FOREIGN EXCHANGE MARKET

• In this unit we discuss the financial dealings in international

markets.
• The current unit focuses on exchange rates and is a more in-
depth study of foreign exchange markets from the
perspective of financial economics.
• We look at foreign exchange markets as markets for financial
assets and see who the actors in these markets are, what the
mechanisms and devices for trade in these assets are, and
how the prices of these currencies are determined.
• The foreign exchange market or forex market is the market
where currencies are traded. The forex market is the world’s
largest financial market where trillions are traded daily.
Foreign exchange market
• A foreign exchange market (sometimes informally called the forex
market, or denoted FEM) is a market in which different currencies are
bought and sold.
• Foreign exchange markets arise because various countries have different
monetary systems and require different currencies to buy goods, services
and financial assets.
• So people demand different currencies since they have demand for
goods, services and financial assets of other countries.
• The market in which national monetary units or claims are exchanged
for the foreign monetary units is defined as foreign exchange market.
• Exchange rate is an important aspect in this regard.
• The foreign exchange market operates worldwide, that is, the reach of the foreign
exchange market is global.
• The foreign exchange is by far the largest market in the world, in terms of cash value
traded, and includes trading between large banks, central banks, currency speculators,
multinational corporations, governments, and other financial markets and
institutions.
• The trade happening in the forex markets across the globe currently exceeds $1.9
trillion/day (on average).
• The FEM is not a physical place; rather, it is an electronically linked network of big
banks, dealers and foreign exchange brokers who are all the time bringing buyers and
sellers together.
• Since there is no physical market place for the participants to meet and execute the
transactions, forex market is stated as an Over the Counter (OTC) market. It is more like
an informal arrangement between the brokers and the banks working in a financing
center purchasing and selling currencies, connected to each other by
telecommunications like telex, telephone and a satellite communication network,
SWIFT(Society for Worldwide Interbank Financial Telecommunication)
Structure/ organisation of forex market
Foreign exchange market

spot market derivatives market

Whloesale Reatail market Forwards, futures, options and

swaps

inter bank market

Direct market Indirect market

• The foreign exchange market is classified on the basis of whether
foreign exchange transactions are spot or forward. Accordingly, there
are two kinds of foreign exchange markets: spot market and forward
market.
(i) Spot Market. The spot market refers to that segment of the foreign
exchange market in which sale and purchase of foreign currency
are settled within two days of the deal.
(ii) Forward Market/ derivatisves markets: The forward exchange
market refers to the deals for sale and purchase of a foreign currency at
some future date at a presettled exchange rate
• The foreign exchange market has two parts: wholesale and retail.
• The retail market deals with exchange of bank notes, bank drafts,
currency, and travellers’ cheques between private customers, tourists and
banks.
• The wholesale FEM includes the central bank, but is mainly composed
of an inter-bank market in which major banks trade in currencies held in
different currency-denominated bank accounts, that is, they transfer bank
deposits from sellers’ to buyers’ accounts.
• The inter-bank market has two parts: direct and indirect.
• In the direct market, banks deal directly with each other. Banks quote
buying and selling prices directly to each other and all participating
banks are market makers.
• The indirect part of the wholesale markets, banks put orders with
brokers who try to match purchases and sales of different currencies.
Functions of forex market
• Transfer function: refers to transferring purchasing power between countries. The
basic and the most obvious function of the foreign exchange market is to
transfer the funds or the foreign currencies from one country to another
for settling their payments. The market basically converts one’s currency to
another.
• Credit function: providing credit channels. The FOREX provides short-term
credit to the importers in order to facilitate the smooth flow of goods and
services from various countries. The importer can use his own credit to
finance foreign purchases.
• Hedging function: The third function of a foreign exchange market is
to hedge the foreign exchange risks. The parties in the foreign exchange
are often afraid of the fluctuations in the exchange rates, which means the
price of one currency in terms of another currency. This might result in a
gain or loss to the party concerned.
Participants
• Authorised dealers (commercial banks)
• Forex brokers
• Customers: individuals and corporates/ MNCs/ small business groups
• Central bank
Nature of forex market
• Volatile in nature
• Affected by the demand and supply
• Affected by rate of interest, BOP surplus and deficit, inflation rate etc.
• Spot and forward rate are different
• It can be quoted directly and indirectly.
• Affected by political condition, policies of govt etc
• Economic stability of the country is influencing the forex market.
• Doesn't have any physical existence. (OTC set up). It is a global network
• Trading 24 hours in a day.
• Integration of various trading centres.
Exchange rate
• The exchange rate is the price of one country's currency in terms of
another currency.
• The rate at which one currency is exchanged for another currency.
• There are two ways to express an exchange rate
for example, $ and Rs.
one can either write $/Rs or Rs/$
1$= 73 Rs.

Rs 73/$
Types of Exchange rate
• Spot exchange rate
• Forward exchange rate
• Cross rates
• Nominal exchange rate: relative price of currency or it is the price of
foreign currency in terms of domestic currency
• Real exchange rate: Actual
Appreciation and depreciation/ revaluation
and devaluation
• It is useful to understand the meaning and measures of exchange rate
changes at this juncture
• There is a convention to distinguish devaluation(revaluation) from
depreciation(appreciation)
• Devaluation and revaluation: it refers to a policy determined decrease or
increase in its official exchange rate or par value relative to gold or
another currency.
it is the changes in the value of currency under fixed exchange rate system
I $= 50 rs reduces to 40
Incrseases to 60
• Depreciation or appreciation: it refers to the decline/ increase in the
price or exchange rate of a currency relative to a foreign currency in
the market under flexible exchange rate system.
USD AND Rs. $/Rs= 1/73
1 $= 73 , one USD buys 73 units of indian Rs.
Value has increased 83
1 $= 83 Rs. USD has been appreciated and Rs. has been depreciated
Value has decreased to 63.
1 $ = 63 Rs. USD has been depreciated and Rs has been appreciated.
Exchange rate systems
• This means that every government will have to decide how its 0wn
currency should be related to other currencies of the world.
• major exchange rate systems include the following
1. Fixed exchange rate system/ pegged
2. Flexible exchange rate system
• We saw already that under a truly flexible exchange rate system, a
deficit or surplus in the nation’s balance of payments is automatically
corrected by a depreciation or an appreciation of the nation’s
currency, respectively, without any government intervention and loss
or accumulation of international reserves by the nation.
• On the other hand, pegging or fixing the exchange rate at one level,
just as fixing by law the price of any commodity, usually results in
excess demand for or excess supply of foreign exchange (i.e., a deficit
or a surplus in the nation’s balance of payments), which can only be
corrected by a change in economic variables other than the exchange
rate.
• The fixed and flexible exchange rate system can be explained
graphically.
Other exchange rate systems
• Target zone system/ wider band system.
• Crawling peg system
• Dual exchange rate system/mixed exchange rate system
• Managed or dirty float
Determinants of exchange rate
• Growth in GDP
• Inflation/ PPPT
• Interest rate
• Foreign debt/ public debt
• Terms of trade
• Rates of profit
• Money supply
• Speculation/ confidence
• Expected exchange rate
• Trade barriers
• BOP
Determination of exchange rate
• Purchasing power parity theory
• Demand- supply approach
• Asset market approach
Purchasing power parity theory
• A Swedish Economist, Gustav Cassel, developed the concept of
equilibrium rate of exchange,2 popularly known as the purchasing
power parity theory, (PPP)
• The Purchasing Power Parity (PPP) Theory starts with the law of one
price which states that price of an asset or commodity will be the
same when exchange rates are taken into consideration.
• a dollar will be able to buy the same amount of goods anywhere in
the world. If not, then substitution will cause the exchange rates
and/or prices to change to equalize the purchasing power .
• PPP theory states that price differentials are not sustainable in the
long run as market forces will equalize prices among countries and
change exchange rates in doing so.
• The theory states that equilibrium exchange rate between two
inconvertible paper currencies is determined by the equality of the
relative change in relative prices in the two countries.
• In other words, the rate of exchange between two countries is
determined by their relative price levels.
• There is an absolute and a relative version of the PPP theory.
• Absolute Purchasing-Power Parity Theory: The absolute purchasing-
power parity theory postulates that the equilibrium exchange rate
between two currencies is equal to the ratio of the price levels in the
two nations.
R = P/P∗
where R is the exchange rate or spot rate and P and P∗ are,
respectively, the general price level in the home nation and in the
foreign nation.
• The theory can be explained with the help of an example.
• Suppose India and England are on inconvertible paper standard and by spending
Rs. 60, the same bundle of goods can be purchased in India as can be bought by
spending £ 1 in England. Thus according to the purchasing power parity theory,
the rate of exchange will be Rs. 60 = £ 1.
• If the price levels in the two countries remain the same but the exchange rate
moves to Rs. 50 = £ 1. This means that less rupees are required to buy the same
bundle of goods in India as compared to £ 1 in England
• This will encourage imports and discourage exports by India. As a result, the
demand for pounds will increase and that of rupees will fall. This process will
ultimately restore the normal exchange rate of Rs. 60 = £ 1
• In the converse case, if the exchange rate moves to Rs. 70 = £ 1, the Indian
currency becomes undervalued. As a result, exports are encouraged and imports
are discouraged. The demand for rupees will rise and that for pounds will fall so
that the normal exchange rate of Rs. 60 = £ 1 will be restored.
• Relative Purchasing-Power Parity Theory: The more refined relative
purchasing-power parity theory postulates that the change in the
exchange rate over a period of time should be proportional to the
relative change in the price levels in the two nations over the same
time period.
• if we let the subscript 0 refer to the base period and the subscript 1 to
a subsequent period, the relative PPP theory postulates that

where R1 and R0 are, respectively, the exchange rates in period 1 and

in the base period.
• Purchasing power parity states that the price level in the domestic
economy times the exchange rate (expressed as foreign currency per
unit of domestic currency) equals the price level in a foreign country
Pd ×e = Pf
• where Pd is price level in the domestic economy, Pf is price level in a
foreign country, and e is the exchange rate.
Demand and supply approach/ monetary approach/
BOP theory of exchange rate determination
• Under a flexible exchange rate system, balance-of-payments disequilibria are immediately
corrected by automatic changes in exchange rates without any international flow of money
or reserves.
• Since the foreign exchange rate is a price, economists apply supply- demand conditions of
price theory in the forex market.
• The exchange rate in a free market is determined by the demand for and the supply of
foreign exchange. The equilibrium exchange rate is the rate at which the demand for
foreign exchange equals to supply of foreign exchange
• The value of one currency in terms of another currency depends upon demand for and
supply of foreign exchange.
• Demand for foreign exchange: the demand for foreign currency is generated when the
people or business firms want to make payments to the foreign country.
• The demand curve for foreign exchange is negative sloping. It implies that the lower the
exchange rate on any currency, the larger will be the quantity of that currency demanded in
the foreign exchange market, and vice versa.
• Supply of foreign exchange: supply of foreign exchange is generated
when the receipts are received. In a simi­lar fashion, we can determine
supply of for­eign exchange. If the foreign nationals and firms intend to
purchase Indian goods or buy Indian assets or give grants to the
Government of India, the sup­ply of foreign exchange is generated.
• The SS curve is upward sloping. As the exchange rate on rupee
increases, the greater is the quantity of rupee supplied in the foreign
exchange market.
• The equilibrium exchange rate is determined where the demand for
supply of foreign exchange are equal.
• Equilibrium exchange rate
• Change in demand forces
• Change in supply forces
Changes in equilibrium exchange rate
• Change in domestic prices
• Change in real income
• Change in rate of interest
• Structural change
• speculative demand and supply
All these factors keep the exchange rate floating.
Monetary approach
• The monetary approach to the balance of payments, developed in the early 1960s, recognizes that the balance
of payments can be viewed not only as the sum of its constituent parts, e.g., goods, services, financial capital,
etc., but also as the movement of money internationally.
• A balance of payments deficit means that, net, money flows out of a country, and a balance of payments
surplus means, net, money flows into a country
• Md=k(PY)
• Ms= Mb
• Equilibrium: Md=Ms
Asset market approach
• The asset market approach is based majorly on the interest parity condition. Interest rate parity holds when
the rate of return on one currency is equal to another . RoR($)= RoR(Pound)
• The objective of saving is basically to transfer present consumption to the future. Rate of return refers to the
increase in value an asset offers over time
• we often cannot say with certainty what will happen over time while the decision to buy an asset must be
made in the present.
• Hence, we make use of an estimate known as the expected rate of return
• In the foreign exchange market, investors base their demands for deposits of different currencies on a
comparison of these assets’ expected rates of return
• For comparing return rate on various kinds of deposits. First, they need to know how the money values of the
deposits will change. Second, they need to know how exchange rates will change so that they can translate
rates of return measured in different currencies into comparable terms
• When all expected rates of returns are equal, there is no excess
supply of certain type of deposit and no excess demand for another
• Thus, the foreign exchange market is in equilibrium when the
following condition is met:
• Expected rate of return on foreign deposits = Expected rate of return
on domestic deposits
• The portfolio balance approach (also called the asset market approach) to exchange rates views money as just
one asset of many and views the exchange rate as that which equates the supply and demand for assets
• In the portfolio balance approach, every owner of wealth allocates wealth in some way between domestic
money, foreign bonds and domestic bonds,.
• The significant aspect of the portfolio approach is that it focuses attention on the relationship between all the
sectors of the economy.
Fixed exchange rate determination
• The flexible exchange rate system has certain serious disadvantages.
The most serious disadvantage of flexible exchange rate is that it causes
instability in trade, foreign investment, balance of payments and
employment, A section of economists have, therefore, argued for fixed
exchange rate system.
• The IMF has implemented a system of fixed exchange rate for its
member nations with a provision of flexibility within a limited range.
• When the monetary authority of a country fixes the exchange rate
between the domestic currency and a foreign currency with a
provision of fluctuation of the rate within a small upper and lower
margin, it is called fixed exchange rate.
• a number of different systems of fixing the exchange rate and its
management were evolved by different groups of the nations. The different
systems of exchange rate adopted by different group of countries are listed
below.
1. Independent floating:
2. Managed floating
3. Conventional fixed peg arrangement
4. Currency board arrangements
5. Crawling bands
6. Crawling peg
7. Pegged exchange rate within horizontal band peg
8. No separate legal tender
• It may be added here that the basic purpose of adopting fixed exchange rate
system is to ensure stability in foreign trade and capital movements
Pegging of the currency
• When the value of domestic currency is tied to the value of another
currency, it is called ‘pegging.’
• Under the fixed exchange rate system, a currency is pegged to a
reserve currency or to a basket of ‘key’ currencies.
• The value of a pegged currency is allowed to vary within a certain
lower and upper limit.
Arguments in favour of fixed exchange rate
system
• The first and most powerful argument in favour of fixed exchange rate is
that it provides stability in the foreign exchange market.
• Secondly, fixed exchange rate system creates conditions for a smooth flow
of foreign capital between the nations as it ensures a given return on the
foreign investment.
• Thirdly, the fixed exchange rate eliminates the possibility of speculative
transactions in foreign exchange.
• Fourthly, fixed exchange rate system reduces the possibility of competitive
exchange depreciation or devaluation of currencies.
• Finally, a case for fixed exchange rate is also made on the basis of the
existence of the currency unions and areas
Arguments in favour of flexible exchange
rate system
• First, flexible exchange rate provides a good deal of autonomy in respect of
domestic policies as it does not require any obligatory constraints arising out
of international market conditions.
• Second, flexible exchange rate is self-adjusting and therefore it does not
devolve on the government to maintain an adequate foreign exchange
reserves to stabilize the exchange rate.
• Third, since flexible exchange rate is based on a theory, it has a great
advantage of predictability and has the merit of automatic adjustment.
• Fourth, flexible exchange rate serves as a barometer of actual purchasing
power of a currency in the foreign exchange market.
• Finally, some economists argue that the most serious charge against the
flexible exchange rate, that is, uncertainty, is not tenable because speculative
tendency under this system itself creates conditions for certainty and stability
The Kinds of Foreign Exchange Market
• The foreign exchange market is classified on the basis of whether
foreign exchange transactions are spot or forward. Accordingly, there
are two kinds of foreign exchange markets: spot market and forward
market.
(i) Spot Market. The spot market refers to that segment of the foreign
exchange market in which sale and purchase of foreign currency
are settled within two days of the deal.
(ii) Forward Market/ derivatisves markets: The forward exchange
market refers to the deals for sale and purchase of a foreign currency at
some future date at a presettled exchange rate
The Nature of Foreign Exchange
Transactions
• On the basis of their riskiness and profitability, foreign exchange transactions
can be classified as (i) hedging, (ii) arbitrage, and (iii) speculation.
• Hedging. Hedging is an important feature of the forward exchange market.
When exporters and importers enter an agreement to sell and buy goods at
some future date at current prices and exchange rate, it is called hedging.
• Arbitrage. Arbitrage is an act of simultaneous purchase and sale of different
foreign currencies in different exchange markets. The objective of arbitraging
is to make profit by taking the advantage of different exchange rates in
different exchange markets.
• Speculation: take a position in the forex marketon the expectation of a
favourable currency rate change
• Speculation. Speculative transactions in foreign exchange are
opposite of hedging. In hedging, the buyers and sellers try to avoid
risk, if any, due to fluctuation in the exchange rate, whereas
speculation in foreign exchange is a deliberate attempt under the
condition of risk to make profits from the fluctuations in the exchange
rate.
Role of hedging in forex market
• Foreign exchange hedging is common among investors and
companies involved in international operations. It allows them to
manage their exposure to currency exchange movements and
minimize the impact of adverse fluctuations.
• hedging methods mostly consist of specific contracts or agreements
meant to exchange currency at a fixed rate.