UNIT 3

Foreign Exchange and Balance of

Payment
FOREX Market
• Meaning
• Characteristics
a) Lower Trading Costs
b) Superior Liquidity
c) Excellent transparency
d) Strong market trends
FOREX MARKET Participants
1. Consumers and Travelers
2. Businesses
3. Investors and Speculators
4. Commercial and Investment Banks
5. Government and Central Banks
Functions
• Transfer Functions
• Credit Function
• Hedging Function
Intermediaries

I Dealers II Types of FOREX Markets

• Retails Clients • Retail Markets
• Commercial Banks • Wholesale Markets
• FOREX Brokers • Other Participants
• Central Banks • Brokers
• Price Takers
• Three Tiers
• RBI and Ads, ADs and Ads and
Ads and Corporate customers
• What is the national currency of Afghanistan?
• A. Afghan Afghani
• B. US Dollar
• C. Afghan Dollar
• D. Afghan yen
Answer A
• What is the national currency of Australia?
• A. Australian pound
• B. Australian dollar
• C. Australian euro
• D. Australian renmin
• Answer B
What is the national currency of Bangladesh?
• A. Bangladeshi taka
• B. Bangladeshi rupee
• C. Bangladeshi renmin
• D. Bangladeshi dollar
Answer: Option A
What is the national currency of Brazil?
A. Brazilian peso
B. Brazilian dollar
C. Brazilian real
D. Brazilian riel

Answer: Option C
Exchange Rate Mechanism
• Home Currency/ Domestic Currency
• Foreign currency
• Ratio of exchange rate is know as FOREIGN
EXCHANGE RATE
• Expression of this is FOREIGN EXCHANGE
QUOTATION
Types of quotation
Direct and Indirect
Direct
How many units of home currency I need to buy one unit of foreign
currency ?
Ex: 1$= Rs 71.11
Home currency price of foreign currency.

Indirect- reciprocal of direct quote

Unit of domestic currency expressed in terms of foreign currency/ the
number of units of FC that can be bought with one unit of HC.

Ex. Rs 1= 0.014 $

* In India Foreign Exchange rates are quoted directly.

Terms
• Currency pairs
https://www.dailyfx.com/usd-inr

• Cross currency
• Quote currency
• Base currency
• Appreciation
• Depreciation

• Foreign currency appreciation and home currency depreciation

• Ex: 1$= Rs 71.11 to Ex: 1$= Rs 72.11
Foreign Exchange Rate
• Meaning
• Value of one currency in terms of another currency

• Importance
• Value of the country
• Exports and imports

• Objectives Foreign exchange rate policy

• Maintain international reserves
• Keep the volatility under control
• Moderate the appreciation and depreciation
Types of FOREX Rates
1. Spot rate/ Cable Rate/ Telegraph Transfer Rate- the
rate indicates the market expectations- settled
immediately.
2. Forward Rate
3. Long rate- banks purchases and sells foreign
currency bills which are payable at a fixed future
date.
4. Fixed exchange rate
5. Flexible exchange rate
6. Multiple exchange rate
7. Two tier rate system
Factors affecting the FOREX Rate
1. Monetary policy
2. Political situation- 1987 buying USD and dumping
Yen and Deutsche Mark
3. Balance of payment
4. Interest rates
5. Market judgement
6. Speculation – Example US’s Position after WW II
and Vietnam War
Fixed exchange rate and flexible exchange
rate.
I. Fixed or Pegged Exchange Rate
• Referred to as official parity
• Used by smaller countries
Advantages
1. Promotes international Trade Disadvantages
2. Necessary for small nations 1. Outdated system
3. Promotes International Investment 2. Monetary dependence
4. Removes speculation 3. Discourages foreign investment
5. Necessary fro developing countries 4. Cost price relationship in not
6. Not permanently fixed reflected
7. Orderly growth 5. Not a genuinely fixed system
8. smooth functioning, elimination of
uncertainty and risk
9. Useful in times of troubled
relations.
Fixed exchange rate and flexible exchange
rate.
I. Floating or Flexible Exchange Rate
• Determined by demand and supply
• Used by many countries
Disadvantages
1. Uncertainty
Advantages 2. Lack of investments
1. Independent Monetary Policy 3. Speculation
2. Shock Absorber 4. Effect on the economy
3. Solutions to Balance of payment
5. Inflation impacts the value
problems
4. Automatic stabilization
5. Free internal policy
6. Absence of crisis
Theories

THEORIESOFFOREIGNEXCHANGE
BOP
• Accounting record of all monetary transactions
• Between a country and rest of the world
• Difference between total payments and total receipts
• Payments- Receipts!!!
• Payments- Arising out of
Imports of goods and services
Transfers of capital, interest, grants etc.
• Receipts- Arising out of
Exports of goods and services
Transfers from abroad of capital, interest, grants etc.
• For a year
• Single currency
• Domestic currency
• Sources of funds are surplus (+) -exports or receipts
• Uses of funds are deficit (-)- imports or investment in
FC
• Total must be zero
• Sources>uses = surplus
• Uses > sources = deficit
Meaning
• Systematic record of nation‘s total payments to a
foreign countries and total receipts.

• Definition
• “ Balance of payment is an accounting record of all
monetary transactions between a country and the rest
of the world”
Components
Disequilibrium
Causes
Measures to correct