Foreign Exchange Market

Dr. K. B. Rangappa Associate Professor Department of Studies in Economics Davangere University, Shivagangothri Davangere

Foreign Exchange Markets

The foreign exchange market is a global, worldwide decentralized over-the-counter financial market for trading currencies. It provides the physical and institutional structure through which
The money of one country is exchanged for that of another country The rate of exchange between currencies is determined Foreign exchange transactions are physically completed

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 rate

Functions of The Foreign Exchange Market

Transfer Function: The basic and primary function of foreign exchange market is to transfer purchasing power between countries. Credit Function: Another important function of foreign exchange market is to provide credit to the importer debtor. The exports draw the bill of exchange on Importers or on their bankers. On acceptance of the bills by importer or their banker, the exporter will get the money realized on the maturity of the bills. In case the exporters are anxious to receive the payment earlier, the bills can be discounted from their bankers, or foreign exchange banks or discount houses.

Hedging Function: The foreign exchange market performs the hedging function covering the risks on foreign exchange transactions. There are frequent fluctuations in exchange rates. In order to avoid the risk involved, the foreign exchange market provides hedges or actual claims through forward contracts in exchange against such fluctuations. The agencies of foreign currencies guarantee payment of foreign exchange at a fixed rate. The exchange agencies bear the risks of fluctuation of exchange rate.

Nature of Foreign Exchange Market

The nature of foreign exchange market can be analyzed under the following headings;
The geographic extent Its functions The markets participants Its daily transaction volume Types of transactions including spot, forward and swaps Methods of stating exchange rates, quotations, and changes in exchange rates

Geographic Extent of the Market

Geographically, the FOREX market spans the globe with prices moving and currencies trading every hour of every business day.

The markets participants

Bank and non bank foreign exchange dealers
They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price Competition among dealers narrows the spread between the bid and offer rate contributing to the markets efficiency Currency trading is profitable and often contributes between 10% - 20% of a banks average net income

Individuals and Firms:

Importers, exporters, portfolio investors, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions. Some of these participants use the market to hedge foreign exchange rate risk

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The markets participants

Speculators and arbitragers
Speculators and arbitragers seek to profit from trading in the market itself. They operate for their own interest. Speculators seek all their profit from exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates in different markets Central banks and treasuries use the market to acquire or spend their countrys currency reserves as well as to influence the price at which their own currency trades They may act to support the value of their currency. Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests

Central Banks and Treasuries

Its daily transaction volume

According to the Bank for International Settlement, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion;

Out of which, $1.490 trillion in spot transactions, $475 billion in outright forwards, $1.765 trillion in foreign exchange swaps

Main foreign exchange market turnover, 19882007, measured in billions of USD

Transactions in the Forex Market

Transactions within this market can be executed on a spot, forward, or swap basis SPOT: A spot transaction requires almost immediate delivery of foreign exchange. A spot transaction in the inter bank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day. The settlement date is often referred to as the value date FORWARD: A forward transaction requires delivery of foreign exchange at some future date. This transaction requires delivery at a future value date of a specified amount of one currency for another. The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed.

Transactions in the Forex Market

SWAP: A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Both purchase and sale are conducted with the same counterpart

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Foreign Exchange Rates & Quotations

A foreign exchange quote is a statement of willingness to buy or sell at an announced rate Direct and Indirect Quotes
Rs.45/$ is a direct quote in India

A direct quote is a home currency price of a unit of a foreign currency

An indirect quote is a foreign currency price in a unit of the home currency

Interbank quotes are given as a bid and ask

$0.0222/Rs. is (a direct quote in the US and) an indirect quote in India

The bid is the price at which a dealer will buy another currency The ask or offer is the price at which a dealer will sell another currency

Determinants of Exchange Rates

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 (Few Rs. Per doller). Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners (More Rs. Per each dollar). Differentials in Interest Rates: Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and led to increase in currency value. 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.

Interest rate parity, or sometimes known as International Fisher effect is an economic concept, expressed as a basic algebraic identity that relates interest rate and exchange rate

Determinants of Exchange Rates

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. 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 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 (lower value of domestic currency)/(more Rs per dollar) until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. 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. Less demand for such currency and depreciate the value (More Rs/dollar)

Determinants of Exchange Rates

Terms of Trade: A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the BoP. 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). (Less Rs/dollar)

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. Political stability improve the value of a currency (Less rs/dollar)

Purchasing Power Parity Theory

Purchasing Power Parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute PPP theory This theory assumes that equilibrium in the exchange rate between two currencies will force their purchasing power to be equal.

Terms of Trade (ToT)

Terms of trade is an index of the price of a country's exports in terms of its imports. It is the rate at which two countries exchanged their good and services.
ToT = (Export price Index/Import price Index)*100

If export prices are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports. If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade.

Currency convertibility
Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa. Convertibility in that sense is the elimination of controls or restrictions on currency transactions. While current account convertibility refers to freedom in respect of payments and transfers for current international transactions , capital account convertibility (CAC) would mean freedom of currency conversion in relation to capital transactions in terms of inflows and outflows.