Foreign Exchange

Introduction

• Foreign Exchange Market

• Where individuals, firms and banks buy and sell foreign currencies or foreign
exchange.
Functions of the Foreign Exchange Markets

1. Transfer purchasing power from one nation and

currency to another.
 Demand for currency arises when:
 Tourists visit another country
 Domestic firm wants to import from other countries
 Individual wants to invest abroad
 Supply of currency arises from:
 Foreign tourist expenditures
 Export earnings
 Receiving foreign investments
Functions of the Foreign Exchange Markets

2. Provide credit for foreign transactions

 Credit is needed when goods are in transit, and to allow the buyer time to
resell the goods to make the payment.

3. Provide the facilities for hedging and speculation.

 About 90% of foreign exchange trading reflects purely financial
transactions, and only about 10% trade financing.
Functions of the Foreign Exchange Markets

• Participants
• Those needing currency to fund transactions
• Tourists, importers, exporters, investors, etc.
• Commercial banks
• Serve as the clearinghouses for currency exchange
• Foreign exchange brokers
• Clearinghouse for surpluses and shortages between the commercial banks
• Central banks
• Buyer or seller of last resort in the foreign exchange market
Foreign Exchange Rates

• Assume only two economies, the United States and the European
Monetary Union.
• Domestic currency = dollar ($)
• Foreign currency = euro (€)
• The exchange rate between the dollar and the euro (R) is equal to the
number of dollars needed to purchase one euro.
R = $/€
If R = $/€ = 1, then one dollar is required to purchase one euro.
Foreign Exchange Rates

• Under a flexible exchange system, R is determined by the intersection of market

demand and supply curves for euros.
• Depreciation is an increase in the domestic price of the foreign currency.
• If the dollar price of the euro increases from $1 to $1.50, the dollar has depreciated.
• Appreciation refers to a decline in the domestic price of the foreign currency.
• If the dollar price of the euro decreases from $1 to $0.50, the dollar has appreciated.
FIGURE 1. The Exchange Rate Under a Flexible Exchange
Rate System.
Foreign Exchange Rates

 Cross exchange rate

 Once the exchange rate between each of a pair of currencies with respect
to the dollar is established, the exchange rate between the two
currencies themselves, or cross exchange rate, can be calculated.
 Example:
 Suppose $/€ exchange rate is $1.25 and the $/£ exchange rate is $2.

R = €/£ = $ value of £ = 2 = 1.60

$ value of € 1.25
Foreign Exchange Rates

 Effective exchange rate

 A weighted average of the exchange rates between
the domestic currency and the nation’s most
important trading partners.
Foreign Exchange Rates

 Arbitrage
 The purchase of currency in one market for immediate re-sell in another
market.
 Arbitrage keeps the exchange rate between any two currencies the same
across different markets.
 The purchase/re-selling closes differences in exchange rates by reducing
currency available in the low price market and increasing availability in
the high price market.
Spot and Forward Rates, Currency Swaps, Futures, and Options

 Spot rate
 The exchange rate that calls for payment and receipt of the foreign
exchange within two business days from the date when the transaction
was made.
 Forward rate
 The exchange rate that calls for delivery of the foreign exchange one,
three, six, twelve or twenty-four months after the date the contract is
signed.
Spot and Forward Rates, Currency Swaps, Futures, and Options

 Currency Swap
 A spot sale of a currency combined with a forward
repurchase of the same currency – as part of a
single transaction.
 Most interbank trading involving the purchase or
sale of currencies for future delivery are done as
currency swaps.
Spot and Forward Rates, Currency Swaps, Futures, and Options

 Foreign Exchange Futures

 Forward currency contracts for standardized
currency amounts and select dates trade on an
organized market.
 Traded currencies:
 Japanese yen
 Canadian dollar
 British pound
 Swiss franc
 Australian dollar
 Mexican peso
 Euro
Spot and Forward Rates, Currency Swaps, Futures, and Options

 Foreign Exchange Options

 Contracts giving the purchaser the right, but not the obligation, to buy
(call option) or to sell (put option) a standard amount of a traded
currency on a stated date (European option) or any time before the
stated date (American option) at a stated price (strike or exercise
price).
Foreign Exchange Risks, Hedging, and Speculation

• Whenever a future payment must be made or

received in foreign currency, a foreign exchange risk
is involved because spot rates vary over time.
Foreign Exchange Risks, Hedging, and Speculation
• Contracted future foreign currency payments may become more
expensive if the domestic currency falls in value.
• Example:
• A contract requires a €100,000 payment in three months time.
• If the exchange rate is currently $1/€1, the expected dollar cost
is $100,000.
• If the exchange rate changes to $1.10/ €1 in the intervening
months, the dollar cost rises to $110,000.
Foreign Exchange Risks, Hedging, and Speculation
• Contracted future foreign currency receipts may fall in
value if the domestic currency increases in value.
• Example:
• A producer expects to receive a payment of €100,000
in three months time.
• If the exchange rate is currently $1/€1, the expected
dollar receipt is $100,000.
• If the exchange rate changes to $0.90/ €1 in the
intervening months, the dollar receipt falls to
$90,000.
Foreign Exchange Risks, Hedging, and Speculation

• Hedging is the avoidance of foreign exchange risk.

• Options:
1. Buy at the current spot rate and deposit the receipts
in an interest earning account until the funds are
needed.
2. Buy a forward contract
• Typically entails paying a forward premium, increasing the
cost of the transaction.
3. Buy a call option
• If not exercised, the premium is lost.
Foreign Exchange Risks, Hedging, and Speculation

• Speculation, the opposite of hedging, is the acceptance of foreign

exchange risk in the hope of making a profit.
• Example:
• If the speculator expects the spot rate in three months time to be $1/€1,
she may sell euros at a current three month forward rate of $1.10/€1 with
the expectation that she will be able to buy euros to cover her sale at the
lower spot rate.
Balance of Payments
Contents
• Meaning
• Objective
• Characteristics
• Structure
• Components
• Balance of payments ‘Surplus’ and ‘Deficit’
• Ways of Measuring of Deficit and Surplus
• Meaning of disequilibrium in balance of payments
• Causes of disequilibrium in balance of payments
• Measures to correct disequilibrium in Balance of Payments
 Balance of Payments
“A record of international transactions between residents of one
country and the rest of the world”
Objective
• Its main objective is to represent the economic position of a
country, whether its currency is rising or falling in its external
value.
 Characteristics of Balance of Payments

• It is statement having two sides.

• It is a record of economic transaction.
• It shows a relation between receipts & payments.
• Visible & Invisible items both are included in this statement.
• It is prepared for a certain period of time.
 Structure of balance of payments accounts

• The balance of payments account of a country is based on

the principle of double-entry book-keeping.
Each transaction is entered on the credit and debit side of
statement. But balance of payments accounting differ from
business accounting in one respect. In business accounting,
debit(-) are shown on the left side and credits (+) on the
right side of statement . But in the balance of payments
accounting, debits are shown on the right side and credits
on the left side of the statement. For example:
When a payment is received from a foreign country, it is a
credit transaction while payment to a foreign country is a
debit transaction
 Components of Balance of payments

• Current Account
• Capital Account
• Financial Account
Current Account
• Current Account- The current account of a country consists of all
transactions related to trade in goods and services and unilateral
transfers. The current account is used to monitor the inflow and
outflow of goods and services between countries.
• This account covers all the receipts and payments made with respect
to raw materials and manufactured goods. It also includes receipts
from engineering, tourism, transportation, business services, stocks,
and royalties from patents and copyrights.
• When all the goods and services are combined, together they make
up to a country’s Balance Of Trade (BOT).
Continued..
• Capital Account- All capital transactions between the countries are monitored
through the capital account. Capital transactions include the purchase and sale of
assets (non-financial) like land and properties. The capital account also includes the
flow of taxes, purchase and sale of fixed assets etc by migrants moving out/in to a
different country. The deficit or surplus in the current account is managed through
the finance from capital account and vice versa.
• There are 3 major elements of capital account:
• Loans & borrowings – It includes all types of loans from both the private and public
sectors located in foreign countries.
• Investments – These are funds invested in the corporate stocks by non-residents.
• Foreign exchange reserves – Foreign exchange reserves held by the central bank of
a country to monitor and control the exchange rate does impact the capital account.
Continued..
• Financial Account: The financial account monitors the flow of funds
pertaining to investments in businesses, real estate, and stocks.
• It also includes government-owned assets such as gold and Special
Drawing Rights (SDRs) held with the International Monetary Fund
(IMF).
• In addition, it includes foreign investments and assets held abroad by
nationals. Similarly, the financial account includes a record of the
assets owned by foreign nationals.
Meaning of disequilibrium in balance of payments
• A country’s balance of payments is in disequilibrium when there is no
perfect equality between the demand and supply for foreign
exchange.
BOP Surplus and Deficit
1. A BoP surplus indicates that a country’s exports are more than its
imports.
2. A BoP deficit, on the other hand, indicates that a country’s imports
are more than exports. Both scenarios have short-term and long-
term effects on the country’s economy.
 Causes of disequilibrium in balance of
payments
• Temporary causes
• National Income
• Inflation
• Economic Development
• Borrowing and Lending
• Change in exchange rate
• Political factors-like instable govt.
Continued…

• Temporary Causes- Temporary causes may arises due to variations in

the trade, effect of weather on agriculture production etc.
• National Income - Another cause is the change in country’s national
income. If the national income of a country increases, it will lead to
an increase in imports thereby creating a deficit in balance of
payments.
Continued….
• Inflation- Inflation is another cause of disequilibrium
in the balance of payment. If there is inflation in the
country prices of exports increase, thus increase in
export prices leading to decline in exports and rise in
imports result in adverse.
Continued….
• Economic Development- A country’s balance of
payments also depends on its stage of economic
development. If a country is developing it will have a
deficit in its balance of payments.
Continued…
• Borrowing and lending- A country which gives loans
and grants on a large scale to other countries has a
deficit in its balance of payments on capital account.
On the other hand, a developing country borrowing
large funds from other countries may have a
favourable balance of payments.
Continued….
• Change in exchange rate – This change arise due to
change in exports and imports. If exports of the
country are more then imports the demand for its
currency increase so that the rate of exchange moves
in favours. On the other hand if imports are more
than exports the demand for the foreign currency
increase and the rate of exchange will against the
country.
Continued…
• Political factors like instable govt.
• Lack of export substitution
• More imports
 Measures for correction of disequilibrium in Balance of Payments

• Full convertibility of rupee

• Export promotion
• Import substitution
• Export oriented units
• Special economic zones
• Devaluation of Currency
• Improvement in advance licensing
• Foreign loans
• Encouragement to foreign investment
• Incentives to tourism
Balance of Trade
• The difference between a country's imports and its exports. Balance
of trade is the largest component of a country's balance of payments.
• Debit items include imports, foreign aid, domestic spending abroad
and domestic investments abroad.
• Credit items include exports, foreign spending in the domestic
economy and foreign investments in the domestic economy.
• When exports are greater than imports than the BOT is favourable
and if imports are greater than exports then it is unfavourable
 BOP vs. BOT
BOP BOT
1. It is a broad term. 1. It is a narrow term.
2. It includes all transactions related 2. It includes only visible items.
to visible, invisible and capital 3. It can be favourable or
transfers. unfavourable.
3. It always balances itself. 4. BOT = Net Earning on Export - Net
4. BOP = Current Account + Capital payment for imports.
Account + or - Balancing item 5. Following are main factors which
(Errors and omissions) effect BOT
5. Following are main factors which • cost of production
affect BOP • availability of raw materials
• Conditions of foreign lenders. • Exchange rate
• Economic policy of Govt. • Prices of goods manufactured at
• all the factors of BOT home