INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 1

UNIT-I
An Introduction to the Foreign Exchange Markets

The foreign exchange market is the largest market in the world and each day, huge amounts
of money flow through it. What makes the FX market unique is its structure. Currencies are
traded OTC (over-the-counter), meaning there is no centralized place where the exchange
occurs. While OTC trading has its advantages, like lower fees and taxes, it allows the
presence of private information. Dealers and institutional traders have a clear advantage over
uninformed market participants and actively make use of it.
Asset classes like futures, which are traded on exchanges like the CME, are regulated and
thanks to the introduction of electronic trading platforms, traders have access to the same
information, no matter where they are located. On the other side, the amount and quality of
information you receive in the FX market depends on your contacts. While retail traders
usually have a distorted image of institutional traders, it is true that they have direct
advantage because of the information they receive.
The foreign exchange market can be seperated in two tiers. The first tier represents the
interbank market where dealers trade with each other. They commonly do so via interbank
platforms like Reuters and EBS. The second tier is where market makers trade with their
customers.
Since the foreign exchange market has no central exchange like i.e. the NYSE, dealers have to
deal directly with other banks across the globe. To make the process easier, electronic
brokerage services appeared in the 1990s. They essentially represent the inner core of the FX
market with EBS and Reuters Dealing being the leading platforms in this field. While EBS
dominates trading in EUR, JPY and CHF, Reuters is commonly used for GBP, AUD and CAD
trading.
Multibank trading platforms have gained in popularity in the past few years with companies
like FXAll (owned by Thomson Reuters) seeing constantly rising trading volumes. They
essentially allow banks to stream quotes simultaneously with customers, both providing
liquidity and anonymous trading.
Leveraged funds and similar participants can trade directly in the interbank markets via prime
brokerage arrangements with the major international banks. Prime brokerage clients trade
with other dealers in the prime brokers name using the prime brokers existing credit lines, a
privilege for which they pay a fee based on trading volume. Any trades executed with FX
dealers other than the prime broker are given up to the prime broker, who becomes the
counterparty to both legs of the trade. Hedge fund Alpha, for example, might pay UBS to be
its prime broker, thereby gaining access to the EBS and Thomson Reuters trading platforms.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 2

For the large banks, prime brokerage arrangements generate new, fee-based revenue that
leverages their technology and operating infrastructure.
Currencies trade over-the-counter and are open 24 hours a day, starting from Monday
morning Sydney to Friday evening New York. The United Kingdoms favorable location allows it
overlap both the Asian and US trading session, making it the dominant player by turnover. In
2013, 41 % of the daily average turnover ($5.3 trillion) traded in the UK, followed by the
United States with 19 %. Other major trading centres include Singapore, Tokyo, Hong Kong,
Frankfurt and Zrich.



Definitions of 'Foreign Exchange Market'

1) The market in which participants are able to buy, sell, exchange and speculate on
currencies. Foreign exchange markets are made up of banks, commercial companies, central
banks, investment management firms, hedge funds, and retail forex brokers and investors.
The forex market is considered to be the largest financial market in the world.

2) According 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. FX swaps were
the most actively traded instruments in April 2013, at $2.2 trillion per day, followed by spot
trading at $2.0 trillion.
3) 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. 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

The foreign exchange market (forex, FX, or currency market) is a global decentralized market
for the trading of currencies. The main participants in this market are the larger international
banks. Financial centers around the world function as anchors of trading between a wide range
of different types of buyers and sellers around the clock, with the exception of
weekends. Electronic Broking Services (EBS) and Reuters 3000 Xtra are two main interbank
FX trading platforms. The foreign exchange market determines the relative values of different
currencies.

INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 3

The foreign exchange market works through financial institutions, and it operates on several
levels. Behind the scenes banks turn to a smaller number of financial firms known as
dealers, who are actively involved in large quantities of foreign exchange trading. Most
foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the
interbank market, although a few insurance companies and other kinds of financial firms are
involved. Trades between foreign exchange dealers can be very large, involving hundreds of
millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has
little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investment by enablingcurrency
conversion. For example, it permits a business in the United States to import goods from
the European Union member states, especially Eurozone members, and payeuros, even
though its income is in United States dollars. It also supports direct speculation in the value of
currencies, and the carry trade, speculation based on the interest rate differential between two
currencies.

In a typical foreign exchange transaction, a party purchases some quantity of one currency by
paying some quantity of another currency. The modern foreign exchange market began
forming during the 1970s after three decades of government restrictions on foreign exchange
transactions (the Bretton Woods system of monetary management established the rules for
commercial and financial relations among the world's major industrial states after World War
II), when countries gradually switched to floating exchange rates from the previous exchange
rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of the following characteristics:
its huge trading volume representing the largest asset class in the world leading to
high liquidity;
its geographical dispersion;
its 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);
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.

Forex Market Structure

For the sake of comparison, let us first examine a market that you are probably very familiar
with: the stock market. This is how the structure of the stock market looks like:

INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 4

I have no choice but to go through a centralized exchange!
By its very nature, the stock market tends to be very monopolistic. There is only one entity,
one specialist that controls prices. All trades must go through this specialist. Because of this,
prices can easily be altered to benefit the specialist, and not traders.
How does this happen?
In the stock market, the specialist is forced to fulfill the order of its clients. Now, lets say the
number of sellers suddenly exceed the number of buyers. The specialist, which is forced to
fulfill the order of its clients, the sellers in this case, is left with a bunch of stock that he
cannot sell-off to the buyer side.
In order to prevent this from happening, the specialist will simply widen thespread or increase
the transaction cost to prevent sellers from entering the market. In other words, the
specialists can manipulate the quotes it is offering to accommodate its needs.


Trading Spot FX is Decentralized
Unlike in trading stocks or futures, you dont need to go through a centralized exchange like
the New York Stock Exchange with just one price. In the forex market, there is no single price
that for a given currency at any time, which means quotes from different currency dealers
vary.

So many choices! Awesome!
This might be overwhelming at first, but this is what makes the forex market so freakin
awesome! The market is so huge and the competition between dealers is so fierce that you get
the best deal almost every single time. And tell me, who does not want that?
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 5


Also, one cool thing about forex trading is that you can do it anywhere. Its just like trading
baseball cards. You want that mint condition Mickey Mantle rookie card, so it is up to you to
find the best deal out there. Your colleague might give up his Mickey Mantle card for just a
Babe Ruth card, but your best friend will only part with his Mickey Mantle rookie card for your
soul.
The FX Ladder
Even though the forex market is decentralized, it isnt pure and utter chaos! The participants
in the FX market can be organized into a ladder. To better understand what we mean, here is
a neat illustration:

At the very top of the forex market ladder is the interbank market. Composed of the largest
banks of the world and some smaller banks, the participants of this market trade directly with
each other or electronically through the Electronic Brokering Services (EBS) or the Reuters
Dealing 3000-Spot Matching.

The competition between the two companies the EBS and the Reuters Dealing 3000-Spot
Matching is similar to Coke and Pepsi. They are in constant battle for clients and continually
try to one-up each other for market share. While both companies offer most currency pairs,
some currency pairs are more liquid on one than the other.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 6

For the EBS plaform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF, and USD/CHF are more liquid.
Meanwhile, for the Reuters platform, GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD
are more liquid.
All the banks that are part of the interbank market can see the rates that each other is
offering, but this doesnt necessarily mean that anyone can make deals at those prices.
Like in real life, the rates will be largely dependent on the establishedCREDIT relationship
between the trading parties. Just to name a few, theres the B.F.F. rate, the customer rate,
and the ex-wife-you-took-everything rate. Its like asking for a loan at your local bank. The
better your credit standing and reputation with them, the better the interest rates and the
larger loan you can avail.

Next on the ladder are the hedge funds, corporations, retail market makers, and retail ECNs.
Since these institutions do not have tight credit relationships with the participants of the
interbank market, they have to do their transactions via commercial banks. This means that
their rates are slightly higher and more expensive than those who are part of the interbank
market.

At the very bottom of the ladder are the retail traders. It used to be very hard for us little
people to engage in the forex market but, thanks to the advent of the internet, electronic
trading, and retail brokers, the difficult barriers to entry in forex trading have all been taken
down. This gave us the chance to play with those high up the ladder and poke them with a
very long and cheap stick.

FUNCTIONS OF FOREIGN EXCHANGE MARKET
Foreign exchange is also referred to as forex market. Participants are importers,
exporters, tourists and investors, traders and speculators, commercial banks, brokers and
central banks.
Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are
the important foreign exchange instruments used in foreign exchange market to carry out its
functions.
The Foreign Exchange Market performs the following functions.
1. Transfer Of Purchasing Power I Clearing Function

The basic function of the foreign exchange market is to facilitate the conversion
of one currency into another i.e. payment between exporters and importers. For eg. Indian
rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety
of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills.
Telegraphic transfer is the quickest method of transferring the purchasing power.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 7

The basic function of the foreign exchange market is to facilitate the conversion of one
currency into another, i.e., to accomplish transfers of purchasing power between two
countries. This transfer of purchasing power is effected through a variety of credit
instruments, such as telegraphic transfers, bank drafts and foreign bills.
In performing the transfer function, the foreign exchange market carries out payments
internationally by clearing debts in both directions simultaneously, analogous to domestic
clearings.

2. Credit Function
The foreign exchange market also provides credit to both national and
international, to promote foreign trade. It is necessary as sometimes, the international
payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are
used in international payments, a credit for about 3 months, till their maturity, is required.
For eg. Mr. A can get his bill discounted with a foreign exchange bank in New
York and this bank will transfer the bill to its correspondent in India for collection of money
from Mr. B after the stipulated time.
Another function of the foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is required.

3. Hedging Function
A third function of foreign exchange market is to hedge foreign exchange risks. By
hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange
rates. Under this function the foreign exchange market tries to protect the interest of the
persons dealing in the market from any unforseen changes in exchange rate. The exchange
rates under free market can go up and down, this can either bring gains or losses to
concerned parties. Hedging guards the interest of both exporters as well as importers, against
any changes in exchange rate.
Hedging can be done either by means of a spot exchange market or a forward exchange
market involving a forward contract.

A third function of the foreign exchange market is to hedge foreign exchange risks. In a free
exchange market when exchange rates, i.e., the price of one currency in terms of another
currency, change, there may be a gain or loss to the party concerned. Under this condition, a
person or a firm undertakes a great exchange risk if there are huge amounts of net claims or
net liabilities which are to be met in foreign money.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 8

Exchange risk as such should be avoided or reduced. For this the exchange market provides
facilities for hedging anticipated or actual claims or liabilities through forward contracts in
exchange. A forward contract which is normally for three months is a contract to buy or sell
foreign exchange against another currency at some fixed date in the future at a price agreed
upon now. No money passes at the time of the contract. But the contract makes it possible to
ignore any likely changes in exchange rate.



Foreign Exchange Market: An Introduction



3.1 Introduction to Forex Market:


For most of us, the focal point of understanding international finance revolves around foreign
exchange market. The foreign exchange market (also known as the currency, forex, or FX) is
where currency trading takes place. It is a market where banks, companies, exporters,
importers, fund managers, individuals, central banks of different countries buy and sell of
foreign currencies.

Forex trading involves a foreign exchange transaction, defined as the simultaneous buying of
one currency and selling of another currency. As forex rates are quoted in pairs, e.g.
Euro/US$, US$/Japanese Yen, US$/INR, etc., a trader trading in forex sells one of the
currency pair and buys the other.

As the subject progresses, we will develop more understanding about which currency is
bought and which currency is sold and other aspects of forex trading.

The forex market is an ongoing 24-hour, 365 days year market. Trading in forex market does
not necessarily involve an exchange. Hence, the trading goes on the over-the-counter market
(OTC market henceforth). Major foreign currency trading centers are located in London,
Tokyo, New York. As the markets remain open at different time on a given day, normally GMT
is used to refer the trading hours at different locations. For example, the trading duration in
Asia is from GMT.00.00 till GMT 08.00. Trading duration in London is during GMT 07:00 till
GMT 15:00. Trading in USA commences during GMT 13.00 till GMT 22.00. Trading in London
starts at GMT 8.00 and ends at GMT 17.00. Trading in Tokyo starts in GMT 0.00 ( midnight)
and ends GMT 9.00.

Presently, the FX market is one of the largest and liquid financial markets in the world, and
includes trading between large banks, central banks, currency speculators, corporations,
governments, financial institutions, exporters and importers. The average daily volume in the
global foreign exchange and related markets is continuously growing. The daily turnover was
reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements
(BIS). The Since then, the market has continued to grow.

INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 9



INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 10

According to Euromoney's annual FX Poll, trading volumes in USA grew a further 41% between
2007 and 2008.

The Bank for International Settlements undertakes triennials survey to regarding various
facets of foreign exchange market. According to the last survey conducted in 2007, average
daily turnover in global foreign exchange markets is estimated at $3.2 trillion. It has grown in
an unprecedented 69% compared to 2004. The Bank for International Settlements is regular
with the publication of these triennial surveys. The readers must check the official website for
the latest survey report to get update on details discussed in this module.

As the 2007 report, average daily turnover of US$3.2 trillion comes from foreign exchange
spot, forward and swap transactions.

US$1.005 trillion in spot transactions
US$362 billion in outright forwards transactions
US$1.714 trillion in foreign exchange swaps
US$129 billion estimated gaps in reporting

The spot market relates to immediate purchase and sale of foreign currency while in a forward
transaction parties agree to buy and sell foreign currency later. In swap transactions, parties
agree to swap payment and receipt of foreign currency over a specified period. These last two
sentences very briefly summarize the difference between spot, forward and swap transactions.
In later modules , these contracts are explained in detail.


3.2 Foreign Exchange Market, Trading Volumes :


Foreign exchange market is one of the fastest growing segments in the financial world. Details
given in Table 2.A extracted from the Triennial Central Bank Survey December 2007 Foreign
exchange and derivatives market activity in 2000 prepared by Bank of International
Settlement (BIS) indicates the growth of the forex market.

The 2007 survey shows an unprecedented rise in activity in traditional foreign exchange
markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an
increase of 69% at current exchange rates as given in Table 3.A.









INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 11


Table 3.A. Global foreign exchange market turnover (*)

Daily averages in April, in billions
ofUS$
2004


YEAR 1992 1995 1998 2001 ( **) 2007
Spot transactions 394 494 568 387 631 1,005
Outright forwards 58 97 128 131 209 362
Up to 7 days 50 65 51 92 154
Over 7 days 46 62 80 116 208
Foreign exchange swaps 324 546 734 656 954 1,714
Up to 7 days 382 528 451 700 1,329
Over 7 days 162 202 204 252 382
Estimated gaps in reporting 44 53 60 26 106 129
Total traditional turnover 820 1,190 1,490 1,200 1,900 3,210
Turnover at April 2007 exchange
rates( ***) 880 1,150 1,650 1,420 1,970 3,210

1 Adjusted for local & cross-border double-counting. Due to incomplete
breakdown, components do not always sum to totals.
2. Date for 2004 have been revised.
3 Non-US dollar legs of foreign currency transactions were converted from current US
dollar amounts into original currency amounts at average exchange rates for April of each
survey year and then reconverted into US dollar amounts at average April 2007 exchange
rates.





Table 3.A indicates that forex swaps have grown strongest compared to the other two, i.e,
spot and forward.

Table 3.B indicates the percentage share of different currencies in average daily turnover
during 2007. As expected, US dollar has the highest average daily turnover of 86% followed
by Euro (37%) and Yen( 19%). Surprisingly the sum total of percentage of these currencies is
142% !!! The clue lies in the Table 3.B.

In addition, it is heartening to see that Indian currency average daily turnover has increased
from 0.3% to 0.7%. So also the Chinese Renminbi.










INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 12


Table 3.B:Currency distribution of reported foreign exchange market turnover(*)

Percentage shares of average daily turnover in April 2007
2004


2001 (**) 2007
US dollar 90.3 88.7 86.3
Euro 37.6 36.9 37
Yen 22.7 20.2 16.5
Pound sterling 13.2 16.9 15
Swiss franc 6.1 6 6.8
Australian Dollar 4.2 5.9 6.7
Canadian dollar 4.5 4.2 4.2
Swedish krona 2.6 2.3 2.8
Hong Kong dollar 2.3 1.9 2.8
Norwegian krone 1.5 1.4 2.2
New Zealand dollar 0.6 1 1.9
Mexican peso 0.9 1.1 1.3
Singapore dollar 1.1 1 1.2
Won 0.7 1.2 1.1
Rand 1 0.8 0.9
Danish krone 1.2 0.9 0.9
Rouble 0.4 0.7 0.8
Zloty 0.5 0.4 0.8
Indian rupee 0.2 0.3 0.7
Renminbi 0 0.1 0.5
New Taiwan dollar 0.3 0.4 0.4
Brazilian real 0.4 0.2 0.4
All currencies 200 200 200
Emerging market currencies (***) 16.9 15.4 19.8

(*) Because two currencies are involved in each transaction, the sum of the percentage
shares of individual currencies totals 200% instead of 100%. Adjusted for local and
cross-border double-counting. (**) Data for 2004 have been revised.
(***) Defined as the residual after accounting
for the top eight currencies and the New Zealand dollar and the Danish krone.


















INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 13







Table 3.C highlights foreign exchange market turnover by currency pair.


Table 3.C: Reported foreign exchange market turnover by currency pair


Daily averages in April, in billions of US dollars and per cent
YEAR 2001
%
2004( **)
%
2007

Amount Amount Share Amount Share Amount % Share
US dollar/euro 354 30 503 28 840 27
US dollar/yen 231 20 298 17 397 13
US dollar/sterling 125 11 248 14 361 12
US dollar/Australian dollar 47 4 98 5 175 6
US dollar/Swiss franc 57 5 78 4 143 5
US dollar/Canadian dollar 50 4 71 4 115 4
US dollar/Swedish krona
(***) 56 2
US dollar/other 195 17 295 16 572 19
Euro/yen 30 3 51 3 70 2
Euro/sterling 24 2 43 2 64 2
Euro/Swiss franc 12 1 26 1 54 2
Euro/other 21 2 39 2 112 4
Other currency pairs 26 2 42 2 122 4
All currency pairs 1,173 100 1,794 100 3,081 100

(*) Adjusted for local and cross-border double-counting.
(**)Data for 2004 have been revised.
(***)The US dollar/Swedish krona pair could not be separately identified before 2007 and
is included in other.

As usual, US dollar/Euro is the most preferred currency pair followed by US dollar/Yen and US
dollar/Pound Sterling. However, the percentage share of US dollar/Euro pair is going down
from 30% in 2001 to 27% in 2007.

Table 3.D indicates the distribution of average daily turnover of each currency based on spot,
forward and swaps transactions. For some currencies, the spot transactions is highest ( like
Indian Rupees, Chinese Renmimbi, Turkish Lira etc.) while for others swap transactions have
the highest percentage ( like US dollar, Australian Dollar, Swedish Krona etc.).

This difference clearly indicates the degree of development of forex market in different
currencies. Currencies with higher percentage of swap contract indicate the maturity of the
currency market. In addition, currencies with higher percentage in spot market may be
experiencing greater degree of capital control, preventing traders from these markets to enter
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 14

into long-term contracts.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 15

Table 3.D Reported foreign exchange turnover by currency and instrument


Percentage shares of average daily turnover in April 2007
Spot Outright Foreign Exchange
Forwards Swaps
US dollar 29.7 10.9 59.4
Euro 36.9 12.1 51.1
Yen 40.4 12.1 47.5
Pound sterling 32.5 10 57.4
Swiss franc 42.2 10.1 47.7
Australian dollar 25.7 10 64.3
Canadian dollar 29.7 11.8 58.6
Swedish krona 20.7 10 69.3
Hong Kong dollar 18.4 7 74.6
Norwegian krone 18.4 9.7 71.9
New Zealand dollar 29.4 11.3 59.3
Mexican peso 37.4 11.7 50.9
Singapore dollar 22.5 7.9 69.6
Won 44.7 29.4 25.9
Rand 19.9 12.1 68
Danish krone 21.8 10.3 67.9
Rouble 70.7 5 24.3
Zloty 20 10.9 69.1
Indian rupee 42.6 27.5 29.8
Renminbi 61.4 31.3 7.4
New Taiwan dollar 47.1 40.6 12.3
Brazilian real 50.2 47.3 2.5
Forint 34.1 15.7 50.2
Czech koruna 23.8 20.9 55.3
Baht 18.9 13.3 67.8
Turkish lira 61.4 11.4 27.2
Philippine peso 36.9 32.5 30.5
Rupiah 43.7 39.3 17
All currencies 32.6 11.7 55.6

1 Adjusted for local and cross-border double-counting.

Table 3.E shows the major countrywise average daily foreign exchange turnover. The major
countries are Australia, Hong Kong, Japan, Singapore, Switzerland, United Kingdom and USA. It
is to be noted here that percentage column for all countries for a given year do not add upto
100% as some country details have been deleted from the master document to arrive at this
table.




INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 16





Table 3.E Major Countrywise Foreign Exchange Daily Average

Turnover


1998 2001 2004 2007
Amou % Amou % Amou % Amou %
nt nt nt nt
Australia 47 2.4 52 3.2 102 4.2 170 4.3
Canada 37 1.9 42 2.6 54 2.2 60 1.5
China 0 0.0 0 0.0 1 0.0 9 0.2
France 72 3.7 48 3.0 64 2.6 120 3.0
Germany 94 4.8 88 5.5 118 4.8 99 2.5
HongKong 79 4.0 67 4.1 102 4.2 175 4.4
India 2 0.1 3 0.2 7 0.3 34 0.9
Japan 136 6.9 147 9.1 199 8.2 238 6.0
Korea 4 0.2 10 0.6 20 0.8 33 0.8
Russia 7 0.4 10 0.6 30 1.2 50 1.3
Saudi Arabia 2 0.1 2 0.1 2 0.1 4 0.1
Singapore 139 7.1 101 6.2 125 5.2 231 5.8
Switzerland 82 4.2 71 4.4 79 3.3 242 6.1
United 637 32.5 504 31.2 753 31.0 1,359 34.1
Kingdom
United States 351 17.9 254 15.7 461 19.2 664 16.6
Total 1,969 100 1,616 100 2,429 100 3,988 100




Table 3.E indicates that Japans daily average foreign exchange turnover is going down while
countries like Switzerland, Australia and Hong Kong are showing an increasing trend. It is also
interesting to note that foreign exchange turnover percentage in United Kingdom is turnover
almost double the size that of United Statesproving that London still enjoys status of global
financial hub than New York.




3.3: Evolution of Foreign Exchange Market and Foreign
Exchange System



Since time immemorial, commodity money was used during barter system. From a wide
variety of commodities, gold, silver, silk and bronze became standardized commodity money.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 17

During 17
th
century, countries and kingdoms started using coins as the medium of exchange.
These coins had their own intrinsic value that was not related to any commodity.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 18


Normally coins were made up gold, silver or bronze. Some other unusual materials like stone
and limestone and slate were also used. Can anyone imagine -- Coins were traded weighing
8800 lbs! Box 3.1 has some interesting facts about Rai stones. The content of gold, silver or
bronze in a coin measured the intrinsic value of these coins, hence the exchange rate between
coins was governed by the amount of gold /silver/bronze content of the coins. When an
individual received/paid a coin, it meant that he was giving/receiving a certain weight of metal
backed by these currencies. The value of the coins also influenced by intangibles associated
these coins as mentioned in Box 2.2

By the end of 17
th
century, countries started using paper money. Though paper money had its
presence in China from 1050 till 1400, paper currency became accepted globally only during
17
th
century. Like the coins, the paper money was also backed by gold and silver. Exchange
rate between paper money was determined by the amount of gold/silver backed by respective
paper money. It is worth mentioning that, different countries started introducing paper money
at different point of time between 10
th
and 17
th
century.





Box 3.1 : Rai Stones as Coins

Rai stones are large, circular stone disks carved out of limestone in the island of Yap,
Micronesia. Locals have used these stones as a form of unusual currency, a "stone
money." Rai stones are circular disks carved out of limestone with a large hole in the
middle. The size of the stones varies widely; the largest are 3 meters (10 ft) in diameter,
0.5 meters (1.5 ft) thick and weigh 4 metric tons (8,800 lb). The extrinsic (perceived)
value of a specific stone is based not only on its size and craftsmanship but also on the
history of the stone. If many people - or no one at all - died when the specific stone was
transported, or a famous sailor brought it in, the value of the rai stone increases.
Rai stones were used in social transactions such as marriage, inheritance, political deals,
sign of an alliance, ransom of the battle dead or just in exchange for food. Many of them
are placed in front of meetinghouses or specific pathways. Though the ownership of a
particular stone changes, the stone itself is rarely moved. The names of previous owners
are passed down to the new one.





















INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 19


According to a Economist (1999) article titled Paper Money, Sweden was the first country in
Europe to introduce paper money in 1661 and other countries joined later.,
In 1694 the Bank of England started printing paper money used to be known as "running cash
notes

With increase in international trade, gold became universally accepted commodity to back
issuance of paper money. This led to the emergence of gold standard. During 1870, major
countries agreed to hold gold to back their currency notes. The value of any countrys
banknotes depended on the gold reserve held by a country and exchange rates

between two currencies depended on the amount of gold backed by respective currencies. The
gold standard existed until the First World War.

During 1944, Bretton Woods Agreement system came into existence. The Bretton
Woods Conference of 1944 established an international fixed exchange rate regime in which
currencies were pegged to the US Dollar, which in turn was based on the gold standard.
Bretton Woods agreement is considered as the most important economic and political
accomplishment of the cold ware era. Gavin (1996) in paper titled The legends of Bretton
Woods noted Bretton woods is the most revered name in international monetary history,
perhaps in economic history. As part of the agreement, from 1944 till 1971 , different
countries permitted the exchange rates to vary within a narrow band. Central governments
needed to intervene in the forex market regularly to keep the exchange rate within the band.
However, this led to substantial imbalances in the forex rates i.e, some currencies became
undervalued and some became overvalued. However significant changes have happened
during 1971.

The Smithsonian Agreement in 1971, countries were allowed to increase the band within which
currency rates can fluctuate (from 1 % to 2.25%). In this agreement, the member countries
i.e, Group Ten also decided to devalue US$ against most other currencies. The Smithsonian
Agreement of 1973 completely abandoned the band and currencies became free float.

Even though major changes were brought in 1973, but visible changes in forex market only
began to emerge in 1978, when worldwide currencies were allowed to 'float' according to
supply and demand. In 1992, twelve European countries joined common currency called Euro.

In a floating exchange rate system, supply and demand situation influences the exchange
rate. Though we see great deal of volatility in exchange rate, rarely any country has pure free
floating exchange rate. Most governments through their central banks influence the exchange
rate by changing their interest rates and adopting other means of control. Many-a-times
exchange rate changes when governors of central banks or high ranking officials of a central
bank just even casually remarks about whether their currency is under/overvalued.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 20


To sum it up, the fixed/semi-fixed vs, floating exchange rate system can be differentiated as
follows:

In fixed/semi-fixed exchange rate system, exchange rate is maintained at a specific level or
fluctuates within a given range. In such exchange rate system, the central banks play a crucial
role and regularly buy and sell foreign currency to maintain the exchange rate. Also the
central banks dictate the rate of interest so that the exchange rate remains at a given value or
remains within the range. This system provides great deal of advantage to exporters and
importers as they are not exposed to forex risk.

Fully fixed and fully floating exchange rates are at the two ends of broad spectrum of
exchange rate systems prevailing in different countries. However, rarely a country will have
fully fixed or fully floating exchange rate system.

In a fully fixed exchange rate, there could divergence between the official rate and the
currency true value. If the divergence is significant, a parallel black market starts operating
where the currencys true value is reflected. Periodically, the government of the country with
fixed exchange rate has to revalue or devalue the official rate. Similarly, very few countries
have fully floating exchange rate system. Central banks periodically intervene in currency
market to align the currency within an acceptable range. If a countrys central bank
aggressively intervenes to keep the exchange under control, then this is known as dirty float
currency regime. In most cases, central banks interventions are more of symbolic in nature
i.e., to send a message to the market participants regarding the true value of the currency.

In a floating exchange rate system, the exchange rate is determined mainly through supply
and demand. Hence, export-import balance, capital flows, countrys fiscal deficit etc. governs
the exchange rate. Fluctuating exchange rate poses significant forex risk to the exporter and
importers of the country.

Floating rate system led to the increase in forex trading. Initially forex trading was undertaken
mostly by banks and large multinational corporations. But with the proliferation of the
internet, individuals, exporters, importers, mutual funds, hedge funds are actively
participating in the forex market. The spread of electronic trading platforms has led to
tremendous growth as it has enabled large financial institutions to set up algorithmic trading
systems and has provided trading facilities to retail investors.



Foreign Exchange Brokers:

Foreign exchange brokers are agents who facilitate trading between dealers without
themselves becoming principals in the transaction. For this service, they charge a small
commission, and maintain access to hundreds of dealers worldwide via open telephone lines.



It is a broker's business to know at any moment exactly which dealers want to buy or sell any
currency. This knowledge enables the broker to find a counterpart for a client quickly without
revealing the identity of either party until after an agreement has been reached.

INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 21

Transactions in the Interbank Market Transactions in the foreign exchange market can be
executed on a spot, forward, or swap basis.

Spot Transactions:

A spot transaction requires almost immediate delivery of foreign exchange.
In the interbank market, a spot transaction involves 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."
Spot transactions are the most important single type of transaction (43 % of all
transactions).



Outright Forward Transactions:
A forward transaction requires delivery at a future value date of a specified amount of one
currency for a specified amount of another currency.
The exchange rate to prevail at the value date is established at the time of the agreement, but
payment and delivery are not required until maturity.
Forward exchange rates are normally quoted for value dates of one, two, three, six, and
twelve months. Actual contracts can be arranged for other lengths.
Outright forward transactions only account for about 9 % of all foreign exchange
transactions.

Swap Transactions:
A swap transaction involves the simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates.

The most common type of swap is a spot against forward, where the dealer buys a
currency in the spot market and simultaneously sells the same amount back to the same back
in the forward market. Since this agreement is executed as a single transaction, the dealer
incurs no unexpected foreign exchange risk.
Swap transactions account for about 48 % of all foreign exchange transactions.




Foreign Exchange Rates and Quotations

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.

Interbank Quotations:
The most common way that professional dealers and brokers state foreign exchange
quotations, and the way they appear on all computer trading screens worldwide, is called
European terms. The European terms quote shows the number of units of foreign currency
needed to purchase one USD:


CAD 1.5770 / USD

An alternative method is called the American terms. The American terms quote shows the
number of units of USD needed to purchase one unit of foreign currency:

USD 0.6341 / CAD

Clearly, those two quotations are highly related. Define the price of a USD in CAD to be Also,
define the price of a CAD in USD to be

INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 22

S(CAD /USD) CAD1.5770 /USD

Also, define the price of a CAD in USD to be

S(USD /CAD) USD0.6341/CAD
Then, it must be that


S (CAD USD)= 1/S (USD CAD)

Because CAD 1.5770 / USD = 1 / {USD 0.6341 / CAD}.

These rules also apply to forward rates as well. We will denote an outright forward quote using
the following notation:

F(CAD /USD)

Direct and Indirect Quotations:

A direct quote is a home currency price of a unit of foreign currency.


An indirect quote is a foreign currency price of a unit of home currency.
In the US, a direct quote for the CAD is

USD 0.6341 / CAD

This quote would be an indirect quote in Canada.


Bid and Ask Quotations:
Interbank quotations are given as "bid" and "ask".

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.

Dealers buy at the bid price and sell at the ask price, profiting from the spread between the
bid and ask prices: bid < ask.

Bid and ask quotations are complicated by the fact that the bid for one currency is the ask for
another currency:




S( USD CAD)=1/S (CAD USD)


S (USD CAD)=1/S (CAD USD)

Example 4.1: A dealer provides you the following quote:
USD 0.6333 - 0.6349/ CAD.

This suggests that the bid price for the CAD is USD 0.6333/CAD and
that the ask price is USD 0.6349/ CAD.

The indirect version of this quote would be
CAD 1.5750 - 1.5790/USD

Clearly, a dealer willing to purchase CAD at a price of USD 0.6333/USD is implicitly
willing to sell USD at the reciprocal price of CAD 1.5790/USD.

The spread between bid and ask prices exists for two reasons:
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 23

1. Transaction costs and dealers as financial intermediaries and
2. Profits.



The Law of One Price and Cross Rates
The law of one price states that homogenous goods and assets should have the same price
everywhere (efficient markets and free trade).

Cross Rates:

Many currency pairs are only inactively traded, so their exchange rate is determined
through their relationship to a widely traded third currency (generally the USD):
For example, imagine that an investor in Thailand would like to purchase some Barbados
Dollars (BBD). As both currencies are quoted against the USD, the investor can figure out the
price of the Thai Baht (THB) against the BBD. Assuming that the exchange rates are;


Quotations:
Thai Baht: --- THB 41.6982/USD
Barbados Dollars: --- BBD 2.0116/USD


The cross rate is THB/BBD is:


THB 41.6982/ USD/ 2.0116/ USD= THB 20.7289/ BBD






Global Economy - A Historical Perspective

The process of globalization is not a new phenomenon. Some communication and trade took
place among distant civilizations even in ancient times. In spite of occasional interruptions, the
degree of economic globalization among different societies, around the world has generally
been rising. More than a century ago, Marx and Engels rightly sensed the unprecedented
efficiency of the industrial capitalism and predicted that capitalism would sweep through the
entire world. Eventually capitalism spread to nearly the entire world, in a complex and
sometimes fierce process. (Brookings Papers on Economic Activity, 1995).

Indeed, during the past half century, the pace of economic globalization has been particularly
rapid. With the exception of human migration, global economic integration today is greater
than it ever has been and is likely to deepen further

It was the instrument of colonial expansion rather than the economic reforms through which
the global capitalism came into existent. Western European powers with their superior
industrial and military powers expanded their kingdom around the world. By the 1870s, the
industrial revolution and colonial expansion led to establish, a global market. Improvements in
the technological progress in transportation and communication sectors, changing tastes and
preferences of individuals and societies and public policies have significantly influenced the
character and pace of economic globalization. Global economic system started functioning with
the development of long distance communication system. Monetary standards, based on gold
and silver, provided the vital support for the stability and spread of economic globalization.

First World War, Great Depression of the 1930s and political upheaval created unprecedented
crises to global economy. The free trade regimes of 19
th
century were replaced by highly
protected trade, state planning, authoritarianism and limited market based economy. At the
end of the Second World War, the international economic system was in a state of collapse.
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 24

International markets for trade in goods, services, and financial assets were essentially
nonexistent. However, there was a silver lining in the midst of black cloud. It gave an
opportunity for a completely new beginning for the world economy.

The new beginning started in the formation of International Monetary Fund for world level
monetary standard. It also led in the establishment of various other international institutions
like the International Bank for Reconstruction and Development, General Agreement on Trade
and Tariff etc. Those institutions have contributed in the integration of world economy. After
the World War II, most national governments began to lower their entry barriers, to make
them more permeable for world trade.

The multilateral negotiations under the auspices of the General Agreement on Trade and
Tariffs (GATT) stand out as the most prominent examples of reduction of barriers for trade in
goods. The years between 1970 and 1990 have witnessed the most remarkable institutional
harmonization and economic integration among nations in the world history. The decade of
1980, witnessed the integration of the communist world with the world economy as capitalism
spread to their economies. The decade of 1980s also witnessed the practice of open economy
macroeconomic policies by many developing countries. Several Latin American and Asian
Countries had implemented financial reform policies or eliminated Government control of
domestic interest rates, credit allocation and exchange rate etc. Countries like Korea,
Malaysia, Chile, Argentina, Uruguya, Japan, Hong Kong, India and China have liberalized their
economies. They have undertaken many policy decisions to reform their financial markets.
One of the primary aims of financial reforms programme of these countries has been to
integration of the various segments of financial markets.

The decade of 1990s is generally considered as the decade of re-unification of global economy.
The world reached its climax in the process of integration of developed and developing worlds.
Disintegration of the Soviet Union, the emergence of market-oriented economies in Asia, the
creation of a single European market, formation of new era of trade liberalization through
World Trade Organization etc., are few events of 1990s which led to global financial and
economic integration. Development of IT-based communication system and services have
significantly contributed in the further expansion of global financial system.


Financial Globalization-The Missing Link

If there is any arena of economic activity that has become extremely global in recent decades,
it is finance. The world of finance has changed markedly over the past 40 years or so. During
the early part of 1970s world economy witnessed scarcity of international liquidity primarily
due to gold linked fixed monetary standard. There was also a growing realization that for
achieving sustained growth with stability, it would be necessary to have open trade, liberalized
external capital movements and a relatively flexible domestic monetary policy. Industrialized
countries and emerging market economies took steps to liberalize capital account and allow
capital to move across the globe.

Simultaneously, efforts were made to remove distortions in the domestic financial sector
through financial sector reform measures. With the technological improvements in electronic
payments, world economy became increasingly integrated in terms of trade, investment and
financial flows among countries over the past decades.

There are primarily three traceable aspects of the growth of financial markets, which have led
to financial globalization.
These are:
(i) Significant expansion and deepening of the existing markets,
(ii) Emergence of new financial markets like derivatives
(iii) Development of secondary markets for many instruments.

A number of developing countries, especially in Asia, that moved early on to the path of
economic liberalization had experienced large capital inflows. Large capital inflows, however,
carried with it risk of financial sector vulnerability. The world economy had witnessed many
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 25

financial crises. The experiences helped in for setting regulatory and supervisory framework, in
proper place, to ensure the safety and stability of financial systems. The costs of financial
crisis falling on the sovereign governments, the notion of financial stability has come to occupy
a centre-stage in public policy along with the requirement of ensuring that the efficiency of
financial sector is high.

The sub-prime crisis, which engulfed the world economy, has called for establishing a new
international financial architecture. According to the IMF's Global Financial Stability Report
(GFSR), the widening and deepening fallout from the U.S. subprime mortgage crisis would
have profound implications on financial system. Financial markets remain considerably
stressed because of a combination of weakening balance sheets of financial institutions,
continued process of deleveraging, free fall in asset prices and difficult macroeconomic
environment in the wake of debilitating global growth.



Experiences from India

Indias link with international trade is as old as the Indian civilization. Prior to colonial rule,
India was known as the hub of manufacturing goods and artifacts. During the colonial rule
India was converted to a raw materials suppliers to rest of the World. On the eve of
independence in 1947, foreign trade of India was typical of a colonial and agricultural
economy. Trade relations were mainly confined to Britain and other commonwealth countries.
Exports consisted chiefly of raw materials and plantation crops while imports composed of light
consumer goods and other manufactures. Over the last 60 years, India's foreign trade has
undergone a complete change in terms of composition and direction. The exports cover a wide
range of traditional and non-traditional items while imports consist mainly of capital goods,
petroleum products, raw materials, and chemicals to meet the ever-increasing needs of a
developing and diversifying economy.

For about 40 years (1950-90), foreign trade of India suffered from strict bureaucratic and
discretionary controls. Similarly, foreign exchange transactions were tightly controlled by the
government and the Reserve Bank of India. From 1947 till mid-1990s, India, with some
exceptions, always faced deficit in its balance of payments, i.e. imports always exceeded
exports. This was characteristic of a developing country struggling for reconstruction and
modernisation of its economy. Imports galloped because of increasing requirements of capital
goods, defence equipment, petroleum products, and raw materials. Exports remained
relatively sluggish owing to lack of exportable surplus, competition in the international market,
inflation at home, and increasing protectionist policies of the developed countries.

Beginning mid-1991, the government of India introduced a series of reforms to liberalize and
globalize the Indian economy. Reforms in the external sector of India were intended to
integrate the Indian economy with the world economy. India's approach to openness has been
cautious, contingent on achieving certain preconditions to ensure an orderly process of
liberalization and ensuring macroeconomic stability. This approach has been vindicated in
recent years with the growing incidence of financial crises elsewhere in the world. All the
same, the policy regime in India in regard to liberalization of the foreign sector has witnessed
very significant change. Over the years issues related to trade policy, export strategy, tariff
policy, current account dynamics, exchange rate management, foreign exchange reserves,
capital account liberalization, external debt and aid, foreign investments and WTO have been
the center of discussion under the International Trade and Finance.


Functions of International Financial Manager


In order to achieve the firms primary goal of maximizing stockholders wealth, the financial
manager performs three major functions:
(1) Financial planning and control (supportive tools);
(2) Efficient allocation of funds among various assets (investment decisions);
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 26

(3) Acquisition of funds on favorable terms (financing decisions).

Financial planning and control must be considered simultaneously. For purposes of control, the
financial manager establishes standards, such as budgets, for comparing actual performance
with planned performance. The preparation of these budgets is a planning function, but their
administration is a controlling function.

The foreign exchange market and international accounting play a key role when an MNC
attempts to perform its planning and control function. For example, once a company crosses
national boundaries, its return on investment depends on not only its trade gains or losses
from normal business operations but also on exchange gains or losses from currency
fluctuations. International reporting and controlling have to do with techniques for controlling
the operations of an MNC.

Meaningful financial reports are the cornerstone of effective management. Accurate financial
data are especially important in international business, where business operations are typically
supervised from a distance. When the financial manager plans for the allocation of funds, the
most urgent task is to invest funds wisely within the firm. Every dollar invested has alternative
uses. Thus, funds should be allocated among assets in such a way that they will maximize the
wealth of the firms stockholders. There are 200 countries in the world where a large MNC, can
invest its funds. Obviously, there are more investment opportunities in the world than in a
single country, but there are also more risks. International financial managers should consider
these two simultaneously when they attempt to maximize their firms value through
international investment.

One of the primary roles of the financial manager is to acquire funds on favorable terms. If
projected cash outflow exceeds cash inflow, the financial manager will find it necessary to
obtain additional funds from outside the firm. Funds are available from many sources at varying
costs, with different maturities, and under various types of agreements. The critical role of the
financial manager is to determine the combination of financing that most closely suits the
planned needs of the firm. This requires obtaining the optimal balance between low cost and
the risk of not being able to pay bills as they become due. MNCs can still raise their funds in
many countries thanks to recent financial globalization.

This globalization is driven by advances in data processing and telecommunications,
liberalization of restrictions on cross-border capital flows, and deregulation of domestic capital
markets. International financial managers use a puzzling array of fund acquisition strategies.
Instead of merely focusing on the efficient allocation of funds among various assets and the
acquisition of funds on favorable terms, financial managers must now concern themselves with
corporate strategy. The chief financial officer is emerging as a strategic planner. In an era of
heightened global competition and hard-to-make-stick price increases, the financial fine points
of any new strategy are more crucial than ever before.



Forex Market Participants:


The foreign exchange market as discussed in Session 3, is the largest market in the world
with average daily turnover of US$ 3.2 trillion. It spans allover the world and operates 24
hours a day In this session, broad generic categories of forex market participants and the
different types of the forex products traded in the market are discussed.

INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 27

Types of forex market participants:

The forex market is a OTC market without any centralized clearinghouse. It consists of
two tiers.

The interbank or wholesale market,
Client or retail market.


Five broad categories of participants operate within these two tiers:
Bank and non bank foreign exchange dealers
Foreign exchange brokers
Hedgers, Speculators and arbitragers
Central banks and treasuries
Individuals and firms conducting commercial or investment transactions
Madam

Wholesale Forex Market: Major forex trading in the wholesale forex markets is
undertaken by banks popularly known as interbank market. In this market, banks and
non-bank financial institutions transact with each other. They undertake trading on behalf
of customers, but majority of trading is undertaken for their own account by proprietary
desks.

Besides banks and non-bank financial institutions, multinational corporations, hedge
funds, pension and provident funds, insurance companies, mutual funds etc. participate in
the wholesale market.


Big multinational companies earn their revenue and incur expenses in many different
currencies. For example, Switzerland based Nestle operates in 86 countries across the
globe. To hedge their foreign exchange risk these multinational companies directly
participate in the wholesale market. Hedge funds are also major player in this market.
Hedge funds collect huge sums from high net worth individuals and undertake
speculative trades in equity, debt, forex and derivatives market. Mutual funds with
international equity portfolio are also major players in this market.




Foreign Exchange Dealers and Brokers: The role of foreign exchange dealers and
brokers need to be discussed in detail. But, let us first understand who forex dealers are.
Dealers: Banks and some nonblank financial institutions act as foreign exchange dealer.
These dealers quote both bid and ask for a particular currency pair (for spot,
forward and swap contracts) and take opposite side to either buyers or sellers of currency.
They make profit from the spreads between buying and selling prices ie., bid and ask rate.
Brokers are agents, which merely match buyers and sellers and get a brokerage fee.

Before the internet, the brokers, dealers and clients were communicating over telephone
or telex and through satellite communication. SWIFT (Society for Worldwide
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 28

Interbank Financial Telecommunication) facilitated the communication between these
brokers and banks. More details about Swift are discussed in Section 4.2. Brokers and
dealers used to have terminals from Reuters and Bloomberg indicating the bid and ask
spread quoted by different currency transactions.



These dealers are also known as market maker. As market makers, these dealers
stand willing at all time to buy and sell currencies at the quoted rate. Dealers do not
necessarily make markets for all currency but specialize in some currency pair. A
person/company intending to trade may directly get in touch with the dealer to get a two
way quote and execute a trade.


Brokers: Brokers on the other hand, help clients to get a better rate on the currency
trade by making available different quotes offered by dealers. Traders can compare rates
and accordingly take a decision. Brokers charge a commission for providing these
services. Communication between brokers and clients also used to be through dedicated
telephone lines. A broker continuously remains connected to dealers to get latest quotes,
depth of the market. The broker compares the rates offered by the dealers and provides
the best rates to the clients i.e, highest bid prices quoted by different dealers when the
client wants to sell and lowest ask price quoted by different dealers when the clients
wants to buy. With the emergence of communication technology, now most of the most
of broker deals are happening in electronic brokering system.

Foreign exchange dealers trade among themselves through direct dealing and through
brokers. In case of direct dealing, two dealers contact each other directly and undertake a
trade. Like any other traders, dealers may contact brokers for executing their proprietary
trades if these dealers want anonymity in trading.



Hedger, Speculators and Arbitrageurs: Traders buying and selling foreign
exchange can take the role of hedgers, or speculators or arbitrageurs.

Hedgers are traders who undertake forex trading because they have assets or liability in
foreign currency. For example, when an importer requiring foreign currency, sells
domestic currency to buy foreign currency, he is termed as a hedger. The importer has a
foreign currency liability. Similarly, an exporter sells foreign currency and buys domestic
currency is a hedger. The exporter has assets denominated in foreign currency. A MNC
entering into a foreign currency forward contract so that it can repatriate its earning to
parent company. An Indian company swapping its foreign currency interest payment
obligations to INR interest obligation. All these are examples of hedging. Hedgers use
the foreign currency market to hedge the risk associated with volatility in foreign
exchange market.

Speculators are traders who essentially buy and sell foreign currency to make profit from
the expected futures movement of the currency. These traders do not have any genuine
requirement for trading foreign currency. They do not hold any cash position in the
currency.

INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 29

Arbitrageurs buy and sell the same currency at two different markets whenever there is
price discrepancy. The principle of law of one price governs the arbitrage principle.
Arbitrageurs ensure that market prices move to rational or normal levels. With the
proliferation on internet, cross currency, cross currency arbitrage possibility has increased
significantly.

Central Banks and Treasuries: All most all central bank and treasuries participate in
the forex market. Central banks play very important role in foreign exchange market.
However, these banks do not undertake significant volume of trading. Each central bank
has official/unofficial target of the forex rate for its home currency. If the actual price
deviates from the target rate, the central banks intervene in the market to set a tone.
Besides central banks, other commercial banks also buy and sell forex primarily for
Retail Market:
In the retail market, individuals (tourists, foreign students, patients traveling to other
countries for medical treatment) small companies, small exporters and importers operate.
Money transfer companies/remittance companies (for example like Western Union) are
also major players in the retail market.



Retail traders buy/sell currency for their genuine business/personal requirements. For
example, an exporter enters into forward contract to convert foreign currency to domestic
currency. A tourist buys foreign currency in the spot market before undertaking the
journey. A UK patient visiting India to undertake an operation that would have cost him
a fortune at UK.

Majority of retail trading happens in the spot market. Why? As retailers requirements
are normally not repetitive in nature, they buy or sell the currency as when the
requirement arises.

Forex Trading and SWIFT


In an interbank forex transaction, no real money changes hand. All transactions are done
electronically through SWIFT. Banks undertaking forex transactions simply transfer bank
deposits through SWIFT to settle a transaction.

SWIFT is the Society for Worldwide Interbank Financial Telecommunication is a
cooperative organization headquartered at Belgium. The Swift network connects around
8300 banks, financial institutions and companies operating 208 countries. Swift provides
a standardized messaging service to these members. As and when two counterparties
undertake a transaction, SWIFT transports the message to both financial parties in a
standard form. As the forex market is mainly an OTC market, SWIFT message provides
some kind of legitimacy to the transactions. The following line captures summarizes the
activities at SWIFT.

SWIFT is solely a carrier of messages. It does not hold funds nor does it manage
accounts on behalf of customers, nor does it store financial information on an ongoing
basis. As a data carrier, SWIFT transports messages between two financial
institutions. This activity involves the secure exchange of proprietary data while
INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 30

ensuring its confidentiality and integrity. For every participating member, SWIFT
assigns a unique code. This code is used to transport messages.

Robots & Forex Trading :


Computers and internet have become the must have requirement for anybody undertaking
forex trading. Many companies are selling software packages guaranteeing unthinkable
profit by installing these packages. These packages are popularly known as forex robots.
These are not robots in real sense of the word, but these are software which would
automate trades based some setting given by the trader. The trader need not physically
remain present when they trade is placed and executed.

The variety of such packages available runs into hundreds if not thousands. A typical
forex robot would entice traders with tagline like Our 100% no loss robot will
automatically enter and exit profitable trades for you. Imagine always being in the
market and making profitable trades while you are free to spend time with the
family, go to work, and live life ...


INTERNATIONAL FINANCIAL MANAGEMENT

D.NAGARAJU MBA., (M,COM) AP SET Page 31