ASSIGNMENT ON ROLE OF RBI

IN
FOREX MARKET

SUBMITTED TO
K. RAGHU SIR
SUBMITTED BY
K.MAHESH REDDY
ROLL NO :Y9BU72014

Role of RBI in FOREX Market

Introduction

The Indian FOREX market owes its origin to the important step that RBI

took in 1978 to allow banks to undertake intraday trading in foreign

exchange. As a consequence, the stipulation of maintaining “Square” or

“near square” position was to be complied with only at the close of business

each day. During the period 1975-1992, the exchange rate of rupee was

officially determined by the RBI in terms of a weighted Basket of currencies

of India’s major trading partners and there were significant restrictions on

the current account transactions.

The initiation of economic reforms in July 1991 saw significant two-step

downward adjustment in the exchange rate of the rupee on July 1 and 3,

1991 with a view to placing it at an appropriate level in line with the

inflation differential to maintain the competitiveness of exports.

Subsequently,

Following the recommendations of the High Level Committee on Balance of

Payments (Chairman: Dr C. Rangarajan) the Liberalized Exchange Rate

Management System (LERMS) involving dual exchange rate mechanism

was instituted in March 1992 which was followed by the ultimate

convergence Of the dual rates effective from March 1, 1993(christened

modified LERMS). The unification of the exchange rate of the rupee marks

the beginning of the era of market determined exchange rate regime of

rupee, based on demand and supply in the forex market. It is also an

important step in the progress towards current account convertibility, which

was finally achieved in August 1994 by accepting Article VIII of the

Articles of Agreement of the International Monetary Fund.

Exchange Rate
Exchange Rate is the price of one country's currency expressed in another

country's currency. In other words, the rate at which one currency can be

exchanged for another. e.g.

Rs. 48.50 per one USD.

Major currencies of the World

➢ USD

➢ EURO

➢ YEN

➢ POUND STERLING

What is a Foreign Exchange Transaction?

➢ Any financial transaction that involves more than one currency is a

foreign exchange transaction.

➢ Most important characteristic of a foreign exchange transaction is that it

involves Foreign Exchange Risk.

Types of Exchange Rates

There are 4 types of Exchange rates:

1. Ready

2. Value Tom

3. Spot Transaction

4. Forward Transaction

1) Ready: Settlement of funds on the same day (date of the deal).

2) Value Tom: Settlement of funds takes place on the next working day of

the date of the deal.

3) Spot Transaction: Settlement of funds takes place on the second working

day following the date of the deal.

4) Forward Transaction: Delivery takes place on any day after the date of

the deal.

What Does Price Maker Mean?

A monopoly or a firm within monopolistic competition that has the power to

influence the price it charges as the good it produces does not have perfect

substitutes.
Price Maker

A monopoly is a price maker as it holds a large amount of power over the

price it charges.

A price maker that is a firm within monopolistic competition produces

goods that are differentiated in some way from its competitors' products.

This kind of price maker is also aprofit-maximizer as it will increase output

only as long as its marginal revenue is greater than its marginal cost, in other

words, as long as it's producing a profit.

W hat Does Price-Taker Mean?

1. An investor who’s buying or selling transactions are assumed to have no

effect on the market.

2. A firm that can alter its rate of production and sales without significantly

affecting the market price of its product.

Price-Taker

1. In the context of the stock market, individual investors are Price-takers.

2. Suppose you sell water, which of course is supplied by millions of other

places, including the sky. If you decide to set the price of a gallon of your

water at $10, you will likely sell nothing because this commodity is readily

available elsewhere for a much cheaper price.

The main purpose of the foreign currency exchange market is to make

money but it is different from other equity markets.

There are various technical terminologies and strategies a trader must know

to deal with currency exchange. In the Currency Exchange market the

commodity that is traded is the foreign currency. These foreign currencies

are always priced in pairs. The value of one unit of a foreign currency is

always expressed in terms of another foreign currency. Thus all trades

incorporate the purchase and sale of two foreign currencies at the same time.

You have to buy a currency only when you expect the value of that currency

to increase in the future.

They are always quoted in pairs as USD/JPY. The first currency is the base

currency and the second one is the quote currency. The quote value depends

on the currency conversion rates between the two currencies under

consideration. Mostly the USD will be used as based currency but

sometimes euro, pound sterling is also used.

The profit of the broker depends on the bid and the ask price. The bid is the

price the broker is ready to pay to buy base currency for exchanging the

quote currency. The ask is the price the broker is ready to sell the base

currency for exchanging the quote currency. The difference between these
two prices is called the spread which determines the profit or loss of the

trade.

RATE QUOTATION CONVENTIONS:

An exchange system quotation is given by stating the number of units of

"term currency" (or "price currency" or "quote currency") that can be bought

in terms of 1 "unit currency" (also called "base currency"). For example, in a

quotation that says the EURUSD exchange rate is 1.4320 (1.4320 USD per

EUR), the term currency is USD and the base currency is EUR.

There is a market convention that determines which is the base currency and

which is the term currency. In most parts of the world, the order is: EUR –

GBP – AUD – NZD – USD – others. Thus if you are doing a conversion

from EUR into AUD, EUR is the base currency, AUD is the term currency

and the exchange rate tells you how many Australian dollars you would pay

or receive for 1 Euro. Cyprus and Malta which were quoted as the base to

the USD and others were recently removed from this list when they joined

the Euro. In some areas of Europe and in the non-professional market in the

UK, EUR and GBP are reversed so that GBP is quoted as the base currency

to the euro. In order to determine which the base currency is where both

currencies are not listed (i.e. both are "other"), market convention is to use

the base currency which gives an exchange rate greater than 1.000. This
avoids rounding issues and exchange rates being quoted to more than 4

decimal places. There are some exceptions to this rule e.g. the Japanese

often quote their currency as the base to other currencies. Quotes using a

country's home currency as the price currency (e.g., EUR 0.63 = USD 1.00

in the euro zone) are known as direct quotation or price quotation (from that

country's perspective) [1] and are used by most countries. Quotes using a

country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.58 in

the euro zone) are known as indirect quotation or quantity quotation and are

used in British newspapers and are also common in Australia, New Zealand

and the Euro zone.

1. DIRECT QUOTATION:

Direct quotation: 1 foreign currency unit = x home currency units

“Price of one Unit of Domestic Currency in terms of Foreign Currency”

Five Currencies are quoted in Direct Terms

) Pound Sterling

2) Euro

3) Australian Dollar

4) New Zealand Dollar

5) Irish Punt

2. IN-DIRECT QUOTATION:
“Price of one Unit of Foreign Currency in terms of Domestic Currency”

Indirect quotation:

1 home currency unit = x foreign currency units

In the international market, almost all currencies are quoted indirectly.

Note that, using direct quotation, if the home currency is strengthening (i.e.,

appreciating, or becoming more valuable) then the exchange rate number

decreases. Conversely if the foreign currency is strengthening, the exchange

rate number increases and the home currency is depreciating. Market

convention from the early 1980s to 2006 was that most currency pairs were

quoted to 4 decimal places for spot transactions and up to 6 decimal places

for forward out rights or swaps. (The fourth decimal place is usually referred

to as a "pip.") An exception to this was exchange rates with a value of less

than 1.000 which were usually quoted to 5 or 6 decimal places. Although

there is no fixed rule, exchange rates with a value greater than around 20

were usually quoted to 3 decimal places and currencies with a value greater

than 80 were quoted to 2 decimal places. Currencies over 5000 were usually

quoted with no decimal places (e.g. the former Turkish Lira). e.g.

(GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 - EURJPY :

165.29). In other words, quotes are given with 5 digits. Where rates are

below 1, quotes frequently include 5 decimal places. In 2005 Barclays

Capital broke with convention by offering spot exchange rates with 5 or 6

decimal places on their electronic dealing platform. The contraction of

spreads (the difference between the bid and offer rates) arguably

necessitated finer pricing and gave the banks the ability to try and win

transaction on multibank trading platforms where all banks may otherwise

have been quoting the same price. A number of other banks have now

followed this.

Risk Management and Settlement of

Transactions in the Foreign Exchange Market

1. The foreign exchange market is characterized by constant changes and

rapid innovations in trading methods and products. While the

innovative products and ways of trading create new possibilities for

profit, they also pose various kinds of risks to the market. Central

banks all over the world, therefore, have become increasingly

concerned of the scale of foreign exchange settlement risk and the

importance of risk mitigation measures. Behind this growing

awareness are several events in the past in which foreign exchange

settlement risk might have resulted in systemic risk in global financial

markets, including the failure of Bankhaus Herstatt in 1974 and the

closure of BCCI SA in 1991.

2. The foreign exchange settlement risk arises because the delivery of

the two currencies involved in a trade usually occurs in two different

countries, which, in many cases are located in different time zones.

This risk is of particular concern to the central banks given the large

values involved in settling foreign exchange transactions and the

resulting potential for systemic risk. Most of the banks in the EMEs

use some form of methodology for measuring the foreign exchange

settlement exposure. Many of these banks use the single day method,

in which the exposure is measured as being equal to all foreign

exchange receipts that are due on the day. Some institutions use a

multiple day approach for measuring risk. Most of the banks in EMEs

use some form of individual counterparty limit to manage their

exposures. These limits are often applied to the global operations of

the institution. These limits are sometimes monitored by banks on a

regular basis. In certain cases, there are separate limits for foreign

exchange settlement exposures, while in other cases, limits for

aggregate settlement exposures are created through a range of

instruments. Bilateral obligation netting, in jurisdictions where it is

legally certain, is an important way for trade counterparties to mitigate

the foreign exchange settlement risk. This process allows trade

 counterparties to offset their gross settlement obligations to each other

in the currencies they have traded and settle these obligations with the

payment of a single net amount in each currency.

3. Several emerging markets in recent years have implemented domestic

real time gross settlement (RTGS) systems for the settlement of high

value and time critical payments to settle the domestic leg of foreign

exchange transactions. Apart from risk reduction, these initiatives

enable participants to actively manage the time at which they

irrevocably pay way when selling the domestic currency, and

reconcile final receipt when purchasing the domestic currency.

Participants, therefore, are able to reduce the duration of the foreign

exchange settlement risk.

4. Recognizing the systemic impact of foreign exchange settlement risk,

an important element in the infrastructure for the efficient functioning

of the Indian foreign exchange market has been the clearing and

settlement of inter-bank USD-INR transactions. In pursuance of the

recommendations of the Sodhani Committee, the Reserve Bank had

set up the Clearing Corporation of India Ltd. (CCIL) in 2001 to

mitigate risks in the Indian financial markets. The CCIL commenced

settlement of foreign exchange operations for inter-bank USD-INR

spot and forward trades from November 8, 2002 and for inter-bank

USD-INR cash and tom trades from February 5, 2004. The CCIL

undertakes settlement of foreign exchange trades on a multilateral net

basis through a process of notation and all spot, cash and tom

transactions are guaranteed for settlement from the trade date. Every

eligible foreign exchange contract entered between members gets

notated or replaced by two new contracts – between the CCIL and

each of the two parties, respectively. Following the multilateral

netting procedure, the net amount payable to, or receivable from, the

CCIL in each currency is arrived at, member-wise. The Rupee leg is

settled through the members’ current accounts with the Reserve Bank

and the USD leg through CCIL’s account with the settlement bank at

New York. The CCIL sets limits for each member bank on the basis

of certain parameters such as member’s credit rating, net worth, asset

value and management quality. The CCIL settled over 900,000 deals

for a gross volume of US $ 1,180 billion in 2005-06. The CCIL has

consistently endeavored the entire gamut of foreign exchange

transactions under its purview. Intermediation, by the CCIL thus,

provides its members the benefits of risk mitigation, improved

 efficiency, lower operational cost and easier reconciliation of accounts

with correspondents.

5. An issue related to the guaranteed settlement of transactions by the

CCIL has been the extension of this facility to all forward trades as

well. Member banks currently encounter problems in terms of huge

outstanding foreign exchange exposures in their books and this comes

in the way of their doing more trades in the market. Risks on such

huge outstanding trades were found to be very high and so were the

capital requirements for supporting such trades. Hence, many member

banks have expressed their desire in several for a that the CCIL should

extend its guarantee to these forward trades from the trade date itself

which could lead to significant increase in the liquidity and depth in

the forward market. The risks that banks today carry in their books on

account of large outstanding forward positions will also be

significantly reduced (Gopinath, 2005). This has also been one of the

recommendations of the Committee on Fuller Capital Account

Convertibility.

6. Apart from managing the foreign exchange settlement risk,

participants also need to manage market risk, liquidity risk, credit risk

and operational risk efficiently to avoid future losses. As per the

guidelines framed by the Reserve Bank for banks to aligns and

exposure in derivative markets as market makers, the boards of

directors of Ads (category-I) are required to frame an appropriate

policy and fix suitable limits for operations in the foreign exchange

market. The net overnight open exchange position and the aggregate

gap limits need to be approved by the Reserve Bank. The open

position is generally measured separately for each foreign currency

consisting of the net spot position, the net forward position, and the

net options position. Various limits for exposure, viz., overnight,

daylight, stop loss, gap limit, credit limit, value at risk (VaR), etc., for

foreign exchange transactions by banks are fixed. Within the contour

of these limits, front office of the treasury of ADs transacts in the

foreign exchange market for customers and own proprietary

requirements. These exposures are accounted, confirmed and settled

by back office, while mid-office evaluates the profit and monitors

adherence to risk limits on a continuous basis. In the case of market

risk, most banks use a combination of measurement techniques

including and managed by most banks on an aggregate counter-party

basis so as to include all exposures in the underlying spot and

derivative markets. Some banks also monitor country risk through

 cross-border country risk exposure limits. Liquidity risk is generally

estimated by monitoring asset liability profile in various currencies in

various buckets and monitoring currency-wise gaps in various

buckets. Banks also track balances to be maintained on a daily basis in

Nostro accounts, remittances and committed foreign currency term

loans while monitoring liquidity risk.

7. To sum up, the foreign exchange market structure in India has

undergone substantial transformation from the early 1990s. The

market participants have become diversified and there are several

instruments available to manage their risks. Sources of supply and

demand in the foreign exchange market have also changed in line with

the shifts in the relative importance in balance of payments from

current to capital account. There has also been considerable

improvement in the market infrastructure in terms of trading platforms

and settlement mechanisms. Trading in Indian foreign exchange

market is largely concentrated in the spot segment even as volumes in

the derivatives segment are on the rise. Some of the issues that need

attention to further improve the activity in the derivatives segment

include flexibility in the use of various instruments, enhancing the

knowledge and understanding the nature of risk involved in

transacting the derivative products, reviewing the role of underlying in

booking forward contracts and guaranteed settlements of forwards.

Besides, market players would need to acquire the necessary expertise

to use different kinds of instruments and manage the risks involved.