INTRODUCTION
The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. EBS and Reuters’ dealing 3000 are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment by enabling currency conversion.
For example, it permits a business in the United to import goods from the European Union member states especially Euro zone members and pay Euros, even though its income is in United. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.
To study what exactly is foreign exchange n its unique features. To understand the different participants and types of foreign exchange markets. To get knowledge about the foreign exchange markets in India.
Research is defined as a systematic, gathering recording and analysis of data about problem relating to any particular field. It determines strength reliability and accuracy of the project. 1. Research Design: Research Design pertains to the great research approach or strategy adopted for a particular project. A research project has to be the conducted scientifically making sure that the data is collected adequately and economically. The study used a descriptive research design for the purpose of getting an insight over the issue. It is to provide an accurate picture of some aspects of market environment.
Descriptive research is used when the objective is to provide a systematic description that is as factual and accurate as possible. 2. Method of Data Collection: Secondary Data: Through the internet and published data.
HISTORY
Forex first existed in ancient times. Money-changing people, people helping others to change money and also taking a commission or charging a fee were living in the times of the Talmudic writings These people used city-stalls, at feast times the temples Court of the Gentiles instead. The money-changer was also in more recent ancient times silver-smiths and, or, gold-smiths.
During the fourth century the Byzantium government kept a monopoly on forexes. Medieval and later During the fifteenth century the Medici families were required to open banks at foreign locations in order to exchange currencies to act for textile merchants. To facilitate trade the bank created the nostro account book which contained two columned entries showing amounts of foreign and local currencies, information pertaining to the keeping of an account with a foreign bank. During the 17th (or 18th) century Amsterdam maintained an active forex market.
During 1704 foreign exchange took place between agents acting in the interests of the nations of England and Holland. Early modern The firms Alexander Brown & Sons traded foreign currencies exchange sometime about 1850 and were a leading participant in this within the U. S. of A. During 1880 J. M. do Santo de Silva applied for and was given permission to begin to engage in a foreign exchange trading business. 1880 is considered by one source to be the beginning of modern foreign exchange, significant for the fact of the beginning of the gold standard during the year. Modern to post-modern
Before WWII From 1899 to 1913 holdings of countries foreign exchange increased by 10. 8%, while holdings of gold increased by 6. 3%. At the time of the closing of the year 1913, nearly half of the world’s forexes were being performed using sterling. The number of foreign banks operating within the boundaries of London increased in the years from 1860 to 1913 from 3 to 71. In 1902 there were altogether two London foreign exchange brokers. In the earliest years of the twentieth century trade was most active in Paris, New York and Berlin, while Britain remained largely uninvolved in trade until 1914.
Between 1919 and 1922 the employment of a foreign exchange brokers within London increased to 17, in 1924 there were 40 firms operating for the purposes of exchange. During the 1920s the occurrence of trade in London resembled more the modern manifestation; by 1928 forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors, in Europe and Latin America, hampered any attempt at wholesale prosperity from trade for those of 1930’s London. After WWII After WWII the Bretton Woods Accord was signed allowing currencies to fluctuate within a range of 1% to the currencies par.
In Japan the law was changed during 1954 by the Foreign Exchange Bank Law, so, the Bank of Tokyo was to become because of this the centre of foreign exchange by September of that year. Between 1954 and 1959 Japanese law was made to allow the inclusion of many more Occidental currencies in Japanese forex. President Nixon is credited with ending the Bretton Woods Accord, and fixed rates of exchange, bringing about eventually a free-floating currency system. After the ceasing of the enactment of the Bretton Woods Accord (during 1971) the Smithsonian agreement allowed trading to range to 2%.
During 1961-62 the amount of foreign operations by the U. S. of America’s Federal Reserve was relatively low. Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased this in March of 1973, when sometime afterward none of the major currencies were maintained with a capacity for conversion to gold, organizations relied instead on reserves of currency. During 1970 to 1973 the amount of trades occurring in the market increased three-fold. At some time some of the markets’ were “split”, so a two tier currency market was subsequently introduced, with dual currency rates.
This was abolished during March of 1974. Reuters introduced during June of 1973 computer monitors, replacing the telephones and telex used previously for trading quotes. After 1973 In fact 1973 marks the point to which nation-state, banking trade and controlled foreign exchange ended and complete floating, relatively free conditions of a market characteristic of the situation in contemporary times began (according to one source), although another states the first time a currency pair were given as an option for U. S. A. traders to purchase was during 1982, with additional currencies available by the next year.
UNIQUE FEATURES
Forex is a worldwide market that decides the currency value of global countries and allows performing international currency exchange or trading. The trading centers across the world allow varied buyers and sellers to trade currencies 24 hours, except weekends. With globalization and advancements in telecommunication, countries across the globe has increasingly became interdependent on each other, due to which requirement for exchanging goods and services between international boundaries occurs.
Here is when foreign currency exchange comes in picture to assist the international trade by allowing swift international currency exchange. As compare to stock market or other financial investment markets, foreign currency exchange is gigantic in nature and has following unique features :
- International currency exchange is done in great volumes i. e. in trillions every day which makes foreign currency exchange the highly liquid market.
- Foreign currency exchange market works 24 hours a day and only off on weekends. So no matter which place in the world the trader lives, the foreign currency exchange transactions can be performed.
- Foreign currency exchange market has its presence in all the countries worldwide facilitating international currency exchange with any geographical limitations.
- There are various factors such as country’s national income, bank savings, inflation, crises, etc. affects the currency rates of the country.
- In Foreign currency exchange traders or brokers negotiate directly with one another having no central exchange or clearing house in between.
Foreign currency exchange trading involves worldwide banks, governments, multinational companies, financial institutes, trading corporations, and even individual currency speculators. To have knowledge on how the foreign currency exchange works is very essential not just for the large size companies but also for an individual who deals in a foreign country. The popularity of foreign currency exchange has increased significantly due to the quick earning opportunities obtained during rapidly fluctuating currency rates.
Foreign currency exchange companies are great source of getting trading knowledge and perform low cost transactions to transfer money abroad. These companies have online websites which provide good understanding; one can also take an account to practice Forex trading. Facilities like booking currency rate are available which enables a buyer to book the currency rate in advance and within 18 months they can buy the currency at booked rate. Such facility lets an individual to avail the benefit of low currency rates and earn high return on investments 1. 6. Functions Of Foreign Exchange Market
The foreign exchange market is the mechanism, by which a person of firm transfers purchasing power from one country to another, obtains or provides credit for international trade transactions, and minimizes exposure to foreign exchange risk. Following are some of the functions of foreign exchange market: Transfer of Purchasing Power: Transfer of purchasing power is necessary because international transactions normally involve parties in countries with different national currencies. Each party usually wants to deal in its own currency, but the transaction can be invoiced in only one currency. Provision of Credit:
Because the movement of goods between countries takes time, inventory in transit must be financed. Minimizing Foreign Exchange Risk: The foreign exchange market provides “hedging” facilities for transferring foreign exchange risk to someone else.
MARKET SIZE AND LIQUIDITY
Main foreign exchange market turnover, 1988–2007, measured in billions of USD. 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. 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%. 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.
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 economies 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 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 high-frequency 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 (see retail foreign exchange platform). 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 centre 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.
MARKET PARTICIPANTS
In this market, banks and non-bank financial institutions transact with each other. They undertake trading on behalf of customers, but majority of trading is undertaken for their own account by proprietary desks. Besides banks and non-bank financial institutions, multinational corporations, hedge funds, pension and provident funds, insurance companies, mutual funds etc. participate in the wholesale market. Big multinational companies earn their revenue and incur expenses in many different currencies. For example, Switzerland based Nestle operates in 86 countries across the globe.
To hedge their foreign exchange risk these multinational companies directly participate in the wholesale market. Hedge funds are also major player in this market. Hedge funds collect huge sums from high net worth individuals and undertake speculative trades in equity, debt, forex and derivatives market. Mutual funds with international equity portfolio are also major players in this market. Foreign Exchange Dealers and Brokers: The role of foreign exchange dealers and brokers need to be discussed in detail. But, let us first understand who forex dealers are.
Dealers: Banks and some nonblank financial institutions act as foreign exchange dealer. These dealers quote both “bid” and “ask” for a particular currency pair (for spot, forward and swap contracts) and take opposite side to either buyers or sellers of currency. They make profit from the spreads between buying and selling prices i. e. , bid and ask rate. Brokers are agents, which merely match buyers and sellers and get a brokerage fee. Before the internet, the brokers, dealers and clients were communicating over telephone or telex and through satellite communication These dealers are also known as “market maker”.
As market makers, these dealers stand willing at all time to buy and sell currencies at the quoted rate. Dealers do not necessarily make markets for all currency but specialize in some currency pair. A person/company intending to trade may directly get in touch with the dealer to get a two way quote and execute a trade. Dealers also trade foreign exchange as part of their own proprietary trade. In proprietary trading, dealers invest their own capital and undertake currency trading. Unlike the smaller margin received by dealers from the bid-ask spread, in proprietary trades, dealers expect a larger profit margin.
They mainly undertake trades based on directional view about a currency depending on interest rate change, major policy move etc. Brokers: Brokers on the other hand, help clients to get a better rate on the currency trade by making available different quotes offered by dealers. Traders can compare rates and accordingly take a decision. Brokers charge a commission for providing these services. A broker continuously remains connected to dealers to get latest quotes, depth of the market.
The broker compares the rates offered by the dealers and provides the best rates to the clients i. e, highest bid prices quoted by different dealers when the client wants to sell and lowest ask price quoted by different dealers when the clients wants to buy. With the emergence of communication technology, now most of the most of broker deals are happening in electronic brokering system. Foreign exchange dealers trade among themselves through direct dealing and through brokers. In case of direct dealing, two dealers contact each other directly and undertake a trade. Like any other traders, dealers may contact brokers for executing their proprietary trades if these dealers want anonymity in trading.
In India, RBI (Reserve Bank of India), gives permission to an entity to act as authorized dealer in foreign exchange. In fact, RBI has sanctioned three different categories of Authorized Dealers. Categorization is done by RBI, depending upon the kind of services an entity is permitted to offer. Hedger, Speculators and Arbitrageurs: Traders buying and selling foreign exchange can take the role of hedgers, or speculators or arbitrageurs. Hedgers are traders who undertake forex trading because they have assets or liability in foreign currency.
For example, when an importer requiring foreign currency, sells domestic currency to buy foreign currency, he is termed as a hedger. The importer has a foreign currency liability. Similarly, an exporter sells foreign currency and buys domestic currency is a hedger. The exporter has assets denominated in foreign currency. A MNC entering into a foreign currency forward contract so that it can repatriate its earning to parent company. An Indian company swapping its foreign currency interest payment obligations to INR interest obligation. All these are examples of hedging.
Hedgers use the foreign currency market to hedge the risk associated with volatility in foreign exchange market. Speculators are traders who essentially buy and sell foreign currency to make profit from the expected futures movement of the currency. These traders do not have any genuine requirement for trading foreign currency. They do not hold any cash position in the currency. Arbitrageurs buy and sell the same currency at two different markets whenever there is price discrepancy. The principle of “law of one price” governs the arbitrage principle. Arbitrageurs ensure that market prices move to rational or normal levels.
With the proliferation on internet, cross currency, cross currency arbitrage possibility has increased significantly. Central Banks and Treasuries: All most all central bank and treasuries participate in the forex market. Central banks play very important role in foreign exchange market. However, these banks do not undertake significant volume of trading. Each central bank has official/unofficial target of the forex rate for its home currency. If the actual price deviates from the target rate, the central banks intervene in the market to set a tone. Retail Market:
In the retail market, individuals (tourists, foreign students, patients traveling to other countries for medical treatment) small companies, small exporters and importers operate. Money transfer companies/remittance companies (for example like Western Union) are also major players in the retail market. Retail traders buy/sell currency for their genuine business/personal requirements. For example, an exporter enters into forward contract to convert foreign currency to domestic currency. A tourist buys foreign currency in the spot market before undertaking the journey. A UK patient visiting India to undertake an operation that would have cost him a fortune at UK.
PRINCIPLES OF FOREIGN EXCHANGE DEALING
To be able to explain how foreign exchange dealing actually happens in practice using a number of examples, it is important to understand some of the principles underlying the money market transactions involved. In addition to exchange rate quotation, this chapter also explains how dealers manage positions, and describes the most fundamental operation of all, the spot transaction.
In the introduction to this booklet, the exchange rate was defined as the price of a foreign currency in domestic currency units. This definition of an exchange rate is also termed a “direct quotation,” and is used by most countries. The price of (as a rule) one hundred units of foreign currency, but only the price of one unit in the case of the dollar and sterling, is quoted in the domestic currency. In Switzerland, therefore, foreign currencies are quoted in CHF, but there are exceptions to this rule. Since the decimal system was not used in Britain in the early years, the equivalent of sterling was quoted in the foreign currency.
This method is known as “indirect quotation. ” Even today, sterling is still quoted indirectly. To ensure that the market functions smoothly, it needs other conventions. In professional foreign exchange dealing between banks, dealers normally quote dollar rates. This means that the values of the various local currencies are expressed by indicating the price of one USD in the local currency Foreign exchange Traders Each bank’s foreign exchange trading is the responsibility of a designated trader or dealer, who is responsible for meeting the needs of the bank’s customers.
For example, a U. S. business purchasing a machine made in Sweden will need Swedish krona to pay for it. So, a bank’s foreign exchange trader will supply the krona in exchange for dollars from the U. S. company. Operations in the foreign exchange market All activities that make up a nation’s balance of payments will influence trading in that country’s currency. Regardless of whether the currency used is one’s own currency or a foreign currency, almost every international transaction involves one party’s being exposed to exchange risk. Payments for Imports and Exports In practice, many U. S. firms and individuals receive foreign exchange in payment for goods and services sold abroad. Others make payments to foreigners in their currency rather than in U. S. dollars.
TYPES OF FOREX MARKETS
Spot Market: The term spot exchange refers to the class of foreign exchange transaction which requires the immediate delivery or exchange of currencies on the spot. In practice the settlement takes place within two days in most markets. The rate of exchange effective for the spot transaction is known as the spot rate and the market for such transactions is known as the spot market.
The forward transactions is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency be the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market. The foreign exchange regulations of various countries generally regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market.
In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions. Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations be entering into an appropriate forward exchange contract. With reference to its relationship with spot rate, the forward rate may be at par, discount or premium. If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making the contract the forward exchange rate is said to be at par.
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 rate on a per annum basis. The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on a per annum basis. The forward exchange rate is determined mostly be the demand for and supply of forward exchange.
Naturally when the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par. Futures: While a focus contract is similar to a forward contract, there are several differences between them. While a forward contract is tailor made for the client be his international bank, a future contract has standardized features the contract size and maturity dates are standardized.
Futures cab traded only on an organized exchange and they are traded competitively. Margins are not required in respect of a forward contract but margins are required of all participants in the futures market an initial margin must be deposited into a collateral account to establish a futures position.
While the forward or futures contract protects the purchaser of the contract fro m the adverse exchange rate movements, it eliminates the possibility of gaining a windfall profit from favorable exchange rate movement. 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 as 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 a 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.
With reference to their exercise characteristics, there are two types of options, American and European. A European option cab is exercised only at the maturity or expiration date of the contract, whereas an American option can be exercised at any time during the contract.
Commercial banks who conduct forward exchange business may resort to a swap operation to adjust their fund position. 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.
The spot is swapped against forward. Operations consisting of a simultaneous sale or purchase of spot currency accompanies 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. Arbitrage: Arbitrage is the simultaneous buying and selling of foreign currencies with intention of making profits from the difference between the exchange rate prevailing at the same time in different markets.
TYPES OF EXCHANGE RATES
Fully fixed exchange rates In a fixed exchange rate system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target. It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate. Semi-fixed exchange rates Currency can move within a permitted range, but the exchange rate is the dominant target of economic policy-making. Interest rates are set to meet the target exchange rate.
The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the main factors affecting the exchange rate. The definition of a floating exchange rate system is a monetary system in which exchange rates are allowed to move due to market forces without intervention by national governments. The Bank of England, for example, does not actively intervene in the currency markets to achieve a desired exchange rate level. With floating exchange rates, changes in market supply and demand cause a currency to change in value.
Pure free floating exchange rates are rare – most governments at one time or another seek to ‘manage’ the value of their currency through changes in interest rates and other means of controls. Managed floating exchange rates Most governments engage in managed floating systems, if not part of a fixed exchange rate system. The advantages of fixed exchange rates Fixed rates provide greater certainty for exporters and importers and, under normal circumstances, there is less speculative activity – though this depends on whether dealers in foreign exchange markets regard a given fixed exchange rate as appropriate and credible.
The advantages of floating exchange rates Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. A second key advantage of floating exchange rates is that it allows the government/monetary authority flexibility in determining interest rates as they do not need to be used to influence the exchange rate.
