FOREIGN EXCHANGE MARKET

INTRODUCTION:

The foreign exchange market is a market where foreign currencies are bought and sold.
Foreign exchange means the money of a foreign country; that is, foreign currency bank
balances banknotes, checks and drafts. The foreign exchange market is alternatively
known as Forex (or FX) Market. The Forex market was founded in 1970’s.i t Comprises of
trading and selling of currencies. It refers to buying the currency of one country, while
selling the currency of another country. The FOREX market is the largest and the most
liquid financial market in the world. A foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount of one currency will be delivered for some
other currency at a specified date. They are many types of transactions that involve the
purchase and sale of different currencies.

 Foreign exchange market is over the counter market.

 It operate round the clock
 It involves normally transaction of strong, stable and convertible currencies.

MAJOR PARTICIPANTS

Customer buying US$ for Indian rupee

Buyers local bank

Major banks representing inter-bank market Foreign exchange broker

Sellers local bank

Customer selling US dollar to get Indian rupees

  All Scheduled Commercial Banks (Authorized Dealers only).
 Reserve Bank of India (RBI).
 Corporate Treasuries.
 Public Sector/Government.
 Inter Bank Brokerage Houses.
 Resident Indians
 Non Residents
 Speculators and Arbitragers

Foreign exchange regime:

 Fixed:

-Austria, France, Italy, Spain

 Pegged:

-Thailand, S. Korea

 Managed Float:

-India, Bangladesh, Singapore

 Free Floating:

-USA, UK, Japan

Short Position = supply of a currency < demand for currency

Long position = supply of a currency > demand for currency

Square position = supply of a currency equal to demand for currency

SPOT MARKET
Features:

The foreign exchange market is classified either as spot market or as forward market. It
is the timing of actual delivery of foreign exchange that distinguishes between spot market and
forward market transactions. In the spot market, currencies are traded for immediate delivery
at a rate existing on the day of transaction. For making book-keeping entries, delivery takes tow
working days after the transaction is complete although in the case of Canadian dollar the
delivery of currencies takes place the very next working day. if the currency is delivered the
same day, it is known as the value same day contract. If it is done the next day, the contract is
known as the value next day contract.
Currency Arbitrage in Spot Market:

With fast development in the telecommunication system rates are expected to be

uniform in different foreign exchange markets. Buy a particular currency at cheaper rate in one
market and sell it at a higher rate in the other. This process is known as currency arbitrage. This
process influences the demand for and supply of the particular currency in the two markets
which leads ultimately to removal of inconsistency in the value of currencies in two markets.

Speculation in spot market:

Speculation in the spot market occurs when the speculator anticipates a change in the value of
a currency.

FORWARD MARKET
In the forward market, contracts are made to buy and sell currencies for future delivery,
say, after a fortnight, one month, two month, and so on. The rate of exchange for the
transaction is agreed upon on the very day the deal is finalized. The forward rates with varying
maturity are quoted in the newspapers and those rates from the basis of the contract.

Forward market hedging:

The forward market is used not only by the arbitrageurs but by the hedgers too. The risk
is reduced or hedged through forward market transactions. Under the process of hedging
currencies are bought and sold forward.

Export long position----------------- sale of foreign currency

Import short position-----------------purchase of foreign currency

Speculation in forward market:

In addition to the arbitrageur or the hedger, speculators are also very active in forward
market operations. Their purpose is not to reduce the risk but to reap profits from the changes
rates.

Swapping of forward contracts:

The purpose of swap in the forward contract is to reap profits. There are two kinds of
swap. One is known as an option forward while the other is known as a forward-forward swap.
In the former, the basis of swap is the difference between the spot rate and the forward rate
and in the latter; it is the difference between the two forward rates.
 Besides spot and forward markets, foreign currencies are traded in the market for
currency futures and the market for currency options. The market for currency futures and
options is known as the market for derivatives.

FUTURES MARKET
Currency futures market is an organized market and not over the counter for the sale
and purchase of specified amount of currencies. Currency futures are traded only in limited
number of currencies. The size of contract is standardized involving a fixed amount of different
currencies. The date of delivery is also fixed normally on the third Wednesday of the month.

OPTIONS
Currency options contract confers on options buyer privilege of not exercising when
exchange rate is not in his favour.

TYPES OF OPTION MARKET

Listed currency options market: the first such market was set up at the Philadelphia stock
exchange in December 1982. Initially trading was done in British pounds, but subsequently
some other currencies such as the Australian dollar, Canadian dollar, deutsche mark, French
franc, Japanese yen and Swiss franc were added to the list. Listed currency options are standard
contracts.

Currency futures options market: in this market which is basically a listed currency options
market, the contracts present a mixture of currency futures and currency options. They are
basically currency options because the buyer of the contract possesses the privilege of either
exercising the option or letting it expire.

Over-the –counter options market: the second type of market for currency options is known as
the interbank currency options market or the over the counter market. Such a market is
centered in New York and London and the size of transactions is many times that of the market
in the organized exchanges.
TYPES OF OPTIONS
There are two types of options. In a call option, the buyer of the option agrees to buy
the underlying currency, while in a put option contract; the buyer of the option agrees to sell
the underlying currency.

European options cannot be exercised before maturity. American options can be.

Option buyer: a person or a firm who gets the right to buy options, is also known as the option
holder.

Option seller: the party having obligation to perform if option is exercised or the party who
charges the premium for granting such privilege to the buyer, is also known as the option
writer.

Call option: an option bought by an option buyer for buying a particular currency.

Put option: an option bought by an option buyer to sell a particular currency.

Exercise price: the price at which options are exercised is also known as the strike price.

At the money: the situation is known as the at the money when the strike price is equal to the
spot price on the maturity date.

In the money: the situation is known as in the money If in case of a call option the strike price is
lower than the spot rate. In case of a put option, an in the money situation warrants that the
spot rate should be lower than the strike price.

Out the money: the spot rate should be lower than the strike rate in case of a call option, and
higher than the strike rate in case of put option.

Time value of money: in the case of call option, it is the excess of the current spot rate over the
strike price. If S is the current spot rate and X the strike price , the intrinsic value of a call option
is

I call = S-X
The intrinsic value of a put option will naturally be represented by an excess of strike price over
the current spot rate. In other words the intrinsic value of put option is

I put = X-S
Payoff for buyer of call options buyer of put option

Payoff for writer of call options seller of put option