Research Paper

On
Foreign Exchange Market in India
CCA- II
Guidance By- Mr. Vaze Sir.
By Group No-10

Name Roll No
Akshay Kawde FN-08
Pratik Tiwari FN-53
Ram Agrawal FN-57
Sayali Bangale FN-67
Vivek Kadam FN-88
Title : Foreign Exchange Market in India

Objectives:

i) To gain the knowledge of Foreign Exchange market in India

and to study that how forex market works

ii) Investigating the relationship between the foreign exchange

market and stock market in India. To see that weather there is
a significant relationship or dynamic linkage between the two
markets.

iii) find out which variable is leading and which variable is

lagging. The lead-lag relationship illustrates how well the two
markets are linked, and how fast one market reflects new
information from the other. If relation between foreign
exchange market and stock market exist, then it is possible
that investor may use this information to predict the exchange
rate movement or indices movement.

Data collection & Methodology:

The data set comprises of daily closing price of Sensex, Nifty and
INR/USD exchange rates obtained from the respective Stock
Exchange and Reserve Bank of India websites. The series span the
period from 1st April 2019 to 31st March 2020. The daily stock index
and INR/USD returns are continuously compounded rate of return,
computed as the first difference of the natural logarithm of the daily
stock index and INR/USD exchange rate value.
The stationary status of series should be tested when investigating the
relationship between exchange rate and stock market price. In order to
test the unit roots i.e. stationarity in the Sensex, Nifty and INR/USD
exchange rates.

The Foreign Exchange Market:

The forex market is special in a number of ways. We cannot designate any

physical location where forex traders get together to exchange currencies.
Rather, traders are located in offices of major commercial banks around the
world and communicate using computer terminals, telephones and other
information channels. The international scope of the forex market implies the
absence of any central regulatory authority. Instead the forex market provides
an example of private regulation, where market participants agree on a common
set of rules governing transactions and their settlement. Hence, the forex market
is certainly not a chaotic realm of lawlessness. In fact, ethical and professional
standards are essential in an economic environment in which a single verbal
agreement on a telephone can commit millions of dollars or euros. The forex
market differs from other financial markets in a number of respects. First, it is
by far the world’s largest financial market in terms of transaction volume. The
daily transaction volume in all currencies is estimated to amount to $3.98
trillion a day. This is gigantic even in comparison to a very active equity market
like the New York Stock Exchange, which reaches an average daily volume of
approximately US$296 billion a day. Secondly, the forex market is also a
market with extraordinarily low transaction costs. A common measure to
express transaction costs is to calculate quoted spreads as the price difference
between a buy (ask) and a sell (bid) order for a currency rate relative to the mid-
price. Such quoted spreads in the forex inter-bank market can become as low as
0.5 to 1.5 basis points (a basis point is 1% of 1%, i.e. 0.0001) for the most liquid
currency pairs. Quoted spreads in equity markets tend to be 50 times larger even
for the most liquid stocks. These are some of the reasons why the forex market
is known as the fairest market of the world.
FOREIGN EXCHANGE MARKETS IN
INDIA

The foreign exchange market in India started when in 1978 the government
allowed banks to trade foreign exchange with one another. Foreign Exchange
Market in India operates under the Central Government of India and executes
wide powers to control transactions in foreign exchange. The Foreign Exchange
Management Act, 1999 or FEMA regulates the whole Foreign Exchange
Market in India. Before the introduction of this act, the foreign exchange market
in India was regulated by the Reserve Bank of India through the Exchange
Control Department, by the Foreign Exchange Regulation Act or FERA, 1947.
Interbank foreign exchange Trading is regulated by the Foreign Exchange
Dealers Association of India (FEDAI) created in 1958, a self-regulatory
voluntary association of dealers or banks specializing in the foreign exchange
activities in India that regulates the governing rules and determines the
commissions and charges associated with the interbank foreign exchange
business. Since 2001, clearing and settlement functions in the foreign exchange
market are largely carried out by the Clearing Corporation of India Limited
(CCIL) that handles transactions of approximately 3.5 billion US dollars a day,
about 80% of the total transactions.

The foreign exchange market in India consists of 3 segments or tires.

 Segment 1
transactions between the R
the authorized dealers
Foreign Exchange
market in India - 3 Segment 2
Segments the interbank market in wh
AD’s deal with each oth

Segment 3
transactions between AD’s an
corporate customers.

The first consists of transactions between the RBI and the authorized dealers
(AD). The latter are mostly commercial banks. The second segment is the
interbank market in which the AD’s deal with each other. And the third segment
consists of transactions between AD’s and their corporate customers. As in any
market essentially the demand and supply for a particular currency at any
specific point in time determines its price (exchange rate) at that point. Prior to
1990s fixed Exchange rate of the rupee was officially determined by RBI.

During the early years of liberalization, the Rangarajan committee

recommended that India’s exchange rate be flexible. India moved from a fixed
exchange rate regime to “market determined” exchange rate system in 1993.
This is explained as under.

A country’s currency exchange rate is typically affected by the supply and

demand for the country’s currency in the international foreign exchange market.
Let’s take the example of Rupee Dollar exchange. The rupee/dollar rate is a
two-way rate which means that the price of 1 dollar is quoted in terms of how
much rupees it takes to buy one dollar. The value of one currency against
another is based on the demand of the currency. If the demand for dollar
increases, the value of dollar would appreciate. As the quotation for Rs/$ is a
two-way quote, an appreciation in the value of dollar would automatically mean
the depreciation in Indian rupee and vice-versa. Besides the primary powers of
demand and supply, the Indian exchange rate is affected by following factors:
 RBI Intervention: When there is too much volatility in the rupee-dollar
rates, the RBI prevents rates going out of control to protect the domestic
economy.  The RBI does this by buying dollars when the rupee appreciates
too much and by selling dollars when the rupee depreciates way too much.

 Inflation: When inflation increases there will be less demand of domestic

goods and more demand of foreign goods i.e. increases demand for foreign
currency), thus value of foreign currency increases and home currency
depreciates thus negatively affecting exchange rate of home currency.

 Imports and Exports: Importing foreign goods requires us to make

payment in foreign currency thus strengthening the foreign currency’s
demand. Increase in demand increases the value of foreign currency and
exports do the reverse.

 Interest rates: The interest rates on Government bonds in emerging

countries such as India attract foreign capital to India.
If the rates are high enough to cover foreign market risk, money would start
pouring in India and thus would provide a push to rupee demand thus
appreciating rupee value for exchange.

 Operations: The major sources of supply of foreign exchange in the Indian

foreign exchange market are receipts on account of exports and invisibles
in the current account, drafts, traveller’s cheque and inflows in the capital
account such as foreign direct investment (FDI), portfolio investment,
external commercial borrowings (ECB) and non-resident deposits. On the
other hand, the demand for foreign exchange rises from imports and
invisible payments in the current account, amortisation of ECB (including
short-term trade credits) and external aid, redemption of NRI deposits and
outflows on account of direct and portfolio investment.
 Typ es Foreign M arket
Spot market

op erati o n
Forward market

Exchange settlement
and dealings

 Spot market (current market): Spot market for foreign exchange is that

market which handles only spot transactions or current transactions. Spot
rate of exchange prevails at the time when transactions are incurred. it is of
daily nature.
 Forward market (derivative market): It is meant for future delivery i.
determines forward exchange rate at which forward transaction are to be
honored. It deals in following instruments: foreign exchange forwards,
currency futures, currency swaps, currency options.
 Exchange settlement and dealings: Nostro and Vostro account facilitate
settlement of foreign exchange transaction.

Nostro account: A foreign currency ac maintained by a bank in India with a

bank in abroad. For example, Bank of India US dollar account with Citi bank.

Vostro account: A rupee account of a foreign bank abroad with a bank in India.
For example, Citi bank rupee ac with bank of India.
Forex Transactions are as follows;

o Spot Transactions
o Forward Transaction,
o Option Transaction
o Future Transaction
o Swap Transaction.

8 Key Factors that Affect Foreign Exchange Rates

1. Inflation Rates
2. Interest Rates
3. Recession
4. Speculation
5. Country’s Balance of Payment
6. Government Debt
7. Terms of Trade
8. Political Stability & Performance
exchange rate is the value of one nation's currency versus the
currency of another nation or economic zone. The present values
of currencies.
1.00 INR inv. 1.00 INR
US Dollar 0.013022 76.793600
Euro 0.012008 83.280114
British Pound 0.010457 95.631958
Australian Dollar 0.020649 48.427896
Canadian Dollar 0.018397 54.355536
Singapore Dollar 0.018591 53.788397
Swiss Franc 0.012622 79.229539
Malaysian Ringgit 0.056879 17.581301
Japanese Yen 1.401645 0.713447
Chinese Yuan Renminbi 0.092193 10.846800
Indian Rupee 1.00 INR inv. 1.00 INR

Exchange rates
120

100
95.63
80 83.28
76.79 79.23

60
54.36 53.79
40 48.43

20 17.58
10.85
1.40.71 0.09
0
US
0.01
Dollar 0.01
Euro 0.01
British Australian
0.02 Canadian
0.02 Singapore
0.02 0.01
Swiss 0.06
Malaysian japanese chinese
Pound Dollar Dollar Dollar Franc Ringgit Yen Yuan

1.00 INR Column1

DETERMINANTS OF EXCHANGE RATE IN INDIA

In a floating exchange rate mechanism, foreign exchange rate is determined

much in the same way as the price of any commodity in a free market economy.
Appreciation or depreciation of the domestic currency thus depends on the
supply of foreign exchange reserves, liquidity conditions in the economy as
determined by money supply, central bank’s policy intentions and differences in
the interest yield on dated securities of the concerned economies. Literature on
similar studies for various economies, especially developed economies, is an
inspiration for the present work. At the same time, there is a need to understand
the determinants of foreign exchange rate under the shifting exchange rate
policy in case of Indian economy. The determinants of exchange rate are
discussed as follows:

The Bank Rate:

Changes in the bank rate indicate the monetary policy intentions of the RBI. If
such a change is unanticipated, economic agents alter their expectations
regarding the future monetary policy. Thus, an increase in the bank rate
indicates a tight monetary policy, and is counter-reacted with an expectation
that the bank rate will decline in future. This results in a depreciation of the
domestic currency. On the contrary, the increase in bank rate may also result in
further tightening of the monetary policy by the RBI, which is necessary for
lowering the inflation in the domestic economy as against the foreign economy.
A future appreciation of domestic currency is anticipated here, causing an
appreciation of the current exchange rate. To incorporate this effect, data on
bank rate are included. Simultaneously, the impact of the differences between
the cost of long-term and short-term liquidity are also included by introducing
the difference between inter-bank call money rate and the bank rate. Five-period
lag values point out any lag effect of the same on the exchange rate.

Interest Yield Differentials:

The relation between short-term and long-term interest yield differentials and
exchange rate is complex. An increase in the interest differential between
domestic securities and foreign securities indicates a rise in the gain from
capital inflows into the economy. This is expected to result in a depreciation of
the domestic currency. The nominal interest differential reflects both the real
interest differential and the inflation differential. The inverse relation between
the exchange rate and nominal interest differential is due to the inflation
differential. Thus, if inflation in India exceeds the inflation in the US, the
nominal interest differential is positive, making a positive gain on capital in
India possible.

Liquidity:
The growth rates of broad money and foreign exchange reserves indicate
increased liquidity in the economy. Such an increase in the liquidity is expected
to cause depreciation in the exchange rate. An anticipation of inflation due to
increased liquidity and increase in the aggregate demand are two major causes
behind such depreciation. However, an increase in the foreign exchange
reserves also implies an increase in the supply of foreign currency, which often
results in appreciation of the domestic currency.

External Shocks:
The concept of external shock affecting the exchange market can be explained
by two real life examples. The first such shock relates to the month of
December 1997. In spite of strong economic fundamentals, market sentiment
weakened sharply during September 1997 to January 1998. Profit taking by FIIs
on the stock exchanges added to the pressure on the rupee in November. The
market was driven by downside expectations created largely in the backwash of
the currency turmoil in South- East Asia and political developments within the
country. Excess demand conditions reflected in the intensified spot merchant
transactions too. The volatility in the exchange market and the swing in the
market sentiments were reflected in the significant spurt in inter-bank and
merchant turnover by November and December 1997 in relation to April June
1997 levels. Over the quarter October-December 1997, there was a nominal
depreciation of Page | 10 the spot exchange rate by about 7.6 per cent, and the
value of rupee eroded by more than 5.3 per cent in the month of December
alone. Another major shock was felt in April 2007, when the rupee appreciated
by almost 4.3 per cent. This was mainly due to strong domestic economic
growth vis-à-vis moderating of the US economy during the previous two years,
robust growth in the euro area and narrowing interest differentials. Large capital
inflows due to increasing investor interest, dampening crude oil prices in the
world market and depreciation in dollar against other currencies further added
to appreciation of the rupee.
INTEGRATION BETWEEN FOREIGN EXCHANGE AND
CAPITAL MARKETS IN INDIA
There have been several reasons that the need for well-developed, efficient and
integrated financial markets is being increasingly being stressed. In finance
theory, this refers to a market condition that reduces arbitrage opportunities and
also helps investors to diversify their portfolio across different markets (and
hence reduce risk exposures). An economist considers one such development as
a facilitator of savings, investment and consequent economic growth. Moreover,
under such development, as impulses in one market get reflected quickly in
other markets, transmission mechanism of monetary policy becomes smooth
and speedy and thus policy intervention becomes more effective in bringing
fruits in desired direction within specified time horizon. The development of
deep and integrated financial markets, therefore, has been emphasized by
monetary policy makers in modern days. In fact, this has been a precondition
for „inflation targeting approach‟, a new paradigm of monetary policy, to
function credibly and effectively.

Prior to 1990s, Indian financial system was full of substantial structural

rigidities and was under sever administrative control. Administered interest rate
structure, thin foreign exchange market and prevailing fixed exchange rate
mechanism, under-developed secondary markets for government securities, lack
of adequate depth of money and capital markets, and also inadequate
institutional arrangements/framework are a few characteristics of the financial
sector, which had resulted into substantial amount of segmentation of financial
markets during those years. One of the major objectives of the economic
reforms that have been initiated in India since 1991, therefore, has been
development of financial markets into an integrated one. Accordingly, several
policy measures have been taken, in phases, towards innovations of new
financial instruments, improving market depth/conditions, strengthening
institutional and regulatory framework and so on. Now, it is believed that Indian
financial system has achieved the international standard in its market practices.

Some of the specific developments that have taken place during the reforms
process and might have impacted on the extent of financial markets integration
are:

 Dismantling of various price and non-price controls in financial markets;

like other Asian emerging economies, Indian equity market has continued
 to grow and has seen the relaxation of foreign investment restrictions
primarily through country deregulation.
 The issuance of American Depository Receipts (ADR‟s) or General
Depository Receipts (GDR‟s) has facilitated the trade of foreign
securities on the NYSE, NASDAQ or on non-American exchanges.
 Allowing Indian Rupee to be determined by market forces (though at
times market intervention by Reserve Bank of India, the concerned
authority, took place). Gradual move towards full convertibility of Indian
Rupee has had an impact in the Indian capital market as international
investors have invested substantial amount (about US $15 billion) in
Indian capital market.
 The two-way fungibility of ADRs/GDRs allowed by RBI has also
possibly strengthened the linkages between the stock and foreign
exchange markets in India. In view of above, the extent of financial
markets integration in the liberalization era needs to be scrutinized
empirically. Though some recent studies have investigated related issues,
further research on the subject is needed primarily because the Indian
economy is still passing through a transition phase and impact of reform
measures initiated in different phases during the liberalization era might
have not yet reflected fully in the economy. Thus, the extent of markets
integration is perhaps changing over time – indicating the possibility of
getting different conclusion on market integration for the period, which
was not covered in previous studies.

The two national-level stock exchanges, BSE and the National Stock Exchange
(NSE), have currency derivatives segments. The Metropolitan Stock Exchange
of India (MSEI) also has such a segment but the volumes are a fraction of that
witnessed on the BSE or the NSE. One can trade in currency derivatives
through brokers.
The 2019 survey, showed that over-the-counter trades in the Indian rupee
accounted for 1.7 percent of the total global forex turnover, compared with 1.1
percent in the 2016 survey. India’s rank of 16 compared with 18 in the previous
survey.

the average daily turnover for the U.S. dollar-Indian rupee pair in the OTC
market was $110 billion in April 2019, compared with $56 billion in April
2016.
  Foreign Exchange Reserves in India over the period of time

 India - Official exchange rate (LCU per US$, period average) - actual
values, historical data, forecasts and projections were sourced from the
World Bank on April of 2020.

Observation and Current Scenario:

In recent times there has been increased volatility in the financial
markets specially in the forex segment. The fluctuations in the currency
markets tend to have repercussions on the money market’s expectations
get built on possible interest rate action by the RBI. The stock market too
reacts to such developments though the impact may be limited to
specific trading sessions.
India had accumulated substantial forex reserve of around$ 425 by
March 2018. However, after the rupee has come under pressure after
May, there has been drawdown of reserves to support the currency.
Widening of the CAD in Q1-FY19 on account of higher trade deficit
mainly due to rising crude oil prices has affected the net balance of
payments. There has also been sale of dollars by the RBI. However, the
level of reserves at around $ 400 bn as of end-August looks fairly
satisfactory today with import cover of ~9 months.
In the foregoing study we look at:
-Depreciation of the rupee vis-à-vis the dollar relative to other currencies.
This will give an idea of whether the decline has been driven more by
external factors or fundamentals.

-Movement in GSec yields. Of late with the rupee depreciating at a

faster rate, there are expectations that the RBI will increase rates further
in the October policy which has caused the 10-years GSec yield to go to
the 8.1-8.2% range.

-Stock market movements have generally been driven by a variety of

factors and a weaker rupee or higher interest rate regime may not have
a long lasting impact. In this context, these movements are compared
across other major indices.

Foreign Exchange Derivative Instruments in India

  Foreign Exchange Forwards
Authorised Dealers (ADs) (Category-I) are permitted to issue forward contracts to
persons resident in India with crystallised foreign currency/foreign interest rate exposure
and based on past performance/actual import-export turnover, as permitted by the
Reserve Bank and to persons resident outside India with genuine currency exposure to
the rupee, as permitted by the Reserve Bank. The residents in India generally hedge
crystallised foreign currency/foreign interest rate exposure or transform exposure from
one currency to another permitted currency. Residents outside India enter into such
contracts to hedge or transform permitted foreign currency exposure to the rupee, as
permitted by the Reserve Bank .
 Foreign Currency Rupee Swap
A person resident in India who has a long-term foreign currency or rupee liability is
permitted to enter into such a swap transaction with ADs (Category-I) to hedge or
transform exposure in foreign currency/foreign interest rate to rupee/rupee interest rate.
Foreign Currency Rupee Options
ADs (Category-I) approved by the Reserve Bank and ADs(Category-I) who are not
market makers are allowed to sell foreign currency rupee options to their customers on
a back-to-back basis, provided they have a capital to risk-weighted assets ratio (CRAR)
of 9 per cent or above. These options are used by customers who have genuine foreign
currency exposures, as permitted by the Reserve Bank and by ADs (Category-I) for the
purpose of hedging trading books and balance sheet exposures .
 Cross-Currency Options
ADs (Category-I) are permitted to issue cross-currency options to a person resident in
India with crystallised foreign currency exposure, as permitted by the Reserve Bank. The
clients use this instrument to hedge or transform foreign currency exposure arising out of
current account transactions. ADs use this instrument to cover the risks arising out of
market-making in foreign currency rupee options as well as cross currency options, as
permitted by the Reserve Bank .
 Cross-Currency Swaps
Entities with borrowings in foreign currency under external commercial borrowing (ECB)
are permitted to use cross currency swaps for transformation of and/or hedging foreign
currency and interest rate risks. Use of this product in a structured product not
conforming to the specific purposes is not permitted

Conclusion:
The Indian foreign exchange market has operated in a liberalised environment for
more than a decade. A cautious and well-calibrated approach was followed while
liberalising the foreign exchange market with an emphasis on the need to
safeguard against potential financial instability that could arise due to excessive
speculation. The focus was on gradually dismantling controls and providing an
enabling environment to all entities engaged in external transactions. The
approach to liberalisation adopted by the Reserve Bank has been characterised
by greater transparency, data monitoring and information dissemination and to
move away from micromanagement of foreign exchange transactions to macro
management of foreign exchange flows. The emphasis has been to ensure that
procedural formalities are minimised so that individuals are able to conduct
hassle free current account transactions and exporters and other users of the
market are able to concentrate on their core activities rather than engage in
avoidable paper work. With a view to maintaining the integrity of the market,
strong know-your-customer (KYC)/anti-money laundering (AML)guidelines have
also been put in place.

Banks have been given significant autonomy to undertake foreign exchange

operations. In order to deepen the foreign exchange market, several products
have been introduced and new players have been allowed to enter the market.
Full convertibility on the current account and extensive liberalisation of the
capital account have resulted in large increase in transactions in foreign currency.
These have also enabled the corporates to hedge various types of risks
associated with foreign currency transactions. The impact of these reform
initiatives is clearly discernible in terms of depth and efficiency of the market.

Exchange rate regimes do influence the regulatory framework when it comes to

the issue of providing operational freedom to market participants in respect of
their foreign exchange market operations. Notwithstanding a move towards
greater exchange rate flexibility by most EMEs, almost all central banks in EMEs
actively participate in their foreign exchange markets to maintain orderly
conditions. While the use of risk management instruments is encouraged by
many emerging markets for hedging genuine exposures linked to real and
financial flows, their overall approach towards risk management has remained
cautious with an emphasis on the need to safeguard against potential financial
instability arising due to excessive speculation in the foreign exchange market.

In the coming years, the challenge for the Reserve Bank would be to further build
up on the strength of the foreign exchange market and carry forward the reform
initiatives, while simultaneously ensuring that orderly conditions prevail in the
foreign exchange market. Besides, with the Indian economy moving towards
further capital account liberalisation, the development of a well-integrated foreign
exchange market also becomes important as it is through this market that cross-
border financial inflows and outflows are channelled to other markets.
Development of the foreign exchange market also need to be co-ordinated with
the capital account liberalisation. Reforms in the Financial markets is a dynamic
process and need to be harmonised with the evolving macro economic
developments and the level of maturity of participating financial institutions and
other segments of the financial market.

Bibliography

Information mainly collected through RBI and SEBI website & google articles.
And reference by:
Indian Rupee Market‟, by Vikram Murarka “
Foreign Exchange Market‟ by Dun and Bradstreet”
Development of forex market in India‟ by K.J. Udeshi”
 Where does India stand in global forex market?‟ by Commodity Online”
 What is special about the forex market? “ by Harald Hau, William Killeen and
Michael Moore”
Foreign Exchange Regulatory Regimes in India: From Control to
Management‟ by: “Shyamala Gopinath”
ICFAI Journals, Forex Markets‟ by GRK Murthy”
Why canonize exchange rate? “by: N.A. Majumdar”
 Exchange rate sense and nonsense‟ by: S.S. Tarapore “
 Relationship Between Exchange Rate and Stock Prices in India‟ by Golaka C
Nath and G P Samanta”