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Exchange rate is a key determinant in international finance and turning of world into a
global village has just made this variable all the more important. Forex markets have
undergone many changes from setting up of Bretton Woods System in 1944 according to
which each country had to fix its currency exchange rate plus or minus 1 percent to its
abandonment in 1984 due to increased Balance of Trade deficit of U.S. Then it has
witnessed East Asian crisis of 1997 when majority of the currencies of East Asian countries
depreciated.
Now most of the countries follow a free floating exchange rate system. India's approach can
be characterized as intermediate since it follows a system between a freely floating and fully
managed system. This type of system is known as managed float system .Exchange rates
are allowed to float freely, but RBI intervenes when it feels necessary in the way it
considers suitable. For e.g. in order to curb appreciation of INR it may buy USD from the
market or it may increase the interest rates.

   

The Forex market like any other market is essentially governed by the law of supply and
demand. According to the law of supply, as prices rise for a given commodity (in this case
currency), the quantity of the item that is supplied will increase; conversely, as the price
falls, the quantity provided will fall. The law of demand states that as the price for an item
rises, the quantity demanded will fall. As the price for an item falls, the quantity demanded
will rise.

In the case of currency, it is the demand and supply of both domestic and foreign currency
that is considered. It is the interaction of these basic forces that results in the movement of
currency prices in the Forex market.


    

There are various factors in a macro-economic environment which affect the demand and
supply of a currency and in return affect the exchange rate.
µ?    
If there are higher interest rates in home country then it will attract
investments from abroad in the form of FII, FDI and increased borrowings. This will
lead to increased supply of foreign currency. On the other hand, if the interest rates
are higher in the other country, investments will flow out leading to decreased supply
of foreign currency. 
µ?      -If inflation rates are high then the central bank will have to
reduce the supply of domestic currency in order to curb it. This would ultimately lead
to strong currency and vice versa. 
µ?  
      - All exchange rates are susceptible to political
instability and anticipations about the new government. All the market players get
worried about the policies and may start unwinding their positions thereby affecting
the demand and supply. 
 µ? Æ 
 
    Strong domestic financial markets will also lead to
the strengthening of domestic currency as investors will be less worried about their
investments and vice versa. 

µ? ²  Æ 
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 If the domestic economy is strong then there will be
lots of investments from abroad which will lead to increased supply of foreign
currency, ultimately leading to strengthening of domestic currency. And if there is
weaker domestic economy it would lead to outflow of funds from a country. 

µ? „ c - Positive indications (in terms of government policy,

competitive advantages, market size, etc.) increase the demand for currency, as
more and more enterprises want to invest there. Any positive indications abroad will
lead to strengthening of foreign currency. 
µ? ² 
 - The major stock indices also have a correlation with currency rates
as investors link the growth in markets to the economic growth of a country. 
µ? c

   Economic data such as labor reports (payrolls, unemployment rate
and average hourly earnings), Consumer Price Indices (CPI), Gross Domestic Product
(GDP), International Trade, Productivity, Industrial Production, Consumer Confidence
etc, also affect fluctuations in currency exchange rates. 
µ? „
  - If the exports to other countries are more than the exchange rate
will be stronger as there will be inflow of foreign currency. More one relies on
imports, weaker will be the exchange rate because there will be outflow of domestic
currency. A large, consistent government deficit will lead to outflow of domestic
borrowing. 
µ? Ú     
 !- If a government runs into deficit, it has
to borrow money (by selling bonds). If it can't borrow from its own citizens, it must
borrow from foreign investors. That means selling more of its currency, increasing
the supply and thus driving the prices down. 
µ?   Any rumor in the markets also leads to fluctuation in the values. Any
favourable news will lead to strengthening of domestic currency and any negative
rumor will lead to weakening of the currency.
 ²

About four years ago, we used to pay approximately Rs 48 for getting one USD. But now it
is moving in a band of Rs 40.40 to Rs 41 per USD which means there has been an
appreciation of about 15% in the value of INR over the years.
During the year 2004, the exchange value for a USD touched a high of Rs 46.46 and a low
of Rs 43.39. In all there was an appreciation of 4.40% during the year. In the year 2005, it
touched a high of Rs 46.63 and a low of Rs 43.33 and in all there was a depreciation of
3.34%. In the year 2006, it touched a high of Rs 46.95 and a low of Rs 44.07 and in all
there was an appreciation of Rs 1.83%.?
 ?

This year (2007), a new chapter was written in the history of Indian Forex markets. INR has
shown considerable appreciation during the first half of the year. The year opened with a
value of Rs 44.20. It showed a minor depreciation of 0.9% in the first two weeks. It got
stabilised after this and moved within a range of Rs 44 ± 44.25 till February end. Again it
depreciated by 1% in the first week of March and closed at Rs 44.56 on 6 th March. But
since then USD has appreciated considerably. The rate went to Rs 40.6 at the end of June.
During the period between March and June there was an appreciation of about 9% in the
value of INR. ?
This appreciation is mainly on account of huge capital inflows and due to other steps taken
by the Government to control the inflation.
 of all, RBI increased the "    by 50 BPS in order to reduce the
disbursal of loans by banks and thereby reducing the money supply. Moreover it also
refrained from buying dollars from the market which led to decrease in demand of the
dollar. It also issued   ²  #  „  in order to remove liquidity form the
market.
²
 $ there has been a massive capital inflow in the form of c"„$ Æ this
year. ECBs in the first six months were 5.5 billion USD which is almost the double of what
was borrowed in the whole of 2006. Similarly in case of FIIs, they have already invested
USD 8.45 billion in first six months this year as compared to USD 7.99 billion last year. FDI
in India has also increased many folds. In the first four months itself, there has been an
investment of USD 8007 million and if we look at the same period of four months last year it
was just USD 2500 million recording an increase of over 200%.

%

Oil is an important commodity. India's oil import growth is at a 5 year low of 5.33% in the
first four months of the year 2007-08 as compared to massive growth rate of 43.23% last
year. India's Oil imports during the period were valued at US$ 19.878 billion as compared to
18.87 billion last year. We can't say that oil consumption has decreased as economy is
doing well so consumption is bound to increase. On the other hand the price per barrel has
increased sharply. So we can attribute this slowdown in growth to appreciation of INR
because this would have reduced the bills of the oil companies.

 

„„
The question arises whether an appreciation of a currency is good or bad for a country. We
can say that it has its own advantages and disadvantages.
  

 µ? The importers have benefited as they have to pay less of domestic currency in order
to pay their bills in foreign currency. The foreign products have become cheaper for
the domestic consumer which helps in keeping the inflation down.

µ? Consumers benefit when they travel abroad as the domestic currency will be able to
fetch more of foreign currency while exchanging.
µ? Investors can buy foreign stocks and bonds at lower prices.
Æ  

µ? It has reduced the competitiveness of the exporters in the international markets as

their goods have become expensive.
µ? Many exporters have incurred huge losses on account of INR appreciation.
µ? It has also put pressure on the domestic suppliers as there will be inflow of foreign
goods and that to at lower prices.?
µ? Foreign tourists will find it more expensive to visit the country.
À ??
 Æ
 once said, î   À  ²
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"Hedging is a strategy designed to minimize exposure to an unwanted business risk, while
still allowing the business unit to profit from a business activity." Every business is exposed
to a certain risks like banks are exposed to asset liability mismatches or oil companies are
exposed to increase or decrease in the prices of oil.
Similarly, a company faces certain risks when it is dealing with the foreign exchange which
must be properly hedged. It faces mainly three types of risks i.e. transactional risk,
translation risk, and economic exposure risk which it needs to hedge because the investors
invest in a firm's ability to profit from its line of business and not from its ability to
speculate in the currency markets. The hedging cost must be made part of cost of the
product.
Although, while hedging the risk the company is saved from any possible loss arising on
account of fluctuation in currency value, on the other hand it also mitigates the possibility of
making the profit on account of any favourable change.
For e.g. XYZ ltd is an exporter. It enters into a contract for supplying 1 lakh auto
components to ABC Ltd in U.S @ of $5 per piece. Its cost per unit comes out to be Rs 200
per piece. The USD/INR rate at the time of entering the contract was Rs 45 per USD. This
means company will make a profit of Rs 5 lakh if the rate remains the same i.e. Rs 45. But
at the time of payment XYZ ltd receives payment in terms of USD. At that time INR
appreciates and exchange rate comes down to Rs 39. The company will suffer a loss of Rs 1
lakh in the transaction. On the other hand, if INR depreciates and Exchange rate goes to Rs
46, then company will make a profit of Rs 6 lakh. So it creates a dilemma in the minds of
the managers on whether to go for hedging or not. A manager needs to consider factors like
objective for hedging, type of risk involved and availability of the hedging instruments
available in the market. It needs to maintain balance between uncertainty and opportunity
loss.
There are many hedging instruments available which have different trade offs between
uncertainty and opportunity loss.
À &
'


The hedging techniques could be sub-divided under two heads-

(
 
   
' ± There are various in-house techniques
like Leading, Lagging, Pricing, Netting, Offsetting, Choice of Invoicing Currency etc.
)
 Æ   
      - There are various derivative
products that are available in the market. Although these are available Over the
Counter (OTC) only and there is no exchange in India which provides such products.
The main types of derivative products available in India are Forward Contracts,
Options, Currency Swaps, Forward Rate Agreement, and Interest Rate Swaps. These
products could be modified according to the needs of a particular company.
The Reserve Bank has made the following regulations, to promote orderly development and
maintenance of foreign exchange derivative market in India. According to these, no person
in India should enter into a foreign exchange derivative contract without the prior
permission of the Reserve Bank. ?
The exposures for which the * 
 
 are allowed under the existing RBI
notification for various participants are as follows: ?
(
   A person resident in India may enter into a forward contract with an
authorized dealer in India to hedge an exposure to exchange risk. But it is subjected
to following terms and conditions- ?
`? There should be genuine underlying exposures out of trade/business. The
authorized dealer must be satisfied about the genuineness of the underlying
exposure. The maturity of the hedge should not exceed the maturity of the
underlying transaction.
`? The contract can be booked on the basis of a reasonable estimate if the exact
amount of underlying exposure is not ascertainable.?
`? Exposures due to foreign currency loans and bonds approved by RBI can also
be hedged.
`? Receipts from GDR issued can be hedged in case issue price has been
finalized.
`? Balances in Exchange Earners Foreign Currency Accounts (EEFC) can also be
hedged, but these can't be cancelled. However, these could be rolled over.
2.     
`? They should have exposures in India.
`? alue should not exceed 15% of equity as of 31 March 1999 plus increase in
market value.??
 3. 
   !%" „ The NRI/OCB can enter
into a forward- contract for the underlying transactions such as dividends from
holdings in an Indian company and for their deposits in FCNR and NRE accounts.

4. "

 * 
 
 are also allowed to the companies. For
example, a corporate having underlying exposure in Yen, may book forward contract
between Dollar and Sterling.
&   
 
    * 
 
 
  $ ²$  
% *

A person resident in India can enter into contracts other than forward contracts with the
authorized dealer subject to the following rules and regulations-
µ? The RBI has given approval for borrowing in the foreign currency.
µ? A resident in India who has a liability in foreign currency can enter into foreign
currency-rupee swap with an authorized dealer. But once cancelled, it can not be
rebooked under any derivative product. Moreover it is restricted to USD 50 million.
µ? The notional principal amount should not exceed the amount of foreign currency
loan.
µ? A person can enter into a foreign currency option contract (which doesn't involve
rupee) with an authorized dealer and it can be easily rebooked or cancelled.??
 
   c
Æ 
 

An authorized dealer in India may remit outside India foreign exchange in respect of a
transaction, undertaken in accordance with these Regulations, in the following cases,
namely.
µ? Option premium payable by a person resident in India to a person resident outside
India ,

µ? Remittance by a person resident in India of amount incidental to a foreign exchange

derivative contract entered into in accordance with RBI guidelines.
µ? Any other remittance related to a foreign exchange derivative contract approved by
Reserve Bank.??
"

Indian economy is going through a series of changes and it is showing its effects on the
Indian industry. There is high volatility in the value of INR/USD. The recent appreciation in
the value of INR has swept away huge chunk of profits of the companies which export from
India which mainly comprised of Textile sector, IT Sector, ITES, Gems and Jewellery etc.
This is evident from the quarterly results of various Corporates.
There are lots of developments taking place even now. Forex markets are still volatile. The
economy is growing at a strong rate of about 9%. The capital inflows are pouring in.
Recently issue of Sub-Prime Crisis in US has also emerged which has affected the flow of
funds. We are talking about implementing full Capital Account Convertibility in India in the
coming years.
But then, we need to agree that Forex markets in India are not fully developed. It is still
controlled by RBI indirectly. We need to have strong Forex markets and this could be
achieved to a certain extent if Futures market is developed for Currency.




1. www.rbi.org.in

2. www.sebi.com

3. www.apexforex.com

4. www.economictimes.com

5. www.businessline.com?