Types of foreign exchange market | Factors affecting the exchange rate.
Introduction: Treasury products are largely related to derivatives and forex derivatives form a significant part of it. So we need to understand Forex operations thoroughly to know about Treasury products.
Interest and its circulation is another area in which Treasury products are used but on a much smaller scale than the foreign exchange market.
What is the foreign exchange market (Forex Market)
The foreign exchange market (forex market) deals with the buying and selling of foreign currencies. The bulk of the market is “over the counter” (OTC) i.e. not through an exchange that is well regulated.
International trade and investment essentially require foreign markets. Banks act as intermediaries and carry out currency exchange transactions by quoting buy and sell prices.
In India, the Foreign Exchange Management Act (FEMA) 1999 is the law relating to foreign exchange transactions and aims to develop, liberalize and promote the foreign exchange market and its effective use.
Types of Forex Markets
1. Spot Market – The spot market is a market in which a currency is bought or sold for immediate delivery or delivery in the near future. Trading in the spot market takes place on the second working day. Delivery and payment both happen on the second day.
The quoted rate is called the ‘spot rate’, the settlement date is known as the ‘value date’, and the transaction is called a ‘spot transaction’.
2. Forward Market: The forward market includes contracts for the delivery of foreign currency at a specified future date beyond the spot date and the transaction is called a ‘forward transaction’.
The rate quoted at the time of the agreement is called the forward rate and is usually quoted for price dates of one, two, three, six, or twelve months.
3. Integrated and Dual Markets – Integrated markets are found where there is only one market for foreign exchange transactions in a country. They have greater liquidity, increased price discovery, less short-term exchange rate volatility, and reliable access to foreign exchange.
In contrast, dual markets are found in countries with multiple exchange markets. For example, one country may consider the foreign exchange market for current account transactions and a separate exchange or market for trade transactions for capital transactions, and another market for regulated transactions such as India was in the early 1990s. When dual exchange rates were prevalent.
4. Offshore and Onshore Markets – During the early stages of financial development, the forex market operated onshore, ie within India. But after the liberalization of the economy, offshore markets have flourished and instruments based on foreign currencies issued by Indian firms are traded in foreign markets.
What is Exchange Rate Mechanism
The exchange rate mechanism (ERM) deals with the process by which the value of one currency is converted into the value of another currency. For example, as of January 2013, one US dollar is converted to 53. The exchange rate is determined by the rules prevailing in the foreign exchange market.
There are two types of ERMs:
1. Floating (market-based) exchange rate – In this system, the exchange rate is determined by the free market. There is no central bank intervention and market forces decide the prevailing exchange rates.
Therefore the values of the currencies will float freely. US$, UK£, Japanese, and Euro€ are some examples of floating/market-based currencies.
2. Fixed (regulated) exchange rate – In this system, the value of one nation’s currency is matched to that of another currency or any other measure such as gold or a basket of currencies.
As long as the reference value does not change, the value of the currency pegged does not change. It helps in reducing exchange rate fluctuations and reduces volatility in the economy.
There are three main types of floating exchange rates:
- Managed Float – A floating exchange rate with the involvement of a central bank to reduce excessive volatility in the money market. They are also known as ‘Dirty Floats’. The Indian Rupee is an example of a managed float currency.
- Denominated currency – the exchange rate is pegged to another foreign currency such as US$ or €. The Saudi Riyal is an example of a currency pegged to the US Dollar.
- Fixed exchange rate or creeping peg – exchange rates that are fixed for some par or another currency and therefore have a small degree of flexibility. The Chinese yuan is an example of such a currency.
What are the Factors Affecting the Exchange Rate
1. Difference in Inflation
2. Difference in interest rates
3. Current Account Deficit
4. Public Debt
5. Trade Terms
6. Political Stability and Economic Performance
Treasury Products and Delivery Period
Exporters and importers buy and sell currencies and related products from their banks based on business needs. Forex dealers in banks quote rates based on volume and delivery period. Delivery can be immediate or in the future.
1. Spot Market
The spot market trades in commodities and financial instruments for cash on immediate delivery. The spot market is also known as the cash market or physical market. The rate quoted for spot delivery is called the spot rate and the settlement date is known as the price date.
The Forex spot rate is valid for settlement up to two working days from the date of the transaction.
The Forex spot market can be broadly classified as:
- Interbank trade – This is the market for bankers who buy and sell currency for delivery and settlement with other banks.
- Merchant Trading – This market consists of private traders who transact with banks for their business needs.
Factors that affect a currency’s spot rate include inflationary trends, the state of the balance of payments, government and central bank policies, and other economic indicators of a country.
2. Forward Markets
The futures market deals with the delivery of products for a future date at agreed prices on the date of the contract. The rate at which the forward transaction is to be completed is negotiated and agreed upon between the parties.
Futures contracts are a means of hedging against sharp fluctuations in prices, especially in the commodity and currency markets. The exporters and importers receive and pay the foreign currency amount at a future date. Buying futures contracts reduces their price risk and is called hedging.
What are Futures Contracts
A futures contract is an agreement that requires the seller to deliver a specified quantity of a security, commodity, or foreign currency to the buyer at an agreed price in the future.
Futures contracts are traded on organized exchanges, unlike forwarding contracts which are executed over the counter. The terms of future contracts are standardized and hence transaction costs are very low.
Features of Futures Market: Organized Exchange, Standardization, Clearing House, Margin, and Marking to Market. The actual distribution is rare.
What is Swap
Swaps are the exchange of rights or obligations for another set of rights or obligations. Financial swaps allow borrowers to exchange one stream of payment to settle a liability with another stream of payment. Similarly, investors use swaps to exchange inflows that represent one type of risk with inflows with a different risk element.
1. Foreign Currency Swap
Forex swaps are transactions in which one currency is bought spot or forward on a given day, and the same amount is sold on a different price date. In fact, there are therefore two transactions involved:
• spot purchases in foreign exchange, and
• Selling futures in foreign currency
2. Currency Exchange
A currency swap is an agreement to exchange contracted interest/principal payments in one currency for payment in a different currency for the same value calculated according to the exchange rate on the date of the swap.
Thus if a currency is seen to move up sharply, that currency may cause future payments to be exchanged for payments in another currency that is more stable. This helps to eliminate the risk of adverse changes. Corporates deploy currency swaps from time to time on payments relating to loans taken in foreign currency.
3. Forex Swap Vs Currency Swap
A forex swap is a type of hedge against currency risks but a currency swap only transfers the risk from one currency to another. Forex swaps are exclusive to banks and forex dealers and are not open to corporates.
Currency swaps can be entered into by corporate treasurers to move their exposure between different currencies.
4. Interest Rate Swap
An interest rate swap is a customized agreement to replace one stream of future interest payments with another based on a specific principal amount. Typically, the exchange takes place between a fixed interest payment and a floating interest payment linked to reference interest rates.
Organizations typically use swaps to manage exposure to interest rate fluctuations or to achieve lower-margin interest rates. These are widely used by banks, other financial institutions, and governments, and can be effectively deployed by corporates in their long-term loans.
There are three types of interest rate swaps:
- Coupon swap: Fixed or vice versa at floating rates
- Base Swap: Exchange of one benchmark interest rate for another benchmark interest rate (MIBOR* or T-Bill^ rate)
- Cross-currency interest rate swaps: Fixed-rate flows in one currency flow into floating-rate flows in another currency.
The major benefits of interest swaps are:
• It helps in obtaining low-cost funding.
• It provides a hedge against interest rate risk and yields high returns in investment assets.
• It helps in asset or liability management.
Definition of commodity markets
The commodity market is the market in which commodities like oil, gold, and agricultural products are traded. It works on agreements to buy and sell items at agreed prices on a specific date. The main commodity markets are in London, New York, and Chicago.
In India, the commodity market facilitates multi-barter exchange within and outside the country depending on the requirements. The Indian commodity market has seen tremendous growth after the liberalization of the economy.
The demand for commodities in the Indian domestic and global market is projected to grow fourfold in the next five years.
⇒ Regulators of Commodity Markets
The commodity market is regulated by government commissions that process trading.
In India, the Forward Markets Commission (FMC) acts as the regulator. Headquartered in Mumbai, FMC oversees the Ministry of Corporate Affairs.
FMC helps to introduce new instruments like options, thereby benefitting stakeholders including farmers who benefit from price discovery and price risk management.
⇒ Commodity Exchange
Commodity exchange refers to commodity purchase and trading contracts for future delivery. These exchanges facilitate the trading of physical goods such as corn, timber, or oil. Most commodity exchanges trade in a single commodity product such as oil or rice.
⇒ Players in the Commodity Market
- Rescuers and Intermediaries – The group includes the production, processing, or sale of a commodity. Most trade-in commercial commodity markets.
- Large speculators – a group of investors who pool their money to reduce risk and increase profits. Large speculators consist of money managers making investment decisions for the overall investor group.
- Small speculators – a group of individual commodity traders who trade on their own account or through brokers.
The Forex market generates a high level of liquidity and provides an opportunity for traders to invest. This includes spots and forwards and can be either an integrated or a double market.
Forex markets are both onshore and offshore. ERM refers to the method by which the value of one currency is exchanged for the value of another currency.
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