1.

Introduction
During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash, derivatives and debt instruments put together in the country, and the sheer size of the foreign exchange market becomes evident. Since then, the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,foreign exchange constitutes the largest financial market by far. Liberalization has radically changed India‟s foreign exchange sector. Indeed the liberalization process itself was sparked by a severe Balance of Payments and foreign exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe import and foreign exchange controls and a thriving black market is being replaced with a less regulated, “market driven” arrangement. While the rupee is still far from being “fully floating” (many studies indicate that the effective pegging is no less marked after the reforms than before), the nature of intervention and range of independence tolerated have both undergone significant changes. With an overabundance of foreign exchange reserves, imports are no longer viewed with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in the foreign exchange markets not always to support the rupee but often to avoid an appreciation in its value. Full convertibility of the rupee is clearly visible in the horizon. The effects of these development s are palpable in the explosive growth in the foreign exchange market in India. Definition and characteristics of the foreign exchange market The foreign exchange market is the market in which national currencies are bought and sold against one another. This market is called the „foreign exchange‟ market and n ot the „foreign currency‟ market because the „commodity‟ that is traded on the market is more appropriately called „foreign exchange‟ than „foreign currency‟: the latter is only a small part of what is traded. Foreign exchange consists mainly of bank deposits denominated in various currencies. Still, the term „foreign currency‟ will be used interchangeably with the term „foreign exchange‟.
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The foreign exchange market is the largest and most perfect of all markets. It is the largest in terms of trading volume (turnover), which currently stands at over one trillion US dollars per day. It is the most perfect market because it possesses the requirements for market perfection: a large number of buyers and sellers; homogenous products; free flow of information; and the absence of barriers to entry. The foreign exchange market is made up of a vast number of participants (buyers and sellers). The products traded on the foreign exchange market are currencies: no matter where you buy your yens, euros, dollars or pounds they are always the same.There is no restriction on access to information, and insider trading is much less important than, for example, in the stock market. Finally, anyone can participate in the market to trade currencies. The importance of the foreign exchange market stems from its function of determining a crucial macroeconomic variable, the exchange rate, which affects to a considerable extent the performance of economies and businesses.This market is needed because every international economic transaction requires a foreign exchange transaction. Unfortunately, however, its function of exchange rate determination is not very well understood in the sense that economists are yet to come up with a theory of exchange rate determination that appears empirically valid. Unlike the stock market and the futures market, which are organised exchanges, the foreign exchange market is an over-thecounter (OTC) market, as participants rarely meet and actual currencies are rarely seen.There is no building called the „Sydney Foreign Exchange Market‟, but there are buildings called the „Sydney Stock Exchange‟ and the „Sydney Futures Exchange‟. It is an OTC market in the sense that it is not limited to a particular locality or a physical location where buyers and sellers meet. Rather, it is an international market that is open around the clock, where buyers and sellers contact each other via means of telecommunication.The buyers and sellers of currencies operate from approximately 12 major centres (the most important being London, New York and Tokyo) and many minor ones. Because major foreign exchange centres fall in different time zones, any point in time around the clock must fall within the business hours of at least one centre. The 24 hours of a day are almost covered by these centres, starting with the Far Eastern centres (Sydney, Tokyo and Hong Kong), passing through the Middle East (Bahrain), across Europe (Frankfurt and London), and then passing through the US centres, ending up with San Francisco.
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The Sodhani Committee set up in 1994 recommended greater freedom to participating banks. The growth of the foreign exchange market in the last few years has been nothing less than momentous. while swap transactions (essentially repurchase agreements with a one-way transaction – spot or forward – combined with a longer. Foreign Exchange Markets in India – a brief background The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade foreign exchange with one another. about half (48%) of the transactions were spot trades. The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day. In the last 5 years. though there is an unmistakable downward trend in that proportion. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. about 80% of the total transactions. allowing them to fix their own trading limits. from 2000-01 to 2005-06. Since 2001. clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI). (Part of this dominance. growing at a compounded annual rate exceeding 25%.horizon forward transaction in the reverse direction) accounted for 34% and forwards and forward cancellations made up 11% and 7% respectively. and a single inter-bank transaction leads to a purchase as well as a sales entry. About 3 . result s from doublecounting since purchase and sales are added separately. a self regulatory association of dealers.2. Figure 1 shows the growth of foreign exchange trading in India between 1999 and 2006.) This is in keeping with global patterns. The inter-bank forex trading volume has continued to account for the dominant share (over 77%) of total trading over this period. though. trading volume in the foreign exchange market (including swaps.5 billion US dollars a day. The liberalization process has significantly boosted the foreign exchange market in the country by allowing both banks and corporations greater flexibility in holding and trading foreign currencies. forwards and forward cancellations) has more than tripled. interest rates on FCNR deposits and the use of derivative products. In March 2006.

As a host of foreign exchange trading activity. In 2004. according to the triennial central bank survey of foreign exchange and derivative markets conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee featured in the 20th position among all currencies in terms of being on one side of all foreign transactions around the globe and its share had tripled since 1998. India ranked 23rd among all countries covered by the BIS survey in 2004 accounting for 0. Trading is relatively moderately concentrated in India with 11 banks accounting for over 75% of the trades covered by the BIS 2004 survey. 4 .two-thirds of all transactions had the rupee on one side.3% of the world turnover.

This would indicate arbitrage opportunities and market imperfections provided we could be sure of the comparability of the interest rates considered. exhibits long-lived swings on both sides of the zero line.5% for the 6-months period. The interest rate differential explains about 20% of the total variation in the forward discount. With these two figures in the same ballpark (particularly given that bank deposit rates and inter-bank rates are not strictly comparable). Chakrabarti (2006) reports that between late 1997 and mid-2004 the average discount on the rupee was about 4% per annum. Features of the Forward premium on the Indian rupee The Indian rupee has had an active forward market for some time now. the forward exchange rate is considered to be an unbiased predictor of the future spot rate. Therefore. 5 . however. The forward premium or discount on the rupee (vis-à-vis the US dollar. Under market efficiency. While the prediction errors of forward rates on the rupee appear to show some degree of persistence. while the behavior of the forward premium on the Indian rupee is broadly in lines with the CIP. During the period the average difference between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was about 4.3. for instance) reflects the market‟s beliefs about future changes in its value. The deviation of the Indian rupee-US dollar from the covered interest parity.5% for 3-months and 3. annual averages of interest rate differences and the forward exchange premium also indicate a moderate degree of co-movement between the two variables. insure the returns in the original currency by selling his anticipated proceeds in the forward market and make profits without risk through this process. The CIP is a no-arbitrage relationship that ensures that one cannot borrow in a country. any conclusion in this matter too must await more rigorous analysis. with random prediction errors. The strength of the relationship of this forward premium with the interest rate differential between India and the US – the Covered Interest Parity (CIP) condition – gives us a measure of India‟s integration with global markets. more careful empirical analysis involving directly comparable interest rates is necessary to measure the strength of the covered interest parity condition and the efficiency of the foreign exchange market. convert to and lend in another currency.

During the early years of liberalization.Intervention in Foreign Exchange Markets The two main functions of the foreign exchange market are to determine the price of the different currencies in terms of one another and to transfer currency risk from more riskaverse participants to those more willing to bear it. It is safe to say that over the years since liberalization. India had a de facto crawling peg to the US dollar between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995. Meanwhile the dollar appreciated against major currencies in the late 90‟s and then went into an extended decline particularly during 2003 and 2004. The lock-step pattern of the US dollar and the Rupee is best reflected in the movements in the two currencies against a third currency like the Euro. Based on volatility. to maintain the value of a currency at or near its “desired” level.94. India moved from a fixed exchange rate regime to “market determined” exchange rate system in 1993. foreign exchange markets frequently witness government intervention in one form or another. with a 6 . Officially speaking. has been to manage “volatility” in exchange rates without targeting any specific levels. As in any market essentially the demand and supply for a particular currency at any specific point in time determines its price (exchange rate) at that point. Interventions can range from quantitative restrictions on trade and cross border transfer of capital to periodic trades by the central bank of the country or its allies and agents so as to move the exchange rate in the desired direction. This has been hard to do in practice. The correlation of the exchange rates of the two currencies against the Euro during 1999-2004 was 0. Several studies have established the pegged nature of the rupee in recent years (see Chakrabarti (2006) for a more detailed discussion). since the value of a country‟s currency has significant bearing on its economy. India has allowed restricted capital mobility and followed a “managed float” type exchange rate policy. In recent years India has witnessed both kinds of intervention though liberalization has implied a long-term policy push to reduce and ultimately remove the former kind. The Indian rupee has had a remarkably stable relationship with the US dollar. The overt objective of India‟s exchange rate policy. However. the Rangarajan committee recommended that India‟s exchange rate be flexible. according to various policy pronouncements.

Clearly the Indian rupee has been an excellent “tracker” of the US dollar. particularly the SBI often aided or veiled the intervention process. the devaluation in the Indian Rupee.01 – tenth highest among the 53 countries considered. the two variables have had visible comovements with a correlation of about 0. the rupee reverted to a crawling peg arrangement in practice. in more extreme situations. From mid-1995 to end-2001. the US dollar-Euro exchange rate explained about 97% of all movements in the Indian rupee-Euro exchange rate – highest among all the 53 countries considered. In its dynamic form PPP holds that that the rate of depreciation of a currency should equal the excess of its inflation rate to that in the other country. indicates that India had a dollar beta of 1. the measures were mostly in the nature of crisis management of saving-the-rupee kind and sometimes the direct deals would be repeated over several days till the desired outcome was accomplished. Over a reasonably long period of time. It is instructive to consider the Rupee-Dollar exchange rate in the light of the purchasing power parity (PPP) holding that the exchange rate between two currencies should equal the ratio of price levels in two countries. forward and swap transactions (see Ghosh (2002)).57 (Chakabarti (2006)). Other public sector banks. vis-àvis the US dollar does seem to have an association with the difference in the inflation rates in the two countries. 7 . More importantly. Between 1991 and 2003. This may be a result of Indo-US trade flows dominating the exchange rate markets but it is perhaps more likely that it reflects the exchange rate management principles of the monetary authorities The Reserve Bank of India has used a varied mix of techniques in intervening in the foreign exchange market – indirect measures such as press statements (sometimes called “open mouth operations” in central bank speak) and.major devaluation in March 1993. A comparison of the sensitivity (beta) of the Dollar-rupee rate with the Euro-rupee rate for a three year period (1999 through 2001). monetary measures to affect the value of the rupee as well as direct purchase and sale in the foreign exchange market using spot. An analysis of the ratio of the variance of the exchange rate to the sum of the variances of the interest rate and the foreign exchange reserves reveals a move even closer to the fixed exchange rate system. Till around 2002.

defined the concept as “the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange” and laid down fiscal consolidation. India gave out most complete information on intervention strategy (along with three others). foreign direct and portfolio investments. India has been having close to a de facto peg to the dollar and simultaneously has been liberalizing its foreign currency flow regime. Close on the heels of the adoption of market determined exchange rate (within limits) in 1993 came current account convertibility in 1994. In 1997. The Tarapore Committee report had urged more transparency in the intervention process and recommended. and tapping foreign capital markets by Indian 8 . the Tarapore committee. something yet to be implemented. free flow of capital across its borders and autonomy in its monetary policy. in 1997. which essentially states that a country may have any two but not all of the following three things – a fixed exchange rate. Since liberalization. Regulation of cross-border currency flows A feature of the economy that is intricately related with the exchange rate regime followed is the freedom of cross-border capital flows.The exact details of the interventions are shrouded in mystery. the Bank for International Settlements (BIS (2005b)) found that out of 11 emerging market countries considered. not unusual for central banks ever wary of disclosing too much of their hand to the currency speculators. that a „Monitoring Exchange Rate Band‟ of ± 5% be used around an announced neutral real effective exchange rate (REER). On the whole it ranked fourth most opaque in matters of foreign exchange intervention among the eleven countries compared. Meanwhile capital flows have been gradually liberalized. allowing. a mandated inflation target and strengthening of the financial system as its three main preconditions. on Capital Account Convertibility. on the inflow side. no information on actual interventions (five others did the same) and did not cover foreign exchange intervention in annual reports (like two other countries). This relationship comes from the so-called “impossible trinity” or “trilemma” of international finance. In a recent survey on foreign exchange market intervention in emerging markets. with weekly publication of relevant figures.

and on the outflow side. the lack of convertibility that protected India from contamination during the Asian contagion in 1997-98. In 2000. fiscal discipline. Starting from a situation in 1990-91 with foreign exchange reserves level barely enough to cover two weeks of imports. During these two years the US dollar fell against the Euro by 19% and against the rupee by 9%. In any case. viz. the argument goes.companies as well as considerably better remittance privileges for individuals. for instance. in fact. Expectedly. It can also contribute to greater efficiency in the banking and financial systems. Advocates of convertibility cite the “consumption smoothing” benefits of global funds flow and point out that it actually improves macroeconomic discipline because of external monitoring by the global financial markets. though it is not expected to be accomplished before 2009. the wisdom of the move has been hotly debated . Convertibility can spur domestic investment and growth because of easier and cheaper financing. India‟s foreign exchange position rocketed to one of the largest in the world with over $155 billion in mid-2006. with a public sector deficit of 7. this implies a compounded annual growth rate of about 28% with the years 2003 and 2004 having the most stunning rises at 48% and 45% respectively. the latter figure is likely to have been larger and the reserves accumulation less spectacular. The ultimate goal of capital account convertibility now seems to be within the government‟s sights and efforts are on to chalk out the roadmap for the last leg. On the other hand. and about $32 billion at the beginning of 2000. international expansion of domestic companies. Since 2000. Without RBI intervention.6% of the GDP and the ratio of public debt to GDP of over 83% in 2005-06. The Dynamics of Swelling Reserves-An important corollary of India‟s foreign exchange policy has been the quick and significant accumulation of foreign currency reserves in the past few years. the benefits of convertibility do not necessarily outweigh the risks and cross-border shortterm bank loans – usually the last item to be liberalized – are the most volatile. the infamous Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign Exchange Management Act (FEMA) that gave participants in the foreign exchange market a much greater leeway. It is generally held that it was. 9 . skeptics like Williamson (2006). points out that India is yet to fulfill at least one of the three major preconditions to Capital Account Convertibility set out by the Tarapore committee.

directly or indirectly.4. These classes of participants enter the market as arbitragers. There are five broad categories of participants in the foreign exchange market: customers. Finally. Hedgers enter the market to cover open positions in an attempt to reduce or eliminate foreign exchange risk (an open position arises. when an exchange rate assumes two different values in two financial centres at the same time). Exporters sell the foreign currencies they obtain from foreigners buying their products. Arbitragers seek to make profit by exploiting exchange rate anomalies (for example. real estate. buy and sell currencies. by buying the foreign currency forward. whereas those coming from abroad (foreign tourists) buy the domestic currency to pay for their living expenses while they are on holiday. Immigrants buy foreign currencies when they transfer funds to relatives in their home countries. Market participants Market participants are foreign exchange traders who. inter alia. investors buy and sell currencies as part of their acquisition and disposal of assets (bonds. immigrants and investors. Speculators. This position can be covered. for example. on the other hand. when an importer has to meet a foreign currency payment. shares. importers. hedgers and speculators.). tourists. 10 . commercial banks. which means that they buy currencies at the exchange rates quoted by market makers.Thus. realising profit if the currency appreciates subsequently (and realising loss otherwise). Importers buy the foreign currencies they need to pay for the foreign goods they buy from foreign suppliers. etc. but for the time being we concentrate on the institutional classification of market participants. which is due some time in the future). for example. Customers include individuals and companies utilising the services of commercial banks to buy and sell foreign exchange in order to finance international trade and investment operations. Tourists going abroad buy foreign currencies. bear risk deliberately by taking decisions involving open positions to make profit if their expectations turn out to be correct. brokers and central banks. exporters. other financial institutions. We will come across and elaborate on these concepts throughout this book.A speculator would buy a currency if it were expected to appreciate. Customers are price takers in the foreign exchange market. customers include.

central banks often intervene in the foreign exchange market by buying and selling currencies. Finally. Commercial banks participate in the foreign exchange market mainly as speculators. or to contact them via an electronic dealing system. central banks participate in the foreign exchange market because they act as bankers for their governments and also because they run the exchange rate and monetary policies. These dealers may specialise in the trading of a particular currency. Brokers differ from dealers in that they do not take positions themselves. a group of currencies or a particular type of transaction (for example. Dealers representing commercial banks. Other financial institutions (such as investment banks and mutual funds) and large companies may deal directly by conducting foreign exchange operations themselves and not through banks. They also make profit on their dealings with customers from the differences between the buying and selling rates. which houses a group of dealers. other financial institutions and large companies do business with each other in two ways. trying to make short term profit by getting exposed to foreign exchange risk. servicing the interbank market around the clock. Major brokerage houses are global in nature. The function of a broker is to spread market information and to bring together buyers and sellers with matching needs. acting via their foreign exchange dealers.Large commercial banks are market makers in the sense that they stand ready to buy and sell currencies at the exchange rates they declare. dealing can be carried out indirectly via a broker. but on the wholesale side they deal in the interbank market or the wholesale market (that is.With the introduction of online trading systems. On the retail side commercial banks deal with customers. with the objective of „smoothing out‟ exchange rate movements or to prevent the domestic currency from appreciating or depreciating excessively. but obtain their „living‟ by charging commission fees. All of these functions require market participation. a new (direct) mode of trading has emerged. 11 . The direct way is to telephone other dealers directly. For example. Otherwise. thus preserving anonymity. spot transactions as opposed to forward transactions). They execute this function via the dealing desk or dealing room. with other banks). under a system of managed floating.

Nevertheless. normally the largest banks. Thus. Furthermore. like other traders would. and their trades often have little short term impact on market rates. the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses. Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. and/or interest rates and often have official or unofficial target rates for their currencies. who are willing to reciprocate quotes in a number of currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Central banks National central banks play an important role in the foreign exchange markets. not all banks are equally active in the interbank market. Nevertheless. (ii) other major interbank dealers. as well as the fact that banks accept an obligation of reciprocity in quoting to other interbank dealers. including banks that are active primarily in their domestic currencies and those unwilling to reciprocate quotes and often dealing in small amounts. However. the buying and selling of currencies among banks. and (iii) second-tier banks. participants in the interbank market are classified into: (i) market makers.The foreign exchange market is dominated by interbank operations. They try to control the money supply. trade flows are an important factor in the long-term direction of a currency's exchange rate. The liquidity of the interbank market is due to large-volume transactions. and there is no convincing evidence that they do make a profit trading. 12 . it is by no means true that the interbank market is completely homogenous. inflation.

they were solely speculating on the movement of that particular currency. if the economic fundamentals are in the hedge funds' favor. They control billions of dollars of equity and may borrow billions more. The combined resources of the market can easily overwhelm any central bank. The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency. the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. Central banks do not always achieve their objectives. rather.[66] Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse. Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. and thus may overwhelm intervention by central banks to support almost any currency. In other words. Banks. and in more recent times in Asia. but aggressive intervention might be used several times each year in countries with a dirty float currency regime.Foreign exchange fixing Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. which manage clients' currency exposures with the aim of generating 13 . Fixing exchange rates reflects the real value of equilibrium in the market. Hedge funds have gained a reputation for aggressive currency speculation since 1996. Some investment management firms also have more speculative specialist currency overlay operations. For example. dealers and traders use fixing rates as a trend indicator.

while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association have in the past been subjected to periodic Foreign exchange fraud. in 2010 the NFA required its members that deal in the Forex markets to register as such (I. Non-bank foreign exchange companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies.e. they participate indirectly through brokers or banks. Currently. typically act as principal in the transaction versus the retail customer. 14 . can generate large trades.[67][68] To deal with the issue.e.profits as well as limiting risk. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers... and quote a price they are willing to deal at. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i. While the number of this type of specialist firms is quite small. many have a large value of assets under management and. Forex CTA instead of a CTA). are subject to greater minimum net capital requirements if they deal in Forex. Dealers or market makers. by contrast. They charge a commission or mark-up in addition to the price obtained in the market. Brokers serve as an agent of the customer in the broader FX market. Retail foreign exchange traders Individual retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange platforms. Those NFA members that would traditionally be subject to minimum net capital requirements. both in size and importance. there is usually a physical delivery of currency to a bank account). Retail brokers. FCMs and IBs. A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for differences and financial spread betting. by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. hence.

for the first time. The spot exchange rate The function of a market is the determination of the price of the commodity in which it is traded. we will just call them currencies. The first is the introduction of the euro and the abolition of the national currencies in 12 European countries. The second reason is consolidation in the banking industry via mergers and acquisitions. including spot and forward transactions.5. currencies and bank deposits denominated in various currencies. In this survey. banks and financial institutions are asked about their foreign exchange activity. Figure 2. which includes spot and forward transactions only. The global total is measured by adding up turnover in individual financial markets. which is conducted every three years in April. The commodity that is traded on the foreign exchange market is „foreign exchange‟. The size and composition of the foreign exchange market The size of the (global) foreign exchange market is measured by the sum of daily turnover in foreign exchange centres around the world. The 19. Although the trading of the euro has been more than that of the former German mark. as compared with the previous survey. the survey has been re-designed to cover OTC derivatives activity. The exposition here is restricted to the so-called „traditional foreign exchange market‟. For simplicity. it has also been less than the combined trading of the national currencies. including currency and interest rate derivatives (such as currency options). As we can see from Figure 2. Since 1995.5 per cent decline to USD1200 is attributed to at lease two factors. This is normally done through a survey that is coordinated by the Bank for International Settlements (BIS) and conducted in each financial centre by the domestic central bank (for example. the Sydney survey is conducted by the Reserve Bank of Australia). 15 .1 shows the volume of daily turnover in the global foreign exchange market as measured through the BIS surveys since 1989.1. forward transactions (consisting of outright operations and swap operations) comprise the bulk of transactions in the foreign exchange market. In 2001 daily turnover declined.

because two currencies are involved in the transaction. but. each bank will in two business days credit the other‟s account with the prescribed currency and amount agreed upon. This is still regarded as an immediate delivery.When a transaction between two bank dealers is concluded today.The second date. 2. meaning at once. and so the underlying exchange rate is a spot exchange rate.5 When the exchange of currencies takes place immediately. typically (but not necessarily) the domestic and a foreign currency. the done date or the trade date) is the date on which the transaction is concluded at the exchange rate prevailing on the same date. no matter what happens. The forward exchange rate 16 . the dealing date.The exchange rate prevailing in the market may actually change between the two dates. The word „immediate‟ means different things. This is also called a cash transaction. then the underlying operation is a forward transaction. is called the delivery date or value date. the exchange of currencies does not take place at once. but rather in two business days (where a business day is a day on which banks and other foreign exchange market participants are open for business). If the delivery takes place some time in the future. When you use the services of a moneychanger at Melbourne Airport to exchange some Australian dollars for Hong Kong dollars because you are about to board a plane to Hong Kong. on the other hand.The price of one currency in terms of another is called a bilateral exchange rate. In an interbank transaction. you obtain the Hong Kong dollars that you have bought immediately. the exchange of the currencies takes place at the exchange rate agreed upon when the transaction is concluded. the underlying operation is called a spot transaction. Confusion may arise because the exchange rate is the price of one kind of money in terms of another kind of money. and so we define the spot exchange rate as the rate applicable to transactions involving immediate exchange of the currencies. Two dates are involved in such a transaction. which falls two business days later.The first (called the contract date.A foreign exchange market participant would normally want to buy one currency and sell another.

The specific date is then fixed according to one of two conventions: (i) the modified following business day convention. and (ii) the end/end rule.The end/end rule is that if the value date is the last business day of the current calendar month. If that falls in the next calendar month. forward contracts extend up to one year. in maturities of one month.Typically. but if that falls on a non-business day. the forward value date of a sale of one week forward agreed on 16 June would be one week from the spot value date of 18 June.The forward exchange rate is a rate contracted today for the delivery of a currency at a specified date in the future. which would be 25 June. The interval until a forward value date is calculated from the spot value date. two months. which is a whole number of weeks or months after the spot value date (for example. thus providing protection against adverse exchange rate movements. otherwise the underlying transaction will be a spot transaction. forward contracts of maturities longer than one year can also be found. However. not from the transaction date. one month). A special kind of forward contract is called a break forward contract. It may also be called forward with optional exit. but by agreeing on a term. not by agreeing on a specific date.This date in the future (called the forward value date) must be more than two business days away. the date is moved to the following day. it would be moved to the last business day of the current calendar month. If the delivery takes place one week after the transaction has been concluded. The modified following business day convention works as follows: the maturity date is set to be the value date. For example. maturity will be the last business day of the final calendar month. abbreviated as FOX. then the underlying rate is a one-week forward rate. 17 . and so on. This contract can be terminated at a predetermined date. The forward value date is usually fixed.

a few days. involves cash rather than a contract. and interest is not included in the agreed-upon transaction. Turkish Lira. Forward One way to deal with the foreign exchange risk is to engage in a forward transaction. months or years. In a swap. Canadian Dollar. The average contract length is roughly 3 months. This trade represents a “direct exchange” between two currencies. A deposit is often required in order to hold the position open until the transaction is completed. money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future. Swap The most common type of forward transaction is the foreign exchange swap. a forex broker will charge a small fee to the client to roll-over the expiring transaction into a new identical transaction for a continuum of the trade. In this transaction. as opposed to the futures contracts. Future Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. 18 . Futures contracts are usually inclusive of any interest amounts. The duration of the trade can be one day. regardless of what the market rates are then. Spot trading is one of the most common types of Forex Trading. and the transaction occurs on that date. Often. has the shortest time frame. Euro and Russian Ruble.6. These are not standardized contracts and are not traded through an exchange. which settle the next business day). two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. This roll-over fee is known as the "Swap" fee. Usually the date is decided by both parties. which are usually three months. Then the forward contract is negotiated and agreed upon by both parties. Financial instruments Spot A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar.

In addition they are traded by speculators who hope to capitalize on their expectations of exchange rate movements.[81] Also to be considered is the rise in foreign exchange autotrading. currency speculation does not. The options market is the deepest. largest and most liquid market for options of any kind in the world. according to this view. Speculation Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly.Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. but differ from forward contracts in the way they are traded. to those who do. trading has increased from 2% in 2004 up to 45% in 2010. or automated. [79] Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics. Large hedge funds and other well capitalized "position traders" are the main professional speculators.[where?] While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital. it is simply gambling that often interferes with economic policy. 19 . Option A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. algorithmic. economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it. Thus the currency futures contracts are similar to forward contracts in terms of their obligation. [82] Currency speculation is considered a highly suspect activity in many countries. They are commonly used by MNCs to hedge their currency positions. According to some economists. individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors. Nevertheless.

Some USD/GBP transactions were executed by using the trans-Atlantic cable laid in 1858 between London and New York (hence the pound‟s nickname. is initially conducted via the telephone or other means of telecommunication. • Settlement: this involves completing the transaction by making payments in one currency and receiving payments in another. Physical delivery in foreign exchange persisted until quite recently: cheques and mail transfers were used until the 1970s.A decision may be taken to close the position subsequently. Execution. In continental European centres some form of physical location continued to exist until the 1980s. The following are the main technological devices used in conducting foreign exchange business: • The first means of telecommunication used in the foreign exchange market was the telegraph. 20 . which is the transaction itself. • Decision making: the dealer seeks information to support the decision to execute the transaction. Foreign exchange market technology applies to all of these processes.7. Cable). The following is a brief outline of the historical development of foreign exchange technology. This requires an assessment of the liquidity of the market and the expectation held by others about future changes in the exchange rate. as commercial banks met daily with the central bank to fix the rate at which to settle customer orders. Post-transaction processes were also settled manually with a physical delivery of bills. the foreign exchange market had physical locations. Prior to World War I. calculating profit and loss. The mechanics and technology of foreign exchange trading A foreign exchange transaction consists of the following sequential processes: • Price discovery: the dealer judges the exchange rate at which the transaction can be executed. where pre-transaction processes and execution were carried out manually.This function is performed by the so-called back office rather than by the dealers to allow an independent check on their activities. • Position keeping: the dealer monitors the resulting position.

In 1997 an Internet-based foreign exchange dealing service (aimed mainly at wealthy individuals) was established in the United Kingdom by the Currency Management Corporation. • The next stage in the development of screen-based systems involved the automation of the execution process. For more details.The first was the Reuters‟ Monitor. 21 . This was followed by other vendors such as Telerate. which was introduced in 1973. which are networks that connect terminals. such as Currenex (April 2000). It largely supplanted the telegraph after World War II.• Although telephone deals may be traced back to 1926. • Then there was the telex. Automatic order matching systems are networks of terminals where dealers enter orders in the form of a buying and/or selling price for a given amount of currency. it was not until the late 1970s that reliable international networks were installed in banks‟ dealing rooms. A dealer with a terminal can use it to call another dealer with a terminal on the same network. see the box below. which materialised in 1992 when Reuters introduced its automatic matching system. • By the second half of the 1980s the major part of communication in the foreign exchange market had shifted to screen-based automated dealing systems (also known as conversational dealing systems). Fxall (May 2001) and Atriax (August 2000). • In decision making and settlement the successor to the telex was the fax. including the emergence of Internet-based multidealer foreign exchange services. which is a telephone line with an automatic typewriter. • A breakthrough for price discovery and decision making was the screen-based information system carrying news and prices from other banks. By 1984. there were some 40 electronic information services in London. • The Internet is another development. Open access to the Internet removes the need to build dedicated connections to counterparties or customers. • More recent developments pertain to online foreign exchange trading. The network selects and displays the best buying and selling orders for each currency pair.

That means that. except for the natural bid/ask market spread between the supply and the demand price. that in conjunction with highly variable currency quotations. Margin: the credit “leverage” (margin) in the FOREX market is only determined by an agreement between a customer and the bank or the brokerage house that pushes it to the market and is normally equal to 1:100. Flexible regulation of the trade arrangement system: a position may be opened for a pre-determined period of time in the FOREX market.8.000 pledge. Market trend: currency moves in a quite specific direction that can be tracked for rather a long period of time. upon making a $1.000. Features of foreign exchange market:- Liquidity: the market operates the enormous money supply and gives absolute freedom within opening or closing a position in the current market quotation. It is such extensive credit “leverage”. at the investor‟s discretion. One-valued quotations: with high market liquidity. which presents investment managers with the opportunities to manipulate the FOREX market. which enables to plan the timing of one‟s future activity in advance. most sales may be carried out at the uniform market price. Promptness: with a 24-hour work schedule. because it gives him or her the freedom to open or to close a position of any size whatever. a market participant need not wait to respond to any given event. High liquidity is a powerful magnet for any investor. Value: the Forex market has traditionally incurred no service charges. as is the case in many markets. making this market highly profitable and also highly risky. thus enabling you to avoid the instability problem existing with futures and other forex investments where limited quantities of currency only can be sold concurrently and at a specified price. Availability: a possibility to trade round-the-clock. participants in the FOREX market need not wait to respond to any given event. Each particular currency demonstrates its own typical temporary changes. a customer can enter into transactions for an amount equivalent to $100. 22 .

including an analysis of the forex trader's risk exposure. risk tolerance and preference of strategy. Because spot contracts have a very short-term delivery date (two days). These components make up the forex hedge: 23 . however are one of the most popular methods of currency hedging. to buy or sell the currency pair at a particular exchange rate at some time in the future. He take advantage of price or exchange rate differences in the two markets. to limit the loss potential of a given trade. can protect themselves from downside risk.9. Arbitrage:Arbitrage refers to the activities of a dealer in foreign exchange. see A Beginner's Guide To Hedging. while the trader that is short a foreign currency pair.) Forex hedging strategy A forex hedging strategy is developed in four parts. such as long straddles. (For more. Foreign currency options. and Foreign currency options. Regular options strategies can be employed. a trader that is long a foreign currency pair. but not the obligation. It refers to the avoidance of foreign exchange risk. Hedging:Hedging is an important features of the foreign exchange market. Regular spot contracts are usually the reason that a hedge is needed. the foreign currency option gives the purchaser the right. As with options on other types of securities. The primary methods of hedging currency trades for the retail forex trader is through:   Spot contracts. When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates. 2. long strangles and bull or bear spreads. When importers and exporters enter into an agreement normally with a commercial bank dealing in foreign exchange to buy and sell goods at some future specified date at the pre-determined exchange rate if is called hedging. rather than used as the hedge itself. By utilizing a forex hedge properly. Spot contracts are essentially the regular type of trade that is made by a retail forex trader. For example: 1 $ = Rs 44 in US and in India it is 1 $ =Rs 45. In the process the dealer in foreign exchange market makes profits. He bye a currency at one place and sells it at another place simultaneously. they can be said to have entered into a forex hedge. can protect against upside risk.Nature of Transaction of foreign exchange market:1. they are not the most effective currency hedging vehicle. As a result the market for a given currency remain unified in different money markets in the world.

From there. Determine forex hedging strategy: If using foreign currency options to hedge the risk of the currency trade. ostensibly to stabilize foreign exchange. So much of being a trader is money and risk management. the trader must identify what the implications could be of taking on this risk un-hedged.S. 3.1. Determine risk tolerance: In this step. On 3 December 2009 U. A number of proposals have been made in the past to try and limit speculation that were never enacted. risk will stay minimized. and hedging is just one way that a trader can help to minimize the amount of risk they take on. 24   . The forex currency trading market is a risky one. which would specifically target speculators by taxing financial market securities transactions. it is up to the trader to determine the level of risk they are willing to take. In May 2008 German leaders planned to propose a worldwide ban on oil trading by speculators. Be sure to research fully the broker you use before beginning to trade. to determine how much of the position's risk needs to be hedged. and how much they are willing to pay to remove the excess risks. these have included:  The Tobin tax is a tax intended to reduce short-term currency speculation. Speculation:Speculation is the opposite of hedging. that having another tool like hedging in the arsenal is incredibly useful. the trader must determine which strategy is the most cost effective. proposed the introduction of a financial transaction tax. the trader uses their own risk tolerance levels. 4. While a hedger seeks to cover the foreign exchange risk a speculator accepts and even seeks out a foreign exchange risk or an open position in the hope of the making a profit. and determine whether the risk is high or low in the current forex currency market. who blamed "reckless speculation" for the 2008 financial crisis. Not all retail forex brokers allow for hedging within their platforms. Analyze risk: The trader must identify what types of risk (s)he is taking in the current or proposed position. If the speculator correctly anticipates the future changes in spot rate he stands to gain or else he would incur losses. 3. blaming the 2008 oil price rises on manipulation by hedge funds. 2. Congressman Peter DeFazio. Implement and monitor the strategy: By making sure that the strategy works the way it should. No trade will ever have zero risk.

so this behind-the-scenes market is sometimes called the “interbank market”. in India too. and the sheer size of the foreign exchange market becomes evident. As in the rest of the world. derivatives and debt instruments put together in the country.foreign exchange constitutes the largest financial market by far. The main participants in this market are the larger international banks.10. Most foreign exchange dealers are banks. The foreign exchange market works through financial institutions. Since then. Trades between foreign exchange dealers can be very large. Behind the scenes banks turn to a smaller number of financial firms known as “dealers. The foreign exchange market (forex. involving hundreds of millions of dollars. and it operates on several levels.” who are actively involved in large quantities of foreign exchange trading. or currency market) is a global decentralized market for the trading of currencies. although a few insurance companies and other kinds of financial firms are involved. 25 . Forex has little (if any) supervisory entity regulating its actions. Electronic Broking Services (EBS) and Reuters 3000 Xtra are two main interbank FX trading platforms. FX. over ten times the daily turnover of the Bombay Stock Exchange. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock. the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD in 2005-2006. The foreign exchange market determines the relative values of different currencies. with the exception of weekends. Conclusion During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash. Because of the sovereignty issue when involving two currencies.