The market where one currency is traded for another is called foreign exchange market. Every international sale or purchase of commodities, services or assets, there corresponds an international sale or purchase of currencies.

Features of Foreign Exchange Market:

  1. Location: OTC Market – banks and brokers at a financial centre
  2. Wholesale and Retail segments
  3. Size : Daily turnover of over USD 2 trillion
  4. 24 hours market
  5. Efficiency
  6. Currencies traded

Participants:

  • Corporates
  • Commercial banks
  • Exchange brokers
  • Central banks

Settlement of Transactions

SWIFT : 

Society for Worldwide Interbank Financial Telecommunications.
- a co-operative society owned by about 250 banks in Europe and North America.
- registered in Brussels, Belgium.

CHIPS : 

Clearing House Interbank Payment System- an electronic payment system owned by 12 private commercial banks constituting New York Clearing House Association.

CHAPS : 

Clearing House Automated Payment System - London

The foreign exchange market has two segments:

  1. Spot Market
  2. Forward Market
The rate at which one currency is traded for another is called exchange rate.

Spot Market:
  • The exchange rate for immediate delivery is called Spot Exchange Rate and is denoted by S (.) e.g. S (Rs./$) = Rs.46.85/$.
  • Here immediate delivery means delivery after two business days.
  • The market where the purchase and sale of currencies is contracted for spot delivery is called the Spot Market.

Quotations at the FX Market

  • The quotes are usually made in the form of ‘buy’ and ‘sell’ or ‘bid’ and ‘ask’ rates.
  • Sometimes ‘ask’ is also referred as ‘offer’ price.

Direct & Indirect Quotes

In case of ‘direct’ quotes, a unit of foreign currency is quoted in terms of domestic currency.

For example: At New York foreign exchange market , the Deutsche mark ( DM) is quoted as:
                     Spot (bid) = $ 2.4000/DM
     Spot (ask) = $ 2.4017/ DM

In case of ‘indirect’ quotes, a unit of domestic currency is quoted in terms of foreign currency.

For example: At London foreign exchange market , the quotation are made as:

     Spot (bid) = $ 3.0201/BP
     Spot (ask) = $ 3.0180/ BP

Sometimes the quotes are made against 100 units of a currency instead of a unit of the currency. European quotes are indirect quotes. Indian quotes are direct quotes.

Relationship between Bid/ Ask prices

When a bank quotes for a currency, it simultaneously offers another currency in lieu i.e. if it buys dollars for rupees, it is simultaneously offering rupees for dollars.
Thus, there are two sides of all quotes.

S (x/bid y) = 1/ S (y/ask x) and S (x/ask y) = 1/ (y/bid x)
Where:
x and y are currencies of two countries.

Spread

Ask and bid differential is called the spread
    When quotes are direct :
                                  Spread = Ask – Bid
    When quotes are indirect :
                                  Spread = Bid – Ask
Spread represents cost of transaction. It is represented by the percentage of spread and is given by:
1.  [( Ask- Bid)/ Ask] x 100 when quotes are direct.
2. [(Bid – Ask)/ Bid] x 100 when quotes are indirect.

How ‘ BID’ and ‘ASK’ rates are formed

Let ‘c’ be one side average cost of transaction and
‘M’ be the mid rate, then the bid and ask rates are
given as:
S (bid) = M x ( 1-c) and
S (ask) = M x (1+c)

The mid rate is issued by the central banks of the countries if convertibility conditions exist Spread equals twice the one side average cost of transaction.

Determinants of Spread

  1. The currency being traded.
  2. The volume of currency being traded.
  3. The nature of organisation making quotes.
  4. Overall perception of the Dealer about the conditions of the economy and forex market.
Usually these spreads are regulated by foreign exchange dealers associations such as FEDAI.

Forward Market

Forward contracts are bought and sold at forward exchange rates.

Hedging and speculation are the main activities which pertain to forward markets.

Forward Exchange Rate

The exchange rates for delivery and payment .at specified future dates are called Forward Exchange Rates and is denoted by F(.)

For example, 60 days F (Rs./$) : forward rate between rupees and dollar is the rate at which the foreign exchange dealer can arrange a transaction between rupees and dollar 60 days hence.

Forward Exchange Rate

Forward exchange rates are determined by forward demand and forward supply of various currencies.

A foreign currency is said to be at a forward premium if its future value exceeds its present value in terms of domestic currency and it is said to be at discount if the converse is true.

For example : S (Rs./$)  = Rs. 45.70 
                  F3 (Rs./$) = Rs. 46.60

Participants in the Forward Market

  1.    Traders
  2.    Arbitrageurs
  3.    Hedgers
  4.    Speculators
  5.    Banks
  6.    Governments

Indian Forex Market

In Indian forex market, not all currencies are bought or sold.

For non-traded currencies, the banks use London, New York or Singapore markets.

Exchange Market Segments:
  1. RBI and ADs( Commercial Banks)
  2. Interbank market
  3. Retail segment – ADs with corporate clients and other retail customers.