Meaning of Foreign Exchange

According to Hartly Withers, “ Foreign exchange is the art and science of international monetary exchange”

The forex market is the world’s largest financial market. Over $4 trillion dollars worth of currency are traded each day. The amount of money traded in a week is bigger than the entire annual GDP of the United States.

The main currency used for forex trading is the US dollar.

Meaning of Foreign Exchange

The term Foreign exchange implies two things: a)foreign currency and b) exchange rate

Foreign exchange generally refers to foreign currency, eg for india it is dollar, euro, yen, etc… &

the other part of foreign exchange is exchange rate which is the price of one currency in terms of the other currency.

Forex is the international market for the free trade of currencies. Traders place orders to buy one currency with another currency.

Forex Trading in India – Legal or Illegal

In India, Foreign Exchange or Forex trading is not allowed. If someone is found trading Forex instruments on the forex market by the Reserve Bank of India’s representatives, he/she is immediately charged of violation of law. Hence it is legally a crime to involve in Forex trading and the charges of the crime are imprisonment in jail in this country. The offence is considered immense, the prediction of intensity can be deduced from this fact that it has been labeled to be non-bail able.

Forex trading in the world

Foreign exchange market

Foreign exchange market is that market in which national currencies are traded for one another..

The major participants in this market are commercial banks, forex brokers, and authorised dealers and the monetary authorities.

Besides, transfer of funds form one country to another , speculation is an important dimension of foreign exchange market.

Its where money in one currency is exchanged for another

Advantages of Forex market

It’s already the world’s largest market and it’s still growing quickly

It makes extensive use of information technology – making it available to everyone

Traders can profit from both strong and weak economies

Trader can place very short-term orders – which are prohibited in some other markets

The market is not regulated

Brokerage commissions are very low or non-existent

The market is open 24 hours a day during weekdays

Terms related to Foreign Exchange

Foreign exchange reserves- holdings of other countries' currencies

Foreign exchange controls- controls imposed by a government on the purchase/sale of foreign currencies

Retail foreign exchange platform- speculative trading of foreign exchange by individuals using electronic trading platforms

Foreign exchange risk- arises from the change in price of one currency against another

International trade- the exchange of goods and services across national boundaries

Foreign exchange company- a broker that offers currency exchange and international payments

Bureau de change- a business whose customers exchange one currency for another

Currency pair- the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market

Digital currency exchanger- market makers which exchange fiat currency for electronic money

Exchange rate

According to haines, “Exchange rate is the price of the currency of a country can be exchanged for the number of units of currency of another country.”

Exchange rate is that rate at which one unit of currency of a country can be exchanged for the number of units of currency of another country.

It’s the the price for which one currency is exchanged for another

Factors influencing Exchange Rates

As with any market, the forex market is driven by supply and demand:If buyers exceed sellers, prices go upIf sellers outnumber buyers, prices go down

The following factors can influence exchange rates:National economic performanceCentral bank policyInterest ratesTrade balances – imports and exportsPolitical factors – such as elections and policy changesMarket sentiment – expectations and rumoursUnforeseen events – terrorism and natural disasters

Despite all these factors, the global forex market is more stable than stock markets; exchange rates change slowly and by small amounts.

Types of exchange rates

Fixed and Floating exchange rates

Fixed exchange rate is the official rate set by the monetary authorities of the Governance for one or more currencies.

Under floating exchange rate, the value of the currency is decided by supply and demand factors

Direct and indirect exchange rates

Direct method - Under this, a given number of units of local currency per unit of foreign currency is quoted. They are designated as direct/certain rates because the rupee cost of single foreign currency unit can be obtained directly. Direct quotation is also called home currency quotation.

Indirect method – Under this, a given number of units of foreign currency per unit of local currency is quoted. Indirect quotation is also called foreign currency quotation

Buying and selling

Exchange rates are quoted as two way quotes –

for purchase

and for sale

transactions by the Bank

Spot and forward

The delivery under a foreign exchange transaction can be settled in one of the following ways

Ready or cash – To be settled on the same day

Tom – To be settled on the day next to the date of transaction

Spot – To be settled on the second working day from the date of contract

Forward – To be settled at a date farther than the spot date

Theories of exchange rate determination

Meaning:

Theories which determine the prices of forex rate considering inflation, interest rate, and elasticity of price etc..

Methods:

a) Long run theory

b) Short run theory

Long Run Theory of Exchange rate Determination:

This are the theories which predominately take into account the fundamental changes of economy. Here fundamental changes refers to the change which are going to change the economic performance of the economy Purchasing power for all times to come.

Types of theory:

Purchasing power parity.1) Absolute purchasing power parity.2) Relative purchasing power parity.

Interest Rate parity1) Covered Interest Rate parity2) Uncovered Interest Rate parity

Short Run theory of exchange rate determination

This theories are based more on current information or immediate performance of economic variables.

This theories try to take into account the short run factor which may be eliminated in the long run.

Purchasing power parity theory

Founder –Swedish economist Gustav Cassel in 1918.

Meaning : According to this theory ,the price levels and the changes in these price levels in different countries determine the exchanges rates of these countries currencies.

The basic principle of this theory is that the exchange rates between various currencies reflect the purchasing power of these currencies .This theory is based law of one price.

Absolute form of PPP Theory

If the law of one price were to hold good for each and every commodity then the theory is termed as Absolute form of PPP Theory.

This theory describes the link between the spot exchange rate and price levels at a particular point of time

Relative form of PPP

This theory describes the link between the changes in spot exchange rate and in the price levels over a period of time.

According to this theory ,changes in spot rates over a period of time reflect the changes in the price level over the same period in the concerned economies.

This theory relaxes three assumptions of PPP ie Absences of transportation cost ,transaction costs and tariffs.

Interest Rate Parity Theory

Definition :

The process that ensures that the annualized forward premium or discount equals the interest rate differential on equivalent securities in two currencies.

International Fisher effect:

Expected Rate of change = Interest rate of the exchange rate differential

Interest Rate = Real Interest Expected Differential Rate + inflation rate

Modern theory: demand & supply theory

The most satisfactory explanation of the determination of the rate of exchange is that a free exchange rate tends to be such as to equate the demand and supply of foreign exchange..

The intersection of supply curve and demand curve gives the equilibrium price

Modern theory also called balance of payments theory of foreign exchange

Foreign Exchange Risk

Exposure to exchange rate movement. Any sale or purchase of foreign currency

entails foreign exchange risk. Foreign exchange transaction affects the

net asset or net liability position of the buyer/seller.

Carrying net assets or net liability position in any currency gives rise to exchange risk.

Risk management

Controlling losses

You could control your losses, by mental stop or hard stop. Mental stop means that you already set you limit of your loss. A hard stop is your initiative to stop when you think you must to stop it.

Using correct lot size

As a beginning just use smaller lots you could stay flexible and logic than emotions while you trade.

Tracking overall exposure

sample: you go to short on EUR/USD and long on USD/CHF, you exposed two times for USD in the same direction. If USD goes down , you have a double dose of pain. So, keep your overall exposure limited, it keeps you for the long haul for trading

The bottom line

Trading is about opportunities, you must take action while the opportunities arise.

References

http://www.forex.com/uk/index.html

http://www.forex.com/uk/trading-platforms/forextrader.html

http://www.marketcalls.in/forex/forex-trading-in-india-legal-or-illegal-a-critical-analysis.html