"Business Economics-II: "Foreign Exchange Market"
"Business Economics-II: "Foreign Exchange Market"
"Business Economics-II: "Foreign Exchange Market"
“Business Economics-II
Himani Shah
SYBMS – B
Roll No- 45
Phone. No. 9769077928
Gmail: [email protected]
Index
Sr. No Topic Name Page Number
1 What is foreign 2
exchange market
(introduction)
2 Understanding foreign 2
exchange market
3 Foreign exchange 4
market in India
4 Functions of foreign 5
exchange market
5 Types of foreign 6
exchange market
6 Dealers in foreign 7
exchange market
7 Spot exchange rate 8
8 Forward exchange rate 10
9 Hedging, speculation, 10
arbitrage.
10 4 ways to determine the 12
rate of foreign exchange
11 History of Indian 14
foreign exchange market
12 Recommendation of 15
expert group on foreign
exchange market
13 Conclusion 17
INTRODUCTION
What Is the Foreign Exchange Market?
The foreign exchange market (also known as forex, FX, or the currency
market) is an over-the-counter (OTC) global marketplace that determines
the exchange rate for currencies around the world. Participants are able
to buy, sell, exchange, and speculate on currencies.
It is, by far, the largest financial market in the world and is comprised of a
global network of financial centres that transact 24 hours a day, closing
only on the weekends.
Currencies are always traded in pairs, so the "value" of one of the currencies in
that pair is relative to the value of the other. This determines how much of
country A's currency country B can buy, and vice versa. Establishing this
relationship (price) for the global markets is the main function of the foreign
exchange market. This also greatly enhances liquidity in all other financial
markets, which is key to overall stability.
One of the most unique features of the forex market is that it is comprised of a
global network of financial centers that transact 24 hours a day, closing only on
the weekends. As one major forex hub closes, another hub in a different part of
the world remains open for business. This increases the liquidity available in
currency markets, which adds to its appeal as the largest asset class available to
investors.
USD/JPY
GBP/USD
Forex Leverage
The leverage available in FX markets is one of the highest that traders and
investors can find anywhere. Leverage is a loan given to an investor by their
broker. With this loan, investors are able to increase their trade size, which could
translate to greater profitability. A word of caution, though: losses are also
amplified.
For example, investors who have a $1,000 forex market account can trade
$100,000 worth of currency with a margin of 1%. This is referred to as having a
100:1 leverage. Their profit or loss will be based on the $100,000 notional
amount.
There are some key factors that differentiate the forex market from others, like
the stock market.
There are fewer rules, which means investors aren't held to the strict standards
or regulations found in other markets.
There are no clearing houses and no central bodies that oversee the forex
market.
Most investors won't have to pay the traditional fees or commissions that you
would on another market.
Because the market is open 24 hours a day, you can trade at any time of day,
which means there's no cut-off time to be able to participate in the market.
Finally, if you're worried about risk and reward, you can get in and out whenever
you want, and you can buy as much currency as you can afford based on your
account balance and your broker's rules for leverage.
The market in which international currency trade takes place that is where
foreign currencies are bought and sold simultaneously is called the Foreign
Exchange (Forex) Market. It is the organizational framework within which banks,
merchants, firms, investors, individuals and government exchange foreign
currencies for one another. Foreign Exchange
For example, in India the currency in circulation is called the rupee INR and in
the United States, the currency in circulation is called the US Dollar (USD).
The value for which one currency is exchanged for another or the value of one
currency in terms of another currency is called exchange rate. For example, US
dollar can be bought for 63 INR rupees. This is the exchange rate for Indian
rupees in US dollars.
The foreign exchange market in India started when in 1978 the government
allowed banks to trade foreign exchange with one another. Foreign Exchange
Market in India operates under the Central Government of India and executes
wide powers to control transactions in foreign exchange. The Foreign Exchange
Management Act, 1999 or FEMA regulates the whole Foreign Exchange Market in
India. Before the introduction of this act, the foreign exchange market in India
was regulated by the Reserve Bank of India through the Exchange Control
Department, by the Foreign Exchange Regulation Act or FERA, 1947. Interbank
foreign exchange Trading is regulated by the Foreign Exchange Dealers
Association of India (FEDAI) created in 1958, a self-regulatory voluntary
association of dealers or banks specializing in the foreign exchange activities in
India that regulates the governing rules and determines the commissions and
charges associated with the interbank foreign exchange business. 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.
Transfer Function: The basic and the most visible function of foreign
exchange market is the transfer of funds (foreign currency) from one
country to another for the settlement of payments. It basically includes
the conversion of one currency to another, wherein the role of FOREX is to
transfer the purchasing power from one country to another.
For example, If the exporter of India import goods from the USA and the
payment is to be made in dollars, then the conversion of the rupee to the
dollar will be facilitated by FOREX. The transfer function is performed
through a use of credit instruments, such as bank drafts, bills of foreign
exchange, and telephone transfers.
There are several dealers in the foreign exchange markets, the most important
amongst them are the banks. The banks have their branches in different
countries through which the foreign exchange is facilitated, such service of a
bank is called as Exchange Banks.
Types of Foreign Exchange Market
Broadly, the foreign exchange market is classified into two categories on the
basis of the nature of transactions. These are:
Thus, the spot and forward markets are the important kinds of foreign exchange
market that often helps in stabilizing the foreign exchange rate.
1. Banks:
The banks dealing in foreign exchange have branches (called exchange banks) in
different countries and maintain substantial foreign currency balances in these
branches to serve the needs of their customers.
These branches discount and sell foreign bills of exchange, issue bank drafts,
make telegraphic transfers etc. If a bank has excess foreign currency balances, it
can sell these balances to other banks, foreign currency brokers, and sometimes
to foreign monetary institutions.
Similarly, if an exchange bank has deficit foreign currency balances, the other
banks, the brokers and the foreign monetary institutions become the sources of
foreign currency supply.
2. Brokers:
Banks do not deal directly with one another. They use the services of foreign
exchange brokers. The brokers bring together the buyers and sellers of foreign
exchange among banks. By using the brokers, the banks save time and effort.
If a bank wants to buy or sell foreign exchange, it informs the broker the amount
and the rate of exchange in which it is interested. If the broker succeeds in
carrying out the transaction, he receives a commission from the selling bank.
3. Acceptance Houses:
Acceptance houses also deal in foreign exchange. They accept bills on behalf of
their customers and thus help in foreign remittances.
KEY TAKEAWAYS
The spot exchange rate is the current market price for changing one
currency directly for another.
Generally, the spot rate is set by the forex market, but some countries
actively set or influence spot exchange rates through mechanisms like a
currency peg.
Currency traders follow spot rates to identify trading opportunities not
only in the spot market but also in futures, forwards, or options markets.
The spot exchange rate is best thought of as how much you would have to pay
in one currency to buy another at this moment in time. The spot exchange rate
is usually decided through the global foreign exchange market where currency
traders, institution and countries clear transactions and trades. The forex
market is the largest and most liquid market in the world, with trillions of dollars
changing hands daily. The most actively traded currencies are the U.S. dollar, the
euro—which is used in many continental European countries including
Germany, France, and Italy—the British pound, the Japanese yen and the
Canadian dollar.
Trading takes place electronically around the world between large, multinational
banks. Other active market participants include corporations, mutual funds,
hedge funds, insurance companies and government entities. Transactions are
for a wide range of purposes, including import and export payments, short- and
long-term investments, loans and speculation.
On the transaction date, the two parties involved in the transaction agree on the
price, which is the number of units of currency A that will be exchanged for
currency B. The parties also agree on the value of the transaction in both
currencies and the settlement date. If both currencies are to be delivered, the
parties also exchange bank information. Speculators often buy and sell multiple
times for the same settlement date; in which case the transactions are netted
and only the gain or loss is settled.
Structure: An outright forward lock in an exchange rate or the forward rate for
an exchange of specified funds at a future value (delivery) date. Outright
Forward Contract in an NDF a principal amount, forward exchange rate, fixing
date and forward date, are all agreed on the trade date and form the basis for
the net settlement that is made at maturity in a fully convertible currency. At
maturity of the NDF, in order to calculate the net settlement, the forward
exchange rate agreed at execution is set against the prevailing market 'spot
exchange rate' on the fixing date which is two days before the value (delivery)
date of the NDF. The reference for the spot exchange rates i.e., the fixing basis
varies from currency to currency and can be the Reuters or Bloomberg pages.
Non-Deliverable Forward Contract.
The risk involved in dealing in the forward foreign exchange market can be
covered by activities like hedging, speculation and arbitrage.
~ The activities allow the dealers not only to cover the risks involved but also to
earn profit by taking advantage of the forward exchange market.
*HEDGING:
~ Hedging covers the risk arising out of changes in the exchange rate. It is
especially essential for firms having large amounts receivables or commitments
to pay in foreign currencies.
*SPECULATION:
~ Speculation involves purchase and sale of foreign exchange in the forwards
market with the intention of making profit by taking advantage of changes in
foreign exchange rates.
~ They speculate on the basis of their own calculation of the difference between
the forward rate and spot rate that may prevail at a future date.
*ARBITRAGE:
~ Arbitrage refers to purchase of an asset in a low-price market and its sale in a
higher price market.
~ This process leads to equalisation of price of an asset in all the segments of the
market.
~ They purchase foreign currency from the foreign exchange market with lower
exchange rate and sell the same in market with a higher exchange rate.
~ Arbitrage is also possible within the country where two banks offer two
different bids and asking rate.
~ When arbitrage involves only two currencies or two countries, it is called two-
point arbitrage. It increases the supply of dearer currency.
(a) Demand for foreign exchange (currency) (b) Supply of foreign exchange (c)
Determination of exchange rate (d) Change in Exchange Rate!
In a system of flexible exchange rate, the exchange rate of a currency (like price
of a good) is freely determined by forces of market demand and supply of
foreign exchange.
Let us assume that there are two countries—India and USA—and the exchange
rate of their currencies, viz., rupee and dollar are to be determined. Presently
there is floating or flexible exchange regime in both India and USA. Therefore,
the value of currency of each country in terms of the other currency depends
upon the demand for and supply of their currencies.
Demand for foreign exchange is caused (I) to purchase abroad goods and
services by domestic residents, (ii) to purchase assets abroad, (iii) to send gifts
abroad, (iv) to invest directly in shops, factories abroad, (v) to undertake foreign
tours, (vi) to make payment of international trade, etc. The demand for dollars
varies inversely with rupee price of dollar, i.e., higher the price, the lower is the
demand. The demand curve in Fig. 10.1 is downward sloping because there is
inverse relationship between foreign exchange rate and its demand.
(I) when foreigners purchase home country’s (say, India’s) goods and services
through our exports
(ii) when foreigners make direct investment in bonds and equity shares of home
country
This is determined at a point where demand for and supply of foreign exchange
are equal. Graphically, intersection of demand and supply curves determines the
equilibrium exchange rate of foreign currency. At any particular time, the rate of
foreign exchange must be such at which quantity demanded of foreign currency
is equal to quantity supplied of that currency. It is proved with the help of the
following diagram. The price on the vertical axis is stated in terms of domestic
currency (i.e., how many rupees for one US dollar).
As a result, demand for Indian goods increases. Thus, our exports should
increase as the exchange rate increases. This will bring greater supply of foreign
exchange. Hence, the supply of foreign exchange increases as the exchange rate
increases which proves the slope of supply curve.
In the Fig. 10.1, demand curve and supply curve of dollars intersect each other at
point E which implies that at exchange rate of OR (QE), quantity demanded and
supplied are equal (both being equal to OQ). Hence, equilibrium exchange rate is
OR and equilibrium quantity is OQ.
Likewise, an increase in supply of US dollar will cause supply curve SS shift to S’S’
and as a result exchange rate will fall from OR to OR 2. It indicates appreciation of
Indian currency (rupees) because cost of US dollar in terms of rupees has now
fallen, say, 1 dollar = Rs 48, i.e., less rupees are required to buy 1 US dollar or
now Rs 48 instead of Rs 50 can buy 1 dollar. Thus, appreciation of currency
means ‘a rise in the price of home currency.
The evolution of India’s foreign exchange market may be viewed in line with the
shifts in India’s exchange rate policies over the last few decades from a par value
system to a basket-peg and further to a managed float exchange rate system.
During the period from 1947 to 1971, India followed the par value system of
exchange rate. Initially the rupee’s external par value was fixed at 4.15 grains of
fine gold. The Reserve Bank maintained the par value of the rupee within the
permitted margin of ±1 per cent using pound sterling as the intervention
currency. Since the sterling-dollar exchange rate was kept stable by the US
monetary authority, the exchange rates of rupee in terms of gold as well as the
dollar and other currencies were indirectly kept stable. The devaluation of rupee
in September 1949 and June 1966 in terms of gold resulted in the reduction of
the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold,
respectively. The exchange rate of the rupee remained unchanged between
1966 and 1971 (Chart VI.1). 6.19 Given the fixed exchange regime during this
period, the foreign exchange market for all practical purposes was defunct.
Banks were required to undertake only cover operations and maintain a ‘square’
or ‘near square’ position at all times. The objective of exchange controls was
primarily to regulate the demand for foreign exchange for various purposes,
within the limit set by the available supply. The Foreign Exchange Regulation Act
initially enacted in 1947 was placed on a permanent basis
Conclusion:
To sum up, the foreign exchange market structure in India has undergone
substantial transformation from the early 1990s. The market participants have
become diversified and there are several instruments available to manage their
risks. Sources of supply and demand in the foreign exchange market have also
changed in line with the shifts in the relative importance in balance of payments
from current to capital account. There has also been considerable improvement
in the market infrastructure in terms of trading platforms and settlement
mechanisms. Trading in Indian foreign exchange market is largely concentrated
in the spot segment even as volumes in the derivatives segment are on the rise.
Some of the issues that need attention to further improve the activity in the
derivatives segment include flexibility in the use of various instruments,
enhancing the knowledge and understanding the nature of risk involved in
transacting the derivative products, reviewing the role of underlying in booking
forward contracts and guaranteed settlements of forwards. Besides, market
players would need to acquire the necessary expertise to use different kinds of
instruments and manage the risks involved.