UNIT1 : INTRODUCTION TO INTERNATIONAL BANKING 10Hrs

Introduction – Meaning – Functions – Financing of Exports – Financing of Imports –

International Payment Systems.

UNIT 2 : INTERNATIONAL CAPITAL MARKETS 10Hrs

Introduction – Meaning and Definition – Types – Financial market flow beyond national
boundaries – Debt and non – debt flows – Volatile and Stable flows – Interest Rate
Differentials - Demand for and supply of funds across borders.

UNIT 3 : OFFSHORE BANKING CENTRES 10Hrs

Introduction – Meaning – Role in International Financing – Global Balance sheet of banks –
Asset and Liability Management of Foreign Banks.

UNIT 4: FOREIGN EXCHNAGE AND MARKETS 14Hrs

Introduction – Meaning – Elements – Importance – Evolution of Exchange Rate System –
International Monetary System – Gold Standard – Types of Exchange Rates – Fluctuations in
Foreign
Exchange rates – Causes and Effects – Need for Stable Foreign Exchange Rates –
Determination of
Exchange rates – Theories of Determination of Foreign Exchange Rates.

UNIT 5 : FOREX MARKET IN INDIA 12Hrs

Introduction – Meaning – Types – Operations – Convertibility - Objectives of Foreign
Exchange
Control – Problems of Foreign Exchange markets in India – Mechanism to settle the
problems - Role
of RBI in settlement of foreign exchange problems in India.
 International Banking
International banking is any type of banking that takes place across international borders.
According to the Bank for International Settlements' Committee on the Global Financial
System, international banking is when a bank headquartered in one country extends credit
and other banking services to residents of another country

Advantages of international banking

 Banking in different markets
 Multi-currency and multi-asset capabilities
 Enhanced range of asset-classes
 International diversification of your portfolio
 Comprehensive expertise and execution capabilities provided by a single bank with a global
network
 Access to client advisors in other countries

Export financing
„Export finance‟ refers to credit facilities and techniques of payments for exporting goods
from one country to another country..

Sources
 Commercial bank
 The Reserve Bank of India (RBI)
 Industrial Development Bank of India (IDBI) provide refinance facilities to the
commercial banks.
 Export-Import Bank

Methods/ types

 Pre- shipment
 Post shipment
 Factoring
 forfeiting
preshipment
Pre-shipment finance refers to the financial assistance provided to the exporters before actual
shipment of goods
 Procure raw materials.
 Carry out manufacturing process.
 Provide a secure warehouse for goods and raw materials.
 Process and pack the goods.
 Ship the final goods to the buyers.
 Meet other financial cost of the business.

This facility is provided to an exporter who have

 A ten digit importer exporter code number
  Exporter should not be in the caution list of RBI.
 Pre-shipment credits are granted by the banks under concessional rates of interest at
7.5 per cent. Credit can be extended up to a maximum period of 6 months.

Post Shipment Finance

Post Shipment Finance is a kind of loan provided by a financial institution to an exporter or
seller against a shipment that has already been made. This type of export finance is granted
from the date of extending the credit after shipment of the goods to the realization date of the
exporter proceeds.
It is provided by a bank to an exporter of goods from India from the date of extending the
credit after shipment of goods to the date of realization of export proceeds.”
Such loan is usually provided for a maximum period of 6 months. Interest is charged at the
rate of 8.65 per cent.

Factoring
Factoring is the Sale of Book Debts by a firm (Client) to a financial institution
(Factor) on the understanding that the Factor will pay for the Book Debts as
and when they are collected or on a guaranteed payment date. Normally, the
Factor makes a part payment (usually upto 80%) immediately after the debts are purchased
thereby providing immediate liquidity to the Client.

PROCESS OF FACTORING
 Client concludes a credit sale with a customer.
 Client sells the customer‟s account to the Factor and notifies the customer.
 Factor makes part payment (advance) against account purchased, after adjusting for
commission and interest on the advance.
 Factor maintains the customer‟s account and follows up for payment.
 Customer remits the amount due to the Factor.
 Factor makes the final payment to the Client when the account is collected or on the
guaranteed payment date.

Forefaiting
Forfait” is derived from French word „A Forfait‟ which means surrender of fights.
Forfaiting is a means of financing used by exporters that enables them to receive cash
immediately by selling their medium-term receivables and eliminate risk by making the sale
without recourse

The parties/agencies involved in a forfaiting transaction include the exporter, the importer,
a forfaiting agency, a bank that stands guarantee for the bills of exchange or promissory

1. Forfeiter and Exporter agreed upon a Forfaiting Agreement.

2. Sales Contract has been signed between Exporter and Importer.
3. Shipment is initiated by the exporter.
4. The importer obtains a guarantee from his bank..
5. Exporter gives documents to forfaiter.
6. Forfeiter controls the documents pays for them as indicated on the Forfaiting
Agreement.
7. Forfeiter presents documents to bank at maturity date.
 8. Importer pays to bank at maturity date.
9. Bank pays to forfeiter at maturity date.

Export-Import Bank of India – Role, Functions and Facilities

1 Export-Import Bank of India (Exim Bank) was set up by an Act of the Parliament “THE
EXPORT-IMPORT BANK OF INDIA ACT, 1981” for providing financial assistance to
exporters and importers, and for functioning as the principal financial institution for co-
ordinating the working of institutions engaged in financing export and import of goods and
services with a view to promoting the country‟s international trade and for matters connected
therewith or incidental thereto

Exim Bank offers the following Export Credit facilities, which can be availed of by Indian
companies, commercial banks and overseas entities.

Pre-shipment credit
Exim Bank's Pre-shipment Credit facility, in Indian Rupees and foreign currency, provides
access to finance at the manufacturing stage - enabling exporters to purchase raw materials
and other inputs.
Pre-shipment credits are usually extended by exporters‟ commercial banks for period upto
180 days.
Exim Bank extends pre-shipment / post-shipment credit either directly or in participation
with commercial banks.

Supplier's Credit
Post-shipment Supplier‟s Credit is extended to Indian exporters upto the extent of the
deferred credit portion of the export contract, either in Rupees or in Foreign currency. The
period of credit will generally depend on the nature of goods or nature of projects, as per
guidelines RBI.

For Project Exporters

Indian project exporters (including those under Deemed Exports category) Exim Bank's
facility helps them meet these expenses for incur expenditure in rupee or foreign currency
while executing contracts i.e. costs of mobilisation/acquisition of materials, personnel and
equipment etc

Capital Equipment Finance Programme (CEFP)

CEFP provides direct access to Exim Bank‟s finance for eligible Indian companies for
procurement of indigenous and imported capital equipment for executing overseas projects /
deemed export projects.

For Exporters of Consultancy and Technological Services

Exim Bank offers a special credit facility to Indian exporters of consultancy and technology
services, so that they can, in turn, extend term credit to overseas importers.

With a view to facilitate credit flow to the MSME sector at competitive rates, Exim Bank has
EXPORT ADVISORY SERVICES GROUP (EAS)

The Bank provides a wide range of information, advisory and support services, which
complement its financing programmes. These services are provided on a fee basis to Indian
companies and overseas entities. The scope of services includes market-related information,
sector and feasibility studies, technology supplier identification, partner search, investment
facilitation and development of joint ventures both in India and abroad.

IMPORT TRADE FINANCE

1. Consignment Purchase
2. Cash-in-Advance (Pre-Payment)
3. Down Payment
4. Open Account
5. Documentary Collections
6. Letters of Credit

1. Consignment Purchase
In a consignment purchase arrangement, the importer/distributor makes payment to the
overseas supplier only after sales to end user is made and payment received. Consignment
purchase terms can be the most advantageous to an importer/distributor. It is also considered
the most risky term for the overseas supplier.

2. Cash-in-Advance (Pre-Payment)
Under these terms of purchase, the importer must send payment to the supplier prior to
shipment of goods. The importer must trust that the supplier will ship the product on time and
that the goods will be as advertised. Basically, Cash-in- advance terms place all of the risk
with the importer/buyer. An Importer may find his seller requiring prepayment in the
following circumstances:
(1) The Importer has not been long established.
(2) The Importer's credit status is doubtful, unsatisfactory and/or the country political and
economic risks are very high.
(3) The product is in heavy demand and the seller does not have to accommodate an
Importer's financing request in order to sell the merchandise.

3. Down Payment
The Buyer pays the Seller a portion of the cost of the goods "in advance" when the contract is
signed or shortly thereafter. There are advantages and disadvantages of down payment terms.
The down payment method induces the Seller to begin performance without the Buyer paying
the full agreed price in advance. The disadvantage is that there is a possibility the Seller may
never deliver the goods even though it has the Buyer's down payment. This option must be
combined with one of the other options to cover the full cost of goods.
4. Open Account
Open Account allows the importer to make payments at some specific date in the future and
without the buyer issuing any negotiable instrument evidencing his legal commitment to pay
at the appointed time.
This method is common when the importer/buyer has a strong credit history and is well-
known to the seller and buyer is having monopoly position . This mechanism offers the seller
no protection in case of non-paymentto minimize the risk the exporter can reduce the
repayment period and retain title to the goods until payment is made

5. Documentary Collections
Under this arrangement, the sale transaction is settled by the bank through an exchange of
documents like sight draft, term draft etc, thus enabling simultaneous payment and transfer
of title.
The importer is not obliged to pay for goods prior to shipment and the exporter retains title to
the goods until the importer either pays for the value of the draft upon presentation (sight
draft) or accept to pay at a later date and time (term draft). The principal obligations of parties
to a documentary collection arrangement are set out in the guidelines of the "Uniform Rules
for Collection" (URC) drafted by the Paris- based International Chamber of Commerce.

Letter of Credit
A letter from a bank guaranteeing that buyer's payment to a seller if the buyer is unable to
make payment on the purchase.The letter of credit is a formal bank letter, issued for a bank's
customer, which authorizes an individual or company to draw drafts on the bank under
certain conditions. It is an instrument through which a bank furnishes its credit in place of its
customer's credit. The bank plays an intermediary role to help complete the trade transaction.
The bank deals only in documents and does not inspect the goods themselves
 UNIT 2 : INTERNATIONAL CAPITAL MARKETS

Financial market flow beyond national boundaries

FOREIGN DIRECT INVESTMENT

FDI refers to an investment made to acquire lasting or long-term interest in enterprises

operating outside of the economy of the investor.The investment is direct because the
investor, which could be a foreign person, company or group of entities, is seeking to control,
manage, or have significant influence over the foreign enterprise.

Entry routes for fdi

Investments can be made by non-residents in Indian company, through two routes;

1. The Automatic Route: under the Automatic Route, the non-resident investor or the Indian
company does not require any approval from the RBI or Government of India for the
investment.
2. The Government Route: under the Government Route, prior approval of the Government
of India through Foreign Investment Promotion Board (FIPB) is required. Proposals for
foreign investment under Government route as laid down in the FDI policy from time to time,
are considered by the Foreign Investment Promotion Board (FIPB) in Department of
Economic Affairs (DEA), Ministry of Finance

'Foreign Institutional Investor - FII'

An investor or investment fund that is from or registered in a country outside of the one in
which it is currently investing. Institutional investors include hedge funds, insurance
companies, pension funds and mutual funds.

The term is used most commonly in India to refer to outside companies investing in the
financial markets of India. International institutional investors must register with the
Securities and Exchange Board of India to participate in the market. One of the major market
regulations pertaining to FIIs involves placing limits on FII ownership in Indian companies.

Euro currency market

Euro currency is any freely convertible currency deposited in bank outside the its
country.Eurocurrency is any deposits residing in banks that are located outside the borders of
the country that issues the currency the deposit is denominated in. For example a deposit
denominated inUS dollars residing in a European bank is a Eurocurrency deposit, or more
specifically a Eurodollar deposit
Characteristics

1. It is large international market free from the government regulations and interference
2. Deposits are mainly for short term
3. Transaction is in large volume.
4. 80% of market is of interbank transactions
5. Deposits are generally of savings and time deposits
6. Euro dollar is most popular instrument in euro currency market

'Eurodollar'
The term eurodollar refers to U.S. dollar-denominated deposits at foreign banks or foreign
branches of American banks; by being located outside of the United States, eurodollars
escape regulation by the Federal Reserve Board, including reserve requirements.

Features

1. Deposits from overnight out to a week are priced based on the fed funds rate.
2. Prices for longer maturities are based on the corresponding London Interbank Offered
Rate (LIBOR).
3. Eurodollar deposits are for a minimum of $100,000 and generally for more than $5
millionA 2014 study by the Federal Reserve Bank showed an average daily volume in
the market of $140 billion.
4. Most transactions in the eurodollar market are overnight, which means they mature on
the next business day. With weekends and holidays, an overnight transaction can be
as long as four days.
5. The transactions usually start on the same day they are executed, with money paid
between banks via the Fed Wire and CHIPS systems

Foreign bonds

. A foreign bond issue is an instrument offered by a foreign borrower to investors in a

national capital market and denominated in that nation‟s currency.

DEPOSITORY RECEIPT

A depository receipt is a certificate issued by a depository bank, which purchases shares of

foreign companies and deposits it on the account. DRs represent ownership of an underlying
companies number of shares.
It is a negotiable certificate denominated in US dollors that represent a non US company‟s
publically traded local currency shares
.
Types of depository receipts

1. ADR American Depository Receipt.

2. GDR Global Depository Receipt

ADR American Depository Receipt.

ADR is a U.S. dollar denominated form of equity ownership in a non-U.S. company.

It is a stock that trades in the US but represent a specified number of shares in
aforeign corporation.
It represents the foreign shares of the company held on deposit by a custodian bank in
the company 's home country and carries the corporate and economic rights of the
foreign shares, subject to the terms specified on the ADR certificate.
Among the Indian ADRs listed on the US markets, are Infy (the Infosys Technologies
ADR), WIT (the Wipro ADR), Rdy(the Dr Reddy‟s Lab ADR), and Say (the Satyam
Computer ADS)

Advantages to issuing company

 Broadens share holders base

 Broaden global visibility
 Enable to tap us equity market
 Raise capital from foreign market
 Enhance good will of company

Advantages to the investors

 Easy and cost effective way to buy foreign shares

 They are liquid
 Easy to buy and sell
 Cost effective they are globally dealed instruments

GDR Global Depository Receipt

GDR is a certificate issued by a depository bank, which purchases shares of foreign
companies and deposits it on the account. GDRs represent ownership of an underlying
number of shares.

Prices of global depositary receipt are often close to values of related shares, but they are
traded and settled independently of the underlying share.
Interest Rate Differential

An interest rate differential is a difference in interest rate between two currencies in a pair. If one
currency has an interest rate of 3 percent and the other has an interest rate of 1 percent, it has a 2
percent interest rate differential.

If an investor/dealer wanted to buy the currency that pays 3 percent against the currency the pays
1 percent, it would be paid on the difference with daily interest payments.

The interest rate differential (IRD) is a differential measuring the gap in interest rates
between two similar interest-bearing assets. Traders in the foreign exchange market use
interest rate differentials (IRD) when pricing forward exchange rates. Based on the interest
rate parity, a trader can create an expectation of the future exchange rate between two
currencies and set the premium, or discount, on the current market exchange rate futures
contracts
 Unit -3 OFF SHORE BANKING
Offshore banking refers to the deposit of funds by a company or individual in a bank that is
located outside their national residence. these banks are located on islands, many offshore
banks are, in fact, found in onshore locations, such as Panama, Luxembourg and Switzerland.
Offshore banks also offer the same services as domestic banks, and frequently they offer
more anonymity than would otherwise be available in "onshore" banks.

Origins of Offshore Banking

The term "offshore bank" originated with banks that were established on the British Channel
Islands, off the coast of northwest France. These institutions were set up as tax havens to
attract more investment. Currently, many jurisdictions where offshore banks are located do
not tax deposits. Offshore banking is also known as "private banking."

Features of offshore bank

Reasons for off shore banking and investment

There are several reasons why people invest offshore:

Tax Reduction - Many countries (known as tax havens) offer tax incentives to foreign
investors. The favorable tax rates in an offshore country are designed to promote a healthy
investment environment that attracts outside wealth. For a tiny country with very few
resources and a small population, attracting investors can dramatically increase economic
activity.

Asset Protection - Offshore centers are popular locations for restructuring ownership of
assets. Through trusts, foundations or through an existing corporation individual wealth
ownership can be transferred from people to other legal entities. Many individuals who are
concerned about lawsuits, or lenders foreclosing on outstanding debts elect to transfer a
portion of their assets from their personal estates to an entity that holds it outside of their
home country.

Confidentiality - Many offshore jurisdictions offer the complimentary benefit of secrecy

legislation. These countries have enacted laws establishing strict corporate and banking
confidentiality. If this confidentiality is breached, there are serious consequences for the
offending party. Off shore laws will allow identity disclosure in clear instances of drug
trafficking, money laundering or other illegal activities

Diversification of Investment - In some countries, regulations restrict the international

investment opportunities of citizen.Offshore accounts are much more flexible, giving
investors unlimited access to international markets and to all major exchanges
Advantages of Offshore Banking
1 Offshore banks provide access to politically and economically stable jurisdictions. This
may be an advantage for those resident in areas where there is a risk of political turmoil who
fear their assets may be frozen, seized or disappear

2 Some offshore banks may operate with a lower cost base and can provide higher interest
rates than the legal rate in the home country due to lower overheads and a lack of
governement intervention.

3 Offshore finance is one of the few industries, along with tourism, that geographically
remote island nations can competitively engage in. It can help developing countries source
investment and create growth in their economies, and can help redistribute world finance
from the developed to the developing world.

4 Interest is generally paid by offshore banks without tax deducted. This is an advantage to
individuals who do not pay tax on worldwide income,

5 Some offshore banks offer banking services that may not be available from domestic banks
such as anonymous bank accounts, higher or lower rate loans based on risk and investment
opportunities not available elsewhere.

6 Offshore banking is often linked to other services, such as offshore companies, trusts or
foundations, which may have specific tax advantages for some individuals.

Disadvantages of Offshore Banking

A Offshore banking has been associated with the underground economy and organized crime,
through money laundering. Following September 11, 2001, offshore banks and tax havens,
along with clearing houses, have been accused of helping various organized crime gangs,
terrorist groups, and other state or non-state actors.

B The existence of offshore banking encourages tax evasion, by providing tax evaders with
an attractive place to deposit their hidden income.

C Offshore jurisdictions are often remote, so physical access and access to information can
be difficult..
D Developing countries can suffer due to the speed at which money can be transferred in and
out of their economy as “hot money”. This “Hot money” is aided by offshore accounts, and
can increase problems in financial disturbance.

E Offshore banking is usually more accessible to those on higher incomes, because of the
costs of establishing and maintaining offshore accounts. The tax burden in developed
countries thus falls disproportionately on middle-income groups.

tax cuts have tended to result in a higher proportion of the tax take being paid by high-income
groups,
Asset liability management (ALM)

In banking institutions, asset and liability management is the practice of managing various
risks that arise due to mismatches between the assets and liabilities (loans and advances) of
the bank.

Banks face several risks such as the risks associated with assets,interest,currency exchange
risks. Asset Liability management (ALM) is at tool to manage interest rate risk and liquidity
risk faced by various banks, other financial services companies

(ALM) is as the comprehensive and dynamic framework for measuring, monitoring

and managing the financial risks associated with changing interest rates, foreign
exchange rates and other factors that can affect the organisation’s liquidity.

Definition of ALM:
 UNIT 4: FOREIGN EXCHANGE AND MARKETS

Foreign Exchange market

The foreign exchange market is merely a part of the money market in the financial centers is
a place where foreign moneys are bought and sold. The buyers and sellers of claims on fore
money and the intermediaries together constitute a foreign exchange market.

Dealers/ Transactors intermediaries in forex market

There is a wide variety of dealers in the foreign exchange market.

Ist level dealers-

1) Retail dealers-It includes variousretail dealers like tourists, importers, exporters,

investors. They are the immediate users and suppliers of forex

II nd level dealers –

2)Commercial banks.- Banks dealing in foreign exchange have branches with substantial
balances in different countries. Through their branches and correspondents the services of
such banks, usually called 'Exchange Banks', are available all over the world.

These banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic
transfers and other credit instruments, and discount and collect amounts for such documents..

3) Acceptance houses are another class of dealers in foreign exchange. They help foreign
remittances by accepting bills on behalf of customers.

4)Non bank dealers-non banking financial institutions will also deal in foreign exchange

IIIrd level dealers

4)FX Brokers – who act as an intermediate and through whom the nations inflow and out
flow of foreign exchange happens

5) Speculators-they are deliberate risk takers who are involved in day trading.

6) Arbitrageurs- They are intermediaries who will make profit by discovering price
differences between pairs of currencies at different dealers i of bank

7) Hedgers- Those who limit their potential losses by locking in guaranteed foreign exchange
positions

VI th level dealers
8)The central bank -- are also dealers in foreign exchange. Both may intervene in the market
occasionally and manage exchange rates and implement exchange controls in various ways.
In India, there is a strict exchange control system and there is no foreign exchange market as
such. Government or treasury of a country

Functions of the Foreign Exchange Market:

The foreign exchange market performs the following important functions:

(i) to effect transfer of purchasing power between countries- transfer function;

(ii) to provide credit for foreign trade - credit function; and

(iii) to furnish facilities for hedging foreign exchange risks - hedging function.

Transfer Function:

The basic function of the foreign exchange market is to facilitate the conversion of one
currency into another, i.e., to accomplish transfers of purchasing power between two
countries. This transfer of purchasing power is affected through a variety of credit
instruments, such as telegraphic transfers, bank drafts and foreign bills.

In performing the transfer function, the foreign exchange market carries out payments
internationally by clearing debts in both directions simultaneously, analogous to domestic
clearings.

Credit Function:

Another function of the foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is required.

Hedging Function:

A third function of the foreign exchange market is to hedge foreign exchange risks. In a free
exchange market when exchange rates, change, there may be a gain or loss to the party
concerned. Under this condition, a person or a firm undertakes a great exchange risk if there
are huge amounts of net claims or net liabilities which are to be met in foreign money.

Exchange risk as such should be avoided or reduced. For this the exchange market
provides facilities for hedging anticipated or actual claims or liabilities through
different instruments

International Monetary system( IMS)

International monetary systems are set of internationallyagreedrules , conventions and
supporting institutions that Facilitates international trade, crossborder investment and
allocation of capital between states

Features/role/functions of IMS

1. It‟s the part of the institutional framework that binds national economies
2. It proves payment mechanismacceptablebetween buyer and seller
3. It helps in capitalmovement and provides liquidity for trade
4. It helps in correction of global imbalance of economy
5. It provides stability in exchange value
6. Effectivesystem creates confidence in the business firms and investors

gold standard

The gold standard is a monetary system in which the standard economic unit of
account is based on a fixed quantity of gold. For international transaction to decide
the exchange rate of countries currency gold standards was used

The International Monetary Fund (IMF)

It is an international organization initiated in 1944 at the Bretton Woods Conference and

formally created in 1945 by 29 member countries. , headquartered in Washington with
currently of 185 member countries, with the purpose to oversee global financial health and
provide assistance when needed to its members.

Objectives of IMF
 To promote international monetary cooperation
 To provide temporary financial assistance to countries to help ease balance of
payments adjustment
 Promoting global monetary and exchange stability.
Facilitating the expansion and balanced growth of international trade.
 Assisting in the establishment of a multilateral system of payments for current
transactions.
 Lower trade barriers between countries and to stabilize currencies by monitoring
the foreign exchange systems of member countries, and lending money to
developing nations.

Exchange Rate Mechanism

Exchange rate between two currencies is the rate at which one currency will be exchanged
for another. It is also regarded as the value of one country‟s currency in terms of another
currency
Factors influence Exchange rate

 Trade movements- export and import goods and services

 Interest Rates.
 Capital flows- inflows and out flows of capital
 Sale and purchase of securities
 Banking operations
 Relative inflation Rates.
 Balance of Payments.
If a country has a large current account deficit it means it is importing more goods and
services than it is exporting.
 Speculative buying.
Foreign currencies are heavily traded and some investment banks try to make profit
from buying and selling.
 Political factors- government policies , stability
 Economic factors. –monetary policy, fiscal policy,bank rate,inflation
 Exchange control measures

Types of exchange rate

Broadly speaking, there can be two types of exchange rate systems;

(a) fixed exchange rate system; and (b) flexible exchange rate system.

1. Fixed Exchange rate system:/pegged system

Fixed exchange rate system is a system where the rate of exchange between two or more
countries does not vary or varies only within narrow limits.

Under the fixed or stable exchange rate system, the government of a country use to fix the
rate and central bank operate it by exchange stabilization fund.

Advantages of Fixed Exchange Rates

1. Avoid Currency Fluctuations. If the value of currencies fluctuate significantly this

can cause problems for firms engaged in trade.

2. Stability encourages investment. The uncertainty of exchange rate fluctuations can

reduce the incentive for firms to invest in export capacity

3. Keep inflation Low. Governments who allow their exchange rate to devalue may
cause inflationary pressures to occur.

4. A rapid appreciation in the exchange rate will badly effect manufacturing firms who
export, this may also cause a worsening of the current account.
5. Joining a fixed exchange rate may cause inflationary expectations to be lower

reduce speculations in foreign exchange markets.

Disadvantage of Fixed Exchange Rates

1. Conflict with other objectives. To maintain a fixed level of the exchange rate may
conflict with other macroeconomic objectives.

2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil

importer may face a balance of payments deficit if oil price increases, but in a fixed exchange
rate there is little chance to devalue.

3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate is too
high, it will make exports uncompetitive. If it is too low, it could cause inflation.

4. Current Account Imbalances. Fixed exchange rates can lead to current account
imbalances. For example, an overvalued exchange rate could cause a current acc

2. Flexible Exchange Rate System:

Flexible or free exchange rate system, on the other hand, is a system where the value of one
currency in terms of another is free to fluctuate and fixed through the forces of demand and
supply.

Under the flexible exchange rate system, the rate of exchange is allowed to vary to suit the
economic policies of the government; it is a system of changing key to the lock. The flexible
exchange rates are determined by the forces of demand and supply in the exchange market.

There are no restrictions on the buying and selling of the foreign currencies by the monetary
authority and the exchange rates are free to change according to the changes in the demand
and supply of foreign exchange.

Advantage of Flexible Exchange Rates

Flexible exchange rate system is claimed to have the following advantages:

1. Independent Monetary Policy:

, a country is free to adopt an independent policy to conduct properly the domestic economic
affairs..

2. Shock Absorber:
it protects the domestic economy from the shocks produced by the disturbances generated in
other countries. Thus, it acts as a shock absorber and saves the internal economy from the
disturbing effects from abroad.

3. Promotes Economic Development:

. The exchange rates can be changed in accordance with the requirements of the monetary
policy of the country to achieve the planned national objectives.

4. Solutions to Balance of Payment Problems:

automatically removes the disequilibrium in the balance of payments. When, there is deficit
in the balance of payments, the external value of a country's currency falls. As a result,
exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the
balance of payment.

5. Promotes International Trade:

. Restrictions on international trade are removed and there is free movement of capital and
money between countries.

6. Increase in International Liquidity:

eliminates the need for official foreign exchange reserves, and the problem of international
liquidity is automatically solved..

7. Market Forces at Work:

rates are determined by the market forces of demand and supply and Market is cleared off
automatically through changes in exchange rates and the possibility of scarcity or surplus of
any currency does not exist.

Disadvantage of Flexible Exchange Rates

The following are the main drawbacks of the system of flexible exchange rates :

1. Low Elasticities:

. When import and export elasticities are very low, the exchange market becomes unstable.
Hence, the depreciation of the weak currency would simply tend to worsen the balance of
payments deficit further.

2. Unstable conditions:

Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to
reduce the volume of international trade and foreign investment. Long-term foreign
investments arc greatly reduced because of higher risks involved.

3. Adverse Effect on Economic Structure:

. Fluctuating exchange rates cause changes in the price of imported and exported goods
which, in turn, destabilise the economy of the country.

4. Unnecessary Capital Movements:leads to unnecessary international capital movements.

by encouraging speculative activities,.
5. Depression Effects of Capital Movements:

It lead to the problem of extremely high liquidity preference where , people tend to hoard
currency, interest rates rise, investment falls and there is large-scale unemployment in the
economy.

6. Inflationary Effect:Inflationary rise in prices leads to further depreciation of the external

value of the currency.

Theories of Exchange rate determination

Purchasing Power Parity PPP Theory

The first original reference of PPP Theory was made by David Ricardo. However, Gustav
Cassel popularized this theory in 1918. According to PPP theory, when exchange rates are of
a fluctuating nature, the rate of exchange between two currencies in the long run will be fixed
by their respective purchasing powers in their own nations.

Purchasing power parity (PPP) is a theory which states that exchange rates between
currencies are in equilibrium when their purchasing power is the same in each of the two
countries. This means that the exchange rate between two countries should equal the ratio of
the two countries' price level of a fixed basket of goods and servicesIt asks how much money
would be needed to purchase the same goods and services in two countries, and uses that to
calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has
the same purchasing power in different countries

The basis for PPP is the "law of one price". In the absence of transportation and other transaction
costs, competitive markets will equalize the price of an identical good in two countries when the
prices are expressed in the same currency

PPP calculation

The simplest way to calculate purchasing power parity between two countries is to compare the
price of a "standard" good that is in fact identical across countries. Every year The
Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that
compares the price of a McDonald's hamburger around the world. More sophisticated versions of
PPP look at a large number of goods and services. One of the key problems is that people in
different countries consumer very different sets of goods and services, making it difficult to
compare the purchasing power between countries.
Balance of payment theory or demand and supply theory

As per this modern theory of exchange, which is currently accepted as the standard, the rate of
exchange equates to the demand and supply of foreign exchange. Furthermore, the rate of exchange
is the price point where there is equilibrium between the forces of demand and supply.

When there is a surplus in the balance of payments the demand and consecutively the rate of
exchange will decrease due to unhindered flow of foreign exchange. On the other hand, a country
with a negative balance of payment will struggle to manage the foreign exchange reserve needs.
Correspondingly, the demand and rate of exchange will increase.

The theory is comprehensive, practical and realistic. Even though the theory is widely accepted,
still it suffers drawbacks from assumptions related to balance of payments
 UNIT 5 : FOREX MARKET IN INDIA

Foreign Exchange market

A foreign exchange market refers to buying foreign currencies with domestic currencies and
selling foreign currencies for domestic currencies. Thus it is a market in which the claims to
foreign moneys are bought and sold for domestic currency. Exporters sell foreign currencies for
domestic currencies and importers buy foreign currencies with domestic currencies.
.

Foreign Exchange Dealer's Association of India (FEDAI)is a self regulatory body which is
incorporated under Section 25 of The Companies Act, 1956 set up in 1958 as an Association of
banks dealing in foreign exchange in India.It's major activities include framing of rules
governing the conduct of inter-bank foreign exchange business among banks vis-à-vis public
and liaison with RBI for reforms and development of forex market.

functions

 Guidelines and Rules for Forex Business.

 Training of Bank Personnel in the areas of Foreign Exchange Business.
 Accreditation of Forex Brokers
 Advising/Assisting member banks in settling issues/matters in their dealings.
 Represent member banks on Government/Reserve Bank of India/Other Bodies.
 Announcement of daily and periodical rates to member banks.

.
1) Spot Exchange Rate :-
When foreign exchange is bought and sold for immediate delivery, it is called spot
exchange. It refers to a day or two in which two currencies are involved. The basic principle of
spot exchange rate is that it can be analysed like any other price with the help of demand and
supply of The exchange rate of dollar is determined by intersection of demand for and supply of
dollars in
2) Forward Exchange Rate
Here foreign exchange is bought or sold for future delivery i.e., for the period of 30,
60 or 90 days: There are transactions for 180 and 360 days also. Thus, forward market deals in
contract for future delivery. The price for such transactions is fixed at the time of contract, it is
called a forward rate.
Forward exchange rate differs from spot exchange rate as the former may either be at
a premium or discount. If the forward rate is above the present spot rate, the foreign exchange rate
 is said to be at a premium. If the forward rate is below the present spot rate, the foreign exchange
rate is said to be at a discount. Thus foreign exchange rate may be at forward premium or at
forward discount.

Currency convertibility is the ease with which a country's currency can be converted into
gold or another currency. Convertibility is extremely important for international commerce.
When a currency in inconvertible, it poses a risk and barrier to trade with foreigners who
have no need for the domestic currency.

Currency convertibility means that currency of a country can be freely converted into foreign
exchange at market determined rate of exchange that is, exchange rate as determined by
demand for and supply of a currency.

Foreign Exchange Control:

In modern times various devices have been adopted to control international trade and regulate
international indebtedness arising out of international workings and dealings.

The spirit of economic nationalism induces every country to look primarily to its own
economic interests. Foreign Exchange control is one of the devices adopted for the purpose.

Foreign Exchange control is a system in which the government of the country intervenes not
only to maintain a rate of exchange which is quite different from what would have prevailed
without such control and to require the home buyers and sellers of foreign currencies to
dispose of their foreign funds in particular ways.

Objectives of Foreign Exchange Control:

Important objectives of Exchange Control are as follows:
1. Correcting Balance of Payments:
.

2. To Protect Domestic Industries:

3. To Maintain an Overvalued Rate of Exchange:
4. To Prevent Flight of Capital:
5. Policy of Differentiation:
.
ROLE OF RBI IN FOREIGN EXCHANGE MARKET
The role of RBI in the foreign exchange market is revealed by the provisions of FERA
(1973).
Administrative Authority
The RBI is the administrative authority for exchange control in India. The
RBI has been given powers to issue licences to those who are involved in foreign exchange
transactions.
Authorised Dealers
The RBI has appointed a number of authorised dealers. They are permitted to carry out ail
transactions involving foreign exchange. The above provision is laid down in Section 3 of
FERA.
Issue Of Directions
The 'Exchange Control Manual' contains all directions and procedures given by RBI to
authorised dealers from time to time.
Fixation Of Exchange Rates :-
The RBI has the responsibility of fixing the exchange value of home currency in terms of
other currencies. This rate is known as official rate of exchange. All authorised dealers and
money lenders are required to follow this rate strictly in all their foreign exchange
transactions.
Foreign Investments :-
Non-residents can make investments in India only after obtaining the necessary permission
from Central Government or RBI. Great investment opportunities are provided to non-
resident Indians.
Foreign Travel :-
Indian residents can get foreign exchange released from RBI upto a
specified amount for travelling abroad through proper application.

Import Trade
The RBI regulates import trade. Imports are permitted only against proper
licenses. The items of imports that can be imported freely are specified under Open General
Licence.
Export Trade
The RBI controls export trade. Export of gold and jewellery are allowed
only with special permission from RBI.
 Gold.Silver.Currency Notes Etc.
In recent years, the limits fixed for bringing gold, silver, currency notes etc. has
been relaxed considerably.
Submission Of Returns
All foreign exchange transactions made by authorised dealers must be
reported to RBI. This enables the RBI to have a close watch on foreign exchange dealings in
India.

Strategies adopted by central banks to control exchange rates

Basically, all the methods adopted to implement exchange rate control can be classified under
two groups. They are:

a. Direct and indirect methods

If the exchange control strategy affects the conversion rate straight away then it is called as
the direct method. If the tactic affects some other sector but finally influences a change in the
exchange rate then it is called as the indirect method.

b. Unilateral, bilateral and multilateral methods

Unilateral methods are strategies implemented by the central bank of a country without
taking into consideration the opinion of other countries. Bilateral and multilateral methods
are those exchange rate control mechanisms applied with mutual consent of two or more
countries.
Unilateral methods

a. Exchange intervention or pegging

It is a soft form of intervention in the market. As per this strategy, the central bank of a
country will intervene in the market to bring the exchange rate to a desired level, if there is a
concern about speculators driving the price too high or low.

If the central bank buys the currency with an intention to increase the exchange rate then the
currency is said to be pegged up. Similarly, the currency is stated to be pegged down when
the central bank intervenes in the market to decrease the exchange rate. It should be noted
that the intervention will not cause permanent trend change.

b. Foreign currency exchange restrictions

By controlling the demand and supply of currency, the central bank of a country can
influence the exchange rate. The following are the widely adopted measures to keep the
exchange rate under check:

i. Blocked account

The bank accounts of foreigners are blocked under this system. If there is a dire necessity the
central bank will even transfer funds from all the blocked accounts into one single account.
However, it will create bad impression about the country thereby leading to lasting negative
effects on the economy as a whole.

ii. Multiple exchange rates

Under this system, a central bank will have total control over the foreign currency and offer
different rates for purchase and sale by the importers and exporters respectively. This is done
to control the capital outflow from the country. It can be construed as rationing of foreign
currency by price instead of volume. The system is complex and only creates additional
headaches to the central bank.

iii. Rationing of foreign exchange

In this method, the control over foreign exchange will solely lie in the hands of the central
bank, which will decide the quantum of foreign exchange to be distributed for every
incoming request. No individual or corporate can hold foreign currency. Only urgent needs
would be considered.

iv. Exchange Equalization Account (EEA)

To control short-term volatility in the exchange rate, the central bank of UK, following the
exit from the Gold Standard, created a fund named Exchange Equalization Account in 1932
to prevent unwanted volatility in the exchange rate of Pound Sterling. The strategy was later
adopted by USA (Exchange Stabilization Fund) and other European countries including
Switzerland and France.

Bilateral and multilateral methods

a. Payment agreements

Under this system, the debtor and creditor country enters into a payment agreement to
overcome the delay in the settlement of international transactions. The agreement will
stipulate the methods to be followed for controlling the exchange rate volatility. Usually, the
method includes but not limited to the controlled distribution and rationing of the foreign
exchange.
b. Clearing agreements

This exchange rate control strategy is implemented through an agreement between two or
more countries. Based on the agreement, the exporters and importers respectively will receive
proceeds and make payments in their domestic currency. For this purpose a clearing account
with the central bank is used. Thus, the need for foreign exchange is avoided, which in turn
reduces the exchange rate volatility. The system was used by Germany and Switzerland
during great depression in 1930.

c. Standstill agreements

Under this system, through a moratorium, a central bank converts short term debt into long-
term debt. Such a process offers adequate time for repayment. This removes the downward
pressure on the exchange rate. The system was implemented by Germany in 1931.

d. Compensation agreement

The process involves a barter agreement between two countries. One country will be a net
exporter and other one will be a net importer. The value of exports and imports will be equal.
Thus, the need for a foreign currency is avoided and the exchange rate remains stable.

e. Transfer moratoria

Under this system, the central bank bans all kind of payments to creditors abroad. The
debtors should make domestic currency payment to the central bank, which will disburse
funds when there is overall improvement in foreign exchange reserves.

Indirect methods

a. Regulation of bank interest rates

When bank interest rate is increased, capital inflow (through foreign investors) goes up. This
will increase the demand for domestic currency thereby making the exchange rate stronger.
The opposite scenario happens when the interest rate is lowered. Thus, whenever it is
necessary, the central bank indirectly controls the exchange rate by altering the bank interest
rates.
 b. International trade regulations

When the balance of trade becomes unfavorable, a government can impose import
restrictions through a series of measures (tough clauses, changes in policy, quota system and
additional tariffs). Simultaneously, exports can be promoted (international business
exhibitions, subsidies etc.). This will ultimately make imports unattractive and boost exports.
The net gain in the foreign exchange reserves will obviously strengthen the exchange rate.

c. Gold import policy

Barring few countries in Africa, almost all others are net importers of gold. By restricting
(increasing import duties) the import of gold, the exchange rate can be altered. This tactics is
often used by India, which imports about 700tons of gold every year. When import decreases,
foreign exchange reserves increases thereby resulting in a better exchange rate.

India

1. Until 1973, the central bank (Reserve Bank of India) kept the Rupee linked to the Pound
Sterling.
2. From 1975 onwards, a managed floating exchange rate system, linked to a basket of
currencies (major trading partners‟), was followed.
3. Increased trade deficit led the RBI to devalue Rupee twice in 1991. The central bank also
adopted the Liberalized Exchange Rate Management Systems under which a dual
(effective and market) rate was followed.
4. From 1993, market determined unified exchange rate is followed.

Advantages of foreign exchange control

1. Results in exchange rate stability.

2. Enables correcting adverse balance of payment scenario.
3. Prevents depletion of gold reserves and foreign exchange reserves.
4. Preserves capital flight.
5. Fuels economic growth and stability.

Disadvantages of foreign exchange control

1. Indirectly increases the level of administrative corruption.

2. A large number of competent officials are required to manage the smooth functioning of
the economy.
3. Creates misunderstanding with major economic powers.
4. Multinational companies are discouraged from making large commitments.
5. By and large, fundamental disequilibrium is created.
6. Volume of international trade declines as a whole.
Exchange control measures can be considered as a double-edged sword. There may be
situations where exchange control measures would be temporarily necessary. However,
stringent and hasty decisions can put a country‟s economy into an unrecoverable financial
chaos.

History has proven that only those countries with liberalized exchange control mechanisms
ward off financial difficulties at the earliest and register remarkable economic growth. After
all, the nature of human being is to break away from any kind of restrains and exchange
control is no exception to that.