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 Foreign exchange market

 Principal players
 Customer of banks
 Commercial bank and other primary market makers
 Secondary price makers
 Price taker
 Advisory services
 Exchange brokers
 Speculators
 Central banks
 The term foreign exchange market is used in an
abstract sense.
 It is more like the National Stock Exchange where
participants or members buy and sell foreign
exchange through communication devices.
 It is screen based, genuinely international and open
for business 24 hours a day.
 There are many buyers and sellers; prices adjust
rapidly and for the most part smoothly.
 A single international currency would need no foreign
exchange market.
 The purpose of the foreign exchange market is to permit
transfers of purchasing power denominated in one
currency for another currency.
 Inconvenience to the individual buyers and sellers of
foreign exchange, saw the birth of the Foreign Exchange
Market.
 Foreign Exchange Market is not a physical place.
 It is a network of Banks, Foreign Exchange Brokers and
Dealers, whose function is to bring buyers and sellers of
foreign exchange together.
 It is not confined to one country.
 It is dispersed throughout the leading financial centers of
the world - London, New York City, Tokyo, Frankfurt and
Paris.
Trading is generally done by telephone, computer based
electronic dealing systems or telex machines.
Foreign Exchange traders in each Bank usually operate
out of a separate Foreign Exchange Trading Room.
Each trader has several telephones and is surrounded by
display monitors, computers and telex machines feeding
upto the minute information.
Most transactions are either screen based or based on
oral communications.
Written confirmation occurs later.
 Foreign Exchange Market.
◦ Most currency transactions are channeled
through the worldwide interbank market, the
wholesale market in which major banks trade
with each other.
 Spot Market.
◦ Settlement of transactions is done within two
business days after the transaction has been
concluded.
 Forward Market
◦ The contracts are made to buy or sell currencies
for future deliveries.
Principal Players

 The principal players in the Foreign Exchange

Market are
◦ the customers of commercial banks
◦ commercial banks
◦ foreign exchange brokers
◦ central banks
which intervene in the market from time to time to
smooth exchange rate fluctuations or to maintain
exchange rates.
Customers of banks

 Bank customers involved in foreign trade will have a

need to buy or sell foreign exchange.
 Foreign exchange will also be needed by importers of
capital goods to pay for the goods imported and by
companies to pay for services.
 To buy or sell foreign exchange customers will
approach their banks to settle their foreign
obligations or to sell foreign currency that they have
for local currency.
Commercial banks and other primary
market makers
 Commercial banks participate in the foreign
exchange market on behalf of customers. These
are normally known as merchant transactions or
customer related transactions.
 Banks may also buy or sell foreign exchange on
its own account. These could be for two reasons :-
◦ Banks may need foreign exchange to make some
payment such as a subscription or to repay a loan it has
taken in foreign exchange.
◦ Bank may trade in foreign exchange to take advantage of
rate movements or to speculate.
 “Overbought” position.
When a bank buys more foreign exchange than it
actually needs.
 “Oversold” position.
When the Bank sells more foreign exchange than it
has bought
This occurs when the Bank has agreed to sell foreign
exchange at a future date in anticipation of a fall in its
price in the future.
 Both overbought and oversold positions are risky
and foreign exchange dealers are expected to
square off their positions at the end of every day.
 Merchant transactions are by and large an
insignificant amount of the foreign exchange
transaction that takes place.
 Banks speculate on foreign exchange movements by
selling or purchasing foreign exchange.
 They may hold it for a time in the expectation of a
profit.
 They may even take advantage of rate differentials in
an imperfect market. This is known as arbitrage.
 Most transactions are settled through brokers,
telephones, telexes, dealing systems (such as
Reuters Dealing 2000) and the like.
 These are known as OTC or “Over the Counter”
transactions.
 Major banks often act as market makers.
 In India, the market maker is clearly the State
Bank of India because of its huge needs and
resources.
 Abroad some banks specialise in certain
currencies while others act as market makers in
other major currencies by offering two way
quotes.
 Commercial banks and their dealers are normally
considered as primary price makers as they, by their
trading often determines or makes the price.
 Primary price makers also include investment dealers and
some large corporations.
 Investment dealers have provided specialised services to
corporations on account of both the globalisation of the
markets and the profits made by banks.
 In regard to corporations in the west, several have become
price makers.
 The financial requirements and their needs are so great that
they need to cover themselves against interest rate and
foreign exchange risks. However, most corporations prefer
to leave this to the experts.
Secondary Price Makers
 These make foreign exchange prices but do not
deal in the market on a two way reciprocity basis.
 These include service businesses such as
restaurants and hotels which accept a customer’s
foreign currency as payment for bills.
 These are also companies that specialise in buying
and selling foreign exchange to the general public
(money changers).
 These have fairly large spreads between their
buying and selling rates.
 They sell their surplus positions to commercial
banks and other secondary price makers.
Price Takers

 These consist of those who take the prices of primary

or secondary price makers and deal for their own
purposes.
 They do not reciprocate and make market prices.
 They are price takers.
 These include corporations, banks and wealthy
individuals.
Advisory Services
 Foreign exchange rates are volatile and it is
imperative for corporations to be aware of how
rates are likely to move to protect their foreign
exchange exposure or on how and when they
should buy or sell foreign exchange.
 This need has given rise to advisory services that
help their clients to determine and formulate their
strategies.
 There are also services (including banks) that
either daily or weekly send out information in the
form of a letter or a fax with recommendations.
Exchange brokers

 Any firm engaged in the business of foreign

exchange dealing as an intermediary is known as
an exchange broker.
 The firm has to get its name registered ( with the
Foreign Exchange Dealer's Association in India
and any other similar body in other countries)
before it can start transacting any exchange
business for and on behalf of banks.
 The work of exchange brokers is a specialized job
and one error can prove very costly to the
concerned parties and in turn to the exchange
broker.
 For any company to act as a exchange broker, it
has to have the following infra structure:
◦ Office Space
◦ Telephones
◦ Staff
◦ Teleprinters
◦ Telex Machines
◦ Hot lines with banks.
 Deals have to be concluded within the shortest
possible time and confirmed to the parties
concerned.
The functions of brokers are:
 To bring buyers and sellers together.
 To quote market prevalent rates.
 To confirm immediately on telephone the amount,
rate, value date and the counter party to both the
buyer and the seller.
 To send the broker notes to the buyer and the
seller confirming the details in writing already
provided on telephone.
 To get any exception to the contract resolved on
receipt of confirmation from the counter party.
 Exchange brokers or forex brokers facilitate transactions.
 The broker would complete the transaction for a fee
known as the brokerage.
 Using a broker allows a bank to show prices to the market
on an anonymous basis.
 If the prices are good as or better than the other ones
available to the broker, the broker will quote these prices
to the market.
 It must be remembered that brokers are not principal
dealers.
 They do not buy or sell currencies on their own account.
 When a trade is completed they advise the two parties that
they have dealt with each other and send each of them the
deal ticket or broker notes.
 Speculators play an extremely important role.
 Over 95 percent of all transactions are speculative in
nature.
 The major speculators are:
◦ Banks.
◦ Companies/ Customers
◦ Governments
◦ Individuals
◦ Entities
 Each of these entities can gain or lose depending
on the exchange movements.
 Speculation in foreign exchange is very large and
does cause major swings in rates that are
detrimental.
 Some speculation is required in markets to
provide liquidity for handling non speculative
deals.
 If this liquidity does not exist the bid/offer spreads
would be much larger, there would be delays in
receiving prices and it would be more difficult to
execute larger transactions.
 Thus speculation is the reason for the efficiency of
the markets.
 Central Banks are responsible for managing the
monetary policy – the country’s supply of credit
and money both for the short term and for the long
term.
 The Central Bank is the Government’s Bank.
 It maintains the Government’s money as the
Government’s Bank.
 If the Government needs money it issues short
term or long term debt.
 In managing money for the Government, Central
Banks:
◦ Advise Governments on what debt should be issued
and at what rates.
◦ Look after the issuance and redemption of the debt.
◦ Does the actual buying and selling of debt
instruments.
 Inflation and economic growth are concerns of the
Central Bank.
 Interest rates are used to control and adjust exchange
rates.
 If interest rates are high there will be an inflow of
foreign capital.
 If the currency is stronger imports become cheaper
and pressures domestic prices down.
 It also slows economic growth.
 On the other hand if interest rates are lowered there
will be an outflow of funds resulting in a fall in the
value of the currency.
 Imports will become more expensive, inflation will
rise and economic growth will be more.
 The ways Central Banks influence interest are as follows:
◦ Open Market Operations. This is by purchasing or
selling government debt.
◦ Withdrawing or increasing cash in the banking system.
This is normally by raising or lowering the cash reserve
ratio (CRR) that commercial banks are required to keep
with the Central Bank.
◦ Cash can also be injected into the banking system by
printing notes and putting it in circulation.
◦ Monetizing debt issued.
◦ Raising/ lowering interest rates
 Central Banks maintain, raise or lower the value
of their currency in the international market or to
support their currency.
 Demand and supply determine currency values.
 Intervention can be defined as the purchase or sale
of foreign exchange to maintain the price of a
given currency against another currency.
 Central banks intervene by buying directly from
banks, through brokers or through other central
banks.
 They have been known to intervene through the
futures market.
 Intervention apart from maintaining an orderly
market is done to turn the market or to test the impact
of a particular action.
 Central Banks intervene only if they have to.
 They normally hope the market will correct itself on
its own.
Summary

◦ The foreign exchange market is vast and has no

boundaries.
◦ Purchase and sale is done by phone, fax, dealing
systems, telex and computers.