Forex se
I. FEATURES OF EXCHANGE MARKET
Foreign exchange market is described as an Over the Counter market as there is no physical place where the participants meet to execute the deals, as in the case of stock exchange. It is more an informal arrangement among the banks and brokers operating in a financial centre purchasing and selling currencies connected to each other by tele-communications like telex, telephone and a satellite communication network. The term foreign exchange market is used to refer to the wholesale segment of the market, where the dealings take place among the banks. The retail segment refers to the dealings take place between banks and their customers. This retail segment is situated at a large number of places. They can be considered not as foreign exchange markets, but as the counters of such markets.
Foreign exchange market is the largest financial market with a daily turnover of over USD 2 trillion. Foreign exchange markets were primarily developed to facilitate settlement of debts arising out of international trade. But these markets have developed on their own so much so that a turnover of about three days in the foreign exchange market is equivalent to the magnitude of world trade in goods and services. The largest foreign exchange market is London, followed by New York, Tokyo, Zurich and Frankfurt.
The markets are situated throughout the different time zones of the globe in such a way that when one market is closing the other is beginning its operations. Thus at any point of time one market or the other is open. Therefore, it is stated that foreign exchange market is functioning throughout 24 hours of the day. However, a specific market will function only during the business hours. Some of the banks having international network and having centralized control of funds management may keep their foreign exchange department in the key centre open throughout to keep up with developments at other centers during their normal working hours.
Developments in communication have largely contributed to the efficiency of the market. Any significant development in any market is almost instantaneously received by the other market situated at a far off place and thus has global impact. This makes the foreign exchange market very efficient as if the functioning goes under one roof.
In most markets, US dollar is the vehicle currency, viz., the currency used to denominate international transactions. This is despite the fact that with currencies like Euro and Yen gaining larger share, the share of US dollar in the total turnover is shrinking.
In few centers like Paris and Brussels, foreign exchange business takes place at a fixed place, such as the local stock exchange buildings. At these physical markets, the banks meet and in the presence of the representative of the central bank and on the basis of bargains, fix rates for a number of major currencies. This practice is called fixing. The rates thus fixed are used to execute customer orders previously placed with the banks. An advantage claimed for this procedure is that exchange rate for commercial transactions will be market determined, not influenced by any one bank. However, it is observed that the large banks attending such meetings with large commercial orders backing up tend to influence the rates.
II. PARTICIPANTS
The participants in the foreign exchange market comprise:
i. Corporates
ii. Commercial banks
iii. Exchange brokers
iv. Central banks
III. TRANSACTIONS IN INTERBANK MARKETS
The exchange rates quoted by banks to their customers are based on the rates prevalent in the inter bank market. The big banks in the market are known as market makers as they are willing to buy or sell foreign currencies at the rates quoted by them up to any extent. Depending upon its resources a bank may be a market maker in one or few major currencies. When a banker approaches the market maker it would not reveal its intention to buy or sell the currency. This is done in order to get a fair price from the market maker.
Spot and forward transactions
The transactions in the inter bank market may place for settlement
a. On the same day; or
b. Two days later; or
c. Some day late; say after a month.
Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash or ready transaction. It is also known as value today.
The transaction where the exchange of currencies takes place two days after the date of the contact is known as spot transaction. The transaction in which the exchange of currencies takes place at a specified future date subsequent to the spot date is known as forward transaction.
IV. FACTORS DETERMINING FORWARD MARGIN
1. Rate of interest. The difference in the rate of interest prevailing at the home centre and the concerned foreign centre determines the forward margin. If the rate of interest at the foreign centre is higher than that prevailing at the home centre, the forward margin would be at discount. Conversely if the rate of interest at the foreign centre is lower than that at the home centre, the forward margin would be at premium.
2. Demand and supply. Forward margin is also determined by the demand for and the supply of foreign currency. If the demand for foreign currency is more than its supply, forward rate would be at premium. If the supply exceeds the demand, the forward rate would be at discount.
3. Speculation about spot rates. Since the forward rates are based on spot rates, any speculation about the movement of spot rates would influence forward rates also. If the exchange dealers anticipate the spot rate to appreciate, the forward rate would be quoted at premium. If they expect the spot rate to depreciate, the forward rates would be quoted at a discount.
4. Exchange regulations. Exchange control regulations may put some conditions on the forward dealings and may obstruct the influence of the above factors on the forward margin. Such restrictions may be with respect to keeping of balances abroad, borrowing overseas. Intervention in the forward market by the central bank may also do to influence the forward margin.
V. FACTORS DETERMINING SPOT EXCHANGE RATES
1. Balance of payments represents the demand for and supply of foreign exchange which ultimately determine the value of the currency. Exports, both visible and invisible represent the supply side for foreign exchange. Imports visible and invisible create demand for foreign exchange. When the balance of payments of a country is continuously at deficit, it implies that the demand for the currency of the country is lesser than its supply. Therefore its value in the market declines. If the balance of payments is surplus continuously, it shows that the demand for the currency in the exchange market is higher than its supply and therefore the currency gains in value.
2. Inflation in the country would increase the domestic prices of the commodities. With increase in prices exports any dwindle because the price may not be competitive. With the decrease in exports the demand for the currency would also decline, this in turn would result in the decline of external value of the currency. It may be noted that it is the relative rate of inflation in the two countries that cause changes in exchange rates.
3. Interest rate has a great influence on the short term movement of capital. When the interest rate at the centre rises, it attracts short term funds from other centers. This would increase the demand for the currency at the centre and its value. Rising of interest rate may be adopted by a country due to tight money conditions or as a deliberate attempt to attract foreign investment.
4. An increase in money supply in the country will affect the exchange rate through causing inflation in the country. It can also affect the exchange rate directly.
5. An increase in national income reflects increase in the income of the residents of the country. This increase in the income increases the demand for goods in the country. If there is under utilized production capacity in the country, this will lead to increase in production. There is a chance for growth in exports too. But more often it takes time for the production to adjust to the increased income. Where the production does not increase in sympathy with income rise, it leads to increased imports and increased supply of the currency of the country in the foreign exchange market.
6. When the country is able to discover key resources, its currency gains in value.
7. There are many factors that influence movement of the capital from one country to another. Short term movement of capital may be influenced by the offer higher interest in a country. If interest rate in a country rises due to increase in bank rate or otherwise, there will be a flow of short term funds into the country and the exchange rate of the currency will rise. Reverse will happen in case of fall in interest rates.
8. Political stability induces confidence in the investors and encourages capital inflow into the country. This has the effect of strengthening the currency of the country. On the other hand, where the political situation in the country is unstable, it makes the investors withdraw their investments. The outflow of capital from the country would weaken the currency. Any news about change in the government or political leadership or about the policies of the government would also have the effect of temporarily throwing out of gear the smooth functioning of exchange rate mechanism.
9. Psychological factors and speculation. The behavior of the major participant in the market can affect the exchange rate. The influence may make the rate move differently from that determined by long term economic forces. A large scale buying or selling by the major participant would make others in the market to follow suit. This will have the effect of accentuating the trend.
10. Technical and market factors. Isolated large transactions in the market may upset the markets ability to balance the supply of and demand for the currency. The immediate effect will be wide distortion to the exchange rate. The situation will continue till the amount is fully absorbed in the market and normalcy is restored.
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