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

1

EXECUTIVE SUMMARYThe foreign exchange market is the mechanism by which a person of firm transfers

purchasing power from 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.

2

INTRODUCTIONBeing 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 formally known as foreign exchange or currency exchange. 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

which is floating currency and pegged currency. 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 exchange rate.

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 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

3

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 inflation rate. 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.

4

HISTORYThe 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.

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.

5

MEANING:Foreign exchange market is the market in which foreign currencies are bought and sold.

The buyers and sellers include individuals, firms, foreign exchange brokers, commercial

banks and the central bank.

Like any other market, foreign exchange market is a system, not a place. The transactions

in this market are not confined to only one or few foreign currencies. In fact, there are a

large number of foreign currencies which are traded, converted and exchanged in the

foreign exchange market.

DEFINITION OF 'FOREIGN EXCHANGE MARKET'

The market in which participants are able to buy, sell, exchange and speculate on

currencies. Foreign exchange markets are made up of banks, commercial companies,

central banks, investment management firms, hedge funds, and retail forex brokers and

investors. The forex market is considered to be the largest financial market in the world.

INVESTOPEDIA EXPLAINS 'FOREIGN EXCHANGE'

Foreign exchange transactions encompass everything from the conversion of currencies by

a traveler at an airport kiosk to billion-dollar payments made by corporate giants and

governments for goods and services purchased overseas. Increasing globalization has led to

a massive increase in the number of foreign exchange transactions in recent decades. The

global foreign exchange market is by far the largest financial market, with average daily

volumes in the trillions of dollars.

6

WHY THE FOREIGN EXCHANGE MARKET IS UNIQUE? 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, as of April 2010, average daily turnover n global foreign

exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the

$3.21 trillion daily volumes of April 2007. Some firms specializing on foreign exchange

market had put the average daily turnover 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

$43 billion currency swaps

$207 billion in options and other product.

7

ADVANTAGES AND DISADVANTAGES OF FOREIGN

EXCHANGE MARKET.

Advantages

The forex market is extremely liquid; hence it’s 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 overseeing

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

as a whole.

Investors need a lot of capital to make good profits because the profit margins on

small-scale trades are very low.

8

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, which

affects 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

Central Bank

External value of the domestic currency is controlled and assigned by central bank of

every county. Each country has a central or apex bank. For example In India Reserve Bank

of India is the central Bank9

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 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 corporation’s

anointer bank markets.

10

Commercial Bank  

Commercial banks are the one which has the most number of branches. With its wide

branch network 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 converting currency from one to another.

Exchange Brokers

Services of brokers are used to some extent, Forex market has some practices and tradition

depending on this the residing in other countries are utilised. Local brokers can conduct

Forex transactions as per the rules and regulations of the Forex governing body of their

respective country.

Overseas Forex market

:The Fore market operates all around the clock and the market day initiates with Tokyo and

followed by Bahrain Singapore, India, Frankfurt, Paris, London, New York, and

Sydney before things is back with Tokyo the next day

Speculators

In order to make profit on the account of favorable 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

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 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 organization.

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.) Monday to

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 the night if the Japanese Yen rises in the Hong Kong market, the trader can sell in

the Hong Kong market. More number of opportunities is 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

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 

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 from 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 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 exchange

market. 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

flow freely. When the value of the currency becomes low it makes the imports more athe

exports are cheaper, so the countries domestic goods and services are demanded more in

foreign 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

the country assures the investors for the stable and constant value of investment in the

country. Monetary policy of the country becomes ineffective. In this type the exchange

rates the imports 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 an

adjusted central value. Pegged allow some adjustments and stability. No artificial rates are

found in fixed 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 rate

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 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.

16

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 projects and

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 17

lowering 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

.

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.

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 favorable. Conversely, for countries facing balance of payment deficit, the

exchange rate will be adverse. Continuous and ever growing deficit in balance of payment

18

indicates over valuation of the currency concerned and the dis-equilibrium 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 as a

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 19

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 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 favor of co-ordinate 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 success up 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 raise 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

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

PLAYERS IN FOREIGN EXCHANGE MARKETA 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.

 

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 22

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 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.

 

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...

 

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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 country 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.

 

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

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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

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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 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

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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 deviation values. Alternatives such as average absolute deviation

and semi variance have been advanced for measuring financial risk.

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

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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 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

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

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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.

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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 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.

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Apart from the Authorized Dealers and brokers, there are some others who are provided

with their stricter rights to accept the foreign currency or traveler’s 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.

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 their commendation of the Public Accounts Committee, the Indian

government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act

became famous as FEMA

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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

and a solid understanding of the market.

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.

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.

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BIBLIOGRAPHY

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

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