1. Module 3 - Foreign Exchange Market
Chapter 1 - Concept of Foreign Exchange Market
Introduction
Meaning of Foreign Exchange Market
Features of Foreign Exchange Market
Functions of Foreign Exchange Market
Dealers of Foreign Exchange Market
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2. Introduction
Say, I purchase 100 US$ for Rs. 60 per $. Therefore, I paid Rs. 6,000.
After a week, the rate of $ was Rs. 62. Now, I sell these 100 US $ and I earn Rs. 6,200 thereby making a profit of Rs. 200.
Now, suppose, the rate of $ was Rs. 54 after a week and if I sell these 100 $, I will get Rs. 5,400 and suffer a loss of Rs. 600.
Rs.60/$
Rs. 6000
PURCHASES
Rs.62/$
Rs. 6200
(Rs. 200 Profit)
SALES
Rs.54/$
Rs. 5400
(Rs 600 Loss)
SALES

3. Introduction
So, basically, the foreign exchange market works on the same principle of a share market.
The only difference is that in the foreign exchange market, “currency” is traded,
while in the share market, “shares” are traded.

4. Meaning of Foreign Exchange Market
A foreign exchange (forex) market is a financial market where the participants of the market are able to buy and sell currencies. The participants include individuals, government, companies etc.

5. Need For A FOREX Market
In internal trade, the buyer and the seller belong to same country. Hence, the currency used is also same. Thus, a buyer in India can make payment to Indian seller in Rupee.
BUYER
SELLER

6. Need For A FOREX Market
However, in international trade, the buyer and the seller are situated in different countries. The seller would always prefer that he receives the payment from the buyer in his (seller’s) home country currency.
BUYER
SELLER

7. Meaning of Foreign Exchange Market
E.g.: Suppose an importer “A” who is in India, imports some goods from an exporter “B” who is in U.S.
The exporter B would prefer to receive the payment in U.S. Dollars (USD). So the Indian importer has to exchange rupees for USD
and then pay the price of the commodity to ‘B’ in USD.

8. Meaning of Foreign Exchange Market
Though, the forex markets came into existence for the purpose of international trade & travel, now there are various participants in forex markets who trade in currencies with a view to earn profit.

9. Features of Foreign Exchange Market1
LOCATION 2
PARTICIPANTS 3
SIZE 4
COMMONLY TRADED CURRENCIES 5
WORKING HOURS 6
HIGHLY SENSITIVE

10. COMMONLY TRADED CURRENCIES
LOCATION
PARTICIPANTS
SIZE
COMMONLY TRADED CURRENCIES
WORKING HOURS
HIGHLY SENSITIVE
A forex market is not restricted to one place. There is no central market place for the exchange of currency. It is spread in all countries all over the world.

11. COMMONLY TRADED CURRENCIES
LOCATION
PARTICIPANTS
SIZE
COMMONLY TRADED CURRENCIES
WORKING HOURS
HIGHLY SENSITIVE
The major participants of the forex market are central banks, foreign institutional investors (FIIs), individuals and corporate.
The participants participate in the forex market either to earn profits from trading
or in order to exchange currency to make foreign currency payments.
Central banks participate in the forex market with a view to control the supply of foreign currency in the country.

12. COMMONLY TRADED CURRENCIES
LOCATION
PARTICIPANTS
SIZE
COMMONLY TRADED CURRENCIES
WORKING HOURS
HIGHLY SENSITIVE
The average daily turnover in the global forex market has crossed 5.3 trillion USD as per a report by the Bank of International Settlements (BIS).
1 trillion = 1 lac crore.
The average daily turnover in the foreign exchange market in India is around 31 billion USD.
1 billion = 1000 crores.

13. COMMONLY TRADED CURRENCIES
LOCATION
PARTICIPANTS
SIZE
COMMONLY TRADED CURRENCIES
WORKING HOURS
HIGHLY SENSITIVE
All countries trade with each other. Therefore, all currencies are purchased and sold on the forex market. But the most commonly traded currencies are:
US$
Euro
Pound Sterling
and Japanese Yen

14. COMMONLY TRADED CURRENCIES
LOCATION
PARTICIPANTS
SIZE
COMMONLY TRADED CURRENCIES
WORKING HOURS
HIGHLY SENSITIVE
As the forex market is spread all over the world, it works for all the 24 hours of the day. When there is night in some countries and the market is closed, there is day in some other countries and the market is open there. However, it is closed on Saturdays and Sundays throughout the world.

15. COMMONLY TRADED CURRENCIES
LOCATION
PARTICIPANTS
SIZE
COMMONLY TRADED CURRENCIES
WORKING HOURS
HIGHLY SENSITIVE
The forex market is a highly sensitive market. Any incident in any part of the world produces far reaching effects on the forex market.

16. Functions of Foreign Exchange Market
The institutions which work on the foreign exchange market discharge the following functions :
Transfer of Purchasing Power
Provision of Credit
Covering Foreign Exchange Risks

17. TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
Purchasing power in reference to foreign exchange markets refers to the power of purchasing from another (foreign) country. Foreign exchange markets enable the transfer of purchasing power.

18. TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
Residents of one country may require the currency of another country for importing goods & services, unilateral payments, investment, payment of dividend or for any other transaction. This foreign currency can be made available only due to the existence of the foreign exchange market. Thus, foreign exchange markets enable the transfer of purchasing power and helps international trade.

19. TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
Arjun who is a resident of Mumbai has imported some designer clothes from a designer, Mr. Andrew who is a resident of New York. Arjun wants to remit $ 1000 to Andrew towards the price of the clothes which he has imported.
$ 1000
Please

20. SBI, PAY EQUIVALENT OF $1000 TO ANDREW
Arjun has his account with SBI Mumbai and Andrew has his account with American Express Bank, New York.
Arjun gives an instruction to SBI Mumbai to pay an equivalent of $ 1000 to Andrew.
SBI, PAY EQUIVALENT OF $1000 TO ANDREW

21. Debit Arjun’s account by Rs. 60000/-
Suppose on that day, the rate of exchange is $ 1 = Rs. 60, SBI Mumbai will debit the account of Arjun by Rs. 60,000 and will instruct the American Express Bank, New York to pay $ 1000 to Andrew.
On receiving this intimation from SBI Mumbai, the American Express Bank, New York will credit the account of Andrew by the same amount
Debit Arjun’s account by Rs /-
Pay $ 1000 to Andrew

22. TRANSFER OF PURCHASING POWER PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
Importers of goods & services may require a certain time period before making the full payment to the exporter. Thus, at times, importer requires certain credit period. For this purpose, the importer may issue credit instruments like foreign exchange bill, drafts, letter of credit etc.

23. TRANSFER OF PURCHASING POWER PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
These instruments can be discounted by the exporter within his bank in the domestic country. Thus, foreign exchange market facilitates the provision of credit in foreign exchange transactions.

24. COVERING FOREIGN EXCHANGE RISKS
TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
International trade involves receipts and payments in foreign currency. Foreign exchange rates keep fluctuating constantly. The importers and exporters may bear losses on account of these foreign exchange fluctuations. They therefore try to protect themselves from such fluctuations.

25. COVERING FOREIGN EXCHANGE RISKS
TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
The risk on account of foreign exchange fluctuation has been explained below:
IMPORTER
Suppose, Mr. A has imported goods from U.S.A. worth 20,000$ on At that time, the rate was 1$= Rs. 50. Therefore, if he had to pay immediately, he would have to pay Rs. 1,00,000.
$20000 = Rs. 1,00,000

26. COVERING FOREIGN EXCHANGE RISKS
TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
He enjoys a credit period of 3 months after which payment has to be made to the exporter. Now, on 31st January, 2014, the foreign exchange rate is 1$=Rs. 60. Therefore, now he has to pay Rs. 1,20,000 i.e. Rs. 20,000 more.
$20000 = Rs. 1,00,000 + Rs. 20,000

27. COVERING FOREIGN EXCHANGE RISKS
TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
EXPORTER
Suppose, Mr. A had exported goods to U.S.A. worth 20,000 USD on At that time, the rate was $ 1= Rs. 50. Therefore, if he had received the payment immediately, he would have received Rs. 1,00,000.
$20000 = Rs. 1,00,000

28. COVERING FOREIGN EXCHANGE RISKS
TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
He extended a credit period of 3 months. Now, on 31st January, 2014, the foreign exchange rate is 1$=Rs. 40. Therefore, now he receives only Rs. 80,000 i.e. Rs. 20,000 less.
$20000 = Rs. 1,00,000 – Rs

29. COVERING FOREIGN EXCHANGE RISKS
TRANSFER OF PURCHASING POWER
PROVISION OF CREDIT
COVERING FOREIGN EXCHANGE RISKS
The foreign exchange market helps the importers and exporters to cover their risks by way of hedging. Hedging is done by importers and exporters to protect themselves from the loss that they may suffer due to fluctuations in the foreign exchange market.
Note: Hedging has been explained in detail later in the chapter.

30. Dealers of Foreign Exchange Market
A dealer is an individual or an institution which purchases and sells a particular commodity. Similarly, a foreign exchange dealer is an individual or an institution which purchases or sells different currencies. The following are the dealers on the foreign exchange market:
Commercial Banks
Dealers of Bills of Exchange
Investment Firms
Central Bank of the Country

31. DEALERS OF BILLS OF EXCHANGE
COMMERCIAL BANKS
DEALERS OF BILLS OF EXCHANGE
INVESTMENT FIRMS
CENTRAL BANK
This is the largest group of foreign exchange dealers. The banks have branches in different parts of the country and also in several countries in the world. They use these branches for undertaking functions of the foreign exchange market such as remitting money from place to place, advancing loans to the importers and exporters, hedging etc.

32. DEALERS OF BILLS OF EXCHANGE
COMMERCIAL BANKS
DEALERS OF BILLS OF EXCHANGE
INVESTMENT FIRMS
CENTRAL BANK
Bills are drawn when some goods are sold. The seller (exporter) draws a bill on the buyer (importer). This bill is accepted by the buyer. The seller can sell that bill or can discount it with some other individual or institution. The bill brokers work as intermediates between the seller of the bill and the buyer of the bill.

33. DEALERS OF BILLS OF EXCHANGE
COMMERCIAL BANKS
DEALERS OF BILLS OF EXCHANGE
INVESTMENT FIRMS
CENTRAL BANK
Investment firms are one of the important dealers on the foreign exchange market. They handle the investments of their clients. At the same time, they deal in foreign currencies.

34. DEALERS OF BILLS OF EXCHANGE
COMMERCIAL BANKS
DEALERS OF BILLS OF EXCHANGE
INVESTMENT FIRMS
CENTRAL BANK
Every country has a central bank which regulates the supply of money and bank money. One of the functions of the central bank is to deal in foreign exchange.
TO PROVIDE THE REQUIRED FOREIGN EXCHANGE TO THE GOVERNMENT:
In any country the government requires foreign exchange for different purposes. The government imports several commodities and the government has to pay for them. The government has to meet the expenditure of the different embassies working in different countries. The government also requires foreign currencies for making unilateral payments by way of prizes, awards and donations to other countries. The central bank purchases foreign exchange from the market and provides it to the government.

35. DEALERS OF BILLS OF EXCHANGE
COMMERCIAL BANKS
DEALERS OF BILLS OF EXCHANGE
INVESTMENT FIRMS
CENTRAL BANK
TO STABILIZE THE RATE OF EXCHANGE:
The price of a currency fluctuates from day to day depending upon the demand for and supply of the currency. Marginal fluctuations are tolerable but extreme fluctuations are harmful. If a currency depreciates to a large extent, the imports become costly which may cause inflation. On the contrary, if a currency appreciates beyond a particular level, goods exported by using that currency become costly in the foreign market. The foreign demand for them may fall and the country may lose foreign markets. Hence it is necessary to control the rates of exchange within a permissible margin. This responsibility is discharged by central bank of the country.

36. DEALERS OF BILLS OF EXCHANGE
COMMERCIAL BANKS
DEALERS OF BILLS OF EXCHANGE
INVESTMENT FIRMS
CENTRAL BANK
TO STABILIZE THE RATE OF EXCHANGE:
E.g. If the dollar is appreciating fast in terms of the rupees, the RBI sells dollar in large amount. The supply of dollars increases with the effect that price of the dollar in term of rupees comes down.

37. DEALERS OF BILLS OF EXCHANGE
COMMERCIAL BANKS
DEALERS OF BILLS OF EXCHANGE
INVESTMENT FIRMS
CENTRAL BANK
TO STABILIZE THE RATE OF EXCHANGE:
On the other hand, if the dollar is fast depreciating in terms of rupees, the RBI purchases dollars in large amounts. The demand for dollars increases with the effect that the price of the dollar in terms of rupees increases.

38. For your understanding
When a currency depreciates, more amount of currency is required to purchase foreign currency. When a currency appreciates, less amount of currency is required to purchase foreign currency.
Current exchange rate
Appreciates
Depreciates
$1 = Rs.60/-
$1 = Rs.55/-
$1 = Rs.65/-

39. For your understanding
When Rupee appreciates, lesser amount is required to purchase $1. Thus, previously Rs.60/- were required to purchase $1. Once rupee appreciates, only Rs.55 is required to purchase $1. However, if rupee depreciates, more amount of rupees is to be spent to purchase $1.
Rs. 60
$ 1
Rs. 55
$ 1

40. For your understanding
If a rupee depreciates, imports become costly. This is because, say importer has to pay 1000 dollars to purchase commodities. At the current rate, he is required to spend only Rs.60,000/- (1000 x 60). However, once the rupee depreciates he is required to spend Rs.65,000/-.
If a rupee appreciates, the foreign demand falls as price of goods increases. Say, an importer is US buys goods worth Rs.1,20,000 from Indian seller. At current exchange rate, he can buy Rs.1,20,000 by selling 2,000 dollars. However, if the rupee appreciates to Rs.55/-, he has to now spend 2,182 dollars ( / 55). Thus, the expenditure of importer has now increased.