FOREIGN CURRENCY MARKETS AND EXHANGE RATES

Objectives: Explain the Foreign Currency Market and Exchange Rates

Explain the factors determining Exchange Rates

Every country has some kind of money. Usually a country’s money, also
referred to as its currency, is called by its own unique name. For example, the United
States has money called the U.S. Dollar. Japan has money called the Japanese Yen.
Germany has money called the Deutsche Mark. Colombia has money called the
Colombian Peso.

In most cases, it’s easy to trade one currency for another. Just as you can trade
the goods you own–that is, you can trade corn for rice or high-tech steel knives or
computers–you can trade one kind of money for another. All you have to do is find
someone with whom to trade. Markets in which you can trade one kind of money for
another are called currency markets or foreign exchange markets.

Definition of Foreign Exchange:

Foreign Exchange Management Act (FEMA), 1999, (Section 2) defines

foreign exchange as:
“Foreign Exchange means foreign currency, and includes:
(i) All deposits, credits and balances payable in foreign currency, and any drafts,
traveller’s cheques, letters of credit and bills of exchange, expressed or drawn in
Indian currency and payable in any foreign currency,

(ii) Any instrument payable at the option of the drawee or holder, thereof or any
other party thereto, either in Indian currency or in foreign currency, or partly in one
and partly in the other.”

Thus, broadly speaking, foreign exchange is all claims payable abroad, whether
consisting funds held in foreign currency with banks abroad or bills, checks payable
abroad.

In other sense, a foreign exchange transaction is a contract to exchange funds in one

currency for funds in another currency at an agreed rate and arranged basis.
Exchange rates thus denote the price or the ratio or the value at which one currency
is exchanged for another currency.

The exchange rate is a dynamic rate, which varies from day-to-day, minute-to-
minute and second to second, and in practice a few times per second, depending
upon a variety of factors. We shall learn more about the forex markets and other
aspects as we go ahead.
Characteristics of Foreign Exchange:
Thus the characteristics of foreign exchange market can be listed as
under:
i. A 24-hour market

ii. An over the counter market

iii. A global market with no barriers/no specific location

iv. A market that supports large capital and trade flows

v. Highly liquid markets

vi. High fluctuations in currency rates (every 4 seconds)

vii. Settlements affected by time zone factor

viii. Markets affected by governmental policies and controls.

Foreign Exchange Markets:

Foreign exchange markets comprise a large spectrum of market participants, which
include individuals, business entities, commercial and investment banks, central
banks, cross border investors, arbitrageurs and speculators across the globe, who buy
or sell currencies for their needs.

It is a communication system-based market, with no boundaries, and operates round

the clock, within a country or between countries. It is not bound by any four-walled
marketplace, which is a common feature for commodity markets, say vegetable
market, or fish market. It is a profit centre with simultaneous potential for losses.

Forex markets are dynamic markets and work round-the-clock, in different time
zones, in which various countries are located. Geographically, forex markets extend
from Tokyo and Sydney in the east, through Hong Kong, Singapore, Bahrain, London
and New York in the west.

If we view the markets as per GMT, when the London and other European markets
start the day it is almost lunch time for the Indian markets, and when the Indian
markets are about to close, the New York market is about to begin its day.

Further, while the New York market operates for some-time alongside the London
and European markets, the markets in the east: Tokyo, Hong Kong and Singapore
are ready to start, before New York closes. The Indian and Middle East markets are
ready to start the day, before close of Singapore and Hong Kong markets.

The world currency market is a very large market, with a large number of
participants.
Major participants of forex markets are:
i. Central Banks:
Managing their reserves and using currency markets to smoothen out the value of
their home currency.

ii. Commercial Banks:

Offering exchange of currencies to their retail clients and hedging and investing their
own assets and liabilities, as also on behalf of their clients, and also speculating on
the movements in the markets.

iii. Investment Funds/Banks:

Moving funds from one country to another using exchange markets as a vehicle for
investments as also hedging their investments in various countries/currencies.

iv. Forex Brokers:

Acting as middleman, between other participants, and at times taking positions on
their books.

v. Corporations:
Moving funds between different countries and currencies for investment or trade
transactions or even speculation in currency markets.

vi. Individual:
Ordinary or high net worth individuals using markets for their investment, trade,
personal, and travel and tourism needs.

As given here, the participants not only use the forex markets for trade or travel
purposes, but also for investments, hedging and speculative, thus generating large
volumes for the market.

It may be surprising to note that the global forex market handles total turnover of
approx. US dollar 3.20 trillion (USD 3200 billion) per day, while the daily world
trade turnover is approx. 2.00 % of this forex turnover.

This means that around 98% of the global forex trading relates to investments, or
speculative trading. The Indian forex markets too, trade over USD 30 billion per day,
which is again a good multiple of the India’s average daily export/import trade
turnover, mostly because of regulatory exchange control regime and restrictive flow
of foreign currency.

The forex markets are highly dynamic, that on an average the exchange rates of
major currencies (say GBP/USD) fluctuate every four seconds, which effectively
means it registers 21,600 changes in a day (15 × 60 × 24). Now that means that you
look aside for a second and when you turn back for the rate, the same could have
moved either way.

Forex markets usually operate from ‘Monday to Friday’ globally, except for the
Middle East or other Islamic countries which function on Saturday and Sunday with
restrictions, to cater to the local needs, but are closed on Friday.
The bulk of the forex markets are OTC (over the counter), meaning that the trades
are concluded through telephone or other electronic systems (dealing systems of
various news agencies, banks, brokers or Internet-based solutions).

Banks in London quite commonly deal with banks in Paris, Frankfurt, Mumbai and
New York and even in Tokyo or Singapore, which are totally in a different time zone.
Large dealing rooms of global banks or Corporates, operate round the clock, to be
with all major markets across the globe.

A few traders are provided dealing platforms in their homes, to enable them to trade
in any time zone. Now with the internet accessibility on the mobile, the markets can
be accessed any time any place. Major Banks, which act as market makers offer two-
way quotes, (buy and sell), and leave upon the caller to either buy or sell as per his
needs. This generates greater market depth and volumes.

Mechanism of Foreign Exchange:

Debts between two countries may be settled with the help of following
mechanisms:
(i) Bills of exchange,

(ii) Cheques or drafts,

(iii) Telegraphic transfer (T.T.),

(iv) Mail transfers (M.T.).

A bill of exchange is an order drawn by a person upon a bank or another person,

asking the latter to make certain payments to a third party. The exporters sell these
to their banks, who get them collected in the foreign countries and credit to their
accounts.

For speedier payments telegraphic transfers (T.T.) are used: the Indian bank wires to
the foreign bank with which it has an account to transfer the deposit at once to the
account of a specified person. Mail transfers (M.T.) are similar to telegraphic
transfers, except that they are sent by post. Both M.T.’s and T.T.’s are safer than
drafts or cheques since there is no danger from loss.

Factors Determining Exchange Rates:

A. Fundamental Reasons:
These include all those causes or events, which affect the basic economic and
monetary policies of the concerned government. The causes normally affect the long-
term exchange rates, while in the short- run, many of these are found ineffective.

In a long run, exchange rates of all currencies are linked to

fundamentals, as given under:
i. Balance of Payment:
Generally a surplus leads to a stronger currency, while a deficit weakens a currency.
ii. Economic Growth Rate:
A high growth leads to a rise in imports and a fall in the value of currency, and vice
versa.

iii. Fiscal Policy:

An expansionary policy, e.g., lower taxes can lead to a higher economic growth.

iv. Monetary Policy:

The way, a central bank attempts to influence and control interest and money supply
can impact the value of currency of their country.

v. Interest Rates:
High domestic interest rates tend to attract overseas capital, thus the currency
appreciates in the short term. In the longer term, however, high interest rates slow
the economy down, thus weakening the currency.

vi. Political Issues:

Political stability is likely to lead the economic stability, and hence a steady currency,
while political instability would have the opposite effect.

B. Technical Reasons:
Government controls can lead to an unrealistic value of a currency, resulting in
violent exchange rates. Freedom or restriction on capital movement can affect
exchange rates to a larger extent. This is a recent phenomenon, as seen in Indonesia,
Korea, etc.

Huge surpluses generated in the petroleum exporting countries, (due to the sudden
spurt in petroleum prices), which could not be utilised in these countries, had to be
invested overseas. This creates huge movement of capital overseas and resultant
appreciation of the relative currency.

Capital tends to move from lower yielding to higher yielding currencies, and results,
is movement in exchange rates.

C. Speculation:
Speculative forces can have a major effect on exchange rates. In an expectation, that
a currency will be devalued, the speculator will short sell the currency for buying it
back cheaper at a later date. This very act can lead to vast movements in the market,
as the expectation for devaluation grows and extends to other market participants.

Speculative deals provide depth and liquidity to the market and at times, act as a
cushion too, if the views do not lead to a contagious effect.

Control of Foreign Exchange:

Foreign exchange control is the child of economic difficulty born out of depression or
war. The second World War brought about a great deal of exchange control in more
or less all countries. In depression many countries found they could not meet all their
overseas debts, e.g., interest payments, on account of a big drop in the value of their
exports, so in order to prevent heavy sales of their currency from depreciating it, they
blocked the bank balances due to foreigners and merely refused to allow them to be
offered in exchange from foreign currency.

The problem of excess demand for foreign currency was solved by cutting off the
demand at source; the foreigners were left with their funds in the debtor country in
which they had to spend their money themselves, since they were not allowed to
exchange it for their own currencies.

Exchange control coupled with the power to control imports is thus an alternative to
a very heavy depreciation of the exchange value of a currency. Exchange control
enables a country to control its foreign trade.

All exporters are obliged to sell the foreign currency they receive, to the authorised
Government Bank, where it is resold to the importers of such goods as the state
desires to import. State authorises imports only upto the amount of foreign exchange
available from exports.

The aim of exchange control is to keep exchange rates stable. The rate of exchange
may be either higher or lower than the equilibrium rate of a free market. A country
pegging the rate at a low level-that is under-valuing its currency-may do so to
stimulate its export trade.

https://www.businessmanagementideas.com/essays/foreign-exchange/essay-on-foreign-
exchange-top-7-essays-international-banking/12486