Seminar report
Financial management
Foreign exchange markets
Submitted to:
Ms. Shakila b.
Assistant professor
Department of business administration
Sjec, mangalore.
Submitted by:
Avinash, Ivon mendonca,
Mitchelle vaz, Raylen d’souza, swathi
4th may, 2010
FOREIGN EXCHANGE MARKET
The term foreign exchange refers to the process of converting the home currencies into foreign currencies and vice versa. According to Dr. Paul Einzing “Foreign exchange is the system or process of converting one national currency into account, and of transferring money from one country to another”.
The market where foreign exchange transitions take place is called a foreign exchange market. It does not refer to a market place in the physical sense of the term. In fact, it consists of a number of dealers, banks and brokers engaged in the business of buying and selling foreign exchange. It also includes the central bank of each country and the treasury authorities who enter into this market as controlling authorities. Those engaged in the foreign exchange business are controlled by the foreign exchange maintenance act (FEMA).
FUNCTIONS:
The most important functions of this market are:
- To most important necessary arrangements to transfer purchasing power from one country to another.
- To provide adequate credit facilities for the promotion of foreign trade.
- To cover foreign exchange risks by providing hedging facilities.
In
- Trading between banks and their commercial customers.
- Trading between banks through authorized brokers.
- Trading with banks abroad.
Brokers play an important role in the foreign exchange market in
CHARACTERISTICS:
Some of the important features of foreign exchange market are:
1) Electronic market
Foreign exchange market does not have a physical place. It is a market where trading in foreign currencies takes place through the electronically linked network banks , foreign exchange brokers and dealers whose function is to bring together buyers and sellers of foreign exchange.
2) Geographical dispersal
A redeeming feature of the foreign exchange market is that it is not to be found in one place. The market is vastly dispersed throughout the leading financial centers of the world such as
3) Transfer of purchasing power
Foreign exchange market aims at permitting the transfer of purchasing power denominated in one currency to another whereby one currency to another whereby one currency is traded for another currency. For example, an Indian exporter sells software to a U.S firm for dollars and a U.S firm sells super computers to an Indian company for rupees. In these transactions, firms of respective countries would like to have the payment settled in their currencies, i.e. Indian firm in rupees and U.S dollars. It is the foreign exchange market, which facilitates such a settlement between countries in their respective currency units.
4) Intermediary
Foreign exchange markets provide a convenient way of converting the currencies earned into currencies wanted of their respective countries. For this purpose, the market acts as an intermediary between buyers and sellers of foreign exchange.
5) Volume
A special feature of the FEM is that out of the total trading transactions that take place in the FEM, around 95% takes the form of cross border purchase and sales of assets, that is, international capital flows. Only around 5% relates to the export and import activities.
6) Provision of credit
A foreign exchange market provider’s credit through specialized instruments such as banker’s acceptance and letters of credit. The credit thus provided is of much help to the traders and businessmen in the international market.
7) Minimizing risks
The FEM helps the importer and exporter in the foreign trade to minimize their risks of trade. This is being done through the provision of ‘Hedging’ facility. This enables traders to transact business in the international market with a view to earning a normal business profit without exposure to an expected change in anticipated profit. This is because exchange rates suddenly change.
CONSTITUENTS:
The activities of the foreign exchange market are carried out predominantly through the world wide bank interbank market. The trading is generally done by telephone, telex or the swift (Society for Worldwide Interbank Financial Telecommunications) system. In addition, there are a number of players who assist in trading of foreign currencies. The various of the foreign exchange market are discussed briefly.
The Interbank market: It is an important segment of the foreign exchange market. It is the wholesale market through which most currency transactions are channeled. It is used for trading amongst bankers. It is a typical foreign exchange market through which around 95 percent of the foreign exchange transactions are carried out. 20 major banks dominate the market.
There are three constituents of interbank market. They are spot market, forward market and swap market. The spot market, currencies are traded for immediate delivery extending for a period not exceeding two business days after the completion of the transaction. Spot transactions account for a share of 60 percent of the foreign exchange market. In the case of forward market, delivery of currencies takes place at a future date and contracts for buying and selling take place at the current date. Its transactions account for 10 percent of the foreign exchange market. Swap market comprises around 30 percent of the transactions of the foreign exchange market.
The swift: The swift is an important mode of trading in a foreign exchange market. It is an international bank communications network that links electronically all brokers and traders in foreign exchange.
PARTICIPANTS:
The categories of participants take part in the operations of the foreign exchange market. They are bank and non-bank foreign exchange dealers, individuals and firms conducting commercial and investment transactions, speculators and arbitragers, central banks, and treasuries and foreign exchange brokers.
Foreign Exchange Dealers
Banks and non-bank agencies take part in the activities of the foreign exchange dealers. Their role comprise, in actual market making. They are the actual market makers in the foreign exchange market. They actively deal in foreign exchange for their own accounts. These banks buy and sell major foreign currencies on a continuous basis. They trade with other banks in their own monetary centers and in other centers of the world in order to maintain the inventory of foreign currencies within the trading limits. Their profit comes from buying foreign exchange at a bid price and reselling it at a slightly higher offer/ask price. Competition among dealers worldwide makes the foreign exchange market efficient and vibrant.
Individuals and Firms
These are the exporters and importers, international portfolio investors, MNCs, tourists and others who use foreign exchange market to facilitate the execution of commercial or investment transactions. Firms that operate internationally must pay suppliers and workers in the local currency of each country in which they operate and may receive payments from customers in many different countries. They will eventually convert their foreign currency earnings into their home currency. In fact, for ages, supporting international trade and travel has been the main aim of currency trading. It is interesting to note that some of these participants use the foreign exchange market for hedging foreign exchange risks.
The activities of FDI require the investor to obtain the currency of the foreign country. Large sums of money are committed to international portfolio investments, the purchase of bonds, shares or other securities denominated in a foreign currency. For this purpose, the investor needs to enter the foreign exchange markets to obtain the currency to make a purchase, to convert the earnings from its foreign investments into home currency and repatriate the capital when the investment is terminated.
Speculators and Arbitragers
Speculators buy and sell currencies solely to profit from anticipated changes in exchange rates, without engaging in other sorts of business dealings for which foreign exchange is essential. Currency speculation is often combined with speculation in short-term financial instruments, such as treasury bills. The biggest speculators include leading banks and investment banks. Speculators and arbitragers trade in the foreign exchange market in their own way trying to make profit through normal and speculative operations. Main source of profit for dealers is the spread between the bid price and offer price whereas speculators profit from exchange rate changes. It is interesting to note that a large portion of the speculation and arbitrage takes place on behalf of major banks.
Central Banks and Treasuries
National treasuries or central banks may trade currencies for the purpose of affecting exchange rates. A government’s deliberate attempt to alter the exchange rate between two currencies by buying one and selling the other is called ‘intervention’. The amount of currency intervention varies greatly from country to country and time to time, and depends mainly on how the government has decided to manage its foreign exchange arrangements.
Central banks and treasuries use the foreign exchange market for the purposes of buying and selling country’s foreign exchange reserves. They also aim at influencing the value of their own currencies in accordance with the priorities of the national economic planning. They also use the foreign exchange market to work in unison with the commitment entered into with the international trade agreements such as European Monetary System etc. This is often done by the central bank in order to ensure stability and orderliness in the matters of foreign currency transactions.
Foreign Exchange Brokers
These are the commission agents who bring together suppliers and buyers of foreign currency. They specialize in certain currency although they deal in all major foreign currencies such as American Dollar, British Pound,
TRANSACTIONS:
Several types of transactions are carried out in a foreign exchange market among the various players. They are: Spot transactions, Forward transactions and Swap transactions.
Spot Transaction:
An inter-bank transaction whereby the purchase of foreign exchange, and delivery and payment for the same take place between banks usually on the following second business day is referred to as ‘spot transaction’. The rate quoted in such transactions is called ‘spot rate’. The date of settlement is known as ‘value date’. It is on this date most dollar settlements in the world take place through the mechanism of ‘CHIPS’ in
Forward Transaction:
Where a specified amount of one currency is exchanged for a specified amount of another currency at a future value date, it is a case of a ‘forward transaction’. Under this transaction, only the delivery and payment take place at a future date, the exchange rate being determined at the time of agreement. The rate quoted in such transactions is called ‘forward rate’. Forward exchange rates are normally quoted for value dates of one, two, three, six and twelve months.
Swap Transaction:
The simultaneous purchase and sale of a given amount of foreign exchange for different value dates is referred to as ‘swap transactions’. Both the purchase and sale are with the same counter party. There are two types of swap transactions. They are spot-against-forward swaps and forward-forward swaps. In the case of spot-against-forward swaps, the dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market. The dealer incurs no unexpected foreign exchange risk since the transaction is executed within a single counter party.
A more sophisticated swap transaction viz. the forward-forward swap facilities borrowing another currency on a fully collateralized basis. A recent addition to the family of swaps is the ‘non-deliverable forward’ being offered by the largest providers of foreign exchange derivatives such as Citibank. A peculiar characteristic of these transactions is that the settlements take place only in U.S. dollars and the primarily for emerging market currencies where currencies do not have much liquidity.
BIBLIOGRAPHY:
- Financial Markets and Services
Gordon Natraj
- Financial Markets and Institutions
Dr. S. Guruswamy
Vijay Nicole Imprints Pvt. Ltd.
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