The foreign exchange market (Forex, FX, or currency market) is a
global decentralized or over-the-counter (OTC) market for the trading of currencies.
This market determines foreign exchange rates for every currency. It includes all aspects
of buying, selling and exchanging currencies at current or determined prices. In terms
of trading volume, it is by far the largest market in the world, followed by the credit
market.
According to the Bank for International Settlements , foreign
exchange markets averaged US$6.6 trillion per day, forex industry
stands at $2.409 quadrillion (2019) comprises 170 different
currencies.
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Foreign exchange market and different economics scenarios.pdf
1. Foreign Exchange Market & Economic Scenarios
The foreign exchange market (Forex, FX, or currency market) is a
global decentralized or over-the-counter (OTC) market for the trading of currencies.
This market determines foreign exchange rates for every currency. It includes all aspects
of buying, selling and exchanging currencies at current or determined prices. In terms
of trading volume, it is by far the largest market in the world, followed by the credit
market.
According to the Bank for International Settlements , foreign
exchange markets averaged US$6.6 trillion per day, forex industry
stands at $2.409 quadrillion (2019) comprises 170 different
currencies.
The $6.6 trillion break-down is as follows:
•$2 trillion in spot transactions
•$1 trillion in outright forwards
•$3.2 trillion in foreign exchange swaps
•$108 billion currency swaps
•$294 billion in options and other products
Dr. Bhupendra Kumar , Professor Business & Economics , Debre Tabor University Ethiopia
2. The foreign exchange market is unique because of the following characteristics:
Its huge trading volume, representing
The largest asset class in the world leading to high liquidity;
Its geographical dispersion;
Its continuous operation: 24 hours a day except for weekends, i.e., trading from
22:00 UTC on Sunday (Sydney) until 22:00 UTC Friday (New York);
The variety of factors that affect exchange rates;
The low margins of relative profit compared with other markets of fixed income; and
The use of leverage to enhance profit and loss margins and with respect to account
size.
Traders include governments and central banks, commercial banks, other institutional
investors and financial institutions, currency speculators, other commercial
corporations, and individuals.
As such, it has been referred to as the market closest to the ideal of perfect
competition, notwithstanding currency intervention by central banks.
3. Top 10 Currency Traders & Currencies
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
6. US Dollar Dominance &How Long Will The U.S. Dollar Reign?
Today’s shifting geopolitical and economic
landscape presents challenges to the U.S.
dollar’s global status.
China has overtaken the U.S. as the world’s
major trading partner, and is looking to leverage
its power to expand the presence of the RMB.
Two factors that limit the RMB’s potential as an
international currency are tight government
controls and a lack of transparency.
Another threat to the USD’s dominance is the
use of financial sanctions, which limit foreign
access to the U.S. financial system. While these
sanctions may be effective from a foreign policy
perspective, they can also undermine the global
role of the USD.
America’s M2 money supply has grown
significantly since the 2008 global financial
crisis, and even more so during the COVID-19
pandemic. M2 includes cash, checking deposits,
and liquid vehicles such as money market
securities.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
7. US Dollar Dominance &How Long Will The U.S. Dollar Reign?
U.S. inflation is expected to accelerate .The U.S.
debt to GDP ratio is currently over 100%, and by
2050, it’s expected to reach 195%. With so much
debt being issued, sustained inflation can
gradually undermine the real value of these
liabilities. The tradeoff, of course, is a further
weakening of the U.S. dollar
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
10. Dollar dominance and the international adjustment to global risk
The US and the dollar play a special role in the global economy, both for trade and for financial flows (Rey 2013, Maggiori et
al. 2018, Gopinath 2020). The dollar’s dominance also manifests itself in times of elevated global risk. Figure 1 illustrates this
for the Global Financial Crisis and the early stage of the COVID-19 pandemic in March 2020. In both instances, global risk,
measured by the VIX, increases sharply while the dollar appreciates strongly. At a theoretical level, co-movement between the
dollar and measures of global risk can be rationalized on the ground that some US assets are particularly safe and/or liquid
(Farhi and Gabaix 2016, Bianchi et al. 2021, Jiang et al. 2021a).
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
11. 6000 BC – Barter System and The Introduction of Gold Coins
The Mesopotamia tribes introduced the oldest method of exchange, the barter system, in 6000 BC. The barter
system involved the exchange of goods via ships. As the system evolved, salt and spices emerged as the most
popular methods of exchange.
Introduced by Mesopotamia tribes, bartering was adopted by Phoenicians. Phoenicians bartered goods to those
located in various other cities across oceans. Babylonians also improvised their existing bartering system wherein
goods were exchanged for food, tea, weapons, and spices. The barter system saw a significant change with the
widespread adoption of gold coins in the 6th century BC.
Gold Coin became a mode of exchange because of its durability, divisibility, acceptability, and uniformity. The
wide popularity of metal as a medium of exchange formed the foundation of coinage. Ancient Egypt used gold
bars of predetermined weight from the 4th millennium BC and finally developed gold rings as currency3.
However, coinage was not part of foreign trade until the late 4th century AD.
Gold rings served dual purposes for a long time as an accessory and currency. Gold and silver bars which could be
cut into segments also supplemented gold coins. The availability of metal determined the material that would be
used. Coins or bars became a challenging mode of exchange in international trade because there was no
standardized method to ascertain their value.
This authentication problem could be solved by using coins produced by a single, trusted issuer. The first coin to
be widely accepted for international trade was the Aegina “turtle” coin, a silver coin minted on the island of
Aegina.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
13. History of USD-INR Exchange Rate
1947 till 1971,-Par value system :The Rupee’s external par value was fixed at 4.15 grains of fine gold
within the permitted margin of ±1% using pound sterling as the intervention currency.
The devaluation of the rupee in September 1949 and June 1966 in terms of gold resulted in the reduction of
the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. Since 1966, the
exchange rate of the rupee remained constant till 1971. With the breakdown of the Bretton Woods System, in
December 1971, the rupee was linked with pound sterling. Sterling being fixed in terms of US dollar under the
Smithsonian Agreement of 1971and than basket of Currencies ,confidential by the Reserve Bank to discourage
speculation. CAD 3% of GDP and Forex reserves USD 1 billion , BoP problems.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
14. Chronology of the Indian Exchange Rate
Year The Foreign Exchange Market and Exchange Rate
1947-1971 Par Value system of exchange rate. Rupee’s external par value was fixed in terms of gold with the pound sterling as the
intervention currency.
1971 Breakdown of the Bretton-Woods system and floatation of major currencies. Rupee was linked to the pound sterling in
December 1971.
1975 To ensure stability of the Rupee, and avoid the weaknesses associated with a single currency peg, the Rupee was pegged to a
basket of currencies. Currency selection and weight assignment was left to the discretion of the RBI and not publicly
announced.
1978 RBI allowed the domestic banks to undertake intra-day trading in foreign exchange.
1978-1992 Banks began to start quoting two-way prices against the Rupee as well as in other currencies. As trading volumes increased, the
‘Guidelines for Internal Control over Foreign Exchange Business’ were framed in 1981. The foreign exchange market was still
highly regulated with several restrictions on external transactions, entry barriers and transactions costs. Foreign exchange
transactions were controlled through the Foreign Exchange Regulations Act (FERA). These restrictions resulted in an extremely
efficient unofficial parallel (hawala) market for foreign exchange.
1990-1991 Balance of Payments crisis
July 1991 To stabilize the foreign exchange market, a two step downward exchange rate adjustment was done (9% and 11%). This was a
decisive end to the pegged exchange rate regime.
March 1992 To ease the transition to a market determined exchange rate system, the Liberalized Exchange Rate Management System
(LERMS) was put in place, which used a dual exchange rate system. This was mostly a transitional system.
March 1993 The dual rates converged, and the market determined exchange rate regime was introduced. All foreign exchange receipts could
now be converted at market determined exchange rates.
Source : Reserve Bank of India
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
15. The Report of the High Level Committee on Balance of Payments (Chairman Dr. C. Rangarajan) laid the
framework for a credible macroeconomic, structural and stabilization programme encompassing trade, industry,
foreign investment, exchange rate and the foreign exchange reserves. With regard to the exchange rate policy, the
committee recommended that consideration be given to
(i) A realistic exchange rate,
(ii) Avoiding use of exchange mechanisms for subsidization,
(iii) Maintaining adequate level reserves to take care of short-term fluctuations,
(iv) Continuing the process of liberalization on current account, and
(v) Reinforcing effective control over capital transactions.
The key to the maintenance of a realistic and a stable exchange rate is containing inflation through macro-
economic policies and ensuring net capital receipts of the scale not beyond the expectation.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
16. Determinants of Exchange rates
In a fixed exchange rate regime, exchange rates are decided by the government, while a number of theories have
been proposed to explain (and predict) the fluctuations in exchange rates in a floating exchange rate regime,
including:
•International parity conditions:
1- Relative purchasing power parity,
2- Interest rate parity
3- Domestic Fisher effect
4- International Fisher effect.
To some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these
theories falter as they are based on challengeable assumptions (e.g., free flow of goods, services, and capital)
which seldom hold true in the real world.
•Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the
increasing role of global capital flows. It failed to provide any explanation for the continuous appreciation of the
US dollar during the 1980s and most of the 1990s, despite the soaring US current account deficit.
•Asset market model : It views currencies as an important asset class for constructing investment portfolios. Asset
prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn
depends on their expectations on the future worth of these assets. The asset market model of exchange rate
determination states that “the exchange rate between two currencies represents the price that just balances the
relative supplies of, and demand for, assets denominated in those currencies.”
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
17. None of the models developed so far succeed to explain exchange rates and volatility in the
longer time frames. For shorter time frames (less than a few days), algorithms can be devised
to predict prices.
It is understood from the above models that many macroeconomic factors affect the exchange
rates and in the end currency prices are a result of dual forces of supply and demand.
The world's currency markets can be viewed as a huge melting pot: in a large and ever-
changing mix of current events, supply and demand factors are constantly shifting, and the
price of one currency in relation to another shifts accordingly. No other market encompasses
(and distills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any
single element, but rather by several. These elements generally fall into three categories:
1. Economic factors,
2. Political conditions and
3. Market psychology.
Determinants of Exchange rates
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
18. • Economic factors
• Economic factors include: (a) economic policy, disseminated by government agencies and central banks, (b) economic
conditions, generally revealed through economic reports, and other economic indicators.
• Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by
which a government's central bank influences the supply and "cost" of money, which is reflected by the level
of interest rates).
• Government budget deficits or surpluses: The market usually reacts negatively to widening government budget
deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
• Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services,
which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and
services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on
a nation's currency.
• Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if
inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that
particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that
the central bank will raise short-term interest rates to combat rising inflation.
• Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others,
detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's
economy, the better its currency will perform, and the more demand for it there will be.
• Productivity of an economy: Increasing productivity in an economy should positively influence the value of its
currency. Its effects are more prominent if the increase is in the traded sector
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
19. • Political conditions
• Internal, regional, and international political conditions and events can have a profound
effect on currency markets.
• All exchange rates are susceptible to political instability and anticipations about the new
ruling party. Political upheaval and instability can have a negative impact on a nation's
economy.
For example, destabilization of coalition governments in Pakistan , Russia, Ukraine,
Thailand can negatively affect the value of their currencies. Similarly, in a country
experiencing financial difficulties, the rise of a political faction that is perceived to be
fiscally responsible can have the opposite effect.
Also, events in one country in a region may spur positive/negative interest in a neighboring
country and, in the process, affect its currency.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
20. • Market psychology
Market psychology and trader perceptions influence the foreign exchange market
in a variety of ways:
Flights to quality: Unsettling international events can lead to a "flight-to-quality", a type
of capital flight whereby investors move their assets to a perceived "safe haven". There
will be a greater demand, thus a higher price, for currencies perceived as stronger over
their relatively weaker counterparts. The US dollar, Swiss franc and gold have been
traditional safe havens during times of political or economic uncertainty
Long-term trends: Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may
rise from economic or political trends.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
21. • Market psychology
"Buy the rumor, sell the fact": This market truism can apply to many currency situations. It
is the tendency for the price of a currency to reflect the impact of a particular action before it
occurs and, when the anticipated event comes to pass, react in exactly the opposite direction.
This may also be referred to as a market being "oversold" or "overbought".
To buy the rumor or sell the fact can also be an example of the cognitive
bias known as anchoring, when investors focus too much on the relevance of
outside events to currency prices
Economic numbers: While economic numbers can certainly reflect economic policy, some
reports and numbers take on a talisman-like effect: the number itself becomes important to
market psychology and may have an immediate impact on short-term market moves. "What
to watch" can change over time. In recent years, for example, money supply, employment,
trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations: As in other markets, the accumulated price movements in
a currency pair such as EUR/USD can form apparent patterns that traders may attempt to
use. Many traders study price charts in order to identify such patterns.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
22. Financial instruments for Forex market
Spot : A spot transaction is a two-day delivery transaction (except in the case of trades between the US
dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which settle the next business day), as
opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange”
between two currencies, has the shortest time frame, involves cash rather than a contract, and interest is
not included in the agreed-upon transaction. Spot trading is one of the most common types of forex
trading. Often, a forex broker will charge a small fee to the client to roll-over the expiring transaction into
a new identical transaction for a continuation of the trade. This roll-over fee is known as the "swap" fee.
Forward: One way to deal with the foreign exchange risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A buyer and seller
agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of
what the market rates are then. The duration of the trade can be one day, a few days, months or years.
Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by
both parties.
Non-deliverable forward (NDF) : Forex banks, ECNs, and prime brokers offer NDF contracts, which are
derivatives that have no real deliver-ability. NDFs are popular for currencies with restrictions such as the
Argentinian peso. In fact, a forex hedger can only hedge such risks with NDFs, as currencies such as the
Argentinian peso cannot be traded on open markets like major currencies.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
23. Swap: The most common type of forward transaction is the foreign exchange swap. In a swap, two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not
standardized contracts and are not traded through an exchange. A deposit is often required in order to hold the
position open until the transaction is completed.
Futures: Futures are standardized forward contracts and are usually traded on an exchange created for this
purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest
amounts.
Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged
on a specific settlement date. Thus the currency futures contracts are similar to forward contracts in terms of
their obligation, but differ from forward contracts in the way they are traded. In addition, Futures are daily
settled removing credit risk that exist in Forwards. They are commonly used by MNCs to hedge their currency
positions. In addition they are traded by speculators who hope to capitalize on their expectations of exchange
rate movements.
Option: A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has
the right but not the obligation to exchange money denominated in one currency into another currency at a pre-
agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market
for options of any kind in the world.
Financial instruments for Forex market
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
24. Speculation
Controversy about currency speculators and their effect on currency devaluations and national economies recurs
regularly. Economists, such as Milton Friedman, have argued that speculators ultimately are a stabilizing
influence on the market, and that stabilizing speculation performs the important function of providing a market
for hedgers and transferring risk from those people who don't wish to bear it, to those who do.
Other economists, such as Joseph Stiglitz, consider this argument to be based more on politics and a free market
philosophy than on economics.
Large hedge funds and other well capitalized "position traders" are the main professional speculators. According
to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger
and better informed actors.
Currency speculation is considered a highly suspect activity in many countries. While investment in traditional
financial instruments like bonds or stocks often is considered to contribute positively to economic growth by
providing capital, currency speculation does not; according to this view, it is simply gambling that often
interferes with economic policy. For example, in 1992, currency speculation forced Sweden's central bank,
the Riksbank , to raise interest rates for a few days to 500% per annum, and later to devalue the krona.
Mahathir Mohamad, one of the former Prime Ministers of Malaysia, is one well-known proponent of this view.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
25. Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce"
international agreements and anticipate the effects of basic economic "laws" in order to profit. In this view,
countries may develop unsustainable economic bubbles or otherwise mishandle their national economies, and
foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even
be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad
and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the
unsustainable economic conditions.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
26. Why are Parity Models Important?
• Testing the “correctness” of a spot rate.
• Could be important for a trading strategy.
• Is the currency overvalued or undervalued?
• Overvalued: perhaps a sell short strategy.
• Undervalued: perhaps a buy long strategy.
• Establishing a future spot rate
• Could be important for:
• International capital budgeting decisions
• Converting estimated foreign currency cash flows into MNC’s home currency as part of the capital
budgeting process (location decision).
• Investment and Financing decisions
• Converting estimated investment inflows from investments into home currency equivalents and
converting estimated financing outflows into home currency equivalents.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
27. What are Parity Models?
• Parity is defined as a state of equilibrium.
• Foreign exchange parity models “estimate” what the equilibrium spot
exchange rate should be (under the model’s assumptions):
• (1) Is today’s spot rate appropriate?
• (2) What might the spot rate be in the future (forecasting future spot rates).
• Generally involving a long term forecasting horizon.
• Parity models have an economic basis (i.e., theory) for their spot rate
determination.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
28. Purchasing Power Parity Theory
• The Purchasing Power Parity (PPP) explains and quantifies the relationship
between inflation and spot exchange rates.
• The theory of Purchasing Power Parity says that in the long run, differences in
inflation rates between countries are transmitted through changes in relative
exchange rates. I
• The theory states that the spot exchange rate between two currencies should
be equal to the ratio of the two countries’ price levels.
• Idea was first proposed by the classical economist, David Ricardo, in the 19th century.
• The concept was expanded by the Swedish economist, Gustav Cassel, during the years
after WW1 (1918 -) when countries in Europe were experiencing hyperinflation.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
29. Two Forms of PPP
• Absolute PPP:
• At a point in time, the equilibrium spot exchange rate is that rate
which results in the prices of similar goods in two different countries
being equal.
• This form of the PPP can be used to test how “appropriate” a current spot
exchange rate is and to indicate a future move in the exchange rate.
• Relative PPP:
• Over time, the change in the exchange rate between two currencies
should be equal to the rate of change in the prices of similar goods
between the two countries.
• This form of the PPP is used to forecast the equilibrium spot exchange rate in
the future and generally over a long time horizon.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
30. Rationale Behind the PPP: The Law of One Price
• The Purchasing Power Parity model is based on the Law of One Price:
• The Law of One Price states that all else equal (i.e., no transaction costs or other
frictions, like tariffs or cultural differences) a product’s price (adjusted by the
exchange rate) should be the same in all markets.
• Why will the product’s price be the same?
• The principle of competitive markets assumes that prices will equalize as consumers shift their
purchases to those markets (or countries) where prices are the lowest.
• Also arbitrage activities will (might) result in similar prices.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
32. Relative Purchasing Power Parity
• The second PPP model, the Relative Purchasing Power Parity model, is
concerned with the “change” in the exchange rate over time.
• The Relative Purchasing Power is not assessing the “correctness” of the
current spot rate.
• The relative PPP model suggests that spot exchange rates move in a
manner opposite to the inflation differential between the two
countries.
• Specifically, the Relative PPP model suggests that the percent change in a spot
exchange rate should be equal to, but opposite in direction to, the difference
in the rates of inflation between countries.
• This is a model which may be used to forecast an actual future spot rate.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
34. • Foreign exchange risk is the risk that the value of an asset or liability will change because of a change
in exchange rates.
• Because these international obligations span time, foreign exchange risk can arise.
• Sources of Risk
• Transaction Exposure: The risk that the domestic cost or proceeds of a transaction
may change.
• Translation Exposure: The risk that the translation of value of foreign-currency-
denominated assets is affect by exchange rate changes.
• Economic Exposure: The risk that exchange rate changes may affect the present
value of future income streams.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
35. Forward Premium
• The difference between the spot and forward rates is expressed as the standard (or
annualized) forward premium or discount.
• The standard premium is calculated as the difference between the two rates as a
percent of the spot rate, which is then annualized (simple basis).
For example, suppose the spot rate is 1.6035 ($/£) and the 3-month forward rate is
1.6050.
The forward premium on the pound is:
[(1.6050-1.6035)/1.6035]*(12/3)*100 = 0.37%
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
36. Example
• For example, suppose the spot rate is 1.6035 ($/£) and the 3-month
forward rate is 1.6050.
• The forward premium on the pound is:
[(1.6050-1.6035)/1.6035]*(12/3)*100 =
0.37%
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
37. S0 = Current spot
S1 = Expected future spot
hb = Inflation rate in country for which the spot is quoted
(base currency)
hc = Inflation rate in the other country. (counter currency)
F0 = Forward rate
ib = interest rate for base currency
ic = interest rate for counter currency
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
43. Capital Flows and Exchange Rates: The Indian Experience
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
44. The balance of payments (BOP) of a country records all economic transactions of a country (that is, of its
individuals, businesses and governments) with the rest of the world during a defined period, usually one
year.
These transactions are broadly divided into two heads – current account and capital account.
The current account covers exports and imports of goods and services, factor income and unilateral
transfers.
The capital account records the net change in foreign assets and liabilities held by a country.
Convertibility refers to the ability to convert domestic currency into foreign currencies and vice versa to
make payments for balance of payments transactions.
Current account convertibility is the ability or freedom to convert domestic currency for current account
transactions while capital account convertibility is the ability or freedom to convert domestic currency for
capital account transactions.
The Tarapore Committee (2006), for instance, defined capital account convertibility as the “freedom to
convert local financial assets into foreign financial assets and vice versa.”
The degree of BOP convertibility of a country usually depends on the level of its economic development
and degree of maturity of its financial markets. Therefore, advanced economies (AEs) are almost fully
convertible while emerging market economies (EMEs) are convertible to different degrees.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
45. Free capital mobility, or internationalization of capital markets is commonly recognized
as an engine of global growth. Specifically, benefits of internationalization of capital
markets are well accepted, in terms of broadening the investor base for recipient country
financial assets, improved liquidity in financial markets and positive pressures for market
infrastructure and market practices. International capital markets, by enabling access to a
global savings pool and to different currencies, can potentially reduce borrowing costs,
facilitate better risk allocation and enhance global liquidity (OECD, 2017).
The various currency and banking crises experienced over the last few decades have
simultaneously highlighted the costs and risks of internationalization such as exposure to
global shocks, credit and asset bubbles, exchange rate volatility associated with sudden
exit of capital and higher refinancing risk. Increased globalization has brought to the fore
the vulnerability to contagion effects. While it was argued that such risks are the short-
term pains needed to reap long term gains (Kaminsky and others, 2008).
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
46. There is now a wider acceptance that benefits of internationalization are not an unmixed
blessing and that there is a nuanced trade off between growth and crisis risk. Such
awareness has led to policy focus on three fronts.
• a. First, that benefits of internationalization presupposes sound macroeconomic
fundamentals, a well developed financial system and a sound market infrastructure,
including efficient markets for funding and risk transfer.
• b. Second, that countries need to develop appropriate tools to deal with the risks of
internationalization, in particular, tools to manage the volume and composition of
capital inflows and macro prudential tools.
• c. And third, that different types of capital flows carry different risks – some are riskier
than others. The agreed hierarchy of capital flows is that foreign direct investment is
the least risky, followed by equity investment, followed by debt capital. While FDI is
seen to contribute to long-run growth, portfolio equity gives a shorter run boost. Debt
flows, while necessary, are susceptible to be volatile. Understandably, the focus of
capital flow regulations, and macro-prudential regulations, has been debt flows.
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
49. References
• Kumar Sanjeev, Kumar B. et al. (2022). The continuous investment in artificial intelligence and its impact on ensuring customer satisfaction. Korea review of international studies, ISSN - 1226-4741
Volume 15, Special Issue 03
• Kumar Sumit, Kumar B. et al. (2022). Application of blockchain technology as a support tool in economic & financial development. Manager- The British Journal of Administrative Management,
ISSN:1746-1278, Volume 58 Special Issue 01
• Kumar B. et al. (2022). The Role of IOT and Cyber Warfare in Developing the Health Care Devices. Mathematical Statistician and Engineering Applications, Page Number: 1185-1194 Publication
Issue: Vol. 71 No. 3s (2022)
• Bala B., Kumar B. et al.(2021). Cyber Security in African Union and Ethiopia and Its anticipation. International Journal of Mechanical Engineering, ISSN: 0974-5823 Vol. 6 (Special Issue, Nov.-Dec.
2021)
• Kumar B. et al. (2022). The Role of IOT and Cyber Warfare in Developing the Health Care Devices. Mathematical Statistician and Engineering Applications, Page Number: 1185-1194 Publication
Issue: Vol. 71 No. 3s (2022)
• Bala B., Kumar B. et al.(2021). Cyber Security in African Union and Ethiopia and Its anticipation. International Journal of Mechanical Engineering, ISSN: 0974-5823 Vol. 6 (Special Issue, Nov.-Dec.
2021)
• Kumar Bhupendra (2016). Exchange traded fund in India - Performance analysis with mutual fund and global perspectives. International Journal of Marketing & Financial Management, Volume 4,
Issue 7, Oct-2016, pp 22-35, ISSN: 2348 –3954 (Online) ISSN: 2349 –2546 (Print)
• Rajshree Sharma, Shivani Gupta, Bhupendra Kumar (2016). Satyam computer scam – pre and post diagnosis. International Journal of Marketing & Financial Management, Volume 4, Issue 9, Dec-
2016, pp 53-68 ,ISSN: 2348 –3954 (Online) ISSN: 2349 –2546 (Print)
• Rajesh Kumar, Kumar Bhupendra (2018). Study on role of banking institutions in rural development – an evaluation. International Journal of Marketing & Financial Management, Volume 6, Issue 1,
Jan -2018, pp 52-57 , ISSN: 2348 -3954 (Online) ISSN: 2349 - 2546 (Print)
• Kumar B. (2021). Determinants of internet financial reporting: in the case of Ethiopian insurance and banking sector companies. Innovations , Journal article
• Kumar B.(2020). Determinants of dividend payout ratio: empirical evidence from Ethiopian private banks. Palarch’s Journal of Archaeology of Egypt/Egyptology
• Kumar B. (2019). The effect of remittance on economic growth of eastern African countries. International Journal of Social Science & Management Studies Vol. - 6, No. – 1 Page-13-26
• Kumar Bhupendra (2011). Special Economic Zones – a comparative study of export and FDI performance with India. Metamorphosis- A Journal of Management Research, Vol. 2, pp. 18-28
Dr. Bhupendra Kumar Debre Tabor University Ethiopia
50. • Kumar B. (2021). Innovation in corporate cash holding & management: an empirical investigation. Empirical Economics
Letters, ISSN 1681 8997
• Kumar B. & D. Singh (2021). The impact of branch expansion dimensions on deposit mobilization with special reference
Dashen bank S.C, Ethiopia. International Journal of Mechanical Engineering I ISSN: Vol. 6 P.625-636
• Srivastava A.K., Kumar B. et al. (2014). Special Economic zones- Overview on Growth and Export performance. European
Journal of Academic Essays 1(9): 15-19, 2014 ISSN (online): 2183-1904 ISSN (print): 2183-3818
• G. B. Bezabh , Kumar B. (2020). The Effect of Remittance on Economic Growth of Eastern African Countries.
International Journal of Social Science & Management Studies, ISSN : 2454 - 4655, Vol. - 6, No. – 1, Feb. 2020 Page-13-
26
• Abebaw Yenesew, Kumar B. (2018). A study of micro finance institutions and their financial performance with special
reference to Ethiopia. International Journal of Research and Analytical Reviews, Volume 5, Special Issue, April 2018, E-
ISSN 2348 –1269, Print ISSN 2349-5138
• Umamaheswari K. , Kumar B., et al. (2021). Money Management Among the Individual Working Personnel in India – A
Study with Special Reference to Coimbatore District. PSYCHOLOGY AND EDUCATION, 58(2): 376-389,
www.psychologyandeducation.net
• Neha Saini, Kumar Bhupendra, et al. (2017). A Conceptual study of Micro Finance in India. International Journal of
Marketing & Financial Management, Vol. 5, pp. 75-82. ISSN: 2348 -3954 (Online) ISSN: 2349 - 2546 (Print).
• Kumar T., Kumar B. et al. (2022). Optimal Facial Feature Based Emotional Recognition Using Deep Learning Algorithm.
Computational Intelligence and Neuroscience. Hindawi Volume 2022, Article ID 8379202, 10
pageshttps://doi.org/10.1155/2022/8379202
• Kumar B. (2022) . The Impact of Covid 19- Towards Insurance and its Benefits to the Public. Mathematical Statistician and
Engineering Applications ISSN: 2094-0343 2326-9865 . Page Number: 1484 – 1491 Publication Issue: Vol. 71 No. 3s (2022)
Dr. Bhupendra Kumar Debre Tabor University Ethiopia