FOREIGN EXCHANGE MARKET IN INDIA

Chapter 1
International Foreign Exchange
Foreign Exchange Market:
The need for a foreign exchange market therefore arises out of the fact that the power of
domestic legal tender, circulating in the form of currency notes, to redeem commercial liabilities legally, is
limited by national boundaries. Both the seller and buyer want to receive and make payments in their
respective domestic currencies. The task of fulfilling this requirement is handled by international
commercial banks.
All the countries have their own currencies. Any economic transaction that takes place between
residents of two countries involves exchange of some currency between those two residents. This may
involve import/ export of goods or services, investments or redemptions, borrowing or lending, or personal
transfers such as family maintains, tourism etc. in all these cases, the source of purchasing power is
available in one currency whereas its utilisation after conversation is in another currency. When these
transactions get executed through the intermediation of banks, one currency gets converted into another.
This process is called Foreign Exchange.

International Foreign Exchange:

The foreign exchange market is the largest and the most liquid financial market in the world. Traders
include large banks, central banks, currency speculators, corporations, governments, foreign currency
remittance companies and other financial institutions.
Fluctuations in exchange rates are usually caused by actual monetary flows as well as by the
anticipation of changes in monetary flows caused by changes in GDP growth, inflation ( purchasing power
parity theory), interest rates ( interest rates parity theory), budget and trade deficits or surpluses , large
cross border deals and other macroeconomic developments.
Supply and demand for any given currency, and thus its value, are not influenced by any single element,
but rather by several in different proportions. These elements generally fall into 3 categories: economic
factors, political conditions and market psychology.

Fact File on International Market:

Average daily turnover is USD3trillion with an additional USD2 trillion turnover in foreign currency
derivatives major component of this turnover is speculative.

This market is predominantly made up of day-traders which means that positions build up in
currencies are mostly squared off during the day and there is very little carry forward of open speculative
positions.

US dollar is the most heavily traded currency. The most heavily used currency pairs are EUR/USD,
GBP/USD (called CABLE) and USD/JPY.
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FOREIGN EXCHANGE MARKET IN INDIA

London, New York, Tokyo are the biggest foreign exchange canters and Deutsch Bank (Germany) is
the single largest trading entity in international foreign exchange markets.

Unlike a stock market, the foreign exchange market is divided into levels of access which means that
all participants cannot operate in all segments of the market and are subject to different categories of
exchange rates. At the wholesale level (banks transact with each other), generally called the interbank
market, interbank rates are used between participants whereas, at the retail level (banks transact with
customers) the rates uses are called Merchant rates. Each localized market is governed by the domestic
exchange control regulations which determine the different levels of access.

Generally, for a given currency pair, either currency can function as the base currency while the other
acts as the variable or quoted currency. By convention the LHS currency is stronger than the RHS currency
at the time of creation of the pair. However the euro was created, the European Central bank mandated that
EUR be the base currency in any pairing. Similarly GBP has traditionally been the base currency in all
cases.

Characteristics of the international foreign exchange market:

The primary objective of the foreign exchange market is to facilitate international trade and
investment, by allowing end-users to convert one currency into another. The conversion rates between
currencies are called as foreign exchange rates. The market also facilitates speculation, arbitrage and
lending/borrowing of currencies for financing different transactions. Therefore this market connects
exchange rates with interest rates. The modern foreign exchange market started with the introduction of the
Flexible exchange rate system during 1970s.
The principle characteristics of this market are:

It is decentralised, over the counter market, engaged in negotiated transactions.

In comparison to all other markets, it enjoys the highest trading volume, which results in high
liquidity.

International foreign currency transactions do not involve transfers of currencies in physical cash
form. All settlements, receipts and payments are conducted through demand deposit accounts with
commercial banks and since only banks
provide such accounts it follows that all transactions in this market get routed through the banking system.

The actual settlement of transactions is done through a network of NOSTRO and VOSTRO accounts
maintained by banks worldwide.

It is geographically dispersed across all countries which makes it universal market. However in each
country there is a domestic foreign exchange market governed by individual regulations.

It operates 24 hours a day, except weekends, across all time zones.

It operates on very fine (low) profit margins compared to other markets (fixed income securities,
commodities, etc.)
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FOREIGN EXCHANGE MARKET IN INDIA

It provides for a Barter of currencies. If a person A wants to sell USD to get INR, there must be
person wanting to sell INR for the USD, at the same exchange rate. Therefore, as in the case of Barter there
has to be double coincidence of wants. The foreign exchange market thus functions as an international
clearing mechanism or a Currency Exchange bringing together participants wishing to exchange
currencies at mutually agreed exchange rates.

It has no physical existence and operates as an electronically connected network of end-users, banks,
brokers, and service providers.

The most modern communication systems are used thereby reducing transaction cost, eliminating
interest loss factor and the problem of idle funds. Settlement systems worldwide have been synchronised so
that participants are able to shift from one market to another and from one currency into another without
settlement gaps.

Chapter 2
Exchange rates
The foreign exchange market includes end-users (individuals and corporate) commercial banks,
brokers, central banks and service providers such as SWIFT (messaging service providers), etc.
The foreign exchange market provides the environment for establishing the demand supply
equilibrium between currencies based on which the rate of conversion is established. These conversion
rates are called Foreign exchange rates or Exchange rates. Thus the rate of exchange for a currency is
known from the quotation in the foreign exchange market.

Classification of rates:
1.
Direct Rate: A foreign exchange rate which provides a relationship between fixed number of units of
foreign currency against variable number of units of domestic currency is called a Direct Rate.( This format
of expressing exchange is operative in India since 1993). In such rates the foreign currency acts as the base
currency whereas the domestic currency acts as the variable currency.
2.
Indirect Rate: A foreign exchange rate which provides a relationship between fixed number of units
of domestic currency against variable number of units of foreign currency is called an Indirect Rate.( this
form of expressing rates prevailed in India prior to August 1993). In such rates the domestic currency acts
as the base currency whereas the foreign currency acts as the variable currency.
3.
Cross Currency Rate: A foreign exchange rate which provides a relationship between two non
domestic currencies is called a cross currency rate.

Characteristics of exchange rates:

1.

Foreign exchange rates are quoted by banks on a two-way basis. Eg: USD/INR 41.0625- 41.0675

2.
The LHS rate in the quotation is called bid rate and represents the rate at which the bank would buy
one unit of the base currency.
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3.
The RHs rate in the quotation is called ASK or OFFER rate and represents the rate at which the bank
would sell one unit of the base currency.
4.
The difference between the Ask and the Bid rates, in a given quotation is called spread. Therefore
spread is denoted as (Ask-Bid). Since Ask > Bid, the spread is always positive.
5.
Foreign exchange rates are normally quoted upto two or four decimals. In India, the general practise
in the interbank market is to quote rates upto four decimal places.
6.
Foreign exchange rates are always expressed to the base of 1, 10, 100 or 1000 units of base currency.
In India, rates are expressed either to the base of 1 unit or 100 units of base currency.
7.

Unless otherwise specified, an interbank quotation in India is usually valid for USD 1 million.

VEHICLE CURRENCY:
The international foreign exchange market is an aggregate of individual markets operating in each country.
At the start of every trading day, the value of the domestic currency in each country is locally
established against each one, major, universally accepted, international/ foreign currency such as USD,
GBP, EUR, etc. this currency is called the vehicle currency for the domestic currency.
In India, effective from August 1991, the USD is considered as vehicle currency for INR. This means
the Indian Foreign Exchange Market establishes only the USD/INR quotation.
Since the vehicle currency is normally a universally traded currency, quotations of this currency
against most international currencies are easily available, this currency therefore acts as a vehicle to help
establish value of the domestic currency against any desired international currency.
The factors which influence the choice of vehicle currency are composition of foreign currency
reserves of the country, pattern of invoicing import export trade of the country, ready acceptability of the
vehicle currency, ready availability of cross currency quotations against the vehicle currency, proportion of
use of the vehicle currency in invoicing of international trade.

CROSS RATES:
The cross currency rates are used in combination with the vehicle currency rate against the domestic
currency to establish the value of the domestic currency against all international currencies. This process is
called crossing and the resultant exchange rates are called cross rates.

INTERBANK RATES:
All the exchange rates that are exchanged and dealt with between banks are called as Interbank Rates.
Interbank contracts are settled at interbank rates. Interbank foreign exchanges do not involve any pre/post
payment of either currency.

MERCHANT RATES:

FOREIGN EXCHANGE MARKET IN INDIA

Rates quoted by banks for their customers are called merchant rates and involve an addition or subtraction
of Exchange Margin which represents the profit margin, transaction handling commission and overhead
expenses.

Factors affecting foreign exchange rates:

Foreign exchange rates are influenced by several factors in the international market. All tangible
factors are captured in the Balance of Payments Account and the net disequilibrium in the BOP is the single
most important demand-supply element affecting an exchange rate. However there are other tangible
factors such as Economic indicators, political factors, view of speculators, etc. which influence the
exchange rate.
1.
Gross domestic Product (GDP): GDP is the broadest measure of aggregate economic activity in a
country and represents the total value of final goods and services produced in a country. GDP is the
primary indicator of the strength of economic activity. So the growth in the GDP positively influences the
foreign exchange price of the currency. A fast growing economy will reflect strength in the exchange rate
and vice versa.
2.
Trade balance: it represents the difference between imports and exports of tangible goods. The
changes in exports and imports are recorded in the current account of the BOP and therefore have
immediate effect on the demand- supply equilibrium. This data is widely followed by foreign exchange
market. A positive BOP would result in an appreciation in the domestic currency which would make
imports cheaper and exports costlier and vice versa.
3.
Inflation: inflation is the rate of change in the price level of a fixed basket of goods and services in
an economy. Inflation reduces the purchasing power of the currency. This reduction in domestic purchasing
power gets reflected internationally through depreciation in the exchange rate of the domestic currency.
4.
Employment levels: It reflects the development and stability in the economy. An expanding
economy would result in greater investments which would result in more employment generation. Higher
employment reflects a growing economy and leads to appreciation in the domestic currency.
5.
Interest Rate Differentials: Interest rate applicable to a currency has a dual impact on the currency
valuation. If increase in the interest rate is reflection of the strength of the economy then it would have a
positive effect on the exchange rate. However if the interest rates increase due to expectations of higher
inflation then it would have a negative effect on the value of the currency. In any exchange rate there are
two currencies involved. Therefore there are situations when interest rates of both the currencies may rise
simultaneously. In such situations the interest rate differential is relevant. Sometimes the interest rates of
the two currencies could move in opposite directions thereby increasing the gap between the two. In such
cases the effect the exchange rate would be more pronounced.
6. Exchange rate policy: the exchange rate policy is decided by the Finance Ministry while monetary
policy is decided by the central bank of the country. The execution of exchange rate policy is always
managed by the central bank. The central bank of the country participates in the local foreign exchange
market by way of intervention to stabilize the exchange rate or maintain it in a particular range. This also
affects the exchange rate of the currency.
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7. Political factors: the foreign exchange market can be influenced by political events and changes. These
events may be expected or unexpected. Some of the common political developments are elections, public
announcements by central bank or government officials, military takeovers, political instability, etc. affect
the exchange rate.
8. View of speculators: more than 90% of the turnover in international foreign exchange markets
represents speculative activity. The view or perception of the likely value of the currency of these
participants in the market has a critical effect on the exchange rate. The forces of demand and supply
determine the prices of commodities (foreign currency) in a free market. If at any given rate, the demand
for a currency is greater than its supply, its price will rise. If supply exceeds demand then price will fall.

The Exchange Rate Systems

The history of foreign exchange can be traced back to the time moneychangers in the middle-east would
exchange coins from all over the world. Foreign exchange dealings with gold as the standard of value
started around 1880 after more than a hundred years of bimetallism where both gold and silver were
commonly used as a measure of value.

The Gold Standard

Under the gold standard, the exchange rate of two currencies was based on the intrinsic value of gold in the
unit of each currency. This also came to be known as the mint parity theory of exchange rates. Under the
gold standard exchange rates could only fluctuate within a narrow band known as the upper and lower gold
points. A country, which had a balance of payments deficit had to part with some of its gold and transfer it
to the other country. The transfer of gold would reduce the volume of money in the deficit country and lead
to deflation while the inflow of gold in the surplus country would have an inflationary impact on that
economy. The country which was in deficit would then be able to export more and restrict its imports as a
result of the fall in domestic prices and reduce its BOP deficits. A lowering of the discount rates in a
country with a surplus and a hike in discount rates in the deficit country also aided in reducing the
imbalance in the BOP.
The main types of gold standard were:

The gold specie standard.

The Gold Bullion standard.

The Gold Exchange standard.

The Gold Specie Standard 1880 1914

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Under the gold specie standard, gold was recognized as a means of settling domestic as well as
international payments. There were no restrictions on the use of gold and it could be melted down or be
sent to a mint for conversion to coins. Import and export of gold was freely allowed and Central Banks
guaranteed the issue or purchase of gold at a fixed price, on demand. The price of gold varied according to
the supply of the metal in the market and the value of gold coins was based on their intrinsic value.

The Gold Bullion Standard 1922 - 1936

The gold bullion standard started after the first world war, as increased expenditures to fund the war effort
exposed the weaknesses of the gold standard. It was decided at an international conference in Brussels in
1922 to reintroduce the gold standard but in a modified form. Under the gold bullion standard, paper
money was the main form of exchange. It could however be exchanged for gold at any time. As it was
unlikely that there would be a great demand for converting currency notes to gold at any given time, the
banks could issue currency notes in excess of the value of gold they were holding. The gold bullion
standard too could not last long as many major currencies were highly over or under valued leading to a
distortion in balance of payment positions. In 1925, the sterling was overvalued against the dollar by nearly
44% and necessitated devaluation. This devaluation had an impact on other currencies too and led to an
exchange rate war. England withdrew from the gold standard in 1931, America in 1933 and Italy, France,
Belgium, Switzerland and Holland remained. It finally collapsed in 1936 with the devaluation of the
French franc and the Swiss franc.

The Gold Exchange Standard 1944- 1970

During the second world war, international trade suffered with runaway inflation and devaluation of
currencies. A need was felt to bring out a new monetary system that would be stable and conducive to
international trade. The process was started in 1943 by Britain and the US and finally in July 1944 the
American proposal was accepted at the Bretton Woods conference. The new system aimed to bring about
convertibility of all currencies, eliminate exchange controls and establish an international monetary system
with stable exchange rates.
The IMF was set up in 1946 under the Bretton Woods agreement and the new exchange rate system also
came to be known as the Bretton Woods system. Under the Bretton Woods system, member countries were
required to fix parities of their currencies to gold or the US dollar and ensure that rates did not fluctuate
beyond 1% of the level fixed. It was also agreed that no country would effect a change in the parity without
the prior approval of the IMF.

Flexible Exchange Rate System

There are two primary models of currency management used to maintain the exchange rate under the
flexible exchange rate system. They are clean float or free float and managed or dirty float.

Clean float or free float:

FOREIGN EXCHANGE MARKET IN INDIA

It is a model under which there is no official participation in establishing currency values. The central bank
does not set any target range or price and the value of a currency is determined by market forces of demand
and supply. The central bank or the government does not participate in the establishment of exchange rate.
The disadvantage of this system was that currencies of weaker economies became vulnerable to speculative
attacks but most major economies floated their currencies.

Managed or dirty float:

Most medium and small economies adopted the system of pegging their currency either to one of the major
international currencies or SDRs (special drawing rights) or a basket of currencies. The disadvantage of
this mechanism was that the exchange rate of a country did not reflect the economic fundamentals of the
home country, but its value depended upon the economic performance of the country to whose currency the
domestic currency was pegged. This resulted in several adverse effects such as imported inflation, etc.
gradually most such economies adopted the managed float concept.
A managed float or a dirty float is a form of exchange rate management where the countrys central bank
does not set a target price nor does it set a target range. Whenever the currency exhibits volatility the
central bank intervenes by participating in the domestic foreign exchange market. It does so in order to
ensure stability and also to ensure that the exchange rate reflects the underlying status of the economy.
Essentially, in this concept the currency is floated but the central bank participates in the domestic market
to influence the exchange rate movement in such a way as to reflect the true fundamentals of the currency.
The central bank does not announce any target rate but take suitable intervention action, as and when
necessary. Intervention under the managed float system does not involve reversing the trend set by the
market forces but controls the rate of depreciation or appreciation of the domestic currency.
India adapted this model for controlling the exchange rate of INR under the flexible exchange rate system.
In India the Reserve Bank of India intervenes when the value of INR depreciates or appreciates against the
foreign currencies.

Advantages:
The managed float attempts to combine the advantages of both the fixed and flexible exchange rate
systems, depending on the degree of instability. The less instability, the less intervention is necessary by
central banks and they can pursue quasi-independent domestic monetary policies to stabilize their own
economies. The greater the instability, the more intervention is necessary by central banks and the less free
they are to pursue independent domestic monetary policies because they are frequently required to use their
money supplies to calm disturbances in the foreign exchange markets.

Disadvantages
The big problem with a managed float comes in determining the timing and magnitude of the instability
and the necessary intervention. If the central banks are too quick to respond or if the amount of intervention
is inappropriate, their actions may be further destabilizing. This increased instability has a tendency to
dampen international flows and contract world trade. If they wait too long, permanent damage may be done
to some countries' trade and investment balances.
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Chapter 3
Foreign Exchange Market in India
History of Foreign Exchange Market in India
The foreign exchange currency trading in India is growing at a really good pace however it is said
that the forex market is still in the early phase in India. Nevertheless there are already several big players in
the Indian forex market.
The history of forex market in India owes its origin to an important decision taken by the Reserve Bank of
India (RBI) in the year 1978 which allows banks to undertake intra-day trading in foreign currency
exchange. As a result of this step, the agreement of maintaining square or near square position was to be
complied with only at the close of business every day. The history of currency trading in India also clearly
shows that during the initial period when these economic reforms started, the exchange rate of national
currency i.e. Indian rupee used to be determined by the RBI in terms of a weighted basket of currencies of
Indias major trading partners. Moreover, there were some fairly significant restrictions on the current
account transactions.
Then again during early nineties, more economic reforms were introduced which witnessed the
important two-step downward adjustment in the exchange rate of the Indian rupee in order to place it at a
suitable level in line with the inflation differential so that the competitiveness in exports could be
maintained. With these economic reforms which resulted in the unification exchange rate of the rupee
heralded the commencement of the new era of market determined forex currency rate regime of rupee in
the Indian forex history which was based on the demand and supply principle in the forex market.
Another landmark in Forex history of India came with the appointment of an Expert Group committee
on Forex currency in 1994. This committee was made to study the forex market in detail so that step can be
taken out to develop, deepen and widen the forex market in India. The result of this exercise was that banks
were significant freedom in many of its market operations related to like forex market development and
liberalization. The freedom was granted to banks in term of fixing their trading limits, allowed to borrow
and invest funds in the overseas markets up to specified limits, accorded freedom to make use of derivative
products for asset-liability management purposes.
The corporate were granted the flexibility to book forward cover based on previous turnover and
were given freedom to make use of financial instruments like interest rates and currency swaps in the
international currency exchange market. The other feature of forex history in India is that a large sum of
foreign exchange in India came through the large Indian population working in foreign countries.
However, the common man was not much interested in forex trading. the things are changing now and with
the growing economy more and more people are showing interest in forex trading and are looking out for
hedging currency risks.
National Stock Exchange of India popularly known as NSE was the first recognized exchange in
Indian forex history to launch forex currency futures trading in India. These currency futures are beneficial
over overseas forex trading especially to comparatively small traders and retail investors. Another
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important point to know is that before discussing the history of forex market in India, it is important to
know the central government of India has the powers to control transactions in foreign exchange and hence
forex transactions in India are managed by the government authorities

Evolution of the forex derivatives market in India:

This tremendous growth in global derivative markets can be attributed to a number of factors. They
reallocate risk among financial market participants, help to make financial markets more complete, and
provide valuable information to investors about economic fundamentals. Derivatives also provide an
important function of efficient price discovery and make unbundling of risk easier. In India, the economic
liberalization in the early nineties provided the economic rationale for the introduction of forex derivatives.
Business houses started actively approaching foreign markets not only with their products but also as a
source of capital and direct investment opportunities. With limited convertibility on the trade account being
introduced in 1993, the environment became even more conducive for the introduction of the hedge
products. Hence, the development in the Indian forex derivatives market should be seen along with the
steps taken to gradually reform the Indian financial markets.

Developments in the capital inflows:

Since early nineties, we are on the path of a gradual progress towards capital account convertibility. The
emphasis has been shifting away from debt creating to non-debt creating inflows, with focus on more
stable long-term inflows in the form of foreign direct investment and portfolio investment. In 1992, foreign
institutional investors were allowed to invest in Indian equity & debt markets and the following year,
foreign brokerage firms were also allowed to operate in India. Non-Resident Indians (NRIs) and Overseas
Corporate Bodies (OCBs) were allowed to hold together about 24 percent of the paid up capital of Indian
companies which was further raised to 40 percent in 1998. In1992, Indian companies were also encouraged
to issue ADRs/GDRs to raise foreign equity, subject to rules for repatriation and end use of funds. These
rules were further relaxed in 1996 after being tightened in 1995 following a spurt in such issues. Presently,
the raising of ADRs/GDRs/FCCBs is allowed through the automatic route without any restrictions. FDI
norms have been liberalized and more and more sectors have been opened up for foreign investment.
Initially, investments upto 51 percent were allowed through the automatic route in 35 priority sectors. The
approval criteria for FDI in other sectors was also relaxed and broadened. In 1997, the list of sectors in
which FDI could be permitted was expanded further with foreign investments allowed upto 74 percent in
nine sectors. Ever since 1991, the areas covered under the automatic route have been expanding. This can
be seen from the fact that while till 1992 inflows through the automatic route accounted for only 7 percent
of the total inflows; this proportion has increased steadily with investments under the automatic route
accounting for about 25 percent of total investment in India in 2001. In 2000, the Indian Government
permitted the raising of fresh ECBs for an amount upto US$ 50 million and refinancing of all existing
ECBs through the automatic route. Corporates no longer had to seek prior approval from the Ministry of
Finance for fresh ECBs of upto US$ 50 million and for refinancing of prevailing ECBs.

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Developments in capital outflows:

Thus, while the inflows from abroad have been freed to a large extent, outflows associated with these
inflows like interest, profits, sale proceeds and dividend etc. are completely free of any restriction. All
current earnings of NRIs in the form of dividends, rent etc. have been made fully repatriable. But
convertibility in terms of outflows from residents, however, still remains more restricted although these
restrictions are gradually reduced. Residents are not allowed to hold assets abroad. However, direct
investment abroad is permissible through joint ventures and wholly owned subsidiaries. An Indian entity
can make investments in overseas joint ventures and wholly owned subsidiaries to the tune of US$ 100
million during one financial year under the automatic route. At the same time investments in Nepal and
Bhutan are allowed to the tune of INR 3.50 billion in one financial year. Units located in Special Economic
zones (SEZs) can invest out of their balances in the foreign currency account. Such investments are
however subject to an overall annual cap of US$ 500 million. Indian companies are also permitted to make
direct investments without any limit out of funds raised through ADRs/GDRs. Recently mutual funds have
been allowed to invest in rated securities of countries with convertible currencies within existing limits. A
deep and liquid market for the underlying is necessary for the development of an efficient derivative
market. The easy movement of capital between different markets and currencies is essential to eliminate
pricing discrepancies and efficient functioning of the markets. The steps mentioned above to increase
convertibility on the capital account and the current account aided the process of integration of the Indian
financial markets with international markets. These reforms set in motion the process of the development
of the forex derivatives markets by gradually opening the Indian financial markets and developing the
foreign exchange and the money markets.

Growth of Foreign Exchange markets in India:

Presently the Indian Forex market is the 16th largest Forex market in the world in terms of daily turnover
as per the BIS Triennial Survey report. As per this report the daily turnover of the Indian Forex market is
around US$ 100 billion including the OTC derivative segment.
The growth of the Indian Forex market owes to the tremendous growth of the Indian economy in the last
few years. Today India holds a significant position in the Global economic scenario and it is considered to
be one of the emerging economies in the World. The steady growth of the Indian economy and
diversification of the industrial sectors in India has contributed significantly to the rapid growth of the
Indian Forex market. The main centre of Foreign Exchange in India is Mumbai, the commercial capital of
the country and other centers including the major cities like Kolkata, New Delhi, Chennai, Bangalore and
Cochin. All these Foreign Exchange Markets of India work collectively deploying latest technology. The
Foreign Exchange Market in India is a flourishing ground of profit and initiatives taken time to time by the
Indian Central Government also strengthen the foundation.
It is during the year 2008 that Indian Forex market has seen a great advancement that took the Indian Forex
trading at par with the global Forex markets. It is the introduction of future derivative segment in Forex
trading through the largest stock exchange in country National Stock Exchange. This step not only
increased the Indian Forex market volume too many folds also gave the individual and retail investor a
chance to trade at the Forex market, that was till this time remained a forte of the banks and large
corporate. Indian Forex market got yet another boost when the SEBI and Reserve Bank of India permitted
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the trade of derivative contract at the leading stock exchanges NSE and MCX for three new currency pairs.
In its recent circulars Reserve Bank of India accepting the proposal of SEBI, permitted the trade of
INRGBP (Indian Rupee and Great Britain Pound), INREUR (Indian Rupee and Euro) and INRYEN (Indian
Rupee and Japanese Yen). This was in addition with the existing pair of currencies that is US$ and INR.
From inclusion of these three currency pairs in the Indian Forex circuit the Indian Forex scene is expected
to boost even further as these are some of the most widely traded currency pairs in the world.

Structure of Indian Foreign Exchange Market

Regulatory framework:
Foreign currencies cannot be created domestically and hence every country tries to balance their
inflow and outflow. This process is called Exchange Control. The term exchange control thus essentially
deals with quantitative control. Effectively, any directive or regulation which restricts the free play of
demand supply forces, in the foreign exchange market can be described or deemed as exchange control. It
was introduced in India in 1939 and various regulations made in regard were consolidated into the Foreign
Exchange Regulation Act (1973). In 1991, the LPG model was introduced in India. FERA was replaced by
foreign exchange management act (1999). The objectives of FEMA were
1.
To facilitate international trade and investments. This means both domestic and foreign operators
were to be provided greater freedom in international operations.

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2.
To promote an orderly development and maintenance of the domestic foreign exchange market. The
RBI focuses on providing a competitive environment through exchange rate management and on
dismantling controls to provide operational ease to all market participants.
Sections 41, 46 and 47 of the foreign exchange management act, 1999 collectively provide the RBI
with the powers as well as the responsibility to administer foreign exchange business in the country.
However the RBI does not transact with private entities and therefore has delegated this function as
provided in the act.
The Foreign Exchange Management Act (1999) or in short FEMA has been introduced as a
replacement for earlier Foreign Exchange Regulation Act (FERA). FEMA became an act on the 1st day of
June, 2000. FEMA was introduced because the FERA didnt fit in with post-liberalisation policies. A
significant change that the FEMA brought with it was that it made all offenses regarding foreign exchange
civil offenses, as opposed to criminal offenses as dictated by FERA.
The Foreign Exchange Management Act, 1999 is focused towards consolidating and amending the law
relating to Foreign Exchange utilisation with the objective of facilitating external trade and payments. It
was also formulated to promote the orderly development and maintenance of foreign exchange market in
India.
The FEMA head-office, also known as Enforcement Directorate is situated in New Delhi and is
headed by a Director. The Directorate is further divided into 5 zonal offices in Delhi, Mumbai, Kolkata,
Chennai and Jalandhar and each office is headed by a Deputy Director. Each zone is further divided into 7
sub-zonal offices headed by the Assistant Directors and 5 field units headed by Chief Enforcement
Officers.
The important features in the new Act as compared with previous Act are:
A)

The classification of current account and capital account transactions has been clearly defined;

B) The new enactment is positive, that is, all current account transactions not specifically restricted can
be freely carried on;
C) The FERA provided for criminal proceedings against violations whereas the FEMA provides for only
civil liabilities against violations;
D) The definitions of residents and non-residents now takes into account the duration of their stay in
India as in the case of Income Tax Act;
E) The FERA dealt with Demand side management whereas the FEMA deals with Supply side
management of foreign currency resources of the economy.

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Authorised Persons:
Although the RBI has the sole authority to administer foreign exchange business in India, it does not
deal with individuals and other private entities and therefore cannot undertake this function by itself.
Foreign exchange is received or required by a large number of individuals, exporters and importers in the
country spread over a vast geographical area. It is not possible for RBI to deal with them individually. The
Reserve Bank provides licences to three categories of persons called Authorised Dealers, Money Changers
and Offshore Banking Units (OBUs) to transact with the public at all different levels. All such transactions,
with end-users are governed by the Exchange Control Regulations provided by the Reserve Bank of India.
Authorised persons are mandatorily required to comply with the directions or orders of the RBI in all the
foreign exchange dealings undertaken by them. Before undertaking any transactions in foreign exchange,
necessary declarations and information should be obtained from the customer so as to ensure that the
provisions of the Act are not violated.

Authorised dealers:
The bulk of the foreign exchange transactions undertaken in the country involve end-users and banks.
Banks and selected entities licensed by the RBI to undertake these transactions are called Authorised
Dealers (Ads). They are permitted to undertake all categories of transactions pertaining to both the Current
and Capital Accounts of the Balance Of Payments.
An authorised dealer is required to comply with the directions and instructions of the RBI. Such
instructions are collectively called Exchange Control Regulations and are contained in the Exchange
control Manual. All amendments to the exchange control manual are intimated to authorised dealers by the
Reserve Bank in the form of its AD (MA series) circulars. Further, directions pertaining to general
procedures are given in the form of its AD (GP series) circulars.
With regard to the operational of foreign exchange transactions such as charging of commission,
methods of quotation of rates etc., the authorised dealer is required to comply with the rules of the Foreign
Exchange Dealers Association of India (FEDAI).

Authorised Money Changers:

Money changers are licensed entities permitted to provide facilities for encashment of foreign currency
denominated travel related instruments such as foreign currency notes and travellers cheques. Licences to
operate as money changers are normally provided to hotels, travel agencies, etc. Authorised money
changers are sub-classified as full-fledge money changers and restricted money changers. A full fledged
money changer is permitted to undertake both purchase and sale transactions with the public such as Travel
agencies. A restricted money changer is permitted only to purchase foreign currency notes and travellers
cheques e.g. five star hotels. All collections need to be surrendered to an authorised dealer in foreign
exchange through a back to back arrangement.

Offshore Banking Units:

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Branches of banks in India established in Special Economic Zones (SEZ) are accorded the status of
Offshore Banking Units (OBUs). The OBUs are allowed to undertake banking operations only in
designated foreign currencies essentially with non-residents. Each such OBU has a minimum start up
capital of USD 10 million and its balance sheet is prepared in designated foreign currencies.

Classification
The foreign exchange market in India may be broadly classified into:
1.

The Retail Market, and

2.

The Wholesale Market

RETAIL MARKET:
1.

In this segment end-users of foreign currencies which includes individuals who receive and make
remittance, exporters and importers who sell or buy their foreign currency requirements from commercial
banks and travellers and tourists who exchange one currency for another in the form of currency notes and
foreign currency travellers cheques approach Ads for their requirements.
2.
Ads provide committed rates for such transactions. Therefore this is the segment in which exchange
rates are used. These rates are called merchant rates.
3.
Total turnover and individual transaction size is very small. Transactions are customised in terms of
amount and maturity to meet the requirement of individual customers.
4.
All transactions undertaken in this segment are governed by the Exchange Control Regulations of
RBI. ADs also need to maintain tariffs and commissions as per FEDAI guidelines.
5.

Brokers and other intermediaries are not allowed in this segment.

WHOLESALE MARKET:
1.
The wholesale market is also referred to as inert-bank market. It includes the transactions between
ADs as also operations between ADs and the RBI.
2.
Transactions in this segment are conducted in standard market lots and the average transaction size is
large.
3.
Transactions are conducted at inter-bank rates. This is the segment in which exchange rates are
determined. The external value of the domestic currency as a function of market demand and supply gets
established in this segment.
4.
A large portion of inter-bank transactions are conducted through approved / authorised foreign
exchange brokers.
5.
All transactions are conducted in accordance with the code of conduct established by RBI and FEDAI
in this regard.
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Participants in the Indian Foreign Exchange Market:

END USERS:
End-users represented by individuals, business houses, international investors, and multinational
corporations operate in the market to meet their genuine trade or investment requirements. They also buy or
sell currencies to speculate or trade in currencies to the extent permitted by the exchange control
regulations. They operate by replacing orders with the commercial banks. The deals between the banks and
their clients represent the retail segment of foreign exchange market. Speculative and arbitrage transactions
constitute a major portion of market turnover.

COMMERCIAL BANKS:
Commercial banks are the major players in the market. They buy and sell currencies for their clients.
They may also operate on their own account. This is called proprietory trading. When a bank undertakes
transactions to adjust a sale or purchase position in a foreign currency arising from its deals with its
customers, such transactions are called cover operations. Such transactions constitute only 15% of the total
transactions done by a trading bank. A major portion of the volume is accounted by proprietary trading in
currencies to gain from exchange rate movements. All foreign exchange transactions are conducted through
the banking system and thus banks are ideally situated to establish demand-supply equilibrium. Thus,
banks actively participate in establishing the exchange rates between currencies. Banks may deal directly
among themselves, or use the services of foreign exchange brokers. Foreign exchange (and derivatives)
trading profits are a very important source of revenue for major international banks.

FOREIGN CURRENCY BROKERS:

Foreign exchange brokers function as intermediaries between Authorised Dealers transacting in the
wholesale interbank market. Banks place orders with the brokers indicating the amount and rate at which
they would be interesting in buying or selling specified currencies. These orders enable the brokers to
create very fine combination quotes. When market makers or users approach them, the brokers are able to
provide these ready quotes and match their requirements. The details of counter parties are conveyed to
complete the transaction.
Brokers in India are not permitted to maintain open positions or trade on proprietary account. They
only act as deal facilitators. The rates of brokerage and general operational aspects are governed by
guidelines from the Foreign Exchange Dealers Association Of India (FEDAI).
Foreign exchange brokers in India require licence from the RBI to operate. This licence is renewed
based on the periodic review undertaken by FEDAI which makes the necessary recommendations to RBI.
All such entities are required to maintain specifies security deposit with FEDAI.

RESERVE BANK OF INDIA:

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The central bank may intervene in the market to influence the exchange rate or to reduce volatility. The
basic intention in such actions is to redefine the demand - supply equilibrium. The central bank may
transact in the market on its own for the above purpose or on behalf of the government, when undertaking
transactions which may involve foreign currency payments and receipts. Under the Flexible Exchange Rate
System currently in operation, Central banks are under no obligation to defend any particular exchange rate
but still intervene to change market sentiment.
The role of RBI in the exchange market is as follows:

Monitoring and management of exchange rates without a pre-determined target rate or range with
intermittent intervention as and when necessary has been the basis of the Managed Float system followed
in India.

A policy to build a higher level of foreign exchange reserves, which takes into account not only
anticipated current account deficits but also liquidity requirements arising from unanticipated capital
outflows.

A judicious policy for management of capital account transactions, with progressive liberalisation of
such transactions.

Balancing the external economy represented by the exchange rate and the internal economy
represented by interest rates, inflation, money supply, etc.

FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA (FEDAI):

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. Its major activities include framing of
rules governing the conduct of inter-bank foreign exchange business between banks, transactions between
banks and public and liaison with RBI for reforms and development of foreign exchange market.
Presently their main functions are as follows:

Frame guidelines and rules for foreign exchange business.

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FOREIGN EXCHANGE MARKET IN INDIA

Training of bank personnel in the areas of foreign exchange business.

Accreditation of foreign exchange brokers and periodic review of their operations. They also advise
the RBI regarding licensing of new brokers.

Advising/ assisting member banks in settling issues/matters in their dealings. They provide a
standardized dispute settlement process for all market participants.

Represent member banks in discussions with government / Reserve Bank of India / other bodies and
provide a common platform for Authorised Dealers to interact with the government and RBI.

Announcement of daily and periodical rates to member banks. At the end of each calendar month
they provide a schedule of forward rates to be used by ADs for revaluing foreign currency denominated
assets and liabilities.

Announcement of spot date at the start of each trading day to ensure uniformity in settlement
between different market participants.

Circulate guidelines for quotation of rates, charging of commissions etc. by ADs to their customers
and by brokers for interbank transactions.
Due to continuing integration of the global financial markets and increased pace of de-regulation, the role
of self-regulatory organizations like FEDAI has also transformed. In such an environment, FEDAI plays a
catalytic role for smooth functioning of the markets through closer co-ordination with the RBI, other
organizations like FIMMDA (fixed income money market and derivatives association), the Forex
Association of India and various market participants. FEDAI also maximizes the benefits derived from
synergies of member banks through innovation in areas like new customized products, bench marking
against international standards on accounting, market practices, risk management systems, etc.

The Role of Reserve Bank of India In The Control And Growth Of The Foreign
Exchange Market In India
In terms of Reserve Bank of India Act, 1934 the RBI is the custodian of the foreign currency assets of
the country. In terms of foreign exchange management act,1999 the RBI is responsible for controlling and
supervising the foreign exchange business in the country. The primary role of the RBI in the context of
these two acts therefore is to maintain stability to the external value of the rupee. This objective is
approached through a balance between its domestic policy and the regulation of the foreign exchange
market. The role of the RBI in the Indian Foreign Exchange Market is as follow:
1.

To identify and implement an appropriate exchange rate mechanism.

2.
To manage the external value of the Indian Rupee. (i.e. the exchange rate. Currently through the
Managed Float Mechanism)
3.

To achieve the convergence between domestic monetory policy and exchange control regulations.

4.

To manage the Foreign Exchange Management Act, 1999.

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FOREIGN EXCHANGE MARKET IN INDIA

Too progressively build higher reserves and manage the same in a cost effective manner.

6.
To progressively liberalize Capital Account transactions to meet the demands of the growing
economy.
7.
To achieve a viable balance between the external and internal economy of the country. (This is
achieved through mechanisms such as the market stabilisation scheme)
8.
To interact and negotiate with other monetary authorities and with international banks and financial
institutions such as the IMF, World Bank, etc.
9.
To manage the investment of reserves in gold, shares and securities issued by foreign governments
and deposits with international banks and financial institutions.
10. To periodically disclose foreign exchange related data to achieve transparency regarding market
operations and the extent of RBI participation.
11. To specify policy guidelines for risk management relating to foreign exchange operations in banks.
(at a universal level standard guidelines are developed by the Bank of International Settlements-BIS)
12. The RBI is also responsible for licensing of banks and money changers to deal in foreign exchange
and reviewing the same. The role of the RBI as a proactive participant in the domestic foreign exchange
Market, for stabilizing that market and the INR exchange rate has become more critical with the floating of
the INR and introduction of convertibility on capital account.

Statistical and Graphical Data

USD v/s INR

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Indian Rupee per 1 US Dollar

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Indian Rupee per 1 Euro

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Indian Rupee per 1 British Pound

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Indian Rupee per 100 Japanese Yen

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FOREIGN EXCHANGE MARKET IN INDIA

1 Indian Rupee Rates table

Conclusion:
Foreign exchange market is one of the influential areas in the economy of the country.

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