Chapter 2 Introduction to Currency Markets.

A foreign exchange deal is always done in currency pair, for example:-

US dollar Indian Rupee ( USD-INR )

British Pound Indian Rupee ( GBP-INR )

 Currency Table: INR - Indian

Rupee
Currency code Currency name

Mid-market rates as of 18-07-2013

Units per INR INR per Unit

EUR USD

Euro US Dollar

0.0128043564 78.0984194517 0.0167632849 59.6541790150

GBP
INR AUD CAD AED

British Pound
Indian Rupee Australian Dollar Canadian Dollar Emirati Dirham

0.0110179423 90.7610487447
1.0000000000 1.0000000000

0.0182799538 54.7047334662 0.0174555539 57.2883566654 0.0615715473 16.2412679748

 Fixed Exchange Rate Regime and Floating Exchange Rate Regime

There are mainly two methods employed by government to determine the value of domestic currency vis--vis other currencies :Fixed and Floating Exchange Rate.

 Fixed Exchange Rate Regime

Fixed exchange rate, Also known as Pegged Exchange Rate, is when a currency value is maintained at a fixed ratio to the value of other currency or to the basket to currencies or to any other of value. ExampleGold, in order to maintain a fixed exchange rate, a govt. participates in a open currency market.

 Floating Exchange Rate Regime

It is determined by a market mechanism through supply and demand of currency.

ExampleIf the demand of the currency is low, its value will decrease thus making imported goods more expensive and exports relatively cheaper.

 Factors Affecting Exchange Rates

There are many factors affecting a exchange rate of the currency. They can be classified as fundamental factors, technical factors, political factors and speculative factors.

 Fundamental Factors
The fundamental factors are basic economic policies followed by government in relation to inflation, balance of payment position, unemployment, capacity utilization, trends in imports and export etc.

 Technical Factors
Interest rate
Rising interest rates in the country may lead to inflow of hot money in the country thereby raising demand for the domestic currency.

 Inflation Rate
High inflation rate in the country reduces the relative competitiveness of the export sector of that country.

 Exchange Rate Policy and Central bank Interventions

Government sometimes participate in foreign exchange market through its central bank in order to control the demand and supply of domestic currency.

 Political factor

Political stability influences the exchange rate. Exchange rates are susceptible to political instability and can be very volatile during times of political crises.

 Speculation
Speculative activities by traders worldwide also affect exchange rate movement. Example :If a speculator thinks that the currency of the country is over valued and will devalue in the neat future, they will put out there money from that country resulting in reduced demand for that currency and depreciates its value.

 Quotes
In currency market, the rates are generally quoted in terms of USD. The price of a currency in terms of another currency is called Quote. A Quote where USD is considered as base currency is called Direct Quote While the Quote where USD is considered as term currency is known as Indirect Quote.

 Tick Size
Tick size refers to the minimum price differential at which trader can enter Bids and Offers. Example :-

The currency future contracts traded at the NSE have the tick size of 0.0025 . So if the prevailing futures price is 48.5000, the minimum permissible price movement can cause the new price either 48.4975 or 48.5025

 Spreads
Spreads or the dealers margin is the difference between the BID price (the price at which a dealer is willing to buy a foreign currency) and ASK price (the price in which the dealer is willing to sell the foreign currency).

 Spot Transaction
The spot market transaction does not imply immediate exchange of currency, rather the settlement takes place on a value date, which is usually two business days after the trade date. The price at which the deal takes place is known as the spot rate.

 Forward Transaction
It is the currency transaction wherein the actual settlement date is at a specific future date, which is more than the two working days after the deal date. The date of the settlement and the rate of exchange is specified in the contract. The difference between the spot rate and forward rate is called forward margin.