FOREIGN EXCHANGE MARKET

Meaning Of Foreign ExchangeAccording to Hartly Withers, “ Foreign exchange is

the art and science of international monetaryexchange”

The forex market is the world’s largest financialmarket. Over $4 trillion dollars worth of currencyare traded each day. The amount of money traded ina week is bigger than the entire annual GDP of theUnited States.

The main currency used for forex trading is the USdollar.

Meaning Of Foreign Exchange

The term Foreign exchange implies two things:a)foreign currency and b) exchange rate

Foreign exchange generally refers to foreigncurrency, eg for india it is dollar, euro, yen, etc… &

The other part of foreign exchange is exchange ratewhich is the price of one currency in terms of theother currency.

Forex is the international market for the free trade ofcurrencies. Traders place orders to buy one currencywith another currency.

Definition and Organization of the Foreign Exchange Markets

Foreign exchange markets are markets on whichindividuals, firms and banks buy and sell foreigncurrencies:

– foreign exchange trading occurs with the help of thetelecommunication net between buyers and sellers offoreign exchange that are located all over the world

– a single international foreign exchange market forevery single currency

– foreign exchange trading takes place at least in someof the world financial centers in every moment

Forex Trading in India – Legal or Illegal

In India, Foreign Exchange or Forex trading is notallowed. If someone is found trading Forexinstruments on the forex market by the ReserveBank of India’s representatives, he/she isimmediately charged of violation of law. Hence it islegally a crime to involve in Forex trading and thecharges of the crime are imprisonment in jail inthis country. The offence is considered immense,the prediction of intensity can be deduced fromthis fact that it has been labeled to be non-bailable.

The Currency Market

Where money denominated in one currency isbought and sold with money denominated inanother currency.

International Trade and Capital Transactions:

• facilitated with the ability to transfer

purchasing power between countries.

Location

1. OTC-type: no specific location

2. Most trades by phone, telex, or SWIFT

SWIFT: Society for Worldwide Interbank Financial Telecommunications

Foreign Exchange Market

Foreign exchange market is that market in whichnational currencies are traded for one another..

The major participants in this market arecommercial banks, forex brokers, and authorizeddealers and the monetary authorities.

Besides, transfer of funds form one country toanother , speculation is an important dimensionof foreign exchange market.

Its where money in one currency is exchanged foranother

Participants in the Foreign Exchange Market

Participants at 2 Levels1. Wholesale Level (95%) - major banks2. Retail Level (business customers)

Two Types of Currency Markets1. Spot Market:

- Immediate transaction- Recorded by 2nd business day

2. Forward Market:- Transactions take place at a specified future date

Participants by Market

Spot Marketa. commercial banksb. Brokersc. customers of commercial and central banks

Forward Marketa. arbitrageursb. tradersc. hedgersd. speculators

CLEARING SYSTEMS

A. Clearing House Interbank Payments System (CHIPS)

- used in U.S. for electronic fund transfers.

B.Fed Wire

- operated by the Fed

- used for domestic transfers

Foreign Exchange Market FunctionsClearing of Currencies and Provision of Credit

Clearing of currencies:

– Service of exchanging one currency for another

Provision of Credit:

– Trader that bought a certain good from themanufacturer, needs time to sell this good to thefinal customer and to pay the manufacturer withthe money he received from the customer

Foreign Exchange Market and Insurance Against Foreign Exchange Risk

Activities with which the foreign exchange market participants avoid exchange rate risk or activities with which they are closing their open foreign exchange position

closed foreign exchange position:

• Size of the assets in a certain currency is equal to the size of the liabilities in the same currency

• Full insurance against exchange rate risk with respect to this currency

Foreign Exchange Market and Insurance Against Foreign Exchange Risk

Open foreign exchange position:

• long: net assets in a certain currency

• short: net liabilities in a certain currency

In the spot or forward foreign exchange market

Standardized forward contracts and options

Foreign Exchange Markets and Conscious Foreign Exchange Risk Acceptance

• Activities in which economic agents consciously open their foreign exchange positions – long or short – hoping to get profits in all foreign exchange market segments

Foreign Exchange Market ParticipantsEconomic Agents and Types of Activities on

Foreign Exchange Markets Client buys $

with €

Local bank

Main banks’

interbank market

Local bank

Client buys €

with $

Purchases and sales

of big multinational

companies

Brokers

Economic Agents and Types of Activities on Foreign Exchange Markets

Bank clients (individuals, firms, non-banking financial institutions):– All those groups of legal and physical persons that

need foreign currency in doing their commercial or investment business

commercial banks:The most important group of foreign exchange

market participants

They buy and sell foreign currencies for their clients and trade for themselves

Economic Agents and Types of Activities on Foreign Exchange Markets

Brokers:

– Agents that connects dealers interested in buyingand selling foreign exchange, but does notbecome an active client in the transaction

– They provide their client, the bank, with theinformation about the exchange rates at whichbanks are willing to buy or sell a particularcurrency

Economic Agents and Types of Activities on Foreign Exchange Markets

central banks:

Foreign exchange market interventions are meant to influence the exchange rate of the domestic currency in a way that is beneficial for the domestic economy and, consequently, for the country

It does not necessarily have a profit, it can also have a loss

Economic Agents and Motivation for the Foreign Exchange Market Participation

Arbitragers:• They want to earn a profit without taking

any kind of risk (usually commercial banks):• Try to profit from simultaneous exchange rate

differences in different markets

• Making use of the interest rate differences that exist in national financial markets of two countries along with transactions on spot and forward foreign exchange market at the same time (covered interest parity)

Economic Agents and Motivation for the Foreign Exchange Market Participation

Hedgers and Speculators:Hedgers do not want to take risk while

participating in the market, they want to insure themselves against the exchange rate changes

Speculators think they know what the future exchange rate of a particular currency will be, and they are willing to accept exchange rate risk with the goal of making profit

Every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transaction

Size and Structure of Foreign Exchange Market Transactions

The biggest share of all financial markets in the world

Most traded currencies by value

Currency distribution of global foreign exchange market turnover

Rank CurrencyISO 4217 code

(Symbol)

% daily share

(April 2013)

1 United States dollar USD ($) 87.0%

2 Euro EUR (€) 33.4%

3 Japanese yen JPY (¥) 23.0%

4 Pound sterling GBP (£) 11.8%

5 Australian dollar AUD ($) 8.6%

6 Swiss franc CHF (Fr) 5.2%

7 Canadian dollar CAD ($) 4.6%

8 Mexican peso MXN ($) 2.5%

9 Chinese yuan CNY (¥) 2.2%

10 New Zealand dollar NZD ($) 2.0%

11 Swedish krona SEK (kr) 1.8%

12 Russian ruble RUB (₽) 1.6%

13 Hong Kong dollar HKD ($) 1.4%

14 Norwegian krone NOK (kr) 1.4%

15 Singapore dollar SGD ($) 1.4%

16 Turkish lira TRY (₺) 1.3%

17 South Korean won KRW (₩) 1.2%

18 South African rand ZAR (R) 1.1%

19 Brazilian real BRL (R$) 1.1%

20 Indian rupee INR (₹) 1.0%

21 Danish krone DKK (kr.) 1.0%

22 Israeli new shekel ILS (₪) 1.0%

Other 8.3%

Total 200%

Types of Foreign Exchange Market TransactionsSpot Foreign Exchange Transactions

Almost immediate delivery of foreign exchange.

Outright Forward Transactions

Buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity

Forward exchange rates: 1, 3, 6, 9 months, one year

Swap Transactions

Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates:

– “Spot against forward” swaps:

Hedging

The act of reducing exchange rate risk

Forward Rate Quotations

Two Methods:

a) Outright Rate: quoted to commercialcustomers.

b) Swap Rate: quoted in the interbankmarket as a discount or premium.

Forward Contract

An agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

Futures

Basic characteristics of futures:– The amount of the currency that is being traded – Type of currency quotation– Contract expiration– Last day of trading with the contract– Settlement day– Margin requirements

Information about futures tradingFutures usage:

– Arbitrage between outright forward contract and futures

– Rarely used as an insurance instrument (rigidity!)

Futures positions

Futures are similar to forwards

First, futures positions require a margin deposit to beposted and maintained daily.

If a loss is taken on the contract, the amount is debitedfrom the margin account after the close of trading.

In other words, these futures are cash settled and nounderlying instruments or principals are exchanged.

Secondly, all contract specifications such as expirationtime, face amount, and margins are determined by theexchange instead of by the individual trading parties.

similarities and differences between outright forward contract and futures:– both need to be executed unconditionally

– they are usually established for at most one year

Characteristic Futures Outright Forward Contract

Size of the contracts standardized for a given currency depends on the individual needs of the

client

Location and trade

activity

at the stock exchange or at a given

location; actively traded in an

organized market

with the provision of agents, connected

among each other with the help of

telecommunications; not traded in an

organized market

Duration of the

contract

standardized, but at most a year depends on the individual needs of the

client , but not more than a year

Contract has to be

executed yes yes

Insurance and

Security of doing

Business with the

Instrument

insurance explicitly required (marg in

requirements); high security of doing

business with the instrument

insurance not required exp licitly

(implicit insurance are affiliat ions of

two partners up till now); lower

security than futures

Trade regulation regulated with the stock exchange

rules

regulation not exp licit ly determined

Options

Basic characteristics of options:– Financial instrument that gives the buyer the right,

but not the obligation, to buy or sell a standardizedamount of a foreign currency, that is traded, at a fixedprice at a particular time, or until a particular time inthe future

– Call option and put option– American and European options– Three different prices:

• Exercise/strike price• Cost, price or value of the option• Underlying or actual spot exchange rate

Options

• Options are a way of buying or selling a currencyat a certain point in the future.

• An option is a contract which specifies the priceat which an amount of currency can be bought ata date in the future called the expiration date.

• Unlike forwards and futures, the owner of anoption does not have to go through with thetransaction if he or she does not wish to do so.

Types of options

The buyer of a call has the right but not the obligation to buy theunderlying asset at the strike price on or before a specified date inthe future.

However, the seller has a potential obligation to sell the underlyingasset at the strike price on or before a specified date in the future ifthe holder of the option exercises his or her right.

The buyer of a put has the right but not the obligation to sell theunderlying asset at the strike price on or before a specified date inthe future.

On the other hand, the seller of a put has a potential obligation tobuy the underlying asset at the strike price on or before a specifieddate in the future if the holder of the option exercises his/her right.

OptionsTypes of options trading:

– In organized markets:• standardized contracts with given strike prices,

standardized durations (1, 3, 6, 9, 12 months) and expirations

• only certain currencies, contract amounts are standardized

– over-the-counter trading:• expiration date, strike price and contract amount depend

on the individual needs of the client

• counterparty risk!

• retail and interbank market

Options

Usage of options:– when the economic agent expects that the

exchange rate trend of a particular currency could change drastically

– when the economic agent does not know for sure that a certain foreign exchange flow will occur in the future

– Advantages:• Fixed option costs

• Options do not need to be executed

Advantages Of Forex Market

It’s already the world’s largest market and it’s stillgrowing quickly

It makes extensive use of information technology –making it available to everyone

Traders can profit from both strong and weakeconomies

Trader can place very short-term orders – which areprohibited in some other markets

The market is not regulated Brokerage commissions are very low or non-existent The market is open 24 hours a day during weekdays

Terms Related to Foreign Exchange Foreign exchange reserves- holdings of other countries' currencies Foreign exchange controls- controls imposed by a government on

the purchase/sale of foreign currencies Retail foreign exchange platform- speculative trading of foreign

exchange by individuals using electronic trading platforms Foreign exchange risk- arises from the change in price of one

currency against another International trade- the exchange of goods and services across

national boundaries Foreign exchange company- a broker that offers currency exchange

and international payments Bureau de change- a business whose customers exchange one

currency for another Currency pair- the quotation of the relative value of a currency unit

against the unit of another currency in the foreign exchange market Digital currency exchanger- market makers which exchange fiat

currency for electronic money

Exchange Rate

According to haines, “Exchange rate is the priceof the currency of a country can be exchanged forthe number of units of currency of anothercountry.”

Exchange rate is that rate at which one unit ofcurrency of a country can be exchanged for thenumber of units of currency of another country.

It’s the price for which one currency is exchangedfor another

Factors Influencing Exchange RatesAs with any market, the forex market is driven by supply and demand: If buyers exceed sellers, prices go up If sellers outnumber buyers, prices go downThe following factors can influence exchange rates: National economic performance Central bank policy Interest rates Trade balances – imports and exports Political factors – such as elections and policy changes Market sentiment – expectations and rumours Unforeseen events – terrorism and natural disastersDespite all these factors, the global forex market is more stable than stock markets; exchange rates change slowly and by small amounts.

Types Of Exchange Rates

Fixed and Floating Exchange Rates

Fixed exchange rate is the official rate set bythe monetary authorities of the Governancefor one or more currencies.

Under floating exchange rate, the value of thecurrency is decided by supply and demandfactors

Direct and Indirect Exchange Rates

Direct method - Under this, a given number ofunits of local currency per unit of foreigncurrency is quoted. They are designated asdirect/certain rates because the rupee cost ofsingle foreign currency unit can be obtaineddirectly. Direct quotation is also called homecurrency quotation.

Indirect method – Under this, a given number ofunits of foreign currency per unit of localcurrency is quoted. Indirect quotation is alsocalled foreign currency quotation

Buying and Selling

Exchange rates are quoted as two way quotes –

for purchase and

for sale

Transactions by the Bank

Spot and Forward

The delivery under a foreign exchange transaction can be settled in one of the following ways

Ready or cash – To be settled on the same day

Tom – To be settled on the day next to the date of transaction

Spot – To be settled on the second working day from the date of contract

Forward – To be settled at a date farther than the spot date

Theories of Exchange Rate Determination

Meaning:

Theories which determine the prices of forex rate considering inflation, interest rate, and elasticity of price etc..

Methods:

a)Long run theory

b)Short run theory

Long Run Theory Of Exchange Rate Determination:

This are the theories which predominately take into account the fundamental changes of economy.

Here fundamental changes refers to the change which are going to change the economic performance of the economy Purchasing power for all times to come.

Types of theory:Purchasing power parity.1) Absolute purchasing power parity.2) Relative purchasing power parity.Interest Rate parity.1) Covered Interest Rate parity.2) Uncovered Interest Rate parity.

Short Run Theory Of Exchange Rate Determination

This theories are based more on currentinformation or immediate performance ofeconomic variables.

This theories try to take into account the shortrun factor which may be eliminated in thelong run.

Purchasing power parity Theory

Founder –Swedish economist Gustav Cassel in 1918.

Meaning : According to this theory ,the price levelsand the changes in these price levels in differentcountries determine the exchanges rates of thesecountries currencies.

The basic principle of this theory is that theexchange rates between various currencies reflectthe purchasing power of these currencies .Thistheory is based law of one price.

Absolute Form Of PPP Theory

If the law of one price were to hold good for each and every commodity then the theory is termed as Absolute form of PPP Theory.

This theory describes the link between the spot exchange rate and price levels at a particular point of time

Relative Form Of PPP

This theory describes the link between the changes in spot exchange rate and in the price levels over a period of time.

According to this theory ,changes in spot rates over a period of time reflect the changes in the price level over the same period in the concerned economies.

This theory relaxes three assumptions of PPP i.e. Absences of transportation cost ,transaction costs and tariffs.

Interest Rate Parity Theory

Definition :

The process that ensures that the annualized forwardpremium or discount equals the interest rate differentialon equivalent securities in two currencies.

International Fisher effect:

Expected Rate of change = Interest rate of theexchange rate differential

Interest Rate = Real Interest Expected Differential Rate+ inflation rate

Modern theory: Demand & Supply Theory

The most satisfactory explanation of the determination of the rate of exchange is that a free exchange rate tends to be such as to equate the demand and supply of foreign exchange..

The intersection of supply curve and demand curve gives the equilibrium price

Modern theory also called balance of payments theory of foreign exchange

Foreign Exchange Risk

Exposure to exchange rate movement.

Any sale or purchase of foreign currency entails foreign exchange risk.

Foreign exchange transaction affects the net asset or net liability position of the buyer/seller.

Carrying net assets or net liability position in any currency gives rise to exchange risk.

Risk Management

Controlling losses You could control your losses, by mental stop or hard stop. Mental stop

means that you already set you limit of your loss. A hard stop is your initiative to stop when you think you must to stop it.

Using correct lot size As a beginning just use smaller lots you could stay flexible and logic than

emotions while you trade.Tracking overall exposure sample: you go to short on EUR/USD and long on USD/CHF, you exposed

two times for USD in the same direction. If USD goes down , you have a double dose of pain. So, keep your overall exposure limited, it keeps you for the long haul for trading

The bottom line Trading is about opportunities, you must take action while the

opportunities arise.

By G.SATHYA SAIMBA IV sem BIMS