Chapter Meaning of foreign exchange

Foreign Exchange is the system or process of converting one national currency

into another and of transferring the ownership of money from one country to
another country.
For those unfamiliar with the term, FOREX (FOReign EXchange market),
refers to an international exchange market where currencies are bought and
sold. The Foreign Exchange Market that we see today began in the 1970's, when
free exchange rates and floating currencies were introduced. In such an
environment only participants in the market determine the price of one currency
against another, based upon supply and demand for that currency.
Foreign exchange refers to the process or mechanism by which the currency of
one country is converted into the currency of another country and thereby
involves the international transfer of money. It is the means and method by
which rights to wealth in a countrys currency are converted into rights to
wealth in another countrys currency. In banks when we talk of foreign
exchange, we refer to the general mechanism by which a bank converts
currency of one country into that of another. Foreign trade gives rise to foreign
exchange. Foreign trade is transacted either in the currency of the exporters
country or that of the importers country, or that of a third country acceptable to
both the exporter and the importer.
o Dr. Paul Einzig
Foreign exchange is the system or process of converting one national currency
into another and of transferring the ownership of money from one country to
another.

FOREX is a somewhat unique market for a number of reasons. Firstly, it is one

of the few markets in which it can be said with very few qualifications that it is
free of external controls and that it cannot be manipulated. It is also the largest
liquid financial market, with trade reaching between 1 and 1.5 trillion US
dollars a day. With this much money moving this fast, it is clear why a single
investor would find it near impossible to significantly affect the price of a major
currency. Furthermore, the liquidity of the market means that unlike some rarely
traded stock, traders are able to open and close positions within a few seconds
as there are always willing buyers and sellers.
Foreign exchange is that section of economic science which deals with the
means and methods by which rights to wealth in one countrys currency are
converted into rights to wealth in terms of another countrys currency. It
involves the investigation of the method by which the currency of one country
is exchanged for that of another, the causes which render such exchange
necessary, the forms which in exchange may take and the ratios or equivalent
values at which such exchanges are effected.

The term currency as earlier stated includes not only such notes and coins as
are legal tenders, but also bank balances and deposits in foreign currency and all
instruments- credit instruments which are capable of being used as currency,
such as bills of exchange, promissory notes, letter of credit, travelers cheques,
cheques, drafts, airmail transfers, telegraphic transfers (TT) and all other
instruments which convey to holder a right to wealth.
Thus foreign exchange means foreign currency and includes
I. All deposits, credits and balances payable in any foreign currency and

any drafts, travelers cheques, letters of credit and bills of exchange, expressed
or drawn in local currency but payable in any foreign currency; and
II. Any instrument payable, at the option of the drawee or holder thereof or any
other party thereto, either in local currency or in foreign currency or party in
one and party in the other.
Foreign

exchange is

concerned

with

the

settlement

of

international

indebtedness, the methods of effecting the settlements and the instruments used
in this connection, and the variation in the rates of exchange at which settlement
of international indebtedness is made.

Another somewhat unique characteristic of the FOREX money market is the

variance of its participants. Investors find a number of reasons for entering the
market, some as longer term hedge investors, while others utilize massive credit
lines to seek large short term gains. Interestingly, unlike blue-chip stocks, which
are usually most attractive only to the long term investor, the combination of
rather constant but small daily fluctuations in currency prices, create an
environment which attracts investors with a broad range of strategies.
Chapter Theory of purchasing power parity
In economics, purchasing power parity (PPP) asks how much money would be
needed to purchase the same goods and services in two countries, and uses that
to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of
money thus has the same purchasing power in different countries. Among other
uses, PPP rates facilitate international comparisons of income, as market
exchange rates are often volatile, are affected by political and financial factors
that do not lead to immediate changes in income and tend to systematically

understate the standard of living in poor countries, due to the Balassa

Samuelson effect.
The idea originated with the School of Salamanca in the 16th century and was
developed in its modern form by Gustav Cassel in 1918.[1][2] The concept is
based on the law of one price, where in the absence of transaction costs and
official trade barriers, identical goods will have the same price in different
markets when the prices are expressed in the same currency.[3]
Another interpretation is that the difference in the rate of change in prices at
home and abroadthe difference in the inflation ratesis equal to the
percentage depreciation or appreciation of the exchange rate.
Deviations from parity imply differences in purchasing power of a "basket of
goods" across countries, which means that for the purposes of many
international comparisons, countries' GDPs or other national income statistics
need to be "PPP-adjusted" and converted into common units. The best-known
purchasing power adjustment is the GearyKhamis dollar (the "international
dollar"). The real exchange rate is then equal to the nominal exchange rate,
adjusted for differences in price levels. If purchasing power parity held exactly,
then the real exchange rate would always equal one. However, in practice the
real exchange rates exhibit both short run and long run deviations from this
value, for example due to reasons illuminated in the BalassaSamuelson
theorem.
There can be marked differences between purchasing power adjusted incomes
and those converted via market exchange rates.[4] For example, the World
Bank's World Development Indicators 2005 estimated that in 2003, one GearyKhamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power
parity[5]considerably different from the nominal exchange rate. This
discrepancy has large implications; for instance, when converted via the

nominal exchange rates GDP per capita in India is about US$1,704.063[6] while
on a PPP basis it is about US$3,608.196.[7] At the other extreme, Denmark's
nominal GDP per capita is around US$62,100, but its PPP figure is US$37,304.

Chapter Purchasing Power Parity Theory of Exchange Rate is a theory,

which establishes the fact that the exchange rates between currencies are in
equilibrium in the event of equality in the purchasing power of each of the
countries. This precisely means that the ratio of the price level of a fixed amount
of goods and services of the two countries and the exchange rate between those
two countries must be equivalent. PPP is based on the Law of One Price. If the
inflation rate within a countrys economy increases then the value of the
currency needs to depreciate to revive the PPP. In the absence of transportation
and other similar expenses, the competitive market will equalize the price of an
identical object in two countries when the prices are expressed by the same
currency. However, one has to be careful with the Law of one Price. The
application of the Law of One Price is contingent upon certain conditions. They
are:
A competitive market must be present in both the countries for the goods and
services
The law is only applicable to the goods that can be traded between the
countries.
Transport expenses and other transaction expenses must be checked since they
are considered hindrances in trading.

Types of PPP

There are two types of PPP. They are:

Absolute Purchasing Power Parity that is based on the maintenance of equal

prices in two concerned countries.
Relative PPP describes the inflation rate. This describes the appreciation rate of
a currency, which is decided by calculating the difference between the exchange
rates of two countries.

Calculation of PPP
Purchasing Power Parity is calculated by comparing the price of an identical
good in both the countries. The Hamburger Index in The Economist magazine
presents the index in a jovial manner every year. But the calculation is not free
from problem because consumers in every country consume different types of
products. Another index is the iPOD Index. The iPOD is considered to be one of
the standard consumer products these days. Hence PPP can be calculated by
comparing its price.
The PPP is unable to display the right picture of the standard of living. There are
certain difficulties since the PPP number vary with specific amount of goods.
PPP is very often utilized to measure the poverty rates in countries.

Chapter foreign exchange market

The foreign exchange market is the "place" where currencies are traded.
Currencies are important to most people around the world, whether they realize
it or not, because currencies need to be exchanged in order to conduct foreign
trade and business. If you are living in the U.S. and want to buy cheese from
France, either you or the company that you buy the cheese from has to pay the
French for the cheese in euros (EUR). This means that the U.S. importer would
have to exchange the equivalent value of U.S. dollars (USD) into euros. The
same goes for traveling. A French tourist in Egypt can't pay in euros to see the
pyramids because it's not the locally accepted currency. As such, the tourist has
to exchange the euros for the local currency, in this case the Egyptian pound, at
the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is
the largest, most liquid financial market in the world. It dwarfs other markets in
size, even the stock market, with an average traded value of around U.S. $2,000
billion per day. (The total volume changes all the time, but as of April 2004,
the Bank for International Settlements (BIS) reported that the forex market
traded U.S. $1,900 billion per day.)
One unique aspect of this international market is that there is no central
marketplace for foreign exchange. Rather, currency trading is conducted
electronically over-the-counter (OTC), which means that all transactions occur
via computer networks between traders around the world, rather than on one
centralized exchange. The market is open 24 hours a day, five and a half days a

week, and currencies are traded worldwide in the major financial centers of
London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and
Sydney - across almost every time zone. This means that when the trading day
in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As
such, the forex market can be extremely active any time of the day, with price
quotes changing constantly.
Chapter Different types of exchange rate :
After the Bretton Woods system broke down, the world finally accepted the use
of floating foreign exchange rates during the Jamaica agreement of 1976. This
meant that the use of the gold standard would be permanently abolished.
However, this is not to say that governments adopted a pure free-floating
exchange rate system.
Throughout history, various international monetary systems and different types
of foreign exchange rate regimes existed. They served to manage not only
countries' domestic economic affairs but also international trade relations.
Course material from the University of West Georgia points out everything from
the gold standard and fixed rates to the fiat money and floating currencies.
Foreign exchange rates have become ever more visible in the increasingly
global economic environment and are very useful for both promoting trade and
maintaining

monetary

stability.

a. Floating Rates : Floating rates are the main type of foreign exchange rates
and the primary reason for currency fluctuations in foreign exchange
markets. All major economies from developed countries allow the value
of their currencies to float freely under market forces. Floating rates are
preferable if a country's economy is strong enough to withstand the
constant change in the value of its currency. For example, a country's

currency may lose value in the foreign exchange market if trade deficit is
causing weak demand for the currency and strong demand for foreign
currencies. As a lower currency value is making imports more expensive
and exports cheaper, both local and foreign buyers may switch their
demand to the country's domestic goods and services. An economy that
has the resources and means to meet the shifting demand can
automatically adjust both foreign trade and domestic economic activities.
Eventually the value of its currency can bounce back up.
b. Fixed Rates: The smaller economies of developing countries use fixed
foreign exchange rates to promote trade and attract foreign investments.
For example, by fixing its currency against the currencies of other
countries, a country keeps export prices affordable to foreign buyers and
accumulates trade surplus over time. Fixed currency rates also allow a
country to assure foreign investors of the stable value of their investments
in the country. However, under fixed rates, a country's monetary policies
can become ineffective, especially when trying to stimulate domestic
economic activities by consumers at home. Injecting more money into the
economy would normally reduce a country's currency value against
foreign currencies under floating rates. As imports become more
expensive, consumers would gradually focus their demand on domestic
products, potentially lifting up the economy. With fixed rates, however,
the exchange value of domestic currency does not move and more money
means more buying power for imports. Such an outcome does not achieve
policy makers' intention to increase domestic demand.
c. Pegged Rates :Pegged foreign exchange rates are a compromise between
floating rates and fixed rates. Under pegged rates, a country allows its
currency to fluctuate within a fixed band around a periodically adjusted

central value. Pegged rates are more appropriate for a transitioning,

developing economy. They allow both stability and a certain degree of
market adjustments. While no artificial exchange rates, fixed or pegged,
can fix economic problems single-handed, they do provide an opportunity
for growth. Countries hope that economic improvements can bring in the
foreign currency reserves required to keep the stated rates. When an
economy fails to produce the expected results, such a system cannot
maintain the fixed value for long, according to Brigham Young
University in "Fixed Exchange Rates vs. Floating Exchange Rates."

Chapter The Forex Market - What, When and Why?

Concept FX market
One of the largest businesses carried out by the commercial bank is foreign
trading. The trade among various countries falls for close link between the
parties dealing in trade. The situation calls for expertise in the field of foreign
operations. The bank, which provides such operation, is referred to as rending
international banking operation. Mainly transactions with overseas countries are
respects of import; export and foreign remittance come under the preview of
foreign exchange transactions. International trade demands a flow of goods
from seller to buyer and of payment from buyer to seller. In this case the bank
plays a vital role to bridge between the buyer and seller.
Forex, FX and the Forex market are some common abbreviations for the
Foreign Exchange market. Actually it is the largest financial market in the
world, where money is sold and bought freely. In its present condition the Forex

market was launched in the seventies, when free exchange rates were
introduced, and only the participants of the market determine the price of one
currency against the other proceeding from demand and supply. As far as the
freedom from any external control and free competition are concerned, the
Forex market is a perfect market.
With a daily turnover of over trillions of dollars, the Foreign Exchange market
conducts more than three times the aggregate amount volume of the United
States Equity and Treasury markets combined. The Forex market is an over-thecounter market where buyers and sellers conduct foreign exchange business
using different means of communication.
Unlike other financial markets, the Forex market has no physical location or
central exchange. Since the Forex market lacks a physical exchange, the market
trades continuously on a 24-hour basis, moving from one time zone to the next,
across each of the worlds major financial centers every day. Trillions of dollars
of foreign exchange activity takes place every day. From 1997 to the end of
2000, daily forex trading volume surged approximately from US$5 billion to
US$1.5 trillion and more (according to various recent studies it has touched
$1.7 trillion per day and dwarfs all other markets for trading in size and
volume). It is really difficult, if not impossible; to determine an absolutely exact
number because trading is not centralized on an exchange. But one thing is for
sure that the Forex market continues to grow at a phenomenal rate.
Before the advent of Internet and ecommerce, only big corporations,
multinational banks and wealthy individuals could trade currencies in the Forex
market through the use of the proprietary trading systems of banks. These
systems required as much as US$1 million to open an account. Thanks to
advancements in online technology, today investors with only a few thousand

dollars can have access to the Forex market 24 hours a day and around 5 days
of a week.
The Forex market is a nonstop cash market where currencies of nations are
traded, typically via brokers called forex brokers. Foreign currencies are
constantly and simultaneously bought and sold across local and global markets
while traders increase or decrease value of an investment upon currency
movements. Foreign exchange market conditions can change at any time in
response to real-time events so it is also considered to be a highly volatile and
fragile market too. Conditions of the Forex market never remain the same they
changes every second.

chapter Functions of foreign exchange market

The foreign exchange market performs the following important functions:

(i) to effect transfer of purchasing power between countries- transfer function;
(ii) to provide credit for foreign trade - credit function; and
(iii) to furnish facilities for hedging foreign exchange risks - hedging function.

Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion
of one currency into another, i.e., to accomplish transfers of purchasing power
between two countries. This transfer of purchasing power is effected through a
variety of credit instruments, such as telegraphic transfers, bank drafts and
foreign bills.

In performing the transfer function, the foreign exchange market carries out
payments internationally by clearing debts in both directions simultaneously,
analogous to domestic clearings.
Credit Function:
Another function of the foreign exchange market is to provide credit, both
national and international, to promote foreign trade. Obviously, when foreign
bills of exchange are used in international payments, a credit for about 3
months, till their maturity, is required.
Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange
risks. In a free exchange market when exchange rates, i.e., the price of one
currency in terms of another currency, change, there may be a gain or loss to the
party concerned. Under this condition, a person or a firm undertakes a great
exchange risk if there are huge amounts of net claims or net liabilities which are
to be met in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange
market provides facilities for hedging anticipated or actual claims or liabilities
through forward contracts in exchange. A forward contract which is normally
for three months is a contract to buy or sell foreign exchange against another
currency at some fixed date in the future at a price agreed upon now. No money
passes at the time of the contract. But the contract makes it possible to ignore
any likely changes in exchange rate.
The existence of a forward market thus makes it possible to hedge an exchange
position.
Foreign Exchange Market Features

Foreign exchange market is the market where the currency of one country is
exchanged for the currency of another country. In other words it is a market
where currencies are bought and sold just like equity shares are bought and sold
in equity markets. Given below are some of the main features of foreign
exchange market
1. Foreign exchange market is the only market which is open 24 hours a day,
except for weekends unlike equity or commodities market which are open only
for few hours.
2. Volume of transactions which are executed in foreign exchange market is
extremely huge because of many big players in foreign exchange market.
Foreign exchange markets are more liquid than any other market because of this
reason.
3. Foreign Exchange Market are present in every country and therefore
geographically they are located everywhere in the world, which makes them
quite unique.
4. Foreign exchange markets are the most difficult market to trade in as the
exchange rates of countries are affected by so many factors like interest rates,
liquidity, geopolitical factor and so on.
5. Foreign exchange market is a big player market, because mostly it is the big
banks and government who are the players in foreign exchange market.

Chapter Need of foreign Exchange :

There was a time in human civilization that money, whether in coins or in paper,
didn't exist. When you needed something, you would have to give up one of
your possessions for another's. For example, if a farmer sees a travelling
merchant visiting their community to sell some precious and delicate china
porcelains, he would have to exchange a portion of his rice for the merchant's
china. Such an agreement is called barter where one thing is exchanged for
another that were believed to be of the same value.
Of course, this hardly ever happens now as barter, except maybe for e-bay, as it
could become a very complicated process in the large-scale. Money has become
an effective tool to make businesses and ultimately, our daily lives, easy and
simple. When you need a commodity or service, all you need to do is to have
the right amount of money in order to have that thing you desire.
Because of globalization and with more countries opening up to the world, it is
inevitable that we become more involved with each other. The young Koreans
have found it important to see and travel the world with a certain fondness for
the beaches in the Southeast Asia. The Americans travel all the time to France
and Italy to see the latest fashion and the great landmarks. The Africans are
selling their nicely-crafted home designs to the Europeans. All of these are
indicative as to how we are all connected, one way or another. However, when
you travel, you cannot bring your nation's money alone and expect to live on a
foreign land. This is where foreign exchange becomes important to you.

Each nation is represented by its own national currency. The US has the
American dollar while the Japanese has the yen, just to name a few. When an
American travels to Japan, he would need to exchange his dollars to yen in
order to buy things in that country. This is called foreign exchange. In order for
him to have a benchmark as to how many yen his dollars could buy, he would
need to now the current exchange rate in local banks or money exchange. If it
says 1 dollar = 101 yen, it means that his dollar is highly valued and could
already buy 101 yen.
If the exchange rate the following day changes and becomes 1 dollar = 100 yen,
his dollar had depreciated against the yen and now could buy one yen less than
the other day. A depreciation and appreciation of a currency indicates the
strength of that particular currency and is always in reference to another
currency.
Multiple countries are also doing business with each other and this is another
situation where foreign exchange becomes important. When a Filipino exporter
exports his mangoes to the US, he does not get paid in pesos but in dollar
equivalent. Foreign exchange is an exchange of two national currencies, in this
case, the peso and the dollar.
So now we have seen how foreign exchange works and how we are affected by
it one way or another. It is not as complicated as how it looks like in the
business papers. All you need to do is to have a clear grasp on how the
exchange of money happens and you would do just fine.

Chapter Player in FX market:

Unlike a stock market, the foreign exchange market is divided into levels of
access. At the top is the interbank market, which is made up of the

largest commercial banks and securities dealers. Within the interbank market,
spreads, which are the difference between the bid and ask prices, are razor sharp
and not known to players outside the inner circle. The difference between the
bid and ask prices widens (for example from 0-1 pip to 1-2 pips for a currencies
such as the EUR) as you go down the levels of access. This is due to volume. If
a trader can guarantee large numbers of transactions for large amounts, they can
demand a smaller difference between the bid and ask price, which is referred to
as a better spread. The levels of access that make up the foreign exchange
market are determined by the size of the "line" (the amount of money with
which they are trading). The top-tier interbank market accounts for 53% of all
transactions. From there, smaller banks, followed by large multi-national
corporations (which need to hedge risk and pay employees in different
countries), large hedge funds, and even some of the retail market makers.
According to Galati and Melvin, Pension funds, insurance companies, mutual
funds, and other institutional investors have played an increasingly important
role in financial markets in general, and in FX markets in particular, since the
early 2000s. (2004) In addition, he notes, Hedge funds have grown markedly
over the 20012004 period in terms of both number and overall size.Central
banks also participate in the foreign exchange market to align currencies to their
economic

needs.

Commercial Banks. Traditionally known as a savings and lending

institution, banks are certainly one of the major players in forex market.
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 everyday. Some of the trades are undertaken on behalf

of their clients while most are through proprietary desks.

Central Banks. Central banks play an important role in the forex

market and that role is controlling the supply of different currencies. They
are also responsible for regulating inflation and interest rate.
Central banks are also responsible for stabilizing the forex market. They
do this by 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.

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.

Retail Forex Brokers. 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 estimates
retail volume of between 25 to 50 billion dollars each day. Their volume is
estimated to make up 2% of the total market volume.

Speculators. 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.

The Foreign Exchange Interbank Market

According to an April 2007 report by the Bank for International Settlements, the
foreign exchange market has an average daily volume of close to $3 trillion,
making it the largest market in the world. Unlike most other exchanges such as
the New York Stock Exchange or the Chicago Board of Trade, the FX market is
not a centralized market. In a centralized market, each transaction is recorded by
price dealt and volume traded. There is usually one central place back to which
all trades can be traced and there is often one specialist or market maker. The
currency market, however, is a decentralized market. There isn't one "exchange"
where every trade is recorded. Instead, each market maker records his or her
own transactions and keeps it as proprietary information. The primary market
makers who make bid and ask spreads in the currency market are the largest
banks in the world. They deal with each other constantly either on behalf of
themselves or their customers. This is why the market on which banks conduct
transactions is called the interbank market.
The competition between banks ensures tight spreads and fair pricing. For
individual investors, this is the source of price quotes and is where forex brokers

offset their positions. Most individuals are unable to access the pricing available
on the interbank market because the customers at the interbank desks tend to
include the largest mutual and hedge funds in the world as well as large
multinational corporations who have millions (if not billions) of dollars. Despite
this, it is important for individual investors to understand how the interbank
market works because it is one the best ways to understand how retail spreads
are priced, and to decide whether you are getting fair pricing from your broker.
Read on to find out how this market works and how its inner workings can
affect your investments.

Who makes the prices?

Trading in a decentralized market has its advantages and disadvantages. In a
centralized market, you have the benefit of seeing volume in the market as a
whole but at the same time, prices can easily be skewed to accommodate the
interests of the specialist and not the trader. The international nature of the
interbank market can make it difficult to regulate, however, with such important
players in the market, self-regulation is sometimes even more effective than
government regulations. For the individual investor, a forex broker must be
registered with the Commodity Futures Trading Commission as a futures
commission merchant and be a member of the National Futures Association
(NFA). The CFTC regulates the broker and ensures that he or she meets strict
financial standards. (For more insight on determining whether you're getting a
fair price from your broker, read Is Your Forex Broker A Scam? and Price
Shading In The Forex Markets.)

Most of the total forex volume is transacted through about 10 banks. These
banks are the brand names that we all know well, including Deutsche Bank
(NYSE:DB),

UBS

(NYSE:UBS),

Citigroup

(NYSE:C)

and

HSBC

(NYSE:HBC). Each bank is structured differently but most banks will have a
separate group known as the Foreign Exchange Sales and Trading Department.
This group is responsible for making prices for the bank's clients and for
offsetting that risk with other banks. Within the foreign exchange group, there is
a sales and a trading desk. The sales desk is generally responsible for taking the
orders from the client, getting a quote from the spot trader and relaying the
quote to the client to see if they want to deal on it. This three-step process is
quite common because even though online foreign exchange trading is
available, many of the large clients who deal anywhere from $10 million to
$100 million at a time (cash on cash), believe that they can get better pricing
dealing over the phone than over the trading platform. This is because most
platforms offered by banks will have a trading size limit because the dealer
wants to make sure that it is able to offset the risk.
On a foreign exchange spot trading desk, there are generally one or two market
makers responsible for each currency pair. That is, for the EUR/USD, there is
only one primary dealer that will give quotes on the currency. He or she may
have a secondary dealer that gives quotes on a smaller transaction size. This
setup is mostly true for the four majors where the dealers see a lot of activity.
For the commodity currencies, there may be one dealer responsible for all three
commodity currencies or, depending upon how much volume the bank sees,
there may be two dealers.
This is important because the bank wants to make sure that each dealer knows
its currency well and understands the behavior of the other players in the
market. Usually, the Australian dollar dealer is also responsible for the New

Zealand dollar and there is often a separate dealer making quotes for the
Canadian dollar. There usually isn't a "crosses" dealer - the primary dealer
responsible for the more liquid currency will make the quote. For example, the
Japanese yen trader will make quotes on all yen crosses. Finally, there is one
additional dealer that is responsible for the exotic currencies such as the
Mexican peso and the South African rand. This setup is usually mimicked
across three trading centers - London, New York and Tokyo. Each center passes
the client orders and positions to another trading center at the end of the day to
ensure that client orders are watched 24 hours a day. (To continue reading about
currency crosses, see Make The Currency Cross Your Boss and Identifying
Trending & Range-Bound Currencies.)

How do banks determine the price?

Bank dealers will determine their prices based upon a variety of factors
including, the current market rate, how much volume is available at the current
price level, their views on where the currency pair is headed and their inventory
positions. If they think that the euro is headed higher, they may be willing to
offer a more competitive rate for clients who want to sell euros because they
believe that once they are given the euros, they can hold onto them for a few
pips and offset at a better price. On the flip side, if they think that the euro is
headed lower and the client is giving them euros, they may offer a lower price
because they are not sure if they can sell the euro back to the market at the same
level at which it was given to them. This is something that is unique to market
makers that do not offer a fixed spread.
How does a bank offset risk?

Similar to the way we see prices on an electronic forex broker's platform, there
are two primary platforms that interbank traders use: one is offered by Reuters
Dealing and the other is offered by the Electronic Brokerage Service (EBS). The
interbank market is a credit-approved system in which banks trade based solely
on the credit relationships they have established with one another. All of the
banks can see the best market rates currently available; however, each bank
must have a specific credit relationship with another bank in order to trade at the
rates being offered. The bigger the banks, the more credit relationships they can
have and the better pricing they will be able access. The same is true for clients
such as retail forex brokers. The larger the retail forex broker in terms of capital
available, the more favorable pricing it can get from the interbank market. If a
client or even a bank is small, it is restricted to dealing with only a select
number of larger banks and tends to get less favorable pricing.

Both the EBS and Reuters Dealing systems offer trading in the major currency
pairs, but certain currency pairs are more liquid and are traded more frequently
over either EBS or Reuters Dealing. These two companies are continually trying
to capture each other's market shares, but as a guide, the following is the
breakdown where each currency pair is primarily traded:

EBS
EUR/USD
USD/JPY
EUR/JPY
EUR/CHF
USD/CHF

Reuters
GBP/USD
EUR/GBP
USD/CAD
AUD/USD
NZD/USD

Cross currency pairs are generally not quoted on either platform, but are
calculated based on the rates of the major currency pairs and then offset through
the legs. For example, if an interbank trader had a client who wanted to go long
EUR/CAD, the trader would most likely buy EUR/USD over the EBS system
and buy USD/CAD over the Reuters platform. The trader then would multiply
these rates and provide the client with the respective EUR/CAD rate. The twocurrency-pair transaction is the reason why the spread for currency crosses, such
as the EUR/CAD, tends to be wider than the spread for the EUR/USD.
The minimum transaction size of each unit that can be dealt on either platform
tends to one million of the base currency. The average one-ticket transaction
size tends to five million of the base currency. This is why individual investors
can't access the interbank market - what would be an extremely large trading
amount (remember this is unleveraged) is the bare minimum quote that banks
are willing to give - and this is only for clients that trade between $10 million
and $100 million and just need to clear up some loose change on their books.
(To learn more, see Wading Into The Currency Market.)

19 . Forex trading

Forex trading is the act of trading currencies from different countries against
each other. Forex is acronym for foreign exchange.

For example, in Europe the currency in circulation is called the Euro (EUR) and
in the United States, the currency in circulation is called the US Dollar (USD).
An example of a forex trade is to buy the Euro while simultaneously selling the
US Dollar. This is called going long on the EUR/USD.
Forex trading is typically done through a broker or market maker. As a forex
trader you can choose a currency pair that you feel is going to change in value
and place a trade accordingly.
Orders can be placed with just a few clicks and the broker then passes the order
along to a partner in the Interbank Market to fill your position.
When you close your trade, the broker closes the position on the Interbank
Market and credits your account with the loss or gain. This can all happen in
seconds.
The main enticements of currency dealing for private investors and attraction
for short-term forex trading are:
24-hour trading, 5 days a week with non-stop access to global forex

dealers.
An enormous liquid market making it easy to trade most currencies.
Volatile markets offering profit opportunities.
Standard instruments for controlling risk exposure.
The ability to profit in rising or falling markets.
Leveraged trading with low margin requirements.

 Many options for zero commission trading.

To know if you made a good investment in forex trading, one needs to compare
this investment option to alternative investments.
At the very minimum, the return on investment (ROI) should be compared to
the return on a 'risk-free' investment. One example of a risk-free investment is
long-term US government bonds since there is practically no chance for a
default, i.e. the US government going bankrupt or being unable or unwilling to
pay its debt obligation.
When trading currencies, trade only when you expect the currency you are
buying to increase in value relative to the currency you are selling.
If the currency you are buying does increase in value, you must sell back the
other currency in order to lock in a profit.
An open trade (also called an open position) is a trade in which a trader has
bought or sold a particular currency pair and has not yet sold or bought back the
equivalent amount to close the position.
However, it is estimated that anywhere from 70%-90% of the forex market is
speculative.
In other words, the person or institution that bought or sold the currency has no
plan to actually take delivery of the currency in the end; rather, they were solely
speculating on the movement of that particular currency.

20. Multilateral Netting & Benefits :

Multilateral netting allows a multinational firm to reduce the transaction costs
that arise when many transactions occur between its subsidiaries. These
transaction costs are the commissions paid to foreign exchange dealers for
foreign exchange transactions and the fees charged by banks for transferring
cash between locations. The volume of such transactions is likely to be
particularly high in a firm that has a globally dispersed web of interdependent
value creation activities. Netting reduces transaction costs by reducing the
number of transactions.
Multilateral netting is an extension of bilateral netting. Under bilateral netting,
if a French subsidiary owes a Mexican subsidiary $6 million and the Mexican
subsidiary simultaneously owes the French subsidiary 44 Million, a bilateral
settlement will be made with a single payment of $2 million from the French
subsidiary to the Mexican subsidiary the remaining debt being canceled.
Under multilateral netting, the simple concept is extended to the transactions
between multiple subsidiaries within an international business. Consider a firm
that wants to establish multilateral netting among four European subsidiaries
based in Germany, France, Spain, and Italy. These subsidiaries all trade with
each other, so at the end of each month a large volume of cash transactions must
be settled.

Process
When a company decides to do business with another affiliate, it must first
contact the netting center to confirm the details of the deal. The netting center
documents the specifics and converts all money involved to a common
exchange rate. It also maintains account receivable receipts in each company's
local currency and handles the payments for the transaction.
Outsourcing
Multilateral netting can be outsourced to banks or private firms. Netting
software is available, but, because the netting process is complex, companies
tend to allow a third party to handle netting transactions.
Benefits
Using multilateral netting helps companies avoid dealing with banks and other
financial entities, whereby reducing bank fees and currency conversion
expenses. Also, netting systems establish clear guidelines and time frames for
affiliated companies in regard to payment for goods and services.

Chapter Structure of foreign exchange market

The major participants in the foreign exchange markets are commercial banks;
foreign exchange brokers and other authorized dealers, and the monetary
authorities.
It is necessary to understand that the commercial banks operate at retail level for

individual exporters and corporations as well as at wholesale levels in the inter

bank market.

The foreign exchange brokers involve either individual brokers or corporations.

Bank dealers often use brokers to stay anonymous since the identity of banks
can influence short term quotes.

The monetary authorities mainly involve the central banks of various countries,
which intervene in order to maintain or influence the exchange rate of their
currencies within a certain range and also to execute the orders of the
government.

It is important to recognize that, although the participants themselves may be

based within the individual countries, and countries may have their own trading
centers, the market itself is world wide.
The trading centers are in close and continuous contact with one another, and
participants will deal in more than one market.

Primarily, exchange markets function through telephone and telex. Also, it is

important to note that currencies with limited convertibility play a minor role in
the exchange market.

Besides this, only a small number of countries have established their full
convertibility of their currencies for full transactions.

The foreign exchange market in India consists of 3 segments or tires. The first
consists of transactions between the RBI and the authorized dealers.
The latter are mostly commercial banks. The second segment is the interbank
market in which the ADs deal with each other. And the third segment consists
of transactions between ADs and their corporate customers.
The retail market in currency notes and travelers cheques caters to tourists. In
the retail segment in addition to the ADs there are moneychangers, who are
allowed to deal in foreign currencies.
Chapter 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 self
regulatory 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 Sodhani 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 3 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 inter-bank forex trading volume has continued to
account for the dominant share (over 77%) of total trading over this period,
though there is an unmistakable downward trend in that proportion. (Part of this
dominance, though, result s from double-counting since purchase and sales are
added separately, and a single inter-bank transaction leads to a purchase as well
as a sales entry.) This is in keeping with global patterns.

In March 2006, about half (48%) of the transactions were spot trades, while
swap transactions (essentially repurchase agreements with a one-way
transaction spot or forward combined with a longer- horizon forward
transaction in the reverse direction) accounted for 34% and forwards and
forward cancellations made up 11% and 7% respectively. About two-thirds of
all transactions had the rupee on one side. In 2004, according to the triennial
central bank survey of foreign exchange and derivative markets conducted by
the Bank for International Settlements (BIS (2005a)) the Indian Rupee featured
in the 20th position among all currencies in terms of being on one side of all
foreign transactions around the globe and its share had tripled since 1998. As a
host of foreign exchange trading activity, India ranked 23rd among all countries
covered by the BIS survey in 2004 accounting for 0.3% of the world turnover.

Trading is relatively moderately concentrated in India with 11 banks accounting

for over 75% of the trades covered by the BIS 2004 survey.
Chapter Foreign Exchange Dealer's in India :
Foreign Exchange Dealer's Association of India (FEDAI) was set up in
1958 as an Association of banks dealing in foreign exchange in India
(typically called Authorised Dealers - ADs) as a self regulatory body and is
incorporated under Section 25 of The Companies Act, 1956. It's major
activities include framing of rules governing the conduct of inter-bank
foreign exchange business among banks vis--vis public and liaison with RBI
for reforms and development of forex market.
Presently some of the functions are as follows:
Guidelines and Rules for Forex Business.
Training of Bank Personnel in the areas of Foreign Exchange Business.
Accreditation of Forex Brokers
Advising/Assisting member banks in settling issues/matters in their
dealings.
Represent member banks on Government/Reserve Bank of India/Other
Bodies.
Announcement of daily and periodical rates to member banks.
Due to continuing integration of the global financial markets and increased
pace of de-regulation, the role of self-regulatory organizations like FEDAI
has also transformed. In such an environment, FEDAI plays a catalytic role

for smooth functioning of the markets through closer co-ordination with the
RBI, other organizations like FIMMDA, the Forex Association of India and
various market participants. FEDAI also maximizes the benefits derived from
synergies of member banks through innovation in areas like new customized
products, bench marking against international standards on accounting,
market practices, risk management systems, etc.
Chapter
Foreign Exchange Market in India works under the central government in India
and executes wide powers to control transactions in foreign exchange.
The Foreign Exchange Management Act, 1999 or FEMA regulates the whole
foreign exchange market in India. Before this act was introduced, the foreign
exchange market in India was regulated by the reserve bank of India through the
Exchange Control Department, 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
urgently felt and on the recommendation of the Public Accounts Committee, the
Indian government passed the Foreign Exchange Regulation Act, 1973 and
gradually, this act became famous as FEMA.
Until 1992 all foreign investments in India and the repatriation of foreign capital
required previous approval of the government. The Foreign-Exchange
Regulation Act rarely allowed foreign majority holdings for foreign exchange in
India. However, a new foreign investment policy announced in July 1991,
declared automatic approval for foreign exchange in India for thirty-four
industries. These industries were designated with high priority, up to an
equivalent limit of 51 percent. The foreign exchange market in India is

regulated by the reserve bank of India through the Exchange Control

Department.

Initially the government required that a company`s routine approval must rely
on identical exports and dividend repatriation, but in May 1992 this requirement
of foreign exchange in India was lifted, with an exception to low-priority
sectors. In 1994 foreign and nonresident Indian investors were permitted to
repatriate not only their profits but also their capital for foreign exchange in
India. Indian exporters are enjoying the freedom to use their export earnings as
they find it suitable. However, transfer of capital abroad by Indian nationals is
only allowed in particular circumstances, such as emigration. Foreign exchange
in India is automatically made accessible for imports for which import licenses
are widely issued.

Indian authorities are able to manage the exchange rate easily, only because
foreign exchange transactions in India are so securely controlled. From 1975 to
1992 the rupee was coupled to a trade-weighted basket of currencies. In
February 1992, the Indian government started to make the rupee convertible,
and in March 1993 a single floating exchange rate in the market of foreign
exchange in India was implemented. In July 1995, Rs 31.81 was worth US$1, as
compared to Rs 7.86 in 1980, Rs 12.37 in 1985, and Rs17.50 in 1990.

Since the onset of liberalization, foreign exchange markets in India have

witnessed explosive growth in trading capacity. The importance of the exchange
rate of foreign exchange in India for the Indian economy has also been far
greater than ever before. While the Indian government has clearly adopted a

flexible exchange rate regime, in practice the rupee is one of most resourceful
trackers of the US dollar.

Predictions of capital flow-driven currency crisis have held India back from
capital account convertibility, as stated by experts. The rupee`s deviations from
Covered Interest Parity as compared to the dollar) display relatively long-lived
swings. An inevitable side effect of the foreign exchange rate policy in India has
been the ballooning of foreign exchange reserves to over a hundred billion
dollars. In an unparalleled move, the government is considering to use part of
these reserves to sponsor infrastructure investments in the country.

The foreign exchange market India is growing very rapidly, since the annual
turnover of the market is more than $400 billion. This foreign exchange
transaction in India does not include the inter-bank transactions. According to
the record of foreign exchange in India, RBI released these transactions. 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 in the sector of foreign exchange in India 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 is made up of the buyers, sellers, market
mediators and the monetary authority of India. The main center of foreign
exchange in India is Mumbai, the commercial capital of the country. There are
several other centers for foreign exchange transactions in India including the
major cities of Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and

Cochin. With the development of technologies, all the foreign exchange markets
of India work collectively and in much easier process. Read more
indiaforex.com

Foreign Exchange Dealers Association is a voluntary association that also

provides some help in regulating the market. The Authorized Dealers and the
attributed brokers are qualified to participate in the foreign Exchange markets of
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
usually do not have any role to play. Besides the Authorized Dealers and
brokers, there are some others who are provided with the limited rights to accept
the foreign currency or travelers` cheque, they are the authorized
moneychangers, travel agents, certain hotels and government shops. The IDBI
and Exim bank are also permitted at specific times to hold foreign currency.

The Foreign Exchange Market in India is a flourishing ground of profit and

higher initiatives are taken by the central government in order to strengthen the
foundation.