The study analyses India's exchange rate policy and discusses the structure of the foreign exchange market in India in terms of participants, instruments and trading platform, as also, turnover in the Indian foreign exchange market and forward premia.

The study also covers the exchange rate policy of India in the background of large capital flows. The movement of the Indian rupee is largely influenced by the capital flow movements rather than traditional determinants like trade flows. Though capital flows are generally seen to be beneficial to an economy, a large surge in flows over a short span of time in excess of the domestic absorptive capacity can be a source of stress to the economy giving rise to upward pressures on the exchange rate, overheating of the economy, and possible asset price bubbles.

The main findings are :

i. The monetary model generally outperforms the naïve model. This negates the findings of the seminal study by Meese and Rogoff (1983) that finds that models which are based on economic fundamentals cannot outperform a naive random walk model.

ii. The result that it is possible to beat the naïve model may be due to the fact that the intervention by the central bank may help to curb volatility arising due to demand-supply mismatch and stabilise the exchange rate. The exchange rate policy of the Reserve Bank is guided by the need to reduce excess volatility.

iii. Forecast accuracy can be improved by extending the monetary model to include forward premium, volatility of capital inflows and order flow.

iv. Information on intervention by the central bank helps to improve forecasts at the longer end.

v. Bayesian vector autoregressive models generally outperform their corresponding VAR variants.

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