UNIT – II

FOREIGN EXCHANGE MARKET

The Foreign Exchange Market (Forex, FX, or currency market) is a
form of exchange for the global decentralized trading of international
currencies. Financial centers around the world function as anchors of
trading between a wide range of buyers and sellers around the clock,
with the exception of weekends. The foreign exchange market determines
the relative values of different currencies. The foreign exchange market
assists international trade and investment by enabling currency
conversion. For example, it permits a business in the United States to
import goods from the European Union member states, especially Euro
zone members, and pay Euros, 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. 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 20:15 GMT on Sunday 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.

The foreign exchange market merely a part of the money market in the
financial centers is a place where foreign currencies are bought and
sold. The buyers and sellers of claims on foreign money and the
intermediaries together constitute a foreign exchange market. It is not
restricted to any given country or a geographical area. Thus, the foreign
exchange market is the market for a national currency (foreign money)
anywhere in the world, as the financial centers of the world are united in
a single market. The foreign exchange market performs the following
important functions: (i) to effect transfer of purchasing power between
countries- transfer function; (ii) to provide credit for foreign trade -
credit function; and (iii) to furnish facilities for hedging foreign
exchange risks - hedging function.

Different Terms Used in a Foreign Exchange Market

1. EXCHANGE RATE It is the price of one currency quoted in terms of
another currency.
2. SPOT RATE It is the exchange rate applicable for an immediate
settlement, i.e. the exchange rate prevailing now.
3. FORWARD RATE It is the exchange rate contracted today for
exchange of currencies at a future date.
4. DIRECT QUOTE It refers to the expression of exchange rate where
one unit of foreign currency is expressed in terms of number of units of
local / domestic currency. Example $1 = `40.00 [in India
5. INDIRECT QUOTE It refers to quoting per unit of Local / Domestic
Currency in terms of number of u n i t s of Foreign Currency. Example:
`1 = $0.025.
6. TWO WAY QUOTE Two Way Quote refers to quoting Exchange
Rates by an Exchange Dealer in terms of Buying (Bid) Rate and Selling
(Ask) Rate.
7. BID RATE Bid Rate is the price at which the Exchange Dealer will
buy currency. It is also called as Buy Rate. [It is the rate at which a
Customer can sell a Foreign Currency]
8. OFFER RATE Offer Rate is the rate at which the Exchange Dealer
will sell currency. It is also called as Sell Rate or Ask Rate. [It is the rate
at which a Customer can Buy a Foreign Currency]
9. AMERICAN QUOTE It refers to quoting per unit of any currency in
terms of American Dollars.
10. EUROPEAN QUOTE It refers to quoting per unit of American
Dollars in terms of any other currency an indirect quotation whereby the
value of foreign currency is stated as per unit measure of the U.S Dollar.

FOREIGN EXCHANGE RATE

A foreign exchange rate, which is also called a forex rate or currency
rate, represents the value of a specific currency compared to that of
another country. For example, an interbank exchange rate of 91
Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91
will be exchanged for each US$1 or that US$1 will be exchanged for
each ¥91.
Exchange rates are determined in the foreign exchange market, which
is open to a wide range of different types of buyers and sellers where
currency trading is continuous: 24 hours a day except weekends.
Currency rates are applicable only on currency pairs. The currency
listed on the left is called the reference (or base) currency while the one
listed to the right is the quote (or term) currency. Exchange rates are
always written in the form of quotations. A quotation reflects the number
of quote currencies that can be bought by using a single unit of
reference currency.
Foreign Exchange Rates – Determinants
1. Interest Rate Differentials: Higher rate of interest for an investment
in a particular currency can push up the demand for that currency,
which will increase the exchange rate in favour of that currency.
2. Inflation Rate Differentials: Different countries’ have differing
inflation rates, and as a result, purchasing power of one currency may
depreciate faster than currency of some other country. This contributes
to movement in exchange rate.
3. Government Policies: Government may impose restriction on
currency transactions. Through RBI, the Government, may also buy or
sell currencies in huge quantity to adjust the prevailing exchange rates.
4. Market Expectations: Expectations on changes in Government,
changes in taxation policies, foreign trade, inflation, etc. contribute to
demand for foreign currencies, thereby affecting the exchange rates.
5. Investment Opportunities: Increase in investment opportunities in
one country leads to influx of foreign currency funds to that country.
Such huge inflow will amount to huge supply of that currency, thereby
bringing down the exchange rate.
6. Speculations: Speculators and Treasury Managers influence
movement in exchange rates by buying and selling foreign currencies
with expectations of gains by exploiting market inefficiencies. The
quantum of their operations affects the exchange rates.

BID-ASK RATE
The bid price is the highest price that someone is willing to pay for
buying an asset at that moment. The foreign exchange market is nothing
more than an ongoing auction to buy and sell. Just as with any auction,
buyers place bids. The asking price is the lowest price at which someone
is willing to sell at that moment. Think of it as when you sell a house or
other item, you are “asking” a certain price for it. Sellers place asking
prices. Therefore, if you are interested in buying dollars, you should
look at the asking price of a seller. You would have a buyer matched
with a seller and the trade could be executed. Likewise, if you are
interested in selling dollars, you should look at the bid price since of a
buyer. Again, you’d have a buyer matched with a seller and the trade
could get executed. The bids and offers come from “limit” orders placed
by buyers and sellers. For instance, assume that a rupee has a bid of
$50 and an asking price of $50.30. If you place a limit order to buy 100
rupees at $50.10 that means your order could only get executed if you
pay $50.10 or less. The bid would be raised to $50.10. The new quote
would be bidding $50.10 and asking $50.30. You are now the highest
bidder and get posted to the board. Likewise, if someone placed a limit
order to sell at $50.20 that means they will only sell their rupees if they
can get that price or higher. The new quote would be bid $50.10 and
asking $50.20. They are now the lowest offer so get posted to the board.

SPREAD
Spread is the difference between the dealer’s Ask Rate and Bid Rate. If
the exchange rate is expected to be stable, the spread will be narrow. If
the exchange rate is volatile, the spread will be wider. Where volume of
transactions is very high, the Bid-Offer Spread will be very low. In case
of a thinly-traded currency, the spread will be wider.

DIRECT AND INDIRECT QUOTE

A direct quote is a foreign exchange rate involving a quote in fixed units
of foreign currency against variable amounts of the
domestic currencyDirect quotation is where the cost of one unit of
foreign currency is given in units of local currency, whereas indirect
quotation is where the cost of one unit of local currency is given in units
of foreign currency.
EXAMPLE:
Your local currency is EUR:
- Direct exchange rate: 1USD = 0.92819 EUR
- Indirect exchange rate: 1EUR = 1.08238 USD
The term indirect quote is a currency quotation in the foreign exchange
market that expresses the variable amount of foreign currency required
to buy or sell fixed units of the domestic currency. An indirect quote is
also known as a “quantity quotation,” since it expresses the quantity of
foreign currency required to buy units of the domestic currency. In other
words, the domestic currency is the base currency in an indirect quote,
while the foreign currency is the counter currency.

An indirect quote is the opposite or reciprocal of a direct quote, also

known as a “price quotation,” which expresses the price of a fixed
number of units of a foreign currency as compared with a variable
number of units of the domestic currency.

A direct quote can be calculated using the following formula:

DQ = 1/IQ

Where:

• DQ = Direct Quote
• IQ = Indirect Quote

CROSS RATE
A cross rate is the currency exchange rate between two currencies when
neither are the official currencies of the country in which the exchange
rate quote is given. For instance, a British-based trader may seek the
cross rate between the euro and the yen, without directly involving the
pound in any way. Cross rates are the relation of two currencies against
each other, based on the rate of each of them against a third currency.
For example, the Bank of England sells or purchases euros for yen. To
calculate the cross rate of the EURJPY, the bank will use the
dollar quotes for the two pairs, EURUSD and USDJPY. As such,
the Ask and Bid quotes of EURJPY will be calculated as follows:
Bid EURJPY = Bid EURUSD x Bid USDJAPY; Ask EURJPY = Ask
EURUSD x Ask USDJPY

SPOT AND FORWARD RATE

The forward rate and spot rate are different prices, or quotes, for
different contracts. A spot rate is a contracted price for a transaction
that is taking place immediately (it is the price on the spot). A forward
rate, on the other hand, is the settlement price of a transaction that will
not take place until a predetermined date in the future; it is a forward-
looking price. Forward rates typically are calculated based on the spot
rate.
Spot Rate
A spot rate, or spot price, represents a contracted price for the purchase
or sale of a commodity, security, or currency for immediate delivery and
payment on the spot date, which is normally one or two business days
after the trade date. The spot rate is the current price of the asset quoted
for the immediate settlement of the spot contract.
Spot prices are most frequently referenced in relation to the price of
commodity futures contracts, such as contracts for oil, wheat, or gold.
This is because stocks always trade at spot.
Forward Rate
Unlike a spot contract, a forward contract, or futures contract, involves
an agreement of contract terms on the current date with the delivery and
payment at a specified future date. Contrary to a spot rate, a forward
rate is used to quote a financial transaction that takes place on a future
date and is the settlement price of a forward contract. However,
depending on the security being traded, the forward rate can be
calculated using the spot rate. Forward rates are calculated from the
spot rate and are adjusted for the cost of carry to determine the future
interest rate that equates the total return of a longer-term investment
with a strategy of rolling over a shorter-term investment.
PURCHASING POWER PARITY (PPP)
PPP is a measurement of prices in different countries that uses the
prices of specific goods to compare the absolute purchasing power of
the countries' currencies. In many cases, PPP produces an inflation rate
that is equal to the price of the basket of goods at one location divided
by the price of the basket of goods at a different location. The PPP
inflation and exchange rate may differ from the market exchange
rate because of poverty, tariffs, and other transaction costs.
Purchasing power parity (PPP) is an economic theory of exchange rate
determination. It states that the price levels between two countries
should be equal.

This means that goods in each country will cost the same once the
currencies have been exchanged. For example, if the price of a Coca
Cola in the UK was 100p, and it was $1.50 in the US, then
the GBP/USD exchange rate should be 1.50 (the US price divided by the
UK’s) according to the PPP theory.

However, if you were then to look at the market exchange rate of the
GBP/USD pair, it is actually closer to 1.25. The discrepancy occurs
because the purchasing power of these currencies is different. As with
any asset, there is the real value of a currency and the notional value,
which financial markets trade at. The aim of the PPP measurement is to
make comparisons between two currencies more valid, by adjusting for
local purchasing power differences.
 The theory of purchasing power parity relies on the idea of arbitrage –
the opportunity to buy an item in one place, and sell it for higher price
immediately in another, taking advantage of price differentials. This
would eventually cause prices to converge, as the buying and selling
would balance prices. However, in reality, there are transaction costs,
government taxation and barriers to trade that prevent costs from
equalising.

• Purchasing power parity (PPP) is an economic theory that suggests the

prices of goods and services between two countries should be equal,
once their currencies have been exchanged

• PPP was introduced to be a more accurate and effective measure of a

currency’s power

• It is split into two types: absolute PPP, which doesn’t adjust for
inflation, and relative PPP, which does

• PPP is used to compare economic productivity and living standards

between countries

• Purchasing power parity is used to measure GDP and is used as an

alternative to nominal GDP

• The theory argues that tradable goods are more closely aligned with
nominal exchange rates, while non-tradeable goods and services are
closer to the PPP rate

• PPP can also be used to assess socioeconomic situations, such as

carbon emissions, global poverty, government manipulation and
financial markets
• Traders will often use PPP to assess a currency’s long-term forecast
and exchange rate valuation – using it to identify over- and under-
valued currencies

• PPP can then be used to decide whether to take a long or a short

position

• PPP can also be used in share trading, to decide whether to hedge

against currency risk

• There are multiple indices that are used to measure PPP, including the
OECD comparative price index, Big Mac index and KFC index

• PPP is found in everyday life to explain the differences in living costs

between two countries

• There are significant limitations to the theory, such as its exclusion of

other transactional costs, taxes and barriers to trade

INTEREST RATE PARITY

Interest Rate Parity (IPR) theory is used to analyze the relationship
between the spot rate and a corresponding forward (future) rate of
currencies.
The IPR theory states interest rate differentials between two different
currencies will be reflected in the premium or discount for the forward
exchange rate on the foreign currency if there is no arbitrage - the
activity of buying shares or currency in one financial market and selling
it at a profit in another.
The theory further states size of the forward premium or discount on a
foreign currency should be equal to the interest rate differentials
between the countries in comparison.
The interest rate parity (IRP) is a theory regarding the relationship
between the spot exchange rate and the expected spot rate
or forward exchange rate of two currencies, based on interest rates. The
theory holds that the forward exchange rate should be equal to the spot
currency exchange rate times the interest rate of the home country,
divided by the interest rate of the foreign country.
Interest Rate Arbitrage
Opportunities for interest arbitrage arise when the money rates differ
among countries. Gold arbitrage and securities arbitrage operate in
principle very much like commodity arbitrage in the domestic market,
except that in the two former cases exchange rates are important, either
because funds must be remitted abroad for the operation or because the
proceeds must be brought home at the end of the operation.
Covered Interest Arbitrage
An arbitrage transaction that takes advantage of any instance when the
forward premium or forward discount between two currencies does not
equal the interest rate differential. When this occurs, arbitrageurs can use
covered interest arbitrage to generate profits until the relationships
return to equilibrium. This may be done by buying / selling one currency
in the spot market and simultaneously selling / buying it in the forward
market and using the sale proceeds to invest in an asset denominated in
the spot currency; when the asset matures, the proceeds are used to fulfill
the purchase and the arbitrage transaction concludes with a riskfree
profit.

Implications of Interest Rate Parity Theory

If IRP theory holds then arbitrage is not possible. No matter whether an
investor invests in domestic country or foreign country, the rate of return
will be the same as if an investor invested in the home country when
measured in domestic currency.
If domestic interest rates are less than foreign interest rates, foreign
currency must trade at a forward discount to offset any benefit of higher
interest rates in foreign country to prevent arbitrage.
If foreign currency does not trade at a forward discount or if the forward
discount is not large enough to offset the interest rate advantage of foreign
country, arbitrage opportunity exists for domestic investors. So domestic
investors can benefit by investing in the foreign market.
If domestic interest rates are more than foreign interest rates, foreign
currency must trade at a forward premium to offset any benefit of higher
interest rates in domestic country to prevent arbitrage.
If foreign currency does not trade at a forward premium or if the forward
premium is not large enough to offset the interest rate advantage of
domestic country, arbitrage opportunity exists for foreign investors. So
foreign investors can benefit by investing in the domestic market.
Limitations of Interest Rate Parity Model
In recent years the interest rate parity model has shown little proof of
working.
In many cases, countries with higher interest rates often experience
currency appreciation due to higher demands and higher yields and has
nothing to do with risk-less arbitrage.

MARKET PARTICIPANTS IN FOREX MARKET

Forex Dealers
Forex dealers are amongst the biggest participants in the Forex market.
They are also known as broker dealers. Most Forex dealers in the world
are banks. It is for this reason that the market in which dealers interact
with one another is also known as the interbank market. However, there
are some notable non-bank financial institutions also that deal in
foreign exchange.
These dealers participate in the Forex markets by providing bid-ask
quotes for currency pairs at all times. All brokers do not participate in
all currency pairs. Rather, they may specialize in a specific currency
pair. Alternatively, a lot of dealers also use their own capital to conduct
proprietary trading operations. When both these operations are
combined, Forex dealers have a significant participation in the Forex
market.
Brokers
The Forex market is largely devoid of brokers. This is because a person
need not deal with brokers necessarily. If they have sufficient
knowledge, they can directly call the dealer and obtain a favorable rate.
However, there are brokers in the Forex market. These brokers exist
because they add value to their clients by helping them obtain the best
quote. For instance, they may help their clients obtain the lowest buying
price or the highest selling price by making available quotes from
several dealers. Another major reason for using brokers is creating
anonymity while trading. Many big investors and even Forex dealers use
the services of brokers who act as henchmen for the trading operations
of these big players.
Hedgers
There are many businesses which end up creating an asset or a liability
priced in foreign currency in the regular course of their business. For
instance, importers and exporters engaged in foreign trade may have
open positions in several foreign currencies. They may therefore be
impacted if there is a fluctuation in the value of foreign currency. As a
result, to protect themselves against these losses, hedgers take opposite
positions in the market. Therefore if there is an unfavorable movement
in their original position, it is offset by an opposite movement in their
hedged positions. Their profits and losses and therefore nullified and
they get stability in the operations of their business.
Speculators
Speculators are a class of traders that have no genuine requirement for
foreign currency. They only buy and sell these currencies with the hope
of making a profit from it. The number of speculators increases a lot
when the market sentiment is high and everyone seems to be making
money in the Forex markets. Speculators usually do not maintain open
positions in any currency for a very long time. Their positions are
transient and are only meant to make a short term profit.
Arbitrageurs
Arbitrageurs are traders that take advantage of the price discrepancy in
different markets to make a profit. Arbitrageurs serve an important
function in the foreign exchange market. It is their operations that
ensure that a market as large, as decentralized and as diffused as the
Forex market functions efficiently and provides uniform price quotations
all over the world. Whenever arbitrageurs find a price discrepancy in
the market, they start buying in one place and selling in another till the
discrepancy disappears.
Central Banks
Central Banks of all countries participate in the Forex market to some
extent. Most of the times, this participation is official. Although many
times Central Banks do participate in the market by covert means. This
is because every Central Bank has a target range within which they
would like to see their currency fluctuate. If the currency falls out of the
given range, Central Banks conduct open market operations to bring it
back in range. Also, whenever the currency of a given nation is under
speculative attack, Central Banks participate extensively in the market
to defend their currency.
Retail Market Participants
Retail market participants include tourists, students and even patients
who are travelling abroad. Then there are also a variety of small
businesses that indulge in foreign trade. Most of the retail participants
participate in the spot market whereas people with long term interests
operate in the futures market. This is because these participants only
buy/sell currency when they have a personal/professional requirement
and dealing with foreign currencies is not a part of their regular
business.