Foreign exchange market

Foreign exchange market
Source: Tavaga

Foreign exchange markets are those where currencies from different countries are traded against each other. It is an over-the-counter (OTC) marketplace and one of the largest markets in the world.

Forex markets facilitate cross-border capital flows that connect global financial markets and international trade.

Globally, foreign exchange markets witness the largest trade volumes, as these markets are extremely liquid as values up to four decimal points matter are taken into account.

The forex markets have participants from every time zone, connected through electronic communications networks that link everyone from large investment funds to individual retail traders, in real-time. Therefore, there is no geographical location. It is open for 24 hours.

There are three segments of a Forex market in India

  1. Central Bank i.e., RBI dealing with Authorised Dealers who are usually Commercial Banks
  2. Commercial Banks dealing with one another
  3. Dealings between Authorised Dealers and Corporate customers

Factors that affect foreign exchange rates

  1. Amount of Imports and Exports
  2. Interest rates
  3. RBI’s policy and Intervention in the market
  4. Inflation rates in the economy
  5. The sources of foreign exchange such as external aid, external commercial borrowings, NRI deposits, etc.

The most-traded currencies in the foreign exchange market are US Dollar, Sterling Pound, Canadian Dollar, Deutsche Mark, and Japanese Yen.

The five foreign exchange markets are:-

  1. Spot Market
  2. Futures Market
  3. Forwards Market
  4. Options Market
  5. Swaps Market

Futures, Options, and Swaps are derivatives as they derive their value from the underlying asset that is traded.

Three types of accounts that are involved in Foreign exchange markets are:-

  1. Nostro Account (Our money with you)- It implies that a local bank has their account with a foreign bank
  2. Vostro Account (Your money with us)- It implies that a foreign bank has their account with a local bank
  3. Loro Account (Their money)- It implies crediting money in a foreign bank account to credit it in the account of another foreign bank. Here three banks are involved