Foreign Exchange Market (Forex, Fx, or Currency Market)
Foreign Exchange Market is a global decentralized market for the trading of
currencies. The main participants in this market are the larger international banks. Financial
centers around the world function as anchors of trading between a wide range of different
types of buyers and sellers around the clock, with the exception of weekends. EBS and
Reuters’ dealing 3000 are two main interbank FX trading
The foreign exchange market works through financial institutions, and it operates on
several levels. Behind the scenes banks turn to a smaller number of financial firms known
as “dealers,” who are actively involved in large quantities of foreign exchange trading. Most
foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the
“interbank market”, although a few insurance companies and other kinds of financial firms
are involved.
Trades between foreign exchange dealers can be very large, involving hundreds of
millions of dollars. Because of the sovereignty issue when involving two currencies, Forex
has little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investment by enabling
currency conversion. For example, it permits a business in the United States to import goods
from the European Union member states, especially Eurozone members, and pay euros,
even though its income is in United States dollars. It also supports direct speculation in the
value of currencies, and the carry trade, speculation based on the interest rate differential
between two currencies.[2]
In a typical foreign exchange transaction, a party purchases some quantity of one
currency by paying some quantity of another currency. The modern foreign exchange market
began forming during the 1970s after three decades of government restrictions on foreign
exchange transactions (the Bretton Woods system of monetary management established
the rules for commercial and financial relations among the world’s major industrial states
after World War II), when countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed as per the Bretton Woods system.
Market Participants
Commercial Companies
An important part of this market comes from the financial activities of companies
seeking foreign exchange to pay for goods or services. Commercial companies often trade
fairly small amounts compared to those of banks or speculators, and their trades often have
little short term impact on market rates. Nevertheless, trade flows are an important factor
in the long-term direction of a currency’s exchange rate. Some multinational companies can
have an unpredictable impact when very large positions are covered due to exposures that
are not widely known by other market participants.
Central Banks
National central banks play an important role in the foreign exchange markets.
They try to control the money supply, inflation, and/or interest rates and often have official
or unofficial target rates for their currencies. They can use their often substantial foreign
exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank
“stabilizing speculation” is doubtful because central banks do not go bankrupt if they make
large losses, like other traders would, and there is no convincing evidence that they do make
a profit trading.
Hedge Funds as Speculators
About 70% to 90% of the foreign exchange transactions are speculative. In other
words, the person or institution that bought or sold the currency has no plan to actually
take delivery of the currency in the end; rather, they were solely speculating on the
movement of that particular currency. Hedge funds have gained a reputation for aggressive
currency speculation since 1996. They control billions of dollars of equity and may borrow
billions more, and thus may overwhelm intervention by central banks to support almost any
currency, if the economic fundamentals are in the hedge funds’ favor.
Investment Management Firms
Investment management firms (who typically manage large accounts on behalf of
customers such as pension funds and endowments) use the foreign exchange market to
facilitate transactions in foreign securities. For example, an investment manager bearing an
international equity portfolio needs to purchase and sell several pairs of foreign currencies
to pay for foreign securities purchases.
Some investment management firms also have more speculative specialist currency
overlay operations, which manage clients’ currency exposures with the aim of generating
profits as well as limiting risk. While the number of this type of specialist firms is quite
small, many have a large value of assets under management and, hence, can generate large
trades.
Retail Foreign Exchange Traders
Individual Retail speculative traders constitute a growing segment of this market
with the advent of retail foreign exchange platforms, both in size and importance. Currently,
they participate indirectly through brokers or banks. Retail brokers, while largely controlled
and regulated in the USA by the Commodity Futures Trading Commission and National
Futures Association have in the past been subjected to periodic
Non-Bank Foreign Exchange Companies
Non-bank foreign exchange companies offer currency exchange and international
payments to private individuals and companies. These are also known as foreign exchange
brokers but are distinct in that they do not offer speculative trading but rather currency
exchange with payments (i.e., there is usually a physical delivery of currency to a bank
account).
Money Transfer/Remittance Companies and Bureaux De Change
Money transfer companies/remittance companies perform high-volume low-value
transfers generally by economic migrants back to their home country. In 2007, the Aite
Group estimated that there were $369 billion of remittances (an increase of 8% on the
previous year). The four largest markets (India, China, Mexico and the Philippines) receive
$95 billion. The largest and best known provider is Western Union with 345,000 agents
globally followed by UAE Exchange
International Bond Market
Bonds are an important source of long term capital for firms. A bond is debt. A firm
(or government) issues a certificate, called a bond that states that the firm will make coupon
payments to the holder of the bond and will, at maturity pay the holder the par value of
the bond. Coupon payments are simply the interest payments on the debt and the par value
is the principal. Firms sell these bonds to investors (thereby borrowing money). The key
difference between borrowing money by issuing bonds rather than borrowing directly from
a bank is that there exists a secondary market for bonds. That is, if you buy a bond from
a firm (lending that firm money) you can later sell the bond to another investor. The act
of firms selling bonds directly to investors is termed the primary market, while investors
trading bonds among themselves is the secondary market.
There exists a well developed domestic market for bonds (Canadian firms issuing
bonds denominated in Canadian dollars and selling them in Canada). However, there also
exists an international bond market. The international bond market is really a set of loosely
connected individual markets around the world. There are many different bond markets in
many countries, taken together as a whole they constitute the international bond market.
The international bond market can be broken down into two parts:
1) Foreign Bonds
2) Eurobonds
1) Foreign bonds are simply bonds issued in a bond market by a foreign company.
For example, a Japanese firm issuing a U.S. dollar denominated bond in the U.S. is
issuing a foreign bond.
Because foreign bonds are simply a part of the domestic bond market, the only real
difference is their treatment under the law. In many countries, foreign bonds are subject to
different tax treatment, registration requirements et cetera.
The most important foreign bond markets are located in Zurich, New York, Tokyo,
Frankfurt, London and Amsterdam.
The reasons that a company may go to another country to issue bonds include the
simple fact that there may not be enough demand in the domestic market. Going to a foreign
market opens up a whole new set of potential investors to the firm. For instance, a German
pharmaceutical firm may wish to borrow DM 500 million. However, its investment bank
tells it that there is only demand for DM 250 million of its bonds. In order to float the rest
it would have to offer a much higher yield. But, for some reason there is demand in the US
for the debt of pharmaceutical firms, and that demand is not being met by US companies.
2) Eurobonds are bonds denominated in one currency but issued in a country that is
not the home of that currency. For example, a bond denominated in $Can but issued
in London is a Eurobond. Similarly, a Sfr denominated bond issued in Germany is a
Eurobond.
Most countries have very few regulations governing the issuance of Eurobonds
(since they are not denominated in that country’s currency, the government does not care
all that much about them). While some countries have tried to control issues of bonds
denominated in their currency even if issued in a foreign country, this is very hard to do
for obvious reasons. One thing that this means is that interest paid on Eurobonds is usually
free of all
Global Depository Receipt (GDR)
A Global Depository Receipt (GDR) is a dollar denominated instrument traded on
a stock exchange in Europe or the US or both. It represents a certain number of underlying
equity shares.
The shares are issued by the company to an intermediary called depository in whose
name the shares are registered. It is the depository which subsequently issues the GDRs. The
physical possession of the equity shares is with another intermediary called the custodian
who is an agent of the depository. Thus while a GDR represents the issuing company’s
shares, it has a distinct identity and in fact does not figure in the books of issuer.
The concept of GDRs has been in use since 1927 in Western capital markets.
Originally they were designed as an instrument to enable US investors to trade in securities
that were not listed in US exchanged in the form of American depository receipts (ADRs).
Issue traded outside the US were called International Depository Receipt (IDR) issues.
Thus, a global depository receipt or global depositary receipt (GDR) is a certificate
issued by a depository bank, which purchases shares of foreign companies and deposits
it on the account. GDRs represent ownership of an underlying number of shares. Global
depository receipts facilitate trade of shares, and are commonly used to invest in companies
from developing or emerging markets.
Prices of global depositary receipt are often close to values of related shares, but they
are traded and settled independently of the underlying share.
Characteristics of GDRs
1. It is an unsecured security
2. A fixed rate of interest is paid on it
3. It may be converted into number of shares
4. Interest and redemption price is public in foreign agency
5. It is listed and traded in the share market
American Depositary Receipt (ADR)
ADRs are financial assets that are issued by U.S. banks and represent indirect
ownership of a certain number of shares of a specific foreign firm that are held on deposit in
a bank in the firm’s home country. The advantage of ADRs over direct ownership is that the
investor need not worry about the delivery of the stock certificates is that the investor need
not worry about the delivery of the stock certificates or converting divided payments from
a foreign currency into U.S. dollors. The depository bank automatically does the converting
for the investor and also forwards all financial reports from the firm. The investor pays the
bank a relatively small fee for these services. Typically non-Canadian firms utilize ADRs.
For example, Mexican firms are traded in this manner in the United States – at yearend
1993, all 13 Mexican firms with their stock listed on the NYSE utilised ADRs. In March
1999, the first even ADR issue by an Indian firm took off. The Information Technology Ltd.,
floated ADRs which were received very well.
This is an excellent way to buy shares in a foreign company while realizing any
dividends and capital gains in U.S. dollars. However, ADRs do not eliminate the currency
and economic risks for the underlying shares in another country. For example, dividend
payments in Euros would be converted to U.S. dollars, net of conversion expenses and
foreign taxes and in accordance with the deposit agreement. ADRs are listed on NYSE,
AMEX or Nasdaq as well as OTC.
Foreign Bonds
For starters, there is a veritable plethora of securities, such as Euro-bonds, Yankee
bonds, Samurai bonds, and Dragon bonds which tap the European, US, Japanese, and Asia-
Pacific markets, respectively. More specifically, Eurobonds are unsecured debt securities
maturing at least a year after the launch. Usually fixed-rate instruments, with bullet
repayments-one-shot redemption-these bonds are listed on stock exchanges abroad. And
borrowers access
Fixed/Floating Rate Notes
This debt instrument matures in 90 days’ time but it can be extended at the issuer’s
option for an additional period at each maturity date; simultaneously, the interest rate also
increases. Several variations are possible; extendable bonds and stepped-up coupon put
table bonds. As the term suggests, hold on to the bonds for some more time usually at a
higher coupon rate.
Zero Coupan Bonds
These bonds are purchased at a substantial discount from the face value of the bond
and are redeemed at face value on maturity. There are no interim interest payments. The
difference between the purchase price and face value is the return on the investment.
These bonds are similar to cumulative deposits or cash certificates of banks in our
country.
International Money Market Instrument
a. Euro Notes
Legal tender in the form of a banknote that can be used in exchange for goods
and services in the eurozone. Euro notes come in 5, 10, 15, 20, 50, 100, 200 and 500 euro
denominations. The supply of euro notes is controlled by the European Central Bank, which
controls the monetary policy in order to maintain price stability in the European Union.
b. Banker’s Acceptance - BA
A short-term debt instrument issued by a firm that is guaranteed by a commercial
bank. Banker’s acceptances are issued by firms as part of a commercial transaction. These
instruments are similar to T-Bills and are frequently used in money market funds. Banker’s
acceptances are traded at a discount from face value on the secondary market, which can
be an advantage because the banker’s acceptance does not need to be held until maturity.
Banker’s acceptances are regularly used financial instruments in international trade.
c. Letter of Credit
It is a document issued by a financial institution, or a similar party, assuring payment
to a seller of goods and/or services provided certain documents have been presented to
the bank. These are documents that prove that the seller has performed the duties under
an underlying contract (e.g., sale of goods contract)and the goods (or services) have been
supplied as agreed. In return for these documents, the beneficiary receives payment from
the financial institution that issued the letter of credit. The letter of credit serves as a
guarantee to the seller that it will be paid regardless of whether the buyer ultimately fails to
pay. In this way, the risk that the buyer will fail to pay is transferred from the seller to the
letter of credit’s issuer. The letter of credit can also be used to ensure that all the agreed upon
standards and quality of goods are met by the supplier, provided that these requirements are
reflected in the documents described in the letter of credit.
d. Repurchase Agreement - Repo’
A form of short-term borrowing for dealers in government securities. The dealer
sells the government securities to investors, usually on an overnight basis, and buys them
back the following day. For the party selling the security (and agreeing to repurchase it in
the future) it is a repo; for the party on the other end of the transaction, (buying the security
and agreeing to sell in the future) it is a reverse repurchase agreement.
Forward Rate Agreements (FRAs): It is a contact for delivery of foreign
currency at a specified future date at a fixed exchange system.