Global Foreign Exchange Market

8/16/2019 Global Foreign Exchange Market

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Global Foreign Exchange Market

"Global Foreign Exchange Market”

Project submitted in partial fulfillment of the requirements for the award of the Degree of

MASTER OF BUSINESS ADMINISTRATION

O

BANGA!ORE UNI ERSIT#

By

Bha$ana %eg&e

Regi'ter No( )*)G+MD,-)

Under the guidance of

Mr( Ra.i$ /ro e''or

Rashtreeya Sikshana Samithi Trust

R INSTITUTE OF MANAGEMENTC !"#$ %&th Cross$ '&th (ain$ ) th *T+ ,lock$

-ayanagar$ ,angalore . /&0 0)"

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Global Foreign Exchange and Capital Markets

Introduction:-

The foreign exchange market (forex, FX, or currency market) is a

global decentralized market for the trading of currencies. This includes all aspects of buying,

selling and exchanging currencies at current or determined prices. In terms of olume of

trading, it is by far the largest market in the !orld. The main participants in this market are

the larger international banks. Financial centres around the !orld function as anchors of

trading bet!een a !ide range of multiple types of buyers and sellers around the clock, !ith

the exception of !eekends. The foreign exchange market does not determine the relati e

alues of different currencies, but sets the current market price of the alue of one currency as

demanded against another.

The foreign exchange market !orks through financial institutions, and it operates on se eral

le els. "ehind the scenes banks turn to a smaller number of financial firms kno!n as

#dealers,# !ho are acti ely in ol ed in large $uantities of foreign exchange trading. %ost

foreign exchange dealers are banks, so this behind&the&scenes market is sometimes called the

#interbank market#, although a fe! insurance companies and other kinds of financial firms

are in ol ed. Trades bet!een foreign exchange dealers can be ery large, in ol ing hundreds

of millions of dollars. "ecause of the so ereignty issue !hen in ol ing t!o currencies, forex

has little super isory entity regulating its actions.

Nature of foreign exchange:-

• 'olatile, affected by hedger, arbitrager, speculator.

• ffected by demand and supply.

• ffected by rate of interest.

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• ffected by balance of payment surplus and deficit.

• ffected inflation rate.

• pot and for!ard rates are different.

• ffected by the economic stability of the country.

• ffected by the fiscal policy of the go ernment.

• ffected by the political condition of the country.

• It can be $uoted directly or indirectly

The foreign exchange market is uni ue because of the follo!ing characteristics:-

• its huge trading olume representing the largest asset class in the !orld leading to

high li$uidity*

• its geographical dispersion*

• its continuous operation+ - hours a day except !eekends, i.e., trading from

+ /%T on unday ( ydney) until + /%T Friday (0e! 1ork)*

• the ariety of factors that affect exchange rates*

• the lo! margins of relati e profit compared !ith other markets of fixed income* and

• The use of le erage to enhance profit and loss margins and !ith respect to accountsize.

s such, it has been referred to as the market closest to the ideal of perfect competition,

not!ithstanding currency inter ention by central banks.

"d#antages of Forex market:-

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• It2s already the !orld2s largest market and it2s still gro!ing $uickly

• It makes extensi e use of information technology 3 making it a ailable to e eryone

• Traders can profit from both strong and !eak economies

• Trader can place ery short&term orders 3 !hich are prohibited in some other markets

• The market is not regulated

• "rokerage commissions are ery lo! or non&existent

• The market is open - hours a day during !eekdays.

Terms related to Foreign Exchange:-

• Foreign exchange reser es& holdings of other countries4 currencies

• Foreign exchange controls& controls imposed by a go ernment on the purchase5sale of

foreign currencies

• 6etail foreign exchange platform& speculati e trading of foreign exchange by

indi iduals using electronic trading platforms

• Foreign exchange risk& arises from the change in price of one currency against

another

• International trade& the exchange of goods and ser ices across national boundaries

• Foreign exchange company& a broker that offers currency exchange and international

payments

• "ureau de change& a business !hose customers exchange one currency for another

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• 7urrency pair& the $uotation of the relati e alue of a currency unit against the unit of

another currency in the foreign exchange market

• 8igital currency exchanger& market makers !hich exchange fiat currency for

electronic money.

Market si$e and li uidit%:-

The foreign exchange market is the most li$uid financial market in the !orld. Traders include

large banks, central banks, institutional in estors, currency speculators,

corporations, go ernments, other financial institutions, and retail in estors. The a erage daily

turno er in the global foreign exchange and related markets is continuously gro!ing.

ccording to the 9 Triennial 7entral "ank ur ey, coordinated by the "ank for

International ettlements, a erage daily turno er !as : ; trillion in pril 9 ( s ;9.?

trillion in 9==>). @f this ; trillion, ;9.A trillion !as spot transactions and ; .A trillion !as

traded in outright for!ards, s!aps and other deri ati es.

In pril 9 , trading in the :nited Bingdom accounted for


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%ost de eloped countries permit the trading of deri ati e products (like futures and options

on futures) on their exchanges. ll these de eloped countries already ha e fully con ertible

capital accounts. ome go ernments of emerging markets do not allo! foreign exchange

deri ati e products on their exchanges because they ha e capital controls. The use of

deri ati es is gro!ing in many emerging economies. 7ountries such as outh Borea, outh

frica, and India ha e established currency futures exchanges, despite ha ing some capital

controls.

Foreign exchange trading increased by D bet!een pril ? and pril 9 and has more

than doubled since -. The increase in turno er is due to a number of factors+ the gro!ing

importance of foreign exchange as an asset class, the increased trading acti ity of high&

fre$uency traders, and the emergence of retail in estors as an important market segment. The

gro!th of electronic execution and the di erse selection of execution enues has lo!ered

transaction costs, increased market li$uidity, and attracted greater participation from many

customer types. In particular, electronic trading ia online portals has made it easier for retail

traders to trade in the foreign exchange market. "y 9 , retail trading is estimated to

account for up to 9 D of spot turno er, or ;9A billion per day.

Foreign exchange is an o er&the&counter market !here brokers5dealers negotiate directly !ith

one another, so there is no central exchange or clearing house. The biggest geographic trading

center is the :nited Bingdom, primarily Hondon, !hich according to The 7ity :B estimates

has increased its share of global turno er in traditional transactions from


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Foreign exchange market: banks and currency exchanges that buy and sell foreign currencies and

other exchange instruments.

a market for con erting the currency of one country into that of another countryJ

The Foreign Exchange Market: Ma)or *egments:-

• @ er&the&counter (@T7) market+ commercial and in estment banks.

most foreign exchange acti ity occurs hereJ• Gxchange&traded market+ specialized securities exchanges !here particular types of

foreign&exchange instruments are traded.

Instruments such as futures and options are exchange&tradedJ

The :. . dollar is the most !idely traded currency in the !orld because it ser es as+K an in estment currency in many capital markets

K a reser e currency held by many central banks

K a transaction currency in many international commodity markets

K an in oice currency in many contracts

K an inter ention currency employed by monetary authorities in market operations to influence

their o!n exchange rates

The most fre$uently traded currency pairs are+

& The :. . dollar5euro >DJ

& The :. . dollar5yen 9?DJ

Ma)or *ources of Eurocurrencies:-

K Foreign go ernments or indi iduals !ho !ant to hold dollars outside of the :nited

tates.

K %0Gs that ha e cash in excess of current needs.

K Guropean banks !ith foreign currency in excess of current needs.K 7ountries such as /ermany, Eapan, and Tai!an that ha e large balance&of&trade

surpluses held as reser es.

+emand for Eurocurrencies:-

K 8emand for Gurocurrencies reflects+

– greater con enience

– increased security

– lo!er rates and thus higher yields

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K 8emand for Gurocurrencies comes from+

– so ereign go ernments

– supranational agencies (e.g., the Lorld "ank)

– firms and indi iduals

Eurocurrenc% &orro!ing:-

K Guro credit+ a type of loan or line of credit that matures in one to fi e years.

K yndication+ the process of pooling the specific resources of se eral banks in order to spread

the risks associated !ith large loans.

K Hondon Inter&bank @ffered 6ate (HI"@6)+ reflects the interest rate Hondon banks charge one

another for short&term Gurocurrency loans.

Traditional loans are made at a certain percentage abo e the HI"@6.J

,ocation of the Foreign Exchange Market:-

K Hondon is the largest foreign exchange market (follo!ed by 0e! 1ork, Tokyo, and

ingapore) because of its strategic location bet!een sia and the mericas.

K %arket acti ity f irst heightens !hen Gurope and sia are open and again !hen

Gurope and the :nited tates are open.

K 7ross&trading+ using the :. . dollar as a ehicle currency for trades bet!een t!oother currencies

– 7ross rate+ the exchange rate bet!een t!o non&:. . dollar currencies that is

computed from the exchange rate of each currency in relation to the :. . dollar

:se currency to buy currency 7 (: ;9), and then use currency 7 to buy currency ".J

Foreign Exchange Terms and Con#entions:-

K "id+ the price at !hich a trader is !illing to buy a foreign currencyK @ffer+ the price at !hich a trader is !illing to sell a foreign currency

K pread+ the difference bet!een the bid and the offer rates, i.e., the trader2s profit

K merican terms+ the :. . point of ie!, i.e., the number of :. . dollars per unit of

foreign currency

Guropean terms (indirect $uote)+ the number of units of foreign currency per :. . dollar.

• $uote in merican terms (: ;5Fx) is al!ays the reciprocal of a $uote in Guropean

terms (Fx5: ;).;9. 5M. =-< M9 C. -5;9.

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• "ase currency+ the $uoted, underlying, or fixed currency.• Traders al!ays $uote the base currency (the denominator) first, follo!ed by

the terms currency (the numerator).• n example+

8ollar&yen $uote+ dollar N base, yen N terms

@ct. 9 , - pril >, A

M99 .=C5;9. M9 C. -5;9.

The dollar (base) !eakened* the yen (terms) strengthened.

T%pes of Foreign Exchange Markets:-

• *pot market: The market in !hich foreign exchange transactions occur Oon the

spot,P i.e., for deli ery !ithin t!o business days follo!ing the date of agreement to

trade.

– pot rate+ the rate $uoted for transactions that re$uire immediate deli ery, i.e.

!ithin t!o days.

Qrinciple characteristics+&

pot %arket is of daily nature. It does not trade in future deli eries.

pot rate of exchange is that rate !hich happens to pre ail at the time !hen

transactions are incurred.

• For!ard market: the market in !hich foreign exchange transactions occur at a set

rate for deli ery beyond t!o business days follo!ing the date of agreement to trade.

– For!ard rate+ a contractually established exchange rate bet!een a foreign

exchange trader and the trader2s client for deli ery of foreign currency on a

specified date.

For!ard discount+ the for!ard rate is less than the spot rate

For!ard premium+ the for!ard rate is higher than the spot rate

Qrinciples 7haracteristics+&

It only caters to for!ard transaction.

It determines for!ard exchange rate at !hich for!ard transaction are to be honored.

For!ard Future Instruments:-

K For!ard contract+&

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contract bet!een a firm or indi idual and a bank to deli er foreign currency at a

specific exchange rate on a future date.

K @utright for!ard+&

for!ard contract that is not connected to a spot transaction, i.e., a contact to deli er

foreign currency beyond t!o days follo!ing the date of agreement at the for!ard rate.

K Fx s!ap+&

simultaneous spot and for!ard trans&action, i.e., one currency is s!apped for

another on one date and then s!apped back on a future date.

7urrency s!ap+ the exchange of principal and interest payments ia interest&bearing @T7

financial instruments (e.g., bonds).

K Futures contract+&

n agreement bet!een t!o parties to buy or sell a gi en currency at a gi en

(negotiated) price on a particular future date, as specified in a standardized contact to

all participants in that currency futures exchange not as flexible as a for!ard

contractJ

K @ption+

n instrument traded both @T7 and on exchanges that gi es the purchaser the right

(but not the obligation) to buy or sell a certain amount of foreign currency at a

specified exchange rate !ithin a specified amount of time more expensi e but also

more flexible than a for!ard contractJ

– trike price+ the exchange rate specified in the option, i.e., the exercise price.

– Qremium+ the fee paid to the !riter of the option.

Exchange .ates in the ,ong .un: Theor% of /urchasing /o!er /arit% '///(:-

• The theory of QQQ states that exchange rates bet!een t!o currencies !ill adRust to reflect

changes in price le els.

• QQQ⇒ 8omestic price le el ↑ 9 D, domestic currency ↓ 9 D

o pplication of la! of one price to price le els

o Lorks in long run, not short run

Qroblems !ith QQQ+&

o ll goods are not identical in both countries

(i.e., Toyota ersus 7he y)

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o %any goods and ser ices are not traded (e.g., haircuts, land, etc.)

Exchange .ates in the ,ong .un: Factors "ffecting Exchange .ates in ,ong .un:-

•"asic Qrinciple+ If a factor increases demand for domestic goods relati e to foreign

goods, the exchange rate ↑

• The four maRor factors are relati e price le els, tariffs and $uotas, preferences for

domestic . foreign goods, and producti ity.

• 6elati e price le els+ a rise in relati e

price le els cause a country2s currency

to depreciate.

• Tariffs and $uotas+ increasing trade barriers causes a country2s currency to appreciate.• Qreferences for domestic . foreign goods+ increased demand for a country2s good causes

its currency to appreciate* increased demand for imports causes the domestic currency to

depreciate.

• Qroducti ity+ if a country is more producti e relati e to another, its currency appreciates.

• The follo!ing table summarizes these relationships. "y con ention, !e are $uoting, for

example, the exchange rate, G, as units of foreign currency 5 9 : dollar.

Exchange .ates in the *hort .un:-

• In the short run, it is key to recognize that an exchange rate is nothing more than the

price of domestic bank deposits in terms of foreign bank deposits.

• "ecause of this, !e !ill rely on the tools de eloped in 7hapter - for the determinants

of asset demand.

Expected .eturns on +omestic and Foreign "ssets:-

• Le !ill illustrate this !ith a simple example

• FranSois the Foreigner can deposit excess euros locally, or he can con ert them to

:. . dollars and deposit them in a :. . bank. The difference in expected returns depends

on t!o things+ local interest rates and expected future exchange rates.

• l the merican has a similar problem. e can deposit excess dollars locally, or he

can con ert them to euros and deposit them in a foreign bank. The difference in expected

returns depends on t!o things+ local interest rates and expected future exchange rates.

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Exchange-based #s0 1#er-the-Counter Fx Instruments:-

Foreign Exchange Con#ertibilit%:-

7on ertibility+ & the ability of residents and nonresidents to purchase foreign currency !ith

a gi en (domestic) currency !ithout go ernment restrictions.

Gxternal con ertibility+ & the ability of non& residents to purchase foreign currency !ith a

gi en currency !ithout go ernment limitations.

0oncon ertibility+ & the inability of residents and nonresidents to con ert a gi en currency

into foreign currency because of go ernment limitations.

Fully con ertible currencies are those that go ernments allo! both residents and nonresidents

to purchase in unlimited amounts, i.e., they are freely traded and accepted by central banks.

ard currencies are fully con ertible, relati ely stable, and tend to be comparati ely

strong. oft (!eak) currencies are not fully con ertible.

go ernment may control the con ertibility of its currency through+

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– licensing

– a multiple exchange rate system

– ad ance import deposits

– $uantity controls7urrency controls add to the cost of doing business and thus ser e as serious

impediments to trade and in estment.

Exchange rate fluctuations:-

reliable forecast or future spot rate is called study of empirical patterns of exchange rate

fluctuation. It pro ides essential information for an exchange rate exposure.

The 2ses of Foreign Exchange :-

• The role of commercial banks+

– buy and sell foreign exchange

– ser e as ehicles for payments bet!een domestic and foreign customers

– lend money in foreign denominations

• "usiness purposes+

– settlement of international business transactions

– hedging risk reduction through loss protectionJ

– speculation currency trading on expectations of future pricesJ

– arbitrage risk&free profit based on price differentialsJ

K Interest arbitrage.

The Fx Trading /rocess:-

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K To settle foreign exchange balances, companies may !ork through+

– local banks

– commercial and in estment banks (@T7 market)

– securities exchange brokers"anks deal !ith each other in the interbank market, primarily through foreign&

exchange brokers.

"rokers are specialist intermediaries !ho facilitate transactions in the interbank

market by matching the best bid and offer $uotes.

K "anks2 fx dealers can trade foreign exchange+

– directly !ith other dealers

– through oice brokers

– through electronic brokerage systems

*tructure of Foreign Exchange Markets:-

Foreign Exchange Transactions:-

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The 1#er-the-Counter Market: Commercial and In#estment &anks:-

Top banks in the interbank fx markets are so ranked because of their ability to+

• trade in specific market locations• handle maRor currencies• handle maRor cross trades• deal in specific currencies• handle deri ati es (for!ards, options, futures, s!aps)• conduct key market research

Foreign Exchange .isk:-

• Gxposure to exchange rate mo ement.

• ny sale or purchase of foreign currency entails foreign exchange risk.

• Foreign exchange transaction affects the net asset or net liability position of the

buyer5seller.

• 7arrying net assets or net liability position in any currency gi es rise to exchange risk.

.isk management:-

7ontrolling losses

• 1ou could control your losses, by mental stop or hard stop. %ental stop means that

you already set you limit of your loss. hard stop is your initiati e to stop !hen you

think you must to stop it.

:sing correct lot size

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• s a beginning Rust uses smaller lots you could stay flexible and logic than emotions

!hile you trade.

Tracking o erall exposure

• ample+ you go to short on G:65: 8 and long on : 857 F, you exposed t!o timesfor : 8 in the same direction. If : 8 goes do!n, you ha e a double dose of pain.

o, keep your o erall exposure limited, it keeps you for the long haul for trading

The bottom line

• Trading is about opportunities, you must take action !hile the opportunities arise.

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Global Foreign Exchange Market