FOREIGN EXCHANGE, FOREIGN EXCHANGE RATE, AND FOREIGN ECHANGE MARKET

DEFINATIONS AND MEANING

Foreign exchange refers to foreign currency and where the exchange of these foreign currencies
takes place is known as foreign exchange market. The stock of foreign exchange with a country (say
india) refers to stock of all foreign currencies with the RBI (reserve bank of india) at a point of time.
The standard practice is to measure the entire stock in terms of US dollars, by converting the value
of all currencies into US dollars. The rate at which domestic currencies can be exchanged for a
foreign currency is known as foreign exchange rate. It is price paid in domestic currency for buying a
unit of the foreign exchange. Example: if 100 rupees are to be paid buy one us dollar, then exchange
rate is:

$1 : 100 Rs.

FEATURES OF FOREIGN EXCHANGE MARKET AND SYSTEM OF EXCHANGE RATE

Features

Foreign exchange market is described as an OTC (Over the counter) market as there is no physical
place where the participants meet to execute their deals. It is more an informal arrangement among
the banks and brokers operating in a financing centre purchasing and selling currencies, connected
to each other by tele communications like telex, telephone and a satellite communication network,
SWIFT. The term foreign exchange market is used to refer to the wholesale a segment of the market,
where the dealings take place among the banks. The retail segment refers to the dealings take place
between banks and their customers. The retail segment refers to the dealings take place between
banks and their customers. The retail segment is situated at a large number of places. They can be
considered not as foreign exchange markets, but as the counters of such markets

Size of the market: Foreign exchange market is the largest financial market with a daily turnover of
over USD 2 trillion. Foreign exchange markets were primarily developed to facilitate settlement of
debts arising out of international trade. But these markets have developed on their own so much so
that a turnover of about 3 days in the foreign exchange market is equivalent to the magnitude of
world trade in goods and services. The largest foreign exchange market is London followed by New
York, Tokyo, Zurich and Frankfurt.

24 Hours Market: The markets are situated throughout the different time zones of the globe in such
a way that when one market is closing the other is beginning its operations. Thus at any point of
time one market or the other is open. Therefore, it is stated that foreign exchange market is
functioning throughout 24 hours of the day.

In India, the market is open for the time the banks are open for their regular banking business. No
transactions take place on Saturdays.

Efficiency: Developments in communication have largely contributed to the efficiency of the market.
The participants keep abreast of current happenings by access to such services like Dow Jones
Telerate and Teuter. Any significant development in any market is almost instantaneously received
by the other market situated at a far off place and thus has global impact. This makes the foreign
exchange market very efficient as if the functioning under one roof.
Currencies traded: In most markets, US dollar is the vehicle currency, Viz., the currency used to
denominate international transactions. This is despite the fact that with currencies like Euro and Yen
gaining larger share, the share of US dollar in the total turnover is shrinking.

Physical market: In few centers like Paris and Brussels, foreign exchange business takes place at a
fixed place, such as the local stock exchange buildings. At these physical markets, the banks meet
and in the presence of the representative of the central bank and on the basis of bargains, fix rates
for a number of major currencies. This practice is called fixing. The rates thus fixed are used to
execute customer orders previously placed with the banks. An advantage claimed for this procedure
is that exchange rate for commercial transactions will be market determined, not influenced by any
one bank. However, it is observed that the large banks attending such meetings with large
commercial orders backing up, tend to influence the rates.

System of exchange market

Broadly, two systems of exchange rate have evolved over time:

I. Fixed exchange rate system, and

II. Flexible (or floating) exchange rate system.

Fixed exchange rate

Fixed exchange rate consists of (i) rigid peg with a horizontal band, (ii) crawling peg and (iii) crawling
band.

Rigid peg with a horizontal peg:

It is an exchange rate system under which the exchange rate fluctuation is maintained by the central
bank within a range that may be specified (Iceland) or not specified (Croatia). The specified band
may be one-sided (+7% in Vietnam), a narrow range (+ 2.25% in Denmark) or a broad range (+ 77.5%
in Libya).

Crawling Peg:

The par value of the domestic currency is set with reference to a selected foreign currency (or
precious metal or currency basket) and is reset at intervals, according to pre-set criteria such as
change in inflation rate. The central bank decides the new par value based on the average exchange
rate over the previous few weeks or months in the foreign exchange market. The biggest advantage
of the crawling peg is its responsiveness to the market value of the domestic currency.

Crawling band

The domestic currency is on a crawling peg which is maintained within a range (band).

Flexible exchange rate

This consist of (i) managed float and (ii) free float

Managed float

A managed floating exchange rate is a regime that allows an issuing central bank to intervene
regularly in FX markets in order to change the direction of the currency’s float and shore up its
balance of payments in excessively volatile periods. This regime is also known as a “dirty float”.

Free float
A free-floating exchange rate, sometimes referred to as clean or pure float, is a flexible exchange
rate system solely determined by market forces of demand and supply of foreign and domestic
currency, and where government intervention is totally inexistent. Clean floats are a result of laissez-
faire or free market economics.

India: Exchange rate regime and recent trends

The movement towards market determined exchange rates in India began with the official
devaluation of the rupee in July 1991. In March 1992 a dual exchange rate system was introduced in
the form of the Liberalized Exchange Rate Management System (LERMS). Under this system all
foreign exchange receipts on current account transactions were required to be submitted to the
Authorized dealers of foreign exchange in full, who in turn would surrender to RBI 40% of their
purchases of foreign currencies at the official exchange rate announced by RBI. The balance 60%
could be retained for sale in the free market. As the exchange rate aligned itself with market forces,
the Re/$ rate depreciated steadily from 25.83 in March 1992 to 32.65 in February 1993. The LERMS
as a system in transition performed well in terms of creating the conditions for transferring an
augmented volume of foreign exchange transactions onto the market. Consequently, in March 1993,
India moved from the earlier dual exchange rate regime to a single, market determined exchange
rate system. The deepening of the foreign exchange market has been aided by the implementation
of some of the recommendations of the Sodhani Committee on Foreign Exchange Markets (1995)
and the Tarapore Committee on Capital Account Convertibility (1997). The Sodhani Committee
(1995) made recommendations to develop, deepen and widen the forex market. A number of its
recommendations regarding introduction of various products and removal of restrictions in foreign
exchange markets to improve efficiency and increase integration of domestic foreign exchange
markets with foreign markets have been implemented. Liberalisation measures undertaken on the
capital account relate to foreign direct investment, portfolio investment, investment in joint
ventures/wholly owned subsidiaries abroad, project exports, opening of Indian corporate offices
abroad, and raising of Exchange Earners Foreign Currency entitlement.

DETERMINATION OF EXCHANGE RATE

Free market is driven by the forces of supply and demand. Accordingly, exchange rate as determined
in a free market is called free rate of exchange or variable rate of exchange: it varies according to
variations in supply-demand parameters. In the words of kurihara, “a free exchange rate tends to be
such as to equate the demand for and supply of foreign exchange.”

Now two pertinent questions that usually arise in the foreign exchange market are to be answered
now. Firstly, how is equilibrium exchange rate determined and, secondly, why exchange rate moves
up and down?

There are two methods of foreign exchange rate determination. One method falls under the classical
gold standard mechanism and another method falls under the classical paper currency system.
Today, gold standard mechanism does not operate since no standard monetary unit is now
exchanged for gold.

All countries now have paper currencies not convertible to gold. Under inconvertible paper currency
system, there are two methods of exchange rate determination. The first is known as the purchasing
power parity theory and the second is known as the demand-supply theory or balance of payments
theory. Since today there is no believer of purchasing power parity theory, we consider only
demand-supply approach to foreign exchange rate determination.
(i) Demand for foreign exchange:

When Indian people and business firms want to make payments to the US nationals for buying US
goods and services or to make gifts to the US citizens or to buy assets there, the demand for foreign
exchange (here dollar) is generated. In other words, Indians demand or buy dollars by paying rupee
in the foreign exchange market.

A country releases its foreign currency for buying imports. Thus, what appears in the debit side of
the BOP account is the sources of demand for foreign exchange. The larger the volume of imports
the greater is the demand for foreign exchange.

The demand curve for foreign exchange is negative sloping. A fall in the price of foreign exchange or
a fall in the price of dollar in terms of rupee (i.e., dollar depreciates) means that foreign goods are
now more cheaper.

Thus, an Indian could buy more American goods at a low price. Consequently, imports from the USA
would increase resulting in an increase in the demand for foreign exchange, i.e., dollar. Conversely, if
the price of foreign exchange or price of dollar rises (i.e., dollar appreciates) then foreign goods will
be expensive leading to a fall in import demand and, hence, fall in the demand for foreign exchange.

Since price of foreign exchange and demand for foreign exchange move in opposite direction, the
importing country’s demand curve for foreign exchange is downward sloping from left to right.

In Fig. 5.4, DD1 is the demand curve for foreign exchange. In this figure, we measure exchange rate
expressed in terms of domestic currency that costs 1 unit of foreign currency (i.e., dollar per rupee)
on the vertical axis. This makes demand curve for foreign exchange negative sloping.

If exchange rate is expressed in terms of foreign currency that could be purchased with 1 unit of
domestic currency (i.e., dollar per rupee), the demand curve would then exhibit positive slope. Here
we have chosen the former one.

(b) Supply of foreign exchange:

In a similar fashion, we can determine supply of foreign exchange. Supply of foreign currency comes
from its receipts for its exports. If the foreign nationals and firms intend to purchase Indian goods or
buy Indian assets or give grants to the Government of India, the supply of foreign exchange is
generated.

In other words, what the Indian exports (both goods and invisibles) to the rest of the world is the
source of foreign exchange. To be more specific, all the transactions that appear on the credit side of
the BOP account are the sources of supply of foreign exchange.

A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to foreigners in
terms of dollars. This will induce India to export more. Foreigners will also find that investment is
now more profitable. Thus, a high price or exchange rate ensures larger supply of foreign exchange.
Conversely, a low exchange rate causes exchange rate to fall. Thus, the supply curve of foreign
exchange, SS1, is positive sloping.

Now we can bring both demand and supply curves together to determine foreign exchange rate. The
equilibrium exchange rate is determined at that point where demand for foreign exchange equals
supply of foreign exchange. In Fig. 5.4, DD1 and SS1 curves intersect at point E. The foreign exchange
rate thus determined is OP. At this rate, quantities of foreign exchange demanded (OM) equals
quantity supplied (OM). The market is cleared and there is no incentive on the part of the players to
change the rate determined.

Suppose that at the rate OP, Rs. 50 = $1, demand for foreign exchange is matched by the supply of
foreign exchange. If the current exchange rate OP1 exceeds the equilibrium rate of exchange (OP)
there occurs an excess supply of dollar by the amount ‘ab’. Now the bank and other institutions
dealing with foreign exchange—wishing to make money by exchanging currency—would lower the
exchange rate to reduce excess supply.

Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand for foreign
exchange by the amount ‘cd’ arises if the exchange rate falls below OP, i.e., OP2. Thus, banks would
experience a shortage of dollars to meet the demand. Rate of foreign exchange will rise till demand
equals supply.

The exchange rate that we have determined is called a floating or flexible exchange rate. (Under this
exchange rate system, the government does not intervene in the foreign exchange market.) A
floating exchange rate, by definition, results in an equilibrium rate of exchange that will move up
and down according to a change in demand and supply forces. The process by which currencies float
up and down following a change in demand or change in supply forces is, thus, illustrated in Fig. 5.5.

Equilibrium Exchange Rate

Let us assume that national income rises. This results in an increase in the demand for imports of
goods and services and, hence, demand for dollar rises. This results in a shift in the demand curve
from DD1 to DD2. Consequently, exchange rate rises as from OP1 to OP2 determined by the
intersection of new demand curve and supply curve. Note that dollar appreciates from Rs. 50 = $1 to
Rs. 53 = $1, while rupee depreciates from $1 = Rs. 50 to $1 = Rs. 53.

Similarly, if supply curve shifts from SS1 to SS2, as shown in Fig. 5.6, new exchange rate thus
determined would be OP2. If Indian goods are exported more, following an increase in national
income of the USA, the supply curve would then shift rightward. Consequently, dollar depreciates
and rupee appreciates. New exchange rate is settled at that point where the new supply curve (SS2)
intersects the demand curve at E2.

Equlibrium Exchange Rate

This is the balance of payments theory of exchange rate determination. Wherever government does
not intervene in the market, a floating or a flexible exchange rate prevails. Such system may not
necessarily be ideal since frequent changes in demand and supply forces cause frequent as well as
violent changes in exchange rate. Consequently, an air of uncertainty in trade and business would
prevail.

Such uncertainty may be damaging for the smooth flow of trade. To prevent this situation,
government intervenes in the foreign exchange rate. It may keep the exchange rate fixed. This
exchange rate is called a fixed exchange rate system where both demand and supply forces are
manipulated or calibrated by the central bank in such a way that the exchange rate is kept pegged at
the old level.

Often managed exchange rate is suggested. Under this system, exchange rate, as usual, is
determined by demand for and supply of foreign exchange. But the central bank intervenes in the
foreign exchange market when the situation demands to stabilise or influence the rate of foreign
exchange. If rupee depreciates in terms of dollar, the RBI would then sell dollars and buy rupee in
order to reduce the downward pressure in the exchange rate.

WHY IS FOREIGN EXCHANGE DEMANDED?

1. Imports of Goods and Services:

Foreign Exchange is demanded to make the payment for imports of goods and services.

2. Tourism:

Foreign exchange is needed to meet expenditure incurred in foreign tours.

3. Unilateral Transfers sent abroad:

Foreign exchange is required for making unilateral transfers like sending gifts to other countries.

4. Purchase of Assets in Foreign Countries:

It is demanded to make payment for purchase of assets, like land, shares, bonds, etc. in the foreign
countries.

5. Speculation:

Demand for foreign exchange arises when people want to make gains -from appreciation of
currency.

Reasons for ‘Rise in Demand’ for Foreign Currency:

The demand for foreign currency rises in the following situations:

1. When price of a foreign currency falls, imports from that foreign country become cheaper. So,
imports increase and hence, the demand for foreign currency rises. For example, if price of 1 US
dollar falls from Rs 50 to Rs 45, then imports from USA will increase as American goods will become
relatively cheaper. It will raise the demand for US dollars.

2. When a foreign currency becomes cheaper in terms of the domestic currency, it promotes tourism
to that country. As a result, demand for foreign currency rises.

3. When price of a foreign currency falls, its demand rises as more people want to make gains from
speculative activities.

Demand Curve of Foreign Exchange:

Demand curve of foreign exchange slope downwards due to inverse relationship between demand
for foreign exchange and foreign exchange rate.

Demand Curve of Foreign Exchange

In Fig. 11.1, demand for foreign exchange (US dollar) and rate of foreign exchange are shown on the
X- axis and Y-axis respectively. The negatively sloped demand curve (DD) shows that more foreign
exchange (OQ1) is demanded at a low rate of exchange (OR1), whereas, demand for US dollars falls
to OQ2 when the exchange rate rises to OR2

FOREIGN EXCHANGE MARKET

ABOUT FOREIGN EXCHANGE MARKET
Particularly for foreign exchange market there is no market place called the foreign exchange
market. It is mechanism through which one country’s currency can be exchange i.e. bought or sold
for the currency of another country. The foreign exchange market does not have any geographic
location.

Foreign exchange market is described as an OTC (over the counter) market as there is no physical
place where the participant meets to execute the deals, as we see in the case of stock exchange. The
largest foreign exchange market is in London, followed by the new york, Tokyo, Zurich and Frankfurt.
The market is situated throughout the different time zone of the globe in such a way that one
market is closing the other is beginning its operation. Therefore, it is stated that foreign exchange
market is functioning throughout 24 hours a day.

In most market US dollar is the vehicle currency, viz., the currency sued to dominate international
transaction. In India, foreign exchange has been given a statutory definition. Section 2 (b) of foreign
exchange regulation ACT,1973 states:

Foreign exchange means foreign currency and includes:

 All deposits, credits and balance payable in any foreign currency and any draft, traveler’s
cheques, letter of credit and bills of exchange. Expressed or drawn in India currency but payable
in any foreign currency.
 Any instrument payable, at the option of drawee or holder thereof or any other party thereto,
either in Indian currency or in foreign currency or partly in one and partly in the other.

In order to provide facilities to members of the public and foreigners visiting India, for exchange of
foreign currency into Indian currency and vice-versa. RBI has granted to various firms and
individuals, license to undertake money-changing business at seas/airport and tourism place of
tourist interest in India. Besides certain authorized dealers in foreign exchange (banks) have also
been permitted to open exchange bureaus.

Participants in foreign exchange market

The main players in foreign exchange market are as follows:

1.CUSTOMERS

The customers who are engaged in foreign trade participate in foreign exchange market by availing
of the services of banks. Exporters require converting the dollars in to rupee and imporeters require
converting rupee in to the dollars, as they have to pay in dollars for the goods/services they have
imported.

2.COMMERCIAL BANK

They are most active players in the forex market. Commercial bank dealing with international
transaction offer services for conversion of one currency in to another. They have wide network of
branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the
importers of goods. As every time the foreign exchange bought or oversold position. The balance
amount is sold or bought from the market.

3. CENTRAL BANK

In all countries Central bank have been charged with the responsibility of maintaining the external
value of the domestic currency. Generally this is achieved by the intervention of the bank.
4. EXCHANGE BROKERS

Forex brokers play very important role in the foreign exchange market. However the extent to
which services of foreign brokers are utilized depends on the tradition and practice prevailing at a
particular forex market center. In India as per FEDAI guideline the Ads are free to deal directly
among themselves without going through brokers. The brokers are not among to allowed to deal in
their own account allover the world and also in India.

5. OVERSEAS FOREX MARKET

Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The
international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading in
world forex market is constituted of financial transaction and speculation. As we know that the forex
market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens, thereafter
India, followed by Bahrain, Frankfurt, paris, London, new york, Sydney, and back to Tokyo.

6. SPECULATORS

The speculators are the major players in the forex market.

 Bank dealing are the major pseculators in the forex market with a view to make profit on
account of favorable movement in exchange rate, take position i.e. if they feel that rate of
particular currency is likely to go up in short term. They buy that currency and sell it as soon as
they are able to make quick profit.
 Corporation’s particularly multinational corporation and transnational corporation having
business operation beyond their national frontiers and on account of their cash flows being large
and in multi currencies get in to foreign exchange exposures. With a view to make advantage of
exchange rate movement in their favor they either delay covering exposures or do not cover
until cash flow materialize.
 Individual like share dealing also undertake the activity of buying and selling of foreign exchange
for booking short term profits. They also buy foreign currency stocks, bonds and other assets
without covering the foreign exchange exposure risk. This also result in speculations.