(i) The foreign Exchange market transfers funds (foreign currency) from one country to another where they are needed in the settlement of payments(ii) It provides short-term credit to the importers and, thereby, facilitates the smooth flow of goods and services from one country to another(iii) The spot and forward market work in such way that it helps often in stabilizing the foreign Exchange rate
Types of Foreign Exchange Market• Spot Market – Transactions settled within 2 days• Forward Market – Agreement to transact after 90days of deal
Nature of Transactions in Foreign Exchange Market• Hedging – Settle exchange rate in advance – Covers risk of exchange rate fluctuation
• Arbitrage – Act of simultaneous purchase and sale of different currency in two or more exchange markets – Works as stabilizing factor in foreign exchange markets.• Speculation – Buying and selling currency under uncertain condition to make profit – “Buy forward and Sell on the spot” & “Sell Forward and Buy on the spot”
Exchange Rate Regime• The exchange-rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market.• Closely related to monetary policy and the two are generally dependent on many of the same factors.
Floating/ Fluctuating exchange rate• Currencys value is allowed to fluctuate according to the foreign exchange rate.• Belize(Located on the north eastern coast of Central America ) is an example of floating exchange rate.• Mundell-Fleming Model( fixed exchange rate, free capital movement, and an independent monetary policy )• Fear of Floating
Fixed Exchange Rate• Value of currencies kept constant• Worth of its currency in terms of either a fixed weight of gold, a fixed amount of other currency or a “basket of other currencies”• The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payment imbalances.
Types of Fixed Exchange Rate• The Gold Standard• Price Specie Flow Mechanism• Reserve Currency Standard• Gold Exchange Standard
Pegged Float• Crawling Bands: the rate is allowed to fluctuate in a band around a central value, which is adjusted periodically• Crawling pegs: the rate itself is fixed, and adjusted as above.• Pegged with horizontal bands:The currency is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.
DollarizationDollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.
JAGJIT• DETERMINATION OF ER IN – FREE MARKET – REGULATED MARKET
FREE MARKETDemand for Supply of FX FX Demand for Supply of foreign foreign goods, services goods, services & securities & securities Speculators Speculators willing to get rid willing to build of their FXtheir FX reserves reserves
FREE MARKET S’ ROUGH WORKExchange Rate (Rs. Per $) D D P’ 1$= Rs.48 1$=Rs.45 48 S W W S P 45 ER US D2 India’s demand for $ Supply S D1 increases Rs. Prices of foreign goods 10 13 $ demanded per time unit Demand of foreign goods (million) Demand $ Demand for foreign exchange India
FREE MARKET• Rise in domestic prices Rise in ER Increases demand for FX Demand curve shifts upwards Fall in exports Supply curve shifts leftward• ROI (domestic) > ROI (foreign) Fall in ER Capital inflow increases Increased supply for FX Capital outflow decreases
FREE MARKET• Rise in real income (domestic) Rise in ER Increase in imports Increased demand for FX• Rise in real income (abroad) Fall in ER Increase in exports Increased supply for FX
REGULATED MARKET• ER is fixed by the Central Bank• Flexibility, if any, usually 10%• Currency’s par value• Central Bank undertakes the buy & sell of FX in the FX market• Any change in ER is made by the Central Bank• Devaluation• Revaluation
REGULATED MARKET D’ S’Exchange Rate (Rs. Per $) D D’’ P’ T F B P D’ S D’’ D O M N Q R $ demanded per time unit (million)
International trade• If a country’s imports are higher, the demand for foreign currency in this country will be high. Higher demand for foreign currency means high value of foreign currency and low value of the domestic currency.• This is a typical case for underdeveloped countries which rely on imports for development needs. The current account balance (deficit or surplus) thus reflects the strength and weakness of the domestic currency.
Capital movements• International investments in the form of Foreign direct investment (FDI) and Foreign institutional investments (FII) have become the most important factors affecting the exchange rate in today’s open world economy.• Countries which attract large capital inflows through foreign investments, will witness an appreciation in its domestic currency as its demand rises. Outflow of capital would mean a depreciation of domestic currency.
Change in prices• Domestic inflation or deflation affects the exchange rate by affecting the demand and supply of domestic currency in the foreign exchange market.• For example, if prices in India go up, making Indian goods costlier, the demand for Indian goods will go down. When exports go down, the demand for rupee will fall, causing depreciation in its exchange value.
Speculations• Uncertainties are always there in the financial market.• If the speculators expect a fall in the value of a currency in the near future, they will sell that currency and start buying the other currency that they expect to appreciate. The selling of the former currency will thus increase its supply in the foreign exchange market and bring down its value. The other currency appreciates as its demand increases.
Strength of the economy-• If the economic fundamentals of a country are strong, the exchange rate of its domestic currency remains stable and strong• Fiscal balance, international current account balance, international liabilities, foreign exchange reserves, resilience to international trade fluctuations, GDP, inflation rate all are indicators of a country’s economic strength.
Government policies-• In countries where there is fixed or managed float, the central bank becomes an important player in the foreign exchange market.• The bank influences the value of the currency by its market operations like buying and selling of bills and currencies.• The bank rate also influences the exchange rate by influencing investments and thereby the demand and supply of the domestic currency.
Stock exchange operations• Stock exchange operations in foreign securities, debentures, stocks and shares, influence the demand and supply of related currencies, thus influencing their exchange rate.
Political factors• Political scenario of the country ultimately decides the strength of the country. An economy with a strong, positive image will obviously have a strong domestic currency. This is the reason why speculations rise considerably during the parliament elections, with various predictions of the future government and its policies.• In 1998, the Indian rupee depreciated against the dollar due to the American sanctions after India conducted the Pokharan nuclear test.