What is FOREIGN EXCHANGE MARKETS

FOREIGN EXCHANGE MARKETS

A foreign exchange market is one where currencies of other countries are bought and sold. Had all countries one common currency, there would have been no foreign exchange market. People demand currency for payments of imports, tourism, sending gifts and investing abroad. When foreigners buy Indian goods, come to India, invest in India it becomes a sources of foreign exchange supply. Therefore, a market gets established where transactions are taking place. This market facilitates foreign trade. It is a cash interbank or interdealer market. Let us understand the concept of exchange rates to understand the concept of forex market better. 

The rate at which currency of one country is traded for other is called exchange rate. It can be written as ` For $ or $ for ` V is the `/$ and E is $/` i.e. 1/V. value of one currency is always given in terms of another. Therefore, value of Japanese Yen in terms of rupee is `/Yen exchange rate. It is not possible to give value of rupee in terms of rupee. It has to be given in terms of something else. There may be two types of quotes in foreign exchange market: direct and indirect. 

(a) Direct Quote: 

It refers to the number of units of a foreign currency exchangeable for one unit of a local currency. 

(b) Indirect Quote: 

It is number of units of foreign currency that can be purchased in return of one unit of local currency. Indirect quote and direct quote are reciprocals of each other. 

When price of one currency increases in terms of other currency, it is said to have appreciated. On the other hand, when price of one currency falls in respect to other, it is said to be depreciated. For example, if exchange rate of India was ` 50 per dollar and it becomes ` 48 per dollar then rupee has appreciated and dollar has depreciated. The rate of appreciation or depreciation is the percentage change in value of a currency over a given period of time. An appreciation is decline in direct quote and a rise in indirect quote. 

Foreign exchange market is a worldwide market which includes trading between large banks, central banks, currency speculators, MNCs, governments and financial institutions. It exceeds $1.9 trillion per day on an average. Foreign exchange market is an electronically connected network of big banks, dealers and Foreign exchange market brokers. The biggest Foreign exchange market centre is in London. Transactions go on 247. SWIFT (Society of Worldwide International Financial Telecommunications) is a satellite based communication network through which operations go on in Foreign exchange markets. However, there is a small margin between buying and selling price of currencies but volumes traded are so large that total profits or losses come out to be very large. 

There are two parts of foreign exchange markets: 

(a) Retail Market: 

Under retail market, we include exchange of bank notes, bank drafts, currency, and travelers’ cheques of private customers, banks and tourists. 

(b) Wholesale Market: 

It includes the central bank and mainly composed of an inter-bank market in which major banks of different countries trade in currencies held in different currency-denominated bank accounts. This inter-bank market has two parts direct and indirect. When banks deal strictly with banks, it is called direct market. When banks put orders with brokers it is called indirect market. The brokers take their commission from buyers as well as sellers. 

Currencies are traded on different bases: 

(i) Arbitrage: 

It means buying a product when its price is low and selling it at a future date when its price is high and making a profit in between. It is also possible to buy from one market and selling in other. Arbitragers tend to bring prices in different market to equality. 

(ii) Spot Exchange Rate: 

The rate which is prevalent in present market is called spot rate. Practically, it takes two days in transaction to take place. 

(iii) Forward Exchange Rate: 

When rate at which a currency will be traded in future is determined today, it is called forward exchange rate. It may be for 30 days to a year or longer. Forward exchange rates prevail for reducing exchange risk and a kind of hedging. When the forward ER is such that it forward trade costs is les than spot trade costs , it is said to be forward discount. When forward trade costs is more than spot trade costs, it is said to be forward premium. 

(iv) Hedging: 

Hedging is a contract whereby a trader enters into a forward contract to protect himself form market fluctuations. It also leads to loss of an opportunity of making a gain.