Finalprojectofforeignexchangemarket 141028123049 Conversion Gate02(1)

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TABLE OF CONTENT INTRODUCTION 5 HISTORY 7 SUMMARY 8 WHY THE FOREIGN EXCHANGE MARKET IS UNIQUE ? 9 ADVANTAGES & DISADVANTAGE OF FOREIGN EXCHANGE MARKET 1 V ARIOUS !A RTICI!A NTSOF FOREIGN EXCHANGE MARKET 11 CHARACTERI SICS OF FOREIGN EXCHANGE MARKET 1" FINANCIAL INSTRUMENTS OF FOREIGN EXCHANGE MARKET 15 FUNCTION OF FOREIGN EXCHANGE MARKET 1# TY!ES OF FOREIGN EXCHANGE MARKET 17 FA CTORS AFFECTING MOVEMENT OF EXCHANGE RAT ES 18 !LAY ERS IN FOREIGN EXCHANGE MARKET $" FOREIGN EXCHANGE RISK $8 FOREIGN EXCHANGE MARKET IN INDIA %$ CONCLUSION %" REFERENCES %# 1

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Transcript of Finalprojectofforeignexchangemarket 141028123049 Conversion Gate02(1)

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TABLE OF CONTENT

INTRODUCTION 5

HISTORY 7

SUMMARY 8

WHY THE FOREIGN EXCHANGE MARKET IS UNIQUE ? 9

ADVANTAGES & DISADVANTAGE OF FOREIGN EXCHANGE

MARKET 1

VARIOUS !ARTICI!ANTSOF FOREIGN EXCHANGE MARKET 11

CHARACTERISICS OF FOREIGN EXCHANGE MARKET 1"

FINANCIAL INSTRUMENTS OF FOREIGN EXCHANGE MARKET 15

FUNCTION OF FOREIGN EXCHANGE MARKET 1#

TY!ES OF FOREIGN EXCHANGE MARKET 17

FACTORS AFFECTING MOVEMENT OF EXCHANGE RATES 18

!LAYERS IN FOREIGN EXCHANGE MARKET $"

FOREIGN EXCHANGE RISK $8

FOREIGN EXCHANGE MARKET IN INDIA %$

CONCLUSION %"

REFERENCES %#

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INTRODUCTION

Being the main force driving the global economic market, currency is no doubt an essential

element for a country. However, in order for all the countries with different currencies to trade

with one another, a system of exchange rate between their currencies is needed; this system, is

formallyknownasforeignexchangeorcurrencyexchange.

In the early days, the system of currency exchange is supported solely by the gold amount held inthe vault of a country. However, this system is no longer appropriate now due to inflation and

hence, the value of one’s currency nowadays is determined through the market forces alone. In

order to determine the value of a currency’s exchange rate, two main types of system is used

whichisfloatingcurrencyandpeggedcurrency.

or floating exchange rate, its value is determined by the supply and demand of the global

market where the supply and demand is bound by all these factors such as foreign investment,

inflation and ratios of import and export. !ormally, this system is adopted by most of the

advance countries like for example "#, "$ and %anada. &ll of these countries have a similarity

where their market is well developed and stable in economic terms. 'hese countries choose to

 practice this system due to the reason where floating exchange rate is proven to be much more

efficient compared to the pegged exchange rate. 'he reason behind this is because for floating

exchange rate, the market itself will re(ad)ust the exchange rate real(time in order to portray the

actual inflation and other economic forces. However, every system has its own flaw and so does

the floating exchange rate system. or instance, if a country suffers from economic instability

due to various reasons such as political issues, a floating exchange rate system will certainly

discourage investment due to the high risk of suffering from inflationary disaster or sudden slum

in exchangerate. &nother form of exchange rate is known as pegged exchange rate. 'his is a

system where the value of the exchange rate is fixed by the government of a country and not the

supply and demand of the market. 'his system is called pegged exchange rate because the value

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of a country’s currency is fixed to another country’s currency. &s a result, the value of the pegged

currency will not fluctuate unlike the floating currency. 'he working principle behind this system

is slightly complicated where the government of a country will fixed the exchange rate of their 

currency and when there is a demand for a certain currency resulting a rise in the exchange rate,

the government will have to release enough of that currency into the market in order to meet that

demand. However, there is a fatal flaw in this system where if the pegged exchange rate is not

controlled properly, panics may arise within the country and as a result of that, people will be

rushing to exchange their money into a more stable currency. *hen that happens, the sudden

overflow of that country’s currency into the market will decrease the value of their exchange rate

and in the end, their currency will be worthless. +ue to this reason, only those under(developed

or developing countries will practice this method as a form to control the inflationrate. However,

the truth is, most of the countries do not fully practice the floating exchange rate or the pegged

exchange rate method in reality. Instead, they use a hybrid system known as floating peg.

loating peg is the combination of the two main systems where one country will normally fixed

their exchange rate to the "$ +ollars and after that, they will constantly review their peg rate in

order to stay in line with the actual market value.

'he oreign exchange market, or commonly known as -/, is the largest and most prolific

financial market because each day, more than 0 trillion worth of currency exchange takes place

 between investors, speculators and countries. rom this, we can deduce that the actual

mechanism behind the world of foreign exchange is far more complicated than what we may

already know, and that, the information mentioned earlier is )ust the tip of an iceberg.

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HISTORY

'he foreign exchange market 1fx or forex2 as we know it today originated in 0345. However,

money has been around in one form or another since the time of 6haraohs. 'he Babylonians are

credited with the first use of paper bills and receipts, but 7iddle astern moneychangers were

the first currency traders who exchanged coins from one culture to another. +uring the middle

ages, the need for another form of currency besides coins emerged as the method of choice.

'hese paper bills represented transferable third(party payments of funds, making foreign

currency exchange trading much easier for merchants and traders and causing these regional

economies to flourish.

rom the infantile stages of forex during the 7iddle &ges to **I, the forex markets were

relatively stable and without much speculative activity. &fter **I, the forex markets became

very volatile and speculative activity increased tenfold. $peculation in the forex market was not

looked on as favorable by most institutions and the public in general. 'he 8reat +epression and

the removal of the gold standard in 0350 created a serious lull in forex market activity. rom

0350 until 0345, the forex market went through a series of changes. 'hese changes greatly

affected the global economies at the time and speculation in the forex markets during these times

was little, if any.

19"" 9 Bretton *oods &ccord is established to help stabili:e the global economy after *orld

*ar II.

1971 $mithsonian &greement established to allow for greater fluctuation band for currencies.

197$ uropean oint loat established as the uropean community tried to move away from its

dependency on the ".$. dollar.

197% $mithsonian &greement and uropean oint loat failed and signified the official switch to

a free(floating system.

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1978 'he uropean 7onetary $ystem was introduced so other countries could try to gain

independence from the ".$. dollar.

1978 ree(floating system officially mandated by the I7.

199% uropean 7onetary $ystem fails making way for a world(wide free(floating system.

SUMMARY

• 'he foreign exchange market is the mechanism by which a person of firm transfers

 purchasing power form one country to another, obtains or provides credit for 

international trade transactions, and minimi:es exposure to foreign exchange risk.

• & foreign exchange transaction is an agreement between a buyer and a seller that a given

amount of one currency is to be delivered at a specified rate for some other currency.• & foreign exchange rate is the price of a foreign currency. & foreign exchange <uotation

or <uote is a statement of willingness to buy or sell at an announced rate.

• 'he foreign exchange market consists of two tiers= the interbank or wholesale market,

and the client or retail market. 6articipants include banks and nonbank foreign exchange

dealers, individuals and firms conducting commercial and investment transactions,

speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

• 'ransactions are effectuated either on a spot basis or on a forward or swap basis. & spot

transaction is for an 1almost2 immediate value date while a forward transaction is for avalue date somewhere in the future.

• >uotations can be classified either as uropean and &merican terms or as direct and

indirect <uotes.

• In the real world, <uotations include a bid(ask spread. & bid is the exchange rate in one

currency at which a dealer will buy another currency. &n ask is the exchange rate at

which a dealer will sell the other currency. 'he spread is the difference between the bid

 price and the ask price. 'his spread reflects the existence of commissions and transaction

costs.• & cross rate is an exchange rate between two currencies, calculated from their common

relationship with a third currency.

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W' () *+,)-./ E02/.) M2,3)( -4 U/-6)?

• its huge trading volume representing the largest asset class in the world leading tohigh

li<uidity;

• its geographical dispersion;

• its continuous operation= ?@ hours a day except weekends, i.e. trading from ?A=0 87'

on$unday until ??=AA 87' riday;

• 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 si:e.

• &s such, it has been referred to as the market closest to the ideal of perfect

competition,notwithstanding currency intervention by central banks. &ccording to the

Bank for International$ettlements,as of &pril ?A0A, average dailyturnover in global

foreign exchange markets isestimated at C5.3D trillion, a growth of approximately ?AE

over the C5.?0 trillion daily volumeas of &pril ?AA4. $ome firms speciali:ing on foreign

exchange market had put the average dailyturnover in excess of "$C@ trillion.

• 'he C5.3D trillion break(down is as follows=

  C0.@3A trillion in spot transactions

C@4 billion in outright forwardsC0.4F trillion in foreign exchange swapsC@5 billion currency swapsC?A4 billion in options and other product.

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ADVANTAGES AND DISADVANTAGES OF

FOREIGN EXCHANGE MARKET

A2/(2.)4

• 'he forex market is extremely li<uid, hence its rapidly growing popularity. %urrencies

may be converted when bought or sold without causing too much movement in the price

and keeping losses to a minimum.

• &s there is no central bank, trading can take place anywhere in the world and operates on

a ?@(hour basis apart from weekends.

• &n investor needs only small amounts of capital compared with other investments. orex

trading is outstanding in this regard.

• It is an unregulated market, meaning that there is no trade commission over seeing

transactions and there are no restrictions on trade.

• In common with futures, forex is traded using a Ggood faith deposit rather than a loan.

'he interest rate spread is an attractive advantage.

D-422/(2.)4

 

• 'he ma)or risk is that one counterparty fails to deliver the currency involved in a very

large transaction. In theory at least, such a failure could bring ruin to the forex market asawhole.

• Investors need a lot of capital to make good profits because the profit margins on small(

scale trades are very low.

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V2,-+64 :2,(--:2/(4 O* *+,)-./ E02/.)

M2,3)(;G+),/<)/(4;  8overnments have re<uirements for foreign currency, such as paying

staff salaries and local bills for embassies abroad, or for arraigning a foreign currency credit line,

most often in dollars, for industrial or agricultural development in the third world, interest on

which ,as well as the capital sum, must periodically be paid. oreign exchange rates concern

governments because changes affect the value of product and financial instruments, whichaffects

the health of a nation’s markets and financial systems.

B2/34; 'here are different types of banks, all of which engage in the foreign exchange market to

greater or lesser extent. $ome work to signal desired movement in the market without causing

overt change, while some aggressively manage their reserves by making speculative risks. 'he

vast ma)ority, however, use their knowledge and expertise is assessing market trends for 

speculative gain for their clients

B,+3),-/. H+64)4= 'hese exist primarily to bring buyer and seller together at a mutually agreed price. 'he broker is not allowed to take a position and must act purely as a liaison. Brokers

receive a commission from both sides of the transaction, which varies according to currency

handled. 'he use of human brokers has decreased due mostly to the rise of the interbank 

electronic brokerage systems

I/(),/2(-+/2= M+/)(2,' M2,3)(= 'he International 7onetary 7arket 1I772 in %hicago trades

currencies for relatively small contract amounts for only four specific maturities a year.

riginally designed for the small investor, the I77 has grown since the early 034As, and the

ma)or banks, who once dismissed the I77, have found that it pays to keep in touch with its

developments, as it is often a market leader 

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M+/)' M2/2.),4= 'hese tend to be large !ew ork commission houses that are often very

aggressive players in the foreign exchange market. *hile they act on behalf of their clients, they

also deal on their own account and are not limited to one time :one, but deal around the world

through their agents.F. %orporations= %orporations are the actual end(users of the foreign

exchange market. *ith the exception only of the central banks, corporate players are the ones

who affect supply and demand. $ince the corporations come to the market to offset currency

exposure they permanently change the li<uidity of the currencies being dealt with.

R)(2-= C=-)/(4= 'his includes smaller companies, hedge funds, companies speciali:ing in

investment services linked by foreign currency funds or e<uities, fixed income brokers, the

financing of aid programs by registered worldwide charities and private individuals. -etail

investors trade foreign exchange using highly leveraged margin accounts. 'he amount of their 

trading in total volume and in individual trade amounts is dwarfed by the corporations andinter 

 bank markets.

 

C)/(,2= B2/3 

xternal value of the domestic currency is controlled and assigned by central bank of 

everycounty. ach country has a central or apex bank. or example In India -eserve Bank of 

Indiais the central Bank 

C+<<),-2= B2/3

%ommercial banks are the one which has the most number of branches. *ith its wide

 branchnetwork the %ommercial banks buy the foreign exchange and sell it to the importers.

'hese banks are the most active among the market players and also provide services like

convertingcurrency from one to another.

E02/.) B,+3),4

 $ervices of brokers are used to some extent, orex market has some practices and

traditiondepending on this the residing in other countries are utilised.Jocal brokers canconduct

orex transactions as per the rules and regulations of the orex governing body of their

respective country.

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O),4)24 F+,)0 <2,3)(

='he orexmarket operates all around the clock and the market day initiates with 'okyo

andfollowed by Bahrain $ingapore, India, rankfurt, 6aris, Jondon, !ew ork, and

$ydney before things are back with 'okyo the next day

S:)6=2(+,4

In order to make profit on the account of favourable exchange rate, speculators buy foreign

currency if it is expected to appreciate and sell foreign currency if it is expected to depreciate.

'hey follow the practice of delaying covering exposures and not offering a cover till the time

cash flow is materiali:ed.

 

O(), *-/2/-2= -/4(-(6(-+/4 involved in the foreign exchange market include=

 $tock brokers %ommodity

 irms Insurance

 %ompanies %harities

 6rivate Institutions

  6rivate Individuals

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 C2,2(),-4(-4 O* F+,)-./ E02/.) M2,3)(

C2/.-/. W)2=(;

'he ratios between the currencies of two countries are exchange rates in forex. If one currency

loss its value in the market and at the same time the value of the another currency increases this

causes the fluctuations in the exchange rate in foreign exchange market. or xample, over ?A

years ago a single "$ dollar bought 5FA apanese en, whereas at present0 "$ dollar buys 00A

apanese en; this explains that the apanese en has risen in value ,and the "$ dollar hasdecreased in value 1relative to the en2. 'his is said to be a shift in wealth, as a fixed amount of 

apanese en can now purchase many more goods than two decades ago

.

N+ C)/(,2=->) M2,3)(

'he foreign exchange market does not have a centrali:ed market like a stock exchange. Brokers

in the foreign exchange market are not approved by a governing agency. Business network and

operation market of foreign exchange takes place without any unification in transaction. oreign

exchange currency trading has been reformed into a non(formal and global network organi:ation

it consists of advanced information system. 'rader of forex should not be a member of any

organisation.

C-,6=2(-+/ +,3

oreign exchange market has member from all the countries, each country has differentgeo

graphical positions so forex operates all around the clock on working days 1i.e.2 7ondayto

riday every week. Because the time in &ustralia is different than in uropean countries, this

kind of ?@ hours operation, free from any time is an ideal environment for investors.

or instance, a trader may buy the apanese en in the morning at the !ew ork market, and in

the night if the apanese en rises in the Hong #ong market, the trader can sell in the Hong#ong

market. more number of opportunities are available for the forex traders. In -/ market most

trading takes place in only a few currencies; the ".$. +ollar 1C2, uropean

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%urrency "nit 1K2, apanese en 1L2, British 6ound $terling 1M2, $wiss ranc 1$f2, %anadian

+ollar 1%anC2, and to a lesser extent, the &ustralian and !ew Nealand +ollars

 F-/2/-2= I/4(,6<)/(4 +* *+,)-./ )02/.) <2,3)(S:+( M2,3)(

$pot market involves the <uickest transaction in the foreign exchange market. 'his involves

immediate payment at the current exchange rate is called as spot rate. 'he spot market accounts

for 0O5rdof all the currency exchange, trades in ederal -eserve that takes place within two days

of the agreement. 'he traders open to the volatility of the currency market, which can raise or 

lower the price between the agreement and the trade.

 F6(6,)4 M2,3)(

'hese kind transactions involve future payment and future delivery at an agreed exchange rate.

uture market contracts are standardi:ed, it is non(negotiable and the elements of the agreement

are set. It also takes the volatility of the currency market, specifically the spot market, out of the

e<uation. 'his type of market is popular for $teady return on their investment that is done on

large currency transactions.

F+,2, M2,3)(

the terms are negotiable between the two parties. 'he terms can be changes according to the

needs of the participants. It allows for more flexibility. 'wo entities swap currency for an agreed

amount of time, and then return the currency at the end of the contract.

S2: T,2/42(-+/4

In swap two parties are involves where they exchange the currencies for certain time and agree to

reserve the transaction at a later date. $wap is the most commonly used forward

transaction. In swap transaction it is not traded through the exchange and there is no

standardi:ation. "ntil the transaction is completed the deposit is re<uired to hold the position.

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F6/(-+/4 +* () F+,)-./ E02/.) M2,3)('he foreign exchange market is the mechanism by which a person of firm transfers purchasing

 power form one country to another, obtains or provides credit for international trade transactions,

and minimi:es exposure to foreign exchange risk.

T,2/4*), +* !6,24-/. !+),

'ransfer of one country to another and from one national currency to another is called the

transfer of purchasing power. International transactions normally involve different people from

countries with different national currencies. %redit instruments and bank drafts are used to

transfer the purchasing power this is one of the important function in forex. In forex the

transaction can only be done in one currency.

!,+-4-+/ +* ,)-( *+, *+,)-./ (,2)

 'he forex takes time to move the goods from a seller to buyer so the transaction must be

financed. oreign exchange market provides credit to the traders. %redit facility is need by

exporters when the goods are transited. 8oods some on the other need credit facility when this

kind of special credit facility is used the forex exchange department is extended to finance the

foreign trade

F+,)-./ E02/.) D)2=),4

oreign exchange dealers, deal both with interbank and client market. 'he profit of the dealers is

there buying at a bid price and sells it at a high price. *orldwide competitions among dealers

narrows the spread between bid and ask and so contributes to making the foreign exchange

market efficient in the same sense as securities markets. +ealers in the foreign exchange

departments of large international banks often function as market makers. 'hey stand willing to

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 buy and sell those currencies in which they speciali:e by maintaining an inventory position in

those currencies.

M-/-<->-/. F+,)-./ E02/.) R-43;  'he foreign exchange market provides PhedgingP

facilities for transferring foreign exchange risk to someone else.

T':)4 +* F+,)-./ E02/.) R2()4

;F=+2(-/. R2()4

loating rates is one of the primary reasons for fluctuation of currency in foreign

exchangemarket. 'his is one of the most important commonly and main type of exchange rate.

"nder this market force all the economies of developed countries allow there currency to

flowfreely. *hen the value of the currency becomes low it makes the imports more and

theexports are cheaper, so the countries domestic goods and services are demanded more

inforeign buyers. 'he country can withstand the fluctuation only if the economy is strong.

*hen the country’s economy is able to meet the demand then it can ad)ust between the

foreign trade and domestic trade automatically.

F-0) R2()4

ixed exchange rates are used to attract the foreign investments and to promote foreigntrade.'his type of rates is used only by small developed countries. By ixed exchange rates

thecountry assures the investors for the stable and constant value of investment in the country.

&monetary policy of the country becomes ineffective. In this type the exchange rates theimports

 become expensive. 'he exchange value of the currency does not move. 'his

normally reduces the country’s currency against foreign currencies.

!)..) R2()4

'his rate is between the floating rate and the fixed rate. 6egged rates appropriate more

for developed country. & country allows its currency to fluctuation to some extend for a

ad)ustedcentral value. 6egged allow some ad)ustments and stability. !o artificial rates are found

infixed and floating exchange rates. 6egged can fix the economic problem by itself and provide

growth opportunity also. *hen a fixed value is not maintains by the country it can’t follow

the fixed exchange rat

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F2(+,4 2**)(-/. M+)<)/( +* E02/.) R2()4

&side from factors such as interest rates and inflation , exchange rate is one of the most important

determinants of a countryQs relative level of economic health. xchange rates play a vital role in a

countryQs level of trade, which is critical to every free market economy in the world. or this

reason, exchange rates are among the most watched ,analy:ed and governmentally manipulated

economic measures. But exchange rates matter on a smaller scale as well= they impact the real

return of an investorQs portfolio. Here we look at some of the ma)or forces behind exchange rate

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

affect a nationQs trading relationships with other nations. & higher currency makes a countryQs

exports  more expensive and imports  cheaper in foreign markets; a lower currency makes a

countryQs exports cheaper and its imports more expensive in foreign markets. & higher exchange

rate can be expected to lower the countryQs  balance of trade, while a lower exchange rate would

increase it. !umerous factors determine exchange rates, and all are related to the trading

relationship between two countries. -emember, exchange rates are relative, and are expressed as

a comparison of the currencies  of two countries. 'he following are some of the principal

determinants of the exchange rate between two countries. !ote that these factors are in no

 particular order; like many aspects of economics ,the relative importance of these factors is

sub)ect to much debate.

D-**),)/(-2=4 -/ I/*=2(-+/

 &s 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. +uring the last half of the

twentieth century, the countries with low inflation included apan ,8ermany and $wit:erland,

while the ".$. and %anada achieved low inflation only later. 'hose countries with higher 

inflation typically see depreciation in their currency in relation to the currencies of their trading

 partners. 'his is also usually accompanied by higher interest rates.

D-**),)/(-2=4 -/ I/(),)4( R2()4

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Interest rates, inflation and exchange rates are all highly correlated. 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. 'herefore, higher interest rates attract foreign capital and

cause the exchange rate to rise. 'he impact of higher interest rates is mitigated, however, if 

inflation in the country is much higher than in others, or if additional factors serve to drive the

currency down. 'he opposite relationship exists for decreasing interest rates ( that is, lower 

interest rates tend to decrease exchange rates.

 

C6,,)/(@A+6/( D)*--(4

'he 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. & 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

re<uires more foreign currency than it receives through sales of exports, and it supplies more of 

its own currency than foreigners demand for its products. 'he excess demand for foreign

currency lowers the countryQs exchange rate until domestic goods and services are cheap enough

for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

!6=- D)(

%ountries will engage in large(scale deficit financing to pay for public sector pro)ect sand

governmental funding. *hile such activity stimulates the domestic economy ,nations with large

 public deficits and debts are less attractive to foreign investors. 'he reasonR & 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.

 In the worst case scenario, a government may print money to pay part of a large debt, but

increasing the money supply inevitably causes inflation. 7oreover, if a government is not able to

service its deficit through domestic means 1selling domestic  bonds, increasing the money

supply2, then it must increase the supply of securities for sale to foreigners, thereby lowering

their prices. inally, a large debt may prove worrisome to foreigners if they believe the country

risks defaulting on its obligations. oreigners will be less willing to own securities denominated

in that currency if the risk of default is great. or this reason, the countryQs debt rating 1as

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determined by 7oodyQs or  $tandard S 6oorQs,  for example2 is a crucial determinant of its

exchange rate

.

T),<4 +* T,2)

'rade of goods and services between countries is the ma)or reason for the demand and supply of 

foreign currencies. & 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 countryQs 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 countryQs exports. 'his, in turn, results in rising revenues

from exports, which provides increased demand for the countryQs currency 1and an increase in the

currencyQs value2. If the price of exports rises by a smaller rate than that of its imports, the

currencyQs value will decrease in relation to its trading partners. 'his is a typical case for 

underdeveloped countries which rely on imports for development needs. 'he current account

 balance1deficit or surplus2 thus reflects the strength and weakness of the domestic currency.

F. undamental actors vi:. 6olitical $tability and conomic 6erformance

undamental factors include all such events that affect the basic economic and fiscal policies of 

the concerned government. 'hese factors normally affect the long(term exchange rates of any

currency. n short(term basis on many occasions, these factors are found to be rather inactive

unless the market attention has turned to fundamentals. However, in the long run exchange rates

of all the currencies are linked to fundamental causes. 'he fundamental factors are basic

economic policies followed by the government in relation to inflation, balance of payment

 position, unemployment ,capacity utili:ation, trends in import and export, etc. !ormally, other 

things remaining constant the currencies of the countries that follow the sound economic policies

will always be stronger. $imilar for the countries which are having balance of payment surplus,

the exchange rate will always be favourable. %onversely, for countries facing balance of payment

deficit, the exchange rate will be adverse. %ontinuous and ever growing deficit in balance of 

 payment indicates over valuation of the currency concerned and the dis(e<uilibrium created can

 be remedied through devaluation. oreign investors inevitably seek out stable countries with

strong economic performance in which to invest their capital. & country with such positive

attributes will draw investment funds away from other countries perceived to have more political

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and economic risk. 6olitical turmoil, for example, can cause a loss of confidence in a currency

and a movement of capital to the currencies of more stable countries.

!+=-(-2= 2/ !4'+=+.-2= *2(+,4

6olitical and psychological factors are believed to have an influence on exchange rates.7any

currencies have a tradition of behaving in a particular way for e.g. $wiss ranc asa refuge

currency. 'he "$ +ollar is also considered a safer haven currency whenever there is a political

crisis anywhere in the world.

 S:)6=2(-+/

$peculation or the anticipation of the market participants many a times is the prime reason for 

exchange rate movements. 'he total foreign exchange turnover worldwide is many times the

actual goods and services related turnover indicating the grip of speculators over the market.

'hose speculators anticipate the events even before the actual data is out and position themselves

accordingly in order to take advantage when the actual data confirms the anticipations. 'he

initial positioning and final profit taking make exchange rates volatile. 'hese speculators many

times concentrate only on one factor affecting the exchange rate and as a result the market

 psychology tends to concentrate only on that factor neglecting all other factors that have e<ual

 bearing on the exchange rate movement. "nder these circumstances even when all other factors

may indicate negative impact on the exchange rate of the currency if the one factor that the

market is concentrating comes out positive the currency strengthens.

 C2:-(2= M+)<)/(

'he phenomenon of capital movement affecting the exchange rate has a very recent origin. Huge

surplus of petroleum exporting countries due to sudden spurt in the oil prices could not be

utili:ed by these countries for home consumption entirely and needed to be invested elsewhere

 productively. 7ovement of these petro dollars, started

affecting the exchange rates of various currencies. %apital tended to move from lower yielding to

higher yielding currencies and as a result the exchange rates moved. International investments in

the form of oreign direct investment 1+I2 and oreign institutional investments 1II2 have

 become the most important factors affecting the

exchange rate in today’s open world economy. %ountries which attract large capital

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inflows through foreign investments, will witness an appreciation in its domestic currency as its

demand rises. utflow of capital would mean a depreciation of domestic currency.

I/(),)/(-+/

xchange rates are also influenced in no small measure by expectation of changes in regulation

relating to exchange markets and official intervention. fficial intervention can smoothen an

otherwise disorderly market but it is also the experience that if the authorities attempt half(

heartedly to counter the market sentiments through intervention in the market, ultimately more

steep and sudden exchange rate swings can occur. In the second <uarter of 03D the movement of 

exchange rates of ma)or currencies reflected the change in the "$ policy in favour of co(

ordinated exchange market intervention as a measure to bring down the value of dollar.

S(+3 E02/.) O:),2(-+/4

$tock exchange operations in foreign securities, debentures, stocks and shares, influence the

demand and supply of related currencies, thus influencing their exchange rate

.

!+=-(-2= F2(+,4

6olitical scenario of the country ultimately decides the strength of the country. $table efficient

government at the centre will encourage positive development in the country, creating successf ul

investor confidence and a good image in the international market. &n economy with a strong,

 positive image will obviously have a strong domestic currency. 'his is the reason why

speculations rise considerably during the parliament elections, with various  predictions of the

future government and its policies. In 033D,the Indian rupee depreciated against the dollar due to

the &merican sanctions after India conducted the 6okharan nuclear test

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.

O(),4

'he turnover of the market is not entirely trade related and hence the funds placed at the disposal

of foreign exchange dealers by various banks, the amount which the dealers can raise in various

ways, banksQ attitude towards keeping open position during the course of a day, at the end of the

day, on the eve of weekends and holidays ,window dressing operations as at the end of the half 

year to year, end of the month considerations to cover operations for the returns that the banks

have to submit the central monetary authorities etc. ( all affect the exchange rate movement of 

the currencies. Talue of a currency is thus not a simple result of its demand and supply, but a

complex mix of multiple factors influencing the demand and supply.

It’s a tight rope walk for any

country to maintain a strong, stable currency, with policies taking care of conflicting demands

like inflation and export promotion, welcoming foreign investments and avoiding an appreciation

of the domestic currency, all at the same time.

 

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!=2'),4 -/ F+,)-./ E02/.) M2,3)(

& key goal of exchange rate economics is to understand currency returns. xchange rates

like asset prices more generally move in response to new information about their fundamental

value. ver the past decade microstructure research has revealed

that this Uprice discovery process involves different categories of market participants. ach‖

 participant’s distinct role is determined by 1a2 whether the agent

is a li<uidity maker or taker, and 1b2 the extent to which the agent is informed. 'he original /

market participants were traders in goods and services. %urrencies came into existence because

they solved the problem of the coincidence of wants with

respect to goods. 7ost countries have their own currencies so international trade in goods

re<uires trade in currencies. 'he motives for currency exchange have expanded over the

centuries to include speculation, hedging, and arbitrage with the list of key players expanding

accordingly. Beyond importers and exporters, the ma)or categories of market participants now

include asset managers, dealers, central banks, small individual 1retail2 traders, and most recentlyhigh(fre<uency traders.

'he orex over the counter market is formed by different participants

with varying needs and interests that trade directly with each other. 'hese participants can be

divided in two groups= the interbank market and the retail market.

T) I/(),2/3 M2,3)(

'he interbank market designates orex transactions that occur between central banks,

commercial banks and financial institutions.

 

C)/(,2= B2/34

 !ational central banks 1such as the "$ ed, the %B, -.B.I.2play an important role in the orex

market. &s principal monetary authority, their role consists in achieving price stability and

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economic growth. 'heir main purpose is to provide ade<uate trading conditions. 'o do so, they

regulate the entire money supply in the economy by setting interest rates and reserve

re<uirements. 'hey also manage the countryQs foreign exchange reserves that they can use in

order to influence market conditions and exchange rates. %entral banks intervene in economic or 

financial imbalance in the foreign exchange market.  %entral banks are also responsible for 

stabili:ing the forex market. 'hey do this by balancing the countryQs foreign exchange reserves.

In addition, they also have official target rates for the currencies that they are handling. Because

of this role, central banks are sometimes )okingly referred to as circus performers because of the

daily balancing act that they have to perform. 'heir intervention in the foreign exchange market

is not to earn profit from foreign currency trading.

 

C+<<),-2= B2/34

'raditionally known as a savings and lending institution, banks are certainly one of the ma)or 

 players in forex market. 'hey are the natural players in foreign exchange as all other participants

must deal with them. oreign exchange currency trading began as an added service to deposits

and loans offered by commercial banks. Banks are usually involved in both large <uantities of 

speculative trading and also daily commercial turnover. 'he really big and well(established

 banks trade in the billions of dollars in foreign currencies every day. %ommercial banks provide

li<uidity to the orex market due to the trading volume they handle every day. $ome of this

trading represents foreign currency conversions on behalf of customersQ needs while some is

carried out by the banksQ proprietary trading desk for speculative purpose. 'he profitability

of foreign exchange trading is a perfect characteristic for banks to be involved

 

F-/2/-2= I/4(-(6(-+/4

 inancial institutions such as money managers, investment funds, pension funds and brokerage

companies trade foreign currencies as part of their obligations to seek the best investment

opportunities for their clients. or example, a manager of an international e<uity portfolio will

have to engage in currency trading in order to buy and sell foreign stocks.

 

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T) R)(2-= M2,3)(

'he retail market designates transactions made by smaller speculators and investors .'hese

transactions are executed through orex brokers who act as a mediator between the retail market

and the interbank market. 'he participants of the retail market are investment firms, hedge funds,

corporations and individuals O retail forex brokers and speculators..

 

I/)4(<)/( F-,<4

 Investment management firms commonly manage huge accounts on behalf of their clients such

as endowments and pension funds. $ometimes, these investments re<uire the exchange of foreign

currencies so they have to facilitate these transactions through the use of the foreign exchange

market. 'hese situations exist because there are basically no limitations to the nationalities of 

customers that an investment firm can attract. 'herefore, investment managers with an

international e<uity portfolio, needs to purchase and sell several pairs of foreign currencies to

 pay for foreign securities purchases

 

H).) F6/4

 Hedge funds are private investment funds that speculate in various assets classes using leverage.

7acro Hedge unds pursue trading opportunities in the orex 7arket. 'hey design and execute

trades after conducting a macroeconomic analysis that reviews the challenges affecting acountry

and its currency. +ue to their large amounts of li<uidity and their aggressive strategies, they are a

ma)or contributor to the dynamics of orex 7arket.

 

C+,:+,2(-+/4

'hey represent the companies that are engaged in importOexport activities with foreign

counterparts. 'heir primary business re<uires them to purchase and sell foreign currencies in

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exchange for goods, exposing them to currency risks. 'hrough the orex market, they convert

currencies and hedge themselves against future fluctuations. Initially, they were not interested in

foreign exchange trading, but the trend of companies going international and tight competition

amongst them made them think twice

.

 

I/--62=4 R)(2-= F+,)0 B,+3),4

  Individual traders or investors trade orex on their own capital in order to profit from

speculation on future exchange rates

'hey mainly operate through orex platforms that offer tight spreads, immediate execution and

highly leveraged margin accounts. 'hese can be individuals or groups of individuals. 'hey

handle a fraction of the total volume of the entire forex market, but do not let that fool you. &

single retail forex broker estimate retail volume of between ? to A billion dollars each day.

'heir volume is estimated to make up ?E of the total market volume.

 

S:)6=2(+,4

& person, who trades in currencies with a higher than average risk in return for higher than

average profit potential. 'hese are the individuals or private investors who purchase and sell

foreign currencies and profit through fluctuations on their price. $peculators are a PhardyP bunch

simply because they are more adept at handling and maybe even sidestepping risks that

regular investors would prefer not to be involved with. $peculators take large risks, especially

with respect to anticipating future price movements, in the hope of making <uick large gains.

$peculators are risk(taking investors with expertise in the market1s2 in which they are trading and

will usually use highly leveraged investments such as futures and options

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FOREIGN EXCHANGE RISK 

oreign exchange risk 1also known as exchange rate risk or currency risk2 is a financial risk  

 posed by an exposure to unanticipated changes in the exchange rate between two currencies.

Investors and multinational businesses exporting or importing goods and services or making

foreign investments throughout the global economy are faced with an exchange rate risk which

can have severe financial conse<uences if not managed appropriately. 7any businesses were

unconcerned with and did not manage foreign exchange risk under the Bretton *oods system of

international monetary order. It wasnQt until the onset of floating exchange rates following the

collapse of the Bretton *oods system that firms perceived an increasing risk from exchange rate

fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge

their exposure. 'he outbreak of currency crises in the 033As and early ?AAAs, such as the

7exican peso crisis, &sian currency crisis, 033D -ussian financial crisis, and the &rgentine peso

crisis, substantial losses from foreign exchange have led firms to pay closer attention to foreign

exchange risk.

MANAGEMENT

7anagers of multinational firms employ a number of foreign exchange hedging strategies in

order to protect against exchange rate risk. 'ransaction exposure is often managed either with the

use of the money markets, foreign exchange derivatives such as forward contracts, futures

contracts, options, and swaps, or with operational techni<ues such as currency invoicing, leading

and lagging of receipts and payments, and exposure netting.

irms may exercise alternative strategies to financial hedging for managing their economic or

operating exposure, by carefully selecting production sites with a mind for lowering costs, using

a policy of flexible sourcing in its supply chain management, diversifying its export market

across a greater number of countries, or by implementing strong research and development

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activities and differentiating its products in pursuit of greater inelasticity and less foreign

exchange risk exposure.

'ranslation exposure is largely dependent on the accounting standards of the home country and

the translation methods re<uired by those standards. or example, the "nited $tates ederal

&ccounting $tandards Board specifies when and where to use certain methods such as the

temporal method and current rate method. irms can manage translation exposure by performing

a balance sheet hedge. $ince translation exposure arises from discrepancies between net assets

and net liabilities on a balance sheet solely from exchange rate differences. ollowing this logic,

a firm could ac<uire an appropriate amount of exposed assets or liabilities to balance any

outstanding discrepancy. oreign exchange derivatives may also be used to hedge against

translation exposure.

MEASUREMENT

If foreign exchange markets are efficient such that purchasing power parity, interest rate parity,

and the international isher effect hold true, a firm or investor neednQt protect against foreign

exchange risk due to an indifference toward international investment decisions. & deviation from

one or more of the three international parity conditions generally needs to occur for an exposure

to foreign exchange risk.

inancial risk is most commonly measured in terms of the variance or standard deviation of a

variable such as percentage returns  or rates of change. In foreign exchange, a relevant factor 

would be the rate of change of the spot exchange rate between currencies. Tariance represents

exchange rate risk by the spread of exchange rates, whereas standard deviation represents

exchange rate risk by the amount exchange rates deviate, on average, from the mean exchange

rate in a probability distribution. & higher standard deviation would signal a greater currency

risk. conomists have critici:ed the accuracy of standard deviation as a risk indicator for its

uniform treatment of deviations, be they positive or negative, and for automatically s<uaring

deviation values. &lternatives such as average absolute deviation  and semivariance  have been

advanced for measuring financial risk.

VALUE AT RISK 

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6ractitioners have advanced and regulators have accepted a financial risk management techni<ue

called value at risk  1T&-2, which examines the tail end of a distribution of returns for changes in

exchange rates to highlight the outcomes with the worst returns. Banks in urope have been

authori:ed by the Bank for International $ettlements to employ T&- models of their own design

in establishing capital re<uirements for given levels of market risk . "sing the T&- model helps

risk managers determine the amount that could be lost on an investment portfolio over a certain

 period of time with a given probability of changes in exchange rates.

TY!ES OF FOREIGN EXCHANGE RISK 

T,2/42(-+/ E0:+46,)

& firm has transaction exposure whenever it has contractual cash flows 1receivables and

 payables2 whose values are sub)ect to unanticipated changes in exchange rates due to a contract

 being denominated in a foreign currency. 'o reali:e the domestic value of its foreign(

denominated cash flows, the firm must exchange foreign currency for domestic currency. &s

firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign

exchange market with exchange rates constantly fluctuating, the firms face a risk of changes inthe exchange rate between the foreign and domestic currency. It refers to the risk associated with

the change in the exchange rate between the time an enterprise initiates a transaction and settles

it.

E+/+<- E0:+46,)

& firm has economic exposure 1also known as operating exposure2 to the degree that its market

value is influenced by unexpected exchange rate fluctuations. $uch exchange rate ad)ustments

can severely affect the firmQs market share position with regards to its   competitors, the firmQs

future cash flows, and ultimately the firmQs value. conomic exposure can affect the present

value of future cash flows. &ny transaction that exposes the firm to foreign exchange risk also

exposes the firm economically, but economic exposure can be caused by other business activities

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T,2/4=2(-+/ E0:+46,)

& firmQs translation exposure is the extent to which its financial reporting is affected by exchange

rate movements. &s all firms generally must prepare consolidated financial statements for 

reporting purposes, the consolidation process for multinationals entails translating foreign assets

and liabilities or the financial statements of foreign subsidiary subsidiaries from foreign to

domestic currency. *hile translation exposure may not affect a firmQs cash flows, it could have a

significant impact on a firmQs reported earnings and therefore its stock price. 'ranslation

exposure is distinguished from transaction risk as a result of income and losses from various

types of risk having different accounting treatments.

C+/(-/.)/( )0:+46,)

& firm has contingent exposure when bidding for foreign pro)ects or negotiating other contractsor foreign direct investments. $uch an exposure arises from the potential for a firm to suddenly

face a transactional or economic foreign exchange risk, contingent on the outcome of some

contract or negotiation. or example, a firm could be waiting for a pro)ect bid to be accepted by a

foreign business or government that if accepted would result in an immediate receivable. *hile

waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that

receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a

transaction exposure, so a firm may prefer to manage contingent exposures.

F+,)-./ E02/.) M2,3)( I/ I/-2

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'he foreign exchange market India is growing very rapidly. 'he annual turnover of the market is

more than C@AA billion. 'his transaction does not include the inter(bank transactions. &ccording

to the record of transactions released by -BI, the average monthly turnover in the merchant

segment was C@A. billion in ?AA5(A@ and the inter(bank transaction was C05@.? for the same

 period.

.'he foreign exchange market India is growing very rapidly. 'he annual turnover of the market is

more than C@AA billion. 'his transaction does not include the inter(bank transactions. &ccording

to the record of transactions released by -BI, the average monthly turnover in the merchant

segment was C@A. billion in ?AA5(A@ and the inter(bank transaction was C05@.? for the same

 period.

.'he average total monthly turnover was about [email protected] billion for the same period. 'he

transactions are made on spot and also on forward basis, which include currency swaps and

interest rate swaps.

'he Indian foreign exchange market consists of the buyers, sellers ,market intermediaries and the

monetary authority of India. 'he main center of foreign exchange transactions in India is

7umbai, the commercial capital of the country. 'here are several other centers for foreign

exchange transactions in the country including #olkata, !ew +elhi, %hennai, Bangalore,

6ondicherry and %ochin.

'he foreign exchange market India is regulated by the reserve bank of India through the

xchange %ontrol +epartment. &t the same time, oreign xchange +ealers

&ssociation1voluntary association2 also provides some help in regulating the market. 'he

&uthori:ed +ealers 1&uthori:ed by the -BI2 and the accredited brokers are eligible to participate

in the foreign xchange market in India. *hen the foreign exchange trade is going on between

&uthori:ed +ealers and -BI or between the &uthori:ed +ealers and the verseas banks, the

 brokers have no role to play.

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.&part from the &uthori:ed +ealers and brokers, there are some others who are provided with

there stricted rights to accept the foreign currency or travelers che<ue. &mong these, there are the

authori:ed money changers, travel agents, certain hotels and government shops. 'he I+BI and

xim bank are also permitted conditionally to hold foreign currency.

'he whole foreign exchange market in India is regulated by the oreign xchange 7anagement

&ct, 0333 or 7&. Before this act was introduced, the market was regulated by the -& or

oreign xchange -egulation &ct ,03@4. &fter independence, -& was introduced as a

temporary measure to regulate the inflow of the foreign capital. But with the economic and

industrial development, the need for conservation of foreign currency was felt and on there

commendation of the 6ublic &ccounts %ommittee, the Indian government passed the oreign

xchange -egulation &ct,0345 and gradually, this act became famous as 7&

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CONCLUSION

'he foreign monetary exchange market is the biggest financial market in the world. Bigger than

the !ew ork $tock xchange and utures 7arket combined. &nd with reduced Pbuy(inP limitsnow, even small(time players can )oin the orex trading marketplace. 'hat doesnQt mean

everyone should )oin, however. Buying an auto(trading program sold to you with the promise of

making you millions probably wonQt. In fact, it may cost you everything you own. 'he only way

to win in orex trading is the good, old(fashioned way ( hard work

andasolidunderstandingofthemarket.

ne has to be clued in to global developments, trends in world trade as well as economic

indicators of different countries. 'hese include 8+6 growth, fiscal and monetary policies,

inflows and outflows of the currency, local stock market performance and interest rates.

'he currency derivatives market is highly leveraged. In the stock futures market, a ?AE margin

gains a five(fold leverage. In forex futures, the margin payable is )ust 5E, so the leverage is 55

times. 'his means that even a 0E change can wipe out a third of the investment. However, the

Indian currency markets are well(regulated and there is almost no counter(party risk. Investors

should start small and gradually invest more.

ne has to be clued in to global developments, trends in world trade as well as economic

indicators of different countries. 'hese include 8+6 growth, fiscal and monetary policies,

inflows and outflows of the currency, local stock market performance and interest rates.

'he currency derivatives market is highly leveraged. In the stock futures market, a ?AE margin

gains a five(fold leverage. In forex futures, the margin payable is )ust 5E, so the leverage is 55

times. 'his means that even a 0E change can wipe out a third of the investment. However, the

Indian currency markets are well(regulated and there is almost no counter(party risk. Investors

should start small and gradually invest more.

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Jiberali:ation has transformed India’s external sector and a direct beneficiary of this has been the

foreign exchange market in India. rom a foreign exchange(starved, control(ridden economy,

India has moved on to a position of C0A billion plus in international reserves with a confident

rupee and drastically reduced foreign exchange control. &s foreign trade and cross(border capital

flows continue to grow, and the country moves towards capital account convertibility, the foreign

exchange market is poised to play an even greater role in the economy, but is unlikely to be

completely free of -BI interventions any time soon.

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REFERENCES

http=OOwww.slashdocs.comOkvuttxOfem.htm

http://www.travelspk.com/forex/Forex-evelopme!t-"#stor$.htm

http://www.%lo&al-v#ew.com/forex-e'(cat#o!/forex-lear!#!%/%ftfxh#st.html

http=OOen.wikipedia.orgOwikiOoreignVexchangeVrisk