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CHAP III: THEORETICAL FOUNDATIONS 3.1 Foreign exchange 3.1.

1 Definition Exchange with dynamic and static two meanings: the dynamic sense, foreign exchange, is that people will convert one currency into another currency, credit and debt settlement of international behavior. In this sense, the concept of foreign exchange equivalent to the international settlement. Static sense, the foreign exchange broad and narrow sense there: Broad sense refers to all the static exchange with foreign currency assets. China and other countries in the Foreign Exchange Management Act generally follow the concept. Such as in China, according to January 20, 1997 release of the revised The People Republic of China Foreign Exchange Management Regulations provisions of the Exchange means: (1) Foreign currency, including banknotes, coins, etc.; (2) Payable in foreign currency, including bills, bank deposit certificates, and postal savings certificates, etc; (3) Foreign securities, including government bonds, corporate bonds, stocks, etc; (4) Special Drawing Rights, the European currency unit; (5) Other foreign currency assets. In this sense, foreign exchange is the foreign currency assets.

The narrow sense refers to the foreign currency exchange can be used between the settlement of international means of payment. In this sense, only the foreign currency deposit funds in foreign banks, and bank deposits will obtain the right to a specific foreign currency notes will constitute foreign exchange, including: bank drafts, checks, bank deposits. This is the usual meaning of the concept of foreign exchange. According to Dr. Paul Einzig Foreign exchange is the system or process of converting one national currency into another and of transferring the ownership of money from one country to another.1 While Mr. H. E. Evitt stated: Foreign exchange is that section of economic science which deals with the means and methods by which rights to wealth in one countrys currency are converted into rights to wealth in terms of another countrys currency. It involves the investigation of the method by which the currency of one country is exchanged for that of another, the causes which render such exchange necessary, the forms which in exchange may take and the ratios or equivalent values at which such exchanges are effected. 3.1.2 The development of the world's foreign exchange trading Each day around the world, massive sums of currency are exchanged, seemingly with nothing more than a click of a computer mouse or a brief satellite-connected telephone conversation between traders on different continents. Technology has helped to evolve the foreign exchange industry a long way from its rather humble beginnings. Developing an appreciation for how this system developed over time as well as an understanding of the modern analytical tools at a traders disposal can greatly aid in investment decision-making.
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Paul Einzig, The History of Foreign Exchange. London: Macmillan, 1962. xvi + 319 pp. (second

edition, 1970, xxi + 362 pp.)

For as long as trade between countries with different currencies has taken place, foreign exchange has been in existence. According to Julian Walmsley, author of The Foreign Exchange and Money Markets Guide, although foreign exchange has existed since before biblical times, a formal global market for foreign exchange did not develop until the 1800s with cable transfers taking place between London and New York. The foundations of modern foreign exchange: The beginnings of modern currency trading can be traced back to the origins of money itself. A key tenet of foreign exchange theory involves a shared belief that various forms of money have value, and can be readily exchanged for products, services and other commodities. Currency has a long history of being backed by the value of various precious metals, including silver and gold. During the nineteenth century, most of the currencies in worldwide circulation were backed by stores of gold bullion, a concept first initiated by the government of England. However, global turmoil in the twentieth century gradually led to a rescinding of the gold standard. Recognition of the United States of America as a global economic superpower meant that the U.S. dollar was almost universally accepted around the world as a medium for barter and trade. Today, the U.S. dollar continues its dominance by playing a role in an astounding 70% of all foreign exchange transactions. In the period of the dawn of global economic cooperation: Already long recognized as one of the strongest nations in the world both economically and militarily the United States of America assumed an important role in the global economy. Having emerged from World War I with its industrial might intact, the inherent strength of the U.S. dollar allowed this currency to become a very popular form of legal tender in transactions outside of the United States. The outbreak of the Second World War in 1939 introduced new economic pressures in many nations. In a few short years, Europe had been decimated, both literally and figuratively. If there were to be any global 3

economic stability after the defeat of the Axis Powers, the U.S. and its almighty dollar would surely need to play a role in building that stability. To lay the groundwork, a conference of Allied nations was held in rural New Hampshire in 1944. Known as the Bretton Woods Conference, the meeting was intended to foster international cooperation and economic stability in the years following the war. Participating nations agreed to create a gold-based exchange rate for their own individual currencies. At this time, the value of the U.S. dollar was set at $35 per ounce of gold, and the currency exchange rates of participating nations were expressed in terms of dollars. The Bretton Woods Conference also led to the creation of the World Bank and the International Monetary Fund two important entities that would help to ensure the flow of capital and currency between nations during the rebuilding phase. For obvious reasons, foreign exchange between Allied and Axis powers was suspended during wartime. Exchanges with the German mark resumed in 1950, and exchanges with the Japanese yen resumed in 1956. As the United States continued to contribute huge sums of money to global economic stabilization in the post-war years, the popularity of the U.S. dollar continued to grow. While gold reserves continued to back the value of the U.S. dollar on an international basis, the U.S. simultaneously exported significant amounts of gold to back the currencies of other friendly nations. By 1970, foreign nations held almost $47 billion in U.S. currency, and the U.S. had to face the fact that it no longer had the necessary gold reserves to back this massive exposure. In 1971, the U.S formally decided that its dollars would no longer be tied to the gold standard, and the modern foreign exchange market was born. This became known as a floating rate system, under which prevailing currency exchange rates would fluctuate according to supply and demand. Historically, governments attempted to set exchange rates themselves to improve a country's trade position. If a country set its exchange rate low 4

relative to others, it could improve the country's trade position by making its exports more affordable and imports from other countries less affordable. Such policies led to trade wars as countries struggled to improve their trade positions. Since the early 1970s, however, most major currencies have been allowed to "float," which means allowing exchange rates to be determined by supply and demand on the currency markets. Most countries still fine tune exchange rates by keeping a reserve of gold or foreign currencies, known as foreign exchange reserves, which they buy and sell to stabilize their own currency when necessary. Geopolitical change continues to affect the currency markets. From the dissolution of the former Soviet Union, to the formal expiration of Britains lease on the colony of Hong Kong and its subsequent repatriation to China, to the birth of new democracies in the Middle East the transforming face of the world also helps to transform the currency trading marketplace. One of the most dramatic changes in foreign exchange occurred on January 1, 1999, when the euro was adopted as the new currency of the European Union member states. While actual euro notes and coin were not introduced into circulation until January 1, 2002, the new currency had a profound effect on the global economy. The euro was primarily intended to create a unified trade market amongst members and improve liquidity of the financial markets, but it also created new opportunities for foreign exchange, and hence, new opportunities for profit. Nowadays, the development of foreign exchange trading still continues to happen with some trends as following: the U.S. dollar continues to represent the king of all global currencies, and plays a role in an estimated 70% of all foreign exchange transactions today, attesting to its strength. In years to come, developing industrial economies such as those of China, India and Brazil will undoubtedly have an impact the foreign exchange markets, but the greenback shows no imminent signs of relinquishing its 5

domination. So we all would together observe and follow the development of this truly important economic factor. 3.1.3 The functions of forex trading As different view-angles lead to different viewpoints, there are many ways to state the functions of an issue. So are the methods to list functions of foreign exchange trading. In this section of the report, the author would like to divide forex functions into six parts as follows. 3.1.3.1 Primary function The primary function of foreign currency exchange markets is to convert the currency of one country into another currency. For example, the U.S dollar may be changed into Mexican Pesos or English Pounds. The amount of currency converted depends on the exchange rate, which can be fixed or can fluctuate. The exchange rate between two currencies is dependent upon official or private participants to buy and sell its currency. The U.S. dollar is a currency that has a fluctuating exchange rate that is based on market demand. Some countries, like China, have a fixed exchange rate determined by their central bank. 3.1.3.2 Participation in the growth of developing nations The international use of currency creates many benefits to issuing countries. First, it obtains profit from minting coins, because the noninterestbearing claims on it are expressed in its own currency and is able to do this by unexpectedly inflating its currency. Second, as the international use of a currency expands, loans, investments, and purchases of goods and services will increasingly be executed through the financial institutions of the issuing country. Thus, we can say that another function of FOREX is the participation in the growth of developing nations; helping to eliminate poverty and internationalize their goods and services. 3.1.3.3. International Transactions Facilitation

Foreign currency exchange markets serve to facilitate international financial transactions. These transactions may be the purchasing and selling of goods, direct investment in buildings and equipment in a foreign country or the purchase of investment vehicles like foreign bonds. For example, a U.Sbased company may want to purchase goods manufactured in China. The foreign currency exchange market allows them to exchange U.S. dollars and make the purchase in Chinese RMB (Renminbi, the currency of the People's Republic of China). The FOREX also makes it possible for U.S. citizens to travel to foreign nations and buy goods and services. Whether the shops in the foreign country accepts the dollar at a determined exchange rate or the U.S. citizen exchanges their dollars at a bank for a foreign currency, business transactions can be made. 3.1.3.4. Investment Fund managers and investment professionals use the foreign currency exchange market to help diversify their portfolios and potentially increase their returns. Through calculated risks, investors can bet on a change in the price or exchange rate of a currency. They want to speculate on exchange rate movements, and earn profits on the changes they expect. If they expect a foreign currency to appreciate relative to its domestic currency, they will convert its domestic funds into the foreign currency. Alternately stated, they expect its domestic currency to depreciate relative to the foreign currency. Just like with the stocks, if currency is purchased at a low price and sold at a higher price, the investor makes money. 3.1.3.5. Currency value control The value of a country's currency can influence international trade, consumers' purchasing power and inflation. Central banks of a county or region, like the U.S. Federal Reserve, seek to minimize the impact of currency fluctuations. The foreign currency exchange market functions as a tool for central banks to control the value of their currency by buying or selling 7

currency, which influences the total amount in worldwide circulation. The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. The higher a country's interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to sell their currency to keep it stable. Once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit. Thats the reason why foreign exchange trading is said to be a crucial tool for central bank to control the value of its country currency. 3.1.3.6. Loss Protection The fact that exchange rates can change on a daily basis depending upon the relative supply and demand for different currencies increases the risks for firms entering into contracts where they must be paid or pay in a foreign currency at some time in the future. International companies that work in multiple countries are subject to gains and losses based on exchange rate fluctuations. To help prevent losses, companies can make forward transactions where they make a binding agreement to exchange currency for another currency at a fixed rate. This function of the foreign currency exchange market helps a company minimize the risk of foreign exchange on future expenses. For example, if a U.S.-based company places an order with a firm in Taiwan that will be ready in five months, the company can enter a forward transaction agreement that fixes the price based on the current exchange rate at the time of order. The company knows the value and cost of the purchase and will not be hit with a future loss based on a change in exchange rates. In summary, as mentioned above, foreign exchange trading has proven to be valuable to international community. It has many different functions, but most importantly, allows international business to be a reality. Without foreign 8

exchange trading, international investments, trade and tourism could not be possible. It would be left to the negotiations of individuals and nations to barter goods to receive goods. 3.2 The forex market 3.2.1 Definition The Forex market, established in 1971, was created when floating exchange rates began to materialize. The Forex market is not centralized, like in currency futures or stock markets. Trading occurs over computers and telephones at thousands of locations worldwide. The Foreign Exchange market, commonly referred as FOREX, is where banks, investors and speculators exchange one currency to another. The largest foreign exchange activity retains the spot exchange (i.e.., immediate) between five major currencies: US Dollar, British Pound, Japanese Yen, Eurodollar and the Swiss Franc. It is also the largest financial market in the world. In comparison, the US stock market may trade $10 billion in one day, whereas the Forex market will trade up to $2 trillion in one single day. The Forex market is an opened 24 hours a day market where the primary market for currencies is the 24-hour Interbank market. This market follows the sun around the world, moving from the major banking centres of the United States to Australia and New Zealand to the Far East, to Europe and finally back to the Unites States. Until now, professional traders from major international commercial and investment banks have dominated the FX market. Other market participants range from large multinational corporations, global money managers, registered dealers, international money brokers, and futures and options traders, to private speculators. 3.2.1 Characteristics of forex market 3.2.1.1 Accessibility 9

Its no wonder that the Forex market has the trading volume of three trillions a day, all anyone needs to take part in the action is a computer with an internet connection. There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-thecounter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called forex market-space opened in 2007 and aspired but failed to the role of a central market clearing mechanism. 3.2.1.2 Twenty-hour market Another distinguishing characteristic of forex is its global, decentralized nature. Essentially, it is an over - the - counter (OTC) market, where the different currency trading locations around the globe electronically form a unified, interconnected market entity. Among other advantages stemming from this fact, all currencies can be traded electronically 24 hours a day as the major global markets open, overlap, and close, one after another. From the perspective of New York time (U.S. Eastern Time), the markets open up as follows. The very beginning of the week falls on Sunday afternoon in New York, when the New Zealand banks open at 2:00 pm New York time. At 5:00 pm (still New York time) the financial markets in Sydney, Australia, open. Tokyo then opens at 7:00 pm, followed by Hong Kong and Singapore concurrently at 9:00 pm. At this point, all five of these currency10

trading financial markets are open: New Zealand, Australia; Japan; Hong Kong; and Singapore. In the wee hours of Monday, Frankfurt, Germany, opens up the primary euro market at 2:00 am, New York time. By this time, New Zealand and Australia are already closed, and the East Asian markets of Tokyo, Hong Kong, and Singapore are on their last legs. The European time zone continues shortly thereafter with the opening of the pivotal London session. Customarily the market with the most liquidity (as most foreign exchange trading has traditionally occurred within the London market), London session opens an hour after Frankfurt, at 3:00 AM NY time. Finally, at 8:00 am on Monday morning, the New York financial markets are the last of the major global markets to open. Since New York is also a strong foreign exchange trading market, much like London and Frankfurt, the overlap between these three markets around 8:00 to 11:00 am NY time represents among the most active, liquid, and volatile trading hours available in forex. At the same time, however, the period surrounding the London opening currently takes the crown for the most active foreign exchange market. A couple of hours before the close of the New York market, the New Zealand market opens up again at 2:00 pm to begin the whole globe hopping process all over again. After Monday, this seamless process continues on every weekday until Friday, when the close of the last foreign exchange market in New York signals the end of the trading week at around 4:00 to 5:00 pm New York time. Therefore, from around 2:00 pm on Sunday to 5:00 pm on Friday, forex trading takes place 24 hours a day, five days a week. One important note to keep in mind about trading currencies at all hours of the day and night is that even though a particular market happens to be closed, it does not mean that the currency specific to that market is not being traded. For example, when London opens in the middle of the night in 11

New York while the U.S. markets are closed, some of the most active trading of the U.S. dollar occurs. Beginning traders are often under the mistaken impression that a countrys currency is only traded when that countrys markets happen to be open. This is untrue only because the foreign exchange markets are traded by people and institutions around the world via a global, decentralized network. Therefore, U.S. dollar trading, for example, is not dependent on the business hours of any centralized, physical exchange located in the United States. The fact that foreign exchange can be traded 24 hours a day means that traders have the advantage of choosing when it is most convenient to trade, considering their own personal schedules. For this reason, many traders hold full - time jobs while trading forex during off - hours. This provides a tremendous amount of exibility that is not offered in other major trading markets. Of course, those traders that choose to take advantage of the most active markets must necessarily watch the currencies during the most active times, like during London or New York market openings. But the fact that all currencies can be traded 24 hours a day means that there is almost always price movement available upon which to trade. 3.1.2.3 Big and liquidity When most people first hear about the foreign exchange market, they are usually introduced first to the sheer size of the global forex system. Along with this size comes a magnitude of liquidity almost unimaginable in any other financial market. Liquidity is defined simply as the degree to which an asset, like a currency, can be bought or sold in the market without having a significant effect on the assets price. The liquidity of currencies, especially the major ones like the U.S. dollar and the euro, is unrivaled by any other financial instrument, including stocks, bonds, and futures contracts. Among other implications of this high level of liquidity, because of the staggeringly high volume of transactions and the countless number of 12

traders (both institutional and retail) involved in this market, it is extremely difficult for any individual market participant to manipulate foreign exchange prices artificially in any significant manner. This blanket statement, however, notably excludes the worlds central banks (e.g., the U.S. Federal Reserve (the Fed), the European Central Bank (ECB), the Bank of Japan (BOJ)), which can and do attempt to manipulate the markets. This type of manipulation activity, however, has become an accepted part of the forex trading game, and generally does not offer an unfair advantage to any speculative market participant. Furthermore, central bank attempts to manipulate currencies for the purposes of furthering national economic policy are usually much easier to accept than, for example, the profit - minded manipulation of individual stocks by often unscrupulous traders. Apart from potential central bank manipulation, just how big is the foreign exchange market that it can claim its place as the most liquid market the world has known? According to the most recent statistics issued by the Bank for International Settlements (BIS), which serves as an international organization and bank for central banks the average daily turnover in the primary foreign exchange markets is estimated to be around $ 3.2 trillion (as of April 2007). This figure represents an unprecedented three-year growth rate of 69%, and far eclipses the volume traded in any other financial market in the world. Of this $3.2 trillion, about $1 trillion is in spot foreign exchange trades, which, as mentioned earlier, are forex trades that are distinguished by immediate delivery of the currency. Spot foreign exchange is the type of trading that most individual traders in the retail forex market are primarily concerned with. While some individual traders get involved with currency futures and other derivative financial instruments, the growth of the spot foreign exchange arena has largely eclipsed these smaller markets. 3.2.3 Major currencies on forex market 13

The U.S. Dollar: The United States dollar is the world's main currency an universal measure to evaluate any other currency traded on Forex. All currencies are generally quoted in U.S. dollar terms. Under conditions of international economic and political unrest, the U.S. dollar is the main safehaven currency, which was proven particularly well during the Southeast Asian crisis of 1997-1998. As it was indicated, the U.S. dollar became the leading currency toward the end of the Second World War along the Breton Woods Accord, as the other currencies were virtually pegged against it. The introduction of the euro in 1999 reduced the dollar's importance only marginally. The other major currencies traded against the U.S. dollar are the euro, Japanese yen, British pound, and Swiss franc. The Euro: The euro was designed to become the premier currency in trading by simply being quoted in American terms. Like the U.S. dollar, the euro has a strong international presence stemming from members of the European Monetary Union. The currency remains plagued by unequal growth, high unemployment, and government resistance to structural changes. The pair was also weighed in 1999 and 2000 by outflows from foreign investors, particularly Japanese, who were forced to liquidate their losing investments in euro-denominated assets. Moreover, European money managers rebalanced their portfolios and reduced their euro exposure as their needs for hedging currency risk in Europe declined. The Japanese Yen: The Japanese yen is the third most traded currency in the world; it has a much smaller international presence than the U.S. dollar or the euro. The yen is very liquid around the world, practically around the clock. The natural demand to trade the yen concentrated mostly among the Japanese keiretsu, the economic and financial conglomerates. The yen is much more sensitive to the fortunes of the Nikkei index, the Japanese stock market, and the real estate market. 14

The British Pound: Until the end of World War II, the pound was the currency of reference. The currency is heavily traded against the euro and the U.S. dollar, but has a spotty presence against other currencies. Prior to the introduction of the euro, both the pound benefited from any doubts about the currency convergence. After the introduction of the euro, Bank of England is attempting to bring the high U.K. rates closer to the lower rates in the euro zone. The pound could join the euro in the early 2000s, provided that the U.K. referendum is positive. The 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 four 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. Therefore, in terms of political uncertainty in the East, the Swiss franc is favored generally over the euro. Typically, it is believed that the Swiss franc is a stable currency. Actually, from a foreign exchange point of view, the Swiss franc closely resembles the patterns of the euro, but lacks its liquidity. As the demand for it exceeds supply, the Swiss franc can be more volatile than the euro. 3.2.4 The components participating in the forex market 3.2.4.1 Central Banks The national central banks play an important role in the (FOREX) markets. Ultimately, central banks seek to control the money supply and often have official or unofficial target rates for their currencies. As many central banks have very substantial foreign exchange reserves, their intervention power is significant. Among the most important responsibilities of a central bank is the restoration of an orderly market in times of excessive

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exchange rate volatility and the control of weakening currency.

the inflationary impact of

Frequently, the mere expectation of central bank intervention is sufficient to stabilize a currency, but in case of aggressive intervention the actual impact on the short-term supply/demand balance can lead to the desired moves in exchange rates. If a central bank does not achieve its objectives, the market participants can take on a central bank. The combined resources of the market participants could easily overwhelm any central bank. Several scenarios of (ERM) collapse and 1997 throughout South East Asia. 3.2.4.2 Commercial banks The Interbank market caters to both the majority of commercial turnover as well as enormous amounts of speculative trading. It is not uncommon for a large bank to trade billions of dollars daily. Some of this trading activity is undertaken on behalf of corporate customers, but a banks treasury room also conducts a large amount of trading, where bank dealers are taking their own positions to make the bank profits. The Interbank market has become increasingly competitive in the last couple of years and the godlike status of top foreign exchange traders has suffered as equity traders are again back in charge. A large part of the banks trading with each other is taking place on electronic booking systems that have negatively affected traditional foreign exchange brokers. 3.2.4.3 The forex brokers Until recently, foreign exchange brokers were doing large amounts of business, facilitating Interbank trading and matching anonymous counterparts for comparatively small fees. With the increased use of the Internet, a lot of this business is moving onto more efficient electronic systems that are functioning as a closed circuit for banks only. 16 this nature were seen in the 1992-93 with the European Exchange Rate Mechanism

The traditional broker box, which lets bank traders and brokers hear market prices, is still seen in most trading rooms, but turnover is noticeably smaller than just a few years ago due to increased use of electronic booking systems. The arrival of the Internet has brought us a host of retail brokers. There is a numbered amount of these non-bank brokers offering foreign exchange dealing platforms, analysis, and strategic advice to retail customers. The fact is many banks do not undertake foreign exchange trading for retail customers at all, and do not have the necessary resources or inclination to support retail clients adequately. The services of such retail foreign exchange brokers are more similar in nature to stock and mutual fund brokers and typically provide a service-orientated approach to their clients. 3.2.4.4 Commercial companies The commercial companies international trade exposure is the backbone of the foreign exchange markets. A multinational company has exposure in accounts receivables and payables denominated in foreign currencies. They can be protected against unfavorable moves with foreign exchange. That is why these markets are in existence. Commercial companies often trade in sizes that are insignificant to short term market moves, however, as the main currency markets can quite easily absorb hundreds of millions of dollars without any big impact. It is also clear that one of the decisive factors determining the long-term direction of a currencys exchange rate is the overall trade flow. Some multinational companies, whose exposures are not commonly known to the majority of market, can have an unpredictable impact when very large positions are covered. 3.2.4.5 Hedge funds Hedge funds have gained a reputation for aggressive currency speculation in recent years. There is no doubt that with the increasing amount 17

of money some of these investment vehicles have under management, the size and liquidity of foreign exchange markets is very appealing. The leverage available in these markets also allows such a fund to speculate with tens of billions at a time. The herd instinct that is very apparent in hedge fund circles was seen in the early 1990s with George Soros and others squeezing the GBP out of the European Monetary System. It is unlikely, however, that such investments would be successful if the underlying investment strategy was not sound. It is also argued that hedge funds actually perform a beneficial service to foreign exchange markets. They are able to exploit economical weakness and to expose a countries unsustainable financial plight, thus forcing realignment to more realistic levels. 3.2.4.6 Speculators and Investors In all efficient markets, the speculator has an important role taking over the risks that a commercial participant hedges. The boundaries of speculation in the foreign exchange market are unclear, because many of the above mentioned players also have speculative interests, even central banks. The foreign exchange market is popular with investors due to the large amount of leverage that can be obtained and the liquidity with which positions can be entered and exited. Taking advantage of two currencies interest rate differentials is another popular strategy that can be efficiently undertaken in a market with high leverage. We have all seen prices of 30 day forwards, 60 day forwards etc, that is the interest rate difference of the two currencies in exchange rate terms. 3.2.3 The functions of forex market The foreign exchange market is the mechanism by which a person of firm transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, and minimizes exposure to foreign exchange risk. 18

3.2.3.1 Transfer of Purchasing Power: The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign exchange markets plays a very important role in facilitating international trade and capital movements. Transfer of purchasing power is necessary because international transactions normally involve parties in countries with different national currencies. Each party usually wants to deal in its own currency, but the transaction can be invoiced in only one currency. 3.2.3.2 Provision of Credit: The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign exchange markets plays a very important role in facilitating international trade and capital movements. Because the movement of goods between countries takes time, inventory in transit must be financed. 3.2.3.3 Minimizing Foreign Exchange Risk: The other important function of the foreign exchange market is to provide hedging facilities. Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to guard themselves against losses arising from fluctuations in exchange rates. The foreign exchange market provides "hedging" facilities for transferring foreign exchange risk to someone else. 3.3 The operations on the forex market 3.3.1 Spot transaction Currency spot trading is the most popular foreign currency instrument around the world, making up 37 percent of the total activity (See Figure

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3.3.1.1). The features of the fast-paced spot market are high volatility and quick profits (as well losses).

Figure 3.3.1: Market share of US spot trading (in % of the volume): 1 Forwards and swaps; 2 options; 3 - futures; 4 spots. A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from counterparty, based on an agreed exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed next business day. The two-day spot delivery check for out all currencies was developed details long before technological Although breakthroughs in information processing. This time period was necessary to transactions' among counterparties. technologically feasible, the contemporary markets did not find it necessary to reduce the time to make payments. Human errors still occur and they need to be fixed before delivery. By the entering into a contract on the spot market a bank serving a trader tells the latter the quota an evaluation of the currency traded against the U.S. dollar or an other currency. A quota consists from two figures (for example, USD/JPY = 133.27/133.32 or, which is the same, USD/JPY = 133.27/32). The first from these figures (the left part) is called the bid price

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(that is a price at which the trader sells), the second (the right part) is called the ask price (the price at which the trader buys the currency). The difference between asks and bid is called the spread. The spread, as any currency price alteration, is being measured in points (pips). In terms of volume, currencies around the world are traded mostly against the U.S. dollar, because the U.S. dollar is the currency of reference. The other major currencies are the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Other currencies with significant spot market shares are the Canadian dollar and the Australian dollar. In addition, a significant share of trading takes place in the currencies crosses, a non-dollar instrument whereby foreign currencies are quoted against other foreign currencies, such as euro against Japanese yen. The spot market is characterized by high liquidity and high volatility. Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. For instance, in an active global trading day (24 hours), the euro/dollar exchange rate may change its value 18,000 times "flying" 100-200 pips in a matter of seconds if the market gets wind of a significant event. On the other hand, the exchange rate may remain quite static for extended periods of time, even in excess of an hour, when one market is almost finished trading and waiting for the next market to take over. For example, there is a technical trading gap between around 4:30 PM and 6 PM EDT. In the New York market, the majority of transactions occur between 8 AM and 12 PM, when the New York and European markets overlap. The activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support. (See Figure 3.3.2) Overnight trading is limited, as very few banks have overnight desks. Most of the banks send their overnight orders to branches or other banks that operate in the active time zones.

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The reasons of the spot-market popularity, in addition to the fast liquidity-taking place thanks to the volatility, belong also the short time of a contract execution. Therefore the credit risk is on that market restricted. The profit and loss can be either realized or unrealized. The realized P&L is a certain amount of money netted when a position is closed. The unrealized P&L consists of an uncertain amount of money that an outstanding position would roughly generate if it were closed at the current rate. The unrealized P&L changes continuously in tandem with the exchange rate. 3.3.2 Forward transaction On the forward Forex are used two tools: forward outright deals and exchange deals or swaps. A swap deal is a combination of a spot deal and a forward outright deal. According to figures published by the Bank for the International Settlements, the percentage share of the forward market was 57 percent in 1998. (See Figure 1.2). Translated into U.S. dollars, out of an estimated daily gross turnover of US$1.49 trillion, the total forward market represents US$900 billion. In the forward market there is no norm with regard to the settlement dates, which range from 3 days to 3 years. Volume in currency swaps longer than one year tends to be light but, technically, there is no impediment to making these deals. Any date past the spot date and within the above range may be a forward settlement, provided that it is a valid business day for both currencies. The forward markets are decentralized markets, with players around the world entering into a variety of deals either on a one-on-one basis or through brokers.

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Figure 3.3.2: Diagram of the trade activity (in % of the volume) of US Forex in time distribution 1 from 12 pm till 4 pm, 2 from 4 pm till 8 pm, 3 from 8 am till 12 pm. The forward price consists of two significant parts: the spot exchange rate and the forward spread. The spot rate is the main building block. The forward spread is also known as the forward points or the forward pips. The forward spread is necessary for adjusting the spot rate for specific settlement dates different from the spot date. It holds, then, that the maturity date is another determining factor of the forward price. 3.3.3 Future transaction Currency futures are specific types of forward outright deals. Because they are derived from the spot price, they are derivative instruments (See Figure 3.3.1). They are specific with regard to the expiration date and the size of the trade amount. Whereas, generally, forward outright dealsthose that mature past the spot delivery datewill mature on any valid date in the two countries whose currencies are being traded, standardized amounts of foreign currency futures mature only on the third Wednesday of March, June, September, and December. The following characteristics of currency futures that make them attractive. They are open to all market participants, individuals included. It is 23

a central market, just as efficient as the cash market, and whereas the cash market is a very decentralized market, futures trading takes place under one roof. It eliminates the credit risk because the Chicago Mercantile Exchange Clearinghouse acts as the buyer for every seller, and vice versa. In turn, the Clearinghouse minimizes its own exposure by requiring traders who maintain a nonprofitable position to post margins equal in size to their losses. Although the futures and spot markets trade closely together, certain divergences between the two occur, generating arbitraging opportunities. Gaps, volume, and open interest are significant technical analysis tools solely available in the futures market. Because of these benefits, currency futures trading volume has steadily attracted a large variety of players. Because futures are forward outright contracts and the forward prices are generally slow movers, the elimination of the forward spreads will transform the futures contracts into spot contracts. For traders outside the exchange, the prices are available from on-line monitors. The most popular pages are found on Bridge, Telerate, Reuters, and Bloomberg. Telerate presents the currency futures on composite pages, while Reuters and Bloomberg display currency futures on individual pages shows the convergence between the futures and spot prices. 3.3.4 Option transaction A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency; and gives the seller, or writer, the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option. More factors affect the option price relative to the prices of other foreign currency instruments. Unlike spot or forwards, both high and low 24

volatility may generate a profit in the options market. For some, options are a cheaper vehicle for currency trading. For others, options mean added security and exact stop-loss order execution. Currency options constitute the fastest-growing segment of the foreign exchange market. As of April 1998, options represented 5 percent of the foreign exchange market. (See Figure 3.3.3). The biggest options trading center is the United States, followed by the United Kingdom and Japan. Options prices are based on, or derived from, the cash instruments. Often, however, traders have misconceptions regarding both the difficulty and simplicity of using options. There are also misconceptions regarding the capabilities of options. Trading an option on currency futures will entitle the buyer to the right, but not the obligation, to take physical possession of the currency future. Unlike the currency futures, buying currency options does not require an initiation margin. The option premium, or price, paid by the buyer to the seller, or writer, reflects the buyer's total risk. However, upon taking physical possession of the currency future by exercising the option, a trader will have to deposit a margin.

Figure 3.3.3: volume)

Market share of the currency options (in %% of the

1 - OTC; 2 organized exchanges

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The currency price is the central building block, as all the other factors are compared and analyzed against it. It is the currency price behavior that both generate the need for options and impacts on the profitability of options. 3.4 Risk management of forex trading 3.4.1 Definition A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm (Madura, 1989)2. In particular, it is defined as the possible direct loss (as a result of an unhedged exposure) or indirect loss in the firms cash flows, assets and liabilities, net profit and, in turn, its stock market value from an exchange rate move. To manage the exchange rate risk inherent in every multinational firms operations, a firm needs to determine the specific type of current risk exposure, the hedging strategy and the available instruments to deal with these currency risks. The goal of risk management is to ensure that an institution's trading, positioning, sales, credit extension, and operational activities do not expose the institution to excessive losses. The primary components of sound risk management include: A comprehensive risk measurement strategy for the entire organization, Detailed internal policies on risk taking, Strong information systems for managing and reporting risks, and A clear indication of the individuals or groups responsible for assessing and managing risk within individual departments. The qualitative and quantitative assumptions implicit in an institution's risk management system should be revisited periodically. Risk management methodologies vary in complexity; the rule of thumb is that the sophistication of a risk management method should be commensurate with the level of risk
2

Madura, J, 1989, International Financial Management, 2nd Edition. St. Paul, Minnesota: West

Publishing company.

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undertaken by the institution. While systems and reports are elements of risk control, effective communication and awareness are just as vital in a risk management program. 3.4.2 Types of risks with forex transactions Institutions and individuals should be aware of the various types of risk exposure in foreign exchange transactions: Market risk refers to adverse changes in financial markets. It can include exchange rate risk, interest rate risk, basis risk, and correlation risk. Credit risk occurs with counterparty default and may include delivery risk and sovereign risk. Settlement risk3 is specifically defined as the capital at risk from the time an institution meets its obligation under a contract (through the advance of funds or securities) until the counterparty fulfills its side of the transaction. Liquidity risk refers to the possibility that a reduction in trading activity will leave a firm unable to liquidate, fund, or offset a position at or near the market value of the asset. Operational/technology risk emanates from inadequate systems and controls, human error, or management failure. Such risk can involve problems of processing, product pricing, and valuation. Legal risk relates to the legal and regulatory aspects of financial transactions or to problems involving suitability, appropriateness, and compliance. 3.4.3 Forex risk management framework4 Once a firm recognizes its exposure, it then has to deploy resources in managing it. A heuristic for firms to manage this risk effectively is
3

The Committees 1994 document, Reducing Foreign Exchange Settlement Risk, provides a detailed

assessment of how to measure settlement risk and numerous suggestions to limit institutional exposure. While many of these suggestions have been implemented by the industry, others have yet to become common practice.
4

Based on inputs from Kshitij Consultancy Services

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presented below which can be modified to suit firm-specific needs i.e. some or all the following tools could be used. 1. Forecasts: After determining its exposure, the first step for a firm is to develop a forecast on the market trends and what the main direction/trend is going to be on the foreign exchange rates. The period for forecasts is typically 6 months. It is important to base the forecasts on valid assumptions. Along with identifying trends, a probability should be estimated for the forecast coming true as well as how much the change would be. 2. Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit or loss for a move in rates according to the forecast) and the probability of this risk should be ascertained. The risk that a transaction would fail due to market-specific problems5 should be taken into account. Finally, the Systems Risk that can arise due to inadequacies such as reporting gaps and implementation gaps in the firms exposure management system should be estimated. 3. Benchmarking: Given the exposures and the risk estimates, the firm has to set its limits for handling foreign exchange exposure. The firm also has to decide whether to manage its exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm are not adversely affected beyond a point. A profit centre approach on the other hand is a more aggressive approach where the firm decides to generate a net profit on its exposure over time. 4. Hedging: Based on the limits a firm set for itself to manage exposure, the firms then decides an appropriate hedging strategy. There are various financial instruments available for the firm to choose from:
5

For example, the foreign exchange market of a developing country may be highly regulated and thus

exposed to sudden swings due to frequent policy changes

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futures, forwards, options and swaps and issue of foreign debt. Hedging strategies and instruments are explored in a section. 5. Stop Loss: The firms risk management decisions are based on forecasts which are but estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there should be certain monitoring systems in place to detect critical levels in the foreign exchange rates for appropriate measure to be taken. 6. Reporting and Review: Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/loss status on open contracts after marking to market, the actual exchange/ interest rate achieved on each exposure, and profitability vis--vis the benchmark and the expected changes in overall exposure due to forecasted exchange/ interest rate movements. The review analyses whether the benchmarks set are valid and effective in controlling the exposures, what the market trends are and finally whether the overall strategy is working or needs change.

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Figure: 3.4.1 Framework of forex risk management 3.4.4 Forex risk management instruments 3.4.4.1 For market risks 3.4.4.1.1 Techniques for measuring market risks Nominal measure also called notional measure. One of the basic gauges of market risk, nominal measure refers to the amount of holdings or transactions on either a gross or net basis. An institution would use this measure, for example, when trying to determine an aggregate limit on a spot currency position, or when calculating a limit on the percentage of open interest on an exchange-traded contract. Factor sensitivity measure Used to ascertain the sensitivity of an instrument or portfolio to a change in a primary risk factor. Examples of factor sensitivity measures are duration risk and beta risk6. Optionality measure includes the "Greek" measures delta, vega, theta, rho, and gamma. The optionality measure estimates the sensitivity of an option's value to changes in the underlying variables in a value function (corresponding, in the first four cases, to price, volatility, time, and interest rates). Gamma measures the degree to which an options delta will change as the underlying price changes. Value at risk Represents the estimated maximum loss on an instrument or portfolio that can be expected over a given time interval and with a specified level of probability. Stress testing Involves the testing of positions or portfolios to determine their possible value under exceptional conditions. Any assumptions used in stress testing should be critically questioned and should mirror changes in market conditions such as variations in liquidity. Most stress testing models rely on dynamic hedging or some other method to estimate a portfolio's
6

Duration risk is defined as the sensitivity of the present value of a financial instrument to a change in

interest rates; beta risk in equities is defined as the sensitivity of an equitys or portfolios value to a change in a road equity index.

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hypothetical response to certain market movements. In disrupted or chaotic markets, the difficulty in executing trades tends to rise and actual market risk may also be higher than measured. Scenario simulation assesses the potential change in the value of instruments or portfolios under different conditions or in the presence of different risk factors. 3.4.4.1.2 Measures used to limit the market risks Aggregate limits may be gross (restricting the size of a long or short position) or net (recognizing the natural offset of some positions or instruments). Institutions generally employ both forms. Maximum allowable loss (stop loss) limits are designed to prevent an accumulation of excessive losses. They usually specify some time frameworkfor example, cumulative losses for a day, week, or month. If reached, a maximum allowable loss limit generally requires a management response. Value-at-risk limits specify loss targets for a portfolio given a particular change in the underlying environment (for example, a 100-basispoint change in interest rates) or for scenarios defined at some specific confidence interval (for example, 99 percent of possible occurrences over a time horizon). Maturity gap limits are used to control losses that may result from nonparallel shifts in the yield curve and/or changes in a forward yield curve. Acceptable amounts of exposure are established for specific time frames. Option limits are nominal limits for each of the Greek risks (the delta, gamma, vega, theta, and rho functions). Liquidity limits restrict the exposure that may occur when an institution is unable to hedge, offset, or finance its position because of volatile market conditions or other adverse events. 3.4.4.2 For credit risks 3.4.4.2.1 Types of credit risks 31

Credit risk in financial markets is measured as a combination of the position's current value (also termed replacement cost) and an estimate of potential future exposure relative to the change in replacement cost over the life of the contract. More specific types of credit risk exposure are listed below: Pre-settlement risk measured by the current carrying value (market or fair value) of the instrument or position prior to its maturity and settlement. If a counterparty defaults on a financial contract before settlement, and the contract is in the money for the non-defaulting party, the non-defaulting party has suffered a credit loss equal to the current replacement cost of the contract.7 Potential future exposure Represents risk and credit exposure given future changes in market prices. In calculating potential future exposure, some institutions add on factors for tenor and volatility. Others use statistical techniques to estimate the maximum probable value of a contract over a specified time horizon or the life of the contract. Aggregate exposure Refers to the sum of pre-settlement credit risk with a single counterparty. This measure is obtained by combining all transactions, by netting (if legally enforceable bilateral netting agreements are in place), or by measuring potential credit exposure on a portfolio basis. Global exposure Refers to the total credit risk to a single counterparty from both capital market products and loans. Many institutions convert both on- and off-balance sheet capital market exposures to loan-equivalent amounts. 3.4.4.2.2 Measures of enhancing credit positions Collateral arrangements in which one or both parties to a transaction agree to post collateral (usually cash or liquid securities) for the purpose of securing credit exposures that may arise from their financial transactions.
7

Additional information on pre-settlement risk can be found in the Committees 1992 paper,

Measuring Pre-Settlement Credit Exposures with Loan-Equivalent Risk.

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Special purpose vehicles Specially capitalized subsidiaries or designated collateral programs organized to obtain high third-party credit ratings. Mark-to-market cash settlement techniques The scheduling of periodic cash payments prior to maturity that equal the net present value of the outstanding contracts. Close-out contracts, or options to terminate Arrangements in which either counterparty, after an agreed upon interval, has the option to instruct the other party to cash settle and terminate a transaction. Material change triggers Arrangements in which counterparty has the right to change the terms of, or to terminate, a contract if a pre-specified credit event, such as a ratings downgrade, occurs. Netting agreements that reduce the size of counterparty exposures by requiring the counterparties to offset trades so that only a net amount in each currency is settled. Multilateral settlement systems (such as CLS) Collaborations that may reduce settlement risk among groups of wholesale market counterparties. 3.4.4.3 Derivatives instruments A derivative is a financial contract whose value is derived from the value of some other financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. The main role of derivatives is that they reallocate risk among financial market participants, help to make financial markets more complete. This section outlines the hedging strategies using derivatives with foreign exchange being the only risk assumed. 3.4.4.3.1 Forwards: A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. The depreciation of the receivable currency 33

is hedged against by selling a currency forward. If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward. E.g if RIL wants to buy crude oil in US dollars six months hence, it can enter into a forward contract to pay INR and buy USD and lock in a fixed exchange rate for INRUSD to be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this example the downside is an appreciation of Dollar which is protected by a fixed forward contract. The main advantage of a forward is that it can be tailored to the specific needs of the firm and an exact hedge can be obtained. On the downside, these contracts are not marketable, they cant be sold to another party when they are no longer required and are binding. 3.4.4.3.2 Futures A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. The futures market. Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double coincidence. Futures require a small initial outlay (a proportion of the value of the future) with which significant amounts of money can be gained or lost with the actual forwards price fluctuations. This provides a sort of leverage. The previous example for a forward contract for RIL applies here also just that RIL will have to go to a USD futures exchange to purchase standardized dollar futures equal to the amount to be hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the tailorability of the futures contract is limited i.e. only standard denominations of money can be bought instead of the exact amounts that are bought in forward contracts. 3.4.4.3.3 Options

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A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend. Again taking the example of RIL which needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified date, there are two scenarios. If the exchange rate movement is favorable i.e the dollar depreciates, then RIL can buy them at the spot rate as they have become cheaper. In the other case, if the dollar appreciates compared to todays spot rate, RIL can exercise the option to purchase it at the agreed strike price. In either case RIL benefits by paying the lower price to purchase the dollar. 3.4.4.3.4 Swaps A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. The advantages of swaps are that firms with limited appetite for exchange rate risk may move to a partially or completely hedged position through the mechanism of foreign currency swaps, while leaving the underlying borrowing intact. Apart from covering the exchange rate risk, swaps also allow firms to hedge the floating interest rate risk. Consider an export oriented 35

company that has entered into a swap for a notional principal of USD 1 mn at an exchange rate of 42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures. 3.4.4.3.5 Foreign debt Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile so, to hedge this, he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. The theory assures that the gain realized by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan.

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