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UNIT-IV: Foreign Exchange Market: Nature of transactions in foreign exchange market and

types of players, Exchange rate determination, Convertibility of rupee – Euro currency market.

Foreign Exchange Market

Foreign Exchange
Foreign exchange is the system or process of converting one national
currency into another, and of transferring money from one country to

Foreign Exchange Market

• The foreign exchange market is a market in which foreign exchange
transactions take place

Functions of foreign exchange market

• Transfer of purchasing power
• Provision of credit
• Provision of Hedging facilities

Transactions in the foreign exchange markets

• Spot and forward exchanges
• Swap operations
• arbitrage

Participants in foreign exchange markets

• Traders- commercial banks
• Brokers- brokerages firms
• Speculators- long position and short position
• Hedgers
• Arbitrageurs
• Governments

Exchange control

Exchange control is one of the important means of achieving certain national

objectives like
- an improvement in the balance of payments position
- restriction of inessential imports and conspicuous consumption
- facilitation of import of priority items
- control of outflow of capital and
- maintenance of the external value of the currency.

Objectives of Exchange Control

• To Conserve Foreign Exchange

• To Check Capital Flight
• To Improve Balance of Payments
• To Curb Conspicuous Consumption
• To make Possible Essential Imports
• To Protect Domestic Industries
• To Check Recession-induced Exports into the Country
• To regulate foreign companies.
• To regulate Export and Transfer of Securities
• Facilitate Discrimination and Commercial Bargaining
• Enable the Government to Repay Foreign Loans
• To Lower the Price of National Securities held Abroad
• To Freeze Foreign Investments and Prevent Repatriation of Funds
• To Obtain Revenue

Determination of exchange rates

• Purchasing power parity (PPP)- Gustav Cassel

• Balance of payment theory-Demand and supply theory

Purchasing power parity

• The purchasing power parity (PPP) theory uses the long-term
equilibrium exchange rate of two currencies to equalize their
purchasing power.
• Developed by Gustav Cassel in 1920, it is based on the law of one
price: the theory states that, in ideally efficient markets, identical
goods should have only one price.
• This purchasing power SEM rate equalizes the purchasing power of
different currencies in their home countries for a given basket of
• Using a PPP basis is arguably more useful when comparing
differences in living standards on the whole between nations
because PPP takes into account the relative cost of living and the
inflation rates of different countries, rather than just a nominal gross
domestic product (GDP) comparison.
• The best-known and most-used purchasing power parity exchange
rate is the Geary-Khamis dollar (the "international dollar").
• PPP exchange rates (the "real exchange rate") fluctuations are
mostly due to market exchange rates movements.

Balance of payment theory

• The balance of payments theory of exchange rate is also named as
general equilibrium theory of exchange rate.
• According to this theory, the exchange rate of the currency of a
country depends upon the demand for and supply of foreign
• If the demand for foreign exchange is higher than its supply, the
price of foreign currency will go up. In case, the demand of foreign
exchange is lesser than its supply, the price of foreign exchange will
• The demand for foreign exchange and supply of foreign exchange
arises from the debit and credit items respectively in the balance of
• The demand for foreign exchange comes from the debit side of
balance of payments.
• The debit items in the balance of payments are import of goods and
services and loans and investments made abroad.
• The supply of foreign exchange arises from the credit side of the
balance of payments.
• It is made up of the exports of goods and services and capital
receipts. If the balance of payments of a country is unfavourable, the
rate of foreign exchange declines.
• On the other hand, if the balance of payments is favourable, the rate
of exchange will go up. The domestic currency can purchase more
amounts of foreign currencies.

Exchange Rate Systems

• Fixed exchange rates

• Flexible exchange rates

Fixed Exchange Rates

• Countries following the fixed exchange rate (also known as stable
exchange rate and pegged exchange rate) system agree to keep their
currencies at a fixed, pegged rate and to change their value only at fairly
infrequent intervals, when the economic situation forces them to do so.
• Under the gold standard, the values of currencies were fixed in terms of
gold. Until the breakdown of the Bretton Woods System in the early 1970,
each member country of the IMF defined the value of its currency in terms
of gold or the US dollar and agreed to maintain (to peg) the market value
of its currency within:!: I per cent of the defined (par) value.

Flexible Exchange Rates

• Under the flexible exchange rate system, exchange rates are freely
determined III on open market primarily by private dealings, and they, like
other market prices, vary from day-to-day.
• Under the flexible exchange rate system, the first impact of any tendency
toward a surplus or deficit in the balance of payments is on the exchange
rate. surplus in the balance of payments will create an excess demand for
the tOlIl1try's currency and the exchange rate will tend to rise. On the
other hand, deficit in the balance of payments will give rise to an excess
supply of the country’s currency and the exchange rate will, hence, tend
to fall.
• Automatic variations in the exchange rates, in accordance with the
variation in the balance of payment position, tend to automatically restore
the balance of payments equilibrium.

Convertibility of the Rupee

• Free convertible-
• Partial convertibility -1992-93 in current account
• LERMS- Market rate and Official rate

Free convertible
• Free convertibility of a currency means that the currency can be
exchanged for any other convertible currency, without any
restriction, at the market determined exchange rates.
• Convertibility of the rupee, thus means that the rupee can be freely
converted into dollar, pound sterling', yen, Deutsche mark, etc. and
vice versa at the rates of exchange determined by the demand and
supply forces.
• According the Liberalized Exchange Rate Management System
(LERMS) introduced in March 1992, 60 per cent of all receipts under
current transactions (merchandise exports and invisible receipts)
could be converted at the free market exchange rate quoted by the
authorized dealers.
• The rate applicable for the remaining 40 per cent was the official
rate fixed by the Reserve. Bank.
• This 40 per cent of the total foreign exchange receipts under the
current account was exclusively meant to cover government needs
and to import essential commodities.
• In addition, foreign exchange at official rate was to be made
available to meet 40 percent of the value of the advance licenses and
special import licenses.
• In short, it was a dual exchange rate system.

Why partial convertibility?

• To make foreign exchange available at a low price for essential prices.

• At times of large deficit in current account- it is risky to go for full
• To bring in a stability in rupee value
• One major reason for introducing partial convertibility was to make
foreign exchange available at a low price for essential imports so that the
prices of the essentials would not be pushed up by the high market price
of the foreign exchange.
• It was risky to introduce full convertibility when the current account
showed large deficit.
• While introducing the partial convertibility, the government announced its
intentions to introduce full convertibility on the current account in three to
five years, However, full convertibility on trade account was introduced by
the Budget for 1993-94.
• The fact that the free market rate was ruling fairly stable at a reasonable
Ievel might have encouraged the government to introduce full

Merits of convertibility

• Real value of rupee

• It encourages exports
• Encourages import substitutions
• Attracts remittances by NRIs
• It gives an indication of the real value of the rupee.
• It encourages exports by increasing the profitability of the exports
• Profitability increases as the free market rate is higher than the official
exchange rate.
• It encourages those exports with no or less import intensity. As the
proportion of the imported inputs in the exportables increases, the prof-
itability cause of the higher free market exchange rate gets correspond-
ingly reduced. This could encourage import substitution in export pro-
• The high cost of foreign exchange could encourage import substitution in
other areas also It provides incentives for remittances by NRIs.
• The convertibility and the liberalisation of gold imports have been ex-
pected to make illegal remittances and gold smuggling less attractive.
thereby increasing the remittances through proper channels.
• It is described as a self balancing mechanism because the total imports
and other current account payments will be confined to the. total current
account receipts unless there are imports financed by foreign currency

Eurocurrency market
• The money market in which Eurocurrency, currency held in banks
outside of the country where it is legal tender, is borrowed and lent .
Definition and background

• The Eurocurrency market consists of banks (called Eurobanks) that

accept deposits and make loans in foreign currencies.
• A Eurocurrency is a freely convertible currency deposited in a bank
located in a country which is not the native country of the currency.
• The deposit can be placed in a foreign bank or in the foreign branch of
a domestic US bank. [Note of caution! The prefix Euro has little or
nothing to do with the newly emerging currency in Europe.]
• In the Eurocurrency market, investors hold short-term claims on
commercial banks which intermediate to transform these deposits into
long-term claims on final borrowers.
• The Eurocurrency market is dominated by US $ or the Eurodollar.
• Occasionally, during weak dollar periods (latter part of 1970s and
1980s), the EuroSwiss franc and the EuroDM markets increased in
• The Eurodollar market originated post WWII in France and England
thanks to the fear of Soviet Bloc countries that dollar deposits held in
the US may be attached by US citizens with claims against communist


By using Euromarkets, banks and financiers are able to circumvent / avoid

certain regulatory costs and restrictions. Some examples are:

a) Reserve requirements
b) Requirement to pay FDIC fees
c) Rules or regulations that restrict competition among banks

• Continuing government regulations and taxes provide opportunities to

engage in Eurocurrency transactions.
• However, ongoing erosion of domestic regulations have rendered the
cost and return differentials much less significant than before.
• As a result, the domestic money market and Eurocurrency markets
are closely integrated for most major currencies, effectively creating a
single worldwide money market for each participating currency.