2. Foreign Exchange Market
• Foreign exchange refers to the exchange of one currency for some other
currency.
• In a typical foreign exchange transaction, a party purchases some quantity of
one currency by paying with some quantity of another currency.
• The foreign exchange market indicates a market in which the various
participants are able to buy, sell, exchange and speculate on currencies
depending upon their rates.
• The various components and participants that make up foreign exchange
market include banks, commercial companies, hedge funds, investors, central
banks, retail foreign exchange brokers and investment management firms.
• The market mainly determines the foreign exchange rate.
• The foreign exchange market assists international trade and investments by
enabling currency conversion.
3. UNIQUE FEATURES OF FOREX MARKETS
• Liquidity – this market is characterized by high liquidity since the
dealing takes place in highly liquid assets and on frequent basis.
• Operates 24 hours, 5 days a week - Since foreign exchange deals with
the currencies of different nations. Thus, in case of Forex market as
one major foreign exchange market closes in one part, another
market in a different part of the world opens for business.
• Leverage- leverage is a form of loan given by a broker to his investor.
With this loan investors are able to enhance profits.
• Trading Volume – trading volume in this form of market is huge
because of the large number of people who participate in it.
4. FOREX MARKET – BASIC FUNCTIONS
• The basic function of a foreign exchange market is to determine foreign exchange rate.
• Exchange rate refers to the rate at which one currency is exchanged for another currency.
• The exchange rate can be spot or forward.Spot rate is the current exchange rate whereas
forward rate is the rate quoted for a forward contract.
• Exchange rate is a relative concept. Broadly there are 2 types of exchange rates- fixed
exchange rates and flexible exchange rates.
• The exchange rates which are determined by the foreign exchange market and fluctuate on
a moment to moment basis are flexible rates.
• Fixed exchange rates do not fluctuate according to the foreign exchange market, they
remain constant.
• Exchange rate isn’t determined on the basis of a single factor, it is determined and
influenced by a variety of factors and all are related to the trading relationship between two
countries.
• Some of them being: balance of payments, interest rate level, inflation rate of a nation, the
fiscal and monetary policy of a country, venture capital, terms of trade, the extent of
government intervention in the market and the economic strength of a country.
5. FUNCTIONS OF FOREX MARKETS
• TRANSFER FUNCTION
It aids the transfer o funds and purchasing power from one
country to another
• CREDIT FUNCTION
The market helps to provide credit for smooth international trade
activities
• HEDGING FUNCTION.
Hedging facilities are provided for investors (customers)
8. FOREX FINANCIAL INSTRUMENTS
• CASH: a cash transaction refers to the fastest mode of settling transaction, here the payment is made
right away.
• TOM: Tom indicates the transactions that will be completed by the next day i.e. tomorrow. Thus, if a
transaction is entered into today it will be settled by tomorrow.
• SPOT: a spot transaction in most days refers to a 2-day delivery transaction. These 2 days refer to
business days. It represents a direct exchange between 2 currencies in a shortest time frame.
• FORWARD: in case of a forward contract money changes hands on a specified future date. The
transaction occurs on a future date pre-determined mutually by the buyer and seller. The transaction
takes place on that specific date regardless of the market rates at that point of time. The duration may
vary from days to years.
• NON-DELIVERABLE FORWARD (NDF): NDF contracts are derivatives with no real deliver-
ability. NDFs are offered by forex banks, prime brokers and ECNs for currencies with restrictions
(currency that cannot be traded on open market with other major currencies).
• FUTURES: futures are standardized forward contracts and are usually traded on an exchange created
for this purpose. They are similar to forward contracts In terms of obligations with an average contract
length of 3 months.
• OPTION: it is a derivative where the owner of the option has the right but not the obligation to
exchange currency at a pre-agreed exchange rate on a specified date.
10. FOREX RISK MANAGEMENT
• TRANSACTION RISK: Exchange rate is a relative figure based upon the currencies the rate is
concerned with. Transaction risk is related the time gap between entering into a transaction and settling
of a transaction. Since exchange rates keep fluctuating, firms face risk of changes in exchange rate
between foreign and domestic currency. As firms negotiate with set prices and delivery dates,
transaction risk indicates the risk associated with fluctuation in exchange rate between the time an
enterprise initiates a transaction and settles it.
• ECONOMIC RISK: Economic risk also known as forecast risk is the risk associated with the firm’s
market share position with regard to its competitors, future cash flows, etc. it refers to the degree to
which the firm’s market value is influenced by unexpected exchange rate fluctuations. Economic risk
can affect the present value of future cash flows
• TRANSLATION RISK: It refers to the impact upon the financial reporting of the firm due to
exchange rate movements. This problem is faced by multinational organizations since they deal in
various nations having different currencies.
• CONTINGENT RISK: A contingent risk arises from the potential chance of a firm to suddenly face a
transnational / economic forex risk. Contingency indicates that the event may or may not occur.
