FOREIGN EXCHANGE MARKET

Meaning Of Foreign Exchange

 According to Hartly Withers, “ Foreign exchange is
the art and science of international monetary
exchange”

 The forex market is the world’s largest financial

market. Over $4 trillion dollars worth of currency
are traded each day. The amount of money traded in
a week is bigger than the entire annual GDP of the
United States.

 The main currency used for forex trading is the US

dollar.
 Meaning Of Foreign Exchange

The term Foreign exchange implies two things:

a)foreign currency and b) exchange rate
 Foreign exchange generally refers to foreign currency,
eg for india it is dollar, euro, yen, etc… &
 The other part of foreign exchange is exchange rate
which is the price of one currency in terms of the
other currency.
Forex is the international market for the free trade of
currencies. Traders place orders to buy one currency
with another currency.
 Definition and Organization of the
Foreign Exchange Markets
 Foreign exchange markets are markets on which
individuals, firms and banks buy and sell foreign
currencies:
– foreign exchange trading occurs with the help of the
telecommunication net between buyers and sellers of
foreign exchange that are located all over the world
– a single international foreign exchange market for
every single currency
– foreign exchange trading takes place at least in some
of the world financial centers in every moment
Forex Trading in India – Legal or Illegal

In India, Foreign Exchange or Forex trading is not

allowed. If someone is found trading Forex
instruments on the forex market by the Reserve
Bank of India’s representatives, he/she is
immediately charged of violation of law. Hence it is
legally a crime to involve in Forex trading and the
charges of the crime are imprisonment in jail in
this country. The offence is considered immense,
the prediction of intensity can be deduced from
this fact that it has been labeled to be non-bail
able.
 The Currency Market
Where money denominated in one currency is
bought and sold with money denominated in
another currency.
International Trade and Capital Transactions:
• facilitated with the ability to transfer
purchasing power between countries.
 Location
1. OTC-type: no specific location
2. Most trades by phone, telex, or
SWIFT SWIFT: Society for Worldwide
Interbank Financial Telecommunications
 Foreign Exchange Market
 Foreign exchange market is that market in which
national currencies are traded for one another..
 The major participants in this market are
commercial banks, forex brokers, and authorized
dealers and the monetary authorities.
 Besides, transfer of funds form one country to
another , speculation is an important dimension
of foreign exchange market.
 Its where money in one currency is exchanged for
another
 Participants in the Foreign Exchange
Market
Participants at 2 Levels
1. Wholesale Level (95%) - major banks
2.Retail Level (business customers)
Two Types of Currency Markets
3. Spot Market:
- Immediate transaction
- Recorded by 2nd business day
4. Forward Market:
- Transactions take place at a specified
future date
 Participants by Market
 Spot Market
a. commercial banks
b. Brokers
c. customers of commercial and central banks
 Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators
 CLEARING SYSTEMS
A.Clearing House Interbank Payments System
(CHIPS)
- used in U.S. for electronic fund
transfers.
B.Fed Wire
- operated by the Fed
- used for domestic transfers
 Foreign Exchange Market Functions
Clearing of Currencies and Provision of Credit
 Clearing of currencies:
– Service of exchanging one currency for another
 Provision of Credit:
– Trader that bought a certain good from the
manufacturer, needs time to sell this good to the
final customer and to pay the manufacturer with
the money he received from the customer
Foreign Exchange Market and Insurance
Against Foreign Exchange Risk
Activities with which the foreign exchange
market participants avoid exchange rate risk
or activities with which they are closing
their open foreign exchange position
closed foreign exchange position:
• Size of the assets in a certain currency is equal
to the size of the liabilities in the same currency
• Full insurance against exchange rate risk with
respect to this currency
Foreign Exchange Market and Insurance
Against Foreign Exchange Risk
 Open foreign exchange position:
• long: net assets in a certain currency
• short: net liabilities in a certain currency
 In the spot or forward foreign exchange market
 Standardized forward contracts and options
Foreign Exchange Markets and Conscious
Foreign Exchange Risk Acceptance
• Activities in which economic agents
consciously open their foreign exchange
positions – long or short – hoping to
get profits in all foreign exchange
market segments
 Foreign Exchange Market Participants
Economic Agents and Types of Activities on
Foreign Exchange Markets
Client bu y s $
with €

Local ba nk

Purchases and sales

Main banks’ of big mu
Brokers interbank market ltinational
companies

Local ba nk

Client bu y s €
with $
 Economic Agents and Types of Activities
on Foreign Exchange Markets
 Bank clients (individuals, firms, non-banking
financial institutions):
– All those groups of legal and physical persons that
need foreign currency in doing their commercial
or investment business
 commercial banks:
 The most important group of foreign exchange
market participants
 They buy and sell foreign currencies for their
clients and trade for themselves
 Economic Agents and Types of Activities
on Foreign Exchange Markets
 Brokers:
– Agents that connects dealers interested in buying
and selling foreign exchange, but does not become
an active client in the transaction
– They provide their client, the bank, with the
information about the exchange rates at which
banks are willing to buy or sell a particular
currency
 Economic Agents and Types of Activities
on Foreign Exchange Markets
 central banks:
 Foreign exchange market interventions are meant
to influence the exchange rate of the domestic
currency in a way that is beneficial for the
domestic economy and, consequently, for the
country
 It does not necessarily have a profit, it can also
have a loss
 Economic Agents and Motivation for the
Foreign Exchange Market Participation
Arbitragers:
• They want to earn a profit without taking
any kind of risk (usually commercial banks):
• Try to profit from simultaneous exchange rate
differences in different markets
• Making use of the interest rate differences that
exist in national financial markets of two
countries along with transactions on spot and
forward foreign exchange market at the same
time (covered interest parity)
 Economic Agents and Motivation for the
Foreign Exchange Market Participation
Hedgers and Speculators:
 Hedgers do not want to take risk while
participating in the market, they want to insure
themselves against the exchange rate changes
 Speculators think they know what the future
exchange rate of a particular currency will be, and
they are willing to accept exchange rate risk with
the goal of making profit
 Every foreign exchange market participant can
behave either as a hedger or as a speculator in the
context of a particular transaction
 Size and Structure of Foreign
Exchange Market Transactions
 The biggest share of all financial markets in the world
Most traded currencies by value
Currency distribution of global foreign exchange market turnover

ISO 4217 code % daily share

Rank Currency
(Symbol) (April 2013)

1 United States dollar USD ($) 87.0%

2 Euro EUR (€) 33.4%

3 Japanese yen JPY (¥) 23.0%

4 Pound sterling GBP (£) 11.8%

5 Australian dollar AUD ($) 8.6%

6 Swiss franc CHF (Fr) 5.2%

7 Canadian dollar CAD ($) 4.6%

8 Mexican peso MXN ($) 2.5%

9 Chinese yuan CNY (¥) 2.2%

10 New Zealand dollar NZD ($) 2.0%

11 Swedish krona SEK (kr) 1.8%

12 Russian ruble RUB ( ₽ ) 1.6%

13 Hong Kong dollar HKD ($) 1.4%

14 Norwegian krone NOK (kr) 1.4%

15 Singapore dollar SGD ($) 1.4%

16 Turkish lira TRY (₺) 1.3%

17 South Korean won KRW (₩) 1.2%

18 South African rand ZAR (R) 1.1%

19 Brazilian real BRL (R$) 1.1%

20 Indian rupee INR (₹) 1.0%

21 Danish krone DKK (kr.) 1.0%

22 Israeli new shekel ILS (₪) 1.0%

Other 8.3%

Total 200%
 Types of Foreign Exchange Market Transactions
Spot Foreign Exchange Transactions
 Almost immediate delivery of foreign
exchange.
Outright Forward Transactions

 Buyer and seller establish the exchange rate at the time of the
agreement, payment and delivery are not required until
maturity
 Forward exchange rates:
 1, 3, 6, 9 months, one year
 Swap Transactions
 Simultaneous purchase and sale of a given
amount of foreign exchange for two different
value dates:
– “Spot against forward” swaps:
 Hedging
 The act of reducing exchange rate risk
Forward Rate Quotations
Two Methods:
a) Outright Rate: quoted to
commercial customers.
b) Swap Rate: quoted in the
interbank
market as a discount or premium.
 Forward Contract
An agreement between a bank and a
customer to deliver a specified amount of
currency against another currency at a
specified future date and at a fixed
exchange rate.
 Futures
 Basic characteristics of futures:
– The amount of the currency that is being traded
– Type of currency quotation
– Contract expiration
– Last day of trading with the contract
– Settlement day
– Margin requirements
 Information about futures trading
 Futures usage:
– Arbitrage between outright forward contract and
futures
– Rarely used as an insurance instrument (rigidity!)
 Futures positions
 Futures are similar to forwards
 First, futures positions require a margin deposit to be
posted and maintained daily.
 If a loss is taken on the contract, the amount is debited
from the margin account after the close of trading.
 In other words, these futures are cash settled and no
underlying instruments or principals are exchanged.
 Secondly, all contract specifications such as expiration
time, face amount, and margins are determined by the
exchange instead of by the individual trading parties.
 similarities and differences between outright forward contract
and futures:
– both need to be executed unconditionally
– they are usually established for at most one year
Characteristic Futures Outright Forward Contract
Size of the contracts standardized for a given currency depends on the individual needs of the
client
Location and trade at the stock exchange or at a given with the provision of agents, connected
activity location; actively traded in among each other with the help of
an organized market telecommun ications; not traded in
an organized market
Duration of the standardized, but at most a year depends on the individual needs of the
contract client , but not more than a year
Contract has to be yes yes
executed
Insurance and insurance explicitly required (marg insurance not required exp licitly
Security of doing in requirements); high security of (imp licit insurance are affiliations
Business with doing business with the instrument of two partners up till now); lower
the security than futures
Instrument
Trade regulation regulated with the stock regulation not exp licitly determined
exchange rules
 Options
 Basic characteristics of options:
– Financial instrument that gives the buyer the right,
but not the obligation, to buy or sell a standardized
amount of a foreign currency, that is traded, at a fixed
price at a particular time, or until a particular time in
the future
– Call option and put option
– American and European options
– Three different prices:
• Exercise/strike price
• Cost, price or value of the option
• Underlying or actual spot exchange rate
 Options
• Options are a way of buying or selling a currency
at a certain point in the future.
• An option is a contract which specifies the price
at which an amount of currency can be bought at
a date in the future called the expiration date.
• Unlike forwards and futures, the owner of an
option does not have to go through with the
transaction if he or she does not wish to do so.
 Types of options
 The buyer of a call has the right but not the obligation to buy the
underlying asset at the strike price on or before a specified date in
the future.
 However, the seller has a potential obligation to sell the underlying
asset at the strike price on or before a specified date in the future if
the holder of the option exercises his or her right.
 The buyer of a put has the right but not the obligation to sell the
underlying asset at the strike price on or before a specified date in
the future.
 On the other hand, the seller of a put has a potential obligation to
buy the underlying asset at the strike price on or before a specified
date in the future if the holder of the option exercises his/her right.
 Options
 Types of options trading:
– In organized markets:
• standardized contracts with given strike prices,
standardized durations (1, 3, 6, 9, 12 months) and
expirations
• only certain currencies, contract amounts are
standardized
– over-the-counter trading:
• expiration date, strike price and contract
amount depend
on the individual needs of the client
• counterparty risk!
• retail and interbank market
 Options
 Usage of options:
– when the economic agent expects that the
exchange rate trend of a particular currency could
change drastically
– when the economic agent does not know for sure
that a certain foreign exchange flow will occur in
the future
– Advantages:
• Fixed option costs
• Options do not need to be executed
 Advantages Of Forex Market
 It’s already the world’s largest market and it’s
still growing quickly
 It makes extensive use of information
technology – making it available to everyone
 Traders can profit from both strong and
weak economies
 Trader can place very short-term orders – which
are prohibited in some other markets
 The market is not regulated
 Brokerage commissions are very low or non-existent
 The market is open 24 hours a day during weekdays
 Terms Related to Foreign Exchange
 Foreign exchange reserves- holdings of other countries' currencies
 Foreign exchange controls- controls imposed by a government on
the purchase/sale of foreign currencies
 Retail foreign exchange platform- speculative trading of
foreign exchange by individuals using electronic trading platforms
 Foreign exchange risk- arises from the change in price of
one
currency against another
 International trade- the exchange of goods and services
across national boundaries
 Foreign exchange company- a broker that offers currency exchange
and international payments
 Bureau de change- a business whose customers exchange
one
currency for another
 Currency pair- the quotation of the relative value of a currency unit
against the unit of another currency in the foreign exchange market
 Digital currency exchanger- market makers which exchange
 Exchange Rate
 According to haines, “Exchange rate is the price
of the currency of a country can be exchanged for
the number of units of currency of another
country.”
 Exchange rate is that rate at which one unit of
currency of a country can be exchanged for the
number of units of currency of another country.
 It’s the price for which one currency is exchanged
for another
Factors Influencing Exchange Rates
As with any market, the forex market is driven by supply and demand:
 If buyers exceed sellers, prices go up
 If sellers outnumber buyers, prices go down
The following factors can influence exchange rates:
 National economic performance
 Central bank policy
 Interest rates
 Trade balances – imports and exports
 Political factors – such as elections and policy changes
 Market sentiment – expectations and rumours
 Unforeseen events – terrorism and natural disasters
Despite all these factors, the global forex market is more stable than
stock markets; exchange rates change slowly and by small amounts.
Types Of Exchange Rates
 Fixed and Floating Exchange Rates

 Fixed exchange rate is the official rate set by

the monetary authorities of the Governance
for one or more currencies.
 Under floating exchange rate, the value of the
currency is decided by supply and demand
factors
Direct and Indirect Exchange Rates
 Direct method - Under this, a given number of
units of local currency per unit of foreign
currency is quoted. They are designated as
direct/certain rates because the rupee cost of
single foreign currency unit can be obtained
directly. Direct quotation is also called home
currency quotation.
 Indirect method – Under this, a given number
of units of foreign currency per unit of local
currency is quoted. Indirect quotation is also
called foreign currency quotation
 Buying and Selling

Exchange rates are quoted as two way quotes –

 for purchase and
 for sale
Transactions by the Bank
 Spot and Forward
The delivery under a foreign exchange transaction
can be settled in one of the following ways
 Ready or cash – To be settled on the same day
 Tom – To be settled on the day next to the
date of transaction
 Spot – To be settled on the second working
day from the date of contract
 Forward – To be settled at a date farther than
the spot date
 Theories of Exchange Rate
Determination
Meaning:
Theories which determine the prices offorex
rate considering inflation, interest rate, and
elasticity of price etc..
Methods:
a)Long run theory
b)Short run theory
 Long Run Theory Of Exchange Rate
Determination:
 This are the theories which predominately take into
account the fundamental changes of economy.
 Here fundamental changes refers to the change which are
going to change the economic performance of the
economy Purchasing power for all times to come.
Types of theory:
 Purchasing power parity.
1) Absolute purchasing power parity.
2) Relative purchasing power parity.
 Interest Rate parity.
1) Covered Interest Rate parity.
2) Uncovered Interest Rate parity.
 Short Run Theory Of Exchange Rate
Determination

 This theories are based more on current

information or immediate performance of
economic variables.
 This theories try to take into account the short
run factor which may be eliminated in the
long run.
 Purchasing power parity Theory
Founder –Swedish economist Gustav Cassel in 1918.
Meaning : According to this theory ,the price levels
and the changes in these price levels in different
countries determine the exchanges rates of these
countries currencies.

The basic principle of this theory is that the

exchange rates between various currencies reflect
the purchasing power of these currencies .This
theory is based law of one price.
 Absolute Form Of PPP Theory

 If the law of one price were to hold good for

each and every commodity then the theory is
termed as Absolute form of PPP Theory.
 This theory describes the link between the
spot exchange rate and price levels at a
particular point of time
 Relative Form Of PPP
 This theory describes the link between the
changes in spot exchange rate and in the price
levels over a period of time.
 According to this theory ,changes in spot rates
over a period of time reflect the changes in the
price level over the same period in the concerned
economies.
 This theory relaxes three assumptions of PPP i.e.
Absences of transportation cost ,transaction costs
and tariffs.
 Interest Rate Parity Theory

Definition :
The process that ensures that the annualized forward
premium or discount equals the interest rate differential
on equivalent securities in two currencies.
 International Fisher effect:
 Expected Rate of change = Interest rate of
the exchange rate differential
 Interest Rate = Real Interest Expected Differential Rate
+ inflation rate
 Modern theory: Demand & Supply
Theory
 The most satisfactory explanation of the
determination of the rate of exchange is that a
free exchange rate tends to be such as to
equate the demand and supply of foreign
exchange..
 The intersection of supply curve and demand
curve gives the equilibrium price
 Modern theory also called balance of
payments theory of foreign
exchange
 Foreign Exchange Risk

 Exposure to exchange rate movement.

 Any sale or purchase of foreign currency
entails foreign exchange risk.
 Foreign exchange transaction affects the net
asset or net liability position of the
buyer/seller.
 Carrying net assets or net liability position in
any currency gives rise to exchange risk.
 Risk Management
Controlling losses
 You could control your losses, by mental stop or hard stop. Mental stop
means that you already set you limit of your loss. A hard stop is your
initiative to stop when you think you must to stop it.
Using correct lot size
 As a beginning just use smaller lots you could stay flexible and logic
than
emotions while you trade.
Tracking overall exposure
 sample: you go to short on EUR/USD and long on USD/CHF, you exposed
two times for USD in the same direction. If USD goes down , you have a
double dose of pain. So, keep your overall exposure limited, it keeps you
for the long haul for trading
The bottom line
 Trading is about opportunities, you must take action while the
opportunities arise.