MODULE 4: FOREIGN EXCHANGE MARKET

MEANING AND CONCEPTS RELATED TO FOREIGN EXCHANGE MARKET

Meaning: The foreign exchange market is the market in which different currencies are
bought and sold for one another.
Participants in the Foreign Exchange Market:
The main participants are (i) retail clients ii) commercial banks iii) Foreign Exchange
brokers and other authorized agents. The central banks too participate in this market as
per its policy decisions. Let us briefly explain the main participants in the foreign
exchange market.
Retail Clients: These comprise people, international investors, multinational
corporations and others who need foreign exchange. Retail clients deal through
commercial banks and authorized agents.
Commercial Banks: They carry our buy and sell orders from their retail clients and of
their own account. They deal with other commercial banks and also through foreign
exchange brokers.
Foreign Exchange Brokers: Each foreign exchange market centre has some authorized
brokers. Brokers acts as intermediate between buyers and sellers, mainly the banks.
Commercial banks prefer the broker as banks could obtain the most favorable quotations
from them.
Central Bank: Under the floating exchange rate the central bank of a country normally
does not interfere in the exchange market. Since 1973 however most of the central banks
frequently intervened to buy and sell the currencies and in an attempt to influence the rate
at which their currencies are traded.
They function 24 hours a day with the fastest possible communication through
telephones, telexes computers and other means of communications with the help of
satellites. Some of the major foreign exchange markets centers are Newyork, London
Tokyo, Frankfurt, Zurich, Paris, Singapore & Hong Kong.
Functions of the foreign exchange Market:
1. Transfer of purchasing power:
International trade involves different currencies. Indians require purchasing power in the
form of U.S. dollars ($) to purchase goods and services from that country. Similarly
residents of other countries require Indian currency or any other acceptable currency for
purchasing or investing in India. Foreign exchange market helps transfer purchasing
power (currencies) between the people.
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2. Provision of credit instruments and credit:

For the purpose of transferring credit, credit instruments are used. These are in the form
of telegraphic transfer, foreign exchange bill, drafts etc. Instruments with time period i.e.
a bill of foreign exchange of 90 days can be discounted before the due date. Such a
provision enables to obtain credit from the commercial banks or authorized agents.
1. Coverage risk:
Exporter and importers may cover the possible risk due to a future change in the
exchange rate through forward exchange market.
Thus Foreign Exchange Market plays very important role in
1) Transfer funds through one currency of a country to another currency.
2) Provision of short term credit to finance trade between countries through various
credit instruments.
3) And to facilitate avoidance of foreign exchange risks or provision of Hedging &
speculation facilities.
Methods of foreign payments:
The Foreign Exchange Market performs its functions through various methods of Foreign
payments are made in the currency of the country to when the payments is to be made,
but countries mostly prefer u.s. dollars. Payment is made through Demand Draft,
Telegraphic transfer mail Transfer, Bankers cheque, Bills of Exchange, travellers cheque.
International credit card or by international money orders.
Foreign Exchange Transactions:
Following are the important transaction carried out in the Foreign Exchange Market.
1. Spot Exchange Market:
Spot exchange is a type of foreign exchange transaction in which immediate delivery or
exchange of currency on the spot takes place. The foreign exchange transaction involves
the payment and receipt of the foreign exchange within two business days after the day
the transaction is agreed.
The exchange rate at which the transaction takes place is the spot rate. The spot exchange
rate is determined by immediate market demand supply of foreign exchange.
2. Forward Exchange Market:
In the forward exchange market the foreign exchange is bought and sold for delivery at
future date at an agreed rate today. The rate at which the forward exchange contract is
agreed upon is called the forward rate. The usual forward exchange contract is for 1
month, 3 months, 6 months 9 months and 1 year. As compared the spot rate, the forward
rate may be at par, at discount or at premium.

At par:
The foreign exchange rate is at par when it quoted at a rate equal to the spot rate at the
time of making the contract.
At premium:
When one unit of a currency buys more units of another currency in the forward rate than
in the spot rate, the former is at a premium. The premium is usually expressed as a
percentage deviation from the spot rate on a per annum basis.
At discount:
When the forward rate is lower than the spot rate, the former is at discount. The discount
is usually expressed as a percentage deviation from the spot rate per annum.

B. FLEXIBLE EXCHANGE RATES

Meaning: Flexible, floating or fluctuating exchange rates are determined by market
forces. The monetary authority does not intervene for the purpose of influencing the
exchange rate.
Working of flexible exchange rare: Under flexible exchange rate system, if there is an
excess supply of a currency, the value of that currency in foreign exchange markets will
fall. It will lead to depreciation of the exchange rate. Consequently, equilibrium will be
restored in the exchange market. On the other hand, shortage of a currency will lead to
appreciation of exchange rate thereby leading to restoration of equilibrium in the
exchange market. These market forces operate automatically without any intervention on
the part of monetary authority. This is illustrated in the following diagram.

S
A

Rate of
Exchange

E2
E

P
G

E1

H
S

D
Q1 Q2 Q Q 3 Q4
X
Quantity of Money Supply

In the above diagram DD and SS are the demand and supply curves of currency which
intersects at point P and the equilibrium exchange rate E is determined.
Suppose the exchange rate rises to E 2, the quantity of currency (Rs.) supplied. OQ 3 is
more than quantity demanded OQ2. When currency is in excess supply, the price of
currency in terms of other currency (say dollars) will depreciate now less currency (Say
Rs.) will be supplied and more will be demanded ultimately equilibrium will be reestablished at the exchange rate E. On the other hand, if the exchange rate falls to E 1, the
quantity of currency (Rs.) demanded OQ4 is more than the quantity supplied OQ1. When
there is a shortage of currency (Rs.) in the foreign exchange market, the price of currency
(Rs.) in terms of other currency (Say dollar) will appreciate, the rise in the price of
currency will reduce the demand for them and increase their supply, and this process will
continue till equilibrium exchange rate E is re-established at point P.
POSITIVE IMPACT (Advantages of Exchange rate fluctuation) :
1. Ensure Balance of Payments equilibrium:
In a flexible exchange rate, especially in a floating exchange rate system, the exchange
rate automatically adjusts the imbalance in the balance of payment through demand and
supply forces. A deficit in the balance of payments leads to depreciation of currency
resulting in an increase in exports and decrease in imports. A surplus on the other hand
results in the appreciation of the currency which restricts the exports and encourages
imports.
2. Monetary Autonomy:
Flexible exchange rate system provides monetary autonomy to the authorities. Each
country under this system is free to follow inflationary of deflationary policies. In other
words independent monetary policy can be pursued by an individual country rather than
linking it with other countries as is the case under fixed exchange rate.
3. Promotes Economic Stability:
According to Milton Friedman the flexible exchange rate system is more conducive to
economic stability. It is easier to allow exchange rate to appreciate or depreciate for
external adjustment rather than initiative price changes (usually deflation). It is difficult
to reduce the domestic price level as it is resistant to downward pressure.
4. Insulates domestic Economy:
Domestic economy under the flexible exchange rate can operate independently to a great
extent. An appreciation of the domestic currency would prevent the import of other
countries inflation. Under fixed exchange rate, a country will enjoy surplus in the balance
of payments when the rest of the world has inflation but in turn will be subjected to
inflation due to increase in money supply. The increase in money supply is due to
pegging operation or and conversion of foreign exchange into domestic currency.

5. Stabilizes the Private Speculation:

Speculators who buy at a low price and sell at a higher value, narrow down in the
process, the gap between the two prices. Thus the speculative activities move the
exchange rate towards its fundamental equilibrium value.
6. Easy to Determine the Exchange Rate:
An obvious merit of flexible exchange rate is its simplicity. Just as the price of a
commodity is determined by demand and supply, the rate of exchange too is determined
on the basis of demand and supply of foreign exchange.
7. Smooth Adjustment in Balance of Payments:
Flexible exchange rates bring about a smoother adjustment in balance of payments. As
Scammel says of all the variables, the exchange rate is the easiest to alter. As soon as
there is the deficit in the balance of payments, the rate depreciates, exports go up, imports
come down and balance payments is brought into equilibrium. The rate appreciates when
there is a surplus in the balance of payments takes place.
8. Suitable for Full Employment:
Flexible rates are suitable to countries seeking to follow the policy of full employment.
Inflation and deflation inflicted upon economies under gold standard are not necessary
under flexible exchange rates. Flexible rates reflect the true cost price structure
relationship.
9. Settles at Natural Level:
A system of flexible exchange rates enables the rates find their natural levels - as per the
forces of demand and supply.
NEGATIVE IMPACT (disadvantages of Exchange rate fluctuation) :
1. Creates Uncertainty: Frequent fluctuations in the exchange rate creates an
environment uncertainty for exports and importers. They remain unsure about the
amount required for the payment or the one which they expect to receive.
2. Discourage Investment and Borrowing: Foreign investment is discouraged due to
uncertainty. So also international lending and borrowing. Thus the flexible exchange
rate, it I argued, is not conductive for promoting economic growth.
3. Lacks Stability in Macro-economic Policies: Under flexible exchange rate system
internal policies undergo frequent changes in order to prevent wild fluctuation in
exchange rate. Whereas under fixed exchange rate such frequent changes are not
needed.
4. Irrational Speculation: under flexible exchange rate, speculation is continuous.
Speculators may have a wrong assessment of the strength and weakness of different
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currencies. Such wrong judgments lead to irrational speculation and destabilization of

the exchange rate.
5. Poor International Co-operation: Flexible exchange rate does not bring in the cooperation between the countries. Since each country allows the exchange rate to be
determined in the market, it is not binding on them establish co-ordination with other
countries. Thus flexible exchange rate may not be suitable for open economies.
6. Inflationary in Nature: Flexible exchange rate, it is agreed, has an inherent
inflationary bias because depreciation increases prices of traded goods but
appreciation does not cause parallel reduction in prices. Thus flexible exchange rate
may result in frequent increase in prices.
7. Unstable because of Small Trade Elasticities: A change (depreciation) in exchange
rate may create instability because it may increase the price more than it decreases the
quantity of imports. Depreciation also may not increase exports if demand elasticity is
small. Therefore if the demand elasticities (of import and export) are small, flexible
exchange rate may not bring the desired result
8. Causes Structural Unemployment: Under the flexible exchange rate, depreciation
of currency may lead to an increase in cost of production due to higher imports price.
An increase in domestic price subsequently reduces demand for exports. This may
cause structural unemployment especially in developing countries.
Many of the above arguments advanced for and against are very difficult to prove.
However, they have the elements to truth. For example, fixed exchange rates can provide
a stable exchange rate framework for international trade but so also floating rates.
Speculation can at times be stabilizing and at other times may be destabilizing. Since the
traditional approach o advantage and disadvantages has a lot of scope for disagreement,
economists have attempted to develop an alternative, more modern methods of evaluating
a system of exchange rate.

C CURRENCY CONVERTIBILITY
Introduction:
The currencies of various countries are converted into each other in the foreign exchange
market. The rate at which a currency can be converted is determined by the norms of
convertibility followed by the countries. Convertibility refers to the extent to which a
currency can be used for international payments. Currency conversion is to enable the
purchase of goods from the other countries or to make financial investments. A country
may impose restrictions on the amount allowed to be converted or on the end use of the
converted currency. In such a case the residents are not allowed to use the foreign
exchange to purchase assets abroad without government's prior permission.
Under the Bretton Woods System the par values of the currencies were declared in
terms of gold, dollar or pound. When the Bretton woods' system collapsed in 1971; the
various countries switched over to the floating foreign exchange system, where the
exchange rates were allowed, to be determined by the demand for and supply of
currencies.. But many countries continue to impose, restrictions on the free convertibility
of currencies since it may create BOP difficulties. Under convertibility of a currency
there are authorized dealers of foreign exchange which constitute the foreign 'exchange
market. The exporters can convert the dollar or pound sterling into rupees. Importers who
require foreign exchange can go to the dealers and get rupees converted into foreign
exchange.
Meaning:
Convertibility of a currency refers to its convertibility in to a foreign currency as desired
by its holder. The currency is fully convertible if the holder can convert it into any other
currency at rates determined by the forces of demand and supply and without any
interference from the government.
The convertibility therefore involves two aspects.
1) The rate of exchange should be determined by the market and not by the regulatory
authority and thus the holder does not incur any loss on conversion and.
2) There should not be any quantitative restrictions on the repatriation of the currency.
Essential conditions and pre-requisites for a successful convertible system: The A
currency is converted to effect remittances, either from the country or into the country
from abroad. Remittances are broadly classified into two categories
i)
ii)

Those on current account &

Those on capital account

This classification is based on the current and capital accounts in the balance of
payments. Remittance on the current account represents transactions relating to trade in
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goods and services. For such remittances no reserve flow of funds in the future is
anticipated. Remittances on capital account relates to investments, loans etc. These
represent the external debt of a country and reverse flow in the form of interest / dividend
and repatriation of capital is expected. various benefits of capital account convertibility
can be enjoyed by countries, provided certain essential conditions are satisfied. These
refer to the following:
1. Maintenance of domestic economic stability.
2. Adequate foreign exchange reserves.
3. Restrictions on essential imports if the foreign exchange position is not very
comfortable
4. Comfortable current account position.
5. An appropriate industrial policy and a conducive investment climate.
6. An outward oriented development strategy and sufficient incentives for export
growth.
Thus a reversal to the process of capital account liberalization can" be prevented if
reforms are appropriately sequenced. The initial conditions achieved by the economy will
decide the success of the policy. Hence macro stabilization is the basic precondition for
adopting capital account liberalization. Countries which complete the process of macro
economic stabilization first can remove exchange controls on current account transactions
to start with. This can be followed by capital account openness as the benefits of
domestic" reforms on growth and financial stability become visible and appear durable.
Generally speaking, liberalization on the capital account should follow the current
account since the former may involve a real appreciation of the exchange rate.
Advantages of currency convertibility:
The following points highlight the advantages of currency convertibility.
1. Currency Convertibility Encourages Export: Exporters are motivated to increase
their exports since there is possibility of making more profits under currency
convertibility conditions. As a result of, convertibility on current account, higher profits
will be earned since market exchange rate will give higher returns as compared to the
officially fixed exchange rate. From the given exports, they earn more foreign exchange.
2. Encourages Import Substitution: Since the market determined exchange rate is
higher than the officially fixed exchange 'rate, imports become more expensive. This
makes countries to go in for import substitution.
3. Incentives to Send Remittances from Abroad: Indian workers employed abroad and
NRls find it convenient to' send remittances of foreign exchange without hassle. This also
encouraged illegal remittances like 'hawala money' and smuggling.
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4. Self-adjusting Process in the Correction of Surplus or Deficits in Balance of

Payments: In case, a country faces a deficit due to overvalued exchange rate, the
currency of the country will depreciate. This will encourage exports 'by lowering the
prices and discourages imports by raising their prices. In this manner the deficit or
surplus in the BOP gets corrected without the intervention of the government.
5. Specialize in the Production of Goods for which they have a Comparative
Advantage: Each country will be able to engage in the production of goods in
accordance with their comparative advantage and resource endowments. When there is
currency convertibility, market exchange rate truly reflects the purchasing power of their
currencies which is based on the prices and costs of goods in different countries. In a
competitive environment, lower prices of goods which reflect the comparative advantage
will enable countries to increase exports. Thus currency convertibility will lead to
specialization and international trade on the basis of comparative advantage. This will be
beneficial for all countries in trade.
6. Integration of World Economy: Currency convertibility enables better integration of
the world 'economy. The easy availability of foreign exchange helps in the growth of
trade and increased capital flows between countries. This will enable the growth of all
countries which is important in the context of globalization.
Disadvantages of currency convertibility
1. Inflation: Currency convertibility can give rise to problems of inflation in the
domestic economy. The market determined exchange rate is generally higher than the
officially fixed exchange rate. This leads to a rise in prices of essential imports which can
result in a situation of cost push inflation in an economy. If people monitoring is not
done, convertibility can result in the depreciation of the domestic currency. Undue
depreciation of a currency can make people loose confidence in the currency itself. This
can adversely affect the trade and capital flows of a country.
2. Speculation: Speculative activities may increase under free convertibility, making the
exchange rates highly volatile. Speculation can lead to depreciation of currencies and
flight of capital.
3. Risks: Under capital account convertibility, a country is given the freedom to transact
in financial assets with foreign countries without restrictions. Such an arrangement is to
enable increased investment activities. But there are risks attached to it. A very likely
possibility is that of capital flight at the first sign of an internal economic problem. The
short-term capital flights termed as "hot money" transfers can destabilize an economy
unless precautionary or counter measures are taken to achieve stability.

Convertibility of Indian rupee:

Earlier the rupee was made partially convertible when dual exchange rate was introduced
and 60% of the remittance into India was converted at the market determined rates. Now
the value of rupee is fully determined by the market forces. Thus rupee now fulfills the
first condition of convertibility i.e. the exchange rate should be determined by market
forces.
Current Account convertibility: Rupees is now fully convertible on current account
fulfilling also the second condition of convertibility i.e. no quantitative ceiling on
remittances abroad. Through subject to certain regulations. As a part of liberalization of
foreign exchange transaction. The reserve Bank has enhanced the discretionary powers
for authorized dealers for making various remittances abroad. The limits on remittances
for various purpose like travel, studies medical treatments, gifts services etc have become
indicative.
As an affirmation of the convertibility of rupee on current account, with effect from
August 20, 1994. India moved to articles VIII status in the IMF. IMF members accepting
the obligations of Article VIII undertake to refrain from imposing restrictions on the
making of payments and transfers for current international transactions or from engaging
in discriminatory currency arrangements or multiple currency practices without IMF
approval.
CAPITAL ACCOUNT CONVERTIBILITY:
The RBI appointed a committee on capital account convertibility (CAC) under the
chairmanship of Sri.S.S.Tarapore then Deputy Governor of Reserve Bank of in Feb 1997.
The Committee submitted its report on May 30 1997.
Benefits of CAC
The committee has listed following advantages from CAC
1) It makes available a large capital stock to supplement domestic resources and
thereby enable the economy to register higher growth.
2) It allows residents to hold an internationally diversified portfolio which reduces
the vulnerability of income streams and wealth to domestic stocks.
3) Allocative efficiency improves. This can stimulate innovation and improve
productivity.
4) The capital controls turn progressively ineffective, costly and even distortive. On the
other hand, an open account would bring the weakness of the Indian financial
system under a sharper focus. It would impose a strong discipline upon the
financial system.

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Preconditions for CAC:

1) A strong balance of payment position.
2) The strengthening of the financial system.
3) Fiscal consolidation.
4) Conduct of an appropriate exchange rate policy.
Preconditions for CAC in India:
The committee stipulated preconditions in three important areas for the implementation
of CAC. They are
1) Fiscal consolidation : The ratio of centres gross fiscal deficit to gross domestic
production to be reduced from a budgeted 4.5% in 1997-98 to 4.% in 1998-99 and
further to 3.5 % in 1999-2000 accompanied by a reduction in states deficit.
2) Mandated inflation rate : The inflation for the three year period should be an
average of 3-5 percent.
3) Strengthening of Financial System : Interest rates should be fully deregulated in
1997-98. The average effective CRR should be reduced to 8% in 1997-98, 6% in
1998-99 and further to 3% in 1999-2000. Gross non-performing assets to brought
down to 12% in 1997-98, 9% in 1998-99 and 5 % in 1999-2000.
The committee recommended that CAC should be implemented in 3 phases over three
years, Phase I 1997-98, Phase II 1998-99 and Phase III 1999-2000. The implementation
of measures contemplated for each phase should be based on a careful and continuous
monitoring of the preconditions.
Implementation in India:
India is already moving towards capital convertibility though not at the speed envisaged
by the committee. The recent asian currency crisis has moderated the implementation of
CAC. The Reserve Bank of India and the government are progressively relaxing the
conditions attached to such areas as investments abroad, investments into India and
maintenance of foreign currency accounts by banks, Thus India is cautiously moving
towards convertibility of its currency on capital account.
Risk of convertibility:
1.

Credit rating institutions will play a vital role in decision making by the investors.
The changed view of these institutions or changes in the interest / exchanges rates
may have a destabilizing effect on the portfolio flows.

2.

It exposes banks liabilities and assets to more price and exchange risks the effect of
increased volatility of exchange rate will be felt on the banks open foreign currency
positions.
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3.
4.

5.

Banks may supplement their domestic deposit base with borrowing from off-share
market. The volatility in interest and exchange rates can be dangerous to weak
banks.
Fluctuations in interest may affect the cost of borrowing for emerging markets and
alter the relative attractiveness of investing in these markets. Real exchange rate
volatility may cause currency and maturity mismatches, creating large losses for
bank borrowers.
Due to increased competition, the margins for the banks may be reduced.

D SIGNIFICANCE OF FOREIGN EXCHANGE RESERVES

Foreign exchange (Forex) reserves is the result of a excess inflow of foreign currency or
gold. Domestic official holding of gold also adds up the forex. Usually forex comprises
gold reserve and foreign currency assets held by the Central bank of a country, and the
credit balance of SDRs in the IMF.
The central banks buy or sell the reserve currency to stabilize the exchange rate. Thus,
foreign exchange reserves are instrument to maintain or manage the exchange rate, while
enabling orderly absorption of international capital flows. Official reserves are mainly
held for precautionary and transaction motives, keeping in view the aggregate of national
interests, to achieve balance between demand for and supply of foreign' currencies, for
intervention and to preserve confidence in the country's ability to carry out external
transactions.
In a floating exchange rate system, the central bank clears any excess demand or
supply of foreign exchange by purchasing or selling the foreign currency. Foreign
exchange operations that are unsterilized will cause an expansion or contraction in the
amount of domestic currency in circulation and hence directly affect monetary policy and
inflation. In the event of low foreign exchange reserves to defend a weak currency, a
foreign exchange crisis will be the result, leading to devaluation. An appreciated currency
value can lead to an increase in domestic money supply resulting in inflation. This will
reduce' the demand for goods leading to a reduction in reserves.
Determinants of the demand for reserves:
A broad based approach to identify the potential determinants of reserves was adopted by
Lane and Burke in 2001. The following factors influenced the demand for money.
1. Trade openness and financial deepening are the most important variables.
2. Smaller countries which are industrially developing hold large reserves compared to
larger countries since they face volatile situations in the economy.
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3. Countries hold reserves to avoid debt situations.

According to RBI, the following are the objectives of maintaining reserves.
1. To maintain confidence in monetary and exchange rate policies.
2. To enhance the capacity to intervene in foreign exchange markets.
3. To limit the external vulnerability by maintaining foreign currency liquidity to absorb
shocks during times of crisis including national disasters or emergencies.
4. To provide confidence to the markets, including credit rating agencies, that external
obligations can always be met.
5. To increase the comfort of the market participants, by demonstrating the backing of
domestic currency by external assets.
Significance of Foreign Exchange Reserves:
In a fixed exchange rate system a country holds forex in order to maintain the external
value of its currency stable. In a floating exchange rate, theoretically speaking an
economy need not hold any forex as the system is self correcting. As most of the
countries have adopted a managed float, a certain amount of foreign exchange reserves is
essential for the purpose of market intervention. The following points highlight the
importance of forex reserve:
1)

Autonomy in policy making: An economy can have independent

monetary policy if it has enough forex. It also has confidence to avoid wide
fluctuations in the foreign exchange rate.

2)

Enhancing the capacity: Through under flexible exchange rate the market
plays a major role, yet it is necessary to intervene in the market to maintain the
exchange rate within a margin.

3)

Limiting external vulnerability: In an open system the foreign capital

flows in and out freely. Speculators usually tries to take advantages of market. Any
instability may give rise to take advantages of market. Any instability may give rise
to serious repercussions. Hence the intervention is necessary and it is possible only
with sufficient forex, a buffer against external vulnerability.

4)

Providing confidence: The knowledge and information of having enough

forex with the government imparts a sense of confidence in the market.

5)

Reducing volatility: Foreign exchange market becomes less volatile when

it is known that the monetary authorities are capable of disciplining market with the
help forex at their disposal.

6)

Risk management: Reserves help the countries manage the international

financial risks they face. They also infuse confidence in both the country and
13

currency. They buffer against unexpected changes in the cost of debt caused by an
increase in interest rate. A large reserve helps in preventing short-term hot money
situation.
7)

To Maintain Internal and External Stability: A country with a

comfortable foreign exchange reserves find it 'easier to implement independent
monetary policy and any discrepancies in exchange rate can be easily corrected.

The size of foreign exchange reserves: Size of reserves: How much forex should a
country hold depends on many factors. The important of them are i) size of the country 2)
Current account deficit 3) Capital account vulnerability 4) Vulnerability of exchange rate
flexibility and 5) opportunity cost.
The size of the country viewed form the population and GDP angle demands additional
reserve as both the variables increase. If the current and capital account are more open,
greater the requirement of forex. Exchange rate flexibility also influences the required
reserves to enable the government / Central Bank of the country to intervene as and when
required. Holding a large amount of forex has an opportunity cost in terms of lost
opportunity of using the forex in a profitable manner.
The level of foreign exchange rate system followed by that country. In a fixed exchange
rate system the monetary authority do require more forex to maintain the desired
exchange rate. In a floating exchange rate system, the exchange rate would adjust itself
according to the market forces. Hence, there is no need to absorb excess inflows in the
reserves.
High demand for forex in some of the developing countries arises out of political
instability, high fiscal deficit resulting in unproductive investment and finally their affect
on foreign exchange market.
How much foreign exchange reserve should a country maintain is nor a precisely settled
question. Many economists suggest some ratio of gross reserve to annual imports as a
criterion to judge the adequacy. Robert Triffin after studying the case of 12 leading
countries during the period of 1950 to 1957 concluded that 35 percent of liquidity or
reserve as a ratio of annual imports as adequate. Reserves below this ratio, according t
him would compel the country in question to adopt import restrictions.
According to another criterion, the international liquidity is adequate if it is sufficient to
meet cyclical fluctuations without imposing undesirable restrictions on world trade.
In recent years, it is pointed out that a country must possess foreign exchange reserve
(Forex) equal to three months imports. Reserves less than this would compel a country to
impose import restrictions. If a country cannot restrict its imports then it has to borrow
14

from various sources. Such situation may also lead to depreciation or devaluation of
currency.
India and foreign exchange reserves: India's approach to reserve management, till the
BOP crisis of 1991 was essentially based on the traditional approach which implied the
maintenance of an appropriate level of import cover defined in terms of number of
months of imports equivalent to reserves. However, the developments in India and the
world led to a shift. With the changing profile of capital flows, the traditional approach to
assessing reserve adequacy in terms of import cover has been broadened to include a
number of parameters which take into account the size, composition and risk profiles of
various types of capital flows as well as the types of external shocks to which the
economy is vulnerable. The following indicators have been proposed by the Committee
on Capital Account Convertibility for evaluating the adequacy of foreign exchange
reserves. .
The reserves should cover at least six month's of import. Three month's imports cover
plus half of annual debt service payments plus one month's imports and exports to
take into account the possibilities of leads and lags.

The short-term debt and portfolio stock should not be more than 60% of the level of
reserves.

The ratio of net foreign exchange assets to currencies in circulation to be maintained

around 70% with a minimum of 40%.
The last few' years witnessed an increase in Indias forex reserves. From the year
1990-91, when the reform process started in India there has been a steady growth in forex
reserves. On August 2012, it stood at 289.169 billion dollars. The relatively comfortable
position enjoyed by India in its trade dealings is reflected in the foreign exchange
reserves. This has given confidence to investors who are responding positively to the
developments in India.

15

E. FOREIGN EXCHANGE RISKS

Introduction and Meaning:
Foreign exchange risk is a financial risk caused due to an exposure to unanticipated
changes in the exchange rate between two currencies. The risk arises when the value of
investments changes due to changes in currency exchange rate creates uncertainties.
Foreign exchange risk affects businesses or production units that export or import. It can
affect investors making international investments. Exchange risks are the risks which
arise due to the inability to adjust prices and .costs to offset changes in the exchange rate.
Fluctuations in the exchange rate cause uncertainty and entails risks for importers and
exporters. The exporters and importers are not sure of the amount of foreign currency by
paying less in domestic currency
Types of foreign exchange risks:
Exchange of currency between countries often involves loss to either the buyer or the
seller, this is due to inherent risk of exchange rate fluctuations. The exchange rate is
highly volatile. The main exchange risks encountered may be classified as, economic
risk, trading risk, balance-sheet risk, exposure risk.
1. Economic Risk :
Economic risk occurs as a result of changes in the real exchange rates. If competition
exists between two countries i.e. India and Srilanka, there will be inflation in India is
double the rate of inflation in Srilanka, In real terms. As a result of this Indian exporters
will be priced out of the international market by their rivals in Srilanka. In order to
counter this, the Indian exporter will be forced to lower his price thus narrowing his profit
margin. Sometimes, the exchange rate might change after the price has been quoted. An
economic risk prevents sales from taking place.
2. Trading Risks :
Risks arises because of change in the value of the currency i.e. there may be either an
appreciation or a depreciation. This risk is created because of the time lag between the
pricing decision and the conversion of the sales proceeds into the currency in which the
costing is done. When the actual exchange rate differs from the estimated exchange rate
then the exporter will gain if the currency in which the sales are made appreciates.
Similarly, the importer will gain if the currency in which imports are made depreciates
and will lose if the currency in which imports are made appreciates.
3. Balance sheet Risks :
Balance-sheet risks take place because all companies must prepare financial statements in
a specified currency. However, it is not possible to make entries of the assets as well as
liabilities in the currency of the reporting country. Therefore it is necessary to convert
these in the currency of the reporting country and as a result of changes in the exchange
16

rate there is likely to be either a loss or gain. Since the value of the exports and imports
have to be converted or translated into the domestic currency they are referred to as
translation risks and because they are an accounting phenomenon, they are often referred
to as an accounting risk.
4. Transaction Risk:
Transaction risk arise out of various types of transactions such as international trade,
borrowing and lending in foreign currencies and the local purchasing and sale activities
of foreign subsidiaries that require settlement in a foreign currency. Transaction risk
exists whenever it has contractual cash flows whose values are subject to unanticipated
changes in exchange rate due to a contract being denominated in a foreign currency. As
firms negotiate contracts with set price and delivery dates in the face of a volatile foreign
exchange market with exchange rates constantly fluctuating, the firms face a risk of
changes in exchange rate between the foreign and the domestic currency.
5. Contingent Risk :
A firm has contingent risk when bidding for foreign projects or negotiating other
contracts or FDI.
6. Operating Risk:
Operating Risk refer to change in expected future cash flows (from future sale and
production) due to an unexpected change in the exchange rates. It affects the firm's
present value. It has a major influence on the stock process for listed companies.
7. Exposure risk :
Exchange risk arises because of exogenous factors. Since these are factors that are
outside the firm cannot do anything to protect itself against such risks. There are a
number of variables that determine the firms exposure to exchange or currency risk.
These are:
a)

Product mix: If undifferentiated products are sold the company exposes

itself to foreign currency risk, thus by introducing different products the firm can
reduce its exchange risk.

b) Product age: This is linked to the product life cycle. As the product matures the
number of rivals / imitators increase. This makes the commodity price sensitive.
c) Ownership structure: If the firm has subsidiaries in a number of countries the
currency risk is lower when the parent company manages the foreign exchange
portfolio.
d) Currency management and currency mix, influences the extent to which a
country has to bear foreign currency risk. If the inflow of currency does not
match the outflow then a currency risk arises.
17

A foreign exchange risk arises not only from transactions involving future payments and
receipts in a foreign currency (transactional exposure), but also from the need to value
inventories and assets held abroad in terms of the domestic currency for inclusion in the
firms consolidated balance-sheet (transaction or accounting exposure) and in estimating
the domestic currency value of the future probability of the firm (the economic
exposure).
Techniques of management of foreign exchange risk:
Foreign exchange risk is associated with adverse currency movements that translate into
lost profits and purchasing power. Private individuals and businesses can manage foreignexchange risk with diversification, currency derivatives and currency swap techniques.
1. Diversification:
Diversification is a currency risk management strategy that enables you to profit across
multiple economic scenarios. It is possible to assemble a foreign exchange portfolio of
several currencies to diversify. For example, a currency portfolio featuring U.S. dollars
and Russian rubles could serve as a diversification play against commodity prices. High
commodity prices typically translate into economic recession and inflation for the United
States. At that point, the U.S. dollar weakens, as foreigners begin to liquidate American
assets. Meanwhile, your Russian rubles will be appreciating in value, because Russia is a
primary exporter of oil and natural gas, and benefits from high commodity prices.
Beyond trading currencies, large corporations diversify against currency risk by
establishing global businesses within several different countries. For example, CocaCola's international profits stabilize the firm when the American economy and dollar are
weak. Individual investors, however, may lack the financial resources and expertise to
establish overseas businesses. Smaller investors may purchase shares of stock in
multinational corporations, such as Coca-Cola, or buy global mutual funds to protect
themselves against currency risks.
2. Derivatives:
Currency derivatives are financial contracts that manage foreign exchange risk by
establishing predetermined exchange rates for set periods of time. Currency derivatives
include futures, options and forwards. Currency futures and options contracts trade upon
organized financial exchanges, such as the Chicago Mercantile Exchange. In exchange
for premium payments, options grant you the choice to accept foreign exchange rates
until the contract expires. Futures , however, enforce the delivery of currencies at agreed
upon valuations at later dates. Meanwhile, forwards are customized agreements between
two parties that negotiate future exchange rates between themselves. Currency
derivatives function as foreign exchange risk management tools because they allow
investors to lock in predetermined exchange rates for set periods of time.
3. Currency Swaps:
18

Currency swaps are agreements between separate parties to exchange payments in

different currencies between themselves. Instead of simultaneously exchanging infinite
currency payments, swaps feature netting. Netting calculates one payment, where the
winning party receives one payment for the total difference between currency values that
occurred during the contract's duration. Currency swaps may be combined with interest
rate swaps, where trading partners exchange fixed and adjustable-rate interest payments.
So, foreign exchange risk is like in any kind of domestic business risk but its scope is
very vast. It has available in various types, as well as there are various factors affecting
the FOREX risk like interest rate, central bank actions etc. there are also various
techniques to manage foreign exchange risks like currency swaps, diversion, derivatives
etc.

F. GLOBAL LINKAGE OF FOREIGN EXCHANGE MARKETS

19

Introduction:
The foreign exchange market is a forum for exchange of global decentralized trading of
international currencies. The financial centers in various countries function as anchors of
trading between a wide range of different types of buyers and sellers round the clock. The
foreign exchange market assists international trade and investments by enabling currency
conversion. It also supports direct speculation in the value of currencies and carry trade
speculation based on' the interest rate differentials between two currencies.
Unique features: The foreign exchange market is unique due to the following
characteristics:
1. Highly liquid: The trading volume is huge representing the largest asset class in the,
world and has high liquidity. Foreign Exchange Market is the largest and most liquid
market in the world. The estimated turnover is $ 1.5 trillion a day. It is equivalent to more
than $ 200 in foreign exchange market transactions, every business day of the year for
every man, woman and child on earth. It has been estimated that the worlds most active
exchange rates can change upto 18,000 times during a single day.
2. Geographically dispersed: It is geographically dispersed. In a globalised economy
where the world is treated as global village, the foreign exchange centers are linked
into a single, united, cohesive worldwide market. Foreign exchange trading takes place
among the dealers in a large number of individual financial centers but the trade takes
place in the same currencies. The access to different markets throughout the world being
available through the vast amount of market information transmitted simultaneously and
most instantly, the foreign exchange rate, at any time, tends to be virtually identical in all
the financial centers
.
3. Twenty-Four Hour Market: Foreign Exchange markets operate 24 hours per day per
day. It is said that the foreign exchange market follows the sun around the earth. Twenty
four hours market means that exchange rates can change at any time due to change in
market conditions or other events at anytime and any where. This demands alertness on
the part of dealers to the possibility of a change in exchange rate anywhere.
4. Volume of transaction: According to the Bank of International Settlements as on
April 2010, the average daily turnover in global foreign exchange market was estimated
to be at $ 3.98 trillion, 20% growth over the $ 3.21 trillion daily volume as on April 2007.
Of the total transactions, almost two-thirds of the total represents transactions among the
reporting dealers themselves, with the remaining one-third accounted for by their
transactions with financial wand non-financial customers. Among the various financial
centers around the world, the largest amount of the foreign exchange trading takes place
in the United Kingdom, through the pound sterling is less widely traded than several
other currencies. The three largest markets are UK, USA and Japan.

20

5. Network of Dealers: Foreign exchange dealers are geographically dispersed and

located in numerous financial centers around the world. They are however, linked to and
in close communication with each other through telephones, computers and other
electronic means. There are more than 2000 dealer institutions whose foreign exchange
activities are covered by the Bank for International Settlements of these 2000 only 100200 are major players.
6. Vehicle or Base Currency: Transactions in international centres take place through a
more widely traded currency. Majority of the exchanges now take place through the
dollar. Such currency is termed or called as investment currency, reserve currency,
transaction currency invoice currency or intervention currency. More popularly known as
Vehicle or Base currency. The use of Vehicle currency reduces the number of exchange
rates that must be dealt with in a multilateral system. It is estimated that in a system of 10
currencies, with the help of vehicle currency, the market has to deal with only 9
exchanges rates as against 45 exchange rates in the absence of a Vehicle currency. At
present Dollar and Euro are the leading Vehicle currencies.
7. SWIFT: The rapid improvement in communication and technology has enabled the
foreign exchange dealers worldwide to link together through telephone, telex and satellite
communication network called the Society for Worldwide International Financial
Communication (SWIFT). The communication system based in Brussels, Belgium, links
banks and brokers in every financial centres.
8. Global linkages and history of Foreign exchange transactions: Prior to the
institution of IMF, the international monetary system was following the fixed exchange
rate system based on international gold standard. Under the gold standard the value of the
currency was kept equal to the value of a fixed weight of gold. Over the years the gold
standard took 3 forms.
a) Gold currency standard.
b) Gold bullion standard.
c) Gold exchange standard.
9. IMF and global linkage: The IMF was instituted soon after the Second World War
with the objective of facilitating smooth running of international trade and betterment of
all nations of the world. It was thought that a system of fixed exchange rate would be
necessary for smooth functioning of international finance.
For about two decades the system worked smoothly. Slowly during the 60s the deficiency
of the system began to surface themselves up. One of the major difficulties was that the
growth of means of settlement of international debts did not keep pace with the increase
in the volume of international trade. Another reason for the failure of the system was the
huge deficits in balance of payments in U.S.A. the dollar could not hold its value in the
foreign exchange market
10. Emergence of SDR:
21

The committee of 20 which had 20 Principal members both from developed and
developing countries-made a number of far reaching recommendations on reforming the
IMF system. The major recommendations relate to replace of gold in the IMF system and
the use of SDR.
SDR (Special Drawing Rights), also known as the paper gold are a form of international
reserves created by IMF to solve the problem of international liquidity. They are not
paper notes or currency. They are international units of account in which the official
accounts of the IMF are kept. They are allocated to the IMF members in proportion to
their fund quotas and are used to settle balance of payment deficits between them.
11. Channels of global linkages: IMF conducted a study on the channels by which
increased volatility in foreign exchange can affect trade, A crisis in. an economy is
transmitted through three channels i.e, trade channel, financial channel and confidence
channel. As a result, economic phenomena in one country can easily spread to the other
countries. This has increased uncertainties. This also implies the need to have strong
macroeconomic fundamentals for countries and also a diversifIed investment and trade
portfolio which can absorb shocks and remain resilient in adverse conditions also. .
Conclusion: With greater interdependence across countries, -international linkages have
become imperative and stronger. From the late 90's, real and financial linkages have
become more important and shocks are transmitted from especially large powerful
economies to the developing or weaker countries. Any type of economic disturbance
originating in one of the large countries can impact on the other countries and this will be
reflected in the' quantum of trade. Global disturbances can take a number of forms.
The developed countries have experienced synchronized pattern of movements in output,
inflation, interest rates etc. Countries are interdependent on each other than ever before.
This increasing interdependence could' be measured through the increase in trade flows,
FDI and financial flows and labour movements between nations. The international
linkages can enhance productivity and help to raise the income of nations thus improving
the standard of living. International linkages or technology transfers lead to increase in
productivity growth.
As per the IMF study, exchange rate in principle can influence trade in many ways. Real
exchange rate have a potentially strong impact on the incentive to allocate resources. i.e.
labour and capital. Real exchange rates are measures of real competitiveness since they
capture the relative prices, costs and productivity of one particular country vis-a..vis the
rest of the world.
Thus it is clear that globally the foreign exchange markets are linked with each other
due to globalization of trade and increased connectivity.
G. OPEN AND CLOSED: INTEREST PARITY CONDITIONS
22

Introduction: People hold wealth in various forms .like stocks, bonds, cash, real estate,
diamonds etc. The objective of acquiring wealth or savings is to transfer purchasing
power into the future. The desirability of an asset depends on its rate of return or
percentage increase in value it offers over some time period. To calculate the expected
rate of return over some time period, one has to make the best forecast of the assets' total
value at the periods' end. The percentage difference between that expected future value
and the price one pays for the asset today equals the assets expected rate return over the
time period.
The savers are interested in the expected real rate of return. This is so since the ultimate
goal of saving is future consumption and only the real return measures the goods and
services a saver can buy in the future in return for giving up some consumption today.
Fisher effect: It brings out the difference between nominal and the real interest rate.
Nominal interest rate includes real required rate of return and the inflation premium,
which is the expected rate of inflation. So real interest rate = Normal Interest Inflation rate. The investors look for the real interest rate differences while investing
their funds. Real interest rate differences will lead to the flow of capital to those countries
offering higher real interest rates. As a result, ultimately the real interest rates will
become equal across countries. Hence individuals prefer to hold assets offering the
highest expected real rate of return. The other consideration while selecting an asset are
the risk and liquidity.
Situation of Interest Parity: To compare the returns on different deposits, market
participants need 2 pieces of information. First they "need to know how the money value
of the deposits will change. Secondly, they need to know how the exchange rate will
change so that they can translate rates of return measured in different currencies into
comparable terms. If the potential holders of foreign currency deposits view all assets as
equally desirable, it is a situation of interest parity. This is a situation of no arbitrage
condition.
Interest arbitrage refers to buying a foreign currency, spot and selling it forward to take
advantage of the higher interest rate. Interest arbitrage is riskless because it is covered by
a forward sale of the foreign currency. This is also called covered interest arbitrage.
There is covered interest parity when the interest differential is positive in favor of the
foreign monitory centre and equals the forward discount on the foreign currency. In such
a situation no arbitrage will take place. But arbitrage opportunities will exist so long as
the interest differential between the two monetary centres exceeds the premium or
discount of the forward exchange rate.
Interest rates and arbitrage:
There is a relationship between interest rate and rate of inflation. According to Irvin
Fisher, a countrys nominal interest rate (i) is the sum of required real rate of interest (r)
23

and the expected rate of inflation over the period for which the funds are to be lent (I) this
can be stated as
i=r+I
If the real rate of interest in a country is 5 percent and annual inflation is 7 percent, the
nominal interest rate will be 12 percent. The relationship is called Fisher Effect,
according to which, a strong relationship seems to exist between inflation rates and
interest rates.
If the real interest rates between the countries differ then arbitrage takes place.
There is a link between inflation and exchange rate and as the interest rates reflect
expectations about inflation, if follows that there must also be a link between interest rate
and exchange rate. Such a link is known as International Fisher Effect. It states that for
any two countries, the spot exchange rate should change in an equal amount but in the
opposite direction to the difference in nominal interest rates between the two countries.
If Indias nominal rate of interest is higher than USAs with the expectation o higher rate
of inflation, the value of Rupee against dollar should fall by that interest rate differential
in future
Interest Parity Conditions
It is a state under which investors will be indifferent to interest rates available on bank
deposits in two countries. The fact that this condition does not always hold allows for
potential opportunities to earn riskless profits from covered interest arbitrage. Two
assumptions which are central to interest rate parity are capital mobility and perfect
substitutability of domestic and foreign assets. Interest rate parity conditions imply that
the expected return on domestic assets will equal the exchange rate adjusted expected
return on foreign currency assets. Investors cannot then earn arbitrage profits, exchanging
back to their domestic currency at maturity."
Interest arbitrage may be uncovered or covered.
Uncovered Arbitrage: In this system, arbitrageurs would take a risk to earn profit by
investing in a high interest bearing risk free securities in a foreign market. His earnings
would be according to his calculations if the currency of the foreign market where he
invested does not depreciate. If the depreciations is equal to the difference in interest rate,
the investor would not incur loss. However, if the depreciation is more than interest rate
differential, then the arbitrageur will incur loss.
Covered Arbitrage: International investors would like to avoid the foreign exchange
risk, thus interest arbitrage is usually covered. For this purpose the investors purchase
foreign currency to invest the same in a foreign currency which has higher rate of
interest.

24

At the same time the investor sells forward the amount of the foreign currency he is
investing plus the interest in the invested amount for a period which will coincide with
the maturity of the investment. The covered interest arbitrage refers to the spot purchase
of the foreign currency to make the investment and offsetting simultaneous forward sale
(swap) of the foreign currency to cover the foreign exchange risk. Under this system
when the foreign investment matures (usually 3 months) the investor will get the
domestic currency equivalent of the amount invested, plus interest earned. However, the
currency with higher rate of interest is usually at a forward discount, the net return on the
investment is roughly equal to the interest differential (higher interest) minus the forward
discount on foreign currency.
The less earnings due to forward discount can be considered as the cost of insurance
against foreign exchange risk.
As covered interest arbitrage continues, the difference in interest again diminishes and
finally the gain arising out of interest arbitrage completely disappears.
Interest parity takes 2 forms - covered and uncovered. Economists have found
empirical evidence that covered interest rate parity holds though: subjected to various
conditions like the various types of risks, costs, taxation etc. When uncovered interest
rate parity and the purchasing power parity hold together, it leads to a situation of real
interest rate parity. This condition can be attained when there are no country risk premia
and zero change in the expected real exchange rate.
This parity condition suggests that the real interest rates will equalize between countries
and capital mobility will result in capital flows that eliminate opportunities for arbitrage.
Covered Interest Arbitrage Parity: The difference in interest rates in monetary centres
of different countries and the forward premium and discount which lead to a outflow or
inflow of foreign currency may ultimately result in elimination of gain out of arbitrage.
When funds move abroad, interest rate at home tends to rise and declines abroad. As the
forward dealings increase, the forward rate also declined but the spot rate increases. As
the spot transactions increase the spot rate goes up. The process leads to the point zero
indicating no gain from arbitrage. At this point the inflow and outflow come to end. In
reality according to Dominik Salvatore the process of flow in and out of monetary centres
comes to an end.
If capital is completely free to move between the countries and the real and nominal rates
of interest are also the same, the exchange rate between the two currencies must also be
the same in the foreign exchange markets of the two countries.
The arbitrage process would induce the transfer of capital and consequent changes in the
interest rate and finally equality of exchange rates. The arbitrage opportunity which arises
due to difference in rate of interest brings the exchange rates in the two markets on par.
25

H. EUROCURRENCY, EUROEQUITY & EURO BOND MARKET

EUROCURRENCY MARKET
Eurocurrency refers to commercial bank deposits outside the country of their issue.
Thus, any country internationally supplied and demanded and in which a foreign bank is
willing to accept liabilities and loan assets is eligible to become Eurocurrency. For
example, a US dollar deposit held in London or Paris is a Euro-dollar deposit. A
deutschemark deposit held in New York, London and Paris is a Euromark deposit.
Similarly, a pound sterling deposit in a French Commercial Bank or in a French Branch
of a British bank is Eurosterling, a deposit in euros in a Swiss bank is simply a Eurodeposit (to avoid the awkward Euroeuro) and so on. These balances are usually
borrowed or loaned by major international corporations, and governments when they
need to acquire to invest additional funds.
The market in which borrowing and lending in Eurocurrency takes place is called the
Eurocurrency market. It has two sides to it, that is the receipt of deposits and the loaning
of that deposit.
Thus, Euromarkets are also referred to as offshore market if such deposits have more
widespread geographical base. The most important Eurocurrency is the Eurodollar. It is
followed by the Euromark, Eurofranc (Swiss), Eurosterling and Euroyen.
Initially, only the dollar was used in this fashion, and the market was therefore called the
Eurodollar market. Subsequently, the other lending currencies such as the German mark,
the Japanese yen, the British pound sterling, and the French and Swiss franc, began also
to be used in this way. Thus, the market is now called the Eurocurrency market.
Eurodollars are deposit liabilities, denominated in US dollars, of banks located outside
the United States and traded in Europe. The basic characteristics of Eurodollars are that:
1) they are short-term obligations of banks to pay US dollars, and 2) these banks are
located outside the US.
There also exist a Eurobonds market. Eurobonds are the bonds offered in Europe but
denominated in US dollars. It is the long-term market for Eurobonds and it provide longterm loans than was usual with Eurodollars.
The term Eurodollar came to be used because the market has its origin and earlier
development with dollar transactions in the European money markets. When the
European banks expanded their operations to accept deposits and make loans in
currencies other than the dollar, the more general terms such as Eurocurrency market and
Euromarket come into use.

26

Reasons for the development of the Eurocurrency market: There are several reasons
for the existence and spectacular growth of the Eurocurrency market. They are.
1)

Soviets deposit of dollar in European banks: In the 1950s Soviet Union was
earning dollars from the export of gold and raw materials. The Soviet did not want
to keep them in the banks in the United States out of the fear that the US may freeze
them due to the Cold War. The Soviets wanted dollar claims that were not subject
to any control by the US government. The Soviets solved this problem by depositing
their dollar earning with dollar-denominated deposits with banks in Britain and
France. These Soviet deposits marked the birth of the Eurocurrency market.

2)

Restriction upon sterling credit facilities: In 1957, the bank of England introduced
restrictions on UK banks ability to lend sterling to foreigners and foreigners ability
to borrow sterling. This induced the British banks to run to the US dollars as an
alternative means to finance the world trade. This provided a stimulus for the growth
of the Eurocurrency market.

3)

Abolition of the European Payments Union and Restoration of Currency

Convertibility: The European payments Union (EPU) enabled the European
member countries to settle trade credits among themselves with the minimum use of
dollars. In 1958, EPU was abolished and convertibility of European Currencies was
restored. Thus, European banks could hold US dollars without being forced to
convert their dollar holdings with their central banks for domestic currencies.

4)

US dollar as a key currency: The fundamental cause for the development of

Eurocurrency market was the special position of the dollar as a key, or vehicle,
currency. The dollar continuous to be the main currency that is used to carry out the
international transactions.

5)

Regulation Q: In 1963 the US authorities introduced Regulation Q which fixed a

ceiling on the interest rate that US banks could pay on time deposits. Since this
regulation did not apply to offshore banks many US banks set up subsidiaries abroad
to escape the banking regulations.

6.

Convenient to hold balances abroad: International corporations often found it

very convenient to hold balances abroad for short period in the country in which
they needed to make payments. Since the dollar is the most important international
and vehicle currency in making and receiving international payments, it is only
natural a large proportion o the Eurocurrency to be in Eurodollars.

7.

Overcome Domestic Credit Restrictions: An important reason for the growth of

the Eurocurrency market is that the international corporations can overcome
domestic credit restrictions by borrowing in the Eurocurrency market.
27

8.

Deposit of surplus funds by OPEC Countries: After the oil price increase of
1973, the OPEC countries began to deposit large amounts of dollars in European
banks. The Eurocurrency market experienced phenomenal growth after 1973.

Characteristics of the Eurocurrency market:

1.

Free of government regulation: The Eurocurrency market is an important channel

or mobilizing funds and developing them on an international scale. The important
centres are London, Paris, Hongkong and Singapore. It is generally outside the
direct control of any government regulation.

2.

Short-term nature: The deposits and loans of Eurobanks are predominantly of a

short-term nature. The maturity nature of some deposits is as short as one day and
majority are under six months.

3.

Close maturity of assets and liabilities: There is a close matching of the maturity
structure of assets (loans) and liabilities (deposits). This is due to the fact that
Eurobanks have to be cautions about the sudden large withdrawals of short-term
funds by the depositors.

4.

Eurobanks themselves the users of Eurocurrencies: A large proportion of

Eurocurrencies are used by the Eurobanks themselves. Those Eurobanks with
surplus funds loan to Eurobanks having lending possibilities but are short of funds.
The other users of Eurocurrency market facilities are non-Eurobank financial
institutions, Multinational corporations, international institutions like World Bank
and governments.

5.

Wholesale market: Eurocurrency market is a wholesale market in the sense that

their size of transactions is very large.

6.

Well organized and efficient market: Eurocurrency market is well organized and
very efficient. It serves a number of roles for multinational business operations. It is
an important and convenient device for multinational corporations to hold their
excess liquidity. It is an important source of short term loans to finance corporate
working capital needs and foreign trade.

Economic impact of Eurocurrency market: The emergence and the growth of

Eurocurrency market and its ability to create multiple expansion of credit without any
apparent control mechanism have given rise to certain problems and advantages.
PROBLEMS:
The important problems associated with it are discussed below:
1) The Eurocurrency market facilities short-term speculative capital flows. This creates
difficulties for central banks in their efforts to stabilize the exchange rates.
28

2) The national monetary authorities lose effective control over monetary policy since
domestic residents can make their efforts less effective by borrowing or lending
abroad. Since Eurocurrency market contributes to increasing the degree of
international mobility of capital, it makes monetary policy less effective.
Eurocurrency market provides opportunities for avoiding many of the regulations that
the monetary authorities try to enforce on domestic money markets.
3. Since the Eurocurrency market can be a source of international liquidity it can
contribute to inflationary tendencies in the world economy.
4. The Eurocurrency market allows the central banks of deficit countries to borrow for
balance o payments purposes. This may make these countries to postpone the needed
balance of payments adjustment measures.
ADVANTAGES:
Despite these problems arising from the growth of Eurocurrency market, it has given rise
to many advantages.
1) It has helped to alleviate considerably the international liquidity problem.
2) It has provided credit to countries to finance the balance of payments deficits. In other
words, it has played an important role in recycling funds from surplus to deficit
countries.
3) It has helped to meet the short-term credit requirements of business corporations.
4) It has provided a market for profitable investment of funds by commercial banks.
5) It has enabled the exporters and importers to obtain credit.
6) This Eurocurrency market has helped to accelerate the economic development of some
countries like South Korea, Taiwan & Brazil.
7) It has been largely responsible for the increased degree of financial integration
between economies.

29

EUROBOND MARKETS
Meaning: Eurobonds are long-term debt securities that are sold outside the borrowers
country to raise long-term capital in a currency other than the currency of the country
where the bonds are sold.
An example is given by a US corporation selling bonds in London denominated in euros
or US dollars. In 1989 the funds raised by Eurobonds amounted to $300 billion. In 1997,
new issues of Eurobonds amounted to $ 735 billion. The incentive for Eurobonds is that
they generally represent a lower cost of borrowing long-term funds than available
alternatively.
Eurobonds VS Domestic and Foreign bonds: Eurobonds differ from most domestic
bonds. Eurobonds are usually unsecured, that is they do not require collateral, while
domestic bonds are secured
Eurobonds are different from foreign bonds. Foreign bonds refer simply bonds sold in a
foreign country but denominated in the currency of the country in which the bonds are
being sold. An example is a US multinational corporation selling bonds are bonds sold in
a foreign country and denominated in another currency.
Nature of Eurobonds: Eurobonds are attractive financing tools as they give issuers 'the
flexibility to choose the country in which to offer their bond according to the countrys
regulatory constraints. They may also denominate their Eurobond in their preferred
currency. Eurobond are. attractive to investors as they have small par values and high
liquidity. So a Eurobond is an international bond that' is denominated in a currency not
native to the country where it is issued. It can be categorized according to the country in
which it is issued. London is one of the centers of the Eurobonds market. Eurobonds are
named after the currency they are denominated in. For example, Euroyen and Eurodollar.
bonds are denominated in Japanese Yen and American dollar respectively. Eurobonds are
bearer bonds and also free of withholding tax. The bank Will pay the holder of the
coupon the interest premium. Usually no official records .are kept. The leading centers of
the eurobond market are London, Frankfurt, New York and Tokyo. The maturity period of
eurobonds is short upto five years.
Interest rates: Eurobonds may be with fixed interest rates or floating interest. rates. In
fixed rate of interest bearing bonds, the rate of interest remains the same throughout the
duration of the bond. Such bonds have higher interest rate risk. In floating interest based
Eurobonds returns vary as per the movements in interest rate.
The interest rates on Eurocredit are expressed as a mark-up or spread over LIBOR (the
London Interbank Offer Rate) or EUROBOR (the Brussel-set rate). This is the rate at
which Eurobanks lend funds to one another. The spread varies according' to the
creditworthiness of the borrower and range from 1 % for the best or prime borrowers to
2% for, borrowers with weak credit ratings. The weaker banks can negotiate a lower
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spread by paying various fees up front. There are a management fees for the banks or
banks organizing the syndication, a participation fee to all participating banks based on
the amount lent by each as well as a commitment fee on any undrawn portion of the loan.
The rapid growth of these markets is taking us to a truly global banking system.
Transactions and leading centers: The leading centers in the Eurobond market are
London, Frankfurt, New York and Tokyo. In 2001 corporations, banks and countries
raised about $ 1,350 billion in Eurobonds. The sharp increase was made possible by the
opening up of capital markets in these international debt securities by several countries
including France, Germany and Japan. The incentive to issue Eurobonds and Euronotes is
that they generally represent a lower cost of borrowing long term funds than available
alternatives. In 2001, about 48% of Eurobonds and Euronotes were denominated in U.S.
dollars, 44% were denominated in euros, 5% in pound sterling, 1% in Japanese Yen and
smaller percentages in other currencies.
Some Eurobonds are denominated in more than one currency in order to give the
lender the choice of the currencies in which to be repaid, thus providing some exchange
rate protection to the lender. A large issue of Eurobonds or Euronotes is usually
negotiated by a group (called a syndicate) of banks so as to spread the credit risk among
numerous banks in many countries. Eurobonds and Euronates usually have floating rates.
The interest rates charged are re-fixed usually every three to six months in line with the
changes in market conditions. After an issue of Eurobonds and Euronotes is sold by the
syndicate, a secondary market in the international note or bond emerges in which the
investors can sell their holdings.
EUROEQUITY MARKETS
A Euro equity issue, according to Michael R. Czinkota and others is the simultaneous sale
of a firms share in several different countries, with or without listing the shares on
exchange in that country. The sale takes place through investment banks. Once issued,
most euro-equities are listed at least on the computer screen quoting system of the
international Stock Exchange (ISE) in London.
Euro market is an important financial market for raising finance through euro equities
or Eurobonds. Global Depository Receipts (GDRs) are financial instruments for raising
funds in more than one foreign market, except in the domestic market of the issuing
company. Euro equities are sold through GDRs in the international market. A GDR is a
financial instrument which represents one or more shares of an issuing firm or company.
GDRs are issued in the following manner. A company which issues the shares deposits
them with a depository bank. The bank and brokers sell these .shares through GDRs. The
investors get the depository receipts. Since the investors have rights to the receipts only
and not the actual shares of the company, they have no voting rights.
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The following steps are involved in raising funds through euro-equity.

1. The company wants to raise capital for expansion of capital base through euroequities.
2. The depository bank issues GDRs.. The local custodian appointed has to supervise
the issue and cancellation of GDRs.
3. The investment bankers form the syndicate of participating banks. They also work
out all the technicalities in the issue of GDRs. The custodian will be in possession
of the underlying ordinary shares of the company and the GDRs are issued based
on these shares. The GDRs are sold or marketed through various channels.
A company can raise equity capital in the international market in two ways
1. By issuing shares in the Euro-market which are listed on the foreign stock
exchange.
2. Through the issue of American Depository Receipt (ADRs), European Depository
Receipt (EDRs) or Global Depository Receipts (GDRs).
.i
The Factors Responsible for the Expansion of Euro-equity Market: The expansion of
Euro-equity market has been facilitated by a I number 'Of factors and innovations. They
are:
1. International syndicates of banks act as lead managers and brokerage I firms that are
capable of handling euro-issues within short period of time have emerged.
2. Syndication and distribution fees for euro-equities are much lower compared to
domestic issues.
3. The innovative approach to, investment in foreign equities have helped to I
overcome the stringent regulations in the U.S. It enabled the MNCs to issue new
instruments without costly registration and lengthy procedures.
.
4. Euro-equity IPOs (Initial Public Offer) allow as many investors as possible. This
enables the newly opened public company to raise more capital.
5. Issue of euro-equities enables companies to raise funds from various sources since
they are sold on several international markets.
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