FOREIGN EXCHANGE

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 FOREIGN EXCHANGEForeign Exchange refers to the currencies of  other countries.

FOREIGN EXCHANGE RATE

•       It is the rate at which one currency is exchanged for the other.

•       It is the price of one currency in terms of the other.

•       For example, if one dollar can be exchanged for eighty four rupees, then the value of rupees is:

$1 = Rs.84

 Types of Foreign Exchange

(i)                   FIXED EXCHANGE RATE

(ii)                FLEXIBLE EXCHANGE RATE

(iii)               MANAGED FLOATING SYSTEM

FIXED EXCHANGE RATE

•       It is a system in which the exchange rate is fixed by the Government in terms of gold or foreign currency.

•       It enables stability in foreign trade.

•       It encourages foreign trade.

•       If the value of currency is fixed in terms of another currency, it is called pegging. Peg – Relate To

•       If the value of a currency is fixed in terms of gold, it is called parity value of currency. Par = Equal

Merits of Fixed Exchange Rate System

(i)Stability in the exchange rate

(ii) Promotes international trade

(iii) Promotes international investment 

(iv) Prevent speculative activities


Demerits of Fixed Exchange Rate System

(i) Huge foreign exchange reserves

(ii) Difficulty in fixing the exchange rate

(iii) Exchange rate is not fixed

  FLEXIBLE EXCHANGE RATE

•       Under this system the exchange rate is determined by the forces of demand and supply of different currencies in the market.

•       It is also called Floating Exchange rate System

Merits of Flexible Exchange Rate System

(i) Maintain `equilibrium level

(ii) No need for huge foreign exchange reserves 

(iii) Optimum utilisation of resources


Demerits Flexible Exchange Rate System 

(i) Instability in the exchange rate

(ii) Speculative activities

(iii) Creates inflationary situation

MANAGED FLOATING SYSTEM

•       It is a system in which exchange rate is determined by the market forces of demand and supply and the central bank interferes in the market to influence the exchange rate.

•       When the central bank finds the floating rate is too high, it starts selling foreign exchange from its reserves to bring down the rate.

•       When it finds rates are too low then they starts buying foreign currencies  to raise the rate.

•       It is also called dirty floating

Reasons for Rise in Demand for Foreign Currency

1.    Import of goods & services: Foreign exchange is demanded to make the payment for import of goods & services.

2.    Tourism: Foreign exchange is needed to meet expenditures incurred in foreign tours.

3.    Purchase of assets in foreign countries: It is demanded to make payments for the purchase of assets like land shares, bonds, etc. in foreign countries.

4.    Unilateral transfers to abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.

5.    Speculation: Demand for foreign exchange arises when people want to gain from the appreciation of the currency.

Reasons for Rise in Supply of Foreign Exchange

1.    Exchange of goods & services: Supply of foreign exchange comes through exports of goods & services.

2.    Foreign investments: The amount foreigners invest in home countries increases the supply of foreign exchange.

3.    Uni-lateral transfers from abroad: Supply of foreign exchange increases in the form of gifts & other remittances from abroad.

4.    Speculation: Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.

 

Difference between Currency Appreciation & Currency Depreciation

Basis

Currency Depreciation

Currency Appreciation

Meaning

It refers to a decrease in the value of domestic currency in terms of foreign currency.

It refers to an increase in the value of domestic currency in terms of foreign currency.

Effect on exports/imports

It makes domestic goods cheaper in foreign countries as more such goods can now be purchased with the same amount of foreign currency.
So, it leads to an increase in exports.

It makes foreign goods cheaper in domestic countries as more such goods can now be purchased with the same amount of domestic currency.
So, it leads to an increase in imports.

Example

A change from $1=Rs.80 to $1=Rs.85 represents that the Indian rupee is depreciating.

A change from $1=Rs.80 to $1=Rs.75 represents that the Indian rupee is appreciating.

 

Foreign Exchange Market

Foreign Exchange Market is a market in which foreign currencies are bought and sold. The buyers & sellers include individuals, firms, commercial banks, central banks & foreign exchange brokers. Foregin Exchange Market

foreign exchange market is the market where foreign currencies are bought and sold....

1.   Transfer Function

2.   Credit Function

3.   Heging Function

 

1.   Transfer Function

Transfer function refers to transferring of purchasing power among countries.

1.   Credit Function

It implies provision of credit in terms of foreign exchange for the export and import of goods and services across different countries of the world.

2.   Hedging function

Hedging function pertains to protecting against foreign exchange risks. Where Hedging is an activity which is designed to minimize the risk of loss.

 

Concept kinds of foreign exchange market

 

1.   Spot market

If the operation is of daily nature. In other words it is the market in which receipt and payments are made immediately . it is called spot market or current market

 

2.   Forward Market

A market for foreign exchange for future delivery is known as forward market.

 


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