INTRODUCTION TO FOREIGN EXCHANGE

● Foreign exchange refers to foreign currency.

● The Stock of foreign exchange with a country refers to the stock of all foreign currencies with the RBI at a point of time.

● The standard practice to measure the entire stock in terms of US dollar by converting the value of all currencies into US dollars.

● The rate at which domestic currency can be exchanged for a foreign currency is known as foreign exchange rate.

● It is the price paid in domestic currency for buying a unit of the foreign currency in the international money markets.

EXTERNAL VALUE OF THE DOMESTIC CURRENCY

• Exchange rate expresses the ratio of exchange between the currencies of two countries.
• It is the price of a currency expressed in terms of another country.
• The rate of exchange measures number of units of one currency which is exchanged in the foreign market for one unit of another.

FIXED EXCHANGE RATE

• Fixed exchange rate is a regime applied by a country whereby the government or central bank ties the Offical exchange rate to another country or the price of gold.
• The basic purpose of adopting this method is to ensure stability in foreign exchange.
• It is also known as Pegged exchange rate system.
• The government may set it at a level higher or lower than the equilibrium rate as determined by the market forces of supply and demand.
• It leads to devaluation and revaluation of the domestic currency.

MERITS

• Market stability : It promotes investment across nation.
• Stable macroeconomic policies: Given the fixed exchange rate, the central bank can frame its monetary policy and the government can frame its fiscal policy, independent of the external shocks relating to fluctuations in exchange rate.
• Devaluation- A key tool to expand foreign market for domestic producers: Fixed exchange rate system allows devaluation of the currency. It is a planned fall in the value of the domestic currency. It helps to expand foreign market for the domestic producers.

DEMERITS

• Reserves of forex: To maintain the rate of exchange at the desired level, the government need to keep a large stock of foreign exchange.
• Inefficient allocation of resources: Exchange rate fixed by the government often deviates from the equilibrium exchange rate. To the extent, allocation of resources may not be efficient.
• Small size of Forex market: When rate of exchange is fixed, foreign exchange does not emerge as a trading commodity. Size of forex remain small. This act as a hurdle in the global economic growth.

FLEXIBLE EXCHANGE RATE

• Flexible rate of exchange is that rate which is determined by the supply and demand forces.
• There is no government intervention in the Foreign exchange market.
• It leads to depreciation of the domestic currency and appreciation of the domestic currency.
• Degree of speculation is very high because of the uncertainty of market forces of supply and demand.
• It is also known as par rate of exchange or Equilibrium rate of exchange.

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MERITS

• Large reserves of forex not required: It does not require large reserves of foreign exchange with the government. Market forces of supply and demand automatically drive the rate of exchange to the point of equilibrium.
• Efficient allocation of resources: of resources is achieved, as the system is ruled by the free play of the market forces.
• International mobility of liquidity: since large reserves of forex are not required, flexible exchange rate tends to promote international mobility of liquidity. This is good for the less developed countries, where foreign investment is a significant determinant of GDP growth.

DEMERITS

• Marginalisation of weak currencies: It leads to marginalisation of weak currencies in the international money market. Weak currencies often suffer huge depreciation in relation to strong currencies. Accordingly, gains of international trade accrue more to the large economics than the small economics.
• Uncertainty of the market: There is a high degree of uncertainty in the market. Owing to the frequently changing rate of exchange, it becomes difficult to formulate a stable monetary policy in the domestic economy.
• External shocks: Flexible exchange rate system exposes the domestic economy to external shocks.

MANAGED FLOATING EXCHANGE RATE

• When exchange rate is determined by the forces of supply and demand, at times the central bank [RBI] intervenes to manage the exchange rate so that it does not slip out of the desired limits.
• It is the mixture of both flexible and fixed exchange rate systems. It comprises the elements of flexible exchange rate.
• It is also known as DIRTY FLOATING.
• For this, central bank maintain Reserves of forex to ensure that exchange rate stays within targeted value.

WHY DOLLAR IS SUPERIOR?

• Value of US Dollar in INDIA is 81.84 as per indian rupee.

The dollar is strong because the US economy is healthier than

those of many countries and because the federal reserves keep

raising interest rates.

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《 FACTORS AFFECTING THE EXCHANGE RATE 》

• Exchange rate is impacted by Some factors :
• Economic factors : are known to cause variation in foreign exchange rate

are inflation, trade balances and government policies.

• Political factors : that can cause change are political unrest or instability in

The country and also political conflicts.

• Psychological factors: that impact forex rate is the psychology of participants involved in foreign exchange

DEMAND FOR FOREIGN EXCHANGE �

• Repayment of international loans
• Investment in the Rest of the world
• Direct purchases Abroad
• Grants and Donations
• Payment of Incomes
• Speculative techniques
• Imports

DEMAND FOR FOREIGN EXCHANGE

SUPPLY OF FOREIGN EXCHANGE �

• Exports
• Investment from Rest of the world
• Direct purchases by Rest of the world
• Loans from Rest of the world
• Grants and Donations from Rest of the world
• Income Receipts
• Remittances by the Non residents.

SUPPLY OF FOREIGN EXCHANGE

DETERMINATION OF EQUILIBRIUM EXCHANGE � RATE

CURRENCY DEPRECIATION

• Currency depreciation refers to decrease in the value of domestic currency in terms of foreign currency.
• When domestic currency depreciates (or losses its value)in relation to a foreign currency. So,that you need less rupees to buy a dollar.
• CAUSES
• Increase in demand of foreign exchange.
• Decrease in supply of foreign exchange.
• Example: Exchange rate rises from (1US$: 60Rs) to (1US$: 70Rs)

CURRENCY APPRECIATION

• Currency appreciation refers to increase in the value of domestic currency in terms of foreign exchange.
• When domestic currency appreciates (or gains its value) in relation to a foreign currency. So that, you need more rupees to buy a dollar.
• CAUSES
• Increase in supply of foreign exchange.
• Decrease in demand for foreign exchange.
• Example: Exchange rate falls from (1US$: 70Rs) to (1US$: 60Rs).

DEVALUATION REVALUATION

DEVALUATION OF CURRENCY

• Devaluation of currency occurs when the value of the domestic currency is deliberately reduced by the government by raising the exchange rate.
• The market forces of supply and demand play no role whatsoever.
• It leads to excess supply of foreign currency in the international money market.
• It will lead to fall in exchange rate. So, government tries to absorb the excess supply by way of its own purchase of the foreign currency in international money market.
• Accordingly, the government reserves of forex must rise.

REVALUATION OF CURRENCY

• Revaluation of currency occurs when the value of the domestic currency rises in the international money market, because of the market forces of supply and demand.
• The government plays no role whatsoever.
• Revaluation leads to excess demand for foreign currency in the international money market.
• The RBI must fulfills this excess demand by releasing supplies from its reserves of forex.
• In case supplies are not released, there may emerge a black market for the sale and purchase of dollars.

FOREIGN EXCHANGE� MARKET

FOREIGN EXCHANGE MARKET

• Foreign exchange market refers to the market for national currencies of different countries in the world.
• It’s a center of trade for different currencies.
• Buyers and sellers in foreign exchange market wish to buy or sell foreign exchange.
• It’s a made up of banks, commercial Companies, central banks, investment management, firms and retail forex brokers and investors.
• The foreign exchange market is a global decentralised or over the counter market for the trading of currencies.

TRANSFER FUNCTION

It implies transfer of purchasing power in

Terms of foreign exchange across different

countries of the world.

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EXAMPLE: If an exporter of india import goods from the usa and the payment

is to be made in dollars, then the conversion of rupee to dollar will be

facilitated by forex.

CREDIT FUNCTION

It implies provision of credit in terms of foreign exchange for

the export and import of goods and services across different

countries of the world.

The main purpose of credit function is to help the importer in

taking possession of goods, sell them and obtain money

to pay the bills.

HEDGING FUNCTION

• It implies protection against risk related to variations

in foreign exchange rate.

• Exchange rate is locked for future supplies of foreign exchange.
• When exporter and importer enter into the agreement to sell and buy

Goods on some future dates at current prices and exchange rate.

• The purpose of hedging is to avoid losses that might be caused due to

Exchange rate variations in future.

OPERATIONS OF FOREIGN EXCHANGE MARKET ����SPOT MARKET ��FORWARD MARKET

SPOT MARKET

• Spot market for foreign exchange is that market which handles only spot transactions or current transactions.
• Characteristics
• In terms of period of transaction, spot market is of daily nature.
• It doesn’t trade in future deliveries.
• The rate of exchange which is determined in the spot market
• Is known as spot rate of exchange.
• Spot rate of exchange is that rate which prevails at the time when transactions are made.

FORWARD MARKET

• Forward market of foreign exchange is that market which handles such transactions of foreign exchange that are meant for future delivery.
• Such transactions are signed today but are to materialise on some future date.
• Characteristics:-
• It only caters to forward transactions, it does not deal with spot transactions in foreign exchange.
• It defines forward exchange rate, the exchange rate at which forward transactions are to be honoured.

WHO HANDLES FOREIGN TRADE

• Directorate general of foreign trade [DGFT]. This directorate, with headquarters at new delhi is responsible for formulating and implementing the foreign trade policy .
• The main objective of promoting India‘s exports. The DGFT also issues scrips/authorization to exporters and monitors their corresponding obligations through a network of 24 regional offices.

FOREIGN EXCHANGE MANAGEMENT ACT,1999�[FEMA]

The Government of India, Ministry of finance dated 1^st may 2000 has notified that the foreign exchange management act, 1999 shall come into force on the 1^st day of June 2000.

The main objective of FEMA was to help facilitate external trade and payments in India. It was also meant to help orderly development and maintenance of foreign exchange market in India. It defines the procedure, formalities, dealings of all foreign exchange transactions in India.

CONCLUSION

Today’s scenario presents that even after some steps taken by government.

There is no stabilization in value of rupees. Along with it INR is not only Currency depreciating. Except from US almost every country showed depreciating Pressure on their currencies.

Both domestic and global conditions endicating the downward Pressure on rupee to remain to maintain in future. RBI has responded with timely intervention by selling dollars.

Thus,RBI should continue its policy mix of controlled intervention in forex market and administrative measure to curb volatility in Rupee.