Forex Summer Project

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Overview On FOREX Management

A PROJECT REPORT

Submitted by

Chirag Shah

Batch 2009-2011

in partial fulfillment for the award of the degree

POST GRADUATE DIPLOMA IN MANAGEMENT

Under the Guidance of

Prof Aditi Mahajan

THAKUR INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

KANDIVILI

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ACKNOWLEDGEMENT

Two months of summer training at Anugrah Stock & Broking Pvt Ltd. has been a great value addition to my career that would not have been possible without continuous guidance and administration of certain key people. I would like to place on record, my sincere gratitude to each of them.

I am grateful to Dr. Mrinalini Kohojkar, Director, Thakur Institute Of Management Studies and Research for giving me this opportunity.

I would like to express my appreciation towards Mr. Balkishan Sharma for giving me the opportunity to work on this project. I express my gratitude and indebtedness to him for guiding me in every aspect for making this effort a great success.

I sincerely thank Prof. Aditi Mahajan, Thakur Institute Of Management Studies and Research for the valuable guidance extended by them during my entire course in the preparation of this dissertation and for letting me their valuable time when ever I was in need.

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Executive Summary

This project gives an in-depth analysis and understanding of Foreign Exchange Markets in India. It helps to understand the History and the evolution of the foreign market in India.

It gives an overview of the conditions existing in the current global economy. It gives an overview of the Foreign exchange market.

It talks about the foreign exchange management act applicable and also gives details about the participants in the forex markets.

It also talks about what are the sources of demand and supply of foreign exchange in the market all over the world.

The report also talks about the Foreign Exchange trading platform and how the efficiency and the transparency is maintained.

The report focuses on corporate hedging for foreign exchange risk in India. The report contains details about some companies Foreign Exposure and how they have maintained it.

It also talks about the determinants to be taken care of while taking corporate hedging decisions. It gives insights about the Regulatory guidelines for the use of Foreign Exchange derivatives, Development of Derivatives markets in India and also the Hedging instruments for Indian firms. The report gives an in-depth analysis of the currency risk management by talking about what currency risk is, the types of currency risk – Transaction risk ,Translation risk and Economic risk. It also contains details about the companies in the index sensex and nifty showing their transaction is foreign currency like the imports, exports, Loans, Interst payments and the other expenses. It then shows the sensitivity analysis of how the currency rates impact the gains/ profits of the company.

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Foreign Exchange Market Overview

Globally, operations in the foreign exchange market started in a major way after the breakdown of the Bretton Woods system in 1971, which also marked the beginning of floating exchange rate regimes in several countries. Over the years, the foreign exchange market has emerged as the largest market in the world. The decade of the 1990s witnessed a perceptible policy shift in many emerging markets towards reorientation of their financial markets in terms of new products and instruments, development of institutional and market infrastructure and realignment of regulatory structure consistent with the liberalized operational framework. The changing contours were mirrored in a rapid expansion of foreign exchange market in terms of participants, transaction volumes, decline in transaction costs and more efficient mechanisms of risk transfer.

The origin of the foreign exchange market in India could be traced to the year 1978 when banks in India were permitted to undertake intra-day trade in foreign exchange. However, it was in the 1990s that the Indian foreign exchange market witnessed far reaching changes along with the shifts in the currency regime in India. The exchange rate of the rupee, that was pegged earlier was floated partially in March 1992 and fully in March 1993 following the recommendations of the Report of the High Level Committee on Balance of Payments (Chairman: Dr.C. Rangarajan). The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility, which was achieved in August 1994. 6.3 A further impetus to the development of the foreign exchange market in India was provided with the setting up of an Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani), which submitted its report in June 1995. The Group made several recommendations for deepening and widening of the Indian foreign exchange market. Consequently, beginning from January 1996, wide-ranging reforms have been undertaken in the Indian foreign exchange market. After almost a decade, an Internal Technical Group on the Foreign Exchange Market (2005) was constituted to undertake a comprehensive review of the measures initiated by the Reserve Bank and identify areas for further liberalization or relaxation of restrictions in a medium-term framework.

The momentous developments over the past few years are reflected in the enhanced risk-bearing capacity of banks along with rising foreign exchange trading volumes and finer margins. The foreign exchange market has acquired depth (Reddy, 2005). The conditions in the foreign exchange market have also generally remained orderly (Reddy, 2006c). While it is not possible for any country to remain completely unaffected by developments in international markets, India was able to keep the spillover effect of the Asian crisis to a minimum through constant monitoring and timely action, including recourse to strong monetary measures, when necessary, to prevent emergence of self fulfilling speculative activities

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In today’s world no economy is self sufficient, so there is need for exchange of goods and services amongst the different countries. So in this global village, unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries. So whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. So we can imagine that if all countries have the same currency then there is no need for foreign exchange.

Need for Foreign Exchange:

Let us consider a case where Indian company exports cotton fabrics to USA and invoices the goods in US dollar. The American importer will pay the amount in US dollar, as the same is his home currency. However the Indian exporter requires rupees means his home currency for procuring raw materials and for payment to the labor charges etc. Thus he would need exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then importer in USA will get his dollar converted in rupee and pay the exporter. From the above example we can infer that in case goods are bought or sold outside the country, exchange of currency is necessary. Sometimes it also happens that the transactions between two countries will be settled in the currency of third country. In that case both the countries that are transacting will require converting their respective currencies in the currency of third country. For that also the foreign exchange is required.

About foreign exchange market:

Particularly for foreign exchange market there is no market place called the foreign exchange market. It is mechanism through which one country’s currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange market does not have any geographic location. Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participant meets to execute the deals, as we see in the case of stock exchange. The largest foreign exchange market is in London, followed by the New York, Tokyo, Zurich and Frankfurt. The markets are situated throughout the different time zone of the globe in such a way that one market is closing the other is beginning its operation. Therefore it is stated that foreign exchange market is functioning throughout 24 hours a day. In most market US dollar is the vehicle currency, viz., the currency sued to dominate international transaction. In India, foreign exchange has been given a statutory definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states: Foreign exchange means foreign currency and includes:

All deposits, credits and balance payable in any foreign currency and any draft, traveler’s cheques, letter of credit and bills of exchange. Expressed or drawn in India currency but payable in any foreign currency.

Any instrument payable, at the option of drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other. In order to provide facilities to members of the public and foreigners visiting India, for exchange of foreign

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currency into Indian currency and vice-versa RBI has granted to various firms and individuals, license to undertake money-changing business at seas/airport and tourism place of tourist interest in India. Besides certain authorized dealers in foreign exchange (banks) have also been permitted to open exchange bureaus. Following are the major bifurcations:

Full fledge moneychangers – they are the firms and individuals who have been authorized to take both, purchase and sale transaction with the public.

Restricted moneychanger – they are shops, emporia and hotels etc. that have been authorized only to purchase foreign currency towards cost of goods supplied or services rendered by them or for conversion into rupees.

Authorized dealers – they are one who can undertake all types of foreign exchange transaction. Banks are only the authorized dealers. The only exceptions are Thomas cook, western union, UAE exchange which though, and not a bank is an AD. Even among the banks RBI has categorized them as follows:

Branch A – They are the branches that have Nostro and Vostro account.

Branch B – The branch that can deal in all other transaction but do not maintain Nostro and Vostro a/c’s fall under this category. For Indian we can conclude that foreign exchange refers to foreign money, which includes notes, cheques, bills of exchange, bank balance and deposits in foreign currencies.

Foreign Exchange Market: An Assessment

The continuous improvement in market infrastructure has had its impact in terms of enhanced depth, liquidity and efficiency of the foreign exchange market. The turnover in the Indian foreign exchange market has grown significantly in both the spot and derivatives segments in the recent past. Along with the increase in onshore turnover, activity in the offshore market has also assumed importance. With the gradual opening up of the capital account, the process of price discovery in the Indian foreign exchange market has improved as reflected in the bid-ask spread and forward premia behaviour.

Foreign Exchange Market Turnover

As per the Triennial Central Bank Survey by the Bank for International Settlements (BIS) on

“Foreign Exchange and Derivatives Market Activity”, global foreign exchange market activity rose markedly between 2001 and 2004 (Table 6.4). The strong growth in turnover may be attributed to two related factors. First, the presence of clear trends and higher volatility in foreign exchange markets between 2001 and 2004 led to trading momentum, where investors took large positions in currencies that followed persistent appreciating trends. Second, positive interest rate differentials encouraged the so-called “carry trading”, i.e., investments in high interest rate currencies financed by positions in low interest rate currencies. The growth in outright forwards between 2001 and 2004 reflects heightened interest in hedging. Within the EM countries, traditional foreign exchange

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trading in Asian currencies generally recorded much faster growth than the global total between 2001 and 2004. Growth rates in turnover for Chinese renminbi, Indian rupee, Indonesian rupiah, Korean won and new Taiwanese dollar exceeded 100 per cent between April 2001 and April 2004 (Table 6.5). Despite significant growth in the foreign exchange market turnover, the share of most of the EMEs in total global turnover, however, continued to remain low.

The Indian foreign exchange market has grown manifold over the last several years. The daily average turnover impressed a substantial pick up from about US $ 5 billion during 1997-98 to US $ 18 billion during 2005-06. The turnover has risen considerably to US $ 23 billion during 2006-07 (up to February 2007) with the daily turnover crossing US $ 35 billion on certain days during October and November 2006. The inter-bank to merchant turnover ratio has halved from 5.2 during 1997-98 to 2.6 during 2005-06, reflecting the growing participation in the merchant segment of the foreign exchange market (Table 6.6 and Chart VI.2). Mumbai alone accounts for almost 80 per cent of the foreign exchange turnover.

6.60 Turnover in the foreign exchange market was 6.6 times of the size of India’s balance of payments during 2005-06 as compared with 5.4 times in 2000-01 (Table 6.7). With the deepening of the foreign exchange market and increased turnover, income of commercial banks through treasury operations has increased considerably. Profit from foreign exchange transactions accounted for more than 20 per cent of total profits of the scheduled commercial banks during 2004-05 and 2005-06

Forex Market: A Historical Perspective

Early Stages: 1947-1977

The evolution of India’s foreign exchange market may be viewed in line with the shifts in India’s exchange rate policies over the last few decades from a par value system to a basket-peg and further to a managed float exchange rate system. During the period from 1947 to 1971, India

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followed the par value system of exchange rate. Initially the rupee’s external par value was fixed at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the permitted margin of ±1 per cent using pound sterling as the intervention currency. Since the sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates of rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable. The devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. The exchange rate of the rupee remained unchanged between 1966 and 1971 (Chart VI.1).

Given the fixed exchange regime during this period, the foreign exchange market for all practical purposes was defunct. Banks were required to undertake only cover operations and maintain a ‘square’ or ‘near square’ position at all times. The objective of exchange controls was primarily to regulate the demand for foreign exchange for various purposes, within the limit set by the available supply. The Foreign Exchange Regulation Act initially enacted in 1947 was placed on a permanent basisin 1957. In terms of the provisions of the Act, the Reserve Bank, and in certain cases, the Central Government controlled and regulated the dealings in foreign exchange payments outside India, export and import of currency notes and bullion, transfers of securities between residents and non-residents, acquisition of foreign securities, etc3 .

With the breakdown of the Bretton Woods System in 1971 and the floatation of major currencies, the conduct of exchange rate policy posed a serious challenge to all central banks world wide as currency fluctuations opened up tremendous opportunities for market players to trade in currencies in a borderless market. In December 1971, the rupee was linked with pound sterling. Since sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971, the rupee also remained stable against dollar. In order to overcome the weaknesses associated with a single currency peg and to ensure stability of the exchange rate, the rupee, with effect from September 1975, was pegged to a basket of currencies. The currency selection and weights assigned were left to the discretion of the Reserve Bank. The currencies included in the basket as well as their relative weights were kept confidential in order to discourage speculation. It was around this time that banks in India became interested in trading in foreign exchange

Formative Period: 1978-1992

The impetus to trading in the foreign exchange market in India came in 1978 when banks in India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and were required to comply with the stipulation of maintaining ‘square’ or ‘near square’ position only at the close of business hours each day. The extent of position which could be left uncovered overnight (the open position) as well as the limits up to which dealers could trade during the day were to be decided by the management of banks. The exchange rate of the rupee during this period was officially determined by the Reserve Bank in terms of a weighted basket of currencies of India’s major trading partners and the exchange rate regime was characterised by daily announcement by the Reserve Bank of its buying and selling rates to the Authorised Dealers (ADs)

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for undertaking merchant transactions. The spread between the buying and the selling rates was 0.5 per cent and the market began to trade actively within this range. ADs were also permitted to trade in cross currencies (one convertible foreign currency versus another). However, no ‘position’ in this regard could originate in overseas markets.

As opportunities to make profits began to emerge, major banks in India started quoting two way prices against the rupee as well as in cross currencies and, gradually, trading volumes began to increase. This led to the adoption of widely different practices (some of them being irregular) and the need was felt for a comprehensive set of guidelines for operation of banks engaged in foreign exchange business. Accordingly, the ‘Guidelines for Internal Control over Foreign Exchange Business’, were framed for adoption by the banks in 1981. The foreign exchange market in India till the early 1990s, however, remained highly regulated with restrictions on external transactions, barriers to entry, low liquidity and high transaction costs. The exchange rate during this period was managed mainly for facilitating India’s imports. The strict control on foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets for foreign exchange in the world, i.e., the hawala (unofficial) market.

By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and structural factors had contributed to balance of payments difficulties. Devaluations by India’s competitors had aggravated the situation. Although exports had recorded a higher growth during the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8 per cent of GDP in 1990-91), trade imbalances persisted at around 3 percent of GDP. This combined with a precipitous fall in invisible receipts in the form of private remittances, travel and tourism earnings in the year 1990-91 led to further widening of current account deficit. The weaknesses in the external sector were accentuated by the Gulf crisis of 1990-91. As a result, the current account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital flows also dried up necessitating the adoption of exceptional corrective steps. It was against this backdrop that India embarked on stabilisation and structural reforms in the early 1990s.

Post-Reform Period: 1992 onwards

This phase was marked by wide ranging reform measures aimed at widening and deepening the foreign exchange market and liberalisation of exchange control regimes. A credible macroeconomic, structural and stabilization programme encompassing trade, industry, foreign investment, exchange rate, public finance and the financial sector was put in place creating an environment conducive for the expansion of trade and investment. It was recognised that trade policies, exchange rate policies and industrial policies should form part of an integrated policy framework to improve the overall productivity, competitiveness and efficiency of the economic system, in general, and the external sector, in particular. As a stabilsation measure, a two step downward exchange rate adjustment by 9 per cent and 11 per cent between July 1 and 3, 1991 was resorted to counter the massive drawdown in the foreign exchange reserves, to instill confidence

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among investors and to improve domestic competitiveness. A two-step adjustment of exchange rate in July 1991 effectively brought to close the regime of a pegged exchange rate. After the Gulf crisis in 1990-91, the broad framework for reforms in the external sector was laid out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). Following the recommendations of the Committee to move towards the market-determined exchange rate, the Liberalised Exchange Rate Management System (LERMS) was put in place in March 1992 initially involving a dual exchange rate system. Under the LERMS, all foreign exchange receipts on current account transactions (exports, remittances, etc.) were required to be surrendered to the Authorised Dealers (ADs) in full. The rate of exchange for conversion of 60 per cent of the proceeds of these transactions was the market rate quoted by the ADs, while the remaining 40 percent of the proceeds were converted at the Reserve Bank’s official rate. The ADs, in turn, were required to surrender these 40 per cent of their purchase of foreign currencies to the Reserve Bank. They were free to retain the balance 60 per cent of foreign exchange for selling in the free market for permissible transactions. The LERMS was essentially a transitional mechanism and a downward adjustment in the official exchange rate took place in early December 1992 and ultimate convergence of the dual rates was made effective from March 1, 1993, leading to the introduction of a market-determined exchange rate regime.

The dual exchange rate system was replaced by a unified exchange rate system in March 1993, whereby all foreign exchange receipts could be converted at market determined exchange rates. On unification of the exchange rates, the nominal exchange rate of the rupee against both the US dollar as also against a basket of currencies got adjusted lower, which almost nullified the impact of the previous inflation differential. The restrictions on a number of other current account transactions were relaxed. The unification of the exchange rate of the Indian rupee was an important step towards current account convertibility, which was finally achieved in August 1994, when India accepted obligations under Article VIII of the Articles of Agreement of the IMF.

With the rupee becoming fully convertible on all current account transactions, the risk-bearing capacity of banks increased and foreign exchange trading volumes started rising. This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with the Government to remove market distortions and deepen the foreign exchange market. The process has been marked by ‘gradualism’ with measures being undertaken after extensive consultations with experts and market participants. The reform phase began with the Sodhani Committee (1994) which in its report submitted in 1995 made several recommendations to relax the regulations with a view to vitalising the foreign exchange market.

In addition, several initiatives aimed at dismantling controls and providing an enabling environment to all entities engaged in foreign exchange transactions have been undertaken since the mid-1990s. The focus has been on developing the institutional framework and increasing the instruments for effective functioning, enhancing transparency and liberalising the conduct of

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foreign exchange business so as to move away from micro management of foreign exchange transactions to macro management of foreign exchange flows (Box VI.3).

An Internal Technical Group on the Foreign Exchange Markets (2005) set up by the Reserve Bank made various recommendations for further liberalisation of the extant regulations. Some of the recommendations such as freedom to cancel and rebook forward contracts of any tenor, delegation of powers to ADs for grant of permission to corporates to hedge their exposure to commodity price risk in the international commodity exchanges/markets and extension of the trading hours of the inter-bank foreign exchange market have since been implemented.

Along with these specific measures aimed at developing the foreign exchange market, measures towards liberalising the capital account were also implemented during the last decade, guided to a large extent since 1997 by the Report of the Committee on Capital Account Convertibility (Chairman: Shri S.S. Tarapore). Various reform measures since the early 1990s have had a profound effect on the market structure, depth, liquidity and efficiency of the Indian foreign exchange market.

Basic Concepts in Forex Trading

:

Bid and Ask Rate:

The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market taker will buy ("bid") from a wholesale or retail customer. The customer will buy from the market-maker at the higher "ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade.

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Foreign exchange is normally traded on margin. A relatively small deposit can control much larger positions in the market. For trading the main currencies, Saxo Bank requires a 1% margin deposit. This means that in order to trade one million dollars, you need to place just USD 10,000 by way of security.

In other words, you will have obtained a gearing of up to 100 times. This means that a change of, say 2%, in the underlying value of your trade will result in a 200% profit or loss on your deposit. Stop-loss discipline:

There are significant opportunities and risks in foreign exchange markets. Aggressive traders might experience profit/loss swings of 20-30% daily. This calls for strict stop-loss policies in positions that are moving against you.

Fortunately, there are no daily limits on foreign exchange trading and no restrictions on trading hours other than the weekend. This means that there will nearly always be an opportunity to react to moves in the main currency markets and a low risk of getting caught without the opportunity of getting out. Of course, the market can move very fast and a stop-loss order is by no means a guarantee of getting out at the desired level. For speculative trading, it is recommended to place protective stop-loss orders.

Spot and forward trading:

When you trade foreign exchange you are normally quoted a spot price. This means that if you take no further steps, your trade will be settled after two business days. This ensures that your trades are undertaken subject to supervision by regulatory authorities for your own protection and security. If you are a commercial customer, you may need to convert the currencies for international payments. If you are an investor, you will normally want to swap your trade forward to a later date. This can be undertaken on a daily basis or for a longer period at a time. Often investors will swap their trades forward anywhere from a week or two up to several months depending on the time frame of the investment.

Although a forward trade is for a future date, the position can be closed out at any time - the closing part of the position is then swapped forward to the same future value date.

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Currency Traded Across Globe & India

The FOUR major currency pairs

 EUR/USD  USD/JPY  USD/CHF  GBP/USD Currency Crosses  EUR/CHF  EUR/JPY  GBP/JPY  EUR/GBP Currencies traded in India:

 USD/INR

 EUR/INR

 GBP/INR

 JPY/INR

Currency Exchanges in India:

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2. National Stock Exchange (NSE) 3. United Stock Exchange (USE)

The daily turnover of NSE and MCX – SX together is around 30,000 cr.

Trading Platforms

Indian Perspective

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12. 29 currency pairs

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Alpari Direct Pro

Alpari Direct Pro is an institutional-level platform that offers the most direct route to optimum liquidity and institutional-level prices from the world’s leading banks, and highly competitive spreads on major currencies.

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Features

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View the most comprehensive picture of the market with current orders displayed by price and volume. This provides a more transparent picture of the Forex market and the best opportunity to make the most informed trading decisions possible.

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Factors Affecting Foreign Exchange

There are various factors affecting the exchange rate of a currency. They can be classified as fundamental factors, technical factors, political factors and speculative factors.

Fundamental factors:

The fundamental factors are basic economic policies followed by the government in relation to inflation, balance of payment position, unemployment, capacity utilization, trends in import and export, etc. Normally, other things remaining constant the currencies of the countries that follow sound economic policies will always be stronger. Similarly, countries having balance of payment surplus will enjoy a favorable exchange rate. Conversely, for countries facing balance of payment deficit, the exchange rate will be adverse.

Technical factors:

Interest rates: Rising interest rates in a country may lead to inflow of hot money in the country, thereby raising demand for the domestic currency. This in turn causes appreciation in the value of the domestic currency.

Inflation rate: High inflation rate in a country reduces the relative competitiveness of the export sector of that country. Lower exports result in a reduction in demand of the domestic currency and therefore the currency depreciates.

Exchange rate policy and Central Bank interventions: Exchange rate policy of the country is the most important factor influencing determination of exchange rates. For example, a country may decide to follow a fixed or flexible exchange rate regime, and based on this, exchange rate movements may be less/more frequent. Further, governments sometimes participate in foreign exchange market through its Central bank in order to control the demand or supply of domestic currency.

Political factors:

Political stability also influences the exchange rates. Exchange rates are susceptible to political instability and can be very volatile during times of political crises.

Speculation:

Speculative activities by traders worldwide also affect exchange rate movements. For example, if speculators think that the currency of a country is overvalued and will devalue in near future, they will pull out their money from that country resulting in reduced demand for that currency and depreciating its value.

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Foreign Exchange Management Act, 1999

The change in the entire approach towards exchange control regulation has been the result of the replacement of the Foreign Exchange Regulation Act, 1973, by the Foreign Exchange Management Act, 1999. The latter came into effect from June 1, 2000. The change in the preamble itself signifies the dramatic change in approach -- from "for the conservation of the foreign exchange resources" in FERA 1973, to "facilitate external trade and payments" under FEMA 1999. Any FEMA violations are civil, not criminal, offences, attracting monetary penalties, and not arrests or imprisonment.

The scheme of FEMA and the notifications issued thereunder take into the account the convertibility of the rupee for all current account transactions. Indeed, there is now general freedom to authorised dealers to sell currency for most current account transactions. One old limitation continues. All transactions in foreign exchange have to be with authorised dealers, i.e. banks authorised to act as dealers in foreign exchange by the Reserve Bank. The original rules, regulations, notifications, etc., under FEMA are contained in the A.D. (M.A. series) Circular No. 11 of May 16, 2000. Subsequent circulars have been issued under the A.P. (DIR series) nomenclature. It is obviously impossible to incorporate all the current regulations in a book of this type, particularly since the regulations keep changing. An outline of the basic framework of exchange control under FEMA is in Annexure 5.3. But its contents should not be considered as either definitive or current and those interested need to keep up with the various circulars and other communications on the subject.

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Participants in foreign exchange market

Market Players

Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers – individuals, corporates, who need foreign exchange for their transactions. Though customers are major players in the foreign exchange market, for all practical purposes they depend upon ADs and brokers. In the spot foreign exchange market, foreign exchange transactions were earlier dominated by brokers. Nevertheless, the situation has changed with the evolving market conditions, as now the transactions are dominated by ADs. Brokers continue to dominate the derivatives market.

The Reserve Bank intervenes in the market essentially to ensure orderly market conditions. The Reserve Bank undertakes sales/purchases of foreign currency in periods of excess demand/supply in the market. Foreign Exchange Dealers’ Association of India (FEDAI) plays a special role in the foreign exchange market for ensuring smooth and speedy growth of the foreign exchange market in all its aspects. All ADs are required to become members of the FEDAI and execute an undertaking to the effect that they would abide by the terms and condition stipulated by the FEDAI for transacting foreign exchange business. The FEDAI is also the accrediting authority for the foreign exchange brokers in the interbank foreign exchange market.

The licences for ADs are issued to banks and other institutions, on their request, under Section 10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided into different categories. All scheduled commercial banks, which include public sector banks, private sector banks and foreign banks operating in India, belong to category I of ADs. All upgraded full fledged money changers (FFMCs) and select regional rural banks (RRBs) and co-operative banks belong to category II of ADs. Select financial institutions such as EXIM Bank belong to category III of ADs. Currently, there are 86 (Category I) Ads operating in India out of which five are co-operative banks (Table 6.3). All merchant transactions in the foreign exchange market have to be necessarily undertaken directly through ADs. However, to provide depth and liquidity to the inter-bank segment, Ads have been permitted to utilise the services of brokers for better price discovery in their inter-bank transactions. In order to further increase the size of the foreign exchange market and enable it to handle large flows, it is generally felt that more ADs should be encouraged to participate in the market making. The number of participants who can give two-way quotes also needs to be increased.

The customer segment of the foreign exchange market comprises major public sector units, corporates and business entities with foreign exchange exposure. It is generally dominated by select large public sector units such as Indian Oil Corporation, ONGC, BHEL, SAIL, Maruti Udyog and also the Government of India (for defence and civil debt service) as also big private sector corporates like Reliance Group, Tata Group and Larsen and Toubro, among others. In recent

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years, foreign institutional investors (FIIs) have emerged as major players in the foreign exchange market.

The main players in foreign exchange market are as follows: 1. Customers:

The customers who are engaged in foreign trade participate in foreign exchange market by availing of the services of banks. Exporters require converting the dollars in to rupee and importers require converting rupee in to the dollars, as they have to pay in dollars for the goods/services they have imported.

2. Commercial Bank:

They are most active players in the forex market. Commercial bank dealings with international transaction offer services for conversion of one currency in to another. They have wide network of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of goods. As every time the foreign exchange bought or oversold position. The balance amount is sold or bought from the market.

3. Central Bank:

In all countries Central bank have been charged with the responsibility of maintaining the external value of the domestic currency. Generally this is achieved by the intervention of the bank.

4. Exchange Brokers:

Forex brokers play very important role in the foreign exchange market. However the extent to which services of foreign brokers are utilized depends on the tradition and practice prevailing at a particular forex market center. In India as per FEDAI guideline the Ads are free to deal directly among themselves without going through brokers. The brokers are not among to allowed to deal in their own account allover the world and also in India.

5. Overseas Forex Market:

Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading in world forex market is constituted of financial transaction and speculation. As we know that the forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York, Sydney, and back to Tokyo.

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The speculators are the major players in the forex market. Bank dealing are the major speculators in the forex market with a view to make profit on account of favorable movement in exchange rate, take position i.e. if they feel that rate of particular currency is likely to go up in short term. They buy that currency and sell it as soon as they are able to make quick profit.

Corporation’s particularly multinational corporation and transnational corporation having business operation beyond their national frontiers and on account of their cash flows being large and in multi currencies get in to foreign exchange exposures. With a view to make advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize.

Individual like share dealing also undertake the activity of buying and selling of foreign exchange for booking short term profits. They also buy foreign currency stocks, bonds and other assets without covering the foreign exchange exposure risk. This also results in speculations.

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Countries of the world have been exchanging goods and services amongst themselves. This has been going on from time immemorial. The world has come a long way from the days of barter trade. With the invention of money the figures and problems of barter trade have disappeared. The barter trade has given way ton exchanged of goods and services for currencies instead of goods and services. The rupee was historically linked with pound sterling. India was a founder member of the IMF. During the existence of the fixed exchange rate system, the intervention currency of the Reserve Bank of India (RBI) was the British pound, the RBI ensured maintenance of the exchange rate by selling and buying pound against rupees at fixed rates. The inter bank rate therefore ruled the RBI band. During the fixed exchange rate era, there was only one major change in the parity of the rupee- devaluation in June 1966. Different countries have adopted different exchange rate system at different time.

The following are some of the exchange rate system followed by various countries. The Gold Standard

Many countries have adopted gold standard as their monetary system during the last two decades of the 19he century. This system was in vogue till the outbreak of World War 1. Under this system the parties of currencies were fixed in term of gold. There were two main types of gold standard:

1) Gold specie standard

Gold was recognized as means of international settlement for receipts and payments amongst countries. Gold coins were an accepted mode of payment and medium of exchange in domestic market also. A country was stated to be on gold standard if the following condition were satisfied:

• Monetary authority, generally the central bank of the country, guaranteed to buy and sell gold in unrestricted amounts at the fixed price.

• Melting gold including gold coins, and putting it to different uses was freely allowed.

• Import and export of gold was freely allowed.

The total money supply in the country was determined by the quantum of gold available for monetary purpose.

2) Gold Bullion Standard:

Under this system, the money in circulation was either partly of entirely paper and gold served as reserve asset for the money supply. However, paper money could be exchanged for gold at any time. The exchange rate varied depending upon the gold content of currencies. This was also known as “ Mint Parity Theory “ of exchange rates. The gold bullion standard prevailed from about 1870 until 1914, and intermittently thereafter until 1944. World War I brought an end to the gold standard.

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During the world wars, economies of almost all the countries suffered. In order to correct the balance of payments disequilibrium, many countries devalued their currencies. Consequently, the international trade suffered a deathblow. In 1944, following World War II, the United States and most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity exchange-rate system under which exchange rates were fixed (Pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in response to financial chaos that had reigned before and during the war. In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund (IMF) to act as the “custodian” of the system. Under this system there were uncontrollable capital flows, which lead to major countries suspending their obligation to intervene in the market and the Bretton Wood System, with its fixed parities, was effectively buried. Thus, the world economy has been living through an era of floating exchange rates since the early 1970. Floating Rate System

In a truly floating exchange rate regime, the relative prices of currencies are decided entirely by the market forces of demand and supply. There is no attempt by the authorities to influence exchange rate. Where government interferes’ directly or through various monetary and fiscal measures in determining the exchange rate, it is known as managed of dirty float. PURCHASING POWER PARITY (PPP) Professor Gustav Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms states that currencies are valued for what they can buy and the currencies have no intrinsic value attached to it. Therefore, under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. As per this theory if there were no trade controls, then the balance of payments equilibrium would always be maintained. Thus if 150 INR buy a fountain pen and the same fountain pen can be bought for USD 2, it can be inferred that since 2 USD or 150 INR can buy the same fountain pen, therefore USD 2 = INR 150.For example India has a higher rate of inflation as compared to country US then goods produced in India would become costlier as compared to goods produced in US. This would induce imports in India and also the goods produced in India being costlier would lose in international competition to goods produced in US. This decrease in exports of India as compared to exports from US would lead to demand for the currency of US and excess supply of currency of India. This in turn, cause currency of India to depreciate in comparison of currency of US that is having relatively more exports.

Foreign Exchange Market Structure

Market Segments

Foreign exchange market activity in most EMEs takes place onshore with many countries prohibiting onshore entities from undertaking the operations in offshore markets for their currencies. Spot market is the predominant form of foreign exchange market segment in

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developing and emerging market countries. A common feature is the tendency of importers/exporters and other end-users to look at exchange rate movements as a source of return without adopting appropriate risk management practices. This, at times, creates uneven supplydem and conditions, often based on ‘‘news and views’’. The lack of forward market development reflects many factors, including limited exchange rate flexibility, the de facto exchange rate insurance provided by the central bank through interventions, absence of a yield curve on which to base the forward prices and shallow money markets, in which market-making banks can hedge the maturity risks implicit in forward positions (Canales-Kriljenko, 2004).

Most foreign exchange markets in developing countries are either pure dealer markets or a combination of dealer and auction markets. In the dealer markets, some dealers become market makers and play a central role in the determination of exchange rates in flexible exchange rate regimes. The bidoffer spread reflects many factors, including the level of competition among market makers. In most of the EMEs, a code of conduct establishes the principles that guide the operations of the dealers in the foreign exchange markets. It is the central bank, or professional dealers association, which normally issues the code of conduct (Canales-Kriljenko, 2004). In auction markets, an auctioneer or auction mechanism allocates foreign exchange by matching supply and demand orders. In pure auction markets, order imbalances are cleared only by exchange rate adjustments. Pure auction market structures are, however, now rare and they generally prevail in combination with dealer markets.

The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments – the spot and the derivatives market. In the spot market, currencies are traded at the prevailing rates and the settlement or value date is two business days ahead. The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad. The derivatives market encompasses forwards, swaps and options. Though forward contracts exist for maturities up to one year, majority of forward contracts are for one month, three months, or six months. Forward contracts for longer periods are not as common because of the uncertainties involved and related pricing issues. A swap transaction in the foreign exchange market is a combination of a spot and a forward in the opposite direction. As in the case of other EMEs, the spot market is the dominant segment of the Indian foreign exchange market. The derivative segment of the foreign exchange market is assuming significance and the activity in this segment is gradually rising.

Fundamentals in Exchange Rate

Exchange rate is a rate at which one currency can be exchange in to another currency, say USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice versa.

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There are two methods of quoting exchange rates. 1) Direct method:

Foreign currency is kept constant and home currency is kept variable. In direct quotation, the principle adopted by bank is to buy at a lower price and sell at higher price.

2) Indirect method:

Home currency is kept constant and foreign currency is kept variable. Here the strategy used by bank is to buy high and sell low. In India with effect from august 2, 1993, all the exchange rates are quoted in direct method. It is customary in foreign exchange market to always quote two rates means one for buying and another rate for selling. This helps in eliminating the risk of being given bad rates i.e. if a party comes to know what the other party intends to do i.e. buy or sell, the former can take the letter for a ride. There are two parties in an exchange deal of currencies. To initiate the deal one party asks for quote from another party and other party quotes a rate. The party asking for a quote is known as’ asking party and the party giving a quotes is known as quoting party. The advantage of two–way quote is as under

• The market continuously makes available price for buyers or sellers

• Two way prices limit the profit margin of the quoting bank and comparison of one quote with another quote can be done instantaneously.

• As it is not necessary any player in the market to indicate whether he intends to buy or sale foreign currency, this ensures that the quoting bank cannot take advantage by manipulating the prices.

• It automatically insures that alignment of rates with market rates.

• Two way quotes lend depth and liquidity to the market, which is so very essential for efficient market. In two way quotes the first rate is the rate for buying and another for selling.

We should understand here that, in India the banks, which are authorized dealer, always, quote rates. So the rates quoted- buying and selling is for banks point of view only. It means that if exporters want to sell the dollars then the bank will buy the dollars from him so while calculation the first rate will be used which is buying rate, as the bank is buying the dollars from exporter. The same case will happen inversely with importer as he will buy dollars from the bank and bank will sell dollars to importer.

Factors Affecting Exchange Rates

In free market, it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange rate fluctuation, some times wild. The volatility of exchange rates cannot be traced to the single reason and consequently, it becomes difficult to precisely define the factors that affect exchange rates. However, the more important among them are as follows:

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• Strength of Economy

Economic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an American economist, developed a theory relating exchange rates to interest rates. This proposition, known as the fisher effect, states that interest rate differentials tend to reflect exchange rate expectation. On the other hand, the purchasing- power parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios.

• Political Factor

The political factor influencing exchange rates include the established monetary policy along with government action on items such as the money supply, inflation, taxes, and deficit financing. Active government intervention or manipulations, such as central bank activity in the foreign currency market, also have an impact. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Finally, there is also the influence of the international monetary fund.

• Expectation of the Foreign Exchange Market

Psychological factors also influence exchange rates. These factors include market anticipation, speculative pressures, and future expectations. A few financial experts are of the opinion that in today’s environment, the only ‘trustworthy’ method of predicting exchange rates by gut feel. Bob Eveling, vice president of financial markets at SG, is corporate finance’s top foreign exchange forecaster for 1999. eveling’s gut feeling has, defined convention, and his method proved uncannily accurate in foreign exchange forecasting in 1998.SG ended the corporate finance forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to eveling’s intuition on any currency is keeping abreast of world events. Any event, from a declaration of war to a fainting political leader, can take its toll on a currency’s value. Today, instead of formal modals, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment.

Fiscal policy Interest rates Monetary policy Balance of payment Exchange control

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Speculation Technical factors

Sources of Supply and Demand in the Foreign exchange

Exchange Market

The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and invisibles in the current account and inflows in the capital account such as foreign direct investment (FDI), portfolio investment, external commercial borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign exchange

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emanates from imports and invisible payments in the current account, amortization of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and outflows on account of direct and portfolio investment. In India, the Government has no foreign currency account, and thus the external aid received by the Government comes directly to the reserves and the Reserve Bank releases the required rupee funds. Hence, this particular source of supply of foreign exchange is not routed through the market and as such does not impact the exchange rate. During last five years, sources of supply and demand have changed significantly, with large transactions emanating from the capital account, unlike in the 1980s and the 1990s when current account transactions dominated the foreign exchange market. The behavior as well as the incentive structure of the participants who use the market for current account transactions differs significantly from those who use the foreign exchange market for capital account transactions. Besides, the change in these traditional determinants has also reflected itself in enhanced volatility in currency markets. It now appears that expectations and even momentary reactions to the news are often more important in determining fluctuations in capital flows and hence it serves to amplify exchange rate volatility (Mohan, 2006a). On many occasions, the pressure on exchange rate through increase in demand emanates from “expectations based on certain news”. Sometimes, such expectations are destabilizing and often give rise to self-fulfilling speculative activities. Recognizing this, increased emphasis is being placed on the management of capital account through management of foreign direct investment, portfolio investment, external commercial borrowings, nonresident deposits and capital outflows. However, there are occasions when large capital inflows as also large lumpiness in demand do take place, in spite of adhering to all the tools of management of capital account. The role of the Reserve Bank comes into focus during such times when it has to prevent the emergence of such destabilising expectations. In such cases, recourse is undertaken to direct purchase and sale of foreign currencies, sterilisation through open market operations, management of liquidity under liquidity adjustment facility (LAF), changes in reserve requirements and signaling through interest rate changes. In the last few years, despite large capital inflows, the rupee has shown two - way movements. Besides, the demand/supply situation is also affected by hedging activities through various instruments that have been made available to market participants to hedge their risks.

Derivative Market Instruments

Derivatives play a crucial role in developing the foreign exchange market as they enable market players to hedge against underlying exposures and shape the overall risk profile of participants in the market. Banks in India have been increasingly using derivatives for managing risks and have also been offering these products to corporates. In India, various informal forms of derivatives contracts have existed for a long time though the formal introduction of a variety of instruments in the foreign exchange derivatives market started only in the post-reform period, especially since the mid-1990s. Cross-currency derivatives with the rupee as one leg were introduced with some restrictions in April 1997. Rupee-foreign exchange options were allowed in July 2003. The foreign

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exchange derivative products that are now available in Indian financial markets can be grouped into three broad segments, viz., forwards, options (foreign currency rupee options and cross currency options) and currency swaps (foreign currency rupee swaps and cross currency swaps) Available data indicate that the most widely used derivative instruments are the forwards and foreign exchange swaps (rupee-dollar). Options have also been in use in the market for the last four years. However, their volumes are not significant and bid offer spreads are quite wide, indicating that the market is relatively illiquid. Another major factor hindering the development of the options market is that corporates are not permitted to write/sell options. If corporates with underlying exposures are permitted to write/sell covered options, this would lead to increase in market volume and liquidity. Further, very few banks are market makers in this product and many deals are done on a back to back basis. For the product to reachthe farther segment of corporates such as small and medium enterprises (SME) sector, it is imperative that public sector banks develop the necessary infrastructure and expertise to transact in options. In view of the growing complexity, diversity and volume of derivatives used by banks, an Internal Group was constituted by the Reserve Bank to review the existing guidelines on derivatives and formulate comprehensive guidelines on derivatives for banks

With regard to forward contracts and swaps, which are relatively more popular instruments in the Indian derivatives market, cancellation and rebooking of forward contracts and swaps in India have beenregulated. Gradually, however, the Reserve Bank has been taking measures towards eliminating such regulations. The objective has been to ensure that excessive cancellation and rebooking do not add to the volatility of the rupee. At present, exposures arising on account of swaps, enabling a corporate to move from rupee to foreign currency liability (derived exposures), are not permitted to be hedged. While the market participants have preferred such a hedging facility, it is generally believed that equating derivedexposure in foreign currency with actual borrowing in foreign currency would tantamount to violation of the basic premise for accessing the forward foreign exchange market in India, i.e., having an underlying foreign exchange exposure. This feature (i.e., ‘the role of an underlying transaction in the booking of a forward contract’) is unique to the Indian derivatives market. The insistence on this requirement of underlying exposure has to be viewed against the backdrop of the then prevailing conditions when it was imposed. Corporates in India have been permitted increasing access to foreign currency funds since 1992. They were also accorded greater freedom to undertake active hedging.

However, recognising the relatively nascent stage of the foreign exchange market initially with the lack of capabilities to handle massive speculation, the ‘underlying exposure’ criterion was imposed as a prerequisite. Exporters and importers were permitted to book forward contracts on the basis of a declaration of an exposure and on the basis of past performance.

Eligible limits were gradually raised to enable corporates greater flexibility. The limits are computed separately for export and import contracts. Documents are required to be furnished at the time of maturity of the contract. Contracts booked in excess of 25 per cent of the eligible limit had

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to be on a deliverable basis and could not be cancelled. This relaxation has proved very useful to exporters of software and other services since their projects are executed on the basis of master agreements with overseas buyers, which usually do not indicate the volumes and tenor of the exports (Report of Internal Group on Foreign Exchange Markets, 2005). In order to provide greater flexibility to exporters and importers, as announced in the Mid-term review of the Annual Policy 2006-07, this limit has been enhanced to 50 per cent.

Notwithstanding the initiatives that have been taken to enhance the flexibility for the corporates, the need is felt to review the underlying exposure criteria for booking a forward contract. The underlying exposure criteria enable corporates to hedge only a part of their exposures that arise on the basis of the physical volume of goods (exports/imports) to be delivered4. With the Indian economy getting increasingly globalised, corporates are also exposed to a variety of ‘economic exposures’ associated with the types of foreign exchange/commodity risks/ exposures arising out of exchange rate fluctuations.

At present, the domestic prices of commodities such as ferrous and non-ferrous metals, basic chemicals, petro-chemicals, etc. are observed to exhibit world import parity. Given the two-way movement of the rupee against the US dollar and other currencies in recent years, it is necessary for the producer/ consumer of such products to hedge their economic exposures to exchange rate fluctuation. Besides, price-fix hedges are also available for traders globally. They enable importers/exporters to lock into a future price for a commodity that they plan to import/export without actually having a crystallised physical exposure to the commodity. Traders may also be affected not only because of changes in rupee-dollar exchange rates but also because of changes in cross currency exchange rates. The requirement of ‘underlying criteria’ is also often cited as one of the reasons for the lack of liquidity in some of the derivative products in India. Hence, a fixation on the ‘underlying criteria’ as India globalises may hinder the full development of the forward market. The requirement of past performance/underlying exposures should be eliminated in a phased manner. This has also been the recommendation of both the committees on capital account convertibility. It is cited that this pre-requisite has been one of the factors contributing to the shift over time towards the non deliverable forward (NDF) market at offshore locations to hedge such exposures since such requirement is not stipulated while booking a NDF contract. An attempt has been made recently provide importers the facility to partly hedge their economic exposure by permitting them to book forward contracts for their customs duty component.

The Annual Policy Statement for 2007-08, released on April 24, 2007 announced a host of measures to expand the range of hedging tools available to market participants as also facilitate dynamic hedging by residents. To hedge economic exposures, it has been proposed that ADs (Category- I) may permit (a) domestic producers/users to hedge their price risk on aluminium, copper, lead, nickel and zinc in international commodity exchanges, based on their underlying economic exposures; and (b) actual users of aviation turbine fuel (ATF) to hedge their economic exposures in the international commodity exchanges based on their domestic purchases.

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Authorised dealer banks may approach the Reserve Bank for permission on behalf of customers who are exposed to systemic international price risk, not covered otherwise. In order to facilitate dynamic hedging of foreign exchange exposures of exporters and importers of goods and services, it has been proposed that forward contracts booked in excess of 75 per cent of the eligible limits have to be on a deliverable basis and cannot be cancelled as against the existing limit of 50 per cent. With a view to giving greater flexibility to corporates with overseas direct investments, the forward contracts entered into for hedging overseas direct investments have been allowed to be cancelled and rebooked. In order to enable small and medium enterprises to hedge their foreign exchange exposures, it has been proposed to permit them to book forward contracts without underlying exposures or past records of exports and imports. Such contracts may be booked through ADs with whom the SMEs have credit facilities. They have also been allowed to freely cancel and rebook these contracts. In order to enable resident individuals to manage/hedge their foreign exchange exposures, it has been proposed to permit resident individuals to book forward contracts without production of underlying documents up to an annual limit of US $ 100,000, which can be freely cancelled and rebooked.

Corporate Hedging for Foreign Exchange Risk in India

Introduction

In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favour of market-determination of foreign exchange rates; a regime of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world owing to increased inflation and the oil shock. Corporates struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that financial derivatives – foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations.

In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. However derivative use is still a highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps and options are available in India and the use of foreign currency derivatives is permitted for hedging purposes only.