CAIIB BANKING FINANCIAL MANAGEMENT | INTERNATIONAL BANKING | FOREX BUSINESS
BANKING FINANCIAL MANAGEMENT:- The term ‘Forex’ is made up of two words, foreign currency, and exchange. Foreign exchange is the process of converting one currency into another for varied reasons, most popularly either for commerce, trade, or tourism purposes.
As per the triennial report of BIS (bank for international settlements) 2019 report, the trading volume for Forex had reached $6.6 trillion (daily) in April 2019.
The ‘foreign exchange’ is also known by the terms ‘forex’ or ‘FX’ market. When referred to as such it is defined as a global marketplace to exchange national currencies.
Phonics is the market where different currencies are traded. The trade of currencies is important in itself because they allow us to buy goods & services across the local as well as international borders. They allow us to do foreign trade and business.
For International Trade
For example, as an Indian Residence, you want to buy a bag from France, then either you or the company from which you want to buy the bag has to pay the currency of French (i.e Franc) for the bag in Rupees (INR). This means that the Indian importer has to exchange the equivalent value of Indian rupees into the franc.
For Local Trade
The same goes for local trade. Take traveling as an example. Suppose, as an Indian tourist in Egypt, you can’t pay in rupees to see the pyramids because rupees is not the currency that is accepted locally. You would need to exchange the Rupees for the local currency i.e Egyptian pound, at the exchange rate that is prevalent in the market.
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OVER THE COUNTER TRANSACTIONS
What is important to note is that there is no central marketplace to conduct this foreign exchange. Rather, the trading of currency is done electronically over the counter i.e all trading transactions among the world traders occur on computer networks instead of one centralized exchange.
The foreign market remains open 24 hours a day for 5 & a half days a week, & currencies are traded worldwide in the major financial centers of Hong Kong, London, Frankfurt, New York, Singapore, Sydney, Paris, Tokyo, & Zurich—across almost every time zone. It means that when creating ends in the USA, the forex market starts a new in Hongkong and Tokyo. In this way, the forex markets are extremely active markets while their prices keep changing constantly.
The terms ‘FX’, foreign exchange market, forex & currency market are used interchangeably & is referred to as one & same.
FOREX: BRIEF HISTORY
The currencies have been getting exchanged for centuries the term foreign market is a relatively modern invention.
Commercial, as well as investment banks, do most of the trading in forex markets on the client’s behalf, but professional and individual investors also get speculative opportunities by trading one currency against another.
Through which one can earn from the forex market:
- Differences in interest rate: By buying the higher interest rate currency while shorting the lower interest rate currency (known as carrying Trade).
- Profit from exchange rate changes
Before the period of the internet, very difficult to do currency trading. Then large MNCs, hedge funds, and high net worth individuals were the parties that used to do the foreign trading as there was a lot of capital required to do the same.
Now with the advent of the internet, individual traders also have access to these exchange markets either through banks or brokers.
AN OVERVIEW OF FOREX MARKETS
In simple words, FX is a market where currencies are traded. As mentioned in the history section, the foreign market used to be accessible to Institutional firms & large banks but has become more retail-oriented in the past years.
The interesting thing about world forex markets is that no buildings are required as a trading venue for the markets to operate. Only a series of connections that are made up of trading terminals and computer networks is required.
These markets are more transparent than any other financial market. Although the currencies are traded in over-the-counter markets, there the disclosures are not mandatory.
Institution firms have large liquidity pools in this market. Considering this, one would think that the economic parameters of the nation would be the most important criteria for price determination. But it is not so. As per a 2019 survey, the most important role in the determination of currency prices is the motive of the large Financial Institutions.
The forex market is more popular with the people who want or need to hedge their foreign exchange risks.
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It is a market where currencies are sold and bought at their trading prices. These trading prices depend on the supply and demand of the currencies and some other factors such as current interest rates, economic performance, perception of future performance of one currency, expectation towards the ongoing political situations (whether local or International), etc. When a deal is finalized, it is known as a spot deal. It’s basically a bilateral transaction where one party delivers a currency amount to the other for a specified amount of another currency at an agreed-upon rate of exchange.
The positions taken in the spot markets are closed (settled) in cash only. The settlement takes around 2 days.
The spot market is the largest Market because it reads the biggest underlying assets in the forward and futures markets. As the transactions in Forex begin electronically, the trading volume for forex spot markets has increased.
FORWARDS AND FUTURES MARKETS
Forward Contract: An agreement between two parties to buy a particular currency at a pre-determined price at a future date in the over-the-counter market is known as a forwarding contract.
In other words, it is a standardized agreement between two parties on the delivery of a currency at future date and at a predetermined price. It should be noted that futures are traded on the exchanges while forward contracts are traded on the over-the-counter.
What is interesting to see is that forwards and futures markets do not actually trade the currencies like spot markets. Instead, contracts are entered into to claim certain currencies at a future date and at a specific price which will be settled in the cash.
In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves. In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange (CME).
Future Contract: While in the future market, a future contract that we would be used on a standard lot size which has a settlement date on public commodities market or exchanges by whatever name they are called with.
Future contracts contain specific details regarding the number of units that are being traded, settlement and delivery dates, minimum price increments which are not allowed to be customized. Here, the exchange act as a counterparty e to the trader and provides clearance and settlement services.
Both future and forward contracts are binding in nature and get settled in cash upon the expiry. But that does not mean that these contracts cannot be both or sold before the expiry dates.
The currency forward and futures markets were primarily set up to offer protection against trading currency risk. These markets are used to hedge against future exchange fluctuations by the big international corporations but speculators also trade in these markets to do speculations.
USES OF THE FOREX MARKETS
FOREX FOR HEDGING
Companies that have business in foreign Nations are always it was due to the fluctuations that keep happening in the currency values whenever they buy or sell goods and services out of their domestic markets. And foreign exchange markets opportunity by fixing the rate at which the transaction they want to be completed.
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To do this, a trader or a business can buy or sell currencies in the forward markets in advance at pre-determined exchange rates.
For example, A company wants to sell India-made cosmetics in Europe when the exchange rate between the euro and rupee is at parity i.e Rs.1 = €1.
Suppose, a lipstick costs Rs.100 to manufacture and the Indian company wants to sell it for 150 Euro while remaining competitive with other lipstick brands that are made in Europe. If the plan becomes successful, the company will make a profit of Rs.50 per product at the given exchange rate.
But if so happens that the Indian Rupee begins to rise in value vs. Euro & the rate becomes 0.80 (Rs/USD), meaning, it will cost Rs.0.80 to buy €1.00.
The problem that the company will face will be that while it costs Rs.100 to manufacture one lipstick, it can sell the product at €150, which when converted to Rupees will amount to only Rs.120.00 leading to much smaller profit than what the company expected.
Risk Mitigation: The Indian Company could have mitigated this risk by short-selling the euro while buying the Indian rupees when they were at parity. This way when the Indian rupee rose in value, the profit from the forex trade would have offset the reduced profit from the sale of lipstick.
If the U.S. dollar fell in value, then the more favorable exchange rate would increase the profit from the sale of blenders, which offsets the losses in the trade. The opposite position can be taken when the currency prices of the domestic country are on the fall.
The above process is known as hedging which can be done in the currency futures market. This way the trader or a company can take advantage of the futures contract because they are standardized contracts and get cleared by the central authority.
FOREX FOR SPECULATION
Factors such as rate of interest, tourism, economics Trend, risk of geopolitics, trade flows affect the demand and supply of currencies thereby creating volatility in the forex market. There exists an opportunity to make profits from these changes that we increase or reduce one currency’s value when compared to another.
An expectation that one currency will be is as same as zooming that the other will strengthen because the currencies get traded in pairs.
Now imagine a trader who is expecting that interest rates will increase if compared to Australia when the exchange rate between the two countries’ currencies is (AUD/Rs.) 0.71. This means that it will take Rs.0.70 to buy $1.00 AUD.
As a creative believe that the Indian interest rates will increase the demand for AUD, and therefore AUD/Rs. Will fall because it will require to see fewer Rs to purchase an AUD.
And if that traders’ expectation comes true and the interest rate rises, which will decrease the AUD/Rs. to 0.50. That is to say, the trader will require Rs.0.50 to buy $1 AUD. And if the investor had taken a short position in AUD and long on Rupee, then he or she would have made a profit from the change in value.
In this way, regular investor and companies can hedge their funds & mitigate or reduce the risk that arises on account of currency rate changes & interest rate changes. The different exchange rates also give an opportunity to speculate on the same leading to the entry of speculators in the forex markets too.
Well, whatever the case, one to his own. They can do either, hedge or speculate and chose what purpose they want to achieve.