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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 10

VARIOUS PARTICIPANTSOF FOREIGN EXCHANGE MARKET 11

CHARACTERISICS OF FOREIGN EXCHANGE MARKET 14

FINANCIAL INSTRUMENTS OF FOREIGN EXCHANGE MARKET 15

FUNCTION OF FOREIGN EXCHANGE MARKET 16

TYPES OF FOREIGN EXCHANGE MARKET 17

FACTORS AFFECTING MOVEMENT OF EXCHANGE RATES 18

PLAYERS IN FOREIGN EXCHANGE MARKET 24

FOREIGN EXCHANGE RISK 28

FOREIGN EXCHANGE MARKET IN INDIA 32

CONCLUSION 34

REFERENCES 36

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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 in

the 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.

For 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. Normally, this system is adopted by most of the

advance countries like for example UK, US and Canada. All of these countries have a similarity

where their market is well developed and stable in economic terms. These 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. The reason behind this is because for floating

exchange rate, the market itself will re-adjust 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. For 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. Another form of exchange rate is known as pegged exchange rate. This 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. This 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. As a result, the value of the

pegged currency will not fluctuate unlike the floating currency. The 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. When 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. Due 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. Floating peg is the combination of the two main systems where one

country will normally fixed their exchange rate to the US Dollars and after that, they will

constantly review their peg rate in order to stay in line with the actual market value.

The Foreign exchange market, or commonly known as FOREX, is the largest and most prolific

financial market because each day, more than 1 trillion worth of currency exchange takes place

between investors, speculators and countries. From 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 just the tip of an iceberg.

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HISTORY

The foreign exchange market (fx or forex) as we know it today originated in 1973. However,

money has been around in one form or another since the time of Pharaohs. The Babylonians are

credited with the first use of paper bills and receipts, but Middle Eastern moneychangers were

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

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

These 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.

From the infantile stages of forex during the Middle Ages to WWI, the forex markets were

relatively stable and without much speculative activity. After WWI, the forex markets became

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

looked on as favorable by most institutions and the public in general. The Great Depression and

the removal of the gold standard in 1931 created a serious lull in forex market activity. From

1931 until 1973, the forex market went through a series of changes. These changes greatly

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

was little, if any.

1944 – Bretton Woods Accord is established to help stabilize the global economy after World

War II.

1971 Smithsonian Agreement established to allow for greater fluctuation band for currencies.

1972 European Joint Float established as the European community tried to move away from its

dependency on the U.S. dollar.

1973 Smithsonian Agreement and European Joint Float failed and signified the official switch to

a free-floating system.

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1978 The European Monetary System was introduced so other countries could try to gain

independence from the U.S. dollar.

1978 Free-floating system officially mandated by the IMF.

1993 European Monetary System fails making way for a world-wide free-floating system.

SUMMARY

The 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 minimizes exposure to foreign exchange risk.

A 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.

A foreign exchange rate is the price of a foreign currency. A foreign exchange quotation

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

The foreign exchange market consists of two tiers: the interbank or wholesale market,

and the client or retail market. Participants 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.

Transactions are effectuated either on a spot basis or on a forward or swap basis. A spot

transaction is for an (almost) immediate value date while a forward transaction is for a

value date somewhere in the future.

Quotations can be classified either as European and American terms or as direct and

indirect quotes.

In the real world, quotations include a bid-ask spread. A bid is the exchange rate in one

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

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

price and the ask price. This spread reflects the existence of commissions and transaction

costs.

A cross rate is an exchange rate between two currencies, calculated from their common

relationship with a third currency.

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Why the foreign Exchange Market is Unique?

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

liquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT

onSunday until 22:00 GMT Friday;

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 size.

As such, it has been referred to as the market closest to the ideal of perfect

competition,notwithstanding currency intervention by central banks. According to the

Bank for InternationalSettlements,as of April 2010, average dailyturnoverin global

foreign exchange markets isestimated at $3.98 trillion, a growth of approximately 20%

over the $3.21 trillion daily volumeas of April 2007. Some firms specializing on foreign

exchange market had put the average dailyturnover in excess of US$4 trillion.

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

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$43 billion currency swaps

$207 billion in options and other product.

ADVANTAGES AND DISADVANTAGES OF

FOREIGN EXCHANGE MARKET.

Advantages

The 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 over seeing

transactions and there are no restrictions on trade.

In common with futures, forex is traded using a “good faith deposit” rather than a loan.

The interest rate spread is an attractive advantage.

Disadvantages

The 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 asa

whole.

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

scale trades are very low.

Various participants Of foreign Exchange

Market:

Governments: Governments have requirements 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. Foreign 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.

Banks: There are different types of banks, all of which engage in the foreign exchange market to

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

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

vast majority, however, use their knowledge and expertise is assessing market trends for

speculative gain for their clients

Brokering Houses: These exist primarily to bring buyer and seller together at a mutually agreed

price. The 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. The use of human brokers has decreased due mostly to the rise of the interbank

electronic brokerage systems

International Monetary Market: The International Monetary Market (IMM) in Chicago trades

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

Originally designed for the small investor, the IMM has grown since the early 1970s, and the

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major banks, who once dismissed the IMM, have found that it pays to keep in touch with its

developments, as it is often a market leader

Money Managers: These tend to be large New York commission houses that are often very

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

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

through their agents.6. Corporations: Corporations are the actual end-users of the foreign

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

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

exposure they permanently change the liquidity of the currencies being dealt with.

Retail Clients: This includes smaller companies, hedge funds, companies specializing in

investment services linked by foreign currency funds or equities, fixed income brokers, the

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

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

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

bank markets.

Central Bank

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

everycounty. Each country has a central or apex bank. For example In India Reserve Bank of

Indiais the central Bank

Commercial Bank

Commercial banks are the one which has the most number of branches. With its wide

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

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

convertingcurrency from one to another.

Exchange Brokers

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Services of brokers are used to some extent, Forex market has some practices and

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

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

respective country.

Overseas Forex market

:The Forexmarket operates all around the clock and the market day initiates with Tokyo

andfollowed by Bahrain Singapore, India, Frankfurt, Paris, London, New York, and

Sydney before things are back with Tokyo the next day

Speculators

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.

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

cash flow is materialized.

Other financial institutions involved in the foreign exchange market include:

Stock brokers Commodity

Firms Insurance

Companies Charities

Private Institutions

Private Individuals

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Characteristics Of Foreign Exchange Market

Changing Wealth:

The 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. For Example, over 20

years ago a single US dollar bought 360 Japanese Yen, whereas at present1 US dollar buys 110

Japanese Yen; this explains that the Japanese Yen has risen in value ,and the US dollar has

decreased in value (relative to the Yen). This is said to be a shift in wealth, as a fixed amount of

Japanese Yen can now purchase many more goods than two decades ago

.

No Centralized Market

The foreign exchange market does not have a centralized 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. Foreign

exchange currency trading has been reformed into a non-formal and global network organization

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

organisation.

Circulation work

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

graphical positions so forex operates all around the clock on working days (i.e.) Mondayto

Friday every week. Because the time in Australia is different than in European countries, this

kind of 24 hours operation, free from any time is an ideal environment for investors.

For instance, a trader may buy the Japanese Yen in the morning at the New York market, and in

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the night if the Japanese Yen rises in the Hong Kong market, the trader can sell in the HongKong

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

trading takes place in only a few currencies; the U.S. Dollar ($), European

Currency Unit (€), Japanese Yen (¥), British Pound Sterling (£), Swiss Franc (Sf), Canadian

Dollar (Can$), and to a lesser extent, the Australian and New Zealand Dollars

Financial Instruments of foreign exchange market

Spot Market

Spot market involves the quickest transaction in the foreign exchange market. This involves

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

for 1/3rdof all the currency exchange, trades in Federal Reserve that takes place within two days

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

lower the price between the agreement and the trade.

Futures Market

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

Future market contracts are standardized, 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

equation. This type of market is popular for Steady return on their investment that is done on

large currency transactions.

Forward Market

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

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

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

Swap Transactions

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

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

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

standardization. Until the transaction is completed the deposit is required to hold the position.

Functions of the Foreign Exchange Market

The 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 minimizes exposure to foreign exchange risk.

Transfer of Purchasing Power

Transfer 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. Credit 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.

Provision of credit for foreign trade

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

financed. Foreign exchange market provides credit to the traders. Credit facility is need by

exporters when the goods are transited. Goods 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

Foreign Exchange Dealers

Foreign exchange dealers, deal both with interbank and client market. The profit of the dealers is

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

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

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

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

buy and sell those currencies in which they specialize by maintaining an inventory position in

those currencies.

Minimizing Foreign Exchange Risk: The foreign exchange market provides "hedging"

facilities for transferring foreign exchange risk to someone else.

Types of Foreign Exchange Rates

:Floating Rates

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

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

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

flowfreely. When 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. The country can withstand the fluctuation only if the economy is strong.

When the country’s economy is able to meet the demand then it can adjust between the

foreign trade and domestic trade automatically.

Fixed Rates

Fixed exchange rates are used to attract the foreign investments and to promote foreign

trade.This type of rates is used only by small developed countries. By Fixed exchange rates

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

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

become expensive. The exchange value of the currency does not move. This

normally reduces the country’s currency against foreign currencies.

Pegged Rates

This rate is between the floating rate and the fixed rate. Pegged rates appropriate more

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

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adjustedcentral value. Pegged allow some adjustments and stability. No artificial rates are found

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

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

the fixed exchange rat

Factors affecting Movement of Exchange Rates

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

determinants of a country's relative level of economic health. Exchange rates play a vital role in a

country's level of trade, which is critical to every free market economy in the world. For this

reason, exchange rates are among the most watched ,analyzed and governmentally manipulated

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

return of an investor's portfolio. Here we look at some of the major forces behind exchange rate

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

affect a nation's trading relationships with other nations. A higher currency makes a country's

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

country's exports cheaper and its imports more expensive in foreign markets. A higher exchange

rate can be expected to lower the country's balance of trade, while a lower exchange rate would

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

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

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

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

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

subject to much debate.

. Differentials in Inflation

As 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. During the last half of the

twentieth century, the countries with low inflation included Japan ,Germany and Switzerland,

while the U.S. and Canada achieved low inflation only later. Those countries with higher

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

partners. This is also usually accompanied by higher interest rates.

. Differentials in Interest Rates

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. Therefore, higher interest rates attract foreign capital

and cause the exchange rate to rise. The 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. The opposite relationship exists for decreasing interest rates - that is, lower

interest rates tend to decrease exchange rates.

Current-Account Deficits

The 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. A 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

requires more foreign currency than it receives through sales of exports, and it supplies more of

its own currency than foreigners demand for its products. The excess demand for foreign

currency lowers the country's exchange rate until domestic goods and services are cheap enough

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

Public Debt

Countries will engage in large-scale deficit financing to pay for public sector project sand

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

public deficits and debts are less attractive to foreign investors. The reason? A 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. Moreover, if a government is not able to

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

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

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

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

in that currency if the risk of default is great. For this reason, the country's debt rating (as

determined by Moody's or Standard& Poor's, for example) is a crucial determinant of its

exchange rate

.

Terms of Trade

Trade of goods and services between countries is the major reason for the demand and supply of

foreign currencies. A 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 country's 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 country's exports. This, in turn, results in rising revenues

from exports, which provides increased demand for the country's currency (and an increase in the

currency's value). If the price of exports rises by a smaller rate than that of its imports, the

currency's value will decrease in relation to its trading partners. This is a typical case for

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

balance(deficit or surplus) thus reflects the strength and weakness of the domestic currency.

6. Fundamental Factors viz. Political Stability and Economic Performance

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

the concerned government. These factors normally affect the long-term exchange rates of any

currency. On 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. The fundamental factors are basic

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

position, unemployment ,capacity utilization, trends in import and export, etc. Normally, other

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

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

the exchange rate will always be favourable. Conversely, for countries facing balance of

payment deficit, the exchange rate will be adverse. Continuous and ever growing deficit in

balance of payment indicates over valuation of the currency concerned and the dis-equilibrium

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created can be remedied through devaluation. Foreign investors inevitably seek out stable

countries with strong economic performance in which to invest their capital. A country with such

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

political and economic risk. Political turmoil, for example, can cause a loss of confidence in a

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

Political and Psychological factors

Political and psychological factors are believed to have an influence on exchange rates.Many

currencies have a tradition of behaving in a particular way for e.g. Swiss Franc asa refuge

currency. The US Dollar is also considered a safer haven currency whenever there is a political

crisis anywhere in the world.

Speculation

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

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

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

Those 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. The

initial positioning and final profit taking make exchange rates volatile. These 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 equal

bearing on the exchange rate movement. Under 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.

Capital Movement

The 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

utilized by these countries for home consumption entirely and needed to be invested elsewhere

productively. Movement of these petro dollars, started

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

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

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the form of Foreign direct investment (FDI) and Foreign institutional investments (FII) have

become the most important factors affecting the

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

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

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

Intervention

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

relating to exchange markets and official intervention. Official 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 quarter of 1985 the movement

of exchange rates of major currencies reflected the change in the US policy in favour of co-

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

Stock Exchange Operations

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

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

.

Political Factors

Political scenario of the country ultimately decides the strength of the country. Stable 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. An economy with a

strong, positive image will obviously have a strong domestic currency. This is the reason why

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

future government and its policies. In 1998,the Indian rupee depreciated against the dollar due to

the American sanctions after India conducted the Pokharan nuclear test

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.

Others

The 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, banks' 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. Value 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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Players in Foreign Exchange Market

A key goal of exchange rate economics is to understand currency returns. Exchange rates

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

value. Over the past decade microstructure research has revealed

that this ―price discovery‖ process involves different categories of market participants. Each

participant’s distinct role is determined by (a) whether the agent

is a liquidity maker or taker, and (b) the extent to which the agent is informed. The original FX

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

they solved the problem of the coincidence of wants with

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

requires trade in currencies. The 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 major categories of market participants now

include asset managers, dealers, central banks, small individual (retail) traders, and most recently

high-frequency traders.

The Forex over the counter market is formed by different participants

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

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

The Interbank Market

The interbank market designates Forex transactions that occur between central banks,

commercial banks and financial institutions.

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Central Banks

National central banks (such as the US Fed, the ECB, R.B.I.)play an important role in the Forex

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

economic growth. Their main purpose is to provide adequate trading conditions. To do so, they

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

requirements. They also manage the country's foreign exchange reserves that they can use in

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

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

stabilizing the forex market. They do this by balancing the country's 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 jokingly referred to as circus performers because of the

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

is not to earn profit from foreign currency trading.

Commercial Banks

Traditionally known as a savings and lending institution, banks are certainly one of the major

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

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

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

speculative trading and also daily commercial turnover. The really big and well-established

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

liquidity to the Forex market due to the trading volume they handle every day. Some of this

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

carried out by the banks' proprietary trading desk for speculative purpose. The profitability

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

Financial Institutions

Financial 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

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opportunities for their clients. For example, a manager of an international equity portfolio will

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

The Retail Market

The retail market designates transactions made by smaller speculators and investors .These

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

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

corporations and individuals / retail forex brokers and speculators..

Investment Firms

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

as endowments and pension funds. Sometimes, these investments require the exchange of foreign

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

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

customers that an investment firm can attract. Therefore, investment managers with an

international equity portfolio, needs to purchase and sell several pairs of foreign currencies to

pay for foreign securities purchases.

Hedge Funds

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

Macro Hedge Funds pursue trading opportunities in the Forex Market. They design and execute

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

and its currency. Due to their large amounts of liquidity and their aggressive strategies, they are a

major contributor to the dynamics of Forex Market.

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Corporations

They represent the companies that are engaged in import/export activities with foreign

counterparts. Their primary business requires them to purchase and sell foreign currencies in

exchange for goods, exposing them to currency risks. Through the Forex 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

.

Individuals / Retail Forex Brokers

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

speculation on future exchange rates

They mainly operate through Forex platforms that offer tight spreads, immediate execution and

highly leveraged margin accounts. These can be individuals or groups of individuals. They

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

single retail forex broker estimate retail volume of between 25 to 50 billion dollars each day.

Their volume is estimated to make up 2% of the total market volume.

Speculators

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

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

foreign currencies and profit through fluctuations on their price. Speculators are a "hardy" bunch

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

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

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

Speculators are risk-taking investors with expertise in the market(s) in which they are trading and

will usually use highly leveraged investments such as futures and options

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FOREIGN EXCHANGE RISK

Foreign exchange risk (also known as exchange rate risk or currency risk) 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 consequences if not managed appropriately. Many businesses were

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

international monetary order. It wasn't until the onset of floating exchange rates following the

collapse of the Bretton Woods 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. The outbreak of currency crises in the 1990s and early 2000s, such as the

Mexican peso crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso

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

exchange risk.

MANAGEMENT

Managers of multinational firms employ a number of foreign exchange hedging strategies in

order to protect against exchange rate risk. Transaction 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 techniques such as currency invoicing, leading

and lagging of receipts and payments, and exposure netting.

Firms 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

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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

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

exchange risk exposure.

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

the translation methods required by those standards. For example, the United States Federal

Accounting Standards Board specifies when and where to use certain methods such as the

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

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

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

a firm could acquire an appropriate amount of exposed assets or liabilities to balance any

outstanding discrepancy. Foreign 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 Fisher effect hold true, a firm or investor needn't protect against foreign

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

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

to foreign exchange risk.

Financial 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. Variance 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. A higher standard deviation would signal a greater currency

risk. Economists have criticized the accuracy of standard deviation as a risk indicator for its

uniform treatment of deviations, be they positive or negative, and for automatically squaring

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deviation values. Alternatives such as average absolute deviation and semivariance have been

advanced for measuring financial risk.

VALUE AT RISK

Practitioners have advanced and regulators have accepted a financial risk management technique

called value at risk (VAR), 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 Europe have been

authorized by the Bank for International Settlements to employ VAR models of their own design

in establishing capital requirements for given levels of market risk. Using the VAR 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.

TYPES OF FOREIGN EXCHANGE RISK

Transaction Exposure

A firm has transaction exposure whenever it has contractual cash flows (receivables and

payables) whose values are subject to unanticipated changes in exchange rates due to a contract

being denominated in a foreign currency. To realize the domestic value of its foreign-

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

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 in

the 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.

Economic Exposure

A firm has economic exposure (also known as operating exposure) to the degree that its market

value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments

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can severely affect the firm's market share position with regards to its competitors, the firm's

future cash flows, and ultimately the firm's value. Economic exposure can affect the present

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

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

Translation Exposure

A firm's translation exposure is the extent to which its financial reporting is affected by exchange

rate movements. As 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. While translation exposure may not affect a firm's cash flows, it could have a

significant impact on a firm's reported earnings and therefore its stock price. Translation

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

types of risk having different accounting treatments.

Contingent exposure

A firm has contingent exposure when bidding for foreign projects or negotiating other contracts

or foreign direct investments. Such 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. For example, a firm could be waiting for a project bid to be accepted by a

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

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.

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Foreign Exchange Market In India

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

more than $400 billion. This transaction does not include the inter-bank transactions. According

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

segment was $40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the same

period.

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

is more than $400 billion. This transaction does not include the inter-bank transactions.

According to the record of transactions released by RBI, the average monthly turnover in the

merchant segment was $40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the

same period.

.The average total monthly turnover was about $174.7 billion for the same period. The

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

interest rate swaps.

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

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

Mumbai, the commercial capital of the country. There are several other centers for foreign

exchange transactions in the country including Kolkata, New Delhi, Chennai, Bangalore,

Pondicherry and Cochin.

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

Exchange Control Department. At the same time, Foreign Exchange Dealers

Association(voluntary association) also provides some help in regulating the market. The

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Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate

in the foreign Exchange market in India. When the foreign exchange trade is going on between

Authorized Dealers and RBI or between the Authorized Dealers and the Overseas banks, the

brokers have no role to play.

.Apart from the Authorized Dealers and brokers, there are some others who are provided with

there stricted rights to accept the foreign currency or travelers cheque. Among these, there are

the authorized money changers, travel agents, certain hotels and government shops. The IDBI

and Exim bank are also permitted conditionally to hold foreign currency.

The whole foreign exchange market in India is regulated by the Foreign Exchange Management

Act, 1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or

Foreign Exchange Regulation Act ,1947. After independence, FERA 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 Public Accounts Committee, the Indian government passed the Foreign

Exchange Regulation Act,1973 and gradually, this act became famous as FEMA

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CONCLUSION

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

the New York Stock Exchange and Futures Market combined. And with reduced "buy-in" limits

now, even small-time players can join the Forex trading marketplace. That doesn't mean

everyone should join, however. Buying an auto-trading program sold to you with the promise of

making you millions probably won't. In fact, it may cost you everything you own. The only way

to win in Forex trading is the good, old-fashioned way - hard work

andasolidunderstandingofthemarket.

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

indicators of different countries. These include GDP growth, fiscal and monetary policies,

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

The currency derivatives market is highly leveraged. In the stock futures market, a 20% margin

gains a five-fold leverage. In forex futures, the margin payable is just 3%, so the leverage is 33

times. This means that even a 1% 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.

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

indicators of different countries. These include GDP growth, fiscal and monetary policies,

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

32

The currency derivatives market is highly leveraged. In the stock futures market, a 20% margin

gains a five-fold leverage. In forex futures, the margin payable is just 3%, so the leverage is 33

times. This means that even a 1% 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.

Liberalization has transformed India’s external sector and a direct beneficiary of this has been

the foreign exchange market in India. From a foreign exchange-starved, control-ridden economy,

India has moved on to a position of $150 billion plus in international reserves with a confident

rupee and drastically reduced foreign exchange control. As 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 RBI interventions any time soon.

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REFERENCES

http://www.slashdocs.com/kvuttx/fem.htm

http://www.travelspk.com/forex/Forex-Development-History.htm

http://www.global-view.com/forex-education/forex-learning/gftfxhist.html

http://en.wikipedia.org/wiki/Foreign_exchange_risk