Economics Notes on Foreign Exchange

By Ajeet Kumar, MA Economics

This is a concise notes on Foreign Exchange useful for Economics students.

Exchange stands for give and take actions. Foreign exchange means exchange of commodities or currencies between two countries. In practice, the term is applied in the sense of exchange of currencies of different nations only.

Foreign Exchange:  The mechanism of converting the currency of one country into that of another is known as foreign exchange. The conversion of currency is done by some banks which are authorized to deal in foreign currencies. These banks maintain stock of foreign currencies in the form of balances with banks abroad.

Foreign exchange can be defined as the instruments which are used to make international payments. Thus, the term foreign exchange includes not only currency, but also to a much larger extent of cheques, drafts, or bill of exchange which is simply orders to pay currency.

Illustration of Foreign Exchange Mechanism:  For example, suppose an Indian importer wants to import some computers from USA. For this, the importer would approach his bank in India and by paying Indian rupees he would require a draft in US dollars payable at, say, New York. The bank in India would have an account with a bank in US. On receiving rupees from the importer, it would issue a draft on the US bank with which it is maintaining the account. The draft is sent to the exporter who presents it to the bank on which it is drawn. The US bank pays it to the debit of Indian bank’s account with it.

Foreign currency accounts: There are three types of accounts to facilitate the mechanism involved in foreign exchange. These are 1. Nostro account, 2. Vostro account and 3.Loro account.

Nostro, Vostro and Loro are Italian words that stand for ‘our’, ‘your’ and ‘their’ respectively.

Nostro Account: Nostro account is maintained by a bank in home country/India with a bank in a foreign country. This account is maintained in the currency of the foreign country. While dealing with the foreign bank, the bank in India would refer its account with former as nostro account (our account with you). All foreign exchange transactions are routed through nostro accounts.

Vostro Account: Vostro account is maintained by a foreign bank with a bank in India and it is maintained in rupees.  While dealing with the foreign bank, the bank in India would refer this account with former as vestry account (your account with us). The vostro accounts are designated by the Indian Exchange Control as “Non resident Rupee Accounts” of foreign banks and branches abroad of banks in India.

Loro Account:  If the foreign exchange transactions between a bank in India and a foreign bank are routed through a third bank‘s account, then such an account in the third bank is called a loro account. This type of account is maintained either in rupee or in the currency of the foreign bank.

Foreign Exchange Transactions:  There are two types of foreign exchange transactions that can take place in a bank that deals with foreign exchange. First is purchase transaction and second is sale transaction.

Purchase and Sale Transactions: In purchase transaction, a bank takes foreign currency from an individual and gives him home/domestic currency.  On the other hand, in sale transaction the bank takes home currency from a person and gives him foreign currency. Thus the bank purchases and sells foreign currencies as if they are commodities.

Methods of Quoting Exchange Rates: There are two methods to quote exchange rates. First, direct quotation or home currency quotation and Second, indirect quotation or foreign currency quotation.

Direct Quotation or Home Currency Quotation:  In direct quotation method, a unit of foreign currency is expressed in terms of home currency. For example, 1 U.S. dollar = Rs 45.

Indirect Quotation or Foreign Currency Quotation:  In indirect quotation method, a unit of home currency is expressed in terms of foreign currency. For example, Re1 =. 1/45 U.S. dollar.

Two-Way Quotation:  The foreign exchange rates are generally expressed in pairs such as 1 U.S. dollar = Rs 43 – Rs 46. The first rate (lower) is offered by the buyers of the foreign exchange and second rate (higher) is offered by the sellers. 

Foreign Exchange Rate: foreign exchange rate refers to the number of units of home currency that must be foregone in order to obtain a unit of foreign currency. In other words, the number of units of home currency per unit foreign currency represents the foreign exchange rate. For example, if forty rupees of Indian currency is equivalent to one unit of American dollar then the foreign exchange rate of American dollar in Indian context will be said to be $1=Rs40.Thus, foreign exchange rate is the price of one currency in terms of another.

Importance of foreign exchange rate: By linking together the currencies of different nations, foreign exchange rate renders the comparison of international costs and prices possible and consequently play a vital role in determining the volume, composition and direction of international trade.

A country can promote its export by reducing the value of its own currency in comparison with foreign currencies without reducing the prices of its goods.

Demand For Foreign Exchange: Its Sources: (1) to import goods and services,(2) to send gifts in foreign country,  (3) to buy financial assets like shares and bonds of foreign countries, (4) to make direct investment in factories, houses, shops, etc.in foreign countries, (5) to speculate on the value of foreign exchange, (6) to  tour abroad etc.

Supply of Foreign Exchange: Its Sources The following activities lead to supply of foreign exchange: (1) export of goods and services, (2) remittances and gifts sent by the Indians who are in foreign countries, (3) purchase of financial assets like shares and bonds by foreigners, (4) direct investment in factories, houses, shops, etc.by foreign companies, (5) visit/ tour by the foreign tourists.

Foreign Exchange Market: Foreign exchange market refers to the market in which the foreign currencies of different countries are exchanged to each other. The market is not located at a single centre, but is international, with transaction carried out by telephone and cable. The foreign exchange market is vital for international trade and commerce.

Who Are the Buyers and Sellers in the Forex Market: The buyers and sellers in foreign exchange market are individuals like exporters, importers, investors, tourists, and immigrants, firms, foreign exchange brokers, commercial banks, and the central banks.

Structure of the foreign exchange market: Central bank occupies the top-most position in the foreign exchange market and thereafter comes the exchange brokers. They are the link between central bank and the commercial banks and between different banks. They themselves do not buy or sell foreign exchange but strikes the deal between buyers and sellers on commission basis.  Commercial banks occupy third position in the hierarchy of the structure of foreign exchange market. They play the role of market makers in the sense that they quote the daily exchange rates for buying and selling. They clear the market by buying the foreign currency in demand from the brokers and selling it to the buyers. So they work also as the clearing houses. The other individuals like exporters, importers, investors, tourists, and immigrants, firms, occupy the position at bottom. They are the real users of the foreign exchange.

Exchange Control:  Exchange control, also called exchange pegging, refers to the the operations of foreign exchange that is carried out by officially approved channels, usually through a central bank or some officially approved authority. Any firm or individual that wants foreign currencies to buy foreign goods and services or discharge foreign debts is required to apply through these channels for the privilege of buying exchange. This is also termed as foreign exchange rationing. Application for such exchange release may or may not be allowed in part or full on the basis of merits of each application. In general, exchange control requires that the government, rather than the free market, decide the order of priority for the importation of goods and services. This decision may then be implemented by allocating the limited supply of foreign exchange among competing uses.

Pegging:   Pegging refers to the activity in which the value of home currency is tied or pegged with the value of another currency. The value of home currency can be pegged to a reserve currency or a basket of key currencies. Pegging of a currency to a basket of currencies is called composite currency pegging. This system is adopted to avoid frequent adjustment problem that might arise if the value of reserve currency varies frequently. In this system the exchange rate is fixed on the basis of weighted average value of the selected currencies.

Devaluation:  Devaluation refers to the official act which makes a domestic currency cheaper in terms of gold or foreign currencies. It is typically designated to increase a nation’s exports while reducing its imports.

Merits of Exchange Control: The exchange control can be instituted for a number of reasons: (1) to provide better centralized control over the economy; (2) to reduce wide economic fluctuations; (3) to eliminate persistent deficit in the balance of payments; and (40 to assure essential imports for hastening economic growth and development.

Demerits of exchange control: (1) it encourages the creation of an illegal market in foreign exchange. (2) By preventing or even limiting the importation of certain goods, controls may shift the demand for these goods to domestic producers, thereby stimulating inflation at home as well as an exodus of resources out of export industries. This will encourage drop in exports and aggravate rather than cure the deficit disequilibrium. (3) By curbing imports, controls help bring on deflation in those countries whose export industries are adversely affected; this may encourage retaliatory measures by the injured nations; thereby reducing trade.

Functions of Foreign Exchange Market: Foreign exchange market performs number of important functions which can be classified into three parts: 1. transfer function i.e. transferring foreign currency from one country to another where it is needed in the settlement of payments 2. Credit function (e.g. providing short term credit to the importers) and 3. Hedging function (e.g. stabilizing the foreign exchange rate through spot and forward markets).

1. Transfer function: Transfer function of foreign exchange market refers to the transfer of purchasing power among countries. It means that by exchanging one currency into another, exchanging parties are able to buy and sell goods and services in each other countries. The most fundamental function performed by the foreign exchange markets is that they provide a means for transferring purchasing power from one country to another and from one currency to another. Without them, international trade would be virtually limited to barter. The purchasing power is transferred through the use of credit instrument. The chief credit instrument used to transfer the purchasing power is telegraphic transfer, or cable order by one bank in the country to its corresponding abroad to pay to the named individual funds out of its deposits account to a designated account or order. The telegraphic transfer is a sort of cheque which is wired or radioed rather than sent by post. Purchasing power may be transferred via bank drafts or commercial bill of exchange as well. A bill of exchange is a written order by the exporter directing the importer to pay the party’s bank / discounting house or any other financial institution with which the exporter has discounted the bill.

2. Credit function refers to providing credit channels for foreign trade. Like domestic trade, international trade also requires credit.  In 19^th century, London was the hub of international finance and the world used to finance its trade in sterling since sterling commanded the position of international reserve and vehicle currency.

3. Hedging function is an important feature of forward exchange market. When exporters and importers enter an agreement to sell and buy goods at some future date at current prices and exchange, it is called hedging. The purpose of hedging is to avoid the losses that might be caused by exchange rate variations in the future. The forward exchange market provides an opportunity to cover the risk arising out of exchange rate fluctuation and to avoid the resulting loss. Hedging takes place through commercial bank.

Speculation: Speculation is opposite of hedging. In hedging, the buyers and sellers try to avoid risk arising out of fluctuation of exchange rate whereas speculation is a deliberate action of taking risk with view to earn profit.

Types of speculators: The speculators are of two types: bears and bulls. Bears are those who are pessimistic and expect that the exchange rate may fall in future. So they try to sell out their exchange holdings to avoid loss. Bulls are those who are optimistic and expect that the exchange rate may rise in future. So they try to buy exchange so as to make profit.

Determination of equilibrium foreign exchange rate: The equilibrium exchange rate is determined differently under different monetary systems. The determination of equilibrium exchange rate under gold standard is based on the mint parity theory of foreign exchange rate.

Under in convertible paper currency money standard, the equilibrium exchange rate is determined by purchasing power parity theory.

Difference between mint parity and purchasing power parity is that while the former is a fixed parity, later is a moving parity which moves with fluctuations in prices in the countries concerned.

According to balance of payments theory, the equilibrium exchange rate is determined by autonomous factors which are not related to money supply and internal prices. A deficit BOP leads to fall/depreciation in the exchange rate while a surplus BOP leads to rise/appreciation in the exchange rate.

Reason: An adverse BOP refers to situation in which the demand for foreign currency is more than its supply at a given exchange rate. As a result, its price in terms of home currency must rise. In other words, the external value of the home currency depreciates. Similarly, we can explain the opposite situations i.e. favorable BOP. A favorable BOP refers to situation in which the demand for foreign currency is less than its supply at a given exchange rate. As a result, its price in terms of home currency must fall. In other words, the external value of the home currency appreciates.

Suggestions to Improve Monetary Systems: Three proposals have been suggested to improve the world’s monetary system: (1) Freely fluctuating or floating exchange rates, (2) An adjustable pegs system, and (3) A crawling peg system

Bretton woods Adjustable peg system Vs IMF’s Crawling peg exchange rate: Under the adjustable peg exchange rate system, the changes in par value of exchange rate (exchange parity) is permitted if a nation has had long run disequilibrium in its BOP. It allows also for short run variations within a narrow range of a few percent around the par value. The most desirable feature of adjustable peg system is that it would operate efficiently only if the par rate were consistent with the nation’s long run equilibrium in its BOP, so that the adjustment problem is then entirely of a short run nature. The most desirable feature is that the threat of speculation and disruption of foreign exchange markets would exist when a change in the basic par rate becomes necessary.