1.

Introduction
During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash, derivatives and debt instruments put together in the country, and the sheer size of the foreign exchange market becomes evident. Since then, the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,foreign exchange constitutes the largest financial market by far. Liberalization has radically changed Indias foreign exchange sector. Indeed the liberalization process itself was sparked by a severe Balance of Payments and foreign exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe import and foreign exchange controls and a thriving black market is being replaced with a less regulated, market driven arrangement. While the rupee is still far from being fully floating (many studies indicate that the effective pegging is no less marked after the reforms than before), the nature of intervention and range of independence tolerated have both undergone significant changes. With an overabundance of foreign exchange reserves, imports are no longer viewed with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in the foreign exchange markets not always to support the rupee but often to avoid an appreciation in its value. Full convertibility of the rupee is clearly visible in the horizon. The effects of these development s are palpable in the explosive growth in the foreign exchange market in India. Definition and characteristics of the foreign exchange market The foreign exchange market is the market in which national currencies are bought and sold against one another. This market is called the foreign exchange market and n ot the foreign currency market because the commodity that is traded on the market is more appropriately called foreign exchange than foreign currency: the latter is only a small part of what is traded. Foreign exchange consists mainly of bank deposits denominated in various currencies. Still, the term foreign currency will be used interchangeably with the term foreign exchange.
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The foreign exchange market is the largest and most perfect of all markets. It is the largest in terms of trading volume (turnover), which currently stands at over one trillion US dollars per day. It is the most perfect market because it possesses the requirements for market perfection: a large number of buyers and sellers; homogenous products; free flow of information; and the absence of barriers to entry. The foreign exchange market is made up of a vast number of participants (buyers and sellers). The products traded on the foreign exchange market are currencies: no matter where you buy your yens, euros, dollars or pounds they are always the same.There is no restriction on access to information, and insider trading is much less important than, for example, in the stock market. Finally, anyone can participate in the market to trade currencies. The importance of the foreign exchange market stems from its function of determining a crucial macroeconomic variable, the exchange rate, which affects to a considerable extent the performance of economies and businesses.This market is needed because every international economic transaction requires a foreign exchange transaction. Unfortunately, however, its function of exchange rate determination is not very well understood in the sense that economists are yet to come up with a theory of exchange rate determination that appears empirically valid. Unlike the stock market and the futures market, which are organised exchanges, the foreign exchange market is an over-thecounter (OTC) market, as participants rarely meet and actual currencies are rarely seen.There is no building called the Sydney Foreign Exchange Market, but there are buildings called the Sydney Stock Exchange and the Sydney Futures Exchange. It is an OTC market in the sense that it is not limited to a particular locality or a physical location where buyers and sellers meet. Rather, it is an international market that is open around the clock, where buyers and sellers contact each other via means of telecommunication.The buyers and sellers of currencies operate from approximately 12 major centres (the most important being London, New York and Tokyo) and many minor ones. Because major foreign exchange centres fall in different time zones, any point in time around the clock must fall within the business hours of at least one centre. The 24 hours of a day are almost covered by these centres, starting with the Far Eastern centres (Sydney, Tokyo and Hong Kong), passing through the Middle East (Bahrain), across Europe (Frankfurt and London), and then passing through the US centres, ending up with San Francisco.
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2. 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 Sodhani 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 inter-bank forex trading volume has continued to account for the dominant share (over 77%) of total trading over this period, though there is an unmistakable downward trend in that proportion. (Part of this dominance, though, result s from doublecounting since purchase and sales are added separately, and a single inter-bank transaction leads to a purchase as well as a sales entry.) This is in keeping with global patterns. In March 2006, about half (48%) of the transactions were spot trades, while swap transactions (essentially repurchase agreements with a one-way transaction spot or forward combined with a longer- horizon forward transaction in the reverse direction) accounted for 34% and forwards and forward cancellations made up 11% and 7% respectively. About
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two-thirds of all transactions had the rupee on one side. In 2004, according to the triennial central bank survey of foreign exchange and derivative markets conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee featured in the 20th position among all currencies in terms of being on one side of all foreign transactions around the globe and its share had tripled since 1998. As a host of foreign exchange trading activity, India ranked 23rd among all countries covered by the BIS survey in 2004 accounting for 0.3% of the world turnover. Trading is relatively moderately concentrated in India with 11 banks accounting for over 75% of the trades covered by the BIS 2004 survey.

3. Features of the Forward premium on the Indian rupee

The Indian rupee has had an active forward market for some time now. The forward premium or discount on the rupee (vis--vis the US dollar, for instance) reflects the markets beliefs about future changes in its value. The strength of the relationship of this forward premium with the interest rate differential between India and the US the Covered Interest Parity (CIP) condition gives us a measure of Indias integration with global markets. The CIP is a no-arbitrage relationship that ensures that one cannot borrow in a country, convert to and lend in another currency, insure the returns in the original currency by selling his anticipated proceeds in the forward market and make profits without risk through this process. Chakrabarti (2006) reports that between late 1997 and mid-2004 the average discount on the rupee was about 4% per annum. During the period the average difference between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was about 4.5% for 3-months and 3.5% for the 6-months period. With these two figures in the same ballpark (particularly given that bank deposit rates and inter-bank rates are not strictly comparable), annual averages of interest rate differences and the forward exchange premium also indicate a moderate degree of co-movement between the two variables. The interest rate differential explains about 20% of the total variation in the forward discount. The deviation of the Indian rupee-US dollar from the covered interest parity, however, exhibits long-lived swings on both sides of the zero line. This would indicate arbitrage opportunities and market imperfections provided we could be sure of the comparability of the interest rates considered. Therefore, while the behavior of the forward premium on the Indian rupee is broadly in lines with the CIP, more careful empirical analysis involving directly comparable interest rates is necessary to measure the strength of the covered interest parity condition and the efficiency of the foreign exchange market. Under market efficiency, the forward exchange rate is considered to be an unbiased predictor of the future spot rate, with random prediction errors. While the prediction errors of forward rates on the rupee appear to show some degree of persistence, any conclusion in this matter too must await more rigorous analysis.

Intervention in Foreign Exchange Markets The two main functions of the foreign exchange market are to determine the price of the different currencies in terms of one another and to transfer currency risk from more riskaverse participants to those more willing to bear it. As in any market essentially the demand and supply for a particular currency at any specific point in time determines its price (exchange rate) at that point. However, since the value of a countrys currency has significant bearing on its economy, foreign exchange markets frequently witness government intervention in one form or another, to maintain the value of a currency at or near its desired level. Interventions can range from quantitative restrictions on trade and cross border transfer of capital to periodic trades by the central bank of the country or its allies and agents so as to move the exchange rate in the desired direction. In recent years India has witnessed both kinds of intervention though liberalization has implied a long-term policy push to reduce and ultimately remove the former kind. It is safe to say that over the years since liberalization, India has allowed restricted capital mobility and followed a managed float type exchange rate policy. During the early years of liberalization, the Rangarajan committee recommended that Indias exchange rate be flexible. Officially speaking, India moved from a fixed exchange rate regime to market determined exchange rate system in 1993. The overt objective of Indias exchange rate policy, according to various policy pronouncements, has been to manage volatility in exchange rates without targeting any specific levels. This has been hard to do in practice. The Indian rupee has had a remarkably stable relationship with the US dollar. Meanwhile the dollar appreciated against major currencies in the late 90s and then went into an extended decline particularly during 2003 and 2004. The lock-step pattern of the US dollar and the Rupee is best reflected in the movements in the two currencies against a third currency like the Euro. The correlation of the exchange rates of the two currencies against the Euro during 1999-2004 was 0.94. Several studies have established the pegged nature of the rupee in recent years (see Chakrabarti (2006) for a more detailed discussion). Based on volatility, India had a de facto crawling peg to the US dollar between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995, with a
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major devaluation in March 1993. From mid-1995 to end-2001, the rupee reverted to a crawling peg arrangement in practice. An analysis of the ratio of the variance of the exchange rate to the sum of the variances of the interest rate and the foreign exchange reserves reveals a move even closer to the fixed exchange rate system. A comparison of the sensitivity (beta) of the Dollar-rupee rate with the Euro-rupee rate for a three year period (1999 through 2001), indicates that India had a dollar beta of 1.01 tenth highest among the 53 countries considered. More importantly, the US dollar-Euro exchange rate explained about 97% of all movements in the Indian rupee-Euro exchange rate highest among all the 53 countries considered. Clearly the Indian rupee has been an excellent tracker of the US dollar. It is instructive to consider the Rupee-Dollar exchange rate in the light of the purchasing power parity (PPP) holding that the exchange rate between two currencies should equal the ratio of price levels in two countries. In its dynamic form PPP holds that that the rate of depreciation of a currency should equal the excess of its inflation rate to that in the other country. Over a reasonably long period of time, the devaluation in the Indian Rupee, vis-vis the US dollar does seem to have an association with the difference in the inflation rates in the two countries. Between 1991 and 2003, the two variables have had visible comovements with a correlation of about 0.57 (Chakabarti (2006)). This may be a result of Indo-US trade flows dominating the exchange rate markets but it is perhaps more likely that it reflects the exchange rate management principles of the monetary authorities The Reserve Bank of India has used a varied mix of techniques in intervening in the foreign exchange market indirect measures such as press statements (sometimes called open mouth operations in central bank speak) and, in more extreme situations, monetary measures to affect the value of the rupee as well as direct purchase and sale in the foreign exchange market using spot, forward and swap transactions (see Ghosh (2002)). Till around 2002, the measures were mostly in the nature of crisis management of saving-the-rupee kind and sometimes the direct deals would be repeated over several days till the desired outcome was accomplished. Other public sector banks, particularly the SBI often aided or veiled the intervention process.

The exact details of the interventions are shrouded in mystery, not unusual for central banks ever wary of disclosing too much of their hand to the currency speculators. The Tarapore Committee report had urged more transparency in the intervention process and recommended, in 1997, that a Monitoring Exchange Rate Band of 5% be used around an announced neutral real effective exchange rate (REER), with weekly publication of relevant figures, something yet to be implemented. In a recent survey on foreign exchange market intervention in emerging markets, the Bank for International Settlements (BIS (2005b)) found that out of 11 emerging market countries considered, India gave out most complete information on intervention strategy (along with three others); no information on actual interventions (five others did the same) and did not cover foreign exchange intervention in annual reports (like two other countries). On the whole it ranked fourth most opaque in matters of foreign exchange intervention among the eleven countries compared. Regulation of cross-border currency flows A feature of the economy that is intricately related with the exchange rate regime followed is the freedom of cross-border capital flows. This relationship comes from the so-called impossible trinity or trilemma of international finance, which essentially states that a country may have any two but not all of the following three things a fixed exchange rate, free flow of capital across its borders and autonomy in its monetary policy. Since liberalization, India has been having close to a de facto peg to the dollar and simultaneously has been liberalizing its foreign currency flow regime. Close on the heels of the adoption of market determined exchange rate (within limits) in 1993 came current account convertibility in 1994. In 1997, the Tarapore committee, on Capital Account Convertibility, defined the concept as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange and laid down fiscal consolidation, a mandated inflation target and strengthening of the financial system as its three main preconditions. Meanwhile capital flows have been gradually liberalized, allowing, on the inflow side, foreign direct and portfolio investments, and tapping foreign capital markets by Indian
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companies as well as considerably better remittance privileges for individuals; and on the outflow side, international expansion of domestic companies. In 2000, the infamous Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign Exchange Management Act (FEMA) that gave participants in the foreign exchange market a much greater leeway. The ultimate goal of capital account convertibility now seems to be within the governments sights and efforts are on to chalk out the roadmap for the last leg, though it is not expected to be accomplished before 2009. Expectedly, the wisdom of the move has been hotly debated . Advocates of convertibility cite the consumption smoothing benefits of global funds flow and point out that it actually improves macroeconomic discipline because of external monitoring by the global financial markets. Convertibility can spur domestic investment and growth because of easier and cheaper financing. It can also contribute to greater efficiency in the banking and financial systems. On the other hand, skeptics like Williamson (2006), for instance, points out that India is yet to fulfill at least one of the three major preconditions to Capital Account Convertibility set out by the Tarapore committee, viz. fiscal discipline, with a public sector deficit of 7.6% of the GDP and the ratio of public debt to GDP of over 83% in 2005-06. In any case, the argument goes, the benefits of convertibility do not necessarily outweigh the risks and cross-border shortterm bank loans usually the last item to be liberalized are the most volatile. It is generally held that it was, in fact, the lack of convertibility that protected India from contamination during the Asian contagion in 1997-98. The Dynamics of Swelling Reserves-An important corollary of Indias 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, Indias 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 likely to have been larger and the reserves accumulation less spectacular.
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4. Market participants
Market participants are foreign exchange traders who, directly or indirectly, buy and sell currencies. These classes of participants enter the market as arbitragers, hedgers and speculators. Arbitragers seek to make profit by exploiting exchange rate anomalies (for example, when an exchange rate assumes two different values in two financial centres at the same time). Hedgers enter the market to cover open positions in an attempt to reduce or eliminate foreign exchange risk (an open position arises, for example, when an importer has to meet a foreign currency payment, which is due some time in the future). This position can be covered, for example, by buying the foreign currency forward. Speculators, on the other hand, bear risk deliberately by taking decisions involving open positions to make profit if their expectations turn out to be correct.A speculator would buy a currency if it were expected to appreciate, realising profit if the currency appreciates subsequently (and realising loss otherwise). We will come across and elaborate on these concepts throughout this book, but for the time being we concentrate on the institutional classification of market participants. There are five broad categories of participants in the foreign exchange market: customers, commercial banks, other financial institutions, brokers and central banks. Customers include individuals and companies utilising the services of commercial banks to buy and sell foreign exchange in order to finance international trade and investment operations.Thus, customers include, inter alia, exporters, importers, tourists, immigrants and investors. Exporters sell the foreign currencies they obtain from foreigners buying their products. Importers buy the foreign currencies they need to pay for the foreign goods they buy from foreign suppliers. Tourists going abroad buy foreign currencies, whereas those coming from abroad (foreign tourists) buy the domestic currency to pay for their living expenses while they are on holiday. Immigrants buy foreign currencies when they transfer funds to relatives in their home countries. Finally, investors buy and sell currencies as part of their acquisition and disposal of assets (bonds, shares, real estate, etc.). Customers are price takers in the foreign exchange market, which means that they buy currencies at the exchange rates quoted by market makers.
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Large commercial banks are market makers in the sense that they stand ready to buy and sell currencies at the exchange rates they declare, acting via their foreign exchange dealers. On the retail side commercial banks deal with customers, but on the wholesale side they deal in the interbank market or the wholesale market (that is, with other banks). Commercial banks participate in the foreign exchange market mainly as speculators, trying to make short term profit by getting exposed to foreign exchange risk. They also make profit on their dealings with customers from the differences between the buying and selling rates. They execute this function via the dealing desk or dealing room, which houses a group of dealers. These dealers may specialise in the trading of a particular currency, a group of currencies or a particular type of transaction (for example, spot transactions as opposed to forward transactions). Other financial institutions (such as investment banks and mutual funds) and large companies may deal directly by conducting foreign exchange operations themselves and not through banks. Dealers representing commercial banks, other financial institutions and large companies do business with each other in two ways. The direct way is to telephone other dealers directly, or to contact them via an electronic dealing system. Otherwise, dealing can be carried out indirectly via a broker, thus preserving anonymity.With the introduction of online trading systems, a new (direct) mode of trading has emerged. The function of a broker is to spread market information and to bring together buyers and sellers with matching needs. Brokers differ from dealers in that they do not take positions themselves, but obtain their living by charging commission fees. Major brokerage houses are global in nature, servicing the interbank market around the clock. Finally, central banks participate in the foreign exchange market because they act as bankers for their governments and also because they run the exchange rate and monetary policies. All of these functions require market participation. For example, under a system of managed floating, central banks often intervene in the foreign exchange market by buying and selling currencies, with the objective of smoothing out exchange rate movements or to prevent the domestic currency from appreciating or depreciating excessively.

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The foreign exchange market is dominated by interbank operations, the buying and selling of currencies among banks. The liquidity of the interbank market is due to large-volume transactions, as well as the fact that banks accept an obligation of reciprocity in quoting to other interbank dealers. However, it is by no means true that the interbank market is completely homogenous. Furthermore, not all banks are equally active in the interbank market. Thus, participants in the interbank market are classified into: (i) market makers, normally the largest banks; (ii) other major interbank dealers, who are willing to reciprocate quotes in a number of currencies; and (iii) second-tier banks, including banks that are active primarily in their domestic currencies and those unwilling to reciprocate quotes and often dealing in small amounts. Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. Central banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

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Foreign exchange fixing Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator. The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[66] Several scenarios of this nature were seen in the 199293 European Exchange Rate Mechanism collapse, and in more recent times in Asia. Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating
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profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and, hence, can generate large trades. Retail foreign exchange traders Individual retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange platforms, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association have in the past been subjected to periodic Foreign exchange fraud.[67][68] To deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA instead of a CTA). Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for differences and financial spread betting. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at. Non-bank foreign exchange companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account).
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5. The size and composition of the foreign exchange market

The size of the (global) foreign exchange market is measured by the sum of daily turnover in foreign exchange centres around the world. This is normally done through a survey that is coordinated by the Bank for International Settlements (BIS) and conducted in each financial centre by the domestic central bank (for example, the Sydney survey is conducted by the Reserve Bank of Australia). In this survey, which is conducted every three years in April, banks and financial institutions are asked about their foreign exchange activity, including spot and forward transactions. Since 1995, the survey has been re-designed to cover OTC derivatives activity, including currency and interest rate derivatives (such as currency options). The exposition here is restricted to the so-called traditional foreign exchange market, which includes spot and forward transactions only. Figure 2.1 shows the volume of daily turnover in the global foreign exchange market as measured through the BIS surveys since 1989. The global total is measured by adding up turnover in individual financial markets. In 2001 daily turnover declined, as compared with the previous survey, for the first time. The 19.5 per cent decline to USD1200 is attributed to at lease two factors. The first is the introduction of the euro and the abolition of the national currencies in 12 European countries. Although the trading of the euro has been more than that of the former German mark, it has also been less than the combined trading of the national currencies. The second reason is consolidation in the banking industry via mergers and acquisitions. As we can see from Figure 2.1, forward transactions (consisting of outright operations and swap operations) comprise the bulk of transactions in the foreign exchange market. The spot exchange rate The function of a market is the determination of the price of the commodity in which it is traded. The commodity that is traded on the foreign exchange market is foreign exchange, currencies and bank deposits denominated in various currencies. For simplicity, we will just call them currencies.

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A foreign exchange market participant would normally want to buy one currency and sell another, typically (but not necessarily) the domestic and a foreign currency.The price of one currency in terms of another is called a bilateral exchange rate, because two currencies are involved in the transaction. Confusion may arise because the exchange rate is the price of one kind of money in terms of another kind of money. 2.5 When the exchange of currencies takes place immediately, the underlying operation is called a spot transaction, and so we define the spot exchange rate as the rate applicable to transactions involving immediate exchange of the currencies. The word immediate means different things. When you use the services of a moneychanger at Melbourne Airport to exchange some Australian dollars for Hong Kong dollars because you are about to board a plane to Hong Kong, you obtain the Hong Kong dollars that you have bought immediately, meaning at once. This is also called a cash transaction. In an interbank transaction, on the other hand, the exchange of currencies does not take place at once, but rather in two business days (where a business day is a day on which banks and other foreign exchange market participants are open for business).When a transaction between two bank dealers is concluded today, each bank will in two business days credit the others account with the prescribed currency and amount agreed upon. This is still regarded as an immediate delivery, and so the underlying exchange rate is a spot exchange rate. If the delivery takes place some time in the future, then the underlying operation is a forward transaction. Two dates are involved in such a transaction.The first (called the contract date, the dealing date, the done date or the trade date) is the date on which the transaction is concluded at the exchange rate prevailing on the same date.The second date, which falls two business days later, is called the delivery date or value date.The exchange rate prevailing in the market may actually change between the two dates, but, no matter what happens, the exchange of the currencies takes place at the exchange rate agreed upon when the transaction is concluded. The forward exchange rate

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The forward exchange rate is a rate contracted today for the delivery of a currency at a specified date in the future.This date in the future (called the forward value date) must be more than two business days away, otherwise the underlying transaction will be a spot transaction. If the delivery takes place one week after the transaction has been concluded, then the underlying rate is a one-week forward rate.Typically, forward contracts extend up to one year, in maturities of one month, two months, and so on. However, forward contracts of maturities longer than one year can also be found. A special kind of forward contract is called a break forward contract. This contract can be terminated at a predetermined date, thus providing protection against adverse exchange rate movements. It may also be called forward with optional exit, abbreviated as FOX. The interval until a forward value date is calculated from the spot value date, not from the transaction date. For example, the forward value date of a sale of one week forward agreed on 16 June would be one week from the spot value date of 18 June, which would be 25 June. The forward value date is usually fixed, not by agreeing on a specific date, but by agreeing on a term, which is a whole number of weeks or months after the spot value date (for example, one month). The specific date is then fixed according to one of two conventions: (i) the modified following business day convention; and (ii) the end/end rule. The modified following business day convention works as follows: the maturity date is set to be the value date, but if that falls on a non-business day, the date is moved to the following day. If that falls in the next calendar month, it would be moved to the last business day of the current calendar month.The end/end rule is that if the value date is the last business day of the current calendar month, maturity will be the last business day of the final calendar month.

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6. Financial instruments Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, Euro and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a direct exchange between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. Spot trading is one of the most common types of Forex Trading. Often, a forex broker will charge a small fee to the client to roll-over the expiring transaction into a new identical transaction for a continuum of the trade. This roll-over fee is known as the "Swap" fee. Forward One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties. Swap The most common type of forward transaction is the foreign exchange swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange. A deposit is often required in order to hold the position open until the transaction is completed. Future Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
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Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. Thus the currency futures contracts are similar to forward contracts in terms of their obligation, but differ from forward contracts in the way they are traded. They are commonly used by MNCs to hedge their currency positions. In addition they are traded by speculators who hope to capitalize on their expectations of exchange rate movements. Option A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The options market is the deepest, largest and most liquid market for options of any kind in the world. Speculation Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton

Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. [79] Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics. Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors.[81] Also to be considered is the rise in foreign exchange autotrading; algorithmic, or automated, trading has increased from 2% in 2004 up to 45% in 2010. [82] Currency speculation is considered a highly suspect activity in many countries.[where?] While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy.
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7. The mechanics and technology of foreign exchange trading

A foreign exchange transaction consists of the following sequential processes: Price discovery: the dealer judges the exchange rate at which the transaction can be executed. This requires an assessment of the liquidity of the market and the expectation held by others about future changes in the exchange rate. Decision making: the dealer seeks information to support the decision to execute the transaction. Execution, which is the transaction itself, is initially conducted via the telephone or other means of telecommunication. Settlement: this involves completing the transaction by making payments in one currency and receiving payments in another.This function is performed by the so-called back office rather than by the dealers to allow an independent check on their activities. Position keeping: the dealer monitors the resulting position, calculating profit and loss.A decision may be taken to close the position subsequently. Foreign exchange market technology applies to all of these processes. The following is a brief outline of the historical development of foreign exchange technology. Prior to World War I, the foreign exchange market had physical locations, where pre-transaction processes and execution were carried out manually. Post-transaction processes were also settled manually with a physical delivery of bills. Physical delivery in foreign exchange persisted until quite recently: cheques and mail transfers were used until the 1970s. In continental European centres some form of physical location continued to exist until the 1980s, as commercial banks met daily with the central bank to fix the rate at which to settle customer orders. The following are the main technological devices used in conducting foreign exchange business: The first means of telecommunication used in the foreign exchange market was the telegraph. Some USD/GBP transactions were executed by using the trans-Atlantic cable laid in 1858 between London and New York (hence the pounds nickname, Cable).
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 Although telephone deals may be traced back to 1926, it was not until the late 1970s that reliable international networks were installed in banks dealing rooms. Then there was the telex, which is a telephone line with an automatic typewriter. It largely supplanted the telegraph after World War II. In decision making and settlement the successor to the telex was the fax. A breakthrough for price discovery and decision making was the screen-based information system carrying news and prices from other banks.The first was the Reuters Monitor, which was introduced in 1973. This was followed by other vendors such as Telerate. By 1984, there were some 40 electronic information services in London. By the second half of the 1980s the major part of communication in the foreign exchange market had shifted to screen-based automated dealing systems (also known as conversational dealing systems), which are networks that connect terminals. A dealer with a terminal can use it to call another dealer with a terminal on the same network. The next stage in the development of screen-based systems involved the automation of the execution process, which materialised in 1992 when Reuters introduced its automatic matching system. Automatic order matching systems are networks of terminals where dealers enter orders in the form of a buying and/or selling price for a given amount of currency. The network selects and displays the best buying and selling orders for each currency pair. The Internet is another development. Open access to the Internet removes the need to build dedicated connections to counterparties or customers. In 1997 an Internet-based foreign exchange dealing service (aimed mainly at wealthy individuals) was established in the United Kingdom by the Currency Management Corporation. More recent developments pertain to online foreign exchange trading, including the emergence of Internet-based multidealer foreign exchange services, such as Currenex (April 2000), Fxall (May 2001) and Atriax (August 2000). For more details, see the box below.
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8. Features of foreign exchange market:-

Liquidity: the market operates the enormous money supply and gives absolute freedom within opening or closing a position in the current market quotation. High liquidity is a powerful magnet for any investor, because it gives him or her the freedom to open or to close a position of any size whatever. Promptness: with a 24-hour work schedule, participants in the FOREX market need not wait to respond to any given event, as is the case in many markets. Availability: a possibility to trade round-the-clock; a market participant need not wait to respond to any given event. Flexible regulation of the trade arrangement system: a position may be opened for a pre-determined period of time in the FOREX market, at the investors discretion, which enables to plan the timing of ones future activity in advance. Value: the Forex market has traditionally incurred no service charges, except for the natural bid/ask market spread between the supply and the demand price. One-valued quotations: with high market liquidity, most sales may be carried out at the uniform market price, thus enabling you to avoid the instability problem existing with futures and other forex investments where limited quantities of currency only can be sold concurrently and at a specified price. Market trend: currency moves in a quite specific direction that can be tracked for rather a long period of time. Each particular currency demonstrates its own typical temporary changes, which presents investment managers with the opportunities to manipulate the FOREX market. Margin: the credit leverage (margin) in the FOREX market is only determined by an agreement between a customer and the bank or the brokerage house that pushes it to the market and is normally equal to 1:100. That means that, upon making a $1,000 pledge, a customer can enter into transactions for an amount equivalent to $100,000. It is such extensive credit leverage, that in conjunction with highly variable currency quotations, making this market highly profitable and also highly risky.

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9.Nature of Transaction of foreign exchange market:1. Arbitrage:Arbitrage refers to the activities of a dealer in foreign exchange. He bye a currency at one place and sells it at another place simultaneously. As a result the market for a given currency remain unified in different money markets in the world. In the process the dealer in foreign exchange market makes profits. He take advantage of price or exchange rate differences in the two markets. For example: 1 $ = Rs 44 in US and in India it is 1 $ =Rs 45. 2. Hedging:Hedging is an important features of the foreign exchange market. It refers to the avoidance of foreign exchange risk. When importers and exporters enter into an agreement normally with a commercial bank dealing in foreign exchange to buy and sell goods at some future specified date at the pre-determined exchange rate if is called hedging. When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that is long a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair, can protect against upside risk. The primary methods of hedging currency trades for the retail forex trader is through:

Spot contracts, and Foreign currency options.

Spot contracts are essentially the regular type of trade that is made by a retail forex trader. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. Regular spot contracts are usually the reason that a hedge is needed, rather than used as the hedge itself. Foreign currency options, however are one of the most popular methods of currency hedging. As with options on other types of securities, the foreign currency option gives the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles and bull or bear spreads, to limit the loss potential of a given trade. (For more, see A Beginner's Guide To Hedging.) Forex hedging strategy A forex hedging strategy is developed in four parts, including an analysis of the forex trader's risk exposure, risk tolerance and preference of strategy. These components make up the forex hedge:
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1. Analyze risk: The trader must identify what types of risk (s)he is taking in the current or proposed position. From there, the trader must identify what the implications could be of taking on this risk un-hedged, and determine whether the risk is high or low in the current forex currency market. 2. Determine risk tolerance: In this step, the trader uses their own risk tolerance levels, to determine how much of the position's risk needs to be hedged. No trade will ever have zero risk; it is up to the trader to determine the level of risk they are willing to take, and how much they are willing to pay to remove the excess risks. 3. Determine forex hedging strategy: If using foreign currency options to hedge the risk of the currency trade, the trader must determine which strategy is the most cost effective. 4. Implement and monitor the strategy: By making sure that the strategy works the way it should, risk will stay minimized. The forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize the amount of risk they take on. So much of being a trader is money and risk management, that having another tool like hedging in the arsenal is incredibly useful. Not all retail forex brokers allow for hedging within their platforms. Be sure to research fully the broker you use before beginning to trade.

3. Speculation:Speculation is the opposite of hedging. While a hedger seeks to cover the foreign exchange risk a speculator accepts and even seeks out a foreign exchange risk or an open position in the hope of the making a profit. If the speculator correctly anticipates the future changes in spot rate he stands to gain or else he would incur losses. A number of proposals have been made in the past to try and limit speculation that were never enacted, these have included:

The Tobin tax is a tax intended to reduce short-term currency speculation, ostensibly to stabilize foreign exchange. In May 2008 German leaders planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds. On 3 December 2009 U.S. Congressman Peter DeFazio, who blamed "reckless speculation" for the 2008 financial crisis, proposed the introduction of a financial transaction tax, which would specifically target speculators by taxing financial market securities transactions.
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10. Conclusion

During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash, derivatives and debt instruments put together in the country, and the sheer size of the foreign exchange market becomes evident. Since then, the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,foreign exchange constitutes the largest financial market by far. The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. Electronic Broking Services (EBS) and Reuters 3000 Xtra are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies. The foreign exchange market works through financial institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as dealers, who are actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the interbank market, although a few insurance companies and other kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

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