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execute the deals, as we see in the case of stock exchange.

The largest foreign exchange market is in London, followed by the new york, Tokyo, Zurich and Frankfurt. The market are situated throughout the different time zone of the globe in such a way that one market is closing the other is beginning its operation. Therefore it is stated that foreign exchange market is functioning throughout 24 hours a day. In most market US dollar is the vehicle currency, viz., the currency sued to dominate international transaction. In India, foreign exchange has been given a statutory definition. Section 2 (b) of foreign exchange regulation ACT,1973 states: Foreign exchange means foreign currency and includes : All deposits, credits and balance payable in any foreign currency and any draft, traveler‟s cheques, letter of credit and bills of exchange. Expressed or drawn in India currency but payable in any foreign currency. Any instrument payable, at the option of drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other. In order to provide facilities to members of the public and foreigners visiting India, for exchange of foreign currency into Indian currency and vice-versa. RBI has granted to various firms and individuals, license to undertake money-changing business at seas/airport and tourism place of tourist interest in India. Besides certain authorized dealers in foreign exchange (banks) have also been permitted to open exchange bureaus. Following are the major bifurcations: Full fledge moneychangers – they are the firms and individuals who have been authorized to take both, purchase and sale transaction with the public. Restricted moneychanger – they are shops, emporia and hotels etc. that have been authorized only to purchase foreign currency towards cost of goods supplied or services rendered by them or for conversion into rupees. Authorized dealers – they are one who can undertake all types of foreign exchange transaction. Bank are only the authorized dealers. The only exceptions are Thomas cook, western union, UAE exchange which though, and not a bank is an AD. Even among the banks RBI has categorized them as followes: Branch A – They are the branches that have nostro and vostro account. Branch B – The branch that can deal in all other transaction but do not maintain nostro and vostro a/c’s fall under this category. For Indian we can conclude that foreign exchange refers to foreign money, which includes notes, cheques, bills of exchange, bank balance and deposits in foreign currencies. Participants in foreign exchange market

6. take position i. Sydney. thereafter India.e. As every time the foreign exchange bought or oversold position. They buy that currency and sell it as soon as they are able to make quick profit. Exporters require converting the dollars in to rupee and imporeters require converting rupee in to the dollars. The brokers are not among to allowed to deal in their own account allover the world and also in India. In India as per FEDAI guideline the Ads are free to deal directly among themselves without going through brokers. if they feel that rate of particular currency is likely to go up in short term. The international trade however constitutes hardly 5 to 7 % of this total turnover. CUSTOMERS The customers who are engaged in foreign trade participate in foreign exchange market by availing of the services of banks. Corporation’s particularly multinational corporation and transnational corporation having business operation beyond their national frontiers and on account of their . new york. However the extent to which services of foreign brokers are utilized depends on the tradition and practice prevailing at a particular forex market center. Generally this is achieved by the intervention of the bank. 4. 2. 5. EXCHANGE BROKERS forex brokers play very important role in the foreign exchange market.COMMERCIAL BANK They are most active players in the forex market. As we know that the forex market is 24-hour market. the day begins with Tokyo and thereafter Singapore opens.The main players in foreign exchange market are as follows: 1. OVERSEAS FOREX MARKET Today the daily global turnover is estimated to be more than US $ 1. London. and back to Tokyo. SPECULATORS The speculators are the major players in the forex market. as they have to pay in dollars for the goods/services they have imported. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of goods. CENTRAL BANK In all countries Central bank have been charged with the responsibility of maintaining the external value of the domestic currency. Commercial bank dealing with international transaction offer services for conversion of one currency in to another. Bank dealing are the major pseculators in the forex market with a view to make profit on account of favorable movement in exchange rate. The balance amount is sold or bought from the market. Frankfurt. paris.5 trillion a day. The rest of trading in world forex market is constituted of financial transaction and speculation. They have wide network of branches. 3. followed by Bahrain.

This system was in vogue till the outbreak of world war 1. Melting gold including gold coins. The inter bank rate therefore ruled the RBI band. the intervention currency of the Reserve Bank of India (RBI) was the British pound. there was only one major change in the parity of the rupee. and putting it to different uses was freely allowed. During the fixed exchange rate era. With the invention of money the figures and problems of barter trade have disappeared. This has been going on from time immemorial. guaranteed to buy and sell gold in unrestricted amounts at the fixed price. India was a founder member of the IMF. A country was stated to be on gold standard if the following condition were satisfied: Monetary authority. . Countries of the world have been exchanging goods and services amongst themselves. under this system the parties of currencies were fixed in term of gold. With a view to make advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize. This also result in speculations. During the existence of the fixed exchange rate system. There were two main types of gold standard: 1) gold specie standard Gold was recognized as means of international settlement for receipts and payments amongst countries. bonds and other assets without covering the foreign exchange exposure risk. the RBI ensured maintenance of the exchange rate by selling and buying pound against rupees at fixed rates. Different countries have adopted different exchange rate system at different time. The rupee was historically linked with pound sterling. generally the central bank of the country. Gold coins were an accepted mode of payment and medium of exchange in domestic market also. Individual like share dealing also undertake the activity of buying and selling of foreign exchange for booking short term profits. They also buy foreign currency stocks. The barter trade has given way ton exchanged of goods and services for currencies instead of goods and services. The world has come a long way from the days of barter trade. The following are some of the exchange rate system followed by various countries.cash flows being large and in multi currencies get in to foreign exchange exposures. THE GOLD STANDARD Many countries have adopted gold standard as their monetary system during the last two decades of the 19th century.devaluation in June 1966.

Thus. which set up an adjustable parity exchange-rate system under which exchange rates were fixed (Pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. There is no attempt by the authorities to influence exchange rate. was effectively buried. The total money supply in the country was determined by the quantum of gold available for monetary purpose. following World War II. Where government interferes‟ directly or through various monetary and fiscal measures in determining the exchange rate. BRETTON WOODS SYSTEM During the world wars. . the world economy has been living through an era of floating exchange rates since the early 1970. the United States and most of its allies ratified the Bretton Woods Agreement. the international trade suffered a deathblow. However. was in response to financial chaos that had reigned before and during the war. FLOATING RATE SYSTEM In a truly floating exchange rate regime.. In 1944. the money in circulation was either partly of entirely paper and gold served as reserve asset for the money supply. In addition to setting up fixed exchange parities ( par values ) of currencies in relationship to gold.Import and export of gold was freely allowed. 1) Gold Bullion Standard Under this system. many countries devalued their currencies. the relative prices of currencies are decided entirely by the market forces of demand and supply. In ordere to correct the balance of payments disequilibrium. World War I brought an end to the gold standard. the agreement extablished the International Monetary Fund (IMF) to act as the “custodian” of the system. This was also known as “ Mint Parity Theory “ of exchange rates. it is known as managed of dirty float. Consequently. fostered by a new spirit of international cooperation. which lead to major countries suspending their obligation to intervene in the market and the Bretton Wood System. with its fixed parities. and intermittently thereafter until 1944. economies of almost all the countries suffered. The exchange rate varied depending upon the gold content of currencies. Under this system there were uncontrollable capital flows. This agreement. paper money could be exchanged for gold at any time. The gold bullion standard prevailed from about 1870 until 1914.

then the balance of payments equilibrium would always be maintained. if a party comes to know what the other party intends to do i. This in turn. The theory. buy or sell.e.all the exchange rates are quoted in direct method. There are two parties in an exchange deal of currencies. 1993. In India with effect from august 2. to put in simple terms states that currencies are valued for what they can buy and the currencies have no intrinsic value attached to it. cause currency of India to depreciate in comparison of currency of Us that is having relatively more exports. iii. This decrease in exports of India as compared to exports from US would lead to demand for the currency of US and excess supply of currency of India.e. therefore USD 2 = INR 150. The party asking for a quote is known as‟ asking party and the party giving a quotes is known as quoting party. Thus if 150 INR buy a fountain pen and the samen fountain pen can be bought for USD 2. v2) In direct method: Home currency is kept constant and foreign currency is kept variable.PURCHASING POWER PARITY (PPP) Professor Gustav Cassel. it can be inferred that since 2 USD or 150 INR can buy the same fountain pen. under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. the former can take the letter for a ride. Two way price limits the profit margin of the quoting bank and comparison of one quote with another quote can be done instantaneously. To initiate the deal one party asks for quote from another party and other party quotes a rate. Here the strategy used by bank is to buy high and sell low. This would induce imports in India and also the goods produced in India being costlier would lose in international competition to goods produced in US. Therefore. As per this theory if there were no trade controls. . This helps in eliminating the risk of being given bad rates i. The market continuously makes available price for buyers or sellers ii. The advantage of two–way quote is as under i. introduced this system. a Swedish economist. For example India has a higher rate of inflation as compaed to country US then goods produced in India would become costlier as compared to goods produced in US. It is customary in foreign exchange market to always quote two rates means one for buying and another rate for selling.

also have an impact. trade imbalance. This proposition.As it is not necessary any player in the market to indicate whether he intends to buy or sale foreign currency. FACTOR AFFECTINGN EXCHANGE RATES In free market. in India the banks. always quote rates. • POLITICAL FACTOR The political factor influencing exchange rates include the established monetary policy along with government action on items such as the money supply. `In two way quotes the first rate is the rate for buying and another for selling. Irving fisher. So the rates quoted. Two way quotes lend depth and liquidity to the market. It means that if exporters want to sell the dollars then the bank will buy the dollars from him so while calculation the first rate will be used which is buying rate. In its absolute version. It automatically insures that alignment of rates with market rates. Other political . and deficit financing. v. interest rates. some times wild. this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. However. such as central bank activity in the foreign currency market. as the bank is buying the dollars from exporter. which are ultimately the cause of the exchange rate fluctuation. states that interest rate differentials tend to reflect exchange rate expectation. which are authorized dealer. developed a theory relating exchange rates to interest rates.power parity theory relates exchange rates to inflationary pressures. The same case will happen inversely with importer as he will buy dollars from the bank and bank will sell dollars to importer. known as the fisher effect. inflation. it becomes difficult to precisely define the factors that affect exchange rates. the purchasing. The volatility of exchange rates cannot be traced to the single reason and consequently.buying and selling is for banks point of view only. Active government intervention or manipulation. The relative version of the theory relates changes in the exchange rate to changes in price ratios. this ensures that the quoting bank cannot take advantage by manipulating the prices. and euro market activities. iv. it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors. which is so very essential for efficient market. the more important among them are as follows: • STRENGTH OF ECONOMY Economic factors affecting exchange rates include hedging activities. taxes. We should understand here that. inflationary pressures. On the other hand. an American economist.

is corporate finance‟s top foreign exchange forecaster for 1999. and his method proved uncannily accurate in foreign exchange forecasting in 1998. vice president of financial markets at SG. defined convention. Bob Eveling. • EXPACTATION OF THE FOREIGN EXCHANGE MARKET Psychological factors also influence exchange rates. Any event. and future expectations.SG ended the corporate finance forecasting year with a 2. The secret to eveling‟s intuition on any currency is keeping abreast of world events. instead of formal modals. the buyer stands to gain in exercising the option. the most accurate among 19 banks. eveling‟s gut feeling has. it may be noted that if on maturity the spot price is less than the INR 43.66% error overall. Finally. can take its toll on a currency‟s value. The buyer can buy the underlying asset at strike price and sell the same at current market price thereby make profit. The agreed exchange rate is known as the strike rate or exercise rate. most forecasters rely on an amalgam that is part economic fundamentals. A few financial experts are of the opinion that in today‟s environment. the only „trustworthy‟ method of predicting exchange rates by gut feel. CURRENCY OPTIONS A currency option is a contract that gives the holder the right (but not the obligation) to buy or sell a fixed amount of a currency at a given rate on or before a certain date. Fiscal policy Interest rates Monetary policy Balance of payment Exchange control Central bank intervention Speculation Technical factors (Scenario-3) If the spot price is higher than the strike price at the time of maturity. part model and part judgment.from a declaration of war to a fainting political leader. there is also the influence of the international monetary fund. . speculative pressures. These factors include market anticipation.factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Today.52 (inclusive of the premium) the buyer will stand to loose. However.

A Currency Option. or to buy or sell at market rates if they are more favorable.98 % of the USD amount (in this case USD 1000000). Market parameters : Current Spot Rate is 1. In this example. Outcomes : If. Enter into a forward contract and buy at a rate of 1. in one months time. offers protection against unfavorable changes in exchange raters without sacrificing the chance of benefiting from more favorable rates. the exchange rate is 1. a company acquires greater flexibility and at the same time receives protection against unfavorable changes in exchange rates.6000 for exercise in one month’s time. A Put Option is an option to sell a fixed amount of currency. In company wil gain if the dollar strengthens. It is protected if the dollar strengthens and still has the chance to benefit if it weakens. The company will gain if the dollar weakens (say 1.5000. but will lose if it weakens. How are Currency Options are different from Forward Contracts ? A Forward Contract is a legal commitment to buy or sell a fixed amount of a currency at a fixed rate on a given future date.6200) but will lose if it strengthens (say 1.6000 for exercise in one month‟s time. i.5800). Types of Options : A Call Option is an option to buy a fixed amount of currency.6000 on a date one month in the future (European Style). on the other hand.An option is usually purchased for an up front payment known as a premium.6000 Solutions available : Do nothing and buy at the rate on offer in one months time. How does the option work ? The company buys the option to buy USD 1000000 at a rate of 1. Option premiums : By buying an option. let‟s assume that the option premium quoted is 0. The option then gives the company the flexibility to buy or sell at the rate agreed in the contract. 2. The protection is paid for in the form of a premium.600. not to exercise the option. In this case the company can buy in one months time at whichever rate is more attractive. But a call option with a strike rate of 1.e. one month forward rate is 1. the cost of . The European style option is an option that can only be exercised at the specific expiry date of the option. Example : A company has a requirement to buy USD 1000000 in one months time. Both types of options are available in two styles : 1. The American style option is an option that can be exercised at any time before its expiry date. This cost amounts to USD 9800 or IEP 6125.

the company can exercise its Call Option and buy USD 1000000 at 1. However. . So. The company pays IEP 588235 for USD 1000000 and saves IEP 36765 over the cost of forward cover at 1.7000. The company has a net saving of IEP 30640 after taking the cost of the option premium into account. the company will only have to pay IEP 625000 to buy the USD 1000000 and saves IEP 41667 over the cost of buying dollars at the prevailing rate. In a world of changing and unpredictable exchange rates.667.6000. On the other hand. the overall net saving for the company is IEP 35542. if the exchange rate in one months time is 1. The company can choose not to exercise the Call Option and can buy USD 1000000 at the prevailing rate of 1.buying USD 1000000 is IEP 666. Taking the cost of the potion premium into account. the payment of a premium can be justified by the flexibility that options provide.6000.7000.

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