FOREX OPERATIONS IN P.N.

B WITH INTEREST RATES AND CURRENCY MOVEMENT (UNDER TREASURY DIVISION OF)

PROJECT REPORT Submitted in partial fulfillment of the requirements for the award of the degree of MASTER OF BUSINESS ADMINISTRATION By ******** Under the guidance of Faculty guide ******** Company Guide ******** (********.TreasuryDiv.) ******** (********Treasury Div.)

********INSTITUTE OF MANAGEMENT ******** CERTIFICATE FACULTY GUIDE

This is to certify that the Project titled FOREX OPERATIONS IN P.N.B WITH INTEREST RATES AND CURRENCY MOVEMENT is an

authentic record of the project work carried out by ********) under my guidance and support, in fulfillment of the requirements for the award of Master of Business Administration

********Faculty Guide ******** ******** Institute of Management

Date:Place:-

LETTER FROM THE CORDINATOR

This is to certify that M******** (Reg. No. ) is a bona fide student of ********Institute of Management (MBA batch) and has successfully completed her Summer Internship Project on the title FOREX OPERATIONS IN P.N.B WITH INTEREST RATES AND CURRENCY MOVEMENT at treasury division, ********

.. Prof. ******** Coordinator

********of Management
Date:Place:-

DECLARATION

I, ********hereby , declare that the project report titled FOREX OPERATIONS IN P.N.B WITH INTEREST RATES AND CURRENCY MOVEMENT is submitted for the partial fulfillment of the requirements for the award of the Master of Business Administration is my original work and has been carried out under the guidance of ******** ,(Faculty Guide), ******** Institute of Management and ******** (D********Analyst, Treasury Division) and ******** (********Division)

********DATE...

ACKNOWLEDGEMENT
Theoretical knowledge without practical application is incomplete. The exposure to practical world gives a new dimension to whatever has been grasped till time and it also gives a chance to understand that where the learned knowledge can be applied. I feel great pleasure in thanking the management of ********SInstitute of Management and PUNJAB NATIONAL BANK, who gave me an opportunity to work on this project that helped to get an insight of the actual world outside and understand its implications I extend my sincere thanks to my mentor ********who helped me at each and every step of my project and guided me with his valuable suggestions so as to bring about and present my project in its best form. I am also thankful to all my colleagues and guides at PUNJAB NATIONAL BANK without whose contribution this project would have been a failure altogether. Words are never sufficient to express gratitude but here my words are just a medium to express what I feel.

EXECUTIVE SUMMARY
Interest rates are the dough of the fundamental forex pie. Globally interest rates are one of the primary drivers of currency exchange rates. Generally speaking, when all other variables are kept equal, rising interest rates (central bank tightening) have a tendency to contribute to an appreciation in a currency. This is because higher yielding currencies attract more demand from large institutional investors, who are consistently in search of ways to earn more on their money. If, on the other hand, there is a lowering of interest rates (central bank easing), the tendency is towards a depreciation of the currency. This is due to decreasing demand by the institutional investors, who generally tend to move their money away from lower - yielding assets. Although this may constitute a simplistic assumption regarding international capital flows, as so many other factors contribute to exchange rate movement, interest rates generally tend to exert their influence in this manner. It should be kept in mind, from a foreign exchange trading perspective, that the appreciation or depreciation in an exchange rate is less a product of the absolute value of the interest rate than the direction of change in the interest rate. In other words, although the current interest rate for a countrys currency is important in helping the market to determine its exchange value, the direction of interest rate change is even more important. Just because a currency carries a high - yield does not ensure an appreciation in the exchange rate. But if the currencys central bank continues to raise interest rates and indicates an intention to keep doing so, this can have a considerable impact on appreciation in the currency. Changes in interest rates are initiated by central banks based on its monetary policy. In India Reserve Bank Of India is the central bank which takes decisions related to interest rates and changes thereafter. While in the United States, its the Federal Reserve (informally called the Fed ). Other major central banks include the European Central Bank (ECB), the Bank of England (BOE), the Bank of Japan (BOJ), the Bank of Canada (BOC), and the Reserve Bank of Australia (RBA).
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These institutions make decisions that help determine the direction of interest rates. Interest rate changes have huge affect on the entire economy. Like, increase in interest rates do much more than slowing down an economy; they also act as a magnet to attract capital to bonds and other interest-bearing instruments which in turn increases the value and value of the currency. Globally the flow of capital in and out of a country can be substantially affected by the difference in interest rates between one country and another. In recent years the outflow of capital from Japan to New Zealand, Australia, and Great Britain has reflected money chasing more yields and has been a major multibillion-dollar feature called the carry trade. The carry trade was driven by the interest rate differential that has existed, for example, between Japan (0.50) and New Zealand (8.0), causing lowcost borrowing in yen to invest in higher-yielding kiwis.

TABLE OF CONTENTS

CHAPTERS

TOPIC

PAGE NO.

1. 2. 3.

INTRODUCTION PROJECT DESIGN INDUSTRIAL AND ORGANISATIONAL PROFILE DATA ANALYSIS ANS INTERPRETATION FINDINGS, SUGGESTIONS AND CONCLUSION

1 6 8

4.

75

5.

85

CHAPTER 1 INTRODUCTION

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INTRODUCTION
FOREX is the acronym for the foreign exchange market, where one countrys currency is exchanged for that of another through a floating exchange- rate system. It is the worlds largest financial market, with an estimated daily average turnover of upwards of $2.5 trillion. FOREX trading is not bound to any one trading floor and is not a market in the traditional sense because there is no central exchange. Instead, the entire market is run electronically, within a network of banks, continuously over a 24-hour period. The market opens Sunday at 5 P.M. (EST) and goes thru Friday afternoon at 4:30 P.M. (EST). Banks have a natural flow of foreign exchange business from their customers, who buy and sell currency according to their individual needs. The banks must manage their own currency deposits in the changing light of their customers transactions. Foreign exchange trading is essentially about trading money. There are several reasons why people and institutions would want to trade money. The two primary reasons are currency conversion and speculation. Currency conversion is simply the changing of money from one currency to another. Every transaction in the world settles in a currency. Whether it is a consumer purchase, an imported or exported item, an investment in an equity or even cash under the mattress, the worlds economic activity is essentially a flow of money. What makes forex fascinating as a market and as a trading vehicle is the fact that currencies provide an intimate linkage to the world economy. For an Indian company to buy British goods, for example, would necessitate the conversion of Indian Rupees to British pounds. A Foreign exchange market is a market in which currencies are bought and sold. It is to be distinguished from a financial market where currencies are borrowed and lent. Foreign exchange market is described as an OTC (Over the counter) market as there is no physical place where the participants meet to execute their deals. It is more an informal arrangement among the banks and brokers operating in a financing centre purchasing and selling currencies, connected to each other by tele communications like telex, telephone and a satellite communication

network,SWIFT. The term foreign exchange market is used to refer to the

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wholesale a segment of the market, where the dealings take place among the banks. The retail segment refers to the dealings take place between banks and their customers. The retail segment refers to the dealings take place between banks and their customers. The retail segment is situated at a large number of places. They can be considered not as foreign exchange markets, but as the counters of such markets. The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi is other centres accounting for bulk of the exchange dealings in India. The policy of Reserve Bank has been to decentralize exchanges operations and develop broader based exchange markets. As a result of the efforts of Reserve Bank, Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of foreign exchange market. Size of the Market Foreign exchange market is the largest financial market with a daily turnover of over USD 2 trillion. Foreign exchange markets were primarily developed to facilitate settlement of debts arising out of international trade. But these markets have developed on their own so much so that a turnover of about 3 days in the foreign exchange market is equivalent to the magnitude of world trade in goods and services. The largest foreign exchange market is London followed by New York, Tokyo, Zurich and Frankfurt. The business in foreign exchange markets in India has shown a steady increase as a consequence of increase in the volume of foreign trade of the country, improvement in the communications systems and greater access to the international exchange markets. Still the volume of transactions in these markets amounting to about USD 2 billion per day does not compete favourably with any well developed foreign exchange market of international repute. The reasons are not far to seek. Rupee is not an internationally traded currency and is not in great demand. Much of the external trade of the country is designated in leading currencies of the world,Viz., US dollar, pound sterling, Euro, Japanese yen and Swiss franc. Incidentally, these are the currencies that are traded actively in the foreign exchange market in India.

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24 Hours Market The markets are situated throughout the different time zones of the globe in such a way that when one market is closing the other is beginning its operations. Thus at any point of time one market or the other is open. Therefore, it is stated that foreign exchange market is functioning throughout 24 hours of the day. However, a specific market will function only during the business hours. Some of the banks having international network and having centralized control of funds management may keep their foreign exchange department in the key centre open throughout to keep up with developments at other centres during their normal working hours In India, the market is open for the time the banks are open for their regular banking business. No transactions take place on Saturdays. Efficiency Developments in communication have largely contributed to the efficiency of the market. The participants keep abreast of current happenings by access to such services like Dow Jones Telerate and Teuter. Any significant development in any market is almost instantaneously received by the other market situated at a far off place and thus has global impact. This makes the foreign exchange market very efficient as if the functioning under one roof. Currencies Traded
In most markets, US dollar is the vehicle currency, Viz., the currency used to denominate international transactions. This is despite the fact that with currencies like Euro and

Yen gaining larger share, the share of US dollar in the total turnover is shrinking. Physical Markets In few centres like Paris and Brussels, foreign exchange business takes place at a fixed place, such as the local stock exchange buildings. At these physical markets, the banks meet and in the presence of the representative of the central bank and on the basis of bargains, fix rates for a number of major currencies. This practice is called fixing. The rates thus fixed are used to execute customer orders previously placed with the banks. An advantage claimed for this procedure is that exchange rate for commercial transactions will be market determined, not influenced by any

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one bank. However, it is observed that the large banks attending such meetings with large commercial orders backing up tend to influence the rates. Participants

The participants in the foreign exchange market comprise: Corporate Commercial banks Exchange brokers Central banks

World Currency Distribution

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CHAPTER 2 PROJECT DESIGN

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PROJECT DESIGN
Objectives of the study This project attempts to study the intricacies of forex market, with emphases on interest rates fluctuations and there affect on currency value, volume of trade and exchange rate. The main purpose of the study is: To study the basics of foreign exchange and the risk associated with it. To study the various fundamental factors that affects the movement of exchange rate. To study the various factors that affects the movement of interest rates. To study the trend of interest rates in India To study the trend of exchange rate in India To study the effect of change economic variables on exchange rates.

Scope of the study This study outlines the basics of foreign exchange, with the view to understand the interbank forex transaction and interest rates and their effect on currency movement to help the dealers develop a fundamental understanding of the forex market. Methodology (Data Sources) The study conducted in PUNJAB NATIONAL BANK is based on information collected from interaction with the office staff, the internet, reference material given by bank and records of the bank. Limitations of the study The data collected from various sources have been rounded off. The movement of currency is affected by many factors other than what I have included. The analysis could not be extended to a period greater than 5 year due to difficulty in obtaining data.

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CHAPTER 3 Industrial and organizational Profile

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INDUSTRY AND ORGANIZATION PROFILE

Banking Industry in India Banking in India originated in the first decade of the 18th century with the Bank of India coming into existence in 1786. During the first phase the growth was very slow and banks also experienced periodic failures between 1913 and 1948. There were approximately 1100 banks, mostly small. Later in 1935 the Reserve Bank of India took on the responsibility of regulating the Indian banking sector. To streamline the functioning and activities of commercial banks, the Government of India came up with the Banking Companies Act, 1949 which was later changed to Banking Regulation Act. The first phase of financial reforms resulted in the nationalization of 14 major banks in 1969 and resulted in a shift from Class banking to Mass banking. Seven banks forming subsidiary of State Bank of India were nationalized on 19th July, 1969. It was the effort of then Prime Minister of India, Mrs. Indira Gandhi, 14 major commercial banks in the country were nationalized. This in turn resulted in a significant growth in the geographical coverage of banks. The next wave of reforms saw the nationalization of 6 more commercial banks in 1980. Since then the number of scheduled commercial banks increased four-fold and the number of bank branches increased eight-fold. After the second phase of financial sector reforms and liberalization of the sector in the early nineties, the Public Sector Banks (PSB) found it extremely difficult to compete with the new private sector banks and the foreign banks. The new private sector banks first made their appearance after the guidelines permitting them were issued in January 1993. As far as the present scenario is concerned the Banking Industry in India is going through a transitional phase. The Public Sector Banks (PSBs), which are the base of the Banking sector in India account for more than 78 per cent of the total banking industry assets. Unfortunately they are burdened with excessive Non Performing assets (NPAs), massive manpower and lack of modern technology. On the other hand the Private Sector Banks are making tremendous progress. They are leaders in Internet banking, mobile banking, phone banking, ATMs. As far as
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foreign banks are concerned they are likely to succeed in the Indian Banking Industry. Currently, India has 96 scheduled commercial banks (SCBs) - 27 public sector banks (that is with the Government of India holding a stake), 31 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 38 foreign banks. They have a combined network of over 53,000 branches and 49,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively. The growth of financial sector in India at present is nearly 8.5% per year. The financial policies and the monetary policies are able to sustain a stable growth rate. The reforms pertaining to the monetary policies and the macroeconomic policies over the last few years have influenced the Indian economy to the core. The major step towards opening up of the financial market further was the nullification of the regulations restricting the growth of the financial sector in India. To maintain such a growth for a long term the inflation has to come down further. Financial Service Industry in India The financial sector in India had an overall growth of 15%, which has exhibited stability over the last few years although several other markets across the Asian region were going through turmoil. The development of the system pertaining to the financial sector was the key to the growth of the same. With the opening of the financial market variety of products and services were introduced to suit the need of the customer. The Reserve Bank of India (RBI) played a dynamic role in the growth of the financial sector of India. The growth of financial sector in India was due to the development in sectors Growth of the banking sector in India The banking system in India is the most extensive. The total asset value of the entire banking sector in India is nearly US$ 270 billion. The total deposits are nearly US$ 220 billion. Banking sector in India has been transformed completely.
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ORGANISATIONAL PROFILE

Profile
With over 56 million satisfied customers and more than 5000 offices including 5 overseas branches, PNB has continued to retain its leadership position amongst the nationalized banks. The bank enjoys strong fundamentals, large franchise value and good brand image. Besides being ranked as one of India's top service brands, PNB has remained fully committed to its guiding principles of sound and prudent banking. Apart from offering banking products, the bank has also entered the credit card, debit card; bullion business; life and non-life insurance; Gold coins & asset management business, etc. Since its humble beginning in 1895 with the distinction of being the first Swadeshi Bank to have been started with Indian capital, PNB has achieved significant growth in business which at the end of March 2010 amounted to Rs 435931 crore. PNB is ranked as the 2nd largest bank in the country after SBI in terms of branch network, business and many other parameters. During the FY 2009-10, with 40.85% share of CASA deposits, the Bank achieved a net profit of Rs 3905 crore. As on March10, the Bank has the Gross and Net NPA ratio of 1.71% and 0.53% respectively. During the FY 2009-10, its ratio of Priority Sector Credit to Adjusted Net Bank Credit at 40.5% & Agriculture Credit to Adjusted Net Bank Credit at 19.7% was also higher than the stipulated requirement of 40% & 18% respectively. Punjab National Bank continues to maintain its frontline position in the Indian banking industry. In particular, the bank has retained its NUMBER ONE position among the nationalized banks in terms of number of branches, Deposit, Advances, total Business, Assets, Operating and Net profit in the year 2009-10.

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PNB has always looked at technology as a key facilitator to provide better customer service and ensured that its IT strategy follows the Business strategy so as to arrive at Best Fit. The Bank has made rapid strides in this direction. All branches of the Bank are under Core Banking Solution (CBS) since Dec08, thus covering 100% of its business and providing Anytime Anywhere banking facility to all customers including customers of more than 3000 rural & semi urban branches. The Bank has also been offering Internet banking services to its customers which also enables on line booking of rail tickets, payment of utilities bills, purchase of airline tickets, etc. Towards developing a cost effective alternative channels of delivery, the Bank with more than 3700 ATMs has the largest ATM network amongst Nationalized Banks. International presence Backed by strong domestic performance, the Bank is planning to realize its global aspirations. Bank continues its selective foray in international markets with presence in 9 countries, with 2 branches at Hongkong, 1 each at Kabul and Dubai; representative offices at Almaty, Dubai, Shanghai and Oslo; a wholly owned subsidiary in UK; a joint venture with Everest Bank Ltd. Nepal and a JV banking subsidiary DRUK PNB Bank Ltd. in Bhutan. Bank is pursuing up gradation of its representative offices in China & Norway and is in the process of setting up a representative office in Sydney, Australia and taking controlling stake in JSC Dana Bank in Kazakhastan.

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FOREX OPERATIONS IN PUNJAB NATIONAL BANK

Introduction Foreign exchange dealing is highly specialized function and has to be performed by only well trained professionals. Typically a dealing department should consist of dealers, mid and back office staff, which is responsible for the follow up of the deals made by the dealers. The need for the effective control over the dealing operations is of great importance as possibilities exist for the manipulation of the exchange rates, dealing positions, mismatches etc. Segregation The cardinal principle of operation procedure in the area of trading activities is the clear functional segregation of dealing, mid office, back office (processing and control), accounting and reconciliation. In respect of banks which trade actively and offer the whole range of products, dealing activities may be segregated as under: Front office- (dealing room) Mid office (risk management, accounting policies and management information system) Back office (settlement, reconciliation, and accounting)

The deal slip includes the following:Name of the dealer, Name of the counter party bank, Currency Amount Date and time Deal rate Due time

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FOREIGN EXCHANGE -- MEANING:

When trade takes place between the residents of two countries, the two countries being a sovereign state have their own set of regulations and currency. Due to this problem arises in the conduct of international trade and settlement of the transactions .While the exporter would like to get the payment in the currency of their own country, the importer can pay only in the currency of the importers country. This creates a need for the conversion of the currency of importers into that of the exporters country. Foreign exchange is the mechanism by which the currency of one country is gets converted into the currency of another country. The conversion is done by banks who deal in foreign exchange. Meanings of Rate of Exchange The term rate of exchange expresses the price of one currency in terms of another. Thus, it indicates the exchange ratio between the currencies of two countries. Suppose for example, one Indian Rupee is equal to 13 USA Cents. This implies that in the exchange market, one Indian Rupee will fetch 13 Cents. Just as the price of a commodity is determined by its demand and supply conditions, the price of a foreign currency (i.e., the rate of an exchange) is also determined on the basis of demand and supply of the currency. In fact, the rate of exchange of a currency will keep on changing in the foreign exchange market, due to changes in demand and supply conditions of the currency. In this section we shall study about exchange rate varies under different monetary standards. Rate of Exchange under the Gold Standard Under the Gold Standard the monetary authorities are committed to a policy of converting gold into currency and currency into gold. This means, the buying and selling of fold at a specified fixed price in unlimited quantities will be allowed. If two countries are on the Gold Standard, the rate of exchange between the two currencies concerned will be fixed on the basis of par value. This means that the monetary authorities would first establish gold value of the countrys monetary unit. This is called par value of the currency, Buying and selling of gold will be allowed between the two countries. This will establish pars of exchange.
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The rate, at which the currency units of one country will exchange for the currency units of the other, would depend upon the quantity and purity of gold represented by each. The ratio between the quantities of gold represented by the gold represented by the two units is termed as the mint par of exchange of mint parity. Mint par of exchange or mint parity is defined as the exact equivalent of the currency unit of one country expressed in terms of the currency unit of another based upon the weight and fineness of the metal contained in two coins according to the respective mint regulations. The mint par of exchange, hence expresses the number of units of one currency which should legally contain the same amount of pure metal as does (legally) a given number of units of another currency. Rate of Exchange under Managed Paper Standard When the two countries are on inconvertible paper standard, there is no link with any metal, gold or silver. As such the rate of exchange is determined on the basis of demand and supply of foreign currencies. The exact rate of exchange is mainly influenced by their purchasing power parity. The Purchasing Power Parity Theory is associated with Swedish economist Gustav Cassel. The theory states that where the exchange rate between two countries is free to move without limit, if tends to approximate to the point, where each currency will buy as many goods in the other countrys market as in its own home market. This can be briefly illustrated by means of an example. Suppose, a bale of cotton is sold for Rs.500 in India (price in the home-market) and the same bale of cotton is sold for 10 dollars in USAs market, then the rate of exchange between Rupee and Dollar will be 50 Rupees for a Dollar, ignoring transport costs. This Purchasing Power Parity theory is defective in several respects: Price in the home-market depends upon price level internally, which will be affected by the inflationary conditions in the economy. Different types of goods enter into the international trade to find the rate of exchange will be impossible.

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The theory wrongly assumed that changes in price level induce changes in the exchange rate. Infact, it is the exchange rate that influence the price level; and The theory does not consider the demand for foreign exchange, reciprocal demand for commodities, capital movement, etc., which will affect the exchange rate.

Rate of Exchange under Exchange Control The term exchange control refers to the regulation of transactions involving foreign exchange to relieve pressure on the exchange value of a particular currency. The exchange control may take any form. In the most extreme form, it involves maintaining, for an indefinite period, an artificial value of the currency. This will be entrusted with the Central Banking authority, which will administer the exchange control legislations. In such a situation, the rate of exchange is not determined on the basis of demand and supply forces, but is fixed arbitrarily by the central authorities. To maintain that rate, all the citizens of the country are compelled to surrender foreign exchange to the Central Authorities at specified rates, and then the proceeds will be rationed among those who are in need of foreign exchange on the basis of priorities. Essentials of a Sound Currency System It must maintain a reasonable stability of prices in the country. This means that its internal value (or purchasing power in terms of goods and services in the country concerned) must not fluctuate too violently. This involves regulation of the amount of money in circulation to suit the requirements of trade and industry in the country. A sound currency system must maintain stability of the external value of the currency. This means that its purchasing power over goods and services in foreign countries, through its command over a definite amount of foreign currency, should remain constant. The system must be economical. A costly medium of exchange is a national waste. It is unnecessary. That is why all countries use mostly paper money.

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The currency must be elastic and automatic so that it expands or contracts in response to the requirements of trade and industry. The currency system must be simple so that an average man can understand it. A complicated system cannot inspire public confidence.

FOREIGN EXCHANGE RATE When one currency is converted into another, there must be some basis in effecting the conversion. The basis by which the currency unit of one country gets converted into currency units of another country is known as foreign exchange rate. Foreign exchange rate is therefore the price of one currency in terms of another. The rate of exchange for a currency is known from the quotation in the foreign exchange market.

FOREIGN EXCHANGE MARKET

Unlike commodity market where we see specific locations dealing various commodities, there is no specific locations for foreign exchange market. An American company importing goods from Germany with their price denominated in Deutschmark may buy marks in order to pay for the goods. An American company exporting goods to Germany, again with the price denominated in marks receives Deutschmarks which it may sell in exchange for dollars. The currency aspects of these transactions involve use of the foreign exchange markets. Foreign exchange market exists even in a remote village where the villager approaches a bank of his village to get converted the remittance received from his relative working abroad. To that extent, foreign exchange market exists throughout the world. However, the volumes of transactions in these markets are so few that they are not well recognized as foreign exchange markets. Based on the volume of transactions carried out, we can distinguish foreign exchange markets like London, New York, Tokyo, etc. However, in most of these centers, the foreign exchange market has no central, physical market place. Business is conducted by telephone or telex. The main dealers are commercial banks and central banks.
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FOREIGN EXCHANGE TRANSACTIONS

Purchase and Sale Transactions The transaction in foreign exchange market is synonymous with commodity market. While a trader has to purchase goods from his suppliers which he sells to his customers, in a similar way the bank which is authorized to deal in foreign exchange purchases as well as sells its commoditythe foreign currency. Therefore, the foreign currency can be considered as a commodity in foreign exchange dealings. Whenever we talk about foreign exchange two points need to be kept in mind viz., the transaction is always from the banks point of view; and the item referred to is the foreign currency. Therefore, when we say a purchase, we imply that the bank has purchased; and it has purchased foreign currency. Similarly, when we say a sale, we imply that the bank has sold; and it has sold foreign currency. In a purchase transaction the bank acquires foreign currency and parts with home currency. In a sale transaction the bank parts with foreign currency and acquires home currency.

FOREIGN EXCHANGE TRANSACTION

PURCHASE SE

SALE

BANK

BANK

Acquire foreign currency

Parts with home currency

Acquires home currency

Parts with foreign currency

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EXCHANGE QUATATIONS
Methods of Quotation The exchange rate may be quoted in two ways. 1. Direct quotation or home currency quotation and 2.Indirect quotation or foreign currency quotation. For instance, a fruit vendor may express the price of apples in either of the following two ways:

Method I: - One apple costs Rs.10 Method II:-For Rs.100, 10 apples

In both the case the value of apple or the rupee is the same though expressed differently .In method I, the price per apple is quoted in rupees. In method II, the unit of rupees kept constant at 100, and the quantity of fruits is varied to reflect their prices. The same is also true for foreign currency. In foreign exchange also the rate of exchange can be quoted in two ways:

Method I:- USD 1= Rs.43.20 or USD 1=43.30 Method II:-Rs.100 = USD 2.3409 or Rs.100 = 2.3200

The quotation under Method I, in which exchange rate is expressed as the price per unit of one US dollar in terms of the home currency is known as Home Currency Quotation or Direct Quotation. It may be noted that under direct quotation the number of units of foreign currency is kept constant and any change in the US dollar quoted at under different values of rupees.

Under Method II, the unit of home currency is kept constant and the exchange rate is expressed as so many units of foreign currency for a fixed unit of home currency is known as Foreign Currency Quotation or Indirect Quotation. Under indirect quotation, any change in exchange rate will be effected by changing the number of units of foreign currency. For instance, the rate

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Rs.100=USD 2, 3400 may become in due course USD 2.2450 or USD 2.3785, and so on. The indirect quotation is used in London foreign exchange market. In New York and other foreign exchange markets mostly the direct method is in vogue. In India, earlier we had used indirect method. However, from August 2, 1993, India has switched over to direct method of quotation. The change has been introduced in order to simplify and establish transparency in exchange rates in India.

TRANSACTIONS QUOTATIONS

UNDER

DIRECT

AND

INDIRECT

Under direct quotation the bank buys the foreign currency at lower price and selling it to a customer at a higher price. For instance a bank may buy US dollar at Rs.46 and sell at 46.20 and thus book a profit. Therefore, under direct quotation the maxim is buy low; Sell high.

In the case of indirect quotations, while buying, the bank would acquire more units of foreign currency for a fixed unit of home currency and while selling part with lesser units of foreign currency for more units of home currency. Therefore, the maxim under indirect quotation is buy high and sell low.

TWO WAY QUOTATIONS

The first area of mystique in foreign exchange quotations arises from the fact that there are two ways of quoting rates; the direct quote and the indirect quote that we already discussed. The former gives the quotation in terms of the number of units of home currency necessary to buy one unit of foreign currency. The latter gives the quotation in terms of the number of units of foreign currency bought with one unit of home currency. Foreign exchange dealers quote two prices, one for selling and the other for buying. Therefore, in the foreign exchange market; quotations are always for both buying and selling. For instance a bank may quote its rate for dollars as follows: One US dollar=Rs.46.57- 46.75 or Rs.100=USD 2.2432- 2.2768. While in the case of One US dollar=Rs.46.57- 46.75 the first Rs.46.57 is the buying rate, the
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second 46.75 is the selling rate. On the other hand in the case of Rs.100=USD 2.2432- 2.2768, the bank agrees to sell at the rate of USD 2.2432 for Rs.100, the bank is willing to buy at USD 2.2768 for Rs.100. The buying rate is known as the bid rate and the selling rate is known as offer rate. Continental European dealers normally quote via the direct method. In London dealers use the indirect method. In the US, both quotation methods are used. When a bank is dealing with a customer within the US direct quotation is given but when dealing with other banks in Europe (except the UK) the indirect quotation is used. Foreign exchange dealers quote two prices: the rate at which they are prepared to sell a currency and that at which they are prepared to buy. The difference between the bid rate and the offer is the dealers spread which is one of the potential sources of profit for dealers. Whether using the direct quotation method or the indirect quote, the smaller rate is always termed the bid rate and the higher is called the offer or ask rate. The size of the bid/offer spread varies according to the depth of the market and its stability at any particular time. Depth of a market refers to the volume of transactions in a particular currency. Deep markets have many deals, shallow markets have a few. High percentage spreads are associated with high uncertainty and low volume s of transactions in a currency. Lower spreads are associated with stable, high volume markets. Deep markets usually have narrower spreads than shallow one.

SPOT AND FORWARD TRANSACTIONS

In foreign exchange transactions the transactions are not completed on the same date. The actual exchange of currencies may take place at different time periods For instance let us suppose that there are two banks in the foreign exchange transaction. Bank of India agrees to buy from Bank of Baroda, British pounds one lakh. The actual exchange may take place (1) on the same day or (2) two days later or (3) Some day late say after a month.

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Case 1. Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash transaction. It is also known as value today.

Case 2, if the settlement takes place, within two days, the rate of exchange effective for the transaction is known as spot rate.

Case 3, while the delivery and payment takes place after a month, then the transaction in which the exchange of currencies takes place at a specified future date is known as forward transaction.

The forward transaction is an agreement between two parties requiring the delivery of some specified future date of a specified amount of foreign currency by one of the parties against payment in domestic currency by the other party at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transaction is known as forward market.

Cross Rates
A cross rate may be defined as an exchange rate which is calculated from two (or more) other rates. Thus the rate for the Deutschmark to the Swedish crone will be derived as the cross rate from the US dollar to the Deutschmark and the US dollar to the crone. The practice in world foreign exchange market is that currencies are quoted against the US dollar. If one bank asks another bank for its Deutschmark rate, that rate will be quoted against the US dollar unless otherwise specified. Most dealings are done against the US dollar hence it follows that the market rate for a currency at any moment is most accurately reflected in its exchange rate against the US dollar. A bank that was asked to quote sterling against the Swiss franc would normally do so by calculating this rate from the sterling/dollar rate and the dollar/Swiss franc rate. Thus, the cross rates would be used to determine the quotations.
31

This could be explained with the help of an illustration. Let us suppose that we require a quote for Swiss francs against the Deutschmark. The quotation which we would receive was derived through the quote of both currencies against US dollar. If these rates against the dollar were $1=Sfr 1.1326/1.1336 and $1=DM1.3750/1.3755, It would be possible to derive the cross rate for the Swiss franc against Deutschmark. Our aim is to derive the selling and buying rates for Swiss francs in terms of Deutschmarks. If we are selling Swiss francs we will be buying Deutschmarks. So we begin with the rate for selling Swiss francs and buying dollars; we then move to selling dollars and buying Deutschmarks. The amalgamation of these two rates gives us the rate for selling Swiss francs and buying Deutschmarks. The rate for selling Swiss francs to the dealer and buying dollars is Sfr 1.1336; the rate for selling Swiss dollars and buying Deutschmarks is DM 1.3750. So selling $0.8822 gives DM1.2120. Thus the rate for selling Swiss francs and buying Deutschmarks is Sfr 1=DM 1.2130, or DM1=Sfr 0.8244. Example: Let us assume that the interbank rate for US dollar to Indian rupee is $1=Rs.34.2400 34.2600 and the rates in the interbank for US dollar and French franc are $1=French fr 4.9660 -4.9710. From the above information we can arrive at the rupee franc rate as follows:

In the first instance the customer buys US dollar from the market in India at $1 selling rate of Rs.34.2600.The US dollar thus acquired is disposed off in the London market for French franc at the market buying rate $1=French franc4.9660. Therefore the rupee franc rate is:

French franc 1= 34.2600/4.9660=6.8989 or Rs. 6.8990.

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Cross Rates and Chain Rule

In India, buying rates are calculated on the assumption that the foreign exchange acquired is disposed of abroad in the international market and the proceeds realized in US dollars. The US dollars thus acquired would be sold in the local interbank market to realize the rupee. For example, if the bank purchased a CHF 10,000 bill it is assumed that it will sell the Swiss francs at the Singapore market and acquire US dollars there. The US dollars are then sold in the interbank market against Indian rupee. The bank would get the rate for US dollars in terms of Indian rupees in India. This would be the interbank rate for US dollars. It would also get the rate for US dollars in terms of Swiss franc at the Singapore market. The bank has to quote the rate to the customer for Swiss franc in terms of Indian rupees. The fixing of rate of exchange between the foreign currency and Indian rupee through the medium of some other currency is done by a method known as Chain Rule. The rate thus obtained is the Cross rate between these currencies. For example, Let us assume that in the interbank market dollar is quoted at Rs.42.50 and at Singapore market dollar is quoted at CHF 1.8000. From this information the rate of exchange of Swiss Franc in terms of rupees may be calculated as follows: ? RS =CHF 1 .. (1) If CHF 1.8000 =USD 1 .. (2) And USD 1 =Rs.42.50 (3)

It should be noted that the currency which appears as the second item (right hand side) in the first equation appears as first item (left hand side) in the next equation. Thus franc appears on the right hand side in the first equation left hand side in the second equation. US dollar which appears on the right hand side in the second equation appears on the left hand side in the third equation. The rate of exchange

33

between Indian rupee and Swiss franc can be calculated by dividing the product of the right hand side by the product of the left hand side. 42.50 x 1 x 1 / 1.8000 = Rs.26.5620

Ready Rates Based on Cross Rates

The exchange rates for other currencies are quoted to customers based on the rates for the currency concerned prevailing in international foreign exchange markets like London, Singapore and Hong Kong. There rates are available in terms of US dollar. They have to be converted into rupee terms before quoting to the customers. We shall first examine how exchange rate are quoted in international markets and then we shall see how these rates are used for quoting rates for currencies other then US dollar in India. Exchange quotations in International Markets In International markets, barring few exceptions, all rates are quoted in term of US dollar. For instance, at Singapore Swiss franc may be quoted at 1.5425/5440 and Japanese yen at 104.67/70. This should be understood as; USD 1 = CHF 1.5425 1.5440 USD 1 = JPY 104.67 104.70

In interpreting an international market quotation, we may approach from the variable currency or the base currency, viz., the dollar. For instance we may take a transaction in which Swiss franc are received in exchange for dollars as Purchase of Swiss francs against Dollar Sale of Dollar against Swiss francs.

The quotation for Swiss franc is CHF 1.5425 and CHF 1.5440 per Dollar. While buying dollar the quoting bank would part with fewer francs per dollar and while selling dollars would require as many francs as possible. Thus, CHF 1.5425 is the dollar buying rate and DEM 1.5440 is the dollar selling rate. It may be observed that when viewed from dollar, the exchange quotation partakes the character of a direct quotation and the maxim Buy low: Sell high is applicable.

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Forward Margin/Swap Points (Dollar/Foreign Currency Quotation)

At Singapore market dollar may be quoted against Deutsche mark and French franc as follows:

Swiss Franc Spot rate 1 month forward 2 month forward 1.5425/40

Japanese Yen 104.67/70

50/60 70/80

17/16 30/29

The forward margin (also called swap margin or swap points) is quoted in terms of points. A point is the last decimal place in the exchange quotation. Thus in a four digit quotation, a point is 0.0001. In a two decimal quotation it is 0.01 As against Swiss franc, the forward margin for dollar is CHF 0.0050/0.0060. Since the order in which the forward margin is ascending, forward dollar is at premium. Premium is added to the spot rate to arrive at the forward rates, both in respect of purchase and sale transactions. Based on the data given above, the forward rates for dollar against Swiss francs are arrived at as follows;

Dollar Buying 1.5425/40 1 month forward 2 month forward CHF 1.5475 CHF 1.5495

Dollar Selling 104.67/70 1.5500 1.5520

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Foreign Currency/Dollar Quotation

Let us assume the following exchange rates are prevailing

Pound sterling Spot rate 1 Month forward 2 Month forward

Euro

1.4326/48 50/53

0.9525/35 65/62

90/93

84/82

Against dollar, the forward pound sterling is at premium. Premium should be added to the spot rate to arrive at the forward rate. Thus the forward rates for pound sterling are as follows.

Pound sterling Buying 1.5425/40 1 month forward 2 month forward USD 1.4376 USD 1.4416

Pound sterling Selling 104.67/70 1.4401

1.4441

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Currency Terminology
As in other businesses and industries, foreign exchange trading has evolved its own vernacular over time. To outsiders, some of the terminology used by professional forex traders may seem a bit peculiar. But it has become virtually a language unto itself for those that deal with currencies on a daily basis. Here are some of the most common examples of currency terminology: Currency or Currency Pair GBP (British Pound) CAD (Canadian Dollar) USD (U.S. Dollar) AUD (Australian Dollar) NZD (New Zealand Dollar) EUR/USD (Euro/U.S. Dollar) GBP/USD (British Pound/U.S. Dollar) USD/JPY (U.S. Dollar/Japanese Yen) Dollar USD/CHF (U.S. Dollar/Swiss Franc) Dollar USD/CAD (U.S. Dollar/Canadian Dollar) Dollar Sterling Loonie Greenback Aussie Kiwi Euro Cable Yen Swiss or Swissy Canada

Leveraging Margin and Leverage The concepts of margin and leverage are extremely important. Margin is the actual amount of trading equity in a traders account that is available to use for controlling currency positions. Leverage is the multiplier by which a trader can magnify the financial controlling power of margin. Because of the high leverage common in foreign exchange trading, a trader is able to trade a large lot amount like $ 100,000 with only a small fraction of this amount in trading account margin. Common leverage ratios currently offered by foreign exchange brokers range from 50:1 on the low side all the way up to 400:1 on the high side. The sheer magnitude of this level of leverage, even on the low side, far eclipses the amount of leverage available in other financial trading markets.
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In practical terms, what this means to the foreign exchange trader is that a standard lot of $ 100,000, for example, can be traded in the USD/CHF currency pair with only $ 250 in trading account margin. This is assuming that the maximum leverage of 400:1 is utilized. In other words, for every $ 1 that a trader has invested in a forex account, that trader can control a whopping $ 400 in a currency trader. In this particular example, the $ 250 in the traders trading account can control a trade of $ 100,000, using 400:1 leverage. Of course, like many good things in life, the massive amount of leverage offered in foreign exchange trading can be viewed as the proverbial double - edged sword. The fact that a small amount of money controls a large amount of money in forex trading can certainly serve to magnify profit potential. But on the flip side of the coin, the amount of risk inherent in highly leveraged trading like this is equally magnified. Therefore, it is advisable to use caution when trading with the substantial leverage common in forex trading. Highly leveraged trading is aggressive trading that is characterized by both high risk and high potential reward.

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Why Trade Foreign Currencies?

There are many benefits and advantages to trading Forex. Here are just a few reasons why so many people are choosing this market: No commissions:-no clearing fees, no exchange fees, no government fees, no brokerage fees. Brokers are compensated for their services through something called the bid-ask spread. No middlemen:- Spot currency trading eliminates the middlemen, and allows you to trade directly with the market responsible for the pricing on a particular currency pair. No fixed lot size.:-In the futures markets, lot or contract sizes are determined by the exchanges. A standard-size contract for silver futures is 5000 ounces. In spot Forex, you determine your own lot size. This allows traders to participate with accounts as small as $250 (although we explain later why a $250 account is a bad idea). Low transaction costs:- The retail transaction cost (the bid/ask spread) is typically less than 0.1 percent under normal market conditions. At larger dealers, the spread could be as low as .07 percent. Of course this depends on your leverage and all will be explained later. A 24-hour market:- There is no waiting for the opening bell - from Sunday evening to Friday afternoon EST, the Forex market never sleeps. This is awesome for those who want to trade on a part-time basis, because you can choose when you want to trade--morning, noon or night. No one can corner the market:- The foreign exchange market is so huge and has so many participants that no single entity (not even a central bank) can control the market price for an extended period of time. Leverage:- In Forex trading, a small margin deposit can control a much larger total contract value. Leverage gives the trader the ability to make nice profits, and at the same time keep risk capital to a minimum. For example, Forex brokers offer 200 to 1 leverage, which means that a $50 dollar margin deposit would enable a trader to buy or sell $10,000 worth of currencies. Similarly, with $500 dollars, one

39

could trade with $100,000 dollars and so on. But leverage is a double-edged sword. Without proper risk management, this high degree of leverage can lead to large losses as well as gains. High Liquidity:- Because the Forex Market is so enormous, it is also extremely liquid. This means that under normal market conditions, with a click of a mouse you can instantaneously buy and sell at will. You are never "stuck" in a trade. You can even set your online trading platform to automatically close your position at your desired profit level (a limit order), and/or close a trade if a trade is going against you (a stop loss order). Mini and Micro Trading:- You would think that getting started as a currency trader would cost a ton of money. The fact is, compared to trading stocks, options or futures, it doesn't. Online Forex brokers offer "mini" and micro trading accounts, some with a minimum account deposit of $300 or less.

The best currencies for trading

Forex trading is mainly focused on the 5 "main" currencies. This is because the governments of their respective countries are stable, their economies are healthy and their central banks take steps to contain the risk of inflation. The US dollar (USD): The dollar is the most exchanged currency in the world, it represents 86% of all currency trading transactions. The euro (EUR): The euro is the second most exchanged currency, representing 37% of all currency transactions. The euro replaced the German deutschmark, which, prior to the euro's creation, represented 25% of all forex transactions. The Japanese yen (JPY): Coming in at third place, the yen is primarily traded against the dollar and the euro, and it represents 20% of the world's exchanges. The demand for Japanese yen is mainly due to Japanese companies repatriating their sales profits. The yen is therefore affected by those companies' financial results as well as the real estate market. The British pound (GBP): The GBP is the currency that is most often traded against the USD and the EUR, and the fourth worldwide, representing 17% of all

40

currency trading. 34% of all currency trading passes through London's City, which is the currency trading capital of the world. The Swiss franc (CHF): The CHF is perceived as being a safe currency. Its economy is stable but this hardly justifies its rank amongst the major currencies. The fact that investors secure their assets by buying CHF is due to its banking system's solid reputation. The Swiss franc tends to be rather volatile due to its lack of liquidity with regards to the other main currencies. The currencies that trade the most on the forex market The most often traded currency pairs are the EUR/USD (approx. 28% of all volume), the USD/JPY (approx. 17% of all volume), and the GBP/USD (approx. 14% of all volume).

Source: IMF Distribution of world currency

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TRANSACTIONS IN INTERBANK MARKETS

The exchange rates quoted by banks to their customer are based on the rates prevalent in the interbank market. The big banks in the market are known as market makers, as they are willing to buy or sell foreign currencies at the rates quoted by them up to any extent. Depending upon its resources, a bank may be a market maker in one or few major currencies. When a banker approaches the market maker, it would not reveal its intention to buy or sell the currency. This is done in order to get a fair price from the market maker. Dealing Position Foreign exchange is such a sensitive commodity and subject to wide fluctuations in price that the bank which deals in it would like to keep the balance always near zero, The bank would endeavour to find a suitable buyer wherever it purchase so as to dispose of the foreign exchange acquired and be free from exchange risk. Likewise, whenever it sells it tries to cover its position by a corresponding purchase. But, in practice, it is not possible to march purchase and sale for each transaction. So the bank tries to match the total purchases of the day to the days total sales. This is done for each foreign currency separately. If the amount of sales and a purchase of a particular foreign currency is equal, the position of the bank in that
42

currency is said to be square. If the purchases exceed sales, then the bank is said to be in overbought or long position. If the sales exceed purchases, then the bank is said to be in oversold of short position. The banks endeavour would be to keep its position square. If it is in overbought or oversold position, it is exposing itself to exchange risk. There are two aspects of maintenance of dealing positions. One is the total of purchase or sale or commitment of the bank to purchase or sell, irrespective of the fact whether actual delivery has taken place or not. This is known as the exchange position. The other is the actual balance in the banks account with its correspondent abroad, as a result of the purchase or sale made by the bank. This is known as the cash position. Exchange Position Exchange position is the new balance of the aggregate purchases and sales made by the bank in particular currency. This is thus an overall position of the bank in a particular currency. All purchases and sales whether spot or forward are included in computing the exchange position. All transactions for, which the bank has agreed for a firm rate with the counterparty, are entered into the exchange position when this commitment is made. Therefore, in the case of forward contracts, they will enter into the exchange position on the date the contract with the customer is concluded. The actual date of delivery is not considered here. All purchases add to the balance and all sales reduce the balance. The exchange position is worked out every day so as to ascertain the position of the bank in that particular currency. Based on the position arrived at, remedial measures as are needed may be taken. For example, If the bank finds that it is oversold to the extent of USD 25,000. It may arrange to buy this amount from the interbank market. Whether this purchase will be spot or forward will depend upon the cash position. If the bank has commitment of deliver foreign exchange soon, but it has no sufficient balance in the nostro account abroad, it may purchase spot. If the bank has no immediate requirement of foreign exchange, it may buy it forward.
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Examples of sources for the bank for purchase of foreign currency are: (i) Payment of DD, MT, TT, travellers cheques, etc. (ii) Purchase of bills, (iii)Purchase of other instruments like cheques. (iv)Forward purchase contracts (entered to the postion of the date of contracts). (v)Realisation of bills sent for collection. (vi)Purchase in interbank/international markets.

Examples of avenues of sale are: (i) Issue of DD, MT, TT, travelers cheques, etc. (ii) Payments of bills drawn on customers. (iii)Forward sale contract (entered in the position on the date of contracts). (iv)Sale to interbank/international markets. Exchange position is also k now as dealing position.

Cash Position
Cash position is the balance outstanding in the banks nostro account abroad. The stock of foreign currency is held by the bank in the form of balances with correspondent bank in the foreign centre concerned. All foreign exchange dealings of the bank are routed through these nostro accounts. For example, an Indian bank will have an account with Bank of America in New York. If the bank is requested to issue a demand draft in Us dollars. It will issue the draft on Bank of America, New York. On presentation at New York the banks account with Bank of America will be debited. Likewise, when the bank purchases a bill in US dollars, it will be sent for collection to Bank of America. Alternatively, the bill may be sent to another bank in the USA, with instructions to remit proceeds of the bill are credited, on realisation, to the banks account with Bank of America. The purchase of foreign exchange by the bank in India increases the balance and sale of foreign exchange reduces the balance in the banks account with its correspondent bank abroad.
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PIP A pip is a very small measure of change in a currency pair in the forex market. It can be measured in terms of the quote or in terms of the underlying currency. A pip is a standardized unit and is the smallest amount by which a currency quote can change, which is usually $0.0001 for U.S.-dollar related currency pairs, which is more commonly referred to as 1/100th of 1%, or one basis point. This standardized size helps to protect investors from huge losses. For example, if a pip was 10 basis points, a one-pip change would cause more extreme volatility in currency values. Assume that we have a USD/EUR direct quote of 0.7747. What this quote means is that for US$1, you can buy about 0.7747 euros. If there was a one-pip increase in this quote (to 0.7748), the value of the U.S. dollar would rise relative to the euro, as US$1 will allow you to buy slightly more euros. The effect that a one-pip change has on the dollar amount, or pip value, depends on the amount of euros purchased. If an investor buys 10,000 euros with U.S. dollars, the price paid will be US$12,908.22 ([1/0.7747] x 10,000). If the exchange rate for this pair experiences a one-pip increase, the price paid would be $12,906.56 ([1/0.7748] x 10,000). In that case, the pip value on a lot of 10,000 euros will be US$1.66 ($12,908.22 - $12,906.56). If, on the other hand, the same investor purchases 100,000 euros at the same initial price, the pip value will be US$16.6. As this example demonstrates, the pip value increases depending on the amount of the underlying currency (in this case euro) that is purchased Interbank Deals Interbank deals refer to purchase and sale of foreign exchange between the banks. In other words it refers to the foreign exchange dealings of a bank in the interbank market. The main features of interbank deals are given in this section. Cover Deals Purchase and sale of foreign currency in the market undertaken to acquire or dispose of foreign exchange required or acquired as a consequence of the dealings with its customers is known as the cover deal. The purpose of cover deal is to insure the bank against any fluctuation in the exchange rates.
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Since the foreign currency is a peculiar commodity with wide fluctuations in price, the bank would like to sell immediately whatever it purchases and whenever it sells it goes to the market and makes an immediate purchase to meet its commitment. In other words, the bank would like to keep its stock of foreign exchange near zero. The main reason for this is that the bank wants to reduce the exchange risk it faces to the minimum. Otherwise, any adverse change in the rates would affect its profits. Trading Trading refers to purchase and sale of foreign exchange in the market other than to cover banks transactions with the customers. The purpose may be to gain on the expected changes in exchange rates. Funding of Nostro Account Funding of nostro account of the bank is done by realization of foreign exchange in the relevant currency purchased by the bank. If sales exceed purchase to avoid overdraft in the nostro account, the bank would purchase the requisite foreign exchange in the interbank market and arrange for its credit to the nostro account Some of the foreign banks who maintain nostro accounts with the bank may fund the account by arranging remittance through some other bank. Or the foreign bank concerned may request the Indian Bank to credit its rupee account and in compensation credit the account of the Indian bank with it. When required to quote a rate for this transaction, the bank in India, would quote the rate at which it could dispose of the foreign exchange in India, viz., the market buying rate. Exchange margin may not be taken for such transactions. Swap Deals A swap deal is a transaction in which the bank buys and sells the specified foreign currency simultaneously for different maturities. Thus a swap deal may involve: (i) Simultaneously purchase of spot and sale of forward or vice versa; or (ii) Simultaneously purchase and sale, both forward but for different maturities,

46

For Instance, the bank may buy one month forward and sell two months forward. Such a deal is known as forward to forward swap

To be precise, a deal should fulfil the following conditions to be called a swap deal: (i) There should be simultaneous buying and selling of the same foreign currency of same value for different maturities; and (ii) The deal should have been concluded with the distinct understanding between the banks that it is a swap deal.

A swap deal is done in the market at a difference from the ordinary deals. In the ordinary deals, the following factors enter into the rates; (i) The difference between the buying and selling rates; and (ii) The forward margin. i.e. the premium or discount. In a swap deal, the first factor is ignored and both buying and selling are done at the snow rate. Only the forward margin enters into the deal same as the swap difference.

Arbitrage Operations If perfect conditions prevail in the market, the exchange rate for a currency should be the same in all centres. For example, if US dollar is quoted at Rs.49,4000 in Mumbai, it should be quoted at the same rate of Rs. 49,4000 at New York. But under imperfect conditions prevailing, the rates in different centres may be different. Thus at New York Indian rupees may be quoted at Rs.49,4800 per dollar. In such a case, it would be advantageous for a bank in Mumbai to buy US dollars locally and arranged to sell them in New York. Assuming the operations to involve Rs.10 lakhs the profit made by the bank would be: At Mumbai US dollars purchased for Rs.10, 00,000 at Rs.494000 would be (10, 00,000 494000) USD 202429. Amount in rupees realized on selling USD 20,242.91 at New York at Rs.49.4800 would be Rs.100619.
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Therefore, the gross profit made by the bank on the transactions is Rs.1,619. The new profit would be after deducting cable charges, etc., incurred for the transactions. The purchase and sale of a foreign currency in different centres to take advantage of the rate differential is known as arbitrage operations. When the arbitrage operations involve only two currencies, as in our illustrations, it is known as simple or direct arbitrage. Two Way Quotations Typically, the quotation in the interbank market is a two way quotation. It means the rate quoted by the market maker will indicate two prices. One at which it is willing to buy the foreign currency, and the other at which it is willing to sell the foreign currency. For example, a Mumbai bank may quote its rate for US dollar as under USD 1 = Rs 48.1525/1650 More often, the rate would be quoted as 1525/1650 since the players in the market are expected to know the big number i.e., Rs 48. In the given quotation, one rate is Rs.48.1525 per dollar and the other rate is Rs.48.1650. per dollar. Direct Quotation. It will be obvious that the quoting bank will be willing to buy dollars at Rs 48.1525 and sell dollars at Rs 48.1650. If one dollar bought and sold, the bank makes a gross profit of Rs. 0.0125. In a foreign exchange quotation, the foreign currency is the commodity that is being bought and sold. The exchange quotation which gives the price for the foreign currency in terms of the domestic currency is known as direct quotation. In a direct quotation, the quoting bank will apply the rule: Buy low; Sell high. Indirect quotation There is another way of quoting in the foreign exchange market. The Mumbai bank quotes the rate for dollar as:

Rs. 100 = USD 2.0762/0767

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This type of quotation which gives the quantity of foreign currency per unit of domestic currency is known as indirect quotation. In this case, the quoting bank will receive USD 2.0767 per Rs.100 while buying dollars and give away USD 2.0762 per Rs.100 while selling dollars. In other world, he will apply the rule: Buy high: Sell low. The buying rate is also known as the bid rate and selling rate as the offer rate. The difference between these rates is the gross profit for the bank and is known as the Spread.

Spot and Forward transactions The transactions in the interbank market may place for settlement (a) On the same day (b) Two days later (c) Some day late; say after a month

Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash or ready transaction. It is also known as value today. The transaction where the exchange of currencies takes place two days after the date of the contact is known as the spot transaction. For instance, if the contract is made on Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the delivery will take place on the next day, i.e., Thursday. Rupee payment is also made on the same day the foreign currency is received. The transaction in which the exchange of currencies takes places at a specified future date, subsequent to the spot date, is known as a forward transaction. The forward transaction can be for delivery one month or two months or three months etc. A forward contract for delivery one month means the exchange of currencies will take place after one month from the date of contract. A forward contract for delivery two months means the exchange of currencies will take place after two months and so on.

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Forward Margin/Swap points Forward rate may be the same as the spot rate for the currency. Then it is said to be at par with the spot rate. But this rarely happens. More often the forward rate for a currency may be costlier or chapter tan its spot rate. The rate for a currency may be costlier or cheaper than its spot rate. The difference between the forward rate and the spot rate is known as the forward margin or swap points. The forward margin may be either at premium or at discount. If the forward margin is at premium, the foreign currency will be costlier under forward rate than under the spot rate. If the forward margin is at discount, the foreign currency will be cheaper for forward delivery then for spot delivery. Under direct quotation, premium is added to spot rate to arrive at the forward rate. This is done for both purchase and sale transactions. Discount is deducted from the spot rate to arrive at the forward rate. Interpretation of Interbank quotations The market quotation for a currency consists of the spot rate and the forward margin. The outright forward rate has to be calculated by loading the forward margin into the spot rate. For instance, US dollar is quoted as under in the interbank market on 25th January as under: Spot USD 1 = Rs.48.4000/4200 Spot/February - 2000/2100 Spot/March -3500/3600

The following points should be noted in interpreting the above quotation; The first statement is the spot rate for dollars. The quoting bank buying rate is Rs.48.4000 and selling rate is Rs.48.4200. The second and third statements are forward margins for forward delivery during the months of February. Spot/March respectively. Spot/February rate is valid for delivery end February. Spot/March rate is valid for delivery end March.

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The margin is expressed in points, i.e., 0.0001 of the currency. Therefore the forward margin for February is 20 paisa and 21 paisa. The first rate in the spot quotation is for buying and second for selling the foreign currency. Correspondingly, in the forward margin, the first rate relates to buying and the second to selling. Taking Spot/February as an example, the margin of 20 paisa is for purchase and 21 paisa is for sale of foreign currency.

Where the forward margin for a month is given in ascending order as in the quotation above, it indicates that the forward currency is at premium. The outright forward rates arrived at by adding the forward margin to the spot rates.

The outright forward rates for dollar can be derived from the above quotations follows

Buying rate February Spot rate Add; Premium 48.4000 0.2000 48.6000 March 48.4000 0.3500 48.7500

Selling rates February 48.4200 0.2100 48.6300 March 48.4200 0.3600 48.7800

From the above calculation we arrive at the following outright rates; Buying Selling

Spot delivery Forward delivery February Forward delivery March

USD 1 = Rs. 48.4000 48.6000 48.7500

48.4200 48.6300 48.7800

If the forward currency is at discount, it would be indicated by quoting the forward margin in the descending order. Suppose that on 20th April, the quotation for pound sterling in the interbank market is as follows:
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Spot Spot/May Spot/June

GBR 1 = Rs. 73.4000/4300 3800/3600 5700/5400

Since the forward margin is in descending order (3800/3600), forward sterling is at discount. The outright forward rates are calculated by deducting the related discount from the spot rate. Thus is shown below:

Buying rate May Spot rate 73.4000 0.3800 73.0200 June 73.4000 0.5700 72.8300

Selling rates May 73.4300 0.3600 73.0700 June 73.4300 0.5400 72.8900

Less; discount

From the above calculations the outright rates for pound sterling cab be restated as follows; ` Spot GBR Forward delivery May Forward delivery June Buying 1 = Rs. 73.4000 73.0200 72.8300 Selling 73.4300 73.0700 72.8900

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Merchant Rate
The foreign exchange dealing of a bank with its customer is known as merchant business and the exchange rate at which the transaction takes place is the merchant rate. The merchant business in which the contract with the customer to buy or sell foreign exchange is agreed to and executed on the same day is known as ready transaction or cash transaction. As in the case of interbank transactions a value next day contract is deliverable on the next business day and a spot contract is deliverable on the second succeeding business day following the date of the contract. Most of the transactions with customers are on ready basis. In practice, the term ready and spot are used synonymously to refer to transactions concluded and executed on the same day. Basis for Merchant Rates When the bank buys foreign exchange from the customer, it expects to sell the same in the interbank market at a better rate and thus make a profit out of the deal. In the interbank market, the bank will accept the rate as dictated by the market. It can, therefore, sell foreign exchange in the market at the market buying rate for the currency concerned. Thus the interbank buying rate forms the basis for quotation of buying rate by the bank to its customer. Similarly, when the bank sells foreign exchange to the customer, it meets tele commitment by purchasing the required foreign exchange from the interbank market. It can acquire foreign exchange from the market at the market selling rate. Therefore the interbank selling rate forms the basis for quotation of selling rate to the customer buy the bank. The interbank rate on the basis of which the bank quotes its merchant rate is known as the base rate. Exchange Margin If the bank quotes the base rate to the customer, it makes no profit. On the other hand, there are administrative costs involved. Further the deal with the customer takes p-lace first. Only after acquiring or selling the foreign exchange from to the customer, the bank goes to the interbank market to sell or acquire the foreign exchange required to cover the deal with the customer. An hour or two might have lapsed by this time. The exchange rates are fluctuating constantly and by the time
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the deal with the market is concluded, the exchange rate might have turned adverse to the bank. Therefore sufficient margin should be built into the rate to cover the administrative cost, cover the exchange fluctuation and provide some profit on the transaction to the bank. This is done by loading exchange margin to the base rate. The quantum of margin that is built into the rate is determined by the bank concerned, keeping with the market trend.

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Forex Risk Management

The following are the major risks in foreign exchange dealings (a) Open Position Risk (b) Cash Balance Risk (c) Maturity Mismatches Risk (d) Credit Risk (e) Country Risk (f) Overtrading Risk (g) Fraud Risk, and (h) Operational Risks Open Position Risk The open position risk or the position risk refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by a bank. Hence, this can also be called the rate risk. The risk can be avoided by keeping the position in foreign exchange square. The open position in a foreign currency becomes inevitable for the following reasons: (a) The dealing room may not obtain reports of all purchases of foreign currencies made by branches on the same day. (b) The imbalance may be because the bank is not able to carry out the cover operation in the interbank market. (c) Sometimes the imbalance is deliberate. The dealer may foresee that the foreign currency concerned may strengthen. Cash Balance Risk Cash balance refers to actual balances maintained in the nostro accounts at the end-of each day. Balances in nostro accounts do not earn interest: while any overdraft involves payment of interest. The endeavour should, therefore, be to keep the minimum required balance in the nostro accounts. However, perfection on the count is not possible. Depending upon the requirement for a single currency more than one nostro account may be maintained. Each of these accounts is operated by a large number of branches. Communication delays from branches to the dealer or from the foreign bank to the dealer may result in distortions.
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Maturity Mismatches Risk

This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby leaving a gap at the end of each period. Therefore, this risk is also known as liquidity risk or gap risk Mismatches in position may arise out of the following reasons: (i) Under forward contracts, the customers may exercise their option on any day during the month which may not match with the option under the cover contract with the market with maturity towards the month end. (ii) Non-availability of matching forward cover in the market for the volume and maturity desired. (iii) Small value of merchant contracts may not aggregative to the round sums for which cover contracts are available. (iv) In the interbank contracts, the buyer bank may pick up the contract on any day during the option period. (v) Mismatch may deliberately created to minimise swap costs or to take advantage of changes in interest differential or the large swings in the demand for spot and near forward currencies. Credit Risk Credit Risk is the risk of failure of the counterparty to the contract Credit risk as classified into (a) contract risk and (b) clean risk. Contract Risk It arises when the failure of the counterparty is known to the bank before it executes its part of the contract. Here the bank also refrains from the contract. The loss to the bank is the loss arising out of exchange rate difference that may arise when the bank has to cover the gap arising from failure of the contract. Clean Risk Arises when The bank has executed the contract, but the counterparty does not. The loss to the bank in this case is not only the exchange difference, but the entire amount already deployed. This arises, because, due to time zone differences between different centres, one currently is paid before the other is received.
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Country Risk Also known as sovereign risk or transfer risk, country risk relates to the ability and willingness of a country to service its external liabilities. It refers to the possibility that the government as well other borrowers of a particular country may be unable to fulfil the obligations under foreign exchange transactions due to reasons which are beyond the usual credit risks. For example, an importer might have paid for the import, but due to moratorium imposed by the government, the amount may not be repatriated. Overtrading Risk A bank runs the risk of overtrading if the volume of transactions indulged by it is beyond its administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank may take up large deals, which a normal prudent bank would have avoided. The deals may take speculative tendencies leading to hug losses. Viewed from another angle, other operators in the market would find that the counterparty limit for the bank is exceeded and quote further transactions at higher premium. Expenses may increase at a faster rate than the earnings. There is, therefore, a need to restrict the dealings to prudent limits. The tendency to overtrading is controlled by fixing the following limits: (a) A limit on the total value of all outstanding forward contracts; and (b) A limit on the daily transaction value for all currencies together (turnover limit). Fraud Risk Frauds may be indulged in by the dealers or by other operational staff for personal gains or to conceal a genuine mistake committed earlier. Frauds may take the form of the dealings for ones own benefit without putting them through the bank accounts. Undertaking unnecessary deals to pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks and customers, etc. The following procedural measures are taken to avoid frauds: (a) Separation of dealing form back-up and accounting functions. (b) On-going auditing, monitoring of positions, etc., to ensure compliance with procedures.
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(c) Regular follow-up of deal slips and contract confirmations. (d) Regular reconciliation of nostro balances and prompts follow-up unreconciled items. (e) Scrutiny of branch reports and pipe-line transactions. (f) Maintenance of up-to records of currency position, exchange position and counterparty registers, etc. Operational Risk These risks include inadvertent mistakes in the rates, amounts and counterparties of deals, misdirection of funds, etc. The reasons may be human errors or administrative inadequacies. The deals are done over telecommunication and mistakes may be found only when the written confirmations are received later.

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Factors Determining Exchange Rates

Balance of Payments o Balance of Payments represents the demand for and supply of foreign exchange which ultimately determine the value of the currency. Exports, both visible and invisible, represent the supply side for foreign exchange. Imports, visible and invisible, create demand for foreign exchange. Put differently, export from the country creates demand for the currency of the country in the foreign exchange market. The exporters would offer to the market the foreign currencies they have acquired and demand in exchange the local currency. Conversely, imports into the country will increase the supply of the currency of the country in the foreign exchange market. o When the balance of payments of a country is continuously at deficit, it implies that the demand for the currency of the country is lesser than its supply. Therefore, its value in the market declines. If the balance of payments is surplus continuously it shows that the demand for the currency in the exchange market is higher than its supply therefore the currency gains in value. Inflation o Inflation in the country would increase the domestic prices of the commodities. With increase in prices exports may dwindle because the price may not be competitive. With the decrease in exports the demand for the currency would also decline; this in turn would result in the decline of external value of the currency. It may be noted that unit is the relative rate of inflation in the two countries that cause changes in exchange rates. If, for instance, both India and the USA experience 10% inflation, the exchange rate between rupee and dollar will remain the same. If inflation in India is 15% and in the USA it is 10%, the increase in prices would be higher in India than it is in the USA. Therefore, the rupee will depreciate in value relative to US dollar.

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o Empirical studies have shown that inflation has a definite influence on the exchange rates in the long run. The trend of exchange rates between two currencies has tended to hover around the basic rate discounted for the inflation factor. The actual rates have varied from the trend only by a small margin which is acceptable. o However, this is true only where no drastic change in the economy of the country is. New resources found may upset the trend. Also, in the short run, the rates fluctuate widely from the trend set by the inflation rate. These fluctuations are accounted for by causes other than inflation. Interest rate o The interest rate has a great influence on the short term movement of capital. When the interest rate at a centre rises, it attracts short term funds from other centers. This would increase the demand for the currency at the centre and hence its value. Rising of interest rate may be adopted by a country due to tight money conditions or as a deliberate attempt to attract foreign investment. o Whatever be the intention, the effect of an increase in interest rate is to strengthen the currency of the country through larger inflow of investment and reduction in the outflow of investments by the residents of the country. Money Supply o An increase in money supply in the country will affect the exchange rate through causing inflation in the country. It can also affect the exchange rate directly. o An increase in money supply in the country relative to its demand will lead to large scale spending on foreign goods and purchase of foreign investments. Thus the supply of the currency in the foreign exchange markets is increased and its value declines. The downward pressure on the external value of the currency then increases the cost of imports and so adds to inflation.

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o The effect of money supply on exchange rate directly is more immediate than its effect through inflation. While in the long run inflation seems to correlate exchange rate variations in a better way, in the short run exchange rates move more in sympathy with changes in money supply. One explanation of how changes in money supply vary the exchange rate is this; the total money supply in the country represents the value of total commodities and services in the country. Based on this the outside world determines the external value of the currency. If the money supply is doubles, the currency will be valued at half the previous value so as to keep the external value of the total money stock of the country constant. Another explanation offered is that the excess money supply flows out of the country and directly exerts a pressure on the exchange rate. The excess money created, the extent they are in excess of the domestic demand for money, will flow out of the country. This will increase the supply of the currency and pull down its exchange rate. National Income o An increase in national income reflects increase in the income of the residents of the country. This increase in the income increases the demand for goods in the country. If there is underutilized production capacity in the country, this will lead to increase in production. There is a chance for growth in exports too. But more often it takes time for the production to adjust to the increased income. Where the production does not increase in sympathy with income rise, it leads to increased imports and increased supply of the currency of the country in the foreign exchange market. The result is similar to that of inflation, viz., and decline in the value of the currency. Thus an increase in national income will lead to an increase in investment or in consumption, and accordingly, its effect on the exchange rate will change. Here again it is the relative increase in national incomes of the countries concerned that is to be considered and not the absolute increase.

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Resource Discoveries o A good example can be the role played by oil in exchange rates. When the supply of oil from major su o ppliers, such as Middles East, became insecure, the demand from the currencies of countries self sufficient in oil arose. o Previous oil crisis favoured USA, Canada, UK and Norway and adversely affected the currencies of oil importing countries like Japan and Germany. Similarly, discovery oil by some countries helped their currencies to gain in value. The discovery of North Sea oil by Britain helped pound sterling to rise to over USD 2.40 from USD 1.60 in a couple of years. Canadian dollar also benefited from discoveries of oil and gas off the Canadian East Coast and the Arctic.

Capital Movements o There are many factors that influence movement of capital from one country to another. Short term movement of capital may be influenced by the offer of higher interest in a country. If interest rate in a country rises due to increase in bank rate or otherwise, there will be a flow of short term funds into the country and the exchange rate of the currency will rise. Reverse will happen in case of fall in interest rates. Bright investment climate and political stability may encourage portfolio investments in the country. This leads to higher demand for the currency and upward trend in its rate. Poor economic outlook may mean repatriation of the investments leading to decreased demand and lower exchange value for the currency of the country. Movement of capital is also caused by external borrowing and assistance. Large scale external borrowing will increase the supply of foreign exchange in the market. This will have a favorable effect on the exchange rate of the currency of the country. When repatriation of principal and interest starts the rate may be adversely affected.

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Political factors o Political stability induced confidence in the investors and encourages capital inflow into the country. This has the effect of strengthening the currency of the country. On the other hand, where the political situation in the country is unstable, it makes the investors withdraw their investments. The outflow of capital from the country would weaken the currency. Any news about change in the government or political leadership or about the policies of the government would also have the effect of temporarily throwing out of gear the smooth functioning of exchange rate mechanism.

Mergers and Acquisitions o While merger and acquisition activity is the least important factor in determining the long-term direction of currencies, it can be the most powerful force in staging near-term currency moves. Merger and acquisition activity occurs when a company from one economic region wants to make a transnational transaction and buy a corporation from another country. o If, for example, a European company wants to buy a Canadian asset for $20 billion, it would have to go into the currency market and acquire the currency to affect this transaction. Typically, these deals are not price sensitive, but time sensitive because the acquirer may have a date by which the transaction is to be completed. Because of this underlying dynamic, merger and acquisition flow can exert a very strong temporary force on FX trading, sometimes skewing the natural course of currency flow for days or weeks.

Purchasing Power Parity o The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. The PPP forecasting approach is based off of the theoretical Law of One Price, which states that identical goods in different countries should have identical prices.

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o For example, this law argues that a pencil in Canada should be the same price as a pencil in the U.S. after taking into account the exchange rate and excluding transaction and shipping costs. In other words, there should be no arbitrage opportunity for someone to buy pencils cheap in one country and sell them in another for a profit. o Based on this underlying principle, the PPP approach forecasts that the exchange rate will change to offset price changes due to inflation. For example, suppose that prices in the U.S. are expected to increase by 4% over the next year while prices in Canada are expected to rise by only 2%. The inflation differential between the two countries is: o 4% - 2% = 2% o This means that prices in the U.S. are expected to rise faster relative to prices in Canada. In this situation, the purchasing power parity approach would forecast that the U.S. dollar would have to depreciate by approximately 2% to keep prices between both countries relatively equal. So, if the current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would forecast an exchange rate of: (1 + 0.02) x (US$0.90per CA$1) = US$0.918per CA$1 o Meaning it would now take 91.8 cents U.S. to buy one Canadian dollar. Speculation o Speculation in a currency raises or lowers the exchange rate. For instance, the foreign exchange market in Kenya is very shallow. If a speculator enters and buys US $1 million, it will raise the value of the US dollar significantly. If a few others do so too, the price of the US dollar will rise even further against the Kenya shilling.
o

The most famous speculator in foreign currency is Mr George Soros who made over a billion pounds sterling in Europe (by correctly predicting the devaluation of the pound) and then is believed to have triggered the free fall of the currencies of South-east Asia.
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Governments Monetary and Fiscal Policies o Governments, through their monetary and fiscal policies affect international trade, the trade balance and the supply and demand for a currency. Increasing the supply of money raises prices and makes imports attractive. Fiscal surpluses will slow economic growth and this will reduce demand for imports and encourage exports. The effectiveness of the policy depends on the price and income elasticitys of demand for the particular goods. High price elasticity of demand means the volume of a good is sensitive to a change in price. o Monetary and fiscal policy supports the currency through a reduction in inflation. These also affect exchange rate through the capital account. Net capital inflows supply direct support for the exchange rate. o Central governments control monetary supply and they are expected to ensure that the governments monetary policy is followed. To this extent they could increase or decrease money supply. For example, the Reserve Bank of India, to curb inflation, restricted and cut money supply. In Kenya, the central bank in order to attract foreign money into the country is offering very high rates on its treasury bills. o In order to maintain exchange rates at a certain price the central bank will also intervene either by buying foreign currency (when there is an excess in the supply of foreign exchange) and selling foreign currency (when demand for foreign exchange exceeds supply). This is known as central bank intervention. o It must be noted that the objective of monetary policy is to maintain stability and economic growth and central banks are expected to - by increasing/decreasing money supply, raising/lowering interest rates or by open market operations - maintain stability.

Exchange Rate Policy and Intervention o Exchange rates are also influenced, in no small measure, by expectation of change in regulations relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market. As explained before, intervention is the buying or selling of
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foreign currency to increase or decrease its supply. Central banks often intervene to maintain stability. It has also been experienced that if the authorities attempt to half-heartedly counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur.

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Interest Rates
Interest rate is the price demanded by the lender from the borrower for the use of borrowed money. In other words, interest is a fee paid by the borrower to the lender on borrowed cash as a compensation for forgoing the opportunity of earning income from other investments that could have been made with the loaned cash. Thus, from the lenders perspective, interest can be thought of as an "opportunity cost or "rent of money" and interest rate as the rate at which interest (or opportunity cost) accumulates over a period of time. The longer the period for which money is borrowed, the larger is the interest (or the opportunity cost). The amount lent is called the principal. Interest rate is typically expressed as percentage of the principal and in annualized terms. From a borrowers perspective, interest rate is the cost of capital. In other words, it is the cost that a borrower has to incur to have access to funds. Factors affecting the level of Interest Rate Interest rates are typically determined by the supply of and demand for money in the economy. If at any given interest rate, the demand for funds is higher than supply of funds, interest rates tend to rise and vice versa. Theoretically speaking, this continues to happen as interest rates move freely until equilibrium is reached in terms of a match between demand for and supply of funds. In practice, however, interest rates do not move freely. The monetary authorities in the country (that is the central bank of the country) tend to influence interest rates by increasing or reducing the liquidity in the system. Broadly the following factors affect the interest rates in an economy: Monetary Policy The central bank of a country controls money supply in the economy through its monetary policy. In India, the RBIs monetary policy primarily aims at price stability and economic growth. If the RBI loosens the monetary policy (i.e., expands money supply or liquidity in the economy), interest rates tend to get
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reduced and economic growth gets spurred; at the same time, it leads to higher inflation. On the other hand, if the RBI tightens the monetary policy, interest rates rise leading to lower economic growth; but at the same time, inflation gets curbed. So, the RBI often has to do a balancing act. The key policy rate the RBI uses to inject/remove liquidity from the monetary system is the repo rates. Changes in repo rates influence other interest rates too. Growth in the economy If the economic growth of an economy picks up momentum, then the demand for money tends to go up, putting upward pressure on interest rates. Inflation: Inflation is a rise in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency. So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against the adverse impact of higher inflation. As a result, with rising inflation, interest rates tend to rise. The opposite happens when inflation declines. Global liquidity If global liquidity is high, then there is a strong chance that the domestic liquidity of any country will also be high, which would put a downward pressure on interest rates. Uncertainty If the future of economic growth is unpredictable, the lenders tend to cut down on their lending or demand higher interest rates from individuals or companies borrowing from them as compensation for the higher default risks that arise at the time of uncertainties or do both. Thus, interest rates generally tend to rise at times of uncertainty. Of course, if the borrower is the Government of India, then the lenders have little to worry, as the government of a country can hardly default on its loan taken in domestic currency.

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Impact of interest rates

There are individuals, companies, banks and even governments, who have to borrow funds for various investment and consumption purposes. At the same time, there are entities that have surplus funds. They use their surplus funds to purchase bonds or Money Market instruments. Alternatively, they can deposit their surplus funds with borrowers in the form of fixed deposits/ wholesale deposits. Changes in the rate of interest can have significant impact on the way individuals or other entities behave as investors and savers. These changes in investment and saving behavior subsequently impact the economic activity in a country. For example, if interest rates rise, some individuals may stop taking home loans, while others may take smaller loans than what they would have taken otherwise, because of the rising cost of servicing the loan. This will negatively impact home prices as demand for homes will come down. Also, if interest rates rise, a company planning an expansion will have to pay higher amounts on the borrowed funds than otherwise. Thus the profitability of the company would be affected. So, when interest rates rise, companies tend to borrow less and invest less. As the demand for investment and consumption in the economy declines with rising interest, the economic growth slows down. On the other hand, a decline in interest rates spurs investment spending and consumption spending activities and the economy tends to grow faster

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A Healthy Interest in Global Bank Rates

Global interest rates are one of the primary drivers of currency exchange rates. Generally speaking, when all other variables are kept equal, rising interest rates (central bank tightening) have a tendency to contribute to an appreciation in a currency. This is because higher - yielding currencies attract more demand from large institutional investors, who are consistently in search of ways to earn more on their money. If, on the other hand, there is a lowering of interest rates (central bank easing), the tendency is towards a depreciation of the currency. This is due to decreasing demand by the institutional investors, who generally tend to move their money away from lower - yielding assets. Although this may constitute a simplistic assumption regarding international capital flows, as so many other factors contribute to exchange rate movement, interest rates generally tend to exert their influence in this manner. It should be kept in mind, from a foreign exchange trading perspective, that the appreciation or depreciation in an exchange rate is less a product of the absolute value of the interest rate than the direction of change in the interest rate. In other words, although the current interest rate for a countrys currency is important in helping the market to determine its exchange value, the direction of interest rate change is even more important. Just because a currency carries a high - yield does not ensure an appreciation in the exchange rate. But if the currencys central bank continues to raise interest rates and indicates an intention to keep doing so, this can have a considerable impact on appreciation in the currency. Changes in interest rates are initiated by central bank policy. In the United States, this central bank is the Federal Reserve (informally called the Fed ). Other major central banks include the European Central Bank (ECB), the Bank of England (BOE), the Bank of Japan (BOJ), the Bank of Canada (BOC), and the Reserve Bank of Australia (RBA). These institutions make decisions that help determine the direction of interest rates. In adjusting interest rates, central banks seek to achieve a delicate balance between attaining a significant level of economic growth while staving off excessive inflation. A certain controlled level of inflation is necessary for
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economic growth, as a country without inflation is a sign of a stagnant economy. At the same time, however, excessive inflation can be enormously disadvantageous to an economy and its consumers. Therefore, each central bank must take both goals of economic growth and inflation control into serious consideration when setting monetary policy. In view of these goals, there are a couple of primary reasons why a central bank would seek to change interest rates. These are by no means the only reasons, but they are usually among the most compelling ones for central banks. Generally speaking, central banks will look to increase interest rates (tighten) in order to help stave off excessive inflation. Conversely, central banks will look to decrease interest rates (ease) in order to help stimulate economic growth. Either way, central banks have the power to impact the foreign exchange markets enormously by making changes in interest rate policy. Often, an actual change in rate policy is not even needed to affect a currencys value. Merely a comment hinting at potential policy intention within a speech by the Fed chairman, for example, is often sufficient to trigger drastic price moves. This highlights the fact that it is not as much the actual fundamentals that move currency exchange rates. Rather, it is more the traders collective perceptions and expectations of the fundamentals that truly drive these markets.

INTEREST RATES IN MAJOY ECONOMIES

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The Role of Inflation

Inflation is in many ways the elusive enemy of central banks throughout the world. Much progress has been made over the decades. In the period of 1973 through 1987, inflation levels in industrialized countries were near the 7.5 percent range. A decade later, in 1989, inflation levels ranged at the much lower level of 3 percent. Today, all you have to do is read the central banks public documents to realize that their major mission is to contain inflation. Many central banks, in fact, announce inflation targets. Central banks around the world monitor inflation and raise interest rates to try to slow down inflation. Central banks often include in their statements accompanying interest rate decisions that they will be vigilant over potential risks of inflation. This is commonly known as being an inflation hawk. Whenever inflation is feared to be lingering in the economy, traders interpret this fear as raising the probability that the interest rates will increase. A fear of lingering inflation tends to generate in the market the anticipation of higher rates, and therefore works to support the buying of a currency. That is also why strong retail prices tend to undermine bond prices. Bondholders fear increased rates because they reduce the attractiveness of the bonds they hold, and the market lowers the prices of the bonds in order to equalize the yield of the old bonds with the new interest rates. Inflation is the ever-present yet stealthy ghost that spooks the forex market and challenges central banks. It is particularly difficult to track. There is ongoing controversy even among the best economists on how to measure and detect inflation, and as a result there are many data sets relating to inflation. Central banks all over the world are trying to get an accurate answer to the question of what is true core inflation. This level of complexity in measuring inflation sets up the forex market for surprises when data comes along that inflation has not been contained. If central banks cant be accurate in measuring inflation, why should an individual trader? Surprises can be expected.
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For example, in December 2006, when inflation data rose the highest in 30 years, it provided a boost in the dollar value as more traders were betting that the Fed would not decrease rates, or might even increase rates. Speaking of the challenge in interpreting monthly inflation numbers during his tenure on the Federal Reserve Board, former vice chairman Alan Blinder said, The name of the game then was distinguishing the signal from the noise, which was often difficult. The key question on my mind was typically: What part of each months observation on inflation is durable and what part is fleeting. The challenge to getting a true measure of inflation has also been a focus of recent activity in the world. The Office of National Statistics is introducing a new inflation calculator that allows persons to calculate their own inflation measure! In other words, the other measures [such as the Retail Price Index (RPI), the Retail Price Index excluding Mortgage Payments (RPIX), and the Harmonized Index of Consumer Prices (HCIP)] are still in force, but there is recognition that inflation needs more measures for an accurate assessment. INFLATION IN INDIA. Today, the biggest concern facing the country is rising prices. Food inflation shot up to 8.55% for the week ended May 14, the highest level in four weeks, as prices of fruits, cereals and protein-based items escalated. Food inflation, as measured by the Wholesale Price Index (WPI), was on a declining trajectory for the previous three weeks. The figure for the seven-day period under review was 1.08 percentage points higher than the 7.47% inflation rate recorded in the previous week. During the week ended May 14, cereals became costlier by 5.03% year-onyear and prices of onions were up by 8.32%, official data released here showed. Prices of fruit rose by 32.37%, milk by 5.53% and eggs, meat and fish by 8.26%. Rice also became 2.63% more expensive and potatoes 0.17% costlier on an annual basis. Food inflation remained in double digits for most of 2010, before showing signs of moderation from March, 2011. Prices of vegetables and pulses have declined by 1.46% and 9.49%, respectively. Also, wheat became cheaper by 0.30% on an
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annual basis. On an annual basis, the primary articles category saw an inflation rate of 11.60%. On the other hand, prices of non-food primary articles were up 23.22% during the week under review. Fibers became dearer by almost 61%, while minerals were up 11.78%. The government and Reserve Bank had said that in the months to come, inflationary pressure would be more from core (non-food) items on account of high global prices of commodities, particularly crude.

Source:-www.rbi.co.in

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Economic Growth
Interest rate and inflation levels are the main ingredients of forex price movements, and economic growth data follows closely in shaping the currency flows. Countries that are experiencing economic growth generate more jobs in their economy. Consumer spending therefore increases. In turn, the demand for housing increases as people have more disposable income and can better afford housing. Other sectors, such as the auto sector, also experience changes in demand as consumers propensity to spend reflects greater confidence regarding their economic conditions. The transactions of a modern economy intimately involve global flows of capital as exports and imports are part and parcel of the vitality of an economy. The term economic growth is really a wide category. How is economic growth measured and tracked by the forex trader? The rate of economic growth or development of a country is mainly measured essentially by its gross domestic product (GDP), so news about GDP becomes an essential ingredient in shaping trader sentiment about the value of a currency. A slowdown or expected slowdown in GDP translates into anticipation that interest rates will not go higher or may even decrease. This anticipation results in pressures to lower a currencys value. The importance of economic development statistics in currency trading is evidenced by the fact that whenever an economic data release is scheduled, the currency market hesitates in its price movements and then often moves vigorously when the news surprises the market. In fact, one of the best times to trade is after a news release Amid rising global commodity prices and high inflation, the government is likely to scale down India's GDP growth projection for the 2011-12 financial year next month from 9% estimated in February, Chief Economic Advisor Kaushik Basu said. "This year because of changing global scenario and many other important organisations having downgraded India's growth rate, we have decided that we would go back and take another look at our (GDP) numbers in mid-June,"
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IMF has pegged India's economic growth at 8.2% in 2011, while RBI sees it at 8% in the fiscal. However rise in crude prices may dent India's economic growth to 8% in 2011-12. India's GDP growth rate for 2010-11 has been pegged at 8.6%, while it was 8% in the previous fiscal. Average price for Indian basket of crude oil in the last fiscal was $85.09 per barrel, but current fiscal's average price stands at $110.55 per barrel. Inflation stood at 8.66% in April, much above the Reserve Bank's comfort level of 5-6%. Food inflation was 8.55% for the week ended May 14. Economic growth of India can be easily seen through Rising per capita income Rising growth rate Rising investments of the people Rising Telecom users Rising Automobile sales Rising Social sector spending Rising FDI and FII in India.

YEAR 2004 2005 2006 2007 2008 2009 2010 2011

GDP - real growth rate 8.30% 6.20% 8.40% 9.20% 9.00% 7.40% 7.40% 8.30%

Source:-www.rbi.co.in

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GDP GROWTH RATES

10 9 8 7 6.2 4.3 8.3 8.4 9.2 9 8.3 7.4 7.4

rates(%)

6 5 4 3 2 1 0 2003 2004 2005 2006 2007 years 2008 2009 2010 2011

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THE ROLE OF CRUDE OIL

Crude oil and its derivative products fuel the engine of economic growth. As long as the world is dependent on hydrocarbon-based energy, oil prices become a factor in stimulating or delaying economic growth. In the near term, higher oil prices result in reducing economic growth expectations as well. Higher hydrocarbon prices portend increases in transportation costs and the per unit cost of outputs in the economy, and therefore become an inflationary factor in the costs of goods. More importantly, crude oil prices moving quickly higher disrupts anticipated prices and further encourages fears of slowdowns. One of the most important aspects of oil prices is that the market reaction to oil price increases often tends to overemphasize its importance, particularly for the U.S. economy. Recent research shows that a 100 percent increase in the price of crude oil . . . translates into only a 3.2 percent price increase in the typical basket of consumption goods. Since unrefined oil is not a consumer good, the oil price shock is passed through indirectly in the prices of many other goods and services A quick rise in oil prices, or even just the fear of a rise, offers trading opportunities. Hurricane Katrina is a good example, as we saw some countries benefit from high crude oil prices, while others did not. The result impacts currency prices as well. Closely tracking oil is important in shaping currency-trading strategies. Oil has another impact. Oil-producing countries have amassed huge sums of money, and what they do with their increasing petrodollars impacts currency values. The International Monetary Fund (IMF) reported that the surplus of dollars to oil producers amounts to $500 billion! The economies of Organization of Petroleum Exporting Countries (OPEC) nations are accumulating current account surplus due to petrodollars that are nearing 30 percent of their GDP! If oil producers start to shift into nondollar assets such as the euro and pound sterling, the dollar fundamentally weakens.

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OIL PRICE MOVEMENT WITH INTEREST RATE

160 140 120 prices/rates 100 80 60 40 20 0 31/01/2007 31/01/2008 31/01/2009 years oil prices INDIA'S INTEREST RATE 31/01/2010 31/01/2011

oil prices
160 140 120 100 80 60 40 20 0 31/01/2007 31/01/2008 31/01/2009 oil prices 31/01/2010 31/01/2011

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10 9 8 7 6 5 4 3 2 1 0 Oct/07 Oct/08 Oct/09 Oct/10 Jan/07 Jan/08 Jan/09 Jan/10

Apr/10

Apr/07

Apr/08

Apr/09

Jan/11

Jul/07

Jul/08

Jul/09

Jul/10

INDIA'S INTEREST RATE

The China Factor

China is becoming increasingly important to forex traders in evaluating trading opportunities. Watching Chinese economic developments is likely to become a daily pastime for many traders all over the world. Since the 1970s, Chinas growth rate has been approaching over 10 percent per year. In 2006, the Chinese reported that Chinas gross domestic product (GDP) reached 20.94 trillion yuan, up 10.7 percent from the year before (Financial Times Information). Almost every day there is news on Chinas economic performance. China is impacting every region of the world and every industry. For example, the Chinese Ministry of Information Industry reported that China has the worlds second largest population of Internet users after the United States, with 137 million people online. In March 2007, China replaced the United States as Europes second biggest source of imports after Britain. This occurred after a 21 percent increase in imports from China to the 25 countries forming the European Union (Financial Times, March 23, 2007,p. 2). Chinas trade with Russia is another example. The trade between China and Russia is reported to exceed the 30 percent per year growth from 1999 to 2005 and is now over $7 billion per year (China economic

Apr/11

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net). Over half of Chinas trade is within Asia, between Japan and South Korea. Regarding China and the United States, it has been reported that from 2000 to 2005, U.S. exports to China grew almost 160 percent, while U.S. exports to the rest of the world rose by only 16 percent. During that period, China accounted for roughly 25 percent of total U.S. export growth (IMF)) CHINA REVALUES YUAN: China is keeping its currency artificially undervalued, thus unfairly helping Chinese exporters China has held the yuan (which is also called the renminbi) in a de-facto peg to the US dollar since the global financial crisis worsened in mid-2008. In doing so, its currency has weakened against those of other trade partners, including Australia, as the value of the US dollar has slid over the past year. Yet long-standing tensions over China's trade surplus and monetary policy remain entrenched. China has repeatedly said that its currency policy has been an important source of stability during a period of international financial turmoil, benefiting both the Chinese and global economic recovery. During the most intense phase of the financial crisis (from September 2008 to March 2009), China's fixed exchange rate to the US dollar actually meant that the yuan appreciated strongly against virtually all other currencies in the world. In July 2005, China began a program of increased yuan flexibility (to use multiple currencies as reference points) and steadily strengthened its value, from about 8.2 yuan to the US dollar to around 6.8 by July 2008. But the yuan has been held at roughly that level ever since. If China discards the existing currency peg and allows market forces to dictate the yuan, then the value of its US debt holdings would decrease relative to the appreciation of the currently undervalued yuan. In the short term however, an appreciation of the yuan would also make it cheaper for China to buy US dollar-denominated commodities. In the longer term, it may find an equilibrium at a lower level since an appreciation would eventually weigh on Chinese exports and GDP growth. But in the interim stages, China may decide to leverage any strength in the value of a free-floating currency to buy commodities while they are relatively cheap. This hypothetical situation would continue to fuel a commodity rally.
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The biggest market risk factor for 2011 comes from the point at which this trend colours US-China relations IMPORTANCE OF CHINESE DOLLAR RESERVES China imports resources for its growth from many countries and exports manufactured goods. Currently, however, this process is not balanced. The Chinese export more than they import, and therefore accumulate a great deal of cash. China also possesses over $1 trillion of reserve currencies, and how it uses and invests this reserve of U.S. dollars will have a major impact on the direction of the U.S. dollar. The Chinese State Administration of Foreign Exchange (SAFE) is the key agency on the future of these dollar reserves. For the forex trader, following Chinese developments and intentions on global trade and currency policies can be rewarding because it can point the way for new trading opportunities. One big effect could result from a possible slowdown in the China economy. The U.S.China Economic and Security Review Commission concluded that: A financial crisis in China would harm its economy, decrease Chinas purchase of U.S. exports, and reduce Chinas ability to fund U.S. borrowing, particularly to cover the U.S. budget deficit. An economic crisis in China has the potential to raise the U.S. interest rates, thereby placing major additional costs on U.S. businesses and individual consumers and producing dislocation in the U.S. economy. It could also exacerbate Chinese domestic political tensions in an unpredictable fashion. This is why the condition of Chinas financial system is of concern to the United States. If a possible slowdown in China worries U.S. traders, possible changes in Chinas investment in U.S. assets worries them even more. The influence of China was most recently demonstrated when during the 2006 Thanksgiving holiday, a statement by the Chinese minister alluding to Chinas potential for investing in non dollar assets started a major slide in the U.S. dollar around the world. Here is an excerpt from recent Congressional testimony: Other currencies do not escape the impact of Chinese economic developments. Since the Chinese growth rate of over 10 percent per year GDP generates a
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voracious appetite for resources such as oil, copper, steel, iron ore, cement, and Ag complex, the countries that provide these resources experience a demand for their dollars. When China buys copper from Australia, renminbi must be converted into Australian dollars. This provides support for the Australian dollar and the Australian economy. Since China imports major resources such as copper from Australia, the aussie would be affected by a potential Chinese slowdown. Also, Japan, a significant trading partner of China, and its currency will often weaken or strengthen on expectations of a Chinese slowdown or sustained growth. Chinese influence has begun to extend also to Africa. For example, Chinese exports are beginning to shift to the Suez Canal, rather than going around Africa. This is causing Turkey, Italy, and other nations to invest in Egypt to tap into Chinese export to Europe. In the coming years, the trading world will focus on whether China can control its growth rate, avoid inflation, and increase its currency float. Therefore, Chinas economic and monetary policy will be valuable to watch. Traders need to keep track of key performance parameters such as Chinese GDP and inflation projections, as well as Chinese interest rate decisions. Between 2006 and July 2007, China increased its interest rates to reach a level of 6.84 percent for one-year notes to try to slow down the economy. But as China, which is now the seventh largest economy in the world and the second largest in purchasing power parity, becomes more of a consumer economy, the status of the Chinese economy will become easier to monitor. Companies such as Home Depot, Wal-Mart, Kingfisher (British), and Best Buy are entering the Chinese market, and many other firms are acquiring Chinese companies. As a result, the coming years will provide more reliable data on Chinese consumer spending and growth. Watching Chinas currency policies can also pinpoint new trading opportunities in the China market. The Shanghai Composite Index is very sensitive to whether the renminbi will strengthen. When the Bank of Chinas governor, Zhou Xiachuan, commented that China wasnt interested in increasing its foreign reserves further, the Shanghai index soared because Chinese company land and property is denominated in Chinese currency.
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The Commodities Connection

The value of a currency and how it moves is related to events in the commodity markets. Commodities are key resources in world growth, and they impact global inflation. GOLD Gold price movements are important for currency traders to understand. Gold acts in many ways as a surrogate currency and a safe haven when money moves out of the dollar in response to geopolitical crises. But gold is also a commodity on its own, adding strength or weakness to currencies of countries that produce gold. South Africa, of course, is the leading producer of gold, but its currency, the rand, is not floating, so traders can look to the Australian dollar and the Canadian dollar for trading those currencies when gold patterns provide trading opportunities. Gold price action can also be a misleading guide to the currency trader. In recent years, Gold has attracted a great deal of investment demand from exchange-traded funds (ETFs). In 2003, ETFs were buying 20 tons of gold, and this rose to 1000 tons in 2010. The trader who looks at gold prices rising may interpret it as a reaction to the dollar, when it actually can be reacting as a function of investment demand. The worlds central banks have about 3.5 trillion dollars in reserves, and 15 percent is in gold. The key variable that can affect currency prices is whether a central bank will increase its gold reserves and thereby decrease its reserves of dollars or another currency. As a result, rumors of central banks increasing gold reserves can disrupt currency prices. The idea that gold is important to currency moves is sound, but needs to be qualified and put in the context of world events. Sometimes gold acts as a store of value a during times of crises. But the correlations between gold moves and currency moves provide a great deal of variation. The trader needs to be vigilant regarding what factors are moving gold.

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1000

1200

1400

1600

1800

200

400

600

800

0 01/01/2000 01/07/2000 01/01/2001 01/07/2001 01/01/2002 01/07/2002 01/01/2003 01/07/2003 01/01/2004 01/07/2004 01/01/2005 01/07/2005 01/01/2006 01/07/2006 01/01/2007 01/07/2007 01/01/2008 01/07/2008 01/01/2009 01/07/2009 01/01/2010 01/07/2010 01/01/2011

MOVEMENT IN GOLD PRICES

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CHAPTER 4 Data Analysis & Interpretation

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THE MAIN INGREDIENT: INTEREST RATES AND INTEREST RATE DIFFERENTIALS

Interest rates are the dough of the fundamental forex pie. They are one of the most important factors that affect forex prices, as interest rates are the modern tool that central banks use as a throttle on their economies. The central banks of the world do not hesitate to use this important tool. In recent years almost all of the central banks increased interest rates. The European Central Bank raised interest rates eight times from December 6, 2005, to June 13, 2007, to a level of 4.0 percent to guide a booming European economy to slow down and avoid too high inflation during that period. The United States central bankthe Federal Reserveincreased interest rates 17 times between June 30, 2004, and August 2006, and then paused when it decided the economy no longer needed the brake of interest rate increases. Interest rate increases do much more than slow down an economy; they also act as a magnet to attract capital to bonds and other interest-bearing instruments. This has been called an appetite for yield, and when applied globally the flow of capital in and out of a country can be substantially affected by the difference in interest rates between one country and another. In recent years the outflow of capital from Japan to New Zealand, Australia, and Great Britain has reflected money chasing more yield and has been a major multibillion-dollar feature called the carry trade. The carry trade was driven by the interest rate differential that has existed, for example, between Japan (0.50) and New Zealand (8.0), causing low-cost borrowing in yen to invest in higher-yielding kiwis. There can be no doubt of the critical role interest rates play in forex price movements. Some forex traders learned this lesson when the U.S. stock market sold off on February 27, 2007. It was precipitated by traders getting out of their carry trade positions. Since billions of dollars were sold to be converted back into yen, equity markets were also affected because equity positions had to be sold to buy back the yen positions.
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INDIAS INTEREST RATE CHARTS

Source:-globalrates.com

Source:-globalrates.com

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RBI latest interest rate changes change date June 16 2011 May 03 2011 March 17 2011 January 25 2011 November 02 2010 September 16 2010 July 27 2010 July 02 2010 April 20 2010 March 19 2010 percentage 7.500 % 7.250 % 6.750 % 6.500 % 6.250 % 6.000 % 5.750 % 5.500 % 5.250 % 5.000 %

8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00%

7.50%

7.25%

6.75%

6.50%

6.25%

6.00%

5.75%

5.50%

5.25%

5.00%

RBI latest interest rate changes percentage

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8.00% 7.00% 6.00% percentage 5.00% 4.00% 3.00% 2.00% 1.00% 0.00%

RBI latest interest rate changes percentage Linear (RBI latest interest rate changes percentage)

AMERICAS INTEREST RATE GRAPHS

Source:- globalrates.com

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91

Fed interest rates

Change date June 2011 January 2011 January 2010 January 2009 December 16 2008 October 29 2008 October 08 2008 April 30 2008 March 18 2008 January 30 2008 January 22 2008 December 11 2007 October 31 2007 September 18 2007 percentage 0.25% 0.25% 0.25% 0.25% 0.25% 1.00% 1.50% 2.00% 2.25% 3.00% 3.50% 4.25% 4.50% 4.75%

5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00%

4.25% 3.50% 3.00% 2.00% 1.50% 1.00% 0.25% 0.25% 0.25% 0.25% 0.25% 2.25%

4.50%

4.75%

FED latest interest rate changes percentage

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INTEREST RATE AND CURRENCY MOVEMENT

INDIA'S INTEREST RATE

10 8 6 4 2 0

INDIA'S INTEREST RATE

India is a developing country which has been growing at healthy rate. The interest movement in India is decided by R.B.I in India. During 2008-2009 faced with world depression R.B.I decreased the interest rates drastically from 9 % in 2008 which happens to be the highest rate till announced by R.B.I to 4.75 % in 2009. These efforts of RBI considerably helped the Indian economy to be insulated from the global recession but since then the interest rate trend is again on a high end.by now in 2011 RBI has increased the rates

AMERICA'S RATE
6 5 4 3 2 1 0

AMERICA'S RATE

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Comparative study

10 9 8 7 6 5 4 3 2 1 0

INDIA'S INTEREST RATE

AMERICA'S RATE

Exchange rates

IND/US
60 50 40 30 20 10 0

IND/US

94

Exchange rates with interest rate changes

60 50 40 30 20 10 0 Mar/07 Mar/08 Mar/09 Mar/10

May/07

May/08

May/09

May/10

Mar/11

Nov/07

Nov/08

Nov/09

Nov/10

Jan/07

Jan/08

Jan/09

Jan/10

Sep/07

Sep/08

Sep/09

Sep/10

Jan/11

Jul/07

Jul/08

Jul/10

Jul/09

INDIA'S INTEREST RATE

AMERICA'S RATE

IND/US

60 50 40 RATES 30 20 10 0 06/Jan/07

06/Jan/08

06/Jan/09 TIME PERIOD

06/Jan/10

06/Jan/11

INDIA'SINTEREST RATE

AMERICA'S INTEREST RATE

IND/US

95

May/11

10 9 8 7 Axis Title 6 5 4 3 2 1 0 06/Jan/07 06/Jan/08 INDIA'SINTEREST RATE 06/Jan/09 06/Jan/10 06/Jan/11

AMERICA'S INTEREST RATE

Trend of interest rate in India and America

10 8 6 4 2 0 -2

INDIA'S INTEREST RATE

AMERICA'S RATE

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CHAPTER 5 Findings, Suggestion & Conclusion

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FINDINGS
A rise in the interest rates attracts funds from abroad, increases demand for domestic currency and raises its value. Interest rates are also used to regulate exchange, like it helps to cut down the demand for foreign currency, lower its value or raise the value of the domestic currency. The phenomenon of interest rate differential and carry trade has been developed based on the interest rate prevailing between two countries. Oil Prices: It is expected that as the Oil prices go up the import bill will increase meaning that dollars flow out of the Indian economy. This will result in Rupee falling and the interest rates going up based on interest rates parity theory. Wholesale Price Index: as per the Fishers interest rate theory investors want to be compensated for inflation so that they get a constant real rate of return. Hence the interest rates will rise. Industrial production: This is a surrogate measure of the GDP. Since this figure is reported monthly it was used in place of GDP. Higher industrial production (which coincides with higher production in other sectors) would mean a higher expected demand for goods leading to higher demand for money and hence higher interest rates. Exchange Rate: As the exchange rate raises the interest rate parity theory implies that interest rates should fall. Stock Exchange Index: As the stock market prices rise money will flow into the stock market and demand for bonds will reduce. A lower demand for bonds will result in lower prices which would imply higher interest rates.

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SUGGESTIONS
Interest rates help in determining the forward margins which can in return help the banks in earning huge profits if they are able to predict interest rates accurately. Interest rates help in determining the spot exchange rate which again form part of the major forex dealing done by banks. Interest rates also affect the forward contracts in foreign exchange dealings which are majorly entered by banks with central banks of other nations, which can again bring them huge profits if they predict them accurately. Interest rates affect the exchange rate of the country thereby affecting the cross rate between that countries currency and that of other currencies of the world, which give huge opportunity of earning profits through carry trade operations in the forex market. Forex dealing should be done after due analysis of risk, mainly credit risk, market/price risk and country risk. Forex data, including traded volumes for derivatives such as foreign currency rupee options, may be made available to the market on a regular basis. The closing time for inter-bank foreign exchange market in PNB may be extended by one hour from 4.00 PM to 5.00 PM. Banks may be permitted to provide capital on the actual overnight open exchange position maintained by them, rather than on their open position limits.

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CONCLUSION
India is a developing country where changes in interest rates have huge impact on the entire economy. Since 2008 the feds has kept a steady interest rate at around 25% whereas India has been rising its interest rate since 2009. Change in interest rate have impact on exchange movement, as it attract investors to invest in high yielding countrys currency thereby increasing demand for the currency and rising its value. Interest rate also impacts the volume of currency traded, as during the 2007-2008 period when the interest rates in India were at their highest the total volume of Indian currency traded in forex increased drastically (IMF report:- dated 20072008) Banks (trading banks) deal with each other in the interbank market, where they are obliged to make a two-way price, i.e. to quote a bid and an offer (a buy and a sell price). This category is perhaps the largest and includes international, commercial and trade banks. The bulk of todays trading activity is concentrated between 100 and 200 banks worldwide, out of a possible 2000 dealer participant. These banks also deal with their clients, some of the more important of which also qualify for two-way prices. In the vast majority of cases, however, most corporations will only be quoted according to their particular requirement. These banks rely on the knowledge of the market and their expertise in assessing trends in order to take advantage of them for speculative gain.

In summary, activity in the foreign exchange market remains predominately the domain of the large professional players for example, major Public sector banks such as P.N.B, S.B.I etc. However, with liquidity and the advent of Internet trading, plus the availability of margin trading, this 24-hour market is accessible to any person with the relevant knowledge and experience. Nevertheless, a much disciplined approach to trading must be followed, as profit opportunities and potential loss are equal and opposite.

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BIBLIOGRAPHY
www.emecklai.com www.icmr-india.org www.forecast-chart.com www.tradingeconomics.com www.finance.intomobile.com www.pnb.co.in. www.in.finance.yahoo.com/currency PNB material PNB annual reports www.rbi.co.in

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