structure of forex markets

1. INTERNATIONAL FINANCIAL
MANAGEMENT
STRUCTURE OF FOREIGN EXCHANGE MARKETS
BY
V S SARMA ,PROF, MBA
VIDYA JYOTHI INSTITUTE OF TECHNOLOGY
1

2. INTERNATIONAL FINANCIAL MANAGEMENT
 Money represents purchasing power
 Possessing money from one country gives the
power to purchase goods and services (G&S)
produced in that country
 purchase of G&S produced by another country
requires first to purchases the currency of other
country by selling own currency, as payment to the
other country is to be made in the legal tender of
the country in which the goods are produced
 This amounts to converting one country’s
purchasing power in to the purchasing power of
another (selling) country
 Foreign Exchange Markets helps the conversion of
purchasing power from one currency in to another.2

3. INTERNATIONAL FINANCIAL MANAGEMENT
 Foreign Exchange markets: a place where one form of money (say Us$) is
exchanged for another
 It is the market for currencies
 Forex market is the largest and most liquid financial market in the world and
includes trading between:
- Large banks - corporations
- Central Banks - Government
- Currency speculators - Other Institutions
STRUCTURE OF FOREIGN EXCHANGE MARKETS
FOREIGN EXCHANGE MARKET
__________________________________________________________
Retail market Whole sale Market
_____________________________
Inter Bank Central Bank
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4. INTERNATIONAL FINANCIAL MANAGEMENT
 RETAIL MARKETS: (Secondary price makers)
 In this market exchange of :
- Bank notes - Cheques
- Bank drafts - TCs
- Currencies
takes place between: (a) Private parties
(b) Tourists
( c) Travelers
 They (a,b,c) exchange one currency for the another in the
form of currency notes o during the period lhe khold it will be borne by him r
Travelers cheques
 Total turnover and average transactions size are very small
 Spread between buying and selling is very large
 RBI has granted two types of money changer’s licenses to
certain:
(a) Established firms
(b) Hotels
(c) Shops and
(d) Other organizations
to deal in currency notes ,m coins, travelers cheques to a limited
extent 4

5. INTERNATIONAL FINANCIAL MANAGEMENT
RETAIL MARKETS: (Secondary price makers) contd..
 LICENCES OF MONEY CHANGERS
 Two types:
(a) Full fledged money changers: They undertake both
sale and purchase transactions with public i.e. travelers,
tourists
(b) Restricted money changers : They only purchase
foreign currencies from the foreign tourists
 They (a,b) are called secondary price makers : Who quotes
forex rates but do not make a two way market
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6. INTERNATIONAL FINANCIAL MANAGEMENT
WHOLESALE MARKET
 It s primarily an Inter Bank Market
 Major banks trade in currencies held in different currency
denominated bank accounts, in this market
 Major participants in this market are:
- Commercial Banks
- Investment Institutions
- Non financial Corporations
- Central Banks
 The market is very larger than the Bank Notes Market e.g. average
transactions in US Market was 4 million US$
 Only Major Commercial Banks are the Market makers(entities
which deal with assets on their own account) in the whole sale
market
 most of small banks do not deal directly with Inter Bank Market6

7. INTERNATIONAL FINANCIAL MANAGEMENT
WHOLESALE MARKET
Inter Bank Markets
 Inter Bank foreign currency transactions do not involve physical
transfer of currency. They simply involve book keeping entries.
 They simply transfer deposits between buyer bank and the seller
bank
 No central location for this market
 continuous trading in this market
 They do not normally charge for currency transactions
 They make profit from the spread between buying and selling
rates
INTER BANK MARKETS______________________________________________________
Direct market Indirect market
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8. INTERNATIONAL FINANCIAL MANAGEMENT
WHOLESALE MARKET
Direct Market:
 Banks quote both buying and selling directly to each other
 All participating Banks are Market Makers (entities who deal with
assets on their own names)
 It is characterized as a ‘ decentralized, continuous, open bid,
double auction market’
Indirect Markets:
 In this, the Banks put orders through brokers who put them on
books and try to match purchases and sales for different
currencies
 They charge commission to both the buyers and sellers
 It is characterized as a ‘ quasi centralized ,continuous, limit book,
single auction market’
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9. INTERNATIONAL FINANCIAL MANAGEMENT
WHOLESALE MARKET
CENTRAL BANKS:
 Even though FE rates of major countries are allowed to
fluctuate freely(1973), Central Banks (RBI) frequently
intervene in buying and selling their currencies in a bid to
arrest wild fluctuations.
 Under a fixed Exchange system the authorities (central
banks) obliged to purchase their currencies when there is
excess supply and sell the currencies when there is
excess demand
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10. INTERNATIONAL FINANCIAL MANAGEMENT
WHOLESALE MARKET (contd..)
PRIMARY PRICE MAKERS OR PROFESSIONAL DEALERS
 In whole sale market the primary price makers play important
role.
 They make a ‘ two way’ market to each other and to their clients
 They quote a two way price – buy and sell
 Primary price makers take positions off the hands of another
dealer or a corporate customer and then offsetting these by doing
an opposite deal with another entity which has a matching
requirement.
 e.g. - PP Maker will sell US$ against Rupee to one customer
- Carry this position for a while and
- Offsets it by buying US$ against rupee from another
customer or professional dealer
- Any exchange rate changes during the period he hold it will
be borne by him 10

11. INTERNATIONAL FINANCIAL MANAGEMENT
WHOLESALE MARKET (contd..)
PRIMARY PRICE MAKERS OR PROFESSIONAL DEALERS (contd..)
 PP Maker will sell US$ against Rupee to one customer
- Carry this position for a while and
- Offsets it by buying US$ against rupee from another
customer or professional dealer
- Any exchange rate changes during the period he hold it will
be borne by him
 E.g. - Sells US$ at Rs 52 per US$. By the time he covers the rate has gone up
to Rs. 54 per US$
- He(PPM) bears the loss of Rs.2/-per US$
 Bid – offer spread ( the difference between buying and selling
prices) provides a cushion against such losses and in addition, it
allows PPM to recover transaction costs and an element of profit
 During high fluctuations the spread tends to be wider 11

12. INTERNATIONAL FINANCIAL MANAGEMENT
WHOLESALE MARKET (contd..)
PRIMARY PRICE MAKERS PYRAMID
 Several layers in the pyramid
 First layer: A few multinational Banks deal in large no. of
currencies in large amounts often deal with each other directly
without brokers.
 E.g. X bank got heavy in flow of US$
Y bank got heavy in flows of British pounds
each bank offloads their excess supply by selling and purchasing
other’s excess currencies
Second layer: consists of large bnks which deal with smaller no. of
currencies and use brokers
Third layer: Small local institutions - deal with a very small no of
major currencies against their home currency
e.g SBI – maintains half dozen currencies mostly US$ and Euro12