FOREIGN EXCHANGE

MARKETS
 Importance of international
finance
• There has been an enormous growth in the
volume of international trade after world war 2.
• No country can think of itself as an economic
entity in itself, in isolation with rest of the world.
• Along with trade, cross border capital flows have
grown enormously.
• To facilitate free exchange of goods and services,
a number of innovations have taken place in
international payments and credit mechanism
 India’s foreign trade
Indian Exports during May, 2010 were valued at US $ 16145 million (Rs.
73964 crore)
Imports during May, 2010 were valued at US $ 27437 million
(Rs.125694  crore)
The forex reserves as on 16th July 2010 stood at Rs.1318898 crores
India is heading towards a regime of full convertibility even on the capital
account

•
 The Foreign Exchange Market
• The foreign exchange market (forex, FX, or currency market) is a
worldwide decentralized over-the-counter financial market for the
trading of currencies
• The primary purpose of the foreign exchange market is to assist
international trade and investment, by allowing businesses to convert
one currency to another currency. For example, it permits a US
business to import European goods and pay Euros, even though the
business's income is in US dollars
• 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.
 Unique features
• Huge trading volume, leading to high liquidity
• Geographical dispersion
• Continuous operation: 24 hours a day except weekends,
i.e. trading from 20:15 GMT on Sunday until 22:00 GMT
Friday
• The variety of factors that affect exchange rates
• The low margins of relative profit compared with other
markets of fixed income
 Structure of Forex Market
• The forex market can be classified as:
• Retail market
• Here travellers and tourists exchange one currency for another.
• The total turnover and average transaction size is very small.
• However, the spread between buying and selling price is large.
• Wholesale market
• Also called as interbank market
• Major players are commercial banks, investment institutions,
companies and central banks.
• The total turnover and average transaction size is very small
 Types of transactions
• Spot transactions
• The settlement date (value date) is two days
ahead of the transaction date
• Forward transactions
• The settlement date is determined according to
the contract features.
• Swap transactions
• It is a combination of a forward and spot
transaction, in the opposite direction
 Codes of selected currencies
• USD: US Dollar
• GBP: British Pound
• JPY: Japanese Yen
• CAD: Canadian Dollar
• EUR: Euro
• AUD: Australian Dollar
• INR: Indian Rupee
• CHF: Swiss Franc
• NZD: New Zealand Dollar
• MEP: Mexican Peso
 Exchange Rate Quotation
• European terms:
• Quotes given as number of units of a currency per USD. Eg. INR 45
per USD
• American terms:
• Quotes given as number of units of USD per unit of a currency . Eg.
USD 0.00148 per INR
• Direct quote:
• Units of a local currency per unit of foreign currency. Thus for India,
INR 45 per USD is direct quote
• Indirect quote:
• Number of units of foreign currency per unit of home currency.
Thus, USD 2.265 per INR100, is an indirect quote for India
 Two way bid ask quote
• A currency pair is denoted by 3 letter SWIFT
codes, like:
• GBP/JPY: British pound-Japanese yen
• 1st currency is base currency(GBP)
• 2nd currency is quoted currency(JPY)
• The exchange rate quotation is given as number
of units of quoted currency per unit of base
currency.
• In our eg., it is number of yens per pound.
• A quotation consists of 2 prices. The left price is
bid price and the right side price is the ask price
• Example: GBP/EUR Spot:1.3025/1.3035
• Bid rate: The dealer will pay 1.3025 Euros
per GBP when selling Euros.
• Ask rate: The dealer will take 1.3035
Euros per GBP when selling GBPs
 Inter Bank Dealing
• A spot transaction will be dealt as follows:
• Monday, 2nd August 10.45am
• BoB: BoB calling. EURO-INR 10 Lacs please.
• Union Bank:60/61
• This means Union bank will buy a Euro for Rs.60
and sell a Euro for Rs.61.
• BoB: Mine.
• This means Bank of Baroda is ready to buy 10lac
Euros @ Rs.61 per Euro.
 Cross Rates
• The cross rate is the currency exchange rate between two
currencies, where neither of the currencies are of the
country in which the exchange rate is given.
• For example, if an exchange rate between the Euro and the
Japanese Yen was quoted in an American newspaper, this
would be considered a cross rate in this context, because
neither the euro or the yen is the standard currency of the U.S.
However, if the exchange rate between the euro and the U.S.
dollar were quoted in that same newspaper, it would not be
considered a cross rate because the quote involves the U.S.
official currency.
 Arbitrage
• Although we hear of the term market rate, the
fact is that different banks will have different
quotes for a given pair of currency at a given
point of time.
• Suppose banks A and B are quoting:
• GBP/USD: 1.4550/1.4560 (Bank A) and
• 1.4538/1.4548 (Bank B)
• Here Pounds can be bought at $1.4548 and sold
at $1.4550
 Methods of exchange rate
control
• Foreign exchange controls are various forms of controls imposed
by a government on the purchase/sale of foreign currencies by
residents or on the purchase/sale of local currency by nonresidents.
• Common foreign exchange controls include:
• Banning the use of foreign currency within the country
• Banning locals from possessing foreign currency
• Restricting currency exchange to government-approved exchangers
• Fixed exchange rates
• Restrictions on the amount of currency that may be imported or
exported
• There are various factors which impact the exchange rate
however, central bank controls the exchange rate in an
economy.
• The most common method to control the exchange rate is
by open market operations. In an open market sale, the
state bank sells the bond to get moneywhich reduces the
money supply. As a result the exchange rate goes up and
vice versa.
• Central bank also has foreign reserves and selling foreign
reserves enhances the exchange rate of local currency and
lower its value when foreign currency is bought.
• Exchange control can also be exercised by regulating
international movements of goods through various
devices.Imposition of import duties and of import quotas
will reduce imports, cut down the demand for foreign
currency, lower its value or raise the value of the
domestic currency.
• High levels of inflation in one country as compared to
some other country makes the goods of the former
costlier and hence demand for imported goods and
eventually foreign currency increases. This will
depreciate the home currency.
• A rise in the interest rates attracts funds from
abroad, increases demand for domestic currency
and raises its value, and vice versa.
• Up to 1939, Germany was a pioneer in the
method of exchange control although exchange
control was adopted in several other European
countries also during the Great Depression
(1929-33).
• Currently, exchange controls are used mostly as a
means to avoid wide fluctations in the rates.
 Forex market regulation
• NFA (National Futures Association) and CFTC
(Commodity Futures Trading Commission) are obligatory
regulating organizations for the Forex brokers that are
based in United States or want to legally deal with the U.S.
residents.
• FSA (Financial Service Authority) regulates the Forex
brokers that are based in U.K. or are dealing with the
British traders.
• SFBC (Swiss Federal Banking Commission) requires all
Forex brokers that are based in Switzerland to obtain the
real Swiss banking license and thus become a regulated
banking institution.
Foreign exchange market in
India
The foreign exchange market India is regulated
by the reserve bank of India through the
Exchange Control Department. At the same time,
Foreign Exchange Dealers Association
(voluntary association) also provides some help
in regulating the market.The whole foreign
exchange market in India is regulated by the
Foreign Exchange Management Act, 1999 or
FEMA.
• 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. The foreign exchange market in India till the
early 1990s,however, remained highly regulated with restrictions on
external transactions, barriers to entry, low
• liquidity and high transaction costs. The exchange
• rate during this period was managed mainly for
• facilitating India’s imports.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 Clearing Corporation of India Limited (CCIL) was set up in 2001
• The Indian foreign exchange market is a
• decentralised multiple dealership market comprising
• two segments – the spot and the derivatives market.
• In the spot market, currencies are traded at the
• prevailing rates and the settlement or value date is
• two business days ahead. The two-day period gives
• adequate time for the parties to send instructions to
• debit and credit the appropriate bank accounts at
• home and abroad.
• The derivatives market encompasses forwards, swaps and
options. Though forward contracts exist for maturities up to one
year, majority of forward contracts are for one month, three
• months, or six months.
• Players in the Indian market include (a) ADs,
• mostly banks who are authorised to deal in foreign
• exchange, (b) foreign exchange brokers who act as
• intermediaries, and (c) customers – individuals,
• corporates, who need foreign exchange for their
• transactions. Though customers are major players in
• the foreign exchange market, for all practical purposes
• they depend upon ADs and brokers. In the spot foreign
• exchange market, foreign exchange transactions were
• earlier dominated by brokers. Nevertheless, the
• situation has changed with the evolving market
• conditions, as now the transactions are dominated
• by ADs. Brokers continue to dominate the derivatives
• market.
• The major sources of supply of foreign
• exchange in the Indian foreign exchange market are
• receipts on account of exports and invisibles in the
• current account and inflows in the capital account
• such as foreign direct investment (FDI), portfolio
• investment, external commercial borrowings (ECB)
• and non-resident deposits. On the other hand, the
• demand for foreign exchange emanates from imports
• and invisible payments in the current account,
• amortisation of ECB (including short-term trade
• credits) and external aid, redemption of NRI deposits
• and outflows on account of direct and portfolio
• investment.
• In the Indian foreign exchange market, spot
• trading takes place on four platforms, viz., FX CLEAR
• of the CCIL set up in August 2003, FX Direct that is a
• foreign exchange trading platform launched by IBS
• Forex (P) Ltd. in 2002 in collaboration with Financial
• Technologies (India) Ltd., and two other platforms by
• the Reuters - D2 platform and the Reuters Market
• Data System (RMDS) trading platform that have a
• minimum trading amount limit of US $ 1 million
 THE FUTURE
• Against the backdrop of corporates in India
• going global, it is essential that the Indian foreign
• exchange market is able to provide them with the
• same types of products and services as are
available in the major markets overseas.
• The agenda for the future should, therefore, include
introduction of more instruments, more participants
and improved market infrastructure in respect of
trading and settlement