FOREIGN EXCHANGE MARKET
The Foreign Exchange Market is the framework of
individuals, firms, banks and brokers who buy and sell
Foreign exchange markets tend to be located in national financial
centers near the local financial markets.
There are main three types of transactions undertaken in these
foreign exchange markets:
1. Spot Transactions
2. Forward deals
3. Future transactions
PLAYERS IN THE FOREIGN
Foreign Exchange- money denominated in the
currency of another nation or group of nations.
1. Deposits, credits, and balances payable in any foreign
2. Drafts, travellers cheques, letters of credits or bills of
exchange, expressed or drawn in Indian currency but
payable in any foreign currency and Vice Versa.
FOREIGN EXCHANGE RATE
-The price of a currency
An exchange rate is the rate at which one currency
can be exchanged for another.
In other words, it is the value of another country's
currency compared to that of your own.
Theoretically, identical assets should sell at the same
price in different countries, because the exchange
rate must maintain the inherent value of one
currency against the other
TYPES OF CURRENCY
Hard currency:- It is usually fully convertible and
strong or relatively stable in value in comparison with
Exotic currency:- It is currency of a developing country
and is often unstable, weak and unpredictable.
Exchange Rate Quotations
An exchange rate quotation is given by stating the number of
units of "term currency" or "price currency" that can be
bought in terms of 1 unit currency (also called
Quotations can be of two types:-
1. Direct quotation (1 foreign currency = x home currency)
2. Indirect quotation (1 home currency = x foreign currency )
International Monetary fund (IMF)
The IMF was organized to promote exchange rate
stability and facilitate the international flow of
The Bretton Wood agreement established a par value or
benchmark value, for each currency initially quoted in
terms of Gold and the USD.
Country’s that freely bought and sold gold in settlement
of international transaction was required to maintain 1%
The IMF’s system was initially one of fixed exchange
Exchange Rate Arrangements
Exchange rate practices can be broadly classified into
Fixed or Pegged Exchange rate.
Floating Exchange rate.
Role of Central Banks.
Fixed Exchange rate
A fixed, or pegged, rate is a rate the
government (central bank) sets and
maintains as the official exchange rate.
A set price will be determined against a
major world currency (usually the U.S.
dollar, but also other major currencies such
as the euro, the yen, or a basket of
Floating Exchange Rate
A floating exchange rate is determined by the private market
through supply and demand.
A floating rate is often termed "self-correcting", as any
differences in supply and demand will automatically be corrected
in the market.
A floating exchange rate is constantly changing.
Black market Closely approximates a price based on
supply and demand for a currency instead of a
government controlled price.
The floating rates eliminates the need of the black market.
Role of Central Banks
The central Banks controls the policies that effects
the value of currencies.
It involves buying and selling of home currency and
foreign currencies with a view of ensuring that
exchange rates move in line with established
targets of governments.
DETERMINATION OF EXCHANGE
1. Floating Rates regime.
2. Managed Fixed Rates regime.
3. Purchasing Power Parity.
4. Interest Rate.
5. Other Factors in exchange rate determination.
Floating Rates Regime
Demand for a Country’s currency is a function of
the demand for that country’s goods and services
and financial assets.
Currencies that float freely respond to supply and
demand conditions free from government
Managed Fixed Rates Regime
A government buys and sell its currency in the open
market as a means of influencing the currency’s price.
Sometimes governments use fiscal or monetary policy-
for example, by raising interest rates- to create a
demand for there currency and to keep the value from
A currency that is pegged to another currency usually is
changed on the formal basis- through devaluation or
revaluation, depending upon the direction of the change.
Purchasing Power Parity
It claims that a change in relative inflation between two
countries must cause a change in exchange rates in order
to keep the prices of goods in two countries fairly similar.
If the domestic inflation rate is lower than that in the
foreign country, the domestic currency should be stronger
than that of the foreign country.
To understand the interrelationship between
interest rates and exchange rates, two key finance
theories are used:
1. The Fisher Effect: The nominal interest rate r in a
country is determined by the real interest rate R
and the inflation rate i as follows:
(1+r) = (1+R)(1+i)
2. International Fisher Effect (IFE): The IFE
implies that the currency of the country with the
lower interest rate will strengthen in the future.
Other Factors In Exchange Rate
Technical Factors like release of Economic
Statistics, seasonal demand for a currency etc.
Social factors like terrorist attacks, scandals and a
swelling budget deficit
THEORIES OF EXCHANGE RATES
Balance of Payment Approach
Overshooting- Dornbusch Model
Portfolio Balance Theory.
FORECASTING EXCHANGE RATE
Managers need to be concerned with the timing,
magnitude, and direction of an exchange rate
Fundamental Forecasting:- It uses trends in
economic variables to predict future exchange
Technical Forecasting:- It uses past trends in
exchange rate movements to spot future trends.
Factors to monitor:-
The institutional setting
BUSINESS IMPLICATIONS OF