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Thursday, April 19, 2012

Global Forex Market

Global currency market is essentially a 24 hour market, geographically spreading across all the time zones from New Zealand in the east to San Francisco in the west of USA. The market opens for the day in New Zealand and Australia, when it is 3 pm in Sydney, and 1 pm in Tokyo; when it is 3 pm in Tokyo it is 2 pm in Hong Kong; when it is 3 pm in Hong Kong it is 1 pm in Singapore; when it is 3 pm in Singapore it is 12 noon in Bahrain; when it is 3 pm in Bahrain it is noon in Frankfurt and Zurich and 11 am in London; when it is 3 pm in London it is 10 am in New York and by the time New York winds up for the day it is noon in Los Angeles. By the time it is 3 pm in Los Angeles it is 9 am of the next day in Sydney by which time it opens for the day’s trading. Thus, the currency market functions all through 24 hours from one centre or the other in the globe. Of course, amongst all these centers, it is London, Tokyo, and New York which are the ones that matter for they account for about 50 percent of the daily traded volume.

The global foreign exchange market is basically characterized by –
·         no physical presence;
·         huge size, dominated by financial flows;
·         deep, highly liquid and efficient;
·         Preponderance of inter-bank flows;
·         sleek being screen-based;
·         highly volatile, and
·         yet a profit centre with simultaneous potential for losses.

Essentially, the major participants in the wholesale forex market are large commercial banks, investment institutions, multi national corporations, large commercial customers, foreign exchange brokers in the inter bank market, and central banks of various countries, which are known to intervene in their respective markets from time to time to check volatility in exchange rates. Most of the trading is just confined to a few currencies: US Dollar, Euro, Pound Sterling, Swiss Franc, Japanese Yen, Canadian Dollar, and Australian Dollar. They are mostly centered around organized markets like New York, Tokyo, London, Zurich, Hong Kong, Singapore etc., that daily trade hundreds of billions of dollars worth of currencies of the world.

Transactions in this market can either be spot or forward. Around 40% of the transactions in the market are meant for spot delivery of currencies i.e. delivery of currencies traded within 2 business days after the transaction has been entered into; 9% is meant for forward transactions i.e. delivery after two days, normally upto a maximum period of one year; and the balance 51% constitutes swap transactions. The major participants in the forward market are arbitrageurs (those who attempt to make risk free profit by taking advantage of differences in interest rates among countries): traders (those who use forward contracts to cover the risk of loss on exports or imports): hedgers (mostly MNCs who protect the home currency value of their assets denominated in foreign currency): speculators (those who actively expose themselves to currency risk by buying or selling foreign currencies to make profit from exchange rate fluctuations): and Hedge Funds (the investment vehicles for wealthy individuals that are popular in the US: funds are privately placed, minimum subscription being in seven digits dollars and purely supervised.) The market is dominated by the “market makers” – makers at commercial and investment banks, who trade currencies with each other either directly or through brokers. True to their name, market makers “make a market” in one or more currencies by providing big and ask prices upon demand. They may even trade for their own accounts – maintain a long or a short passion for foreign currency to make problems.

A decade back electronic trading systems were installed for automatically matching the deals. It has reduced the cost of trading by two ways: one, by eliminating forex brokers and two, by minimizing the number of transactions a trader is required to engage to obtain information on market prices. In over twenty years of time (1974 -1995) the global Forex market grew by some 1,200 percent, and such uninterrupted growth is likely to continue, as more countries and companies deal across borders and capital-flows increase. Over and above, as more and more countries are abolishing exchange rate regulations, trading volumes are likely to rise further.

 Euromarkets: What are they?
     During the fifties, the East European block nations fearing that deteriorating political relations with Washington could motivate the United States to freeze their dollar balances in American banks, transferred their dollar holdings to European banks, a move that set the stage for the birth of the Euromarket.
In the sixties, United States’ large balance of payments deficit contributed substantially to the expansion of Euromarket, as non Americans coming into the possession of US $ could invest at banks outside USA.
The Regulation Q of the US which stipulates maximum interest rate limits for domestic
deposits has also encouraged US residents to invest their dollar earnings outside US.
All these factors have cumulatively sustained the Eurodollar market growth. Today, “Euromarket” covers all international money and capital markets on which currencies held  outside their countries of origin are traded. Eurodollars, for example, are dollar funds  deposited at Banks outside United States. If a bank in London or Frankfurt receives such funds, it will immediately reinvest them, with or without converting them into other currencies, or lend them out as part of its credit operations. In the initial stages of development of Euromarket, dollar was virtually the only currency used for transactions, but as of now the spectrum of currencies is broadened.
The Euromarket is not limited to a narrowly delineated geographical region but is truly a worldspanning market. Euromarket operations are conducted not only in Europe, but also in Japan, in the Middle and Far East, in Africa and South America, in such offshore centres as the Bahamas, Bermuda, the Cayman Islands and Panama, etc.
The Euromarket can be divided into three segments:
  • Euro Money Market – Euro currencies are invested at banks from one day to one  year.
  • Euro Credit Market – Banks either jointly or alone grant loans to companies/governments with maturities of 5-10 years.
  • Euro Capital Market – Usually, investment banks in groups, issuing medium and long term bonds, FRNs, GDRs, etc.
Offshore Financial Centers
During 70s oil exporting countries accumulated a huge amount of dollars and were looking for safe avenues for investment. They were however not comfortable with institutions located in western cities though their investments would be safe there, since they were not accustomed to such kind of tax systems and regulatory mechanisms.
The international financial community and countries which saw a good business potential in these countries, responded by establishing what are called “offshore financial centers” in various zones of the world. An offshore center can be broadly defined as a place where financial activity, geared to the special needs of international enterprises and investments can be carried out without  conflict with domestic fiscal or monetary policy. These centers have developed to provide two distinct kinds of facilities: one, as a tax haven – where assets can be held without any local tax consequences or at least where such transactions involve substantially smaller tax liability than elsewhere; and two, an active physical market phenomenon – where international financial business can be carried out in a fiscally neutral way. Some such tax havens are: Bahamas, Bermuda, The Cayman Islands, Channel Islands, Isle of Man, Luxembourg, New Hebrides, and Bahrain, where there are practically no taxes while communication systems with the rest of the world are as excellent as anywhere else. Unlike tax havens, offshore financial centers such as Singapore, Hong Kong, Bahrain, Panama etc., are duly monitored by the local regulators while, at the same time, extending active market support in terms of spot and forward trading in foreign currencies are duly supported by refinance facilities.
The emergence of Euro currencies is, perhaps, one of the strongest factors that influenced the establishment and sustenance of offshore centers.
London: Forex Capital of the World
London was, is and will perhaps remain as the principal foreign exchange trading center, if not for anything else, at least due to its sheer geographical location that enables it to function when both the Asian and American markets are in action. During April 1995, it transacted a daily turnover of $464 bn, accounting for 35 percent of the world’s total daily volume. The same went up to US $637 billion by 1998. This trading volume in London is more than the combined trading volumes of the next two important centers i.e. US $351 billion in New York and US $149 billion in Tokyo. It became the key center in the Eurodollar market when British banks began lending dollars as an alternative to pounds. In London, US dollar/Euro and US dollar/Japanese yen trading accounts for 22 percent and 17 percent respectively, of all transactions. A larger share of business in both the US dollar (30 percent) and Euro (28 percent) takes place in London than in either US (16 percent) or Germany (10 percent).

Exchange Rate Regimes: Global Scenario

· Fixed Exchange Rate Systems
A fixed exchange rate can provide a nominal anchor which helps the country achieve price stability. It encourages inflow of foreign capital and, by appearing to eliminate exchange rate volatility, can keep interest rates lower than they would otherwise be. But there is also a danger: The real exchange rate becomes overvalued either because the domestic price level increases more rapidly than that of competing countries or because of a relative decline in the nominal value of the competing currencies to which the home currency is not pegged. Should such a situation emerge, the foreign lenders may flee the country fearing devaluation. Even domestic residents may move their funds outside the country. These events may ultimately lead to currency decline. The fixed exchange rate system has many variations:

Pegged to single currency: The parity is fixed to a single currency, say like dollar. Pegged to a basket of currencies: The parity is fixed to a pool of currencies, such as special drawing rights, Euro and Dollar.

Crawling peg: An atomic system revises the parity exchange rate, typically based on the par value on recent experience of the actual exchange rates within its support points. It allows exchange rates to move to world equilibrium levels in the long run while reducing fluctuations in the short run.

Currency board: It is an independent monetary agency that links the growth of its money supply to the foreign exchange holdings. It issues domestic money in exchange for foreign currency at fixed exchange rates. Countries having currency board cannot exercise independent monetary policy.

A decrease in the stated par value of a pegged currency is denoted by the word – “Devaluation”
and an increase in its par value is described as – “Revaluation”.

· Floating Exchange Rate Systems

Relative prices of currencies are determined purely by forces of demand and supply. Authorities make no attempt to hold the exchange rate at any particular level.

Normally, a growing current account deficit under floating rate regime automatically gets corrected as the value of the currency declines due to market participants selling the currency in their anxiety to protect themselves from a potential future currency fall owing to rising current deficit.

Free float: Truly free float in rates are only a theoretical concept, as authorities are known to intervene in the forex markets.

Managed float: Central Banks occasionally intervene in the foreign exchange markets to private extreme changes in exchange rates. It is also known as dirty float.

Losing of value by a floating currency is described as “Depreciation” and gaining of value is termed as “Appreciation”.
Global Forex Market: What is Unique about It?
Global currency market offers unparalleled personal and financial freedom to make money as well as lose it in no time. It is described as the “fairest market on earth”, for it is so large that no one player, not even a large government, can completely control its direction. Being highly volatile, it offers a vast scope for profit-making, though no one can guarantee it. A skillful trader can profit from the market fluctuations by buying a specific currency when it is weaker and selling it when it is stronger. The worldwide gross volume of foreign exchange transactions is mind-boggling: almost nine tenths of these transactions amounting to US $1.3 trillion per business day or reversed within a week or mostly within a day. And many of them are speculative in nature.

One of the greatest benefits of the forex market is the leveraging effect. The individual or corporate can buy or sell one currency against another in multiples of available funds. The leverage factor allows individuals to profit from very small market movements with a relatively modest investment. At the same time, they can also go broke within no time. There are no bear markets in foreign exchange. The economic recession or boom has little or no effect on making profit under foreign exchange trading. Unlike in commodities or stock markets, forex markets do not charge trade commission which means there is scope for more profit on trading in foreign exchange markets.

Profits are generated in the forex markets from the trading differentials while economic forces determine the exchange rates. However, in the recent past, economic fundamentals are observed to be increasingly failing in predicting the exchange rate movement. And that is where behavioural finance is making entry into currency dealing rooms. Of late, the attitude of professional currency traders towards a particular currency is being considered as one of the determinants of exchange rate – at least in the short run. The chart-based traders believe that market behaves sequentially. So, they look for such prominent or obscure thread of continuity and cause and effect rationale that ties each movement of market behaviour to those that preceded it. There is an axiom in the market – “Whenever a given piece of information is held by everyone, it ceases to be of value to anyone.” Therefore, the market cliché that often defines the market movement in the short run is, “buy the rumor and sell the news.” Thus, a propensity for strong and sustained price trends give inter-bank currency traders a profit making edge that’s unavailable in any other market.

Indian Currency Market 
                                                              to be contd...


Ruchi Agrawal said...

Amazing information on market and forex Tips. I am very much impressed by your research on the topic, a great read for me. Thanks again.

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