The market in which international currency trade takes place i.e. where foreign currencies are bought and sold simultaneously is called the Foreign Exchange (Forex) Market. It is the organisational framework within which banks, merchants, firms, investors, individuals and government exchange foreign currencies for one another.
For example, in India the currency in circulation is called the rupee INR and in the United States, the currency in circulation is called the US Dollar (USD).
An example of a Forex trade is to sell the Indian rupee while simultaneously buying the US Dollar.
Forex market has no geographical location, it is electronically linked network and is open 24 hours a day.
The value for which one currency is exchanged for another or the value of one currency in terms of another currency is called exchange rate. For example, US dollar can be bought for 63 INR rupees. This is the exchange rate for Indian rupees in US dollars.
The foreign exchange market in India started when in 1978 the government allowed banks to trade foreign exchange with one another. Foreign Exchange Market in India operates under the Central Government of India and executes wide powers to control transactions in foreign exchange. The Foreign Exchange Management Act, 1999 or FEMA regulates the whole Foreign Exchange Market in India. Before the introduction of this act, the foreign exchange market in India was regulated by the Reserve Bank of India through the Exchange Control Department, by the Foreign Exchange Regulation Act or FERA, 1947. Interbank foreign exchange Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI) created in 1958, a self-regulatory voluntary association of dealers or banks specializing in the foreign exchange activities in India that regulates the governing rules and determines the commissions and charges associated with the interbank foreign exchange business. Since 2001, clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions.
The foreign exchange market in India consists of 3 segments or tires. The first consists of transactions between the RBI and the authorized dealers (AD). The latter are mostly commercial banks. The second segment is the interbank market in which the AD’s deal with each other. And the third segment consists of transactions between AD’s and their corporate customers. As in any market essentially the demand and supply for a particular currency at any specific point in time determines its price (exchange rate) at that point. Prior to 1990s fixed Exchange rate of the rupee was officially determined by RBI.
During the early years of liberalization, the Rangarajan committee recommended that India’s exchange rate be flexible. India moved from a fixed exchange rate regime to “market determined” exchange rate system in 1993. This is explained as under..
A country’s currency exchange rate is typically affected by the supply and demand for the country’s currency in the international foreign exchange market. Let’s take the example of Rupee Dollar exchange. The rupee/dollar rate is a two-way rate which means that the price of 1 dollar is quoted in terms of how much rupees it takes to buy one dollar. The value of one currency against another is based on the demand of the currency. If the demand for dollar increases, the value of dollar would appreciate. As the quotation for Rs/$ is a two way quote, an appreciation in the value of dollar would automatically mean the depreciation in Indian rupee and vice-versa. Besides the primary powers of demand and supply, the Indian exchange rate is affected by following factors:
- RBI Intervention: When there is too much volatility in the rupee-dollar rates, the RBI prevents rates going out of control to protect the domestic economy. The RBI does this by buying dollars when the rupee appreciates too much and by selling dollars when the rupee depreciates way too much.
- Inflation: When inflation increases there will be less demand of domestic goods and more demand of foreign goods i.e. increases demand for foreign currency), thus value of foreign currency increases and home currency depreciates thus negatively affecting exchange rate of home currency.
- Imports and Exports: Importing foreign goods requires us to make payment in foreign currency thus strengthening the foreign currency’s demand. Increase in demand increases the value of foreign currency and exports do the reverse.
- Interest rates: The interest rates on Government bonds in emerging countries such as India attract foreign capital to India.
If the rates are high enough to cover foreign market risk, money would start pouring in India and thus would provide a push to rupee demand thus appreciating rupee value for exchange.
- Operations: The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and invisibles in the current account, drafts, travellers cheque and inflows in the capital account such as foreign direct investment (FDI), portfolio investment, external commercial borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign exchange rises from imports and invisible payments in the current account, amortisation of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and outflows on account of direct and portfolio investment.
Types of foreign market operations
- Spot market (current market): Spot market for foreign exchange is that market which handles only spot transactions or current transactions. Spot rate of exchange prevails at the time when transactions are incurred. it is of daily nature.
- Forward market (derivative market): It is meant for future delivery i. determines forward exchange rate at which forward transaction are to be honored. It deals in following instruments: foreign exchange forwards, currency futures, currency swaps, currency options.
- Exchange settlement and dealings: Nostro and Vostro account facilitate settlement of foreign exchange transaction.
Nostro account: A foreign currency ac maintained by a bank in India with a bank in abroad. For example, Bank of India US dollar account with Citi bank.
Vostro account: A rupee account of a foreign bank abroad with a bank in India. For example, Citi bank rupee ac with bank of India.
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