FOREIGN EXCHANGE

Foreign Exchange refers to foreign currencies possessed by a country for making payments to other countries. It may be defined as exchange of money or credit in one country for money or credit in another.

It covers methods of payment, rules and regulations of payment and the institutions facilitating such payments.

FOREIGN EXCHANGE MARKET

A foreign exchange market refers to buying foreign currencies with domestic currencies and selling foreign currencies for domestic currencies. Thus it is a market in which the claims to foreign moneys are bought and sold for domestic currency. Exporters sell foreign currencies for domestic currencies and importers buy foreign currencies with domestic currencies. Foreign Exchange transactions result in inflow & outflow of foreign exchange.

CHARACTERISTICS OF FOERIGN EXCHANGE MARKET

o

Largest of all financial markets with average daily turnover of over $2 trillion! 66% of all foreign exchange transactions involve cross-border counterparties. Only 11% of daily spot transactions involve non-financial customers. London is the largest FX market. US dollar involved in 87% of all transactions.

FUNCTION OF FOERIGN EXCHANGE MARKET

The foreign exchange market is the mechanism by which participants:

transfer purchasing power between countries; obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes.

IMPORTANT CURRENCIES

STRUCTURE OF THE FOREX MARKET

FOREIGN EXCHANGE MARKET PLAYERS

FOREX MARKET PLAYERS

The foreign exchange market is used by banks, investment companies, companies and even individuals who want to either cover themselves against the risk of foreign exchange fluctuations or to speculate in hopes of making a profit. 95% of all forex transactions are purely speculative in nature. Only 5% of all forex transactions result from international companies who need to convert their money back to the company's main operating currency. Commercial banks are the main participants in the forex market, but their "market share" is slowly shrinking. Currently, 43% of all transactions pass through the interbank market, as opposed to 63% in 1998 and 53% in 2004. In terms of forex trading activity, the main role of banks is to serve as middlemen for the other market participants. Their objective is to make profits through "market making", which means that they offer their clients a "buy" price and a "sell" price. Institutional investors are the second biggest players. They include investment and insurance companies, pension funds and hedge funds. They participate in forex trading in order to cover their stock, bond and currency portfolios and they represent 30% of all foreign exchange transactions. Central banks intervene to manage their stock of currency and state money. Their transactions represent 5% to 10% of all forex trading volume. The central banks can also intervene in order to defend their respective currencies and to adjust economic or financial inbalances.

1.

2.

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4.

Brokers allow private individuals to access the forex market by transmitting their clients' orders to commercial banks or to trading platforms such as EBS, Reuters Dealing, HotSpot, FXall, etc... They get paid from the spread or by charging a commission on each transaction. Also, there are many brokers that operate as market makers; like commercial banks, they also provide their clients with a buy/sell (bid/ask) price to earn the spread if they are able to find a buyer and seller at the same time. If the market maker doesn't find a buyer and a seller, it will try to profit by covering its client's position on the interbank market.

5.

Multinational companies participate in forex trading in order to convert their money during import or export activities. Their transactions represent approximately 5% of all global forex transactions. Some companies even have their own trading floors, with traders speculating in order to make profits and to reduce the risks related to exchange rate fluctuations.

6.

Private investors/individuals have recently been trading the forex market as well, thanks to the internet, which allows them to have real-time access to currency exchange rates. Today, their transaction volume adds up to over 5% of all forex transactions. Currency trading is now suitable for various investor types, who can now profit, just like the bigger players, by properly applying leverage and money management principles.

TRANSACTIONS
Types of Transactions

A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day. The date of settlement is referred to as the value date.

Types of Transactions

An outright forward transaction (usually called just forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months. Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)

Types of Transactions
A

swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. purchase and sale are conducted with the same counterparty. different types of swaps are:

Both

Some

spot against forward, forward-forward, Non deliverable forwards (NDF).

Types of Transactions

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TYPES OF FOREIGN EXCHANGE MARKET

TYPES OF FOREIGN EXCHANGE MARKET

Foreign Exchange Market is of two types retail and wholesale market. 1. Retail Market The retail market is a secondary price maker. Here travelers, tourists and people who are in need of foreign exchange for permitted small transactions, exchange one currency for another. Wholesale Market The wholesale market is also called interbank market. The size of transactions in this market is very large. Dealers are highly professionals and are primary price makers. The main participants are Commercial banks, Business corporations and Central banks. Multinational banks are mainly responsible for determining exchange rate. Other Participants Brokers Brokers have more information and better knowledge of market. They provide information to banks about the prices at which there are buyers and sellers of a pair of currencies. They act as middlemen between the price makers. a)

2.

3.

b)

Price Takers Price takers are those who buy foreign exchange which they require and sell what they earn at the price determined by primary price makers.

c)

Indian Foreign Exchange Market It is made up of three tiers

i. Here dealings take place between RBI and Authorized dealers (ADs) (mainly commercial banks). ii. Here dealings take place between Ads

iii.

Here ADs deal with their corporate customers.

SPOT AND FORWARD EXCHANGE RATES

EXCHANGE RATE
Transactions in exchange market are carried out at what are termed as exchange rates. In foreign exchange market two types of exchange rate operations take place. They are spot exchange rate and forward exchange rate.

1)

Spot Exchange Rate

When foreign exchange is bought and sold for immediate delivery, it is called spot exchange. It refers to a day or two in which two currencies are involved. The basic principle of spot exchange rate is that it can be analyzed like any other price with the help of demand and supply forces. The exchange rate of dollar is determined by intersection of demand for and supply of dollars in foreign exchange. The Remand for dollar is derived from countrys demand for imports which are paid in dollars and supply is derived from countrys exports which are sold in dollars. The exchange rate determined by market forces would change as these forces change in market. The primary price makers buy (Bid) or sell (ask) the currencies in the market and the rates continuously change in a free market depending on demand and supply. The primary dealer (bank) quotes two-way rates i.e., buy and sell rate.

(Bid) Buy Rate 1 US $ = ` 45.50 (Ask) Sell Rate 1 US $ = ` 45.75 The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The difference of Rs.0.25 is the profit margin of dealer.

2)

Forward Exchange Rate Here foreign exchange is bought or sold for future delivery i.e., for the period of 30, 60 or 90 days: There are transactions for 180 and 360 days also. Thus, forward market deals in contract for future delivery. The price for such transactions is fixed at the time of contract, it is called a forward rate. Forward exchange rate differs from spot exchange rate as the former may either be at a premium or discount. If the forward rate is above the present spot rate, the foreign exchange rate is said to be at a premium. If the forward rate is below the present spot rate, the foreign exchange rate is said to be at a discount. Thus foreign exchange rate may be at forward premium or at forward discount. For Eg. an Indian importer may enter into an agreement to purchase US $ 10,000 sixty days from today at 1 US $ = Rs. 48. No amount is paid at the time of agreement, except for usual security margin money of about 10% of the total amount. 60 days form today, the importer will get 10,000 US $ in exchange for Rs. 4,80,000 irrespective of the Spot exchange rate prevailing on that date.

a)
i) ii) iii) iv) v) vi) vii)

Factors Influencing Forward Exchange Rate

Interest rates. Degree of speculation in foreign exchange market. Inflation rate. Foreign investors confidence in domestic country. Economic situation in the country. Political situation in the country. Balance of payments position etc.

b)

Need For Forward Exchange Rate Contracts To overcome the possible risk of loss due to fluctuations in exchange rate, exporters, importers and investors in other countries may enter in forward exchange rate contracts.

In floating or flexible exchange rate system the possibility of wide fluctuation in exchange is more. Thus, both exporters and importers safeguard their position through a forward arrangement. By entering into such an arrangement both parties minimize their loss.

REGULATORS OF FOREIGN EXCHANGE MARKETS

RBIS ROLE IN THE FOREX MARKET

To manage the exchange rate mechanism. Regulate inter-bank forex transactions and monitor the foreign exchange risk of the banks. Keep the stable. exchange rate

Manage and country's foreign reserves.

maintain exchange

RBIs Role in the Forex Market

RBI has imposed foreign exchange exposure limits on banks (FE 12 of 1999). The limits are tied with the Paid up capital of the bank. Previously banks had NOP limit, which was based on foreign exchange volume handled by the bank.

TREASURY OPERATIONS AT RBI

1.

All Central Banks have treasuries to implement policy objectives vis a vis EXCHANGE RATE & INTEREST RATES Dealing room catered to the FX market only Money market was being looked after by the Securities department It soon became apparent that the two cannot work in isolation with each other as the linkage between the money market & exchange market became pronounced

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Finally the dealing room and securities department were merged to form EDMD to from first ever Treasury of RBI.

FOREIGN EXCHANGE MANAGEMENT ACT, 1999 (FEMA)

INTRODUCTION

A system of exchange control was first time introduced through a series of rules under the Defense of India Act, 1939 on temporary basis. The foreign crises persisted for a long time and finally it got enacted in the statute under the title Foreign Exchange Regulation Act, 1947. Subsequently, this act was replaced by the Foreign Exchange Regulation Act, 1973(FERA) which was came into force with effect from January 1, 1974 and regulating foreign exchange for more than 26 years under this Act. In 1991 Government of India initiated the policy of economic liberalization. After this foreign investment in many sectors were permitted in India. In 1997, Tarapore committee on Capital Account Convertibility, constituted by the Reserve Bank of India, recommended change in the legislative framework governing foreign exchange transactions. Accordingly, the Foreign Exchange Regulation Act, 1973 was repealed and replaced by the new Foreign Exchange Management Act, 1999 (FEMA) with effect from June 01, 2000. Under FEMA the emphasis was on management of foreign exchange.

APPLICABILITY OF FEMA
The Foreign Exchange Management Act, 1999 was enacted to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and for promoting the orderly development and maintenance of foreign exchange market in India. FEMA extends to the whole of India. The Act also applies to all branches, offices and agencies outside India owned or controlled by a person resident in India and also to any contravention committed there under outside India by any person to whom this Act is applies.

OVERALL STRUCTURE
The overall structure of Foreign Exchange Management Act, 1999 is covered by legislations, rules and regulations. These legislations, rules and regulations relating to Foreign Exchange Management Act, 1999, can be divided in to the followings: 1. FEMA contains 7 chapters divided into 49 sections (Supreme Legislation) 2. 5 sets of Rules made by Ministry under section 46 of FEMA. (Delegated legislations) 3. 23 sets of Regulations made by RBI under section 47 of FEMA. (Subordinate Legislations) 4. Master Circular issued by Reserve Bank of India every year. 5. Foreign Direct Investment (FDI) policy issued by Department of Industrial Policy and Promotion (DIPP) time to time. 6. Notifications and Circulars issued by Reserve Bank of India. 7. Enforcement Directorate.

AUTHORITIES AND ENFORCEMENT MACHINARY

FEMA in itself is not an independent and isolated law. The provisions of FEMA are spread at different place and so there are regulatory bodies. Reserve Bank of India makes Regulations for FEMA and the Rules are made by Central Government. Authorities governing the enforcement of FEMA are:

1. Foreign Exchange Department of Reserve Bank of India.

2. Directorate of Enforcement, Department of Revenue, Ministry of Finance.

3. Capital Market Division, Department of Economic Affairs, Ministry of Finance.

4. Foreign Trade Division, Department of Economic Affairs, Ministry of Finance.

FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA - FEDAI

FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA ( FEDAI )

An association of banks specializing in the foreign exchange activities in India. Established in 1958, FEDAI (Foreign Exchange Dealers' Association of India) is a group of banks that deals in foreign exchange in India as a self regulatory body under the Section 25 of the Indian Company Act (1956).

THE ROLE AND RESPONSIBILITIES OF FEDAI ARE AS FOLLOWS:

Formulations of FEDAI guidelines and FEDAI rules for Forex business. Training of bank personnel in the areas of Foreign Exchange Business. Accreditation of Forex Brokers. Advising/Assisting member banks in settling issues/matters in their dealings. Represent member banks on Government/Reserve Bank of India and other bodies. Rules of FEDAI also include announcement of daily and periodical rates to its member banks.

FEDAI guidelines play an important role in the functioning of the markets and work in close coordination with Reserve Bank of India (RBI), other organizations like Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex Association of India and various other market participants.

Thank You