Foreign Exchange& Xchange Rates

8/6/2019 Foreign Exchange& Xchange Rates

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FOREIGN EXCHANGE

Meaning, Problems and Importance

In today’s world economy, the existence of separate monetary unites under

different monetary system poses a great problem, in the settlement of

international transactions. Each party will like to get the payments in the

currency of his own country. This complex situation makes the conversion of

different world currencies compulsory.

Foreign exchange is the mechanism by which the currency of one country

gets converted into the currency of another.

International trade and money and capital movements resulting from

financial transactions are the basis of foreign dealings. Clearly the day that

sees the arrival of a single world currency will also witness thedisappearance of foreign exchange business.

MEANING OF FOREIGN EXCHANGE

The term “Foreign Exchange” is used in three different senses:

i. In the sense of foreign currency or foreign bills – Some economists use

the term Foreign Exchange in a narrow sense. According to them,

foreign exchange refers to sale and purchases of foreign currencies

like US $(dollar) British Pound or Sterling £ and Japanese Yen.

ii. In the sense of Rate of Exchange – According to this sense, foreign

exchange refers the rate of exchange or the rate at which the

currency of one country is converted into the currency of another

country. In other words, the external value of domestic currency is

the rate of exchange.

iii. In the sense of an Entire System of International Money Changing –

According to this wider sense, the term Foreign Exchange refers to

that entire operational system by which the countries clear off their

international obligations. It is a science and art of international

money changing. It includes:

a. All those institutions which facilitate international payments.

b. All methods and instruments used for making international

payment.



c. The rate at which the currency of one country is converted into

the currency of another country.

In order to explain the term foreign exchange in more elaborate

manner, we take the help of some definitions given by well-known

economists and others.

DEFINITIONS

S.E.Thomas, “Foreign Exchange is that branch of science of economics in

which we seek to determine the principles on which the peoples of the world

settle their debts one to the other.”

Hartley Withers, “Foreign Exchange is a mechanism by which international

indebtedness is settled between one country and another. It is an art and

science of international money changing.”

Encyclopaedia Britannica. “The Foreign Exchange is a system by which

commercial nations discharge their debts to each other.”

Paul Einzig, “Foreign Exchange (in singular) as a system or process of

converting one national currency into another and transferring money from

one country to another. Foreign Exchanges (in plural) as the mean of

payment in which currencies are converted, international transfers are

made, also the activity of transacting business in such means.”

FERA/ FEMA defines the term Foreign Exchange means foreign currency andincludes-

1. All deposits, credits and balances payable in any foreign currency and

any drafts, traveler cheques, letters of credit and bills of exchange,

expressed or drawn in Indian currency but payable in any foreign

currency.

2. Any instrument payable at the option of the drawer 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, foreign exchange

includes foreign currencies, balances kept abroad and instruments

payable in foreign currency with the help of which countries of the

world clear off their international obligations.

PROBLEMS OF FOREIGN EXCHANGES



In world economy, we know that every country has its own monetary system

and separate monetary unit. For making international payment, the currency

of one country has to be converted into the currency of another country. The

problem of foreign exchange was not so complicated under the gold

standard as it is today under the managed and regulated paper currency

standard. The reason was that under gold standard, the payments were

executed in terms of gold but it is not possible under present system. Due to

this problem and in order to make international payment, the study of

foreign exchange has become highly significant.

1. Existence of Different Currencies With Different Values – In

today’s world economy, each country is having its own monetary

system and monetary units and all the currencies of the world have

different values. No currency has been accepted as an international

currency for making international payments.

2. Disequilibrium in Demand and Supply of Currencies – All the

currencies of the world are not equally demanded. They have

imbalances in their demand and supply. Some currencies have more

demand in comparison to the supply and vice versa. Some currencies

having more demand in international market are called Hard or Dear

currency while the currencies having more supply in comparison to

their demand are called Soft Currencies. This situation also presents

grave problem.

3. Lack of Stability in Exchange rates – The foreign exchange rates

also fluctuates frequently due to several reasons. Due to lack of

stability in their rates also there are many problems.

4. Problem of the methods of International Payments- There are

several methods which are being used in making international

payments. There is no generally accepted means and there are several

problems in accepting payments in soft currency. Due to these

problems, the international payments become more complicated.

5. Problem of Transfer of Payments- There are several problems intransferring payments because of so many hurdles and barriers

imposed nu the countries under exchange control.

6. Problems of Determination of Rate of Exchange- How to

determine the rate of exchange for one country’s currency with the



other currency of another country? There is no unanimity on this

problem.

7. Problems of Restrictions imposed by Countries- Many measures

of control restrictions are being imposed by almost all the countries of

the world and create several types of problems.

IMPORTANCE OF FOREIGN EXCHANGES

In today’s world economy, despite several problems of foreign exchange the

volume of international economic and monetary transactions has

tremendously increased and all countries of the world have been so

integrated with each other that not a single country of the world could claim

to be a “self reliant economy”. Its increasing importance can be explained as

under:

1. For solving the Problems- For solving problems of foreign exchange

enumerated above, the study of foreign had become vitally important.

2. Vital Role in International Trade- The foreign exchange plays a

vital role in making international trade possible. Through the help of

foreign exchange, a country can import essential goods, raw materials,

machinery and other capital goods etc and export its surplus goods

and earn foreign exchange.

3. Trade in Services – With the help of foreign exchange, a country

could render services in different fields like travels, transportation,communication, banking insurance and other can get services from

other parts of the world.

4. Transfer of Technology- Foreign exchange also facilitates easy

transfer of technology from one country to another.

5. Global Capital Movement- Capital is flowing throughout the world

and it is due to foreign exchange.

6. International Remittance and Payments- from various parties like

businessmen, tourists, NRIs and others huge amount is remitted and

all these transactions have become possible with the help of foreign

exchange.

7. It Facilitates Convertibility of All Currencies- Convertibility of

currencies of the world has become easier under foreign exchange.



8. Development of a Separate Branch in Economics Science- Due

to increasing importance, the foreign exchange has been developed as

a distinct and important branch of economics science which deals in

settling international obligations.

9. To Know the Complex Mechanism of International Payment- Theforeign exchange has become more essential in the present complex

and complicates system of international payment. So, in order to study

that mechanism it has gained much significance.

10.Developed as a Powerful Market- Foreign exchange market has

become the most powerful market among all international markets.

The average daily foreign exchange dealings have exceeded $1 trillion

which is very high in comparison to the volume of transactions in other

international financial markets like security and capital market, Gold

and Bullion markets. The growth of foreign exchange market hadoutpaced the output of goods and services in the world.

FOREIGN EXCHANGE RATES (Meaning and Types)

Foreign Exchange Rate refers to the rate at which the currency of one

country can be converted into the currency of another country. The rate of

exchange, this, indicated the exchange ratio between the currencies of two

countries, for example, if one US $ Dollar is equal to forty Indian Rupees.

What this implies that one US $ can fetch forty rupees in the exchange

market.

Dealings in foreign exchange markets are carried out at specified rate or

price of a unit of one currency in terms of another currency. It could beregarded as an external value of domestic currency in terms of other foreign

currencies. Simply the rate is parity between two currencies. The rate at

which one currency buys exchanges for another currency is known as foreign

exchange rate. The rate of exchange is expressed in foreign exchange

market in two ways:



1. Expressing the rate in terms of domestic currency. By taking the one

unit of foreign currency we take the value of domestic currency. For

example, one US dollar is equal to forty Indian rupees. This is also

called as direct rate.

Direct method: US $ 1 = Rs. 40.00

2. Expressing the rate of exchange in terms of foreign currency or

indirect rate method – In this method, the home currency unit is kept

constant and foreign currency unit is varied. The rate is stated to be

quoted in the indirect method.

Indirect method: Rs. 100 = US $ 2.50

DEFINITIONS

Some important definitions given by prominent economists are given asunder:

Crowther- “It (rate of exchange) measures the number of unites of one

currency which exchanges in foreign exchange market for one unit of

another.”

Haynes- “Exchange rate is the price of currency stated in terms of another

currency.”

R.S. Sayers-“The prices of currencies in terms of each other are called

foreign exchange rates.”

S.E. Thomas- “The price of one currency unit in terms of another currency

at any particular time is called the rate of exchange between two

currencies.”

P.T. Ellsworth-“An exchange rate is frequency defined as the price in

domestic currency of a unit of foreign currency. It might equally well be

defined as the price in a foreign currency of a unit of domestic currency.”

Norman Crump-“The rate of exchange between two currencies is theamount of one currency which in foreign exchange market will exchange for

given amount of the other.”

In a nutshell, foreign exchange trade can be defined as an exchange ratio of

two currencies.

TYPES OF FOREIGN EXCHANGE RATES



These are several types of foreign exchange rates. The important types are

as follows:

1. Normal Rate and Actual Rate- Normal or true rate or par of

exchange rate is determined by forces that are of different nature from

those influencing the actual rate. Normal rate may be fixed throughexchange control while the actual rate or the current rate or market

rate is determined by the market forced of demand and supply of

foreign exchange. This actual rate fluctuate from day to day due to

changes in demand and supply but these changes take place around

the rate which is called normal rate. The actual rate may be above or

below the normal rate. For example, if the normal rate of Re and $ is

40:1 the actual rate may be 42:1 or 38:1.

2. Spot Rate and Forward Rate- The spot rate refers to that rate of

exchange at which the delivery of foreign exchange is made to thebuyer by the seller at the spot or delivery of currency bought or sold, is

immediate. Forward rates at those quoted for forward or future

delivery of currency, the rate of exchange is fixed at the time of deal

but actual delivery is effected at contacted future date at this rate. The

forward rate is quoted either at a premium or at a discount over the

spot rate. This rate is calculated by making an allowance of premium

or discount or in other words, forward margin is adjusted.

3. Single Rate and Multiple Rates- In general circumstances, there is

only one single rate for all purposes. But in certain special

circumstances, a country may adopt more than one, two, or three

rates with another currency. This is known as the Multiple Exchange

Rate system. For example, the government of a country adopts one

rate for export and another for imports.

4. Direct Rate and Indirect Rate- From the point of view of expressing

the quotation in the foreign exchange market, the rate could be direct

and indirect. Under direct rate, the foreign currency unit is kept

constant and the home currency is varied, the rate is said to be quoted

in direct method. While in indirect method of quotation, the home

currency unit is kept constant and foreign currency unit id varied, the

rate is called indirect for example:

Direct Rate US $ 1 + Rs. 40 / Indirect Rate Rs. 100 = $2.50



5. Buying Rate and Selling Rate-As the foreign market is very

lucrative and competitive market, the parties engaged in this business,

naturally and to earn maximum profit. The dealers will quote the rates

of foreign currencies in two ways. They will give low rate when they will

buy foreign currencies in two ways. They will give low rate when they

will buy foreign currency and change high rates in case of sale of

foreign exchange. These buying and selling rates are quoted on the

basis of T.T., M.T. or bills.

6. Favorable Rate and Unfavorable Rate- The rate of exchange can

either be favorable or unfavorable to a country. If the external value of

the domestic currency increases in terms of the foreign currency, there

will be favorable rate and vice-versa.

7. Official and Unofficial Exchange Rates- When the International

trade and other transactions are carried on the basis of pre-determinedand authorized rates, these rates are called official rates and if the

transactions are executed on the basis of other rates, they are called

unauthorized and unofficial rates. These rates are also termed as Black

Market rates.

8. Fixed and Flexible Exchange Rates: The fixed rates of exchange

refer to maintenance of external value of the currency at a pre-

determined level that is fixed by the country. Whenever the rate differs

from this level, it is corrected through official intervention. After the

collapse of gold standard, IMP was instituted under article IV of IMP

fixed exchange rates system was adopted and member countries

adopted this system and agreed not to change these rates except in

consultation with the fund. This system was abolished in 1978 with the

amendment in the article of IMF, still the fixed rates continue in many

countries in the form of pegging their currencies to a major currency.

The world economy now has been living in an era of flexible or floating

exchange rates. Currencies outside their home countries have lost the

character of money and have become more like commodities.

The flexible free or floating rates refer to the

system where the exchange rates are determined by the conditions of

market forces viz the demand and supply of foreign exchange in the

market. The rates are free to fluctuate according to the changes in

demand and supply forces with no restrictions on buying and selling of

foreign currencies in the exchange market.

Foreign Exchange& Xchange Rates

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