1. Introduction

The market for foreign exchange involves the purchase and sale of national

currencies. A foreign exchange market exists because economies employ national

currencies. If the world economy used a single currency there would be no need for

foreign exchange markets. In Europe 11 economies have chosen to trade their

individual currencies for a common currency. But the euro will still trade against

other world currencies. For now, the foreign exchange market is a fact of life.

The foreign exchange market is extremely active. It is primarily an over

the counter market, the exchanges trade futures and option (more below) but most

transactions are OTC .It is difficult to assess the actual size of the foreign exchange

market because it is traded in many markets. For the US the Fed has estimated

turnover (in traditional products) in 1998to be $351 billion per day, after adjusting

for double counting. This is a 43% increase over1995, and about 60 times the

turnover in 1977. The Bank of International Settlements did survey currency

exchanges in 26 major centers and this provides some evidence. In figure 1we

present some evidence of the daily trading volume in the major cities. This shows

the size and growth of the market. Daily trading volumes on the foreign exchange

market often exceed $1 trillion1which is much larger than volumes on the New

York Stock Exchange (the total volume of trade on “Black Monday” in 1987 was

$21 billion). The annual volume off foreign exchange trading is some 60 times

larger than annual world trade ($5.2 trillion), and even 10-12 times larger than

world GNP (about $25-30 trillion in 1995). You can also verify from figure 1 that

the UK still accounts for the largest share of actual trades, more than 31%.

2. Objectives

The objectives of this chapter are:

To describe the basic features of the foreign exchange market.

To identify market participants and traded currencies.

To describe the mechanics and technology of foreign exchange trading.

To introduce some exchange rate concepts.

To introduce some foreign exchange jargon.

3. Methodology

Data collection:- (Secondary data)

In data collection method we shall collect the secondary data from the following sources.

•Books

•Magazine

•Internet

STATICAL TOOL’S

•MS EXCEL

•MS Word.

•MS Power point

Meaning

Foreign exchange market refers to the buying and selling of one national

currency for another I.e. buying foreign currencies with domestic currencies and

selling foreign currencies foe domestic currencies

Import-Export traders convert their foreign earnings into home currencies or home

currencies into foreign currencies to meet their obligations abroad.

Institutions like the Treasury. Central Bank , foreign exchange bank etc, involved

in the purchase and sale of foreign exchange currencies constitute the foreign

exchange market

Definition of 'Foreign Exchange Market'

The market in which participants are able to buy, sell, exchange and

speculate on currencies. Foreign exchange markets are made up of banks,

commercial companies, central banks, investment management firms, hedge funds,

and retail forex brokers and investors. The forex market is considered to be the

largest financial market in the world.

Forex Market - Features

• The Market Has No Physical Presence.

• It Is The Largest Market On The Planet “ Earth ”.

• It Is Mostly Speculative In Nature.

• It Is A 24 – Hour Market.

• Some New York banks maintain 2 shifts (one arriving at office at 3 am when

London and Frankfurt are open) office at 3 am when London and Frankfurt are

open). Large New York banks also have branches in Tokyo, Frankfurt, and

London. Thus, they are in contact with all financial centers 24 hours.

• Daily Turn Over – 2.75 To 3.00 Trillion Dollar Per Day

• Most Deals Are On Spot Basis.

• The Market Is Deep, Liquid And Efficient. p, q

• Deals Are Screen Based.

• Market Is Volatile Because Of Floating Nature Of

Exchange Rates Exchange Rates 

FUNCTIONS OF FOREIGN EXCHANGE MARKET

The foreign exchange market performs three important function as follows

1. clearing function 2.credit function 3.Hedging function

1. Clearing function

The is the primary function of the foreign exchange market. The foreign

exchange market helps to transfer the purchasing power between countries. This

transfer is done by converting domestic currency into foreign currencies and vice-

versa. Such a clearing mechanism helps to carry out international payments and

transactions.

Various credit instruments like foreign exchange bills and telegraphic transfer are

used for the purpose of affecting the transfer of purchasing power. The

telegraphic transfer is the quickest method and hence it is more popular.

The foreign bill of exchange is a draft or a commercial paper. The mechanism of

payment is similar to the mechanism of domestic payments through inter-bank

transactions.

The telegraphic transfer is an order by one bank in a country to its correspondent

in another country to pay the exporter out of rues foreign exchange account. The

foreign exchange market enables a complex pattern of multi-lateral payments.

2. Credit function

The foreign exchange market provides national and International credit to

promote foreign trade. International payments may be delayed as exporters and

importers may not be able to fulfill their obligations immediately. They may delay

payment for 60 or 90 days.in such cases, the foreign exchange market may provide

credit by discounting foreign exchange bills.

For e.g is bank Mr. X can get his bill discounted with a foreign exchange bank in

New York and this bank will transfer the bill to its correspondent in India for

collection of money from Mr. Y after the stipulated time.

3. Hedging Function

Hedging means covering foreign exchange risks arising out of fluctuations

in exchange rates. An importer who has to make payments to a foreign country

may lose if he expects the price to rise in future. To cover the risk, he may deposit

his own funds in the foreign country or buy forward the foreign exchange.

An exporter may lose if expects the price to fall in the foreign country to which

he exports. To cover the risk, he may burrito from abroad at the present rate of

exchange or sells forward his expected foreign exchange.

Hedging can be done either by means of a spot market or a forward market

involving a forward contract.

FOREX MARKET – ADVANTAGES AND DISADVANTAGES

Advantages of Forex markets:

1. Minimal or no commissions - There are no clearing fees, no exchange fees, no

government fees and no brokerage fees.

2. Easy access – if you compare the money you need on the market in comparison

with the amount needed for entering the stock, options or futures market, it’s a

huge difference. The amount of capital is very low and it allows numerous types of

people to easily enter the foreign exchange market.

3. No middlemen – spot currency trading is decentralized and eliminates

middlemen, allowing you to trade directly.

4. Lots of free courses and demo possibilities – On the internet you can find huge

opportunities for learning how the Forex market works and what you need to

become a good trader. Also, most online Forex brokers offer demo accounts to

practice trading and build your skills, using real-time charts and news feeds. They

are more valuable than you could even imagine and, before starting your real

money on the market, try to see if you are built and ready for it by practicing with

these types of software.

5. Time and location flexibility – the market is open 24 hours each day, so you

don’t have to match your schedule with the one of the market. It doesn’t require a

full-time engagement and you can choose the hours that suit your best. Also, you

can operate from any corner of the world, as long as you have an Internet

connection.

6. Low transaction costs – the transaction cost, determined by the bid/ask spread, is

usually less than 0.1%, and it can go even lower in the case of large dealers.

7. A high liquidity market – the market is huge, so is extremely liquid. Around 4

trillion dollars are exchanged every day, according to the latest figures released by

the Bank of International Settlements (BIS). That becomes an advantage, as you

don’t have to struggle so much until you will find someone who wants to buy your

currency or sell you one. You can’t get stuck and, by using features like stop lose,

you will close your position automatically, while not even being in front of the

computer.

8. Leverage – with a little investment you can move large amounts of money.

Leverage gives the trader the ability to make nice profits and keep risk capital to a

minimum.

9. No forced deadlines – no one and no rule is forcing you to close a position. You

can stay open as long as you consider necessary.

10. No fixed lot size requirements – your contract size it’s your decision and you

are the only one who determines your own lot.

11. Transparency - due to multi-day market movement, its size and the high

number of participants, it is virtually impossible to market manipulation.

disadvantages of Forex markets :

1. Differences between retail and wholesale pricing – around two-thirds of the

trades are made between dealers and large organizations such as hedge funds and

banks. They trade at wholesale prices, while the investor trades at a retail price.

Like this it can become a challenge to compete against bigger organization that

start with a lower entry point and sell more profitably.

2. Risk of choosing an inexperienced broker – you can find on the internet many

people who are targeting fraud so be careful when choosing the broker.

3. Where there is a winner, there is also a looser – don’t expect necessarily to win

lots of money. Remember that for someone to get rich, another has to lose money

on the Forex market.

4. Requires knowledge and time – Without completely knowing the market’s rules

and without having patience, your investment might very well soon vanish.

When you enter Forex market, you have to be fully aware of its advantages, but

also disadvantages. Don’t count only on the benefits of this investment to think

that you will succeed. Study, practice, improve your skills, keep an eye on all the

news and factors that influence the market, and always stick to your established

system.

EXCHANGE RATE SYSTEMS

The first exchange rate system popularly called Gold standard prevailed

during 1879-1934 with the exception of World war years, Under the Gold standard

currencies of different countries were tied to gold E.g. the value of currency of

each country was fixed in terms of a certain quantity of gold. Thus the exchange

rate between different countries got automatically fixed. The gold standard

represented the fixed exchange rate system.

From the end of world war ll to 1971, another Fixed Exchange Rate System

known as the Bretton Woods System prevailed. Under this , the U.S. dollar was

tied to certain quantity of gold and the currencies of other countries were tied to

dollar or in some countries , directly to gold. Due to the persistent deficit in the

balance of payments in the US in 1971, the Bretton Woods system also broke

down.

Since then, the Flexible or the Floating Exchange rate system has been existing

since the Govt. or Central Bank of many countries intervenes to keep the

international value of their currencies (exchange rate) within certain limits, the

exchange rate system has not been purely flexible even after 1971. Hence it been

called Managed Float System.

 

There are three types of Exchange rate systems.

1. Fixed Exchange Rate:

When the government through its Central Bank officially fixes the

exchange rate of its currency in terms of gold or foreign currency it is known Fixed

exchange rate system. The exchange rate is fixed by the government by means of

pegging operations (ie buying and selling of foreign exchange at a particular

exchange rate.)

The Central bank seeks to maintain the exchange rate within a specific

margin of predetermined value in other currency. When the market rate falls below

the specific level, the currency is purchased and vice versa to maintain exchange

rate stability.

The fixed exchange rate system hes to maintain rigid parity and the

Central Banks has to regularly intervene in the foreign exchange market. Fixed

exchange rate system was adopted by countries till 1971 where the exchange rate

was maintained within specific limits of the par values of the currencies.

2. Flexible Exchange rate system:

Free or flexible exchange rates are determined by the forces of demand

& supply in the foreign exchange market without government intervention.

Flexible exchange rates fluctuate freely based on marked mechanism and there can

be no limit upto which exchange rates between currencies would move.

The free floating exchange rate is allowed to seek its own level as no par of

exchange is fixed. Since 1980s , the International Monetary Fund (IMF) has been

forced to adopt a flexible exchange rate system as many countries were in favour

of the same. Flexible exchange rate was adopted since 1973 where the exchange

rates were fixed by market forces of demand and supply.

3. Managed Exchange Rate System:

Under the managed system, the currency is pegged or linked to a single

currency or a basket of currencies with discretionary intervention by the Central

Bank to attain stability in exchange rate. Under the managed or controlled

flexibility of exchange rate system, the range of flexibility around fixed par values

is determined by the country as per its economic need and the prevailing trend in

the international monetary system.

A system of managed flexibility emerged to take the merits of flexible

exchange rate system and avoid their demerits. The managed or floating exchange

rate system is based on the per value concept under IMF guidelinrs.

Types of Exchange Rate

Floating Rate– A completely floating exchange rate is one whose level is

determined exclusively by underlying balance of supply and demand for the

currencies balance of supply and demand for the currencies involved

with no outside intervention i.e. Cable, Euro/$

Fixed Rate– A fixed exchange rate is one in which case the government

guarantees a stable price for foreign currency This achieved through

interventions by central currency. This achieved through interventions

by central bank whenever exchange rate varies from a stated % from fixed

rate i.e. Kuwaiti Dinar

 

Foreign Exchange Markets in India – a brief background

The foreign exchange market in India started in earnest less than three

decades ago when in 1978 the government allowed banks to trade foreign

exchange with one another. Today over 70% of the trading in foreign exchange

continues to take place in the inter-bank market. The market consists of over 90

Authorized Dealers (mostly banks) who transact currency among themselves and

come out “square” or without exposure at the end of the trading day. Trading is

regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self-

regulatory association of dealers. Since 2001, clearing and settlement functions in

the foreign exchange market are largely carried out by the Clearing Corporation of

India Limited (CCIL) that handles transactions of approximately 3.5 billion US

dollars a day, about 80% of the total transactions.

The liberalization process has significantly boosted the foreign exchange

market in the country by allowing both banks and corporations greater flexibility in

holding and trading foreign currencies. The Sod Hani Committee set up in 1994

recommended greater freedom to participating banks, allowing them to fix their

own trading limits, interest rates on FCNR deposits and the use of derivative

products.

The growth of the foreign exchange market in the last few years has been

nothing less than momentous. In the last 5 years, from 2000-01 to 2005-06, trading

volume in the foreign exchange market (including swaps, forwards and forward

cancellations) has more than tripled, growing at a compounded annual rate

exceeding 25%. Figure 1 shows the growth of foreign exchange trading in India

between 1999 and 2006.

The Dynamics of Swelling Reserves

An important corollary of India’s foreign exchange policy has been the

quick and significant accumulation of foreign currency reserves in the past few

years. Starting from a situation in 1990-91 with foreign exchange reserves level

barely enough to cover two weeks of imports, and about $32 billion at the

beginning of 2000, India’s foreign exchange position rocketed to one of the largest

in the world with over $155 billion in mid-2006. Since 2000, this implies a

compounded annual growth rate of about 28% with the years 2003 and 2004

having the most stunning rises at 48% and 45% respectively. During these two

years the US dollar fell against the Euro by 19% and against the rupee by 9%.

Without RBI intervention, the latter figure is lik reserves accumulation less

spectacular.

A sizable foreign exchange reserve acts as liquidity cover and protects

against a run on the country’s currency, and reduces the rate of interest on Indian

debt in the world market by lowering the country risk perception by international

rating agencies. However, beyond a point, it begins to affect the money supply in

the country, and interest rates. There are significant “sterilization costs” to avoid

this and the RBI loses money by e l y to have been larger and the earning low

returns on the safe assets used to park the reserves. Given this low rate of return,

there has been discussion about the unique proposal to use part of the reserves to

fund infrastructure projects.

Structure of the FOREX Market

The structure of the foreign exchange market is an outgrowth of one of the

primary functions of a commercial banker: to assist clients in the conduct of

international commerce. For example, a corporate client desiring to import

merchandise from abroad would need a source for foreign exchange if the import

was invoiced in the exporter’ shome currency. Alternatively, the exporter might

need a way to dispose of foreign ex-change if payment for the export was invoiced

and received in the importer’s home currency. Assisting in foreign exchange

transactions of this type is one of the services that commercial banks provide for

their clients, and one of the services that bank customers expect from their

bank .The spot and forward foreign exchange market is an over-the-counter

(OTC)market; that is, trading does not take place in a central marketplace where

buyers and sellers congregate. Rather, the foreign exchange market is a worldwide

linkage of bank currency traders, nonbank dealers, and FX brokers who assist in

trades connected to one another via a network of telephones, telex machines,

computer terminals, and automated dealing systems. Reuters and EBS are the

largest vendors of quote screen monitors used in trading currencies. The

communications system of the foreign ex-change market is second to none,

including industry, governments, and the military and national security and

intelligence operations. Twenty-four-hour-a-day currency trading follows the sun

around the globe. Three major market segments can be identified: Australasia,

Europe, and North America. Australasia includes the trading centers of Sydney,

Tokyo, Hong Kong, Singapore, and Bahrain; Europe includes Zurich, Frankfurt,

Paris, Brussels, Amsterdam, and London; and North America includes New York,

Montreal, Toronto, Chicago, San Francisco, and Los Angeles. Most trading rooms

operate over a 9- to 12-hour working day,

THE DETERMINATION OF EXCHANGE RATES

I. SETTING THE EQUILIBRIUM

A. Exchange Rates

Market- clearing prices that equilibrate the quantities supplied and demanded of foreign currency

B. How Americans Purchase German Goods

1. Foreign Currency Demand-derived from the demand for foreign country’s goods, services, and financial assets e.g. The demand for German goods by Americans

2. Foreign Currency Supply:

A. derived from the foreign country’s demand for local goods.

b. They must convert their currency to purchase. e.g. German demand for US goods means Germans convert DM to US $ in order to buy.

3. Equilibrium Exchange Rate:

occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local price.

C. How Exchange Rates Change

1. Increased demand as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.

2. Home Currency Depreciation

a. Foreign currency becomes more valuable than the home currency.

b. Conversely, the foreign currency’s value has appreciated against the home currency

Purpose of the Foreign Exchange Market

Identification

Consumers acquire foreign exchange so they can purchase overseas goods.

Alternatively, businesses might receive foreign exchange and enter the market to

convert that money back into domestic currency.

The foreign exchange market also serves the purpose of attracting investors.

Investors diversify and increase their asset holdings with currency reserves.

Features

Foreign exchange rates describe the amount of another currency that one

unit of a certain currency can buy. Because of their association with specific

nations, foreign exchange rates gauge economic and political sentiment. Low

exchange rates translate into weak demand for a currency, as foreign investors

liquidate that country’s stocks, bonds and real estate. At that point,

foreigners might fear recession, or politics that are hostile to foreign investment.

For example, high tax rates on foreign profits can cause foreigners to withdraw

from a particular country.

Conversely, high exchange rates define strong economies and effective political

regimes. Investors are then encouraged to trade for that currency and to purchase

its home nation& rsquo;s assets. The increased demand for the currency supports

elevated exchange rates.

Considerations

Government officials can manage their home economies through foreign exchange

transactions. Low exchange rates for the domestic currency improve the export

economy, because these goods become more affordable to foreign buyers.

However, domestic consumers prefer higher exchange rates, which grant them

more purchasing power for imported goods.

Government leaders use foreign exchange reserves to influence currency

exchange rates. Nations can buy large amounts of foreign exchange reserves to

devalue the home currency. China owned $900 billion worth of U.S. treasuries as

of April 2010, the U.S. Treasury reported. These holdings lower exchange rates for

the Chinese Yuan and support China’s export economy.

Warning

Foreign exchange markets do introduce distinct risks of financial losses and

contagion. Institutions that hold a particular currency lose purchasing power when

its exchange rates deteriorate. However, as a home currency strengthens,

multinational corporations suffer sales declines because their wares become more

expensive overseas.

"Contagion" refers to the process of financial distress in one region growing into a

global crisis. For example, Mexico might default on its sovereign debt, which

causes the peso to collapse. From there, foreign businesspeople with exposure to

Mexico might be forced to sell off all assets to raise cash. The selling compounds,

and it causes markets to crash globally.

Strategy

Foreign exchange markets offer currency derivatives to hedge against risks.

Currency derivatives, such as futures, forwards and options establish

predetermined exchange rates over set periods of time. Futures and options trade

on major exchanges, such as the Chicago Mercantile Exchange. Forwards are

private agreements between two parties to negotiate exchange rates at later points

in time.