PRESENTED BY STUDENTS OF T.Y.B.

Com(A&F)
Name of the student Roll. No Signature

Sanjay Acharya

01

Priya Lambda

36

Priyanka Sureka

54

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ACKNOWLEDGEMENT
We are thankful to our economics professor Shri Oberoi for giving us an opportunity to present our economics project, in Foreign Exchange Market of India. The project enlightened our horizons about the foreign exchange and debt market of India. Our work on the project helped us gaining valuable information about internal debt, foreign exchange instrument and many vital aspects. It will not only help us now but also keep us updated in the near future. We also thank our group members for their constructive contribution in the project.

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INDEX
SR.NO CONTENTS 1 Introd Introduction Foreign Exchange Foreign Exchange Market Market Size and Liquidity 2 3 Exchange rate systems Exchange Rate Gold Standard System Bretton Woods System Smithsonian Agreement Current Exchange Rates Foreign exchange transaction Working of An FX transaction Determination of Contract rate Market Types 6 Spot Market 14-16 8 9-11 PG.NO 5-7

4 5

12 13

Forward and Futures Market Market Participants Government and Central Banks Banks and other financial institutions Hedgers Speculators

17-18

8 9 10 11

Understanding the FOREX jargon Exchange Rate Determinants Foreign Exchange Market Risk Indian foreign exchange market

19-22 23-25 26-28 29

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12 13 14 15 16 17 18 19 20 21 22 23 24

Foreign trade How is foreign trade different from domestic trade? Methods of payment in international trade FERA & FEMA Role of government in foreign exchange market Role of central bank in foreign exchange market Role of FEDAI in foreign exchange market Present status of foreign exchange market External debt Indias External debt as at the end of march 2011 Conclusion Abbreviation Bibliography

30 31 32-33 34-38 39 40 41 42-43 44-46 47-48 49 50 51

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INTRODUCTION
Foreign exchange Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's currency is valued according to factors of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value also may be fixed by the country's government. However, most countries float their currencies freely against those of other countries, which keep them in constant fluctuation. The value of any particular currency is determined by market forces based on trade, investment, tourism, and geo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of his or her home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency. Another important factor of demand occurs when a foreign company seeks to do business with a company in a specific country. Usually, the foreign company will have to pay the local company in their local currency. At other times, it may be desirable for an investor from one country to invest in another, and that investment would have to be made in the local currency as well. All of these requirements produce a need for foreign exchange and are the reasons why foreign exchange markets are so large.

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Foreign exchange market The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business' income is in US dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of: Its huge trading volume representing the largest asset class in the world leading to high liquidity; Its geographical dispersion; Its continuous operation: 24 hours a day except weekends, i.e. Trading from 20:15 gmt on Sunday until 22:00 gmt Friday; The variety of factors that affect exchange rates; The low margins of relative profit compared with other markets of fixed income; and The use of leverage to enhance profit and loss margins and with respect to account size.

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As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion. The $3.98 trillion break-down is as follows: $1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion Currency swaps $207 billion in options and other products

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MARKET SIZE AND LIQUIDITY

Main foreign exchange market turnover, 19882007, measured in billions of USD. The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (v/s $1.7 trillion in 1998). Of this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other currency derivatives. Trading in the UK accounted for 36.7% of the total, making UK by far the most important global center for foreign exchange trading. In second and third places, respectively, trading in the USA accounted for 17.9%, and Japan accounted for 6.2%.

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EXCHANGE RATE SYSTEMS

Exchange rate In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

In the retail currency exchange market, the actual buying rate and selling rate quoted by money dealers will usually be different. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. Most trades are to or from the local currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as traveller's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document; while the cash is available for resale immediately. There are variations in the quoted buying and selling rates for a currency, and these variations can be significant. For example, consumer exchange rates used by Visa and MasterCard offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com. This study, which examined the U.S. dollar-to-Euro exchange rates provided by the major worldwide credit card networks, 15 of the largest consumer banks in the U.S., and Travelex, showed that the credit card networks save travelers about 8% relative to banks and roughly 15% relative to airport companies.

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Exchange Rate systems Gold Standard System The creation of the Gold standard monetary system in 1875 marks one of the most important events in the history of the forex market. Before the gold standard was implemented, countries would commonly use gold and silver as means of international payment. The main issue with using gold and silver for payment is that their value is affected by external supply and demand. For example, the discovery of a new gold mine would drive gold prices down. The underlying idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency would be backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for currency exchanges. During the late nineteenth century, all of the major economic countries had defined an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first standardized means of currency exchange in history. The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the excess currency that the governments were printing off. Although the gold standard would make a small comeback during the inter-war years, most countries had dropped it again by the onset of World War II. However, gold never ceased being the ultimate form of monetary value.

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Bretton Woods System Before the end of World War II, the Allied nations believed that there would be a need to set up a monetary system in order to fill the void that was left behind when the gold standard system was abandoned. In July 1944, more than 700 representatives from the Allies convened at Bretton Woods, New Hampshire, to deliberate over what would be called the Bretton Woods system of international monetary management. To simplify, Bretton Woods led to the formation of the following: A method of fixed exchange rates; The U.S. dollar replacing the gold standard to become a primary reserve currency; and The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT). One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main Standard of convertibility for the worlds currencies; and furthermore, the U.S. dollar became the only currency that would be backed by gold. (This turned out to be the primary reason that Bretton Woods eventually failed.) Over the next 25 or so years, the U.S. had to run a series of balance of payment deficits in order to be the worlds reserved currency. By the early 1970s, U.S. gold reserves were so depleted that the U.S. treasury did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve. Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, and the U.S. announced to the world that it would no longer exchange gold for the U.S. dollars that were held in foreign reserves. This event marked the end of Bretton Woods. Even though Bretton Woods didnt last, it left an important legacy that still has a significant effect on todays international economic climate. This legacy exists in the form of the three international agencies created in the 1940s: the IMF, the International Bank for Reconstruction and Development (now part of the World Bank) and GATT, the precursor to the World Trade Organization.

Smithsonian Agreement The Smithsonian Agreement was a December 1971 agreement that ended the fixed exchange rates established at the Bretton Woods Conference of 1944.

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CURRENT EXCHANGE RATES

After the Bretton Woods system broke down, the world finally accepted the use of floating foreign exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold standard would be permanently abolished. However, this is not to say that governments adopted a pure freefloating exchange rate system. Most governments employ one of the following three exchange rate systems that are still used today: Dollarization; Pegged rate; and Managed floating rate.

Dollarization This event occurs when a country decides not to issue its own currency and adopts a foreign currency as its national currency. Although dollarization usually enables a country to be seen as a more stable place for investment, the drawback is that the countrys central bank can no longer print money or make any sort of monetary policy. An example of dollarization is El Salvador's use of the U.S. dollar. Pegged Rates Or Fixed Exchange Rate System Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the country will have somewhat more stability than a normal float. More specifically, pegging allows a countrys currency to be exchanged at a fixed rate with a single or a specific basket of foreign currencies. The currency will only fluctuate when the pegged currencies change. For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997 and July 21, 2005. The downside to pegging would be that a currencys value is at the mercy of the pegged currencys economic situation. For example, if the U.S. dollar appreciates substantially against all other currencies, the yuan would also appreciate, which may not be what the Chinese central bank wants. Managed Floating Rates This type of system is created when a currencys exchange rate is allowed to freely change in value subject to the market forces of supply and demand. However, the government or central bank may intervene to stabilize extreme fluctuations in exchange rates. For example, if a countrys currency is depreciating far beyond an acceptable level, the government can raise short-term interest rates. Raising rates should cause the currency to appreciate slightly; but understand that this is a very simplified example. Central banks typically employ a number of tools to manage currency.

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FOREIGN EXCHANGE TRANSACTION

An FX transaction may be useful in managing the currency risk associated with importing or exporting goods and services denominated in foreign currency, investing or borrowing overseas, repatriating profits, converting foreign currency denominated dividends, or settling other foreign currency contractual arrangements. Working of an FX transaction When you enter into an FX transaction, you nominate the amount (the contract amount) and the two currencies to be exchanged. These currencies are known as the currency pair and must be acceptable to your foreign exchange provider. You also nominate the maturity date on which you want the exchange of currencies to take place. Your FX provider will then determine the exchange rate, known as the contract rate, based on the date and currencies nominated by you. The contract rate is the rate at which the currencies will be exchanged. On the contract date the contract amount must be exchanged with your FX provider at the contract rate, irrespective of where the foreign exchange rate is at the time. Determination of Contract Rate It is the agreed exchange rate at which the currency pair will be exchanged on the date of maturity. Your currency provider determines the contract rate, taking several factors into account including: the currency pair and the time zone you choose to trade in the maturity date set by you inter-bank spot foreign exchange rates the contract amount, and your currency providers ability to trade small amounts on the interbank market market volatility Inter-bank interest rates of the countries of the currency pair. Contract rates are quoted as spot exchange rates, value today exchange rates, value tomorrow exchange rates, or forward exchange rates, depending on the maturity date nominated by you.

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MARKET TYPES
Spot Market and the Forwards and Futures Markets There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

What is the spot market? More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another. When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement. What are the forwards and futures markets? Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement. In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves. Futures market This is a derivative contract in which the quantity, rate and date of a future purchase is agreed upon 14 | P a g e

today for a given asset. At this pre-decided date, the buyer of the futures contract gets the delivery of the pre-decided quantity of the given asset at the pre-decided price. Similarly, the seller of the futures contract gives the delivery of the pre-decided quantity of the given asset at the pre-decided price. In a futures contract, both the buyer and seller are bound to honour their commitment the buyer has to take delivery, and the seller has to make delivery according to the terms of the contract. Thus, even if the price of the asset goes down, the buyer has to get the asset from the seller at the pre-decided price. And even if the price goes up, the seller has to give the seller at the pre-decided price. There is no upfront cost involved in the purchase of a futures contract, apart from brokerage. Example: A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price is Rs. 3200 and the expiry date is 3 months away. Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would deliver 200 shares of Reliance Industries to B at Rs. 3200. Options As the name suggests, here, the buyer has an option to take delivery of the asset, and not the obligation. Thus, if the market price of the asset goes up, and buyer of an option would exercise the option and get profits. But if the market price of the asset goes down, the buyer of the option would not exercise it, and would allow the option to lapse. Thus, Options are more flexible for the buyers compared to futures. But the seller of the option has the obligation to deliver the assets if the buyer chooses to exercise the option. In case of options, the pre-decided price for the exchange of asset is called the Strike Price. One thing to remember though is that in reality, not many people actually exercise their options people do not actually exchange the asset at the time of exercise. Since the options are traded in the market, instead of exercising them, the buyers just sell them in the market. The logic behind this when an option is in the money (that is, when it becomes profitable for the buyer), its option premium or the price goes up. So, one can sell it and make profit instead of exercising it. This is easier, and therefore is done by most people. American and European Options The options are of two types American and European. In American options, the option can be exercised any time upto the settlement date. In European options, the option can be exercised only on the settlement date. Thus, American options are much more flexible (In India, only American options are traded).

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Cost There is a cost involved for options the buyer of the option has to pay the seller an Option Premium, which is the fee the option seller (also called the Option Writer) gets in return for the one-sided guarantee he extends to the buyer. Since the option writer assumes the risk of the price movement, this fee is well justified. Example: A writes the option of Reliance Industries stock to B. Quantity is 200 shares, strike price is Rs. 3200 and the expiry date is 3 months away. The option premium is Rs. 25.

Now, during these 3 months, say the price of Reliance Industries stock goes up to Rs. 3400. In this case, B would exercise the option, and would get the shares at Rs. 3200 from A. Thus, B would make a profit of Rs. 3400 Rs. 3200 Rs. 25 (Option premium) = Rs. 175. Similarly, A would make a loss of Rs. 175. But if the price of Reliance Industries stock remains less than Rs. 3200 for the 3 month duration, B 16 | P a g e

would not exercise the option. In this case, the option buyer B would make a loss equal to the option premium Rs. 25 in this case, and the option writer would make a profit equal to the option premium Rs. 25.

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MARKET PARTICIPANTS
Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the forex market. Governments and Central Banks Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy. Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets. Banks and Other Financial Institutions In addition to central banks and governments, some of the largest participants involved with forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market. The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers. The smaller the bank, the less credit relationships it has and the lower the priority it has on the pricing scale. Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.

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Hedgers Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies. If there is one thing that management (and shareholders) detests, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more euros at the time of delivery. One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need. Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction. For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts. Speculators Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels. The most famous of all currency speculators is probably George Soros. The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson, a derivatives trader with Englands Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the company. Some of the largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that employ unconventional investment strategies in order to reap large returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a central banker. Given that they can place such massive bets, they can have a major effect on a countrys currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness of Asian central bankers. Either way, speculators can have a big sway on the currency markets, particularly big ones. Now that you have a basic understanding of the forex market, its participants and its history, we can move on to some of the more advanced concepts that will bring you closer to being able to trade within this massive market. The next section will look at the main economic theories that underlie the forex market. 19 | P a g e

UNDERSTANDING THE FOREX JARGON

Reading a Quote When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen. The forex quote includes the currency abbreviations for the currencies in question. Direct Currency Quote vs. Indirect Currency Quote There are two ways to quote a currency pair, either directly or indirectly. A direct currency quote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit. For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which means with C$1, you can purchase US$0.85. The indirect quote for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that USD$1 will purchase C$1.18. In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. In these cases, it is called a direct quote. This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen. However, not all currencies have the U.S. dollar as the base. The Queen's currencies those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro, which is relatively new, is quoted the same way as well. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect quote. This is why the EUR/USD quote is given as 1.25, for example, because it means that one euro is the equivalent of 1.25 U.S. dollars. Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places. 20 | P a g e

Cross Currency When a currency quote is given without the U.S. dollar as one of its components, this is called a cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the forex market, but it is important to note that they do not have as much of a following (for example, not as actively traded) as pairs that include the U.S. dollar, which also are called the majors. Bid and Ask As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency. The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency. The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the ask price. Let's look at an example:

If you want to buy this currency pair, this means that you intend to buy the base currency and are therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars. However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency, you would look at the bid price. It tells you that the market will buy US$1 base currency (you will be selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars, which is the quoted currency. Whichever currency is quoted first (the base currency) is always the one in which the transaction is being conducted. You either buy or sell the base currency. Depending on what currency you want to use to buy or sell the base with, you refer to the corresponding currency pair spot exchange rate to determine the price.

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Spreads and Pips The difference between the bid price and the ask price is called a spread. If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points. Although these movements may seem insignificant, even the smallest point change can result in thousands of dollars being made or lost due to leverage. Again, this is one of the reasons that speculators are so attracted to the forex market; even the tiniest price movement can result in huge profit. The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day. Currency Quote Overview USD/CAD = 1.2232/37 Base Currency Quote/Counter Currency Bid Price Currency to the left (USD) Currency to the right (CAD) Price for which the market maker will buy the base currency. Bid is always smaller than ask. Price for which the market maker will sell the base currency.

1.2232

Ask Price

1.2237

Pip

One point move, in USD/CAD it is . The pip/point is the smallest 0001 and 1 point change would be movement a price can make. from 1.2231 to 1.2232 Spread in this case is 5 pips/points; difference between bid and ask price (1.2237-1.2232).

Spread

Currency Pairs in the Forwards and Futures Markets One of the key technical differences between the forex markets is the way currencies are quoted. In the forwards or futures markets, foreign exchange always is quoted against the U.S. dollar. This means that pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other currency. Remember that in the spot market some currencies are quoted against the U.S. dollar, while for others, the U.S. dollar is being quoted against them. As such, the forwards/futures market and the spot market quotes will not always be parallel one another. For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD. 22 | P a g e

This is the same way it would be quoted in the forwards and futures markets. Thus, when the British pound strengthens against the U.S. dollar in the spot market, it will also rise in the forwards and futures markets. On the other hand, when looking at the exchange rate for the U.S. dollar and the Japanese yen, the former is quoted against the latter. In the spot market, the quote would be 115 for example, which means that one U.S. dollar would buy 115 Japanese yen. In the futures market, it would be quoted as (1/115) or .0087, which means that 1 Japanese yen would buy .0087 U.S. dollars. As such, a rise in the USD/JPY spot rate would equate to a decline in the JPY futures rate because the U.S. dollar would have strengthened against the Japanese yen and therefore one Japanese yen would buy less U.S. dollars.

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EXCHANGE RATE DETERMINANTS

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government): International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world. Balance of payments model : This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit. Asset market model : Views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology. Economic factors These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators. Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates). 24 | P a g e

Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency. Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency. Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation. Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be. Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector. Political conditions Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency. Market psychology Market psychology and trader perceptions influence the foreign exchange market in a variety of ways: Flights to quality: Unsettling international events can lead to a "flight to quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty. Long-term trends: Currency markets often move in visible long-term trends. Although currencies do 25 | P a g e

not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices. Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight. Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

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FOREIGN EXCHANGE MARKET RISK

What are the different risks associated with foreign exchange that an individual or corporate is exposed to? A part from the fluctuations in the rate of exchange, there are many other risks to which a person/corporate dealing in foreign exchange is exposed to. We could broadly categorize them as under Transaction risk Position risk Credit risk Maturity mismatch Country risks Frauds Operational risks

Transaction Risk The risk is inherent in all foreign currency transaction. These could be Trading items-like trade receivables and payables in foreign currencies. Capital item-foreign currency loans, dividend and interest payment in foreign currency, equipment purchase designated in foreign currency. Let us assume that a company has to receive US$10000 for goods which it has exported after a month. If in means while the US$ depreciates, the company would receive much less than what it had planned for. Control Aspects: The transaction risk is controlled by helping, which is, by covering the risks involved by buying a suitable forex product like forward contract, LTFC, or other derivative Products. Position risk The banks face this type of risk. Banks deal with their customers continuously, purchasing/selling foreign exchange. This results in the creation of a position. A position risk occurs when the dealer in a bank has an overbought (long) position or an oversold (short) position. These positions are entered into deliberately in anticipation of favorable movements in the rates. This position risk, also called open position risk, in inevitable for the following reasons The dealing rooms may not get reports of the purchases/sales of all the currency since o Smaller purchases and sales are not reported.

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o Larger deals may fail to get reported due to communication problems. o There could be wrong reporting Operations in the inter-bank are done in round sums, and absolutely square position (i.e. where purchase and sale of a currency is equal) are impossible to maintain as aggregate customer transactions will rarely result in marketable lots. Some imbalance may be because the bank is unable to carry out cover operations in the inter-bank market which could be due to the absence of a counter party for the same tenor and volume for a currency.

Control Aspects: The bank adopts the following internal control systems Day-light Limits or Intra-day Limit for each currency. This is the limit upto which the dealer himself can deal can deal himself without reference to higher authorities. For example, if the bank has fixed a day-light limit of US$10 million, it means that the dealer can purchase and sell dollars as long as the balance outstanding at any given point of time is less than US$10 million. Overnight Limits: The extent to which the currency position can be kept open at the end of the day. Normally the overnight limits are much lower than the day-light limits. These limits are for individual currency. Apart this you have aggregate limits on foreign exchange position for all the currencies put together. Cut-Loss Limits: This is fixed to restrict loss due to adverse movement in the exchange rates.

Credits Risks Credit risk is the risk of failure of the counterparty to the contract. Credit risk can be classified: Pre-settlement risk: in this case the failure of the counterparty is known to the bank even before it (bank) executes its part of the contract. Thus a bank, is exposed to risk if on the due date the customers does not take delivery of the currency, whereas its own obligation under the forward purchase contract, which it must have booked position, must be fulfilled. The loss to the bank has to cover the gap arising from the non-performance of the counter party. Settlement risk: This rises when the bank has fulfilled its part in the contract but the counterparty does not. The loss in the case is not only the exchange differences but the entire fund that has been deployed. Settlement risk arises due to time differences at different centers.

Control Aspects: The risk is controlled by fixing counterparty limits, both of the bank and the Merchant customers.

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Maturity Mismatch Risk The risk arise son account of the maturity period of purchase and sale contracts not coinciding or matching. There could any number of reasons for mismatch Under a forward contract the customer may exercise the opinion of taking delivery or giving delivery, but the cover contract with the market will be at some other date. Non-availability of a matching forward contract of same tenor and volume. Small value merchants contracts mat not aggregate to round sums for which cover is available in the market.

The mismatches may be covered with a swap deal. But risks involved may be high. Control Aspects: At monthly intervals the purchase and the sales are aggregated maturity-wise and the net balance is arrived at, and permissible gap limits are stipulated, which limits are fixed for individual currency. Cumulative gap limits are stipulated for all maturities for each currency and also for all currencies. This, to a certain extent, controls the risk due mismatches. Country Risk This is also known as the sovereign risk or transfer risk. This relates to the ability of the country to service its external liabilities. It refers to the possibility of government or borrowers defaulting for reasons which are beyond the usual credit risk. Control aspects: the country risk analysis is made taking into consideration political, economical and social situations prevailing in the country, and a limit for the exposure to that country is fixed. 29 | P a g e

Frauds Frauds may be indulged in by the dealers or operational staff for personal gains or for covering up genuine mistakes committed earlier. Frauds could also be committed by the dealer putting through the transaction for his own benefits without routing them through banks book. Control aspects: Regular follow up of deal slips and contract confirmation. Surprise checks, inspections and on going auditing. Separation of dealings and back offices. Proper maintenance of up-to-date records of currency position, exchange position and counter party registers.

Operational risks This covers all other types of risks which are not categorized above. These include inadvertent mistakes in rates, double reporting, and wrong applications of funds. These may creep in due to human error or deficient administration. Control aspects: Regular follow up of deal slips and contract confirmation. Surprise checks, inspections and on going auditing. Separation of dealings and back offices. Proper maintenance of up-to-date records of currency position, exchange position and counter party registers.

INDIAN FOREIGN EXCHANGE MARKET

The Indian foreign exchange (forex) market consists of the buyers, sellers, market intermediaries and the monetary authority of India. The main center of foreign exchange transactions in India is Mumbai, the commercial capital of the country. There are several other centers for foreign exchange transactions in the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin. In past, due to lack of communication facilities all these markets were not linked. But with the development of technologies, all the foreign exchange markets of India are working collectively. The foreign exchange market India is regulated by the reserve bank of India through the Exchange Control Department. At the same time, Foreign Exchange Dealers Association (voluntary association) also provides some help in regulating the market. The Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate in the foreign Exchange market in India. When the foreign exchange trade is going on between Authorized Dealers and RBI or between the Authorized Dealers and the Overseas banks, the brokers have no role to play. Apart from the Authorized Dealers and brokers, there are some others who are provided with the 30 | P a g e

restricted rights to accept the foreign currency or travelers cheque. Among these, there are authorized money changers, travel agents, certain hotels and government shops. The whole foreign exchange market in India is regulated by the Foreign Exchange Management Act, 1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign Exchange Regulation Act, 1947. After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the economic and industrial development, the need for conservation of foreign currency was felt and on the recommendation of the Public Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act became famous as FEMA.

FOREIGN TRADE
Foreign trade can be considered a number of different things, depending on the type of trade one is talking about. Generally speaking, foreign trade means trading goods and services that are destined for a country other than their country of origin. Foreign trade can also be investing in foreign securities, though this is a less common use of the term. Foreign trade is all about imports and exports. The backbone of any foreign trade between nations is those products and services which are being traded to some other location outside a particular country's borders. Some nations are adept at producing certain products at a cost-effective price. Perhaps it is because they have the labor supply or abundant natural resources which make up the raw materials needed. No matter what the reason, the ability of some nations to produce what other nations want is what makes foreign trade work. In some cases, the products produced in a foreign trade situation are very similar to other products being produced around the world, at least in their raw form. Therefore, these products, known as commodities, are often pooled together in one mass market and sold. This is called trading commodities. The most common commodities often sold in foreign trade are oil and grain.

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FOREIGN TRADE: DIFFERENT FROM DOMESTIC TRADE

The following are the major differences between domestic trade and foreign trade:Mobility in Factor Of Production Domestic Trade: Free to move around factors of production like land, labor, capital and labor capital and entrepreneurship from one state to another within the same country International Trade: Quite restricted Movement of goods Domestic trade: easier to move goods without many restrictions. Maybe need to pay sales tax, etc. International Trade: Restricted due to complicated custom procedures and trade barriers like tariff, quotas or embargo

Usage of different currencies Domestic trade: same type of currency used International trade: different countries used different currencies Broader markets Domestic trade: limited market due to limits in population, etc International trade: Broader markets

Language And Cultural Barriers Domestic trade: speak same language and practice same culture International trade: Communication challenges due to language and cultural barriers

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METHODS OF PAYMENT IN INTERNATIONAL TRADE

There are 3 standard ways of payment methods in the export import trade international trade market:

Clean Payment Collection of Bills Letters of Credit L/c

Clean Payments

In clean payment method, all shipping documents, including title documents are handled directly between the trading partners. The role of banks is limited to clearing amounts as required. Clean payment method offers a relatively cheap and uncomplicated method of payment for both importers and exporters. There are basically two types of clean payments: Advance Payment In advance payment method the exporter is trusted to ship the goods after receiving payment from the importer. Open Account In open account method the importer is trusted to pay the exporter after receipt of goods. The main drawback of open account method is that exporter assumes all the risks while the importer get the advantage over the delay use of company's cash resources and is also not responsible for the risk associated with goods.

Payment Collection of Bills in International Trade

The Payment Collection of Bills also called Uniform Rules for Collections is published by International Chamber of Commerce (ICC) under the document number 522 (URC522) and is followed by more than 90% of the world's banks. In this method of payment in international trade the exporter entrusts the handling of commercial and often financial documents to banks and gives the banks necessary instructions concerning the release of these documents to the Importer. It is considered to be one of the cost effective methods of evidencing a transaction for buyers, where documents are manipulated via the banking system. There are two methods of collections of bill: Documents Against Payment D/P In this case documents are released to the importer only when the payment has been done. 34 | P a g e

Documents Against Acceptance D/A In this case documents are released to the importer only against acceptance of a draft.

Letter of Credit L/c

Letter of Credit also known as Documentary Credit is a written undertaking by the importers bank known as the issuing bank on behalf of its customer, the importer (applicant), promising to effect payment in favor of the exporter (beneficiary) up to a stated sum of money, within a prescribed time limit and against stipulated documents. It is published by the International Chamber of Commerce under the provision of Uniform Custom and Practices (UCP) brochure number 500. Various types of L/Cs are: Revocable & Irrevocable Letter of Credit (L/c) A Revocable Letter of Credit can be cancelled without the consent of the exporter. An Irrevocable Letter of Credit cannot be cancelled or amended without the consent of all parties including the exporter. Sight & Time Letter of Credit If payment is to be made at the time of presenting the document then it is referred as the Sight Letter of Credit. In this case banks are allowed to take the necessary time required to check the documents. If payment is to be made after the lapse of a particular time period as stated in the draft then it is referred as the Term Letter of Credit. Confirmed Letter of Credit (L/c) Under a Confirmed Letter of Credit, a bank, called the Confirming Bank, adds its commitment to that of the issuing bank. By adding its commitment, the Confirming Bank takes the responsibility of claim under the letter of credit, assuming all terms and conditions of the letter of credit are met.

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FERA AND FEMA

In India, all transactions that include foreign exchange were regulated by Foreign Exchange Regulations Act (FERA),1973. The main objective of FERA was conservation and proper utilization of the foreign exchange resources of the country. It also sought to control certain aspects of the conduct of business outside the country by Indian companies and in India by foreign companies. It was a criminal legislation which meant that its violation would lead to imprisonment and payment of heavy fine. It had many restrictive clauses which deterred foreign investments. In the light of economic reforms and the liberalized scenario, FERA was replaced by a new Act called the Foreign Exchange Management Act (FEMA),1999.The Act applies to all branches, offices and agencies outside India, owned or controlled by a person resident in India. FEMA emerged as an investor friendly legislation which is purely a civil legislation in the sense that its violation implies only payment of monetary penalties and fines. However, under it, a person will be liable to civil imprisonment only if he does not pay the prescribed fine within 90 days from the date of notice but that too happens after formalities of show cause notice and personal hearing. FEMA also provides for a two year sunset clause for offences committed under FERA which may be taken as the transition period granted for moving from one 'harsh' law to the other 'industry friendly' legislation. Broadly, the objectives of FEMA are: (i) To facilitate external trade and payments; and (ii) To promote the orderly development and maintenance of foreign exchange market. The Act has assigned an important role to the Reserve Bank of India (RBI) in the administration of FEMA. The rules, regulations and norms pertaining to several sections of the Act are laid down by the Reserve Bank of India, in consultation with the Central Government. The Act requires the Central Government to appoint as many officers of the Central Government as Adjudicating Authorities for holding inquiries pertaining to contravention of the Act. There is also a provision for appointing one or more Special Directors (Appeals) to hear appeals against the order of the Adjudicating authorities. The Central Government also establishes an Appellate Tribunal for Foreign Exchange to hear appeals against the orders of the Adjudicating Authorities and the Special Director (Appeals). The FEMA provides for the establishment, by the Central Government, of a Director of Enforcement with a Director and such other officers or class of officers as it thinks fit for taking up for investigation of the contraventions under this Act. FEMA permits only authorized person to deal in foreign exchange or foreign security. Such an authorized person, under the Act, means authorized dealer, money changer, off-shore banking unit or any other person for the time being authorized by Reserve Bank. The Act thus prohibits any person who: Deal in or transfer any foreign exchange or foreign security to any person not being an authorized person; Make any payment to or for the credit of any person resident outside India in any manner; Receive otherwise through an authorized person, any payment by order or on behalf of any 36 | P a g e

person resident outside India in any manner; Enter into any financial transaction in India as consideration for or in association with acquisition or creation or transfer of a right to acquire, any asset outside India by any person is resident in India which acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India. The Act deals with two types of foreign exchange transactions.

Capital account transactions Capital account transaction is defined as a transaction which: Alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India. In other words, it includes those transactions which are undertaken by a resident of India such that his/her assets or liabilities outside India are altered (either increased or decreased). For example: - (i) a resident of India acquires an immovable property outside India or acquires shares of a foreign company. This way his/her overseas assets are increased; or (ii) a resident of India borrows from a non-resident through External commercial Borrowings (ECBs). This way he/she has created a liability outside India. Alters the assets or liabilities in India of persons resident outside the India. In other words, it includes those transactions which are undertaken by a non-resident such that his/her assets or liabilities in India are altered (either increased or decreased). For example, (i) a non-resident acquires immovable property in India or acquires shares of an Indian company or invest in a Wholly Owned Subsidiary or a Joint Venture with a resident of India. This way his/her assets in India are increased; or (ii) a non-resident borrows from Indian housing finance institute for acquiring a house in India. This way he/she has created a liability in India.

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The Act also contains a list of some of the most common capital account transactions: Transfer or issue of any foreign security by a person resident in India; Transfer or issue of any security by a person resident outside India; Transfer or issue of any security or foreign security by any branch, office or agency in India of a person resident outside India; Any borrowing or lending in rupees in whatever form or by whatever name called; Any borrowing or lending in rupees in whatever form or by whatever name called between a person resident in India and a person resident outside India; Deposits between persons resident in India and persons resident outside India; Export, import or holding of currency or currency notes; Transfer of immovable property outside India, other than a lease not exceeding five years, by a person resident in India; Acquisition or transfer of immovable property in India, other than a lease not exceeding five years, by a person resident outside India; Giving of a guarantee or surety in respect of any debt, obligation or other liability incurred(i) By a person resident in India and owed to a person resident outside India; or (ii) By a person resident outside India. The Act has empowered the Reserve Bank of India (RBI) to specify, in consultation with the Central Government, the permissible capital account transactions and the limits upto which foreign exchange may be drawn for these transactions. But it shall not impose any restriction on the drawal of foreign exchange for payments due on account of amortization of loans or for depreciation of direct investments in the ordinary course of business. The permitted capital account transactions have been classified into two categories:Capital account transactions by persons resident in India includes, Investment in foreign securities; Foreign currency loans raised in India and abroad; Acquisition and transfer of immovable property outside India; Guarantees issued in favor of a person resident outside India; Export, import and holding of currency or currency notes; Loans and overdrafts (borrowings) from a person resident outside India; Maintenance of foreign currency accounts in India and outside India; Taking out the insurance policy from an insurance company outside India; Remittance outside India of capital assets of a person resident in India; Sale and purchase of foreign exchange derivatives in India and abroad and commodity derivatives abroad.

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Capital account transactions by non- residents includes, Investment in India such as (i) issue of security by a body corporate or an entity in India and investment therein by a non-resident and (ii) investment by way of contribution to the capital of a firm or a proprietary concern or an association of persons in India; Acquisition and transfer of immovable property in India; Guarantee in favor of, or on behalf of, a person resident in India; Import and export of currency/currency notes into/from India; Deposits between a person resident in India and a person resident outside India; Foreign currency accounts in India of a non-resident Remittance of the assets in India held by a non-resident.

There are generally two types of prohibitions on capital account transactions: General Prohibition:- A person shall not undertake or sell or draw foreign exchange to or from an authorized person for any capital account transaction. This prohibition is subjected to the conditions specified by Reserve Bank in its circulars and notifications. For example, Reserve Bank of India has issued an AP (DIR) Circular, wherein a resident individual can draw from an authorized person foreign exchange up to US$ 25,000 per calendar year for a capital account transaction specified in Schedule I to the Notification. Special Prohibition:- A nonresident person shall not make investment in India in any form, in any company or partnership firm or proprietary concern or any entity, whether incorporated or not, which is engaged or proposes to engage:- (i) in the business of chit fund, or (ii) as Nidhi Company, or (iii) in agricultural or plantation activities or (iv) in real estate business, or construction of farm houses or (v) in trading in Transferable Development Rights (TDRs).

Current account transactions The Act defines the term 'current account transaction' as a transaction other than a capital account transaction and without prejudice to the generality of the foregoing such transaction includes, Payments due in connection with Foreign trade, Other current business Services, and Short-term banking and credit facilities in the ordinary course of business; Payments due as Interest on loans and Net income from investments, Remittances for living expenses of parents, spouse and children residing abroad, and 39 | P a g e

expenses in connection with foreign travel, education and medical care of parents, spouse and children. In the above definition, the words without prejudice to the generality of the foregoing such transaction includes imply that even if the transactions listed above may fit into the definition of capital account transactions, such transactions shall be treated current account transactions. For example, resident of India imports goods from outside India on a short term credit (for a period of less than 6 months), he is creating a liability outside India and thus, it can be treated a capital account transaction but, it is specifically included in the above definition as a current account transaction. As a general rule, any person may sell or draw foreign exchange if such sale or drawal is a current account transaction. Under the Act, Central Government may, in public interest and in consultation with the Reserve Bank, impose such reasonable restrictions for current account transactions as may be prescribed. Accordingly, the Central Government has issued the Foreign Exchange Management (Current Account Transaction) Rules, 2000. It contains the list of current account transactions for which drawal of foreign exchange is:

Totally prohibited; Permitted, subject to the prior approval of concerned Ministry, Central Government; Permitted, subject to prior approval of the Reserve Bank of India; No restrictions or limits are applicable for undertaking the transactions that are not covered by the above rules and the authorized dealers are free to release foreign exchange upon the satisfaction that the transactions will not involve and is not designed for the purpose of, violation of the Act, or any rules, regulations made there under.

In today's changed scenario, Indian rupee has become fully convertible so far as current account transactions are concerned. This implies that foreign exchange is freely available to the residents for remittance on account of current account transactions for the various purposes like foreign travel, foreign education, and medical treatment abroad etc. The non residents are also freely allowed to remit outside India the income or capital gain generated in India. But, even today, the Indian rupee, in respect of capital account transactions, is not fully convertible.

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ROLE OF GOVERNMENT IN FOREIGN EXCHANGE MARKET

To increase the constancy of Financial Institutions and Markets Government intervenes in the interest rates and money supply in the Money Markets. Government has several ways to control income and interest rates which can be divided into two broad groups such as, Fiscal policy Monetary policy

The government to adjust the exchange rate intervenes with the foreign exchange markets; there may be a result on the financial base and the supply of money. When the currency is falling, foreign currencies should be sold and the currency should be bought to steady its price. The use of deposits of the national currency to do this suggest that the prepared deposits of the banking sector must be reduced, causing the financial base to fall, affecting the supply of money. Equally by selling the national currency to decrease its rate, the monetary base will increase. Securities may be sold on the open market in an effort to dampen the effects of inflows of the national currency, but this would imply a raise in interest rates and cause the currency to rise further still. A number of institutions can affect the supply of money but the greatest impact on the money supply is had by the Reserve bank and the commercial banks.

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ROLE OF CENTRAL BANK (RBI) IN FOREIGN EXCHANGE MARKET

Firstly the central bank could do this by setting a necessary reserve ratio, which would restrict the ability of the commercial banks to increase the money supply by loaning out money. If this condition were above the ratio the commercial banks would have wished to have then the banks will have to create fewer deposits and make fewer loans then they could otherwise have profitably done. If the central bank imposed this requirement in order to reduce the money supply, the commercial banks will probably be unable to borrow from the central bank in order to increase their cash reserves if they wished to make further loans. They might try to attract further deposits from customers by raising their interest rates but the central bank may retaliate by increasing the necessary reserve ratio. The central bank can influence the supply of money through special deposits. These are deposits at the central bank which the banking sector is required to lodge. These are then frozen, thus preventing the sector from accessing them even though interest is paid at the average Treasury bill rate. Making these special deposits reduces the level of the commercial banks operational deposits which forces them to cut back on lending. The supply of money can also be prohibited by the central bank by adjusting its interest rate which it charges when the commercial banks wish to borrow money (the discount rate). Banks generally have a ratio of cash to deposits which they consider to be the minimum safe level. If command for cash is such that their reserves fall below this level they will able to borrow money from the central bank at its discount rate. If market rates were 8% and the discount rate were also 8%, then the banks might decrease their cash reserves to their minimum ratio knowing that if demand exceeds supply they will be able to borrow at 8%. The central bank, even if, may raise its discount rate to a value above the market level, in order to encourage banks not to reduce their cash reserves to the minimum during excess loans. By raising the discount value to such a level, the commercial banks are given an incentive to hold more reserves thus reducing the money multiplier and the money supply.

Another way the money supply can be affected by the central bank is through its operation of the interest rate. By raising or lowering interest rates the demand for money is respectively reduced or increased. If it sets them at a certain level it can clear the market at level by supplying sufficient money to match the demand. Alternatively it could fix the money supply at a convinced rate and let the market clear the interest rates at the balance. Trying to fix the money supply is not easy so central banks regularly set the interest rate and provide the amount of money the market demands. The central bank may also involve the money supply through operating on the open market. This allows it to influence the money supply through the financial base. It may choose to either buy or sell securities in the marketplace which will either inject or remove money respectively. Thus the monetary base will be affected causing the money supply to modify. 42 | P a g e

ROLE OF FEDAI IN FOREIGN EXCHANGE MARKET

Established in 1958, FEDAI (Foreign Exchange Dealers' Association of India) is a group of banks that deals in foreign exchange in India as a self regulatory body under the Section 25 of the Indian Company Act (1956). The role and responsibilities of FEDAI are as follows:

Formulations of FEDAI guidelines and FEDAI rules for Forex business. Training of bank personnel in the areas of Foreign Exchange Business. Accreditation of Forex Brokers. Advising/Assisting member banks in settling issues/matters in their dealings. Represent member banks on Government/Reserve Bank of India and other bodies. Rules of FEDAI also include announcement of daily and periodical rates to its member banks.

FEDAI guidelines play an important role in the functioning of the markets and work in close coordination with Reserve Bank of India (RBI), other organizations like Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex Association of India and various other market participants.

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PRESENT STATUS OF FOREIGN EXCHANGE MARKET

Global foreign exchange turnover rose in April 2011 from October 2010, driven by increasing volume across spot, forwards, swaps and options activities, according to a semiannual survey released by major central banks. A 2011 study about the current dominant reserve currency in central banks shows that dollar may not be the obvious dominant currency, because of the major part of Unallocated Reserves increasingly reported by central banks since 2001. Spot, outright forward and foreign exchange swap volumes increased by about 6 percent, 18 percent, and 3 percent, respectively, from October 2010. Trades executed on electronic systems nearly doubled at the interbank level, while also rising significantly for customer transactions.

NEW YORK: Global foreign exchange turnover rose in April 2011 from October 2010, driven by increasing volume across spot, forward, swaps and options activities, according to a semiannual survey released by major central banks. Average daily turnover in UK foreign exchange markets rose to a record $2.191 trillion in April, keeping intact Londons status as the worlds largest FX market, according to the Bank of England. The increase in UK turnover was driven by a 32 percent rise in spot transactions to $919 billion and a 19 percent increase in FX swaps to $909 billion. In North America, the average daily turnover in over-the-counter foreign exchange instruments hit a record $799 billion in April, a survey conducted by the New York Federal Reserve-sponsored Foreign Exchange Committee showed. That was a 3.5 percent increase from the last survey done in October 2010. The increase in daily volume in North America was driven by a rise in outright forward, swaps, and foreign exchange options, expanding by $13 billion, $17 billion, and $7 billion, respectively. That offsets a decline in average daily volume in spot transactions of $10 billion, the survey showed. In North American market, reported turnover in euro/dollar accounts for 31 percent, also the highest share of turnover by currency pair. The dollar kept its role as the most actively traded currency, although its share in both the UK and North American markets slipped a touch. Dollar/euro was the most traded currency pair in the UK market at 33.5 percent, although it fell slightly from October 2010. Broken down by currency pair, overall transactions for all major currencies versus the dollar rose, while turnover in the dollar and euro versus the yen decreased. A separate survey from the Singapore Foreign Exchange Market Committee showed average daily reported traditional turnover in Singapore rose 12.9 percent in the six months from October 2010 to $314 billion. The increase was largely driven by a rise in spot and FX swaps transactions. In the Japanese market, a slight rise in spot transactions helped lift average daily turnover to $284.6 billion in April from $263.6 billion in the same month last year. FX options transactions fell during the period. Japan participates in the global survey once a year, compared with twice for the other major central banks.

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The Australian market reported an average daily turnover of $219.1 billion in April, up around 12 percent from October 2010, largely due to a jump in transactions for outright forward, FX swaps and options.

In Canada, average daily turnover rose 5.9 percent to $61.2 billion in April from October. India: According to The Hindu survey, the daily average turnover in foreign exchange market in India declined around 30 per cent to $27.4 billion in April 2010 from $38.4 billion in April 2007. Interestingly, the daily average turnover in USD/INR pair in 2010 is higher at $36 billion. Since not all the trading in foreign exchange market in India is in USD/INR pair alone, it can be assumed that more than 23 per cent of the trading in the USD/INR pair takes place overseas.

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EXTERNAL DEBT
The economic development of a country may be financed either by domestic savings or by allowing and encouraging foreign investment. But, when there is a gap between domestic savings and investments and foreign direct investments are not significantly forthcoming, a country may resort to borrowing from internal or external sources. In particular, when a country runs a current account deficit on its balance of payments, to finance the deficit, it may borrow from external sources apart from encouraging foreign investments. It is normal for developing countries to run current account deficits which lead to external borrowings. India has been borrowing both from internal and external sources since Independence. The borrowings of the Government are called Public Debt. Borrowing from internal sources is referred to as internal debt whereas borrowing from external sources is called external debt. External debt (or foreign debt) is that part of the total debt in a country that is owed to creditors outside the country. The debtors can be the government, corporations or private households. The debt includes money owed to private commercial banks, other governments, or international financial institutions such as the IMF and World Bank. The growth of external debt has more serious implications than the growth of internal debt:

Internal debt may be deferred or even annulled. The same for external debt would not only affect countrys international relations but may upset further inflow of capital and disturb trade flows. Internal debt can be monetized, i.e., repaid by printing money but external debt cannot be repaid that way. Internal debt can be repaid by privatization. But selling off assets to foreigners to repay external debt may seriously harm a countrys sovereignty. Internal debt can be serviced if the return on capital invested is more than the cost of borrowing and amortization. In the case of external debt, however, this will not be adequate. In addition, the foreign exchange earnings of the country through exports or otherwise must rise in relation to external debt servicing. Thus, the complexities of issues involved in external debt are different from that of internal debt. In fact, the level of Indias external debt and debt servicing burden have steadily gone up since Independence. Simultaneously, the composition and sources of Indias external debt have undergone significant changes.

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EXTERNAL DEBT: SCOPE AND CLASSIFICATION

Indias external debt may be broadly classified under eight categories. These include multilateral, bilateral and commercial loans and cover both the Government and non-government sectors. These also comprise highly concessional loans as well as loans on market terms. Multilateral Debt This refers to loans and credits extended by multilateral organizations to the Government or, in some cases, with Government guarantee, to Public and Private sector corporate bodies. This includes long term credits (40 years) of International Development Association (IDA) and long term loans from the World Bank or the Asian Development Bank (ADB) which have market interest rates and long repayment period (15-20 years). Bilateral Loans This refers to borrowing on varying degrees of concessionality, from other governments. Such loans are given to the government and in some cases to public sector organizations. Loans from the International Monetary Fund (IMF) The IMF debt assumed significance in the early 1980s, when India resorted to withdrawals under the Extended Fund Facility (EFF)/supplementary Financing Facility (SFF) to ease out the balance of payments difficulties. Export Credit This comprises buyers credit, suppliers and export credit for defence purchases. Buyers credit and suppliers credit are treated as forms of commercial borrowing. Commercial Borrowing This includes market borrowings abroad by corporate entities and public sector undertakings and includes commercial bank loans, securitized borrowings (including India Development Bonds) and loans or securitized borrowings with multilateral or bilateral guarantees. Commercial borrowings also include loans from International Finance Corporation (IFC), Washington, and self liquidating loans.

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Non-Resident Deposits This refers to various types of Non-Resident (NR) deposits and Foreign Currency (Banks & others) Deposits with maturities of over one year.

Rupee Debt This refers to debt denomination in rupees owed to Russia (with some very small amounts owed to other East European Countries) and paid through exports. Rupee debt is broken up into a defence and a civilian component. Since March 1990, the civilian component of rupee debt has also included rupee suppliers credits.

Short-term Debt This refers to debt with a maturity period of upto one year. This is usually trade related debt. The first seven categories may be termed as long term debt. The eighth category is short term, as the very name suggests. A comprehensive definition of Indias external debt must include all these items although in different contexts external debt is defined to include only some of these categories.

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INDIAS EXTERNAL DEBT AS AT THE END OF MARCH 2011

As per the standard practice, India's external debt statistics for the quarters ending March and June are released by the Reserve Bank of India and those for the quarters ending September and December by the Ministry of Finance, Government of India. The external debt data are released with a lag of one quarter. The external debt data, as compiled in the standard format, as at end-March 2011 in Rupees and US dollar terms and revised data for the earlier quarters are set out in Statement 1 and 2. The major developments relating to Indias external debt as at end-March 2011 are presented in the following paragraphs. Major Highlights Indias external debt, as at end-March 2011, was placed at US $ 305.9 billion (17.3 per cent of GDP) recording an increase of US $ 44.9 billion or 17.2 per cent over the end-March 2010 level on account of significant increase in commercial borrowings, short-term trade credits, bilateral and multilateral borrowings. Excluding the valuation effects due to depreciation of US dollar against other major international currencies and Indian Rupee, the stock of external debt has increased by US$ 38.4 billion over the stock as at end-March 2010. The share of commercial borrowings stood highest at 28.9 per cent as at end-March 2011 followed by short-term debt (21.2 per cent), NRI deposits (16.9 per cent) and multilateral debt (15.8 per cent). The debt service ratio declined to 4.2 per cent during 2010-11 as compared to 5.5 per cent during 2009-10. Based on residual maturity, short-term debt accounted for 42.2 per cent of the total external debt as at end-March 2011. Whereas the share of short-term debt, by original maturity, was 21.2 per cent of the total external debt stock. The ratio of short-term debt to foreign exchange reserves at 21.3 per cent as at end- March 2011 was higher compared to 18.8 per cent as at end-March 2010. The US dollar accounted for 59.9 per cent of the total external debt stock as at end-March 2011 followed by Indian rupee (13.2 per cent) and Japanese Yen (11.4 per cent). Indias foreign exchange reserves provided a cover of 99.6 per cent to the external debt stock at the end of March 2011 as compared with 106.9 per cent as at end-March 2010. Indias External Debt as at end-March 2011 Indias external debt, as at end-March 2011, was placed at US$ 305.9 billion (17.3 per cent of GDP) recording an increase of US$ 44.9 billion or 17.2 per cent over the end-March 2010 level on account of significant increase in commercial borrowings, short-term trade credits, bilateral and multilateral borrowings. The long-term debt at US$ 240.9 billion and short-term debt at US$ 65.0 billion accounted for 78.8 per cent and 21.2 per cent, respectively, of the total external debt as at end-March 2011. The share of commercial borrowings continued to be highest at 28.9 per cent in the total external debt as at end-March 2011 followed by short-term debt (21.2 per cent), NRI deposits (16.9 per cent) and multilateral debt (15.8 per cent). 50 | P a g e

Valuation Changes The valuation effect reflecting the depreciation of the US dollar against other major international currencies and Indian rupee resulted in an increase in Indias external debt by US$ 6.5 billion during 2010-11. This implies that excluding the valuation effects, the stock of external debt as at end-March 2011 would have increased by US$ 38.4 billion over the level at end-March 2010. Compared with the previous quarter (end-December 2010), the valuation effect reflecting the depreciation of the US dollar against other major international currencies and Indian rupee resulted in an increase of US$ 1.3 billion in Indias external debt. This implies that excluding the valuation effects, the stock of external debt as at end-March 2011would have increased by US$ 8.7 billion over the level at end-December 2010. Currency Composition of Indias External Debt The currency composition of Indias external debt consists of major international currencies such as US Dollar, Japanese Yen, Euro, Pound Sterling, Special Drawing Rights (SDR) and the domestic currency i.e., Indian Rupee. The US Dollar denominated debt continues to be the largest with a share of 59.9 per cent in the total external debt as at end-March 2011. The share of Indian rupee in the total external debt stock accounted for 13.2 per cent as at end-March 2011 followed by Japanese Yen (11.4 per cent), and SDR (9.7 per cent). The share of Euro accounted for 3.7 per cent as at end-March 2011.

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CONCLUSION
Initially, Indian investors were not aware of different types of trading in forex like futures and derivates that could lead to more sustained profits in the long run. They are now hedging, swapping and going for options trading these days. FOREX can also be traded online these days and investors are also finding out the benefits in currency trading. Earlier, they had very few options to make money from speculative trades with commodities and stocks being the only available options. The Indian forex traders have also come to realize that a small ripple felt in a far corner of the globe can affect markets in India. We are more interconnected and no country can remain unaffected from the changes happening in the world these days. If you are planning to invest in forex trading in India, this could be the best opportunity as things have kick started and would be on a roll soon. Currencies are also interlinked and any changes in a major currency price can affect other weaker currencies of the world. Forex trading takes benefit from the rise and falls in prices of currencies.

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ABBREVIATIONS
US: United States FX: Foreign exchange USD: United States Dollar GMT: Greenwich Mean Time IMF: International Monetary Fund GATT: General Agreement on Tariffs and Trade OTC: Over the Counter CAD: Canadian Dollar GBP: Great Britain Pound RBI: Reserve Bank of India FEMA: Foreign Exchange Management Act FERA: Foreign Exchange Regulation Act ICC: International Chamber of Commerce UCP: Uniform Customs and Practices TDR: Transferable Development Rights FEDAI: Foreign Exchange Dealers Association of India FIMMDA: Fixed Income Money Market & Derivatives Association ADB: Asian Development Bank IDA: International Development Association EFF: Extended Fund Facility SFF: Supplementary Fund Facility IFC: International Finance Corporations

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BIBLIOGRAPHY
http://www.investopedia.com/university/forexmarket http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=24646 http://www.thehindubusinessline.in/bline/2010/09/25/stories/2010092551040500.htm http://en.wikipedia.org/wiki/Foreign_exchange_market http://business.gov.in/doing_business/fema.php http://business.gov.in/doing_business/cap_account_transaction.php http://business.gov.in/doing_business/current_account_transaction.php http://en.wikipedia.org/wiki/External_debt http://www.taxmanagementindia.com/wnew/detail_rss_feed.asp?id=1963 http://vedyadhara.ignou.ac.in/wiki/images/d/d8/MITI-024-B-4-Unit-17.pdf Foreign Exchange Markets, Authors Surendra S. Jadhav, P.K.Jain, Max Peyrard, PublicationMacmillan Foreign Exchange Simplified, Author: B Shrinivasan, Publication: TATA, Mc Graw- Hill Publishing Company Ltd.

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