Unit – 3

Foreign Exchange Market

The foreign exchange market deals with the buying and selling of foreign currencies.
The foreign exchange market is the market in which currencies of different
currencies are bought and sold by the individuals, firms banks and foreign exchange
brokers.
It is also known as Fx or Forex market. It is the place where currencies are traded.
Features:
1. Location:
There is no single or centrally cleared market to deal in foreign exchange business.
There are a number of interconnected market places where different currencies and
instruments are traded.
The main trading centres are London, New York city, Tokyo, Hong Kong, Singapore
etc
2. Size of the market:
It constitutes the largest financial market. Trading between foreign exchange
dealers are very large, involving hundreds of millions of dollars. It is most liquid
financial market in the world.
3. 24 hours market:
The foreign exchange markets are situated throughout the different zones of the
globe. When one market is closing, the other is beginning it operates. Thus any point
of time one market or the other market is open.
4. Efficiency:
The efficiency of the Forex market has been made possible by tremendous
development in communication. Any development in any market is immediately
received by the other markets across the globe.
5. Currencies traded:
The major currencies traded in foreign exchange market are Dollar, Euro, Yen,
Pound, Australian Dollar, Swiss Franc, Indian rupee.
6. Physical Markets:
It may be noted that in few cases, like Paris and Brussels, foreign exchange transaction
takes place at a fixed place such as, the local stock exchange buildings.
7. Types of foreign exchange market:
The Forex market can be classified into 2 types- Retail Forex market and wholesale Forex
market.
When individuals like, travellers, tourists, students and small entrepreneurs involved in
exchange in foreign currency into home currency and vice versa. Such foreign exchange
market is known as Retail foreign exchange market.
In wholesale foreign exchange market, medium size and giant corporates are involved in
foreign exchange transactions.
8. Factors influencing exchange rate:
The foreign exchange market is influenced by variety of factors. It includes, economic
policy of govt and economic condition of the country. Internal, regional and international
political of the conditions have effect on currency market.

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Participants of the foreign exchange market:
1. Commercial banks:
They occupy important position in the foreign exchange market. They operate by
buying and selling foreign currency for their clients.
For scale transaction banks may deal directly among themselves. But for smaller
transactions, the intermediation of foreign exchange brokers may be used.
For the banks foreign exchange dealing is a specialized activity with good
potential for profit. To carryout foreign transactions banks have to keep sufficient
stocks of foreign exchange. These are kept in the form of bank accounts abroad.
2. Corporates and Entrepreneurs:
Corporates are the players in the foreign exchange market to satisfy their need
of payment in foreign currency towards import of goods and services.
Corporates comprise of business houses, international investors and MNCs. They
operate in the foreign exchange market to meet their trade or investment needs.
3. Foreign exchange brokers:
They do not buy or sell foreign currency on their own account. They work as link
between buyers and sellers of foreign currencies. They are the major sources of market
information. They earn only the fee in the form of brokerage charges.
It is through the foreign exchange brokers that commercial banks undertake their
foreign exchange inflows among themselves.
4.Central Banks:
The central bank of a country also takes part in the foreign exchange market. It act as
the “custodian of foreign exchange reserves of its country.” it also manages exchange
control. It intervenes in the foreign exchange market in order to stabilize the exchange
rate of the country’s currency.
In addition, the central banks buy and sells foreign exchange. When the rate market of
currency reaches the upper line, the central bank increases the sale of it’s currency in
exchange for other currencies. On the other hand, when the market rate of currency
reaches the lower line, the central bank buys it’s currency and sells foreign currencies
5. Non bank foreign exchange companies:
These companies offer currency exchange & international payments to private
individuals and companies. These companies offer better exchange rates or cheaper
payments than the customer’s banks.
6. Money transfer remittance companies:
These companies also perform high volume low value transfers generally by
economic migrants back to their home country. The largest and best known provided
is Western Union with 3,45,000 agents, followed by UAE exchange.
7. Foreign exchange banks:
They are joint stock banks incorporated in foreign countries and operating in the
other countries. They are engaged mainly in the financing of foreign trade. In India,
there are 30 foreign exchange banks.
Functions of foreign exchange market:
1. Transfer function:
The most importance function of the foreign exchange market is the transfer of
purchasing power from one country to another and converting one currency to another.
The rate at which one currency is converted into another is called the exchange rate.
The foreign exchange market perform the transfer function by using a variety of credit
instrument. Such as, telegraphic transfers, mail transfers bank drafts, foreign bills etc.
Recent development:
Some of the important recent developments taken place in transferring purchasing
power from one country to another are,
a. SWIFT:
The Society of World-wide Interbank Financial Transactions is a co-operative society
registered in Brussels, Belgium and about 250 banks situated in Europe and North
America are its members. Few selected banks in India have became its members. SWIFT
network supports to transmit the information relating to messages and support to
foreign exchange transactions.
b. CHIPS:
It means ‘Clearing House Inter-bank Payment System’. It is an electronic
payment system. It is owned by 12 private commercial banks constituting the New
York clearing house association. It is the world largest foreign exchange payment
system.
c. CHAPS:
It represents ‘Clearing House Automated Payments System’ It is an electronic
payment system among the banks at London and other countries.
d. Fed Wire:
The Fed Wire System has been developed by the federal reserve system of U.S.A in
order to satisfy the need of domestic payments, interbank transfers etc.
It is a communication network that links more than 7000 banks of the Federal
Reserve Banks.
2. Credit function:
The foreign exchange market performs the credit function both nationally and
internationally to promote foreign trade.
The important function performed by the foreign exchange department of a bank is
providing credit facilities to the exporter and importers.
a. Export credit:
Commercial banks provides 2 types of export credit. They are
i. Pre-shipment credit
ii. Post-shipment credit
b. Import Credit:
To finance imports, the foreign exchange department of a bank issue letters of credit
on behalf of their importer-customers. The importers will be financed in the following
two forms:
a. Cash credit or loan
b. Pledge or mortgage of the items imported.
 The availability of foreign currency is assured to the following main sources.
a. Euro currency market:
It is the international financial market, which specialises in the borrowing and
lending of the U.S. dollars and other European currencies, outside their respective
countries of issue. Its centres include London, Paris, Frankfurt, Zurich, etc.
b. Export Credit Facilities:
These facilities are available by several countries through an institutional frame
work in which the EXIM banks plays a vital role.
c. International Bond Market:
This market provides facilities to raise long-term loans by using different types of
instruments. It is famously known as Euro Bond Market.
d. International Financial Institutions:
It includes IMF, World Bank, IFC, IDA, ADB ,etc. provides finance in foreign
currencies.
3. Hedging Functions:
Hedging of foreign exchange risk is the another important function performed by
the foreign exchange market. This function is performed by a way of providing
facilities for buying and selling spot or forward exchange control.
In a forward exchange contract a banker or a customer or another banker entire
into a contract to buy or sell a fixed amount of foreign currency on a specified
future date, at a pre-determined rate of exchange.
In this way the exporters and importers can hedge their foreign exchange risk,
arise from sudden and unexpected changes in foreign exchange rate.
Thus, the forward exchange contracts enable the banks, to fix exchange position in
a foreign exchange market.
 Instruments Traded in Foreign Exchange Market:
1. Telegraphic transfer (TT):
It is a quickest method of transferring money from one centre to another. A TT is an
order for the payment of money sent by telegraph or cable. The customer purchasing a
TT pays the money to the bank in the currency of his country. The bank informs it’s
banking correspondent through oversees cable communication service to make
payment in foreign currency to a specified payee.
The cost of the telegram cable is included by the selling bank in the amount
recovered.
Advantages:
1. It is the quickest method of transferring funds from one country to another.
2. There is no gain or loss of interest.
3. There is no risk of loss of instrument in the transaction.
4. It is the more safe and principal means of effecting international payment.
2. Mail transfer: (MT)
It is an order by a bank to it's a correspondent bank in abroad to pay a specific
amount of money to a particular person. The instructions are sent by mail usually by
air mail.
A mail-transfer is like a cheque effecting payment or transfer of funds but is not
negotiable or transferable.
Mail transfer has the following disadvantages:
1. It is time consuming as it takes much time to reach it’s destination.
2. There is loss of interest to the purchaser.
3. There is loss of instrument during transaction.
3. Bank drafts and cheques:
A bank draft is a pay order issued by a bank on its own branch or correspondent bank
abroad. The bank draft or demand draft is handed over to the buyer who sends it to
the beneficiary. The beneficiary obtains payments on presentation to the bank on
which the draft is drawn.
 The name of the beneficiary is indicated on the draft or cheque. Banks charge
commission for issuing the bank draft and direct the branch manager of that country
to pay the specified amount in foreign exchange to the beneficiary.
It may be noted that a draft may be drawn in the currency of the country where
the debtor resides.
The drawback of remittances by draft or cheque is the risk of loss of draft or
cheque in transit and delay in effecting the payment to the beneficiary. It involves
the loss of interest as like mail transfer.
4. Bill of exchange:
It is a written order issued by the exporter through which the importer is directed
to pay the specified amount in specific currency on a specified date to him or his
representative.
There are 3 parties involved in a bill of exchange, They are:
a. The drawer b. The drawee c. The payee
 The drawer is the exporter or the future receiver of funds.
The drawee is the person or the firm who is liable to pay the funds.
The payee is the person who is entitled to receive the funds other than the
drawer.
An exporter prepares a bill of exchange which is drawn on an overseas importer
or an a third party designated in the export contract for the sum agreed.
The bill of exchange is classified into sight draft and term draft. The Sight draft
is payable at sight or on demand. But Term draft is payable at a fixed or
determinable future time. It is also called as Usance bill.
Further, bills are also classified into trade bills and bank bills. Trade bills arise
out of trade transactions, while bank bills include bank drafts and commercial bills
which are accepted by the banks.
5. Letter of Credit:
It is a document issued by a banker of the importer. Through the letter of credit,
the bank agrees to honour a draft drawn on the importer, subject to conditions.
It is an instrument authorising a person to draw a bill or a cheque for a specific
sum on the issuing bank at a specific time. An importer in a country requests his
bank to open a credit in foreign currency in favour of his exporter at a bank in the
foreign country. It is issued against the payment of amount by the importer or
against proper security.
The letter of credit authorises the exporter to draw a draft under its terms and
sell to a specified bank in his country. The LOC make the exporter willing to ship the
goods to the importer for the payment is assumed by the bank.
6. Bill of Lading:
It is a shipping document issued to an exporter firm or its bank by the transport
agency or the transporter. It is a evidence that the transporter is required to
deliver the goods to the importer in exchange for certain charges, as an evidence of
the ownership of goods.
 Methods of Quoting Exchange Rates:
The rate of exchange for a currency is known from the quotation in the foreign
exchange market. In foreign exchange dealing the rate of exchange can be quoted in
two methods.
1. Direct Quotation: (Buy low, Sell high)
In this method, exchange rate is expressed as the price per unit of foreign
currency in terms of the home currency. It is also known as home currency quotation.
Under the direct quotation, the number of units of foreign currency is kept
constant and any change in the exchange rate will be made by changing the value of
in terms of home currency. Under this method, home currency will be the variable
unit.
For eg: 1 US Dollar= ₹ 71
1 Euro= ₹ 78
1 Pound= ₹ 92
 Direct Quotation

Buy low Sell high

For a fixed unit

Pay lesser units Receive more
of foreign
of home units of home
currency
currency currency

In foreign exchange market, the banker buy the foreign currency at a lower rate
and sells at a higher rate to earn a margin.
For example, a bank may buy U.S.$ from its customer for Rs. 71.94 and sell it to
another customer at Rs. 72.14
2. Indirect Method ( Buy high and Sell low ):
Under this method, the foreign exchange rate is expressed as number of units
of foreign currency per unit of home currency.
In this method, home currency is kept constant and exchange rate is expressed
as so many units of foreign currency quotation.
Under this method, the foreign currency will be variable units. Any change in
foreign exchange rate will be effected by change in the units of foreign currency.
For eg:
₹100=2.5 US
₹100=1.5 Pound
₹100=2.1 Euro
 Indirect Quotation

Buy high Sell low

For a fixed unit

Acquire more Part with lesser
of home
units of foreign units of foreign
currency
currency currency

In this method, the banker buys the foreign currency at a higher price from a
customer and sells at a lower price to another customer
For eg For ₹100 the bank may quote a selling rate of dollar 2.3290 and buying rate
Dollar 2.3390
In India, till 1966. direct quotation was introduced. But after 1993, India has
adopted direct quotation.
the indirect quotation is used in London. Both methods are used in USA.
FEDAI ( Foreign Exchange Dealers Association of India ):
It is the association of all dealers in foreign exchange which determines rules
and regulation relating to day to day transaction in foreign exchange business in
India.
It was formed with the approval RBI in 1958. It act as a self regulatory body and is
incorporated under the section 25 the Companies Act 1956.
Its major activities include framing of rule, governing the conduct of inter-bank
foreign exchange business among banks and the public and works with RBI for
reforms and development of Forex market.
All public sector banks, foreign banks, private sector and co-operative banks and
certain financial institutions are the members of FEDAI.
It has its headquarter in Mumbai and local offices at Bengaluru, Kolkata, Chennai
and Delhi.
Management
FEDAI’s management consists of:
a. Chairman.
b. Vice-chairman.
c. Additional Vice-chairman.
d. Managing committee.
Functions
The following are the main functions performed by FEDAI:
1. Framing rules:
The FEDAI is the authority to frame rules for the conduct of foreign exchange
business in India. All the member are required to abide by the rules framed by
FEDAI.
2. Coordination:
The FEDAI coordinates with the RBI in the proper administration of exchange
control.
3. Circulating information:
The FEDAI circulates information about foreign exchange business, international
trade etc. Which will be of use and interest to its member. It acts as a clearing
house for exchange information among its members.
4. Training:
The FEDAI assists member banks by acting as an advisor and assists with the
training of personnel. It undertakes various sessions/workshops/seminars with the
main objective of educating exporters in their day-to-day transactions with the
banks.
Role and responsibilities of FEDAI:
1. Formulation of FEDAI guidelines and FEDAI rules foreign exchange business.
2. Training of bank personnel in the areas of foreign exchange business.
3. Accreditation of foreign exchange brokers.
4. Advising or assisting member banks is settling issues or matters in their
dealings.
5. Representing member banks or government or RBI and other bodies.
6. Announcement of daily and periodical rates to its member.
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