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.
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.
The foreign exchange market is unique because of the following characteristics:
➢➢ 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 20:15 GMT on
Sunday 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 International Settlements,[3] the preliminary global results from the 2013
Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that
trading in foreign exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0
trillion in April 2010 and $3.3 trillion in April 2007. FX swaps were the most actively traded
instruments in April 2013, at $2.2 trillion per day, followed by spot trading at $2.0 trillion.
According to the Bank for International Settlements, as of April 2010, average daily turnover in global
foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the
$3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had
put the average daily turnover in excess of US$4 trillion.
Market Participants
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the
interbank market, which is made up of the largest commercial banks and securities dealers. Within
the interbank market, spreads, which are the difference between the bid and ask prices, are razor
sharp and not known to players outside the inner circle. The difference between the bid and ask
prices widens (for example from 0 to 1 pip to 1–2 pips for a currencies such as the EUR) as you go
down the levels of access. This is due to volume. If a trader can guarantee large numbers of
transactions for large amounts, they ca n demand a smaller difference between the bid and ask
price, which is referred to as a better spread. The levels of access that make up the foreign exchange
market are determined by the size of the “line” (the amount of money with which they are trading).
The toptier interbank market accounts for 39% of all transactions.[60] From there, smaller banks,
followed by large multi-national corporations (which need to hedge risk and pay employees in
different countries), large hedge funds, and even some of the retail market makers.
According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other
institutional investors have played an increasingly important role in financial markets in general, and
in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have
grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks
also participate in the foreign exchange market to align currencies to their economic needs.
Spot Market
Spot market is the market where the transactions are conducted on the spot delivery of currencies.
In spot exchange market, the business is transacted throughout the world on a continual basis. So, it
is possible to make transactions in foreign exchange markets 24 hours a day. The standard settlement
period in this market is 48 hours after the execution of the transaction. The spot foreign exchange is
similar to over-the-counter market for securities. There is no centralized meeting place and no fixed
opening or closing time. There is no physical transfer of currency, simply a book-keeping transfer
entry among the banks. Exchange rates are determined by demand and supply forces in the market.
The rate at which one currency is traded for another is called the exchange rate. The exchange rate
for immediate delivery is called spot exchange rate and is denoted by S (.). It is a relative price. e.g., S
(`/$) = 47.35. This shows the relation between Indian rupee and American dollar where one dollar is
equivalent to 47.35/- on a spot.
Foreign Exchange Quotations
A quotation is the amount of a currency necessary to buy or sell a unit of another currency. When it
is expressed in currency terms, it is called out right rate. If $ 1= ` 47; it means with 47 rupees we can
get one USA dollar. It is an outright rate between rupee and dollar. The quotes are made in the form
of ‘buy’ and ‘sell’ / ‘ask’ / ‘bid’ rates. The buy quote is the price at which the exchange dealer is ready
to buy a currency for which the quote is made and sell quote indicates the price at which the dealer
is ready to sell the currency. There are two ways of quoting exchange rates.
• Direct method: Number of units of domestic currency stated against one unit of foreign currency.
• Indirect method: Number of units of the foreign currency per unit of domestic currency.
Most countries use direct method. Spot (bid) = ` 47.2500/$; Spot (Ask) = ` 47.3000/$ These quotes
are direct and the exchange dealer quotes is ready to buy dollar at ` 47.2500 and ready to sell at `
47.3000. Spot (bid) = $ 0.0215/ `; Spot (Ask) = $ 0.0211 / ` These quotes are indirect because here a
unit of domestic currency is expressed in term of foreign currency.
The difference between buying and selling rates is called as spread. Generally, selling rate is higher
than the buying rate. Since in this market, the players are usually banks and financial institutions,
they are dealing simultaneously in buying and selling of a particular currency. They are called as
market makers as they create market by quoting bid and ask prices.
When quotes are direct; Spread = Ask- Bid But when quotes are indirect Spread = Bid - Ask Example:
When Direct Quotes are given The bid price of a dollar at Spot S (` / Bid $) = 48.5645 and The ask
price is S (` / Ask $) = 48.6545, therefore the spread is Ask - Bid = 48.6545 - 48.5645 = ` 0.0900
When the quotes are Indirect The Bid price for dollar is S( $ / bid DM) = $ 1.5900 / DM The ask price
is S ( $ / ask DM) = $ 1.5800 / DM Spread is Bid- Ask = 1.5900 - 1.5800 = $ 0.0100
Determinants of Exchange Rates
The following theories explain the fluctuations in exchange rates in a floating exchange rate regime
(In a fixed exchange rate regime, rates are decided by its government):
1. International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic
Fisher effect, International Fisher effect. Though to some extent the above theories provide logical
explanation for the fluctuations in exchange rates, yet these theories falter as they are based on
challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in
the real world.
2. Balance of payments model: This model, however, focuses largely on tradable goods and services,
ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous
appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account
deficit.
3. Asset market model: views currencies as an important asset class for constructing investment
portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities
of assets, which in turn depends on their expectations on the future worth of these assets. The asset
market model of exchange rate determination states that “the exchange rate between two
currencies represents the price that just balances the relative supplies of, and demand for, assets
denominated in those currencies.
None of the models developed so far succeed to explain exchange rates and volatility in the longer
time frames. For shorter time frames (less than a few days) algorithms can be devised to predict
prices. It is understood from the above models that many macroeconomic factors affect the
exchange rates and in the end currency prices are a result of dual forces of demand and supply.
The world’s currency markets can be viewed as a huge melting pot: in a large and ever-changing mix
of current events, supply and demand factors are constantly shifting, and the price of one currency in
relation to another shifts accordingly. No other market encompasses (and distills) as much of what is
going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single
element, but rather by several. These elements generally fall into three categories: economic factors,
political conditions and market psychology.
Around-the-clock market
Important foreign exchange trading centres are located in Hong Kong, Singapore, Paris and
Frankfurt, amongst others, while the biggest three are New York, Tokyo and London, of which
London is the largest. The foreign exchange market is open 24 hours per day throughout the week
(Monday to Friday at each centre).
Cross Rate
The exchange rate that is obtained by the cross product of two exchange rates is called cross-rate.
DM/US $=x/y Rupee/US $=a/b Rupee/DM = a/x It can be defined as a rate between third pair of
currencies by using the rates of two pairs, in which one currency is common. It is a derived rate. The
following equations can be used to find out the cross rates between two currencies 1 and 2. If the
rates between 1 and 3 and 2 and 3 are given, then:
(1 / 2) ask = (1 / 3) ask × (3 / 2) bid
(1 / 2) bid = (1 / 3) bid × (3 / 2) ask
(1 /3) bid = (3 / 1) ask
Each economy has a foreign sector representing the economy’s external transactions. These
transactions can be economic, commercial or financial in nature. These result in receipt into and
payments out of the domestic economy. Such receipts and payments involve exchange of domestic
currency as against all foreign currencies of countries with which economy has dealings. If an Indian
bank buys dollar, it will pay rupees for dollars and if it sells dollars, it will receive rupees for dollars.
An exporter in India receives dollars from the USA; he surrenders the bill of exchange along with
other documents to his bank. The bank buys the currency from exporter. An importer in India,
importing from USA is in need of dollars to pay to the exporter. The importer’s bank will buy from the
bank and send to the party in USA. Demand for and supply of foreign currencies arises from
exporters or importers of goods.
Forward Exchange Rate
The exchange rate for delivery and payment at specified future dates are called Forward Exchange
rate and is denoted by F (.) that specifies a relationship between domestic and foreign currency. The
forward exchange rate is contracted in the present for future delivery of foreign exchange. These are
determined by forward demand and forward supply of various currencies.
A forward currency is said to be at a forward premium if its future value exceeds its present value in
terms of domestic currency. E.g. If an Indian exporter is expecting his payment after two months, to
reduce the risk of exchange rate volatility, he may enter into a sixty day forward contract. If the spot
rate is S (` / $) = ` 47.50 / $ and two months forward is F2 (` / $) = ` 47.75/ $; this implies that the
dollar is at a premium and rupee is at discount in the forward market.
A forward currency is said to be at a forward discount if its future value is less than its present value.
E.g. If the spot rate is S (` / $) = ` 47.50/ $ and two months forward is F2 (` / $) = ` 47.35/ $; this
implies that the rupee is at a premium and dollar is at discount in the forward market.
The premium / discount on foreign currency for a period is defined as:
Premium / discount = [F (.) – S (.)] / S (.) × 100, Here the premium is on foreign currency and discount
on domestic currency.
When the quotes are in months (N), the Annualized premium and discount are given as:
Premium / discount = [F (.) – S (.)] / S (.) × (12/N) × 100
When the quotes are in days (ND), premium and discount are given as:
Premium / discount = [F (.)-S (.)] / S (.) x (360/ND) x 100
Structure of Foreign Exchange Market in India
The foreign market in India has three segments. The first segment consists of transactions between
RBI and the authorized dealer (AD). The second segment is the interbank market in which the banks
deal among themselves. The third segment is the retail segment in which the ADs deal with the
corporate clients and other retail customers. In the retail segment, money changers also operate.
These are licensed dealers in the currency market to cater to the needs of retail customers. In the
interbank market, the quotes appear in swap points. There are currency brokers who match the
buyers and sellers and work on commission basis.
Derivative markets
Derivative markets are for those assets which are synthetic financial products derived from the real
assets or stock or commodities. After floating exchange rate system replaced the fixed exchange rate
system, there was high volatility in some currencies due to speculation. The regulatory bodies were
forced to find new ways to reduce the risk attached to the Forex business. For managing risks on
account of volatility in the exchange rates and interest rates, new products were designed and were
called derivatives. They derive their value from other products. These are used for risk reduction
from the high volatility of financial markets. The major problem of these derivative markets is over
speculation which has to be controlled by a right degree of regulation.
Derivative market includes the following instruments:
• Forward Rate Agreements (FRAs): It is a contact for delivery of foreign currency at a specified
future date at a fixed exchange system.
• Swaps: It is a deal in which a bank buys a specified foreign currency and sells the same at different
maturity dates.
• Options: The contracts with a right to buy or sell a stated currency without any obligation, at a
fixed rate on a future date.
THE INTERNATIONAL MONEY MARKET
The international money market is a market where international currency
transactions between numerous central banks of countries are carried on.
The transactions are mainly carried out using gold or in US dollar as a base.
The basic operations of the international money market include the money
borrowed or lent by the governments or the large financial institutions.
The international money market is governed by the transnational monetary
transaction policies of various nations currencies. The international money
markets major responsibility is to handle the currency trading between the
countries. This process of trading a countrys currency with another one is
also known as FOREX TRADING.
Unlike share markets, the international money market sees very large funds
transfer. The players of the market are not individuals; they are very big
financial institutions. The international money market investments are less
risky and consequently, the returns obtained from the investments are less
too. The best and most popular investment method in the international
money market is via money market mutual funds or treasury bills.
The international money market keeps track of the exchange rates between
currency- pairs on a regular basis. Currency bands, fixed exchange rate,
exchange rate regime, linked exchange rates, and floating exchange rates
are the common indices that govern the international money market in a
subtle manner.
The International Monetary Market (IMM) was formed in December 1971 and
was established in May 1972. The roots of IMM can be linked to the finish of
Bretton Woods via the 1971 Smithsonian Agreement and then, Nixon's
abolition of US dollar's convertibility to gold.
The IMM was formed as a separate entity of the Chicago Mercantile Exchange
(CME). By the end of 2009, IMM was the second biggest futures exchange in
terms of currency volume in the world. The major purpose of the IMM is to
trade currency futures. It is comparatively a new product which was earlier
studied by the academics as a tool to operate a freely-traded exchange
market to initiate trade among the nations.
The first futures transactions included trades of currencies against the US
dollar, such as the British Pound, Swiss Franc, German Deutschmark,
Canadian Dollar, Japanese Yen, and the French Franc. The Australian Dollar,
the Euro, emerging market currencies such as the Russian Ruble, Brazilian
Real, Turkish Lira, Hungarian Forint, Polish Zloty, Mexican Peso, and South
African Rand were later introduced as well.