Structure of foreign exchange Market
Structure of Market
The forex market is formed by Foreign Exchange Dealers Association and the Foreign Exchange: Brokers Association. One can participate in the foreign exchange market through a broker only unless one is the member of the foreign exchange dealers association. Foreign exchange market, are generally located in major financial centers such as New York, Paris, Frankfurt, Zurich, Tokyo, Singapore, Hongkong, Mumbai, etc., For foreign exchange there are no specific trading locations like those for securities or commodities. It is non-localised market. The participants arrange transactions over telephone, telex or use other modern means of communications. The size of the market depends on the size of international transactions, i.e.,the trade flows and investments. Since foreign exchange markets are spread over the whole globe, therefore the market for foreign exchange never closes on the globe. In India’ foreign exchange Dealers Association of India (FEDAI) sets the rules of the game in the Indian forex market. FEDAI fixes the exchange margins, interest rates on various types of payment orders.
Why the Market for Foreign Exchange Exists
International Payments This is because, in the absence of barter, for every real (commodity) transaction there is a currency transaction, i.e.,for every purchase of goods or services, currency is to be paid. We know that there are two types of transactions in the forex market:
(a) Spot transactions and
(b) Forward transactions. Spot transaction in the forex market represent the counterpart of a trade transaction in commodities or assets. Now question arises that why do the forward contracts exist? There are two reasons for this:
(i) Speculation and
Speculation- Speculators can speculate in the for-
ward market by buying and selling currencies when they expect that the future spot rate will differ from the forward rate. If speculator expect the future spot rate to overshoot forward rate, the speculator will buy in the forward market. If the converse is expected, the speculators will sell the currency in the forward.
Hedging- Hedging by definition means protecting
oneself against adverse exchange rate movements. We can understand the meaning of hedging by the following example:
Suppose an Indian importer has ordered import of a machine from Germany for DM 20,000. The payment is to be made at the time of delivery, which is scheduled 30 days hence. His finance advisor expects rupee to depreciate against DM and advises him to hedge the transaction. He buys DM 20,000 in the forward market at the quoted one month forward rate. As per this contract, the importer will receive OM 20,000 in exchange for rupees at the agreed rate one month hence. This activity of the importer is called hedging.
Fundamentally, all hedging transactions are speculative in nature because there is an expectation that hedging will provide better solution than the non-hedged situation.nIn the above hedging example, it is the finance advisor of the importer who strongly felt that Indian rupees will depreciate against OM, therefore he advises the importer to hedge the transaction.
Forward Contract and Future Contract
Forward Contract – A forward contract is a contract for future delivery of a currency at the agreed price. The price is fixed in the present. The forward contract for the future delivery of a particular currency must have the following information:
1.name of the principal party,
2.name of the counter party,
3.name of the currency to be delivered,
4.amount of currency to be delivered,
5.date of delivery,
6.place of delivery,
7.price agreed upon,
8.the date when the contract is sold,
9.the value date, and
10.bank accounts from where provided and where to be delivered.
The buyer of a forward exchange contract is obli-
gated to take delivery under the terms of the contract and seller of the forward exchange contract is obligated to make delivery under the terms of the contract. There is a difference between a forward contract and futures contract. The difference is not of functional content but of institutional arrangements for carrying out the deal.
When two persons strike out a deal for delivery at
any future date, it has the characteristic of a forward contract. In such a deal, the parties are free to make specifica tions, i.e.,forward contract can be tailored as per the customer’s requirement.
Future Contract: It is a standardised contract in
terms of amount and the time of delivery. A British Pound future comprises of BP 62,500 and it matures every third Wednesday of March, June, September and December in an year at Chicago Mercantile Exchange (CME). Different currency futures have different standardised amounts in them, e.g. a German mark future has, OM 125,000. Forward contract is a contract between two individuals where as the futures Contract is a contract between customer and the future exchange.
Future Market is a speculative market. Detailed discussion is given in the chapter on derivatives.
Value Dates and Cash Flows
Identification of foreign cash flows in any organization requires the specification of dates on which the cash flow is going to take place. One more characteristic which identifies a cash flow is the location where it occurs. This is given country or city. usually identified, in terms of name of an institution in a Fund manager will want to verify that in each transaction the following characteristics of the given cash flows are well understood by the parties to the transaction:
1.The name of other party to the transaction;
2.Whether the specific currency or money market instrument is being purchases or sold;
3.The amount involved;
4.The location where the funds or instrument pur-
chased is required(wanted);
5.The location where the other party wants the funds or instrument purchased to be placed;
6.The rate to be used for the transaction; and
7.The value date
If there are many cash flows in several currencies, as is the case with the banks, the value dates of interest are to be observed. There are two summary measures of cash flows that are of particular interest to the fund manager. One is net cash flow each currency specific to a value date. The other is the net exchange position in each currency for the aggregate of value dates being managed. The net cash flow in a currency, for a given value date, is computed as the net of inflows and outflows or that currency on the given value date. The net cash flow is either net inflow or net outflow. Net exchange position in a given currency is the difference between all cash inflows and outflows in that currency aggregated for all the value dates of interest. If inflows are larger than outflows for that period of time, we have a net long or net over bought position in that currency. If outflows are larger than inflows we have net short or oversold position. If inflows are equal to outflows, then we have a square position.
Value Dates – Because of the technicalities involved in expressing the time when a cash flow is to take place, we shall discuss the concept of value dates. As we know that there are two major time dimensions in foreign exchange market:
1. Spot transactions are for a value date, two business days following the day when the transaction is closed.
2.Forward transactions are for value dates in future usually computed as a number of months from the spot value date at the time of transaction.
Value dates as of ‘Right Now’ are also possible. However this will not be genuine spot transaction and the spot rate would not apply in spite of its resemblance to spot transaction. In India we have two specific transactions resembling to spot transaction. These are OIN, i.e.,over night, and T/N, i.e.,tomorrow night. These are also not genuine spot transactions. If we deal with value date today, an adJustment of the spot rate may be necessary to reflect interest rates for the two, days between today and the value date of the spot transaction.
Eligible Value Dates To be an eligible value date, a
value date must be a business day in the home country of the currency involved in the transaction. In most countries,
the business days are from Monday to Friday.
Treatment of two Business Days Involved In Spot
Transaction for Fixing the Value Date- For the two business days involved in the spot transactions, interest is paid to the parties. The customer who buys dollars receives interest on dollars and the counter party receives the interest on rupees if the deal is for the purchase of dollars against rupees.
Settlement of Transactions in the International Forex Markets: Western markets are developed financial markets and their settlement systems are electronically equipped. European markets settle their transactions through a satellite communication network called SWIFT (Society for World wide International Financial Telecommunications). The banks and brokers are linked together with telephone, telex and ultimately with SWIFT. This is a computer based in Brussels, Belgium. The banks and brokers are in constant touch with SWIFT and as soon as the contracts are sold, the settlement is positioned and executed at proper time. The activity in some of these financial markets runs 24 hours a day. In dollar market, the settlement is done through CHIPS an acronym used for Clearing House Inter Bank Payment System. This is also computer based system which links banks and brokers via satellite. From SWIFT one can enter the CHIPS and vice Versa. The CHIPS is located in New York.
In India, all transactions are reported to Reserve Bank of India. The details of the transactions are sent to the RBI and clearance is sought if needed. The settlement is done by the banks from their accounts held in different currencies.