Foreign Exchange Market in India

Sahil Sarbhai – PGPM-17 -114
Sathishkumar R – PGPM-17 -116
Vaibhavi Jani – PGPM-17 -132
Vishal Mathur – PGPM-17 -134

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Foreign Exchange Market in India
I. Introduction to Forex market
The Forex market is the most traded market and the largest one worldwide with daily transactions close to over $5 trillion. The Foreign Exchange (Forex) market is a global online network for the trading of currencies. It has no physical location and operates 5.5 days a week for 24 hours daily. Through all the buying, selling and exchanging that takes place in the Forex market the foreign exchange rates are determined. Apart from buying, selling and exchanging it also provides a platform for speculation of currencies.
The Forex market is unregulated and hence, there is no intermediary (clearing house) to guarantee the obligations both the parties have acquired. Every transaction has a private contract between the two parties. The Forex market has a wide variety with respect to the participants and the currencies traded, the major currencies being Dollar, Euro, Yen and Pound. The market consists of 2 tiers –
1. Interbank Market : The biggest banks exchange currencies with each other. Less players but high in volume.
2. OTC Market : It is the decentralized market through which all the individuals trade.

The Forex Market in India was established in 1978 by the government where it allowed banks to trade with each other. The Foreign Exchange Management Act, 1999 regulates the whole Forex Market in India. Before the introduction of this act the Forex market was regulated by RBI through the Foreign Exchange Regulation Act, 1947. Interbank foreign exchange is regulated by the Foreign Exchange Dealers Association of India. Since 2001, Clearing Corporation of India Limited takes care of clearing and settlement – daily volume of transaction handled is close to $3.5 billion. RBI has granted licenses to certain authorized money changers to facilitate encashment of foreign currencies to visitors from abroad. Authorized dealers are the banks and financial institutions which have been granted licenses to operate.
The 3 major types of forex market operations are:
? Spot Market
? Forward Market
? Exchange settlement and dealings

II. Functions and uses of the Forex market
? Set the prices of a currency relative to the value of any other currency.
? Help in providing a currency risk coverage
? Help maintain a balance of liquidity across organizations and countries
? Use leverage to enhance profit & loss margins
? Provide valuable information to investors about economic fundamentals
? Enable efficient price discovery
? Provides transfer function which helps in transferring the purchasing power from one nation to another – it is performed through instruments like bills, bank drafts etc.
? Provides credit function – through credit for both national and international trade. Foreign bills of exchange for international payments have a credit period of 3 months
? Provides hedging function to facilitate buying and selling of forward/spot contracts. Hedging helps in protecting oneself from any fluctuations in the exchange rate
III. Market factors affecting the Forex Market in India:

1. Commodities Market
The commodities market have a great impact on forex market in India. Let us take an example of crude oil commodity. Oil prices can rise sharply because of value of the U.S. dollar declining relative to major global currencies. So, the price of oil must go up in order to equalize the price that other foreign countries buy in their home currencies.

India rupee is positively correlated to oil prices. Therefore, as the price of oil rises, the INR value tends to depreciate against other major currencies. India being an Oil importer; when oil prices are high, India would shell out more rupees to buy it, which means more rupees are going out of the country and hence the INR value will weaken. Indian Rupee is also positively correlated with gold. India, one of the biggest gold producers, causes the INR value to move in unison with price movements in gold . Thus, when prices of gold rise significantly, the INR would also tend to appreciate against other major currencies.
2. Equity Markets
In general, when a domestic equity market rises, confidence in that specific country grows as well, leading to an inflow of funds from foreign investors. In India, in such a situation, demand for INR increases, causing it to rise against other foreign currencies. On the other hand, when a domestic equity market doesn’t perform well, investors lose confidence, causing them to convert their invested funds back into their own local currencies. A weak INR value favours exporters in India. When Indian rupee is weak, exports become relatively cheaper. That leads to further growth and profits due to increase in exports.

3. Capital Markets

India is a sector driven and a heavily commodity-based market. In this case, the Indian rupee is largely dependent on the movements of commodities such as crude oil and metals. Rise in oil prices would likely lead to the appreciation of Indian rupee relative to other currencies. Commodity traders, like forex traders, rely heavily on economic data for their trades, so in most cases that economic data will have a direct impact on both markets. In general, Bond markets also have an impact on forex market, since both fixed income securities and currencies rely heavily on interest rates. Movements in Treasuries lead to movements in currencies, which means that any change in yields will have direct impact on the currency.

IV. Impact of Capital Inflows on Exchange Rate
In India, capital inflows occur in the form of Foreign Direct Investment (FDI) or when foreign institutional inves¬tors (FII) and NRIs buy equity in stock market.

Let’s take an example where foreign institutional investors (FII) and NRIs buy shares of the Indian companies. They will therefore bring dollars and convent them into rupees for buying shares of the Indian companies. These capital inflows will increase the supply of US dollars causing a shift in the supply curve to the right (S1S1). The new supply curve of dollars S1S1 intersects the demand curve DD of dollars at point M and determine the new exchange rate OR (Rs. 60/dollar). This causes Indian Rupee to appreciate. Here, the overall balance of payments will also be in equilibrium.

However, due to capital inflows as shown in figure below, current account must be in deficit while the overall balance of payments is in equilib¬rium. Due to this capital inflow, exchange rate of rupee appreciates, causing exports to decline.

Total exports of goods and services at the new exchange rate OR (Rs. 60/dollar) is given by the point X on the original supply curve – SS corresponding to this new exchange rate OR. From the above figure, we observe that total exports RX are less than total imports R’M. Thus, there is deficit of AM on current account. This deficit on current account is met by surplus in capital inflows of capital account since overall balance of payments balances at the new equilibrium exchange rate.

V. Impact of Capital outflows on Exchange Rate
Let us take an example where the rate of ROI rises in the USA or Rate of Interest falls in India as compared to that of US. This leads to capital outflows from India and results in shift in the the demand curve of US dollars in foreign exchange market.

This is illustrated in Figure below, where demand curve of USD DD and supply curve SS of USD determine equilibrium exchange rate (Rs.61/dollar) when there are no capital flows. Now when the net capital outflows occur due above factors, investors in India would want to invest in the US by converting Indian rupees into USD. This would cause an increase in demand for US dollars resulting in a shift of the demand curve for US dollars to the right – D1D1.

This leads to a new equilibrium point T with the new exchange rate (OR) (Rs. 62/dollar), i.e. US dollar appre¬ciates and the Indian rupee depreciates. Since the Indian rupee depreciates, exports will rise (to R”T) as depreciation will cause the price of goods and services to decrease.

On the other hand, depreciation of Indian rupee will make imports costlier, thus leading to decrease in imports to R”M at the new exchange rate OR”. Thus, there will be surplus in balance of payments on current account of India which is nothing but the capital outflows.

VI. REER (Real Effective Exchange Rate)

REER = NEER – Inflation Differential
? REER is calculated using inflation differentiation based on CPI for both India as well as partner countries.
? REER is used to measure the value of domestic currency against an average group of major currencies.
? Increase in REER denotes that the domestic goods become costlier and the foreign goods become cheaper.
? REER is a measure of competitiveness of an economy.
? REER includes transactional costs associated with the imported goods.
? REER is of utmost importance when conducting economic analysis and policymaking.
Example:
Let us consider that a sandwich cost worth of $1. Now being an Indian I would calculate the price of same sandwich in INR using exchange rate ($1=65.05 INR). But when you ordered the same sandwich in India, the price would be Rs.70 (assumed).
Here, if we consider price of sandwich to be Rs.65.05 then we are not considering inflation differential between the currencies of India and USA. Thus, we can say that
Nominal effective exchange rate (NEER) ? Rs.65.05
Real effective exchange rate (REER) ? Rs.70
Inflation Differential ? Rs.4.95
REER of USD vs. INR = (USD/INR)*(Exchange rate)*100
Hence,
• If REER = 100, then US prices are at par with Indian prices.
• If REER