FOREIGN EXCHANGE

MARKET
FX MARKET
 FOREIGN EXCHANGE MARKET

• FOREIGN EXCHANGE MARKET IS THE MARKET IN WHICH FOREIGN CURRENCIES ARE

BOUGHT AND SOLD. THE BUYERS AND SELLERS INCLUDE INDIVIDUALS, FIRMS,
FOREIGN EXCHANGE BROKERS, COMMERCIAL BANKS AND THE CENTRAL BANK.

• LIKE ANY OTHER MARKET, FOREIGN EXCHANGE MARKET IS A SYSTEM, NOT A PLACE.
THE TRANSACTIONS IN THIS MARKET ARE NOT CONFINED TO ONLY ONE OR FEW
FOREIGN CURRENCIES. IN FACT, THERE ARE A LARGE NUMBER OF FOREIGN
CURRENCIES WHICH ARE TRADED, CONVERTED AND EXCHANGED IN THE FOREIGN
EXCHANGE MARKET.
 UNIQUENESS OF THE FOREX MARKET

• ITS HUGE TRADING VOLUME REPRESENTING THE LARGEST ASSET CLASS IN THE WORLD LEADING TO
HIGH LIQUIDITY;
• ITS GEOGRAPHICAL DISPERSION;
• ITS CONTINUOUS OPERATION: 24 HOURS A DAY EXCEPT WEEKENDS, I.E., TRADING FROM 22:00 GMT
ON SUNDAY (SYDNEY) UNTIL 22:00 GMT FRIDAY (NEW YORK);
• THE VARIETY OF FACTORS THAT AFFECT EXCHANGE RATES;
• THE LOW MARGINS OF RELATIVE PROFIT COMPARED WITH OTHER MARKETS OF FIXED INCOME; AND
• THE USE OF LEVERAGE TO ENHANCE PROFIT AND LOSS MARGINS AND WITH RESPECT TO ACCOUNT
SIZE.
 CHARACTERISTICS

Geographical Market Lower

Market Size Transparency
Extent Participants Trading Cost

Strong
High
Market Hours Leverage Market
Liquidity
Trends
PARTICIPANTS OF FOREX MARKET
Foreign Exchange Regulation Act (FERA)
Parliament of India passed the Foreign Exchange
Regulation Act in 1973
FERA came into force from January 1, 1974.
FERA was repealed in 1998 by Vajpayee Government
FERA has 81 sections
FERA was conceived with the notion that Foreign
Exchange is a scarce resource.
FERA rules regulated foreign payments.
The objective of FERA was conservation of Foreign
Exchange
The definition of “Authorized Person” was narrow.
Banking units did not come under the definition of
Authorized Person.
Foreign Exchange Management Act (FEMA)
Parliament of India enacted Foreign Exchange
Management Act (FEMA) on 29 December 1999
replacing FERA.
FEMA came into force from June 2000.
FEMA succeeded FERA
FEMA has 49 sections
FEMA was conceived with the notion that Foreign
Exchange is an asset.
FEMA focused on increasing the foreign exchange
reserves of India, focused on promoting foreign
payments and forein trade.
The objective of FEMA is Management of Foreign
Exchange
The definition of “Authorized Person” was widened
Banking units came under the definition of Authorized
Person.
ROLE OF A FOREX
MANAGER Idea about the Historical Development of the
International Trade and Evolvement of Forex
Management

Forecast the Future Trends

Comparative Analytical Skills

Knowledge of Forex Market

Knowledge of Interest Rates

Willingness to Undertake Risk

Hedging Strategies
 Foreign Market

Whole sale
Retail Segment
Segment
Established in 1958, FEDAI (Foreign Exchange Dealers' Association of India) is a group of banks that deals in
foreign exchange in India as a self regulatory body under the Section 25 of the Indian Company Act (1956).

The role and responsibilities of FEDAI are as follows:

• Formulations of FEDAI guidelines and FEDAI rules for Forex business.

• Training of bank personnel in the areas of Foreign Exchange Business.
• Accreditation of Forex Brokers.
• Advising/Assisting member banks in settling issues/matters in their dealings.
• Represent member banks on Government/Reserve Bank of India and other bodies.
• Rules of FEDAI also include announcement of daily and periodical rates to its member banks.

FEDAI guidelines play an important role in the functioning of the markets and work in close coordination with
Reserve Bank of India (RBI), other organizations like Fixed Income Money Market and Derivatives Association
(FIMMDA), the Forex Association of India and various other market participants.
FOREIGN EXCHANGE

• FOREIGN EXCHANGE, ALSO TERMED AS FOREX

REFERS TO THE CONVERSION OF ONE COUNTRY’S
CURRENCY INTO ANOTHER COUNTRY’S CURRENCY.
A SINGLE COUNTRY’S CURRENCY IS VALUED
AGAINST ANOTHER’S CURRENCY OR AGAINST A
BASKET OF CURRENCIES.

• THE GLOBAL FOREIGN EXCHANGE MARKET

INVOLVES DAILY VOLUMES RANGING IN TRILLIONS
OF DOLLARS THEREBY MAKING IT THE LARGEST
FINANCIAL MARKET IN THE WORLD. FOREIGN
EXCHANGE TRANSACTIONS ARE EXECUTED OVER
THE COUNTER AND THERE IS NO SPECIFIC
CENTRALISED MARKET FOR THE SAME.
THE FOREIGN EXCHANGE MARKET IS A FLOOR PROVIDED FOR BUYING, SELLING,
EXCHANGING AND SPECULATION OF CURRENCIES. FOREIGN EXCHANGE MARKET ALSO
UNDERTAKES CURRENCY CONVERSION FOR INVESTMENTS AND INTERNATIONAL TRADE.
THE FOREIGN EXCHANGE MARKETS ALSO TERMED AS, FOREX MARKETS, CONSISTS OF
INVESTMENT MANAGEMENT FIRMS, CENTRAL BANKS, COMMERCIAL COMPANIES, RETAIL
FOREX BROKERS, AND INVESTORS.
 TYPES OF FOREIGN EXCHANGE
TRANSACTIONS

• SPOT TRANSACTIONS
THIS METHOD OF TRANSACTION IS THE FASTEST WAY TO EXCHANGE CURRENCIES. SPOT
TRANSACTION REFERS TO THE EXCHANGE OR SETTLEMENT OF THE CURRENCIES BY THE BUYER AND
SELLER WITHIN TWO DAYS OF THE DEAL WITHOUT A SIGNED CONTRACT. THE SPOT EXCHANGE RATE
IS THE PREVAILING EXCHANGE RATE IN THE MARKET.
FORWARD TRANSACTIONS
FORWARD TRANSACTIONS ARE FUTURE TRANSACTIONS WHEN THE BUYER AND SELLER ENTER INTO
AN AGREEMENT OF PURCHASE AND SALE OF CURRENCY AFTER 90 DAYS. THE AGREEMENT IS
FRAMED ON THE BASIS OF A FIXED EXCHANGE RATE FOR A DEFINITE DATE IN THE FUTURE. THE RATE
AT WHICH THE DEAL IS FIXED IS TERMED AS FORWARD EXCHANGE RATE.
 TYPES OF FOREIGN EXCHANGE
TRANSACTIONS
• FUTURE TRANSACTION

FUTURE TRANSACTIONS ALSO DEALS WITH CONTRACTS IN THE SAME MANNER AS FORWARD TRANSACTIONS.
HOWEVER, IN CASE OF FUTURE TRANSACTIONS, STANDARDIZED CONTRACTS IN TERMS OF FEATURES, DATE,
AND SIZE SHOULD BE FOLLOWED. WHEREAS, REGULAR FORWARD TRANSACTIONS HAVE FLEXIBILITY AND CAN
BE CUSTOMISED. IN FUTURE TRANSACTIONS, AN INITIAL MARGIN IS FIXED AND KEPT AS COLLATERAL IN
ORDER TO ESTABLISH A FUTURE POSITION.
• SWAP TRANSACTIONS

A SIMULTANEOUS LENDING AND BORROWING OF TWO DIFFERENT CURRENCIES BETWEEN TWO INVESTORS
ARE REFERRED TO AS SWAP TRANSACTION. ONE INVESTOR BORROWS A CURRENCY AND REPAYS IN THE FORM
OF A SECOND CURRENCY TO THE SECOND INVESTOR. SWAP TRANSACTIONS ARE DONE TO PAY OFF
OBLIGATIONS WITHOUT SUFFERING A FOREIGN EXCHANGE RISK.
 TYPES OF FOREIGN EXCHANGE
TRANSACTIONS
• OPTION TRANSACTIONS
THE EXCHANGE OF CURRENCY FROM ONE DENOMINATION TO ANOTHER AT AN
AGREED RATE ON A SPECIFIC DATE IS AN OPTION FOR AN INVESTOR. EVERY
INVESTOR OWNS THE RIGHT TO CONVERT THE CURRENCY BUT IS NOT OBLIGATED
TO DO SO.
 TYPES OF EXCHANGE RATES

• SPOT RATE
• THE SPOT RATE IS THE CURRENT EXCHANGE RATE FOR ANY CURRENCY. IT IS THE RATE AT WHICH
YOUR CURRENCY SHALL BE CONVERTED IF YOU DECIDED TO EXECUTE A FOREIGN TRANSACTION
“RIGHT NOW”. THEY REPRESENT THE DAY-TO-DAY EXCHANGE RATE AND VARY BY A FEW BASIS
POINTS EVERY DAY.
• ADVANTAGE: TRADING AT A SPOT RATE DOES NOT REQUIRE DEEP MATHEMATICAL OR STATISTICAL
ANALYSIS. IT IS WHAT IT IS. IT IS A STRAIGHTFORWARD RATE WITHOUT ANY AMBIGUITY.
• DISADVANTAGE: SPOT RATES CAN BE A MISLEADING INDICATOR IN TIMES OF ECONOMIC CRISIS,
UNREASONABLE DEMAND OR SUPPLY PATTERNS OR TEMPORARY TRANSITIONAL PHASES IN AN
ECONOMY.
 TYPES OF EXCHANGE RATES

• A FORWARD RATE IS A ONE THAT IS DETERMINED AS PER THE TERMS OF A FORWARD CONTRACT. IT STIPULATES THE PURCHASE OR
SALE OF A FOREIGN CURRENCY AT A PREDETERMINED RATE AT SOME DATE IN THE FUTURE. A FORWARD CONTRACT IS GENERALLY
ENTERED INTO BY EXPORTERS AND IMPORTERS WHO ARE EXPOSED TO FOREX FLUCTUATIONS. THE FORWARD RATE IS QUOTED AT
A PREMIUM OR DISCOUNT TO THE SPOT PRICE.

• ADVANTAGE: A FORWARD CONTRACT FREEZES THE RATE OF EXCHANGE FOR BOTH THE PARTIES AND THUS ELIMINATES THE
ELEMENT OF UNCERTAINTY. THEREFORE, IT PROVIDES A COMPLETE HEDGE AGAINST ALL UNRULY MOVEMENTS IN THE MARKET.

• DISADVANTAGE: A FORWARD CONTRACT IS NOT BACKED BY ANY EXCHANGE. THEREFORE THE POSSIBILITY OF DEFAULT IS QUITE
HIGH. ALSO FREEZING THE RATES MAY PROVE TO BE A LOSS-MAKING DECISION IN SOME SITUATIONS. FOR EXAMPLE, A LONG
FORWARD IN A BEARISH MARKET OR A SHORT FORWARD IN A BULLISH MARKET ARE INSTANCES OF THE FORWARD BACKFIRING.
 INTERPRETING CURRENCY EXCHANGE
QUOTES

• DIRECT & INDIRECT QUOTES

• A DIRECT CURRENCY QUOTE USES THE DOMESTIC OR HOME CURRENCY AS THE BASE.
FOR EXAMPLE, FOR AN AMERICAN NATIONAL, THE DIRECT CURRENCY QUOTE TO
OBTAIN EUROS WILL LOOK LIKE USD/EUR 1.17.
• AN INDIRECT CURRENCY QUOTE DENOTES THE DOMESTIC CURRENCY AS THE
QUOTED CURRENCY. OR IN SIMPLER TERMS, THE VALUE OF OUR HOME CURRENCY IS
EXPRESSED IN TERMS OF THE FOREIGN CURRENCY SOUGHT TO BE ACQUIRED OR SOLD.
FOR EXAMPLE, EUR/USD 0.87. THIS MEANS THAT A EUROPEAN CURRENCY HOLDER WILL
HAVE TO GIVE UP 0.87 EUROS TO ACQUIRE 1 USD.
• BID & ASK PRICE
• IN THE PRACTICAL LIFE, CURRENCY QUOTES ARE ALWAYS QUOTED AS USD/EUR 1.1681-
1.1685
THE FORMER PART OF THE QUOTE USD/EUR 1.1681 IS KNOWN AS THE BID RATE. BID
RATE IS THE RATE AT WHICH THE BANK WILL PAY YOU SHOULD YOU GO TO IT TO BUY
EUROS AGAINST USD. IT IS NOTHING BUT THE BUYING RATE FOR THE BANK.
• THE LATTER PART OF THE QUOTE USD/EUR 1.1685 IS KNOWN AS THE ASK RATE. ASK
RATE IS THE RATE WHICH THE BANK “ASKS” FROM YOU TO OBTAIN A UNIT OF EURO
AGAINST VALUE IN DOLLAR. IT IS NOTHING BUT THE SELLING RATE FOR THE BANK.
• IT IS IMPORTANT TO KNOW THAT THE ASK RATE WILL ALWAYS EXCEED THE BID RATE.
THE BANK WILL ALWAYS BUY AT A LOWER RATE AND SELL AT A HIGHER RATE. THE
SIMPLE REASON FOR IT BEING THAT THE DIFFERENCE IS THE MARGIN THAT THE BANK
EARNS FOR FACILITATING SUCH CURRENCY EXCHANGE.
• ASK RATE > BID RATE
• INVERSE RATE

1/ BID RATE = ASK RATE

1/ ASK RATE = BID RATE
 CROSS CURRENCY RATE

• RESERVE CURRENCY OR AN ANCHOR CURRENCY IS ESSENTIALLY THE ONE IN TERMS OF WHICH

MOST OTHER CURRENCIES ARE EXPRESSED. SUCH CURRENCY IS HELD IN LARGE AMOUNTS BY
GOVERNMENTS AS FOREX RESERVES. THE US DOLLAR IS CURRENTLY THE MOST WIDELY HELD
RESERVE CURRENCY FOLLOWED BY THE EURO.

• CONSEQUENTLY, A CURRENCY QUOTE NOT EXPRESSED IN TERMS OF USD IS KNOWN AS A CROSS

RATE. ALL DOMINANT AND FREQUENTLY TRADED CURRENCIES ARE TRANSLATED IN TERMS OF
USD. HOWEVER, CERTAIN TRANSACTIONS MAY BE SUCH THAT THEY DO NOT CONTAIN THE
DOLLAR COMPONENT AT ALL. IN SUCH CASES, THE CURRENCY QUOTES ARE REQUIRED TO BE
EXPRESSED AT A RATE RELATIVE TO ONE ANOTHER TO FACILITATE THAT EXCHANGE.
 CROSS CURRENCY RATE
• THE FOLLOWING EXAMPLE SHALL CLEAR THE CONCEPT.
• A MANUFACTURER IN GERMANY WANTS TO OBTAIN CERTAIN AUTOMOBILE PARTS
FROM A SUPPLIER IN AUSTRALIA. THE SUPPLIER ONLY ACCEPTS PAYMENT IN
AUSTRALIAN DOLLARS (AUD). THEREFORE, THE GERMAN MANUFACTURER WILL
BE COMPULSORILY REQUIRED TO CONVERT EUR TO AUD TO CLOSE THE
CONTRACT. THE AMOUNT PAYABLE TO THE AUSTRALIAN SUPPLIER IS AUD 350,000.
• THE FOLLOWING QUOTES ARE QUOTED BY THE EXCHANGE.
EUR/USD 1.1670-1.1674
USD/AUD 1.3561-1.3570
• THE QUOTE RELEVANT TO THE GERMAN MANUFACTURER IS EUR/AUD
THEREFORE, THE SAME IS OBTAINED BY CARRYING OUT THE SIMPLE WORKING
MENTIONED BELOW
The simple multiplication of (bid*bid)-(ask*ask) gives the required cross rate.
= (1.1670*1.3561) -(1.1674-1.3570)
=1.5826-1.5841
Therefore, the amount payable to the bank to obtain AUD 350,000 is
(350,000/1.5841) EUR 220,945.1,2