LESSON - 26

FOREIGN EXCHANGE - 1

Learning outcomes

After studying this unit, you should be able to:

Define foreign exchange

Know foreign exchange markets
functions of foreign exchange market
methods affecting international payment
determine exchange rates

Introduction:
Now we are discussing a very interesting lesson that is foreign exchange. Every one of us
irrespective of his or her job profile wants to know the exchange rates. Whether we are into
foreign exchange market or not than also we are concerned about the exchange rates.
Can anyone tell me what is this exchange rates or what do you mean by the term exchange rate?
Well in general terms exchange rates can be anything or any rate for or with which we can
exchange anything. But when talking to foreign exchange rate it can be defined as that rate by
which we can exchange the currency of one nation with the another nations currencies

Meaning of foreign exchange market:

H.E. Evitt, has defined foreign exchange market as follows:
“that section of economic science which deals with the means and methods by which rights to
wealth in one country's currency are converted into rights to wealth in terms of another country's
currency”.

he further observes that,

“it…involves the investigation of the method by which the currency of one country is exchanged
for that of another, the causes which render such exchange necessary, the forms which such
exchange may take, and the ratios or equivalent values at which such exchanges are effected”.

There are different interpretations of the term foreign exchange, of which the following two are
most important and common:
1. Foreign exchange is the system or process of converting one national currency into
another, and of transferring money from one country to another.
2. Secondly, the term foreign exchange is used to refer to foreign currencies. For example,
the Foreign Exchange Regulation Act, 1973 (FERA) defines foreign exchange as “foreign
currency and includes all deposits, ('I edits and balance payable in any foreign currency
and any drafts, traveler’s cheques, letters of credits and bills of exchange, expressed or
drnwl1 in Indian currency, but payable in any foreign currency.

FUNCTIONS OF FOREIGN EXCHANGE MARKET

The foreign exchange market is a market in which foreign exchange transactions
take place. In other words, it is a market in which national currencies are bought and sold against
one another.
A foreign exchange market performs three important functions:

Transfer of Purchasing Power

The primary function of a foreign exchange market is the transfer of
purchasing power from one country to another and from one currency to another. The
international clearing function performed by foreign exchange markets plays a very important role
in facilitating international trade and capital movements.

Provision of Credit
The credit function performed by foreign exchange markets also plays a
very important role in the growth of foreign trade, for international trade depends to a great extent
on credit facilities. Exporters may get pre-shipment and postshipment credit. Credit facilities are
available also for importers. The Eurodollar market has emerged as a major international credit
market.

Provision of Hedging Facilities

The other important function of the foreign exchange market is to
provide hedging facilities. Hedging refers to covering of export risks, and it provides a mechanism
to exporters and importers to guard themselves against losses arising from fluctuations in
exchange rates.

METHODS OF AFFECTING INTERNATIONAL PAYMENTS

There are five important methods to effect international payments.

Telegraphic Transfer
By this method, a sum can be transferred from a bank in one country to a
bank in another part of the world by cable or telex. It is, thus, the quickest method of transmitting
funds from one centre to another.

Mail Transfer
Just as it is possible to transfer funds from a bank account in one centre to an
account in another centre within the country by mail, international transfers of funds can be
accomplished by Mail Transfer. These are usually made by air mail.

Cheques and Bank Drafts

International payments may be made by means of cheques and
bank drafts. The latter is widely used. A bank draft is a cheques drawn on a bank instead of a
customer's personal account. It is an acceptable means of payment when the person tendering is
not known, since its value is dependent on the standing of a bank which is widely known, and not
on the credit-worthiness of a I1rl11 or individual known only to a limited number of people.

Foreign Bill of Exchange

A bill of exchange is an unconditional order in writing, addressed by one person to another,

requiring the person to whom it is addressed to pay a certain sum on demand or on a specified
future date.
 There are two important differences between inland and' foreign bills. The date on which an
inland bill is due for payment is calculated from the date on which it was drawn, but the period of
a foreign bill runs from the date on which the bill was accepted. The reason for this is that the
interval between a foreign bill being drawn and its acceptance may be considerable, since it may
depend on the time taken for the bill to pass from the drawer's country to that of the acceptor. The
second important difference between the two types of bill is that the foreign, bill is generally
drawn in sets of three, although only one of them bears a stamp, and of course, one of them is
paid.
Nowadays, it is mostly the documentary bill that is employed in international trade. This is
nothing more than a bill of exchange with the various shipping documents-the bill of lading, the
insurance certificate and the consular invoice-attached to it. By using this, the exporter can make
the release of the documents conditional upon either (a) payment of the bill, if it has been drawn
at sight, or (b) its acceptance by the importer if it has been drawn for a period.

Documentary (or reimbursement) Credit Under this method, a bill of exchange is necessarily
employed, but the distinctive feature of the documentary credit is the opening by the importer of a
credit in favour of the exporter, at a bank in the exporter's country.

Illustration:
To illustrate the use of the documentary credit, let us assume that Mr. Menon of
Cochin intends to purchase goods from Mr Ronald of New York and that the terms of the deal
have been agreed upon 'by them. Then the transaction would be carried through the following
stages.

(a) Mr Menon, the importer, instructs his bank, say the State Bank of India (SBI), to open a
credit in favour of Mr Ronald, the exporter, at the New York branch of the SBI (if the SBI
has no branch in New York, it will appoint some other bank to act as its agent there). The
SBI will then inform Mr Ronald by a letter of credit that it will pay him a specified sum in
exchange for the bill of exchange and the shipping documents.
(b) Mr Ronald may now despatch the goods to Mr Menon at Cochin, draw n bill of exchange
on the SBI and then present the documentary bill to the New York branch of the SBI. If all
the documents are in order, the hunk will pay Mr Ronald. The bank will charge for its
services, and will also charge interest if the bill is not payable at sight.
(c) The New York branch of the SBI then sends the documentary bill to its Cochin office for
payment or acceptance, as the case may be, by Mr Menon. When the bill is paid, Mr
Menon's account will be debited by that amount. Every thing being in order, the banker
will release the bill of lading from the bill to enable Mr Menon to claim the goods on their
arrival at the Cochin port.

TRANSACTIONS IN THE FOREIGN EXCHANGE MARKET

A very brief account of certain important types of transactions conducted in the foreign exchange
market is given below.
Spot and Forward Exchanges
The term spot exchange refers to the class of foreign exchange transaction which requires the
immediate delivery, or exchange of currencies on the spot. In practice, the settlement takes place
within two days in most markets. The rate of exchange effective for the spot transaction is known
as the spot rate and the market for such transactions is known as the spot market.
The forward transaction is an agreement between two parties, requiring the delivery at some
specified future date of a specified amount of foreign currency by one of the parties, against
payment in domestic currency by the other party, at the price agreed upon in the, contract. The
rate of exchange applicable to the forward contract is called the forward exchange rate and the
market for forward transactions is known as the forward market.

The foreign exchange regulations of various countries, generally, regulate the forward exchange
transactions with a view to curbing speculation in the foreign exchanges market. In India, for
example, commercial banks are permitted to offer forward cover only with respect to genuine
export and import transactions.

Forward exchange facilities, obviously, are of immense help to exporters and importers as they
can cover the risks arising out of exchange rate fluctuations by entering into an appropriate
forward exchange contract.

Forward Exchange Rate

With reference to its relationship with the spot rate, the forward rate may be
at par, discount or premium.

At Par
If the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the
contract, the forward exchange rate is said to be at par.

At Premium
The forward rate for a currency, say the dollar, is said to be at a premium with respect to the spot
rate when one dollar buys more units of another currency, say rupee, in the forward than in the
spot market. The premium is usually expressed as a percentage deviation from the spot rate on a
per annum basis.

At Discount
The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot
rate when one dollar buys fewer rupees in the forward than in the spot market, The discount is
also usually expressed as a percentage deviation from the spot rate on per annum basis.

The forward exchange rate is determined mostly by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange exceeds its supply, the forward rate
will be quoted at a premium and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand
for forward exchange, the forward rate will tend to be at par.

Swap Operation
Commercial banks who conduct forward exchange business may resort to a swap operation to
adjust their fund position. The term swap means simultaneous sale of spot currency for the
forward purchase of the same currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations consisting of a simultaneous sale or
purchase of spot currency accompanied by a purchase or sale, respectively, of 'the same
currency for forward delivery, are technically known as swaps or double deals, as the spot
currency is swapped against forward.

Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with the intention of making
profits from the differences between the exchange rate prevailing at the same time in different
markets.
For illustration, assume that the rate of exchange in London is £ I = $ 2 while in New York £ 1 = $
2.10. This presents a situation wherein one can purchase one pound sterling in London for two
dollars and earn profit of $ 0.10 by selling the pound sterling in New York for $ 2.10. This situation
would, hence, lead to an increase in demand for sterling in London and consequently, an
increase in the supply of sterling in New York. Such operations, i.e., arbitrage, could result in
equalising the exchange rates in different lI1urkets (in our example London and New York).

Arbitrage in .foreign currencies is possible because of the ease and speed of modern means of
communication between commercial centers throughout the world. Thus, an operator in New
York might buy dollars in Amsterdam and sell them a few minutes later in London.
The effect of arbitrage, as has already been mentioned, is to iron out (differences in the rates of
exchange of currencies in different centres, thereby creating, theoretically speaking, a single-
world market in foreign exchange.

DETERMINATION OF EXCHANGE RATES

How are exchange rates between different currencies determined under the paper currency
standard? There are two important theories which attempt to explain the mechanism of exchange
rate determination, namely, the purchasing power parity theory and the balance of payments or
the demand and supply theory
Diagrammatical representation of exchange rate and quantity of foreign exchange

Purchasing Power Parity Theory

According to the purchasing power parity theory, put forward by Gustav Cassel in the years
following the First World War, when the exchange rates are free to fluctuate, the rate of exchange
between two currencies in the long run will be determined by their respective purchasing powers.
In the words of Cassel, "the rate of exchange between two currencies must stand essentially on
the quotient of the internal purchasing powers of these currencies.4
The essence of the theory is clearly expressed by Professor S.E. Thomas as follows:

...while the value of the unit of one currency in terms of another currency is determined at any
particular time by the market conditions of demand and supply, in the long run, that value is
determined by the relative values of the two currencies as indicated by their relative purchasing
power over goods and services (in their respective countries). In other words, the rate of
exchange tends to rest at that point which expresses equality between the respective purchasing
powers of the two currencies. This point is called the purchasing power parity.5
Thus, according to the purchasing power parity theory, the exchange rate between one currency
and another is in equilibrium when their domestic purchasing powers at that rate of exchange are
equivalent. For example, assume that a particular bundle of goods in India costs Rs 45.00 and
the same in USA costs $ 1. Then the exchange rate will be in equilibrium if the exchange rate is $
1 = Rs 45.00. Once the equilibrium is established, the market forces will operate to restore the
equilibrium if there are some deviations. For example, if the exchange rate changes to $ 1 = Rs
46.50 when the purchasing powers of these currencies remain stable, dollar holder will convert
dollars into rupees because, by doing so, they can save Rs 1.50 when they purchase a
commodity worth $ 1. This will increase the demand for the Indian currency and the supply of
dollars will increase in the foreign exchange market and ultimately, the equilibrium rate of
exchange will be re-established.

A change in the purchasing power of currencies will be reflected in their exchange rates. The
index number of prices may be made use of to determine the purchasing power parity. If there is
a change in prices (i.e., the purchasing power of the currencies), the new equilibrium rate of
exchange can be found out by the following formula.
Pd
ER = Er x
 Pi
where ER = Equilibrium exchange rate
Er = Exchange rate in the reference period

Pd = Domestic price index

Pf = Foreign country's price index
Criticisms of the Theory
The purchasing power parity theory is subject to the following criticisms:

(i) The theory makes use of the price index number to measure the changes in the
equilibrium rate of exchange and hence the theory suffers from the various limitations
of the price index number.
(ii) The composition of the national income varies in different countries and hence the
types of goods and services included in the index number may vary from country to
country, rendering comparisons on the basis of such index number unrealistic.
(iii) The quality of goods and services may vary from country to country.
(iv) Comparison of prices without regard to the quality is unrealistic.
(v) The price index number includes the price of all commodities and services, including
those which are not internationally traded and hence the rate of exchange calculated
on the basis of such price indices cannot be realistic.
(vi) The theory is rendered further unrealistic by ignoring the cost of transport in
international trade.
(vii) Another very unrealistic assumption made by the theory is that international trade is
free from all barriers.
(viii) The purchasing power parity theory ignores the effects of international capital
movements on the foreign exchange market. International capital movements may
cause changes in the exchange rate. For example, if there is capital inflow to India
from USA, the supply of the dollar and the demand for rupees increases in the
foreign exchange market, causing an appreciation in the value of the rupee and
depreciation in the value of the dollar.
(ix) Another defect of the theory is that it ignores the impact of changes in the exchange
rates on the prices. For example, if, as a result of large capital inflows to India, Indian
currency appreciates in terms of foreign currencies, Indian exports may decline and
as a result, the supply of goods in India may exceed the demand and may cause a
fall in prices.
(x) The theory does not explain the demand for supply of foreign exchange. When the
exchange rate is determined largely by demand and supply conditions, any theory
that does not pay adequate attention to these aspects proves to be unsatisfactory.
(xi) The purchasing power parity theory starts with a given rate of exchange, but rails to
explain how that particular rate of exchange is arrived at. Thus, the theory only tells
us how, with a given rate of exchange, changes in the purchasing powers or two
currencies affect the exchange rate.
(xii) The theory is based on the wrong assumption that the elasticity of demand for
exports and imports is equal to unity i.e., this theory is valid only if the exports and
imports change in the same proportion as the change in prices. But this is a very rare
occurrence.
(xiii) No satisfactory explanation of short term changes in exchange rates is provided by
the theory.
 (xiv) Lastly, the purchasing power parity theory goes contrary to general experience.
Critics point out that there has hardly been any case when the rate of exchange
between two currencies has been equivalent to the ratio of their purchasing powers.

Despite its many defects and deficiencies, the purchasing power parity theory exposes some
very important aspects of exchange rate detern1ination.
(i) It indicates the relationship between the internal price levels and exchange rates.
(ii) It explains the state of the trade of a country as well as the nature of its balance of payments
at a particular time.
(iii) Further, the theory is applicable, to some extent, to all sorts of monetary standards.

DIGRAMATICAL REPRESENTATION OF QUALITY OF FOREIGN EXCHANGE:l

Balance of Payments Theory

The balance of payments theory, also known as the Demand and Supply Theory and the General
Equilibrium Theory of exchange rate, holds that the foreign exchange rate, under free market
conditions, is determined by the conditions of demand and supply in the foreign exchange
market. Thus, according to this theory, the price of a currency i.e., the exchange rate, is
detern1ined just like the price of any commodity is determined by the free play of the forces of
demand and supply.
The value of a currency appreciates when the demand for it increases and depreciates when the
demand falls, in relation. to its supply in the foreign exchange market.
The extent of the demand for and supply of a country's currency in the foreign exchange market
depends on its balance of payments position. When the balance of payments is in equilibrium, the
supply of and demand for the currency are equal. But when there is a deficit in the balance of
payments, supply of the currency exceeds its demand and causes a fall in the external value of
the currency; when there is a surplus, demand exceeds supply and causes a rise in the external
value of "the currency.

Evaluation of the Theory

The balance of payments theory provides a fairly satisfactory explanation of the determination of
the rate of exchange. This theory has the following merits.

(i) Unlike the purchasing power parity theory, the balance of payments theory recognises the
importance of all the items in the balance of payments, in determining the exchange rate
(ii) This demand and supply theory is In conformity with the general theory of value-like the price
of any commodity in a free market, the rate of exchange is determined by the forces of demand
and supply.
(iii) This theory brings the determination of the rate of exchange within the purview of the General
Equilibrium Theory. That is why this theory is also called the general equilibrium theory of
exchange rate determination.
(iv) It also indicates that balance of payments disequilibrium can be corrected by adjustments is
the exchange rate (i.e., by devaluation or revaluation), rather than by internal deflation or inflation.
The main defect of the theory is that it does not recognise the fact that the rate of exchange may
influence the balance of payments.

POINTS TO PONDER:
___________________________________
Foreign exchange
Meaning of Foreign exchange:
___________________________________
It can be defined as
that section of economic science which deals ___________________________________
with the means and methods by which rights
to wealth in one country's currency are
converted into rights to wealth in terms of ___________________________________
another country's currency.
___________________________________
___________________________________
___________________________________

___________________________________
Foreign exchange market
The foreign exchange market is a market in
___________________________________
which foreign exchange transactions takes
place. In other words, it is a market in which ___________________________________
national currencies are bought and sold
against one another.
___________________________________
___________________________________
___________________________________
___________________________________
FUNCTIONS OF FOREIGN ___________________________________
EXCHANGE MARKET
There are three main functions of foreign
___________________________________
exchange market:
Transfer of Purchasing Power ___________________________________
Provision of Credit
Provision of Hedging Facilities ___________________________________
___________________________________
___________________________________
___________________________________

METHODS AFFECTING ___________________________________

INTERNATIONAL PAYMENTS
There are five main methods affecting
___________________________________
international payment:
Mail Transfer ___________________________________
Cheques and Bank Drafts
Foreign Bill of Exchange ___________________________________
Telegraphic Transfer
Documentary (or reimbursement) Credit
___________________________________
___________________________________
___________________________________

DETERMINATION OF ___________________________________
EXCHANGE RATES
There are two important theories which attempt
___________________________________
to explain the mechanism of exchange rate
determination: ___________________________________
1. Purchasing Power Parity Theory
2. Balance of Payments Theory
___________________________________
___________________________________
___________________________________
___________________________________
 ___________________________________
Purchasing Power Parity Theory
Meaning of purchasing power parity theory:
___________________________________
According to the
purchasing power parity theory, put forward ___________________________________
by Gustav Cassel in the years following the
First World War, when the exchange rates
are free to fluctuate, the rate of exchange ___________________________________
between two currencies in the long run will be
determined by their respective purchasing
powers.
___________________________________
___________________________________
___________________________________

Balance of Payments Theory ___________________________________

Meaning of balance of payment:

The balance of payments theory, also known
as the Demand and Supply Theory and the
General Equilibrium Theory of exchange rate,
holds that the foreign exchange rate, under
free market conditions, is determined by the
conditions of demand and supply in the
foreign exchange market.
___________________________________
___________________________________
___________________________________
___________________________________
___________________________________
___________________________________