Question

1.

a. Explain how the foreign exchange market differs from or is similar to other financial markets. (Identify at least three differences.)

b. Explain how foreign exchange transactions in the interbank market are settled. (That is how is the currency sold delivered to the seller and the currency purchased received by the buyer.)

Answer 1

a) The foreign exchange market might, in many ways look similar to other financial markets. However there a few differing points between them.

1. Other financial markets like the equity market provide a lot of alternatives and options to transact on. The foreign exchange market, on the other hand, has very few alternatives to choose from. There are not more than 7-8 major currency pairs around the world to trade on but any stock market gives us a few thousand options to choose from.

2. Foreign exchange market is a very liquid market, thereby the margins required are way lower than that of the equity market. To go into numbers, the margin requirement in the foreign exchange market can be as low as 2% but is mostly greater than 50% in an equity scenario.

3. The foreign exchange market is open 24/7 around the year and is thus, much more volatile than other markets which are open only for a few hours each day.

b) Foreign exchange settlement refers to the process of payment for transactions and receipt of the currency between buyer and seller. Let us explain the basic structure of a USD/INR transaction between two parties: Here the buyer sends USD and receives INR while the seller sends INR and receives USD.

When a transaction is completed, there is a time period of 3 days to transfer such currencies between required parties. The settlement is done by an intermediary bank( for ex: CLS Bank) which  maintains accounts of all banks with other banks they are transacting with and debit and credit entries are passed in its books. At the end of the day, the net value payable is transferred from one bank to the other. This way payments are received and the banks pass on the purchased currencies to the buyers and sellers.