6. In foreign trade, goods and services are
traded across national boundaries but the
currency of one country is not acceptable
in another country
7. The price of one currency in terms of
another is called the Exchange Rate
8. There are two different conditions under which the
rate of exchange will determined
(i) When foreign Exchange market works freely
(ii) When foreign Exchange market is controlled
and regulated
10. (i) The foreign Exchange market transfers funds
(foreign currency) from one country to another
where they are needed in the settlement of payments
(ii) It provides short-term credit to the importers
and, thereby, facilitates the smooth flow of goods
and services from one country to another
(iii) The spot and forward market work in such way that
it helps often in stabilizing the foreign Exchange
rate
12. Types of Foreign Exchange
Market
• Spot Market
– Transactions settled within 2 days
• Forward Market
– Agreement to transact after 90days of deal
13. Nature of Transactions in Foreign
Exchange Market
• Hedging
– Settle exchange rate in advance
– Covers risk of exchange rate fluctuation
14. • Arbitrage
– Act of simultaneous purchase and sale of different currency in
two or more exchange markets
– Works as stabilizing factor in foreign exchange markets.
• Speculation
– Buying and selling currency under uncertain condition to make
profit
– “Buy forward and Sell on the spot” & “Sell Forward and Buy on
the spot”
15. Exchange Rate Regime
• The exchange-rate regime is the way a
country manages its currency in relation to
other currencies and the foreign exchange
market.
• Closely related to monetary policy and the
two are generally dependent on many of
the same factors.
17. Floating/ Fluctuating exchange rate
• Currency's value is allowed to fluctuate
according to the foreign exchange rate.
• Belize(Located on the north eastern coast
of Central America ) is an example of
floating exchange rate.
• Mundell-Fleming Model( fixed exchange
rate, free capital movement, and an
independent monetary policy )
• Fear of Floating
18. Fixed Exchange Rate
• Value of currencies kept constant
• Worth of its currency in terms of either a fixed
weight of gold, a fixed amount of other
currency or a “basket of other currencies”
• The central bank of a country remains
committed at all times to buy and sell its
currency at a fixed price. The central bank
provides foreign currency needed to
finance payment imbalances.
19. Types of Fixed Exchange Rate
• The Gold Standard
• Price Specie Flow Mechanism
• Reserve Currency Standard
• Gold Exchange Standard
20. Pegged Float
• Crawling Bands: the rate is allowed
to fluctuate in a band around a central
value, which is adjusted periodically
• Crawling pegs: the rate itself is fixed, and
adjusted as above.
• Pegged with horizontal bands:The
currency is allowed to fluctuate in a fixed
band (bigger than 1%) around a central
rate.
21. Dollarization
Dollarization occurs when the inhabitants of
a country use foreign currency in parallel
to or instead of the domestic currency. The
term is not only applied to usage of the
United States dollar, but generally to the
use of any foreign currency as the national
currency.
23. FACTORS DETERMINING
ECONOMIC VALUE OF CURRENCY
• Import and export
– Payment in dollars
– Forexample:-
• 1$=1Rs
–But current 1$ = 50Rs
–Finally govt. will have no “$”
31. FREE MARKET
Demand for Supply of
FX FX
Demand for
Supply of foreign
foreign
goods, services
goods, services
& securities
& securities
Speculators
Speculators
willing to get rid
willing to build
of their FX
their FX reserves
reserves
32. FREE MARKET
S’ ROUGH WORK
Exchange Rate (Rs. Per $)
D
D
P’ 1$= Rs.48 1$=Rs.45
48
S W W S
P
45
ER
US
D2 India’s demand for $
Supply
S D1 increases Rs.
Prices of foreign goods
10 13
$ demanded per time unit Demand of foreign goods
(million) Demand
$
Demand for foreign exchange
India
33. FREE MARKET
• Rise in domestic prices Rise in ER
Increases demand for FX Demand curve shifts upwards
Fall in exports Supply curve shifts leftward
• ROI (domestic) > ROI (foreign) Fall in ER
Capital inflow increases
Increased supply for FX
Capital outflow decreases
34. FREE MARKET
• Rise in real income (domestic) Rise in ER
Increase in imports Increased demand for FX
• Rise in real income (abroad) Fall in ER
Increase in exports Increased supply for FX
35. REGULATED MARKET
• ER is fixed by the Central Bank
• Flexibility, if any, usually 10%
• Currency’s par value
• Central Bank undertakes the buy & sell of FX in the
FX market
• Any change in ER is made by the Central Bank
• Devaluation
• Revaluation
36. REGULATED MARKET
D’
S’
Exchange Rate (Rs. Per $)
D
D’’ P’
T
F
B P
D’
S D’’ D
O M N Q R
$ demanded per time unit
(million)
40. International trade
• If a country’s imports are higher, the demand for
foreign currency in this country will be high. Higher
demand for foreign currency means high value of
foreign currency and low value of the domestic
currency.
• This is a typical case for underdeveloped countries
which rely on imports for development needs. The
current account balance (deficit or surplus) thus
reflects the strength and weakness of the domestic
currency.
41. Capital movements
• International investments in the form of
Foreign direct investment (FDI) and Foreign
institutional investments (FII) have become the
most important factors affecting the exchange
rate in today’s open world economy.
• Countries which attract large capital inflows
through foreign investments, will witness an
appreciation in its domestic currency as its
demand rises. Outflow of capital would mean a
depreciation of domestic currency.
42. Change in prices
• Domestic inflation or deflation affects the
exchange rate by affecting the demand and
supply of domestic currency in the foreign
exchange market.
• For example, if prices in India go up, making
Indian goods costlier, the demand for Indian
goods will go down. When exports go
down, the demand for rupee will fall, causing
depreciation in its exchange value.
43. Speculations
• Uncertainties are always there in the financial market.
• If the speculators expect a fall in the value of a
currency in the near future, they will sell that
currency and start buying the other currency that they
expect to appreciate. The selling of the former
currency will thus increase its supply in the foreign
exchange market and bring down its value. The other
currency appreciates as its demand increases.
44. Strength of the economy-
• If the economic fundamentals of a country are
strong, the exchange rate of its domestic currency
remains stable and strong
• Fiscal balance, international current account
balance, international liabilities, foreign exchange
reserves, resilience to international trade
fluctuations, GDP, inflation rate all are indicators of a
country’s economic strength.
45. Government policies-
• In countries where there is fixed or managed
float, the central bank becomes an important player in
the foreign exchange market.
• The bank influences the value of the currency by its
market operations like buying and selling of bills and
currencies.
• The bank rate also influences the exchange rate by
influencing investments and thereby the demand and
supply of the domestic currency.
46. Stock exchange operations
• Stock exchange operations in foreign
securities, debentures, stocks and shares, influence
the demand and supply of related currencies, thus
influencing their exchange rate.
47. Political factors
• Political scenario of the country ultimately decides
the strength of the country.
An economy with a strong, positive image will
obviously have a strong domestic currency. This is
the reason why speculations rise considerably during
the parliament elections, with various predictions of
the future government and its policies.
• In 1998, the Indian rupee depreciated against the
dollar due to the American sanctions after India
conducted the Pokharan nuclear test.
