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International Financial Management

[FOREIGN EXCHANGE MARKET]

FOREIGN EXCHANGE MARKET And DETERMINATION OF EXCHANGE RATE

Introduction According to Kindlebereger The foreign exchange market is place where foreign moneys are bought and sold. Foreign exchange market is an institutional arrangement for buying and selling of foreign currencies. Exporters sell the foreign currencies. Importers buy them. The foreign exchange market is merely a part of the money Market in the financial centres. It is a place where foreign moneys are bought and sold. The buyers and sellers of claim on foreign money and the intermediaries together constitute a foreign exchange market. It is not restricted to any given country or a geographical area. Thus, the foreign exchange market is the market for a national currency (foreign money) anywhere in the world, as the financial centres of the world are united in a single market.

Functions of Foreign Exchange Market 1. Transfer Function The basic function of any foreign exchange market is to facilitate the conversion of one currency into another, i.e.to accomplish transfer of purchasing power between two countries. This transfer of purchasing power is affected through a variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills. 2. Credit Function Another function of foreign exchange market is to provide credit, both national & international, to promote foreign trade; obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required. 3. Hedging Function The third function of the FEM is to hedge foreign exchange risk. In a free exchange market when exchange rate, i.e., the price of one currency in term of another currency, change there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange if there are huge amount of net claims or net liabilities which are to be met in foreign money. Exchange risk such should be avoided or reduced. For this
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International Financial Management

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exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell. Foreign exchange against another currency at some fixed date in the future at a price agreed upon now; no money passes at the time of the contract. But contract makes it possible to ignore any likely changes in exchange rate. The existence of a forward market thus makes it possible to hedge an exchange position.

Participants In Foreign Exchange Market 1. Central Banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too highthat is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading. 2. Commercial Companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. 3. Investment Management Firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small,

International Financial Management

[FOREIGN EXCHANGE MARKET]

many have a large value of assets under management (AUM), and hence can generate large trades. 4. Retail Foreign Exchange Brokers Retail traders (individuals) constitute a growing segment of this market, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the CFTC and NFA have in the past been subjected to periodic foreign exchange scams. To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal atthe customer has the choice whether or not to trade at that price. In assessing the suitability of an FX trading service, the customer should consider the ramifications of whether the service provider is acting as principal or agent. When the service provider acts as agent, the customer is generally assured of a known cost above the best inter-dealer FX rate. When the service provider acts as principal, no commission is paid, but the price offered may not be the best available in the marketsince the service provider is taking the other side of the transaction, a conflict of interest may occur.

Types of Transactions and Settlement Dates Settlement of a transaction takes place by transfer to deposits between the two parties. The day on which these transfers are affected is called the settlement date or the value date. Obviously, to affect the transfers, bank in the countries of two currencies involved, must be open for business. The relevant countries are called settlement locations, which need not be the same as settlement locations. Thus a London bank can sell Swiss franc against US dollar to a Paris bank. Settlement location may be New York and Geneva, while dealing location are London and Paris. The transaction can be settled only on a day on which both the US and Swiss banks are open. Depending upon the time elapsed between the transaction date and the settlement date, foreign exchange transactions can be categorized into spot and forward transaction. A third category called swaps is a combination of a spot and forward transaction.

International Financial Management

[FOREIGN EXCHANGE MARKET]

Rate of Exchange Rate of Exchange between any two currencies is the rate at which they are exchanged or sold against each other. Transactions in the exchange market are carried out at what are termed at exchange rates. An exchange rate is the price of currency. It i the number of units of one currency that buys one unit of another currency, and this number can change daily. The rate at which the currencies of two nations are exchanged for each other is called the rate of exchange. For example, if 1 US dollar is exchanged for Rs. 10 then foreign exchange rate is 1 U.S. $ = Rs. 10. In other words the rate of exchange is nothing but the value or price of a countrys currency expressed in terms of a foreign currency.

Exchange Rate Quotations and Arbitrage The foreign exchange market includes both the spot and forward exchange rates. The spot rate is the rate paid for delivery within two business days after the day the transaction takes place. If the rate is quoted for delivery of foreign currency at some future date, it is called the forward rate. In the forward rate, the exchange rate is established at the time of the contract, though payment and delivery are not required until maturity. Forward rates are usually quoted for fixed periods of 30, 66, 90 or 180 days from the day of the contract.

Major Foreign Exchange Instruments The major foreign exchange instruments are:I. Spot Market II. Forward Market III. Currency Options IV. Currency Futures I. Spot Market Spot rate (spot exchange rate) is that exchange rate which applies to those sale/purchase transactions in foreign exchange for which payments and receipts are to be effected on the spot ( in practice, it normally means a specified short period, say two working days or so). The most common way of stating a foreign exchange quotation is in terms of the number of units of foreign currency needed to buy one unit of home currency. Thus, India quotes its exchange rate in terms of the amount of rupees that can be exchanged for one unit of foreign currency. For example, if the Indian rupee is the home; currency and the foreign
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International Financial Management

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currency is the French franc (FF) then the exchange rate between the rupee and the French franc might be stated as FF 0.1462/Rs.1 reads 0.1462, French franc per rupee. This means that for one Indian rupee one can buy 0.1462 French francs. In this method, known as the European terms, the rate quoted in terms of the number of units pf the foreign currency for one unit of the domestic currency. This is called indirect quote. The alternative method, called the American terms, expresses the home currency price of one unit of the foreign currency. For example, continuing with the same example, the exchange rate between the FF and rupee can be expressed as Rs. 6.84/FF read as Rs. 6.84 per French franc. This is also called direct quote. Hence, a relationship between FF and rupee can be expressed in two different ways which have the same meaning 1. One can buy 0.1462 French franc for one Indian rupee or 2. Rs. 6.84 Indian rupee is needed to buy one French franc. Both direct and indirect quotes are in use. In the US, it is common to use the direct quote for domestic business. For international business, banks generally European terms. II. Forward Market A forward rate (or forward exchange rate) is the one which applies to a foreign exchange transaction to be effected on a specified future date. Both the buyer and seller of exchange in the forward market agree that the forward rate will sell a stated amount of the foreign currency at an agreed exchange rate to the buyer on specified future date (say, three months hence) irrespective of the actual exchange rate that may, prevail on the said future date. The deal also involves a corresponding payment, in (normally) domestic currency by the buyer of foreign currency to the seller of it. The spot market is for foreign exchange traded within two business days. However, some transactions may be entered onto on one day but not completed until some times in the future. For example, a French exporter of perfume might sell perfume to a US importer with immediate delivery but not require payment for 30 days. The US importer has an obligation to pay the required francs in 30 days, so he or she may enter into a contract with a trader to deliver dollars foe francs in 30 days at a forward rate, the rate future for delivery. Thus, the forward rate is the rate quoted by foreign exchange traders for the purchase or sale of foreign exchange in the future. There is a difference between the spot rate and the forward rate known as the spread in the forward market. In order to understand how forward
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International Financial Management

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and spot rate is determined, we should first know how to calculate the spread between the spot and forward rates. Consider another example, suppose the spot Japanese yen of august 6, 1991, sold at $0.006879 while 90 days forward yen was priced at $0.006902. Based on these rates, the swap rate for the 90 day forward yen was quoted as a 23 point premium (0.006902 0.006879). Similarly, because the 90 day British pound was quoted at $ 1.6745 while the spot pound was $1.777015, the 90 day British pound was $1.7015, the 90 day British pound sold at a 2.70 point discount. Where reference to its relationship with the spot rate, the forward rate may be at par, at a discount or at a premium. 1. At Par: - if the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract, forward exchange rate is said to be at par. 2. At Premium: - the forward rate of a currency, say the US dollar, is said to be at a premium with respect to the spot rate when one dollar buys more units of another currency, say the rupee, in the forward rather than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis. 3. At Discount: - the forward rate for a currency, say the US dollar, are said 10 be at a discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount, too, is usually expressed as a percentage deviation from the spot rate on a per annum basis. Participants in the Forward Market The main participants in the forward market are 1. Traders: - Traders use spot and forward markets to eliminate the risk of loss of value of export or import orders that are denominated in foreign currencies. The purpose is usually to hedge a position. Traders buy and sell currency in the spot and forward market. 2. Arbitrageurs: - this class of participants seek to earn risk- free profit by seeking advantage of differences in prices of currencies (spatial arbitrage), in interest rates among countries (interest rate arbitrage). They use forward contract to hedge risk. 3. Hedgers:- many multinational firms engage themselves in forward contract to protect the home currency values of foreign currency denominated assets and liabilities on their balancesheet that are not to be realized over the life of the contract. These companies also hedge receivable and payables. 4. Speculators: - this class of participant actively expose themselves to currency risk by buying and selling currencies in the forward market to profit from the exchange rate fluctuation. The speculators keep their positions open. The participation of this class does not

International Financial Management

[FOREIGN EXCHANGE MARKET]

depend on their business transaction in other currencies; instead these are based on current prices in the forward market and their expectations about future spot rates. 5. Banks: - the banks participate in the foreign exchange market for various reasons. When bank keeps their position open, they are speculating and become speculators. The bank also appears as hedgers when they hedge their position. Since the bank provides foreign exchange services therefore these also conduct transactions on behalf of their clients. 6. Governments: - the participation of the government in the foreign exchange market for stabilizing the exchange rates is very important activity because these activities infuse confidence in the functioning of forex markets. Government may regularly monitor markets and intervene for policy targets they set in for the economy. III. Currency Options A currency option confers on its buyer the right either to buy or to sell a specified amount of a currency at a set price known as the strike price. An option that gives the right to buy is known as a call while one that gives the right to sell is known as a put. Depending on the contract terms, an option may be exercisable on any date during the specified period or it may be exercisable only on the final or expiration date of the period covered by the option contract. In return guaranteeing the exercise of an option at its strike price, the option seller or a writer charges a premium which the buyer usually pays upfront. Under favourable circumstances, the buyer may choose to exercise it. Alternatively the buyer may be allowed to sell it. Options Terminology Before we proceed to discuss option pricing and applications, we must understand the market terminology associated with options. While our context is that of options on spot foreign currencies, the term described below carryover to other types of options as well. The two parties to an option contract are the option buyer and the option seller also called writer. For exchange trade options, as in the case of futures, once an agreement is reached between two traders, the exchange, interposes itself between the two parties, becoming buyer to every seller and seller to every buyer. The clearing house guarantees performance on the part of every seller. 1. Call Option: - A call option gives the option buyer the right to purchase a currency Y against a currency X; at a stated price Y/X, on or before a stated date. For exchange traded options, one contract represents a standard amount of the currency Y; the writer of the call option must deliver the currency Y if the option buyer chooses to exercise his option. 2. Put Option: - A put option gives the option buyer the right to sell a currency Y against a currency X; at the specified price, on or before specified date. The writer of a put option must take delivery if the option is exercised.

International Financial Management

[FOREIGN EXCHANGE MARKET]

3. Strike Price: - Also called exercise price: the price specified in the option contract at which the option buyer can purchase the currency (call), or sell the currency (put) Y against X. Note carefully that is not the price of the option: it is the rate of exchange between X and Y that applies to the transaction if the option buyer decides to exercise his option. 5. Maturity Date: - The date on which the option contract expires. Exchange traded option have standardized maturity dates. 6. American Option: - An option, call or put that can be exercised buy the buyer on any business day from initiation to maturity. 7. European Option: - An option that can be exercised only on the maturity date. 8. Option Premium (Option Price, option value):- The fee that the option buyer must pay the option writer up-front, that is, at the time the contract is the initiated. This fee is like an insurance premium; it is non-refundable whether the option is exercised or not. 9. Intrinsic Value of an Option: - The intrinsic value of an option is the extent to which an option is profitable to exercise. In the case of a call option, if the spot price of the underlying currency is above the option exercise price. Then the excess of the price over the exercise price is the intrinsic value of the option. The option with intrinsic value are said to be in the money. If spot DM 35 option has the price $0.35, and DM 32 call would have an intrinsic value of $0.03 [=$0.35-0.32]. 10. Time Value of an Option: - The time value of an American option at any time prior to expiration must be at least equal to its intrinsic value. The general it will be greater. This is because, there is a possibility that the spot price will move further in favour of the option holder. The difference between the value of the option and its intrinsic value is the time value option. For European option, this argument does not hold because the option is to be exercised on the day of maturation, therefore option will have less value before expiration date than their intrinsic value which is know at the time of exercise. 11. Option at the Money: - An option whose exercise price is the same as the spot price, we may call that the option is at the money (exercise price = spot price). 12. Option Out of Money: - A call option whose exercise price is above the current spot price and a put option having exercise price is below the current spot price are out of money. 13. Option in the Money: - in the case of a call option, the option is said to be in the money if the market price is the underlying currency exceed the exercise price. In the case of put option, the option is said to be in the money if the current spot rate is below the exercise price. ADVANTAGES Options are used by buyers just like an insurance policy against movement in rates. Thus, they are alternatives to using the futures market or to the forward exchange market.

International Financial Management

[FOREIGN EXCHANGE MARKET]

The main advantages of using options are:1. The option buyer, at the outset, judges the worst case scenario. Once premium is paid, no further case is payable and when the main objective is to limit downside risk, this is powerful advantage. 2. Since there is no obligation to exercise in option, options are hedging contingent cash flows which may or may not materialise, such as tenders. 3. Options provide a flexible hedge offering a range of prices where the option can be exercised, whereas forward or future markets only deal at the forward price which exist at the time of deal is made. 4. Option provides major possibilities in the range of tools available to treasures and traders. They can be used on their own to hedge or they can be combined with the forward and futures market to achieve more complex hedges. 5. Futures require daily margins to cover credit risk while forwards require a bank credit line. An option buyer can dispense with either depending on the specific market in which he operates. IV. Currency Futures Definition A future contract represents a contractual agreement to purchase or sell a specified asset in future for a specified price that is determine today. The underlying asset could be a foreign currency, a stock index, a treasury bill or any number of other assets. The specified price is known as the future price. Each contract also specifies the delivery month, which may be nearby or more deferred in time. The undertaker in a futures market can have two positions in the contract: i) Long position when the buyer of a futures contract agrees to purchase the underlying asset. ii) Short position when the seller agrees to sell the asset. Future contract represent an institutionalized, standardized form of forward contracting they are traded on an organized exchange which is a physical place or trading floor where listed contracts are traded face to face.

Major Features of Futures Contracts

International Financial Management

[FOREIGN EXCHANGE MARKET]

As mentioned above, a futures contract is an agreement for future delivery of a specified quantity of a commodity at a specific price. The principle features of the contract are as follows; 1. Organized Exchange: - Unlike forward contracts which are traded in an over-the-counter market. Futures are traded on organized futures exchanges either with a designated physical location where trading takes place or screen based trading. This provides a ready, liquid market in which future can be bought and sold at any time like in a stock market. Only members of the exchange can trade on the exchange. Others must trade through the members who act as brokers. They are known as Futures Commission Merchants (FCMS). 2. Standardization: - As we saw in the case of forward currency contract, the amount of the commodity to be delivered in the maturity date are negotiated between the buyer and the seller and can be customized to buyers requirements. In a futures contract both these are standardized by the exchange on which the contract is traded. 3. Clearing House: - The clearing house is the key institution in a future market. It may be a part of the exchange in which case a subset of the exchange members are clearing members, or an independent institution which provides clearing services to many exchanges. They perform several functions. Among them are recording and matching trades, calculating net open positions of clearing members, collecting margins and , most important, assuring financial integrity of the market by guaranteeing obligations among clearing members. 4. Initial Margins: - Only members of an exchange can trade in futures contracts on the exchange. The general public use the members services as brokers to trade on their behalf. (Of course an exchange member can also trade on its own account). A subset of exchange members are clearing members, that is, members of the clearing house when the clearing house is a subsidiary of exchange. The exchange requires that a performance bond in the form of a margin must be deposited with the clearing house by the clearing members. Every transaction is thus between an exchange member and the exchange clearing house by a clearing members who enters into a future commitment on his own behalf or on the behalf of his broker-client whose transaction he is clearing or a public customer. A clearing member acting on behalf of a broker client, in turn requires the broker-client to post a margin with the clearing member. 5. Marking to Market: - Marking to market essentially means that at the end of a trading session, all outstanding contracts are re-priced at the settlement price of that session. Margin accounts of those who made losses are debited and of those who gained are credited. This is explained in detail below but a quick example here will be useful. 6. Actual Delivery is Rate: - in most if not all forward contracts, the commodity is actually delivered by the seller and the accepted by the buyer. Forward contracts are entered into for acquiring disposing off the commodity at a future date but at a price known today. In contrast, in most financial futures contracts. Actual delivery takes place in less than one percent of the contract traded. Futures are used as a hedging device against price risk and as a way of betting on price movement rather than as a means of physical acquisition of the underlying asset. Most
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International Financial Management

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of the contracts are extinguished before maturity by entering into a matching contract in the opposite direction. Exchange Rate Calculation Foreign exchange contracts are for cash or ready delivery which means delivery same day, value next day which means delivery next business day, and spot which is to business days ahead. For forward contracts, either the delivery date may be fixed in which case the tenor is computed from the spot value date, or it may be an option forward in which case delivery may be during a specific week or fortnight, in any case not exceeding one calendar month. The rates quoted by banks to their non-bank customers are called Merchant Rates. Banks quote a variety of exchange rates. The so called TT rates (the abbreviation TT denotes Telegraphic Transfer) are applicable for clean inward or outward remittances, that is, the bank undertakes only currency transfers and does not have to perform any other function such as handling documents. For instance, suppose an individual purchases from Citibank in New York, a demand draft foe $2000 drawn on Citibank Bombay. The New York Bank credit the Bombay banks accounts with itself immediately. When the individual sells the draft to Citibank Bombay, the bank will buy the dollars at its TT Buying Rates. Similarly, TT Selling Rate is applicable when the bank sells a foreign currency draft or MT. TT Buying Rates also applies when a exporter asks the bank to collect an export bill, and the bank pays the exporter only when it receives payment from the foreign b buyer as well as in cancellation of forward sale contracts. (In these cases there will be additional flat fees). When there is some delay between the bank paying the customer and itself getting paid, for instance, when the bank discounts export bills, various margin are subtracted from the TT buying rates. Similarly on the selling side, when the bank has to handle documents such as letters of credit, shipping documents and so forth apart from effecting the payment, margins are added to the TT selling rate. The margins are the subject to selling specified by the FEDAI (Foreign Exchange Dealers Association of India) though a bank can charge less. All this is best illustrated by some examples:Spot TT Buying Rate This rate is calculated as: Spot TT Buying Rate= A Base Rate- Exchange Margin The base rate is the interbank rate. Thus suppose the inter-bank US dollar quote is Rs. 46.75/46.76 and the bank wants exchange margin of 0.125% the TT buying rate would be: (46.75)(1.0.00125)=46.6916 rounded off to 46.69.23. Thus, if a draft for $10,000 is cashed by the bank where its overseas account has already been credit, it will give Rs. [46.69 * 10000] = Rs. 466900 Spot Bill Buying Rate
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International Financial Management

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Exporters draw bills of exchange on their foreign customers. They can sell these bills to an AD for immediate payment. The AD buys the bill & collects payment from the importer. Since there is delay between the AD paying the exporter & itself getting paid, various margins have to be subtracted from the TT buying rate to compute the bill buying rate. Bills are of two kinds, sight or demand bills require payment by the drawee on presentation. The delay involved in such a bill is only the transit period, time or usance bills give time to the importer to settle the payment, that is, the exporter has agreed to give credit to the importer. In such cases the delay involved is transit period plus the usance period. Spot bill buying rate = inter-bank forward rate for a forward tenor equal to transit + usance period of the bill if any exchange margin. Spot TT Selling Rate This rate is computed as follows: TT selling rate = A base rate + Exchange Margin The base rate here is the inter-bank spot selling rate. As usual, the exchange margin is subject to a ceiling specified by the FEDAI. Thus, suppose a customer wishes to purchase a draft drawn a London for 10,000.the inter-bank /Rs. Selling rate is Rs. 69.50/. The bank wants an exchange margin of 0.15%. The TT selling rate would be 69.50 (1+0.0015) =69.6042 rounded off to Rs. 69.60. The customer will have to pay Rs. (10,000*69.60) =Rs.696, 000 apart from any other bank charges. Bill Selling Rate When an importer requests the bank to make a payment to a foreign supplier against a bill drawn on the importer, the bank has to handle documents related to the transaction. For this, the bank loads another margin over the TT selling rate to arrive at the bill selling rate. Thus, Spot Bill Selling Rate = TT Selling Rate + Exchange Margin.

DETERMINATION OF EXCHANGE RATE

Determination of The Exchange Rate

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The rate of exchange being a price of national currency in terms of another, is determined in the in the foreign exchange market in accordance with the general principle of the theory of value that is by the interaction of forces of demand and supply . Thus, the rate of exchange in the foreign exchange market will be determined by the interaction between by the demand for foreign exchange and the supply for the foreign exchange. The demand function for foreign exchange shows functional relationship between alternative rate of exchange and corresponding amount of foreign exchange demanded. When the rate of exchange tends to be high because there will be high inclination to import. The supply function of foreign exchange represents the functional relationship between the rate of exchange and the amount of foreign exchange supplied. When the rate of exchange is high more foreign will be supplied as there will be more export due to high foreign demand .Equilibrium rate of exchange is determined at a point of where the demand for foreign exchange equals its supply.

Demand & Supply of Foreign Exchange ()

In figure above, OP is the rate of exchange determined at which OM is the demand as well as supply of foreign exchange. Any variation in demand or supply will lead to a variation in the rate of exchange.

Equilibrium Rate of Exchange As in the commodity market, in the foreign exchange market also there is a normal or equal rate of exchange and there is a market of short term rate of exchange. The equilibrium rate is the norm around which the market rate of exchange oscillates

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The equilibrium or normal rate of exchange is determined differently under different monetary standards. The market rate of exchange will reflect the temporary influences of forces of demands and supply in a foreign exchange market, but it will be oscillating around the normal rate of exchange. In simple words, however, the equilibrium rate of exchange is the of exchange is the rate of exchange at which the par value of home currency with foreign currency is maintained at a stable level over a long period of time, which means it is neither undervalued or overvalued.Inshor5t the exchange rate to be an equilibrium rate must be maintained at par values of different currencies . Now the question may be raised: what determines the par values? There are various theoretical explanation advanced in this regard ,because the par values and the equilibrium or normal rates of exchange are determined differently under monetary systems .thus there are four theories in this regard : I. Mint Parity Theory II. Purchasing Power Theory III. Balance of Payment Theory IV. Interest Rate Parity Theory

I. Mint Parity Theory 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 parity of mint ratios between the currencies of two countries .Thus ,the theory explaining the determination exchange rate between countries which are on the same standard (say, gold coin ) is known as the mint parity theory of foreign exchange rate. In practice also, before world 1,England and America were simultaneously on a fullfledged gold standard. While gold sovereign (Pound) contained 113.0016 grains of gold, the gold dollar contained 23.2200 grains of gold of standard purity. Since the mint parity is the reciprocity of the gold content ratio between the two currencies, the exchange rate between the American dollar and the British Sovereign (Pound) based on mint parity, was 113.0016/ 23.2200, i,e 4.8665. That means, the exchange rate 1= 4.8665 can be defined as the mint par exchange between the exchange between the Pound and the dollar. Assumptions of the Theory 1) The price of gold is fixed by a country in terms of its currency. 2) It buys and sells gold in any amount at that price.

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3) Its supply of money consists of gold or paper currency which is backed by gold. 4) Its price level varies directly with its money supply. 5) There is movement of gold between countries. 6) Capital is mobile within countries. 7) The adjustment mechanism is automatic. Explanation of the Theory Given these assumptions, the exchange rate under the gold standard is determined by the forces of demand and supply between the gold points and is prevented from moving outside the gold points by shipments of gold. Figure below shows the determination of the exchange rate under the gold standard. The exchange rate OR is set up At point E where the demand and supply curves DDX and SS1 intersect. The exchange rate need not be at the mint parity. It can be anywhere between the gold points depending on the shape of the demand and supply curves. The mint parity is simply meant to define e the US gold export points ($ 5.97) .Since the US treasury is prepared to sell any quantity of gold at a price of $36 per ounce, no American would pay more than $6.03 per pound because he can get any quantity of pounds at that price by exporting gold. That is why, the US supply curves of pat the US gold export point .This is shown by the horizontal portion S1, of the SS1 supply curve. Similarly , as the US treasury is prepared to buy any quantity of gold at $36 per ounce, no American would sell pounds less than $5.97 because he can sell any quantity of pounds at the price by gold imports. Thus the USdemand curve for pounds becomes perfectly elastic at the USgold import point. This is shown by the horizontal portion D1of the demand curve DD1.

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Criticism Today, however the method of determining currency value in terms of gold content 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 . iii) Most of the countries today are on paper standard or Fiat currency system. iv) This theory assumes flexibility of internal prices, but modern governments follow independent domestic price policy un related to fluctuations in exchange rate.

II. Purchasing Power Parity (PPP) Theory Cassel suggested purchasing power parity as the appropriate level at which to set the exchange rate. Principle The basic principle underlying the purchasing power parity theory is that foreign exchange (foreign money) is demanded by the nationals of a country because it has the power to command goods (purchasing power) in its own country (the foreign country) .When the
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domestic currency of a nation is exchanged for foreign currency what in fact happens is that domestic purchasing power is exchanged for foreign purchasing power. It follows that the main factor determining the exchange rate is the relative purchasing power of the two currencies and when two currencies. Thus, the equilibrium rate of exchange should be such that the exchange of currencies would involve the exchange of equal amounts of purchasing power .Hence, it is the parity (equality)of the purchasing power of the currencies which determined the exchange rate. Thus the theory states that the rate of exchange tends to rest at a point at which there is equality between the respective purchasing power of the currencies. In other words, the rate of exchange between two inconvertible paper currencies tends to approximate the ratio of their purchasing power. Two Versions The PPP theory has two versions, namely the Absolute or Positive Version and the Comparative Version. 1. Absolute or Positive Version: - In this version, for tile period under consideration, an identical bundle of goods and services is chosen, and its aggregate prices found out in the two countries in their respective currencies. Then the ratio of these aggregate prices equals tile equilibrium rate of exchange between the two currencies. As an example ,if the cost of the chosen bundle of goods and services in U.S.A is $10 and in India it is Rs400 ,then according to this version of PPP theory ,equilibrium rate of exchange is $10=Rs400,or $=Rs.40 Criticism a) Firstly though the absolute version appears to be very elegant arid simple it is totally useless because it measures the absolute levels of internal prices .And we know that the value (or purchasing power) of money cannot be measured in terms . b) Secondly, the goods produced and demanded in two different countries are not of the same kind and quality, therefore the equalization of goods prices - internal purchasing power of two currencies cannot be envisaged. c) As a matter of fact, the relative price structure between two countries cannot be identical on account of differences in qualities and characteristics of goods and services, differences in demand patterns, differences in technology, influence of transport costs , differ-ring tariff policies ii) Comparative Version:- This versions differs from the earlier one in terms of the method of calculating current equilibrium rate of exchange .Here we take base period and assume that the rate of exchange between two currencies was in equilibrium .and on this basis the current equilibrium rate is calculated by taking into account the shifts in price level in the two countries symbolically ,let Ph represents the ratio of (price index in current period / price index in the base period) in the home country ;and let p1 represents the ratio of (price index in current

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period/ price index in the base period) in the foreign country .Then, the equilibrium exchange rate as the price of home currency in terms of foreign currency is given by Base period rate of exchange *(pf/ph) And similarly the equilibrium exchange rate as the price of foreign currency in terms of currency is given by Base period rate of exchange*( Ph / Pf) For example, if in the base period, one dollar was equal to Rs 30 and it is assumed to be the equilibrium rate in that base period. Further, compared with the base period rate, equilibrium exchange rate in current moves against dollar with an increase with an US prices and fall in Indian prices , and vice versa. Criticisms of the Purchasing Power Parity Theory i) It is Difficult to Measure Accurately the Purchasing of the Currency Units of the Two Countries: As pointed out above, the rate of exchange between two countries, according to this theory, is determined by the power parity theory. The purchasing power of the currency units of two countries are determined by the price-index numbers. According to the critics, there are three main defects in these price-index numbers. a) These index numbers are connected with the past prices. They do not with the present prices in the two countries. As, they lose their importance in practical life. b) These price index numbers include the prices of even those commodities which are not internationally or which do not enter into international trade .in fact , the prices of those commodities should included in the index number which into international trade . c) The defect of these index numbers is that they do not include the same commodities in both the countries. In other words, the index numbers include different types of commodities. As such; it becomes to establish equality between the purchasing of two countries. ii) It Neglects the Cost of Transportation: This theory has neglected the cost incurred on transportation of goods from one country to another. iii) It Neglects the Price of Goods: This does not take into account the qualities of those goods the prices of which are compared between the two countries. iv) It Does Not Study Other Elements Which Influence the Balance of Payments : this theory furnishes no explanation of other elements which effect the rate exchange by influencing the of payments between the two countries .This theory ,as it is ,studies only those elements which influence the internal price- levels of the two countries . In fact, ,there are several elements which produce no effect on the internal price-Level , but do influence the balance of payments of a country , and as such its rate of exchange with the other countries.

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v) The changes in the Rate of Exchange Influence the Price Level : According to this theory the changes in the internal price-Level of the two countries .But, according to the critics , the rate of exchange between the two countries also influence the internal price level . vi) This theory is contrary to General Experience :there hardly any example , according to the critics , where the rate of exchange between the two countries has been fixed on the basis of the purchasing power parity of their currencies. Since this theory is contrary to general experience, it has little importance in practical life. vii) This Theory does not explain the Demand of Foreign Currencies-This theory does not offer a complete explanation of the manner in which the rate of exchange between the two countries is determined in actual practice. Infact, the rate of exchange is determined in the same manner as the price of a commodity. Just as the integral value of currency is determined by its demand and supply, in the same manner, the external value of that currency (or its rate of exchange)in the foreign exchange market is also determined by its demand and supply. viii) This theory assumes a Given Rate of Exchange-A serious defect of this theory is that it starts with a given rate of exchange. How that rate of exchange is arrived at, is not explained by this theory. As already explained this theory before establishing the parity between the purchasing powers of the two countries assumes a certain rate of exchange as the given rate. The reason is that ,without assuming a given rate of exchange ,it is not possible to establish the parity between the purchasing powers of the two countries Thus, this theory tells us how with a given rate of exchange ,the changes in the purchasing powers of the two countries affects the exchange situation. ix) This Theory is Based on a Wrong Conception of Elasticity of Demand- This theory is based on the wrong assumption the elasticity of the foreigners demand for the goods of the country is equal to unity. In others words, the foreigners demand for the goods declines in the same proportion in which their prices decline. But this assumption is not true. In fact, the demand for goods in foreign countries does not vary in proportions in changes in prices .In other words the elasticity of demand can either be more or less than unity. x) The theory offers only a Long Term Explanation of the Rate of Exchange-unfortunately, this theory not explain how the rate of exchange between the countries is determined in the short period. Actually speaking the rate of exchange between the two countries is influenced by a large variety of factors during the short period, but this theory unfortunately omits to take such elements into account. From this point of view, the theory cannot be looked upon a satisfactory one.

Conclusion

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The, theory as we seen above, suffers from a number of shortcomings and drawbacks. It was on account of these shortcomings and drawbacks that Prof. Denham was led to call it a dubious guide to practical action in the field of foreign exchange. Despite the above critics, the theory has not lost its importance which will be obvious from the following points: i) This theory very clearly tells us that how the rate of exchange between two counties on inconvertible paper currency standard determined. It also establishes a close relationship between the internal price level and the rate of exchange of a country. ii) This theory is applicable to all sorts of monetary standards. iii) This theory also explains the state of the trade of a country as well as the nature of its balance of payments at a particular time. iv) This theory also explains how the foreign trade and the rate of exchange of a country are affected by the depreciation and appreciation of its currency.

III. Balance of Payment Theory According to the balance of payment theory also known as demand and supply theory of exchange rate, the foreign exchange rate free market conditions is determined by the demand and supply conditions in the foreign exchange market. Thus, according to this theory the price of a currency i.e. the exchange rate is determined in the same way in which the price of any commodity is determined by the free play of the force of demand and supply. The value of a currency appreciates when the market for it increases and depreciates when the demand falls in relation its supply in the foreign exchange market. The extent of the demand or the supply of a countrys currency in the foreign exchange market depends on the balance of payment position .when the balance of payment is in equilibrium, the supply of and demand for the currency are equal, but when there is a deficit in the balance of payments , the supply of the currency exceeds its demand and causes a fall in the external value of the currency. When there is a surplus, the demand exceeds the supply, and causes a rise in the external value of the currency. Merits 1. It provides an explanation of the determination of demand and supply schedules of a currency in the foreign exchange market. For this reason, it is better than those theories which ignore this explanation.

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2. The theory is more realistic in the sense that the domestic price of a foreign currency is seen as a function of many significant variables, not just its purchasing power expressing general price levels. 3. The theory can be extended to incorporate the fact that balance of payment of a country is influenced by several factors, and may also be adjusted through various policy measures.

4.

The theory is able to accommodate unilateral capital movements irrespective of their nature, duration and magnitude. Thus, it explicitly recognizes the fact that rate of exchange is subject to diverse pressures, including for example , war preparations, servicing of outstanding foreign debts, speculative flights of capital and so on.

Demerits 1. It assumes perfect competition and non intervention of the government in the foreign exchange market. This is not very realistic in the present day of exchange controls. 2. The theory does not explain what determines the internal value of a currency. For this we have to resort to purchasing power parity theory. 3. It unrealistically assumes the balance of payments at a fixed quantity. 4. According to the theory, there is no causal connection between the rate of exchange and the internal price level. But, in fact , there should be such connection , as the balance of payments position may be influenced by the price cost structure of the country. 5. The theory is indeterminate at a time. It states that the balance of payments determines the rate of exchange. However, the balance of payments itself is a function of the rate of exchange. Thus, there is a tautology, what determines what, is not clear.

IV. Interest Rate Parity Theory The determinations of exchange rate is a forward market finds an important place in the theory of interest rate parity(IRP). The IRP theory states that equilibrium is achieved when the forward rate differential is approximately equal to the interest rate differential. In other words, the forward rate differs from the spot rate by n amount that represents the interest rate differential. In this process, the currency of a country with a lower interest rate should be at a forward premium in relation to the currency of a country with a higher interest rate. Equating forward rate differential, we find: A*(n- day F-S)/S=1+Ra/1+Rb-1

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On the basis of the IRP theory, the forward exchange rate can easily be determined. One has simply to fin d out the value of the forward rate(F) in above equation. The equation shall be rewritten as F= S/A[1+rA/1+rB-1]+S Suppose interest rate in India and the United States Of America is , respectively , 10% and 7%. The spot rate is Rs. 40/US$. The 90-day forward rate can be calculated as follows: F=40/4[1.10/1.07-1]+40 F= Rs.40.28/ US$ This means that a higher interest rate in India will push down the forward value of the rupee from 40 a dollar to 40.28 a dollar. Covered Interest Arbitrage If forward rate differential is not equal to interest rate differential, covered interest arbitrage will begin and it will continue till the two differentials become equal. In other words, a positive interest rate differential in a country is offset by annualized forward premium. Finally, the two differentials will be equal. In fact, this is the point where forward rate is determined. The process of covered interest arbitrage may be explained with the help of an example. Suppose, the spot rate is Rs 40/US$ and three month forward rate is Rs 40.28/US$ involving a forward differential of 2.8 %. INTEREST rate is 18% in India and it is 12% in United States Of America, involving an interest rate differential of 5.3%. since the two differentials are not equal, covered interest arbitrage will begin. The successive steps shall be as follows:
Borrowing in the USA ,say US$1000 AT 12% interest rate.

Converting the US$ dollar into rupees at spot rate to get Rs 40000/ Investing Rs40000 in India at 18% interest rate. Selling the Rupee 90 day forward at Rs40.28/US$. After 3 months, liquidating Rs 40000 investment , which would fetch Rs.41.800.
Selling Rs 41.800 for US dollar at the rate of Rs 40.28/ US$ to get US $1038. Repaying a loan in USA, this amounts to US$ 1030. repaying profit :US $1038-1030=

US$8 So long as the inequality continues between forward rate differential and interest rate differential, arbitrageurs will reap profit and the process of arbitrage will go on. However , with this process, the differential will be wiped out because:

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1. Borrowing in USA will raise the interest retie there. 2. In vesting in India shall in crease the invested funds and thereby, lower the interest rate there. 3. Buying rupees at spot rate will increase the spot rate of rupee. 4. Selling rupees forward will depress the forward rate of the rupee. The first two narrow the interest differential while the latter two widen the forward rate differential.

Causes of Changes / Fluctuations In Exchange Rates The various theories of exchange rate determination, as we have seek to explain only the equilibrium or normal long [period exchange rates. The market rates(or day-to-day rates) of exchange are however, subject to fluctuations in response to the supply of and demand for international money transfers. In fact , there are various factors which affect or influence the demand for and supply of foreign currency ( or mutual demand for each others currencies) which are ultimately responsible for the short term fluctuations in the exchange rate. Important among these are: 1. Trade Movements Any change in imports or exports will certainly cause a change in the rate of exchange . If imports exceed exports, the demand for foreign currency rises, hence the rate of exchange moves against the country. Conversely, if exports exceed imports, the supply for domestic currency rises and the fate of exchange moves in favour of the country. 2. Capital Movements International capital movements from one country for short periods to avail of the high rate of interest prevailing g abroad or of long periods for the purpose of making long- term investment abroad. Any export or import of capital from one country to another will bring about a change in the of exchange. 3. Stock Exchange Operation These include granting of loans, payment of interest on foreign loans, repatriation of foreign capital, purchase and sale of foreign securities etc, which influence demand for foreign funds and through it the exchange rates. For instance, when a loan is given by the home country to a foreign nation, the demand for foreign money increase and the rate of exchange tends to move unfavourably for the home country. But, when foreigners repay their loan, the demand for home currency exceeds its supply and the rate of exchange becomes favourable.
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4. Speculative Transactions These include transactions ranging from anticipation of season al movements in exchange rates to the extreme one, viz, flight of capital. In periods of political uncertainty, there is heavy speculation in foreign money. There is a scramble for purchasing certain currencies and some currencies are unloaded. Thus, speculative activities bring about wide fluctuations in exchange rates. 5. Banking Operations Banks are the major dealers in foreign exchange. They sell drafts, transfer funds, issue letters of credit, accept foreign bills of exchange, take up arbitrage, etc. These operations influence the demand for and supply of foreign exchange, and hence the exchange rates. 6. Monetary Policy An expansionist monetary policy has generally an inflationary impact, while a contractions policy tends to have a deflationary inflation. Inflation and deflation bring about a change in the internal value of money. This reflects in a similar change in the external value of money. Inflation means a rise in the domestic price level, fall in the internal purchasing power of money, and hence a fall in the exchange rate. 7. Political Conditions Political stability of a country can help very much to maintain a high exchange rate for its currency, for it attracts foreign capital which causes the foreign exchange rate to move in its favour. Political instability, on the other hand, causes a panic flight of capital from the country, hence the home currency depreciates in the eyes of foreigners and consequently, its exchange value fails. 8. Inflation Rates Higher domestic inflation means less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency). 9. Interest Rates Higher domestic (real) interest rates attract investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency. 10. Economic Growth Stronger economic growth attracts investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency. 11. Political & Economic Risk Higher political or economic risk in the domestic country results in increased demand and reduced supply of foreign currency.
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12. Changes in Future Expectations Any improvement in future expectations regarding the domestic currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency.

13. Government Intervention Maintain weak currency to improve export competitiveness. Foreign Exchange Rate Policy I. Fixed Exchange Rate Under fixed exchange rate system, a country officially fixes a specific exchange rate of its currency in terms of a given foreign currency and maintains the same over a period of time. Arguments for Fixed Exchange Rate 1. Risk of Uncertainty Exchange rate is the factor by which price of one currency is expressed in terms of the other .As a result, in international transactions; a payer is expressed to an additional risk if he is to pay in foreign currency. Similarly, the payee is exposed to an additional risk if the payment is not denominated in his home currency. A fixed exchange rate protects both the payer and the payee from such a risk. 2. Monetary and Fiscal Discipline Assuming that authorities are committed to maintain a fixed exchange rate, but without the use of exchange control , then they will have to operative adequate self discipline and harmonize their monetary and fiscal policies with those of the members of the international payments system .In case, they fail to do so, they may face a situation of fundamental disequilibrium that is a situation of continuous one sided pressures on balance of payments. 3. Convenience Traders and bankers favour a fixed exchange rate for its sheer convenience and safety. There are no sudden movements to destabilize a commercial transaction. 4. Need There may be circumstances in which it may be advisable to pursue a policy of fixed exchange rate even if is to be maintained with an exchange control 5. Source of Economic Benefit

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If rate of exchange is chosen by taking into account the relevant elastics of demand and supply of traded goods, it can be economically beneficial. 6. Historical Relevance A regime of fixed rates {subject to adjustment in case of a fundamental disequilibrium} was adopted by members of the IMF and thus system prevailed for over two decades. 7. Prevents Capital Outflow Flexible and unstable exchange rate may at times of difficult economic situation may encourage flight of capital, on the other hand, a stable exchange rate ensures that such capital outflow would not occur. 8. Promotes Capital Movements Another advantage of fixed exchange rate is that it facilitates capital movement by private firms. A stable currency does not involve any uncertainties about capital loss on account of changes in exchange rate. Therefore, fixed exchange rate system would attract foreign capital investments., the fixed exchange system would promote rapid economic growth of the developing countries. Arguments against Fixed Exchange Rate 1. Domestic Stability With a fixed exchange rate, adjustment of domestic price level vis a vis that of the rest of the world has to be brought about through an inflationary domestic policy. This implies sacrificing domestic stability for the sake of exchange rate stability. 2. Curbing Comparative Market Forces If we believe in the virtues of a comparative market, we should opt for a flexible and not a fixed rate. This is because a fixed rate regime is the one in which competitive market forces are not allowed to operate freely .In particular, a policy of exchange convertibility and free international trade imply that fixed exchange is a baseless policy. 3. Choice of Rate There is no objective method of estimating the most appropriate fixed rate of exchange and adopt it, its estimation would involve a number of factors including those prevailing in international markets and policies adopted by other countries. Whether or not the rate chosen is optimum can be judged only by first adopting it and studying its impact on the economy. 4. Transient Nature

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There is no rate which is optimum for all times to come. The very dynamism of modern economies means that exchange rates should also be adjusted n response to the changing situation 5. Economic Cost of Control A successful policy of fixed exchange rate necessitates a system of control which has its own economic cost, including possibilities of misallocation of productive resources. 6. Retarding Trade and Capital Flows Procedural hurdles restrict and retards international trade and capital flows which could be ends in themselves for exchange control authorities based on various priorities before them.

II. Flexible Exchange Rate Under this system the rate of exchange is allowed to be freely determined by the interaction between the demand and supply of foreign exchange market. The relative position of demand and supply of foreign exchange depend on the deficit of or surplus in the balance of payment of the country. Exchange rates are, thus, not rigidly fixed up but allowed to float with the changing condition.

Arguments for Flexible Exchange Rate 1. Shock Absorption Flexible rate act as an absorber of shocks originating from other countries. To a certain extent it provides an automatic adjustment and insulation against foreign exchange disturbances. 2. Effectiveness of Monetary and Fiscal Policy It increases the effectiveness of monetary policy for domestic stability which can be achieved with less forceful monetary and fiscal measures. 3. Balance of Payment Adjustment It helps in restoring in balance of payment equilibrium. 4. Foreign Exchange Reserves If the rate responds to market force within limits the authority need not intervene at all.And even if they do they shall need comparatively less of foreign exchange reserves act as a buffer since such forces are usually self regulatory .

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Arguments against Flexible Exchange Rate 1. Risk to the Economy Exchange rate is determined by the operation of free market forces carries several risks for the economy. If it fluctuates violently over a wide range it can cause severe economic disruption in the domestic economy. 2. Business Risk In international transaction, each contract is denominated in a single currency which is a foreign currency to atleast one of the following parties. With a flexible exchanged rate, a party making or receiving a payment in the foreign currency is exposed to a additional business risk if constraints of time or other causes prevent taking out adequate forward cover. This is turn have the effect of retarding international transactions. 3. Money Supply In most countries supply of high powered money varies in direct proportion to changes in foreign exchange reserves of monetary authorities; each variation in H results in a multifold variation in the supply of total money and credit.

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Conclusion
The foreign exchange market is held to be the biggest financial market in the world, and one which is closest to the ideal of perfect competition held by economists the world over. The traders in this market include currency speculators, banks, central banks, governments, multinational corporations, and other financial organizations. Thus Foreign Exchange Market plays a major in the buying and selling of currencies.

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References

International Financial Management by V Sharan International Financial Management by Jeff Madura www.google.com www.wikipedia.org

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