1 UNIVERSITY OF MUMBAI Project Report on FOREIGN EXCHANGE MARKETS IN THE DEVELOPED NATIONS Submitted By WAGH VIVEK M.COM PART-I (SEMESTER II) Roll NO.144 PROJECT GUIDANCE PROF. A CHOUGULE THE SYDENHAM COLLEGE OF COMMERCE AND ECONOMICS ‘B’ ROAD, CHURCHGATE, MUMBAI –400 020
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UNIVERSITY OF MUMBAI
Project Report on
FOREIGN EXCHANGE MARKETS IN THE DEVELOPED NATIONS
Submitted By
WAGH VIVEK
M.COM PART-I (SEMESTER II)
Roll NO.144
PROJECT GUIDANCE
PROF. A CHOUGULE
THE SYDENHAM COLLEGE OF COMMERCE AND ECONOMICS
‘B’ ROAD, CHURCHGATE, MUMBAI – 400 020
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DECLARATION
I hereby declare that the project work entitled “Foreign Exchange Markets In The DevelopedNations” submitted to the “THE SYDENHAM COLLEGE OF COMMERCE AND ECONOMICS”, is agenuine record of an original work done by me under the guidance of Prof. A Chougale myprofessor and this project work is submitted in the partial fulfilment of the requirements for theaward of the degree of master of commerce.
I assert that the statements made and conclusions drawn are an outcome of the project work. Ifurther declare that to the best of my knowledge and belief that the project report does not containany part of any work has been submitted for the award of any other degree/diploma/certificate inthis university or any other university
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CERTIFICATE
This is to certify that this project report entitled “Foreign Exchange Markets In The DevelopedNations” submitted to Sydenham College Of Commerce And Economics, is a bonafide record ofwork done by “Wagh Vivek Dinesh” under my supervision.
_________________________
Internal Guide
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INDEX
SR
NO.
TOPIC PAGE NO.
1 Chapter 1-Introduction 5-10
1.1 Importance Of Foreign Exchange Markets In DevelopedNations
8
1.2 Significance 9
1.3 Objectives 10
2 Chapter 2-Reasearch Methodology 11-22
2.1 Primary And Secondary Data 13
2.2 Hedging In Developed Nations 20
3 Chapter 3- List Of Foreign Brokers Of Developed Nations 23-30
3.1 List Of Foreign Brokers 23
3.2 Exposure Management in Foreign Exchange Risk 25
4 Chapter 4- Conclusion And Bibliography 31-32
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CHAPTER 1
INTRODUCTION
The foreign exchange market (forex, FX, or currency market ) is a global decentralized market
for the trading of currencies. The main participants in this market are the larger international
banks. Financial centres around the world function as anchors of trading between a wide range of
multiple types of buyers and sellers around the clock, with the exception of weekends. The foreign
exchange market determines the relative values of different currencies.
The foreign exchange market works through financial institutions, and it operates on several levels.
Behind the scenes banks turn to a smaller number of financial firms known as “dealers,” who are
actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers are
banks, so this behind-the-scenes market is sometimes called the “interbank market”, although a few
insurance companies and other kinds of financial firms are involved. Trades between foreign
exchange dealers can be very large, involving hundreds of millions of dollars. Because of the
sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity
regulating its actions.
The foreign exchange market assists international trade and investments by enabling currency
conversion. For example, it permits a business in the United States to import goods from the
European Union member states, especially Eurozone members, and pay euros, even though itsincome is in United States dollars. It also supports direct speculation and evaluation relative to the
value of currencies, and the carry trade, speculation based on the interest rate differential between
two currencies.
In a typical foreign exchange transaction, a party purchases some quantity of one currency by
paying for some quantity of another currency. The modern foreign exchange market began forming
during the 1970s after three decades of government restrictions on foreign exchange transactions
(the Bretton Woods system of monetary management established the rules for commercial and
financial relations among the world's major industrial states after World War II), when countries
gradually switched to floating exchange rates from the previous exchange rate regime, which
A spot transaction is a two-day delivery transaction (except in the 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 are usually three months. This trade represents a “direct
exchange” between two currencies, has the shortest time frame, involves cash rather than a
contract; and interest is not included in the agreed-upon transaction.
Forward
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A buyer
and seller agree on an exchange rate for any date in the future, and the transaction occurs on that
date, regardless of what the market rates are then. The duration of the trade can be one day, a few
days, months or years. Usually the date is decided by both parties. Then the forward contract is
negotiated and agreed upon by both parties.
Swap
The most common type of forward transaction is the FX swap. In an FX swap, two parties exchange
currencies for a certain length of time and agree to reverse the transaction at a later date. These are
not standardized contracts and are not traded through an exchange.
Future
Futures are standardized and are usually traded on an exchange created for this purpose. The
average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest
amounts.
Option
A foreign exchange option (commonly shortened to just FX option) is a derivative where the ownerhas the right but not the obligation to exchange money denominated in one currency into another
The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In
a fixed exchange rate regime, FX rates are decided by its government):
(a) International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic
Fisher effect, International Fisher effect. Though to some extent the above theories provide logical
explanation for the fluctuations in exchange rates, yet these theories falter as they are based on
challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in
the real world.
(b) Balance of payments model (see exchange rate): This model, however, focuses largely on
tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide
any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face
of soaring US current account deficit.
(c) Asset market model (see exchange rate): views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly by people's willingness to
hold the existing quantities of assets, which in turn depends on their expectations on the future
worth of these assets. The asset market model of exchange rate determination states that “the
exchange rate between two currencies represents the price that just balances the relative supplies
of, and demand for, assets denominated in those currencies.”
None of the models developed so far succeed to explain FX rates levels and volatility in the longer
time frames. For shorter time frames (less than a few days) algorithms can be devised to predict
prices. It is understood from the above models that many macroeconomic factors affect the
exchange rates and in the end currency prices are a result of dual forces of demand and supply. The
world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of
current events, supply and demand factors are constantly shifting, and the price of one currency in
relation to another shifts accordingly. No other market encompasses (and stills) as much of what isgoing on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single
element, but rather by several. These elements generally fall into three
categories: economic factors, political conditions and market psychology.
(a)economic policy, disseminated by government agencies and central banks,
(b)economic conditions, generally revealed through economic reports, and other economic
indicators.
Economic policy comprises government fiscal policy (budget/spending practices) and monetary
policy (the means by which a government's central bank influences the supply and "cost" of money,
which is reflected by the level of interest rates).
Government budget deficits or surpluses: The market usually reacts negatively to widening
government budget deficits, and positively to narrowing budget deficits. The impact is reflected in
the value of a country's currency.
Balance of trade levels and trends: The trade flow between countries illustrates the demand for
goods and services, which in turn indicates demand for a country's currency to conduct trade.
Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's
economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in
the country or if inflation levels are perceived to be rising. This is because inflation
erodes purchasing power, thus demand, for that particular currency. However, a currency may
sometimes strengthen when inflation rises because of expectations that the central bank will raise
short-term interest rates to combat rising inflation.
Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity
utilization and others, detail the levels of a country's economic growth and health. Generally, themore healthy and robust a country's economy, the better its currency will perform, and the more
demand for it there will be.
Productivity of an economy: Increasing productivity in an economy should positively influence the
value of its currency. Its effects are more prominent if the increase is in the traded sector.
Political conditions
Internal, regional, and international political conditions and events can have a profound effect on
Technical trading considerations: As in other markets, the accumulated price movements in a
currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many
traders study price charts in order to identify such patterns.
2.2- Hedging In Developed Nations
Traders use foreign exchange derivatives, which "derive" their valuations and costs from the spotmarket. Options and futures contracts effectively lock in exchange rates for a set period, to hedge
against the risks of currency fluctuations.
How to Invest in Foreign Currency Exchange Contracts (Currency Trading)
The Foreign Exchange Market or FX market is estimated to be one of the largest markets in the
world. It is volatile and risky. The basic underlying transactions in these contracts are the purchase
and sale of currencies.
Spot and Forward currencies are the two types of foreign exchange contracts. Banks, brokers and
other financial institutions participate in this market. Historically, these contracts were used by
banks and companies but in recent years it has become a market accessible to individuals. These
are some ideas on how to buy foreign exchange contracts.
Instructions
Decide which type of Foreign Exchange contract or Forex you want to buy. The choices are a
Spot currency trading contract or a Forward currency contract. Also, decide which currency
you are going to trade.
Understand the rules about each type of currency trading contract. In a Spot contract the
buyer and the seller agree to buy/sell the currency at a specific price on the spot. In a
Forward contract, the buyer and the seller agree to buy/sell at a specific price on a date in
the future. The money is exchanged sometime in the future.
If you already have a broker account, find out if it provides currency trading services. You
will need to sign a contract to be able to invest or trade in foreign currencies. Once your
contract is on file you can buy/sell currency contracts from your account.
Open a Foreign Exchange trading account at a retail foreign exchange broker. If your broker
doesn't offer this service you will need to open a new account at a broker that does. Choose a
broker that offers training and education on foreign exchange markets. Also, make sure that
the broker has licensed customer service representatives.
Fund your account after it has been set up. Some brokers require a minimum account
balance to start currency trading.
Develop a strategy and start trading foreign exchange contracts in your account. In this stage
you should decide: what currencies to trade, how much money you will invest in each
contract, the expiration date of each contract (30 days, 60 days, 90 days etc.) and trade a
spot or forward contract. Remember that currency trading can be risky, currency prices can fluctuate often and in
large amounts. The amount you invest in Forex contracts should be in proportion to how
much money you can afford to lose.
Types of Foreign Exchange Transactions
At its simplest, currency exchange is just the buying of the currency of one country with the
currency of another country. Individuals, businesses and traders all engage in various types of
foreign currency exchange transactions. Some participants in currency exchange do so as part of
business dealings while others speculate on the foreign exchange (Forex) market in hopes of
profiting off of exchange rate fluctuations. The main types of foreign currency exchange
transactions they employ are described below.
Basic Currency Exchange
If you've ever traveled to a foreign country, chances are you've used some of your cash to buy
euros, yen or whatever the local currency was. The price you paid was determined by the exchange
rate between the two currencies. Your purchase is an example of the most basic type of foreign
currency exchange transaction.
Currency exchange rates change continuously, mainly in response to demand for one currency
relative to others. Demand for a currency in turn is affected by many factors, including differences
in interest rates, inflation and monetary policy.
Forward Contracts
Financial institutions and businesses frequently want to protect themselves against possible losses
due to changes in exchange rates. The forward contract is a way of doing this. A forward contract is
like a futures contract except it is a private agreement, rather than an exchange-traded security. In
forwards, one party agrees to buy (or sell) a foreign currency from (or to) another party. The
currency is delivered at a future date at a predetermined price. A variation of this is the forward
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window contract. Instead of delivery on a specific date, the transaction is settled during a "window"
of time between two dates.
Swaps
Suppose you are a businessperson who needs euros to do some business in Europe, but all you have
are U.S. dollars. You don't want to convert to euros and run the risk of losing money if exchange
rates go the wrong way. A currency swap is your solution. You simultaneously borrow euros from
someone else (usually a currency dealer) and lend your dollars to the other party. You can use the
euros as you see fit until a specific date. Then you return the euros and get your dollars back at a
predetermined exchange rate.
Forex
Most of the volume of trading on the Forex market actually is generated by speculators, not as part
of other business activity. Forex traders use forwards and swaps. The basic Forex trade, however, is
a simple currency exchange but with one crucial difference. When a Forex trader buys one currency
for another, it is a margin transaction. This means the trader puts up only a little money (often less
than $1,000 for a $100,000 lot of currency). With extreme leverage like this, even small changes in
currency exchange rates mean big profits or big losses. This makes Forex trading very attractive to
many people but also very risky.
Forex Options
Forex options work like any other options contract. A trader pays a premium to a Forex dealer for
an option to buy or sell a currency at a specific strike price. If the exchange rate moves in the
trader's favor before the option expires, she can exercise the option for a profit. If the exchange rate
doesn't move the right way enough to cover the premium paid, the option will expire and the trader
loses her money. Unlike stock options, the buyer of a Forex option contract may choose the strike
price and expiration date
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CHAPTER-3
List Of Foreign Brokers Of Developed Nations
3.1- List of Foreign Exchange Brokers
Foreign exchange, also known as FOREX or FX, brokers allow individuals and firms to trade
currencies in the interbank foreign exchange market. Essentially, there are three types of retail
foreign exchange brokers. The first type includes independent foreign exchange brokers such as
Oanda and Saxobank. The second type is dominated by large, multinational investment banks like
Deutsche Bank. The third type of brokers, which you should avoid, are scams. Due to a large
number of shoddy brokers, work with well-established firms.
Oanda
Oanda is one of the best foreign exchange brokers. Mention the name of the company to any foreign
exchange trader and he will probably give positive or neutral opinion about this company. The
company is based in Toronto, Canada. The broker is a registered Retail Foreign Exchange Dealer
(RFED) with the U.S. Commodity Futures Trading Commission (CFTC) and a Forex Dealer Member
(FDM) of the National Futures Association (NFA). The firm is incorporated in Delaware.
Saxo Bank
Saxo Bank is a technically a bank, though it engages in little activity other than foreign exchange
trading. The company is based in Denmark. It offers a wide range of FX instruments, including spots
and options. It also allows users to trade stocks and CFDs.
Deutsche Bank
Deutsche Bank is often cited as a leading foreign exchange trader in the interbank market. The
largest bank in Germany, it is also among the biggest banks in the world. Its retail currency
brokerage division offers competitive spread on 34 currency pairs. The spread on the EUR/USD
currency pair stands at 1.7 pips, for example.
FOREX.com
FOREX.com is another well-established foreign exchange broker. The broker's website and trading
platform comes in many languages, including Japanese, Chinese and even Russian. The firm offers a
wide range of instruments to trade, including currencies, metals, oil and indices.
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GFT FOREX
GFT FOREX is an independent broker. It offers more than 120 currency pairs to trade. The company
allows customers to trade such exotic currencies as South African rand, Singapore dollar, Swedish
krona and Hungarian forint
What Is the Meaning of Foreign Exchange Risk Management In Developed Nations?
Businesses that sell goods or services to customers overseas, and are paid in a foreign currency, are
exposed to foreign exchange risk. To manage that exposure effectively, they must understand the
inner workings of foreign exchange risk.
Definition
From the point of view of a U.S. exporter, foreign exchange risk is the exposure to the risk that the
foreign currency that his client pays him in will be devalued against the U.S. dollar. This would
mean that the exporter would receive less money than he anticipated. The handling of such risk is
what makes up foreign exchange risk management.
Features
Considering that currency markets are volatile, anyone engaged in trade with overseas
counterparties faces the risk of financial losses. The main objective of foreign exchange risk
management is to cut down on losses from potential unfavorable currency movements. The
simplest way of avoiding this sort of exposure is to ask your customer to pay in advance so that you
are not exposed to foreign exchange risk. This is not always possible and a more sophisticated way
of managing such risk is to hedge your risk by taking out a forward contract that delivers you at
some specified future time a specific dollar value for a specific amount of foreign currency.
Benefits
By taking on foreign exchange exposure and effectively managing the risks involved, a U.S. exporter
could expand his overseas markets, since overseas clients usually prefer to pay in their local
currencies. By cutting down on losses due to foreign exchange exposure, the importer would also
add to her profits.
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3.2- Exposure Management in Foreign Exchange Risk
Foreign exchange exposure is the risk of a firm's profitability and net cash flow to potentially
change due to a change in exchange rates. Managers must limit a firm's exposure to changes in
exchange rate because profitability and cash flow are two of the main ways investors judge a firm's
value. Managers use forward contracts, options and money market transactions to hedge potentialforeign exchange risk.
Foreign Exchange Exposure
Foreign exchange risk can significantly reduce a firm's profit margin on a business transaction. For
example, if a U.S. company makes a deal with a firm in Britain to sell it a product for 1 million
British pounds, the exchange rate play a role in exactly how many dollars the U.S. company will
receive. If the British company agrees to make the payment in three months, and the dollar
strengthens in value relative to the pound, the U.S. company will actually receive fewer dollars than
anticipated. For instance, a change in rates from $1.5 per pound to $1.2 per pound will lower the
U.S. company's revenue from $1.5 million to $1.2 million.
Hedging Risk
To reduce the amount of risk a company faces because of a change in exchange rates, many
managers choose to hedge against that exposure. When managers hedge against a position, they do
so to reduce the risk they face by protecting themselves from a major losses and eliminating much
of the unanticipated upside of an investment. As a result, hedging decreases the variability of your
expected cash flow, both positive and negative.
Forward Contracts
One of the common ways to reduce exposure to foreign exchange risk is to hedge, using forward
contracts. A forward contract is an agreement between two private parties to make a transaction at
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an agreed upon rate sometime in the future, at an agreed upon time. Thus, if a managers want to
hedge against foreign exchange risk, they can enter a forward contract that has an agreed-upon
future exchange rate, therefore eliminating any risk. Although forward contracts eliminate
uncertainty and foreign exchange risk, they also eliminate any additional profits that can be earned
with a favourable movement in exchange rates.
Options
Currency option hedging is another way to manage a company's foreign exchange risk. An option is
a contract that gives the owner the right, but not the obligation, to make either a purchase or sale at
an agreed-upon price until the contract expires. Companies reduce exchange rate risk when
purchasing currency options because if a rate moves in an unfavourable direction, the company can
exercise that option to get their predetermined rate. As a result, an option creates a floor for a
company's potential profit. However, if the rates move in a favourable direction, than the company
does not need to exercise that option and can enjoy the additional profits. Thus, options create a
floor, but not a ceiling for a company's investment. On the other hand, option contracts cost a fee
and may yield less profit if exercised than a forward contract would.
Un-Hedged Positions
Some managers choose to not protect themselves from foreign exchange risk because they argue
that currency risk management does not increase expected cash flows, but it simply consumes
resources and reduces variability. In addition, some argue that shareholders are more capable of
diversifying their risk than each individual firm can. As a result, it is more beneficial to the
shareholders to not hedge. Most managers do end up hedging against exposure to benefit
themselves and protect against potential losses.
Banks
The interbank market caters for both the majority of commercial turnover and large amounts of
speculative trading every day. Many large banks may trade billions of dollars, daily. Some of this
trading is undertaken on behalf of customers, but much is conducted by proprietary desks, which
are trading desks for the bank's own account. Until recently, foreign exchange brokers did large
amounts of business, facilitating interbank trading and matching anonymous counterparts for large
fees. Today, however, much of this business has moved on to more efficient electronic systems. The
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broker squawk box lets traders listen in on going interbank trading and is heard in most trading
rooms, but turnover is noticeably smaller than just a few years ago.
Commercial companies
An important part of this market comes from the financial activities of companies seeking foreign
exchange to pay for goods or services. Commercial companies often trade fairly small amounts
compared to those of banks or speculators, and their trades often have little short term impact on
market rates. Nevertheless, trade flows are an important factor in the long-term direction of a
currency's exchange rate. Some multinational companies can have an unpredictable impact when
very large positions are covered due to exposures that are not widely known by other market
participants.
Central banks
National central banks play an important role in the foreign exchange markets. They try to control
the money supply, inflation, and/or interest rates and often have official or unofficial target rates
for their currencies. They can use their often substantial foreign exchange reserves to stabilize the
market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because
central banks do not go bankrupt if they make large losses, like other traders would, and there is no
convincing evidence that they do make a profit trading.
Forex Fixing
Forex fixing is the daily monetary exchange rate fixed by the national bank of each country. The
idea is that central banks use the fixing time and exchange rate to evaluate behaviour of their
currency. Fixing exchange rates reflects the real value of equilibrium in the forex market. Banks,
dealers and online foreign exchange traders use fixing rates as a trend indicator.
The mere expectation or rumour of central bank intervention might be enough to stabilize a
currency, but aggressive intervention might be used several times each year in countries witha dirty float currency regime. Central banks do not always achieve their objectives. The combined
resources of the market can easily overwhelm any central bank. Several scenarios of this nature
were seen in the 2011-2012 ERM collapse, and in more recent times in Southeast Asia.
Hedge funds as speculators
About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person
or institution that bought or sold the currency has no plan to actually take delivery of the currencyin the end; rather, they were solely speculating on the movement of that particular currency. Hedge
funds have gained a reputation for aggressive currency speculation since 1996. They control
It is evident that foreign exchange markets are well developed in developed nations. And can help
in the growth of economy and is the backbone of the large and developed economies of the world
The development of such nations is due to development in the foreign exchange markets. Foreign
exchange markets can yield great incomes.
The currency markets are the largest and most actively traded financial markets in the world with
daily trading volume of more than $3 trillion. Each transaction in the currency market involves two
different trades: the sale of one currency and the purchase of another. As the world's reserve
currency, the U.S. dollar is the most actively traded currency; pairs involving the dollar make up the
majority of transactions. Most currency trading strategies fall into two broad categories: hedging
and speculating. To avoid possible loss from fluctuating currencies, companies can hedge, orprotect themselves, by trading currency pairs. In arbitrage trades, an investor simultaneously buys
and sells the same security (or currency) at slightly different prices, hoping to make a small risk-
free profit. Another popular category of currency trade is the carry trade, which involves selling the
currency of a country with very low interest rates and investing the proceeds in the currency of a
country with high interest rates. There are several markets available to currency traders, including
the forex market, derivatives markets and exchange-traded funds.
The foreign exchange markets in the developed nations are well developed and are vastly helpful in
bringing the nation’s economy and making it developed.