FOREIGN EXCHANGE MARKETS

Submitted in partial fulfilment of the requirements

for the award of the degree B.Com., LL.B. (Hons)

Submitted by

KRISHNA B.A
BC0150010
Submitted to

Dr T.S. AGILLA

TAMIL NADU NATIONAL LAW SCHOOL

TIRUCHIRAPPALLI 620 009

OCTOBER, 2016

Declaration
1
 I, Krishna B.A do hereby declare that the case analysis entitled
Foreign Exchange Market submitted to Tamil Nadu National law
school in partial fulfilment of requirement of award of degree in
undergraduate in law is a record of original work done by me under the
supervision and guidance of Professor T.S. Agilla, department of
Commerce, Tamil Nadu National law school and has not formed basis
for award of any degree or diploma or fellowship or any other title to
any candidate of any university.

Krishna B.A
B.Com.,LL.B
(Hons)

2
 Certificate
This is to certify that the case analysis entitled FOREIGN
EXCHANGE MARKET submitted to Tamil Nadu National law
school in partial fulfillment of requirement of award of degree of under
graduate in Law done by B.A. Krishna under the supervision and
guidance of Professor T.S. Agilla, department of Commerce, Tamil
Nadu National Law School.

Prof. T.S. Agilla ( )

Place :
Tiruchirappalli

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 ACKNOWLEDGEMENTS

At the outset, I take this opportunity to thank my Professor T.S.

Agilla from the bottom of my heart who has been of immense help
during moments of anxiety and torpidity while the project was taking its
crucial shape.
Thirdly, the contribution made by my parents and friends by
foregoing their precious time is unforgettable and highly solicited.
Their valuable advice and timely supervision paved the way for the
successful completion of this project.
Finally, I thank the Almighty who gave me the courage and
stamina to confront all hurdles during the making of this project. Words
arent sufficient to acknowledge the tremendous contributions of various
people involved in this project, as I know Words are Poor Comforters.
I once again wholeheartedly and earnestly thank all the people who
were involved directly or indirectly during this project making which
helped me to come out with flying colours.

Research Methodology

4
The research methodology used in this project is analytical and
descriptive. Data has been collected from various materials, journals and
web sources. This project has been done after a thorough research of
materials from various sources and analysing the information carefully.

5
 INDEX

1. INTRODUCTION
2. FEATURES OF A FOREIGN EXCHANGE
MARKET
3.FUNCTIONS OF A FOREIGN EXCHANGE
MARKET
4.STRUCTURE OF A FOREIGN EXCHANGE
MARKET
5.PARTICIPANTS OF A FOREIGN
EXCHANGE MARKET
6.QUOTATIONS OF A FOREIGN
EXCHANGE MARKET
7.SPOT AND FORWARD EXCHANGE
MARKET

INTRODUCTION

The Foreign Exchange Market is the market in which participants are able to buy, sell,
exchange and speculate on currencies. Foreign exchange markets are made up of banks,
commercial companies, central banks, investment management firms, hedge funds, and retail

6
forex brokers and investors. The forex market is considered the largest financial market in the
world.1

The Foreign Exchange Market (Hereinafter referred to as FEM) is also known as forex, or
currency market is the market place where the investors trade in currencies of the world. The
FEM has certain unique characteristics which make it highly attractive to investors around
the world. It is universally considered to be highly profitable by investors around the world.

The foreign exchange market is considered to be very profitable by the investors and is
present in all the countries of the world. It can be safely assumed that the trading in
currencies never stops and is one of the most important factors which are said to affect the
value of a currency in relation to other currencies.

The foreign exchange market is an important part of any countrys structure because a
nations economy is dependent upon many factors and the value of one countrys currency in
comparison to another countrys currency is an important factor to be considered when the
economic growth of a country is to be measured. The value of a countrys currency in the
foreign exchange market is considered to be an indicator of the economic prowess of that
particular nation.

Thus, the foreign exchange market is one of the most important institutions which has a direct
effect on the economy and an indirect effect on the standard of living and other related
factors.

FEATURES OF A FOREIGN EXCHANGE MARKET

The foreign exchange market has a few basic features, which attract potential investors to
invest in the foreign exchange market. There are six basic features a forex market possesses.
They are:
1 http://www.investopedia.com/terms/forex/f/foreign-exchange-markets.asp#ixzz4MstSxqcN

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 1. LIQUIDITY

First of all, the foreign exchange market is highly liquid and it is one of the reasons to attract
investors. Investors generally prefer those investments which are highly liquid. The forex
market is a market where the investments and securities traded are highly liquid and therefore
attract a lot of investors.

2. CONTINUITY

The forex market is a market that is virtually open for 24 hours a day for 5 days. This is due
to the simple reason that if one market closes in one country, it is open in a few other
countries due to the presence of forex markets around the world. This is one of the reasons
for investors to choose the forex markets.

3. LEVERAGE

The leverage offered by the forex market is one of the highest in the world. Leverage can be
defined as the loan given to an investor by the broker. With the help of such a loan, the
investors are able to reap the profits of the market.

4. BIGGEST MARKET IN THE WORLD

In a survey conducted in 2013, the Triennial Central Bank Survey of Foreign exchange and
OTC Derivatives Market Activity provided statistics on the amount of currencies traded daily,
and has stated an average of $4 trillion traded daily. The break-down of this amount shows
that $1.490 trillion were traded in spot transactions, $475 billion in outright forwards, $1.765
trillion in foreign exchange swaps, $43 billion in currency swaps, and $207 billion in options
and other forex products.2

5. BIG PLAYER MARKET

Foreign exchange market is a big player market, because mostly it is the big banks and
government who are the players in foreign exchange market. Since only the government and
banks are the only organisations dealing with currencies in the forex market.

2http://www.investopedia.com/terms/forex/f/foreign-exchange-
markets.asp#ixzz4Mtg5WObz

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 6. HIGHLY DYNAMIC MARKET

Foreign exchange markets are the most difficult market to trade in as the exchange rates of
countries are affected by so many factors like interest rates, liquidity. Hence, the foreign
exchange market rates are not stable and change from day-to-day based on many factors.

The forex market, like any other securities market, facilitates the participants to buy, sell,
exchange and speculate on currencies. The market is generally made up of banks, commercial
companies, investment management firms etc,. The currency market is considered to be the
biggest market in the world where everyday transactions amount to billions of dollars.

FUNCTIONS OF A FOREIGN EXCHANGE MARKET.

The forex market performs certain basic functions which facilitate the buying, selling and
converting of foreign currencies. The foreign exchange market is merely a part of the money
market in the financial centres. The buyers and sellers of claim on foreign money and the

9
intermediaries together constitute a foreign exchange market. The Functions of a foreign
exchange market are listed below:

1. TRANSFER FUNCTION

A forex market helps in the transfer of currencies from one country to another, which also
leads to the transfer of purchasing power from one country to another. Such a transfer can be
facilitated through bills of remittances from other countries or can be made through electronic
or telegraphic means. In performing the transfer function, the foreign exchange market carries
out payments internationally by clearing debts in both directions simultaneously.

2. CREDIT FUNCTION

Another function of the foreign exchange market is to provide credit, both national and
international, to promote foreign trade. When foreign bills of exchange are used in
international payments, a credit for a time period of about 3 months till their maturity is
required.

3. HEDGING FUNCTION

Another function of the forex market is to hedge foreign exchange risks. Hedging is the
avoidance of foreign exchange risks. In a free exchange market, the prices of the currencies
are not stable. They fluctuate constantly. In such a market, the investors look to minimise the
risks.

Exchange risk as such should be avoided or reduced. For this the exchange market provides
facilities for hedging anticipated or actual claims or liabilities through forward contracts in
exchange. A forward contract which is normally for three months is a contract to buy or sell
foreign exchange against another currency at some fixed date in the future at a price agreed
upon now.

Foreign bills of exchange, telegraphic transfer, bank draft, letter of credit, etc., are the
important foreign exchange instruments used in the foreign exchange market to carry out its
functions.3

3 http://www.yourarticlelibrary.com/foreign-trade/foreign-exchange-market-and-its-
important-functions/26067/

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THE STRUCTURE OF A FOREIGN EXCHANGE MARKET OR A FOREX MARKET.

The Structure of a foreign exchange market is generally an over the counter market and has a
lot of players who are involved in the regulatory and operative functions of the foreign
exchange market. The forex market is generally regulated by the Reserve Bank of India and
the Central Government, who through their own agents or authorised agents and firms

11
actively participate in the foreign exchange market. The Government of India has passed the
Foreign Exchange Market Act for regulating the dealings in foreign currencies.

At the apex of the foreign exchange market are the inter country banks foreign exchange
brokers and other authorised dealers, and the monetary authorities. These people participate
because they are the regulating authorities and the exchange rate has a significant impact on
their workings.

Commercial Banks: The commercial banks operate at retail level for individual exporters and
corporations as well as at wholesale levels in the interbank market.

Foreign Exchange Brokers: The foreign exchange brokers involve either individual brokers
or corporations. Bank dealers often use brokers to stay anonymous since the identity of banks
can influence short-term quotes.

Monetary Authorities: The monetary authorities mainly involve the central banks of various
countries, which intervene in order to maintain or influence the exchange rate of their
currencies within a certain range and also to execute the orders of the government.

The foreign exchange market in India consists of 3 segments or tiers. The first segment or tier
consists of transactions between the RBI and the authorised dealers. The latter part is mostly
composed of commercial banks. The second segment is the interbank market in which the
authorised dealers deal with each other. And the third segment consists of transactions
between authorised dealers and their corporate customers.

Apart from the authorised dealers currency brokers engage in the business of matching sellers
with buyers, in the interbank market collecting a commission from both. FEDAI rules
required that deals between authorised dealers in the same market centers must be brought
into effect through accredited brokers.

PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET (FOREX MARKET)

The major participants of the Forex market are banks of the world. These banks include both
commercial banks as well as regulatory banks. However, large corporations that are engaged
in foreign economic activity, investment and hedge funds, brokerage firms, dealing centres

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and individuals participate in this process as well. All these firms and corporations are able to
participate in the foreign exchange market due to their immense financial power.

COMMERCIAL BANKS

Commercial banks carry the main volume of trading. They are involved in taking deposits
from individuals and legal entities and operating according to their goals with subsequent
return of money to the owners.

CENTRAL BANKS

The main aim of central banks is to provide financial services to the government and
commercial banks of their countries. Their main functions are:

Money supply and exchange rate regulation;

Control of the release of national currency's notes;
Lending and accepting deposits from commercial banks, as well as control of their
activity;
Management of country's debt;
Maintenance of the gold currency reserves of the country;
Interaction with other central banks.

Forex attracts more people day after day because of the fact that many people want to benefit
from rate fluctuations.

LARGE CORPORATIONS

Large corporations, engaged in foreign economic activity, use Forex to exchange national
currency into foreign currency and to forward, conduct short-term deposits, and hedge their
future deals. These companies use the services of commercial banks because they do not have
direct access to the currency exchange market.

INVESTMENT AND HEDGE FUNDS

Companies that carry foreign assets invest and place the investor's funds into different
securities as well.

FOREX COMPANIES (Brokers and Dealing Centres)

They are brokers and dealing centres which act as agents who bring buyers and sellers
together to carry out conversion transactions. They charge brokerage or commission for their

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work either by adding a spread or taking commission fee with accordance to the quantum of
the transaction.

INDIVIDUALS

Individuals are those people who are involved in non-commercial operations of currency
exchange, for example, money transfers, currency exchange while visiting foreign countries,
etc. Individuals got the chance to use Forex in speculative purposes only in 1986. Individuals
may conduct various speculative operations through Forex companies.

QUOTATIONS OFFERED IN THE FOREIGN EXCHANGE MARKET

Currencies are quoted in pairs, for example the USD/EUR is the U.S. dollar/euro. Using this
quotation, the value of a currency is determined by its comparison to another currency. The
first currency of a currency pair is called the base currency, and the second currency is called

14
the quote currency. The currency pair shows how much of the quote currency is needed to
purchase one unit of the base currency.

The Quotations in the forex market can be quite complicated for an average human being.
Any Foreign exchange market quotation always uses the abbreviation of the currency under
question. There are standard currency keys or currency codes that have been created by
International Standards Organization (ISO). These keys are used for transactions worldwide.

The keys used for such transactions generally consist of three alphabets, which is mostly the
abbreviation of the currency. For instance, the United States Dollar is abbreviated all over the
world as USD and the Indian Rupee is abbreviated as INR. Form this it can be observed that
the first two alphabets of the key denote the country to which the currency belongs whereas
the third alphabet of the key is the first alphabet of the currency.4

Direct Quotation

A direct quotation or a direct quote is a foreign exchange rate quoted as the domestic
currency per unit of the foreign currency.5

Meaning: Under this method, the quote is expressed in terms of domestic currency. This
means that the rate expresses how one unit of domestic currency relates to the foreign
currency. Therefore, if unit of the domestic currency were to be exchanged, how many units
of the foreign currency would it beget? This method is also alternatively referred to as the
price quotation method.

Therefore, if the value of the domestic currency increases, a smaller amount of it would have
to be exchanged. Conversely a decline in value would create a situation where a large amount
of the domestic currency would have to be exchanged. Hence, it can be said that the quotation
rate has an inverse relationship with the value of the domestic currency.

The value of the domestic currency is assumed to be 1 in case of a direct quotation. The price
being quoted explains the number of units of foreign currency that can be exchanged for a
single unit of domestic currency.
4 http://www.investopedia.com/walkthrough/forex/getting-started/quotes.aspx

5 http://www.investopedia.com/terms/d/directquote.asp#ixzz4N2XiB95C (accessed on 14-

10-2016, 12:25 pm)

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Example: An example of direct quotation would be

United States Dollar: 143.15

Japanese Yen: 18.00

This quote suggests that roughly 143 units of Japanese Yen can be exchanged for 1 unit of
United States Dollar. The two rates provided are bid and ask rates, that is the different rates at
which the market maker is willing to buy and sell the currency.

The direct quote method is one of the most widely used quotation methods across the world.
This is the norm for quoting Forex prices and is assumed de facto until another method has
been explicitly mentioned.

Indirect Quotation

An indirect quotation or an indirect quote expresses the amount of foreign currency required
to buy or sell one unit of the domestic currency in the foreign exchange markets.6

Meaning: This method is the opposite of the direct quotation method. Under this method, the
quote is expressed in terms of foreign currency. Therefore this rate assumes one unit of
foreign currency. It then expresses how many units of domestic currency are required to
obtain a single unit of a foreign currency. Sometimes this quote is also expressed in terms of
100 units of foreign currency. This method is often referred to as the quantity quotation
method.

Since this method is quoted in terms of foreign currency, the quoted rate has a direct
correlation with the domestic rate. If the quote goes up, so does the value of the domestic
currency and vice versa.

Example

Euro: 0.875

United States Dollar: 79.00

In this case, the first currency is the Euro is the domestic currency. Therefore, the indirect
quote refers to approximately 0.875 Euros being exchanged for 1 unit of the United States

6 http://www.investopedia.com/walkthrough/forex/getting-started/quotes.aspx

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Dollar. Once again the two rates provided are the bid ask rate i.e. the two different rates at
which market makers are willing to buy and sell the currency.

The usage of indirect currency quotation is extremely rare. It is only in the Commonwealth
countries like United Kingdom and Australia that the indirect quotation method is used as a
result of convention.7

SPOT AND FORWARD EXCHANGE

7 http://www.investopedia.com/walkthrough/forex/getting-started/quotes.aspx

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SPOT EXCHANGE RATE

The spot is a market for financial instruments such as commodities and securities which are
traded immediately or on the spot. In spot markets, spot trades are made with spot prices.
Unlike the futures market, orders made in the spot market are settled instantly. Spot markets
can be organized markets or exchanges or over-the-counter (OTC) markets.

The spot market is also referred to as the physical market or the cash market because of
the instant and immediate pace and movement of orders made as orders are made at current
market prices. Market prices are unlike forward prices, which cover prices at a later date.

SPOT TRADE

A spot trade is the purchase of financial instruments done on the spot or immediately. These
trades are settled instantly and do not follow a set date in the future. Futures trades that are
about to end in the current month may also be considered spot trades.

SPOT PRICE

The current price of a financial instrument is called the spot price. It is the price which a
particular instrument can be sold or bought during a particular time and specified place.8

Spot trading most commonly refers to the spot forex market, on which currencies are traded
electronically around the world. Most spot currency trades settle two business days after the
execution of the trade, with the exception of the U.S. dollar vs. the Canadian dollar, which
settles the next business day. Holidays can cause the settlement date to be far more than two
calendar days after execution, especially during the Christmas and Easter seasons. The
settlement date must be a valid business day in both currencies. Money generally changes
hands on the settlement date, which means that there is credit risk between the two parties.9

Spot prices tend to be subject to extreme volatility. While the spot price of security,
commodity or currency is important in terms of immediate buy-and-sell transactions, it
perhaps has more importance in regard to the multitrillion-dollar derivatives markets.

8 http://www.investopedia.com/terms/s/spotmarket.asp#ixzz4N2d6UHaC

9 http://www.investopedia.com/terms/s/spotmarket.asp#ixzz4N2e2RiOy

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Options, futures contracts and other derivatives allow buyers and sellers of securities or
commodities to lock in a specific price for a future time when they expect to make a
transaction. Through derivatives, buyers and sellers can partially control the risk posed by the
constantly fluctuating spot prices of the commodities.

FORWARD EXCHANGE MARKET

A forward market is an over-the-counter marketplace that sets the price of a financial

instrument or asset for future delivery. Forward markets are used for trading a range of
instruments, but the term is primarily used with reference to the foreign exchange market.10

Prices in the forward market are interest-rate based. In the foreign exchange market, the
forward price is derived from the interest rate differential between the two currencies, which
is applied over the period from the transaction date to the settlement date of the contract. In
interest rate forwards, the price is based on the yield curve to maturity.11

The forward exchange market is based on forward contracts and future contracts. Forward
contracts may be used for both hedging and speculation and can be tailored according to the
needs of the requirements of the customers while future contracts have standardized features
in terms of their contract size and maturity. Forward contracts are more commonly executed
between banks while future contracts are executed in the foreign exchange market. The
flexibility of the forward contracts is one characteristic which attract the customers to invest
in such contracts.

FOREIGN EXCHANGE MARKET FORWARD CONTRACTS

Interbank forward foreign exchange markets are priced and executed as swaps. This means
that currency A is purchased vs. currency B for delivery on the spot date at that the spot rate
in the market at the time the transaction is executed. At maturity, currency A is sold vs.
currency B at the original spot rate plus or minus the forward points; this price is set when the
swap is initiated. The interbank market usually trades for straight dates, such as a week or a
month from the spot date. Three- and six-month maturities are among the most common,

10 http://www.investopedia.com/terms/f/forwardmarket.asp#ixzz4N2fgZPDV

11 http://www.investopedia.com/terms/f/forwardmarket.asp#ixzz4N2hVpaXA

19
while the market is less liquid beyond 12 months. Amounts are commonly $25 million or
more and can range into the billions.

Customers, both corporations and financial institutions such as hedge funds and mutual
funds, can execute forwards with a bank counter-party either as a swap or an outright
transaction. In an outright forward, currency A is bought vs. currency B for delivery on the
maturity date, which can be any business day beyond the spot date. The price is again the spot
rate plus or minus the forward points, but no money changes hands until the maturity date.
Outright forwards are often for odd dates and amounts; they can be for any size.12

The most commonly traded currencies in the forward market are United States Dollar,
Japanese Yen, British Pound Sterling and the Euro.

12 http://www.investopedia.com/terms/f/forwardmarket.asp#ixzz4N5H57l97

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