A Grand Project Report On Potentiality of Futures and Options in Forex in India -:Submitted to:L. J.

Institute of Management Studies

In requirement of partial fulfillment of Masters of Business Administration (MBA) 2-year full time programme of Gujarat University -:Submitted on:February 28, 2007

PADIA PINAKIN J. Roll No : 58 Batch: 2005-07

GUPTA RAVI R. Roll No :28 Batch : 2005-07

-:Preface:Today everywhere it is heard: India has come off age IT has put India and
the Indians all over the globe. The winds of change are blowing through the corporate corridors. It is not only geeks but also Indian corporates who are looking outside India for greener pastures. Indian corporates are acquiring companies outside India. Blue chip companies are aggressively mobilizing capital from global financial markets. FIIs are pretty active in Indian bourses. Indian companies are listing themselves in NASDAQ and New York Stock Exchanges. All these feel good factors are adequately reflecting in the countrys surging Forex Reserves. Foreign currencies are flowing in ad out of the country as matter of routine and that. Too, in such sums that were unheard of a decade ago. Companies are becoming conscious of comparative advantages and, in the process, attempting to become multi-locational. It is heartening to note Indian corporates metamorphosing themselves into bundle of competitors even for multinationals. Today, no Indian company can dare envision business without foreign exchange. Suddenly, everyone has become interest in foreign exchange market. This new found enthusiasm is seeking explanations for many questions.

-:Acknowledgement:-

This is to acknowledge that we, PADIA PINAKIN J. AND GUPTA RAVI R. has performed the project on Potentiality of Futures and Options in Forex in India. This project is in partial fulfillment of Master of Business

Administration[MBA] year -2 of Gujarat University. We take this opportunity to express our sincere gratitude to The Gujarat University that gave us a chance to brighten our academic qualification. While submitting the project report, it is our bounded duty to offer our sincere thanks to all who have guided us in the training and preparing this report work. We would like to express our heartiest thanks to Dr. P. K. Mehta, Honorable Director of LJMBA For providing infrastructure and facilities necessary to complete our project. We are glade to express profound sentiments of gratitude to Mr. Aspy Bharucha Head of Forex Dept.- Vadilal Forex, Ahmedabad for given us information, valuable guidance and his precious time for our project. We would like to thanks Prof. Subhra Anand for providing us a proper guidelines on this project work. Thanks to all who have supported us directly or indirectly in this project. Thanks

Executive Summary:-

INDEX
Preface Executive Summary Forex Market What is Forex Market? Trade systems on Forex Pitfalls of trading system Forex Currencies Advantages of Forex Risk Management in Forex Forex Spread Derivative market of forex currencies Currency Future Market Currency Forward Market Currency Swap Market Currency Option Market Foreign Exchange Derivatives Market in India Status and Prospects

Perspective on the Indian forex market and Suggestions

Experts Opinion Research Methodology Bibliography Annexure-1

1.0 WHAT IS FOREX MARKET?

The international currency market Forex is a special kind of the world financial market. Traders purpose on the Forex to get profit as the result of foreign currencies purchase and sale. The exchange rates of all currencies being in the market turnover are permanently changing under the action of the demand and supply alteration. The latter is a strong subject to the influence of any important for the human society event in the sphere of economy, politics and nature. Consequently current prices of foreign currencies, evaluated for instance in US dollars, fluctuate towards its higher and lower meanings. Using these fluctuations in accordance with a known principle buy cheaper sell higher traders obtain gains. Forex is different in compare to all other sectors of the world financial system thanks to his heightened sensibility to a large and continuously changing number of factors, accessibility to all individual and corporative traders, exclusively high trade turnover which creates an ensured liquidity of traded currencies and the round the clock business hours which enable traders to deal after normal hours or during national holidays in their country finding markets abroad open. Just as on any other market the trading on Forex, along with an exclusively high potential profitability, is essentially risk - bearing one. It is possible to gain a success on it only after a certain training including a familiarization with the structure and kinds of Forex, the principles of currencies price formation, the factors affecting prices alterations and trading risks levels, sources of the information necessary to account all those factors, techniques of the analysis and prediction of the market movements as well as with the trading tools and rules.

Foreign exchange market is an over the counter market in which currencies of different countries are bought and sold against each other. Foreign Exchange is nothing but claims of the residents of a country to foreign currency payable abroad. It is a method of converting one country's currency into another. So long as there is a cross border flow of funds, the need for such conversion/exchange continues to arise.

Forex markets are quite decentralised. Participants like market makers, brokers, corporates and individual customers are physically separated from each other. They communicate with each other via, telephone, telex, computer network, etc. It is the commercial banks that offer such conversion facility through their dealing rooms. Today, it is a giant market.

1.1 Trade systems on Forex

Trading with brokers. Foreign exchange brokers, unlike equity brokers, do not take positions for themselves; they only service banks. Their roles are to bring together buyers and sellers in the market, to optimize the price they show to their customers and quickly, accurately, and faithfully executing the traders' orders. The majority of the foreign exchange brokers execute business via phone using an open box system a microphone in front of the broker that continuously transmits everything he or she says on the direct phone lines to the speaker boxes in the banks.

This way, all banks can hear all the deals being executed. Because of the open box system used by brokers, a trader is able to hear all prices quoted; whether the bid was hit or the offer taken; and the following price. What the trader will not be able to hear is the amounts of particular bids and offers and the names of the banks showing the prices. Prices are anonymous. The anonymity of the banks that are trading in the market ensures the market's efficiency, as all banks have a fair chance to trade. Sometimes brokers charge a commission that is paid equally by the buyer and the seller. The fees are negotiated on an individual basis by the bank and the brokerage firm. Brokers show their customers the prices made by other customers, either two-way ( bid and offer) prices or one way (bid or offer) prices from his or her customers. Traders show different prices because they "read" the market differently; they have different expectations and different interests. A broker who has more than one price on one or both sides will automatically optimize the price. In other words, the broker will always show the highest

bid and the lowest offer. Therefore, the market has access to an optimal spread possible. Fundamental and technical analyses are used for forecasting the future direction of the currency. A trader might test the market by hitting a bid for a small amount to see if there is any reaction. Another advantage of the brokers' market is that brokers might provide a broader selection of banks to their customers. Some European and Asian banks have overnight desks so their orders are usually placed with brokers who can deal with the American banks, adding to the liquidity of the market. Direct dealing. Direct dealing is based on trading reciprocity. A market maker the bank making or quoting a price expects the bank that is calling to reciprocate with respect to making a price when called upon. Direct dealing provides more trading discretion, as compared to dealing in the brokers' market. Sometimes traders take advantage of this characteristic. Direct dealing used to be conducted mostly on the phone. Phone dealing was error-prone and slow. Dealing errors were difficult to prove and even more difficult to settle. Direct dealing was forever changed in the mid-1980s, by the introduction of dealing systems. Dealing systems are on-line computers that link the contributing banks around the world on a one-on-one basis. The performance of dealing systems is characterized by speed, reliability, and safety. Dealing systems are continuously being improved in order to offer maximum support to the dealer's main function: trading. The software is rather reliable in picking up the big figure of the exchange rates and the standard value dates. In addition, it is extremely precise and fast in contacting other parties, switching among conversations, and accessing the database. The trader is in continuous visual contact with the information exchanged on the monitor. It is easier to see than hear this information, especially when switching among conversations. Most banks use a combination of brokers and direct dealing systems. Both approaches reach the same banks, but not the same parties, because corporations, for instance, cannot deal in the brokers' market. Traders develop personal relationships with both brokers and traders in the markets, but select their trading medium based on price quality, not on personal feelings. The market share between dealing systems and brokers fluctuates based on market conditions. Fast market conditions are beneficial to dealing systems, whereas regular market conditions are more beneficial to brokers.

Matching systems. Unlike dealing systems, on which trading is not anonymous and is conducted on a one-on-one basis, matching systems are anonymous and individual traders deal against the rest of the market, similar to dealing in the brokers' market. However, unlike the brokers' market, there are no individuals to bring the prices to the market, and liquidity may be limited at times. Matching systems are well-suited for trading smaller amounts as well. The dealing systems' characteristics of speed, reliability, and safety are replicated in the matching systems. In addition, credit lines are automatically managed by the systems. Traders input the total credit line for each counterparty. When the credit line has been reached, the system automatically disallows dealing with the particular party by displaying credit restrictions, or shows the trader only the price made by banks that have open lines of credit. As soon as the credit line is restored, the system allows the bank to deal again. In the inter-bank market, traders deal directly with dealing systems, matching systems, and brokers in a complementary fashion.

Trading Forex works remarkably easy. But you have to make your own trading system. A trading system is created by generating signals, setting up a decision making procedure, and incorporating risk management into the system. A trading system is supposed to be objective and mechanical. The analyst combines a set of objective trading rules (usually in a formula or algorithm). As a general rule, good technical analysis indicators are the building blocks of good trading systems. However, as previously mentioned, even good technical analysis indicators can lose their validity when combined in a trading system. Therefore, it is important to not only back-test your system but to also forward-test your system in real time.

1.2 Pitfalls of Trading Systems

Trading systems are supposed to be objective and mechanical. They take the intuition out of trading. Buy when the system tells you to and sell when the system tells you to. The problem is that there are not a lot of good trading systems out there. However, some are created for certain institutions to take advantage of arbitrage opportunities, or tricky derivative strategies. They are not at all suitable for the average trader. Traders tend to lose objectivity when using technical analysis indicators. The trader is not able to remain objective and the subjectivity of using the indicator overwhelms him. Traders have a tendency to test their trading systems and technical analysis indicators on an insufficient amount of data. Analysts need to test trading systems and technical analysis indicators on a wide array of data in different types of trading markets. Additionally, many traders and analysts don't forward test their trading systems and technical analysis indicators in real time. They rush to trade based on insufficient back-testing and forward-testing. Thus, they are trading on not a sound, valid basis. Many traders fail to incorporate sound risk management techniques in their trading systems. Additionally, many traders fail to incorporate stop loss orders with their initial orders when using technical analysis indicators only. Traders also tend to over-optimize their trading systems. They start asking the what-if question and back-test the trading system with different parameters. They are always trying to trade with the parameters which generate the highest amount of wins. However, in real time these over-optimized systems rarely perform well. Another trap traders fall into is to use too many technical analysis indicators. Find the few that work consistently well for you and go with them. There are basically two types of Forex trading systems, mechanical and discretionary systems. The trading signals that come out of mechanical systems are

mainly based off technical analysis applied in a systematic way. On the other hand, discretionary systems use experience, intuition or judgment on entries and exits. We will first analyze the advantages and disadvantages of each system. Advantages Disadvantages Mechanical systems This kind of system can be automated and backtested efficiently. It has very rigid rules. Either, there is a trade or there isnt. Mechanical traders are less susceptible to emotions than discretionary traders. Most traders backtest Forex trading systems incorrectly. In order to produce accurate results you need tick data. The Forex market is always changing. The Forex market (and all markets) has a random component. The market conditions may look similar, but they are never the same. A system that worked successfully the past year doesnt necessary mean it will work this year. Discretionary systems Discretionary systems are easily adaptable to new market conditions They cannot be backtested or automated, since there is . Trading decisions are based on experience. Traders learn to see which trading signals have higher probability of success. At early stages this can be dangerous. It takes time to develop the experience required to trade successfully and track trades in a discretionary way. always a thought decision to be made.

1.3 FOREX CURRENCIES

There are 7 most traded currencies in forex market.

Currencies are traded in dollar amounts called "lots". One lot is equal to $1,000, which controls $100,000 in currency. This is what is known as the "margin". You can control $100,000 worth of currency for only 1,000 dollars. This is what is called "High Leverage". Currencies are always traded in pairs in the FOREX. Here are some of the common symbols used in the Forex:

USD - The US Dollar EUR - The currency of the European Union "EURO" GBP - The British Pound JPN - The Japanese Yen CHF - The Swiss Franc AUD - The Australian Dollar CAD - The Canadian Dollar A currency can never be traded by itself. So you can not ever trade a EUR by

itself. You always need to compare one currency with another currency to make a trade possible. The Euro is the dominant base currency against all other global currencies. Thus, currencies paired with the EUR will always be identified with the EUR acronym first in the sequence. The British Pound is next in the hierarchy of currency name domination and usually USD after that. (Aside from the EUR and GBP, the only case where the USD is not the base currency of a pair is with the Australian & New Zealand dollars). Every foreign exchange transaction is an exchange between two currencies, each denoted by a unique three-letter code. Currency pairings are expressed as two codes usually separated by a division symbol (e.g. GBP/USD), the first representing the base currency and the other the secondary currency. The base currency is the one that you are buying or selling.

The exchange rate is the price of one currency in terms of another. For example GBP/USD = 1.5545 denotes that one unit of sterling (the base currency) can be exchanged for 1.5545 US dollars (the secondary currency). Pairings with the US dollar are known as the majors. The big four majors are:

EUR/USD: euro/US dollar GBP/USD: sterling/US dollar (known as cable) USD/JPY: US dollar /Japanese yen USD/CHF: US dollar/Swiss franc

Pairings of non-U.S. Dollar currencies from the aforementioned major pairings are known as crosses. EUR/GBP EUR/JPY GBP/CAD GBP/CHF AUD/CAD CHF/JPY AUD/JPY AUD/NZD CHF/NZD

EUR/CHF EUR/AUD GBP/JPY

Exotic pairings involve currencies not included in the eight major currencies. There are hundreds of currencies around the world, most of which are not easily traded on the open market. There are a few exotics some speculators will venture into; however, the spreads on these currencies tend to be very wide and the degree of risk makes them generally unattractive to most traders.

The seven categories of forex currencies:

Top currency
This rarified rank is reserved only for the most esteemed of international currencies - those whose use dominates for most if not all types of cross-border purposes and whose popularity is more or less universal, not limited to any particular geographic region. During the era of territorial money, just two currencies could truly be said to have qualified for this exalted status: Britain's pound sterling before World War I and the U.S. dollar after World War II.

Patrician currency
Just below the top rank we find currencies whose use for various cross-border purposes, while substantial, is something less than dominant and/or whose popularity, while widespread, is something less than universal. Obviously included in this category today would be the euro, as natural successor to the DM; most observers would still also include the yen, despite some recent loss of popularity. Both are patricians among the world's currencies.

Elite currency
In this category belong currencies of sufficient attractiveness to qualify for some degree of international use but of insufficient weight to carry much direct influence beyond their own national frontiers. Here we find the more peripheral of the international currencies, a list that today would include inter alia Britain's pound (no longer a Top Currency or even Patrician Currency), the Swiss franc, and the Australian dollar.

Plebian currency
One step further down from the elite category are Plebian Currencies - more modest monies of very limited international use. Here we find the currencies of the smaller industrial states, such as Norway or Sweden, along with some middle-income emerging-market economies (e.g., Israel, South Korea, and Taiwan) and the wealthier oil-exporters (e.g., Kuwait, Saudi Arabia, and the United Arab Emirates).

Internally, Plebian Currencies retain a more or less exclusive claim to all the traditional functions of money, but externally they carry little weight (like the plebs, or common folk, of ancient Rome). They tend to attract little cross-border use except perhaps for a certain amount of trade invoicing.

Permeated currency
Included in this category are monies whose competitiveness is effectively compromised even at home, through currency substitution. Although nominal monetary sovereignty continues to reside with the issuing government, foreign currency supersedes the domestic alternative as a store of value, accentuating the local money's degree of inferiority. Permeated Currencies confront what amounts to a competitive invasion from abroad. Judging from available evidence, it appears that the range of Permeated Currencies today is in fact quite broad, encompassing perhaps a majority of the economies of the developing world, particularly in Latin America, the former Soviet bloc, and Southeast Asia.

Quasi-currency
One step further down are currencies that are superseded not only as a store of value but, to a significant extent, as a unit of account and medium of exchange, as well. Quasi-Currencies are monies that retain nominal sovereignty but are largely rejected in practice for most purposes. Their domain is more juridical than empirical. Available evidence suggests that some approximation of this intensified degree of inferiority has indeed been reached in a number of fragile economies around the globe, including the likes of Azerbaijan, Bolivia, Cambodia, Laos, and Peru.

Pseudo-currency
Finally, we come to the bottom rank of the pyramid, where currencies exist in name only - Pseudo-Currencies. The most obvious examples of Pseudo-Currencies are

token monies like the Panamanian balboa, found in countries where a stronger foreign currency such as the dollar is the preferred legal tender.

1.4 FOREX MARKET ADVANTAGES

There are many benefits and advantages to trading Forex. Here are just a few reasons why so many people are choosing this market as a profitable business opportunity:

1. Powerful forex leverage

In Forex trading, a small margin deposit can control a much larger total contract value. Leverage gives the trader the ability to make extraordinary profits and at the same time keep risk capital to a minimum.

2. Liquidity
Because the Forex Market is so large, it is also extremely liquid. This means that 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 the online trading platform to automatically close your position at your desired profit level (limit order), and/or close a trade if a trade is going against you (stop order).

3. Forex trading online is instant.

The FX market is fast. Orders are executed, filled and confirmed usually within 1-2 seconds. Since this is all done electronically with no humans involved, there is little to slow it down!

4. Zero forex commissions

Because you access the market directly through electronic online forex trading you pay zero commissions or exchange fees.

5. Limited risk
Your risk is strictly limited. You can never lose more than you have in your forex account. This means you can never have a negative equity balance. You can also define and limit your risk with stop-loss orders, which are guaranteed by stocks on all forex orders up to $1 million in size.

6. Guaranteed prices and Instantaneous Fills

You get instantaneous execution and total price certainty on all orders up to $1 million in size. This allows you to trade forex with confidence off real-time, two-way quotes. And this price guarantee applies to stop-loss and limit orders as well.

7. 24-hour market
Forex is a 24-hour-a-day market that literally follows the sun around the world, from the U.S. to Australia and New Zealand to Hong Kong, the Far East, Europe and then back again to the U.S. The huge number and diversity of forex investors involved make it difficult even for governments to control the direction of the forex market. The unmatched liquidity, and around-the-clock global activity make forex the ideal market to trade.

8. Free 'demo' accounts, news, charts and analysis

Most Online Forex firms offer free 'Demo' accounts to practice trading, along with breaking Forex news and charting services. These are very valuable resources for traders who would like to hone their trading skills with 'virtual' money before opening a live trading account.

9. 'Mini' trading
One might think that getting started as a currency trader would cost a lot of money. The fact is, it doesn't. Some Forex firms now offer 'mini' trading accounts with a

minimum account deposit of only $200 with no commission trading. This makes Forex much more accessible to the average individual, without large, start-up capital.

1.5 Risk Management in Forex

Trading foreign currencies is a challenging and potentially profitable opportunity for educated and experienced investors. However, before deciding to participate in the Forex market, you should carefully consider your investment objectives, level of experience and risk appetite. Most importantly, do not invest money you cannot afford to lose. There is considerable exposure to risk in any foreign exchange transaction. Any transaction involving currencies involves risks including, but not limited to, the potential for changing political and/or economic conditions that may substantially affect the price or liquidity of a currency. Moreover, the leveraged nature of FX trading means that any market movement will have an effect on your deposited funds proportionally equal to the leverage factor. This may work against you as well as for you. The possibility exists that you could sustain a total loss of initial margin funds and be required to deposit additional funds to maintain your position. If you fail to meet any margin call within the time prescribed, your position will be liquidated and you will be responsible for any resulting losses. Investors may lower their exposure to risk by employing risk-reducing strategies such as 'stop-loss' or 'limit' orders. There are also risks associated with utilizing an internet-based deal execution software application including, but not limited, to the failure of hardware and software and communications difficulties. The Forex Market is the largest and most liquid financial market in the world. Since macroeconomic forces are one of the main drivers of the value of currencies in the global economy, currencies tend to have the most identifiable trend patterns. Therefore, the Forex market is a very attractive market for active traders, and presumably where

they should be the most successful. However, success has been limited mainly for the following reasons: Many traders come with false expectations of the profit potential, and lack the discipline required for trading. Short term trading is not an amateur's game and is not the way most people will achieve quick riches. Simply because Forex trading may seem exotic or less familiar then traditional markets (i.e. equities, futures, etc.), it does not mean that the rules of finance and simple logic are suspended. One cannot hope to make extraordinary gains without taking extraordinary risks, and that means suffering inconsistent trading performance that often leads to large losses. Trading currencies is not easy, and many traders with years of experience still incur periodic losses. One must realize that trading takes time to master and there are absolutely no short cuts to this process. The most enticing aspect of trading Forex is the high degree of leverage used. Leverage seems very attractive to those who are expecting to turn small amounts of money into large amounts in a short period of time. However, leverage is a double-edged sword. Just because one lot ($10,000) of currency only requires $100 as a minimum margin deposit, it does not mean that a trader with $1,000 in his account should be easily able to trade 10 lots. One lot is $10,000 and should be treated as a $100,000 investment and not the $1000 put up as margin. Most traders analyze the charts correctly and place sensible trades, yet they tend to over leverage themselves (get in with a position that is too big for their portfolio), and as a consequence, often end up forced to exit a position at the wrong time. For example, if your account value is $10,000 and you place a trade for 1 lot, you are in effect, leveraging yourself 10 to 1, which is a very significant level of leverage. Most professional money managers will leverage no more then 3 or 4 times. Trading in small increments with protective stops on your positions will allow one the opportunity to be successful in Forex trading.

Currency Trade Profit/Loss Calculation Example

The current bid/ask price for USD/CHF is 1.6322/1.6327, meaning you can buy $1 US for 1.6327 Swiss Francs or sell $1 US for 1.6322. Suppose you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF). To execute this strategy, you would buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise. So you make the trade: purchasing US$100,000 and selling 163,270 Francs. (Remember, at 1% margin, your initial margin deposit would be $1,000.) As you expected, USD/CHF rises to 1.6435/40. You can now sell $1 US for 1.6435 Francs or buy $1 US for 1.6440 Francs. Since you're long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit. You sell US$100,000 at the current USD/CHF rate of 1.6435, and receive 164,350 CHF. Since you originally sold (paid) 163,270 CHF, your profit is 1080 CHF. To calculate your P&L in terms of US dollars, simply divide 1080 by the current USD/CHF rate of 1.6435. Total profit = US $657.13

1.6 FOREX SPREADS

One of the main forex terms is forex spread.

As with other financial commodities, there is a buying (offer or ask) and a selling (bid) exchange rate. The difference is known as the bid-offer spread or the spread. The forex spread is written in a particular format. For example, GBP/USD = 1.5545/50 means that the bid price of GBP is 1.5545 USD and the offer price is 1.5550 USD. The spread in this case is 5 points. Every purchase of the base currency implies a sale of the secondary currency. Likewise, sale of the base currency implies the simultaneous purchase of the secondary currency. For example, when I sell GBP/USD, I am selling GBP and buying USD. Similarly, when I buy GBP I am simultaneously selling USD. We can express this equivalence by inverting the GBP/USD exchange rate and rotating the bid and offer reciprocals to derive the USD/GBP rate. For example, if GBP/USD = 1.5545/50 then USD/GBP = 1/1.5550 (bid)/(1/1.5545 (offer) = 0.6431/33 The basic unit of trading for private investors is known as a lot which represents 100,000 units of the base currency. Some brokers permit trading in mini-lots. The purchase of a single lot of GBP/USD at 1.5852 implies 100,000 GBP bought at 158,520 USD. The sale of a single lot of GBP/USD at 1.5847 entails the sale of 100,000 for 158,470 USD. The spot forex trading spread is how brokers make their money. Wider spreads will result in a higher asking price and a lower bid price. The end result is that you have to pay more when you buy and get less when you sell, which makes it more difficult to realize a profit. Brokers generally don't earn the full spread, especially when they hedge client positions. The spread helps to compensate for the market maker for taking on risk from

the time it starts a client trade to when the broker's net exposure is hedged (which could possibly be at a different price). Spot forex trading spreads are important because they affect the return on your trading strategy in a big way. As a trader, your sole interest is buying low and selling high (like futures and commodities trading). Wider spreads means buying higher and having to sell lower. A half-pip lower spread doesn't necessarily sound like much, but it can easily mean the difference between a profitable trading strategy and one that isn't profitable. { Spread Terminology - "Pip" The term used in currency market to represent the smallest incremental move an exchange rate can make. Depending on context normally one basis point (0.0001 in the case of EUR/USD, GBP/USD, USD/CHF and 0.01 in the case of USD/JPY). } The tighter the spread is the better things are going to be for you. However tight spreads are only meaningful when they are paired up with good execution. Quality of execution will decide whether you actually receive tight spreads. A good example of this is when your screen shows a tight spread, but your trade is filled a few pips to your disadvantage or is mysteriously rejected. Spread policies change a great deal from broker to broker, and the policies are often difficult to see through. This certainly makes comparing brokers much more difficult. Some brokers actually offer fixed spreads that are guaranteed to remain the same regardless of market liquidity. But since fixed spreads are traditionally higher than average variable spreads, you are paying an insurance premium during most of the trading day so that you can get protection from short-term volatility. Other brokers offer traders variable spreads depending on market liquidity. Spreads are tighter when there is good market liquidity but they will widen as liquidity dries up. When it comes to choosing between fixed and variable rates, the choice depends on your individual trading pattern. If you trade primarily on news

announcements that you hear, you may be better off with fixed spreads. But only if quality of execution is good. Some brokers have different spreads for different clients based on their accounts. For example; those clients that have larger accounts or those who make larger trades may receive tighter spreads, while the clients that are referred by an introducing broker might receive wider spreads in order to cover the costs of the referral. Some offer the same spreads to everyone. Problems can come up when you are trying to learn about a company's spread policy because this information, along with information on trade execution and orderbook depth is rather difficult to get. Because of this, many traders get caught up in all of the promises they hear, and take a broker's words at face value. This can be dangerous. The only real way to find out is to try out various brokers or talk to those who have. In summary, the spread is the difference between the price that you can sell currency at ( Bid ) and the price you can buy currency at ( Ask ). The spread on majors is usually 5 pips under normal market conditions. A pip is the smallest unit by which a cross price quote changes. When trading forex you will often hear that there is a 5-pip spread when you trade the majors. This spread is revealed when you compare the bid and the ask price, for example EURUSD is quoted at a bid price of 0.9875 and an ask price of 0.9880. The difference is USD 0.0005, which is equal to 5 "pips". On a contract or position, the value of a pip can easily be calculated. You know that the EURUSD is quoted with four decimals, so all you have to do is the cancel-out the four zeros on the amount you trade and you will have one pip. Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a USDJPY 100,000 contract, one pip is equal to 1000 yen, because USDJPY is quoted with only two decimals.

2.0 DERIVATIVE MARKET OF FOREX CURRENCIES

The following Forex types will be reviewed in this part:

Currency futures Currency forwards Currency swaps Currency options Derivatives play an important and useful role in the economy, but they also pose

several dangers to the stability of financial markets and the overall economy. Derivatives are often employed for the useful purpose of hedging and risk management, and this role becomes more important as financial markets grow more volatile. Derivatives are also used to commit fraud and to manipulate markets. Derivatives are powerful tools that can be used to hedge the risks normally associated with production, commerce and finance. Derivatives facilitate risk management by allowing a person to reduce his exposure to certain kinds of risk by transferring those risks to another person that is more willing and able to bear such risks. Today, derivatives are traded in most parts of the world, and the size of these markets is enormous. Data for 2002 by the Bank of International Settlements puts the amount of outstanding derivatives in excess of $151 trillion and the trading volume on organized derivatives exchanges at $694 trillion. By comparison, the IMFs figure for worldwide output, or GDP, is $32.1 trillion. A derivative is a financial contract whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative refers to how the price of these contracts is derived from the price the underlying item. Typical examples of derivatives include futures, forwards, swaps and options, and these can be combined with traditional securities and loans in order to create structured securities which are also known as hybrid instruments.

Warren Buffet says: Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Reasons why Companies are moving away from it: 1) They face pretty high trading costs to a build a replicating portfolio 2) To replicate a call option one has to shuffle the replicating portfolio that involves repeated trades in which the prices of underlying asset changes. 3) Difficulty in identifying the correct replicating strategy

2.1 Risks involved in Derivatives

Credit Risks Market Risks Operational Risks Entrepreneurial Risks Systematic Risks

Forward deals are a form of insurance against the risk that exchange rates will change between now and the delivery date of the contract. A forward is a simple kind of a derivative - a financial instrument whose price is based on another underlying asset. The price in a forward contract is known as the delivery price and allows the investor to lock in the current exchange rate and thus avoid subsequent forex fluctuations. Futures contracts are like forwards, except that they are highly standardized. The futures contracts traded on most organized exchanges are so standardized that they are fungible - meaning that they are substitutable one for another. This fungibility facilitates trading and results in greater trading volume and greater market liquidity. While futures and forward contracts are both a contract to trade on a future date, key differences include:

Futures are always traded on an exchange, whereas forwards always trade overthe-counter Futures are highly standardized, whereas each forward is unique The price at which the contract is finally settled is different: Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end) Forwards are settled at the forward price agreed on the trade date (i.e. at the start) The credit risk of futures is much lower than that of forwards: The profit or loss on a futures position is exchanged in cash every day. After this the credit exposure is again zero. The profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing In case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty on a futures contract is chosen randomly by the exchange.

In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodic margin calls. Foreign currency swaps can be defined as a financial foreign currency contract

whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. It is worth mentioning in this regard that the buyer and seller exchange fixed or floating rate interest payments in there respective swapped currencies over the term of the contract. According to experts upon the maturity, the principal amount is effectively reswapped at a predetermined exchange rate so that the parties end up with their original currencies. Foreign currency swaps are more often than not been used by commercials as a foreign currency-hedging vehicle rather than by retail forex traders.

Options allow investors even greater flexibility. Although more expensive than futures contracts, options are valued because they allow investors to choose whether to

exercise a futures contract or not. The option-holder is under no obligation to buy or sell the underlying asset. Call options give an investor the right, but not the obligation, to purchase the indicated asset at a specified (strike) price by a certain date. An investor who buys a call option is hoping, or betting, that the price of the asset will rise above the strike price. Put options give the option-holder the right, but not the obligation, to sell the security by a certain date. The purchaser of a put option is hoping or betting that the price of the asset will fall below the contracts strike price. An option contract gives the its holder the option (or the right) to buy (or sell) the underlying item at a specific price at a specific time period in the future. There are two kinds of options. Buying a call option provides an investor the right to buy an asset while a put option gives the investor the right to sell the asset.

2.2 CURRENCY FUTURE MARKET:

Futures Contract is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan).

The trail of a Future Trade - The flow of future trade:-

Buy Customer Broker Buy Floor Broker Sell Floor Trader Swiss franc pit

Long

Short shor t

Short Short

Short

Long Long Long

Long

Broker Account

Customer Account Clearing House Pool

The path followed by a customers order for a future contract is complex. Here, a customer wishes to purchase a contract for a Swiss franc. He phones his order to a

broker who. In turn, phones the order to a floor broker on the exchange. The floor broker fills the order by trading with a floor trader who sells him the same contract. At this point, the floor broker has a long position, and the floor trader a short position. At the end of the trading session, both positions are entered in the clearinghouse account. The clearinghouse holds all positions in an unmatched condition. They are assigned to the various customers accounts, and he marked to market daily. When an offsetting position is assigned to the same account, the two are matched up, closing the position. Both positions disappear from the customers account, resulting in a realized gain or loss.

A futures contract is a standardized commitment that describes the key features of a transaction:

The quantity and quality of the commodity being exchanged The date on which the exchange is to take place The method of delivery The price at which the commodity will be purchased

Example: Yen contracts: 12.5m (approx $116,000), Pound: 62,500 (approx. $112,500), Euro: 125,000 (approx $160,000), SF: 125,000 (approx $104,000), etc. Expiration dates: March, June, Sept, Dec. on the 3rd Wednesday. Currency futures started trading in 1972 at the Chicago Mercantile Exchange (CME), which opened in 1898 (largest futures exchange in U.S., 4 product areas: stock indexes, interest rates, currency, commodities) Why then? Actually, trading in many derivative markets started to explode in the 70s. Why? 1. Fixed exchanges rates until 1973 meant no currency risk. 2. Interest rates were fixed by federal law for savings accounts (Reg. Q) and checking accounts (i = 0%), and some mortgages (led to "points"). 3. Inflation was low and stable, 2-3% in the 50s, 60s and early 70s. 4. Interest rates on T-bills were low and stable 1-2%. 5. Price of oil was low and stable.

Economic and financial volatility increased dramatically in the 1970s. Fixed exrates were abandoned, started to float. Req Q was eventually repealed. Inflation and int. rates rose and became volatile in the 1970s. Oil prices doubled and tripled in the two oil shocks of the 1970s (74-75 and 79-80). Led to an explosion in the derivative markets for futures contracts. Unlike the purchase or sale of a security, no price is paid or received upon the purchase or sale of a futures contract. Initially, the Account will be required to deposit in a custodial account an amount of cash, United States Treasury securities, or other permissible assets equal to approximately 5% of the contract amount. This amount is known as initial margin. The nature of initial margin in futures transactions is different from that of margin in security transactions in that futures contract margin does not involve the borrowing of funds by the customer to finance the transactions. Rather, the initial margin is in the nature of a performance bond or good faith deposit on the contract, which is returned to the Account upon termination of the futures contract assuming all contractual obligations have been satisfied. The initial investment required to establish a futures position, usually 3-5% of the contract value. To buy one U.K. pound contract, you would have to put up about $4500 ($112,500 x 4%). You would also have to keep a "maintenance margin" usually about 75% of the initial margin. In this case, you could never let your account go below $3375 (75% of $4500). If you can't make margin call, your contract is liquidated by broker. There are two types of futures contracts, those that provide for physical delivery of a particular commodity and those that call for an even dual cash settlement. The commodity itself is specifically defined, as is the month when delivery or settlement is to occur. A July futures contract, for example, provides for delivery or settlement in July. It should be noted that even in the case of delivery-type futures contracts, very few actually result in delivery. Not many speculators want to take or make delivery of 5,000 bushels of grain or 40,000 pounds of pork. Rather, the vast majority of both speculators and hedgers choose to realize their gains or losses by buying or selling an offsetting futures contract prior to the delivery date.

Selling a contract that was previously purchased liquidates a futures position in exactly the same way that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by making an offsetting purchase. In either case, profit or loss is the difference between the buying price and the selling price, less transaction expenses. Cash settlement futures contracts are precisely that, contracts that are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading. Participants of currency futures market 1. Speculators - pure speculative bet/investment, with no business interest in the underlying commodity/currency. 2. Hedgers - someone with a business/personal interest in the underlying currency, and is using futures trading to minimize, eliminate or control currency risk, e.g., MNCs, banks, exporters, importers, etc. If a hedger is short (long) and a speculator is long (short), the hedger is "selling" their risk to the speculator.

Hedgers
The details of hedging can be somewhat complex but the principle is simple. By buying or selling in the futures market now, individuals and firms are able to establish a known price level for something they intend to buy or sell later in the cash market. Buyers are thus able to protect themselves againstthat is, hedge againsthigher prices and sellers are able to hedge against lower prices. Hedgers can also use futures to lock in an acceptable margin between their purchase cost and their selling price. A jewelry manufacturer will need to buy additional gold from its supplier in six months to produce jewelry that it is already offering in its catalog at a published price. An increase in the cost of gold could reduce or wipe out any profit margin. To minimize

this risk, the manufacturer buys futures contracts for delivery of gold in six months at a price of $300 an ounce. If, six months later, the cash market price of gold has risen to $320, the manufacturer will have to pay that amount to its supplier to acquire gold. But the $20 an ounce price increase will be offset by a $20 an ounce profit if the futures contract bought at a price of $300 is sold for $320. The hedge, in affect, provided protection against an increase in the cost of gold. It locked in a cost of $300, regardless of what happened to the cash market price. Had the price of gold declined, the hedger would have incurred a loss on the futures position but this would have been offset by the lower cost of acquiring gold in the cash market. Whatever the hedging strategy, the common denominator is that hedgers are willing to give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.

Risk Minimizing Hedge strategy

As stated earlier, the objective of hedging is to minimize risk, not to maximize profits from currency speculation. Using futures contracts, this is typically accomplished by taking a short position in the futures market to offset any gains or losses in the spot market. From a portfolio perspective, the hedger would have a portfolio consisting of a long position in the cash market, and a short position in the futures market. The return on the portfolio is equal to the return on the spot position (denoted S) plus the return on the futures position (denoted F):

Return = S + hF where h - denotes the number of futures contracts held in the portfolio, or the 'hedge ratio'. In most instances, h will be negative, depicting a short position. The optimal value for h is

the one that minimizes the variance of the portfolio: Var(S + hF) = Var(S) + h2Var(F) + 2hCov(S,F)

Taking the first derivative with respect to h and setting it equal to zero yields the hedge ratio that minimizes the portfolio variance: 2hVar(F) + 2Cov(S,F) = 0 h* = -2Cov(S,F)/Var(F) where h* - is the variance-minimizing hedge ratio. Because spot prices and futures prices are highly correlated, h* should be fairly close to 1. The hedge ratio is calculated using historical returns in the cash and futures market. Since exchange rate levels exhibit non-stationarity (i.e. they can deviate from their long-term mean level for prolonged periods of time), means and variances are not meaningful unless returns are used. The covariance between cash returns and futures returns is assumed to be relatively stable over the hedging horizon, although hedge ratios can be dynamically updated over the hedging horizon if one wants a more precise hedge.

Speculators
Were you to speculate in futures contracts by buying to profit from a price increase or selling to profit from a price decrease, the party taking the opposite side of your trade on any given occasion could possibly be a hedger or it might be another speculator, someone whose opinion about the probable direction and timing of prices differs from your own. Buying futures contracts with the hope of later being able to sell them at a higher price is known as "going long." Conversely, selling futures contracts with the hope of being able to buy back identical and offsetting futures contracts at a lower price is

known as "going short." An attraction of futures trading is that it is equally as easy to profit from declining prices (by selling) as it is to profit from rising prices (by buying). The difference between the price of a commodity in the cash (or 'spot') market and the currency futures market is called the 'basis', and is determined by relative interest rates for financial futures. The price is established by an arbitrage argument which asserts that the payoff from converting a unit of domestic currency at the spot rate, lending in another currency and converting the proceeds in the forward market should yield the same profit as lending the unit of domestic currency at home provided he or she can borrow and lend at the risk-free rate. Using S as the spot rate, F as the forward rate both in terms of domestic currency per unit of foreign currency r as the domestic effective interest rate and rf as the foreign effective interest rate, the above equality produces the identity: (1+r) = (1/S)*(1+rf)*F, or F = S*(1+r)/(1+rf) If this condition does not hold, then arbitrageurs would take advantage of the opportunity by borrowing unlimited amounts in the country with low interest rate, investing in the country with the high interest rate and converting at the forward rate for a risk-free profit. This would lead to an adjustment in the exchange rate until the opportunity was no longer profitable. This relationship is more commonly known as 'interest rate parity'. Slight deviations from parity may be apparent in the market due to transaction costs.

2.2.1 Currency Futures as a Hedging Tool:

Currency future contracts can be used as an alternative to the forward market as a hedging tool. A UK importer having an unmatured dollar payable could either buy dollars in the forward market, or sell sterling futures contracts approximately equal in amount to the dollar exposure, and maturing as near as possible to the due date of payment. His profit or loss in the cash market will be compensated by the loss or profit in reversing the futures transaction. In the effect, he will get the exchange rate he had contracted while selling the sterling future contracts. An example will help clarify the situation. A UK importer has to pay $ 1,60,000 to his creditor on 20th April for imports made in January. In February, he is worried that the dollar may appreciate against the pound and desires to cover the exchange risk in the futures market. The amount of the LIFFE sterling, dollar contract is pounds 25,000 and the maturity 2nd Wednesday of June. The current spot rate in the cash market is $1.50 per pound, the forward rate delivery 20th April is $ 1.48, and the June contract is being traded at say $ 1.45. He therefore decides to sell four June contracts at $ 1.45. On the 20 th April the spot rate in the cash market is say $ 1.40 and the June future contract is now trading at say $ 1.36. The purchase $ 1,60,000 in the cash market will now cost him PDS 1,14,285.71, or a loss of PDS 6,177.61 compared to the forward rate of $ 1.48 ruling when he decided to hedge the risk. In the future market he can now buy back the four contracts sold at $ 1.45, at the current price of $ 1.36, or a profit of 9 cents per pound or $ 9,000. This profit is equal to PDS 6,428.57 at the current spot rate, and compensates him for the loss. The example of also evidences that the hedge is not perfect the profit and loss do not match exactly because amounts and maturities do not coincide/ The spot rate and futures contract price have not moved by the same amount, nor was the entire $ 1,60,000 hedged.

2.2.2 Futures are not perfect Hedges

The advantage of the standardized amounts and maturity are tradeability and liquidity, the disadvantage is that future market does not in general provide a perfect hedge since the amount and maturity of the exposure one is trying to hedge will rarely coincide with the standardized amount and maturities of the contracts traded on the exchange. It will be appreciated that prices of the currency futures contracts will run in close tandem with the forward rates in the cash market. Discrepancies will lead to arbitrage opportunities and arbitraged trading will correct them. Also on the maturity date the prices in the futures and cash market will have to be identical, as a counter party has a right to insist upon delivery of the currency. Future contracts rarely provide perfect hedges because of standardized maturities and amounts. But they have also some significant advantages over the counter parts in the OTC market, namely forwards contracts. The most important are transparency of prices, ease in taking and unwinding of the positions and no counter party risk. Forward contracts are generally dealt over the telephone the result is that same point of time different counterparties may be quoted different prices for the same currency and maturity. This is not the case in the future exchange, at a given point of time there will be one price for a particular contract. Liquidity in the future exchange also facilitates the taking and unwinding of positions, that too at market rates. This is all the more important as the most positions in the future market are unwound well before maturity, by doing a reverse transaction, and not by exchange of the underlying currencies, as in the case of forward contract. The elimination of counter party risk come through the system of initial margin and its adjustments daily to reflect change in the prices of the contracts. This is yet another difference with the forward contract. Under the letter cash flow will be

exchanged only on maturity, in futures the cash flow would be affected daily because of margin system.

2.3 CURRENCY FORWARD MARKET:

Forward (Cash) Contract is a cash contract in which a seller agrees to deliver a specific cash commodity to a buyer sometime in the future. Forward contracts, in contrast to futures contracts, are privately negotiated and are not standardized. Many market participants want to exchange currencies at a time other than two days in advance but would like to know the rate of exchange now. Forward foreign exchange contracts are generally used by importers, exporters and investors who seek to lock in exchange rates for a future date in order to hedge their foreign currency cash flows. For example, if a company had contracted to purchase equipment for the price of GBP 1 million payable in 3 months time but was concerned that the GBP would rise against the Australian dollar in the interim, the company could agree today to buy the USD for delivery in 3 months time. In other words, the company could negotiate a rate at which it could buy GBP at some time in the future, setting the amount of GBP needed, the date needed etc. and hence be sure of the Australian Dollar purchasing price now. There are two components to the price in forward transaction and they are the spot price and the forward rate adjustment. The spot rate is simply the current market rate as determined by supply and demand. The forward rate adjustment is a slightly more complicated calculation that involves the applicable interest rates of the currencies involved. Forward Exchange Contracts, both Buying and Selling, may be either fixed or optional term contracts.

Fixed Term Contracts

With a Fixed Term Contract the customer specifies the date on which delivery of the overseas currency is to take place. An earlier delivery can be arranged but it may involve a marginal adjustment to the Forward Contract Rate.

Optional Term Contracts

Optional Term Contracts can be entered into for a specific period, and the customer states the period within which delivery is to be made (normally for periods not more than one month) eg. a contract may be entered into for a six month period with the customer having the option of delivery at anytime during the last week. In each case there is a firm contract to effect delivery by both the Bank and the customer. An optional delivery contract does not give the customer an option to not deliver the Forward Exchange Contract. It is only the period during which delivery may occur that is optional. Forward rates are quoted for transactions where settlement is to take place more than two business days after the transaction date. Forward Contract rates consist of the Spot rate for the currency concerned adjusted by the relative Forward Margin. Forward Margins are a reflection of the interest rate differentials between currencies, and not necessarily a forecast of what the spot rate will be at the future date. The Forward rate may be expressed as being at parity (par), or at a Premium (dearer) or at a Discount (cheaper), when related to the spot rate. It follows therefore that premiums are deducted from the spot rate and discounts are added to the spot rate. Forward Rates incorporating a 'Premium' are more favourable to exporters and less favourable to importers than the relative spot rates on which they are based. Similarly, Forward rates incorporating a 'Discount' are more favourable to importers and less favourable to exporters that the relative spot rates on which they are based. The general rule in determining whether a currency will be quoted at a premium or a discount is as follows:

The currency with the higher interest rate will be at a discount on a forward basis against the currency with the lower interest rate. The currency with the lower interest rate will be at a premium on a forward basis against the currency with the high interest rate.

As the interest differential between the currencies widens then the premium or discount margin increases (i.e. moves farther from parity) and similarly as the interest differential narrows then the premium or discount margin decreases (ie moves towards parity).

Comparison between currency Futures and Currency Forward Markets:Features

Size of contract Quotation Maturity Location of trading Price Settlement

Currency Futures
Standardized Generally U.S. Dollar/Currency unit Standardized , generally shorter than one year Futures exchanges Fixed on the market Generally no settlement but compensation through reverse

Currency Forwards
Negotiated/Tailor made US $/ Currency Unit Negotiated Linkages by telephone or fax Quotation of rates Generally delivery of currencies

operations Counterparties Generally do not know each Negotiation Hours Guarantee Marking to market other During market sessions Guarantee Deposit Gains or losses on positions settled every day

Generally in contact with each other Round the clock No guarantee deposit No marking to market

2.4CURRENCY SWAP MARKET:

Currency swap is the type of forex derivative. It is an agreement between two parties to buy or sell currency at spot rates, which reverts at the end of an agreed period for a specified price (the forward rate). The forward rate is calculated from the spot rate, forward points (premium on the spot rate based on the interest rate differential between the currencies) and length of the agreement in days. In a currency swap, the holder of an unwanted currency exchanges that currency for an equivalent amount of another currency to improve the market liquidity of a currency owned or to obtain bank financing at a lower rate. For example, company ONE obtains five-year below market financing from a German bank, and swaps deutschmarks for dollars with company TWO, which has more U.S. Dollars than it needs. At maturity, the swap is reversed. A cross-currency swap involves the exchange of a fixed rate obligation in one currency for a floating rate obligation in another. swaps are technically borrowings, but unlike bank loans they are not ordinarily disclosed on the balance sheet. Currency swaps can be negotiated for a variety of maturities up to at least 10 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by United States accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract. Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies "shop" for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency. Interest Rate swaps is a financial interest rate contracts whereby the buyer and seller swap interest rate exposure over the term of the contract. The most common swap contract is the fixed-to-float swap whereby the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Other types of swap include fixed-to-fixed and float-to-float. Interest rate swaps are more often utilized by commercials to re-allocate interest rate risk exposure.

In other words, a currency swap involves two principal amounts, one for each currency. There is an exchange of the principal amounts and the rate generally used to determine the two principal amounts is the then prevailing spot rate. Alternatively, the parties to the swap transaction can also enter into delayed/forward start swaps by agreeing to use the forward rate. A currency swap is similar to a series of foreign exchange forward contracts, which are agreements to exchange two streams of cash flows in different currencies. Like all forward contracts, the currency swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency and the swap leg the party agrees to receive is an asset in the other currency. The first mentioned swap is generally the preferred swap. In the stated case, the customer enters into the swap with the bank to receive floating interest rate (USD Libor) payments and USD principal and simultaneously pays INR fixed interest rate and equivalent INR principal amount arrived at based on the spot rate prevailing on the transaction date.

2.5 CURRENCY OPTION MARKET:

Forex option is a contract that conveys the right, but not the obligation, to buy or sell a particular item at a certain price for a limited time. Only the seller of the option is obligated to perform. Simply stated, a buyer of a currency option acquires the right - but not the obligation - to buy (a call) or sell (a put) a specific amount of one currency for another at a predetermined price and date in the future. The cost of the option is called a premium and is paid by the buyer to the seller. The seller determines the price of the premium at which they are willing to grant the option, based on current rates, nominated delivery and expiry dates, the nominated strike rate and option style. It is entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to perform. Call option Call Option - an option to BUY an underlying asset (stock or currency) at an agreed upon price (Strike Price or Exercise Price) on or before the expiration date. Since this option has economic value, you have to pay a price, called the Premium. Example: Microsoft (MSFT) was recently selling at $29.50/share, and there were 4 different options. For example, for $1.00 (premium) you could buy one call option that would allow you to buy a share of MSFT for $30 (strike P) on or before January 16, 2005. You will exercise the option if P > $30, and you will make money if the P > $31.00 ($30 + $1.00). If P = $30, you will not exercise the option, it will expire worthless and you will lose the premium ($1.50). Next example shows two ways to calculate profit from call option: You have paid a premium of $187.50 in July that gives you the right to buy SF @ $0.67 on or before September 10. If the SF sells at $.7025 on expiration, you can exercise your right to buy @$0.67 and then sell at $0.7025, for proceeds of $2,031.25. Subtracting the cost of your option premium of $187.50, you have a net profit of $1,843.75 ($2,031.25 - $187.50). The writer (seller) of the call option would lose $1,843.75.

1. Profit = S - (Exercise Price + Premium) x SF62,500 Profit = $.7025 - ($0.670 + $0.003) = $0.0295/SF x SF62,500 = $1,843.75 2. Profit = (S - Exercise Price) x SF62,500 - PREMIUM Profit = ($0.7025 - $0.67) x SF62,500 = $2,031.25 - $187.50 = $1,843.75 ROI: Your return on investment (ROI) would be $1843.75 / $187.50 (Profit / Investment) = 983% for 2 months! Illustrates leverage. You control about $42,000 worth of SFs (SF62,500 x $.67/SF) with only $187.50, or less than 1% of the underlying value of the currency. If spot rate at expiration is only $.6607/SF (or any rate < $.67/SF), the option expires worthless, you lose the premium of $187.50, which would be the gain to the writer (seller) of the call. Note: If the spot rate was between $.67 and $.673, you would exercise, but lose money. For example, if S = $0.671, you would lose ($.671 - .673) x SF62,500 = -$125 by exercising, vs. -$187.50 without exercising. Like futures trading, option trading is a zero-sum game. The buyer of the option purchases it from the seller or the person who "writes" the call. Options are traded in units of 100 shares. Put option Put Option - gives the owner the right, but not the obligation to sell an underlying asset at a stated price on or before the expiration date. Example: MSFT $30 January 2005 puts were selling for $2 (premium). You will make money if the P < $28. You will exercise if P < $30, exercise but lose money if P $28-30. If P > $30, put will expire worthless. The option extends only until the expiration date. The rate at which one currency can be purchased or sold is one of the terms of the option and is called the exercise price

or strike price. The total description of a currency option includes the underlying currencies, the contract size, the expiration date, the exercise price and another important detail: that is whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put. A Currency Option is a bilateral contract between two counterparties, and therefore each party is responsible for assessing the credit standing and capacity of the other party, before entering into a transaction. There are two types of option expirations - American-style and European-style. American-style options can be exercised on any business day prior to the expiration date. European-style options can be exercised at expiration only. Currency options give the holder the right, but not the obligation, to buy or sell a fixed amount of foreign currency at a specified price. 'American' options are exercisable at any time prior to the expiration date, while 'European' options are exercisable only on the expiration date. Most currency options have 'American' exercise features. Call options give the holder the right to buy foreign currency, while put options give the holder the right to sell foreign currency. Call options make money when the exchange rate rises above the exercise price (allowing the holder to buy foreign currency at a lower rate), while put options make money when the exchange rate falls below the exercise price (allowing the holder to sell foreign currency at a higher rate). If the exchange rate doesn't reach a level at which the option makes money prior to expiration, it expires worthless unlike forwards and futures, the holder of an option does not have an obligation to buy or sell if it is not advantageous to do so.

2.5.1 Other Types of Currency Options:

1) Average Rate Option

Unlike a conventional option, which is settled by comparing the strike with the spot rate at expiration, an average rate option is settled by comparing the strike with the average of the spot rate over the option period. This hedges against price movements without locking in a fixed price or rate upfront. The average can be geometric or arithmetic and can begin at any point during the option period. The sampling process frequency and interval of underlying price observations can be tailored to suit the user. Unlike a straight American or European-style option, an average rate option can be settled more than once over its life. So for example, the holder of a one-year average rate option can choose to settle the option monthly versus the average price or rate of the underlying the previous month. Average rate options are cheaper than conventional options because the averaging process smooths out the underlying price movements thereby reducing volatility and hence the premium of the option. Typically the volatility of an average rate option is about half the volatility of a conventional option. Also known as an Average Price or Asian option. Averaging has been applied to a wide range of swaps and options.

2) Average Strike Option

An Average strike option is similar to a standard option except that the strike price is taken to be the arithmetic average of the price of the underlying asset during the life of the option. Currency options were originally traded OTC (dealer network), not on organized exchanges. Currency traders were intl. banks, investment banks, brokerage houses. Options in OTC can be customized for the traders - maturity, contract size, exercise price, usually in large amounts of $1m, the size of most currency trades in the spot market. Since 1982, currency options have been traded on the Philadelphia Stock Exchange, see Exhibit 9.6 on p. 210 for contracts. Option contract sizes are half of the

futures contracts, e.g., 31,250 instead of 62,500, approx $56,000. Contracts are traded on a March, June, Sept, Dec cycle with original maturities of 3, 6, 9, 12 months. In addition, one and two month contracts are also traded so that there are always 1, 2 and 3 month contracts. Also, long term option contracts are traded for 18, 24, 30, 36 months. OTC trading dominates currency options trading on the Philadelphia exchange, $60B/day OTC vs. $1.5B/day for exchange-traded contracts. See WSJ story on p. 211. Big currency traders (banks) prefer OTC market, it operates 24 hours/day (necessary now in global market - time zone differences in Asia, Europe/currency crises), contract size is much bigger ($1m vs. $45,000 avg. PHLX), more efficient, lower transactions cost. PHLX limits traders to 100,000 max contracts. Also, trading is thin in exchangetraded currency derivative markets (3% of worldwide total), so prices tend to be less reliable, more volatile. For a $100m trade, it would be cheaper OTC vs. exchange trade. 3) Tunnel with Zero Premium (Range Forward or Cylinder Option)

In order that covering enterprise does not have to pay a premium, banks offer tunnels by which a cover between tow limits is possible without any premium. If spot rate on maturity is located between the two limits, the enterprise then avails of that spot rate. Exercise price X1 & X2 on the two sides of the range are chosen in such a manner that they are almost symmetrical around forward rate. It can be seen that a purchase of tunnel option is equivalent to a portfolio of options, consisting of a long position in a call with strike price of X2 and a short position in put with strike price of X1.The value of X1 and X2 are found by finding a call with the strike of X2 which has the same premium as the put with the strike of X1. The two premia cancel each other out. If the maturity spot is between X1 and X2 neither option is exercised. If it is less than X1 the seller of tunnel exercise his put option and if it is less than X1 the seller of tunnel exercises his put option and if it is greater than X2 the buyer of tunnel exercises his call option. It is easy to know that X1 must be less than the outright forward rate andX2 must be greater than the outright forward rate. Else the buyer of tunnel will make risk less profit in case X1 and X2 are less than outright forward, while seller will make risk less profit if X1 and X2 are greater than outright forward rate. The amount covered with

tunnels is generally of the order of magnitude of 1,00,000 US Dollar or equivalent in other currencies. The disadvantage is that tunnel does not allow the benefit that one might receive if the rates move beyond the tunnel boundaries. The above figure is a graphic representation of tunnel option:

Total Payments or Total Receipts

Tunnel Option X2

X1

X1

X2

Exchange rate on maturity

4) Look Back Option :

A look back option is the one whose exercise price is determined at the moment of the exercise of the option and not when it is bought. The exercise price is the one that is most favorable to the buyer of the option during the life of the option. Thus, for a look back call option the exercise price will be the lowest attained during its life and for a look back put option, it will be the highest attained during the life of the option. Since it is favorable to the option holder the premium paid on a look back option is higher. There are other variants of options such as knock in and knock out options and hybrid option. These are not discussed here. Most of these variants aim at reducing the premia of option and are the instruments tailor made for a particular purpose.

COMPARISION BETWEEN CURRENCY OPTION ON OTC AND ORGANISED MARKETS:

Options on OTC market are tailor-made to the needs of banks clients in term of the amount, date of maturity and exercise price. On the other hand, options on organized market are standardized but they are more liquid in case of resale of an option whereas on the OTC market, there is no secondary market. The following are the differences: Feature Volume of contract Date of maturity Mode of transaction Secondary Market Commission Participants Organized market Standardized Standardized on the market On the market On going Negotiable Members of exchange OTC market Negotiated Negotiated Bank and client or bank and bank Only possibility to resell to the bank Negotiable but often included in the premium Banks, enterprises and

financial institutions

2.6 Swaption:This is a combination of an option and a swap in fact an option to enter into a swap. In interest swaps, two variations are common: 1) A payer swaption gives the buyer the right to pay an agreed fixed rate and receive a floating rte as per the agreed benchmark (typically, LIBOR) 2) A receiver swaption gives the buyer the right to receive an agreed fixed rte and pay floating rate. The payer swaption could be used by borrowers with floating rate debt to hedge the interest rate risk. (Needless to say, there will be an upfront fee, or premium, to buy the swaption). In general, in a positive yield curve environment, the floating rate will be lower than the fixed rate at which it can be swapped. The payer swaption gives the flexibility to the buyer/borrower of continuing to pay the floating rate so long as it is low. He will exercise the swaption. At the previously agreed fixed rate, when interest rates go up. Best of both the worlds- but at the cost of the upfront premium.

3.0 Foreign Exchange Derivatives Market in India Status and Prospects

The gradual liberalization of Indian economy has resulted in substantial inflow of foreign capital into India. Simultaneously dismantling of trade barriers has also facilitated the integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. The global market for derivatives has grown substantially in the recent past. The Foreign Exchange and Derivatives Market Activity survey conducted by Bank for International Settlements (BIS) points to this increased activity. The total estimated notional amount of outstanding OTC contracts increasing to $111 trillion at end December 2001 from $94trillion at end June 2000. This growth in the derivatives segment is even more substantial when viewed in the light of declining activity in the spot foreign exchange markets. The turnover in traditional foreign exchange markets declined substantially between 1998 and2001. In April 2001, average daily turnover was $1,200 billion, compared to $1,490 billion in April 1998, a 14% decline when volumes are measured at constant exchange rates. Whereas the global daily turnover during the same period in foreign exchange and interest rate derivative contracts, including what are considered to be "traditional" foreign exchange derivative instruments, increased by an estimated 10% to $1.4 trillion.

Reserve Bank of India

Forex Market

Inter bank-forex market (Dealing rooms of Commercial Banks, Financial Institutions)

Retail Market (Commercial Bank, Financial Institutions) Foreign branches of Indian banks, branches of foreign banks and correspondents

Money Changers

Tourists

Customers (Exporters, Importers, Remitters, External commercial borrowers, tourists etc.)

3.1 Evolution of the forex derivatives market in India

This tremendous growth in global derivative markets can be attributed to a number of factors. They reallocate risk among financial market participants, help to make financial markets more complete, and provide valuable information to investors about economic fundamentals. Derivatives also provide an important function of efficient price discovery and make unbundling of risk easier. In India, the economic liberalization in the early nineties provided the economic rationale for the introduction of FX derivatives. Business houses started actively approaching foreign markets not only with their products but also as a source of capital and direct investment opportunities. With limited convertibility on the trade account being introduced in 1993, the environment became even more conducive for the introduction of these hedge products. Hence, the development in the Indian forex derivatives market should be seen along with the steps taken to gradually reform the Indian financial markets. As these steps were largely instrumental in the integration of the Indian financial markets with the global markets.

Rupee Forwards

An important segment of the forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporates, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted.

Although due to the Asian crisis, freedom to rebook cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers.

The forward contracts are also allowed to be booked for foreign currencies (other than Dollar) and Rupee subject to similar conditions as mentioned above. The banks are also allowed to enter into forward contracts to manage their assets liability portfolio. The cancellation and rebooking of the forward contracts is permitted only for genuine exposures out of trade/business up-to 1 year for both exporters and importers, whereas in case of exposures of more than 1 year, only the exporters are permitted to cancel and rebook the contracts. Also another restriction on booking the forward contracts is that the maturity of the hedge should not exceed the maturity of the underlying transaction.

RBI Regulations: These contracts were allowed with the following conditions: These currency options can be used as a hedge for foreign currency loans provided that the option does not involve rupee and the face value does not exceed the outstanding amount of the loan, and the maturity of the contract does not exceed the unexpired maturity of the underlying loan. Such contracts are allowed to be freely rebooked and cancelled. Any premia payable on account of such transactions does not require RBI approval Cost reduction strategies like range forwards can be used as long as there is no net inflow of premia to the customer.

Banks can also purchase call or put options to hedge their cross currency proprietary trading positions. But banks are also required to fulfill the condition that no stand alone transactions are initiated.

If a hedge becomes naked in part or full owing to shrinking of the portfolio, it may be allowed to continue till the original maturity and should be marked to market at regular intervals. There is still restricted activity in this market but we may witness increasing

activity in cross currency options as the corporates start understanding this product better.

In short, The Indian forex derivatives market is still in a nascent stage of development but offers tremendous growth potential. The development of a vibrant forex derivatives market in India would critically depend on the growth in the underlying spot/forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure. Factors such as market liquidity, investor behavior, regulatory structure and tax laws will have a heavy bearing on the behavior of market variables in this market. Increasing convertibility on the capital account would accelerate the process of integration of Indian financial markets with international markets. Some of the necessary preconditions to this as suggested by the Tarapore committee report are already being met. Increasing convertibility does carry the risk of removing the insularity of the Indian markets to external shocks like the South East Asian crisis, but a proper management of the transition should speed up the growth of the financial markets and the economy. Introduction of derivative products tailored to specific corporate requirements would enable corporate to completely focus on its core businesses, de-risking the currency and interest rate risks while allowing it to gain despite any upheavals in the financial markets.

Increasing convertibility on the rupee and regulatory impetus for new products should see a host of innovative products and structures, tailored to business needs. The possibilities are many and include INR options, currency futures, exotic options, rupee forward rate agreements, both rupee and cross currency swap options, as well as structures composed of the above to address business needs as well as create real options. A further development in the derivatives market could also see derivative products linked to commodities, weather, etc which would add great value in an economy where a substantial section is still agrarian and dependent on the vagaries of the monsoon.

3.2 Perspective on the Indian forex market

The Indian forex market is made up of banks authorized to deal in foreign exchange, known as Authorized Dealers (ADs), foreign exchange brokers, money changers and customers - both resident and non-resident, who are exposed to currency risk. It is predominantly a transaction-based market with the existence of underlying forex exposure generally being an essential requirement for market users. The Indian forex market has grown manifold over the last several years. Average daily total turnover has increased from US$3.67 billion in 1996-97 to US$9.71 billion in 2003-04. The normal spot market quote has a spread of 0.50 to 1 paise while swap quotes are available at 1 to 2 paise spread. The derivatives market activity has shown tremendous growth as well, especially after the MIFOR (Mumbai Inter-bank Forward Offered Rate) swap curve evolved in 2000. Many policy initiatives have been taken to develop the forex market. ADs have been permitted to have larger open position and aggregate gap limits, linked to their capital. They have been given permission to borrow overseas up to 25 per cent of their Tier-I capital and invest up to limits approved by their respective Boards. Cash reserve requirements have been exempted on inter-bank borrowings. Exporters and importers are, in general, permitted to freely cancel and rebook forward contracts booked in respect of their foreign currency exposures, except in respect of forward contracts booked to cover import and non-trade payments falling due beyond one year. They have also been permitted to book forward contracts on the basis of past performance (without production of underlying documents evidencing transactions at the time of booking the contract). Corporates have been permitted increasing access to foreign currency funds. General permission has been given to ADs for approving External Commercial Borrowings of their customers up to a limit of US $ 500 million; appropriate restrictions have been placed on the end-use of such funds. While exchange earners in select categories such as Export Oriented Units (EOU) are permitted to retain 100 per cent of their export earnings, others are permitted to retain

50 per cent of their forex receipts in EEFC accounts. Residents may also enter into forward contracts with ADs in respect of transactions denominated in foreign currency but settled in Indian rupee. They can hedge the exchange risk arising out of overseas direct investments in equity and loan. Residents engaged in export/import trade, are permitted to hedge the attendant commodity price risk in international commodity exchanges/ markets using exchange traded as well as OTC contracts. Non-residents are permitted to hedge the currency risk arising on account of their investments in India. However, once cancelled, these contracts cannot be rebooked for the same exposure. Enabling Environment for Reforms in the Forex Market: In order to embark upon further deregulation of the foreign exchange market, including relaxation of capital controls, an enabling environment is needed for the reforms to proceed on a sustainable basis. It is in this context that liberalization of various sectors has to proceed in tandem to derive synergies of the reforms encompassing multiple sectors. Sound macroeconomic policies and a competitive domestic sector improve the capacity of the economy to absorb higher capital inflows and provide cushion against unexpected shocks. Some of the parameters recommended by the Tarapore Committee on Capital Account Convertibility such as reduction in the combined fiscal deficit, inflation between 3 and 5 percent and further reduction in the gross NPAs of the banking sector are required to be achieved for creating an enabling environment for further liberalization in the forex markets.

3.4 Suggestions made by market participants for further liberalization, along with their implications.
During the decade that has elapsed since the Report of the Expert Group on Foreign Exchange Markets in India, the forex market has grown and matured significantly. Due to volatility in exchange rates and interest rates, a need for greater freedom to hedge exposures dynamically has been expressed. With gradual integration of the Indian economy with the world economy and lowering of custom tariffs, the need to hedge price risk on domestically procured commodities has grown. A demand has emerged to afford the same flexibility to our corporates as is available to their competitors overseas in order for them to compete effectively in the global arena. The various suggestions received and the views of the experts in regard thereto are discussed in the following paragraphs. At the same time, the experts strongly advocated the necessity of having an enabling environment in place for further reforms in the forex market. In this context, a reference is drawn to para I.42 of Annex I, which deals with the matter at length. The experts felt that the sequencing with regard to implementation of all reforms recommended for implementation would have to invariably take into account the enabling conditions for further progress towards capital account convertibility, liberalization in other sectors of the economy as well as the trend in overall balance of payments.

Suggestions relating to flexibility to corporates to dynamically hedge their exposures

Hedging of competitive exposures. There are three types of exchange rate exposures that a firm runs: (i) (ii) (iii) Transaction exposure Contractual exposure, and Competitive exposure

The essential distinguishing factor in respect of the three types of exposures is the time horizon over which the exposure arises. Transaction exposure is the extent to which the value of transactions already entered into is affected by exchange rate risk. Contractual exposures are slightly longer-term exposures, for instance exposures four quarters from now. These are exposures which are not associated with booked transactions. The exporter will have contractual agreements, implicit or explicit, that affect her exposure at that horizon. The exposure at long horizons is known as competitive exposure. For instance, the exposure of cash flows three years from now. Competitive exposure in respect of an exporter arises when the overseas sales both quantity as well as the price per unit - are affected by exchange rate changes. This exposure is so known, because the exporters competitive position and not just the profitability of current operations - is altered by exchange rate changes. Competitive exposure is a complex phenomenon and depends on the markets in which the exporter does business. At present, transactional and contractual exposures are permitted to be hedged. Transactional exposures are permitted to be hedged on the basis of documentary evidence and up to the amount of the underlying exposure. Contractual exposures are permitted to be hedged up to the extent of the previous years turnover or the average of the previous three years turnover, whichever is higher. Documents have to be presented at the time of maturity of the contract. With regard to the competitive exposure of exporters in overseas markets, international experience suggests the following: (i) Measurement of competitive exposure is an inexact science (ii) Since competitive exposure arises over a longer time horizon, the response needs to be strategic in nature, depending upon the particular situation the exporter is

confronted with. This includes changes in technology, product mix, sources of inputs, marketing approach, shifting of production base etc. (iii) Hedging of competitive exposure by way of exchange rate contracts is not commonplace, especially because, as pointed out earlier, the risk factor in competitive exposure is the real exchange rate and not the nominal exchange rate. Accordingly, the experts is of the view that exporters may not, for the present, be permitted to hedge their competitive exposures; this requirement may best be addressed at the time of going in for capital account convertibility.

Hedging of derived exposures

A derived foreign currency exposure arises in the Indian market when a customer who has a rupee exposure converts it into a foreign currency exposure through a rupee-foreign currency swap. Thus, for instance, if a customer swaps from a fixed rupee liability into a floating Japanese yen liability, she is exposed to the following two risks: 1. 2. contract Under current regulations, the customer cannot hedge these risks since these are derived exposures. The only option available is to unwind the entire transaction, which then cannot be rebooked. The experts has considered the above arguments and has concluded that there is ample justification for permitting hedging of interest rate risk as also foreign currency exposure for pairs of currency other than rupee ( for eg: a corporate moving from a rupee exposure to yen exposure and seeking to hedge the dollar-yen currency risk) arising on account of such derived exposures.. However the argument of equating derived exposure in foreign currency with an actual borrowing in foreign currency Depreciation of rupee vs. yen; i.e., appreciation of yen vs. dollar or Upward movement in yen LIBOR interest rates during the tenor of the

appreciation of dollar vs. rupee, or both

needs to be accepted with caution at the present stage of development of the market. While there are well laid down rules for accessing foreign currency borrowings, the derived or synthetic exposure has entirely different connotations. Permitting free cancellation and rebooking of such exposures would be tantamount to giving freedom to freely access the foreign exchange market without an underlying forex exposure. This has larger implications and would need to be considered only at a later stage when the country is closer to capital account convertibility. The experts, therefore, recommends that, for the present, the corporates who have derived foreign exchange exposures may be permitted to hedge the interest rate risk and cross currency exposures only. Rupeeforeign currency swaps, as above, cannot be rebooked on cancellation.

Foreign Currency- Rupee Options- Liberalization

In the foreign currency-rupee options market, corporates can purchase plain vanilla calls and puts, as also enter into packaged products involving cost reduction structures provided the structure does not increase the underlying risk and does not involve net receipt of premium. As options are complex products, the volumes in foreign currency-rupee options market has expectedly been sedate, but is expected to pick up as knowledge and therefore comfort about the product grows. There are only a few market-makers and that too concentrated in the metros. Customer appetite has mostly been for zero-cost structures. The liquidity has not been very good, leading to wide bid-offer spreads. One of the reasons stated is that customers cannot sell options. Therefore, the market is essentially divided into two camps: market-makers who can sell protection and corporates who can buy protection. (Of course, cost-reduction structures which are permitted have enabled customers to be slightly short volatility.) The resultant risk has to be warehoused amongst the banks themselves, as corporates cannot be net receivers of premium. If say, an exporter is permitted to sell a call against her underlying, it will enable her to express her view in the market and earn a premium for the same, without adding to incremental risk. The market will also be benefited by the additional liquidity and the fact that risks can be shared among the market-makers and the end-users. Bid-offer spreads would reduce, in turn attracting greater all-round participation. In view of the above, the experts recommends that, in principle,

corporates subject to adequate risk management systems being in place, be permitted to sell/write covered calls and puts. However, it is imperative that necessary accounting standards and adequate disclosure norms for the corporates are in place before permitting this facility.

Suggestions relating to banks

Ensuring customer suitability and appropriateness Greater liberalization requires greater control and discretion with banks; they need to act with responsibility and develop the confidence of corporate entities going in for derivative transactions. The appropriateness standard ensures that banks use the same principles for taking credit decisions for derivative transactions as they do for nonderivative transactions. The bank would evaluate the purpose of the derivative transaction and make an assessment as to whether it is appropriate to the customers needs and level of sophistication. While several banks already have an appropriateness policy in place, many banks do not. It is recommended that all banks should introduce a customer suitability and appropriateness policy forthwith. A case in point is the quanto swap which several corporates, financial institutions and, indeed, banks themselves have entered into, without fully appreciating the risk involved, nor being made adequately aware of the associated risk by the marketmaking banks. A quanto swap is an interest rate swap which involves payment or receipt of the difference between money market interest rates in two different currencies. The customer expresses a view on a foreign interest rate without taking on the exchange rate risk. Assuming a customer has contracted to pay US$ LIBOR and receive a fixed rate in INR, she is exposed to the risk of LIBOR rising by more than what is forecasted. A related issue is that ADs should ensure that the Board of Directors of the corporate has drawn up a risk management policy, laid down clear guidelines for concluding the transactions and institutionalized the arrangements for a periodic review of operations and annual audit of transactions to verify compliance with the regulations.

The periodic review reports and annual audit reports should be obtained from the corporate concerned by the ADs. While this guideline is already in place, it is reported that banks find it difficult to implement it in the face of certain other banks not insisting on such a policy. All ADs should ensure compliance to this regulation, and refrain from offering derivative structures to those corporates which do not submit the requisite information. The closing time for inter-bank foreign exchange market in India. The Forex Association of India (FAI) has requested Reserve Bank to grant a grace period of half an hour (i.e. up to 4.30PM) for concluding trades like end of day position adjustments, correction of wrong reporting, late reporting of branches and cover operations for customer transactions concluded close to 4.00PM. It is reported that FIIs also access the market for varying amounts close to 4PM; further, vostro account funding operations also take place after the official trading hours. The experts has examined the issue and accepts the validity of the request. It is suggested that the closing time for inter-bank foreign exchange market in India be extended by one hour from 4PM to 5PM. Accordingly, the trading hours for the interbank foreign exchange market would be from 9.00AM to 5.00PM. Capital charge for open position Banks should ideally maintain capital on their actual overnight open exchange position rather than on the limit available. The current requirement to maintain capital on the limit available is on account of the practical difficulties in computing the amount of capital to be maintained by each bank. However, as on date, banks are required to report online to Foreign Exchange Department (FED) their overnight open position maintained on each day by the close of business on the following working day.. The proposal to maintain capital on the actual open position (rather on the limit approved by Reserve Bank) is, accordingly, recommended for implementation. The modalities for

actually computing the capital charge may be worked out based on, say, monthly averages.

Monitoring of interest rate risk using the VaR The current method of computation of interest rate risk uses the gap method.

Aggregate Gaps takes into account only the sum of the monthly mismatches and does not adequately address issues regarding the period of the exposure and attendant interest rate risk. The ceiling on Aggregate Gap Limit (AGL) is fixed at 6 times the net owned funds. Further, on account of the rolling month basis for determining the buckets, the aggregate gap maintained may exhibit a rise despite no transactions having taken place. With rise in business volumes, several banks have found it difficult to stay within the prescribed AGL. It is recommended that the current method be discontinued and a Value at Risk (VaR) method be introduced for monitoring of gaps. The issue regarding capital charge on the VaR maintained by banks is required to be addressed, though. Further, with rise in derivatives market activity, many banks have gaps in the 1-3, 3-5 and >5year sectors, which the model also needs to address. An appropriate model may be suggested by FEDAI in consultation with Reserve Bank. The VaR number can be released by FEDAI for each bucket and followed uniformly by all banks. Ultimately the system should move towards the adoption of a VaR model for interest rate risk on the entire portfolio (including that on the rupee book). Overseas borrowing limit In developed markets, while Covered Interest Rate Parity Principle invariably holds, in India it does not. Permitting banks to borrow a greater amount of foreign currency (FC), though a necessary condition, is not a sufficient one for the above principle to hold. In case the overriding feeling in the market is that of continued rupee appreciation, corporates could borrow in foreign currency and sell it to generate rupee for working capital purposes. Reserve Bank would have to mop up the excess supply.

The tendency of the banks would be to go in for more and more Buy/Sell swaps to generate FC for lending as also to meet FC payment requirements. Premia would move into discount. Only if entities that are naturally long in FC were permitted access to the market, would they do sell/buy swaps to avail of the arbitrage advantage which would ensure that covered interest parity prevails. However, this would have capital account convertibility implications. Accordingly, it is recommended that this suggestion may be examined for implementation at a later date. Release of data on derivatives Release of data to the market improves transparency and enables participants to gauge the volumes being transacted. This suggestion is recommended for implementation. Reserve Bank may design a suitable format in consultation with FEDAI.

Regulatory and accounting convergence in respect of derivatives. There is regulatory divergence in the permissible structures of rupee and

forex derivatives. These restrictions have been put in place on account of prudential considerations and the fact that India is not fully convertible on the capital account. The experts recommends that till such time as capital account restrictions are in place, it would be desirable to maintain differential regulations with respect to rupee interest rate derivatives and forex derivatives. There should be full convergence between the accounting treatment of all types of derivatives (Rupee as well as foreign exchange). and also amongst banks and corporates. The objective here is to eliminate all incentives to drive any wedge between onbalance sheet and offbalance sheet items. Moreover, there is need to put in place

objective conditions to determine whether a derivative is in the nature of a hedge or not. Wherever the derivative is in the form of a hedge, the accounting treatment should be the same as that for the underlying. The experts recommends that derivatives accounting norms on the lines of IAS 39 be introduced for adoption by banks and corporates alike. However, in the case of banks, a somewhat stricter and conservative accounting norms may be necessary on prudential considerations, in view of the pivotal position of banks in the countrys financial and payments systems. Para I.40 of Annex I may be seen for a more detailed analysis. Implications of further liberalization & Safeguards The implications of liberalization measures recommended by the experts for the overall forex market and its two major constituents users and banks are as follows: Forex market Going by international experience, more freedom on outflows would cause more inflows, particularly when the outlook on the rupee is bullish. Thus, further liberalization would possibly lead to increased supply and more volume and liquidity in the spot and derivatives segments of the forex market. Market users With increase in the international trade volumes, greater access to international funds by way of borrowings and enlargement in scope for investments overseas, it is imperative that Indian corporates have the necessary systems to manage their foreign exchange risk. The proposed liberalization measures would offer more flexibility to corporates to manage their risks dynamically and lead to more efficient reallocation of risks. The competitive position of Indian entities engaged in international trade will be enhanced as a result of the suggested measures. Liberalization measures pertaining to hedging of commodity price risk would ensure that corporates dealing in commodities

whose prices are linked to international prices would be able to compete effectively with their competitors.

Banks Authorized dealers will benefit from the larger array of products and higher volumes. Banks as users will also benefit in the same way as all other users in better management of their market risks.

Safeguards
Phased implementation The recommendations need to be implemented in a phased manner so as to allow time to all categories of participants to adequately prepare for the new products/activities that will ensue. Monitoring of user activities Information Enhanced flexibility to users should go hand in hand with availability of critical information for monitoring purposes. At present, there is a substantial information gap as regards what the market-users are doing . This is important for market monitoring purposes, particularly since forex activities of the treasuries of large corporates are increasingly becoming profit-seeking. Large corporates often use more than one authorized dealer for forex operations. Hence, it would be a good idea to designate one authorized dealer for each large customer to collect and collate information in respect of their forex operations. Transparency

From a systemic perspective, guaranteed settlement of forex transactions, particularly of the derivatives, provides a fair degree of stability. Also, it becomes easier for authorities to monitor and regulate activities in the derivative markets if all information is concentrated on the clearing/settlement mechanism. CCIL has been offering clearing and guaranteed settlement of spot US$/INR transactions. Guaranteed settlement of US$/INR forward transactions from trade date is likely to commence soon. Centralized clearing and settlement for derivatives by CCIL would rid banks of their concerns regarding credit risk on account of the derivative positions of the counterparty banks; dissemination of information by CCIL would bring about more transparency. In short, Further liberalization requires better transparency and ready availability of information. It would therefore be essential to put in place a comprehensive reporting system for all derivatives transactions. The reports should be such that they bring into focus not only the volumes transacted but also the quantum of risk faced by banks on account of their derivative positions.

Summary of recommendations for implementation in the short-term.

3.5 Perspective on the Indian Forex Market.

The wide-ranging structural reforms in the 1990s in response to the unprecedented external payment crisis of 1990-91 led to strength and resilience in the external sector of the economy. With the country moving to a market determined exchange rate regime and becoming fully convertible on current account transactions, the risk-bearing capacity of banks increased and trading volumes started rising. The first major initiative toward further developing the forex market along modern lines in the early years of reform was the appointment of an Expert Group in November 1994 to study, in-depth, the shortcomings of the foreign exchange market and to recommend measures for its efficient and orderly growth, including the introduction of new derivative products. The Expert Group, popularly known as the Sodhani Committee,

made 33 major recommendations. Reserve Bank accepted these for implementation and the period starting from January 1996 saw wide-ranging reforms in the Indian foreign exchange market. Certain measures, such as permission to Foreign Institutional Investors (FIIs) to hedge their investments in India, which were not found suitable for implementation initially, were also implemented subsequently. The Indian forex market is made up of banks authorized to deal in foreign exchange, known as Authorized Dealers (ADs), foreign exchange brokers, money changers and customers - both resident and non-resident, who are exposed to currency risk. It is predominantly a transaction-based market with the existence of underlying forex exposure generally being an essential requirement for market users. The entire gamut of regulations on hedging of currency exposures is predicated on the fact that the entity accessing the forex market should have an underlying. Foreign Exchange Dealers Association of India (FEDAI) plays a special role in the foreign exchange market as a Developmental Agency for smooth and speedy growth of the forex market in all its aspects. All ADs are required to become members of FEDAI and to execute an undertaking to the effect that they would abide by the terms and conditions stipulated by FEDAI for transacting forex business. FEDAI is also the accrediting authority for the forex brokers in the interbank forex market. AD licences are issued to banks, on their request, under Section 10(1) of the Foreign Exchange Management Act, 1999. The AD licences are co-terminus with the banking licences and allow ADs to undertake the entire range of foreign exchange activities. All merchant transactions are required to be undertaken through ADs. ADs are freely allowed to buy/sell/swap foreign exchange and enter into forward and derivative contracts with other banks. Currently, there are 88 ADs operating in India out of which two are Urban Co-operative banks (UCBs) and one is a State Co-operative Bank. Some UCBs have been granted Full Fledged Money Changers licence, which allows them to buy foreign currency and sell foreign currency for private and business visits. A few of them have also been granted permission by Reserve Bank to maintain NRE/NRO deposits. Some financial institutions, which have large volumes of foreign exchange transactions and wish to run their own treasuries, have been granted restricted authorized persons licence. Under this licence, their foreign exchange transactions have

to be restricted to those listed out in their licence. While they are allowed to hedge their underlying forex risk, they are generally not permitted to trade/ initiate positions. As mentioned above, AD licences are granted to banks co-terminus with their banking licences. However, it is well acknowledged that managing forex risk requires expertise, both in terms of human resources and systems, on an ongoing basis. It, therefore, bears examination as to whether one should consider issuing an AD licence initially for a period of, say, three years. During this period, the banks forex operations would be monitored and only if the systems and procedures adopted are found to be satisfactory, would the licence be renewed. If any major violation of guidelines is detected warranting discontinuation of the AD licence, the same would not be renewed. AD licence would not be granted or if granted, would be withdrawn, in case of banks whose balance sheets are weak, and which could possibly face a difficult financial situation. Primary Dealers (PDs), who primarily deal in government securities, have evinced interest in obtaining AD licences. Their specific interest appears to be in acting as market makers in derivative products. However, as dealers in Indian securities, they are not exposed to foreign exchange risk. In addition, PDs are financial intermediaries mandated to perform a specialised role in Government Securities Market; their role as market- makers in foreign exchange has not been envisaged, and may, in fact, come in the way of effective discharge of their responsibilities as primary dealers. As such, PDs may not be granted AD licences for the present. The request of PDs for permission to invest in overseas securities is currently under consideration. In case such investments are approved, PDs would be exposed to exchange risk insofar as their overseas investments are concerned and would be permitted access to the domestic forex market as users, through their ADs. All merchant transactions in the forex market have to be necessarily undertaken directly through authorized dealers. However, to provide depth and liquidity to the interbank segment, ADs have been permitted to utilise the services of brokers for better price discovery in their interbank transactions. Inter-bank contracts can be concluded between ADs through direct negotiations over the telephone or through an electronic negotiated

dealing system where the counterparties directly contact each other over an electronic dealing platform and negotiate the terms of the contract. Alternatively, such deals can be put through a voice broker over telephone or t hrough an electronic order matching system, where counterparties leave their bid/ offer quotes on an electronic system which are displayed to the market participants. The Sodhani Committee had seconded the proposal of Reserve Bank for setting up of a clearing house for forex transactions, considering the substantial benefits which would accrue to banks such as reduction in the cost of settlement, reduction in counterparty risk due to the settlement guarantee offered by the Clearing House, better utilisation of counterparty limits on account of netting, etc. Accordingly the Clearing Corporation of India Ltd. (CCIL) was set up in 2001 and has been undertaking guaranteed settlement of interbank US$/INR spot and forward contracts since November, 2002. Forward deals are guaranteed for setlement from the S-2 day; the proposal for guaranteed settlement of forward deals from trade date is currently under examination. Subsequently, CCIL has been undertaking guaranteed settlement of cash (value same day) and tom (value next working day) contracts also. The settlement is undertaken on a multilateral net basis, through a process of novation, and all trades accepted are guaranteed for settlement. To take care of the risks associated with guaranteed settlement, CCIL has set up a robust risk management mechanism by setting exposure limits for its members and also putting in place a sound allocation mechanism. CCIL has recently been granted pemission for aggregation of cross currency deals of ADs through the Continuous Linked Settlement (CLS) process by becoming a third party user in the CLS system. CLS settlement is however not a guaranteed settlement and only ensures that settlement takes place on a Payment Versus Payment basis. Once the CLS facility is operational, the feasibility of extending it to banks in our neighbouring countries (such as those under the Asian Clearing Union mechanism) needs to be explored. General permission has been given to ADs to open/close rupee accounts of their overseas branches or non-resident banks with whom correspondent relationship is established. No interest is payable on the balances in these accounts. Funding of the vostro accounts can be done only on up to spot basis, for which ADs are permitted to

quote only the bid side. ADs are not permitted to make two way or forward quotes to overseas banks. Reserve Bank issued guidelines to banks in November 2002 for opening and maintenance of Off-shore Banking Units (OBUs) at the Special Economic Zones set up at the behest of the Ministry of Commerce, Government of India. The OBUs are expected to provide world class facilities and funds at global rates to the export oriented units situated in these zones. OBUs are not permitted to deal in rupees at all except for their day to day expenses. There has to be a clear fire wall between their activities and the domestic forex and money markets. To this end, they have been prohibited from lending to their parents/branches in India. They are also permitted to lend only 25 per cent of their total liabilities as on the previous working day to units in the Domestic Tariff Area (DTA). While OBUs are permitted to invest overseas, they are not permitted to lend outside India.

Policy initiatives to develop the forex market

Relaxations for banks:

Overnight Open Position Limit (OPL) The Sodhani Committee recognised that a vibrant forex market would have to allow banks to make two way quotes and take larger open positions. Until 1994, ADs were not permitted to take any view on currency movements and were required to maintain square or near square positions. Subsequently in May 1994, all banks were uniformly allowed an overnight open position limit of Rs 15 crore. As per the Sodhani Committee recommendation, banks were given the freedom to fix their own open exchange position limit and seek approval of Reserve Bank in this regard. The revised limits became operative from January, 1996. Obviously the limits should have a reasonable relation to the trading volumes, merchant turnover and the capital structure of the banks.

It has been observed that as the banks sophistication and volumes have grown, they have gradually sought to increase their OPL. The combined OPL of the banking system today is several times the OPL that was prevailing in 1996.

Aggregate Gap Limit (AGL) Depending upon the asset-liability profile, dealing expertise and such other relevant factors, ADs have been accorded freedom to fix their own gap limits for more efficient management of their assets and liabilities, subject to Reserve Bank approval. The ceiling on AGL is fixed at 6 times the net owned funds of the AD. AGL seeks to control an ADs liquidity or mismatched maturity risk. Such risks occur when liabilities and contracts to sell in a given currency mature earlier/later than assets and contracts to purchase in that currency. The maturity mismatch is basically a problem of excess or shortage of funds on any given day; generally, banks are more concerned about a negative gap than a positive gap since it could imply having to fund such shortage at higher than anticipated interest costs (in case of borrowing) or swap costs (in case the currency is purchased to match the shortage and re-sold for another date). The current method of capturing the risk associated with asset-liability maturity mismatch of the forex book of ADs through an indicator (AGL), which is the aggregate of the monthly mismatches, is not very accurate. Banks which are permitted higher Aggregate Gap Limits are required to mark-to-market their gaps on a daily basis using value-at-risk (VaR) models. A VaR methodology is better than the current methodology for estimating the risk associated with gaps. While ADs have sought to increase their AGL in tune with their business volumes, the utilisation of AGL for accommodating maturity mismatches on account of derivative transactions has also increased. Initiating cross currency position in the overseas markets:

With globalisation and significant increase in cross border capital flows, banks commenced taking views on cross currency movements also. The banks which had put in place adequate risk management systems, on approval of Reserve Bank, were permitted to trade in the overseas markets, subject to observance of the overall position/gap discipline. Currently, banks do not need prior approval of Reserve Bank for initiating cross-currency trading positions overseas. Asset - liability management by banks: Once the foreign currency balance-sheet of the banks started swelling on account of liberalization, banks were permitted to use interest rate swaps, currency swaps and FRAs for their own asset liability management, subject to a proper risk management policy being approved by their top management. They can also purchase call or put options to hedge their cross currency proprietary trading positions. Permission for overseas borrowings and investments One of the major shortcomings of the Indian foreign exchange market is that the forward price of the rupee is not determined by the interest rate differentials alone, but is influenced in a major way by (a) supply of and demand for forward dollars, (b) interest differentials and expectations of future interest rates, and (c) expectations of future US$/INR rate. This would indeed be the case in all countries that still have exchange and capital controls. To initiate the process of integration between the two markets, Reserve Bank has permitted limited access to banks to borrow from and invest in the overseas markets. Presently, banks are permitted to borrow overseas up to 25 per cent of their Tier I capital or US$10 million, whichever is higher. However, overseas borrowings of banks for funding export credit are not included in this limit. The interest and exchange rate scenario, prevailing over the last two years has led to increased demand by exporters for foreign currency denominated loans leading to manifold increase in the overseas borrowings of banks to fund these loan assets. In March 2004, rationalization of the various avenues for foreign currency borrowings of banks was undertaken and a system of monthly reporting was introduced. Current data indicates

that the banking systems overseas borrowing is quite close to the overall ceiling and if borrowings for funding of export credit are also included, the total overseas borrowings are significantly higher. A reference is also drawn to the Report of the Internal Group on External Liabilities of Scheduled Commercial Banks constituted by Reserve Bank. In its report dated May 24, 2004, the experts had stated as follows: International liabilities of banks are now nearly double of their international assets which is an issue of serious concern. There has been some thought on whether a cap should be placed on the total overseas borrowings of banks at, say, 50 per cent of each banks Tier-I capital. The concern about residents borrowing in foreign currency is that it might lead to a ballooning of unhedged exposures which may have adverse implications for the stability of the foreign exchange market as well as the quality of loan assets in the books of banks. However, foreign currency loans for funding export credit cannot be considered to be unhedged since exporters have a natural hedge in terms of their export proceeds. The only apprehension would then be if exporters were to sell their foreign currency proceeds forward and repay the foreign currency loans out of rupee resources. One point of view is that with the withdrawal of quotas for many manufactured goods, Indian exports are set to take off and this may not be the right time to restrict the availability of foreign currency funds to the exporters and therefore, no limit should be placed on banks borrowings for funding export credit. Another issue for examination is whether smaller banks, for whom US$10 million is higher than 25 per cent of their Tier-I capital, should be permitted to borrow only up to the 25 per cent limit. This could be justified in the sense that being a smaller bank, its risk-taking appetite would also be smaller and the prudential limit of 25 per cent would be an appropriate ceiling. On the other hand, such small banks are few in number; they have limited merchant base and restricting their borrowing would further starve them of opportunities in the market. ADs are free to undertake overseas investments up to the limits approved by their respective Boards. Such investments may be made in deposits with banks or money market/debt instruments of approved rating with residual maturity up to one

year. Investments in fixed income securities of longer tenor are permitted for undeployed FCNR (B) funds subject to the condition that the maturity of the securities does not exceed the maturity of the underlying deposits.

Foreign Direct Investments

ADs are permitted to enter into forward contracts with residents outside India to hedge their investments made in India since January 1, 1993, subject to verification of the exposure in India, as also the dividend receivable on their investments. Residents outside India are permitted to enter into forward sale contracts with ADs to hedge the currency risk arising out of their proposed foreign direct investment in India. Such contracts, if cancelled, are not eligible to be rebooked for the same inflows and exchange gains, if any, on cancellation, are not allowed to be passed on to the overseas investor.

Foreign Institutional Investors

Foreign Institutional Investors (FIIs) have been permitted to hedge the market value of their entire investment in equity and/or in debt in India. While there is no absolute limit on the amounts that FIIs can invest in equity subject to sectoral caps, FIIs, as a whole, can invest only up to US$ 1.75 billion in Government securities and Treasury Bills and US$ 500 million in corporate debt.

Regulatory and accounting convergence in respect of derivatives

The derivatives mentioned above and combinations thereof are permitted to be transacted in the Indian forex market. Interest rate swaps, forward rate agreements and exchange-traded interest rate futures are currently available for hedging the rupee interest rate risk in the books of banks and corporates. There are regulatory disparities in the permissible structures of rupee and forex derivatives. For instance, a limit of US$ 50

million per AD is placed for net supply in the market on account of foreign currency/rupee swaps whereas there are no such limits in place for rupee/rupee swaps. Further, there is a limit of 25% of Tier I capital (or US$10 million) up to which banks are permitted to borrow overseas. The current regulatory approach toward derivatives involving foreign currency/rupee has been shaped by the considerations of (i) existing restrictions on capital account (ii) impact on the local forex market (iii) encouraging use of derivatives for risk reduction or hedging, etc. While optionality is permitted to be built into the pricing of foreign currency/rupee swaps (so long there is no increase in risk or net receipt of premium), structures having option elements, such as caps and collars, are not permitted in the case of rupee interest rate swaps. On the other hand, while foreign currency/rupee swaps cannot be rebooked on cancellation, there is no such restriction for rupee interest rate swaps. The restriction on foreign currency/rupee swaps has been placed to ensure that excessive cancellation and rebooking does not add to the volatility of the rupee. These restrictions have been put in place on account of prudential considerations and the fact that India is not convertible on the capital account. Till such time as capital account restrictions are in place, it would be desirable to maintain differential regulations with respect to rupee interest rate derivatives and forex derivatives. In respect of structured products, the regulation needs to be so framed in order to ensure that residents are not able to circumvent the applicable restrictions on accessing the underlying cash market abroad through derivatives. In other words, regulation should examine the permissibility of all the individual elements comprising any structured product. Further, while derivatives involving at least one foreign currency have a clear legal standing under FEMA, there is some legal ambiguity in regard to OTC rupee derivatives. As regards the accounting treatment for derivatives, there should be full convergence between all types of derivatives and also amongst banks and corporates. The objective here is to stop all incentives to drive any wedge between on-balance sheet

and offbalance sheet items. Moreover, there is a need to put in place objective conditions to determine whether a derivative is in the nature of a hedge or not. Wherever the derivative is in the form of a hedge, the accounting treatment should be the same as for the underlying. Consequently, the experts has recommended that derivatives accounting norms on the lines of IAS 39 should be introduced for adoption by banks and corporates alike.

Recommendations of the Sodhani Committee Status.

Most of the recommendations, including the setting up of the Clearing Corporation of India Ltd. which conducts inter-bank forex clearing and settlement operations, among other activities, have been implemented and have had a beneficial impact on the market. Recommendations which have not been implemented chiefly relate to accounting of derivative transactions and disclosure norms. The ICAI is still in the process of formulating them. Second, laws relating to withholding tax are still not unambiguous. Third, the recommendation that all market participants should put in place risk management policies and internal control systems before being allowed to transact in forex and interest rate derivative products, has not been followed in practice. Few corporates have an appropriate risk management policy and systems in place. Banks frequently report that they find it very difficult to obtain these policies. Further, even from corporates that have such policies in place, they find it difficult to obtain a review report and annual audit report, as required under the extant regulations.

Enabling Environment for Reforms in the Forex Market

The approach towards financial sector reforms in India has been cautious with appropriate sequencing of reform measures, mutually reinforcing norms, complementary reforms across sectors (e.g., monetary, fiscal and external sector), and development of financial institutions and markets. In order to embark upon further deregulation of the foreign exchange market, including relaxation of capital controls, an enabling environment is needed for the reforms to proceed on a sustainable basis. It is in

this context that liberalization of various sectors has to proceed in tandem to derive synergies of the reforms encompassing multiple sectors. The Indian approach to opening the external sector and developing the foreign exchange market in a phased manner from current account convertibility to the ongoing process of capital account liberalization is perhaps the most striking success relative to other emerging market economies. The move towards a market-based exchange rate regime in 1993 and the subsequent adoption of current account convertibility were the key measures in reforming the Indian foreign exchange market. Reforms in the foreign exchange market focused on market development with prudential safeguards without de-establishing the market. Authorized Dealers of foreign exchange have been allowed to carry on a large range of activities. Banks have been given large autonomy to undertake foreign exchange operations. In order to deepen the foreign exchange market, a large number of products have been introduced and entry of newer players has been allowed in the market. Full convertibility on the current account and extensive liberalization of the capital account transactions have facilitated not only transactions in foreign currency, these have enabled the corporates to hedge various types of risks associated with foreign currency transactions. A comparative analysis of the crucial reforms pending in various sectors provides an idea of the complementary sectoral reforms required for the success of external sector reforms. The foremost challenge to the external sector reforms arise from the persistence of large fiscal deficit and debt. Large fiscal deficit has the potential of making the foreign exchange market vulnerable in a liberalized capital account regime. A conducive environment for further reduction in capital account restrictions, thus, necessitates reduction of fiscal deficit and debt stock to more sustainable levels as the first order condition. The banking sector is still vulnerable to the possibility of rise in non-performing assets (NPAs), though the magnitude of such NPAs has come down significantly in recent years. More particularly, the financial institutions still carry large burden of NPAs. The pace of enduring liberalization of foreign exchange market is determined by the robustness of the banking system. Further, the liberalization of

foreign exchange transactions is to be aligned with price alignments in the form of tariff structure, which are still higher in India vis--vis the East Asian countries.

The enabling environment also encompasses harmonization of reforms in the financial sector with the real sector, where the issues relating to reforms in labor market, de-reservation for SSIs and liberalization of sectoral caps on FDI remain to be resolved. Importantly, large gaps exist in demand-supply of infrastructure services such as transportation, electricity, ports etc., where regulatory and procedural hurdles, pricing and user charges are crucial for attracting foreign investment and ensuring export competitiveness of the Indian industry. It needs to be emphasized that sound macroeconomic policies and a competitive domestic sector improve the capacity of the economy to absorb higher capital inflows, reduce the cost of capital, translate external inflows into higher investment levels and provide cushion against unexpected shocks in more liberalized external markets.

POTENTIALITY OF FOREX MARKET OF INDIA

Table II. 2:Geographical Distribution of Reported Foreign Exchange Market Turnover1
Daily averages in April, in billions of US dollars 1992 1995 1998
Country Amount Share (%) 27 15.5 11.2 6.9 5.1 5.6 2.7 6.1 3.1 2.0 1.2 0.3 Amount Share (%) 464 244 161 105 76 90 40 87 58 30 19 5 29.5 15.5 10.2 6.7 4.8 5.7 2.5 5.5 3.7 1.9 1.2 0.3 Amount Share (%) 637 351 136 139 94 79 47 82 72 37 7 4 22 9 9 2 5 5 1 2 1 3 2 0 1 1,969 32.5 17.9 6.9 7.1 4.8 4.0 2.4 4.2 3.7 1.9 0.4 0.2 1.1 0.5 0.5 0.1 0.3 0.3 0.1 0.1 0.1 0.2 0.1 0 0.1 100

2001
Amount Share (%) 504 254 147 101 88 67 52 71 48 42 10 10 13 9 10 3 4 5 2 4 1 2 0 1 1,618 31.2 15.7 9.1 6.2 5.5 4.1 3.2 4.4 3.0 2.6 0.6 0.6 0.8 0.5 0.6 0.2 0.3 0.3 0.1 0.2 0.1 0.1 0 0.1 100

2005
Amount Share (%) 753 461 199 125 118 102 81 79 64 54 30 20 14 15 10 7 8 3 2 2 2 3 1 1 1 2,408 31.3 19.2 8.3 5.2 4.9 4.2 3.4 3.3 2.7 2.2 1.2 0.8 0.6 0.6 0.4 0.3 0.3 0.1 0.1 0.1 0.1 0.1 0 0 0 100

UK 291 USA 167 Japan 120 Singapore 74 Germany 55 Hong Kong 60 Australia 29 Switzerland 66 France 33 Canada 22 Russia Korea Luxembourg 13 Mexico South Africa 3 India Taiwan Brazil Chile Indonesia Malaysia Thailand Argentina China Philippines -

Total 1,076 100 1,572 100 Source: BIS, Triennial Central Bank Survey, 2004

Country

Total foreign exchange turnover 753 461 199 125 118 102 81 79 64 54 30 20 14 15 10 7 8 3 2 2 2 3 1 1 1 2,408

Spot foreign exchange turnover 223 217 53 43 36 36 26 23 13 18 24 10 3 11 2 3 5 3 2 1 1 1 1 1 0 829

UK USA Japan Singapore Germany Hong Kong Australia Switzerland France Canada Russia Korea Luxembourg Mexico South Africa India Taiwan Brazil Chile Indonesia Malaysia Thailand Argentina China Philippines Total

Outright foreign exchange turnover 103 61 21 11 12 5 5 7 5 4 0 4 2 1 0 1 1 0 1 0 0 0 0 260

Foreign exchange swap turnover 428 183 125 72 70 61 50 49 46 32 5 6 10 3 8 2 2 0 0 1 0 1 0 1,318

Geographical distribution of reported OTC derivatives market activity

Country United Kingdom United States France Germany Italy Japan Belgium Netherlands Australia Canada Switzerland Singapore Austria Hong Kong SAR Taiwan, China Brazil India Korea April 2001 628 285 106 158 36 132 22 49 8 43 63 73 8 52 2 2 2 4

Total April 2005 1,176 599 205 127 53 185 45 61 23 53 74 100 23 82 6 2 4 11

Foreign exchange Interest rate April April April April 2001 2005 2001 2005 390 613 238 563 169 41 65 12 116 8 25 4 33 53 69 4 49 2 2 2 4 281 54 85 15 154 14 42 9 41 62 91 9 70 5 1 3 10 116 65 94 24 16 14 24 4 10 10 3 4 3 0 0 0 0 317 151 43 38 31 31 19 14 12 12 9 14 11 2 1 1 1

Experts Opinion :- (Concern to F&O in Forex in India)

1) The volume of daily foreign exchange market all over the world is USD 8 trillion. 2) Rupee is not fully convertible. 3) Government is not able to track the inflow of the foreign currencies. 4) Government invites and offer to utilize the foreign currency but people are not utilizing it. 5) If F&O in Forex will introduced, Rupee value will be more stronger. 6) Government has large volume of unliquidated foreign currencies(specially dollar) 7) Gambling on the currency will be high, if this concept will be implemented. 8) Importer and exporters will have more scope of hedging their transactions. 9) Options provided by the banks are very complex at present. 10) Very few traders are using forward and swap as a hedging tool. 11) At present there are better softwares available like Value at Risk and Mark to Market 12) There will be very few players who will might use F&O in Forex 13) It will take more than 3-4 years to implement this concept 14) Experts has doubt about the success of this concept. 15) Forex trading are not available.

Future Assumptions
This concept will take at least 3-4 years to be operated in India. Rupee will become more stronger. Importers & Exporters will have more scope of hedging their transaction. There will be very few players who will use F&O as a hedging tool. Due to this the gambling on the currency will be on a higher side. But experts Doubt about the success of this concept.

Why Future and Option are not Accepted at a large extend?

Capital Account Convertibility. Liberalization are not at desired extend. Rupee is not fully convertible. RBI, FEMA regulations. Market is not highly volatile Margin are very low. Cost of derivative is very high. Options are very complex to exercise Govt. is not able to track the inflow of foreign currencies. Govt. invites & offer to utilize the foreign currencies but people are not using it. Govt. has large volume of un liquidated foreign currencies. Exchange rate regime.

Suggestions made by Experts : Convertibility such as reduction in the combined fiscal deficit, inflation between 3 and 5 percent and further reduction in the gross NPA of the banking sector are required to be achieved for creating an enabling environment for further liberalization in the forex markets. All forward contracts booked by residents, regardless of tenor, should be allowed to be cancelled and rebooked freely. Foreign currency rupee swaps booked to hedge genuine foreign currency exposures should also be permitted to be rebooked on cancellation. Expert says that sequencing should be such that the introduction of derivative structure is only after ICAI puts in place accounting guidelines like IAS-39 in respect of derivative accounting. All entities transacting in such products to reflect the MTM of such structure in their P&L A/c. and Balance sheet.

Transparency and disclosure is essential. Corporates should be permitted to sell/write covered call & put options subject to adequate accounting standards & risk management systems being in place. The operational freedom in use of risk management instruments has to go along with a proper internal risk control mechanism and efficient prudential and supervisory system.

Forex data including trade volume for derivatives such as foreign currency options should be available in the market on regular basis. Forex Association of India (FAI) has requested Reserve Banks to grant a grace period of half an hour (i.e. up to 4.30PM)

RESEARCH METHODOLOGY
This study aims to delineate the methodology, employed to undertake this study. Research is a common parlance, which refers to a search for knowledge. One can define research as scientific and systematic search for pertinent. Research is of a great importance to find out the nature, extent and cause of the research issue under study. Research Methodology is the process in which various steps that are generally adopted by a research are outlined.

OBJECTIVE OF STUDY:Primary Objective:

To study the Forex market of India To aware of derivative market of Forex in India. To find out the potentiality of Future & Options in Forex in India.

Secondary Objective:
To know Forex market of India and its current environment. To study about different types of derivative tools(especially Future & Options) in Forex. To find how Future & Options are working in Forex in other countries. .

 RESEARCH DESIGN :A research design is the arrangement of conditions for collection and analysis of data. Actually it is the blue print of Research Project. The research design can be divided following :

Descriptive Research
a. Questionnaire Method

SOURCES OF DATA :-

Sound market research depends upon the existence facts or directly related to problem studied. To fulfill a aforesaid objective of study, the information gathered from the primary as well as secondary sources.

Primary source information :

I ) Method of obtaining data : Questionnaire (Annexure-1)

Secondary source information :

I ) Internal : Company internal information II ) External : Books, magazines, journals and internet. In our study we have used secondary as well as primary data. For this research purpose all secondary data were collected.

RESEARCH TECHNIQUES:Questionnaire:
Questionnaire was structure with open and prepared for importers, exporters and money changers. (Annexure-1)

Collection of information:
The respondents were personally approached to explain the objective of survey. During the meeting the questionnaire was fulfilled by the respondents.

SAMPLE DESIGN :Sample Design refers to the technique as the procedure that a researcher would adopt in selective item for the sample.

Target population or sampling unit :

The study of the insurance importers, exporters and money changers.

Sample size:
The sample size taken for the study is 8 to 10 respondents.

Sampling Method:
The respondents had been selected on the basis of purposive sampling. The study is a sample survey, which consist of small size sample, have much awareness of derivative market of forex.

DATA PROCEDURE AND ANALYSIS

FINDINGS:
Sample size 8 to 10 Importers-Exporters, money changers, etc. There are 11 questions included in this questionnaire. Now the analysis of the questions included in this questionnaire will be done. As our questionnaire was open ended, we could not predict exact data. But we have put the thoughts, suggestions, views, approaches of the experts. As this concept is not been introduced in India, we could not able to find out the exact data of the market.

Bibliography:
Primary Data Source: Mr. Aspy Bharucha, Head of Forex Dept., Vadilal Forex, Ahmedabad Mr. Anurag Gupta, Manager, Weizmann Forex Ltd., Ahmedabad Mr. Secondary Data Source: 1)Foreign Exchange Markets Author :- Surendra S. Yadav & P.K.Jain 2)Foreign Exchange International Finance and Risk Management Author :- A.V. Rajwade 3) Foreign Exchange Risk Author :- Raghu Palat 4)Foreign Currency Management Author :- Gary Shoup 5)Currency Market Derivatives Author :- GRK Murty Websites: www.bis.org www.goforex.net www.fema.gov www.fema.rbi.org.in www.rbi.org.in www.femaonline.com www.fedai.org.in www.forextheory.com
www.forexindia.org www.igidr.ac.in/~susant/DERBOOK/PAPERS/ngmg-outline www.forexcap.com

www.sebi.com www.nseindia.com www.bseindia.org

Annexure: 1

Questionnaire for Forex Traders

Name of the person:____________________________ Organization Name:____________________________ ____________________________ ____________________________ Contact NO: ____________

1) In which of the following forex market derivatives you deal with? Future Forward Options Swaps

2) Approximately how much volume you trade in a month? ____________________________________________________________________________ ____________________________________________________________________ 3) Are you using any forex trading software or system? If Yes, Please Specify: ______________________________________________________ ________________________________________________________________________ ________________________________________________________________________ 4) Is your organization is member of any national or international forex trading organization? If Yes, Please Specify: ______________________________________________________ ________________________________________________________________________ ________________________________________________________________________ 5) Are there any problems in present forex trading system of India? If Yes, Please Specify: ______________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________

6) According to your opinion what will be the effect of Futures & Options on the economy of India? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ____________________________________________________________ 7) Will your organization trade in forex with Future, if available in India? If Yes, Please Specify the Reason: ____________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ 8) Will your organization trade in forex with Options, if available in India? If Yes, Please Specify the Reason: ____________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ 9) Approximately how much percentage of your trading volume diversified in the following derivative tools? Spot Market: ____% Future Market: ___% Forward Market: ___% Options Market: ___%

10) Why Future & Options has not been able to capture a large market share as a derivative tool in Forex? (with concern to Global Scenario) ________________________________________________________________________ ________________________________________________________________________

________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________

11)

According to your opinion is Indian Forex system capable to adopting Futures and Options as a derivative tool? (Please specify the Reason)

____________________________________________________________________________ ____________________________________________________________________________ ____________________________________________________________________________ ____________________________________________________________________________ ________________________________________________________