Forex market

Introduction

The Indian economy being an open economy, it is now essential to extend the discussion
of the Indian financial system to international dimension. In terms of international trade
and financial flows, its openness has increased consistently over the years. The aggregate
of India’s imports and exports in relation to its GDP varied between 9% - 17% till 1991,
and it was 22.5% in 1995 – 1996.

International trade and investment would not be possible without the arrangements and
mechanism for buying and selling foreign currency because rupee is not international
means of exchange. The foreign exchange market (FEM) is a necessary concomitant to
international transaction in an open economy. It is cleared at a conversion price i.e., at the
exchange rate, which is important part of financial analysis. The wealth accumulated in a
given country is not always committed to the financial institutions there.

Need for Foreign Exchange

Let us consider a case where a Japanese company exports electronic goods to USA and
invoices the goods in US Dollars. The American importer will pay the amount in US
Dollars, as the same as his home currency. However the Japanese exporter requires Yen
means his home currency for procuring raw materials and for payment to the labour
charges, etc. For this he would need exchanging US dollars for Yen. If the Japanese
exporters invoice his goods in Yen, then importer in USA will get his dollars converted in
Yen and pay the exporter.

From the above example we can infer that in case goods are bought or sold outside the
country, exchange of currency in necessary.

Sometimes it also happens that transaction between two countries will be settled in the
currency of the third country. That case both the countries, which are transacting will
require converting their perspective currencies in the currency of the third country. For

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that also the foreign exchange is required. For example, an Indian exporter, exporting
goods to Singapore may raise an invoice for the goods sold in US dollars and as the
importer in Singapore has to make payment in US Dollars, he will have to exchange his
Singapore dollars into US dollars. The Indian exporter on receipt of US dollars will
exchange them into Indian rupees. Thus, the transaction will give rise to exchange of
currencies in the exporter’s country as well as importer’s country. Such transaction may
give rise to conversation of currencies at two stages.

Why Trade Foreign Exchange?

Foreign Exchange is the prime market in the world. Take a look at any market trading
through the civilised world and you will see that everything is valued in terms of money.
Fast becoming recognised as the world's premier trading venue by all styles of traders,
foreign exchange (forex) is the world's largest financial market with more than $1.5
trillion US $ traded daily. Forex is a great market for the trader and it's where "big boys"
trade for large profit potential as well as commensurate risk for speculators.

Forex used to be the exclusive domain of the world's largest banks and corporate
establishments. For the first time in history, it's barrier-free offering an equal playing-
field for the emerging number of traders eager to trade the world's largest, most liquid
and accessible market, 24 hours a day.

Trading forex can be done with many different methods and there are many types of
traders - from fundamental traders speculating on mid-to-long term positions to the
technical trader watching for breakout patterns in consolidating markets. The methods for
trading foreign exchange are many.

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Opportunities from Around the World

Over the last three decades the foreign exchange market has become the world's largest
financial market, with over $1.5 trillion USD traded daily. Forex is part of the bank-to-
bank currency market known as the 24-hour interbank market. The Interbank market
literally follows the sun around the world, moving from major banking centres of the
United States to Australia, New Zealand to the Far East, to Europe then back to the
United States.

Until recently, the forex market wasn't for the average trader or individual speculator.
With the large minimum transaction sizes and often-stringent financial requirements,
banks, hedge funds, major currency dealers and the occasional high net-worth individual
speculator were the principal participants. These large traders were able to take advantage
of the many benefits offered by the forex market vs. other markets, including fantastic
liquidity and the strong trending nature of the world's primary currency exchange rates.

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The Nature of FEM

The open economy reality introduces two kinds of monetary units in transactions or
exchange mechanism, namely, the domestic monetary unit and the foreign monetary unit.
The latter is called the foreign exchange. In addition to coins, notes, and bank deposits
denominated in foreign monetary units, foreign exchange generally includes a variety of
highly liquid claims denominated in foreign monetary units. In the Indian context,
according to foreign Exchange Regulation Act (FERA), 1973, foreign exchange means
foreign currency and it includes –

All deposits, credits and balances payable in any foreign currency, and any drafts,
travellers cheques, letters of credit and bills of exchange expressed or drawn in Indian
currency but payable in 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.

“The market in which national monetary units are claims are exchanged for the
foreign monetary units is known as the foreign exchange market.”

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The Organisation and Structure of FEM is given in the figure below –

Foreign exchange market

Retail Wholesale

Banks and money Interbank Central Bank

Changers (bank accounts or
(Currencies, bank deposits)
note, cheques)

Direct Indirect
(Through brokers)

Spot Forward Derivatives

(Outright & (futures, options,
Swaps) etc.)

Merchandise Non-merchandise
(Arbitrage, hedge,
Speculation)

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Like other parts it has two parts: Wholesale and Retail

The exchange of bank notes, bank drafts, currency, ordinary and travellers cheques
between private customers, tourists and banks takes place in the retail market.

The wholesale market is primarily an interbank market in which major banks trade in
currencies held in different currency dominated bank accounts i.e. they transfer bank
deposits from seller’s to buyer’s accounts. This market is far larger than the bank notes
market. Only the head offices and the regional offices of the major commercial are the
market makers in the wholesale market. Most of the small banks and the local offices of
even the major banks do not deal directly in the interbank market. They usually have a
credit line with large banks or with their head offices and they serve their customers
through the latter. Through correspondent relationship with banks in other countries,
major banks have ready access to foreign currencies. Interbank foreign currency
transactions usually do not involve a physical transfer of currency; they simply involve
book keeping entries among banks. There is no central location for this market and
trading in it is continuous. Banks do not normally charge a commission on their currency
transactions, they profit from the spread between the buying and selling rates.

At present there are 84 banks in India who have been authorised to deal in foreign
exchange; they are known as authorised dealers (AD), and the public has to conduct all
their foreign exchange transactions through them.

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The Organisation of FEM

The interbank can be said to have two parts: direct and indirect.

In the direct markets, banks quote buying and selling prices directly to each other and
all participating banks are market makers. It ahs been sometimes characterised as a
“decentralised, continuous, open bid, double auction” market.

In the indirect markets, banks put orders with brokers who put them on “books”, and try
to match purchases and sales orders for different currencies. They charge commission to
both the buyers and sellers. This market is characterised as “quasi – centralised,
continuous, limit – book, single auction” market.

The currencies are traded on “spot” or “cash” basis, i.e., for immediate delivery, and on
“forward” basis, for delivery at sometime in future at the price fixed today.

The FEMs in developed and developing countries differ in two important respects.

First, in the former they are generally more free then in the latter, although this
difference has diminished in the recent past.

Second, in the latter they are expected to provide service more to the import and export
trade rather than for pure exchange trading as in the case of the former.

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Forex Market

An exchange rate can be defined as the number of units of one currency that must be
given to acquire one unit of a currency of another country. It is the price paid in the home
currency to purchase a certain quantity of funds in the currency of another country.

The foreign exchange market includes both the spot market and the forward exchange
rates. The spot rate is the rate paid for delivery within two business days after the day the
transaction takes place. If the rate is quoted for delivery of foreign currency at some
future date, it is called the forward rate.

Forex Market In India

The Rupee’s Exchange Rate: A Brief History

India was a founder member of the IMF. During the existence of the fixed exchange rate
system, the intervention currency of the Reserve Bank was the British pound; the RBI
ensured maintenance of the exchange rate by selling and buying pounds against rupees at
fixed rates. The interbank rate therefore ruled within the RBI band. During the fixed
exchange rate era, there was only one major change in the parity of the rupee-
devaluation in June1996.

After the collapse of the fixed exchange rate system in 1971 also, the RBI continued to
maintain the parity with the pound, with some minor changes; the exchange rates against
other currencies were determined through their cross rate against the pound.

This link with the pound continued until September 1975. By then, in recognition of the
fact that India’s trade had substantially diversified in terms of both currencies and
destinations and that, therefore, the link with the pound was no longer very logical the
rupee’s exchange rate was linked to a basket of currencies. The composition of this
basket was kept secret and the pound continued as the intervention currency. Its exchange

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rate against the rupee was so fixed by the RBI daily, and sometimes changed intra-day, as
to ensure that the value of the (secret) basket of the currencies remained reasonably
steady in the rupee terms.

Overseas Forex Markets

Today, the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The
international trade however constitutes hardly 5 to 7 % of this turnover. The rest of
trading in world forex markets is constituted of financial transaction and speculation.
London has been the biggest market and continues to be so even today. However, many
other cities have developed as major trading centres. As we know that the forex market is
24 – hour market, the day begins with Tokyo and thereafter Singapore opens, thereafter
India, followed by Bahrain, Frankfurt, Paris, London, New York, Sydney and back to
Tokyo. Dealers have access to the dealing not only during their business hours but remain
active from their residences also.

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Arbitrage

The term arbitrage refers to the purchase of a currency by speculators in the monetary
centre where it is cheaper for immediate resale in the monetary centre where it is more
expensive to make a profit the process of arbitrage helps in keeping the exchange rate
between any two currencies the same in different monetary centres.

Example:

If the dollar price of pounds were $ 1.98 in New York and $ 2.01 in London, an
arbitrager (usually a commercial bank or a foreign exchange dealer) would purchase
pounds at $ 1…98 in New York and immediately resell them in London for $ 2.01, thus
realising a profit of $ 0.03 per pound.

However as arbitrage continues, the exchange arte between two currencies tends to get
equalised in the two monetary centres. What actually happens is that the sale of pounds in
London increases the supply of pounds there, thus resulting a decrease in the dollar price
of pounds in London. In New York, arbitrage increases the demand for pounds in New
York, thereby increasing the dollar price of pounds in New York. This process continues
till the dollar prices become equal in the two countries so that arbitrage does not remain
profitable now.

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Forex v/s Other Markets

Other Markets Forex Markets

Limited floor trading hours dictated by the The Forex market is open 24 hours a day,
time zone of the trading location, 5.5 days a week. Because of the
significantly restricting the number of decentralised clearing of trades and overlap
hours a market is open and when it can be of major markets in Asia, London and the
accessed. United States, the market remains open and
liquid throughout the day and overnight.

Threat of liquidity drying up after market Most liquid market in the world eclipsing
hours or because many market participants all others in comparison. Most transactions
decide to stay on the sidelines or move to must continue, since currency exchange is a
more popular markets. required mechanism needed to facilitate
world commerce.

Traders are gouged with fees, such as Commission-Free

commissions, clearing fees, exchange fees
and government fees.

Large capital requirements, high margin One consistent margin rate 24 hours a day
rates, restrictions on shorting, very little allows Forex traders to leverage their
autonomy. capital more efficiently with as high as
100-to-1 leverage.

Short selling and stop order restrictions. None.

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Main Participants in FEM

There are four levels of participants in the foreign exchange market.

At the first level, are tourists, importers, exporters, investors, and so on. These are the
immediate users and suppliers of foreign currencies.

At the second level, are the commercial banks, which act as clearing houses between
users and earners of foreign exchange.

At the third level, are foreign exchange brokers through whom the nation’s commercial
banks even out their foreign exchange inflows and outflows among themselves.

Finally at the fourth and the highest level is the nation’s central bank, which acts as the
lender or buyer of last resort when the nation’s total foreign exchange earnings and
expenditure are unequal. The central then either draws down its foreign reserves or adds
to them.

 Customers

The customers who are engaged in foreign trade participate in foreign exchange markets
by availing of the services of banks. Exporters require converting the dollars into rupee
and importers require converting rupee into the dollars as they have to pay in dollars for
the goods / services they have imported. Similar types of services may be required for
setting any international obligation i.e., payment of technical know-how fees or
repayment of foreign debt, etc.

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 Commercial Banks

They are most active players in the forex market. Commercial banks dealing with
international transactions offer services for conversation of one currency into another.
These banks are specialised in international trade and other transactions. They have wide
network of branches. Generally, commercial banks act as intermediary between exporter
and importer who are situated in different countries. Typically banks buy foreign
exchange from exporters and sells foreign exchange to the importers of the goods.
Similarly, the banks for executing the orders of other customers, who are engaged in
international transaction, not necessarily on the account of trade alone, buy and sell
foreign exchange. As every time the foreign exchange bought and sold may not be equal
banks are left with the overbought or oversold position. If a bank buys more foreign
exchange than what it sells, it is said to be in ‘overbought/plus/long position’. In case
bank sells more foreign exchange than what it buys, it is said to be in
‘oversold/minus/short position’. The bank, with open position, in order to avoid risk on
account of exchange rate movement, covers its position in the market. If the bank is
having oversold position it will buy from the market and if it has overbought position it
will sell in the market. This action of bank may trigger a spate of buying and selling of
foreign exchange in the market. Commercial banks have following objectives for being
active in the foreign exchange market:

• They render better service by offering competitive rates to their customers

engaged in international trade.

• They are in a better position to manage risks arising out of exchange rate
fluctuations.

• Foreign exchange business is a profitable activity and thus such banks are in a
position to generate more profits for themselves.

• They can manage their integrated treasury in a more efficient manner.

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 Central Banks

In most of the countries central bank have been charged with the responsibility of
maintaining the external value of the domestic currency. If the country is following a
fixed exchange rate system, the central bank has to take necessary steps to maintain the
parity, i.e., the rate so fixed. Even under floating exchange rate system, the central bank
has to ensure orderliness in the movement of exchange rates. Generally this is achieved
by the intervention of the bank. Sometimes this becomes a concerted effort of central
banks of more than one country.

Apart from this central banks deal in the foreign exchange market for the following
purposes:

• Exchange rate management:

Though sometimes this is achieved through intervention, yet where a central bank
is required to maintain external rate of domestic currency at a level or in a band so
fixed, they deal in the market to achieve the desired objective

• Reserve management:

Central bank of the country is mainly concerned with the investment of the
countries foreign exchange reserve in a stable proportions in range of currencies
and in a range of assets in each currency. These proportions are, inter alias,
influenced by the structure of official external assets/liabilities. For this bank has
involved certain amount of switching between currencies.

Central banks are conservative in their approach and they do not deal in foreign exchange
markets for making profits. However, there have been some aggressive central banks but
market has punished them very badly for their adventurism. In the recent past Malaysian
Central bank, Bank Negara lost billions of dollars in foreign exchange transactions.

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Intervention by Central Bank

It is truly said that foreign exchange is as good as any other commodity. If a country is
following floating rate system and there are no controls on capital transfers, then the
exchange rate will be influenced by the economic law of demand and supply. If supply of
foreign exchange is more than demand during a particular period then the foreign
exchange will become cheaper. On the contrary, if the supply is less than the demand
during the particular period then the foreign exchange will become costlier. The exporters
of goods and services mainly supply foreign exchange to the market. If there are no
control over foreign investors are also suppliers of foreign exchange.

During a particular period if demand for foreign exchange increases than the supply, it
will raise the price of foreign exchange, in terms of domestic currency, to an unrealistic
level. This will no doubt make the imports costlier and thus protect the domestic industry
but this also gives boost to the exports. However, in the short run it can disturb the
equilibrium and orderliness of the foreign exchange markets. The central bank will then
step forward to supply foreign exchange to meet the demand for the same. This will
smoothen the market. The central bank achieves this by selling the foreign exchange and
buying or absorbing domestic currency. Thus demand for domestic currency which,
coupled with supply of foreign exchange, will maintain the price of foreign currency at
desired level. This is called ‘intervention by central bank’.

If a country, as a matter of policy, follows fixed exchange rate system, the central bank is
required to maintain exchange rate generally within a well-defined narrow band.
Whenever the value of the domestic currency approaches upper or lower limit of such a
band, the central bank intervenes to counteract the forces of demand and supply through
intervention.

In India, the central bank of the country, the Reserve Bank of India, has been enjoined
upon to maintain the external value of rupee. Until March 1, 1993, under section 40 of
the Reserve Bank of India act, 1934, Reserve Bank was obliged to buy from and sell to

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authorised persons i.e., AD’s foreign exchange. However, since March 1, 1993, under
Modified Liberalised Exchange Rate Management System (Modified LERMS), Reserve
Bank is not obliged to sell foreign exchange. Also, it will purchase foreign exchange at
market rates. Again, with a view to maintain external value of rupee, Reserve Bank has
given the right to intervene in the foreign exchange markets.

 Exchange Brokers

Forex brokers play a very important role in the foreign exchange markets. However the
extent to which services of forex brokers are utilized depends on the tradition and
practice prevailing at a particular forex market centre. In India dealing is done in
interbank market through forex brokers. In India as per FEDAI guidelines the AD’s are
free to deal directly among themselves without going through brokers. The forex brokers
are not allowed to deal on their own account all over the world and also in India.

How Exchange Brokers Work?

Banks seeking to trade display their bid and offer rates on their respective pages of
Reuters screen, but these prices are indicative only. On inquiry from brokers they quote
firm prices on telephone. In this way, the brokers can locate the most competitive buying
and selling prices, and these prices are immediately broadcast to a large number of banks
by means of hotlines/loudspeakers in the banks dealing room/contacts many dealing
banks through calling assistants employed by the broking firm. If any bank wants to
respond to these prices thus made available, the counter party bank does this by clinching
the deal. Brokers do not disclose counter party bank’s name until the buying and selling
banks have concluded the deal. Once the deal is struck the broker exchange the names of
the bank who has bought and who has sold. The brokers charge commission for the
services rendered.

In India broker’s commission is fixed by FEDAI.

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 Speculators

Speculators play a very active role in the foreign exchange markets. In fact major chunk
of the foreign exchange dealings in forex markets in on account of speculators and
speculative activities.

The speculators are the major players in the forex markets.

Banks dealing are the major speculators in the forex markets with a view to make profit
on account of favourable movement in exchange rate, take position i.e., if they feel the
rate of particular currency is likely to go up in short term. They buy that currency and sell
it as soon as they are able to make a quick profit.

Corporations particularly Multinational Corporations and Transnational Corporations

having business operations beyond their national frontiers and on account of their cash
flows. Being large and in multi-currencies get into foreign exchange exposures. With a
view to take advantage of foreign rate movement in their favour they either delay
covering exposures or do not cover until cash flow materialize. Sometimes they take
position so as to take advantage of the exchange rate movement in their favour and for
undertaking this activity, they have state of the art dealing rooms. In India, some of the
big corporate are as the exchange control have been loosened, booking and cancelling
forward contracts, and a times the same borders on speculative activity.

Governments narrow or invest in foreign securities and delay coverage of the exposure
on account of such deals.

Individual like share dealings also undertake the activity of buying and selling of foreign
exchange for booking short-term profits. They also buy foreign currency stocks, bonds
and other assets without covering the foreign exchange exposure risk. This also results in
speculations.

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Corporate entities take positions in commodities whose prices are expressed in foreign
currency. This also adds to speculative activity.

The speculators or traders in the forex market cause significant swings in foreign
exchange rates. These swings, particular sudden swings, do not do any good either to the
national or international trade and can be detrimental not only to national economy but
global business also. However, to be far to the speculators, they provide the much need
liquidity and depth to foreign exchange markets. This is necessary to keep bid-offer
which spreads to the minimum. Similarly, liquidity also helps in executing large or
unique orders without causing any ripples in the foreign exchange markets. One of the
views held is that speculative activity provides much needed efficiency to foreign
exchange markets. Therefore we can say that speculation is necessary evil in forex
markets.

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Advantages of Forex Market

Although the forex market is by far the largest and most liquid in the world, day traders
have up to now focus on seeking profits in mainly stock and futures markets. This is
mainly due to the restrictive nature of bank-offered forex trading services.
Advanced Currency Markets (ACM) offers both online and traditional phone forex-
trading services to the small investor with minimum account opening values starting at
5000 USD.

There are many advantages to trading spot foreign exchange as opposed to trading stocks
and futures. Below are listed those main advantages.

 Commissions:

ACM offers foreign exchange trading commission free. This is in sharp contrast to (once
again) what stock and futures brokers offer. A stock trade can cost anywhere between
USD 5 and 30 per trade with online brokers and typically up to USD 150 with full service
brokers. Futures brokers can charge commissions anywhere between USD 10 and 30 on a
round turn basis.

 Margins requirements:

ACM offers a foreign exchange trading with a 1% margin. In layman's terms that means
a trader can control a position of a value of USD 1'000'000 with a mere USD 10'000 in
his account. By comparison, futures margins are not only constantly changing but are
also often quite sizeable. Stocks are generally traded on a non-margined basis and when
they are, it can be as restrictive as 50% or so.

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 24 hour market:

Foreign exchange market trading occurs over a 24 hour period picking up in Asia around
24:00 CET Sunday evening and coming to an end in the United States on Friday around
23:00 CET. Although ECNs (electronic communications networks) exist for stock
markets and futures markets (like Globex) that supply after hours trading, liquidity is
often low and prices offered can often be uncompetitive.

 No Limit up / limit down:

Futures markets contain certain constraints that limit the number and type of transactions
a trader can make under certain price conditions. When the price of a certain currency
rises or falls beyond a certain pre-determined daily level traders are restricted from
initiating new positions and are limited only to liquidating existing positions if they so
desire. This mechanism is meant to control daily price volatility but in effect since the
futures currency market follows the spot market anyway, the following day the futures
market may undergo what is called a 'gap' or in other words the futures price will re-
adjust to the spot price the next day. In the OTC market no such trading constraints exist
permitting the trader to truly implement his trading strategy to the fullest extent. Since a
trader can protect his position from large unexpected price movements with stop-loss
orders the high volatility in the spot market can be fully controlled.

 Sell before you buy:

Equity brokers offer very restrictive short-selling margin requirements to customers. This
means that a customer does not possess the liquidity to be able to sell stock before he
buys it. Margin wise, a trader has exactly the same capacity when initiating a selling or
buying position in the spot market. In spot trading when you're selling one currency,
you're necessarily buying another.

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Problems Faced

Problems faced due to operation in two different foreign exchange markets

A business trying to operate in two different foreign exchange markets would face
certain problems.

On the free market, which fluctuates with supply and demand, the cost of foreign
exchange is higher than on the official market. But, since only certain types of
transactions qualify for foreign exchange at the official rate, a business trying to import
parts, machinery or raw materials must convince the government that their imports are
essential to nation’s long term viability.

Another problem arises because of the probable lack of means for forward cover of
foreign exchange repayments. This may be especially true of the transactions in the free
market. Such instruments may be available from a national bank but only at a prohibitive
cost and only for designated transactions.

A business operating in two different exchange markets faces risk and uncertainty
regarding the cost and availability of foreign exchange.

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