# Mechanics of Foreign Exchange

What is foreign Exchange?  In narrow sense currency of another country.  In broader sense, foreign exchange refers to exchange methods and mechanism through which payments amongst individuals, businesses and countries are settled.  It includes:
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Methods of exchange Forms in which exchange takes place Ratio or rate of Exchange.

Mechanics of Foreign Exchange

Effects of exchange rate fluctuations when a country’s currency appreciates (rises in value relative to other currencies), this country’s goods become more expensive in foreign country and when a country’s currency depreciates, its goods become cheaper in foreign country and foreign goods import into this country become more expensive, (we can say that exports become cheaper at the receiving end from the country of depreciated currency and imports to this country become expensive).

Mechanics of Foreign Exchange

Equilibrium Foreign Exchange Rate: At the point intersection of demand for and supply of base currency. Market forces tend to bring the exchange rate towards the equilibrium point. PPP theory (purchasing power parity theory) and BOP theory (Balance of payments theory) of Exchange Rate Determination

Mechanics of Foreign Exchange

Equilibrium Foreign Exchange Rate: cont…  PPP Theory: According to PPP theory, normal equilibrium point between two currencies is determined at the point at which there is equality between the respective purchasing power of two currencies. For example a basket of goods purchased in Pakistan cost Pak Rs.100,000/== The same basket cost Us Dollars 1000 in U.S.A. Assume that there is no cost on account of transportation, insurance etc.

Mechanics of Foreign Exchange

Equilibrium Foreign Exchange Rate: cont… In the above situation exchange rate between US Dollars and Pak Rupee shall be IUS = Pak Rupees 100/= The above exchange rate is based on the purchasing power of both the currencies. One US Dollar can purchase as much goods as Rs 100/-

Mechanics of Foreign Exchange

BOP theory ( Balance of Payment theory) According to this theory the exchange rate of a currency of a country vis-à-vis other currency depends upon the demand for and supply of base currency. (assuming there are only two currencies) when the exchange rate of a country falls below equilibrium exchange rate, it is the case of adverse balance of payments. In this situation exports increase and eventually Adverse Balance of Payments is eliminated and vice versa. This is a self- correcting mechanism.

Mechanics of Foreign Exchange

Factors, influencing Exchange Rate:  Economic Factors  Non-Economic Factors Economic Factors include: • Trade balance • Fiscal Policies • Level of interest rates • Inflation Rate and Inflationary Expectations • Performance of Business sector • Position of economy in business cycle

Mechanics of Foreign Exchange

Non-Economic Factors include:
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Perceived political stability Confidence in government policies Increasing importance of capital flows

Types of Foreign Exchange Transactions: (A) Spot Deals, (At Spot Rates) (B) Forward Deals. (At Forward Rates) Spot Deal: a spot deal is one where foreign exchange is sold and purchased immediately or latest delivery within two days.

Mechanics of Foreign Exchange

Spot rate: Spot rate refers to the transaction that is required to be completed within two days after the agreement to buy or sell the currency. Spot rate is the exchange rate of the country. Forward Deal: A forward deal is one where it is agreed to exchange currency at a specified rate but actual delivery of the currency is for some time in future, such as one month, three months, six months etc.

Mechanics of Foreign Exchange

Forward Rate: forward rate is the price of a currency in terms of another at which it can be bought or sold for delivery at a future date. Two- Way Quotation Or Two- Way- Quote: in foreign exchange markets, foreign currencies are the commodities being bought or sold and exchange rate is the price, as such market always quotes a two way price, one at which it is prepared to buy that foreign currency and the other at which it is prepared to sell that foreign currency. The market quotation is Bid (to buy) and offer to (sell).

Mechanics of Foreign Exchange

Premium and Discount: Forward margins are referred to as premium or Discount. One side’s premium is said to be other side's discount and vice versa. At Premium: a currency is said to be at premium in the forward market in relation to another currency, when it’s rate is higher (expensive) in the forward market than in the spot market.

Mechanics of Foreign Exchange

At Discount: a currency is said to be at discount in the forward market in respect of another currency when it is less expensive in the forward market than at spot rate. • In case of direct quote premium is added and discount is deducted from spot rate, in case of indirect quote premium is deducted and discount is added to spot rate.

Mechanics of Foreign Exchange
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Foreign Exchange Position Management – Maintaining a ‘position’: Exchange position: reveals the total holdings of a bank in foreign currencies in spot and forward transactions and its liabilities in foreign currencies to the clients, other banks and foreign correspondents. Overbought & Oversold Position: Over bought Position or long position: means that a bank’s assets and purchases of a particular foreign currency exceeds the liabilities and sales.

Mechanics of Foreign Exchange

Oversold position or short position: means that a bank’s liabilities and sales in a particular foreign currency exceed the assets and purchases of that currency. Oversold position is corrected by buying that currency and vice versa, so as to avoid risks on account of exchange rate movements. Square position: is the one in which overall sales of foreign exchange match with overall purchases.