FOREIGN EXCHANGE MARKET The Foreign Exchange Market is the framework of individuals, firms, banks and brokers who buy and sell foreign currencies. 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 EXCHANE MARKET
Foreign Exchange- money denominated in the currency of another nation or group of nations.
Deposits, credits, and balances payable in any foreign currency.
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 other currencies.
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 base currency ).
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 currencies.
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% margin.
The IMF’s system was initially one of fixed exchange rates.
Exchange Rate Arrangements
Exchange rate practices can be broadly classified into two:-
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 currencies).
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 RATES
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 intervention.
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 falling.
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 Determination
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 MOVEMENTS
Managers need to be concerned with the timing, magnitude, and direction of an exchange rate movement.
Fundamental Forecasting:- It uses trends in economic variables to predict future exchange rates.
Technical Forecasting:- It uses past trends in exchange rate movements to spot future trends.