Global Foreign Exchange Market

"Global Foreign Exchange Market

Project submitted in partial fulfillment of the requirements for the award of
the Degree of
MASTER OF BUSINESS ADMINISTRATION
Of
BANGALORE UNIVERSITY

By
Bhavana Hegde
Register No. 141GCMD021
Under the guidance of

Mr. Rajiv
Professor

Rashtreeya Sikshana Samithi Trust

R V INSTITUTE OF MANAGEMENT
CA-17, 36th Cross, 26th Main, 4th T Block,
Jayanagar, Bangalore 560 041
20152016

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Global Foreign Exchange Market

Global Foreign Exchange and Capital Markets

Introduction:The foreign

exchange

market (forex, FX,

or currency

market)

is

global decentralized market for the trading of currencies. This includes all aspects of buying,
selling and exchanging currencies at current or determined prices. In terms of volume of
trading, it is by far the largest market in the world. The main participants in this market are
the larger international banks. Financial centres around the world function as anchors of
trading between a wide range of multiple types of buyers and sellers around the clock, with
the exception of weekends. The foreign exchange market does not determine the relative
values of different currencies, but sets the current market price of the value of one currency as
demanded against another.
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 supervisory entity regulating its actions.

Nature of foreign exchange:

Volatile, affected by hedger, arbitrager, speculator.

Affected by demand and supply.

Affected by rate of interest.

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Global Foreign Exchange Market

Affected by balance of payment surplus and deficit.

Affected inflation rate.

Spot and forward rates are different.

Affected by the economic stability of the country.

Affected by the fiscal policy of the government.

Affected by the political condition of the country.

It can be quoted directly or indirectly

The foreign exchange market is unique because of the following characteristics:its huge trading volume representing the largest asset class in the world leading to

high liquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e., trading from
22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);

the variety of factors that affect exchange rates;

the low margins of relative profit compared with other markets of fixed income; and

The use of leverage to enhance profit and loss margins and with respect to account
size.
As such, it has been referred to as the market closest to the ideal of perfect competition,
notwithstanding currency intervention by central banks.

Advantages of Forex market:-

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Global Foreign Exchange Market

Its already the worlds largest market and its still growing quickly

It makes extensive use of information technology making it available to everyone

Traders can profit from both strong and weak economies

Trader can place very short-term orders which are prohibited in some other markets

The market is not regulated

Brokerage commissions are very low or non-existent

The market is open 24 hours a day during weekdays.

Terms related to Foreign Exchange:

Foreign exchange reserves- holdings of other countries' currencies

Foreign exchange controls- controls imposed by a government on the purchase/sale of

foreign currencies

Retail foreign exchange platform- speculative trading of foreign exchange by

individuals using electronic trading platforms

Foreign exchange risk- arises from the change in price of one currency against
another

International trade- the exchange of goods and services across national boundaries

Foreign exchange company- a broker that offers currency exchange and international
payments

Bureau de change- a business whose customers exchange one currency for another

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Global Foreign Exchange Market

Currency pair- the quotation of the relative value of a currency unit against the unit of
another currency in the foreign exchange market

Digital currency exchanger- market makers which exchange fiat currency for
electronic money.

Market size and liquidity:The foreign exchange market is the most liquid financial market in the world. Traders include
large

banks,

central

banks,

institutional

investors,

currency speculators,

corporations, governments, other financial institutions, and retail investors. The average daily
turnover in the global foreign exchange and related markets is continuously growing.
According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for
International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7
trillion in 1998). Of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was
traded in outright forwards, swaps and other derivatives.
In April 2010, trading in the United Kingdom accounted for 36.7% of the total, making it by
far the most important centre for foreign exchange trading. Trading in the United States
accounted for 17.9% and Japan accounted for 6.2%.

In April 2013, for the first time, Singapore surpassed Japan in average daily foreign-exchange
trading volume with $383 billion per day. So the rank became: the United Kingdom (41%),
the United States (19%), Singapore (5.7)%, Japan (5.6%) and Hong Kong (4.1%).
Turnover of exchange-traded foreign exchange futures and options have grown rapidly in
recent years, reaching $166 billion in April 2010 (double the turnover recorded in April
2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange
turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago
Mercantile Exchange and are actively traded relative to most other futures contracts.

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Global Foreign Exchange Market

Most developed countries permit the trading of derivative products (like futures and options
on futures) on their exchanges. All these developed countries already have fully convertible
capital accounts. Some governments of emerging markets do not allow foreign exchange
derivative products on their exchanges because they have capital controls. The use of
derivatives is growing in many emerging economies. Countries such as South Korea, South
Africa, and India have established currency futures exchanges, despite having some capital
controls.
Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more
than doubled since 2004. The increase in turnover is due to a number of factors: the growing
importance of foreign exchange as an asset class, the increased trading activity of highfrequency traders, and the emergence of retail investors as an important market segment. The
growth of electronic execution and the diverse selection of execution venues has lowered
transaction costs, increased market liquidity, and attracted greater participation from many
customer types. In particular, electronic trading via online portals has made it easier for retail
traders to trade in the foreign exchange market. By 2010, retail trading is estimated to
account for up to 10% of spot turnover, or $150 billion per day.
Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly with
one another, so there is no central exchange or clearing house. The biggest geographic trading
center is the United Kingdom, primarily London, which according to The City UK estimates
has increased its share of global turnover in traditional transactions from 34.6% in April 2007
to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's
quoted price is usually the London market price. For instance, when the International
Monetary Fund calculates the value of its special drawing rights every day, they use the
London market prices at noon that day.

Foreign Exchange: Basic Concepts:Foreign exchange (Fx): money denominated in the currency of another nation or group of nations.
[a financial instrument issued by a foreign country]
Exchange rate: the price of one currency expressed in terms another currency.
[the number of units of a given currency needed to buy one unit of another currency]

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Global Foreign Exchange Market

Foreign exchange market: banks and currency exchanges that buy and sell foreign currencies and
other exchange instruments.
[a market for converting the currency of one country into that of another country]

The Foreign Exchange Market: Major Segments:

Over-the-counter

[most foreign exchange activity occurs here]

Exchange-traded market: specialized securities exchanges where particular types of

(OTC)

market:

commercial

and

investment

banks.

foreign-exchange instruments are traded.

[Instruments such as futures and options are exchange-traded]
The U.S. dollar is the most widely traded currency in the world because it serves as:

an investment currency in many capital markets

a reserve currency held by many central banks

a transaction currency in many international commodity markets

an invoice currency in many contracts

an intervention currency employed by monetary authorities in market operations to influence

their own exchange rates
The most frequently traded currency pairs are:
- The U.S. dollar/euro [28%]
- The U.S. dollar/yen [17%]

Major Sources of Eurocurrencies:

Foreign governments or individuals who want to hold dollars outside of the United
States.

MNEs that have cash in excess of current needs.

European banks with foreign currency in excess of current needs.

Countries such as Germany, Japan, and Taiwan that have large balance-of-trade
surpluses held as reserves.

Demand for Eurocurrencies:

Demand for Eurocurrencies reflects:

greater convenience

increased security

lower rates and thus higher yields

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Global Foreign Exchange Market

Demand for Eurocurrencies comes from:

sovereign governments

supranational agencies (e.g., the World Bank)

firms and individuals

Eurocurrency Borrowing:

Euro credit: a type of loan or line of credit that matures in one to five years.

Syndication: the process of pooling the specific resources of several banks in order to spread
the risks associated with large loans.

London Inter-bank Offered Rate (LIBOR): reflects the interest rate London banks charge one
another for short-term Eurocurrency loans.
[Traditional loans are made at a certain percentage above the LIBOR.]

Location of the Foreign Exchange Market:

London is the largest foreign exchange market (followed by New York, Tokyo, and
Singapore) because of its strategic location between Asia and the Americas.

Market activity first heightens when Europe and Asia are open and again when
Europe and the United States are open.

Cross-trading: using the U.S. dollar as a vehicle currency for trades between two
other currencies

Cross rate: the exchange rate between two non-U.S. dollar currencies that is
computed from the exchange rate of each currency in relation to the U.S. dollar
[Use currency A to buy currency C (US $1), and then use currency C to buy currency B.]

Foreign Exchange Terms and Conventions:

Bid: the price at which a trader is willing to buy a foreign currency

Offer: the price at which a trader is willing to sell a foreign currency

Spread: the difference between the bid and the offer rates, i.e., the traders profit

American terms: the U.S. point of view, i.e., the number of U.S. dollars per unit of
foreign currency

European terms (indirect quote): the number of units of foreign currency per U.S. dollar.

A quote in American terms (US$/Fx) is always the reciprocal of a quote in European

terms (Fx/US$).
$1.00/.009430

106.04/$1.00
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Global Foreign Exchange Market

Base currency: the quoted, underlying, or fixed currency.

Traders always quote the base currency
(the denominator) first, followed by

the terms currency (the numerator).

An example:
Dollar-yen quote: dollar = base, yen = terms
Oct. 10, 2004

April 28, 2005

110.96/$1.00

106.04/$1.00

The dollar (base) weakened; the yen (terms) strengthened.

Types of Foreign Exchange Markets:

Spot market: The market in which foreign exchange transactions occur on the
spot, i.e., for delivery within two business days following the date of agreement to
trade.

Spot rate: the rate quoted for transactions that require immediate delivery, i.e.
within two days.

Principle characteristics:

Spot Market is of daily nature. It does not trade in future deliveries.

Spot rate of exchange is that rate which happens to prevail at the time when
transactions are incurred.

Forward market: the market in which foreign exchange transactions occur at a set
rate for delivery beyond two business days following the date of agreement to trade.

Forward rate: a contractually established exchange rate between a foreign

exchange trader and the traders client for delivery of foreign currency on a
specified date.

Forward discount: the forward rate is less than the spot rate
Forward premium: the forward rate is higher than the spot rate
Principles Characteristics:

It only caters to forward transaction.

It determines forward exchange rate at which forward transaction are to be honored.

Forward/Future Instruments:

Forward contract:-

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Global Foreign Exchange Market

A contract between a firm or individual and a bank to deliver foreign currency at a
specific exchange rate on a future date.

Outright forward:A forward contract that is not connected to a spot transaction, i.e., a contact to deliver
foreign currency beyond two days following the date of agreement at the forward rate.

Fx swap:A simultaneous spot and forward trans-action, i.e., one currency is swapped for
another on one date and then swapped back on a future date.

Currency swap: the exchange of principal and interest payments via interest-bearing OTC
financial instruments (e.g., bonds).

Futures contract:An agreement between two parties to buy or sell a given currency at a given
(negotiated) price on a particular future date, as specified in a standardized contact to
all participants in that currency futures exchange [not as flexible as a forward
contract]

Option:
An instrument traded both OTC and on exchanges that gives the purchaser the right
(but not the obligation) to buy or sell a certain amount of foreign currency at a
specified exchange rate within a specified amount of time [more expensive but also
more flexible than a forward contract]

Strike price: the exchange rate specified in the option, i.e., the exercise price.

Premium: the fee paid to the writer of the option.

Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP):

The theory of PPP states that exchange rates between two currencies will adjust to reflect
changes in price levels.

PPP Domestic price level 10%, domestic currency 10%

o Application of law of one price to price levels

o Works in long run, not short run
Problems with PPP:o All

goods

are

not

identical

(i.e., Toyota versus Chevy)

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in

both

countries

Global Foreign Exchange Market

o Many goods and services are not traded (e.g., haircuts, land, etc.)
Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run:

Basic Principle: If a factor increases demand for domestic goods relative to foreign
goods, the exchange rate

The four major factors are relative price levels, tariffs and quotas, preferences for
domestic v. foreign goods, and productivity.

Relative
price

levels

price

levels:
cause

a
a

rise

in

countrys

relative
currency

to depreciate.

Tariffs and quotas: increasing trade barriers causes a countrys currency to appreciate.

Preferences for domestic v. foreign goods: increased demand for a countrys good causes
its currency to appreciate; increased demand for imports causes the domestic currency to
depreciate.

Productivity: if a country is more productive relative to another, its currency appreciates.

The following table summarizes these relationships. By convention, we are quoting, for
example, the exchange rate, E, as units of foreign currency / 1 US dollar.

Exchange Rates in the Short Run:

In the short run, it is key to recognize that an exchange rate is nothing more than the
price of domestic bank deposits in terms of foreign bank deposits.

Because of this, we will rely on the tools developed in Chapter 4 for the determinants
of asset demand.

Expected Returns on Domestic and Foreign Assets:

We will illustrate this with a simple example

Franois the Foreigner can deposit excess euros locally, or he can convert them to
U.S. dollars and deposit them in a U.S. bank. The difference in expected returns depends
on two things: local interest rates and expected future exchange rates.

Al the American has a similar problem. He can deposit excess dollars locally, or he
can convert them to euros and deposit them in a foreign bank. The difference in expected
returns depends on two things: local interest rates and expected future exchange rates.
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Exchange-based vs. Over-the-Counter Fx Instruments:-

Foreign Exchange Convertibility:Convertibility: - the ability of residents and nonresidents to purchase foreign currency

with

a given (domestic) currency without government restrictions.

External convertibility: - the ability of non- residents to purchase foreign currency with a
given currency without government limitations.
Nonconvertibility: - the inability of residents and nonresidents to convert a given currency
into foreign currency because of government limitations.
Fully convertible currencies are those that governments allow both residents and nonresidents
to purchase in unlimited amounts, i.e., they are freely traded and accepted by central banks.
Hard currencies are fully convertible, relatively stable, and tend to be comparatively
strong. Soft (weak) currencies are not fully convertible.
A government may control the convertibility of its currency through:
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Global Foreign Exchange Market

licensing

a multiple exchange rate system

advance import deposits

quantity controls

Currency controls add to the cost of doing business and thus serve as serious
impediments to trade and investment.

Exchange rate fluctuations:A reliable forecast or future spot rate is called study of empirical patterns of exchange rate
fluctuation. It provides essential information for an exchange rate exposure.

The Uses of Foreign Exchange:

The role of commercial banks:

buy and sell foreign exchange

serve as vehicles for payments between domestic and foreign customers

lend money in foreign denominations

Business purposes:

settlement of international business transactions

hedging [risk reduction through loss protection]

speculation [currency trading on expectations of future prices]

arbitrage [risk-free profit based on price differentials]

Interest arbitrage.

The Fx Trading Process:Page 13

Global Foreign Exchange Market

To settle foreign exchange balances, companies may work through:

local banks

commercial and investment banks (OTC market)

securities exchange brokers

Banks deal with each other in the interbank market, primarily through foreignexchange brokers.
Brokers are specialist intermediaries who facilitate transactions in the interbank
market by matching the best bid and offer quotes.

Banks fx dealers can trade foreign exchange:

directly with other dealers

through voice brokers

through electronic brokerage systems

Structure of Foreign Exchange Markets:-

Foreign Exchange Transactions:-

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The Over-the-Counter Market: Commercial and Investment Banks:Top banks in the interbank fx markets are so ranked because of their ability to:

trade in specific market locations

handle major currencies
handle major cross trades
deal in specific currencies
handle derivatives (forwards, options, futures, swaps)
conduct key market research
Foreign Exchange Risk:

Exposure to exchange rate movement.

Any sale or purchase of foreign currency entails foreign exchange risk.

Foreign exchange transaction affects the net asset or net liability position of the
buyer/seller.

Carrying net assets or net liability position in any currency gives rise to exchange risk.

Risk management:Controlling losses

You could control your losses, by mental stop or hard stop. Mental stop means that
you already set you limit of your loss. A hard stop is your initiative to stop when you
think you must to stop it.

Using correct lot size

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Global Foreign Exchange Market

As a beginning just uses smaller lots you could stay flexible and logic than emotions
while you trade.

Tracking overall exposure

Sample: you go to short on EUR/USD and long on USD/CHF, you exposed two times
for USD in the same direction. If USD goes down, you have a double dose of pain.
So, keep your overall exposure limited, it keeps you for the long haul for trading

The bottom line

Trading is about opportunities, you must take action while the opportunities arise.

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