UNIT III – FOREIGN EXCHANGE MARKET

Foreign Exchange Market:

The foreign exchange market is the market in which currencies are bought and sold against
each other. It is the largest market in the world. The foreign exchange market is an over-the-
counter market. This means that there is no single physical or electronic market place or an
organised exchange (like a stock exchange) with a central trade clearing mechanism where
traders meet and exchange currencies. The market itself is actually a worldwide network of
inter-bank traders, consisting primarily of banks, connected by telephone lines and computers.

The foreign exchange market allows for the exchange of one currency for another. Large
commercial banks serve this market by holding inventories of each currency so that they can
accommodate requests by individuals or MNCs. Individuals rely on the foreign exchange
market when they travel to foreign countries. People from the United States exchange dollars
for Mexican pesos when they visit Mexico, or euros when they visit Italy, or Japanese yen
when they visit Japan. The forex market is a global market. It is not segregated into local
markets or national markets. Exchange rates are determined in the FOREX market, which is
open to a wide range of different types of buyers and sellers where currency trading is
continuous 24 hours a day except on weekends.
The currencies of the world are represented by a three-letter code which is internationally
accepted. Some currencies are also represented by special symbols. Currencies are traded
against one another. The first currency in the pair is the base currency and the second currency
is the counter currency. Conventionally, the stronger currency in the pair is used as the base
currency, and the weaker currency as the counter currency. There are typically two levels or
tiers in the forex market. The first tier is the inter-bank market which is characterized by large
volumes of transactions. Within the inter-bank market, the spread (difference between the bid
and ask prices) is very thin on account of large volumes. The second tier involves the banks
and the customers who either need foreign currencies or have foreign currencies for sale.
Functions of Foreign Exchange Market:
• Transfer Function: Though this function, the foreign exchange market brings about a
transfer of purchasing power between two countries. In order to do that it has to convert
one country’s currency into another country ‘s currency.
• Credit Function: International trade also requires credit to finance international trade
transactions when the payment is postponed till future date. When the goods are
imported it takes time for the actual delivery of the goods because of shipment and
transportation of goods. The foreign exchange market gives loans to the needy
countries. Exporters may get pre-shipment and post shipment credit.
• Hedging Function: It provides a mechanism for both the exporters and importers to
guard themselves against the future fluctuations in the foreign exchange rate and the
consequent lossless thereof. It is the function of the foreign exchange market to enter
into forward contract to sell the foreign exchange at a predetermined rate.

ANJANA BASTIN 1
Features of Foreign Exchange Market:
• Exchange Traded and Over-the-counter Markets: Unlike most financial securities
and markets, the foreign exchange markets are mainly over-the-counter (OTC) markets.
While spot markets in the foreign currencies are mainly OTC, the derivatives on foreign
currency are traded on exchanges as well as OTC. Currency futures are exchange-
traded. Forward contracts. swaps, etc. on foreign currency are OTC. Options are mostly
OTC but are also exchange-traded.
• Timings: Unlike exchange-traded markets that remain open only for fixed duration,
the foreign exchange markets work round-the-clock. The major centres of foreign
exchange trades are New York, London, Paris, Zurich, Tokyo, Sydney, Singapore, etc.
Some markets open before the others close, thus providing continuous trading and
exchange rates. Banking hours govern the trading duration in the foreign exchange
markets in a country.
• Geographical/Currency Concentrations: Trading in foreign currencies is dominated
by few currencies as well as in terms of trading centres. The dominance of US dollar as
most active currency is evident as it constitutes 43.5% of global trade. Euro is a distant
second with about 17% of global trade. The dominance of US dollar in global trading
may be attributed to the legacy of Bretton Woods making the availability of US dollar
in abundance and the practice of international settlement in US dollars.
• Communication: Communication among the participants in the foreign exchange
markets takes place on a medium called Society for Worldwide Interbank Financial
Telecommunication (SWIFT). In order to eliminate any miscommunication and
misunderstanding, all currencies in the world have been assigned a three-letter code
that is used while communicating internationally.
Significance of Foreign Exchange Market:
• Market is large and global: The foreign exchange market is truly expansive with
traders participating from all parts of the world. The importance of foreign exchange
market is evident from the fact that more than $4 trillion are exchanged on an average
in the currency market every day. Other factors that make it a lucrative trading place
are largely derived from the fact of the market's sheer size.
• Good for beginners: First-time traders looking to make small investments can easily
enter the forex market. One of the many advantages of foreign exchange is that brokers
offer a provision of demo accounts.
• Round the clock market: Given that the forex market is global, trading can take place
almost continuously as long as a market is open somewhere in the world. It operates
five days a week, for 24 hours each day. The first major market opens in Australia’s
Sydney at 5 pm on Sunday and trading ends when the US’ New York market closes at
5 pm on Friday.
• Leverage: Foreign exchange brokers allow retail traders to borrow against a small
amount of capital, thereby offering a chance to open a high position. The amount of
money you raise from leverage is generally represented as a ratio.
• Liquidity: Due to the large volume of trading activity that occurs round the clock in
the forex market, it is considered the most liquid market in the world. Liquidity refers
to the ability of assets to be bought and sold with little effect on their value. In the case
of forex markets, liquidity allows you to trade with minimal risk.

ANJANA BASTIN 2
 • Volatility: Geopolitics, economic stability, policies, natural calamities and trade deals
are among a long list of forces that influence the market. A small development in any
of these translates into a major shift in the market. This sensitivity of a market is called
its volatility. When values of currencies change for the better due to these determinants,
they result in major profits. However, if the values are affected adversely, traders can
suffer significant losses.
• No restrictions on directional trading: Unlike the stock market, the foreign exchange
market does not have any restrictions on directional trading. Since traders are always
either buying or selling a currency according to the state of the market, you can easily
go long or sell short depending on your prediction of change in their value. Because of
the high liquidity of currencies, brokers do not charge any transaction fees for such
trading that are required in stock markets.
• Nobody controls the market: There is a large number of participants in the forex
market, which is why no single player, but only external factors such as the economy
can control prices. This factor reflects the importance of foreign exchange as an
investment option on traders’ portfolios. No middlemen exist in this market, and
brokers only help connect buyers and sellers.
• Low transactional charges: A small capital sum is enough to start online forex
trading, without any major costs of conducting transactions. The cost of transactions
largely comprises the broker’s fee, which he earns from spreads. The spread is
measured in pips or points in percentage, which is the difference between the ask price
and the bid.
• Technology: Since this market is relatively new, among the advantages of foreign
exchange is that its participants have embraced technology willingly. There are plenty
of software and mobile applications that facilitate trade in real-time from around the
world.
Participants of Foreign Exchange Market:
• Commercial Banks: These banks serve their retail clients, the bank customers, in
conducting foreign commerce or making international investment in financial assets
that require foreign exchange.
• Foreign exchange brokers: They operate in the international currency market and act
as agents who facilitate trading between dealers. Unlike the banks, brokers serve merely
as matchmakers and do not put their own money at risk.
• Central banks: Another important player in the foreign market is Central bank of the
various countries. Central banks frequently intervene in the market to maintain the
exchange rates of their currencies within a desired range and to smooth fluctuations
within that range.
• MNCs: They are the major non-bank participants in the forward market as they
exchange cash flows associated with their multinational operations. MNCs often
contract to either pay or receive fixed amounts in foreign currencies at future dates, so
they are exposed to foreign currency risk. This is why they often hedge these future
cash flows through the inter-bank forward exchange market.
• Individuals and Small Businesses: Individuals and small businesses also use foreign
exchange market to facilitate execution of commercial or investment transactions. The
foreign needs of these players are usually small and account for only a fraction of all
foreign exchange transactions.
• Fund Managers, Hedge Funds, and Sovereign Wealth Funds: They are basically
transnational and home country’s money managers who may deal in hundreds of
ANJANA BASTIN 3
 millions of dollars, as their portfolios of investment funds are often quite large. The
major aim of hedge funds is to make profits and grow their portfolios.

Components/ Types of Foreign exchange rate:

❖ Fixed exchange rate System or Pegged exchange rate system: The pegged exchange
rate or the fixed exchange rate system is referred to as the system where the weaker
currency of the two currencies in question is pegged or tied to the stronger currency.
Fixed exchange rate is determined by the government of the country or central bank
and is not dependent on market forces.
To maintain the stability in the currency rate, there is purchasing of foreign exchange
by the central bank or government when the rate of foreign currency increases and
selling foreign currency when the rates fall. This process is known as pegging and that’s
why the fixed exchange rate system is also referred to as the pegged exchange rate
system.
Advantages of Fixed Exchange Rate System

1. It ensures stability in foreign exchange that encourages foreign trade.

2. There is a stability in the value of currency which protects it from market
fluctuations.
3. It promotes foreign investment for the country.
4. It helps in maintaining stable inflation rates in an economy.
Disadvantages of Fixed Exchange Rate System
1. There is a constant need for maintaining foreign reserves in order to stabilise
the economy.
2. The government may lack the flexibility that is required to bounce back in
case an economic shock engulfs the economy.
❖ Flexible Exchange Rate System: Flexible exchange rate system is also known as the
floating exchange rate system as it is dependent on the market forces of supply and
demand. There is no intervention of the central banks or the government in the floating
exchange rate system.
Advantages of Floating Exchange Rate System
1. There is no need to maintain foreign reserves in this exchange system.
2. Any deficiencies or surplus in Balance of Payment is automatically
corrected in this system.
Disadvantages of Floating Exchange Rate System
1. It encourages speculation that may lead to fluctuations in the exchange rate
of currencies in the market.
2. If the fluctuations in exchange rates are too much it can cause issues with
movement of capital between countries and also impact foreign trade.
3. It will discourage any type of international trade and foreign investment.

❖ Managed floating exchange rate system: Managed floating exchange rate system is
the combination of the fixed (managed) and floating exchange rate systems. Under this
system the central banks intervene or participate in the purchase or selling of the foreign
currencies.
Types of foreign exchange transactions:
• Business Transactions: Importers need foreign currencies to make payments for their
imports, while exporters possess foreign currencies received as export proceeds.
ANJANA BASTIN 4
 Importers need to buy foreign currencies, while exporters need to sell foreign
currencies. These are genuine business transactions in foreign currencies, carried out
with the purpose of either acquiring foreign currencies or disposing them of.
• Hedging: The parties who are thus exposed to risk on account of fluctuations in the
exchange rates would like to hedge their risk. Derivative instruments such as currency
forwards, futures, options and swaps may be used for hedging the risk in foreign
exchange dealings. Thus, several transactions in the forex market are carried out for
hedging risk.
• Arbitrage: Fluctuations in the exchange rates sometimes provide opportunities for
making riskless profits. When such variation exceeds the transaction cost of buying and
selling the pair of currencies in two markets, there arises an opportunity for making
riskless profit by buying in the centre offering lower rates and selling in the centre
offering higher rates This type of transaction is known as arbitrage and the parties
engaging in such transactions are known as arbitrageurs. Arbitrage is a process of
simultaneous buying and selling of foreign exchanges for the sake of realizing profits
from discrepancies between exchange rates prevailing at the same time in different
centres, or between forward margins for different maturities.
• Speculation: Speculation is basically making short-term profit from difference in rates
or prices of assets A speculator buys an asset in anticipation of increase in the price of
the asset in the near future. Speculative activities always involve some risk, as the
anticipation of the speculator may always materialize.
Types of Forex Instruments:
• Spot Contracts: A spot transaction is one in which the actual exchange of currencies
takes place immediately. In a spot transaction, delivery of the currencies takes place on
the second working day after the day of the contract this is the international convention.
However, the exchange. rate applicable is the rate prevailing at the time of striking the
deal. In a spot transaction, the delivery date is referred to as the spot date.
• Forward Contracts: A forward exchange contract is one in which a party enters into
a contract with a bank to buy or sell a fixed amount of foreign currency at a specified
future date at a predetermined rate of exchange (op. cit., p. 150). Under this contract, a
buyer and seller agree on an exchange rate for exchange of currencies on a future date.
Thus, in a forward contract, currencies are bought and sold for delivery on a future date.
• Futures: Futures are contracts for exchanging currencies in the future at a
predetermined exchange rate in this respect they are similar to forward contracts. But
futures are standardized contracts with standard contract sizes and maturity dates.
Moreover, futures are traded on an organized exchange created for this purpose. The
settlement of the deal, that is, the delivery of the currencies by the buyer and the seller,
is facilitated by the clearing house of the exchanges.
• Options: It is a contract that gives the buyer of the option the right, but not the
obligation, to buy or sell a particular currency at a pre-agreed exchange rate, known as
the strike rate, within a specified period the option that gives the right to buy a particular
currency is referred to as call option, while the option giving the right to sell a currency
is referred to as put option.
Types of Exchange Rate Quotations:
❖ Direct method of quotations: The direct method expresses the number of units of the
home currency required to buy one unit of a foreign currency.
ANJANA BASTIN 5
 1 US $ = Rs. 75.36 100 US $ = Rs 7,536.30
This means that Rs. 75.36 is needed to buy one US dollar. In other words, it is the home
currency price of a foreign currency. When the exchange rate is expressed up to four
decimal places, the last decimal place is known as a point. If the dollar rupee exchange
rate moves from Rs. 75.3642 to Rs. 75.3645, the rate is said to have moved up by three
points.
❖ Indirect method of quotations: The indirect method of quoting exchange rates
expresses the number of units of a foreign currency that can be bought with one unit of
the home currency or, alternatively, with one hundred units of the home currency.
Re. 1 = US $ 0.013 Rs. 100 = US $ 1.33
This means that with Rs. 100 we can buy US $ 1.33. In India, all the banks are now
required to quote foreign exchange rates in the direct method.
❖ Cross Rates of quotations: Exchange rates are readily available for currencies which
are frequently transacted. However, exchange rates may not be available for currencies
which have only limited transactions. In such a situation, the home currency can be
converted into a common currency such as the US $ or the Euro, and the common
currency can then be converted into the desired currency. This is referred to as cross
rate trading which is a three-way transaction involving three currencies, namely, the
home currency, the common currency and the desired currency. The exchange rate
established through this three-way transaction is referred to as the cross rate.
1 US $ = Rs 75.04 - Rs. 75.14
1 US $ = CAD 1.04 - CAD 1.24
Therefore, 1 CAD = Rs (75.14/1.04) – Rs (75.04 /1.24)
Currency Appreciation and Currency Depreciation:
When the home currency price of a foreign currency increases or moves up, there is an
appreciation in the value of the foreign currency and the foreign currency is said to be
appreciating against the home currency. For example, if the dollar rupee exchange rate is 1
US $ = Rs. 42.35 and it moves up to Rs. 43.75, it signifies appreciation in the value of the
dollar. This is foreign currency appreciation. In this case, the value of the home currency
in terms of the foreign currency would be declining.
When the dollar-rupee exchange rate is Rs. 42.35/US $, the value of the rupee in terms of
US dollars would be US $ 0.0236, being the reciprocal of Rs. 42.35. When the exchange
rate moves up to Rs. 43.75, the value of the rupee declines to US $ 0.0229. This is home
currency depreciation.
Bid, Ask and Spread:
Foreign exchange dealers usually quote two prices, one for buying and the other for selling
the foreign currency. The buying rate is termed the bid rate while the selling rate is termed
the offer or ask rate. The offer rate would be higher than the bid rate. The difference
between the offer rate and bid rate is termed the bid-offer spread and it is one of the sources
of profit for the forex dealers.

ANJANA BASTIN 6
 In the direct method of quotation, the first rate quoted would be the buying rate (or bid rate)
and the second rate quoted would be the selling rate (or offer rate). The two rates for dollar-
rupee exchange may be 1 US $ = Rs 75.26 - Rs. 75.36. This means that the dealer quoting
the rates is prepared to buy one US dollar for Rs. 75.26 but he is prepared to sell one US
dollar only for Rs. 75.36. By buying US dollars at Rs. 75.26 and selling them at Rs. 75.36,
the dealer makes a profit of Re. 0.10 or 10 paise (75.36 - 75.26) per dollar traded.
The spread percentage is calculated as →( (Ask-Bid)/Ask) x 100
The size of the spread depends on a number of factors such as the demand and supply
position of the foreign currency, the volume of trade in the currency and the type of the
customer, whether individuals, firms or banks.
Spot and Forward Markets:
In the spot market, deals are arranged for immediate delivery. Here, settlement takes place
on the second working day after the date of transaction. The exchange rate between two
currencies is the number of units of one currency per unit of the other currency. The
exchange rate determined in the spot market is known as the spot exchange rate.
In the forward market, parties enter into forward foreign exchange contracts. A forward
foreign exchange contract is an agreement between two parties to exchange one currency
for another at some future date, with the exchange rate, the delivery date and the quantity
involved being fixed at the time of the agreement. The exchange rate agreed upon by the
parties to a forward foreign exchange contract where the foreign currency is to be delivered
in the future is known as the forward exchange rate.
Forward Premium and Forward Discount:
The forward exchange rate is likely to be either higher or lower than the spot exchange rate.
The difference between the forward exchange rate and the spot exchange rate is known as
the forward rate differential. Let us consider the following spot and forward exchange rates.
• Spot Rate: 1 US $ = Rs. 43.51
• 3-month forward: 1 US $ = Rs. 43.96
When it becomes necessary to pay more for forward delivery than for spot delivery of a
foreign currency, the foreign currency is said to trade at a forward premium.
When it becomes necessary to pay less for forward delivery than for spot delivery of a
foreign currency, the foreign currency is said to trade at a forward discount.
Forward rate Quotations:
As per forex market convention, spot rates and forward rate differentials (that is, forward
premiums and discounts) are quoted separately. To arrive at the forward rates, the spot rate
has to be adjusted for the forward pointer Forward premium points have to be added to the
spot rate, while forward discount points are deducted from the spot rate to arrive at the
forward rate.
The exporters to the USA would be receiving the export proceeds in the US dollars and
would wish to sell these dollars to the forex dealer who quotes the rate for buying the dollars
from them. Hence, the rate quoted to the exporters is the buying rate. Likewise, the rate
quoted by the dealer to the importers is the selling rate for selling dollars to the importers
who need them to make payments abroad for their import consignments.

ANJANA BASTIN 7
International Purchasing Power Parity (PPP) Theory:
According to PPP, the exchange rate of two currencies must be equal to the ratio of prices
of the common basket of goods denominated in their respective currencies.
The PPP theory is based on the law of one price. Any commodity or product cannot
command two prices in two different markets. If so, one would buy in one market at lower
price and sell in the other at higher price to derive profit. Buying pressure in the market
with lower price would cause the value of the product to go up. Similarly, selling pressure
in the market with higher price would drive its value down. The process continues till prices
in both the markets become equal.
Purchase power parity (PPP) is an economic theory that allows for the comparison of the
purchasing power of various world currencies to one another. It is the theoretical exchange
rate at which you can buy the same amount of goods and services with another currency.
The PPP theory focuses on the inflation-exchange rate relationships.
Forms of PPP Theory:
❖ ABSOLUTE PPP THEORY: The absolute PPP theory postulates that the
equilibrium exchange rate between currencies of two countries is equal to the ratio
of the price levels in the two nations. Thus, prices of similar products of two
different countries should be equal when measured in a common currency as per
the absolute version of PPP theory. Let Pa refer to the general price level in nation
A; Pb the general price level in nation B and Rab is the exchange rate between the
currency of nation A and currency of nation B. Then the absolute purchasing power
parity theory postulates that
Rab= Pa/Pb
❖ RELATIVE PPP THEORY: The relative form of PPP theory is an alternative
version which postulates that the change in the exchange rate over a period of time
should be proportional to the relative change in the price levels in the two nations
over the same time period. This form of PPP theory accounts for market
imperfections such as transportation costs, tariffs and quotas. Relative PPP theory
accepts that because of market imperfections prices of similar products in different
countries will not necessarily be the same when measured in a common currency.
Base period (o) = 2020, current period (i)= 2021; Po = 5, Pi = 6
Rab1 = (Pai/Pao) / (Pbi/Pbo) x Rabo = (6/5)

Advantages of PPP Theory:

❖ PPP exchange rates are stable compared with the market. PPP exchange rates stay
relatively stable when compared with financial world market rates. Comparing
GDP using market rates can mean more volatility in comparisons, even when the
individual countries' markets are stable.
❖ It accounts for non-traded goods. GDP measures a country’s economic productivity
as it relates to the sale of tangible, internationally traded goods. However, PPP
accounts for the cost of non-traded goods and services—like haircuts or massages—
which also speaks to the productivity of a given economy.
❖ It provides real-world examples of living costs and standards. Every year, The
Economist releases a comparative list of what 55 countries around the world charge

ANJANA BASTIN 8
 for a McDonald’s Big Mac called the Big Mac Index. This example of PPP uses a
recognizable good as a point of comparison between the living costs around the
world.
Disadvantages of PPP Theory:
❖ Taxes and tariffs are not accounted for. Different countries' sales taxes can alter
prices of goods and services between states and countries, making a PPP
comparison less precise. This also applies to transportation costs as well. Things
like value-added tax can also affect the comparative value of currency.
❖ Market competition is not considered. Price levels between different goods in
different financial markets may differ due to the competitiveness of that country’s
demand for that commodity.
❖ Some countries are not accounted for in global comparisons. Every year, a new
survey reporting on the PPP of 176 different countries is released. However, the
reports do not include every country around the world.
International Interest Rate Parity Theory:
Interest rate parity (IRP) is a theory in which the interest rate differential between two
countries is equal to the differential between the forward exchange rate and the spot
exchange rate.
Forward exchange rates for currencies are exchange rates at a future point in time, as
opposed to spot exchange rates, which are current rates. The interest rate parity presents an
idea that there is no arbitrage in the foreign exchange markets.
Interest rate parity is a non-arbitrage condition which says that the returns from borrowing
in one currency, exchanging that currency for another currency and investing in interest-
bearing instruments of the second currency, while simultaneously purchasing futures
contracts to convert the currency back at the end of the holding period, should be equal to
the returns from purchasing and holding similar interest-bearing instruments of the first
currency. If interest rate parity is violated, then an arbitrage opportunity exists.

ANJANA BASTIN 9
❖ Covered Interest Parity Theory: When the no-arbitrage condition is
satisfied with the use of a forward contract to hedge against exposure to exchange
rate risk, interest rate parity is said to be covered. Assuming the arbitrage
opportunity does not exist, then the relationship for US dollars and pounds sterling
is:
(1 + r£ )/(1 + r$ ) = (£/$f )/(£/$s )
where r£ is the sterling interest rate (till the date of the forward), r$ is the dollar
interest rate, £/$ f is the forward sterling to dollar rate, £/$s is the spot sterling to
dollar rate. Unless interest rates are very high or the period considered is long, this
is a very good approximation:
r£ = r$ + f
where f is the forward premium: (£/$f ) / (£/$s ) – 1
❖ Uncovered Interest Parity Theory: When the no-arbitrage condition is
satisfied without the use of a forward contract to hedge against exposure to
exchange rate risk, interest rate parity is said to be uncovered.
Assuming uncovered interest arbitrage leads us to a slightly different relationship:
r = r2 + E[∆S]
Where E[∆S] is the expected change in exchange rates.
Implications of Interest Rate Parity:
• When domestic interest rate is below foreign interest rates, the foreign currency
must trade at a forward discount. This is applicable for prevention of foreign
currency arbitrage So, domestic investors can sometimes benefit from foreign
investment.
• When domestic rates exceed foreign interest rates, the foreign currency must
trade at a forward premium. This is again to offset prevention of domestic
country arbitrage. So, the foreign investors can gain profit by investing in the
domestic market.

ANJANA BASTIN 10