WHAT IS FOREIGN EXCHANGEForeign exchange is the mechanism by which

the currency of one country gets converted into the currency of another country.

The conversion of currency is done by the banks who deal in foreign exchange. These banks maintain stocks of one currencies in the form of balances with banks

Contd……It also refers to the stock of foreign currencies and

other foreign assets. The foreign exchange management ACT 1999 defines “Foreign exchange means foreign currency and includes…

(a) Deposits credits and balances payable in any foreign currency.

(b) Draft traveler’s cheques, letter or credit or bills of exchange expressed or drawn in Indian currency but payable in any foreign currency.

(c) Drafts travelers cheques, letter of credit or bills of exchange drawn by banks, institution or persons outside India, but payable in Indian currency

Nature of foreign exchangeVolatile, affected by hedger, arbitrager, speculator. Affected by demand and supply. Affected by rate of interest. Affected by balance of payment surplus and deficit. Affected inflation rate. Spot and forward rates are different. Affected by the economic stability of the country. Affected by the fiscal policy of the government. Affected by the political condition of the country.It can be quoted directly or indirectly

Exchange Rate►Fixed Exchange Rate SystemFixed rates provide greater certainty for

exporters and importers. ►Flexible Exchange Rate SystemFlexible exchange rate or floating exchange

rates change freely and are determined by trading in the forex market. 

FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE MARKETA foreign exchange market refers to buying

foreign currencies with domestic currencies and selling foreign currencies for domestic currencies

According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid claim on foreign money"

FOREIGN EXCHANGE MARKET STRUCTURE

Market SegmentsForeign exchange market activity takes place

onshore with many countries prohibiting onshore entities from undertaking the operations in offshore markets for their currencies. It is the central bank, or professional dealers association, which normally issues the code of conduct (Canales-Kriljenko, 2004).In auction markets, an auctioneer or auction mechanism allocates foreign exchange by matching supply and demand orders.

The Foreign Exchange Market for Beginners► The foreign exchange market or forex market as it is

often called is the market in which currencies are traded. ► Currency Trading is the world’s largest market

consisting of almost trillion in daily volumes and as investors learn more and become more interested, market continues to rapidly grow.

► All trades that take place in the foreign exchange market involve the buying of one currency and the selling of another currency simultaneously. This is because the value of one currency is determined by its comparison to another currency.

► The first currency of a currency pair is called the “base currency,” while the second currency is called the counter currency.

Contd….►Foreign exchange Capital Markets (FXCM) is an

online currency trading firm that offers a free demo account to traders who are new and interested in the foreign exchange market.

►Registering for a demo account allows a new trader to download the online trading platform that is used by the company’s clients trading live accounts and make trades as if they were doing it with real money.

►NB You can try opening a demo account using this link http://www.forex.com/uk/forex_demo_thanks.html

How to go about getting a demo account You can try opening a demo account using this link

http://www.forex.com/uk/forex_demo_thanks.html

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Characteristics of foreign exchange market1. It has huge trading volume representing the

largest asset class in the world leading to high liquidity;

2. It has wide geographical dispersion;3. It’s a 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);

4. the variety of factors that affect exchange rates;5. the use of leverage to enhance profit and loss

margins and with respect to account size6. low margins of relative profit compared with other

markets of fixed income

FUNCTIONS OF FOREIGN EXCHANGE MARKET1. Transfer of Purchasing Power /Clearing

Function-The basic function of the foreign exchange market is to facilitate the conversion of one currency into another

2. Credit Function-The foreign exchange market also provides credit to both national and international, to promote foreign trade

3. Hedging Function-By hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange rates. foreign exchange market tries to protect the interest of the persons dealing in the market from any unforseen changes in exchange rate

PARTICIPANTS / DEALERS IN FOREIGN EXCHANGE MARKET

1. Retail Clients- They deal through commercial banks and authorised agents. They comprise people, international investors, multinational corporations and others who need foreign exchange.

2. Commercial Banks- Commercial banks carry out buy and sell orders from their retail clients and of their own account. They deal with other commercial banks and also through foreign exchange brokers.

PARTICIPANTS / DEALERS IN FOREIGN EXCHANGE MARKET cont…..3. Foreign Exchange Brokers- Each foreign

exchange market centre has some authorized brokers. Brokers act as intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers.

4. 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.

TYPES OF FOREIGN EXCHANGE MARKET

1. Retail Market - The retail market is a secondary price maker. Here travellers, tourists and people who are in need of foreign exchange for permitted small transactions, exchange one currency for another.

2. Wholesale Market-The wholesale market is also called interbank market. The size of transactions in this market is very large. Dealers are highly professionals and are primary price makers. The main participants are Commercial banks, Business corporations and Central banks. Multinational banks are mainly responsible for determining exchange rate.

Contd……3. Other Participantsa)Brokers- Brokers have more information and

better knowledge of market. They provide information to banks about the prices at which there are buyers and sellers of a pair of currencies. They act as middlemen between the price makers

b)Price Takers - Price takers are those who buy foreign exchange which they require and sell what they earn at the price determined by primary price makers.

Operation of foreign exchange market:Foreign exchange market operates either as:-1. Spot Market: (Current Market)-Spot market for foreign

exchange is that market which handles only spot transaction or current transactions.

 Principle characteristics:- Spot Market is of daily nature. It does not trade in future

deliveries. Spot rate of exchange is that rate which happens to

prevail at the time when transactions are incurred.

Contd….2. Forward Market: -Forward Market for foreign exchange

is that market which handles such transaction of foreign exchange as are meant for future delivery.

Principles Characteristics:- It only caters to forward transaction. It determines forward exchange rate at which forward

transaction are to be honored.

Factors Influencing Forward Exchange Rate

a) Interest rates.b) Degree of speculation in foreign

exchange market.c) Inflation rated) Foreign investor’s confidence in

domestic country.e) Economic situation in the countryf) Political situation in the country.g) Balance of payments position etc.

Top 10 Currency Traders as on May 2012

Top 10 Most traded currenciesRank Currency

ISO 4217 code(Symbol)

 % daily share(April 2013)

1 United States dollar

USD ($) 87.0%

2  Euro EUR (€) 33.4%

3  Japanese yen JPY (¥) 23.0%

4  Pound sterling GBP (£) 11.8%

5 Australian dollar

AUD ($) 8.6%

6  Swiss franc CHF (Fr) 5.2%

7 Canadian dollar

CAD ($) 4.6%

8  Mexican peso MXN ($) 2.5%

9  Chinese yuan CNY (¥) 2.2%

10 New Zealand dollar

NZD ($) 2.0%

Trend in the global forex marketAccording to the Bank for International Settlements,[the

preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010 and $3.3 trillion in April 2007. Foreign exchange swaps were the most actively traded instruments in April 2013, at $2.2 trillion per day, followed by spot trading at $2.0 trillion.

According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.

Contd…….The $3.98 trillion break-down is as follows:$1.490 trillion in spot transactions$475 billion in outright forwards$1.765 trillion in foreign exchange swaps$43 billion currency swaps$207 billion in options and other products

Merits and Demerits of foreign Exchange marketAdvantagesThe forex market is extremely liquid, hence its rapidly

growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum.

As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis apart from weekends.

An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in this regard.

It is an unregulated market, meaning that there is no trade commission overseeing transactions and there are no restrictions on trade.

Contd….In common with futures, forex is traded using a

“good faith deposit” rather than a loan. The interest rate spread is an attractive advantage.

DemeritsThe major 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 as a whole.

Investors need a lot of capital to make good profits because the profit margins on small-scale trades are very low.

CURRENCY TRADING RULES

Plan your trade and trade your plan.The trend is your friend.Focus on capital preservation.Know when to cut loss.Take profit when trade is good.Be emotionlessNot trade based on a tip from a friend or a

brocker.

Mistakes of Foreign exchange TradersTrading Out of Boredom or AngerHaving Unrealistic Expectations.Taking Highly Correlated Trades.Failing to Use a Stop.Taking Unnecessary Risks.Being Too Patient With Losers and Not

Patient Enough With Winners.Being a “Possum Trader”.

Referenceshttp://www.bloomberg.com http://research.stlouisfed.org/fredhttp://www.imf.orgArcher, Michael Duane. Getting Started in

Currency Trading: Winning in Today’s Market. 4th ed. Hoboken, NJ: Wiley, 2012.

Chen, James. Essentials of Foreign Exchange Trading. Hoboken, NJ: Wiley, 2009.