Foreign Exchange Rate


Foreign Exchange Rate


Definition
It is the rate at which one unit of the (foreign) currency is exchanged for the number of units of (domestic) currency.
Eg-. $1 = Rs. 50

Foreign exchange reserve or foreign exchange
It is a reserve of foreign currencies, securities & bonds held by central bank.

System of Exchange rate or types of Exchange rates
There are two types of exchange rate systems:
1.      Fixed exchange rate system
2.      Flexible exchange rate system

Fixed Exchange Rate System

A. Gold Standard System

1.                  In this system every country used to define the value of its currency in terms of gold.
2.                  Value of one currency in terms of other currency was fixed considering the gold value of each currency.
E.g.                       $1 = 10 gm of Gold
                              Rs. 1 = 1 gm of Gold
Therefore            $1 = Rs. 10

B. Bretton Woods System
1.                  It is also called adjustable peg.
2.                  In this system of adjustment of exchange rate was allowed with the permission of IMF.
3.                  Each country used to peg its currency to one currency. i.e. dollar
4.                  Dollar was assigned the gold value
5.                  Ultimate parity of all the currencies was with gold.

Flexible Exchange Rate System
1.                  Under this system rate of exchange is determined by market forces i.e. demand  and supply of foreign currency in international market.
2.                  R = f (D, S)
3.      R = rate of exchange
4.      D = demand for foreign currency
5.      S = supply of foreign currency

Demand for Foreign Exchange



      It arises due to:
            1.      Imports from rest of the world.
            2.      Investment in rest of the world.
            3.      Direct purchases abroad.
            4.      Remittances to abroad.
            5.      Payment of international loans or external debt.
            6.      Speculative trading in foreign exchange (also called 
                   venture capital). 



Supply of Foreign Exchange


      It comes from:
          1.      Exports of goods and services.
          2.      Foreign Investment
               a.      Foreign Direct Investment (FDI): It is in the form of acquisition, joint ventures and opening of new factories by foreigners in India
               b.      Foreign Institutional Investment (FII): This is in the form of purchase of shares of our companies by foreigners. It is also called ‘hot money’.
           3.      Direct purchases by non-residents in our country
           4.      Remittances by non-residents living in foreign countries.



Exchange Rate Determination





Equilibrium is established where demand for and supply of foreign exchange coincides.
As we can see from the diagram, equilibrium is at point E, where demand for & supply of foreign exchange coincide (at R)
  





Depreciation of Currency

1.                  It is a situation when value of domestic currency falls in comparison to foreign currency.
2.                  More of domestic currency is required to get one unit of foreign currency.
3.                  Domestic currency becomes weaker.
4.                  Exports increase, Imports decrease.
5.                  It may be due to increase in demand or decrease in supply of foreign exchange.

Appreciation of Currency

1.                  It is a situation when value of domestic currency rises in comparison to foreign currency.
2.                  Less of domestic currency is required to get one unit of foreign currency.
3.                  Domestic currency becomes stronger.
4.                  Exports decrease, Imports increase.
5.                  It may be due to decrease in demand or increase in supply of foreign exchange.
Depreciation and Devaluation

1.                  Depreciation of currency occurs due to increase in demand or decrease in supply of foreign exchange, while Devaluation is done by government.
2.                  New equilibrium exchange rate is set due to depreciation, Devaluation may not necessarily be the equilibrium rate.

Appreciation and Revaluation

1.                  Appreciation of currency occurs due to decrease in demand or increase in supply of foreign exchange, while Revaluation is done by government.
2.                  New equilibrium exchange rate is set due to depreciation, Revaluation may not necessarily be the equilibrium rate.

Floating Exchange Rate

1.                  Under this system exchange rate is determined through market forces of demand and supply but however under special circumstances government appointed authority (RBI) may intervene to correct balance of payments.
2.                  Managed Float: when RBI intervenes within the prescribed limit set by IMF, it is called Managed Float.
3.                  However when intervention is beyond this limit then it is termed as Dirty Float.

Functions of Foreign Exchange Market

1.                               Transfer function- It helps in transferring the value or purchasing power.
2.                                       Credit Function- It helps in export and import of goods.
3.                              Hedging Function- It avoids risks and gives protection against risk. 


Types of Foreign Exchange Market:

    Spot Market
a.      It is related to spot or current transaction.
b.      It is periodic in nature.
c.      Exchange rate determined in this market is called spot rate.

Forward Market
a.      In this market transactions are meant for future deliveries.
b.      Contracts are signed today but they are utilized in future.
c.      Exchange rate determined in this market is called forward rate.


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