Forex PDF

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What is foreign exchange market? Who are its participants? What are its functions? *INTRODUCTION: ~ Foreign exchange market is a medium through which individuals, business, governments and banks bu and sell foreign currencies! Foreign exchange market is a medium through which individuals, business, governments and banks bu and self foreign currencies! ~ Foreign exchange market is a worldwide market that operates round the clock! "n fact, it is the largest and the most li#uid market in the world! ~ Foreign exchange market is not a single ph sical place, but a worldwide market which operates round the clock! "t is the largest and the most li#uid market in the world! *MEANING: ~ Foreign exchange market is a mechanism where various national currencies are purchased and sold like an other commodit ! ~ The foreign exchange rate is determined b the demand for and suppl of foreign exchange! ~ $ foreign exchange market can be free or restricted! %estrictions on the market var from countr to countr ! ~ "n "ndia, restrictions are made on foreign exchange convertibilit whereb full convertibilit is allowed onl on current account and not on capital account! ~ &ven under the free foreign exchange market, the 'overnment intervenes whenever there is a wide fluctuation in the exchange rate so as to avoid adverse effects of unstable exchange rate on the econom ! *TYPE OF FOREIGN EXCHANGE MARKET: ~ The foreign exchange market is broadl divided into two categories( ) %etail *arket

) Wholesale market! +RETAIL MARKET: ~ The retail foreign exchange market is a secondar price marker wherein travellers, tourists and people who are in need of foreign currenc carr out small permitted transactions! +WHOLESALE MARKET: ~ The wholesale foreign exchange market is also called the interbank market wherein large transactions of foreign exchange are carried out! The dealers in this market are highl professional and are the primar price makers! *PARTICIPANTS: ~ The following are the main participants in the foreign exchange market( i) RETAIL CLIENTS: ~ %etail clients are the ones who deal through commercial banks and authorised dealers! ~ These include individuals, international investors, multi,national corporations and others who need foreign exchange! ii) COMMERCIAL BANKS: ~ -ommercial banks deal through other commercial banks and also through foreign exchange brokers! ~ The bu and sell foreign exchange for their retail clients and also carr out their own foreign exchange transactions! iii) FOREIGN EXCHANGE BROKERS: ~ &ach foreign exchange market centre has some authorised brokers who act as intermediaries between bu ers and sellers mainl banks! ~ -ommercial banks prefer foreign exchange brokers as banks obtain the most favourable #uotations from them!

iv) CENTRAL BANKS: ~ .nder the floating rate the central bank of a countr normall does not intervene in the exchange market! ~/owever, since 0123, most of the central banks fre#uentl intervened the foreign exchange market to bu and sell their currencies in order to influence the rate at which their currencies are traded! ~ The above groups generate demand and suppl forces and help to determine the foreign exchange rate! ~ The brokers are the middlemen between the price makers and possess more information and better knowledge of the market! ~ The large commercial banks and foreign exchange brokers who participate in foreign exchange market are linked together b telephone, telex and satellite communications network called 4ociet for Worldwide "nternational Financial Telecommunications 54W"FT6! ~ This s stem is based in 7russels 57elgium6 and links banks and brokers in ever financial centre! This s stem reacts to all the events that influence the foreign exchange rate and thus makes the foreign exchange market efficient and conventional! *INDIAN FOREIGN EXCHANGE MARKET: ~ "ndian foreign exchange market is made up of three tiers( ) 0st level 8 Deals between %7" and authorised dealers 5mainl commercial banks6 ) 9nd level 8 Deals among authorised dealers! ) 3rd level 8 Deals between authorised dealers and their corporate customers! *FUNCTIONS: ~ The main functions of the foreign exchange market are( 06 TRANSFER OF PURCHASING POWER:

~ "nternational trade involves different currencies! The residents of one countr re#uire the currenc of another countr to make pa ments in respect of the following transactions( +"mport of goods and services +Dividend, interest and profit to foreign firms! +.nilateral pa ments! +-apital outflow in the form of investments abroad, short : long term lending, etc! ~ This involves transfer of purchasing power from the pra er;s countr to the receiver;s countr ! ~ 4imilarl , the residents of the other countr receive the foreign currenc in respect of the following transaction! +%eceipts on account of export of goods and services! +%eceipt of dividend, interests and profit b firms! +.nilateral receipts! +-apital inflow in the form of foreign investments in "ndia, <%" deposits, borrowings, etc! ~ Thus foreign exchange market helps transfer purchasing power between people of different countries! 96 PROVISION OF CREDIT INSTUMENTS AND CREDIT: ~ The foreign exchange market facilitates provision of credit for foreign trade through credit instruments like telegraphic transfer, letters of credit, bill of exchange, drafts, etc! ~ *oreover, instruments with time period 5eg! 7ill of foreign exchange of 1= da s or more6 can be discounted with commercial banks or authorised agents before due date! 3) COVERGE OF RISK: ~&xports and imports ma cover the risk due to future change in exchange rate through forward exchange market whereb currencies are exchanged 5at a

~ "n foreign exchange market, two t pes of exchange rate operations take place, spot exchange rate and forward exchange rate! *SPOT EXCHANGE RATE: ~ 4pot exchange rate is the current exchange rate! "t is determined b market forces 5demand for and suppl of foreign exchange6 ~ $t the spot rate, immediate deliver of foreign exchange has to be made! ~ /owever, in practice, there is a two da time lag between the transaction and actual deliver for paper work, verification and clearing of pa ments! ~ 4ince the spot exchange rate is determined b market forces, an change in the demand or suppl will change the exchange rate! ~ The primar price makers in the foreign exchange market continuousl >bid; or >ask; the currencies, hence the exchange rate also changes continuousl in a free market! ~ 4ince the primar dealers #uote two,wa prices and are read to deal on either side 5i!e! to bu and sell6 the rate is #uoted in the following manner( )"<% :.4D ?@!A= bid : ?@!2A ask *SPOT RATE: ~ 4pot date refers to the deliver date of the currenc ! ~ "t is the settlement date when actual exchange of currencies takes place! ~ The deliver of currenc of the spot transaction takes place on the second working da after the date of settlement! *SPOT TRANSACTION: ~ 4pot transactions account for two,thirds of the total business transacted in the international foreign exchange market! ~ The spot dealings between an individual like a tourist and banks are settled on the spot b exchanging the currencies immediatel !

*FORWARD EXCHANGE RATE: ~ "n the foreign exchange forwards market, the purchase:sale of foreign exchange is done currentl for deliver and pa ment at a fixed date in future at a specified exchange rate! This is known as the foreign exchange rate! ~ These contracts usuall have maturities of 3=, B= or 1= da s! 4ome transactions also have maturities of 0@= =r 3B=da s! ~ Forward exchange rate ma either be at a premium or discount in relation to the spot exchange rate( +"f the forward exchange rate is above the present spot rate, it is said to be at a >premium;! +"f the forward exchange rate is below the present spot rate, it is said to be at a >discount; ~ The #uotation foe forward exchange rate can be done as follows( +"t is expressed in terms of the amount of local currenc at which the dealer will bu or sell a unit of foreign currenc ! This is termed as the >outright rate;! +"t can also be expressed in terms of points 5called the forward points6! These points are added to the spot rate if the foreign currenc is traded at a premium! These points are deducted from the spot rate if the currenc is traded at a discount! *NEED FOR FORWARD CONTRACTS: ~ &xporters, importers and investors enter into forward exchange rate contracts to overcome the possible risk of loss due to fluctuations in the exchange rate! ~ $lso, in the forwards market, swap agreements take place to cover the risk involved in the forward deal! .suall banks which enter into forward arrangement to sell foreign currenc at a certain rate would cover their risk b entering into an agreement with another bank to purchase the currenc at a fixed rate! 4uch swaps help the banks to match the outflow and inflow of currencies and earn profit based on swap margin! *FACTORS INFLUENCING FORWARD EXCHANGE RATE:

~ Forward exchange rate is influenced b various factors that ma prevail at a future date! These include( +7alance of pa ments position +"nflation rate! +"nterest rate! +Degree of speculation in foreign exchange market! +&conomic situation in the countr ! +Political situation in the countr ! +'overnment policies, etc! ~ Thus, in a full floating exchange rate s stem, the forward exchange rate is left to the speculation of dealers, whereas in a managed float, the role of the central bank also influences the forward rate! C3( Write a note on %isk -overage in the forward foreign exchange market? $ns( The risk involved in dealing in the forward foreign exchange market can be covered b activities like hedging, speculation and arbitrage! ~ The activities allow the dealers not onl to cover the risks involved but also to earn profit b taking advantage of the forward exchange market! *HEDGING: ~ /edging covers the risk arising out of changes in the exchange rate! "t is especiall essential for firms having large amounts receivables or commitments to pa in foreign currencies! ~ The strateg of hedging involves increasing the currenc that is likel to appreciate and decreasing the currenc that is likel to depreciate! ~ "t also involves decreasing liabilities in the currenc that is likel to appreciate and increasing liabilities in the currenc that is likel to depreciate!

*SPECULATION: ~ 4peculation involves purchase and sale of foreign exchange in the forwards market with the intention of making profit b taking advantage of changes in foreign exchange rates! ~ The speculate on the basis of their own calculation of the difference between the forward rate and spot rate that ma prevail at a future date! ~ 4peculators tr to minimise their loss b entering in spot and forward agreements simultaneousl ! ~ 4peculation ma have stabilising or destabilising effect! ~ 4tabilising speculation refers to purchase of foreign currenc when the domestic price of a foreign currenc when the domestic price of a foreign currenc falls with the expectation of its increase in the future! ~ Destabilising speculation refers to sale of foreign currenc when the exchange rate falls with the expectation that it would fall further! This magnifies exchange rate fluctuations and proves highl disruptive to the international flow of trade and investment! *ARBITRAGE: ~ $rbitrage refers to purchase of an asset in a low price market and its sale in a higher price market! ~ This process leads to e#ualisation of price of an asset in all the segments of the market! ~ $rbitrageurs take advantage of the different exchange rates prevailing in various foreign exchange markets due to different interest rates! ~ The purchase foreign currenc from the foreign exchange market with lower exchange rate and sell the same in market with a higher exchange rate! ~ $rbitrage is also possible within the countr where two banks offer two different bids and asking rate! ~ When arbitrage involves onl two currencies or two countries, it is called two,point arbitrage! "t increases the suppl of dearer currenc !

*INTEREST RATE AND ARBITRAGE: ~ The interest rate of a countr is influenced b the rate of inflation prevailing in that countr ! ~ -urrenc convertibilit , as an aspect of a countr Ds exchange rate polic , refers to the ease with which domestic currenc can be traded for foreign currenc , for a particular usage and at a given exchange rate! -urrenc convertibilit polic of a government has two aspects( 5a6 current account convertibilit and 5b6 capital account convertibilit ! -urrent account convertibilit allows residents to make and receive trade,related pa ments, i!e! receive foreign currenc for export of goods and services and pa foreign currenc for import of goods and services like travels, medical treatment and studies abroad! "n other words, it permits free inflows and outflows for all purposes other than for capital purposes! -apital account convertibilit allows freedom to make investment in foreign e#uit , extend loans to foreigners, bu real estate in foreign lands and vice versa! 7roadl speaking, it allows an one to move freel from local currenc into foreign currenc and back! -urrent account convertibilit was introduced in "ndia in $ugust 011? with the acceptance of the obligations under $rticle E""" of the "*FDs $rticles of $greement! This drastic measure contributed significantl to boost "ndiaDs exports! Presentl , there is almost full convertibilit on the current account and partial convertibilit on the capital account!

CAC has 5 basic statements designed as points of action: All types of liquid capital assets must be able to be exchanged freely, between any two nations in the world, with standardized exchange rates. The amounts must be a significant amount in excess of !5"","""#. Capital inflows should be in$ested in semi%liquid assets, to pre$ent churning and excessi$e outflow. &nstitutional in$estors should not use CAC to manipulate fiscal policy or exchange rates. 'xcessi$e inflows and outflows should be buffered by national ban(s to pro$ide collateral.