Foreign exchange refers to the exchange of one currency for another. The foreign exchange market determines the exchange rates between currencies. It is the largest financial market in the world, with over $4 trillion traded daily. Exchange rates are influenced by factors such as economic performance, interest rates, trade balances, and political events. Currencies can have a fixed exchange rate set by a central bank or float based on supply and demand. Arbitrage opportunities in exchange rates are quickly eliminated by traders in the foreign exchange market.

3. Meaning of Foreign Exchange
The term Foreign exchange implies two things: a)foreign
currency and b) exchange rate
 Foreign exchange generally refers to foreign currency, eg
for india it is dollar, euro, yen, etc… &
 the other part of foreign exchange is exchange rate
which is the price of one currency in terms of the other
currency.
Forex is the international market for the free trade of
currencies. Traders place orders to buy one currency with
another currency.

4. forex cntd…
 According to Hartly Withers, “ Foreign exchange is the art
and science of international monetary exchange”
 The forex market is the world’s largest financial market.
Over $4 trillion dollars worth of currency are traded each
day. The amount of money traded in a week is bigger
than the entire annual GDP of the United States!
 The main currency used for forex trading is the US dollar.

5. Foreign exchange market
 Foreign exchange market is that market in which
national currencies are traded for one another..
 The major participants in this market are commercial
banks, forex brokers, and authorised dealers and the
monetary authorities.
 Besides, transfer of funds from one country to another ,
speculation is an important dimension of foreign
exchange market.
 Its where money in one currency is exchanged for
another

6. Advantages of Forex market
 It’s already the world’s largest market and it’s still
growing quickly
 It makes extensive use of information technology –
making it available to everyone
 Traders can profit from both strong and weak economies
 Trader can place very short-term orders – which are
prohibited in some other markets
 The market is not regulated
 Brokerage commissions are very low or non-existent
 The market is open 24 hours a day during weekdays

7. Terms related to Foreign
Exchange
 Foreign exchange reserves- holdings of other countries' currencies
 Foreign exchange controls- controls imposed by a government on the
purchase/sale of foreign currencies
 Retail foreign exchange platform- speculative trading of foreign exchange
by individuals using electronic trading platforms
 Foreign exchange risk- arises from the change in price of one currency
against another
 International trade- the exchange of goods and services across national
boundaries
 Foreign exchange company- a broker that offers currency exchange and
international payments
 Bureau de change- a business whose customers exchange one currency
for another
 Currency pair- the quotation of the relative value of a currency unit
against the unit of another currency in the foreign exchange market
 Digital currency exchanger- market makers which exchange fiat currency
for electronic money

8. Exchange rate
 According to haines, “Exchange rate is the price the
currency of a country can be exchanged for the number
of units of currency of another country.”
 Exchange rate is that rate at which one unit of currency
of a country can be exchanged for the number of units
of currency of another country.
 It’s the price for which one currency is exchanged for
another

9. Factors influencing Exchange
Rates
As with any market, the forex market is driven by supply and demand:
 If buyers exceed sellers, prices go up
 If sellers outnumber buyers, prices go down
The following factors can influence exchange rates:
 National economic performance
 Central bank policy
 Interest rates
 Trade balances – imports and exports
 Political factors – such as elections and policy changes
 Market sentiment – expectations and rumors
 Unforeseen events – terrorism and natural disasters
Despite all these factors, the global forex market is more stable than
stock markets; exchange rates change slowly and by small amounts.

10. Types of exchange rates

11. Fixed and Floating
exchange rates
 Fixed exchange rate is the official rate set by
the monetary authorities of the Governance
for one or more currencies.
 Under floating exchange rate, the value of
the currency is decided by supply and
demand factors

12. Direct and indirect
exchange rates
 Direct method - Under this, a given number of units of
local currency per unit of foreign currency is quoted.
They are designated as direct/certain rates because the
rupee cost of single foreign currency unit can be
obtained directly. Direct quotation is also called home
currency quotation.
 Indirect method – Under this, a given number of units
of foreign currency per unit of local currency is quoted.
Indirect quotation is also called foreign currency
quotation

13. Buying and selling
Exchange rates are quoted as two way
quotes –
 for purchase
 and for sale
transactions by the Bank

14. Spot and forward
The delivery under a foreign exchange transaction can be
settled in one of the following ways
 Ready or cash – To be settled on the same day
 Tom – To be settled on the day next to the date of
transaction
 Spot – To be settled on the second working day from
the date of contract
 Forward – To be settled at a date farther than the spot
date

15. Theories of exchange rate
determination
 Meaning:
Theories which determine the prices of forex rate
considering inflation, interest rate, and elasticity of price
etc..
Methods:
a) Long run theory
b) Short run theory

16. Long Run Theory of Exchange
rate
Determination:
 These are the theories which predominately take into
account the fundamental changes of economy.
 Here fundamental changes refers to the change which are
going to change the economic performance of the economy
Purchasing power all times to come.
Types of theory:
Purchasing power parity.
 1) Absolute purchasing power parity.
 2) Relative purchasing power parity.
Interest Rate parity
 1) Covered Interest Rate parity
 2) Uncovered Interest Rate parity

17. Short Run theory of exchange
rate determination
 This theories are based more on current information or
immediate performance of economic variables.
 This theory tries to take into account the short run factor
which may be eliminated in the long run.

18. Purchasing power parity theory
Founder –Swedish economist Gustav Cassel in 1918.
 Meaning : According to this theory ,the price levels and
the changes in these price levels in different countries
determine the exchanges rates of these countries
currencies.
 The basic principle of this theory is that the exchange
rates between various currencies reflect the purchasing
power of these currencies .This theory is based law of
one price.

19. Absolute form of PPP Theory
 If the law of one price were to hold good for each and
every commodity then the theory is termed as Absolute
form of PPP Theory.
 This theory describes the link between the spot
exchange rate and price levels at a particular point of
time

20. Relative form of PPP
 This theory describes the link between the changes in
spot exchange rate and in the price levels over a period
of time.
 According to this theory ,changes in spot rates over a
period of time reflect the changes in the price level over
the same period in the concerned economies.
 This theory relaxes three assumptions of PPP i.e.
Absences of transportation cost ,transaction costs and
tariffs.

21. Interest Rate Parity Theory
 Definition :
The process that ensures that the annualized forward
premium or discount equals the interest rate differential on
equivalent securities in two currencies.
 International Fisher effect:
 Expected Rate of change = Interest rate of the exchange
rate differential
 Interest Rate = Real Interest Expected Differential Rate
+ inflation rate

22. Modern theory: demand & supply
theory
 The most satisfactory explanation of the determination
of the rate of exchange is that a free exchange rate
tends to be such as to equate the demand and supply of
foreign exchange..
 The intersection of supply curve and demand curve gives
the equilibrium price
 Modern theory also called balance of payments theory of
foreign exchange

23. Foreign Exchange Risk
 Exposure to exchange rate movement.
 Any sale or purchase of foreign currency
entails foreign exchange risk.
 Foreign exchange transaction affects the
net asset or net liability position of the
buyer/seller.
 Carrying net assets or net liability position
in any currency gives rise to exchange
risk.

24. Risk management
Controlling losses
 You could control your losses, by mental stop or hard stop. Mental
stop means that you already set you limit of your loss. A hard stop
is your initiative to stop when you think you must to stop it.
Using correct lot size
 As a beginning just use smaller lots you could stay flexible and
logic than emotions while you trade.
Tracking overall exposure
 sample: you go to short on EUR/USD and long on USD/CHF, you
exposed two times for USD in the same direction. If USD goes
down , you have a double dose of pain. So, keep your overall
exposure limited, it keeps you for the long haul for trading
The bottom line
 Trading is about opportunities, you must take action while the
opportunities arise.

25. Arbitrage in Spot Market
(Between Banks)
 All banks may not have identical quotes for a
given pair of currencies at a given point of
time – For £/$, following are quotes in two
banks:
Bank A Bank B
 £/$ 1.4550/1.4560 1.4538/ 1.4548
 In such a situation, £ can be bought from B
@1.4548 @ sold to A @1.4550 –till B will ↑its
Ask rate / A will↓ its Bid rate
 Such arbitrage opportunity will rarely emerge,
& even if it is there, it will disappear very fast.

26. Arbitrage in Spot Market
(Between Banks)
 But if the quotes for £/$, are in the following way, what
will happen?
 Bank A Bank B
 £/$ 1.4550/1.4560 1.4545/ 1.4555
 There is no Arbitrage opportunity (A will face many
sellers in £ than buyers, & B will have large buyers of £
than sellers).
 Rule: Two quotes must overlap to prevent arbitrage.

27. Inverse Quotes & Two-Point
Arbitrage
 Buying a currency at one market & selling it at higher price in
another market is known as “Two-Point Arbitrage”.
 Consider the following spot quotations: Zurich Bank quotes:
USD/CHF 1.4955/1.4962 & a Bank in New York quotes: CHF/USD
0.6695/0.6699
 Can there be an arbitrage?
 To acquire one million Swiss francs from Zurich Bank $(1,000,000
÷ 1.4955)=$6,68,700 has to be invested.
 At New York Bank, $ (0.6695 X 1,000,000) = $6,69,500has to be
spent to acquire one million Swiss francs
 There is arbitrage if we buy one million Swiss francs against $ from
the Zurich bank & sell them to New York bank i.e. $800.
 To prevent arbitrage, New York bank’s (CHF/USD) quotes must
overlap the (CHF/USD) quotes implied by the Zurich Bank (worked
out to be 0.6686/0.6690).
 Foreign exchange markets very quickly eliminate two-point
arbitrage.

28. Cross Rates & Triangular
Arbitrage
 Suppose the following exchange rates are quoted:
 Citibank quotes US $ per € - $0.9045/ €
 Barclays Bank quotes US $ per £ - $1.4443/ £
 Deresdner Bank quotes € per £ - € 1.6200/ £
 The cross rate between Citibank & Barclays Bank is:
($1.4443/ £) ÷ ($0.9045/ €) = €1.5968/ £
 But this cross rate is not the same as Dresdner Bank’s
quotation – thus opportunity exists to profit from
arbitrage among three markets - Triangular Arbitrage.

29. Triangular Arbitrage……contd.
 A market trader with $1,000,000 can sell that sum
spot to Barclays Bank for ($1,000,000 ÷ $1.4443/£)
= £692,377.
 Simultaneously, these £ can be sold to Dresdner
Bank for (£692,377 X €1.6200/ £) = € 1,121,651;
 Now, the trader can sell these euros to Citibank for
$: (€1,121,651 X $ 0.9045/ €) = $1,014,533.
 The profit on one such turn is a risk free $14,533.
 Such Triangular Arbitrage will continue till exchange
rate equilibrium is re-established i.e. calculated cross
rate equals the actual quotation (less any tiny
margin for transaction cost).

30. Discounts & Premiums in
the Forward Market
Consider the following pair of spot & forward quotes:
 £/$ Spot: 1.5677/1.5685
 £/$ 1-month Forward: 1.5575/1.5585
 The £ is cheaper for delivery one month hence compared
to Spot £.
 So the £ is said to be at a forward discount in relation to
a $ or, equivalently, the $ is at a forward premium in
relation to the £.

31. CALCULATING THE FORWARD
PREMIUM OR DISCOUNT
F-S x 12 x 100
S n
where F = the mid forward rate of exchange
S = the mid spot rate of exchange
n = the number of months in the
forward contract
= {(1.5580 – 1.5681)÷ 1.5681} X 12 X100 = -7.73%
 For any quotation (A/B), a negative answer would indicate
that currency B is at Forward Premium vis-à-vis Currency A
where as a positive answer would imply that B is at a
forward discount against A.