What Is Foreign Exchange (Forex)?

Foreign Exchange (forex or FX) is the trading of one currency for another. For example, one can swap the
U.S. dollar for the euro. Foreign exchange transactions can take place on the foreign exchange market,
also known as the Forex Market.

The forex market is the largest, most liquid market in the world, with trillions of dollars changing hands
every day. There is no centralized location, rather the forex market is an electronic network of banks,
brokers, institutions, and individual traders (mostly trading through brokers or banks).

 Foreign Exchange (forex or FX) is a global market for exchanging national currencies with one
another.
 Foreign exchange venues comprise the largest securities market in the world by nominal value,
with trillions of dollars changing hands each day.
 Foreign exchange trading utilizes currency pairs, priced in terms of one versus the other.
 Forwards and futures are another way to participate in the forex market.

Functions:
The foreign exchange market performs the following important functions:
1. Transfer Function:
The basic function of the foreign exchange market is to transfer purchasing power between
countries, i.e., to facilitate the conversion of one currency into another. The transfer function is
performed through the credit instruments like, foreign bills of exchange, bank draft and
telephonic transfers.
2. Credit Function:
Another function of foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Bills of exchange used in the international payments
normally have a maturity period of three months.
Thus, credit is required for that period to enable the importer to take possession of goods, sell
them and obtain money to pay off the bill.
3. Hedging Function:
In a situation of exchange risks, the foreign exchange market performs the hedging function.
Hedging is the act of equating one’s assets and liabilities in foreign currency to avoid the risk
resulting from future changes in the value of foreign currency.
In a free exchange market, when the value of foreign currency varies, there may be a gain or
loss to the traders concerned. To avoid or reduce this exchange risk, the exchange market
provides facilities for hedging anticipated actual claims or liabilities through forward contracts
in exchange.
Forward contract is a contract of buying or selling foreign currency at some fixed date in future
at a price agreed upon now. Thus, without transferring any currency, the forward contract
makes it possible to ignore the likely change in the exchange rate and avoid the possible losses
from such change.
What is a Foreign Exchange Rate?

Definition: A foreign exchange rate is the price of the domestic currency stated in terms of another
currency. In other words, a foreign exchange rate compares one currency with another to show their
relative values. Since standardized currencies around the world float in value with demand, supply, and
consumer confidence, their values change relative to each over time. For instance, one US dollar in 2011
was worth about .68 Euros. In 2014, one US dollar is worth .75 Euros. This means the dollar has increased
in value over this three-year span, but the Euro is still 25% more valuable.

Example: If a Kashmiri shawlmaker sells his goods to a buyer in Kanyakumari, he will receive
in terms of Indian rupee.

This suggests that domestic trade is conducted in terms of domestic currency. But if the
Indian shawl- maker decides to go abroad, he must exchange Indian rupee into franc or
dollar or pound or euro.

To facilitate this exchange form, banking institutions appear. Indian shawlmaker will then
go to a bank for foreign currencies. The bank will then quote the day’s exchange rate—the
rate at which Indian rupee will be exchanged for foreign currencies. Thus, foreign currencies
are required in the conduct of international trade.
8 Key Factors that Affect Foreign Exchange Rates
1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than
another's will see an appreciation in the value of its currency. The prices of goods and services increase at a slower
rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a
country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest
rates
 

2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are
all correlated. Increases in interest rates cause a country's currency to appreciate because higher interest rates
provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates
 

3. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number
of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its
currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments
fluctuates exchange rate of its domestic currency.
 

4. Government Debt
Government debt is public debt or national debt owned by the central government. A country with government debt is
less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the
market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will
follow.
 

5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices.
A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in
higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value.
This results in an appreciation of exchange rate.
 

6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country with less risk for
political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with
more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its
domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of
its currency. But, a country prone to political confusions may see a depreciation in exchange rates.
 

7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign
capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange
rate.
 

8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit
in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in
currency value comes a rise in the exchange rate as well.
A number of methods or instruments are used to facilitate foreign payments. Important
among them are discussed below:
1. Bill of Exchange
2. Bank Draft
3. Letter of Credit
4. Cable Transfers
5. Other Instruments: Other means of foreign payments are: traveler’s cheques, personal
cheques, international money orders, home currency, gold, etc.

1. Bill of Exchange:
The bill of exchange is a commonly used instrument in international payments. It is an order from the
drawer (creditor) to the drawee (debtor) to pay the specified sum of money on demand or on some
specified future date. The following example makes the mechanism of foreign payment through bill
of exchange clear: Suppose trader in Bombay imports machinery from trader B in London. Similarly,
another trader C in London imports tea from trader D in Bombay.

Also assume that the value of the traded machinery is equal to the value of the traded tea. In this
case, the British creditor (exporter of machinery) B will draw a bill for the amount equal to the value
of machinery and get it accepted by his Indian debtor (importer of machinery) A. B then sells this bill
to C, the British debtor (importer of tea) who has to pay money to India.

C will send this bill to his creditor D (exporter of Tea) in India who collects the money from A, the
Indian debtor (importer of machinery), who had originally accepted the bill. This mechanism of
foreign bills of exchange, however, assumes that each international payment in one direction is
matched by the equal payment in the opposite direction.

2. Bank Draft:

Bank draft is an order of a bank to its branch or some other bank to pay the bearer the specified
amount. The debtor (importer) in foreign transaction gets a bank draft from the bank and sends it to
his creditor (exporter) who in turn, collects the specified amount from the bank in his own country.

3. Letter of Credit:
A letter of credit is an assurance from the writer of the letter (a commercial bank) to the creditor on
behalf of the debtor that the former will receive payment.
In the international transaction, for example, an importer may arrange a letter of credit from his
commercial bank according to which the exporter may draw bill on the bank rather than on the
importer.

4. Cable Transfers:
A cable transfer is a telegraphic order sent by a bank to its correspondent bank abroad to pay the
specified amount to certain person from its deposit account. For example, an American importer who
wants to make payment abroad can arrange for a cable transfer from his American bank.

The American bank will direct its correspondent bank abroad to transfer the specified sum from its
account of the exporter.

5. Other Instruments:
Other means of foreign payments are: traveler’s cheques, personal cheques, international money
orders, home currency, gold, etc.

Definition:
The equilibrium exchange rate is the long-term exchange rate that equals the purchasing power parity
(PPP) of a currency in a world where all goods are traded and where markets are fully efficient. Such
convergence, proposed by the “PPP theory of exchange rates” would imply that the same price levels
should be observed across countries.

Exchange Rates – A Matter of Supply and Demand

A country’s exchange rates with other countries will move to ensure that the total demand for its currency equals the total supply

of its currency (as the price of apples changes to match the demand and supply of apples). The total demand and supply for a

country’s currency is recorded in its balance of payments.

Whenever someone sells a country’s domestic currency (for the UK the Pound) for foreign currency (for the UK, Euros, Dollars

etc) they create a demand for foreign currency/a supply of domestic currency. Conversely if someone buys a country’s domestic

currency with foreign currency they create a demand for domestic currency/a supply of foreign currency.

If the total demand for domestic currency/supply of foreign currency equals the total supply of domestic currency/demand for

foreign currency that country’s balance of payments is in balance. There is no reason for its exchange rates to rise or fall; its

exchange rates can stay constant.

If a country’s balance of payments moves into deficit (the supply of domestic currency exceeds the demand for domestic

currency) its exchange rates will fall/depreciate (reducing the price of domestic currency/increasing the price of foreign currency)

until the overall balance of payments is in balance again.

If a country’s balance of payments moves into surplus (demand for domestic currency exceeds the supply of domestic currency)

its exchange rates will rise/appreciate until overall balance in its balance of payments is restored.

As foreign exchange markets are very centralised (for example in London) and competitive exchange rates rapidly adjust to

surpluses or deficits in the balance of payments making such imbalances very short lived (with adjustment possible today in

seconds as computers automatically buy and sell currencies). But why do people actually buy and sell currencies?

Supply of Foreign Exchange

The supply (inflow) of foreign exchange comes from those people who receive it due to
following reasons.

1. Exports of Goods and Services

2. Foreign Investment
3. Unilateral transfers Supply of foreign exchange increases in the form of
gifts and other remittances from abroad.

4. Speculation: Supply of foreign exchange comes from those who want to speculate
on the value of foreign exchange.
Supply Curve of Foreign Exchange:
Supply curve of foreign exchange slope upwards due to positive relationship between supply
for foreign exchange and foreign exchange rate. In Fig. 11.2, supply of foreign exchange (US
Dollar) and rate of foreign exchange have been shown on the X-axis and Y-axis respectively.
The positively sloped supply curve (SS) shows that supply of foreign exchange rises from
OQ1 to OQ2 when the exchange rate rises from OR, to OR2.
 Demand for Foreign Exchange

The demand (or outflow) of foreign exchange comes from those people who need it to
make payment in foreign currency.

It is demanded by the domestic residents for the

following reasons
1. Imports of Goods and Services
2. Tourism
3. Unilateral Transfers sent abroad
4. Purchase of Assets in Foreign Countries

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.
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

Determination of Rate of Exchange under Different Monetary Systems

Let us now see how the rate of exchange is determined under different monetary systems.

Under Gold Standard:

When two trading countries are both on the gold standard, their currencies can be
converted into gold at a fixed rate.

The exchange rate between two such currencies will not depart much from the mint par, and
will move between the two points of export and import of gold. These points are also called
“Specie Points” or “Gold Points”.

These points are discovered by adding or subtracting the cost of transporting gold from the
mint par.

If the rate of exchange goes beyond these points, gold will either be imported or exported.
The mint par of exchange is discovered by comparing the real gold contents of the two
currencies. Such a system does not exist anywhere now.

One Country on Gold Standard and the Other on Silver Standard:

Suppose there are two countries, one having a gold standard, say, Britain, and the other has
a silver standard, say, China. How will the rate of exchange between the British pound and
Chinese dollar be determined? In order to clear their dues, the Chinese importers wish to
buy the British currency, which is gold, with the Chinese dollars, which is silver. Hence, the
rate in Peking will depend on the price of gold in terms of silver. In the same manner, in
London the rate of exchange will depend on the price of silver in terms of gold. This system
also does not prevail anywhere.

Purchasing Power Parity Theory:

No country today is rich enough to have a free gold standard—not even the U.S.A. All
countries have paper currencies. The exchange situation is difficult in such cases. It becomes
complex when either both the countries have inconvertible paper currencies or one is on a
gold standard and the other on an inconvertible paper standard. In such circumstances, the
rate of exchange between the two currencies is determined by their respective purchasing
powers.

Suppose a bundle of commodities can be purchased in India for Rs. 15 and a similar group
of commodities can be purchased in Britain for £ 1. Obviously, the rate of exchange will be £
1 = Rs. 15, for the purchasing power of £ 1 is equal to the purchasing power of Rs. 15 Such a
rate is not a fixed par. It fluctuates with changes in the purchasing power of the respective
currencies as measured by changes in the index number of price levels. This theory is called
Purchasing Power Parity Theory.

The actual rates, however, do not necessarily correspond to the respective purchasing
powers of the two currencies. This theory is only a statement of a tendency. To sum up: “At
any particular time, the value of the unit of a currency in terms of another is determined by
the market conditions of demand and supply; in the long run, that value is determined by
the relative values of the two currencies as indicated by their relative purchasing power over
goods and services.”

Fluctuations in the Rate of Exchange:

The long-term parity may be the mint par as under gold standard or purchasing power
parity as under inconvertible paper. But, during the short period, there are various causes
that may lead to fluctuations in the rate of exchange above or below this equilibrium level.

These influences can be grouped under two heads:

(a) Those affecting demand for, and/or supply of, foreign currency, and

(b) Those affecting currency conditions.

As regards (a), the demand for, and supply of, foreign currency
These arise from three sources:
(i) Trade conditions;

(ii) Stock exchange influences; and

(iii) Banking influences.

The Balance of Payments Theory:

The balance of payments (BOP) is a statement of all transactions made between entities in one country and the rest
of the world over a defined period of time, such as a quarter or a year

The balance of payments theory of exchange rate maintains that rate of exchange of the
currency of one country with the other is determined by the factors which are autonomous
of internal price level and money supply. It emphasizes that the rate of exchange is
influenced, in a significant way, by the balance of payments position of a country.

A deficit in the balance of payments of a country signifies a situation in which the demand
for foreign exchange (currency) exceeds the supply of it at a given rate of exchange. The
demand for foreign exchange arises from the demand for foreign goods and services. The
supply of foreign exchange, on the contrary, arises from the supply of goods and services by
the home country to the foreign country.

In other words, the excess of demand for foreign exchange over the supply of foreign
exchange is coincidental to the BOP deficit. The demand pressure results in an appreciation
in the exchange value of foreign currency. As a consequence, the exchange rate of home
currency to the foreign currency undergoes depreciation.

A balance of payments surplus signifies an excess of the supply of foreign currency over the
demand for it. In such a situation, there is a depreciation of foreign currency but an
appreciation of the currency of the home country.
The equilibrium rate of exchange is determined, when there is neither a BOP deficit nor a
surplus. In other words, the equilibrium rate of exchange corresponds with the BOP
equilibrium of a country. The determination of equilibrium rate of exchange can be shown
through Fig. 22.8.
In Fig. 22.8, the demand for and supply of foreign exchange are measured along the
horizontal scale and rate of exchange is measured along the vertical scale. D is the negatively
sloping demand function of foreign currency. S is the positively sloping supply function of
foreign currency. The equilibrium rate of exchange is OR0 which is determined by the
intersection between the demand and supply functions of foreign currency where D0R0 =
S0R0.
The equality between the demand for and supply of foreign exchange signifies also the BOP
equilibrium of the home country. If the rate of exchange is OR1 which is higher than the
equilibrium rate of exchange OR0, the demand for foreign currency D1R1 falls short of the
supply of foreign currency S1R1. In this situation, the home country has a BOP surplus.
The excess supply of foreign exchange lowers the exchange value of foreign currency relative
to home currency. The appreciation in the exchange rate of home currency reduces exports
and raises imports. In this way, the BOP surplus gets reduced and the system tends towards
the BOP equilibrium and also the equilibrium rate of exchange.

If the rate of exchange is OR2 which is lower than the equilibrium rate of exchange OR0, the
demand for foreign currency D2R2 exceeds the supply of foreign currency S2R2. The excess
demand of foreign currency D2S2 signifies the BOP deficit. As a result of the excess demand
for foreign currency, the exchange value of foreign currency appreciates while the home
currency depreciates.
The depreciation of the exchange value of home currency leads to a rise in exports and a
decline in imports. Thus the BOP deficit gets reduced and the exchange rate appreciates to
approach finally the equilibrium rate of exchange OR0 where the BOP is also in a state of
equilibrium.
If there are changes in demand or supply or both, the rate of exchange will be accordingly
influenced. Apart from the changes in demand and supply, the rate of exchange is affected
by the foreign elasticity of demand for exports, the domestic elasticity of demand for
imports, the domestic elasticity of supply of exports and the foreign elasticity of supply of
imports. The stability of the equilibrium rate of exchange requires that the demand
elasticities should be high whereas the supply elasticities should be low.

Merits:
The balance of payments theory of rate of exchange has certain significant merits. Firstly,
this theory attempts to determine the rate of exchange through the forces of demand and
supply and thus brings exchange rate determination in purview of the general theory of
value. Secondly, this theory relates the rate of exchange to the BOP situation.
It means this theory, unlike PPP theory, does not restrict the determination of rate of
exchange only to merchandise trade. It involves all the forces which can have some effect on
the demand for and supply of foreign currency or the BOP position.

Thirdly, this theory is superior to both the PPP theory and mint parity theory from the
policy point of view. It suggests that the disequilibrium in the BOP can be adjusted through
marginal variations in the exchange rate, viz., devaluation or revaluation. The PPP or mint
parity theories, on the opposite, could correct BOP disequilibrium through deliberate
policies to cause inflation or deflation. The price variations are likely to have more
widespread destabilizing effects compared with the variations in exchange rates.

Criticism:
The BOP theory of exchange rate is criticized mainly on the following grounds:
(i) Assumption of Perfect Competition:
This theory rests upon the assumptions of perfect competition and free international trade.
In fact there are serious imperfections in the market on account of trade and exchange
restrictions imposed by the different countries. Therefore, the BOP theory is clearly
unrealistic.

(ii) No Causal Connection between Rate of Exchange and Price Level:

The BOP theory assumes that no causal connection exists between the exchange rate and
the internal price level. Such an assumption is false. The variations in the internal price level
can certainly have their impact on the balance of payments situation which in turn can affect
the rate of exchange.

(iii) Neglect of Basic Value of Currency:

Under the gold standard, the metallic content of the standard unit of money indicates the
basic or optimum value of the currency. The demand and supply theory applied to the
inconvertible paper currency cannot measure the optimum or basic value of the currency. In
fact, it neglects this aspect.

(iv) Truism:
The BOP theory of exchange rate is just a truism. If it is recognised that the BOP must
necessarily be in a state of balance, the possibility of change in the exchange rate will stand
completely ruled out. The equilibrium exchange rate does not, in fact, necessarily coincide
with BOP equilibrium. There may be equilibrium rates of exchange compatible with the
BOP deficit or surplus.
(v) Indeterminate Theory:
This theory holds that the rate of exchange is a function of balance of payments. The
variations in the rate of exchange, at the same time, are supposed to bring about adjustment
in the BOP deficit or surplus. It implies that the BOP itself is a function of the rate of
exchange.

Mint Parity Theory of Equilibrium Rate of Exchange!

When the currencies of two countries are on a metallic standard (gold or silver), the rate of
exchange between them is determined on the basis of parity of mint ratios between the
currencies of the two countries. Thus, the theory explaining the determination of exchange
rate between countries which are on the same metallic standard (say, gold coin standard) is
known as the Mint Parity Theory of foreign exchange rate.

By mint parity is meant that the exchange rate is determined on a weight-to-weight basis of
the two currencies, allowance being made for the parity of the metallic content of the two
currencies. Thus, the value of each coin (gold or silver) will depend upon the amount of
metal (gold or silver) contained in the coin and it will freely circulate between the countries.

Under the system of gold standards, for instance, the rate of foreign exchange is determined
in terms of the gold content of the two given currency units. This is referred to as mint
parity. Thus, if currency A contains 10 grams of gold and В contains 5 grams of gold, then
rate of exchange is: 1A = 2B.

In practice also, before World War I, England and America were simultaneously on a full-
fledged gold standard. While gold sovereign (Pound) contained 113.0016 grains of gold the
gold dollar contained 23.2200 grains of gold of standard purity.

Today, however, the method of determining currency value in terms of gold content or mint
parity is obsolete for the obvious reasons that: (i) none of the modern countries in the world
is on gold or metallic standard, (ii) free buying and selling of gold internationally is not
permitted, by various governments and as such it is not possible to fix par value in terms of
gold content or mint parity, and (iii) most of the countries today are on paper standard or
Fiat currency system