1.

5 Foreign Exchange Market

The history of foreign exchange ( Forex ) market in India could be traced back to 1978 when
an important decision taken by the Reserve Bank of India (RBI), which allowed banks to
undertake intra-day trading in foreign currency exchange. Consequent to this step, the
system of squaring up the position as far as possible at end of days’ business daily was
established. There were significant restrictions on the Forex Transaction which were
governed by Foreign Exchange Regulation Act ( FERA ), 1947, which was modified through
FERA rules 1978.The value of Indian rupee used to be determined by the RBI in terms of a
weighted basket of currencies of India’s major trading partners.
It was during the ‘90s when the Indian Forex Market witnessed changes in the currency
regime in India when the exchange rates were allowed to float in stages since 1992 after the
recommendations of the high level committee on Balance of Payments, headed by Dr
C.Rangarajan. Further relaxations in forex trading were allowed in 1994 when the banks
were given freedom in many of their forex market operations. The freedom was granted to
banks in term of fixing their trading limits, allowed to borrow and invest funds in the
overseas markets up to specified limits, besides the use of derivative products for asset-
liability balancing. The corporate sector was granted the flexibility to book forward cover
based on previous turnover and was given freedom to make use of financial instruments like
interest rates and currency swaps in the international currency exchange market.
With secure and controlled foreign exchange transaction, the Government of India could
manage the exchange rates without much difficulty till 1975. From 1975 to 1992 the Rupee
was linked to a trade-weighted basket of currencies and the exchange rate per US$ was
Rs.7.86 in 1980, Rs.12.37 in 1985, Rs. 17.50 in 1990. Since February 1992, the Rupee became
partly convertible, and in March 1993 a single floating Exchange Rate in the market of
Foreign Exchange in India was implemented. With the abolition of liberalized exchange rate
management system (LERMS) in 1993, the exchange rate of the rupee became market
determined. In July 1995, Rs. 31.81 was worth US$1, as compared to 17.50 in 1990. After
the onset of liberalisation, Foreign Exchange Markets in India have witnessed explosive
growth in trading capacity. The importance of the Exchange Rate of Foreign Exchange in
India for the Indian Economy has also been far greater than ever before. While the Indian
Government has clearly adopted a flexible exchange rate regime, in practice the Rupee is
one of most resourceful trackers of the US dollar.
Over the last two decades, after liberalisation, there has explosion in the forex transactions
and the banks have gained substantial experience in handling the large volumes. Thanks to
the better control mechanisms, effective monitoring and timely action, India escaped the
adverse effects of the Asian Financial Crisis that caused immense damage to the economies
of most of the Asian countries in July 1997.

Page | 1
Generally, the developing countries have either pure dealer markets or a combination of
auction market and dealer market. In the former case some dealers become the market
makers who play the major role in the determination of the two way (bid and offer)
exchange rates. In the pure auction markets the exchange rates are determined by matching
the demand and supply orders. In such case, the order imbalances are cleared through
adjustment of exchange rates. Therefore the pure auction markets are rare and generally a
combination of auction and dealer markets prevails.

Indian Foreign exchange market is made up of a multiple dealerships and consists of two
segments – spot market and derivatives market. Spot market is the dominant one and the
derivative market is gradually becoming popular. In the spot market the currencies are
traded at the prevailing rates and the settlement or value date is two business days ahead,
so as to give time to the parties to send instructions to their banks for debiting their
accounts at home and abroad. The derivatives market consists of forward swaps and
options. Forward contracts are available for one month, three months or six months.
Contracts for longer periods are not popular in view of the uncertainties and higher costs.

The Market Players in Indian Forex Market are:

 Authorised Dealers (AD) –mostly the Banks are the authorised dealers to deal in
Forex.
 Forex Brokers – who essentially act as intermediaries
 Customers- individuals & Corporates who need Forex for personal and business
transactions.

There are three types of participants in the forex market

o Hedgers - face the risk associated with the price of the currency in question who use
the derivatives to manage the risk.
o Speculators – bet on the future movement of currencies and the derivatives allow
them to buy the same without having to pay the full value or sell it without owning it
or delivering it immediately. They gain from these deals with small investments.
o Arbitrageurs – take advantage of the discrepancy of differences in prices in two
different markets

Determinants of Exchange Rates:

Exchange Rate refers to the rates at which a particular currency can be bought or sold with
the domestic currency. In India, US$, Sterling £, Euro Є, Japanese Yen ¥, Singapore S$ are
traded routinely and the rates for these are available on a daily basis. These rates fluctuate
due to various domestic and international reasons as listed below:

Page | 2
 1. Inflation: Inflation in a country results due to lower production/higher demands, or
higher money supply, etc. The inflation would result in the depreciation in the value
of currency in relation to other currencies. Inflation would eventually be followed by
a raising interest rates.
2. Interest Rates: Higher interest rate could influence higher investment or attract
foreign capital from other countries and could eventually result in the strengthening
of the domestic currency. Lower Interest rates would produce the opposite results.
3. Current Account Deficit: Current Account refers to the balance of trade transactions
like supply of goods and services , besides the investment return between a country
and its trading partners. If it is deficit, it would mean it is spending more or its
foreign trade than its earning, which would effectively translate into borrowing from
overseas to make up for the deficit. Thus there would be higher demand for the
foreign currency making the domestic currency weak.
4. Public Debt: Higher debt through deficit financing will eventually cause higher
inflation and would make the domestic currency weak. Overseas lenders would be
less attracted since the debts would be serviced by cheaper dollar in the future.
5. Political Situation: Unstable political situation and/ or unattractive investment
policies could deter the overseas investors and would result in weak currency.
There also currency futures and currency options as in the case of stocks.

Overall, financial markets in India, unlike global financial markets, have exhibited greater
stability and resilience. The outlook for foreign portfolio flows to India also remains quite
positive during 2015, as India is quite well placed vis-à-vis its peers on account of the
positive factors mentioned above and remains an attractive investment destination.
Additionally, unlike commodity exporting countries like Russia, India stands to gain
substantially from the steep fall in crude oil prices through improvement in current account
deficit, fall in inflation, reduction in fiscal burden on account of oil subsidy, etc. All these
factors would contribute towards ensuring stable conditions in the domestic forex market in
2015.

Page | 3