INTRODUCTION

RISK IN FOREIGN EXCHANGE MARKET

1.1. PURPOSE

This document sets out the minimum policies and procedures that each financial institution needs to have in place and apply within its foreign exchange risk management programme, and the minimum criteria it should use to prudently manage and control its exposure to foreign exchange risk. Foreign exchange risk management must be conducted in the context of a comprehensive business plan. Although this document focuses on the responsibility of an institution for managing foreign exchange risk, it is not meant to imply that foreign exchange risk management can be conducted in isolation from other risks or asset/liability management considerations, such as the paramount need to maintain adequate liquidity.

1.2. DEFINITION

Foreign exchange risk is the exposure of an institution to the potential impact of movements in foreign exchange rates. The risk is that adverse fluctuations in exchange rates may result in a loss in Jamaican dollar terms to the institution. Foreign exchange risk arises from two factors: currency mismatches in an institutions assets and liabilities (both on- and off-balance sheet) that are not subject to a fixed exchange rate vis-a-vis the Jamaican dollar, and currency cash flow mismatches. Such risk continues until the foreign exchange position is covered. This risk may arise from a variety of sources such as foreign currency retail accounts and retail cash transactions and services, foreign exchange trading, investments denominated in foreign currencies and
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investments in foreign companies. The amount at risk is a function of the magnitude of potential exchange rate changes and the size and duration of the foreign currency exposure.

1.3. FOREIGN EXCHANGE RISK MANAGEMENT PROGRAMME Managing foreign exchange risk is a fundamental component in the safe and sound management of all institutions that have exposures in foreign currencies. It involves prudently managing foreign currency positions in order to control, within set parameters, the impact of changes in exchange rates on the financial position of the institution. The frequency and direction of rate changes, the extent of the foreign currency exposure and the ability of counterparts to honour their obligations to the institution are significant factors in foreign exchange risk management. Although the particulars of foreign exchange risk management will differ among institutions depending upon the nature and complexity of their foreign exchange activities, a comprehensive foreign exchange risk management programme requires: establishing and implementing sound and prudent foreign exchange risk management policies; and developing and implementing appropriate and effective foreign exchange risk management and control procedures.

2.1 FOREIGN EXCHANGE RISK MANAGEMENT POLICIES Well articulated policies, setting forth the objectives of the institutions foreign exchange risk management strategy and the parameters within which this strategy is to be controlled, are the focal point of effective and prudent foreign exchange risk management. These policies need to include: a statement of risk principles and objectives governing the extent to which the institution is willing to assume foreign exchange risk; explicit and prudent limits on the institutions exposure to foreign

exchange risk; and clearly defined levels of delegation of trading authorities.

2.2 STATEMENT OF FOREIGN EXCHANGE RISK PRINCIPLES AND OBJECTIVES

Before foreign exchange risk limits and management controls can be set it is necessary for an institution to decide the objectives of its foreign exchange risk management programme and in particular its willingness to assume risk. The tolerance of each institution to assume foreign exchange risk will vary with the extent of other risks (e.g. liquidity, credit risk, interest rate risk, investment risk and the institutions ability to absorb potential losses. As with other aspects of financial management, a trade-off exists between risk and return. Although the avoidance of foreign currency exposure or the hedging of such exposure may eliminate foreign exchange risk, such a position may not be desirable for other sound business reasons. Accordingly, the objective of foreign exchange risk management need not necessarily be the complete elimination of exposure to changes in exchange rates. Rather, it should be to manage the impact of exchange rate changes within self imposed limits after careful consideration of a range of possible foreign exchange rate scenarios.
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2.3 FOREIGN EXCHANGE RISK LIMITS Each institution needs to establish explicit and prudent foreign exchange limits, and ensure that the level of its foreign exchange risk exposure does not exceed these limits. Where applicable, these limits need to cover, at a minimum: the currencies in which the institution is permitted to incur exposure; and the level of foreign currency exposure that the institution is prepared to assume. Foreign exchange risk limits need to be set within an institutions overall risk profile, which reflects factors such as its capital adequacy, liquidity, credit quality, investment risk and interest rate risk. Foreign exchange positions should be managed within an institutions ability to quickly cover such positions if necessary. Moreover, foreign exchange risk limits needs to be reassessed on a regular basis to reflect potential changes in exchange rate volatility, the institutions overall risk philosophy and risk profile. Authorised currencies will normally include currencies in which the institution may be called on to settle foreign exchange transactions. These are usually the currencies in business. Limits on an institutions foreign exchange exposure should reflect both the specific foreign currency exposures that arise from daily foreign currency dealing or trading activities (transactional positions) and those exposures that arise from an institutions overall asset/liability infrastructure, both on- and offbalance sheet (structural or translational positions). The establishment of which the institution or its customers conduct

aggregate foreign exchange limits that reflect both foreign currency dealing and structural positions helps to ensure that the size and composition of both
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positions are appropriately and prudently managed and controlled and do not overextend an institutions overall foreign exchange exposure. Usually, risk limits are established in terms of a relationship between the foreign exchange position and earnings or capital, or in terms of foreign

exchange volume, such as total dollars or numbers of transactions. Although the overall assessment of foreign exchange counterparties is an integral component of any foreign exchange operation, this may be conducted by an institutions credit risk management function, thus obviating the need for separate counterparty assessment within the institutions foreign exchange operations.

2.4 DELEGATION OF AUTHORITY Clearly defined levels of delegated authority help to ensure that an institutions foreign exchange positions do not exceed the limits established under its foreign exchange risk management policies. Authorities may be absolute, incremental or a combination thereof, and may also be individual, pooled, or shared within a committee. The delegation of authority needs to be clearly documented, and must include at a minimum, the absolute and/or incremental authority being delegated; the units, individuals, positions or committees to whom authority is being delegated; the ability of recipients to further delegate authority; and the restrictions, if any, placed on the use of delegated authority. The extent to which authority is delegated will vary among institutions according to a number of factors including: the institutions foreign exchange risk philosophy; the size and nature of an institutions foreign exchange operations; and

 the experience and ability of the individuals for carrying out the foreign exchange risk management activities.

3.1 FOREIGN EXCHANGE RISK MANAGEMENT AND CONTROL PROCEDURES

Each institution engaged in foreign exchange activities is responsible for developing, implementing and overseeing procedures to manage and control foreign exchange risk in accordance with its foreign exchange risk management policies. These procedures must be at a level of sophistication commensurate with the size, frequency and complexity of the institutions foreign exchange activities. Foreign exchange risk management procedures need to include, at a minimum: accounting and management information systems to measure and monitor foreign exchange positions, foreign exchange risk and foreign exchange gains or losses; controls governing the management of foreign currency activities; and independent inspections or audits.

3.2 MEASUREMENT OF FOREIGN EXCHANGE RISK Managing foreign exchange risk requires a clear understanding of the amount at risk and the impact of changes in exchange rates on this foreign currency exposure. To make these determinations, sufficient information must be readily available to permit appropriate action to be taken within acceptable, often very short, time periods. It is only through the accurate and timely recording and reporting of information on exchange transactions and currency transfers that foreign currency exposure can be measured and foreign exchange risk controlled. Accordingly, each institution engaged in foreign exchange activities needs to have an effective accounting and management information system in place that accurately and frequently records and measures: its foreign exchange exposure; and the impact of potential exchange rate changes on the institution.
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At a minimum, each institution should have in place monitoring and reporting techniques that measure: the net spot and forward positions in each currency or pairings of currencies in which the institution is authorised to have exposure; the aggregate net spot and forward positions in all currencies; and transactional and translational gains and losses relating to trading and structural foreign exchange activities and exposures.

3.3 CONTROL OF FOREIGN EXCHANGE ACTIVITIES

Although the controls over foreign activities will vary among institutions depending upon the nature and extent of their foreign exchange activities, the key elements of any foreign exchange control programme are well-defined procedures governing: organizational controls to ensure that there exists a clear and effective segregation of duties between those persons who; controls to ensure that foreign exchange activities are monitored frequently against the institutions foreign exchange risk, counterparty and other limits and that excesses are reported.

3.4 INDEPENDENT INSPECTIONS/AUDITS Independent inspections/audits are a key element in managing and controlling an institutions foreign exchange risk management programme. Each institution should use them to ensure compliance with, and the integrity of, the foreign exchange policies and procedures. Independent inspections/audits should, at a
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minimum, and over a reasonable period of time, test the institutions foreign exchange risk management activities in order to: ensure foreign exchange management policies and procedures are being adhered to; ensure effective management controls over foreign exchange positions; verify the adequacy and accuracy of management information reports regarding the institutions foreign exchange risk management activities; ensure that foreign exchange hedging activities are consistent with the institutions foreign exchange risk management policies, strategies and procedures; and ensure that personnel involved in foreign exchange risk management are provided with accurate and complete information about the institutions foreign exchange risk policies and risk limits and positions and have the expertise required to make effective decisions consistent with the foreign exchange risk management policies.

4.1 EXCHANGE RATE DYNAMICS & CURRENCY FACTORS: Top 5 Factors Affecting Exchange Rates

1. Interest Rates "Benchmark" interest rates from central banks influence the retail rates financial institutions charge customers to borrow money. For instance, if the economy is under-performing, central banks may lower interest rates to make it cheaper to borrow; this often boosts consumer spending, which may help expand the economy. To slow the rate of inflation in an overheated economy, central banks raise the benchmark so borrowing is more expensive. Interest rates are of particular concern to investors seeking a balance between yield returns and safety of funds. When interest rates go up, so do yields for assets denominated in that currency; this leads to increased demand by investors and causes an increase in the value of the currency in question. If interest rates go down, this may lead to a flight from that currency to another.

2. Employment Outlook Employment levels have an immediate impact on economic growth. Asunemployment increases, consumer spending falls because jobless workers have less money to spend on non-essentials. Those still employed worry for the future and also tend to reduce spending and save more of their income. An increase in unemployment signals a slowdown in the economy and possible devaluation of a country's currency because of declining confidence and lower demand. If demand continues to decline, the currency supply builds and further exchange rate depreciation is likely. One of the most anticipated employment reports is the U.S. Non-Farm Payroll (NFP), a reliable indicator of U.S. employmentissued the first Friday of every month.
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3. Economic Growth Expectations To meet the needs of a growing population, an economy must expand. However, if growth occurs too rapidly, price increases will outpace wage advances so that even if workers earn more on average, their actual buying power decreases. Most countries target economic growth at a rate of about 2% per year. With higher growth comes higher inflation, and in this situation central banks typically raise interest rates to increase the cost of borrowing in an attempt to slow spending within the economy. A change in interest rates may signal a change in currency rates. Deflation is the opposite of inflation; it occurs during times of recession and is a sign of economic stagnation. Central banks often lower interest rates to boost consumer spending in hopes of reversing this trend.

4. Trade Balance A country's balance of trade is the total value of its exports, minus the total value of its imports. If this number is positive, the country is said to have a favorable balance of trade. If the difference is negative, the country has a trade gap, or tradedeficit. Trade balance impacts supply and demand for a currency. When a country has a trade surplus, demand for its currency increases because foreign buyers must exchange more of their home currency in order to buy its goods. A trade deficit, on the other hand, increases the supply of a countrys currency and could lead to devaluation if supply greatly exceeds demand. 5. Central Bank Actions With interest rates in several major economies already very low (and set to stay that way for the time being), central bank and government officials are
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now resorting to other, less commonly used measures to directly intervene in the market and influence economic growth. For example, quantitative easing is being used to increase the money supply within an economy. It involves the purchase of government bonds and other assets from financial institutions to provide the banking system with additional liquidity. Quantitative easing is considered a last resort when the more typical responselowering interest ratesfails to boost the economy. It comes with some risk: increasing the supply of a currency could result in a devaluation of the currency.

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5.1 RISKS IN FOREIGN EXCHANGE TRADING Forex Currency trading is quite a lucrative option to gain huge profits but there are risks involved too, which a trader needs to understand well before jumping into forex trading. While trading in forex, investors come across various types of risks in foreign exchange trading. The four main types of risks involved in foreign exchange trading are defined below.

1. Exchange Rate Risk : The exchange rate risks in forex trading arise due to the continuous ongoing supply and demand balance shift in the worldwide forex market. A position is a subject of all the price changes as long as it is outstanding. In order to cut short these exchange rate risks and to have profitable positions, the trading should be done within manageable limits. The common steps are the position limit and the loss limit. The limits are a function of the policy of the banks along with the skills of the traders and their specific areas of expertise. There are two types of position limits daylight and overnight. The daylight position limit establishes the maximum amount of a certain currency which a trader is allowed to carry at any single time during. The limit should reflect both the trader's level of trading skills and the amount at which a trader peaks. Whereas, the overnight position limit which should be smaller than daylight limits refers to any outstanding position kept overnight by traders. te position and loss limits can now be implemented more conveniently with the help of computerized systems which enable the treasurer and the chief trader to have continuous, instantaneous, and comprehensive access to accurate figures for all the positions and the profit and loss.

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2. Interest Rate Risk: The interest rate risks in foreign exchange trading are related to the currency swaps, futures, forward out rights and options in foreign currency exchange trading. The interest rate risks are those foreign exchange trading risks which refer to the profit and loss generated by both the fluctuations occurred in the forward spreads and by forward amount mismatches and maturity gaps among various transactions in the forex book. The mismatch amount is the difference between the spot and the forward amounts. On a daily basis, traders balance the net payments and receipts for each currency through a special type of swap, called tomorrow or rollover. Limits of the total size of mismatches are set up by the management to minimize interest rate risks in forex trading. However, different banks have different policies to cut back the losses. However, the most common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. Then all the transactions are put into computerized systems to calculate the positions for all the delivery dates and the profit and loss. There is a continuous analysis of the interest rate environment necessary to forecast any changes that may affect the outstanding gaps.

3. Credit Risk: Other kinds of risks involved in foreign exchange trading are credit risks. These are associated with the probability that an outstanding currency position might not be repaid as agreed upon because of a voluntary or involuntary action by the other party. In such a case, the forex trading occurs on regulated exchanges, where all trades are settled by the learning house. In these types of forex exchanges, the investors of all sizes can deal without any credit concern. The following forms of credit risk are known. There are two types of credit risks in foreign exchange trading, the Replacement risk and the settlement risk.

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4. Country Risk: The country risks in forex trading are arise in case of there are a party is unable to receive an expected amount of payment because of the government interference in the matters of insolvency of an individual bank or institution. The country foreign exchange trading risks are linked to the interference of government in forex markets. It falls under the joint responsibility of the treasurer and the credit department. The government control on foreign exchange activities is still present and implemented actively. For the investors, it is important to know or how to be able to anticipate any restrictive changes concerning the free flow of currencies.

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6.1

MAJOR

PARTICIPANTS

IN

THE

FOREIGN

EXCHANGE

MARKET Market Makers. Commercial and/or investment banks are the market makers in the foreign exchange market. The prices they quote are the rates of exchange between currencies. These rates provide market users with indications of the latest prices on offer from various market makers. Banks acting as market makers are willing to take on currency risk and will usually be involved in currency trading and speculation.

Brokers. Brokers in the foreign exchange market do not quote their own rates of exchange. Rather, they rely on the rates quoted by market makers to other market participants. The broker will not reveal the name of the party making the price until a positive commitment has been made and the trade concluded. The broker receives commission or brokerage for the service provided.

Central Authorities. Central authorities intervene in the foreign exchange market to implement monetary policies of governments. This intervention is usually to smooth out fluctuations in the domestic currency which they consider unrealistic or unfavourable by buying or selling the domestic currency. Alternatively, they can use domestic market intervention to influence the exchange rate, i.e. vary domestic interest rates to bring about changes in the level of the exchange rate.

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 International Corporations. Corporate users of the foreign exchange market normally participate in the market as part of their involvement in international trade. Their involvement may take the form of the exchange of currencies to facilitate trade, or as a result of trade, or alternatively to hedge currency exposures that arise in relation to trade.

6.2 FOREIGN EXCHANGE POSITIONS The position of a dealing operation refers to the net balance maintained in foreign currencies. More specifically, a net exchange position in a given currency is the difference between all cash inflows (purchases) and outflows (sales) in that currency totalled for all maturity dates. Net long/overbought position arises when inflows are larger than outflows for a given currency, i.e. the purchases exceed sales. Net short/oversold position arises when outflows exceed inflows of a currency, i.e. sales exceed purchases. If inflows = outflows then a square or flat position exists, i.e. no net position. The key point about net exchange positions is that they involve exposure to exchange rate movements. Hence, the profitability of the net position will be dictated by changes in exchange rates. Long position is when dealers take a long position in a currency if they expect it to appreciate in value relative to other currencies. Short position is when dealers expecting a depreciation in a particular currency relative to other currencies, take a short position in that currency.

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7.1 FOREIGN CURRENCY TRADING The global foreign exchange market is a 24-hour market moving with the sun from Tokyo to London to New York and then, at the beginning of the next day, around to Tokyo again. Consequently, foreign exchange trading is continuous.10This adds to the risk a Canadian FIfaces from a mismatched foreign exchange position if it does not monitor that position in real time after its daily close of business in Canada. Foreign Exchange Trading Activities An FIs position in the foreign exchange markets generally reflects four trading activities. 1. The purchase and sale of foreign currencies to allow customers to partake in andcomplete international commercial trade and other business transactions. 2. The purchase and sale of foreign currencies to allow customers (or the FI itself) totake positions in foreign real and financial investments. 3. The purchase and sale of foreign currencies for hedging purposes to offset customer (or FI) exposure in any given currency. 4. The purchase and sale of foreign currencies for speculative purposes through forecasting or anticipating future movements in foreign exchange rates.In the first two activities, the FI normally acts for a fee as an agent of its customers and does not assume the foreign exchange risk itself. In the third activity, the FI acts defensively as a hedger to reduce foreign exchange exposure. Thus, risk exposure most seriously relates to the fourth activity, the FIs taking open positions as a principal for speculative purposes. It usually does this by taking an unhedged position in a foreign currency in its foreign exchange trading with other FIs.
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7.2 MEASURING THE POTENTIAL LOSS AMOUNT DUE TO MARKET RISK As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use Value at Risk. The conventions of using Value at risk is well established and accepted in the short-term risk management practice. However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant. The Variance Covariance and Historical Simulation approach to

calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress. In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.

1. Travel Expenses and Payments

Whenever travel for pleasure or business occurs, local currency must be exchanged for foreign currency. During the time period of travel, the possibility always exists that the value of the original transaction will depreciate due to
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changes in the exchange rate. In most cases, this cannot be avoided because the amounts that have been exchanged are relatively small and the time frames for usage are short term. 2. International Investments

Investments in foreign countries are subject to foreign exchange market risk. Whenever investments are made by the residents of one country in the markets of another country involving such items as real estate, factories, bonds and stock, the foreign exchange conversion risk is always present and cannot be determined until the investment is liquidated and proceeds from the sale are converted back into domestic funds. 3. Foreign Trade

Importers and exporters of goods and services between different countries are subject to market value exchange rate risk. For example, a German importer of machinery parts who buys goods from the U.S. may experience a loss in value if the rate of the U.S.dollar increases relative to the euro at the time that he must pay for his purchase in U.S dollars. 4.Economic Changes

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Foreign exchange market risks are often brought about by changes in the economic structure of a country. When the demand for a currency is greater than its supply, the exchange rate will increase and visa versa when the demand is less than its supply. The demand and exchange rate for a currency is affected by issues such as inflation, business cycles, central bank policies, stock market prices, tax laws and political developments. These types of changes can occur rapidly, which increase the risks of holding foreign currency or contractually agreeing to pay a certain sum of foreign currency in the future.

5. Hedging Foreign Exchange Risk

Large foreign currency amounts or transactions should be hedged in order to reduce the amount of risk assumed. The most common and inexpensive tool used is the foreign exchange forward transaction. This type of transaction is typically purchased by importers and exporters who must pay amounts in foreign currencies on a fixed day. For example, if an importer in the U.S must pay 1 million euros to an exporter in Germany on October 1 for goods that he purchased on June 1, he will want to know how much the 1 million euros is worth in dollars on June 1. Assuming that the 1 million euros on June 1 is worth $1.4 million, the U.S. importer can purchase a forward exchange contract due on Oct 1 that will guarantee him a payment of $1.4 million to one million euros. This transaction will guarantee that he will not suffer a loss

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7.3 RISK AND TURNOVER IN THE FOREIGN Exchange MarketThe foreign exchange market is the largest and fastestgrowing financial market in the world. Yet the microstructure of the foreign exchange market is only now receiving serious attention. As described in table 1.1, daily turnover in the foreign exchange market was $880 billion as of April 1992. To put these numbers in perspective, consider the following data: as of 1992, daily U.S. GNP was $22 billion; daily worldwide exports amounted to $13 billion; the stock of central bank reserves totaled $1,035 billion, barely more than one day's worth of trading. The volume of trading can also be compared to that of the busiest stock exchange, the New York Stock Exchange (NYSE), about $5 billion daily,1 or to that of the busiest bond market, the U.S. Treasury market, about $143 billion daily (Federal Reserve Monthly Review [April 1992]). Since the advent of flexible exchange rates in the early 1970s, the foreign exchange market has been growing at a record rate. Figure 1.1 compares the volume of world exports to the volume of trading in deutsche mark (DM) currency futures, both expressed on a daily basis. I use futures volume because futures markets provide the only reliable source of daily volume information even if they account for only a small fraction of the foreign exchange market. The figure shows that, since the early 1970s, trading in deutsche mark futures has increased much faster than the volume of world trade. This reflects the overall growth in the foreign exchange market, where turnover has increased from $110 billion in 1983 to $880 billion in 1992. Because transaction volume is many times greater than the volume of trade flows, it cannot be ascribed to the servicing of international trade.

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8.1 SETTLEMENT RISK IN FOREIGN EXCHANGE MARKETS The collapse of Herstatt highlighted the fact that major disruptions can arise out of the risk exposures involved in the traditional method of settling foreign exchange. These exposures come about because settlement typically takes place in the countries of issue of each currency, so that the separate legs of a foreign exchange transaction are settled independently and in many cases at significantly different times. A market survey conducted by central banks in 1995 found that there was commonly a lag of at least one or two business days between the time when a party to a foreign exchange transaction can no longer cancel unilaterally a payment instruction for the currency it sells and the time when the currency purchased has been received with finality (CPSS (1996)). In addition, the survey found that it could take a further one or two business days for a bank to establish with certainty whether it had received payment. Hence, more than three days plus any intervening holidays and weekends could elapse before the bank knew with certainty that it had received the currency it had bought. One key problem was that the major payment systems used to transfer largevalue funds between banks did not operate to a daily timetable that permitted simultaneous or near simultaneous settlement of the currencies. There was limited overlap in the operating hours between time zones. Moreover, many of these payment systems were designed in such a way that final settlement of each days payments took place at a single point in time, namely the end of the systems operating day. In 1996, the G10 central banks set out a three-track strategy to reduce the systemic risk associated with foreign exchange settlement. The strategy comprised action by individual banks to control their foreign
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exchangesettlement exposures, action by industry groups to provide riskreducing multicurrency services and action by central banks to induce rapid private sector progress (CPSS (1996)). Subsequently, two complementary approaches were followed to reduce settlement risk. The first approach aimed to shorten the duration of settlement exposures. One way in which this was achieved was through improved measurement and management of exposures by individual banks. In addition, improvements in high-value payment systems increased the potential for a closer alignment of settlement timings. Intraday final settlement was introduced more widely, through the adoption of real-time gross settlement (RTGS) systems. RTGS systems process and settle payments on an item by item basis in real time during the systems operating hours. These operating hours were extended in the 1990s, increasing the overlap between time zones (Graph 1). The second approach focused on reducing the settlement flows between counterparties associated with the original trades. This was achieved mainly by private sector initiatives to develop bilateral and multilateral arrangements for the netting of foreign exchange transactions accompanied by legislative changes to recognise netting arrangements. In bilateral netting arrangements, such as FXNET, trades are netted by counterparty pair each day, resulting in netting arrangement, ECHO, also operated for a few years in the 1990s. Amounts owed among ECHO members were netted each day through a clearing house, resulting in one payment per member per currency to or from the clearing house. Multilateral netting reduced the settlement flows to which it was applied by an estimated 70%, compared with 50% for bilateral netting (CPSS (1998)). While these various measures reduced either the size or the duration of settlement exposures and certainly reduced liquidity pressures, they did not achieve simultaneous finality of received payments. Hence, all these initiatives contributed to a decrease in settlement risk but did not eliminate it.
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9.1 FOREIGN EXCHANGE MARKETS IN INDIA A BRIEF BACKGROUND The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade 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 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 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 momentous. In the last 5 years, from 2000-01 to 200506, trading volume in the foreign exchange market (including swaps, forwards and forward cancellations) has more 3 than tripled, growing at a compounded annual rate exceeding 25%. growth of foreign exchange trading in India between 1999 and 2006. The inter-bank forex trading volume has continued to account for the dominant share (over 77%) of total trading over this period, though there is an unmistakable downward trend in that proportion. (Part of this

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dominance, though, results from double-counting since purchase and sales are added separately, and a single inter-bank transaction leads to a purchase as well as a sales entry.) This is in keeping with global patterns

9.2 FEATURES OF THE FORWARD PREMIUM ON THE INDIAN RUPEE The Indian rupee has had an active forward market for some time now. The forward premium or discount on the rupee (vis--vis the US dollar, for instance) reflects the markets beliefs about future changes in its value. The strength of the relationship of this forward premium with the interest rate differential between India and the US the Covered Interest Parity (CIP) condition gives us a measure of Indias integration with global markets. The CIP is a no-arbitrage relationship that ensures that one cannot borrow in a country, convert to and lend in another currency, insure the returns in the original currency by selling his anticipated proceeds in the forward market and make profits without risk through this process. Chakrabarti (2006) reports that between late 1997 and mid-2004 the average discount on the rupee was about 4% per annum. During the period the average difference between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was about 4.5% for 3-months and 3.5% for the 6-months period. With these two figures in the same ballpark (particularly given that bank deposit rates and inter-bank rates are not strictly comparable), annual averages of interest rate differences and the forward exchange premium also indicate a moderate degree of co-movement between the two variables. The interest rate differential explains about 20% of the total variation in the forward discount. The deviation of the Indian rupee-US dollar from the covered interest parity, however, exhibits long-lived swings on both sides of the zero line. This would indicate arbitrage opportunities and
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market imperfections provided we could be sure of the comparability of the interest rates considered. Therefore, while the behavior of the forward premium on the Indian rupee is broadly in lines with the CIP, more careful empirical analysis involving directly comparable interest rates is necessary to measure the strength of the covered interest parity condition and the efficiency of the foreign exchange market. Under market efficiency, the forward exchange rate is considered to be an unbiased predictor of the future spot rate, with random prediction errors. While the prediction errors of forward rates on the rupee appear to show some degree of persistence, any conclusion in this matter too must await more rigorous analysis

9.3 INTERVENTION IN FOREIGN EXCHANGE MARKETS The two main functions of the foreign exchange market are to determine the price of the different currencies in terms of one another and to transfer currency risk from more risk-averse participants to those more willing to bear it. 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. However, since the value of a countrys currency has significant bearing on its economy, foreign exchange markets frequently witness government intervention in one form or another, to maintain the value of a currency at or near its desired level. Interventions can range from quantitative restrictions on trade and cross-border transfer of capital to periodic trades by the central bank of the country or its allies and agents so as to move the exchange rate in the desired direction. In recent years India has witnessed both kinds of intervention though liberalization has implied a long-term policy push to reduce and ultimately
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remove the former kind. It is safe to say that over the years since liberalization, India has allowed restricted capital mobility and followed a managed float type exchange rate policy. During the early years of liberalization, the Rangarajan committee recommended that Indias exchange rate be flexible. Officially speaking, India moved from a fixed exchange rate regime to market determined exchange rate system in 1993. The overt objective of Indias exchange rate policy, according to various policy pronouncements, has been to manage volatility in exchange rates without targeting any specific levels. This has been hard to do in practice.The Indian rupee has had a remarkably stable relationship with the US dollar. Meanwhile the dollar appreciated against major currencies in the late 90s and then went into an extended decline particularly during 2003 and 2004. The lock-step pattern of the US dollar and the Rupee is best reflected in the movements in the two currencies against a third currency like the Euro. The correlation of the exchange rates of the two currencies against the Euro during 1999-2004 was 0.94. Several studies have established the pegged nature of the rupee in recent years (see Chakrabarti (2006) for a more detailed discussion). Based on volatility, India had a de facto crawling peg to the US dollar between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995, with a major devaluation in March 1993. From mid-1995 to end-2001, the rupee reverted to a crawling peg arrangement in practice. An analysis of the ratio of the variance of the exchange rate to the sum of the variances of the interest rate and the foreign exchange reserves reveals a move even closer to the fixed exchange rate system. A comparison of the sensitivity (beta) of the Dollar-rupee rate with the Eurorupee rate for a three year period (1999 through 2001), indicates that India had a dollar beta of 1.01 tenth highest among the 53 countries considered. More importantly, the US dollar-Euro exchange rate explained about 97% of all
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movements in the Indian rupee-Euro exchange rate highestamong all the 53 countries considered. Clearly the Indian rupee has been an excellent tracker of the US dollar.

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10. THE DYNAMICS OF SWELLING RESERVES An important corollary of Indias foreign exchange policy has been the quick and significant accumulation of foreign currency reserves in the past few years. Starting from a situation in 1990-91 with foreign exchange reserves level barely enough to cover two weeks of imports, and about $32 billion at the beginning of 2000, Indias foreign exchange position rocketed to one of the largest in the world with over $155 billion in mid-2006. Since 2000, this implies a compounded annual growth rate of about 28% with the years 2003 and 2004 having the most stunning rises at 48% and 45% respectively. During these two years the US dollar fell against the Euro by 19% and against the rupee by 9%. Without RBI intervention, the latter figure is likely to have been larger and the reserves accumulation less spectacular.A sizable foreign exchange reserve acts as liquidity cover and protects against a run on the countrys currency, and reduces the rate of interest on Indian debt in the world market by lowering the country risk perception by international rating agencies. However, beyond a point, it begins to affect the money supply in the country, and interest rates. There are significant sterilization costs to avoid this and the RBI loses money by earning low returns on the safe assets used to park the reserves. Given this low rate of return, there has been discussion about the unique proposal to use part of the reserves to fund infrastructure projects.

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11.OUTLOOK Liberalization has transformed Indias external sector and a direct beneficiary of this has been the foreign exchange market in India. From a foreign exchangestarved, control-ridden economy, India has moved on to a position of $150 billion plus in international reserves with a confident rupee and drastically reduced foreign exchangecontrol. As foreign trade and cross-border capital flows continue to grow, and the country moves towards capital account convertibility, the foreign exchange market is poised to play an even greater role in the economy, but is unlikely to be completely free of RBI interventions any time soon

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12. REFERENCES Bank for International Settlements, 2005a. Triennial Central Bank Survey: Foreign exchange and derivatives market activity in 2004, Basel, Switzerland. Bank for International Settlements, 2005b. Foreign exchange market intervention in emerging markets: motives, techniques and implications, BIS Paper No.24, Basel, Switzerland. Chakrabarti, Rajesh, 2006. The Financial Sector In India: Emerging Issues, Oxford University Press, New Delhi, 2006. Ghosh, Soumya Kanti, 2002. RBI Intervention in the Forex Market: Results from a Tobit and Logit Model Using Daily Data, Economic and Political Weekly, June 15, pp.2333-2348. Williamson, John, 2006, Why Capital account Convertibility in India is Premature, Economic and Political Weekly, May 13, pp.1848-1850.

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