Foreign exchange rate impact (1)

Foreign exchange rate

A.VINOD ITM,BATCH :7

Coverage Foreign Exchange rate Functions of F X marketCharacteristics of F X marketIndian Foreign exchange systemTypes of TransactionsMarket Participants

Foreign exchange rate

An exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.

FX rate can be spot rate as well as forward rate.

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

The foreign exchange market is the mechanism by which participants:

transfer purchasing power between countries;

obtain or provide credit for international trade transactions, and

minimize exposure to the risks of exchange rate changes.

Functions of FX Market

Characteristics of FX Market

Largest of all financial markets with average daily turnover of over $2 trillion!

66% of all foreign exchange transactions involve cross-border counterparties.

Only 11% of daily spot transactions involve non-financial customers.

London is the largest FX market. US dollar involved in 87% of all

transactions.

Increasing Turnover

Daily foreign exchange market turnover in billions of US dollars

(Bank for International Settlements Triennial Central Bank Survey 2008)

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A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day.

The date of settlement is referred to as the value date.

Types of Transactions

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An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.

The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.

Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.

Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)

Types of Transactions

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A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

Both purchase and sale are conducted with the same counterparty.

Some different types of swaps are:spot against forward,forward-forward,nondeliverable forwards (NDF).

Types of Transactions

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The foreign exchange market consists of two tiers:the interbank or wholesale market (multiples of $1M

US or equivalent in transaction size), and the client or retail market (specific, smaller amounts).

Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

Market Participants

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Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.

They profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.

Dealers in the foreign exchange department of large international banks often function as “market makers.”

These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.

Market Participants

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Individuals (such as tourists) and firms (such as importers, exporters ) conduct commercial and investment transactions in the foreign exchange market.

Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose.

Some of the participants use the market to “hedge” their foreign exchange risk.

Market Participants

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Speculators and arbitragers seek to profit from trading in the market itself.

They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.

While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

Market Participants

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Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.

They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.

The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.

As willing loss takers, central banks and treasuries differ in motive from all other market participants.

Market Participants

Indian foreign exchange system

India’s FX rate system was on the fixed rate model till the 90s, when it was switched to floating rate model. Fixed FX rate is the rate fixed by the central bank against major world currencies like US dollar, Euro, GBP, etc. Like 1USD = Rs. 50. Floating FX rate is the rate determined by market forces based on demand and supply of a currency.