UNIVERSITY OF MUMBAI

PROJECT REPORT ONFOREIGN EXCHANGE MARKET

MASTER OF COMMERCE (BANKING & FINANCE)SUBJECT:-.INTERNATIONAL FINANCESEMESTER III2015-2016

In Partial Fulfilmentof the Requirement uder Semester Based CreditAnd Grading System for Post Gradutes (P.G)Programme under Faculty of Commerce

SUBMITTED BYVISHAKHA H MARUROLL NO:-36

PROJECT GUIDE PROF:- SHEETAL MODY

K.P.B HINDUJA COLLEGE OF COMMERCE315, NEW CHARNI ROAD, MUMBAI-400 004

M.Com (Banking and Finance)3RD SEMESTER

FOREIGN EXCHANGE MARKET

SUBMITTED BYMiss. VISHAKHA HARISH MARUROLL NO: 36

CERTIFICATEThis is to certify that Ms. MARU VISHAKHA HARISH of M.Com BANKING AND FINANCE Semester- 3 [2015-2016] has successfully completed the Project on FOREIGN EXCHANGE MARKET under the guidance of PROF SHEETAL MODY.

Project Guide________________

Course Coordinator________________

Internal Examiner________________

External Examiner________________

Principal________________

Date: ______Place: MumbaiDECLARATION

I, Ms. VISHAKHA HARISH MARU student of M.Com-Banking and Finance, semester- 3 (2015-2016), hereby declare that I have completed the project on .INTERNATIONAL FINANCE.The information submitted is true and original copy to the best of my knowledge.

VISHAKHA MARU

ACKNOWLEDGEMENT

I owe my special thanks to the Principle Dr. Chitra Natrajan and the Co-coordinator of M.com PROF KULDEEP SHARMA for giving me an opportunity for this project work. I would like to give my thanks to the Project Guide PROF .SHEETAL MODY for her guidance and kind assessment that she has provided me and the inspiration in valued guidance and ideas throughout the project. I am also thankful to the library staff of K. P. B. Hinduja College Of Commerce who co-operated with me and even all those seen and unseen hands and heads which helped me in her completion of this project.

INDEXSR- NO.TOPICSPAGE NO.

CH1FOREIGN EXCHANGE MARKET1-2

1.1INTRIDUCTION2

1.2WHY DO ME MAKE USE OF FOREIGN EXCHANGE ?2-3

1.3CHARCHERISTIC OF FOREIGN EXCHANGE MARKET3-5

1.4FOREIGN EXCHANGE MEANING,FUNCTION,KIND. 5-6

1.5FOREX MARKET PARTICIPANTS6-7

1.6FOREIGN EXCHANGE INSTRUMENTS.8

CH2THE FOREIGN EXCHANGE RATE9

2.1WHAT IS FOREIGN EXCHANGE RATE?9-10

2.2TYPES OF FOREIGN EXCHANGE10-12

2.3DETERMINATION OF EXCHANGE RATE13-16

2.4FACTOR INFLUENCE EXCHANGE RATE16-19

CH3FOREIGN EXCHANGE INSTRUMENT & RISK MANAGEMENT20

3.1FOREIGN EXCHANGE INSTRUMENT20-22

3.2FOREIGN EXCHANGE RISK22-23

3.3TYPES OF RISK24-26

3.4TYPES OF EXPOUSURE26-27

3.5FOREIGN EXCHANGE RISK MANAGEMENT28-30

4.BIBOLOGRAPHY31

CH:1 FOREIGN EXCHANGE MARKET

INTRODUCTIONTheforeign exchange market(forex,FX, orcurrency market) is a globaldecentralizedmarket for the trading ofcurrencies. This includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of volume of trading, it is by far the largest market in the world. The main participants in this market are thelarger international banks.Financial centres around the world function as anchors of trading between a wide range of multiple 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 foreign exchange market works throughfinancial institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as dealers, who are actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the interbank market, although a few insurance companies and other kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, forex has little (if any) supervisory entity regulating its actions.The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in theUnited Statesto import goods fromEuropean Unionmember states, especiallyEurozonemembers, and payEuros, even though its income is inUnited States dollars. It also supports direct speculation and evaluation relative to the value of currencies, and thecarry trade, speculation based on the interest rate differential between two currencies. In a typical foreign exchange transaction, a party purchases some quantity of one currency by 0paying with some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (theBretton Woods systemof monetary management established the rules for commercial and financial relations among the world's major industrial states afterWorld War II), when countries gradually switched tofloating exchange ratesfrom the previousexchange rate regime, which remainedfixedas per the Bretton Woods system.

Why do we make use of the Foreign Exchange Market?Trading in a domestic market is substantially different from doing business in an offshore market. In the complex world of international trade, merchants face a number of risks that need to be managed in order to ensure the success of their cross border transactions. In order to protect themselves, these corporations apply hedging techniques using various foreign exchange instruments and products in order to negate the impacts of exchange rate fluctuations. Successful companies employ effective risk management techniques when making business decisions, and evaluate commercial risk in an explicit and logical manner in order to offset financial loss occasioned by the volatility in exchange rates (currency risk).. Characteristics of the Foreign Exchange MarketThe Forex market does not exist physically, it is a framework where participants are connected by computers, telephones and telex (SWIFT) and operates in most financial centres globally. Because the Forex market is so highly integrated globally, it can operate 24 hours a day when one major market is closed, another major market is open to facilitate trade occurring 24 hours a day moving from one major market to another. Most exchanges of currency are made through bank deposits i.e. transferred electronically from one account to another.The volume of foreign exchange transactions worldwide is assumed to be approximately USD 2 trillion per day. The average daily turnover in the South African market is R11 billion per day and Standard Bank is the recognised leader in the domestic foreign exchange market, handling more than 30% of South Africa's foreign exchange volume. The Forex market is an over-the-counter market i.e. trading in financial instruments that are not listed or available on an officially recognised exchange (such as the JSE Johannesburg Stock Exchange), but traded in direct negotiation between buyers and sellers. Trading takes place telephonically or electronically.The foreign exchange market is unique because of the following characteristics: its huge trading volume representing the largest asset class in the world leading to highliquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00GMTon Sunday (Sydney) until 22:00 GMT Friday (New York); the variety of factors that affectexchange rates; the low margins of relative profit compared with other markets of fixed income; and the use ofleverageto enhance profit and loss margins and with respect to account size.

Foreign Exchange Market: Meaning, Functions and KindsMeaning:Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and the central bank.Like any other market, foreign exchange market is a system, not a place. The transactions in this market are not confined to only one or few foreign currencies. In fact, there are a large number of foreign currencies which are traded, converted and exchanged in the foreign exchange market.

Functions of Foreign Exchange Market:Foreign exchange market performs the following three functions:1.Transfer Function:It transfers purchasing power between the countries involved in the transaction. This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.2.Credit Function:It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are generally used for international payments. Credit is required for this period in order to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.3.Hedging Function:When exporters and importers enter into an agreement to sell and buy goods on some future date at the current prices and exchange rate, it is called hedging. The purpose of hedging is to avoid losses that might be caused due to exchange rate variations in the future.

Kinds of Foreign Exchange Markets:Foreign exchange markets are classified on the basis of whether the foreign exchange transactions are spot or forward accordingly, there are two kinds of foreign exchange markets:(i) Spot Market,(ii) Forward Market.

(i) Spot Market:Spot market refers to the market in which the receipts and payments are made immediately. Generally, a time of two business days is permitted to settle the transaction. Spot market is of daily nature and deals only in spot transactions of foreign exchange (not in future transactions). The rate of exchange, which prevails in the spot market, is termed as spot exchange rate or current rate of exchange.The term spot transaction is a bit misleading. In fact, spot transaction should mean a transaction, which is carried out on the spot (i.e., immediately). However, a two day margin is allowed as it takes two days for payments made through cheques to be cleared.(ii) Forward Market:Forward market refers to the market in which sale and purchase of foreign currency is settled on a specified future date at a rate agreed upon today. The exchange rate quoted in forward transactions is known as the forward exchange rate. Generally, most of the international transactions are signed on one date and completed on a later date. Forward exchange rate becomes useful for both the parties involved in the transaction.Forward Contract is made for two reasons:(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);(b) To make profit (through speculation).

Forex Market ParticipantsConsumers and Travelers Consumers may purchase goods in a foreign country or via the internet with their credit card. The amount consumers pay in the foreign currency will be converted to their home currency on their credit card statement. Travelers must go to a bank or currency exchange bureau to convert one currency (their "home" currency) into another (the "destination" currency) when using cash to pay for goods and services in a foreign country. Travelers need to be aware of exchange rates to ensure they receive a fair deal.

Businesses Businesses often need to convert currencies when they conduct trade outside their home country. Large companies need to convert huge amounts of currency; a multinational company such as General Electric (GE) for instance, converts tens of billions of dollars each year.

Investors and Speculators Investors and speculators require currency exchange whenever they deal in any foreign investment, be it equities, bonds, bank deposits, or real estate. Investors and speculators also trade currencies in an attempt to benefit from movements in the currency exchange markets.

Commercial and Investment Banks Commercial and investment banks trade currencies as a service to their commercial banking, deposit, and lending customers. These institutions also participate in the currency market for hedging and speculative purposes.

Governments and Central Banks Governments and central banks trade currencies to improve economic conditions or to intervene in an attempt to adjust economic or financial imbalances. Because they are non-profit, governments and central banks do not trade with the intention of earning a profit, but because they tend to trade on a long-term basis, it is not unusual for some trades to earn revenue.

Foreign Exchange InstrumentsA number of foreign exchange instruments have been designed for effective hedging as well as enhancement of returns. The following instruments and products are most common to the Foreign Exchange Market to facilitate international trade and will be covered in future Forex Bulletins: Spot transactions, Forward Transactions (FECs), Options (Derivatives of exchange rates), International money transfers, Guarantees, Commercial Customer Foreign Currency accounts, Documentary Credit and Collections,

CH:2 THE EXCHANGE RATE:-INTRODUCTION:-. Infinance, anexchange rate(also known as aforeign-exchange rate,forex rate,FX rateorAgio) between twocurrenciesis 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.[1]For example, an interbank exchange rate of 119Japanese yen(JPY, ) to theUnited States dollar(US$) means that 119 will be exchanged for each US$1 or that US$1 will be exchanged for each 119. In this case it is said that the price of a dollar in terms of yen is 119, or equivalently that the price of a yen in terms of dollars is $1/119.Exchange rates are determined in theforeign exchange market,[2]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 20:15GMTon Sunday until 22:00 GMT Friday. Thespot exchange raterefers to the current exchange rate. Theforward exchange raterefers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.. What is foreign exchange rate or exchange rate?An exchange rate is simply the price of one currency in terms of another. The process by which that price is determined depends on the particular exchange rate mechanism adopted. In a floating rate system, the exchange rate is determined directly by market forces, and is liable to fluctuate continually, as dictated by changing market conditions. In a 'fixed', or managed rate system, the authorities attempt to regulate the exchange rate at some level that they consider appropriate. Such a system often seems appealing to those who are troubled by the uncertainties of the present, highly volatile, floating rate environment. But the choice of exchange rate regime involves considerations that extend beyond the stability or otherwise of currency prices. This will become clearer after an examination of some fundamentals of the foreign exchange market. TYPES OF EXCHANGE RATE:-1.FLOATING EXCHANGE RATE.2.FLEXIBLE EXCHANGE RATE.3.LINKAGE EXCHANGE RATE.

Floating exchange rate:-Afloating exchange rateor fluctuating exchange rate is a type ofexchange-rate regimein which a currency's value is allowed to fluctuate in response toforeign-exchange marketmechanisms. A currency that uses a floating exchange rate is known as a floating currency. A floating currency is contrasted with afixed currencywhose value is tied to that of another currency, gold or to acurrency basket.In the modern world, most of the world's currencies are floating; such currencies include the most widely traded currencies: the United States dollar, theeuro, theNorwegian krone, theJapanese yen, theBritish pound, and theAustralian dollar. However, central banks often participate in the markets to attempt to influence the value of floating exchange rates. TheCanadian dollarmost closely resembles a "pure" floating currency, because the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second, with very little change in itsforeign reserves; in contrast, Japan and the UK intervene to a greater extent.From 1946 to the early 1970s, theBretton Woods systemmade fixed currencies the norm; however, in 1971, the US decided no longer to uphold the dollar exchange at 1/35th of an ounce of gold, so that the currency was no longer fixed. After the 1973Smithsonian Agreement, most of the world's currencies followed suit. However, some countries, such as most of the Gulf States, fixed their currency to the value of another currency, which has been more recently associated with slower rates of growth. When a currency floats, targets other than the exchange rate itself are used to administer monetary policy (seeopen-market operations).

Fixed exchange-rate .Afixed exchange rate, sometimes called apegged exchange rate, is a type ofexchange rate regimewhere acurrency's value is fixed against either the value of another single currency, to abasket of other currencies, or to another measure of value, such asgold. There are benefits and risks to using a fixed exchange rate. A fixed exchange rate is usually used in order to stabilize the value of a currency by directly fixing its value in a predetermined ratio to a different, more stable or more internationally prevalent currency (or currencies), to which the value is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, the wayfloating currencieswill do. This makes trade and investments between the two currency areas easier and more predictable, and is especially useful for small economies in which external trade forms a large part of theirGDP.A fixed exchange-rate system can also be used as a means to control the behavior of a currency, such as by limiting rates ofinflation. However, in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the value(s) of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to theMundellFleming model, with perfectcapitalmobility, a fixed exchange rate prevents a government from using domesticmonetary policyin order to achievemacroeconomicstability.In a fixed exchange-rate system, a countryscentral banktypically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged. The central bank provides the assets and/or the foreign currency or currencies which are needed in order to finance anypayments imbalances.[1]

Linked exchange rateAlinked exchange ratesystem is a type ofexchange rate regimeto link the exchange rate of acurrencyto another. It is the exchange rate system implemented inHong Kongto stabilise the exchange rate between theHong Kong dollar(HKD) and theUnited States dollar(USD). TheMacao pataca(MOP) is similarly linked to theHong Kong dollar.Unlike afixed exchange ratesystem, the government orcentral bankdoes not actively interfere in the foreign exchange market by controlling supply and demand of the currency in order to influence the exchange rate. The exchange rate is instead stabilized by an exchange mechanism, whereby theHong Kong Monetary Authority(HKMA) authorises note-issuing banks to issue new banknotes provided that they deposit an equivalent value of U.S. dollars with the HKMA.

Exchange-rate flexibility.Aflexible exchange-rate systemis amonetarysystem that allows theexchange rateto be determined bysupply and demand.[1]Every currency area must decide what type of exchange rate arrangement to maintain. Between permanently fixed and completely flexible however, are heterogeneous approaches. They have different implications for the extent to which national authorities participate in foreign exchange markets. According to their degree of flexibility, post-Bretton Woods-exchange rate regimes are arranged into three categories:currency unions, dollarized regimes,currency boardsand conventional currency pegs are described as fixed-rate regimes; Horizontal bands, crawling pegs and crawling bands are grouped into intermediate regimes; Managed and independent floats are described as flexible regimes. All monetary regimes except for the permanently fixed regime experience thetime inconsistencyproblem and exchange rate volatility, albeit to different degrees.

Determination of Exchange RatesThree aspects of exchange rate determination are discussed below. First, there is a brief description of some of the broad approaches to exchange rate determination. Second, there are some comments on the problems of exchange rate forecasting in practice. Third, central bank intervention and its effects on exchange rates are discussed.Some approaches to exchange rate determination: The Purchasing Power Parity ApproachPurchasing Power Parity (PPP) theory holds that in the long run, exchange rates will adjust to equalize the relative purchasing power of currencies. This concept follows from the law of one price, which holds that in competitive markets, identical goods will sell for identical prices when valued in the same currency.The law of one price relates to an individual product. A generalization of that law is the absolute version of PPP, the proposition that exchange rates will equate nations overall price levels. More commonly used than absolute PPP is the concept of relative PPP, which focuses on changes in prices and exchange rates, rather than on absolute price levels. Relative PPP holds that there will be a change in exchange rates proportional to the change in the ratio of the two nations price levels, assuming no changes in structural relationships. Thus, if the U.S. price level rose 10 percent and the Japanese price level rose 5 percent, the U.S. dollar would depreciate 5 percent, offsetting the higher U.S. inflation and leaving the relative purchasing power of the two currencies unchanged.PPP is based in part on some unrealistic assumptions: that goods are identical; that all goods are tradable; that there are no transportation costs, information gaps, taxes, tariffs, or restrictions of trade; and implicitly and importantlythat exchange rates are influenced only by relative inflation rates.But contrary to the implicit PPP assumption, exchange rates also can change for reasons other than differences in inflation rates. Real exchange rates can and do change significantly over time, because of such things as major shifts in productivity growth, advances in technology, shifts in factor supplies, changes in market structure, commodity shocks, shortages, and booms.In addition, the relative version of PPP suffers from measurement problems:What is a good starting point, or base period? Which is the appropriate price index? How should we account for new products, or changes in tastes and technology?. The Balance of Payments and the Internal- External Balance ApproachPPP concentrates on one part of the balance of paymentstradable goods and services and postulates that exchange rate changes are determined by international differences in prices, or changes in prices, of tradable items. Other approaches have focused on the balance of payments on current account, or on the balance of payments on current account plus long-term capital, as a guide in the determination of the appropriate exchange rate.But in todays world, it is generally agreed that it is essential to look at the entire balance of paymentsboth current and capital account transactionsin assessing foreign exchange flows and their role in the determination of exchange rates.. The Monetary ApproachThe monetary approach to exchange rate determination is based on the proposition that exchange rates are established through the process of balancing the total supply of, and the total demand for, the national money in each nation. The premise is that the supply of money can be controlled by the nations monetary authorities, and that the demand for money has a stable and predictable linkage to a few key variables, including an inverse relationship to the interest ratethat is, the higher the interest rate, the smaller the demand for money. In its simplest form, the monetary approach assumes that: prices and wages are completely flexible in both the short and long run, so that PPP holds continuously, that capital is fully mobile across national borders, and that domestic and foreign assets are perfect substitutes. Starting from equilibrium in the money and foreign exchange markets, if the U.S. money supply increased, say, 20 percent, while the Japanese money supply remained stable, the U.S. price level, in time, would rise 20 percent and the dollar would depreciate 20 percent in terms of the yen.In this simplified version, the monetary approach combines the PPP theory with the quantity theory of moneyincreases or decreases in the money supply lead to proportionate increases or decreases in the price level over time, without any permanent effects on output or interest rates. More sophisticated versions relax some of the restrictive assumptionsfor example, price flexibility and PPP may be assumed not to hold in the short runbut maintain the focus on the role of national monetary policies. The Portfolio Balance ApproachThe portfolio balance approach takes a shorter-term view of exchange rates and broadens the focus from the demand and supply conditions for money to take account of the demand and supply conditions for other financial assets as well. Unlike the monetary approach, the portfolio balance approach assumes that domestic and foreign bonds are not perfect substitutes. According to the portfolio balance theory in its simplest form, firms and individuals balance their portfolios among domestic money, domestic bonds, and foreign currency bonds, and they modify their portfolios as conditions change. It is the process of equilibrating the total demand for, and supply of, financial assets in each country that determines the exchange rate..These actions to balance portfolios will influence exchange rates. Accordingly, a nation with a sudden increase in money supply would immediately purchase both domestic and foreign bonds, resulting in a decline in both countries interest rates, and, to the extent of the shift to foreign bonds, a depreciation in the nations home currency. Over time, the depreciation in the home currency would lead to growth in the nations exports and a decline in its imports, and thus, to an improved trade balance and reversal of part of the original depreciationhe portfolio balance channel postulates that the exchange rate is determined by the balance of supply and demand for available stocks of financial assets held by the private sector. It holds that sterilized intervention will alter the currency composition of assets available to the global private sector, and that if dollar and foreign currency-denominated assets are viewed by investors as imperfect substitutes, sterilized intervention will cause movements in the exchange rate to reequilibrate supply and demand for dollar assets. The size of this portfolio balance effect would depend on the degree of substitutability between assets denominated in different currencies and on the size of the intervention operation.

.Factors influencing exchange ratesForeign exchange rates are extremely volatile and it is incumbent on those involved with foreign exchange - either as a purchaser, seller, speculator or institution - to know what causes rates to move. Actually, there are a variety of factors - market sentiment, the state of the economy, government policy, demand and supply and a host of others. The more important factors that influence exchange rates are discussed below: Strength of the Economy :The strength of the economy affects the demand and supply of foreign currency. If an economy is growing fast and is strong it will attract foreign currency thereby strengthening its own. On the other hand, weaknesses result in an outflow of foreign exchange. If a country is a net exporter (as were Japan and Germany), the inflow of foreign currency far outstrips the outflow of their own currency. The result is usually a strengthening in its value. Political and Psychological Factors: Political or psychological factors are believed to have an influence on exchange rates. Many currencies have a tradition of behaving in a particular way such as Swiss francs which are known as a refuge or safe haven currency while the dollar moves (either up or down) whenever there is a political crisis anywhere in the world. Exchange rates can also fluctuate if there is a change in government. Some time back, Indias foreign exchange rating was downgraded because of political instability and consequently, the external value of the rupee fell. Wars and other external factors also affect the exchange rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November 1999), the Pakistani rupee weakened. Economic Expectations :Exchange rates move on economic expectations. After the 1999 budget in India there was an expectation that the rupee would fall by 7% to 9%. Since such expectations affect the external value of the rupee, all economic data - the balance of payments, export growth, inflation rates and the likes - are analysed and its likely effect on exchange rates is examined. If the economic downturn is not as bad as anticipated the rate can even appreciate. The movement really depends on the market sentiment - the mood of the market - and how much the market has reacted or discounted the anticipated/expected information. Inflation Rates : It is widely held that exchange rates move in the direction required to compensate for relative inflation rates. For instance, if a currency is already overvalued, i.e. stronger than what is warranted by relative inflation rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary to note that an exchange rate is a relative price and hence the market weighs all the relative factors in relative terms (in relation to the counterpart countries). The underlying reasoning behind this conviction is that a relatively high rate of inflation reduces a countrys competitiveness and weakens its ability to sell in international markets. This situation, in turn, will weaken the domestic currency by reducing the demand or expected demand for it and increasing the demand or expected demand for the foreign currency (increase in the supply of domestic currency and decrease in the supply of foreign currency). Capital Movements : Capital movements are one of the most important reasons for changes in exchange rates. Capital movements of foreign currency are usually more than connected with international trade. This occurs due to a variety of reasons - both positive and negative. When India began its economic liberalisation and invited Foreign Institutional Investors (FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the country strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the country weakening the currency. These were capital outflows. One of the reasons popularly believed for the rupee not depreciating in the manner other South-east Asian currencies did in 1997-98 was because the rupee was not convertible on the capital account. Speculation : Speculation in a currency raises or lowers the exchange rate. For instance, the foreign exchange market in Kenya is very shallow. If a speculator enters and buys US $1 million, it will raise the value of the US dollar significantly. If a few others do so too, the price of the US dollar will rise even further against the Kenya shilling. The most famous speculator in foreign currency is Mr George Soros who made over a billion pounds sterling in Europe (by correctly predicting the devaluation of the pound) and then is believed to have triggered the free fall of the currencies of South-east Asia. . Balance of Payments : As mentioned earlier, a net inflow of foreign currency tends to strengthen the home currency vis--vis other currencies. This is because the supply of the foreign currency will be in excess of demand. A good way of ascertaining this would be to check the balance of payments. If the balance of payments is positive and foreign exchange reserves are increasing, the home currency will become stronger. Governments Monetary and Fiscal Policies : Governments, through their monetary and fiscal policies affect international trade, the trade balance and the supply and demand for a currency. Increasing the supply of money raises prices and makes imports attractive. Fiscal surpluses will slow economic growth and this will reduce demand for imports and encourage exports. The effectiveness of the policy depends on the price and income elasticities of demand for the particular goods. High price elasticity of demand means the volume of a good is sensitive to a change in price. Monetary and fiscal policy support the currency through a reduction in inflation. These also affect exchange rate through the capital account. Net capital inflows supply direct support for the exchange rate. Central governments control monetary supply and they are expected to ensure that the governments monetary policy is followed. To this extent they could increase or decrease money supply. For example, the Reserve Bank of India, to curb inflation, restricted and cut money supply. In Kenya, the central bank in order to attract foreign money into the country is offering very high rates on its treasury bills. In order to maintain exchange rates at a certain price the central bank will also intervene either by buying foreign currency (when there is an excess in the supply of foreign exchange) and selling foreign currency (when demand for foreign exchange exceeds supply). This is known as central bank intervention. It must be noted that the objective of monetary policy is to maintain stability and economic growth and central banks are expected to - by increasing/decreasing money supply, raising/lowering interest rates or by open market operations - maintain stability. Exchange Rate Policy and Intervention: Exchange rates are also influenced, in no small measure, by expectation of change in regulations relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market. As explained before, intervention is the buying or selling of foreign currency to increase or decrease its supply. Central banks often intervene to maintain stability. It has also been experienced that if the authorities attempt to half-heartedly counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur. Interest Rates : An important factor for movement in exchange rates in recent years is interest rates, i.e. interest differential between major currencies. In this respect the growing integration of financial markets of major countries, the revolution in telecommunication facilities, the growth of specialised asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign trading as profit centres per se and the tremendous scope for bandwagon and squaring effects on the rates, etc. have accelerated the potential for exchange rate volatility. Kenya intrinsically has a very weak economy but the rates offered within the country have always been very high. To illustrate this point the treasury bill rate in September 1998 was as high as 23%. High interest rates attract speculative capital moves so the announcements made by the Federal Reserve on interest rates are usually eagerly awaited - an increase in the same will cause an inflow of foreign currency and the strengthening of the US dollar. Tariffs and Quotas : Tariffs and quotas exist to protect a countrys foreign exchange by reducing demand. Till before liberalisation, India followed a policy of tariffs and restrictions on imports. Very few items were permitted to be freely imported. Additionally, high customs duties were imposed to discourage imports and to protect the domestic industry. Tariffs and quotas are not popular internationally as they tend to close markets. When India lifted its barriers, several industries such as the mini steel and the scrap metal industries collapsed (imported scrap became cheaper than the domestic one). Quotas are not restricted to developing countries. The United States imposes quotas on readymade garments and Japan has severe quotas on non-Japanese goods.

CH:- 3 FOREIGN EXCHANGE INSTRUMENT & RISK MANAGEMENT.Foreign Exchange InstrumentsA number of foreign exchange instruments have been designed for effective hedging as well as enhancement of returns. The following instruments and products are most common to the Foreign Exchange Market to facilitate international trade and will be covered in future Forex Bulletins: Spot transactions, Forward Transactions (FECs), Options (Derivatives of exchange rates), International money transfers, Guarantees, Commercial Customer Foreign Currency accounts, Documentary Credit and Collections, THE FOLLOWING ARE THE FOREIGN MARKET INSTRUMENTS:-1.FUTURE MARKET:-Afutures exchangeorfutures marketis a central financial exchange where people can trade standardizedfutures contracts; that is, a contract to buy specific quantities of acommodityorfinancial instrumentat a specified price withdeliveryset at a specified time in the future. These types of contracts fall into the category ofderivatives. Suchinstrumentsare priced according to the movement of the underlying asset (stock, physical commodity, index, etc.). The aforementioned category is named "derivatives" because the value of these instruments arederivedfrom another asset class.

2.FORWARD MARKET:-In finance, aforward contractor simply aforwardis a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrumentThis is in contrast to aspot contract, which is an agreement to buy or sell an asset on its Spot Date, which may vary depending on the instrument, for example most of the FX contracts have Spot Date two business days from today. The party agreeing to buy the underlying asset in the future assumes along position, and the party agreeing to sell the asset in the future assumes ashort position. The price agreed upon is called thedelivery price, which is equal to theforward priceat the time the contract is entered into.The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as thevalue datewhere thesecuritiesthemselves are exchanged.Theforward priceof such a contract is commonly contrasted with thespot price, which is the price at which the asset changes hands on thespot date. The difference between the spot and the forward price is theforward premiumor forward discount, generally considered in the form of aprofit, or loss, by the purchasing party.Forwards, like other derivative securities, can be used tohedgerisk (typically currency or exchange rate risk), as a means ofspeculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive..

3.SPOT MARKET:-Thespot marketorcash marketis apublicfinancial marketin whichfinancial instrumentsor commodities are traded forimmediate delivery. It contrasts with afutures market, in which delivery is due at a later date. In spot market,settlementhappens int+2working days, i.e., delivery of cash and commodity must be done after two working days of thetrade date. A spot market can be: an organized market; anexchange; or over-the-counter(OTC)Spot markets can operate wherever theinfrastructureexists to conduct the transaction.

4.RETAIL FOREIGN MARKET:-Retail foreign exchange tradingis a small segment of the largerforeign exchange marketwhere individualsspeculateon the exchange rate between different currencies. This segment has developed with the advent of dedicatedelectronic trading platformsand the internet which have allowed individuals to access the global currency markets. In 2013 it had been speculated that volume from retail foreign exchange trading represents 5 percent of the whole foreign exchange market which amounts to $250 billion in daily trading turnover.[1]Prior to the development of forex trading platforms in late 1990s forex trading was restricted to large financial institutions.[2]It was the development of the internet, trading software and forex brokers allowing trading onmarginthat started the growth of retail trading.Tradersare able to tradespot currencieswithmarket makerson margin. Meaning they need to put down only a small percentage of the trade size and can buy and sell currencies in seconds.

INTRODUCTION OF FOREIGN EXCHANGE RISK

The risk of an investment's value changing due to changes in currency exchange rates.The risk that an investor will have to close out a long or short position inaforeign currency at a lossdue to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk. This risk usually affects businesses that export and/or import, but it can also affect investors making international investments.For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange ratewill cause that investment's valueto either decrease or increase when the investment is sold and converted back into the original currency.

The risk that the exchange rate on a foreign currency will move against the position held by an investor such that the value of the investment is reduced. For example, if an investor residing in the United States purchases a bond denominated in Japanese yen, deterioration in the rate at which the yen exchanges for dollars will reduce the investor's rate of return, since he or she must eventually exchange the yen for dollars. Also called exchange rate risk.

CAUSES OF FLUCTUATIONS IN FOREIGN CURRENCY

1. Foreign exchange rates are influenced by domestic as well as international factors and happenings.2. Foreign exchange dealings cross national boundaries and rates move on the basis of governmental regulations, fiscal policies, political instabilities and a variety of other causes.3. Foreign exchange rate movements, like the stock market, are influenced by sentiments that may not always be logical.4. Foreign exchange is traded hours a day at different markets and dealers cannot be in control at all times.5. The ratings of credit agencies can affect the exchange rate. For instance, when Indians foreign exchange rating was downgraded by Moodys in the mid1990s, the value of rupee fell.6. A rate move instantaneously and very fast. A hesitation of a few seconds or minutes can change a profit to a loss and vice versa

TYPES OF FOREIGN EXCHANGE RISK

Risks associated with foreign exchange may be broadly classified as:

1. Transaction risk.2. Position risk.3. Settlement or credit risk.4. Mismatch or liquidity risk.5. Operational risk.6. Sovereign risk.7. Cross- country risk.

A. Transaction risk:Any transaction leading to future receipts in any form or creation of long term asset. This consists of a number of:1. Trading items (foreign currency, invoiced trade receivables and payables) and2. Capital items (foreign currency dividend and loan payments)3. Exposure associated with the ownership of foreign currency denominated assets and liabilities.

B. Position risk:Bank dealings with customers continuously, both on spot and forward basis, results in positions (buy i.e. long position or sell i.e. short position) being created in currencies in which these transactions are denominated. A position risk occurs when a dealer in bank has an overbought (long) or an oversold (short) position. Dealers enter into these positions in anticipation of a favorable movement.The risk arising out of open positions is easy to understand. If one currency is overbought and it weakens, one would be able to square the overbought position only by selling the currency at a loss. The same would be the position if one is oversold and the currency hardens.

C. Settlement or credit risk:Also known as time zone risk, this is a form of credit risk that arises from transactions where the currencies settle in different time zones. A transaction is not complete until settlement has taken place in the latest applicable time zone. This is also referred to as Herstatt Risk. Arising from the failure or default of a counterparty. Technically, this is a credit risk where only one side of the transaction has settled. If a counterparty fails before any settlement of a contract occurs, the risk is limited to the difference between the contract price and the current market price (i.e. an exchange rate risk).Settlement risk is the risk of a counterparty failing to meet its obligations in a financial transaction after the bank has fulfilled its obligations on the date of settlement of the contract. Settlement risk exposure potentially exists in foreign exchange or local currency money market business.

D. Mismatch or liquidity risk:In the foreign exchange business it is not always possible to be in an ideal position where sales and purchases are matched or according to maturity and there are no mismatched situations. Some mismatching of maturities is in general unavoidable. Liquidity risk'arises from situations in which a party interested in trading anassetcannot do it because nobody in themarketwants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if oneparty cannot find anotherpartyinterested in trading the asset, this can potentially be only a problem of themarketparticipants with finding each other. This is why liquidity risk is usually found higher in emerging markets or low-volume markets.Liquidity risk isfinancial riskdue to uncertainliquidity. An institution might lose liquidity if itscredit ratingfalls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If thecounterpartythat owes it apaymentdefaults, the firm will have to raise cash from other sources to make itspayment. Should it be unable to do so, it too will default. Here, liquidityriskis compoundingcredit risk.E. Operational risk:Operational risk are related to the manner in which transactions are settled or handled operationally. Some of the risks are discussed below:a) Dealing and settlement: This functions must be properly separated, as otherwise there would be inadequate segregation of duties.b) Confirmation: Dealing is usually done by telephone/telex/Reuters or some other electronic system. It is essential that these deals are confirmed by written confirmations. There is a risk of mistakes being made related to amount, rate, value, date and the likes.c) Pipeline transactions: There are, at times, faults in communication and often cover is not available for pipeline transactions entered into by branches. There can be delays in conveying details of transactions to the dealer for a cover resulting in the actual position of the bank being different from what is shown by the dealers position statement.d) Overdue bills and forward contracts: The trade finance departments of banks normally monitor the maturity of export bills and forward contracts. A risk exists in that the monitoring may not be done properly.F. Sovereign risk: Another risk which banks and other agencies that deal in foreign exchange have to be aware of is sovereign risk- the risk on the government of a country.G. Cross-country risk: It is often not prudent to have large exposures on any one country may go through troubled times. I such a situation, the bank/entity that has an exposure could suffer large losses. To control and limit risks arising out of cross country exposures, management normally lay down cross country exposure limits. Risk management in foreign exchange is imperative as the lack of these could even result in the bankruptcy and closure of the organization.

TYPES OF EXPOSUREAn Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose magnitude is not certain at the moment. The magnitude depends on the value of variables such as Foreign Exchange rates and Interest rates. Exposures can be broadly classified into three groups, viz., Transaction, Economic and Translation exposure.1. Transaction exposure:It is a measure of companys vulnerability to currency related losses arising from known, contractual future cash payments or receipts in foreign currencies. The value of a firms cash inflows received in various currencies will be affected by respective exchange rates of these currencies when converted into the currency desired. Similarly, value of a firms cash outflows in various currencies will be dependent on the respective exchange rates of these currencies. The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.

2. Economic exposure:3. The degree to which a firms present value of future cash flows can be influenced by exchange rate fluctuations is referred to as economic exposure to exchange rates. Economic exposures thus is a comprehensive effect of potential transaction exposure on the project investment of an MNC.

4. Translation exposure: The exposure of MNCs consolidated financial statement to exchange rate fluctuations is known as translation exposure. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries financial statements into the parents reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent.

FOREIGN EXCHANGE RISK MANAGEMENT POLICY

The foreign exchange risk management policy should clearly define instruments in which the bank is authorized to trade, risk limits commensurate with the banks activities, regularity of reports to management, and who is responsible for producing such reports. The policy should be reviewed on a regular basis, normally at least annually, to ensure that it remains appropriate. The main points that need to be considered when drawing up a policy are given below:

a) Open position limits commensurate with customer driven turnover, andthe banks appetite for market risk.

b) Separate limits should be allocated for each currency, together with anoverall cap limit. Banks that assume risk on a proprietary trading basisshould also introduce measures to limit intraday risk (normally amaximum of five times the overnight cap limit).

c) Where a bank trades with counterparties other than members of theirown group located in Zone A countries, settlement and country limitsshould be addressed and clearly defined.

d) Forward foreign exchange mismatch limits.

e) List of approved instruments.

f) Use of foreign exchange derivatives.

g) The expertise and experience of authorized personnel.

h) Authority to trade with counterparties other than group companies.

i) Monitoring and reporting systems.

j) Recording and follow up of limit excesses.

k) Impact on P&L of an adverse 10% movement in exchange rates onmaximum permitted exposure.

l) Imposition of a stop loss limit to restrict or prevent any further tradingother than client deals and hedging.

m) Segregation of duties.

n) Trading mandates for authorized personnel.

o) Limitation on out of hours trading.

p) List of authorized brokers (if applicable).

q) Code of Conduct for authorized personnel.

PROCEDURES AND SYSTEMS

The Commission requires banks to monitor their foreign exchange risk on afrequent and timely basis. The Commission would expect banks that assumeany foreign exchange risk to be in a position to measure their positions on anongoing basis and to report to management daily. It follows from this that abank must have adequate procedures and systems for monitoring foreignexchange risk. This requires:

a) A clear allocation of the responsibility for measuring and reportingforeign exchange risk.

b) The maintenance of reliable systems that can produce accuratereports promptly.

c) Active senior management involvement in, and clearly allocatedresponsibility for, foreign exchange risk reporting.

d) Regular reporting to group or parent companies.

The system that produces the foreign exchange risk reports should be linkedto the banks core systems, and be capable of being reconciled to core data.

Reports should follow the principles of good management information, forexample:a) Clarityb) Highlight key information, in particular breaches or exceptionsc) Highlight unutilized limit capacityd) Use of an exception based commentary

BibliographyBooks :-1. Managerial Economics by D.N. Dwivedi.2. Managerial Economics by Chaturvedi.

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