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Definition:
The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought or sold against one another. In words of H.E.Evitt, it is a that section of economic science which deals with the means and methods by which right to wealth in one countrys currency are converted into rights to wealth in terms of another countrys currency. It also involves the investigation of the method by which render such exchange necessary, the forms which such exchange may take, and the ratios or equivalent values at which such exchanges are affected. The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized over-the-counter financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different 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 primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of
Its huge trading volume, leading to high liquidity; Its geographical dispersion; Its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday; The variety of factors that affect exchange rates; The low margins of relative profit compared with other markets of fixed income; and
The use of leverage to enhance profit margins with respect to account size.
As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover 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
day matching buy and sell orders between clients. Many of their functions are computerized, which means deals are done fast. Banks pay a fee to have these brokers handle their transactions. Central Banks Pontikis writes that most developed countries have central banks, whose main role is to maintain the validity of the national currency. Central banks usually monitor and test prices on the Forex, and have a great deal of sway with banks, brokers and other players in the Forex market. The reason? Central banks print the money. For that reason alone, their opinions are always respected and rarely ignored. Corporations When a corporation in the United States makes a purchase in France, that company must find a way to make that purchase in foreign currency. That's where the Forex comes in. The U.S. Corporation uses the market to purchase the foreign currency they need to complete the transaction. Fund Managers There are two types. The fund managers are money managers who deal in funds that amount to hundreds of millions of dollars. They invest that money across a range of investments and a diverse list of clients, including pensions, individuals and governments. Those who manage hedge funds take bigger risks, as they're seeking to realize leverage potential and will exploit the use of derivatives.
foreign exchange market, where one countrys currency is traded for another, is estimated to be about $1.5 trillion a day. One of the biggest differences between the forex markets and markets for other asset classes is that the forex markets are open 24 hours a day. The trading session starts when the Tokyo market opens and once Tokyo closes, London opens. London then passes the baton to New York to complete the day. Since no other markets are open 24 hours a day, no other markets offer the potential for profit (or loss) the way the forex does.
are the authorized money changers, travel agents, certain hotels and government shops. The IDBI and Exim bank are also permitted conditionally to hold foreign currency. The whole foreign exchange market in India is regulated by the Foreign Exchange Management Act, 1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign Exchange Regulation Act, 1947. After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the economic and industrial development, the need for conservation of foreign currency was felt and on 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.
There are three exchange rate systems. They are as follows: Fixed Exchange Rate (Pegged) Floating Exchange Rate (Free floating) Managed Exchange Rate (Rate is fixed by govt.)
Currency Forecasting:
As the name suggests, currency forecasting refers to the ability to predict the long-term value and price of a currency. It is possible to do so but it is difficult. The factors that influence exchange rates are numerous and they act in an extremely complex interactive and proactive manner. Moreover, those who participate in the market and actually move the exchange rates do
not always have theoretical and statistical equipment or the inclination for in depth analysis that theorists often attribute to them. There are mainly five approaches in currency forecasting. They are as follows: Market based forecasting Interest rate parity theory Fundamental analysis forecasting Technical forecasting Mixed forecasting
Market based Forecasting: Here both the spot rate & forward rate are influenced by
current expectation of the future events. Market based forecasting of exchange rate can be derived from current forward rates. The relationship between forward rate & future spot rate can be explained as follows: Unbiased nature of forward rate (UFR) means the forward rate should reflect the expected future spot rate. A particular currency is trading at a forward premium against another currency shows a collective judgment forex market participants that the currency is expected to appreciate in future against the other currency. This may or may not materialize as it depends on a number of factors like interest rate difference, efficiency of the financial & exchange markets in two currencies, govt. intervention, etc. whether or to which extent the prediction can be true depend on all these factors. Secondly, in market based forecasting is limited to one year because forward contracts are not made for longer than one year generally.
Interest Rate Parity Theory: The currency of the country with a lower interest rate should
be at forward premium that the currency of the country with a higher interest rate. The interest differential will be equal to the forward differential. Capital moves from low interest rate country till the international rates in two countries are equal. The interest rate differential could be used to predict the exchange rate beyond one year also.
Technical forecasting: Historical rates are used for estimating future value. These are based
on price pattern & trend analysis.
Mixed Forecasting: Relying on particular techniques may not give absolute accurate result,
so a mix of various techniques is used. A weighted is given to particular techniques which are multiplied by its result. These are finally summed up to get the final forecasting. The exporters can also subscribe to forecasting services (long term predictions of general trades or short term trading advice). Examples: Citibank, New York Roths Child, London
countries must cause a change in the exchange rate in order to re-establish parity in price in two countries. If inflation rate in India is more as compared to USA that rupees will be fall against US Dollar. Example: A car cost Rs. 200000 in India & a similar car cost US$ 10000 in USA. Exchange rate = 200000/10000 US$ 1 = Rs. 20 If inflation rate is 10% in India & 5% in USA, New exchange rate = 220000/10500 US$ 1 = Rs. 20.95 Other factors that influence the exchange rate:
Interest rate: The country will higher interest rates have weaker currency Confidence in the currency Technical factors such as: release of national economic statistics, seasonal demand of currency, internal disturbance etc.
Fischer Effect:
According to Fischer, a change in interest rate affects the exchange rate. First we should study the relationship between inflation & interest rate in the two countries which can be best done by Fischer effect theory. There are three key elements in Fischer effect: Nominal rate of interest Rate of inflation in the country Real interest rate
The effect proposes that if the real interest rate is equal to the nominal interest rate minus the expected inflation rate, and if the real interest rate were to be held constant, that the nominal rate and the inflation rate have to be adjusted on a one-for-one basis. Real interest rate =nominal interest rate - inflation rate. In simple terms: an increase in inflation will result in an increase in the nominal interest rate. For example, if the real interest rate is held at a constant 5.5% and inflation increased from 2% to 3%, the Fisher Effect indicates that the nominal interest rate would have to increase from 7.5% (5.5%real rate+ 2% inflation rate) to 8.5% (5.5% real rate + 3% inflation rate).
borders. Usually the capital markets of the developed countries are integrated in nature. It has been seen that in the underdeveloped countries the currency flow is restricted. The International Fisher theory is calculated by the following formula: E = [(i1-i2)/(1+i2)] (i1-i2) Where: E represents the percentage change in exchange rate i1 represents the interest rate of country A i2 represents the interest rate of country B An example may help to understand the value of the theory. For example, if the interest rate of country A is 10% and that of country B is 5%, then the currency of country B should appreciate roughly 5% compared to the currency of country A. The International Fisher Theory observation holds that a country with higher interest rate will also be inclined to have a higher inflation rate. The International Fisher Theory also estimates the future exchange rates based on the nominal interest rate relationships. The estimate of the spot exchange rate 12 months from now is calculated by multiplying the current spot exchange rate by the nominal annual U.S. interest rate and then dividing it by the nominal annual British interest rate. Example: Suppose that the current spot exchange rate for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5 percent in the U.S. and 7 percent in Britain, what is the expected spot exchange per pound rate 12 months from now according to the International Fisher Effect? The International Fisher Effect estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 = $1.4071.
of imports. Devaluation of currencies usually leads to further deficit in trade balance initially. It finally shows favorable balance of trade resulting into J curve on the graph.
In free economies, business is always influence by this. The boom in the economy is followed by recession followed by depreciation & depreciation by recovery. Due to these boom income arise which intern leads to more imports & less exports. These phenomenon lead to disequilibrium. On the contrary, at depreciation stage in business cycle income forms which interns lead to less imports & less exports. This phenomenon leads to disequilibrium. Reason for decline in BOP initially: It will take time for the country to increase substantially its domestic output, so as to offset the decline in the realization per unit Payment for import will be higher per unit. Later, there will be a decline in imports due to substantial domestic products which will more than offset the increase in import payments per unit.
Exchange-traded options
Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include: stock options, commodity options, bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts callable bull/bear contract Call and put option.
Over-the-counter
Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: 1. interest rate options 2. currency cross rate options, and
Option styles
Naming conventions are used to help identify properties common to many different types of options. These include:
European option an option that may only be exercised on expiration. American option an option that may be exercised on any trading day on or before expiry. Bermudan option an option that may be exercised only on specified dates on or before expiration.
Barrier option any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised.
Exotic option any of a broad category of options that may include complex financial structures. Vanilla option any option that is not exotic
Exchange Traded Fund They are open ended financial instruments which can be traded anytime during the course of the trading day. These basically follow stock movements or price movements of renowned currencies and then increase or decrease the value of their currency based on the trend of price movements.