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Forex Markets

What is a Foreign Currency ?

Foreign Currency in a broad way refers to foreign exchange : Dollar, Pounds, Francs, Yens and Dinars are all foreign currencies from Indias point of view and we can refer to them as foreign exchange also.

What are Foreign Transactions?

Foreign Transactions refers to such international transactions which are related with the import and exports of the country.

What is Foreign Exchange ?

As per H.E. Evitt it is that section of economic science which deals with the means and methods by which rights to wealth in one countrys currency are converted into rights to wealth in terms of another countrys currency There are some different interpretations of the term foreign exchange ,of which the following two are most important and common:

1) Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another.
2) Secondly, the term foreign exchange is used to refer to foreign currencies. For example: The Foreign Exchange Management Act ( FEMA) defines foreign exchange as foreign currency and includes all deposits, credits and balance payable in any foreign currency and any drafts, traveler's cheques, letter of credits and bills of exchange drawn by banks, institutions or persons outside India but payable in Indian currency.

What is a Foreign Exchange Market?

The Foreign exchange market is one in which currencies are bought and sold against each other. It is the largest market in the world.

Foreign Exchange Market : 1) Foreign exchange market is an over the country market. 2) There is no physical or electronic market place or an organized exchange with a central trade clearing mechanism where traders meet and exchange currencies. 3) The market is actually a world wide network of inter-banks traders, consisting primarily of banks , connected by telephone lines and computers. 4) Large part of Inter-Bank trading takes place with the electronic trading system such as Reuters Dealing 2000 and Electronic Broking system. 5) These transactions are done through telephone and later on the bid/ask price is fed in the computer.

Location of the Foreign Exchange Market

1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Inter-bank Financial Telecommunications

Participants in the Foreign Exchange Market

1. Wholesale Level (95%) - major banks 2. Retail Level - business customers.

Participants in the Foreign Exchange Market

Commercial & Investment Banks (Inter-bank market) amounts > $1m, typically $10m liquid market (vis--vis loans) with limited credit exposure for clients and themselves allows bit players to economize on transactions costs Central Banks non-commercial motives relatively small portion of trading volume may intervene to address perceived economic/financial imbalances Hedge Funds partnership of high net-worth individuals highly leveraged global investing add liquidity, flexibility, and sometimes instability to FX markets

Corporations mostly act through intermediaries Individuals tourists ~ insignificant volume

Intermediaries Brokers mostly service commercial banks and trading houses anonymous connected to many banks ~ shop for best price (exchange rate)
Direct Dealing through dealing system quotes valid for 20 sec.

Transactions in the foreign Exchange Market :

Following are the certain important transactions conducted in the foreign exchange market : 1) Spot and Forward Exchanges a) Spot Market b) Forward Market 2) 3) 4) 5) Futures Options Swap Arbitrage

a) Spot Market :
In the spot market, foreign exchange transactions are completed on the spot or immediately. Currencies are exchanged on the spot. Settlement takes place within two days in most markets. The rate at which the transaction is done is called spot exchange rate and the , market for such transactions is known as the spot market. The rate of the agreed deal on telephone is called the contract date. The value date is one when the deposit is actually credited or debited.
For e.g. : A Deal done on Tuesday will get settled on Thursday and a deal done on Friday will settle on the following Tuesday. As both the banks should be open for business in both settlement countries which is called a business day.

b) Forward Market :
In a forward market forward contracts are delivered at a specified future date. Forward exchange facilities' are of immense help to exporters and importers, as they can cover the risks arising out of exchange rate fluctuations by entering into appropriate forward exchange contract. Forward exchange rate is determined mostly by the demand for and supply of forward exchange. Forward rate can be 1) at par

2) Forward rate at premium The forward rate for a currency , say the dollar is said to be at premium with respect to the spot rate when one dollar buys more units of another currency say rupee in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis.

Forward Rate Spot Rate Spot Rate 3) Forward rate at discount

12 * 100 Forward Contract length in months

2) Futures :
Future contract are similar to a forward contract but there are some differences like forward contract are tailor made for the client by his international bank, while a futures contract has standardized futures.( the contract size and maturity dates are standardized) . Organized exchange is required for futures contract and margin money is also required to be deposited.

3) Options :
An option is a contract or financial instrument that gives holder the right, but not the obligation, to sell or buy a given quantity of an asset at a specified price at a specified future date. An option to buy the underlying asset is known as a call option and an option to sell the underlying asset is known as put option. Buying or Selling the underlying asset via the option is known as exercising the option. The stated price paid (or received ) is known as the exercise or striking price. The buyer of an option is known as the long and the seller of an option is known as the writer of the option, or the short. The price for the option is known as premium.

Types of Options
European option - This option can be exercised only at the maturity or expiration date of the contract. American option This option can be exercised only at any time during the contract.

4) Swap Operations:
The term swap means simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency. Operations consisting of a simultaneous sale or purchase of spot currency accompanied by a purchase or sale , respectively, of the same currency for forward delivery, are technically known as swaps or double deals, as the spot currency is swapped against forward.

5) Arbitrage:
Arbitrage is the simultaneous buying and selling of foreign currencies with the intention of making profits from the differences between the exchange rate prevailing at the same time in different markets.
Example In London pound 1 = $ 2 and in New York pound 1 = $ 2.10 So.. The effect of arbitrage is to iron out the differences in the rate of exchange of currencies in different centers. Arbitrage tends to equalize exchange rates across the world. This leads to a singleworld market in foreign exchange.

Quoting in the FE Market:

Foreign exchange rates are quoted either for immediate delivery ( spot rate ) or For delivery at a future date ( Forward rate ).

What is FE Quotation ??
FE quotation is the price of a currency expressed in the units of another currency. Quotations can be in American Terms or European Terms 1) American Terms They are given as number of US dollar per unit of a currency. For e.g. : USD 2.22 per 100 Rs 2) European Terms They are given as number of units of a currency per US dollar. For e.g.: Rs 45 per USD

Quotations can also be Direct or Indirect quotations. 1) Direct Quotation: Number of units of local currency per unit of foreign currency. For e.g. Rs 46 = 1 $ this is a Direct Quotation for US dollar in India. 2) Indirect Quotation : Variable units of Foreign currency as equivalent to a fixed number of units of home currency. For e.g. In India $ 2.17 = 100 Rs is an indirect quote.

1) Two Way Quote:

A Dealer quotes a given currency the price at which he is buying ( bid price ) and the price at which he is selling ( offer or ask price ) the currency. For e.g. 1$ = Rs 46 / Rs 46.50 Foreign exchange rates are always quoted as a two-way price. a) Bid price - Rate at which the Bank or Dealer willing to buy the foreign currency b) Ask or Offer price - The rate at which Bank or Dealer willing to sell the foreign currency. So the Bid price is always less then the Ask price , so that profit can be earned.

How to Read a Currency Quote

Currency Pair Base Currency Quote Currency Bid Price Ask Price


2) Spread :
A Spread means a difference between a banks buying ( Bid ) and selling ( ask or offer ) rates in an exchange rate quotation or an interest quotation. The Spread represents the gross return to the dealer for the risks inherent in making a market. The Spread can also be expressed as a percentage: For e.g.
Normally last two digits are quoted i.e US $ 1 = Rs 46.0050 46.0080 it may be quoted as 50-80 The last digits are called points e.g a point is 1/10000 part of the unit or One point = US $ 0.0001. A pip is one further decimal place to the right i.e US $ 0.00001 and represents 1/100000 part of a dollar. Most of the currencies are expressed to four decimal places but the currencies with low value relative to others are quoted up to two decimal places. For e.g. Japanese and Lira.

3) Cross Rate :
Cross Rate is the price of any currency other than the home currency. It is the direct relationship between two non-home currencies in a foreign exchange market concerned with or used in transactions in a country to which none of the currencies belongs. For e.g. $ / FFr
So if a importer buys goods from Paris as there is no direct quote for Rs / FFr then we have to consider dollar.

Settlements in Forex Market :

1) Cash:
Cash rate or Ready rate is the rate when the exchange of currencies takes place on the date of the deal. If the delivery is made on the day the contract is booked it is called a Telegraphic Transfer ( TT ) or cash or Value day deal.

2) Tom:
When the exchange of currencies takes place on the next working day after the date of deal , it is called the TOM ( tomorrow) rate.

Foreign Currency Accounts

Nostro Account (our account with you): The foreign currency account maintained by banks in India with banks aboard. The currency of the account depends on the currency of the country where the account is maintained All foreign exchange transactions are routed through Nostro accounts. Maintenance of minimum balance is necessary. It is just like current account Vostro Account (your account with us): Foreign banks may open rupee accounts with Indian banks. The account is also known as non-resident account.

Vostro Account (your account with us): Foreign

banks may open rupee accounts with Indian banks.
The account is also known as non-resident account.

Determination of Exchange Rates:

How are exchange rates between different currencies determined under paper currency standard? There are two important theories which explain the mechanism of exchange rate determination: 1) Traditional Theory or Long Run exchange rate determination: a) Purchasing Power Parity b) Interest Rate Parity c) International Fisher Effect d) Asset Market Model e) Portfolio Balance Approach 2) Modern Theory or Short Run exchange rate determination: a) Theory of Demand and Supply b) The Balance of Payment Approach c) The Monetary Approach

1) Traditional Theory or Long Run exchange rate determination: a) The Purchasing Power Parity Theory According to Gutsav Castel , when the exchange rates are free to fluctuate the rate of exchange between two currencies must stand essentially on the quotient of the internal purchasing powers of these currencies.

There are two versions of PPP as below: 1) Absolute PPP 2) Relative PPP 1) Absolute PPP : The Absolute PPP theory is closely related to the law of one price. It suggests that a product that is easily traded in a perfectly competitive global market should have the same price everywhere. We can say that P = e . Pf means 2) Relative PPP : The Relative PPP between two countries states that the percentage change in the bilateral exchange rate is equal to the difference in the percentage change in the national price levels over any given period of time.

So the PPP theory by Prof S.E. Thomas clearly expresses that , while the value of the unit of one currency in terms of the another currency is determined at any particular time by the market conditions of demand and supply, in the long run, that value is determined by the relative values of the two currencies as indicated by their relative purchasing power over goods and services. The rate of exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two currencies. This point is called the purchasing power parity.

Effects of PPP :
The exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. For e.g. . If there is a change in prices ( i.e. the purchasing power of the currencies ) the new equilibrium rate of exchange can be found out by the following formula :

Exchange Control

Exchange Control Methods

Exchange rate Systems:

1) Fixed Exchange rate 2) Flexible Exchange Rates

What Changes the Equilibrium Rate?

Inflation rates:
Higher domestic inflation means less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

Interest rates:
Higher domestic (real) interest rates attract investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

Economic growth:
Stronger economic growth attracts investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

What Changes the Equilibrium Rate?

Political & economic risk:
Higher political or economic risk in the domestic country results in increased demand and reduced supply of foreign currency.

Changes in future expectations:

Any improvement in future expectations regarding the domestic currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency.

Government intervention:
Maintain weak currency to improve export competitiveness.

Forecasting in Practice

Numerous foreign exchange forecasting

services exist, many of which are provided by banks and independent consultants.

Some multinational firms have their

own in-house forecasting capabilities. econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.

Predictions can be based on elaborate

Forecasting in Practice
Technical analysts, traditionally referred to as
chartists, focus on price and volume data to
determine past trends that are expected to continue into the future.

The single most important element of technical

analysis is that future exchange rates are based on the current exchange rate. three periods:

Exchange rate movements can be subdivided into


Short-term (several days to several months)


Forecasting in Practice
The longer the time horizon of the forecast,
the more inaccurate the forecast is likely to be.

Whereas forecasting for the long run must

depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.