What is foreign exchange market? Who are its participants? What are its functions?

What is foreign exchange market? Who are its participants

? What are its functions?

CH 21: FOREIGN EXCHANGE MARKET

Q1: What is foreign exchange market? Who are its participants? What are its functions?

Ans: Foreign Exchange Market.

*INTRODUCTION:

~ Foreign exchange market is a medium through which individuals, business, governments and banks buy and sell foreign currencies.

~ Foreign exchange market is not a single physical place, but a worldwide market which operates round the clock. It is the largest and the most liquid market in the world.

*MEANING:

~ Foreign exchange market is a mechanism where various national currencies are purchased and sold like any other commodity.

~ The foreign exchange rate is determined by the demand for and supply of foreign exchange.

~ A foreign exchange market can be free or restricted. Restrictions on the market vary from country to country.

~ In India, restrictions are made on foreign exchange convertibility whereby full convertibility is allowed only on current account and not on capital account.

~ Even under the free foreign exchange market, the Government intervenes whenever there is a wide fluctuation in the exchange rate so as to avoid adverse effects of unstable exchange rate on the economy.

*TYPE OF FOREIGN EXCHANGE MARKET:

~ The foreign exchange market is broadly divided into two categories:

^ Retail Market

^ Wholesale market.

RETAIL MARKET:

~ The retail foreign exchange market is a secondary price marker wherein travellers, tourists and people who are in need of foreign currency carry out small permitted transactions.

WHOLESALE MARKET:

~ The wholesale foreign exchange market is also called the interbank market wherein large transactions of foreign exchange are carried out. The dealers in this market are highly professional and are the primary price makers.

*PARTICIPANTS:

~ The following are the main participants in the foreign exchange market:

i) RETAIL CLIENTS:

~ Retail clients are the ones who deal through commercial banks and authorised dealers.

~ These include individuals, international investors, multi-national corporations and others who need foreign exchange.

ii) COMMERCIAL BANKS:

~ Commercial banks deal through other commercial banks and also through foreign exchange brokers.

~ They buy and sell foreign exchange for their retail clients and also carry out their own foreign exchange transactions.

iii) FOREIGN EXCHANGE BROKERS:

~ Each foreign exchange market centre has some authorised brokers who act as intermediaries between buyers and sellers mainly banks.

~ Commercial banks prefer foreign exchange brokers as banks obtain the most favourable quotations from them.

iv) CENTRAL BANKS:

~ Under the floating rate the central bank of a country normally does not intervene in the exchange market.

~However, since 1973, most of the central banks frequently intervened the foreign exchange market to buy and sell their currencies in order to influence the rate at which their currencies are traded.

~ The above groups generate demand and supply forces and help to determine the foreign exchange rate.

~ The brokers are the middlemen between the price makers and possess more information and better knowledge of the market.

~ The large commercial banks and foreign exchange brokers who participate in foreign exchange market are linked together by telephone, telex and satellite communications network called Society for Worldwide International Financial Telecommunications (SWIFT).

~ This system is based in Brussels (Belgium) and links banks and brokers in every financial centre. This system reacts to all the events that influence the foreign exchange rate and thus makes the foreign exchange market efficient and conventional.

*INDIAN FOREIGN EXCHANGE MARKET:

~ Indian foreign exchange market is made up of three tiers:

^ 1st level Deals between RBI and authorised dealers (mainly commercial banks)

^ 2nd level Deals among authorised dealers.

^ 3rd level Deals between authorised dealers and their corporate customers.

*FUNCTIONS:

~ The main functions of the foreign exchange market are:

1)TRANSFER OF PURCHASING POWER:

~ International trade involves different currencies. The residents of one country require the currency of another country to make payments in respect of the following transactions:

Import of goods and services

Dividend, interest and profit to foreign firms.

Unilateral payments.

Capital outflow in the form of investments abroad, short / long term lending, etc.

~ This involves transfer of purchasing power from the prayer's country to the receiver's country.

~ Similarly, the residents of the other country receive the foreign currency in respect of the following transaction.

Receipts on account of export of goods and services.

Receipt of dividend, interests and profit by firms.

Unilateral receipts.

Capital inflow in the form of foreign investments in India, NRI deposits, borrowings, etc.

~ Thus foreign exchange market helps transfer purchasing power between people of different countries.

2)PROVISION OF CREDIT INSTUMENTS AND CREDIT:

~ The foreign exchange market facilitates provision of credit for foreign trade through credit instruments like telegraphic transfer, letters of credit, bill of exchange, drafts, etc.

~ Moreover, instruments with time period (eg. Bill of foreign exchange of 90 days or more) can be discounted with commercial banks or authorised agents before due date.

3) COVERGE OF RISK:

~Exports and imports may cover the risk due to future change in exchange rate through forward exchange market whereby currencies are exchanged (at a fixed rate) at some specified date.

Q2: Write a note on spot and forward exchange rate?

Ans:*INTRODUCTION:

~ Foreign exchange market is a medium through which individuals, business, governments and banks buy and self foreign currencies.

~ Foreign exchange market is a worldwide market that operates round the clock. In fact, it is the largest and the most liquid market in the world.

~ In foreign exchange market, two types of exchange rate operations take place, spot exchange rate and forward exchange rate.

*SPOT EXCHANGE RATE:

~ Spot exchange rate is the current exchange rate. It is determined by market forces (demand for and supply of foreign exchange)

~ At the spot rate, immediate delivery of foreign exchange has to be made.

~ However, in practice, there is a two day time lag between the transaction and actual delivery for paper work, verification and clearing of payments.

~ Since the spot exchange rate is determined by market forces, any change in the demand or supply will change the exchange rate.

~ The primary price makers in the foreign exchange market continuously bid' or ask' the currencies, hence the exchange rate also changes continuously in a free market.

~ Since the primary dealers quote two-way prices and are ready to deal on either side (i.e. to buy and sell) the rate is quoted in the following manner:

^INR /USD 48.50 bid / 48.75 ask

*SPOT DATE:

~ Spot date refers to the delivery date of the currency.

~ It is the settlement date when actual exchange of currencies takes place.

~ The delivery of currency of the spot transaction takes place on thesecond working day after the date of settlement.

*SPOT TRANSACTION:

~ Spot transactions account for two-thirds of the total business transacted in the international foreign exchange market.

~ The spot dealings between an individual like a tourist and banks are settled on the spot by exchanging the currencies immediately.

*FORWARD EXCHANGE RATE:

~ In the foreign exchange forwards market, the purchase/sale of foreign exchange is done currently for delivery and payment at a fixed date in future at a specified exchange rate. This is known as the foreign exchange rate.

~ These contracts usually have maturities of 30, 60 or 90 days. Some transactions also have maturities of 180 0r 360days.

~ Forward exchange rate may either be at a premium or discount in relation to the spot exchange rate:

If the forward exchange rate is above the present spot rate, it is said to be at a premium'.

If the forward exchange rate is below the present spot rate, it is said to be at a discount'

~ The quotation foe forward exchange rate can be done as follows:

It is expressed in terms of the amount of local currency at which the dealer will buy or sell a unit of foreign currency. This is termed as the outright rate'.

It can also be expressed in terms of points (called the forward points). These points are added to the spot rate if the foreign currency is traded at a premium. These points are deducted from the spot rate if the currency is traded at a discount.

*NEED FOR FORWARD CONTRACTS:

~ Exporters, importers and investors enter into forward exchange rate contracts to overcome the possible risk of loss due to fluctuations in the exchange rate.

~ Also, in the forwards market, swap agreements take place to cover the risk involved in the forward deal. Usually banks which enter into forward arrangement to sell foreign currency at a certain rate would cover their risk by entering into an agreement with another bank to purchase the currency at a fixed rate. Such swaps help the banks to match the outflow and inflow of currencies and earn profit based on swap margin.

*FACTORS INFLUENCING FORWARD EXCHANGE RATE:

~ Forward exchange rate is influenced by various factors that may prevail at a future date. These include:

Balance of payments position

Inflation rate.

Interest rate.

Degree of speculation in foreign exchange market.

Economic situation in the country.

Political situation in the country.

Government policies, etc.

~ Thus, in a fully floating exchange rate system, the forward exchange rate is left to the speculation of dealers, whereas in a managed float, the role of the central bank also influences the forward rate.

Q3: Write a note on Risk Coverage in the forward foreign exchange market?

Ans: The risk involved in dealing in the forward foreign exchange market can be covered by activities like hedging, speculation and arbitrage.

~ The activities allow the dealers not only to cover the risks involved but also to earn profit by taking advantage of the forward exchange market.

*HEDGING:

~ Hedging covers the risk arising out of changes in the exchange rate. It is especially essential for firms having large amounts receivables or commitments to pay in foreign currencies.

~ The strategy of hedging involves increasing the currency that is likely to appreciate and decreasing the currency that is likely to depreciate.

~ It also involves decreasing liabilities in the currency that is likely to appreciate and increasing liabilities in the currency that is likely to depreciate.

*SPECULATION:

~ Speculation involves purchase and sale of foreign exchange in the forwards market with the intention of making profit by taking advantage of changes in foreign exchange rates.

~ They speculate on the basis of their own calculation of the difference between the forward rate and spot rate that may prevail at a future date.

~ Speculators try to minimise their loss by entering in spot and forward agreements simultaneously.

~ Speculation may have stabilising or destabilising effect.

~ Stabilising speculation refers to purchase of foreign currency when the domestic price of a foreign currency when the domestic price of a foreign currency falls with the expectation of its increase in the future.

~ Destabilising speculation refers to sale of foreign currency when the exchange rate falls with the expectation that it would fall further. This magnifies exchange rate fluctuations and proves highly disruptive to the international flow of trade and investment.

*ARBITRAGE:

~ Arbitrage refers to purchase of an asset in a low price market and its sale in a higher price market.

~ This process leads to equalisation of price of an asset in all the segments of the market.

~ Arbitrageurs take advantage of the different exchange rates prevailing in various foreign exchange markets due to different interest rates.

~ They purchase foreign currency from the foreign exchange market with lower exchange rate and sell the same in market with a higher exchange rate.

~ Arbitrage is also possible within the country where two banks offer two different bids and asking rate.

~ When arbitrage involves only two currencies or two countries, it is called two-point arbitrage. It increases the supply of dearer currency.

*INTEREST RATE AND ARBITRAGE:

~ The interest rate of a country is influenced by the rate of inflation prevailing in that country.

~ According to Irvin Fisher, a country's nominal interest rate is the sum of its real' rate of interest and the expected rate of inflation over a period of time.

~ Thus, i = r + I where:

^ i = nominal interest rate.

^ r = real rate of interest.

^ I = rate of inflation.

~ This relationship is called FISHER EFFECT'

~ Arbitrage takes place when the real interest rates between the countries differ, whereby money will flow from the country having low interest rate to the country having high interest rate.

~ According to the purchasing power parity theory, exchange rates are influenced by inflation.

~ Since interest rates are also influenced by inflation, there is a link between the interest rates and exchange rates.

~ This is known as INTERNATIONAL FISHER EFFECT'.

~ According to International Fisher Effect, for any two countries, the spot exchange rate should change in an equal amount but in opposite direction to the difference in nominal interest rates between the two countries.

Eg:- (S1 S2) / S2 x 100 = i $ i INR.

Where: S1= Spot exchange rate at the beginning of the period.

S2 = Spot exchange rate at the end of the period.

i$ = Nominal interest rate in U.S.A

i INR = Nominal interest rate in India.

i.e if the nominal interest rate of India is higher, then the value of the Rupee against the dollar should fall by that interest rate differential.

*TYPES OF INTEREST ARBITRAGE:

~ Interest arbitrage can be:covered, uncovered.

UNCOVERED INTEREST ARBITRAGE:

~ In the system, arbitrageurs take risks to earn profit by investing in high interest bearing risk free securities in a foreign market.

~ He will profit if the currency of the foreign market where he invested dose not depreciate.

~ In case of depreciation, if the depreciation is more than the interest rate differential, he will incur a loss.

COVERED INTEREST ARBITRAGE:

~ Interest arbitrage is usually covered as it minimises foreign exchange risk.

~ The investors purchase foreign currency to invest it in a foreign country which has higher rate of interest.

~ At the same time, he sells forward the amount invested with the interest amount for a period which will coincide with the maturity of investment.

~ Thus, it refers to spot purchase of foreign currency with forwards sale to cover foreign exchange risk.

~ The net return on investment is usually equal to the interest differentials less forward discount on that currency.

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