FOREIGN EXCHANGE MARKET

Definition:
The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought or sold against one another. In words of H.E.Evitt, it is a that section of economic science which deals with the means and methods by which right to wealth in one countrys currency are converted into rights to wealth in terms of another countrys currency. It also involves the investigation of the method by which render such exchange necessary, the forms which such exchange may take, and the ratios or equivalent values at which such exchanges are affected. The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized over-the-counter financial market for trading currencies. 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. The foreign exchange market determines the relative values of different currencies. The primary purpose of the foreign exchange 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 British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began 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. The foreign exchange market is unique because of

Its huge trading volume, leading to high liquidity; Its geographical dispersion; Its 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; and

The use of leverage to enhance profit margins 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, 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. 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

Participants of FOREX Market:

The Foreign Exchange Market is the best way to trade currency around the world. Known by the nickname Forex, more than 100 types of currency are traded each day and more than $3 trillion is exchanged daily. There are plenty of participants in the Forex, including those that serve investors, middle men for currency purchase and companies in need of international funds. There are five types of market participantsbanks, brokers, central banks, corporations & fund managers. Banks Banks participate in the Forex in order to manage the foreign exchange risks of their bank and their clients, according to Peter Pontikis, who writes for Forex Journal Magazine. They can also speculate in the market. Their main goal is to make profits through direct trade of currency and through managing their clients' trading positions. This gives the bank access to both the buying and selling interests of their clients. Brokers Brokers in the Forex are the middle men between banks who trade currency on a daily basis. Their role is no different than a trader on the floor of the stock market. Brokers spend their

day matching buy and sell orders between clients. Many of their functions are computerized, which means deals are done fast. Banks pay a fee to have these brokers handle their transactions. Central Banks Pontikis writes that most developed countries have central banks, whose main role is to maintain the validity of the national currency. Central banks usually monitor and test prices on the Forex, and have a great deal of sway with banks, brokers and other players in the Forex market. The reason? Central banks print the money. For that reason alone, their opinions are always respected and rarely ignored. Corporations When a corporation in the United States makes a purchase in France, that company must find a way to make that purchase in foreign currency. That's where the Forex comes in. The U.S. Corporation uses the market to purchase the foreign currency they need to complete the transaction. Fund Managers There are two types. The fund managers are money managers who deal in funds that amount to hundreds of millions of dollars. They invest that money across a range of investments and a diverse list of clients, including pensions, individuals and governments. Those who manage hedge funds take bigger risks, as they're seeking to realize leverage potential and will exploit the use of derivatives.

Working Hours of FOREX Market:

The worlds largest and most liquid financial market, which operates 24 hours a day, day
except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. Turnover in the

foreign exchange market, where one countrys currency is traded for another, is estimated to be about $1.5 trillion a day. One of the biggest differences between the forex markets and markets for other asset classes is that the forex markets are open 24 hours a day. The trading session starts when the Tokyo market opens and once Tokyo closes, London opens. London then passes the baton to New York to complete the day. Since no other markets are open 24 hours a day, no other markets offer the potential for profit (or loss) the way the forex does.

Foreign Exchange Market in India:

During the early 1990s, India embarked on a series of structural reforms in the foreign exchange market. The exchange rate regime, that was earlier pegged, was partially floated in March 1992 and fully floated in March 1993.The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and was an important step in the progress towards total current account convertibility, which was achieved in August 1994.Although liberalization helped the Indian forex market in various ways. The foreign exchange market India is growing very rapidly. The annual turnover of the market is more than $400 billion. This transaction does not include the inter-bank transactions. According to the record of transactions released by RBI, the average monthly turnover in the merchant segment was $40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the same period. The average total monthly turnover was about $174.7 billion for the same period. The transactions are made on spot and also on forward basis, which include currency swaps and interest rate swaps. The Indian foreign exchange market consists of the buyers, sellers, market intermediaries and the monetary authority of India. The main center of foreign exchange transactions in India is Mumbai, the commercial capital of the country. There are several other centers for foreign exchange transactions in the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin. In past, due to lack of communication facilities all these markets were not linked. But with the development of technologies, all the foreign exchange markets of India are working collectively. 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 Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate in the foreign Exchange market in India. When the foreign exchange trade is going on between Authorized Dealers and RBI or between the Authorized Dealers and the overseas banks, the brokers have no role to play. Apart from the Authorized Dealers and brokers, there are some others who are provided with the restricted rights to accept the foreign currency or travelers cheque. Among these, there

are the authorized money changers, travel agents, certain hotels and government shops. The IDBI and Exim bank are also permitted conditionally to hold foreign currency. The whole foreign exchange market in India is regulated by the Foreign Exchange Management Act, 1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign Exchange Regulation Act, 1947. After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the economic and industrial development, the need for conservation of foreign currency was felt and on the recommendation of the Public Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act became famous as FEMA.

Determination of Exchange Rate:

Asset market view of the currency value, according to these the sounder of the policies of govt., higher the expected aerial refuse which in term led the currency stronger. The more unsound, the economic & political situations of a country the riskier are its assets & weaker its currency. The value of the money depends on its purchasing power, the demand will be more for a currency if: Expected rate of inflation is low. Higher economic activity / economic growth at a faster rate. Demand for goods, services & assets denominated in that currency.

There are three exchange rate systems. They are as follows: Fixed Exchange Rate (Pegged) Floating Exchange Rate (Free floating) Managed Exchange Rate (Rate is fixed by govt.)

Currency Forecasting:
As the name suggests, currency forecasting refers to the ability to predict the long-term value and price of a currency. It is possible to do so but it is difficult. The factors that influence exchange rates are numerous and they act in an extremely complex interactive and proactive manner. Moreover, those who participate in the market and actually move the exchange rates do

not always have theoretical and statistical equipment or the inclination for in depth analysis that theorists often attribute to them. There are mainly five approaches in currency forecasting. They are as follows: Market based forecasting Interest rate parity theory Fundamental analysis forecasting Technical forecasting Mixed forecasting

Market based Forecasting: Here both the spot rate & forward rate are influenced by
current expectation of the future events. Market based forecasting of exchange rate can be derived from current forward rates. The relationship between forward rate & future spot rate can be explained as follows: Unbiased nature of forward rate (UFR) means the forward rate should reflect the expected future spot rate. A particular currency is trading at a forward premium against another currency shows a collective judgment forex market participants that the currency is expected to appreciate in future against the other currency. This may or may not materialize as it depends on a number of factors like interest rate difference, efficiency of the financial & exchange markets in two currencies, govt. intervention, etc. whether or to which extent the prediction can be true depend on all these factors. Secondly, in market based forecasting is limited to one year because forward contracts are not made for longer than one year generally.

Interest Rate Parity Theory: The currency of the country with a lower interest rate should
be at forward premium that the currency of the country with a higher interest rate. The interest differential will be equal to the forward differential. Capital moves from low interest rate country till the international rates in two countries are equal. The interest rate differential could be used to predict the exchange rate beyond one year also.

Fundamental Analysis Forecasting: It is most common approach to forecast further

exchange rates. It is done on the basis of examination of the macro economic variables & policies that are expected to influence the currencies prospects through exchange in its demand & supply. Variables such as relative inflation & interest rate, national income growth, the changes in money supply, etc. are analyzed. For example, if there is a chance of rapid growth in money supply that currency will suffer a dealing in its value simplicity if the govt. Impose a heavy taxation there will be flight of foreign currency from that country & the domestic currencies value will decline. All the different macro-economic variables are likely to effect the demand & supply for a given foreign currencies help in predicting its future exchange rates, these is analyzed then the currencies future value is determined by estimating the exchange rate of which supply just equals demand that is, when any current a/c in balance is just matched by a net capital flows. The use of PPP Theory can be also made in this technique. Drawback of this theory is that the exact timing of impact of particular variables is not known, so forecast may be go wrong.

Technical forecasting: Historical rates are used for estimating future value. These are based
on price pattern & trend analysis.

Mixed Forecasting: Relying on particular techniques may not give absolute accurate result,
so a mix of various techniques is used. A weighted is given to particular techniques which are multiplied by its result. These are finally summed up to get the final forecasting. The exporters can also subscribe to forecasting services (long term predictions of general trades or short term trading advice). Examples: Citibank, New York Roths Child, London

Purchasing Power Parity Theory

The exchange rate between two currencies will be determined by their relative purchasing power. This theory also suggested the changes in relative inflation rates between two

countries must cause a change in the exchange rate in order to re-establish parity in price in two countries. If inflation rate in India is more as compared to USA that rupees will be fall against US Dollar. Example: A car cost Rs. 200000 in India & a similar car cost US$ 10000 in USA. Exchange rate = 200000/10000 US$ 1 = Rs. 20 If inflation rate is 10% in India & 5% in USA, New exchange rate = 220000/10500 US$ 1 = Rs. 20.95 Other factors that influence the exchange rate:

Interest rate: The country will higher interest rates have weaker currency Confidence in the currency Technical factors such as: release of national economic statistics, seasonal demand of currency, internal disturbance etc.

Relationship between forward rate & future spot rate:

A forward rate for a currency can be higher or lower than its spot rate. If a particular currency is expected appreciate in future a speculator will buy the currency forward to make a profit. The importer takes a forward cover for his imports in that case. If the forward rate is more than spot rate value the currency would be trading at a forward premium. In the reverse case if forward rate is less than spot rate it would be treated as a forward discount.

Forward Premium = forward rate spot rate Spot rate

12 forward contract period (in months)

Forward Discount = spot rate forward rate Spot rate

12 forward contract period (in months)

Fischer Effect:
According to Fischer, a change in interest rate affects the exchange rate. First we should study the relationship between inflation & interest rate in the two countries which can be best done by Fischer effect theory. There are three key elements in Fischer effect: Nominal rate of interest Rate of inflation in the country Real interest rate

The effect proposes that if the real interest rate is equal to the nominal interest rate minus the expected inflation rate, and if the real interest rate were to be held constant, that the nominal rate and the inflation rate have to be adjusted on a one-for-one basis. Real interest rate =nominal interest rate - inflation rate. In simple terms: an increase in inflation will result in an increase in the nominal interest rate. For example, if the real interest rate is held at a constant 5.5% and inflation increased from 2% to 3%, the Fisher Effect indicates that the nominal interest rate would have to increase from 7.5% (5.5%real rate+ 2% inflation rate) to 8.5% (5.5% real rate + 3% inflation rate).

International Fischer Effect:

International Fisher Theory states that an estimated change in the current exchange rate between any two currencies is directly proportional to the difference between the two countries' nominal interest rates at a particular time. According to International Fisher Theory hypothesis, the real interest rate in a particular economy is independent of monetary variables. With the assumption that real interest rates are calculated across the countries, it can also be concluded that the country with lower interest rate would also have a lower inflation rate. This will make the real value of the country's currency rise over time. This theory is also known as the assumption of Uncovered Interest Parity. According to the generalized International Fisher Theory, the real interest rates should be same across the borders. But the validity of generalized Fisher theory largely depends on the integration of the capital market. That is, the capital in the market needs to be free to flow across

borders. Usually the capital markets of the developed countries are integrated in nature. It has been seen that in the underdeveloped countries the currency flow is restricted. The International Fisher theory is calculated by the following formula: E = [(i1-i2)/(1+i2)] (i1-i2) Where: E represents the percentage change in exchange rate i1 represents the interest rate of country A i2 represents the interest rate of country B An example may help to understand the value of the theory. For example, if the interest rate of country A is 10% and that of country B is 5%, then the currency of country B should appreciate roughly 5% compared to the currency of country A. The International Fisher Theory observation holds that a country with higher interest rate will also be inclined to have a higher inflation rate. The International Fisher Theory also estimates the future exchange rates based on the nominal interest rate relationships. The estimate of the spot exchange rate 12 months from now is calculated by multiplying the current spot exchange rate by the nominal annual U.S. interest rate and then dividing it by the nominal annual British interest rate. Example: Suppose that the current spot exchange rate for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5 percent in the U.S. and 7 percent in Britain, what is the expected spot exchange per pound rate 12 months from now according to the International Fisher Effect? The International Fisher Effect estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 = $1.4071.

J Curve Effect of Devaluation:

The theory stating that a country's trade deficit will worsen initially after the depreciation of its currency because higher prices on foreign imports will be greater than the reduced volume

of imports. Devaluation of currencies usually leads to further deficit in trade balance initially. It finally shows favorable balance of trade resulting into J curve on the graph.

In free economies, business is always influence by this. The boom in the economy is followed by recession followed by depreciation & depreciation by recovery. Due to these boom income arise which intern leads to more imports & less exports. These phenomenon lead to disequilibrium. On the contrary, at depreciation stage in business cycle income forms which interns lead to less imports & less exports. This phenomenon leads to disequilibrium. Reason for decline in BOP initially: It will take time for the country to increase substantially its domestic output, so as to offset the decline in the realization per unit Payment for import will be higher per unit. Later, there will be a decline in imports due to substantial domestic products which will more than offset the increase in import payments per unit.

Financial Instruments Available in the Forex Market

The Forex Market is one of the busiest financial markets in the world with millions and millions of money being traded every day. A lot of Corporates, banks and other foreign exchange institutions play a pivotal part in making the Forex Market a huge success. There are a lot of financial instruments that are made

use of, in the Forex market. They are:

1. Spot 2. Forward 3. . Futures 4. Swap 5. Option 6. Exchange Traded fund

Spot This is quickest financial instruments of the Forex market and the tenure of this is only two days. The transaction happens within two days. It is the most voluminous financial transaction in terms of trades processed. A spot price is decided for settlement of a currency or security and the transaction is closed in two business days. Forward - A forward contract is one of the most sought after financial instruments in the Forex market, because risk can be minimized. Both the seller and the buyer agree to carry out a transaction at a future date and time and there is no financial exchange between the parties until the specified date comes up. On the particular date of the transaction, the goods and services are brought or sold irrespective of the currency trading on that day. Forward contracts are not limited by time. A transaction can be agreed to carry out on a future date which are a few days or a few years later than the current date. Futures Future contracts are similar to forward contracts. The only difference between a forward contract and a futures contract is that, in a futures contract, a transaction can be agreed to be carried out at a time, which is not more than 3 months from the current date. There is a time boundary within which the transaction must be closed. The size and the time period of the transaction are fixed in a futures contract unlike a forward contract. Swap This is another type of forward transaction. Here both the parties agree to do a currency swap for a specified period of time. They also agree to reverse this swap and revert to their original positions at a future point of time. It is not necessary that a swap transaction has to be carried out only in an exchange. It is just an agreement between two parties. This is one of the most common forms of forward transaction. Option Options are rights given to the owners to exchange their currencies to other denomination. However it is only a right and not an obligation for the owner to exchange his currency. The Options can be classified into following types:

Exchange-traded options
Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include: stock options, commodity options, bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts callable bull/bear contract Call and put option.

Over-the-counter
Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: 1. interest rate options 2. currency cross rate options, and

3. Options on swaps or swaptions.

Other option types

Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Option styles
Naming conventions are used to help identify properties common to many different types of options. These include:

European option an option that may only be exercised on expiration. American option an option that may be exercised on any trading day on or before expiry. Bermudan option an option that may be exercised only on specified dates on or before expiration.

Barrier option any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised.

Exotic option any of a broad category of options that may include complex financial structures. Vanilla option any option that is not exotic

Exchange Traded Fund They are open ended financial instruments which can be traded anytime during the course of the trading day. These basically follow stock movements or price movements of renowned currencies and then increase or decrease the value of their currency based on the trend of price movements.