Foreign Exchange Market

Foreign Exchange [Currency] Market

The foreign exchange market in India is regulated by Reserve Bank of India [RBI]. Guidelines have been established for trading in foreign exchange. Limits for investments abroad and policy for purchase of foreign exchange when an individual is travelling to a foreign country or for any other purpose has been clearly specified by the RBI.

Exposure to derivative transactions for foreign currency as the underlying asset can be done only by corporate who have exposure to imports/exports. Recently, trading in USDINR currency futures has been launched by RBI and SEBI on national level currency futures exchanges. This provides for SME and MSME to also hedge their risk on currency futures segment.

Currency derivatives transactions in the OTC market can be undertaken only with banks. Banks, in turn, need to hedge their exposures on a back-to-back basis, with counterparties in India or abroad [Especially for Non-USDINR derivatives transactions].

During the early 1990s, India embarked on a series of structural reforms in the foreign exchange market. The exchange rate regime that was pegged earlier was floated partially in March, 1992 and fully in March, 1993. The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility, which was achieved in August, 1994. Banks are now permitted to approve proposals for commodity hedging in international exchanges from their corporate customers. Cancellation and rebooking of all eligible forward contracts booked by residents, irrespective of tenor, has been allowed. The closing time for inter-bank foreign exchange market in India has been extended by one hour up to 5.00 p.m. The ceiling for remittances for resident individual under the Liberalized Remittance Scheme for Resident Individuals has been enhanced in an phased manner and currently it stands at US $ 200,000 [Per financial year].

The limit on remittances for overseas investments to facilitate overseas acquisitions by corporates has been enhanced and the guidelines for external commercial borrowings have also been liberalized by raising the prepayment limits. The foreign exchange market has acquired a distinct vibrancy as evident from the range of products, participation, liquidity and turnover.

The phrase “Foreign Exchange” itself refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his own nation’s currency for money denominated in another nation’s currency acquires foreign exchange.

This holds true whether the amount of the transaction is equal to a few rupees or to billions of rupees; whether the person involved is a tourist cashing a Traveler’s Cheque in a restaurant abroad or an investor exchanging hundreds of millions of rupees for the acquisition of a foreign company; and whether the form of money being acquired is foreign currency notes, foreign currency-denominated bank deposits, or other short term claims denominated in foreign currency.

A foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian rupee [INR] is, broadly speaking, “Foreign Exchange“. Foreign exchange can be cash, funds available on credit cards and debit cards, traveler’s cheques, bank deposits, or other short-term claims. It is still “Foreign Exchange” if it is a short-term negotiable financial claim denominated in a currency other than INR.

Almost every nation has its own national currency or monetary unit – Rupee, Dollar, Peso – used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for “Foreign Exchange” transactions: exchanges of one currency for another.

The exchange rate is a price, the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency. There are scores of ‘Exchange Rates’ for INR and other currencies, say US dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the euro or the International Monetary Fund’s Special Drawing Rights [SDRs]. There are also various “Trade-Weighted” or “Effective” rates designed to show a currency’s movements against an average of various other currencies [e.g., US dollar index, which is a weighted index against world major currencies like euro, pound sterling, yen, and Canadian dollar]. Quite apart from the spot rates, there are additional exchange rates for other delivery dates in the forward markets.

A market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank, or another official body is a key participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range. But in countries like the United States, which follows a complete free floating regime, the authorities do not intervene in the foreign exchange market on a continuous basis to influence the exchange rate. The market participation is made up of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling US dollars at that particular time.

The participants in the foreign exchange market are thus a heterogeneous group. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whatever is the constitution of participants, and whether their motive is investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market price at that instant. Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain business. At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much else. The role of the foreign exchange market in the determination of that price is critically important.

During the past quarter century, the concept of a 24-hour market has become a reality. Somewhere on the planet, financial centers are open for business, and banks and other institutions are trading the dollar and other currencies every hour of the day and night, except for possible minor gaps on weekends. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade. The foreign exchange market follows the sun around the earth.

Business is heavy when both the US markets and the major European markets are open; that is, when it is morning in New York and afternoon in London. In the New York market, nearly two-thirds of the day’s activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have opened.

Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the 24-hour market does provide a continuous ‘real-time’ market assessment of the ebb and flow of influences and attitudes with respect to the traded currencies, and an opportunity for a quick judgment of unexpected events. With many traders carrying pocket monitors, it has become relatively easy to stay in touch with market developments at all times.

 

Currency Market Participants

The market consists of a limited number of major dealer institutions that are particularly active in foreign exchange, trading with customers and [more often] with each other. Most of these institutions, but not all, are commercial banks and investment banks. These institutions are geographically dispersed, located in numerous financial centers around the world. Wherever they are located, these institutions are in close communication with each other; linked to each other through telephones, computers, and other electronic means.

Each nation’s market has its own infrastructure. For foreign exchange market operations as well as for other matters, each country enforces its own laws, banking regulations, accounting rules, and tax code, and, as noted above, it operates its own payment and settlement systems. Thus, even in a global foreign exchange market with currencies traded on essentially the same terms simultaneously in many financial centers, there are different national financial systems and infrastructures through which transactions are executed, and within which currencies are held.

With access to all the foreign exchange markets generally open to participants from all countries, and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross-border foreign exchange trading among dealers as well as between dealers and their customers.

At any moment, the exchange rates of major currencies tend to be virtually identical in all the financial centers where there is active trading. Rarely are there such substantial price differences among major centers as to provide major opportunities for arbitrage. In pricing, the various financial centers that are open for business and active at anyone time are effectively integrated into a single market.

The dollar is by far the most widely traded currency. In part, the widespread use of the dollar reflects its substantial international role as ‘Investment‘ currency in many capital markets, ‘Reserve‘ currency held by many central banks, ‘Transaction‘ currency in many international commodity markets, ‘Invoice‘ currency in many contracts, and ‘Intervention‘ currency employed by monetary authorities in market operations to influence their own exchange rates.

In addition, the widespread trading of the dollar reflects its use as a ‘Vehicle‘ currency in foreign exchange transactions, a use that reinforces, and is reinforced by, its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the dollar, although very recently euro also has become an important vehicle.

Thus, a trader who wants to shift funds from one currency to another, say from INR to Philippine peso, will probably sell INR for USD and then sell the USD for peso. Although this approach results in two transactions rather than one, it may be the preferred way since the USDINR market and the USD/Philippine peso market are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other. By using the dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle.

Use of a vehicle currency greatly reduces the number of exchange rates that must be dealt with in a multilateral system. In a system of 10 currencies, if one currency is selected as vehicle currency and used for all transactions, there would be a total of nine currency pairs or exchange rates to be dealt with [i.e., one exchange rate for the vehicle currency against each of the others], whereas if no vehicle currency were used, there would be 45 exchange rates to be dealt with. In a system of 100 currencies with no vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates [the formula is: n(n-l)/2], Thus, using a vehicle currency can yield the advantages of fewer, larger, and more liquid markets with fewer currency balances, reduced informational needs, and simpler operations.

The US dollar took on a major vehicle currency role with the introduction of the Bretton Woods par value system, in which most nations met their IMF exchange rate obligations by buying and selling US dollars to maintain a par value relationship for their own currency against the US dollar. The dollar was a convenient vehicle because of its central role in the exchange rate system and its widespread use as a reserve currency. The dollar’s vehicle currency role was also due to the presence of large and liquid dollar money and other financial markets, and, in time, the euro-dollar markets, where the dollars needed for [or resulting from] foreign exchange transactions could conveniently be borrowed [or placed].

 

Some Major Currencies

• • Euro: The euro was designed to become the premier currency in trading by simply being quoted in American terms. Like the US dollar, the euro has a strong international presence and over the years has emerged as a premier currency, second only to the US dollar.

• • Yen: The Japanese yen is the third most traded currency in the world. It has a much smaller international presence than the US dollar or the euro. The yen is very liquid around the world, practically around the clock.

• • Pound: Until the end of World War-II, the pound was the currency of reference. The nickname cable is derived from the telegrams used to update the GBP/USD rates across the Atlantic. The currency is heavily traded against the euro and the US dollar, but it has a spotty presence against other currencies. The two year bout with the Exchange Rate Mechanism [ERM], between 1990 and 1992, had a soothing effect on the British pound, as it generally had to follow the Deutsche mark’s fluctuations, but the crisis conditions that precipitated the pound’s withdrawal from the ERM had a psychological effect on the currency.

• • Swiss Franc: The Swiss franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. Although the Swiss economy is relatively small, the Swiss franc is one of the major currencies, closely resembling the strength and quality of the Swiss economy and finance. Switzerland has a very close economic relationship with Germany, and thus to the euro zone.

 

Need For Exchange Traded Currency Futures

With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April, 2008, recommended the introduction of exchange traded currency futures.

 

OTC And Exchange Traded Derivatives

Exchange traded futures as compared to OTC forwards serve the same economic purpose, yet differ in fundamental ways. An individual entering into a forward contract agrees to transact at a forward price on a future date. On the maturity date, the obligation of the individual equals the forward price at which the contract was executed. Except on the maturity date, no money changes hands. Only cash settlement of the positions is done. This enhances the counterparty default risk in over-the-counter markets.

 

On The Other Hand, In The Case Of An Exchange Traded Futures Contract

• • Mark to market obligations are settled on a daily basis. Since the profits or losses in the futures market are collected/paid on a daily basis, the scope for building up of mark to market losses in the books of various participants gets limited.

• • The counterparty risk in a futures contract is further eliminated by the presence of a clearing corporation, which by assuming counterparty guarantee eliminates credit risk.

• • Further, in an Exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market, equitable opportunity is provided to all classes of investors whether large or small to participate in the futures market.

• • The transactions on an exchange are executed on a price time priority ensuring that the best price is available to all categories of market participants irrespective of their size.

• • Other advantages of an Exchange traded market would be greater transparency, efficiency and accessibility.

• • Margining system based on Value-at-risk measures with extreme loss margins to be incorporated to ensure exchange and clearing corporation manage settlement risk. Real-time management and monitoring of MTM obligations and margins requirements would be in place.

The main beneficiaries of the currency futures trading would include anybody having exposure to imports or exports [corporates] as well as banks who are authorized dealers of forex. They would benefit due to the better price discovery of the fair value of the USD/INR and also due to smaller lot sizes, better risk management capabilities [due to mark to market of profits/losses], settlement on next day, etc.

 

Benefit Of Trading In Currency Futures

The benefit of trading in Currency Futures is encapsulated as follows:

• • Linear Payoff – not complicated for market participants to understand.
  • Standardized Contracts, small lot size – US$ 1,000.
  • Electronic Settlement of MTM Profit/Loses.
  • No counterparty default risk – novation by clearing house.
  • Efficient price discovery due to high liquidity.
  • Large number of market participants.
  • Transparency – real-time dissemination of prices.
  • Access through internet from remote locations.
  • Additional tool for hedging currency risk.
  • Broader participation – leading to enlarged forex market.
  • Permit trades other than hedges with a view to moving gradually towards fuller capital account convertibility.
  • Enhanced retail participation.
  • Efficient method of credit risk transfer through the Exchange.
  • Facilitate large volume transactions.
  • Trade match is anonymous.
  • Well regulated structure.
  • Ready national level reference rates at any point of time during trading hours.

 

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