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Transcript of Finalprojectofforeignexchangemarket 141028123049 Conversion Gate02(1)
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TABLE OF CONTENT
INTRODUCTION 5
HISTORY 7
SUMMARY 8
WHY THE FOREIGN EXCHANGE MARKET IS UNIQUE ? 9
ADVANTAGES & DISADVANTAGE OF FOREIGN EXCHANGE
MARKET 1
VARIOUS !ARTICI!ANTSOF FOREIGN EXCHANGE MARKET 11
CHARACTERISICS OF FOREIGN EXCHANGE MARKET 1"
FINANCIAL INSTRUMENTS OF FOREIGN EXCHANGE MARKET 15
FUNCTION OF FOREIGN EXCHANGE MARKET 1#
TY!ES OF FOREIGN EXCHANGE MARKET 17
FACTORS AFFECTING MOVEMENT OF EXCHANGE RATES 18
!LAYERS IN FOREIGN EXCHANGE MARKET $"
FOREIGN EXCHANGE RISK $8
FOREIGN EXCHANGE MARKET IN INDIA %$
CONCLUSION %"
REFERENCES %#
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INTRODUCTION
Being the main force driving the global economic market, currency is no doubt an essential
element for a country. However, in order for all the countries with different currencies to trade
with one another, a system of exchange rate between their currencies is needed; this system, is
formallyknownasforeignexchangeorcurrencyexchange.
In the early days, the system of currency exchange is supported solely by the gold amount held inthe vault of a country. However, this system is no longer appropriate now due to inflation and
hence, the value of one’s currency nowadays is determined through the market forces alone. In
order to determine the value of a currency’s exchange rate, two main types of system is used
whichisfloatingcurrencyandpeggedcurrency.
or 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. !ormally, this system is adopted by most of the
advance countries like for example "#, "$ and %anada. &ll of these countries have a similarity
where their market is well developed and stable in economic terms. 'hese 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. 'he reason behind this is because for floating
exchange rate, the market itself will re(ad)ust 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. or instance, if a country suffers from economic instability
due to various reasons such as political issues, a floating exchange rate system will certainly
discourage investment due to the high risk of suffering from inflationary disaster or sudden slum
in exchangerate. ¬her form of exchange rate is known as pegged exchange rate. 'his 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. 'his system is called pegged exchange rate because the value
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of a country’s currency is fixed to another country’s currency. &s a result, the value of the pegged
currency will not fluctuate unlike the floating currency. 'he working principle behind this system
is slightly complicated where the government of a country will fixed the exchange rate of their
currency and when there is a demand for a certain currency resulting a rise in the exchange rate,
the government will have to release enough of that currency into the market in order to meet that
demand. However, there is a fatal flaw in this system where if the pegged exchange rate is not
controlled properly, panics may arise within the country and as a result of that, people will be
rushing to exchange their money into a more stable currency. *hen 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. +ue to this reason, only those under(developed
or developing countries will practice this method as a form to control the inflationrate. However,
the truth is, most of the countries do not fully practice the floating exchange rate or the pegged
exchange rate method in reality. Instead, they use a hybrid system known as floating peg.
loating peg is the combination of the two main systems where one country will normally fixed
their exchange rate to the "$ +ollars and after that, they will constantly review their peg rate in
order to stay in line with the actual market value.
'he oreign exchange market, or commonly known as -/, is the largest and most prolific
financial market because each day, more than 0 trillion worth of currency exchange takes place
between investors, speculators and countries. rom 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 )ust the tip of an iceberg.
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HISTORY
'he foreign exchange market 1fx or forex2 as we know it today originated in 0345. However,
money has been around in one form or another since the time of 6haraohs. 'he Babylonians are
credited with the first use of paper bills and receipts, but 7iddle astern moneychangers were
the first currency traders who exchanged coins from one culture to another. +uring the middle
ages, the need for another form of currency besides coins emerged as the method of choice.
'hese 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.
rom the infantile stages of forex during the 7iddle &ges to **I, the forex markets were
relatively stable and without much speculative activity. &fter **I, the forex markets became
very volatile and speculative activity increased tenfold. $peculation in the forex market was not
looked on as favorable by most institutions and the public in general. 'he 8reat +epression and
the removal of the gold standard in 0350 created a serious lull in forex market activity. rom
0350 until 0345, the forex market went through a series of changes. 'hese changes greatly
affected the global economies at the time and speculation in the forex markets during these times
was little, if any.
19"" 9 Bretton *oods &ccord is established to help stabili:e the global economy after *orld
*ar II.
1971 $mithsonian &greement established to allow for greater fluctuation band for currencies.
197$ uropean oint loat established as the uropean community tried to move away from its
dependency on the ".$. dollar.
197% $mithsonian &greement and uropean oint loat failed and signified the official switch to
a free(floating system.
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1978 'he uropean 7onetary $ystem was introduced so other countries could try to gain
independence from the ".$. dollar.
1978 ree(floating system officially mandated by the I7.
199% uropean 7onetary $ystem fails making way for a world(wide free(floating system.
SUMMARY
• 'he foreign exchange market is the mechanism by which a person of firm transfers
purchasing power form one country to another, obtains or provides credit for
international trade transactions, and minimi:es exposure to foreign exchange risk.
• & 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.• & foreign exchange rate is the price of a foreign currency. & foreign exchange <uotation
or <uote is a statement of willingness to buy or sell at an announced rate.
• 'he foreign exchange market consists of two tiers= the interbank or wholesale market,
and the client or retail market. 6articipants 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.
• 'ransactions are effectuated either on a spot basis or on a forward or swap basis. & spot
transaction is for an 1almost2 immediate value date while a forward transaction is for avalue date somewhere in the future.
• >uotations can be classified either as uropean and &merican terms or as direct and
indirect <uotes.
• In the real world, <uotations include a bid(ask spread. & bid is the exchange rate in one
currency at which a dealer will buy another currency. &n ask is the exchange rate at
which a dealer will sell the other currency. 'he spread is the difference between the bid
price and the ask price. 'his spread reflects the existence of commissions and transaction
costs.• & cross rate is an exchange rate between two currencies, calculated from their common
relationship with a third currency.
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W' () *+,)-./ E02/.) M2,3)( -4 U/-6)?
• its huge trading volume representing the largest asset class in the world leading tohigh
li<uidity;
• its geographical dispersion;
• its continuous operation= ?@ hours a day except weekends, i.e. trading from ?A=0 87'
on$unday until ??=AA 87' riday;
• 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 si:e.
• &s such, it has been referred to as the market closest to the ideal of perfect
competition,notwithstanding currency intervention by central banks. &ccording to the
Bank for International$ettlements,as of &pril ?A0A, average dailyturnover in global
foreign exchange markets isestimated at C5.3D trillion, a growth of approximately ?AE
over the C5.?0 trillion daily volumeas of &pril ?AA4. $ome firms speciali:ing on foreign
exchange market had put the average dailyturnover in excess of "$C@ trillion.
• 'he C5.3D trillion break(down is as follows=
C0.@3A trillion in spot transactions
C@4 billion in outright forwardsC0.4F trillion in foreign exchange swapsC@5 billion currency swapsC?A4 billion in options and other product.
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ADVANTAGES AND DISADVANTAGES OF
FOREIGN EXCHANGE MARKET
A2/(2.)4
• 'he forex market is extremely li<uid, hence its rapidly growing popularity. %urrencies
may be converted when bought or sold without causing too much movement in the price
and keeping losses to a minimum.
• &s there is no central bank, trading can take place anywhere in the world and operates on
a ?@(hour basis apart from weekends.
• &n investor needs only small amounts of capital compared with other investments. orex
trading is outstanding in this regard.
• It is an unregulated market, meaning that there is no trade commission over seeing
transactions and there are no restrictions on trade.
• In common with futures, forex is traded using a Ggood faith deposit rather than a loan.
'he interest rate spread is an attractive advantage.
D-422/(2.)4
• 'he ma)or 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 asawhole.
• Investors need a lot of capital to make good profits because the profit margins on small(
scale trades are very low.
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V2,-+64 :2,(--:2/(4 O* *+,)-./ E02/.)
M2,3)(;G+),/<)/(4; 8overnments have re<uirements 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. oreign exchange rates concern
governments because changes affect the value of product and financial instruments, whichaffects
the health of a nation’s markets and financial systems.
B2/34; 'here are different types of banks, all of which engage in the foreign exchange market to
greater or lesser extent. $ome work to signal desired movement in the market without causing
overt change, while some aggressively manage their reserves by making speculative risks. 'he
vast ma)ority, however, use their knowledge and expertise is assessing market trends for
speculative gain for their clients
B,+3),-/. H+64)4= 'hese exist primarily to bring buyer and seller together at a mutually agreed price. 'he 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. 'he use of human brokers has decreased due mostly to the rise of the interbank
electronic brokerage systems
I/(),/2(-+/2= M+/)(2,' M2,3)(= 'he International 7onetary 7arket 1I772 in %hicago trades
currencies for relatively small contract amounts for only four specific maturities a year.
riginally designed for the small investor, the I77 has grown since the early 034As, and the
ma)or banks, who once dismissed the I77, have found that it pays to keep in touch with its
developments, as it is often a market leader
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M+/)' M2/2.),4= 'hese tend to be large !ew ork commission houses that are often very
aggressive players in the foreign exchange market. *hile they act on behalf of their clients, they
also deal on their own account and are not limited to one time :one, but deal around the world
through their agents.F. %orporations= %orporations are the actual end(users of the foreign
exchange market. *ith the exception only of the central banks, corporate players are the ones
who affect supply and demand. $ince the corporations come to the market to offset currency
exposure they permanently change the li<uidity of the currencies being dealt with.
R)(2-= C=-)/(4= 'his includes smaller companies, hedge funds, companies speciali:ing in
investment services linked by foreign currency funds or e<uities, fixed income brokers, the
financing of aid programs by registered worldwide charities and private individuals. -etail
investors trade foreign exchange using highly leveraged margin accounts. 'he amount of their
trading in total volume and in individual trade amounts is dwarfed by the corporations andinter
bank markets.
C)/(,2= B2/3
xternal value of the domestic currency is controlled and assigned by central bank of
everycounty. ach country has a central or apex bank. or example In India -eserve Bank of
Indiais the central Bank
C+<<),-2= B2/3
%ommercial banks are the one which has the most number of branches. *ith its wide
branchnetwork the %ommercial banks buy the foreign exchange and sell it to the importers.
'hese banks are the most active among the market players and also provide services like
convertingcurrency from one to another.
E02/.) B,+3),4
$ervices of brokers are used to some extent, orex market has some practices and
traditiondepending on this the residing in other countries are utilised.Jocal brokers canconduct
orex transactions as per the rules and regulations of the orex governing body of their
respective country.
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O),4)24 F+,)0 <2,3)(
='he orexmarket operates all around the clock and the market day initiates with 'okyo
andfollowed by Bahrain $ingapore, India, rankfurt, 6aris, Jondon, !ew ork, and
$ydney before things are back with 'okyo the next day
S:)6=2(+,4
In order to make profit on the account of favourable exchange rate, speculators buy foreign
currency if it is expected to appreciate and sell foreign currency if it is expected to depreciate.
'hey follow the practice of delaying covering exposures and not offering a cover till the time
cash flow is materiali:ed.
O(), *-/2/-2= -/4(-(6(-+/4 involved in the foreign exchange market include=
$tock brokers %ommodity
irms Insurance
%ompanies %harities
6rivate Institutions
6rivate Individuals
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C2,2(),-4(-4 O* F+,)-./ E02/.) M2,3)(
C2/.-/. W)2=(;
'he ratios between the currencies of two countries are exchange rates in forex. If one currency
loss its value in the market and at the same time the value of the another currency increases this
causes the fluctuations in the exchange rate in foreign exchange market. or xample, over ?A
years ago a single "$ dollar bought 5FA apanese en, whereas at present0 "$ dollar buys 00A
apanese en; this explains that the apanese en has risen in value ,and the "$ dollar hasdecreased in value 1relative to the en2. 'his is said to be a shift in wealth, as a fixed amount of
apanese en can now purchase many more goods than two decades ago
.
N+ C)/(,2=->) M2,3)(
'he foreign exchange market does not have a centrali:ed 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. oreign
exchange currency trading has been reformed into a non(formal and global network organi:ation
it consists of advanced information system. 'rader of forex should not be a member of any
organisation.
C-,6=2(-+/ +,3
oreign exchange market has member from all the countries, each country has differentgeo
graphical positions so forex operates all around the clock on working days 1i.e.2 7ondayto
riday every week. Because the time in &ustralia is different than in uropean countries, this
kind of ?@ hours operation, free from any time is an ideal environment for investors.
or instance, a trader may buy the apanese en in the morning at the !ew ork market, and in
the night if the apanese en rises in the Hong #ong market, the trader can sell in the Hong#ong
market. more number of opportunities are available for the forex traders. In -/ market most
trading takes place in only a few currencies; the ".$. +ollar 1C2, uropean
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%urrency "nit 1K2, apanese en 1L2, British 6ound $terling 1M2, $wiss ranc 1$f2, %anadian
+ollar 1%anC2, and to a lesser extent, the &ustralian and !ew Nealand +ollars
F-/2/-2= I/4(,6<)/(4 +* *+,)-./ )02/.) <2,3)(S:+( M2,3)(
$pot market involves the <uickest transaction in the foreign exchange market. 'his involves
immediate payment at the current exchange rate is called as spot rate. 'he spot market accounts
for 0O5rdof all the currency exchange, trades in ederal -eserve that takes place within two days
of the agreement. 'he traders open to the volatility of the currency market, which can raise or
lower the price between the agreement and the trade.
F6(6,)4 M2,3)(
'hese kind transactions involve future payment and future delivery at an agreed exchange rate.
uture market contracts are standardi:ed, 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
e<uation. 'his type of market is popular for $teady return on their investment that is done on
large currency transactions.
F+,2, M2,3)(
the terms are negotiable between the two parties. 'he terms can be changes according to the
needs of the participants. It allows for more flexibility. 'wo entities swap currency for an agreed
amount of time, and then return the currency at the end of the contract.
S2: T,2/42(-+/4
In swap two parties are involves where they exchange the currencies for certain time and agree to
reserve the transaction at a later date. $wap is the most commonly used forward
transaction. In swap transaction it is not traded through the exchange and there is no
standardi:ation. "ntil the transaction is completed the deposit is re<uired to hold the position.
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F6/(-+/4 +* () F+,)-./ E02/.) M2,3)('he foreign exchange market is the mechanism by which a person of firm transfers purchasing
power form one country to another, obtains or provides credit for international trade transactions,
and minimi:es exposure to foreign exchange risk.
T,2/4*), +* !6,24-/. !+),
'ransfer 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. %redit 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.
!,+-4-+/ +* ,)-( *+, *+,)-./ (,2)
'he forex takes time to move the goods from a seller to buyer so the transaction must be
financed. oreign exchange market provides credit to the traders. %redit facility is need by
exporters when the goods are transited. 8oods 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
F+,)-./ E02/.) D)2=),4
oreign exchange dealers, deal both with interbank and client market. 'he profit of the dealers is
there buying at a bid price and sells it at a high price. *orldwide 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. +ealers in the foreign exchange
departments of large international banks often function as market makers. 'hey stand willing to
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buy and sell those currencies in which they speciali:e by maintaining an inventory position in
those currencies.
M-/-<->-/. F+,)-./ E02/.) R-43; 'he foreign exchange market provides PhedgingP
facilities for transferring foreign exchange risk to someone else.
T':)4 +* F+,)-./ E02/.) R2()4
;F=+2(-/. R2()4
loating rates is one of the primary reasons for fluctuation of currency in foreign
exchangemarket. 'his is one of the most important commonly and main type of exchange rate.
"nder this market force all the economies of developed countries allow there currency to
flowfreely. *hen the value of the currency becomes low it makes the imports more and
theexports are cheaper, so the countries domestic goods and services are demanded more
inforeign buyers. 'he country can withstand the fluctuation only if the economy is strong.
*hen the country’s economy is able to meet the demand then it can ad)ust between the
foreign trade and domestic trade automatically.
F-0) R2()4
ixed exchange rates are used to attract the foreign investments and to promote foreigntrade.'his type of rates is used only by small developed countries. By ixed exchange rates
thecountry 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 theimports
become expensive. 'he exchange value of the currency does not move. 'his
normally reduces the country’s currency against foreign currencies.
!)..) R2()4
'his rate is between the floating rate and the fixed rate. 6egged rates appropriate more
for developed country. & country allows its currency to fluctuation to some extend for a
ad)ustedcentral value. 6egged allow some ad)ustments and stability. !o artificial rates are found
infixed and floating exchange rates. 6egged can fix the economic problem by itself and provide
growth opportunity also. *hen a fixed value is not maintains by the country it can’t follow
the fixed exchange rat
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F2(+,4 2**)(-/. M+)<)/( +* E02/.) R2()4
&side from factors such as interest rates and inflation , exchange rate is one of the most important
determinants of a countryQs relative level of economic health. xchange rates play a vital role in a
countryQs level of trade, which is critical to every free market economy in the world. or this
reason, exchange rates are among the most watched ,analy:ed and governmentally manipulated
economic measures. But exchange rates matter on a smaller scale as well= they impact the real
return of an investorQs portfolio. Here we look at some of the ma)or forces behind exchange rate
movements. Before we look at these forces, we should sketch out how exchange rate movements
affect a nationQs trading relationships with other nations. & higher currency makes a countryQs
exports more expensive and imports cheaper in foreign markets; a lower currency makes a
countryQs exports cheaper and its imports more expensive in foreign markets. & higher exchange
rate can be expected to lower the countryQs balance of trade, while a lower exchange rate would
increase it. !umerous factors determine exchange rates, and all are related to the trading
relationship between two countries. -emember, exchange rates are relative, and are expressed as
a comparison of the currencies of two countries. 'he following are some of the principal
determinants of the exchange rate between two countries. !ote that these factors are in no
particular order; like many aspects of economics ,the relative importance of these factors is
sub)ect to much debate.
D-**),)/(-2=4 -/ I/*=2(-+/
&s 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. +uring the last half of the
twentieth century, the countries with low inflation included apan ,8ermany and $wit:erland,
while the ".$. and %anada achieved low inflation only later. 'hose countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. 'his is also usually accompanied by higher interest rates.
D-**),)/(-2=4 -/ I/(),)4( R2()4
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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. 'herefore, higher interest rates attract foreign capital and
cause the exchange rate to rise. 'he 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. 'he opposite relationship exists for decreasing interest rates ( that is, lower
interest rates tend to decrease exchange rates.
C6,,)/(@A+6/( D)*--(4
'he 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. & 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
re<uires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. 'he excess demand for foreign
currency lowers the countryQs exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
!6=- D)(
%ountries will engage in large(scale deficit financing to pay for public sector pro)ect sand
governmental funding. *hile such activity stimulates the domestic economy ,nations with large
public deficits and debts are less attractive to foreign investors. 'he reasonR & 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. 7oreover, if a government is not able to
service its deficit through domestic means 1selling domestic bonds, increasing the money
supply2, then it must increase the supply of securities for sale to foreigners, thereby lowering
their prices. inally, a large debt may prove worrisome to foreigners if they believe the country
risks defaulting on its obligations. oreigners will be less willing to own securities denominated
in that currency if the risk of default is great. or this reason, the countryQs debt rating 1as
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determined by 7oodyQs or $tandard S 6oorQs, for example2 is a crucial determinant of its
exchange rate
.
T),<4 +* T,2)
'rade of goods and services between countries is the ma)or reason for the demand and supply of
foreign currencies. & 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 countryQs 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 countryQs exports. 'his, in turn, results in rising revenues
from exports, which provides increased demand for the countryQs currency 1and an increase in the
currencyQs value2. If the price of exports rises by a smaller rate than that of its imports, the
currencyQs value will decrease in relation to its trading partners. 'his is a typical case for
underdeveloped countries which rely on imports for development needs. 'he current account
balance1deficit or surplus2 thus reflects the strength and weakness of the domestic currency.
F. undamental actors vi:. 6olitical $tability and conomic 6erformance
undamental factors include all such events that affect the basic economic and fiscal policies of
the concerned government. 'hese factors normally affect the long(term exchange rates of any
currency. n 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. 'he fundamental factors are basic
economic policies followed by the government in relation to inflation, balance of payment
position, unemployment ,capacity utili:ation, trends in import and export, etc. !ormally, other
things remaining constant the currencies of the countries that follow the sound economic policies
will always be stronger. $imilar for the countries which are having balance of payment surplus,
the exchange rate will always be favourable. %onversely, for countries facing balance of payment
deficit, the exchange rate will be adverse. %ontinuous and ever growing deficit in balance of
payment indicates over valuation of the currency concerned and the dis(e<uilibrium created can
be remedied through devaluation. oreign investors inevitably seek out stable countries with
strong economic performance in which to invest their capital. & country with such positive
attributes will draw investment funds away from other countries perceived to have more political
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and economic risk. 6olitical turmoil, for example, can cause a loss of confidence in a currency
and a movement of capital to the currencies of more stable countries.
!+=-(-2= 2/ !4'+=+.-2= *2(+,4
6olitical and psychological factors are believed to have an influence on exchange rates.7any
currencies have a tradition of behaving in a particular way for e.g. $wiss ranc asa refuge
currency. 'he "$ +ollar is also considered a safer haven currency whenever there is a political
crisis anywhere in the world.
S:)6=2(-+/
$peculation or the anticipation of the market participants many a times is the prime reason for
exchange rate movements. 'he total foreign exchange turnover worldwide is many times the
actual goods and services related turnover indicating the grip of speculators over the market.
'hose 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. 'he
initial positioning and final profit taking make exchange rates volatile. 'hese 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 e<ual
bearing on the exchange rate movement. "nder 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.
C2:-(2= M+)<)/(
'he 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
utili:ed by these countries for home consumption entirely and needed to be invested elsewhere
productively. 7ovement of these petro dollars, started
affecting the exchange rates of various currencies. %apital tended to move from lower yielding to
higher yielding currencies and as a result the exchange rates moved. International investments in
the form of oreign direct investment 1+I2 and oreign institutional investments 1II2 have
become the most important factors affecting the
exchange rate in today’s open world economy. %ountries which attract large capital
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inflows through foreign investments, will witness an appreciation in its domestic currency as its
demand rises. utflow of capital would mean a depreciation of domestic currency.
I/(),)/(-+/
xchange rates are also influenced in no small measure by expectation of changes in regulation
relating to exchange markets and official intervention. fficial 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 <uarter of 03D the movement of
exchange rates of ma)or currencies reflected the change in the "$ policy in favour of co(
ordinated exchange market intervention as a measure to bring down the value of dollar.
S(+3 E02/.) O:),2(-+/4
$tock exchange operations in foreign securities, debentures, stocks and shares, influence the
demand and supply of related currencies, thus influencing their exchange rate
.
!+=-(-2= F2(+,4
6olitical scenario of the country ultimately decides the strength of the country. $table efficient
government at the centre will encourage positive development in the country, creating successf ul
investor confidence and a good image in the international market. &n economy with a strong,
positive image will obviously have a strong domestic currency. 'his is the reason why
speculations rise considerably during the parliament elections, with various predictions of the
future government and its policies. In 033D,the Indian rupee depreciated against the dollar due to
the &merican sanctions after India conducted the 6okharan nuclear test
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.
O(),4
'he 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, banksQ 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. Talue 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.
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!=2'),4 -/ F+,)-./ E02/.) M2,3)(
& key goal of exchange rate economics is to understand currency returns. xchange rates
like asset prices more generally move in response to new information about their fundamental
value. ver the past decade microstructure research has revealed
that this Uprice discovery process involves different categories of market participants. ach‖
participant’s distinct role is determined by 1a2 whether the agent
is a li<uidity maker or taker, and 1b2 the extent to which the agent is informed. 'he original /
market participants were traders in goods and services. %urrencies came into existence because
they solved the problem of the coincidence of wants with
respect to goods. 7ost countries have their own currencies so international trade in goods
re<uires trade in currencies. 'he 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 ma)or categories of market participants now
include asset managers, dealers, central banks, small individual 1retail2 traders, and most recentlyhigh(fre<uency traders.
'he orex over the counter market is formed by different participants
with varying needs and interests that trade directly with each other. 'hese participants can be
divided in two groups= the interbank market and the retail market.
T) I/(),2/3 M2,3)(
'he interbank market designates orex transactions that occur between central banks,
commercial banks and financial institutions.
C)/(,2= B2/34
!ational central banks 1such as the "$ ed, the %B, -.B.I.2play an important role in the orex
market. &s principal monetary authority, their role consists in achieving price stability and
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economic growth. 'heir main purpose is to provide ade<uate trading conditions. 'o do so, they
regulate the entire money supply in the economy by setting interest rates and reserve
re<uirements. 'hey also manage the countryQs foreign exchange reserves that they can use in
order to influence market conditions and exchange rates. %entral banks intervene in economic or
financial imbalance in the foreign exchange market. %entral banks are also responsible for
stabili:ing the forex market. 'hey do this by balancing the countryQs 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 )okingly referred to as circus performers because of the
daily balancing act that they have to perform. 'heir intervention in the foreign exchange market
is not to earn profit from foreign currency trading.
C+<<),-2= B2/34
'raditionally known as a savings and lending institution, banks are certainly one of the ma)or
players in forex market. 'hey are the natural players in foreign exchange as all other participants
must deal with them. oreign exchange currency trading began as an added service to deposits
and loans offered by commercial banks. Banks are usually involved in both large <uantities of
speculative trading and also daily commercial turnover. 'he really big and well(established
banks trade in the billions of dollars in foreign currencies every day. %ommercial banks provide
li<uidity to the orex market due to the trading volume they handle every day. $ome of this
trading represents foreign currency conversions on behalf of customersQ needs while some is
carried out by the banksQ proprietary trading desk for speculative purpose. 'he profitability
of foreign exchange trading is a perfect characteristic for banks to be involved
F-/2/-2= I/4(-(6(-+/4
inancial 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. or example, a manager of an international e<uity portfolio will
have to engage in currency trading in order to buy and sell foreign stocks.
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T) R)(2-= M2,3)(
'he retail market designates transactions made by smaller speculators and investors .'hese
transactions are executed through orex brokers who act as a mediator between the retail market
and the interbank market. 'he participants of the retail market are investment firms, hedge funds,
corporations and individuals O retail forex brokers and speculators..
I/)4(<)/( F-,<4
Investment management firms commonly manage huge accounts on behalf of their clients such
as endowments and pension funds. $ometimes, these investments re<uire the exchange of foreign
currencies so they have to facilitate these transactions through the use of the foreign exchange
market. 'hese situations exist because there are basically no limitations to the nationalities of
customers that an investment firm can attract. 'herefore, investment managers with an
international e<uity portfolio, needs to purchase and sell several pairs of foreign currencies to
pay for foreign securities purchases
H).) F6/4
Hedge funds are private investment funds that speculate in various assets classes using leverage.
7acro Hedge unds pursue trading opportunities in the orex 7arket. 'hey design and execute
trades after conducting a macroeconomic analysis that reviews the challenges affecting acountry
and its currency. +ue to their large amounts of li<uidity and their aggressive strategies, they are a
ma)or contributor to the dynamics of orex 7arket.
C+,:+,2(-+/4
'hey represent the companies that are engaged in importOexport activities with foreign
counterparts. 'heir primary business re<uires them to purchase and sell foreign currencies in
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exchange for goods, exposing them to currency risks. 'hrough the orex 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
.
I/--62=4 R)(2-= F+,)0 B,+3),4
Individual traders or investors trade orex on their own capital in order to profit from
speculation on future exchange rates
'hey mainly operate through orex platforms that offer tight spreads, immediate execution and
highly leveraged margin accounts. 'hese can be individuals or groups of individuals. 'hey
handle a fraction of the total volume of the entire forex market, but do not let that fool you. &
single retail forex broker estimate retail volume of between ? to A billion dollars each day.
'heir volume is estimated to make up ?E of the total market volume.
S:)6=2(+,4
& person, who trades in currencies with a higher than average risk in return for higher than
average profit potential. 'hese are the individuals or private investors who purchase and sell
foreign currencies and profit through fluctuations on their price. $peculators are a PhardyP bunch
simply because they are more adept at handling and maybe even sidestepping risks that
regular investors would prefer not to be involved with. $peculators take large risks, especially
with respect to anticipating future price movements, in the hope of making <uick large gains.
$peculators are risk(taking investors with expertise in the market1s2 in which they are trading and
will usually use highly leveraged investments such as futures and options
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FOREIGN EXCHANGE RISK
oreign exchange risk 1also known as exchange rate risk or currency risk2 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 conse<uences if not managed appropriately. 7any businesses were
unconcerned with and did not manage foreign exchange risk under the Bretton *oods system of
international monetary order. It wasnQt until the onset of floating exchange rates following the
collapse of the Bretton *oods 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. 'he outbreak of currency crises in the 033As and early ?AAAs, such as the
7exican peso crisis, &sian currency crisis, 033D -ussian financial crisis, and the &rgentine peso
crisis, substantial losses from foreign exchange have led firms to pay closer attention to foreign
exchange risk.
MANAGEMENT
7anagers of multinational firms employ a number of foreign exchange hedging strategies in
order to protect against exchange rate risk. 'ransaction 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 techni<ues such as currency invoicing, leading
and lagging of receipts and payments, and exposure netting.
irms 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
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activities and differentiating its products in pursuit of greater inelasticity and less foreign
exchange risk exposure.
'ranslation exposure is largely dependent on the accounting standards of the home country and
the translation methods re<uired by those standards. or example, the "nited $tates ederal
&ccounting $tandards Board specifies when and where to use certain methods such as the
temporal method and current rate method. irms can manage translation exposure by performing
a balance sheet hedge. $ince translation exposure arises from discrepancies between net assets
and net liabilities on a balance sheet solely from exchange rate differences. ollowing this logic,
a firm could ac<uire an appropriate amount of exposed assets or liabilities to balance any
outstanding discrepancy. oreign 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 isher effect hold true, a firm or investor neednQt protect against foreign
exchange risk due to an indifference toward international investment decisions. & deviation from
one or more of the three international parity conditions generally needs to occur for an exposure
to foreign exchange risk.
inancial 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. Tariance 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. & higher standard deviation would signal a greater currency
risk. conomists have critici:ed the accuracy of standard deviation as a risk indicator for its
uniform treatment of deviations, be they positive or negative, and for automatically s<uaring
deviation values. <ernatives such as average absolute deviation and semivariance have been
advanced for measuring financial risk.
VALUE AT RISK
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6ractitioners have advanced and regulators have accepted a financial risk management techni<ue
called value at risk 1T&-2, 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 urope have been
authori:ed by the Bank for International $ettlements to employ T&- models of their own design
in establishing capital re<uirements for given levels of market risk . "sing the T&- model helps
risk managers determine the amount that could be lost on an investment portfolio over a certain
period of time with a given probability of changes in exchange rates.
TY!ES OF FOREIGN EXCHANGE RISK
T,2/42(-+/ E0:+46,)
& firm has transaction exposure whenever it has contractual cash flows 1receivables and
payables2 whose values are sub)ect to unanticipated changes in exchange rates due to a contract
being denominated in a foreign currency. 'o reali:e the domestic value of its foreign(
denominated cash flows, the firm must exchange foreign currency for domestic currency. &s
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 inthe 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.
E+/+<- E0:+46,)
& firm has economic exposure 1also known as operating exposure2 to the degree that its market
value is influenced by unexpected exchange rate fluctuations. $uch exchange rate ad)ustments
can severely affect the firmQs market share position with regards to its competitors, the firmQs
future cash flows, and ultimately the firmQs value. conomic exposure can affect the present
value of future cash flows. &ny transaction that exposes the firm to foreign exchange risk also
exposes the firm economically, but economic exposure can be caused by other business activities
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T,2/4=2(-+/ E0:+46,)
& firmQs translation exposure is the extent to which its financial reporting is affected by exchange
rate movements. &s 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. *hile translation exposure may not affect a firmQs cash flows, it could have a
significant impact on a firmQs reported earnings and therefore its stock price. 'ranslation
exposure is distinguished from transaction risk as a result of income and losses from various
types of risk having different accounting treatments.
C+/(-/.)/( )0:+46,)
& firm has contingent exposure when bidding for foreign pro)ects or negotiating other contractsor foreign direct investments. $uch 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. or example, a firm could be waiting for a pro)ect bid to be accepted by a
foreign business or government that if accepted would result in an immediate receivable. *hile
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.
F+,)-./ E02/.) M2,3)( I/ I/-2
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'he foreign exchange market India is growing very rapidly. 'he annual turnover of the market is
more than C@AA billion. 'his transaction does not include the inter(bank transactions. &ccording
to the record of transactions released by -BI, the average monthly turnover in the merchant
segment was C@A. billion in ?AA5(A@ and the inter(bank transaction was C05@.? for the same
period.
.'he foreign exchange market India is growing very rapidly. 'he annual turnover of the market is
more than C@AA billion. 'his transaction does not include the inter(bank transactions. &ccording
to the record of transactions released by -BI, the average monthly turnover in the merchant
segment was C@A. billion in ?AA5(A@ and the inter(bank transaction was C05@.? for the same
period.
.'he average total monthly turnover was about [email protected] billion for the same period. 'he
transactions are made on spot and also on forward basis, which include currency swaps and
interest rate swaps.
'he Indian foreign exchange market consists of the buyers, sellers ,market intermediaries and the
monetary authority of India. 'he main center of foreign exchange transactions in India is
7umbai, the commercial capital of the country. 'here are several other centers for foreign
exchange transactions in the country including #olkata, !ew +elhi, %hennai, Bangalore,
6ondicherry and %ochin.
'he foreign exchange market India is regulated by the reserve bank of India through the
xchange %ontrol +epartment. &t the same time, oreign xchange +ealers
&ssociation1voluntary association2 also provides some help in regulating the market. 'he
&uthori:ed +ealers 1&uthori:ed by the -BI2 and the accredited brokers are eligible to participate
in the foreign xchange market in India. *hen the foreign exchange trade is going on between
&uthori:ed +ealers and -BI or between the &uthori:ed +ealers and the verseas banks, the
brokers have no role to play.
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.&part from the &uthori:ed +ealers and brokers, there are some others who are provided with
there stricted rights to accept the foreign currency or travelers che<ue. &mong these, there are the
authori:ed money changers, travel agents, certain hotels and government shops. 'he I+BI and
xim bank are also permitted conditionally to hold foreign currency.
'he whole foreign exchange market in India is regulated by the oreign xchange 7anagement
&ct, 0333 or 7&. Before this act was introduced, the market was regulated by the -& or
oreign xchange -egulation &ct ,03@4. &fter independence, -& was introduced as a
temporary measure to regulate the inflow of the foreign capital. But with the economic and
industrial development, the need for conservation of foreign currency was felt and on there
commendation of the 6ublic &ccounts %ommittee, the Indian government passed the oreign
xchange -egulation &ct,0345 and gradually, this act became famous as 7&
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CONCLUSION
'he foreign monetary exchange market is the biggest financial market in the world. Bigger than
the !ew ork $tock xchange and utures 7arket combined. &nd with reduced Pbuy(inP limitsnow, even small(time players can )oin the orex trading marketplace. 'hat doesnQt mean
everyone should )oin, however. Buying an auto(trading program sold to you with the promise of
making you millions probably wonQt. In fact, it may cost you everything you own. 'he only way
to win in orex trading is the good, old(fashioned way ( hard work
andasolidunderstandingofthemarket.
ne has to be clued in to global developments, trends in world trade as well as economic
indicators of different countries. 'hese include 8+6 growth, fiscal and monetary policies,
inflows and outflows of the currency, local stock market performance and interest rates.
'he currency derivatives market is highly leveraged. In the stock futures market, a ?AE margin
gains a five(fold leverage. In forex futures, the margin payable is )ust 5E, so the leverage is 55
times. 'his means that even a 0E 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.
ne has to be clued in to global developments, trends in world trade as well as economic
indicators of different countries. 'hese include 8+6 growth, fiscal and monetary policies,
inflows and outflows of the currency, local stock market performance and interest rates.
'he currency derivatives market is highly leveraged. In the stock futures market, a ?AE margin
gains a five(fold leverage. In forex futures, the margin payable is )ust 5E, so the leverage is 55
times. 'his means that even a 0E 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.
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Jiberali:ation has transformed India’s external sector and a direct beneficiary of this has been the
foreign exchange market in India. rom a foreign exchange(starved, control(ridden economy,
India has moved on to a position of C0A billion plus in international reserves with a confident
rupee and drastically reduced foreign exchange control. &s 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 -BI interventions any time soon.
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REFERENCES
http=OOwww.slashdocs.comOkvuttxOfem.htm
http://www.travelspk.com/forex/Forex-evelopme!t-"#stor$.htm
http://www.%lo&al-v#ew.com/forex-e'(cat#o!/forex-lear!#!%/%ftfxh#st.html
http=OOen.wikipedia.orgOwikiOoreignVexchangeVrisk