Foreign exchange market is one of the important components of any economy today. It involves currency exchange, remittances, import & export, investments etc. This article gives an idea about what is foreign exchange & foreign exchange market. It also throws light on basic terminology involved in foreign exchange transactions.
In this era of globalization and highly interconnected economies, foreign exchange market has become very prominent. In fact, it has a huge role to play in a developing economy like India. Financial institutions like banks are constantly looking for professionals well-versed in foreign exchange market as the volume of transactions & the participation is increasing at a rapid rate. In this article we will try to get the basics of foreign exchange.
Meaning of foreign exchange
In simple terms, foreign exchange means exchange of currency of one nation into that of another nation. You can relate it directly with the export & import of the commodities between two nations. So an import-export relationship between two people in USA and India would involve exchange of Dollar & Rupee. In broader terms, however, the definition of foreign exchange encompasses a lot of other things. The Foreign Exchange Management Act (FEMA), 1999, has given a broad definition of foreign exchange. To keep the things simple for the beginners, foreign exchange in this article refers to foreign currency & exchange of one currency into another. Foreign exchange is also called Forex.
Foreign exchange market
So what is a foreign exchange market? Is it a market based out of some place? No, we can’t define the foreign exchange market in the same way as we define a normal market, say a commodity market. This is because forex market is not bounded by any boundary. It is not confined to 4 walls in a particular place. Moreover, it is a 24*7 market and works round the clock.
A forex market refers to a market where different participants can buy, sell and exchange currencies. It’s a decentralized market i.e. the foreign exchange activities take place across the globe in different time zones. So, even when the Indian market is calling it a day, the US market is initiating its daily operations. In this way it keeps on going across the world. As the world economies are highly interconnected today, forex market is always open at some place.
We mentioned the word participants in the definition of forex market. Who are the participants actually? The participants are the entities who seek foreign exchange for their needs. They can be banks, investors, or any individual etc. Let’s go through the different types of participants in the forex market.
Central & commercial banks: A central Bank, like RBI, make use of forex market to manage their reserves and take corrective steps whenever home currency (say Rupee) faces abrupt devaluation. Commercial banks, on the other hand, need forex market for the exchange of currencies for their clients. They also use it for the purpose of investments.
Investment Banks: As their name implies, investment banks primarily use forex market for the purpose of investment.
Broker: A broker, like the one in the stock market, works as a middleman between two participants of forex market.
Individuals: Normal people who seek forex market for different purposes like investment, business, travel etc.
Basic terminology related to foreign exchange
An exchange rate refers to the rate at which one currency can be exchanged with another. So if someone says that exchange rate between USD and Rupee is 64 that means one USD can be exchanged for INR 64. We understand the exchange rate by looking at the quotes.
Direct & Indirect Quotes
A quote is a way of expressing one currency in certain units of the other currency. So 1 USD = Rs. 64 would mean 1 unit of USD is equivalent to 64 units of Indian Rupee. The quotes can be given in two ways – direct and indirect. Under direct method, local currency or the home currency is variable. For instance, the quote we mentioned above is a direct quote as we can get the value of home currency against USD directly. Direct quote is also known as Home currency.
In indirect quote, the foreign currency is variable while home currency is fixed. For instance, Rs. 128 = 2 USD is an indirect quote. Generally direct quotes are used across the globe with few notable exceptions
Cross Rate Mechanism
Sometimes, in a particular market, we might not get a quote between two currencies and we need to exchange them. In such a case we make use of cross rate mechanism. Under this, we make use of a currency having quotes with both of the above currencies. The most common example is that of USD. So we will obtain direct quotes involving USD for both the currencies and by simply crossing them out using plain mathematics, we can get the desired quote.
Most of the forex transactions are not necessarily settled on the same day. They may be settled in future also. So, depending on the settlement time, the exchange also varies. Generally, the settlement of forex transactions takes place on the second working day. The rate then applied is called Spot rate. Even though the word ‘spot’ indicates a quick settlement, the actual transaction is completed only on the second working day.
If settlement of funds takes place after second working day i.e. spot date, then the rate applied is called forward rate. This rate is derived from the spot rate.
When the settlement takes place on the same day of the deal, it is called Ready or Cash.
If settlement takes place on next working day of the deal, it is referred to as Tom.
Premium & Discount
If the forward rate is more than spot rate of a currency, then that currency is said to be at premium. On the other hand, if the forward rate is less than spot rate, the currency is said to be at discount. This relationship can be expressed as
Forward Rate = Spot rate +Premium ( or – discount)
Bid & Offered rate
They are nothing but buying & selling rates of currencies. So a bid rate refers to the rate at which a financial institution is ready to buy currency while offer rate is the rate at which it is ready to sell currency.
The authorized dealers are the entities who are authorized to deal in foreign exchange. They are basically financial institutions who have been allowed to undertake transactions pertaining to forex by RBI. There was a change in the definition of the authorized dealers in the year 2005. As per new definition, these entities are called Authorized Persons. Moreover, they have been divided into three different categories.
Authorised Person: Category I refer to financial institutions that are authorized to handle all types of forex transactions.
Authorised Person: Category II refers to entities who can deal with buying/selling of foreign currency, remittances, travelers cheques etc.
Authorised Person: Category III refers to entities who are authorized for purchasing of foreign currency and traveler’s cheques only.
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