CHAPTER # 7CHAPTER # 7Foreign Exchange Foreign Exchange

MarketMarket

Professor Dr. Md. Abu SinaProfessor Dr. Md. Abu Sina

Definition of FOREX MarketDefinition of FOREX Market It is a market where transaction in It is a market where transaction in

foreign currencies takes place. It is a foreign currencies takes place. It is a medium of international trade. In fact, it medium of international trade. In fact, it is an institutional arrangement for is an institutional arrangement for transacting business in international transacting business in international currencies. Kindleberger defines a foreign currencies. Kindleberger defines a foreign exchange market as, “a place where exchange market as, “a place where foreign moneys are bought and sold. foreign moneys are bought and sold.

The The foreign exchangeforeign exchange market, also known market, also known as the forex, FX, or currency market, as the forex, FX, or currency market, involves the trading of one currency for involves the trading of one currency for another. another.

Foreign exchange markets exist to allow Foreign exchange markets exist to allow businessbusiness owners to purchase currency in owners to purchase currency in another country so they can do business another country so they can do business in that country. in that country.

ParticipantsParticipantsThere are approximately five different There are approximately five different

types of entities that use the foreign types of entities that use the foreign exchange markets on a daily basis. exchange markets on a daily basis. Commercial banksCommercial banks are the leaders in are the leaders in this market and are the main source this market and are the main source of currency transactions. of currency transactions. Traditional Traditional usersusers refer to entities that do refer to entities that do business across national borders. business across national borders. Central banksCentral banks are the official players are the official players in this market, and each country has in this market, and each country has a central bank to manage its money a central bank to manage its money supply. supply. BrokersBrokers work as go-betweens work as go-betweens for banks, typically during large for banks, typically during large transactions. And, transactions. And, traderstraders and and speculatorsspeculators work to take advantage work to take advantage of short-term trends in the market.of short-term trends in the market.

FeaturesFeatures The major features of foreign The major features of foreign

exchange market are as follows:exchange market are as follows:

1.1. Bank & customers/clients,Bank & customers/clients,

2.2. Different Banks in FEM,Different Banks in FEM,

3.3. Different Bank of different Different Bank of different countries,countries,

4.4. Central Bank & Commercial Bank,Central Bank & Commercial Bank,

5.5. Central Bank of different country,Central Bank of different country,

6.6. Public of a country.Public of a country.

Where This HappensWhere This HappensUnlike the New York Stock Unlike the New York Stock

Exchange, which has a physical Exchange, which has a physical building, currency exchange takes building, currency exchange takes place all over the world and has no place all over the world and has no central building. Most transactions central building. Most transactions are done by phone or computer. are done by phone or computer. Estimates have the international Estimates have the international currency exchange driving $180 currency exchange driving $180 billion in business per day. The billion in business per day. The majority of transactions take place majority of transactions take place in London, New York and Tokyo, in London, New York and Tokyo, with cities such as Singapore, with cities such as Singapore, Zurich, Frankfurt and Hong Kong Zurich, Frankfurt and Hong Kong handling transactions as well.handling transactions as well.

Features of FOREX MarketFeatures of FOREX Market The FX market is a two-tiered market:The FX market is a two-tiered market:

– Interbank Market (Wholesale)Interbank Market (Wholesale) About 100-200 banks worldwide stand About 100-200 banks worldwide stand

ready to make a market in foreign ready to make a market in foreign exchange.exchange.

Nonbank dealers account for about 40% of Nonbank dealers account for about 40% of the market.the market.

There are FX brokers who match buy and There are FX brokers who match buy and sell orders but do not carry inventory and sell orders but do not carry inventory and FX specialists.FX specialists.

– Client Market (Retail)Client Market (Retail) Market participants include international Market participants include international

banks, their customers, non-bank dealers, FX banks, their customers, non-bank dealers, FX brokers, and central banks.brokers, and central banks.

Correspondent Banking RelationshipsCorrespondent Banking Relationships

Bank A is in London, Bank B is in New Bank A is in London, Bank B is in New York.York.

The current exchange rate is £1.00 = The current exchange rate is £1.00 = $2.00. $2.00.

A currency trader employed at Bank A A currency trader employed at Bank A buys £100m from a currency trader at buys £100m from a currency trader at Bank B for $200m settled using its Bank B for $200m settled using its correspondent relationship.correspondent relationship.

Bank A

London

$200

£100

Bank B

NYC

SizeSize Fx Market =The largest financial market in the Fx Market =The largest financial market in the

worldworld Most important markets: (daily turnover in Most important markets: (daily turnover in

1995)1995) London London $464 billion$464 billion NYNY $244 billion$244 billion TokyoTokyo $161 billion$161 billion

Less important markets:Less important markets: Singapore, Hong Kong, Zurich ($90-$115b) Singapore, Hong Kong, Zurich ($90-$115b)

Markets:Markets:– Spot MarketSpot Market– Forward MarketForward Market– Futures MarketFutures Market– Options MarketOptions Market

What is arbitrage?What is arbitrage? Making two markets, by buying and Making two markets, by buying and

selling between them, a single market is selling between them, a single market is called arbitrage.called arbitrage.

An arbitrager, usually a large bank, may An arbitrager, usually a large bank, may notice that in N.Y. 1 £ = $2.42 and in notice that in N.Y. 1 £ = $2.42 and in London, 1 £ = $2.40. London, 1 £ = $2.40.

An agent will buy pounds in London (for An agent will buy pounds in London (for $2.4 billion) and sell them in N.Y. (for $2.4 billion) and sell them in N.Y. (for $2.42 billion), earning a quick $20 $2.42 billion), earning a quick $20 million.million.

The increased demand in London pulls the The increased demand in London pulls the price up, and the increased supply in price up, and the increased supply in New York pushes the price down, New York pushes the price down, equalizing the pound/dollar price.equalizing the pound/dollar price.

Types of FEX MarketTypes of FEX Market1. Spot Market1. Spot Market These are the quickest transactions These are the quickest transactions

involving currency in foreign markets. involving currency in foreign markets. These transactions involve immediate These transactions involve immediate payment at the current exchange rate, payment at the current exchange rate, which is also called the spot rate. The which is also called the spot rate. The Federal Reserve says the spot market Federal Reserve says the spot market accounts for one-third of all currency accounts for one-third of all currency exchange, and trades usually take place exchange, and trades usually take place within two days of the agreement. This within two days of the agreement. This does leave the traders open to the does leave the traders open to the volatility of the currency market, which volatility of the currency market, which can raise or lower the price between can raise or lower the price between the agreement and the trade. the agreement and the trade.

Types of FEX MarketTypes of FEX Market2. Futures Market2. Futures Market As the name implies, these transactions As the name implies, these transactions

involve future payment and future involve future payment and future delivery at an agreed exchange rate, delivery at an agreed exchange rate, also called the future rate. These also called the future rate. These contracts are standardized, which contracts are standardized, which means the elements of the agreement means the elements of the agreement are set and non-negotiable. It also takes are set and non-negotiable. It also takes the volatility of the currency market, the volatility of the currency market, specifically the spot market, out of the specifically the spot market, out of the equation. These are popular among equation. These are popular among traders who make large currency traders who make large currency transactions and are seeking a steady transactions and are seeking a steady return on their investments.return on their investments.

Types of FEX MarketTypes of FEX Market3. Forward Market3. Forward Market These transactions are identical to the These transactions are identical to the

Futures Market except for one important Futures Market except for one important difference---the terms are negotiable difference---the terms are negotiable between the two parties. This way, the between the two parties. This way, the terms can be negotiated and tailored to terms can be negotiated and tailored to the needs of the participants. It allows the needs of the participants. It allows for more flexibility. In many instances, for more flexibility. In many instances, this type of market involves a currency this type of market involves a currency swap, where two entities swap currency swap, where two entities swap currency for an agreed-upon amount of time, and for an agreed-upon amount of time, and then return the currency at the end of then return the currency at the end of the contract. the contract.

IMMIMMThe International Monetary Market (IMM), a The International Monetary Market (IMM), a

spin-off from the old Chicago Mercantile spin-off from the old Chicago Mercantile Exchange and largely the creation of Exchange and largely the creation of Leo Leo MelamedMelamed, is today one of three divisions of the , is today one of three divisions of the Chicago Mercantile ExchangeChicago Mercantile Exchange (CME), the largest (CME), the largest futures exchangefutures exchange in the in the United StatesUnited States and the and the second largest in the world after Eurex, for second largest in the world after Eurex, for the trading of futures contracts and options the trading of futures contracts and options on futures. The IMM was started on May 16, on futures. The IMM was started on May 16, 1972. Two of the more prevalent contracts 1972. Two of the more prevalent contracts traded are currency futures and interest rate traded are currency futures and interest rate futures, specifically, 3-month Eurodollar time futures, specifically, 3-month Eurodollar time deposits and 90-day U.S. Treasury bills. The deposits and 90-day U.S. Treasury bills. The other two CME divisions includes the Index other two CME divisions includes the Index and Option Market (IOM) and Growth and and Option Market (IOM) and Growth and Emerging Markets (GEM). All products fall Emerging Markets (GEM). All products fall under one of these three divisions.under one of these three divisions.

Elements of Exchange MarketElements of Exchange MarketThe elements of foreign exchange market are as The elements of foreign exchange market are as

follows:follows:1.1. Foreign currency exchange rate,Foreign currency exchange rate,2.2. Rules of foreign currency exchange rates Rules of foreign currency exchange rates

(spot rate, forward rate(advance))(spot rate, forward rate(advance))3.3. Sales Rules:Sales Rules:

TTTT -- Telegraphic Transfer.Telegraphic Transfer.BCBC -- Bills for CollectionBills for Collection

4.4. Purchase Rules:Purchase Rules:TTTT (Clean)(Clean)TTTT (Document),(Document),ODOD (Overdraft)(Overdraft)

5.5. Rules of determination of FEMsRules of determination of FEMsLocal current markets (direct)Local current markets (direct)Foreign current markets (indirect)Foreign current markets (indirect)

Types of Exchange MarketTypes of Exchange Market

ARABINDAARABINDA The selected items / types of The selected items / types of

foreign exchange markets in foreign exchange markets in Bangladesh are as follows;Bangladesh are as follows;

Central bank and Central bank and authorized dealer authorized dealer

Bank and foreign branches Bank and foreign branches Bank and foreign exchangeBank and foreign exchange

FunctionsFunctions

According to M.C. Vaish, Foreign According to M.C. Vaish, Foreign Exchange Market performs the three Exchange Market performs the three important functions as under:important functions as under:

1.1. Transferring the purchasing power Transferring the purchasing power

2.2. Providing credit for financing foreign Providing credit for financing foreign tradetrade

3.3. Furnishing facilities for hedging Furnishing facilities for hedging foreign exchange risksforeign exchange risks

FunctionsFunctions

5. Exchange rates change on a daily basis. 5. Exchange rates change on a daily basis. The price at any given time is called the The price at any given time is called the spot rate, and is the rate for currency spot rate, and is the rate for currency exchanges at that particular time. One exchanges at that particular time. One can obtain the current exchange rates can obtain the current exchange rates from a newspaper or online.from a newspaper or online.

6. The fact that exchange rates can 6. The fact that exchange rates can change on a daily basis depending change on a daily basis depending upon the relative supply and demand upon the relative supply and demand for different currencies increases the for different currencies increases the risks for firms entering into contracts risks for firms entering into contracts where they must be paid or pay in a where they must be paid or pay in a foreign currency at some time in the foreign currency at some time in the future. future.

FunctionsFunctions7. Forward exchange rates allow a firm to lock in a future 7. Forward exchange rates allow a firm to lock in a future

exchange rate for the time when it needs to convert exchange rate for the time when it needs to convert currencies. Forward exchange occurs when two parties currencies. Forward exchange occurs when two parties agree to exchange currency and execute a deal at some agree to exchange currency and execute a deal at some specific date in the future. The book presents an example specific date in the future. The book presents an example of a laptop computer purchase where using the forward of a laptop computer purchase where using the forward market helps assure the firm that will won’t lose money on market helps assure the firm that will won’t lose money on what it feels is a good deal. It can be good to point out what it feels is a good deal. It can be good to point out that from a firm’s perspective, while it can set prices and that from a firm’s perspective, while it can set prices and agree to pay certain costs, and can reasonably plan to agree to pay certain costs, and can reasonably plan to earn a profit; it has virtually no control over the exchange earn a profit; it has virtually no control over the exchange rate. When spot exchange rate changes entirely wipe out rate. When spot exchange rate changes entirely wipe out the profits on what appear to be profitable deals, the firm the profits on what appear to be profitable deals, the firm has no recourse.has no recourse.

8. When a currency is worth less with the forward rate than it 8. When a currency is worth less with the forward rate than it is with the spot rate, it is selling at forward discount. is with the spot rate, it is selling at forward discount. Likewise, when a currency is worth more in the future Likewise, when a currency is worth more in the future than it is on the spot market, it is said to be selling at a than it is on the spot market, it is said to be selling at a forward premium, and is hence expected to appreciate. forward premium, and is hence expected to appreciate. These points can be illustrated with several of the These points can be illustrated with several of the currencies.currencies.

9. A currency swap is the simultaneous purchase and sale of a 9. A currency swap is the simultaneous purchase and sale of a given amount of currency at two different dates and given amount of currency at two different dates and values.values.

What is the Difference Between Forex and Stock?  What is the Difference Between Forex and Stock?  The Forex market has a lot of advantages compare to stock The Forex market has a lot of advantages compare to stock

market:market: A Forex trader could make profit through the market no A Forex trader could make profit through the market no

matter if it is bearish and bullish which is different from the matter if it is bearish and bullish which is different from the capital market, Forex has no strict regulation in speculation, capital market, Forex has no strict regulation in speculation, no matter whether it is a long-term or a short-term no matter whether it is a long-term or a short-term transaction there is still a hidden profit, moreover, Forex transaction there is still a hidden profit, moreover, Forex market is a double-transaction market which means Forex market is a double-transaction market which means Forex traders could make profit through both upward and traders could make profit through both upward and downward trend.downward trend.

Forex traders could obtain a much larger transaction Forex traders could obtain a much larger transaction compared to the stock market, through the Forex trading, compared to the stock market, through the Forex trading, Forex traders could obtain 100 times larger transaction Forex traders could obtain 100 times larger transaction compared to the stock market. According to the present US compared to the stock market. According to the present US situation, if a Forex trader invests $1,000 in the stock situation, if a Forex trader invests $1,000 in the stock market, the trader may obtain $2,000 of stock domination market, the trader may obtain $2,000 of stock domination property with a proportion of 2:1, but through Forex trading, property with a proportion of 2:1, but through Forex trading, a Forex trader can do transaction with a proportion up to a Forex trader can do transaction with a proportion up to 100:1.100:1.

Forex trader may make profit from the ordinary news, like Forex trader may make profit from the ordinary news, like the interest rate change, Forex market is closely related to the interest rate change, Forex market is closely related to various countries' politic, economy and culture, Forex traders various countries' politic, economy and culture, Forex traders could also obtain profit from other kinds of news, for could also obtain profit from other kinds of news, for example interest rate level change, will influence the interest example interest rate level change, will influence the interest of the Forex deposit.of the Forex deposit.

What is the Difference Between Forex and Stock?What is the Difference Between Forex and Stock? Forex traders could do 24 hours trading. The stock market Forex traders could do 24 hours trading. The stock market

can only be traded during daytime at a specific time, can only be traded during daytime at a specific time, generally from 9:30a.m. to 4:00p.m.. If you too have your generally from 9:30a.m. to 4:00p.m.. If you too have your own full time job, then you will face the dilemma - either to own full time job, then you will face the dilemma - either to give up your full time job or forgo the trading opportunity. give up your full time job or forgo the trading opportunity. But Forex market can be traded 5 days a week and 24 But Forex market can be traded 5 days a week and 24 hours a day, Forex traders can trade during their free time hours a day, Forex traders can trade during their free time which is normally at night after working hour.which is normally at night after working hour.

If a trader analyze based on technical analysis, Forex If a trader analyze based on technical analysis, Forex trading would be much more suitable for such traders trading would be much more suitable for such traders because the Forex market has a very large trading volume. because the Forex market has a very large trading volume. Currently the Forex market has daily trading volume of 190 Currently the Forex market has daily trading volume of 190 billion Dollar, such giant market will completely digest a billion Dollar, such giant market will completely digest a fore trader's transaction cash, under such situation the fore trader's transaction cash, under such situation the accuracy of the technical analysis would be much higher accuracy of the technical analysis would be much higher then any financial market, the chances of using technical then any financial market, the chances of using technical analysis to make profit would be much more higher.analysis to make profit would be much more higher.

In the stock market there are hundred and thousand kinds In the stock market there are hundred and thousand kinds of stocks, then choosing stock will be a very difficult of stocks, then choosing stock will be a very difficult matter. But in the Forex market, the currency combination matter. But in the Forex market, the currency combination is extremely limited, this may enable Forex traders to is extremely limited, this may enable Forex traders to concentrate on these currencies combination, and could concentrate on these currencies combination, and could follow the trend quickly. follow the trend quickly.

ImportanceImportance1.1. Foreign exchange solves various Foreign exchange solves various

problems concerned with the problems concerned with the payments for the imports and exports.payments for the imports and exports.

2.2. Foreign exchange situation in one Foreign exchange situation in one country indicates the strengths of the country indicates the strengths of the economy.economy.

3.3. Shortage of Foreign exchange affects Shortage of Foreign exchange affects the BOP in an adverse order. It is the BOP in an adverse order. It is essential to bring the BOT in order and essential to bring the BOT in order and for achieving it Foreign exchange for achieving it Foreign exchange should be preserved carefully. should be preserved carefully.

ImportanceImportance4. Foreign exchange simplifies the 4. Foreign exchange simplifies the

complexities out of the vast complexities out of the vast participation of the nations in the participation of the nations in the international trade. The mutual international trade. The mutual payment are easily undertaken as the payment are easily undertaken as the accepted and predetermined rates accepted and predetermined rates already settled by the countries.already settled by the countries.

5. Foreign exchange rate shows a direct 5. Foreign exchange rate shows a direct relationship between the prices of the relationship between the prices of the commodities in the national market commodities in the national market and the prices in the international and the prices in the international market.market.

ImportanceImportance6. The stability in the Foreign exchange 6. The stability in the Foreign exchange

rates is of high importance without rates is of high importance without stability the various problems relating stability the various problems relating to valuation and pricing of the to valuation and pricing of the commodities will become difficult.commodities will become difficult.

7. Foreign exchange rates also speak of 7. Foreign exchange rates also speak of the economic soundness of a country. the economic soundness of a country.

Thus it is clear that the study of Foreign Thus it is clear that the study of Foreign exchange is of the first-rate importance exchange is of the first-rate importance in case one thinks to understand the in case one thinks to understand the various problems surrounding the various problems surrounding the international trade.international trade.

Needs of Foreign TradeNeeds of Foreign Trade1.1. It concerns every citizen of a It concerns every citizen of a

nationnation2.2. Increasing of employmentIncreasing of employment3.3. Procurement & disposal of goodsProcurement & disposal of goods4.4. Flow of investmentFlow of investment5.5. Tax payer’s benefit (Less duty)Tax payer’s benefit (Less duty)6.6. Economic independence of nationsEconomic independence of nations7.7. Repayment of debtsRepayment of debts8.8. Rapid growth of the economyRapid growth of the economy9.9. Best use of national resourcesBest use of national resources

Needs of Foreign TradeNeeds of Foreign Trade In addition to the above:In addition to the above:1.1. Upgrading the standard of living Upgrading the standard of living

of peopleof people2.2. Major share and role of export Major share and role of export

trade in national incometrade in national income3.3. Promotion of mutual national Promotion of mutual national

interestsinterests4.4. Factor in political relations & Factor in political relations &

peacepeace5.5. Promotion of international Promotion of international

collaborationcollaboration

Problems in foreign tradeProblems in foreign tradeThere are many problems in foreign trades. There are many problems in foreign trades. 1.1. Language:Language: When the goods are exported to a foreign When the goods are exported to a foreign

country, the labels, informative literature, packing country, the labels, informative literature, packing technical handout etc. should be prepared in the technical handout etc. should be prepared in the language of the century in which the goods are language of the century in which the goods are marketed. There should also be salesmen who are marketed. There should also be salesmen who are versed with that language and know the habits and versed with that language and know the habits and likings of the people.likings of the people.

2.2. Standardized Units:Standardized Units: In some countries of the world, the In some countries of the world, the units of length, weight, capacity, voltage are not the units of length, weight, capacity, voltage are not the same. The exporters therefore shall have to see that the same. The exporters therefore shall have to see that the goods are prepared and supplied according to the goods are prepared and supplied according to the standard specification of the importing country. standard specification of the importing country.

3.3. Sale in foreign currency:Sale in foreign currency: Every country has its own Every country has its own currency which is not legal tender in the other country. currency which is not legal tender in the other country. Buyer abroad prefers to buy the goods in his own Buyer abroad prefers to buy the goods in his own currency just as seller prefers to sell in the currency of currency just as seller prefers to sell in the currency of his own country. The exporter therefore has to calculate his own country. The exporter therefore has to calculate the selling price of the goods into the the selling price of the goods into the currencycurrency units of units of country where the goods are sold taking into consideration due country where the goods are sold taking into consideration due fluctuations in the foreign exchange rate. fluctuations in the foreign exchange rate.

Problems in foreign trade…Problems in foreign trade…4. Licenses and documents:4. Licenses and documents: When goods When goods

are exported or imported a number of are exported or imported a number of documents are to be prepared.documents are to be prepared.

5. Economic risks:5. Economic risks: It includes the risk of It includes the risk of insolvency of the buyers. It is the risk insolvency of the buyers. It is the risk of non-acceptance, risk of of non-acceptance, risk of exchange rateexchange rate and risk of changing standards and and risk of changing standards and regulations of the trading countries. regulations of the trading countries.

6. Political risks:6. Political risks: It involves the risk of It involves the risk of cancellation or renewal of trade cancellation or renewal of trade license. It also includes the war risk, license. It also includes the war risk, risk of trade risk of trade tariffstariffs, relations with , relations with countries and changing political conditions countries and changing political conditions in the trading countries.in the trading countries.