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INTERNSHIP PROJECT SUMMER 2017 NAME VAKIL MOHIT RAJESH

AREA OF INTEREST FINANCIAL SERVICES

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Letter of Intent Respected Sir/Madam,

I am Mohit Vakil. I’m an A level student at Aditya Birla World Academy. I have opted for the subjects Physics, Chemistry, Mathematics and English at the AS Level.

Over the years, studying at school, I have realized that we learn the most when we work with other people as a team to create something. It develops three key qualities – teamwork, creativity and critical thinking. At school, I have managed school projects and teams- for the science fair and inter house competitions in debating and quizzes. I was a school topper in the IGCSE (Std X) examination in my previous school (Trinity International) and was country topper in the subject Environmental Management.

I am keen to get some work experience from an internship, at the end of Year 11. I realize that internships require skill, knowledge and discipline and I assure you that I have the maturity and the seriousness that is required to take up such an assignment. Since a very young age I have developed a great deal of scientific temperament that makes me want to question, ‘Why?’. This is reflected in my various research projects and essays, at my previous school.

Last year, I had started working on hobby electronics projects with the Arduino Microcontroller. I started out small and learnt to code on the Arduino IDE. I experimented using the electronics kit, and then started designing and making projects. One was a cryptography project, and another was an Ultrasound based range calculator. I documented these projects on my YouTube channel. Further, I started working on a self-designed quadcopter. I failed the first time, with the quadcopter crashing almost immediately. I didn’t let that disappointment stop me and I started designing another quadcopter this summer. There have been some issues and I am still trying to work out the specifics, but I am confident that I can get it flying.

Another recent hobby has been video editing and short film creation. I participated in an All-India Cambridge short film making competition on the topic ‘Robotics’, and came in the top 10.

College experience gives students a lot of independence, maturity and makes them responsible. Realizing that, this Summer, from mid-June to the first week of August, I was at Harvard for a summer program. I took an 8-credit Undergraduate Economics Course. It was an amazing course, and I learnt a lot. I finished the course with a weighted average of 93.25%. The course taught me the Principles of both Micro and Macro Economics and imparted practical

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knowledge of real world economics. I had always been interested in understanding how economic agents interact and how the economic machine works on both a micro and a macro scale. I had the privilege of learning from and interacting with some of the best faculty from top universities in the USA including Harvard and University of Chicago.

I had taken ICT at the IGCSE level. I am proficient in Microsoft Excel and HTML coding with web design software like Microsoft Frontpage. I can also write Arduino IDE codes and use video editing applications like Adobe Premiere Pro. By the end of Year 11, I will also be proficient in using calculus and statistics.

While I can make scaled diagrams and rough sketches, I have always struggled at art and free hand drawings. I have improved over the years at school but I still wouldn’t say I am good at it. I am also very passionate about my work and I get things done, even if it infringes on my leisure time.

I believe I have the knowledge, skills, and perseverance to succeed at any internship. I have a broad range of interests, and I believe in doing everything with hard work. I am a fast learner and can pick up skills I lack, very fast.

I am fascinated by financial markets, and how its dynamics affect the national and global economy. One of the largest industries today is the financial services industry and it plays a key role in running the economic machine. In a broad sense, financial services mobilize and allocate savings. It includes all activities involved in the transformation of savings into investment like banking, insurance, investments management, etc.

In spite of a large transformation in the last decade, around a quarter of Indian citizens still remain unbanked. At the same time, less than 2% of Indian savers invest in capital markets and largely rely on fixed deposits.

There is great untapped potential in both banking services and investments and I would like to make this the focus of my internship.

I understand that one can never be completely prepared to work in a real life scenario under pressure; but, I am willing to learn.

Thank you,

Mohit Vakil.

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Financial Markets

A financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees, and market forces determining the prices of securities that trade. Financial markets can be found in nearly every nation in the world. Some are very small, with only a few participants, while others - like the New York Stock Exchange (NYSE) and the global forex markets - trade trillions of dollars daily.

The Markets 1. Capital Markets

A capital market is one in which individuals and institutions trade financial securities. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, they raise money through the sale of securities - stocks and bonds to investors. These are then traded (bought and sold) by different participants. . Stock Markets Stock markets allow investors to buy and sell shares in publicly traded companies. They are one of the most vital areas of a market economy as they provide companies with access to capital and investors with a slice of ownership in the company and the potential for gains based on the company's future performance.

This market can be split into two main sections: the primary market and the secondary

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market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market. The prices on the primary market are pre-determined, whereas those on the secondary market adjust themselves based on supply and demand. In India, BSE - Bombay Stock Exchange and NSE - National Stock Exchange of India are the two major stock exchanges.

Bond Markets A bond is a debt investment in which an investor loans money to an entity (corporate or governmental), which borrows the funds for a defined period at a fixed interest rate. Bonds are used by companies, municipalities, states and central governments to finance a variety of projects and activities.

Bonds can be bought and sold by investors on credit markets around the world. This market is alternatively referred to as the debt, credit or fixed-income market. It is much larger in nominal terms than the world's stock markets. The main categories of bonds are corporate bonds, municipal bonds, and Government bonds, notes and bills, which are collectively referred to as simply "Treasuries."

Bond Pricing: Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When the price changes, so does the yield.

Buying a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Because you are getting the same guaranteed $100 on the asset, If the price goes down to $800, then the yield goes up to 12.5%. ($100/$800).

The factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.

2. Money Market

The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), Treasury bills, commercial paper and repurchase agreements (repos). Money market investments are also called cash investments because of their short maturities.

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3. Commodities Market

A commodity market is a physical or virtual marketplace for buying, selling and trading raw or primary products, and there are currently about 50 major commodity markets worldwide that facilitate investment trade in approximately 100 primary commodities.

Commodities are split into two types: hard and soft commodities. Hard commodities are typically natural resources that must be mined or extracted (such as gold, rubber and oil), whereas soft commodities are agricultural products or livestock (such as corn, wheat, coffee, sugar, soybeans and pork).

The big commodity exchange markets in India are the MCX and NCDEX. Other big markets internationally include – CME and CBOT.

4. Currency Markets

The Currency market is a global decentralized market for the trading of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of volume of trading, it is by far the largest market in the world. The main participants in this market are the larger international banks.

The currency market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.

The currency market is unique because of the following characteristics: its huge trading volume representing the largest asset class in the world leading

to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends. the variety of factors that affect exchange rates; the use of leverage to enhance profit and loss margins and with respect to

account size.

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Derivatives

The derivative is named so for a reason: its value is derived from its underlying asset or assets. A derivative is a contract, but in this case the contract price is determined by the market price of the underlying asset. Examples of common derivatives are futures and options (both listed on the exchange).

To understand futures and options contracts, let’s use a common example:

There is a milk producer and an ice-cream factory. Price of milk will fluctuate due to demand and supply factors. When the price of the milk is low, the milk-producer loses money, and when the price is high, the ice-cream factory loses money (their production costs go up). It’s in both their best interest to have the prices stable, so they have reliable profits and not much risk.

Futures:

Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. This means that the volatility in pricing of goods or services can be avoided. This reduces risk (and often means giving up significant reward). Let’s look at this from the perspective of the previous example.

The milk producer signs a futures contract with a third-party investor that works this way: If the price of the milk dips below a set value, say Rs 50 / litre, the investor would pay the difference. If the price were to rise above Rs 50 / litre, the investor gets the excess profit. The ice-cream factory could cut a similar deal to insure itself from any price changes.

Apart from hedging risks, futures contracts could also be used for speculation – especially because futures positions are highly leveraged. The initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky)

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Options:

An option is a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer (paying a premium to obtain the option) the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

This again is done either to hedge the risk, or to speculate in the market. Speculating in options is often considered a risky strategy. Let’s look at how call and put options would work in our previous example.

If the milk producer thinks that the price of milk might fall in the future, he buys an option from an investor, to ‘put’ or sell the milk at Rs. 50 / litre. If the market places the price of his milk above Rs. 50 / litre, he doesn’t exercise his option, and the investor keeps the premium. However, if the price is below Rs. 50 / litre, the milk producer exercises his option and sells the milk at Rs. 50 / litre to the investor.

The ice-cream factory might decide to buy an option as well. They buy an option, to ‘call’ or buy the milk for Rs. 50. If the price goes below Rs. 50, they do not exercise their option, and the investor keeps the premium paid. If the price goes above Rs 50, they exercise their option, and get the milk for Rs. 50 / litre from the investor.

This effectively, hedges the risk, of both parties.

Leverage:

Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

Think of an investment that has a stable 10% interest per annum. If Max invested Rs. 100 in cash, he would make Rs. 10 profit in interest. However, if he borrowed Rs.9900 at an interest rate of 5% from his bank and invested a total of Rs. 10000, he would get Rs. 11000 at the end of one year. Max would owe his bank Rs. 495 interest + Rs. 9900 principal = total Rs. 10395; thus keeping Rs. 605 for himself. This would mean a profit of Rs. 505 (or 505%) as compared to the 10% if he had used no leverage.

Futures and Options are often highly leveraged positions. One often only needs a small amount of capital to take a position several times larger. Therefore, huge sums could be made in profits in leveraged futures and options.

When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract.

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The minimum-level margin is determined by the futures exchange and is usually 10% to 15% of the futures contract. These predetermined initial margin amounts are continuously under review : at times of high market volatility, initial margin requirements can be raised.

Leverage helps investors to make super normal returns. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would’ve been if the investment had not been leveraged - leverage magnifies both gains and losses.

Financial Market Participants (Instituions):

A financial institution is an establishment that conducts financial transactions such as investments, loans and deposits. Almost everyone deals with financial institutions on a regular basis. Everything from depositing money to taking out loans and exchanging currencies must be done through financial institutions. Wall Street, Bay Street and Mumbai’s Dalal Street are synonymous to these institutions and the financial markets in general. An overview of a few big financial institutions and what role they play in financial markets, is given below.

Commercial Banks:

Commercial banks accept deposits and provide security and convenience to their customers. With banks, consumers no longer need to keep large amounts of currency on hand; transactions can be handled with checks, debit cards or credit cards, instead. Commercial banks also make loans that individuals and businesses use to buy goods or expand business operations, which in turn leads to more deposited funds that make their way to banks. The banks lend money at a higher interest rate than they pay for funds, thereby making a profit.

Insurance Companies: Insurance companies pool risk by collecting premiums from a large group of people who want to protect themselves and/or their loved ones against a loss, such as a fire, car accident, illness, lawsuit, disability or death. Insurance helps individuals and companies manage risk and preserve wealth. By insuring many people, insurance companies can operate profitably and at the same time pay for claims that may arise.

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Brokerages

A brokerage acts as an intermediary between buyers and sellers to facilitate securities transactions. Brokerage companies are compensated via commission after the transaction has been successfully completed. For example, when a trade order for a stock is carried out, an individual often pays a transaction fee for the brokerage company's efforts to execute the trade. Investment Banks: Investment banks create capital for other companies, governments and other entities. Investment banks underwrite new debt and equity securities for all types of corporations, aid in the sale of securities, and help to facilitate mergers and acquisitions, reorganizations and broker trades for both institutions and private investors. Essentially, investment banks serve as middlemen between a company and investors when the company wants to issue stock or bonds. The investment bank assists with pricing financial instruments so as to maximize revenue and with navigating regulatory requirements. Investment Management Companies: Investment Management Company actively manages a portfolio of securities to achieve its investment objectives of its clients. Examples include Mutual Funds, Hedge Funds , Private Equity , and Venture Capital.

Mutual Funds:

A mutual fund is an investment vehicle made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. One of the main advantages of mutual funds is they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gain or loss of the fund. Mutual funds invest in a wide amount of securities, and performance is usually tracked as the change in the total market cap of the fund, derived by aggregating performance of the underlying investments.

Index Funds:

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the NSE and BSE. An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. Investing in an index fund is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund. Also, many mutual funds fail to beat broad indexes. Index funds are generally considered ideal core portfolio holdings for retirement accounts.

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Since the fund managers of an index fund are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others that assist in the stock selection process. Many actively managed funds, with higher management fees, struggle to keep up with their benchmarks. In the 10-year period ending in 2015, 82% of large-cap funds failed to beat the index.

Hedge Funds:

Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns.

Hedge Funds, usually have wealthy investors, and are relatively less regulated. Hedge Funds, aggressively take risk, and charge their investors higher fees, for better than average performance. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually. Private Equity Firms:

Private equity comes primarily from institutional investors and accredited investors, who can dedicate substantial sums of money for extended time periods. In most cases, considerably long holding periods are often required for private equity investments, in order to ensure a turnaround for distressed companies or to enable liquidity events such as an initial public offering (IPO) or a sale to a public company.

Since the 1970s, the private equity market has strengthened readily. Pools of funds are sometimes created

by private equity firms to privatize extra-large companies. A significant number of private equity firms perform actions known as leveraged buyouts (LBOs). Through LBOs, substantial amounts of money are provided to finance large purchases. After this transaction, private

equity firms attempt to improve the prospects, profits and overall financial health of the company, with the goal being a resale of the company to a different firm or cashing out through an IPO.

Venture Capital:

Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. This is often provided by ‘High Net Worth Individuals’ or ‘angel investors’. For start-ups without access to capital markets, venture capital is an essential source of money. Risk is typically high for investors, but the downside for the start up is that these venture capitalists usually get a say in company decisions

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Currency Markets – A deep dive

Currency and Currency Markets:

Currency is a widely accepted form of money, including coins and paper notes, issued by a government and circulated within an economy. This acts as a medium of exchange for goods and services – making currency the very basis of trade.

Generally, each country has its own currency. An exception would be the euro, which is used as the currency for several European countries. While these currencies can be specific to a nation, other countries have declared foreign currency to be legal tender in their own country. For example, El Salvador and Panama allow the use of the U.S. dollar as legal tender.

Investors often trade currency on the foreign exchange market - the most heavily traded markets in the world - with over 1.5 trillion USD being traded each day.

What are exchange rates?

An exchange rate is the rate at which two currencies can be exchanged against each other. These rates can be ‘floating’ or ‘fixed’; floating being that the value of the currency changes in relationship to foreign exchange market mechanisms, fixed currency is currency tied to another currency like gold or a currency basket.

The demand for dollars in exchange for yuan in the first graph is downward sloping, because a dollar appreciation (a movement from A to B) increases the price of U.S. goods faced by Chinese firms, reducing the quantity of dollars they demand. The supply of dollars in exchange of the yuan is upward sloping because a dollar appreciation from A to B, increases the quantity of dollars they supply to the market. The intersection of the curves, becomes the exchange rate.

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What’s Devaluation?

Devaluation is a deliberate downward adjustment to the value of a country's currency relative to another currency, group of currencies or standard. Devaluation is a monetary policy tool used by countries that have a fixed exchange rate or semi-fixed exchange rate.

Devaluing a currency is decided by the government issuing the currency, and unlike depreciation, is not the result of non-governmental activities. One reason a country may devaluate its currency is to combat trade imbalances.

Devaluation causes a country's exports to become less expensive, making them more competitive in the global market. This, in turn, means that imports are more expensive, making domestic consumers less likely to purchase them, further strengthening domestic businesses. This relation can be seen from the graph on the right. The higher the real exchange rate, the less the exports.

Defending a Devalued Currency:

Defending a devalued currency, for example the yuan, would require, the central bank to buy dollars to artificially increase the demand of USD in exchange of Yuan, to drive the yuan-dollar exchange rate higher (or devalue the Yuan)

To support an undervalued yuan, the government would need to soak up an excess supply of dollars by buying dollars in exchange of yuan. The quantity of dollars that must be purchased is given by the difference between the quantity of dollars demanded at the pegged rate.

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Devaluation of the Yuan & The Chinese Growth Story

A cornerstone of China’s economic policy is managing the yuan exchange rate to benefit its exports. China does not have a floating exchange rate that is determined by market forces, as is the case with most advanced economies. Instead it pegs its currency, the yuan (or renminbi), to the U.S. dollar.

China’s rapid growth since the 1980s has been fuelled by massive exports. A significant chunk of these exports goes to the U.S., which overtook the European Union as China’s largest export market in 2012. China, in turn, was the United States’ second-largest trading partner in 2013, its third-largest export market, and by far its biggest source of imports.

The tremendous expansion in economic ties between the U.S. and China - which accelerated with China’s entry into the World Trade Organization in 2001 - is evident in the more than 100-fold increase in total trade between the two nations, from $5 billion in 1981 to $559 billion in 2013.

The yuan was pegged to the greenback at 8.28 to the dollar for more than a decade starting in 1994. It was only in July 2005, because of pressure from China’s major trading partners, that the yuan was permitted to appreciate by 2.1% against the dollar, and was also moved to a “managed float” system against a basket of major currencies including the US dollar.

China continued to appreciate the Yuan gradually, over the next several years, with a brief halt during the Global Crisis. By December 2013, the renminbi had cumulatively appreciated to 6.11.

The true value of the yuan is difficult to ascertain, and although various studies over the years suggest a wide range of undervaluation - from as low as 3% to as high as 50% - the general agreement is that the currency is substantially undervalued.

By keeping the yuan at artificially low levels, China makes its exports more competitive in the global marketplace. China achieves this by pegging the yuan to the U.S. dollar at a daily reference rate set by the People’s Bank of China (PBOC) and allowing the currency to fluctuate within a fixed band (set at 1% as of January 2014) on either side of the reference rate.

Because the yuan would appreciate significantly against the greenback if it were allowed to float freely, China caps its rise by buying dollars and selling yuan. This relentless dollar accumulation led to China’s foreign exchange reserves growing to a record $3.82 trillion by the fourth quarter of 2013.

China has consistently resisted calls for a substantial upward revision of the yuan, since such a revaluation could adversely impact exports and economic growth, which could in turn cause political instability. There is a precedent for this caution, going by Japan’s experience in the late-1980s and 1990s. The 200% appreciation in the yen against the dollar from 1985 to 1995 contributed to a prolonged deflationary period in Japan and a “lost decade” of economic growth for the nation.

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Revaluing the Yuan:

The yen’s steep rise was precipitated by the 1985 Plaza Accord, an agreement to depreciate the dollar to stem the surging U.S. current account deficit and massive current account surpluses in Japan and Europe in the early 1980s.

Demands in recent years by U.S. lawmakers to revalue the yuan have grown in direct proportion to the nation’s burgeoning trade deficit with China, which soared from $10 billion in 1990 to $315 billion in 2012. Critics of China’s currency policy claim that the undervalued yuan exacerbates global imbalances and costs jobs.

The Trade Deficit between China and the USA:

According to a study by the Economic Policy Institute in 2011, the U.S. lost 2.7 million jobs - mainly in the manufacturing sector - between 2001(when China entered the WTO) and 2011, resulting in $37 billion in annual wage losses because these displaced skilled workers had to settle for jobs that paid much less.

Another criticism of China’s currency policy is that it hinders the emergence of a strong domestic consumer market in the nation because:

a) the low yuan encourages over-investment in China’s export manufacturing sector at the expense of the domestic market, and

b) the undervalued currency makes imports into China more expensive and out of reach for the ordinary

Overall, the effects of China’s currency policy are quite complex. On the one hand, the undervalued yuan is akin to an export subsidy that gives U.S. consumers access to cheap and abundant manufactured goods, thereby lowering their expenses and cost of living. As well, China recycles its huge dollar surpluses into purchases of U.S. Treasuries, which helps the U.S. government fund its budget deficits and keeps bond yields low. China was the world’s

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biggest holder of U.S. Treasuries as of November 2013, holding $1.317 trillion or about 23% of the total issued.

On the other hand, the low yuan makes U.S. exports into China relatively expensive, which limits U.S. export growth and will therefore widen the trade deficit. As noted earlier, the undervalued yuan has also led to the permanent transfer of hundreds of thousands of manufacturing jobs out of the U.S.

A substantial and abrupt revaluation in the yuan, while unlikely, would render Chinese exports uncompetitive. Although the flood of cheap imports into the U.S. would slow down, improving its trade deficit with China, U.S. consumers would have to source many of their manufactured goods - such as computer and communications equipment, toys and games, apparel and footwear - from elsewhere. Yuan revaluation may do little to stem the exodus of U.S. manufacturing jobs, however, as these may merely move from China to other lower-cost jurisdictions.

Currency Convertibility:

Most currencies, like the U.S. dollar can be traded (or converted) for another currency in a money market. Individuals, like international tourists, who want to trade hard currency usually do so at an exchange window or at a bank without any restriction or artificially imposed fixed value. These currencies are considered fully convertible.

Convertibility is the ease with which a country's currency can be converted into gold or another currency. It indicates the extent to which the regulations allow inflow and outflow of capital to and from the country.

Partially convertible currencies are currencies that a central bank controls. Central banks sometimes do this to control hot money flows and international investment. Non-convertible currencies are currencies that don’t participate in the foreign exchange market and aren’t allowed to be converted.

National Perspective – Partially Convertible INR:

The Indian currency, the rupee (INR), is not yet fully convertible. However, there are talks of making it fully convertible and setting up an onshore INR market. There are many advantages and disadvantages associated with rupee convertibility, which have led to a long continuous debate over the last two decades since reforms were first introduced during the early 1990s.

Until the early 1990s (pre-reform period), anyone willing to transact in a foreign currency would need permission from the Reserve Bank of India (RBI), regardless of the purpose. People wanting to engage in foreign travel, foreign studies, the purchase of imported goods or to get cash for foreign currencies received (like with exports) were all required to go through RBI. All such forex exchanges occurred at pre-determined forex rates finalized by the RBI.

After liberal economic reforms were introduced in 1991, many significant developments occurred that impacted the way forex transactions and businesses were conducted. Exporters and importers could exchange foreign currencies for the trade of unbanned goods and

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services, there was easy access to forex for studying or travel abroad and a relaxation on foreign business and investments with minimal restrictions depending on the industry sectors.

However, Indians still require regulatory approvals if they want to invest an amount above a pre-determined threshold level for investments or purchasing assets overseas. Similarly, incoming foreign investments in certain sectors (like insurance or retail) are capped at a specific percentage and require regulatory approvals for higher limits.

As of today, the Indian rupee is partly convertible, which means that although there is a lot of freedom to exchange local and foreign currency at market rates, a few important restrictions remain for higher amounts and these still need approvals. The regulators also pitch in from time-to-time to keep the exchange rates within permissible limits, instead of keeping INR as a completely free-floating currency left to the market dynamics. In the case of extreme volatility in rupee exchange rates, the RBI swings into action by purchasing/selling U.S. dollars (kept as foreign reserve) to stabilize the rupee.

Full convertibility will mean the rupee exchange rate would be left to market factors, without any regulatory intervention. There may be no limit on inflow or outflow of capital for various purposes.

The rupee continues to remain capital account non-convertible. Capital account convertibility allows freedom to convert local financial assets into foreign financial assets and vice-versa. It includes easy and unrestricted flow of capital for all purposes which may include free movement of investment capital, dividend payments, interest payments, foreign direct investments in domestic projects and businesses, trading of overseas equities by local citizens and domestic equities by foreigners, foreign remittances and the sale/purchase of immovable property globally. As of today, one can still bring in foreign capital or take out local money for these purposes, but there are ceilings imposed by the government that need approvals.

Advantages of Making the Rupee Completely Convertible:

Sign of stable and mature markets: Free and open entry to an enormous number of global market participants would increase the risk of losing regulatory control due to large market size and huge flow of capital. Opening up to fully convertible currency is a solid sign that a country and its markets are stable and mature enough to handle free and unrestricted movement of the capital, which attracts investments making the economy better.

Increased liquidity in financial markets: Full capital account convertibility opens the country’s markets to global players, including investors, businesses and trade partners. This allows easy access to capital for different businesses and sectors, positively impacting a nation’s economy.

Onshore rupee market development: The growing international interest in the Indian rupee is evident from the development of offshore rupee markets in locations like Dubai, London, New York and Singapore. This can be seen from the rise in the average daily foreign exchange market turnover from $16 billion in 2005-06 to nearly $55 billion in 2014-15 so far. However, due to existence

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of capital controls in local Indian markets, the offshore centres are gaining the trading business. Making the rupee fully convertible will enable these trades to happen in India.

Better access to a variety of goods and services: Amid current restrictions, one does not see much variety in India for foreign goods and services. Wal-Mart Stores, Inc. (WMT) and Tesco stores aren’t that common, although a handful exist in partnership with local retail chains. Full convertibility will open doors for all global players to the Indian market, making it more competitive and better for consumers and the economy alike. It will also boost foreign investment in Indian local businesses.

Progress in multiple industry sectors: Sectors like insurance, fertilizers, retail, etc. have restrictions on foreign direct investments. Full convertibility will open the doors of many big international players to invest in these sectors, enabling much-needed reforms and bringing variety to the Indian masses.

Improved financial system: Indian businesses will be able to issue foreign currency-denominated debt to local Indian investors. Businesses will be able to hold foreign currency deposits in local Indian banks for capital requirements. Indian banks will be able to borrow/lend to foreign banks in foreign currencies.

Disadvantages

High volatility: Amid a lack of suitable regulatory control and rates subject to open markets with large number of global market participants, high levels of volatility, devaluation or inflation in forex rates may happen, challenging the country’s economy.

Foreign debt burden: Businesses can easily raise foreign debt, but they are prone to the risk of high repayments if exchange rates become unfavourable. Imagine an Indian business taking a U.S. dollar loan at a rate of 4%, compared to one available in India at 7%. However, if the U.S. dollar appreciates against Indian rupee, more rupees will be needed to get same number of dollars, making the repayment costly.

Affects balance of trade, and exports: A rising unregulated rupee makes Indian exports less competitive in the international markets. Export-oriented economies like India and China prefer to keep their exchanges rates lower to retain the low-cost advantage. Once the regulations on exchange rates go away, India risks losing its competitiveness in the international market.

Lack of fundamentals: Full capital account convertibility has worked well in well-regulated nations that have a robust infrastructure in place. India’s basic challenges—high dependence on exports, burgeoning population, corruption, socio-economic complexities and challenges of bureaucracy—may lead to economic setbacks post-full rupee convertibility.

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India is expected to become a truly global economy in near future, and it will need a fuller integration into the world economic system. Making the rupee fully convertible is an expected step in that direction.

What Currency Trading is and Why it is Important?

Currency trading is the market where currencies are exchanged at the market determined price. When the investor sells Euros to buy US Dollars, he is going short on the Euro and long on the Dollar.

Its important to note that this is the most liquid market in the world. It trades 24 hours a day, from 330 am IST Monday to 330 am IST Saturday, and it rarely has any gaps in price. Its sheer size and scope (from Asia to Europe to North America) makes the currency market the most accessible market in the world.

In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000.

The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%. Among the major currencies, the only exception to that rule is the Japanese yen. One Japanese yen is now worth approximately US$0.01; so, in the USD/JPY pair, the quotation is only taken out to two decimal points (i.e. to 1/100th of yen, as opposed to 1/1000th with other major currencies).

The Forex market is the most liquid market, completely unregulated, and runs purely on speculation. This makes Forex ideal for many actively traded funds. Phenomenal events like the Brexit and the Swiss Franc Black Swan, provide opportunities to make a great deal of money, if you speculate right, that is. With no limits on the size of an investment, no uptick rules, and no insider trading, Forex is the ‘Wild West’ of Finance.

How does the forex market differ from other markets?

Unlike stocks, futures or options, currency trading does not take place on a regulated exchange. It is not controlled by any central governing body. All members trade with each other based on credit agreements. Essentially, business in the largest, most liquid market in the world depends on nothing more than a metaphorical handshake.

This arrangement works exceedingly well in practice; because participants in FX must both compete and cooperate with each other, self-regulation provides very effective control over the market.

The FX market is different from other markets in some other key ways that are sure to raise eyebrows. Think that the EUR/USD is going to spiral downward? Feel free to short the pair at will. There is no uptick rule in FX as there is in stocks. There are also no limits on the size of your position (as there are in futures); so, in theory, you could sell $100 billion worth of currency if you had the capital to do it.

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If your biggest Japanese client, who also happens to golf with the governor of the Bank of Japan tells you on the golf course that BOJ is planning to raise rates at its next meeting, you could go right ahead and buy as much yen as you like. No one will ever prosecute you for insider trading should your bet pay off. There is no such thing as insider trading in FX.

A market with no brokerage fees:

Investors who trade stocks, futures or options typically use a broker, who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it as per the customer's instructions. For providing this service, the broker is paid a commission when the customer buys and sells the tradable instrument.

The FX market does not have commissions. Unlike exchange-based markets, FX is a principals-only market. FX firms are dealers, not brokers. Unlike brokers, dealers assume market risk by serving as a counterparty to the investor's trade, making their money through the bid-ask spread.

Once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gain is pure profit to the investor.

What are you selling or buying in the currency market?

The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader's account.

The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations that need to trade currencies continually (for example, for payroll, payment for costs of goods and services from foreign vendors, and merger and acquisition activity).

However, these day-to-day corporate needs comprise only about 20% of the market volume. 80% of trades in the currency market are speculative in nature, put on by large financial institutions, multibillion dollar hedge funds and even individuals who want to express their opinions on the economic and geopolitical events of the day.

While all transactions are simply computer entries, the consequences are no less real.

What is a currency carry trade?

The carry trade is one of the most popular trading strategies in the currency market.

The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K.

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Mechanically, putting on a carry trade involves nothing more than buying a high yielding currency and funding it with a low yielding currency, like the adage "buy low, sell high."

The most popular carry trades involve buying currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest rate spreads of these currencies pairs are very high. The first step in putting together a carry trade is to find out which currency offers a high yield and which one offers a low yield.

As of November 2016, the central bank interest rates for some of the currencies in the world were as follows:

Australia (AUD) 1.50%

New Zealand (NZD) 1.75%

Eurozone (EUR) 0.00%

Canada (CAD) 0.50%

U.K. (GBP) 0.25%

U.S. (USD) 0.50%

Swiss franc (CHF) -0.75%

Japanese yen (JPY) -0.10%

Indian Rupee (INR) 6.25%

Chinese Yuan (CHY) 4.35%

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With these interest rates in mind, you can mix and match the currencies with the highest and lowest yields. Interest rates can be changed at any time and forex traders can stay on top of these rates by visiting the websites of the central banks.

Since New Zealand and Australia have the highest yields on our list while Japan has the lowest, it is extremely intuitive that AUD/JPY is the poster child of carry trades. Currencies are traded in pairs so all an investor needs to do to put on a carry trade is to buy NZD/JPY or AUD/JPY through a forex trading platform.

The Japanese yen's low borrowing cost is a unique attribute that has also been capitalized by equity and commodity traders around the world. Over the past decade, investors in other markets have started to put on their own versions of the carry trade by shorting the yen and buying U.S. or Chinese stocks, for example. This had once fuelled a huge speculative bubble in both markets and is the reason why there has been a strong correlation between carry trades and stocks.

The Mechanics of Earning Interest

(Interest Rate of the Currency that you are Long – Interest Rate of the Currency that you are Short) x Notional Value of Your Position/ Number of Days

Notional value is the total value of a leveraged position's assets. This term is commonly used in the options, futures and currency markets because of leverage, wherein a small amount of invested money can control a large position in the markets.

For 1 lot of INR/EUR that has a notional value of €100,000, we compute interest the following way (interest rates plugged in from table above):

0.01(6.25 – 0.00) x 100,000/365 = approximately €17 a day

The amount will not be exactly €17 because banks will use an overnight interest rate that will fluctuate daily.

Why has a strategy this simple become so popular?

Between January, 2000 and May, 2007, the Australian dollar/Japanese yen currency pair (AUD/JPY) offered an average annual interest of 5.14%. For most people, this return is a pittance, but in a market where leverage is as high as 200:1, even the use of five- to 10-times leverage can make that return extremely extravagant.

Investors earn this return even if the currency pair fails to move one penny. However, with so many people addicted to carry trades, the currency almost never stays stationary. For example, between February and April of 2010, the AUD/USD exchange rate gained nearly 10%. Between January, 2001 and December, 2007, the value of the AUD/USD increased approximately 70%.

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When do carry trades work?

Central Bank Increasing Interest Rates Carry trades work when central banks are either increasing interest rates or plan to increase them. Money can now be moved from one country to another at the click of a mouse, and big investors are not hesitant to move around their money in search of not only high, but also increasing, yield. The attractiveness of the carry trade is not only in the yield, but also the capital appreciation. When a central bank is raising interest rates, the world notices and there are typically many people piling into the same carry trade, pushing the value of the currency pair higher in the process.

Low Volatility, Risk-Seeking Environment Carry trades also perform well in low volatility environments because traders are more willing to take on risk. What carry traders are looking for is the yield - any capital appreciation is just a bonus. Therefore, most carry traders, especially the big hedge funds that have a lot of money at stake, are perfectly happy if the currency does not move one penny, because they will still earn the leveraged yield. As long as the currency doesn't fall, carry traders will essentially get paid. Also, traders and investors are more comfortable with taking on risk in low volatility environments.

When do carry trades fail?

Central Bank Reduces Interest Rates The profitability of carry trades comes into question when the countries that offer high interest rates begin to cut them. The initial shift in monetary policy tends to represent a major shift in trend for the currency. For carry trades to succeed, the currency pair either needs to not change in value or appreciate. When interest rates decrease, foreign investors are less compelled to go long the currency pair and are more likely to look elsewhere for more profitable opportunities. When this happens, demand for the currency pair wanes and it begins to sell off. It is not difficult to realize that this strategy fails instantly if the exchange rate devalues by more than the average annual yield. With the use of leverage, losses can be even more significant, which is why when carry trades go wrong, the liquidation can be devastating.

Central Bank Intervenes in Currency Carry trades will also fail if a central bank intervenes in the foreign exchange market to stop its currency from rising or to prevent it from falling further. For countries that are export dependent, an excessively strong currency could take a big bite out of exports while an excessively weak currency could hurt the earnings of companies with foreign operations. Therefore if the Aussie or Kiwi, for example, gets excessively strong, the central banks of those countries could resort to verbal or physical intervention to stem the currency's rise. Any hint of intervention could reverse the gains in carry trades.

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An effective carry trade strategy does not simply involve going long a currency with the highest yield and shorting a currency with the lowest yield. While the current level of the interest rate is important, what is even more important is the future direction of interest rates. For example, the U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is done tightening.

Also, carry trades only work when the markets are complacent or optimistic. Uncertainty, concern and fear can cause investors to unwind their carry trades. The 45% sell-off in currency pairs such as the AUD/JPY and NZD/JPY in 2008 was triggered by the Subprime turned Global Financial Crisis. Since carry trades are often leveraged investments, the actual losses were probably much greater.

Benefiting from the Carry Trade

The carry trade is a long-term strategy that is far more suitable for investors than traders because investors will revel in the fact that they will only need to check price quotes a few times a week rather than a few times a day. True, carry traders, including the leading banks on Wall Street, will hold their positions for months (if not years) at a time. The cornerstone of the carry trade strategy is to get paid while you wait, so waiting is a good thing.

Partly due to the demand for carry trades, trends in the currency market are strong and directional. This is important for short-term traders as well because in a currency pair where the interest rate differential is very significant it may be far more profitable to look for opportunities to buy on dips in the direction of the carry than to try to fade it.

When it comes to carry trades, at any point in time, one central bank may be holding interest rates steady while another may be increasing or decreasing them. With a basket that consists of the three highest and the three lowest yielding currencies, any one currency pair only represents a portion of the whole portfolio; therefore, even if there is carry trade liquidation in one currency pair, the losses are controlled by owning a basket.

This is the preferred way of trading carry for investment banks and hedge funds. This strategy may be a bit tricky for individuals because trading a basket would naturally require greater capital, but it can be done with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based upon the interest rate curve and monetary policies of the central banks.

A Case Study: Swiss Franc Black Swan

The Swiss Franc has been regarded as a safe haven currency, for a very long time. Especially after the 2008 Financial Crisis, a lot of investors parked their funds in Switzerland. This caused the currency to appreciate, and made the Swiss economy relatively uncompetitive.

In September 2011, the Swiss National Bank pegged the Swiss Franc to the Euro at 1.20 Francs for a Euro. The depreciation of the Euro, meant that this arrangement, required continued intervention by the SNB – selling Swiss Francs.

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After three years, flows of funds into Switzerland intensified, the Euro continued its downward spiral. Indications like expected Quantitative Easing by the European Central Bank, amplified the parking of funds in Switzerland. This meant that the SNB had to increase its intervention in the Swiss Franc markets the SNB removed the peg and cut interest rates.

Following the announcement - the Swiss Franc soared, moving by over 40% (with the stock market following suit). This Black Swan took the market by surprise. The SNB decided to reverse its decision the next day.

A lot of investors lost money, shorting the Swiss Franc, foreseeing a continued trend of the Franc going down against the dollar, as the Euro pulls it down. A lot of hedge funds and investment banks suffered losses in the hundreds of millions of dollars. However, investors who predicted SNB’s move were shorting Euros, and those who hedged their risk, didn’t suffer as much exposure

This case study gives a good example of how Currency Trading, although significantly profitable, has high risks, also highlighting, the importance of risk diversification. Fund managers need to realize the large unpredictability and volatility of the currency markets. It was observed that Fund managers that had a diverse investment portfolio, did well, especially since the stock market had an upward trend following the Black Swan.

The fund managers that didn’t hedge the risk effectively – suffered unsurmountable losses and some had to shut down.

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A Case Study: Black Wednesday

Nigel Lawson, a believer in a fixed exchange rate, admired the low inflationary record of West Germany. He attributed it to the strength of the Deutsche Mark) and the management of the Bundesbank (the German Central Bank)

TheExchange Rate Mechanism(or ERM) was a system introduced by the European Economic Community in March 1979, as part of the European Monetary System (EMS), to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union (the EU)

Prime Minister Margaret Thatcher entered the pound into the ERM mechanism at DM 2.95 to the pound. Hence, if the exchange rate ever neared the bottom of its permitted range, DM 2.773, the government would be obliged to intervene. With UK inflation at three times the rate of Germany's, and interest rates at 15%, the conditions for joining the ERM were not favourable at the time.

From the beginning of the 1990s, high German interest rates, set by the Bundesbank to counteract inflationary effects related to excess expenditure on German reunification, caused significant stress across the whole of the ERM.

George Soros, the Hungarian-born American investor, had been building a huge short position in Pound Sterling that would become immensely profitable if the pound fell below the lower band of the ERM. Soros recognized the unfavourable position at which the United

Kingdom joined the ERM, believing that the rate at which the United Kingdom was brought into the Exchange Rate Mechanism was too high, their inflation was also much too high (triple the German rate).

The UK government attempted to prop up the depreciating pound to avoid withdrawal from the monetary system the country had joined two years previously. The Bank of England raised interest rates to 10 percent and authorised the spending of billions worth of foreign currency reserves to buy up the sterling being sold on the currency markets but the measures failed to prevent the pound falling below its minimum level in the ERM. The Treasury took the decision to defend the sterling's position, believing that to devalue would be to promote inflation.

George Soros' Quantum Fund began a massive sell-off of Pounds on Tuesday, 15 September 1992. When the markets opened in London the next morning, the Bank of England began their attempt to prop up their currency. They began buying orders to the amount of 300 million pounds twice before 8:30 AM to little effect. The Bank of England’s intervention was not effective because Soros' Quantum Fund was dumping pounds far faster. The Bank of England continued to buy and Quantum continued to sell until Lamont told Prime Minister John Major that their pound purchasing was failing to produce results.

At 10:30 AM on 16 September, the British government announced a rise in the base interest rate from an already high 10 to 12 percent to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 7:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM.

Soros is believed to have made profits over 1 billion USD!

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Conclusion:

As the world shrinks, there is an ever-increasing likelihood that we will be required to address the risks associated with the fact that there are different currencies used all around the world and that these currencies will have an immediate impact on our world.

Investors with no intention of directly trading foreign currencies, however, can benefit from a better understanding of the links between international currencies – because these currency movements can ultimately affect the value of other financial assets. We must be able to evaluate the effects of, and actively respond to, changes in exchange rates with respect to our consumption decisions, investment portfolios, business plans, government policies, and other life choices

We are used to seeing prices quoted in terms of monetary units; money is usually not thought of as the traded asset or underlying. The foreign exchange markets are all about buying and selling money, and, as famous author, Mignon McLaughlin tells us, “Money is much more exciting than anything it buys.”

Citations:

Ramage, James. "Investors Get Creative for 'Carry' Trade." WSJ. Wsj.com, 11 Mar. 2015. Web

"United States | Economic Indicators." United States | Economic Indicators. N.p., n.d. Web.

"Euro Area | Economic Indicators." Euro Area | Economic Indicators. N.p., n.d. Web.

O., and February 2. HEDGE FUND MANAGERS AND THE SWISS BLACK SWAN (n.d.): n. pag. Web.

"China | Economic Indicators." China | Economic Indicators. N.p., n.d. Web.

GLOBAL PRIVATE EQUITY REPORT 2015 Bain & Company’s Private Equity Business(n.d.): n. pag. Web.

"Go for the Juglar." The Atlantic. Atlantic Media Company, n.d. Web.

Acemoglu, Daron, David I. Laibson, and John A. List. Economics. Boston: Pearson, 2016. Print.

"India Favours Full Rupee Convertibility to Become Top Economy." Reuters. Thomson Reuters, 15 Apr. 2015.

Parker, Tim. "The Basics Of Currency Trading." Investopedia. N.p., n.d. Web

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Lansing, John. "Markets 101: Stocks, Bonds, Currencies and Commodities." InvestorPlace. N.p., 04 Mar. 2013.