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PRESENTATION
Foreign Exchange Market (FOREX MARKET) By Dr.N.Moogana Goud
Professor and Director MBA Programme

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Foreign Exchange Market (FOREX MARKET)
WATER FALLS

US DOLLORS

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Foreign Exchange Market
MEANING It is a mechanism for exchanging one currency for another. A means to reduce the exposure to the risks of fluctuating exchange rates It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions

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Foreign Exchange Market- Cntd

The foreign exchange market is unique because of: its trading volume, the extreme liquidity of the market, the large number of, and variety of, traders in the market, its geographical dispersion, its long trading hours - 24 hours a day (except on weekends). the variety of factors that affect exchange rates,

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Foreign Exchange Market- Cntd 
Characteristics of the Market

The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years. New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore). The integration of financial centers implies that there can be no significant arbitrage. 

The process of buying a currency cheap and selling it dear.

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Foreign Exchange Market- Cntd

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Foreign Exchange Market- Cntd

Geographical Extent of the Foreign Exchange Market Global currency trading is a 24-hour-a-day process. Many large international banks operate trading rooms in major trading center on a round-the-clock basis. Some currency trading is conducted on an official trading floor by open bidding but most of it is done through dealers.

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Foreign Exchange Market- Cntd

Functions of the Foreign Exchange Market Transfer of Purchasing Power Financing of Inventory in Transit Hedging Facilities Currency Conversions Reducing Foreign Exchange Risks: the risk exist that the exchange values of National Currency may fluctuate i.e. Transaction Exposure.

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Foreign Exchange Market- Cntd

Nature of Foreign Exchange Market: It is the net work of Banks, Brokers, and FE dealers. Important exchange markets in London, New York, Zurich, Frankfurt, Tokyo, Singapore, Hong Kong and Paris FEM is governed by an unwritten code of conduct of all participants. FEM are large commercial banks that operate at two levels ± retail and interbank.

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Foreign Exchange Market- Cntd

Market Participants (Actors) There are five main categories of market participants in the foreign exchange market:  Bank and Nonbank Foreign Exchange Dealers  Individuals and Firms Conducting Commercial and 
Investment Transactions  Speculators and Arbitrageurs  Central Banks and Treasuries  Foreign Exchange Brokers.

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Foreign Exchange Market- Cntd 

Terminology  Terminology

In the markets, currency names are shortened to 3 3 letters to In the markets, currency names are shortened to letters to meet the needs ofof screen-based tables. These were meet the needs screen-based tables. These were developed by the International Organisation for developed by the International Organisation for Standardisation and are called ISO codes oror SWIFT Standardisation and are called ISO codes SWIFT codes. We use these conventions throughout. codes. We use these conventions throughout.

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Terminology

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Foreign Currency Futures and Options
Future Contracts:  FC is traded for only a limited number of currencies and for a given delivery date. Amount of transaction and maturity date is fixed by FE markets. Foreign Currency Options:  A currency option is the right but not the obligation to Buy (Call) or Sell (Put).

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Foreign Currency Futures and Options Calls and Puts The two types of equity options are Calls and Puts.  Call Option: A call option gives its holder the right to buy shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to sell the shares.  Put option: The opposite of a call option is a put option, which gives its holder the right to sell the shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to buy the shares.

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Foreign Currency Futures and Options

Holder (Buyer)

Writer (Seller)

Call Option Put Option

Right to Buy Right to sell

Obligation to sell Obligation to buy

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Languages of FE
Spot Market: Currencies are traded for immediate delivery. Delivery is on the second following business day (value date). E.g. Travelers going abroad Forward Market: It is market for exchange of currencies in the future, at a specified date in the future, typically 30, 60, or 90 days from now, and at a price (forward exchange rate) that is agreed upon today. Delivery is at a future value date. E, g. International business transactions.  Forward Markets exist only for the major currencies  Both forward rates and spot rates are published in News papers.

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Languages of FE Arbitrage: Simultaneous purchase and sale of a given amount of foreign exchange in two different markets for profits from unwarranted differences in prices. Both purchase and sale are conducted with the same counterparty. ³Spot against forward´, ³forward-forward swaps´, ³no deliverable forwards (NDFs)´. Price discrepancies in different Markets create arbitrage opportunities.

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Languages of FE Foreign Exchange Swaps
Spot sales of a currency combined with a forward repurchase of the currency.  They make up a significant proportion of all foreign exchange trading. 

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EXCHANGE RATE DETERMINATION 
Equilibrium of Exchange Rate= DD for FE & SS of FE  According Rogner Nurkse ³that rate which over a

certain period of time keeps the balance of payments in equilibrium´ Equilibrium Exchange Rates can be determined by two Methods
1. DD for and SS of Dollars 2. DD for and SS of Indian Rupees ( if trade between two

countries)

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EXCHANGE RATE DETERMINATION - Contd

DD for FE arises because:  Import of goods and services  FDI in other countries  Payment by one Govt to other for settlement of transactions.  other outflows SS of FE arises because:  Country exports goods and services to other countries  inflow of foreign capital  payment made by other countries  other types of inflows

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EXCHANGE RATE DETERMINATION - Contd

TYPES OF EXCHANGE RATES 1. FIXED EXCHANGE RATE:  It is also called as pegged exchange rate  IMF member countries follow this procedure  Government use to fix the exchange rates. Advantages of Fixed Exchange Rate  Ensure certainty and confidence.  Promotes long term investments  It helps for economic stabilization

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EXCHANGE RATE DETERMINATION - Contd

Disadvantages Fixed Exchange Rate  It needs large foreign exchange reserves  It leads to large scale speculations  Long run capital may not be altered

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EXCHANGE RATE DETERMINATION - Contd

]FREE FLOATING (Flexible Exchange Rates)  Value of the currency is determined solely by market demand for and supply of the currency in the foreign exchange market.  Trade flows and capital flows are the main factors affecting the exchange rate 
In the long run it is the macro economic performance of

the economy (including trends in competitiveness) that drives the value of the currency

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EXCHANGE RATE DETERMINATION - Contd 

No pre-determined official target for the exchange rate is

set by the Government. The government and/or monetary authorities can set interest rates for domestic economic purposes rather than to achieve a given exchange rate target  It is rare for pure free floating exchange rates to exist most governments at one time or another seek to "manage" the value of their currency through changes in interest rates and other controls

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EXCHANGE RATE DETERMINATION - Contd

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EXCHANGE RATE DETERMINATION - Contd

Advantages of Flexible Exchange Rates: ‡Simple to operate ‡Adjustment is a common process ‡Helps to promote foreign trade ‡There exist a free trade Disadvantages of Flexible Exchange Rates ‡Market mechanism may fail to bring appropriate FER ‡It is difficult to define FE Rate ‡It breeds uncertainty and impede international trade.

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Should Exchange Rates be Fixed or Flexible
Depends on the 1) The effects of the exchange rate system on monetary policy 2) The effects of the exchange rate system on trade and economic integration

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Theories of Foreign Exchange
Purchasing Power parity Theory (PPPT)  The theory developed by Cassel in 1921 and Officer in 1976  The theory suggests that ³at a given time, the rate of exchange between currencies is determined by their purchasing power´ If ³e´ is the exchange rate and PA and PB are the purchasing power of two countries currencies , A and B countries can be written as

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Theories of Foreign Exchange

E= PA/PB The exchange rate adjustment is a sequel to inflation. In case of inflation  Exports will fall  Import price becomes cheaper PPPT is useful in understanding the long term movements in spot rates; it has definite limitation over the short term.

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Theories of Foreign Exchange

This theory suggests that  A country with high rate of inflation should devaluate the currency to the currency of the country with lower inflation rate.  It is a real exchange rate (base ER) and the nominal exchange rates that has a bearing on the performance of the country. The theory holds good, only if,  Changes in economy because of monetary sector  Relative prices in different sector remains stable  There are no structural changes in the economy.

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Theories of Foreign Exchange

Criticism of PPP Theory: y No direct link between PP and rate of exchange. Exchange rate can be influenced by other factors such as a tariff, speculation and capital movement. y Difficulty in comparing price indices Prices of domestic goods and internationally traded goods differ. y Changes in the exchange rate as the cause- exchange rate can influence over price level which is ignored in this theory. y Other factors which influence the exchange rate are capital movement, interest rate, and government restriction.

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Theories of Foreign Exchange

Fisher theory of FE  Fisher uses the interest rate rather than inflation rate differentials to explain why exchange rates change overtime but it is closely related to the PPP theory because interest rates are often highly co-related with inflation rates.  According to fisher effect, nominal risk free interest rates contain a real rate of return and anticipated inflation

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Theories of Foreign Exchange 

If investors of all the countries require the same real

return, interest differentials between countries may be the result of differentials in expected inflation.  If the real interest rates are the same across the countries any difference in nominal interest rates could be attributed to the differences in expected inflation  IFE suggests that ³Foreign currency will relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation´

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Theories of Foreign Exchange 

The concept of real interest rate applies to all investments,

like domestic and foreign. An investor invests in a foreign country if the real interest rate differentials are likely to be his favour, but when such a differential exists, arbitrage begins in the form of international capital flow that ultimately equals the real interest rate across the countries.

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Foreign Exchange Market

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