project of foreign exchange market
- 1. 1 TABLE OF CONTENT INTRODUCTION 5 HISTORY 7 SUMMARY 8 WHY THE FOREIGN EXCHANGE MARKET IS UNIQUE ? 9 ADVANTAGES & DISADVANTAGE OF FOREIGN EXCHANGE MARKET 10 VARIOUS PARTICIPANTSOF FOREIGN EXCHANGE MARKET 11 CHARACTERISICS OF FOREIGN EXCHANGE MARKET 14 FINANCIAL INSTRUMENTS OF FOREIGN EXCHANGE MARKET 15 FUNCTION OF FOREIGN EXCHANGE MARKET 16 TYPES OF FOREIGN EXCHANGE MARKET 17 FACTORS AFFECTING MOVEMENT OF EXCHANGE RATES 18 PLAYERS IN FOREIGN EXCHANGE MARKET 24 FOREIGN EXCHANGE RISK 28 FOREIGN EXCHANGE MARKET IN INDIA 32 CONCLUSION 34 REFERENCES 36
- 2. 2 INTRODUCTION Being the main force driving the global economic market, currency is no doubt an essential element for a country. However, in order for all the countries with different currencies to trade with one another, a system of exchange rate between their currencies is needed; this system, is formallyknownasforeignexchangeorcurrencyexchange. In the early days, the system of currency exchange is supported solely by the gold amount held in the vault of a country. However, this system is no longer appropriate now due to inflation and hence, the value of one’s currency nowadays is determined through the market forces alone. In order to determine the value of a currency’s exchange rate, two main types of system is used whichisfloatingcurrencyandpeggedcurrency. For floating exchange rate, its value is determined by the supply and demand of the global market where the supply and demand is bound by all these factors such as foreign investment, inflation and ratios of import and export. Normally, this system is adopted by most of the advance countries like for example UK, US and Canada. All of these countries have a similarity where their market is well developed and stable in economic terms. These countries choose to practice this system due to the reason where floating exchange rate is proven to be much more efficient compared to the pegged exchange rate. The reason behind this is because for floating exchange rate, the market itself will re-adjust the exchange rate real-time in order to portray the actual inflation and other economic forces. However, every system has its own flaw and so does the floating exchange rate system. For instance, if a country suffers from economic instability due to various reasons such as political issues, a floating exchange rate system will certainly discourage investment due to the high risk of suffering from inflationary disaster or sudden slum in exchangerate. Another form of exchange rate is known as pegged exchange rate. This is a system where the value of the exchange rate is fixed by the government of a country and not the supply and demand of the market. This system is called pegged exchange rate because the value
- 3. of a country’s currency is fixed to another country’s currency. As a result, the value of the pegged currency will not fluctuate unlike the floating currency. The working principle behind this system is slightly complicated where the government of a country will fixed the exchange rate of their currency and when there is a demand for a certain currency resulting a rise in the exchange rate, the government will have to release enough of that currency into the market in order to meet that demand. However, there is a fatal flaw in this system where if the pegged exchange rate is not controlled properly, panics may arise within the country and as a result of that, people will be rushing to exchange their money into a more stable currency. When that happens, the sudden overflow of that country’s currency into the market will decrease the value of their exchange rate and in the end, their currency will be worthless. Due to this reason, only those under-developed or developing countries will practice this method as a form to control the inflationrate. However, the truth is, most of the countries do not fully practice the floating exchange rate or the pegged exchange rate method in reality. Instead, they use a hybrid system known as floating peg. Floating peg is the combination of the two main systems where one country will normally fixed their exchange rate to the US Dollars and after that, they will constantly review their peg rate in order to stay in line with the actual market value. The Foreign exchange market, or commonly known as FOREX, is the largest and most prolific financial market because each day, more than 1 trillion worth of currency exchange takes place between investors, speculators and countries. From this, we can deduce that the actual mechanism behind the world of foreign exchange is far more complicated than what we may already know, and that, the information mentioned earlier is just the tip of an iceberg. 3
- 4. 4 HISTORY The foreign exchange market (fx or forex) as we know it today originated in 1973. However, money has been around in one form or another since the time of Pharaohs. The Babylonians are credited with the first use of paper bills and receipts, but Middle Eastern moneychangers were the first currency traders who exchanged coins from one culture to another. During the middle ages, the need for another form of currency besides coins emerged as the method of choice. These paper bills represented transferable third-party payments of funds, making foreign currency exchange trading much easier for merchants and traders and causing these regional economies to flourish. From the infantile stages of forex during the Middle Ages to WWI, the forex markets were relatively stable and without much speculative activity. After WWI, the forex markets became very volatile and speculative activity increased tenfold. Speculation in the forex market was not looked on as favorable by most institutions and the public in general. The Great Depression and the removal of the gold standard in 1931 created a serious lull in forex market activity. From 1931 until 1973, the forex market went through a series of changes. These changes greatly affected the global economies at the time and speculation in the forex markets during these times was little, if any. 1944 – Bretton Woods Accord is established to help stabilize the global economy after World War II. 1971 Smithsonian Agreement established to allow for greater fluctuation band for currencies. 1972 European Joint Float established as the European community tried to move away from its dependency on the U.S. dollar. 1973 Smithsonian Agreement and European Joint Float failed and signified the official switch to a free-floating system.
- 5. 5 1978 The European Monetary System was introduced so other countries could try to gain independence from the U.S. dollar. 1978 Free-floating system officially mandated by the IMF. 1993 European Monetary System fails making way for a world-wide free-floating system. SUMMARY The foreign exchange market is the mechanism by which a person of firm transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, and minimizes exposure to foreign exchange risk. A foreign exchange transaction is an agreement between a buyer and a seller that a given amount of one currency is to be delivered at a specified rate for some other currency. A foreign exchange rate is the price of a foreign currency. A foreign exchange quotation or quote is a statement of willingness to buy or sell at an announced rate. The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market. Participants include banks and nonbank foreign exchange dealers, individuals and firms conducting commercial and investment transactions, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers. Transactions are effectuated either on a spot basis or on a forward or swap basis. A spot transaction is for an (almost) immediate value date while a forward transaction is for a value date somewhere in the future. Quotations can be classified either as European and American terms or as direct and indirect quotes. In the real world, quotations include a bid-ask spread. A bid is the exchange rate in one currency at which a dealer will buy another currency. An ask is the exchange rate at which a dealer will sell the other currency. The spread is the difference between the bid price and the ask price. This spread reflects the existence of commissions and transaction costs. A cross rate is an exchange rate between two currencies, calculated from their common relationship with a third currency.
- 6. Why the foreign Exchange Market is Unique? its huge trading volume representing the largest asset class in the world leading tohigh 6 liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT onSunday until 22:00 GMT Friday; 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. As such, it has been referred to as the market closest to the ideal of perfect competition,notwithstanding currency intervention by central banks. According to the Bank for InternationalSettlements,as of April 2010, average dailyturnoverin global foreign exchange markets isestimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volumeas of April 2007. Some firms specializing on foreign exchange market had put the average dailyturnover in excess of US$4 trillion. The $3.98 trillion break-down is as follows: $1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps
- 7. 7 $43 billion currency swaps $207 billion in options and other product. ADVANTAGES AND DISADVANTAGES OF FOREIGN EXCHANGE MARKET. Advantages The forex market is extremely liquid, hence its rapidly growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum. As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis apart from weekends. An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in this regard. It is an unregulated market, meaning that there is no trade commission over seeing transactions and there are no restrictions on trade. In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is an attractive advantage. Disadvantages The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at least, such a failure could bring ruin to the forex market asa whole.
- 8. Investors need a lot of capital to make good profits because the profit margins on small-scale 8 trades are very low. Various participants Of foreign Exchange Market: Governments: Governments have requirements for foreign currency, such as paying staff salaries and local bills for embassies abroad, or for arraigning a foreign currency credit line, most often in dollars, for industrial or agricultural development in the third world, interest on which ,as well as the capital sum, must periodically be paid. Foreign exchange rates concern governments because changes affect the value of product and financial instruments, whichaffects the health of a nation’s markets and financial systems. Banks: There are different types of banks, all of which engage in the foreign exchange market to greater or lesser extent. Some work to signal desired movement in the market without causing overt change, while some aggressively manage their reserves by making speculative risks. The vast majority, however, use their knowledge and expertise is assessing market trends for speculative gain for their clients Brokering Houses: These exist primarily to bring buyer and seller together at a mutually agreed price. The broker is not allowed to take a position and must act purely as a liaison. Brokers receive a commission from both sides of the transaction, which varies according to currency handled. The use of human brokers has decreased due mostly to the rise of the interbank electronic brokerage systems International Monetary Market: The International Monetary Market (IMM) in Chicago trades currencies for relatively small contract amounts for only four specific maturities a year. Originally designed for the small investor, the IMM has grown since the early 1970s, and the
- 9. major banks, who once dismissed the IMM, have found that it pays to keep in touch with its developments, as it is often a market leader Money Managers: These tend to be large New York commission houses that are often very aggressive players in the foreign exchange market. While they act on behalf of their clients, they also deal on their own account and are not limited to one time zone, but deal around the world through their agents.6. Corporations: Corporations are the actual end-users of the foreign exchange market. With the exception only of the central banks, corporate players are the ones who affect supply and demand. Since the corporations come to the market to offset currency exposure they permanently change the liquidity of the currencies being dealt with. Retail Clients: This includes smaller companies, hedge funds, companies specializing in investment services linked by foreign currency funds or equities, fixed income brokers, the financing of aid programs by registered worldwide charities and private individuals. Retail investors trade foreign exchange using highly leveraged margin accounts. The amount of their trading in total volume and in individual trade amounts is dwarfed by the corporations andinter bank markets. Central Bank External value of the domestic currency is controlled and assigned by central bank of everycounty. Each country has a central or apex bank. For example In India Reserve Bank of Indiais the central Bank Commercial Bank Commercial banks are the one which has the most number of branches. With its wide branchnetwork the Commercial banks buy the foreign exchange and sell it to the importers. These banks are the most active among the market players and also provide services like convertingcurrency from one to another. 9 Exchange Brokers
- 10. 10 Services of brokers are used to some extent, Forex market has some practices and traditiondepending on this the residing in other countries are utilised.Local brokers canconduct Forex transactions as per the rules and regulations of the Forex governing body of their respective country. Overseas Forex market :The Forexmarket operates all around the clock and the market day initiates with Tokyo andfollowed by Bahrain Singapore, India, Frankfurt, Paris, London, New York, and Sydney before things are back with Tokyo the next day Speculators In order to make profit on the account of favourable exchange rate, speculators buy foreign currency if it is expected to appreciate and sell foreign currency if it is expected to depreciate. They follow the practice of delaying covering exposures and not offering a cover till the time cash flow is materialized. Other financial institutions involved in the foreign exchange market include: Stock brokers Commodity Firms Insurance Companies Charities Private Institutions Private Individuals
- 11. 11 Characteristics Of Foreign Exchange Market Changing Wealth: The ratios between the currencies of two countries are exchange rates in forex. If one currency loss its value in the market and at the same time the value of the another currency increases this causes the fluctuations in the exchange rate in foreign exchange market. For Example, over 20 years ago a single US dollar bought 360 Japanese Yen, whereas at present1 US dollar buys 110 Japanese Yen; this explains that the Japanese Yen has risen in value ,and the US dollar has decreased in value (relative to the Yen). This is said to be a shift in wealth, as a fixed amount of Japanese Yen can now purchase many more goods than two decades ago . No Centralized Market The foreign exchange market does not have a centralized market like a stock exchange. Brokers in the foreign exchange market are not approved by a governing agency. Business network and operation market of foreign exchange takes place without any unification in transaction. Foreign exchange currency trading has been reformed into a non-formal and global network organization it consists of advanced information system. Trader of forex should not be a member of any organisation. Circulation work Foreign exchange market has member from all the countries, each country has differentgeo graphical positions so forex operates all around the clock on working days (i.e.) Mondayto Friday every week. Because the time in Australia is different than in European countries, this kind of 24 hours operation, free from any time is an ideal environment for investors. For instance, a trader may buy the Japanese Yen in the morning at the New York market, and in
- 12. the night if the Japanese Yen rises in the Hong Kong market, the trader can sell in the HongKong market. more number of opportunities are available for the forex traders. In FOREX market most trading takes place in only a few currencies; the U.S. Dollar ($), European Currency Unit (€), Japanese Yen (¥), British Pound Sterling (£), Swiss Franc (Sf), Canadian Dollar (Can$), and to a lesser extent, the Australian and New Zealand Dollars 12 Financial Instruments of foreign exchange market Spot Market Spot market involves the quickest transaction in the foreign exchange market. This involves immediate payment at the current exchange rate is called as spot rate. The spot market accounts for 1/3rdof all the currency exchange, trades in Federal Reserve that takes place within two days of the agreement. The traders open to the volatility of the currency market, which can raise or lower the price between the agreement and the trade. Futures Market These kind transactions involve future payment and future delivery at an agreed exchange rate. Future market contracts are standardized, it is non-negotiable and the elements of the agreement are set. It also takes the volatility of the currency market, specifically the spot market, out of the equation. This type of market is popular for Steady return on their investment that is done on large currency transactions. Forward Market the terms are negotiable between the two parties. The terms can be changes according to the needs of the participants. It allows for more flexibility. Two entities swap currency for an agreed amount of time, and then return the currency at the end of the contract. Swap Transactions In swap two parties are involves where they exchange the currencies for certain time and agree to reserve the transaction at a later date. Swap is the most commonly used forward
- 13. transaction. In swap transaction it is not traded through the exchange and there is no standardization. Until the transaction is completed the deposit is required to hold the position. 13 Functions of the Foreign Exchange Market The foreign exchange market is the mechanism by which a person of firm transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, and minimizes exposure to foreign exchange risk. Transfer of Purchasing Power Transfer of one country to another and from one national currency to another is called the transfer of purchasing power. International transactions normally involve different people from countries with different national currencies. Credit instruments and bank drafts are used to transfer the purchasing power this is one of the important function in forex. In forex the transaction can only be done in one currency. Provision of credit for foreign trade The forex takes time to move the goods from a seller to buyer so the transaction must be financed. Foreign exchange market provides credit to the traders. Credit facility is need by exporters when the goods are transited. Goods some on the other need credit facility when this kind of special credit facility is used the forex exchange department is extended to finance the foreign trade Foreign Exchange Dealers Foreign exchange dealers, deal both with interbank and client market. The profit of the dealers is there buying at a bid price and sells it at a high price. Worldwide competitions among dealers
- 14. narrows the spread between bid and ask and so contributes to making the foreign exchange market efficient in the same sense as securities markets. Dealers in the foreign exchange departments of large international banks often function as market makers. They stand willing to buy and sell those currencies in which they specialize by maintaining an inventory position in those currencies. Minimizing Foreign Exchange Risk: The foreign exchange market provides "hedging" facilities for transferring foreign exchange risk to someone else. 14 Types of Foreign Exchange Rates :Floating Rates Floating rates is one of the primary reasons for fluctuation of currency in foreign exchangemarket. This is one of the most important commonly and main type of exchange rate. Under this market force all the economies of developed countries allow there currency to flowfreely. When the value of the currency becomes low it makes the imports more and theexports are cheaper, so the countries domestic goods and services are demanded more inforeign buyers. The country can withstand the fluctuation only if the economy is strong. When the country’s economy is able to meet the demand then it can adjust between the foreign trade and domestic trade automatically. Fixed Rates Fixed exchange rates are used to attract the foreign investments and to promote foreign trade.This type of rates is used only by small developed countries. By Fixed exchange rates thecountry assures the investors for the stable and constant value of investment in the country. Amonetary policy of the country becomes ineffective. In this type the exchange rates theimports become expensive. The exchange value of the currency does not move. This normally reduces the country’s currency against foreign currencies. Pegged Rates This rate is between the floating rate and the fixed rate. Pegged rates appropriate more for developed country. A country allows its currency to fluctuation to some extend for a
- 15. adjustedcentral value. Pegged allow some adjustments and stability. No artificial rates are found infixed and floating exchange rates. Pegged can fix the economic problem by itself and provide growth opportunity also. When a fixed value is not maintains by the country it can’t follow the fixed exchange rat 15 Factors affecting Movement of Exchange Rates Aside from factors such as interest rates and inflation ,exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to every free market economy in the world. For this reason, exchange rates are among the most watched ,analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. Here we look at some of the major forces behind exchange rate movements. Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it. Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics ,the relative importance of these factors is subject to much debate. . Differentials in Inflation As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan ,Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher
- 16. inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. . Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. Current-Account Deficits The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. Public Debt Countries will engage in large-scale deficit financing to pay for public sector project sand governmental funding. While such activity stimulates the domestic economy ,nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering 16
- 17. their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard& Poor's, for example) is a crucial determinant of its exchange rate 17 . Terms of Trade Trade of goods and services between countries is the major reason for the demand and supply of foreign currencies. A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners. This is a typical case for underdeveloped countries which rely on imports for development needs. The current account balance(deficit or surplus) thus reflects the strength and weakness of the domestic currency. 6. Fundamental Factors viz. Political Stability and Economic Performance Fundamental factors include all such events that affect the basic economic and fiscal policies of the concerned government. These factors normally affect the long-term exchange rates of any currency. On short-term basis on many occasions, these factors are found to be rather inactive unless the market attention has turned to fundamentals. However, in the long run exchange rates of all the currencies are linked to fundamental causes. The fundamental factors are basic economic policies followed by the government in relation to inflation, balance of payment position, unemployment ,capacity utilization, trends in import and export, etc. Normally, other things remaining constant the currencies of the countries that follow the sound economic policies will always be stronger. Similar for the countries which are having balance of payment surplus, the exchange rate will always be favourable. Conversely, for countries facing balance of payment deficit, the exchange rate will be adverse. Continuous and ever growing deficit in balance of payment indicates over valuation of the currency concerned and the dis-equilibrium
- 18. created can be remedied through devaluation. Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. Political and Psychological factors Political and psychological factors are believed to have an influence on exchange rates.Many currencies have a tradition of behaving in a particular way for e.g. Swiss Franc asa refuge currency. The US Dollar is also considered a safer haven currency whenever there is a political crisis anywhere in the world. Speculation Speculation or the anticipation of the market participants many a times is the prime reason for exchange rate movements. The total foreign exchange turnover worldwide is many times the actual goods and services related turnover indicating the grip of speculators over the market. Those speculators anticipate the events even before the actual data is out and position themselves accordingly in order to take advantage when the actual data confirms the anticipations. The initial positioning and final profit taking make exchange rates volatile. These speculators many times concentrate only on one factor affecting the exchange rate and as a result the market psychology tends to concentrate only on that factor neglecting all other factors that have equal bearing on the exchange rate movement. Under these circumstances even when all other factors may indicate negative impact on the exchange rate of the currency if the one factor that the market is concentrating comes out positive the currency strengthens. Capital Movement The phenomenon of capital movement affecting the exchange rate has a very recent origin. Huge surplus of petroleum exporting countries due to sudden spurt in the oil prices could not be utilized by these countries for home consumption entirely and needed to be invested elsewhere productively. Movement of these petro dollars, started affecting the exchange rates of various currencies. Capital tended to move from lower yielding to higher yielding currencies and as a result the exchange rates moved. International investments in 18
- 19. the form of Foreign direct investment (FDI) and Foreign institutional investments (FII) have become the most important factors affecting the exchange rate in today’s open world economy. Countries which attract large capital inflows through foreign investments, will witness an appreciation in its domestic currency as its demand rises. Outflow of capital would mean a depreciation of domestic currency. Intervention Exchange rates are also influenced in no small measure by expectation of changes in regulation relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market but it is also the experience that if the authorities attempt half-heartedly to counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur. In the second quarter of 1985 the movement of exchange rates of major currencies reflected the change in the US policy in favour of co-ordinated 19 exchange market intervention as a measure to bring down the value of dollar. Stock Exchange Operations Stock exchange operations in foreign securities, debentures, stocks and shares, influence the demand and supply of related currencies, thus influencing their exchange rate . Political Factors Political scenario of the country ultimately decides the strength of the country. Stable efficient government at the centre will encourage positive development in the country, creating successf ul investor confidence and a good image in the international market. An economy with a strong, positive image will obviously have a strong domestic currency. This is the reason why speculations rise considerably during the parliament elections, with various predictions of the future government and its policies. In 1998,the Indian rupee depreciated against the dollar due to the American sanctions after India conducted the Pokharan nuclear test
- 20. 20 . Others The turnover of the market is not entirely trade related and hence the funds placed at the disposal of foreign exchange dealers by various banks, the amount which the dealers can raise in various ways, banks' attitude towards keeping open position during the course of a day, at the end of the day, on the eve of weekends and holidays ,window dressing operations as at the end of the half year to year, end of the month considerations to cover operations for the returns that the banks have to submit the central monetary authorities etc. - all affect the exchange rate movement of the currencies. Value of a currency is thus not a simple result of its demand and supply, but a complex mix of multiple factors influencing the demand and supply. It’s a tight rope walk for any country to maintain a strong, stable currency, with policies taking care of conflicting demands like inflation and export promotion, welcoming foreign investments and avoiding an appreciation of the domestic currency, all at the same time.
- 21. 21 Players in Foreign Exchange Market A key goal of exchange rate economics is to understand currency returns. Exchange rates like asset prices more generally move in response to new information about their fundamental value. Over the past decade microstructure research has revealed that this ―price discovery‖ process involves different categories of market participants. Each participant’s distinct role is determined by (a) whether the agent is a liquidity maker or taker, and (b) the extent to which the agent is informed. The original FX market participants were traders in goods and services. Currencies came into existence because they solved the problem of the coincidence of wants with respect to goods. Most countries have their own currencies so international trade in goods requires trade in currencies. The motives for currency exchange have expanded over the centuries to include speculation, hedging, and arbitrage with the list of key players expanding accordingly. Beyond importers and exporters, the major categories of market participants now include asset managers, dealers, central banks, small individual (retail) traders, and most recently high-frequency traders. The Forex over the counter market is formed by different participants with varying needs and interests that trade directly with each other. These participants can be divided in two groups: the interbank market and the retail market. The Interbank Market The interbank market designates Forex transactions that occur between central banks, commercial banks and financial institutions.
- 22. Central Banks National central banks (such as the US Fed, the ECB, R.B.I.)play an important role in the Forex market. As principal monetary authority, their role consists in achieving price stability and economic growth. Their main purpose is to provide adequate trading conditions. To do so, they regulate the entire money supply in the economy by setting interest rates and reserve requirements. They also manage the country's foreign exchange reserves that they can use in order to influence market conditions and exchange rates. Central banks intervene in economic or financial imbalance in the foreign exchange market. Central banks are also responsible for stabilizing the forex market. They do this by balancing the country's foreign exchange reserves. In addition, they also have official target rates for the currencies that they are handling. Because of this role, central banks are sometimes jokingly referred to as circus performers because of the daily balancing act that they have to perform. Their intervention in the foreign exchange market is not to earn profit from foreign currency trading. Commercial Banks Traditionally known as a savings and lending institution, banks are certainly one of the major players in forex market. They are the natural players in foreign exchange as all other participants must deal with them. Foreign exchange currency trading began as an added service to deposits and loans offered by commercial banks. Banks are usually involved in both large quantities of speculative trading and also daily commercial turnover. The really big and well-established banks trade in the billions of dollars in foreign currencies every day. Commercial banks provide liquidity to the Forex market due to the trading volume they handle every day. Some of this trading represents foreign currency conversions on behalf of customers' needs while some is carried out by the banks' proprietary trading desk for speculative purpose. The profitability of foreign exchange trading is a perfect characteristic for banks to be involved. Financial Institutions Financial institutions such as money managers, investment funds, pension funds and brokerage companies trade foreign currencies as part of their obligations to seek the best investment 22
- 23. opportunities for their clients. For example, a manager of an international equity portfolio will have to engage in currency trading in order to buy and sell foreign stocks. 23 The Retail Market The retail market designates transactions made by smaller speculators and investors .These transactions are executed through Forex brokers who act as a mediator between the retail market and the interbank market. The participants of the retail market are investment firms, hedge funds, corporations and individuals / retail forex brokers and speculators.. Investment Firms Investment management firms commonly manage huge accounts on behalf of their clients such as endowments and pension funds. Sometimes, these investments require the exchange of foreign currencies so they have to facilitate these transactions through the use of the foreign exchange market. These situations exist because there are basically no limitations to the nationalities of customers that an investment firm can attract. Therefore, investment managers with an international equity portfolio, needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Hedge Funds Hedge funds are private investment funds that speculate in various assets classes using leverage. Macro Hedge Funds pursue trading opportunities in the Forex Market. They design and execute trades after conducting a macroeconomic analysis that reviews the challenges affecting acountry and its currency. Due to their large amounts of liquidity and their aggressive strategies, they are a major contributor to the dynamics of Forex Market.
- 24. Corporations They represent the companies that are engaged in import/export activities with foreign counterparts. Their primary business requires them to purchase and sell foreign currencies in exchange for goods, exposing them to currency risks. Through the Forex market, they convert currencies and hedge themselves against future fluctuations. Initially, they were not interested in foreign exchange trading, but the trend of companies going international and tight competition amongst them made them think twice . Individuals / Retail Forex Brokers Individual traders or investors trade Forex on their own capital in order to profit from speculation on future exchange rates They mainly operate through Forex platforms that offer tight spreads, immediate execution and highly leveraged margin accounts. These can be individuals or groups of individuals. They handle a fraction of the total volume of the entire forex market, but do not let that fool you. A single retail forex broker estimate retail volume of between 25 to 50 billion dollars each day. Their volume is estimated to make up 2% of the total market volume. Speculators A person, who trades in currencies with a higher than average risk in return for higher than average profit potential. These are the individuals or private investors who purchase and sell foreign currencies and profit through fluctuations on their price. Speculators are a "hardy" bunch simply because they are more adept at handling and maybe even sidestepping risks that regular investors would prefer not to be involved with. Speculators take large risks, especially with respect to anticipating future price movements, in the hope of making quick large gains. Speculators are risk-taking investors with expertise in the market(s) in which they are trading and will usually use highly leveraged investments such as futures and options 24
- 25. 25 FOREIGN EXCHANGE RISK Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies. Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately. Many businesses were unconcerned with and did not manage foreign exchange risk under the Bretton Woods system of international monetary order. It wasn't until the onset of floating exchange rates following the collapse of the Bretton Woods system that firms perceived an increasing risk from exchange rate fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge their exposure. The outbreak of currency crises in the 1990s and early 2000s, such as the Mexican peso crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso crisis, substantial losses from foreign exchange have led firms to pay closer attention to foreign exchange risk. MANAGEMENT Managers of multinational firms employ a number of foreign exchange hedging strategies in order to protect against exchange rate risk. Transaction exposure is often managed either with the use of the money markets, foreign exchange derivatives such as forward contracts, futures contracts, options, and swaps, or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting. Firms may exercise alternative strategies to financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using
- 26. 26 a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of greater inelasticity and less foreign exchange risk exposure. Translation exposure is largely dependent on the accounting standards of the home country and the translation methods required by those standards. For example, the United States Federal Accounting Standards Board specifies when and where to use certain methods such as the temporal method and current rate method. Firms can manage translation exposure by performing a balance sheet hedge. Since translation exposure arises from discrepancies between net assets and net liabilities on a balance sheet solely from exchange rate differences. Following this logic, a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be used to hedge against translation exposure. MEASUREMENT If foreign exchange markets are efficient such that purchasing power parity, interest rate parity, and the international Fisher effect hold true, a firm or investor needn't protect against foreign exchange risk due to an indifference toward international investment decisions. A deviation from one or more of the three international parity conditions generally needs to occur for an exposure to foreign exchange risk. Financial risk is most commonly measured in terms of the variance or standard deviation of a variable such as percentage returns or rates of change. In foreign exchange, a relevant factor would be the rate of change of the spot exchange rate between currencies. Variance represents exchange rate risk by the spread of exchange rates, whereas standard deviation represents exchange rate risk by the amount exchange rates deviate, on average, from the mean exchange rate in a probability distribution. A higher standard deviation would signal a greater currency risk. Economists have criticized the accuracy of standard deviation as a risk indicator for its uniform treatment of deviations, be they positive or negative, and for automatically squaring
- 27. deviation values. Alternatives such as average absolute deviation and semivariance have been advanced for measuring financial risk. 27 VALUE AT RISK Practitioners have advanced and regulators have accepted a financial risk management technique called value at risk (VAR), which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. Banks in Europe have been authorized by the Bank for International Settlements to employ VAR models of their own design in establishing capital requirements for given levels of market risk. Using the VAR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain period of time with a given probability of changes in exchange rates. TYPES OF FOREIGN EXCHANGE RISK Transaction Exposure A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. It refers to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it. Economic Exposure A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments
- 28. can severely affect the firm's market share position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities 28 Translation Exposure A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiary subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments. Contingent exposure A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.
- 29. 29 Foreign Exchange Market In India The foreign exchange market India is growing very rapidly. The annual turnover of the market is more than $400 billion. This transaction does not include the inter-bank transactions. According to the record of transactions released by RBI, the average monthly turnover in the merchant segment was $40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the same period. .The foreign exchange market India is growing very rapidly. The annual turnover of the market is more than $400 billion. This transaction does not include the inter-bank transactions. According to the record of transactions released by RBI, the average monthly turnover in the merchant segment was $40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the same period. .The average total monthly turnover was about $174.7 billion for the same period. The transactions are made on spot and also on forward basis, which include currency swaps and interest rate swaps. The Indian foreign exchange market consists of the buyers, sellers ,market intermediaries and the monetary authority of India. The main center of foreign exchange transactions in India is Mumbai, the commercial capital of the country. There are several other centers for foreign exchange transactions in the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin. The foreign exchange market India is regulated by the reserve bank of India through the Exchange Control Department. At the same time, Foreign Exchange Dealers Association(voluntary association) also provides some help in regulating the market. The
- 30. Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate in the foreign Exchange market in India. When the foreign exchange trade is going on between Authorized Dealers and RBI or between the Authorized Dealers and the Overseas banks, the brokers have no role to play. .Apart from the Authorized Dealers and brokers, there are some others who are provided with there stricted rights to accept the foreign currency or travelers cheque. Among these, there are the authorized money changers, travel agents, certain hotels and government shops. The IDBI and Exim bank are also permitted conditionally to hold foreign currency. 30 The whole foreign exchange market in India is regulated by the Foreign Exchange Management Act, 1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign Exchange Regulation Act ,1947. After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the economic and industrial development, the need for conservation of foreign currency was felt and on there commendation of the Public Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act,1973 and gradually, this act became famous as FEMA
- 31. 31 CONCLUSION The foreign monetary exchange market is the biggest financial market in the world. Bigger than the New York Stock Exchange and Futures Market combined. And with reduced "buy-in" limits now, even small-time players can join the Forex trading marketplace. That doesn't mean everyone should join, however. Buying an auto-trading program sold to you with the promise of making you millions probably won't. In fact, it may cost you everything you own. The only way to win in Forex trading is the good, old-fashioned way - hard work andasolidunderstandingofthemarket. One has to be clued in to global developments, trends in world trade as well as economic indicators of different countries. These include GDP growth, fiscal and monetary policies, inflows and outflows of the currency, local stock market performance and interest rates. The currency derivatives market is highly leveraged. In the stock futures market, a 20% margin gains a five-fold leverage. In forex futures, the margin payable is just 3%, so the leverage is 33 times. This means that even a 1% change can wipe out a third of the investment. However, the Indian currency markets are well-regulated and there is almost no counter-party risk. Investors should start small and gradually invest more. One has to be clued in to global developments, trends in world trade as well as economic indicators of different countries. These include GDP growth, fiscal and monetary policies, inflows and outflows of the currency, local stock market performance and interest rates.
- 32. 32 The currency derivatives market is highly leveraged. In the stock futures market, a 20% margin gains a five-fold leverage. In forex futures, the margin payable is just 3%, so the leverage is 33 times. This means that even a 1% change can wipe out a third of the investment. However, the Indian currency markets are well-regulated and there is almost no counter-party risk. Investors should start small and gradually invest more. Liberalization has transformed India’s external sector and a direct beneficiary of this has been the foreign exchange market in India. From a foreign exchange-starved, control-ridden economy, India has moved on to a position of $150 billion plus in international reserves with a confident rupee and drastically reduced foreign exchange control. As foreign trade and cross-border capital flows continue to grow, and the country moves towards capital account convertibility, the foreign exchange market is poised to play an even greater role in the economy, but is unlikely to be completely free of RBI interventions any time soon.
- 33. 33 REFERENCES http://www.slashdocs.com/kvuttx/fem.htm http://www.travelspk.com/forex/Forex-Development-History.htm http://www.global-view.com/forex-education/forex-learning/gftfxhist.html http://en.wikipedia.org/wiki/Foreign_exchange_risk