Foreing Exchange Market
The foreign exchange market is the market where one currency is traded for another. It is the largest market in the world. The foreign exchange market is an over-the-counter market.
This means that there is no single physical or electronic market place or an organized exchange with a central trading clearing mechanism, where traders meet and exchange currencies. The market is actually a worldwide network of inter-bank traders, consisting of banks, connected by telephone lines and computers. With direct dialing telephone services anywhere in the world, foreign exchange markets have become truly global in the sense that currency transactions now require only single telephone calls and take place twenty-four hours a day.
Geographically, the markets span all the time zones from New Zealand to the West Coast of the United States. When it is 3:00 PM in Tokyo, it is 2:00 PM in Hong Kong. When it is 3:00 PM in Hong Kong, it is 1:00 PM in Singapore. At 3:00 PM in Singapore, it is 12:00 noon in Bahrain. When it is 3:00 PM in Bahrain, it is noon in Frankfurt and Zurich, and 11:00 AM in London. When it is 3:00 PM in London, it is 10:00 AM in New York. By the time New York is starting to wind down at 3:00 PM, it is noon in Los Angeles. By the time it is 3:00 PM in Los Angeles, it is 9:00 AM of the next day in Sydney. The gap between New York closing and Tokyo opening is about 2.5 hours. Thus, the market functions 24 hours enabling a trader to offset a position created in one market using another market.
Types of transactions and settlement dates
Settlement of a transaction takes place by transfer of deposits between the two parties and the day when these transactions are effected is called the settlement date, or the value date. The countries where the transfers take place are called settlement locations. The locations of the two banks in the countries of the two currencies involved in the trade, are dealing locations, which need not be the same as settlement locations. For e.g. a London bank can sell Swiss francs against US dollar to a Paris bank. Settlement locations may be New York and Geneva, while dealing locations are London and Paris. Depending upon the time elapsed between the transaction date and the settlement date; FOREX transactions can be categorized into ‘spot’ and ‘forward’ transactions. A third category called ‘swaps’ is a combination of a spot and a forward transaction.
In a spot transaction, the settlement or value date is two business days ahead for European currencies, or the Yen traded against the dollar. The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad. A complete requirement under the forex regulations and the exchange rate at which the transaction takes place is called the spot rate. A forward transaction involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today. The typical forward contract is for one month; three months; or six months, with three months being most common. Forward contracts for longer periods are not as common because of the great uncertainties involved. However, forward contract can be renegotiated for one or more periods when they become due.
The equilibrium forward rate is determined at the intersection of the market demand and supply forces of forex for future delivery. The demand and supply of forward forex arise in the course of hedging, from forex speculation and from covered interest arbitrage.
A swap transaction in the forex market is a combination of a spot and a forward in the opposite direction. Thus, a bank will buy Euros spot against US dollar and enter into a forward transaction with the same counter party to sell Euros against US dollar. A spot 60-day dollar-euro swap will consist of a spot purchase of dollars against the euro coupled with a 60-day forward sale of dollar against euro. When both the transactions are forward transactions, we have a forward-forward swap. Thus, a 1-3 month dollar-sterling swap will consist of purchase of sterling versus dollars one month forward, coupled with a sale of sterling versus dollars three months forward. The term “swap” implies a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. Forward contracts without an accompanying spot deal are known as “outright forward contracts” to distinguish them from swaps.
Exchange rate regimes and the forex market in india
Exchange Rate Calculations
Forex contracts are for “cash” or “ready” delivery which means delivery same day, “value next day” which means delivery next business day and “spot” which is two business days ahead. The rates quoted by banks to their non-bank customers are called “Merchant Rates”. Banks quote a variety of exchange rates. The so-called “TT” rates are applicable for clean inward or outward remittances. “TT buying rate” applies when an exporter asks the bank to collect an export bill and the bank pays the exporter only when it receives payment from the foreign buyer as well as in cancellation of forward sale contracts. “TT selling rate” is applicable when the bank sells a foreign currency draft.
Spot TT Buying Rate
This rate is calculated as: Spot TT Buying Rate = A Base Rate – Exchange Margin The base rate is the inter-bank rate. The purpose of exchange margin is to recover the costs involved and provide a profit margin to the bank.
Spot Bill Buying Rate
This rate is calculated as: Spot Bill Buying Rate = Inter-bank forward rate for a forward tenor equal to transit plus issuance period of the bill of any exchange margin For a forward bill purchase, the bank will start from the inter-bank forward rate for a tenor, which includes •Interval between current time and delivery date of the bill •Transit period •Issuance period of the bill and deduct an exchange margin
Spot TT Selling Rate
This rate is calculated as: TT Selling Rate = A Base Rate + Exchange Margin The base rate is the inter-bank spot selling rate. The exchange margin is subject to a ceiling specified by the FEDAI (Foreign Exchange Dealers’ Association of India).
Bill Selling Rate
When an importer requests the bank to make a payment to a foreign supplier against a bill drawn on the importer, the banker has to handle documents related to the transaction. For this, the bank loads another margin over the TT selling rate to arrive at the Bill Selling Rate. Thus, Spot Bill Selling Rate = TT Selling Rate + Exchange Margin
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