FOREIGN EXCHANGE MARKETPrepared By

Ms.Navneet Kaur Bhatia

FOREIGN EXCHANGE

• Foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another country.

• Foreign exchange rate is simply the ratio of a unit of currency of one country to a unit of currency of another country at the time of sell or buy transaction.

Introduction• FEM is the largest financial market in the world.

• Leading centers are London, NewYork, Paris, Zurich, Tokyo, Milan and Frankfurt.

• Trading in FEM is usually done 24 hours.

• It includes coins, notes and bank deposits and also a variety of highly liquid claims denominated in foreign currency.

• It operates on very narrow spread.

Characteristics of FEM

• FEM is described as an OTC market.• Largest financial market in the world.• 24 hours market.• Operating throughout different time zones of the

globe.• In India, it is open for the time banks are open for

their regular business.• It is very efficient market having highly developed

communications network.

Participants of FEM

• Corporates

• Commercial banks

• Exchange brokers; and

• Central banks

• Authorized Dealers

• Exchange Brokers

Structure of FEM

Retail Wholesale

Bank & Money Changer Inter-bank

CentralBank

Direct Indirect

Spot Forwards Derivatives

Merchandise Non-merchandise

Trading

• Trading is generally done by telephone or telex machine. Foreign exchange traders in each bank usually operate out of a separate foreign exchange trading room.

• Spot• Forward• Other derivatives Banks earn spread and

brokers earn commission through FEM operations

Different terms used in FEM

• Foreign Exchange Reserves (FER) FER is the surplus money or capital that a country parks or

maintains in the foreign country in form of currency, bond and other kind of securities.

•Transaction Costs • The bid-ask spread-that is, the spread between

bids and asks rates for a currency is based on the breadth and depth of the market for that currency as well as in the currency volatility.

• Devaluation• Depreciation

Exchange Rate System

• The exchange rate systems can be classified according to the degree by which exchange rates are controlled by the government.

• Fixed exchange rate system- exchange rates are either held constant or allowed to fluctuate only within the prescribed boundaries stipulated by the central bank.

• Floating exchange rate system- the exchange rates are determined by market forces without intervention by governments.

Arbitrage It is the exploitation of price differentials for risk less

guaranteed' profits. Buying low in one market and selling high in the other market • Financial Centre Arbitrage - This type of arbitrage ensures

that the dollar pound exchange rate quoted in New York will be the same as that quoted in London and other financial centres.

• If the exchange rate is $1.61/£1 in New York but only $1.59/£1 in London, it would be profitable for banks to buy pounds in London and simultaneously sell them in New York and make a guaranteed 2 cents on every pound bought and sold.

• The act of buying pounds in London will lead to depreciation of the dollar in London, while selling pounds in New York will lead to an appreciation of dollar in New York. Such a process continues until the quoted in the two centers coincides at say $1.60/£1.

Current Trends

• Foreign exchange reserves stood at USD 279.6 billion in April 2010 from USD 251.7 billion April 2009. This increase is subject to the recent surge in the foreign investments inflows.

• USD: US Dollar EUR: Euro • GBP: British Pound IEP: Irish Pound (Punt) • JPY: Japanese Yen CHF: Swiss Franc • CAD: Canadian Dollar AUD: Australian Dollar • DEM: Deutschemark SEK: Swedish Kroner • NLG: Dutch Guilder BEF: Belgian Franc • FRF: French Franc DKK: Danish Kroner • ESP: Spanish Peseta ITL: Italian Lira • INR: Indian Rupee SAR: Saudi Riyal