CHAPTER 1: DESIGN OF STUDY

Objectives of the study-

1) To overview the mechanism of foreign exchanges market.

2) To understand determination and participants in forex market.

3) To understand features and importance of forex market.

4) To study recent developments in forex market.

5) To know the various functions of forex market.

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Limitations-

Time constraints-

The time stipulated for the project is less and thus there are chances that some information might have been left out, however due care is taken to include all information needed.

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Executive summery-

India is now a well-integrated with the world economy and moves in tandem with global developments, both on the economic front as well on the currency front. The far-reaching changes in the Indian economy since liberalization in the early 1990s have had a deep impact on the Indian financial sector. The development in the Indian foreign exchange (FX) derivatives market should be seen along with the steps taken to gradually reform the Indian financial markets.

The resultant spurts in foreign investments led to substantial increase in the quantum of inflows and outflows in different currencies, with varying maturities. The reforms provided the economic rationale for the introduction of foreign exchange (FX) derivatives and risk management since then has under gone a paradigm shift.

Foreign exchange future market refers to a type of financial derivative in which two parties enter into a contract to buy/sell a particular currency at a pre-determined price on a specific future date.

A foreign exchange future market provides an opportunity to hedge risk and speculate against the exchange rate fluctuations.

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CHAPETR 2: INTRODUCTION TO FOREIGN EXCHANGE MARKET

The foreign exchange market (forex or FX for short) is one of the most exciting, fast-paced markets around. Until recently, forex trading in the currency market had been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through  online brokerage accounts.

Daily currency fluctuations are usually very small. Most currency pairs move less than one cent per day, representing a less than 1% change in the value of the currency. This makes foreign exchange one of the least volatile financial markets around. Therefore, many currency speculators rely on the availability of enormous leverage to increase the value of

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potential movements. In the retail forex market, leverage can be as much as 250:1. Higher leverage can be extremely risky, but because of round-the-clock trading and deep liquidity, foreign exchange brokers have been able to make high leverage an industry standard in order to make the movements meaningful for currency traders.

Extreme liquidity and the availability of high leverage have helped to spur the market’s rapid growth and made it the ideal place for many traders. Positions can be opened and closed within minutes or can be held for months. Currency prices are based on objective considerations of supply and demand and cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks, to move prices at will.

 There are several  avenues for retail customers to make investments. Individuals can use investments instruments in financial markets by using long term goals or short term trading i.e. shares, options, derivatives, swaps, commodity, real estate, gold, silver, bonds etc., some of these instruments give an opportunity for people to make money. Indian financial market is still only 2+ decades old and requires lot of maturity. Recently some of trading instruments are available in the market because of the online facility and many folks are using the technology to make additional money by trading in futures or cash market along with commodity. There are bound to be many changes going to happen in the coming years because of the stake taken in BSE and NSE by foreign exchanges and substantial developments are going to happen w.r.t technology and access to retail investors.

 There are many new products will be launched in the financial market, which provides easy access for retail investors to benefit from the same. One such trading activity is FOREX, which is now accessible for many retail investors. Most of the folks are not aware of how to use this trading avenue to make additional money and the beauty of this product is that you can trade 24hrs which provides opportunity for folks who can do some bit of trading during later hours or after work or early in the morning. As we all know that FOREX trading is the biggest market globally and there are so many combinations individuals can hedge. The project study is an attempt to delve into details of different strategies used in FOREX trading and apply some of the commonly used strategies to profit from these new instruments which is rapidly catching up in India.

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Definition of 'Foreign Exchange'-

The exchange of one currency for another or the conversion of one currency into another currency. Foreign exchange also refers to the global market where currencies are traded virtually around-the-clock. The term foreign exchange is usually abbreviated as "forex" and occasionally as "FX."

Foreign exchange transactions encompass everything from the conversion of currencies by a traveler at an airport kiosk to billion-dollar payments made by corporate giants and governments for goods and services purchased overseas. Increasing globalization has led to a massive increase in the number of foreign exchange transactions in recent decades. The global foreign exchange market is by far the largest financial market, with average daily volumes in the trillions of dollars.

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CHAPTER 3: STUDY ON FOREIGN EXCHANGE MARKET

Key Features of Forex Market –

There are several features of Indian forex market which, are briefly stated as under.

1) Participants

The foreign exchange market in India comprises of customers, Authorised Dealers (ADs) in foreign exchange and Reserve Bank of India. The ADs are essentially banks authorised by RBI to do foreign exchange business. Major public sector units, corporates and other business entities with foreign exchange exposure, access the foreign exchange market through the intermediation of ADs. The foreign exchange market operates from major centres - Mumbai, Delhi, Calcutta, Chennai, Bangalore, Kochi and Ahmedabad, with Mumbai accounting for the major portion of the transactions. Foreign Exchange Dealers Association of India (FEDAI) plays an important role in the forex market as it sets the ground rules for fixation of commissions and other charges and also involves itself in matters of mutual interest of the Authorised Dealers. The customer segment is dominated by Indian Oil Corporation and certain other large public sector units like Oil and Natural Gas Commission, Bharat Heavy Electricals Limited, Steel Authority of India Limited, Maruti Udyog and also Government of India (for defence and civil debt service) on the one hand and large private sector corporates like Reliance Group, Tata Group, Larsen and Tubro, etc., on the other. Of late, the Foreign Institutional Investors (FIIs) have emerged as a major component in the foreign exchange market and they do account for noticeable activity in the market.

2) Segments

The foreign exchange market can be classified into two segments. The merchant segment consists of the transactions put through by customers to meet their transaction needs of acquiring/offloading foreign exchange,

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and inter-bank segment encompassing transactions between banks. At present, there are over 100 ADs operating in the foreign exchange market. The banks deal among themselves directly or through foreign exchange brokers. The inter-bank segment of the forex market is dominated by few large Indian banks with State Bank of India (SBI) accounting for a large portion of turnover, and a few foreign banks with benefit of significant international experience.

3) Market Makers

In the inter-bank market, SBI along with a few other banks may be considered as the market-makers, i.e., banks which are always ready to quote two-way prices both in the spot and swap segments. The market makers are expected to make a good price with narrow spreads both in the spot and the swap segments. The efficiency and liquidity of a market are often gauged in terms of bid-offer spreads. Wide spreads are an indication of an illiquid market or a one way market or a nervous condition in the market. In India, the normal spot market quote has a spread of 0.5 to one paisa, while the swap quotes are available at 2 to 4 paise spread. At times of volatility, the spread widens to 5 to 10 paise.

4) Turnover

The turnover in the Indian forex market has been increasing over the years. The average daily gross turnover in the dollar-rupee segment of the Indian forex market (merchant plus inter-bank) was in the vicinity of US $ 3.0 billion during 1998-99. The daily turnover in the merchant segment of the dollar-rupee segment of foreign exchange market was US $ 0.7 billion, while turnover in the inter-bank segment was US $ 2.3 billion. Looking at the data from the angle of spot and forward market, the data reveals that the average daily turnover in the spot market was around US $ 1.2 billion and in the forward and swap market the daily turnover was US$ 1.8 billion during 1998-99.

5) Forward Market

The forward market in our country is active up to six months where two way quotes are available. As a result of the initiatives of the RBI, the maturity profile has since recently elongated and there are quotes available up to one year. In India, the link between the forward premia and interest rate differential seems to work largely through leads and lags. Importers and exporters do influence the forward markets through availment of/grant of credit to overseas parties. Importers can move between sight payment and 180 days usance and will do so depending on

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the overseas interest rate, local interest rate and views on the future spot rate. Similarly, importers can move between rupee credit and foreign currency credit. Also, the decision, to hedge or not to hedge exposure depending on expectations and forward premia, itself affects the forward premia as also the spot rate. Exporters can also delay payments or receive funds earlier, subject to conditions on repatriation and surrender, depending upon the interest on rupee credit, the premia and interest rate overseas. Similarly, decision to draw bills on sight/usance basis is influenced by spot market expectations and domestic interest rates. The freedom to avail of pre/post-shipment credit in forex and switch between rupee and foreign currency credit has also integrated the money and forex markets. Further, banks were allowed to grant foreign currency loans out of FCNR (B) liabilities and this too facilitated integration as such foreign currency demarcated loans did not have any use restriction. The integration is also achieved through banks swapping/unswapping FCNR (B) deposits. If the liquidity is considerable and call rates are easy, banks consider deployment either in forex, government or money/repo market. This decision also affects the premia. Gradually, with the opening up of the capital account, the forward premia is getting aligned with the interest rate differential. However, the fact remains that free movement in capital account is only a necessary condition for full development of forward and other forex derivatives market. The sufficient condition is provided by a deep and liquid money market with a well-defined yield curve in place. Developing a well integrated, consistent and meaningful yield curve requires considerable market development in terms of both volume and liquidity in various time and market segments. No doubt, the integration between the domestic market and the overseas market operates more often through the forward market. This integration is facilitated now by allowing ADs to borrow from their overseas offices/correspondents and invest funds in overseas money market up to the same amount.

6) Data on Forex Markets

The RBI publishes daily data on exchange rates, forward premia, foreign exchange turnover etc. in the Weekly Statistical Supplement (WSS) of the RBI Bulletin with a lag of one week. The movement in foreign exchange reserves of the RBI on a weekly basis are furnished in the same publication. The RBI also publishes data on Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER), RBI's purchases and sales in the foreign exchange market along with outstanding forward liabilities on reserves etc. in the monthly RBI Bulletin with a time lag of one month. Since July 1998, the Reserve Bank of India started publishing the 5-country trade based NEER and REER in

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addition to 36-country NEER and REER in the RBI Bulletin. Way ahead of many developing and industrial country central banks, the RBI has been publishing the size of its gross intervention (purchase and sale) each month and its net forward liability position.

7) Linkages among Markets and Policy Responses

Since the introduction of the reform measures, broad segments of the market, viz., money market, Government securities market, capital market, and foreign exchange market, have exhibited some degree of integration. The markets have become inter-linked to the extent participants can move freely from one market to another. The linkages between the forex market and domestic markets essentially depend on the foreign currency liabilities and assets banks can maintain and the extent and degree to which they are swapped into rupees and vice versa. Thus, on the liabilities side, we have foreign currency borrowings from overseas offices/correspondents, borrowings for lending to exporters, FCNR-B deposits and EEFC/RFC deposits. These funds can be used either for raising rupee resources through swaps or for lending in foreign currency. A significant step was taken by the RBI when it allowed banks to lend in foreign currency to companies in India for any productive purpose without linking to exports or import financing. This effectively meant that companies had the choice to borrow either in foreign currency or rupees depending on the cost, taking into account both exchange risk and interest cost. Thus, companies can substitute rupee credit for foreign credit freely. Similarly, exporters also have the ability to substitute rupee credit for foreign currency credit.

The integration of foreign exchange market with other markets like money market and government securities market meant closer co-ordination of monetary and exchange rate policy. For instance, in January 1998, when the foreign exchange market came under severe pressure, Reserve Bank of India undertook strong monetary policy measures leading to sharp withdrawal of liquidity and increase in short-term interest rates. The impact of monetary management was such that by February 1998 orderly conditions were restored in the forex market and normalcy was attained in money market. At times of highly speculative exchange rate movements, simultaneous intervention in foreign exchange and domestic market is called for to have an immediate strong effect on both the exchange rate and money market conditions. Thus, to maximise the effectiveness of the foreign exchange market intervention as a signaling device, it is also carefully co-ordinated with monetary management. These co-ordinated intervention strategies require close

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day-to-day monitoring of the supply of banking system liquidity and an active use of open market operations to adjust liquidity conditions. However, driving a wedge between money and forex markets at times, becomes necessary when it is felt that liquidity conditions may put pressure on the forex market, while tightening liquidity could hurt the real sector.

The recent initiatives of RBI to usher in the rupee interest rate derivatives should facilitate the development of rupee term money market and define the rupee yield curve across maturities. Besides bringing about greater integration of the money and forex markets, the move has set the stage for the take-off of rupee-foreign currency derivatives.

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Unique Features of Indian Forex Market

1) Gold Policy

Liberalisation of gold policy had an indirect but, significant impact on the forex market. The logic behind the changes in the gold policy was explained in my earlier speeches on the subjects of capital flight and gold. The major thrust of the liberalisation process in gold policy centred around opening up of additional channels of import, a logical consequence of which was the reduction in differential between the international and domestic price of gold. The price differential of gold was as high as 67 per cent in 1992 when the structural reform process was initiated; it fell to 6 per cent by the end of 1998. The unofficial market in foreign exchange which drew its sustenance from the illegal trade in gold went out of existence as an immediate fall out. In essence, the import of gold which was largely on unofficial account in earlier years, was officialised, and correspondingly the foreign exchange used to finance such unofficial imports was also officialised, mainly through enhanced flow under invisibles account.

2) NRI Deposits

Various deposit schemes have been designed from time to time to suit the requirements of non-resident Indians (NRIs). Currently, we have three NRI deposit schemes, viz., Non Resident External (NRE) account which is denominated in rupees, Non Resident Non Repatriable (NRNR) account, which is non-repatriable rupee account except for the interest component which is repatriable, and the Foreign Currency Non Resident (Bank) (FCNR-B) account which is a foreign currency account. Banks have also been allowed considerable freedom in deployment of these funds. Of interest to forex markets is the operation of FCNR-B scheme, because banks have to bear exchange risk. Banks either hold these deposits in foreign currency investing them abroad or lend in foreign currency to corporates in India or swap into rupees and lend to Indian corporates in rupees. When corporates borrow in foreign currency, there is an inflow into the market but there may be hedging by corporates. When banks swap into rupees and lend, there is an impact on forex

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markets but forward premia and lending rates in rupees are critical. Thus, tracking the use of FCNR (B) deposits is essential in appreciating forex markets.

3) Public Enterprises

Operations of large public sector undertakings have a significant impact especially on spot market, and their procedures for purchase or sale of foreign currency also impact on market sentiments. To this end, and in order to enable Public Sector Enterprises (PSEs) to equip themselves in formulating an approach to management of foreign currency exposure related risks, the Government of India had set up a Committee in January 1998. The Report of the Committee explicitly brings out the approach that is appropriate for risk management with reference to the foreign currency exposure of PSEs. PSEs with large volume of foreign exchange exposure were also advised by the Committee to consider setting up Dealing Room for undertaking treasury functions both for rupee and foreign exchange which include management of rupee resources, foreign exchange transactions and risk management. Adoption of approaches recommended would enable the PSEs to spread their demand and supply in forex market, in a non-disruptive way to the benefit of both the PSE concerned and functioning of forex market in India.

4) Off-shore Banking Units

The setting up of Off-shore banking units at this advanced stage of financial liberalisation in our country is considered by many to be unnecessary and that the time for an offshore banking unit has gone. In a country of our size, the issue of linkages between off-shore sector and the domestic sector is undoubtedly an important one. We need to make a clear distinction between the financial issues and the non-financial issues on the subject. From the central bank's perspective, designing appropriate regulatory framework is important and the most important issue is ensuring of a firewall between the off-shore transactions and domestic transactions. Physical location is not relevant, especially when deposit taking and cash transactions are not permitted in off-shore business. In fact, we do not have a good model of real off-shore centre in a country with capital controls. Confederation of Indian Industry (CII) with assistance from the Government of Maharashtra is engaged in a detailed study of the various issues to make recommendations to the RBI and the Government of India.

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5) Clearing House

The idea of establishing a Foreign Exchange Clearing House (FXCH) in India was mooted in 1994. The Expert Group on Foreign Exchange Markets in India also recommended introduction of foreign exchange clearing and making netting legally enforceable. The Scheme was conceived as multilateral netting arrangement of inter-bank forex transactions in US dollar. The membership would be open to all ADs in foreign exchange participating in the inter-bank foreign exchange market. RBI will also be a participating member. The net position of each bank arrived at the end of the trading day would be settled through a Clearing Account to be maintained by RBI. It was recognised that a substantial reduction in number of Nostro account transactions of the participating banks would lead to economy in settlement cost and efficiency in settlement. Other benefits include easing the process of reconciliation of Nostro accounts balances by banks, reduction in size of credit and liquidity exposure of participating banks and hence systemic risk, etc. The long-term objective is to establish clearing house as a separate legal entity with risk and liquidity management features, infrastructure and operational efficiency akin to other leading clearing systems. However, to start with, we may aim at commencing the operation with such minimum modification to the scheme as may be necessary. For the present, the focus areas are legal, risk and liquidity aspects and operational infrastructure, and all these issues are under examination in the RBI.

6) Role of FEDAI

In a regime where exchange rates were fixed and there were restrictions on outflow of foreign exchange, the RBI encouraged the banks to constitute a self regulatory body and lay down rules for the conduct of forex business. In order to ensure that all the banks participated in the arrangement, the RBI placed a condition while issuing foreign exchange licence that every licensee agree to be bound by the rules laid down by the banker’s body – the FEDAI. FEDAI also accredited brokers through whom the banks put through deals. There is increasing emphasis now on competition, and fixing or advising charges by professional bodies is being viewed with disfavour and often treated as a restrictive trading practice. It is currently argued by some that with the growth in volumes and giant strides in telecommunication, banks may no longer need to deal through brokers when efficient match making arrangements exist. As in

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some other markets, the deals are concluded on the basis of voice broking and it is sometimes held that this often results in conclusion of deals which are less than transparent, evidenced by instances where deals have been called off on payment of differences. Under the circumstances, there is perhaps a need to review several aspects, viz., compatibility of advising or prescribing fees with pro-competition policy; role of brokers; electronic dealing vis-à-vis voice broking; and relationship between the RBI, FEDAI and authorized dealers.

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Functions of foreign exchange market

Foreign exchange is also referred to as forex market. Participants are importers, exporters, tourists and investors, traders and speculators, commercial banks, brokers and central banks.

Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the important foreign exchange instruments used in foreign exchange market to carry out its functions.

The Foreign Exchange Market performs the following functions.

1. Transfer Of Purchasing Power I Clearing Function

The basic function of the foreign exchange market is to facilitate the conversion of one currency into another i.e. payment between exporters and importers. For eg. Indian rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills. Telegraphic transfer is the quickest method of transferring the purchasing power.

2. Credit Function

The foreign exchange market also provides credit to both national and international, to promote foreign trade. It is necessary as sometimes, the international payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required.

For eg. Mr. A can get his bill discounted with a foreign exchange bank in New York and this bank will transfer the bill to its correspondent in India for collection of money from Mr. B after the stipulated time.

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3.             Hedging Function

A third function of foreign exchange market is to hedge foreign exchange risks. By hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange rates. Under this function the foreign exchange market tries to protect the interest of the persons dealing in the market from any unforseen changes in exchange rate. The exchange rates under free market can go up and down, this can either bring gains or losses to concerned parties. Hedging guards the interest of both exporters as well as importers, against any changes in exchange rate.

Hedging can be done either by means of a spot exchange market or a forward exchange market involving a forward contract.

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Participants / dealers in foreign exchange market

Foreign exchange market needs dealers to facilitate foreign exchange transactions. Bulk of foreign exchange transaction is dealt by Commercial banks & financial institutions. RBI has also allowed private authorized dealers to deal with foreign exchange transactions i.e. buying & selling foreign currency. The main participants in foreign exchange markets are

1. Retail Clients

Retail Clients deal through commercial banks and authorized agents. They comprise people, international investors, multinational corporations and others who need foreign exchange.

3. Commercial Banks

Commercial banks carry out buy and sell orders from their retail clients and of their own account. They deal with other commercial banks and also through foreign exchange brokers.

4. Foreign Exchange Brokers

Each foreign exchange market centre has some authorised brokers. Brokers act as intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers.

5. Central Banks

Under floating exchange rate central bank does not interfere in exchange market. Since 1973, most of the central banks intervened to buy and sell their currencies to influence the rate at which currencies are traded.

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From the above sources demand and supply generate which in turn helps to determine the foreign exchange rate.

5.        Other Participants

a) Brokers

Brokers have more information and better knowledge of market. They provide information to banks about the prices at which there are buyers and sellers of a pair of currencies. They act as middlemen between the price makers.

b)        Price Takers

Price takers are those who buy foreign exchange which they require and sell what they earn at the price determined by primary price makers.

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Pros and cons of foreign exchange market

The foreign exchange (forex) market is the interbank market where institutions trade currencies. It is also accessible to retail investors through online dealers or brokers. The forex market has several pros and cons that investors and traders should be aware of. Knowing what's involved with participating in the forex market will increase your chances of success.

Size

The foreign exchange market's size gives it several advantages. The large number of participants provides liquidity, meaning currencies are easily bought or sold, and orders are typically filled right away. The size of the market also prevents any single entity from exercising too much control over the market. Large participants, such as central banks, may influence the market, but only for a short amount of time.

Accessibility

The forex market is open 24 hours a day, five days a week. Some brokers are even open on weekends. This allows for flexibility to trade when you want. Brokers require low opening deposits, offer low transaction costs and typically charge only the bid-ask spread per trade, which is the difference between the buying and selling price. Traders can also use leverage to trade a larger amount of money than they have in their account.

Trading Styles

The forex market accommodates different trading styles. Investors can buy long or sell short in the foreign exchange market without restrictions. Investors can participate in the forex market using futures, exchange-traded funds or options, or directly through a broker in the spot market. This caters to different investment objectives.

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Loose Regulations

The forex market is an over-the-counter market with no central exchange. It is less regulated than other markets. Traders typically place trades directly with their broker, who takes the other side of the trade. The lack of a central exchange results in a lack of information on certain market statistics, such as trading volume, and creates a greater risk of mispricing.

Broker Risk

The loose regulation of online brokers increases the potential for fraud. Traders must research a broker carefully before opening an account. Funds deposited with a forex broker are typically not protected if the broker goes bankrupt. Any outages in a broker's trading system could leave a trader unable to manage open trades.

Risk of Loss

There is the potential to lose all of your money. Using leverage to trade more money than is in your account magnifies the potential loss if the market moves against you. You may be responsible for losses greater than the funds in your account. Because currency prices are influenced by many factors, the amount of fundamental information to analyze is daunting

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Types of foreign exchange market

Spot Market-These are the quickest transactions involving currency in foreign markets. These transactions involve immediate payment at the current exchange rate, which is also called the spot rate. The Federal Reserve says the spot market accounts for one-third of all currency exchange, and trades usually take place within two days of the agreement. This does leave the traders open to the volatility of the currency market, which can raise or lower the price between the agreement and the trade.

Futures Market-

As the name implies, these transactions involve future payment and future delivery at an agreed exchange rate, also called the future rate. These contracts are standardized, which means the elements of the agreement are set and non-negotiable. It also takes the volatility of the currency market, specifically the spot market, out of the equation. These are popular among traders who make large currency transactions and are seeking a steady return on their investments.

Forward Market-These transactions are identical to the Futures Market except for one important difference---the terms are negotiable between the two parties. This way, the terms can be negotiated and tailored to the needs of the participants. It allows for more flexibility. In many instances, this type of market involves a currency swap, where two entities swap currency for an agreed-upon amount of time, and then return the currency at the end of the contract.

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CHAPTER 4 - FACTORS AFFECTING CURRENCY MOVEMENT IN FORIENG MARKET

Where economic theory will affect the Forex market on a long-term basis, the affect of changes in economic data is much more immediate. Oftentimes, the biggest companies in the exchange market are the various countries that participate in market activities and there currency is likened to shares in that country. It follows then that the country's economic data is analogous to the earnings data of a company or business entity.

News and information regarding a country's economy can have a direct impact on the direction that the country's currency is heading in much the same way that current events and financial news affect stock prices, hence the importance of economic factors. The following eight economic factors will directly affect a currency's movements in the Forex market.

Factor 1 - Employment DataNon-farm payrolls is the name given to the data that pertains to the number of people who are employed within the US economy, and it is released the first Friday of every month by the Bureau of Labor Statistics. Strong decreases in employment indicate a contracting economy, while strong increases are perceived indicators of a prosperous economy.

Factor 2 - Interest RatesThis is always a major focus in the forex market. Since the central banks mandate monetary policy and supply, they are the prime focus of investors and the various market participants.

Factor 3 - InflationThis is the measure of increases or decreases in pricing levels over a period of time. Due to the immense number of goods and services available in a country, usually a grouping of these goods and services are used to measure changes in the pricing. Increases in pricing indicate an increase in the inflation rate which in turn can devalue that country's

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currency.

Factor 4 - Gross Domestic ProductThis is the measurement for goods and services that were finished over a period of time. The GDP is broken down into 4 categories:

1. business spending2. government spending3. private consumption4. total net exports

Factor 5 - Retail Sales

The measurement of sales recorded by retailers over a period of time is a reflection of either increased or decreased consumer spending, depending on whether sales are up or down for the comparative period a year ago. This indicator gives market participants an idea as to how strong or weak the economy is.

Factor 6 - Durable GoodsGoods that have a lifespan of three or more years are considered durable goods and they are measured in quantities that are ordered, shipped, or unfilled over a period of time. These are also an indicator of economic spending or the lack of it.

Factor 7 - Trade and Capital FlowsCurrency values can be significantly impacted by monetary flows that result from certain interactions between countries. When imports exceed exports, there is a tendency for the currency value to decline. Increased investments in a country can lead to the opposite result.

Factor 8 - Macroeconomic and Geopolitical EventsElections, financial crises, monetary policy changes, and wars can influence the biggest changes in the Forex market. These events can either change and/or lead to reshaping of a country's economy.

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CHAPETER 5: EMERGING TRENDS IN FOREIGN EXCHANGE MARKET

Recent Volatility Trends

Volatility is typically measured in one of two ways. Historical volatility is a measure of how much an exchange rate—or any asset—has varied, on average, over a specified period, say one month. As its name suggests, historical volatility is backward looking. An alternative measure, implied volatility, is extracted from options prices. This measure has the advantage of telling us something about expected volatility over the tenor of the contract. It therefore has a forward-looking component. For this discussion, We will focus on one-month at-the-money forward implied volatility.

Over long periods, these two measures of volatility generally move together, though at times they can, and have, diverged. Note that these measures are independent of trends in the underlying spot rate. An exchange rate might have a substantial cumulative move that is steady and gradual over the course of a year, but shorter term realized and option-implied volatility may still remain low. Contrast that behavior with an exchange rate that ended the year where it began, but in the interim frequently moved with sudden swings in both directions. Despite ending the year where it began, the shorter term measures of historical and option-implied volatility are high.

With that introduction in place, let me turn to the facts. In the major exchange rate pairs, both historical and implied volatility have been declining in recent years. During the 1990s, daily quotations of one-month at-the-money implied volatility of the dollar/deutsche mark commonly traded in the double digits. However, that average does not convey the swings in implied volatility that were observed, for example, during the ERM crisis. Put differently, if somewhat awkwardly, the volatility of implied volatility was high.

With the transition in Europe to the single currency, implied volatility in the euro/dollar initially looked similar to that of the dollar/deutsche mark exchange rate. In 2000, implied volatility of the euro/dollar averaged about 13 percent, before beginning a steady decline over subsequent years. In 2005, one-month implied volatility in the euro/dollar averaged

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about 8.7 percent. In 2006, it has been just above 8.0 percent. Again, looking at average implied volatility does not convey the full story. Not only is implied volatility low on average, it has also been persistently low. Whereas spikes were common in the 1990s, they have been few and far between more recently. Even dramatic events such as the terrorist attacks in 2001 barely nudged the vol meter, and volatility is nowhere near the peaks reached in the mid-1990s and 1998. In short, average implied volatility is low and the volatility of implied volatility is much lower than it used to be.

We observe the same phenomenon in the dollar/yen currency pair. One-month implied volatility averaged almost 16 percent in 1998, with spikes into the high 20s. This average fell to 11.3 percent in 2000 and to 8.4 percent by 2005. Although the last couple of weeks have seen implied volatility tick higher, overall average implied volatility thus far in 2006 remains just below 9 percent.

We find this longer term phenomenon in many emerging market currencies as well, including some that experienced currency crises in the recent past. The volatilities of currencies from Mexico, Brazil, South Korea, Taiwan, Turkey and Russia moderated from 2003 through 2005—although some of these volatilities have picked up in recent weeks.

The decline in volatility is not isolated to foreign exchange. Other financial assets exhibit some of the same broad patterns. Fixed-income volatility and equity market volatility as measured, respectively, by indices such as MOVE and VIX are at near-record lows. Only commodity prices are bucking that low vol trend.

Market Factors

In addition to broad macroeconomic factors, structural market forces may be at work. Two that We will comment on are increased transparency and participation, and heightened activity in the options market.

We mentioned technology's importance to the market. Besides simplifying transactions, technology has enabled greater price transparency and a wider range of agents to participate in the marketplace. Newer players include smaller fund managers, individuals and so-called algorithmic traders—all of whom participate mostly or exclusively through e-trading systems, particularly in the spot market. A

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larger number of participants trading more actively results in higher turnover, narrower bid-offer spreads and continuous pricing. Some of these newer participants may be more willing to provide liquidity at “slower” times of the day. With more participants supplying prices, the probability of price gaps in the spot market may be reduced, thereby lowering realized and option-implied volatility.

As more players have entered the spot market, more have become involved in the options market. The expertise of pricing options has become more diffuse in recent years, as traders have moved from market-making banks to hedge funds and brought with them the pricing and risk management expertise that only a few firms had at one time. One theory is that this diffusion of expertise has led to a decrease in implied volatility—which frequently was higher than historical volatility—as the newer participants sold what they knew were “expensive” options that they knew how to hedge.

A less benign explanation for the low level of implied volatility is that market participants are selling options to generate premiums. Under this theory, the supply/demand dynamic may have driven down the price of the options and the implied volatility. If option protection is sold too cheaply, the seller may not be compensated adequately for the risk assumed.

Looking Ahead

As my remarks suggest, foreign exchange markets have been unusually stable in recent years. We don't know why they have been so stable. Optimists point to structural changes in how the global economy operates. Greater macroeconomic stability across countries, coupled with increased exchange rate flexibility among many countries, has allowed for gradual exchange rate adjustments. The optimists argue that these factors have reduced risk premia and thus a reduction of volatility is justified by these benign conditions.

Pessimists counter that fundamentals have not changed. Rather, investors are now willing to take on large risks for little extra compensation. The pessimists believe that the current environment is one with huge uncertainties associated with geopolitical risks, energy prices and productivity that markets are mispricing.

We cannot determine which of these two scenarios is correct—or whether a third one might exist. With profits in the financial sector strong, it is

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seductive to assume the current benign period will persist. The danger is that this current period may not persist if, for example, the economic backdrop changes. There have after all been other times when low volatilities have been followed by an increase in risk aversion, a sudden widening of risk spreads and a spike in volatility.

We don't know the direction of exchange rates or the speed at which they will move in the future. But firms should not be lulled into complacency by the recent period and assume that market volatilities—and risks—are permanently lower. Risk managers should be conscious of how the inclusion of the most recent data is affecting their risk models. Statistical risk measures, such as value at risk, may not capture the full extent of so-called “tail events,” even during periods of normal volatility. These measures are even more likely to paint too rosy a picture of risk when market volatilities are low. As a result, managing and sizing tail events—through stress testing and other risk containment tools—is particularly important in the present market environment.

More broadly, the stress testing of positions and exposures is an especially important tool for sizing FX risks, because correlations between the foreign exchange market and other markets are famously unstable. For this reason, we should be extremely skeptical of risk measures based on the status quo assumption that volatility will remain low. This is precisely because the events that we should be most concerned about are those that have the ability to turn the status quo on its head.

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RECENT DEVELOPMENTS IN FOREX MARKET-

The forex market has seen profound changes since the early 1970s, not only in its size but also in the way in which it operates, as a result of structural shifts in the world economy and in the international financial system. Some of the main changes which have occurred in the world's financial environment include:

1. A fundamental change in the international monetary system from the fixed exchange rates arising out of the Bretton Woods agreement to a much more flexible system in which countries can float their exchange rates or follow other exchange rate practices of their own choosing.

2. Major financial deregulation across the globe including the elimination of government controls and restrictions in almost every country, which has resulted in far greater freedom in national and international financial transactions and hugely increased competition among financial institutions.

3. A fundamental change in savings and investment, with funds managers and investment institutions around the world diversifying their investments across international borders and into multiple currencies.

4. Major changes in, and liberalization of, international trade as a result of a series of trade agreements including the Tokyo and the Uruguay Rounds of the General Agreement on Tariffs and Trade, the North American Free Trade Agreement, and US bilateral trade initiatives with the European Union, China and Japan.

5. Technological advances which have made it possible to achieve the real-time transmission of huge amounts of market information worldwide and to analyze that information rapidly so that market opportunities can be identified and exploited. In addition, financial transactions can now be executed quickly and safely, with a level of efficiency which allows costs to be kept at level well below those which were possible previously.

6. New thinking in terms of both the theory and practice of finance which have resulted in the development of many new financial instruments and derivative products. Advances in thinking have also served to change our understanding of the international financial system and the techniques we

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need to use to operate within it.

As markets have grown and developed since the 1970s in a climate of much greater freedom and competition, the role of the markets themselves has changed and we have developed the tools and techniques to allow us to exploit these growing markets to the full. One major beneficiary of these changes has been the forex trader who has an investment vehicle available today which was undreamt of a few years ago and which will continue to provide the small investor with an excellent trading opportunity for many years to come.

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CHAPTER 6: RECOMMENDATIONS AND CONCLUSION

Recommendations-

First, there are some limits on freedom accorded to banks, such as ones on borrowing and investing overseas; ceilings on interest rates and maturities of non-resident foreign currency deposits; and these could be reviewed at appropriate time, with a view to liberalising them prudently.

Second, the medium-term objective of reducing cash reserve requirements to the minimum prescribed in the statute and the longer term objective of proposing amendments to the statute to make all the reserve requirements flexible will be pursued, consistent with developments in fiscal and monetary conditions.

Third, the restoration of freedom to corporates to hedge anticipated exposures is continuously under review. However, the issue of restoration of facility to rebook cancelled contracts needs to be reviewed with caution.

Fourth, the extension of facility of forward cover to FIIs is also under continuous review, though facilities available now are yet to be fully utilised by FIIs.

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Fifth, trading in derivatives is a desirable objective, but a number of preconditions are to be satisfied in the matter of institutional as well as regulatory arrangements. This is a complex task, but certainly is on the agenda of reform.

Sixth, setting up a forex clearing house is on the agenda and it is essential to design it on par with other leading clearing systems in the world.

Seventh, a number of recommendations of Tarapore Committee have been accepted, and others are also reviewed from time to time. A view will have to be taken on each one of them only in the context of overall liberalisation of capital account, which in turn, depends on, among other things, progress of our financial sector reforms and evolving international financial architecture.

Eighth, development of deep and liquid money market with a well-defined yield curve in place is an accepted objective of RBI. The actions taken and those contemplated to perform this hard task have already been articulated in my earlier speeches on money and debt markets, and the recent Monetary and Credit Policy Statement of April 1999 has provided evidence of RBI's approach in this regard.

Ninth, implementation of the recommendations of the Report on Public Sector Enterprises will facilitate the efficient management of their foreign currency risks and also even out lumpy demand and supply situations in the forex market.

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Tenth, while there is a dominant view that setting up Mumbai as an off-shore financial centre is no longer a necessity, the views of CII, which is posing the issue, may have to be awaited and considered seriously.

Eleventh, in any effort to develop markets, role of self regulatory bodies is critical. The role of FEDAI in achieving greater competition, efficiency and transparency in the forex markets needs to be reviewed on a continuous basis, so as to keep pace with developments in technology and financial sector reforms.

Twelfth, a number of legislative changes are under contemplation, and of these the ones relating to Foreign Exchange Management and Money Laundering are critical to development of forex markets. Harmonisation between existing institutions, regulations and practices, including transition path to new legislative framework would be a significant task in the context of forex market development.

Thirteenth, several representations have been received by Regulations Review Authority to simplify, streamline and rationalise some of the regulatory and reporting requirements pertinent to foreign exchange. The RRA should be taking a final view in the matter, on the basis of expected report of group of Amicus Curiae, within a few weeks.

Fourteenth, in the area of technology, on-line connectivity has been initiated in respect of data transmission by market to the RBI. Once this system is fully established, it will lead to a very prompt and effective on-line monitoring by RBI as well as reduction in multiplicity of reporting statements. Similarly, initiatives are underway to expedite back office linkage between banks

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themselves and with RBI for settlement, which will fructify once the VSAT is fully operational.

Conclusion-

To conclude, the medium-term objective of developing an efficient and vibrant forex market continues to be an important priority within the overall framework of development of financial markets. Naturally, the pace and sequencing have to be determined by both the domestic and international developments. In particular, the unique features of Indian forex markets, legal, institutional and technological factors, and developments related to macro-economic policies would govern the path of moving towards the medium-term objective, without sacrificing freedom in tactical measures to respond to unforeseen circumstances in the very short-term.

Besides, with the Indian economy moving towards further capital account liberalisation, the development of a well-integrated foreign exchange market also becomes important as it is through this market that cross-border financial inflows and outflows are channeled to other markets. Development of the foreign exchange market also needs to be co-ordinated with the capital account liberalisation. Reforms in the financial markets is a dynamic process and need to be harmonised with the evolving macroeconomic developments and the level of maturity of participating financial institutions and other segments of the financial market.

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