FOREIGN EXCHANGE MARKET

Introduction:
The foreign exchange market (currency, forex, or FX) trades currencies. It lets
banks and other institutions easily buy and sell currencies.

The purpose of the foreign exchange market is to help international trade and
investment. A foreign exchange market helps businesses convert one currency to
another. For example, it permits a U.S. business to import European goods and
pay Euros, even though the business's income is in U.S. dollars.

In a typical foreign exchange transaction a party purchases a quantity of one

currency by paying a quantity of another currency. The modern foreign exchange
market started forming during the 1970s when countries gradually switched to
floating exchange rates from the previous exchange rate regime, which remained
fixed as per the Bretton Woods system.

The foreign exchange market is unique because of

 its trading volumes,

 the extreme liquidity of the market,
 its geographical dispersion,
 its long trading hours: 24 hours a day except on weekends (from
22:00 UTC on Sunday until 22:00 UTC Friday),
 the variety of factors that affect exchange rates.
 the low margins of profit compared with other markets of fixed
income (but profits can be high due to very large trading volumes)
 the use of leverage

As such, it has been referred to as the market closest to the ideal perfect
competition, notwithstanding market manipulation by central banks. According to
the Bank for International Settlements, average daily turnover in global foreign
exchange markets is estimated at $3.98 trillion. Trading in the world's main
financial markets accounted for $3.21 trillion of this. This approximately $3.21
trillion in main foreign exchange market turnover was broken down as follows:

 $1.005 trillion in spot transactions

 $362 billion in outright forwards
 $1.714 trillion in foreign exchange swaps
 $129 billion estimated gaps in reporting

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The foreign exchange market in India is growing in both volume and depth.
Various kinds of transactions are facilitated by the banks both on a spot and on a
forward basis. These include hedging transactions such as currency swaps and
interest rate swaps.

Foreign and Indian banks also assist in offshore loan syndication. Other services
provided include, financing of foreign trade, arranging the most economical
source of supplier credit, etc. Banks also assist in foreign exchange management
such as currency management strategies and designing, assessing of liability
structures vis-a-vis swaps, interest rates, income, etc.

The origin of the foreign exchange market in India could be traced to the year
1978 when banks in India were permitted to undertake intra-day trade in foreign
exchange. However, it was in the 1990s that the Indian foreign exchange market
witnessed far reaching changes along with the shifts in the currency regime in
India. The exchange rate of the rupee that was pegged earlier was floated partially
in March 1992 and fully in March 1993 following the recommendations of the
Report of the High Level Committee on Balance of Payments (Chairman: Dr.C.
Rangarajan). The unification of the exchange rate was instrumental in developing
a market-determined exchange rate of the rupee and an important step in the
progress towards current account convertibility, which was achieved in August
1994.
A further impetus to the development of the foreign exchange market in India was
provided with the setting up of an Expert Group on Foreign Exchange Markets in
India (Chairman: Shri O.P. Sodhani), which submitted its report in June 1995.
The Group made several recommendations for deepening and widening of the
Indian foreign exchange market. Consequently, beginning from January 1996,
wide-ranging reforms have been undertaken in the Indian foreign exchange
market.
After almost a decade, an Internal Technical Group on the Foreign Exchange
Market (2005) was constituted to undertake a comprehensive review of
the measures initiated by the Reserve Bank and identify areas for further
liberalisation or relaxation of restrictions in a medium-term framework.The
momentous developments over the past few years are reflected in the enhanced
risk-bearing capacity of banks along with rising foreign exchange
trading volumes and finer margins.

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The Market for Foreign Exchange

In the market for foreign exchange (forex), people trade one country's money for
another's. If, for example, you decide to travel to Thailand, you will need to buy
some bahts, the currency of Thailand, either before you go or once you get there.
In your transaction, you will supply dollars to the foreign exchange market and
demand bahts.

The foreign exchange market provides an excellent illustration of how financial

markets can transmit disturbances. The market is usually considered to be an
efficient market, not subject to runaway speculative binges. The heart of the
market is the trading by a number of very large banks. A trade worth a million
dollars is very small in this market, but it is the prices of these very large bank
transactions that newspapers report when they publish exchange rates. When you
deal in smaller amounts when you travel to Thailand, you will get less favorable
prices.

The market for foreign exchange can be analyzed in terms of supply and demand.
Americans demand foreign money (and supply dollars) when they buy things
abroad, such as vacations, goods, services, factories, and financial assets.
Foreigners supply foreign currency (and demand dollars) when they buy things
here, such as vacations, goods, services, factories, and financial assets. Although
when you buy a Japanese camera, you do not deal in the foreign exchange market,
someone did in the process of bringing the camera to you. It may have been the
American importer, who would have sold dollars to buy yen, and then used the
yen to buy the camera. Or it may have been the Japanese exporter, who sold
cameras for dollars and then sold the dollars for yen. In either case, dollars were
supplied to the foreign exchange market and yen were demanded.

The exchange rate, or the price of foreign money, is an important price when we
buy things made in other countries. For example, the manufacturer of the camera
in the previous paragraph paid its workers in yen. The camera has a yen price.
Suppose the price of the camera in yen is 50,000 yen. How much will this camera
cost in terms of dollars? To determine this, we must know the value of yen in
terms of dollars, or the exchange rate. Suppose one dollar is worth 250 yen.

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Then to find the value of the camera in dollars, we can use this equation:

(1) Dollar price = exchange rate x yen price

(2) Dollar price = (number of dollars/number of yen) x yen price.

Substituting the values we have we find:

(3) Dollar price = ($1/(250 yen)) x (50,000 yen/(1 camera))

Canceling out where we can gives us:

(4) Dollar price = $200/1 camera.

Two things affect the price of the Japanese camera as seen from America. The
first is the yen price of the camera, and the second is the dollar price of the yen. If
either one increases, Japanese cameras will become more expensive, and
Americans will want fewer of them. The exchange rate also affects the price of
American goods as seen in Japan. One can use the same equation to compute what
the yen price of a bushel of soybeans will be if the dollar value is $10.
Substituting into equation 2 we get:

(5) $10/1 bushel of soybeans = ($1/250 yen) x yen price.

Ninth grade algebra tells us to divide through by the exchange rate to get the
equation into the form:

(6) ($10/1 bushel of soybeans) x (250 yen/$1) = yen price.

Solving gives us

(7) 2500 yen/1 bushel = yen price,

or that a bushel of soybeans will cost 2500 yen.

The graph below shows a supply and demand graph for foreign exchange. When
foreign currency is cheap, foreign products are cheap in dollars and Americans
will want a lot of them. To buy these foreign products, Americans must buy a lot
of foreign exchange. When the price of foreign exchange is expensive, so too will

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be foreign products, and Americans will not want many. Hence, they will not need
as much foreign exchange. Thus, the demand for foreign exchange will have the
negative slope that demand curves are supposed to have.

Let us consider what will happen if the United States increased its tariffs. Because
tariffs are taxes on imports, foreign products will become more expensive for
Americans. As a result, Americans will want to buy fewer imports, which is
usually the desired result of tariffs. However, if the exchange rate is a floating
rate, that is, one that can take whatever value supply and demand dictate, the story
has not ended. As a result of the tariff and the resulting decrease in imports, the
demand curve for foreign exchange shifts to the left. As a result, foreign money
becomes cheaper for Americans and American dollars become more expensive for
foreigners. If dollars become more expensive, foreigners will find American
goods more expensive. (You can check this by seeing what the yen price of
soybeans becomes if the dollar rises in value so that it is worth 300 yen.) As
dollars become more expensive, foreigners will reduce the amounts that they buy
from us. The end effect of a tariff with floating exchange rates, then, is to cut not
just imports, but to cut exports as well. This latter effect is a totally unintended

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consequence but one that illustrates how financial markets can transmit effects
from one place to another.

Fixed Exchange Rates

If a country treats the market for foreign exchange as any other market, allowing
the marketplace determine the price of foreign money, it has a system of floating
exchange rates. This is what most of the Western world has had since the 1970s.
However, governments have often fixed prices in this market. 1 In doing so they
simultaneously establish price floors and price ceilings--they will neither let the
price rise nor fall (except within a small range).

There are two ways a government can keep exchange rates fixed. One method,
which has been common in less-developed nations, is called a fixed and
unconvertible exchange rate because the exchange rate is fixed, but domestic
currency cannot be freely converted into foreign money. Governments using it
almost always set the price of foreign exchange below the market-clearing price
(which means that they price their own currency too high), and thereby cause a
shortage of foreign money. The government prevents the market from increasing
price to eliminate this shortage by outlawing private transactions in foreign
exchange and requiring citizens who obtain foreign exchange to sell it to the
government. Because the government becomes the only legal source of foreign
money, those who want to buy products from abroad must obtain those funds
from the government, which rations these funds to those purposes it deems most
worthy. Although this system is hard to justify on economic grounds, and is often
evaded with extensive black-marketing, the system gives rulers a powerful tool to
reward friends and punish enemies. We will not discuss this system further.

The second method is a fixed and convertible exchange rate. With this method a
government does not abolish the private market for foreign exchange, but fixes
exchange rates by standing ready to absorb any surpluses or to fill any shortages.
During the 1950s and most of the 1960s, for example, the United States pegged
the dollar to gold ($35.00 was equal to one ounce of gold), and most other
countries had pegged their currencies to the dollar (the German Mark was fixed at
four marks equal to one dollar for much of this time). The U.S. government would
buy or sell gold at $35.00 per ounce to foreign governments on demand, and the
German government would buy and sell dollars at a price of four marks per dollar.

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Supply and demand analysis tells us that if the price of foreign exchange is set
above the market-clearing price, there will be a surplus of foreign exchange (and a
shortage of the domestic currency). At this price people will want to sell more
foreign exchange than they want to buy. The government can prevent this surplus
from lowering price by stepping into the market and buying the excess foreign
exchange. On the other hand, if the price that the government sets is below the
market-clearing price, there will be a shortage of foreign exchange called a
balance of payments deficit. The government can prevent the shortage from
raising price by selling foreign exchange into the market. The government can
obtain this foreign exchange from reserves it stored up when there was a surplus,
or by borrowing from other countries, or by selling assets such as gold. It should
be obvious that a government can only fill a balance of payments shortage
temporarily and that if it runs for too long, the country will run out of foreign
exchange to provide to the market.

The attempt to estimate the size of the shortage or surplus of foreign exchange
when countries fixed exchange rates was once of considerable importance, but no
longer is now that most of the industrial world has floating exchange rates.

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Market size and liquidity

The foreign exchange market is the largest and most liquid financial market in the
world. Traders include large banks, central banks, currency speculators,
corporations, governments, and other financial institutions. The average daily
volume in the global foreign exchange and related markets is continuously
growing. Daily turnover was reported to be over US$3.2 trillion in April 2007 by
the Bank for International Settlements. Since then, the market has continued to
grow. According to Euromoney's annual FX Poll, volumes grew a further 41%
between 2007 and 2008.

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Main foreign exchange market turnover, 1988 - 2007, measured in billions of USD.

Of the $3.98 trillion daily global turnover, trading in London accounted for around
$1.36 trillion, or 34.1% of the total, making London by far the global center for
foreign exchange. In second and third places respectively, trading in New York
accounted for 16.6%, and Tokyo accounted for 6.0%. In addition to "traditional"
turnover, $2.1 trillion was traded in derivatives.

Exchange-traded FX futures contracts were introduced in 1972 at the Chicago

Mercantile Exchange and are actively traded relative to most other futures
contracts.

Several other developed countries also permit the trading of FX derivative

products (like currency futures and options on currency futures) on their
exchanges. All these developed countries already have fully convertible capital
accounts. Most emerging countries do not permit FX derivative products on their
exchanges in view of prevalent controls on the capital accounts. However, a few
select emerging countries (e.g., Korea, South Africa, India) have already
successfully experimented with the currency futures exchanges, despite having
some controls on the capital account.

FX futures volume has grown rapidly in recent years, and accounts for about 7%
of the total foreign exchange market volume, according to The Wall Street Journal
Europe (5/5/06, p. 20).

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Top 10 currency traders

% of overall volume, May 2009
Rank Name Market Share
1 Deutsche Bank 20.96%
2 UBS AG 14.58%
3 Barclays Capital 10.45%
4 Royal Bank of Scotland 8.19%
5 Citi 7.32%
6 JPMorgan 5.43%
7 HSBC 4.09%
8 Goldman Sachs 3.35%
9 Credit Suisse 3.05%
10 BNP Paribas 2.26%

Foreign exchange trading increased by 38% between April 2005 and April 2006
and has more than doubled since 2001. This is largely due to the growing
importance of foreign exchange as an asset class and an increase in fund
management assets, particularly of hedge funds and pension funds. The diverse
selection of execution venues have made it easier for retail traders to trade in the
foreign exchange market. In 2006, retail traders constituted over 2% of the whole
FX market volumes with an average daily trade volume of over US$50-60 billion
(see retail trading platforms). Because foreign exchange is an OTC market where
brokers/dealers negotiate directly with one another, there is no central exchange or
clearing house. The biggest geographic trading centre is the UK, primarily
London, which according to IFSL estimates has increased its share of global
turnover in traditional transactions from 31.3% in April 2004 to 34.1% in April
2007. The ten most active traders account for almost 80% of trading volume,
according to the 2008 Euromoney FX survey. These large international banks
continually provide the market with both bid (buy) and ask (sell) prices. The
bid/ask spread is the difference between the price at which a bank or market
maker will sell ("ask", or "offer") and the price at which a market taker will buy
("bid") from a wholesale or retail customer. The customer will buy from the
market-maker at the higher "ask" price, and will sell at the lower "bid" price, thus
giving up the "spread" as the cost of completing the trade. This spread is minimal

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for actively traded pairs of currencies, usually 0–3 pips. For example, the bid/ask
quote of EUR/USD might be 1.2200/1.2203 on a retail broker. Minimum trading
size for most deals is usually 100,000 units of base currency, which is a standard
"lot".

These spreads might not apply to retail customers at banks, which will routinely
mark up the difference to say 1.2100/1.2300 for transfers, or say 1.2000/1.2400
for banknotes or travelers' checks. Spot prices at market makers vary, but on
EUR/USD are usually no more than 3 pips wide (i.e., 0.0003). Competition is
greatly increased with larger transactions, and pip spreads shrink on the major
pairs to as little as 1 to 2 pips.

Foreign exchange trading increased by 38% between April 2005 and April 2006
and has more than doubled since 2001. This is largely due to the growing
importance of foreign exchange as an asset class and an increase in fund
management assets, particularly of hedge funds and pension funds.

Because foreign exchange is an OTC market where brokers/dealers negotiate

directly with one another, there is no central exchange or clearing house. The
biggest geographic trading centre is the UK, primarily London, which according
to IFSL estimates has increased its share of global turnover in traditional
transactions from 31.3% in April 2004 to 34.1% in April 2007.

Market participants
Unlike a stock market, where all participants have access to the same prices, the
foreign exchange market is divided into levels of access. At the top is the inter-
bank market, which is made up of the largest commercial banks and securities
dealers. Within the inter-bank market, spreads, which are the difference between
the bid and ask prices, are razor sharp and usually unavailable, and not known to

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players outside the inner circle. The levels of access that make up the foreign
exchange market are determined by the size of the "line" (the amount of money
with which they are trading). After that there are usually smaller banks, followed
by large multi-national corporations. According to Galati and Melvin, “Pension
funds, insurance companies, mutual funds, and other institutional investors have
played an increasingly important role in financial markets in general, and in FX
markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge
funds have grown markedly over the 2001–2004 period in terms of both number
and overall size” Central banks also participate in the foreign exchange market to
align currencies to their economic needs.

Banks

The interbank market caters for both the majority of commercial turnover and
large amounts of speculative trading every day. A large bank may trade billions of
dollars daily. Some of this trading is undertaken on behalf of customers, but much
is conducted by proprietary desks, trading for the bank's own account. Today,
however, much of this business has moved on to more efficient electronic
systems, the broker squawk box.

Commercial companies

An important part of this market comes from the financial activities of companies
seeking foreign exchange to pay for goods or services. Commercial companies
often trade fairly small amounts compared to those of banks or speculators, and
their trades often have little short term impact on market rates. Nevertheless, trade
flows are an important factor in the long-term direction of a currency's exchange
rate. Some multinational companies can have an unpredictable impact when very
large positions are covered due to exposures that are not widely known by other
market participants.

Central banks

National central banks play an important role in the foreign exchange markets.
They try to control the money supply, inflation, and/or interest rates and often
have official or unofficial target rates for their currencies. They can use their often
substantial foreign exchange reserves to stabilize the market. Milton Friedman
argued that the best stabilization strategy would be for central banks to buy when
the exchange rate is too low, and to sell when the rate is too high—that is, to trade

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for a profit based on their more precise information. Nevertheless, the

effectiveness of central bank "stabilizing speculation" is doubtful because central
banks do not go bankrupt if they make large losses, like other traders would, and
there is no convincing evidence that they do make a profit trading.

Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions are speculative. In other
words, the person or institution that bought or sold the currency has no plan to
actually take delivery of the currency in the end; rather, they were solely
speculating on the movement of that particular currency. Hedge funds have gained
a reputation for aggressive currency speculation since 1996. They control billions
of dollars of equity and may borrow billions more, and thus may overwhelm
intervention by central banks to support almost any currency, if the economic
fundamentals are in the hedge funds' favor

Investment management firms

Investment management firms (who typically manage large accounts on behalf of

customers such as pension funds and endowments) use the foreign exchange
market to facilitate transactions in foreign securities. For example, an investment
manager bearing an international equity portfolio needs to purchase and sell
several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist

currency overlay operations, which manage clients' currency exposures with the
aim of generating profits as well as limiting risk. Whilst the number of this type of
specialist firms is quite small, many have a large value of assets under
management (AUM), and hence can generate large trades.

Retail foreign exchange brokers

There are two types of retail brokers offering the opportunity for speculative
trading: retail foreign exchange brokers and market makers. Retail traders
(individuals) are a small fraction of this market and may only participate indirectly
through brokers or banks. Retail brokers, while largely controlled and regulated
by the CFTC and NFA might be subject to foreign exchange scams.[8][9] At
present, the NFA and CFTC are imposing stricter requirements, particularly in
relation to the amount of Net Capitalization required of its members. As a result

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many of the smaller, and perhaps questionable brokers are now gone. A move
toward NDD (No Dealing Desk) and STP (Straight Through Processing) has
helped to resolve some of these concerns and restore trader confidence.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international

payments to private individuals and companies. These are also known as foreign
exchange brokers but are distinct in that they do not offer speculative trading but
currency exchange with payments. I.e., there is usually a physical delivery of
currency to a bank account. Send Money Home offer an in-depth comparison into
the services offered by all the major non-bank foreign exchange companies.

It is estimated that in the UK, 14% of currency transfers/payments are made via
Foreign Exchange Companies. These companies' selling point is usually that they
will offer better exchange rates or cheaper payments than the customer's bank.
These companies differ from Money Transfer/Remittance Companies in that they
generally offer higher-value services.

Money transfer/remittance companies

Money transfer companies/remittance companies perform high-volume low-value

transfers generally by economic migrants back to their home country. The largest
and best known provider is Western Union with 345,000 agents globally. Send
Money Home is an international money transfer price comparison site that allows
consumers access to a range of alternative products and rates available when
remitting (transferring) money worldwide.

Trading characteristics
There is no unified or centrally cleared market for the majority of FX trades, and
there is very little cross-border regulation. Due to the over-the-counter (OTC)
nature of currency markets, there are rather a number of interconnected
marketplaces, where different currencies instruments are traded. This implies that
there is not a single exchange rate but rather a number of different rates (prices),
depending on what bank or market maker is trading, and where it is. In practice
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the rates are often very close, otherwise they could be exploited by arbitrageurs
instantaneously. Due to London's dominance in the market, a particular currency's
quoted price is usually the London market price. A joint venture of the Chicago
Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and
aspired but failed to the role of a central market clearing mechanism.

The main trading center is London, but New York, Tokyo, Hong Kong and
Singapore are all important centers as well. Banks throughout the world
participate. Currency trading happens continuously throughout the day; as the
Asian trading session ends, the European session begins, followed by the North
American session and then back to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as

well as by expectations of changes in monetary flows caused by changes in gross
domestic product (GDP) growth, inflation (purchasing power parity theory),
interest rates (interest rate parity, Domestic Fisher effect, International Fisher
effect), budget and trade deficits or surpluses, large cross-border M&A deals and
other macroeconomic conditions. Major news is released publicly, often on
scheduled dates, so many people have access to the same news at the same time.
However, the large banks have an important advantage; they can see their
customers' order flow.

Currencies are traded against one another. Each currency pair thus constitutes an
individual trading product and is traditionally noted XXXYYY or YYY/XXX,
where XXX and YYY are the ISO 4217 international three-letter code of the
currencies involved. The first currency (XXX) is the base currency that is quoted
relative to the second currency (YYY), called the counter currency (or quote
currency). For instance, the quotation EURUSD (USD/EUR) 1.5465 is the price of
the euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. Historically,
the base currency was the stronger currency at the creation of the pair. However,
when the euro was created, the European Central Bank mandated that it always be
the base currency in any pairing.

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Most traded currencies
Currency distribution of reported FX market turnover
ISO 4217  % daily
Rank Currency code share
(Symbol) (April 2007)
 United States
1 USD ($) 86.3%
dollar
2  Euro EUR (€) 37.0%
3  Japanese yen JPY (¥) 17.0%
4  Pound sterling GBP (£) 15.0%
5  Swiss franc CHF (Fr) 6.8%
6  Australian dollar AUD ($) 6.7%
7  Canadian dollar CAD ($) 4.2%
8-9  Swedish krona SEK (kr) 2.8%
 Hong Kong
8-9 HKD ($) 2.8%
dollar
10  Norwegian krone NOK (kr) 2.2%
 New Zealand
11 NZD ($) 1.9%
dollar
12  Mexican peso MXN ($) 1.3%
13  Singapore dollar SGD ($) 1.2%
 South Korean
14 KRW (₩) 1.1%
won
Other 14.5%
Total 200%

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes
positive currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the BIS study, the most heavily traded products
were:

 EURUSD: 27%
 USDJPY: 13%
 GBPUSD (also called cable): 12%

and the US currency was involved in 86.3% of transactions, followed by the euro
(37.0%), the yen (17.0%), and sterling (15.0%) (see table). Volume percentages

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for all individual currencies should add up to 200%, as each transaction involves
two currencies.

Trading in the euro has grown considerably since the currency's creation in
January 1999, and how long the foreign exchange market will remain dollar-
centered is open to debate. Until recently, trading the euro versus a non-European
currency ZZZ would have usually involved two trades: EURUSD and USDZZZ.
The exception to this is EURJPY, which is an established traded currency pair in
the interbank spot market. As the dollar's value has eroded during 2008, interest in
using the euro as reference currency for prices in commodities (such as oil), as
well as a larger component of foreign reserves by banks, has increased
dramatically. Transactions in the currencies of commodity-producing countries,
such as AUD, NZD, CAD, have also increased.

Speculation
Controversy about currency speculators and their effect on currency devaluations
and national economies recurs regularly. Nevertheless, economists including
Milton Friedman have argued that speculators ultimately are a stabilizing
influence on the market and perform the important function of providing a market
for hedgers and transferring risk from those people who don't wish to bear it, to
those who do. Other economists such as Joseph Stiglitz consider this argument to
be based more on politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main
professional speculators. According to some economists, individual traders could
act as "noise traders" and have a more destabilizing role than larger and better
informed actors.

Currency speculation is considered a highly suspect activity in many countries.

While investment in traditional financial instruments like bonds or stocks often is
considered to contribute positively to economic growth by providing capital,
currency speculation does not; according to this view, it is simply gambling that
often interferes with economic policy. For example, in 1992, currency speculation
forced the Central Bank of Sweden to raise interest rates for a few days to 500%
per annum, and later to devalue the krona. Former Malaysian Prime Minister
Mahathir Mohamad is one well known proponent of this view. He blamed the

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devaluation of the Malaysian ringgit in 1997 on George Soros and other

speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to

"vigilantes" who simply help "enforce" international agreements and anticipate the
effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or otherwise

mishandle their national economies, and foreign exchange speculators allegedly
made the inevitable collapse happen sooner. A relatively quick collapse might
even be preferable to continued economic mishandling. Mahathir Mohamad and
other critics of speculation are viewed as trying to deflect the blame from
themselves for having caused the unsustainable economic conditions. Given that
Malaysia recovered quickly after imposing currency controls directly against
International Monetary Fund advice, this view is open to doubt.

Algorithmic trading in foreign exchange

Electronic trading is growing in the FX market, and algorithmic trading is
becoming much more common. According to financial consultancy Celent
estimates, by 2008 up to 25% of all trades by volume will be executed using
algorithm, up from about 18% in 2005.

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Determinants of FX rates
The following theories explain the fluctuations in FX rates in a floating exchange
rate regime (In a fixed exchange rate regime, FX rates are decided by its
government):

(a) International parity conditions viz; Relative Purchasing Power Parity,

interest rate parity, Domestic Fisher effect, International Fisher effect. Though to
some extent the above theories provide logical explanation for the fluctuations in
exchange rates, yet these theories falter as they are based on challengeable
assumptions [e.g., free flow of goods, services and capital] which seldom hold
true in the real world.

(b) Balance of payments model This model, however, focuses largely on

tradable goods and services, ignoring the increasing role of global capital flows. It
failed to provide any explanation for continuous appreciation of dollar during
1980s and most part of 1990s in face of soaring US current account deficit.

(c) Asset market model views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly by
people’s willingness to hold the existing quantities of assets, which in turn
depends on their expectations on the future worth of these assets. “The exchange
rate between two currencies represents the price that just balances the relative
supplies of, and demand for, assets denominated in those currencies.”

It is understood from above models that many macroeconomic factors affect the
exchange rates and in the end currency prices are a result of dual forces of demand
and supply. The world's currency markets can be viewed as a huge melting pot: in
a large and ever-changing mix of current events, supply and demand factors are
constantly shifting, and the price of one currency in relation to another shifts
accordingly. Supply and demand for any given currency, and thus its value, are

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not influenced by any single element, but rather by several elements such as
economic factors, political conditions and market psychology.

Economic factors
These include: (a)economic policy, disseminated by government agencies and
central banks, (b)economic conditions, generally revealed through economic
reports, and other economic indicators.

1. Economic policy comprises government fiscal policy (budget/spending

practices) and monetary policy (the means by which a government's central
bank influences the supply and "cost" of money, which is reflected by the
level of interest rates).

2. Economic conditions include:

Government budget deficits or surpluses

The market usually reacts negatively to widening government budget
deficits, and positively to narrowing budget deficits. The impact is reflected
in the value of a country's currency.

Balance of trade levels and trends

The trade flow between countries illustrates the demand for goods and
services, which in turn indicates demand for a country's currency to conduct
trade. Surpluses and deficits in trade of goods and services reflect the
competitiveness of a nation's economy. For example, trade deficits may
have a negative impact on a nation's currency.

Inflation levels and trends

Typically a currency will lose value if there is a high level of inflation in the
country or if inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand, for that particular
currency. However, a currency may sometimes strengthen when inflation

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rises because of expectations that the central bank will raise short-term
interest rates to combat rising inflation.

Economic growth and health

Reports such as GDP, employment levels, retail sales, capacity utilization
and others, detail the levels of a country's economic growth and health.
Generally, the more healthy and robust a country's economy, the better its
currency will perform, and the more demand for it there will be.
Productivity of an economy
Increasing productivity in an economy should positively influence the value
of its currency. Its effects are more prominent if the increase is in the traded
sector.

Political conditions
Internal, regional, and international political conditions and events can have a
profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about
the new ruling party. Political upheaval and instability can have a negative impact
on a nation's economy. For example, destabilization of coalition governments in
Pakistan and Thailand can negatively affect the value of their currencies.
Similarly, in a country experiencing financial difficulties, the rise of a political
faction that is perceived to be fiscally responsible can have the opposite effect.
Also, events in one country in a region may spur positive or negative interest in a
neighboring country and, in the process, affect its currency.

Market psychology
Market psychology and trader perceptions influence the foreign exchange market
in a variety of ways:

Flights to quality
Unsettling international events can lead to a "flight to quality," with
investors seeking a "safe haven." There will be a greater demand, thus a
higher price, for currencies perceived as stronger over their relatively
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weaker counterparts. The Swiss franc and gold have been traditional safe
havens during times of political or economic uncertainty.

Long-term trends
Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical
commodities, business cycles do make themselves felt. Cycle analysis looks
at longer-term price trends that may rise from economic or political trends.
"Buy the rumor, sell the fact"
This market truism can apply to many currency situations. It is the tendency
for the price of a currency to reflect the impact of a particular action before
it occurs and, when the anticipated event comes to pass, react in exactly the
opposite direction. This may also be referred to as a market being
"oversold" or "overbought". To buy the rumor or sell the fact can also be an
example of the cognitive bias known as anchoring, when investors focus
too much on the relevance of outside events to currency prices.

Economic numbers
While economic numbers can certainly reflect economic policy, some
reports and numbers take on a talisman-like effect: the number itself
becomes important to market psychology and may have an immediate
impact on short-term market moves. "What to watch" can change over time.
In recent years, for example, money supply, employment, trade balance
figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations

As in other markets, the accumulated price movements in a currency pair
such as EUR/USD can form apparent patterns that traders may attempt to
use. Many traders study price charts in order to identify such patterns.

Exchange Rate of the US Dollar and the Euro

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  Exchange rate of the euro

  Exchange rate of the US dollar

Financial instruments
Spot

A spot transaction is a two-day delivery transaction (except in the case of trades

between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which
settle the next business day), as opposed to the futures contracts, which are usually
three months. This trade represents a “direct exchange” between two currencies,
has the shortest time frame, involves cash rather than a contract; and interest is not
included in the agreed-upon transaction. The data for this study come from the
spot market. Spot transactions have the second largest turnover by volume after
Swap transactions among all FX transactions in the Global FX market. NNM

Forward

One way to deal with the foreign exchange risk is to engage in a forward
transaction. In this transaction, money does not actually change hands until some
agreed upon future date. A buyer and seller agree on an exchange rate for any date
in the future, and the transaction occurs on that date, regardless of what the market
rates are then. The duration of the trade can be a one day, a few days, months or
years. Usually the date is decided by both parties.

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Future

Foreign currency futures are exchange traded forward transactions with standard
contract sizes and maturity dates — for example, $1000 for next November at an
agreed rate. Futures are standardized and are usually traded on an exchange
created for this purpose. The average contract length is roughly 3 months. Futures
contracts are usually inclusive of any interest amounts.

Swap

The most common type of forward transaction is the currency swap. In a swap,
two parties exchange currencies for a certain length of time and agree to reverse
the transaction at a later date. These are not standardized contracts and are not
traded through an exchange.

Option

A foreign exchange option (commonly shortened to just FX option) is a derivative

where the owner has the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed exchange rate
on a specified date. The FX options market is the deepest, largest and most liquid
market for options of any kind in the world.

Exchange-traded fund

Exchange-traded funds (or ETFs) are open ended investment companies that can
be traded at any time throughout the course of the day. Typically, ETFs try to
replicate a stock market index such as the S&P 500.

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Foreign Exchange Market in India

Foreign Exchange Market in India works under the central government in India
and executes wide powers to control transactions in foreign exchange.
The Foreign Exchange Management Act, 1999 or FEMA regulates the whole
foreign exchange market in India. Before this act was introduced, the foreign
exchange market in India was regulated by the reserve bank of India through the
Exchange Control Department, by the FERA or Foreign Exchange Regulation
Act, 1947. After independence, FERA was introduced as a temporary measure to
regulate the inflow of the foreign capital. But with the economic and industrial
development, the need for conservation of foreign currency was urgently felt and
on the recommendation of the Public Accounts Committee, the Indian government

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passed the Foreign Exchange Regulation Act, 1973 and gradually, this act became
famous as FEMA.
Until 1992 all foreign investments in India and the repatriation of foreign capital
required previous approval of the government. The Foreign Exchange Regulation
Act rarely allowed foreign majority holdings for foreign exchange in India.
However, a new foreign investment policy announced in July 1991, declared
automatic approval for foreign exchange in India for thirty-four industries. These
industries were designated with high priority, up to an equivalent limit of 51
percent. The foreign exchange market in India is regulated by the reserve bank of
India through the Exchange Control Department.
Initially the government required that a company’s routine approval must rely on
identical exports and dividend repatriation, but in May 1992 this requirement of
foreign exchange in India was lifted, with an exception to low-priority sectors. In
1994 foreign and nonresident Indian investors were permitted to repatriate not
only their profits but also their capital for foreign exchange in India. Indian
exporters are enjoying the freedom to use their export earnings as they find it
suitable. However, transfer of capital abroad by Indian nationals is only allowed in
particular circumstances, such as emigration. Foreign exchange in India is
automatically made accessible for imports for which import licenses are widely
issued.
Indian authorities are able to manage the exchange rate easily, only because
foreign exchange transactions in India are so securely controlled. From 1975 to
1992 the rupee was coupled to a trade-weighted basket of currencies. In February
1992, the Indian government started to make the rupee convertible, and in March
1993 a single floating exchange rate in the market of foreign exchange in India
was implemented. In July 1995, Rs 31081 was worth US $1, as compared to Rs
7.86 in 1980, Rs 12.37 in 1985, and Rs 17.50 in 1990.
Predictions of capital flow-driven currency crisis have held India back from
capital account convertibility, as stated by experts. An inevitable side effect of the
foreign exchange rate policy in India has been the ballooning of foreign exchange
reserves to over a hundred billion dollars. In an unparalleled move, the
government is considering to use part of these reserves to sponsor infrastructure
investments in the country.
The foreign exchange market in India is growing very rapidly, since the annual
turnover of the market is more than $400 billion. This foreign exchange
transaction in India does not include the inter-bank transactions. According to the

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record of foreign exchange in India, RBI released these transactions. The average
monthly turnover in the merchant segment was $40.5 billion in 2003-04 and the
inter-bank transaction was $134.2 for the same period. The average total monthly
turnover in the sector of foreign exchange in India was about $174.7 billion for
the same period. The transactions are made on spot and also on forward basis,
which include currency swaps and interest rate swaps.
The Indian foreign exchange market is made up of the buyers, sellers, market
mediators and the monetary authority of India. The main center of foreign
exchange in India is Mumbai, the commercial capital of the country. There are
several other centers for foreign exchange transactions in India including the
major cities of Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin.
With the development of technologies, all the foreign exchange markets in India
work collectively and in much easier process.
Foreign Exchange Dealers Association is a voluntary association that also
provides some help in regulating the market. The Authorized Dealers and the
attributed brokers are qualified to participate in the foreign exchange markets of
India. When the foreign exchange trade is going on between Authorized Dealers
and RBI or between the Authorized Dealers and the overseas banks, the brokers
usually do not have any role to play. Besides the Authorized Dealers and brokers,
there are some others who are provided with the limited rights to accept the
foreign currency or travelers cheque, they are the authorized money chargers,
travel agents, certain hotels and government shops. The IDBI and EXIM are also
permitted at specific times to hold foreign currency.
The Foreign Exchange Market in India is a flourishing ground of profit and higher
initiatives are taken by the central government in order to strengthen the
foundation.

Intervention in Foreign Exchange Markets

The two main functions of the foreign exchange market are to determine the price
of the different currencies in terms of one another and to transfer currency risk
from more risk-averse participants to those more willing to bear it. As in any
market essentially the demand and supply for a particular currency at any specific
point in time determines its price (exchange rate) at that point. However, since the
value of a country’s currency has significant bearing on its economy, foreign
exchange markets frequently witness government intervention in one form or
another, to maintain the value of a currency at or near its “desired” level.

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Interventions can range from quantitative restrictions on trade and cross-border

transfer of capital to periodic trades by the central bank of the country or its allies
and agents so as to move the exchange rate in the desired direction. In recent years
India has witnessed both kinds of intervention though liberalization has implied a
long-term policy push to reduce and ultimately remove the former kind. It is safe
to say that over the years since liberalization, India has allowed restricted capital
mobility and followed a “managed float” type exchange rate policy.

During the early years of liberalization, the Rangarajan committee recommended

that India’s exchange rate be flexible. Officially speaking, India moved from a
fixed exchange rate regime to “market determined” exchange rate system in 1993.
The overt objective of India’s exchange rate policy, according to various policy
pronouncements, has been to manage “volatility” in exchange rates without
targeting any specific levels.This has been hard to do in practice.

The Indian rupee has had a remarkably stable relationship with the US dollar.
Meanwhile the dollar appreciated against major currencies in the late 90’s and
then went into an extended decline particularly during 2003 and 2004. The lock-
step pattern of the US dollar and the Rupee is best reflected in the movements in
the two currencies against a third currency like the Euro. The correlation of the
exchange rates of the two currencies against the Euro during 1999-2004 was 0.94.
Several studies have established the pegged nature of the rupee in recent years
(see Chakrabarti (2006) for a more detailed discussion). Based on volatility, India
had a de facto crawling peg to the US dollar between 1979 and 1991 which
changed to a de facto peg from mid-1991 to mid-1995, with a major devaluation
in March 1993. From mid-1995 to end-2001, the rupee reverted to a crawling peg
arrangement in practice. An analysis of the ratio of the variance of the exchange
rate to the sum of the variances of the interest rate and the foreign exchange
reserves reveals a move even closer to the fixed exchange rate system. A
comparison of the sensitivity (beta) of the Dollar-rupee rate with the Euro-rupee
rate for a three year period (1999 through 2001), indicates that India had a dollar
beta of 1.01 – tenth highest among the 53 countries considered. More importantly,
the US dollar-Euro exchange rate explained about 97% of all movements in the
Indian rupee-Euro exchange rate – highest among all the 53 countries considered.
Clearly the Indian rupee has been an excellent “tracker” of the US dollar.
It is instructive to consider the Rupee-Dollar exchange rate in the light of the
purchasing power parity (PPP) holding that the exchange rate between two
currencies should equal the ratio of price levels in two countries. In its dynamic
form PPP holds that that the rate of depreciation of a currency should equal the
excess of its inflation rate to that in the other country. Over a reasonably long
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period of time, the devaluation in the Indian Rupee, vis-à-vis the US dollar does
seem to have an association with the difference in the inflation rates in the two
countries. Between 1991 and 2003, the two variables have had visible co-
movements with a correlation of about 0.57 (Chakabarti (2006)). This may be a
result of Indo-US trade flows dominating the exchange rate markets but it is
perhaps more likely that it reflects the exchange rate management principles of the
monetary authorities.

The Reserve Bank of India has used a varied mix of techniques in intervening in
the foreign exchange market – indirect measures such as press statements
(sometimes called “open mouth operations” in central bank speak) and, in more
extreme situations, monetary measures to affect the value of the rupee as well as
direct purchase and sale in the foreign exchange market using spot, forward and
swap transactions (see Ghosh (2002)). Till around 2002, the measures were
mostly in the nature of crisis management of saving-the-rupee kind and sometimes
the direct deals would be repeated over several days till the desired outcome was
accomplished. Other public sector banks, particularly the SBI often aided or
veiled the intervention process.
The exact details of the interventions are shrouded in mystery, not unusual for
central banks ever wary of disclosing too much of their hand to the currency
speculators. The Tarapore Committee report had urged more transparency in the
intervention process and recommended, in 1997, that a ‘Monitoring Exchange
Rate Band’ of ± 5% be used around an announced neutral real effective exchange
rate (REER), with weekly publication of relevant figures, something yet to be
implemented. In a recent survey on foreign exchange market intervention in
emerging markets, the Bank for International Settlements (BIS (2005b)) found
that out of 11 emerging market countries considered, India gave out most
complete information on intervention strategy (along with three others); no
information on actual interventions (five others did the same) and did not cover
foreign exchange intervention in annual reports (like two other countries). On the
whole it ranked fourth most opaque in matters of foreign exchange intervention
among the eleven countries compared.

Regulation of cross-border currency flows

A feature of the economy that is intricately related with the exchange rate regime
followed is the freedom of cross-border capital flows. This relationship comes
from the so-called “impossible trinity” or “trilemma” of international finance,
which essentially states that a country may have any two but not all of the
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following three things – a fixed exchange rate, free flow of capital across its
borders and autonomy in its monetary policy. Since liberalization, India has been
having close to a de facto peg to the dollar and simultaneously has been
liberalizing its foreign currency flow regime.

Close on the heels of the adoption of market determined exchange rate (within
limits) in 1993 came current account convertibility in 1994. In 1997, the Tarapore
committee, on Capital Account Convertibility, defined the concept as “the
freedom to convert local financial assets into foreign financial assets and vice
versa at market determined rates of exchange” and laid down fiscal consolidation,
a mandated inflation target and strengthening of the financial system as its three
main preconditions. Meanwhile capital flows have been gradually liberalized,
allowing, on the inflow side, foreign direct and portfolio investments, and tapping
foreign capital markets by Indian companies as well as considerably better
remittance privileges for individuals; and on the outflow side, international
expansion of domestic companies. In 2000, the infamous Foreign Exchange
Regulation Act (FERA) was replaced with the much milder Foreign Exchange
Management Act (FEMA) that gave participants in the foreign exchange market a
much greater leeway.

The ultimate goal of capital account convertibility now seems to be within the
government’s sights and efforts are on to chalk out the roadmap for the last leg,
though it is not expected to be accomplished before 2009. Expectedly, the wisdom
of the move has been hotly debated. Advocates of convertibility cite the
“consumption smoothing” benefits of global funds flow and point out that it
actually improves macroeconomic discipline because of external monitoring by
the global financial markets. Convertibility can spur domestic investment and
growth because of easier and cheaper financing. It can also contribute to greater
efficiency in the banking and financial systems. On the other hand, skeptics like
Williamson
(2006), for instance, points out that India is yet to fulfill at least one of the three
major preconditions to Capital Account Convertibility set out by the Tarapore
committee, viz. fiscal discipline, with a public sector deficit of 7.6% of the GDP
and the ratio of public debt to GDP of over 83% in 2005-06. In any case, the
argument goes, the benefits of convertibility do not necessarily outweigh the risks
and cross-border short-term bank loans – usually the last item to be liberalized –
are the most volatile. It is generally held that it was, in fact, the lack of
convertibility that protected India from contamination during the Asian contagion
in 1997-98.

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The Dynamics of Swelling Reserves

An important corollary of India’s foreign exchange policy has been the quick and
significant accumulation of foreign currency reserves in the past few years.
Starting from a situation in 1990-91 with foreign exchange reserves level barely
enough to cover two weeks of imports, and about $32 billion at the beginning of
2000, India’s foreign exchange position rocketed to one of the largest in the world
with over $155 billion in mid-2006. Since 2000, this implies a compounded
annual growth rate of about 28% with the years 2003 and 2004 having the most
stunning rises at 48% and 45% respectively. During these two years the US dollar
fell against the Euro by 19% and against the rupee by 9%. Without RBI
intervention, the latter figure is likely to have been larger and the reserves
accumulation less spectacular.

A sizable foreign exchange reserve acts as liquidity cover and protects against a
run on the country’s currency, and reduces the rate of interest on Indian debt in the
world market by lowering the country risk perception by international rating
agencies. However, beyond a point, it begins to affect the money supply in the
country, and interest rates. There are significant “sterilization costs” to avoid this
and the RBI loses money by earning low returns on the safe assets used to park
the reserves. Given this low rate of return, there has been discussion about the
unique proposal to use part of the reserves to fund infrastructure projects.

Outlook

Liberalization has transformed India’s external sector and a direct beneficiary of

this has been the foreign exchange market in India. From a foreign exchange-
starved, control-ridden economy, India has moved on to a position of $150 billion
plus in international reserves with a confident rupee and drastically reduced
foreign exchange control. As foreign trade and cross-border capital flows continue
to grow, and the country moves towards capital account convertibility, the foreign

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exchange market is poised to play an even greater role in the economy, but is
unlikely to be completely free of RBI interventions any time soon.

Conclusion:

The Indian foreign exchange market has operated in a liberalized environment for
more than a decade. A cautious and well-calibrated approach was followed while
liberalising the foreign exchange market with an emphasis on the need to
safeguard against potential financial instability that could arise due to excessive

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speculation. The focus was on gradually dismantling controls and providing an

enabling environment to all entities engaged in external transactions. The
approach to liberalisation adopted by the Reserve Bank has been characterised by
greater transparency, data monitoring and information dissemination and to move
away from micro management of foreign exchange transactions to macro
management of foreign exchange flows. The emphasis has been to ensure that
procedural formalities are minimised so that individuals are able to conduct hassle
free current account transactions and exporters and other users of the market are
able to concentrate on their core activities rather than engage in avoidable paper
work. With a view to maintaining the integrity of the market, strong knowyour-
customer (KYC)/anti-money laundering (AML) guidelines have also been put in
place.

Banks have been given significant autonomy to undertake foreign exchange

operations. In order to deepen the foreign exchange market, several products have
been introduced and new players have been allowed to enter the market. Full
convertibility on the current account and extensive liberalisation of the capital
account have resulted in large increase in transactions in foreign currency. These
have also enabled the corporates to hedge various types of risks associated with
foreign currency transactions. The impact of these reform initiatives is clearly
discernible in terms of depth and efficiency of the market.

Exchange rate regimes do influence the regulatory framework when it comes to

the issue of providing operational freedom to market participants in respect of
their foreign exchange market operations. Notwithstanding a move towards
greater exchange rate flexibility by most EMEs, almost all central banks in EMEs
actively participate in their foreign exchange markets to maintain orderly
conditions. While the use of risk management instruments is encouraged by many
emerging markets for hedging genuine exposures linked to real and financial
flows, their overall approach towards risk management has remained cautious
with an emphasis on the need to safeguard against potential financial instability
arising due to excessive speculation in the foreign exchange market.

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In the coming years, the challenge for the Reserve Bank would be to further build
up on the strength of the foreign exchange market and carry forward the reform
initiatives, while simultaneously Foreign Exchange Market ensuring that orderly
conditions prevail in the foreign exchange market. Besides, with the Indian
economy moving towards further capital account liberalisation, the development
of a well-integrated foreign exchange market also becomes important as it is
through this market that cross-border financial inflows and outflows are channeled
to other markets. Development of the foreign exchange market also needs to be
co-ordinated with the capital account liberalisation. Reforms in the financial
markets is a dynamic process and need to be harmonised with the evolving
macroeconomic developments and the level of maturity of participating financial
institutions and other segments of the financial market.

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