Introduction to Foreign Exchange Market (FOREX Market)

The foreign exchange market has witnessed unprecedented growth after the
1980s. the developments such as the introduction of the World trade
organizations(WTO), the globalization of trade, growth in the international
investments, reduction in tariffs, control and quotas, removal of other
restrictions, which in turn has led to the expansions of international trade.

All these above factors have significantly contributed to the overall

transformation of the foreign exchange market in terms of the size, coverage
and operations.

Money is a measure of value of all goods and services. The value of money is
terms of its purchasing power of goods and services. Different countries have
different currencies as their monetary unit. People in different countries can
use their respective currencies as the medium of exchange for all goods and
services within the geographical boarders of their currencies as the
geographical boarders of their countries.

International transactions require the use of foreign currencies to be settled.

The foreign exchange market (Forex, FX, or currency market) is the market
which accommodates the currency preferences to the parties involved in
international transactions (export and import) and helps convert one
currency into the other currency. Financial centers around the world function
as an anchors between a wide range of different types of buyers and sellers
round the clock, with the exception of weekends. The transactions in foreign
exchange market took place through the network of telephone, telex,
satellite, facsimile and computer communications between forex market
participants.

MEANING OF 'FOREX MARKET'

Foreign exchange market is a market where currency of one country is

exchanged for the currency of another country. Most currency transactions
are channeled through the worldwide interbank market.

DEFINITION OF 'FOREX MARKET'

According to Ellsworth, "A Foreign Exchange Market comprises of all those
institutions and individuals who buy and sell foreign exchange which may be
defined as foreign money or any liquid claim on foreign money". Foreign
Exchange transactions result in inflow & outflow of foreign exchange.
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NEED FOR FOREIGN EXCHANGE

1. The principal function of foreign exchange is to transfer funds from one

nation currency to another.
2. Transfer of purchasing power is necessary because international trade
and capital transaction usually involve parties living in countries with
different national currencies.
3. Money represents purchasing power and processing of money or
foreign currencies gives a person to purchase goods and services
produced by the residents of another country.
4. Foreign exchange is very important for the import of food items,
petroleum products, technology, life saving drugs from foreign
countries.
5. Foreign exchange is important for availing the services such as
education, tourism, healthcare, insurance, banking, hospitality,
telecommunication and entertainment

CHARACTERISTICS OF THE FOREX MARKET

1. 24 hour market
The forex market works 24 hours a day. There is no need to wait for the
market to get opened trading can be done at any time. Trading is possible at
morning, noon or night or at any time they are free.

2) Geographical dispersal
A redeeming feature of the foreign exchange market is that it is not to be
found in one place. The market is vastly dispersed throughout the leading
financial centers of the world such as London, New York, Paris, Zurich,
Amsterdam, Tokyo, Hong Kong, Toronto, Frankfurt, Milan, and other cities.

3) Transfer of purchasing power

Foreign exchange market aims at permitting the transfer of purchasing
power denominated in one currency to another whereby one currency to
another whereby one currency is traded for another currency. For example,
an Indian exporter sells software to a U.S firm for dollars and a U.S firm sells
super computers to an Indian company for rupees. In these transactions,
firms of respective countries would like to have the payment settled in their
currencies, i.e. Indian firm in rupees and U.S dollars. It is the foreign
exchange market, which facilitates such a settlement between countries in
their respective currency units.

4) Intermediary
Foreign exchange markets provide a convenient way of converting the
currencies earned into currencies wanted of their respective countries. For

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this purpose, the market acts as an intermediary between buyers and sellers
of foreign exchange.

5) Volume
A special feature of the FEM is that out of the total trading transactions that
take place in the FEM, around 95% takes the form of cross border purchase
and sales of assets, that is, and international capital flows. Only around 5%
relates to the export and import activities.

6) Provision of credit
A foreign exchange market providers credit through specialized instruments
such as bankers acceptance and letters of credit. The credit thus provided is
of much help to the traders and businessmen in the international market.

7) Minimizing risks
The FEM helps the importer and exporter in the foreign trade to minimize
their risks of trade. This is being done through the provision of Hedging
facility. This enables traders to transact business in the international market
with a view to earning a normal business profit without exposure to an
expected change in anticipated profit. This is because exchange rates
suddenly change.

8) Superior liquidity
In a forex market, traders are free to buy and sell currencies of their own
choosing. The superior liquidity of the forex market enables traders to easily
exchange currencies without affecting the prices of the currencies being
traded. So whether you trade a few thousand dollars or several millions, you
can be assured of the same currency prices during the time an order was
placed and then executed. The forex market's superior liquidity allows you to
get the profits you expect at the time you made the trade.

9) Electronic market
Foreign exchange market does not have physical place. It is a market
whereby trading in foreign currencies takes place through the electronically
linked networking of banks, foreign exchange brokers and dealers whose
function is to bring together buyers and sellers of foreign exchange.

FOREIGN EXCHANGE MARKET INTERMEDIARIES

There are plenty of participants in the Forex, including those that serve
investors, middle men for currency purchase and companies in need of
international funds. The foreign exchange market consist of two tiers, they
are
1. The interbank or wholesale market
2. The client or retail market

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Keeping the above aspects in mind, the foreign exchange market
intermediaries are grouped into following categories

1. International banks-
International banks provide the core of the FX market Approximately 100 to
200 banks worldwide actively Make a market in foreign exchange, that is
they stand willing to buy or sell foreign currency for their own account. These
international banks serve their retail clients, the bank customers in
conducting foreign commerce or making international investments in
financial assets that require foreign exchange.

2. Bank customers
Bank customers broadly include MNCs, Money managers and private
speculators. According to 2007 BIS statistics, retail trading volume or bank
clint transactions account for approximately 13 percent of FX trading volume.
The other 87 percent of trading volume is from inter bank traders between
international banks of non bank dealers.

3. Non bank Dealers

Non bank dealers are large non bank financial institutions such asinvestment
banks, whose size and frequency of trades make it cost-effective to establish
their own dealing rooms to trade directly in the inter bank market for their
foreign exchange needs, in 2007, non bank dealers accounted for 28 percent
of interbank trading volumes.

4. FX brokers
FX brokers match dealer orders to buy and sell currencies for a fee, but not
take any possession themselves. Brokers have knowledge of the quotes
offered by many dealers I the market. Consequently inter bank traders will
use a broker primerly to disseminate as quickly as possible a currency quote
to many other dealers.

5. Central banks
Central banks of major industrialized countries also frequently intervene in
the foreign exchange market to influence the value of their currency relative
to a trading partner.

6. Arbitragers
They are intermediaries who make profit by discovering price differences
between pairs of currencies at different dealers of banks. Their operations
are risk free as they buy cheap and sell dear. For example, a market operator
found out that there is a difference between the rates of two dealers. While
the dealer A is quoting a rate of Rs 45 per dollar, the dealer B is quoting Rs
45.10 per dollar. The market operator will, without loosingtime, buy dollar
cheap from the dealer A and sell the same to the dealer B. In the process, he
will make again of Re 0.10 per dollar.

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7. Speculators
They are deliberate risk-takers. They participate in the market to make a
gain which results from an unanticipated change in exchange rate. An open
position in a foreign currency is speculation. Speculators can be either bulls
or bears, Bulls expect that a currency is going to appreciate in near future.
So they buy now or, in other words, they take a long position. They sell it
when its value rises, thus making a gain. On the other hand, bears expect
that a particular currency is going to become cheaper in future. So they sell
it now, or in other words, they take a short position. They buy it back when it
depreciates, thus making a gain.

8. Hedgers
The foreign exchange hedgers are those who limit their potential losses by
locking in a guaranteed foreign exchange positions. Many firms engage in
foreign exchange hedging.

9. Governments
In order to maintain the price of their currencies in the forex markets,
governments may buy or sell foreign currencies in forex markets.

MAJOR FOREIGN EXCHANGE MARKETS

Foreign exchanges markets represent by far the most important financial

markets in the world. Their role is paramount importance in the system of
international payments. In order to play their role effectively, its necessary
that their operations/dealings be reliable. For these purpose foreign
exchange market can be subdivided in to:

1. Spot market
2. Forward market
3. Futures market
4. Options Market
5. Swaps market

Spot market refers to the transactions involving sale and purchase of

currencies for immediate delivery. In practice, it may take one or two days to
settle transaction.

Forward market transactions are meant to be settled on a future date as

specied in the contract. Though forward rates are quoted just like spot rates,
actually delivery of currencies takes place much later, on a date in future.

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 Futures Market is a localized exchange where derivative instruments that
called futures are traded. Currency futures are somewhat similar to forward,
yet distinctly different.

Options are derivative instruments that give a choice to foreign exchange

market operator to buy or sell a foreign on or up to a date (Maturity date) at
a specified rate (strike price)

Swaps as the term suggests are simply the instruments that permit
exchange of two streams of cash flows in two different currencies.

FOREIGN EXCHANGE RATE

Exchange rate can be understood as the number of units of a given currency
that can be purchased for one unit of another currency.

Foreign Exchange Rate Systems

1. Fixed Exchange rate
2. Freely floating exchange rates
3. Managed floating exchange rates

1. Fixed Exchange rate

a. Fixed against a single currency :This where a country fixes its
exchange rate against the currency of other countrys currency. More
than 50 countries fix their rates this way, mostly against the US
Dollars. Fixed rates are not always fixed and periodic revaluations and
devaluations occur when the economic fundementals of the country
concerned strongly diverge.(inflation)

b. Fixed against a basket of currencies : Using a basket of currencies is

aimed at fixing the exchange rate against a more stable currency base
than would occur with single currency mix. The basket is often devised
to reflect the major trading links of the country concerned.

2. Freely floating exchange rates

It is a system under which exchange rates are not fixed by government
policy but are allowed to float up or down in accordance with the supply and
demand. However the central bank of each country does intervene to some
extent buying and selling its currency to smooth out exchange rate
fluctuation.

3. Managed floating exchange rate

The central bank of countries using a managed float will attempt to keep
currency relationships with a pre-determined range of values and will often
intervene in the foreign exchange markets by buying or selling their currency
to remain within the range.
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