1.

Introduction
During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion about 120 billion ! dollar"# $om%are thi" &ith the monthly trading volume of ! dollar" for all ca"h' derivative" and debt in"trument" %ut together in

the country' and the "heer "i(e of the foreign exchange market become" evident# !ince then' the foreign exchange market activity ha" more than doubled &ith the average monthly turnover reaching 35) billion !D in 2005-200*' over ten time" the daily turnover of the +ombay !tock ,xchange# -" in the re"t of the &orld' in India too'foreign exchange con"titute" the large"t financial market by far# .iberali(ation ha" radically changed India/" foreign exchange "ector# Indeed the liberali(ation %roce"" it"elf &a" "%arked by a "evere +alance of 0ayment" and foreign exchange cri"i"# !ince 1))1' the rigid' four-decade old' fixed exchange rate "y"tem re%lete &ith "evere im%ort and foreign exchange control" and a thriving black market i" being re%laced &ith a le"" regulated' 1market driven2 arrangement# 3hile the ru%ee i" "till far from being 1fully floating2 4many "tudie" indicate that the effective %egging i" no le"" marked after the reform" than before5' the nature of intervention and range of inde%endence tolerated have both undergone "ignificant change"# 3ith an overabundance of foreign exchange re"erve"' im%ort" are no longer vie&ed &ith fear and "ke%tici"m# 6he 7e"erve +ank of India and it" allie" no& intervene occa"ionally in the foreign exchange market" not al&ay" to "u%%ort the ru%ee but often to avoid an a%%reciation in it" value# 8ull convertibility of the ru%ee i" clearly vi"ible in the hori(on# 6he effect" of the"e develo%ment " are %al%able in the ex%lo"ive gro&th in the foreign exchange market in India# Definition and characteristics of the foreign exchange market 6he foreign exchange market i" the market in &hich national currencie" are bought and "old again"t one another# 6hi" market i" called the 9foreign exchange/ market and not the 9foreign currency/ market becau"e the 9commodity/ that i" traded on the market i" more a%%ro%riately called 9foreign exchange/ than 9foreign currency/: the latter i" only a "mall %art of &hat i" traded# 8oreign exchange con"i"t" mainly of bank de%o"it" denominated in variou" currencie"# !till' the term 9foreign currency/ &ill be u"ed interchangeably &ith the term 9foreign exchange/#
1

6he foreign exchange market i" the large"t and mo"t %erfect of all market"# It i" the large"t in term" of trading volume 4turnover5' &hich currently "tand" at over one trillion ! dollar" %er day# It i" the mo"t %erfect market becau"e it %o""e""e" the re;uirement" for market %erfection: a large number of buyer" and "eller"< homogenou" %roduct"< free flo& of information< and the ab"ence of barrier" to entry# 6he foreign exchange market i" made u% of a va"t number of %artici%ant" 4buyer" and "eller"5# 6he %roduct" traded on the foreign exchange market are currencie": no matter &here you buy your yen"' euro"' dollar" or %ound" they are al&ay" the "ame#6here i" no re"triction on acce"" to information' and in"ider trading i" much le"" im%ortant than' for exam%le' in the "tock market# 8inally' anyone can %artici%ate in the market to trade currencie"# 6he im%ortance of the foreign exchange market "tem" from it" function of determining a crucial macroeconomic variable' the exchange rate' &hich affect" to a con"iderable extent the %erformance of economie" and bu"ine""e"#6hi" market i" needed becau"e every international economic tran"action re;uire" a foreign exchange tran"action# nfortunately' ho&ever' it" function of exchange nlike the rate determination i" not very &ell under"tood in the "en"e that economi"t" are yet to come u% &ith a theory of exchange rate determination that a%%ear" em%irically valid# "tock market and the future" market' &hich are organised exchanges' the foreign exchange market i" an over-the-counter (OTC) market' a" %artici%ant" rarely meet and actual currencie" are rarely "een#6here i" no building called the 9!ydney 8oreign ,xchange =arket/' but there are building" called the 9!ydney !tock ,xchange/ and the 9!ydney 8uture" ,xchange/# It i" an >6$ market in the "en"e that it i" not limited to a %articular locality or a %hy"ical location &here buyer" and "eller" meet# 7ather' it i" an international market that i" o%en around the clock' &here buyer" and "eller" contact each other via mean" of telecommunication#6he buyer" and "eller" of currencie" o%erate from a%%roximately 12 ma?or centre" 4the mo"t im%ortant being .ondon' @e& Aork and 6okyo5 and many minor one"# +ecau"e ma?or foreign exchange centre" fall in different time (one"' any %oint in time around the clock mu"t fall &ithin the bu"ine"" hour" of at lea"t one centre# 6he 24 hour" of a day are almo"t covered by the"e centre"' "tarting &ith the 8ar ,a"tern centre" 4!ydney' 6okyo and Bong Cong5' %a""ing through the =iddle ,a"t 4+ahrain5'

acro"" ,uro%e 48rankfurt and .ondon5' and then %a""ing through the ! centre"' ending u% &ith !an 8ranci"co#

2# Foreign Exchange

arkets in India ! a "rief "ackground

6he foreign exchange market in India "tarted in earne"t le"" than three decade" ago &hen in 1)7D the government allo&ed bank" to trade foreign exchange &ith one another# 6oday over 70E of the trading in foreign exchange continue" to take %lace in the inter-bank market# 6he market con"i"t" of over )0 -uthori(ed Dealer" 4mo"tly bank"5 &ho tran"act currency among them"elve" and come out 1";uare2 or &ithout ex%o"ure at the end of the trading day# 6rading i" regulated by the 8oreign ,xchange Dealer" -""ociation of India 48,D-I5' a "elf regulatory a""ociation of dealer"# !ince 2001' clearing and "ettlement function" in the foreign exchange market are largely carried out by the $learing $or%oration of India .imited 4$$I.5 that handle" tran"action" of a%%roximately 3#5 billion ! dollar" a day' about D0E of the total tran"action"# 6he liberali(ation %roce"" ha" "ignificantly boo"ted the foreign exchange market in the country by allo&ing both bank" and cor%oration" greater flexibility in holding and trading foreign currencie"# 6he !odhani $ommittee "et u% in 1))4 recommended greater freedom to %artici%ating bank"' allo&ing them to fix their o&n trading limit"' intere"t rate" on 8$@7 de%o"it" and the u"e of derivative %roduct"# 6he gro&th of the foreign exchange market in the la"t fe& year" ha" been nothing le"" than momentou"# In the la"t 5 year"' from 2000-01 to 2005-0*' trading volume in the foreign exchange market 4including "&a%"' for&ard" and for&ard cancellation"5 ha" more than tripled' gro&ing at a com%ounded annual rate exceeding 25E# 8igure 1 "ho&" the gro&th of foreign exchange trading in India bet&een 1))) and 200*# 6he inter-bank forex trading volume ha" continued to account for the dominant "hare 4over 77E5 of total trading over thi" %eriod' though there i" an unmi"takable do&n&ard trend in that %ro%ortion# 40art of thi" dominance' though' re"ult " from double-counting "ince %urcha"e and "ale" are added "e%arately' and a "ingle interbank tran"action lead" to a %urcha"e a" &ell a" a "ale" entry#5 6hi" i" in kee%ing &ith global %attern"# In =arch 200*' about half 44DE5 of the tran"action" &ere "%ot trade"' &hile "&a% tran"action" 4e""entially re%urcha"e agreement" &ith a one-&ay tran"action F "%ot or
3

for&ard F combined &ith a longer- hori(on for&ard tran"action in the rever"e direction5 accounted for 34E and for&ard" and for&ard cancellation" made u% 11E and 7E re"%ectively# -bout t&o-third" of all tran"action" had the ru%ee on one "ide# In 2004' according to the triennial central bank "urvey of foreign exchange and derivative market" conducted by the +ank for International !ettlement" 4+I! 42005a55 the Indian 7u%ee featured in the 20th %o"ition among all currencie" in term" of being on one "ide of all foreign tran"action" around the globe and it" "hare had tri%led "ince 1))D# -" a ho"t of foreign exchange trading activity' India ranked 23rd among all countrie" covered by the +I! "urvey in 2004 accounting for 0#3E of the &orld turnover# 6rading i" relatively moderately concentrated in India &ith 11 bank" accounting for over 75E of the trade" covered by the +I! 2004 "urvey#

#. Features of the For$ard %remium on the Indian ru%ee

6he Indian ru%ee ha" had an active for&ard market for "ome time no&# 6he for&ard %remium or di"count on the ru%ee 4vi"-G-vi" the ! dollar' for in"tance5 reflect" the market/" belief" about future change" in it" value# 6he "trength of the relation"hi% of thi"
4

for&ard %remium &ith the intere"t rate differential bet&een India and the ! F the $overed Intere"t 0arity 4$I05 condition F give" u" a mea"ure of India/" integration &ith global market"# 6he $I0 i" a no-arbitrage relation"hi% that en"ure" that one cannot borro& in a country' convert to and lend in another currency' in"ure the return" in the original currency by "elling hi" antici%ated %roceed" in the for&ard market and make %rofit" &ithout ri"k through thi" %roce""# $hakrabarti 4200*5 re%ort" that bet&een late 1))7 and mid-2004 the average di"count on the ru%ee &a" about 4E %er annum# During the %eriod the average difference bet&een )0-1D0 day bank de%o"it rate" in India and the inter-bank !D offer rate &a" about 4#5E for 3-month" and 3#5E for the *-month" %eriod# 3ith the"e t&o figure" in the "ame ball%ark 4%articularly given that bank de%o"it rate" and inter-bank rate" are not "trictly com%arable5' annual average" of intere"t rate difference" and the for&ard exchange %remium al"o indicate a moderate degree of co-movement bet&een the t&o variable"# 6he intere"t rate differential ex%lain" about 20E of the total variation in the for&ard di"count# 6he deviation of the Indian ru%ee- ! dollar from the covered intere"t %arity' ho&ever' exhibit" long-lived "&ing" on both "ide" of the (ero line# 6hi" &ould indicate arbitrage o%%ortunitie" and market im%erfection" %rovided &e could be "ure of the com%arability of the intere"t rate" con"idered# 6herefore' &hile the behavior of the for&ard %remium on the Indian ru%ee i" broadly in line" &ith the $I0' more careful em%irical analy"i" involving directly com%arable intere"t rate" i" nece""ary to mea"ure the "trength of the covered intere"t %arity condition and the efficiency of the foreign exchange market# nder market efficiency' the for&ard exchange rate i" con"idered to be an unbia"ed %redictor of the future "%ot rate' &ith random %rediction error"# 3hile the %rediction error" of for&ard rate" on the ru%ee a%%ear to "ho& "ome degree of %er"i"tence' any conclu"ion in thi" matter too mu"t a&ait more rigorou" analy"i"#

Intervention in Foreign Exchange

arkets

6he t&o main function" of the foreign exchange market are to determine the %rice of the different currencie" in term" of one another and to tran"fer currency ri"k from more ri"kaver"e %artici%ant" to tho"e more &illing to bear it# -" in any market e""entially the demand and "u%%ly for a %articular currency at any "%ecific %oint in time determine" it"
5

%rice 4exchange rate5 at that %oint# Bo&ever' "ince the value of a country/" currency ha" "ignificant bearing on it" economy' foreign exchange market" fre;uently &itne"" government intervention in one form or another' to maintain the value of a currency at or near it" 1de"ired2 level# Intervention" can range from ;uantitative re"triction" on trade and cro""-border tran"fer of ca%ital to %eriodic trade" by the central bank of the country or it" allie" and agent" "o a" to move the exchange rate in the de"ired direction# In recent year" India ha" &itne""ed both kind" of intervention though liberali(ation ha" im%lied a longterm %olicy %u"h to reduce and ultimately remove the former kind# It i" "afe to "ay that over the year" "ince liberali(ation' India ha" allo&ed re"tricted ca%ital mobility and follo&ed a 1managed float2 ty%e exchange rate %olicy# During the early year" of liberali(ation' the 7angara?an committee recommended that India/" exchange rate be flexible# >fficially "%eaking' India moved from a fixed exchange rate regime to 1market determined2 exchange rate "y"tem in 1))3# 6he overt ob?ective of India/" exchange rate %olicy' according to variou" %olicy %ronouncement"' ha" been to manage 1volatility2 in exchange rate" &ithout targeting any "%ecific level"# 6hi" ha" been hard to do in %ractice# 6he Indian ru%ee ha" had a remarkably "table relation"hi% &ith the ! dollar# =ean&hile the dollar a%%reciated again"t ma?or currencie" ! dollar and the 7u%ee i" be"t reflected in the movement" in in the late )0/" and then &ent into an extended decline %articularly during 2003 and 2004# 6he lock-"te% %attern of the the t&o currencie" again"t a third currency like the ,uro# 6he correlation of the exchange rate" of the t&o currencie" again"t the ,uro during 1)))-2004 &a" 0#)4# !everal "tudie" have e"tabli"hed the %egged nature of the ru%ee in recent year" 4"ee $hakrabarti 4200*5 for a more detailed di"cu""ion5# +a"ed on volatility' India had a de facto cra&ling %eg to the ! dollar bet&een 1)7) and 1))1 &hich changed to a de facto %eg from mid-1))1 to mid1))5' &ith a ma?or devaluation in =arch 1))3# 8rom mid-1))5 to end-2001' the ru%ee reverted to a cra&ling %eg arrangement in %ractice# -n analy"i" of the ratio of the variance of the exchange rate to the "um of the variance" of the intere"t rate and the foreign exchange re"erve" reveal" a move even clo"er to the fixed exchange rate "y"tem# com%ari"on of the "en"itivity 4beta5 of the Dollar-ru%ee rate &ith the ,uro-ru%ee rate for a three year %eriod 41))) through 20015' indicate" that India had a dollar beta of 1#01 F tenth
6

highe"t among the 53 countrie" con"idered# =ore im%ortantly' the

! dollar-,uro

exchange rate ex%lained about )7E of all movement" in the Indian ru%ee-,uro exchange rate F highest among all the 53 countrie" con"idered# $learly the Indian ru%ee ha" been an excellent 1tracker2 of the ! dollar# It i" in"tructive to con"ider the 7u%ee-Dollar exchange rate in the light of the %urcha"ing %o&er %arity 40005 holding that the exchange rate bet&een t&o currencie" "hould e;ual the ratio of %rice levels in t&o countrie"# In it" dynamic form 000 hold" that that the rate of de%reciation of a currency "hould e;ual the exce"" of it" inflation rate to that in the other country# >ver a rea"onably long %eriod of time' the devaluation in the Indian 7u%ee' vi"-Gvi" the ! dollar doe" "eem to have an a""ociation &ith the difference in the inflation rate" in the t&o countrie"# +et&een 1))1 and 2003' the t&o variable" have had vi"ible comovement" &ith a correlation of about 0#57 4$hakabarti 4200*55# 6hi" may be a re"ult of Indo- ! trade flo&" dominating the exchange rate market" but it i" %erha%" more likely that it reflect" the exchange rate management %rinci%le" of the monetary authoritie" 6he 7e"erve +ank of India ha" u"ed a varied mix of techni;ue" in intervening in the foreign exchange market F indirect mea"ure" "uch a" %re"" "tatement" 4"ometime" called 1o%en mouth o%eration"2 in central bank "%eak5 and' in more extreme "ituation"' monetary mea"ure" to affect the value of the ru%ee a" &ell a" direct %urcha"e and "ale in the foreign exchange market u"ing "%ot' for&ard and "&a% tran"action" 4"ee Hho"h 4200255# 6ill around 2002' the mea"ure" &ere mo"tly in the nature of cri"i" management of "aving-theru%ee kind and "ometime" the direct deal" &ould be re%eated over "everal day" till the de"ired outcome &a" accom%li"hed# >ther %ublic "ector bank"' %articularly the !+I often aided or veiled the intervention %roce""# 6he exact detail" of the intervention" are "hrouded in my"tery' not unu"ual for central bank" ever &ary of di"clo"ing too much of their hand to the currency "%eculator"# 6he 6ara%ore $ommittee re%ort had urged more tran"%arency in the intervention %roce"" and recommended' in 1))7' that a 9=onitoring ,xchange 7ate +and/ of I 5E be u"ed around an announced neutral real effective exchange rate 47,,75' &ith &eekly %ublication of relevant figure"' "omething yet to be im%lemented# In a recent "urvey on foreign exchange market intervention in emerging market"' the +ank for International !ettlement" 4+I!
7

42005b55 found that out of 11 emerging market countrie" con"idered' India gave out mo"t com%lete information on intervention strategy 4along &ith three other"5< no information on actual intervention" 4five other" did the "ame5 and did not cover foreign exchange intervention in annual re%ort" 4like t&o other countrie"5# >n the &hole it ranked fourth mo"t o%a;ue in matter" of foreign exchange intervention among the eleven countrie" com%ared# &egu'ation of cross-"order currenc( f'o$s - feature of the economy that i" intricately related &ith the exchange rate regime follo&ed i" the freedom of cro""-border ca%ital flo&"# 6hi" relation"hi% come" from the "o-called 1im%o""ible trinity2 or 1trilemma2 of international finance' &hich e""entially "tate" that a country may have any t&o but not all of the follo&ing three thing" F a fixed exchange rate' free flo& of ca%ital acro"" it" border" and autonomy in it" monetary %olicy# !ince liberali(ation' India ha" been having clo"e to a de facto %eg to the dollar and "imultaneou"ly ha" been liberali(ing it" foreign currency flo& regime# $lo"e on the heel" of the ado%tion of market determined exchange rate 4&ithin limit"5 in 1))3 came current account convertibility in 1))4# In 1))7' the 6ara%ore committee' on $a%ital -ccount $onvertibility' defined the conce%t a" 1the freedom to convert local financial a""et" into foreign financial a""et" and vice ver"a at market determined rate" of exchange2 and laid do&n fi"cal con"olidation' a mandated inflation target and "trengthening of the financial "y"tem a" it" three main %recondition"# =ean&hile ca%ital flo&" have been gradually liberali(ed' allo&ing' on the inflo& "ide' foreign direct and %ortfolio inve"tment"' and ta%%ing foreign ca%ital market" by Indian com%anie" a" &ell a" con"iderably better remittance %rivilege" for individual"< and on the outflo& "ide' international ex%an"ion of dome"tic com%anie"# In 2000' the infamou" 8oreign ,xchange 7egulation -ct 48,7-5 &a" re%laced &ith the much milder 8oreign ,xchange =anagement -ct 48,=-5 that gave %artici%ant" in the foreign exchange market a much greater lee&ay# 6he ultimate goal of ca%ital account convertibility no& "eem" to be &ithin the government/" "ight" and effort" are on to chalk out the roadma% for the la"t leg' though it i" not ex%ected to be accom%li"hed before 200)# ,x%ectedly' the &i"dom of the move ha" been hotly debated # -dvocate" of convertibility cite the 1con"um%tion
8

"moothing2

benefit" of global fund" flo& and %oint out that it actually im%rove"

macroeconomic di"ci%line becau"e of external monitoring by the global financial market"# $onvertibility can "%ur dome"tic inve"tment and gro&th becau"e of ea"ier and chea%er financing# It can al"o contribute to greater efficiency in the banking and financial "y"tem"# >n the other hand' "ke%tic" like 3illiam"on 4200*5' for in"tance' %oint" out that India i" yet to fulfill at lea"t one of the three ma?or %recondition" to $a%ital -ccount $onvertibility "et out by the 6ara%ore committee' vi(# fi"cal di"ci%line' &ith a %ublic "ector deficit of 7#*E of the HD0 and the ratio of %ublic debt to HD0 of over D3E in 2005-0*# In any ca"e' the argument goe"' the benefit" of convertibility do not nece""arily out&eigh the ri"k" and cro""-border "hort-term bank loan" F u"ually the la"t item to be liberali(ed F are the mo"t volatile# It i" generally held that it &a"' in fact' the lack of convertibility that %rotected India from contamination during the -"ian contagion in 1))7-)D# The D(namics of )$e''ing &eserves--n im%ortant corollary of India/" foreign exchange %olicy ha" been the ;uick and "ignificant accumulation of foreign currency re"erve" in the %a"t fe& year"# !tarting from a "ituation in 1))0-)1 &ith foreign exchange re"erve" level barely enough to cover t&o &eek" of im%ort"' and about J32 billion at the beginning of 2000' India/" foreign exchange %o"ition rocketed to one of the large"t in the &orld &ith over J155 billion in mid-200*# !ince 2000' thi" im%lie" a com%ounded annual gro&th rate of about 2DE &ith the year" 2003 and 2004 having the mo"t "tunning ri"e" at 4DE and 45E re"%ectively# During the"e t&o year" the ! dollar fell again"t the ,uro by 1)E and again"t the ru%ee by )E# 3ithout 7+I intervention' the latter figure i" likely to have been larger and the re"erve" accumulation le"" "%ectacular#

*.

arket %artici%ants

arket %artici%ants are foreign exchange trader" &ho' directly or indirectly' buy and "ell currencie"# 6he"e cla""e" of %artici%ant" enter the market a" ar"itragers' hedgers and s%ecu'ators# -rbitrager" "eek to make %rofit by ex%loiting exchange rate anomalie" 4for exam%le' &hen an exchange rate a""ume" t&o different value" in t&o financial centre" at the "ame time5# Bedger" enter the market to cover o%en %ositions in an attem%t to reduce or eliminate foreign exchange ri"k 4an o%en %o"ition ari"e"' for exam%le' &hen an im%orter ha" to meet a foreign currency %ayment' &hich i" due "ome time in the future5# 6hi"
9

%o"ition can be covered' for exam%le' by buying the foreign currency for&ard# !%eculator"' on the other hand' bear ri"k deliberately by taking deci"ion" involving o%en %o"ition" to make %rofit if their ex%ectation" turn out to be correct#- "%eculator &ould buy a currency if it &ere ex%ected to a%%reciate' reali"ing %rofit if the currency a%%reciate" "ub"e;uently 4and reali"ing lo"" other&i"e5# 3e &ill come acro"" and elaborate on the"e conce%t" throughout thi" book' but for the time being &e concentrate on the in"titutional cla""ification of market %artici%ant"# 6here are five broad categorie" of %artici%ant" in the foreign exchange market: cu"tomer"' commercial bank"' other financial in"titution"' broker" and central bank"# $u"tomer" include individual" and com%anie" utili"ing the "ervice" of commercial bank" to buy and "ell foreign exchange in order to finance international trade and inve"tment o%eration"#6hu"' cu"tomer" include' inter alia' ex%orter"' im%orter"' touri"t"' immigrant" and inve"tor"# ,x%orter" "ell the foreign currencie" they obtain from foreigner" buying their %roduct"# Im%orter" buy the foreign currencie" they need to %ay for the foreign good" they buy from foreign "u%%lier"# 6ouri"t" going abroad buy foreign currencie"' &herea" tho"e coming from abroad 4foreign touri"t"5 buy the dome"tic currency to %ay for their living ex%en"e" &hile they are on holiday# Immigrant" buy foreign currencie" &hen they tran"fer fund" to relative" in their home countrie"# 8inally' inve"tor" buy and "ell currencie" a" %art of their ac;ui"ition and di"%o"al of a""et" 4bond"' "hare"' real e"tate' etc#5# $u"tomer" are %rice takers in the foreign exchange market' &hich mean" that they buy currencie" at the exchange rate" ;uoted by market makers# .arge commercial bank" are market maker" in the "en"e that they "tand ready to buy and "ell currencie" at the exchange rate" they declare' acting via their foreign exchange dea'ers# >n the retail "ide commercial bank" deal &ith cu"tomer"' but on the &hole"ale "ide they deal in the inter"ank market or the $ho'esa'e market 4that i"' &ith other bank"5# $ommercial bank" %artici%ate in the foreign exchange market mainly a" "%eculator"' trying to make "hort term %rofit by getting ex%o"ed to foreign exchange ri"k# 6hey al"o make %rofit on their dealing" &ith cu"tomer" from the difference" bet&een the buying and "elling rate"# 6hey execute thi" function via the dea'ing desk or dea'ing room' &hich hou"e" a grou% of dealer"# 6he"e dealer" may "%eciali"e in the trading of a %articular currency' a
10

grou% of currencie" or a %articular ty%e of tran"action 4for exam%le' s%ot transactions a" o%%o"ed to for$ard transactions5# >ther financial in"titution" 4"uch a" inve"tment bank" and mutual fund"5 and large com%anie" may deal directly by conducting foreign exchange o%eration" them"elve" and not through bank"# Dealer" re%re"enting commercial bank"' other financial in"titution" and large com%anie" do bu"ine"" &ith each other in t&o &ay"# 6he direct &ay i" to tele%hone other dealer" directly' or to contact them via an electronic dealing "y"tem# >ther&i"e' dealing can be carried out indirectly via a "roker' thu" %re"erving anonymity#3ith the introduction of on'ine trading s(stems' a ne& 4direct5 mode of trading ha" emerged# 6he function of a broker i" to "%read market information and to bring together buyer" and "eller" &ith matching need"# +roker" differ from dealer" in that they do not take %o"ition" them"elve"' but obtain their 9living/ by charging commission fees# =a?or brokerage hou"e" are global in nature' "ervicing the interbank market around the clock# 8inally' central bank" %artici%ate in the foreign exchange market becau"e they act a" banker" for their government" and al"o becau"e they run the exchange rate and monetary %olicie"# -ll of the"e function" re;uire market %artici%ation# 8or exam%le' under a "y"tem of managed floating' central bank" often intervene in the foreign exchange market by buying and "elling currencie"' &ith the ob?ective of 9"moothing out/ exchange rate movement" or to %revent the dome"tic currency from a%%reciating or de%reciating exce""ively# 6he foreign exchange market i" dominated by interbank o%eration"' the buying and "elling of currencie" among bank"# 6he li;uidity of the interbank market i" due to large-volume tran"action"' a" &ell a" the fact that bank" acce%t an obligation of reci%rocit( in ;uoting to other interbank dealer"# Bo&ever' it i" by no mean" true that the interbank market i" com%letely homogenou"# 8urthermore' not all bank" are e;ually active in the interbank market# 6hu"' %artici%ant" in the interbank market are cla""ified into: 4i5 market maker"' normally the large"t bank"< 4ii5 other ma?or interbank dealer"' &ho are &illing to reci%rocate ;uote" in a number of currencie"< and 4iii5 "econd-tier bank"' including bank" that are active %rimarily in their dome"tic currencie" and tho"e un&illing to reci%rocate ;uote" and often dealing in "mall amount"# Commercia' com%anies
11

-n im%ortant %art of thi" market come" from the financial activitie" of com%anie" "eeking foreign exchange to %ay for good" or "ervice"# $ommercial com%anie" often trade fairly "mall amount" com%ared to tho"e of bank" or "%eculator"' and their trade" often have little "hort term im%act on market rate"# @everthele""' trade flo&" are an im%ortant factor in the long-term direction of a currencyK" exchange rate# !ome multinational com%anie" can have an un%redictable im%act &hen very large %o"ition" are covered due to ex%o"ure" that are not &idely kno&n by other market %artici%ant"# Centra' "anks @ational central bank" %lay an im%ortant role in the foreign exchange market"# 6hey try to control the money "u%%ly' inflation' andLor intere"t rate" and often have official or unofficial target rate" for their currencie"# 6hey can u"e their often "ub"tantial foreign exchange re"erve" to "tabili(e the market# @everthele""' the effectivene"" of central bank M"tabili(ing "%eculationM i" doubtful becau"e central bank" do not go bankru%t if they make large lo""e"' like other trader" &ould' and there i" no convincing evidence that they do make a %rofit trading#

Foreign exchange fixing 8oreign exchange fixing i" the daily monetary exchange rate fixed by the national bank of each country# 6he idea i" that central bank" u"e the fixing time and exchange rate to evaluate behavior of their currency# 8ixing exchange rate" reflect" the real value of e;uilibrium in the market# +ank"' dealer" and trader" u"e fixing rate" a" a trend indicator# 6he mere ex%ectation or rumor of a central bank foreign exchange intervention might be enough to "tabili(e a currency' but aggre""ive intervention might be u"ed "everal time" each year in countrie" &ith a dirty float currency regime# $entral bank" do not al&ay" achieve their ob?ective"# 6he combined re"ource" of the market can ea"ily over&helm any central bank#N**O !everal "cenario" of thi" nature &ere "een in the 1))2F)3 ,uro%ean ,xchange 7ate =echani"m colla%"e' and in more recent time" in -"ia# +edge funds as s%ecu'ators -bout 70E to )0E of the foreign exchange tran"action" are "%eculative# In other &ord"' the %er"on or in"titution that bought or "old the currency ha" no %lan to actually take
12

delivery of the currency in the end< rather' they &ere "olely "%eculating on the movement of that %articular currency# Bedge fund" have gained a re%utation for aggre""ive currency "%eculation "ince 1))*# 6hey control billion" of dollar" of e;uity and may borro& billion" more' and thu" may over&helm intervention by central bank" to "u%%ort almo"t any currency' if the economic fundamental" are in the hedge fund"K favor# Investment management firms Inve"tment management firm" 4&ho ty%ically manage large account" on behalf of cu"tomer" "uch a" %en"ion fund" and endo&ment"5 u"e the foreign exchange market to facilitate tran"action" in foreign "ecuritie"# 8or exam%le' an inve"tment manager bearing an international e;uity %ortfolio need" to %urcha"e and "ell "everal %air" of foreign currencie" to %ay for foreign "ecuritie" %urcha"e"# !ome inve"tment management firm" al"o have more "%eculative "%eciali"t currency overlay o%eration"' &hich manage client"K currency ex%o"ure" &ith the aim of generating %rofit" a" &ell a" limiting ri"k# 3hile the number of thi" ty%e of "%eciali"t firm" i" ;uite "mall' many have a large value of a""et" under management and' hence' can generate large trade"# &etai' foreign exchange traders Individual retail "%eculative trader" con"titute a gro&ing "egment of thi" market &ith the advent of retail foreign exchange %latform"' both in "i(e and im%ortance# $urrently' they %artici%ate indirectly through broker" or bank"# 7etail broker"' &hile largely controlled and regulated in the
N*DO

!- by the $ommodity 8uture" 6rading $ommi""ion and @ational

8uture" -""ociation have in the %a"t been "ub?ected to %eriodic 8oreign exchange fraud#N*7O 6o deal &ith the i""ue' in 2010 the @8- re;uired it" member" that deal in the 8orex market" to regi"ter a" "uch 4I#e#' 8orex $6- in"tead of a $6-5# 6ho"e @8- member" that &ould traditionally be "ub?ect to minimum net ca%ital re;uirement"' 8$=" and I+"' are "ub?ect to greater minimum net ca%ital re;uirement" if they deal in 8orex# - number of the foreign exchange broker" derivative" o%erate trading from the C that under 8inancial !ervice" for -uthority regulation" &here foreign exchange trading u"ing margin i" %art of the &ider over-the-counter indu"try include" $ontract difference" and financial "%read betting#
13

6here are t&o main ty%e" of retail 8P broker" offering the o%%ortunity for "%eculative currency trading: brokers and dealers or market makers# Brokers "erve a" an agent of the cu"tomer in the broader 8P market' by "eeking the be"t %rice in the market for a retail order and dealing on behalf of the retail cu"tomer# 6hey charge a commi""ion or mark-u% in addition to the %rice obtained in the market# Dealers or market makers' by contra"t' ty%ically act a" %rinci%al in the tran"action ver"u" the retail cu"tomer' and ;uote a %rice they are &illing to deal at# ,on-"ank foreign exchange com%anies @on-bank foreign exchange com%anie" offer currency exchange and international %ayment" to %rivate individual" and com%anie"# 6he"e are al"o kno&n a" foreign exchange broker" but are di"tinct in that they do not offer "%eculative trading but rather currency exchange &ith %ayment" 4i#e#' there i" u"ually a %hy"ical delivery of currency to a bank account5#

-. The si.e and com%osition of the foreign exchange market

6he "i(e of the 4global5 foreign exchange market i" mea"ured by the "um of daily turnover in foreign exchange centre" around the &orld# 6hi" i" normally done through a "urvey that i" coordinated by the +ank for International !ettlement" 4+I!5 and conducted in each financial centre by the dome"tic central bank 4for exam%le' the !ydney "urvey i" conducted by the 7e"erve +ank of -u"tralia5# In thi" "urvey' &hich i" conducted every three year" in -%ril' bank" and financial in"titution" are a"ked about their foreign exchange activity' including "%ot and for&ard tran"action"# !ince 1))5' the "urvey ha" been re-de"igned to cover >6$ derivative" activity' including currency and intere"t rate derivative" 4"uch a" currency o%tion"5# 6he ex%o"ition here i" re"tricted to the "o-called 9traditional foreign exchange market/' &hich include" "%ot and for&ard tran"action" only# 8igure 2#1 "ho&" the volume of daily turnover in the global foreign exchange market a" mea"ured through the +I! "urvey" "ince 1)D)# 6he global total i" mea"ured by adding u% turnover in individual financial market"# In 2001 daily turnover declined' a" com%ared &ith the %reviou" "urvey' for the fir"t time# 6he 1)#5 %er cent decline to !D1200 i" attributed to at lea"e t&o factor"# 6he fir"t i" the introduction of the euro and the abolition of the national currencie" in 12 ,uro%ean countrie"# -lthough the trading of the euro ha" been
14

more than that of the former Herman mark' it ha" al"o been le"" than the combined trading of the national currencie"# 6he "econd rea"on i" con"olidation in the banking indu"try via merger" and ac;ui"ition"# -" &e can "ee from 8igure 2#1' for&ard tran"action" 4con"i"ting of outright o%erations and s$a% o%erations5 com%ri"e the bulk of tran"action" in the foreign exchange market# The s%ot exchange rate 6he function of a market i" the determination of the %rice of the commodity in &hich it i" traded# 6he commodity that i" traded on the foreign exchange market i" 9foreign exchange/' currencie" and bank de%o"it" denominated in variou" currencie"# 8or "im%licity' &e &ill ?u"t call them currencie"# - foreign exchange market %artici%ant &ould normally &ant to buy one currency and "ell another' ty%ically 4but not nece""arily5 the dome"tic and a foreign currency#6he %rice of one currency in term" of another i" called a "i'atera' exchange rate' becau"e t&o currencie" are involved in the tran"action# $onfu"ion may ari"e becau"e the exchange rate i" the %rice of one kind of money in term" of another kind of money# /.- 3hen the exchange of currencie" take" %lace immediately' the underlying o%eration i" called a "%ot tran"action' and "o &e define the s%ot exchange rate a" the rate a%%licable to tran"action" involving immediate exchange of the currencie"# 6he &ord 9immediate/ mean" different thing"# 3hen you u"e the "ervice" of a moneychanger at =elbourne -ir%ort to exchange "ome -u"tralian dollar" for Bong Cong dollar" becau"e you are about to board a %lane to Bong Cong' you obtain the Bong Cong dollar" that you have bought immediately' meaning at once# 6hi" i" al"o called a cash transaction# In an inter"ank transaction' on the other hand' the exchange of currencie" doe" not take %lace at once' but rather in t&o bu"ine"" day" 4&here a bu"ine"" day i" a day on &hich bank" and other foreign exchange market %artici%ant" are o%en for bu"ine""5#3hen a tran"action bet&een t&o bank dealer" i" concluded today' each bank &ill in t&o bu"ine"" day" credit the other/" account &ith the %re"cribed currency and amount agreed u%on# 6hi" i" "till regarded a" an immediate de'iver(' and "o the underlying exchange rate i" a "%ot exchange rate# If the delivery take" %lace "ome time in the future' then the underlying o%eration i" a forward transaction#

15

6&o date" are involved in "uch a tran"action#6he fir"t 4called the contract date' the dea'ing date' the done date or the trade date5 i" the date on &hich the tran"action i" concluded at the exchange rate %revailing on the "ame date#6he "econd date' &hich fall" t&o bu"ine"" day" later' i" called the de'iver( date or va'ue date#6he exchange rate %revailing in the market may actually change bet&een the t&o date"' but' no matter &hat ha%%en"' the exchange of the currencie" take" %lace at the exchange rate agreed u%on &hen the tran"action i" concluded# The for$ard exchange rate 6he for$ard exchange rate i" a rate contracted today for the delivery of a currency at a "%ecified date in the future#6hi" date in the future 4called the for$ard va'ue date5 mu"t be more than t&o bu"ine"" day" a&ay' other&i"e the underlying tran"action &ill be a "%ot tran"action# If the delivery take" %lace one &eek after the tran"action ha" been concluded' then the underlying rate i" a one-&eek for&ard rate#6y%ically' for&ard contract" extend u% to one year' in maturitie" of one month' t&o month"' and "o on# Bo&ever' for&ard contract" of maturitie" longer than one year can al"o be found# - "%ecial kind of for&ard contract i" called a "reak for$ard contract# 6hi" contract can be terminated at a %redetermined date' thu" %roviding %rotection again"t adver"e exchange rate movement"# It may al"o be called for$ard $ith o%tiona' exit' abbreviated a" 8>P# 6he interval until a for&ard value date i" calculated from the "%ot value date' not from the tran"action date# 8or exam%le' the for&ard value date of a "ale of one &eek for&ard agreed on 1* Qune &ould be one &eek from the "%ot value date of 1D Qune' &hich &ould be 25 Qune# 6he for&ard value date i" u"ually fixed' not by agreeing on a "%ecific date' but by agreeing on a term' &hich i" a &hole number of &eek" or month" after the "%ot value date 4for exam%le' one month5# 6he "%ecific date i" then fixed according to one of t&o convention": 4i5 the modified fo''o$ing "usiness da( convention < and 4ii5 the end0end ru'e# 6he modified follo&ing bu"ine"" day convention &ork" a" follo&": the maturity date i" "et to be the value date' but if that fall" on a non-bu"ine"" day' the date i" moved to the follo&ing day# If that fall" in the next calendar month' it &ould be moved to the la"t bu"ine"" day of the current calendar month#6he endLend rule i" that if the value date i" the la"t bu"ine"" day
16

of the current calendar month' maturity &ill be the la"t bu"ine"" day of the final calendar month#

1. Financia' instruments )%ot

- "%ot tran"action i" a t&o-day delivery tran"action 4exce%t in the ca"e of trade" bet&een the ! Dollar' $anadian Dollar' 6urki"h .ira' ,uro and 7u""ian 7uble' &hich "ettle the next bu"ine"" day5' a" o%%o"ed to the future" contract"' &hich are u"ually three month"# 6hi" trade re%re"ent" a 1direct exchange2 bet&een t&o currencie"' ha" the "horte"t time frame' involve" ca"h rather than a contract< and intere"t i" not included in the agreed-u%on tran"action# !%ot trading i" one of the mo"t common ty%e" of 8orex 6rading# >ften' a forex broker &ill charge a "mall fee to the client to roll-over the ex%iring tran"action into a ne& identical tran"action for a continuum of the trade# 6hi" roll-over fee i" kno&n a" the M!&a%M fee# For$ard >ne &ay to deal &ith the foreign exchange ri"k i" to engage in a for&ard tran"action# In thi" tran"action' money doe" not actually change hand" until "ome agreed u%on future date# - buyer and "eller agree on an exchange rate for any date in the future' and the tran"action occur" on that date' regardle"" of &hat the market rate" are then# 6he duration of the trade can be one day' a fe& day"' month" or year"# )$a% 6he mo"t common ty%e of for&ard tran"action i" the foreign exchange "&a%# In a "&a%' t&o %artie" exchange currencie" for a certain length of time and agree to rever"e the tran"action at a later date# 6he"e are not "tandardi(ed contract" and are not traded through "ually the date i" decided by both %artie"# 6hen the for&ard contract i" negotiated and agreed u%on by both %artie"#

17

an exchange# - de%o"it i" often re;uired in order to hold the %o"ition o%en until the tran"action i" com%leted# Future 8uture" are "tandardi(ed for&ard contract" and are u"ually traded on an exchange created for thi" %ur%o"e# 6he average contract length i" roughly 3 month"# 8uture" contract" are u"ually inclu"ive of any intere"t amount"# $urrency future" contract" are contract" "%ecifying a "tandard volume of a %articular currency to be exchanged on a "%ecific "ettlement date# 6hu" the currency future" contract" are "imilar to for&ard contract" in term" of their obligation' but differ from for&ard contract" in the &ay they are traded# 6hey are commonly u"ed by =@$" to hedge their currency %o"ition"# In addition they are traded by "%eculator" &ho ho%e to ca%itali(e on their ex%ectation" of exchange rate movement"# O%tion - foreign exchange o%tion 4commonly "hortened to ?u"t 8P o%tion5 i" a derivative &here the o&ner ha" the right but not the obligation to exchange money denominated in one currency into another currency at a %re-agreed exchange rate on a "%ecified date# 6he o%tion" market i" the dee%e"t' large"t and mo"t li;uid market for o%tion" of any kind in the &orld# )%ecu'ation $ontrover"y about currency "%eculator" and their effect on currency devaluation" and national economie" recur" regularly# @everthele""' economi"t" including =ilton 8riedman have argued that "%eculator" ultimately are a "tabili(ing influence on the market and %erform the im%ortant function of %roviding a market for hedger" and tran"ferring ri"k from tho"e %eo%le &ho donKt &i"h to bear it' to tho"e &ho do# N7)O >ther economi"t" "uch a" Qo"e%h !tiglit( con"ider thi" argument to be ba"ed more on %olitic" and a free market %hilo"o%hy than on economic"# .arge hedge fund" and other &ell ca%itali(ed M%o"ition trader"M are the main %rofe""ional "%eculator"# -ccording to "ome economi"t"' individual trader" could act a" Mnoi"e trader"M and have a more de"tabili(ing role than larger and better informed actor"#ND1O -l"o to be con"idered i" the ri"e in foreign exchange autotrading< algorithmic' or automated' trading ha" increa"ed from 2E in 2004 u% to 45E in 2010#ND2O
18

$urrency "%eculation i" con"idered a highly "u"%ect activity in many countrie"# Nwhere?O 3hile inve"tment in traditional financial in"trument" like bond" or "tock" often i" con"idered to contribute %o"itively to economic gro&th by %roviding ca%ital' currency "%eculation doe" not< according to thi" vie&' it i" "im%ly gambling that often interfere" &ith economic %olicy#

2. The mechanics and techno'og( of foreign exchange trading

- foreign exchange tran"action con"i"t" of the follo&ing "e;uential %roce""e": R 3rice discover(4 the dealer ?udge" the exchange rate at &hich the tran"action can be executed# 6hi" re;uire" an a""e""ment of the li;uidity of the market and the ex%ectation held by other" about future change" in the exchange rate# R Decision making: the dealer "eek" information to "u%%ort the deci"ion to execute the tran"action# ,xecution' &hich i" the tran"action it"elf' i" initially conducted via the tele%hone or other mean" of telecommunication# R )ett'ement4 thi" involve" com%leting the tran"action by making %ayment" in one currency and receiving %ayment" in another#6hi" function i" %erformed by the "o-called "ack office rather than by the dealer" to allo& an inde%endent check on their activitie"# R 3osition kee%ing4 the dealer monitor" the re"ulting %o"ition' calculating %rofit and lo""#deci"ion may be taken to clo"e the %o"ition "ub"e;uently# 8oreign exchange market technology a%%lie" to all of the"e %roce""e"# 6he follo&ing i" a brief outline of the hi"torical develo%ment of foreign exchange technology# 0rior to 3orld 3ar I' the foreign exchange market had %hy"ical location"' &here %re-tran"action %roce""e" and execution &ere carried out manually# 0o"t-tran"action %roce""e" &ere al"o "ettled manually &ith a %hy"ical delivery of bill"# 0hy"ical delivery in foreign exchange %er"i"ted until ;uite recently: che;ue" and mail tran"fer" &ere u"ed until the 1)70"# In continental ,uro%ean centre" "ome form of %hy"ical location continued to exi"t until the 1)D0"' a" commercial bank" met daily &ith the central bank to fix the rate at &hich to "ettle cu"tomer order"# 6he follo&ing are the main technological device" u"ed in conducting foreign exchange bu"ine"":

19

R 6he fir"t mean" of telecommunication u"ed in the foreign exchange market &a" the telegra%h# !ome !DLH+0 tran"action" &ere executed by u"ing the tran"--tlantic cable laid in 1D5D bet&een .ondon and @e& Aork 4hence the %ound/" nickname' $able5# R -lthough tele%hone deal" may be traced back to 1)2*' it &a" not until the late 1)70" that reliable international net&ork" &ere in"talled in bank"/ dealing room"# R 6hen there &a" the telex' &hich i" a tele%hone line &ith an automatic ty%e&riter# It largely "u%%lanted the telegra%h after 3orld 3ar II# R In deci"ion making and "ettlement the "ucce""or to the telex &a" the fax# R - breakthrough for %rice di"covery and deci"ion making &a" the screen-"ased information s(stem carrying ne&" and %rice" from other bank"#6he fir"t &a" the 7euter"/ =onitor' &hich &a" introduced in 1)73# 6hi" &a" follo&ed by other vendor" "uch a" 6elerate# +y 1)D4' there &ere "ome 40 electronic information "ervice" in .ondon# R +y the "econd half of the 1)D0" the ma?or %art of communication in the foreign exchange market had "hifted to screen-"ased automated dea'ing s(stems 4al"o kno&n a" conversationa' dea'ing s(stems5' &hich are net&ork" that connect terminal"# - dealer &ith a terminal can u"e it to call another dealer &ith a terminal on the "ame net&ork# R 6he next "tage in the develo%ment of "creen-ba"ed "y"tem" involved the automation of the execution %roce""' &hich materiali"ed in 1))2 &hen 7euter" introduced it" automatic matching "y"tem# 5utomatic order matching s(stems are net&ork" of terminal" &here dealer" enter order" in the form of a buying andLor "elling %rice for a given amount of currency# 6he net&ork "elect" and di"%lay" the be"t buying and "elling order" for each currency %air# R 6he Internet i" another develo%ment# >%en acce"" to the Internet remove" the need to build dedicated connection" to counter%artie" or cu"tomer"# In 1))7 an Internet-ba"ed foreign exchange dealing "ervice 4aimed mainly at &ealthy individual"5 &a" e"tabli"hed in the nited Cingdom by the $urrency =anagement $or%oration# R =ore recent develo%ment" %ertain to on'ine foreign exchange trading' including the emergence of Internet-ba"ed multidealer foreign exchange "ervice"' "uch a" $urrenex 4-%ril 20005' 8xall 4=ay 20015 and -triax 4-ugu"t 20005# 8or more detail"' "ee the box belo&#
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6. Features of foreign exchange market4-

7i8uidit(4 the market o%erate" the enormou" money "u%%ly and give" ab"olute freedom &ithin o%ening or clo"ing a %o"ition in the current market ;uotation# Bigh li;uidity i" a %o&erful magnet for any inve"tor' becau"e it give" him or her the freedom to o%en or to clo"e a %o"ition of any "i(e &hatever# 3rom%tness4 &ith a 24-hour &ork "chedule' %artici%ant" in the 8>7,P market need not &ait to re"%ond to any given event' a" i" the ca"e in many market"# 5vai'a"i'it(4 a %o""ibility to trade round-the-clock< a market %artici%ant need not &ait to re"%ond to any given event# F'exi"'e regu'ation of the trade arrangement s(stem4 a %o"ition may be o%ened for a %re-determined %eriod of time in the 8>7,P market' at the inve"tor/" di"cretion' &hich enable" to %lan the timing of one/" future activity in advance# 9a'ue4 the 8orex market ha" traditionally incurred no "ervice charge"' exce%t for the natural bidLa"k market "%read bet&een the "u%%ly and the demand %rice# One-va'ued 8uotations4 &ith high market li;uidity' mo"t "ale" may be carried out at the uniform market %rice' thu" enabling you to avoid the in"tability %roblem exi"ting &ith future" and other forex inve"tment" &here limited ;uantitie" of currency only can be "old concurrently and at a "%ecified %rice# arket trend4 currency move" in a ;uite "%ecific direction that can be tracked for rather a long %eriod of time# ,ach %articular currency demon"trate" it" o&n ty%ical tem%orary change"' &hich %re"ent" inve"tment manager" &ith the o%%ortunitie" to mani%ulate the 8>7,P market# argin4 the credit 1leverage2 4margin5 in the 8>7,P market i" only determined by an agreement bet&een a cu"tomer and the bank or the brokerage hou"e that %u"he" it to the market and i" normally e;ual to 1:100# 6hat mean" that' u%on making a J1'000 %ledge' a cu"tomer can enter into tran"action" for an amount e;uivalent to J100'000# It i" "uch exten"ive credit 1leverage2' that in con?unction &ith highly variable currency ;uotation"' making thi" market highly %rofitable and al"o highly ri"ky#
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:.,ature of Transaction of foreign exchange market41.

5r"itrage4-rbitrage refer" to the activitie" of a dealer in foreign exchange# Be bye a currency at one %lace and "ell" it at another %lace "imultaneou"ly# -" a re"ult the market for a given currency remain unified in different money market" in the &orld# In the %roce"" the dealer in foreign exchange market make" %rofit"# Be take advantage of %rice or exchange rate difference" in the t&o market"# 8or exam%le: 1 J S 7" 44 in ! and in India it i" 1 J S7" 45#

2.

+edging4Bedging i" an im%ortant feature" of the foreign exchange market# It refer" to the avoidance of foreign exchange ri"k# 3hen im%orter" and ex%orter" enter into an agreement normally &ith a commercial bank dealing in foreign exchange to buy and "ell good" at "ome future "%ecified date at the %redetermined exchange rate if i" called hedging#

3hen a currency trader enter" into a trade &ith the intent of %rotecting an exi"ting or antici%ated %o"ition from an un&anted move in the foreign currency exchange rate"' they can be "aid to have entered into a forex hedge# +y utili(ing a forex hedge %ro%erly' a trader that i" long a foreign currency %air' can %rotect them"elve" from do&n"ide ri"k< &hile the trader that i" "hort a foreign currency %air' can %rotect again"t u%"ide ri"k# 6he %rimary method" of hedging currency trade" for the retail forex trader i" through: !%ot contract"' and 8oreign currency o%tion"# !%ot contract" are e""entially the regular ty%e of trade that i" made by a retail forex trader# +ecau"e "%ot contract" have a very "hort-term delivery date 4t&o day"5' they are not the mo"t effective currency hedging vehicle# 7egular "%ot contract" are u"ually the rea"on that a hedge i" needed' rather than u"ed a" the hedge it"elf#

8oreign currency o%tion"' ho&ever are one of the mo"t %o%ular method" of currency hedging# -" &ith o%tion" on other ty%e" of "ecuritie"' the foreign currency o%tion give" the %urcha"er the right' but not the obligation' to buy or "ell the currency %air at a %articular exchange rate at "ome time in the future# 7egular o%tion" "trategie" can be em%loyed' "uch a" long "traddle"' long "trangle" and bull or bear "%read"' to limit the lo"" %otential of a given trade# 48or more' "ee A Beginner's Guide To edging#5 8orex hedging "trategy
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- forex hedging "trategy i" develo%ed in four %art"' including an analy"i" of the forex traderK" ri"k ex%o"ure' ri"k tolerance and %reference of "trategy# 6he"e com%onent" make u% the forex hedge:
1.

2.

3.

4.

-naly(e ri"k: 6he trader mu"t identify &hat ty%e" of ri"k 4"5he i" taking in the current or %ro%o"ed %o"ition# 8rom there' the trader mu"t identify &hat the im%lication" could be of taking on thi" ri"k un-hedged' and determine &hether the ri"k i" high or lo& in the current forex currency market# Determine ri"k tolerance: In thi" "te%' the trader u"e" their o&n ri"k tolerance level"' to determine ho& much of the %o"itionK" ri"k need" to be hedged# @o trade &ill ever have (ero ri"k< it i" u% to the trader to determine the level of ri"k they are &illing to take' and ho& much they are &illing to %ay to remove the exce"" ri"k"# Determine forex hedging "trategy: If u"ing foreign currency o%tion" to hedge the ri"k of the currency trade' the trader mu"t determine &hich "trategy i" the mo"t co"t effective# Im%lement and monitor the "trategy: +y making "ure that the "trategy &ork" the &ay it "hould' ri"k &ill "tay minimi(ed# 6he forex currency trading market i" a ri"ky one' and hedging i" ?u"t one &ay that a trader can hel% to minimi(e the amount of ri"k they take on# !o much of being a trader i" money and ri"k management' that having another tool like hedging in the ar"enal i" incredibly u"eful# @ot all retail forex broker" allo& for hedging &ithin their %latform"# +e "ure to re"earch fully the broker you u"e before beginning to trade#

3.

)%ecu'ation4!%eculation i" the o%%o"ite of hedging# 3hile a hedger "eek" to cover the foreign exchange ri"k a "%eculator acce%t" and even "eek" out a foreign exchange ri"k or an o%en %o"ition in the ho%e of the making a %rofit# If the "%eculator correctly antici%ate" the future change" in "%ot rate he "tand" to gain or el"e he &ould incur lo""e"#

- number of %ro%o"al" have been made in the %a"t to try and limit "%eculation that &ere never enacted' the"e have included: 6he 6obin tax i" a tax intended to reduce "hort-term currency "%eculation' o"ten"ibly to "tabili(e foreign exchange# In =ay 200D Herman leader" %lanned to %ro%o"e a &orld&ide ban on oil trading by "%eculator"' blaming the 200D oil %rice ri"e" on mani%ulation by hedge fund"#
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>n 3 December 200) #!# $ongre""man 0eter De8a(io' &ho blamed Mreckle"" "%eculationM for the 200D financial cri"i"' %ro%o"ed the introduction of a financial tran"action tax' &hich &ould "%ecifically target "%eculator" by taxing financial market "ecuritie" tran"action"# 1;. Conc'usion

During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion ! dollar"# $om%are thi" &ith the monthly trading volume of about 120 billion ! dollar" for all ca"h' derivative" and debt in"trument" %ut together in the country' and the "heer "i(e of the foreign exchange market become" evident# !ince then' the foreign exchange market activity ha" more than doubled &ith the average monthly turnover reaching 35) billion !D in 2005-200*' over ten time" the daily turnover of the +ombay !tock ,xchange# -" in the re"t of the &orld' in India too'foreign exchange con"titute" the large"t financial market by far# 6he foreign exchange market 4forex' F<' or currenc( market5 i" a global decentrali(ed market for the trading of currencie"# 6he main %artici%ant" in thi" market are the larger international bank"# 8inancial center" around the &orld function a" anchor" of trading bet&een a &ide range of different ty%e" of buyer" and "eller" around the clock' &ith the exce%tion of &eekend"# ,lectronic +roking !ervice" 4,+!5 and 7euter" 3000 Ptra are t&o main interbank 8P trading %latform"# 6he foreign exchange market determine" the relative value" of different currencie"# 6he foreign exchange market &ork" through financial in"titution"' and it o%erate" on "everal level"# +ehind the "cene" bank" turn to a "maller number of financial firm" kno&n a" 1dealer"'2 &ho are actively involved in large ;uantitie" of foreign exchange trading# =o"t foreign exchange dealer" are bank"' "o thi" behind-the"cene" market i" "ometime" called the 1interbank market2' although a fe& in"urance com%anie" and other kind" of financial firm" are involved# 6rade" bet&een foreign exchange dealer" can be very large' involving hundred" of million" of dollar"# +ecau"e of the "overeignty i""ue &hen involving t&o currencie"' 8orex ha" little 4if any5 "u%ervi"ory entity regulating it" action"#

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