Foreign exchange Market

Introduction

The foreign exchange market is basically a market that survives wherever one currency is traded for one more. It is also considered to be the largest market in the world, this market deals with cash value traded, and comprises of trading amid large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions.  

The foreign exchange market is slightly different from the other financial markets (stock market) since one does not exchange a valuable against some money, but a currency for another currency. Every transaction price involves a pair of currencies, e.g. EURO, POUND. 

Foreign exchange markets provide the mechanism of exchanging different monetary units. Such a facility/mechanism is essential when countries trade with each other. Apart from trade, sometimes, nationals of one country may prefer to hold financial assets in a foreign currency or dominate in a foreign currency because domestic currency is subject to high inflation and therefore less attractive as a store of value. 

International trade as well as the movement of capital among different countries necessitates the conversion of currencies. Exchange dealers (also called campsites) do the job of exchange of currencies. The demand and supply in the foreign exchange market permits the establishment of rates of different currencies in terms of local currency. These markets represent institutional arrangements where foreign exchange operations take place.    The foreign exchange market is not a physical place; it is an informal, electronically linked network of big banks, foreign exchange brokers and dealers whose function is to bring buyers and sellers together. The foreign exchange market operates on very narrow spreads between buying and selling prices; they can be smaller than a tenth of a per cent of the value of currency traded, and they are about one-fiftieth or less of the spread faced on bank notes by international travelers. Yet, because the volumes of transactions involved are huge, traders in foreign exchange market stand to make huge profits or losses. 

The foreign exchange market is basically a market that survives wherever one currency is traded for one more. It is also considered to be the largest market in the world, this market deals with cash value traded, and comprises of trading amid large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions.

Structure of foreign exchange rate

The organization and structure of foreign exchange market is divided in two parts 

Ø Wholesale 

Ø Retail 

 Retail market:

The exchange of bank notes, bank drafts, currency, ordinary and traveler’s cheques between private customers, tourists and banks take place in the retail market. 

The Reserve bank of India has granted two types of money changer’s licenses to certain established firms, hotels, shops, and other organizations to deal in currency notes, coins, and traveler’s  cheques to a limited extent. While the “full-fledged money changers” can undertake both purchase and sale transactions with the public, “restricted money chargers” can only purchase foreign currency from the foreign tourists. 

Wholesale Market:

The wholesale market is primarily an inter-bank market in which major banks trade in currencies held in different currency-dominated bank accounts i.e., they transfer bank deposits from sellers to buyer’s accounts. This market is far larger than the bank notes market. Only the head offices and regional offices of the major commercial banks are the market makers (entities which deal with assets on their own accounts) in the wholesale market. Most of the small banks and the local offices of even the major banks do not deal directly in the inter-bank market. They usually have a credit line with large banks or with their head offices and they serve their customers through latter. 

Through correspondent relationship with banks in other countries, major banks have ready access to foreign currencies. As indicated earlier, inter-bank foreign currency transactions usually do not involve a physical transfer of currency, they simply involve bookkeeping entries among banks. There is no central location for this market and trading in it is continuous, banks do not normally charge a commission on their currency transactions, they profit from the spread between the buying and selling rates. 

Inter-Bank Market:

The inter- bank market can thus be said to have two parts: direct and indirect. In the direct market, banks quote buying and selling prices directly to each other and all participating banks are market makers. It has been sometimes characterized as a “decentralized, continuous, open-bid, double-auction” market. In the direct market, the banks put orders with brokers who put them on “books”, and try to match purchases and sales orders for different currencies. They charge commission to both the buyers and sellers. This market is characterized as “quasi-centralized, continuous, limit-book, single-auction” market. 

Forward exchange market:

The banks selling or buying currencies forward constitute the forward market. This market fixes the rates at which currencies will be exchanged on a future date. The forward market primarily deals in currencies that are frequently used and are in demand in international trade such as US dollars, Pound sterling, Deutschmark etc. There is little or no forward market for the currencies of developing countries. Forward rates are quoted with reference to spot rates as they are always traded at a premium or discount Vis-a- Vis spot rate in interbank market. The forward market can further be divided into two parts: 

Ø Merchandise

Ø Non merchandise 

Spot:

Spot transactions in the foreign exchange market are increasing in volume. These transactions are in forms of buying and selling of currency notes, encashment of traveler’s cheques and transfer foreign exchange reserves through banking channels.  Major participants on spot exchange market are: 

Ø Commercial banks

Ø Dealers, brokers, arbitrageurs and speculators

Ø  Central banks 

Relation between spot rate and futures price: 

The price of futures is closely related linked with spot rate. The difference between the two is dependent on the number of days to maturity and interest rates of the two currencies. This is called “basis” and given by the equation:          

     Basis = Future rate – Spot rate

                          Or       

                         

     Future rate = Spot rate + Basis

The foreign exchange market is unique because of 

Ø its trading volumes 

Ø the extreme liquidity of the market

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

Ø its geographical dispersion 

Ø its long trading hours: 24 hours a day 

Ø the variety of factors that affect exchange rates. 

Ø the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes) 

Organization of foreign exchange market in India

At present, there are 84 banks in India who have been authorized to deal in foreign exchange; they are known as Authorized Dealers (Ads), and the public has to conduct all their foreign exchange transactions through them. Of these, foreign banks and bigger Indian banks are more active, giving two-way quotes. The market operates from the major centers such as Mumbai, Delhi, Calcutta, Chennai, Bangalore, Kochi, and Ahmedabad, with Mumbai, accounting for the major part of the transactions. These authorized dealers have formed an organization called Foreign Exchange Dealers Association of India (FEDAI), which sets the ground rules for fixation of commission and other charges.

Besides banks, financial institutions such as IDBI, ICICI, IFC, etc. have been given license to undertake forex transactions incidental to their main business activities. A large part of inter-bank transactions is conducted through 40 exchange brokers who are specialists in matching supplies and demands of banks, who work for a commission. The currencies are traded by the RBI on its own behalf and also on behalf of the government. 

Global Forex Market & Indian Market:   

The foreign exchange market in developed countries different foreign exchange reserves in two important respects. First, in the former they are generally freer than in latter, although such a difference has diminished in the recent past.  Second, in the latter they are expected to provide service more to the import and export trade rather than for pure exchange trading as is the case in the former.

Foreign exchange risk management

Foreign exchange risk is the exposure of a company’s financial strength to the potential impact of movements in foreign exchange rates.  The risk is that adverse fluctuations in exchange rates may result in a reduction in measures of financial strength. 

It is acknowledged that specific foreign exchange risk practices may differ among banks depending upon factors such as the institution’s size, and the nature and complexity of its activities. However, a comprehensive foreign exchange risk program should deal with, at minimum, good management information systems, contingency planning and other managerial and analytical techniques.

A Board of Directors should: 

a) Approve a policy on foreign exchange risk; 

b) Review, at least once a year, the policy, techniques, procedures, and information systems referred to in that policy;

c) Ensure adherence to the policy techniques, procedures and informational systems referred to in that policy; 

d) Ensure that qualified and competent persons i.e. senior management, are employed to manage and control the bank’s exposure to foreign exchange; and 

e) Direct senior management to submit a comprehensive written report to the board of directors of the bank on the management of exposure to foreign exchange risk at least once a year, and to submit such other reports at such intervals as the board may require. 

Strategy, Monitoring and Control 

A bank should establish a written policy on foreign exchange risk that:

a) Includes a statement of principles and objectives governing the extent to which a bank is willing to assume foreign exchange risk; 

b) Establishes prudent limits on a bank’s exposure to foreign exchange risk; and  

c) Clearly defines the levels of personnel who have the authority to trade in foreign exchange.

d) Clearly identifies the different currencies, which have been approved for transaction within the company. 

Internal audit 

a)     Banks should have in place adequate internal audit coverage of the foreign exchange and the settlement process to ensure that operating procedures are adequate to minimize risk. A bank’s board of directors – either directly or through its audit committee - should ensure that the scope and frequency of the foreign exchange internal audit program is appropriate to the risks involved. 

b)    The board of directors or its audit committee should ensure that audit reports are distributed to appropriate levels of management for information and so that timely corrective action can be taken. Management should detail, in writing, the action taken. The board of directors or its audit committee should regularly review this and consider any outstanding issues. Where appropriate it should ensure that a follow-up audit is undertaken. 

c) When audit findings identify areas for improvement in the foreign exchange or settlement area, other areas of the bank on which this may have an impact should be notified. This could include credit risk management, reconciliations/accounting, systems development, and management information systems. In automated settlement processing, the internal audit department should have some level of specialization in information technology auditing, especially if the bank maintains its own computer facility.

Foreign Exchange settlement risk

When dealing with foreign exchange transactions the issue of settlement risk often arises.  Foreign Exchange Settlement risk is the risk of loss when a bank in a foreign exchange transaction pays the currency it sold but does not receive the currency it bought.  Settlement risk exists for any traded product, but the size of the foreign exchange market makes foreign exchange transactions the greatest source of settlement risk for many market participants. In light of the aforementioned, a bank should have systems that provide appropriate and realistic estimates of foreign exchange exposures on a timely basis.  These systems would include policies and procedures similar to those mentioned in the previous section with emphasis on understanding settlement risk and formulating a clear and firm plan on its management.

Procedures for managing fails and other problems 

Ø Operational errors

Operational errors are the most common source of fails. While such mistakes may be inadvertent and corrected within a reasonable time, they may in some cases be indicative of more fundamental problems, including credit problems, and so banks should have procedures for quickly identifying fails and taking appropriate action. Such action should normally involve informing the credit department, so that a judgement can be made about the seriousness of the problem. Because a fail represents continued exposure to the counter-party for the full principal value of the trade, banks should include fails in their measures of current and expected. Banks may also need to take steps to obtain the funds due and to try to avoid recurrences.  

Ø When reacting to a fail or to another potential problem with the settlement of an FX deal, banks need to strike a balanced approach. If there appears to be an underlying credit-worthiness problem, the bank may decide that it is prudent to reduce its limit for that counter-party. In more extreme cases, it may decide that, to protect itself from settlement risk, it needs to suspend issuing payment instructions for outstanding deals with that counter-party or to cancel existing payment instructions (if possible). However, failure to pay could have serious consequences; it could constitute a breach of contract by the bank and may cause liquidity problems for the counter-party. Such action should thus only be taken when, after a careful but prompt review of the circumstances, the bank's senior management judges that the situation warrants it.  

Ø Contingency planning 

Contingency planning and stress testing should be an integral part of the FX settlement risk management process. Contingency plans should be established to include a broad spectrum of stress events, ranging from internal operational difficulties to individual counter-party failures to broad market related events. Adequate contingency planning in the FX settlement risk area includes ensuring timely access to key information, such as payments made, received or in process, and developing procedures for obtaining information and support from correspondent institutions. An institution should also have a contingency plan in place to ensure continuity of its FX settlement operations if its main production site becomes unusable. This plan should be documented and supported by contracts with outside vendors, where such vendors provide services to the bank that are necessary either to the bank's normal FX settlement or to its contingency plans. Because in many cases the action taken will be similar, contingency planning for FX settlement problems should be coordinated with the planning for other problems (such as payment system or trading room failures). Contingency plans should be tested periodically.

Conclusion

Exchange control process is ever evolving towards less of control and more of regulation. Foreign exchange markets provide the mechanism of exchanging different monetary units in circulation in different countries and thus facilitate transfer of purchasing power from one country to another. When there is trade or a financial transaction, there is a transfer of purchasing power from one country to another. Due to globalization of exchanges, the foreign exchange market has become a market without frontiers even as individual states may adopt policies to control the exchange.  

Exchange markets help with providing cover against exchange rate risk. In international trade operations, participants protect themselves from exchange risk by buying or selling currencies forward. Likewise, banks reduce risk of loss by not keeping the exchange positions open for too long at a time. It is common in foreign exchange transactions to specify limits to the dealers in order to reduce risks. The internal limits are given by the higher management of a bank. These limits are in terms of Spot or Forward position on each currency. The external limits may be fixed by central banks.