Foreign exchange

Foreign
Exchange
PREPARED BY
UMAIR

Introduction to Foreign Exchange
In simple words we can say that:
Foreign Exchange means the currency of other
countries. Not technically it means foreign currency.
In other words:
“It may be thought of as the means of which mutual
indebtedness of the nation is paid of.”
According to Encyclopedia Britannica:
“The system by which commercial nations discharge
their debts to each other”

Introduction to Foreign Exchange
According to Hartley Whither
“A mechanism by which international indebtedness is
settled between one country and another.”
According to H.E. Evitt:
“The means and methods by which rights of wealth
expressed in terms of the currency of one country are
converted into rights to wealth in terms of the currency
of another country are known as foreign exchange.”

Foreign Exchange Market
Definitions:
It is a market in which the currencies of different
countries are traded against each other, just like
the trading of goods and services in an ordinary
market.
In foreign exchange market it is one countries’
money that in exchanged for another countries
money.

Foreign Exchange Market
Definitions:
In words of Kindlebeger:
“Foreign exchange market is a place where foreign
money is bought and sold.”

Need of Foreign Exchange
Market
Money is essential for the smooth running of
every modern economy. Every govt. has her own
authorized currency. However, the currency of a
particular country is acceptable only in the
geographical boundaries of that particular
country. So if you purchase wheat form USA, you
are bound to make payment in US$.

Features of Foreign
Exchange Market:
Foreign exchange market resembles very mush to
our usual markets.
1. Medium of Exchange is $:
2. Sensitivity:

1. Medium of Exchange is $.
Every market has a medium of exchange which is
also legal tender prevailing in that country. You
can trade with the help of ‘rupee’ in any market
situated anywhere in Pakistan. Similarly one can
purchase any commodity against ‘pound’ form any
market situated in UK.

2. Sensitivity:
Foreign exchange market can be called the most
sensitive market. It has its effects on the whole
capital market of the country and variety of
factors have their direct effects in the working of
this market.

Function of Foreign Exchange
Market
The most important function of the foreign exchange
market is the determination of exchange rate.
1. Determination of Exchange Rate:
Exchange rate are determined in the foreign
exchange market.
Demand Side:
(a) Pak Exports:
(b) Capital Inflows:
(c) Reserve Currency:

(a) Pak Exports:
One important reason for the demand of
Pak rupee in international foreign
exchange market is our exports. This
demand comes form those people who
wish to purchase our exported goods.

(b) Capital Inflows:
The Second source comprises those
people, firms who wish to purchase
Pakistan’s assets. In order to buy any
asset in Pakistan, they first have to
convert their currencies in rupees. So
capital inflows are accompanied by the
demand for local currency.

Government often hold and accumulate
foreign exchange reserves. Just as we
people hold savings account. The
government of some countries say
"Turkey” may decide to increase her
holdings of “Rupees”. Then in this case
she will be demanding rupees.

Supply Side:
(a)Imports:
(b)Capital Outflows:
(c)Reserve Currency:

(a) Imports:
The main source of supply of ‘rupee’ is
the imports to Pakistan. Suppose I wish
to purchase a Japanese radio. Then I
will be supplying ‘rupees’ and
purchasing Japanese Yens.

(b) Capital Outflows:
Capital outflows will also result in the
supply of rupees. For instance, a
Pakistani citizen may with to purchase
assets in UAE. Now the will be
supplying rupees to purchase Dirham.

Also if a country holding rupees as
foreign exchange reserves may decide
that they offer poor return and that it
should sell these rupees to buy any
other currency. In this case, such a
country will be supplying rupees.

The Shape of Demand Curve for
Rupees.
The demand for rupees in terms of any
other currency say £can be shown by a
negatively sloped demand curve. Now
why the demand curve for rupees in
negatively slopped? The answer is as
follows. The demand in rupee arise from
our exports.

The Shape of Demand Curve for
Rupees.
The Supply curve for rupees is positively
sloped. The reason for this is as follows.
When the rupee falls in value, rupee price of
all the important goods rises. It takes more
rupees to purchase a single £. So Pakistani
citizen will buy less / fewer imported goods
and will supply less rupees.

Aggregate Demand & Supply:
The sum total of all the sources of demand
give us aggregate demand for rupees.
AD is the aggregate demand for rupees.
AS is the aggregate supply of rupees.

II. Transfer Function:
The foreign exchange market transfers the
purchasing power between countries. If at
same level of exchange rate and general price
level, a currency has more purchasing power
at home then aboard, then the people will try
to accumulate local currency to take
advantage of local cheaper goods.

III. Credit Function:
This refers to the working of foreign exchange
bills. By this, the exchange market provides
credit to the debtors or importers. During an
international trade, the exporters can draw the
bill of exchange on importers. On acceptance
of this bill of exchange. The exporters can get
the payment at the time of maturity of the bill
or they can also discount them.

Factors Influencing Foreign
Exchange
Foreign exchange market is a very sensitive
market so are the foreign exchange rates. A
variety of factors have their direct influence on
foreign exchange market and the exchange
rates which are determined in these markets.
Following are some of the important factors
which have their direct influence on exchange
rates.

Factors Influencing Foreign
Exchange
1. Changes in Price Levels
2. Capital Movement:
3. Speculations:
4. Exports and Imports:
5. Structural Changes:
6. Political Stability:
7. Exploration of Natural Reserves:
8. Influence of Bank Rates:
9. Stock Exchange Influence:

1. Changes in price Levels:
Price level of a country plays a significant role
in determining the trends of exchange rate.
Take the case of 2 countries Pakistan and
England. If the price level in Pakistan rises
due to inflation, this means that our goods
have now become more expensive.

2. Capital Movement:
Capital movements across borders of
countries exert strong influences over
exchange rates. In a country where capital is
flying in at a high rate, the currency
appreciate. On the other hand, the currency of
the country form where the capital flies out,
depreciates also, if any country attracts
investments form aboard then the currency of
the country will appreciate.

3. Speculations:
Uncertainty about future exchange rate
induces people to speculate about them. This
also influences exchange rates. If foreigners
expect ‘rupee’ to appreciate, they will rush to
buy Pakistani assets, and goods that are
denominated in rupees. This will increase the
current demand for rupees and hence rupees
will appreciate.

4. Exports and Imports:
Volume of exports and imports of a country
also produce significant changes on exchange
rates. If exports of country are higher than its
imports, then this means that demand for the
currency of this country is also high.

5. Structural Changes:
Structural changes refer to the changes and
improvement in the state of technology,
innovations, inventions of new products and
new ways of producing old products. All these
advancements lead to the change in the
pattern of comparative advantage.
Innovations and advancements results in the
productions of new and improved products
which attracts thousands of new customers.

6. Political Stability:
Political stability, sound infrastructure,
security, uncertainty about future ---- and
these factors play significant role in the
determination of exchange rate. If there is
political stability in a country, returns are
healthy, future is predictable then such
country attracts investments from all over the
world.

7. Exploration of natural
Reserves:
When a country explores more neural
resources, it takes a further step towards self
sufficiency and independence which means
less reliance on others. This also effects
exchange rates.
For instance assume that Pakistan fulfills 75%
of its total petrol consumptions demand from
outside and only 25% is produced locally.

8. Influence of Bank Rates:
The banking operations and variations in the
bank rates also influence exchange rates. If
bank rate is high, borrowing will be expensive
and funds form outside the country will flow –
in to earn high return. This will lead to the
appreciation of currency.

9. Stock Exchange Influence:
Working and status of stock exchange
markets also influence exchange rates. If in a
country, there is an active capital market and
healthy business of stocks, shares,
debentures is going on then funds will flow in
to take advantage of these factors.

Conclusion:
These are the factors which normally effect
exchange rates. In real world, the situation is
not so simple. Besides these, many other
apparently irrelevant factors can also produce
serious effects on the exchange rate.

Exchange Rate System
There are basically two types of exchange
rate system. Fixed exchange rate system and
floating exchange rate system. These are
explain below.
1. Fixed Exchange Rate System:
2. Floating Exchange Rate System:

1. Fixed Exchange Rate System:
Meaning & History:
Under the fixed exchange rate system, the
exchange rate is fixed. But it is not absolutely
fixed, rather fixation of rate means that it is
only allowed to fluctuate between some limits.
The fixed exchange rate system was adopted
by majority of countries of world (except the
Communist block) after world war II. The
decision was taken in the Bretton Woods
conference of 1944 and it was supported by
international monetary fund.

Advantages of Fixed Exchange
System:
Following are the advantages of this
system.
 It ensures better control over the
exchange rates.
 It allows more powers to central bank
so that it can exert considerable
influence of BOP (Balance of Payment)
or other macro economic variables.
 It provides the hedge against
unnecessary depreciation of currency.
 It eradicates the speculative business to
a great extend.

disadvantages of Fixed
Exchange System:
Following are the advantages of this system.
 First of all it reduce the central bank
liquidity. This is because central bank
always has to hold huge gold and
exchange reserves just for the buying
selling of home currency in home market.
 The system does not give any method of
changing the rate once fixed initially. The
need to change the rate arises in
response the fundamental disequilibrium
in country's balance of payments.

Conclusion:
The system remained in force in major part of
the world after the world war II. However
afterwards the instability arises due to the major
reason that this system had reduced the world’s
liquidity. After the sterling devaluation in 1967,
many leading economists of world started
advocating for flowing rate system.

2. Floating Exchange Rate
System:
The idea behind this is simple. In case the
disequilibrium occurs and there is either
an upward or downward pressure on the
exchange rate, it is allowed to float freely.
Central bank does not intervene in the
foreign exchange market to buy or sell
local currency. The theory says that once
an equilibrium is altered, the forces of
market i.e., demand and supply will come
into play and a new equilibrium will be
soon found.

Advantages of Floating
Exchange Rate System:
The major advantage is that it has
increased the world’s liquidity. Central banks
are no longer required to hold huge gold and
exchange reserves for the foreign exchange
market operations and hence these reserves
can be used in other productive areas.
In this system, the exchange rate
management is automatically done by the
market, so it is argued that government can
focus her attention on domestic policies.

Disadvantages of Floating
Exchange Rate System:
 This system gives rise to massive speculation
as the rates are not controlled by any central
authority the speculators work freely in such
system.
 Another disadvantage is that traders feel
problem under such system, as rates are
constantly changing. For this reason, forward
exchange rates are widely used by traders
under such system.
 This system is also dangerous in the aspect
that it can rob the economic policies of the
government. Further as in this system, there is
no intervention from any central authority, there
is a risk of collapse of the currency.

Kinds of Exchange rates:
Rate of exchange depends not only on
actual worth of currencies but also on
ongoing circumstances and events. It also
depends on nature of transaction for
which rate is being calculated.
1. Spot Rate:
2. Forward Rate:
3. Selling / Buying Rate:
4. Inter Bank Rate:
5. Official Rate:

1. Spot Rate:
It means the rate at the spot or at he
moment. If you go to any currency dealer
and ask him the exchange rate, he will
give you the spot rate.

2. Forward Rate:
Forward rates are related to future
deliveries or transactions. They in fact
provide hedge against anticipated
devaluation to importer, Suppose Mr. A
has entered into a trade deal whereby Mr.
X in America will sent him 100 cars in 3
months Mr. A knows that in case
devaluation occur in future 3 months, he
will have to pay more rupee and his cost
of purchase will rise.

3. Selling / Buying Rate:
Selling rate is one at which currency
dealers sell the foreign exchange. Buying
rate is one at which they are willing to buy
foreign exchange. Normally the selling
rate is little bit higher than buying rate, for
example if the buying rate is Rs. 60.25 per
dollar then the selling rate will might be
about 60.45.

4. Inter Bank Rate:
It is the rate at which central bank and
commercial banks sell and buy foreign
exchange in the inter bank market.

5. Official Rate:
It is the rate which is issued by the central
bank and at which all trade dealings take
place.

Instruments of Making Foreign
Payments
We know that currency of our country is
not a legal tenders in other countries and
hence it will no be accepted abroad in
discharge of debts and obligations. All
importers face this problem that their
exporter in other countries require
payments in their homeland currency.

Instruments of Making Foreign
Payments
1. Letter of Credit
2. Bill of Exchange
3. Cable Transfer, Mail Transfer
4. Travellers Cheque:
5. Foreign Bank Draft:
6. International Money Order:

1. Letter of Credit:
A letter of credit or LC as it is often called
is most widely used instrument that
ensures maximum safety and reliability.
In words of Pritchard.
“ A letter of credit is a commitment on the part
of buyer’s banks to pay or accept drafts
drawn upon it, provided drafts do not exceed
a specified amount”.

2. Bill of Exchange:
A bill of exchange is just like a post dated
cheques. The only difference is that a bill
of exchange can be discounted at the
bank but a post dated cheque can’t be
discounted. A bill of exchange is an order
from the drawer to the drawee to pay a
certain sum of money on demand or on
certain specified date.

3. Cable Transfer, Mail
Transfer:
Cable transfer and mail transfer are
traditionally used instruments for making
payments abroad. Banks have been
sending messages to other banks in other
countries through mail or cable since
long. ‘Cable transfer’ involves a
telegraphic order while written messages
are sent via mail in ‘mail transfer’.

4. Travellers Cheque:
Travellers cheques are commonly called
TCs. The basic purpose is to ensure
safety in transmission of cash. However
they are also used as instrument of
foreign payment. In actual a TC is an order
drawn by a bank in its own branch to pay
the sum of money (as determined by the
value of TCs) on demand to the purchaser
of TCs.

5. Foreign Bank Draft:
Foreign bank drafts work in same way as
the ordinary bank drafts. In actual, it is an
order drawn by a bank on its branch in
foreign country to pay a certain amount of
money on demand to the bearer of draft or
to the order of the bearer.

6. International Money Order:
International money order also works in
the same way as a local money order. It is
widely used by the people working aboard
to send money to homeland.

Exchange Control
Meaning:
Broadly speaking the Exchange Control
refers to those action which a government of
a country adopt to effect exchange rates.
Objective of Exchange Control:
Exchange controls are basically
implemented to safe guard the interest of
whole of the economy. Their basic aim is to
maintain the exchange value of the local
currency, but they also help in curing other
economic and fiscal ills.

Exchange Control
1. Stabilization of Exchange Rate:
2. Foreign Payment:
3. Protectionism:
4. Balance of Payment
5. Safeguarding Foreign Exchange
Reserve.
6. Watch Eye on Capital Movements.
7. Forming Cartels
8. Under Valuation:
9. Over Valuation:
10. Source of Income

1. Stabilization of Exchange Rate:
The basic object is to stabilize and
maintain exchange rate. Such controls
help the central bank to maintain
exchange rates without spending precious
reserves on buying and selling of local
currency.

2. Foreign Payment:
Exchange controls are exercised with the
intention to accumulate enough funds for
making foreign payments.

3. Protectionism:
Exchange controls are an important tool
of protectionism policies. They are used
to protect and flourish the home industry
against foreign competitive firms.

4. Balance of Payment
Exchange controls are used to turn the
balance of payments favorable by
reducing BOP deficit. Exchange control
policy may be aimed at increasing inflows
and reducing outflows.

5. Safeguarding Foreign
Exchange Reserve:
Government hold foreign exchange
reserves, just as we people hold bank
deposits and saving certificates. Such
foreign exchange reserves are of vital
importance for the government.

6. Watch Eye on Capital
Movements:
Capital flights in and out of the country
are of vital importance. Sometimes the
economic situation is such that the
returns are not healthy and future is non-
predictable.

7. Forming Cartels:
Exchange controls can be used mutually
by group of countries to form cartels for
their mutual benefits. Under cartels, the
group of some countries gain economic
advantages at the expense of others.

8. Under Valuation:
It means to fix a rate, lower then it would
be in a free floating exchange system. The
basic aim for under valuation is the
protection of local industry and favour of
local exporters.

9. Over Valuation:
This is appreciation i.e., the exchange rate
is fixed over and above its normal level.
This policy is adopted in following cases.
When a country has a massive foreign
debt an appreciation will lessen the
burden of debt.
When supply of local currency is
extraordinary higher than its demand.
When country is facing high inflation.
When the BOP shows extremely
unfavorable situations.

10. Source of Income:
Exchange controls are also source of
income for the government. Since during
exchange controls, the government
directly retains the foreign exchange and
as foreign exchange is directly sold by
government so difference between buying
and selling rate goes to the government
as income.

Methods of Exchange Control
The basic theory of exchange control is
that the government orders to all exports
and foreign exchange dealers, brokers
etc. to surrender all their foreign exchange
directly to the central bank.
Different method of exchange control are
as follows:

Methods of Exchange Control
1. Exchange Pegging
2. Exchange Equalization Account
3. Multiple Exchange Rate:
4. Quota Systems:
5. Block Accounts
6. Clearing Agreements:
7. Barter Trade/ Compensation
Agreement:
8. Stand Still Agreement / Rescheduling
9. Payment Agreements.

1. Exchange Pegging
It means to peg (fix) the exchange rate
over or under the equilibrium rate. In case
it is over valued i.e., over the equilibrium
level it is called ‘pegging up’.

2. Exchange Equalization
Account
It is a fund which is set up by the central
authority. Once equilibrium has been
disturb then, the reserves of this fund are
used to restore exchange rate.

3. Multiple Exchange Rate:
Under this system as the name suggest,
different rates are prescribed by central
bank for trading with different countries.
Rates also differ for trade of different
commodities.

4. Quota Systems:
Quota systems are the part of import
policy. They are used to ration fixed
amount of foreign exchange among
import of various items. Quota system
besides acting as an exchange control
also help to check import of invalid and
luxurious goods.

5. Block Accounts:
Block account technique varies form
ordinary blocking to the complete freezing
of foreign exchange accounts (this is what
Pakistani government did after test of
nuclear devices).

6. Clearing Agreements:
Clearing agreements are used to improve
the liquidity of national trade. Under such
agreements central banks of two
countries negotiate with each other a
suitable exchange rate for a particular
future period.

7. Barter Trade / Compensation
Agreement:
Although barter came to an end with the
invention of money yet it is used
sometimes in international trade. Under
compensation agreements the trading
countries simultaneously trade in equal
value of goods i.e., they import and export
goods of same value thus no need of
change of currency arises.

8. Stand still Agreement /
Rescheduling:
Stand still agreements or re-scheduling
means altering the schedule of payment of
loans. Debtor country may negotiate with
the creditor country to repay debts in easy
installments after some time in future.

9. Payment Agreements:
Under payment agreements the debtor
country enter into a settlement with the
creditor country whereby the creditor
country agrees to have more and more
imports form debtor country. On the other
hand, debtor country tends to have
minimum imports from creditor country.
This also help in clearing BOP deficits.

Summing Up:
These are different exchange
controls which are applied form time to
time by different countries to maintain
their exchange rates in favorable area and
to turn BOP favorable.
In the modern world, the highly
developed countries have restricted
developing countries form practicing any
strong protectionism policies (Pakistan
also as member of WTO is unable to
impose extra tariffs on imports).

Foreign exchange

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