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									The Foreign Exchange Market
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Foreign Exchange Market
• The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the largest financial market in the world, with a daily average turnover of US$1.9 trillion — 30 times larger than the combined volume of all U.S. equity markets. • "Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY). • Foreign Exchange Market:The market where one country’s currency is traded for another’s.

International Foreign Exchange Market
It is the oldest and largest financial market in the world—more than $1 trillion. – Participants: importers, exporters, traders, foreign exchange brokers, speculators, portfolio managers. – FEM is essentially OTC market: No central location – FEM has no central trading floor where buyers and sellers meet. – FEM extends from Tokyo and Sydney in the East to New York and San Francisco in the West. – Is open twenty-four hours a day, except for short gaps on weekends. – Global banks account for about two-thirds of the market volume, while foreign exchange brokers and dealers account for approximately 20 percent. – Speculative transactions account for more than 95 per cent of the turnover of FEM.

Foreign Exchange Market in India
• Very small market • Key participants: RBI, authorized Banks, and Business undertakings. • FEM in India is a Controlled market by RBI • Business undertakings can participate in the FEM in India only to the extent that they need cover for exchange exposure arising from merchant transaction (can not involve in speculative transactions) • Banks are permitted to have net overbought or oversold subject limits notified by the RBI.

How a Foreign Exchange Transaction is Conducted

Location of the Foreign Exchange Market 1. OTC-type: no specific location
2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Inter-bank Telecommunications Financial

Participants in the Foreign Exchange Market 1. Wholesale Level (95%) - major banks
2. Retail Level - business customers.

Participants in the Foreign Exchange Market
• Commercial & Investment Banks (―Inter-bank‖ market)
– – – – amounts > $1m, typically $10m liquid market (vis-à-vis loans) with limited credit exposure for clients and themselves allows ―bit‖ players to economize on transactions costs

• Central Banks
– non-commercial motives – relatively small portion of trading volume – may intervene to address perceived economic/financial imbalances

• Hedge Funds
– partnership of high net-worth individuals – highly leveraged global investing – add liquidity, flexibility, and sometimes instability to FX markets

• Corporations
– mostly act through intermediaries

• Individuals
– tourists ~ insignificant volume

• Intermediaries – Brokers
– mostly service commercial banks and trading houses – anonymous – connected to many banks ~ shop for best price (exchange rate)

• Direct Dealing
– through dealing system – quotes valid for 20 sec.

Exchange Control Regimes
• Fixed Exchange Rate vis-à-vis One Currency (Official parity) – This was adopted under Bretton-woods Agreement in 1945 – allows ―bit‖ players to economize on transactions costs • Fixed Exchange Rate vis-à-vis a Basket – This system adopted after 1972 – A target parity for a basket of currencies was adopted – European Currency Unit (ECU) – Basket is revised every five years • Flexible Exchange Rates – Form 1996 most of the countries adopted

Exchange Rates
• Exchange Rate = Relative Price of Currencies • Exchange Rate: The price of one currency expressed in terms of another. • Direct Quote (Natural or Right Quote/American Terms): The exchange rate for a foreign currency is quoted in terms of the number of units of local currency that are equal to a unit of the foreign currency. (Rs.45 for one dollar) • dollar price of 1 unit foreign currency; $/FX1 = dollars per unit foreign exchange

• used in futures market

• Indirect Quote (Reverse or Left Quote/European Terms): The exchange rate for a foreign currency is quoted in terms of the number of units of foreign currency that are equal to a unit of the local currency. ($2.25 for Rs. 100) • foreign currency price of $; FX/$1
• used in Cash market. Most currencies quoted this way, except £

• Spot Exchange Rate: The rate applicable to transactions in which settlement (delivery) is made in two business days after the date of transaction.
• Forward Exchange Rate: The exchange rate fixed today but the settlement is at some specified date in the future.

How to Read a Currency Quote
• • • • • Currency Pair Base Currency Quote Currency Bid Price Ask Price


Foreign Exchange Exposure (Risk)
• Foreign Exchange Risk: The risk that the value of
a future receipt or obligation will change due to variations in foreign exchange rates.

• Types of Foreign Exchange (Risk) Exposure
– Transaction exposure – Translation exposure – Economic exposure (Operating)

Types of Foreign Exchange Risk Exposure
• Transaction Exposure: The risk that the revenues
or costs associated with a transaction expressed in terms of the domestic currency changes due to exchange rate variations.

• Translation Exposure: Foreign exchange risk
resulting from the conversion of a firm’s foreigncurrency-denominated assets and liabilities into the domestic currency value.

• Economic Exposure: The risk that changes in
exchange values might alter today’s value of a firm’s future income streams

Hedging Foreign Exchange Risk
• Hedging: The act of offsetting or eliminating risk

• Covered Exposure: A foreign exchange risk that
has been completely eliminated with a hedging instrument. • Forward contract for foreign exchange • Derivative instruments

Foreign Currency Accounts
• Nostro Account (our account with you): The foreign currency account maintained by banks in India with banks aboard. • The currency of the account depends on the currency of the country where the account is maintained • All foreign exchange transactions are routed through Nostro accounts. • Maintenance of minimum balance is necessary. • It is just like current account • Vostro Account (your account with us): Foreign banks may open rupee accounts with Indian banks. • The account is also known as non-resident account.

• Vostro Account (your account with us): Foreign
banks may open rupee accounts with Indian banks.
• The account is also known as non-resident account.

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