30242907 Foreign Exchange Market P P T

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PRESENTATION

Foreign Exchange Market

(FOREX MARKET)

ByDr.N.Moogana Goud

Professor and DirectorMBA Programme

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Foreign Exchange Market(FOREX MARKET)

WATER FALLS

US DOLLORS

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MEANING

It is a mechanism for exchanging one currency for another.

A means to reduce the exposure to the risks of fluctuating exchange rates

It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions

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Foreign Exchange Market- Cntd

The foreign exchange market is unique because of:

its trading volume,

the extreme liquidity of the market,

the large number of, and variety of, traders in the market,

its geographical dispersion,

its long trading hours - 24 hours a day (except on weekends).

the variety of factors that affect exchange rates,

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Characteristics of the Market

The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years.

New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).

The integration of financial centers implies that there can be no significant arbitrage.

The process of buying a currency cheap and selling it dear.

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Geographical Extent of the Foreign Exchange Market

Global currency trading is a 24-hour-a-day process. Many large international banks operate trading rooms in major trading center on a round-the-clock basis. Some currency trading is conducted on an official trading floor by open bidding but most of it is done through dealers.

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Functions of the Foreign Exchange Market

Transfer of Purchasing Power

Financing of Inventory in Transit

Hedging Facilities

Currency Conversions

Reducing Foreign Exchange Risks: the risk exist that the exchange values of National Currency may fluctuate i.e. Transaction Exposure.

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Nature of Foreign Exchange Market:

It is the net work of Banks, Brokers, and FE dealers.

Important exchange markets in London, New York, Zurich, Frankfurt, Tokyo, Singapore, Hong Kong and Paris

FEM is governed by an unwritten code of conduct of all participants.

FEM are large commercial banks that operate at two levels – retail and interbank.

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Market Participants (Actors)

There are five main categories of market participants in the foreign exchange market:

Bank and Nonbank Foreign Exchange Dealers Individuals and Firms Conducting Commercial and Investment Transactions Speculators and Arbitrageurs Central Banks and Treasuries Foreign Exchange Brokers.

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Terminology

In the markets, currency names are shortened to 3 letters to meet the needs of screen-based tables. These were developed by the International Organisation for Standardisation and are called ISO codes or SWIFT codes. We use these conventions throughout.

Terminology

In the markets, currency names are shortened to 3 letters to meet the needs of screen-based tables. These were developed by the International Organisation for Standardisation and are called ISO codes or SWIFT codes. We use these conventions throughout.

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Terminology

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Foreign Currency Futures and Options

Future Contracts: FC is traded for only a limited number of currencies and

for a given delivery date. Amount of transaction and maturity date is fixed by FE markets.

Foreign Currency Options: A currency option is the right but not the obligation to

Buy (Call) or Sell (Put).

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Calls and Puts

The two types of equity options are Calls and Puts. Call Option: A call option gives its holder the right to

buy shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to sell the shares.

Put option: The opposite of a call option is a put option, which gives its holder the right to sell the shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to buy the shares.

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Holder(Buyer)

Writer(Seller)

CallOption

Right toBuy

Obligationto sell

PutOption

Right tosell

Obligationto buy

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Languages of FE

Spot Market: Currencies are traded for immediate delivery. Delivery is on the second following business day (value date). E.g. Travelers going abroad

Forward Market: It is market for exchange of currencies in the future, at a specified date in the future, typically 30, 60, or 90 days from now, and at a price (forward exchange rate) that is agreed upon today. Delivery is at a future value date. E, g. International business transactions.

Forward Markets exist only for the major currencies Both forward rates and spot rates are published in News

papers.

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Languages of FE

Arbitrage: Simultaneous purchase and sale of a given amount of foreign exchange in two different markets for profits from unwarranted differences in prices. Both purchase and sale are conducted with the same counterparty. “Spot against forward”, “forward-forward swaps”, “no deliverable forwards (NDFs)”.

Price discrepancies in different Markets create arbitrage opportunities.

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Languages of FE

Foreign Exchange Swaps Spot sales of a currency combined with a forward repurchase

of the currency. They make up a significant proportion of all foreign

exchange trading.

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EXCHANGE RATE DETERMINATION

Equilibrium of Exchange Rate= DD for FE & SS of FE According Rogner Nurkse “that rate which over a

certain period of time keeps the balance of payments in equilibrium”

Equilibrium Exchange Rates can be determined by two Methods

1. DD for and SS of Dollars

2. DD for and SS of Indian Rupees ( if trade between two countries)

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EXCHANGE RATE DETERMINATION - Contd

DD for FE arises because: Import of goods and services FDI in other countries Payment by one Govt to other for settlement of transactions. other outflows

SS of FE arises because: Country exports goods and services to other countries inflow of foreign capital payment made by other countries other types of inflows

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TYPES OF EXCHANGE RATES

1. FIXED EXCHANGE RATE: It is also called as pegged exchange rate IMF member countries follow this procedure Government use to fix the exchange rates.

Advantages of Fixed Exchange Rate Ensure certainty and confidence. Promotes long term investments It helps for economic stabilization

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Disadvantages Fixed Exchange Rate It needs large foreign exchange reserves It leads to large scale speculations Long run capital may not be altered

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]FREE FLOATING (Flexible Exchange Rates) Value of the currency is determined solely by market

demand for and supply of the currency in the foreign exchange market.

Trade flows and capital flows are the main factors affecting the exchange rate

In the long run it is the macro economic performance of the economy (including trends in competitiveness) that drives the value of the currency

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No pre-determined official target for the exchange rate is set by the Government. The government and/or monetary authorities can set interest rates for domestic economic purposes rather than to achieve a given exchange rate target

It is rare for pure free floating exchange rates to exist - most governments at one time or another seek to "manage" the value of their currency through changes in interest rates and other controls

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Advantages of Flexible Exchange Rates:•Simple to operate•Adjustment is a common process•Helps to promote foreign trade•There exist a free tradeDisadvantages of Flexible Exchange Rates•Market mechanism may fail to bring appropriate FER•It is difficult to define FE Rate•It breeds uncertainty and impede international trade.


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Should Exchange Rates be Fixed or Flexible

Depends on the

1) The effects of the exchange rate system on monetary policy

2) The effects of the exchange rate system on trade and economic integration

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Theories of Foreign Exchange

Purchasing Power parity Theory (PPPT) The theory developed by Cassel in 1921 and Officer in

1976 The theory suggests that “at a given time, the rate of

exchange between currencies is determined by their purchasing power”

If “e” is the exchange rate and PA and PB are the purchasing power of two countries currencies , A and B countries can be written as

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E= PA/PB

The exchange rate adjustment is a sequel to inflation. In case of inflation

Exports will fall Import price becomes cheaper

PPPT is useful in understanding

the long term movements in spot

rates; it has definite limitation over

the short term.

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This theory suggests that A country with high rate of inflation should devaluate the

currency to the currency of the country with lower inflation rate.

It is a real exchange rate (base ER) and the nominal exchange rates that has a bearing on the performance of the country.

The theory holds good, only if, Changes in economy because of monetary sector Relative prices in different sector remains stable There are no structural changes in the economy.

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Criticism of PPP Theory: No direct link between PP and rate of exchange.

Exchange rate can be influenced by other factors such as a tariff, speculation and capital movement.

Difficulty in comparing price indices

Prices of domestic goods and internationally traded goods differ. Changes in the exchange rate as the cause- exchange rate can

influence over price level which is ignored in this theory. Other factors which influence the exchange rate are capital

movement, interest rate, and government restriction.

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Fisher theory of FE Fisher uses the interest rate rather than inflation rate

differentials to explain why exchange rates change overtime but it is closely related to the PPP theory because interest rates are often highly co-related with inflation rates.

According to fisher effect, nominal risk free interest rates contain a real rate of return and anticipated inflation

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If investors of all the countries require the same real return, interest differentials between countries may be the result of differentials in expected inflation.

If the real interest rates are the same across the countries any difference in nominal interest rates could be attributed to the differences in expected inflation

IFE suggests that “Foreign currency will relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation”

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The concept of real interest rate applies to all investments, like domestic and foreign. An investor invests in a foreign country if the real interest rate differentials are likely to be his favour, but when such a differential exists, arbitrage begins in the form of international capital flow that ultimately equals the real interest rate across the countries.

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THANK YOU

30242907 Foreign Exchange Market P P T

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