Financial Management Assignment

THEMATIC PAPER
QUESTIONS FOR PRACTISE
CASELETS

SUBMITTED BY:
DEEPAK GEORGE
1 MBA J
1021013
Forex Market

The foreign exchange market is a worldwide decentralized over-the-counter financial market for the

trading of currencies. Financial centres around the world function as anchors of trading between a
wide range of different types of buyers and sellers around the clock, with the exception of weekends.
The foreign exchange market determines the relative values of different currencies. It is the market
where one country’s currency is traded for another’s. It is the largest financial market in the world its
importance has risen manifold due to the increased integration of world economies together and due
to the operation of MNC’s and transnational corporations.

The foreign exchange market is the largest and most liquid financial market in the world.
Traders include large banks, central banks, institutional investors, currency speculators,
corporations, governments, other financial institutions, and retail investors. The average
daily turnover in the global foreign exchange and related markets is continuously growing.
According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for
International Settlements, average daily turnover was US$3.98 trillion in April 2010. Of this
$3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded
in outright forwards, FX swaps and other currency derivatives.

Foreign exchange trading increased by 20% between April 2007 and April 2010 and has
more than doubled since 2004. The increase in turnover is due to a number of factors: the
growing importance of foreign exchange as an asset class, the increased trading activity of
high-frequency traders, and the emergence of retail investors as an important market
segment. The growth of electronic execution methods and the diverse selection of execution
venues have lowered transaction costs, increased market liquidity, and attracted greater
participation from many customer types. In particular, electronic trading via online portals
has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail
trading is estimated to account for up to 10% of spot FX turnover, or $150 billion per day.

The market is important because any business that is done in a country is usually carried out in local
currency. In Forex Market the currency is traded. To understand better lets take an example, suppose
India wishes to buy machinery from USA so the price of the machinery cant be given in rupees it has
to be in $(dollars) thus India needs to buy dollars to pay the money thus India goes to Forex market
and gives Rupees to buy dollars so that the amount is paid in dollars to USA the amount India will
have to pay will depend upon the prevailing exchange rate at that time. Exchange rate is the price of a
country’s currency expressed in terms of currency of another country. Exchange rate can be quoted in
2 ways direct and indirect.

Direct- rs 45 for $1.

Indirect $.0222 for rs 1.

When it comes to Indian scenario the major participants in Forex market are:

 Reserve Bank Of India

 Banks
 Business undertakings
The exchange rate plays a very important role in the functioning of an economy and if speculative
practices are involved it will cause the downfall of the economy that is why RBI always has a tight
control over the rates and it sets limits. China is able to earn a lot of profit because of tweaking the
exchange rates so that the exporters benefit.

There are concept called ask price and bid price.

 Ask price- rate quoted to sell foreign currency

 Bid price- Rate quoted to buy foreign currency
 The difference between the ask and bid price is known as spread

During the transaction there are further rates known as spot rates and forward rates. Spot rates are
the applicable when there is immediate purchase and delivery of the sought currency. Forward rates
on the other hand are used when the payment is made on future date. There are 2 options in forward
rates, One to pay according to prevailing spot rate on the due date of payment. Second to arrive at an
agreement and fix the rate of exchange in advance and pay it at the time of due date irrespective of
the spot rate prevailing on that day. There may be two situations again one the rate may be premium
it happens when there is a rise in rate of exchange and the discount happens when there is a fall in
exchange rate.

Cross rates happen if there is no provision of exchanging currency of one country to another both
have to convert their currency to a common currency say $ and proceed with the transaction.

Arbitrage is the act of buying currency from a market where it is available in cheap rates and selling it
in market where it is costly and thus establishing the equilibrium in exchange rates of different
currencies.

It might be clear that the exchange rates are not independent and are not arbitrarily decided upon
there are a lot of factors that go into it before arriving at a conclusion. Several factors play an
important role they are

 Inflation rates
 Interest rates
 Balance of payment position
 Volume of international reserves
 Level of employment

If inflation rates are low then the domestic products are cheaper and so exports will rise and
eventually the foreign currency will flow in and the domestic currency grows stronger and less of it is
given in exchange of the foreign currency. If the domestic inflation is higher then the imports will
increase as the goods are cheaper when imported and more of domestic currency flows out and it
weakens the local currency meaning that more is paid to get one unit of foreign currency.

If the interest rates are higher in another country then the funds will flow there so that investors earn
more profit and the currency of that country grows stronger and more of local currency will have to be
given to buy the unit of foreign currency. The reverse happens if the interest rate falls.

If the country is heavily dependent on imports it is likely that there is a deficit in the balance of
payments position and the currency of the country will tend to be weaker because they are supposed
to give back the foreign currency and relieve themselves off the debt. So a country with a low BOP
deficit has a strong currency and vice versa.
The amount of foreign exchange reserve in form of gold determines whether the domestic currency is
weak or strong. If the domestic currency depreciates then the reserves can be released and
equilibrium can be reached. This can be done as long as there are international reserves with the
country.

Growing economies have a stronger currency because there is potential of growth and returns. And
investors see it as a hot spot for their money to grow.

Along with these factors political stability and the environment prevailing also plays a major rolein
determining the Forex rates .