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• Foreign exchange markets are made up of banks, commercial companies, central banks,
investment management firms, hedge funds, and retail forex brokers and investors.
• FX is the largest financial market in the world.
• The foreign exchange market in India started operating in 1978 and grown significantly over the years.
The market is regulated by the Reserve Bank of India on behalf of central government, under
Foreign Exchange Management Act, 1999.
• In FOREX, currencies are always traded in pairs, so the "value" of one of the currencies in that pair is
relative to the value of the other. This determines how much of country A's currency country B can buy,
and vice versa.
• Establishing this relationship (price) for the global markets is the main function of the foreign
exchange market. This also greatly enhances liquidity in all other financial markets, which is key to
overall stability.
• The value of a country's currency depends on whether it is a "free float" or "fixed float".
• Free floating currencies are those whose relative value is determined by free market forces, such as
supply / demand relationships.
• A fixed float is where a country's governing body sets its currency's relative value to other currencies,
often by pegging it to some standard.
• Free floating currencies include the U.S. Dollar, Japanese Yen and British Pound, while examples of fixed
floating currencies include the Chinese Yuan and the Indian Rupee.
• One of the most unique features of the forex market is that it is comprised of a global network of financial
centers that transact 24 hours a day, closing only on the weekends. As one major forex hub closes,
another hub in a different part of the world remains open for business. This increases the liquidity
available in currency markets, which adds to its appeal as the largest asset class available to investors.
Forex Leverage
• The leverage available in FX markets is one of the highest that traders and investors can find anywhere.
Leverage is a loan given to an investor by their broker. With this loan, investors are able to increase
their trade size, which could translate to greater profitability. A word of caution, though: losses are also
amplified.
4. Traders and Speculators: The traders and speculators are the opportunity seekers and look forward
to making a profit through trading on short-term market trends.Brokers: They are considered to be
financial experts who act as an intermediary between the dealers and the investors by providing the
best quotations.
• Market Transparency: It is effortless to monitor the fluctuations in the value of currencies of different
countries in a forex market easily through account tracking and real-time portfolio, without the
involvement of brokers.
• Dollar is Extensively Traded Currency: The USD, which is paired with almost every country’s
currency and listed on the forex, is the most widely traded currency in the world.
• Most Dynamic Market: The value of the currencies in the forex market keeps on changing every second
and function twenty-four hours a day. This makes it one of the most active markets in the world.
• International Network of Dealers: The foreign exchange market establishes a medium among the
dealers and also with the customers. There are dealer’s institutions located globally to carry out the
exchange and trading activities.
• “Over-The-Counter” Market: In different countries, the forex market is the highly unregulated market
initiating over the counter trade by the banks through telex and telephone.
• Twenty-Four Hour Market: The foreign exchange market is operational for twenty-four hours of the
day, initiating the active trade and exchange of currencies at any time.
Hedging Function: The globally trading business entities can hedge the risk of currency fluctuations by
adopting means like a letter of credit or forward contract. Here, the goods are to be delivered on a pre-
determined future date and at a mutually agreed price.
Transfer Function: The forex market majorly functions to exchange the currency of one country into that
of other, to facilitate international trade activities.
Credit Function: Providing the credit facility at the time of making overseas payments through foreign
bill of exchange to its maturity or execution, is another significant function of the forex market.
Advantages of Foreign Exchange Market
As we know that ‘trade makes everyone better-off’ and so goes for the exchange or trade of currencies.
Let us now discuss the various benefits of the foreign exchange market:
Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation
rate than another's will see an appreciation in the value of its currency. The prices of goods and services
increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate
exhibits a rising currency value while a country with higher inflation typically sees depreciation in its
currency and is usually accompanied by higher interest rates.
Government Debt
Government debt is public debt or national debt owned by the central government. A country with more
government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their
bonds in the open market if the market predicts government debt within a certain country. As a result, a
decrease in the value of its exchange rate will follow.
Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to
import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports
prices. This results in higher revenue, which causes a higher demand for the country's currency and an
increase in its currency's value. This results in an appreciation of exchange rate.
Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire
foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering
the exchange rate.
Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to
make a profit in the near future. As a result, the value of the currency will rise due to the increase in
demand. With this increase in currency value comes a rise in the exchange rate as well.
Economic Planning
• Exchange control is an important part of economic policy in any planned economy. Planning involves a
very careful use of foreign exchange resources of the country so that only those goods are imported
which are essential for the implementation of the plans.
• Exchange controls are resorted to regular the exports and imports in the light of plans.
Exchange Quotations
• We have seen that exchange rates can be quoted in either of the two ways;
1. Direct quotation
• The quotation in which exchange rate is expressed as the price per unit of foreign currency in terms of
the home currency is k known as Home currency quotation or Direct quotation. It may be noted
that under direct quotation the number of units of foreign currency is kept constant and any change in
the exchange rate will be made by changing the value in term of rupees. For instance, US dollar quoted
at INR 70 may be quoted at INR 68 or INR 71 as may be warranted.
• The quotation in which the unit of home currency is kept constant and the exchange rate is expressed
as so many unit of foreign currency is known as Foreign Currency quotation or Indirect quotation
or simply Currency Quotation. Under indirect quotation, any change in exchange rate will be effected
by changing the number of units of foreign currency.
• For instance, a fruit vendor may express the price of apples in either of the following two ways:
Method I: One apple costs INR 10
Method II: For INR 100, 10 apples
• In both the case the value of apple or the rupee is the same though expressed differently. In method I,
the price per apple is quoted in rupees. In method II, the unit of rupees kept constant at 100, and the
quantity of fruits is varied to reflect their prices.
• The same is also true for foreign currency. In foreign exchange also the rate of exchange can be quoted
in two ways:
Method I: USD 1=INR 70.20
Method II: INR 100 = USD 1.4245
• The quotation under Method I, in which exchange rate is expressed as the price per unit of one US dollar
in terms of the home currency is known as “Home Currency Quotation” or “Direct Quotation‘. It may be
noted that under direct quotation the number of units of foreign currency is kept constant and any
change in the US dollar quoted at under different values of rupees.
• Under Method II, the unit of home currency is kept constant and the exchange rate is expressed as so
many units of foreign currency for a fixed unit of home currency is known as “Foreign Currency
Quotation” or “Indirect Quotation”. Under indirect quotation, any change in exchange rate will be effected
by changing the number of units of foreign currency. For instance, the rate INR/.100=USD 1.4245 may
become in due course USD 1.4100 or USD 1.4300, and so on.
• The indirect quotation is used in London foreign exchange market. In New York and other foreign
exchange markets mostly the direct method is in vogue.
• In India, earlier we had used indirect method. However, from August 2, 1993, India has switched over
to direct method of quotation. The change has been introduced in order to simplify and establish
transparency in exchange rates in India.
• In the case of indirect quotations, while buying, the bank would acquire more units of foreign currency
for a fixed unit of home currency and while selling part with lesser units of foreign currency for more
units of home currency. Therefore, the maxim under indirect quotation is buy high and sell low.
• Foreign exchange dealers quote two prices, one for selling and the other for buying. Therefore, in the
foreign exchange market; quotations are always for both buying and selling. For instance a bank may
quote its rate for dollars as follows:
• One US dollar=INR 70.57- 70.75 or INR 100=USD 1.4134- 1.4170. While in the case of One US
dollar=INR 70.57- 70.75 the first INR 70.57 is the buying rate, the second 70.75 is the selling rate.
On the other hand in the case of INR 100= USD 1.4134- 1.4170, the bank agrees to sell at the rate
of USD 1.4134 for INR 100, the bank is willing to buy at USD 1.4170 for INR 100. The buying rate is
known as the bid rate and the selling rate is known as offer rate.
• Continental European dealers normally quote via the direct method. In London dealers use the indirect
method. In the US, both quotation methods are used. When a bank is dealing with a customer within
the US direct quotation is given but when dealing with other banks in Europe (except the UK) the indirect
quotation is used. Foreign exchange dealers quote two prices: the rate at which they are prepared to
sell a currency and that at which they are prepared to buy. The difference between the bid rate and the
offer is the dealer‘s spread which is one of the potential sources of profit for dealers. Whether using the
direct quotation method or the indirect quote, the smaller rate is always termed the bid rate and the
higher is called the offer or ask rate.
The size of the bid/offer spread varies according to the depth of the market and its stability at any particular
time. Depth of a market refers to the volume of transactions in a particular currency. Deep markets have
many deals, shallow markets have a few. High percentage spreads are associated with high uncertainty and
low volume s of transactions in a currency. Lower spreads are associated with stable, high volume markets.
Deep markets usually have narrower spreads than shallow one.
Objectives of FEMA
The main objective for which FEMA was introduced in Indian was to
facilitate external trade and payments. In addition to this, FEMA was also
formulated to assist orderly development and maintenance of the Indian forex market. FEMA outlines the
formalities and procedures for the dealings of all foreign exchange transactions in India. These foreign
exchange transactions have been classified into two categories — Capital Account Transactions and Current
Account Transactions.
Under the FEMA Act, the balance of payment is the record of dealings between the citizen of different
countries in goods, services and assets. It is mainly divided into two categories, i.e. Capital Account and
Current Account. Capital Account comprises all capital transactions whereas Current Account comprises
trade of merchandise.
Current Account transactions are those transactions which involve inflow and outflow of money to and from
the country/countries during a year, due to the trading/rendering of commodity, service, and income. The
current account is an indicator of an economy’s status.
As mentioned above the balance of payment comprises current and capital accounts, the remainder of the
Balance of Payment is Capital Account, which consists the movement of capital in the economy due to capital
receipts and expenditure. Capital account recognises domestic investment in foreign assets and foreign
investment in domestic.
The Current Account transactions under the FEMA Act has been categorized into three parts which, namely-
(i) Transactions prohibited by FEMA,
(ii) The transaction requires Central Government’s permission,
(iii) The transaction requires RBI’s permission.
Exports:
• With regards to exports, below are the operations which commercial banks undertake as part of its
Foreign exchange operations:
1. Pre-shipment Advances: Pre-shipment is also referred as “packing credit”. It is working capital finance
provided by commercial banks (such as export-import bank or trade development bank) to the exporter
prior to shipment of goods. The finance required to meet various expenses before shipment of goods is
called pre-shipment finance or packing credit.
2. Post-shipment Advances: Also referred as Post shipment credit, is extended to exporters by commercial
banks (such as export-import bank or trade development bank) with low interest rate till realization of
their export proceeds. Post shipment loan helps exporters to get finance without waiting amount of sales
from their overseas buyers.
3. Advising/Confirming Letter of Credit: When a Letter of Credit (LC) is issued, the LC Issuing Bank sends
the LC either to its branch office or correspondent bank, which is normally located in the seller’s
(beneficiary) country. The commercial banks that receives the LC is known as the Advising Bank
authenticate the LC to ensure that the LC comes from a genuine source there by providing its
confirmation on the LC.
4. Facilitating project exports: Commercial bank (EXIM Bank) support existing or new projects, plants or
processes that require additional assistance in processes such as international competitive bidding:
including multilaterally funded projects in India. EXIM Bank has extended funded and non-funded
facilities to export of projects and services categorized as:
Civil Engineering and Construction Projects
Turnkey Projects
Technical and Consultancy Service Contracts
Supplies
Few other operations undertaken by commercial banks are Bills for collection etc.
Imports:
• With regards to imports, below are the operations which commercial banks undertake as part of its
Foreign exchange operations.
Few other operations undertaken by commercial banks are Import loans and guarantees, Advance bills etc.
Exchange Dealings
With regards to exchange dealings, below are the operations which commercial banks undertake as part of
its Foreign exchange operations.
1. Rate computation
2. Maintaining Nostro/Vostro Accounts
3. Forward Contracts
4. Nostro and Vostro (Middle Italian, from Latin, noster and voster; English, ours and yours) are accounting
terms used to distinguish an account you hold for another entity from an account another entity holds
for you. The entities in question are almost always, but need not be, banks.
5. Nostro: An account at foreign bank where a domestic bank keeps reserves of a foreign currency. A bank
keeps a nostro account so that it does not have to make a currency conversion (which brings with it
foreign exchange risk) should an account holder make a depositor a withdrawal in that foreign currency
6. Vostro: An account that a bank holds on behalf of another bank in another country.