Foreign Exchange Market

Introduction

The mechanism through which payments are effected between two countries having different currency system is called foreign exchange.
In simple words, by foreign exchange we mean foreign currencies. However, in broad sense, the term refers to the system of external or international payments. It covers methods of payment, rules and regulations of payment
and institutions facilitating such payments.

The foreign exchange market is the market where foreign exchange or foreign currencies are bought and sold. The foreign exchange market places at the disposal of buyers and sellers of foreign currencies, the specialised services of intermediaries. It implies that the buyers and sellers claims on foreign money and intermediarids constitute the structure of foreign exchange market. In the words of Kindelberger : 'The foreign exchange market is the market for a national currency (foreign money) anywhere in the world, as the centres of the world are limited in a single market.

Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participants meet to execute their deals. It is more an informal arrangement among the banks and brokers operating in a financing centre purchasing and selling currencies, connected to each other by tele-communications like telex,telephone and a satellite communication. network- SWIFT (Society for worldwide interbank Financial Telecommunications).

Foreign Exchange Market

Participants of two levels.

Wholesale level : 95% of the foreign exchange market is whole sale market where the dealings take place among the banks.

Retail level : The retail market refers to the dealings which take place between banks and their customers. The retail segment is situated at a large number of places. They can be considered not as foreign exchange markets, but as the counters of such markets.

Types of Currency Markets

On the basis of transaction, there are two types of currency markets.

Spot market :

In such a market, the spot transactions of foreign exchange is required to deliver the foreign exchange he has sold (i.e. within two days). The buyer, on the other hand, will receive immediately (within two days) the foreign exchange he has bought.

The main participants of spot market are :

Commercial banks : The most important participants of spot market are commercial banks. Banks dealing in foreign exchange have branches with substantial balances in different countries. Through theirbranches and correspondents the services of such banks, usually called 'Exchange Banks', are available all over the world. These banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic transfers and other credit instruments and discount and collect amounts for such documents.

Brokers : Brokers help sellers and buyers in foreign bills to come together. They are intermediaries and unlike banks are not direct dealers. Still another category of intermediaries are the acceptance houses. They accept the bills on behalf of the customers and assist in foreign remittances.

Central Banks : Central banks sometimes intervene in the market. Now-a-days, these authorities manage exchange rates and
implement exchange controls in various ways.

Forward market :

The forward exchange market is concerned with such transactions of foreign exchange in case of which, the contract to buy or sell foreign exchange delivery of foreign exchange takes place at a future date at a price agreed upon in advance. The period for settlement of contract between the buyers and sellers of foreign exchange is usually three months.

The main participants of forward market are :

Arbitrageurs: The arbitrage is the act of simultaneously buying a currency in one market and selling it in another market to make profit by taking advantage of price or exchange rate differences in the two markets. If the arbitrage operations are confined to two markets only, they will be known as 'two point' arbitrage. If they extend to three or more markets, they are known as 'three point' or 'multi-point' arbitrage.

Traders : They exchange domestic currency for foreign currency or foreign currency for domestic currency to execute the international
transactions.

Hedgers : Hedging refers to the avoidance of a foreign exchange risk or the covering of an open position. Hedgers in international dealings are persons who have a home currency and insist on having an exact balance between their liabilities and assets in foreign currencies.

Speculators : Speculation is the opposite of hedging whereas a hedger seeks to cover a foreign exchange risk, a speculator accepts and even seeks out a foreign exchange risk, or an open position, in the hope of making a profit.

Clearing systems : In the foreign exchange market there are two types of clearing system.

Chips : Chips stand for clearing House Interbank Payment of System. It is an electronic payment system owned by 12 private commercial banks constituted the New York Clearing House Association. It provides the mechanism for settlement of every day payment and receipts of numerous dollar transactions among member banks at new York, without the need for physical exchange of cheques/funds for each such
transactions.

Fedwire : Fedwire is a networked system for payment processing between member banks themselves or other Fedwire member participants members can consists of depository financial institutions in the United States, as well as US branches of certain foreign banks or government groups, provided that they maintain an account with a Federal Reserve Bank. It is owned and operated by the 12 Federal Reserve Banks.

The Fedwire funds transfer system, operated by the Federal Reserve Bank are used primarily for domestic payments, bank to bank and third party transfers such as interbank overnight funds sales and purchased and settlement transactions. Fed guarantees settlement on all payments sent
to receivers even if the sender fails.

Electronic trading : Electronic trading is mainly concerned with automated trading.

Automated Trading

Forex autotrading is a slang term for automated market, wherein trades are executed by a computer system based on a trading strategy implemented as a program run by the computer system. The main results of automated trading that it reduces the cost of trading, provide liquidity and also threatens traders' oligopoly of information.

Size of the Market

Largest in the world

Unlike other financial markets like the New York Stock Exchange, the forex market has neither physical location nor central exchange. The forex market is considered on over-the counter (OTC) or 'interbank' market due to the fact that the entire market is run electronically, within a network of banks, continuously over a 24-hour period. The dollar is the most traded currency, taking up 84.9 % of all transactions. The euro share is second at 39.1% while that of yen is third
at 19.0%.

Market Centres : London market is by far the largest where 90 billion dollar foreign currency is transacted each day, followed by New York, Tokyo. German, Japan markets respectively. So far as India is concerned, till recently, it was having a regime of strict exchange control. The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi. As a result of the efforts of Reserve Bank, Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of forex market.

Swift (Society for Worldwide on interbank Financial Telecommunications )

Foreign exchange markets make extensive use of the latest developments in telecommunications for transmitting as well as settling foreign exchange transaction. Banks use the exclusive network SWIFT to communicate messages and settle the transactions at electronic clearing houses such as CHIPS at New York.

SWIFT: SWIFT is a acronym for Society for Worldwide Interbank Financial Telecommunications, a co-operative society owned by about 250 banks in Europe and North America and registered as a co- operative society in Brussels, Belgium. It is a communications network for international financial market transactions linking effectively more than 25,000 financial institutions throughout the world who have been allotted bank identified codes. The messages are transmitted from country to
country via central interconnected operating centers located in Brussels, Amsterdam and Culpeper, Virginia. 'The member countries are connected to the centre through regional processors in each country. The local banks
in each country reach the regional processors through the national networks.

The SWIFT System enables the member banks to transact among themselves quickly (i) international payments (ii) Statements (iii) other messages connected with international banking. Transmission of messages takes place within seconds and therefore this method is economical as well as time saving. Selected banks in India have become members of SWIFT. The regional processing centre is situated at Mumbai.

Advantages of Swift

The swift provides following advantages for the local banking community:
(i) Provides a reliable (time tested) method of sending and receiving messages from a vast number of banks in a large number of
locations around the world.

(ii) Reliability and accuracy is further enhanced by the built in authentication facilities, which has only to he exchanged with each counterparty before they can be activated or further communications.

(iii) Message relay is instantaneous enabling the counterparty to respond immediately, if not prevented by time differences.

(iv) Access is available to vast number of banks global for launching new cross border initiatives.

(v) Since communication in SWIFT is to be done using structure formats for various types of banking transactions, the matter to be conveyed will be very clear and there will not be any ambiguity of any sort for the received to revert for clarifications. this is mainly because the formats are used all over the world on a standardised basis for conducting all types of banking transactions.

(vi) Usage of SWIFT structure formats for message transmission to counterparties will entail the generation of local banks internal
records using at least minimum level of automation. This will accelerate the local banks internal automation activities, since the maximum utilisation of SWIFT a significant internal automation level is
required.

Functions of Foreign Exchange Market

Transfer function : The most fundamental 'function of a foreign exchange market is to effect transfer of funds or purchasing power from one country and currency to another. The transfer of purchasing power is brought about by various instruments such as foreign hills, bank drafts, telegraphic transfers and direct dialling telephone service. The foreign exchange market facilitates simultaneous international settlement of claims in both directions exactly as happens in the domestic clearing houses.

Credit function : the foreign exchange market performs another function of the financing of trade. It is called as the credit function. Credit is usually required when goods are in transit and also to allow the buyer to resell the goods and make the payment.
In general, the exporters allow 90 days to the importer to pay. This permits the payment to the exporters right away but the commercial banks will eventually collect the payment from importers when due. Thus the foreign exchange market permits time to the importers in making payment, on the one hand, and permits instant payment to
exporters through discounting facility, on the other.

Hedging function: Another function of the foreign exchange market is to furnish facilities for hedging exchange risks. In a free exchange market, the variations in exchange rates result in a gain or loss to the concerned parties. If there is rise in the exchange value of the foreign currency between the time at which obligation arises and the time at which it is discharged, the importer is faced with a risk of loss. To protect himself from such an exchange risk, the importer can avail himself of the hedging facility. Hedging means covering of
an exchange risk, which can be avoided reduced through a forward contract. It is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon presently.

All the commercial transactions never covered when some traders are confident that the spot rate of exchange will not change or alternatively, when it is possible for them to make accurate
anticipation of the direction or magnitude of its movement, they may not feel the necessity of hedging. It means those traders are clearly engaged in speculation about the rate of exchange.