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Wednesday, April 18, 2012

What is a Forex Market?

Forex market is the acronym for foreign exchange market. As seen earlier, it is an over the counter market in which currencies of different countries are bought and sold. Forex markets enable one to transfer one’s ‘purchase power’ denominated in one currency to another. It simply acts as an intermediary between seller and buyer of foreign currencies and thus facilitates international trade and investment.  Foreign exchange market operates at two levels: one, the retail market, where the branches of commercial bank’s purchase and sell foreign currencies from/to its retail clientele, and two, the wholesale market or dealer market which is also known as the inter-bank forex market where large banks trade on foreign currencies for catering to the needs of their individual customers, corporates, exporters/importers, multinationals etc., or on their own behalf for profit making. Indeed, some of the large banks specialize in dealing in specific currencies that are important from the point of view of their clientele. Some of them even maintain an inventory in these currencies so as to make them immediately available to their customers. Some of them even trade on their own account to arbitrage or to make speculative profits. It is the banks that are interposed between international investors, multinational companies, tourists, individualized transfers and the larger national and global financial markets. Transactions in the inter-dealer market are generally carried out in multiples of one million dollars in foreign currency. However, in retail market transactions are entertained for any amount.

The foreign exchange market is quite decentralized and operates through an electronic network that links various market participants. The participants in the market are commercial banks; foreign exchange brokers in the inter-bank market; exporters/importers; corporations; tourists and other retail customers needing small exchanges. They communicate with each other via telephone, telex, computer network, etc. Forex market is not confined to any one single country. It is spread all over the world. There are of course leading world centers such as London, New York, Tokyo, Paris, Zurich, Frankfurt, Hong Kong, Singapore, etc. Most of the currency trading in these markets is not just confined to export and import activities as we otherwise tend to presume, but mostly related to cross border purchases and sales of assets, which define the cross border flow of capital.

Foreign exchange transactions, buying or selling, involve payment in home currency against reimbursement in foreign currency or vice versa. The rates, at which these conversions are effected, are called “Exchange Rates”. Exchange rates are the price of one currency in terms of another. Exchange of currencies with domestic currency and vice-versa is thus effected at the prevailing exchange rates.

Box 1: Forex Markets: Different Kinds of Transactions and Exchange Rates
Exchange of currencies on the very date of deal:       
Exchange of currencies on the next working day i.e. tomorrow:     
Exchange of currencies on the second working day after the date of deal: 
Exchange of currencies after a period of spot date:                   
Simultaneous purchase and sale of identical amounts of a currency for different value dates:

In the Forex market, currencies are always priced and traded in pairs. Thus, buying of one currency and selling of another currency happens simultaneously. There is a convention in the forex market that the first currency in the quote is referred to as the ‘base’ currency and the second currency as the ‘counter’ or ‘quote’ currency. As a convention, the US dollar, being the world’s dominant currency, is used as the base currency in the quote: for example, US dollar/Japanese Yen; US dollar/Indian rupee, etc. There is of course an exception to this general convention: Euro, Great Britain Pound and Australian Dollar are quoted as dollars for foreign currency. The forex quotes contain ‘bid’ and ‘ask’ rates. The bid is the rate at which a bank is willing to buy the currency under reference and offer rate is the rate at which it is ready to sell the currency. There are two ways in which exchange rates are quoted in the market:

Direct Quote/Home Currency Quote: Under this method of quoting, the unit of foreign currency is kept  constant against the amount of home currency to be exchanged for it. It otherwise means how much of home currency is worth one unit of foreign currency.

Example: US $ 1 = INR 43.60

Since 2.8.1993, Indian Markets are using Direct Quote.

Indirect Quote/Foreign Currency Quote: It is just the opposite of Direct Quote i.e. it indicates the number of units of foreign currency which will be exchanged for a fixed number of home currency units.

Example: INR 100 = US $ 2.16

This conviction may pose a problem in understanding when the quote is for a pair of currencies in which home currency is not involved. In such situations, the exchange rate quotes can be differentiated into direct and indirect quote on the following basis:

Direct quote  – when currency dealt in is expressed as fixed unit
e.g. EUR 1 = 0.8650 USD
It means, deals are done in Euro terms and parties contract to buy or sell Euro.
Indirect quote – currency dealt in is the one whose quantity is variable
i.e. just the reverse of direct quote
Example: USD 1 = 1.1560 EUR

Foreign exchange markets are open to all in the major currencies; they are large and liquid in the major currencies, and extremely efficient relative to other financial markets. But they are quite sensitive to a large and continuously changing number of factors – both economic and non-economic.

Let us now understand how a spot transaction involving foreign currency takes place in the market. Presume M/s. Jaya Software, a 25 million start-up, purchased from a US vendor hardware worth US $2 million. The goods have arrived and M/s Jaya Software has to arrange for payment. So, the CFO has called on the bank corporate Forex table and telephonically places a buy order for US $2 million. To cater to the customer’s need the bank’s Forex dealer enters inter-bank foreign exchange market for buying US $2 million through a Forex broker. The broker located a bank ‘B’ which is wishing to sell dollars at a spot exchange rate of US $ 1= Rs.43.30. Bank ‘A’ will then telephonically place a buy order on bank ‘B’ for the delivery of US $ 2 million @ US $1 = Rs.43.30. The delivery of actual currencies takes place on the second business day from the date of order. On the due date, bank ‘B’ telephonically advices the bank in America with which it is maintaining a nostro account to transfer $2 million from its account to the credit of bank A’s nostro account (maintained with whatever bank). On the same day, bank A will credit rupees equivalent to $2 million that it has collected from the customer – Jaya Software – to bank B’s current account maintained with the Reserve Bank of India. Simultaneously, bank A instructs the bank located in America to transfer US $2 million to the hardware supplier of Jaya Software.

What led to Forex market growth?

To have a fair idea of factors that led to an incredulous growth in world forex markets, it is in order here to take a peep into historical perspective of exchange rates. In July 1944, the allies, the US, Great Britain, and France met at the United Nation’s monetary and financial conference held at the Mount Washington hotel in Bretton   Woods, New Hampshire, to discuss and design financial future of the new economic order. The conference, with an objective to bring about an economic growth and prosperity internationally, through stable currencies, decided to peg currencies and establish International Monetary Fund.

The conference decided to peg major trading currencies to the US dollar. It was further decided to allow the currencies to fluctuate only one percent on either side of the pegged rate. If the currency exceeds this range market by intervention points, the central bank of the respective country must buy or sell the currency, as the situation demands to bring it back to the range. Simultaneously, the US dollar was pegged to gold at US $35 per ounce. That is how the US dollar became the world’s reserve currency.

The resolutions of the Bretton Woods conference were institutionalized: Article IV of the IMF provided for fixed exchange rates and member countries agreed not to change the rates except in consultation with the fund. The consent from the Fund for such changes was also codified: Fund can agree for such changes only when the country is facing a ‘fundamental disequilibrium’ in the external position and their initiative for such change has to come from the member country. However, this degree of freedom was not available to the US which had to maintain the gold value of the dollar. But, the US had the advantage of member countries accumulating dollar balances in exchange for goods and services, and thus enjoyed the benefit of seigniorage gains. In other words, the US can acquire real goods and services by merely ‘printing more dollars’ as long as other countries were willing to hold dollars. Of course, this could only continue as long as the member countries had faith that they could effect international payments though dollars or convert their dollars into gold whenever they wanted.

Thus, right from the inception, Bretton Woods system had been mostly a one-nation show. Once recovered from the war destruction, Japan & Europe Started providing competition to the countries within the dollar block. With the increased growth rate in world trade international liquidity as measured in terms of aggregate reserves of member countries, has become a bottle neck. By the late 60’s, the differences in the rates of growth and the rates of inflation among the new major economies were widening. After 1965, the US was perceived as the exporter of inflation. As the West European countries started gaining economic strength and increased their ability to resist the imported inflation, the US went on expending its liabilities abroad on the basis of the reserve currency role of the dollar. In the process, the US gradually lost its trade advantage. As a sequel to the current account deficit of the US, the dollars held by member countries increased. This posed a question: could US meet its undertaking to convert dollars into gold at the fixed rate US$ 35 per ounce of gold? The net result is falling world confidence in dollar. Member countries were also unhappy at the time taken for adjustment in ‘par values’ by the prevailing fixed exchange rate system, to reflect changing economic fundamentals. All this cumulatively generated momentum for flexible exchange rates and by 1971 Bretton Wood system collapsed and along with it the United States abandoned the pegging of dollar with the price of gold.

With the collapse of the Bretton Woods Agreement, and along with it the fixed exchange rate regime, the currencies of major industrialized nations have become more freely floating, controlled mainly by the market forces viz., demand and supply. This signaled the rebirth of the global capital markets. America and Germany stopped trying to control the inflow and outflow of capital. Britain abolished capital controls in 1979 and Japan in 1980. Secondly, growing imbalances between savings and investments within the individual countries necessitated massive-cross border financial flows. For instance, during the eighties, the large current account deficits of the US had to be financed primarily from the mounting surpluses in Japan and Germany. The Euro dollars and Euro market that emerged in the late 50s had only gained further momentum and strength with the removal of exchange regulations among the developed countries and this has contributed its own mite to boost the currency trading in international forex markets.

The other factor which contributed to growing volumes in currency trading is the increased preference of the investors for international diversification of their asset portfolios. This move for diversification of asset portfolios across the globe has further been accentuated by either abolition or easing of exchange control regulations, restrictions on the kind of securities they can issue and hold portfolios, interest rate ceilings, barriers to FII accessing national markets etc. by many developed and developing countries. The other most important development in the financial markets that contributed to the growth of global forex market was the emergence of ‘offshore financial centers’/‘offshore banking’ as a response to the demands of ‘petrodollar’ owners from oil exporting nations who needed outlets for financial investments and expert services on par with those available in western financial centers but sans their tax and control systems. The combined result of all these processes has been the emergence of a global financial market transcending national boundaries and thus currency trading has become a bigger business. The daily turnover in foreign exchange markets in 1977 was US $5 billion which by 1987 increased to around US $600 billion and by 1992 it touched a trillion mark. Today it is said to be hovering around US $1.5 trillion.

Currency volatility is another important factor for the growth in trading volumes. In fact, volatility is a sine qua non for forex trading. Similarly, internationalization of economies impacted the interest rates in the developed countries besides internationalization of their businesses. This increased internationalization of businesses has resulted in increased trade in foreign exchange.

Global Forex Markets be continued.

                                                                                                                                - GRK Murty


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