INTRODUCTION

The foreign exchange market is a global decentralized market for the trading of
currencies. This includes all aspects of buying, selling and exchanging currencies
at current or determined prices. In terms of volume of trading, it is by far the
largest market in the world.[1] The main participants in this market are the larger
international banks. Financial centers around the world function as anchors of
trading between a wide range of multiple types of buyers and sellers around the
clock, with the exception of weekends. The foreign exchange market does not
determine the relative values of different currencies, but sets the current market
price of the value of one currency as demanded against another.
The foreign exchange market works through financial institutions, and it operates
on several levels. Behind the scenes banks turn to a smaller number of financial
firms known as dealers, who are actively involved in large quantities of foreign
exchange trading. Most foreign exchange dealers are banks, so this behind-thescenes market is sometimes called the interbank market, although a few
insurance companies and other kinds of financial firms are involved. Trades
between foreign exchange dealers can be very large, involving hundreds of
millions of dollars. Because of the sovereignty issue when involving two
currencies, forex has little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by
enabling currency conversion.

FEATURES OF FOREIGN EXCHANGE MARKET

MEANING OF A FOREIGN EXCHANGE MARKET:
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.
According to Ellsworth, "A Foreign Exchange Market comprises of all
those institutions and individuals who buy and sell foreign exchange which may be
defined as foreign money or any liquid claim on foreign money". Foreign
Exchange transactions result in inflow & outflow of foreign exchange.
FEATURES OF FOREIGN EXCHANGE MARKET:
Foreign exchange market is the market where the currency of one country is
exchanged for the currency of another country. In other words it is a market where
currencies are bought and sold just like equity shares are bought and sold in equity
markets. Given below are some of the main features of foreign exchange market
1. Foreign exchange market is the only market which is open 24 hours a day,
except for weekends unlike equity or commodities market which are open only for
few hours.

2. Volume of transactions which are executed in foreign exchange market is

extremely huge because of many big players in foreign exchange market. Foreign
exchange markets are more liquid than any other market because of this reason.
3. Foreign Exchange Market are present in every country and therefore
geographically they are located everywhere in the world, which makes them quite
unique.
4. Foreign exchange markets are the most difficult market to trade in as the
exchange rates of countries are affected by so many factors like interest rates,
liquidity, geo political factor and so on.
5. Foreign exchange market is a big player market, because mostly it is the big
banks and government who are the players in foreign exchange market.
Foreign Exchange Market and its Important Functions!
As Kindle-Berger put, the foreign exchange market is a place where foreign
moneys are bought and sold. Foreign exchange market is an institutional
arrangement for buying and selling of foreign currencies. Exporters sell the foreign
currencies. Importers buy them.
The foreign exchange market is merely a part of the money market in the financial
centres. It is a place where foreign moneys are bought and sold. The buyers and
sellers of claim on foreign money and the intermediaries together constitute a
foreign exchange market.
These banks discount and sell foreign bills of exchange, issue bank drafts, effect
telegraphic transfers and other credit instruments, and discount and collect amounts
on the basis of such documents. Other dealers in foreign exchange are bill brokers
3

who help sellers and buyers in foreign bills to come together. They are
intermediaries and unlike banks are not direct dealers.
Acceptance houses are another class of dealers in foreign exchange. They help
effect foreign remittances by accepting bills on behalf of customers. The central
bank and treasury of a country are also dealers in foreign exchange. Both may
intervene in the market occasionally.
Today, however, these authorities manage exchange rates and implement exchange
controls in various ways. In India, however, where there is a strict exchange
control system, there is no foreign exchange market as such.
The following are the important functions of a foreign exchange market:
1. To transfer finance, purchasing power from one nation to another. Such transfer
is affected through foreign bills or remittances made through telegraphic transfer.
(Transfer Function).
2. To provide credit for international trade. (Credit Function).
3. To make provision for hedging facilities, i.e., to facilitate buying and selling spot
or forward foreign exchange. (Hedging Function).
1. Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion of
one currency into another, i.e., to accomplish transfers of purchasing power
between two countries. This transfer of purchasing power is effected through a
variety of credit instruments, such as telegraphic transfers, bank draft and foreign
bills.

In performing the transfer function, the foreign exchange market carries out
payments internationally by clearing debts in both directions simultaneously,
analogous to domestic clearings.
2. Credit Function:
Another function of the foreign exchange market is to provide credit, both national
and international, to promote foreign trade. Obviously, when foreign bills of
exchange are used in international payments, a credit for about 3 months, till their
maturity, is required.
3. Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange risks.
Hedging means the avoidance of a foreign exchange risk. In a free exchange
market when exchange rate, i. e., the price of one currency in terms of another
currency, change, there may be a gain or loss to the party concerned. Under this
condition, a person or a firm undertakes a great exchange risk if there are huge
amounts of net claims or net liabilities which are to be met in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange market
provides facilities for hedging anticipated or actual claims or liabilities through
forward contracts in exchange. A forward contract which is normally for three
months is a contract to buy or sell foreign exchange against another currency at
some fixed date in the future at a price agreed upon now.
No money passes at the time of the contract. But the contract makes it possible to
ignore any likely changes in exchange rate. The existence of a forward market thus
makes it possible to hedge an exchange position.

Foreign bills of exchange, telegraphic transfer, bank draft, letter of credit, etc., are
the important foreign exchange instruments used in the foreign exchange market to
carry out its functions.
It is not restricted to any given country or a geographical area. Thus, the foreign
exchange market is the market for a national currency (foreign money) anywhere
in the world, as the financial centres of the world are united in a single market.
There is a wide variety of dealers in the foreign exchange market. The most
important among them are the banks. Banks dealing in foreign exchange have
branches with substantial balances in different countries. Through their branches
and correspondents, the services of such banks, usually called Exchange Banks,
are available all over the world.

FACTORS AFFECTING FOREIGN EXCHANGE RATES

Foreign Exchange rate (ForEx rate) is one of the most important means through
which a countrys relative level of economic health is determined. A country's
foreign exchange rate provides a window to its economic stability, which is why it
is constantly watched and analyzed. If you are thinking of sending or receiving
money from overseas, you need to keep a keen eye on the currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency may be
converted into another." It may fluctuate daily with the changing market forces of
supply and demand of currencies from one country to another. For these reasons;
when sending or receiving money internationally, it is important to understand
what determines exchange rates.
This article examines some of the leading factors that influence the variations and
fluctuations in exchange rates and explains the reasons behind their volatility,
helping you learn the best time to send money abroad.

1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country
with a lower inflation rate than another's will see an appreciation in the value of its
currency. The prices of goods and services increase at a slower rate where the
inflation is low. A country with a consistently lower inflation rate exhibits a rising
currency value while a country with higher inflation typically sees depreciation in
its currency and is usually accompanied by higher interest rates
2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates,
interest rates, and inflation are all correlated. Increases in interest rates cause a
country's currency to appreciate because higher interest rates provide higher rates
to lenders, thereby attracting more foreign capital,
3. Countrys Current Account / Balance of Payments
A countrys current account reflects balance of trade and earnings on foreign
investment. It consists of total number of transactions including its exports,
imports, debt, etc. A deficit in current account due to spending more of its currency
on importing products than it is earning through sale of exports causes
depreciation. Balance of payments fluctuates exchange rate of its domestic
currency.
4. Government Debt

Government debt is public debt or national debt owned by the central government.
A country with government debt is less likely to acquire foreign capital, leading to
inflation. Foreign investors will sell their bonds in the open market if the market
predicts government debt within a certain country.
5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio
of export prices to import prices. A country's terms of trade improves if its exports
prices rise at a greater rate than its imports prices. This results in higher revenue,
which causes a higher demand for the country's currency and an increase in its
currency's

value.

This

results

in

an

appreciation

of

exchange.

6. Political Stability & Performance

A country's political state and economic performance can affect its currency
strength. A country with less risk for political turmoil is more attractive to foreign
investors, as a result, drawing investment away from other countries with more
political and economic stability. Increase in foreign capital, in turn, leads to an
appreciation in the value of its domestic currency. A country with sound financial
and trade policy does not give any room for uncertainty in value of its currency.
But, a country prone to political confusions may see a depreciation in exchange
rates.

7. Recession
When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency weakens
in comparison to that of other countries, therefore lowering the exchange rate.

8. Speculation
If a country's currency value is expected to rise, investors will demand more of that
currency in order to make a profit in the near future. As a result, the value of the
currency will rise due to the increase in demand. With this increase in currency
value

comes

rise

in

the

exchange

rate

as

well.

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and are
expressed as a comparison of the currencies of two countries. The following are
some of the principal determinants of the exchange rate between two countries.
Note that these factors are in no particular order; like many aspects of economics,
the relative importance of these factors is subject to much debate.

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1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies.
During the last half of the 20th century, the countries with low inflation included
Japan, Germany and Switzerland, while the U.S. and Canada achieved low
inflation

only

later.

Those

countries

with

higher

inflation

typically

see depreciation in their currency in relation to the currencies of their trading

partners. This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation and
exchange rates, and changing interest rates impact inflation and currency values.
Higher interest rates offer lenders in an economy a higher return relative to other
countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve
to drive the currency down. The opposite relationship exists for decreasing interest
rates - that is, lower interest rates tend to decrease exchange rates.
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services, interest and
dividends. A deficit in the current account shows the country is spending more on
foreign trade than it is earning, and that it is borrowing capital from foreign sources
to make up the deficit. In other words, the country requires more foreign currency
11

than it receives through sales of exports, and it supplies more of its own currency
than foreigners demand for its products. The excess demand for foreign currency
lowers the country's exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to generate sales for
domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to foreign
investors. The reason? A large debt encourages inflation, and if inflation is high,
the debt will be serviced and ultimately paid off with cheaper real dollars in the
future.
In the worst case scenario, a government may print money to pay part of a large
debt, but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply of
securities for sale to foreigners, thereby lowering their prices. Finally, a large debt
may prove worrisome to foreigners if they believe the country risks defaulting on
its obligations. Foreigners will be less willing to own securities denominated in
that currency if the risk of default is great. For this reason, the country's debt rating
(as determined by Moody's or Standard & Poor's, for example) is a crucial
determinant of its exchange rate.
5. Terms of Trade

12

A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports
rises by a greater rate than that of its imports, its terms of trade have favorably
improved. Increasing terms of trade shows greater demand for the country's
exports. This, in turn, results in rising revenues from exports, which provides
increased demand for the country's currency (and an increase in the currency's
value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes
will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of more
stable countries.
The Bottom Line
The exchange rate of the currency in which a portfolio holds the bulk of its
investments determines that portfolio's real return. A declining exchange rate
obviously decreases the purchasing power of income and capital gains derived
from any returns. Moreover, the exchange rate influences other income factors
such as interest rates, inflation and even capital gains from domestic securities.
While exchange rates are determined by numerous complex factors that often leave
even the most experienced economists flummoxed, investors should still have

13

some understanding of how currency values and exchange rates play an important
role in the rate of return on their investments.

MAJOR PARTICIPANTS OF FOREIGN EXCHANGE MARKET

Foreign exchange markets represent by far the most important financial markets in
the world. Their role is of paramount importance in the system of international
payments. In order to play their role effectively, it is necessary that their
operations/dealings be reliable. Reliability essentially is concerned with contractual
obligations being honored. For instance, if two parties have entered into a forward
sale or purchase of a currency, both of them should be willing to honor their side of
contract by delivering or taking delivery of the currency, as the case may be.
14

The major foreign exchange markets that exist are:

(a) Spot markets
(b) Forward markets
(c) Futures markets
(d) Options markets
(e) Swaps markets.
Futures, Options and Swaps are called derivatives because they derive their value
from the underlying exchange rates.
Spot market refers to the transactions involving sale and purchase of currencies for
immediate delivery. In practice, it may take one or two days to settle transactions.
Forward market transactions are meant to be settled on a future date as specified in
the contract. Though forward rates are quoted just like spot rates, but actual
delivery of currencies takes place much later, on a date in future.
Futures market is a localized exchange where derivative instruments called
'futures' are traded. Currency futures are somewhat similar to forward, yet
distinctly different.
Options are derivative instruments that give a choice to a foreign exchange market
operator to buy or sell a foreign currency on or up to a date (maturity date) at a
specified rate (strike price).
Swaps, as the term suggests, are simply the instruments that permit exchange of
two streams of cash flows in two different currencies.

15

The most active foreign exchange market is that of UK (London), followed by that
of USA, Japan, Singapore, Switzerland, Hong Kong, Germany, France and
Australia. All other markets, combined together, represent only about 15 per cent
of the total volume, traded globally.
Volume of Transactions
As far as the nature of transactions on foreign exchange markets is concerned,
statistics indicate that international trade represents only a small part of foreign
exchange operations. In contrast, movement of capital and currency positions held
by banks constitute a major segment of exchange business. Over the years, there
has been a sizeable growth in foreign exchange operations. This increase, in great
measure, may be attributed to very active participation of financial institutions and
corporate as they go about trying to manage their exchange rate risk. About 5 per
cent of volume traded on markets represents the need of international trade and
international tourism. This figure is higher at 10 to 15 per cent, pertaining to
movement of capital like investment funds. The larger part of currency movements
are of short-term type. The bulk share of foreign exchange operations comes from
big commercial banks.

These relative proportions, however, may undergo changes in future. Firstly,

because foreign exchange needs due to trade are developing at a faster pace than
those due to interbank exchanges. More and more exchange operations are
concentrated m certain banks such as Citibank, Morgan, Union des Banques
Suisses, Barclays and Midland.
The existing profit levels emanating from foreign exchange operations are quite
significant in cases of certain banks. However, in future, it would perhaps be
16

difficult to maintain such high profits on this count. For example, after coming into
existence of the common currency, Euro, profits due to exchange operations made
by different banks within the European Union are going to disappear. Of course,
new currencies have been created in the countries of Eastern and Central Europe,
which will necessitate new exchange operations. But the magnitude of these
operations is likely to be insignificant for quite some time in future.
SPOT MARKET:
Spot transactions in the foreign exchange market are increasing in volume. These
transactions are primarily m forms of buying/ selling of currency notes,
encashment of travellers' cheques and transfers through banking channels. The last
category accounts for the majority of transactions. It is estimated that about 90 per
cent of spot transactions are carried out exclusively for banks. The rest are meant
for covering the orders of the clients of banks, which are essentially enterprises.
The Spot market is the one in which the exchange of currencies takes place within
48 hours. This market functions continuously, round the clock. Thus, a spot
transaction effected on Monday will be settled by Wednesday, provided there is no
holiday between Monday and Wednesday. As a matter of fact, certain length of
time is necessary for completing the orders of payment and accounting operations
due to time differences between different time zones across the globe.
Magnitude of Spot Market
According to a Bank of International Settlements (BIS) estimate, the daily volume
of spot exchange transactions is about 50 per cent of the total transactions of
exchange markets. London market is the first market of the world not only in terms
of the volume but also in terms of diversity of currencies traded. While London
market trades a large number of currencies, the New York market trades, by and
17

large, Dollar (75 per cent of the total), Deutschmark, Yen, Pound Sterling and
Swiss Franc only. Amongst the recent changes observed on the exchange markets,
it is noted that there is a relative decline m operations involving dollar while there
is an increase in the operations involving Deutschmark. Besides, deregulation of
markets has accelerated the process of international transactions.
Major participants on the spot exchange market are:
(1) Commercial banks,
(2) Dealers, brokers, arbitrageurs and speculators, and
(3) Central banks.
Commercial Banks
Commercial banks intervene in the spot market through their foreign exchange
dealers either for their own account or for their clients. The banks are
intermediaries between seekers and suppliers of currency. The role of banks is to
enable their clients to change one currency into another. Also, they operate on these
markets to make a profit through speculation and the process of arbitrage. Big
commercial banks serve as market-makers. They simultaneously quote, bid and ask
prices, indicating their willingness to buy and sell foreign currencies at quoted
rates. The purchases and sales of large commercial banks seldom match, leading
to large variation in their holdings of foreign currencies exposing them to exchange
risk. When they assume the risk deliberately, they act as speculators. However,
banks prefer to keep their exposure low and not get into unduly large speculations.
Dealers, Brokers, Arbitrageurs and Speculators

18

Dealers are basically involved in buying currencies when they are low and selling
them when they are high. Dealers' operations are wholesale and majority of their
transactions are interbank in nature although, once in a while, they may deal with
corporate and central banks. They have low transaction costs as well as thin
spreads which reflect their long experience in exchange risk management as well
as the intense competition among banks. Wholesale transactions account for 90 per
cent of the total value of foreign exchange deals. Dealers at the retail level cater to
needs of customers wishing to buy or sell foreign exchange. The spread is wide in
these transactions.
Exchange brokers specialize in playing the role of intermediaries between different
banks. They are not very large in number. For example, at the Paris exchange
market, there are about 20 brokers. They are not authorized to take a position on
the market. Their job is to find a buyer and a seller for the same amount for the
given currencies. Their remuneration is in the form of brokerage. They are
constantly in liaison with banks and in search of counterparties. A large portion of
foreign exchange transactions is conducted through brokers. While they tend to
specialize in certain currencies, they virtually handle all major currencies. Brokers
exist because they lower the dealers' costs, reduce their risks and provide
anonymity. In interbank trade, brokers charge a small commission of around 0.01
per cent of the transaction amount. In illiquid currency dealings, they charge higher
commissions. Payment of commission is split between trading parties. Banks are
able to avoid undesirable positions with the help of brokers.
Arbitrageurs make gains by discovering price discrepancies that allow them to buy
cheap and sell dear. Their operations are risk-free, hi a free and open market, the
scope for currency arbitrage tends to be low and it is, by and large, accessible only
to dealer banks.
19

Unlike arbitrageurs, speculators expose themselves to risk. Speculation gives rise

to financial transactions that develop when an individual's expectations differ from
the expectations of the market. Speculators transact in foreign exchange primarily
because of an anticipated but uncertain gain as a result of an exchange rate change.
An open position denominated in foreign currency constitutes speculation. Banks
or corporate, when they accept either a net asset or a net liability in foreign
currency, are indulging in speculation.
Speculators are classified as bulls and bears. A bull expects a currency to become
more expensive in the future. He buys the currency either Spot or Forward today in
the belief that he can sell it at a higher price in the future. Bulls take a long position
in the particular currency. A bear expects a particular currency to become cheaper
in the future. He sells either Spot or Forward today in the hope of buying it back at
a cheaper rate in the future. Bears take a short position on a particular currency.
Central Banks
Central banks intervene in the market to reduce fluctuations of the domestic
currency and to ensure an exchange rate compatible with the requirements of the
national economy. Their objective is not to make profit out of these interventions
but to influence the value of national currency in the interest of country's economic
well being. For example, if rupee shows signs of depreciating, central bank may
release (sell) a certain amount of foreign currency. This increased supply of foreign
currency will halt the depreciation of rupee. The reverse operation may be done to
stop rupee from appreciation.
Equilibrium on Spot Markets
In inter-bank operations, the dealers indicate a buying rate and a selling rate
without knowing whether the counterparty wants to buy or sell currencies. That is
20

why it is important to give 'good' quotations. When differences exist between the
Spot rates of two banks, the arbitrageurs may proceed to make arbitrage gains
without any risk. Arbitrage enables the re-establishment of equilibrium on the
exchange markets. However, as new demands and new offers come on the market,
this equilibrium is disturbed constantly.
On the Spot exchange market, two types of arbitrages are possible:
(1) Geographical arbitrage, and
(2) Triangular arbitrage.
Geographical Arbitrage
Geographical arbitrage consists of buying a currency where it is the cheapest, and
selling -it where it is the dearest so as to make a profit from the difference in the
rates. In order to make an arbitrage gain, the selling rate of one bank needs to be
lower than the buying rate of the other bank.

Triangular Arbitrage
Triangular arbitrage occurs when three currencies are involved. This can be
realised when there is distortion between cross rates of currencies.
The arbitrage operations on the market continue to take place as long as there are
significant differences between quoted and cross rates. These arbitrages lead to the
reestablishment of the equilibrium on currency markets.
Forward Market

21

Like the Spot exchange market, the Forward exchange market is not located at any
specific place. The banks selling or buying currencies forward constitute the
Forward market. This market fixes the rates at which currencies will be exchanged
on a future date. The Forward market primarily deals in currencies that are
frequently used and are in demand in the international trade, such as US dollar,
Pound Sterling, Deutschmark, French franc, Swiss franc, Belgian franc, Dutch
Guilder, Italian lira, Canadian dollar and Japanese yen. There is little or almost no
Forward market for the currencies of developing countries. Forward rates are
quoted with reference to Spot rates as they are always traded at a premium or
discount vis-a-vis Spot rate in the inter-bank market. The bid-ask spread increases
with the forward time horizon.
Importance of Forward Markets
The Forward market can be divided into two partsOutright Forward and Swap
market. The Outright Forward market resembles the Spot market, with the
difference that the period of delivery is much greater than 48 hours in the Forward
market. A major part of its operations is for clients or enterprises who decide to
cover against exchange risks emanating from trade operations.
The Forward Swap market comes second in importance to the Spot market and it is
growing very fast. The currency swap consists of two separate operations of
borrowing and of lending. That is, a Swap deal involves borrowing a sum in one
currency for short duration and lending an equivalent amount in another currency
for the same duration. US dollar occupies an important place on the Swap market.
It is involved in 95 per cent of transactions.
Major participants in the Forward market are banks, arbitrageurs, speculators,
exchange brokers and hedgers. Commercial banks operate on this market through
22

their dealers, either to cover the orders of their clients or to place their own cash in
different currencies. Arbitrageurs look for a profit without risk, by operating on the
interest rate differences and exchange rates. Speculators take risk in the hope of
making a gain in case their anticipation regarding the movement of rates turns out
to be correct. As regards brokers, their job involves match making between seekers
and suppliers of currencies on the Spot market. Hedgers are the enterprises or the
financial institutions who want to cover themselves against the exchange risk.

Quotations on Forward Markets

Forward rates are quoted for different maturities such as one month, two months,
three months, six months and one year. Usually, the maturity dates are closer to
month-ends. Apart from the standardised pattern of maturity periods, banks may
quote different maturity spans, to cater to the market/client needs.
The quotations may be given either in outright manner or through Swap points.
Outright rates indicate complete figures for buying and selling

Quotation for Odd Number of Days

Normally, forward quotations are made for standard maturity periods such as 1
month, 2 months, 3 months, 6 months and 9 months. For odd (broken) period, the
rates can be negotiated. However, a convenient way is to interpolate the rates
between two standard dates.
Formation of Forward Rates

23

Currency Forward rate links exchange market and money market. In order to know
Forward buying and selling rates, it is necessary to know interest rates. Forward
rate is based on Spot rate and differential of interest rates of two currencies. If
currency A has a rate of interest higher than currency B, currency A will be quoted
at Forward discount in relation to currency B or inversely, currency B will be at
Forward premium with respect to currency A.

LEVELS OF FOREIGN EXCHANGE MARKET

Probably the most influential players in the forex world are the central banks and
the Governments they represent. More often than not you see Central Banks world
executing policy matters in line with the existing Governments political ideology,
the economic demands and the steps necessary to keep the economic situation of a
country in good state. The central banks monetary policy generally outlines the
24

particular countrys vision for growth, how they are tackling issues like
inflation/deflation and stance on interest rates. The Central Banks stance on
interest rates is crucial as this is what determines the money supply for a country
and its currency rate globally. While many countries have strict Govt intervention
while some Central Banks have relative independence in their day to day function.
However they continue to be a core player in the forex market essentially to
execute the Govt key monetary goals by maintaining the foreign reserve volumes.
These concerns also make them very active stakeholders in the world of forex
trades and their deep pockets ensure any move by any of these banks can bring
about significant change.
There are four levels of participants in the foreign exchange market.
At the first level, are tourists, importers, exporters, investors, and so on. These are
the immediate users and suppliers of foreign currencies. At the second level, are
the commercial banks, which act as clearing houses between users and earners of
foreign exchange. At the third level, are foreign exchange brokers through whom
the nations commercial banks even out their foreign exchange inflows and
outflows among themselves. Finally at the fourth and the highest level is the
nations central bank, which acts as the lender or buyer of last resort when the
nations total foreign exchange earnings and expenditure are unequal. The central
then either draws down its foreign reserves or adds to them.
CUSTOMERS:
The customers who are engaged in foreign trade participate in foreign
exchange markets by availing of the services of banks. Exporters require
converting the dollars into rupee and importers require converting rupee into the
25

dollars as they have to pay in dollars for the goods / services they have imported.
Similar types of services may be required for setting any international obligation
i.e., payment of technical know-how fees or repayment of foreign debt, etc.
COMMERCIAL BANKS
They are most active players in the forex market. Commercial banks
dealing with international transactions offer services for conversation of one
currency into another. These banks are specialised in international trade and other
transactions. They have wide network of branches. Generally, commercial banks
act as intermediary between exporter and importer who are situated in different
countries. Typically banks buy foreign exchange from exporters and sells foreign
exchange to the importers of the goods. Similarly, the banks for executing the
orders of other customers, who are engaged in international transaction, not
necessarily on the account of trade alone, buy and sell foreign exchange. As every
time the foreign exchange bought and sold may not be equal banks are left with the
overbought or oversold position. If a bank buys more foreign exchange than what
it sells, it is said to be in overbought/plus/long position. In case bank sells more
foreign exchange than what it buys, it is said to be in oversold/minus/short
position. The bank, with open position, in order to avoid risk on account of
exchange rate movement, covers its position in the market. If the bank is having
oversold position it will buy from the market and if it has overbought position it
will sell in the market. This action of bank may trigger a spate of buying and
selling

of

foreign

exchange

in

the

market.

Commercial

banks

have

following objectives for being active in the foreign exchange market:

1. They render better service by offering competitive rates to their customers engaged
in international trade.

26

2.They are in a better position to manage risks arising out of exchange rate
fluctuations.
3. Foreign exchange business is a profitable activity and thus such banks are in a
position to generate more profits for themselves.
4.They can manage their integrated treasury in a more efficient manner.
CENTRAL BANKS
In most of the countries central bank have been charged with the
responsibility of maintaining the external value of the domestic currency. If the
country is following a fixed exchange rate system, the central bank has to take
necessary steps to maintain the parity, i.e., the rate so fixed. Even under floating
exchange rate system, the central bank has to ensure orderliness in the movement
of exchange rates. Generally this is achieved by the intervention of the bank.
Sometimes this becomes a concerted effort of central banks of more than one
country.
Exchange rate management:
Though sometimes this is achieved through intervention, yet where a
central bank is required to maintain external rate of domestic currency at a level or
in a band so fixed, they deal in the market to achieve the desired objective

Reserve management:
Central bank of the country is mainly concerned with the investment of the
countries foreign exchange reserve in a stable proportions in range of currencies
and in a range of assets in each currency. These proportions are, inter alias,
influenced by the structure of official external assets/liabilities. For this bank has
involved certain amount of switching between currencies.
27

Central banks are conservative in their approach and they do not deal in
foreign exchange markets for making profits. However, there have been some
aggressive central banks but market has punished them very badly for their
adventurism. In the recent past Malaysian Central bank, Bank Negara lost billions
of dollars in foreign exchange transactions.
Intervention by Central Bank
It is truly said that foreign exchange is as good as any other commodity. If a
country is following floating rate system and there are no controls on capital
transfers, then the exchange rate will be influenced by the economic law of
demand and supply. If supply of foreign exchange is more than demand during a
particular period then the foreign exchange will become cheaper. On the contrary,
if the supply is less than the demand during the particular period then the foreign
exchange will become costlier. The exporters of goods and services mainly supply
foreign exchange to the market. If there are no control over foreign investors are
also suppliers of foreign exchange.
During a particular period if demand for foreign exchange increases than
the supply, it will raise the price of foreign exchange, in terms of domestic
currency, to an unrealistic level. This will no doubt make the imports costlier and
thus protect the domestic industry but this also gives boost to the exports.
However, in the short run it can disturb the equilibrium and orderliness of the
foreign exchange markets. The central bank will then step forward to supply
foreign exchange to meet the demand for the same. This will smoothen the market.
The central bank achieves this by selling the foreign exchange and buying or
28

absorbing domestic currency. Thus demand for domestic currency which, coupled
with supply of foreign exchange, will maintain the price of foreign currency at
desired level. This is called intervention by central bank.
If a country, as a matter of policy, follows fixed exchange rate system, the
central bank is required to maintain exchange rate generally within a well-defined
narrow band. Whenever the value of the domestic currency approaches upper or
lower limit of such a band, the central bank intervenes to counteract the forces of
demand and supply through intervention.
In India, the central bank of the country, the Reserve Bank of India, has
been enjoined upon to maintain the external value of rupee. Until March 1, 1993,
under section 40 of the Reserve Bank of India act, 1934, Reserve Bank was
obliged to buy from and sell to authorised persons i.e., ADs foreign exchange.
However, since March 1, 1993, under Modified Liberalised Exchange Rate
Management System (Modified LERMS), Reserve Bank is not obliged to sell
foreign exchange. Also, it will purchase foreign exchange at market rates. Again,
with a view to maintain external value of rupee, Reserve Bank has given the right
to intervene in the foreign exchange markets.

EXCHANGE BROKERS
Forex brokers play a very important role in the foreign exchange markets.
However the extent to which services of forex brokers are utilized depends on the
tradition and practice prevailing at a particular forex market centre. In India
dealing is done in interbank market through forex brokers. In India as per FEDAI
29

guidelines the ADs are free to deal directly among themselves without going
through brokers. The forex brokers are not allowed to deal on their own account all
over the world and also in India.
How Exchange Brokers Work?
Banks seeking to trade display their bid and offer rates on their respective
pages of Reuters screen, but these prices are indicative only. On inquiry from
brokers they quote firm prices on telephone. In this way, the brokers can locate the
most competitive buying and selling prices, and these prices are immediately
broadcast to a large number of banks by means of hotlines/loudspeakers in the
banks dealing room/contacts many dealing banks through calling assistants
employed by the broking firm. If any bank wants to respond to these prices thus
made available, the counter party bank does this by clinching the deal. Brokers do
not disclose counter party banks name until the buying and selling banks have
concluded the deal. Once the deal is struck the broker exchange the names of the
bank who has bought and who has sold. The brokers charge commission for the
services rendered.

In India brokers commission is fixed by FEDAI.

SPECULATORS

30

Speculators play a very active role in the foreign exchange markets. In fact
major chunk of the foreign exchange dealings in forex markets in on account of
speculators and speculative activities.
The speculators are the major players in the forex markets.
Banks dealing are the major speculators in the forex markets with a view to
make profit on account of favourable movement in exchange rate, take position
i.e., if they feel the rate of particular currency is likely to go up in short term. They
buy that currency and sell it as soon as they are able to make a quick profit.
Corporations particularly Multinational Corporations and Transnational
Corporations having business operations beyond their national frontiers and on
account of their cash flows. Being large and in multi-currencies get into foreign
exchange exposures. With a view to take advantage of foreign rate movement in
their favour they either delay covering exposures or does not cover until cash flow
materialize. Sometimes they take position so as to take advantage of the exchange
rate movement in their favour and for undertaking this activity, they have state of
the art dealing rooms. In India, some of the big corporate are as the exchange
control have been loosened, booking and cancelling forward contracts, and a times
the same borders on speculative activity.
Governments narrow or invest in foreign securities and delay coverage of
the exposure on account of such deals.
Individual like share dealings also undertake the activity of buying and
selling of foreign exchange for booking short-term profits. They also buy foreign
31

currency stocks, bonds and other assets without covering the foreign exchange
exposure risk. This also results in speculations.
Corporate entities take positions in commodities whose prices are
expressed in foreign currency. This also adds to speculative activity.
The speculators or traders in the forex market cause significant swings in
foreign exchange rates. These swings, particular sudden swings, do not do any
good either to the national or international trade and can be detrimental not only to
national economy but global business also. However, to be far to the speculators,
they provide the much need liquidity and depth to foreign exchange markets. This
is necessary to keep bid-offer which spreads to the minimum. Similarly, liquidity
also helps in executing large or unique orders without causing any ripples in the
foreign exchange markets. One of the views held is that speculative activity
provides much needed efficiency to foreign exchange markets. Therefore we can
say that speculation is necessary evil in forex markets.
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.
ARBITRAGE
32

Arbitrage is the act of simultaneously buying a currency in one

market and selling it in another to make a profit by taking advantage of exchange
rate differences in two markets. If the arbitrages are confined to two markets only
it is said two-point arbitrage. If they extend to three or more markets they are
known as three-point or multi-point arbitrage. Those who deal with arbitrage
are called arbitrageurs.
A Spot sale of a currency when combined with a forward repurchase in
a single transaction is called Currency Swap". The Swap rate is the difference
between spot and forward exchange rates in currency swap.
Arbitrage opportunities may exist in a foreign exchange market..
Suppose the rate of exchange is 1 US $ = `. 50 in US market and 1 US $ = `. 55 in
Indian Markets, then an arbitrageur can buy dollars in US market and sell it in
Indian market and get a profit of `. 5 per dollar..
In todays modern well connected and advanced markets, arbitrageurs
(which are mainly banks) can spot it quickly and exploit the opportunity. Such
opportunities vanish over a period of time and equilibrium is again maintained.
For Eg.
Bank A

` / $ = 50.50 / 50.55

Bank B

` / $ = 50.40 / 50.45

The above rates are very close. The arbitrageur may take advantage and he
can purchase $ 1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A
at `. 50.50, thus making a profit of 0.05. The total profit would be (1,00,000 x 0.05)
= `. 5,000. The profit is earned without any risk and blocking of capital.
B. ARBITRAGE.AND INTEREST RATE
Interest arbitrage refers to differences in interest rates in domestic
market and in overseas markets. If interest rates are higher in overseas market than
33

in domestic market, an investor may invest in overseas market to take the

advantage of interest differential.
Interest arbitrage may be covered and uncovered.
1)

Uncovered Arbitrage
In this system, arbitrageurs would take a risk to earn profit by

investing in a high interest bearing risk free securities in a foreign market. His
earnings would be according to his calculations if the currency of foreign market
where he invested does not depreciate. If depreciation is equal to the difference in
interest rate, the investor would not incur loss. However, if depreciation is more
than interest rate, then the arbitrageur will incur loss.
For Eg. In New York interest rate on 6 month Treasury Bill is 6% and
in Spain it is 8%. An US investor may convert US dollars in EURO and invest in
Spain, thereby taking an advantage of +2% interest rate. Now when bill matures,
US investor will convert EURO into dollars. However, by that time EURO may
have depreciated the US investor will get less dollars per EURO. If EURO
depreciates by 1%, US investor will gain only +1% (+2 1%). If EURO
depreciates by 2% or more, US investor will not gain anything or incur loss. If
EURO appreciates, US investor will gain, +2% and interest rate differential

2)

Covered Arbitrage
International investors would like to avoid the foreign exchange risk, thus

interest arbitrage is usually covered. The investor converts the domestic currency
for foreign currency at the current spot rate for the purpose of investment. At the
34

same time, investor sells forward the amount of foreign currency which he is
investing plus the interest that he will earn so as to coincide with maturity of
foreign investment.
The covered interest arbitrage refers to spot purchase of foreign currency to
make investment and offsetting simultaneous forward sale of foreign currency to
cover foreign exchange risk. When treasury bills mature, the investor will get the
domestic currency equivalent of foreign investment plus interest without a foreign
exchange risk.

ROLE OF RBI IN FOREIGN EXCHANGE MARKET

The role of RBI in the foreign exchange market is revealed by the provisions of
FERA (1973).
35

Administrative Authority
The RBI is the administrative authority for exchange control in India. The RBI has
been given powers to issue licenses to those who are involved in foreign exchange
transactions.
Authorized Dealers
The RBI has appointed a number of authorized dealers. They are permitted to carry
out ail transactions involving foreign exchange. The above provision is laid down
in Section 3 of FERA.
Issue Of Directions
The 'Exchange Control Manual' contains all directions and procedures given by
RBI to authorized dealers from time to time.
Fixation Of Exchange Rates :The RBI has the responsibility of fixing the exchange value of home currency in
terms of other currencies. This rate is known as official rate of exchange. All
authorized dealers and money lenders are required to follow this rate strictly in all
their foreign exchange transactions.

Foreign Investments :-

36

Non-residents can make investments in India only after obtaining the necessary
permission from Central Government or RBI. Great investment opportunities are
provided to non-resident Indians.
Foreign Travel
Indian residents can get foreign exchange released from RBI upto a specified
amount for travelling abroad through proper application.
Import Trade
The RBI regulates import trade. Imports are permitted only against proper
licenses. The items of imports that can be imported freely are specified under Open
General License.
Export Trade
The RBI controls export trade. Export of gold and jewellery are allowed only with
special permission from RBI.
Gold. Silver. Currency Notes Etc.
In recent years, the limits fixed for bringing gold, silver, currency notes etc. has
been relaxed considerably.
Submission Of Returns
All foreign exchange transactions made by authorized dealers must be reported to
RBI. This enables the RBI to have a close watch on foreign exchange dealings in
India

37

Thus, from above points we can say that RBI is the apex bank that intervenes,
supervises, controls the foreign exchange markets in order to create an stable and
active exchange market.
FERA AND EXCHANGE CONTROLS :In 1939, under the Defence of India Rules (DIR), the Exchange Control was
imposed. In 1973, FERA was amended. India has accepted a system of multilateral
payments, i.e., the rupee should be freely convertible to currencies of all member
countries of IMF. But the RBI adopted exchange controls under FERA, in order to
conserve India's Foreign exchange reserves.
Foreign exchange was rationed out strictly according to availability.
Purchase and Sale of foreign securities by Indians were strictly controlled.
All external payments had to be made through authorized dealers controlled by
RBI.
Exporters who acquired foreign exchange had to surrender their earnings to
authorized dealers and get rupees in exchange Imports were rigidly controlled and
imports of unnecessary items were prohibited.
The RBI as the apex bank supervised and controlled the foreign exchange market.
The RBI decided the exchange rate of rupee in terms of pound sterling on a day to
day basis. It would sell pound sterling against specific demand and would also buy
US dollar, pound sterling, German mark and Japanese yen. In 1992, the Pound
sterling was replaced by dollar as intervention currency. Hence, RBI would sell
only dollar and continue to buy Dollar, Pound, Mark and Yen.
In New Industrial Policy of 1991, the government announced major concessions to
FERA companies.

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FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)

The relaxation of FERA encouraged the inflow of foreign capital and the growth of
Multi National Corporations (MNC's) in India. FERA was replaced by FEMA in
1999.
Under FERA RBI's permission was necessary. Under FEMA, except for
Section 3 (relates to foreign exchange) no other permission is required from RBI.
The purpose of FEMA is to facilitate external trade and payments and promote
orderly development and maintenance of foreign exchange market in India.
FEMA has simplified the provisions of FERA. The two key aspects of FEMA are
the relaxation of foreign exchange controls and move towards capital account
convertibility. To facilitate foreign trade restrictions drawls of foreign exchange for
current and capital account transactions have been removed. FEMA regulates both
import and export trade methods of payment.
If any person contravenes any provisions of FEMA, he shall be liable to a penalty
up to twice the sum involved in such contravention. There would be no punishment
by way of imprisonment.

39

CONCLUSION

The forex markets have become the worlds most liquid and continuous markets
with trillions of dollars being traded daily. Whether trading in the spot market, the
futures markets, or the options markets, speculators and hedgers can find an
instrument and the leverage that meet their needs. From complex speculative
strategies to everyday hedging techniques, the forex markets provide the forum for
dealing with currency fluctuations.
Although foreign exchange may be confusing, in todays global marketplace, there
is a critical need for almost everyone to understand foreign exchange like never
before. As the world shrinks, there is an ever-increasing likelihood that we will be
required to address the risks associated with the fact that there are different
currencies used all around the world and that these currencies will have an
immediate impact on our world. We must be able to evaluate the effects of, and
actively respond to, changes in exchange rates with respect to our consumption
decisions, investment portfolios, business plans, government policies, and other
life choices (both financial and otherwise). Moreover, there is an ever-increasing
probability that we will have to transact in these foreign exchange marketsin our
personal or professional life.

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