foreign exchange market 1

8/8/2019 Foreign Exchange Market 1

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Importance of international

finance There has been an enormous growth in the

volume of international trade after world war 2.

No country can think of itself as an economicentity in itself, in isolation with rest of the world.

Along with trade, cross border capital flows havegrown enormously.

To facilitate free exchange of goods and services,a number of innovations have taken place ininternational payments and credit mechanism


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Indias foreign trade

Indian Exports during May, 2010 were valued at US $Indian Exports during May, 2010 were valued at US $

16145 million (Rs. 73964 crore)16145 million (Rs. 73964 crore)

Imports during May, 2010 were valued at US $ 27437Imports during May, 2010 were valued at US $ 27437

million (Rs.125694million (Rs.125694 crore)crore)

The forex reserves as on 16The forex reserves as on 16thth July 2010 stood atJuly 2010 stood atRs.1318898 croresRs.1318898 crores

India is heading towards a regime of full convertibilityIndia is heading towards a regime of full convertibility

even on the capital accounteven on the capital account


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The Foreign Exchange Market

The foreign exchange market (forex, FX, or currency market) is a

worldwide decentralized over-the-counterfinancial market for the

trading of currencies

The primary purpose of the foreign exchange market is to assist

international trade and investment, by allowing businesses to convert

one currency to another currency. For example, it permits a US

business to import European goods and pay Euros, even though the

business's income is in US dollars

The modern foreign exchange market started forming during the

1970s when countries gradually switched to floating exchange ratesfrom the previous exchange rate regime, which remained fixed as per

the Bretton Woods system.


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Unique features

Huge trading volume, leading to high liquidity

Geographical dispersion

Continuous operation: 24 hours a day except weekends,

i.e. trading from 20:15 GMT on Sunday until 22:00 GMT

Friday

The variety of factors that affect exchange rates

The low margins of relative profit compared with other

markets of fixed income


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Structure of Forex Market

The forex market can be classified as:

Retail market

Here travellers and tourists exchange one currency for another.

The total turnover and average transaction size is very small. However, the spread between buying and selling price is large.

Wholesale market

Also called as interbank market

Major players are commercial banks, investment institutions,companies and central banks.

The total turnover and average transaction size is very small


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Types of transactions

Spot transactions

The settlement date (value date) is two daysahead of the transaction date

Forward transactions

The settlement date is determined according tothe contract features.

Swap transactions It is a combination of a forward and spot

transaction, in the opposite direction


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Codes of selected currencies

USD: US Dollar

GBP: British Pound

JPY: Japanese Yen CAD: Canadian Dollar

EUR: Euro

AUD: Australian Dollar

INR: Indian Rupee CHF: Swiss Franc

NZD: New Zealand Dollar

MEP: Mexican Peso


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Exchange Rate Quotation

European terms:

Quotes given as number of units of a currency per USD. Eg. INR 45per USD

American terms:

Quotes given as number of units of USD per unit of a currency . Eg.USD 0.00148 per INR

Direct quote:

Units of a local currency per unit of foreign currency. Thus for India,INR 45 per USD is direct quote

Indirect quote: Number of units of foreign currency per unit of home currency. Thus,

USD 2.265 per INR100, is an indirect quote for India


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Two way bid ask quote

A currency pair is denoted by 3 letter SWIFTcodes, like:

GBP/JPY: British pound-Japanese yen

1st currency is base currency(GBP)

2nd currency is quoted currency(JPY)

The exchange rate quotation is given as number

of units of quoted currency per unit of basecurrency.

In our eg., it is number of yens per pound.


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A quotation consists of 2 prices. The left price is

bid price and the right side price is the askprice

Example: GBP/EUR Spot:1.3025/1.3035 Bid rate: The dealer will pay 1.3025 Euros

per GBP when selling Euros.

Ask rate: The dealer will take 1.3035Euros per GBP when selling GBPs


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Inter Bank Dealing

A spot transaction will be dealt as follows:

Monday, 2nd August 10.45am

BoB: BoB calling. EURO-INR 10 Lacs please. Union Bank:60/61

This means Union bank will buy a Euro for Rs.60and sell a Euro for Rs.61.

BoB: Mine. This means Bank of Baroda is ready to buy 10lac

Euros @ Rs.61 per Euro.


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Cross Rates

The cross rate is the currency exchange rate between two

currencies, where neither of the currencies are of the

country in which the exchange rate is given.

For example, if an exchange rate between the Euro and theJapanese Yen was quoted in an American newspaper, thiswould be considered a cross rate in this context, becauseneither the euro or the yen is the standard currency of the U.S.However, if the exchange rate between the euro and the U.S.dollar were quoted in that same newspaper, it would not beconsidered a cross rate because the quote involves the U.S.

official currency.


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Arbitrage

Although we hear of the term market rate, thefact is that different banks will have differentquotes for a given pair of currency at a given

point of time. Suppose banks A and B are quoting:

GBP/USD: 1.4550/1.4560 (Bank A) and

1.4538/1.4548 (Bank B)

Here Pounds can be bought at $1.4548 and soldat $1.4550


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Methods of exchange rate

control Foreign exchange controls are various forms of controls imposed by

a government on the purchase/sale of foreign currenciesby residents

or on the purchase/sale of local currency by nonresidents.

Common foreign exchange controls include:

Banning the use of foreign currency within the country

Banning locals from possessing foreign currency

Restricting currency exchange to government-approved exchangers

Fixed exchange rates

Restrictions on the amount of currency that may be imported orexported


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There are various factors which impact the exchange ratehowever, central bank controls the exchange rate in aneconomy.

The most common method to control the exchange rate isby open market operations. In an open market sale, thestate bank sells the bond to get moneywhich reduces themoney supply. As a result the exchange rate goes up andvice versa.

Central bankalso has foreign reserves and selling foreignreserves enhances the exchange rate of local currency and

lower its value when foreign currency is bought.


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Exchange control can also be exercised by regulatinginternational movements of goods through variousdevices.Imposition of import duties and of import quotaswill reduce imports, cut down the demand for foreigncurrency, lower its value or raise the value of thedomestic currency.

High levels of inflation in one country as compared tosome other country makes the goods of the former

costlier and hence demand for imported goods andeventually foreign currency increases. This will

depreciate the home currency.


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A rise in the interest rates attracts funds fromabroad, increases demand for domestic currencyand raises its value, and vice versa.

Up to 1939, Germany was a pioneer in themethod of exchange control although exchangecontrol was adopted in several other Europeancountries also during the Great Depression

(1929-33). Currently, exchange controls are used mostly as a

means to avoid wide fluctations in the rates.


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Forex market regulation

NFA (National Futures Association) and CFTC(Commodity Futures Trading Commission) are obligatoryregulating organizations for the Forex brokers that are

based in United States or want to legally deal with theU.S. residents.

FSA (Financial Service Authority) regulates the Forexbrokers that are based in U.K. or are dealing with theBritish traders.

SFBC (Swiss Federal Banking Commission) requires allForex brokers that are based in Switzerland to obtain thereal Swiss banking license and thus become a regulated

banking institution.


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Foreign exchange market in

IndiaThe foreign exchange market India is regulated

by the reserve bank of India through the

Exchange Control Department. At the same time,

Foreign Exchange Dealers Association

(voluntary association) also provides some help

in regulating the market.The whole foreign

exchange market in India is regulated by the

Foreign Exchange Management Act, 1999 or

FEMA.


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The origin of the foreign exchange market in

India could be traced to the year 1978 when banks

in India were permitted to undertake intra-day trade

in foreign exchange. The foreign exchange market in India tillthe early 1990s,however, remained highly regulated withrestrictions on external transactions, barriers to entry, low

liquidity and high transaction costs. The exchange

rate during this period was managed mainly for

facilitating Indias imports.However, it was in the 1990s

that the Indian foreign exchange market witnessed far reaching changes along with the shifts in the

currency regime in India

The Clearing Corporation of India Limited (CCIL) was set up in2001


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The Indian foreign exchange market is a

decentralised multiple dealership market comprising

two segmentsthe spot and the derivatives market.

In the spot market, currencies are traded at the

prevailing rates and the settlement or value date is

two business days ahead. The two-day period gives

adequate time for the parties to send instructions to

debit and credit the appropriate bank accounts at

home and abroad.

The derivatives market encompasses forwards, swaps andoptions. Though forward contracts exist for maturities up to oneyear, majority of forward contracts are for one month, three

months, or six months.


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Players in the Indian market include (a) ADs,

mostly banks who are authorised to deal in foreign

exchange, (b) foreign exchange brokers who act as

intermediaries, and (c) customersindividuals,

corporates, who need foreign exchange for their

transactions. Though customers are major players in

the foreign exchange market, for all practical purposes

they depend upon ADs and brokers. In the spot foreign

exchange market, foreign exchange transactions were

earlier dominated by brokers. Nevertheless, the

situation has changed with the evolving market

conditions, as now the transactions are dominated

by ADs. Brokers continue to dominate the derivatives

market.


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The major sources of supply of foreign

exchange in the Indian foreign exchange market are

receipts on account of exports and invisibles in the

current account and inflows in the capital account

such as foreign direct investment (FDI), portfolio

investment, external commercial borrowings (ECB)

and non-resident deposits. On the other hand, the

demand for foreign exchange emanates from imports

and invisible payments in the current account,

amortisation of ECB (including short-term trade

credits) and external aid, redemption of NRI deposits

and outflows on account of direct and portfolio

investment.


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In the Indian foreign exchange market, spot

trading takes place on four platforms, viz., FX CLEAR

of the CCIL set up in August 2003, FX Direct that is a

foreign exchange trading platform launched by IBS Forex (P) Ltd. in 2002 in collaboration with Financial

Technologies (India) Ltd., and two other platforms by

the Reuters - D2 platform and the Reuters Market

Data System (RMDS) trading platform that have a

minimum trading amount limit of US $ 1 million


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THE FUTURE

Against the backdrop of corporates in India

going global, it is essential that the Indian foreign

exchange market is able to provide them with the

same types of products and services as areavailable in the major markets overseas.

The agenda for the future should, therefore, includeintroduction of more instruments, more participants

and improved market infrastructure in respect oftrading and settlement

foreign exchange market 1

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