Topics to Study:-

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t is Foreign Currency?
Any currency that is in use in a foreign
country, but not in one's own

î
t is Foreign Exc
nge?

The exchange of currency from one country

for currency from another country.
 S
ient Fe
tures of Foreign Exc
nge
 n any economy there are two types of Monetary
units:-
G Domestic Monetary Unit(DMU)
G Foreign Monetary Unit(FMU)
The FMU is known as ³Foreign Exchange´
 Acc. To FERA,1973 Foreign Exchange means
Foreign Currency, which includes:-
GAny draft,
GTraveler's Cheque,
GLetters of credit,
GBills of Exchange expressed or drawn in ndian currency
but payable in foreign currency.
S
ient Fe
tures cont«..
 FEM is not a physical place. t is an
electronically linked network of Big Banks, forex
brokers & dealers who buy & sell forex.
FEM is spread out in big and small financial
centers in world. Some of the leading FEM are:-
GLondon
GNew York
GParis
GZurich
GTokyo
GFrankfurt
S
ient Fe
tures cont«..
 Trading is done 24hrs. A day through
Telephones, telex, fax machines, nternet &
satellite communication system called SWFT
i.e. Society for worldwide nternational
Financial Telecommunications.
As the volume of transactions involved are
huge, thus, traders in FEM stand to incur huge
losses or profit.
S
ient Fe
tures cont«..
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 Structure of FEM
FEM is divided in two categories:-
1. Retail Market
2. Wholesale Market

Retail Market
 The exchange of bank notes, bank drafts,
currency & traveller¶s cheques between Private
customers, tourists & banks takes place here.
 RB has granted ³Money Changer¶s Licences´
to certain hotels, Shops & other organisations to
deal in above mentioned instruments.
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 Structure of FEM cont«.
 There are 2 types of Lisences:-
G³Full-Fledged Money Changer´
G³Restricted Money Changer´
Wholesale Market
 t is primarily an inter-bank market in which
major banks deal in currencies held in different
currency-dominated bank accounts.
Only head-offices & regional-offices of major
commercial banks are market makers here.
nter-bank foreign currency transactions do not
involve a physical transfer of currency. t involves
 Structure of FEM cont«.

 Book-keeping entries among banks.

 Banks profit from the spread between the
buying and selling rates.
 T e Org
nis
tion of FEM
G There are 84 banks in ndia who have been authorised to deal in foreign
exchange, they are known as Authorised Dealers (ADs).
G Public has to conduct all their foreign exchange transactions through them.
G Foreign banks and bigger ndian banks are more active, giving two-way
quotes.
G The market operates from major cities, such as:-
GMumbai
GChennai
GDelhi
GCalcutta
GBangalore
GKochi
GAhmadabad etc.
GBut Mumbai accounted major part of it.
Org
nis
tion of FEM cont«.
GThese ADs have formed an organisation called FEDA,
which sets the ground rules for fixation of commission &
other charges.
Gnstitutions like DB, CC, FC etc. have been given the
licence to undertake business of FOREX transactions.
GThe currencies are traded by RB on in its own behalf &
also on behalf of the government.

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-  

GThe inter-bank market has two parts:-
GDirect
GOr ndirect,
 nter--B
nk M
rket cont«..
nter
GDirect market:- Banks quote buying & selling part
to each other & all participating banks are market
makers.
GKnown as ³Decentralized, continuous, open-bud,
double-auction market.´
Gndirect Market:- The banks put orders with
brokers who put them on ³books´, & try to match
purchases & sales orders for different currencies.
GKnown as ³quasi-centralised, continuous, limit-
book, single-auction market´.
 Ã
yers in FEM in ndi

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 Forex Tr
ding
GV
ue c
s : This means that the transaction is
agreed to be the put through on the very day the
deal has been contracted, Alternative terms ³Same
day value´, ³Value today´ , ³Ready transactions´
GV
ue Tom: ³Tom´ an abbreviation for
Tomorrow. Any agreement or contract that is due
for delivery the working day following the day of
contracts are called ³Value Tom´
GSÃOT tr
ns
ction
tr
ns
ction:- A spot transaction is a two-day
delivery transaction
GThis trade represents a ³direct exchange´ between
two currencies, has the shortest time frame,
involves cash rather than a contract; and interest is
not included in the agreed-upon transaction.
GForward transactions are those where the currency
the amount the rate and the time of delivery
(forward date) are all agreed upon and the fixed in
advance i.e on the day of transaction is agreed upon
the parties.
GThe actual delivery , exchange of funds takes
place on the future date as per contract.
Gnterest are also levied in certain contracts.
G%1 Constitutes of a pair of back to back
transactions entered into at the same time ,with the
same counter party bank for the same currency and
amount but for the two different delivery dates at
the rates which almost always are different.
GA future contract or A  &
, also 8

 or   
, is a future
contract to exchange one currency for another at a
specified date in the future at a price (exchange
rate) that is fixed on the purchase date
GA   
 (commonly shortened
to just FX option) is a derivative where the owner
has the right but not the obligation to exchange
money denominated in one currency into another
currency at a pre-agreed exchange rate on a
specified date.
 Foreign Exc
nge R
te T
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 Tr
ding Ã
tform
Gn ndia forex market ,spot trading takes place on 4
platforms:-
GFX CLEAR of CCL(clearing corporation of ndia) set
up to in August 2003,
GFX direct which is foreign exchange trading platform
launched by BD Forex (P) ltd. n 2002 in
collaboration with Financial Technologies ndia Ltd.
GAnd the two other platforms by the Reuters which are
GReturs D2 platform .
GThe returs Market data system (rmds) Trading
Platform .
 î
t Does Foreign Exc
nge Risk Me
n?
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 Risk M
n
gement in FEM
GFEM involves constant & rapid changes in
innovation & trading methods which makes it
convenient and attractive option to invest in, but
Gt also creates various possibilities of Risk
associated with it, such as:-
GSettlement risk,
GMarket risk,
GCredit risk,
G& Operational risk.
GSettement Risk:- Settlement risk is the risk
that a settlement in a transfer system does not take
place as expected.
GSettlement risk was a problem in the forex market
up until the creation of continuously linked
settlement (CLS), which is facilitated by CLS Bank
nternational, which eliminates time differences in
settlement, providing a safer forex market.
GReal-time gross settlement systems are even used
to eliminate the time lag problem and settle
payments efficiently.
GRealising the systemic impact of settlement risk in
pursuance of recommendations by Sodhani
Committee, RB has set up CCL (Clearing
Corporation of ndia Limited) in 2001 to mitigate
the risk of ndian Financial Markets.
GApart from this risk participants also need to
manage other risks as follows:-
G6iquidity risk:- Refers to the risk that a
counterparty will not settle for full value at due
date but could do so at some unspecified time
thereafter; causing the party which did not receive
its expected payment to finance the shortfall at
short notice.
GLiquidity risk is estimated by monitoring assets
liability profile in various currencies in various
buckets .
GBanks also track balances in Nastro Accounts,
remittances & committed foreign currency term
loans while monitoring Liquidity risk.

GAcc. To RB the BoD of ADs(category ) are

required to frame an appropriate policy and fix
suitable limits for operation ion Foreign Exchange
Market.
GThe Open Exchange Positions & Gap limits are
required to be approved by RB.
GThe ~

    shall be considered
6
 if foreign exchange assets in a certain foreign
currency are not equal to foreign exchange
liabilities in the respective foreign currency.

G 
 ~  ~

   
represents the difference between the amount of
foreign exchange assets in a certain foreign
currency and the amount of foreign exchange
liabilities in the respective currency.
GM
rket Risk:- The day-to-day potential for an
investor to experience losses from fluctuations in
securities prices.
GBank use various models to measure this risk, such
as VaR(value at risk model)
GCredit Risk:- The risk of loss of principal or loss
of a financial reward stemming from a borrower's
failure to repay a loan or otherwise meet a
contractual obligation.
Gt is generally measured & managed by most banks
on an aggregate counter-party basis so as to include
all exposures in markets.
 Forex M
rket Efficiency
GThe efficiency/liquidity of the forex market is often
gauged in terms of bid-ask spread.
GDefining ³id-¦sk spread´ as:- The amount by which
the ask price exceeds the bid. This is essentially the
difference in price between the highest price that a
buyer is willing to pay for an asset and the lowest price
for which a seller is willing to sell it.
GÚ
, if the bid price is $20 and the ask
price is $21 then the "bid-ask spread" is $1.
GThe Bid Price is the current highest price at which
someone in the market is willing to buy a stock.
GThe Ask Price is the current lowest price that
someone is willing to sell a stock.
GThe bid-ask spread reflects the operating &
transaction cost involved in transaction of currency.
Gn sport market it may also include the cost
incurred in holding the Forex.
GThe Bid/Ask Spread is determined mainly by
liquidity. f a stock is highly liquid, meaning there
is a large volume of shares being bought and sold,
the Bid/Ask Spread will be much lower.
GThe finance theory indentifies 3 basic sources of bid-ask
spread:-
GOrder-processing cost
Gnventory Holding cost
Gnformation cost of market making
GEach of the above factor is influenced by trading volume in a
particular manner.
GA low & stable bid-ask spread in FEM indicates that market is :-
GEfficient with
GLow volatility
GHigh liquidity
GLess information asymmetry.
GThe spread in ndian FEM has declined overtime & is very low at
present.
Gn ndia, the normal spot market quote has a spread of 0.25 of a
paisa to 1 paisa.
GThus, flat and low spread can be attributed to lower volatility in
the FEM.
GÚ
, on a certain low volume stock, if the Bid Price is
$69.33 and the Ask Price is $70.33 the Bid/Ask Spread would be
$1.00.
Gf you were to buy 1,000 shares and then immediately sell them
using market orders (assuming everything stays the same and not
factoring in commissions) your loss would be $1,000 just because
of the spread.
GThus, A low Bid/Ask Spread is important to traders because the
extra cost that you pay in the spread will eat away at the profits of
your trades.