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 singleworld 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) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) 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. 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. The quality of goods and services may vary from country to country. Comparison of prices without regard to the quality is unrealistic. 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. The theory is rendered further unrealistic by ignoring the cost of transport in international trade. Another very unrealistic assumption made by the theory is that international trade is free from all barriers. 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. 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. 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. 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. 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. 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.