The Foreign-exchange Trading Process

When a company sells goods or services to a foreign customer and receives foreign
currency, it needs to convert the foreign currency into the domestic currency. When
importing, the company needs to convert domestic to foreign currency to pay the foreign
supplier. This conversion takes place between the company and its bank, and most of these
transactions take place in the OTC market. Originally, the commercial banks were the ones
that provided foreign-Exchange services for their customers. Eventually, some of these
commercial banks in New York and other U.S.money centers such as Chicago and San
Francisco began to look at foreign Exchange trading as a major business activity instead of
just a service. They became interme- diaries for smaller banks by establishing correspondent
relationships with them. They also became major dealers in foreign exchange.
The left side of Figure 8.4 shows what happens when a U.S. company needs to sell euros
for dollars. This situation could arise when a customer had to pay in euros or when a
German subsidiary had to send a dividend to the U.S. Company in euros. The right side of
the figure 8.4 shows what happens when a U.S. company needs to buy euros with dollars.
This situation could arise when a company had to pay euros to a German supplier.
However, there are other markets and institutions in which foreign exchange is traded.
Most of the foreign-exchange activity takes place in the traditional instru- ments of spot,
outright forward, and FX swaps, and commercial banks and investment banks or other
financial institutions basically trade these instruments. However, companies could also
deal with an exchange, such as the Philadelphia Stock Exchange to buy or sell an option
contract and the Chicago Mercantile Exchange to deal in foreign-currency futures.
The Bank for International Settlements estimates that there are about 2,000 dealer
institutions worldwide that make up the foreign-exchange market. Of these, about 100 to
200 are market-making banks, which means that they are willing to quote bid and offer rates
to any one in the currency or currencies in which they deal. Of this group, only a select few
are major players, and they will be identified and discussed shortly in the section on
commercial and investment banks.
As noted earlier, most of the foreign-exchange trades take place in the OTC market in which
most of the dealers operate. These dealers operate more in the interbank market with dealers
of other

Banks than they do with corporate clients. The BIS estimated in 2001 that 59 percent of the
foreign-exchange trades took place among reporting dealers. Fifty-seven percent of the
business between dealers takes place across national borders, whereas 43 percent the dealers’
business with nonfinancial customers takes place in the domestic market. This number is
declining rapidly, compared with 64 percent in 1998.
When a company needs foreign exchange, it typically goes to its commercial bank for help. If
that bank is a large market maker, the company can get its foreign exchange fairly easily.
However, if the company is located in a small market and uses a local bank, where does the
bank get its foreign exchange? Figure 8.5 illustrates how foreign-exchange dealers at the banks
trade foreign exchange. A bank, dealing either on its own account or for a client, can trade
foreign exchange with another bank directly or through a broker. In the broker market, it can
use a voice broker or an electronic brokerage system (EBS). In both the U.S. and U.K.markets,
direct dealing is by far the most widely used method of trading currency; however, the use of
electronic brokerages is increasing. An increase in electronic brokerage system shows that
dealers are directly trading less actively among themselves. The share of electronic brokerages
in interdealer trading volume was around 5 percent in 1992, 10 percent in 1995,40 percent in
1998, and 60 percent in 2001.
A foreign-exchange broker is an intermediary who matches the best bid and offer quotes of
interbank traders. There are a number of brokerage houses around the world, such as the Martin
Brokers Group in London, owned by Trio Holdings, Exco, Tullett & Tokyo Forex
International, and Intercapital Group. These brokers have traditionally dealt in the market by
voice, linking up interbank traders. According to the BIS survey in 1998, there were nine
brokers in the United States, including the two major electronic brokerage systems, down from
17 in 1995.
The use of brokers depends on a number of factors, such as the location of the market and the
size and nature of the foreign-exchange transactions. Voice brokers are especially important
for large foreign-exchange transactions. Brokers have filled an important role because of their
ability to establish networks with a wide variety of banks, thus allowing banks to
buy or sell currency from other banks faster than if they had to try to contact all or different
potential banks themselves.
However, the voice broker market has been rapidly giving way to electronic brokerage
systems. Historically, most trades took place by telephone. A dealer in one bank would call a
dealer in another bank and execute a trade. If it did not have access to enough banks to get the
currency needed, it could operate through a broker. The move from voice to electronic
brokerage systems was initiated by Reuters (its system is called Reuters’ Dealing 3000) and
then followed by other systems such as Icos, an electronic brokerage company.

Foreign-Exchange Transactions
A bank gets access to the automated system by purchasing the service from Reuters by paying
a monthly fee and receiving a link through telephone lines to the bank’s computers. Then the
bank can use the automated system to trade currency. The automated system is efficient,
because it lists bid and sell quotes, allowing the bank to trade immediately. For large
transactions, many dealers prefer the familiarity of a trusted voice broker to find a buyer or
seller. Electronic dealers are efficient but too impersonal for the large transactions. Most
electronic trades average in the $1 million to $2 million range, although a trade of $1 0 million
to $20 million will occasionally show up. Electronic brokerage systems are used in one third
of all transactions for the dollar, euro, and yen. Many voice brokers are leaving the spot market
and focusing more on derivatives, such as forwards and options.
A current trend in currency trading is the establishment of Internet currency trading. During
the Internet boom of the 1990s, large banks and corporations started funding Internet start-ups
that were aimed at facilitating Internet exchange trading. One example is a company called
Atriax, which was formed by Citibank, JPMorgan Chase, and Deutsche Bank. Then the bottom
fell out of the stock market in 2000, many of these companies found themselves in trouble,
including Atriax. Some companies survived, and Internet trading for foreign exchange is
estimated to be around $14 billion a day. Many believe that in 10 to 20 years, there will be a
variety of platforms that allow trading in multiple products. And as banks security issues
associated with Internet trading, activity should pick up.
Commercial and Investment Banks
At one time, only the big money center banks could deal directly in foreign exchange. Regional
banks had to rely on the money center banks to execute trades on behalf of their clients. The
emergence of electronic trading has changed that, however.
Now even there regional banks can hook up to Reuters and EBS and deal directly in the
interbank market or through brokers. In spite of this, the greatest volume of foreign- exchange
activity takes place with the big banks.
There is more to servicing customers in the foreign-exchange market than size alone. Each
year, Euromoney magazine surveys corporations and financial institutions to identify their
customers’ favorite banks and the leading traders in the interbank market. The criteria for
selecting the top foreign- exchange traders include Ranking of banks by corporations and other
banks in specific locations, such as London, Singapore, and New York.
Capability to handle major currencies, such as the u.s. dollar and euro. Capability to handle
major cross-trades-for example, those between the euro and pound or the euro and yen.
Capability to handle specific currencies. Capability to handle derivatives (forwards, swaps,
futures, and options). Capability to engage in research.
Other factors often mentioned are price, quote speed, credit rating, liquidity, back office/
settlement, strategic advice, trade recommendations, out-of-hours service/ night desk, systems
technology, innovation, risk appraisal, and e-commerce func- tions. For this reason, large
companies may use several banks to deal in foreign exchange, selecting those that specialize
in specific geographic areas, instruments, or currencies. For example, AT&T uses Citibank for
its broad geographic spread and wide coverage of different currencies, but it also uses Deutsche
Bank for euros, Swiss Bank Corporation for Swiss francs, NatWest Bank for British pounds,
and Goldman Sachs for derivatives.

Ethical Dilemma
The need for Check and Balances
There are plenty of opportunities for a trader to make money illegally. One of the most
publicized events in the derivatives markets in recent years involved 28-year-old Nicholas
lesson and 233-year old Barings PLC. Lesson, a trader for Barings PLC, went to Singapore in
the early 1990s to help resolve some problems Barings was having. With in a year, he was
promoted to chief trader. The problem was that he was responsible for trading securities and
booking the settlements. This meant that there were no checks and balances on his trading
actions, thus opening the door to possible fraud. When two different people ate assigned to
trade securities and book settlements, the person booking the settlements can confirm
independently whether or not the trades were accurate and legitimate. In 1994, leeson brought
stock index futures on the assumption that the Tokyo stock, market would rise. Unfortunately,
the market fell, and lesson had to come up with cash to cover the margin call on the future
contract. A margin is a deposit made as security for a financial transaction that is otherwise
financed on credit. When the price of an instrument changes and the margin rises, the exchange
“calls” the increased margin from the other party in this case leeson. However, leeson soon ran
out of cash from Barings, so he had to come up with more cash. One approach

Looking to the Future

Exchange Markets in the New Millennium
Significant strides have been made and will continue to be made in the development of
foreignexchange markets. The speed at which transactions are processed and information is
transmitted globally will certainly lead to greater efficiencies and more opportunities for
foreign-exchange trading. The impact on companies is that costs of trading foreign exchange
should come down, and companies should have faster access to more currencies.
In addition, exchange restrictions that hamper the free flow of goods and services should
diminish as governments gain greater control over their economies and as they liberalize
currency markets. Capital controls still impact foreign invest- ment, but they will continue to
become less of a factor for trade in goods and services.
The introduction of the euro has allowed cross-border transactions in Europe to progress more
smoothly. As the euro solidifies its position in Europe, it will reduce exchange-rate volatility
and should lead to the euro taking some of the pressure off the dollar so that it is no longer the
only major vehicle currency in the world.
Finally, technological developments may not cause the foreign- exchange broker to disappear
entirely, but they will certainly cause foreign-exchange trades to be executed more quickly and
cheaply. The growth of Internet trades in currency will take away some of the market share of
dealers and allow more entrants into the foreign-exchange market. Internet trades will also
increase currency price transparency and increase the ease of trading, thus allowing more
investors into the market.
HSBC Holdings plc, one of the world’s largest banks, is faced with a difficult decision
regarding its Argentine subsidiary.

Questions
1) what are the Risk in foreign exchange trading? Elaborate.
Leverage Risks
In forex trading, leverage requires a small initial investment, called a margin, to gain access to
substantial trades in foreign currencies. Small price fluctuations can result in margin
calls where the investor is required to pay an additional margin. During volatile market
conditions, aggressive use of leverage will result in substantial losses in excess of initial
investments. (For more, see: Forex Leverage: A Double-Edged Sword.)
Interest Rate Risks
In basic macroeconomics courses you learn that interest rates have an effect on countries'
exchange rates. If a country’s interest rates rise, its currency will strengthen due to an influx
of investments in that country’s assets putatively because a stronger currency provides higher
returns. Conversely, if interest rates fall, its currency will weaken as investors begin to
withdraw their investments. Due to the nature of the interest rate and its circuitous effect on
exchange rates, the differential between currency values can cause forex prices to dramatically
change. (For more, see: Why Interest Rates Matter For Forex Traders.)
Transaction Risks
Transaction risks are an exchange rate risk associated with time differences between the
beginning of a contract and when it settles. Forex trading occurs on a 24 hour basis which can
result in exchange rates changing before trades have settled. Consequently, currencies may be
traded at different prices at different times during trading hours. The greater the time
differential between entering and settling a contract increases the transaction risk. Any time
differences allow exchange risks to fluctuate, individuals and corporation dealing in currencies
face increased, and perhaps onerous, transaction costs. (For more, see: Corporate Currency
Risks Explained.)
Counterparty Risk
The counterparty in a financial transaction is the company which provides the asset to the
investor. Thus counterparty risk refers to the risk of default from the dealer or broker in a
particular transaction. In forex trades, spot and forward contracts on currencies are not
guaranteed by an exchange or clearing house. In spot currency trading, the counterparty risk
comes from the solvency of the market maker. During volatile market conditions, the
counterparty may be unable or refuse to adhere to contracts. (For more, see: Cross-Currency
Settlement Risk.)
Country Risk
When weighing the options to invest in currencies, one must assess the structure and stability
of their issuing country. In many developing and third world countries, exchange rates are
fixed to a world leader such as the US dollar. In this circumstance, central banks must sustain
adequate reserves to maintain a fixed exchange rate. A currency crisis can occur due to
frequent balance of payment deficits and result in devaluation of the currency. This can have
substantial effects on forex trading and prices. (For more, see: Top Ten Reasons Not to Invest
In The Iraqi Dinar.)
Due to the speculative nature of investing, if an investor believes a currency will decrease in
value, they may begin to withdraw their assets, further devaluing the currency. Those investors
who continue trading the currency will find their assets to be illiquid or incur insolvency from
dealers. With respect to forex trading, currency crises exacerbate liquidity dangers and credit
risks aside from decreasing the attractiveness of a country's currency. This was particularly
relevant in the Asian Financial Crisis and the Argentine Crisis where each country's home
currency ultimately collapsed. (For more, see: Examining Credit Crunches Around The
World.)

2) How to Mitigate foreign Exchange Risk?

Methods of Hedging Risk
Invest in hedged assets: The easiest solution is to invest in hedged overseas assets, such
as hedged exchange-traded funds (ETFs). ETFs are available for a very wide range of
underlying assets traded in most major markets. Many ETF providers offer hedged and
unhedged versions of their funds that track popular investment benchmarks or indexes.
Although the hedged fund will generally have a slightly higher expense ratio than its unhedged
counterpart due to the cost of hedging, large ETFs can hedge currency risk at a fraction of the
hedging cost incurred by an individual investor. For example, continuing with the
aforementioned example of the MSCI EAFE index – the primary benchmark for U.S. investors
to measure international equity performance – the expense ratio for the iShares MSCI EAFE
ETF (EFA) is 0.33%. The expense ratio for the iShares Currency Hedged MSCI EAFE ETF
(HEFA) is 0.70% (although the Fund has waived 35 basis points of the management fee, for a
net fee of 0.35%). The marginally higher fee for the hedged version may have been worth it in
this instance, since the EFA (unhedged ETF) was up 5.64% for the year (to August 14, 2015),
while the HEFA (hedged ETF) was up 11.19%.

Hedge exchange rate risk yourself: If you possess a truly diversified portfolio, chances are
that you have a degree of forex exposure should the portfolio contain foreign-currency stocks
or bonds, or American Depositary Receipts (ADRs – a common misconception is that their
currency risk is hedged; the reality is that it isn't).

Instruments for Hedging Currency Risk In such cases, you can hedge currency risk using one
or more of the following instruments:
Currency forwards: Currency forwards can be effectively used to hedge currency risk. For
example, assume a U.S. investor has a euro-denominated bond maturing in a year's time and is
concerned about the risk of the euro declining against the U.S. dollar in that time frame. He or
she can therefore enter into a forward contract to sell euros (in an amount equal to the maturity
value of the bond), and buy U.S. dollars at the one-year forward rate. While the advantage of
forward contracts is that they can be customized to specific amounts and maturities, a major
drawback is that they are not readily accessible to individual investors. An alternative way to
hedge currency risk is to construct a synthetic forward contract using the money market
hedge (See related: The Money Market Hedge: How It Works).
Currency futures: Currency futures are widely used to hedge exchange rate risk because they
trade on an exchange and need only a small amount of upfront margin. The disadvantages are
that they cannot be customized and are only available for fixed dates. (See related: Introduction
To Currency Futures).
Currency ETFs: The availability of ETFs that have a specific currency as the underlying
asset means that currency ETFs can be used to hedge exchange rate risk. This is probably not
the most effective way to hedge exchange risk for larger amounts. But for individual investors,
their ability to be used for small amounts, plus the fact that they are margin-eligible and can be
traded on the long or short side, are major benefits. (See related: Hedge Against Exchange Rate
Risk With Currency ETFs).
Currency Options: Currency options offer another feasible alternative to hedge exchange rate
risk. Currency options give an investor or trader the right to buy or sell a specific currency in a
specified amount on or before the expiration date at the strike price. (See "Trading Forex
Options: Process and Strategy"). For example, currency options traded on the Nasdaq are
available in denominations of EUR 10,000, GBP 10,000, CAD 10,000 or JPY 1,000,000,
making them well-suited for the individual investor.

3) Indian Context In Foreign Exchange Risk.

India has increasingly become an open economy and external trade currently accounts for 40
percent of GDP, which is more than that of other large supposedly open economies like China
(37 percent) and US (27 percent). Further, acceleration in economic growth offered promising
investment opportunities to foreign investors contributing to surge in capital flows. In this
context, the Reserve Bank of India (RBI) has treaded carefully along the path of opening up
the Indian economy in tandem with growing external linkages through trade and financial
channels. This involved a gradual liberalisation of capital flows, increasing FII limits in a
calibrated manner, simplifying operational procedures with respect to hedging and
implementing measures to deepen and widen forex market in India.

Over last three decades, Indian foreign exchange market has made long strides in terms of
turnover, types of instruments and participation base. Average daily forex turnover has
increased from approximately $27 billion in 2005-06 to $58 billion currently. Today, we have
considerably liquid market as evident in rising forex market turnover and compressing bid ask
spreads. There is well functioning over the counter (OTC) as well as exchange-traded market
providing diversified range of products for hedging currency risks. As an alternative to
traditional forwards market, introduction of derivatives products has helped in minimising cost
of hedging and improving transparency.

However, despite this, India’s unhedged exposures stand quite high with various studies and
estimates suggesting that approximately two-thirds of total gross forex exposures are
unhedged. According to Bureau of Indian Standards (BIS), while the rupee share in OTC
foreign exchange turnover has gone up from 0.2 percent to 1.1 percent in April-2016 survey, it
is still low compared to other smaller emerging market economies like Mexico (1.9 percent)
and Turkey (1.4 percent).

India has been a part of global news lately, for all the right reasons. India has evolved from
being just another ‘developing nation’ to an emerging global power. While this implies
political, military and economic connotations, let us focus on the latter. Very recently, India’s
forex reserves skyrocketed by $4 billion USD, touching a new high of $381 billion USD.

While this is a monumental event, what opportunities does this overflowing chest of forex
reserves offer to the country? What are the opportunity costs? Like any economic development,
this event also has its share of pros and cons. The specific impacts and the immensity of the
$381 billion USD worth of forex reserves must be put in perspective by considering the Indian
context.

The build-up of forex reserves is linked to the inflow of foreign currency. This foreign currency
is predominantly the US Dollar: the currency that the world transacts in. There are several
reasons for the inflow of foreign currency into India. Firstly, being a strong emerging
market, India finds favour among foreign investors as an investment destination.
Secondly, with a young population and rapid reforms by the government, the business
environment is extremely conducive. Thirdly and most importantly, Indians are becoming truly
global in their lifestyle habits, now more than ever. India is also a hub for both MNCs and
startups. In fact, India has the third largest start-up base in the whole world. Foreign investors
are investing into both Indian MNCs and lately, into startups too.

Foreign investments can be made through Foreign Institutional Investments or Foreign Direct
Investments. Foreign Institutional Investments (FII) primarily involve channelling investments
through the capital market in the equity or debt of companies based in India. This is the most
convenient way for a large foreign investor to invest in promising Indian companies without
having to ever set foot here.

Based on the expectations of a strong market, favourable interest rates, and a solid growth in
corporate earnings, FIIs have pumped in unprecedented amounts of capital. Up to April 2017,
net investments through FIIs in Indian equities and debt stood at about $7.5 billion. Ever since
the turn of the millennium, the total FII investments have been to the tune of $185 billion.

Foreign Direct Investments (FDIs) involves setting up of operations in the country. The capital
invested in a country through the FDI route is used for setting up plants, machinery, offices
and other assets. The investing entity thus arrives and operates in the Indian market.

Indian companies showed tremendous resilience to the short-term hiccups arising from the
governmental reforms and gave promising growth signals

There is always a ‘right level’ of reserves that a country must hold as a percentage of its GDP.
Reports suggest that awe might have significantly overshot it at the current record high of more
than $381 billion. A need to pay constant attention to the forex scenario prevents the central
bank from following a truly independent, growth focussed monetary policy. Also, the
constantly rising foreign inflows can push the Rupee up to levels in the international market
that will make Indian exports extremely uncompetitive.

If the current pace and level of forex reserves persist, the Government must start thinking of
alternate investment avenues for this excess foreign capital. Like any capital at the disposal of
the nation, the forex reserves can be deployed within the country for infrastructure development
or invested further in foreign capital markets. The Government and the central bank are walking
a tightrope and one must wait to find out what will happen given the current scenario.

While having healthy forex reserves is considered an indicator of financial well-being, too
much can prove to be harmful. Every Dollar that enters the market essentially increases the
money supply in the economy. This means that too strong an inflow of foreign currency can
cause problems of excess liquidity and result in inflation. Usually, the RBI conducts
‘sterilisation’ of foreign inflows to remove the excess liquidity in the market.

This is done by conducting Open Market Operations (OMOs). OMOs involve the floating of
bonds worth the amount that the central bank wants to suck out of the markets, thus effectively
neutralising the excess liquidity. However, the problem is that the bonds are an obligation
which the central bank needs to collateralise, just like any other borrowing. However, the RBI
cannot take on infinite amounts of liability because that will need infinite amounts of collateral.
As the availability of collateral is limited, the RBI will fast run out of options to suck out this
excess liquidity.