Foreign Exchange
Unit-IV
Introduction
• A foreign exchange market is a market where foreign currencies are exchanged.
• The foreign-exchange market refers to the organizational setting within which individuals,
businesses, governments, and banks buy and sell foreign currencies and other debt
instruments.
• According to Ellsworth, "A Foreign Exchange Market consists of all those individuals and
institutions that buy and sell foreign exchange which can be stated as foreign money or any
liquid claim on foreign money".
• Foreign Exchange markets comprise up of banks, commercial companies, central banks,
investment management firms, hedge funds and retail forex brokers and investors.
• The forex market is considered the biggest financial market in the world.
Exchange Rate: Definition and
Determination
• An exchange rate is the prevailing market price at which a particular currency can be
exchanged for another one.
• For instance, if the exchange rate of a U.S Dollar to Canadian Dollar is $1.60, it
signifies that 1 American Dollar can be exchanged for 1.6 Canadian dollars.
• Exchange Rate is also known as a currency quotation, the foreign exchange rate or
forex rate.
Exchange Rate Equilibrium
• Like any other product sold in markets, the price of a currency is the product of
demand for that currency and its supply.
• Thus, for each possible price of a British pound, there is a corresponding demand
for pounds and a corresponding supply of pounds for sale.
• At a particular point of time, a currency should exhibit the price at which the
demand for that currency is equal to supply and this represents the equilibrium
exchange rate.
• Of course, conditions can change over time, causing the supply or demand for a
given currency to adjust and thereby causing movement in the currency’s price.
Demand for a
Currency
• The demand curve is sloping
downwards since the corporations
and individuals in the U.S will be
encouraged to buy more British
goods when the pound is worth less,
since fewer dollars will be required
to obtain the desired amount of
pounds and vice versa.
Supply of a
Currency
• There is a positive relationship between the
value of the British pound and the quantity of
the British pounds for sale (supplied).
• If the value of pound is high, British consumers
and firms are more inclined to buy U.S goods.
• Thus, they supply a greater number of pounds
to the market, to be exchanged for dollars.
• In contrast, when the value of pound is low, the
supply of pounds is smaller, reflecting less
British desire to obtain U.S goods.
Equilibrium
• The demand and supply schedules for British pounds are combined in the exhibit.
• At an exchange rate of $1.50, the quantity demanded would exceed the supply of pound.
• Consequently, there will be a shortage of pounds at that exchange rate. At an exchange rate
of $1.60, the demand of pounds will be lower than the supply of pounds for sale.
• Therefore, the banks providing exchange services will have a surplus of pounds at that
exchange rate.
• According to the figure exhibited, the equilibrium exchange rate is $1.55 because this rate
equates the quantity of pounds demanded with the supply of pounds for sale.
Factors that influence Exchange Rates
• The equilibrium exchange rate will change at different points in time as and
when there is a change in the demand and supply schedules. The factors due to
which demand and supply schedules tend to change are mentioned here by
relating each factor’s influence to the demand and supply schedules.
• The following equation summarizes the factors that can influence a currency’s
spot rate:
E= f (Change in INF, Change in INT, Change in INC, Change in GC, Change in
EXP)
▪ E = Percentage change in the spot rate
▪ Change in INF- change in the differential between domestic country’s inflation and the
foreign country’s inflation
▪ Change in INT- change in the differential between domestic country’s interest rate and
the foreign country’s interest rate
▪ Change in INC- change in the differential between income level of domestic country and
the income level of foreign country
▪ Change in GC- Change in Government controls
▪ Change in EXP- change in expectations of future exchange rates
Exchange Rate Systems
• Exchange rate systems can be classified on the basis of the degree of
government control over the determination of exchange rates.
• Exchange rate systems basically fall into one of the following categories,
each of which is discussed in turn:
1. Fixed
2. Freely Floating
3. Managed Floating
4. Pegged
