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Foreign Exchange Market:

Meaning, Functions and Kinds


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Foreign Exchange Market: Meaning, Functions and Kinds!


Meaning:
Foreign exchange market is the market in which foreign currencies are bought
and sold. The buyers and sellers include individuals, firms, foreign exchange
brokers, commercial banks and the central bank.

Like any other market, foreign exchange market is a system, not a place. The
transactions in this market are not confined to only one or few foreign
currencies. In fact, there are a large number of foreign currencies which are
traded, converted and exchanged in the foreign exchange market.

Functions of Foreign Exchange Market:


Foreign exchange market performs the following three functions:
ADVERTISEMENTS:

1. Transfer Function:
It transfers purchasing power between the countries involved in the
transaction. This function is performed through credit instruments like bills of
foreign exchange, bank drafts and telephonic transfers.

2. Credit Function:
ADVERTISEMENTS:
It provides credit for foreign trade. Bills of exchange, with maturity period of
three months, are generally used for international payments. Credit is required
for this period in order to enable the importer to take possession of goods, sell
them and obtain money to pay off the bill.

3. Hedging Function:
When exporters and importers enter into an agreement to sell and buy goods
on some future date at the current prices and exchange rate, it is called
hedging. The purpose of hedging is to avoid losses that might be caused due
to exchange rate variations in the future.

Kinds of Foreign Exchange Markets:


Foreign exchange markets are classified on the basis of whether the
foreign exchange transactions are spot or forward accordingly, there are
two kinds of foreign exchange markets:
ADVERTISEMENTS:

(i) Spot Market,

(ii) Forward Market.

(i) Spot Market:


Spot market refers to the market in which the receipts and payments are
made immediately. Generally, a time of two business days is permitted to
settle the transaction. Spot market is of daily nature and deals only in spot
transactions of foreign exchange (not in future transactions). The rate of
exchange, which prevails in the spot market, is termed as spot exchange rate
or current rate of exchange.

ADVERTISEMENTS:

The term spot transaction is a bit misleading. In fact, spot transaction should
mean a transaction, which is carried out on the spot (i.e., immediately).
However, a two day margin is allowed as it takes two days for payments made
through cheques to be cleared.

(ii) Forward Market:


Forward market refers to the market in which sale and purchase of foreign
currency is settled on a specified future date at a rate agreed upon today. The
exchange rate quoted in forward transactions is known as the forward
exchange rate. Generally, most of the international transactions are signed on
one date and completed on a later date. Forward exchange rate becomes
useful for both the parties involved in the transaction.

Forward Contract is made for two reasons:


(a) To minimize the risk of loss due to adverse changes in the exchange rate
(through hedging);

(b) To make profit (through speculation).

Foreign Exchange Market

1. Characteristics of the Foreign Exchange Market


Barter exchange (Double
coincidence of wants): In the
foreign exchange market, for
anybody wanting to sell dollars to
Barter Exchange get British pound, there must be
someone else wanting to sell the
pound for the dollar at the same
exchange rate (like in barter
exchange).

The FE market performs an


international clearing function by
bringing two parties wishing to
trade currencies at agreeable
exchange rates.
The FE market takes place
between dealers and brokers in
financial centers around the world.
During the hours of business
Role common to different time zones,
they rapidly exchange shorthand
messages expressing their bids for
different currencies.
To make a profit on FE
maneuvers, a trader or broker has
to make quick decisions correctly.
Foreign exchange traders lead an
exciting and hectic life, and the
pressure often shortens many
careers.
The fastest possible
communications are used. Before
the trans-Atlantic cable was laid in
1865 by Cyrus West Field (after
many failed attempts), somebody
wanting to exchange dollars for
pounds often had to wait the time
required for a roundtrip voyage to
clear up the transaction. Modern
telephone links have reduced the
transaction costs on foreign
exchange to near zero for large
transactions.

Currencies of the world

2. Origin of Money

Inside the lid, there is a Chinese character


written below. Cowries were used as money
during the Shang dynasty (1600 - 1046 BC)
Dollar is derived from German taler or
Joachimstaler in 1530s, a silver coin minted
from a mine near Joachimstal.
3. Recent Development in the Foreign Exchange Market

The daily volume


of business dealt
with on the foreign
exchange markets
Volume
in 1998 was
estimated to be
over $2.5 trillion
dollars. In 2007,
this volume was
$3.3 trillion In
2014, the daily
volume was about
$5.3 trillion. (60%
increase in 6
years)
UK (41%), US
(19%), Singapore
(5.7%), Japan
(5.6%), Hong
Kong (4.1%),
2014.
Composition: USD
accounts for 87%,
Euro 33%, Yen
23%, Pound
Sterling 12%,
CNY 2.2% (in
2013).
(Daily volume on
New York Stock
Exchanges is
about $20 billion)
The daily volume
of the foreign
exchange market
in North America
in October 2005
was about $440
billion.
The Foreign
Exchange market
expanded
considerably since
President Nixon
closed the gold
window and
currencies were
left afloat vis--vis
other currencies
and speculators
could profit from
their transactions.

Until recently, this


market was used
mostly by banks,
who fully
appreciated the
excellent
Who opportunities to
increase their
profits.
Today, it is
accessible to any
investor who
wants to diversify
his portfolio.

$1.5 trillion in spot


transactions
$0.5 trillion in
forward
transactions
$1.7 trillion in
foreign exchange
swaps (e.g.,
buying a foreign
currency in the
spot and selling it
Composition
in the forward
market to be
delivered during
the same week)
Also opposition
transactions.
the rest currency
swaps, options
Up to 90% are
speculative
transactions.

(i) USD is still the


traded Currencies
dominant
currency.
(ii) The emergence
of Yen as a major
currency, and
(iii) new Euro, in
addition to the
Dollar beside
many other
currencies, and the
frequent
fluctuations in
relative value of
these currencies
provide a great
opportunity to
generate
substantial profits.
(iv) RMB: Chinese
Renminbi is
convertible on
current account,
but not on capital
account. When it
becomes fully
convertible, which
is not likely to
occur until 2020 or
later, it will
fundamentally
affect the foreign
exchange market
due to its sheer
volume.

The foreign
exchange market
operates 24 hours
a day permitting
When intervention in the
major international
foreign exchange
markets at any
point in time.

4. Some FE Customs

Although there is an exchange rate between


traded the domestic currency and every other
currencies currency, most FE transactions involve only
a small number of international currencies.

Before the single currency euro was


launched in 2002, the composition of
Euro foreign currency transactions in the New
York market in 1985 was as follows: Mark
32%, Pound 23%, Canada $ 12%, Yen 10%,
Swiss Franc 10%, others 13%. (Knights
Templar was disbanded by Pope Clement V
in 1312).
The introduction of euro in 2002
dramatically changed the composition of
these foreign currencies as most of
European currencies were no longer
circulated.

The exchange rate is the domestic price of a


foreign currency. The FE quotations list
selling price in dollars or foreign currency
per dollar.
The selling price refers to the price at
which a large customer could have bought
the currency from the dealers. The buying
Selling price at which one could have sold foreign
price currency to the dealers is normally 0.1%
below the selling price, which represents the
commission of FE dealers or banks. This is
called interbank trading as it occurs usually
between foreign exchange dealers in
different banks in major financial centers.
Obviously, the "retail" rates for corporate
customers are less favorable than the
"wholesale" rates.

This spread can be higher in foreign


Spread
exchange markets other than New
York/London, and also in an exchange
crisis, and in rarely traded currencies.
Because the market participants know this
customary spread, usually selling prices are
published.

(i) For most currencies, only a spot rate is


quoted. Spot exchange is foreign exchange
for immediate delivery that is used for
international payments (for imports and
investment). The daily quotations are for
bank (cable) transfers. While transactions
between these banks are instantaneous,
these funds become available for use by
customers 1-2 working days after the
purchase.

Spot (ii) Transactions agreed on Monday will


rates result in payments on Wednesday. Those
agreed on Thursday will be available on
Monday. Canadian/US dollar business is
cleared in one day (because Toronto and
New York are in the same time zone).
(iii) Some New York banks maintain 2
shifts (one arriving at office at 3 am when
London and Frankfurt are open). Large New
York banks also have branches in Tokyo,
Frankfurt, and London. Thus, they are in
contact with all financial centers 24 hours.
(iv) When a FE dealer or broker quotes a
price on the telephone, he can be held to it
for only a few seconds (It used to be up to 1
minute). Dealers may quote different prices
to different customers. Prices change
throughout the day.
Bluffing/counterbluffing for a large sum of
FE. For average customers, it does not pay
to get more than one quote.

Buying and selling rates for bank notes


may be listed. Prices do not change
throughout the day. Selling price for BN
may be higher/lower than the selling price
for Cable transfers. The spread is much
larger than 0.1% for cable transfers, and
Bank may go up to 5-10%.
notes

forward rates are for currency to be


delivered 30, 90 or 180 days later at the
Forward
known price on a given day. Forward rates
rates
are available for major international
currencies.
Currency futures markets were established
by Chicago Mercantille exchange in 1972.
Currency Futures prices are for contracts applicable to
futures a specific calendar dates (Third Wednesday
of June, September, December and
March).

5. Participants of the Foreign Exchange markets

They are importers/exporters of goods,


services and financial assets
(stocks/bonds).
They are most numerous.
They buy and sell FE for transaction
purposes.
Retail
customers These do not usually trade currencies one
another because it is difficult to match
double coincidence of wants. Instead
they go to a commercial bank for the
transactions.
Electronic trading: 10% of spot market.
$150 billion per day.

Foreign (i) FE Dealers are large commercial


Exchange banks, which buy and sell FE. They
dealers assume an open position, and are
(speculators) exposed to exchange risks. Specifically,
they are the international departments of
large commercial banks in the financial
centers of the world: London, New York,
Tokyo, Zurich, Frankfurt, Paris,
Singapore, Hong Kong, Toronto. Their
speculative transactions account for 90%
of daily trade volume. One speculative
episode may last a few minutes.
(ii) Forex scandal. Dealers (e.g., The
Cartel, One Team One Dream, The
Mafia, etc. share confidential
information about clients' intention
through electronic chatroom and
were front-running large client orders
(buying before filling buy orders and
selling before filling sell orders of the
clients) They violate client
confidentiality. Five banks agreed to pay
fines totalling more than $5.7 billion.
(Citibank, HSBC, JPMorgan, RBS and
UBS)
In New York City, there are about 100
such banks.
(iii) Large banks outside the center also
participate through their affiliates.
(iv) Small regional banks do not directly
participate in the FE market. But to meet
their customers' FE need, they deal with
correspondant banks. Almost 14,000
commercial banks maintain corresponent
relationship with FE dealers.
(iv) FE dealers typically maintain a
trading room equipped with telephones
and telex machines. They ususally
communicate directly with the trading
rooms of banks in other centers. They go
through a broker when dealing with other
banks in the same center. They are
exposed to FE risks.
Major dealers: Deutsche Bank, Citi,
Barclays, UBS (Switzerland), HSBC
(HK/Shanghai UK), JP Morgan,
Royal Bank of Scotland, Credit Suisse,
Morgan Stanley, Bank of America.
Salary = up to $2 million.

These are brokers for retail customers,


and work for a commission. There are 8
brokers in New York, and less than 100
FE brokers
in the U.S. They usually specialize in a
few currencies, and earn commission =
1/10 of 1% - 1/8 of 1%.

Central (i) Central banks participate (a) to


Banks facilitate Treasury's transactions, and (b)
to prevent or effect a change in the value
of their currency.
(ii) in the US, Federal Reserve Bank of
NY acts as agent for the entire Federal
Reserve System and the Treasury
Department.
(iii) it usually tries to conceal its
intervention. It may requres an obscure
bank in Midwest to place an order in the
New York market.
(iv) Sometimes it publicizes its buying
intent.

Other numerous, but they participate through


speculators FE dealers.

euro currency market


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Euro Currency Market features and its Instruments:
Presentation By- Rajesh maity sumit das manigandan madhuliar Euro Currency Market features and its Instruments

WHAT IS EURO CURRENCY?:


WHAT IS EURO CURRENCY? Euro Currency- Any currency banked outside its country of origin. Currency deposited by
national governments or corporations in banks outside their home market. This applies to any currency and to banks in any
country. Example - US dollar banked in England is know as euro currency. Euro bank- Banks that accepts deposits and make
loans in foreign countries Example - Euro Currency Bank at Frankfurt franc.

EURO CURRENCY MARKETS:


EURO CURRENCY MARKETS The international currency markets, also known as offshore markets where currencies are
borrowed and lent. Dollar deposits outside USA or sterling deposits outside UK are called offshore funds and have a market, so
long as they are convertible and readily usable in international transactions.

EURO CURRENCY DEPOSIT:


EURO CURRENCY DEPOSIT A deposit in the relevant currency with a bank outside the home country of that currency. A US
dollar deposit with a bank in London is a Euro Dollar deposit, a Sterling deposit with a bank in Luxembourg is a Euro Sterling
deposit. A Eurodollar Loan is a dollar loan made by a bank outside the US to a customer or another bank. Note- .( Location of
the bank matters, neither the ownership of the bank nor the ownership of the deposit )

Euro Currency Market.:


Euro Currency Market. Convertible currency is defined as one, which is widely, accepted international payments and whose
country does not have Current account controls under Article VIII of the I.M.F. Agreements. Thus Euro-currency market is a
market principally located in Europe for lending and borrowing the Worlds most important convertible currencies, namely
Dollar, Sterling, French franc, yen, etc.

EURO CURRENCY MARKETS:


EURO CURRENCY MARKETS The European Currency Market is an external banking system that runs parallel to the domestic
banking system of the country that issued the currency In US, the banks are subject to the Federal reserve Regulation specifying
reserve requirements on bank time deposits. The reduced cost structure has led to the growth of the euro-currency and euro dollar
market. The Eurocurrency market operates at the interbank/ and or wholesale level.

Factors for its emergence.:


Factors for its emergence. Strict rules in the domestic market Lack of Govt. controls on credit allocation & interest rates. No
taxes and prior commitments No need to maintain Reserve Requirement Operates on the basis of market forces Low operating
margins, high turnovers

Its Characteristics:
Its Characteristics International Money market free from govt. regulations Exist as a savings and time deposit Exists for
short term which makes difficult to manage risk Participants- Govt., Public Sector Organizations Euro dollar market dominates
other currencies

EURO CURRENCY CENTERS:


EURO CURRENCY CENTERS Currencies Country Austrian Schilling Austria Belgian Franc Belgium Dutch Guilder
Netherlands Finnish Markka Finland French Franc France German Mark Germany Irish Punt Ireland Italian Lira Italy
Luxembourg Franc Luxembourg Portuguese Escudo Portugal Spanish Peseta Spain

EURO CREDIT SYNDICATES:


EURO CREDIT SYNDICATES Eurocredits Intermediate-term loans of Eurocurrencies made by banking syndicates to corporate
and government borrowers. Eurocredit market Comprises banks that accept deposits and provide loans in large denominations
and in a variety of currencies. The banks that constitute this market are the same banks that constitute the Eurocurrency market;
the difference is that Euro Credit loans are longer-term than so-called Eurocurrency loans. Although the Eurocurrency market
focuses on large-volume transactions, there are times when no single bank is willing to lend the needed amount. A syndicate of
Euro banks may then be composed to underwrite the loans. Front-end management and commitment fees are usually charged for
such syndicated Eurocurrency loans.

DEPOSITORY RECEIPTS:
DEPOSITORY RECEIPTS A negotiable financial instrument issued by a bank to represent a foreign company's publicly traded
securities. The depositary receipt trades on a local stock exchange. Depositary receipts make it easier to buy shares in foreign
companies because the shares of the company don't have to leave the home state.

OUTRIGHT FORWARDS:
OUTRIGHT FORWARDS An outright forward transaction, like a spot transaction, is a straight forward single purchase/ sale of
one currency for another. There is a specific exchange rate for each forward maturity of a currency, almost always different from
the spot rate. The exchange rate at which the outright forward transaction is executed is fixed at the outset. Outright forwards in
major currencies are available over-the-counter from dealers for standard contract periods or straight dates (one, two, three, six,
and twelve months); dealers tend to deal with each other on straight dates.

Role of the Offshore Deposit Markets for Euro-Dollars and Other Currencies :
Role of the Offshore Deposit Markets for Euro-Dollars and Other Currencies With large and liquid offshore deposit markets in
operation, and with information transfers greatly improved and accelerated, it became much easier and quicker to detect any
significant deviations from covered interest rate parity, and to take advantage of any such arbitrage opportunities. These deposits
trade over the telephone like foreign exchange, with a bid/offer spread, and they have similar settlement dates and other trading
conventions. Many of the same counterparties participate in both markets, and credit risks are similar . For currencies not traded
in the offshore Eurocurrency deposit markets in London and elsewhere, deposits in domestic money markets may provide a
channel for arbitraging the forward exchange rate and interest rate differentials

NON DELIVERABLE FORWARDS:


NON DELIVERABLE FORWARDS In recent years, markets have developed for some currencies in non-deliverable
forwards. This instrument is in concept similar to an outright forward, except that there is no physical delivery or transfer of the
local currency. Rather, the agreement calls for settlement of the net amount in dollars or other major transaction currency. NDFs
can thus be arranged offshore without the need for access to the local currency markets, and they broaden hedging opportunities
against exchange rate risk in some currencies otherwise considered unhedgeable . Use of NDFs with respect to certain currencies
in Asia and elsewhere is growing rapidly.

EURO DEPOSITS:
EURO DEPOSITS The Euro currency market has its origins in time deposits - whereby cash was held in a banking system
outside the country of that currencys origin. Euro time deposits generally range from 7 days to 6 months. Banks receiving
Eurocurrencies use them to make loans to international and supranational financial institutions, governments, companies and to
each other The risks of holding euro-deposits are accentuated by the fact that, on average, euro-deposits tend to have shorter
maturities than euro-loans. Euro-deposits are free from reserve requirements and most other national regulations, and as their
attractiveness for hedgers and speculators moves funds into the market, Central Bank control of financial intermediaries declines.

EURO SECURITIES:
EURO SECURITIES As well as euro deposits, money market securities can be euro securities. Such securities include: - Euro
commercial paper (ECP) - Euro certificates of deposit (euro CD) - Euro notes - International repos Whatever the instrument used,
the issuers aims are similar: -To widen the investor base beyond its domestic market, -To avoid the regulatory restrictions of its
domestic market

AMERICAN DEPOSITORY RECIEPT-ADR :


AMERICAN DEPOSITORY RECIEPT-ADR A negotiable certificate issued by a U.S. bank representing a specified number of
shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the
underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would
otherwise be levied on each transaction.

ADR:
ADR It is an excellent way to buy shares in a foreign company while realizing any dividends and capital gains in U.S. dollars.
However, ADRs do not eliminate the currency and economic risks for the underlying shares in another country. For example,
dividend payments in Euros would be converted to U.S. dollars, net of conversion expenses and foreign taxes and in
accordance with the deposit agreement. ADRs are listed on either the NYSE, AMEX or Nasdaq .

GLOBAL DEPOSITORY RECIEPT-GDR:


GLOBAL DEPOSITORY RECIEPT-GDR A Global Depository Receipt or Global Depositary Receipt (GDR) is a certificate
issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDRs represent
ownership of an underlying number of shares. Global Depository Receipts facilitate trade of shares, and are commonly used to
invest in companies from developing or emerging markets.

GDRs:
GDRs Prices of GDRs are often close to values of related shares, but they are traded & settled independently of the
underlying share. Several international banks issue GDRs, such as JPMorgan Chase, Citigroup, Deutsche Bank, Bank of New
York. They trade on the International Order Boo