Basics and Macro Aspects of Forex

Foreign exchange: ‘Foreign exchange’ as a noun refers to stock of foreign money an entity is having. It includes foreign currencies and foreign currency denominated assets held by an entity. Foreign exchange is the monetary claims that the national entities and individuals of a country have over the rest of the world. Foreign exchange is a vital instrument in the globalized economy. Foreign exchange as an action refers to the simultaneous transaction of one currency for another.

ISO Currency Codes for uniform identification: In a global trade when coded are used for different currencies, standardization is needed in codes. ISO released Currency Codes and some codes and the currencies are: USD =

US Dollar, EUR = Euro, JPY = Japanese Yen, GBP = British Pound, CHF = Swiss Franc, CAD = Canadian Dollar, AUD =Australian Dollar, NZD = New Zealand Dollar, INR =Indian Rupee and so on. Besides,

Certain Currency Pairs have been coded as follows: EUR/USD = “Euro”; USD/JPY = “Dollar Yen”; GBP/USD

= “Cable” or “Sterling”; USD/CHF = “Swissy”; USD/CAD = “Dollar Canada” ; AUD/USD = “Aussie Dollar”;

and NZD/USD = “Kiwi”.

Exchange Rate: Exchange Rate is the value of one currency expressed in terms of another. The exchange rate (a.k.a the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 39 Indian rupees (INR) to the United States dollar (USD) means that a sum of Rs 39 is worth the same as USD 1.

Dynamics of FX rates: Forex rates dynamically change, round the day, round the week, round the year. It is the market without holidays. As forex rates change, the value of transactions change resulting in changes in expected/realized revenues or gains, expenses or losses, assets and liabilities and net worth.

Exchange rate fluctuation lead to Brickbats and Bouquets: The textile exporters, especially the Tirupur garment exporters were seriously affected as the Rupee started gaining against the greenback ( that is the US Dollar) and that Government had to come to their rescue with some fiscal relief packages. Indian IT companies and other exporters in the country also have this problem, but they were not that much affected to make a big cry. But Indian importers are pretty happy as US Dollar is cheaper and that the imports are cheaper. That is what forex rate movement can do, brickbat one group and bouquet the other. When does it hit? When does it help? Whom does it hit? Whom does it help? These are not precisely predictable. Hence are the need for deep analysis and timely action/reaction as signs and signals. So, international business community is wedded to studying the mechanics of forex rate determination, the trend in the rates, ways of protecting against risks, ways of making a profit benefitting from rate changes, and so on. The efforts are always at avoiding Brickbats and seizing Bouquets.

1.8.1.1 Forex Market-the Biggest & the OTC Type

Forex market is by far the largest market in the world, in terms of traded value. It includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. Foreign exchange market is an Over-the-counter (OTC) market where brokers/dealers negotiate directly with one another. There is no central exchange or clearing house. Banks throughout the world participate. As the Asian trading session ends, the European session begins, then the US session, and then the Asian begin in their turns. Traders can react to news when it breaks, rather than waiting for the market to open.

The average daily trade happening in the forex markets across the globe exceeded US$1.9 in 2004. The 2007 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity survey by the Bank for International Settlements shows an unprecedented rise in activity in traditional foreign exchange markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an increase of 71% at current exchange rates and 65% at constant exchange rates. This increase was much stronger than the one observed between 2001 and 2004. Table 1 11 gives the global forex market daily average turnover.

Table 1. 11 Global Forex Market Daily Averages Turnover - in April, in USD billions

Major World Forex Market Centres and Top Traders: The biggest geographic trading centre is the UK, primarily London. The UK extended its leading share of global foreign exchange trading to 34% in April 2007 from 31% in April 2004 according to the new edition of IFSL’s Foreign Exchange report. Twice as many dollars are traded on the foreign exchange market in the UK than in the US, and more than twice as many Euros are traded in the UK than in all the euro-area countries combined. Foreign owned institutions accounted for around 70% of foreign exchange trading in London in April 2007. Other large centres, New York, Tokyo, Germany, and Singapore, saw a decline in their shares during this period, the US from 19.2% to 16.6%, Tokyo from 8.3% to 6.0% and Germany from 4.9% to 2.5%. Table 1.12 gives the Top 10 forex dealers as of May 2006.

Table 1.12: Top 10 Currency Traders% of overall volume, May 2006

Sources: Wikipedia.

1.8.1.2 Types of Foreign Exchange Market

Forex market has several forms, sizes and so on. Table 1.13 gives an account of the types.

Table 1.13 Types of Foreign Exchange Market

i Inter-bank market: Dealings between banks who are authorized dealers in foreign exchange Used to be large in size. About 700 banks worldwide act as market makers in Foreign exchange. Non-bank dealers account for about 20% of the market. International commercial banks communicate with one another instantly and securely with: (a) SWIFT: Society for Worldwide Interbank Financial Telecommunications. (b) CHIPS: Clearing House Inter-bank Payments System (c) ECHO: Exchange Clearing House Limited, the first global clearinghouse for settling inter-bank FOREX transactions.

ii Merchant deals market: Dealings between authorized dealers and others business entities. This is generally retail market or client market, as it is alternatively called.

iii Wholesale market: Large scale foreign exchange dealings especially interbank deals and some deals involving large corporations.

iv Retail market: Small foreign exchange deals involving less than, say $10000.

v Over the counter market: In over the counter the dealers or parties directly settle accounts. No clearing house is involved.

vi Exchange market: Foreign exchange dealings are done in an exchange and settlements are through the clearing house of the exchange.

vii Transaction market: Foreign exchange deals representing trade or financial transactions.

viii Hedging market: Foreign exchange deals that are done to cover risk of exposure in currencies

ix Speculation: Open deals that involve taking position in the exchange to make profit when expected price movement materializes.

x Spot Market: Spot market is market for delivery normally two days after the deal. Suppose on 2-1-2008 you buy $100,000 in the spot market. It is to be delivered on 4-1-2008. If 4-1-2008 happens to be a banking holiday, you will get delivery the nextday, which is 5-1-2008. You don’t prefer this. Then you should book the contract on ‘tom’ basis on 2-1-2008 so that you can take delivery on 3-1-2008 itself.

xi Forward Market: Forward market is a market for future delivery, but rate or price is predetermined.

Forward market is used by importers to buy forward forex needed in future and by exporters to sell forward the forex receivable in future. Speculators use forward market to speculate. If speculators expect a particular currency to depreciate they will sell forward that currency. If their expectation is appreciation of a currency, they will buy forward the currency.

Delivery date Determination: Suppose on 5-1-2008 you buy $100,000 two months forward. What is the delivery date? The delivery date is fixed adding two calendar months to delivery date of a spot deal booked on the same date, that is 5-1-2008. The spot delivery date is 7-1-2008. Adding 2 calendar months to this, the forward delivery date is 7-3-2008. If 7-3-2008 happens to be holiday, the next day happens to be the delivery date.

Apart plain forward buying and forward selling contracts, there are option forward contracts and rollover forward contracts. In option forward contracts, the client has time option to spread the exercise of his contract over a certain period. Roll over forward contracts involve rolling over of the forward contracts again and again for further periods.

xii. Arbitrage Market: Simultaneous buying (or selling) in one market and selling (or buying) of the same in another market to profit out of price differences is arbitrage. Arbitrage is done without investment and a risk-less profit is booked. There are single point, multipoint, covered and uncovered arbitrages.

Single point arbitrage: Suppose the bid-ask rates given by two banks are as follows:

There is arbitrage opportunity here. Buy $ from Bank B at £ 0.7082 and sell the same at £ 0.7086 and make a risk-less profit (£ 0.7086 - £ 0.7082) of £ 0. 0004 per $. This is single point arbitrage, as mere buying and selling of the same currency is involved.

Multi-point arbitrage: A chain of buying and selling of different currencies at different markets in order to make a profit is called multi-point arbitrage.

xiii. Options Market: An Options contract involves one person known as option writer or option seller giving another called option buyer or option holder the right to buy (in call option), or right to sell (in put option) or right to buy or sell (in call and put option) an underlying asset at a specified price per unit called the strike or exercise price for delivery on or before a certain day (in the case of American option) or on a certain day (in the case of European option), for an upfront commission or option premium or option price. The determination of option price or commission or premium is the main task of the options market. Several variables are involved here. A theorem given by Black-Sholes on Option Pricing got the Noble Prize in the 1990s. The Chicago Board of Options Trade (CBOT) is a premier institution in options dealings.

xiv. Futures Market: Futures contract is similar to forwards, but is exchange done and standardized in most aspects. Famous foreign exchange futures markets are: the London International Financial Futures Exchange (LIFFE), Tokyo International Financial Futures Exchange (TIFFE), Singapore International Financial Futures Exchange (SIFFE), etc. Futures market can be used for hedging as well as speculation. Open position speculation and spread strategy speculation are available. Under spread speculation inter-commodity and intra-commodity Speculation strategies exist. Spread speculation limits loss and of course profits too. Open position is riskier and hence may reward smartly.

xv. Swaps Market: Swap deals involve temporary exchange, with agreement to reverse back to original situation. Temporary exchanges could be, like: (i) Buying in the spot and selling in the forward market, (ii) Exchanging a fixed return asset for a floating return asset and so on.. There are assets swaps, liabilities swap, currency swaps, interest rate swap, etc.