Foreign Exchange Market

International Business
Jaypee Business School
DDM (2009-14)

GROUP-1

Nitish Vashishth(09502901) Anupam Kumar(09502903) Rohit Varma(09502904) Raghav Chawla(09502905) Anmol Kaushik(09502907)

Foreign Exchange Market

Introduction
The term FOREX simply means the foreign exchange market or currency market is the market where one currency is traded for another. It is one of the largest markets in the world. Some of the participants in this market are simply seeking to exchange a foreign currency for their own, like multinational corporations which must pay wages and other expenses in different nations than they sell products in. However, a large part of the market is made up of currency traders, who speculate on movements in exchange rates, much like others would speculate on movements of stock prices. Currency traders try to take advantage of even small fluctuations in exchange rates which vary 18 times a minute. In the foreign exchange market there is little or no 'inside information'. Exchange rate fluctuations are usually caused by actual monetary flows as well as anticipations on global macroeconomic conditions. Significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time. Foreign exchange market is a not actually a place but as exchange of currencies takes place which can be through any bank or broker anytime 24x7 throughout the year 365 days (as this market never closes always there is some place in the world where the FOREX market is open) so its termed as a market. Unlike stocks and futures exchange, foreign exchange is indeed an interbank, over-the-counter (OTC) market which means there is no single universal exchange for specific currency pair. The foreign exchange market operates 24 hours per day throughout the week between individuals with FOREX brokers, brokers with banks, and banks with banks. If the European session is ended the Asian session or US session will start, so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets. The foreign exchange market is unique because of the following characteristics: its huge trading volume representing the largest asset class in the world leading to high liquidity; its geographical dispersion; its continuous operation: 24x7 the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and

The use of leverage to enhance profit and loss margins and with respect to account size.

Most traded currencies by value

Currency distribution of global foreign exchange market turnover Rank Currency 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Other Total ISO 4217 code % daily share 84.90% 39.10% 19.00% 12.90% 7.60% 6.40% 5.30% 2.40% 2.20% 1.60% 1.50% 1.40% 1.30% 1.30% 0.90% 12.20% 200%

United States dollar USD ($) Euro Japanese yen Pound sterling Australian dollar Swiss franc Canadian dollar Hong Kong dollar Swedish krona South Korean won Singapore dollar Norwegian krone Mexican peso Indian rupee EUR () JPY () GBP () AUD ($) CHF (Fr) CAD ($) HKD ($) SEK (kr) KRW () SGD ($) NOK (kr) MXN ($) INR ( )

New Zealand dollar NZD ($)

The total sum is 200% because each currency trade always involves a currency pair.

Kinds of Foreign Exchange Market

The foreign exchange currency markets allow buying and selling of various currencies all over the world. Business houses and banks can purchase currency in another country in order to do business in that particular company. The FOREX market also known as FX market has a worldwide presence and a network of different currency traders who work around the clock to complete these FOREX transactions, and their work drives the exchange rate for currencies around the world. Since the foreign exchange currency market is one of the biggest markets of the world, the market is sub divided into different kinds of foreign exchange market. There are different features and characteristics associated with the different foreign exchange markets have different trading characteristics. The main three types of foreign exchange markets- the spot foreign exchange market, the forward foreign exchange market and the future foreign exchange market are discussed below. Youll get detailed information regarding different FOREX currency markets types below: Spot Market The spot kinds of foreign exchange market are those in which the commodity is bought or sold for an immediate delivery or delivery in the very near future. The trades in the spot markets are settled on the spot. The spot foreign currency market is among the most popular foreign currency instrument around the globe, contributing about 37 percent of the total activity happening in all other types of foreign exchange markets. Spot FOREX currency markets types are opposite to other kinds of foreign exchange market such as the future market, in which there is a set date is mentioned. The perfect example of most common kinds of trades of spot foreign exchange market is FOREX contracts. If these contracts are not settled immediately, the FOREX traders would expect to be compensated for the time value of their money for the duration of the delivery. The important point to note is that these contracts are settled electronically thus making FOREX markets essentially instantaneous. The spot FOREX currency markets types are considered to be highly paced markets and volatility and quick profits and losses are its important features. A spot deal in foreign exchange market comprises of a bilateral contract between two parties in which a party transfers a set amount of a particular given currency against the receipt of a specified amount of another currency from the counterparty, based on an agreed exchange rate, within two business days of the date when the deal gets finalized. The name spot does not mean that the currency exchange happens the same business day on which the deal is executed. FOREX currency transactions which require delivery on the same day are called as cash transactions. It is interesting to know that the two day spot delivery has been in place since long before there were any technological breakthroughs in information processing facilitating the instantaneous transactions. This time period was required to check all the transactions details

among the participating companies. Despite the technological breakthrough in FOREX trading markets, the contemporary markets dont find it necessary to reduce the time to make payments. Because human errors still happen and time is required to fix the errors, if any before the delivery. In case of wrong deliveries happen in a spot deal in foreign exchange market, the fine is imposed. The most traded currency in spot types of foreign exchange markets in terms of volume is US dollar. The reason being is that U.S. dollar is the currency of reference. The other major most common currencies traded in spot markets are the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Forward Market The forward FOREX currency markets types comprise of two currency trading instrumentsforward outright deals and swaps. The swap currency deal is different from the other kind of FOREX instruments in a way that it consists of two deals, while all other transactions consist of single deals. A swap is a combination of a spot deal and a forward outright deal. Generally, forward foreign exchange market deals in cash transactions only. This is the reason why the transactions of the forward types of foreign exchange markets are separately analyzed. Based on the data shared by the Bank for International Settlements, the percentage share of the forward kinds of foreign exchange market was 57% in the year 1998. The forward markets have no set terms with regard to the settlement dates and this range from 3 days to 3 years. The volume in currency swaps longer than one year tends to be light but, technically, there is no impediment to making these deals. Any date past the spot date and within the above range may be a forward settlement, provided that it is a valid business day for both currencies. The nature of forward types of foreign exchange markets is decentralized, with participants from all over the world entering into a different types of FOREX deals either on a one on one basis or through FOREX brokers. In contrast to this, the currency futures Foreign exchange market is a centralized one and where all the deals are executed on trading floors provided by different exchanges. Whereas in the futures market only a small number of foreign currencies are traded in multiples of standardized amounts. The forward types of foreign exchange markets are open to any currencies in any amount. Futures Market Future FOREX currency markets types are specific types constitute the forward outright deals which in general take up small part of the foreign exchange currency trading market. Since future contracts are derivatives of spot price, they are also known as derivative instruments. They are specific with regard to the expiration date and the size of the trade amount. In general, the forward outright deals which get mature past the spot delivery date will mature on any valid date

in the two countries whose currencies are being traded, standardized amounts of foreign currency futures mature only on the third Wednesday of March, June, September, and December. Future kinds of foreign exchange markets have many features, which attracts traders to future markets. The first thing is that anyone can trade in future market. It is open to all kind of traders in foreign exchange market including individual traders. This is the difference between the future foreign exchange market and the spot foreign exchange market, since spot market is closed to individuals traders except in case there are deals of high net worth. The future FOREX currency market types are central markets, just as efficient as the cash market, and whereas the cash market is a much decentralized market, futures trading take place under one roof. The futures market provides various benefits for currency traders because futures are special types of forward outright contracts which corporate firms can use for hedging purposes.

Functions of the Foreign Exchange Market:

The foreign exchange market performs the following important functions: (i) To affect transfer of purchasing power between countries- transfer function; (ii) To provide credit for foreign trade - credit function; and (iii) To furnish facilities for hedging foreign exchange risks - hedging function. Transfer Function: The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is affected through a variety of credit instruments, such as telegraphic transfers, bank drafts and foreign bills. In performing the transfer function, the foreign exchange market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings. Credit Function: Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade. Another important function of foreign exchange market is to provide credit to the importer debtor. The exporters draw the bill of exchange on importers on their bankers. On acceptance of the bills by the importer or their bankers, the exporter will get the money realized on the maturity of the bills. In case the exporters are anxious to receive the payment earlier, the bills can be discounted from their bankers, or foreign exchange banks or discount houses.

Hedging Function: A third function of the foreign exchange market is to hedge foreign exchange risks. In a free exchange market when exchange rates, i.e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money. Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate. The existence of a forward market thus makes it possible to hedge an exchange position

Players in Foreign exchange market:

The market for foreign exchange can be viewed as a two tier market. One tier is wholesale or interbank market and the other one is retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, corporations or individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other 86 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market. The players in FX market can be categorized into different groups: international banks, commercial banks, MNCs, FX brokers, central banks and individuals. International banks: Provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange.

Commercial Banks: It participates in foreign exchange on behalf of their clients. At retail level enters through interbank market or through specialized brokers. At bulk level enters through inter-bank wholesale market or international banks and brokers. MNCs: MNCs have businesses spread in different parts of the world. So they have to transact in different currencies in different countries. And they use the FX market for their transaction so that the currency can be exchanged. FX Brokers: They act as agents who facilitate trading between dealers. FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers. Central Banks: Central banks sometimes intervene in the foreign exchange market in an attempt to influence the Price of its currency against that of a major trading partner, or a country that it fixes or pegs its currency against. Intervention is the process of using foreign currency reserves to buy ones own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling ones own currency for foreign currency in order to increase its supply and lower its price. Individuals: Individuals can also participate in FX market for different reasons. E.g. when a traveler or tourist travels in a different country he has to exchange its currency for another. It can be exchanged in form of currency notes or traveler cheques.

Foreign Exchange Regime

1) Fixed Exchange Rate A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP. It can also be used as a means to control inflation A fixed exchange rate sometimes called a pegged exchange rate is also referred to as the Tag of particular Rate, which is a type of exchange rate regime where a currency's value is fixed against the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. 2) Floating Exchange Rate A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Thus, floating exchange rates change freely and are determined by trading in the FOREX market. This is in contrast to a "fixed exchange rate" regime. 3) Managed Float Exchange Rate Managed float regime is the current international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries exchange rates by buying and selling currencies. It is also known as a dirty float. In an increasingly integrated world economy, the currency rates impact any given country's economy through the trade balance. In this aspect, almost all currencies are managed since central banks or Governments intervene to influence the value of their currencies.