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

• However in the free rate scenario a big or consistent deficit would be a forewarning for depreciation of a nation’s currency a) Current Account The current account records imports and exports of goods, services and unilateral transfers during a year. It relates to all activities which do not alter the values of assets and liabilities of a country. Current account deals with real and short-term transactions. This transaction includes income, output and employment of a country through transfer of goods and services. Thus, balance of current account can be estimated as the sum total of balance of trade. The main components of current account of BOP are: Components of current account: i) Export and import of goods ii) Export and import of services iii) Unilateral transfers (Transfer receipts/ payments) iv) Investment income (Factor income from land, bonds, shares abroad) b) Capital account The capital account records all such transactions between residents of a country and the rest of the world which relate to purchase and sale of foreign assets and liabilities during a year. In simple words, it is a record of inflows and outflows of capital which brings a change in country’s foreign assets and liabilities. Components of capital account i) Foreign investment This refers to investment to and from rest of the world. Investment may be direct or portfolio. Direct investment means purchasing an asset and acquiring control of the same, e.g., purchase of a house abroad. Portfolio investment means acquisition of an asset that does not give control over asset. E.g., purchase of a bond issued by foreign government. ii) Foreign loans These refer to credit granted by foreign governments and international institutions like IME. External commercial borrowings are also included. iii) Banking capital and other capital Banking capital includes foreign assets and foreign liabilities of banking sector excluding the central bank. Deposits by non-residents are also included. iv) Monetary movements or changes in foreign exchange reserve 51 CU IDOL SELF LEARNING MATERIAL (SLM)

This reserve keeps on changing depending upon the net balance of other private and official transactions. 3.6 STABILIZATION MEASURES BY INDIAN GOVERNMENT To correct the balance of payments disequilibrium and control the hyper-inflation, these measures were undertaken. These measures are: 1. Liberalization 2. Privatization and 3. Globalization 1. Liberalization The aim of liberalization was to put an end to those restrictions which became hindrances in the development and growth of the nation. 2. Privatization It is the increment of the dominating role of private sector companies and the reduced role of public sector companies. In other words, it is the reduction of ownership of the management of a government-owned enterprise. Government companies can be converted into private companies in two ways: a) By disinvestment b) By withdrawal of governmental ownership and management of public sector companies. 3. Globalisation It means to integrate the economy of one country with the global economy. During globalization, the main focus is on foreign trade & private and institutional foreign investment. 3.7 METHODS OF QUOTING EXCHANGE RATES There are two common ways to quote exchange rates: i. Direct method ii. Indirect Method i. Direct method A direct quote indicates the number of units of the domestic currency required to buy one unit of foreign currency. For e.g., 1$ = ₹ 72.59 is direct quote. It means, 72.59 units of Rupees is required to purchase 1 unit of US$. 52 CU IDOL SELF LEARNING MATERIAL (SLM)

The more valuable the domestic currency, the smaller the amount of domestic currency needed to exchange for a foreign currency unit and this gives a lower exchange rate and vice versa. The most common way of quoting the exchange rate is A/B where A is the price currency and B is the price currency. In direct quote, the base currency is foreign currency and price currency is home currency. We can write the above example as ₹/$ - 72.59 which means 1$ is equal to 72.59 INR. ii. Indirect method An indirect quote on the other hand indicates the number of units of foreign currency that can be exchanged for one unit of the domestic currency. So, we can say, Indirect quote = 1/ Direct quote. We will rewrite the above example to make the concept easy to understand. ₹1 = $ 0.01378 which means one rupee can be exchanged for 0.01378 units of US$. 3.8 TYPES OF EXCHANGE RATES Fixed Exchange Rate A fixed exchange rate is linked to another currency or asset (often gold) to derive its value. Such an exchange rate mechanism ensures the stability of the exchange rates by linking it to a stable currency itself. A country with a fixed exchange rate system is attractive to foreign investors who are lured to invest in that country due to the stability it offers. But the disadvantage is that the government has to maintain a huge amount of foreign exchange or gold reserves to maintain its value. Flexible or Floating Exchange Rate Flexible or Floating exchange rate systems are ones whereby the rate of a currency is determined by the market forces of demand and supply. The determination of rate by the market forces of demand and supply promotes efficiency and robustness of operations. Here, the disadvantage is that floating rate systems are prone to greater volatility since they are determined by the market forces. Forward Rate A forward rate is a one that is determined as per the terms of a forward contract. It stipulates the purchase or sale of a foreign currency at a predetermined rate at some date in the future. A forward contract is generally entered into by exporters and importers who are exposed to Forex fluctuations. The forward rate is quoted at a premium or discount to the spot price. This type of forward contract used as a hedging strategy to protect the exporters and importers from losses. The disadvantage is that freezing the rates may prove to be a loss-making decision in some situations. 53 CU IDOL SELF LEARNING MATERIAL (SLM)

Spot Rate The spot rate is the current exchange rate for any currency. They represent the day-to-day exchange rate and vary by a few basis points every day. It is a straightforward rate without any ambiguity. Rate quoted for transactions that will settled two business days from the transaction date (T+2) Dual Exchange Rate In this type of system, the currency rate is maintained separately by two values-one rate applicable for the foreign transactions and another for the domestic transactions. Countries enforcing a dual exchange rate can enforce separate rates for capital and current account transactions. Therefore, a significant amount of control is with the government whereby it can influence revenues from capital or current sources depending upon the need of the hour. It also becomes easier to regulate international trade and at the same time protect the domestic markets. Cash rate Rate quoted for transactions that will settled on the same day (T+0) 4. Tom rate Rate quoted for transactions that will be settled in one business day form the date of transaction (T+1) 3.9 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. 3.10 KEYWORDS  Covering: A transaction in the forward foreign exchange market or money market which protects the value of future cash flows 54 CU IDOL SELF LEARNING MATERIAL (SLM)

 Devaluation: A drop in the spot foreign exchange value of a currency that is pegged to other currencies or to gold.  Flexible exchange rates: The opposite of fixed exchange rate is adjusted periodically by the country‘s monetary authorities in accordance with their judgement and/or an external set of economic indicators.  Floating Exchange rates: Foreign exchange rates determined by demand and supply in an open market that is presumably free of government interference.  Recession - Recession is a slowdown or a massive contraction in economic activities.  Speculation- Transaction with a hope of gain but with a risk of loss 3.11 LEARNING ACTIVITY 1. Suppose your Nostro Account is credited with USD 100000 what rate is used to convert into Rupees? ___________________________________________________________________________ ___________________________________________________________________________ 3.12 PRATICAL APPLICATIONS A garment exporter had hedged his receivables and sold EURINR forward @85.60 for Dec 2020 but part of their order got cancelled. They were able to cancel the balance contract only on maturity @89.90, booking a loss of INR 4.3 per Euro. Solution: The Euro was trading at its multiyear peak, with the view that there would be correction in at least 2 months’ time, the view could’ve been executed by rolling over the forward contract. The contract would’ve been booked as anticipated exposure, but unlike earlier the gains on cancellation would’ve not been credited due to amended RBI regulation. Advised them to short EUR INR futures in the stock exchange for end February 2021 @ 90.1375. At the end of 2 months client exited the position with a gain of INR 2.14 on 150 lots (1 lot = $1,000). 3.13 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain the term foreign exchange rate 2. Define features of the current exchange rate regime in India 3. List out the various determinants of foreign exchange rates 4. Explain balance of payment 55 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Define balance of trade 6. What are the various stabilization measures taken by Indian Government? 7. Define the methods of quoting exchange rates Long Questions 1. Explain the various features of the current exchange rate regime in India 2. State and explain the various determinants of foreign exchange rates 3. Discuss the term balance of payment and Balance of Trade. 4. Explain Balance of payments 5. Explain the term Foreign Exchange Rate. B. Multiple Choice Questions 1. India’s foreign exchange rate system is? a. Free float b. Managed float c. Fixed d. Fixed target of band 2. Hedging transaction is indicated by a. Transactions in odd amounts b. Presentation of documentary support. c. Frequency of such transactions. d. None of these 3. The acronym SWIFT stands for a. Safety Width in Financial Transactions. b. Society for Worldwide International Financial Telecommunication. c. Society for Worldwide Interbank Financial Telecommunication. d. Swift Worldwide Information for Financial Transaction. 4. 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 the above. d. None of these 56 CU IDOL SELF LEARNING MATERIAL (SLM)

5. A paddy farmer buys a weather insurance to protect himself if there is less rainfall in his region. This is like a derivative contract what is the underlying for this weather derivative? a. Temperature recorded b. Actual rainfall c. Storms and hurricanes d. None Answers 1-b 2-c 3-a 4-d 5-b 3.14 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) 57 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 4: FOREIGN EXCHANGE MARKET AND ITS STRUCTURE Structure 4.0 Learning Objectives 4.1 Introduction 4.2 Different kinds of Interbank Forex markets 4.3 Highly traded Markets – Cash/OTC 4.4 Nature of transactions 4.5 Cross Border Currency Flows 4.6 Liberalization of Exchange Control 4.7 Role of Banks in Forex market 4.8 Factors Impacting Forex market 4.9 Derivatives 4.10 Currency Futures and Options 4.10.1 Currency Futures: 4.10.2 Currency Options 4.11 Summary 4.12 key words 4.13 Learning activity 4.14 Practical Applications 4.15 Unit End Questions 4.16 References 4.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Outline the meaning of Forex Trading  Significance and importance of Foreign Exchange Market in India  Various Currency Futures and Options  The role of Forex Exchange Market in India 58 CU IDOL SELF LEARNING MATERIAL (SLM)

4.1 INTRODUCTION The foreign exchange market or forex market is the market where currencies are traded. The forex market is the world’s largest financial market where trillions are traded daily. It is the most liquid among all the markets in the financial world. Moreover, there is no central marketplace for the exchange of currency in the forex market. Trading of currency in the forex market involves the simultaneous purchase and sale of two currencies. In this process the value of one currency (base currency) is determined by its comparison to another currency (counter currency). The price at which one currency can be exchanged for another currency is called the foreign exchange rate. Foreign exchange markets can be considered as a linkage of banks, nonbank dealers, and forex dealers and brokers who all are connected via a network of telephones, computer terminals, and automated dealing systems. Electronic Broking Services and Reuters are the largest vendors of quote screen monitors used in trading currencies. The foreign exchange market in India started in earnest less than four decades ago when in 1978 the government allowed banks to trade in foreign exchange with one another. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self regulatory association of dealers. Since 2001, clearing and settlement functions in the foreign exchange market is largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions. The liberalization process has significantly boosted the foreign exchange market in the country by allowing both banks and corporations greater flexibility in holding and trading foreign currencies. The Sodhani Committee set up in 1994 recommended greater freedom to participating banks, allowing them to fix their own trading limits, interest rates on FCNR deposits and the use of derivative products. The growth of the foreign exchange market in the last few years has been nothing less than phenomenal. Meaning of Foreign Exchange Market In this section, we shall study about meaning of Foreign Exchange Market. The foreign exchange market is not confined to any given country or region. There is no physical place where the participants meet to execute the deals, as we see in the case of commodity markets or stock exchange market. It is more an informal arrangement among the banks an d brokers 59 CU IDOL SELF LEARNING MATERIAL (SLM)

operating in a financial centre, purchasing and selling currencies connected to each other, by telecommunications like telex, telephone and a satellite communication network called SWIFT, which is an abbreviation for Worldwide Interbank Financial Telecommunications. Since it is a cooperative society, it is called Society for Worldwide Interbank Financial Telecommunications (SWIFT). This society is owned by about 250 banks in Europe and North America and registered as a cooperative society in Brussels, Belgium. It has got communication network at the international field, connecting more than 25,000 financial institutions throughout the world. Each Bank is allotted an identifier code. This system enables the member banks to transact among themselves very quickly and make international payments. Actually transmission of message takes only few seconds. In India, the regional processing centre is at Mumbai. With improvements in telecommunication systems, the foreign exchange market in the world has witnessed phenomenal expansion during the last two decades. Transactions between Mumbai, New York, Tokyo, London and Bonn can be carried out in a few seconds. The Foreign Exchange Market is the largest financial market with a daily turnover of around 2 trillion US Dollars. The wholesale segment of the market refers to the dealings taking place among the banks. The retail segment refers to the dealings between the banks and customers. The largest exchange market is London, followed by New York, Tokyo, Zurich and Frankfurt. In India, the leading foreign exchange market is Mumbai and Kolkata, Chennai, Delhi and other centres for foreign exchange dealings. Recently, Bangalore, Cochin, Ahmedabad and Goa have also emerged as new centres of foreign exchange market. 4.2 DIFFERENT KINDS OF INTERBANK FOREX MARKETS The interbank market is the top-level foreign exchange market where banks exchange different currencies. The banks can either deal with one another directly, or through electronic brokering platforms. The Electronic Broking Services (EBS) and Thomson Reuters Dealing are the two competitors in the electronic brokering platform business and together connect over 1000 banks. The currencies of most developed countries have floating exchange rates. These currencies do not have fixed values but, rather, values that fluctuate relative to other currencies. The interbank market is an important segment of the foreign exchange market. It is a wholesale market through which most currency transactions are channeled. It is mainly used for trading among bankers. The three main constituents of the interbank market are: 60 CU IDOL SELF LEARNING MATERIAL (SLM)

the spot markets the forward market The interbank market is unregulated and decentralized. There is no specific location or exchange where these currency transactions take place. However, foreign currency options are regulated in a number of countries and trade on a number of different derivatives exchanges. Central Banks in many countries publish closing spot prices on a daily basis. 4.3 HIGHLY TRADED MARKETS – CASH/OTC Cash Market: Cash market is a market for sale of security against immediate delivery, as opposed to the futures market. The following table provides us a gist of trading volumes on national stock exchanges, BSE & NSE for past one year: Forward Markets: Forward markets are over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. Contracts entered into in the forward market are binding on the parties involved. Forward markets are used for trading a range of instruments including currencies and interest rates, as well as assets such as commodities and securities. While forward contracts, like futures contracts, may be used for both hedging and speculation, there are some notable differences between the two. Forward contracts can be 61 CU IDOL SELF LEARNING MATERIAL (SLM)

customized to fit a customer's requirements, while futures contracts have standardized features in terms of their contract size and maturity. The lack of standard features means that forward contracts seldom trade on exchanges, whereas futures contracts are generally exchange-listed. Since forward contracts generally tend to be large in size, the forward market is dominated by financial institutions, government bodies and large corporations. Futures and Options Market: Futures is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a future exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. Future and options are registering remarkable volumes on national stock exchanges which are depicted in following table: Exchange Traded and Over-the-counter Market: An exchange-traded fund is an investment fund that is traded on a stock exchange, just like stocks. An ETF holds assets such 62 CU IDOL SELF LEARNING MATERIAL (SLM)

as stocks, commodities or bonds and trades in value, around its (NAV) over the course of the trading day. Most ETFs track an index such as a stock index or a bond index. ETFs are attractive investments because of their low costs, diversified holdings, tax efficiency and stock-like features. ETFs are the most popular type of exchange-traded products in the USA and Europe. Exchange Traded Funds are simple and easy to understand. Most ETFs also have an intrinsically lower risk due to their diversified portfolio. This diversification coupled with low expenses allows the smallest of the investors to reap the benefits of market based returns. Retail investors can use ETF’s as an easy entry vehicle into the capital markets. Equity investments are most likely to give you attractive long term growth. And, this growth is reflected in market indices, like the NSE Nifty. Seven asset management companies have launched ETFs on CNX Nifty Index which are listed on NSE. Indian stock exchanges have been witnessing high trading volumes in Gold ETFs in the recent past. Over the counter market: The OTC markets are informal markets where trades are negotiated. Most of the trades in government securities take place in the OTC market. All the spot trades where securities are traded for immediate delivery and payment occur in the OTC market. The other option is to trade using the infrastructure provided by the stock exchanges. The exchanges in India follow a systematic settlement period. Since OTC markets are informal markets and most of the trades take place over the phone, it is difficult to track volumes. 4.4 NATURE OF TRANSACTIONS The Foreign Exchange Market is an over-the-counter (OTC) market, which means that there is no central exchange and clearing house where orders are matched. With different levels of access, currencies are traded in different market makers: The Inter-bank Market - Large commercial banks trade with each other through the Electronic Brokerage System (EBS). Banks will make their quotes available in this market only to those banks with which they trade. This market is not directly accessible to retail traders. The Online Market Maker - Retail traders can access the FX market through online market makers that trade primarily out of the US and the UK. These market makers typically have a relationship with several banks on EBS; the larger the trading volume of the market maker, the more relationships it likely has. 63 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 4.1 Nature of Transactions Market Hours Forex is a market that trades actively as long as there are banks open in one of the major financial centers of the world. This is effectively from the beginning of Monday morning in Tokyo until the afternoon of Friday in New York. In terms of GMT, the trading week occurs from Sunday night until Friday night, or roughly 5 days, 24 hours per day. Price Reporting Trading Volume Unlike many other markets, there is no consolidated tape in Forex, and trading prices and volume are not reported. It is, indeed, possible for trades to occur simultaneously at different prices between different parties in the market. Good pricing through a market maker depends on that market maker being closely tied to the larger market. Pricing is usually relatively close between market makers, however, and the main difference between Forex and other markets is that there is no data on the volume that has been traded in any given time frame or at any given price. Open interest and even volume on currency futures can be used as a proxy, but they are by no means perfect. Cash The marketplace for immediate settlement of transactions involving commodities and securities is called cash market. In a cash market, the exchange of goods and money between the seller and the buyer takes place in the present, as opposed to the futures market where such an exchange takes place on a specified future date. Also known as the spot market, since such transactions are settled \"on the spot.\" Cash market transactions can take place either on a regulated exchange or over-the-counter (OTC). In contrast, transactions involving futures are conducted exclusively on exchanges, 64 CU IDOL SELF LEARNING MATERIAL (SLM)

while forward transactions, such as currency forwards, are generally executed on the OTC market. For a specific commodity, the price in the cash market is usually less than its price in the futures market. This is because there are carrying costs, such as storage and insurance, involved in holding a commodity until it can be delivered at some point in the future. OTC Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase \"over-the-counter\" can be used to refer to stocks that trade via a dealer network as against on a centralized exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network. In general, the reason why a stock is traded over-the-counter is usually that because the company is small, it is unable to meet exchange listing requirements. Also known as \"unlisted stock\", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. Although NASDAQ operates as a dealer network, NASDAQ stocks are generally not classified as OTC because the NASDAQ is considered a stock exchange. As such, OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB) or on the pink sheets. Be very wary of some OTC stocks, however; the OTCBB stocks are either penny stocks or are offered by companies with bad credit records. Instruments such as bonds do not trade on a formal exchange and are, therefore, also considered OTC securities. Most debt instruments are traded by investment banks making markets for specific issues. If an investor wants to buy or sell a bond, he or she must call the bank that makes the market in that bond and asks for quotes. 4.5 CROSS BORDER CURRENCY FLOWS A feature of the economy that is intricately related with the exchange rate regime followed is the freedom of cross-border capital flows. This relationship comes from the so-called “impossible trinity” or “trilemma” of international finance, which essentially states that a country may have any two but not all of the following three things – a fixed exchange rate, free flow of capital across its borders and autonomy in its monetary policy. Since liberalization, India has been having close to a de facto peg to the dollar and simultaneously has been liberalizing its foreign currency flow regime. Close on the heels of the adoption of 65 CU IDOL SELF LEARNING MATERIAL (SLM)

market determined exchange rate (within limits) in 1993 came current account convertibility in 1994. In 1997, the Tara pore committee, on Capital Account Convertibility, defined the concept as “the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange” and laid down fiscal consolidation, a mandated inflation target and strengthening of the financial system as its three main preconditions. Meanwhile capital flows have been gradually liberalized, allowing, on the inflow side, foreign direct and portfolio investments, and tapping foreign capital markets by Indian companies as well as considerably better remittance privileges for individuals; and on the outflow side, international expansion of domestic companies. In 2000, the infamous Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign Exchange Management Act (FEMA) that gave participants in the foreign exchange market a much greater leeway. 4.6 LIBERALIZATION OF EXCHANGE CONTROL The exchange control regulations have been liberalized over the years to facilitate the remittance of funds both into and out of India. The changes have been introduced on a continuous basis in line with the government policy of economic liberalization. Still, in few cases, specific approvals are required from the regulatory authorities for foreign exchange transactions/remittances. The exchange control regulations in India are governed by the Foreign Exchange Management Act (FEMA). The apex exchange control authority in India is the Reserve Bank of India (RBI) which regulates the law and is responsible for all key approvals FEMA is not only applicable to all parts of India but is also applicable to all branches, offices and agencies outside India which are owned or controlled by a person resident in India. FEMA regulates all aspects of foreign exchange and has direct implications on external trade and payments FEMA is an important legislation which impacts foreign nationals who are working in India and also Indians who have gone outside India. It is important to be compliant with the exchange control regulations 4.7 ROLE OF BANKS IN FOREX MARKET Commercial banks do not create money--they are simply the intermediaries that move money from the capital markets to businesses and institutions. Banks get their money through business checking or deposit accounts, service fees and by issuing certificates of deposit (CD) 66 CU IDOL SELF LEARNING MATERIAL (SLM)

and banker's acceptances--money market instruments that are collateralized by letters of credit (LOC) used in trade finance--and commercial paper. Commercial banks offer services such as trade finance, project finance, payroll, foreign exchange transactions and trading, lock boxes for collecting payments and general corporate finance. Significance Without commercial banks, the international finance and import-export industry would not exist. Commercial banks make possible the reliable transfer of funds and translation of business practices between different countries and different customs all over the world. The global nature of commercial banking also makes possible the distribution of valuable economic and business information among customers and the capital markets of all countries. Commercial banking also serves as a worldwide barometer of economic health and business trends. Trade Finance Commercial banks doing international business are also called merchant banks because they finance trade between companies and customers located in different countries. This is done by issuing LOCs that indicate the customer has deposited the full amount due on an order with a company located in a different country. The seller company can then feel assured of being paid if it ships goods to its offshore customer. The LOC may also be used by the company to guarantee a manufacturer's loan, allowing it to finance the manufacture of the goods to be delivered. Without LOCs, companies would face considerable expense in investigating their foreign customers to make sure they are legitimate and creditworthy, and complying with laws and regulations of the different countries in which they do business. Foreign Exchange In order to facilitate international trade and development, commercial banks convert and trade foreign currencies. When a company is doing business in another country it may be paid in the currency of that country. While some of these revenues will be used to pay workers in that country and for administrative expense such as office rent, utilities and supplies, the company may need to purchase goods from a neighboring country in that country's currency, or convert cash to its native currency for return to the home office. 67 CU IDOL SELF LEARNING MATERIAL (SLM)

4.8 FACTORS IMPACTING FOREX MARKET Like most commodities, demand and supply forces in the market influence currency prices. These forces, in turn, are influenced by many factors which increase demand at times and supply at others, causing the currency values to fluctuate. There are several factors which influence forex prices in this way. Anything that affects the flow of money in a country or between countries may impact currency values. Here are some of the key factors that affect the value of a currency: Economy The state of a country’s economy determines its currency value. A growing economy is generally the foundation for a stable currency that is valued highly in comparison with others. Any factors which impact the growth of the economy, either positively or negatively also affect currency prices. For example, during inflation, currency values typically fall. Inflation reduces the purchasing power of money so that less can be bought for each unit of money. There are many economic indicators that need to be considered before making a forex trade decision. These indictors represent various aspects of the economy. As the general economic condition influences the currency value, these indicators are very useful in determining how the currency prices will fare given the current economic conditions. GDP – The Gross Domestic product of a country measures the industrial growth and production. This figure is a good indicator of how active the economy is. A steady GDP is the indication of a healthy, growing economy. Currency values are likely to rise when such circumstances prevail. Purchasing Power Parity – PPP measures the comparative power of a currency to purchase goods and services in a country. Consider two countries, A and B. 100 units of currency of A are equal to 1 unit of currency of B as per prevailing exchange rates in the market. PPP aims to measure the purchasing power of A’s currency with respect to B’s currency. What can be bought for 100 units of local currency in country A should be available for 1 unit of local currency in country B. Then the countries are at par as far as purchasing power is concerned. If the countries are not evenly matched with respect to PPP and one currency has greater purchasing power than the other then it has a higher value in the forex market.  Interest Rate Parity – The interest rates prevalent in both countries must also be comparable so that investments yield similar returns. The ability of a country’s 68 CU IDOL SELF LEARNING MATERIAL (SLM)

currency to multiply in this way ultimately determines its own value. This is why interest rate parity is also an important factor in determining currency prices.  Employment Levels – Employment levels determine the productivity of a nation. This is an indicator of future growth in the economy. A high level of employment means that most of the country’s population is engaged in contributing to economic growth. A good employment rate is a sign of a healthy economy and forms the basis for more investments.  This, in turn, increases the currency value. A low employment rate shows that fewer people are contributing to the economy. Production of goods and services is being carried out by a smaller proportion of the population, although consumption is at the same level. Currency value will be subdued when employment levels are low.  Consumer Spending – The amount of money which the people of a country are spending gives an idea of what they think about the economy. If spending is low and saving is high, then it shows that people fear an economic downturn. This indicates that the currency value may fall in future. Increased consumer spending shows that people are confident of their future earnings and investment yields. Consumer spending is also an indicator of the purchasing power of the average citizen and the standard of living. A prosperous economy is one where consumer spending is at a sustainable level. Such an economy is likely to have a stable currency with a high value. Government Policies The government constantly assesses the economy and takes necessary action. Government policies are created and implemented to encourage prevailing economic conditions during a positive trend and to correct the imbalance if the economy is not doing well. Most economic policies fall under two categories – fiscal policies and monetary policies. Fiscal policies are those which outline the spending of the government. The annual budget is a part of the fiscal policy. It determines the areas where the government will be spending money. Government spending boosts the prospects of industries and segments of the economy. Monetary policies are those which influence the various components of the country’s financial fabric to improve or sustain the economy. The central bank of a country implements the government’s policies by using various investment strategies in the markets. Given the 69 CU IDOL SELF LEARNING MATERIAL (SLM)

huge amount of funds the central bank can control, any action by the bank has a huge impact on the market. An inflationary trend can be curbed, falling prices can be shored up and many other economic imbalances can be set right by central banks though their market activities. Both monetary and fiscal policies affect currency prices, though the impact of monetary policies are almost immediate. Natural Factors A natural disaster like floods, famine or drought in a country will have a negative impact on its currency value. The flow of money within the county’s boundaries is restricted severely under adverse circumstances like these. The general public is more cautious in spending and there is likely to be a dramatic reduction in the overall amount of funds which are being used for investments. High risk investments like forex do not find many takers during these times. Government spending is also reduced because of huge expenditure on relief measures. Any excess funds are diverted toward rehabilitation programs because the government’s focus is on getting the country back on its feet. International Trade Countries trade with each other to buy and sell products and services. As with any transaction, this too requires an exchange of money. In fact, the level of international trade is a good indicator of demand for a country’s currency. When countries with different currencies trade, the deal influences the value of currencies for both of them. Such international trade is a permanent feature of any economy with goods and services being bought and sold from many different countries at any given point in time. When imports are higher than exports, the economy is said to have a trade deficit and when exports are higher than imports, there is a trade surplus. Governments publish the balance of trade figures showing this status every month. A government has to pay for its purchases or imports and it receives money for its exports. In a trade deficit situation, it will be spending more of the domestic currency to buy foreign currency to fund the purchases. In this case, the domestic currency will fall in value in comparison with the foreign one. When exports exceed imports, there is a trade surplus which also translates into a higher domestic currency value. The status of this equation is given by the capital flow of a country. 70 CU IDOL SELF LEARNING MATERIAL (SLM)

Both capital flow and balance of trade are combined into the balance of payments statistics, which are released by the government. Three components make up the balance of payments of a country:  Current account – Measures the goods bought and sold in international trade.  Capital account – Measures the acquisition of disposal of assets that are non-financial in nature.  Financial account – Measures the cross-border flow of money. The balance of payments statistics play an important role in determining currency value of any country. This is one of the most important factors that a forex trader must consider when he makes investment decisions, especially long-term ones. Market Sentiment Market sentiments play an important role in determining currency values. These directly influence demand and supply within the market. During times of global economic unrest, values will increase for stronger currencies which are linked to countries viewed as stable. A country whose inflation levels are high will be viewed as a poor prospect for forex trading because future economic growth is likely to be hampered by high prices. Investors’ perception of an economy and interpretation of various economic indicators determine the overall market sentiment for a currency. Political Factors Politics often determines the direction which an economy will take. Political unrest brings a lot of uncertainty about the future and subdues both economic growth and currency value. An upcoming election or war may give rise to a cautious investment approach, reducing the capital flow into a country. A change in leadership also often subdues the price movement of a currency in the forex market. Until the new leadership’s political views, monetary and fiscal policies and views on international trade become clear, the markets do not show a clear trend in the currency’s value. A country that is considered politically unstable will not be a favored trading partner. This will affect its forex trade and the value of its currency in the market. On the other hand, a progressive political leader and a stable leadership pave the way for increased investments as investor confidence becomes strong. 71 CU IDOL SELF LEARNING MATERIAL (SLM)

The foreign exchange market in India started when in 1978 the government allowed banks to trade foreign exchange with one another. Foreign Exchange Market in India operates under the Central Government of India and executes wide powers to control transactions in foreign exchange. The Foreign Exchange Management Act, 1999 or FEMA regulates the whole Foreign Exchange Market in India. Before the introduction of this act, the foreign exchange market in India was regulated by the Reserve Bank of India through the Exchange Control Department, by the Foreign Exchange Regulation Act or FERA, 1947. Interbank foreign exchange Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI) created in 1958, a self-regulatory voluntary association of dealers or banks specializing in the foreign exchange activities in India that regulates the governing rules and determines the commissions and charges associated with the interbank foreign exchange business. Since 2001, clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions. The foreign exchange market in India consists of 3 segments or tires. The first consists of transactions between the RBI and the authorized dealers (AD). The latter are mostly commercial banks. The second segment is the interbank market in which the AD’s deal with each other. And the third segment consists of transactions between AD’s and their corporate customers. As in any market essentially the demand and supply for a particular currency at any specific point in time determines its price (exchange rate) at that point. Prior to 1990s fixed Exchange rate of the rupee was officially determined by RBI. During the early years of liberalization, the Rangarajan committee recommended that India’s exchange rate be flexible. India moved from a fixed exchange rate regime to “market determined” exchange rate system in 1993. This is explained as under. A country’s currency exchange rate is typically affected by the supply and demand for the country’s currency in the international foreign exchange market. Let’s take the example of Rupee Dollar exchange. The rupee/dollar rate is a two-way rate which means that the price of 1 dollar is quoted in terms of how much rupees it takes to buy one dollar. The value of one currency against another is based on the demand of the currency. If the demand for dollar increases, the value of dollar would appreciate. As the quotation for Rs/$ is a two way quote, an appreciation in the value of dollar would automatically mean the depreciation in Indian 72 CU IDOL SELF LEARNING MATERIAL (SLM)

rupee and vice-versa. Besides the primary powers of demand and supply, the Indian exchange rate is affected by following factors:  RBI INTERVENTION: When there is too much volatility in the rupee-dollar rates, the RBI prevents rates going out of control to protect the domestic economy. The RBI does this by buying dollars when the rupee appreciates too much and by selling dollars when the rupee depreciates way too much.  INFLATION: When inflation increases there will be less demand of domestic goods and more demand of foreign goods i.e. increases demand for foreign currency), thus value of foreign currency increases and home currency depreciates thus negatively affecting exchange rate of home currency.  IMPORTS AND EXPORTS: Importing foreign goods requires us to make payment in foreign currency thus strengthening the foreign currency’s demand. Increase in demand increases the value of foreign currency and exports do the reverse.  INTEREST RATES: The interest rates on Government bonds in emerging countries such as India attract foreign capital to India. If the rates are high enough to cover foreign market risk, money would start pouring in India and thus would provide a push to rupee demand thus appreciating rupee value for exchange.  OPERATIONS: The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and invisibles in the current account, drafts, traveler’s cheque and inflows in the capital account such as foreign direct investment (FDI), portfolio investment, external commercial borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign exchange rises from imports and invisible payments in the current account, amortization of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and outflows on account of direct and portfolio investment. Types of Foreign Market Operations  Spot market (current market): Spot market for foreign exchange is that market which handles only spot transactions or current transactions. Spot rate of exchange prevails at the time when transactions are incurred. it is of daily nature.  Forward market (derivative market): It is meant for future delivery i. determines forward exchange rate at which forward transaction are to be honored. It deals in 73 CU IDOL SELF LEARNING MATERIAL (SLM)

following instruments: foreign exchange forwards, currency futures, currency swaps, currency options.  Exchange settlement and dealings: Nostro and Vostro account facilitate settlement of foreign exchange transaction.  Nostro account: A foreign currency ac maintained by a bank in India with a bank in abroad. For example, Bank of India US dollar account with Citi bank.  Vostro account: A rupee account of a foreign bank abroad with a bank in India. For example, Citi bank rupee ac with bank of India. 4.9 DERIVATIVES Derivatives ‐ Definition Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate). The underlying asset can be equity, foreign exchange, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the \"underlying\". Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post 1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R) A] defines \"Derivative\" to include‐ 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. 74 CU IDOL SELF LEARNING MATERIAL (SLM)

The term derivative has also been defined in section 45U(a) of the RBI act as follows: An instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency‐rupee swaps, foreign currency options, foreign currency‐rupee options or such other instruments as may be specified by RBI from time to time. Derivative products Though derivatives can be classified based on the underlying asset class (such as forex derivatives, equity derivatives, etc), it is more useful to classify them based on cash flow pattern into four “generic“ types of forward, futures, option and swap. We take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized OTC contract between two parties, where Settlement takes place on a specific date in the future at today's pre‐agreed price. Futures: It is similar to forward except that it is an Exchange‐trade product. The term “Futures” refer to the derivative and the term “future” to a later point in time. Thus, the “Futures price” is the current price of derivatives and the “future” price is the price that Will prevail on a later point of time. Options: Option does not buy or sell the underlying directly but buys or sells the right without obligation on the underlying. The right can be the right to buy (when it is called call option) and the right to sell (when it is called put option). Swaps: Swaps are agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:  Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.  Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Growth drivers of derivatives Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: 75 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international financial Markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing a wider choice of risk management strategies, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk and lower transactions costs as compared to individual financial assets. Market players The following three broad categories of participants ‐ hedgers, speculators, and arbitrageurs ‐ trade in the derivatives market. Hedgers face risk associated with the price of an underlying asset and they use derivative markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an underlying asset. Derivatives give them an ability to buy the underlying without paying for it fully or to sell it without owning it or delivering it immediately. In the process, the potential gains and losses are amplified. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Key economic function of derivatives Despite the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions. 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus, derivatives help in discovery of future prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for risks. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 76 CU IDOL SELF LEARNING MATERIAL (SLM)

4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these types of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well‐educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefits of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Financial market stability: Exchange‐traded vs. OTC derivatives The OTC derivatives markets have witnessed rather sharp growth over the last few years which have accompanied the modernization of commercial and investment banking and globalization of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange‐traded and OTC derivative contracts offer many benefits, there are significant differences between the two. The key difference being that exchange traded derivatives are standardized, more transparent, the counterparty risk is borne by a centralized corporation with stringent margining systems while OTC contracts are customized, opaque in pricing, risk management is decentralized and individual institutions/ clients take counterparty risk of each other. The exchange traded market can offer hedging solution to even small size requirements whereas in OTC market, hedging a very small size requirement may not be possible or the transaction cost may be prohibitive. The clearing, settlement and risk management part of OTC contracts, if not managed well could lead to unsustainable counter party credit risk exposure leading to rapid unwinding of positions during periods of sharp volatility and movement is asset prices. A default by one or two large counterparties may leads to domino effect of default by other counterparties also and thereby making financial market unstable. We had observed this phenomenon during financial crisis of 2008. World over regulators and governments are now trying to move more and more derivative contracts to be exchange traded with centralized clearing and settlement. 77 CU IDOL SELF LEARNING MATERIAL (SLM)

4.10 CURRENCY FUTURES AND OPTIONS 4.10.1 Currency Futures: Currency futures ‐ Definition A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity futures contract”. When the underlying is an exchange rate, the contract is termed a “currency futures contract”. Both parties of the futures contract must fulfill their obligations on the settlement date. Currency futures are a linear product, and calculating profits or losses on these instruments is similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also the “tick” value. A tick is the minimum size of price change. The market price will change only in multiples of the tick. Tick values differ for different currency pairs and different underlying. For e.g. in the case of the USDINR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupee. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs 67.7500. One tick move on this contract will translate to Rs67.7475 or Rs 67.7525 depending on the direction of market movement. The contract amount (or “market lot”) is the minimum amount that can be traded. Therefore, the profit/loss associated with change of one tick is: tick x contract amount. The value of one tick on each USDINR contract is Rupees 2.50 (which is 1000 X 0.0025). So if a trader buys 5 contracts and the price moves up by 4 ticks, he makes Rs 50 (= 5 X 4 X 2.5). (Note: The above examples do not include transaction fees and any other fees, which are essential for calculating final profit and loss). Futures terminology Some of the common terms used in the context of currency futures market are given below: 78 CU IDOL SELF LEARNING MATERIAL (SLM)

 Spot price: The price at which the underlying asset trades in the spot market.  Futures price: The current price of the specified futures contract  Contract cycle: The period over which a contract trades. The currency futures contracts on the SEBI recognized exchanges have one‐month, two‐month, and three‐ month up to twelve‐month expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in time.  Value Date/Final Settlement Date: The last business day of the month will be termed as the Value date / Final Settlement date of each contract. The last business day would be taken to be the same as that for Inter‐bank Settlements in Mumbai. The rules for Inter‐bank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by Foreign Exchange Dealers’ Association of India (FEDAI).  Expiry date: Also called Last Trading Day, it is the day on which trading ceases in the contract; and is two working days prior to the final settlement date.  Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. In the case of USDINR it is USD 1000; EURINR it is EUR 1000; GBPINR it is GBP 1000 and in case of JPYINR it is JPY 100,000. Further, in case of EURUSD, the contract size is EUR 1000, for GBPUSD it is GBP 1000 and for USDJPY it is USD 1000.  Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.  Marking‐to‐market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking‐to‐market. Rationale behind currency futures The rationale for introducing currency futures in the Indian context has been outlined in the Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008) as follows: “The rationale for establishing the currency futures market is manifold. Both residents and non‐residents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, 79 CU IDOL SELF LEARNING MATERIAL (SLM)

the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for nonresidents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a long – run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller than the long‐run, which is typically inter‐generational in the context of exchange rates. Per se, there is a strong need to hedge currency risk and this need has grown manifold with fast growth in cross‐ border trade and investments flows. The argument for hedging currency risks appear to be natural in case of assets, and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need for hedging currency risks. But there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns, there are strong arguments to use instruments to hedge currency risks. Currency risks could be hedged mainly through forwards, futures, swaps and options. Each of these instruments has its role in managing the currency risk. The main advantage of currency futures over its closest substitute product, viz. forwards which are traded over the counter lies in price transparency, elimination of counterparty credit risk and greater reach in terms of easy accessibility to all. Currency futures are expected to bring about better price discovery and also possibly lower transaction costs. Apart from pure hedgers, currency futures also invite arbitrageurs, speculators and those traders who may take a bet on exchange rate movements without an underlying or an economic exposure as a motivation for trading. From an economy‐wide perspective, currency futures contribute to hedging of risks and help traders and investors in undertaking their economic activity. There is a large body of empirical evidence which suggests that exchange rate volatility has an adverse impact on foreign trade. Since there are first order gains from trade which contribute to output growth and consumer welfare, currency futures can potentially have an important impact on real economy. Gains from international risk sharing through trade in assets could be of relatively smaller magnitude than gains from trade. However, in a dynamic setting these investments 80 CU IDOL SELF LEARNING MATERIAL (SLM)

could still significantly impact capital formation in an economy and as such currency futures could be seen as a facilitator in promoting investment and aggregate demand in the economy, thus promoting growth”. Distinction between futures and forward contracts Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the probability of future price uncertainty. However futures have some distinct advantages over forward contracts as they eliminate counterparty risk and offer more liquidity and price transparency. However, it should be noted that forwards enjoy the benefit of being customized to meet specific client requirements. The advantages and limitations of futures contracts are as follows: Advantages of Futures:  Price transparency.  Elimination of Counterparty credit risk.  Access to all types of market participants. The OTC market is restricted to Authorized Dealers (banks which are licensed by RBI to deal in FX), individuals and entities with forex exposures. Retail speculators with no exposure to FX cannot trade in OTC market.  Generally speaking, futures offer low cost of trading as compared to OTC market. Limitations of Futures:  The benefit of standardization, though improves liquidity in futures, leads to imperfect hedge since the amount and settlement dates cannot be customized.  While margining and daily settlement is a prudent risk management policy, some 36 clients may prefer not to incur this cost in favor of OTC forwards, where collateral is usually not demanded. Interest rate parity and pricing of currency futures Concept of interest rate parity Let us assume that risk free interest rate for one year deposit in India is 7% and in USA it is 3%. You as smart trader/ investor will raise money from USA and deploy it in India and try to capture the arbitrage of 4%. You could continue to do so and make this transaction as a non-ending money making machine. Life is not that simple! And such arbitrages do not exist for very long. 81 CU IDOL SELF LEARNING MATERIAL (SLM)

We will carry out the above transaction through an example to explain the concept of interest rate parity and derivation of future prices which ensure that arbitrage does not exist. Assumptions: 1. Spot exchange rate of USDINR is 68 (S) 2. One year future rate for USDINR is F 3. Risk free interest rate for one year in USA is 3% (RUSD) 4. Risk free interest rate for one year in India is 7% (RINR) 5. Money can be transferred easily from one country into another without any restriction of amount, without any taxes etc You decide to borrow one USD from USA for one year, bring it to India, convert it in INR and deposit for one year in India. After one year, you return the money back to USA. On start of this transaction, you borrow 1 USD in US at the rate of 3% and agree to return 1.03 USD after one year (including interest of 3 cents or 0.03 USD). This 1 USD is converted into INR at the prevailing spot rate of 68. You deposit the resulting INR 68 for one year at interest rate of 7%. At the end of one year, you receive INR 4.76 (7% of 68) as interest on your deposit and also get back your principal of INR 68 i.e., you receive a total of INR 72.76. You need to use these proceeds to repay the loan taken in USA. Two important things to think before we proceed:  The loan taken in USA was in USD and currently you have INR. Therefore you need to convert INR into USD  What exchange rate do you use to convert INR into USD? At the beginning of the transaction, you would lock the conversion rate of INR into USD using one year future price of USDINR. To ensure that the transaction does not result into any risk free profit, the money which you receive in India after one year should be equal to the loan amount that you have to pay in USA. We will convert the above argument into a formula: S(1+RINR) = F(1+RUSD) Or, F/ S = (1+RINR) / (1+RUSD) 82 CU IDOL SELF LEARNING MATERIAL (SLM)

Another way to illustrate the concept is to think that the INR 72.76 received after one year in India should be equal to USD 1.03 when converted using one year future exchange rate. Therefore, F/ 68 = (1+0.07) / (1+0.03) F= 70.6408 Approximately, F is equal to the interest rate difference between two currencies i.e., F = S + (RINR‐ RUSD)*S This concept of difference between future exchange rate and spot exchange rate being approximately equal to the difference in domestic and foreign interest rate is called the “Interest rate parity”. Alternative way to explain, interest rate parity says that the spot price and futures price of a currency pair incorporates any interest rate differentials between the two currencies assuming there are no transaction costs or taxes. A more accurate formula for calculating, the arbitrage‐free forward price is as follows. F = S  (1 + RQC  Period) / (1 + RBC  Period) Where F = forward price S = spot price RBC = interest rate on base currency RQC = interest rate on quoting currency Period = forward period in years For a quick estimate of forward premium, following formula mentioned above for USDINR currency pair could be used. The formula is generalized for other currency pair and is given below: F = S + (S  (RQC – RBC)  Period) In above example, if USD interest rate were to go up and INR interest rate were to remain at 7%, the one year future price of USDINR would decline as the interest rate difference between the two currencies has narrowed and vice versa. Traders use expectation on change in interest rate to initiate long/ short positions in currency futures. Everything else remaining the same, if USD interest rate is expected to go up (say from 2.5% to 3.0%) and INR interest rate are expected to remain constant say at 7%; a trader would initiate a short position in USDINR futures market. Illustration: Suppose 6 month interest rate in India is 5% (or 10% per annum) and in USA are 1% (2% per annum). The current USDINR spot rate is 68. What is the likely 6 month USDINR futures price? 83 CU IDOL SELF LEARNING MATERIAL (SLM)

As explained above, as per interest rate parity, future rate is equal to the interest rate differential between two currency pairs. Therefore approximately 6 month future rate would be: Spot + 6 month interest difference = 68 + 4% of 68 = 68 + 2.72 = 70.72 The exact rate could be calculated using the formula mentioned above and the answer comes to 70.69. 70.69 = 68 x (1+0.10*0.5) / (1+0.02*0.5) Concept of premium and discount Therefore 6 month future price of USDINR pair is 70.69 when spot price is 68. It means that INR is at discount to USD and USD is at premium to INR. Intuitively to understand why INR is called at discount to USD, think that to buy same 1 USD you had to pay INR 68 now and you have to pay 70.69 after 6 months i.e., you have to pay more INR to buy same 1 USD. And therefore future value of INR is at discount to USD. Therefore in any currency pair, future value of a currency with high interest rate is at a discount (in relation to spot price) to the currency with low interest rate. 4.10.2 Currency Options Options – Definition, basic terms As the word suggests, option means a choice or an alternative. To explain the concept through an example, take a case where you want to a buy a house and you finalize the house to be bought. On September 1st 2015, you pay a token amount or a security deposit of Rs 1,00,000 to the house seller to book the house at a price of Rs 10,00,000 and agree to pay the full amount in three months i.e., on November 30th 2015. After making full payment in three months, you get the ownership right of the house. During these three months, if you decide not to buy the house, because of any reasons, your initial token amount paid to the seller will be retained by him. In the above example, at the expiry of three months you have the option of buying or not buying the house and house seller is under obligation to sell it to you. In case during these three months the house prices drop, you may decide not to buy the house and lose the initial 84 CU IDOL SELF LEARNING MATERIAL (SLM)

token amount. Similarly if the price of the house rises, you would certainly buy the house. Therefore by paying the initial token amount, you are getting a choice/ option to buy or not to buy the house after three months. The above arrangement between house buyer and house seller is called as option contract. We could define option contract as below: Option: It is a contract between two parties to buy or sell a given amount of asset at a pre‐ specified price on or before a given date. We will now use the above example, to define certain important terms relating to options.  The right to buy the asset is called call option and the right to sell the asset is called put option.  The pre‐specified price is called as strike price and the date at which strike price is applicable is called expiration date. The difference between the date of entering into the contract and the expiration date is called time to maturity.  The party which buys the rights but not obligation and pays premium for buying the right is called as option buyer and the party which sells the right and receives premium for assuming such obligation is called option seller/ writer.  The price which option buyer pays to option seller to acquire the right is called as option price or option premium  The asset which is bought or sold is also called as an underlying or underlying asset.  Buying an option is also called as taking a long position in an option contract and selling is also referred to as taking a short position in an option contract. To make these terms more clear, let us refer to the earlier example of buying a house and answer few questions. 1. Does the above example constitute an option contract? If yes, 2. Is it a call option or put option? 3. What is the strike price? 4. What is the expiration date? 5. What is the time to maturity? 6. Who is the option buyer and who is the option seller? 7. What is the option premium? 8. What is the underlying asset? 85 CU IDOL SELF LEARNING MATERIAL (SLM)

Now let us assess the answers to these questions: 1. Does the above example constitute an option contract?  The above example constitutes an option contract as it has all the properties – two parties, an underlying asset, a set price, and a date in future where parties will actually transact with right without obligation to one party. 2. Is it a call option or put option?  It is a call option as you are paying the token amount to buy the right to buy the house 3. Who is the option buyer and who is the option sellers?  You are the option buyer and house seller is option seller 4. What is the strike price?  Rs 10,00,000 5. What is the expiration date?  November 30th 2015 6. What is the time to maturity?  Three months 7. What is the option premium?  Rs 1,00,000 8. What is the underlying asset?  The house is an underlying asset Let us also take a real life example of a put option. When you get your car insured, you pay an insurance premium to the insurance company and the insurance company guarantees to compensate you for the damages to your car during the insurance period. In this example, you are buying a put option from the insurance company and paying it an option premium in form of insurance premium. If your car gets damaged during the insurance period, you can use your policy to claim the compensation and if all goes well and you do not need to claim the compensation, the insurance company keeps the premium in return for taking on the risk. Difference between futures and options Let us first highlight the similarities between two types of derivative contracts – Futures and Options. The similarities are as follows:  Both the contracts have a buyer and seller  Both the contract have a set price for the underlying asset  Both the contracts have a set settlement date 86 CU IDOL SELF LEARNING MATERIAL (SLM)

The difference between two contracts is that in futures both the parties are under right as well as obligation to buy or sell and therefore face similar risk. Whereas in options, the buyer has only rights and no obligation and therefore he faces only the risk of premium paid and option seller is under obligation to buy or sell (depending on whether put option is sold or a call option is sold, respectively) and therefore faces unlimited risk. At the same time, the option buyer has chances to get unlimited upside and the option seller has limited upside equal to the premium received. The call option buyer would exercise the option only if the price of underlying asset is higher than the strike price and premium paid. Similarly the put option buyer would exercise the option if the price of the underlying asset is less than the strike price and the premium paid. Just like futures, options can be used for hedging, or to generate returns by taking a view on the future direction of the market, or for arbitrage. Options in financial market Options are very actively traded instruments in most financial assets like equities, currency, commodities and interest rate. Currency options trading witnessed an explosive growth in 1990 when trading of options started in the interbank market. It is impossible to be precise about overall size of currency options market because the majority of trading takes place in the private interbank market. Options market in India Exchange traded equity index options commenced trading in India on June 4, 2001 followed by single stock specific options on July 2001. Since then, the volume in options is on a continuous growth path. RBI allowed banks to offer foreign currency‐INR European options to its customers with effect from July 7, 2003. Banks were allowed to run option book subject to their 68 meeting certain parameters with respect to net worth, profitability, capital adequacy and NPA%. The currency options have now been also allowed for trading on exchanges. The exchanges started trading in currency options from November 10, 2010. Difference between OTC and exchange traded currency options In OTC option market, the select scheduled commercial banks are permitted to be market makers in currency options market and resident Indians are allowed to be net buyer of options i.e., they should be paying a net premium when undertaking an option structure and they 87 CU IDOL SELF LEARNING MATERIAL (SLM)

should not be the net receiver of premium. The options are mainly used by corporates to hedge their exposure arising out of import, export of any other foreign currency related receipts or payments. There are strict guidelines related to amount and tenor or option contracts that a corporate can book. The amount and tenor of option contract has to be lower than or equal to the amount and tenor of the underlying trade transaction. For example, if you are crude oil importer in the country and you have USD payment of USD 10 Mn to be made after three months. Under this trade transaction, you can buy a call option on USDINR for a maximum amount of USD 10 Mn and a maximum tenor/ maturity of 3 months. The corporates have to submit a proof of underlying trade transaction to the bank from whom it is buying the option before booking the contract. While for an exchange traded option, the restriction on amount and tenor are not related to the underlying FX transaction but are restricted by open interest and total volume. In terms of currency pair, in OTC market the client can get quotes for any currency pair and in exchange traded market the prices are currently available only for USDINR option contracts. In currency option, every option is simultaneously call and put on different currencies. For example, when you buy call on USD against INR, you have the right to buy USD with INR, which is the same as the right to sell INR and receive USD. Therefore, USD call is also INR put. Style of options Based on when the buyer is allowed to exercise the option, options are classified into two types: A. European options: European options can be exercised by the buyer of the option only on the expiration date. In India, all the currency options in OTC market are of European type. B. American options: American options can be exercised by the buyer any time on or before the expiration date. Currently American options are not allowed in currencies in India. Moneyless of an option The buyer of call option would exercise his right to buy the underlying asset only if the spot price of underlying asset is higher than the strike price at the maturity of the contract. Similarly, the buyer of a put option would exercise his right to sell the underlying asset only if the spot price of underlying asset is lower than the strike price at the maturity of the contract (assuming zero transaction charge and zero option premium). If these costs are included, the decision of option buyer would take into account these costs also. 88 CU IDOL SELF LEARNING MATERIAL (SLM)

Moneyness of an option indicates whether the contract would result in a positive cash flow, negative cash flow or zero cash flow for the option buyer at the time of exercising it. Based on these scenarios, moneyness of option can be classified in three types: In the money (ITM) option: An option is said to be in the money, if on exercising it, the option buyer gets a positive cash flow. Thus a call option would be in the money, if underlying price is higher than the strike price and similarly a put option would be in the money if underlying price is lower than the strike price. Out of the money (OTM) option: An option is said to be out of the money, if on exercising it, the option buyer gets a negative cash flow. Thus a call option would be out of the money, if underlying price is lower than the strike price and similarly a put option would be out of the money if underlying price is higher than the strike price. At the money (ATM) option: An option is said to be at the money if spot price is equal to the strike price. Any movement in spot price of underlying from this stage would either make the option ITM or OTM. Basics of option pricing and option Greeks There have been scholarly works on option pricing since 1877 when in 1877‐ Charles Castelli wrote a book “The Theory of Options in Stocks and Shares”. And subsequently, the successors advanced the works of their predecessors and the theory got developed over time. The modern option pricing model was first articulated by Fischer Black and Myron Scholes in their 1973 paper, \"The Pricing of Options and Corporate Liabilities\". Subsequently, other models and methods were developed. The determinants of option price for currency options are as follows.  Spot price of the underlying asset  Strike price  Annualized volatility of the currency pair  Time to expiration  Risk free interest rate on base currency and quoting currency 4.11 SUMMARY  Forex operations including purchase and sale of currencies of different countries in order to meet payments and receipts requirements as a result of foreign trade 89 CU IDOL SELF LEARNING MATERIAL (SLM)

 Money tends to move towards country offering a higher interest rate thereby resulting in more demand for the foreign country’s currency.  futures contract is purchased and the buyer agrees to receive delivery of the underlying assets  Option Contract give its holder the right, but not the obligation, to take or make delivery on or before a specified date at a stated price.  Contracts are standardized and there’s centralized trading ensuring liquidity.  American style option are those contracts where the option can be exercised on or before the expiration date. Currency Options for whom i.e. who needs Currency Options Currency options are useful for all those who are the players or the users of the foreign currency. This is particularly useful for those who want to gain if the exchange rate improves but simultaneously want a protection it the exchange rate deteriorate. The most the holder of an option can lose is the premium he paid for it. Naturally, the option writer faces the mirror image of the holder‘s picture: if you sell an option, the most you can get is the premium if the option dies for lack of exercise. The writer of a call option can face a substantial loss if the option is exercised: he is forced to deliver a currency-futures contract at a below-market price. If he wrote a put option and the put is exercised, then he is obliged to buy the currency at an above-market price.  Foreign exchange options present an asymmetrical risk profile unlike futures, forwards and currency options. This lopsidedness works in favor of the holder and to the disadvantage of the writer. This is why because the holder pays for it i.e. he takes the risk. When two parties enter into a symmetrical contract; ole a forward, both can gain or lose equally and neither party feels obliged to charge the other for the privilege. Forwards, futures, and swaps are mutual obligations; options are one-sided. The holder of a call has a downside risk limited to the premium paid up front; beyond that he gains one-for –one as the price of the underlying security.  One who has brought p put option gains one-for-one as the price of the underlying instrument falls below the strike price. Traders who have written or sold options face the upside down mirror image profit profile of those who have bought the same options.  From the asymmetrical risk profile of options, it follows that options are ideally suited to offsetting exchange risks that are themselves asymmetrical. The risk of a forward-rate agreement is symmetrical; hence, matching it worth a currency option will not be a perfect hedge. Because doing so would leave you with an open, or speculative, position. 90 CU IDOL SELF LEARNING MATERIAL (SLM)

Forward contracts, futures or currency swaps are suitable hedges for symmetrical risks. Currency options are suitable in which currency risk is already lopsided, and for those who choose to speculate on the direction and volatility of rates.  Options are not only for hedgers, but also for those who wish to take a ―view‖. However, for one who is, say, bearish on the deutschemark, a DM put is not necessarily the best choice. One can easily bet on the direction of a currency by suing futures or forwards. A DM bear would simply sell DM futures, limiting his loss, if wants to do so, via a stop loss order.  For an investor who has a view on direction and on volatility, the option is the right choice. If you think the DM is likely to fall below the forward rate, and you believe that the market has underestimated the mark‘s volatility, then buying a put on German marks is the right strategy.  Who needs American option? Because if offers an additional right- the privilege of exercise on any date up to the expiration date- it gives the buyer greater flexibility and the writer greater risk. American options will therefore tend to be priced slightly higher than European options. Even so, the American option is almost always worth more alive ‘than deadly, meaning that it pays to sell rather than exercise early. The reason for this statement lies in the fact that most option trade at a price higher than the gain that would be made from exercising the option. 4.12 KEYWORDS  Contagion: A form of financial panic, in which the devaluation of exchange rates by one country leads to similar devaluations at about the same time by other, often nearby, countries. Market  Capital mobility: The degree to which private capital moves freely from country to country seeking the most promising investment opportunities.  Freely floating exchange rates: Exchange rates determined in a free market without government interference. 4.13 LEARNING ACTIVITY 1. Which is the largest Foreign exchange market in the world and how does it control or influence exchange rates in other markets? 91 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________________________________ 4.14 PRATICAL APPLICATIONS A Bengaluru based exporter, banking with a leading private bank, had an inward of USD 79,586. He had to convert the inward remittance into Indian Rupee. to assist in the conversion process. Solution: Exporter should call the bank treasury to convert the inward remittance to Indian Rupees. The USDINR spot rate was trading at 74.10. The client had a 13 paisa bank margin and the cash spot was 2 paisa. The net rate he should have received was INR 73.95 (74.10-0.13-0.02) after adjusting for cash spot and bank margin. However the bank was quoting INR 73.76 per dollar. After an hour long discussion with the treasury, client ended up getting a rate of INR 74.2375 per dollar. During the one-hour discussion, the USDINR spot rate had increased from INR 74.10 to 74.3875, which was fortunately in favor of the client. The client ended up getting the right rate after extensive negotiations. The client saved INR 11,937.9 in a single transaction. 4.15 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Briefly explain the forex market in India 2. Who were the participants in forex market in India 3. Explain the term Future contract 4. Define Option contract 5. Define the methods of option contracts that exists in the market Long Questions 1. Explain the various features and participants in forex market in India 2. State and explain the various methods of foreign exchange market 3. Differentiate between Future and Option Contracts. 4. Explain the term Forex trading. 5. What are the various positions in Futures contracts B. Multiple Choice Questions 92 CU IDOL SELF LEARNING MATERIAL (SLM)

1. India is facing continuous deficit in its balance of payments. In the foreign exchange market rupee is expected to a. Depreciate. b. Appreciate. c. Show no specific tendency. d. Depreciate against currencies of the countries with positive balance of payment and appreciate against countries with negative balance of payment. 2. The effect of speculation on exchange rate is a. It causes violent fluctuations in exchange rate. b. It aggravates the market trends. c. Either or both of A and B. d. Neither A nor B. 3. Who among the following are the participants in currency futures a. Hedgers b. Speculators c. Arbitrageurs d. All of these 4. Which of the following is not a advantage of Futures contract a. Price transparency b. Elimination of counterparty credit risk c. Futures offers low cost of trading as compared to OTC market. d. Amount and settlement dates cannot be customized. 5. ______________Swaps are agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. a. Options b. Swaps c. Futures d. Forwards Answers 1 – b 2 – c 3- d 4 - d 5 – b 4.16 REFERENCES  OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition 93 CU IDOL SELF LEARNING MATERIAL (SLM)

 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) 94 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 5: FOREIGN EXCHANGE RISK EXPOSURES Structure 5.0 Learning Objectives 5.1 Introduction 5.2 Foreign Exchange Risk - Meaning 5.3 Exchange Rate Forecasting 5.4 Exchange Rate Determination 5.5 Foreign Exchange Exposure 5.6 Risks in Foreign Exchange Business 5.7 Types of Risk in Foreign Exchange 5.8 Other Classifications of Forex Risks 5.9 Summary 5.10 Keywords 5.11 Learning activity 5.12 Practical Applications 5.13 Unit End Questions 5.14 References 5.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain the meaning of Forex Risk & its exposures  Significance and importance of Exchange rate Forecasting  Various Risk involved in Forex Business  The various solutions towards the risks involved in Forex Exchange Market. 5.1 INTRODUCTION Foreign exchange risk, also termed as FX risk, exchange rate risk or currency risk is a financial risk that occurs when a financial deal is denominated in a currency other than that of the base currency of the company. This type of risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the reporting currency of the combined entity. The risk is that there may be an opposing movement in the exchange rate of 95 CU IDOL SELF LEARNING MATERIAL (SLM)

the denomination currency in relation to the base currency before the date when the transaction is completed (Levi, 2005). Depositors and businesses exporting or importing goods and services or making foreign investments have an exchange rate risk which can have severe financial consequences; but steps can be taken to lessen the risk. This risk frequently affects businesses that export and/or import. It also affects investors making international investments. Many financial reports signified that financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk FOREX-Management of exposure risks. Foreign Exchange Exposure is a measure of the potential change in a firm's profitability; net cash flow and /or market value of net assets due to a change in exchange rates. 5.2 FOREIGN EXCHANGE RISK - MEANING Foreign Exchange Exposure refers to the risk associated with the foreign exchange rates that change frequently and can have an adverse effect on the financial transactions denominated in some foreign currency rather than the domestic currency of the company. 5.3 EXCHANGE RATE FORECASTING The foreign exchange market has changed dramatically over the past few years. The amounts traded each day in the foreign exchange market are now huge. In this increasingly challenging and competitive market, investors and traders need tools to select and analyze the right data from the vast amounts of data available to them to help them make good decisions. Corporates need to do the exchange rate forecasting for taking decisions regarding hedging, short-term financing, short- term investment, capital budgeting, earnings assessments and long-term financing. Techniques of Exchange Rate Forecasting: There are numerous methods available for forecasting exchange rates. They can be categorized into four general groups- technical, fundamental, market-based and mixed. Technical Forecasting: It involves the use of historical data to predict future values. For example time series models. Speculators may find the models useful for predicting day-to- day movements. However, since the models typically focus on the near future and rarely provide point or range estimates, they are of limited use to MNCs. Fundamental Forecasting: It is based on the fundamental relationships between economic variables and exchange rates. For example subjective assessments, quantitative measurements based on regression models and sensitivity analyses. 96 CU IDOL SELF LEARNING MATERIAL (SLM)

In general, fundamental forecasting is limited by:  the uncertain timing of the impact of the factors,  the need to forecast factors that have an immediate impact on exchange rates,  the omission of factors that are not easily quantifiable and  changes in the sensitivity of currency movements to each factor over time. Market-Based Forecasting: It uses market indicators to develop forecasts. The current spot/forward rates are often used, since speculators will ensure that the current rates reflect the market expectation of the future exchange rate. Mixed Forecasting: It refers to the use of a combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts developed. 5.4 EXCHANGE RATE DETERMINATION An exchange rate is, simply, the price of one nation’s currency in terms of another currency, often termed the reference currency. For example, the rupee/dollar exchange rate is just the number of rupee that one dollar will buy. If a dollar will buy 100 rupees, the exchange rate would be expressed as ` 100/$ and the rupee would be the reference currency. Equivalently, the dollar/ rupee exchange rate is the number of dollars one rupee will buy. Continuing the previous example, the exchange rate would be $0.01/Rs (1/100) and the dollar would now be the reference currency. Exchange rates can be for spot or forward delivery. The foreign exchange market includes both the spot and forward exchange rates. The spot rate is the rate paid for delivery within two business days after the day the transaction takes place. If the rate is quoted for delivery of foreign currency at some future date, it is called the forward rate. In the forward rate, the exchange rate is established at the time of the contract, though payment and delivery are not required until maturity. Forward rates are usually quoted for fixed periods of 30, 60, 90 or 180 days from the day of the contract. The Spot Market: The most common way of stating a foreign exchange quotation is in terms of the number of units of foreign currency needed to buy one unit of home currency. Thus, India quotes its exchange rates in terms of the amount of rupees that can be exchanged for one unit of foreign currency. Illustration If the Indian rupee is the home currency and the foreign currency is the US Dollar then what is the exchange rate between the rupee and the US dollar? 97 CU IDOL SELF LEARNING MATERIAL (SLM)

Solution US$ 0.0217/`1 reads \"0.0217 US dollar per rupee.\" This means that for one Indian rupee one can buy 0.0217 US dollar. In this method, known as the European terms, the rate is quoted in terms of the number of units of the foreign currency for one unit of the domestic currency. This is called an indirect quote. The alternative method, called the American terms, expresses the home currency price of one unit of the foreign currency. This is called a direct quote. This means the exchange rate between the US dollar and rupee can be expressed as: ` 46.08/US$ reads \"` 46.08 per US dollar.\" Hence, a relationship between US dollar and rupee can be expressed in two different ways which have the same meaning: One can buy 0.0217 US dollars for one Indian rupee. ` 46.08 Indian rupees are needed to buy one US dollar. The Forward Market: A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the currency at some future date. They agree to transact a specific amount of currency at a specific rate at a specified future date. The forward exchange rate is set and agreed by the parties and remains fixed for the contract period regardless of the fluctuations in the spot exchange rates in future. The forward exchange transactions can be understood by an example. A US exporter of computer peripherals might sell computer peripherals to a German importer with immediate delivery but not require payment for 60 days. The German importer has an obligation to pay the required dollars in 60 days, so he may enter into a contract with a trader (typically a local banker) to deliver Euros for dollars in 60 days at a forward rate – the rate today for future delivery. So, a forward exchange contract implies a forward delivery at specified future date of one currency for a specified amount of another currency. The exchange rate is agreed today, though the actual transactions of buying and selling will take place on the specified date only. The forward rate is not the same as the spot exchange rate that will prevail in future. The actual spot rate that may prevail on the specified date is not known today and only the forward rate for that day is known. The actual spot rate on that day will depend upon the supply and demand forces on that day. The actual spot rate on that day may be lower or higher than the forward rate agreed today. 98 CU IDOL SELF LEARNING MATERIAL (SLM)

An Indian exporter of goods to London could enter into a forward contract with his banker to sell pound sterling 90 days from now. This contract can also be described as a contract to purchase Indian Rupees in exchange for delivery of pound sterling. In other words, foreign exchange markets are the only markets where barter happens – i.e., money is delivered in exchange for money! 5.5 FOREIGN EXCHANGE EXPOSURE “An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose magnitude is not certain at the moment. The magnitude depends on the value of variables such as Foreign Exchange rates and Interest rates.” In other words, exposure refers to those parts of a company’s business that would be affected if exchange rate changes. Foreign exchange exposures arise from many different activities. For example, travelers going to visit another country have the risk that if that country's currency appreciates against their own their trip will be more expensive. An exporter who sells his product in foreign currency has the risk that if the value of that foreign currency falls then the revenues in the exporter's home currency will be lower. An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate thereby making the local currency cost greater than expected. Fund Managers and companies who own foreign assets are exposed to fall in the currencies where they own the assets. This is because if they were to sell those assets their exchange rate would have a negative effect on the home currency value. 99 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 5.1 Moment in time when exchange rate changes a. Transaction Exposure It measures the effect of an exchange rate change on outstanding obligations that existe8d before exchange rates changed but were settled after the exchange rate changes. Thus, it deals with cash flows that result from existing contractual obligations. Example: If an Indian exporter has a receivable of $100,000 due in six months hence and if the dollar depreciates relative, to the rupee a cash loss occurs. Conversely, if the dollar appreciates relative to the rupee, a cash gain occurs. The above example illustrates that whenever a firm has foreign currency denominated receivables or payables, it is subject to transaction exposure and their settlements will affect the firm’s cash flow position. It measures the changes in the value of outstanding financial obligation incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. In fact, the transaction exposures are the most common ones amongst all the exposures. Let’s take an example of a company which exports to US and the export receivables are also denominated in USD. While doing budgeting the company had assumed USD/INR rate of ` 62 per USD. By the time the exchange inward remittance arrives. USD/INR could move 100 CU IDOL SELF LEARNING MATERIAL (SLM)