CHAPT ER

5
LEARNING OBJECTINES
Forelgn Exchange
Market

therein. In
The present chapter deals with the foreign exchange market and the operations
particular, it:

Explains the distinctive characteristics of foreign exchange market.

Delineates who actually participates in the foreign exchange market.

transactions take place in spot and forward markets.

Describes how various types of

of currencies.
ne of the major international financial functions is the exchange
O Currencies are exchanged or, in other words, bought
and sold
in foreign

exchange market that is spread around the globe. The present chapter
deals with the various aspects of the foreign exchange market and with
thus
the varieties
of transactions taking place therein.

DISTINCTIVE FEATURES

The foreign exchange market is a market where foreign currencies are bought and
sold. If an Indian importer imports goods from the USA and has to make payments
in US dollars, it will approach the foreign exchange market to buy US dollars for
rupees. An exporter converts the export proceeds obtained in a foreign currency
into its own currency. These two are the simplest examples of transactions in the
foreign exchange market. There are many types of transactions that involve the
purchase and sale of different currencies.

105
 Financial
Management
over-the-counter
Kot. It doeH not don
market.
nternational

106 in fo
(emmun!
Calion markot
an
assemble
and transnct

foreivn
dealing in
exchange
The foreign where
dealers
agencies
change
floor
KS place or
desks at major telephone,
ex,
telex otc. This in why
particular
da consists of trading connected by communicatio
It may
( it are
written
y.
by global, th
Rather,
world that followed
ket is
is global, the mnar
the on oral market
throughout
based normally
the
although regulatory Iramework
framewe
are that the local
transactions

be
mentioned
by reguntory
however, influenced communicai on
are more on the
ange
Foreign exchange features in each country market
relies
USA, the European countrieu
,
market: In the UK o r the Paris and some other customary.
1. is over-the network; while
in Frankfurt, is als0
counter market, participants at bourses o v e r the globe, the
of spread all
round- physical meeting dealers are
upon the
2 operates
the-clock, Since foreign
exchange
one place
to another depending
3. involves normally differs from
transaction t r a n s a c t s at 10 A.M.,
it will iugt
time of dealer in India
transaction of place. Ifa dealers from diflerent
strong, stable and longitude of the order to
accommodate

London. In function round-the-clock

convertible be 4.30 A.M. in market has to
exchange markets are normally
currencies. countries, the foreign exchange
transacted in the foreign because of
Again, the
currencies
which are great demand in
convertible currencies
the strong, stable
and
4 valaclIe
Vvalaclye
Hh01
4. HIJhY1
and convertibility. atrd
their strength, stability 5. 3*ord Cy
. t Can te ghor
MAJOR PARTICIPANTS

market are individuals, firms, banks,

the foreigm exchange
The participants in international agencies.Individuals
are normally
the
governments, and occasionally currencies, as also migrants
sending a part
who exchange the
the tourists their home countries
Participants are family members living in
individuals, firms, of their income to their and exporters. An exporter prefers
banks, central The firms are generally the importers convertible currency.
or in a strong
banks and to get the payments in its own currency
international need foreign exchange for making payments for their imports
Importers local
the local branch of a bank, the
When firms and individuals approach
organisations.
Functionally, they in its regional
branch in turn approaches the foreign exchange department
are hedgers,
in foreign exchange with
arbitrageurs and office or head office. The latter deals actually
speculators other banks on behalf of the customers.
Thus there are two tiers in the foreign exchange market: one
tier_involves the
tier consists
transactions between ultimate customers and the banks while the other 1s
of the transactions between banks. Since the purpose of inter-bank transactions
not only to meet the foreign exchange demand of the ultimate customers
but also
to reap gains out of movement in foreign exchange rates, it is the second tier ot
the market that accounts for the largest segment of the total foreign exchange
transactions in the market. In some cases, the inter-bank dealings take place
directly without any help from an intermediary., but generally the banks operate
through foreign exchange brokers.
d i t d u w l s- M u i l Two tiet
u gr a n t S

E p o M L
Customiy -Banl H bonK7 Somefimud
ur,
, hranhe
po
15ank
ns- a bank

e.dpt oh
a li n f anbeho
V

ustom
th
 Chapter 5 Foreign Exchanze Market 107
Foreign Exchange Market
Ratio of Turnover in India
280 Inter-bank to
Marchant Turnover 4.0

240

200 3.5

160

3.0 3
120

80
2.5 E
40-

2.0

OMerchant Turnover O Inter-bank Turnover

Source: RBI, Annual Report, 2003-04.

It is either because of the length of transactions passing through two short position
tiers of the market or because of the profit motiseinvolved the transactions suppy
in
that there is often a gap between the amount of purchase and the amount currency
of a

for
ofsale of a currency by banks. knownIf a bank buys less of a currency than itdemand
Currenc
contracts to sell, the position is as a short position in that currency.
Long positon
more of a currency than it
The r e v e r s e situation, where a bank buys
in that currency. When the rren**
contracts to sell, is known as a long position
and
purchase is equal, the equality denotes a square demand for
quantum of sale currency
position.
banks dominate, the governments Square position
Though it is a fact that commercial in the supply of a
foreign exchange market
=

authorities to0 participate

or monetary currency
domestic currency. The market intervention demand for
but to help stabilise the value of
has been discussed in detail in Chapter
3.
by the monetary authorities purchase and sell foreign currencies in
currency
International agencies sometimes
but that is not a routine affair.
the foreign exchange market,
be grouped also according to their motive and
Again, the participants may transactions as follows:
behaviour in their foreign exchange
which simply exchange currencies to honour their
Non-banking entitis
the desired currency.
obligations or to get
such as traders that use the foreign exchange market
y ' Non-banking entities
y their foreign exchange exposure on account of.
for the purpose of hedging
rate.
changes in the exchange
on behalf of their customers. In such
Banks which exchange currencies
to the amount of spread between the bid and the
their profit is limited
cases,
ask rates.
 International Financial fanagrment
108
Arbitrageurs who change currencies because of varying rates of exch
different markets. The varying rates are the source of their profit angeiin
Saoculators who buy or sell currencies
when they
expect movement in tho
exchange rate in a particular direction. They make their e
profit from movema
of exchange rate in the desired direction. mmtdaG
ddia dpioment

tSPOT MARKET
Features n t
a

The foreign exchange market is classified either as

market. It is the timing of spot market or as forward
actual.delivery,
between spot market and forward market of
toreign exchange that distinguishes
are traded for immediate transactions. In the spot market, currencies
delfvery'at rate existing on the day of transaction. For
making book-keeping entries,
a

delivery takes two working days after the

Spot market omplete although in the case of Canadian dollar the transaction
transactions takes place the very next delivery of currencies
require immediate Saturday and working day. If a particular market is closed
delivery of the Sunday
of currency shall and if transaction takes place on on
traded currency.
In forward the alue date or
take place on
Monday. Monday in thisThursday, delivery
case is known
settlement date. Sometimes there are as
market, where the time zones permit the short-date contracts
currencies are If the
currency
is delivered the
delivery of the
currency even
delivered at a
day contract. same day, it is known as earlier.
future date. If it is done the the
value-next-day contract. next day, the contract is
known
value-same
a l u t
d a t
In view of the
as the
huge amounts involved in the
actual movement of
bank accounts of thecurrencies. Rather, debit andtransactions, there
credit entries
is seldom anay
dale
transfer of funds seller and the are made in the
electronically purchaser. Most of the markets
thus saving time
in New York is known
as the and effect the
Clearing House Inter-bankenergy. The system existing
Currency Arbitrage in Spot Market Payment System (CHIPS)
With fast
uniform development in the telecommunication
in different
at times.
The foreign exchange markets. system, rates'are èxpected to be
by buying and arbitrageurs take advantage of theNevertheless,
in selling of
market and sell itcurrencies.
one
They inconsistencyinconsistency
and
exists
at buy particular a garner profits
currency arbitrage. The higher rate in the other. currencyat cheaper
a

particular currency in the process

influences the demandThis process is knownrate
inconsistency in the two markets
value of for, and
which leads supply of, the
as

Suppose, currencies
markets.ultimately
in two to removal of
In New
York: $ 1.980 10/£; and
In London:
o^us
Rs2
The 1.9700 TOE
profitarbitrageurs will
of $ 1.9810- sell pound in New
In the 1.9700 $ 0.0110 York and buy
above example,
=

particular currency is pound inLondon

twoorcurrenciesperarepound sterling
There are' also bought involved making a
currencies and examples sold. This is why it is and two markets
of three-point
three markets known
arbitrage where the as
are
involved. or
two-point arbitrage.
triangular arbitrage where three
 Suppose, bid rate in:
hapter 5
Forrign Echange Murket
New York:
$ 1.9810/E,
London: DM 3.1G50/£, and
Frankfurt: $ 0.6250/DM
In this case, the
arbitrageur will
Frankfurt get DM 1,600. He will exchange the dollar, sny $ 1,000 for
to
to get £ 505.63. Finally, he convert DM 1,600 for DM in
pound sterling in London
$1,001.46. This means that hewillwould
sell £ 505.63 for
dollars in New York to
gain $ 1.46 per $ 1,000 get
arbitrage through triangular
The above example does
not, of course, include
transaction cost exists that lowers the amount of
transaction cost. In real worlda
0.5 per cent. When $ 1,000 is gain. Suppose, transaction cOst is
converted into DM in
receive DM 1,600 x (1 0.005) or DM
-
Frankfurt, the arbitrageur would
will be similarly lower at the other 1,592 and the receipt of the exchanged currency
two points. It
will take place only when the burden follows, therefore, that arbitragea
of transaction
the exchange. cost is lower than the gain trom/

PROBLEM 5.1
If the rate of exchange is:
US $ 2.0000-2.0100/£ in New York
US $ 1.9800-1.9810/£ in Londón
Explain how the arbitrageurs will gain.
Solution
The arbitrageur will sell Pound in New York and with the same dollar, buy Pound
in London. The profit per pound, assuming no transaction cost, will be:
$ 2.0100 1.9800 = 0.0300.
Note: It is the difference between the selling rate and the buying rates of Pound
in the two markets.

(Speculation in Spot Market

Speculation in the spot market occurs when the speculator anticipates a change in
the value of a currency. Suppose the exchange rate today is Rs. 40/US $. The
speculator anticipates this rate to become Rs. 41/US $ within the coming thre
months. Under these circumstances, he will buy US $ 1,000 for Rs. 40,000 and hol
this amount for three months, although he is not committed to this particular time
horizon. When the target exchange rate is reached, he will sell US $ 1,000 at the
new exchange rate, that is at Rs. 41 per dollar ánd earn a profit of Rs. 41,000
40,000 Rs. 1,000.)

PROBLEM 5.2
Presently, the spot rate is Rs. 44.50/US $., A speculator feels that, after a week,
US dollar should appreciate to Rs. 44.60. What should he do if he has Rs. 10,000
at his disposal?