Foreign Exchange Market: Unit 2
Foreign Exchange Market: Unit 2
A foreign exchange market exists because economies employ national currencies. If the
world economy used a single currency there would be no need for foreign exchange
markets. In Europe 11 economies have chosen to trade their individual currencies for a
common currency.
But the euro will still trade against other world currencies. For now, the foreign
exchange market is a fact of life. The foreign exchange market is extremely active.
It is primarily an over the counter market, the exchanges trade futures and option (more
below) but most transactions are OTC.
It is difficult to assess the actual size of the foreign exchange market because it is traded
in many markets.
2.1 Foreign Exchange Market
Foreign Exchange:
After liberalisation, globalisation gathered momentum in India in 1991, Foreign Exchange
Market have assumed greater significance in India. The Indian economy which was closed and
regulated, got converted into an open economy. With the opening of the economy, various types
of transactions started taking place among international and Indian parties with minimum
intervention from RBI or Government of India.
A) Meaning :
By ‘Foreign Exchange’ we mean broadly, a vast array of foreign currencies such as Pound
Sterling, US Dollars, French Francs, Deutsch Marks, Yens etc. apart from currency, near
money assets denominated in foreign exchange are also included in foreign exchange.
B) Definition :
1) Foreign Exchange Management Act 1999 :
“All deposits, credits, balances payable in any foreign currency and any drafts, travellers
cheques, letters of credit, bills of exchange expressed or drawn in Indian currency but
payable in any foreign currency”.
2.1 Foreign Exchange Market
Physical Settlement of
Participants
Markets Transactions
2.1 Foreign Exchange Market
Provision of Credit
Political
Differentials
Stability and
in Interest
Economic
Rates
Performance
Current-
Terms of
Account
Trade
Deficits
Public Debt
2.1 Foreign Exchange Market
3) Current-Account Deficits:
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest and dividends.
2.1 Foreign Exchange Market
5) Terms of Trade:
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a
greater rate than that of its imports, its terms of trade have favorably improved.
The foreign exchange market in India is relatively very small. The major players in that market
are the RBI, banks and business enterprises. Indian foreign exchange market is controlled and
regulated by the RBI.
Speculato
Banks
r
Overseas
Forex Brokers
Markets
2.2 Participants in Foreign Exchange Market
International
Financial Central Bank
Institutions
Authorised
Speculators
Dealers
Foreign
Exchange
Markets
abroad
2.2 Participants in Foreign Exchange Market
Corporates need to do the exchange rate forecasting for taking decisions regarding hedging,
short-term financing, short-term investment, capital budgeting, earnings assessments and long-
term financing etc.
Investment and
Financing
Capital Budgeting Pricing Decisions Strategic Planning
Decisions
Decisions
Fundament
Technical
al
Forecasting
Forecasting
Market
Mixed
Based
Forecasting
Forecasting
1) Technical Forecasting:
Technical forecasting involves the use of historical exchange rate data to predict future
values; There may be a trend of successive daily exchange rate adjustments in the same
direction, which could lead to a continuation of that trend.
2.3 Forecasting Exchange Rate
4) Mixed Forecasting:
Mixed forecasting is the natural result of the lack of a single and superior method of
predicting rates of exchange. Essentially, mixed forecasting assigns weighted values to
the results derived from other valuation techniques.
2.3 Forecasting Exchange Rate
C) Forecasting Models:
There are two exchange rate forecasting models. These are as follows:
Reduced-form
Model
Forecast may be
Conditional
C) Forecasting Models:
1) Econometric Forecasting Models :
Econometric models, as the term is used, are models that are specified on the basis of
some economic theory and estimated by an econometric method.
a) Single-equation Models:
In the case of single-equation models (also called reduced form models), the exchange
rate (or its rate of change) is to depend on one or more variables.
In general, a single-equation model may be specified as
tS (X X
1,t X )
2,t ..... n ,t
1) Reduced-form Model:
A single-equation econometric model is called a reduced-form model because it
explains the value of the exchange rate in terms of other variables without telling
us how these explanatory variables are determined.
2) Forecast may be Conditional:
Second, the forecast may be conditional on the future values of the explanatory
variables. If this is the case, our forecast of the exchange rate depends on the
accuracy of the forecasts of the explanatory variables.
2.3 Forecasting Exchange Rate
C) Forecasting Models:
1) Econometric Forecasting Models :
a) Single-equation Models:
3) Estimated from Historical Data:
The underlying assumption is that the equation as estimated from historical data
will remain valid over the forecasting horizon, which implies that the estimated
coefficients are constant.
4) Measurement Errors:
There are measurement errors in some explanatory variables. For example, the
balance of payments position is measured with a significant errors and omissions
item.
5) Variables are Qualitative in Nature:
A bigger problem arises when some of the explanatory variables are qualitative in
nature, such as market sentiment.
b) Multi-equation Econometric Models:
The first problem associated with single-equation econometric models can be dealt
with by specifying a structural multi-equation model. This can be done by specifying
equations to explain the explanatory variables X1,, ..., Xn.
2.3 Forecasting Exchange Rate
C) Forecasting Models:
2) Time Series Forecasting Models:
What distinguishes time series models from what we call econometric models is that the
former are based entirely on the past history of the exchange rate. The level of the
exchange rate is postulated to depend on its past levels, in this case the model is written
as:
St (St 1,t X t 2..... X t n )
2.4 Foreign Exchange Management Act (FEMA), 1999
In India, all transactions that include foreign exchange are regulated by the Foreign Exchange
Management Act (FEMA), 1999. It repealed the Foreign Exchange Regulations Act (FERA),
1973. FEMA has been enacted to facilitate external trade and payments and to promote the
orderly development and maintenance of foreign exchange market.
Gives Permission to
Provided the
Issues Licences hold Foreign
Exchange Facility
Currency
In the foreign exchange market, at a particular time, there exists, not one unique exchange rate,
but a variety of rates, depending upon the credit instruments used in the transfer function.
1) Spot Rates:
In finance, a spot contract, spot transaction, or simply "spot," is a contract of buying or
selling a commodity, security, or currency for settlement (payment and delivery) on the
spot date, which is normally two business days after the trade date. The settlement price
(or rate) is called a "spot price" or "spot rate."
2) Forward Rates:
A spot contract is in contract with a forward contract where contract terms are agreed
now but delivery and payment will occur at a future date. The settlement price of a
forward contract is called a "forward price" or "forward rate. "
3) Cross Rates:
A cross rate is the currency exchange rate between two currencies, both of which are
not the official currencies of the country in which the exchange rate quote is given in.
2.5 Foreign Exchange Rate
Currency Pegging
3) Currency Pegging:
Currency pegging is the idea of fixing the exchange rate of a currency by matching its
value to the another single currency or to a basket of other currencies, or to another
measure of value, such as gold or silver.
2.6 Parity Relations
The international parity relationships are the basis of analysis of exchange rate behaviour. In the
absence of barriers to international capital movements, there is a relationship between spot
exchange rates, forward rates, interest rates and inflation rates.
Foreign exchange risk is the risk of an investment’s value changing due to changes in currency
exchange rates. It is the risk that an investor will have to close out a long or short position in a
foreign currency at a loss due to an adverse movement in exchange rates.
A) Types of Risks :
There are various types of risks involved in foreign exchange markets. They are discussed
below:
Exchange Rate Risk or Position Risk
Operational Risk
Country Risk
Legal Risk
A) Types of Risks :
1) Exchange Rate Risk or Position Risk :
This type of risk refers to the risk of change in exchange rates affecting the overbought or
oversold position in foreign currency held by a bank. If the amount of currency
purchased by a bank is more than the amount of currency sold to the foreign exchange
dealer the bank is said to have “over purchase” or “long or plus position” on the other
hand, if the amount of currency purchased by the bank is less than the amount of
currency sold to the foreign dealer, the bank is said to have “Over sold” or “Short or
Minus Position”.
2) Operational Risk :
Human mistakes, faults in working procedures may create operational risk in case of
exchange transactions. Banks should take precautions about these risks and try to take
proper action in time.
3) Country Risk :
Country risk is also known as sovereign risk or transfer risk. This risk relates to the
ability and willingness of a country to service its external liabilities. It refers to the
possibility that the Government as well as other borrowers of a particular country may be
unable to fulfill their obligations under foreign exchange transactions due to reasons
which are beyond the usual credit risks.
2.7 Foreign Exchange Risk
A) Types of Risks :
4) Legal Risk :
This risk is created due to events happening in one country or events happening in the
country of origin in case of the currencies in which banks have exchange transactions.
This risk may be created in a country in which a bank as a counter party makes exchange
transactions.
5) Counter Party Risk or Credit Risk :
Counter party risk is related to risk of loss which may be created in case of outstanding
contracts where a counter party fails to fulfill obligations. Owing to lack of ability to
repay or due to unwillingness on the part of a borrower he is not able to repay the loans,
there will be a Credit Risk.
2.7 Foreign Exchange Risk
Currency Currency
Forward Futures
Contracts Contracts
Currenc
Currenc
y Option
y Swap
Contract
4) Currency Swap:
A currency swap is defined as an agreement where two parties exchange a series of cash
flows in one currency for a series of cash flows in another currency at agreed intervals
over an agreed period.
2.7 Foreign Exchange Risk
Hedging Techniques
Speculation means raking a foreign exchange risk in the hope of making profit. Speculation is
based on the expectations about the future rate of a foreign currency.
Buying currency in one market and selling the same in another market is called ‘currency
arbitrage'. With the increasing amount of currency trade taking place not with U.S. dollar, but
with non-U.S. dollars, it provides an opportunity to foreign exchange dealers to benefit from
differences in exchange rates prevailing in many financial centers of the world.
The Indian rupee has a market determined exchange rate. However, the RBI trades actively in
the USD/INR currency market to impact effective exchange rates. Thus, the currency regime in
place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate.
However, unlike China, successive administrations have not followed a policy of pegging the
INR to a specific foreign currency at exchange rate.