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Foreign Exchange Market
International BusinessProf. J. K. NayakDepartment of Management StudiesIndian Institute of Technology, RoorkeeLecture – 29Foreign Exchange, Foreign Exchange Market, Features, ParticipantsWelcome everyone, to our course of International Business. So, in the last lecture wewere discussing about balance of payment, what balance of payment is and what are itscomponents. So, we discussed about the major components like the capital account, theyou know the financial account right, the current account. And, then the you know wediscussed on how balance of payment of a country gives an idea about its economicposition right.So, whether it is in a surplus, it is in a deficit and how the balance of payment has toalways match. It has to be a balanced account right, like any balance sheet the both thedebit and the credit side has to be balanced. So, from there today we will talk on anothervery important issue which has a very large influence on the world finance and thefinancial markets is foreign exchange right.Recently, you must have come across a company called Cox and Kings which has beenyou know in the verge of close down in India right. It is basically nothing more than atravel agent, it was a travel agent, but why I am saying it they were basically foreignexchange regulators. So, they help you in currency exchange when you go from onecountry to another. So, for example, we have Thomas Cook, Cox and Kings right.So, these are some examples. So, what is foreign exchange? When you understand theforeign the word foreign exchange is when you have to go outside to another countrymay be on a for on a tourist visit or a educational trip or something, you need somecurrencies of another country right. So, when you so, how do you do that? You give yourown currency here may be your Indian rupee and in exchange you take a dollar or someother currency which is particularly from that country.So, suppose you are going to some European countries; you need euros, you may needpounds so, you need dollars. So, basically it happens that sometimes the dollar is onecurrency which is may be used in almost most of the countries right. So, it has a veryhigh applicability. So, what is this foreign exchange and why do we need it and how itimpacts businesses across the world? So, today that is our major discussion.(Refer Slide Time: 02:55)So, what is foreign exchange? As it says as you can see this diagram. So, there issomething like you know we are somebody is giving you know Indian denominations of2000 rupees and an in exchange they are taking the dollars, 100 rupees dollars right. So,as I said when I am going to a let us say to attend a conference abroad; so, I need dollars.So, whichever country I am going, suppose I am going to even Turkey or I am going toCanada or I am going to any country; I can take a few that the local you knowdenominations of that particular currency of that country. And may be a few amount Ican keep in dollars, because dollars is used everywhere across the world right.So, what is this foreign currency, foreign exchange? Foreign exchange is the process oftrading of one currency for another or system of converting one national currency intoanother. So, for example, as I said rupee for dollar right; so or some you know onecurrency against the other right; dollar versus euro right; so, euro dollar. So, all thesething; when you are converting or exchanging it is termed as foreign exchange.It also involves trading one currency for another right; an exchange rate. So, how do youhow do you determine? How do you exchange the currency? Right. Its not that you give1 rupee note and you get 1 dollar; so, there has to be some equivalence. So, thisequivalence is known as the exchange rate right. So, this exchange rate is the price of acurrency or value of one currency in relation to the other.So; that means, for example, as of today the Indian rupees 1 US dollar is equal to todayNovember, you know in the month of November 22nd, 23rd it is 71.19 rupees is equal to1 US dollar. So, suppose you need let us say a 100 US dollars; that means, you need 100US dollars you have to pay out 7119 rupees right. So, that is what it says.The most popular in the world is the US dollar followed by the euro. There are in dollaralso you know there are several dollars. For example: the US, the Australian, theCanadian; but we are talking about here the US dollar which is the most popularfollowed by the euro right. So, as it says for example, how many Indian rupees does ittake to buy 1 US dollar?As of December 24, 2019 the exchange rate is 71.19; meaning it takes rupees 71.19 tobuy 1 US dollar right. So, this is the basic meaning. So, as you can understand, this hasthis will have an effect on two important points: one this exchange has an impact onpeople like me or individuals or this is called the retail market right. And, where it is on aorganizational basis right.So, where large organizations trying to import some items; so, they have to pay right so,they have to pay in dollars. So, in such conditions when you are trying to make anytransaction, make any business. So, the organizations have to pay or buy whatever theyare getting money or they you know giving money, the currency is the dollar. So, at thattime also they would require a exchange right. So, according to the currency of thatparticular country they would have to make the exchange.(Refer Slide Time: 06:21)So, what is this foreign exchange market then? So, as you see, you can see this tableright; this you know diagram. So, this is like US dollar, US dollar, euro. So, there aresomething some like this looks like kind of a chart right. So, it says a market in whichthe national currencies are bought and sold against one another; some foreign exchangemarkets are for example, Mumbai, London, New York, Tokyo, Zurich, Frankfurt right.So, these are some of the major locations, exactly it is not that there is a place right. Theforeign exchange market happens Over The Counter, it is an OTC right. So, as it iswritten over here. So, it is a non-localized market which exists in the network of ainformation system. So, the business is done through telephone may be internet today hascome up and foreign exchange markets have grown tremendously.So, all these thing has works on the information system right. So, the foreign exchangemarket is one of the largest and the most liquid markets in the world. In fact, when youtalk about financial markets nothing can be considered more bigger than the foreignexchange market. It is dominated by the US dollar, the Euro, the Japanese yen and theBritish pound right.According to the Bank for International Settlements report of 2016, the foreign exchangemarket cap averaged 5.1 trillion per day that is in 2016. But, if you look at today, theforeign exchange market, the foreign the Forex market which is basically said foreignexchange is Forex has an estimated turnover of 6.6 trillions a day.So, now you can imagine as of 2019 how big is this. The entire business that is done inthis Forex market in 1 to 2 days or 3 days is even bigger than the GDP of some of themost popular nations right. Without the foreign exchange market international trade andinternational investment would be just impossible. Companies would have to resort tobarter system then.That means, if I am buying let us say iron, iron ore and you know if or I am selling youknow if, but the currency would not have been there. So, to buy iron may be I have togive something that I had may be oil right. So, if one country would have given oil, theother country would have given you know iron ore to it. So, this would have happenedhad the transaction this foreign exchange market would not have been there.Only barter system which is this one is the barter system would have been possible, butbarter system; obviously, is a very very old and nearly obsolete system so. So, todaythese international markets they work only because, it is possible due to the this foreignexchange market and, the feasibility of transferring one currency or exchanging onecurrency with the other.So, if you I need something form Japan to buy something from Japan, I would need yen.If I need to buy something from Australia, I would need dollars; if I need to buysomething from you know some other country, I would need the host country’s youknow currency. So, all these things are possible only because of the Forex market.(Refer Slide Time: 09:43)So, what are the features of this foreign exchange market? First of all you have tounderstand this market is a 24 hour market ; I have mentioned it. Let us see. The foreignexchange market is a global network of who? Who are the members? The banks, thebrokers, the foreign exchange dealers; all connected even you know the individualretailers also, the individuals also by electronic communication systems.So, these people the banks, the brokers, the banks could be the commercial banks, thecentral bank of a country right. So, the brokers may be the you know the fund agenciesand others, the foreign exchange dealers and so, the corporations. So, basically what itsays is the it is a global network of banks, brokers and foreign exchange dealersconnected by a communication system.So, for example, the popular ones are like JP Morgan Chase, Bank of America, MerrillLynch, Citi, Goldman Sachs, HSBC, Deutsche Bank, Standard Chartered. These aresome of the names of the most involved or the most popular participants in the global inthe foreign exchange market. So, these people are have a play big role right and in thetransaction, in the entire transaction systems.The foreign exchange market functions 24 hours of the day different time zonesaccording to the different time zones of the globe. So that means, it is one market whichnever you know takes rest. So, as you can you can also you must have heard the Citibanks punch line which says a bank which never sleeps Citi bank right. So, no wonderthey are correct because when they work for 24 hours; so, there is no time to sleep.If exchange rates quoted in different markets were not essentially the same, there wouldbe an opportunity for arbitrage. Now, what is arbitrage? Very very simple of you knowunderstanding, but has a very high impact. Now, arbitrage is the process of buying acurrency low and selling it high. Now, let us take in two different markets A and B right.So, if we take two markets for example, A and B, A and B. Now, if the dollar price of theeuro is 0.99 in New York and 1.01 in Frankfurt, let us say.This would help the arbitrager would buy or purchase the Euros at 0.99 here and in NewYork and immediately resell them in Frankfurt for 1.01, thus realizing a profit of 0.02.So, this phenomena of buying at the same time may be at a lesser price and selling thesame item at another market at a higher price is called arbitrage. Arbitrage is takingadvantage of the difference of the value in two different markets.So, the variety of factors that affect exchange rates are like the inflation rate, interestrate, money supply etcetera right. So, these factors affect the exchange rate basically ok.(Refer Slide Time: 12:53)So, if you look at the market share of the leading foreign exchange currencies in 2019,by value of turnover you will get a understanding that no wonder the US dollar leads therace and it is it has the highest market share right ah. So, it is about 88 percent followedby the euro 32 percent, yen 17 percent, British pound 13 percent, Australian dollar 7percent; it goes in a hierarchy right.And, the last around you know the Mexican peso is around 2 percent. So, what it says isbasically it you have to understand here that the euro and the US dollar, the yen and thepound; these four they are leading from the front right. They have the highest marketshare. In terms of global liquidity and all over the place by far the most utilized currencyis the US dollar - known widely as the world’s reserve currency.Because, every country on the planet keeps large sums of dollars in reserve in order tomake hard currency trades on major commodities like oil, gas, grain and gold which isthe commodities basically right. This advantage is what gives Washington unprecedentedpower and leverage in international affairs. Most transactions involve US dollars on oneside; the US dollar is a vehicle currency.So, what it says basically is if you look at the amount of use of the US dollar in fact,many people many critics, economists they feel that the entire even the you know politicsbehind the behind keeping the dollar as a number 1 you know currency is there is a largepolitics behind it right. And, many countries are trying to dismantle the US dollar, butthe US has its own interest; obviously.So, it works very hard in order to keep the US dollar at the top right. If the US dollarwould not be the most used currency, automatically its business would come down thebusiness or you can say the importance would fall. So, many countries would not eventhen use the US dollar for doing their business and; that means, the US dollarsimportance if it once comes down, the US economy will be will be greatly affected right.So, if you look at the countries like Iran and all they want the US dollar to come down,but on the other hand the US government works very hard. In fact, there is a lot of youknow if (Refer Time: 15:26) shadow, wars and other things that happen in order to keepthe US dollar at the top ok. So, as it says the US dollar is a vehicle currency. So, vehiclecurrency means it is used for most of most of the transactions right.The Bretton Woods Agreement established that the central banks would maintain fixedexchange rates between their currencies and the dollar. Because; that means, the dollar issuch a powerful currency that almost all the countries because and it is also called as theworlds reserve currency; almost all the countries they have to keep some amount ofreserves as in form of the dollar right. Because, almost all the transactions that you doacross the world, all international transactions; they are largely done by the through thedollar ok.(Refer Slide Time: 16:18)Now, when you come to the participants in the foreign exchange market, the when youtalk about as I said. So, the banks for example, JP Morgan Chase, Bank of America, Citietcetera. So, there are large corporations right for example, the MNC’s and all who arebasically doing the business. So, somebody wants to buy some you know importsomething or you know even export cars or something you know. So, whatever; so, thelarge corporations are there.Individuals are also there so, but they hold a very small value right and very very smallvalue. Then there are central banks like for example, we have our RBI in India right.Every country has a central bank which basically controls the money supply in thatparticular country. Then you have the hedge funds, investment funds right.So, there are large agencies again, there are very popular hedge fund agencies also andthese fund agencies also are basically they work to improve their portfolios right andthere are Forex companies. So, these are some of the members, the participants in theforeign exchange market or the Forex market. Now, let us see each one of them and tryto understand.(Refer Slide Time: 17:26)The first comes the commercial banks. In fact, if you will it is interesting to know that 90percent of the transactions in the Forex or the foreign exchange market is due to theinterbank, interbank transactions happens due to the inter bank transactions right; 90percent right. And, less than or the rest you can say the rest will be between the banksand the may be companies right, or corporations and others right.So, this interbank is basically the largest or the most significant amount of the transactionthat is happening in here. So, what are commercial banks? These banks serve their retailclients, the bank customers in conducting foreign commerce or making internationalinvestment in financial assets that require foreign exchange.So, the commercial banks are those banks who help their customers in conductingforeign or making international investments right. So, these banks are one of the they arethe largest among the largest players who are the most important participants in theForex market.Then you have members like the foreign exchange brokers, central banks, MNC’s,individuals and fund managers. So, when you say about the brokers, they operate in theinternational currency market and act as agents who facilitate trading between thedealers. Unlike the banks these brokers are mainly as matchmakers and do not put theirown money at risk. So, what are these people basically doing? They are responsible fordisseminating the information regarding the value of the currencies right.So, these brokers are matchmakers, who are only disseminating the information acrossthe globe right; about the value of the currencies. The next is the central bank, as I saidanother important player is the central bank of the various countries right. Now, thesebanks frequently intervene in the market to maintain the exchange rate of their currencieswithin a desired range and to smooth fluctuations within that range.Now, if you are following the economic times or financial express or any good paper orsomething or the news at least, then you must be understanding that the central bank orthe for example, the reserve bank in of India is trying to maintain the exchange rate right.So, it is trying it intervenes in the market to maintain the exchange rate, it does not allowthe exchange rate to go up tremendously right. So, within it wants to keep it within adesired range in an you know optimal range right.So, that the transactions become necessarily smooth and they there is not much of chaosright that develops. So, these central banks are basically they are operating in thesemarkets; they are controlling the other banks also and trying to control the entire theexchange rate right of this currencies. And, they make lot of rules also accordingly howyou have to manage the exchange rates, the currencies basically how much you can keep,what are the different.For example, the Indian government has certain rules that how much you know acurrencies of different different countries you can hold at one point of time. The MNC’sare the major non-bank participants. So, these are the corporations basically participantsin the forward market as they exchange cash flows associated with their multinationaloperations. Now, there are two markets: the one is the spot market and the forwardmarket.Now, here we are talking about the forward market for something that you have to payright in the future. And, then you have a spot market which you have to pay immediatelyright, on the spot let us understand that way. So, the MNC’s often contract to either payor receive fixed amounts in foreign currencies at future dates. So, that is what I amsaying the forward market, it is a future date right. So, they are exposed to foreigncurrency risk.Now, suppose today I have to I have made a deal and I have to pay the money aftersometime may be right; after the goods the you know the product has reaches me. Now,the time which I am at which I am paying, by that time let us say according to thebecause of the change in the currency or volatility of the currencies the I am I have topay higher amount, than what I would have paid today.So, in such a condition the players or the corporations who are making business in largeamounts, their entire business can be can have a very; it having a very serious effect ontheir business just because the currency value has changed. So, today what it is? Let ussay today it is 71.19; 1 dollar is 71.19 and tomorrow it changes to either 70 or let us say73. So, in both the cases one it is a it has come down and other it has gone up.So, both the cases, there will be some effect on this corporations right because they arenot buying in very small amount; they are buying in bulk amounts right. In suchconditions, this is why they try to always hedge the future cash flows through theinterbank forward exchange market. Now, what is hedging? Hedging is basically to trywhen the companies try to hedge means, they try to reduce the risk right through somemechanisms and connection with this banks right.So, since the business is a perennial is a continuous thing that is happening. So, theseMNC’s, these corporations have to keep in mind all the time the currency situation; ifwhether it is in their favor or not. So, but if you say if it one things in terms of favor oryou know against, then it will be also a very risky proposition. So, in order to you knowreduce this uncertainty, they try to hedge their values right.Individuals and small businesses are also use foreign exchange market to facilitateexecution of commercial or investment transactions. The foreign needs of these playersare usually small, only account for a they account for a very small fraction of the entireforeign exchange transactions. Here even individuals who are paying a education fee orfor remittances, anything that would also be considered, but that is a very very smallamount.Last is the hedge funds, the wealth funds and the fund managers. They are basicallytransnational and home country’s money managers who may deal in hundreds ofmillions of dollars, as their portfolios of investment funds are often quite large right. Themajor aim of these hedge funds is to make profits and grow their portfolios. So, as wesee the foreign exchange market has 6 important participants right.The commercial bank, the foreign exchange brokers, the central banks, the MNC’s or thecorporations, the individuals and small businesses and finally, the funds; the fundmanagers or the fund wealth funds and all these right players. So, all these playerstogether make up the foreign exchange market right. And, if I say it is the biggestfinancial market as I said right. And, this market has a huge you know effect on thetransaction or the business transactions for any corporation for any country anythingright.Because, the entire businesses that happen among countries, all countries are routedthrough this foreign exchange market. So, the entire businesses of different all thecountries across the world are routed through this foreign exchange; because the way totransact can only be done by having the right currency because, today you do not have abarter system.So, in order to have that currency and in order to take advantage of that currency youknow currencies system, one has to be extremely sharp, one has to be extremely carefuland has to understand the dynamism of the foreign exchange market right. So, a verysmall fluctuation also can have a very large impact just because, of the volume of thesheer size of the businesses that are happening right. Even a point let us say 0001percentage up or down may result in millions of dollars of loss or gain for corporationsand countries right.So, today we have only started with the foreign exchange market, we have tried tounderstand it little bit. And, in the next session I will take up little, we will try to talkdeep into it; we will go deep into it and try to understand what are its implications andhow it affects the entire international or the business right.So, thank you very much, have a wonderful day.