17-08-2013, 04:41 PM
Foreign Exchange Markets
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General Features
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. The term foreign exchange market is used to refer to the wholesale a
segment of the market, where the dealings take place among the banks. The retail
segment refers to the dealings take place between banks and their customers. The
retail segment refers to the dealings 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.
Size of the Market
Foreign exchange market is the largest financial market with a daily
turnover of over USD 2 trillion. Foreign exchange markets were primarily
developed to facilitate settlement of debts arising out of international trade. But
these markets have developed on their own so much so that a turnover of about 3
days in the foreign exchange market is equivalent to the magnitude of world trade in
goods and services. The largest foreign exchange market is London followed by
New York, Tokyo, Zurich and Frankfurt.
The business in foreign exchange markets in India has shown a steady
increase as a consequence of increase in the volume of foreign trade of the country,
improvement in the communications systems and greater access to the international
exchange markets. Still the volume of transactions in these markets amounting to
about USD 2 billion per day does not compete favorably with any well developed
foreign exchange market of international repute. The reasons are not far to seek.
Rupee is not an internationally traded currency and is not in great demand. Much of
the external trade of the country is designated in leading currencies of the world,
Viz., US dollar, pound sterling, Euro, Japanese yen and Swiss franc. Incidentally,
these are the currencies that are traded actively in the foreign exchange market in
India.
Efficiency
Developments in communication have largely contributed to the efficiency
of the market. The participants keep abreast of current happenings by access to such
services like Dow Jones Telerate and Teuter. Any significant development in any
market is almost instantaneously received by the other market situated at a far off
place and thus has global impact. This makes the foreign exchange market very
efficient as if the functioning under one roof.
Currencies Traded
In most markets, US dollar is the vehicle currency, Viz., the currency used
to denominate international transactions. This is despite the fact that with currencies
like Euro and Yen gaining larger share, the share of US dollar in the total turn over
is shrinking.
Settlement of Transactions
Foreign exchange markets make extensive use of the latest developments in
telecommunications for transmitting as well 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 net works.
Direct Quotation.
It will be obvious that the quoting bank will be willing to buy dollars at Rs
48.1525 and sell dollars at Rs 48.1650. If one dollar bought and sold, the bank
makes a gross profit of Rs. 0.0125. In a foreign exchange quotation, the foreign
currency is the commodity that is being bought and sold. The exchange quotation
which gives the price for the foreign currency in terms of the domestic currency is
known as direct quotation. In a direct quotation, the quoting bank will apply the
rule: ―Buy low; Sell high‖.
Forward Margin/Swap points
Forward rate may be the same as the spot rate for the currency. Then it is
said to be ̳at par‘ with the spot rate. But this rarely happens. More often the forward
rate for a currency may be costlier or chapter tan its spot rate. The rate for a
currency may be costlier or cheaper than nits spot rate. The difference between the
forward rate and the spot rate is known as the ̳forward margin‘ or swap points. The
forward margin may be either at ̳premium‘ or at ̳discount‘. If the forward margin
is at premium, the foreign correct will be costlier under forward rate than under the
spot rate. If the forward margin is at discount, the foreign currency will be cheaper
for forward delivery then for spot delivery.
Functions of foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place.
Transfer of Purchasing Power
The Primary function of a foreign exchange market is the transfer of
purchasing power from one country to another and from one currency to another.
The international clearing function performed by foreign exchange markets plays a
very important role in facilitating international trade and capital movement.
Provision of credit
The credit function performed by foreign exchange markets also plays a
very important role in the growth of foreign trade, for international trade depends to
a great extent on credit facilities. Exporters may get pre shipment and post shipment
credit. Credit facilities are available also for importers. The Euro dollar market has
emerged as a major international credit market.
Provision of Heding Facilities
The other important of the foreign exchange market is to provide hedging
facilities. Heding refers to covering of foreign trade risks, and it provides a
mechanism to exporters and importers to guard themselves against losses arising
from fluctuations in exchange rates.
Cheques and Bank Drafts
International payments may be made be means of cheques and bank drafts.
The latter is widely used. A bank draft is a cheque drawn on a bank instead of a
customer‘s personal account. It is an acceptable means of payment when the person
tendering is not known, since its value is dependent on the standing of a bank which
is widely known, and not on the credit worthiness of a firm or individual known
only to a limited number of people.
Foreign Bill of Exchange
A bill of exchange is an unconditional order in writing, addressed by one
person to another, requiring the person to whom it is addressed to pay a certain sum
or demand or on a specified future date.
There are two important differences between inland and foreign bills. The
date on which an inland bill is due for payment is calculated from the date on which
it was drawn, but the period of a foreign bill runs fro m the date on which the bill
was accepted. The reason for this is that the interval between a foreign bill being
drawn and its acceptance may be considerable, since it may depend on the time
taken for the bill to pass fro m the drawers country to that of the acceptor. The
second important difference between the two types of bill is that the foreign bill is
generally drawn in sets of three, although only one of them bears a stamp and of
course one of them is paid.
Options
While the forward or futures contract protects the purchaser of the contract
fro m the adverse exchange rate movements, it eliminates the possibility of gaining
a windfall profit from favorable exchange rate movement.
An option is a contract or financial instrument that gives holder the right, but
not the obligation, to sell or buy a given quantity of an asset as a specified price at a
specified future date. An option to buy the underlying asset is known as a call
option and an option to sell the underlying asset is known as a put option. Buying or
selling the underlying asset via the option is known as exercising the option. The
stated price paid (or received) is known as the exercise or striking price. The buyer
of an option is known as the long and the seller of an option is known as the writer
of the option, or the short. The price for the option is known as premium.
Types of options: With reference to their exercise characteristics, there are two
types of options, American and European. A European option cab is exercised only
at the maturity or expiration date of the contract, whereas an American option can
be exercised at any time during the contract.