Assignment 3

Gaurav Sonkeshariya
191131

Q.1. Write a note on the functions, organization and participants of foreign

exchange market. Explain briefly the features of futures, forwards and options.

Ans:- Meaning:
Foreign exchange market is the market in which foreign currencies are bought and sold.
The buyers and sellers include individuals, firms, foreign exchange brokers, commercial
banks and the central bank.

Like any other market, foreign exchange market is a system, not a place. The
transactions in this market are not confined to only one or few foreign currencies. In
fact, there are a large number of foreign currencies which are traded, converted and
exchanged in the foreign exchange market.

Functions of Foreign Exchange Market:

1. Foreign exchange market transfers purchasing power across different countries,

which results in enhancing the feasibility of international trade and overseas
investment.

2. It acts as a central focus whereby prices are set for different currencies.

3. With the help of foreign exchange market investors can hedge or minimize the risk of
loss due to adverse exchange rate changes.

4. Foreign exchange market allows traders to identify risk free opportunities and
arbitrage these away.

5. It facilitates investment function of banks and corporate traders who are to expose
their firms to currency risks.
Participants in Foreign Exchange Market:

1.Commercial Banks:

The major participants in the foreign exchange market are the large Commercial banks
who provide the core of market. As many as 100 to 200 banks across the globe actively
“make the market” in the foreign exchange.

2.Foreign Exchange Brokers:

Foreign exchange brokers also operate in the international currency market. They act as
agents who facilitate trading between dealers. Unlike the banks, brokers serve merely as
matchmakers and do not put their own money at risk.

3.Central banks:

Another important player in the foreign market is Central bank of the various countries.
Central banks frequently intervene in the market to maintain the exchange rates of their
currencies within a desired range and to smooth fluctuations within that range.

4.MNCs:

MNCs are the major non-bank participants in the forward market as they exchange cash
flows associated with their multinational operations. MNCs often contract to either pay
or receive fixed amounts in foreign currencies at future dates, so they are exposed to
foreign currency risk.

5.Individuals and Small Businesses:

Individuals and small businesses also use foreign exchange market to facilitate
execution of commercial or investment transactions. The foreign needs of these players
are usually small and account for only a fraction of all foreign exchange transactions.
Organisation of the Foreign Exchange Market

The foreign exchange market consists of a number of different aspects and is the largest
and most liquid market in the world, measured by dollar volume of trade. It is open
around the clock (i.e. 24 hours) as the major financial centres where currencies are
traded have different geographic locations.

Structure of the Foreign Exchange Market

Features of Futures Contracts

1. Organised Exchanges:
Unlike forward contracts which are traded in an over-the-counter market, futures are
traded on organised exchanges with a designated physical location where trading takes
place.

2. Standardisation:
In the case of forward currency contracts, the amount of commodity to be delivered and
the maturity date are negotiated between the buyer and seller and can be tailor-made to
buyer’s requirements.

3. Clearing House:
The exchange acts as a clearing house to all contracts struck on the trading floor. Upon
entering into the records of the exchange, this is immediately replaced by two contracts,
one between A and the clearing house and another between B and the clearing house.

4. Margins:
Like all exchanges, only members are allowed to trade in futures contracts on the
exchange. Others can use the services of the members as brokers to use this instrument.
Thus, an exchange member can trade on his own account as well as on behalf of a client.

5. Marking to Market:
The exchange uses a system called marking to market where, at the end of each trading
session, all outstanding contracts are reprised at the settlement price of that trading
session. This would mean that some participants would make a loss while others would
stand to gain.
Q.2. Explain the Purchasing Power Parity (Product value method) theory of
determining exchange rates. 

Ans:-
Purchasing power parity (PPP) is a measurement of prices in different countries that
uses the prices of specific goods to compare the absolute purchasing power of the
countries' currencies. In many cases, PPP produces an inflation rate that is equal to the
price of the basket of goods at one location divided by the price of the basket of goods at
a different location. The PPP inflation and exchange rate may differ from the market
exchange rate because of poverty, tariffs, and other transaction costs.

According to this theory, rate of exchange between two countries depends upon
the relative purchas ing power of their respective currencies. Such will be the rate
which equates the two purchasing powers.

For example, if a certain assortment of goods can be had for £1 in Britain and a
similar assortment with Rs. 80 in India, then it is clear that the purchasing power
of £ 1 in Britain is equal to the purchasing power of Rs. 80 in India. Thus, the
rate of exchange, according to purchasing power parity theory, will be £1 = Rs.
80. Let us take another example. Suppose in the USA one $ purchases a giv en
collection of commodities.

In India, same collection of goods cost 60 rupees. Then rate of exchange will tend
to be $ 1 = 60 rupees. Now, suppose the price levels in the two countries remain
the same but somehow exchange rate moves to $1=61 rupees. This means that one
US$ can purchase commodities worth more than 46 rupees. It will pay people to
convert dollars into rupees at this rate, ($1 = Rs. 61), purchase the given
collection of commodities in India for 60 rupees and sell them in U.S.A. for one
dolla r again, making a profit of 1 rupee per dollar worth of transactions. This will
create a large demand for rupees in the USA while supply thereof will be less
because very few people would export commodities from USA to India. The value
of the rupee in term s of the dollar will move up until it will reach $1 = 60
rupees. At that point, imports from India will not give abnormal profits. $ 1 = 60
rupees and is called the purchasing power parity between the two countries. Thus ,
while the value of the unit of one currency in terms of another currency is
determined at any particular time by the market conditions of demand and
supply, in the long run the exchange rate is determined by the relative values of
the two currencies as in respective purchasing powers over goods and services.
Indicated by their respective purchasing powers over goods and services.
Q.3. Explain the Interest Parity Theory (Asset value method) of determining
exchange rates. 

Ans:-

INTEREST RATE PARITY (IRP) Interest Rate Parity (IRP) is a theory in which
the differential between the interest rates of two countries remains equal to the
differential calculated by using the forward exchange rate and the spot exchange
rate techniques. Interest rate parity connects interest, spot exchange, and foreign
exchange rates. It plays a crucial role in Forex markets.

IRP theory comes handy in analysing the relationship between the spot rate and
a relev ant forward (future) rate of currencies. According to this theory, there will
be no arbitrage in interest rate differentials between two different currencies and
the differential will be reflected in the discount or premium for the forward
exchange rate on the foreign exchange.

The theory also stresses on the fact that the size of the forward premium or
discount on a foreign currency is equal to the difference between the spot and
forward interest rates of the countries in comparison.

Example Let us conside r investing € 1000 for 1 year. Now there are two options
or cases

Case I: Home Investment In the US, let the spot exchange rate be $1.2245 / €1.
So, practically, we get an exchange for our €1000 @ $1.2245 = $1224.50 We can
invest this money $1224.50 at the rate of 3% for 1 year which yields $1261.79 at
the end of the year.

Case II: International Investment We can also invest €1000 in an international

market, where the rate of interest is 5.0% for 1 year. So, €1000 @ of 5% for 1
year = €1051.27

Let the forward exchange rate be $1.20025 / €1. So, we buy forward 1 year in
the future exchange rate at $1.20025/€1 since we need to convert our €1000 back
to the domestic currency, i.e., the U.S. Dollar. Then, we can convert € 1051.27 @
$1.20025 = $1261.79

Thus, when there is no arbitrage, the Return on Investment (ROI) is equal in both
cases, regardless the choice of investment method. Arbitrage is the activity of
purchasing shares or currency in one financial market and selling it at a premium
(profit) in anothe r. Covered Interest Rate Parity (CIRP) According to Covered
Interest Rate theory, the exchange rate forward premiums (discounts) nullify the
interest rate differentials between two sovereigns.