BoP and Forex

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Balance of Payments, Foreign Exchange Markets
Balance of Payments (BoP):

BoP systematically summarizes the economic transactions of an economy with the rest of
the world for a given period of time specifically for a financial year. BoP is transaction
between residents of a country with the rest of the world. So, BoP of India will record all
transactions which happens between the Indian residents (individuals, companies,
governments etc.) and non-residents/ foreigners/ foreign entities. RBI is responsible for
preparing BoP and it shall be consistent with the BoP manual of International Monetary
Fund (IMF) .
(Money flowing in the country is taken as + and money going out of the country is taken as
negative). For example, when India exports something it earns foreign currency and is taken
as positive in BoP record and when India imports something, we need to pay in foreign
currency and money goes out of the country and is taken as negative.
BoP has three main components viz. current account, capital account and foreign
exchange reserves (Forex).
BoP
Current Account Capital Account Forex
Merchandise Invisibles Foreign Loan Banking

(Exports & Imports Investment (ECB) Capital
of goods) (FDI, FPI) (NRI deposits)
Services Factor Income Transfers

(Banking, Telecom etc.) 1. Employee 1. Gifts
Compensation 2. Grants
2. Investment 3. Remittances
Income
(Profit, Interest, dividend
on the assets abroad)
Current Account: Current account deals in those transactions which does not create any
future obligations or liabilities. Current account comprises of visible trade (export and
import of goods), invisible trade (export and import of services), unilateral transfers and
investment income (income earned from factors of production such as land, foreign shares,
loans etc.).
Capital Account: The capital account is a record of the inflows and outflows of capital that directly
affect a country’s foreign assets and liabilities. Transactions under capital account create future
obligations and liabilities or settles previous obligations. Capital account comprises of foreign
investments like FDI and FPI, Loans by companies and governments and banking capital such as
NRI deposits.
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Explanation: When a person is purchasing shares abroad, it comes under capital account as it is
a change in assets. But when the person will receive dividend from the shares then it comes under
current account as it is not changing the assets. In the same way when we are taking loan from
an international agency then it comes under capital account as it is creating liability. But when
we are paying interest on this loan then it comes under current account as interest payment is
not reducing previous liabilities. Similarly if we are receiving gifts or grants or remittances then it
is not creating any obligation or liability for future and hence will come under current account.
Let us consider an example to understand BoP in a better way:
As on 01.04.17 01.04.2017 - 31.03.2018 As on 01.04.18

Forex Forex
1. Current A/c balance = $ -100 billion
2. Capital A/c balance = $ +150 billion
$ 350 Billion 3. Balance of Payment = $ + 50 billion $ 400 Billion
4. Increase in Reserve = $ 50 billion
Assume that on 1st April 2017, RBI was having foreign exchange reserve (Forex) of $ 350 billion. Suppose,
in the FY 2017-18, there was deficit in current account balance of $ 100 billion and a surplus in capital account
balance of $ 150 billion. So the overall balance of payment will be + $ 50 billion in the FY 2017-18. Since we
have earned net foreign exchange worth $ 50 billion in the FY 2017-18, so our foreign exchange reserves
will increase at the end of the financial year to $ 400 billion.
Current A/c + Capital A/c = Overall balance of payment = Change in Forex
The Reserve Bank of India (RBI) has been compiling and publishing Balance of Payments (BoP)
data for India since 1948
Trade Account: Shows receipts and payments from imports and exports of goods. Example: The
import of goods like crude oil and export of goods like textiles are recorded here.
Invisible account: Shows receipts and payments from imports and exports of services including
software, tourism, income receipts (resulting out of investment), gifts and remittances.
For India, invisible account has a surplus for most years. The software exports and private
remittances are included here. Similarly, foreign companies take out money through income
account as they have made investment in India in the past.
Credit in the BoP: Any activity that results in dollar earnings/inflows is a credit item.
For example, receipt of dollar from the export of good/service is a credit item. Borrowings
from foreign countries for us is also a credit as we get dollar from such borrowings.
Debit in the BoP: Any activity that results in dollar spending/outflows is a debit item.
Payment (in dollars) for imports of goods and services is a debit item. Similarly, investment
by Indian companies in foreign countries is a debit transaction as the companies take
away dollars from India to foreign countries.

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Surplus in current account arises when exports are more than imports. It indicates net
inflow of foreign exchange.
Deficit in current account arises when imports are more than exports. It indicates net
outflow of foreign exchange.
Trade Deficit: if payments for imports of goods are greater than receipts from exports of
goods, we will have a deficit in the trade account.
Trade Surplus: when receipts from export of goods are greater than payment for imports
of goods, we will have a surplus in the trade account.
Balance of Trade (BOT): It is the difference between the money value of exports and
imports of material goods [called visible items or merchandise) during a year. Examples of
visible items are clothes, shoes, machines, etc. Clearly, the two transactions which
determine BOT are exports and imports of goods.
Foreign capital: Investable money from foreign countries to India. FDI, FPI, ECBs,
Depository Receipts, Rupee Denominated Bonds etc. are types of foreign capital. The most
popular form of foreign capital is foreign investment in the form of FDI and FPI.
The balance of payment deficit or surplus is obtained after adding the current account
and capital account balance which is then added or subtracted from the foreign exchange
reserves. A country is said to be in BoP equilibrium when the sum of its current account
and capital account equals zero. The reserve transactions are seen as the accommodating
item in the BoP.
India is having trade deficit historically. Continuous and high trade deficit is the most
undesirable feature of India’s BoP.
India is having invisible surplus. Software exports is the largest surplus item in the
invisible account.
Private Remittances sent by NRIs from oversea is the second largest item in the invisible
account.
Foreign exchange reserve: If there is net dollar inflow in the balance of payment account
it will be absorbed into the foreign exchange reserve. On the other hand, if there is deficit,
it will be taken out of the reserves.
Current account deficit shows India is a net importer of goods and services together.
India’s income account is in deficit as foreign companies are repatriating income from
their past investment from India. Income in the form of profit, royalty, interest, dividend
etc. are repatriated.
India is having a surplus in the capital account most years due to FDI, FPI, ECBs and
NRI Deposits.
Currency convertibility refers to the freedom to convert domestic currency into other
internationally accepted currencies and vice versa. Exporters, importers, foreign investors,
domestic investors investing abroad, residents and corporate etc., would like to convert
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domestic currency into foreign currency and vice versa to meet their international
engagements.
Convertibility is viewed for the purpose for which it has been used- whether it is
for current account purpose or for capital account purpose.
Current account convertibility: Current account convertibility means freedom to convert
domestic currency into foreign currency and vice versa to execute trade in goods and
invisibles.
Capital account convertibility: Capital account convertibility is the freedom of foreign
investors to purchase Indian financial assets (shares, bonds etc.) and that of the domestic
citizens to purchase foreign financial assets. It provides rights for firms and residents to
freely buy into overseas assets such as equity, bonds, property and acquire ownership of
overseas firms besides free repatriation of proceeds by foreign investors.
Current Account Convertibility: RBI allows full conversion of Rupee into foreign
currencies and foreign currencies into Rupee (at market price i.e. Nominal Exchange Rate)
for any transactions under current account of BoP. This is called "rupee is fully convertible
at current account". So suppose someone wants to import commodities worth $10 billion
in India then RBI will convert that many Rupees into $10 billion without any restriction
for import purpose. As a part of the economic reforms initiated in 1991 rupee was made
fully convertible at current account in 1993.
Capital Account Convertibility: RBI does not allow full conversion of Rupee into foreign
currencies and foreign currencies into Rupee for transactions under capital account of
BoP. There are restrictions/limits imposed by the RBI and government on the value of
transactions that anybody can do under capital account. This is called "rupee is partially
convertible at capital account". So suppose someone wants to borrow $5 billion as
External Commercial Borrowing (ECB) then RBI may not convert the whole $5 billion into
Rupees.
Rupee will move to full capital account convertibility as the macroeconomic parameters
like current account deficit, fiscal deficit, external debt, inflation are in low range and
stable. Since capital convertibility is risky and makes foreign exchange rate more volatile,
it is introduced only sometime after the introduction of convertibility on current account
when exchange rate of currency of a country is relatively stable, deficit in balance of
payments is well under control and enough foreign exchange reserves are available with
the Central Bank.
Tarapore committee on capital account convertibility: In 1997, RBI appointed a

committee on the capital account convertibility under the chairmanship of Mr. S.S.
Tarapore, the former Deputy Governor of The Reserve Bank of India. As per the committee,
capital account convertibility refers to the freedom to convert the foreign financial assets
with the local financial assets and vice versa at the exchange rate determined by the
market forces of demand and supply.

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Forex Market
Foreign Exchange, Forex (FX) as it is called is trading of a single currency for another at
a certain price and bank deposits on the over-the-counter (OTC) market place. It simply
means buying one currency and selling the other. The values appreciate and depreciate
as a result of various economic and geopolitical factors.
The objective of FX trader is to make profits from these fluctuation in prices, speculating
on which way the foreign exchange rates are likely to move in the future.
It does not have any regular market timings, operates 24 hours 7 days week 365 days a
year.
Forex transactions are generally quoted in pairs because when one currency is bought,
the other is sold. The first currency is called the ‘base currency’ and the second currency
called the ‘quote currency’.
The largest foreign exchange market is London followed by New York, Tokyo, Zurich and
Frankfurt.
The origin of the foreign exchange market in India could be traced to the year1978 when
banks in India were permitted to undertake intra-day trade in foreign exchange.
Following the recommendations of the Dr. C. Rangarajan Committee to move towards the
market determined exchange rate, the Liberalised Exchange Rate Management System
(LERMS) was put in place in March 1992 initially involving a dual exchange rate system.
Currently, the following instruments are available in the Indian forex market:
Spot, Cash and Tom
Forwards
FX swaps
Currency Swaps
FX options (includes Cost Reduction structures and Covered Calls & Puts)
Exchange Traded Currency Futures and Options.
Reserve Bank had set up the Clearing Corporation of India Ltd. (CCIL) in 2001 to reduce
settlement risks in the Indian financial markets. The CCIL undertakes settlement of
foreign exchange trades of all spot, cash, tom and forwards transactions are guaranteed
for settlement from the trade date.
The Reserve Bank oversees the foreign exchange market in India. It supervises and
regulates it through the provisions of the Foreign Exchange Management Act, 1999.
Like other markets, the foreign exchange market has also evolved over time and the
Reserve Bank has been modulating its approach towards its function of supervising the
foreign exchange transactions.
Foreign Exchange Management Act (FEMA) 1999 was enacted in 1999 to replace
FERA, 1973 with effect from June 1, 2000.
The express objective of FEMA was to facilitate external trade and payments (not
conservation of foreign exchange) and promote orderly development and maintenance of
the foreign exchange market in India.
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Emphasizing the shift in focus, the Reserve Bank in due course also amended (since
January 31, 2004) the name of its department dealing with the foreign exchange
transactions from Exchange Control Department (ECD) to Foreign Exchange
Department (FED).
Foreign Exchange Dealer's Association of India (FEDAI) was set up in 1958 as an

Association of banks dealing in foreign exchange in India (typically called Authorised
Dealers - ADs) as a self regulatory body and is incorporated under Section 25 of The
Companies Act, 1956. 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.
Presently some of the functions are as follows:

 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.
The main players of the Forex market are:

 Governments and Central Banks
 Commercial banks and companies
 Hedge funds
 Brokerage companies
 Investors
 Retail Forex traders
 Speculators
Types of foreign exchange market operations
 Spot market operations (current market): the market which handles the spot
transactions or current transactions of foreign currencies are known as spot
market. They handle only spot transactions and transactions are of daily in nature.
 Forward Market (or derivative market): Forward Market deals with future delivery
of foreign exchange instruments. Forward Market transactions determine the
forward exchange rate at which the forward transactions are honored. It deals with
instruments such as currency futures, currency swaps, foreign exchange forward,
and currency options etc.
Important Definitions:
Hard currencies: A currency used as medium of exchange in international transactions.

US Dollar, Euro, British Pound Sterling, Japanese Yen and Chinese Renminbi. The status
for hard currencies are symbolically included under the IMF’s SDR Basket.
Exchange rate: Exchange rate (foreign exchange rate) is the rate at which domestic
currency is traded for a foreign currency. Similarly, it is the rate which shows the value of
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domestic currency in terms of other currencies. Here, the value of Rupee means the value
measured in terms of other currencies like the US Dollar.
Exchange rate system (ERS): Exchange rate system refers to the arrangement for the
movement of exchange rate. There are basically three types of exchange rate systems
globally: flexible or floating exchange rate system, fixed exchange rate system and
managed floating (intermediate exchange rate system).
Fixed ERS: Here, the exchange rate is kept fixed by the central bank. It is the central
bank’s discretion to change the exchange rate. Presently, many developing countries are
having fixed ERS. Under fixed ERS, when the central bank reduces the external value of
the domestic currency, it is called devaluation. Similarly, when the central bank increases
the external value of the domestic currency, it is called revaluation.
Flexible or Floating ERS: Here, the exchange rate is determined in the foreign exchange
market by the operation of market forces. Demand and supply of foreign currency is the
main market forces that determine the exchange rate. The central bank never intervenes
in the foreign exchange market to stabilise the exchange rate. Presently, most of the
advanced countries are having floating ERS. Under floating exchange rate system, the
currency movements are appreciation and depreciation. Appreciation is increase in the
external value of the domestic currency due to the operation of the market forces.
Depreciation is decrease in the external value of the domestic currency.
Managed floating or Intermediate Exchange rate System: In this hybrid exchange rate
system, the exchange rate is determined in the foreign exchange market through the
operation of market forces. But during extreme fluctuations, the central bank intervenes
in the foreign exchange market. Hence, there will be depreciation and appreciation
depending on the environment. India is having this type of exchange rate system.
Pegged Exchange Rate: A pegged exchange rate, also known as a fixed exchange rate, is
where the currency of one country is tied to a usually stronger currency, such as the euro,
US dollar or pound sterling. The purpose of this is to attempt to maintain the currency’s
value, keeping it at a “fixed” rate and to avoid exchange rate fluctuations.
Revaluation: It refers to the increase in the external value of the domestic currency
deliberately made by the central bank under a fixed exchange rate system. Eg. 1$ = Rs 65
to 1$ = Rs 50)
How external value is increased:
For example, an imported camera worth $ 100 will cost us Rs 6500, if the exchange rate
is $1 = Rs 60 and if rate is $1 = Rs 50 then will cost Rs 5000 means Rupees value is
increased as more/additional goods/services can be purchased in Rs 6500.
Devaluation: refers to the decrease in the external value of the domestic currency
deliberately made by the central bank under a fixed exchange rate system. (eg. 1$ Rs 40
to 1$ = Rs 50).
For example, an imported camera worth $ 100 will cost us Rs 40000, if the exchange rate
is $1 = Rs 40 and if rate is $1 = Rs 50 then will cost Rs 5000 means Rupees value is
decreased as extra rupees have to pay for import.
Depreciation: refers to the decrease in the external value of the domestic currency
occurred due to the operation of market forces. Here, the exchange rate is moving with
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demand and supply of dollar. Depreciation happens under a flexible exchange rate system
or under a managed flexibility. (Eg. 1$ = Rs 40 to 1$ = Rs 50)
Appreciation: refers to the increase in the external value of the domestic currency
occurred due to the operation of market forces. Here, the exchange rate is moving in
accordance with the demand and supply of dollar. Appreciation happens under a flexible
exchange rate system or under a managed floating (India’s exchange rate system). (Eg. 1$
= Rs 65 to 1$ = Rs 50).
Currency War: One of the leading issues related with international trade at present is the
gain in exports by some countries through the manipulation of exchange rate. By keeping
domestic currency undervalued, a country can increase exports and reduce imports.
Undervalued currency means we have to pay more of the domestic currency to get a single
unit of international currency like Dollar.
The RBI never tries to make the rupee an undervalued currency and never indulges in
currency war. The example below is for understanding the concept. In India, the rupee is
depreciating mainly because of high trade deficit.
Undervalued currency
Suppose that the exchange rate of rupee is Rs 60 per one US $. This is the exchange rate
prevailing in the Indian foreign exchange market. Now, imagine that the RBI buys dollar
from the market substantially, thereby causing high demand for dollar. As a result, the
exchange rate will increase to Rs 65 or like. In this case, the rupee becomes an
undervalued currency. Meaning is that the currency’s value is artificially lower, and
otherwise it would have been much higher vis a vis the dollar. An undervalued currency
is one whose value is lower than it ought to be.
The new exchange rate implies that now foreigners can get Rs 65 worth of
commodities by spending one dollar from India compared to just Rs 60 worth of
commodities previously. This will encourage India’s exports.
On the import side, previously we were paying just 60 rupees to import a dollar
worth commodity. Now we have to pay Rs 65 to get a commodity whose price is one dollar
in the international market. Hence, our imports will come down. Here, as a result of a
smart and calculated intervention by the central bank by buying the dollar in the domestic
market, our exports have increased and imports decreased, bringing trade gains.
Nominal Exchange Rate, PPP Exchange Rate and Real Exchange Rate
Nominal Exchange Rate (NER)

NER = Value of foreign currency expressed in terms of domestic currency.
For example, value of 1 dollar expressed in terms of Indian Rupees (currently $ 1 = Rs.
69)
NER means how many rupees somebody will get when he sells one dollar in the exchange
market. The NER depends on the market forces of demand and supply. If more and more
people are purchasing dollars in the exchange market then the demand of dollar increases
and dollar will become stronger or appreciate. But if more and more tourists are coming
to India and are converting their dollars and demanding rupees then rupee will appreciate.
Purchasing Power Parity (PPP) Exchange Rate

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Suppose NER is $1 = Rs.70 (for simple calculation) and India and US produces just
burgers.
India US
And, Burger Price Rs. 35 $1
PPP exchange rate means that if $1 can purchase one burger in US then that same burger
can be purchased in how many rupees in India.
To calculate PPP exchange rate in the above case, we just need to compare the prices of
the burger in both the countries.
In the above case by comparing the prices of burger in India and US, we get, $1 = Rs. 35.
So, $1 = Rs. 35 is the PPP exchange rate. And this implies that whatever Rs. 35 can
purchase in India, $1 can purchase in US i.e. purchasing power of Rs. 35 in India is equal
to purchasing power of $1 in US.
Above was a case of just one product. If both the countries are producing several
commodities then consider a basket of commodities which are produced in both the
countries and compare the prices, whatever we will get will be the PPP exchange rate.
Consider another example:
India US
Consider a Consider the

basket of one same basket
unit each of of
100 commodities
commodities as in India
Suppose the price of the basket of commodities in India is Rs 1200 and the price of the
same basket of commodities in US is $100. This means that purchasing power of Rs. 1200
in India is same as purchasing power of $100 in US.
So PPP exchange rate will be Rs. 1200 = $ 100

i.e. $1 = Rs. 12
And so, if the inflation rate is different in both the countries then PPP exchange rate will
change. But if there is same inflation rate or no inflation then PPP exchange rates will not
change over time and will be constant.
When Nominal Exchange Rate becomes equal to PPP exchange rate, we say that the
currencies of the two countries are at purchasing power parity.
As per IMF "The purchasing power parity between two countries is the rate at which the
currency of one country needs to be converted into that of a second country to ensure that a
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given amount of the first country's currency will purchase the same volume of goods and
services in the second country as it does in the first."
Real Exchange Rate: Consider the above example of burger:

(NER) $1 = Rs. 70
India US
1 1
burger burger
= Rs. 35 = $1
In the present situation, US will import burgers from India (or India will export burgers to
US) because a US person will get one burger in $1 and if he sells his $1 and buys Rs. 70
from the exchange market then with Rs. 70 he can purchase two burgers from India.
(Considering transportation cost is negligible.)
Whether India will continue to export burgers to US or not will depend on three
parameters.
 Price of Burger in US (if it increases, exports to US will increase)

 Price of Burger in India (if it increases, exports to US will reduce)
 Nominal Exchange Rate (if it increases, exports to US will increase)
Whether India's exports/trade are competitive with US or not will also depend on these
three parameters
 Price of Burger in US (if it increases, India's export competitiveness will increase)

 Price of Burger in India (if it increases, India's export competitiveness will reduce)
 Nominal Exchange Rate (if it increases, India's export competitiveness will increase)
Which implies that, India's trade competitiveness Price of burger in US

1/Price of burger in India
Nominal exchange rate
India's trade competitiveness = Price of burger in US X Nominal exchange rate

Price of burger in India
And trade competitiveness is basically represented by the real exchange rate, so
Real Exchange Rate = Price of burger in US X Nominal exchange rate

Price of burger in India
Real Exchange Rate = Nominal Exchange Rate

(Price of burger in India/Price of Burger in US)

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Real Exchange Rate = Nominal Exchange Rate
PPP Exchange Rate
= ($1) X (Rs. 70/$)

(Rs. 35)
=2
Till Real Exchange Rate > 1, India will continue to export its burgers to US.
If Real Exchange Rate becomes equal to 1, then export & import will stop.
If Real Exchange Rate < 1, then US will start exporting its burgers to India.
So Real Exchange Rate determines export competitiveness between two countries.
When Real Exchange Rate = 1, Nominal Exchange Rate = PPP Exchange rate and we say
that the currencies are at purchasing power parity. This means that goods cost the same
in two countries when measured in the same currency.
If India wants to measure its export competitiveness with all its trading partners with just
one parameter then it calculates Real Effective Exchange Rate (REER) which is a weighted
average (with respect to trade value) of the Real Exchange Rates of its trading partners.
Similarly if India wants to calculate its nominal exchange rate with respect to a group of
other countries then it can calculate Nominal Effective Exchange Rate.
The nominal effective exchange rate is the exchange rate of the domestic currency vis-
à-vis the basket currencies, weighted by the shares of the basket country’s trade in the
domestic country’s trade.
On the other hand, REER is a weighted average of nominal exchange rates adjusted for
relative price differential between the domestic and foreign countries, based upon the
purchasing power parity (PPP) hypothesis
Spot and Forward transactions:

The transactions in the interbank market may place for settlement
(a) on the same day; or
(b) two days later; or
(c) some day late; say after a month
Where the agreement to buy and sell is agreed upon and executed on the same date, the
transaction is known as cash or ready transaction. It is also known as value today.
The transaction where the exchange of currencies takes place two days after the date of
the contact is known as the spot transaction. For instance, if the contract is made on
Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the
delivery will take place on the next day, i.e., Thursday. Rupee payment is also made on
the same day the foreign currency is received.
The transaction in which the exchange of currencies takes places at a specified future
date, subsequent to the spot date, is known as a forward transaction. The forward
transaction can be for delivery one month or two months or three months etc. A forward
contract for delivery one month means the exchange of currencies will take place after one
month from the date of contract. A forward contract for delivery two months means the
exchange of currencies will take place after two months and so on.
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Direct and Indirect quotes :
American Term and European Term
Quotes in American terms are the rates quoted in amounts of U.S. dollar per unit of foreign
currency. While rates quoted in amounts of foreign currency per U.S. dollar are known as
quotes in European terms.
For example, U.S. dollar 0.2 per unit of Indian rupee is an American quote while INR 44.92
per unit of U.S. dollar is a European quote.
Direct quotes: • No of units of the domestic currency per unit of foreign currency • E.g.
1$ = Rs 49.50 is a dollar direct quote of an Indian rupee in India. However the same quote
when quoted in US is not a direct quote for an American.
Indirect quotes: • No of units of a foreign currency per fixed number of domestic currency;
• E.g. Rs 100 = $0.2245
Two way quotes:

Bid price and offer (ask) price • Bid is the price at which a dealer is willing to buy another
currency and offer is the rate at which he is willing to sell the currency.
• E.g. a quote of Rs /$ is Rs42.50 / 42.55 it means that the dealer will buy $ at Rs 42.50
and sell dollar at 42.55
Spreads • Spread is the difference between the bid rate and the offer rate and usually
represents the profit margins that a dealer expects to make.
E.g. a quote of Rs /$ is Rs42.50 / 42.55 means spread is 0.05
Premium: A currency is said to be at a premium if it is more expensive in the forward

than in the spot.
If Rs / $ spot is 44.95 and 3 months forward is 45.20 we say that dollar is at a premium.
Discount: A currency is said to be at a discount when it is quoting higher in the spot and
cheaper in the forward.
If Rs / $ spot is 45.20 and 3 months forward is 44.95 we say that dollar is at a discount.
Cross currency rates:

In India all buy and sell transactions are routed through the US $. Hence all deals
involving any other currency would necessarily involve converting in US$ and then
converting the US$ into INR.
Thus if an Indian importer wishes to buy Yen he would first have to sell rupees and buy
dollar; then he would sell dollar and buy Yen.
The banker would obtain the Yen / $ rate from Singapore or Tokyo and then apply the Rs
/$ rate to determine the amount of rupees required to buy the desired Yen.
Hedging: A foreign exchange hedging strategy is a concept referring to the rules and
procedures followed by investors to protect their profit margins from foreign exchange
volatility when trading currencies. The most common method of hedging currency risk is
through the use of hedging products, such as currency swaps, forward contracts and
options.

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Speculation: Currency speculation is the act of purchasing and holding foreign currency
in the hopes of selling that currency at an appreciated, or higher, rate in future.
Arbitrage Arbitrage is the simultaneous buying and selling of foreign currencies with
intention of making profits from the difference between the exchange rate prevailing at the
same time in different markets.
Forward exchange contract: A forward exchange contract is an agreement under which

a business agrees to buy a certain amount of foreign currency on a specific future date.
The purchase is made at a predetermined exchange rate. By entering into this contract,
the buyer can protect itself from subsequent fluctuations in a foreign currency's exchange
rate.
Example of How a Forward Contract Works

ABC Factory in India is looking to buy goods from USA. The business meets with
the supplier, and agrees to pay USD $10000 in 3 months from now.
The current INR/ USD exchange rate at the time of the deal is USD $1.00 =
INR60.00
ABC Factory therefore expects to pay INR 600000 for the equipment.
In 3 months’ time, USD $1.00 = INR65.00
Here is what could happen;

Scenario 1: If ABC Factory doesn’t use a Forward contract
In 3 months’ time, when the business is ready to pay for the goods from USA, the
exchange rate has moved adversely for ABC Factory, USD $1.00 = INR65.00. This
means that the goods would cost INR 650000.
ABC Factory would pay 50000 more than anticipated originally.
Scenario 2: ABC Factory does use a Forward contract

After 3 months, ABC Factory is ready to purchase the equipment from Taiwan. ABC
Factory negotiated a forward contract of 3 months with a currency provider at
current exchange rate USD $1.00 = INR60.00 which means currency provider will
provide foreign exchange after 3 months at current exchange rate USD $1.00 =
INR60.00.
After 3 months, the exchange rate has moved adversely, however, as USD $1.00 =
INR65.00, The result is that ABC Factory saves 50000 by thinking ahead and
protecting itself with a forward currency contract.
Forwards Rates Agreements (FRAs): The forward rate is different from the spot rate.
Depending upon whether the forward rate is greater than the spot rate, given the currency
in consideration, the forward may either be at a 'discount' or at a 'premium'. Forward
premiums and discounts are usually expressed as an annual percentages of the difference
between the spot and the forward rates.
 Premium: When a currency is costlier in forward or say, for a future value date, it is
said to be at a premium. In the case of direct method of quotation, the premium is added
to both the selling and buying rates.

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 Discount: If the currency is cheaper in forward or for a future value date, it is said to
be at a discount. In case of direct quotation the discount is deducted from both the selling
and buying rate. The following example explains how to calculate Premium / Discount
both under Indirect/Direct quotes.
Example:
For instance, if the Spot rate between INR and USD is Rs. 55 to a dollar and the six months
forward rate is Rs. 60 to a dollar, it is clear that the forward rate is at a premium.
The premium is ` 5 for six months forward rate.
For instance, if the Spot rate between INR and USD is Rs. 55 to a dollar and the six months
forward rate is Rs. 50 to a dollar, it is clear that the forward rate is at a discount.
The discount is ` 5 for six months forward rate.
TT (Telegraphic Transfer) buying rate indicates the rate at which bank convert foreign
inward remittances to INR. TT Selling rate indicates the rate at which the bank sends an
outward remittance through telegraphic transfer.
Bretton Woods Agreement: The Bretton Woods Agreement, implemented in 1946,

whereby each member government pledged to maintain a fixed, or pegged, exchange rate
for its currency vis-à-vis the dollar or gold. These fixed exchange rates were supposed to
reduce the riskiness of international transactions, thus promoting growth in world trade.
Exchange Rate Theories:

Interest Rate Parity (IRP) Interest rate parity is a theory which states that ‘the size of the
forward premium (or discount) should be equal to the interest rate differential between
the two countries of concern”. It was made popular in 1920s by economists such as John
M. Keynes.
Expected spot rate = Current Spot Rate x expected difference in interest rates
S0 is the current spot rate (Direct Quote)

Id is the interest rate in the domestic country (home country)
If is the interest rate in the foreign country
Purchasing Power Parity (PPP) The spot rate of one currency w.r.t. another will change
in reaction to the differential in inflation rates between two countries. Consequently, the
purchasing power for consumers when purchasing goods in their own country will be
similar to their purchasing power when importing goods from foreign country.

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S0 is the current spot rate (Direct Quote)

Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country
The International Fisher Effect: The relationship between the percentage change in the
spot exchange rate over time and the differential between comparable interest rates in
different national capital markets is known as the international Fisher effect.
 The Fisher Effect: The Fisher effect, named after economist Irving Fisher, states
that nominal interest rates in each country are equal to the required real rate of
return plus compensation for expected inflation.
Currency Swap: A currency swap contract (also known as a cross-currency swap contract)
is a derivative contract between two parties that involves the exchange of interest
payments, as well as the exchange of principal amounts in certain cases, that are
denominated in different currencies. Although currency swap contracts generally imply
the exchange of principal amounts, some swaps may require only the transfer of the
interest payments. Currency swaps are traded over the counter.
Example: In order to understand the mechanism behind currency swap contracts, let’s
consider the following example. Company A is a US-based company that is planning to
expand its operations in India. Company A requires INR 850,000 to finance its European
expansion.
On the other hand, Company B is an Indian company that operates in the United States.
Company B wants to acquire a company in the United States to diversify its business. The
acquisition deal requires US$1 million in financing.
Neither Company A or Company B holds enough cash to finance their respective projects.
Thus, both companies will seek to obtain the necessary funds through debt financing.
Company A and Company B will prefer to borrow in their domestic currencies (that can
be borrowed at a lower interest rate) and then enter into the currency swap agreement
with each other.
The currency swap between Company A and Company B can be designed in the following
manner. Company A obtains a credit line of $1 million from Bank in USA with a fixed
interest rate of 3.5%. At the same time, Company B borrows INR 850,000 from Indian
Bank with the floating interest rate of 6-month MIBOR. The companies decide to create a
swap agreement with each other.
According to the agreement, Company A and Company B must exchange the principal
amounts ($1 million and INR 850,000) at the beginning of the transaction. In addition, the
parties must exchange the interest payments semi-annually.

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Company A must pay Company B the floating rate interest payments denominated in INR,
while Company B will pay Company A the fixed interest rate payments in US dollars. On
the maturity date, the companies will exchange back the principal amounts at the same
rate ($1 = INR 0.85).
Types of Currency Swaps contracts:
 Fixed vs. float: One leg of the currency swap represents a stream of fixed interest
rate payments while another leg is a stream of floating interest rate payments.
 Float vs. float (basis swap): The float vs. float swap is commonly referred to as
basis swap. In a basis swap, both swaps’ legs both represent floating interest rate
payments.
 Fixed vs. fixed: Both streams of currency swap contracts involve fixed interest rate
payments.
Currency Derivatives in India: Exchange traded
Currency Derivatives (Options and Futures) are available on four currency pairs viz. US
Dollars (USD)-INR, Euro (EUR) -INR, Great Britain Pound (GBP) -INR and Japanese Yen
(JPY) -INR.
Cross Currency Futures & Options contracts on EUR-USD, GBP-USD and USD-JPY are
also available for trading in Currency Derivatives segment.
Foreign Exchange Management Act (FEMA): FEMA, 1999 extends to the whole of India.
It is also applicable to all branches, offices and agencies located outside India, which are
owned and controlled by a person resident in India and also to any contravention
committed outside India by any person to whom this Act applies.
Types of Transactions FEMA classifies all foreign exchange transactions into two broad
categories viz. Current Account and Capital Account transactions. As defined under FEMA
A “capital account transaction” is a transaction which

 Alters the assets and liabilities outside India of a person resident in India or Alters
the assets and liabilities in India of a person resident outside India.
 Liabilities include contingent liabilities also.

 Example – Foreign Direct investment, External Commercial Borrowings, FII/FPI
investment, Non-resident deposits etc.
A “current account transaction” is transaction other than a capital account

transaction i.e. mostly of a revenue nature:
 Example – Exports, Imports, Personal remittances, Gift, Income etc.
Type of Persons Applicability of FEMA is generally dependent upon the residential status
of a person and the nature of the transaction undertaken. A 'person' can be an individual,
a HUF, a company, a firm, an association of persons etc. A “person” under FEMA is either
a “person resident in India” or a “person resident outside India”. The residential status of
a person is not only based on the period of stay in India but also the intent to stay for a
long/uncertain period.
Person Resident in India(Resident) - On that basis, the resident definition as per FEMA
broadly includes “a person residing in India for more than 182 days(120 days proposed
in budget) in the preceding financial year”; any person or body corporate registered /
incorporated in India; an office, branch or agency in India owned or controlled by a person
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resident outside India; an office, branch or agency outside India owned or controlled by a
person resident in India. With regards to intent, any person who has come to or stays in
India for taking up employment in India, or carrying on business or vocation in India or
any other purpose which indicates his intention to stay in India for an uncertain period is
considered a Resident.
Person Resident outside India (Non-Resident) – A person who does not fall under the
definition of a Resident is considered a non-Resident and also includes persons who have
gone out of India or who stay outside India for taking up employment in India or carrying
on business or vocation in India or any other purpose which indicates his intention to stay
outside India for an uncertain period.
Authorised Persons (APs):

Reserve Bank authorises persons designated as Authorised Persons to deal in foreign
exchange as, inter alia, an Authorised Dealer or a Money Changer.
Reserve Bank also permits AD Cat – I Banks, AD Cat - II entities and FFMCs to enter
into franchisee (also referred as agency) agreements at their option for the purpose of
carrying on Restricted Money Changing business i.e. conversion of foreign currency notes,
coins or travellers' cheques into Indian Rupees.
Current Account Transactions: The Government has prescribed the Current Account
Transaction Rules, 2000 for the purpose. The Rules have three schedules appended.

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In addition to transactions mentioned in Schedule I, drawal of foreign exchange is also

prohibited for travel to Nepal or Bhutan or a transaction with a person resident in Nepal
or Bhutan.
Capital Account Transactions: Some of the types of capital flows are described below:
Non-Resident Deposits – Deposit accounts for non-resident Indians was one of the
earliest measures to strengthen capital inflows.
 NRE account – NRE or Non-Resident (External) Rupee Account:

o The account can be opened by NRIs and PIOs.
o This account can be opened as savings, current, recurring and fixed
deposit
o This account is denominated in Indian Rupees.
o Income earned in the accounts is exempt from income tax and balances
exempt from wealth tax.
 FCNR(B) Account – FCNR(B) or Foreign Currency (Non-Resident) Account

(Banks):
o The account can be opened by NRIs and PIOs.
o This account can be opened as a term deposit (For terms not less than 1
year and not more than 5 years)
o This account can be opened in any freely convertible foreign currency
o Income earned in the accounts is exempt from income tax and balances
exempt from wealth tax.
 NRO Account – NRO or Non-Resident Ordinary Rupee Account:

 The account can be opened by any non-resident.
 This account can be opened as savings, current, recurring and fixed deposit.
 This account is denominated in Indian Rupees.
 Income earned in the accounts is taxable.
For All the above accounts, Individual/entities of Pakistan and Bangladesh shall
requires prior approval of the Reserve Bank of India.

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 SNRR Account – Special Non-Resident Rupee (SNRR) Account: can be opened
by any non-resident having a business interest in India for the purpose of putting
through bona fide transactions in Rupees. The account can be opened as a current
account and does not bear any interest.
Foreign Direct Investment: The framework for FDI, which gets legal sanctity under the
regulations notified by the Reserve Bank under FEMA, is set by the Government of India
in consultation with the Reserve Bank of India, and the only restriction on FDI pertains
to sectoral investment limits. Except a handful of activities like investments in gambling,
betting, nidhi companies, lottery business etc. which are prohibited for foreign investment,
a person resident outside India or an incorporated entity outside India can invest either
with the specific prior approval of the Government of India or under the Automatic route.
Investment under automatic route is permissible without approval of the Government or

the Reserve Bank subject to the prescribed sectoral cap.
 American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) -

Depository Receipts (DRs) are foreign currency denominated instruments issued by
a foreign Depository in a permissible jurisdiction against a pool of permissible
securities issued or transferred to that foreign depository and deposited with a
domestic custodian. An Indian corporate can raise foreign currency resources
abroad through the issue of American Depository Receipts (ADRs) or Global
Depository Receipts (GDRs) subject to certain conditions.
Portfolio Investments by Foreign Portfolio Investors (FPIs) / Nonresident Indians

(NRIs) – Registered Foreign Portfolio Investors (RFPIs) registered with SEBI and Non-
resident Indians are eligible to purchase shares and convertible debentures under the
Portfolio Investment Scheme. Portfolio investment flows exhibit some volatility and surge
either way and hence are subject to certain limits.
 Investment by individual FPIs should be less than 10 per cent of the paid up
capital of the Indian company on a fully diluted basis. The aggregate investment by
FPIs should not exceed 24 per cent of the paid up capital of an Indian Company
on a fully diluted basis.
 Non- Resident Indian (NRIs) can purchase or sell FDI compliant instruments of
Indian companies on the Stock Exchanges under the Portfolio Investment Scheme.
An NRI can purchase shares up to 5 per cent of the paid up capital of an Indian
company on a fully diluted basis. All NRIs taken together cannot purchase more
than 10 per cent of the paid up value of the company.
 Foreign Portfolio Investors (FPIs), Non-Resident Indians (NRIs), Foreign Central

Banks, Multilateral Development Bank, Long term investors like Sovereign Wealth
Funds (SWFs), Multilateral Agencies, Endowment Funds, Insurance Funds, Pension
Funds which are registered with SEBI are also allowed to invest in Central
Government Securities, State Development Loans and Corporate Bonds subject to
various limits.
External Commercial Borrowings – External Commercial Borrowings (ECBs) are bi-

partite loan contracts denominated in foreign currency and initiated by the domestic
borrowers. The approach here has been that since the external liability of the economy
should not be allowed to expand excessively, the ECBs need to be allocated, as it were, to
their most productive use. This objective is sought to be achieved through a regulatory
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regime comprising restrictions in regard to quantum of loan, end use, tenor, lender
credentials and cost of borrowing. ECBs can also be raised as FCCBs and FCEBs:
 Foreign Currency Convertible Bond (FCCB) –

o A bond expressed in foreign currency.
o The principal and the interest of which is payable in foreign currency.
o The issuer of the bond is an Indian company.
o The bonds are subscribed by a person resident outside India.
o The bonds are exchangeable into equity shares of same company (issuer of
bond)
 Foreign Currency Exchangeable Bond (FCEB) –

o A bond expressed in foreign currency.
o The principal and the interest of which is payable in foreign currency.
o The issuer of the bond is an Indian company.
o The bonds are subscribed by a person resident outside India.
o The bonds are exchangeable into equity shares of another company which is
also called the offered company.
o It may be noted that issuing company is to be the part of promoter group of
offered company and the offered company is to be listed and be eligible to
receive foreign investment.
o For example, company ABC Ltd issues FCEBs, then these FCEBs will be
convertible into shares of company XYZ Ltd that are held by company ABC
Ltd and where companies ABC Ltd and XYZ Ltd form part of the same
promoter group.
Rupee Denominated Bonds Overseas (Masala Bonds) – A framework for issuance of

rupee denominated bonds overseas, also called Masala Bonds, was put in place in
September 2015. Any corporate or body corporate (entity specially created out of a specific
act of the Parliament) and Indian banks are eligible to issue Rupee denominated bonds
overseas. Investments in these bonds can be done by foreign investors of a FATF compliant
country or by Multilateral and Regional Financial Institutions where India is a member
country. The bonds can either be placed privately or listed on exchanges as per host
country regulations.
 A rupee denominated bond is a bond issued by an Indian entity in foreign markets

and the interest payments and principal reimbursements are denominated
(expressed) in rupees.
 Masala bonds are bonds issued outside India but denominated in Indian Rupees,
rather than the local currency. Masala is an Indian word and it means spices. The
term was used by IFC to evoke the culture and cuisine of India. Unlike dollar bonds,
where the borrower takes the currency risk, masala bond makes the investors bear
the risk.
 The International Finance Corporation (IFC) – a World Bank affiliate is the first
major issuer of rupee denominated bonds in the name tag of ‘masala bonds’.
 In July 2016 HDFC became the first Indian company to issue masala bonds. In the
month of August 2016 public sector unit NTPC issued first corporate green masala
bonds.

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 Minimum original maturity period for Rupee denominated bonds/masala bonds
raised up to USD 50 million equivalent in INR per financial year should be 3 years
and for bonds raised above USD 50 million equivalent in INR per financial year
should be 5 years.
 Any corporate or body corporate, banks, NBFCs are eligible to issue such bonds.
REITs and INVITs coming under the regulatory framework of the SEBI are also
eligible. Other resident entities like Limited Liability Partnerships and Partnership
firms, etc. are also not eligible to issue these bonds.
Overseas Investments by Residents - In a capital scarce economy like India, it is perhaps

logical that there should be close monitoring of outbound investments. The case for
overseas direct investment (ODI) rests on permitting Indian entrepreneurs to exploit
avenues for profitable investment abroad. The case for portfolio investment abroad and
setting up of companies abroad by resident individuals, which can be done through LRS,
rests on affording an opportunity to Indian residents to diversify their portfolio.
Permissible sources for funding overseas direct investment:
i. Drawal of foreign exchange from an AD bank in India.
ii. Swap of shares
iii. Capitalization of exports and other dues and entitlements.
iv. Proceeds of External Commercial Borrowings / Foreign Currency Convertible Bonds.
v. Balances held in Exchange Earners Foreign Currency account of the Indian Party
maintained with an Authorized Dealer.
vi. Proceeds of foreign currency funds raised through ADR / GDR issues.
Foreign Currency Accounts by Resident Individuals – Residents can open foreign

currency denominated accounts in India such as Exchange Earners Foreign Currency
Account (EEFC), Resident Foreign Currency (Domestic) Account [RFC(D)], Resident
Foreign Currency Account (RFC) etc. A Foreign Currency Account is an account held or
maintained in currency other than the currency of India or Nepal or Bhutan.
 Exchange Earners' Foreign Currency Account (EEFC) is an account maintained

in foreign currency with an Authorised Dealer Category - I bank i.e. a bank
authorized to deal in foreign exchange. It is a facility provided to the foreign
exchange earners, including exporters, to credit 100 per cent of their foreign
exchange earnings to the account, so that the account holders do not have to
convert foreign exchange into Rupees and vice versa, thereby minimizing the
transaction costs.
 All categories of foreign exchange earners, such as individuals, companies,

etc., who are resident in India, may open EEFC accounts.
 An EEFC account can be held only in the form of a current account.

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 No interest is payable on EEFC accounts.
Foreign Exchange Reserves Management:
Until the balance of payments crisis of 1991, India's approach to foreign exchange reserves
was essentially aimed at maintaining an appropriate import cover.
The approach underwent a paradigm shift following the recommendations of the

High Level Committee on Balance of Payments chaired by Dr. C. Rangarajan (1993).
The committee stressed the need to maintain sufficient reserves to meet all external
payment obligations, ensure a reasonable level of confidence in the international
community about India's capacity to honour its obligations and counter speculative
tendencies in the foreign exchange market.
In 1997, the Report of the Committee on Capital Account Convertibility under the
chairmanship of Shri S.S. Tarapore, suggested alternative measures for adequacy of
reserves. The committee, in addition to trade-based indicators, also suggested money-
based and debt-based indicators. Similar views have been also held by the Committee on
Fuller Capital Account Convertibility (Chairman: Shri S. S. Tarapore, July 2006)
Management of Foreign Exchange Reserves:

In India, the foreign exchange reserves are managed by Reserve Bank of India. The foreign
exchange reserves include:
 Foreign Currency Assets (FCA),
 Special Drawing Rights (SDRs),
 Reserve Tranche Position (RTP) with the IMF and
 Gold.
The basic parameters of the Reserve Bank's policy for foreign exchange reserves
management are safety, liquidity and returns. While safety and liquidity are the twin-
pillars of reserves management, return optimization is an embedded strategy within this
framework.
Within the overall framework of reserve management, the Reserve Bank focuses on:
 Maintaining market's confidence in monetary and exchange rate policies.
 Enhancing the Reserve Bank's intervention capacity to act in the event of undue
volatility in the foreign exchange markets.
 Limiting external vulnerability by maintaining foreign currency liquidity to absorb
shocks during times of crisis, including national disasters or emergencies.
 Providing confidence to foreign investors that all external obligations will be met,
thus reducing the costs at which foreign exchange resources are available to market
participants.
 Adding to the comfort of market participants by demonstrating the backing of
domestic currency by external assets.
Legal Framework:
The Reserve Bank of India Act, 1934 provides the overarching legal framework for
deployment of reserves in different foreign currency assets and gold within the broad

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parameters of currencies, instruments, issuers and counterparties. In terms of Section
17 of the RBI Act, the forex reserves are generally invested in:
 Deposits with Bank for International Settlements and other central banks
 Deposits with foreign commercial banks
 Debt instruments representing sovereign or sovereign-guaranteed liability of not
more than 10 years of residual maturity
 Other instruments and institutions as approved by the Central Board of the Reserve
Bank in accordance with the provisions of the Act
 Certain types of derivatives
Risk Management in Reserve Management The broad strategy for reserve management
including currency composition and investment policy is decided in consultation with the
Government of India.
The risk management functions are aimed at ensuring development of a sound governance
structure in line with the best international practices, improved accountability, a culture
of risk awareness across all operations, efficient allocation of resources and development
of in-house skills and expertise.
The following risks are there in Foreign Exchange Market:
Credit Risk: This risk arises from the possibility of a counterparty making a default. This
risk may appear either during the period of contract or at the maturity date. It can be
reduced by fixing the limits of operations per client, based on the creditworthiness of the
client, by incorporating the clauses for rescinding the contract if the rating of a
counterparty goes down. To encounter this, investments by The Reserve Bank's is done in
bonds/treasury bills represent debt obligations of highly rated sovereigns, central banks
and supranational entities. Further, deposits are placed with central banks, the BIS and
overseas branches of foreign commercial banks.
Market Risk This risk results from adverse movements in the level or volatility of the
market prices of interest rate instruments, equities, commodities, and currencies. Market
risk for a multi-currency portfolio represents the potential change in valuations that result
from movements in financial market prices, for example, changes in interest rates, foreign
exchange rates, equity prices and commodity prices. The major sources of market risk for
central banks are currency risk, interest rate risk and movement in gold prices.
Gains/losses on valuation of FCA and gold due to movements in the exchange rates
and/or price of gold are booked under a balance sheet head named the Currency and Gold
Revaluation Account (CGRA).
a. Currency Risk/Exchange Rate Risk Currency risk arises due to movements in

the exchange rates. Decisions are taken on the long-term exposure to different
currencies, depending on the likely movements in exchange rates and other
considerations in the medium and long-term (e.g., maintenance of major portion of
reserves in the intervention currencies, benefit of diversification, etc.). The decision
making is supported by strategy reviews on a regular basis.
b. Interest Rate Risk

Interest rate fluctuations have a significant impact on a country’s exchange rate. A
rise in interest rates typically strengthens the country’s exchange rate due to an
increase in investments since a stable currency yields higher returns to investors.
On the other hand, when a country’s interest rates fall, its currency depreciates an
investors pull out their investments. Due to the relationship between interest rates
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and exchange rates, the resulting differential between different currencies can cause
forex price fluctuations.
Interest rate risk can be minimized either by diversifying the investment across a
broad mix of security types or by hedging. In case of hedging, an investor can enter
into an interest rate swap.
Liquidity Risk Liquidity risk is the risk of not being able to sell an instrument or close a
position when required. The reserves need to have a high level of liquidity at all times in
order to be able to meet any unforeseen and emergency needs.
Operational Risk: The risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events.
In tune with the global trend, close attention is paid to strengthen the operational risk
control arrangements by RBI.
The Reserve Bank uses SWIFT as the messaging platform to settle its trades and send
financial messages to its counterparties, banks with whom Nostro accounts are
maintained, custodians of securities and other business partners.
All international best practices with respect to usage of SWIFT are ensured.
The Reserve Bank along with most of the other central banks has adopted the Special
Data Dissemination Standards (SDDS) template of the IMF for publication of the detailed
data on foreign exchange reserves.
Country Risk
Country risk refers to the risk of investing or lending possibly due to economic and/or
political environment in the buyer’s country, which may result in an inability to pay for
imports.
Foreign exchange risk: there are three types of risks.
 Transaction risk
Transaction risk is the risk a company faces when it’s buying or selling a product
from a company located in another country. The risk being the adverse effect that
the FX rate can have on a completed transaction prior to settlement.
If a vendor’s currency were to appreciate versus the buyer’s currency, then the buyer
will have to make a larger payment in their domestic currency to meet the contracted
price.
This risk generally increases when there is a longer period of time between entering
a contract and settling it as there is more opportunity for the currencies to fluctuate.
Mitigating transaction risk can generally be done through utilising forward
contracts and FX options.
For example, an Indian company with operations in USA would need to bring their
USD 1000 earnings to the Indian account. If the agreed rate was 1USD = 60 INR,
and the exchange rate falls to1USD = 50 INR prior to the payment settlement, the
company expecting INR 60,000 in return would instead receive INR 50,000.
 Translation risk
Translation risk, also known as ‘translation exposure’, refers to a situation where a
parent company owns a subsidiary in another country and the subsidiary’s revenue
or profits are converted to the parent company’s currency at a lower value. As

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exchange rates change constantly, there can often be variances in the reported
figures between quarterly financial statements.
This creates risk for a company because the volume of currency to translate back
to the reporting currency can vary. In real terms, if a company has a greater
proportion of assets, liabilities or equities denominated in a foreign currency, and if
the currency is more volatile, the translation risk is higher.
 Economic risk
This refers to the way in which a company’s market value is impacted by an
unavoidable exposure to currency fluctuations and shifts in the economic
landscape. It’s also commonly known as ‘forecast risk’.
This risk can be created by macroeconomic conditions like exchange rates,
government regulations and geopolitical stability. It’s one of the reasons why
international investment can be more risky than domestic investment and it
typically affects the shareholders and bondholders of a company. An example of
economic risk in 2019 is that potentially faced by Hong Kong as protest to express
displeasure over the proposed Extradition Bill.
Settlement of Transactions Foreign exchange markets make extensive use of the latest
developments in telecommunications for transmitting as well settling foreign exchange
transaction, Banks use the exclusive network SWIFT to communicate messages and settle
the transactions at electronic clearing houses such as CHIPS at New York.
1. SWIFT: SWIFT is an acronym for Society for Worldwide Interbank Financial

Telecommunications, a co-operative society owned by about 250 banks in Europe and
North America and registered as a co-operative society in Brussels, Belgium.
The SWIFT System enables the member banks to transact among themselves quickly (i)
international payments (ii) Statements (iii) other messages connected with international
banking.
SWIFT codes are usually formed of 8 (or) 11 characters.

 The first four characters are used as the bank codes. Only letters can be used.
 The next two characters, only letters, are to describe or give the country code.
 The next two characters can be a mix of both numbers and letters. These are used
for location-based codes.
 The last three characters of the code can be digits and letters, and are optional.
These last three characters in a SWIFT code are used to give details about the
branch code.
2. CHIPS: CHIPS stands for Clearing House Interbank Payment System located at New
York. It is an electronic payment system owned by 12 private commercial banks
constituting the New York Clearing House Association. A CHIP began its operations in
1971 and has grown to be the world‘s largest payment system.
Foreign exchange and Euro dollar transactions are settled through CHIPS.
It provides the mechanism for settlement every day of payment and receipts of numerous
dollar transactions among member banks at New York, without the need for physical
exchange of cheques/funds for each such transaction.

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Fisher Effect: Interest rates and inflation are objects of financial fascination around the
world. The Fisher effect is a theory about the relationship between the two, basically
stating that when one rises, so does the other. The Fisher Effect is an economic hypothesis
stating that the real interest rate is equal to the nominal rate minus the expected rate of
inflation. It states that, in response to a change in the money supply, the nominal interest
rate changes in tandem with changes in the inflation rate in the long run.
Exchange Rate Risk: Foreign exchange risk is the level of uncertainty that a company
must manage for changes in foreign exchange rates that will adversely affect the money
the company receives for goods and services over a period of time.
For example, a company sells goods to a foreign company. They ship the goods today, but
will not receive payment for several days, weeks or months. During this grace period, the
exchange rates fluctuate. At the time of settlement, when the foreign company pays the
domestic company for the goods, the rates may have traveled to a level that is less than
what the company contemplated. As a result, the company may suffer a loss or the profits
may erode.
Correspondent Accounts:Banks have three types of correspondent bank accounts

namely Nostro, Vostro and Loro accounts.
 Nostro account: It means our account with you. The account of a bank in India
with a Foreign correspondent bank abroad in Foreign currency is called Nostro
account. For example, account of PNB Delhi with City Bank New york.
 Vostro account: It means your account with us. The account of a foreign
correspondent bank abroad with a bank in India in Indian Rupees will be a Vostro
account. For example, account of City Bank NewYork with PNB Delhi.
 Loro Account: Their account with them. For example, PNB has account with City
Bank New York. For PNB, this account is Nostro account. For City Bank, this
account is Vostro account. For any other bank, this account is Loro account.
 All foreign exchange transactions are settled through Nostro accounts.
LIBERALISED REMITTANCE SCHEME (LRS) FOR RESIDENT INDIVIDUALS: RBI

introduced LRS on Feb 04, 2004.
Eligibility:
All resident individuals including minors and non-individuals are eligible.
Remittances under the facility can be consolidated in respect of family members subject
to individual family members complying with the terms and conditions.
It is mandatory to have PAN number to make remittances.
Forex can be purchased from authorised person which indude AD Category-1 Banks, AD
Category-2 and Full Fledged Money Changers.
Capital Accounts transactions Remittances up to USD 250,000 per financial year

can be allowed for permissible capital account transactions as under:
i) opening of foreign currency account abroad;
ii) purchase of property abroad;
ill) making investments abroad;
iv) setting up Wholly owned subsidiaries and Joint Ventures abroad;

Crack Grade B 27
v) loans including in Indian Rupees to Non-resident Indians relatives as defined in
Companies Act, 2013.
Facilities for Individuals: Individuals can avail of forex facility for the following purposes
within the limit of USD 250000 in a Financial Year. Additional remittance shall require
prior approval of RBI.
 Private visits other than to Nepal and Bhutan
 Gift/donation
 Going abroad on employment
 Emigration
 Maintenance of close relatives abroad
 Business trip
 Medical treatment abroad
 Students for pursuing their studies abroad
External Commercial Borrowings:
Forms of ECB: The ECB Framework enables permitted resident entities to borrow from
recognized non-resident entities in the following forms:
 Loans including bank loans;
 Securitized instruments (e.g. floating rate notes and fixed rate bonds, non-
convertible, optionally convertible or partially convertible preference shares /
debentures)
 Buyers’ credit;
 Suppliers’ credit;
 Foreign Currency Convertible Bonds (FCCBs);
 Financial Lease; and
 Foreign Currency Exchangeable Bonds (FCEBs)
However, ECB framework is not applicable in respect of the investment in Non-

convertible Debentures (NCDs) in India made by Registered Foreign Portfolio
Investors (RFPIs).
RBI Guidelines for External Commercial Borrowings (ECB):
Companies doing trading business (whether online or otherwise), companies involve in

activities like tourism, beauty parlour / beauty clinics, entertainment business, retail
sales, e-commerce companies, etc., on any other activity not covered within these
provisions; are not eligible to raise ECB.
Companies who are into designing and engineering consultancy, servicing of third-party
software, providing ancillary IT related services, ITeS, etc., are not considered as software
development companies for ECB purposes.
All other companies/Institutions except above are entitled for ECB. Indian banks are not
permitted to raise ECB. They can act as ECB lenders (through their overseas branches /
subsidiaries) only.
As LLPs are not eligible to receive FDI, they cannot raise ECBs.

Crack Grade B 28
Entities engaged in micro-finance activities to be eligible to raise ECB should have a

satisfactory borrowing relationship for at least three years with an AD Category I bank in
India.
Recognised Lenders/Investors:
 International banks
 International capital markets.
 Multilateral financial institutions (such as, IFC, ADB, etc.) / regional financial
institutions and Government owned (either wholly or partially) financial institutions.
 Export credit agencies.
 Suppliers of equipment.
 Foreign equity holders.
 Overseas long term investors such as:
a. Prudentially regulated financial entities;
b. Pension funds
c. Insurance companies;
d. Sovereign Wealth Funds;
e. Financial institutions located in International Financial Services Centres in
India
f. Overseas branches / subsidiaries of Indian banks
Foreign Currency denominated ECB:

ECB can be raised in any freely convertible Foreign Currency.
All entities eligible to receive FDI. Further, the following entities are also eligible to raise
ECB:
i. Port Trusts;
ii. Units in SEZ;
iii. SIDBI; and
iv. EXIM Bank of India.
Foreign branches / subsidiaries of Indian banks are permitted as recognised lenders only
for Foreign currency (FCY) denominated ECB (except FCCBs and FCEBs).
INR denominated ECB:

ECB can be raised in Indian Rupee.
All entities eligible to raise FCY ECB; and Registered entities engaged in micro-finance
activities, viz., registered Not for Profit companies, registered societies/trusts/
cooperatives and Non-Government Organisations also eligible to raise ECB.
Individual Limits:
 Up to USD 750 million or equivalent for the companies in infrastructure and
manufacturing sectors, Non-Banking Financial Companies -Infrastructure Finance

Crack Grade B 29
Companies (NBFC-IFCs), NBFCs-Asset Finance Companies (NBFC-AFCs), Holding
Companies and Core Investment Companies;
 Up to USD 200 million or equivalent for companies in software development sector;
 Up to USD 100 million or equivalent for entities engaged in micro finance activities;
and
 Up to USD 500 million or equivalent for remaining entities.
Minimum Average Maturity Period:

3 years for ECB.
ECB raised by manufacturing companies up to USD 50 million or its equivalent per
financial year will have MAMP 1 year.
ECB is raised from foreign equity holder and utilised for working capital purposes, general
corporate purposes or repayment of Rupee loans, MAMP will be 5 years
5 years for Foreign Currency Convertible Bonds (FCCBs)/ Foreign Currency Exchangeable
Bonds (FCEBs) irrespective of the amount of borrowing
Currency of Borrowing: ECB can be raised in Indian Rupees (INR) and / or any
convertible currency.
INR denominated ECB can not be converted into foreign currency ECB
Hedging Requirements: 100 percent hedging has been mandated by the RBI, ECB
borrowers shall keep their ECB exposure hedged 100 per cent at all times, which would
be verified by the Authorised Dealer Category-I bank concerned and reported to RBI.
Issuance of Guarantee, etc. by Indian banks and Financial Institutions: Issuance of

guarantee, standby letter of credit, letter of undertaking or letter of comfort by Indian
banks, All India Financial Institutions and NBFCs relating to ECB is not permitted.
Further, financial intermediaries (viz. Indian banks, All India Financial Institutions, or
NBFCs) shall not invest in FCCBs in any manner whatsoever.
ECB facility for Startups: AD Category-I banks are permitted to allow Govt recognized
Startups to raise ECB under the automatic route. Minimum average maturity period will
be 3 years. The borrowing per Startup will be limited to USD 3 million or equivalent per
financial year either in INR or any convertible foreign currency or a combination of both.
Cost: The all-in-cost ceiling is prescribed through a spread over the benchmark, i.e., 450
basis points per annum over 6 month LIBOR or applicable benchmark for the respective
currency.
ECB borrowers are also allowed to park ECB proceeds in term deposits with AD Category
I banks in India for a maximum period of 12 months.

Crack Grade B 30
TRADE CREDITS FRAMEWORK:
Trade Credits (TC) refer to the credits extended by the overseas supplier, bank, financial
institution and other permitted recognised lenders for maturity, as prescribed in this
framework, for imports of capital/non-capital goods permissible under the Foreign Trade
Policy of the Government of India. Depending on the source of finance, such TCs include
suppliers’ credit and buyers’ credit from recognised lenders.
Eligible borrower: Person resident in India acting as an importer.
Forms of TC: Buyers’ Credit and Suppliers’ Credit.
Limits: Up to USD 150 million or equivalent per import transaction for oil/gas refining &
marketing, airline and shipping companies. For others, up to USD 50 million or equivalent
per import transaction.
Recognised Lenders:
1. For suppliers’ credit: Supplier of goods located outside India.

2. For buyers’ credit: Banks, financial institutions, foreign equity holder(s) located
outside India and financial institutions in IFSCs located in India.
The period of TC:

 The period of TC, reckoned from the date of shipment, shall be up to three years
for import of capital goods.
 For non-capital goods, this period shall be up to one year or the operating cycle
whichever is less.
 For shipyards / shipbuilders, the period of TC for import of non-capital goods can
be up to three years.
Currency: TC for imports into India can be raised in any freely convertible foreign currency
(FCY denominated TC) or Indian Rupee (INR denominated TC).
The Asian Clearing Union (ACU) was established with its head-quarters at Tehran, Iran,
on December 9, 1974 at the initiative of the United Nations Economic and Social
Commission for Asia and Pacific (ESCAP), for promoting regional co-operation. The main
objective of the clearing union is to facilitate payments among member countries for
eligible transactions on a multilateral basis, thereby economizing on the use of foreign
exchange reserves and transfer costs, as well as promoting trade among the participating
countries.
The Central Banks and the Monetary Authorities of Bangladesh, Bhutan, India, Iran,
Maldives, Myanmar, Nepal, Pakistan and Sri Lanka are currently the members of the ACU.

Crack Grade B 31
FOREIGN EXCHANGE MANAGEMENT ACT, 1999: The Government of India, Ministry

of Finance notified that the Foreign Exchange Management Act, 1999 came into force on
the 1st day of June 2000.
The Foreign Exchange Management Act 1999 (FEMA) was enacted on December 02, 1999
to replace Foreign Exchange Regulation Act (FERA) 1973. The Act came into on June 01,
2000 and extends to the entire country, all branches, offices, agencies outside India -
those owned or controlled by a person residing in India.
Introduction:
1. In India, forex transactions are subject to Foreign Exchange Management Act 1999.
2. The Act came into operation with effect from1.6.2000.
3. The main objective of the Act is to ensure orderly conduct of forex transactions. Prior
to FEMA, forex transactions were regulated by Foreign Exchange Regulation Act which
provided for criminal proceedings also whereas FEMA provides for only civil proceedings.
4. In India, exchange control is exercised by RBI and trade control is exercised by DGFT
(Director General of Foreign Trade).
5. Balance of Trade means export of goods minus import of goods. Balance of Payment
means receipt of forex minus payment of forex.
6. Only Authorised persons i.e. who are authorised by RBI can undertake forex
transactions. Authorised persons would include Authorised Dealers (AD) and Full fledged
money changers.
7. Under FEMA – a person, who has been residing in India for more than 182 days (120
days as per Budget 2020-21), will be considered a Resident.
8. Any monetary transaction with Nepal or Bhutan – in rupees – these two countries
recognize and accept ‘Rupees’ – will not fall under FEMA.
9. A person who is a citizen of Pakistan, Bangladesh, Sri Lanka, Afghanistan, China, Iran,
Nepal or Bhutan requires approval of Reserve Bank for acquisition or transfer of property
in India other than lease not exceeding 5 years, or opening of a branch or office or a place
of business in India, purchase of shares or debentures issued by Indian companies or any
other Indian security.
10. A resident of India, who has gone out of India on a temporary visit may bring into India
at the time of his return from any place outside India (other than Nepal and Bhutan),
currency notes of Government of India and Reserve Bank of India notes up to an amount
not exceeding Rs.25,000.
11. A person may bring into India from Nepal or Bhutan, currency notes of Government
of India and Reserve Bank of India notes, in denomination not exceeding Rs.100.
12. Travellers going to all countries are allowed to purchase foreign currency notes / coins
only up to USD 3000 per visit. Balance amount can be carried in the form of store value
cards, travellers cheque or banker’s draft. Exceptions to this are:
(a) travellers proceeding to Iraq and Libya who can draw foreign exchange in the form of
foreign currency notes and coins not exceeding USD 5000 or its equivalent per visit;

Crack Grade B 32
(b) travellers proceeding to the Islamic Republic of Iran, Russian Federation and other
Republics of Commonwealth of Independent States who can draw entire foreign exchange
(up-to USD 250,000) in the form of foreign currency notes or coins.
(c)For travellers proceeding for Haj/ Umrah pilgrimage, full amount of entitlement (USD
250,000) in cash or up to the cash limit as specified by the Haj Committee of India.
13. Foreign exchange can be purchased from any authorised person, such as an AD
Category-I bank and AD Category II. Full-Fledged Money Changers (FFMCs) are also
permitted to release exchange for business and private visits. An Authorised Dealer (AD)
is any person specifically authorized by the Reserve Bank .
14. A person coming into India from abroad can bring with him foreign exchange without
any limit but he has to declare it in customs if value of currency alone exceeds USD 5000.
15. Foreign exchange for travel abroad can be purchased from an authorized person
against rupee payment in cash below Rs.50,000/-. However, if the sale of foreign exchange
is for the amount equivalent to Rs 50,000/- and above, the entire payment should be
made by way of a crossed cheque/ banker’s cheque/ pay order/ demand draft/ debit card
/ credit card / prepaid card only.
16. In return from a foreign trip, travellers are required to surrender unspent foreign
exchange held in the form of currency notes and travellers cheques within 180 days of
return. However, they are free to retain foreign exchange up to USD 2,000, in the form of
foreign currency notes.
Drawal of exchange for the following transactions is prohibited:

 Travel to Nepal or Bhutan
 Transactions with a person resident in Nepal or Bhutan (unless specifically
exempted by Reserve Bank by general or special order)
 Remittance out of lottery winnings
 Remittance of income from racing/riding etc. or any other hobby.
 Remittance for purchase of lottery tickets, banned/proscribed magazines, football
pools, sweepstakes, etc.
 Payment of commission on exports made towards equity investment in Joint
Ventures/Wholly Owned Subsidiaries abroad of Indian companies.
 Remittance of dividend by any company to which the requirement of dividend
balancing is applicable.
 Payment of commission on exports under Rupee State Credit Route.
 Payment related to "Call Back Services" of telephones.
 Remittance of interest income on funds held in Non-Resident Special Rupee (NRSR)
account scheme.
Prevention of Money Laundering Act, 2002 (PMLA): The PMLA came into effect from
1st July 2005. Necessary Notifications / Rules under the said Act were published in the
Gazette of India on 1st July, 2005 by the Department of Revenue, Ministry of Finance,
Government of India.
The Directorate of Enforcement in the Department of Revenue, Ministry of Finance is

responsible for investigating the cases of offence of money laundering under Prevention of
Money Laundering Act, 2002.

Crack Grade B 33
Financial Intelligence Unit - India (FIU-IND) under the Department of Revenue, Ministry
of Finance is the central national agency responsible for receiving, processing, analyzing
and disseminating information relating to suspect financial transactions to enforcement
agencies and foreign FIUs.
How does Money Laundering actually take place:

The process of Money Laundering generally involve the following three stages :
(a) Placement:- The Money Launderer, who is holding the money generated from criminal
activities, introduces the illegal funds into the financial systems. This might be done by
breaking up large amount of cash into less conspicuous smaller sums which are deposited
directly into a Bank Account or by purchasing a series of instruments such as Cheques,
Bank Drafts etc., which are then collected and deposited into one or more accounts at
another location.
(b) Layering:- The second stage of Money Laundering is layering. In this stage, the Money
Launderer typically engages in a series of continuous conversions or movements of funds,
within the financial or banking system by way of numerous accounts, so as to hide their
true origin and to distance them from their criminal source. The Money Launderer may
use various channels for movement of funds, like a series of Bank Accounts, sometimes
spread across the globe, especially in those jurisdictions which do not co– operate in anti
Money Laundering investigations.
(c) Integration:- Having successfully processed his criminal profits through the first two
stages of Money Laundering, the Launderer then moves to this third stage in which the
funds reach the legitimate economy, after getting inseparably mixed with the legitimate
money earned through legal sources of income. The Money Launderer might then choose
to invest the funds into real estate, business ventures & luxury assets, etc so that he can
enjoy the laundered money, without any fear of law enforcement agencies.
The above three steps may not always follow each other. At times, illegal money may be
mixed with legitimate money, even prior to placement in the financial system. In certain
cash rich businesses, like Casinos (Gambling) and Real Estate, the proceeds of crime may
be invested without entering the mainstream financial system at all.
Financial Action Task Force (FATF): In response to mounting concern over money
laundering, the Financial Action Task Force (FATF) on Money Laundering was established
by the G-7 Summit in Paris in 1989 to develop a co-ordinated international response. One
of the first tasks of the FATF was to develop Recommendations, which set out the
measures national governments should take to implement effective anti-money laundering
programmes. India is an active member of the FATF. The Secretariat is located at the
OECD Headquarters in Paris.

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Crack Grade B 1

Balance of Payments, Foreign Exchange Markets

Balance of Payments (BoP):

Current Account Capital Account Forex

Merchandise Invisibles Foreign Loan Banking

Services Factor Income Transfers

Let us consider an example to understand BoP in a better way:

As on 01.04.17 01.04.2017 - 31.03.2018 As on 01.04.18

Current A/c + Capital A/c = Overall balance of payment = Change in Forex

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Tarapore committee on capital account convertibility: In 1997, RBI appointed a

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Foreign Exchange Dealer's Association of India (FEDAI) was set up in 1958 as an

Presently some of the functions are as follows:

The main players of the Forex market are:

Types of foreign exchange market operations

Hard currencies: A currency used as medium of exchange in international transactions.

Nominal Exchange Rate (NER)

Purchasing Power Parity (PPP) Exchange Rate

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Consider another example:

Consider a Consider the

So PPP exchange rate will be Rs. 1200 = $ 100

Real Exchange Rate: Consider the above example of burger:

 Price of Burger in US (if it increases, exports to US will increase)

 Price of Burger in US (if it increases, India's export competitiveness will increase)

Which implies that, India's trade competitiveness Price of burger in US

India's trade competitiveness = Price of burger in US X Nominal exchange rate

And trade competitiveness is basically represented by the real exchange rate, so

Real Exchange Rate = Price of burger in US X Nominal exchange rate

Real Exchange Rate = Nominal Exchange Rate

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= ($1) X (Rs. 70/$)

Spot and Forward transactions:

Two way quotes:

Premium: A currency is said to be at a premium if it is more expensive in the forward

Cross currency rates:

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Forward exchange contract: A forward exchange contract is an agreement under which

Example of How a Forward Contract Works

In 3 months’ time, USD $1.00 = INR65.00

Here is what could happen;

ABC Factory would pay 50000 more than anticipated originally.

Scenario 2: ABC Factory does use a Forward contract

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The premium is ` 5 for six months forward rate.

The discount is ` 5 for six months forward rate.

Bretton Woods Agreement: The Bretton Woods Agreement, implemented in 1946,

Exchange Rate Theories:

S0 is the current spot rate (Direct Quote)

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S0 is the current spot rate (Direct Quote)

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Types of Currency Swaps contracts:

A “capital account transaction” is a transaction which

 Liabilities include contingent liabilities also.

A “current account transaction” is transaction other than a capital account

Authorised Persons (APs):