CHAPTER 12

INTERNATIONAL
TIME VALUE OF MONEY

BANKING
MODULE-A

BANK FINANCIAL MANAGEMENT- CAIIB

EXCHANGE RATE &

FOREX BUSINESS
 CHAPTER 01 EXCHANGE RATE & FOREX BUSINESS

CONTENTS
1. INTRODUCTION
2. FOREIGN EXCHANGE
3. FOREX EXCHANGE MARKET
4. SIZE OF MARKET
5. VARIOUS PARTICIPANTS’ ROLE IN FOREX MARKET
6. TOD, TOM, SPOT, FORWARD, SWAP
7. FACTORS DETERMINING FOREX EXCHANGE RATE
8. FORWARD MARGIN/SWAP POINTS – PREMIUM & DISCOUNTS
9. TWO WAY QUOTATIONS
10. DIRECT QUOTATION & INDIRECT QUOTATION
11. FIXED Vs. FLOATING RATES
12. FOREIGN EXCHANGE DEALING ROOM OPERATIONS
13. MANAGEMENT AND CONTROL OF A DEALING ROOM

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 CHAPTER 01 EXCHANGE RATE & FOREX BUSINESS

The foreign exchange market (Forex, FX, or

currency market) is a global decentralized or over-
the-counter (OTC) market for the trading of
currencies. This market determines the foreign
exchange rate. It includes all aspects of buying,
selling and exchanging currencies at current or
determined prices. In terms of trading volume, it
is by far the largest market in the world, followed
by the Credit market. The main participants in this
market are the larger international banks.
Financial centers around the world function as
anchors of trading between a wide range of
multiple types of buyers and sellers around the
clock, with the exception of weekends. Since
currencies are always traded in pairs, the foreign
exchange market does not set a currency's
EXCHANGE
RATE & FOREX
absolute value but rather determines its relative
value by setting the market price of one currency
if paid for with another. Ex: 1 USD is worth X CAD,
or CHF, or JPY, etc. The foreign exchange market

BUSINESS
works through financial institutions, and operates
on several levels. Behind the scenes, banks turn to
a smaller number of financial firms known as
3 "dealers", who are involved in large quantities of
foreign exchange trading.
 CHAPTER 01 EXCHANGE RATE & FOREX BUSINESS

FOREIGN EXCHANGE
Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free
economy, a country's currency is valued according to factors of supply and demand. In other words, a
currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a
basket of currencies. A country's currency value also may be fixed by the country's government.
However, most countries float their currencies freely against those of other countries, which keeps them
in constant fluctuation.
The value of any particular currency is determined by market forces based on trade, investment, tourism,
and geo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods and
services using the currency of the host country. Therefore, a tourist must exchange the currency of his or
her home country for the local currency. Currency exchange of this kind is one of the demand factors for
a particular currency. Another important factor of demand occurs when a foreign company seeks to do
business with a company in a specific country. Usually, the foreign company will have to pay the local
company in their local currency. At other times, it may be desirable for an investor from one country to
invest in another, and that investment would have to be made in the local currency as well. All of these
requirements produce a need for foreign exchange and are the reasons why foreign exchange markets
are so large.

FOREIGN EXCHANGE MARKETS

Foreign exchange market is described as an OTC (Over the counter) market as there is no physical place
where the participants meet to execute their deals. It is more an informal arrangement among the banks
and brokers operating in a financing centre purchasing and selling currencies, connected to each other by
tele-communications like telex, telephone and a satellite communication network, SWIFT. The term
4
foreign exchange market is used to refer to the wholesale a segment of the market, where the dealings
take place among the banks. The re tail segment refers to the dealings take place between banks and
 CHAPTER 01 EXCHANGE RATE & FOREX BUSINESS

their customers. The retail segment refers to the dealings take place between banks and their customers.
The retail segment is situated at a large number of places. They can be considered not as foreign
exchange markets, but as the counters of such markets.
The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi is other centres
accounting for bulk of the exchange dealings in India. The policy of Reserve Bank has been to
decentralize exchanges operations and develop broader based exchange markets. As a result of the
efforts of Reserve Bank Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of foreign
exchange market.

SIZE OF THE MARKET

Foreign exchange market is the largest financial market with a daily turnover of over USD 2 trillion.
Foreign exchange markets were primarily developed to facilitate settlement of debts arising out of
international trade. But these markets have developed on their own so much so that a turnover of about
3 days in the foreign exchange market is equivalent to the magnitude of world trade in goods and
services. The largest foreign exchange market is London followed by New York, Tokyo, Zurich and
Frankfurt.

The business in foreign exchange markets in India has shown a steady increase as a consequence of
increase in the volume of foreign trade of the country, improvement in the communications systems and
greater access to the international exchange markets. Still the volume of transactions in these markets
amounting to about USD 2 billion per day does not compete favourably with any well-developed foreign
exchange market of international repute. The reasons are not far to seek. Rupee is not an internationally
traded currency and is not in great demand. Much of the external trade of the country is designated in
leading currencies of the world, Viz., US dollar, pound sterling, Euro, Japanese yen and Swiss franc.
5 Incidentally, these are the currencies that are traded actively in the foreign exchange market in
India
 CHAPTER 01 EXCHANGE RATE & FOREX BUSINESS

VARIOUS PARTICIPANTS’ ROLE IN FOREX MARKET

Consumers and Travelers

Consumers may purchase goods in a foreign country or via the internet with their credit card. The
amount consumers pay in the foreign currency will be converted to their home currency on their credit
card statement. Travellers must go to a bank or currency exchange bureau to convert one currency
(their "home" currency) into another (the "destination" currency) when using cash to pay for goods and
services in a foreign country. Travellers need to be aware of exchange rates to ensure they receive a fair
deal.

Business
Businesses often need to convert currencies when they conduct trade outside their home country. Large
companies need to convert huge amounts of currency; a multinational company such as General
Electric (GE) for instance, converts tens of billions of dollars each year.

Investors and Speculators

Investors and speculators require currency exchange whenever they deal in any foreign investment, be
it equities, bonds, bank deposits, or real estate. Investors and speculators also trade currencies in an
attempt to benefit from movements in the currency exchange markets.

Commercial and Investment Banks

Commercial and investment banks trade currencies as a service to their commercial banking, deposit,
and lending customers. These institutions also participate in the currency market for hedging and
speculative purposes.
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 CHAPTER 01 EXCHANGE RATE & FOREX BUSINESS

Governments and Central Banks

Governments and central banks trade currencies to improve economic conditions or to intervene in an
attempt to adjust economic or financial imbalances, because they are non-profit, governments and
central banks do not trade with the intention of earning a profit, but because they tend to trade on a long-
term basis, it is not unusual for some trades to earn revenue.

FACTORS DETERMINING FOREX EXCHANGE RATE

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