CoverageForeign Exchange rateFunctions of F X marketCharacteristics of F X marketIndian Foreign exchange systemTypes of TransactionsMarket Participants
Foreign exchange rateAn exchange rate (also known as the foreign-exchange rate, forex rate orFX rate) between two currencies is the rate at which one currency will beexchanged for another. It is also regarded as the value of one country’scurrency in terms of another currency.FX rate can be spot rate as well as forward rate.The spot exchange rate refers to the current exchange rate. The forwardexchange rate refers to an exchange rate that is quoted and traded today butfor delivery and payment on a specific future date.
The foreign exchange market is the mechanism bywhich participants:transfer purchasing power between countries;obtain or provide credit for international tradetransactions, andminimize exposure to the risks of exchange ratechanges.Functions of FX Market
Characteristics of FX Market Largest of all financial markets with average dailyturnover of over $2 trillion! 66% of all foreign exchange transactions involve cross-border counterparties. Only ≈11% of daily spot transactions involve non-financial customers. London is the largest FX market. US dollar involved in 87% of all transactions.
Increasing TurnoverDaily foreign exchange market turnover in billions of US dollars(Bank for International Settlements Triennial Central Bank Survey 2008)
7A Spot transaction in the interbankmarket is the purchase of foreignexchange, with delivery and paymentbetween banks to take place, normally,on the second following business day.The date of settlement is referred to asthe value date.Types of Transactions
8An outright forward transaction (usually called just“forward”) requires delivery at a future value date of aspecified amount of one currency for a specified amount ofanother currency.The exchange rate is established at the time of theagreement, but payment and delivery are not requireduntil maturity.Forward exchange rates are usually quoted for value datesof one, two, three, six and twelve months.Buying Forward and Selling Forward describe the sametransaction (the only difference is the order in whichcurrencies are referenced.)Types of Transactions
9A swap transaction in the interbank market is thesimultaneous purchase and sale of a given amount offoreign exchange for two different value dates.Both purchase and sale are conducted with the samecounterparty.Some different types of swaps are:spot against forward,forward-forward,nondeliverable forwards (NDF).Types of Transactions
10The foreign exchange market consists of two tiers:the interbank or wholesale market (multiples of $1M US orequivalent in transaction size), andthe client or retail market (specific, smaller amounts).Five broad categories of participants operate within thesetwo tiers: bank and nonbank foreign exchange dealers,individuals and firms, speculators and arbitragers, centralbanks and treasuries, and foreign exchange brokers.Market Participants
11Banks and a few nonbank foreign exchange dealers operate inboth the interbank and client markets.They profit from buying foreign exchange at a “bid” price andreselling it at a slightly higher “offer” or “ask” price.Dealers in the foreign exchange department of largeinternational banks often function as “market makers.”These dealers stand willing at all times to buy and sell thosecurrencies in which they specialize and thus maintain an“inventory” position in those currencies.Market Participants
12Individuals (such as tourists) and firms (such as importers,exporters ) conduct commercial and investmenttransactions in the foreign exchange market.Their use of the foreign exchange market is necessary butnevertheless incidental to their underlying commercial orinvestment purpose.Some of the participants use the market to “hedge” theirforeign exchange risk.Market Participants
13Speculators and arbitragers seek to profit from trading inthe market itself.They operate in their own interest, without a need orobligation to serve clients or ensure a continuousmarket.While dealers seek the bid/ask spread, speculators seekall the profit from exchange rate changes and arbitragerstry to profit from simultaneous exchange rate differencesin different markets.Market Participants
14Central banks and treasuries use the market to acquire or spendtheir country’s foreign exchange reserves as well as to influencethe price at which their own currency is traded.They may act to support the value of their own currency becauseof policies adopted at the national level or because ofcommitments entered into through membership in jointagreements such as the European Monetary System.The motive is not to earn a profit as such, but rather to influencethe foreign exchange value of their currency in a manner that willbenefit the interests of their citizens.As willing loss takers, central banks and treasuries differ in motivefrom all other market participants.Market Participants
Indian foreign exchange systemIndia’s FX rate system was on the fixed rate model till the 90s,when it was switched to floating rate model. Fixed FX rate is therate fixed by the central bank against major world currencies likeUS dollar, Euro, GBP, etc. Like 1USD = Rs. 50. Floating FX rateis the rate determined by market forces based on demand andsupply of a currency.