DEFINITION

The foreign exchange market, also known as the forex, FX, or currency market, involves the
trading of one currency for another. Prior to 1996 the market was confined to large corporate
banks and international corporations. However it has since opened up to include all traders and
speculators. Today, the average daily turnover in forex markets is US$1.9 trillion, according to
the Bank of International Settlement’s Triennial Survey. The market is growing rapidly as
investors gain more information and develop more interest.

In trading foreign exchange, investors bet that one currency will appreciate over another; they
profit when they bet correctly and collect the profit in the form of aninterest rate spread when
they return to the original currency. The profit marginsare low compared with other fixed-
income markets. Large trading volumes can, however result, in very high profits. Most forex
trading takes place in London, New York, and Tokyo, with most trading activity in London,
which dominates the market at 30% of all transactions. New York’s market share is 16%, and
Tokyo’s has fallen to 10% due to the growing prominence of Singapore and Hong Kong.
Singapore has become the fourth largest exchange market globally, and Hong Kong is the fifth,
having overtaken Switzerland. The various players in the foreign exchangemarket include bank
dealers, 16% of which are international investors and speculators. Banks account for almost two-
thirds of forex transactions; of the rest, about 20% is mainly attributable to securities firms that
operate in the international debt and equity markets.

One type of very short-term transaction is the spot transaction between two currencies,

delivering over two days and using cash as opposed to a contract.

In a forward transaction, the money is not exchanged until an arranged date and anexchange
rate is agreed in advance. The time period ranges from days to years.Currency swaps are a
popular type of forward transaction; these involve the exchange of currency by two parties for an
agreed length of time and an arrangement to swap currencies at an agreed later date. Another
type is a foreign currency future, which is inclusive of interest. A standard contract is drawn up
and amaturity date arranged. The time schedule is about three months.

In a foreign exchange option (FX option), the most liquid and biggest options market in the
world, the owner may elect to exchange money in a designated currency for another currency at
an agreed date in the future. This type of transaction depends on the availability of option
contracts on an organized exchange. Otherwise, such forex deals may be carried out using an
over-the-counter (OTC) contract.
 ADVANTAGES

 The forex market is extremely liquid, hence its rapidly growing popularity. Currencies
may be converted when bought or sold without causing too much movement in the price and
keeping losses to a minimum.
 As there is no central bank, trading can take place anywhere in the world and operates on
a 24-hour basis apart from weekends.
 An investor needs only small amounts of capital compared with other investments. Forex
trading is outstanding in this regard.
 It is an unregulated market, meaning that there is no trade commission overseeing
transactions and there are no restrictions on trade.
 In common with futures, forex is traded using a “good faith deposit” rather than a loan.
The interest rate spread is an attractive advantage.

DISADVANTAGES

 The major risk is that one counterparty fails to deliver the currency involved in a very
large transaction. In theory at least, such a failure could bring ruin to the forex market as a
whole.
 Investors need a lot of capital to make good profits because the profit marginson small-
scale trades are very low

THE STRUCTURE OF FOREIGN EXCHANGE MARKETS

The purpose of the foreign exchange market is to facilitate the trading of various
currencies around the world. Although many different types of currency are exchanged, the
majority of trades involve only a small number of them, including the U.S. Dollar, Yen, Euro,
Swiss Franc, Pound Sterling, Australian Dollar, and Canadian Dollar. The U.S. Dollar is
involved in over 90% of all exchanges on the forex markets. Contrary to popular belief, there is
no one centralized market in which all currency trading occurs; rather, the foreign exchange is a
loose conglomerate of several different markets, each of which has its own rules and regulations.
Major markets are located in the U.S., London, and Tokyo, and each is open during different
hours according to their time zones. Naturally, trading is heaviest when the market hours
overlap, and almost two thirds of the trading activity at the New York market takes place during
the morning while the European markets are still open.

Because there is no centralized market, a single exchange rate for a given currency does not
exist. Because of the over-the-counter (OTC) nature of the markets, the bid and ask rates for a
currency can vary among different geographic markets and market makers, although they are
usually fairly close to each other. Since the price of a currency must be given in relation to
another currency, it is expressed in the form XXX/YYY, where each trio of letters represents the
international currency code. For example, the price of Euros in U.S. Dollars is written as
EUR/USD. Traditionally, the first currency in the pair, called the base currency, is always the
one that was strongest when the pair was created, and the other currency is known as the counter
currency. The actual prices themselves are in decimal form, typically rounded to the nearest ten-
thousandth of a unit.

The forex markets make up the largest marketplace in the world, with the equivalent of $1.9
trillion changing hands every 24 hours. It is largely a short term, speculative market, with more
than 40% of positions closed out before two days, and nearly 4 out of 5 lasting less than a week.
It is an extremely liquid market, much more so than equities, due to the many participants
throughout the world and the very high daily turnover. The top ten most active traders, however,
account for nearly 73% of total trading volume. Made up of international banks, these huge
players provide the market with bid and ask prices that are far tighter than retail customers can
expect, and trading activity that occurs between them is known as the “interbank market”.

Introduced in 1972 at the Chicago Mercantile Exchange, forex futures contracts are derivative
instruments that are actively traded as well, as they account for around seven percent of total
foreign exchange volume. In addition, foreign exchange options have taken hold as a popular
hedging strategy. They represent contracts to buy currency at a certain price on a set day in the
future, and investors often purchase these derivatives to offset any potential losses they may
suffer due to the decline in price of a currency. Another way traders are able to mitigate risk is
through a swap, in which both parties agree to exchange one currency for another for a set period
of time, and will then reverse the transaction after the period expires.

The foreign exchange market is a fast-paced, international currency exchange that is without
rival among financial markets. Its immense popularity among large banks, financial institutions,
international companies, and even retail investors ensures that its growth will continue into the
future.

FUNCTIONS OF FOREX MARKET:

1. The foreign exchange market serves two functions: converting currencies and reducing risk.
There are four major reasons firms need to convert currencies.

2. First, the payments firms receive from exports, foreign investments, foreign profits, or
licensing agreements may all be in a foreign currency. In order to use these funds in its home
country, an international firm has to convert funds from foreign to domestic currencies.

3. Second, a firm may purchase supplies from firms in foreign countries, and pay these suppliers
in their domestic currency.

4. Third, a firm may want to invest in a different country from that in which it currently holds
underused funds.
5. Fourth, a firm may want to speculate on exchange rate movements, and earn profits on the
changes it expects. If it expects a foreign currency to appreciate relative to its domestic currency,
it will convert its domestic funds into the foreign currency. Alternately stated, it expects its
domestic currency to depreciate relative to the foreign currency. An example similar to the one in
the book can help illustrate how money can be made on exchange rate speculation. The
management focus on George Soros shows how one fund has benefited from currency
speculation.

6. Exchange rates change on a daily basis. The price at any given time is called the spot rate, and
is the rate for currency exchanges at that particular time. One can obtain the current exchange
rates from a newspaper or online.

7. The fact that exchange rates can change on a daily basis depending upon the relative supply
and demand for different currencies increases the risks for firms entering into contracts where
they must be paid or pay in a foreign currency at some time in the future.

8. Forward exchange rates allow a firm to lock in a future exchange rate for the time when it
needs to convert currencies. Forward exchange occurs when two parties agree to exchange
currency and execute a deal at some specific date in the future. The book presents an example of
a laptop computer purchase where using the forward market helps assure the firm that will won't
lose money on what it feels is a good deal. It can be good to point out that from a firm's
perspective, while it can set prices and agree to pay certain costs, and can reasonably plan to earn
a profit; it has virtually no control over the exchange rate. When spot exchange rate changes
entirely wipe out the profits on what appear to be profitable deals, the firm has no recourse.

9. When a currency is worth less with the forward rate than it is with the spot rate, it is selling at
forward discount. Likewise, when a currency is worth more in the future than it is on the spot
market, it is said to be selling at a forward premium, and is hence expected to appreciate. These
points can be illustrated with several of the currencies.

10. A currency swap is the simultaneous purchase and sale of a given amount of currency at two
different dates and values.
FOREIGN EXCHANGE: MAJOR PLAYERS

Foreign exchange is simply the largest market today. Like any market, foreign exchange trading
materialized to allow buyers and sellers of goods - particularly in foreign exchange, goods refer
to currencies. Transactions and exchanging of assets can be done in foreign exchange currency
trading. The foreign exchange market could be anywhere in the world accessible through phone
or Internet. Physical markets come as financial exchange centers (e.g. Chicago Board of Trade).

Foreign exchange trading can be a very profitable game to be involved with. The bigger the
amount in play, the greater the opportunity to gain more profit. But foreign exchange can be an
expensive game just like other sports - there is equipment and training to think about. A potential
foreign exchange trader needs capital and trading implementation.

Who are the main players in foreign exchange? There are at least six of them: commercial and
investment banks, central banks, hedge funds, corporations, high net-worth individuals, and just
simple individuals.

Commercial and investment banks are the natural players in foreign exchange for all other
foreign exchange trading participants must deal with them. Foreign exchange currency trading
began as an added service to deposits and loans offered by commercial banks. The profitability
of foreign exchange trading is a perfect characteristic for banks to be involved.

Another player, the central bank is separated from commercial and investment banks because it
is not after the profitability of foreign exchange currency trading. The main purpose of central
banks is to provide adequate trading conditions. Central banks intervene in economic or financial
imbalance in the foreign exchange market.

For corporations, another player in foreign exchange market, they were not interested in foreign
exchange trading but the trend of companies going international and the tight competition among
other companies made them think twice about not going into foreign exchange trading.

High net-worth individuals engage in foreign exchange through accessing commercial and
investment banks. Individual players in foreign exchange are mostly tourists using their local
currency to purchase foreign-made products and services (such hotel accommodation).

A relative new player in foreign exchange currency market is the hedge fund. Hedge fund is a
partnership of high net-worth individuals that invest at least a million in foreign exchange
trading.

Even with six major players, the potential of foreign exchange has not yet been consumed
entirely. And so investment and commercial banks together with some trading companies have
paved a way for individual investors to participate in foreign exchange currency trading. Also
foreign exchange information is made available to most individuals through personal computers
and Internet so as to attract more individual investors into foreign exchange.
The foreign exchange market is also known as FX or it is also found to be referred to as
the FOREX. All three of these have the same meaning, which is the trade of trading between
different companies, banks, businesses, and governments that are located in different countries.
Thefinancial market is one that is always changing leaving transactions required to be completed
through brokers, and banks. Many scams have been emerging in the FOREX business, as foreign
companies and people are setting up online to take advantage of people who don't realize that
foreign trade must take place through a broker or a company with direct participation involved in
foreign exchanges.
The forex market is the single largest market around the world not just in terms of average daily
turnover and average revenue per trader but also the largest market in terms of participants. As
the saying goes, the more the merrier. Therefore it is no wonder why so much money can be
made (or lost) in this one single market.
Cash, stocks, and currency is traded through the foreign exchange markets. The FOREX market
will be present and exist when one currency is traded for another. Think about a trip you may
take to a foreign country. Where are you going to be able to 'trade your money' for the value of
the money that is in that other country? This is FOREX trading basis, and it is not available in all
banks, and it is not available in all financial centers. FOREX is a specialized trading
circumstance.
If you have always wondered who are the major players, here is the list:
Commercial Banks. Traditionally known as a savings and lending institution, banks are
certainly one of the major players in forex market. Banks are usually involved in both large
quantities of speculative trading and also daily commercial turnover.
The really big and well-established banks trade in the billions of dollars in foreign currencies
everyday. Some of the trades are undertaken on behalf of their clients while most are through
proprietary desks.
Central Banks. Central banks play an important role in the forex market and that role is
controlling the supply of different currencies. They are also responsible for regulating inflation
and interest rate.
Central banks are also responsible for stabilizing the forex market. They do this by balancing the
country's foreign exchange reserves. In addition, they also have official target rates for the
currencies that they are handling. Because of this role, central banks are sometimes jokingly
referred to as circus performers because of the daily balancing act that they have to perform.
Investment Firms. Investment management firms commonly manage huge accounts on behalf
of their clients such as endowments and pension funds. Sometimes, these investments require the
exchange of foreign currencies so they have to facilitate these transactions through the use of the
foreign exchange market.
These situations exist because there are basically no limitations to the nationalities of customers
that an investment firm can attract. Therefore, investment managers with an international equity
portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign
securities purchases.
Retail Forex Brokers. These can be individuals or groups of individuals. They handle a fraction
of the total volume of the entire forex market, but do not let that fool you. A single retail forex
 broker estimates retail volume of between 25 to 50 billion dollars each day. Their volume is
estimated to make up 2% of the total market volume.
Speculators. These are the individuals or private investors who purchase and sell foreign
currencies and profit through fluctuations on their price. Speculators are a "hardy" bunch simply
because they are more adept at handling and maybe even sidestepping risks that regular investors
would prefer not to be involved with.

SETTLEMENTS OF TRANSACTIONS IN FOREX MARKET

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 SWIFT 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:
 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.
 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.
 Message relay is instantaneous enabling the counterparty to respond immediately, if not
prevented by time differences.
 Access is available t a vast number of banks global for launching new cross border
initiatives.
 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 provided to the customers of both
banks (sending and receiving).
 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 world‘s 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.
 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.
 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.
 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.
 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 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 fails.

TYPES OF FOREIGN EXCHANGE TRANSACTIONS:

Foreign currencies

At its simplest, currency exchange is just the buying of the currency of one country with the
currency of another country. Individuals, businesses and traders all engage in various types of
foreign currency exchange transactions. Some participants in currency exchange do so as part
of business dealings while others speculate on the foreign exchange (Forex) market in hopes of
 profiting off of exchange rate fluctuations. The main types of foreign currency exchange
transactions they employ are described below.

1. Basic Currency Exchange

o If you've ever traveled to a foreign country, chances are you've used some of your
cash to buy euros, yen or whatever the local currency was. The price you paid was determined by
the exchange rate between the two currencies. Your purchase is an example of the most basic
type of foreign currency exchange transaction.
Currency exchange rates change continuously, mainly in response to demand for one currency
relative to others. Demand for a currency in turn is affected by many factors, including
differences in interest rates, inflation and monetary policy.
2. Forward Contracts
o Financial institutions and businesses frequently want to protect themselves against
possible losses due to changes in exchange rates. The forward contract is a way of doing this. A
forward contract is like a futures contract except it is a private agreement, rather than an
exchange-traded security. In forwards, one party agrees to buy (or sell) a foreign currency from
(or to) another party. The currency is delivered at a future date at a predetermined price. A
variation of this is the forward window contract. Instead of delivery on a specific date, the
transaction is settled during a "window" of time between two dates.

Swaps
o Suppose you are a businessperson who needs euros to do some business in
Europe, but all you have are U.S. dollars. You don't want to convert to euros and run the risk of
losing money if exchange rates go the wrong way. A currency swap is your solution. You
simultaneously borrow euros from someone else (usually a currency dealer) and lend your
dollars to the other party. You can use the euros as you see fit until a specific date. Then you
return the euros and get your dollars back at a predetermined exchange rate.

Forex
o Most of the volume of trading on the Forex market actually is generated by
speculators, not as part of other business activity. Forex traders use forwards and swaps. The
basic Forex trade, however, is a simple currency exchange but with one crucial difference. When
a Forex trader buys one currency for another, it is a margin transaction. This means the trader
puts up only a little money (often less than $1,000 for a $100,000 lot of currency). With extreme
leverage like this, even small changes in currency exchange rates mean big profits or big losses.
This makes Forex trading very attractive to many people but also very risky.
Forex Options

o Forex options work like any other options contract. A trader pays a premium to a
Forex dealer for an option to buy or sell a currency at a specific strike price. If the exchange rate
moves in the trader's favor before the option expires, she can exercise the option for a profit. If
the exchange rate doesn't move the right way enough to cover the premium paid, the option will
expire and the trader loses her money. Unlike stock options, the buyer of a Forex option contract
may choose the strike price and expiration date

SETTLEMENT DATES:

Settlement date, as the name implies refers to the date on which the transaction is settled
by the transferor of deposits, with reference to foreign exchange transactions. In a Spot exchange
transaction, though the word "Spot" implies "immediate", it usually takes two business days for
the transaction to get settled. Though the spot rate is the rate of the day on which the transaction
has taken place, the execution of the transaction occurs within a maximum of two working days.
But in certain cases of countries currencies, the settlement may take place the very next business
day, an example being currency settlement between US Dollars and Canadian Dollars. There are
two aspects involved in settlement dates: the settlement location and dealing location. Settlement
location refers to the country in which the transaction has to be settled or paid and dealing
location refers to the country in which the bank dealing with the foreign exchange transaction is
located. If the Settlement date falls on a holiday, the next business day would be the settlement
date.

Forward exchange rates are applicable for the delivery of foreign exchange at some future
date, which may be specified. There are two options in forward exchange transactions. Let us
assume that Emirates in UAE is purchasing aircrafts from the United States. Obviously, the
settlement has to be made in US dollars. Suppose if the agreement between the two countries is
to settle the payment after 2 months time, there are now two options available for Emirates,
UAE: one, to remain silent now and after 2 months period, buy the US Dollars at the spot market
at the then prevailing spot rate and settle the payment to the United States. In this case, the
settlement date will be as per the Spot Exchange transaction. Secondly, the country can buy US
dollars at the forward exchange market at the agreed prevailing forward exchange rate, which
would be valid for settlement after two months period, irrespective of the spot rate prevailing at
the time of settlement after two months. The second option avoids uncertainty and risk and the
settlement takes place at the maturity of the forward exchange contract.

Examples of Settlement Dates Calculation: 

Suppose a Spot exchange transaction is entered into on March 1st, the settlement date
would generally be March 3rd. If any of the days in March 2 or 3 happens to be a holiday, the
settlement date would be shifted accordingly to March 4th or March 5th. It may also happen that
the settlement date falls on March 2nd with respect to transactions between certain countries
currencies. These are with respect to Spot exchange transactions. Let us now take an example of
a forward exchange transaction which is entered into on April 1. Firstly, the settlement date
would be calculated as per the spot exchange transaction, which would be April 3rd, if no holiday
falls in between. If the forward exchange contract has a maturity period of 2 months, the
settlement date would then be June 3rd. In this case the month is not calculated with respect to
the number of days in a month, 30 or 31. If 3rd June falls on a holiday, the settlement date would
be June 4th. But, in any case, if the settlement date falls on 30th June and if that day happens to
be a holiday, then the settlement date would be pre-poned to 29th June and not for 1st of July.
Also, in some cases, forward exchange transactions are entered into for number of days rather
than months, like 45-day contract etc. In such cases, the number of days in a month will be
counted to calculate the maturity period and the settlement date of the contract.

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Topics under Foreign Exchange Market (FOREX):

 Currency Options
 Currency Swaps
 Discount and Premium
 Foreign Exchange Market Mechanisms & Conventions
 Forward Rates Vs Spot Rates