final ib w a

8/8/2019 final IB W A

1/32

INTRODUCTION

The foreign exchange market (forex, FX, or currency market) is a worldwide

decentralized over-the-counter financial market for the trading of currencies.

Financial centers around the world function as anchors of trading between a

wide range of different types of buyers and sellers around the clock, with the

exception of weekends. The foreign exchange market determines the relative

values of different currencies.

The primary purpose of the foreign exchange market is to assist international

trade and investment, by allowing businesses to convert one currency to

another currency. For example, it permits a US business to import British

goods and pay Pound Sterling, even though the business's income is in US

dollars. It also supports speculation, and facilitates the carry trade, in which

investors borrow low-yielding currencies and lend (invest in) high-yielding

currencies, and which (it has been claimed) may lead to loss of

competitiveness in some countries.

In a typical foreign exchange transaction a party purchases a quantity of one

currency by paying a quantity of another currency. The modern foreign

exchange market started forming during the 1970s when countries gradually

switched to floating exchange rates from the previous exchange rate regime,

which remained fixed as per the Bretton Woods system.
http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Pound_Sterlinghttp://en.wikipedia.org/wiki/US_dollarshttp://en.wikipedia.org/wiki/US_dollarshttp://en.wikipedia.org/wiki/Carry_tradehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Exchange_rate_regimehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Bretton_Woods_systemhttp://en.wikipedia.org/wiki/Pound_Sterlinghttp://en.wikipedia.org/wiki/US_dollarshttp://en.wikipedia.org/wiki/US_dollarshttp://en.wikipedia.org/wiki/Carry_tradehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Exchange_rate_regimehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Bretton_Woods_systemhttp://en.wikipedia.org/wiki/Over-the-counter_(finance)


2/32

The foreign exchange market is unique because of its

huge trading volume, leading to high liquidity

geographical dispersion

continuous operation: 24 hours a day except weekends, i.e. trading from

20:15 GMT on Sunday until 22:00 GMT Friday

the variety of factors that affect exchange rates

the low margins of relative profit compared with other markets of fixed

income

the use ofleverage to enhance profit margins with respect to account

size

As such, it has been referred to as the market closest to the ideal ofperfect

competition, notwithstanding market manipulation by central banks.

According to the Bank for International Settlements, average daily turnover

in global foreign exchange markets is estimated at $3.98 trillion, as of April

2010 a growth of approximately 20% over the $3.21 trillion daily volume as of

April 2007.

The $3.21 trillion break-down is as follows:

$1.005 trillion in spot transactions

$362 billion in outright forwards

$1.714 trillion in foreign exchange swaps

$129 billion estimated gaps in reporting
http://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/GMThttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Perfect_competitionhttp://en.wikipedia.org/wiki/Perfect_competitionhttp://en.wikipedia.org/wiki/Market_manipulationhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Foreign_exchange_spot_tradinghttp://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Forex_swaphttp://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/GMThttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Perfect_competitionhttp://en.wikipedia.org/wiki/Perfect_competitionhttp://en.wikipedia.org/wiki/Market_manipulationhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Foreign_exchange_spot_tradinghttp://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Forex_swap


3/32

Determinants of FX rates

The following theories explain the fluctuations in FX rates in a floating

exchange rate regime (In a fixed exchange rate regime, FX rates are decided

by its government):

(a) International parity conditions: Relative Purchasing Power Parity,

interest rate parity, Domestic Fisher effect, International Fisher effect.

Though to some extent the above theories provide logical explanation

for the fluctuations in exchange rates, yet these theories falter as they

are based on challengeable assumptions [e.g., free flow of goods, servicesand capital] which seldom hold true in the real world.

(b) Balance of payments model: This model, however, focuses largely on

tradable goods and services, ignoring the increasing role of global

capital flows. It failed to provide any explanation for continuous

appreciation of dollar during 1980s and most part of 1990s in face of

soaring US current account deficit.

(c) Asset market model: views currencies as an important asset class for

constructing investment portfolios. Assets prices are influenced mostly

by peoples willingness to hold the existing quantities of assets, which in

turn depends on their expectations on the future worth of these assets.

The asset market model of exchange rate determination states that the

exchange rate between two currencies represents the price that just

balances the relative supplies of, and demand for, assets denominated in

those currencies.
http://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Relative_Purchasing_Power_Parityhttp://en.wikipedia.org/wiki/Interest_rate_parityhttp://en.wikipedia.org/wiki/Fisher_hypothesishttp://en.wikipedia.org/wiki/International_Fisher_effecthttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Relative_Purchasing_Power_Parityhttp://en.wikipedia.org/wiki/Interest_rate_parityhttp://en.wikipedia.org/wiki/Fisher_hypothesishttp://en.wikipedia.org/wiki/International_Fisher_effect


4/32

None of the models developed so far succeed to explain FX rates levels and

volatility in the longer time frames. For shorter time frames (less than a few

days) algorithm can be devised to predict prices. Large and small institutions

and professional individual traders have made consistent profits from it. It is

understood from above models that many macroeconomic factors affect the

exchange rates and in the end currency prices are a result of dual forces of

demand and supply. The world's currency markets can be viewed as a huge

melting pot: in a large and ever-changing mix of current events, supply and

demand factors are constantly shifting, and the price of one currency in

relation to another shifts accordingly. No other market encompasses (and

distills) as much of what is going on in the world at any given time as foreign

exchange.

Supply and demand for any given currency, and thus its value, are not

influenced by any single element, but rather by several. These elements

generally fall into three categories: economic factors, political conditions and

market psychology.

Economic factors

These include: (a)economic policy, disseminated by government agencies and

central banks,

(b)economic conditions, generally revealed through economic reports, and

other economic indicators.

Economic policy comprises government fiscal policy (budget/spending

practices) and monetary policy (the means by which a government's
http://en.wikipedia.org/wiki/Algo_tradinghttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Economichttp://en.wikipedia.org/wiki/Politicalhttp://en.wikipedia.org/wiki/Market_psychologyhttp://en.wikipedia.org/wiki/Central_bankshttp://en.wikipedia.org/wiki/Economic_indicatorshttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Algo_tradinghttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Economichttp://en.wikipedia.org/wiki/Politicalhttp://en.wikipedia.org/wiki/Market_psychologyhttp://en.wikipedia.org/wiki/Central_bankshttp://en.wikipedia.org/wiki/Economic_indicatorshttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Monetary_policy


5/32

central bank influences the supply and "cost" of money, which is

reflected by the level ofinterest rates).

Government budget deficits or surpluses: The market usually reacts

negatively to widening government budget deficits, and positively to

narrowing budget deficits. The impact is reflected in the value of a

country's currency.

Balance of trade levels and trends: The trade flow between countries

illustrates the demand for goods and services, which in turn indicates

demand for a country's currency to conduct trade. Surpluses and

deficits in trade of goods and services reflect the competitiveness of a

nation's economy. For example, trade deficits may have a negative

impact on a nation's currency.

Inflation levels and trends: Typically a currency will lose value if there

is a high level ofinflation in the country or if inflation levels are

perceived to be rising. This is because inflation erodes purchasing

power, thus demand, for that particular currency. However, a currency

may sometimes strengthen when inflation rises because of expectations

that the central bank will raise short-term interest rates to combat

rising inflation.

Economic growth and health: Reports such as GDP, employment levels,

retail sales, capacity utilization and others, detail the levels of a

country's economic growth and health. Generally, the more healthy and

robust a country's economy, the better its currency will perform, and

the more demand for it there will be.

Productivity of an economy: Increasing productivity in an economy

should positively influence the value of its currency. Its effects are more

prominent if the increase is in the traded sector.
http://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Budget_deficithttp://en.wikipedia.org/wiki/Trade_deficitshttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Employmenthttp://en.wikipedia.org/wiki/Retail_saleshttp://en.wikipedia.org/wiki/Capacity_utilizationhttp://en.wikipedia.org/wiki/Economic_growthhttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Budget_deficithttp://en.wikipedia.org/wiki/Trade_deficitshttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Employmenthttp://en.wikipedia.org/wiki/Retail_saleshttp://en.wikipedia.org/wiki/Capacity_utilizationhttp://en.wikipedia.org/wiki/Economic_growth


6/32

Political conditions

Internal, regional, and international political conditions and events can have a

profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations

about the new ruling party. Political upheaval and instability can have a

negative impact on a nation's economy. For example, destabilization of

coalition governments in Pakistan and Thailand can negatively affect the

value of their currencies. Similarly, in a country experiencing financial

difficulties, the rise of a political faction that is perceived to be fiscallyresponsible can have the opposite effect. Also, events in one country in a

region may spur positive/negative interest in a neighboring country and, in

the process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange

market in a variety of ways:

Flights to quality: Unsettling international events can lead to a "flight to

quality," with investors seeking a "safe haven." There will be a greater

demand, thus a higher price, for currencies perceived as stronger over

their relatively weaker counterparts. The U.S. dollar, Swiss franc and

gold have been traditional safe havens during times of political or

economic uncertainty.

Long-term trends: Currency markets often move in visible long-term

trends. Although currencies do not have an annual growing season like

physical commodities, business cycles do make themselves felt. Cycle
http://en.wikipedia.org/wiki/Politicalhttp://en.wikipedia.org/wiki/Market_psychologyhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Safe_havenhttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Swiss_franchttp://en.wikipedia.org/wiki/Gold_as_investmenthttp://en.wikipedia.org/wiki/Market_trendshttp://en.wikipedia.org/wiki/Business_cyclehttp://en.wikipedia.org/wiki/Politicalhttp://en.wikipedia.org/wiki/Market_psychologyhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Safe_havenhttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Swiss_franchttp://en.wikipedia.org/wiki/Gold_as_investmenthttp://en.wikipedia.org/wiki/Market_trendshttp://en.wikipedia.org/wiki/Business_cycle


7/32

analysis looks at longer-term price trends that may rise from economic

or political trends.

"Buy the rumor, sell the fact": This market truism can apply to many

currency situations. It is the tendency for the price of a currency to

reflect the impact of a particular action before it occurs and, when the

anticipated event comes to pass, react in exactly the opposite direction.

This may also be referred to as a market being "oversold" or

"overbought". To buy the rumor or sell the fact can also be an example

of the cognitive bias known as anchoring, when investors focus too

much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect

economic policy, some reports and numbers take on a talisman-like

effect: the number itself becomes important to market psychology and

may have an immediate impact on short-term market moves. "What to

watch" can change over time. In recent years, for example, money

supply, employment, trade balance figures and inflation numbers have

all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated

price movements in a currency pair such as EUR/USD can form

apparent patterns that traders may attempt to use. Many traders study

price charts in order to identify such patterns. [17]

Algorithmic trading in foreign exchange

Electronic trading is growing in the FX market, and algorithmic trading is

becoming much more common. According to financial consultancy Celent

estimates, by 2008 up to 25% of all trades by volume will be executed using

algorithm, up from about 18% in 2005.
http://en.wikipedia.org/wiki/Cognitive_biashttp://en.wikipedia.org/wiki/Anchoringhttp://en.wikipedia.org/wiki/Economic_indicatorshttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Employmenthttp://en.wikipedia.org/wiki/Trade_balancehttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Technical_analysishttp://en.wikipedia.org/wiki/Foreign_exchange_market#cite_note-17http://en.wikipedia.org/wiki/Electronic_tradinghttp://en.wikipedia.org/wiki/Algorithmic_tradinghttp://en.wikipedia.org/wiki/Cognitive_biashttp://en.wikipedia.org/wiki/Anchoringhttp://en.wikipedia.org/wiki/Economic_indicatorshttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Employmenthttp://en.wikipedia.org/wiki/Trade_balancehttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Technical_analysishttp://en.wikipedia.org/wiki/Foreign_exchange_market#cite_note-17http://en.wikipedia.org/wiki/Electronic_tradinghttp://en.wikipedia.org/wiki/Algorithmic_trading


8/32

Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except in the case of

trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian

Ruble, which settle the next business day), as opposed to the futures contracts,

which are usually three months. This trade represents a direct exchange

between two currencies, has the shortest time frame, involves cash rather than

a contract; and interest is not included in the agreed-upon transaction.

Forward

One way to deal with the foreign exchange risk is to engage in a forward

transaction. In this transaction, money does not actually change hands until

some agreed upon future date. A buyer and seller agree on an exchange rate

for any date in the future, and the transaction occurs on that date, regardless

of what the market rates are then. The duration of the trade can be one day, a

few days, months or years. Usually the date is decided by both parties. and

forward contract is a negotiated and agreement between two parties

Future

Foreign currency futures are exchange traded forward transactions with

standard contract sizes and maturity dates for example, $1000 for next

November at an agreed rate. Futures are standardized and are usually traded

on an exchange created for this purpose. The average contract length is

roughly 3 months. Futures contracts are usually inclusive of any interest

amounts.
http://en.wikipedia.org/wiki/Spot_pricehttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Spot_pricehttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Forward_contract


9/32

Swap

The most common type of forward transaction is the currency swap. In a

swap, two parties exchange currencies for a certain length of time and agree

to reverse the transaction at a later date. These are not standardized contracts

and are not traded through an exchange.

Option

A foreign exchange option (commonly shortened to just FX option) is a

derivative where the owner has the right but not the obligation to exchange

money denominated in one currency into another currency at a pre-agreed

exchange rate on a specified date. The FX options market is the deepest,

largest and most liquid market for options of any kind in the world..

Speculation

Controversy about currency speculators and their effect on currency

devaluations and national economies recurs regularly. Nevertheless,

economists including Milton Friedman have argued that speculators

ultimately are a stabilizing influence on the market and perform the

important function of providing a market for hedgers and transferring risk

from those people who don't wish to bear it, to those who do. Other

economists such as Joseph Stiglitz consider this argument to be based more on

politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main

professional speculators. According to some economists, individual traders
http://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Milton_Friedmanhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Joseph_Stiglitzhttp://en.wikipedia.org/wiki/Hedge_fundshttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Milton_Friedmanhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Joseph_Stiglitzhttp://en.wikipedia.org/wiki/Hedge_funds


10/32

could act as "noise traders" and have a more destabilizing role than larger

and better informed actors.

Currency speculation is considered a highly suspect activity in many

countries. While investment in traditional financial instruments like bonds or

stocks often is considered to contribute positively to economic growth by

providing capital, currency speculation does not; according to this view, it is

simply gambling that often interferes with economic policy. For example, in

1992, currency speculation forced the Central Bank of Sweden to raise

interest rates for a few days to 500% per annum, and later to devalue the

krona. Former Malaysian Prime Minister Mahathir Mohamad is one well

known proponent of this view. He blamed the devaluation of the Malaysian

ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to

"vigilantes" who simply help "enforce" international agreements and

anticipate the effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or

otherwise mishandle their national economies, and foreign exchange

speculators made the inevitable collapse happen sooner. A relatively quick

collapse might even be preferable to continued economic mishandling,

followed by an eventual, larger, collapse. Mahathir Mohamad and other

critics of speculation are viewed as trying to deflect the blame fromthemselves for having caused the unsustainable economic conditions.
http://en.wikipedia.org/wiki/Gamblinghttp://en.wikipedia.org/wiki/Sveriges_Riksbankhttp://en.wikipedia.org/wiki/Mahathir_Mohamadhttp://en.wikipedia.org/wiki/Malaysian_ringgithttp://en.wikipedia.org/wiki/Malaysian_ringgithttp://en.wikipedia.org/wiki/George_Soroshttp://en.wikipedia.org/wiki/Gregory_J._Millmanhttp://en.wikipedia.org/wiki/Economic_bubblehttp://en.wikipedia.org/wiki/Gamblinghttp://en.wikipedia.org/wiki/Sveriges_Riksbankhttp://en.wikipedia.org/wiki/Mahathir_Mohamadhttp://en.wikipedia.org/wiki/Malaysian_ringgithttp://en.wikipedia.org/wiki/Malaysian_ringgithttp://en.wikipedia.org/wiki/George_Soroshttp://en.wikipedia.org/wiki/Gregory_J._Millmanhttp://en.wikipedia.org/wiki/Economic_bubble


11/32

FUNCTIONS OF FOREIGN EXCHANGE MARKET

Aforeign exchangemarket is a place in which foreign

exchange transactions take place. In other words it is a

market where foreign money are bought and sold. It is a

part ofmoney market in the financial center

The foreign exchange market serves two functions: converting currencies and

reducing risk.

There are four major reasons firms need to convert currencies.

1. First, the payments firms receive from exports, foreign investments, foreign

profits, or licensing agreements may all be in a foreign currency. In order to

use these funds in its home country, an international firm has to convert funds

from foreign to domestic currencies.

2. Second, a firm may purchase supplies from firms in foreign countries, and

pay these suppliers in their domestic currency.

3. Third, a firm may want to invest in a different country from that in which it

currently holds underused funds.

4. Fourth, a firm may want to speculate on exchange rate movements, and

earn profits on the changes it expects. If it expects a foreign currency to

appreciate relative to its domestic currency, it will convert its domestic funds

into the foreign currency. Alternately stated, it expects its domestic currency

to depreciate relative to the foreign currency. An example similar to the one in

the book can help illustrate how money can be made on exchange rate
http://www.blurtit.com/q117716.htmlhttp://www.blurtit.com/q144843.htmlhttp://www.blurtit.com/q117716.htmlhttp://www.blurtit.com/q144843.html


12/32

speculation. The management focus on George Soros shows how one fund has

benefited from currency speculation.

Exchange rates change on a daily basis. The price at any given time is called

the spot rate, and is the rate for currency exchanges at that particular time.

One can obtain the current exchange rates from a newspaper or online. The

fact that exchange rates can change on a daily basis depending upon the

relative supply and demand for different currencies increases the risks for

firms entering into contracts where they must be paid or pay in a foreign

currency at some time in the future.

Forward exchange rates allow a firm to lock in a future exchange rate for the

time when it needs to convert currencies. Forward exchange occurs when two

parties agree to exchange currency and execute a deal at some specific date in

the future. The book presents an example of a laptop computer purchase

where using the forward market helps assure the firm that will won't lose

money on what it feels is a good deal. It can be good to point out that from a

firm's perspective, while it can set prices and agree to pay certain costs, and

can reasonably plan to earn a profit; it has virtually no control over the

exchange rate. When spot exchange rate changes entirely wipe out the profits

on what appear to be profitable deals, the firm has no recourse.

When a currency is worth less with the forward rate than it is with the spot

rate, it is selling at forward discount. Likewise, when a currency is worthmore in the future than it is on the spot market, it is said to be selling at a

forward premium, and is hence expected to appreciate. These points can be

illustrated with several of the currencies. A currency swap is the simultaneous


13/32

purchase and sale of a given amount of currency at two different dates and

values.

EXCHANGE RATE DETERMINATION

Theexchange rates(also known as theforeign-exchange

rate,forex rateorFX rate) between

twocurrenciesspecifies how much one currency is worth

in terms of the other. It is the value of a foreign nations

currency in terms of the home nations currency.[1]For

example an exchange rate of 91Japanese yen(JPY, ) to

theUnited States dollar(USD, $) means that JPY 91 is

worth the same as USD 1. Theforeign exchange marketis

one of the largest markets in the world. By some

estimates, about 3.2 trillion USD worth of currency

changes hands every day.

The determination of exchange rate is one question that crops up in

everyones mind, whenever we read reports such as, Rs. appreciating, US

Dollar falling down, everywhere.

In a very simple language ,we can say that Demand and supply determines the

value of any currency against any other currency. Suppose the demand for

Rupee is higher owing to excess supply of dollar (i.e. more number of people

want to convert their dollar in to Rupee), value of dollar will naturally decline

against Rupee. This is the fundamental principle of Demand and Supply

driven Exchange rate.
http://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Exchange_rate#cite_note-0http://en.wikipedia.org/wiki/Japanese_yenhttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Foreign_exchange_markethttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Exchange_rate#cite_note-0http://en.wikipedia.org/wiki/Japanese_yenhttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Foreign_exchange_market


14/32

Not every nation on the earth follows the system of Demand and supply for

determining the exchange rate. Some have pegged the value of their currency

against others (like china) and some follow the route of `Free float` and

intervention (by central bank) now and then whenever required (like India).

`Gold Standard`It was the earliest method used for determining the value of a

currency Under the gold standard, currency issuers guarantee to redeem

notes, upon demand, in that amount of gold. Governments that employ such a

fixed unit of account, and which will redeem their notes to other governments

in gold, share a fixed-currency relationship.This system avoids frivolous

printing of currency and keeps the inflation under check. With expanding

trade beyond geographies and transactions taking place across nations, this

system of Gold standard was ill equipped to address the concerns and

complexities of the new changing and dynamic world order.

Bretton Woods SystemThis new order came in to exisistence in 1944.

Preparing to rebuild the international economic system as World War II was

still raging, 730 delegates from all 44 Allied nations gathered at the Mount

Washington Hotel in Bretton Woods,for the United Nations Monetary and

Financial Conference. The delegates deliberated upon and signed the Bretton

Woods Agreements during the first three weeks of July 1944.Here the

participating countries agreed to fix the value of their currencies with in the

fixed value (i.e. plus or minus some percentage in terms of gold) and it was

also agreed that IMF would help those nations in case of serious problems in

Balance of Payments.But this system also collapsed in 70s when US

unilaterally decided to move out of this system and refused to convert the

dollar into gold.

Demand and Supply This is the simple and most effective method to

determine the value of currency which is used almost everywhere worldwide.


15/32

(With some exceptions and modifications)This is also popularly called as free

float system, where the market forces are given a free hand to determine the

value of any currency based on Demand and supply for respective

currencies. Today in India we follow a middle path that is in-between free

hand to market forces and occasional intervention by central banker. Still we

have very long way to go so that our exchange rate is completely determined

by market forces. , For that various other regulatory issues including `Capital

account convertibility `have to be sorted out. Then what are the advantages or

disadvantages of opting for `no intervention policy by government` is another

topic for debate and we will discuss some time later

Just to give you an example of how the Foreign exchange

rate can work and to help you better understands it we

can compare the United States dollar with the Japanese

yen. Let's say that on a certain day the US dollar is able to

buy one hundred and ten Japanese yens, this would

indicate that the exchange rate for that day is 1:110 or a

one to one hundred and ten ratio. This ratio in the

exchange rate is also known as pairing. When you take it

vice versa you can use it to indicate how many US dollars

a single unit of Japanese yen can buy. Another term that is

used in the Foreign exchange rate is 'cross rates'. This

term however is only used when it does not involve US

dollars; it is only used when relating two foreign

currencies.

FIXED EXCHANGE RATE


16/32

A fixed exchange rate, sometimes called a pegged exchange rate, is a type

ofexchange rate regime wherein a currency's value is matched to the value of

another single currency or to a basket of other currencies, or to another

measure of value, such as gold.

A fixed exchange rate is usually used to stabilize the value of a currency

against the currency it is pegged to. This makes trade and investments

between the two countries easier and more predictable, and is especially

useful for small economies where external trade forms a large part of their

GDP.

It can also be used as a means to control inflation. However, as the reference

value rises and falls, so does the currency pegged to it. There are no major

economic players that use a fixed exchange rate (except the countries using

the Euro). The currencies of the countries that now use the euro are still

existing (e.g. for old bonds). The rates of these currencies are fixed with

respect to the euro and to each other. The most recent such country to

discontinue their fixed exchange rate was the People's Republic of China,which did so in July 2005

Typically, a government wanting to maintain a fixed exchange rate does so by

either buying or selling its own currency on the open market. This is one

reason governments maintain reserves of foreign currencies. If the exchange

rate drifts too far below the desired rate, the government buys its own

currency in the market using its reserves. This places greater demand on themarket and pushes up the price of the currency. If the exchange rate drifts too

far above the desired rate, the government sells its own currency, thus

increasing its foreign reserves.
http://en.wikipedia.org/wiki/Exchange_rate_regimehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Gold_standardhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Eurohttp://en.wikipedia.org/wiki/People's_Republic_of_Chinahttp://en.wikipedia.org/wiki/Exchange_rate_regimehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Gold_standardhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Eurohttp://en.wikipedia.org/wiki/People's_Republic_of_China


17/32

Another, less used means of maintaining a fixed exchange rate is by simply

making it illegal to trade currency at any other rate. This is difficult to enforce

and often leads to a black market in foreign currency. Nonetheless, some

countries are highly successful at using this method due to government

monopolies over all money conversion. This was the method employed by the

Chinese government to maintain a currency peg or tightly banded float

against the US dollar. Throughout the 1990s, China was highly successful at

maintaining a currency peg using a government monopoly over all currency

conversion between the yuan and other currencies

The main criticism of a fixed exchange rate is that flexible exchange rates

serve to automatically adjust the balance of trade. When a trade deficit

occurs, there will be increased demand for the foreign (rather than domestic)

currency which will push up the price of the foreign currency in terms of the

domestic currency. That in turn makes the price of foreign goods less

attractive to the domestic market and thus pushes down the trade deficit.

Under fixed exchange rates, this automatic rebalancing does not occur.

Government also has to invest many resources in getting the foreign reserves

to pile up in order to defend the pegged exchange rate. Moreover a

government, when having a fixed rather than dynamic exchange rate, cannot

use monetary or fiscal policies with a free hand. For instance, by using

reflationary tools to set the economy rolling (by decreasing taxes and injecting

more money in the market), the government risks running into a trade deficit.

This might occur as the purchasing power of a common household increases

along with inflation, thus making imports relatively cheaper.

Additionally, the stubbornness of a government in defending a fixed exchange

rate when in a trade deficit will force it to use deflationary measures
http://en.wikipedia.org/wiki/Black_markethttp://en.wikipedia.org/wiki/Balance_of_tradehttp://en.wikipedia.org/wiki/Black_markethttp://en.wikipedia.org/wiki/Balance_of_trade


18/32

(increased taxation and reduced availability of money) which can lead to

unemployment. Finally, other countries with a fixed exchange rate can also

retaliate in response to a certain country using the currency of theirs in

defending their exchange rate.

FLEXIBLE EXCHANGE RATE

Unlike the fixed rate, a floating exchange rateis

determined by the private market through supply and

demand. A floating rate is often termed "self-correcting",

as any differences in supply and demand will

automatically be corrected in the market. Take a look at

this simplified model: if demand for a currency is low, its

value will decrease, thus making imported goods more

expensive and stimulating demand for local goods and

services. This in turn will generate more jobs, causing an

auto-correction in the market. A floating exchange rate is

constantly changing.


19/32

In reality, no currency is wholly fixed or floating. In a fixed

regime, market pressures can also influence changes in

the exchange rate. Sometimes, when a local currency does

reflect its true value against its pegged currency, a "black

market", which is more reflective of actual supply and

demand, may develop. A central bank will often then be

forced to revalue or devalue the official rate so that the

rate is in line with the unofficial one, thereby halting the

activity of the black market.

In a floating regime, the central bank may also intervene

when it is necessary to ensure stability and to avoid

inflation; however, it is less often that the central bank of

a floating regime will interfere.The floating exchange rate

is a market-driven price for currency, whereby the

exchange rate is determined entirely by the free market

forces of demand and supply of currencies with no

government intervention whatsoever.

Broadly, the floating exchange rate regime consists of the

independent floating system and the managed floating

system. The former is where exchange rate is strictly

determined by the free movement of demand and supply.

For managed floating system, exchange rate is also

determined by free movement of demand and supply but

the monetary authorities intervene at certain times to


20/32

"manage" the exchange rate to prevent high volatilities.

The floating exchange rate boasts various merits. Firstly,

there is automatic correction in the floating exchange rate

as the country simply lets it move freely to the equilibrium

of demand and supply. Secondly, there is insulation from

external economic events as the country's currency is not

tied to a possibly high world inflation rate as is under a

fixed exchange rate. The free movement of demand and

supply helps to insulate the domestic economy from world

economic fluctuations. Thirdly, governments are free tochoose their domestic policy as a floating exchange rate

would allow for automatic correction of any balance

ofpaymentdisequilibrium that might arise from the

implementation of domestic policy.

Nonetheless, there are also specific concerns about the

exchange rate being unstable and uncertain under the

floating exchange rate regime. Also, speculation tends to

be higher in the floating exchange rate regime, hence

leading to more uncertainty especially

fortraders and investors.

FIXED OR FLEXIBLE
http://www.articlesbase.com/finance-articles/fixed-versus-floating-exchange-rate-229803.htmlhttp://www.articlesbase.com/finance-articles/fixed-versus-floating-exchange-rate-229803.htmlhttp://www.articlesbase.com/finance-articles/fixed-versus-floating-exchange-rate-229803.htmlhttp://www.articlesbase.com/finance-articles/fixed-versus-floating-exchange-rate-229803.html


21/32

No one system has operated flawlessly in all circumstances. Hence, the best we

can do is the highlight the pros and cons of each system and recommend that

countries adopt that system that best suits its circumstances.

Probably the best reason to adopt a fixed exchange rate system is to commit to

a loss in monetary autonomy. This is necessary whenever a central bank has

been independently unable to maintain prudent monetary policy leading to a

reasonably low inflation rate. In other words, when inflation cannot be

controlled, adopting a fixed exchange rate system will tie the hands of the

central bank and help force a reduction in inflation. Of course, in order for

this to work, the country must credibly commit to that fixed rate and avoid

pressures that lead to devaluations. Several methods to increase the credibility

include the use of currency boards and complete adoption of the other

country's currency (i.e., dollarization or euroization). For many countries, for

at least a period of time, fixed exchange rates have helped enormously to

reduce inflationary pressures.

Nonetheless, even when countries commit with credible systems in place,

pressures on the system sometimes can lead to collapse. Argentina, for

example, dismantled its currency board after 10 years of operation and

reverted to floating rates. In Europe, economic pressures recently have

resulted in "talk" about giving up the Euro and returning to national

currencies. The Bretton-Woods system lasted for almost 30 years, but

eventually collapsed. Thus, it has been difficult to maintain a credible fixed

exchange rate system for a long period of time.

Floating exchange rate systems have had a similar colored past. Usually,

floating rates are adopted when a fixed system collapse. At the time of a

collapse, no one really knows what the market equilibrium exchange rate

should be and it makes some sense to let market forces (i.e., supply and


22/32

demand) determine the equilibrium rate. One of the key advantages of

floating rates is the autonomy over monetary policy that it affords a country's

central bank. When used wisely, monetary policy discretion can provide a

useful mechanism for guiding a national economy. A central bank can inject

money into the system when the economic growth slows or falls, or it can

reduce money when excessively rapid growth leads to inflationary tendencies.

Since monetary policy acts much more rapidly than fiscal policy, it is a much

quicker policy lever to use to help control the economy.

DISEQUILIBRIUM

Types and causes of disequilibrium in the balance of payments

In general terms, a deficit in the balance of payments is called

disequilibrium. Such a deficit may be at the capital account, current account ;

occasional, chronic ; cyclical, enlarging deficits. Each type is caused by

different set of factors. But in general, disequilibrium is an unfavourable

position in BoP caused by continuous deficits which are large.

Types of disequilibrium in BoP :


23/32

Following are the different types of disequilibrium in BoP :

1. Cyclical disequilibrium : This is caused by the trade cycles. The

economic activity changes in cyclical fashion with boom depression. In

each state, the disequilibrium is caused depending on the spurt of incomes,

intensity of demand for imports, domestic prices and nature of exports and

imports.

The impact of cyclical disequilibrium is found in developed economies

as compared with less developed economies.

2. Secular equilibrium : Secular disequilibrium depends on the level of

growth in an economy.An economy can be a primitive economy, or an

economy under preparatory stage for development or an economy in the

take-off stage or an economy with high mass consumption. Secular

disequilibriumis characterised by the level of population, capital

accumulation, technology and resources.

3. Structural disequilibrium : This is caused mainly due to the nature and

composition of exports and imports. The elasticities of exports and imports

determine the efficiency of any methods of correcting the trade. For

example , stagnant exports and elastic imports cause BoP problems.

Correction of such disequilibrium will need structural changes in the

composition of trade and foreign exchange position.

Causes of disequilibrium in developing countries :


24/32

BoP disequilibrium is common with most developing economies. Study of the

factors and nature of disequilibrium will help in correction and design of

methods of protection.

Following are the important causes of disequilibrium :

Large population, increasing growth rates of population.

Stagnant exports due to out dated products

Increasing demand for imports.

Low productivity and poor growth rates.

Lack of bargaining power.

Large external debt due to which the burden of debt servicing increases.

Adverse terms of trade.

Cyclical fluctuations in economic activity.

Problems of international liquidity.

Absence of ant trading association or regional block

Weak currency

Absence of trade ties with developed economies.

In addition all the problems of under development contribute to

disequilibrium in BoP. Since there is no effective mechanism to correct, the

disequilibrium becomes chronic.

Methods of correcting balance of payments disequilibrium


25/32

There are several methods to correct balance of payment disequilibrium. The

methods depend on the nature and causes of disequilibrium.

The methods can be classified into two groups : viz. monetary and non

monetary methods.

I) Monetary methods :

Monetary methods of correction affect the balance payments by changing the

value or flow of currencies ; both domestic and foreign. Indirectly, it affects

the volume and value of exports and imports.

With flexible exchange rate it is possible to affect the value and volume of

exports and imports.

Following are the various monetary methods of BoP correction :

1. Devaluation : Devaluation means decreasing the value of domestic

currency with respect to a foreign exchange. Devaluation is done by the

Government of the country of origin. Devaluation id done deliberately to

get its advantages.

Export prices Volume of exports

Value of money BoP improve

Import prices Volume of imports


26/32

The Government officially declare the devaluation, indicating the extent

of decrease in the value of its currency. The Government can decide the time

and the amount of decrease.

Devaluation can determine a specific currency with which it is

devalued. In such case the trade with the target country improves. The

devaluation is irreversible. The country can not change the value of currency

frequently. With a decrease in the value of its currency, the country has to pay

more in exchange to a foreign currency In case of exports the price show a

decline to the extent of decrease. The exports become cheaper.

At the same time the imports become expensive because more domestic

currency is payable. With this the exports increase and the imports decrease.

This way the balance of payments position improves. The country gets better

terms of trade.

Devaluation is opted during such times when:

a. The imports are increasing rapidly,

b. The exports are stagnant,

c. The domestic currency has low demand

d. The foreign currency is in high demand

The efficiency of devaluation , however depends on

MARSHALL-LERNER CONDITION.

According to the Marshall-Lerner condition. Devaluation helps only incase

the elasticities of demand of exports and imports is equal to 1

ex + em =1

It is advisable to devalue currency only when the sum of the elasticities of exports

and imports in equal to one.


27/32

Incase the exports and imports are inelastic, the devaluation will help the

country. Generally, the developing countries have inelastic exports and

imports. Devaluation in such countries is not always useful.

In case of inelastic exports , the decrease in price can not get proportionate

increase in the volume. So, there is a decrease in the revenue due to

devaluation When the exports are elastic. The increase in the volume of

exports will be greater than the decrease in the price. The revenue from trade

will increase after devaluation.

Similar case can be proved with imports where, outgoing are larger with

inelastic imports.

The Marshall-Lerner condition stipulates the limitations of applicability of

devaluation. Further, devaluation can also bring in large scale retaliation

from other countries. Which again affect the BoP position the devaluating

country.


28/32

There are some other methods which are similar to devaluation but the

nature is different.

2. Depreciation : Depreciation is similar to devaluation but it is done by the

exchange market. The exchange market is made up of demand and supply of

currency. Depending on the demand and supply, the value of currency can be

appreciated or depreciated, Depreciation is similar to devaluation. It involves

a decrease in value.

Depreciation is done by the market, the Government has no control over the

value. Further, the value changes are small and reversible depending on the

demand and supply conditions.

3. Pegging operations: Pegging down the value of currency is done by the

Government. The Central bank depending on the need may artificially,

increase or decrease the value of currency, temporarily.

Pegging operations can be done any number of times. Since it is done by the

Government, it may be beneficial. It is reversible, it offers the Government the

flexibility to manage the value of the currency for its advantage.

4. Deflation: With flexible exchange rate mechanism, the domestic value of

currency affects the international value of currency. The domestic value of

currency can be improves by any of the anti-inflationary methods. By

reducing the domestic money stock, the value of money can be improved. It

improves the foreign exchange rate aswell.

5. Exchange controls : Deliberate management of exchange markets, value,

and volumes of currencies form the exchange controls. There are several


29/32

methods of exchange controls which can affect the value and flows of

currencies for improving the BoP position.

Exchange controls include methods like, pegging operations, multiple

exchange rates, mutual clearing agreements etc.

It can be seen that, monetary methods of correcting BoP disequilibrium aim

at solving the crisis on capital account and directly managing flow of foreign

exchange. Indirectly, the value of currency can bring equilibrium on current

account as well by changing volume of exports and imports.

II) Non-monetary methods :

Non-monetary methods deal with real sector for correcting BoP

disequilibrium. All the non-monetary methods directly affect exports and

imports. Following are the important non-monetary methods :

1. Export Promotion : The country with deficits can take up export

promotion measures like providing fiscal incentives, financial aid,

Infrastructural facilities, marketing support and support of imported

inputs. The Government offers a package of tax incentives which will

reduce the costs and make exports competitive in the world market.

2. Import Substitution : The economy can progressively develop technology

of import substitution. A country produces those goods which were earlier

imported. It may require import of capital goods, technology or

collaborations.

3. Import Licensing : The Government can have stringent controls over the

usage of imports. This can be done by licensing the users based on

centralised imports.


30/32

4. Quota : Import quotas are important non-tariff barriers. They are

positive restrictions on incoming goods.

5. Tariffs : Tariff is a tax duty levied on imports. The objective is to make

imports expensive, which will in turn produce domestic demand and make

home industry competitive.

Every country has to use a combination of monetary and non-monetary

methods to effectively correct balance of payment disequilibrium and also

prevent retaliation from any developed country.


31/32

INTERNATIONAL

BUSINESS

ASSIGNMENT

SUBMITTED BY:-

ABHISHEK KHETAN

08D1603

V BBA B


32/32

RESEARCH

ARTICLE

final ib w a

Documents