______

Subject BUSINESS ECONOMICS

Paper No and Title 9, Financial Markets and Institutions

Module No and Title 35, Trading Procedures in Forex Markets

Module Tag BSE_P9_M35

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

TABLE OF CONTENTS

1. Learning Outcome 2. Introduction 3. 3.1 Forex Trading 3.2 Currency Pairs 3.3 Two Trade Opportunities 3.4 Currencies Traded in Forex Market 4. Pips, Lots and Leverage 4.1 What is a Pip? 4.2 What is a Lot? 4.3 What is Leverage? 4.4 How do Pips, Lots and Leverage work together? 5. Steps in Forex Trading 6. Arbitrage in Forex Market 6.1 Meaning of Arbitrage 6.2 Arbitrage Strategies in Forex Market 6.2.1 Case 1 6.2.2 Case 2: Arbitrage in Forex Futures Market 7. Government Intervention in Forex Market 7.1 Reasons for Government Intervention 7.2 Types of Government Intervention 7.2.1 Direct Intervention 7.2.2 Indirect Intervention 8. Foreign Exchange Reserves 9. Summary

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

1. Learning Outcomes

After studying this module, you shall be able to -

 Gain an insight about the foreign exchange market and how trading is carried out in this market.  Understand the process of forex trading.  Analyze the meaning of arbitrage and the various arbitrage strategies used in the forex market.  Explain how governments use direct and indirect intervention to influence exchange rates.

2. Introduction

When we travel abroad, we have to exchange our domestic currency for that of the country we are visiting. For this purpose, we make use of exchange rates. An is the rate at which one country’s currency can be converted into another.

Exchanging currencies isn’t just for travelers. The price difference is something you can trade. In the global economy, thousands of business transactions take place every day that require organizations to exchange the value of one currency for that of another. When a United States automobile manufacturer buys steel from Japan, he needs to convert dollars to yen to make the payment. In every exchange, prices need to be adjusted because one currency is typically weaker (has less value) while the other is stronger (has more value).

A decline in a currency’s value is referred to as depreciation. Similarly, an increase in a currency’s value is referred to as appreciation.

For example-

Yesterday, the exchange rate was $1= ₹60 Suppose, today’s exchange rate is $1= ₹62

This means that the rupee has fallen in value (depreciated) and the US dollar has risen in value (appreciated) because now you have to pay more rupees to purchase same amount of dollars.

Throughout the course of the day, the value of one currency compared to another can change in response to political news, economic conditions and interest rate changes. These frequent changes in the value of currencies drive forex trading and a trader’s profit potential in the currency markets.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

Let us understand two important trends in the market-

1. Bull market- A bull market is a market in which prices are rising or are expected to rise. It is characterized by optimism and investor confidence. Bull markets offer investors opportunities to earn profits by buying financial instruments at a lower price and closing their position by selling at a higher price.

2. Bear market- A bear market is a market in which prices are falling or are expected to fall. It is characterized by pessimism and continuous selling which further pushes down the prices. Bear markets offer traders opportunities to sell at a higher price and close positions by buying at a lower price. In a bear market, traders sell to exit the market and minimize losses.

Although, many financial products have restrictions on selling to capitalize on bear market opportunities, forex does not have these restrictions.

3. Foreign Exchange Market

The foreign exchange market is very big. Unlike the stock and bond markets, forex market is open 24 hours a day and 5.5 days a week. It is the most traded markets in the world.

In the forex market, one currency is always strengthening against another (bullish), and therefore, one currency is always weakening against another (bearish). Because of this, you have equal opportunity to buy or sell to enter the market. So, if the US Dollar (USD) is strengthening against the Indian Rupee (INR), it implies that the Indian Rupee (INR) is weakening against the USD.

3.1 Forex Trading

In foreign exchange or currency trading, traders hope to generate a profit by speculating on the value of one currency compared to another. This is why currencies are always traded in pairs— the value of one unit of currency doesn’t change unless it’s compared to another currency.

3.2 Currency Pairs

A currency pair tells us how much of the quote currency is needed to purchase one unit of the base currency.

For example-

CURRENCY PAIR A SAMPLE QUOTE FOR THIS PAIR EUR/USD 1.33820 The first currency listed is called the base So in this case, 1 is worth approximately currency. The second currency is called the 1.33 USD. quote or terms currency.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

3.3 Two Trade Opportunities

SCENARIO 1: BUY TRADE

If a trader believes that the euro is bullish against the US Dollar, i.e. the euro is strengthening against the USD, then he/she may enter a trade to buy , expecting to gain from the stronger value of euro compared to the US Dollar.

SCENARIO 2: SELL TRADE

Conversely, if a trader believes that the euro is bearish against the US Dollar, i.e. the euro is weakening against the USD, then he/she may enter a trade to sell euros in the hope that the currency’s value will become weaker compared to the US dollar.

3.4 Currencies Traded in the Forex Market

Traders can trade almost any currency depending on the currency pairs offered by the dealers. Although some retail dealers trade exotic currencies like the Thai baht or the Czech koruna, the majority trade the eight most liquid currencies in the world that are:

1. U.S. dollar (USD) 2. Canadian dollar (CAD) 3. Euro (EUR) 4. British pound (GBP) 5. Swiss franc (CHF) 6. New Zealand dollar (NZD) 7. Australian dollar (AUD) 8. (JPY)

4. Pips, Lots and Leverage

4.1 What is a Pip?

Pip stands for "percentage in point" and is the smallest measure of change in a currency pair in the forex market.

In the FX market, currency pairs display their prices with four decimal points. The change in that fourth decimal point is called 1 pip. Among the major currencies, the only exception is the Japanese yen which displays two decimal places.

A pip is a standardized unit and is the smallest amount by which a currency quote can change, which is usually $0.0001 for U.S.-dollar related currency pairs, which is more commonly referred to as 1/100th of 1%, or one basis point. This standardized size helps to protect investors from huge losses. For example, if a pip was 10 basis points, a one-pip change would cause more extreme volatility in currency values.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

Since a pip is a very small measurement unit, you may wonder how forex trading can be worthwhile by speculating on such a small fraction of a currency. The answer is that since forex is traded in large volumes, called lots, the pip value also gets multiplied. The higher volume you trade the more each pip will be valued.

This will be clear after studying the following illustration:

Suppose the USD/EUR direct quote is 0.9246.This quote means that for US$1, you can buy about 0.9246 euros. If there was a one-pip increase in this quote (to 0.9247), the value of the U.S. dollar would rise relative to the euro, as US$1 would allow you to buy slightly more euros.

The effect that a one-pip change has on the dollar amount, or pip value, depends on the amount of euros purchased. If an investor buys 10,000 euros with U.S. dollars, the price paid will be US$10,815.49 ([1/0.9246] x 10,000). If the exchange rate for this pair experiences a one-pip increase, the price paid would be $10,814.32 ([1/0.9247] x 10,000). In that case, the pip value on a lot of 10,000 euros will be US$1.17 ($10,815.49-$10,814.32). When the same investor purchases 1,00,000 euros at the same initial price, the pip value will be US$11.7. As this example demonstrates, the pip value increases depending on the amount of the underlying currency purchased (in this case, euros).

4.2 What is a Lot?

In forex, a lot is a standard unit of measurement. At most forex dealers, one standard lot usually equals 100,000 worth of currency.

4.3 What is Leverage?

One of the benefits of foreign exchange market is the ability to trade on leverage. Leverage is necessary in this market because the price deviations (the source of profit) are merely fractions of a cent. Leverage, expressed as a ratio between total capital available to actual capital, is the amount of money a broker will lend you for trading.

For example, a ratio of 50:1 means your broker would lend you $50 for every $1 of actual capital. You don’t need $10,000 in your account to trade the EUR/USD. This means you can control a large position ($10,000) with a small amount of money ($200).

Although the ability to earn profits by leveraging is substantial, leverage can also be risky and may work against the investor. For example, if the currency underlying one of your trade moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoid such a catastrophe, forex traders usually implement a strict trading style that includes the use of stop and limit orders.

Stop and limit orders in the forex market are used by investors in the same way as in the stock market.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

LIMIT ORDER is one that is generally placed on the ‘’better’’ side of the market, and it is always the trader’s intention to get the limit price or better on such an order. So, buy limits are placed below the current market price and will only be filled at or below the limit price. Sell limits are placed above the current price and will only be filled at or above the current price.

STOP ORDERS are the exact opposite of limit orders. These are generally placed on the ‘’worse’’ side of the market and it is the trader’s intention to get into the market in the direction of the momentum. Buy stop orders are placed above the market and sell stop orders are placed below the market.

An investor with a long position can set a limit order at a price above the current market price to take profit and a stop order below the current market price to attempt to cap the loss on the position. An investor with a short position will set a limit price below the current price as the initial target and also use a stop order above the current price to manage risk.

There are no rules that regulate how investors can use stop and limit orders. It is a personal decision because each investor has a different risk tolerance.

4.4 How do Pips, Lots and Leverage work together?

Suppose a trader bought 10,000 EUR/ USD on 50:1 as discussed in the previous example on leverage. He purchased at 1.30000 then closed the trade by selling at 1.30200. This means that he earned 20 pips. 0.0001 X US$10,000 = US$1 per pip .For his 20 pip trade, he would have earned US$20.

Not all of the pips you earn will be worth US$1. The value of a pip depends on the lot size of the trade, how many lots you are trading, the currency pair and your account currency. While you can manually calculate this or use online pip calculators to learn the value of a pip before you trade, most trading applications, like the FOREX Trader platform, automatically calculate pip values and convert them to the currency you’re trading.

When a trader trades a standard lot (Lot size 100,000 with a 50:1 leverage ratio), his earnings will be- 0.0001 X 100,000 = US$10 PER PIP. For his 20 pip trade, he would have earned US$200.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

5. Steps in Forex Trading

After opening an online forex brokerage account, a trader has to go through the following steps: 1. Select a Currency Pair- Decide what currency you want to buy and sell. It is very important to consider the economic and political conditions prevailing in a country as they have a significant impact on exchange rates.  Consider the economic scenario- Reports on a country's economic factors like GDP, employment and inflation, will have an effect on the value of the country's currency. For example- If the U.S economy is in turmoil, which can cause the U.S dollar to weaken, then you may want to sell dollars in exchange for a currency of a country with a strong economic environment.  Consider export potential- If a country has a strong export potential, i.e. many of its goods are demanded by the rest of the world, then the country has good money-making opportunities. This trading advantage will boost the country's economy, thus boosting the value of its currency. It will be profitable to invest in such a currency.  Consider the political environment- During elections in a country, its currency will appreciate if the winner of the election has a fiscally responsible agenda. Also, if the government of a country loosens regulations for economic growth, the currency is likely to increase in value.

For example- Narendra Modi’s win in the 2014 elections in India saw the Indian rupee surge to 11-month high levels, making it the best performing currency in the Asia-Pacific region against the US dollar. Positive sentiments out of the election results contributed to a gain of about 5.3% in the rupee since the start of the year.

2. Analyze the market – Traders should regularly look at current and historical charts, monitor the news for economic announcements, consult indicators and perform other research and analysis activities. Traders can make use of:

 Technical analysis: Technical analysis involves reviewing charts or historical price data to predict how the currency will move based on past events.  Fundamental analysis: This type of analysis involves looking at a country's economic fundamentals and using this information to influence trading decisions.  Sentiment analysis: This type of analysis is very subjective. Traders analyze the mood of the market to figure out if it is "bearish" or "bullish." Although one may not always be sure of market sentiment, one can make a good guess that can influence his/her trades.

3. Read the Price Quotes- Two prices are shown for all currency pairs. One is the price at which you can sell the currency pair. The second is the price at which you can buy the currency pair. The difference between the price at which a currency can be purchased and the price at which it can be sold is called the spread. It is calculated in "pips", and this difference is how forex dealers make money, since they don't charge a commission. Spreads will vary among dealers.

The difference in spreads can be very large, hence traders should spend considerable time in comparing dealers.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

4. Choose Your Position- Unlike the stock and bond markets, because forex traders are buying one currency while selling another at the same time, they can speculate on both up and down movement in the market. 5. Entering a Buy Position- Suppose the current price for the EUR/USD is 1.33820/840. You think that the euro is bullish, so you decide to enter a buy position for one lot of the EUR/USD. Because you are buying, your trade is entered at the price of 1.33840 to cover the spread. Now, let’s say that later in the day, you look at your position and find that the EUR/USD is now at 1.34160/180. Your trade has gained 32 pips. You decide to close your position at the current sell price of 1.34160 and take a profit. Your profit=0.0032 X 100,000 = US$320 6. Entering a Sell Position- Now suppose you think that the euro is bearish. You decide to enter a sell position for one lot of EUR/USD. Because you are selling, your trade is entered at the price of 1.33820. You look at your position later in the day and discover that the EUR/USD is now at 1.34160/180. Your trade has lost 36 pips. You decide to close your position at the current buy price of 1.34180, to cover the spread, and accept your losses. Your loss=0.0036 X 100,000 = US$360.

6. Arbitrage in Forex Market

6.1 Meaning of Arbitrage

Markets are not always perfectly efficient. In such a situation, there can be discrepancy in the prices of same asset at two different places. This results in arbitrage opportunities for traders.

Arbitrage refers to the practice of buying in one market (where price is lower) and simultaneously selling in another, in order to capitalize on the price difference between two or more markets, the profit being the difference between the market prices. This profit is considered to be riskless for the trader. Hence, an arbitrage trader does not bear any market risk.

Arbitrage helps to correct the problem of pricing inefficiencies in the market. For this reason, these opportunities are often available for a very short-time, before being acted upon. Arbitrage currency trading requires the availability of real-time pricing quotes. Traders must act quickly to capitalize on such opportunities. To help in finding these opportunities quickly, forex arbitrage calculators are often used.

6.2 Arbitrage Strategies in Forex Market

Forex Arbitrage involves the buying and selling of different currency pairs to exploit pricing inefficiencies. We can better understand arbitrage strategies by studying the following cases-

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

6.2.1 Case 1

Let’s have a look at the following current exchange rates-

EUR/INR=72.54 EUR/USD=1.09 USD/INR=66.65

In this case, a forex trader can buy one standard lot, i.e. 1,00,000 Euros for ₹72,54,000 INR. The trader can then sell the 1,00,000 Euros for $1,09,000 USD. The $1,09,000 USD can then be sold for ₹72,64,850 INR. Hence, through the arbitrage process, the trader makes a profit of ₹10,850 INR per standard lot (₹72,64,850- ₹72,54,000). The arbitrage process will continue until the pricing inefficiencies are completely eliminated.

6.2.2 Case 2- Arbitrage in Forex Futures Market

The possibility of pricing discrepancy also arises in case of forex futures market. Suppose the following quotes are available:

GBP/USD spot rate =1.51 12-month GBP/USD futures contract trade at 1.50 12-month interest on USD is 1.5% 12-month interest on GBP is 3%

A financial future is a contract to convert an amount of currency at a time in the future, at an agreed rate. Suppose the contract size is 1,000 units. If you buy one GBP/USD contract today, in 12-months time, you will receive £1,000 and give $1,500 in return.

The arbitrageur thinks the price of the futures contract is too high. If he sells one contract, he will have to deliver GBP 1,000 in 12-months time, and in return will receive USD 1,500. He does the following calculations:

To deliver £1,000, the arbitrageur needs to deposit £970.87 now for 12-months @ 3%. He can borrow in US dollars the amount, $1466.01 at 1.5% interest. He can convert this to £970.87 at the spot rate. The cost of the deal is $1466.01 + $21.99 (12-months interest @ 1.5%) = $1,488.

The above deal would create a synthetic futures contract that would convert £1,000 to $1488 in 12- month time. From this, he knows that the 12-month futures price should really be 1.488. The market quote is too high. He does the following trade:

Sell one futures contract @ 1.50. Create the synthetic futures deal as above.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

At the end of 12-months, under the contract he delivers £1,000 and receives $1,500. Using the money, he pays back his loan of $1,488($1466.01, plus $21.99 interest). He makes a riskless profit of $1,500 –$1,488 = $12.

Notice that the arbitrageur did not take any market risk at all. There was no exchange rate risk, and no interest rate risk. The deal was independent of both and the trader knew the profit from the outset.

The cash flows are shown in the diagram below (Figure 6.2.2).

Figure 6.2.2 Cash Flows in Futures Arbitrage

7. Government Intervention in Forex Market

Each country has a central bank that may intervene in the forex markets to control its currency’s value. For example: In the United States, the central bank is the Federal Reserve Bank (the Fed).

7.1 Reasons for Government Intervention

 To smoothen the exchange rate movements- If speculators are causing too much volatility in the currency market, then the central bank may intervene to smooth the currency

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

movements over time. By reducing exchange rate uncertainty, the central bank will encourage international trade.

 To establish implicit exchange rate boundaries- The central bank may intervene to maintain its home currency rates within some unofficial or implicit boundaries. This is done to prevent a currency from falling below or rising above a particular benchmark value.

 To lessen the impact of temporary disturbances- The central bank may also intervene to counter disorderly market conditions. For example: Suppose India exports majority of its goods to Country ‘X’. Recently, a lot of political disturbances are going on in Country ‘X’ which has badly hit Indian exporters. In order to prevent the rupee’s value from falling, the government may devalue its currency to boost Indian exports. The government, therefore, intervenes to offset the downward pressure on its currency (rupee, in this case) caused by such temporary disturbances.

7.2 Types of Government Intervention

Government Intervention can be categorized into:  Direct Intervention  Indirect Intervention

7.2.1 Direct Intervention

Suppose the rupee is depreciating against the dollar. To strengthen the rupee, RBI can exchange dollars for rupees (buy rupees and sell dollars) in the foreign exchange market, thereby putting an upward pressure on the rupee.

For example: RBI has been intervening in the currency market since December 2011, when the rupee hit a record low, to stabilize the currency. A weaker currency pushes up the country’s import bill-you pay more rupees for the same amount of dollars- and contributes to the current account deficit.

To push up the rupee, RBI stepped up its dollar sales.

Similarly, suppose the rupee is appreciating too much against the dollar. To force the rupee to depreciate, RBI can intervene directly by exchanging rupee that it holds as reserves for dollars (sell rupee and buy dollars) in the foreign exchange market. By flooding the market with rupees, the RBI puts a downward pressure on the rupee.

An important point to be noted is that the central bank’s effectiveness to intervene directly depends, to a large extent, on the amount of forex reserves it can use. If the central bank has a low level of reserves, it may not be able to exert much pressure on the currency’s value. Market forces would overwhelm intervention actions.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

Central bank direct intervention is becoming less effective. International financial flows and volume of forex transactions now exceed the combined forex reserves of all central banks. As a result, the number of direct interventions have declined.

Direct Intervention is of two types-

 Non sterilized Intervention: When a country’s central bank intervenes in the foreign exchange market without adjusting for the change in money supply, it is referred to as non-sterilized intervention. For example: Suppose the Chinese yuan is appreciating too much due to the huge volumes of foreign institutional investments and high volumes of export. Too much appreciation in a country’s currency can adversely hit its exporters. Hence, the Chinese central bank may intervene to keep its currency’s value low. To do so, it will start selling Chinese yuan to buy dollars (China is the largest holder of dollar-backed US Treasury paper). Sale of yuan will increase money supply in the Chinese economy and lead to inflation. This type of direct government intervention without adjustments for change in the money supply is known as non –sterilized intervention.

 Sterilized Intervention: When a country’s central bank intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the bond markets, it is referred to as sterilized intervention. As a result, the country’s money supply remains unchanged.

Continuing with the above example, if the increase in money supply leading to rising inflation is viewed as unfavourable for the economy, the Chinese central bank will issue bonds to suck out this excess money supply. Since this type of direct intervention makes adjustments for change in money supply, it is called sterilized intervention.

7.2.2 Indirect Intervention

The central bank of a country can also affect its currency’s value indirectly by influencing the factors that determine it. Factors affecting a currency’s spot rate include:

 Relative inflation rate  Relative interest rate  Relative income levels  Government controls  Expectation of future exchange rates

Thus, the central bank can influence these variables which in turn would affect the exchange rate.

Government Control of Interest Rates- Consider the following example: If RBI wants the rupee to appreciate, it will hike the interest rates. As a result, foreign investors will transfer funds to India to capitalize on higher interest BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

rates in India (high interest rates will also discourage borrowing and control inflation). Increasing investments will lead to more demand for rupees and hence put an upward pressure on its value. As a result, the rupee will appreciate.

Central banks have commonly raised their interest rates if their country experiences a currency crisis in order to prevent a major outflow of funds from the country. However, a common problem is that many a times, indirect intervention not only failed to prevent the withdrawal of funds, it also increased the financing rate by firms in the country. This can cause the economy to weaken further.

8. Foreign Exchange Reserves

Forex reserves are foreign currency assets held by the central banks of countries. These assets include monetary gold, special drawing rights (SDRs), reserve position in the IMF and marketable securities denominated in foreign currencies like treasury bills, government bonds, corporate bonds and equities and foreign currency loans. The main purpose of holding foreign exchange reserves is to make international payments and hedge against exchange rate risks.

Table 1: Foreign Exchange Reserves

Source- www.rbi.org

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS

______

9. Summary

 An exchange rate is the rate at which one country’s currency can be converted into another.  A decline in a currency’s value is referred to as depreciation. Similarly, an increase in a currency’s value is referred to as appreciation.  Just like stock trading, there are bulls and bears in the foreign exchange market- A bull market is a market in which prices are rising or are expected to rise. It is characterized by optimism and investor confidence. A bear market is a market in which prices are falling or are expected to fall. It is characterized by pessimism. In a bear market, traders sell to exit the market and minimize losses.  Eight most traded currencies in the forex market are U.S. dollar (USD), Canadian dollar (CAD), Euro (EUR), British pound (GBP), Swiss franc (CHF), New Zealand dollar(NZD),Australian dollar (AUD) and Japanese yen (JPY).  After opening an online forex brokerage account, a trader has to go through the following steps: Select a currency pair, analyze the market, read the price quotes and choose a position (buy/sell).  Arbitrage refers to the practice of buying in one market and simultaneously selling in another, in order to capitalize on the price difference between two or more markets, the profit being the difference between the market prices. The arbitrageur earns a riskless profit. Foreign exchange arbitrage involves the buying and selling of different currency pairs to exploit pricing inefficiencies.  Each country has a central bank that may intervene in the forex markets to control its currency’s value.  The central bank may intervene to smoothen exchange rate movements, establish implicit exchange rate boundaries and to lessen the impact of temporary disturbances.  Government intervention is of two types- direct and indirect.  Foreign exchange reserves are foreign currency assets held by the central banks of countries. These assets include monetary gold, special drawing rights (SDRs), reserve position in the IMF and marketable securities denominated in foreign currencies like treasure bills, government bonds, corporate bonds and equities and foreign currency loans.

BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS