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The Foreign Exchange Market
The Foreign Exchange Market
Retail market
Exchange of bank notes, bank drafts, travelers cheques, currency etc between private customers, tourists and banks Authorized dealers and money-changers permitted to deal in this segment
A brief history
Dates back to ancient times; barter system; use of gold and silver coins Paper notes used in Italy in late 14th century bankers dealt in the notes and discounted them
according to the relative values of the currencies
Paper money widely used in 18th century- the Gold Standard Bretton Woods System after WWII
Market Participants
Can be grouped into 4 categories: Exporters and Importers Investors (FDI and FPI) Speculators Governments
Long-term movements
Guided by expectations of real interest rates Real interest rates means nominal interest rate less inflation rate Mechanism of covered interest arbitrage Example
- Conventional peg
- Intermediate pegs III. Floating regimes - Managed floating - Independently floating
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11 79 53 26
Based on RBI Report on Currency and Finance
Customers mainly oil companies such as IOC, BPCL, HPCL and other PSUs and also private companies and FIIs
Measures contd..
Banks permitted to
fix net overnight position limits and gap limits (with RBI approval) Determine interest rates (subject to a ceiling) and maturity period of FCNR(B) deposits Use derivatives for asset-liability management
Market participants with genuine exposure permitted to avail forward cover and enter into swaps without any limit Foreign exchange earners permitted to open foreign currency accounts and residents permitted to open such accounts up to a general limit
Market segments
Spot market
immediate delivery in case of bank notes Delivery up to 2 business days in case of inter-bank funds Spot segment is dominant in Indian forex market as in other emerging markets
Derivatives segment
Forward contracts for maturities up to one year; majority are for one month, three months or six months FX swaps are a combination of a spot and a forward in opposite direction Foreign currency options
Change in sources
Capital account transactions acquired more significance over the last few years Expectations and reactions to news affect the capital flows and hence the exchange rate leading to higher volatility RBI attempts to stabilize exchange rate through direct purchase/sale of foreign exchange, sterilization through OMOs and LAF, changes in reserve requirements etc
Indirect quote: Foreign currency price for one unit of home currency
E.g. Re.1 = USD 0.0192 is an indirect quote for an Indian
Risk management
CCIL set up to mitigate risks in Indian financial markets Undertakes settlement of inter-bank spot and forward trades Multilateral netting Net amount payable to or receivable from CCIL in each currency is arrived at member-wise Rupe leg settled through members current account with RBI and USD leg through CCILs account with the settlement bank in New York Limits for each member bank based on its net worth, credit rating etc
Cross-border transactions represented 65% of trading activity in April 2010 and local transactions 35%; forex market activity has thus become more global