Foreign Exchange | International Economics

Foreign Exchange Market

The foreign exchange market is a decentralized worldwide market. Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and the central bank. The transactions in this market are not confined to only one or few foreign currencies. In fact, there are a large number of foreign currencies which are traded, converted and exchanged in the foreign exchange market.

Foreign exchange market is also described as an OTC (Over the Counter) market as there is no physical place where the participants meet to execute their deals. It is more an informal arrangement among the banks and brokers operating in a financing centre purchasing and selling currencies, connected to each other by telecommunications 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. The 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.

The central banks monitor market movements and sentiments and intervene according to government policy. The function of buying and selling of foreign currencies in India is performed by authorized dealers / moneychangers appointed by the RBI. The foreign exchange department of the major banks are linked across the world on a 24-hour basis.

Major commercial centres are London, Amsterdam, Frankfurt, Milan, Paris, New York, Toronto, Bahrain, Tokyo, Hong Kong and Singapore.

Functions of a Foreign Exchange Market

• Purchasing power is transferred across different countries which will enhance the feasibility of international trade and overseas investments.
• The foreign exchange market acts as a central focal point wherein prices of various currencies are discovered.
• Enables the investors to hedge or minimize their risks.
• Enables the traders to arbitrage any inequalities.
• Provides an investment / trading avenue to entities who are willing to expose themselves to this risk.

Foreign Currency and Foreign Exchange

In the context of India, any currency other than Indian rupees is foreign currency. Foreign exchange includes currency, drafts, bills, letters of credits and traveler cheques which are denominated and ultimately payable in foreign currency.

Determinants of Exchange Rate:

Numerous factors determine exchange rates. Many of these factors are related to the trading relationship between the two countries. Exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries.

• Purchasing Power Parity (PPP) (Inflation) Theorem: Difference in inflation rates between two countries is considered as the most important factor for variations in exchange rates. If domestic inflation is high, it means domestic goods are costlier than foreign goods. This results in higher imports creating more demand for foreign currency, making it costlier. (In other words the value of domestic currency will decline). If a basket of goods cost Rs470 in India and $10 in US then it is quite natural that the exchange rate should be Rs47/$1. PPP theory can be expressed by the formula:

PPPr = Spot rate (1+rh) / (1+rf)

where rh is inflation rate at home; rf is the inflation rate of foreign country.

Weakness of PPP Theory: It is not only inflation, which affects foreign currency movements. PPP ignores substitution effects – i.e. instead of importing goods might be substituted.

• Interest Rate Parity Theorem: This is the second most important factor in determining exchange rates after PPP theory. Money tends to move towards a country offering a higher interest rate thereby resulting in more demand for the foreign country’s currency. If interest rates in Japan are lower than interest rates in US then Japanese investors would prefer to invest in US which would result in more demand for US $ in Japan (this will cause US$ to appreciate in Japan). Interest rates provide the basis for computing forward rates as under:

Forward rate = Spot rate × (1+If) / (1+Ih)

• Balance of Payments (BOP) Position: The BOP position has a big impact on the value of a nation’s currency. A big or consistent deficit would mount a pressure on the currency of a nation as deficits require payments in foreign currency. In the case of a fixed currency rate scenario – the local currency would be devalued thereby making imports costlier and exports cheaper. However in the free rate scenario a big or consistent deficit would be a forewarning for depreciation of a nation’s currency.
• Government Intervention: At times the government would intervene by purchasing or selling foreign exchange to control pressures on the nation’s currency.
• Market Expectation: Market expectation as regards interest rates, inflation, taxes, BOP positions etc. would affect the foreign exchange rates. Overseas investment: E.g. if US investments in India increase there would be dollar inflows putting downward pressure on dollar in India.
• Speculation: Speculators, including treasury managers of banks, by virtue of their buying and selling, tend to influence the exchange rates.

Participants in Foreign Exchange Market

Foreign exchange market (Forex market) witnesses a lot of market participants. However, all of these participants have different motives. An understanding of these motives is required to predict their behavior in the markets. Also, some of these participants have deeper pockets, better information and are more active than the others. Therefore, here we discuss the different kinds of participants that they are likely to come across when they trade in this market. The participants have been listed in descending order. This means that dealers are the most active traders in the Forex markets, followed by brokers and so on. It would also be fair to say that dealers have the maximum information about the market, followed by brokers and so on.

Forex Dealers:

• Forex dealers are one amongst the biggest participants in the Forex market. They are also known as broker dealers. Most Forex dealers in the world are banks. It is for this reason that the market in which dealers interact with one another is also known as the interbank market. However, there are some notable non-bank financial institutions also that deal in foreign exchange.
• These dealers participate in the Forex markets by providing bid-ask quotes for currency pairs at all times. All brokers do not participate in all currency pairs. Rather, they may specialize in a specific currency pair. Alternatively, a lot of dealers also use their own capital to conduct proprietary trading operations. When both these operations are combined, Forex dealers have a significant participation in the Forex market.

Brokers:

• The Forex market is largely devoid of brokers. This is because a person need not deal with brokers necessarily. If they have sufficient knowledge, they can directly call the dealer and obtain a favorable rate. However, there are brokers in the Forex market. These brokers exist because they add value to their clients by helping them obtain the best quote. For instance, they may help their clients obtain the lowest buying price or the highest selling price by making available quotes from several dealers.
• Another major reason for using brokers is creating anonymity while trading. Many big investors and even Forex dealers use the services of brokers who act as henchmen for the trading operations of these big players.

Hedgers:

• Hedgers are primary participants in the futures markets. A hedger is any individual or firm that buys or sells the actual physical commodity. Many hedgers are producers, wholesalers, retailers or manufacturers and they are affected by changes in commodity prices, exchange rates, and interest rates.
• A forex trader can create a hedge to fully protect an existing position from an undesirable move in the currency pair by holding both a short position and a long position simultaneously on the same currency pair.

Speculators:

• Speculators are a class of traders that have no genuine requirement for foreign currency. They only buy and sell these currencies with the hope of making a profit from it. The number of speculators increases a lot when the market sentiment is high and everyone seems to be making money in the Forex markets.
• Speculators usually do not maintain open positions in any currency for a very long time. Their positions are transient and are only meant to make a short-term profit.

Arbitrageurs:

• Arbitrageurs are traders that take advantage of the price discrepancy in different markets to make a profit. Arbitrageurs serve an important function in the foreign exchange market. It is their operations that ensure that a market as large, as decentralized and as diffused as the Forex market functions efficiently and provides uniform price quotations all over the world.
• Whenever arbitrageurs find a price discrepancy in the market, they start buying in one place and selling in another till the discrepancy disappears.

Central Banks:

• Central Banks of all countries participate in the Forex market to some extent. Most of the times, this participation is official. Although many times Central Banks do participate in the market by covert means.
• This is because every Central Bank has a target range within which they would like to see their currency fluctuate. If the currency falls out of the given range, Central Banks conduct open market operations to bring it back in range. Also, whenever the currency of a given nation is under speculative attack, Central Banks participate extensively in the market to defend their currency.

Retail Market Participants:

• Retail market participants include tourists, students and patients who are travelling abroad. Then there are also a variety of small businesses that indulge in foreign trade.
• Most of the retail participants participate in the spot market whereas people with long-term interests operate in the futures market. This is because these participants only buy/sell currency when they have a personal/professional requirement and dealing with foreign currencies is not a part of their regular business.