1.

Introduction
The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. Electronic Broking Services (EBS) and Reuters 3000 Xtra are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies. The foreign exchange market works through financial

institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as dealers, who are actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-thescenes market is sometimes called the interbank market, a lthough a few insurance companies and other kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions. The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in theUnited States to import goods from the European Union member states, especially Eurozone members, and pay euros, even though its income is inUnited States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states afterWorld War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of the following characteristics:
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its huge trading volume representing the largest asset class in the world leading to high liquidity;

its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);

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. As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements,[3] the preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010 and $3.3 trillion in April 2007. FX swaps were the most actively traded instruments in April 2013, at $2.2 trillion per day, followed by spot trading at $2.0 trillion. According to the Bank for International Settlements,[4] as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.[5] The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion currency swaps $207 billion in options and other products
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2. History
Ancient Currency trading and exchange first occurred in ancient times.[6] Money-changing people, people helping others to change money and also taking a commission or charging a fee were living in the times of the Talmudic writings (Biblical times). These people (sometimes called "kollybists") used city-stalls, at feast times the temples Court of the Gentiles instead.[7] Money-changers were also in more recent ancient times silver-smiths and, or, gold-smiths. During the fourth century the Byzantium government kept a monopoly on the exchange of currency. Currency and exchange was also a crucial element of trade in the ancient world so that people could buy and sell items like food, pottery and raw materials. [10] If a Greek coin held more gold than an Egyptian coin due to its size or content, then a merchant could trade fewer Greek gold coins for more Egyptian ones, or for more material goods. This is why the vast majority of world currencies are derivatives of a universally recognized standard like silver and gold. Medieval and later During the fifteenth century the Medici family were required to open banks at foreign locations in order to exchange currencies to act for textile merchants.[11][12] To facilitate trade the bank created the nostro (from Italian translated "ours") account book which contained two columned entries showing amounts of foreign and local currencies, information pertaining to the keeping of an account with a foreign bank.[13][14][15][16] During the 17th (or 18th ) century Amsterdam maintained an active forex market.[17] During 1704 foreign exchange took place between agents acting in the interests of the nations of England and Holland. Early modern
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The firm Alexander Brown & Sons traded foreign currencies exchange sometime about 1850 and were a leading participant in this within U.S.A.[19] During 1880 J.M. do Esprito Santo de Silva (Banco Esprito e Comercial de Lisboa) applied for and was given permission to begin to engage in a foreign exchange trading business.[20][21] 1880 is considered by one source to be the beginning of modern foreign exchange, significant for the fact of the beginning of the gold standard during the year.[22] Prior to the first world war there was a much more limited control of international trade. Motivated by the outset of war countries abandoned the gold standard monetary system. [23] Modern to post-modern From 1899 to 1913, holdings of countries' foreign exchange increased at an annual rate of 10.8%, while holdings of gold increased at an annual rate of 6.3% between 1903 and 1913. At the time of the closing of the year 1913, nearly half of the world's foreign exchange was conducted using the Pound sterling.[25] The number of foreign banks operating within the boundaries of London increased in the years from 1860 to 1913 from 3 to 71. In 1902 there were altogether two London foreign exchange brokers.[26] In the earliest years of the twentieth century trade was most active in Paris, New York and Berlin, while Britain remained largely uninvolved in trade until 1914. Between 1919 and 1922 the employment of a foreign exchange brokers within London increased to 17, in 1924 there were 40 firms operating for the purposes of exchange.[27] During the 1920s the occurrence of trade in London resembled more the modern manifestation, by 1928 forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors, in Europe and Latin America, hampered any attempt at wholesale prosperity from trade for those of 1930's London. During the 1920s foreign exchange the Kleinwort family were known to be the leaders of the market, Japhets, S,Montagu & Co. and Seligmans as significant participants still warrant
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recognition.[29] In the year 1945 the nation of Ethiopias' government possessed a foreign exchange surplus. After WWII After WWII, the Bretton Woods Accord was signed allowing currencies to fluctuate within a range of 1% to the currencies par.[31] In Japan the law was changed during 1954 by the Foreign Exchange Bank Law, so, the Bank of Tokyo was to become because of this the centre of foreign exchange by September of that year. Between 1954 and 1959 Japanese law was made to allow the inclusion of many more Occidental currencies in Japanese forex.[32] U.S. President Richard Nixon is credited with ending the Bretton Woods Accord and fixed rates of exchange, eventually bringing about a free-floating currency system. After the ceasing of the enactment of the Bretton Woods Accord during 1971,[33] the Smithsonian Agreement allowed trading to range to 2%. During 196162, the amount of foreign operations by the U.S. Federal Reserve was relatively low.[34][35] Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased this in March 1973, when sometime afterward none of the major currencies were maintained with a capacity for conversion to gold, organisations relied instead on reserves of currency. During 1970 to 1973 the amount of trades occurring in the market increased threefold. At some time (according to Gandolfo during FebruaryMarch 1973) some of the markets' were "split", so a two tier currency market was subsequently introduced, with dual currency rates. This was abolished during March 1974.[41][42][43] Reuters introduced during June 1973 computer monitors, replacing the telephones and telex used previously for trading quotes.[44] Markets close Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float the forex markets were forced to close sometime during 1972 and March 1973. The very largest of all purchases of dollars in the history of 1976 was when the West German government achieved an almost 3 billion dollar acquisition (a figure given as 2.75 billion in
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total by The Statesman: Volume 18 1974), this event indicated the impossibility of the balancing of exchange stabilities by the measures of control used at the time and the monetary system and the foreign exchange markets in "West" Germany and other countries within Europe closed for two weeks (during February and, or, March 1973. Giersch, Paqu, & Schmieding state closed after purchase of "7.5 million Dmarks" Brawley states "... Exchange markets had to be closed. When they re-opened ... March 1 " that is a large purchase occurred after the close). After 1973 In fact 1973 marks the point to which nation-state, banking trade and controlled foreign exchange ended and complete floating, relatively free conditions of a market characteristic of the situation in contemporary times began (according to one source), [51] although another states the first time a currency pair were given as an option for U.S.A. traders to purchase was during 1982, with additional currencies available by the next year.[52][53] On 1 January 1981 (as part of changes beginning during 1978 [54]) the Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading.[55] Sometime during the months of 1981 the South Korean government ended forex controls and allowed free trade to occur for the first time. During 1988 the countries government accepted the IMF quota for international trade.[56] Intervention by European banks especially the Bundesbank influenced the forex market, on February the 27th 1985 particularly.[57] The greatest proportion of all trades world-wide during 1987 were within the United Kingdom, slightly over one quarter, with the U.S. of America the nation with the second most places involved in trading.[58] During 1991 the republic of Iran changed international agreements with some countries from oil-barter to foreign exchange.[59]

3. Market size and participants

Main foreign exchange market turnover, 19882007, measured in billions of USD. The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators,

corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).[4]Of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps and other derivatives. In April 2010, trading in the United Kingdom accounted for 36.7% of the total, making it by far the most important centre for foreign exchange trading. Trading in the United States accounted for 17.9% and Japan accounted for 6.2%.[60] In April 2013, for the first time, Singapore surpassed Japan in average daily foreignexchange trading volume with $383 billion per day. So the rank became: the United Kingdom (41%), the United States (19%), Singapore (5.7)%, Japan (5.6%) and Hong Kong (4.1%).[61] Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April
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2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Most developed countries permit the trading of derivative products (like futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging economies do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies.[62] Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls. Top 10 currency traders [63] Foreign exchange trading

% of overall volume, May 2013 Rank Name 1 2 3 4 5 6 7 8 9 10 Deutsche Bank Citi Barclays Investment Bank UBS AG HSBC JPMorgan Royal Bank of Scotland Credit Suisse Morgan Stanley Market share 15.18% 14.90% 10.24% 10.11% 6.93% 6.07% 5.62% 3.70% 3.15%

increased by 20% between April 2007 and April 2010 and has more than doubled since 2004.[64] The increase in

turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency

traders, and the emergence of retail investors as an

important market segment. The growth execution and of electronic the diverse

Bank of America Merrill Lynch 3.08%

selection of execution venues

has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading is
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estimated to account for up to 10% of spot turnover, or $150 billion per day (see retail foreign exchange platform). Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London, which according

toTheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day. Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is theinterbank market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0 to 1 pip to 12 pips for a currencies such as the EUR) as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier interbank market accounts for 39% of all transactions.[60] From there, smaller banks, followed by large multinational corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail market makers. According to Galati and Melvin, Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s. (2004) In addition, he notes, Hedge funds have grown markedly over the 20012004 period in terms of both number and overall size.[65] Central banks also participate in the foreign exchange market to align currencies to their economic needs.
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Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. Central banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading. Foreign exchange fixing Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator. The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[66] Several scenarios of this nature were seen in the 1992 93 European Exchange Rate Mechanism collapse, and in more recent times in Asia.
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Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and, hence, can generate large trades. Retail foreign exchange traders Individual retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange platforms, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association have in the past been subjected to periodic Foreign exchange fraud.[67][68] To deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA instead of a CTA). Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign
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exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for differences and financial spread betting. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at. Non-bank foreign exchange companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account). It is estimated that in the UK, 14% of currency transfers/payments[69] are made via Foreign Exchange Companies. These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank.[70] These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services. Money transfer/remittance companies and bureaux de change Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange

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4.Types of foreign exchange market

Spot Market:These are the quickest transactions involving currency in foreign markets. These transactions involve immediate payment at the current exchange rate, which is also called the spot rate. The Federal Reserve says the spot market accounts for one-third of all currency exchange, and trades usually take place within two days of the agreement. This does leave the traders open to the volatility of the currency market, which can raise or lower the price between the agreement and the trade.

Futures Market:As the name implies, these transactions involve future payment and future delivery at an agreed exchange rate, also called the future rate. These contracts are standardized, which means the elements of the agreement are set and non-negotiable. It also takes the volatility of the currency market, specifically the spot market, out of the equation. These are popular among traders who make large currency transactions and are seeking a steady return on their investments. Forward Market:These transactions are identical to the Futures Market except for one important difference--the terms are negotiable between the two parties. This way, the terms can be negotiated and tailored to the needs of the participants. It allows for more flexibility. In many instances, this type of market involves a currency swap, where two entities swap currency for an agreedupon amount of time, and then return the currency at the end of the contract.

Participants:There are approximately five different types of entities that use the foreign exchange markets on a daily basis. Commercial banks are the leaders in this market and are the main source of currency transactions. Traditional users refer to entities that do business across national borders. Central banks are the official players in this market, and each country has a central bank to manage its money supply. Brokers work as go-betweens for banks, typically during large transactions. And, traders and speculators work to take advantage of short-term trends in the market.

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5.Features of foreign exchange market:-

Liquidity: the market operates the enormous money supply and gives absolute freedom within opening or closing a position in the current market quotation. High liquidity is a powerful magnet for any investor, because it gives him or her the freedom to open or to close a position of any size whatever. Promptness: with a 24-hour work schedule, participants in the FOREX market need not wait to respond to any given event, as is the case in many markets. Availability: a possibility to trade round-the-clock; a market participant need not wait to respond to any given event. Flexible regulation of the trade arrangement system: a position may be opened for a pre-determined period of time in the FOREX market, at the investors discretion, which enables to plan the timing of ones future activity in advance. Value: the Forex market has traditionally incurred no service charges, except for the natural bid/ask market spread between the supply and the demand price. One-valued quotations: with high market liquidity, most sales may be carried out at the uniform market price, thus enabling you to avoid the instability problem existing with futures and other forex investments where limited quantities of currency only can be sold concurrently and at a specified price.

Market trend: currency moves in a quite specific direction that can be tracked for rather a long period of time. Each particular currency demonstrates its own typical temporary changes, which presents investment managers with the opportunities to manipulate the FOREX market. Margin: the credit leverage (margin) in the FOREX market is only determined by an agreement between a customer and the bank or the brokerage house that pushes it to the market and is normally equal to 1:100. That means that, upon making a $1,000 pledge, a customer can enter into transactions for an amount equivalent to $100,000. It is such extensive credit leverage, that in conjunction with highly variable currency quotations, making this market highly profitable and also highly risky.
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7.Nature of Transaction of foreign exchange market:1. Arbitrage:Arbitrage refers to the activities of a dealer in foreign exchange. He bye a currency at one place and sells it at another place simultaneously. As a result the market for a given currency remain unified in different money markets in the world. In the process the dealer in foreign exchange market makes profits. He take advantage of price or exchange rate differences in the two markets. For example: 1 $ = Rs 44 in US and in India it is 1 $ =Rs 45. 2. Hedging:Hedging is an important features of the foreign exchange market. It refers to the avoidance of foreign exchange risk. When importers and exporters enter into an agreement normally with a commercial bank dealing in foreign exchange to buy and sell goods at some future specified date at the pre-determined exchange rate if is called hedging. When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that is long a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair, can protect against upside risk. The primary methods of hedging currency trades for the retail forex trader is through:

Spot contracts, and Foreign currency options.

Spot contracts are essentially the regular type of trade that is made by a retail forex trader. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. Regular spot contracts are usually the reason that a hedge is needed, rather than used as the hedge itself. Foreign currency options, however are one of the most popular methods of currency hedging. As with options on other types of securities, the foreign currency option gives the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles and bull or bear spreads, to limit the loss potential of a given trade. (For more, see A Beginner's Guide To Hedging.) Forex hedging strategy A forex hedging strategy is developed in four parts, including an analysis of the forex trader's risk exposure, risk tolerance and preference of strategy. These components make up the forex hedge:
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1. Analyze risk: The trader must identify what types of risk (s)he is taking in the current or proposed position. From there, the trader must identify what the implications could be of taking on this risk un-hedged, and determine whether the risk is high or low in the current forex currency market. 2. Determine risk tolerance: In this step, the trader uses their own risk tolerance levels, to determine how much of the position's risk needs to be hedged. No trade will ever have zero risk; it is up to the trader to determine the level of risk they are willing to take, and how much they are willing to pay to remove the excess risks. 3. Determine forex hedging strategy: If using foreign currency options to hedge the risk of the currency trade, the trader must determine which strategy is the most cost effective. 4. Implement and monitor the strategy: By making sure that the strategy works the way it should, risk will stay minimized. The forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize the amount of risk they take on. So much of being a trader is money and risk management, that having another tool like hedging in the arsenal is incredibly useful. Not all retail forex brokers allow for hedging within their platforms. Be sure to research fully the broker you use before beginning to trade.

3. Speculation:Speculation is the opposite of hedging. While a hedger seeks to cover the foreign exchange risk a speculator accepts and even seeks out a foreign exchange risk or an open position in the hope of the making a profit. If the speculator correctly anticipates the future changes in spot rate he stands to gain or else he would incur losses. A number of proposals have been made in the past to try and limit speculation that were never enacted, these have included:

The Tobin tax is a tax intended to reduce short-term currency speculation, ostensibly to stabilize foreign exchange. In May 2008 German leaders planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds. On 3 December 2009 U.S. Congressman Peter DeFazio, who blamed "reckless speculation" for the 2008 financial crisis, proposed the introduction of a financial transaction tax, which would specifically target speculators by taxing financial market securities transactions.
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8. Foreign exchange fluctuation Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. Here we look at some of the major forces behind exchange rate movements. such as interest rates and inflation, the exchange rate is one of the most important determinants of a country's relative level of economic healthy. A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency). Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.) For carrier companies shipping goods from one nation to another, exchange rates can often impact them severely. Therefore, most carriers have a CAF charge to account for these fluctuations.

1.Purchasing power currency:The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given
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country's currency that would be necessary to buy that market basket directly in the given country . Thus the real exchange rate is the exchange rate times the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar relative to that of the euro is the dollar price of a euro (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity(PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1. The rate of change of this real exchange rate over time equals the rate of appreciation of the euro (the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the inflation rate of the dollar. 2.Differentials in Inflation As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.) 3. Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. 4.Current-Account Deficits The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. Adeficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other
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words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)

5. Public Debt Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate. 6.Terms of Trade A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favourably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners. 7.Political Stability and Economic Performance Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
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9. Features of the Forward premium on the Indian rupee

The Indian rupee has had an active forward market for some time now. The forward premium or discount on the rupee (vis--vis the US dollar, for instance) reflects the markets beliefs about future changes in its value. The strength of the relationship of this forward premium with the interest rate differential between India and the US the Covered Interest Parity (CIP) condition gives us a measure of Indias integration with global markets. The CIP is a no-arbitrage relationship that ensures that one cannot borrow in a country, convert to and lend in another currency, insure the returns in the original currency by selling his anticipated proceeds in the forward market and make profits without risk through this process. Chakrabarti (2006) reports that between late 1997 and mid-2004 the average discount on the rupee was about 4% per annum. During the period the average difference between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was about 4.5% for 3-months and 3.5% for the 6-months period. With these two figures in the same ballpark (particularly given that bank deposit rates and inter-bank rates are not strictly comparable), annual averages of interest rate differences and the forward exchange premium also indicate a moderate degree of co-movement between the two variables. The interest rate differential explains about 20% of the total variation in the forward discount. The deviation of the Indian rupee-US dollar from the covered interest parity, however, exhibits long-lived swings on both sides of the zero line. This would indicate arbitrage opportunities and market imperfections provided we could be sure of the comparability of the interest rates considered. Therefore, while the behavior of the forward premium on the Indian rupee is broadly in lines with the CIP, more careful empirical analysis involving directly comparable interest rates is necessary to measure the strength of the covered interest parity condition and the efficiency of the foreign exchange market. Under market efficiency, the forward exchange rate is considered to be an unbiased predictor of the future spot rate, with random prediction errors. While the prediction errors of forward rates on the rupee appear to show some degree of persistence, any conclusion in this matter too must await more rigorous analysis.

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Intervention in Foreign Exchange Markets The two main functions of the foreign exchange market are to determine the price of the different currencies in terms of one another and to transfer currency risk from more riskaverse participants to those more willing to bear it. As in any market essentially the demand and supply for a particular currency at any specific point in time determines its price (exchange rate) at that point. However, since the value of a countrys currency has significant bearing on its economy, foreign exchange markets frequently witness government intervention in one form or another, to maintain the value of a currency at or near its desired level. Interventions can range from quantitative restrictions on trade and crossborder transfer of capital to periodic trades by the central bank of the country or its allies and agents so as to move the exchange rate in the desired direction. In recent years India has witnessed both kinds of intervention though liberalization has implied a long-term policy push to reduce and ultimately remove the former kind. It is safe to say that over the years since liberalization, India has allowed restricted capital mobility and followed a managed float type exchange rate policy. During the early years of liberalization, the Rangarajan committee recommended that Indias exchange rate be flexible. Officially speaking, India moved from a fixed exchange rate regime to market determined exchange rate system in 1993. The overt objective of Indias exchange rate policy, according to various policy pronouncements, has been to manage volatility in exchange rates without targeting any specific levels. This has been hard to do in practice. The Indian rupee has had a remarkably stable relationship with the US dollar. Meanwhile the dollar appreciated against major currencies in the late 90s and then went into an extended decline particularly during 2003 and 2004. The lock-step pattern of the US dollar and the Rupee is best reflected in the movements in the two currencies against a third currency like the Euro. The correlation of the exchange rates of the two currencies against the Euro during 1999-2004 was 0.94. Several studies have established the pegged nature of the rupee in recent years (see Chakrabarti (2006) for a more detailed discussion). Based on volatility, India had a de facto crawling peg to the US dollar between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995, with a
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major devaluation in March 1993. From mid-1995 to end-2001, the rupee reverted to a crawling peg arrangement in practice. An analysis of the ratio of the variance of the exchange rate to the sum of the variances of the interest rate and the foreign exchange reserves reveals a move even closer to the fixed exchange rate system. A comparison of the sensitivity (beta) of the Dollar-rupee rate with the Euro-rupee rate for a three year period (1999 through 2001), indicates that India had a dollar beta of 1.01 tenth highest among the 53 countries considered. More importantly, the US dollar-Euro exchange rate explained about 97% of all movements in the Indian rupee-Euro exchange rate highest among all the 53 countries considered. Clearly the Indian rupee has been an excellent tracker of the US dollar. It is instructive to consider the Rupee-Dollar exchange rate in the light of the purchasing power parity (PPP) holding that the exchange rate between two currencies should equal the ratio of price levels in two countries. In its dynamic form PPP holds that that the rate of depreciation of a currency should equal the excess of its inflation rate to that in the other country. Over a reasonably long period of time, the devaluation in the Indian Rupee, vis-vis the US dollar does seem to have an association with the difference in the inflation rates in the two countries. Between 1991 and 2003, the two variables have had visible comovements with a correlation of about 0.57 (Chakabarti (2006)). This may be a result of Indo-US trade flows dominating the exchange rate markets but it is perhaps more likely that it reflects the exchange rate management principles of the monetary authorities The Reserve Bank of India has used a varied mix of techniques in intervening in the foreign exchange market indirect measures such as press statements (sometimes called open mouth operations in central bank speak) and, in more extreme situations, monetary measures to affect the value of the rupee as well as direct purchase and sale in the foreign exchange market using spot, forward and swap transactions (see Ghosh (2002)). Till around 2002, the measures were mostly in the nature of crisis management of saving-the-rupee kind and sometimes the direct deals would be repeated over several days till the desired outcome was accomplished. Other public sector banks, particularly the SBI often aided or veiled the intervention process.

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The exact details of the interventions are shrouded in mystery, not unusual for central banks ever wary of disclosing too much of their hand to the currency speculators. The Tarapore Committee report had urged more transparency in the intervention process and recommended, in 1997, that a Monitoring Exchange Rate Band of 5% be used around an announced neutral real effective exchange rate (REER), with weekly publication of relevant figures, something yet to be implemented. In a recent survey on foreign exchange market intervention in emerging markets, the Bank for International Settlements (BIS (2005b)) found that out of 11 emerging market countries considered, India gave out most complete information on intervention strategy (along with three others); no information on actual interventions (five others did the same) and did not cover foreign exchange intervention in annual reports (like two other countries). On the whole it ranked fourth most opaque in matters of foreign exchange intervention among the eleven countries compared. Regulation of cross-border currency flows A feature of the economy that is intricately related with the exchange rate regime followed is the freedom of cross-border capital flows. This relationship comes from the so-called impossible trinity or trilemma of international finance, which essentially states that a country may have any two but not all of the following three things a fixed exchange rate, free flow of capital across its borders and autonomy in its monetary policy. Since liberalization, India has been having close to a de facto peg to the dollar and simultaneously has been liberalizing its foreign currency flow regime. Close on the heels of the adoption of market determined exchange rate (within limits) in 1993 came current account convertibility in 1994. In 1997, the Tarapore committee, on Capital Account Convertibility, defined the concept as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange and laid down fiscal consolidation, a mandated inflation target and strengthening of the financial system as its three main preconditions. Meanwhile capital flows have been gradually liberalized, allowing, on the inflow side, foreign direct and portfolio investments, and tapping foreign capital markets by Indian
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companies as well as considerably better remittance privileges for individuals; and on the outflow side, international expansion of domestic companies. In 2000, the infamous Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign Exchange Management Act (FEMA) that gave participants in the foreign exchange market a much greater leeway. The ultimate goal of capital account convertibility now seems to be within the governments sights and efforts are on to chalk out the roadmap for the last leg, though it is not expected to be accomplished before 2009. Expectedly, the wisdom of the move has been hotly debated . Advocates of convertibility cite the consumption smoothing benefits of global funds flow and point out that it actually improves macroeconomic discipline because of external monitoring by the global financial markets. Convertibility can spur domestic investment and growth because of easier and cheaper financing. It can also contribute to greater efficiency in the banking and financial systems. On the other hand, skeptics like Williamson (2006), for instance, points out that India is yet to fulfill at least one of the three major preconditions to Capital Account Convertibility set out by the Tarapore committee, viz. fiscal discipline, with a public sector deficit of 7.6% of the GDP and the ratio of public debt to GDP of over 83% in 2005-06. In any case, the argument goes, the benefits of convertibility do not necessarily outweigh the risks and cross-border shortterm bank loans usually the last item to be liberalized are the most volatile. It is generally held that it was, in fact, the lack of convertibility that protected India from contamination during the Asian contagion in 1997-98. The Dynamics of Swelling Reserves-An important corollary of Indias foreign exchange policy has been the quick and significant accumulation of foreign currency reserves in the past few years. Starting from a situation in 1990-91 with foreign exchange reserves level barely enough to cover two weeks of imports, and about $32 billion at the beginning of 2000, Indias foreign exchange position rocketed to one of the largest in the world with over $155 billion in mid-2006. Since 2000, this implies a compounded annual growth rate of about 28% with the years 2003 and 2004 having the most stunning rises at 48% and 45% respectively. During these two years the US dollar fell against the Euro by 19% and against the rupee by 9%. Without RBI intervention, the latter figure is likely to have been larger and the reserves accumulation less spectacular.
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10. Conclusion

During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash, derivatives and debt instruments put together in the country, and the sheer size of the foreign exchange market becomes evident. Since then, the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,foreign exchange constitutes the largest financial market by far. The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. Electronic Broking Services (EBS) and Reuters 3000 Xtra are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies. The foreign exchange market works through financial institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as dealers, who are actively involved in larg e quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-thescenes market is sometimes called the interbank market, although a few insurance companies and other kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

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