Till date we all must have heard about Forex Market and some of them might have insights about this type of market and some might not be aware off. Well a Forex market is a place where currencies are traded. Whether people realize it or not but in order to transact in any other country be it a foreign trade or business, currencies are the most important medium. For an example: If an Indian tourist wants to visit New York (U.S) than he/she cannot pay Indian rupees to see the Statue of Liberty because it is not a locally accepted currency, so the tourist has to exchange Indian rupees to U.S dollar at the current exchange rate. Therefore, this article will focus about what is Forex Market, participants of Forex Market, instruments of Forex Market etc.
What is Forex Market?
Foreign Exchange Market (Forex Market or Currency Market) is a worldwide regionalized market for the trading of currencies. Forex Market regulates the relative values of different currencies. Forex Market involves a trading between multiple range of buyers and sellers around the forex market clock except for weekends. It involves mainly participants of larger international banks. Forex Market functions on different stages and it works through financial institutions. There are dealers from banking sector & insurance sector who are actively involved in large quantities of forex trading.
Characteristics of Forex Market:
- Its enormous or huge trading volume or size representing the largest asset class in the world leading to high liquidity;
- Its geographical distribution;
- Its continuous operation: 24 hours a day except weekends,
- Exchange rates are affected by various exchange factors
- The low margins of relative profit compared with other markets of fixed income; and
- The use of leverage to enhance profit and loss margins and with respect to forex market account size.
Three Key Essentials of Forex Market:
- Leverage: In forex market order to finance firm’s assets, the amount of debt or loan used. A firm with significantly more debt than equity is considered to be highly leveraged.
- Margin: The amount borrowed which is used to obtain or purchase securities or stocks. This exercise is referred to as “buying on margin”.
- Equity: A stock or any other security representing an ownership interest. This is found in company’s balance sheets as funds contributed by owners and reserves & surplus.
Forex Market in India
The introduction of forex derivative in India took place in the early 90’s, due to the liberalization of Indian Economy there was a significant inflow of foreign currency capital into India. And even the integration of domestic economy with the word economy has been enabled due to the dismantling or removal of trade barriers. Risk management, globalization of trade and free movement of financial assets through derivative products has become a requirement in India too.
Participants in Forex Market
1. Government & Central Bank:
Central banks & governments are the most dominant participant in forex market. In many countries, Central Banks act as an extension of government & conducts its policy in agreement with the government. Central banks & government are on the same level when it comes to monetary policy, thus government representatives usually conducts regular meetings with central bank representatives to discuss monetary policy. In order to meet economic goals, Central banks are usually involved in maintaining foreign reserve volumes.
2. Banks & other Financial Institutions:
Apart from central bank & government, even banks are the largest participants who are involved in foreign exchange transactions. Generally people who require money for small purposes i.e. studying in abroad, travelling etc. deal with local banks. Therefore, banks in general act as a broker or dealer to the one who are willing to buy or sell a currency at the bid/ask rate. Through forex market, banks make money by exchanging currency at a higher price than they paid to obtain it.
To deal with the volatility of fluctuating currencies and foreign exchange risk is a big problem for many multinational companies; this is the foremost thing the shareholders & management of any company hates is about uncertainty. Therefore to deal with these uncertainties banks employ hedging strategies in forex market order to lock a specific exchange rate for the future, or to remove from transactions all the exchange rate risk. And the person who carries out the hedging strategies is known as hedgers.
Instead of hedging against fluctuations in exchange rates, speculators are those participants in forex market who tries to make money by taking benefits or advantage of fluctuating exchange-rate levels.
Over the years Indian Forex market has developed significantly. As per the BIS (Bureau of Indian Standards) Triennial Survey Report with respect to daily turnover, Indian Forex market is the 16th largest forex market in the world. The rapid growth of Forex Market is highly contributed by the stable growth of the Indian Economy & expansion of the industrial sectors in India. Mumbai is the main center of Indian Forex Market & other cities like Kolkata, Chennai, Delhi, Bangalore & Cochin are the commercial capital of the country. Indian forex market got boost when RBI accepted the proposal of SEBI of approving the trade of INR & GBP, INR & EURO, INR & YEN, and these all currencies were the addition in the prevailing pair of currency i.e. INR & USD.
Instruments of Forex Market
1. Foreign Exchange Forwards:
A foreign exchange forward is a contract in order to deal with the exchange of currencies i.e. to buy or sell any specific currency at an agreed future specified date and with a price (rate) agreed upon and this rate is known as forward rate.
So in this case, if a buyer and seller agree on an exchange rate for a future specified date then the transaction will take place on that date regardless whatever the market rates would be at that time. The date of transaction is usually decided by buyer & seller and the time period of the trade can be e day, few days, months or years.
2. Currency Futures:
It is also known as foreign exchange (Forex) future, it is a future contract in order to exchange one currency for another at a future specified date at a future exchange rate. It is alike to forward contract but with few exceptions. Currency futures contracts are traded on exchange markets and in case of forward contracts they are traded on over-the-counter markets (OTC) and even futures contracts are settled down daily on market-to-market basis, whereas forwards contracts are settled only at expiration.
This contract has physical delivery, the one which held till the last forex market trading day & thus actual payments are made in that specific currency. In this type of contracts, an investor can close down his/her contracts at any period of time prior to the contracts delivery date. Basically, investors enter into such type of contracts for speculating or hedging purpose.
3. Currency Swaps:
Currency swaps are closely related to interest rate swaps; these are traded on over the counter and known as over the counter derivatives. In a foreign currency swap there is an exchange of borrowings, where the principal amount and interest payments in one currency are exchanged for principal amount and interest payments in an another currency. Generally, corporates enters into currency swaps, the one with a long term debt or foreign liability in order to get cheaper debt and to hedge themselves against exchange rate fluctuations. Swaps basically consist of fixed and floating rate of interest. For an example of swap transaction is paying fixed dollar and receiving floating foreign currency i.e. Pound interest.
4. Currency Options:
And the option writer grants the option holder right to purchase a specified forex market instrument i.e. currency at a specified price within a specified period of time and if the option holder exercised the right, the option writer is obligated. Futures and Forwards contracts both confer obligations on both parties to sell and buy commodity on a future specified date. But an option contracts gives a right to one party and obligation to other. It is a financial derivative that signifies a contract sold by option writer (seller) to option holder (buyer). This type of contract offers the buyer the right but not the obligation to buy or sell a stock or a security at an agreed – upon price on a future specified date.
Currency options are of two types i.e. Call option & Put Option. By purchasing any currency option an investor can hedge against foreign currency risk. For an example, if an investor believes that the GBP/INR will be going to increase from 83.00 to 85.00 i.e. it will become more expensive for an Indian investor to buy Great Britain Pound. Therefore, the investor would buy a call option on GBP/INR in order to gain from an increase in the exchange rate, thus the call option gives the option holder a right but not an obligation to buy currency on the expiration date.
Forex Market in India has been growing rapidly and will continue to grow. The activity of forex market is mostly concentrated in foreign & few private sector banks but today even the public sector banks are participating in this market as market makers and not just users. As forex market helps an investor to hedge or speculate itself from currency fluctuation risk therefore it is essential to keep in view the risk of extreme leverage, lack of transparency specially in complex products, counterparty exposure, hidden general risk etc. Increasing Convertibility on the capital account would quicken the process of integration of Indian financial markets with international markets thus increasing convertibility carries the risk of removing the narrowness of the Indian markets to external shocks like South East Asian crisis but an appropriate management of the transition will increase the forex market growth of financial markets and the economy. Introduction of tailored derivatives products in particular corporate requirements would allow corporate to completely focus on its core businesses and enabling it to gain despite any changes in the financial markets.
Forex Market Infographic
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