What is foreign exchange?

- Foreign exchange means foreign currency. It indicates the ability to purchase foreign goods
from other countries.
- Foreign exchange or forex is the exchange of one currency for another or the conversion of
one currency into another currency, traded on foreign exchange markets.
- It includes all monetary instruments which give residents of one currency a financial claim on
another currency.
What is foreign exchange rate?
- Foreign exchange rate is the rate at which one currency will be exchanged for another or it is
the conversion rate of one currency into another.
- It expressed as the ration between the values of two currency.
- For example, an exchange rate of 80 Bangladeshi Taka to the United States dollar (US$)
means that Tk. 80 will be exchanged for each US$1 or that US$1 will be exchanged for each
Tk. 80.
Quotation of exchange rate:
The exchange rate can be quoted in two ways:
1. Direct Quotation:
When the value of a unit of foreign currency is expressed in terms of domestic currency, it is known
as direct quotation.
It is generally quoted with fixed external value i.e. foreign currency expressed in unique and domestic
currency in amount.
For example, 1$= Tk.80
2. Indirect Quotation:
When the value of a unit of domestic currency is expressed in terms of foreign currency, it is known
as indirect quotation.
It is generally quoted with fixed internal value i.e. domestic currency expressed in unique number and
foreign currency in amount.
For example, Tk.1= $0.0125
Different types of foreign exchange rate:
a. Spot rate: The spot exchange rate is the exchange rate for the spot transection.
It is quoted for the immediate settlement of the foreign exchange contract, involves the purchase or
sale of a currency for immediate delivery and payment on the spot date, which is normally two
business days after the trade date.
b. Forward rate: The forward exchange rate is the exchange rate for future transection.
It refers to an exchange rate that is quoted and traded today but for delivery and payment on a
specific future date.
The forward rate may be quoted either at a premium or at a discount on the spot rate.
- Premium implies that the foreign currency is expensive and has a high price than the spot
rate and
- Discount implies that foreign currency is cheap and available at a lower rate than spot rate.
Factors that should be considered while calculating forward rate are economic conditions of two
countries, interest rate of two countries, inflation rate between two countries etc.
c. Buying and selling rate: When the government or the central bank of the country hold full
control over the purchase and sale of foreign exchange, two different rates may be fixed for
buying and selling of foreign currencies.
- Buying rate is the rate at which Central bank or their authorized dealer buy foreign exchange.
- Selling rate is the rate at which Central bank or their authorized dealer sell foreign exchange.
d. Cross rate: It is a rate to be found out from two given exchange rate. An exchange rate between
two currencies computed by reference to a third currency, usually the US dollar.
Calculation:
• If both currencies involved in cross transection are quoted in the same form and terms, divided
the spot rate of one currency by the spot rate of the other currency.
For example, TK/$ = 80 and,
Rs. /$= 40
Then, TK/Rs. = 80/40= 2
So, 1Rs. = 2Tk
• If one currency is quoted in one form/term and another currency is quoted in another
form/term, multiply the spot rate/
For example, TK/$= 80 and, $/Rs. = 0.025
Then, TK/Rs. = 80x .0.025= 2

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e. Fixed rate: Fixed exchange rate means the rate which is fixed by the government in terms of
gold. Also known as pegged exchange rate.
Fixed rates provide greater certainty for exporter and importers. This also helps the government
to maintain low inflation, which in the long-run keeps interest rates down and stimulates increased
trade and investment.
f. Flexible rate: Flexible exchange rate involves keeping the exchange rate fixed over short periods
but allowing it to change from time to time according to the change condition of demand and
supply of foreign exchange by government.
g. Floating rate: Floating exchange rate is not determined by government. It is determined by the
market mechanism i.e. demand and supply of foreign currency.
Supply of foreign currency means the inflows of foreign currency by export of goods and service,
export of manpower, FEI etc. Demand of foreign currency means the outflow of foreign currency
i.e. import capital transfer etc.
h. Market rate: The market rate of exchange is a short term rate of exchange that prevails in the
market. It reflects the temporary influence of demand forces and supply forces for foreign
exchange in the foreign exchange market.
i. Equilibrium rate
When market rate has a tendency to oscillate (move or swing back) around the normal rate of
exchange, which is termed as the equilibrium rate.
The equilibrium exchange rate is the rate which equates demand and supply for a particular
currency against another currency.
The equilibrium rate of exchange over a certain period maintains the balance of payment in
equilibrium without any change in the international currency reserve.
Theories of Exchange Rate
1. Mint Parity Theory
The theory which explain that the determination of exchange rate between two currencies of two
countries are based on the same metallic standard (say gold standard) is known as the Mint Parity
theory.
Under gold standard, the value of currency of a country is fixed as the value of gold of a definite
weight and fitness.
The rate at which the currency of the country was converted into gold was known as mint price of
gold.
• Suppose, one ounce of gold in Bangladesh is TK 6000 and in USA is $75
So, $75 = TK 6000
 $1= TK 6000/75 = TK 80
Today, however, the method of determining currency value in terms of gold content or mint parity is
obsolete for the obvious reasons that:
(i) None of the modern countries in the world is on gold or metallic standard,
(ii) Free buying and selling of gold internationally is not permitted by various governments
and as such it is not possible to fix par value in terms of gold content or mint parity, and
(iii) Most of the countries today are on paper standard or Fiat currency system.
2. Purchase Power Parity Theory
The theory which explain that the determination of exchange rate between two currencies of two
countries are based on the purchasing power of that two currencies, is known as purchasing power
parity theory.
The exchange rate between two countries should equal the ratio of the two countries' price level of a
fixed basket of goods and services.
• For example, at a given time, $1 in U.S.A purchases a combination of goods which is
purchased in Bangladesh for TK 80. Then the purchasing power of the Taka and the Dollar will
be the same in the two countries, if the rate of exchange between the currency is $1=Tk. 80
The main theme of this theory was to compare the internal purchasing power of one country’s
currency with the purchasing power of another country’s currency and then to bring exchange rate on
the basis of both currencies purchasing power comparison.
Limitation:
- Prices of all commodities never move uniformly. Prices of some commodities rise or fall much
more than those of others. Under such conditions, no simple comparison can be made
between the price movements in different countries.
- It fails to take into consideration any items in the balance of payments other than
merchandise trade. That is to say, the purchasing power parity theory applies at best only to
current account transactions, neglecting capital account completely.

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 - Difficulties in calculating PPP
3. Balance of Payment Approach

The balance of payments theory holds that the exchange rates are determined by the balance of
payments, connoting demand and supply positions of foreign exchange in the country concerned.

Explanation: Exchange rate or external value of a country’s currency is determined by the demand
for and supply of that currency in the foreign exchange market. The demand for and supply of foreign
exchange arise from the debit and credit item in the balance of payment.

Debit item include all payments made by residents to foreigners and credit items include all payments
made by foreigners to residents during a given period of time.

- A surplus in the balance of payments of a country implies a greater demand for home
currency in a foreign country than the available supply. As a result, the price of home
currency in terms of foreign money rises, i.e., the rate of exchange improves.
- A deficit balance of payments of a country implies that its supply of currency in foreign
exchange market will be more than foreigners’ demand for it. Or, the demand for foreign
exchange exceeds its supply. As a result, the price of foreign money in terms of domestic
currency must rise, i.e., the exchange rate of domestic currency must fall.

The theory states that equilibrium rate of exchange is determined at a point where the demand for
and supply of the country’s currency are equal Fig. shows
this.

• In Fig, D is the foreigners’ demand curve of the

currency of the country. It shows that when price of
the currency in terms of foreign currency, i.e., rate of
exchange, is low, demand for the currency is high and
vice versa.
• S is the supply curve of currency with foreign
exchange market. Its supply rises with price. PM is the
equilibrium rate of exchange, given OM demand and
supply.
• If the country’s export increases, foreigners’ demand
for its currency increases, which is graphically shown
by the shifting of D curve to D 1. Consequently, a new
exchange rate is determined as P 1 M 1 . This happens when a country has a surplus balance of
payments.

• When a country has a deficit balance of payments, its supply of currency in foreign exchange
market will be more than foreigners’ demand for it. Consequently, the rate of exchange will fall.
Reason for fluctuating of foreign exchange rate

SHORT TERM: Short term factors i.e. commercial and financial factor directly influence the supply
and demand for foreign currency, they may be sub divided into-

1. Trade Factors: Any change in imports or exports will certainly cause a change in the rate of
exchange.
- If imports exceed exports, the demand for foreign currency rises; hence the rate of
exchange moves against the country.
- Conversely, if exports exceed imports, the demand for domestic currency rises and the
rate of exchange moves in favor of the country.

For example, suppose, equilibrium rate exchange rate is $1=Tk. 80. When import of Bangladesh from
the USA is increased, Bangladesh has to pay more dollars to the USA. Exchange rate goes more
away from equilibrium rate in USA’s favor. When export of Bangladesh to the USA increase,
exchange rate will fluctuate in Bangladesh’s favor.

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 2. Stock Exchange Factors: These include granting of loans, repayment of loan, payment of
interest on foreign loans, receipt of interest payment, repatriation of foreign capital, purchase
and sale of foreign securities etc. which influence demand for foreign funds and through it the
exchange rates influenced.

For instance, Suppose America is granting a loan to Bangladesh. The demand for Taka will increase
in America. The result is fluctuation of the rate of exchange in Bangladesh’s favor. Conversely when
the loan is repaid the rate will fluctuate in America’s favor.

3. Banking Factors Banks are the major dealers in foreign exchange. They sell drafts, transfer
funds, issue letters of credit, accept foreign bills of exchange, change in bank rate etc. These
operations influence the demand for and supply of foreign exchange, and hence the
exchange rates.

For instance, a high bank rate will make investment profitable in the home country. Foreigners will try
to transfer their fund to that country. This will raise the demand for the currency of the country
concerned and the rate of exchange will move in favor of that country.

LONG TERM:

1. Currency
and Credit
Condition

2. Political
and
Industrial
Condition

Method of Stabilizing Exchange Rate:

1. Forward exchange: The forward exchange rate is the exchange rate for future transection.
It refers to an exchange rate that is quoted and traded today but for delivery and payment on a
specific future date.
2. Exchange Equalization Account: Exchange equalization account is the device adopted for
smoothing out temporary or short term fluctuation in the rate of exchange as a result of any
abnormal movement of capital.
The object of the fund is to iron out the abnormal fluctuation in the rates of exchange by buying
and selling of foreign currencies.
When the demand of foreign currency is greater than supply, then to stabilize exchange rate
government sell more foreign currency. So supply can be increased.
When demand is less than supply, government purchase more foreign currency and reserve it.
3. Exchange Control: Exchange control refers to a government’s intervention and legal restrictions
on the business involving foreign exchange and its sale and purchase in the national market.

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 a) Intervention
i) Multiple Exchange: Under this system, different exchange rates are fixed by government for
import and export of different commodities and for different countries. This system of
exchange is adopted for earning maximum possible foreign exchange by increasing exports
and reducing imports.
ii) Clearing agreement:
- An agreement between the governments of the two countries who agree to clear the accounts in
home currencies through their respective central banks.
- Clearing between individual exporters and importers through private transaction is not allowed.
- It done country-wise at an interval of time.
- Under the system, the importers pay in domestic currency to central bank and exporters get
payment through the central bank in the home currency.
- Central bank acts as a clearing agent.
iii) Standstill agreement:
- If a country is under debt to another country, payments of short term debts may be suspended for
a given period by entering into an agreement called the standstill agreement.
- The creditor country allows the debtor country to repay the debts in easy installments or convert
the short terms debts into long terms debts.
- Standstill agreement aims at maintaining status quo in the relationship between two countries in
terms of capital movement.
iv) Blocked Account:
- Blocked accounts refer to a method by which the foreigners are restricted to transfer funds to their
home countries.
- When the policy of blocked accounts is adopted, the central bank deposits assets of foreign
nationals in their accounts but they are not allowed to convert these credit balances into their
home currencies for some period.
- The extreme step of freezing the bank accounts of the foreigners is taken when the government
faces the acute shortage of foreign exchange say in wartime.
v) Transfer Moratoria: Under this system, the payments for the imported goods or the interest
on foreign capital are not made immediately but are suspended for a predetermined period
called as period of moratorium. A country adopts this method of exchange control for
temporary solving its payments problems.
b) Restriction
i) Discourage of capital export and speculation: Restrictions on the amount of
currency that may be exported.
Speculation involves trading a financial instrument involving high risk, in expectation of
significant returns. The motive is to take maximum advantage from fluctuations in the
market.
ii) Surrender of foreign exchange: Under this system, the government monopolizes the
foreign exchange reserves. The exporters are required to surrender foreign exchange
earnings at the fixed exchange rate to the central bank of the country.
iii) Allocation by permit: Allocation is made by the government for imports on a priority
basis in fixed amount only. Foreign currencies are ration out to the permitted importers.
The importers are allotted foreign exchange at the fixed rate and in fixed amount
4. IMF
- The International Monetary Fund (IMF) is an international organization 189 countries working to
bring up global monetary cooperation, secure financial stability, facilitate international trade,
promote high employment and sustainable economic growth, and reduce poverty around the
world.
- The IMF is run by country contributions. Money is pooled through a quota system from which
countries with payment imbalances can borrow funds on a temporary basis. Almost every country
has own foreign currency reserve in IMF.
- The IMF's stated goal is to stabilize exchange rates and assist the reconstruction of the world's
international payment system after World War II.

- Kumkum Sultana (26th Batch, DM, CU)

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