Foreign Exchange Market – International Business Operations (2024)

Tejinder Sharma

Objectives

The objectives of this lesson are:

  1. To provide a comprehensive description of the nature, structure and operation of foreign exchange market.
  2. To describe the types of foreign exchange transactions and the major participants of foreign exchange market.
  3. To understand the foreign exchange quotations of The Wall Street Journal.

Introduction

The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought or sold against one another. In words of H.E.Evitt, “it is a that section of economic science which deals with the means and methods by which right to wealth in one country’s currency are converted into rights to wealth in terms of another country’s currency. It also involves the investigation of the method by which render such exchange necessary, the forms which such exchange may take, and the ratios or equivalent values at which such exchanges are affected.” The foreign exchange market in terms value of transactions, is largest market in the world, with daily turnover of over USD 2 trillion. It is a 24 hrs market.

Foreign Exchange

Foreign Exchange refers to foreign currencies possessed by a country for making payments to other countries. It may be defined as exchange of money or credit in one country for money or credit in another. It covers methods of payment, rules and regulations of payment and the institutions facilitating such payments.

Foreign Exchange market

A foreign exchange market refers to buying foreign currencies with domestic currencies and selling foreign currencies for domestic currencies. Thus it is a market in which the claims to foreign moneys are bought and sold for domestic currency. Exporters sell foreign currencies for domestic currencies and importers buy foreign currencies with domestic currencies. According to Ellsworth, “A Foreign Exchange Market comprises ofall those institutions and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid claim on foreign money”. Foreign Exchange transactions result in inflow & outflow of foreign exchange.

Nature of foreign exchange market

The foreign exchange market is a decentralized market in the sense that market participants are generally separated from one another and transactions take place through electronic media such as by telephone or through computer networks. Two implications of decentralization are fragmentation and lack of transparency. The foreign exchange market is fragmented in the sense that transactions may occur simultaneously or near simultaneously in the market at different prices. It is opaque–or lacks transparency–in the sense that the absence of a physical market place makes the process of price-information interaction difficult to observe and understand .Although the market is decentralized, it nevertheless has various physical locations or trading centers throughout the world where many of the most important market participants–in particular the market-making dealers– tend to concentrate.

Functions of Foreign exchange market

Foreign exchange is also referred to as forex market. Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the important foreign exchange instruments used in foreign exchange market to carry out its functions. The Foreign Exchange Market performs the following functions.

1. Transfer of Purchasing Power or Clearing Function

The basic function of the foreign exchange market is to facilitate the conversion of one currency into another i.e. payment between exporters and importers. For e.g. Indian rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills. Telegraphic transfer is the quickest method of transferring the purchasing power.

2. Credit Function

The foreign exchange market also provides credit to both national and international, to promote foreign trade. It is necessary as sometimes, the international payments getdelayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required.

3. Hedging Function

A third function of foreign exchange market is to hedge foreign exchange risks. By hedging, means covering of a foreign exchange risk arising out of the changes in exchange rates. Under this function the foreign exchange market tries to protect the interest of the persons dealing in the market from any unforeseen changes in exchange rate. Hedging guards the interest of both exporters as well as importers, against any changes in exchange rate. Hedging can be done either by means of a spot exchange market or a forward exchange market involving a forward contract.

Foreign Exchange market participants

The foreign exchange market consists of two tiers: the inter bank or wholesale market, and the client or retail market.

1.Wholesale Foreign Exchange Market: Major foreign exchange trading in the wholesale foreign exchange markets is undertaken by banks – popularly known as inter bank market. In this market, banks and non-bank financial institutions transact with each other. They undertake trading on behalf of customers, but majority of trading is undertaken for their own account by proprietary desks. Besides banks and non-bank financial institutions, multinational corporations, hedge funds, pension and provident funds, insurance companies, mutual funds etc. participate in the wholesale market.

Foreign Exchange Dealers and Brokers: The role of foreign exchange dealers and brokers need to be discussed in detail. But, let us first understand who foreign exchange dealers are.

Dealers: Banks and some nonblank financial institutions act as foreign exchange dealer. These dealers quote both “bid” and “ask” for a particular currency pair (for spot, forward and swap contracts) and take opposite side to either buyers or sellers of currency. They make profit from the spreads between buying and selling prices i.e., bid and ask rate.

Brokers are agents, which merely match buyers and sellers and get a brokerage fee. Before the internet, the brokers, dealers and clients were communicating over telephone or telex and through satellite communication. SWIFT (Society for Worldwide Inter bank Financial Telecommunication) facilitated the communication between these brokers and banks. These dealers are also known as “market maker”. As market makers, these dealers stand willing at all time to buy and sell currencies at the quoted rate.

Brokers: Brokers on the other hand, help clients to get a better rate on the currency trade by making available different quotes offered by dealers. Traders can compare rates and accordingly take a decision. Brokers charge a commission for providing these services. Communication between brokers and clients also used to be through dedicated telephone lines. A broker continuously remains connected to dealers to get latest quotes, depth of the market. The broker compares the rates offered by the dealers and provides the best rates to the clients i.e, highest bid prices quoted by different dealers when the client wants to sell and lowest ask price quoted by different dealers when the clients wants to buy.

Participants in Commercial and Investment Transactions

Importers and exporters, international portfolio investors, multinational firms, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions. Some of these participants use the foreign exchange market to hedge foreign exchange risk.

Speculators and Arbitragers

Speculators and arbitragers seek to profit from trading in the market. They operate in their own interest, without a need or obligation to serve clients or to ensure a continuous market. Speculators seek all of their profit from exchange rate changes. Arbitragers try to profit from simultaneous exchange rate differences in different markets. Arbitragers buy and sell the same currency at two different markets whenever there is price discrepancy. The principle of “law of one price” governs the arbitrage principle.

Central Banks and Treasuries

Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.

In many instances they do best when they willingly take a loss on their foreign exchange transactions.

Foreign Exchange Brokers

Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction. For this service, they charge a small commission, and maintain access to hundreds of dealers worldwide via open telephone lines. It is a broker’s business to know at any moment exactly which dealers want to buy or sell any currency.

2. Retail Market:

In the retail market, individuals (tourists, foreign students, patients traveling to other countries for medical treatment) small companies, small exporters and importers operate. Money transfer companies/remittance companies (for example like Western Union) are also major players in the retail market. Retail traders buy/sell currency for their genuine business/personal requirements. For example, an exporter enters into forward contract to convert foreign currency to domestic currency. A tourist buys foreign currency in the spot market before undertaking the journey. A UK patient visiting India to undertake an operation that would have cost him a fortune at UK

Transactions in the Inter bank Market

Transactions in the foreign exchange market can be executed on a spot, forward, future, options and swap basis. These are explained as follow:

1. Spot Transactions:

In the spot exchange market, the business is transacted throughout the world on a continual basis. So it is possible to transaction in foreign exchange markets 24 hours a day. The standard settlement period in this market is 48 hours, i.e., 2 days after the execution of the transaction. The spot foreign exchange market is similar to the OTC market for securities. There is no centralized meeting place and no fixed opening and closing time. Since most of the business in this market is done by banks, hence, transaction usually do not involve a physical transfer of currency, rather simply book keeping transfer entry among banks. A spot transaction requires almost immediate delivery of foreign exchange. In the inter bank market,a spot transaction involves the purchase of foreign exchange with delivery and payment between banks to take place, normally, on the second following business day. The date of settlement is referred to as the “value date.”

2. Outright Forward Transactions:

A forward transaction requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate to prevail at the value date is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are normally quoted for value dates of one, two, three, six, and twelve months. Actual contracts can be arranged for other lengths. Outright forward transactions only account for about 9 % of all foreign exchange transactions. The basic objective of a forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed date and is intended to free both the purchaser and the seller from any risk of loss which might incur due to fluctuations in the price of underlying asset. A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. The exchange rate is fixed at the time the contract is entered into. This is known as forward exchange rate or simply forward rate.

3. Swap Transactions:

A swap transaction involves the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. The most common type of swap is a spot against forward, where the dealer buys a currency in the spot market and simultaneously sells the same amount back to the same back in the forward market. Since this agreement is executed as a single transaction, the dealer incurs no unexpected foreign exchange risk. Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts. The currency swap entails swapping both principal and interest between the parties,with the cash flows in one direction being in a different currency than those in the opposite direction. There are a various types of currency swaps like as fixed-to- fixed currency swap, floating to floating swap, fixed to floating currency swap.

4. Future :

A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In another word, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts.

5. Options:

Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ). In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded OTC.

Comparison of Forward and Futures Currency Contract

Foreign Exchange Market – International Business Operations (1)

Summary

The foreign exchange market is the mechanism, by which a person of firm transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, and minimizes exposure to foreign exchange risk. A foreign exchange transaction is an agreement between a buyer and a seller that a given amount of one currency is to be delivered at a specified rate for some other currency. A foreign exchange rate is the price of a foreign currency. A foreign exchange quotation or quote is a statement of willingness to buy or sell at an announced rate. The foreign exchange market consists of two tiers: the inter bank or wholesale market, and the client or retail market. Participants include banks 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.

References

Books:

  1. Sundaram, Anant K. and J. Stewart Black, The International Business Environment: Text and Cases, Prentice Hall of India Pvt. Ltd., New Delhi.
  2. Cherunilam Francis, International Business: Text and Cases, Prentice Hall of India Pvt. Ltd., New Delhi.
  3. Foreign Exchange Market, Jain, Yadav & Peyrard, Macmillan publishers India ltd. New Delhi.
  4. International Business: Competing in the Global Marketplace by Charles W.L.Hill
Foreign Exchange Market – International Business Operations (2024)
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