The Foreign Exchange Market

The Foreign Exchange Market
INTRODUCTION TO FOREIGN EXCHANGE MARKET

Every nation has its own currency. For e.g., the currency of India is rupee and that of USA is dollar. Most international financial transaction involves an exchange of one currency for another. The currency unit of a country can be exchanged for one or more than one unit of the currency of another country. The price of one currency in terms of another is known as exchange rate. Forex markets provide the mechanism of exchanging different monetary units. Such a facility/mechanism is essential when countries trade with each other. Apart from trade, sometimes, nationals of one country may prefer to hold financial assets in a foreign currency or dominate in a foreign currency because domestic currency is subject to high inflation and therefore less attractive as a store of value. International trade as well as the movement of capital among different countries necessitates the conversion of currencies. Exchange dealers do the job of exchange of currencies the demand and supply in the foreign exchange market permits the establishment of rates of different currencies in terms of local currency. These markets represent institutional arrangements where foreign exchange operations take place. To every international sale or purchase of commodities, services or assets, there correspond an international sale or purchase of currencies. In foreign exchange market, a party can never be the demander of one currency without being simultaneously a supplier of another. An Indian purchaser of Toyota simultaneously supplies rupees for the demand for yen with which the Toyota, is to be purchased.
HISTORY OF FOREX TRADING

Centuries ago, the value of goods was expressed in terms of other goods. This sort of economics was based on the barter system between individuals. The obvious limitations of such a system encouraged establishing more generally accepted mediums of exchange. It was important that a common base of value could be established. In some economies, items such as teeth, feathers even stones served this purpose, but soon various metals, in particular gold and silver, established themselves as an accepted means of payment as well as a reliable storage of value. Coins were initially minted from the preferred metal and in stable political regimes, the introduction of a paper form of a governmental currency also gained acceptance during the middle Ages. Before, the First World War, most central banks supported their currencies with convertibility to gold. Paper money could always be exchanged for gold. However combination of a greater supply of paper money without the gold to cover it led to devastating inflation and resulting in political instability. Near the end of World War II, The Bretton Woods agreement was reached on the initiative of the USA in July 1944. International institution such as the IMF, The World Bank and GATT were created in the same period, as the emerging victors of World War II searched for a way to avoid the destabilizing monetary crises leading to the war. The Bretton Woods agreement resulted in a system of fixed exchange rates that reinstated The Gold Standard partly, fixing the US Dollar at 35.00 per ounce of Gold and fixing the other main currencies to the dollar, initially intended to be on a permanent basis. The Bretton woods system came under increasing pressure as national economies moved in different directions during the 1960s.A number of realignments held the system alive for a long time but eventually Bretton wood collapsed in the early 1970s following president Nixons suspension of the gold convertibility in August 1971. The dollar was not any longer suited as the sole international currency.
The Foreign Exchange Market The last few decades have seen foreign exchange trading into the worlds largest global market. Restriction on capital flows have been removed in most countries, leaving the market forces free to adjust foreign exchange rates according to their perceived values. In Europe, the idea of exchange rates had by no means died. The European Economic Community introduced a new system of fixed exchange rates in 1979, the European Monetary System. This attempt to fix exchange rates in 1979, met with near extinction in 1992-1993, when built up economic pressures forced devaluation of a number of weak currencies. The quest continued in Europe for currency stability with the 1991 signing of the Maatricht treaty. This was to not only fix exchange rates but also actually replace many of them with the EURO in 2002. Today, Europe is currently in the Euro final stage. The physical introduction of the Euro has commenced from January 1, 2002. The existing currencies of the 12 participating Euro countries, viz. Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. The three EU countries that have not adopted the euro are the UK, Sweden and Denmark. In Asia, the lack of sustainability of fixed foreign exchange rates has gained new relevance with the events in South East Asia in the latter part of 1997, where currency after currency was depreciated against the US dollar, leaving other fixed exchange rates in particular in South America also looking very vulnerable. Indian History of Forex Market The system of exchange of currencies has a long history and it existed side by side the trade and commerce between various countries. The form of currencies went on changing from couch to metal and to modern paper/ plastic currencies. As the trade between various countries grew the system also grew along with it. The entire system was governed by conventions and customs.
The Foreign Exchange Market As regards India is concerned the exchange pattern was systematized during the British rule. The banking industry also grew during this period, which facilitated exchange of rupee against foreign currencies especially British pound. Prior to World War II (i.e.1939) there was not structured regulation (law) so far foreign exchange is concerned. The convertibility of rupee into foreign currency was easy and was possible across the counter. There were no regulation for possession / holding of foreign currency by individual, acquisition of property in India /outside India or investments. However at the commencement of World War II the Great Britain imposed restrictions in exchange of British pound, as it was felt necessary to mobilize pound resources for war purpose. India being British colony the Foreign Exchange Regulation Act was enacted in India also. In 1947 the view was taken by independent India to continue with the above regulations to preserve the foreign exchange for the implementation of the Five - Year Plans. In 1973 the act was made more comprehensive and large number of restrictions were imposed on current/capital account transactions. The trade account transactions were also covered through Import / Export policies of Government of India. In 1991 however foreign exchange reserve was at the lowest and the possibility of default for international payment was felt. The IMF/World Bank came to rescue but with conditions. The conditions were to liberalize the foreign exchange at current and capital account, with this conditionality, the foreign exchange regulation act 1973 became obsolete and the need was felt for new regulation, which came in force as FEMA in May 2000. The new regulation has brought about relaxations in current and capital account transactions. But full convertibility of rupee as existed prior o 1939 has still not come. It may come depending on various parameters like fiscal deficit, deficit in balance of payment, inflation rate, foreign exchange reserve, and Indias share in International trade.
MECHANICS OF CURRENCY TRADING

The inter bank market deals are done on the telephone. Suppose bank A wishes to buy the British pound sterling against the US dollar. A trader in bank A might call his counterpart in bank B and ask for a price quotation. If the price is acceptable they will agree to do the deal and both will enter the details- the amount bought / sold, the price, the identity of the counter party etc.- in their respective banks computerized record systems and go to the next transaction. Subsequently, written confirmations will be sent containing all the details. On the day of settlement, bank A will turn over a US dollar deposit to bank B and B will in turn hand over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered in the record systems. When asked to quote a price between a pair of currencies, say pound sterling and dollar, a trader gives a two-way quote i.e. he quotes two prices: a price at which he will buy a sterling in exchange for dollars and a price at which he will sell a sterling for dollars. The enquirer does not have to specify whether he wants to sell or buy pounds against dollars; as mentioned above, the market maker is ready to take either side of the transaction. Thus his quotation can be represented, as (the numbers are hypothetical): $ / : 1.7554 / 1.7560 or 1.7554 / 1.7560 The number on the left of the hyphen or the slash is the amount of dollars the trader will pay to buy a pound. This is the traders bid rate for a pound sterling (against dollar). The number on the right is the amount of dollars the trader will require to sell a pound. This is the traders ask rate (also called the offer rate) for a pound sterling against dollar. The difference, (ask-bid), is the bid-ask spread (or the bid-offer spread). Suppose during the course of trading a trader finds that he is being hit on one side of his quote much more than the other side. In our pound - dollar example this means that he is either buying more pounds than he is selling or vice versa. This lead to trader building up a position. If he has sold (bought) more pounds than he has bought (sold) he is set to have a net short position (long position) in pounds. Given the volatility of exchange rates, maintaining a short or long position for too long can be a risky proposition. For instance, 6
The Foreign Exchange Market suppose that a trader has built a net short position in pounds of 1,000,000. The pound suddenly appreciates from say $ 1.7500 to $ 1.7520. This implies that the banks liability increases by $2000 ($ 0.0020 per pounds for one million pounds). Pound depreciation would have resulted in gain. Similarly, a net long position leads to a loss if it has to be covered a lower price and a gain if at a higher price.
THE NEED FOR CURRENCY EXCHANGE

Currency exchange is necessary in numerous circumstances. 1. Consumers: Consumers typically come in to contact with currency exchange when they travel. They go to a bank or currency exchange bureau to convert one currency (typically, their home currency) in to another (i.e.. the currency of the country they intend to travel) so they can pay for goods and services in the foreign country. Consumers may also purchase goods in a foreign country or via the internet with their credit card, in which case they will find that the amount they paid in the foreign currency will have been converted to their home currency on their credit card statement. Although each such currency exchange is a relative small transaction, the aggregate of all such transaction is significant. 2. Businesses: Businesses typically have to convert currencies when they conduct business outside their home country. For example, if they export goods to another country and receive payment in the currency of that foreign country, then payment must often be converted to the home currency. Similarly, if they have to import goods or services, then businesses will often have to pay in a foreign currency, requiring them to first convert their home currency in to the foreign currency. Large companies convert huge amount of currency each year. For example a company such as General Electric (GE) converts tens of billions of dollars each year. The timing of when they convert can have a large affect on their balance sheet and bottom line.
The Foreign Exchange Market 3. Investors and speculators: Investors and speculators require currency whenever they trade in foreign investment be that equities, bonds, bank deposits, or real estate. For example, when Swedish investor buys shares in Sun Micro system on the NASDAQ, he will have to pay for the shares in U.S. Dollars and likely to convert Swedish Crone to U.S. Dollars. Similarly, a Japanese real estate investor who sells a New York property may well want to convert the proceeds of the sale in U.S. Dollars To Japanese Yen. Investors and speculators also trade currencies directly in order to benefit from movements in the currency exchange markets. For example, if an investor believes that the Japanese economy is strengthening and as a result expects the Japanese Yen to appreciate in value (i.e. go up in relation to other currencies), then she may want to buy Japanese Yen and what is referred to as long position. Similarly, if an American investor believes that the Euro will go down over time, and then he may want to sell the Euro to take a short position. Interestingly, investors and speculators can profit equally from currencies becoming stronger (by taking a long position) or from currencies becoming weaker (by taking a short position). Speculators are often day traders, trying to take advantage of market movements in very short periods; buying a currency and then selling it again may happen within hours or even minutes. They are attracted to currency trading for numerous reasons, including: a) The size and daily volatility of the market, b) The almost perfect liquidity of the currency exchange market, c) The fact that the currency exchange market is open 24 hours a day market. 4. Commercial and Investments banks: Commercial and Investments banks trade currencies for their commercial banking, deposit and lending customers. These institutions also generally participate in the currency market for hedging and proprietary trading purposes.
The Foreign Exchange Market 5. Governments and central banks: Governments and central banks trade currencies to improve trading conditions or to intervene in an attempt to adjust economic or financial imbalances. This includes the adjustment of BOP balances, prevention of sudden appreciation of the domestic currency etc. 6. 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 center. In India as per FEDAI guidelines the A Ds 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.
DEALING ROOM All the professionals who deal in Currencies, Options, Futures and Swaps assemble in the dealing room. This is the forum where all transactions related to foreign exchange in a bank are carried out. There are several reasons for concentrating the entire information and communication system in a single room. It is necessary for the dealers to have instant access to the rates coated at different places and to be able to communicate amongst themselves, as well as to know the limits of each counter party etc. This enables them to make arbitrage gains, whenever possible. The dealing room chief manages and coordinates all the activities and acts as a link pin between dealers and higher management.
Objectives of the dealing room

To give the best possible service to customers:Through adequate number of well-attended phones and the telexes, sound counsel about economic development, competitive rates and capability to transact the entire amount of currency deal requested by the customer. To manage the banks position so that inventory in each foreign currency is kept at the desired level:Through matching the inflows and the outflows of various currencies with matching deployment. To produce a profit for the bank while accomplishing the first two objectives:Through exchange rate differentials etc.
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Connection with Commercial Banks Commercial banks, which participate in the market, communicate between themselves through a network of telephones, faxes and the means of communications supplied by Reuters, Telerate, Bloomberg etc. Current rates may be read on the screen at any point of time. Similarly, economic, political, and financial news, which is likely to influence the markets, is communicated rapidly. Automatic Trading System Several automatic trading systems compete with one another. For example, Reuters, which was for a long time the single provider of on-screen information in the market, has introduced a new service called Dealing 2000. Its advantage is that it ensures automatic execution of orders. This means that a dealer who places an order is automatically linked to a counter party instead of his having to search for a counter party. Another system, known as Electronic Booking Service (EBS) has brought together a group of 200 dealers in 60 banks and institutions enabling them to trade in terms of US$ 5 million or equivalent. Another system referred to as MINEX launched its services in April 1993. A consortium of Japanese banks, Japanese brokers, Japanese company of telecommunications KDD and Telerate support it. It is used particularly in the Asian region. The advantage of the above system is that it enables the operators to reduce the commissions charged by brokers. The dealers also use software, which enables them to know rapidly the divergences, which may appear, for instance, with respect to interest rates on the one hand and spot and forward exchange rates on the other. Significant differences may yield arbitrage operations profitable for them.
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Inter-bank Forex Market
The Custome r
Corporate desk of a branch
THE DEALING ROOM
International Forex Market
Decentralization of dealing rooms Till recently, banks provided access to their dealing rooms to only big enterprises and for big orders. Entry was restricted for orders higher than a million US dollars. However, things are now changing. In France, banks have decentralized dealing rooms in provincial branches where they receive orders for smaller amounts. In certain banks, there is a daily reference rate, which enables dealing of small orders on the basis of a buying and selling rate, determined during a certain period of the day. In London, there exist dealing rooms for medium enterprises. In Germany, the structure of dealing rooms has three levels. At the local level, an SME (Small and Medium Enterprise) addresses itself to the client-in charge in the local branch of the bank and asks for the rate of a particular currency. A rate is proposed to it. If the enterprise desires to have a specific advice, it contacts a branch situated in a big city where an exchange specialist is available. In case the operation is of sizeable amount, the transaction passes through one of the three dealing rooms of the national market, situated either at Frankfurt, or 12
The Foreign Exchange Market Dusseldorf or Hamburg. In any case, big enterprises closely follow market fluctuations and intervene when they think that rates are favourable for their operations. The Front Office and the Back Office It would be appropriate to know the other two terms used in connection with dealing rooms. These are Front Office and Back Office. The dealers who work directly in the market and are located in the Dealing Rooms of big banks constitute the Front Office. They meet the clients regularly and advice them regarding the strategy to be adopted with regard to their treasury management. The role of the Front office is to make profit from the operations on currencies. The role of dealers is two folds: to manage the positions of clients and to quote bid-ask rates without knowing whether a client is a buyer or seller. Dealers should be ready to buy or sell as per the wishes of the clients and make profit for the bank. They should take in account the position that the bank has already taken, and the effect that a particular operation might have on that position. They also need to consider the limits fixed by the Management of the bank with respect to each single operation or single counter party or position in a particular currency. Dealers are judged on the basis of their profitability. The operations of front office are divided into several units. There can be sections for money markets and interest rate operations, for spot rate transactions, for forward market transactions, for currency options, for dealing in future and so on. Each transaction involves determination of amount exchanged, fixation of an exchange rate, indication of the date of settlement and instructions regarding delivery. The Back Office consists of a group of persons who work, so to say, behind the Front Office. Their activities include managing of the information system, accounting, control, administration and follow-up of the operations of Front Office. The Back office helps the Front Office so that the latter is rid of jobs other than the operations on market. It should conceive of better information and control system relating to financial operations. It ensures, in a way, an effective financial and management control of market operations. In
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The Foreign Exchange Market principle, the Front Office and Back Office should function in a symbiotic manner, on equal footing. In reality, the movement of information between the Front Office and the Back Office is sometimes difficult. An elaborate reporting system should be place in place so that the banks exchange positions are correctly evaluated. This ensures a good control as also the fixing of limits per counter party or per currency and so on. Sometimes, this division of roles between Front Office and Back Office may not be very clear. This is true, in particular, for small banks or those institutions where dealings in foreign currencies are not large. Foreign exchange markets provide the mechanism of exchanging different monetary units in circulation in different countries and thus facilitate transfer of purchasing power for one country to another. Due to globalization of exchanges, the foreign exchange market has become a market without frontiers even through individual states may adopt policies to control the exchange. Exchange markets help with providing cover against exchange rate risk. In international trade operations, participants protect themselves from exchange risk by buying or selling currencies forward. Likewise, banks reduce risk of loss by not keeping the exchange positions open for too long at a time. It is common in foreign exchange transactions to specify limits to the dealers in order to reduce risks. The higher management of the bank gives the internal limits. These limits are in the terms of Spot or Forward position on each currency. The external limits may be fixed by central bank of the country.
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FOREIGN EXCHANGE RISK The assets and liabilities or cash flows of an enterprise, that are denominated in foreign currencies undergo a change in their value, as measured in domestic currency, over a period of time, because of variation in exchange rate. This variability in the value of assets and liabilities or cash flows is referred to as exchange rate risk. When the value and the maturity dates of assets and liabilities as well as claims and counterclaims in a foreign currency are matched against each other, then there is no net exposure. In such a situation, there is no foreign exchange risk. But foreign exchange risk results from an open position; the position can be either long or short. When an enterprise owns a net claim (or an asset) in foreign currency, it is said to be long; and when it has a liability in foreign currency, it is said to be warrant management or hedging of ris e short. Fluctuations in exchange rates leading to variations in the value of assets and liabilities k. Different categories of exchange risk Exchange risk results from the fact that future costs and cash flows are denominated in foreign currencies. Essentially, what it means is that if exchange rate changes, it affects the amount of cash flows, converted into domestic currency. There are three types of exchange risks. These are: Transaction risk; Translation risk or Consolidation risk; Economic risk.
Transaction risk Transaction risk is related to either: (i) Trade transactions, that is, exports and imports, or
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(ii) (iii)
Financial operations such as borrowing and lending in foreign currencies, or Payment or receipts of dividends and interests.
In other words, a transaction exposure occurs when a company is committed to a foreign currency denominated transaction. As the transaction will result in a future foreign currency cash inflow or outflow, any change in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change in the home currency amount of the cash inflow or outflow. The total position relating to transaction exposure of an enterprise is obtained by grouping together all the debts and credits in foreign currencies of the same maturity or the terms that are sufficiently close. The treasurer of the enterprise calculates difference between debts and credits. If credits exceed debts, it is said that the enterprise has an open long position. The reverse situation is referred to as an open short position. There are different ways of accounting for trade transaction, involving foreign currency by using a reference rate. Normally, finance division of the enterprise communicates the reference rate. All branches or subsidiaries for all of their operations can use this rate. Use of spot rate is also an option and so is the use of forward rate. This rate is used essentially when a transaction has been covered through Forward market. Debts, credits and cash in foreign currencies figure in balance sheet at their counter value at the end of the financial year. The differences resulting from exchange rate variations are noted under the account, called exchange loss or gain. The provision is made for exchange loss. Enterprises have a tendency to cover either a particular operation, such as a purchase or sale, or to cover the totality of purchases or sales planned for next three months or a year or even more.
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The Foreign Exchange Market Translation Risk Translation or consolidation risk relates to assets and liabilities of a balance sheet denominated in foreign currencies. While consolidating the accounts, one uses a rate of exchange to transform the accounts of a foreign subsidiary, denominated in foreign currency to the domestic currency of the parent company. As a matter of fact, investors and financial institutions have an interest in knowing the consolidated position of the whole group in domestic currency. This transformation entails a variation of profits of the group as a function of exchange rate variations. The exchange risk also affects the estate of an enterprise. For instance, a French company, selling a building owned by its Indonesian subsidiary, would obtain a lower price in Euros than that it would have got by selling it before the devaluation of Indonesian Rupiah in 1997. Different methods of translation are used by different enterprises. These are:(a) (b) (c) (d) Current / Non-Current Method; Monetary / Non-Monetary Method; Closing (or current) Rate Method; Temporal Method.
Current / Non-Current Method:Based on the length of life of an asset or liability, this method uses closing rate for converting current assets and liabilities, and historic rates for converting non-current assets and liabilities. Historic rate is the exchange rate, which was used at the time of acquisition of an asset or incurring of a liability, or when these items entered the balance sheet for the first time. The exchange position that results from this method corresponds to the working capital of the enterprise.
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The Foreign Exchange Market An appreciation of foreign currency results in a translation gain if the working capital is positive (current assets are more than current liabilities) and a translation loss if the working capital is negative. Reverse is true in the case of a depreciation of foreign currency. It is possible to modify the exchange position by modifying the factors that affect the working capital. As regards the income statement, its constituent items are converted at the mean rate for the period of the income statement. Exceptions is made for the figures relating to revenues and expenses linked with long term assets and liabilities (say depreciation and amortization) which are converted using historic rates, that is, at the rates as per the corresponding balance sheet items. In other words, different revenue and expense items may be translated at different rates, under this method. Monetary / Non-Monetary Method:This method makes a distinction between monetary assets and liabilities and nonmonetary ones. The monetary accounts consist of long-term debts, receivables, payables and cash. The non-monetary accounts are physical assets and liabilities such as inventories and fixed assets. Monetary assets and liabilities are converted by using closing rates while non-monetary ones are converted at historic rates. The figures of income statement are converted by using the mean rate of the period, except those related to revenues and expenses linked to non-monetary assets and liabilities, which are converted at historic rates. Generally, depreciation expense and cost of goods sold fall in the latter category. These are translated at the same rate as the corresponding balance sheet items. Thus, it is possible that the cost of goods sold may be translated at a different rate from that used to translate sales.
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The Foreign Exchange Market Closing (or current) Rate Method:As per this method all figures are converted by using closing or current rate. Under this method, if a firms foreign currencies denominated assets exceed its foreigncurrency-denominated liabilities, a depreciation of foreign currency will result in a loss and appreciation will result in a gain. Temporal Method:This method is a modified version of the monetary / non-monetary method with the difference that in this method, inventory is translated at the current rate. Income statement items are normally translated at an average rate. However, cost of goods sold and depreciation are translated at historic rates. It is, thus, evident that the methods used give different results as regards as the consolidation position and figures obtained for consolidation gain or loss are also different. The following example illustrates the use of different methods involved in the Translation risk. Example: Suppose there is an Indian subsidiary of a French parent company. The Balance Sheet of the Indian subsidiary at the beginning of the current year is having the rate of Rs. 6.5/FFr 1. Suppose there is no other operation and the rate at the end is Rs.6.75/FFr 1. Using different methods to work out consolidation gains or losses. Balance sheet of the Subsidiary Fixed Assets Inventory Cash Total Assets Owners Funds Long-term Debts Payables Total Liabilities In Rupees 1,00,000 80,000 20,000 2,00,000 1,05,000 67,000 28,000 2,00,000 in French Francs 15,385 12,308 3,077 30,770 16,154 10,308 4,308 30,770
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The Foreign Exchange Market Solution: Balance sheets translated by using different methods are given below: Balance Sheet after Conversion Closing Current / Monetary / Temporal (Current) Non-Current Non-Monetary method Rate method method method Fixed Assets Cash Assets Owners Funds Long-term Debts Payables Liabilities Gains (+)/Loss (-) of consolidation 15,385 Inventory 12,308 11,852 2,963 2,963 29,630 16,154 9,926 4,148 30,228 (-) 598 30,200 16,154 10,308 4,148 30,610 (-) 428 14,815 15,385 11,852 2,963 30,656 16,154 9,926 4,148 30,228 (+) 428 15,385 11,852 2,963 30,200 16,154 9,926 4,148 30,228 (-) 28
It is apparent from the above table that there can be conversion gain or losses depending on the method used for the purpose of conversion. Many companies do not provide cover against consolidation because they think of it as a simple accounting position. There are others, which like to cover this risk. Depending on the method of conversion used, different strategies will be required to reduce the translation risk. For example, companies would try to reduce working capital if the foreign currency is likely to depreciate in the event of their using current/non-current methods. Economic Risk (or Operating Exposure):Economic Risk or economic exposure refers to the impact of exchange rate changes on future cash flow of a company. For this reason, this exposure is known as long-term cash flow exposure. More precisely, if the present value of a company, as measured by future cash flows, is VO and if VO / SO is not zero, the company is said to have economic exposure resulting from exchange rate changes (SO). V O / SO represents
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The Foreign Exchange Market the change in the value of company as a result of unit change in the exchange rate S O. Economic risk can, thus, be defined as variability in the companies present value, caused by uncertain change in exchange rate. Since operating exposure is related to companies future revenues and costs, measuring it requires a long term prospective. Viewed in this prospective, a company face operating exposure whenever it is subjected to foreign competition, when it is sourcing raw-materials or other inputs abroad and so on. The measurement of operating exposure is difficult, as it is not possible to ignore the effect of inflation while considering the impact of exchange rate change. As a consequence this exposure cannot be hedged solely through financial hedging techniques. It would require long term operating adjustments. Appreciation or depreciation of a currency will lead to changes in relative prices of inputs as well as products sold by the company in different countries. The effects of this currency induce changes on corporate revenues and costs depends on the extent of companies international operations, its competitive environment and its degree of operational flexibility. In order to manage these relative price changes, the company may adjust its production process or marketing mix. Moreover, the company may try to shift out of currencies, which are moving against its long-term profitability. For example, over a period 1985 95, a U.K company would have increased its earnings in sterling if it had bought imports denominated in US dollars and sold its exports denominated in Deutsch marks. This is because during this period, pound sterling was appreciating against US dollar and depreciating against Deutsch marks. Exchange Risk for Corporates As enterprises earn more of their revenues/earnings form abroad, they are vulnerable to exchange rate fluctuations. An unfavorable movement of rates can result in sizeable losses and thus may affect their financial results adversely. Given the significance of the issue, the top management of an enterprise formally indicates its policy with regards to exchange risk and puts in place a system for risk management.
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The Foreign Exchange Market The treasury manager centralizes all foreign currency operations of the enterprise or its branches in a manner so as to have a full blue print of all the transactions, entailing exchanges. For the purpose, he may carry out the following activities: 1. Collect the data with respect to foreign trade and financial flows, with details indicating currency involved, the period of transaction and cover required. 2. Assess the total exchange risk of the enterprise. 3. Propose a strategy of covering, that is, whether to cover the net position or to cover each operation. 4. Suggest the best financial instruments to cover the risk-buying or selling forward different currencies, buying or selling an option and so on. 5. Determine the level of risk that the enterprise is ready to accept, in tune with management guidelines and policies in this regard. 6. Manage the exchange position on a permanent and regular basis and review the strategy of risk management regularly. In order to ensure the security of exchange operations on the one hand and to avoid the counter party risk on other, it is desirable to have covering operations with banks, which have high credibility. The risk of unfavorable evolution of exchange rates affects business organisations as well as financial institutions. The increased volatility of currencies has increased the importance of this risk and has induced the creation of new financial instruments, which supplement traditional instruments like Forwards. The treasury manager is expected to understand the dynamics of rate movement so as to effectively hedge the risks resulting from exchange rate changes. He has at his disposal a large gamut of instruments for covering but he must be able to choose the one most suited to his requirements.
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FOREX MARKETS The Forex market is the oldest and the largest financial market in the world. Its daily turnover has increased from approximately 5 billion U.S Dollars in 1977 to an estimated 1.5 trillion U.S Dollars nowadays. To put these numbers into perspective, the estimated annual turnover in the world stock markets-, which is currently 21 trillion U.S Dollars per year-is just 16 days of the volume, traded in foreign exchange. The Forex market is a 24-hour continuous exchange that never closes. There are dealers in every major dealing center (London, New York, Sydney and Hong Kong etc). Major forex transactions in India are done in Mumbai market. The depth of Indian forex market is not much as compared to the daily turnover in some of the centers in Europe. The foreign exchange market has following segments: (a) Spot markets. (b) Forward markets. Futures, Options and Swaps are called derivatives because they derive their value from the exchange rates. (c) Futures markets. (d) Options markets. (e) Swaps markets.
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Spot Market Spot market refers to the transaction involving sale and purchase of currencies for immediate delivery. In practice it may take, only one or two days to settle the transaction. 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 two working days after the transaction is completed. If a particular market is closed on Saturday and Sunday and if transaction takes place on Thursday, delivery of currency takes place on Monday. Monday in this case is known as the value date or settlement date. Sometimes there are short-date contracts where the time zones permit the delivery of the currency even earlier. If the currency is delivered on 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. In view of the huge amount involved in the transactions, there is seldom any actual movement of currencies. Rather, debit and credit entries are made in the bank accounts of the seller and the purchaser. Most of the markets do transfer of funds electronically thus saving time and energy. The system in New York is known as the Clearing House Interbank Payment System (CHIPS). Participants on the spot market Major participants on the spot exchange market are: 1. Commercial banks; 2. Dealers, brokers, arbitrageurs and speculators, and 3. Central banks. (In India it is RBI)
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The Foreign Exchange Market Commercial banks:Commercial banks intervene in spot market through their foreign exchange dealers either for their own account or for their clients. The banks are intermediaries between seekers and supplier of currency. The role of bank 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 (quote is a rate or price charged, bid is the price offered to the party and ask price is the price or rate fixed by both the parties), indicating their willingness to buy and sell foreign currencies at quoted rates. The purchases and sales by large commercial banks seldom match, leading to large variations 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: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 transaction are inter bank in nature although, once in a while, they may deal with corporates and central banks. They have low transaction cost as well as thin spreads, which reflects their long experience in exchange risk management as well as the intense competition among banks. Wholesale transaction account for 90% of the total value of foreign exchange deals. Dealers at the retail level cater to need to 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 counter parties. A large portion of foreign exchange transaction is conducted
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The Foreign Exchange Market through brokers. While they tend to specialize in certain currencies, they virtually handle all major currencies. Brokers exist because they lower the dealers cost, reduce their risk and provide anonymity. In inter bank trade, brokers charge a small commission of around 0.01% 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. In 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. Unlike arbitrageurs, speculators expose themselves to risk. Speculation gives rise to financial transaction that develops when individual expectations differ from the expectations of the market. Speculators transact in foreign exchange primarily because of an anticipated but an uncertain gain as a result of an exchange rate change. An open position denominated in foreign currency constitutes speculation. Banks or corporates, when they accept 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 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 requirement 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 countrys economic well being. For example, if rupee shows signs of depreciating, central bank may release (sell) a certain 26
The Foreign Exchange Market 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 for appreciation. Currency Arbitrage in Spot Market With the fast development in telecommunication system, rates are expected to be uniform in different foreign exchange market. Nevertheless, inconsistency exists at times. The arbitrageurs take advantage of the inconsistency and garner profits by buying and selling of currencies. They 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. The process influences the demand for and supply of, the particular currency in the two markets that leads ultimately removal of inconsistency in the value of currencies in two markets. Suppose, In New York: $ 1.9800 10/: and In London: $ 1.9710 10/. The arbitrageurs will buy the dollar in London and sell in New York making a profit of $ 1.9800- 1.9710 = $ 0.009 per pound sterling. In the above example, two currencies are involved and two markets where the particular currency is bought or sold. This is why it is known as two-point arbitrage. There are also examples of three-point arbitrage or triangular arbitrage where three currencies and three markets are involved. Suppose, bid rate in: New York: $ 1.9810/ London: DM 3.1650/ and Frankfurt: $ 0.6250/DM 27
The Foreign Exchange Market In this case, the arbitrageur will exchange the dollar; say $1000 for DM in Frankfurt to get DM 1,600. He will convert DM 1,600 for pound sterling in London to get 505.63. Finally, he will sell 505.63 for dollars in New York to get $ 1,001.46. This means that he would gain $1.46 per $ 1,000 through triangular arbitrage. Speculation in spot Market Speculation in the spot market occurs when the speculators anticipate a change in the value of a currency, especially an appreciation in the value of foreign currency. Suppose the exchange rate today is Rs. 40/US $. The speculators anticipates this rate to become Rs. 41/US $ within the coming three months. Under these circumstances, he will buy US $ 1,000 for Rs 40,000 and hold this amount for three months, although he is not committed to this particular time zone. When the target exchange rate is reached, he will sell US $ 1,000 at the new exchange rate, that is at Rs. 41 per dollar and earn a profit of Rs 41,000 - 40, 000= Rs 1,000.
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Forward Market 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 take place much letter, on a date in the future. In the forward market, contracts are made to buy and sell currencies for future delivery, say, after a fortnight, one month, two months 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 newspaper and those rates form the basis of the contract. Both parties have to abide by the contract at the exchange rate mentioned therein irrespective of whether the spot rate on the maturity date resembles the forward rate or not. In other words, no party can back out of the deals if changes in the future spot rates are not in his or her favour. The value date in case of forward contract lies definitely beyond the value date applicable to a spot contract. If it is a one-month forward contract, the value date will be the date in the next month corresponding to the spot value date. Suppose a currency is purchased on the 1 August. If it is a spot transaction, the currency will be delivered on 3 August. But if it is one-month forward contract, the value date will fall on 3 September. If the value date falls on a holiday, the subsequent date will be the value date. If the value date does not exist in the calendar, such as the 29 February (if it is not a leap), the value date will fall on the 28 February. Sometimes the value date is structured to enable one of the parties to the transaction to have freedom to select a value date within the prescribed period. This happens when the party does not know in advance the precise date on which it would be able to deliver the currency, for instances, an exporter who sells a foreign currency forward without knowing in advance the precise date of shipment. Again, the maturity period of forward contract is normally for one month, two month, three months and so on but sometimes it may not be for the whole month and a fraction
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The Foreign Exchange Market of a month may also be involved. A forward contract with a maturity period of 35 days is an opposite example. Naturally, in this case, the value date falls on a date between two whole months. Such a contract is known as a broken- date contract. Forward Market Hedging Changes in the exchange rate are a usual phenomenon. Such changes entail some foreign exchange risk in terms of loss or gain to the traders and other participant in the foreign exchange market. The risk is reduced or hedged through forward market transactions. Under the process of hedging, currencies are bought and sold forward. Forward buying and selling depends upon whether the hedger finds himself in a long, or a short position. An export billed in foreign currency creates a long position for the exporter. On the contrary, an import billed in foreign currency leads to a short position for the importer. Export Long Position Sale of Foreign Currency Import Short Position Purchase of Foreign Currency
Let us first take the long position. An Indian exporter enters into a contract for mica export to the USA for US $ 1,000. The exporter proceeds are to be received within three months. The exporter fears a drop in the value of the US dollar that may diminish the export earnings. To avoid this diminution, the exporter opts for a three-month forward contract and sells forward one thousand US dollars. Suppose the spot as well as the forward rate is 40/US $. If the dollar depreciates to Rs.39, but since the exporter has already sold forward similar amount in dollars, the loss due to depreciation of the dollar will be met through the forward contract. By selling dollars, it would fetch Rs.40 thousand that will be equal to the original export value. However, the forward deal has disadvantage too. The advantage is that if the value of the dollar falls, the exporter will not have to suffer any loss of income while the disadvantage is that if the value of the dollar appreciates, the exporter will not benefit from the
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The Foreign Exchange Market appreciation. Moreover in case the importer does not accept a part of the merchandise, the exporter will have to arrange for the dollars to honour the forward contract. In the event of a short position where the Indian importer buys goods from the USA for US $ 1,000, and where the importer fears an appreciation in the value of the US dollar, the forward deal will involve the buying of dollars. If the dollar appreciate to Rs. 41 after three-month period, the importer will have to pay Rs. 1,000 more but if he has opted for a forward deal to buy similar amount in dollars, he will purchase US $ 1,000 with Rs. 40,000 and pay US $ 1,000 to the exporter and so save himself from the Rs.1, 000 loss. Here again, if the dollar appreciates, the importer eliminates the loss, but if it depreciates, the importer does not benefit from the depreciation. In these two examples of forward deals, we have assumed that the spot rate and the forward rate are equal but this is not always true. There may be either a forward premium or a forward discount. Suppose the spot rate is Rs. 40/US $ and the three month forward rate is Rs. 39.50/US $. In this case, if the spot rate after the expiry of three months turn out to be Rs. 39/US $, and if the Indian exporter has a forward contract for selling the same amount in dollars, he well be able to diminish the loss by Rs. 500 because he will get Rs. 39,500 from the forward deal. Had there been no forward contract, the exporter would have received only Rs. 39,000 following the depreciation of the US dollar. If however, the US dollar depreciates only to Rs. 39.80, the forward deal will cause a loss for Rs. 300 because it would fetch only Rs. 39,500 instead of RS. 39,800 that would have been received in the absence of a forward deal. The advantage or disadvantage of the forward deal is reaped not only by the exporter but also by the importer. In case of a short position, a forward discount is favourable to the hedger because it enables the hedger to obtain foreign exchange at a rate lower than the current spot rate. On the contrary, a forward premium is unfavorable because it makes the forward foreign currency costlier. However, the exact magnitude of loss or gain to the importer depends upon the difference between the forward rate and the future spot rate. If the forward rate is Rs. 39.50/US $ and if the future spot rate is Rs. 39.80/US $, the Indian importer will be able to save Rs. 300 because he will get US $ 1,000 only for Rs. 39,500
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The Foreign Exchange Market for one thousand dollars, had there been no forward contract. But if the future spot rate comes down to Rs. 39/Us $, the importer will have to face a loss of Rs. 500 under the forward contract. Thus hedging in a forward market, whether it concerns a long position or a short position, is a double-edged sword and if the trend in the exchange rate movement is not according to expectations, it can result in a loss. Forward Premium and Discount In the above quotes, it is found that the longer the maturity, the greater is the change in the forward rates. Again, with longer maturity, the spread too gets wider. This is because of uncertainty in the future that increases with lengthening of maturity. The change in forward rates may be upward or downward. With such movements, disparity arises between spot and forward rates. If the forward rate is lower than the spot rate, it will be a case of forward discount. On the contrary, if the forward rate were higher than the spot rate, it would be known as forward premium. Forward premium or discount is expressed as an annualized percentage deviation from the spot rate. It is computed as follows: Forward premium (discount) = (n day forward rate spot rate)/ spot rate X 360/n where n is the length of forward contract expressed in number of days. Applying the above example of a one-month forward quotation, we get (39.80 40.00)/40.00 X 360/30 = -0.06 or 6% forward discount. Speculation in Forward Market In addition to 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 in the exchange rates. The source of profits to them being the difference between the forward rate and the future spot rate, they are not very concerned with the direction of the exchange rate change.
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The Foreign Exchange Market Suppose a speculators sells US $ 1,000 three-month forward rate at the rate of Rs. 40.50/US $. If, on maturity, the US dollar depreciates to Rs 40, the speculator will get Rs. 40500 under the forward contract. At the same, he will exchange Rs. 40,500 at the then future spot rate of Rs. 40/US $ and will get US $ 1,012.50. Both these activities- the selling and the purchasing of US $ will be simultaneous. Thus without making any investment, the speculator will make a profit of US $ 12.50 through the forward market deal. This is an example of speculation in the forward market. Forward market speculation cannot be extended beyond the maturity date of the forward contract. However, if the speculator wants to close out the speculation operation prior to the maturity, say by one month, he may buy an offsetting contract. In other words, if he has already entered in to a three-month forward contract for selling US dollars, he would have to opt for a two-month forward contract for buying US dollars. The profit or loss would naturally depend upon the exchange rate involved in the two forward contracts. Cross Rates Sometimes the value of a currency in terms of another one is not known. In such cases, one currency is sold for a common currency; and again, the common currency is exchanged for the desired currency. This is known as cross rate trading and the rate established between the two currencies is known as the cross rate. Suppose, a newspaper quotes Rs. 35.00 35.20/US $; and at the same time, it quotes Canadian $0.76 0.78/US $ but does not quote the exchange rate between the rupee and the Canadian dollar. Thus the rate of exchange between the rupee and the Canadian dollar will be found through the common currency, the US dollar. The technique is similar for both spot and forward cross rates. Spot cross rates The selling rate of the Canadian dollar in India can be worked out by selling the rupee for the US dollar at Rs. 35.20/US $ and then buying Canadian dollars with the US dollar at C$ 0.76/US $. This means
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The Foreign Exchange Market Rs.35.20/US $ 1 X US $ 1/C$ 0.76 = Rs. 46.32/C$ The buying rate of the Canadian dollar in India can be found through buying the Indian rupee for the US dollar at Rs 35.00/US $ and selling the Canadian dollar for US dollar at C$ 0.78/US $. This means that Rs. 35.00/US $ 1 X US $ 1/ C$ 0.78 = Rs. 44.87/C$ Combining the two, we get Rs. 44.87 46.32/C$ Forward cross rate In this case too, the selling rate of one currency is divided by the buying rate of another currency and vice versa. Suppose, one month forward rate in case of the two currencies is Rs. 34.50 34.80/US $ and C$0.79 0.83/US $. The forward rate of the Canadian dollar in term of the rupee can be found as Rs. 34.80/C$ 0.79 = Rs. 44.05/C$ Rs. 34.50/C$ 0.83 = Rs. 41.57. Combining the two, we get Rs. 41.57 44.05/C$ Swapping of Forward Contracts The purpose of swap in the forward market is to reap profits. There are two kinds of swap. One is known as an option forward while the other is known as 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.
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The Foreign Exchange Market Contracts for option forward take place normally between a bank and its customers. Two delivery dates are mentioned on which delivery of currencies is made. One of the two dates is the date on which the deal is finalized. The other is a future date that may be the date of maturity. Similarly, two exchange rates are mentioned. One is the spot rate prevailing on the date when the deal is finalized and the other is the forward rate. The bank exchanges the currency with the customer on any date between the two dates at one of the two rates, which is favourable for it. Suppose there is a contract for an exchange between rupees and dollars and the two dates are 1 January and 1 April. The spot rate on 1 January is Rs.40/ US $ and the three-month forward rate is Rs. 40.50/US $. This shows depreciation of the dollar and in this case, if the customer sells rupees to the bank, the latter will buy them at the spot rate. If the customer buys rupees, the bank will sell them at the forward rate. In case of a forward-forward swap, two futures dates are chosen and profit emerges from the difference between the two forward rates. Suppose the trend of the quotes shows appreciation in the dollar for the next six months followed by depreciation during the following three months. The spot rate and the forward rates would be: Spot rate: 6-month forward rate: 9-month forward rate: Rs. 40.00 40.20/US $ Rs. 41.50 41.80/US $ Rs .40.25 40.75/US $
In this case, it would be beneficial for the customer to sell the dollar six month forward and buy 9-month forward. It involves US $ 1000 the profit will amount to: (Rs. 41.50-40.75) x 1,000 or Rs. 750. Besides spot and forward markets, foreign currencies are traded in the market for currency futures and the market for currency options. These two are known as derivatives because such contracts derive their value of a spot time series. The market for currency futures and options is known as the market for derivatives because the prices in these
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The Foreign Exchange Market markets are driven by the spot market price. Their discussion is an essential part of any foreign exchange market as they are an integral part of the foreign exchange market.
Futures Markets (Currency Futures) Futures market is a localized exchange where derivatives instruments called Futures are traded. Currency futures are somewhat similar to forward, yet distinctly different. The foreign exchange market involving forward contracts has a long history but the market for currency futures has a comparatively recent origin. Currency futures were launched in 1972 on the International Money Market (IMM) at Chicago. They were the first financial Futures that developed after coming into existence of the floating exchange rate regime. It is to be noted that commodity Futures (corn, oats, wheat, soyabeans, butter, eggs and silver) has been in use for a long time. The Chicago Mercantile Exchange (CME) started the future contracts of butter and egg. Later on, other currency Future markets developed at Philadelphia (Philadelphia Board of Trade), London (London International Financial Futures Exchange (LIFFE)), Tokyo (Tokyo International Financial Futures Exchange), Sydney (Sydney Futures Exchanges), and Singapore International Monetary Exchange (SIMEX). The volume traded on the Futures market is much smaller than that traded on Forward market. However, it holds a very significant position in USA and UK (specially London) and it is developing at a fast rate. Futures contracts are traded by a system of open outcry on the trading floor (also called the trading pit) of a centralized and regulated exchange. All traders represent exchange members. Those who trade for their account is called floor traders while those who trade on behalf of others are floor brokers. Some do both and are called dual traders. The variables to be negotiated in any deal are the price and the number of contracts. A buyer
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The Foreign Exchange Market of futures acquires a long position while the seller acquires a short position. When two traders agree on a deal, it is entered as short and a long both vis--vis the clearing-house. When a position is opened, the trader (both the long and the short) must post an initial margin. As prices changes, the contract is marked to market with gains credited to the margin account and losses debited to the account. If, as a result of losses, the amount in the margin account falls below a certain level known as maintenance margin the trader receives a margin call and must make up the amount to the level of the initial margin in a specified time. If the trader fails to do so, his or her position is liquidated immediately. Thus daily marking to market coupled with margins, limit the loss the exchange or a broker may have to incur to almost a few days price change. There are various kinds of orders given to floor traders and brokers. A client may ask his or her broker to buy or sell a certain number of contracts at the best available price (market orders) or may specify upper price PURCHASE ORDER SALES ORDER
BUYER
SELLER
BROKER
BROKER
CLEARING HOUSE
FLOW OF TRANSACTIONS ON FUTURES MARKET
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Major features of Futures Contracts A futures contract is an agreement for future delivery of a specified quantity of a commodity at a specified price. The principle features of the contract are as follows: 1. Organized Exchanges Unlike forward contract which are traded in an over-the-counter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready, liquid market in which futures can be bought and sold at any time like in a stock market. 2. Standardization As we saw in the case of forward currency contracts, the amount of the commodity to be delivered and the maturity date are negotiated between the buyer and the seller and can be tailor-made to buyers requirements. In a futures contract both these are standardized by the exchange on which the contract is traded. Thus for instance, one futures contract in pound sterling on the International Monetary Market (IMM), a financial futures exchange in US, (part of the Chicago Mercantile Exchange or CME), calls for delivery of 62,500 and contracts are always traded in whole numbers e.g. you cannot buy or sell fractional contracts. Similarly, for each contract, the exchange specifies a set of delivery months and specified delivery days within those months. 3. Clearing house
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The Foreign Exchange Market On the trading floor a futures contract is agreed between two parties A and B. when it is recorded by the exchange, the contract between A and B is immediately replaced by two contracts, one between A and clearing house and another between B and the clearing house. Thus the exchange interposes itself in every deal, being buyer to every seller and seller to every buyer. This eliminates the need for A and B to investigate each others creditworthiness and guarantees the financial integrity of the market. The exchange enforces delivery for contracts held till maturity. It protects itself by imposing margin requirements on traders and a system knows as marking to market. 4. Margins Only members of an exchange can trade in futures contracts on the exchange. The general public uses the members services as brokers to trade on their behalf. A subset of exchange members are clearing members i.e. members of the clearinghouse when the clearinghouse is a subsidiary of the exchange. A nonclearing member must clear all its transactions through a clearing member. Every transaction is thus between an exchange member and the exchange clearing house. The exchange requires that a member who enters into a futures commitment must deposit a performance bond in the form of a margin with the clearinghouse. The amount of the margin is generally between 2.5 to 10% of the value of the contract but can vary. 5. Marking to Market Marking to market essentially mean that at the end of a trading session all outstanding contracts are re-priced at the settlement price of that session. Margin accounts of those who made losses are debited and of those who gained are credited. This is explained in detail below by a quick example:Suppose I buy a June delivery pound sterling future say on April 14 at a price of $1.60 per pound or $100,000 per contract (=62500 X 1.06) next day, the price increases and at the end of trading on April 15, the settlement price is 1.62. I have 39
The Foreign Exchange Market made a gain of 2 cents per pound or $1250 per contract. This is credited to my margin account (and I can immediately withdraw it in cash), and my contract is re-priced at 1.62 or $1,01,250. At this stage an important difference marking to market creates between forwards and futures. In forward contract, gains or losses arise only on maturity. There are no intermediate cash flows; in futures contracts, even though the overall gain/loss is same, the time period of its accrual is different- the total gain or loss over the entire period is broken up in to daily series of gains and losses, which clearly has a different present value. Comparison between Forward and Future Markets The features of this market as distinguished from those of the forward market are discussed below:1. Size and Maturity of the Contract Despite the fact that a currency futures contract, like a forward contract, involves trading of an underlying currency at specified exchange rate and for a fixed maturity, there is primary difference between the two. Currency futures are traded only in a limited number of currencies. The size of the contract is standardized involving fixed amount of different currencies. At the Chicago Mercantile Exchange, it is pound 62,500, Can. $100,000, Australia $ 100,000, DM 125000, Swiss Fr. 125,000 and Japanese Yen 12,500,000. The date of delivery is also fixed normally on the third Wednesday of January, March, April, June, July, September, October, and December. On the contrary, in case of forward contract, many currencies are available for the contract:; delivery date is not fixed; nor is the size of the contract. 2. Use of pits A forward contract is finalized on the telephone, etc. meaning that it represents an over-the-counter market. But in the case of currency futures broker can trade for themselves as well as on behalf of their customers. When they trade futures
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The Foreign Exchange Market brokers strike the deals sitting face to face under a trading roof, known as pits. Therefore, they are called locals or floor traders. The locals are sometimes called scalpers who hold their position long or short for not more than a few minutes. They make profit out of volume trading and at the same time provide liquidity to the market. 3. Transactions through a Clearing House In every deal, the exchange or the clearing-house is necessarily involved as a party. Suppose A and B are traders. A strikes a deal with the clearing-house. B too strikes a deal with the clearing-house. A, if it is a buyer of the currency, shall acquire a long position with the clearing-house while B being the seller of the currency shall acquire a short position with the clearing-house. . In fact, the obligation of the buyer and the seller does not lie with each other but with the clearing-house. After a transaction is recorded, the clearing-house substitutes itself for the other party, meaning it becomes the seller to every buyer and buyer from every seller. This way it guarantees the performance of every transaction done on the floor of exchange. 4. Marking to the market In case of forward contracts, the deal is settled on the maturity but in case of currency futures, the rate are matched with the movements in spot rates: and on the basis, gains and losses are settled everyday. This process is called marking to the market. The process of marking to market can be explained with the help of an example. Suppose an investor buys Can. Dollar Futures (Can. $ 100,000) at US $ 0.75 on a Monday morning, which is to mature within two days. At the close of Tuesday, if the price moves up to US $ 0.7555, the investor shall profit 100,000 x (US $ 0.755 0.750) or US $ 500, and if the price falls to US $ 0.749, the investor will have to bear the loss. The amount of loss will be deducted from the margin money. If the loss is big and as a result, the margin money falls below certain 41
The Foreign Exchange Market level, which is known as the maintenance margin the investor receives a margin call for depositing the margin call for depositing the margin money within a specified period. Again, on Wednesday, the prevailing price on that particular day will be compared with the price prevailing on Tuesday and the gain or loss will be determined. On the maturity day, the investor receives the amount of the contract after the adjustment of the profit / loss. The purpose of the daily settlement procedure is to create safer futures market so that less creditworthiness investor could participate. Forward contracts, on the other hand, witness cash flow only on the date of maturity that makes the contract more risky. Nevertheless, Forward contracts are widely used because they are available at many financial centers, their amount can be tailored to individual needs as they have no standard size and maturity of thousand of transactions taking place daily is not necessarily compatible with the fixed maturity of the futures Hedging in Currency Futures Market Traders make use of the market for currency futures in order to hedge their foreign exchange risk. For instance, suppose a French importer importing goods from Germany for DM 1.0 million needs this amount for making payments to the exporter. It will purchase DM futures contract, which would lock in the price to be paid to the exporter in terms of DM at a future settlement date. By holding a futures contract, the importer does not have to worry about any change in the spot rate of the DM over time. On the other hand, if the French exporter exports goods to a German firm and has to receive DM for the exports, the exporter would sell a DM futures contract. This way the exporter will be locking in the price of the export to be received in terms of DM. It will protect itself from the loss that may occur in case of depreciation of the DM over time. Speculation with Currency Futures Speculators make use of the currency futures for reaping profits. When they expect that the spot rate of a particular currency will move up beyond those mentioned in the 42
The Foreign Exchange Market currency futures contract, they will buy currency futures denominated in that particular currency. At maturity, if their expectations come true, the difference in the spot rate and the rate mentioned in the futures contract will be the profit to be reaped by them. Suppose, the futures rate is US $ 1.75/ and the spot rate on maturity is expected to be US $ 1.76/. If the speculator purchases 62,500 at the rate of US $ 1.75 (under the futures contract) and the expectation comes true and so sells that pound at the rate of US $ 1.76 in the spot rate, the profit will be US $ (1.76 1.75) X 62,500 = US $ 625. In other words, the speculators buy currency futures in a currency when the future spot rate of that currency is expected to be greater than the currency futures rate. On the other hand, if the spot rate mentioned in a currency when the future spot rate of that currency is expected to be greater than the currency futures rate. On the other hand, if the spot rate of a particular currency is expected to depreciate below the rate mentioned in the currency futures contract, the speculator will sell currency futures in that currency. For example, if the value of the pound is expected to drop to US $ 1.74 on that maturity date, the speculator will strike a currency futures deal to sell pounds. On the maturity date, it will sell 62,500 at US $ 1.75 and with the sale proceeds to be obtained in US dollars, it will buy pounds at the spot rate. This way, it will make profits equal to US $ (1.75 1.74) X 62,500 or US $625. Types of order: There are different types of order that may be placed: 1. Limit order A limit order that stipulates a particular price at which a deal is to be made. 2. Fill or kill order A fill or kill order in which the commission broker is instructed to fill an order immediately at a specific price. The order is cancelled if it is not transacted quickly.
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The Foreign Exchange Market 3. All-or-none order The all-or-none order in which the commission broker transacts different parts of the deal at different prices. 4. On-the open order On-the open order involves transaction within a few minutes of the stock exchange. 5. On- the- close order An On-the-close orders which means transacting during the closure of the stock exchange. 6. Stop order A stop order, which involves a reversing when the price hits a prescribed limit. Its purpose is to protect against losses on existing position. Option Markets (Currency Option Contracts) Options are derivative instruments that give a choice to a foreign exchange market operator to buy or sell a foreign currency on or up to a date (maturity date) at a specified rate (strike price). Philadelphia Stock Exchange has been dealing within standardized foreign currency option contracts since 1982. It is dealing in (buy and sell) options of seven currencies against the U.S. dollar ($). These currencies are: (1) (2) (3) (4) (5) Sterling (BP) Deutsche marks (DM) Canadian dollars (Can $) Swiss francs (SF) Japanese yen (JY) 44
The Foreign Exchange Market (6) (7) Australian dollars (A$) French franc (FF)
These options are traded on three, six, and nine months, cycle. Other major trading centers are: Chicago International Money Market, Montreal Stock Exchange, Amsterdam Stock Exchange and London Stock Exchange Options are a unique financial instrument that confers upon the holder the right to do something without obligation to do so. More specifically, an option is a financial contract in which the buyer of the option has the right to buy or sell an asset, at a prespecified price, on or up to a specified date if he choose to do so; however there is no obligation for him to do so. In other words, the option buyer can simply let his right lapse by not exercising his option. The seller of the option has an obligation to take the other side of the transaction if the buyer wishes to exercise his option. Obviously, the option buyer has to pay the option seller a fee for receiving such a privilege. Options are available on a large variety of underlying assets including common stock, currencies, debt instrument, and commodities. Also traded are option on stock indices and future contracts (the underlying asset is a future contract) and future-style options. While over-the-counter option trading has had a long chequered history, option trading on organized options exchange is a relatively recent. Foreign currencies are traded in the market for currency options as well. The purpose is either the hedging of foreign exchange exposure or making of profits through speculation. As in currency forward and futures contracts, the buyer of currency options possesses the right to buy or sell foreign currency after the lapse of a specified period at a rate determined on the day contract is made, but the currency options contract has a distinctive feature that is not found in forward or futures contract. It is that the buyer of a currency options has the freedom to exercise the option if agreed upon rate turns in his favour. If the rate does not turn in his favour, he can let the options expire. Thus the exercising of options is the buyers right but not his obligation. For this privilege, the buyer has to pay a premium to the option - seller.
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The Foreign Exchange Market Suppose a person decides to acquire call options to buy Swiss francs at a price of US $ 0.70 along with a premium for US $ 0.02. On the maturity date, if spot rate of the Swiss franc is lower than the agreed upon rate, he will let the option expire because he will be able to buy it in the spot market at a cheaper rate. But if the spot rate is US $ 0.75, he will exercise the option because his cost of buying Swiss francs under the options contract (inclusive of premium) will be $0.72, whereas he can sell this currency in the spot market at a higher rate and can thereby earn a profit. Functioning of option markets and some Related Concepts Currency options are similar to options on ordinary stocks. The buyer of the option cannot loose more than the cost of the option and is not subject to any margin calls. Philadelphia stock exchange is an organized market for options on BP, DM, SF, US $, JY, FF and Can $. The options are traded on three month, six month and nine-month cycles. Currency options provide the right, but not obligation to buy or sell a specific currency at a specified price at any time prior to a specified date. This means that the user of the option obtains an insurance against adverse movement in exchange rate but retains the opportunity to benefit from a favourable movement in exchange rate. At the same time, the maximum risk to the buyer of an option is the actual cost of the option. Currency options are not substitute for forward market, but as a new, distinct and advantageous to those seeking either protection or profit from changes in exchange rates. There are two types of options: 1. American option An option, which can be exercised on any business day within the option period, is called American option. 2. European option An option, which can be exercised only on the expiry date, is called European option.
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The Foreign Exchange Market OPTIONS TERMINOLOGY Call option A call option is an option to purchase a stated number of units of underlying foreign currency at a specified price per unit during a specific period of time. Put option A put option gives the right to sell the underlying foreign currency at the specified price per unit during a specified period of time. Option Buyer The party who obtains the right by paying a premium is called the option buyer. There is no obligation with the buyer. Option seller The party who owns obligation to perform if the option is exercised. He will have to sell currencies if call option is exercised. Also known as the option-writer. Exercised price or strike price of an option The price at which the option holder has the right to purchase or sell the underlying currency. So far as the quotations of options in U.S. is concerned, except for French Francs and Yen, the exercise prices are stated in cents. Suppose a DM 35 call option, would be an option to buy at $ 0.35 per mark. In the case of Japanese Yen option the exercise prices are stated in hundredth of a cent. So JY 54 call options gives the right to the option holder to buy yen at $0.0054 per yen.
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The Foreign Exchange Market Expiration months of an option The expiration months for options are March, June, September and December. At any given time, the trading is available in nearest three of these months. Option premium Also known as the option value or option price, premium is the value or price of the option that the option-buyer pays to the option-seller at the time of signing the contract. It is not refundable even when the option is not exercised. The amount of premium is the sum of the options intrinsic value and its time value, which are explained here under. At-the-money The situation is also known as 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. In that situation when the option-buyer exercises the option, he is in the money because then only he can gain. Out-of-the-money This is the exact opposite situation of the in-the-money situation. This entails that 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 a put option.
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Intrinsic value of an option Given its throwaway feature, the value of an option can never fall below zero. Now consider an American call option on DM with a strike price of $0.5865. If the current spot rate $/DM is 0.6005, an option holder can realize an immediate gain of $(0.6005-0.5865) by exercising the call and selling the currency in the spot market. Therefore the value of call option must be at least equal to this. The intrinsic value of an option is the gain to the holder on immediate exercise. For a call option it is defined as max [(S-X), 0] where S is the current spot rate and X is the strike price. If S > X, the call has a positive intrinsic value. If S < X, intrinsic value is zero. Similarly for a put option, intrinsic value is max [(X-S), 0]. For European options, the concept of intrinsic value is only notional since they cannot be prematurely exercised. Time value of an option The time value of an option represents the sum of money that a buyer is willing to pay over and above the intrinsic value. Time value of an option exists because the spot rate of the underlying currency is expected to move towards an in-the-money position between the signing of the contract and the maturity date. On the maturity date, the time value of the option is zero and the premium is entirely represented by the intrinsic value. Again, if there is an at-the-money position that means that there is no intrinsic value, and option premium is represented entirely by the time value. Between these two positions, the premium is represented partly by the intrinsic value and partly by the time value. Suppose the strike price of a call option is Rs. 60.00/. The premium is Rs. 0.05 per British pound. The spot rate is Rs. 60.02/. The amount of premium Intrinsic value Time value = Rs. 0.05 X 62,500 = Rs. 3,125. = Rs. (60.02 60.00) X 62,500 = Rs. 1,250. = Rs. 3,125 1,250 = Rs.1, 875.
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Opening Transaction A purchase or sale transaction, which establishes an options position, is the opening transaction. Maturity date Maturity date is the date on which the option contract expires. Exchange traded options have standardized maturity dates.
Hedging with currency options

Hedging through purchase of options:In order to hedge their foreign exchange risks, if it is quote, the importers buy a call option and the exporters buy a put option. Take first the case of an importer. Suppose an Indian firm is importing goods for 62,500 and the amount is to be paid after two months, if an appreciation in the pound is expected, the importer will buy a call option on it with maturity coinciding with the date of payment. If the strike price is Rs. 60.00/, the premium is Rs. 0.05 per pound and the spot price at the maturity is Rs. 60.20, the importer will exercise the option. It will have to pay Rs. 62,500 X 60.00 +3,125 = 3,753,125. If the importer had not opted for an option, it would have had to pay Rs. 62,500 X 60.20 = 3,762,500-3,753,125 = 9,375. If, on the other hand, the pound falls to Rs. 59.80, the importer will not exercise the option since its obligation will be lower even after paying the premium. However, one question that arises if whether hedging through buying of an option is preferred only when strong volatility in the exchange rate is expected and volatility is only marginal, forward market hedging is preferred. Suppose, in the earlier example the pound appreciates to only Rs. 60.04 or depreciates to only Rs. 59.97, the amount of premium paid by the importer will be more than the benefit from hedging through
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The Foreign Exchange Market purchase of options. There will then be net positive cost of hedging through buying of option. The exporter buys a put option. Suppose an Indian exporter exports well for pound 62,500. It fears a depreciation of pound within two month when payment is to be received. In order to avoid the risk, it will buy a put option for selling the pound for a two-month maturity. Suppose the strike rate is Rs. 60.00, the premium is Rs. 0.05, and the spot rate at maturity is Rs. 59.80. In case hedge, it will receive Rs. 62,500 X 60.00 3,125 = 3,746,875.In the absence of the hedge it will receive only Rs. 3,737,500. This means, buying of a put option helps increase the exporters earnings, or reduces the exposure, by Rs. 3,746,875 3,737,500 = 9,375. Hedging through selling of options:Hedging through selling of options is advised when volatility in exchange is expected to be only marginal. The importer sells a put option and the exporter sell s a call option. The case of importers:Suppose an Indian importer imports for 62,500. It fears an appreciation in the pound and so it sells a put option on the pound on the strike price of Rs. 60.00/ and at a premium of Rs0.15 per pound. If the spot price at maturity goes up to Rs. 60.05, the buyer of the option will not exercise the option. The importer as the seller of the put option will receive the premium of Rs. 9,375, which it would not have received if it had not, brought the option. If the spot price at maturity falls to Rs. 59.95, the buyer of the option will exercise the option. But in that case, the importer will have to pay the buyer Rs.3,750,000 9,375 = 3,740,625. When there is no hedging through selling of a put option, the importer will have to pay Rs. 3,746,875. Thus the importer reduces its risk through the sale of put option.
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The Foreign Exchange Market The exporters sell the call option. If an Indian exporter exports for 62,500 and fears that the pound will depreciate and sells a call option on the pound at the strike price of Rs.60.00 at the premium of Rs 0.15 per pound. If the spot rate at maturity really falls to Rs. 69.95, the buyer of the call option will not exercise the option. The exporter being the seller of the call option will get Rs. 9375 as the premium. Its total receipt will be Rs. 62,500 X 59.95 + 9,375 = 3,756,250. In the case of no sale of the call option, the total receipt (from the importer) will be only Rs. 3,746,875. Speculating with Options Speculating with call option:Suppose A expects an appreciation in dollar in next two months. He does not have large amounts to purchase dollars and keeps these till the dollar appreciates to realize the expected profit. But A has an amount to pay the premium on option. The call option on dollar is available at a premium of Rs.0.75 per dollar with an exercise price of Rs. 35.75. The current spot rate is Rs. 35.00. The contract size is $100,000.00. A pays Rs. 75000 as premium and buys an option. The dollar appreciates before the expiration date and the spot rate is Rs. 36.90/$. The speculator sells the currency at Rs. 36.90 and exercise the call options and buys the currency at Rs.35.75/$. The possible gains are as follows: The amount received from selling currency per unit The exercise price per unit The premium paid per unit Net gains per dollar sale Gains on the option contract = Rs. 36.90 = -Rs. 35.75. = -Rs. 00.75 = Rs. 00.40 = 100,000 X 00.40 = Rs.40, 000.
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Swaps Markets
Swaps, as the term suggests, are simply the instrument that permits the exchange of two streams of cash flows in two different currencies. Swap is an agreement between two or more parties to exchange set of cash flows over a period in future. The parties that agree to swap are known as counter-parties. The cash flows that the counter parties make are generally tied to the value of debt instruments or to the value of currencies. Therefore, the two basic kinds of swaps are: 1. 2. Currency swap, and Interest rate swap.
A big industry has come up to facilitate swap. Swap facilitators are economic agents who help counter parties to help each other and help the parties to consummate swap transaction. There can be two type of swap facilitator. 1. 2. Brokers: who function as agents that identify and bring counter parties on the table, and Swap dealers: who themselves become counter parties and take over the risk.
Since the swap dealers take over the risk, therefore they face two important problems, namely, (A) (B) (C) How to price swap to provide for his services, and Swap dealer essentially has a portfolio, therefore the second problem is to Manage this portfolio.
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Swap market The market where the counter parties meet and arrange transaction for exchanging the cash is called the swap market. It has the following characteristics. Characteristic of swap Market 1. 2. 3. 4. 5. Swap is contracts of exchanging the cash flows and is tailored to the needs of the counter parties. Swaps can meet specific needs of the customers. Exchange trading necessarily involves loss of some privacy, by contrast, in the swap market the privacy exists and only the counter parties know the transaction. Counter parties can select amounts, currencies, maturity dates, etc. Future, Stock or Option exchanges are subject to considerable regulations. Till today, swap market does not face much of the regulations. Swap market has some limitations, such as: (a) (b) Each party must find a counter party, which wishes to take opposite position. Since swap is an agreement between two parties, therefore it cannot be terminated at ones instance. The termination also requires to be accepted by counter parties. (c) 6. Future and option exchange is guarantors to the transactions, where as there is no such guarantee with the swap. Since swaps are bilateral agreements, therefore the problem of potential default exists.
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Currency swap A currency swap is an agreement between two or more parties to exchange interest obligations/receipts, for an agreed period, between two different currencies, and at the end of the period to re-exchange the corresponding principal amounts at an exchange rate agreed at the beginning of the transaction. The rationale for a currency swap is that one of the parties has a comparative advantage in borrowing in one currency, another has an advantage in the other. This can be explained with the help of following illustrations: Illustration: A prominent Indian firm I wants to raise funds in the U.S.A. At the same time, a prominent American companies wants to raise funds in India. Both the firms are well known in their domestic markets but relatively unknown in the foreign market and may not receive a good credit rating abroad. It would be beneficial to both the companies if the company with a comparative advantage borrows in that particular market and the two swap their liabilities. The rates at which the companies can borrow are: Company I A Quoted interest rate Quoted interest rate Rupees (%) Dollars (%) 19 9 18 6
Company I needs dollars while company A needs rupees. The differential is 1% India but 3% in America. Both the parties stand to gain through the following arrangement through the middleman M. Firm I will borrow in India a sum of Rs.40 crore at 19%. A will borrow $10 million in the U.S. at 6%. Both the parties enter into a swap on the following terms:
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The Foreign Exchange Market 1. The principal sums are exchanged 2. A will pay M dollars at 8.5% and receive rupee interest at 19% 3. Firm I will pay M rupee interests at 17.5% and receive from M dollar interest at the rate of 6%. The cash flows will be as follows: Party Outflow on Swap outflow Swap inflow loan from bank (%) Rs. -19 $. - 6 Nil (%) $ -8.5 Rs. -17.5 Rs. 19.0 $ -6.0 (%) Rs. +19.0 $ +6.0 Rs. s+17.5 $ +8.5 (%) $ -8.5 Rs. 17.5 Rs. 1.5 $ -2.5 Total
I A C
The firm A and I have both achieved a lower cost of capital than if they had borrowed directly in the other currency. M gains 2.5% dollars and loses 1.5% in Rs., producing a net gain of 1%. However it should be noted that m carries an exchange risk.
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Interest Rate Swaps An interest rate swap is an agreement to exchange interested related payments in the same currency from fixed into floating rate (vice versa), or from one type of floating rate to another. New or existing debt can be swapped. Two British companies both wish to borrow 10 million pounds. Company A has an excellent credit rating. Company B has a lower credit rating. Both the companies have the option of borrowing at the floating rate or the fixed rate. Company A would prefer a floating rate transaction while company B would prefer a fixed rate transaction. Company A B Quoted interest rate Fixed (%) 7.5 9.0 Quoted interest rate Floating rate (%) LIBOR+0.5 LIBOR+3.5
Clearly the cost of funds for B is higher than that for A whether fixed or floating rate is considered. However, in the fixed rate case Bs extra cost is 1.5% while in the floating rate the extra cost is 3%. C ltd., a broker comes and arranges a swap. Under the swap A actually borrows 10 million pounds from a bank at LIBOR+0.5% and B borrows 10 million pounds from a bank at 9%. As a separate transaction A, B, C agree as follows: 1. A will pay C at a fixed rate of 7% 2. A will receive from C a floating rate of LIBOR+. 5% 3. B will pay C a floating rate of LIBOR+. 5% 4. B will receive from C a fixed rate of 6.5% It should be noted in a swap that it is independent of the borrowing undertaken initially by the bank A and B and the banks that lent the funds to A and B are in no way concerned with the swap.
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The Foreign Exchange Market To understand the benefits under swap we have to consider the net cash flows of A, B and C. Party Outflow on Swap outflow Swap inflow loan from bank (%) (%) (%) (%) -(LIBOR+.5) -7 + (LIBOR+.5) -7 -9 -(LIBOR+.5) 6.5 -(LIBOR+3) Nil -(LIBOR+.5) + (LIBOR+.5) -6.5 -7 .5 Total
A B C
The net result is For A, a fixed rate obligation at 7%. This is better than the 7.5% A would have paid if it had directly taken a fixed rate loan. For B, a floating rate obligation at LIBOR+3% is better than the Libor+3.5%, which the bank would have paid, if it had taken a floating rate loan. For C a profit of .5 % for arranging the transactions. The gap between the differentials was (3-1.5)% = 1.5%. It is this 1.5%, which is distributed as gains with each getting a 0.5%. The parties in this case swapped their liabilities so it is known as the liability swap. If the parties swap their receipts then it is called an asset swap.
CONCLUSION
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The Foreign Exchange Market Today in the world among all the markets the size of foreign exchange market is biggest. But as compared to the capital markets, derivative markets, commodities markets, foreign exchange markets in India are at very nascent stage. The reasons are the insignificant volumes in the export and imports of goods and services in the world, restriction on the full capital account convertibility, stringent norms of RBI and Government for currency flow etc. As we know the global economy is integrated at very fast speed, sooner or later eventually all the restrictions on the currency flows have to be scraped and Indian currency will be fully convertible on the capital account. So the future of forex markets in India is very bright. With the passage of time the size of Indian Foreign Exchange Markets will grow tremendously. This will give plethora of opportunities to work in this field. This will give rise to probably screen based, highly regulated foreign exchange market from the current OTC market.
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Research Methodology
Primary Research: The interviews were taken of the people involved in the foreign exchange markets. Among those who were interviewed, Mr. D. D. Gokhale is manager, Forex department, United Western Bank, Mr. Sandip Kelkar is Forex Market dealer, and Mr. Barve is the faculty on the international finance in many management institutes in Mumbai. The interview of these people helped to gain insight in the subject matter. It helped to analyze these markets and its functions. Secondary Research: The financial books, business magazines, regulatory reference books and web sites were the main sources of the secondary information.
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The Foreign Exchange Market BIBLIOGRAPHY Books: International Finance by Maurice D. Levi. International Finance by Prof. Apte. International Financial Management by Shapiro. Exchange Risk and Corporate International Finance, Robert Z. International Economics, Richard D. Irwin. Web Sites: www.emacklai.com www.imf.org www.fxcm.com www.refcofx.com www.rbi.org Journals and Magazines: Foreign trade review by IIFT. Foreign Exchange Handbook by Paul Bishop. Analyst magazine by ICFAI. 1.
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The Foreign Exchange Market

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The Foreign Exchange Market