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PRESENTATION

Foreign Exchange
Market
(FOREX MARKET)

By
Sejal Chavda
MBA sem 3
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Foreign Exchange Market

(FOREX MARKET)

WATER FALLS

US DOLLORS
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Foreign Exchange Market

MEANING
It is a mechanism for exchanging one currency for
another.
A means to reduce the exposure to the risks of fluctuating
exchange rates
It is by far the largest market in the world, in terms of cash
value traded, and includes trading between large banks,
central banks, currency speculators, multinational
corporations, governments, and other financial markets
and institutions
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Foreign Exchange Market- Cntd

The foreign exchange market is unique because of:

its trading volume,
the extreme liquidity of the market,
the large number of, and variety of, traders in the market,
its geographical dispersion,
its long trading hours - 24 hours a day (except on
weekends).
the variety of factors that affect exchange rates,
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Foreign Exchange Market- Cntd

Characteristics of the Market

The worldwide volume of foreign exchange trading is
enormous, and it has ballooned in recent years.
New technologies, such as Internet links, are used among the
major foreign exchange trading centers (London, New York,
Tokyo, Frankfurt, and Singapore).
The integration of financial centers implies that there can be
no significant arbitrage.
The process of buying a currency cheap and selling it dear.
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Foreign Exchange Market- Cntd

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Foreign Exchange Market- Cntd

Geographical Extent of the Foreign Exchange Market

Global currency trading is a 24-hour-a-day process. Many
large international banks operate trading rooms in major
trading center on a round-the-clock basis. Some currency
trading is conducted on an official trading floor by open
bidding but most of it is done through dealers.
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Foreign Exchange Market- Cntd

Functions of the Foreign Exchange Market

Transfer of Purchasing Power
Financing of Inventory in Transit
Hedging Facilities
Currency Conversions
Reducing Foreign Exchange Risks: the risk exist that the
exchange values of National Currency may fluctuate i.e.
Transaction Exposure.
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Foreign Exchange Market- Cntd

Nature of Foreign Exchange Market:

It is the net work of Banks, Brokers, and FE dealers.
Important exchange markets in London, New York,
Zurich, Frankfurt, Tokyo, Singapore, Hong Kong and
Paris
FEM is governed by an unwritten code of conduct of
all participants.
FEM are large commercial banks that operate at two
levels retail and interbank.
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Foreign Exchange Market- Cntd

Market Participants (Actors)

There are five main categories of market participants in
the foreign exchange market:
Bank and Nonbank Foreign Exchange Dealers
Individuals and Firms Conducting Commercial and
Investment Transactions
Speculators and Arbitrageurs
Central Banks and Treasuries
Foreign Exchange Brokers.
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Foreign Exchange Market- Cntd

Terminology
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Terminology
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Foreign Currency Futures and Options

Future Contracts:
FC is traded for only a limited number of currencies and
for a given delivery date. Amount of transaction and
maturity date is fixed by FE markets.
Foreign Currency Options:
A currency option is the right but not the obligation to Buy
(Call) or Sell (Put).
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Foreign Currency Futures and Options

Calls and Puts

The two types of equity options are Calls and Puts.
Call Option: A call option gives its holder the right to
buy shares of the underlying security at the strike price,
anytime prior to the options expiration date. The writer (or
seller) of the option has the obligation to sell the shares.
Put option: The opposite of a call option is a put option,
which gives its holder the right to sell the shares of the
underlying security at the strike price, anytime prior to
the options expiration date. The writer (or seller) of the
option has the obligation to buy the shares.
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Foreign Currency Futures and Options

Holder Writer
(Buyer) (Seller)

Call Right to Obligation

Option Buy to sell

Put Right to Obligation

Option sell to buy
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Languages of FE
Spot Market: Currencies are traded for immediate
delivery. Delivery is on the second following business
day (value date). E.g. Travelers going abroad
Forward Market: It is market for exchange of currencies in
the future, at a specified date in the future, typically
30, 60, or 90 days from now, and at a price (forward
exchange rate) that is agreed upon today. Delivery is at a
future value date. E, g. International business transactions.
Forward Markets exist only for the major currencies
Both forward rates and spot rates are published in News
papers.
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Languages of FE

Arbitrage: Simultaneous purchase and sale of a given

amount of foreign exchange in two different markets for
profits from unwarranted differences in prices. Both
purchase and sale are conducted with the same
counterparty. Spot against forward, forward-forward
swaps, no deliverable forwards (NDFs).
Price discrepancies in different Markets create arbitrage
opportunities.
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Languages of FE

Foreign Exchange Swaps

Spot sales of a currency combined with a forward repurchase
of the currency.
They make up a significant proportion of all foreign
exchange trading.
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EXCHANGE RATE DETERMINATION

Equilibrium of Exchange Rate= DD for FE & SS of FE

According Rogner Nurkse that rate which over a
certain period of time keeps the balance of payments
in equilibrium
Equilibrium Exchange Rates can be determined by two
Methods
1. DD for and SS of Dollars
2. DD for and SS of Indian Rupees ( if trade between two
countries)
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EXCHANGE RATE DETERMINATION - Contd

DD for FE arises because:

Import of goods and services
FDI in other countries
Payment by one Govt to other for settlement of transactions.
other outflows
SS of FE arises because:
Country exports goods and services to other countries
inflow of foreign capital
payment made by other countries
other types of inflows
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EXCHANGE RATE DETERMINATION - Contd

TYPES OF EXCHANGE RATES

1. FIXED EXCHANGE RATE:
It is also called as pegged exchange rate
IMF member countries follow this procedure
Government use to fix the exchange rates.
Advantages of Fixed Exchange Rate
Ensure certainty and confidence.
Promotes long term investments
It helps for economic stabilization
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EXCHANGE RATE DETERMINATION - Contd

Disadvantages Fixed Exchange Rate

It needs large foreign exchange reserves
It leads to large scale speculations
Long run capital may not be altered
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EXCHANGE RATE DETERMINATION - Contd

]FREE FLOATING (Flexible Exchange Rates)

Value of the currency is determined solely by market
demand for and supply of the currency in the foreign
exchange market.
Trade flows and capital flows are the main factors
affecting the exchange rate
In the long run it is the macro economic performance of
the economy (including trends in competitiveness) that
drives the value of the currency
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EXCHANGE RATE DETERMINATION - Contd

No pre-determined official target for the exchange rate is

set by the Government. The government and/or monetary
authorities can set interest rates for domestic economic
purposes rather than to achieve a given exchange rate
target
It is rare for pure free floating exchange rates to exist -
most governments at one time or another seek to
"manage" the value of their currency through changes in
interest rates and other controls
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EXCHANGE RATE DETERMINATION - Contd

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EXCHANGE RATE DETERMINATION - Contd

Advantages of Flexible Exchange Rates:

Simple to operate
Adjustment is a common process
Helps to promote foreign trade
There exist a free trade
Disadvantages of Flexible Exchange Rates
Market mechanism may fail to bring appropriate
FER
It is difficult to define FE Rate
It breeds uncertainty and impede international
trade.
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Should Exchange Rates be Fixed or

Flexible
Depends on the
1) The effects of the exchange rate system on monetary
policy
2) The effects of the exchange rate system on trade and
economic integration
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Theories of Foreign Exchange

Purchasing Power parity Theory (PPPT)
The theory developed by Cassel in 1921 and Officer in
1976
The theory suggests that at a given time, the rate of
exchange between currencies is determined by their
purchasing power
If e is the exchange rate and PA
and PB are the purchasing power
of two countries currencies ,
A and B countries can be written as
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Theories of Foreign Exchange

E= PA/PB
The exchange rate adjustment is a sequel to inflation. In case
of inflation
Exports will fall
Import price becomes cheaper
PPPT is useful in understanding
the long term movements in spot
rates; it has definite limitation over
the short term.
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Theories of Foreign Exchange

This theory suggests that

A country with high rate of inflation should devaluate the
currency to the currency of the country with lower inflation
rate.
It is a real exchange rate (base ER) and the nominal
exchange rates that has a bearing on the performance of the
country.
The theory holds good, only if,
Changes in economy because of monetary sector
Relative prices in different sector remains stable
There are no structural changes in the economy.
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Theories of Foreign Exchange

Criticism of PPP Theory:

No direct link between PP and rate of exchange.
Exchange rate can be influenced by other factors such as a tariff,
speculation and capital movement.
Difficulty in comparing price indices
Prices of domestic goods and internationally traded goods differ.
Changes in the exchange rate as the cause- exchange rate can
influence over price level which is ignored in this theory.
Other factors which influence the exchange rate are capital
movement, interest rate, and government restriction.
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Theories of Foreign Exchange

Fisher theory of FE
Fisher uses the interest rate rather than inflation rate
differentials to explain why exchange rates change
overtime but it is closely related to the PPP theory because
interest rates are often highly co-related with inflation
rates.
According to fisher effect, nominal risk free interest rates
contain a real rate of return and anticipated inflation
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Theories of Foreign Exchange

If investors of all the countries require the same real

return, interest differentials between countries may be the
result of differentials in expected inflation.
If the real interest rates are the same across the countries
any difference in nominal interest rates could be attributed
to the differences in expected inflation
IFE suggests that Foreign currency will relatively high
interest rates will depreciate because the high nominal
interest rates reflect expected inflation
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Theories of Foreign Exchange

The concept of real interest rate applies to all investments,

like domestic and foreign. An investor invests in a foreign
country if the real interest rate differentials are likely to be
his favour, but when such a differential exists, arbitrage
begins in the form of international capital flow that
ultimately equals the real interest rate across the countries.
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Foreign Exchange Market

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