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Students of SYBFM present the topic:-
Foreign Exchange Markets
lntroduction
Forex (Foregn Exchange) s the nternatona fnanca market
used for trade of word currences. It has been workng snce 70s
of the 20th century - from the moment when the bggest word
natons decded to swtch from fxed exchange rates to foatng
ones.
Day oume of Forex trade exceeds 4 tron nted States
doars, and ths number s aways growng.
an currency for Forex operatons s the nted States doar
(SD).
Accordng to au Enzg, "he foregn exchange market s the
system n whch the conerson of one natona currency n to
another takes pace wth transferrng money from one country to
another."
Accordng to Kndeberger, "It s pace where foregn moneys are
bought and sod."
In smpe words, the foregn exchange market s a market n
whch natona currences are bought and sod aganst one
another. here are arge numbers of foregn transactons such as
buyng goods abroad, stng foregn country for any purpose.
Correspondng naton n whose currency the transacton s to be
fufed. he foregn exchange market prodes the foregn
currency aganst any natona currency. Howeer, t s to be
understood that unke other markets, ths market s not
restrcted to any partcuar country or any geographc area.
here are arge numbers of deaers' nstruments such as
exchange bs, bank drafts, teegraphc transfers (), etc. here
are certan other deaers such as brokers, acceptance houses as
we as the centra bank and treasury of the naton.
The foreign exchange market is unique because of
Its huge tradng oume, eadng to hgh qudty;
Its geographca dsperson;
Its contnuous operaton: 24 hours a day except weekends,
.e. tradng from 20:15 G on Sunday unt 22:00 G
Frday;
he arety of factors that affect exchange rates;
he ow margns of reate proft compared wth other
markets of fxed ncome; and
he use of eerage to enhance proft margns wth respect
to account sze.
History
Hstorcay the aue of goods was expressed through some
other goods, for exampe - a barter economy where ndduas
exchange goods. he obous dsadantages of such a system
encouraged estabshment of more generay accepted and
understand means of goods exchange ong tme ago n hstory -
to set a common scae of aue. In dfferent paces eerythng
from teeth to |ewery has sered ths purpose but ater metas,
and especay god and ser, were ntroduced as an accepted
means of payment, and aso a reabe form of aue storage.
Orgnay, cons were bascay mnted from the meta, but
stabe potca systems ntroduced a paper form of IOs (I owe
you) whch ganed wde acceptance durng the dde Ages. Such
paper IOs became the bass of our modern currences.
Before Frst Word War most centra banks supported
currences wth god. Een though banknotes aways coud be
exchanged for god, n reaty ths dd not happen that often,
deeopng an understandng that fu reseres are not reay
needed.
Sometmes huge suppy of banknotes wthout god support ed
to gant nfaton and hence potca nstabty. o protect
natona nterests foregn exchange contros were ntroduced to
demand more responsbty from market payers.
Coser to the end of Word War II, the Bretton Woods
agreement was sgned as the ntate of the SA n |uy 1944.
he Bretton Woods Conference re|ected |ohn aynard Keynes
suggeston for a new word resere currency n faour of a
system but on the S doar. Other nternatona nsttutons
such as the IF, the Word Bank and GA (Genera Agreement
on arffs and rade) were created n the same perod as the
emergng ctors of WW2 searched for a way to aod the
destabsng monetary crses whch ed to the war. he Bretton
Woods agreement resuted n a system of fxed exchange rates
that party renstated the god standard, fxng the S doar at
SD35oz and fxng the other man currences to the doar - and
was ntended to be permanent.
he Bretton Woods system came under ncreasng pressure as
natona economes moed n dfferent drectons durng the
sxtes. A number of reagnments kept the system ae for a
ong tme, but eentuay Bretton Woods coapsed n the eary
seentes foowng presdent xon's suspenson of the god
conertbty n August 1971. he doar was no onger sutabe
as the soe nternatona currency at a tme when t was under
seere pressure from ncreasng S budget and trade defcts.
he foowng decades hae seen foregn exchange tradng
deeop nto the argest goba market by far. estrctons on
capta fows hae been remoed n most countres, eang the
market forces free to ad|ust foregn exchange rates accordng to
ther perceed aues.
But the dea of fxed exchange rates has by no means ded.
he EEC (European Economc Communty) ntroduced a new
system of fxed exchange rates n 1979, the European onetary
System. hs attempt to fx exchange rates met wth near
extncton n 1992-93, when pent-up economc pressures forced
deauatons of a number of weak European currences.
eertheess, the quest for currency stabty has contnued n
Europe wth the renewed attempt to not ony fx currences but
actuay repace many of them wth the Euro n 2001.
he ack of sustanabty n fxed foregn exchange rates
ganed new reeance wth the eents n South East Asa n the
atter part of 1997, where currency after currency was deaued
aganst the S doar, eang other fxed exchange rates, n
partcuar n South Amerca, ookng ery unerabe.
But whe commerca companes hae had to face a much
more oate currency enronment n recent years, nestors
and fnanca nsttutons hae found a new payground. he sze
of foregn exchange markets now dwarfs any other nestment
market by a arge factor. It s estmated that more than SD
3,000 bon s traded eery day, far more than the word's stock
and bond markets combned.
Functions of Foreign Exchange Market
A Transfer Function: As mentoned aboe, the foregn
exchange markets are exchange markets engaged n
transferrng the purchasng power between two natons and two
currences. It s prme functon of ths market. In smpe terms, t
s conerson of one currency nto another such as conertng
Indan s. nto .S. and ce ersa at some rate. arous
nstruments ke bank drafts, exchange bs, are used for
transferrng the purchasng power. In ths regard nternatona
cearng to both the drecton s mportant to because t smpfes
the conduct of nternatona trade as we as capta moements
from one country to another.
B Credit Function : nder ths functon the foregn exchange
market prodes credt to the traders such as exporters and
mporters. Exporters can get credt such as reshpment and post-
shpment credt. ecenty started Euro-Doar market s a eadng
credt market at nternatona ee. hs functon of makng
credt aaabe pays a cruca roe n growth and expanson of
the nternatona trade.
C Hedging : Hedgng s a specfc functon. nder ths functon
the foregn exchange market tres to protect the nterest of the
persons deang n the market from any unforeseen changes n
the exchange rate. he exchange rates (prce of one currency
expressed n another currency) under free market stuaton can
go up and down. hs can ether brng gans or osses to the
concerned partes. Foregn exchange market guards the nterest
of both exports as we as mporters, aganst any changes n the
exchange rate.
Drimary
he prmary functon of foregn currency exchange markets s to
conert the currency of one country nto another currency. For
exampe, the .S. doar may be changed nto excan esos or
Engsh ounds. he amount of currency conerted depends on
the exchange rate, whch can be fxed or can fuctuate. he .S.
doar s a currency that has a fuctuatng exchange rate that s
based on market demand. Some countres, ke Chna, hae a
fxed exchange rate determned by ther centra bank.
Elnternational Transactions
Foregn currency exchange markets sere to factate
nternatona fnanca transactons. hese transactons may be
the purchasng and seng of goods, drect nestment n
budngs and equpment n a foregn country or the purchase of
nestment ke foregn bonds. For exampe, a .S.-based
company may want to purchase goods manufactured n Chna.
he foregn currency exchange market aows them to exchange
.S. doars and make the purchase n Chnese B (renmnb,
the currency of the eope's epubc of Chna).
FCurrency Value
he aue of a country's currency can nfuence nternatona
trade, consumers' purchasng power and nfaton. Centra banks
of a county or regon, ke the .S. Federa esere, seek to
mnmze the mpact of currency fuctuatons. he foregn
currency exchange market functons as a too for centra banks
to contro the aue of ther currency by buyng or seng
currency, whch nfuences the tota amount n wordwde
crcuaton.
lnvestment
Fund managers and nestment professonas use the foregn
currency exchange market to hep dersfy ther portfoos and
potentay ncrease ther returns. hrough cacuated rsks,
nestors can bet on a change n the prce or exchange rate of a
currency. |ust ke wth the stocks, f currency s purchased at a
ow prce and sod at a hgher prce, the nestor makes money.
HLoss rotection
Internatona companes that work n mutpe countres are
sub|ect to gans and osses based on exchange rate fuctuatons.
o hep preent osses, companes can make forward
transactons where they make a bndng agreement to exchange
currency for another currency at a fxed rate. hs functon of the
foregn currency exchange market heps a company mnmze
the rsk of foregn exchange on future expenses. For exampe, f
a .S.-based company paces an order wth a frm n awan that
w be ready n fe months, the company can enter a forward
transacton agreement that fxes the prce based on the current
exchange rate at the tme of order. he company knows the
aue and cost of the purchase and w not be ht wth a future
oss based on a change n exchange rates.
Advantages of Forex trading
High leverage
Startng from a mnmum of 100:1, Forex markets offer ts
traders wth huge amounts of eerage whch means that fat
profts can be produced by nestng sma amounts of deposts.
o commission
If deang wth a fnanca market on day bass, the reguar
nestors or traders are the ones who are reay benefted by the
free of commsson tradng. he currency tradng market ets
ts traders keep a whoe 100 of ther tradng profts.
Superior liquidity
Wth most of the currency transactons comprsng of 7 man
currency pars, the huge oume and the goba tradng aspect
heps these currences exhbt prce stabty, tte sppage,
narrow spreads and hgh ees of qudty.
rofitability
Beng an oer the counter market, the tradng done at Forex can
be known as oer the counter tradng, wheren, a trader aways
buys one currency and ses of the other one n rea tme. here
s no organzatona pre|udce n the market and eery nestor
has the equa prospects for proft n t.
24 hours trading
Forex currency tradng market offers ts traders wth a 24 hour
tradng openng, wheren, a Forex nestor can trade any tme of
the day, whateer suts hmher, as the market s open for
tradng 24 hours a day, from Sunday 5:00 pm (E) to Frday 4:30
pm.
hs ges the Forex traders a choce to opt for tmng for the
trade accordng to ther conenence.
Disadvantages of Forex trading
High Leverage
Whe hgh eerage seres as an adantage to attract traders to
the market, t can at tmes aso act as a dsadantage for them.
Wth such hgh ees of eerage aaabe to traders n the
Forex market, comes an equay hgh ee of danger.
hs can be true for the hgh stake postons whch carry aong
wth them, too much rsk, eadng to margn cas. hs s where
effcent money management comes nto pay for payng safe.
24 hours market
Athough t s conenent for the trader to trade wheneer t s
sutabe to hm, t can be a rather tough |ob too. hs s because,
at tmes, t s not possbe for an nddua trader to keep track of
the Forex market, 24 hours a day.
hs s where a broker comes nto the pcture. eta or nddua
nestors shoud try takng hep from a professona broker rather
than dong a the deangs hmsef straght wth the huge market.
he broker w be an experenced professona who w act as an
equa n your transactons, keepng you nformed and updated
about mnute to mnute detas and fuctuatons, and een gude
you about the condtons, when to and when not to trade n the
market.
ke eery other fnanca market, Forex market aso has ts
share of adantages and dsadantages. But keepng n mnd the
two can surey hep a trader become more gant and aware of
what to expect whe tradng Forex.
Market size
As such, t has been referred to as the market cosest to the dea
of perfect competton, notwthstandng market manpuaton by
banks. Accordng to the Bank for Internatona Settements, as of
Apr 2010, aerage day turnoer n goba foregn exchange
markets s estmated at 3.9 tron, a growth of approxmatey
20 oer the 3.21 tron day oume as of Apr 2007.
he 3.9 tron break-down s as foows:
1.490 tron n spot transactons
475 bon n outrght forwards
1.75 tron n foregn exchange swaps
43 bon currency swaps
207 bon n optons and other products
an foregn exchange market turnoer, 192007, measured
n bons of SD.
he foregn exchange market s the argest and most qud
fnanca market n the word. raders ncude arge banks,
centra banks, currency specuators, corporatons, goernments,
and other fnanca nsttutons. he aerage day oume n the
goba foregn exchange and reated markets s contnuousy
growng. Day turnoer was reported to be oer S3.9 tron
n Apr 2010 by the Bank for Internatona Settements.
Of the 3.9 tron day goba turnoer, tradng n ondon
accounted for around 1.5 tron, or 3.7 of the tota, makng
ondon by far the goba center for foregn exchange. In second
and thrd paces respectey, tradng n ew ork Cty accounted
for 17.9, and okyo accounted for .2. In addton to
"tradtona" turnoer, 2.1 tron was traded n derates
Financial instruments
Spot
A spot transacton s a two-day deery transacton (except n
the case of trades between the S Doar, Canadan Doar,
urksh ra, EO and ussan ube, whch sette the next
busness day), as opposed to the futures contracts, whch are
usuay three months. hs trade represents a drect exchange
between two currences, has the shortest tme frame, noes
cash rather than a contract; and nterest s not ncuded n the
agreed-upon transacton.
Forward
One way to dea wth the foregn exchange rsk s to engage n a
forward transacton. In ths transacton, money does not actuay
change hands unt some agreed upon future date. A buyer and
seer agree on an exchange rate for any date n the future, and
the transacton occurs on that date, regardess of what the
market rates are then. he duraton of the trade can be one day,
a few days, months or years. suay the date s decded by both
partes. hen the forward contract s negotated and agreed upon
by both partes.
Swap
he most common type of forward transacton s the currency
swap. In a swap, two partes exchange currences for a certan
ength of tme and agree to reerse the transacton at a ater
date. hese are not standardzed contracts and are not traded
through an exchange.
Future
Foregn currency futures are exchange traded forward
transactons wth standard contract szes and maturty dates
for exampe, 1000 for next oember at an agreed rate 4.5.
Futures are standardzed and are usuay traded on an exchange
created for ths purpose. he aerage contract ength s roughy
3 months. Futures contracts are usuay ncuse of any nterest
amounts.
Option
A foregn exchange opton (commony shortened to |ust F
opton) s a derate where the owner has the rght but not the
obgaton to exchange money denomnated n one currency nto
another currency at a pre-agreed exchange rate on a specfed
date. he F optons market s the deepest, argest and most
qud market for optons of any knd n the word.
Forex ETF
Forex Exchange Traded Funds can be thought of as a stock market existing within the
forex market. The Forex ETF firms create 'forex traded funds' through buying and
holding of foreign currencies. Later on, these funds are sold as shares and traders can
buy any number of stocks for that fund.
The most commonly used currency is the USD in forex ETF. shareholder of the
forex ETF funds makes money when the prices of the term currency improe against
the USD.

Types of Forex ETFs
Forex market deals in many currencies. Therefore, many specialized or diersified
forex ETFs hae emerged with a focus on different number of currencies. They are:

Forex ETFs which track single currency: These firms buy only one currency and their
share represents a fixed amount of that currency. ne can inest in the:
Canadian DoIIar Trust (FXC)
British Pound Trust (FXB)
Euro Currency Trust (FXE)
Currency Swiss Franc Trust (FXF)
AustraIian DoIIar Trust (FXB)
Forex ETFs that track a number of currencies based on their correlation: Funds like
PowerShares DB U.S. Dollar Bearish UDN) and PowerShares DB U.S. Dollar Bullish
UUP) inest in currencies like:
Japanese Yen
Euro
Swedish Krona
British Pound
Canadian DoIIar
Swiss Franc
n these ETFs, the ratio of currencies differs from one fund to another.

Forex ETFs that track currency indexes: There are ery few firms that operate under
this category. The DB G10 Currency Harest Fund DBV) is a popular example.
Currencies traded in the markets
Majors
European non Euro EUR C
nted States Doar USD $
nted Kngdom ound Sterng B
|apanese en ]Y
Swtzerand Swss Franc CHF Sfr.
Minors
Austraa Austraan Doar AUD A$
ew eaand ew eaand Doar ZD Z$
Canada Canadan Doar CAD C$
Exotic Currencies
any other countres exst n the word, and most of them hae
ther own currences. Outsde of the ma|or and mnor currences
s the arge group of the so-caed "exotc currences".
Exotc currences are made up of the hundreds of currences not
n the ma|or or mnor eagues, but whch are neertheess
mportant as we, especay n nternatona commerce and
fnance.
The exotics include:
RUB - the ussan ube
CY - the Chnese uan or emnmb
BRL - the Brazan ea
MX - the excan eso
CL - the Chean eso
lR - the Indan upee
lRR - the Iranan a
hese make up |ust a few of the most actey traded exotc
currences. In some cases, a country w use .S. Doars as ther
currency, such as countres ke Hat for exampe.
Working of forex market
uotes of trades
For exampe, the exchange rate between S doars and the
Swss franc s normay stated:
SF 1$ European terms
Howeer, ths rate can aso be stated as:
$2SF American terms
Excudng two mportant exceptons, most nterbank quotatons
around the word are stated n European terms.
Forward rates are typcay quoted n terms of ponts. A forward
quotaton s expressed n ponts s not a foregn exchange rate as
such. ather, t s the dfference between the forward rate and
the spot rate.
Interbank quotatons are gen as a bd and ask (aso referred to
as offer).A bd s the prce (.e. exchange rate) n one currency at
whch a deaer w buy another currency. An ask s the prce (.e.
exchange rate) at whch a deaer w se the other currency.
Deaers bd (buy) at one prce and ask (se) at a sghty hgher
prce, makng ther proft from the spread between the buyng
and seng prces. A bd for one currency s aso the offer for the
opposte currency.
Foreign exchange transactions are settled through ostro
and Vostro accounts
ostro: our account wth banks abroad. esere Bank of Inda
(BI) mantans arous ostro accounts n a number of
countres.
Vostro: ther account wth us. any mutatera agences (e.g.
IF, Word Bank) mantan ther ostro accounts at esere Bank
of Inda (BI).
SWlFT Society for Worldwide lnterbank Financial
Telecommunications
rice maker and rice Taker
he bank quotng the prce s prce maker or market maker.
he bank askng for the prce or quote s the prce taker or
user.
ET OE OSlTlO- O
A measure of foregn exchange rsk
O s the et Assetet abty poston n a FCs together
(Both BS Off BS).
et Asset oston s aso caed OG or Oerbought
poston.
et abty oston s aso caed SHO or Oersod
poston.
O s a snge statstc that prodes a fary good dea about
exchange rsk assumed by the bank.
Its ma|or faw s that F exposures n thrd currences reman
hdden.
Market participants
he foregn exchange market conssts of two ters:
he nterbank or whoesae market (mutpes of 1 S or
equaent n transacton sze)
he cent or reta market (specfc, smaer amounts)
Fe broad categores of partcpants operate wthn these two
ters; bank and nonbank foregn exchange deaers, ndduas
and frms, specuators and arbtragers, centra banks and
treasures, and foregn exchange brokers.
1 Bank and onbank Foreign Exchange Dealers
Banks and a few nonbank foregn exchange deaers operate n
both the nterbank and cent markets. he proft from buyng
foregn exchange at a bd prce and reseng t at a sghty
hgher offer or ask prce. Deaers n the foregn exchange
department of arge nternatona banks often functon as
market makers.hese deaers stand wng at a tmes to buy
and se those currences n whch they specaze and thus
mantan an nentory poston n those currences.
2 lndividuals and Firms
Indduas (such as toursts) and frms (such as mporters,
exporters and Es) conduct commerca and nestment
transactons n the foregn exchange market. her use of the
foregn exchange market s necessary but neertheess
ncdenta to ther underyng commerca or nestment purpose.
Some of the partcpants use the market to hedge foregn
exchange rsk.
Speculators and Arbitragers
Specuators and arbtragers seek to proft from tradng n the
market tsef. hey operate n ther own nterest, wthout a need
or obgaton to sere cents or ensure a contnuous market.
Whe deaers seek the bdask spread, specuators seek a the
proft from exchange rate changes and arbtragers try to proft
from smutaneous exchange rate dfferences n dfferent
markets.
4 Central Banks and Treasuries
Centra banks and treasures use the market to acqure or spend
ther countrys foregn exchange reseres as we as to nfuence
the prce at whch ther own currency s traded. hey may act to
support the aue of ther own currency because of poces
adopted at the natona ee or because of commtments
entered nto through membershp n |ont agreements such as
the European onetary System. he mote s not to earn a
proft as such, but rather to nfuence the foregn exchange aue
of ther currency n a manner that w beneft the nterests of
ther ctzens. As wng oss takers, centra banks and treasures
dffer n mote from a other market partcpants
Foreign Exchange Brokers
Foregn exchange brokers are agents who factate tradng
between deaers wthout themsees becomng prncpas n the
transacton. For ths serce, they charge a commsson. It s a
brokers busness to know at any moment exacty whch deaers
want to buy or se any currency. Deaers use brokers for ther
speed, and because they want to reman anonymous snce the
dentty of the partcpants may nfuence short term quotes.
RBls role in forex market
o manage the exchange rate mechansm. eguate nter-bank
forex transactons and montor the foregn exchange rsk of the
banks. Keep the exchange rate stabe. anage and mantan
country's foregn exchange reseres.
1 Exposure limits
BI has mposed foregn exchange exposure mts on banks (FE
12 of 1999).he mts are ted wth the ad up capta of the
bank. reousy banks had O mt, whch was based on
foregn exchange oume handed by the bank.
2 Treasury operations at RBl Treasury operations at RBl
A Centra Banks hae treasures to mpement pocy ob|ectes
s a s ECHAGE AE IEES AES Deang room
catered to the F market ony. oney market was beng ooked
after by the Securtes department. It soon became apparent that
the two cannot work n soaton wth each other as the nkage
between the money market exchange market became
pronounced .Fnay the deang room and securtes department
were merged to form EDD to form frst eer reasury of BI.
RBls monitoring
O report.
F nfowoutfow statements.
O payments,
Forward transactons.
arket montorng arket Fows and ther mpact on
exchange rate.
oney arket qudty
Forward rates
arket actty f requred
ates reparaton 2 (Marked to Market), Wtd.
Ag(Weghted Aerage), FCA Conerson.
4 lntervention
o keep exchange rate n ne wth macro ob|ectes BI has to
nterene from tme to tme. Interenton s a process where F
s sod or purchased to keep the rght amount of qudty
aaabe n the F market so that demand suppy equbrum s
mantaned. Interenton can be n EAD or FOWAD
Other Functions
OFFSIE OIOIG
DAI AES FO AKE
HID CEC ACII FO BO AES
ESEE AAGEE
A uantitative function to regulate banks
Foreign Exchange Exposure Limit FEEL
Bascay restrcts the banks to keep a net asset (ong) or net
abty (short) poston n foregn currences. resenty FEE for
each bank s set at 10 of ts pad up capta. In the presence of
FEE, banks net purchases or net saes n foregn exchange on a
gen day hae to be wthn ther FEE.
ISK AAGEE
sk aerson n the forex s a knd of tradng behaor exhbted
by the foregn exchange market when a potentay aderse
eent happens whch may affect market condtons. hs
behaor s caused when rsk aerse traders qudate ther
postons n rsky assets and shft the funds to ess rsky assets
due to uncertanty.
In the context of the forex market, traders qudate ther
postons n arous currences to take up postons n safe haen
currences, such as the S Doar. Sometmes, the choce of a
safe haen currency s more of a choce based on preang
sentments rather than one of economc statstcs. An exampe
woud be the Fnanca Crss of 200. he aue of equtes
across word fe whe the S Doar strengthened. hs
happened despte the strong focus of the crss n the SA.
Hedging with Forwards
Hedgng refers to managng rsk to an extent that makes t
bearabe. In nternatona trade and deangs foregn exchange
pay an mportant roe. Fuctuatons n the foregn exchange rate
can hae sgnfcant mpact on busness decsons and outcomes.
any nternatona trade and busness deangs are sheed or
become unworthy due to sgnfcant exchange rate rsk
embedded n them. Hstorcay, the foremost nstrument used
for exchange rate rsk management s the forward contract.
Forward contracts are customzed agreements between two
partes to fx the exchange rate for a future transacton. hs
smpe arrangement woud easy emnate exchange rate rsk,
but t has some shortcomngs, partcuary gettng a counter
party who woud agree to fx the future rate for the amount and
tme perod n queston may not be easy. In aaysa many
busnesses are not een aware that some banks do prode
forward rate arrangements as a serce to ther customers. By
enterng nto a
Forward rate agreement wth a bank, the busnessman smpy
transfers the rsk to the bank, whch w now hae to bear ths
rsk. Of course the bank n turn may hae to do some knd of
arrangement to manage ths rsk. Forward contracts are
somewhat ess famar, probaby because there exsts no forma
tradng factes, budng or een reguatng body.
An Example of Hedging Using Forward Agreement
Assume that a aaysan constructon company, Bumways |ust
won a contract to bud a stretch of road n Inda. he contract s
sgned for 10,000,000 upees and woud be pad for after the
competon of the work. hs amount s consstent wth Bumways
mnmum reenue of 1,000,000 at the exchange rate of
0.10 per upee. Howeer, snce the exchange rate coud
fuctuate and end wth a possbe deprecaton of upees,
Bumways enters nto a forward agreement wth Frst State Bank
of Inda to fx the exchange rate at 0.10 per upee. he
forward contract s a ega agreement, and therefore consttutes
an obgaton on both sdes. he Frst State Bank may hae to
fnd a counter party for ths transacton ether a party who
wants to hedge aganst the apprecaton of 10,000,000 upees
exprng at the same tme or a party that wshes to specuate on
an upward trend n upees. If the bank tsef pays the counter
party, then the rsk woud be borne by the bank tsef. he
exstence of specuators may be necessary to pay the counter
party poston. By enterng nto a forward contract Bumways s
guaranteed of an exchange rate of 0.10 per upee n the
future rrespecte of what happens to the spot upee exchange
rate. If upee were to actuay deprecate, Bumways woud be
protected. Howeer, f t were to apprecate, then Bumways
woud hae to forego ths faorabe moement and hence bear
some mped osses. Een though ths faourabe moement s
st a potenta oss, Bumways proceeds wth the hedgng snce
t knows an exchange rate of 0.10 per upee s consstent
wth a proftabe enture.
Hedging with Futures
otng the shortcomngs of the forward market, partcuary the
need and the dffcuty n fndng a counter party, the futures
market came nto exstence. he futures market bascay soes
some of the shortcomngs of the forward market. A currency
futures contract s an agreement between two partes a buyer
and a seer to buy or se a partcuar currency at a future date,
at a partcuar exchange rate that s fxed or agreed upon today.
hs sounds a ot ke the forward contract. In fact the futures
contract s smar to the forward contract but s much more
qud. It s qud because t s traded n an organzed exchange
the futures market (|ust ke the stock market). Futures contracts
are standardzed contracts and thus are bought and sod 4 |ust
ke shares n the stock market. he futures contract s aso a
ega contract |ust ke the forward, but the obgaton can be
remoed before the expry of the contract by makng an
opposte transacton. As for hedgng wth futures, f the rsk s an
apprecaton of aue one needs to buy futures and f the rsk s
deprecaton then one needs to se futures. Consder our earer
exampe, nstead of forwards, Bumways coud hae thus sod
upee futures to hedge aganst upee deprecaton. ets
assume accordngy that Bumways sod upee futures at the
rate 0.10 per upee. Hence the sze of the contract s
1,000,000. ow say that upee deprecates to 0.07 per
upee the ery thng Bumways was afrad of. Bumways woud
then cose the futures contract by buyng back the contract at
ths new rate. ote that n essence Bumways bascay bought
the contract for 0.07 and sod t for 0.10. hs woud ge a
futures proft of 300,000 (0.10-0.07) x 10,000,000.
Howeer n the spot market Bumways gets ony 700,000
when t exchanges the10,000,000 upees contract aue at
0.07. he tota cash fow howeer, s 1,000,000
(700,000 from spot and 300,000 proft from futures). Wth
perfect hedgng the cash fow woud be 1 mon no matter
what happens to the exchange rate n the spot market. One
adantage of usng futures for hedgng s that Bumways can
reease tsef from the futures obgaton by buyng back the
contract anytme before the expry of the contract. o enter nto
a futures contract a trader needs to pay a depost (caed an
nta margn) frst. hen hs poston w be tracked on a day
bass so much so that wheneer hs account makes a oss for the
day, the trader woud recee a margn ca (aso known as
araton margn), .e. requrng hm to pay up the osses.
5 Economic Events When Currency Rocked the World
hese are changes n the currency markets whch caused
substanta mpact n the word economy. It s mportant that
peope earn about currency moements and how the occurrence
of such eents prode ucrate opportuntes for currency
nestors to proft from themarkets.
Free Market Capitalism is Born
On August 15 1971, ths date marked the end of the Bretton
Woods system, a system that used to fx the aue of a currency
to the aue of god. he nted States pued out of the Bretton
Woods Accord and took the S off the estabshed God exchange
Standard.
S were runnng a baance of payments defct and a trade
defct back n the eary 1970s due to the costs of etnam War
and ncreased domestc spendng has acceerated nfaton. he
S goernment used up amost a of hs reseres and god
reseres by that tme. Hence t began to prnt more doars to
suppement ts expendture. In short, most countres ost fath n
the doar as t s oeraued aganst god. he nternatona
communty dumped ther doars n exchange for god.
he fact s there was not enough god n the S aut to pay back
the nternatona communty. S goernment had prnted too
much doar and they were broke.
Foowng that, resdent xon shocked the word. he eent
was nformay named xon Shock because resdent xon
and 15 adsors remoed S from the God Exchange System
wthout consutng the members of the nternatona monetary
system.
S doars was the frst currency to be foated- that s, exchange
rates were no onger the prncpa method used by goernments
to admnster monetary pocy but s soey determned by suppy
and demand market forces. By 197, a the ma|or currences
were foated. he forex markets were started.
Devaluation of U.S Dollar - laza ccord
In the eary 190s, the S Federa esere System under au
ocker had oeraued the doar enough to make S exports n
the goba economy ess compette. he .S goernment faced
a arge and growng current account defct, whe |apan and
Germany were facng arge and growng surpuses.
hs mbaance coud create a serous economc dsequbrum
whch woud resut n a dstorton of the foregn exchange
markets and thus the goba economy. he resut of current
account mbaances and the possbty of foregn exchange
dstorton brought mnsters of the words eadng economes
France, Germany, |apan, the nted Kngdom, and the nted
States together n ew ork Cty.
he aza Accord was sgned on September 22, 195 at the aza
Hote n ew ork Cty, agreeng to deprecate the S doar n
reaton to the |apaneseand German Deutsche ark by
nterenng n currency markets.
he effects of the aza Accord agreement were seen
mmedatey wthn 2 years. he doar fe 4 percent and 50
percent aganst the deutsche mark and the |apanese en.
Deauaton of the doar stabse the growng S trade defct
wth ts tradng partners for a short perod of tme. As a resut,
.S. economy became more export-orented whe Germany and
|apan became more mport-orented.
he sgnng of the aza Accord was sgnfcant n that t refected
coordnated actons wth respecte goernments were abe to
reguate the aue of the doar n the forex market. aues of
foatng currences were determned by suppy and demand, but
such forces were nsuffcent, and t was the responsbty of the
words centra banks to nterene on behaf of the nternatona
communty when necessary.
o date, we st see countres that contnue to reguate aue of
ts currency wthn a certan band n the forex market. Exampe
of one country s |apan.
Black Wednesday - The Man Who Broke the Bank
Back Wednesday refers to the eents on 1th September 1992
when George Soros paced a 10 bon specuate bet aganst
the .K. pound and won. He became the man who broke the
Bank of Engand.
In 1990, .K. |oned the Exchange ate echansm (E) at a
rate of 2.95 deutsche marks to the pound and wth a fuctuaton
band of - percent. E gae each partcpatory currency a
centra exchange rate aganst a basket of currences, the
European Currency nt (EC). hs system preents the
exchange rate of partcpatory currences from too much
fuctuaton wth the basket of currences.
nt md 1992, economy began to change n Germany. Foowng
reunfcaton of 199, German goernment spendng surged,
forcng the Bundesbank to prnt more money. German economy
experenced nfaton and nterest rates were rased to curb
nfaton.
Other partcpatory countres n the E were aso forced to rase
nterest rates so as to mantan the pegged currency exchange
rate. he rate hke ed to seere repercussons n the nted
Kngdom. At that tme, .K. had a weak economy and hgh
unempoyment rate. antanng hgh nterest rates s not
sustanabe for .K. n the ong term, and George Soros stepped
nto acton.
George Soros was sad to proft 2 bon from the Back
Wednesday. hs snge eent showed that wth knowedge and
experence, nestors coud proft from the forex market. o
centra banks can contro the forex markets.
sia Currency Crisis
eadng up to 1997, nestors were attracted to Asan
nestments because of ther hgh nterest rates eadng to a hgh
rate of return. As a resut, Asa receed a arge nfow of money.
In partcuar, haand, aaysa, Indonesa, Sngapore and South
Korea experenced unprecedented growth n the eary 1990s.
hese countres fe one after another ke a set of domnos on
|uy 2, 1997, showng the nterdependence of the Asan 5 gers
economes. any economsts beee that the Asan Fnanca
Crss was created not by market psychoogy but by shrouded
endng practces and ack of respecte goernment
transparency.
In eary 1997, haand current account defct has grown
consstenty up to a ee that s beeed to be unsustanabe.
Shrouded endng practces oersupped the country wth credt
and n turn droe up prces of assets. he same type of stuaton
happened n aaysa, and Indonesa.
ees were reached where prce of assets were oeraued and
couped wth a unsustanabe trade defct, nternatona nestors
and hedge fund managers began to se ha baht and
neghborng countres currences hopng to proft from the
punge.
Foowng mass short specuaton and attempted nterenton,
the Asan economes were n shambes. ha baht was sharpy
deaued by as much as 4 percent and Indonesan rupah fe
22 percent from ts preous hgh of 12,950 to the fxed .S.
doar.
he fnanca crss of 1997-199 reeaed the nterconnectty
of economes and ther effects on the goba currency markets.
he nabty of centra banks to nterene n currency markets
proded yet another ucrate opportunty for currency nestors
to proft.
The Euro: Best Reserve Currency after Dollar
he name Euro was offcay adopted on 1 December 1995. he
Euro s the offca currency of 1 of the 27 ember States of the
European non. Euro s the second argest resere currency and
the second most traded currency n the word after the .S.
doar.
As of oember 200, wth more than 751 bon n crcuaton,
the euro s the currency wth the hghest combned aue of cash
n crcuaton n the word, hang surpassed the .S. doar.
Based on IF estmates of 200 GD and purchasng power
party among the arous currences, the Euro zone s the second
argest economy n the word.
aue of Euro and the .S. doar are nersey correated. Shoud
the doar fa, aue of Euro currency w rse. Euro w be the
best choce to shft money to, shoud the aue of .S. doar
contnue to fa. hs makes the Euro the best substtute currency
for the doar.
Conclusion
Seeng the aboe data about the foregn exchange market we
coud concude that the market n Inda s not st deeoped but
s on the growng path.
Foregn exchange market pays a ma|or and mportant roe n
goba fnanca serces actng as an ndcator to the
deeopment of the goba economy.
We hereby concude that f Inda needs to deeop ts foregn
market t needs to deeop the exchange currency market so as
more nestor nests n Inda.
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