1.

Introduction
The market for foreign exchange involves the purchase and sale of national
currencies. A foreign exchange market exists because economies employ national
currencies. If the world economy used a single currency there would be no need for
foreign exchange markets. In Europe 11 economies have chosen to trade their
individual currencies for a common currency. But the euro will still trade against
other world currencies. For now, the foreign exchange market is a fact of life.
The foreign exchange market is extremely active. It is primarily an over
the counter market, the exchanges trade futures and option (more below) but most
transactions are OTC .It is difficult to assess the actual size of the foreign exchange
market because it is traded in many markets. For the US the Fed has estimated
turnover (in traditional products) in 1998to be $351 billion per day, after adjusting
for double counting. This is a 43% increase over1995, and about 60 times the
turnover in 1977. The Bank of International Settlements did survey currency
exchanges in 26 major centers and this provides some evidence. In figure 1we
present some evidence of the daily trading volume in the major cities. This shows
the size and growth of the market. Daily trading volumes on the foreign exchange
market often exceed $1 trillion1which is much larger than volumes on the New
York Stock Exchange (the total volume of trade on Black Monday in 1987 was
$21 billion). The annual volume off foreign exchange trading is some 60 times
larger than annual world trade ($5.2 trillion), and even 10-12 times larger than
world GNP (about $25-30 trillion in 1995). You can also verify from figure 1 that
the UK still accounts for the largest share of actual trades, more than 31%.

2. Objectives
The objectives of this chapter are:

To describe the basic features of the foreign exchange market.

To identify market participants and traded currencies.
To describe the mechanics and technology of foreign exchange trading.
To introduce some exchange rate concepts.
To introduce some foreign exchange jargon.

3. Methodology
Data collection:- (Secondary data)
In data collection method we shall collect the secondary data from the following
sources.
Books
Magazine
Internet

STATICAL TOOLS
MS EXCEL
MS Word.
MS Power point

Meaning
Foreign exchange market refers to the buying and selling of one national
currency for another I.e. buying foreign currencies with domestic currencies and
selling foreign currencies foe domestic currencies
Import-Export traders convert their foreign earnings into home currencies or home
currencies into foreign currencies to meet their obligations abroad.
Institutions like the Treasury. Central Bank , foreign exchange bank etc, involved
in the purchase and sale of foreign exchange currencies constitute 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.

Forex Market - Features

The Market Has No Physical Presence.
It Is The Largest Market On The Planet Earth .
It Is Mostly Speculative In Nature.
It Is A 24 Hour Market.
Some New York banks maintain 2 shifts (one arriving at office at 3 am when
London and Frankfurt are open) office at 3 am when London and Frankfurt are
open). Large New York banks also have branches in Tokyo, Frankfurt, and London.
Thus, they are in contact with all financial centers 24 hours.
Daily Turn Over 2.75 To 3.00 Trillion Dollar Per Day
Most Deals Are On Spot Basis.
The Market Is Deep, Liquid And Efficient. p, q
Deals Are Screen Based.
Market Is Volatile Because Of Floating Nature Of
Exchange Rates Exchange Rates

FUNCTIONS OF FOREIGN EXCHANGE MARKET

The foreign exchange market performs three important function as follows

1. clearing function

2.credit function

3.Hedging function

1. Clearing function
The is the primary function of the foreign exchange market. The foreign
exchange market helps to transfer the purchasing power between countries. This
transfer is done by converting domestic currency into foreign currencies and viceversa. Such a clearing mechanism helps to carry out international payments and
transactions.
Various credit instruments like foreign exchange bills and telegraphic transfer are
used for the purpose of affecting the transfer of purchasing power. The telegraphic
transfer is the quickest method and hence it is more popular.
The foreign bill of exchange is a draft or a commercial paper. The mechanism of
payment is similar to the mechanism of domestic payments through inter-bank
transactions.
The telegraphic transfer is an order by one bank in a country to its correspondent
in another country to pay the exporter out of rues foreign exchange account. The
foreign exchange market enables a complex pattern of multi-lateral payments.

2. Credit function
The foreign exchange market provides national and International credit to
promote foreign trade. International payments may be delayed as exporters and
importers may not be able to fulfill their obligations immediately. They may delay
payment for 60 or 90 days.in such cases, the foreign exchange market may provide
credit by discounting foreign exchange bills.
For e.g is bank Mr. X can get his bill discounted with a foreign exchange bank in
New York and this bank will transfer the bill to its correspondent in India for
collection of money from Mr. Y after the stipulated time.

3. Hedging Function
Hedging means covering foreign exchange risks arising out of fluctuations
in exchange rates. An importer who has to make payments to a foreign country
may lose if he expects the price to rise in future. To cover the risk, he may deposit
his own funds in the foreign country or buy forward the foreign exchange.
An exporter may lose if

expects the price to fall in the foreign country to which

he exports. To cover the risk, he may burrito from abroad at the present rate of
exchange or sells forward his expected foreign exchange.
Hedging can be done either by means of a spot market or a forward market
involving a forward contract.

FOREX MARKET ADVANTAGES AND DISADVANTAGES

Advantages of Forex markets:
1. Minimal or no commissions - There are no clearing fees, no exchange fees, no
government fees and no brokerage fees.
2. Easy access if you compare the money you need on the market in comparison
with the amount needed for entering the stock, options or futures market, its a
huge difference. The amount of capital is very low and it allows numerous types of
people to easily enter the foreign exchange market.
3. No middlemen spot currency trading is decentralized and eliminates
middlemen, allowing you to trade directly.
4. Lots of free courses and demo possibilities On the internet you can find huge
opportunities for learning how the Forex market works and what you need to
become a good trader. Also, most online Forex brokers offer demo accounts to
practice trading and build your skills, using real-time charts and news feeds. They
are more valuable than you could even imagine and, before starting your real
money on the market, try to see if you are built and ready for it by practicing with
these types of software.
5. Time and location flexibility the market is open 24 hours each day, so you
dont have to match your schedule with the one of the market. It doesnt require a
full-time engagement and you can choose the hours that suit your best. Also, you
can operate from any corner of the world, as long as you have an Internet
connection.
6. Low transaction costs the transaction cost, determined by the bid/ask spread, is
usually less than 0.1%, and it can go even lower in the case of large dealers.

7. A high liquidity market the market is huge, so is extremely liquid. Around 4

trillion dollars are exchanged every day, according to the latest figures released by
the Bank of International Settlements (BIS). That becomes an advantage, as you
dont have to struggle so much until you will find someone who wants to buy your
currency or sell you one. You cant get stuck and, by using features like stop lose,
you will close your position automatically, while not even being in front of the
computer.
8. Leverage with a little investment you can move large amounts of money.
Leverage gives the trader the ability to make nice profits and keep risk capital to a
minimum.
9. No forced deadlines no one and no rule is forcing you to close a position. You
can stay open as long as you consider necessary.
10. No fixed lot size requirements your contract size its your decision and you
are the only one who determines your own lot.
11. Transparency - due to multi-day market movement, its size and the high
number of participants, it is virtually impossible to market manipulation.

disadvantages of Forex markets:

1. Differences between retail and wholesale pricing around two-thirds of the
trades are made between dealers and large organizations such as hedge funds and
banks. They trade at wholesale prices, while the investor trades at a retail price.
Like this it can become a challenge to compete against bigger organization that
start with a lower entry point and sell more profitably.
2. Risk of choosing an inexperienced broker you can find on the internet many
people who are targeting fraud so be careful when choosing the broker.
3. Where there is a winner, there is also a looser dont expect necessarily to win
lots of money. Remember that for someone to get rich, another has to lose money
on the Forex market.
4. Requires knowledge and time Without completely knowing the markets rules
and without having patience, your investment might very well soon vanish.
When you enter Forex market, you have to be fully aware of its advantages, but
also disadvantages. Dont count only on the benefits of this investment to think that
you will succeed. Study, practice, improve your skills, keep an eye on all the news
and factors that influence the market, and always stick to your established system.

EXCHANGE RATE SYSTEMS

The first exchange rate system popularly called Gold standard prevailed
during 1879-1934 with the exception of World war years, Under the Gold standard
currencies of different countries were tied to gold E.g. the value of currency of
each country was fixed in terms of a certain quantity of gold. Thus the exchange
rate between different countries got automatically fixed. The gold standard
represented the fixed exchange rate system.
From the end of world war ll to 1971, another Fixed Exchange Rate System
known as the Bretton Woods System prevailed. Under this , the U.S. dollar was
tied to certain quantity of gold and the currencies of other countries were tied to
dollar or in some countries , directly to gold. Due to the persistent deficit in the
balance of payments in the US in 1971, the Bretton Woods system also broke
down.
Since then, the Flexible or the Floating Exchange rate system has been existing
since the Govt. or Central Bank of many countries intervenes to keep the
international value of their currencies (exchange rate) within certain limits, the
exchange rate system has not been purely flexible even after 1971. Hence it been
called Managed Float System.

There are three types of Exchange rate systems.

1. Fixed Exchange Rate:

When the government through its Central Bank officially fixes the
exchange rate of its currency in terms of gold or foreign currency it is known Fixed
exchange rate system. The exchange rate is fixed by the government by means of
pegging operations (ie buying and selling of foreign exchange at a particular
exchange rate.)
The Central bank seeks to maintain the exchange rate within a specific
margin of predetermined value in other currency. When the market rate falls below
the specific level, the currency is purchased and vice versa to maintain exchange
rate stability.
The fixed exchange rate system hes

to maintain rigid parity and the

Central Banks has to regularly intervene in the foreign exchange market. Fixed
exchange rate system was adopted by countries till 1971 where the exchange rate
was maintained within specific limits of the par values of the currencies.

2. Flexible Exchange rate system:

Free or flexible exchange rates are determined by the forces of demand
& supply in the foreign exchange market without government intervention.
Flexible exchange rates fluctuate freely based on marked mechanism and there can
be no limit upto which exchange rates between currencies would move.
The free floating exchange rate is allowed to seek its own level as no par of
exchange is fixed. Since 1980s , the International Monetary Fund (IMF) has been
forced to adopt a flexible exchange rate system as many countries were in favour

of the same. Flexible exchange rate was adopted since 1973 where the exchange
rates were fixed by market forces of demand and supply.

3. Managed Exchange Rate System:

Under the managed system, the currency is pegged or linked to a single
currency or a basket of currencies with discretionary intervention by the Central
Bank to attain stability in exchange rate. Under the managed or controlled
flexibility of exchange rate system, the range of flexibility around fixed par values
is determined by the country as per its economic need and the prevailing trend in
the international monetary system.
A system of managed flexibility emerged to take the merits of flexible
exchange rate system and avoid their demerits. The managed or floating exchange
rate system is based on the per value concept under IMF guidelinrs.

Types of Exchange Rate

Floating Rate A completely floating exchange rate is one whose level is
determined exclusively by underlying balance of supply and demand for the
currencies balance of supply and demand for the currencies involved
with no outside intervention i.e. Cable, Euro/$
Fixed Rate A fixed exchange rate is one in which case the government
guarantees a stable price for foreign currency This achieved through
interventions by central currency. This

achieved through

interventions

by central bank whenever exchange rate varies from a stated % from fixed
rate i.e. Kuwaiti Dinar

Foreign Exchange Markets in India a brief background

The foreign exchange market in India started in earnest less than three
decades ago when in 1978 the government allowed banks to trade foreign
exchange with one another. Today over 70% of the trading in foreign exchange
continues to take place in the inter-bank market. The market consists of over 90
Authorized Dealers (mostly banks) who transact currency among themselves and
come out square or without exposure at the end of the trading day. Trading is
regulated by the Foreign Exchange Dealers Association of India (FEDAI), a selfregulatory association of dealers. Since 2001, clearing and settlement functions in
the foreign exchange market are largely carried out by the Clearing Corporation of
India Limited (CCIL) that handles transactions of approximately 3.5 billion US
dollars a day, about 80% of the total transactions.
The liberalization process has significantly boosted the foreign exchange
market in the country by allowing both banks and corporations greater flexibility in
holding and trading foreign currencies. The Sod Hani Committee set up in 1994
recommended greater freedom to participating banks, allowing them to fix their
own trading limits, interest rates on FCNR deposits and the use of derivative
products.
The growth of the foreign exchange market in the last few years has been
nothing less than momentous. In the last 5 years, from 2000-01 to 2005-06, trading
volume in the foreign exchange market (including swaps, forwards and forward
cancellations) has more than tripled, growing at a compounded annual rate
exceeding 25%. Figure 1 shows the growth of foreign exchange trading in India
between 1999 and 2006.

The Dynamics of Swelling Reserves

An important corollary of Indias foreign exchange policy has been the
quick and significant accumulation of foreign currency reserves in the past few
years. Starting from a situation in 1990-91 with foreign exchange reserves level
barely enough to cover two weeks of imports, and about $32 billion at the
beginning of 2000, Indias foreign exchange position rocketed to one of the largest
in the world with over $155 billion in mid-2006. Since 2000, this implies a
compounded annual growth rate of about 28% with the years 2003 and 2004
having the most stunning rises at 48% and 45% respectively. During these two
years the US dollar fell against the Euro by 19% and against the rupee by 9%.
Without RBI intervention, the latter figure is lik reserves accumulation less
spectacular.
A sizable foreign exchange reserve acts as liquidity cover and protects
against a run on the countrys currency, and reduces the rate of interest on Indian
debt in the world market by lowering the country risk perception by international
rating agencies. However, beyond a point, it begins to affect the money supply in
the country, and interest rates. There are significant sterilization costs to avoid
this and the RBI loses money by e l y to have been larger and the earning low
returns on the safe assets used to park the reserves. Given this low rate of return,
there has been discussion about the unique proposal to use part of the reserves to
fund infrastructure projects.

Structure of the FOREX Market

The structure of the foreign exchange market is an outgrowth of one of the
primary functions of a commercial banker: to assist clients in the conduct of
international commerce. For example, a corporate client desiring to import
merchandise from abroad would need a source for foreign exchange if the import
was invoiced in the exporter shome currency. Alternatively, the exporter might
need a way to dispose of foreign ex-change if payment for the export was invoiced
and received in the importers home currency. Assisting in foreign exchange
transactions of this type is one of the services that commercial banks provide for
their clients, and one of the services that bank customers expect from their bank
.The spot and forward foreign exchange market is an

over-the-counter

(OTC)market; that is, trading does not take place in a central marketplace where
buyers and sellers congregate. Rather, the foreign exchange market is a worldwide
linkage of bank currency traders, nonbank dealers, and FX brokers who assist in
trades connected to one another via a network of telephones, telex machines,
computer terminals, and automated dealing systems. Reuters and EBS are the
largest vendors of quote screen monitors used in trading currencies. The
communications system of the foreign ex-change market is second to none,
including industry, governments, and the military and national security and
intelligence operations. Twenty-four-hour-a-day currency trading follows the sun
around the globe. Three major market segments can be identified: Australasia,
Europe, and North America. Australasia includes the trading centers of Sydney,
Tokyo, Hong Kong, Singapore, and Bahrain; Europe includes Zurich, Frankfurt,
Paris, Brussels, Amsterdam, and London; and North America includes New York,
Montreal, Toronto, Chicago, San Francisco, and Los Angeles. Most trading rooms
operate over a 9- to 12-hour working day,

THE DETERMINATION OF EXCHANGE RATES

I. SETTING THE EQUILIBRIUM

A. Exchange Rates
Market- clearing prices that equilibrate the quantities supplied
and demanded of foreign currency
B. How Americans Purchase German Goods
1. Foreign Currency Demand-derived from the demand for
foreign countrys goods, services, and financial assets e.g. The
demand for German goods by Americans
2. Foreign Currency Supply:
A. derived from the foreign countrys demand for
local goods.
b. They must convert their currency to purchase. e.g. German
demand for US goods means Germans convert DM to US $ in
order to buy.
3. Equilibrium Exchange Rate:
occurs when the quantity supplied equals the quantity demanded
of a foreign currency at a specific local price.

C. How Exchange Rates Change

1. Increased demand as more foreign goods are demanded, the
price of the foreign currency in local currency increases and vice
versa.
2. Home Currency Depreciation
a. Foreign currency becomes more valuable than the home
currency.
b. Conversely, the foreign currencys value has
appreciated against the home currency

Purpose of the Foreign Exchange Market

Identification
Consumers acquire foreign exchange so they can purchase overseas goods.
Alternatively, businesses might receive foreign exchange and enter the market to
convert that money back into domestic currency.
The foreign exchange market also serves the purpose of attracting investors.
Investors diversify and increase their asset holdings with currency reserves.

Features
Foreign exchange rates describe the amount of another currency that one
unit of a certain currency can buy. Because of their association with specific
nations, foreign exchange rates gauge economic and political sentiment. Low
exchange rates translate into weak demand for a currency, as foreign investors
liquidate that country’s stocks, bonds and real estate. At that point,
foreigners might fear recession, or politics that are hostile to foreign investment.
For example, high tax rates on foreign profits can cause foreigners to withdraw
from a particular country.
Conversely, high exchange rates define strong economies and effective political
regimes. Investors are then encouraged to trade for that currency and to purchase
its home nation& rsquo;s assets. The increased demand for the currency supports
elevated exchange rates.

Considerations
Government officials can manage their home economies through foreign exchange
transactions. Low exchange rates for the domestic currency improve the export
economy, because these goods become more affordable to foreign buyers.
However, domestic consumers prefer higher exchange rates, which grant them
more purchasing power for imported goods.
Government leaders use foreign exchange reserves to influence currency
exchange rates. Nations can buy large amounts of foreign exchange reserves to
devalue the home currency. China owned $900 billion worth of U.S. treasuries as
of April 2010, the U.S. Treasury reported. These holdings lower exchange rates for
the Chinese Yuan and support China’s export economy.

Warning
Foreign exchange markets do introduce distinct risks of financial losses and
contagion. Institutions that hold a particular currency lose purchasing power when
its exchange rates deteriorate. However, as a home currency strengthens,
multinational corporations suffer sales declines because their wares become more
expensive overseas.
"Contagion" refers to the process of financial distress in one region growing into a
global crisis. For example, Mexico might default on its sovereign debt, which
causes the peso to collapse. From there, foreign businesspeople with exposure to
Mexico might be forced to sell off all assets to raise cash. The selling compounds,
and it causes markets to crash globally.

Strategy
Foreign exchange markets offer currency derivatives to hedge against risks.
Currency derivatives, such as futures, forwards and options establish
predetermined exchange rates over set periods of time. Futures and options trade
on major exchanges, such as the Chicago Mercantile Exchange. Forwards are
private agreements between two parties to negotiate exchange rates at later points
in time.