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foreign exchange market

Introduction:

 Foreign exchange is the process of changing one currency into another for a
variety of reasons, usually for commerce, trading, or tourism. According to a
2019 triennial report from the Bank for International Settlements (a global bank
for national central banks), the daily trading volume for forex reached $6.6
trillion in April 2019.

The foreign exchange (also known as FX or forex) market is a global

marketplace for exchanging national currencies. Because of the worldwide
reach of trade, commerce, and finance, forex markets tend to be the largest and
most liquid asset markets in the world.

Currencies trade against each other as exchange rate pairs. For example,
EUR/USD is a currency pair for trading the euro against the U.S. dollar.
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A Brief History of Forex

In its most basic sense, the forex market has been around for centuries. People
have always exchanged or bartered goods and currencies to purchase goods
and services. However, the forex market, as we understand it today, is a
relatively modern invention. After the Bretton Woods accord began to collapse
in 1971, more currencies were allowed to float freely against one another. The
values of individual currencies vary based on demand and circulation and are
monitored by foreign exchange trading services.

Commercial and investment banks conduct most of the trading in forex

markets on behalf of their clients, but there are also speculative
opportunities for trading one currency against another for professional and
individual investors.

There are two distinct features to currencies as an asset class:

A-You can earn the interest rate differential between two currencies.

B-You can profit from changes in the exchange rate

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An investor can profit from the difference between two interest rates in two
different economies by buying the currency with the higher interest rate and
shorting the currency with the lower interest rate.

Prior to the 2008 financial crisis, it was very common to short the Japanese
yen (JPY) and buy British pounds (GBP) because the interest rate differential
was very large. This strategy is sometimes referred to as a “carry trade.”

An Overview of Forex Markets

The FX market is where currencies are traded. It is the only truly continuous
and nonstop trading market in the world. In the past, the forex market was
dominated by institutional firms and large banks, which acted on behalf of
clients.

But it has become more retail-oriented in recent years, and traders and
investors of many holding sizes have begun participating in it.

An interesting aspect of world forex markets is that there are no physical

buildings that function as trading venues for the markets. Instead, it is a series
of connections made
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through trading terminals and computer networks. Participants in this market

are institutions, investment banks, commercial banks, and retail investors.

The foreign exchange market is considered more opaque than other financial
markets. Currencies are traded in OTC markets, where disclosures are not
mandatory. Large liquidity pools from institutional firms are a prevalent
feature of the market.

Types of Foreign Exchange Market

Broadly, the foreign exchange market is classified into two categories on the
basis of the nature of transactions. These are:

1-Spot Market: A spot market is the immediate delivery market, representing

that segment of the foreign exchange market where in the transactions (sale
and purchase) of currency are settled within two days of the deal.

That is, when the seller and buyer close their deal for currency within two days
of the deal, is called as Spot Transaction. Thus, a spot market constitutes the
spot sale and purchase of foreign exchange. The rate at which the transaction is
settled is called a Spot
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Major Participants on the Spot Exchange Market

Commercial banks : These banks are the major players in the market. Commercial and
investment banks are the main players of the foreign exchange market; they not only trade
on their own behalf but also for their customers.

A major chunk of the trade comes by trading in currencies indulged by the bank to gain
from exchange movements. Interbank transaction is done in case the transaction volume is
huge. For small volume intermediation of foreign exchange, a broker may be sought.

Central banks

Central banks like RBI in India (RBI) intervene in the market to reduce currency fluctuations of the
country currency (like INR, in India) and to ensure an exchange rate compatible with the
requirements of the national economy.

For example, if rupee shows signs of depreciation, RBI (central bank) may release (sell) a certain
amount of foreign currency (like dollar). This increased supply of foreign currency will halt the
depreciation of rupee. The reverse operation may be done to halt rupee from appreciating too much

Exchange Rate. It is the prevailing exchange rate in the market.

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Major Participants on the Spot Exchange Market

2.Forward Market: The forward exchange market refers to the transactions – sale and
purchase of foreign exchange at some specified date in the future, usually after 90 days of
the deal.

That is, when the buyer and seller enter into a contract for the sale and purchase of foreign
currency after 90 days of the deal at a fixed exchange rate agreed upon now, is called
a Forward Transaction.

Why is forward contracting useful?

Forward contracting is very valuable in hedging and speculation. The classic scenario of
hedging application through forward contract is that of a wheat farmer forward; selling his
harvest at a known fixed price in order to eliminate price risk.

Similarly, a bread factory wants to buy bread forward in order to assist production
planning without the risk of price fluctuations. There are speculators, who based on their
knowledge or information forecast an increase in price.

They then go long (buy) on the forward market instead of the cash market. Now this
speculator would go long on the forward market, wait for the price to rise and then sell it at
higher prices; thereby, making a profit
 Disadvantages of forward markets

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: Before we learn about the option market, we need to understand what an Option is.

What is an option?

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 Indian Rupees (INR, base currency) is a USD call and an INR put. The symbol for this will be USDINR
or USD/INR. Conversely, an option to sell USD for INR is a USD put and an INR call. The symbol for this trade will be like INRUSD or INR/USD

Thus, the forward market constitutes the forward transactions in foreign exchange. The exchange rate at which the buyers or sellers settle the
transactions in the forward market is called a Forward Exchange Rate.
 Risks of foreign exchange market

Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler
terms, foreign exchange risk is the risk that a business’ financial performance or financial position will be impacted by changes in
the exchange rates between currencies.

The risk occurs when a company engages in financial transactions or maintains financial statements in a currency other than where
it is headquartered.

For example, a company based in Canada that does business in China – i.e., receives financial transactions in Chinese yuan –
reports its financial statements in Canadian dollars, is exposed to foreign exchange risk.
Types of Foreign Exchange Risk

The three types of foreign exchange risk include:

Transaction Economic Translation

risk risk risk
Types of Foreign Exchange Transactions
 Types of Foreign Exchange Transactions

Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their payments within the two
days of the deal.

Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale
and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future.

Future Transaction: The future transactions are also the forward transactions and deals with the contracts in the same
manner as that of normal forward transactions.

Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies
between two investors.

Option Transactions: The foreign exchange option gives an investor the right, but not the obligation to exchange the
currency in one denomination to another at an agreed exchange rate on a pre-defined date.
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