forex market basics

8/12/2019 Forex Market Basics

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What is foreign exchange market? Who are its participants? What are its functions?

*INTRODUCTION:

~ Foreign exchange market is a medium through which individuals, business, governments

and banks bu and sell foreign currencies!

Foreign exchange market is a medium through which individuals, business, governments

and banks bu and self foreign currencies!

~ Foreign exchange market is a worldwide market that operates round the clock! "n fact, it

is the largest and the most li#uid market in the world!

~ Foreign exchange market is not a single phsical place, but a worldwide market which

operates round the clock! "t is the largest and the most li#uid market in the world!

*MEANING:

~ Foreign exchange market is a mechanism where various national currencies are

purchased and sold like an other commodit!

~ The foreign exchange rate is determined b the demand for and suppl of foreign

exchange!

~ $ foreign exchange market can be free or restricted! %estrictions on the market var from

countr to countr!

~ "n "ndia, restrictions are made on foreign exchange convertibilit whereb full

convertibilit is allowed onl on current account and not on capital account!

~ &ven under the free foreign exchange market, the 'overnment intervenes whenever

there is a wide fluctuation in the exchange rate so as to avoid adverse effects of unstable

exchange rate on the econom!

*TYPE OF FOREIGN EXCHANGE MARKET:

~ The foreign exchange market is broadl divided into two categories(

) %etail *arket
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) Wholesale market!

+RETAIL MARKET:

~ The retail foreign exchange market is a secondar price marker wherein travellers,

tourists and people who are in need of foreign currenc carr out small permitted

transactions!

+WHOLESALE MARKET:

~ The wholesale foreign exchange market is also called the interbank market wherein large

transactions of foreign exchange are carried out! The dealers in this market are highl

professional and are the primar price makers!

*PARTICIPANTS:

~ The following are the main participants in the foreign exchange market(

i) RETAIL CLIENTS:

~ %etail clients are the ones who deal through commercial banks and authorised dealers!

~ These include individuals, international investors, multinational corporations and others

who need foreign exchange!

ii) COMMERCIAL BANKS:

~ -ommercial banks deal through other commercial banks and also through foreign

exchange brokers!

~ The bu and sell foreign exchange for their retail clients and also carr out their own

foreign exchange transactions!

iii) FOREIGN EXCHANGE BROKERS:

~ &ach foreign exchange market centre has some authorised brokers who act as

intermediaries between buers and sellers mainl banks!

~ -ommercial banks prefer foreign exchange brokers as banks obtain the most favourable

#uotations from them!


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iv) CENTRAL BANKS:

~ .nder the floating rate the central bank of a countr normall does not intervene in the

exchange market!

~/owever, since 0123, most of the central banks fre#uentl intervened the foreign

exchange market to bu and sell their currencies in order to influence the rate at which their

currencies are traded!

~ The above groups generate demand and suppl forces and help to determine the foreign

exchange rate!

~ The brokers are the middlemen between the price makers and possess more information

and better knowledge of the market!

~ The large commercial banks and foreign exchange brokers who participate in foreign

exchange market are linked together b telephone, telex and satellite communications

network called 4ociet for Worldwide "nternational Financial Telecommunications 54W"FT6!

~ This sstem is based in 7russels 57elgium6 and links banks and brokers in ever financial

centre! This sstem reacts to all the events that influence the foreign exchange rate and

thus makes the foreign exchange market efficient and conventional!

*INDIAN FOREIGN EXCHANGE MARKET:

~ "ndian foreign exchange market is made up of three tiers(

) 0st level 8 Deals between %7" and authorised dealers 5mainl commercial banks6

) 9nd level 8 Deals among authorised dealers!

) 3rd level 8 Deals between authorised dealers and their corporate customers!

*FUNCTIONS:

~ The main functions of the foreign exchange market are(

06 TRANSFER OF PURCHASING POWER:


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~ "nternational trade involves different currencies! The residents of one countr re#uire the

currenc of another countr to make paments in respect of the following transactions(

+"mport of goods and services

+Dividend, interest and profit to foreign firms!

+.nilateral paments!

+-apital outflow in the form of investments abroad, short : long term lending, etc!

~ This involves transfer of purchasing power from the praer;s countr to the receiver;s

countr!

~ 4imilarl, the residents of the other countr receive the foreign currenc in respect of thefollowing transaction!

+%eceipts on account of export of goods and services!

+%eceipt of dividend, interests and profit b firms!

+.nilateral receipts!

+-apital inflow in the form of foreign investments in "ndia,


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~ "n foreign exchange market, two tpes of exchange rate operations take place, spot

exchange rate and forward exchange rate!

*SPOT EXCHANGE RATE:

~ 4pot exchange rate is the current exchange rate! "t is determined b market forces

5demand for and suppl of foreign exchange6

~ $t the spot rate, immediate deliver of foreign exchange has to be made!

~ /owever, in practice, there is a two da time lag between the transaction and actual

deliver for paper work, verification and clearing of paments!

~ 4ince the spot exchange rate is determined b market forces, an change in the demand

or suppl will change the exchange rate!

~ The primar price makers in the foreign exchange market continuousl >bid; or >ask; the

currencies, hence the exchange rate also changes continuousl in a free market!

~ 4ince the primar dealers #uote twowa prices and are read to deal on either side 5i!e!

to bu and sell6 the rate is #uoted in the following manner(

)"


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*FORWARD EXCHANGE RATE:

~ "n the foreign exchange forwards market, the purchase:sale of foreign exchange is done

currentl for deliver and pament at a fixed date in future at a specified exchange rate!

This is known as the foreign exchange rate!

~ These contracts usuall have maturities of 3=, B= or 1= das! 4ome transactions also

have maturities of 0@= =r 3B=das!

~ Forward exchange rate ma either be at a premium or discount in relation to the spot

exchange rate(

+"f the forward exchange rate is above the present spot rate, it is said to be at a >premium;!

+"f the forward exchange rate is below the present spot rate, it is said to be at a >discount;

~ The #uotation foe forward exchange rate can be done as follows(

+"t is expressed in terms of the amount of local currenc at which the dealer will bu or sell

a unit of foreign currenc! This is termed as the >outright rate;!

+"t can also be expressed in terms of points 5called the forward points6! These points are

added to the spot rate if the foreign currenc is traded at a premium! These points are

deducted from the spot rate if the currenc is traded at a discount!

*NEED FOR FORWARD CONTRACTS:

~ &xporters, importers and investors enter into forward exchange rate contracts to

overcome the possible risk of loss due to fluctuations in the exchange rate!

~ $lso, in the forwards market, swap agreements take place to cover the risk involved in

the forward deal! .suall banks which enter into forward arrangement to sell foreign

currenc at a certain rate would cover their risk b entering into an agreement with another

bank to purchase the currenc at a fixed rate! 4uch swaps help the banks to match the

outflow and inflow of currencies and earn profit based on swap margin!

*FACTORS INFLUENCING FORWARD EXCHANGE RATE:


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~ Forward exchange rate is influenced b various factors that ma prevail at a future date!

These include(

+7alance of paments position

+"nflation rate!

+"nterest rate!

+Degree of speculation in foreign exchange market!

+&conomic situation in the countr!

+Political situation in the countr!

+'overnment policies, etc!

~ Thus, in a full floating exchange rate sstem, the forward exchange rate is left to the

speculation of dealers, whereas in a managed float, the role of the central bank also

influences the forward rate!

C3( Write a note on %isk -overage in the forward foreign exchange market?

$ns( The risk involved in dealing in the forward foreign exchange market can be covered b

activities like hedging, speculation and arbitrage!

~ The activities allow the dealers not onl to cover the risks involved but also to earn profit

b taking advantage of the forward exchange market!

*HEDGING:

~ /edging covers the risk arising out of changes in the exchange rate! "t is especiall

essential for firms having large amounts receivables or commitments to pa in foreign

currencies!

~ The strateg of hedging involves increasing the currenc that is likel to appreciate and

decreasing the currenc that is likel to depreciate!

~ "t also involves decreasing liabilities in the currenc that is likel to appreciate and

increasing liabilities in the currenc that is likel to depreciate!


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*SPECULATION:

~ 4peculation involves purchase and sale of foreign exchange in the forwards market with

the intention of making profit b taking advantage of changes in foreign exchange rates!

~ The speculate on the basis of their own calculation of the difference between the forward

rate and spot rate that ma prevail at a future date!

~ 4peculators tr to minimise their loss b entering in spot and forward agreements

simultaneousl!

~ 4peculation ma have stabilising or destabilising effect!

~ 4tabilising speculation refers to purchase of foreign currenc when the domestic price of a

foreign currenc when the domestic price of a foreign currenc falls with the expectation of

its increase in the future!

~ Destabilising speculation refers to sale of foreign currenc when the exchange rate falls

with the expectation that it would fall further! This magnifies exchange rate fluctuations and

proves highl disruptive to the international flow of trade and investment!

*ARBITRAGE:

~ $rbitrage refers to purchase of an asset in a low price market and its sale in a higherprice market!

~ This process leads to e#ualisation of price of an asset in all the segments of the market!

~ $rbitrageurs take advantage of the different exchange rates prevailing in various foreign

exchange markets due to different interest rates!

~ The purchase foreign currenc from the foreign exchange market with lower exchange

rate and sell the same in market with a higher exchange rate!

~ $rbitrage is also possible within the countr where two banks offer two different bids and

asking rate!

~ When arbitrage involves onl two currencies or two countries, it is called twopoint

arbitrage! "t increases the suppl of dearer currenc!


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*INTEREST RATE AND ARBITRAGE:

~ The interest rate of a countr is influenced b the rate of inflation prevailing in that

countr!

~

-urrenc convertibilit, as an aspect of a countrs exchange rate polic, refers to the ease

with which domestic currenc can be traded for foreign currenc, for a particular usage and

at a given exchange rate! -urrenc convertibilit polic of a government has two aspects(

5a6 current account convertibilit and 5b6 capital account convertibilit! -urrent account

convertibilit allows residents to make and receive traderelated paments, i!e! receive

foreign currenc for export of goods and services and pa foreign currenc for import of

goods and services like travels, medical treatment and studies abroad! "n other words, it

permits free inflows and outflows for all purposes other than for capital purposes! -apital

account convertibilit allows freedom to make investment in foreign e#uit, extend loans to

foreigners, bu real estate in foreign lands and vice versa! 7roadl speaking, it allows

anone to move freel from local currenc into foreign currenc and back! -urrent account

convertibilit was introduced in "ndia in $ugust 011 with the acceptance of the obligations

under $rticle E""" of the "*Fs $rticles of $greement! This drastic measure contributed

significantl to boost "ndias exports! Presentl, there is almost full convertibilit on the

current account and partial convertibilit on the capital account!

CAC has 5 basic statements designed as points of action:

All types of liquid capitalassets must be able to be exchanged freely, between any two nations in the world,

with standardizedexchange rates.

The amounts must be a significant amount in excess of !5"","""#.

Capital inflows should be in$ested in semi%liquid assets, to pre$ent churning and excessi$e outflow.

&nstitutional in$estorsshould not use CAC to manipulate fiscal policy or exchange rates.

'xcessi$e inflows and outflows should be buffered bynational ban(sto pro$ide collateral.
http://en.wikipedia.org/wiki/Liquid_capitalhttp://en.wikipedia.org/wiki/Liquid_capitalhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Institutional_investorhttp://en.wikipedia.org/wiki/National_bankhttp://en.wikipedia.org/wiki/National_bankhttp://en.wikipedia.org/wiki/National_bankhttp://en.wikipedia.org/wiki/Liquid_capitalhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Institutional_investorhttp://en.wikipedia.org/wiki/National_bank

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