FOREIGN

EXCHANGE &
FOREX RISK
MANAGEMENT
KMBNFM04

By:
Dr. Mohd Danish
FMS, SRGC
 Unit- II

Convertibility of rupee; Current account

convertibility, Capital Account Convertibility; Theories
of Foreign exchange rate: Purchasing power parity
(PPP), International Fisher Effect (IFE), Interest Rate
Parity (IRP); Administration of Foreign Exchange;
Authorized persons, Authorized dealers, Authorized
Money Changers; Foreign Currency Accounts: Nostro
Account, Vostro Account and Loro Account in foreign
transactions.
Convertibility of rupee
Theories of Foreign exchange rate

• This theory proposes that a country with a lower

money supply growth rate will see an appreciation
of its currency value.
• The theory explains that an increase in money
supply growth rate can lead to inflation, which
consequently results in the depreciation of the
currency.
Types of theories of foreign
exchange
• Purchasing power parity (PPP),
• International Fisher Effect (IFE),
• Interest Rate Parity (IRP);
 Purchasing power parity (PPP)

• The purchasing power parity theory was

propounded by Professor Gustav Cassel of Sweden.

• According to this theory, rate of exchange between

two countries depends upon the relative purchasing
power of their respective currencies.

• Such will be the rate which equates the two

purchasing powers.
 Purchasing power parity (PPP)

For example, if a certain assortment of goods can

be had for £1 in Britain and a similar assortment with
Rs. 80 in India, then it is clear that the purchasing power
of £ 1 in Britain is equal to the purchasing power of Rs.
80 in India. Thus, the rate of exchange, according to
purchasing power parity theory, will be £1 = Rs. 80.
 Foreign Currency Accounts

• Foreign currency accounts are an option for

Indians who are looking to deposit overseas
earnings or those who want to protect
themselves against exchange rate fluctuations
domestically.
 RFC Saving Accounts
• An RFC (Resident Foreign Currency) Savings
Account is a savings account maintained in
foreign currencies - USD and GBP - for NRIs
who have returned to India and hold funds in
foreign currency.

• NRI customers need an account which can be

maintained in a currency other than Indian
Rupees. To cater to this need, a Foreign
Currency Account is created for safe parking of
their earnings in Foreign Currency.
Types of foreign currency account

• Nostro Account
• Vostro Account
• Loro Account
 NOSTRO ACCOUNT
• The word “NOSTRO” is derived from the Latin
word “Ours”.

• NOSTRO account is a bank account, that a

bank holds in a foreign country’s currency at
another bank in that country.

• This type of account is used by banks to

facilitate foreign exchange transactions and to
hold funds that belong to their customers who
have accounts in foreign currencies.
 NOSTRO ACCOUNT
To understand better, Consider following
example:
XYZ Bank in Australia wants to conduct business in
India and needs to hold Indian Rupee, it can open a
NOSTRO account with Bank ABC in India. Bank
XYZ can then use the NOSTRO account to facilitate
transactions in Indian Rupee without having to
convert the Australian dollar into Indian Rupee every
time it needs to make a transaction.
 VOSTRO ACCOUNT
• The word “VOSTRO” is derived from the Latin
word “Yours”.

• VOSTRO account is a type of bank account that

is held by a foreign bank at a domestic bank in
the domestic bank’s currency.

• In other words, a VOSTRO account is a foreign

bank’s account at a domestic bank.
 VOSTRO ACCOUNT
To understand better,
XYZ Bank in India wants to conduct business
with Bank ABC in Australia and needs to hold
Australian dollars, Bank XYZ can open a VOSTRO
account with Bank ABC. Bank ABC would hold the
Australian dollars on behalf of Bank XYZ and Bank
XYZ could use the VOSTRO account to facilitate
transactions in Australian dollars without having to
convert Indian Rupee into Australian dollars every time
it needs to make a transaction.
 Nostro vs. Vostro Example
Let's look at an example. GT Bank, a Nigerian bank,
gets a lot of money sent to its customers at home
from the United States in the form of remittances.
Since GT Bank does not have a physical presence in
the United States, it enters into an agreement with
Citibank where the latter has an account remotely
opened for GT Bank in U.S. dollars. This way, money
received by U.S. customers and businesses sending
money to GT Bank account holders in Nigeria will be
deposited in the account that GT Bank has with
Citibank.
 Nostro vs. Vostro Example
This money deposited will then be transferred
by Citibank via SWIFT to GT Bank's U.S.
dollar account in Nigeria. SWIFT refers to the
Society for Worldwide Interbank Financial
Telecommunications, a member-owned
cooperative that offers safe and secure
financial transactions for its members. With the
transfer complete, GT Bank receives the dollar-
denominated funds, converts them into the local
currency (i.e., the naira), and deposits them to
the local accounts of the recipients.
Nostro vs. Vostro Example
From GT Bank's perspective, its U.S.
dollar account with Citibank is a nostro
account. From Citibank's perspective, it is
holding a vostro account for GT Bank in U.S.
dollars.
 LORO ACCOUNT
• The word “LORO” is derived from the Latin word
“Their”.

• LORO account is the opposite, which means an

account that one bank holds with another or third-
party banks.
 LORO ACCOUNT

To understand better,
when ABC bank in India is maintaining
an account with BBC bank in Australia in
Australian dollars when XYZ bank in India
refers to the said account in correspondence
with ABC bank, Australia it is said to be a
LORO account.
 Process of Foreign
Exchange
• Foreign Exchange (FX) transactions involve one
party purchasing a quantity of one currency in
exchange for paying a quantity of another.

• When goods are traded across boundaries, the

selling and the buying firms prefer to
receive/pay consideration in a currency of their
choice.
 Foreign Trade
• Foreign Trade is the exchange of goods and
services between two countries in the
international market.

• It helps in the availability of raw

material/finished product in a country that either
does not have it or has it in scarcity.
• The three types of foreign trade are as follows:
• Import.
• Export.
• Entrepot.