THE FOREIGN EXCHANGE MARKETS
The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. In terms of volume of trading, it is by far the largest market in the world. The main participants in this market are the larger international banks.
Financial centres around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends.
The foreign exchange market determines the relative values of different currencies.
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 investments by enabling currency conversion.
For example,
- It permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars.
- It also supports direct speculation and evaluation relative to the value of currencies, and the carry 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 with 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 (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
CHARACTERISTICS OF FOREIGN MARKET
- Its huge trading volume representing the largest asset class in the world leading to high liquidity.
- Its geographical dispersion.
- Its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
- The variety of factors that affect exchange rates;
- The low margins of relative profit compared with other markets of fixed income; and
- The use of leverage to enhance profit and loss margins and with respect to account size.
PARTICIPANTS IN FOREIGN MARKETS
1.Commercial companies
- An important part of the foreign exchange market comes from the financial activities of companies seeking foreign exchange to pay for goods or services.
- Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short-term impact on market rates.
- Trade flows are an important factor in the long-term direction of a currency's exchange rate.
- Some multinational corporations (MNCs) can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.
2. Central banks
- National central banks play an important role in the foreign exchange markets.
- They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies.
- They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.
3. Foreign exchange fixing
- Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country.
- The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency.
- Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator.
- The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime.
- Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.
- Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Asia.
4. Hedge funds as speculators
- About 70% to 90% of the foreign exchange transactions conducted are speculative. This means the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.
- Since 1996, hedge funds have gained a reputation for aggressive currency speculation.
- They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.
5. Investment management firms
- Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities.
- For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.
- Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and, hence, can generate large trades.
6. Retail foreign exchange traders
- Individual retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange trading, both in size and importance.
- Currently, they participate indirectly through brokers or banks.
- Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association, have in the past been subjected to periodic foreign exchange fraud.
- A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for differences and financial spread betting.
- There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers.
- Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market.
- Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at.
7. Non-bank foreign exchange companies
- Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies.
- These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account).
- These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank.
- These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.
8. Money transfer/remittance companies and bureaux de change
- Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country.
- In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion.
- The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange.
- Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another.
- They access the foreign exchange markets via banks or non bank foreign exchange companies.
FOREIGN EXCHANGE TRANSACTIONS
Foreign Exchange Transactions (FETs) A FET is a binding agreement between you and WUBS in which one currency is sold or bought against another currency at an agreed Exchange Rate on the current date or at a specified future date.
TYPES
- SPOT
- FORWARD
- FUTURE
- OPTION
- SWAPS
- ARBITRAGE
1. Spot Market:
- The term spot exchange refers to the class of foreign exchange transaction which requires the immediate delivery or exchange of currencies on the spot.
- In practice the settlement takes place within two days in most markets.
- The rate of exchange effective for the spot transaction is known as the spot rate and the market for such transactions is known as the spot market.
2. Forward Market:
- The forward transactions is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency be the other party, at the price agreed upon in the contract.
- The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market.
- The foreign exchange regulations of various countries generally regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market.
- In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions.
- Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations be entering into an appropriate forward exchange contract.
- With reference to its relationship with spot rate, the forward rate may be at par, discount or premium. If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making the contract the forward exchange rate is said to be at par.
- The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot rate when one dollar buys more units of another currency, say rupee, in the forward than in the spot rate on a per annum basis.
- The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on a per annum basis.
- The forward exchange rate is determined mostly be the demand for and supply of forward exchange. Naturally when the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par.
3. Futures
- While a focus contract is similar to a forward contract, there are several differences between them.
- While a forward contract is tailor made for the client be his international bank, a future contract has standardized features the contract size and maturity dates are standardized. Futures can be traded only on an organized exchange and they are traded competitively.
- Margins are not required in respect of a forward contract but margins are required of all participants in the futures market an initial margin must be deposited into a collateral account to establish a futures position.
3. Options
- While the forward or futures contract protects the purchaser of the contract from the adverse exchange rate movements, it eliminates the possibility of gaining a windfall profit from favorable exchange rate movement.
- An option is a contract or financial instrument that gives holder the right, but not the obligation, to sell or buy a given quantity of an asset as a specified price at a specified future date.
- An option to buy the underlying asset is known as a call option and an option to sell the underlying asset is known as a put option.
- Buying or selling the underlying asset via the option is known as exercising the option. The stated price paid (or received) is known as the exercise or striking price.
- The buyer of an option is known as the long and the seller of an option is known as the writer of the option, or the short. The price for the option is known as premium.
- Types of options: With reference to their exercise characteristics, there are two types of options, American and European. A European option cab is exercised only at the maturity or expiration date of the contract, whereas an American option can be exercised at any time during the contract.
5. Swap
- Commercial banks who conduct forward exchange business may resort to a swap operation to adjust their fund position.
- The term swap means simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency.
- The spot is swapped against forward.
- Operations consisting of a simultaneous sale or purchase of spot currency accompanies by a purchase or sale, respectively of the same currency for forward delivery are technically known as swaps or double deals as the spot currency is swapped against forward.
6. Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with intention of making profits from the difference between the exchange rate prevailing at the same time in different markets.
