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The Foreign Exchange Market

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Foreign Exchange Market
• The Foreign Exchange market, also referred to as the
"Forex" or "FX" market is the largest financial market in
the world, with a daily average turnover of US$1.9
trillion — 30 times larger than the combined volume
of all U.S. equity markets.
• "Foreign Exchange" is the simultaneous buying of one
currency and selling of another. Currencies are traded in
pairs, for example Euro/US Dollar (EUR/USD) or US
Dollar/Japanese Yen (USD/JPY).
• Foreign Exchange Market:The market where one
country’s currency is traded for another’s.
International Foreign Exchange Market
It is the oldest and largest financial market in the world—more
than $1 trillion.
– Participants: importers, exporters, traders, foreign exchange
brokers, speculators, portfolio managers.
– FEM is essentially OTC market: No central location
– FEM has no central trading floor where buyers and sellers
– FEM extends from Tokyo and Sydney in the East to New
York and San Francisco in the West.
– Is open twenty-four hours a day, except for short gaps on
– Global banks account for about two-thirds of the market
volume, while foreign exchange brokers and dealers account
for approximately 20 percent.
– Speculative transactions account for more than 95 per
cent of the turnover of FEM.
Foreign Exchange Market in India
• Very small market
• Key participants: RBI, authorized Banks, and Business
• FEM in India is a Controlled market by RBI
• Business undertakings can participate in the FEM in India
only to the extent that they need cover for exchange exposure
arising from merchant transaction (can not involve in
speculative transactions)
• Banks are permitted to have net overbought or oversold
subject limits notified by the RBI.
How a Foreign Exchange Transaction is
Location of the Foreign Exchange Market
1. OTC-type: no specific location
2. Most trades by phone, telex, or SWIFT
SWIFT: Society for Worldwide Inter-bank Financial

Participants in the Foreign Exchange


1. Wholesale Level (95%) - major banks

2. Retail Level - business customers.
Participants in the Foreign Exchange Market
• Commercial & Investment Banks (“Inter-bank” market)
– amounts > $1m, typically $10m
– liquid market (vis-à-vis loans) with limited credit exposure
– for clients and themselves
– allows “bit” players to economize on transactions costs
• Central Banks
– non-commercial motives
– relatively small portion of trading volume
– may intervene to address perceived economic/financial imbalances
• Hedge Funds
– partnership of high net-worth individuals
– highly leveraged global investing
– add liquidity, flexibility, and sometimes instability to FX markets
• Corporations
– mostly act through intermediaries

• Individuals
– tourists ~ insignificant volume

• Intermediaries – Brokers
– mostly service commercial banks and trading houses
– anonymous
– connected to many banks ~ shop for best price (exchange rate)

• Direct Dealing
– through dealing system
– quotes valid for 20 sec.
Exchange Control Regimes
• Fixed Exchange Rate vis-à-vis One Currency (Official parity)
– This was adopted under Bretton-woods Agreement in 1945
– allows “bit” players to economize on transactions costs
• Fixed Exchange Rate vis-à-vis a Basket
– This system adopted after 1972
– A target parity for a basket of currencies was adopted
– European Currency Unit (ECU)
– Basket is revised every five years
• Flexible Exchange Rates
– Form 1996 most of the countries adopted
Exchange Rates
• Exchange Rate = Relative Price of Currencies
• Exchange Rate: The price of one currency expressed in terms of
• Direct Quote (Natural or Right Quote/American Terms): The
exchange rate for a foreign currency is quoted in terms of the
number of units of local currency that are equal to a unit of the
foreign currency. (Rs.45 for one dollar)
• dollar price of 1 unit foreign currency; $/FX1 = dollars per
unit foreign exchange
• used in futures market
• Indirect Quote (Reverse or Left Quote/European Terms): The
exchange rate for a foreign currency is quoted in terms of the
number of units of foreign currency that are equal to a unit of the
local currency. ($2.25 for Rs. 100)
• foreign currency price of $; FX/$1
• used in Cash market. Most currencies quoted this way,
except £
• Spot Exchange Rate: The rate applicable to transactions in
which settlement (delivery) is made in two business days after the
date of transaction.
• Forward Exchange Rate: The exchange rate fixed today but the
settlement is at some specified date in the future.
How to Read a Currency Quote

• Currency Pair
• Base Currency
• Quote Currency
• Bid Price
• Ask Price

Foreign Exchange Exposure (Risk)

• Foreign Exchange Risk: The risk that the value of

a future receipt or obligation will change due to
variations in foreign exchange rates.
• Types of Foreign Exchange (Risk) Exposure
– Transaction exposure
– Translation exposure
– Economic exposure (Operating)
Types of Foreign Exchange Risk Exposure
• Transaction Exposure: The risk that the revenues
or costs associated with a transaction expressed in terms
of the domestic currency changes due to exchange rate
• Translation Exposure: Foreign exchange risk
resulting from the conversion of a firm’s foreign-
currency-denominated assets and liabilities into the
domestic currency value.
• Economic Exposure: The risk that changes in
exchange values might alter today’s value of a firm’s
future income streams
Hedging Foreign Exchange Risk
• Hedging: The act of offsetting or eliminating risk
• Covered Exposure: A foreign exchange risk that
has been completely eliminated with a hedging
• Forward contract for foreign exchange
• Derivative instruments
Foreign Currency Accounts
• Nostro Account (our account with you): The foreign
currency account maintained by banks in India with
banks aboard.
• The currency of the account depends on the currency
of the country where the account is maintained
• All foreign exchange transactions are routed through
Nostro accounts.
• Maintenance of minimum balance is necessary.
• It is just like current account
• Vostro Account (your account with us): Foreign banks
may open rupee accounts with Indian banks.
• The account is also known as non-resident account.
• Vostro Account (your account with us):
Foreign banks may open rupee accounts with Indian
• The account is also known as non-resident account.