Fixed Regime to Market Determined Floating Regime

During the period 1991 to 1995, India moved from a fixed exchange rate system to partial float exchange rate system to a free float or floating rate market determined exchange rate system.

In the fixed exchange regime, which India followed till 1991, the exchange rate was fixed by the RBI and was pegged to a basket of currency - US Dollars, Pound Sterling (UK), Deutsche Marks (Germany) and few other currencies.

After the Balance of Payment crisis in 1991, as part of the IMF's stabilization program, India moved to a partial float mechanism. As per this mechanism, the inward flow of foreign currency into the country by way of exports was converted into Rupee in the following ratio - 60% at a rate fixed by RBI which was around Rs.28 to a USD and the balance 40% at a market determined rate - which was generally higher at Rs.32 to a USD. However, anyone in India who wants to buy foreign currency for importing goods has to pay the market determined higher rate of Rs, 32 to a USD.

This partial float of the currency was later changed to fully floating or a market determined exchange rate system, where neither RBI nor the Government of India fixed the exchange rate and allowed the players in the market determine the exchange rate. So any foreign exchange that was brought into the country was converted at a rate determined by the market.

Historic Perspective on India's Forex Position

India's approach to foreign exchange reserve management, until the balance of payments crisis of 1991 was to maintain an appropriate level of reserves required for importing goods and services. It was defined in terms of number of months of imports equivalent of reserves.

For example, let us say India's import for a year was USD 36 billion and India had a foreign exchange reserve of USD 4.5 billion, then it was expressed as our reserves being the equivalent of one and a half months of imports. Emphasis on import cover constituted the primary concern to managing foreign exchange reserves till 1993-94.

The approach to reserve management underwent a paradigm shift in the mid 90s.

The relevant extracts are:

It has traditionally been the practice to view the level of desirable reserves as a percentage of the annual imports-say reserves to meet three months imports or four months imports. However, this approach would be inadequate when a large number of transactions and payment liabilities arise in areas other than import of commodities.

These started happening with the liberalization that led to foreign investors investing in Indian companies either through the Foreign Institutional Investor (FII) route (Morgan Stanleys of the world investing in Indian stock markets) or through Foreign Direct Investment (FDI) route (Enron investing in Dabhol Power Corporation!!). These were instance of foreign currency coming into the country. For each of these inflows, there will be a future outflow either when the FIIs repatriate their investments or the FDIs taking back profits of their investments.

In addition, liabilities may arise either for repaying loans or paying interest on loans. The new approach was aimed at determining the level of forex reserve, by paying attention to the loan repayment and interest payment obligations in addition to the level of imports.

In addition, with the opening up of the economy since the early 90s, the impact of changes in global currency markets is bound to affect Indian shores as well. Further, emphasis was placed on gaining the ability to take care of the seasonal factors in any balance of payments (foreign exchange inflows - foreign exchange outflows) transaction with reference to the possible uncertainties in the monsoon conditions of India and to counter speculative tendencies or anticipatory actions amongst players in the foreign exchange market.

Why hold forex reserves

Technically, it is possible to consider three motives

1. Transaction - International trade gives rise to currency flows, which are generally handled by private banks driven by the transaction.
2. Speculative - Individual or Corporates trade and invest in foreign currencies for gain.
3. Precautionary - Reserve Bank's reserves are characterized primarily as a last resort stock of foreign currency for unpredictable flows, which can classified as a precautionary motive

A list of objectives in broader terms may be encapsulated viz.,

1. Maintaining confidence in monetary and exchange rate policies - i.e the value of Rupee vis a vis major foreign currencies like the dollar, euro etc does not nosedive suddenly.
2. Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis including national disasters or emergencies;
3. Providing confidence to the markets especially credit rating agencies that external obligations (like borrowings from IMF, World Bank etc) can always be met.

Convertibility can be related as the extent to which a country's regulations allow free flow of money into and outside the country.

For instance, in the case of India till 1990, one had to get permission from the Government or RBI as the case may be to procure foreign currency, say US Dollars, for any purpose. Be it import of raw material, travel abroad, procuring books or paying fees for a ward who pursues higher studies abroad. Similarly, any exporter who exports goods or services and brings foreign currency into the country has to surrender the foreign exchange to RBI and get it converted at a rate pre-determined by RBI.

After liberalization began in 1991, the government eased the movement of foreign currency on trade account. I.e. exporters and importers were allowed to buy and sell foreign currency, as long as the items that they are exporting and importing were not in the banned list. They need not get permission on a CASE TO CASE basis as was prevalent in the earlier regime. This was the first concrete step the economy took towards making our currency convertible on trade account.

In the next two to three years, government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purposes like travel abroad, studying abroad, engaging the services of foreign consultants etc. This set the first step towards getting our currency convertible on the current account. What it means is that people are allowed to have access to foreign currency for buying a whole range of consumable products and services. These relaxations coincided with the liberalization on the industry and commerce front - which is why we have Honda City cars, Mars chocolate bars and Bacardi in India.

There was also simultaneous relaxation on the restriction on the funds that foreign investors can bring into India to invest in companies and the stock market in the country. This step led to partial convertibility on the Capital Account.

"Capital Account convertibility in its entirety would mean that any individual, be it Indian or foreigner will be allowed to bring in any amount of foreign currency into the country and take any amount of foreign currency out of the country without any restriction."

Indian companies were allowed to raise funds by way of equities (shares) or debts. The fancy terms like Global Depository Receipts (GDRs), Euro Convertible Bonds (ECBs), Foreign currency syndicated loans became household jargons of Indian investors. Listing in Nasdaq or NYSE became new found status symbols for Indian companies. However, Indian companies or individuals still had to get permission on a case to case basis for investing abroad.

In 2000, the forex policy was further relaxed that allowed companies to acquire other companies abroad without having to go through the rigmarole of getting permission on a case to case basis. Further, Indian debt based mutual funds were also allowed to invest in AAA rated government /corporate bonds abroad. This got further relaxed with Indians being allowed to hold a portion of their foreign exchange earnings as foreign currency, subject to a limit in the recent monetary policy in October 2002.

In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With India's forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts.

The last few steps as and when they happen will allow an individual to invest in Microsoft or Intel shares that are traded on Nasdaq or buy a beach resort on Bahamas without any restrictions.

Forex Reserves

The amount of foreign currency, SDRs and gold that are held by the Reserve Bank of India or the Central Bank of any country is known as the foreign exchange reserves of a country.

The foreign exchange reserves include three items; gold, SDRs and foreign currency assets. As of November, 2002 India has over US $ 65 billion of total reserves, foreign currency assets account the major share. Gold accounts for about US $ 3 billion. In July 1991, as a part of reserve management policy, and as a means of raising resources, the RBI temporarily pledged gold to raise loans. The gold holdings, thus have played a crucial role of reserve management at a time of external crisis. Since then, Gold has played passive role in reserve management.

The level of foreign exchange reserves has steadily increased from US$ 5.8 billion as at end-March, 1991 to US$ 54.1 billion as at end-March 2002 and further to US$ 65 billion as of November, 2002. The traditional measure of trade based indicator of reserve adequacy, i.e., the import cover (defined as the twelve times the ratio of reserves to merchandise imports ) which shrank to 3 weeks of imports by the end of December 1990, has improved to about 11.5 months as at end-March 2002.

The debt-based indicators of reserve adequacy show remarkable improvement in the 1990s. The proportion of short term debt (i.e., debt obligations with an original maturity up to one year) to foreign exchange reserves has substantially declined from 147 per cent as at end-March 1991 to 8 per cent as at end-March 2001. i.e. most of the foreign exchange reserves that we have right now have a repayment obligation that exceeds three years - which reflects a higher quality of reserves.

Foreign Exchange Dealer's Association of India (FEDAI)

Foreign Exchange Dealer's Association of India (FEDAI) was set up in 1958 as anassociation of banks dealing in foreign exchange in India (typically called AuthorizedDealers - ADs). It is a self-regulatory body and has been incorporated under Section 25of The Companies Act, 1956. Main activities include framing of rules governing theconduct of inter-bank foreign exchange business among banks vis-à-vis public andliaison with RBI for reforms and development of forex market.

Some of the functions of FEDAI are given below:

• Guidelines and Rules for Forex Business.
• Training of Bank Personnel in the areas of Foreign Exchange Business.
• Accreditation of Forex Brokers
• Advising/Assisting member banks in settling issues/matters in their dealings.
• Representing member banks on Government/Reserve Bank of India/OtherBodies.
• Announcing daily and periodical rates to member banks.

Vostro, Nostro and Loro accounts

Vostro Account: (Italian, from Latin, Voster; English, 'yours') 

Account held by a foreign bank in a domestic bank is called Vostro account. A Vostro is our account of your money, held by us. A Vostro account with a credit balance (i.e. a deposit) is a liability, and a vostro with a debit balance (a loan) is an asset.

For example Bank A(Barclays Bank of  UK) opening an account in Bank B(ICICI Bank of India), this is Vostro account for Bank B(ICICI Bank of India).

Nostro Account: (Italian, from Latin, Noster ; English, 'ours')

Account held by a particular domestic bank in a foreign bank is called Nostro account. A Nostro is our account of our money, held by you. A bank counts a Nostro account with a credit balance as a cash asset in its balance sheet.

Here in the above example given in Vostro account the same account is a Nostro account for Bank A(Barclays Bank of UK), or if Bank B(ICICI Bank of India) opens an account in Bank A(Barclays Bank of UK) then that account is a Nostro account for Bank B(ICICI Bank of India). Nostro accounts are usually in the currency of the foreign country. This allows for easy cash management because currency doesn't need to be converted.

Loro Account: (Italian, from Latin, Loro; English, 'theirs'). 

An account held by a domestic bank in itself on behalf of a foreign bank.The latter in turn would view this account as a Nostro account. A Loro is our account of their money, held by you. Loro account is a record of an account held by a second bank on behalf of a third party; i.e, my record of their account with you. In practice this is rarely used, the main exception being complex syndicated financing.
If any other bank for the purpose of a transaction refer to an account maintained by yet another bank in some other countries it is known as loro account.
An expression used, for example, by one bank when telling another bank to transfer money to the account of a third bank. In correspondent banking, an account held by one bank on behalf of another bank (the “customer bank”); the customer bank regards this account as its “Nostro account”. The Loro account is an account wherein a bank remits funds in foreign currency to another bank for credit to an account of a third bank.

Forex Transactions in the Spot market

A foreign exchange rate is the price of one currency in terms of another currency. In the institutional foreign exchange market, in which large institutions trade hundreds of millions of dollars, foreign exchange refers to bank deposits. When a bank trades foreign exchange with another bank, it is actually exchanging a bank deposit of one currency for a bank deposit of another currency. Transactions in the spot foreign exchange market simply depend on the needs of the buyer and willingness of the seller. Settlement in the spot market occurs in usually no more than two business days, but individual countries have their own payment and settlement systems.

Various FX Instruments and Strategies

Foreign exchange products traded in the market constitute of the traditional products and recently introduced products.

Spot:
A spot deal involves a direct exchange of one currency for another. The spot rate generally is the current market price, the benchmark price. A swap involves cash and not contracts, and also has the shortest time frame.

Outright Forwards:
An outright forward transaction, like a spot transaction, is also a straightforward single purchase of one currency for another. The only difference is that spot is settled, or delivered, on a value date no later than 2 business days after the deal date, while outright forward is settled on any pre-agreed date, three or more business days after the deal date.

Forex Swaps:
In the FX swap market, one currency is swapped for another for a period of time, and then swapped back, creating an exchange and re-exchange. A FX swap has two separate legs settling on two different value dates, even though it is arranged as a single transaction and is recorded in the turnover statistics as a single transaction. These are not contracts and are not traded through an exchange.

Currency Swaps:
A currency swap is structurally different from the FX swap. In a typical currency swap, counterparties will exchange equal initial principal amounts of two currencies at the spot exchange rate, exchange a stream of fixed or floating interest rate payments in their swapped currencies for the period of the swap,and then re-exchange the principal amount at maturity at the initial spot exchange rate. These are not contracts and are not traded through an exchange.

OTC FX Currency Options:
A FX or currency option contract gives the buyer the right, but not the obligation, to buy (or sell) a specified amount of one currency for another at a specified price on a specified date.

Exchange Traded Futures:
A FX futures contract is an agreement between two parties to buy or sell a particular currency at a particular price on a particular future date, as specified in a standardized contract common to all participants in that currency futures exchange. This instrument is a characteristic of the US exchanges. The average contract length is roughly 3 months. Exchange Traded Currency Options:
Exchange-traded currency options, like exchange-traded futures, utilize standardized contracts-with respect to the amount of the underlying currency, the exercise price, and the expiration date.

Short dated forex options:
These are a type of OTC Forex currency options with maturity up to 90 days.

Source Exotic options:
Types of options which have specific features, such as special expiry conditions. Forex Bonds:
These are bonds issued by a financial institution against a particular foreign currency. It is mainly used in Inter-bank market.

Forward Contract:
Forward Contract is a contract with customer/another Bank for an exchange transaction to be put through at some future date at an agreed exchange rate (import and export of goods).

Hedging:
Hedging involves offsetting the price risk in cash market positions, by taking an equal, yet an opposite position in futures market. In long hedge, buying futures contracts helps shield against possible increasing prices of commodities. On the other hand, short hedge shields against declining prices of commodities.

Participants in Foreign Exchange Market

Institutional foreign exchange market participants include:

• Dealers
• Brokers
• Central banks
• Financial and corporate institutions

Foreign exchange is traded over-the-counter (OTC). It is operating worldwide, roundthe-
clock. A number of foreign exchange instruments, called Derivatives are traded on
exchanges. For traders, forex trading provides an alternative to stock market trading.

Dealers:

Dealers are financial institutions that buy and sell foreign exchange on behalf of their
clients, or even for themselves. Dealers act as one of the counterparties in a transaction,
committing their own capital. The dealer makes profit by finding another party and
closing out its position at a better price. Some dealers are market makers as they bid
and offer prices for one or more currencies and is ready to make a two-sided market for
its clients. In return for this service, the market maker seeks to earn a profit on the
difference between the bid and ask prices. (Bid price is the highest price any buyer is
willing to pay for a given currency at a given time. Offer price is the price at which
currency may be sold in the market. Ask price is the price that the dealer is willing to
pay from the seller of the currency). Foreign Exchange Dealer's Association of India (FEDAI) is an association of banks which deals in foreign exchange.

Broker:
A broker in the OTC FX (Over the Counter Forex) market serves as an intermediary
between two counterparties. The broker tries to unite a buyer and seller and earn a fee
for this service. Brokers do not take positions themselves or commit their own capital as
dealers do.
There are a large number of traders who fall under this category, which is essentially
small in amounts, but large in volume. They offer standard services, 24-hour online
currency trading, 100 to 1 leverage, commission free trading etc.

Electronic Brokerage System (EBS):
EBS is widely used for standardized transactions in the spot market (A market in which
transaction takes place on the spot and delivery immediately thereafter), especially
smaller trades involving the most common currency pairs. With electronic systems,
traders can see, on their computer screens, all bid and offer rates being offered by
acceptable counterparties. If a trader sees a bid or offer rate for an amount that it
accepts, the trader can then match the order and make the deal electronically. Back
office operations confirm the trade and generate the appropriate paperwork for both
parties to conclude the transaction.

Components of Foreign Exchange Market

The main methods of trading FX are direct inter-bank trading, voice brokers and electronic broking systems.

The main components of the forex market are:

• Trade rate
• Counterparty
• Currencies
• Exchange rate
• Amounts
• Value date

Components of Foreign Exchange Market

The main methods of trading FX are direct inter-bank trading, voice brokers and
electronic broking systems. The main components of the forex market are:

• Trade rate


• Counterparty


• Currencies


• Exchange rate


• Amounts


• Value date

Advantages of Forex Market

• 24-hour market: The Forex market is open 24-hours and five days a week. It
  gives facility to the trader to customize trading schedule in different
  geographical areas.
• Liquidity: Forex market operates huge volumes of money, which provides the
  traders with complete freedom to open or close their positions, regardless of
  contract size.
• Leverage: It decreases the size of initial deposit required. If a person deposits Rs
  100000 in his account, he can trade up to the maximum limit of Rs20000000
  (using leverage 200:1).
• Easy access: With technology advances such as Internet and trading platforms,
  the market has become easily accessible to investors in different geographical
  areas.
• Hedging foreign currency risk: One can protect revenues from foreign
  currency transactions by hedging against exposure to adverse rate movements.
• Short selling: Unlike the stock market, there is no restriction on short selling in
  the currency market. Regardless of the market movement and trader being long
  or short, he has ample opportunities in the currency markets. Both on raising as
  well as in falling markets, the trader has equal access to trade.

Features of Forex Market

There are some main characteristics of the foreign exchange market. These include:

• The geographical spread: The forex market is spread across the world, and
  is functional 24 hours a day
• Main function: The market’s main function is the mechanism by which
  participant transferring purchasing power between the countries, obtains
  or provides credit for international trade and minimizes exchange rate risk
  and determines exchange rate between currencies.
• Market participants: The key market participants are-
  § Banks
  § Commercial Companies
  § Central Banks
  § Hedge Funds
  § Retail Forex Brokers
• Types of transaction: The key transactions are spot, forward and swaps
• Liquidity is very high in forex market because the market operates in high
  money supply conditions. It gives freedom in opening and closing position
  in current market quotation.

Foreign Exchange (Forex) Market

Forex or foreign exchange market is one where currencies of different countries are
exchanged. It simply deals with exchanging of currencies of one country with those of
other countries. It involves cross border selling and buying of currencies and movement
of funds. Forex market is the world’s largest financial market and is also one of the most
volatile.
Foreign Exchange transactions take place between two countries on account of
(a) Imports/Exports of goods
(b) Trade in services viz. IT, Insurance, Shipping, Banking, and Consultancy etc.
(c) Remittances from other countries
(d) International travel
(e) Foreign aid, gifts etc.
(f) Repayment of foreign loans

From the bank’s point of view, foreign exchange transactions take place as:

• Sales: Bank gives foreign Currency and customer gives rupees
• Purchases: Bank pays rupees and Customer gives foreign currency

Foreign Exchange processes consist of remittance, other bills collection, traveler's
check, foreign currency, and Visa card transactions and supports stock management
and specialized process function related to these businesses.
There are nine major centers of foreign exchange trading. These are based in, London,
New York, Zurich, Frankfurt, Tokyo, Hong Kong, Singapore, Paris and Sydney.

World’s largest forex market is in UK. DEUTSCHE BANK is the largest trader
of foreign exchange.

Few Terms(FX)

European Currency Quotation
An indirect quotation in the foreign exchange markets whereby the value of a foreign currency is stated as a per-unit measure of the U.S. dollar. This type of quotation shows how much foreign currency it takes to purchase one U.S. dollar.

European Monetary System - EMS
A 1979 arrangement between several European countries to link their currencies in an attempt to stabilize the exchange rate. This system was succeeded by the European Monetary Union (EMU), an institution of the European Union (EU), which established a common currency called the euro. The European Monetary System originated in an attempt to stabilize inflation and stop large exchange-rate fluctuations between European countries. Then in June 1998, the European Central Bank was established and, in Jan 1999, a unified currency, the euro, was born and came to be used by most EU member countries. As of 2005, Britain, Denmark and Sweden were the only original EU members that had not adopted the euro.

European Central Bank - ECB
The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed in Germany in June 1998 and works with the other national banks of each of the EU members to formulate monetary policy that helps maintain price stability in the European Union. The European Central Bank has been responsible for the monetary policy of the European Union since January 1, 1999, when the euro currency was adopted by the EU members. The responsibilities of the ECB are to formulate monetary policy, conduct foreign exchange, hold currency reserves and authorize the issuance of bank notes, among many other things.

Euro LIBOR
London Interbank Offer Rate denominated in euros. This is the interest rate that banks offer each other for large short-term loans in euros. The rate is fixed once a day by a small group of large London banks but fluctuates throughout the day. This market makes it easier for banks to maintain liquidity requirements because they are able to quickly borrow from other banks that have surpluses The Euro LIBOR is based on the average lending rates of 16 banks. These bank rates are available to the public through the British Bankers' Association. Euro LIBOR exists mainly for continuity purposes in swap contracts dating back to pre-euro times and is not very commonly used.

Forex Broker
Firms that provide currency traders with access to a trading platform that allows them to buy and sell foreign currencies. A currency trading broker, also known as a retail forex broker, or forex broker, handles a very small portion of the volume of the overall foreign exchange market. Currency traders use these brokers to access the 24-hour currency market. It is valuable to do some research to find out whether a broker has a good reputation and has the functionality that you are looking for. Most major forex brokers will allow prospective clients to use a practice account so that they can get a good understanding of what the system is like. It is a wise idea to test out as many platforms as possible before deciding on which broker to use.