) Figure 1: Main foreign exchange market turnover, 1988 – 2007, measured in billions of USD. Unique features of Currency Market are: ? ? ? its trading volumes, the extreme liquidity of the market, its geographical dispersion, Critical Examination of Indian Currency Market & its Future | 13 ? ? ? ? its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday) the variety of factors that affect exchange rates. the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes) the use of leverage As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks. According to the Bank for International Settlements, average daily turnover in global foreign exchange markets is estimated at $3. 8 trillion. Trading in the world’s main financial markets accounted for $3. 21 trillion of this. 2. 2. Market size and liquidity The foreign exchange market is one of the largest and most liquid financial markets in the world. Traders include large banks, central banks, currency speculators, corporations, governments, and other financial institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Daily turnover was reported to be over US$3. 2 trillion in April 2007 by the Bank for International Settlements.

Since then, the market has continued to grow. According to Euromoney’s annual FX Poll, volumes grew a further 41% between 2007 and 2008. Of the $3. 98 trillion daily global turnover, trading in London accounted for around $1. 36 trillion, or 34. 1% of the total, making London by far the global center for foreign exchange. In second and third places respectively, trading in New York accounted for 16. 6%, and Tokyo accounted for 6. 0%. In addition to “traditional” turnover, $2. 1 trillion was traded in derivatives. (Appendix II) 2. 3. Market participants

Unlike a stock market, where all participants have access to the same prices, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume.

If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers.

Critical Examination of Indian Currency Market & its Future || 14 Banks The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank’s own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees.

Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates.

Nevertheless, trade flows are an important factor in the long-term direction of a currency’s exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. Central banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market.

Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank “stabilizing speculation” is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading. Hedge funds as speculators It is estimated that about 70% to 90% of the foreign exchange transactions are speculative.

In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Critical Examination of Indian Currency Market & its Future || 15 Some investment management firms also have more speculative specialist currency overlay operations, which manage clients’ currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades. Retail foreign exchange brokers There are two types of retail brokers offering the opportunity for speculative trading: retail foreign exchange brokers and market makers.

Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated by the CFTC (Commodity Futures Trading Commission) and NFA (National Futures Association) might be subject to foreign exchange scams. Non-bank Foreign Exchange Companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. . e. , there is usually a physical delivery of currency to a bank account. Money Transfer/Remittance Companies Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally. . 4. Determinants of FX Rates The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government): (a) International parity conditions viz; purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e. g. free flow of goods, services and capital] which seldom hold true in the real world. (b) Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit. Critical Examination of Indian Currency Market & its Future || 16 (c) Asset market model: views currencies as an important asset class for constructing investment portfolios.

Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. ” None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames.

For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world’s currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly.

No other market encompasses (and distils) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology. (Appendix III) Economic factors 1. Economic policy: it comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government’s central bank influences the supply and “cost” of money, which is reflected by the level of interest rates). . Economic conditions, generally revealed through economic reports, and other economic indicators: Government budget deficits or surpluses, Balance of trade levels and trends, Inflation levels and trends, Economic growth and health, Productivity of an economy and Political conditions Market psychology Market psychology and trader perceptions influence the foreign exchange market in a variety of ways: ? ? ? ? ? Flights to quality Long-term trends “Buy the rumour, sell the fact” Economic numbers Technical trading considerations 2. 5. Algorithmic trading in foreign exchange

Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by Critical Examination of Indian Currency Market & its Future || 17 volume will be executed using algorithm, up from about 18% in 2005. An algorithmic trader needs to be mindful of potential fraud by the broker. Part of the weekly algorithm should include a check to see if the amount of transaction errors when the trader is losing money occurs in the same proportion as when the trader would have made money. 2. 6.

Fundamental trading in foreign exchange Fundamental trading is determined on the basis on regulatory, statutory and economic changes which occur with-in various countries, FX traders are more concerned if central governments will raise rates on its particular currency. Likewise traders also to look to countries which are dependent on commodities or commodity driven such i. e. Australian dollar or Canadian dollar which are heavily influenced by commodities prices. 2. 7. Technical Analysis in foreign exchange Technical Analysis trading is utilized in the FX markets as a way to determine future price movements of a particular currency.

Traders utilize technical indicators to measure overbought and oversold levels. The common use indicator being the Bollinger band or RSI (relative strength index) which measures the particular strength of movement built in a current pairs trending direction. A new wave of measurement tool being utilized amongst traders is VSA or volume spread analysis. The success with the VSA method is that your looking to follow the volume, whether tick volume or not is still a relevant substitute to utilize in determining when professional money is buying or selling. 2. 8. Financial instruments

Spot A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Rubble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot transactions has the second largest turnover by volume after Swap transactions among all FX transactions in the Global FX market NNM.

Forward One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties. Critical Examination of Indian Currency Market & its Future || 18

Future Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate [4],[5]. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts. Swap The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

These are not standardized contracts and are not traded through an exchange. Option A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Exchange-Traded Fund Exchange-traded funds (or ETFs) are open ended investment companies that can be traded at any time throughout the course of the day.

Typically, ETFs try to replicate a stock market index such as the S 500 (e. g. , SPY), but recently they are now replicating investments in the currency markets with the ETF increasing in value when the US Dollar weakens versus a specific currency, such as the Euro. Certain of these funds track the price movements of world currencies versus the US Dollar, and increase in value directly counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated investors and speculators. 2. 9. Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don’t wish to bear it, to those who do. Large hedge funds and other well capitalized “position traders” are the main speculators. Critical Examination of Indian Currency Market & its Future | 19 3. Theory 3. 1. How the Forex market works The forex market comprises of banks, commercial companies, hedge funds, investment management firms, brokers and retail investors. The market does not have any centralized exchange. Trading generally takes place through the interbank market, which is a network of more than a thousand banks. Each bank in the network trades directly with others with the help of an Electronic Broking System (EBS), where buy and sell orders are placed and then matched on the basis of price.

Interbank forex trading continues 24 hours a day, 5. 5 days a week, from Monday through midday on Saturday. On a single trading day, the market opens in Australia and shifts operations throughout the day to Asia, Tokyo, Hong Kong, Singapore, Europe and New York. The forex trading day ends with the close of trading in New York. In the forex market, trading always occurs in currency pairs. The pricing of a currency pair in this market is determined by the demand and supply of a currency in relation to the other in the pair.

Apart from banks, currency pairs are bought and sold by individual investors via brokers. 3. 2. Working of the Indian Currency Market Foreign Exchange Market in India works under the central government in India and executes wide powers to control transactions in foreign exchange. The Foreign Exchange Management Act, 1999 or FEMA regulates the whole foreign exchange market in India. Before this act was introduced, the foreign exchange market in India was regulated by the reserve bank of India through the Exchange Control Department, by the FERA or Foreign Exchange Regulation Act, 1947.

After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the economic and industrial development, the need for conservation of foreign currency was urgently felt and on the recommendation of the Public Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act became famous as FEMA. Foreign Exchange Market in India, Indian Economy Until 1992 all foreign investments in India and the repatriation of foreign capital required previous approval of the government.

The Foreign-Exchange Regulation Act rarely allowed foreign majority holdings for foreign exchange in India. However, a new foreign investment policy announced in July 1991, declared automatic approval for foreign exchange in India for thirty-four industries. These industries were designated with high priority, up to an equivalent limit of 51 percent. The foreign exchange market in India is regulated by the reserve bank of India through the Exchange Control Department. Critical Examination of Indian Currency Market & its Future || 20

Initially the government required that a company`s routine approval must rely on identical exports and dividend repatriation, but in May 1992 this requirement of foreign exchange in India was lifted, with an exception to low-priority sectors. In 1994 foreign and nonresident Indian investors were permitted to repatriate not only their profits but also their capital for foreign exchange in India. Indian exporters are enjoying the freedom to use their export earnings as they find it suitable. However, transfer of capital abroad by Indian nationals is only allowed in particular circumstances, such as emigration.

Foreign exchange in India is automatically made accessible for imports for which import licenses are widely issued. Indian authorities are able to manage the exchange rate easily, only because foreign exchange transactions in India are so securely controlled. From 1975 to 1992 the rupee was coupled to a tradeweighted basket of currencies. In February 1992, the Indian government started to make the rupee convertible, and in March 1993 a single floating exchange rate in the market of foreign exchange in India was implemented. In July 1995, Rs 31. 1 was worth US$1, as compared to Rs 7. 86 in 1980, Rs 12. 37 in 1985, and Rs17. 50 in 1990. Foreign Exchange Dealers Association of India (FEDAI) is a voluntary association that also provides some help in regulating the market. The Authorized Dealers and the attributed brokers are qualified to participate in the foreign Exchange markets of India. When the foreign exchange trade is going on between Authorized Dealers and RBI or between the Authorized Dealers and the overseas banks, the brokers usually do not have any role to play.

Besides the Authorized Dealers and brokers, there are some others who are provided with the limited rights to accept the foreign currency or travelers` cheque, they are the authorized moneychangers, travel agents, certain hotels and government shops. The IDBI and Exim bank are also permitted at specific times to hold foreign currency. 3. 3. Benefits of the Forex Market ? ? ? Highest liquidity: With a daily turnover exceeding $3 trillion, the forex market is the world’s most liquid market. A single trade amounting to $200-$500 million is not uncommon. 24-hour market: The market is open throughout the day at some part of the world.

Hence, investors have the flexibility of making their own trading schedule. Extensive leverage: In this market, leverage can range from 50:1 to up to 500:1. This means that if you have $5,000 in your trading account and your broker is offering 150:1 leverage, you have the option of trading up to $750,000. This kind of leverage offers you an opportunity to earn immense profits, even with limited capital. Market trends: Trends in this market are never bearish, as a decline in the value of one currency represents a rise in the exchange value of another.

Thus, investors have the opportunity to earn profits at all times. No cap on the lot size: An investor can trade a lot of an unlimited size at any given time and price. ? ? 3. 4. Drawbacks of Forex Market ? Highly unpredictable: Since the exchange value of a currency pair is dependent on several Critical Examination of Indian Currency Market & its Future || 21 ? ? factors, it is extremely difficult to predict the course of the market. High losses: As investors can trade with large amounts of cash due to the high leverage offered by brokers, they can suffer substantial losses.

Extremely volatile: The forex market is extremely volatile, with the exchange value of a currency pair changing several times within a trading day. A novice investor might get flustered with the volatility and suffer huge losses. Critical Examination of Indian Currency Market & its Future || 22 4. Currency Market – India 4. 1. Factors influencing Indian Currency Market Every major development in Indian or world economy affects the Indian currency market. India follows the Liberalised Exchange Rate Management System (LERMS), under which it is absolutely essential for corporate executives to understand how the exchange rate moves, and why.

Considering the large volume of transactions, a movement of even 2-3 paisa in the exchange rate can hit the bottom line of any corporate. There are several factors that influence the currency market. Some of the important ones among them, which have impacted the market recently, are discussed below: 4. 1. 1. Change of Interest Rate The value of the currency of any country depends on the interest rate of that country. In case of upward movement of interest rate in the United States, the US Dollar (USD) appreciates against other currencies as well as against the Indian Rupee (INR).

Any change of interest rate by the Federal Reserve Bank of New York (FED) through the Federal Open Market Committee (FOMC) has a great impact on the currency market. In the recent past there have been instances of rate hikes by the FED, as a result of which the USD had appreciated against major international currencies as well as the Indian Rupee. Even an expectation of change of interest rate has a great impact on currency market. Whenever there is any such expectation, the market reacts sharply. The possibility of changes in interest rate is a speculative move, and the market reacts only for a short period of time.

The market generally discounts some portion of such expectations well in advance, before they actually happen. Change of interest rate by the European Commercial Bank (ECB) is now equally important. The value of the Euro is influenced by a change of interest rate by ECB. Recently, there have been several occasions when the Euro strengthened against the USD following a hike in interest rate, or even the expectation of a hike in interest rate by the ECB. 4. 1. 2. Inflow of Foreign Funds The exchange rate depends on demand and supply of currency.

Strong economic fundamentals and good ratings by international rating agencies have boosted foreign investors’ confidence in the Indian market. Huge foreign investments have already come to India, while big investments through Foreign Institutional Investors (FIIs) and Foreign Direct Investment (FDI) are expected in the near future. In the last couple of months, substantial foreign funds have been infused into the Indian market. Since most of these have been in the form of USD, the supply of USD against the Indian Rupee became high, and it depreciated against the Rupee.

On the other hand, at the time when FIIs wanted to withdraw funds from the market, the demand for USD in the Indian market became high, and it appreciated against the Rupee. Critical Examination of Indian Currency Market & its Future || 23 During the last one to one-and-a-half years, the Indian rupee has shown a tendency to appreciate due to a huge inflow of foreign funds in the Indian market by FIIs or through FDIs in the form of External Commercial Borrowings (ECB) and Foreign Currency Convertible Bonds (FCCBs). A direct relationship may be drawn between the USD–INR exchange rate and the BSE index.

Considering all other factors to be constant, whenever overseas FIIs buy shares from the Indian market, there is an upward movement of the BSE index. At the same time, due to inflow of foreign funds (foreign investors have USD to sell—they will buy INR to invest in Indian market against USD) in the Indian market, the supply of USD increases in the market and it depreciates against INR, or INR appreciates against USD. On the other hand, if there is any negative flow of funds by FIIs, there would be a downward movement of the BSE index, and consequently USD would appreciate against INR. . 1. 3. Price of Oil A large portion of India’s import payment is mainly for payment of oil. Internationally, crude prices are named as BRENT, NYMEX, and Dubai Crude. Whenever there is any hike in the oil price per barrel, the Indian Rupee depreciates against the US Dollar. As such, the Indian Government buys more USD against INR to honour the import liability, resulting in heavy demand for USD. Consequently, the Indian rupee depreciates against USD. The Indian currency market largely depends on the price of Dubai Crude.

It is observed that USD appreciates at the end of the month when compared to other days of the month, primarily because of the month-end demand of USD in the wake of payment for imported oil. However, today’s market is mature enough, with players of foreign exchange covering themselves against this type of expected fluctuations in the market. Whenever FIIs book profits by selling their shares, the BSE index falls, and at the same time INR depreciates against the USD. On April 12, 2006, the BSE index fell by more than 300 points due to heavy selling by FIIs, and on the same day the crude price also shot up to around USD70 per barrel.

The Indian Rupee depreciated by 45- 50 paise on the same day, owing to the impact of these two important factors. 4. 1. 4. Comments from Political Leaders Comments from political leaders and top bureaucrats do influence the market, but this is very shortterm. It is quite common in India, particularly when it comes to comments from political leaders or the Governor of the Reserve Bank of India (RBI). We know that the Japanese economy is export-oriented, and that Japanese exporters welcome any move that depreciates the Japanese Yen.

It has been observed that whenever the Yen strengthens against the USD, Japanese politicians tend to pass comments on economy that allows the Yen to slip back to its original level. Political unrests can also strongly influence the currency market, but again only for a short period of time. Extended periods of political uncertainty can, however, cause the rest of the world to lose confidence in that country, and could finally result in a steep fall in the value of that country’s currency. 4. 1. 5. Release of Economic Data

The economic data or surveys released by various national and international agencies, including FED, Critical Examination of Indian Currency Market & its Future || 24 RBI, Moody’s, etc. can influence market sentiments and lead to movement in exchange rates. Some data from the US, such as Non-Form Payroll, Jobless Claim, US trade deficit and GDP growth rate are known to influence the currency market. In the last week of May 2006, the Non-Form Payroll data (monthly data generally released on the first Friday of the month) was released by the US Department of Labour, and it was weaker than market expectations.

As a result, the Euro became stronger against the USD, from 1. 2739 to 1. 2953 between 26 May and 5 June 2006. Annual economic review, RBI credit policy, monetary policy, etc. also strongly influence the currency market. Understanding, interpretation and correlation of different data are important to gain a thorough understanding of the exchange rate movement by any corporate. Any mistake in the interpretation of data released could cause heavy loss to an organisation. 4. 1. 6. RBI Intervention

The RBI, which regulates the Indian currency market, does intervene whenever it feels it is required to stabilise the market, or to keep market volatility under control. It is the responsibility of the RBI to keep the exchange rate unaffected at a time of volatility in the foreign currency market. It has been observed that RBI intervenes in the currency market whenever there is any abnormal movement in the exchange rate, either upward or downward. The RBI buys foreign currency (USD) to depreciate the domestic currency, and sells foreign currency when the domestic currency depreciates abnormally. Sometimes the RBI does not intervene at all.

In April and May 2006, the Indian Rupee depreciated heavily in the wake of the fall of the BSE Index, but the RBI did not intervene, much as previously the Indian Rupee had appreciated (in January and February 2006) to such a level that it needed to be depreciated solely by market forces. 4. 1. 7. Natural Calamities Natural calamities may also affect the currency market for a short period of time. In August 2005, Hurricane Katrina affected the entire region around the Gulf of Mexico. This region contributes around one-third of US oil production and accounts for around half of the nation’s refining capacity.

Besides, a large part of US oil imports reaches ports in this area. The hurricane caused a huge loss in production of crude oil and natural gas. It affected the prices of crude oil and prices shot up to around USD70 per barrel in a very short time. Automatically, the oil price increased globally and at the same time affected the exchange rate. Since India had to buy more USD to honour its import liability, the Rupee became weaker by around 60-65 paise against the USD. Critical Examination of Indian Currency Market & its Future || 25 Figure 2: Exchange Rate Fluctuation. . 2. How India Inc. Handles risk associated with Currency market The increased globalisation of trades and services and volatility in financial markets require companies to be aware of the risks associated with currency fluctuations. The global financial crisis and the economic slowdown have resulted in a high degree of uncertainty and price volatility across all markets — be it the product, labour or financial markets. The currency market has become more volatile on the back of developed economies trying to correct imbalances in their financial sector.

But amidst the challenging environment, the corporate India needs to remain focused on sustaining profit growth. 4. 2. 1. SMEs rely on banks Historically, in a controlled environment, India Inc. relied on banks for covering its foreign exchange requirements. But volatility in currency markets now requires better understanding of the currency exposures that arise due to transactions and use of appropriate tools to manage the risks arising from them. An inadequate understanding of the tools may prove to be extremely costly.

It is ‘inadequate understanding’ of companies and the profit motives of banks that had resulted in huge losses on some of the outstanding exotic derivatives contracts last year. Critical Examination of Indian Currency Market & its Future || 26 Some of the companies trade actively in foreign exchange and have a separate treasury management unit for foreign exchange transactions. However, there are also large numbers of small and medium enterprises which participate in the currency market passively and depend on commercial banks (authorised dealers) for their requirement of foreign exchange and coverage of currency exposure.

Indian companies usually view their foreign exchange transactions as a part of the credit relationship, and some have not made efforts to understand the implication of the currency exposure. Some companies were aware of the risks, but not of the methods to guard against them. 4. 2. 2. Tackling currency risk The currency exposure has to be understood as accounting (or translation) exposure and economic exposure. Currency fluctuations affect the operating cash flows and income statement, thereby affecting the market share and competitive position of the company.

For example, currency fluctuation may affect adversely the price realisation for the exporter and the price of raw materials for the importer. The company has to have a view of the $/INR rate while budgeting for the year and has to continuously monitor the prevailing exchange rate to ensure stability of rupee cash-flows. A company may budget the annual sales/raw material requirements and cover the currency exposure in the forward market with banks. Currently, they can cover in the exchange traded currency futures market.

The futures market provides a transparent platform and offers standardised contracts for companies to cover their foreign exchange exposure. The balance-sheet exposure to foreign currency affects the value of the firm’s assets and liabilities, accounts payable, accounts receivable, inventory and loans. For example, the borrowings under the ECB and the FCCB routes were attractive for their lower interest rates. But the adverse movement in the $/INR exchange rate has changed the balance-sheet picture on these loans significantly.

Any adverse movement in the exchange rates would result in higher cost of assets that was accounted as ‘capitalising the losses’. Traditionally, banks have advised companies to cover the entire foreign currency exposure, say, for six months forward contracts and roll them over semi-annually. The balance-sheet exposure as a thumb rule can be hedged only if the risk can be passed through pricing/marketing strategy of the ultimate product. The $/INR market is traded largely in the OTC (over the counter) market dominated by a few multinational banks, large public sector banks and a few private sector banks.

The rates are quoted to companies as a mark-up over the ruling inter-bank rate. The prices fluctuate widely when large players cover their positions and there is price differential between large and small players. The bankers undertake proprietary trading and offer various contracts to customers, with the result that conflict of interests cannot be ruled out. In addition, they sell various contracts — such as forward, option, plain vanilla and exotic options — to the customers. The past year saw some companies entering into contracts that were not necessarily in their best interest and eventually seeing losses.

Critical Examination of Indian Currency Market & its Future || 27 4. 2. 3. Identify the purpose Companies must clearly identify the purpose of trading in the currency market. The purpose may be speculative with a view on the future movement of exchange rates or it may be hedging an underlying exposure or making use of the arbitrage between markets or different time periods. Having identified the purpose, companies must take care to ensure that their trades fit the purpose. A hedging contract must not have any fine-print that will eventually convert the transaction into one which is speculative in nature.

Any complex contracts that have embedded options and forwards must be handled separately by a treasury specialist. These should be avoided unless the company is aware of the additional risk and sufficient capital has been allocated to such activity to bear the loss in event of adverse payoffs. The exchange based trading ensures better risk management through margins for VaR (Value at Risk) and daily volatility. The increased globalisation of trades and services and volatility in financial markets require companies to be aware of the risks associated with currency fluctuations.

A focus on treasury functions is needed to protect the company’s cash flows by undertaking specific transactions. At the same time, companies need to ensure that they do not undertake undue risks by entering into inappropriate contracts that may jeopardise the core operations. Critical Examination of Indian Currency Market & its Future || 28 5. Currency Futures The collapse of the Bretton Woods system in 1973 and the advent of the flexible exchange rate regime for major currencies necessitated, as also facilitated, the development of foreign exchange markets.

This exchange rate flexibility exposed market participants to risks arising as a result of exchange rate fluctuations. These risks assumed significance in

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