Currencies Market

Introduction
Currency Futures is the latest product introduced in Indian securities markets. It will lead to further maturity and deepening of the financial markets in India. Worldwide, trading in currency futures is a huge market and, given the rapid growth of economy and finance in India, it is poised to assume a significant role in the growth of Indian securities markets.

The dawn of currency futures is perhaps a momentous development in the foreign exchange market of India. It represents a massive stride ahead in the continuing globalization of the country's financial markets. The currency derivatives segment will enable importers, exporters, investors, corporations, and banks to hedge their currency risks at low transaction costs and with greater transparency.
Understanding the meaning of ‘foreign exchange’ is important to know more about currency futures market. Foreign exchange refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his ownnation’s currency for money denominated in anothernation’s currency acquires foreign exchange.
This holds true whether the amountof the transaction is equal to a few rupees or to billions of rupees. A foreign exchange transaction is a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian rupee (INR) is, broadly speaking, ‘foreign exchange’. Foreign exchange can be cash, bank deposit, or a short-term negotiable financial claim denominated in a currency other than INR.
Almost every nation has its own national currency or monetary unit used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for foreign exchange transactions: exchanges of one currency for another.
For all such transactions there is an exchange rate. The exchange rate is a price: the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency. There are scores of ‘exchange rates’ for INR and other currencies, say the US dollar. In the spot market, there is an exchange rate for every other national currency traded in that market.
A market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange market. The market participation is made up of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling currencies at that particular time.
What Is Foreign Exchange?
‘Foreign exchange’ refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his ownnation’s currency for money denominated in anothernation’s currency acquires foreign exchange.
This holds true whether the amountof the transaction is equal to a few rupees or to billions of rupees; whether the person involvedis a tourist cashing a traveller’s cheque in a restaurant abroad or an investor exchanging hundreds of millions of rupees for the acquisition of a foreign company; and whether the form of moneybeing acquired is foreign currency notes, foreign currency-denominated bank deposits, or other short-term claims denominated in foreign currency.
A foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian rupee (INR) is, broadly speaking, ‘foreign exchange’. Foreign exchange can be cash, funds available on credit cards and debit cards, traveller’s cheques, bank deposits, or other short-term claims. It is still ‘foreign exchange’ if it is a short-term negotiable financial claim denominated in a currency other than INR.
Why Do You Need Foreign Exchange?
Almost every nation has its own national currency or monetary unit—its rupee, its dollar, its peso—used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for foreign exchange transactions—exchanges of one currency for another.
Role of the Exchange Rate
The exchange rate is a price—the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency. There are scores of “exchange rates” for INR and other currencies, say the US dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the euro or the International Monetary Fund’s Special Drawing Rights (SDRs). There are also various ‘trade-weighted’ or ‘effective’ rates designed to show a currency’s movements against an average of various other currencies (for example, the US dollar index, which is a weighted index against world’s major currencies like euro, pound sterling, yen, and the Canadian dollar). Quite apart from the spot rates, there are additional exchange rates for other delivery dates in the forward markets.
A market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a key participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range. But in countries like the United States, which follows a complete free floating regime, the authorities do not intervene in the foreign exchange market on a continuous basis to influence the exchange rate. The market participation is made up of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling US dollars at that particular time.
The participants in the foreign exchange market are thus a heterogeneous group. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whatever is the constitution of participants, and whether their motive is investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market price at that instant. Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain business. At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much else. The role of the foreign exchange market in the determination of that price is critically important.
It’s a 24-Hour Market
During the past quarter century, the concept of a 24-hour market has become a reality. Somewhere on the planet, financial centres are open for business, and banks and other institutions are trading the dollar and other currencies every hour of the day and night, except for possible minor gaps on weekends. In financial centres around the world, business hours overlap; as some centres close, others open and begin to trade. The foreign exchange market follows the sun around the earth.
Business is heavy when both the US markets and the major European markets are open—that is, when it is morning in New York and afternoon in London. In the New York market, nearly two-thirds of the day’s activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid- to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have opened.
Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day, and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the 24-hour market does provide a continuous ‘real-time’ market assessment of the ebb and flow of influences and attitudes with respect to the traded currencies, and an opportunity for a quick judgment of unexpected events. With many traders carrying pocket monitors, it has become relatively easy to stay in touch with market developments at all times.
International Markets Are Made Up of an International Network of Dealers
The market consists of a limited number of major dealer institutions that are particularly active in foreign exchange, trading with customers and (more often) with each other. Most of these institutions, but not all, are commercial banks and investment banks. These institutions are geographically dispersed, located in numerous financial centres around the world. Wherever they are located, these institutions are in close communication with each other; linked to each other through telephones, computers, and other electronic means.
Each nation’s market has its own infrastructure. For foreign exchange market operations as well as for other matters, each country enforces its own laws, banking regulations, accounting rules, and tax code, and, as noted above, it operates its own payment and settlement systems. Thus, even in a global foreign exchange market with currencies traded on essentially the same terms simultaneously in many financial centres, there are different national financial systems and infrastructures through which transactions are executed, and within which currencies are held.
With access to all of the foreign exchange markets generally open to participants from all countries, and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross-border foreign exchange trading among dealers as well as between dealers and their customers. At any moment, the exchange rates of major currencies tend to be virtually identical in all of the financial centres where there is active trading. Rarely are there such substantial price differences among major centres as to provide major opportunities for arbitrage. In pricing, the various financial centres that are open for business and active at any one time are effectively integrated into a single market.
The Market’s Most Widely Traded Currency Is the Dollar
The dollar is by far the most widely traded currency. In part, the widespread use of the dollar reflects its substantial international role as ‘investment’ currency in many capital markets, ‘reserve’ currency held by many central banks, ‘transaction’ currency in many international commodity markets, ‘invoice’ currency in many contracts, and ‘intervention’ currency employed by monetary authorities in market operations to influence their own exchange rates.
In addition, the widespread trading of the dollar reflects its use as a ‘vehicle’ currency in foreign exchange transactions, a use that reinforces, and is reinforced by, its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the dollar, although very recently euro also has become an important vehicle.
Thus, a trader wanting to shift funds from one currency to another, say from INR to Philippine pesos, will probably sell INR for US dollars and then sell the US dollars for pesos. Although this approach results in two transactions rather than one, it may be the preferred way, since the dollar/INR market, and the dollar/Philippine peso market are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other. By using the dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle.
Use of a vehicle currency greatly reduces the number of exchange rates that must be dealt with in a multilateral system. In a system of 10 currencies, if one currency is selected as vehicle currency and used for all transactions, there would be a total of ninecurrency pairs or exchange rates to be dealt with (i.e., one exchange rate for the vehicle currency against each of the others), whereas if no vehicle currency were used, there would be 45exchange rates to be dealt with. In a system of 100 currencies with no vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates [the formula is: n(n-1)/2]. Thus, using a vehicle currency can yield the advantages of fewer, larger, and more liquid markets with fewer currency balances, reduced informational needs, and simpler operations.
The US dollar took on a major vehicle currency role with the introduction of the Bretton Woods par value system, in which most nations met their IMF exchange rate obligations by buying and selling US dollars to maintain a par value relationship for their own currency against the US dollar. The dollar was a convenient vehicle because of its central role in the exchange rate system and its widespread use as a reserve currency. The dollar’s vehicle currency role was also due to the presence of large and liquid dollar money and other financial markets, and, in time, the euro-dollar markets, where the dollars needed for (or resulting from) foreign exchange transactions could conveniently be borrowed (or placed).
Other Major Currencies
The Euro
The euro was designed to become the premier currency in trading by simply being quoted in American terms. Like the US dollar, the euro has a strong international presence and over the years has emerged as a premier currency, second only to the US dollar.
The Japanese Yen
The Japanese yen is the third most traded currency in the world. It has a much smaller international presence than the US dollar or the euro. The yen is very liquid around the world, practically around the clock.
The British Pound
Until the end of World War II, the pound was the currency of reference. The nickname cable is derived from the telegrams used to update the GBP/USD rates across the Atlantic. The currency is heavily traded against the euro and the US dollar, but it has a spotty presence against other currencies. The two-year bout with the Exchange Rate Mechanism, between 1990 and 1992, had a soothing effect on the British pound, as it generally had to follow the Deutsche mark's fluctuations, but the crisis conditions that precipitated the pound's withdrawal from the ERM had a psychological effect on the currency.
The Swiss Franc
The Swiss franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. Although the Swiss economy is relatively small, the Swiss franc is one of the major currencies, closely resembling the strength and quality of the Swiss economy and finance. Switzerland has a very close economic relationship with Germany, and thus to the euro zone.
Typically, it is believed that the Swiss franc is a stable currency. Actually, from a foreign exchange point of view, the Swiss franc closely resembles the patterns of the euro, but lacks its liquidity.