1The foreign exchange market or the ‘forex market’, is a system which establishes an international

network allowing the buyers and sellers to carry out trade or exchange of currencies of different
countries. It also can be stated as one of the most liquid financial markets which facilitate ‘over-the-
counter’ exchange of currencies.

 Market Transparency: It is effortless to monitor the fluctuations in the value of

currencies of different countries in a forex market easily through account tracking and
real-time portfolio, without the involvement of brokers.
 Dollar is Extensively Traded Currency: The USD, which is paired with almost every
country’s currency and listed on the forex, is the most widely traded currency in the
world.
 Most Dynamic Market: The value of the currencies in the forex market keeps on
changing every second and function twenty-four hours a day. This makes it one of the
most active markets in the world.
 International Network of Dealers: The foreign exchange market establishes a medium
among the dealers and also with the customers. There are dealer’s institutions located
globally to carry out the exchange and trading activities.
 “Over-The-Counter” Market: In different countries, the forex market is the highly
unregulated market initiating over the counter trade by the banks through telex and
telephone.
 High Liquidity: The currency is considered to be the most widely traded financial
instrument across the globe, making the forex market highly liquid.
 Twenty-Four Hour Market: The foreign exchange market is operational for twenty-four
hours of the day, initiating the active trade and exchange of currencies at any time.

(a) Spot Market:

If the operation is of daily nature, it is called spot market or current market. It handles
only spot transactions or current transactions in foreign exchange.

Transactions are affected at prevailing rate of exchange at that point of time and delivery of
foreign exchange is affected instantly. The exchange rate that prevails in the spot market for
foreign exchange is called Spot Rate. Expressed alternatively, spot rate of exchange refers to the
rate at which foreign currency is available on the spot.

For instance, if one US dollar can be purchased for birr 40 at the point of time in the foreign
exchange market, it will be called spot rate of foreign exchange. No doubt, spot rate of foreign
exchange is very useful for current transactions but it is also necessary to find what the spot rate
is. In addition, it is also significant to find the strength of the domestic currency with respect to
all of home country’s trading partners. Note that the measure of average relative strength of a
given currency is called Effective Exchange Rate (EER).

b) Forward Market:
A market in which foreign exchange is bought and sold for future delivery is known as Forward
Market. It deals with transactions (sale and purchase of foreign exchange) which are contracted
today but implemented sometimes in future. Exchange rate that prevails in a forward contract for
purchase or sale of foreign exchange is called Forward Rate. Thus, forward rate is the rate at
which a future contract for foreign currency is made.

This rate is settled now but actual transaction of foreign exchange takes place in future. The
forward rate is quoted at a premium or discount over the spot rate. Forward Market for foreign
exchange covers transactions which occur at a future date. Forward exchange rate helps both the
parties involved.

4The demand (or outflow) of foreign exchange comes from those people who need it to make
payment in foreign currency.

Reasons for ‘Rise in Demand’ for Foreign Currency:

The demand for foreign currency rises in the following situations:

1. When price of a foreign currency falls, imports from that foreign country become cheaper. So,
imports increase and hence, the demand for foreign currency rises. For example, if price of 1 US
dollar falls from Rs 50 to Rs 45, then imports from USA will increase as American goods will
become relatively cheaper. It will raise the demand for US dollars.

2. When a foreign currency becomes cheaper in terms of the domestic currency, it promotes
tourism to that country. As a result, demand for foreign currency rises.

3. When price of a foreign currency falls, its demand rises as more people want to make gains
from speculative activities.

The supply (inflow) of foreign exchange comes from those people who receive it due to following
reasons

The supply of foreign currency rises in the following situations:

1. When price of a foreign currency rises, domestic goods become relatively cheaper. It induces
the foreign country to increase their imports from the domestic country. As a result, supply of
foreign currency rises. For example, if price of 1 US dollar rises from Rs 45 to Rs 50, then
exports to USA will increase as Indian goods will become relatively cheaper. It will raise the
supply of US dollars.

2. When price of a foreign currency rises, supply of foreign currency rises as people want to
make gains from speculative activities.

5a Foreign exchange (Forex or FX) is the conversion of one currency into another at a specific
rate known as the foreign exchange rate. The conversion rates for almost all currencies are
constantly floating as they are driven by the market forces of supply and demand.
B and c

The nominal exchange rate E is defined as the number of units of the domestic currency that can
purchase a unit of a given foreign currency. A decrease in this variable is termed nominal
appreciation of the currency. (Under the fixed exchange rate regime, a downward adjustment of
the rate E is termed revaluation.) An increase in this variable is termed nominal depreciation of
the currency. (Under the fixed exchange rate regime, an upward adjustment of the rate E is called
devaluation.)

By contrast, the real exchange rate R is defined as the ratio of the price level abroad and the
domestic price level, where the foreign price level is converted into domestic currency units via
the current nominal exchange rate. Formally, R=(E.P*)/P, where the foreign price level is
denoted as P* and the domestic price level as P. A decrease in R is termed appreciation of the
real exchange rate, an increase is termed depreciation. The real rate tells us how many times
more or less goods and services can be purchased abroad (after conversion into a foreign
currency) than in the domestic market for a given amount. In practice, changes of the real
exchange rate rather than its absolute level are important. In contrast to the nominal exchange
rate, the real exchange rate is always ”floating”, since even in the regime of a fixed nominal
exchange rate E, the real exchange rate R can move via price-level changes.

The Real Effective Exchange Rate (REER) is an indicator of the external competitiveness of a
countrys currency. It is the weighted average of a countrys currency against a basket of other
major currencies (after adjusting for inflation differentials). The REER is expressed as an index
number relative to a base year.

(a) Fixed Exchange Rate System:

Fixed exchange rate is the rate which is officially fixed by the government or monetary authority
and not determined by market forces. Only a very small deviation from this fixed value is
possible. In this system, foreign central banks stand ready to buy and sell their currencies at a
fixed price. A typical kind of this system was used under Gold Standard System in which each
country committed itself to convert freely its currency into gold at a fixed price.

(b) Flexible (Floating) Exchange Rate System

The system of exchange rate in which rate of exchange is determined by forces of demand and
supply of foreign exchange market is called Flexible Exchange Rate System. Here, value of
currency is allowed to fluctuate or adjust freely according to change in demand and supply of
foreign exchange.

There is no official intervention in foreign exchange market. Under this system, the central bank,
without intervention, allows the exchange rate to adjust so as to equate the supply and demand
for foreign currency In India, it is flexible exchange rate which is being determined. The foreign
exchange market is busy at all times by changes in the exchange rate.

What Is a Dirty Float?

A dirty float is a floating exchange rate where a country's central bank occasionally intervenes to
change the direction or the pace of change of a country's currency value. In most instances, the
central bank in a dirty float system acts as a buffer against an external economic shock before its
effects become disruptive to the domestic economy. A dirty float is also known as a "managed
float."

Arbitrage occurs when an investor can make a profit from simultaneously buying and selling a
commodity in two different markets.

Definition of Hedging – Setting up an investment positions which helps to protect against losses from a
related investment.

Speculation is the purchase of an asset (a commodity, goods, or real estate) with the hope that it will
become more valuable in the near future. In finance, speculation is also the practice of engaging in risky
financial transactions in an attempt to profit from short term fluctuations in the market value of a
tradable financial instrument—rather than attempting to profit from the underlying financial attributes
embodied in the instrument such as value addition, return on investment, or dividends.

Depreciation and devaluation are two economic events that deal with the value of your country's
currency. Both of these situations cause the value of your currency to drop versus the rest of the world.
However, they have two different causes and long-term effects on your country's economy.
Understanding the difference between these two events will help you better plan your portfolio for the
future.

Depreciation

Depreciation happens in countries with a floating exchange rate. A floating exchange rate means
that the global investment market determines the value of a country's currency. The exchange
rate among various currencies changes every day as investors reevaluate new information. While
a country's government and central bank can try to influence its exchange rate relative to other
currencies, in the end it is the free market that determines the exchange rate. All major
economies use a floating exchange rate. Depreciation occurs when a country's exchange rate
goes down in the market. The country's money has less purchasing power in other countries
because of the depreciation.

Devaluation

Devaluation happens in countries with a fixed exchange rate. In a fixed-rate economy, the
government decides what its currency should be worth compared with that of other countries.
The government pledges to buy and sell as much of its currency as needed to keep its exchange
rate the same. The exchange rate can change only when the government decides to change it. If a
government decides to make its currency less valuable, the change is called devaluation. Fixed
exchange rates were popular before the Great Depression but have largely been abandoned for
the more flexible floating rates. China was the last major economy to openly use a fixed
exchange rate. It switched to a floating system in 2005.

Appreciation is when the value of a currency goes up in comparison to other

currencies. Revaluation is an official rise in the price of the currency within a fixed
exchange rate system. ... The diference is that depreciation occurs in a floating
exchange rate whereas devaluation happens in a fixed exchange rate.
Appreciation is when the value of a currency goes up in comparison to other currencies. Revaluation is
an official rise in the price of the currency within a fixed exchange rate system

1. To Boost Exports

On a world market, goods from one country must compete with those from all other countries.

2. To Shrink Trade Deficits

Exports will increase and imports will decrease due to exports becoming cheaper and imports
more expensive. This favors an improved balance of payments as exports increase and imports
decrease, shrinking trade deficits.

3. To Reduce Sovereign Debt Burdens

A government may be incentivized to encourage a weak currency policy if it has a lot of

government-issued sovereign debt to service on a regular basis. If debt payments are fixed, a
weaker currency makes these payments effectively less expensive over time.

definition: Money market basically refers to a section of the financial market where financial
instruments with high liquidity and short-term maturities are traded. Money market has become a
component of the financial market for buying and selling of securities of short-term maturities, of one
year or less, such as treasury bills and commercial papers.

Description: Money market consists of negotiable instruments such as treasury bills, commercial papers.
and certificates of deposit. It is used by many participants, including companies, to raise funds by selling
commercial papers in the market. Money market is considered a safe place to invest due to the high
liquidity of securities.

It has certain risks which investors should be aware of, one of them being default on securities such as
commercial papers. Money market consists of various financial institutions and dealers, who seek to
borrow or loan securities. It is the best source to invest in liquid assets.
What Is Money?

Money is an economic unit that functions as a generally recognized medium of exchange for

transactional purposes in an economy. Money provides the service of reducing transaction cost,
namely the double coincidence of wants. Money originates in the form of a commodity, having a
physical property to be adopted by market participants as a medium of exchange. Money can be:
market-determined, officially issued legal tender or fiat moneys, money substitutes and fiduciary
media, and electronic cryptocurrencies. 

Understanding Money

Money is commonly referred to as currency. Economically, each government has its own money
system. Cryptocurrencies are also being developed for financing and international exchange
across the world.

Money is a liquid asset used in the settlement of transactions. It functions based on the general
acceptance of its value within a governmental economy and internationally through foreign
exchange. The current value of monetary currency is not necessarily derived from the materials
used to produce the note or coin. Instead, value is derived from the willingness to agree to a
displayed value and rely on it for use in future transactions. This is money's primary function: a
generally recognized medium of exchange that people and global economies intend to hold, and
are willing to accept as payment for current or future transactions.

Economic money systems began to be developed for the function of exchange. The

use of money as currency provides a centralized medium for buying and selling in a
market. This was first established to replace bartering. Monetary currency helps to
provide a system for overcoming the double coincidence of wants. The double
coincidence of wants is a ubiquitous problem in a barter economy, where in order to
trade, each party must have something that the other party wants. When all parties
use and willingly accept an agreed-upon monetary currency, they can avoid this
problem. Functions of Money
Money is often defined in terms of the three functions or services that it provides. Money serves as a
medium of exchange, as a store of value, and as a unit of account.

Medium of exchange. Money's most important function is as a medium of exchange to facilitate

transactions. Without money, all transactions would have to be conducted by barter, which
involves direct exchange of one good or service for another. The difficulty with a barter system
is that in order to obtain a particular good or service from a supplier, one has to possess a good or
service of equal value, which the supplier also desires. In other words, in a barter system,
exchange can take place only if there is a double coincidence of wants between two transacting
parties. The likelihood of a double coincidence of wants, however, is small and makes the
exchange of goods and services rather difficult. Money effectively eliminates the double
coincidence of wants problem by serving as a medium of exchange that is accepted in all
transactions, by all parties, regardless of whether they desire each others' goods and services.
Store of value. In order to be a medium of exchange, money must hold its value over time; that
is, it must be a store of value. If money could not be stored for some period of time and still
remain valuable in exchange, it would not solve the double coincidence of wants problem and
therefore would not be adopted as a medium of exchange. As a store of value, money is not
unique; many other stores of value exist, such as land, works of art, and even baseball cards and
stamps. Money may not even be the best store of value because it depreciates with inflation.
However, money is more liquid than most other stores of value because as a medium of
exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of
value that is available in a number of convenient denominations.

Unit of account. Money also functions as a unit of account, providing a common measure of the
value of goods and services being exchanged. Knowing the value or price of a good, in terms of
money, enables both the supplier and the purchaser of the good to make decisions about how
much of the good to supply and how much of the good to purchase.

Money overcomes the problem of barter system by replacing the C-C economy with monetary economy
(where 'C stands for commodity).
(i) In the barter system, there was a problem of double coincidence of wants. It was very difficult to
match the expectations of two different individuals. Thus, money was invented to overcome the
problem of double . coincidence of wants.
(ii) When there was no money, it was difficult to give common unit of value to goods or commodities,
but when money was evolved, it gave a common unit of value to every goods and services.
(iii) Money facilitates the contractual future payments which were impossible at the time of barter
system.

Monetary policy is a central bank's actions and communications that manage the money supply.
The money supply includes forms of credit, cash, checks, and money market mutual funds. The
most important of these forms of money is credit. Credit includes loans, bonds, and mortgages. 

Monetary policy increases liquidity to create economic growth. It reduces liquidity to prevent
inflation. Central banks use interest rates, bank reserve requirements, and the number of
government bonds that banks must hold. All these tools affect how much banks can lend. The
volume of loans affects the money supply.