Foreign Exchange Market
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î 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.
Sient Fetures of Foreign Exc nge n any economy there are two types of Monetary units:G G
Domestic Monetary Unit(DMU) 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.
Sient Fetures 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
Sient Fetures cont«.. Trading is done 24hrs. A day through Telephones, telex, fax machines, nternet & satellite communication system called SWFT 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.
Sient Fetures cont«.. G $ G G% & G' & G# $ ( G )& $ G $ G* & G & $ $ G+ &
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 Orgnistion 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.
Orgnistion of FEM cont«. GThese ADs have formed an organisation called FEDA, which sets the ground rules for fixation of commission & other charges. Gnstitutions like DB, CC, 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--Bnk Mrket 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.´ Gndirect 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, limitbook, single-auction market´.
Ãyers in FEM in ndi A General Categorisation: 3 3 $ 3 . 3 3 2 &
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Forex Trding GVue cs : 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´
GVue 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 trnsction trnsction:- 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. Gnterest 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 Rte Te M M ¦ ¦ ! " # $
Trding Ãtform Gn ndia forex market ,spot trading takes place on 4 platforms:GFX CLEAR of CCL(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 Men? ¦ & , $ $ $ . . 3 & & Ú 3& * % $ & $ 3 &1 4 .&. $ * % %3 & 4 :; & . :; * % 31
Risk Mngement in FEM GFEM involves constant & rapid changes in innovation & trading methods which makes it convenient and attractive option to invest in, but Gt 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 CCL (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.
GMrket 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. Gt is generally measured & managed by most banks on an aggregate counter-party basis so as to include all exposures in markets.
Forex Mrket Efficiency GThe efficiency/liquidity of the forex market is often gauged in terms of bid-ask spread. GDefining ³ id-¦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. Gn 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 Gnventory Holding cost Gnformation 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. Gn 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. Gf 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.
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