The Basics of the Foreign

Exchange Market
Raghunandan Helwade
• 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 is essential to coordinate global
business. Foreign exchange management is
associated with currency transactions designed to
meet and receive overseas payments.
• Beyond these transactions, foreign exchange
management requires you to understand the
relevant factors that influence currency values.
From that point, you may execute the proper
strategy to manage risks and improve potential
earnings.
 Defining The Foreign Exchange Market
• The Foreign Exchange Market can be defined in terms of
specific functions, or the institutional structure that:
• (1) Facilitates the conversion of one country’s currency into
another.
– Through the buying and selling of currencies.
– Allows global firms to move in and out of foreign currency as needed.
(2) Sets and quotes exchange rates.
– This is the ratio of one currency to another.
– These rates determine costs and returns to global businesses.
• (3) Offers contracts to manage foreign exchange exposure.
– These hedging contracts allow global firms to offset their foreign currency
exposures and manage foreign exchange risk.
– Thus, they can concentrate on their core business.
 Quick Review of Market Characteristics
• World’s largest financial market.
– Estimated at $6.2 trillion dollars per day in trades.
• NYSE-Euronext currently running about $68 billion per day.

• Market is a 24/7 over-the-counter market.

– There is no central trading location.
– Trades take place through a network of computer and telephone connections all over the
world.

• Major trading center is London, England.

– 34% of all trades take place through London (New York second at 17%).

• Most popular traded currency is the U.S. dollar.

– Accounts for 86% of all trades (euro second at 27%).

• Most popular traded currency pair is the U.S. dollar/Euro.

– Represents 27% of all trades (dollar yen second at 13%)
• Currencies are either traded for immediate delivery (spot) or some
specified future delivery (forward).
 How does the FX Market Quote Currencies?
Administration of Fx Market
• (1) American Terms:
– Expresses the exchange rate as the number of U.S. dollars per
one unit of some foreign currency.
• For example, $2.00 per (1) British pound.
• (2) European Terms:
– Expresses the exchange rate as the number of foreign currency
units per one U.S. dollar.
• For example, 120 yen per (1) U.S. dollar.
• Most of the world’s currencies are quoted for trade
purposes on the basis of European terms.
– Exceptions include: British pound, Euro, Australian dollar.
• Newspapers, like the Wall Street Journal, however,
usually quote both.
Management of Foreign Exchange
• Foreign exchange management begins with trading
currencies to exchange goods and services overseas.
• International businesses convert overseas profits
back into their domestic currency to spend at home.
• Meanwhile, consumers exchange domestic currency
for foreign banknotes to buy overseas goods.
• These transactions occur within the foreign exchange
markets, where networks of private individuals,
banks and organized financial exchanges provide the
infrastructure to trade international banknotes.
• Foreign exchange occurs at rates that are associated with
currency valuations.
• Foreign exchange rates describe the amount of one
currency that must be given up to receive one unit of
another currency, and they tend to parallel the political
and economic environment of a particular country.
• For example, domestic foreign exchange rates appreciate
when the economy is strong and the currency is in high
demand to buy the nation’s stocks and real estate.
• Conversely, currency values fall amidst political and
social instability. Foreigners generally liquidate business
assets in war-torn nations that struggle with
development.
• Effective foreign exchange management
requires you to preserve purchasing power by
staying current on any events affecting rates
and operating accordingly.
• You will exploit the buying power of high
exchange rates to acquire overseas goods.
• Alternatively, low exchange rates are an
opportunity to boost overseas sales, as your
wares become relatively cheaper overseas.
 Quotes are Given by Time of Settlement
• Spot Exchange Rate:
– Quotes for immediate transactions (actually
within 1 or 2 business days)

• Forward Exchange Rate:

– Quotes for future transactions in a currency (3
business days and out).
• Forward markets are used by businesses to protect
against unexpected future changes in exchange rates.
– Forward rate allows businesses to “lock” in an exchange rate
for some future period of time.
Observing Changes in Spot Exchange
Rates: What do they Mean?

• Appreciation (or strengthening) of a

currency:
– When the currency’s spot rate has increased in
value in terms of some other currency.

• Depreciation (or weakening) of a currency:

– When the currency’s spot rate has decreased in
value in terms of some other currency.
 Forward Rate Quotes
• As a rule, forward exchange rates are set at either
a premium or discount of their spot rates.
– If a currency’s forward rate is higher in value than its
spot rate, the currency being quoted at a forward
premium.
• For example: the Japanese 1 month forward is greater than its
spot (0.009034 versus 0.008999)

– If a currency’s forward rate is lower in value than its

spot rate, the currency is being quoted at a forward
discount.
• For example, the British pound 6 month forward is less than
its spot (2.0417 versus 2.056).
 What Institutions are Involved in the Foreign
Exchange Market?
• Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank)
acting on behalf of:
– (1) Their “external” clients” (primarily global firms:
exporters, importers, multinational firms)
• Acting in a broker capacity at the request of these clients and meeting the
foreign currency needs of these clients.
– (2) Their own banks (trading to generate profits).
• Acting in a “dealer” (i.e., trading) capacity
• Taking positions in currencies to make a profit.
• In meeting the needs of their clients and their own trading
activities, these global banks “establish” the “tone” of the
market.
– This is through a “market maker” function.
 Making the Market in FX
• The market maker function of any global bank involves
two primary foreign exchange activities:
• (1) A willingness of the market maker to provide the
market with “on-going” (i.e., continuous) two way
quotes upon request:
– (1) Provide a price at which they will buy a currency
– (2) Provide a price at which they will sell a currency
• This function provides the market with transparency
• (2) A willingness of the market maker to actually buy
and/or sell at the prices they quote:
– Thus the market maker offers “firm” prices into the market!
• This function provides the market with liquidity.
 ISO Currency Designations
• All foreign currencies are assigned an International Standards
Organization (ISO) abbreviation.
– E.g., USD; JPY; GBP; EUR; AUD; HKD; CNY; MXN; SGD; ARS; THB; INR;
RUB; ZAR; NZD; CHF; KRW
– For individual countries see:
http://www.oanda.com/site/help/iso_code.shtml
• Since the exchange rate is simply the ratio (i.e., value) of one currency
against another, market makers express this relationship using the two
currencies’ ISO designations.
• For Example:
– USD/JPY
– USD/MXN
– EUR/USD
– GBP/USD
– EUR/JPY (this is a cross rate; since USD in not one of them)
Foreign Exchange Transactions
In the foreign exchange market, at a particular time, there exists, not one unique
exchange rate, but a variety of rates, depending upon the credit instruments used in
the transfer function.

A) Major Types of Exchange Rate:

Major types of exchange rates are as follows:
1) Spot Rates:
In finance, a spot contract, spot transaction, or simply "spot," is a contract of
buying or selling a commodity, security, or currency for settlement (payment and
delivery) on the spot date, which is normally two business days after the trade
date. The settlement price (or rate) is called a "spot price" or "spot rate."
2) Forward Rates:
A spot contract is in contrast with a forward contract where contract terms are
agreed now but delivery and payment will occur at a future date. The settlement
price of a forward contract is called a "forward price" or "forward rate. "
3) Cross Rates:
A cross rate is the currency exchange rate between two currencies, both of which
are not the official currencies of the country in which the exchange rate quote is
given in.
 Base and Quote Currency
• Given that a foreign exchange quote is simply the
ratio of one currency to another, a “complete”
market maker quote must have two ISO designations
(e.g., EUR/USD or USD/JPY):
– The first ISO currency quoted is called the base currency.
– The second ISO currency quoted is called the quote
currency.
• For examples above:
– EUR/USD: EUR is the base currency and USD is the quote currency.
– USD/JPY: USD is the base currency and JPY is the quote currency.
 Bid and Ask Quotes
• Recall that a market maker always provides the
market with two prices, both a buy and sell quote (or
price) for a currency.
• For Example: EUR/USD: 1.2102/1.2106
– The first number quoted by the market maker is the
market maker’s buy price ($1.2102).
• It is called the market maker’s bid quote (or buy price)
– The second quoted number is the market marker’s sell
price ($1.2106).
• It is called the market maker’s ask quote (or sell price)
– Note: The bid quote is always lower than the ask quote.
What Currency is The Market Maker Buying
and Selling?
• Given the example: EUR/USD: 1.2102/1.2106,
which currency is the market maker selling and
which currency is the market maker buying?
– Answer: Market makers are always quoting prices
at which they will buy or sell ONE UNIT of the
base currency (against the quote currency).
– So in the above example:
• The market maker will buy euros for $1.2102
– This is the bid price for euros.
• The market maker will sell euros for $1.2106
– This is the ask price for euros.
 Reading and Understanding Quotes
• When viewing a foreign exchange quote, assign a value of 1
to the base currency (the base currency is the first in the ISO
pair). The quotes you see refer to one unit of this base
currency.
– For example, if you see a market maker’s ask price for the EUR/USD of
1.2811, that means that if you were to buy one Euro (the base
currency) you are going pay $1.2811.
– If you see a market maker’s bid price for the USD/JPY of 120.10 that
means if you were to sell one dollar (the base currency) you are going
to get 120.10 for it.
• Also, whenever the bid and ask prices are moving up, that
means that the base currency is getting stronger and the
quote currency is getting weaker.
 Example of Foreign Exchange
• A trader thinks that the European Central Bank (ECB) will be
easing its monetary policy in the coming months as the
Eurozone’s economy slows. As a result, the trader bets that the
euro will fall against the U.S. dollar and sells short €100,000 at
an exchange rate of 1.15. Over the next several weeks the ECB
signals that it may indeed ease its monetary policy. That causes
the exchange rate for the euro to fall to 1.10 versus the dollar. It
creates a profit for the trader of $5,000.
• By shorting €100,000, the trader took in $115,000 for the short
sale. When the euro fell, and the trader covered their short, it
cost the trader only $110,000 to repurchase the currency. The
difference between the money received on the short-sale and
the buy to cover is the profit. Had the euro strengthened versus
the dollar, it would have resulted in a loss.
 How Big Is the Foreign Exchange
Market?
• The foreign exchange market is extremely liquid and
dwarfs, by a huge amount, the daily trading volume
of the stock and bond markets. According to the
latest triennial survey conducted by the
Bank for International Settlements (BIS), trading in
foreign exchange markets averaged $6.6 trillion per
day in 2019. By contrast, the total notional value of
U.S. equity markets on March 10, 2021 ,was
approximately $688 billion. The largest forex trading
centers are London, New York, Singapore, Hong
Kong, and Tokyo.
 What Is Foreign Exchange
Trading?
• When you're making trades in the forex market, you're
basically buying the currency of a particular country and
simultaneously selling the currency of another country.
But there's no physical exchange of money from one
hand to another. Traders are usually taking a position in a
specific currency, with the hope that there will be some
strength in the currency, relative to the other currency,
that they're buying (or weakness if they're selling) so they
can make a profit. In today's world of electronic
markets, trading currencies is as easy as a click of a
mouse
How Does Foreign Exchange Differ
from Other Markets?
• There are some fundamental differences between
foreign exchange and other markets. There are no
clearing houses and no central bodies to oversee the
forex market which means investors aren't held to the
strict standards or regulations as those in the stock,
futures, or options markets. Second, there aren't the
fees or commissions that exist for other markets that
have traditional exchanges. There is no cutoff time for
trading, aside from the weekend, so one can trade at
any time of day. Finally, its liquidity lends to its ease of
trading access.
 Foreign Exchange Examples for
Governments
• Government officials manage foreign exchange reserves
to influence the domestic economy. On the national
level, low exchange rates are ideal for exporters, while
strong currency valuations benefit consumers with
increased purchasing power for imports. Treasury
leadership may spend domestic currency to buy large
amounts of foreign exchange, which effectively devalues
the home currency. As of May 2019, China had
purchased more than $1.11 trillion in U.S. Treasuries,
which devalues its yuan and supports its export
economy.
 Authorized Forex Dealer
• An authorized forex dealer is a type of financial institution that
has received authorization from a relevant regulatory body to
act as a dealer involved in the trading of foreign currencies.
• In India, RBI is the supreme regulator of Foreign exchange
Transaction with the provision & regulation laid under the
Foreign Exchange Management Act 1999 i.e., FEMA Act
1999.RBI Act & FEMA Act  incorporates the legal provision for
governing the foreign exchange market & reserve .
• The FEMA Act , an Act of Parliament, enacted with the aim to
consolidate & amend the law relating to foreign exchange with
the objective of facilitating external trade & promoting the
orderly development and maintenance of foreign exchange
market in India.
• The term authorized dealer refers to any type of financial institutions
who has received authorization from the RBI as a dealer to involve in
trading of foreign currencies.
• The transaction of the authorized dealer should have been conducted
in pursuance of a legal mode and under the framework established by
law. Authorized dealers are nothing else but the market pronounced
name of AMC i.e., Authorized Money Changer.
• As per master circular no. 10/2013-14 of RBI dated 01st July 2013 it
describes that the AMC/ADs are entities, authorized by the Reserve
Bank under section 10of the Foreign exchange Management Act 1999.
In addition to Authorized Dealers category-I Banks (AD Category –I
Banks) and Authorized Dealer Category – II (Ads category- II), Full
Fledged Money Changers (FFMCs) are authorized by Reserve Bank to
deal in Foreign exchange for specified purposes, to widen the access
of foreign exchange facilities to residents and tourists while ensuring
efficient customer service through competition.
 Categories of Authorized Dealers in India
SI NO. Category of ADs Qualifying Entities Activities/Functions

All Commercial Banks And Scheduled It deals in all type of current ant
Authorized Dealers Category – I banks registered Under RBI Act. capital account transaction
1
(ADs- I ) Urban Co-operative Banks (To some according to the norms and
prescribed extent). procedure laid down by RBI.

Upgraded Full Fledged Money Changer

and another new inclusion like It deals in transaction of foreign
Authorized Dealers Category – II
2 Department Of Post and various type of exchange which is non-trade in
(ADs- II )
NBFCs  who are operated in open characteristics.
market

It deals with the activities which

Financial Institutions, EXIM Bank, SIDBI, are incidental to financing of
Authorized Dealers Category –
3 IFCI, Clearing corporation of India and international trade related
III (ADs- II )
Various Factoring Agents. activities undertaken by these
institutions.

FFMCs are authorized to purchase

It can any entities who are related with foreign exchange from resident
Full Fledged money Changer
4 the finance sector including NBFCs, and non-resident visiting India and
 (FFMCs)
Department of Post etc., to sell Foreign Exchange for
certain approved purposes.
Foreign Exchange Dealer’s Association
 of India (FEDAI)
• FEDAI was set up in 1958 as an association of banks dealing in
foreign exchange in India (classified as Authorized Dealer- ADs), as
a self-regulatory body and is incorporated under section 25 of the
Companies act 1956.
• The main objectives of its establishment were to frame the rules
and guidelines to conducts of foreign exchange business among
the member’s banks and with the public in general. FDAI has to
liaison with RBI for reform and development of forex-market.
• It is on the part of FEDAI to announce the daily and periodical rates
to member banks. Along with regulatory or advisory aspects,
FEDAI also maximize the benefits derived from synergies of
members bank through innovation in area like new customized
products, bench marking against international standards on
accounting, market practices, risk management system, etc.
After globalisation, liberalisation gathered momentum in India in 1991, Foreign
Exchange Market have assumed greater significance in India. The Indian economy
which was closed and regulated, got converted into an open economy. With the
opening of the economy, various types of transactions started taking place among
international and Indian parties with minimum intervention from RBI or Government of
India.

A) Meaning :
By ‘Foreign Exchange’ we mean broadly, a vast array of foreign currencies such as
Pound, Sterling, US Dollars, French Francs, Deutsch Marks, Yens etc. apart from
currency, near money assets denominated in foreign exchange are also included in
foreign exchange.

B) Definition :
1) Foreign Exchange Management Act 1999 :
“All deposits, credits, balances payable in any foreign currency and any drafts,
traveller’s cheques, letters of credit, bills of exchange expressed or drawn in Indian
currency but payable in any foreign currency”.
Foreign Exchange Market:
A) Meaning :
Foreign Exchange Market is a part of money market. It is a place where foreign money
is bought and sold. It is a market for national currency anywhere in the world. The
trading in Foreign Exchange Market is done 24 hours a day by telephone, telex and fax
machine, display monitor, satellite communication, SWIFT .

B) Features of Foreign Exchange Market :

The features of foreign exchange market are given below:
Foreign Exchange Market:
C) Functions of Foreign Exchange Market:
Its main purpose is to assist transfer of purchasing power denominated in one currency
into another.
Foreign Exchange Market:
C) Functions of Foreign Exchange Market:
1) Intermediary between Buyers and Sellers of Foreign Exchange:
Since the foreign exchange markets provide a convenient way of converting the
currencies earned from international trade and other sources, they act as intermediary
between buyers and sellers of foreign exchange.
2) Transfer of Purchasing Power:
The primary function of a foreign exchange market is the transfer of purchasing power
from one country to another and from one currency to another. The international
clearing function performed by foreign exchange markets plays a very important role in
facilitating international trade and capital movements.
3) Provision of Credit:
The credit function performed by foreign exchange markets also plays a very important
role in the growth of foreign trade, for international trade depends to a great extent on
credit facilities.
4) Provision of Hedging Facilities:
The other important function of the foreign exchange market is to provide hedging
facilities. Hedging refers to covering of foreign trade risks, and it provides a mechanism
to exporters and importers to guard themselves against losses arising from fluctuations
in exchange rates.
Foreign Exchange Market:
D) Factors Affecting/ Determinants Foreign Exchange Rates:
Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and are
expressed as a comparison of the currencies of two countries.
Foreign Exchange Market:
D) Factors Affecting/ Determinants Foreign Exchange Rates:
1) Differentials in Inflation:
As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies. During
the last half of the twentieth century, the countries with low inflation included Japan,
Germany and Switzerland, while the U.S.

2) Differentials in Interest Rates:

Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values.

3) Current-Account Deficits:
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest and dividends.
Foreign Exchange Market:
D) Factors Affecting/ Determinants Foreign Exchange Rates:
4) Public Debt:
Countries will engage in large-scale deficit financing to pay for public sector projects
and governmental funding. While such activity stimulates the domestic economy,
nations with large public deficits and debts are less attractive to foreign investors as a
large debt encourages inflation, and if inflation is high, the debt will be serviced and
ultimately paid off with cheaper real dollars in the future.

5) Terms of Trade:
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a
greater rate than that of its imports, its terms of trade have favorably improved.

6) Political Stability and Economic Performance:

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes will
draw investment funds away from other countries perceived to have more political and
economic risk.
The foreign exchange market in India is relatively very small. The major players in that
market are the RBI, banks and business enterprises. Indian foreign exchange market is
controlled and regulated by the RBI.

A) Various Participants in Foreign Exchange Market:

For exchange of currencies of different countries in foreign exchange market services
of following participants are needed:
B) Role Played by Various Participants of Foreign Exchange Market:
These participants play a variety of roles in foreign exchange market as follows:
Corporates need to do the exchange rate forecasting for taking decisions regarding
hedging, short-term financing, short-term investment. capital budgeting, earnings
assessments and long-term financing.

A) Need of Exchange Rate Forecasting:

An exchange rate forecast is necessary for following reasons:
Key Points
Exchange rates are determined in the foreign exchange
market, which is open to a wide range of buyers and sellers
where currency trading is continuous.
In the retail currency exchange market, a different buying
rate and selling rate will be quoted by money dealers.
The foreign exchange rate is also regarded as the value of
one country’s currency in terms of another currency.
Key Terms
exchange rate: The amount of one currency that a person or
institution defines as equivalent to another when either
buying or selling it at any particular moment.
Exchange rates are determined in the foreign
exchange market, which is open to a wide range
of buyers and sellers where currency trading is
continuous. The spot exchange rate refers to the
current exchange rate. The forward exchange rate
refers to an exchange rate that is quoted and
traded today, but for delivery and payment on a
specific future date.
Finding an Equilibrium Exchange Rate
There are two methods to find the equilibrium
exchange rate between currencies; the balance of
payment method and the asset market model.
Key Takeaways
Key Points
The balance of payment model holds that foreign exchange
rates are at an equilibrium level if they produce a stable
current account balance.
The balance of payments model focuses largely on
tradeable goods and services, ignoring the increasing role of
global capital flows.
The asset market model of exchange rate determination
states that the exchange rate between two currencies
represents the price that just balances the relative supplies
of, and demand for, assets denominated in those currencies.
This includes financial assets.
Key Terms
B) Exchange Rate –Regime/System:
Exchange rates are determined by demand and supply. But governments can influence
those exchange rates in various ways.
Following are the new exchange rate system:

1) Fixed Exchange Rate System:

A fixed exchange rate system is an exchange rate regime in which the government of a
country is committed to maintaining a fixed exchange rate for its domestic currency.
There are different kinds of fixed exchange rate regimes.
B) Exchange Rate –Regime/System:
1) Fixed Exchange Rate System:
A fixed exchange rate system is an exchange rate regime in which the government of a
country is committed to maintaining a fixed exchange rate for its domestic currency.
There are different kinds of fixed exchange rate regimes.
Types of Fixed Exchange Rate System:
a) Currency Boards:
A currency board is a country's monetary authority that issues its base money (notes
and coins) and fixes the exchange rate. Under the currency board system, the
domestic currency is anchored to a foreign currency, which is also known as the
reserve currency.
b) Dollarization:
Dollarization is an generic term that refers to the use of any other currency (dollar or
not) in place of a domestic currency as the legal tender, Some nations abandon their
domestic currency and use one of the major reserve currencies.
c) Currency Unions:
When a group of countries feel that multiple currencies and exchange rate fluctuations
are seriously affecting their trade, they may adopt an exchange rate regime known as a
currency union.
Fixed Rates

Afixed, or pegged, rate is a rate the government (central bank) sets

and maintains as the official exchange rate. A set price will be
determined against a major world currency (usually the U.S. dollar,
but also other major currencies such as the euro, the yen, or a
basket of currencies). In order to maintain the local exchange rate,
the central bank buys and sells its own currency on the foreign
exchange market in return for the currency to which it is pegged.

If, for example, it is determined that the value of a single unit of local
currency is equal to US$3, the central bank will have to ensure that it
can supply the market with those dollars. In order to maintain the rate,
the central bank must keep a high level of foreign reserves. This is a
reserved amount of foreign currency held by the central bank that it can
use to release (or absorb) extra funds into (or out of) the market. This
ensures an appropriate money supply, appropriate fluctuations in the
market (inflation/deflation) and ultimately, the exchange rate. The central
bank can also adjust the official exchange rate when necessary.
B) Exchange Rate –Regime/System:
2) Floating/ Flexible Rate System:
During the Bretton Woods era, exchange rates were more or less fixed or pegged.
However, many leading economists argued that they should be allowed to float.
Types of Floating / Flexible Rate System:
Two types of floating system are;
a) Independent Floats :
Independent or free-floating rates refer to the system where exchange rates are
determined by conditions of demand and supply of foreign exchange in the market.
Rates are free to fluctuate according to the changes in demand and supply forces with
no restrictions of foreign exchange in the market. In a free float, the government does
not announce a parity rate; therefore, there is no intervention by the monetary authority
in the foreign exchange market.
b) Managed Floats :
In a free float, exchange rates may change drastically, making international
transactions very risky. Fluctuations in exchange rates can cause a lot of uncertainty
about the future spot rates for market participants. This will vitiate the investment
climate and international transactions.
Floating Rates
Unlike the fixed rate, a floating exchange rate is determined by the private market
through supply and demand. A floating rate is often termed "self-correcting," as any
differences in supply and demand will automatically be corrected in the market. Look
at this simplified model: if demand for a currency is low, its value will decrease, thus
making imported goods more expensive and stimulating demand for local goods and
services. This, in turn, will generate more jobs, causing an auto-correction in the
market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market

pressures can also influence changes in the exchange rate. Sometimes, when a
local currency reflects its true value against its pegged currency, an underground
market (which is more reflective of actual supply and demand) may develop. A
central bank will often then be forced to revalue or devalue the official rate so that
the rate is in line with the unofficial one, thereby halting the activity of the illegal
market.
In a floating regime, the central bank may also intervene when it is necessary to
ensure stability and to avoid inflation. However, it is less often that the central
bank of a floating regime will interfere.
Let us look at some of the points of difference between the fixed and flexible
exchange rates

Fixed Rate Flexible Exchange Rate

Definition
Flexible exchange rate is the system which is
Fixed rate is the system where the government
dependent on the demand and supply of the
decides the exchange rate
currency in the market
Deciding authority
Fixed rate is determined by the central Flexible rate is determined by demand and
government supply forces
Impact on Currency
Currency is devalued and if any changes take Currency appreciates and depreciates in a
place in the currency, it is revalued. flexible exchange rate
Involvement of Government Bank
Government bank determines the rate of
No such involvement of government bank
exchange
Need for maintaining foreign reserve
Foreign reserves need to be maintained No need for maintaining foreign reserve
Impact on BOP (Balance of Payment)
Deficit or surplus in BOP is automatically
Can cause deficit in BOP that cannot be adjusted
corrected
Floating Exchange Rates
With the end of the Bretton Woods system, most of the major
currencies float against each other in value.
Date GBP : USD
27th December 1945 £1.00 : US$4.03 Some currencies are still fixed (or “pegged”)
against another major currency:
18th September 1949 £1.00 : US$2.80
17th November 1967 £1.00 : US$2.40  Jordan, Bahrain, Lebanon, Oman,
17 November 1977
th
£1.00 : US$1.82 Qatar, Saudi Arabia, UAE, Hong
17th November 1987 £1.00 : US$1.76 Kong all peg their currencies to the
17th November 1997 £1.00 : US$1.69 US dollar
17th November 2007 £1.00 : US$2.05
 Morocco, Senegal, Ivory Coast,
17 November 2008
th
£1.00 : US$1.50 Cameroon, New Caledonia, all peg
17th November 2009 £1.00 : US$1.68 their currencies to the euro
17th November 2010 £1.00 : US$1.59
17th November 2011 £1.00 : US$1.58
17th November 2012 £1.00 : US$1.59 Until 2005, China pegged the yuan to the US
17th November 2013 £1.00 : US$1.61
dollar, but now allows it to fluctuate within a
narrow band
17th November 2014 £1.00 : US$1.56

Source: Bank of England

B) Exchange Rate –Regime/System:
3) Currency Pegging:
Currency pegging is the idea of fixing the exchange rate of a currency by matching its
value to the value of another single currency or to a basket of other currencies, or to
another measure of value, such as gold or silver.
Types of Currency Pegging:
a) Pegging to a Single Currency :
When a currency's value is tied to the value of a major currency dominating the world
economy, it is called pegging to a single currency.
b) Pegging to a Basket of Currencies :
As more and more countries started competing economically with the United States,
world monetary management did not remain in the hands of only USA.
c) Pegging to SDRs :
At the IMF meeting in Rio De Janero in 1967, a decision was taken to internationalise
world reserves by the creation of special drawing rights (SDRs).
d) Crawling Peg :
Prominent economists like William Fellner, John Williamson, J. Black, James Meade
and Carters, Murphy proposed the crawling peg system
Calculating Exchange Rates
Imagine there are two currencies, A and B. On the
open market, 2 A’s can buy one B. The nominal
exchange rate would be A/B 2, which means that 2
As would buy a B. This exchange rate can also be
expressed as B/A 0.5.
The real exchange rate is the nominal exchange
rate times the relative prices of a market basket of
goods in the two countries. So, in this example, say
it take 10 A’s to buy a specific basket of goods and
15 Bs to buy that same basket. The real exchange
rate would be the nominal rate of A/B (2) times the
price of the basket of goods in B (15), and divide all
that by the price of the basket of goods expressed
in A (10).
In this case, the real A/B exchange rate is 3.
The international parity relationships are the basis of analysis of exchange rate
behaviour. In the absence of barriers to international capital movements, there is a
relationship between spot exchange rates, forward rates, interest rates and inflation
rates.

1) Purchasing Power Parity:

Purchasing power parity expresses the idea that a bundle of goods in one country
should cost the same in another country after exchange rates are taken into account.
Suppose that with existing relative prices and exchange rates, a basket of goods can
be purchased for fewer U.S. dollars in Canada than in the United States.
2) Interest Rate Parity:
Interest rate parity has to do with the idea that money should (after adjusting for risk)
earn an equal rate of return. Suppose that an investor can earn 6% interest with a
dollar deposit in a United States bank, or can earn 4% interest with a British pound
deposit in a London bank.
Foreign exchange risk is the risk of an investment’s value changing due to changes in
currency exchange rates. It is the risk that an investor will have to close out a long or
short position in a foreign currency at a loss due to an adverse movement in exchange
rates.

A) Types of Risks :
There are various types of risks involved in foreign exchange markets. They are
discussed below:
A) Types of Risks :
1) Exchange Rate Risk or Position Risk :
This type of risk refers to the risk of change in exchange rates affecting the overbought
or oversold position in foreign currency held by a bank. If the amount of currency
purchased by a bank is more than the amount of currency sold to the foreign exchange
dealer the bank is said to have “over purchase” or “long or plus position” on the other
hand, if the amount of currency purchased by the bank is less than the amount of
currency sold to the foreign dealer, the bank is said to have “Over sold” or “Short or
Minus Position”.
2) Operational Risk :
Human mistakes, faults in working procedures may create operational risk in case of
exchange transactions. Banks should take precautions about these risks and try to
take proper action in time.
3) Country Risk :
Country risk is also known as sovereign risk or transfer risk. This risk relates to the
ability and willingness of a country to service its external liabilities. It refers to the
possibility that the Government as well as other borrowers of a particular country may
be unable to fulfill their obligations under foreign exchange transactions due to reasons
which are beyond the usual credit risks.
A) Types of Risks :
4) Legal Risk :
This risk is created due to events happening in one country or events happening in the
country of origin in case of the currencies in which banks have exchange transactions.
This risk may be created in a country in which a bank as a counter party makes
exchange transactions.
5) Counter Party Risk or Credit Risk :
Counter party risk is related to risk of loss which may be created in case of outstanding
contracts where a counter party fails to fulfill obligations. Owing to lack of ability to
repay or due to unwillingness on the part of a borrower he is not able to repay the
loans, there will be a Credit Risk.
The Indian rupee has a market determined exchange rate. However, the RBI trades
actively in the USD/INR currency market to impact effective exchange rates. Thus, the
currency regime in place for the Indian rupee with respect to the US dollar is a de facto
controlled exchange rate. However, unlike China, successive administrations have not
followed a policy of pegging the INR to a specific foreign currency at exchange rate.

•Convertibility is the ease with which a country's currency can be converted into gold or
another currency through global exchanges.
•India's rupee is a partially convertible currency—rupees can be exchanged at market
rates in certain cases, but approval is required for larger amounts.

•Making the rupee a fully convertible currency would mean increased liquidity in
financial markets, improved employment and business opportunities, and easy access
to capital.
•Some of the disadvantages include higher volatility, an increased burden of foreign
debt, and an effect on the balance of trade and exports

.
Convertibility is the ease with which a country's currency can
be converted into gold or another currency through global
exchanges. It indicates the extent to which the regulations
allow inflow and outflow of capital to and from the country.
Currencies that aren't fully convertible, on the other hand, are
generally difficult to convert into other currencies.

Currency convertibility is an important part of global commerce

because it opens up trade with other countries.

Having a convertible currency allows a government to pay for

goods and services in a currency that may not be the buyer's
own. Having a nonconvertible currency makes it harder for a
government to participate in the international market because
these transactions generally take longer to execute.
Current account convertibility refers to the freedom to convert your
rupees into other internationally accepted currencies and vice versa
without any restrictions whenever you make payments.

Similarly, capital account convertibility means the freedom to

conduct investment transactions without any constraints. Typically,
it would mean no restrictions on the amount of rupees you can
convert into foreign currency to enable you, an Indian resident, to
acquire any foreign asset. Similarly, there should be no restraints on
your NRI cousin bringing in any amount of dollars or dirhams to
acquire an asset in India.

India has come a long way in liberating the capital account

transactions in the last three decades and currently has partial
capital account convertibility.
The State of the Indian Currency
Until the early 1990s (pre-reform period), anyone willing to transact in a foreign
currency would need permission from the Reserve Bank of India (RBI), regardless
of the purpose.1 People wanting to engage in foreign travel, foreign studies, the
purchase of imported goods, or to get cash for foreign currencies received (like
with exports) were all required to go through the RBI. All such forex exchanges
occurred at pre-determined forex rates finalized by the RBI.
After liberal economic reforms were introduced in 1991, many significant
developments occurred that impacted the way forex transactions were conducted.
Exporters and importers were allowed to exchange foreign currencies for the trade
of unbanned goods and services, there was easy access to forex for studying or
traveling abroad, and a relaxation on foreign business and investments with
minimal (or no) restrictions depending on the industry sectors.
However, Indians still require regulatory approval if they want to invest an amount
above a pre-determined threshold level for the purpose of investments or
purchasing assets overseas. Similarly, incoming foreign investments in certain
sectors like insurance or retail are capped at a specific percentage and require
regulatory approvals for higher limits.
As of 2019, the Indian rupee is a partially convertible currency. This means that
although there is a lot of freedom to exchange local and foreign currency at market
rates, a few important restrictions remain for higher amounts, and these still need
approval. The regulators also pitch in from time-to-time to keep the exchange rates
within permissible limits instead of keeping the INR as a completely free-floating
currency left to market dynamics. In the case of extreme volatility in rupee
exchange rates, the RBI swings into action by purchasing/selling U.S. dollars (kept
as foreign reserve) to stabilize the rupee.
A) Current Account Convertibility:
The rupee was made convertible on the current account of the balance of
payments in August 1994. Current account transactions refer to transactions in
goods and services. There has been further relaxation of restrictions on
current transactions in 1995-96 and 1996-97.
Indian exporters exporting to Asian Cleaning Union (ACU) countries and
receiving the export proceeds in rupees or in Asian Monetary Units (AMU), or
in the currency of the participating country, were permitted to receive
payments in any permitted currency through banking channels provided it is
offered by the overseas buyer in the ACU country.
Authorised Dealers (ADs) were empowered to release exchange without prior
approval of the Reserve Bank in certain types of foreign travel even in excess
of the indicative limits provided that they are satisfied about the bonafides of
the applicant and the need to release exchange in excess of the prescribed
scale
A) Current Account Convertibility:
Interest income on Non-resident Non-repatriable (NRNR) Rupee deposits which were
not eligible for renewal could be renewed along with principle for deposit accounts
opened on or after October 1, 1994.
ADs were empowered to allow remittances by a family unit of residential Indian
nationals to their families for renewals could be renewed along with the principle for
deposit accounts opened on or after October 1,1994.
ADs were empowered to allow remittances by a family unit of residential Indian
nationals to their close relatives residing abroad for their maintenance expenses up to
US $ 5,000 in a calendar year per beneficiary subject to certain conditions.
ADs were permitted to allow Exchange Earners’ Foreign Currency (EEFC) account
holders to utilise funds held in such accounts for making remittances in foreign
exchange connected with their trade and business related transactions which are of a
current account nature.
ADs were permitted to export their surplus stocks of foreign currency notes and coins
for realisation of proceeds of private money changes abroad, in addition to their
overseas branches or correspondents.
B) Capital Account Convertibility:
Capital account convertibility implies the right to transact in financial assets with
foreign countries without restrictions. Although the rupee is not fully convertible on the
capital account, convertibility exists in respect of certain constituent elements of the
capital account,
Capital account convertibility exists for foreign investors and Non-Resident Indians
(NRIs) for undertaking direct and portfolio investment in India.
Indian investment abroad up to US $ 4 million is eligible for automatic approval by the
RBI subject to certain conditions.
In September 1995, the RBI appointed a special committee to process all applications
involving Indian direct foreign investment abroad beyond US $ 4 million or those not
qualifying for fast track clearance.
Advantages Disadvantages

Market determined exchange rates being higher than

Availability of large funds by improved access to
officially fixed exchange rates can raise import prices
international financial markets.
and cause Cost-push inflation.

Pros and cons

Improper of Capital
management of CACaccount
can lead toConvertibil
currency
Reduction in cost of capital.
depreciation and affect trade and capital flows.

The advantages have been found to be short lived as

The incentive for Indians to acquire and hold
per studies, and also International financial
international securities and assets.
institutions are skeptical about CAC post-2008 crisis.

Speculative activity can lead to capital flight from the

Greater financial competitiveness. country as in case of some South East Asian
economies during 1997-98.

Will help Indian corporate to use External commercial Imposing control would become difficult in a
borrowing route without RBI or Govt approval. globalized environment once CAC is introduced.

Indian residents can hold and transact foreign

currency denominated deposits with Indian banks.

A Certain class of financial institutions and later

NBFCs can access global financial market.
Advantages 
Here are some of the benefits of making the INR into a fully convertible
currency:
Sign of Stable and Mature Markets

Increased Liquidity in Financial Markets

Improved Employment and Business Opportunities
.
Onshore Rupee Market Development

Easy Access to Foreign Capital

Better Access to a Variety of Goods and Services

Progress in Multiple Industry Sectors

Outward Investments
Improved Financial System
Disadvantages 

High Volatility

Foreign Debt Burden

Effects on Balance of Trade and Exports

Lack of Fundamentals

Is India Ready?
India is expected to become a truly global economy in the near future, and it will need
fuller integration into the global economic system. Making the rupee fully convertible
is an expected step in that direction.

The Bottom Line

Despite economic progress being made by India on many fronts, there have been
regular challenges at both the global and local levels including the global financial
crisis of 2008-09 a lack of inflation control, and rising NPAs—all of which have
delayed full convertibility of the rupee. It may take another three to five years for India
to fully prepare itself for full rupee convertibility. 
 Multinational Banking
• Banks have always engaged in international
business. They have dealt in foreign exchange,
extended credit in connection with foreign trade,
traded and held foreign assets, and provided
travellers with letters of credit. All this and some
other types of business the banks historically have
carried out from their domestic locations. There
was no need for a physical presence abroad.
Business that could not be carried out by mail or
telecommunications was handled by
correspondent banks abroad.
• Multinational, also sometimes called
transnational, banking is of relatively recent
origin.
• Its development coincided and accelerated with
the technological improvements and cost-
reductions in international travel and
communications in the post-war period.
• This type of banking involves the physical
presence of a bank abroad.
• The theory of multinational banking explains why
these banks find it profitable to have a physical
presence abroad.