The Foreign Exchange Market

Foreign exchange means the money of a foreign country; that is, foreign currency bank balances, banknotes, cheque and drafts. A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date.

Characteristics of foreign exchange market 1. ‘ An Over The Counter market ’ - No physical presence in the same sense as a stock exchange or commodity market - The participants deal among themselves and settle their transactions directly - There is no exchange or clearing house

Characteristics of foreign exchange market 2.Only market open 24 hours - FX Market is a 24 hour market - It starts when a calendar business day opens in Sydney, Tokyo, Hong Kong, Singapore and then moves to Middle East to Europe to New York to the West Coast of United States where the calendar business comes to a close - FX Market operates seven days a week (Middle East Markets function on Saturdays and Sundays) - Effectively it is a 24 hour a day / seven days a week / 365 days a year Market!

Characteristics of foreign exchange market 3. No single location – no barriers - FX market is not located in a single building - No specific market place exists - FX market has few restrictions in this modern world - FX market is global in nature / character -While the market does not exist at each and every center in the world, it is accessible from any part of the world

Exchange rates fluctuate every four second Highly liquid market

Functions of the Foreign Exchange Market The Foreign Exchange market performs an international clearing function by bringing two parties wishing to trade currencies at agreeable exchange rates.

Market Participants Retail customers = importers/exporters of goods, services and financial assets (stocks/bonds). They are most numerous. They buy and sell FE for transaction purposes. These do not usually trade currencies one another because it is difficult to match double coincidence of wants. Instead they go to a commercial bank for the transaction.

Market Participants Foreign Exchange dealers = they are large commercial banks, which buy and sell FE. Dealers make a two-way market to each other and to their clients

Market Participants Foreign Exchange Broker: These are wholesale dealers. They usually specialize in a few currencies, and earn commission = 1/10 of 1% - 1/8 of 1% Their main function is to provide information to market-making banks

Market Participants Central Bank participate (i) to facilitate Treasury's transactions, and (ii) to prevent or effect a change in the value of their currency

Individuals and Firms Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.

Speculators and Arbitragers Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market. While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

Transactions in the Inter bank Market A Spot transaction -Value date 2 business days from transaction date. If bank holiday in either settlement centre, push to next business day. The date of settlement is referred to as the value date.

Transactions in the Inter bank Market An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency..Working of forward rates- Spot prices of the currencies involved Interest rate differential for the currencies Future period for which the price is worked

Forward rate differential difference between spot and forward rates Forward premium: forward > spot Forward discount: forward < spot

Fixed and Floating Exchange Rates Fixed exchange rate is the official rate set by the monetary authorities for one or more currencies. Under floating exchange rate, the value of the currency is decided by supply and demand factors

Direct and indirect exchange rates Direct method - home currency price of a foreign currency –Example: Rs.46/USD; Rs.58/Euro –Indirect quote: value of one unit of home currency in terms of a foreign currency –Example: Re= USD ; Re= Euro

Bid and Ask Rate Exchange rates are quoted as two way quotes – for purchase and sale transactions Buying rate – Bid rate Selling rate – Offer rate /Ask rate Examples: Rs – 46.45/ USD; Rs – 58.40/ Euro Bid-offer spread: profit of the dealer Size of spread: depends on quantity traded, demand for currency, type of customer

Currency appreciation/depreciation Increase in foreign currency price From Rs.46 to Rs.48/ USD Foreign currency appreciation Home currency depreciation From USD to USD / Re

TT Buying Rate TT Buying Rate (TT stands for Telegraphic Transfer) This is the rate applied when the transaction does not involve any delay in realization of the foreign exchange by the bank. In other words, the nostro account of the bank would already have been credited. The rate is calculated by deducting from the inter-bank buying rate the exchange margin as determined by the Bank.

Bills Buying Rate This is the rate to be applied when a foreign bill is purchased. When a bill is purchased, the proceeds will be realized by the Bank after the bill is presented to the drawee at the overseas center. In the case of a usance bill the proceeds will be realized on the due date of the bill which includes the transit period and the usance period of the bill.

Problem You would like to import machinery from USA worth USD to be payable to the overseas supplier on 31st Oct [a] Spot Rate USD = Rs /8600 Forward Premium September /3000 October /5450 November /7650 [b] exchange margin 0.125% [c] Last two digits in multiples of nearest 25 paise Calculate the rate to be quoted by the bank ?

Solution This is an example Forward Sale Contract. Inter Bank Spot Selling Rate Rs Add Forward Margin Add Exchange Margin Forward Rate Rounded Off to multiple of 25 paise Rs Amount Payable to the bank Rs.46,46,250

Factors influencing exchange rates Short term factors - commercial - financial Long term factors - currency and economic conditions - political and industrial conditions

Market Size In April 2007, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $3988 billion. As per the same survey estimated turnover of Indian Forex Market is 34billion US dollars