Forex Market

THE FOREIGN EXCHANGE MARKET

This is over the counter market ( OTC ) i.e. there is no physical market place to make the deals. Instead it is a net work of banks , brokers and dealers spread across the various financial centers of the world . These players trade in different currency through telephones , faxes , computers and other electronic networks like the SWIFT system ( Society for Worldwide Inter bank Financial Telecommunication) . These traders generally operate through a trading room . The deals are finalized orally with written communication following later .

THE PLAYERS

The main players in the foreign exchange market are : large commercial banks, forex brokers , large corporations and the central banks The central banks enter the market to smoothen out fluctuations in the exchange rates .

FOREIGN EXCHANGE
As defined in Section 2 of FEMA , 1999 foreign exchange includes : all deposits ,credits , balance payable in any foreign currency , any drafts , travelers` cheques , letter of credit and bills of exchange , any instrument giving anyone the option of making it payable either partly or fully in a foreign currency .

Here the term currency includes coins , bank notes , postal notes , postal orders and money orders .

 Market Makers : The large commercial banks which stand ready to buy and sell various currencies at specific prices at all points of time. Retail Market : The market in which the commercial banks deal with the customers both individuals and corporate . Inter bank Market / Wholesale Market: The market in which banks deal with each other. A 24 Hour Market : The world wide forex mkt. is a 24 hour market i.e. trading is going on at least one of the forex market through out the day.

Authorized Dealers ( A Ds ): They are generally the commercial banks .They are permitted to deal in all items classified as foreign exchange in FEMA ,1999 . They have to operate within the rules regulations and guidelines issued by Foreign Exchange Dealers Association of India ( FEDAI ) . Money Changers : They can be either full fledged MC (can both buy and sell) or restricted MC ( can only buy ) are allowed to deal only in notes , coins and travelers` cheque. Foreign Exchange Brokers: They do not actually buy and sell any currency . They do the work of bringing the buyer and seller together .

EXCHANGE RATE QUOTATIONS

An exchange rate quotation is the price of a currency stated in terms of another i.e. the price of one currency quoted in terms of 1unit of the other currency . For e.g. INR / USD : 46.40 / 1USD American Quote : The number of dollars expressed per unit of any other currency . For e.g. USD 1.6689 / 1GBP European Quote : The number of units of any other currency expressed per dollar . For e.g. INR 46.40 / 1USD

 Direct Quote : The quote where the exchange rate is expressed in terms of number of units of the domestic currency per unit of foreign currency. For e.g. INR 46.40 / USD

Indirect Quote : The quote where the exchange rate is expressed in terms of number of units of the foreign currency per unit of domestic currency . For e.g. USD 2.0525 / INR 100 .

Merchant Quote : The quote given by a bank to its retail customers . Inter Bank Quote : The quote given by one bank to another bank .

Variability of exchange rates give rise to : * foreign exchange risk and * foreign exchange exposure Foreign Exchange Risk is the variance of the domestic currency value of an asset , liability or operating income that is attributable to unanticipated changes in exchange rates. Foreign Exchange Exposure means the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates.

Currency Exposure

Short Term

Long Term

Accounting (Translation)

Operating Cash Flow

Strategic

Contractual (Transaction)

Anticipated

Transaction Exposure This is an exposure that arises from foreign currency denominated transactions which an entity is committed to complete .In other words , it arises from contractual , foreign currency , cash flows .
E.g. If a firm has entered into a contract to sell computers to a foreign customer at a fixed price denominated in a foreign currency .The firm will be exposed exchange rate movements till it receives the payment and converts the receipts into the domestic currency.

The exposure of a company in a particular currency is measured in net terms, i.e. after netting off potential cash inflows with outflows.

Translation Exposure This exposure arises from the need to convert values of the assets and liabilities denominated in a foreign currency , into the domestic currency.
E.g. a company having foreign currency deposit would need to translate its value into domestic currency for the purpose of reporting at the time of preparation of its financial statements.

It needs to be noted that this exposure is mostly notional , as there is no real gain or loss due to exchange rate movements since the asset or liability does not stand liquidated at the time of reporting. Hence it is also known as Accounting Exposure.

Operating Exposure The extent to which the firm's future operating cash flows would be affected in the long run due to random changes in exchange rates. This may have a serious impact on the competitive status of the firm forcing it to restructure its business and redefine its long-term strategy.

Management of exposure essentially means: reduction or elimination of exchange rate risk through hedging . it involves taking a position in the forex and / or the money market which cancels out the outstanding position. Steps involved in the management of exposure has two significant dimensions : First, the treasurer must decide whether and to what extent an exposure should be explicitly hedged .The nature of the firms operations may provide some natural hedges .Its market position may occasionally permit it to entirely avoid transactions exposure. Second, at times these hedges may be quite imperfect, or too costly because of their adverse effects on sales or profit margins .Having decided to hedge whole or part of an exposure , the treasurer must evaluate alternative hedging strategies.

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