Foreign Exchange Market

• Foreign exchange market is the market in which foreign currencies are bought and sold.

• The buyers and sellers include individuals, firms, foreign exchange brokers, commercial
banks and the central bank.

• The transactions in this market are not confined to only one or few foreign currencies.

• The foreign exchange market assists international trade and investment by enabling
currency conversion.

• The foreign exchange market (forex, FX, or currency market) is a form of exchange for
the global decentralized trading of international currencies.

Foreign Exchange Market-Characteristics

Characteristics of foreign exchange market

1. Electronic market

2. Geographical Dispersal

3. Transfer of purchasing power

4. Intermediary Volume

5. Provision of credit

6. Minimizing Risk.

Foreign Exchange Market-Functions

Foreign exchange market performs the following three functions

1. Transfer Function

 In performing the transfer function, the foreign exchange market carries out payments
internationally by clearing debts in both directions simultaneously, analogous to
domestic clearings.

2. Credit Function

 It provides credit for foreign trade. Bills of exchange, with maturity period of three
months, are generally used for international payments. Credit is required for this period
in order to enable the importer to take possession of goods, sell them and obtain money
to pay off the bill.
3. Hedging Function

 A third function of the foreign exchange market is to hedge foreign exchange risks.
Hedging means the avoidance of a foreign exchange risk.

Structure of the Foreign Exchange Market

Market participates of foreign exchange Market

 The Market Participants are

A. Commercial Bank

• A type of financial institution and intermediary

• Bank that lends money and provides transactional, savings, and money market
accounts

• Accepts time deposit in order to facilitate international trade and development,

commercial banks convert and trade foreign currencies.

B. Central bank

• Play an important role in the foreign exchange markets.

 • Try to control the money supply, inflation, and/or interest rates and often have
official or unofficial target rates for their currencies.

C. Foreign exchange fixing

• Foreign exchange fixing is the daily monetary exchange rate fixed by the national
bank of each country.

• The idea is that central banks use the fixing time and exchange rate to evaluate
behaviour of their currency.

• Fixing exchange rates reflects the real value of equilibrium in the market.

D. Hedge funds as speculators

• About 70% to 90% of the foreign exchange transactions are speculative.

• Hedge funds have gained a reputation for aggressive currency speculation since
1996. They control billions of dollars of equity and may borrow billions more,

• Overwhelm intervention by central banks to support almost any currency, if the

economic fundamentals are in the hedge funds' favor.

E. Investment management firms

• Investment management is the professional management of various securities

(shares, bonds and other securities) and assets (e.g., real estate) in order to meet
specified investment goals for the benefit of the investors.

These firms (who typically manage large accounts on behalf of customers such as
pension funds and endowments) use the foreign exchange market to facilitate
transactions in foreign securities

F. Retail foreign exchange traders

• One of the most important tools required to perform a foreign exchange transaction is
the trading platform providing retail traders and brokers with accurate currency
quotes.

• Retail foreign exchange trading is a small segment of the large foreign exchange
market.

• Retail foreign exchange dealers are required to become members of the National
Futures Association (NFA), in order to conduct business with the public.

Types of transactions & settlements in FOREX Market

 Transactions refers to the sale and purchase of foreign currencies.

• Spot Market: The term spot exchange refers to the class of foreign exchange transaction
which requires the immediate delivery or exchange of currencies on the spot. ...

• Forward Market: ...

• Futures. ...

• Options. ...

• Swap operation. ...

• Arbitrage.

The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies is an
agreement of exchange of currencies of one country for another at an agreed exchange
rate on a definite date.

1. Spot Transaction

• the buyer and seller of different currencies settle their payments within the two days of the
deal.

• the fastest way to exchange the currencies.

• currencies are exchanged over a two-day period, which means no contract is signed
between the countries.

 The exchange rate at which the currencies are exchanged is called the Spot Exchange
Rate. The market in which the spot sale and purchase of currencies is facilitated is called
as a Spot Market.

2. Forward Transaction

 A forward transaction is a future transaction where the buyer and seller enter into an
agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange
rate on a definite date in the future.

 The rate at which the currency is exchanged is called a Forward Exchange Rate.

 The market in which the deals for the sale and purchase of currency at some future date is
made is called a Forward Market.

3. Future Transaction:
  The future transactions are also the forward transactions and deals with the contracts in the
same manner as that of normal forward transactions.

4. Swap Transactions:

 The Swap Transactions involve a simultaneous borrowing and lending of two different
currencies between two investors. Here one investor borrows the currency and lends
another currency to the second investor.

 The swap contracts allow the investors to utilize the funds in the currency held by him/her
to pay off the obligations denominated in a different currency without suffering a foreign
exchange risk.

Exchange rate quotations

Exchange rate quotations can be quoted in two ways

• Direct quotation and

• Indirect quotation.

 Direct quotation is when the one unit of foreign currency is expressed in terms of
domestic currency.

Indirect quotation is when one unit of domestic currency us expressed in terms of foreign
currency

Currency futures and options markets

Exchange-traded derivative

 Exchange-traded derivative contract are

 standardized derivative contracts such as futures and options. Contracts that are transacted
on an organized futures exchange.

Over The Counter derivatives

 Over the Counter (OTC) derivatives are traded between two parties (bilateral
negotiation) without going through an exchange or any other intermediaries.

 OTC is the term used to refer stocks that trade via dealer network and not any centralized
exchange. These are also known as unlisted stocks where the securities are traded by
broker-dealers through direct negotiations.

Options
  currency option (also known as a forex option) is a contract that gives the buyer the right,
but not the obligation, to buy or sell a certain currency at a specified exchange rate on or
before a specified date. For this right, a premium is paid to the seller.

 Call options provide the holder the right (but not the obligation) to purchase an underlying
asset at a specified price (the strike price), for a certain period of time.

 If the stock fails to meet the strike price before the expiration date, the option expires and
becomes worthless.

 Put Options give the holder the right to sell an underlying asset at a specified price (the
strike price). The seller (or writer) of the put option is obligated to buy the stock at the
strike price. Put options can be exercised at any time before the option expires.

Swaps

 Interest Rate Swaps

 In an interest rate swap, the parties exchange cash flows based on a notional principal
amount (this amount is not actually exchanged) in order to hedge against interest rate
risk.

 Commodity Swaps

 These involve the exchange of a floating commodity price Currency Swaps

 the parties exchange interest and principal payments on debt denominated in different
currencies.

 Debt-Equity Swaps

 This involves the exchange of debt for equity – in the case of a publicly-traded company,
this would mean bonds for stocks. It is a way for companies to refinance their debt or
reallocate their capital structure