Foreign Exchange Market

  • Forex Market is a marketplace where sales and purchase of various currencies take place. This market is used to trade and exchange between various currencies. The word Forex or FX is a short form of Foreign Exchange and Forex Market or FX Market refers to the Foreign Exchange Market.
  • Some of the important facts about the FX market is as below:
    1. The FX market is the world’s largest market
    2. The FX market functions 24 Hours on its business days.
    3. The market participants or buyers and sellers belong to different Geographies and time zones.
  • The Selling Price of Foreign Currency in terms of Domestic Currency is termed as the Exchange Rate.
  • Every Currency in the FX Market has a standard naming format of 3 Letters. For Example, Indian Rupee is named as INR, United States Dollar is named as UDS, etc. The concept of the three-letter naming convention is agreed upon through ISO (International Organisation for Standardisation).
  • Like every other market on this planet, the price of goods and services (Currencies in the case of FX Market) depends upon its supply and demand. If a currency has a high demand (more buyers) and low sellers (less supply) the price of that currency will be relatively higher than other currencies.

Exchange Rate

  • In FX Market, Exchange Rate is the price of One Currency in terms of another currency. For Example, the Exchange Rate of USD to INR is 75. This implies that 1USD = 75INR. Exchange Rate is always defined between two currencies, there cannot be an exchange rate for a single currency.
  • Exchange Rate is the number of units of one currency (Price Currency) that one unit of other currency (Base Currency) can buy. Exchange Rate is the cost of 1 unit of the base currency in terms of the Price Currency.
X/Y = 100. This implies that 1 Unit of Y can buy 100 units of X

Illustration 1: 1 USD = 75 INR. This equation implies that 1 USD can buy 75INR. This is the price of 1USD expressed in INR. It is written as INR/USD = 75
Also, if I say 1 INR = 0.013 USD, this equation implies that 1 INR can buy 0.013 USD. This is the price of 1INR expressed in USD. It is written as USD/INR – 0.013

Real and Nominal Exchange Rates

Illustration 2: Refer to the following data of USD INR exchange rates.
  • 01-March-2020: INR/USD = 73 (1 USD can buy 73 INR)
  • 05-March-2020: INR/USD = 75 (1 USD can buy 75 INR)
  • On March 5, more INR can be bought for 1 USD as compared to March 1, we can say that cost of INR has decreased in the market and it has become cheaper as compared to USD. If we think the other way, on 5-March-2020 I need more INR to buy 1 USD as compared to March 1.
  • In the above case, we say that the USD has appreciated (became costly as more INR is required to buy 1 USD) and INR has depreciated (became cheap as more INR is obtained by selling 1 USD).
  • Hence, we can conclude the following points:
    1. If Exchange Rate A/B goes up or increases, currency A will depreciate, and currency B will Appreciate.
    2. If Exchange Rate A/B goes down or decreases, currency A will Appreciate, and currency B will Depreciate.
  • The Exchange Rates of various currencies are known as its Nominal Rates, the nominal rate has no impact on the purchasing power of the currency in the domestic market. For Example, if Apple costs 1 USD per Kg, the Appreciation or Depreciation of USD in Exchange Rate will not affect the price of apple. Thus, we can say that Nominal Exchange Rates have no impact on Purchasing Power in the domestic markets.
  • Contrary to the Nominal Exchange Rates are Real Exchange Rates, which are derived by economists and analysts in an economy considering the Purchasing Power of the currencies. The Real Exchange Rates are derived by measuring the Price Levels of the Countries, whose currencies are exchanged.
  • Purchasing Power Parity (PPP) is a theory that compares currencies of different countries through a Basket of Goods Approach. According to the Basket of Goods Approach, two currencies are said to be in equilibrium when a basket of goods is priced the same in both the countries. 
  • In practical situations, PPP is not possible as there are many restrictions to the Basket of Goods Approach, for example, the two countries involved may have a different basket of goods, trade barriers, etc. Due to such restrictions, there is always a difference between Nominal Exchange Rates and PPP.

Market Functions

  • The fact that FX Market is the world’s largest market defines its importance. FX Market facilitates the trade in goods and services, corporates, and individuals trade in this market to convert their domestic currency into foreign currencies, which enables them to participate in the sale and purchase of goods and services globally. After the formation of WTO significant increase in cross border trades of goods and services has a sign on the economies.
  • Major Proportion of trade in the FX market is contributed by Capital Market Transactions, where the principal agenda form trading of currency is to invest or disinvest in foreign assets. We will see this in the following Illustration.
Illustration 3: Ram works as an Engineer in a Multi-National Company and is very interested in investments. One day Ram got an investment opportunity in USD Bonds, the total investment was Rs. 14000 but it was to be paid in USD. To purchase the bonds, Ram transacted in the FX market and converted INR to USD.

After few years of Investment, Ram sold the bonds in Market and got the amount in USD, he again transacted in FX Market and converted the USD to INR. The motive of the FX Market transaction the above statement was through Capital Market, hence this FX Market Transaction is contributed by Capital Market Transaction.

Hedging and Speculating

  • As seen in previous sections, the role and influence of the FX market are very large in the global economy. The FX market is a market and is subjected to supply and demand mechanisms independent of the motive of the transaction. A sudden depreciation of a currency is a great risk for the participants of the market and a sudden appreciation of a currency is a great opportunity for them.
  • The appreciation of currency attracts the participants with Speculative Motive whereas the fear of depreciation of currency attracts the participants with Hedging Motive. Hedging and Speculation are two sides of the same coin, but their motives are different.
  • In the FX market, Speculation involves making profits from a change in Exchange Rates of currencies, and traders trading with this intention are said to have Speculative Motive. Hedging implies investing in FX Market to reduce the amount of risk associated with currency price changes, the traders trading with this intention are said to have Hedging Motive.

Types of Transactions

  1. Spot Transactions: Spot Transaction in FX Market refer to transaction involving the immediate exchange of currencies. The rate for Spot Transactions is known as Spot Rate.
    • The global standard for Spot Transactions is T+2 days i.e. settlement of currencies is done in two days after the trading. The only exception to this is trading between USD and Canadian Dollar where the settlement is done in T+1 day.
  2. Forwards: These are agreements to deliver the foreign exchange at a future date on the exchange rate determined today. This is a preferred instrument for Speculation and Hedging as it removes the interest rate risk of the depreciation of the currency in the future (as the exchange rate is determined today). The agreed exchange rate is known as the forward exchange rate. Forwards are also known as Outright Forward Contracts. Forward Contracts cannot be extended beyond the agreed future date.
  3. Swap: Swap involves the simultaneous purchase and sale of one currency for another at different value dates (spot and forward). A Swap is the combination of Future and Spot Transaction, let us see the following illustration
Illustration 4: An Indian company wants USD 10 Lacs for financing its branch in US and it can repay it in 3 months, it can do this in the following ways:
  1. Exchange INR for USD and finance the branch. When the company generates revenue in 3 months, convert USD to INR and get back the invested amount.
  2. Exchange INR to USD and finance the branch, simultaneously purchase a forward (USD to INR) of the same amount for 3 months at a rate determined today. The Future will return the investment in INR.
Both the approaches are same and the company will get back its statement in 3 times, but if there is some sudden issue in US Economy or Indian Economy and the INR depreciates, the company will suffer a loss in 1st Approach, however, the second approach will not make any differences as the company has purchased the Future.

The second option of simultaneously buying and selling USD at two different dates (spot and future) is known as FX Swap.

4. Options: An option is a contract that for a premium/fee gives the purchaser the right, but not the obligation to make an FX Transaction at a future date at a specific rate decided on the day on contract. In simple words, this is a contract that gives a purchaser right to defer his Forward Agreement. Let us see the following illustration.

Illustration 5: Ram entered a forward contract with Peter to buy USD 10000 after 90 days in return for INR at a fixed rate, however, Ram thinks that there are certain chances that the exchange rate may decrease further by that time. Ram purchases an Option by paying a fee that entitles him to defer the earlier forward contract with Peter.

If the rates after 90 days are in favour of Ram, he way entertain the Forward Contract, but if Ram thinks that the present rates are way low and the forward contract be a loss, he uses the Option to defer the Forward Contract.

Market Participants

  1. Commercial and Investment Banks: They are the largest participants of the FX Market (volume-wise). Banks mostly trade in their interbank electronic markets. The transactions of banks in the FX market can be divided into two categories:
    • Facilitating Client Transactions (A person may send USD to India and convert it to INR via a bank)
    • Conducting Speculative Transaction to generate profits on their revenue.
  2. Central Banks: Central Bank of a country keeps reserves for Foreign Exchange to stabilize and maintain its economy, sales and purchase of Forex is done by Central Bank of the country to stabilize its domestic currency. However, the intervention of Central Banks in the FX market is not very frequent, it is done only to regulate the economy and domestic currency.
  3. Investment Managers and Hedge Funds: This combination ranks second in FX trading (volume-wise) after the Banks. Investment Managers of Mutual funds, pension funds, ETFs have a certain level of forex exposure in their portfolio to benefit from the change in forex rates. Hedge Funds manager use the Hedge Funds to reduce the rate risks
  4. Government: Governments also participate in the FX market to fulfil its needs in the interest of the nation e.g. Payment of Purchase of Defence Material, Interest payment on a loan from other countries, etc. Most of the countries assign this responsibility to their Central Banks, but a few keep it to themselves.
  5. Multinational Corporations: MNCs indulge in Forex Markets to facilitate their cross-border transactions of goods and services, E.g. An Indian company may procure raw material from a US company for which payment needs to be done in USD.
  6. Individual Investors: Individual Investors also participate in the FX market to get benefit from the Interest Rate changes, the motive behind individual investors participation in FX Market is Speculative (generate profits).

Market Size and Composition

The market size and composition of the FX market can be done on the following basis:
  1. Currency Basis: This specifies the composition of the market based on trading currencies. As per the BIS (Bank for International Settlements) 2016 survey, the largest market share was occupied by the USD/EUR (23.1%) followed by JPY/USD (17.8%).
  2. Transaction Basis: This specifies the composition of the FX market based on the type of Transactions. As per the BIS (Bank for International Settlements) 2016 survey, the largest market share was occupied by the Swaps (49%) followed by Spot (33%).
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