Foreign Exchange refers to the currencies of countries other than the domestic currency of a given country. In simple terms, it is the aggregation of the Foreign currencies held by the country’s government, and Securities and bonds issued by foreign companies and governments. The rate at which one currency is exchanged for another is called the Foreign Exchange Rate or Foreign Rate of Exchange. It is the price paid in domestic currency for buying a unit in foreign currency. For example, If 60 rupees are to be paid to get one dollar then the exchange rate, in that case, is $ 1: ₹ 60.
What is Foreign Exchange Market?
Every nation has a unique currency that it uses for commerce and business, in India, it’s Indian Rupee, but what about the global market? The lack of flexibility of the currencies makes them a barrier to international trade. The Foreign Exchange Market was formed to solve this problem. This is a specific kind of market where the currency exchange rates are fixed. In absence of a foreign exchange market, the global economy would suffer greatly. The Foreign Exchange Market is the market in which the national currencies are traded for one another.
It refers to the market for national currencies of different countries in the world. It is the center of trade for the different currencies.
In simple words, it is a market in which buying and selling of foreign currencies take place. In this market buyers and sellers constitute people who wish to buy or sell foreign exchange. The buyers can be individuals, firms, commercial banks (like the State Bank of India), the central bank( Reserve Bank of India), commercial companies, and investment brokers.
Sometimes there is a confusion that the foreign exchange market is a physical place where we can go and trade the currencies of different countries. But, the foreign exchange market is not confined to a place, it is a system. Moreover, there are a large number of foreign currencies like the Dollar, Pound, Yen, and many others, which can be traded, converted, and exchanged in this market and not restricted to one or few foreign currencies. The exchange rate for all currencies is decided on the foreign exchange market, which is a global market. Currency Market or Forex are other names for the foreign exchange market. The players in this market can exchange, buy, sell, and speculate on the currencies.
Functions of Foreign Exchange Market
1. Transfer Function:
It is the primary function of the foreign exchange market. It facilitates the transfer of purchasing power in terms of foreign exchange between the countries that are involved in the transactions. Purchasing power (or buying power) is the number of products and services that one unit of currency can purchase. The function is performed through credit instruments like bills of exchange, bank drafts, and telephonic transfers. Therefore, it involves sending money or foreign currencies from one nation to another to settle their accounts.
2. Credit Function:
Just like domestic trade, foreign trade also depends on credit. The Credit Function of the Foreign Exchange Market implies the provision of credit in terms of foreign exchange for the export and import of goods and services. For this, bills of exchange are generally used for making payments internationally. The duration of Bills of Exchange is usually three months. The main purpose of credit is to help the importer in taking possession of goods, sell them and obtain the money to pay the bills.
3. Hedging Function:
It implies to protection against risk related to fluctuations in the foreign exchange rate. Under this system, buyers and sellers agree to sell and buy goods on a future date at some commonly agreed rate of exchange. The basic purpose behind Hedging Function is to avoid losses that might be caused because of variations in the exchange rate in the future.
Types of Foreign Exchange Market
A Foreign Exchange Market can be classified as a Spot Market and Forward Market based on the period of transactions undertaken.
1. Spot Market(Current Market):
Spot market refers to the market in which receipts and payments are made immediately. In this market sales and purchase of foreign currency are affected by the prevailing rate of exchange on the spot. Simply put, it refers to a market in which current transactions in foreign exchange take place. The delivery of foreign exchange takes place in a single moment. The rate at which current transactions take place is called Spot Rate. For example, if a person receives a gift of $50 from a relative abroad, and if the current exchange rate is $1 = ₹60, then the account is credited with ₹3000.
The principles characteristics of a Spot Market are:
i) In the spot market, transactions take place on a daily basis.
ii) The rate of exchange that is determined in the spot market is known as the Spot Exchange Rate or Current Rate of exchange. The spot rate of exchange is the rate that prevails at the time of making transactions.
2. Forward Market:
Forward Market refers to the market in which the sale and purchase of foreign currency are settled on a specific future date at a rate agreed upon today. The rate at which forward transactions take place is called the Forward Exchange Rate. In this market, payment will be made on the specified date in the future. In simple words, these transactions are signed today but they will materialize on some future date.
The principles characteristics of a Forward Market are:
i) In the forward market, only future transactions take place. It does not consider spot transactions in foreign exchange.
ii) The rate of exchange that is determined in the forward market is known as the Forward Exchange Rate. In the forward rate of exchange future delivery of foreign exchange takes place.
A forward contract is entered into for two reasons:
To minimize the risk of loss due to adverse changes in the exchange rate.
To make speculative gains.
Spot Market v/s Forward Market
Basis
Spot Market
Forward Market
Handles
It handles current transactions.
It handles transactions meant for future delivery.
Rate of Transaction
The rate at which current transactions take place is called Spot Rate.
The rate at which forward transactions take place is called the Forward Exchange Rate.
Hedging
It does not allow Hedging.
It allows Hedging.
What is Foreign Exchange Rate?
A medium of exchange for goods and services is called currency. In a nutshell, it is money issued by governments and accepted for payment in the country. It comes in the form of coins and paper. Every nation has a currency that is widely accepted within its boundaries. For example, the Indian rupee (₹) in India, the Pound (£) in England, and the Dollar ($) in the United States of America.
However, a country’s currency cannot be used in another country; For example, the Indian rupee (₹) can not be directly acceptable in the USA. In today’s world, countries have economic relations with each other. Thus, there is an increase in interdependence among the countries. Therefore, in the case of international payments, it has to be first converted into the other country’s currency after this, it can be used in economic transactions. If an Indian resident wants to visit the USA, then he/she has to pay in Dollars ($) to stay there, or if an Indian resident wants to purchase a certain thing from abroad, then he/she has to pay in their respective currency to purchase that thing.
Thus, for this purpose, the currency of one country is converted into the currency of another country and the rate at which one currency is exchanged for another is called the Foreign Exchange Rate or Foreign Rate of Exchange. In simple words, it is the price paid in domestic currency for buying a unit in foreign currency. For example, If 60 rupees are to be paid to get one dollar, then the exchange rate, in that case, is $ 1 = ₹ 60.
Types of Foreign Exchange Rates
There are three types of exchange rates; namely, Fixed Exchange Rate, Flexible Exchange Rate, and Managed Floating Exchange Rate.
1. Fixed Exchange Rate
Under this system, the exchange rate for the currency is fixed by the government. Thus, the government is responsible to maintain the stability of the exchange rate. Each country maintains the value of its currency in terms of some ‘external standard’ like gold, silver, another precious metal, or another country’s currency.
The main purpose of a fixed exchange rate is to maintain stability in the country’s foreign trade and capital flows.
The central bank or government purchases foreign exchange when the rate of foreign currency rises and sells foreign exchange when the rates fall to maintain the stability of the exchange rate.
Thus, government has to maintain large reserves of foreign currencies to maintain a fixed exchange rate.
When the value of one currency(domestic) is tied to another currency then this process is known as pegging and that’s why the fixed exchange rate system is also referred to as the Pegged Exchange Rate System.
When the value of one currency(domestic) is fixed in terms of another currency or in terms of gold, then it is called the Parity Value of currency.
Methods of Fixed Exchange Rate in Earlier Times
1. Gold Standard System (1870-1914): As per this system, gold was taken as the common unit of parity between the currencies of different countries. Each country defines the value of its currency in terms of gold. Accordingly, the value of one currency is fixed in terms of another country’s currency after considering the gold value of each currency.
For example,
1£(UK Pound)= 5g of gold
1$(US Dollar)= 2g of gold
then the exchange rate would be £1(UK Pound) = $2.5(US Dollar)
2. Bretton Woods System (1944-1971): The gold standard system was replaced by the Bretton Woods System. This system was adopted to have clarity in the system. Even in the fixed exchange rate, it allowed some adjustments, thus it is called the ‘adjusted peg system of exchange rate’. Under this system:
Countries were required to fix their currency against the US Dollar($).
US Dollar was assigned gold value at a fixed price.
The value of one currency say £(UK Pound) was pegged in terms of the US Dollar($), which ultimately implies the value of the currency in gold.
Gold was considered an ultimate unit of parity.
International Monetary Fund (IMF) worked as a central institution in controlling this system.
This is the system that was abandoned and replaced by the Flexible Exchange rate in 1977.
Devaluation and Revaluation
Devaluation includes a reduction in the value of the domestic currency in terms of foreign currencies by the government. Under a fixed exchange rate system, the government undertakes devaluation when the exchange rate is increased.
Revaluation refers to an increase in the value of the domestic currency by the government.
Difference between Devaluation and Depreciation
Merits of Fixed Exchange Rate System:
It ensures stability in the exchange rate. Thus it helps in promoting foreign trade.
It helps the government to control inflation in the economy.
It stops speculating in the foreign exchange market.
It promotes capital movements in the domestic country as there are no uncertainties about foreign rates.
It helps in preventing capital outflow.
Demerits of Fixed Exchange Rate System:
It requires high reserves of gold. Thus it hinders the movement of capital or foreign exchange.
It may result in the undervaluation or overvaluation of the currency.
It discourages the objective of having free markets.
The country which follows this system may find it difficult to tackle depression or recession.
Fixed Exchange Rate has been discontinued because of many demerits of the system by all leading economies, including India.
2. Flexible Exchange Rate System
Under this system, the exchange rate for the currency is fixed by the forces of demand and supply of different currencies in the foreign exchange market. This system is also called the Floating Rate of Exchange or Free Exchange Rate. It is so because it is determined by the free play of supply and demand forces in the international money market.
Under the Flexible Exchange Rate system, there is no intervention by the government.
It is called flexible because the rate changes with the change in the market forces.
The exchange rate is determined through interactions of banks, firms, and other institutions that want to buy and sell foreign exchange in the foreign exchange market.
The rate at which the demand for foreign currency is equal to its supply is called the Par Rate of Exchange, Normal Rate, or Equilibrium Rate of Foreign Exchange.
Merits of Flexible Exchange Rate System
With the flexible exchange rate system, there is no need for the government to hold any reserve.
It eliminates the problem of overvaluation or undervaluation of the currency.
It encourages venture capital in the form of foreign exchange.
It also enhances efficiency in the allocation of resources.
Demerits of the Flexible Exchange Rate System
It encourages speculation in the economy.
There is no stability in the economy as the exchange rate keeps on fluctuating as per demand and supply.
Under this, coordination of macro policies becomes inconvenient.
There is uncertainty in the economy that discourages international trade.
3. Managed Floating Exchange Rate
It is the combination of the fixed rate system (the managed part) and the flexible rate system (the floating part), thus, it is also called a Hybrid System. It refers to the system in which the foreign exchange rate is determined by the market forces and the central bank stabilizes the exchange rate in case of appreciation or depreciation of the domestic currency.
Under this system, the central bank acts as a bulk buyer or seller of foreign exchange to control the fluctuation in the exchange rate. The central bank sells foreign exchange when the exchange rate is high to bring it down and vice versa. It is done for the protection of the interest of importers and exporters.
For this purpose, the central bank maintains the reserves of foreign exchange so that the exchange rate stays within a targeted value.
If a country manipulates the exchange rate by not following the rules and regulations, then it is known as Dirty Floating.
However, the central bank follows the necessary rules and regulations to influence the exchange rate.
Example of Managed Floating Exchange Rate
Suppose, India has adopted Managed Floating System and the Reserve Bank of India (Central Bank) wants to keep the exchange rate $1 = ₹60. And, let’s assume that the Reserve Bank of India is ready to tolerate small fluctuations, like from 59.75 to 60.25; i.e., .25.
If the value remains within the above limit, then there is no intervention. But if due to excess demand for the Indian rupee the value of the rupee starts declining below 59.75/$. Then, in that case, RBI will start increasing the supply of rupees by selling the rupees for dollars and acquiring holding of dollars.
Similarly, due to the excess supply of the Indian rupee, if the value of the rupee starts increasing above 60.25/$. Then, in that case, RBI will start increasing the demand for Indian rupees by exchanging the dollars for rupees and running down its holding of dollars.
Hence, in this way, the Reserve Bank of India maintains the exchange rate.
Other types of Exchange Rate System
Over the time period, because of the different changes in the global economic events, the exchange rate systems have evolved. Besides, fixed, flexible, and managed floating exchange rate systems, the other types of exchange rate systems are:
Adjustable Peg System: An exchange rate system in which the member countries fix the exchange rate of their currencies against one specific currency is known as Adjustable Peg System. This exchange rate is fixed for a specific time period. However, in some cases, the currency can be repegged even before the expiry of the fixed time period. The currency can be repegged at a lower rate; i.e., devaluation, or at a higher rate; i.e., revaluation of currency.
Wider Band System: An exchange rate system in which the member country can change its currency’s exchange value within a range of 10 percent is known as Wider Band System. It means that the country is allowed to devalue or revalue its currency by 10 percent to facilitate the adjustments in the Balance of Payments. For example, if a country has a surplus in its Balance of Payments account, then its currency can be appreciated by maximum of 10% from its parity value to correct the disequilibrium.
Crawling Peg System: An exchange rate system which lies between the dirty floating system add adjustable peg system is known as Crawling Peg System. In this system, a country can specify the parity value for its currency and permits a small variation around that parity value. This rate of parity is adjusted regularly based on the requirements of the International Reserve of the country and changes in its money supply and prices.
What is Foreign Exchange?
Foreign exchange refers to foreign currency. For example, for an Indian resident, the Indian rupee (₹) is a domestic currency that can be used as a medium of exchange in India. But the Indian rupee (₹) can not be used as a medium of exchange outside India. The currency used in other countries is treated as foreign currency for India. Therefore, in the case of international transactions, the domestic currency is converted into foreign currency. For example, if a person visits New York for vacation, he/she can not use the Indian rupee (₹) in New York for economic transactions. The person has to convert the Indian rupee into US Dollars ($), only then he/she can stay there. For that reason, it is important to know at what price domestic currency can be converted into foreign currency. This price is known as the Exchange Rate. The market in which domestic currency is traded for others is the “Foreign Exchange Market”.
Foreign Exchange Rate
“The rate at which the domestic currency can be exchanged for the foreign currency is known as Foreign Exchange Rate“. In simple terms, the foreign exchange rate is the price paid in the domestic currency (₹) for buying a unit of foreign currency. It links the currencies of different countries and enables the comparison of international prices. For example, to buy a unit of $(dollar), if you have to pay ₹60, then the exchange rate is ₹60 per dollar. It can be written in the form; of $1=₹60.
Demand and Supply for Foreign Exchange
Demand for Foreign Exchange:
The demand for foreign exchange arises when a person has to make a payment in foreign currency. In simple terms, it indicates the outflow of foreign currency. It is demanded by Indian residents for the following reasons:
Import of Goods and Services: In the case of the Import of goods and services from a foreign country the payment is made by the importer (the person who imports goods and services) in foreign currency; thus, creating a demand for foreign exchange in India’s Foreign Exchange Market.
Unilateral Transfers Sent Abroad: These are the transfers made by the person for free. It includes the transfer of gifts and grants sent by the government or a person to other countries. These are called unilateral transfers because they are not made to get something in return and because of this reason, foreign exchange is required. For example, If a foreigner is working in India. It means that he is earning income in Indian Rupees. Now, if the foreigner wants to send money to his family, he will have to get the currency exchanged, resulting in an increasing demand for foreign exchange.
Tourism: To pay for expenses incurred during international tours, tourists require a foreign exchange, which creates demand for it. Foreign tourists will create a demand for foreign exchange in India’s foreign exchange markets.
Investments: When investments are made by India in other countries foreign exchange is required. Therefore, demand for foreign exchange is created while making investments abroad.
Lending Abroad: If India provides loans to foreign countries, India will demand foreign exchange.
Repayment of Interest and Loans: If loans along with interest are paid to foreign lenders, there is a need for foreign exchange. It results in an increase in the demand for foreign exchange.
Purchase of assets abroad: There is a demand for foreign exchange to make payments for the purchase of assets like land, shares, bonds, etc., abroad.
Speculation: When people earn money from the appreciation of currency it is called speculation. For this purpose, they need foreign exchange. For example, If an Indian resident through analysis expects the price of the US Dollar to be high in the future, he/she will buy more US Dollars today. The main goal of speculation is to earn profits when the dollar becomes expensive.
Reasons for Rising Demand for Foreign Currency
The demand for foreign exchange rises in the following situations:
1. The demand for foreign currency rises because of the appreciation of domestic currency (it can also be said that there is a depreciation in the price of foreign currency). Appreciation of domestic currency refers to an increase in the value of the domestic currency in comparison to foreign currency. For example, if the price of $1 (US Dollar) falls from ₹64 to ₹60, then it means that more goods will be purchased with the same rupees. This indicates that imports from the USA will increase, as American goods become cheaper in India. It will ultimately increase the demand for US Dollars in India.
2. When the price of foreign currency falls, its demand for speculative purposes rises as now it is available at a low price.
3. A fall in the exchange rate of $1= ₹64 to $1= ₹60, increases the level of investment abroad.
4. Tourism to that foreign country increases as travelling abroad has now become relatively cheaper.
Demand Curve of foreign exchange
There is an inverse relationship between the rate of foreign exchange and demand for foreign exchange. It means the higher the rate, the lesser will be the demand for foreign exchange and vice-versa. Due to this reason, the demand curve slopes downwards. The relationship between the rate of foreign exchange and the quantity demanded for foreign exchange can be illustrated graphically with the help of a downward-sloping curve, as shown in Figure 1.
Demand for foreign exchange
Fig 1: Demand for foreign exchange
In the graph, the exchange rate is shown on the Y axis, and demand for foreign exchange is shown on the X axis. The demand curve DD shows the negative relation between the rate of exchange rate and demand for foreign exchange. The DD demand curve (negative sloping) shows that at a lower rate of exchange OR1 more foreign exchange is demanded OQ1, whereas at a higher rate of exchange, i.e., OR2 less foreign exchange is demanded OQ2.
Supply of Foreign Exchange
The supply of foreign exchange involves receipts of foreign exchange. Thus it indicates the inflow of foreign currency into the domestic country. The major sources of supply of foreign exchange are stated below:
Exports: Whenever the foreigner purchases goods and services from a domestic country (India), the payment is made by the foreigner in foreign exchange. Thus, in the case of Exports of goods and services, there is an increase in the supply of foreign exchange in India’s foreign exchange market.
One-sided/Unilateral Transfers from Abroad: These are the transfers made by the person for free. It includes the transfer of gifts and grants sent by the government or a person to other countries. These are called unilateral transfers because these are not made to get something in return. Thus for unilateral transfers, foreign exchange is required. If Indians are working in a foreign country. It means they earn income abroad. When they send back the income earned to their homeland for their families in India, it results in an increase in the supply of foreign exchange in India’s foreign exchange market.
Tourism: To pay for expenses incurred during international tours, tourists require foreign exchange. If foreign tourists come to India, then they need our Indian Rupee for their stay. They supply foreign exchange in return for the Indian Rupee which will in return increase the supply of foreign exchange in India.
Foreign Direct Investments(FDI) in India: FDI refers to the investment made to get direct control of the domestic market. When investments are made by Multinational Companies (like Pizza Hut, and Dominos). In India, there is a flow of foreign exchange.
Foreign Portfolio Investments(FPI) by Foreign Investors: FPI refers to the investment made to earn profit in the domestic market. These are made in form of shares, debentures, bonds, etc. Any purchase in the Indian stock exchange by foreign investors results in the flow of foreign exchange in the Indian share market.
Deposits by Non-Resident Indians(NRI): Foreign exchange flows in the Indian foreign exchange market due to deposits by Non-Resident Indians(NRI) in India.
Speculation: Supply of foreign exchange arises when people earn money from the foreign exchange by speculating.
Reasons for Rising Supply of Foreign Currency
The supply of foreign currency rises in the following situations:
1. The supply of foreign currency rises because of the depreciation of domestic currency (it can also be said that there is an appreciation in the price of foreign currency). Depreciation of the domestic currency refers to the decrease in the value of the domestic currency in comparison to foreign currency. For example, if the price of $1 (US Dollar) rises from ₹60 to ₹64, then it means that more goods will be purchased in rupees with the same dollar. This indicates that exports to the USA will increase, as Indian goods become cheaper in the USA. It will ultimately increase the supply of US Dollars in India.
2. When the price of foreign currency increases, the tendency for speculative gains in the domestic country rises. Thus it increases the supply of foreign exchange.
3. A rise in the exchange rate of $1= ₹60 to $1= ₹64, increases the purchases by the non-resident in India.
4. Tourism in the domestic country increases as travelling in India has now become relatively cheaper.
5. There is an increase in the level of investment from a foreign country as the purchasing power of the foreign currency in the domestic country rises.
Supply Curve of foreign exchange
There is a positive relationship between the rate of foreign exchange and demand for foreign exchange. This means the higher the rate of foreign exchange, the higher will be the supply of foreign exchange and vice-versa. Thus supply curve slopes upwards. The relationship between the rate of foreign exchange and the quantity supplied of foreign exchange can be illustrated graphically with the help of an upward-sloping curve as shown in Figure 2.
Supply for foreign exchange
Fig 2: Supply for foreign exchange
In the graph, the exchange rate is shown on the Y axis, and the supply of foreign exchange is shown on the X axis. The supply curve SS shows the direct (positive) relation between the rate of exchange rate and the supply of foreign exchange. The supply curve (positive sloping) shows that when the rate of foreign exchange rises from OR1 to OR2, then the supply of foreign exchange rises from OQ1 to OQ2.
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