BAE110 FINANCIAL LITERACY

UNIT 2: FOREIGN EXCHANGE AND INVESTMENT

Foreign exchange, often abbreviated as "forex" or "FX," refers to the global decentralized
market where currencies are bought, sold, and exchanged. It's where individuals, businesses,
financial institutions, and governments trade currencies against one another. The primary
purpose is to facilitate international trade and investment by allowing entities to convert one
currency into another.
An exchange rate refers to the value at which one currency can be exchanged for another. It
represents the price of one country's currency in terms of another country's currency. Exchange
rates are crucial in international trade and finance as they determine the relative value of
different currencies, affecting the cost of goods, investments, and financial transactions across
borders.
Exchange rates regimes can be either fixed or floating:
1. Fixed Exchange Rate: In this system, the value of a currency is pegged or fixed to the
value of another currency or a basket of currencies, or sometimes to a commodity like
gold. Governments or central banks often intervene to maintain the fixed rate by buying
or selling their currency as needed.
2. Floating Exchange Rate: Under a floating exchange rate system, the value of a
currency is determined by the forces of supply and demand in the foreign exchange
market. Fluctuations in these forces cause the exchange rate to change continuously.
Most major currencies in the world today operate under a floating exchange rate system.
Factors that influence exchange rate
Exchange rates constantly fluctuate due to various factors. The most fundamental factor
influencing foreign exchange rates is the basic economic principle of supply and demand. That
is the market forces. Other factors that might have a direct or indirect influence are as follows:
 Economic indicators: Like GDP growth, employment data, and trade balance can
impact a currency's value. Positive economic data can bolster a currency’s value. For
instance, a strong GDP growth report can increase confidence in a nation’s economy,
attract foreign investment, and potentially cause its currency to appreciate. Conversely,
poor economic indicators can weaken a currency.
 Inflation rate: If a country has low inflation rates consistently, its currency value
typically rises. This is because the currency’s purchasing power becomes higher than
the other currencies with which it is compared. Conversely, higher inflation rates lead
to the currency depreciating in value, losing out on purchasing power and value against
other currencies.
 Interest rates: Higher interest rates in a country may attract foreign investment and
increase demand for that currency, affecting its exchange rate.
 Political stability and economic performance: Political instability or uncertain
economic conditions can lead to fluctuations in exchange rates.
 Market speculation: Traders and investors buying or selling currencies based on their
expectations about future movements can influence exchange rates.
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 News: Forex markets react swiftly to news releases, and traders often adjust their
positions based on these data points.

Exchange rates are typically quoted in pairs. For example, the exchange rate between the US
dollar (USD) and the euro (EUR) might be expressed as EUR/USD = 1.15, meaning 1 euro can
be exchanged for 1.15 US dollars.
USD/JPY = 110.50: This indicates that 1 US dollar is equivalent to 110.50 Japanese yen. If
someone wants to convert $500 into Japanese yen at this rate, they would receive ¥55,250.
Exchange rate quotations can be presented in two different methods: direct and indirect. These
methods describe how currencies are quoted in relation to each other.
1. Direct Exchange Rate Quotation: In a direct quote, the domestic currency is
expressed as a fixed amount per unit of a foreign currency. It tells you how much of the
foreign currency is needed to buy one unit of the domestic currency.
For instance:
 If the direct quote for EUR/USD is 1.20, it means that 1 Euro is equal to 1.20
US Dollars.
 A direct quote for USD/JPY of 110.50 means that 1 US Dollar is equal to 110.50
Japanese Yen.
In essence, the direct quote gives the price of one unit of a foreign currency in terms of the
domestic currency.
2. Indirect Exchange Rate Quotation: In contrast, an indirect quote expresses the
foreign currency as a fixed amount per unit of the domestic currency. It tells you how
much of the domestic currency is needed to buy one unit of the foreign currency.
For instance:
 An indirect quote for USD/EUR of 0.8333 means that 1 US Dollar is equivalent
to 0.8333 Euros.
 An indirect quote for GBP/USD of 1.35 means that 1 British Pound is equivalent
to 1.35 US Dollars.
In an indirect quote, the price of one unit of the domestic currency is given in terms of the
foreign currency.
These quotes are essentially two sides of the same coin. Direct quotes are more commonly used
in most countries, where the domestic currency is expressed as a fixed amount against a unit
of foreign currency. Indirect quotes are less common but still used in some contexts,
particularly in certain European countries, where the domestic currency is expressed in terms
of a unit of a foreign currency. Both direct and indirect quotes convey the relationship between
two currencies but present this information in opposite ways.
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Appreciation and depreciation of currency refer to changes in the value of a currency relative
to other currencies in the foreign exchange market.
1. Appreciation of Currency: When a currency appreciates, it means that its value
increases relative to other currencies. This can happen due to various factors, such as
increased demand for the currency, positive economic indicators, higher interest rates,
or favourable political stability. For instance, if the US dollar strengthens against the
Euro (EUR/USD), it means that 1 USD can buy more Euros than before. Appreciation
can make imports cheaper but exports more expensive, potentially impacting a
country's trade balance.
2. Depreciation of Currency: Conversely, depreciation occurs when a currency
decreases in value compared to other currencies. Factors such as lower demand for the
currency, economic downturns, decreasing interest rates, or political instability can
contribute to currency depreciation. For example, if the Japanese Yen weakens against
the US dollar (USD/JPY), it means that more Yen is needed to buy one US dollar.
Depreciation can make exports cheaper but increase the cost of imports, potentially
aiding a country's trade balance.
Appreciation and depreciation in currency values have implications for international trade,
investment, inflation, and a country's overall economic health. They can influence export
competitiveness, capital flows, purchasing power, and inflation rates, affecting both domestic
and international economic conditions. Central banks and governments often monitor and
intervene in currency markets to manage and stabilize their currency's value, especially during
times of excessive volatility or to achieve specific economic goals.
Devaluation is the deliberate downward adjustment of the value of a country's money relative
to another currency or standard. It is a monetary policy tool used by countries with a fixed
exchange rate or semi-fixed exchange rate. By devaluing its currency, a country makes its
money cheaper and boosts exports, rendering them more competitive in the global market.
Conversely, foreign products become more expensive, so the demand for imports falls.
Governments use devaluation to combat a trade imbalance and have exports exceed imports.
As exports increase and imports decrease, there is typically a better balance of payments as
the trade deficit shrinks. A country that devalues its currency can reduce its deficit because of
the greater demand for its less expensive exports.
Consequences of devaluation can thus be summarised as;
 Increasing the price of imports protects domestic industries, but they may become less
efficient without the pressure of competition.
 Higher exports relative to imports can also increase aggregate demand, leading
to inflation.
 Manufacturers may have less incentive to cut costs because exports are cheaper,
increasing the cost of products and services over time.

MAJOR FOREIGN EXCHANGE MARKETS ARE:

(a) Spot markets
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(b) Forward markets

(c) Futures markets
(d) Options markets, and
(e) Swaps markets
Transactions where the exchange of currencies takes place two days after the date of the contact
are known as the Spot transactions. The rate of exchange effective for the spot transaction is
known as the spot rate and the market for such transactions is known as the spot market. This
requires the immediate delivery or exchange of currencies on the spot i.e. within 48 hours. 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. Prices in
the spot forex market are determined by the interplay of supply and demand forces. Various
factors influence exchange rates, including interest rates, economic indicators, geopolitical
events, and market sentiment. The spot forex market is highly liquid, with vast amounts of
currencies traded daily. This liquidity ensures that traders can enter and exit positions easily
without significant price slippage.
Currency forward market involves transactions in which the exchange of currencies takes
places at a specified future date, subsequent to the spot date known as a forward transaction.
The forward transaction can be for delivery at a pre-agreed future point in time at a specified
price. So, we can say it is an agreement between two parties, requiring the delivery at some
specified future date of a specified amount of foreign currency by one of the parties, against
payment in domestic currency to the other party, at the price agreed upon in the contract. The
rate of exchange applicable to the forward contract is called the forward exchange rate and the
market for forward transactions is known as the forward market. Forward market transactions
are meant to be settled on a future date as specified in the contract. Though forward rates are
quoted just like spot rates, but actual delivery of currencies takes place much later, on a date in
future.
Forward exchange facilities, obviously, are of immense help to exporters and importers as they
can cover the risks arising out of exchange rate fluctuations by entering into an appropriate
forward exchange contract.
Forward Margin: With reference to its relationship with spot rate, the forward rate may be at
par, discount or premium. Forward rate may be the same as the spot rate for the currency. Then
it is said to be ‘at par’ with the spot rate. But this rarely happens. More often the forward rate
for a currency may be costlier or cheaper than its spot rate. The difference between the forward
rate and the spot rate is known as the forward margin or swap points. If the forward margin is
at premium, the foreign currency will be costlier under forward rate than under the spot rate.
(Forward rate greater than spot rate). The forward rate for a currency, say the dollar, is said to
be at premium with respect to the spot rate when one dollar buys more units of another currency,
say rupee, in the forward than in the spot rate on a per annum basis. If the forward margin is at
discount, the foreign currency will be cheaper for forward delivery than for spot delivery. The
forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate
when one dollar buys fewer rupees in the forward than in the spot market. (Forward rate lesser
than spot rate)
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The forward exchange rate is determined mostly be the demand for and supply of forward
exchange. Naturally when the demand for forward exchange exceeds its supply, the forward
rate will be quoted at a premium and conversely, when the supply of forward exchange exceeds
the demand for it, the rate will be quoted at discount. When the supply is equivalent to the
demand for forward exchange, the forward rate will tend to be at par.
Futures, Options and Swaps are called derivatives because they derive their value from the
underlying exchange rates. With a currency futures contract, one buys or sells a specific
foreign currency for delivery at a designated price in the future. Currency futures contracts are
traded on derivatives exchanges around the world. Currency futures and forwards are very
similar in how they work. The difference is that futures contracts have standardized terms and
are traded on exchanges. Forwards instead have customizable terms and are traded over-the-
counter (OTC). A currency option is the right to buy or sell a foreign currency at a specified
price by a specified date. A currency swap is a transaction in which two parties exchange an
equivalent amount of money with each other but in different currencies. The parties are
essentially loaning each other money and will repay the amounts at a specified date and
exchange rate.
PARTICIPANTS OF FOREIGN EXCHANGE MARKET
The foreign exchange (forex) market involves a diverse range of participants, each with
different objectives and roles in the market. Some of the key participants include:
1. Banks: Commercial banks play a crucial role in the forex market, both on behalf of
their clients and for their own trading purposes. They facilitate currency transactions
for corporations, institutions, and individuals, and also engage in speculative trading to
profit from currency movements.
2. Central Banks: These institutions, like the Federal Reserve (Fed) in the United States
or the European Central Bank (ECB), RBI, conduct monetary policy and often
intervene in the forex market to stabilize their currency or influence exchange rates.
3. Financial Institutions: Besides banks, other financial institutions such as investment
banks, hedge funds, pension funds, and insurance companies participate in forex trading
for investment purposes or to hedge against currency risks.
4. Corporations: Multinational corporations involved in international trade and business
operations often use the forex market to convert currencies for importing/exporting
goods and services or to hedge against adverse currency fluctuations.
5. Retail Traders: Individual traders, including retail investors and speculators,
participate in the forex market through online trading platforms provided by brokers.
They trade smaller volumes compared to institutional players but collectively
contribute to market liquidity.
6. Brokers and Dealers: These entities act as intermediaries between buyers and sellers
in the forex market, executing trades on behalf of clients. They offer trading platforms,
access to liquidity, and often provide leverage to traders.
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7. Governments and Sovereign Wealth Funds: National governments and sovereign

wealth funds may participate in the forex market to manage reserves, stabilize their
currencies, or invest surplus funds in foreign currencies.
Each participant in the forex market brings its own objectives and strategies, contributing to
the overall liquidity and functioning of the market. The interaction between these diverse
entities forms the basis for the dynamic nature of the foreign exchange market.
IMPORTANCE AND USE OF FOREIGN EXCHANGE
1. Facilitating International Trade: Forex allows businesses and individuals to convert
one currency into another, facilitating cross-border trade. Importers and exporters use
the forex market to exchange currencies and settle transactions in different
denominations.
2. Determining Exchange Rates: Exchange rates set through the forex market affect the
costs of imports and exports, influencing trade balances and the competitiveness of
nations in the global market. These rates are vital in determining a country's economic
health and attractiveness to foreign investors.
3. Global Investment and Capital Flows: Investors utilize the forex market to buy and
sell currencies for investment purposes. Foreign exchange markets provide
opportunities for investors to diversify their portfolios by investing in assets
denominated in different currencies.
4. Hedging and Risk Management: Businesses engaged in international trade use forex
to hedge against currency risks. By engaging in currency futures, options, or forward
contracts, they can mitigate potential losses due to adverse currency movements.
5. Central Bank Policies and Monetary Management: Central banks often intervene in
the forex market to stabilize their currency values, manage inflation, control interest
rates, and maintain economic stability. They buy or sell currencies to influence
exchange rates and achieve specific monetary policy goals.
6. Speculation and Profit-Making: Traders, both institutional and individual, participate
in the forex market to speculate on currency movements. They aim to profit from
fluctuations in exchange rates by buying currencies they anticipate will rise in value
and selling those they expect to fall.
7. Global Financial System Stability: The forex market's liquidity and efficiency play a
crucial role in maintaining stability in the broader financial system. It provides a means
for easy conversion of currencies, ensuring smooth financial transactions globally.

REGULATORY ROLE OF RBI

The Reserve Bank of India (RBI) serves as the primary regulator of the foreign exchange
market in India. Its regulatory role encompasses several key functions aimed at ensuring
stability, transparency, and compliance within the forex market:
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1. Formulation of Regulations and Policies: The RBI is responsible for formulating and
implementing regulations, policies, and guidelines related to foreign exchange
transactions. These regulations cover various aspects, including permissible currency
transactions, limits on foreign investment, and rules governing financial institutions'
participation in the forex market.
2. Authorization and Oversight of Entities: The RBI authorizes and oversees entities
involved in foreign exchange transactions, such as authorized dealers (banks and
financial institutions permitted to deal in foreign exchange) and authorized money
changers (entities authorized to deal in foreign exchange for specified purposes, like
currency exchange for travelers).
3. Monitoring and Surveillance: The RBI monitors the activities of authorized dealers
and other entities involved in forex transactions to ensure compliance with regulatory
norms. It conducts regular audits and inspections to maintain market integrity and
prevent malpractices.
4. Foreign Exchange Management Act (FEMA): The RBI enforces the Foreign
Exchange Management Act, 1999 (FEMA), which governs all foreign exchange
transactions in India. FEMA provides the legal framework for regulating forex dealings,
including provisions related to capital account transactions, current account
transactions, and penalties for violations.
5. Foreign Investment Policies: The RBI plays a crucial role in regulating foreign
investment in India. It prescribes guidelines and limits for foreign portfolio investments
(FPI) and foreign direct investments (FDI), ensuring compliance with sectoral caps and
entry routes for investments.
6. Exchange Rate Management: As a regulator, the RBI manages exchange rate policies.
It intervenes in the forex market to stabilize the Indian rupee, maintain orderly
conditions in the currency market, and prevent excessive volatility.
7. Issuance of Circulars and Notifications: The RBI regularly issues circulars,
notifications, and clarifications regarding forex regulations to provide guidance to
market participants and ensure uniform interpretation and adherence to the rules.
8. Acts as the custodian of country’s foreign exchange reserves.
The RBI's regulatory role in the foreign exchange market is essential for maintaining stability,
fostering investor confidence, preventing illicit activities, and facilitating smooth cross-border
transactions while aligning with India's overall economic objectives.
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INVESTMENT
SOME HYBRID INVESTMENT PLANS
1. Systematic Investment Plan (SIP)
It is an investment plan (methodology) commonly offered by Mutual Funds wherein one
could invest a fixed amount in a mutual fund scheme or any other investment vehicle
periodically, at fixed intervals – say once a month, instead of making a lump-sum
investment. The SIP installment amount could be as little as ₹500 per month. SIP is
similar to a recurring deposit where you deposit a small /fixed amount every month. SIP
is a very convenient method of investing in mutual funds through standing instructions to
debit your bank account every month, without the hassle of having to write out a cheque
each time. SIP has been gaining popularity among Indian investors, as it helps in
investing in a disciplined manner without worrying about market volatility and timing the
market.
Common sense suggests that “Buying low and selling high” is perhaps the best way to
get good returns on your investments. But this is easier said than done, even for the most
experienced investors. There are many factors at play when it comes to any market - debt
or equity, and all of them are inextricably linked. SIP is a simpler approach to long term
investing is disciplining and committing to a fixed sum for a fixed period and sticking to
this schedule regardless of the conditions of the market.

Advantages of SIP:
 Rupee Cost Averaging:
The unique feature of SIP is the Rupee Cost Averaging, where you buy more units
when the market is low and buy less when the market is high. This is because of
the inherent feature of SIP, where at every market correction, you will buy more,
reducing your cost of investment and higher gains.
 Flexibility:
SIP provides you with tremendous flexibility. Long-term commitments like
investing in instruments like Public Provident Fund or Unit Linked Insurance
Plans can be avoided with SIP. These are open ended funds to be withdrawn as
per your choice, meaning they do not have a fixed tenor. You can either withdraw
the full or a partial amount from your investment, without incurring any losses.
The amount of investment is also flexible: it can be increased or decreased. Just
remember to have a long investment horizon for wealth creation.
 Higher returns:
As compared to traditional fixed deposits or recurring deposits, SIP provides double
the returns. This can help you beat the inflated costs.
 Power of compounding:
SIP operates on the principle of receiving compound interest on your investments.
In other words, a small amount invested for a long time fetches better returns than
a one- time investment. To put it in simple words, compounding is when the
interest (or income) you earn is reinvested in the original corpus and accumulated
corpus continues to earn (& grow). Every time this happens, your investment
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keeps growing, paving the way for a systematic accumulation of money,

multiplying over time.

To illustrate, a small amount of ₹1000 invested every month at an interest rate of 8% for
25 years would give you ₹ 9.57 Lakh! That means your investment of just ₹ 3 Lakh would
have grown three times over!

2. Value averaging Plan (VIP)

A Value averaging Investment Plan (VIP) is an investment strategy that works like an SIP –
you invest on a pre-determined date, into a fixed mutual fund scheme, thus achieving the
purpose of disciplined investing and following the teachings of finance gurus when they say
'Buy Low'. But while in an SIP the amount is fixed and units may change, in a VIP you have a
target value of your portfolio, which increases by say Rs. x,000 per month, and you invest the
difference between the current value of your portfolio, and the targeted portfolio investment
value. For example, suppose you set a target level of Rs. 5,000 per month. You invest for 2
months (Rs. 10,000 invested totally) and the market falls. So the current portfolio value of your
Rs. 10,000 invested is now Rs. 8,500. To make up for this fall, you invest Rs. 5,000 for your
third month's investment, and also an additional Rs. 1,500 (Rs. 10,000 minus Rs. 8,500). So in
the third month, when the market has fallen, you invest Rs. 5,000 + 1,500 i.e. Rs. 6,500, instead
of Rs. 5,000. Similarly, if the market has risen, and your Rs. 10,000 has grown to Rs. 12,000,
then when the time comes to make your third month's investment, you will not invest Rs. 5,000,
but instead Rs. 3,000 (Rs. 5,000 - Rs. 2,000 = Rs 3,000– the profit you have made due to the
market rise). In essence, the VIP bridges the gap between the target portfolio value, and the
actual current portfolio value. It buys less when the markets are high and more when the
markets are low.

The benefits of this approach:

If the markets go down, you invest more and if the markets go up you invest less. So if there is
value to be held, and if you can buy on the cheap, value investment plans will help you do this.
And if the market rises and investments become 'expensive', the value investment plan strategy
will ensure you do not invest as much. It might even ask you to redeem some of your
investment, booking profits in the process. By buying more when markets go down, you are
also benefiting from the concept of rupee cost averaging. Investing regularly also inculcates
financial discipline, and again you don't have to worry about too much paperwork. One thing
you need to keep in mind though is that you need to have sufficient cash flows to meet the
investment that will be required in market dips, as at these times, you will be investing more –
sometimes much more.
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SIP VIP

Monthly contribution amount remains

Monthly contribution amount varies from month to
constant irrespective of the market
month depending on the market performance.
performance.

The formula to calculate investment amount is

Investment amount remains fixed. Investment Amount = Target Portfolio Value –
Actual Portfolio Value

It follows a simple investment strategy of investing

It follows an investment strategy of
more when market is low and invest less when
investing standard amount every month.
markets are high.

It works on cost averaging investment

It works on value averaging investment methods
method.

SIP requires lesser investor participation VIP requires more investor participation

Final return in case of SIP is not known to Investor can set his target value but not the target
investor. Investment which thus increases uncertainty.

3. Unit Linked Insurance Plan (ULIP)

Unit Linked Insurance Plan is a type of life insurance product that combines insurance
coverage with investment options. ULIPs are offered by insurance companies and provide
policyholders with the dual benefits of insurance protection and the opportunity to invest
in various financial instruments such as stocks, bonds, and mutual funds. When an
individual purchases a ULIP, a portion of the premium paid goes towards life insurance
coverage, while the remaining amount is invested in the chosen investment options. The
policyholder has the flexibility to allocate the premium among different investment funds
based on their risk appetite and financial goals. In addition to long-term wealth creation,
ULIPs make a great way to inculcate investment discipline. You can enjoy good returns
and use the amount invested to meet your long-term financial goals.

Parameters ULIP SIP

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Instrument Offers the combined benefit Offers the benefit of only

Type of life insurance plus investment
investment

Investment In ULIP plans the funds can In SIP, the funds are
Mix be invested in equity and debt majorly invested in the
market equity market

Tax Benefit Tax Benefit can be availed on Tax exemptions are

the premium paid towards
the policy and maturity
proceeds under Section
80C and 10(10D) of Income
Tax Act
applicable only on the
Equity Linked Savings
Scheme (ELSS) up to the
maximum limit of Rs.1.5
lakh.

Life Cover As an investment cum As a pure investment

insurance product, ULIP plan option, SIP does not
offers life cover to the family offer the benefit of life
of the insured cover.

Switching Free switches between funds The investors can make

Option are applicable up to a limited free switches between
number in a year in ULIP funds.
plans.

Death The death benefit is paid to No death benefit is paid

Benefit the beneficiary of the policy to the investors in SIP.
in the event of the
unfortunate demise of the
insured person

Investment IRDAI SEBI

Regulated
By

STARTING EARLY PAYS WELL

To get the best out of your investments, it is very important to invest for the long-term,
which means that you should start investing early, in order to maximize the end returns.

Let’s understand this better through an illustration –

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Let's assume that two friends, both aged 25, decide to invest ₹ 2000 every month for a
period of 5 years and earn 8% p.a. on a monthly compounding basis. The only difference
is that while one starts investing promptly at the age of 25 itself, the other starts investing
10 years later at the age
of 35 years. Both decide to hold on to their investments till they turn 60. So, while both
of them would accumulate principal investment of ₹1.2 Lakh over a period of 5 years, the
investment of the person who started early at the age of 25 appreciates to over ₹ 14 Lakh,
the investment of the second person who started later grows to only about ₹ 6 Lakh.

Thus, you can clearly see the difference between the two and the clear advantage of
investing early.