The market in which international currency trade takes place i.e. where foreign currencies are bought and sold simultaneously is called the Foreign Exchange (Forex) Market. It is the organisational framework within which banks, merchants, firms, investors, individuals and government exchange foreign currencies for one another.
For example, in India the currency in circulation is called the rupee INR and in the United States, the currency in circulation is called the US Dollar (USD).
An example of a Forex trade is to sell the Indian rupee while simultaneously buying the US Dollar.
Forex market has no geographical location, it is electronically linked network and is open 24 hours a day.
The value for which one currency is exchanged for another or the value of one currency in terms of another currency is called exchange rate. For example, US dollar can be bought for 63 INR rupees. This is the exchange rate for Indian rupees in US dollars.
The foreign exchange market in India started when in 1978 the government allowed banks to trade foreign exchange with one another. Foreign Exchange Market in India operates under the Central Government of India and executes wide powers to control transactions in foreign exchange. The Foreign Exchange Management Act, 1999 or FEMA regulates the whole Foreign Exchange Market in India. Before the introduction of this act, the foreign exchange market in India was regulated by the Reserve Bank of India through the Exchange Control Department, by the Foreign Exchange Regulation Act or FERA, 1947. Interbank foreign exchange Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI) created in 1958, a self-regulatory voluntary association of dealers or banks specializing in the foreign exchange activities in India that regulates the governing rules and determines the commissions and charges associated with the interbank foreign exchange business. Since 2001, clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions.
The foreign exchange market in India consists of 3 segments or tires. The first consists of transactions between the RBI and the authorized dealers (AD). The latter are mostly commercial banks. The second segment is the interbank market in which the AD’s deal with each other. And the third segment consists of transactions between AD’s and their corporate customers. As in any market essentially the demand and supply for a particular currency at any specific point in time determines its price (exchange rate) at that point. Prior to 1990s fixed Exchange rate of the rupee was officially determined by RBI.
During the early years of liberalization, the Rangarajan committee recommended that India’s exchange rate be flexible. India moved from a fixed exchange rate regime to “market determined” exchange rate system in 1993. This is explained as under..
A country’s currency exchange rate is typically affected by the supply and demand for the country’s currency in the international foreign exchange market. Let’s take the example of Rupee Dollar exchange. The rupee/dollar rate is a two-way rate which means that the price of 1 dollar is quoted in terms of how much rupees it takes to buy one dollar. The value of one currency against another is based on the demand of the currency. If the demand for dollar increases, the value of dollar would appreciate. As the quotation for Rs/$ is a two way quote, an appreciation in the value of dollar would automatically mean the depreciation in Indian rupee and vice-versa. Besides the primary powers of demand and supply, the Indian exchange rate is affected by following factors:
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Nostro account: A foreign currency ac maintained by a bank in India with a bank in abroad. For example, Bank of India US dollar account with Citi bank.
Vostro account: A rupee account of a foreign bank abroad with a bank in India. For example, Citi bank rupee ac with bank of India.
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