UNIT-IV: Foreign Exchange Market: Nature of transactions in foreign exchange market and
types of players, Exchange rate determination, Convertibility of rupee – Euro currency market.
Foreign Exchange Market
Foreign exchange is the system or process of converting one national currency into
another, and of transferring money from one country to another
Foreign Exchange Market
• The foreign exchange market is a market in which foreign exchange transactions
Functions of foreign exchange market
• Transfer of purchasing power
• Provision of credit
• Provision of Hedging facilities
Transactions in the foreign exchange markets
• Spot and forward exchanges
• Swap operations
Participants in foreign exchange markets
• Traders- commercial banks
• Brokers- brokerages firms
• Speculators- long position and short position
Exchange control is one of the important means of achieving certain national objectives like
- an improvement in the balance of payments position
- restriction of inessential imports and conspicuous consumption
- facilitation of import of priority items
- control of outflow of capital and
- maintenance of the external value of the currency.
Objectives of Exchange Control
• To Conserve Foreign Exchange
• To Check Capital Flight
• To Improve Balance of Payments
• To Curb Conspicuous Consumption
• To make Possible Essential Imports
• To Protect Domestic Industries
• To Check Recession-induced Exports into the Country
• To regulate foreign companies.
• To regulate Export and Transfer of Securities
• Facilitate Discrimination and Commercial Bargaining
• Enable the Government to Repay Foreign Loans
• To Lower the Price of National Securities held Abroad
• To Freeze Foreign Investments and Prevent Repatriation of Funds
• To Obtain Revenue
Determination of exchange rates
• Purchasing power parity (PPP)- Gustav Cassel
• Balance of payment theory-Demand and supply theory
Purchasing power parity
• The purchasing power parity (PPP) theory uses the long-term equilibrium
exchange rate of two currencies to equalize their purchasing power.
• Developed by Gustav Cassel in 1920, it is based on the law of one price: the
theory states that, in ideally efficient markets, identical goods should have
only one price.
• This purchasing power SEM rate equalizes the purchasing power of different
currencies in their home countries for a given basket of goods.
• Using a PPP basis is arguably more useful when comparing differences in
living standards on the whole between nations because PPP takes into account
the relative cost of living and the inflation rates of different countries, rather
than just a nominal gross domestic product (GDP) comparison.
• The best-known and most-used purchasing power parity exchange rate is the
Geary-Khamis dollar (the "international dollar").
• PPP exchange rates (the "real exchange rate") fluctuations are mostly due to
market exchange rates movements.
Balance of payment theory
• The balance of payments theory of exchange rate is also named as general
equilibrium theory of exchange rate.
• According to this theory, the exchange rate of the currency of a country
depends upon the demand for and supply of foreign exchange.
• If the demand for foreign exchange is higher than its supply, the price of
foreign currency will go up. In case, the demand of foreign exchange is lesser
than its supply, the price of foreign exchange will decline.
• The demand for foreign exchange and supply of foreign exchange arises from
the debit and credit items respectively in the balance of payments.
• The demand for foreign exchange comes from the debit side of balance of
• The debit items in the balance of payments are import of goods and services
and loans and investments made abroad.
• The supply of foreign exchange arises from the credit side of the balance of
• It is made up of the exports of goods and services and capital receipts. If the
balance of payments of a country is unfavourable, the rate of foreign exchange
• On the other hand, if the balance of payments is favourable, the rate of
exchange will go up. The domestic currency can purchase more amounts of
Exchange Rate Systems
• Fixed exchange rates
• Flexible exchange rates
Fixed Exchange Rates
• Countries following the fixed exchange rate (also known as stable exchange rate and pegged
exchange rate) system agree to keep their currencies at a fixed, pegged rate and to change
their value only at fairly infrequent intervals, when the economic situation forces them to do
• Under the gold standard, the values of currencies were fixed in terms of gold. Until
the breakdown of the Bretton Woods System in the early 1970, each member country
of the IMF defined the value of its currency in terms of gold or the US dollar and
agreed to maintain (to peg) the market value of its currency within:!: I per cent of the
defined (par) value.
Flexible Exchange Rates
• Under the flexible exchange rate system, exchange rates are freely determined III on open
market primarily by private dealings, and they, like other market prices, vary from day-to-
• Under the flexible exchange rate system, the first impact of any tendency toward a surplus or
deficit in the balance of payments is on the exchange rate. surplus in the balance of payments
will create an excess demand for the tOlIl1try's currency and the exchange rate will tend to
rise. On the other hand, deficit in the balance of payments will give rise to an excess supply
of the country’s currency and the exchange rate will, hence, tend to fall.
• Automatic variations in the exchange rates, in accordance with the variation in the balance of
payment position, tend to automatically restore the balance of payments equilibrium.
Convertibility of the Rupee
• Free convertible-
• Partial convertibility -1992-93 in current account
• LERMS- Market rate and Official rate
• Free convertibility of a currency means that the currency can be exchanged
for any other convertible currency, without any restriction, at the market
determined exchange rates.
• Convertibility of the rupee, thus means that the rupee can be freely converted
into dollar, pound sterling', yen, Deutsche mark, etc. and vice versa at the
rates of exchange determined by the demand and supply forces.
• According the Liberalized Exchange Rate Management System (LERMS) introduced
in March 1992, 60 per cent of all receipts under current transactions (merchandise
exports and invisible receipts) could be converted at the free market exchange rate
quoted by the authorized dealers.
• The rate applicable for the remaining 40 per cent was the official rate fixed by the
• This 40 per cent of the total foreign exchange receipts under the current account was
exclusively meant to cover government needs and to import essential commodities.
• In addition, foreign exchange at official rate was to be made available to meet 40
percent of the value of the advance licenses and special import licenses.
• In short, it was a dual exchange rate system.
Why partial convertibility?
• To make foreign exchange available at a low price for essential prices.
• At times of large deficit in current account- it is risky to go for full convertibility
• To bring in a stability in rupee value
• One major reason for introducing partial convertibility was to make foreign exchange
available at a low price for essential imports so that the prices of the essentials would not be
pushed up by the high market price of the foreign exchange.
• It was risky to introduce full convertibility when the current account showed large deficit.
• While introducing the partial convertibility, the government announced its intentions to
introduce full convertibility on the current account in three to five years, However, full
convertibility on trade account was introduced by the Budget for 1993-94.
• The fact that the free market rate was ruling fairly stable at a reasonable Ievel might have
encouraged the government to introduce full convertibility.
Merits of convertibility
• Real value of rupee
• It encourages exports
• Encourages import substitutions
• Attracts remittances by NRIs
• It gives an indication of the real value of the rupee.
• It encourages exports by increasing the profitability of the exports
• Profitability increases as the free market rate is higher than the official exchange rate.
• It encourages those exports with no or less import intensity. As the proportion of the
imported inputs in the exportables increases, the prof-itability cause of the higher free market
exchange rate gets correspond-ingly reduced. This could encourage import substitution in
• The high cost of foreign exchange could encourage import substitution in other areas also It
provides incentives for remittances by NRIs.
• The convertibility and the liberalisation of gold imports have been ex-pected to make illegal
remittances and gold smuggling less attractive. thereby increasing the remittances through
• It is described as a self balancing mechanism because the total imports and other current
account payments will be confined to the. total current account receipts unless there are
imports financed by foreign currency loans.
• The money market in which Eurocurrency, currency held in banks outside of the
country where it is legal tender, is borrowed and lent .
Definition and background
• The Eurocurrency market consists of banks (called Eurobanks) that accept
deposits and make loans in foreign currencies.
• A Eurocurrency is a freely convertible currency deposited in a bank located in a
country which is not the native country of the currency.
• The deposit can be placed in a foreign bank or in the foreign branch of a
domestic US bank. [Note of caution! The prefix Euro has little or nothing to do
with the newly emerging currency in Europe.]
• In the Eurocurrency market, investors hold short-term claims on commercial
banks which intermediate to transform these deposits into long-term claims on
• The Eurocurrency market is dominated by US $ or the Eurodollar.
• Occasionally, during weak dollar periods (latter part of 1970s and 1980s), the
EuroSwiss franc and the EuroDM markets increased in importance.
• The Eurodollar market originated post WWII in France and England thanks to
the fear of Soviet Bloc countries that dollar deposits held in the US may be
attached by US citizens with claims against communist governments!
THRIVING ON GOVERNMENT REGULATION
By using Euromarkets, banks and financiers are able to circumvent / avoid certain
regulatory costs and restrictions. Some examples are:
a) Reserve requirements
b) Requirement to pay FDIC fees
c) Rules or regulations that restrict competition among banks
• Continuing government regulations and taxes provide opportunities to engage in
• However, ongoing erosion of domestic regulations have rendered the cost and return
differentials much less significant than before.
• As a result, the domestic money market and Eurocurrency markets are closely
integrated for most major currencies, effectively creating a single worldwide money
market for each participating currency.