CU-SEM-III-BBA-Fundamentals of Foreign Exchange Management- Second Draft

BACHELOR OF BUSINESS ADMINISTRATION SEMESTER-III FUNDAMENTALS OF FOREIGN EXCHANGE MANAGEMENT BBA231

2 CU IDOL SELF LEARNING MATERIAL (SLM)

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Prof. (Dr.) R.S.Bawa Pro Chancellor, Chandigarh University, Gharuan, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director – IGNOU Prof. (Dr.) Majulika Srivastava, Director – CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Coordinator – Dr. Rupali Arora Coordinator – Dr. Simran Jewandah Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Coordinator – Dr. Raju Kumar Coordinator – Dr. Manisha Malhotra Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Coordinator – Dr. Aman Jindal Coordinator – Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel &Tourism Management) Coordinator – Dr. Samerjeet Kaur Coordinator – Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Coordinator – Dr. Ashita Chadha Coordinator – Ms. Neeraj Gohlan Academic and Administrative Management Prof. (Dr.) R. M. Bhagat Prof. (Dr.) S.S. Sehgal Executive Director – Sciences Registrar Prof. (Dr.) Manaswini Acharya Prof. (Dr.) Gurpreet Singh Executive Director – Liberal Arts Director – IDOL © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the authors and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: TeamLease Edtech Limited www.teamleaseedtech.com CONTACT NO:- 01133002345 For: CHANDIGARH UNIVERSITY Institute of Distance and Online Learning 3 CU IDOL SELF LEARNING MATERIAL (SLM)

First Published in 2021 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the event the Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action. CONTENTS 4 CU IDOL SELF LEARNING MATERIAL (SLM)

Unit - 1: Foreign Exchange Management .............................................................................. 6 Unit - 2: Forex Management ............................................................................................... 27 Unit - 3: Foreign Exchange ................................................................................................. 38 Unit - 4: Foreign Exchange Market And Its Structure .......................................................... 58 Unit - 5: Foreign Exchange Risk Exposures ........................................................................ 95 Unit - 6: Foreign Exchange Risk Management .................................................................. 111 Unit - 7: Strategies For Managing The Risk ...................................................................... 128 Unit - 8: Recent Developments In Forex Markets .............................................................. 138 Unit – 9: Present Status Of Indian Forex Markets.............................................................. 149 Unit - 10: Foreign Exchange And Hedging Techniques ..................................................... 175 Unit -11: Payment Terms In Foreign Exchange ................................................................. 196 Unit -12: International Taxation And Carbon Credits ........................................................ 218 5 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 1: FOREIGN EXCHANGE MANAGEMENT Structure 1.0 Learning objectives 1.1 Introduction 1.2 Historical overview of Foreign exchange 1.2.1 Exchange rate systems 1.2.2 The gold Standard (1876- 1913) 1.2.3 Bretton Woods (1944) 1.2.4 The Special Drawing Rights (SDRs): 1.2.5 Fixed Vs Floating Exchange Rate Systems: 1.3 Meaning of foreign exchange 1.4 Scope of foreign exchange management 1.5 Significance of foreign exchange management 1.6 Summary 1.7 Keywords 1.8 Learning activity 1.9 Unit end questions 1.10 References 1.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe the meaning of Foreign Exchange.  Identify scope of Foreign Exchange  Significance and importance of Forex in today’s market 1.1 INTRODUCTION International business encompasses a full range of cross-border exchanges of goods, services, or resources between two or more nations. These exchanges can go beyond the exchange of money for physical goods to include international transfers of other resources, such as people, intellectual property (e.g., patents, copyrights, brand trademarks, and data), and contractual 6 CU IDOL SELF LEARNING MATERIAL (SLM)

assets or liabilities (e.g., the right to use some foreign asset, provide some future service to foreign customers, or execute a complex financial instrument). The entities involved in international business range from large multinational firms with thousands of employees doing business in many countries around the world to a small one-person company acting as an importer or exporter. Foreign exchange is essential to coordinate global business. Foreign exchange management is associated with currency transactions designed to meet and receive overseas payments. Beyond these transactions, foreign exchange management requires you to understand the relevant factors that influence currency values. Foreign exchange management begins with trading currencies to exchange goods and services overseas. International businesses convert overseas profits back into their domestic currency to spend at home. Meanwhile, consumers exchange domestic currency for foreign banknotes to buy overseas goods. These transactions occur within the foreign exchange markets, where networks of private individuals, banks and organized financial exchanges provide the infrastructure to trade international banknotes. Foreign exchange occurs at rates that are associated with currency valuations. Foreign exchange rates describe the amount of one currency that must be given up to receive one unit of another currency, and they tend to parallel the political and economic environment of a particular country. For example, domestic foreign exchange rates appreciate when the economy is strong and the currency is in high demand to buy the nation’s stocks and real estate. Conversely, currency values fall amidst political and social instability. Foreigners generally liquidate business assets in war-torn nations that struggle with development. Effective foreign exchange management requires you to preserve purchasing power by staying current on any events affecting rates and operating accordingly. You will exploit the buying power of high exchange rates to acquire overseas goods. Alternatively, low exchange rates are an opportunity to boost overseas sales, as your wares become relatively cheaper overseas. 7 CU IDOL SELF LEARNING MATERIAL (SLM)

1.2 HISTORICAL OVERVIEW OF FOREIGN EXCHANGE Fig 1.1 The History of forex 1.2.1 Exchange rate systems Over the ages, currencies have been defined in terms of gold and other items of value, and the international monetary system has been subject to a variety of international agreements. A brief history of these systems provides useful perspective against which to compare today‘s system and to evaluate weaknesses and proposed changes in the present system. In the following sections various monetary standards that were in practice since 19th century were briefly explained. The international monetary system has evolved historically from the gold standard (1876-1913) of fixed exchange rates, to the interwar years and World War II (1914- 1944) with floating exchange rates, to fixed exchange rates (1945-1973) under the Bretton Woods Agreement, to the present eclectic currency arrangement (1973-present) of fixed, floating, and managed exchange rates. In the following sections an attempt has been made to explain them briefly for understanding of their significance in international monetary environment. 8 CU IDOL SELF LEARNING MATERIAL (SLM)

1.2.2 The gold Standard (1876- 1913) A system of setting currency values whereby the participating countries commit to fix the prices of their domestic currencies in terms of a specified amount of gold. The gold standard as an international monetary system gained acceptance in Western Europe in the 1870s. The United States was something of a latecomer to the system, not officially adopting the standard until 1879. The ―rules of the game‖ under the gold standard were clear and simple. Each country set the rate at which its currency (paper or coin) could be converted to a weight of gold. The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67/ounce of gold (a rate in effect until the beginning of World War 1). The British pound was pegged at £4.2474/ounce of gold. As long as both currencies were freely convertible into gold, the dollar/pound exchange rate was: Because the government of each country on the gold standard agreed to buy or sell gold on demand to anyone at its own fixed parity rate, the value of each individual currency in terms of gold, and therefore the fixed parities between currencies, was set. Under this system it was very important for a country to maintain adequate reserves of gold to back its currency‘s value. The system also had the effect of implicitly limiting the rate at which any individual country could expand its money supply. The growth in money was limited to the rate at which additional gold could be acquired by official authorities. The gold standard worked adequately until the outbreak of World War 1 interrupted trade flows and the free movement of gold. This caused the main trading nations to suspend the operation of the gold standard. Advantages of Gold Standard: Several advantages are claimed for the gold standard, especially when it is adopted simultaneously by a number of countries, i.e., international gold standard. (i) It is an objective system and is not subject to the changing policies of the government or the whims of the currency authority. 9 CU IDOL SELF LEARNING MATERIAL (SLM)

(ii) Gold standard enables the country to maintain the purchasing power of its currency over long periods. This is so because the currency and credit structure is ultimately based on gold in possession of the currency authority. (iii) Another important advantage claimed for gold standard is that it preserves and maintains the external value of the currency (rate of exchange) within narrow limits. As a matter of fact, within the gold standard system, it provides fixed exchanges, which is a great boon to traders and investors. International division of labour is greatly facilitated. (iv) It gives, in fact, all the advantages of a common international currency. It establishes an international measure of value. As Marshall pointed out before the Fowler Committee (Report on Indian Currency) in 1898, the change to a gold basis is like a movement towards bringing the railway gauge on the side branches of the world‘s railway into unison with the main lines. This greatly facilitates foreign trade, because fluctuations in rates of exchange hamper international trade. (v) It is further claimed that gold standard helps to adjust the balance of payments between countries automatically. How this happens may be illustrated by a simple example. Suppose England and America are both on gold standard and only trade with each other, and that a balance of payments is due from England to America. Gold will be exported from England to America. The Bank of England will lose gold. This will contract currency in England and bring about a fall in the British price level. Price level in America will rise due to larger reserves and the expansion of currency and credit. England will become a good market to buy from and a bad market to sell in. Conversely, America will become a good market to sell in and a bad market to buy from. British exports will be encouraged and imports discouraged. American exports will be discouraged and imports encouraged. The balance of payments will tend to move in favour of Britain until equilibrium is reached. It is in this way, that movement of gold, by affecting prices and trade, keeps equilibrium among gold standard countries. Disadvantages of Gold Standard: (i) Gold standard is costly and the cost is unnecessary. We only want a medium of exchange, why should it be made of gold? It is a luxury. ―The yellow metal could tickle the fancy of savages only. (ii) Even the value of gold has not been found to be absolutely stable over long periods. 10 CU IDOL SELF LEARNING MATERIAL (SLM)

(iii) Under the gold standard, currency cannot be expanded in response to the requirements of trade. The supply of currency depends on the supply of gold. But the supply of gold depends on the success of the mining operations, which may have nothing to do with the factors affecting the growth of trade and industry in the country. (iv) Gold standard has also been charged with sacrificing internal stability to external (exchange) stability. It is the international aspect of the gold standard which has been paid more attention to. (v) Another disadvantage is that, under gold standard gold movements lead to changes in interest rates, so that investment is stimulated or checked solely in order to expand or reduce money income. (vi) A country on a gold standard cannot follow an independent policy. In order to maintain the gold standard or to restore it (as in England after World War I), it may have to deflate its currency against its will. Deflation spells ruin to the economy of a country. It brings, in its wake, large-scale unemployment, closing of works and untold suffering attendant on depression. Causes of the Break-down of the Gold Standard The gold standard broke down in country after country soon after its rehabilitation during the post-1914-18 war decade. There were several reasons for this development: (1) Gold was very unevenly distributed among the countries in the inter-war period. While the U.S.A. and France came to possess the bulk of it, other countries did not have enough to maintain a monetary system based in gold. (2) Owing to general political unsettlement, a habit arose on the part of certain Continental countries to keep their funds for short periods in foreign central banks, especially in Great Britain. These funds were liable to be withdrawn at the earliest danger signal. Withdrawal of such funds from Britain on the part of France led to gold standard being suspended in 1931 in the former country. The Bank of England could not afford to lose its gold resources in large quantities at such a short notice. (3) International trade was not free. Some countries often imposed stringent restrictions on imports, which created serious balance of payments problems for other countries. Not having enough gold to cover the gap, they threw the gold standard overboard. This specially happened during the Great Depression of early thirties. 11 CU IDOL SELF LEARNING MATERIAL (SLM)

(4) International obligation in the form of reparations and war debts arose out of World War I. Since the creditor countries refused to accept payments in the form of goods and also refused to continue lending to the debtors’ countries, the debts had to be cleared through gold movements. This led to concentration of 34 per cent of the world ‘s gold in the U.S.A. and France, the two chief creditor countries. The gold left with the other countries was not enough to enable them to maintain gold standard successfully. (5) The gold-receiving countries did not ―play the game of the gold standard‖. They (especially the U.S.A.) did not allow this gold to have any effect on their price levels. The gold was ―sterilised‖ or made ineffective. Had prices risen in these countries, imports would have been encouraged and exports discouraged and an unfavourable balance of trade would have led to movement of gold in the reverse direction. Since this was not allowed to happen, the gold standard failed to work automatically. (6) Gold standard failed also because the economic structure of the countries concerned had become less and less elastic after the World War of 1914-18. This was due to several reasons: The enormous growth in the indebtedness of governments and local authorities resulted in a mass of interest payments fixed by contract over a long period of years. The huge expenditure in the form of payment to social services could not be easily reduced. The trade unions were now able to offer a much stronger resistance to wage cuts than before 1914. The prices of raw materials and finished goods were becoming more and more fixed by partial monopolies, cartel agreements, etc. The result was that prices no longer moved in the directions warranted by gold movements and equilibrium failed to be restored as of old. (7) Another weakness that was discovered in the gold standard in practice was that it was always liable to collapse in a crisis. It has often been called a ‗fair weather standard ‘only. (8) Another objection that was frequently urged against the system was that gold movements caused inconvenient changes in interest rates. Deflation, for instance, may be made necessary at a time of crisis to prevent suspension of the standard. But deflation, which involves falling wages and prices, may prove a cause of serious trouble. Wage cuts are resisted by trade unions, and falling prices increase the burden of fixed payments which the government or the people may have to make. Moreover, falling prices discourage enterprise and create unemployment. A large volume of short-term capital was moving for safely from one financial centre to another. Big flows of this hot money necessitated large gold movements, which the slender gold reserves of the countries could not maintain. Hence, gold standard was given up. Thus, it 12 CU IDOL SELF LEARNING MATERIAL (SLM)

was that country after country abandoned the Gold Standard in the inter-war period (1914- 1944). 1.2.3 Bretton Woods (1944) In 1944, as World War II drew toward a close, the Allied Powers met at Bretton Woods, New Hampshire, in order to create a new post-war international monetary system. The Bretton Woods Agreement, implemented in 1946, whereby each member government pledged to maintain a fixed, or pegged, exchange rate for its currency vis-à-vis the dollar or gold. These fixed exchange rates were supposed to reduce the riskiness of international transactions, thus promoting growth in world trade. The Bretton Woods Agreement established a US dollar- based international monetary system and provide for two new institutions, The IMF and the World Bank. The IMF aids countries with balance of payments and exchange rate problems. The International Bank for Reconstruction and Development (World Bank) helped post-war reconstruction and since then has supported general economic development. The IMF was the key institution in the new international monetary system, and it has remained so to the present. The IMF was established to render temporary assistance to member countries trying to defend their currencies against cyclical, seasonal, or random occurrences. It also assists countries having structural trade problems if they take adequate steps to correct their problems. However, if persistence deficits occur, the IMF cannot save a country from eventual devaluation. In recent years it has attempted to help countries facing financial crises. It has provided massive loans as well as advice to Russia and other former Russian republics, Brazil, Indonesia, and South Korea, to name but a few. Under the original provisions of the Bretton Woods Agreement, all countries fixed the value of their currencies for gold. Only the dollar remained convertible into gold (at $35 per ounce). Therefore, each country decided what it wished its exchange rate to be vis-à-vis the dollar and then calculated the gold per value of its currency to create the desired dollar exchange rate. Participating countries agreed to try to maintain the value of their currencies within 1% (later expanded to 2 ¼ %) of par by buying or selling foreign exchange or gold as needed. Devaluation was not to be used as a competitive trade policy, but if a currency became too weak to defend, a devaluation of up to 10% was allowed without formal approval by the IMF. Larger devaluations required IMF approval. 13 CU IDOL SELF LEARNING MATERIAL (SLM)

1.2.4 The Special Drawing Rights (SDRs): The Bretton Woods also known as IMF system was an improvement on the gold standard. The IMF system had all the merits of the gold standard minus its demerits. It ensured exchange stability without the country having to undergo the expense of maintaining a costly currency system. Under the IMF system, exchange parities were fixed in gold but it was unnecessary to keep large gold reserves for currency purposes. Besides gold stocks and current output were utterly inadequate to meet the requirements of over-expanding volume of international trade, thus giving rise to the serious problem of international liquidity. The IMF sought to provide multilateralism. The IMF quota facilitated foreign exchange transactions and there was no need to export gold to meet a trade deficit. It also facilitated convertibility of currencies and provided adequate and convenient currency reserve for the use of member countries. However, fast changing circumstances are necessitated changes in the IMF system. In September 1967, the Board of Governors approved a plan for a new type of international asset known as the SDRs (Special Drawing Rights). SDRs is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and regional organizations, and it is also the base against which some countries peg the rate of exchange for their currencies. Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several times. It is currently the weighted value of currencies of the five IMF members having the largest exports of goods and services. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country‘s international monetary reserves, along with official holdings of gold, foreign exchange, and its reserve position at the IMF. Members may settle transactions among themselves by transferring SDRs. Under the Scheme, the IMF is empowered to allocate to various member countries SDR‘s on a specified basis, which in effect amounts to raising the limit to which a member country can draw from the IMF in time of need. Besides, the SDR‘s supplement gold, dollars and pounds sterling most countries use as monetary reserves. They can be used unconditionally by the participating countries to meet their liabilities and they are not backed by gold. They are meant to be used by the Central banks of the Fund‘s member countries. With the SDR‘s, the Central banks can buy whatever currencies they need for settling their balance of payments 14 CU IDOL SELF LEARNING MATERIAL (SLM)

deficits. The resources of the new scheme are not a pool of currencies but simply the obligation of participating members to accept the SDR‘s for settlement of payments between them. Thus, SDR‘s serve as an international money as good as other reserve currencies. But a nicely and diligently built up system of exchange stability by the IMF collapsed like a house of cards. This was caused by the dollar crisis created by the adverse American balance of payments. Among the measures taken by the American administration, there was one which delinked dollar from gold. The delinking of dollar from gold knocked out the very foundation of the IMF. In January 1975, the IMF abolished the official price of gold and SDR‘s have instead become the basis of the present international monetary standard. The SDR‘s are not convertible into gold; that is why alternatively the present standard may also be referred to as Paper Gold Standard. 1.2.5 Fixed Vs Floating Exchange Rate Systems: Fixed Exchange Rates, 1945-1973 The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-World War II period of reconstruction and rapid growth in world trade. However, widely diverging national monetary and fiscal policies, differential rates of inflation, and various unexpected external shocks eventually resulted in the system‘s demise. The U.S. dollar was the main reserve currency held by central banks and was the key to the web of exchange rate values. Unfortunately, the United States ran persistent and growing deficits on its balance of payments. A heavy capital outflow of dollars was required to finance these deficits and to meet the growing demand for dollars from investors and businesses. Eventually, the heavy overhang of dollars held abroad resulted in a lack of confidence in the ability of the United States to meet its commitment to convert dollars to gold. On August 15, 1971, President Richard Nixon was forced to suspend official purchases or sales of gold by the U.S. Treasury after the United States suffered outflows of roughly one- third of its official gold reserves in the first seven months of the year. Exchange rates of most of the leading trading countries were allowed to float in relation to the dollar and thus indirectly in relation to gold. By the end of 1971 most of the major trading currencies had appreciated vis-à-vis the dollar. This change was – in effect – a devaluation of the dollar. In early 1973, the U.S. dollar came under attack once again, thereby forcing a second devaluation on February 12, 1973, this time by 10% to $42.22 per ounce. By late February 15 CU IDOL SELF LEARNING MATERIAL (SLM)

1973, a fixed –rate system no longer appeared feasible given the speculative flows of currencies. The major foreign exchange markets were actually closed for several weeks in March 1973. When they reopened, most currencies were allowed to float to levels determined by market forces. Par values were left unchanged. The dollar had floated downward an average of 10% by June 1973. An Eclectic Currency Arrangement, 1973-Present Since March 1973, exchange rates have become much more volatile and less predictable than they were during the ―fixed‖ exchange rate period, when changes occurred infrequently. In general the dollar has been volatile and has weakened somewhat over the long run. On the other hand, the Japanese yen and German mark have strengthened. The emerging market currencies have been exceptionally volatile and have generally weakened. In the wake of the collapse of the Bretton Woods exchange rate system, the IMF appointed the Committee of Twenty which suggested various options for the exchange rate arrangement. These suggestions were approved at Jamaica during February 1976 and were formally incorporated into the text of the Second Amendment to the Articles of Agreement, which came into force from April 1978. The options were broadly: 1. Floating-independent and managed 2. Pegging of currency 3. Crawling peg 4. Target zone arrangement 5. Others 1. Floating Rate System: In a floating-rate system, it is the market forces that determine the exchange rate between two currencies. The advocates of the floating rate system put forth two major arguments. One is that the exchange rate varies automatically according to the changes in the macroeconomic variables. As a result, there is no gap between the real exchange rate and the nominal exchange rate. The country does not need any adjustment, which is often required in a fixed rate regime and so it does not have to bear the cost of adjustment. The other argument is that this system possesses insulation properties, meaning that the currency remains isolated from the shocks emanating from other counties. It also means that the government can adopt an independent economic policy without impinging upon the external sector performance. 16 CU IDOL SELF LEARNING MATERIAL (SLM)

In case of Managed Floating with no preannounced path for the exchange rate, the monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying, or pre-committing to, a pre-announced path for the exchange rate. In case of Independent Floating, the exchange rate is market-determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it. 2. Pegging of Currency: Normally, a developing country pegs its currency to a strong currency or to a currency with which it conducts a very large part of its trade. Pegging involves fixed exchange rate with the result that trade payments are stable. But in case of trading with other countries, stability cannot be guaranteed. This is why pegging to a single currency is not advised if the country‘s trade is diversified In such cases, pegging to a basket of currencies is advised. But if the basket is very large, multi-currency intervention may prove costly. Pegging to SDR is not different insofar as the value of the SDR itself is pegged to a basket of five currencies. 3. Crawling Peg: Again, a few countries have a system of a crawling peg. Under this system, they allow the peg to change gradually over time to catch up with changes in the market- determined rates. It is a hybrid of fixed-rate and flexible rate systems. So this system avoids too much of instability and too much of rigidity. In some of the countries opting for the crawling peg, crawling bands are maintained within which the value of currency is maintained. The currency is adjusted periodically in small amounts at a fixed, preannounced rate or in response to changes in selective quantitative indicators. 4. Target Zone Arrangement: In a target zone arrangement, the intra-zone exchange rates are fixed. An opposite example of such an arrangement was found in European Monetary Union (EMU) before coming in of Euro. However, there are cases where the member countries of a currency union do not have their own currency, rather they have a common currency. Under this group, come the member countries of the Eastern Caribbean Currency Union, the Western African Economic and Monetary Union, and the Central African Economic and Monetary Community. The member countries of the European Monetary Union too came under this group with the Euro substituting their currency in 2002. 17 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Others: Apart from the models discussed above there do different countries follow some more practices. They are: a) Currency Board Arrangements: A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. b) Dollarization: Several countries that have suffered for many years from currency devaluation, primarily as a result of inflation, have taken steps towards dollarization, the use of the U.S. dollar as the official currency of the country. Fixed versus Flexible Exchange Rates: A nation‘s choice as to which currency regime it follows reflects national priorities about all facets of the macro economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may then change as priorities change. At the risk of overgeneralization, the following observations explain why countries pursue certain exchange rate regimes. They are based on the premise that, other things being equal, countries would prefer fixed exchange rates. 1. Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses. 2. Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth. 3. Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) to be used in the occasional defense of their fixed rate. As the international currency markets have grown rapidly in size and volume, this need has become a significant burden to many nations. 4. Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation‘s economy changes, and as trade relationships and 18 CU IDOL SELF LEARNING MATERIAL (SLM)

balances evolve, the exchange rate itself should change. Flexible exchange rates allow this change to happen gradually and efficiently, but fixed rates must be changed administratively- usually too late, with too much publicity, and at too great a one-time cost to the nation‘s economic health. Global Scenario of Exchange Rate Arrangements: Firms engaged in international business must have an idea about the exchange rate arrangement prevailing in different countries as this will facilitate their financial decisions. In this context, it can be said that over a couple of decades, the choice of the member countries has been found shifting from one form of exchange rate arrangement to the other, but, on the whole, preference for the floating rate regime is quite evident. At present as many as 35 of total of 187 countries have an independent float, while the other 51 countries have managed floating system. The other 7 countries have a crawling peg, while 53 countries have pegs of different kinds. The EMU and other 20 countries of Africa and the Caribbean region come under some kind of economic and monetary integration scheme in which they have a common currency. Lastly, nine countries do not have their own currency as legal tender. The recent developments in the field of international monetary environment are worth mentioning. They are launch of Euro as the single currency for 11 of European countries and the currency crises in emerging markets. They are briefly mentioned below: The Launch of Euro: On January 1, 1999, 11 member states of the EU initiated the European Monetary Union. They established a single currency, the Euro, which replaced the individual currencies of the participating member states. On December 31, 1998, the final fixed rates between the 11 participating currencies and the Euro were put into place. On January 4, 1999, the Euro was officially traded. The 15 members of the European Union are also members of the European Monetary System. According to the EU, EMU is a single currency area, now known informally as the Euro Zone, within the EU single market in which people, goods, services and capital move without restrictions. In December 1991, the members of the European Union met at Maastricht, the Netherlands and concluded a treaty that changed Europe‘s currency future. The Maastricht Treaty specified a timetable and a plan to replace all individual currencies with a single currency, now called the Euro. Other steps were adopted that would lead to a full European Economic and Monetary Union. The growth of global markets and the increasing competitiveness of the Americas and Asia drove the members of the EU in the 1980s and 1990s to take actions that would allow their 19 CU IDOL SELF LEARNING MATERIAL (SLM)

residents and their firms to compete globally. The reduction of barriers across all members countries to allow economies of scale (size and cost per unit) and scope (horizontal and vertical integration) was thought to be Europe‘s only hope of not being left behind in the new millennium. The successful implementation of a single, strong, and dependable currency for the conduct of life could well alter the traditional dominance of the U.S. dollar as the world‘s currency. b) Emerging Market Crises: After a number of years of relative global economic tranquility, the second half of the 1990s was racked by a series of currency crises that shook all emerging markets. The devaluation of the Mexican peso in December 1994 served as a harbinger of crises to come. The Asian crisis of July 1997, the Russian ruble‘s collapse in August 1998, and more recently the fall of the Brazilian real in January 1999 provide a spectrum of emerging market economic failures, each with its own complex causes and unknown outlooks. These crises also illustrate the growing problem of capital flight and short-run international speculation in currency and securities markets.  The Asian crisis of 1997. The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from net exporters to net importers. The most visible roots of the crisis were in the excesses of capital flows into Thailand in 1996 and early 1997. As the investment ―bubble‖ expanded, some participants raised questions about the economy‘s ability to repay the rising debt. The bath came under sudden and severe pressure. The Asian crisis – for it was more than just a currency collapse- had many roots besides the traditional balance-of-payments difficulties. The complex structures combining government, society, and business throughout the Far East provide a backdrop for understanding the tenuous linkage between business, government, and society.  The Russian crisis of 1998. The loss of the relatively stable ruble, once considered the cornerstone and symbol of success of President Boris Yeltsin‘s regime, was a potential death blow to the current Russian government and economic system. If nothing else, Russian borrowers may find themselves persona non grata for years to come in the international capital markets.  The Brazilian crisis of 1999. Potentially the mildest of the three currency collapses, the Brazilian real‘s fall in January 1999 was the result of a long expected correction in an ill-conceived currency policy. Because so many major Brazilian firms are publicly 20 CU IDOL SELF LEARNING MATERIAL (SLM)

traded, this crisis serves as an excellent example of how equity markets revalue firms that are exposed to currency devaluations and vice versa. 1.3 MEANING OF FOREIGN EXCHANGE Section 2 (n) of the Foreign Exchange Management Act, 1999 defines exchange of foreign currency and includes, i. Deposits, credits, and balances payable in any foreign currency, ii. Drafts, travellers’ cheques, letters of credit or bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency, iii. Drafts, travellers’ cheques, letters of credit or bills of exchange, drawn by banks, institutions, or persons outside India, but payable in Indian currency. Foreign exchange management is the process of limiting a company's exposure to foreign currency fluctuations. In most cases, this is done by companies that engage in foreign trade. In simple terms, “Foreign exchange” means, exchange of currency of one country into the currency of another country. 1.4 SCOPE OF FOREIGN EXCHANGE MANAGEMENT Any company operating globally must deal in foreign currencies. It has to pay suppliers in other countries with a currency different from its home country’s currency. The home country is where a company is headquartered. The firm is likely to be paid or have profits in a different currency and will want to exchange it for its home currency. Even if a company expects to be paid in its own currency, it must assess the risk that the buyer may not be able to pay the full amount due to currency fluctuations. The foreign exchange market is the mechanism in which currencies can be bought and sold. A key component of this mechanism is pricing or, more specifically, the rate at which a currency is bought or sold. We’ll cover the determination of exchange rates more closely in this section, but first let’s understand the purpose of the FX market. International businesses have four main uses of the foreign exchange markets. Foreign exchange management covers in its ambit all those transactions which involve use of foreign exchange. Consider the following cases: 1. A citizen of India travels abroad on a business visit and purchases foreign currency from an authorized dealer. 21 CU IDOL SELF LEARNING MATERIAL (SLM)

2. An Indian citizen goes to USA for a period of three years under an employment contract. He periodically remits US Dollars to his bank account in India. 3. A sports goods manufacturer of India exports his consignment to Europe and gets paid for it in foreign currency received through banking channels. In all the above cases, foreign currency is involved. When goods or services are imported into a country, these are paid for in the currency of the country exporting these goods or services. When an Indian traveller goes to a foreign country on a short visit, he needs foreign currency of that country for meeting his expenses. When he stays in that country for a longer duration for employment purpose, he earns foreign currency of that country. When an Indian firm exports goods to Europe, it is earning foreign exchange. It is essential to have a broad idea of international banking and trading practices. 1.5 SIGNIFICANCE OF FOREIGN EXCHANGE MANAGEMENT Foreign exchange is the trading of different national currencies or units of account. It is important because the exchange rate, the price of one currency in terms of another, helps to determine a nation's economic health and hence the well-being of all the people residing in it, Most of the countries are economically related to each other through cross border trade, foreign investment and international loans. So, there are foreign exchange inflows and outflows. The tremendous growth in international trade has put up both benefits and challenges. Significance of Foreign Exchange Management 1. For better Planning of Forex Whether you are doing the business or Forex or not, with Forex management, you can make better plan for Forex. For example, if you see that supply of goods is from a country whose exchange rate will appreciate, you can make strategy to invest your money in that currency. You can take this decision on the basis of better understanding of Forex management. 2. For Creating Forex Reserve Forex management is significant for us because it teaches us to create Forex reserve at optimum amount instead of creating reserve in own currency. You just go to your own bank and deposit money is reserve in your own currency. But if you make FD in the foreign bank, it is your Forex reserve. As MNC, you should create multiple currency Forex reserve. 3. For Controlling the Risk of Forex When currency rate will change in Forex market, it may bring loss for you. Forex management can help for you to reduce this loss by providing your advance tool to control 22 CU IDOL SELF LEARNING MATERIAL (SLM)

the risk of Forex. These tools are : a) Forex future Forex future is also called currency future. It means to contract of exchange of one currency to other currency. In this contract, we fix the future date. We just pay the purchase date price and buy it in the future date. In the future date if rate will increase, we will just pay past purchase date price. So, this will be helpful to reduce the risk of Forex because with this, buyer can lock current Forex rate for future date. b) Forex Hedging Forex hedging means to do two opposite future contracts. One contract is of buy the Forex and second contract is of selling Forex. c) Forex Swap Forex Swap is to buy and sell same amount of one currency for any other currency. It is also called currency swap. Currency Swap is an agreement between two parties of two countries for exchanging of principal and interest of loan at its present value. This swap is very useful for controlling foreign exchange risk. 4. For Maximizing the Consolidated Earning of International Business there are lots of big MNCs who does the business in more than 100 countries. All these countries, foreign exchange rate changes day by day. So, with Forex Management, Forex manager make a solid Forex policy in which he does best for maximizing the consolidated earning of international business. For example, A company sells the goods to any country. If this currency will be depreciated, company gets more money from that country. But same time the salary cost will increase when it must pay the salary to the employees who are working in that country. So, company's aim always should be to maximize the consolidated earning not earning from one country due to Forex change. 1.6 SUMMARY  Due to globalisation and liberalisation, there is tremendous growth in foreign trade, foreign investment and international loans.  Hence, there are both inflows and outflows of foreign exchange.  Foreign exchange management covers all transactions which involves foreign currency.  Apart from foreign currency transactions, forex opened opportunities for investors to make profit from its value fluctuations.  However, globalisation of investment has introduced new risks from exchange rates etc. 23 CU IDOL SELF LEARNING MATERIAL (SLM)

 Hence, there is need for better understanding of the mechanism of foreign exchange flows in order to capitalise on the opportunities and to manage the risk associated with it. 1.7 KEYWORDS  Forex – Foreign Exchange  Free Float - An exchange rate system characterized by the absence of government intervention. Also known as a clean float.  Forex Reserve - foreign-currency deposits held by national central banks and monetary authorities  Hot Money: Money which moves internationally from one currency and / or country to another in response to interest rate differences, and moves away immediately when the interest advantage disappears.  Hedging - Risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.  Swap - swaps are a hedging tool that involves two parties exchanging an initial amount of currency, then sending back small amounts as interest and, finally, swapping back the initial amount. 1.8 LEARNING ACTIVITY Many international exchanges of goods and services are facilitated by the exchange of the currencies of the trading countries. Importers often must obtain the currency of the exporter’s country to purchase the goods to be imported. Even when they don’t need the actual currency, they must establish a relative value between currencies. 1. Students are asked to create a chart with the name of countries, currencies, and trading relationships in the world. ___________________________________________________________________________ ___________________________________________________________________________ 1.9 UNIT END QUESTIONS A. Descriptive Questions 24 Short Questions 1. Define International Monetary System. 2. What is Forex Management 3. What is gold standard? 4. List out the causes of breakout of Gold standard. CU IDOL SELF LEARNING MATERIAL (SLM)

5. What is meant by SDR? Long Questions 1. Briefly explain the origin and growth of Forex 2. Describe the scope of Forex Management. 3. Explain the various areas where Forex plays its key role 4. Explain the significance of SDR in international monetary systems 5. Explain the advantages and disadvantages of Gold standard. B. Multiple Choice Questions 1. Maintaining a foreign currency account is helpful to a. Avoid transaction cost. b. Avoid exchange risk. c. Avoid both transaction cost and exchange risk. d. Avoid exchange risk and domestic currency depreciation. 2. Foreign Exchange Management Act Passed int he year a. 1995 b. 1997 c. 1999 d. 2001 3. Euro was launched on a. 1999 b. 2000 c. 2002 d. 2004 4. Paper currency was used for internal use and gold was used for international settlement under _________ standard. a. IMF b. gold bullion c. fixed d. floating 25 CU IDOL SELF LEARNING MATERIAL (SLM)

5. SDR full form is _______ a. Special Drawing Rights b. Special depository Receipts c. Standard Data Rights d. Special Depository Rights Answers 1-c 2-c 3-a 4-b 5 -a 1.10 REFERENCES  OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition  Ranjit Singh, Forex Trading: RT Publications  Shah Paresh, Forex Management, Wiley  Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House  Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing  Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 26 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 2: FOREX MANAGEMENT Structure 2.0 Learning Objectives 2.1 Introduction 2.2 Meaning of Forex Management 2.2.1 Essential Elements of Forex Management. 2.3 Functions of Forex Management 2.4 Forex Manager – Meaning & Role 2.4.1 Skills Required 2.5 Summary 2.6 Keywords 2.7 Learning activity 2.8 Practical Applications 2.9 Unit End Questions 2.10 References 2.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain the meaning of Forex Management.  Significance and importance of Forex management  Various Functions Forex Management  The role & Functions of Forex Manager 2.1 INTRODUCTION Forex, and contraction for Foreign Exchange, is the largest financial market in the world. Every firm and individual operating in international environment is concerned with foreign exchange i.e. the exchange of foreign currency into domestic currency and vice-a-versa. Generally, the firm’s foreign operations earn income denominated in some foreign currency; however, the shareholders expect payment in domestic currency and therefore, the firm must convert the foreign currency into domestic currency. 27 CU IDOL SELF LEARNING MATERIAL (SLM)

Exchange rate is the price of one country’s money in terms of other country’s money. When we say that exchange rate of Indian rupee is 52.40 per US Dollar, we mean than 52.40 Indian Rupees are required to purchase one US Dollar. When this exchange rate becomes 52.90 we say that the value of Indian Rupee has depreciated against the US Dollar. On the other hand when the exchange rate becomes 52.10 we say that Indian Rupee has appreciated against the US dollar. Assuming that there are no exogenous factors restricting the changes in exchange rates, their movement can be traced to pure demand and supply. When Indian rupee depreciates against the US Dollar, it indicates that demand for latter is more than its supply. Similarly when the supply of US dollar is more than its demand, it declines in value against the Indian Rupee. Currency of a country is used for transactions with foreigners. Each country in the world has its own currency. Theoretically, a country should transact with all foreign entities on a one- to-one basis, i.e., for all imports from a foreign country, a host country should pay in the currency of the former and for all exports, the host country should be paid in its currency. But practically this is not possible because it involves keeping record of a multitude of exchange rates and associated payment problems. Therefore, most of the countries choose a common currency for trade amongst themselves. The U.S. dollar has emerged as the strongest international currency for the past sixty years and as such is used as the payment medium for most of the world trade. In the European Union the Euro has established itself as the common currency of about 25 countries. It is clear that the currency of a country is evaluated against a common currency for external transactions. In case of countries having dominant economic power, trade would be held in their currency. Hence a country is required to trade in U.S. dollar or in other dominant currencies like Euro, Pound or the Japanese Yen. Account of a country’s external trade is kept in the form of a Balance of payment account which is a double book entry system. Receipts of foreign currencies are credited to this account while payments in foreign currency are debited to this account. The balance in this account shows a positive or a negative figure depending upon whether the receipts of foreign currency are more or less than the payments. Other things being equal, the presumption is that a country having a deficit balance of payments position would have a weakening national currency and vice versa. A deficit in the balance of payment account results in more demand for foreign currencies. Hence their value vis-à-vis the domestic currency increases. 28 CU IDOL SELF LEARNING MATERIAL (SLM)

2.2 MEANING OF FOREX MANAGEMENT Foreign exchange occurs at rates that are associated with currency valuations. Foreign exchange rates describe the amount of one currency that must be given up to receive one unit of another currency, and they tend to parallel the political and economic environment of a particular country. Forex management may be defined as the science of management of generation, use and storage of foreign currencies in the process of exchange of one currency into other called foreign exchange. Forex Management Forex management is the management of forex rate and makes big business decisions based on foreign currency rates. It is the owner of any company must manage your business by close eye on forex as it is not easy to control on other country's currency value is not possible because there are lots of factors which affects it. Fig 2.1 Forex Management 2.2.1 Essential Elements of Forex Management. 1. It is part of management Science. Forex management is a part of broader management science. Here in forex management, the techniques of management are applied to the broad spectrum of foreign currencies. These techniques include: 29 CU IDOL SELF LEARNING MATERIAL (SLM)

i. Planning for forex (budgeting for forex) ii. Organization of forex (utilization of forex) and iii. Control of forex (creation of forex reserves). The tools of forex management are like domestic currency management except it requires high analytical skills and quicker response due to greater volatility in exchange rates. 2. It refers to generation of forex Forex is generated from international trade transactions. When a country exports goods or services, it earns forex. When goods or services are imported by a country, forex is consumed. If the exports of a country are more than the imports, the forex would be accumulated in reserves of the country. If the imports are more than the exports, the result would be a forex deficit which has to be met by international borrowings. Either way, the forex needs to be generated. 3. It pertains to use of forex The generated forex is to be used in a way that caters the needs of the various user groups. It involves identification of suppliers of goods and services, negotiation of terms and conditions of the transaction and culmination of transaction with the exchange of goods and services with forex. In this entire process, close track of exchange rates needs to be maintained. 4. It covers storage of forex At the firm level, forex storage could be done through forward purchase contracts or through deposits in foreign currency bank accounts. At the national level, forex storage is done through forex reserves which are held in the form of Gold, Special Drawing Right (SDRs) of IMF and foreign currencies. 2.3 FUNCTIONS OF FOREX MANAGEMENT An acceptance house helps effect foreign remittances by accepting bills on behalf of customers. The central bank and treasury of a country are also dealers in foreign exchange. Both may intervene in the market occasionally. However, these authorities manage exchange rates and implement exchange controls in various ways. In India, however, where there is a strict exchange control system, there is no foreign exchange market as such. The following are the important functions of a foreign Exchange market: 30 CU IDOL SELF LEARNING MATERIAL (SLM)

1. To transfer finance, purchasing power from one nation to another. Such transfer is affected through foreign bills or remittances made through telegraphic transfer. (Transfer Function). 2. To provide credit for international trade. (Credit Function). 3. To make provision for hedging facilities, i.e., to facilitate buying and selling spot or forward foreign exchange. (Hedging Function). Fig 2.2 Functions 1. Transfer Function: The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is affected through a variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills. In performing the transfer function, the foreign exchange market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings. 2. Credit Function: 31 CU IDOL SELF LEARNING MATERIAL (SLM)

Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required. 3. Hedging Function: A third function of the foreign exchange market is to hedge foreign exchange risks. Hedging means the avoidance of a foreign exchange risk. In a free exchange market when exchange rate, i. e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money. Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate. The existence of a forward market thus makes it possible to hedge an exchange position. 2.4 FOREX MANAGER Foreign Exchange Manager manages trading functions to meet corporate financial goals. Services clients on international business issues by developing forecasts of hedging exposures. The Foreign Exchange Manager manages subordinate staff in the day-to-day performance of their jobs. The growth in cross border trade has resulted in emergence of new brand of manager called the forex manager. It is a separate category apart from the finance manager or the treasury manager. He deals in currencies of more countries. His vocation is full of opportunities and challenges. 2.4.1 Skills Required The forex manager is expected to have the following skills: 1. Awareness of historical development of world trade 32 CU IDOL SELF LEARNING MATERIAL (SLM)

The forex manager must have the understanding about the historical developments in world trade before it reached the current status. He must have knowledge about the past trade patterns, rise and decline of economic superpowers etc. to better analyses the current situation. 2. Ability to forecast future trends Ability to forecast future trends in international trade flows and exchange rate patterns is a very important skill which enables forex manager to prepare forex budget. 3. Comparative analysis skills The forex manager must be able to carry out a comparative analysis of cost of goods and services when procured locally with the cost of import and make suitable decisions accordingly. 4. In-depth knowledge of stock market The forex manager is expected to have in-depth knowledge about the foreign exchange market, its operations, rules and regulations governing the market, strength and weaknesses of domestic currency etc. to achieve better pricing deals. 5. Knowledge of interest rates Since interest rates have a direct bearing upon exchange values, the forex manager is expected to have knowledge about the domestic as well as the international interest rates. 6. Willingness to undertake risk Foreign exchange market poses various kinds of risks like exchange rate fluctuations etc. The forex manager should have the ability to undertake reasonable level of risks with a view to profit from forex exposures. 33 CU IDOL SELF LEARNING MATERIAL (SLM)

7. Hedging strategies Hedging is a strategy used to protect us from expected losses. For e.g., Forward contracts are entered into by the dealers to protect themselves from future hike in exchange rate. We will discuss this strategy in coming lessons. 2.5 SUMMARY  Forex helps in storage of foreign currencies in the process of exchange of one currency into other.  Foreign exchange management covers all transactions which involves foreign currency.  Foreign Exchange Manager manages trading functions to meet corporate financial goals.  Hedging is a strategy used to protect us from expected losses  Foreign exchange market poses various kinds of risks like exchange rate fluctuations.  The forex manager must have knowledge about the past trade patterns, rise and decline to better analyse the current situation. 2.6 KEYWORDS  Forex management - is the management of forex rate and make big business decisions based on foreign currency rates.  Hedging - means the avoidance of a foreign exchange risk 2.7 LEARNING ACTIVITY 1. A currency depreciates if less of that currency is required to buy one unit of another currency. Comment ___________________________________________________________________________ __________________________________________________________________________ 2.8 PRATICAL APPLICATIONS On 31st December, an exporter had a forward contract of USD 68,500 booked at INR 74.1825 that was expiring on the same day. He was unsure if he should cancel or rollover the contract because inwards were received in a different bank. Apart from this, the exporter had an inward in a different bank of the USD 130,000 on the same day and was considering converting the amount at cash rate 34 CU IDOL SELF LEARNING MATERIAL (SLM)

Solution: Advised the client to cancel the forward contract booked for 31st December and convert the inward at spot rate instead of converting the amount at cash rate because 31st December is the financial year end for U.S. companies and cash spot is usually high during this time period because of lack of liquidity. The cash spot for that day was 0.10-0.15. In order to cancel the export forward contract booked for 31st December, we had to buy USD 68,500.The prevailing cash spot for the day was 10 paisa, however, banks were reluctant to give anything more than 4 paisa. After negotiating the bank, finally agreed to give the 10 paisa cash spot. This helped the client save INR. 4,110. Furthermore, we advised the client to cover the USD 130,000 of inward payment value spot instead of converting the amount at value cash because he would be receiving a high cash spot (15 paisa). However, the client would receive the funds after 4 days (weekend plus two working days) and could have earned an interest of INR 6,240 in a liquid fund yielding 6% p.a. This helped the client save INR 13,260 which he would have to pay if he had covered the amount at cash rate. 2.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain the term Forex Management. 2. Define Forex Management 3. List out the various functions of Forex Management. 4. Who is Forex Manager? 5. Define the role of Forex Manager. Long Questions 1. Explain the various functions of Forex Management. 2. State and explain the functions of a Forex Manager 3. Discuss the term Forex management and its importance in today’s industry. 4. Discuss the roles and responsibilities of a FOREX manager 5. How has the forex manager role evolved over time? Discuss B. Multiple Choice Questions 35 1. The market forces influencing the exchange rate are not fully operational under a. floating exchange rate system b. speculative attack on the market CU IDOL SELF LEARNING MATERIAL (SLM)

c. fixed exchange rate system d. current regulations of IMF 2. Indirect rate in foreign exchange means - a. the rate quoted with the units of home currency kept fixed b. the rate quoted with units of foreign currency kept fixed c. the rate quoted in terms of a third currency d. None of these 3. The transaction in which the exchange of currencies takes place at a specified future date, subsequent to the spot date is known as a a. swap transaction b. forward transaction c. future transaction d. non-deliverable forwards 4. Maintaining a foreign currency account is helpful to a. Avoid transaction cost. b. Avoid exchange risk. c. Avoid both transaction cost and exchange risk. d. Avoid exchange risk and domestic currency depreciation 5. Suppose a trader has a grievance against a trading member and he uses the mechanism of Arbitration to settle the dispute. The arbitrator conducts the arbitration proceeding and passes the award normally within a period of from the date of initial hearing. a. 25 days b. 2 months c. 4 months d. 6 months Answers 1-c 2-a 3-b 4-c 5-c 2.10 REFERENCES 36  OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition  Ranjit Singh, Forex Trading: RT Publications  Shah Paresh, Forex Management, Wiley CU IDOL SELF LEARNING MATERIAL (SLM)

 Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House  Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing  Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 37 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 3: FOREIGN EXCHANGE Structure 3.0 Learning Objectives 3.1 Introduction 3.2 Meaning of Foreign Exchange Rate 3.3 Features of the Current Exchange Rate Regime in India 3.4 Determinants of Foreign Exchange Rates 3.5 Exchange Rates Impacts 3.6 Stabilization Measures by Indian Government 3.7 Methods of Quoting Exchange rates 3.8 Types of Exchange rates 3.9 Summary 3.10 Keywords 3.11 Learning Activity 3.12 Practical Applications 3.13 Unit End Questions 3.14 References 3.0 LEARNING OBJECTIVES After studying this unit, students will be able to:  State the meaning of Forex Exchange rate.  Significance and importance of Determinants of Foreign exchange rate  Explain types of exchange rates  Learn about balance of Trade 3.1 INTRODUCTION We know that the rate of a particular commodity is determined by the demand and supply for that commodity. Like any other commodity, foreign exchange rate is also influenced by the demand and supply of the particular currency. But still there was a need for exchange rate policy in order to reduce excess volatility in rates, prevent the emergence of destabilizing speculative activities, help maintain adequate level of reserves and develop an orderly foreign exchange market. 38 CU IDOL SELF LEARNING MATERIAL (SLM)

Liberalized Exchange Rate Management System (“LERMS”) was introduced from March 1992 which is a dual exchange rate system in the place of a single official rate. It consists of one official rate for select government and private transactions and the market determined rate for the others. General Features Foreign exchange market is described as an OTC (Over the counter) market as there is no physical place where the participants meet to execute their deals. It is more an informal arrangement among the banks and brokers operating in a financing center purchasing and selling currencies, connected to each other by tele communications like telex, telephone and a satellite communication network, SWIFT. The term foreign exchange market is used to refer to the wholesale a segment of the market, where the dealings take place among the banks. The retail segment refers to the dealings take place between banks and their customers. The retail segment refers to the dealings take place between banks and their customers. The retail segment is situated at many places. They can be considered not as foreign exchange markets, but as the counters of such markets. The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi is other centers accounting for bulk of the exchange dealings in India. The policy of Reserve Bank has been to decentralize exchanges operations and develop broader based exchange markets. As a result of the efforts of Reserve Bank Cochin, Bangalore, Ahmadabad, and Goa have emerged as new center of foreign exchange market. 3.2 MEANING OF FOREIGN EXCHANGE RATE A foreign exchange rate is the price of the domestic currency stated in terms of another currency. In other words, a foreign exchange rate compares one currency with another to show their relative values. Since companies are developing increasingly larger international ties and investors, currency rate changes can affect different markets investing power drastically. Investors need to know how their investment will change with changes in their currency. Multi-national companies typically have one reporting currency that they prepare all of their financial statements 3.3 FEATURES OF THE CURRENT EXCHANGE RATE REGIME IN INDIA The features of the current exchange rate mechanism can be briefly stated as follows: 1. The rates of exchange are determined in the market. 2. The freely floating exchange rate regime continues to operate within the framework of exchange control. 39 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Current receipts are deposited to the banking system, which in turn meets the demand for foreign exchange. 4. The US$ is the principal currency for the RBI transactions. 5. RBI can intervene in the market to modulate the volatility and sharp depreciation of the rupee. 6. The RBI also announces a reference rate based on the quotations of select banks on Bombay at 12 noon every day. The Reference Rate is applicable to SDR transactions and transactions routed through the Asia Clearing Union. 7. In short, the Indian Rupee has matured to a regime of the floating exchange rate from the earlier versions of a ‘managed float’. 3.4 DETERMINANTS OF FOREIGN EXCHANGE RATES On the most fundamental level, exchange rates are market-clearing prices that equilibrate supplies and demands in foreign exchange markets. Obviously, it is the supply of, and the demand for, foreign currency that would determine at any time the determinants of foreign exchange rates are: the rate of exchange of a country‘s currency just as the market price of commodities is determined by the forces of demand and supply. Managers of multinational enterprises, international portfolio investors, importers and exporters, and government officials are very much interested in knowing the determinants of exchange rates. An important question to be answered is whether change in exchange rates predictable? Unfortunately, there is no general theory of exchange rate determination. Instead, there are economic theories called parity conditions that attempt to explain long-run exchange rate determinants. Numerous other variables appear to explain short and medium-run exchange rate determinants. A major problem is that the same set of determinants does not explain rates for all countries at all times, or even for the same country at all times. Potential Exchange Rate Determinants Potential foreign exchange rate determinants can be categorized into clusters that are also influenced by exchange rates. They are: 1) parity conditions; 2) infrastructure; 3) speculation; 4) cross-border investment; and 5) political risk. Exhibit 1 provides a road map to identify the potentially most important determinants that have surfaced in recent years. It is observed that most determinants of the spot exchange rate are also in turn affected by changes in the spot rate. In other words, they are not only linked but also mutually determined. Parity conditions are an explanation in classical economics for the long-rung value of exchange rates. These conditions will be described in detail in next sections. Infrastructure 40 CU IDOL SELF LEARNING MATERIAL (SLM)

weaknesses were among the big cause for the recent collapse of exchange rates in the emerging markets. On the other hand, infrastructure strengths helped explain why the US dollar continues to be strong despite record balance-of-payments deficit on current account. Fig 3.1 Potential Exchange Rate Determinants Speculation contributed greatly to the emerging market crises. Some characteristics of speculation were hot money flows into and out of currencies, securities, real estate, and commodities. Cross border foreign direct investment and international portfolio investment into the emerging markets are on the rise in recent times. Political risks have been much reduced in recent years, as capital markets became less segmented from each other and more liquid. Cash flows motivated by any and all of the potential exchange rate determinants eventually show up in the balance of payments (BOP). The BOP provides a means to account for these cash flows in a standardized and systematic manner. The BOP increases the transparency of the whole international monetary environment and enables decision-makers to make more rational policy choices. 41 CU IDOL SELF LEARNING MATERIAL (SLM)

Balance of Payments Approach The International Monetary Fund defines the BOP as a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. BOP data measures economic transactions include exports and imports of goods and services, income flows, capital flows, and gifts and similar ―one-sided‖ transfer payments. The net of all these transactions is matched by a change in the country‘s international monetary reserves. The significance of a deficit or surplus in the BOP has changed since the advent of floating exchange rates. Traditionally, BOP measures were used as evidence of pressure on a country‘s foreign exchange rate. This pressure led to governmental transactions that were compensatory in nature, forced on the government by its need to settle the deficit or face devaluation. Exchange Rate Impacts: The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP data: BOP = (X-M) + (CI-CO) + (FI-FO) +FXB Where: X is exports of goods and services, M is imports of goods and services, (X-M) is known as Current Account Balance CI is capital outflows, CO is capital outflows, (CI-CO) is known as Capital Account Balance FI is financial inflows, FO is financial outflows, (FI-FO) is known as Financial Account Balance FXB is official monetary reserves such as foreign exchange and gold The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system. a) Fixed Exchange Rate Countries. Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. If the sum of the current and capital 42 CU IDOL SELF LEARNING MATERIAL (SLM)

accounts does not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero. It the sum of the current and capital accounts is negative, an exchange supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances to allow it to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue. For fixed exchange rate countries, then, business managers use balance-of-payments statistics to help forecast devaluation or revaluation of the official exchange rate. Normally a change in fixed exchange rates is technically called ―devaluation‖ or ―revaluation, ‖ while a change in floating exchange rates is called either ―depreciation‖ or ―appreciation‖. b) Floating Exchange Rate Countries. Under a floating exchange rate system, the government of a county has no responsibility to peg the foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. As is the case with all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short-to-intermediate term. c) Managed Floats. Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take actions to maintain their desired exchange rate values. They therefore seek to alter the market‘s valuation of a specific exchange rate by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination. A change in domestic interest rates is an attempt to alter capital account balance, especially the short-term 43 CU IDOL SELF LEARNING MATERIAL (SLM)

portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This will alter market forces and create additional market demand for domestic currency. In this process, the government signals exchange market participants that it intends to take measures to preserve the currency‘s value within certain ranges. The process also raises the cost of local borrowing for businesses, however, and so the policy is seldom without domestic critics. For managed-float countries, business managers use BOP trends to help forecast changes in the government policies on domestic interest rates. Parity Conditions There are many potential exchange rate determinants. Economists have traditionally isolated several of these determinants and theorized how they are linked with one another and with spot and forward exchange rates. These linkages are called parity conditions. They are useful in explaining and forecasting the long-run trend in an exchange rate. Prices and Exchange Rates: If the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the product‘s price should be the same in both markets. This is called the law of one price. A primary principle of competitive markets is that prices will equalize across markets if frictions or costs of moving the products or services between markets do not exist. If the two markets are in two different countries, the product‘s price may be stated in different currency terms, but the price of the product should still be the same. Comparison of prices would only require a conversion from one currency to the other. Purchasing Power Parity and the Law of One Price: If the law of one price were true for all goods and services, the purchasing power parity exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, we could determine the ―real‖ or PPP exchange rate which should exist if markets were efficient. The hamburger standard, as it has been christened by The Economist, is a prime example of this law of one price. Assuming that the Big Mac, food item sold by McDonalds is indeed identical in all countries, it serves as one means of identifying whether currencies are currently 44 CU IDOL SELF LEARNING MATERIAL (SLM)

trading at market rates that are close to the exchange rate implied by Big Macs in local currencies. A less extreme form of this principle would say that, in relatively efficient markets, the price of a basket of goods would be the same in each market. This is the absolute version of the theory of purchasing power parity. Absolute PPP state that the spot exchange rate is determined by the relative prices of similar baskets of goods. Relative Purchasing Power Parity: If the assumptions of the absolute version of PPP theory are relaxed a bit more, we observe what is termed relative purchasing power parity. This more general idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. More specifically, if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. Exchange Rate Indices: Real and Nominal: Any single country in the current global market trades with numerous partners. This requires tracking and evaluating its individual currency value against all other currency values in order to determine relative purchasing power, that is, whether it is ―overvalued‖ or ―undervalued‖ in terms of PPP. One of the primary methods of dealing with this problem is the calculation of exchange rate indices. These indices are formed by trade-weighting the bilateral exchange rates between the home country and its trading partners. The nominal effective exchange rate index calculates, on a weighted average basis, the value of the subject currency at different points in time. It does not really indicate anything about the ―true value‖ of the currency, or anything related to PPP. The nominal index simply calculates how the currency value relates to some arbitrarily chosen base period. The real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period. Interest Rates and Exchange Rates In this section we see how interest rates are linked to exchange rates. The Fisher Effect: The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. The International Fisher Effect: 45 CU IDOL SELF LEARNING MATERIAL (SLM)

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect. Fisher-open as it is often termed, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between two countries. Empirical tests lend some support to the relationship postulated by the international Fisher effect, although considerable sort-run deviations occur. However, a more serious criticism has been posed by recent studies that suggest the existence of a foreign exchange risk premium for major currencies. Also, speculation in uncovered interest arbitrage, such as ―carry trade‖, creates distortions in currency markets. Thus the expected change in exchange rates might be consistently more than the difference in interest rates. Interest Rate Parity: The theory of interest rate parity (IRP) provides the linkages between the foreign exchange markets and the international money markets. The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. Covered Interest Arbitrage: The spot and forward exchange markets are not, however, constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for ―riskless‖ or arbitrage profit exists. The arbitrager who recognizes such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return on a covered basis. This is called covered interest arbitrage (CIA). Forward Rate as an Unbiased Predictor of the Future Spot Rate: Some forecasters believe that for the major floating currencies, foreign exchange markets are ―efficient‖ and forward exchange rates are unbiased predictors of future spot exchange rates. Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward rate. The forward exchange rate‘s being an unbiased predictor does not, however, mean that the future spot rate will actually be equal to what the forward rate predicts. Unbiased prediction simply means that the forward rate will, on average, 46 CU IDOL SELF LEARNING MATERIAL (SLM)

overestimate and underestimate the actual future spot rate in equal frequency and degree. The forward rate may, in fact, never actually equal the future spot rate. The Asset Market Approach Along with the BOP approach to long-term foreign exchange rate determination, there is an alternative approach to exchange rate forecasting called the asset market approach. The asset approach to forecasting suggests that whether foreigners are willing to hold claims in monetary form depends partly on relative real interest rates and partly on a country‘s outlook for economic growth and profitability. For example, during the period 1981-1985 the US dollar strengthened despite growing current account deficits. This strength was due partly to relatively high real interest rates in the US. Another factor, however, was the heavy inflow of foreign capital into the US stock market and real estate, motivated by good long-run prospects for growth and profitability in the US. Technical Analysis Technical analysts traditionally referred to as chartists focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of time series analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements, like equity price movements, can be subdivided into periods: (I) day-to-day movement that is seemingly random; (2) short-term movements extending from several days to trends lasting several months; (3) long-term movements, which are characterized by up and down long-term trends. The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long-run must depend on economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short-to medium-term in their time horizon and can be addressed with less theoretical approaches. Time series techniques infer no theory or causality but simply predict future values from the recent past. Forecasters freely mix fundamental and technical analysis, presumably because in forecasting, getting close is all that counts. Exhibit 2 summarizes the various forecasting periods, regimes, and the preferred methodologies. 47 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Inflation rates A change in inflation causes changes in currency exchange rates. There is an inverse relationship between the inflation rate and the value of currency. A country with a lower inflation rate will see an appreciation in the value of its currency while a country with higher inflation sees depreciation in its currency value. Purchasing Power Parity (Inflation) Theorem • Difference in inflation rates between two countries is considered as the most important factor for variations in exchange rates. 48 CU IDOL SELF LEARNING MATERIAL (SLM)

• If domestic inflation is high, it means domestic goods are costlier than foreign goods. This results in higher imports creating more demand for foreign currency, making it costlier. (In other words the value of domestic currency will decline). • If a basket of goods cost Rs470 in India and $10 in US then it is quite natural that the exchange rate should be Rs47/$1 • PPP theory can be expressed by the formula: PPPr = Spot rate (1+rh) (1+rf) where rh is inflation rate at home; rf is the inflation rate of foreign country Weakness of PPP theory: It is not only inflation, which affects foreign currency movements PPP ignores substitution effects – i.e. instead of importing goods might be substituted. Interest rate parity theorem: • The second most important factor in determining exchange rates after PPP theory • Money tends to move towards country offering a higher interest rate thereby resulting in more demand for the foreign country’s currency. • If interest rates in Japan are lower than interest rates in US then Japanese investors would prefer to invest in US which would result in more demand for US $ in Japan (this will cause US$ to appreciate in Japan). • Interest rates provide the basis for computing forward rates as under: Forward rate = Spot rate x (1+If) (1+Ih) 2. Interest rates Forex rates, interest rates and inflation are all correlated. Increase in interest rates cause a country’s currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates. 3. Country’s current account/ balance of payments A deficit in current account due to spending more of its currency on importing products than it is earning through exports causes depreciation in value of its currency. The BOP position has a big impact on the value of a nation’s currency. • A big or consistent deficit would mount a pressure on the currency of a nation as deficits require payments in foreign currency. • In the case of a fixed currency rate scenario – the local currency would be devalued thereby making imports costlier and exports cheaper. • However, in the free rate scenario a big or consistent deficit would be a forewarning for depreciation of a nation’s currency 4. Government debt 49 CU IDOL SELF LEARNING MATERIAL (SLM)

At times the government would intervene by purchasing or selling foreign exchange to control pressures on the nation’s currency. A country with government debt is less likely to acquire foreign capital, leading to inflation. As a result, a decrease in the value of its exchange rate will follow. 5. Terms of trade A country’s terms of trade improves if its exports prices rise at a greater rate than its import prices. This results in higher revenue, which causes a higher demand for the country’s currency and an increase in its currency value. This results in appreciation in exchange rate. 6. Political stability and performance A country’s political stability and economic performance can affect its currency strength. A country with less risk of political confusions is more attractive to foreign investors. Increase in foreign capital leads to an appreciation in the value of its domestic currency. But a country prone to political confusions may see a depreciation in exchange rates. 7. Recession When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate. 8. Speculation Investors who want to make speculative income will invest in currency whose value is expected to rise in the near future. This increase in demand increases the value of the currency and leads to a rise in exchange rate as well. 3.5 EXCHANGE RATES IMPACTS Balance Of Payments: The balance of payments (BoP) is the international balance sheet of a nation that records all international transactions in goods, services and assets over a year. It serves as the most important statistics in the open economy since it summarizes exactly how the domestic economy interacts with the rest of world. The Reserve Bank of India (RBI) is responsible for compilation and dissemination of BoP data. The Balance of payment consists of two accounts: Current account and capital account. The BOP position has a big impact on the value of a nation’s currency. • A big or consistent deficit would mount a pressure on the currency of a nation as deficits require payments in foreign currency. • In the case of a fixed currency rate scenario – the local currency would be devalued thereby making imports costlier and exports cheaper. 50 CU IDOL SELF LEARNING MATERIAL (SLM)