Foreign exchange market

Forex, FX or currency market

Foreign exchange markets, where money in one currency is exchanged for another

Exchange rate, the price for which one currency is exchanged for another

Foreign exchange reserves, holdings of other countries' currencies Foreign exchange controls, controls imposed by a government on

the purchase/sale of foreign currencies Retail foreign exchange platform, speculative trading of foreign

exchange by individuals using electronic trading platforms Foreign exchange risk, arises from the change in price of one

currency against another International trade, the exchange of goods and services across

national boundaries Foreign exchange company, a broker that offers currency

exchange and international payments Bureau de change, a business whose customers exchange one

currency for another Currency pair, the quotation of the relative value of a currency unit

against the unit of another currency in the foreign exchange market

Foreign exchange market

It is a global decentralized market for the trading of currencies.

Participants

Foreign exchange market needs dealers to facilitate foreign exchange transactions.

Bulk of foreign exchange transaction are dealt by Commercial banks & financial institutions.

RBI has also allowed private authorized dealers to deal with foreign exchange transactions i.e. buying & selling foreign currency.

In foreign exchange market two types of exchange rate operations take place.

They are, Spot exchange rate. Forward exchange rate.

   Spot Exchange Rate

When foreign exchange is bought and sold for immediate delivery, it is called spot exchange.

It refers to a day or two in which two currencies are involved.

The basic principle of spot exchange rate is that it can be analyzed like any other price with the help of demand and supply forces.

  Forward Exchange Rate

Here foreign exchange is bought or sold for future delivery i.e., for the period of 30, 60 or 90 days:

There are transactions for 180 and 360 days also.

Thus, forward market deals in contract for future delivery.

The price for such transactions is fixed at the time of contract, it is called a forward rate.

Functions of the Foreign Exchange Market

Transfer FunctionCredit FunctionHedging Function

Hedging Function

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.

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.

Credit Function

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.

Transfer Function

To facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries.

Through a variety of credit instruments, such as telegraphic transfers, bank drafts and foreign bills.

Overview

Before we look at these forces, we should sketch out how exchange rate

movements affect a nation's trading relationships with other nations.

A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets.

A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it.

Determinants of Exchange Rates

Inflation Interest RatesCurrent-Account DeficitsPublic DebtTerms of TradePolitical Stability and Economic

Performance

Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies.

During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later.

Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners.

This is also usually accompanied by higher interest rates.

Interest Rates

By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values.

Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.

Current-Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends.

A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit.

In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products.

The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding.

While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors.

The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments.

If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved.

Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value).

If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital.

A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk.

Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

If the forward rate is above the present spot rate, the foreign exchange rate is said to be at a premium.

If the forward rate is below the present spot rate, the foreign exchange rate is said to be at a discount.

Thus foreign exchange rate may be at forward premium or at forward discount.

Help yourself

http://www.investopedia.com/articles/basics/04/050704.asp

http://en.wikipedia.org/wiki/Foreign_exchange_market

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