CH 05 FOREIGN EXCHANGE MARKET INTRODUCTION Foreign Exchange

CH. 05 FOREIGN EXCHANGE MARKET

INTRODUCTION • Foreign Exchange Market is the most largest & liquid market in the world. • It is referred to a foreign currency market where a party of one country purchases some quantity of a currency in exchange of paying some quantity of another currency. • According to Kindleberger, foreign exchange market is a market where foreign currencies are bought & sold.

Need of Foreign Exchange Market • Protection of Currency: The government protects the trade in order to accumulate reserves. If economy changes then central bank can ensure the reserves are enough to face the situation. • Job Opportunities: With the increased use of internet, online foreign exchange has become a major feature. Many people earn a living by trading currencies online on a daily basis which in turn increase the job opportunities.

• Hedging Facilitator: Foreign exchange acts as a hedging facilitator. It protects business from risk. It provides business owners with mechanisms that guard them against losses. • Facilitates International Trade: The need for purchasing currency arises when there is a deal between the investors of two different countries. • Currency Liquidity: Foreign exchange market provides liquidity for currencies. Liquidity is the process of converting foreign currency into domestic currency easily.

• Credit Provision: It has the facility of credit provision. It helps in the growth of international trade. Many investors dealing in international market are dependent on credit facilities provided to them. It is easier to get credit from foreign exchange markets as they have sufficient reserves.

Characteristics of Foreign Exchange Market • Superior Liquidity: Traders are free to buy or sell the currencies in the foreign exchange market without affecting the prices of the currencies being traded. • Strong Market Trends: Traders make money by acquiring accurate data & then analyzing the direction that the market takes. Most traders use technical analysis to analyze past & present data & then search for trends.

• Purchasing Power: Foreign market aims at transferring the purchasing power of one currency to another currency. • Lower Trading Costs: Any person can open a mini Forex Account by investing small amount of investment, as the cost of trading is low as compared to other investments, this is because there are no commission fees involved. Even small individual investors can make desired profits from Forex trading.

• Intermediary Functions: Buyers & sellers come together to do business in foreign exchange market, thus, Forex Market acts as an intermediary between buyers & sellers. • Electronic Market: Foreign Exchange Market transactions take place through electronically linked network banks, where the buyers & sellers come together to trade. • Credit Provision: Forex provides the facility of credit provision to the buyers in the form of banker’s acceptance & letter of credit. This helps them trade in the international market.

• Best Transparency: Transparency means free access to trading information. Forex trading is a transparent process because the trader has full access to market data & information that is necessary to perform successful transactions.

Functions of Foreign Exchange Market • Transfer of Purchasing Power: Forex allows conversion of one currency to another currency in the market in order to complete the business between two countries. Transfer of Purchasing power can be done through telegraphic transfer, bank draft, foreign bills etc. • Provision of Credit: To promote foreign trade between the countries, foreign exchange market provides credit to both national & international traders. It helps the trader to trade easily.

• Minimizing Foreign Exchange Risk: Foreign exchange market minimizes the risk of trade. Foreign transactions are done through the payment & receipts of foreign currency exchange. Due to the fluctuation in foreign exchange rate there are chances of loss as well. Under this condition, Forex takes the risk of currency fluctuations.

Participants in Foreign Exchange Market • Retailers: Retailers use foreign exchange to operate their business. They are not involved directly in purchasing or selling foreign currency. They buy & sell by placing orders with commercial banks. Generally, international investors, MNCs are the example of retailers. • Commercial Banks: Commercial banks are directly involved in buying & selling of foreign currency in order of their retail clients & for their own proprietary trading. They either deal directly or by help of the foreign exchange brokers.

• Foreign Exchange Brokers: They are also important in foreign exchange market. They collect number of quotations for different currencies from several banks & place most favorable quotation to the banks. The banks give brokerage for such services. • Central Banks: Central Banks are important in foreign exchange market. They frequently intervene to buy & sell the currency. Governments & Central Banks trade currencies to improve economic conditions or to intervene in an attempt to adjust economic or financial imbalances.

• Investors & Speculators: Investors & speculators trade in currencies to gain from the movements in currency prices. They require currency to deal in foreign investments like equities, bonds, bank deposits, real estates etc. • Authorized Dealer: Authorized dealer is a trader who buys & sells currencies. The dealer profits from the difference in exchange rates between currencies.

• Market Maker: A market maker aims to make money by buying a stock at lower price & selling it at a higher price. They can make money in both rising & falling markets by taking advantage of the difference between ‘bid’ & ‘offer’ prices. • Money Changer: A money changer is a person who exchanges the coins or currency of one country for that of another.

International Payment & Settlement Systems • It includes the payment instruments. • It includes common rules, procedures & technical programs that facilitate the implementation of clearing, transfer & execution of settlement. • It can also be done through Loro & Nostro Accounts. • The following are the different types of international payment systems:

• SWIFT: Society for Worldwide Interbank Financial Telecommunication • CHIPS: Clearing House Interbank Payments System • CHAPS: Clearing House Automated Payment System. It is a British company established in 1984 that offers same-day sterling fund transfers. CHAPS transfer is initiated by the sender to move money to the recipient's account • FEDWIRE: Formally known as the Federal Reserve Wire Network, Fedwire is a RTGS fund transfer system operated by the US Federal Reserve Banks that enables financial institutions to electronically transfer funds between its 9, 289 participants.

STRUCTURE OF FOREIGN EXCHANGE MARKET A. Retail Market – There are 2 types of licenses issued by RBI in retail market to do the transactions: - Fully Fledged Money Changers: they can undertake purchase & sell transactions with the public. - Restricted Money Changers: they can only purchase foreign currency from the foreign tourists. The retail market consists of exchange of bank notes, currency, bank drafts, traveler's cheques etc.

B. Wholesale Market – It is an interbank market where the transactions take place through transfer of one country’s currency to another country’s currency. It transfers the bank deposits from buyer’s to seller’s account. The head offices & regional offices of major commercial banks are the market makers. Foreign currency transactions does not involve in physical transfer of money. In wholesale market, profit is earned through the rate difference between buying & selling rates. It is constructed by two segments: - Interbank Market - Central Banks

TYPES OF FOREIGN EXCHANGE MARKET • Spot Market – The spot market or cash market is a public financial market in which financial instruments are traded for immediate delivery. In spot market, settlement happens in t+2 working days. It can be an organized market, an exchange or over-the-counter. • Forward Market – The forward market is an informal over-the-counter market through which the future contracts are traded. These markets are used to deal in variety of instruments. This deals with the sell & purchase transactions at future date.

Pi. P • Pi. P is an acronym for ‘Price Interest Points’. A Pi. P is the smallest unit by a currency quotations can change. Pi. P in foreign currency quotation is similar to the tick size in share quotations.

Holgate Principle • Holgate principle states that premium on base currency is always added whereas, the discount on base currency is always subtracted from the spot rate to arrive at the corresponding forward rate. • This is also called ‘High-Low’ or ‘Low-High’ rule • If Bid rate > Ask rate – points are subtracted from the spot rate – which indicates a ‘Discount’ • If Ask rate > Bid rate – points are added to the spot rate – which indicated a ‘Premium’