Q2.

Give an overview of foreign exchange markets, how they are operated and their effect
on Balance of Payments of a country.
Foreign Exchange Market
The foreign exchange market (also known as forex, FX or the currency market) is an over-
the-counter (OTC) global marketplace that determines the exchange rate for currencies
around the world. Participants are able to buy, sell, exchange, and speculate on currencies.
Foreign exchange markets are made up of banks, forex dealers, commercial
companies, central banks, investment management firms, hedge funds, retail forex
dealers and investors.
Explanation
The foreign exchange market was one of the original financial markets formed to bring
structure to the burgeoning global economy. In terms of trading volume it is, by far, the
largest financial market in the world. Aside from providing a venue for the buying, selling,
exchanging and speculation of currencies, the forex market also enables currency
conversion for international trade settlements and investments.
Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is
relative to the value of the other. This determines how much of country A's currency
country B can buy, and vice versa. Establishing this relationship (price) for the global
markets is the main function of the foreign exchange market. This also greatly enhances
liquidity in all other financial markets, which is key to overall stability.
The value of a country's currency depends on whether it is a "free float" or "fixed float".
Free floating currencies are those whose relative value is determined by free market forces,
such as supply / demand relationships. A fixed float is where a country's governing body sets
its currency's relative value to other currencies, often by pegging it to some standard. Free
floating currencies include the U.S. Dollar, Japanese Yen and British Pound, while examples
of fixed floating currencies include the Chinese Yuan and the Indian Rupee.
One of the most unique features of the forex market is that it is comprised of a global
network of financial centers that transact 24 hours a day, closing only on the weekends. As
one major forex hub closes, another hub in a different part of the world remains open for
business. This increases the liquidity available in currency markets, which adds to its appeal
as the largest asset class available to investors.
The most liquid trading pairs are, in descending order of liquidity:
1. EUR/USD
2. USD/JPY
3. GBP/USD
Forex Leverage
The leverage available in FX markets is one of the highest that traders and investors can find
anywhere. Leverage is a loan given to an investor by their broker. With this loan, investors
are able to increase their trade size, which could translate to greater profitability and
amplified losses.
For example, investors who have a $1,000 forex market account can trade $100,000 worth
of currency with a margin of 1 percent. This is referred to as having a 100:1 leverage. Their
profit or loss will be based on the $100,000 notional amount.
Benefits of Using the Forex Market
There are some key factors that differentiate the forex market from others, like the stock
market.
 There are fewer rules, which means investors aren't held to the strict standards or
regulations found in other markets.
 There are no clearing houses and no central bodies that oversee the forex market.
 Most investors won't have to pay the traditional fees or commissions that you would
on another market.
 Because the market is open 24 hours a day, you can trade at any time of day, which
means there's no cut-off time to be able to participate in the market.
 Finally, if you're worried about risk and reward, you can get in and out whenever you
want, and you can buy as much currency as you can afford.
Major Foreign Exchange Markets: the major foreign exchange markets are Spot Markets,
Forward Markets, Future Markets, Option Markets and Swaps Markets.
Swaps, Future and Options are called the derivative because they derive their value from
the underlying exchange rates.
1. Spot Market
These are the quickest transactions involving currency in the foreign exchange market. This
market provides immediate payment to the buyers and sellers as per the current exchange
rate. The spot market account for almost one-third of all currency exchange, and trades
usually take 1 or 2 days to settle transactions. This allows the traders open to the volatility
of the currency market, which can raise or lower the price, between the agreement and the
trade.
There is an increase in volume of spot transactions in the foreign exchange market. These
transactions are primarily in forms of buying and selling of currency notes, cash-in of
traveller’s cheque and transfers through banking systems. The last category accounts for
almost 90% of all spot transactions are carried out exclusively for banks.
As per the Bank of International Settlements (BIS) estimate, the daily volume of spot
transaction is about 50 percent of all transactions in foreign exchange markets. London is
the hub of foreign exchange market. It generates the highest volume and is diverse with the
currencies traded.
2. Forward Market
In forward contract, two parties (two companies, individual or government nodal agencies)
agree to do a trade at some future date, at a stated price and quantity. No security deposit
is required as no money changes hands when the deal is signed. Forward contracting is very
valuable in hedging and speculation.
3. Future Markets
The future markets help with solutions to a number of problems encountered in forward
markets. Future markets work on similar lines as the forward markets in terms of basic
philosophy. However, contracts are standardized, and trading is centralized (on a stock
exchange like NSE, BSE, KOSPI). There is no counterparty risk involved as exchanges have
clearing corporation, which becomes counterparty to both sides of each transaction and
guarantees the trade. Future market is highly liquid as compared to forward markets as
unlimited persons can enter into the same trade (like, buy FEB NIFTY Future).
4. Option Market
An option is a contract, which gives the buyer of the options the right but not the obligation
to buy or sell the underlying at a future fixed date (and time) and at a fixed price. A call
option gives the right to buy and a put option gives the right to sell. As currencies are traded
in pair, one currency is bought, and another sold.
For example, an option to buy US Dollar ($) for Pakistani Rupees (PKR, base currency) is a
USD call and an PKR put. The symbol for this will be USDPKR or USD/PKR. Conversely, an
option to sell USD for PKR is a USD put and an PKR call. The symbol for this trade will be like
PKRUSD or PKR/USD.
Effects of Foreign Exchange Markets on Balance of Payments:
A balance of payment is a statement of all transactions made between entities in one
country and the rest of the world over a specific time frame, such as a quarter or a year.
Two dynamics are in play which link a country's balance of payment and changes in the
value of its currency: the market for all financial transactions on the international market
(balance of payments) and the supply and demand for a specific currency (exchange rate).
A change in a country's balance of payments can cause fluctuations in the exchange
rate between its currency and foreign currencies. The reverse is also true when a fluctuation
in relative currency strength can alter balance of payments.
The relationship between balance of payments and exchange rates under a floating-rate
exchange system will be driven by the supply and demand for the country's currency and all
transactions taking place with other countries.
Explanation:
Suppose a consumer in France wants to purchase goods from an American company. The
American company is not likely to accept euros as payment; it wants U.S. dollars. Somehow
the French consumer needs to purchase dollars (ostensibly by selling euros in the forex
market) and exchange them for the American product. Today, most of these exchanges are
automated through an intermediary so that the individual consumer doesn't have to enter
the forex market to make an online purchase. After the trade is made, it is recorded in
the current account portion of the balance of payments.
The same holds true for investments, loans, or other capital flows. American companies
normally do not want foreign currencies to finance their operations, thus their expectation
for foreign investors to send them dollars. In this scenario, capital flows between countries
show up in the capital account portion of the balance of payments.
As more U.S. dollars are demanded to satisfy the needs of foreign investors or consumers,
upward pressure is placed on the price of dollars. Put another way: it costs relatively more
to exchange for dollars, in terms of foreign currencies.
The exchange rate for dollars may not rise if other factors are concurrently pushing down
the value of dollars. For example, expansionary monetary policy might increase the supply
of dollars and decrease the currency's value relative to other currencies.
The relationship between balance of payments and exchange rates described here only
exists under a free or floating exchange rate regime. The balance of payments does not
impact the exchange rate in a fixed-rate system because central banks adjust currency flows
to offset the international exchange of funds.
The world has not operated under any single rules-based or fixed exchange-rate system
since the end of Bretton Woods in the 1970s.