Foreign Exchange – Introduction
Mar 2nd, 2012
Interesting by its name, isn’t it? 🙂 The biggest market one couldimagine. This is the only financial market which is active for almost 24 hoursa day. What is it about this market that it’s the biggest market and active formost of the day’s time?
A Foreign Exchange market or a Forex as it is called allowsfor the exchange of currencies.
There can be different reasons one would dothat. Listed below are a few of them.
- A company with global operations and involved incross border, cross currency buying/selling or trading will require a forextransaction.
- A company might want to offset a potential lossdue to its FX exposure. This offsetting of potential loss is called Hedging,and the concept is not just limited to FX market. E.g. ABC Company in India mightimport large amount of raw material from US in 6 months time. It can simply buythe raw material after 6 months by paying in dollars. But this puts ABC at a potentialrisk of dollar appreciating in value in 6 months time. Hence ABC can buydollars now at fixed rate. This transaction relieves ABC of any concerns aboutthe fluctuating FX market rate. Do not worry if it sounds confusing. We willlook closely into the FX market going forward.
- Some investors might also want to guess whichcurrency is going to appreciate or deprecate in value and enter into a FXtransaction in a hope to make profit. This anticipation of future ratemovements in the market is termed as Speculation, which is also not just limitedto the FX market.
Here we now explain the FX transaction, the term that wehave used so frequently.
FX Transaction: Under an FX transaction a particular amount of currency isexchanged for a particular amount of another currency on a given date.
Currency Pair:The combination of base currency and the second currency. <<Base currency/Secondcurrency>>
E.g. USD/INR, USD is the base currency here and INR is thesecond currency.
EUR/USD, EUR is the base currency here and USD is the second currency.
FX Rate: The unitsof second currency exchanged for every unit of base currency is known as the FXrate. The rate is always specified in terms of per unit of base currency.
To make it simple to understand think of the base currencyas some commodity, say a pen. Hence we can say that 1 unit of the base currencyis exchanged for n units of second currency. Suppose the FX rate for USD/INR is49, we can say that USD 1 is exchanged for INR 49. Once we are able tocomprehend the base currency as some commodity, FX transactions will no longerbe complicated and confusing.
The FX market is a global market. There are no exchangesinvolved. It is an over the counter market, which means there is no centralclearing house which guarantees the trade to be fully obligated by the parties.Hence there are chances of default by the counterparty.
There can be different types of FX transactions:
For now we will only have a brief look at each of them.
An FX transaction is an exchange of aparticular amount of currency for a particular amount of another currency on a given date.
The above categorization is because of the different datesat which the exchange is done.
- Spot: The currenciesare exchanged at the spot FX rate and the deal is struck on the current datewith the actual exchange happening after two business days.
- Forward: The currenciesare exchanged at some specific future date but at an FX rate decided at theonset of the deal.
- Swap: Thecurrencies are exchanged at a particular date which is usually the spot dateand there is a second exchange at some future date in the opposite direction.
We will look at the dealing and settlement of FX trades in our comingposts. And also we will try and understand the types of deals with an examplefor each.