FOREIGN

EXCHANGE
MARKET
EXCHANGE RATE
 An exchange rate is a rate at which one currency will be exchanged for another
currency and affects trade and the movement of money between countries.
 Exchange rates are quoted as foreign currency per unit of domestic currency or
domestic currency per unit of foreign currency.
  If the exchange rate for the euro (€) is 132 yen (¥), that means that each Euro
that is purchased will cost 132 yen.
 U.S. dollar and euro are the two most commonly quoted currencies, due to their status as 
reserve currencies at many global central banks. The most popular currency pair is, therefore, the
EUR/USD
 A currency pair is the quotation of two different currencies, with the value of one currency being
quoted against the other.
 Currency pairs compare the value of one currency to another—the base currency (or the first
one) versus the second or the quote currency. It indicates how much of the quote currency is
needed to purchase one unit of the base currency.
 Currencies are identified by an ISO currency code, or the three-letter alphabetic code they are
associated with on the international market. So, for the U.S. dollar, the ISO code would be USD.
APPRECIATION & DEPRECIATION

 Appreciation is an increase in the value of a currency relative to another currency.

 ♦ An appreciated currency is more valuable (more expensive) and therefore can be exchanged
for (can buy) a larger amount of foreign currency.
 ♦ $1/€1 → $0.90/€1 means that the dollar has appreciated against the euro. It now takes
only $0.90 to buy one euro, so that the dollar is relatively more valuable.
 ♦ The euro has depreciated against the dollar: it is now relatively less valuable
 A depreciated currency is less valuable, and therefore it can buy fewer foreign-produced goods
with prices that are quoted in foreign currency terms.
 ♦ How many yen does a Japanese Honda cost?¥3,000,000

 ♦ ¥3,000,000x$0.0098/¥1=$29,400
♦ ¥3,000,000x$0.0100/¥1=$30,000
 • A depreciated currency means that imports are more expensive and domestically produced
goods and exports are less expensive.
 • A depreciated currency lowers the price of exports relative to the price of imports.
 An appreciated currency is more valuable, and therefore it can buy more foreign produced
goods that are denominated in foreign currency.
 ♦ How much does a Honda cost? ¥3,000,000

 ♦ ¥3,000,000x$0.0098/¥1=$29,400
♦ ¥3,000,000x$0.0090/¥1=$27,000
 • An appreciated currency means that imports are less expensive and domestically produced
goods and exports are more expensive.
 • An appreciated currency raises the price of exports relative to the price of imports.
FOREIGN EXCHANGE MARKET
 The foreign exchange market is an over-the-counter (OTC) marketplace that
determines the exchange rate for global currencies
 It is, by far, the largest financial market in the world and is comprised of a global
network of financial centers that transact 24 hours a day, closing only on the
weekends.
 Participants in these markets can buy, sell, exchange, and speculate on the relative
exchange rates of various currency pairs.
 Trading occurs mostly in major financial cities: London, New York, Tokyo, Frankfurt, Singapore.

 The volume of foreign exchange has grown:

- in 1989 the daily volume of trading was $600 billion,
-in 2004 the daily volume of trading was $1.9 trillion.
• Nearly 90% of transactions in 2004 involved US dollars. Why?
--------------US dollar is the main vehicle currency.
FOREIGN EXCHANGE MARKET: THE MAIN PLAYERS

 Commercial banks and other depository institutions: transactions involve buying/selling of bank
deposits in different currencies for investment.
 Non-bank financial institutions (pension funds, insurance funds) may buy/sell foreign assets.

 Private firms: conduct foreign currency transactions to buy/sell goods, assets, or services.

 Central banks: conduct official international reserve transactions; foreign exchange intervention
MAIN TYPES OF FOREIGN EXCHANGE
RATES

  Fixed Exchange Rate System:

 Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed
by the government
 Flexible Exchange Rate System
 Flexible exchange rate system refers to a system in which exchange rate is determined by
forces of demand and supply of different currencies in the foreign exchange market. 
 Flexible exchange rate is also known as ‘Floating Exchange Rate’
 Managed Floating Rate System
 It refers to a system in which foreign exchange rate is determined by market forces and
central bank influences the exchange rate through intervention in the foreign exchange
market.
 Fixed Exchange Rate System:
 Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed
by the government
 A fixed exchange rate is when a country ties the value of its currency to some other widely-
used commodity or currency
 Saudi Arabia: 1$=3.76 Saudi Riyal
 A fixed exchange rate provides currency stability
 Investors always know what the currency is worth. That makes the country's businesses
attractive to foreign direct investors.
 Flexible Exchange Rate System
 Flexible exchange rate system refers to a system in which exchange rate is determined by
forces of demand and supply of different currencies in the foreign exchange market. 
 Flexible exchange rate is also known as ‘Floating Exchange Rate’
 A floating exchange rate functions in an open market where speculations, along with demand
and supply forces, drive the price.
 Floating exchange rate structures mean that changes in long-term currency prices represent
comparative economic strength and differences in interest rates across countries.
 Changes in the short-term floating exchange rate represent disasters, speculations, and the
daily supply and demand of the currency.
  Australia, the United Kingdom, Japan, and the United States
 Managed Floating Rate System
 It refers to a system in which foreign exchange rate is determined by market forces and central
bank influences the exchange rate through intervention in the foreign exchange market.
 A managed floating exchange rate is a system where currencies fluctuate daily but the
regulatory authorities, including the government and the Reserve bank of India, may step in to
control and stabilize the value of the currency.
 By far the most significant system of managed floating exchange rate in recent years is the
Chinese currency regime.
 In order to be credible, a managed floating exchange rate has to be managed by an
autonomous or semi-autonomous central bank with a high level of FX reserves, strong
credibility.
 TYPES OF FOREIGN EXCHANGE MARKET
 Following are the major foreign exchange markets −
 Spot Market

-This market provides immediate payment to the buyers and sellers as per the current exchange
rate. 
-The transactions require instant payment at the prevailing exchange rate which is also known as
the spot rate.
Forward Market
 In forward contract, two parties (two companies, individual or government nodal agencies)
agree to do a trade at some future date, at a stated price and quantity.
 No security deposit is required as no money changes hands when the deal is signed.
  In this case, the parties will negotiate the terms of the transactions and the terms agreed-upon
can be negotiated and altered as per the needs of the concerned parties.
 Future markets
 Future markets work on similar lines as the forward markets in terms of basic philosophy.
However, contracts are standardized and trading is centralized (on a stock exchange like NSE,
BSE, KOSPI). 
 The transaction or agreement is more formal in nature which ensures that the terms of the
transaction are set in stone and cannot be altered.
 In the futures market, the investor has to put some initial deposit into her trading account,
which is known as the initial margin requirement.
 OPTION MARKET
 An option contract is a financial contract which gives an investor a right to either buy or sell
an asset at a predetermined price by a specific date. However, it also entails a right to buy, but
not an obligation.
 A call option is a type of options contract which gives the call owner the right, but not the
obligation to buy a security or any financial instrument at a specified price (or the strike price
of the option) within a specified time frame.
 Put options give the option holder the right to sell an underlying security at a specific strike
price within the expiration date.
 This flexibility comes at a premium built into the price of the option.
 SWAP MARKET
 A financial market in which organizations exchange loan agreements, etc, for ones
that have a different interest rate, currency etc, that suits them better.
HEDGING VS. SPECULATION
 Hedging and speculation refer to strategic activities relating to investing

 Speculation involves trying to make a profit from a security's price change, whereas hedging
attempts to reduce the amount of risk, or volatility, associated with a security's price change.
 Hedging is a risk management strategy employed to offset losses in investments
 For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-
ins, or other unforeseen disasters.
 Speculators trade based on their educated guesses on where they believe the market is headed.

 If hedgers can be characterized as risk-averse, speculators can be seen as risk-lovers.

 Speculators are vulnerable to both the downside and upside of the market; therefore,
speculation can be extremely risky. But when they win, they can win big—unlike hedgers, who
aim more for protection than for profit.
HEDGING TOOLS
 Forward Contract

-A forward contract is an agreement under which a business agrees to buy a certain amount of
foreign currency on a specific future date, and at a predetermined exchange rate.
 Futures Contract

-A futures contract is similar in concept to a forward contract, in that a business can enter into a
contract to buy or sell currency at a specific price on a future date. The difference is that Forward
contracts aren’t regulated at all, while futures are overseen by a central government body. Futures
contracts are also standardized, which means that they come with set terms and an expiration date.
Forwards, on the other hand, are customized to the needs of the parties involved.
Currency Option
-An option gives its owner the right, but not the obligation, to buy or sell an asset at a certain price
(known as the strike price), either on or before a specific date.
FACTORS THAT INFLUENCE CURRENCY EXCHANGE
RATES

 Differentials in Inflation

-A country with a consistently lower inflation rate exhibits a rising currency value, as its
purchasing power Increases relative to other currencies. 
 Differentials in Interest Rates

-Higher interest rates offer lenders in an economy a higher return relative to other countries. As
a general rule, the higher the interest rates, the more foreign investment a country is likely to
attract. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
 Current Account Deficits

The excess demand for foreign currency during the import lowers the country's exchange rate
 Public Debt

-Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding.
-If this government debt outpaces economic growth, it can drive up inflation by deterring
foreign investment from entering the country
 Terms of Trade

If exports exceed its imports, it stimulates economic growth and bolsters the local currency
exchange rate.
 Political Stability

A politically stable country attracts more foreign investment, which helps prop up the currency
rate.
 Economic Health

-A country with low unemployment rates means its citizens have more money to spend,
which helps establish a more robust economy. With a stronger economy, the country
attracts more foreign investment.
THE EFFECTS OF EXCHANGE RATES IN FOREIGN TRADE

 A weaker domestic currency stimulates exports and makes imports more expensive.
Conversely, a strong domestic currency hampers exports and makes imports cheaper.
 For example: A good priced at $10 in the U.S. will be exported to India. With an assumption
that the exchange rate is 50 rupees to USD and ignoring transportation and other transaction
costs, the $10 item would cost the Indian importer 500 rupees.
 In a situation where, the dollar strengthens against the Indian rupee to a level of Rs. 55, and
the price of good remains constant at $10, the increased price would be 550 rupees ($10 x
Rs.55). This may force the importer to look for cheaper components from other locations.
 https://jayeshkawli.ghost.io/how-currency-exchange-rates-affect-import-and-export/
FEMA
 Foreign Exchange Management Act, 1999 (FEMA) came into force by an act of
Parliament.
 It was enacted on 29 December 1999.
 It is a set of regulations that empowers the Reserve Bank of India to pass regulations
and enables the Government of India to pass rules relating to foreign exchange in
tune with the foreign trade policy of India.
 FEMA replaced an act called Foreign Exchange Regulation Act (FERA).
MAIN FEATURES OF FOREIGN EXCHANGE MANAGEMENT ACT, 1999

1. It gives powers to the Central Government to regulate the flow of payments to and from a person
situated outside the country.
2. All financial transactions concerning foreign securities or exchange cannot be carried out
without the approval of FEMA. All transactions must be carried out through “Authorised Persons.
3. In the general interest of the public, the Government of India can restrict an authorized individual
from carrying out foreign exchange deals within the current account.
4. Empowers RBI to place restrictions on transactions from capital Account even if it is carried out
via an authorized individual.
5. As per this act, Indians residing in India, have the permission to conduct a foreign exchange,
foreign security transactions or the right to hold or own immovable property in a foreign country
in case security, property, or currency was acquired, or owned when the individual was based
outside of the country, or when they inherit the property from individual staying outside the
country.
STRUCTURE OF FEMA.
1.The Head Office of FEMA, also known as Enforcement Directorate, headed by the
Director is located in New Delhi.
2.There are 5 zonal offices in Delhi, Mumbai, Kolkata, Chennai, and Jalandhar, each
office is headed by Deputy Director.
3.Every 5 zones are further divided into 7 sub-zonal offices headed by Assistant
Directors and 5 field units headed by Chief Enforcement Officers.
EXCHANGE RATE
DETERMINATION
 The Mint Parity Theory
 The earliest theory of foreign exchange has been the mint parity theory. 
 This theory was applicable for those countries which had the same metallic standard
(gold or silver)
 -freely competitive monetary system in which gold or bank receipts for gold act as the
principal medium of exchange; or to a standard of international trade. Gold coins, as well as
paper notes backed by or which can be redeemed for gold, are used as currency under this
system.
 The value of currency unit under gold standard was defined in terms of weight of gold
of a specified purity contained in it.
 Suppose the official price of gold in Britain was £ 20 per ounce and in the United
States it was $ 80 per ounce, these were the mint prices of gold in the two countries.
The rate of exchange between these two currencies would be determined as £ 20 = $
80 or £ 1 = $ 4.
 This rate of exchange determined on weight-to-weight basis of the metallic contents of
currencies of the two countries was called mint par of exchange or the mint parity.
 The Purchasing Power Parity Theory
 The purchasing power parity theory enunciates the determination of the rate of
exchange between two inconvertible paper currencies. 
 This theory states that the equilibrium rate of exchange is determined by the equality
of the purchasing power of two inconvertible paper currencies. It implies that the rate
of exchange between two inconvertible paper currencies is determined by the internal
price levels in two countries.
 (i) The Absolute Version
 (ii) The Relative Version.
       
 The Absolute Version
 The rate of exchange equals the ratio of outlay required to buy a particular set of goods
at home as compared with what it would buy in a foreign country.
 Suppose 10 units of commodity X, 12 units of commodity Y and 15 units of commodity
Z can be bought through spending Rs. 1500 and the same quantities of X, Y and Z
commodities can be bought in the United States at an outlay of 25 dollars. It signifies
that the purchasing power of 25 dollars is equivalent to that of Rs. 1500 in their
respective countries.
The exchange rate between them can be expressed as: 

      
 The Relative Version

 According to this version, the equilibrium rate of exchange in the current period (R 1)
is determined by the equilibrium rate of exchange in the base period (R1) and the ratio
of price indices of current and base period in one country to the ratio of price indices
of current and base periods in the other country. 
It shows that rupee has depreciated while dollar has appreciated between the
two periods.
 The Balance of Payments Theory:
 The rate of exchange is determined by the flow of funds in the foreign exchange
market.
 It emphasises that the rate of exchange is influenced, in a significant way, by the
balance of payments position of a country. 
 A deficit in the balance of payments of a country signifies a situation in which the
demand for foreign exchange (currency) exceeds the supply of it at a given rate of
exchange. The demand pressure results in an appreciation in the exchange value of
foreign currency. As a consequence, the exchange rate of home currency to the foreign
currency undergoes depreciation.
 The Monetary Approach to Rate of Exchange
 The monetary approach postulates that the rates of exchange are determined through
the balancing of the total demand and supply of the national currency in each country.
 According to this approach, the demand for money depends upon the level of real
income, the general price level and the rate of interest.
 The demand for money is the direct function of the real income and the level of prices.
it is an inverse function of the rate of interest.
 The supply of money, it is determined autonomously by the monetary authorities of
different countries.
 The Portfolio Balance Approach
 The essence of this approach is that the exchange rate is determined in the process of
equilibrating or balancing the demand for and supply of financial assets out of which
money is only one form of asset.
 An immediate fall in the rate of interest-leads to a shift in the asset portfolio from
domestic bonds to foreign bonds. The substitution of foreign bonds for domestic
bonds results in an immediate depreciation of home currency. This depreciation, over
time, causes an expansion in exports and reduction in import. 
 It leads to the appearance of a trade surplus and consequent appreciation of home
currency, which offsets part of the original depreciation. Thus the portfolio balance
approach explains also exchange over-shooting. This explanation, in contrast to the
monetary approach, brings in trade explicitly into the adjustment process in the long
run.
FORECASTING TECHNIQUES
 1. Technical
 2. Fundamental
 3. Market-based and
 4. Mixed
 Market Based Marketing
 Analyzing future spot rates on the basis of a market-determined exchange rate (such as the
current spot rate or forward rate.
 A market-based forecast uses market indicators to forecast exchange rates based on the concept that these
market indicators efficiently incorporate expected future currency changes.
 MNCs often track changes in the spot rate and then use these changes to estimate the future spot rate
Mixed forecasting
 Combination of forecasting methods