FOREIGN EXCHANGE MARKET

Name: Anisha A. Walavalkar

Admin. No: 1332
Seat No.: 327-2013
Sub: International Financial Market

INTRODUCTION:
The market for foreign exchange is the largest financial market in the world by virtually any
standard. It is open somewhere in the world 365 days a year, 24 hours a day. The 2001 triennial
central bank survey compiled by the Bank for International Settlements (BIS) places worldwide
daily trading of spot and forward foreign exchange at $1.2 trillion dollars per day. This is
equivalent to nearly $200 in transactions for every person on earth. This, however, represents a
19 percent decrease over 1998. The decline is due to the introduction of the common euro
currency, which eliminates the need to trade one euro zone currency for another to conduct
business transactions, and to consolidation within the banking industry.
The market for foreign exchange involves the purchase and sale of national currencies. A foreign
exchange market exists because economies employ national currencies. If the world economy
used a single currency there would be no need for foreign exchange markets. In Europe 11
economies have chosen to trade their individual currencies for a common currency. But the euro
will still trade against other world currencies. For now, the foreign exchange market is a fact of
life.
The foreign exchange market is extremely active. It is primarily an over the counter market, the
exchanges trade futures and option (more below) but most transactions are OTC. It is difficult to
assess the actual size of the foreign exchange market because it is traded in many markets. For
the US the Fed has estimated turnover (in traditional products) in 1998 to be $351 billion per
day, after adjusting for double counting. This is a 43% increase over 1995, and about 60 times
the turnover in 1977.
During 2003-04 the average monthly turnover in the Indian foreign exchange market touched
about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion
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US dollars for all cash, derivatives and debt instruments put together in the country, and the sheer
size of the foreign exchange market becomes evident. Since then, the foreign exchange market
activity has more than doubled with the average monthly turnover reaching 359 billion USD in
2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of
the world, in India too, foreign exchange constitutes the largest financial market by far.
Liberalization has radically changed Indias foreign exchange.
Liberalization has radically changed Indias foreign exchange sector. Indeed the liberalization
process itself was sparked by a severe Balance of Payments and foreign exchange crisis. Since
1991, the rigid, four-decade old, fixed exchange rate system replete with severe import and
foreign exchange controls and a thriving black market is being replaced with a less regulated,
market driven arrangement. While the rupee is still far from being fully floating (many
studies indicate that the effective pegging is no less marked after the reforms than before), the
nature of intervention and range of independence tolerated have both undergone significant
changes. With an overabundance of foreign exchange reserves, imports are no longer viewed
with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in
the foreign exchange markets not always to support the rupee but often to avoid an appreciation
in its value. Full convertibility of the rupee is clearly visible in the horizon. The effects of these
development s are palpable in the explosive growth in the foreign exchange market in India.
Foreign Exchange Markets in India a brief background
The foreign exchange market in India started in earnest less than three decades ago when in 1978
the government allowed banks to trade foreign exchange with one another. Today over 70% of
the trading in foreign exchange continues to take place in the inter-bank market. The market
consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves

and come out square or without exposure at the end of the trading day. Trading is regulated by
the Foreign Exchange Dealers.
Association of India (FEDAI), a self regulatory association of dealers. Since 2001, clearing and
settlement functions in the foreign exchange market are largely carried out by the Clearing
Corporation of India Limited (CCIL) that handles transactions of approximately 3.5 billion US
dollars a day, about 80% of the total transactions. The liberalization process has significantly
boosted the foreign exchange market in the country by allowing both banks and corporations
greater flexibility in holding and trading foreign currencies. The Sodhani Committee set up in
1994 recommended greater freedom to participating banks, allowing them to fix their own
trading limits, interest rates on FCNR deposits and the use of derivative products. The growth of
the foreign exchange market in the last few years has been nothing less than momentous. In the
last 5 years, from 2000-01 to 2005-06, trading volume in the foreign exchange market (including
swaps, forwards and forward cancellations) has more than tripled, growing at a compounded
annual rate exceeding 25%. Figure 1 shows the growth of foreign exchange trading in India
between 1999 and 2006. The inter-bank forex trading volume has continued to account for the
dominant share (over 77%) of total trading over this period, though there is an unmistakable
downward trend in that proportion. (Part of this dominance, though, result s from doublecounting since purchase and sales are added separately, and a single inter-bank transaction leads
to a purchase as well as a sales entry.) This is in keeping with global patterns.
SPOT MARKET:
The spot market involves almost the immediate purchase or sale of foreign exchange. Typically,
cash settlement is made two business days (excluding holidays of either the buyer or the seller)
after the transaction for trades between the U.S. dollar and a nonNorth American currency. For

regular spot trades between the U.S. dollar and the Mexican peso or the Canadian dollar,
settlement takes only one business day.1 According to BIS statistics, spot foreign exchange
trading accounted for 33 percent of FX trades in 2001.
The exchange rate is simply the price of foreign currency in terms of domestic currency. The
typical fashion is to quote the foreign currency price of the dollar; hence, the yen has been
trading at approximately Y111.925 to the dollar on September 23, 2003.5 Similarly, the Brazilian
real now trades at approximately 2.898 to the dollar, compared to the 1.2 before the exchange
crisis. Of course, it is arbitrary how we quote the exchange rate; it is equivalent to say that it
takes .87Euro to the dollar or that a Euro is worth 1.147 dollars. To avoid confusion we will
follow the convention that the exchange rate is the price of foreign exchange in terms of
domestic currency
The number of dollars per Euro, because for the US the Euro is foreign exchange. Often, we will
simply treat the rest of the world as one country, and hence we will simply refer to foreign
exchange rather than specify the specific country. In that case the exchange rate, e, is just the
domestic currency price of foreign exchange:

e=

domestic currency
foreign exchange

Intervention in Foreign Exchange Markets

The two main functions of the foreign exchange market are to determine the price of the different
currencies in terms of one another and to transfer currency risk from more risk-averse
participants to those more willing to bear it. As in any market essentially the demand and supply
for a particular currency at any specific point in time determines its price (exchange rate) at that
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point. However, since the value of a countrys currency has significant bearing on its economy,
foreign exchange markets frequently witness government intervention in one form or another, to
maintain the value of a currency at or near its desired level. Interventions can range from
quantitative restrictions on trade and cross-border transfer of capital to periodic trades by the
central bank of the country or its allies and agents so as to move the exchange rate in the desired
direction. In recent years India has witnessed both kinds of intervention though liberalization has
implied a long-term policy push to reduce and ultimately remove the former kind. It is safe to say
that over the years since liberalization, India has allowed restricted capital mobility and followed
a managed float type exchange rate policy.
During the early years of liberalization, the Rangarajan committee recommended that Indias
exchange rate be flexible. Officially speaking, India moved from a fixed exchange rate regime to
market determined exchange rate system in 1993. The overt objective of Indias exchange rate
policy, according to various policy pronouncements, has been to manage volatility in exchange
rates without targeting any specific levels. This has been hard to do in practice. The Indian rupee
has had a remarkably stable relationship with the US dollar. Meanwhile the dollar appreciated
against major currencies in the late 90s and then went into an extended decline particularly
during 2003 and 2004. The lock-step pattern of the US dollar and the Rupee is best reflected in
the movements in the two currencies against a third currency like the Euro. The correlation of the
exchange rates of the two currencies against the Euro during 1999-2004 was 0.94. Several
studies have established the pegged nature of the rupee in recent years (see Chakrabarti (2006)
for a more detailed discussion). Based on volatility, India had a de facto crawling peg to the US
dollar between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995,
with a major devaluation in March 1993. From mid-1995 to end-2001, the rupee reverted to a

crawling peg arrangement in practice. An analysis of the ratio of the variance of the exchange
rate to the sum of the variances of the interest rate and the foreign exchange reserves reveals a
move even closer to the fixed exchange rate system. A comparison of the sensitivity (beta) of the
Dollar-rupee rate with the Euro-rupee rate for a three year period (1999 through 2001), indicates
that India had a dollar beta of 1.01 tenth highest among the 53 countries considered. More
importantly, the US dollar-Euro exchange rate explained about 97% of all movements in the
Indian rupee-Euro exchange rate highest
FORWARD MARKET
In conjunction with spot trading, there is also a forward foreign exchange market. The forward
market involves contracting today for the future purchase or sale of foreign exchange. The
forward price may be the same as the spot price, but usually it is higher (at a premium) or lower
(at a discount) than the spot price. Forward exchange rates are quoted on most major currencies
for a variety of maturities. Bank quotes for maturities of 1, 3, 6, 9, and 12 months are readily
available. Quotations on nonstandard, or brokenterm, maturities are also available. Maturities
extending beyond one year are becoming more frequent, and for good bank customers, a
maturity extending out to 5, and even as long as 10 years, is possible. To learn how to read
forward exchange rate quotations, lets examine Exhibit 4.4. Notice that forward rate quotations
appear directly under the spot rate quotations for four major currencies (the British pound,
Canadian dollar, Japanese yen, and Swiss franc) for one-, three-, and six-month maturities. As an
example, the settlement date of a three month forward transaction is three calendar months from
the spot settlement date for the currency. That is, if today is September 3, 2003, and spot
settlement is September 5, then the forward settlement date would be December 5, 2003, a period
of 93 days from September 3.

In this textbook, we will use the following notation for forward rate quotations. In general,
FN(j/k) will refer to the price of one unit of currency k in terms of currency j for delivery in N
months. N equaling 1 denotes a one-month maturity based on a 360-day bankers year. Thus, N
equaling 3 denotes a three-month maturity. When the context is clear, the simpler notation F will
be used to denote a forward exchange rate. Forward quotes are either direct or indirect, one being
the reciprocal of the other. From the U.S. perspective, a direct forward quote is in American
terms. As examples, lets consider the American term Swiss franc forward quotations in
relationship to the spot rate quotation for Monday, August 19, 2002. The Reserve Bank of India
has used a varied mix of techniques in intervening in the foreign exchange market indirect
measures such as press statements (sometimes called open mouth operations in central bank
speak) and, in more extreme situations, monetary measures to affect the value of the rupee as
well as direct purchase and sale in the foreign exchange market using spot, forward and swap
transactions (see Ghosh (2002)). Till around 2002, the measures were mostly in the nature of
crisis management of saving-the-rupee kind and sometimes the direct deals would be repeated
over several days till the desired outcome was accomplished. Other public sector banks,
particularly the SBI often aided or veiled the intervention process.