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What are the Functions of the Foreign Exchange Market?

The foreign exchange market is merely a part of the money market in the financial centers is a place where foreign moneys are bought and sold. The buyers and sellers of claims on forex money and the intermediaries together constitute a foreign exchange market. It is not restricted to any given country or a geographical area. Thus, the foreign exchange market is the market for a national currency (foreign money) anywhere in the world, as the financial centers of the world are united in a single market. There is a wide variety of dealers in the foreign exchange market. The most important amongst them are the banks. Banks dealing in foreign exchange have branches with substantial balances in different countries. Through their branches and correspondents the services of such banks, usually called 'Exchange Banks', are available all over the world. These banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic transfers and other credit instruments, and discount and collect amounts for such documents. Other dealers in foreign exchange are bill brokers who help sellers and buyers in foreign bills to come together. They are intermediaries and unlike banks are not direct dealers. Acceptance houses are another class of dealers in foreign exchange. They help foreign remittances by accepting bills on behalf of customers. The central bank and treasury of a country are also dealers in foreign exchange. Both may intervene in the market occasionally. Today, however, those authorities manage exchange rates and implement exchange controls in various ways. In India, however, where there is a strict exchange control system, there is no foreign exchange market as such.

Functions of the Foreign Exchange Market:


The foreign exchange market performs the following important functions: (i) to effect transfer of purchasing power between countries- transfer function; (ii) to provide credit for foreign trade - credit function; and (iii) to furnish facilities for hedging foreign exchange risks - hedging function.

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Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is effected through a variety of credit instruments, such as telegraphic transfers, bank drafts and foreign bills. In performing the transfer function, the foreign exchange market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings.

Credit Function:
Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required.

Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange risks. In a free exchange market when exchange rates, i.e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money. Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate. The existence of a forward market thus makes it possible to hedge an exchange position.

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What are the Two Main Types of Foreign Exchange Market?


There are two foreign exchange markets: (a) the retail market and (b) the interbank market.

1. Retail Market:
In the retail foreign exchange market, the individual and firms who require foreign currency can buy it and those who have acquired foreign currency can sell it. The commercial banks dealing in foreign exchange serve their customers by purchasing foreign exchange from some and selling foreign exchange to other. Thus, each bank acts as a clearing house where purchases of exchange can be offset by sales of foreign exchange.

2. Interbank Market:
Interbank foreign exchange market serves to smoothen the excessive purchases or sales made by individual banks. At times, the quantity of foreign exchange supplied exceeds the quantity demanded, or vice versa. When such an imbalance occurs, the exchange rate changes. If the foreign exchange is in excess supply, the exchange rate falls; if the foreign exchange is in excess demand, the exchange rate rises, the movement in the exchange rate helps to correct the situation by encouraging or discouraging additional buyers and sellers into or from the market

What are spot and forward markets in foreign exchange?


Foreign Exchange markets can be studied keeping into view the period for which transac-tions are carried out. If the transaction or operation is of daily nature, it is called current market or spot market. On the other hand, if operation relates to future transaction it is called forward market. In a forward market delivery takes place in future.

1. Spot Market:
In a spot market rate of foreign exchange is known as spot rate of foreign exchange. This rate is useful for current transactions. For understanding the mechanism of spot-rate determination, we should know the strength of the domestic currency with respect to all the countries with which country has trade relations.

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Number of rates can be there depending upon the fact as to whether strength of home currency has been estimated on constant prices or current prices. Current prices take into view changes in prices. Different rates are given below; (i) NEER: Nominal Effective Exchange Rate is the measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of price change. If effect of price changes is eliminated from NEER, it is called EER (Effective Exchange Rate). (ii) REER: Real Effective Exchange Rate is an effective exchange rate based on real exchange rates instead of nominal rates. (iii) RER: Real Exchange Rate is the exchange rate which is based on constant prices. This rate excludes the effect of price changes.

2. Forward Market:
In a forward market for foreign exchange, transactions which take place at a future dates are covered. In a forward market there are parties which demand or supply a given currency at some future point of time. Forward transactions also known as future contacts take place due to two reasons. Firstly, to minimize risk of loss due to adverse change in exchange rate and secondly to make profit. First is called hedging and second is called speculation.

Write a short note on the meaning of Foreign Exchange


The term 'foreign exchange' is used in its narrow as well as broad senses: 1. Narrow Meaning": In the narrow sense, foreign exchange simply means the money of a foreign country. Thus, American dollars are foreign exchange to an Indian and Indian rupees arc foreign exchange to an American. In practice, foreign exchange is often used to refer to a country's actual stock of foreign currency, i.e., foreign currency notes or the means of obtaining such money through travelers cheques or letters of credit. 2. Broader Meaning: In the broader sense, the foreign exchange is related to the mechanism of foreign payments. It refers to the system whereby one currency is exchanged for or converted into another. Foreign exchange market is a market where foreign currencies are bought and sold by the traders' to meet their obligations abroad. According to Encyclopedia Britannica. "Foreign exchange is the system by which com-mercial nations discharge their debts to each other." In the words of Hartly Wethers, "Foreign exchange is the art and science of international monetary exchange."
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What are the Important Functions of Foreign Exchange Market?


The foreign exchange market performs the following important functions: 1. Transfer Function: The basic function of the foreign exchange market is to transfer purchasing power between countries, i.e., to facilitate the conversion of one currency into another. The transfer function is performed through the credit instruments like, foreign bills of exchange, bank draft and telephonic transfers. 2. Credit Function: Another function of foreign exchange market is to provide credit, both national and international, to promote foreign trade. Bills of exchange used in the international payments normally have a maturity period of three months. Thus, credit is required for that period to enable the importer to take possession of goods, sell them and obtain money to pay off the bill. 3. Hedging Function: In a situation of exchange risks, the foreign exchange market performs the hedging function. Hedging is the act of equating one's assets and liabilities in foreign currency to avoid the risk resulting from future changes in the value of foreign currency. In a free exchange market, when the value of foreign currency varies, there may be a gain or loss to the traders concerned. To avoid or reduce this exchange risk, the exchange market provides facilities for hedging anticipated actual claims or liabilities through forward contracts in exchange. Forward contract is a contract of buying or selling foreign currency at some fixed date in future at a price agreed upon now. Thus, without transferring any currency, the forward contract makes it possible to ignore the likely change in the exchange rate and avoid the possible losses from such change.

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What are the Important Dealers in the Foreign Exchange Market?


Important dealers in the foreign exchange market are banks, brokers acceptance houses, central bank and treasury authorities.

1. Banks:
The banks dealing in foreign exchange have branches (called exchange banks) in different countries and maintain substantial foreign currency balances in these branches to serve the needs of their customers. These branches discount and sell foreign bills of exchange, issue bank drafts, make telegraphic transfers etc. If a bank has excess foreign currency balances, it can sell these balances to other banks, foreign currency brokers, and sometimes to foreign monetary institutions. Similarly, if an exchange bank has deficit foreign currency balances, the other banks, the brokers and the foreign monetary institutions become the sources of foreign currency supply.

2. Brokers:
Banks do not deal directly with one another. They use the services of foreign exchange brokers. The brokers bring together the buyers and sellers of foreign exchange among banks. By using the brokers, the banks save time and effort. If a bank wants to buy or sell foreign exchange, it informs the broker the amount and the rate of exchange in which it is interested. If the broker succeeds in carrying out the transaction, he receives a commission from the selling bank.

3. Acceptance Houses:
Acceptance houses also deal in foreign exchange. They accept bills on behalf of their customers and thus help in foreign remittances.

4. Central Bank and Treasury:


The central bank and the Treasury of a country are also the dealers in foreign exchange. These institutions may intervene in the exchange market occasionally. They enter the market both as buyers and sellers to prevent excessive fluctuations in the exchange rates.

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What is Forward Exchange Market?


In the foreign exchange market, forward exchange market functions side by side with the spot exchange market. The transactions of spot exchange market are known as spot exchange and those of the forward exchange market are known as forward exchange. The rates at which the foreign exchange is bought and sold in the spot market are called spot rates and the rates at which the foreign exchange is bought and sold in the forward market are called forward rates. The spot exchange refers to the foreign exchange transactions which require immediate delivery or exchange of currencies on the spot. Normally, the settlement takes place within two days. A forward exchange involves a purchase or sale of foreign currency to be delivered at some future date. The rate at which the transaction is to take place is determined at the time of sale, but the payment is not made until the exchange is not delivered by the seller. The spot rate refers to the rate prevailing at a particular time for spot delivery of a specified type of foreign exchange.The forward exchange rate is the rate at which the future contract for foreign currency is made. With reference to its relationship with the spot rate, the forward rate may be at par, at a premium or at a discount. (i) When the exchange rate is quoted exactly equivalent to the spot rate at the time of making the contract, the forward exchange rate is said to be at par. (ii) The forward rate is said to be at a premium over the spot rate when it is quoted higher than the spot rate. Premium implies that the foreign currency is expensive. One dollar buys more units of other currency in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis. (iii) The forward rate is said to be at a discount with respect to the spot rate when it is quoted lower than the spot rate. Discount implies that the foreign currency is cheaper. One dollar buys less units of other currency in the forward than in the spot market. The discount is also expressed as a percentage deviation from the spot rate on a per annum basis. The forward exchange rate is mostly determined by the demand for and supply of forward exchange. When the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium.When the supply of forward exchange exceeds the demand for it, the forward rate will be quoted at a discount. When the supply and demand for forward exchange are equal, the forward rate will tend to be at par.
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FEMA: What are the basic objectives of FEMA?


FEMA stands for the Foreign Exchange Management Act. It is a soft, liberal and simplified law that aims at boosting foreign trade and investment more in tune with country's new economic environment of globalization of Indian economy. Its main objective is to facilitate external trade and payment and promote the orderly development and maintenance of foreign .exchange market in India. This act is expected to introduce more liberal provisions in keeping with the requirements of liberalized regimes. Main features of FEMA are: (a) Any person may sell or draw foreign exchange, without prior permission and can later on inform RBI. This makes it a more positive feature. (b) Under this act Enforcement Directorate (F, D) will be more investigating in nature. (c) FEMA recognized the possibility of even the Capital Account convertibility i.e. It classifies foreign exchange transaction and current account transactions. (d) The violation of FEMA is a civil offence. (e) Above all FEMA is more concerned with the management instead FERA (Foreign Exchange Regulation Act) was more concerned about exchange regulation or control.

FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA (FEDAI):


The FEDAI was set up in 1958 as an association of banks dealing in foreign exchange in India (called Authorized Dealers ADs). It is a self regulatory body and is incorporated under Section 25 of The Companies Act, 1956. The major activities include framing of rules governing the conduct of foreign exchange business between banks, transactions between banks and the public and liaison with RBI for reforms and development of the foreign exchange market. Presently their main functions are as follows:

operations. They also advise the RBI regarding licensing of new brokers.
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They provide a standardized dispute settlement process for all market participants. /Other Bodies and provide a common platform for ADs to interact with the Government and RBI. f daily and periodical rates to member banks. At the end of each calendar month they provide a schedule of forward rates to be used by ADs for revaluating foreign currency denominated assets and liabilities. each trading day to ensure uniformity in settlement between different market participants. their customers and by brokers for interbank transactions.

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What Exactly Is Forex?


With a daily trade volume of up to 4 trillion USD, forex is the largest financial market in the world. In comparison, the daily trade volume of the New York Stock Exchange is only USD 25 billion. There is an evident disparity in the trade volumes between forex and stock markets. Its actual trade volume is more than 3 times the total trade volume of the stock and futures market! What is traded in the Forex Market? The answer is simple, money. Forex trading is the buying of one currency and the selling of another simultaneously. Forex trades can be carried out through foreign exchange brokers or dealers. Trading of foreign currency is done in pairs, e.g. Euro against US Dollars (EUR/USD) or British Pounds against Japanese Yen (GBP/JPY). Buying and selling foreign currencies is like investing in a countrys stock. When you buy Japanese Yen, for example, you are actually acquiring a stake in Japanese economy. The pricing of the currency is a direct reflection of the immediate and future outcome of the Japanese economy. Foreign Exchange Rates and Quotation Methods 1. Concept of Foreign Exchange Rate We have an expert understanding of domestic trading. When you are in Germany and you buy rice from a shop, you will naturally pay in Euros, and of course, the shop will be willing to accept Euros. This trade can be conducted in Euros. Trading of goods within a country is relatively simple. However, things get complicated if you want to buy a US-made computer. You might have paid in Euros at the shop. However, through transactions in banks and financial institutions, the final payment will be made in US dollars and not Euros. Similarly, when Americans want to buy German products, they will have to eventually pay in Euros. From this example of international trading, we introduce the concept of foreign exchange rate. Foreign exchange rate is the value at which a countrys currency unit is exchanged for another countrys currency unit. For example, the current foreign exchange rate for Euros is: 100 EUR = USD 130. 2. World Currency Symbols USD : US Dollar HKD : Hong Kong Dollar EUR : Euro
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JPY : Japanese Yen GBP : British Pound CHF : Swiss Franc CAD : Canadian Dollar SGD : Singapore Dollar AUD : Australian Dollar RMB : Chinese Renminbi 3. Methods of Quoting Foreign Exchange Rates Currently, domestic banks will determine their exchange rates based on international financial markets. There are two common ways to quote exchange rates, direct and indirect quotation.

Direct quotation:
This is also known as price quotation. The exchange rate of the domestic currency is expressed as equivalent to a certain number of units of a foreign currency. It is usually expressed as the amount of domestic currency that can be exchanged for 1 unit or 100 units of a foreign currency. The more valuable the domestic currency, the smaller the amount of domestic currency needed to exchange for a foreign currency unit and this gives a lower exchange rate. When the domestic currency becomes less valuable, a greater amount is needed to exchange for a foreign currency unit and the exchange rate becomes higher. Under the direct quotation, the variation of the exchange rates are inversely related to the changes in the value of the domestic currency. When the value of the domestic currency rises, the exchange rates fall; and when the value of the domestic currency falls, the exchange rates rise. Most countries uses direct quotation. Most of the exchange rates in the market such as USD/JPY, USD/HKD and USD/RMD are also quoted using direct quotation.

Indirect quotation:
This is also known as the quantity quotation. The exchange rate of a foreign currency is expressed as equivalent to a certain number of units of the domestic currency. This is usually expressed as the amount of foreign currency needed to exchange for 1 unit or 100 units of domestic currency. The more valuable the domestic currency, the greater the amount of foreign currency it can exchange for and the lower the exchange rate. When the domestic currency becomes less valuable, it can exchange for a smaller amount of foreign currency and the exchange rate drops.
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Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in value of the domestic currency. When the value of the domestic currency rises, the exchange rates also rise; and when the value of the domestic currency falls, the exchange rates fall as well. Most Commonwealth countries such as the United Kingdom, Australia and New Zealand use indirect quotation. Exchange rates such as GBP/USD and AUD/USD are quoted indirectly. Direct Quotation Indirect Quotation USD/JPY = 134.56/61 EUR/USD = 0.8750/55 USD/HKD = 7.7940/50 GBP/USD = 1.4143/50 USD/CHF = 1.1580/90 AUD/USD = 0.5102/09 There are two implications for the above quotations: (1) Currency A/Currency B means the units of Currency B needed to exchange for 1 unit of Currency A. (2) Value A/Value B refers to the quoted buy price and sell price. Since the difference between the buy price and sell price is not large, only the last 2 digits of the sell price are shown. The two digits in front are the same as the buy price

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Characteristics of the Forex Market


24-Hour Market Other than the weekends when it is closed, the forex market is open 24 hours a day. There is no need to wait for the market to open and you can trade anytime you like. This flexibility has enabled many working professionals to take on forex trading as a side job. They can trade in the morning, afternoon, night or whenever they are free. The best thing is that this also means that no one can monopolize the market! The forex market is so huge that no single entity, be it an organization, a group, a central bank or even the government can control the market trend. Leverage In forex trading, only a small margin is needed to purchase a contract of a much higher value. Leverage enables you to earn high returns while minimizing capital risks. For example, a leverage of 200:1 granted by a forex broker would allow a trader to buy or sell USD 10,000 worth of currency with a margin of USD 50. Similarly, you would be able to trade USD 100,000 with just USD 500. However, leverage can be a double-edged sword. Without proper risk management, such high leverage trading may result in huge losses or profits. High liquidity In view of the huge trading volume in the forex market, under normal conditions, you can buy or sell currency at your desired price in a mere matter of seconds with just a simple click of the mouse. You can even setup an online trading platform to buy and sell (place order) at the right price so that you can control your profit margin and cut losses. The trading platform will execute everything for you automatically. It is fast and simple. Free! Free! Free! In addition to free simulation accounts, many trading platforms also provide news, charts and analyses free of charge. Market movements in a simulation account are the same as those in the actual forex market. Use a simulation account to build up your trading experience and confidence and find your way to success. What are the tools needed? You will only need a computer with Internet access. It is that simple! There is no need for you to spend thousands of dollars in training and courses that cannot guarantee you success. We believe that you can find your pathway to wealth creation by using the free resources available in our trade simulation system!

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Players in the Forex Market


In general, anyone who carries out a transaction in the forex market can be considered as a player. However, the key players in the forex market largely include the following groups: foreign exchange banks, government or central banks, forex brokers and clients. 1. Foreign Exchange Banks Foreign exchange banks are the primary players in the forex market. They specifically include professional foreign exchange banks and large commercial banks without foreign exchange departments that are designated by the central bank. 2. Central Bank The central bank is the governing body or regulator in the forex market. 3. Forex Brokers Forex brokers are the middleman between the clients and the central or foreign exchange banks. They have very close contacts with both the banks and the clients. 4. Clients In the forex market, any company or individual who participates in forex trading with a foreign exchange bank is considered a client of the bank.

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CHAPTER-18 - FOREIGN EXCHANGE MARKET


Q.1: Define Foreign Exchange and Explain the Functions of Foreign Exchange Market. Ans. A) FOREIGN EXCHANGE Foreign Exchange refers to foreign currencies possessed by a country for making payments to other countries. It may be defined as exchange of money or credit in one country for money or credit in another. It covers methods of payment, rules and regulations of payment and the institutions facilitating such payments. A. FOREIGN EXCHANGE MARKET

A foreign exchange market refers to buying foreign currencies with domestic currencies and selling foreign currencies for domestic currencies. Thus it is a market in which the claims to foreign moneys are bought and sold for domestic currency. Exporters sell foreign currencies for domestic currencies and importers buy foreign currencies with domestic currencies. According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid claim on foreign money". Foreign Exchange transactions result in inflow & outflow of foreign exchange. B. FUNCTIONS OF FOREIGN EXCHANGE MARKET

Foreign exchange is also referred to as forex market. Participants are importers, exporters, tourists and investors, traders and speculators, commercial banks, brokers and central banks. Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the important foreign exchange instruments used in foreign exchange market to carry out its functions. The Foreign Exchange Market performs the following functions.

1. Transfer of Purchasing Power I Clearing Function


The basic function of the foreign exchange market is to facilitate the conversion of one currency into another i.e. payment between exporters and importers. For eg. Indian rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills. Telegraphic transfer is the quickest method of transferring the purchasing power.
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2. Credit Function
The foreign exchange market also provides credit to both national and international, to promote foreign trade. It is necessary as sometimes, the international payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required. For eg. Mr. A can get his bill discounted with a foreign exchange bank in New York and this bank will transfer the bill to its correspondent in India for collection of money from Mr. B after the stipulated time.

3. Hedging Function
A third function of foreign exchange market is to hedge foreign exchange risks. By hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange rates. Under this function the foreign exchange market tries to protect the interest of the persons dealing in the market from any unforeseen changes in exchange rate. The exchange rates under free market can go up and down; this can either bring gains or losses to concerned parties. Hedging guards the interest of both exporters as well as importers, against any changes in exchange rate. Hedging can be done either by means of a spot exchange market or a forward exchange market involving a forward contract.

Q. 2 : Explain the dealers or participants in foreign exchange market.


A) PARTICIPANTS I DEALERS IN FOREIGN EXCHANGE MARKET Foreign exchange market needs dealers to facilitate foreign exchange transactions. Bulks of foreign exchange transaction are dealt by Commercial banks & financial institutions. RBI has also allowed private authorized dealers to deal with foreign exchange transactions i.e buying & selling foreign currency. The main participants in foreign exchange markets are 1. Retail Clients

Retail Clients deal through commercial banks and authorised agents. They comprise people, international investors, multinational corporations and others who need foreign exchange. 2. Commercial Banks

Commercial banks carry out buy and sell orders from their retail clients and of their own account. They deal with other commercial banks and also through foreign exchange brokers.
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3.

Foreign Exchange Brokers

Each foreign exchange market centre has some authorized brokers. Brokers act as intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers. 4. Central Banks

Under floating exchange rate central bank does not interfere in exchange market. Since 1973, most of the central banks intervened to buy and sell their currencies to influence the rate at which currencies are traded. From the above sources demand and supply generate which in turn helps to determine the foreign exchange rate. B. TYPES OF FOREIGN EXCHANGE MARKET Foreign Exchange Market is of two types retail and wholesale market. 1. Retail Market : The retail market is a secondary price maker. Here travelers, tourists and people who are in need of foreign exchange for permitted small transactions, exchange one currency for another. 2. Wholesale Market : The wholesale market is also called interbank market. The size of transactions in this market is very large. Dealers are highly professionals and are primary price makers. The main participants are Commercial banks, Business corporations and Central banks. Multinational banks are mainly responsible for determining exchange rate. 3. Other Participants

a) Brokers : Brokers have more information and better knowledge of market. They provide information to banks about the prices at which there are buyers and sellers of a pair of currencies. They act as middlemen between the price makers. b) Price Takers : Price takers are those who buy foreign exchange which they require and sell what they earn at the price determined by primary price makers. c) Indian Foreign Exchange Market It is made up of three tiers i. ii. iii. Here dealings take place between RBI and Authorised dealers (ADs) (mainly commercial banks). Here dealings take place between ADs Here ADs deal with their corporate customers.

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Q. 3 : Define I Explain I Write note on spot and forward exchange rates.


Ans. A) EXCHANGE RATE Transactions in exchange market are carried out at what are termed as exchange rates. In foreign exchange market two types of exchange rate operations take place. They are spot exchange rate and forward exchange rate.

1) Spot Exchange Rate :When foreign exchange is bought and sold for immediate delivery, it is called spot exchange. It refers to a day or two in which two currencies are involved. The basic principle of spot exchange rate is that it can be analysed like any other price with the help of demand and supply forces. The exchange rate of dollar is determined by intersection of demand for and supply of dollars in foreign exchange. The Remand for dollar is derived from countrys demand for imports which are paid in dollars and supply is derived from countrys exports which are sold in dollars. The exchange rate determined by market forces would change as these forces change in market. The primary price makers buy (Bid) or sell (ask) the currencies in the market and the rates continuously change in a free market depending on demand and supply. The primary dealer (bank) quotes two-way rates i.e., buy and sell rate. (Bid) Buy Rate 1 US $ = ` 45.50 (Ask) Sell Rate 1 US $ = ` 45.75 The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The difference of Rs.0.25 is the profit margin of dealer.

2) Forward Exchange Rate


Here foreign exchange is bought or sold for future delivery i.e., for the period of 30, 60 or 90 days: There are transactions for 180 and 360 days also. Thus, forward market deals in contract for future delivery. The price for such transactions is fixed at the time of contract, it is called a forward rate. Forward exchange rate differs from spot exchange rate as the former may either be at a premium or discount. If the forward rate is above the present spot rate, the foreign exchange rate is said to be at a premium. If the forward rate is below the present spot rate, the foreign exchange rate is said to be at a discount. Thus foreign exchange rate may be at forward premium or at forward discount. For Eg. an Indian importer may enter into an agreement to purchase US $ 10,000 sixty days from today at 1 US $ = Rs. 48. No amount is paid at the time of agreement,
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except for usual security margin money of about 10% of the total amount. 60 days form today, the importer will get 10,000 US $ in exchange for Rs. 4,80,000 irrespective of the Spot exchange rate prevailing on that date. a) Factors Influencing Forward Exchange Rate i) ii) iii) iv) v) vi) vii) b) Interest rates. Degree of speculation in foreign exchange market. Inflation rate. Foreign investors confidence in domestic country. Economic situation in the country. Political situation in the country. Balance of payments position etc.

Need For Forward Exchange Rate Contracts

To overcome the possible risk of loss due to fluctuations in exchange rate, exporters, importers and investors in other countries may enter in forward exchange rate contracts. In floating or flexible exchange rate system the possibility of wide fluctuation in exchange is more. Thus, both exporters and importers safeguard their position through a forward arrangement. By entering into such an arrangement both parties minimize their loss.

Q. 4 : Write note on Arbitrage. Write note on Interest rate and Arbitrage. Ans. A. ARBITRAGE

OR

Arbitrage is the act of simultaneously buying a currency in one market and selling it in another to make a profit by taking advantage of exchange rate differences in two markets. If the arbitrages are confined to two markets only it is said two-point arbitrage. If they extend to three or more markets they are known as three-point or multi-point arbitrage. Those who deal with arbitrage are called arbitrageurs. A Spot sale of a currency when combined with a forward repurchase in a single transaction is called Currency Swap". The Swap rate is the difference between spot and forward exchange rates in currency swap. Arbitrage opportunities may exist in a foreign exchange market.. Suppose the rate of exchange is 1 US $ = `. 50 in US market and 1 US $ = `. 55 in Indian Markets, then

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an arbitrageur can buy dollars in US market and sell it in Indian market and get a profit of `. 5 per dollar.. In todays modern well connected and advanced markets, arbitrageurs (which are mainly banks) can spot it quickly and exploit the opportunity. Such opportunities vanish over a period of time and equilibrium is again maintained. For Eg. Bank A Bank B ` / $ = 50.50 / 50.55 ` / $ = 50.40 / 50.45

The above rates are very close. The arbitrageur may take advantage and he can purchase $ 1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A at `. 50.50, thus making a profit of 0.05. The total profit would be (1,00,000 x 0.05) = `. 5,000. The profit is earned without any risk and blocking of capital.

What are the Major Types of Exchange Rates?


In the foreign exchange market, at a particular time, there exists, not one unique exchange rate, but a variety of rates, depending upon the credit instruments used in the transfer function. Major types of exchange rates are as follows: 1. Spot Rate: Spot rate of exchange is the rate at which foreign exchange is made available on the spot. It is also known as cable rate or telegraphic transfer rate because at this rate cable or telegraphic sale and purchase of foreign exchange can be arranged immediately. Spot rate is the day-to-day rate of exchange. The spot rate is quoted differently for buyers and sellers. For example, $ 1 = Rs 15.50 for buyers and $ 1 = Rs 15.30 for the seller. This difference is due to the transport charges, insurance charges, dealer's commission, etc. These costs are to be born by the buyers. 2. Forward Rate: Forward rate of exchange is the rate at which the future contract for foreign currency is made. The forward exchange rate is settled now but the actual sale and purchase of foreign exchange occurs in future. The forward rate is quoted at a premium or discount over the spot rate. 3. Long Rate: Long rate of exchange is the rate at which a bank purchases or sells foreign currency bills which are payable at a fixed future date. The basis of the long rate of exchange is the interest on the delayed payment.
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The long rate of exchange is calculated by adding premium to the spot rate of exchange in the case of credit purchase of foreign exchange and deducting premium from the spot rate in the case of credit sale. If the spot rate is 1 = $ 2.80 and the rate of interest is 6%, then on 30 days bill, $ 0.014 will be added per pound in case of credit purchase and deducted in case of credit sale of dollars. 4. Fixed Rate: Fixed or pegged exchange rate refers to the system in which the rate of exchange of a currency is fixed or pegged in terms of gold or another currency. 5. Flexible Rate: Flexible or floating exchange rate refers to the system in which the rate of exchange is determined by the forces of demand and supply in the foreign exchange market. It is free to fluctuate according to the changes in the demand and supply of foreign currency. 6. Multiple Rates: Multiple rates refer to a system in which a country adopts more than one rate of exchange for its currency. Different exchange rates are fixed for importers, exporters, and for different countries. 7. Two-Tier Rate System: Two-tier exchange rate system is a form of multiple exchange rate system in which a country maintains two rates, a higher rate for commercial transactions and a lower rate for capital transactions.

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Different types of Foreign Exchange Instruments:


Foreign Exchange Forwards
A forward foreign exchange contract is a deal to exchange currencies - to buy or sell a particular currency - at an agreed date in the future, at a rate, i.e. a price, agreed now. This rate is called the forward rate. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.

Currency Futures
A currency future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a future exchange rate. A futures contract is similar to a forward contract, with some exceptions. Futures contracts are traded on exchange markets, whereas forward contracts typically trade on over-the-counter markets (OTC). Also, futures contracts are settled daily on marked-to-market (M2M) basis, whereas forwards are settled only at expiration. Most contracts have physical delivery, so for those held till the last trading day, actual payments are made in respective currencies. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date. Investors enter into currency futures contract for hedging and speculation purpose.

Currency Swaps
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps A foreign currency swap is an "exchange of borrowings", where the principal and interest payments in one currency are exchanged for principal and interest payments in another currency. Mostly corporate with long-term foreign liability enters into currency swaps to get cheaper debt and to hedge against exchange rate fluctuations. The best example of swap transaction is paying fixed rupee interest and receiving floating foreign currency interest.

Currency Options
Unlike futures or forwards, which confer obligations on both parties, an option contract confers a right on one party and an obligation on the other. The seller of the option
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grants the buyer of the option the right to purchase from, or sell to, the seller a designated instrument (currency) at specified price within a specified period of time. If the option buyer exercises that right, the option seller is obligated. Investors can hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/INR rate is going to increase from 45.00 to 46.00, implies that it will become more expensive for an Indian investor to buy U.S dollars. In this case, the investor would buy a call option on USD/INR so that he or she could stand to gain from an increase in the exchange rate. The call option gives buyer of the option the right (but not the obligation) to buy currency on the expiration date.

Kinds of Foreign Exchange Market


The foreign exchange currency markets allow buying and selling of various currencies all over the world. Business houses and banks can purchase currency in another country in order to do business in that particular company. The forex market also known as FX market has a worldwide presence and a network of different currency traders who work around the clock to complete these forex transactions, and their work drives the exchange rate for currencies around the world. Since the foreign exchange currency market is one of the biggest markets of the world, the market is sub divided into different kinds of foreign exchange market. There are different features and characteristics associated with the different foreign exchange markets have different trading characteristics. The main three types of foreign exchange markets- the spot foreign exchange market, the forward foreign exchange market and the future foreign exchange market are discussed below. Youll get detailed information regarding different forex currency markets types below: Spot Market The spot kinds of foreign exchange market are those in which the commodity is bought or sold for an immediate delivery or delivery in the very near future. The trades in the spot markets are settled on the spot. The spot foreign currency market is among the most popular foreign currency instrument around the globe, contributing about 37 percent of the total activity happening in all other types of foreign exchange markets. Spot forex currency markets types are opposite to other kinds of foreign exchange market such as the future market, in which there is a set date is mentioned. The perfect example of most common kinds of trades of spot foreign exchange market is forex contracts. If these contracts are not settled immediately, the forex traders would expect to be compensated for the time value of their money for the duration of the delivery. The important point to note is that these contracts are settled electronically
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thus making forex markets essentially instantaneous. The spot forex currency markets types are considered to be highly paced markets and volatility and quick profits and losses are its important features. A spot deal in foreign exchange market comprises of a bilateral contract between two parties in which a party transfers a set amount of a particular given currency against the receipt of a specified amount of another currency from the counterparty, based on an agreed exchange rate, within two business days of the date when the deal gets finalized. However, there is an exception in case of Canadian dollar. In Canadian dollar, the Spot delivery happens the very next business day. The name spot does not mean that the currency exchange happens the same business day on which the deal is executed. Forex currency transactions which require delivery on the same day are called as cash transactions. It is interesting to know that the two day spot delivery has been in place since long before there were any technological breakthroughs in information processing facilitating the instantaneous transactions. This time period was required to check all the transactions details among the participating companies. Despite the technological breakthrough in forex trading markets, the contemporary mark ets dont find it necessary to reduce the time to make payments. Because human errors still happen and time is required to fix the errors, if any before the delivery. In case of wrong deliveries happen in a spot deal in foreign exchange market, the fine is imposed. The most traded currency in spot types of foreign exchange markets in terms of volume is US dollar. The reason being is that U.S. dollar is the currency of reference. The other major most common currencies traded in spot markets are the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Forward Market The forward Forex currency markets types comprise of two currency trading instruments- forward outright deals and swaps. The swap currency deal is different from the other kind of forex instruments in a way that it consists of two deals, while all other transactions consist of single deals. A swap is a combination of a spot deal and a forward outright deal. Generally, forward foreign exchange market deals in cash transactions only. This is the reason why the transactions of the forward types of foreign exchange markets are separately analyzed. Based on the data shared by the Bank for International Settlements, the percentage share of the forward kinds of foreign exchange market was 57% in the year 1998. The forward markets have no set terms with regard to the settlement dates and this range from 3 days to 3 years. The volume in currency swaps longer than one year tends to be light but, technically, there is no impediment to making these deals. Any date past the spot date and within the above range may be a forward settlement, provided that it is a valid business day for both currencies. The nature of forward types of foreign exchange markets is decentralized, with participants from all over the world entering into a different types of forex deals either
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on a one on one basis or through forex brokers. In contrast to this, the currency futures Foreign exchange market is a centralized one and where all the deals are executed on trading floors provided by different exchanges. Whereas in the futures market only a small number of foreign currencies are traded in multiples of standardized amounts. The forward types of foreign exchange markets are open to any currencies in any amount. Futures Market Future Forex currency markets types are specific types constitute the forward outright deals which in general take up small part of the foreign exchange currency trading market. Since future contracts are derivatives of spot price, they are also known as derivative instruments. They are specific with regard to the expiration date and the size of the trade amount. In general, the forward outright deals which get mature past the spot delivery date will mature on any valid date in the two countries whose currencies are being traded, standardized amounts of foreign currency futures mature only on the third Wednesday of March, June, September, and December. Future kinds of foreign exchange markets have many features, which attracts traders to future markets. The first thing is that any one can trade in future market. It is open to all kind of traders in foreign exchange market including individual traders. This is the difference between the future foreign exchange market and the spot foreign exchange market, since spot market is closed to individuals traders except in case there are deals of high net worth. The future forex currency market types are central markets, just as efficient as the cash market, and whereas the cash market is a much decentralized market, futures trading take place under one roof. The futures market provides various benefits for currency traders because futures are special types of forward outright contracts which corporate firms can use for hedging purposes. Although the futures and spot markets trade closely together, certain differences between the two occur, thus giving away the arbitraging opportunities. Gaps, volume, and open interest are important technical analysis tools solely available in the futures markets. Because of these benefits, currency futures trading regularly attract a large number of forex traders into this market. The traders who are outside the exchange can have the idea about the prices from on-line monitors. The most common pages regarding future markets are available with Reuters, Bridge, Telerate, and Bloomberg. The rates are presented on composite pages by the Telerate, while the currency futures are represented on individual pages showing the convergence between the futures and spot prices by Reuters and Bloomberg.

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The foreign exchange market, also known as the forex market has emerged as the world's largest market with trading of over $3 trillion in daily volume. It is the market where currencies are traded. It is not only the largest market in the world, but foreign currency market also the most liquid and volatile, thus making it clearly very distinct from the other markets. The trading in forex market is conducted over-the-counter as there is no central marketplace for the exchange of foreign money. This gives complete freedom to the traders to choose from a large number of different dealers and make trades only after comparing the prices. Larger a dealer, the better access they have to pricing at the largest banks in the world. All trades taking place in the foreign exchange market involve buying of one currency and the selling of another currency simultaneously. As the value of one currency is determined by its comparing it to another currency, it becomes very attractive for both the corporate and individual traders to make money on the Forex. The first currency of a currency pair is called the "base currency. Thee second currency is called the counter currency. The currency pair reflects how much of the counter currency is needed to purchase one unit of the base currency. Currency pairs are often thought of as a single unit that can be bought or sold. When purchasing a currency pair, the base currency is being bought, while the counter currency is being sold. The opposite is true, when the sale of a currency pair takes place. There are four most popular currency pairs that are traded most often in the foreign exchange market. These include the EUR/USD, USD/JPY, GBP/USD, and USD/CHF. The foreign currency market is open twenty-four hours a day, five days a week, with currencies being traded around the world in all of the major financial centers. The following features make this market different in compare to all other sectors of the world financial system: a) b) c) d) e) It is highly sensitive to a large and continuously changing number of factors All major currencies are accessible to all the traders Huge volume and liquidity of the market Round-the clock business hours Extremely high efficiency relative to other financial markets.

This purpose of this article is to introduce traders, whether newcomers or professionals to all the essential aspects of forex market, helping them exchange foreign money in a practical manner. It is a good idea to experiment with the foreign exchange market while learning your way around the trading platform using demo accounts. Deciding how much risk to take, deciding how long to stay in the trade, and when to exit the trade, they are a great way to gain practical information on foreign exchange market.

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Risks in Foreign Exchange Trading


Forex Currency trading is quite a lucrative option to gain huge profits but there are risks involved too, which a trader needs to understand well before jumping into forex trading. While trading in forex, investors come across various types of risks in foreign exchange trading. The four main types of risks involved in foreign exchange trading are defined below. Exchange Rate Risk Interest Rate Risk Credit Risk Country Risk Exchange Rate Risk: The exchange rate risks in forex trading arise due to the continuous ongoing supply and demand balance shift in the worldwide forex market. A position is a subject of all the price changes as long as it is outstanding. In order to cut short these exchange rate risks and to have profitable positions, the trading should be done within manageable limits. The common steps are the position limit and the loss limit. The limits are a function of the policy of the banks along with the skills of the traders and their specific areas of expertise. There are two types of position limits daylight and overnight. The daylight position limit establishes the maximum amount of a certain currency which a trader is allowed to carry at any single time during. The limit should reflect both the trader's level of trading skills and the amount at which a trader peaks. Whereas, the overnight position limit which should be smaller than daylight limits refers to any outstanding position kept overnight by traders. te position and loss limits can now be implemented more conveniently with the help of computerized systems which enable the treasurer and the chief trader to have continuous, instantaneous, and comprehensive access to accurate figures for all the positions and the profit and loss. Interest Rate Risk: The interest rate risks in foreign exchange trading are related to the currency swaps, futures, forward out rights and options in foreign currency exchange trading. The interest rate risks are those foreign exchange trading risks which refer to the profit and loss generated by both the fluctuations occurred in the forward spreads and by forward amount mismatches and maturity gaps among various transactions in the forex book. The mismatch amount is the difference between the spot and the forward amounts. On a daily basis, traders balance the net payments and receipts for each currency through a special type of swap, called tomorrow or rollover. Limits of the total size of mismatches are set up by the management to minimize interest rate risks in forex trading. However, different banks have different policies to cut back the losses. However, the most
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common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. Then all the transactions are put into computerized systems to calculate the positions for all the delivery dates and the profit and loss. There is a continuous analysis of the interest rate environment necessary to forecast any changes that may affect the outstanding gaps. Credit Risk: Other kinds of risks involved in foreign exchange trading are credit risks. These are associated with the probability that an outstanding currency position might not be repaid as agreed upon because of a voluntary or involuntary action by the other party. In such a case, the forex trading occurs on regulated exchanges, where all trades are settled by the learning house. In these types of forex exchanges, the investors of all sizes can deal without any credit concern. The following forms of credit risk are known. There are two types of credit risks in foreign exchange trading, the Replacement risk and the settlement risk. Country Risk: The country risks in forex trading are arise in case of there are a party is unable to receive an expected amount of payment because of the government interference in the matters of insolvency of an individual bank or institution. The country foreign exchange trading risks are linked to the interference of government in forex markets. It falls under the joint responsibility of the treasurer and the credit department. The government control on foreign exchange activities is still present and implemented actively. For the investors, it is important to know or how to be able to anticipate any restrictive changes concerning the free flow of currencies.

Factors behind the Volume Growth In Foreign Exchange


In recent times, the world has seen a tremendous growth in foreign exchange currency trading, especially after the different currencies were allowed to float freely against each other in the world market. The daily turnover rose from US $5 billion in 1977 to US $600 billion in 1987 and touched the $1,5 trillion mark by the end of year 2000. Let us study the main factors behind the growth in foreign exchange bellow. The volatile nature of currency trading is also one of the factors responsible for foreign exchange growth. In fact, it wont be inappropriate if we say that the volatility is a sine qua non condition for trading. The only instruments that may be profitable under conditions of low volatility are currency options. 1. Volatility in Interest Rate The growth in foreign exchange can be attributed to the internationalization of world economy. It has a great impact on the rates of interest rates as well. The world economy became greatly interrelated and that added fuel in the need to change interest rates
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faster. Interest rates are generally changed in order to adjust the growth in the economy, and interest rate differentials have a substantial impact on exchange rates. 2. Internationalization of Business In recent times, the competition in business world has increased by great folds thus resulting in tremendous growth in foreign exchange. There is a continuous search for newer markets and cheaper raw materials and labor. The expansion of business houses around the world are also the major factors behind the growth in foreign exchange The speed of economic internationalization increased even more during the 1990s, due to the fall of Communism in Europe and to up-and-down economic and financial development in both Southeast Asia and South America. These changes have been positive toward foreign exchange, since more transactional layers were added. 3. Increasing Corporate Interest The flourishing results of a product or service aboard may be pulled down from the profit point of view by adverse foreign exchange conditions and vice versa. Same way, a careful handling of the foreign exchange may enhance the overall international performance of a product or service. Proper handling of foreign exchange adds substantially to the rate of return. Therefore, interest in foreign exchange has increased in the past decade. Many corporations are using currencies not only for hedging, but also for capitalizing on opportunities that exist solely in the currency markets. 4. Developments in Technology/Telecommunications With the introduction of automated forex dealing systems in the 1980s, of matching systems in the early 1990s, and of Internet trading in the late 1990s completely altered the way foreign exchange was conducted. The dealing systems are online computer systems that link banks on a one-to-one basis, while matching systems are electronic brokers. They are reliable and much faster, allowing traders to conduct more simultaneous trades. They are also safer, as traders are able to see the deals that they execute. The dealing systems had a major role in expanding the foreign exchange business due to their reliability, speed, and safety. 5. Development of Computers and Internet The advent of computer and internet played an important role in the foreign exchange development. The major areas where the results are directly visible are the dealing systems; matching systems simultaneously connect all traders around the world, electronically duplicating the brokers' market. Moreover, the progress in the filed of telecommunications resulted in reliable and much faster trading over the world. The various technical systems allowed traders to conduct more simultaneous trades. They are also safer, as traders are able to see the deals that they execute. The dealing systems had a major role in expanding the foreign exchange business due to their reliability, speed, and safety. These days there are so many softwares available in the market
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which can handle the entire forex trading of a business man on its own with little or no human intervention. No doubts, the computers and internet are important foreign exchange growth factors. All the above listed are equally important Factors responsible for foreign exchange growth.

History of Foreign Exchange Market


The history of foreign exchange is long and can be traced back to the ancient Middle East and Middle Ages, which saw the currency exchange beginning take to take shape. Let us look at the foreign exchange in a historical perspective which is the main focus of this page. At a fairly early stage in the history of currency exchange, the value of goods was expressed in terms of other goods. The economy was based on barter system between individual participants of market. There were obvious limitations. There arose a need to set a common benchmark of value in different economies. Objects like teeth, feathers, pretty stones etc; served this purpose. But soon metals like gold and silver, established themselves as an accepted means of payment. Earlier times saw the minting of coins from the preferred metal. It was only during the Middle Ages that the paper form of governmental IOUs was introduced. One can say that this was a major landmark in the forex history. Most central banks supported their currencies with convertibility to gold before World War I. Paper money could always be exchanged for gold, but in reality this did not happen often. This gave arise to unwelcome notion that there was not necessarily a need for full cover in the central reserves of the government. Sometimes, the abundant supply of paper money without gold cover led to a very disturbing inflation, and often resulting political instability, as the foreign exchange market history reflects. There arose a need to prevent market forces from punishing monetary irresponsibility. History of Foreign Exchange saw the Bretton Woods agreement reached in the latter stages of World War II. U.S.A. took the initiative in July 1944. Other international institutions such as the IMF, the World Bank and GATT (General Agreement on Tariffs and Trade) took birth at the same time, searching for a way to avoid the destabilizing monetary crises which led to the war. The Bretton Woods agreement allowed the system of fixed exchange rates, thus reinstating the gold standard and fixing the US dollar at USD35/oz as well as the other main currencies to the dollar. This was intended to be permanent. In the sixties, forex history saw the national economies moving in different directions. The Bretton Woods system had to face growing pressure as national economies moved in different directions during the sixties. A number of realignments kept the system
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alive for a long time, but eventually Bretton Woods collapsed in the early seventies following president Nixon's suspension of the gold convertibility in August 1971. The dollar was no longer suitable as the sole international currency at a time when it was under severe pressure from increasing US budget and trade deficits. The following periods saw the foreign exchange market developing into the largest global market by far. As restrictions on capital flows were removed in most of the countries, it gave the market forces complete flexibility and freedom to adjust foreign exchange rates according to their perceived values. In 1979, as we course through the history of currency exchange, the European Monetary System was introduced by the EEC. The search for currency stability has continued in Europe till recently with the renewed attempt to not only fix currencies but actually replace many of them with the Euro in 2001. In the latter part of 1997, the lack of sustainability in fixed foreign exchange rates gained new relevance with the events in South East Asia. This period saw the devaluation of currency after currency against the US dollar. Other fixed exchange rates, in particular in South America, looked very vulnerable during these times. Today the size of foreign exchange markets overwhelms any other investment market by a large factor. Investors and financial institutions have found a new playground. It stands at more than USD 3,000 billion is traded every day.

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