Introduction to Exchange

Rate Mechanism
MODULE IV

Introduction

Foreign exchange is the system or process of converting one national currency in

to another, and of transferring money from one country to another

The foreign exchange market is a market in which national currencies are bought
and sold against one another.

Currency names are shortened to 3 letters to meet the needs of screen-based

tables. These were developed by the International Organization for
Standardization and are called ISO codes or SWIFT codes.

It performs three important functions :

Transfer of Purchasing power

Provision of Credit

Provision of Hedging facilities

Introduction

Transfer of Purchasing power - It is the primary function of a foreign

exchange market Transfer of purchasing power from one country to
another and from one currency to another

Provision of Credit - The credit function performed by forex market is

plays an important role in the growth of foreign trade, for international
trade depends to a greater extent on credit facilities.

Provision of Hedging facilities - Hedging refers to covering of foreign

trade risks, and provide a mechanism to exporters and importers to
guard themselves against losses arising from fluctuations in exchange
rates

Introduction
The foreign exchange market is unique because of:

its trading volume,

the extreme liquidity of the market,

the large number of, and variety of, traders in the market,

its geographical dispersion,

its long trading hours - 24 hours a day (except on weekends).

the variety of factors that affect exchange rates,

Participants In Forex Market

Commercial Banks

Brokers & Customers

Central Banks

Non Bank Forex Companies

Participants In Forex Market

COMMERCIAL BANKS :

The inter bank market caters for both the majority of commercial
turnover and large amounts of speculative trading every day.

BROKERS :

Individuals constitute a growing segment of this market, both in size

and importance, they participate indirectly through Brokers. They
charge a commission in addition to the price obtained in the market.

Participants In Forex Market

CENTRAL BANKS :

National central banks are play an important role in the forex market.

They try to control the money supply , inflation and interest rates and
often have official or unofficial target rates for their currencies.

They can use their often substantial foreign exchange reserves to

stabilize the market

Participants In Forex Market

NON-BANK FOREX COMPANIES :

Non-bank forex companies offer currency exchange and international

payments to private individuals and companies.

They are also known as forex brokers, but are distinct in that they do
not offer speculative trading but currency exchange with payments , ie,
there is usually a physical delivery of currency to a bank account.

Exchange Rate Determination

Equilibrium of Exchange Rate= DD for FE & SS of FE

DD for FE arises because:

Import of goods and services

FDI in other countries

Payment by one government to other for settlement of transactions.

other outflows

SS of FE arises because:

Country exports goods and services to other countries

inflow of foreign capital

payment made by other countries

other types of inflows

Types Of Transactions In Forex

Market

SPOT & FORWARD EXCHANGES

FUTURES

OPTIONS

SWAP OPERATIONS

Types Of Transactions In Forex

Market

SPOT - The transactions are completed on the spot or immediately.

This trade represents a direct exchange between two currencies, has
the shortest time frame, involve the cash rather than a contract.

FORWARD Market forward contracts are delivered at a specified future

date. In this, money does not actually change hands until some agreed
up on future trade. A buyer and seller agree on an exchange rate for
any date in the future, and transactions occurs on that date, regardless
of what the market rates are then.

Types Of Transactions In Forex

Market

FUTURES :

Foreign currency futures are exchange traded forward transactions with

standard contract size and maturity dates.

Futures are standardized and are usually traded on an exchange created

for this purpose.

Futures transactions are usually inclusive of any interest amounts.

Types Of Transactions In Forex

Market

OPTIONS : ( FX Option)

FX Option is a derivative where the owner has the right but not the
obligation to exchange money denominated in one currency in to
another currency at a pre-agreed exchange rate on a specified date.

Fx option market is the deepest , largest and most liquid market for
option of any kind in the world.

Types Of Transactions In Forex

Market

SWAP :

The most common type of forward transaction is the Fx Swap.

In an fx swap , two parties exchange currencies for a certain length of

time and agree to reverse the transaction at a later date.

These are not standardized contracts and are not traded through an
exchange.