Chapter three

foreign exchange market

FOREIGN EXCHANGE MARKET:

 It is a global market which deals with the trade of

currencies.
 Banks which are authorized to deal in foreign

currencies can participate in this market.

 Large corporates, governments and individuals make

use of this market for various purposes.

 This system has evolved from Gold standard in 1876 to

a floating exchange rate system which is continuing till

date.
 Foreign exchange plays a vital role in growth and
development of international trade and business.
 It promotes international liquidity.
 The main feature of this market is that it is functioning

throughout the day for 24 hours.

 The two main functions of Forex Markets are:

1. converting currencies and

2. reducing the foreign exchange risk.
The Participants of Foreign
Exchange Markets:
1. Central Banks: The Central Banks of each country
aims to control the money supply, Inflation, interest
rates etc in their country.
 It uses the foreign exchange reserve to bring stability in

the market.
 Their participation is relevant when the currency

fluctuates beyond the target rate.

 Every central bank tries to defend their currency in the

market
2. Forex dealers: they are the largest participants in the
market. The prime responsibility of the foreign
exchange dealer is to buy and sell financial exchange
strategies to customers.
3. Hedgers: Many people invest in foreign currency
and maintain it as an asset. Hence they may be
subject to the risk of foreign exchange fluctuation. In
such a situation the hedgers take a position where
their action will nullify the losses.
4. Speculators: They are people who predict the future
position of the foreign exchange market.
 Such people become active in for a short period.
 Their only motive is profit.
 When the market is improving every day, the number

of speculators playing in the market will also increase

5. Arbitrageurs: They are those traders who take
advantage of the price difference of a currency in
different markets. It is the arbitrageurs who maintain
the decentralized nature of foreign exchange market.
6. Commercial Enterprises. There are many business
enterprises who deal in import and export. They also
trade for smaller values in short terms as compared to
speculators and banks.
7. Individual Participants: They are also called retail
market participants. They are the tourists who travel
abroad like tourists, students, etc.
 they are also short term participants. They engaging in

trading only when they require as this is not their main

source of income
FOREIGN EXCHANGE TRADING:

 It involves the purchase and sales of different

currencies in the foreign exchange market.
 It is also known as FX trading.
 Usually the trading is being done in a currency pair.
 The first currency is called the base currency and the

second currency is called as the quote currency.

 Similar to the normal markets Forex market also is

driven by the demand and supply

Reasons for engaging in Forex trading:

1. It is the most liquid market and it functions 24

hours a day. Hence you can trade at any time if
required. There are easy entry and exit position in the
market.
2. Since there are numerous currencies being traded in
the market it is always easy to find a pair that are
strong and will give better returns.
3. You can choose to engage in trading for various
time frames. It can be traded in time frame which
can 1, 5 or 15 minutes. It can even be weekly or even
long term trading.
4. Forex market is a well coordinated market and is
also unregulated. One can trade without
intermediaries also and thus reduce the transaction
cost by not paying commission or broker fees.
5. Each currency pair is independent. The
fluctuations in one pair do affect the other
pair. Hence one can focus on a single pair or
multiple pairs while trading
FOREIGN EXCHANGE RATE:

 Foreign exchange rate can be defined as the value of

one currency in comparison to the value of another
currency.
 The exchange rate is the price of one currency in

terms of another currency.

 There are two methods of expressing it.

1. Domestic currency per unit of foreign currency.

2. Foreign currency units per unit of the domestic
currency
TYPES OF MARKETS:

1. Spot Market:
 It is the market where the securities, currencies, and

goods are traded and the payment and delivery occurs

on the spot date, i.e. on an immediate date (which is
usually two business days) after the transaction
happens.
 The spot market is also called as cash market.
 In foreign exchange market this is the most common

type of market.
 The exchange rate at which the transaction occurs in

this market are called spot rate.

 The exchange rate which is prevailing at that time is

taken as the spot rate.

 Most of the foreign exchange centers offer this service.
 For example a tourist can exchange his currency at an
exchange center in the airport immediately for the
domestic currency
 The main participants in this market are commercial

banks, brokers, and individual customers

 Examples
 As a tourist you want to travel than you decide to

convert your EUR currency to dollor at rate EUR/USD

1.09, how much dollar you will have if you convert
150EUR
 Spot market transactions can occur in two different
ways.
1. Over the Counter: The currency exchange market is an
over the counter market. There is no third party
supervision during the transactions.
◦ The participants negotiate the terms and conditions of the
transaction on the spot.
◦ The prices in this market are generally private and is not
published anywhere.
2. The organized Market exchange: They are an organized
market where all the procedures are standardized.
 The deal is completed through a broker generally.
Advantages of Spot Market:
1. It is quick and simple. The transactions are completed on
the spot.
2. Based on satisfaction: If the buyers and sellers are not
satisfied with the current rates, then they can hold the
transaction and trade when the rates improve.
3. The transactions are transparent: The participants are
aware of the exchange rate that is dominant at the time of
transaction.
Disadvantages of Spot Market:

1. Inflation: Inflation can affect the prices of the currency.

The buyer may purchase it at an inflated price if he is not
aware of the real price.
2. Once the transaction is completed it cannot be undone.
If the trader notices any divergences after the
transaction after the closure he will not be able to
correct it.
3. Not flexible: The market is not flexible in terms
of the time frame as the transactions are
completed on the spot
2. Forward Market:

 A forward contract is an agreement which

states that a specified amount of money will be
paid at an exchange rate which is already
determined by both the parties signing the
agreement on a specified date in future.
 The parties of the contract are generally

corporations and financial institutions.

 The market that deals with these forward

contracts is called as forward market.

 Multinational Corporations and other large
business institutions use these contracts
against the risk of exchange rate fluctuation.
 Since it is used by large cooperation, the

amount o transactions are also generally very

high
 The most widely used contracts are for 30, 60,

90, 180 and 360 days

 Example: Assume that the spot rate of rupee to
dollar is rupees70/-. The forward rate after 3
months is expected to be Rs.75/-. Hence the
dollar is said to be at premium as its value has
increased by 5 rupees.
 If the dollar value depreciates to Rs.65/- then

dollar is said to be at discount since its value

has reduced by 5 rupees.
Example
 The exchange rate on spot USD/RUP is 80, the
inflation in India and USA are 7% and 3% respectively,
how match the exchange rate of rupees will be after
one year

ANSWER
1 USD will be equal to 83 rupee
Exercise
 The exchange rate on spot USD/RUP is 80, the
inflation in India and USA are 3% and 7% respectively,
how match the exchange rate of rupees will be after
one year
Exercise
 Your are in euro zone, EUR/USD=1.1 at spot
 The inflation in euro is 2% and the inflation in US in

5%
 How much 20 EUR will be equal?
Advantages of Forward Market:

1. The risk of exchange rate fluctuation is eliminated as

the rates for a future date are fixed.
2. These contracts can be customized. Hence the
agreement can be written for any amount of money.
3. They are relatively easy to understand
4. These contracts also protect against the price
fluctuations
Disadvantages of Forward Market:

1. The dates of payment are fixed.

2. The cash flow from such trades will happen
only at a future date. Hence the seller will
not be able to access any payments before
the mentioned date.
3. In the case of an increase in the exchange
rate the receiver of the payment will not be
able to take advantage of the price rise.
Arbitrage:

 Arbitrage in currency market can be defined as

the process of taking advantage of the price
difference of the same currency.
 This happens when one purchases a currency

at a rate in a market and sells the same in a

different market where it is sold at a higher
price.
 For example consider the exchange rate is Rs.70/$. The
interest rate in India is 8% p.a and the interest rate in
USA is 10%. p.a. A trader decides to invest Rs/-70000
for one year.
 If he invests the entire amount in India he will gain

Rs.75600.
 He can also convert the entire amount in dollars and

invest in America. He can invest $1000 for one year

where he will gain $1100
 It is unlikely that the exchange rate after one
year will remain the same.
 If it increases then the trader will gain higher

returns but if it depreciates to Rs.68/$ he will

gain only Rs/. 74800.
 Thetrader will try to avoid this risk by making

a forward contract of a value more than Rs.

70/$.
 Calculation of Arbitrage in Forward Market:
 Example: Calculate the arbitrage gained by using the

data given below.

 The interest rate of rupees is 8% per annum for 3

months and the interest rate for dollars is 10% per

annum for 3 months
 Spot rate is Rs.70/$ and 3 months forward rate is

Rs.69.85/$
 Solution:
 The forward discount of dollar = 70-69.85
 = Rs.0.15
 Here the interest differential is 10%-8% that is 2%.
 Step 1: In this case the arbitrageur can borrow 1000
rupees and purchase dollar immediately.
 It is given that 1 $ is 70 rupees hence he arbitrageur can

purchase 1000/70 dollars=

 $14.28
 Step 2: This can be invested in the money market for

10% interest for 3 months.

 Future value after 3 months= P X [ 1+( r X t)] where
(P= Principal, R= rate of interest, T=time)
 = 14.28 X [ 1+ ( 0.1 x 3/12)]
 = 14.28 X [1+0.025]
 = $ 15.305
 Step 3: This $15.305 can be sold. The price per dollar

at the time would be rupees 69.85. Hencethe

arbitrageur earns Rs/- 1069.05.
 Step 4: The arbitrageur has to pay the principal amount
and 8% interest for the 1000 rupeeswhich was
borrowed before 3 months.
 Value to paid = 1000 X [1+ (0.08 X 3/12)]
 = 1000 X 1.02
 = 1020
 The profit gained = 1069.05-1020
 = Rs/- 49.05
Future Market:

 A future contract is very similar to a forward contract.

 The difference is that it is a standardized contract

where as a forward contract can be customized.

 The contract will determine all the details like the

volume of asset, the price, the delivery date which

cannot be changed by either party
Options Market:

 Options market is a type of financial market that allows

investors to buy or sell the right to purchase or sell an
underlying asset at a fixed price, at a future date.
 Options trading operates on the basis that the buyer has

the option to exercise the contract but is not under any

obligation to do so.
 Options can be categorized into call- option and put-

option.
 When the option is chose to purchase an asset it is called

as call-option and when it is used to sell the asset it is

called as Put-option
FORECASTING EXCHANGE RATE:

 Forecasting refers to the estimation of a future value.

 Forecasting exchange rates involves the study and

analysis of the behavior for foreign exchange to predict

the future value of currency.
 Every large company, government, brokers, and

financial institutions try to predict the future exchange

rate
 The main reason for performing a forecast of the
exchange rate value is to understand the risks and
derive the maximum benefits out of it.
 Foreign currencies are considered as investments
 Companies with a significant amount of idle cash with

them may invest in multiple foreign currencies for a

short term.
 It is important to analyze whether the chance of an

appreciation or depreciation is possible for the

currencies that they are going to invest in
 Foreign exchange market is one of the most volatile
markets in the world.
 The risk associated with investing in foreign currencies

is very high.
 Hence forecasting is performed as a method of hedging

against the risk of exchange rate fluctuations.

 Many large corporations and MNCs who are involved

in international trade are subject to this risk.

TECHNIQUES FOR FORECASTING:

 Forecasting techniques can be categorized into 4 types.

1. Technical forecasting
2. Fundamental forecasting
3. Market based forecasting
4. Mixed forecasting
Technical Forecasting:

 In this method the historical data of exchange rate is

used to estimate the future value.
 This technique can be used if the investments are for a

short period or to study day to day fluctuations.

Fundamental Forecasting:

 This technical is based on the relationship between

various economic variables and the exchange rate.
 An estimate is made by assessing the factors that affect

the exchange rate.

 It may also make use of quantitative methods like

regression analysis.
 For example if we want to forecast the appreciation or
depreciation level of Indian rupees in terms of dollar,
we will have to study economic situations in U.S.A and
India, like the rate of inflation, political stability,
growth of industries etc.
 The conditions prevailing in USA will affect the value

of dollar which will in turn affect the relative value of

rupee to dollar.
 The disadvantage in this method is that unexpected
events in the economy may make the predication
wrong.
 The exact effect of the factors on the exchange rate is

also not easy to calculate and understand.

 One may ignore certain important factors over the

others which will also generate the wrong prediction.

Market Based Forecasting:

 The market indicators like the spot rate and forward

rate are used to make estimates in this method.
 The spot rate of the present day can be used to forecast

the value of spot rate in a future date.

 If a currency appreciates its value today, the traders

may assume that it will appreciate in the future too..

 Hence they would purchase it today which will result
in the appreciation of its value.
 The same is the case for depreciation also. If a currency

falls today people may sell it to off believing that the

trend may continue.
 This would result in the actual depreciation of the

value.
 The forward rate quoted on a predetermined date can

be used to predict the spot rate on that date

Mixed Forecasting:

 It is a combination of different techniques.

 The forecast is prepared based on the weighted average

of the different techniques used in the prediction.

 The techniques which are considered as reliable.
 The choice of the techniques adopted will vary based

on the currency, the term of investment and the purpose

of forecast
MEASURING EXCHANGE RATE MOVEMENTS:

 Exchange rate movement refers to the change in the

exchange rate.
 The main terms associated with the movement of

exchange rate are appreciation, depreciation,

revaluation and devaluation.
 The movement is said to be in upward direction if the

currency is strengthening.
 This is termed as appreciation.
 When the currency weakens from its existing value the
downward movement occurs which is termed as
depreciation.
 The other two terms are mentioned in a fixed exchange

rate system.
 When the government of a country appreciates the

value of the currency deliberately, it is known as

revaluation and devaluation refers to the deliberate
depreciation of the currency by the government.
 International trade and business and the strength of the
society is affected by the movements in the exchange
rate.
 Depreciation of a currency affects the home country

negatively.
 The exported goods will become cheaper over sees and

the imported foreign goods will become expensive for

the country.
 Hence the cash outflow may exceed the cash inflow.
 An appreciation in the currency will have a positive
effect by making the imported goods cheaper and the
exported goods more expensive.
 The movement also affects every corporation,

government and individual who has invested in the

foreign currency or who has lended and borrowed in a
foreign currency.
 Hence the regular study of the day to day movement is

necessary to be protected from the fluctuation risk.

EXCHANGE RATE EQUILIBRIUM:

 In a floating rate system the price of the currency is

affected by the demand and supply of the currency.
 When the demand and supply for a currency against

another currency become equal then it is said to have

attained a state of equilibrium.
 When two countries are engaged in international trade

they import and export the required goods to each other

and the payments for the exported goods are preferred in
the home currency.
 The demand for a currency depends on the demand for

the products exported from that country.

 When the exported products are in demand, the
importing country will have to pay in the currency of
the exporting country hence they will purchase the
currency.
 The supply of a currency depends on the demand of

imported goods in a country.

FACTORS AFFECTING FOREIGN EXCHANGE
FORECASTING

1. Change in prices of goods or services

2. Decline of economy
3. Change in Political conditions
4. Effects of Natural Calamities
5. Error in assumption
6. Error in Quantitative calculations
Change in prices of goods or services

 the PPP( purchasing power parity) theory uses the

prices of the goods in different countries to calculate
the exchange rate.
 The prices of goods can change unexpectedly due to

multiple reasons like demand of supplementary goods,

strikes in an industry, unavailability of raw material,
change in government policy etc.
 If there is an unexpected change in the price the

forecasted rate will be wrong.

Decline of economy
 Forecasting is also based on the relative strength of the
economies of different countries.
 The economy of a country can grow or decline

suddenly.
 A global situation like the Corona has affected the

global economy.
 But the rate of its affect is different in different

countries. Such unexpected movement of the economic

condition can prove the forecasting wrong
Effects of Natural Calamities
 Calamities like floods that continue for months can put
the economy on a standstill and affect the movement of
goods, services and people.
 This will affect the trade and economy which will in

turn affect the exchange rate

Error in assumption
 The forecasting of forward rate is calculated through
the spot rate.
 It is assumed that if the currency appreciates today it

may appreciate tomorrow also. This may not be the

scenario.
 The chance of fluctuation in exchange rate is very high.
 Historical data is also used to forecast assuming that a

similar trend or pattern in the fluctuation that happened

in the previous years may repeat in the future too, but is
not common that historical data will be repeated
Error in Quantitative calculations
 The foreign exchange rate is mathematically and
statistically calculated through different techniques.
 Regression analysis is used to forecast exchange rate

quantitatively.
 An error in the mathematical calculation can result in a

wrong forecast
INTERNATIONAL PARITY RELATIONSHIPS:

 The word parity refers to a state of being equal.

 In the case of international trade it can be related to

exchange rate, purchasing power, the price of goods

and services etc.
 the most important concepts to be studied in the

International parity relationships are Interest Rate

parity, Purchasing Power parity and the International
Fischer Effect.
 INTEREST RATE PARITY:
 It refers to condition where the trader cannot avail an arbitrage due
to the difference in the interest rates.
 This concept holds that if an investor invests in his domestic
currency or if he invests the same amount in a foreign currency the
rate of interest on the returns will be the same.
 This concept holds due to the fact that the spot rate and forward of a
currency differs from each other.
 The Theory that explains this concept is the Interest Rate Parity
Theory.
 It states that the interest rate differences between two different
nations will automatically adjust the exchange rates of those
currencies
PURCHASING POWER PARITY:

 Purchasing power refers to the basket of goods that can

be bought by a unit of currency.
 For example if a citizen in India is able o purchase a

basket of goods consisting of 5 grocery items and one

dress for 1000 rupees.
 In US the same basket of goods can be purchased for

$20. Thus we can conclude that $1 = 50 rupees.

 There are two version of Purchasing power parity i.e.,
Calculation of PPP
 R=Ph/Pf
 R is exchange rate
 Ph is price at home country
 Pf is price at foreign country
 Example: if one phone value in india is 20000 rupee

and the same phone value is 500$ what is exchange

rate of PPP?
INTERNATIONAL FISHER EFFECT:

 This concept is named after the popular American

economist Irving Fisher.
 Fisher effect deals with the relationship between the

inflation rate and the interest rate.

 For example if a money lender gives a loan of rupees

10,000 to an individual at 5% interest rate per annum for

a year the total returns that he receives at the beginning
of the second year would be rupees 10500.
 If the rate of inflation in the economy is 10% then he is

losing 5% as the value of rupees 10000 would have risen

to rupees 11000 by the next year
 The international Fisher effect states that nominal
interest rate has an inverse relationship with inflation
rate.
 The increase in the nominal interest rate results in the

decrease in the inflation rate.

 Nominal interest rate is the interest rate calculated

without the inflation

 Let us look on how it affects the international business. An
Indian investor decides to invest rupees 10 .
 He considers London as one option and New York as the
second option.
 Suppose the interest in London is 10% and the interest rate
in New York is 5%.
 If the investor considers only the interest rate then the
choice would London.
 But suppose the inflation rate in London is 8% and the
inflation rate in New York is 2% then the investor will earn
2% profit from London and 3% profit from New York.
 Nations use this concept while creating monetary
policies.
 A country which shows a deficit in the Balance of

payment would prefer to attract foreign investments

into the country.
 They can choose two different methods to achieve this,

either by controlling inflation or by increasing the

nominal interest rate.
The end