MECHANICS OF FOREX TRADING

Forex trading is an important aspect of forex management. It is basically concerned with various
forex operations including purchase and sale of currencies of different countries in order to meet
payments and receipts requirements as a result of foreign trade. Forex trading is done either in
retail market or in whole sale market (also called inter bank market). Under retail market, the
traveler and tourists exchange one currency for another in form of currency notes or traveler
cheques. Here, the total turnover and average transaction size are very small. The spread between
buying and selling price is large. Whereas wholesale market or inter bank market is a market
with huge turnover. The major market participants of this market include commercial banks,
corporation and central banks.
In the inter bank market deals are done on the telephone or on electronic media. Suppose bank A
wishes to buy the British pound sterling against the US dollar. A trader in bank A might call his
counterpart in bank B and ask for a price quotation. If the price is acceptable they will agree to
do the deal and both will enter the details the amount bought/sold, the price, the identity of the
counter party etc. in their respective banks computerized records systems and go on to the
next transaction. Subsequently, written confirmations will be sent containing all the details. On
the day of settlement, bank A will turn over a US dollar deposit to bank B and B will turn over a
sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered
in the record systems. This enables them to do deals very rapidly. At the international level interbank settlement is effected through the Clearing House Inter Bank Payment System (CHIPS),
located at New York.
When asked to quote a price between a pair of currencies, say pound sterling and dollar, a trader
gives a two-way quote i.e. he quotes two prices: a price at which he will buy a sterling in
exchange for dollars and a price at which he will sell a sterling for dollars. The enquirer does not
have to specify whether he wants to sell or buy pounds against dollars; as mentioned above, the
market maker is ready to take either side of the transaction. Thus his quotation can be
represented as (the numbers are hypothetical);
$/: 1.7554-1.7560 or 1:7554/1.7560
The number on the left of the hyphen or the slash is the amount of dollars the trader will pay to
buy a pound. This is the traders bid rate for a pound sterling (against dollar). The number of the
right is the amount of dollars the trader will require to sell a pound. This is the traders ask rate
(also called the offer rate). For a quote given above the bid-ask spread is 0.0006 dollar or 0.06
cent per pound. This margin is the market makers compensation for the costs incurred and
normal profit on capital invested in the dealing function.
In a normal two-way market, a trader expects to be hit on both sides of his quote in roughly
equal amounts. That is, in the pound-dollar case above, on a normal business day the trader
expects to buy and sell roughly equal amount of pounds (and of course dollars). The Banks
margin would then be the bid-ask spread.
But suppose during the course of trading a trader finds that he is being hit on one side of his
quote much more often than the other side. In our pound-dollar example this means that he is
either buying many more pounds than he is selling or vice versa. This leads to the trader building
up a position. If he has sold (bought) more pounds than he had bought (sold) he is said to
have net short position (long position) in pounds. Given the volatility of exchange rates,
maintaining a short or long position for too long can be a risky proposition. For instance, suppose
that a trader has built up a net short position in pounds of 1,00,000. The pound suddenly
appreciates from say $1.7500 to $1.7520. This implies that the banks liability increases by

$2000 ($0.0020 per pound for 1 million pounds). Of course, a pound depreciation would have
resulted in a gain. Similarly, a net long position leads to a loss if it has to be covered at a lower
price and a gain if at a higher price. (By covering a position we mean undertaking
transactions that will reduce the net position to zero. A trader net long in pounds must sell pounds
to cover; a net short must buy pounds).
The potential gain or loss from a position depends upon the size of the position and the
variability of exchange rates. Building and carrying such net positions for long durations would
be equivalent to speculation and banks exercise tight control over their traders to prevent such
activity. This is done by prescribing the maximum size of net positions a trader can building up
during a trading day and how much can be carried overnight.
In an ordinary foreign exchange transaction, no fees are charged. The bid-ask spread itself is the
transaction cost. Also, unlike the money or capital markets, where different rates of interest are
charged to different borrowers depending on their creditworthiness, in the wholesale foreign
exchange market no much distinction is made. Default risk the possibility that the counter party
in a transaction may not deliver on its side of the deal is handled by prescribing limits on the size
of positions a trader can take with different corporate customers.
Communications pertaining to international financial transitions are handled mainly by a large
network called Society for Worldwide Inter bank Financial Telecommunication (SWIFT). This is
a non-profit Belgian cooperative with main and regional centers around the world connected by
data transmission lines. Depending on the location, a bank can access a regional processor or a
main center which then transmits the information to the appropriate location.