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PART 2 (SEM -3)


In Partial Fulfillment of the requirements
For the Award of the Degree of


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PART 2 (SEM-3), ROLL NO.6, academic year 2016-2017 Studying at S.K. SOMAIYA
COLLEGE OF ARTS, SCIENCE AND COMMERCE, hereby declare that the work done
on the project Entitled FOREIGN EXCHANGE MARKET is true and original and any
Reference used in this project is duly acknowledged.

----------------------------SIGNATURE OF STUDENT

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This is to certify that MRS.KRISHNA BHANUSHALI, studying in MCOM (BANKING
& FINANCE) PART 2 (SEM-3), ROLL NO.6, academic year 2016-2017 at
project on FOREIGN EXCHANGE MARKET under the guidance of PROF. PRAVIN
The information submitted herein is true and original to the best of my knowledge.





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NO. 6 for her project. She has completed the project on FOREIGN EXCHANGE
MARKET successfully.
I, hereby declare that information provided in this project is true as per the best of
my knowledge.

Thank You,
Yours Faithfully,


Project Guide

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It gives me immense pleasure to present a project on FOREIGN EXCHANGE MARKET
As a MCOM student it is a great honour to undergo a project work at an graduate level and I
would like to thank the University of Mumbai for giving me such a golden opportunity.
I am eternally grateful to almighty god for giving me the spirit to put in my best effort
towards my project. I owe my sincere gratitude to DR. SANGEETA KOHLI, the principal
of our college. I am also thankful to my project guide PRAVIN MALU for his valuable
guidance and for providing an insight to the subject.
I am also obliged to the library staff of S.K Somaiya College for the numerous books made
me available for the handy reference.
Although, I have taken every care to check mistake and misprint yet it is difficult to claim
perfection. Any error, omission and suggestion brought to my notice, will be thankfully
acknowledged by me.

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Page Nos




9 -12

Size Of Markets

13 28

Market Participants

29 32

Trading Characteristics

33 34

Determinants of exchange rates


Economics Factors

36 39

Case study on foreign exchange


40 - 41





Foreign Exchange Markets

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The foreign exchange market (forex, FX, or currency market) is a
global decentralized market for the trading of currencies. This includes all
aspects of buying, selling and exchanging currencies at current or determined
prices. In terms of volume of trading, it is by far the largest market in the world.
The main participants in this market are the larger international banks. Financial
centres around the world function as anchors of trading between a wide range of
multiple types of buyers and sellers around the clock, with the exception of
weekends. The foreign exchange market determines the relative values of
different currencies.
The foreign exchange market works through financial institutions, and it
operates on several levels. Behind the scenes banks turn to a smaller number of
financial firms known as dealers, who are actively involved in large quantities
of foreign exchange trading. Most foreign exchange dealers are banks, so this
behind-the-scenes market is sometimes called the interbank market, although
a few insurance companies and other kinds of financial firms are involved.
Trades between foreign exchange dealers can be very large, involving hundreds
of millions of dollars. Because of the sovereignty issue when involving two
currencies, forex has little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by
enabling currency conversion. For example, it permits a business in the United
States to import goods from European Union member states,
especially Eurozone members, and pay Euros, even though its income is
in United States dollars. It also supports direct speculation and evaluation
relative to the value of currencies, and the carry trade, speculation based on the
interest rate differential between two currencies.
In a typical foreign exchange transaction, a party purchases some quantity of
one currency by paying with some quantity of another currency. The modern
foreign exchange market began forming during the 1970s after three decades of
government restrictions on foreign exchange transactions (the Bretton Woods
system of monetary management established the rules for commercial and
financial relations among the world's major industrial states after World War II),
when countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed as per the Bretton Woods
The foreign exchange market is unique because of the following characteristics:
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its huge trading volume representing the largest asset class in the world
leading to high liquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e., trading

from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New


the variety of factors that affect exchange rates;

the low margins of relative profit compared with other markets of fixed

income; and

the use of leverage to enhance profit and loss margins and with respect to

account size.

As such, it has been referred to as the market closest to the ideal of perfect
competition, notwithstanding currency intervention by central banks.
According to the Bank for International Settlements, the preliminary global
results from the 2013 Triennial Central Bank Survey of Foreign Exchange and
OTC Derivatives Markets Activity show that trading in foreign exchange
markets averaged $5.3 trillion per day in April 2013. This is up from $4.0
trillion in April 2010 and $3.3 trillion in April 2007. Foreign exchange swaps
were the most actively traded instruments in April 2013, at $2.2 trillion per day,
followed by spot trading at $2.0 trillion. According to the Bank for International
Settlements, as of April 2010, average daily turnover in global foreign exchange
markets is estimated at $3.98 trillion, a growth of approximately 20% over the
$3.21 trillion daily volume as of April 2007. Some firms specializing on foreign
exchange market had put the average daily turnover in excess of US$4 trillion.
The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions

$475 billion in outright forwards

$1.765 trillion in foreign exchange swaps

$43 billion currency swaps

$207 billion in options and other products

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Currency trading and exchange first occurred in ancient times. Money-changing
people, people helping others to change money and also taking a commission or
charging a fee were living in the times of the Talmudic writings (Biblical times).
These people (sometimes called "kollybists") used city-stalls, at feast times the
temples Court of the Gentilesinstead. Money-changers were also in more recent
ancient times silver-smiths and/or gold-smiths.
During the 4th century, the Byzantine government kept a monopoly on the
exchange of currency
Papyri PCZ I 59021 (c.259/8 BC), shows the occurrences of exchange of
coinage within Ancient Egypt.
Currency and exchange was also a vital and crucial element of trade during the
ancient world so that people could buy and sell items like food, pottery and raw
materials. If a Greek coin held more gold than an Egyptian coin due to its size
or content, then a merchant could barter fewer Greek gold coins for more
Egyptian ones, or for more material goods. This is why, at some point in their
history, most world currencies in circulation today had a value fixed to a
specific quantity of a recognized standard like silver and gold.
Medieval and later
During the 15th century, the Medici family were required to open banks at
foreign locations in order to exchange currencies to act on behalf
of textile merchants. To facilitate trade the bank created the nostro (from Italian
translated "ours") account book which contained two columned entries
showing amounts of foreign and local currencies, information pertaining to the
keeping of an account with a foreign bank. During the 17th (or 18th ) century,
Amsterdam maintained an active forex market. In 1704, foreign exchange took
place between agents acting in the interests of the Kingdom of England and
the County of Holland.
Early modern
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Alex. Brown & Sons traded foreign currencies exchange sometime about 1850
and was a leading participant in this within U.S.A. During 1880, J.M. do
Esprito Santo de Silva (Banco Esprito Santo) applied for and was given
permission to begin to engage in a foreign exchange trading business.
The year 1880 is considered by at least one source to be the beginning of
modern foreign exchange, significant for the fact of the beginning of the gold
standard during the year.
Prior to the first world war, there was a much more limited control of
international trade. Motivated by the outset of war, countries abandoned the
gold standard monetary system.
Modern to post-modern
From 1899 to 1913, holdings of countries' foreign exchange increased at an
annual rate of 10.8%, while holdings of gold increased at an annual rate of 6.3%
between 1903 and 1913.
At the time of the closing of the year 1913, nearly half of the world's foreign
exchange was conducted using the Pound sterling. The number of foreign banks
operating within the boundaries of London increased from 3 in 1860 to 71 in
1913. In 1902, there were altogether two London foreign exchange brokers.
During the earliest years of the 20th century, trade was most active in Paris,
New York and Berlin, while Britain remained largely uninvolved in trade until
1914. Between 1919 and 1922, the employment of foreign exchange brokers
within London increased to 17, in 1924 there were 40 firms operating for the
purposes of exchange. During the 1920s, the occurrence of trade in London
resembled more the modern manifestation, by 1928 forex trade was integral to
the financial functioning of the city. Continental exchange controls, plus other
factors, in Europe and Latin America, hampered any attempt at wholesale
prosperity from trade for those of 1930's London.
During the 1920s, the Kleinwort family were known to be the leaders of the
foreign exchange market; while Japheth, Montagu & Co., and Seligman still
warrant recognition as significant FX traders.
After WWII

After WWII, the Bretton Woods Accord was signed allowing currencies to
fluctuate within a range of 1% to the currencies par. In Japan, the law was
changed during 1954 by the Foreign Exchange Bank Law, so, the Bank of
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Tokyo was to become, because of this, the centre of foreign exchange by

September of that year. Between 1954 and 1959 Japanese law was made to
allow the inclusion of many more Occidental currencies in Japanese forex.
U.S. President Richard Nixon is credited with ending the Bretton Woods Accord
and fixed rates of exchange, eventually bringing about a free-floating currency
system. After the ceasing of the enactment of the "Bretton Woods Accord"
during 1971, the Smithsonian Agreement allowed trading to range to 2%.
During 196162, the amount of foreign operations by the U.S. Federal Reserve
was relatively low Those involved in controlling exchange rates found the
boundaries of the Agreement were not realistic and so ceased this in March
1973, when sometime afterward none of the major currencies were maintained
with a capacity for conversion to gold, organizations relied instead on reserves
of currency. During 1970 to 1973 the amount of trades occurring in the market
increased three-fold. At some time (according to Gandolfo during February
March 1973) some of the markets' were "split", so a two tier currency market
was subsequently introduced, with dual currency rates. This was abolished
during March 1974.
Reuters introduced computer monitors during June 1973, replacing the
telephones and telex used previously for trading quotes.
Markets close

Due to the ultimate ineffectiveness of the Bretton Woods Accord and the
European Joint Float the forex markets were forced to close sometime during
1972 and March 1973. The very largest of all purchases of dollars in the history
of 1976 was when the West German government achieved an almost 3 billion
dollar acquisition (a figure given as 2.75 billion in total by The Statesman:
Volume 18 1974), this event indicated the impossibility of the balancing of
exchange stabilities by the measures of control used at the time and the
monetary system and the foreign exchange markets in "West" Germany and
other countries within Europe closed for two weeks (during February and, or,
March 1973. Giersch, Paqu, & Schmieding state closed after purchase of "7.5
million Dmarks" Brawley states "... Exchange markets had to be closed. When
they re-opened ... March 1 "that is a large purchase occurred after the close).
After 1973
The year 1973 marks the point to which nation-state, banking trade and
controlled foreign exchange ended and complete floating, relatively free
conditions of a market characteristic of the situation in contemporary times
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began (according to one source), although another states the first time a
currency pair were given as an option for U.S.A. traders to purchase was during
1982, with additional currencies available by the next year.
On 1 January 1981, as part of changes beginning during 1978, the People's
Bank of China allowed certain domestic "enterprises" to participate in foreign
exchange trading. Sometime during 1981, the South Korean government ended
forex controls and allowed free trade to occur for the first time. During 1988 the
countries government accepted the IMF quota for international trade.
Intervention by European banks especially the Bundesbank influenced the forex
market, on 27 February 1985 particularly. The greatest proportion of all trades
world-wide during 1987 were within the United Kingdom, slightly over one
quarter, with the United States being the nation with the second most places
involved in trading.
During 1991, Iran changed international agreements with some countries from
oil-barter to foreign exchange.

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Size of the Market:

Foreign exchange market is the largest financial market with a daily turnover of
over USD 2 trillion. Foreign exchange markets were primarily developed to
facilitate settlement of debts arising out of international trade. But these markets
have developed on their own so much so that a turnover of about 3 days in the
foreign exchange market is equivalent to the magnitude of world trade in goods
and services. The largest foreign exchange market is London followed by New
York, Tokyo, Zurich and Frankfurt. The business in foreign exchange markets in
India has shown a steady increase as a consequence of increase in the volume of
foreign trade of the country, improvement in the communications systems and
greater access to the international exchange markets. Still the volume of
transactions in these markets amounting to about USD 2 billion per day does
not compete favorably with any well developed foreign exchange market of
international repute. The reasons are not far to seek. Rupee is not an
internationally traded currency and is not in great demand. Much of the external
trade of the country is designated in leading currencies of the world, Viz., US
dollar, pound sterling, Euro, Japanese yen and Swiss franc. Incidentally, these
are the currencies that are traded actively in the foreign exchange market in
India. 24 Hours Market The markets are situated throughout the different time
zones of the globe in such a way that when one market is closing the other is
beginning its operations. Thus at any point of time one market or the other is
open. Therefore, it is stated that foreign exchange market is functioning
throughout 24 hours of the day. However, a specific market will function only
during the business hours. Some of the banks having international network and
having centralized control of funds management may keep their foreign
exchange department in the key centre open throughout to keep up with
developments at other centers during their normal working hours In India, the
market is open for the time the banks are open for their regular banking
business. No transactions take place on Saturdays. Efficiency Developments in
communication have largely contributed to the efficiency of the market. The
participants keep abreast of current happenings by access to such services like
Dow Jones Telerate and Teuter. Any significant development in any market is
almost instantaneously received by the other market situated at a far off place
and thus has global impact. This makes the foreign exchange market very
efficient as if the functioning under one roof. Currencies Traded In most
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markets, US dollar is the vehicle currency, Viz., the currency used to

denominate international transactions. This is despite the fact that with
currencies like Euro and Yen gaining larger share, the share of US dollar in the
total turn over is shrinking. Physical Markets In few centers like Paris and
Brussels, foreign exchange business takes place at a fixed place, such as the
local stock exchange buildings. At these physical markets, the banks meet and
in the presence of the representative of the central bank and on the basis of
bargains, fix rates for a number of major currencies. This practice is called
fixing. The rates thus fixed are used to execute customer orders previously
placed with the banks. An advantage claimed for this procedure is that exchange
rate for commercial transactions will be market determined, not influenced by
any one bank. However, it is observed that the large banks attending such
meetings with large commercial orders backing up, tend to influence the rates.
Participants The participants in the foreign exchange market comprise; (i)
Corporates (ii) Commercial banks (iii) Exchange brokers (iv) Central banks
Corporates: The business houses, international investors, and multinational
corporations may operate in the market to meet their genuine trade or
investment requirements. They may also buy or sell currencies with a view to
speculate or trade in currencies to the extent permitted by the exchange control
regulations. They operate by placing orders with the commercial banks. The
deals between banks and their clients form the retail segment of foreign
exchange market. In India the foreign Exchange Management (Possession and
Retention of Foreign Currency) Regulations, 2000 permits retention, by
resident, of foreign currency up to USD 2,000. Foreign Currency Management
(Realisation, Repatriation and Surrender of Foreign Exchange) Regulations,
2000 requires a resident in India who receives foreign exchange to surrender it
to an authorized dealer:
(a) Within seven days of receipt in case of receipt by way of remuneration,
settlement of lawful obligations, income on assets held abroad,
inheritance, settlement or gift: and (b) Within ninety days in all other
cases. Any person who acquires foreign exchange but could not use it for
the purpose or for any other permitted purpose is required to surrender
the unutilized foreign exchange to authorized dealers within sixty days
from the date of acquisition. In case the foreign exchange was acquired
for travel abroad, the unspent foreign exchange should be surrendered
within ninety days from the date of return to India when the foreign
exchange is in the form of foreign currency notes and coins and within
180 days in case of travellers cheques. Similarly, if a resident required
foreign exchange for an approved purpose, he should obtain from and
authorized dealer. Commercial Banks are the major players in the market.
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They buy and sell currencies for their clients. They may also operate on
their own. When a bank enters a market to correct excess or sale or
purchase position in a foreign currency arising from its various deals with
its customers, it is said to do a cover operation. Such transactions
constitute hardly 5% of the total transactions done by a large bank. A
major portion of the volume is accounted buy trading in currencies
indulged by the bank to gain from exchange movements. For transactions
involving large volumes, banks may deal directly among themselves. For
smaller transactions, the intermediation of foreign exchange brokers may
be sought.
Exchange brokers facilitate deal between banks. In the absence of exchange
brokers, banks have to contact each other for quotes. If there are 150 banks
at a centre, for obtaining the best quote for a single currency, a dealer may
have to contact 149 banks. Exchange brokers ensure that the most favorable
quotation is obtained and at low cost in terms of time and money. The bank
may leave with the broker the limit up to which and the rate at which it
wishes to buy or sell the foreign currency concerned. From the intends from
other banks, the broker will be able to match the requirements of both. The
names of the counter parities are revealed to the banks only when the deal is
acceptable to them. Till then anonymity is maintained. Exchange brokers
tend to specialize in certain exotic currencies, but they also handle all major
currencies. In India, banks may deal directly or through recognized exchange
brokers. Accredited exchange brokers are permitted to contract exchange
business on behalf of authorized dealers in foreign exchange only upon the
understanding that they will conform to the rates, rules and conditions laid
down by the FEDAI. All contracts must bear the clause subject to the
Rules and Regulations of the Foreign Exchanges Dealers Association of
India. Central Bank may intervene in the market to influence the exchange
rate and change it from that would result only from private supplies and
demands. The central bank may transact in the market on its own for the
above purpose. Or, it may do so on behalf of the government when it buys or
sell bonds and settles other transactions which may involve foreign exchange
payments and receipts. In India, authorized dealers have recourse to Reserve
Bank to sell/buy US dollars to the extent the latter is prepared to transact in
the currency at the given point of time. Reserve Bank will not ordinarily
buy/sell any other currency from/to authorized dealers. The contract can be
entered into on any working day of the dealing room of Reserve Bank. No
transaction is entered into on Saturdays. The value date for spot as well as
forward delivery should be in conformity with the national and international
practice in this regard. Reserve Bank of India does not enter into the market
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in the ordinary course, where the exchages rates are moving in a detrimental
way due to speculative forces, the Reserve Bank may intervene in the market
either directly or through the State Bank of India.
Settlement of Transactions Foreign exchange markets make extensive use of
the latest developments in telecommunications for transmitting as well
settling foreign exchange transaction, Banks use the exclusive network
SWIFT to communicate messages and settle the transactions at electronic
clearing houses such as CHIPS at New York. SWIFT: SWIFT is a acronym
for Society for Worldwide Interbank Financial Telecommunications, a co
operative society owned by about 250 banks in Europe and North America
and registered as a co operative society in Brussels, Belgium. It is a
communications network for international financial market transactions
linking effectively more than 25,000 financial institutions throughout the
world who have been allotted bank identified codes. The messages are
transmitted from country to country via central interconnected operating
centers located in Brussels, Amsterdam and Culpeper, Virginia. The member
countries are connected to the centre through regional processors in each
country. The local banks in each country reach the regional processors
through the national net works. The SWIFY System enables the member
banks to transact among themselves quickly (i) international payments (ii)
Statements (iii) other messages connected with international banking.
Transmission of messages takes place within seconds, and therefore this
method is economical as well as time saving. Selected banks in India have
become members of SWIFT. The regional processing centre is situated at
Mumbai. The SWIFT provides following advantages for the local banking
community: 1. Provides a reliable (time tested) method of sending and
receiving messages from a vast number of banks in a large number of
locations around the world. 2. Reliability and accuracy is further enhanced
by the built in authentication facilities, which has only to be exchanged with
each counterparty before they can be activated or further communications. 3.
Message relay is instantaneous enabling the counterparty to respond
immediately, if not prevented by time differences. 4. Access is available t a
vast number of banks global for launching new cross border initiatives. 5.
Since communication in SWIFT is to be done using structure formats for
various types of banking transactions, the matter to be conveyed will be very
clear and there will not be any ambiguity of any sort for the received to
revert for clarifications. This is mainly because the formats are used all ove3r
the world on a standardized basis for conducting all types of banking
transactions. This makes the responses and execution very efficient at the
receiving banks end thereby contributing immensely to quality service being
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provided to the customers of both banks (sending and receiving). 6. Usage of

SWIFT structure formats for message transmission to counterparties will
entail the generation of local banks internal records using at least minimum
level of automation. This will accelerate the local banks internal automation
activities, since the maximum utilization of SWIFT a significant internal
automation level is required. CHIPS: CHIPS stands for Clearing House
Interbank Payment System. It is an electronic payment system owned by 12
private commercial banks constituting the New York Clearing House
Association. A CHIP began its operations in 1971 and has grown to be the
worlds largest payment system. Foreign exchange and Euro dollar
transactions are settled through CHIPS. It provides the mechanism for
settlement every day of payment and receipts of numerous dollar
transactions among member banks at New York, without the need for
physical exchange of cheques/funds for each such transaction. The
functioning of CHIPS arrangement is explained below with a hypothetical
transaction: Bank of India, maintaining a dollar account with Amex Bank,
New York, sells USD 1 million to Canara Bank, maintaining dollar account
with Citibank. 1. Bank of India intimate Amex Bank debuts the account of
Bank through SWIFT to debit its account and transfer USD 1 million to
Citibank for credit of current account of Canara Bank. 2. Amex Bank debits
the account of Bank of India with USD 1 million and sends the equivalent of
electronic cheques to CHIPS for crediting the account of Citibank. The
transfer is effected the same day. 3. Numerous such transactions are reported
to CHIPS by member banks and transfer effected at CHIPS. By about 4.30
p.m, eastern time, the net position of each member is arrived at and funds
made available at Fedwire for use by the bank concerned by 6.00 p.m.
eastern time. 4. Citibank which receives the credit intimates Canara Bank
through SWIFT. It may be noted that settlement of transactions in the New
York foreign exchange market takes place in two stages, First clearance at
CHIPS and arriving at the net position for each bank. Second, transfer of
fedfunds for the net position. The real balances are held by banks only with
Federal Reserve Banks (Fedfunds) and the transaction is complete only when
Fedfunds are transferred. CHIPS help in expediting the reconciliation and
reducing the number of entries that pass through Fedwire. CHAPS is an
arrangement similar to CHIPS that exists in London. CHAPS stands for
Clearing House Automated Payment System. Fedwire The transactions at
New York foreign exchange market ultimately get settled through Fedwire. It
is a communication network that links the computers of about 7000 banks to
the computers of federal Reserve Banks. The fedwire funds transfer system,
operate by the Federal Reserve Bank, are used primarily for domestic
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payments, bank to bank and third party transfers such as interbank overnight
funds sales and purchases and settlement transactions. Corporate to corporate
payments can also be made, but they should be effected through banks. Fed
guarantees settlement on all payments sent to receivers even if the sender
quoted by banks to their customer are based on the rates prevalent in the
interbank market. The big banks in the market are known as market makers,
as they are willing to buy or sell foreign currencies at the rates quoted by
them up to any extent. Depending buy or sell foreign currencies at the rates
quoted by them up to any extent. Depending upon its resources, a bank may
be a market maker in one or few major currencies. When a banker
approaches the market maker, it would not reveal its intention to buy or sell
the currency. This is done in order to get a fair price from the market maker.
Two Way Quotations Typically, the quotation in the interbank market is a
two way quotation. It means the rate quoted by the market maker will
indicate two prices. One at which it is willing to buy the foreign currency,
and the other at which it is willing to sell the foreign currency. For example,
a Mumbai bank may quote its rate for US dollar as under USD 1 = Rs
48.1525/1650 More often, the rate would be quoted as 1525/1650 since the
players in the market are expected to know the big number i.e., Rs 48. In
the given quotation, one rate is Rs.48.1525 per dollar and the other rate is
Rs.48.1650. per dollar. Direct Quotation. It will be obvious that the quoting
bank will be willing to buy dollars at Rs 48.1525 and sell dollars at Rs
48.1650. If one dollar bought and sold, the bank makes a gross profit of Rs.
0.0125. In a foreign exchange quotation, the foreign currency is the
commodity that is being bought and sold. The exchange quotation which
gives the price for the foreign currency in terms of the domestic currency is
known as direct quotation. In a direct quotation, the quoting bank will apply
the rule: Buy low; Sell high. Indirect quotation There is another way of
quoting in the foreign exchange market. The Mumbai bank quotes the rate
for dollar as: Rs. 100 = USD 2.0762/0767 This type of quotation which gives
the quantity of foreign currency per unit of domestic currency is known as
indirect quotation. In this case, the quoting bank will receive USD 2.0767
per Rs.100 while buying dollars and give away USD 2.0762 per Rs.100
while selling dollars. In other world, he will apply the rule: Buy high: Sell
low. The buying rate is also known as the bid rate and selling rate as the
offer rate. The difference between these rates is the gross profit for the
bank and is known as the Spread. Spot and Forward transactions The
transactions in the interbank market may place for settlement (a) on the same
day; or (b) two days later; or (c) some day late; say after a month Where the
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agreement to buy and sell is agreed upon and executed on the same date, the
transaction is known as cash or ready transaction. It is also known as value
today. The transaction where the exchange of currencies takes place two
days after the date of the contact is known as the spot transaction. For
instance, if the contract is made on Monday, the delivery should take place
on Wednesday. If Wednesday is a holiday, the delivery will take place on the
next day, i.e., Thursday. Rupee payment is also made on the same day the
foreign currency is received. The transaction in which the exchange of
currencies takes places at a specified future date, subsequent to the spot date,
is known as a forward transaction. The forward transaction can be for
delivery one month or two months or three months etc. A forward contract
for delivery one month means the exchange of currencies will take place
after one month from the date of contract. A forward contract for delivery
two months means the exchange of currencies will take place after two
months and so on. Forward Margin/Swap points Forward rate may be the
same as the spot rate for the currency. Then it is said to be at par with the
spot rate. But this rarely happens. More often the forward rate for a currency
may be costlier or chapter tan its spot rate. The rate for a currency may be
costlier or cheaper than nits spot rate. The difference between the forward
rate and the spot rate is known as the forward margin or swap points. The
forward margin may be either at premium or at discount. If the forward
margin is at premium, the foreign correct will be costlier under forward rate
than under the spot rate. If the forward margin is at discount, the foreign
currency will be cheaper for forward delivery then for spot delivery. Under
direct quotation, premium is added to spot rate to arrive at the forward rate.
This is done for both purchase and sale transactions. Discount is deducted
from the spot rate to arrive at the forward rate. Interpretation of Interbank
quotations The market quotation for a currency consists of the spot rate and
the forward margin. The outright forward rate has to be calculated by loading
the forward margin into the spot rate. For instance, US dollar is quoted as
under in the interbank market on 25th January as under: Spot USD 1 =
Rs.48.4000/4200 Spot/February 2000/2100 Spot/March 3500/3600 The
following points should be noted in interpreting the above quotation; 1. The
first statement is the spot rate for dollars. The quoting bank buying rate is
Rs.48.4000 and selling rate is Rs.48.4200. 2. The second and third
statements are forward margins for forward delivery during the months of
February. Spot/March respectively. Spot/February rate is valid for delivery
end February. Spot/March rate is valid for delivery end March. 3. The
margin is expressed in points, i.e., 0.0001 of the currency. Therefore the
forward margin for February is 20 paise and 21 paise. 4. The first rate in the
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spot quotation is for buying and second for selling the foreign currency.
Correspondingly, in the forward margin, the first rate relates to buying and
the second to selling. Taking Spot/February as an example, the margin of 20
paise is for purchase and 21 paise is for sale of foreign currency. 5. Where
the forward margin for a month is given in ascending order as in the
quotation above, it indicates that the forward currency is at premium. The
outright forward rates arrived at by adding the forward margin to the spot
rates. The outright forward rates for dollar can be derived from the above
quotations follows Buying rate Selling rate Spot rate Add; Premium
February 48.4000 0.2000 --------------- 48.6000 March 48.4000 0.3500
------------ 48.7500 February 48.4200 0.2100 ------------- 48.6300 March
48.4200 0.3600 48.7800 From the above calculation we arrive at the
following outright rates; Buying Selling Spot delivery USD 1 = Rs. 48.4000
48.4200 Forward delivery February 48.6000 48.6300 Forward delivery
March 48.7500 48.7800 If the forward currency is at discount, it would be
indicated by quoting the forward margin in the descending order. Suppose
that on 20th April, the quotation for pound sterling in the interbank market is
as follows: Spot GBR 1 = Rs. 73.4000/4300 Spot/May 3800/3600 Spot/June
5700/5400 Since the forward margin is in descending order (3800/3600),
forward sterling is at discount. The outright forward rates are calculated by
deducting the related discount from the spot rate. Thus is shown below:
Buying rate Selling rate Spot rate Less; discount May 73.4000 0.3800
------------ 73.0200 June 73.4000 0.5700 ------------ 72.8300 May 73.4300
0.3600 ------------- 73.0700 June 73.4300 0.5400 72.8900 From the above
calculations the outright rates for pound sterling cab be restated as follows;
Buying Selling Spot GBR 1 = Rs. 73.4000 73.4300 Forward delivery May
73.0200 73.0700 Forward delivery June 72.8300 72.8900 Factors
Determining Spot Exchange Rates 1. Balance of Payments: Balance of
Payments represents the demand for and supply of foreign exchange which
ultimately determine the value of the currency. Exports, both visible and
invisible, represent the supply side for foreign exchange. Imports, visible and
invisible, create demand for foreign exchange. Put differently, export from
the country creates demand for the currency of the country in the foreign
exchange market. The exporters would offer to the market the foreign
currencies they have acquired and demand in exchange the local currency.
Conversely, imports into the country will increase the supply of the currency
of the country in the foreign exchange market. When the balance of
payments of a country is continuously at deficit, it implies that the demand
for the currency of the country is lesser than its supply. Therefore, its value
in the market declines. If the balance of payments is surplus continuously it
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shows that the demand for the currency in the exchange market is higher
than its supply therefore the currency gains in value. (2) Inflation: Inflation
in the country would increase the domestic prices of the commodities. With
increase in prices exports may dwindle because the price may not be
competitive. With the decrease in exports the demand for the currency would
also decline; this in turn would result in the decline of external value of the
currency. It may be noted that unit is the relative rate of inflation in the two
countries that cause changes in exchange rates. If, for instance, both India
and the USA experience 10% inflation, the exchange rate between rupee and
dollar will remain the same. If inflation in India is 15% and in the USA it is
10%, the increase in prices would be higher in India than it is in the USA.
Therefore, the rupee will depreciate in value relative to US dollar. Empirical
studies have shown that inflation has a definite influence on the exchange
rates in the long run. The trend of exchange rates between two currencies has
tended to hover around the basic rate discounted for the inflation factor. The
actual rates have varied from the trend only by a small margin which is
acceptable. However, this is true only where no drastic change in the
economy of the country is. New resources found may upset the trend. Also,
in the short run, the rates fluctuate widely from the trend set by the inflation
rate. These fluctuations are accounted for by causes other than inflation. (3)
Interest rate: The interest rate has a great influence on the short term
movement of capital. When the interest rate at a centre rises, it attracts short
term funds from other centers. This would increase the demand for the
currency at the centre and hence its value. Rising of interest rate may be
adopted by a country due to tight money conditions or as a deliberate attempt
to attract foreign investment. Whatever be the intention, the effect of an
increase in interest rate is to strengthen the currency of the country through
larger inflow of investment and reduction in the outflow of investments by
the residents of the country. (4) Money Supply An increase in money supply
in the country will affect the exchange rate through causing inflation in the
country. It can also affect the exchange rate directly. An increase in money
supply in the country relative to its demand will lead to large scale spending
on foreign goods and purchase of foreign investments. Thus the supply of
the currency in the foreign exchange markets is increased and its value
declines. The downward pressure on the external value of the currency then
increases the cost of imports and so adds to inflation. The effect of money
supply on exchange rate directly is more immediate than its effect through
inflation. While in the long run inflation seems to correlate exchange rate
variations in a better way, in the short run exchange rates move more in
sympathy with changes in money supply. One explanation of how changes in
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money supply vary the exchange rate is this; the total money supply in the
country represents the value of total commodities and services in the country.
Based on this the outside world determines the external value of the
currency. If the money supply is doubles, the currency will be valued at half
the previous value so as to keep the external value of the total money stock
of the country constant. Another explanation offered is that the excess money
supply flows out of the country and directly exerts a pressure on the
exchange rate. The excess money created, the extent they are in excess of the
domestic demand for money, will flow out of the country. This will increase
the supply of the currency and pull down its exchange rate. (5) National
Income: An increase in national income reflects increase in the income of the
residents of the country. This increase in the income increases the demand
for goods in the country. If there is underutilized production capacity in the
country, this will lead to increase in production. There is a chance for growth
in exports too. But more often it takes time for the production to adjust to the
increased income. Where the production does not increase in sympathy with
income rise, it leads to increased imports and increased supply of the
currency of the country in the foreign exchange market. The result is similar
to that of inflation, viz., and decline in the value of the currency. Thus an
increase in national income will lead to an increase in investment or in
consumption, and accordingly, its effect on the exchange rate will change.
Here again it is the relative increase in national incomes of the countries
concerned that is to be considered and not the absolute increase. (6)
Resource Discoveries when the country is able to discover key resources, its
currency gains in value. A good example can be the have played by oil in
exchange rates. When the supply of oil from major suppliers, such as
Middles East, became insecure, the demand fro the currencies of countries
self sufficient in oil arose. Previous oil crisis favoured USA, Canada, UK
and Norway and adversely affected the currencies of oil importing countries
like Japan and Germany. Similarly, discovery oil by some countries helped
their currencies to gain in value. The discovery of North Sea oil by Britain
helped pound sterling to rise to over USD 2.40 from USD 1.60 in a couple of
years. Canadian dollar also benefited from discoveries of oil and gas off the
Canadian East Coast and the Arctic. (7) Capital Movements there are many
factors that influence movement of capital from one country to another.
Short term movement of capital may be influenced buy the offer of higher
interest in a country. If interest rate in a country rises due to increase in bank
rate or otherwise, there will be a flow of short term funds into the country
and the exchange rate of the currency will rise. Reverse will happen in case
of fall in interest rates. Bright investment climate and political stability may
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encourage portfolio investments in the country. This leads to higher demand

for the currency and upward trend in its rate. Poor economic outlook may
mean repatriation of the investments leading to decreased demand and lower
exchange value for the currency of the country. Movement of capital is also
caused by external borrowing and assistance. Large scale external borrowing
will increase the supply of foreign exchange in the market. This will have a
favorable effect on the exchange rate of the currency of the country. When
repatriation of principal and interest starts the rate may be adversely affected.
(8) Political factors Political stability induced confidence in the investors and
encourages capital inflow into the country. This has the effect of
strengthening the currency of the country. On the other hand, where the
political situation in the country is unstable, it makes the investors withdraw
their investments. The outflow of capital from the country would weaken the
currency. Any news about change in the government or political leadership
or about the policies of the government would also have the effect of
temporarily throwing out of gear the smooth functioning of exchange rate
mechanism. Functions of foreign Exchange Market The foreign exchange
market is a market in which foreign exchange transactions take place.
Transfer of Purchasing Power The Primary function of a foreign exchange
market is the transfer of purchasing power from one country to another and
from one currency to another. The international clearing function performed
by foreign exchange markets plays a very important role in facilitating
international trade and capital movement. Provision of credit The credit
function performed by foreign exchange markets also plays a very important
role in the growth of foreign trade, for international trade depends to a great
extent on credit facilities. Exporters may get pre shipment and post shipment
credit. Credit facilities are available also for importers. The Euro dollar
market has emerged as a major international credit market. Provision of
Heding Facilities The other important of the foreign exchange market is to
provide hedging facilities. Heding refers to covering of foreign trade risks,
and it provides a mechanism to exporters and importers to guard themselves
against losses arising from fluctuations in exchange rates. Methods of
Affecting International Payments There are important methods to effect
international payments. Transfers Money may be transferred from a bank in
one country to a bank in another part of the world be electronic or other
means Cheques and Bank Drafts International payments may be made be
means of cheques and bank drafts. The latter is widely used. A bank draft is a
cheque drawn on a bank instead of a customers personal account. It is an
acceptable means of payment when the person tendering is not known, since
its value is dependent on the standing of a bank which is widely known, and
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not on the credit worthiness of a firm or individual known only to a limited

number of people. Foreign Bill of Exchange A bill of exchange is an
unconditional order in writing, addressed by one person to another, requiring
the person to whom it is addressed to pay a certain sum or demand or on a
specified future date. There are two important differences between inland
and foreign bills. The date on which an inland bill is due for payment is
calculated from the date on which it was drawn, but the period of a foreign
bill runs fro m the date on which the bill was accepted. The reason for this is
that the interval between a foreign bill being drawn and its acceptance may
be considerable, since it may depend on the time taken for the bill to pass fro
m the drawers country to that of the acceptor. The second important
difference between the two types of bill is that the foreign bill is generally
drawn in sets of three, although only one of them bears a stamp and of
course one of them is paid. Now days it is mostly the documentary bill that is
employed in international trade. This is nothing more than a bill of exchange
with the various shipping documents the bill of lading, the insurance
certificate and the consular invoice attached to it. By using this the exporter
can make the release of the documents conditional upon either (a) payment
of the bill if it has been drawn at sight or (b) Its acceptance by the importer if
it has been drawn for a period. Transactions in the foreign Exchange Market
A very brief account of certain important types of transactions conducted in
the foreign exchange market is given below Spot and Forward Exchanges
Spot Market The term spot exchange refers to the class of foreign exchange
transaction which requires the immediate delivery or exchange of currencies
on the spot. In practice the settlement takes place within two days in most
markets. The rate of exchange effective for the spot transaction is known as
the spot rate and the market for such transactions is known as the spot
market. Forward Market The forward transactions is an agreement between
two parties, requiring the delivery at some specified future date of a
specified amount of foreign currency by one of the parties, against payment
in domestic currency be the other party, at the price agreed upon in the
contract. The rate of exchange applicable to the forward contract is called the
forward exchange rate and the market for forward transactions is known as
the forward market. The foreign exchange regulations of various countries
generally regulate the forward exchange transactions with a view to curbing
speculation in the foreign exchanges market. In India, for example,
commercial banks are permitted to offer forward cover only with respect to
genuine export and import transactions. Forward exchange facilities,
obviously, are of immense help to exporters and importers as they can cover
the risks arising out of exchange rate fluctuations be entering into an
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appropriate forward exchange contract. With reference to its relationship

with spot rate, the forward rate may be at par, discount or premium. If the
forward exchange rate quoted is exact equivalent to the spot rate at the time
of making the contract the forward exchange rate is said to be at par. The
forward rate for a currency, say the dollar, is said to be at premium with
respect to the spot rate when one dollar buys more units of another currency,
say rupee, in the forward than in the spot rate on a per annum basis. The
forward rate for a currency, say the dollar, is said to be at discount with
respect to the spot rate when one dollar buys fewer rupees in the forward
than in the spot market. The discount is also usually expressed as a
percentage deviation from the spot rate on a per annum basis. The forward
exchange rate is determined mostly be the demand for and supply of forward
exchange. Naturally when the demand for forward exchange exceeds its
supply, the forward rate will be quoted at a premium and conversely, when
the supply of forward exchange exceeds the demand for it, the rate will be
quoted at discount. When the supply is equivalent to the demand for forward
exchange, the forward rate will tend to be at par. Futures While a focus
contract is similar to a forward contract, there are several differences
between them. While a forward contract is tailor made for the client be his
international bank, a future contract has standardized features the contract
size and maturity dates are standardized. Futures cab traded only on an
organized exchange and they are traded competitively. Margins are not
required in respect of a forward contract but margins are required of all
participants in the futures market an initial margin must be deposited into a
collateral account to establish a futures position. Options While the forward
or futures contract protects the purchaser of the contract fro m the adverse
exchange rate movements, it eliminates the possibility of gaining a windfall
profit from favorable exchange rate movement. An option is a contract or
financial instrument that gives holder the right, but not the obligation, to sell
or buy a given quantity of an asset as a specified price at a specified future
date. An option to buy the underlying asset is known as a call option and an
option to sell the underlying asset is known as a put option. Buying or selling
the underlying asset via the option is known as exercising the option. The
stated price paid (or received) is known as the exercise or striking price. The
buyer of an option is known as the long and the seller of an option is known
as the writer of the option, or the short. The price for the option is known as
premium. Types of options: With reference to their exercise characteristics,
there are two types of options, American and European. A European option
cab is exercised only at the maturity or expiration date of the contract,
whereas an American option can be exercised at any time during the
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contract. Swap operation Commercial banks who conduct forward exchange

business may resort to a swap operation to adjust their fund position. The
term swap means simultaneous sale of spot currency for the forward
purchase of the same currency or the purchase of spot for the forward sale of
the same currency. The spot is swapped against forward. Operations
consisting of a simultaneous sale or purchase of spot currency accompanies
by a purchase or sale, respectively of the same currency for forward delivery
are technically known as swaps or double deals as the spot currency is
swapped against forward.

Foreign Exchange Transactions Foreign exchange dealing is a business in

which foreign currency is the commodity. It was seen earlier that foreign
currency is not a legal tender. The US dollar cannot be used for settlement of
debts in India; nevertheless, it has value. The value of US dollar is like the
value of any other commodity. Therefore, the foreign currency can be
considered as the commodity in foreign exchange dealings. Purchase and
Sale transactions Any trading has two aspects (i) Purchase (ii) sale. A trader
has to purchase goods from his suppliers which he sells to his customers.
Likewise the bank (which is authorized to deal in foreign exchange)
purchases as well as sells its commodity the foreign currency. Two points
need be constantly kept in mind while talking of a foreign exchange
transaction: 1. The transaction is always talked of from the banks point of
view 2. The item referred to is the foreign currency. Therefore when we say a
purchase we implied that (i) the bank has purchased (ii) it has purchased
foreign currency Similarly, when we sale a sale, we imply that (i) the bank
has sold (ii) it has sold foreign currency. In a purchase transaction the bank
acquired foreign currency and parts with home currency. In a sale transaction
the bank parts with foreign currency and acquires home currency. Exchange
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Quotations We have seen that exchange rates can be quoted in either of the
two ways; (a)direct quotation (b) indirect quotation. The quotation in which
exchange rate is expressed as the price per unit of foreign currency in terms
of the home currency is k known as Home currency quotation or Direct
quotation. It may be noted that under direct quotation the number of units of
foreign currency is kept constant and any change in the exchange rate will be
made by changing the value in term of rupees. For instance, US dollar
quoted at Rs.48 may be quoted at Rs 46 or Rs.49 as may be warranted. The
quotation in which the unit of home currency is kept constant and the
exchange rate is expressed as so many unit of foreign currency is known as
Foreign Currency quotation or Indirect quotation or simply Currency
Quotation. Under indirect quotation, any change in exchange rate will be
effected by changing the number of units of foreign currency. Basis for
Merchant Rates When the bank buys foreign exchange from the customer, it
expects to sell the same in the interbank market at a better rate and thus
make a profit out of the deal. In the interbank market, the bank will accept
the rate as dictated by the market. It can, therefore, sell foreign exchange in
the market at the market buying rate for the currency concerned. Thus the
interbank buying rate forms the basis for quotation of buying rate by the
bank to its customer. Similarly, when the bank sells foreign exchange to the
customer, it meets tele commitment by purchasing the required foreign
exchange from the interbank market. It can acquire foreign exchange from
the market at the market selling rate. Therefore the interbank selling rate
forms the basis for quotation of selling rate to the customer buy the bank.
The interbank rate on the basis of which the bank quotes its merchant rate is
known as the base rate. Exchange Margin If the bank quotes the base rate to
the customer, it makes no profit. On the other hand, there are administrative
costs involved. Further the deal with the customer takes p-lace first. Only
after acquiring or selling the foreign exchange from to the customer, the
bank goes to the interbank market to sell or acquire the foreign exchange
required to cover the deal with the customer. An hour or two might have
lapsed by this time. The exchange rates are fluctuating constantly and by the
time the deal with the market is concluded, the exchange rate might have
turned adverse to the bank. Therefore sufficient margin should be built into
the rate to cover the administrative cost, cover the exchange fluctuation and
provide some profit on the transaction to the bank. This is done by loading
exchange margin to the base rate. The quantum of margin that is built into
the rate is determined by the bank concerned, keeping with the market trend.

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Market participants:
Unlike a stock market, the foreign exchange market is divided into levels of
access. At the top is the interbank market, which is made up of the
largest commercial banks and securities dealers. Within the interbank
market, spreads, which are the difference between the bid and ask prices, are
razor sharp and not known to players outside the inner circle. The difference
between the bid and ask prices widens (for example from 0 to 1 pip to 12
pips for 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
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market accounts for 39% 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 retailmarket 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 companies
An important part of the foreign exchange market comes from the financial
activities of companies seeking foreign exchange to pay for goods or services.
Commercial companies often trade fairly small amounts compared to those of
banks or speculators, and their trades often have little short-term impact on
market rates. Nevertheless, trade flows are an important factor in the long-term
direction of a currency's exchange rate. Some multinational
corporations (MNCs) can have an unpredictable impact when very large
positions are covered due to exposures that are not widely known by other
market participants.

Central banks
National central banks play an important role in the foreign exchange markets.
They try to control the money supply, inflation, and/or interest rates and often
have official or unofficial target rates for their currencies. They can use their
often substantial foreign exchange reserves to stabilize the market.
Nevertheless, the effectiveness of central bank "stabilizing speculation" is
doubtful because central banks do not go bankrupt if they make large losses,
like other traders would, and there is no convincing evidence that they do make
a profit trading.
Foreign exchange fixing
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Foreign exchange fixing is the daily monetary exchange rate fixed by the
national bank of each country. The idea is that central banks use the fixing time
and exchange rate to evaluate behavior of their currency. Fixing exchange rates
reflects the real value of equilibrium in the market. Banks, dealers and traders
use fixing rates as a market trendindicator.
The mere expectation or rumor of a central bank foreign exchange intervention
might be enough to stabilize a currency, but aggressive intervention might be
used several times each year in countries with a dirty float currency regime.
Central banks do not always achieve their objectives. The combined resources
of the market can easily overwhelm any central bank. Several scenarios of this
nature were seen in the 199293 European Exchange Rate Mechanism collapse,
and in more recent times in Asia.
Hedge funds as speculators
About 70% to 90% of the foreign exchange transactions conducted are
speculative. This means 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. Since
1996, hedge funds have gained a reputation for aggressive currency speculation.
They control billions of dollars of equity and may borrow billions more, and
thus may overwhelm intervention by central banks to support almost any
currency, if the economic fundamentals are in the hedge funds' favour.
Retail foreign exchange traders
Individual retail speculative traders constitute a growing segment of this market
with the advent of retail foreign exchange trading, both in size and importance.
Currently, they participate indirectly through brokers or banks. Retail brokers,
while largely controlled and regulated in the USA by the Commodity Futures
Trading Commission and National Futures Association, have in the past been
subjected to periodic foreign exchange fraud. To deal with the issue, in 2010 the
NFA required its members that deal in the Forex markets to register as such
(I.e., Forex CTA instead of a CTA). Those NFA members that would
traditionally be subject to minimum net capital requirements, FCMs and IBs,
are subject to greater minimum net capital requirements if they deal in Forex. A
number of the foreign exchange brokers operate from the UK under Financial
Services Authority regulations where foreign exchange trading using margin is
part of the wider over-the-counter derivatives trading industry that
includes Contract for differences and financial spread betting.

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There are two main types of retail FX brokers offering the opportunity for
speculative currency trading: brokers and dealers or market
makers. Brokers serve as an agent of the customer in the broader FX market, by
seeking the best price in the market for a retail order and dealing on behalf of
the retail customer. They charge a commission or mark-up in addition to the
price obtained in the market. Dealers or market makers, by contrast, typically
act as principal in the transaction versus the retail customer, and quote a price
they are willing to deal at.
Money transfer/remittance companies and bureaux de change
Money transfer companies/remittance companies perform high-volume lowvalue transfers generally by economic migrants back to their home country. In
2007, the Aite Group estimated that there were $369 billion of remittances (an
increase of 8% on the previous year). The four largest markets
(India, China, Mexico and the Philippines) receive $95 billion. The largest and
best known provider is Western Union with 345,000 agents globally followed
by UAE Exchange.
Bureaux de change or currency transfer companies provide low value foreign
exchange services for travelers. These are typically located at airports and
stations or at tourist locations and allow physical notes to be exchanged from
one currency to another. They access the foreign exchange markets via banks or
non bank foreign exchange companies.

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Trading characteristics:
There is no unified or centrally cleared market for the majority of trades, and
there is very little cross-border regulation. Due to the over-the-counter (OTC)
nature of currency markets, there are rather a number of interconnected
marketplaces, where different currencies instruments are traded. This implies
that there is not a single exchange rate but rather a number of different rates
(prices), depending on what bank or market maker is trading, and where it is. In
practice the rates are quite close due to arbitrage. Due to London's dominance in
the market, a particular currency's quoted price is usually the London market
price. Major trading exchanges include Electronic Broking Services (EBS) and
Thomson Reuters Dealing, while major banks also offer trading systems. A joint
venture of the Chicago Mercantile Exchange and Reuters, called Fx market
space opened in 2007 and aspired but failed to the role of a central
market clearing mechanism.
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The main trading centers are London and New York City, though Tokyo, Hong
Kong and Singapore are all important centers as well. Banks throughout the
world participate. Currency trading happens continuously throughout the day; as
the Asian trading session ends, the European session begins, followed by the
North American session and then back to the Asian session, excluding
Fluctuations in exchange rates are usually caused by actual monetary flows as
well as by expectations of changes in monetary flows caused by changes
in gross domestic product (GDP) growth, inflation (purchasing power
parity theory), interest rates (interest rate parity, Domestic Fisher
effect, International Fisher effect), budget and trade deficits or surpluses, large
cross-border M&A deals and other macroeconomic conditions. Major news is
released publicly, often on scheduled dates, so many people have access to the
same news at the same time. However, the large banks have an important
advantage; they can see their customers' order flow.
Currencies are traded against one another in pairs. Each currency pair thus
constitutes an individual trading product and is traditionally noted XXXYYY or
XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter
code of the currencies involved. The first currency (XXX) is the base
currency that is quoted relative to the second currency (YYY), called
the counter currency (or quote currency). For instance, the quotation EURUSD
(EUR/USD) 1.5465 is the price of the Euro expressed in US dollars, meaning 1
euro = 1.5465 dollars. The market convention is to quote most exchange rates
against the USD with the US dollar as the base currency (e.g. USDJPY,
USDCAD, USDCHF). The exceptions are the British pound (GBP), Australian
dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the
USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).
The factors affecting XXX will affect both XXXYYY and XXXZZZ. This
causes positive currency correlation between XXXYYY and XXXZZZ.
On the spot market, according to the 2013 Triennial Survey, the most heavily
traded bilateral currency pairs were:

EURUSD: 24.1%
USDJPY: 18.3%

GBPUSD (also called cable): 8.8%

and the US currency was involved in 87.0% of transactions, followed by the

euro (33.4%), the yen (23.0%), and sterling (11.8%) (see table). Volume
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percentages for all individual currencies should add up to 200%, as each

transaction involves two currencies.
Trading in the euro has grown considerably since the currency's creation in
January 1999, and how long the foreign exchange market will remain dollarcentered is open to debate. Until recently, trading the euro versus a nonEuropean currency ZZZ would have usually involved two trades: EURUSD and
USDZZZ. The exception to this is EURJPY, which is an established traded
currency pair in the interbank spot market.

Determinants of exchange rates:

The following theories explain the fluctuations in exchange rates in a floating
exchange rate regime (In a fixed exchange rate regime, rates are decided by its
1. International parity conditions: Relative purchasing power parity, interest
rate parity, Domestic Fisher effect, International Fisher effect. Though to
some extent the above theories provide logical explanation for the
fluctuations in exchange rates, yet these theories falter as they are based
on challengeable assumptions [e.g., free flow of goods, services and
capital] which seldom hold true in the real world.
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2. Balance of payments model: This model, however, focuses largely on

tradable goods and services, ignoring the increasing role of global capital
flows. It failed to provide any explanation for continuous appreciation of
dollar during the 1980s and most part of the 1990s in face of soaring US
current account deficit.
3. Asset market model: views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly
by people's willingness to hold the existing quantities of assets, which in
turn depends on their expectations on the future worth of these assets.
The asset market model of exchange rate determination states that the
exchange rate between two currencies represents the price that just
balances the relative supplies of, and demand for, assets denominated in
those currencies.
None of the models developed so far succeed to explain exchange rates and
volatility in the longer time frames. For shorter time frames (less than a few
days), algorithms can be devised to predict prices. It is understood from the
above models that many macroeconomic factors affect the exchange rates and in
the end currency prices are a result of dual forces of demand and supply. The
world's currency markets can be viewed as a huge melting pot: in a large and
ever-changing mix of current events, supply and demand factors are constantly
shifting, and the price of one currency in relation to another shifts accordingly.
No other market encompasses (and distills) as much of what is going on in the
world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not
influenced by any single element, but rather by several. These elements
generally fall into three categories: economic factors, political conditions and
market psychology.

Economic factors:
These include: (a) economic policy, disseminated by government agencies and
central banks, (b) economic conditions, generally revealed through economic
reports, and other economic indicators.

Economic policy comprises government fiscal policy (budget/spending

practices) and monetary policy (the means by which a government's central
bank influences the supply and "cost" of money, which is reflected by the
level of interest rates).
Government budget deficits or surpluses: The market usually reacts
negatively to widening government budget deficits, and positively to
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narrowing budget deficits. The impact is reflected in the value of a country's


Balance of trade levels and trends: The trade flow between countries
illustrates the demand for goods and services, which in turn indicates
demand for a country's currency to conduct trade. Surpluses and deficits in
trade of goods and services reflect the competitiveness of a nation's
economy. For example, trade deficits may have a negative impact on a
nation's currency.

Inflation levels and trends: Typically a currency will lose value if there is
a high level of inflation in the country or if inflation levels are perceived to
be rising. This is because inflation erodes purchasing power, thus demand,
for that particular currency. However, a currency may sometimes strengthen
when inflation rises because of expectations that the central bank will raise
short-term interest rates to combat rising inflation.

Economic growth and health: Reports such as GDP, employment levels,

retail sales, capacity utilization and others, detail the levels of a country's
economic growth and health. Generally, the more healthy and robust a
country's economy, the better its currency will perform, and the more
demand for it there will be.

Productivity of an economy: Increasing productivity in an economy

should positively influence the value of its currency. Its effects are more
prominent if the increase is in the traded sector.

Political conditions
Internal, regional, and international political conditions and events can have a
profound effect on currency markets.
All exchange rates are susceptible to political instability and anticipations about
the new ruling party. Political upheaval and instability can have a negative
impact on a nation's economy. For example, destabilization of coalition
governments in Pakistan and Thailand can negatively affect the value of their
currencies. Similarly, in a country experiencing financial difficulties, the rise of
a political faction that is perceived to be fiscally responsible can have the
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opposite effect. Also, events in one country in a region may spur

positive/negative interest in a neighbouring country and, in the process, affect
its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange
market in a variety of ways:

Flights to quality: Unsettling international events can lead to a "flight-toquality", a type of capital flight whereby investors move their assets to a
perceived "safe haven". There will be a greater demand, thus a higher price,
for currencies perceived as stronger over their relatively weaker
counterparts. The US dollar, Swiss franc and gold have been traditional safe
havens during times of political or economic uncertainty.
Long-term trends: Currency markets often move in visible long-term
trends. Although currencies do not have an annual growing season like
physical commodities, business cycles do make themselves felt. Cycle
analysis looks at longer-term price trends that may rise from economic or
political trends.

"Buy the rumour, sell the fact": This market truism can apply to many
currency situations. It is the tendency for the price of a currency to reflect
the impact of a particular action before it occurs and, when the anticipated
event comes to pass, react in exactly the opposite direction. This may also be
referred to as a market being "oversold" or "overbought". To buy the rumour
or sell the fact can also be an example of the cognitive bias known
as anchoring, when investors focus too much on the relevance of outside
events to currency prices.

Economic numbers: While economic numbers can certainly reflect

economic policy, some reports and numbers take on a talisman-like effect:
the number itself becomes important to market psychology and may have an
immediate impact on short-term market moves. "What to watch" can change
over time. In recent years, for example, money supply, employment, trade
balance figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated

price movements in a currency pair such as EUR/USD can form apparent
patterns that traders may attempt to use. Many traders study price charts in
order to identify such patterns.

Financial instruments:
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A spot transaction is a two-day delivery transaction (except in the case of trades
between the US dollar, Canadian dollar, Turkish lira, euro and Russian ruble,
which settle the next business day), as opposed to the futures contracts, which
are usually three months. This trade represents a direct exchange between two
currencies, has the shortest time frame, involves cash rather than a contract, and
interest is not included in the agreed-upon transaction. Spot trading is one of the
most common types of Forex Trading. Often, a forex broker will charge a small
fee to the client to roll-over the expiring transaction into a new identical
transaction for a continuum of the trade. This roll-over fee is known as the
"Swap" fee.
One way to deal with the foreign exchange risk is to engage in a forward
transaction. In this transaction, money does not actually change hands until
some agreed upon future date. A buyer and seller agree on an exchange rate for
any date in the future, and the transaction occurs on that date, regardless of what
the market rates are then. The duration of the trade can be one day, a few days,
months or years. Usually the date is decided by both parties. Then the forward
contract is negotiated and agreed upon by both parties.
The most common type of forward transaction is the foreign exchange swap. In
a swap, two parties exchange currencies for a certain length of time and agree to
reverse the transaction at a later date. These are not standardized contracts and
are not traded through an exchange. A deposit is often required in order to hold
the position open until the transaction is completed.

Futures are standardized forward contracts and are usually traded on an
exchange created for this purpose. The average contract length is roughly 3
months. Futures contracts are usually inclusive of any interest amounts.
Currency futures contracts are contracts specifying a standard volume of a
particular currency to be exchanged on a specific settlement date. Thus the
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currency futures contracts are similar to forward contracts in terms of their

obligation, but differ from forward contracts in the way they are traded. They
are commonly used by MNCs to hedge their currency positions. In addition they
are traded by speculators who hope to capitalize on their expectations of
exchange rate movements.
A foreign exchange option (commonly shortened to just FX option) is a
derivative where the owner has the right but not the obligation to exchange
money denominated in one currency into another currency at a pre-agreed
exchange rate on a specified date. The FX options market is the deepest, largest
and most liquid market for options of any kind in the world.

Case study on foreign exchange market:

In 2007, India experienced rapid
appreciation of its currency against
the US dollar. The reasons for the
appreciation of the rupee were a
generally weak dollar in
international currency markets and
sharp increase in dollar inflows into
the country, partly due to India's
increasing attractiveness to foreign
investors. Although India had been
seeing a steady rise in dollar inflows
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into the country for quite some time,

on earlier occasions, the Reserve
Bank of India (RBI) had intervened
in the foreign currency market and
purchased excess dollars so as to
prevent any appreciation in the
value of the rupee. Now, the RBI
decided not to intervene, mainly to
control inflation which was around
6 percent in early 2007.
The case discusses the reasons for the appreciation of the rupee and its possible
impact on the Indian economy. It also discusses the measures taken by the RBI
and the government to control rupee appreciation and to try offset the negative
impacts of a strong currency on the economy. The case ends with some views
on the future movement of the rupee.

To understand the importance of exchange rate management.
To examine the reasons for the rapid appreciation of rupee in 2006-07.
To analyze the impact of rupee appreciation on the economy.
To critically analyze the role of the central bank in the foreign exchange
To assess the possible future movement of the rupee vis--vis the US dollar.

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The currency markets are the largest and most actively traded financial
markets in the world with daily trading volume of more than $3 trillion
(Triennial Central Bank Survey 2007).
Each transaction in the currency market involves two different trades: the sale
of one currency and the purchase of another.
As the world's reserve currency, the U.S. dollar is the most actively traded
currency; pairs involving the dollar make up the majority of transactions.
Most currency trading strategies fall into two broad
categories: hedging and speculating.
To avoid possible loss from fluctuating currencies, companies can hedge, or
protect themselves, by trading currency pairs.
In arbitrage trades, an investor simultaneously buys and sells the same
security (or currency) at slightly different prices, hoping to make a small riskfree profit.
Another popular category of currency trade is the carry trade, which involves
selling the currency of a country with very low interest rates and investing the
proceeds in the currency of a country with high interest rates.
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There are several markets available to currency traders, including the forex
market, derivatives markets and exchange-traded funds.
The majority of currency trading takes place in the forex spot market. In the
forex spot market, large banks and other financial institutions trade currencies
among themselves either for immediate delivery (spot market) or for settlement
at a later date (forward market.)
Derivatives include futures, options and exotic, customizable derivative
contracts. While the more exotic derivatives are generally designed for
institutional investors, individual investors often use futures and options.
Individual investors can buy or sell the futures or the options to speculate on
the direction of the currency pair.

1) The Economist Guide to the Financial Markets
2) "What is Foreign Exchange? "Published by the International Business
Times AU. Retrieved: 11 February 2011.
3) An Economic History of England: The 18th Century, Volume 3Taylor &
Francis, 1955 Retrieved 13 July 2012

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