The Foreign Exchange Market

Features of the global forex market

Oldest and biggest financial market in the world Geographically spread out Most active, quick and liquid market Not a physical market; electronically linked network of banks, forex brokers and dealers Round-the-clock trading through telephones, telex and fax machines and the Society for Worldwide International Financial Telecommunications (SWIFT) Two parts : Wholesale and Retail

Structure of the market

Wholesale market
Inter-bank market Head offices of major banks are market-makers Have correspondent relationships with banks in other countries No physical transfer of currencies, simply book entries Continuous 24-hour trading Extremely narrow bid-ask spreads Dealing banks profit from the spread

Retail market
Exchange of bank notes, bank drafts, travelers cheques, currency etc between private customers, tourists and banks Authorized dealers and money-changers permitted to deal in this segment

A brief history
Dates back to ancient times; barter system; use of gold and silver coins Paper notes used in Italy in late 14th century bankers dealt in the notes and discounted them
according to the relative values of the currencies

Paper money widely used in 18th century- the Gold Standard Bretton Woods System after WWII

A brief history contd..

Collapse of Bretton Woods system in 1970s and birth of market-determined exchange rates explosion in currency trading Birth of the Euro in late 1990s led to a decline in volume of currency trading Trading rebounded in 2003-04 because of speculative activities of institutional investors like hedge funds Largest and most widespread market today

Market Participants
Can be grouped into 4 categories: Exporters and Importers Investors (FDI and FPI) Speculators Governments

Determination of exchange rates

Short-term movements influenced by:
Release of domestic economic data and anticipation of the release Release of economic data in foreign countries Central bank actions Central banks making public their thoughts on monetary policy Political developments domestic and global Changes in commodity prices, oil and gold Natural disasters and perception of their impact

Short-term movement scenarios

Scenarios likely to impact exchange rates :
Stock market rally may lead to currency appreciation Oil price surge to record high may weaken currency for an oil importer Increase in unemployment numbers may lead to fall I currency value Surprise hike in interest rates by the central bank of the country could lead to appreciation of currency

Long-term movements
Guided by expectations of real interest rates Real interest rates means nominal interest rate less inflation rate Mechanism of covered interest arbitrage Example

Foreign Exchange Models

Monetarist Model
Exchange rate responds to factors of supply and demand just as any other commodity Hence no formal devaluation and revaluation by government is necessary

Portfolio Balance Model

Demand for and supply of financial assets Forex market participants hold portfolios of domestic money, domestic bonds and foreign currency bonds Exchange rate determined by the process of bringing total demand and supply of financial assets in the country to an equilibrium level

Foreign Exchange Models contd..

Purchasing Power Parity
Exchange rates will adjust to equalize the relative purchasing power of currencies Identical goods will sell at identical prices when valued in same currency Tracked by dividing inflation rate in one country by inflation rate in another Big Mac index published by the Economist

Exchange rate Regimes

Mechanisms adopted by government for managing exchange rates Fixed rate regimes
Gold Standard: No devaluation permitted Bretton Woods arrangement: Conditional devaluation permitted; IMF could lend to countries with BoP problems Pegs: Currency value held constant in terms of another currency, usually a major trading partner

Exchange rate Regimes contd..

Currency Board Type of peg designed to avoid destabilization Board is like a central bank Issues currency only to extent of equivalent forex reserves If investors sell domestic currency, forex reserves decline and automatically reduces domestic money supply to that extent Hence interest rates rise and economy slows down Changing exchange rate under Currency Board requires legislation Hong Kong has a currency board

Shortcomings of fixed interest rates

Interest rates have to remain high so that investors may hold the currency Central bank cannot lower interest rates to fight depression Risk less opportunity for domestic investors to borrow in foreign currency at lower rates and invest in own country at higher rates

Semi-fixed exchange rates

Bands: European Exchange rate Mechanism Target zones Pegs and baskets Crawling peg Asian currency crisis

Floating exchange rates

Monetary policy does not target exchange rates Free movement allowed Floating rates management
Occasional intervention by central bank BOJ, Swiss Bank and Brazilian Central Bank have intervened recently

Countries and exchange rate regimes

Regime I. Hard Peg - No separate legal tender - Currency Board arrangement II. Soft peg 41 7 60 No. of countries as of April 2006 48

- Conventional peg
- Intermediate pegs III. Floating regimes - Managed floating - Independently floating

49
11 79 53 26
Based on RBI Report on Currency and Finance

Forex market in India

Regulated by the RBI Authorised Dealers divided into 3 categories
Category I include all scheduled commercial banks (public sector banks, private banks and foreign banks operating in India) Catgeory II include all upgraded full-fledged money changers, select RRBs and co-operative banks Category III includes select financial institutions like EXIM Bank

All merchant transactions in forex must be undertaken through ADs only

Forex market in India

Forex brokers active in inter-bank transactions Organization of ADs known as the FEDAI
Set up in 1958 as a self-regulatory body under the Companies Act 1956 Concerned with framing rules for conduct of inter-bank forex business and vis--vis the public Liasoning with RBI for reforms and development of the market Currently has 99 members ( as of Feb 2012) including PSU banks, private and foreign banks and institutions like EXIM bank, IFCI and SIDBI and others like Thomas Cook Important role n functioning of forex market and works closely with RBI, FIMMDA, Forex Association of India etc

Customers mainly oil companies such as IOC, BPCL, HPCL and other PSUs and also private companies and FIIs

Definition of foreign exchange

Market in which national monetary units or claims exchanged for foreign monetary units Foreign exchange defined under the FERA 1973 means foreign currency and includes the following:
Deposits, credits and balances payable in any foreign currency Any drafts, travelers cheques, letters of credit and bills of exchange expressed or drawn in Indian currency but payable in any foreign currency Any instrument payable at the option of the drawee or holder thereof or any other party thereto either in Indian currency or in foreign currency or partly in one and partly in the other

Evolution of Indian forex market

Par Value system of exchange rate followed from 1947 to 1971 Rupees external or par value fixed at 4.15 grains of fine gold RBI maintained par value within permitted band of +-1% using sterling as intervention currency Devaluation of rupee in terms of gold in 1966 Exchange rate of rupee in terms of gold, dollar and other currencies remained stable Forex market was defunct; FERA 1947 applied Central government and RBI controlled regulated demand for forex to match available supply Banks required to maintain square position at all times

Evolution of Indian forex market..

With breakdown of Bretton Woods System, rupee linked to sterling in December 1971 As sterling was fixed to the US dollar under the Smithsonian Agreement, the rupee-dollar rate also remained stable From September 1975 rupee pegged to basket of currencies In 1978 banks allowed to undertake intra-day trading and maintain square position only end of day Bank managements allowed to fix open position limits as well as intraday trading limits RBI announced daily its buying and selling rate to ADs for merchant transactions; spread of 0.5 per cent leading to active trading within this limit AD s permitted cross-currency trading

Evolution of Indian forex market..

Trading volumes started building up; banks offered two-way quotes Highly regulated market with restrictions on external transactions, barriers to entry, low liquidity and high transaction costs Exchange rate managed strictly for facilitating countrys imports Strict control through the FERA resulted in parallel, unofficial (hawala) market Trade imbalances, widening of current account deficit, Gulf crisis of 1990-91 and drying up of capital flows led to need for corrective action

Evolution of Indian forex market..

HLC on Balance of Payments (Rangarajan) recommended moving towards market-determined exchange rates Liberalized Exchange Rate Management System (LERMS) introduced in March 1992
Required surrender of all forex receipts on current account to AD s 60% converted at market rates and 40% at RBI rate AD s required to surrender the 40% to RBI and retain the 60% for sellign in market for permissible transactions

Evolution of Indian forex market..

Dual exchange rate system replaced by unified exchange rate system in March 1993 Under this system all forex receipts could be converted at market rates Restrictions on several current account transactions were relaxed Rupee became freely convertible on current account in August 1994

Measures for development of forex market

FERA 1973 replaced by market-friendly FEMA 1999 AD s were delegated power by RBI to release forex for various purposes CCIL set up in 2001 under Sodhani Committee recommendations Introduction of new instruments such as rupee-foreign currency swaps, foreign currency options, cross-currency options, IRS and currency swaps, FRAs, caps and collars AD s permitted to initiate trading positions, borrow and invest in overseas markets subject to their Board approval

Measures contd..
Banks permitted to
fix net overnight position limits and gap limits (with RBI approval) Determine interest rates (subject to a ceiling) and maturity period of FCNR(B) deposits Use derivatives for asset-liability management

Market participants with genuine exposure permitted to avail forward cover and enter into swaps without any limit Foreign exchange earners permitted to open foreign currency accounts and residents permitted to open such accounts up to a general limit

Market segments
Spot market
immediate delivery in case of bank notes Delivery up to 2 business days in case of inter-bank funds Spot segment is dominant in Indian forex market as in other emerging markets

Derivatives segment
Forward contracts for maturities up to one year; majority are for one month, three months or six months FX swaps are a combination of a spot and a forward in opposite direction Foreign currency options

Sources of Demand and Supply

Supply of foreign exchange is through
Receipts on account of exports and invisibles in current account Inflows in capital account by way of FDI, portfolio investment, ECBs and NRI deposits

Demand for forex by way of

Imports and invisible payments on current account Amortisation of ECB Redemption of NRI deposits and outflows on account of direct and portfolio investment

Change in sources
Capital account transactions acquired more significance over the last few years Expectations and reactions to news affect the capital flows and hence the exchange rate leading to higher volatility RBI attempts to stabilize exchange rate through direct purchase/sale of foreign exchange, sterilization through OMOs and LAF, changes in reserve requirements etc

Exchange rate quotation

American term: Exchange rates quoted in amounts of US dollar per unit of foreign currency E.g. USD 0.0192 per unit of INR is an American quote European term: Exchange rates quoted in amounts of foreign currency per US dollar E.g. INR 52 per USD is a European quote Most foreign currencies quoted in European terms

Exchange rate quotation contd..

Direct quote: Home currency price for one unit of foreign currency
Eg. 1 USD = Rs.52 is a direct quote for an Indian

Indirect quote: Foreign currency price for one unit of home currency
E.g. Re.1 = USD 0.0192 is an indirect quote for an Indian

Direct and Indirect quotes are reciprocals of each other

Trading platforms in India

FX Clear set up by CCIL, FX Direct set up by IBS Forex (P) Ltd in collaboration with FTIL, Reuters platforms FX Clear offers straight-through-processing (STP ) as linked to CCILs settlement platform Offer real-time order matching as well as negotiation modes for dealing

Global forex market v/s Indian

Estimated that roughly 90 per cent of global forex market turnover is for arbitrage and speculation Forex market in developed countries more free and deregulated than Indian market Greater emphasis on providing service to exporters and importers than on pure exchange trading in Indian market Hence more exchange control in Indian market

Risk management
CCIL set up to mitigate risks in Indian financial markets Undertakes settlement of inter-bank spot and forward trades Multilateral netting Net amount payable to or receivable from CCIL in each currency is arrived at member-wise Rupe leg settled through members current account with RBI and USD leg through CCILs account with the settlement bank in New York Limits for each member bank based on its net worth, credit rating etc

Risk Management contd..

Board of Directors required to frame appropriate policy for and operational limits for forex business Net overnight open positions and aggregate gap limits need to be approved by the RBI Front-office operates within these limits, exposures confirmed, accounted and settled by back-office and profit/loss and risk compliance monitored by mid-office Market risk generally measured throough VaR techniques Credit risk managed by aggregating all exposures for a counterparty Liquidity risk monitored through asset-liability profile in various currencies in various buckets

Global forex market turnover

Average daily turnover $4 trillion (April 2010) as compared to $3.3 trillion in April 2007 Higher turnover associated with increased trading activity of other financial institutions
Category includes non-reporting banks, hedge funds, pension funds, mutual funds, insurance companies and central banks Turnover by this category grew 42% over 2007 Turnover of this category exceeded inter-bank turnover for the first time in 2010

Cross-border transactions represented 65% of trading activity in April 2010 and local transactions 35%; forex market activity has thus become more global

Global forex market turnover contd..

Spot transactions accounted for 37% of the forex market turnover in April 2010 while outright forwards, forex swaps, currency swaps, currency options and other products accounted for the rest Average daily turnover of OTC currency derivatives (outright forwards, swaps, currency options etc) was around $2.5 trillion in April 2010 as against $168 billion for exchange-traded derivatives Banks in UK accounted for 37% of all forex market turnover followed by US (18%), Japan (6%), Singapore(5%), Switzerland (5%), Hong Kong SAR (5%) and Australia (4%) Top 3 currencies traded are the USD, Euro and JPY; USD/EUR is the dominant pair