Foreign Exchange Market and Arbitrage | UGC NET Economics – Notes

Introduction

• A market is the place where assets are sold and bought. Assets may be in form of a product, a commodity or even a currency. Thus, we may come across a grain market, a cloth market, a furniture market and so on. A foreign exchange market is the one where one currency (foreign currency) is bought and sold against another currency (domestic or home currency). The genesis of foreign currency market is traced to the need for foreign currencies to facilitate international trade, foreign investment and borrowing from or/lending to foreigners. We all know that most of the sovereign nations have their own currency. For example, India’s currency is called rupee while that of USA is called dollar and that of Japan is yen and so on. So, for India, all currencies are foreign currencies, except rupee.

• Every country needs to deal with several foreign countries for trading, investment and other business activities. In fact, this trend is becoming more and more visible with globalisation gaining momentum. Now, in order to be able to pay for imports or receive payments for exports, companies/individuals residing in one country have to acquire or dispose off the currency of another country.

• Foreign exchange markets provide the facility of exchanging different currencies. The price of one currency in terms of another is known as the exchange rate. Exchange dealers do the job of the exchange of currencies. The demand and supply in the foreign exchange markets permits the establishment of the rate of one currency in terms of another. The transaction in the foreign exchange market can be either to exchange cash or to buy/sell some other instruments. The major instruments are:

  • Currency forward

  • Currency futures

  • Currency options

  • Currency swaps

• The market for foreign exchange is the largest financial market in the world. It is open somewhere or the other in the world all the time such that it is said to be a 24 hours-a-day and 356 days-a-year market. The worldwide trading is more than a colossal amount of US $1.5 trillion per day. While London is the world’s largest foreign exchange trading centre, New York is the largest trading centre in the USA. Other trading centres in the world where trading volumes are significant are Tokyo, Singapore, Frankfurt, Paris, Hongkong and Zurich etc.

• In broad sense, the foreign exchange market enables the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options, futures and swaps.

• Spot transactions refer to the transactions involving sale and purchase of currencies for immediate delivery.

• Currency forward contracts are settled on a future date even though the forward rates are quoted at present moment (or today). They are quoted just like spot rate but actual delivery of currencies takes place much later.

• Currency futures are conceptually similar to currency forward. Yet, they are distinctly different from the latter in terms of their quotations and dealing.

• Currency options are the instruments that give choice to their holder to buy or sell a foreign currency on or up to a date (also called maturity date) at a specified exchange rate (also called strike rate).

• Swaps are the instruments that enable two parties to exchange the stream of cashflows in two different currencies.

• The foreign exchange market is the market in which national currencies are bought and sold against one another, and it constitutes the largest and most liquid financial market in the world. It is not a single physical location but a global network of banks, central banks, foreign exchange dealers, brokers, corporations, and individuals linked electronically across major financial centres such as London, New York, Tokyo, and Singapore, functioning virtually 24 hours a day as trading passes from one time zone to another.

• The foreign exchange market performs the essential function of facilitating the transfer of purchasing power across countries, providing credit for international trade, and offering hedging facilities against the risk of adverse exchange rate movements. Closely linked to the functioning of this market is the concept of arbitrage, the process by which market participants exploit price discrepancies across markets to earn riskless profit, and in doing so, drive exchange rates toward a state of equilibrium consistent with parity conditions.