Trade finance implies financial instruments and products that are used by companies or importers and exporters to facilitate global trade and commerce. It is trade finance which makes it possible and painless for the parties involved in the international trade to transact business through trade.
Put simply, trade finance is a broad spectrum. Under it, a lot of things get covered such as- financial products that banks and companies deploy in order to make trade transactions achievable. In international/foreign trade transactions, the role of foreign exchange plays a pivotal role. The foreign exchange market is a huge global online network wherein buyers and sellers buy and sell currencies.
Foreign exchange depends on the value of the currency. And, as far as the valuation of currency is concerned, it again depends on a number of factors such as - trade, investment, tourism, and geopolitical risk. The foreign exchange market also represents central banks, commercial banks, brokers, exporters & importers, immigrants, investors, and tourists.
Structurally, India’s foreign exchange market is not different from that of the global foreign exchange market. When represented hierarchically, the main players of this market and their position, as well as place, can be best described through pictorial representation. Take a look below
Key Points On Foreign Exchange
1. Foreign exchange in simple words implies exchange of native currency to foreign currency of another nation or economic zone. Foreign exchange is closely linked with the global market and the currencies
2. The process includes management of foreign exchange, methods and the instruments that are used to adjust the payment of debts between two nations, employing norms of different currency systems.
3. The foreign exchange market is considered to be an Over the Counter (OTC) market in which trading is done directly between two parties without actually having the need for an exchange.
4. It is one of the largest markets in terms of trading volume as it includes a large spectrum of participants such as banks, international corporations, central banks, investment management firms, hedge funds, retail forex brokers and investors.
As far as the foreign exchange rate is concerned, although most of the exchange rates are free-floating and therefore rise or fall based on supply and demand in the market, there are however some currencies which have restrictions because they are not free floating. Developing countries most often fear free floating of currencies and so the restrictions are prevailing in those countries in order to maintain their exchange rate at the desired level among other things.
In India, for the sake of correct condition for the operation of foreign exchange transactions, an Act by the Reserve Bank of India was introduced. This act is commonly known as FEMA which implies, Foreign Exchange Management Act. The act merges as well as amends law which is related to foreign exchange. The purpose of the act is also to facilitate external trade and payments to further the orderly development and maintenance of foreign exchange market in the country.
Important Features of FEMA
This act extends to the whole of India and applies to all branches, offices, and agencies outside India. It is basically owned as well as controlled by a resident of India and is not applicable to Indian citizen’s resident outside of India. It is also applicable to any violation that’s there under committed outside India by any two people whom this Act is applicable.
1. It is mainly consistent with full current account convertibility and contains provisions for progressive liberalization of capital account transactions.
2. It is more transparent in its application as it lays down the areas requiring specific permissions of the Reserve Bank/Government of India on acquisition/holding of foreign exchange.
3. It classified the foreign exchange transactions in two categories, namely capital account and current account transactions.
4. It gives power to the Reserve Bank for specifying, in, consultation with the central government, the classes of capital account transactions and limits to which exchange is admissible for such transactions.
5. The act accords complete freedom to a person who is a resident of India or one who was an NRI to control/ own/ transfer any sort of foreign security or for that matter any immovable property that’s situated outside India that the individual acquired while living out of India.
6. The act is a civil law and therefore, breach of this act clearly lays issuance of arrest orders in exceptional cases only. In India the foreign exchange market is a vibrant market has been there for over four decades now and the market is fast growing due to various forward looking steps in economic reforms lately. Today, the Indian foreign exchange market has multiple players who facilitate services related to the exchange of currencies. The number of listed brokers as well as authorized institutions in this line is also increasing with the market widening up with time. One finds many non-bank financial institutions that are however legally authorized to offer trade in the Indian market. By and large, this market is strictly regulated by the Central Government and all the aspects of the trade.
The Indian foreign exchange market consists of 3 tiers. In the first tier, it mainly comprises of transactions between the RBI and the authorized dealers (AD). In the second tier, it mainly comprises the interbank market in which the AD’s deal with each other takes place. The third segment, however, comprises of the transactions between AD’s and their corporate customers.
Types of Foreign Market Operations
1. Spot/ Current Market- This kind of market for foreign exchange manages spot transactions or current transactions. Spot rate of exchange is of a daily nature and prevails at the time when transactions are incurred.
2. Forward/Derivative Market- in this type of market, the foreign exchange forwards is honored. Aspects such as foreign exchange forwards, currency futures, currency swaps, and currency options are instrumental in this area.
3. Exchange Settlement and Dealings- here the play of Nostro and Vostro account comes at play as it is through these kinds of accounts that settlement of foreign exchange transaction materializes.
The Nostro account is a kind of account where foreign currency account is maintained by an Indian bank with another bank in abroad. On the other hand, a Vostro account is a type of account which is maintained by a rupee account of a foreign bank abroad with a bank in India.
Foreign Exchange Rate- How is it determined?
Foreign exchange spot rate is mainly determined by supply and demand of currencies. Banks across the world mainly buy as well sell currencies in order to accommodate their customers’ requirement for either trade or say to exchange one currency. To fix foreign exchange rate, the sum total of all banks selling and buying dollars creates a supply and demand for US dollars. So, if the demand for dollars rises, then automatically dollar will appreciate against any other currencies. Similarly, if the demand of dollar drops, then in such a case, dollar gets depreciated against the other currencies. Thus, the rates are set by all the banks who participate in the banks bidding and also who offer currencies throughout the day amongst each other.
Here of course, a nation’s balance of payment also plays an important effect on the exchange rate of its currency. Bills of exchange, drafts, checks and telegraphic orders are the major means of payment in any foreign transactions. The principle demand for foreign exchange in any country comes from importers of foreign goods, purchases of foreign securities, government agencies, purchase of goods and services from abroad and from travelers as well.
In order to maintain the value of currencies value, banks hold foreign reserves. The purpose of holding foreign exchange reserves is to upkeep the value of their currencies to fixed rate. Further, maintaining reserves help countries meet its external obligations. These obligations comprise of international payment obligations that include both sovereign and commercial debts. It also includes financing of imports, and the ability to absorb any unexpected capital movements. Many countries, they use their reserve to upgrade its sectors such like infrastructure. China is one country which is using its Forex reserves to recapitalize some of its state owned banks.
Benefits of Foreign Exchange Trading
The foreign exchange market is one of the largest financial markets and also a liquid market in the world. Foreign exchange trading can help traders control large amount of money by providing small amounts as margins. The foreign exchange trading also assists traders to go long or go short whichever way the market goes. Let’s check the benefits of foreign exchange trading in detail.
1. Traders can control large amount of money by putting incremental amounts as margins only. This gives an edge to the traders to frame a profitable investment strategy and reduce risks involved. But, for this however, the margin balance needs to be kept under regular scrutiny in order to avoid sudden liquidation of position in the market.
2. Foreign Exchange gives an advantage of high liquidity. This therefore helps traders to easily convert and move large amount of foreign currency with minimum price discounts.
3. When traders become aware of the market norms and policies, traders can easily buy as well as sell foreign exchange through spot currency trading. This therefore helps traders to avoid risks and ensure maximum execution time as well.
4. Trading in the foreign exchange market is available 24 hours over the week. Traders can also do it at their convenient time and use pair of currencies any time in between the five days. The continuous nature of this marketplace thus is a huge advantage for those who wish to trade on part-time basis.
5. Traders can avoid commissions and exchange fees while directly trading in the open marketplace. Unlike future trading, in currency trading, traders have the option to avoid brokerage fees and commissions because here trading takes place directly between buyers and sellers at the live foreign exchange rates.
Free marketplace creates an excellent opportunity for the traders to easily invest in any currency pair they wish. There is a minimal restriction in directional trading makes unchallenging for any individual to invest in the market, even if they do not have a lot of capital.
Foreign Exchange Risk
Risks in this area mainly depend on the currency fluctuations. Due to currency risks, foreign exchange risk and exchange rate risk, investment rates tend to lower down. The decrease mainly occurs due to the changes in the relative value of the currencies involved. So, any slight appreciation or depreciation of the denominated currency leads to imbalance in the cash flows stemming out from that transaction. This kind of risk can impact everyone, right from investors to traders in international markets to businesses involved in the import/export of products and services to various countries.
Key Types of Foreign Exchange Risks
Transaction Risk- Companies that buy a product from any companies that is based out in abroad mainly face this kind of risk. The price of such product is mainly denominated in the selling company’s currency. In this kind of trade, if the selling company’s currency were to appreciate with that of the buying company’s currency, then it is the buying company which makes the larger payment in its base currency to meet the contract price.
Economic Risk – Companies face this kind of risk when their market value gets impacted by unavoidable exposure to currency fluctuations.
Translation Risk- Any parent companies owning a subsidiary in another country can face loss if the subsidiary’s financial statements that will be denominated in that country’s currency is to be translated back to the currency of the parent company.
In order to mitigate risks, most companies are advised to implement hedging strategies which involve forward contracts, options and other exotic financial products. If such strategies are implemented properly and on time, it can help businesses from unwanted foreign exchange moves. Here however, the guidance of financial consultants play a major role in helping businesses apply right steps in management of foreign exchange risk management.
Despite having risks, one can hardly miss out the highly opportunistic segment of this market. In fact, the Indian market is advancing fast. It is however far from reaching the level of the major markets in the advanced countries. A positive side of the Indian market is the steady volume of daily transactions and the growth of the market. This would further help in the country maintain a stable growth of currency exchange rate which typically gets affected by supply and demand for the country’s currency in the international exchange market.
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