Foreign Ex Mkt

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INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 1

UNIT-I

An Introduction to the Foreign Exchange Markets

The foreign exchange market is the largest market in the world and each day, huge amounts

of money flow through it. What makes the FX market unique is its structure. Currencies are

traded OTC (over-the-counter), meaning there is no centralized place where the exchange

occurs. While OTC trading has its advantages, like lower fees and taxes, it allows the

presence of private information. Dealers and institutional traders have a clear advantage over

uninformed market participants and actively make use of it.

Asset classes like futures, which are traded on exchanges like the CME, are regulated and

thanks to the introduction of electronic trading platforms, traders have access to the same

information, no matter where they are located. On the other side, the amount and quality of

information you receive in the FX market depends on your contacts. While retail traders

usually have a distorted image of institutional traders, it is true that they have direct

advantage because of the information they receive.

The foreign exchange market can be seperated in two tiers. The first tier represents the

interbank market where dealers trade with each other. They commonly do so via interbank

platforms like Reuters and EBS. The second tier is where market makers trade with their

customers.

Since the foreign exchange market has no central exchange like i.e. the NYSE, dealers have to

deal directly with other banks across the globe. To make the process easier, electronic

brokerage services appeared in the 1990s. They essentially represent the inner core of the FX

market with EBS and Reuters Dealing being the leading platforms in this field. While EBS

dominates trading in EUR, JPY and CHF, Reuters is commonly used for GBP, AUD and CAD

trading.

Multibank trading platforms have gained in popularity in the past few years with companies

like FXAll (owned by Thomson Reuters) seeing constantly rising trading volumes. They

essentially allow banks to stream quotes simultaneously with customers, both providing

liquidity and anonymous trading.

Leveraged funds and similar participants can trade directly in the interbank markets via prime

brokerage arrangements with the major international banks. Prime brokerage clients trade

with other dealers in the prime brokers name using the prime brokers ex isting credit lines, a

privilege for which they pay a fee based on trading volume. Any trades executed with FX

dealers other than the prime broker are given up to the prime broker, who becomes the

counterparty to both legs of the trade. Hedge fund Alpha, for example, might pay UBS to be

its prime broker, thereby gaining access to the EBS and Thomson Reuters trading platforms.


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For the large banks, prime brokerage arrangements generate new, fee-based revenue that

leverages their technology and operating infrastructure.

Currencies trade over-the-counter and are open 24 hours a day, starting from Monday

morning Sydney to Friday evening New York. The United Kingdoms favorable location allows it

overlap both the Asian and US trading session, making it the dominant player by turnover. In

2013, 41 % of the daily average turnover ($5.3 trillion) traded in the UK, followed by the

United States with 19 %. Other major trading centres include Singapore, Tokyo, Hong Kong,

Frankfurt and Zrich.

Definitions of 'Foreign Exchange Market'

1) 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 forex brokers and investors.

The forex market is considered to be the largest financial market in the world.

2) According to theBank for International Settlements,the preliminary global results from

the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets

Activity show that trading in foreign exchange markets averaged $5.3 trillion per day in April

2013. This is up from $4.0 trillion in April 2010 and $3.3 trillion in April 2007. FX swaps were

the most actively traded instruments in April 2013, at $2.2 trillion per day, followed by spot

trading at $2.0 trillion.

3) According to the Bank for International Settlements, as of April 2010, averagedailyturnoverin global foreign exchange markets is estimated at $3.98 trillion, a growth of

approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms

specializing on foreign exchange market had put the average daily turnover in excess of US$4

trillion. The $3.98 trillion break-down is as follows:

$1.490 trillion inspottransactions

$475 billion inoutright forwards

$1.765 trillion inforeign exchange swaps

$43 billioncurrency swaps

$207 billion inoptionsand other products

The foreign exchange market (forex, FX, or currency market) is a global decentralized market

for the trading ofcurrencies.The main participants in this market are the larger international

banks. Financial centers around the world function as anchors of trading between a wide range

of different types of buyers and sellers around the clock, with the exception of

weekends.Electronic Broking Services(EBS) andReuters 3000 Xtraare two main interbank

FX trading platforms. The foreign exchange market determines the relative values of different

currencies.
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The foreign exchange market works through financial institutions, and it operates on several

levels. Behind the scenes banks turn to a smaller number of financial firms known as

dealers, who are actively involved in large quantities of foreign exchange trading. Most

foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the

interbank market, although a few insurance companies and other kinds of financial firms are

involved. Trades between foreign exchange dealers can be very large, involving hundreds of

millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has

little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investment by enablingcurrency

conversion. For example, it permits a business in theUnited Statesto import goods from

theEuropean Unionmember states, especiallyEurozonemembers, and payeuros, even

though its income is inUnited States dollars.It also supports direct speculation in the value of

currencies, and thecarry trade,speculation based on the interest rate differential between two

currencies.

In a typical foreign exchange transaction, a party purchases some quantity of one currency by

paying some quantity of another currency. The modern foreign exchange market began

forming during the 1970s after three decades of government restrictions on foreign exchange

transactions (theBretton Woods systemof monetary management established the rules for

commercial and financial relations among the world's major industrial states afterWorld War

II), when countries gradually switched tofloating exchange ratesfrom the previousexchange

rate regime,which remainedfixedas per the Bretton Woods system.

The foreign exchange market is unique because of the following characteristics:

its huge trading volume representing the largest asset class in the world leading to

highliquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e., trading from

22:00GMTon Sunday (Sydney) until 22:00 GMT Friday (New York);

the variety of factors that affectexchange rates;

the low margins of relative profit compared with other markets of fixed income; and

the use ofleverageto enhance profit and loss margins and with respect to account size.

Forex Market Structure

For the sake of comparison, let us first examine a market that you are probably very familiar

with: the stock market. This is how the structure of the stock market looks like:
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Ihave no choice but to go through a centralized exchange!

By its very nature, the stock market tends to be very monopolistic. There is only one entity,

one specialist that controls prices. All trades must go through this specialist. Because of this,

prices can easily be altered to benefit the specialist, and not traders.

How does this happen?

In the stock market, the specialist is forced to fulfill the order of its clients. Now, lets say the

number of sellers suddenly exceed the number of buyers. The specialist, which is forced to

fulfill the order of its clients, the sellers in this case, is left with a bunch of stock that he

cannot sell-off to the buyer side.

In order to prevent this from happening, the specialist will simply widen thespreador increase

the transaction cost to prevent sellers from entering the market. In other words, the

specialists can manipulate the quotes it is offering to accommodate its needs.

Trading Spot FX is Decentralized

Unlike in trading stocks or futures, you dont need to go through a centralized exchange like

the New York Stock Exchange with just one price. In the forex market, there is no single price

that for a given currency at any time, which means quotes from different currency dealers

vary.

Somany choices! Awesome!

This might be overwhelming at first, but this is what makes the forex market so freakin

awesome! The market is so huge and the competition between dealers is so fierce that you get

the best deal almost every single time. And tell me, who does not want that?
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For the EBS plaform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF, and USD/CHF are more liquid.

Meanwhile, for the Reuters platform, GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD

are more liquid.

All the banks that are part of the interbank market can see the rates that each other is

offering, but this doesnt necessarily mean that anyone can make deals at those prices.

Like in real life, the rates will be largely dependent on the establishedCREDIT relationship

between the trading parties. Just to name a few, theres the B.F.F. rate, the customer rate,

and the ex-wife-you-took-everything rate. Its like asking for a loan at your local bank. The

better your credit standing and reputation with them, the better the interest rates and the

larger loan you can avail.

Next on the ladder are thehedge funds,corporations, retail market makers, and retail ECNs.

Since these institutions do not have tight credit relationships with the participants of the

interbank market, they have to do their transactions via commercial banks. This means that

their rates are slightly higher and more expensive than those who are part of the interbank

market.

At the very bottom of the ladder are the retail traders. It used to be very hard for us little

people to engage in the forex market but, thanks to the advent of the internet, electronic

trading, and retail brokers, the difficult barriers to entry in forex trading have all been taken

down. This gave us the chance to play with those high up the ladder and poke them with a

very long and cheap stick.

FUNCTIONS OF FOREIGN EXCHANGE MARKET

Foreign exchange is also referred to as forex market. Participants are importers,exporters, tourists and investors, traders and speculators, commercial banks, brokers and

central banks.

Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are

the important foreign exchange instruments used in foreign exchange market to carry out its

functions.

The Foreign Exchange Market performs the following functions.

1. Transfer Of Purchasing Power I Clearing Function

The basic function of the foreign exchange market is to facilitate the conversion

of one currency into another i.e. payment between exporters and importers. For eg. Indian

rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety

of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills.

Telegraphic transfer is the quickest method of transferring the purchasing power.
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The basic function of the foreign exchange market is to facilitate the conversion of one

currency into another, i.e., to accomplish transfers of purchasing power between two

countries. This transfer of purchasing power is effected through a variety of credit

instruments, such as telegraphic transfers, bank drafts and foreign bills.

In performing the transfer function, the foreign exchange market carries out payments

internationally by clearing debts in both directions simultaneously, analogous to domestic

clearings.

2. Credit Function

The foreign exchange market also provides credit to both national and

international, to promote foreign trade. It is necessary as sometimes, the international

payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are

used in international payments, a credit for about 3 months, till their maturity, is required.

For eg. Mr. A can get his bill discounted with a foreign exchange bank in New

York and this bank will transfer the bill to its correspondent in India for collection of money

from Mr. B after the stipulated time.

Another function of the foreign exchange market is to provide credit, both national and

international, to promote foreign trade. Obviously, when foreign bills of exchange are used in

international payments, a credit for about 3 months, till their maturity, is required.

3. Hedging FunctionA third function of foreign exchange market is to hedge foreign exchange risks. By

hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange

rates. Under this function the foreign exchange market tries to protect the interest of the

persons dealing in the market from any unforseen changes in exchange rate. The exchange

rates under free market can go up and down, this can either bring gains or losses to

concerned parties. Hedging guards the interest of both exporters as well as importers, against

any changes in exchange rate.

Hedging can be done either by means of a spot exchange market or a forward exchange

market involving a forward contract.

A third function of the foreign exchange market is to hedge foreign exchange risks. In a free

exchange market when exchange rates, i.e., the price of one currency in terms of another

currency, change, there may be a gain or loss to the party concerned. Under this condition, a

person or a firm undertakes a great exchange risk if there are huge amounts of net claims or

net liabilities which are to be met in foreign money.


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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. No money passes at the time of the contract. But the contract makes it possible to

ignore any likely changes in exchange rate.

Foreign Exchange Market: An Introduction

3.1 Introduction to Forex Market:

For most of us, the focal point of understanding international finance revolves around foreign

exchange market. The foreign exchange market (also known as the currency, forex, or FX) is

where currency trading takes place. It is a market where banks, companies, exporters,

importers, fund managers, individuals, central banks of different countries buy and sell of

foreign currencies.

Forex trading involves a foreign exchange transaction, defined as the simultaneous buying of

one currency and selling of another currency. As forex rates are quoted in pairs, e.g.

Euro/US$, US$/Japanese Yen, US$/INR, etc., a trader trading in forex sells one of the

currency pair and buys the other.

As the subject progresses, we will develop more understanding about which currency isbought and which currency is sold and other aspects of forex trading.

The forex market is an ongoing 24-hour, 365 days year market. Trading in forex market does

not necessarily involve an exchange. Hence, the trading goes on the over-the-counter market

(OTC market henceforth). Major foreign currency trading centers are located in London,

Tokyo, New York. As the markets remain open at different time on a given day, normally GMT

is used to refer the trading hours at different locations. For example, the trading duration in

Asia is from GMT.00.00 till GMT 08.00. Trading duration in London is during GMT 07:00 till

GMT 15:00. Trading in USA commences during GMT 13.00 till GMT 22.00. Trading in London

starts at GMT 8.00 and ends at GMT 17.00. Trading in Tokyo starts in GMT 0.00 ( midnight)

and ends GMT 9.00.

Presently, the FX market is one of the largest and liquid financial markets in the world, and

includes trading between large banks, central banks, currency speculators, corporations,

governments, financial institutions, exporters and importers. The average daily volume in the

global foreign exchange and related markets is continuously growing. The daily turnover was

reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements

(BIS). The Since then, the market has continued to grow.


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According to Euromoney's annual FX Poll, trading volumes in USA grew a further 41% between

2007 and 2008.

The Bank for International Settlements undertakes triennials survey to regarding various

facets of foreign exchange market. According to the last survey conducted in 2007, average

daily turnover in global foreign exchange markets is estimated at $3.2 trillion. It has grown in

an unprecedented 69% compared to 2004. The Bank for International Settlements is regularwith the publication of these triennial surveys. The readers must check the official website for

the latest survey report to get update on details discussed in this module.

As the 2007 report, average daily turnover of US$3.2 trillion comes from foreign exchange

spot, forward and swap transactions.

US$1.005 trillion in spot transactions

US$362 billion in outright forwards transactions US$1.714 trillion in foreign exchange swaps US$129 billion estimated gaps in reporting

The spot market relates to immediate purchase and sale of foreign currency while in a forward

transaction parties agree to buy and sell foreign currency later. In swap transactions, parties

agree to swap payment and receipt of foreign currency over a specified period. These last two

sentences very briefly summarize the difference between spot, forward and swap transactions.

In later modules , these contracts are explained in detail.

3.2 Foreign Exchange Market, Trading Volumes :

Foreign exchange market is one of the fastest growing segments in the financial world. Details

given in Table 2.A extracted from the Triennial Central Bank SurveyDecember 2007 Foreign

exchange and derivatives market activity in 2000 prepared by Bank of International

Settlement (BIS) indicates the growth of the forex market.

The 2007 survey shows an unprecedented rise in activity in traditional foreign exchange

markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an

increase of 69% at current exchange rates as given in Table 3.A.


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Table 3.A. Global foreign exchange market turnover (*)

Daily averages in April, in billions

ofUS$

2004

YEAR 1992 1995 1998 2001 ( **) 2007Spot transactions 394 494 568 387 631 1,005

Outright forwards 58 97 128 131 209 362

Up to 7 days 50 65 51 92 154

Over 7 days 46 62 80 116 208

Foreign exchange swaps 324 546 734 656 954 1,714

Up to 7 days 382 528 451 700 1,329

Over 7 days 162 202 204 252 382

Estimated gaps in reporting 44 53 60 26 106 129

Total traditional turnover 820 1,190 1,490 1,200 1,900 3,210

Turnover at April 2007 exchange

rates( ***) 880 1,150 1,650 1,420 1,970 3,210

1 Adjusted for local & cross-border double-counting. Due to incompletebreakdown, components do not always sum to totals.2. Date for 2004 have been revised.3 Non-US dollar legs of foreign currency transactions were converted from current USdollar amounts into original currency amounts at average exchange rates for April of each

survey year and then reconverted into US dollar amounts at average April 2007 exchange

rates.

Table 3.A indicates that forex swaps have grown strongest compared to the other two, i.e,spot and forward.

Table 3.B indicates the percentage share of different currencies in average daily turnover

during 2007. As expected, US dollar has the highest average daily turnover of 86% followed

by Euro (37%) and Yen( 19%). Surprisingly the sum total of percentage of these currencies is

142% !!! The clue lies in the Table 3.B.

In addition, it is heartening to see that Indian currency average daily turnover has increased

from 0.3% to 0.7%. So also the Chinese Renminbi.


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Table 3.B:Currency distribution of reported foreign exchange market turnover(*)

Percentage shares of average daily turnover in April 2007

2004

2001 (**) 2007

US dollar 90.3 88.7 86.3

Euro 37.6 36.9 37Yen 22.7 20.2 16.5

Pound sterling 13.2 16.9 15

Swiss franc 6.1 6 6.8

Australian Dollar 4.2 5.9 6.7

Canadian dollar 4.5 4.2 4.2

Swedish krona 2.6 2.3 2.8

Hong Kong dollar 2.3 1.9 2.8

Norwegian krone 1.5 1.4 2.2

New Zealand dollar 0.6 1 1.9

Mexican peso 0.9 1.1 1.3

Singapore dollar 1.1 1 1.2Won 0.7 1.2 1.1

Rand 1 0.8 0.9

Danish krone 1.2 0.9 0.9

Rouble 0.4 0.7 0.8

Zloty 0.5 0.4 0.8

Indian rupee 0.2 0.3 0.7

Renminbi 0 0.1 0.5

New Taiwan dollar 0.3 0.4 0.4

Brazilian real 0.4 0.2 0.4

All currencies 200 200 200

Emerging market currencies (***) 16.9 15.4 19.8

(*) Because two currencies are involved in each transaction, the sum of the percentage

shares of individual currencies totals 200% instead of 100%. Adjusted for local andcross-border double-counting. (**) Data for 2004 have been revised.(***) Defined as the residual after accountingfor the top eight currencies and the New Zealand dollar and the Danish krone.


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Table 3.C highlights foreign exchange market turnover by currency pair.

Table 3.C: Reported foreign exchange market turnover by currency pair

Daily averages in April, in billions of US dollars and per cent

YEAR 2001

%

2004( **)

%

2007

Amount Amount Share Amount Share Amount % Share

US dollar/euro 354 30 503 28 840 27

US dollar/yen 231 20 298 17 397 13

US dollar/sterling 125 11 248 14 361 12

US dollar/Australian dollar 47 4 98 5 175 6

US dollar/Swiss franc 57 5 78 4 143 5

US dollar/Canadian dollar 50 4 71 4 115 4

US dollar/Swedish krona

(***) 56 2

US dollar/other 195 17 295 16 572 19

Euro/yen 30 3 51 3 70 2

Euro/sterling 24 2 43 2 64 2

Euro/Swiss franc 12 1 26 1 54 2

Euro/other 21 2 39 2 112 4

Other currency pairs 26 2 42 2 122 4

All currency pairs 1,173 100 1,794 100 3,081 100

(*) Adjusted for local and cross-border double-counting.(**)Data for 2004 have been revised.(***)The US dollar/Swedish krona pair could not be separately identified before 2007 andis included in other.

As usual, US dollar/Euro is the most preferred currency pair followed by US dollar/Yen and US

dollar/Pound Sterling. However, the percentage share of US dollar/Euro pair is going down

from 30% in 2001 to 27% in 2007.

Table 3.D indicates the distribution of average daily turnover of each currency based on spot,

forward and swaps transactions.For some currencies, the spot transactions is highest ( like

Indian Rupees, Chinese Renmimbi, Turkish Lira etc.) while for others swap transactions have

the highest percentage ( like US dollar, Australian Dollar, Swedish Krona etc.).

This difference clearly indicates the degree of development of forex market in different

currencies. Currencies with higher percentage of swap contract indicate the maturity of the

currency market. In addition, currencies with higher percentage in spot market may be

experiencing greater degree of capital control, preventing traders from these markets to enter


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into long-term contracts.


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Table 3.D Reported foreign exchange turnover by currency and instrument

Percentage shares of average daily turnover in April 2007

Spot Outright Foreign Exchange

Forwards Swaps

US dollar 29.7 10.9 59.4Euro 36.9 12.1 51.1

Yen 40.4 12.1 47.5

Pound sterling 32.5 10 57.4

Swiss franc 42.2 10.1 47.7

Australian dollar 25.7 10 64.3

Canadian dollar 29.7 11.8 58.6

Swedish krona 20.7 10 69.3

Hong Kong dollar 18.4 7 74.6

Norwegian krone 18.4 9.7 71.9

New Zealand dollar 29.4 11.3 59.3

Mexican peso 37.4 11.7 50.9

Singapore dollar 22.5 7.9 69.6

Won 44.7 29.4 25.9

Rand 19.9 12.1 68

Danish krone 21.8 10.3 67.9

Rouble 70.7 5 24.3

Zloty 20 10.9 69.1

Indian rupee 42.6 27.5 29.8

Renminbi 61.4 31.3 7.4

New Taiwan dollar 47.1 40.6 12.3

Brazilian real 50.2 47.3 2.5

Forint 34.1 15.7 50.2

Czech koruna 23.8 20.9 55.3

Baht 18.9 13.3 67.8

Turkish lira 61.4 11.4 27.2Philippine peso 36.9 32.5 30.5

Rupiah 43.7 39.3 17

All currencies 32.6 11.7 55.6

1 Adjusted for local and cross-border double-counting.

Table 3.E shows the major countrywise average daily foreign exchange turnover. The major

countries are Australia, Hong Kong, Japan, Singapore, Switzerland, United Kingdom and USA. It

is to be noted here that percentage column for all countries for a given year do not add upto

100% as some country details have been deleted from the master document to arrive at this

table.


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Table 3.E Major Countrywise Foreign Exchange Daily Average

Turnover

1998 2001 2004 2007

Amou % Amou % Amou % Amou %

nt nt nt nt

Australia 47 2.4 52 3.2 102 4.2 170 4.3

Canada 37 1.9 42 2.6 54 2.2 60 1.5

China 0 0.0 0 0.0 1 0.0 9 0.2

France 72 3.7 48 3.0 64 2.6 120 3.0Germany 94 4.8 88 5.5 118 4.8 99 2.5

HongKong 79 4.0 67 4.1 102 4.2 175 4.4

India 2 0.1 3 0.2 7 0.3 34 0.9

Japan 136 6.9 147 9.1 199 8.2 238 6.0

Korea 4 0.2 10 0.6 20 0.8 33 0.8

Russia 7 0.4 10 0.6 30 1.2 50 1.3

Saudi Arabia 2 0.1 2 0.1 2 0.1 4 0.1

Singapore 139 7.1 101 6.2 125 5.2 231 5.8

Switzerland 82 4.2 71 4.4 79 3.3 242 6.1

United 637 32.5 504 31.2 753 31.0 1,359 34.1

KingdomUnited States 351 17.9 254 15.7 461 19.2 664 16.6

Total 1,969 100 1,616 100 2,429 100 3,988 100

Table 3.Eindicates that Japans daily average foreign exchange turnover is going downwhile

countries like Switzerland, Australia and Hong Kong are showing an increasing trend. It is also

interesting to note that foreign exchange turnover percentage in United Kingdom is turnover

almost double the size that of United Statesproving that London still enjoys status of global

financial hub than New York.

3.3: Evolution of Foreign Exchange Market and Foreign

Exchange System

Since time immemorial, commodity money was used during barter system. From a wide

variety of commodities, gold, silver, silk and bronze became standardized commodity money.


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During 17thcentury, countries and kingdoms started using coins as the medium of exchange.

These coins had their own intrinsic value that was not related to any commodity.


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According to a Economist (1999) article titled Paper Money,Sweden was the first country in

Europe to introduce paper money in 1661 and other countries joined later.,

In 1694 the Bank of England started printing paper money used to be known as "running cash

notes

With increase in international trade, gold became universally accepted commodity to backissuance of paper money. This led to the emergence of gold standard. During 1870, major

countries agreed to hold gold to back their currency notes. The value of any countrys

banknotes depended on the gold reserve held by a country and exchange rates

between two currencies depended on the amount of gold backed by respective currencies. The

gold standard existed until the First World War.

During 1944, Bretton Woods Agreement system came into existence. The Bretton

Woods Conference of 1944 established an international fixed exchange rate regime in which

currencies were pegged to the US Dollar, which in turn was based on the gold standard.

Bretton Woods agreement is considered as the most important economic and political

accomplishment of the cold ware era. Gavin (1996) in paper titled The legends of Bretton

Woods noted Bretton woods is the most revered name in international monetary history,

perhaps in economic history. As part of the agreement, from 1944 till 1971 , different

countries permitted the exchange rates to vary within a narrow band. Central governments

needed to intervene in the forex market regularly to keep the exchange rate within the band.

However, this led to substantial imbalances in the forex rates i.e, some currencies became

undervalued and some became overvalued. However significant changes have happened

during 1971.

The Smithsonian Agreement in 1971, countries were allowed to increase the band within which

currency rates can fluctuate (from 1 % to 2.25%). In this agreement, the member countries

i.e, Group Ten also decided to devalue US$ against most other currencies. The SmithsonianAgreement of 1973 completely abandoned the band and currencies became free float.

Even though major changes were brought in 1973, but visible changes in forex market only

began to emerge in 1978, when worldwide currencies were allowed to 'float' according to

supply and demand. In 1992, twelve European countries joined common currency called Euro.

In a floating exchange rate system,supply and demand situation influences the exchange

rate. Though we see great deal of volatility in exchange rate, rarely any country has pure free

floating exchange rate. Most governments through their central banks influence the exchange

rate by changing their interest rates and adopting other means of control. Many-a-times

exchange rate changes when governors of central banks or high ranking officials of a centralbank just even casually remarks about whether their currency is under/overvalued.


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To sum it up, the fixed/semi-fixed vs, floating exchange rate system can be differentiated as

follows:

In fixed/semi-fixed exchange rate system, exchange rate is maintained at a specific level or

fluctuates within a given range. In such exchange rate system, the central banks play a crucial

role and regularly buy and sell foreign currency to maintain the exchange rate. Also thecentral banks dictate the rate of interest so that the exchange rate remains at a given value or

remains within the range. This system provides great deal of advantage to exporters and

importers as they are not exposed to forex risk.

Fully fixed and fully floating exchange rates are at the two ends of broad spectrum of

exchange rate systems prevailing in different countries. However, rarely a country will have

fully fixed or fully floating exchange rate system.

In a fully fixed exchange rate, there could divergence between the official rate and the

currency true value. If the divergence is significant, a parallel black market starts operating

where the currencys true value is reflected. Periodically, the government of the country with

fixed exchange rate has to revalue or devalue the official rate. Similarly, very few countries

have fully floating exchange rate system. Central banks periodically intervene in currency

market to align the currency within an acceptable range. If a countrys central bank

aggressively intervenes to keep the exchange under control, then this is known as dirty float

currency regime. In most cases, central banks interventions are more of symbolic in nature

i.e., to send a message to the market participants regarding the true value of the currency.

In a floating exchange rate system, the exchange rate is determined mainly through supply

and demand. Hence, export-import balance, capital flows, countrys fiscal deficit etc. governs

the exchange rate. Fluctuating exchange rate poses significant forex risk to the exporter and

importers of the country.

Floating rate system led to the increase in forex trading. Initially forex trading was undertaken

mostly by banks and large multinational corporations. But with the proliferation of the

internet, individuals, exporters, importers, mutual funds, hedge funds are actively

participating in the forex market. The spread of electronic trading platforms has led to

tremendous growth as it has enabled large financial institutions to set up algorithmic trading

systems and has provided trading facilities to retail investors.

Foreign Exchange Brokers:

Foreign exchange brokers are agents who facilitate trading between dealers withoutthemselves becoming principals in the transaction. For this service, they charge a smallcommission, and maintain access to hundreds of dealers worldwide via open telephone lines.

It is a broker's business to know at any moment exactly which dealers want to buy or sell any

currency. This knowledge enables the broker to find a counterpart for a client quickly withoutrevealing the identity of either party until after an agreement has been reached.


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Transactions in the Interbank Market Transactions in the foreign exchange market can beexecuted on a spot, forward, or swap basis.

Spot Transactions:

A spot transaction requires almost immediate delivery of foreign exchange.In the interbank market, a spot transaction involves the purchase of foreign exchange withdelivery and payment between banks to take place, normally, on the second following

business day.The date of settlement is referred to as the "value date."Spot transactions are the most important single type of transaction (43 % of alltransactions).

Outright Forward Transactions:A forward transaction requires delivery at a future value date of a specified amount of onecurrency for a specified amount of another currency.The exchange rate to prevail at the value date is established at the time of the agreement, but

payment and delivery are not required until maturity.Forward exchange rates are normally quoted for value dates of one, two, three, six, andtwelve months. Actual contracts can be arranged for other lengths.

Outright forward transactions only account for about 9 % of all foreign exchangetransactions.

Swap Transactions:A swap transaction involves the simultaneous purchase and sale of a given amount of foreignexchange for two different value dates.

The most common type of swap is a spot against forward, where the dealer buys acurrency in the spot market and simultaneously sells the same amount back to the same backin the forward market. Since this agreement is executed as a single transaction, the dealerincurs no unexpected foreign exchange risk.

Swap transactions account for about 48 % of all foreign exchange transactions.

Foreign Exchange Rates and Quotations

A foreign exchange rate is the price of a foreign currency.A foreign exchange quotation or quote is a statement of willingness to buy or sell at anannounced rate.

Interbank Quotations:The most common way that professional dealers and brokers state foreign exchangequotations, and the way they appear on all computer trading screens worldwide, is calledEuropean terms. The European terms quote shows the number of units of foreign currencyneeded to purchase one USD:

CAD 1.5770 / USD

An alternative method is called theAmerican terms. The American terms quote shows thenumber of units of USD needed to purchase one unit of foreign currency:

USD 0.6341 / CAD

Clearly, those two quotations are highly related. Define the price of a USD in CAD to be Also,define the price of a CAD in USD to be


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S(CAD/USD) CAD1.5770 /USD

Also, define the price of a CAD in USD to be

S(USD/CAD) USD0.6341/CADThen, it must be that

S (CAD USD)= 1/S (USD CAD)

Because CAD 1.5770 / USD = 1 / {USD 0.6341 / CAD}.

These rules also apply to forward rates as well. We will denote an outright forward quote usingthe following notation:

F(CAD/USD)

Direct and Indirect Quotations:

A direct quote is a home currency price of a unit of foreign currency.

An indirect quote is a foreign currency price of a unit of home currency.

In the US, a direct quote for the CAD is

USD 0.6341 / CAD

This quote would be an indirect quote in Canada.

Bid and Ask Quotations:Interbank quotations are given as "bid" and "ask".

A bid is the exchange rate in one currency at which a dealer will buy another currency An askis the exchange rate at which a dealer will sell the other currency.

Dealers buy at the bid price and sell at the ask price, profiting from the spread between thebid and ask prices: bid < ask.

Bid and ask quotations are complicated by the fact that the bid for one currency is the ask foranother currency:

S( USD CAD)=1/S (CAD USD)

S (USD CAD)=1/S (CAD USD)

Example 4.1: A dealer provides you the following quote:USD 0.6333 - 0.6349/ CAD.

This suggests that the bid price for the CAD is USD 0.6333/CAD andthat the ask price is USD 0.6349/ CAD.

The indirect version of this quote would beCAD 1.5750 - 1.5790/USD

Clearly, a dealer willing to purchase CAD at a price of USD 0.6333/USD is implicitlywilling to sell USD at the reciprocal price of CAD 1.5790/USD.

The spread between bid and ask prices exists for two reasons:


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1. Transaction costs and dealers as financial intermediaries and2. Profits.

The Law of One Price and Cross RatesThe law of one price states that homogenous goods and assets should have the same priceeverywhere (efficient markets and free trade).

Cross Rates:

Many currency pairs are only inactively traded, so their exchange rate is determinedthrough their relationship to a widely traded third currency (generally the USD):For example, imagine that an investor in Thailand would like to purchase some BarbadosDollars (BBD). As both currencies are quoted against the USD, the investor can figure out theprice of the Thai Baht (THB) against the BBD. Assuming that the exchange rates are;

Quotations:Thai Baht: --- THB 41.6982/USDBarbados Dollars: --- BBD 2.0116/USD

The cross rate is THB/BBD is:

THB41.6982/USD/ 2.0116/USD= THB20.7289/BBD

Global Economy - A Historical Perspective

The process of globalization is not a new phenomenon. Some communication and trade tookplace among distant civilizations even in ancient times. In spite of occasional interruptions, the

degree of economic globalization among different societies, around the world has generallybeen rising. More than a century ago, Marx and Engels rightly sensed the unprecedentedefficiency of the industrial capitalism and predicted that capitalism would sweep through theentire world. Eventually capitalism spread to nearly the entire world, in a complex andsometimes fierce process. (Brookings Papers on Economic Activity, 1995).

Indeed, during the past half century, the pace of economic globalization has been particularlyrapid. With the exception of human migration, global economic integration today is greaterthan it ever has been and is likely to deepen further

It was the instrument of colonial expansion rather than the economic reforms through whichthe global capitalism came into existent. Western European powers with their superiorindustrial and military powers expanded their kingdom around the world. By the 1870s, theindustrial revolution and colonial expansion led to establish, a global market. Improvements in

the technological progress in transportation and communication sectors, changing tastes andpreferences of individuals and societies and public policies have significantly influenced thecharacter and pace of economic globalization. Global economic system started functioning withthe development of long distance communication system. Monetary standards, based on goldand silver, provided the vital support for the stability and spread of economic globalization.

First World War, Great Depression of the 1930s and political upheaval created unprecedented

crises to global economy. The free trade regimes of 19th

century were replaced by highly

protected trade, state planning, authoritarianism and limited market based economy. At theend of the Second World War, the international economic system was in a state of collapse.


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International markets for trade in goods, services, and financial assets were essentiallynonexistent. However, there was a silver lining in the midst of black cloud. It gave anopportunity for a completely new beginning for the world economy.

The new beginning started in the formation of International Monetary Fund for world levelmonetary standard. It also led in the establishment of various other international institutionslike the International Bank for Reconstruction and Development, General Agreement on Tradeand Tariff etc. Those institutions have contributed in the integration of world economy. After

the World War II, most national governments began to lower their entry barriers, to makethem more permeable for world trade.

The multilateral negotiations under the auspices of the General Agreement on Trade and

Tariffs (GATT) stand out as the most prominent examples of reduction of barriers for trade ingoods. The years between 1970 and 1990 have witnessed the most remarkable institutionalharmonization and economic integration among nations in the world history. The decade of1980, witnessed the integration of the communist world with the world economy as capitalismspread to their economies. The decade of 1980s also witnessed the practice of open economymacroeconomic policies by many developing countries. Several Latin American and AsianCountries had implemented financial reform policies or eliminated Government control ofdomestic interest rates, credit allocation and exchange rate etc. Countries like Korea,Malaysia, Chile, Argentina, Uruguya, Japan, Hong Kong, India and China have liberalized theireconomies. They have undertaken many policy decisions to reform their financial markets.One of the primary aims of financial reforms programme of these countries has been tointegration of the various segments of financial markets.

The decade of 1990s is generally considered as the decade of re-unification of global economy.The world reached its climax in the process of integration of developed and developing worlds.Disintegration of the Soviet Union, the emergence of market-oriented economies in Asia, thecreation of a single European market, formation of new era of trade liberalization throughWorld Trade Organization etc., are few events of 1990s which led to global financial andeconomic integration. Development of IT-based communication system and services havesignificantly contributed in the further expansion of global financial system.

Financial Globalization-The Missing Link

If there is any arena of economic activity that has become extremely global in recent decades,it is finance. The world of finance has changed markedly over the past 40 years or so. Duringthe early part of 1970s world economy witnessed scarcity of international liquidity primarilydue to gold linked fixed monetary standard. There was also a growing realization that forachieving sustained growth with stability, it would be necessary to have open trade, liberalizedexternal capital movements and a relatively flexible domestic monetary policy. Industrializedcountries and emerging market economies took steps to liberalize capital account and allowcapital to move across the globe.

Simultaneously, efforts were made to remove distortions in the domestic financial sectorthrough financial sector reform measures. With the technological improvements in electronicpayments, world economy became increasingly integrated in terms of trade, investment andfinancial flows among countries over the past decades.

There are primarily three traceable aspects of the growth of financial markets, which have ledto financial globalization.These are:(i) Significant expansion and deepening of the existing markets,(ii) Emergence of new financial markets like derivatives(iii) Development of secondary markets for many instruments.

A number of developing countries, especially in Asia, that moved early on to the path ofeconomic liberalization had experienced large capital inflows. Large capital inflows, however,carried with it risk of financial sector vulnerability. The world economy had witnessed many


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financial crises. The experiences helped in for setting regulatory and supervisory framework, inproper place, to ensure the safety and stability of financial systems. The costs of financialcrisis falling on the sovereign governments, the notion of financial stability has come to occupya centre-stage in public policy along with the requirement of ensuring that the efficiency offinancial sector is high.

The sub-prime crisis, which engulfed the world economy, has called for establishing a newinternational financial architecture. According to the IMF's Global Financial Stability Report

(GFSR), the widening and deepening fallout from the U.S. subprime mortgage crisis wouldhave profound implications on financial system. Financial markets remain considerablystressed because of a combination of weakening balance sheets of financial institutions,continued process of deleveraging, free fall in asset prices and difficult macroeconomic

environment in the wake of debilitating global growth.

Experiences from India

Indias link with international trade is as old as the Indian civilization. Prior to colonial rule,India was known as the hub of manufacturing goods and artifacts. During the colonial ruleIndia was converted to a raw materials suppliers to rest of the World. On the eve of

independence in 1947, foreign trade of India was typical of a colonial and agriculturaleconomy. Trade relations were mainly confined to Britain and other commonwealth countries.Exports consisted chiefly of raw materials and plantation crops while imports composed of lightconsumer goods and other manufactures. Over the last 60 years, India's foreign trade hasundergone a complete change in terms of composition and direction. The exports cover a widerange of traditional and non-traditional items while imports consist mainly of capital goods,petroleum products, raw materials, and chemicals to meet the ever-increasing needs of adeveloping and diversifying economy.

For about 40 years (1950-90), foreign trade of India suffered from strict bureaucratic anddiscretionary controls. Similarly, foreign exchange transactions were tightly controlled by thegovernment and the Reserve Bank of India. From 1947 till mid-1990s, India, with someexceptions, always faced deficit in its balance of payments, i.e. imports always exceededexports. This was characteristic of a developing country struggling for reconstruction and

modernisation of its economy. Imports galloped because of increasing requirements of capitalgoods, defence equipment, petroleum products, and raw materials. Exports remainedrelatively sluggish owing to lack of exportable surplus, competition in the international market,inflation at home, and increasing protectionist policies of the developed countries.

Beginning mid-1991, the government of India introduced a series of reforms to liberalize andglobalize the Indian economy. Reforms in the external sector of India were intended tointegrate the Indian economy with the world economy. India's approach to openness has beencautious, contingent on achieving certain preconditions to ensure an orderly process ofliberalization and ensuring macroeconomic stability. This approach has been vindicated inrecent years with the growing incidence of financial crises elsewhere in the world. All thesame, the policy regime in India in regard to liberalization of the foreign sector has witnessedvery significant change. Over the years issues related to trade policy, export strategy, tariffpolicy, current account dynamics, exchange rate management, foreign exchange reserves,

capital account liberalization, external debt and aid, foreign investments and WTO have beenthe center of discussion under the International Trade and Finance.

Functions of International Financial Manager

In order to achieve the firms primary goal of maximizing stockholders wealth, the financialmanager performs three major functions:(1) Financial planning and control (supportive tools);(2) Efficient allocation of funds among various assets (investment decisions);


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Types of forex market participants:

The forex market is a OTC market without any centralized clearinghouse. It consists oftwo tiers.

The interbank or wholesale market,

Client or retail market.

Five broad categories of participants operate within these two tiers:

Bank and non bank foreign exchange dealers

Foreign exchange brokers

Hedgers, Speculators and arbitragers

Central banks and treasuries

Individuals and firms conducting commercial or investment transactions

Madam

Wholesale Forex Market: Major forex trading in the wholesale forex markets is

undertaken by bankspopularly known as interbank market. In this market, banks and

non-bank financial institutions transact with each other. They undertake trading on behalf

of customers, but majority of trading is undertaken for their own account by proprietary

desks.

Besides banks and non-bank financial institutions, multinational corporations, hedge

funds, pension and provident funds, insurance companies, mutual funds etc. participate in

the wholesale market.

Big multinational companies earn their revenue and incur expenses in many different

currencies. For example, Switzerland based Nestle operates in 86 countries across theglobe. To hedge their foreign exchange risk these multinational companies directly

participate in the wholesale market. Hedge funds are also major player in this market.

Hedge funds collect huge sums from high net worth individuals and undertake

speculative trades in equity, debt, forex and derivatives market. Mutual funds with

international equity portfolio are also major players in this market.

Foreign Exchange Dealers and Brokers:The role of foreign exchange dealers and

brokers need to be discussed in detail. But, let us first understand who forex dealers are.

Dealers: Banks and some nonblank financial institutions act as foreign exchange dealer.

These dealers quote both bid and ask for a particular currency pair (for spot,

forward and swap contracts) and take opposite side to either buyers or sellers of currency.

They make profit from the spreads between buying and selling prices ie., bid and ask rate.

Brokers are agents, which merely match buyers and sellers and get a brokerage fee.

Before the internet, the brokers, dealers and clients were communicating over telephone

or telex and through satellite communication. SWIFT (Society for Worldwide


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Arbitrageurs buy and sell the same currency at two different markets whenever there is

price discrepancy. The principle of law of one price governs the arbitrage principle.

Arbitrageurs ensure that market prices move to rational or normal levels. With the

proliferation on internet, cross currency, cross currency arbitrage possibility has increased

significantly.

Central Banks and Treasuries: All most all central bank and treasuries participate inthe forex market. Central banks play very important role in foreign exchange market.

However, these banks do not undertake significant volume of trading. Each central bank

has official/unofficial target of the forex rate for its home currency. If the actual price

deviates from the target rate, the central banks intervene in the market to set a tone.

Besides central banks, other commercial banks also buy and sell forex primarily for

Retail Market:

In the retail market, individuals (tourists, foreign students, patients traveling to other

countries for medical treatment) small companies, small exporters and importers operate.

Money transfer companies/remittance companies (for example like Western Union) are

also major players in the retail market.

Retail traders buy/sell currency for their genuine business/personal requirements. For

example, an exporter enters into forward contract to convert foreign currency to domestic

currency. A tourist buys foreign currency in the spot market before undertaking the

journey. A UK patient visiting India to undertake an operation that would have cost him

a fortune at UK.

Majority of retail trading happens in the spot market. Why? As retailers requirements

are normally not repetitive in nature, they buy or sell the currency as when the

requirement arises.

Forex Trading and SWIFT

In an interbank forex transaction, no real money changes hand. All transactions are done

electronically through SWIFT. Banks undertaking forex transactions simply transfer bank

deposits through SWIFT to settle a transaction.

SWIFT is the Society for Worldwide Interbank Financial Telecommunicationis a

cooperative organization headquartered at Belgium. The Swift network connects around

8300 banks, financial institutions and companies operating 208 countries. Swift provides

a standardized messaging service to these members. As and when two counterparties

undertake a transaction, SWIFT transports the message to both financial parties in a

standard form. As the forex market is mainly an OTC market, SWIFT message providessome kind of legitimacy to the transactions. The following line captures summarizes the

activities at SWIFT.

SWIFT is solely a carrier of messages. It does not hold funds nor does it manage

accounts on behalf of customers, nor does it store financial information on an ongoing

basis. As a data carrier, SWIFT transports messages between two financial

institutions. This activity involves the secure exchange of proprietary data while


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ensuring its confidentiality and integrity.For every participating member, SWIFT

assigns a unique code. This code is used to transport messages.

Robots & Forex Trading :

Computers and internet have become the must have requirement for anybody undertaking

forex trading. Many companies are selling software packages guaranteeing unthinkable

profit by installing these packages. These packages are popularly known as forex robots.

These are not robots in real sense of the word, but these are software which would

automate trades based some setting given by the trader. The trader need not physically

remain present when they trade is placed and executed.

The variety of such packages available runs into hundreds if not thousands. A typical

forex robot would entice traders with tagline like Our 100% no loss robot will

automatically enter and exit profitable trades for you. Imagine always being in the

market and making profitable trades while you are free to spend time with the

family, go to work, and live life ...


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Documents

Foreign Ex Mkt