forex hard2

8/6/2019 Forex Hard2

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Students of SYBFM present the topic:-


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Foreign Exchange MarketsIntroduction

Forex (Foreign Exchange) is the international financial marketused for trade of world currencies. It has been working since 70sof the 20th century - from the moment when the biggest worldnations decided to switch from fixed exchange rates to floatingones.

Daily volume of Forex trade exceeds 4 trillion United Statesdollars, and this number is always growing.

Main currency for Forex operations is the United States dollar

(USD).

According to Paul Einzig, "The foreign exchange market is thesystem in which the conversion of one national currency in toanother takes place with transferring money from one country toanother."

According to Kindleberger, "It is place where foreign moneys arebought and sold."

In simple words, the foreign exchange market is a market inwhich national currencies are bought and sold against oneanother. There are large numbers of foreign transactions such asbuying goods abroad, visiting foreign country for any purpose.Corresponding nation in whose currency the transaction is to befulfilled. The foreign exchange market provides the foreigncurrency against any national currency. However, it is to beunderstood that unlike other markets, this market is notrestricted to any particular country or any geographic area.

There are large numbers of dealers' instruments such as

exchange bills, bank drafts, telegraphic transfers (TT), etc. Thereare certain other dealers such as brokers, acceptance houses aswell as the central bank and treasury of the nation.

The foreign exchange market is unique because of

Its huge trading volume, leading to high liquidity;
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Its geographical dispersion;

Its continuous operation: 24 hours a day except weekends,i.e. trading from 20:15 GMT on Sunday until 22:00 GMTFriday;

The variety of factors that affect exchange rates;

The low margins of relative profit compared with othermarkets of fixed income; and

The use ofleverage to enhance profit margins with respectto account size.

History

Historically the value of goods was expressed through someother goods, for example - a barter economy where individualsexchange goods. The obvious disadvantages of such a systemencouraged establishment of more generally accepted andunderstand means of goods exchange long time ago in history -to set a common scale of value. In different places everythingfrom teeth to jewelry has served this purpose but later metals,and especially gold and silver, were introduced as an acceptedmeans of payment, and also a reliable form of value storage.

Originally, coins were basically minted from the metal, butstable political systems introduced a paper form of IOUs (I oweyou) which gained wide acceptance during the Middle Ages. Suchpaper IOUs became the basis of our modern currencies.

Before First World War most central banks supportedcurrencies with gold. Even though banknotes always could beexchanged for gold, in reality this did not happen that often,developing an understanding that full reserves are not really

needed.Sometimes huge supply of banknotes without gold support led

to giant inflation and hence political instability. To protectnational interests foreign exchange controls were introduced todemand more responsibility from market players.
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Closer to the end of World War II, the Bretton Woodsagreement was signed as the initiative of the USA in July 1944.

The Bretton Woods Conference rejected John Maynard Keynessuggestion for a new world reserve currency in favour of a

system built on the US dollar. Other international institutionssuch as the IMF, the World Bank and GATT (General Agreementon Tariffs and Trade) were created in the same period as theemerging victors of WW2 searched for a way to avoid thedestabilising monetary crises which led to the war. The BrettonWoods agreement resulted in a system of fixed exchange ratesthat partly reinstated the gold standard, fixing the US dollar atUSD35/oz and fixing the other main currencies to the dollar - andwas intended to be permanent.

The Bretton Woods system came under increasing pressure asnational economies moved in different directions during thesixties. A number of realignments kept the system alive for along time, but eventually Bretton Woods collapsed in the earlyseventies following president Nixon's suspension of the goldconvertibility in August 1971. The dollar was no longer suitableas the sole international currency at a time when it was undersevere pressure from increasing US budget and trade deficits.

The following decades have seen foreign exchange trading

develop into the largest global market by far. Restrictions oncapital flows have been removed in most countries, leaving themarket forces free to adjust foreign exchange rates according totheir perceived values.

But the idea of fixed exchange rates has by no means died.The EEC (European Economic Community) introduced a newsystem of fixed exchange rates in 1979, the European MonetarySystem. This attempt to fix exchange rates met with nearextinction in 1992-93, when pent-up economic pressures forced

devaluations of a number of weak European currencies.Nevertheless, the quest for currency stability has continued inEurope with the renewed attempt to not only fix currencies butactually replace many of them with the Euro in 2001.

The lack of sustainability in fixed foreign exchange ratesgained new relevance with the events in South East Asia in the


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latter part of 1997, where currency after currency was devaluedagainst the US dollar, leaving other fixed exchange rates, inparticular in South America, looking very vulnerable.

But while commercial companies have had to face a much

more volatile currency environment in recent years, investorsand financial institutions have found a new playground. The sizeof foreign exchange markets now dwarfs any other investmentmarket by a large factor. It is estimated that more than USD3,000 billion is traded every day, far more than the world's stockand bond markets combined.

Functions of Foreign Exchange Market

(A) Transfer Function: As mentioned above, the foreignexchange markets are exchange markets engaged intransferring the purchasing power between two nations and twocurrencies. It is prime function of this market. In simple terms, itis conversion of one currency into another such as convertingIndian Rs. into U.S. $ and vice versa at some rate. Variousinstruments like bank drafts, exchange bills, are used fortransferring the purchasing power. In this regard internationalclearing to both the direction is important to because it simplifiesthe conduct of international trade as well as capital movementsfrom one country to another.

(B) Credit Function : Under this function the foreign exchangemarket provides credit to the traders such as exporters and

importers. Exporters can get credit such as reshipment and post-shipment credit. Recently started Euro-Dollar market is a leadingcredit market at international level. This function of makingcredit available plays a crucial role in growth and expansion ofthe international trade.


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(C) Hedging : Hedging is a specific function. Under this functionthe foreign exchange market tries to protect the interest of thepersons dealing in the market from any unforeseen changes inthe exchange rate. The exchange rates (price of one currency

expressed in another currency) under free market situation cango up and down. This can either bring gains or losses to theconcerned parties. Foreign exchange market guards the interestof both exports as well as importers, against any changes in theexchange rate.

(D)Primary

The primary function of foreign currency exchange markets is toconvert the currency of one country into another currency. Forexample, the U.S. dollar may be changed into Mexican Pesos orEnglish Pounds. The amount of currency converted depends onthe exchange rate, which can be fixed or can fluctuate. The U.S.dollar is a currency that has a fluctuating exchange rate that isbased on market demand. Some countries, like China, have afixed exchange rate determined by their central bank.

(E)International Transactions

Foreign currency exchange markets serve to facilitateinternational financial transactions. These transactions may bethe purchasing and selling of goods, direct investment inbuildings and equipment in a foreign country or the purchase ofinvestment vehicles like foreign bonds. For example, a U.S.-basedcompany may want to purchase goods manufactured in China.

The foreign currency exchange market allows them to exchangeU.S. dollars and make the purchase in Chinese RMB (renminbi,the currency of the People's Republic of China).

(F)Currency Value

The value of a country's currency can influence internationaltrade, consumers' purchasing power and inflation. Central banksof a county or region, like the U.S. Federal Reserve, seek tominimize the impact of currency fluctuations. The foreigncurrency exchange market functions as a tool for central banks
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to control the value of their currency by buying or sellingcurrency, which influences the total amount in worldwidecirculation.

(G)Investment

Fund managers and investment professionals use the foreigncurrency exchange market to help diversify their portfolios andpotentially increase their returns. Through calculated risks,investors can bet on a change in the price or exchange rate of acurrency. Just like with the stocks, if currency is purchased at alow price and sold at a higher price, the investor makes money.

(H)Loss Protection

International companies that work in multiple countries aresubject to gains and losses based on exchange rate fluctuations.To help prevent losses, companies can make forwardtransactions where they make a binding agreement to exchangecurrency for another currency at a fixed rate. This function of theforeign currency exchange market helps a company minimizethe risk of foreign exchange on future expenses. For example, ifa U.S.-based company places an order with a firm in Taiwan thatwill be ready in five months, the company can enter a forwardtransaction agreement that fixes the price based on the current

exchange rate at the time of order. The company knows thevalue and cost of the purchase and will not be hit with a futureloss based on a change in exchange rates.

Advantages of Forex trading

High leverage

Starting from a minimum of 100:1, Forex markets offer itstraders with huge amounts of leverage which means that fatprofits can be produced by investing small amounts of deposits.

No commission


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If dealing with a financial market on daily basis, the regularinvestors or traders are the ones who are really benefited by thefree of commission trading. The currency trading market letsits traders keep a whole 100% of their trading profits.

Superior liquidity

With most of the currency transactions comprising of 7 maincurrency pairs, the huge volume and the global trading aspecthelps these currencies exhibit price stability, little slippage,narrow spreads and high levels of liquidity.

Profitability

Being an over the counter market, the trading done at Forex canbe known as over the counter trading, wherein, a trader alwaysbuys one currency and sells of the other one in real time. Thereis no organizational prejudice in the market and every investorhas the equal prospects for profit in it.

24 hours trading

Forex currency trading market offers its traders with a 24 hour

trading opening, wherein, a Forex investor can trade any time ofthe day, whatever suits him/her, as the market is open fortrading 24 hours a day, from Sunday 5:00 pm (ET) to Friday 4:30pm.

This gives the Forex traders a choice to opt for timing for thetrade according to their convenience.

Disadvantages of Forex trading

High Leverage

While high leverage serves as an advantage to attract traders tothe market, it can at times also act as a disadvantage for them.With such high levels of leverage available to traders in theForex market, comes an equally high level of danger.


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This can be true for the high stake positions which carry alongwith them, too much risk, leading to margin calls. This is whereefficient money management comes into play for playing safe.

24 hours market

Although it is convenient for the trader to trade whenever it issuitable to him, it can be a rather tough job too. This is because,at times, it is not possible for an individual trader to keep track ofthe Forex market, 24 hours a day.

This is where a broker comes into the picture. Retail or individualinvestors should try taking help from a professional broker rather

than doing all the dealings himself straight with the huge market.

The broker will be an experienced professional who will act as anequal in your transactions, keeping you informed and updatedabout minute to minute details and fluctuations, and even guideyou about the conditions, when to and when not to trade in themarket.

Like every other financial market, Forex market also has itsshare of advantages and disadvantages. But keeping in mind thetwo can surely help a trader become more vigilant and aware ofwhat to expect while trading Forex.

Market size

As such, it has been referred to as the market closest to the ideal

ofperfect competition, notwithstanding market manipulation bybanks. According to the Bank for International Settlements, as ofApril 2010, average daily turnover in global foreign exchangemarkets is estimated at $3.98 trillion, a growth of approximately20% over the $3.21 trillion daily volume as of April 2007.

The $3.98 trillion break-down is as follows:
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$1.490 trillion in spot transactions

$475 billion in outright forwards

$1.765 trillion in foreign exchange swaps

$43 billion currency swaps

$207 billion in options and other products

Main foreign exchange market turnover, 19882007, measuredin billions of USD.

The foreign exchange market is the largest and most liquidfinancial market in the world. Traders include large banks,

central banks, currency speculators, corporations, governments,and other financial institutions. The average daily volume in theglobal foreign exchange and related markets is continuouslygrowing. Daily turnover was reported to be over US$3.98 trillionin April 2010 by the Bank for International Settlements.

Of the $3.98 trillion daily global turnover, trading in Londonaccounted for around $1.85 trillion, or 36.7% of the total, makingLondon by far the global center for foreign exchange. In secondand third places respectively, trading in New York City accountedfor 17.9%, andTokyo accounted for 6.2%. In addition to"traditional" turnover, $2.1 trillion was traded in derivatives

Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except inthe case of trades between the US Dollar, Canadian Dollar,

Turkish Lira, EURO and Russian Ruble, which settle the next

business day), as opposed to the futures contracts, which areusually three months. This trade represents a direct exchangebetween two currencies, has the shortest time frame, involvescash rather than a contract; and interest is not included in theagreed-upon transaction.

Forward
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One way to deal with the foreign exchange risk is to engage in aforward transaction. In this transaction, money does not actuallychange hands until some agreed upon future date. A buyer andseller agree on an exchange rate for any date in the future, and

the transaction occurs on that date, regardless of what themarket rates are then. The duration of the trade can be one day,a few days, months or years. Usually the date is decided by bothparties. Then the forward contract is negotiated and agreed uponby both parties.

Swap

The most common type of forward transaction is the currency

swap. In a swap, two parties exchange currencies for a certainlength of time and agree to reverse the transaction at a laterdate. These are not standardized contracts and are not tradedthrough an exchange.

Future

Foreign currency futures are exchange traded forwardtransactions with standard contract sizes and maturity dates for example, $1000 for next November at an agreed rate 4.5%.

Futures are standardized and are usually traded on an exchangecreated for this purpose. The average contract length is roughly3 months. Futures contracts are usually inclusive of any interestamounts.

Option

A foreign exchange option (commonly shortened to just FXoption) is a derivative where the owner has the right but not theobligation to exchange money denominated in one currency intoanother currency at a pre-agreed exchange rate on a specifieddate. The FX options market is the deepest, largest and mostliquid market for options of any kind in the world.
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Forex ETF

Forex Exchange Traded Funds can be thought of as a stock market existing within theforex market. The Forex ETF firms create forex traded funds through buying andholding of foreign currencies. Later on, these funds are sold as shares and traders can

buy any number of stocks for that fund.The most commonly used currency is the USD in forex ETF. A shareholder of theforex ETF funds makes money when the prices of the term currency improve againstthe USD.

Types of Forex ETFs

Forex market deals in many currencies. Therefore, many specialized or diversifiedforex ETFs have emerged with a focus on different number of currencies. They are:Forex ETFs which track single currency: These firms buy only one currency and their

share represents a fixed amount of that currency. One can invest in the:

Canadian Dollar Trust (FXC)

British Pound Trust (FXB)

Euro Currency Trust (FXE)

Currency Swiss Franc Trust (FXF)

Australian Dollar Trust (FXB)

Forex ETFs that track a number of currencies based on their correlation: Funds likePowerShares DB U.S. Dollar Bearish (UDN) and PowerShares DB U.S. Dollar Bullish(UUP) invest in currencies like:

Japanese Yen Euro

Swedish Krona

British Pound

Canadian Dollar

Swiss Franc

In these ETFs, the ratio of currencies differs from one fund to another.Forex ETFs that track currency indexes: There are very few firms that operate under

this category. The DB G10 Currency Harvest Fund (DBV) is a popular example.

Currencies traded in the markets

Majors

European Union Euro EUR
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United States Dollar USD $

United Kingdom Pound Sterling GBP

Japanese YenJPY

Switzerland Swiss Franc CHF Sfr.

Minors

Australia Australian Dollar AUD A$

New Zealand New Zealand Dollar NZD NZ$

Canada Canadian Dollar CAD C$

Exotic Currencies

Many other countries exist in the world, and most of them havetheir own currencies. Outside of the major and minor currenciesis the large group of the so-called "exotic currencies".

Exotic currencies are made up of the hundreds of currencies notin the major or minor leagues, but which are neverthelessimportant as well, especially in international commerce andfinance.

The exotics include:

RUB - the Russian Ruble

CNY- the Chinese Yuan or Remnimbi

BRL - the Brazilian Real

MXN - the Mexican Peso

CLP - the Chilean Peso

INR - the Indian Rupee

IRR - the Iranian Rial

These make up just a few of the most actively traded exoticcurrencies. In some cases, a country will use U.S. Dollars as theircurrency, such as countries like Haiti for example.


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Working of forex market

Quotes of trades

For example, the exchange rate between US dollars and theSwiss franc is normally stated:

SF 1.6000/$ (European terms)

However, this rate can also be stated as:

$0.6250/SF (American terms)

Excluding two important exceptions, most interbank quotations

around the world are stated in European terms.

Forward rates are typically quoted in terms of points. A forwardquotation is expressed in points is not a foreign exchange rate assuch. Rather, it is the difference between the forward rate andthe spot rate.

Interbank quotations are given as a bid and ask (also referred toas offer).A bid is the price (i.e. exchange rate) in one currency atwhich a dealer will buy another currency. An ask is the price (i.e.

exchange rate) at which a dealer will sell the other currency.Dealers bid (buy) at one price and ask (sell) at a slightly higherprice, making their profit from the spread between the buyingand selling prices. A bid for one currency is also the offer for theopposite currency.

Foreign exchange transactions are settled through Nostro

and Vostro accounts.

Nostro: our account with banks abroad. Reserve Bank of India(RBI) maintains various Nostro accounts in a number ofcountries.


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Vostro: their account with us. Many multilateral agencies (e.g.IMF, World Bank) maintain their Nostro accounts at Reserve Bankof India (RBI).

SWIFT (Society for Worldwide Interbank Financial

Telecommunications)

Price maker and Price Taker

The bank quoting the price is price maker or market maker.

The bank asking for the price or quote is the price taker oruser.

NET OPEN POSITION- (NOP)

A measure of foreign exchange risk

NOP is the Net Asset/Net Liability position in all FCs together(Both B/S & Off B/S).

Net Asset Position is also called LONG or Overbought position.

Net liability Position is also called SHORT or Oversold position.

NOP is a single statistic that provides a fairly good idea aboutexchange risk assumed by the bank.

Its major flaw is that FX exposures in third currencies remainhidden.

Market participants

The foreign exchange market consists of two tiers:

The interbank or wholesale market (multiples of $1MM US or

equivalent in transaction size)

The client or retail market (specific, smaller amounts)

Five broad categories of participants operate within these twotiers; bank and nonbank foreign exchange dealers, individuals


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and firms, speculators and arbitragers, central banks andtreasuries, and foreign exchange brokers.

1. Bank and Nonbank Foreign Exchange DealersBanks and a few nonbank foreign exchange dealers operate inboth the interbank and client markets. The profit from buyingforeign exchange at a bid price and reselling it at a slightlyhigher offer or ask price. Dealers in the foreign exchangedepartment of large international banks often function asmarket makers.These dealers stand willing at all times to buyand sell those currencies in which they specialize and thusmaintain an inventory position in those currencies.

2. Individuals and Firms

Individuals (such as tourists) and firms (such as importers,exporters and MNEs) conduct commercial and investmenttransactions in the foreign exchange market. Their use of theforeign exchange market is necessary but neverthelessincidental to their underlying commercial or investment purpose.Some of the participants use the market to hedge foreignexchange risk.

3. Speculators and Arbitragers

Speculators and arbitragers seek to profit from trading in themarket itself. They operate in their own interest, without a needor obligation to serve clients or ensure a continuous market.While dealers seek the bid/ask spread, speculators seek all theprofit from exchange rate changes and arbitragers try to profitfrom simultaneous exchange rate differences in differentmarkets.

4. Central Banks and Treasuries

Central banks and treasuries use the market to acquire or spendtheir countrys foreign exchange reserves as well as to influencethe price at which their own currency is traded. They may act to


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support the value of their own currency because of policiesadopted at the national level or because of commitmentsentered into through membership in joint agreements such asthe European Monetary System. The motive is not to earn a

profit as such, but rather to influence the foreign exchange valueof their currency in a manner that will benefit the interests oftheir citizens. As willing loss takers, central banks and treasuriesdiffer in motive from all other market participants

5. Foreign Exchange Brokers

Foreign exchange brokers are agents who facilitate tradingbetween dealers without themselves becoming principals in thetransaction. For this service, they charge a commission. It is abrokers business to know at any moment exactly which dealerswant to buy or sell any currency. Dealers use brokers for theirspeed, and because they want to remain anonymous since theidentity of the participants may influence short term quotes.

RBIs role in forex market

To manage the exchange rate mechanism. Regulate inter-bankforex transactions and monitor the foreign exchange risk of thebanks. Keep the exchange rate stable. Manage and maintain

country's foreign exchange reserves.1. Exposure limits

RBI has imposed foreign exchange exposure limits on banks (FE12 of 1999).The limits are tied with the Paid up capital of thebank. Previously banks had NOP limit, which was based onforeign exchange volume handled by the bank.

2. Treasury operations at RBITreasury operations at RBI

All Central Banks have treasuries to implement policy objectivesvis a vis EXCHANGE RATE & INTEREST RATES Dealing roomcatered to the FX market only. Money market was being lookedafter by the Securities department. It soon became apparent thatthe two cannot work in isolation with each other as the linkagebetween the money market & exchange market became


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pronounced .Finally the dealing room and securities departmentwere merged to form EDMD to form first ever Treasury of RBI.

3. RBIs monitoring

NOP report.

FX inflow/outflow statements.

Oil payments,

Forward transactions.

Market monitoring Market Flows and their impact onexchange rate.

Money Market liquidity

Forward rates

Market activity if required

Rates Preparation M2M (Marked to Market), Wtd.Avg(Weighted Average), FCA Conversion.

4. InterventionTo keep exchange rate in line with macro objectives RBI has tointervene from time to time. Intervention is a process where FXis sold or purchased to keep the right amount of liquidityavailable in the FX market so that demand / supply equilibrium ismaintained. Intervention can be in READY or FORWARD

5. Other Functions

OFFSITE MONITORING

DAILY RATES FOR MARKET

THIRD CURRENCY ACTIVITY FOR BO PAYMENTS

RESERVE MANAGEMENT

6. A Quantitative function to regulate banks


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Foreign Exchange Exposure Limit (FEEL)

Basically restricts the banks to keep a net asset (long) or netliability (short) position in foreign currencies. Presently FEEL foreach bank is set at 10 % of its paid up capital. In the presence of

FEEL, banks net purchases or net sales in foreign exchange on agiven day have to be within their FEEL.

RISK MANAGEMENT

Risk aversion in the forex is a kind of trading behavior exhibitedby the foreign exchange market when a potentially adverseevent happens which may affect market conditions. This

behavior is caused when risk averse traders liquidate theirpositions in risky assets and shift the funds to less risky assetsdue to uncertainty.

In the context of the forex market, traders liquidate theirpositions in various currencies to take up positions in safe havencurrencies, such as the US Dollar. Sometimes, the choice of asafe haven currency is more of a choice based on prevailingsentiments rather than one of economic statistics. An examplewould be the Financial Crisis of 2008. The value of equitiesacross world fell while the US Dollar strengthened. Thishappened despite the strong focus of the crisis in the USA.

Hedging with Forwards

Hedging refers to managing risk to an extent that makes itbearable. In international trade and dealings foreign exchangeplay an important role. Fluctuations in the foreign exchange ratecan have significant impact on business decisions and outcomes.Many international trade and business dealings are shelved orbecome unworthy due to significant exchange rate riskembedded in them. Historically, the foremost instrument usedfor exchange rate risk management is the forward contract.Forward contracts are customized agreements between twoparties to fix the exchange rate for a future transaction. Thissimple arrangement would easily eliminate exchange rate risk,
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but it has some shortcomings, particularly getting a counterparty who would agree to fix the future rate for the amount andtime period in question may not be easy. In Malaysia manybusinesses are not even aware that some banks do provide

forward rate arrangements as a service to their customers. Byentering into a

Forward rate agreement with a bank, the businessman simplytransfers the risk to the bank, which will now have to bear thisrisk. Of course the bank in turn may have to do some kind ofarrangement to manage this risk. Forward contracts aresomewhat less familiar, probably because there exists no formaltrading facilities, building or even regulating body.

An Example of Hedging Using Forward AgreementAssume that a Malaysian construction company, Bumiways justwon a contract to build a stretch of road in India. The contract issigned for 10,000,000 Rupees and would be paid for after thecompletion of the work. This amount is consistent with Bumiwaysminimum revenue of RM1,000,000 at the exchange rate ofRM0.10 per Rupee. However, since the exchange rate couldfluctuate and end with a possible depreciation of Rupees,Bumiways enters into a forward agreement with First State Bank

of India to fix the exchange rate at RM0.10 per Rupee. Theforward contract is a legal agreement, and therefore constitutesan obligation on both sides. The First State Bank may have tofind a counter party for this transaction either a party whowants to hedge against the appreciation of 10,000,000 Rupeesexpiring at the same time or a party that wishes to speculate onan upward trend in Rupees. If the bank itself plays the counterparty, then the risk would be borne by the bank itself. Theexistence of speculators may be necessary to play the counterparty position. By entering into a forward contract Bumiways isguaranteed of an exchange rate of RM0.10 per Rupee in thefuture irrespective of what happens to the spot Rupee exchangerate. If Rupee were to actually depreciate, Bumiways would beprotected. However, if it were to appreciate, then Bumiwayswould have to forego this favorable movement and hence bearsome implied losses. Even though this favourable movement is


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still a potential loss, Bumiways proceeds with the hedging sinceit knows an exchange rate of RM0.10 per Rupee is consistentwith a profitable venture.

Hedging with Futures

Noting the shortcomings of the forward market, particularly theneed and the difficulty in finding a counter party, the futuresmarket came into existence. The futures market basically solvessome of the shortcomings of the forward market. A currencyfutures contract is an agreement between two parties a buyerand a seller to buy or sell a particular currency at a future date,at a particular exchange rate that is fixed or agreed upon today.

This sounds a lot like the forward contract. In fact the futures

contract is similar to the forward contract but is much moreliquid. It is liquid because it is traded in an organized exchangethe futures market (just like the stock market). Futures contractsare standardized contracts and thus are bought and sold 4 justlike shares in the stock market. The futures contract is also alegal contract just like the forward, but the obligation can beremoved before the expiry of the contract by making anopposite transaction. As for hedging with futures, if the risk is anappreciation of value one needs to buy futures and if the risk isdepreciation then one needs to sell futures. Consider our earlier

example, instead of forwards, Bumiways could have thus soldRupee futures to hedge against Rupee depreciation. Letsassume accordingly that Bumiways sold Rupee futures at therate RM0.10 per Rupee. Hence the size of the contract isRM1,000,000. Now say that Rupee depreciates to RM0.07 perRupee the very thing Bumiways was afraid of. Bumiways wouldthen close the futures contract by buying back the contract atthis new rate. Note that in essence Bumiways basically boughtthe contract for RM0.07 and sold it for RM0.10. This would give a

futures profit of RM300,000 [(RM0.10-RM0.07) x 10,000,000].However in the spot market Bumiways gets only RM700,000when it exchanges the10,000,000 Rupees contract value atRM0.07. The total cash flow however, is RM1,000,000(RM700,000 from spot and RM300,000 profit from futures). Withperfect hedging the cash flow would be RM1 million no matterwhat happens to the exchange rate in the spot market. One


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advantage of using futures for hedging is that Bumiways canrelease itself from the futures obligation by buying back thecontract anytime before the expiry of the contract. To enter intoa futures contract a trader needs to pay a deposit (called an

initial margin) first. Then his position will be tracked on a dailybasis so much so that whenever his account makes a loss for theday, the trader would receive a margin call (also known asvariation margin), i.e. requiring him to pay up the losses.

5 Economic Events When Currency Rocked the World

These are changes in the currency markets which causedsubstantial impact in the world economy. It is important that

people learn about currency movements and how the occurrenceof such events provide lucrative opportunities for currency

investors to profit from theforexmarkets.

Free Market Capitalism is Born

On August 15 1971, this date marked the end of the BrettonWoods system, a system that used to fix the value of a currencyto the value of gold. The United States pulled out of the BrettonWoods Accord and took the US off the established Gold exchange

Standard.

US were running a balance of payments deficit and a tradedeficit back in the early 1970s due to the costs of Vietnam Warand increased domestic spending has accelerated inflation. TheUS government used up almost all of his reserves and goldreserves by that time. Hence it began to print more dollars tosupplement its expenditure. In short, most countries lost faith inthe dollar as it is overvalued against gold. The internationalcommunity dumped their dollars in exchange for gold.

The fact is there was not enough gold in the US vault to pay backthe international community. US government had printed toomuch dollar and they were broke.

Following that, President Nixon shocked the world. The eventwas informally named Nixon Shock because President Nixon
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and 15 advisors removed US from the Gold Exchange Systemwithout consulting the members of the international monetarysystem.

US dollars was the first currency to be floated- that is, exchange

rates were no longer the principal method used by governmentsto administer monetary policy but is solely determined by supplyand demand market forces. By 1976, all the major currencieswere floated. The forex markets were started.

Devaluation of U.S Dollar Plaza Accord

In the early 1980s, the US Federal Reserve System under PaulVolcker had overvalued the dollar enough to make US exports inthe global economy less competitive. The U.S government faced

a large and growing current account deficit, while Japan andGermany were facing large and growing surpluses.

This imbalance could create a serious economic disequilibriumwhich would result in a distortion of the foreign exchangemarkets and thus the global economy. The result of currentaccount imbalances and the possibility of foreign exchangedistortion brought ministers of the worlds leading economies France, Germany, Japan, the United Kingdom, and the UnitedStates together in New York City.

The Plaza Accord was signed on September 22, 1985 at the PlazaHotel in New York City, agreeing to depreciate the US dollar in

relation to the Japaneseyenand German Deutsche Mark byintervening in currency markets.

The effects of the Plaza Accord agreement were seenimmediately within 2 years. The dollar fell 46 percent and 50percent against the deutsche mark and the Japanese Yen.Devaluation of the dollar stabilise the growing US trade deficit

with its trading partners for a short period of time. As a result,U.S. economy became more export-oriented while Germany and

Japan became more import-oriented.

The signing of the Plaza Accord was significant in that it reflectedcoordinated actions with respective governments were able toregulate the value of the dollar in the forex market. Values of
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floating currencies were determined by supply and demand, butsuch forces were insufficient, and it was the responsibility of theworlds central banks to intervene on behalf of the internationalcommunity when necessary.

To date, we still see countries that continue to regulate value ofits currency within a certain band in the forex market. Exampleof one country is Japan.

Black Wednesday The Man Who Broke the Bank

Black Wednesday refers to the events on 16th September 1992when George Soros placed a $10 billion speculative bet againstthe U.K. pound and won. He became the man who broke theBank of England.

In 1990, U.K. joined the Exchange Rate Mechanism (ERM) at arate of 2.95 deutsche marks to the pound and with a fluctuationband of +/- 6 percent. ERM gave each participatory currency acentral exchange rate against a basket of currencies, theEuropean Currency Unit (ECU). This system prevents theexchange rate of participatory currencies from too muchfluctuation with the basket of currencies.

Until mid 1992, economy began to change in Germany. Following

reunification of 1989, German government spending surged,forcing the Bundesbank to print more money. German economyexperienced inflation and interest rates were raised to curbinflation.

Other participatory countries in the ERM were also forced to raiseinterest rates so as to maintain the pegged currency exchangerate. The rate hike led to severe repercussions in the UnitedKingdom. At that time, U.K. had a weak economy and highunemployment rate. Maintaining high interest rates is not

sustainable for U.K. in the long term, and George Soros steppedinto action.

George Soros was said to profit $2 billion from the BlackWednesday. This single event showed that with knowledge andexperience, investors could profit from the forex market. Nocentral banks can control the forex markets.


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Asia Currency Crisis

Leading up to 1997, investors were attracted to Asianinvestments because of their high interest rates leading to a highrate of return. As a result, Asia received a large inflow of money.

In particular, Thailand, Malaysia, Indonesia, Singapore and SouthKorea experienced unprecedented growth in the early 1990s.

These countries fell one after another like a set of dominos onJuly 2, 1997, showing the interdependence of the Asian 5 Tigerseconomies. Many economists believe that the Asian FinancialCrisis was created not by market psychology but by shroudedlending practices and lack of respective governmenttransparency.

In early 1997, Thailand current account deficit has grownconsistently up to a level that is believed to be unsustainable.Shrouded lending practices oversupplied the country with creditand in turn drove up prices of assets. The same type of situationhappened in Malaysia, and Indonesia.

Levels were reached where price of assets were overvalued andcoupled with a unsustainable trade deficit, international investorsand hedge fund managers began to sell Thai baht andneighboring countries currencies hoping to profit from the

plunge.

Following mass short speculation and attempted intervention,the Asian economies were in shambles. Thai baht was sharplydevalued by as much as 48 percent and Indonesian rupiah fell228 percent from its previous high of 12,950 to the fixed U.S.dollar.

The financial crisis of 1997-1998 revealed the interconnectivityof economies and their effects on the global currency markets.

The inability of central banks to intervene in currency marketsprovided yet another lucrative opportunity for currency investorsto profit.

The Euro: Best Reserve Currency after Dollar
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The name Euro was officially adopted on 16 December 1995. TheEuro is the official currency of 16 of the 27 Member States of theEuropean Union. Euro is the second largest reserve currency andthe second most traded currency in the world after the U.S.

dollar.As of November 2008, with more than 751 billion in circulation,the euro is the currency with the highest combined value of cashin circulation in the world, having surpassed the U.S. dollar.Based on IMF estimates of 2008 GDP and purchasing powerparity among the various currencies, the Euro zone is the secondlargest economy in the world.

Value of Euro and the U.S. dollar are inversely correlated. Shouldthe dollar fall, value of Euro currency will rise. Euro will be thebest choice to shift money to, should the value of U.S. dollarcontinue to fall. This makes the Euro the best substitute currencyfor the dollar.

Conclusion

Seeing the above data about the foreign exchange market wecould conclude that the market in India is not still developed butis on the growing path.

Foreign exchange market plays a major and important role inglobal financial services acting as an indicator to thedevelopment of the global economy.

We hereby conclude that if India needs to develop its foreignmarket it needs to develop the exchange currency market so asmore investor invests in India.

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