UNIT – III

Foreign Exchange Markets

A Foreign exchange market is a market in which currencies are bought and sold. It is to be distinguished
from a financial market where currencies are borrowed and lent. General Features Foreign exchange
market is described as an OTC (Over the counter) market as there is no physical place where the
participants meet to execute their deals. It is more an informal arrangement among the banks and brokers
operating in a financing centre purchasing and selling currencies, connected to each other by tele
communications like telex, telephone and a satellite communication network, SWIFT. The term foreign
exchange market is used to refer to the wholesale a segment of the market, where the dealings take place
among the banks. The retail segment refers to the dealings take place between banks and their customers.
The retail segment refers to the dealings take place between banks and their customers. The retail segment
is situated at a large number of places. They can be considered not as foreign exchange markets, but as
the counters of such markets.
The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi is other centers
accounting for bulk of the exchange dealings in India. The policy of Reserve Bank has been to
decentralize exchages operations and develop broader based exchange markets. As a result of the efforts
of Reserve Bank Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of foreign
exchange market.

In other words, A market for the purchase and sale of foreign currencies is called a ‘foreign exchange
market’. The purpose of such a market is to facilitate international trade and investments. The need for a
foreign exchange market arises because of the presence of the different international currencies such as
US-dollar, UK-pound sterling, Europe-Euro, Japanese-Yen etc. and the need for trading in such
currencies.
Characteristics / Features of Foreign Exchange Market :
Some of the important features of a foreign exchange market are as follows –
1) Electronic Market : Foreign Exchange market is described as OTC (Over the Counter) market
as there is no physical place where the participants meet to execute the deals. It means, foreign exchange
market does not have a physical place. It is a market whereby trading in foreign currencies takes place
through the electronically linked network of banks, foreign exchange brokers and dealers whose function
is to bring together buyers and sellers of foreign exchange.
2) Geographical spreading: A feature of the foreign exchange market is that it is not to be found
in one place. The market is vastly dispersed throughout the leading financial center of the world such as
London, New York, Amsterdam, Tokyo, Hong Kong Toronto and other cities.
3) Transfer of purchasing power : Foreign exchange market aims at permitting the transfer of
purchasing power denominated in one currency to another whereby one currency is traded for another
currency. For example – an India exporter sells software to a U.S. firm for dollars and a U.S. firms sells
super computers to an Indian Company for rupees. In these transactions, firms of respective countries
would like to have their payment settled in their currencies i.e. Indian firm in rupees and U.S. firm in U.S.
dollars. It is the foreign exchange market, which facilitates such a settlement between countries in their
respective currency units.
4) Intermediary : Foreign exchange markets provide a convenient way of converting the currencies
earned into currencies wanted of their respective countries. For this purpose, the market acts as an
intermediary between buyers and sellers of foreign exchange.
5) Volume : A special feature of the foreign exchange market is that out of the trading transactions
that take place in the foreign exchange market, around 95% takes the firm of cross-border purchase and
sale of assets, that is, international capital flows. Only around 5% relates to the export and import
activities.
6) Provision of credit : A foreign exchange market provides credit through specialized instruments
such as bankers’ acceptance and letters of credit. The credit thus provided is of much help to the traders
and businessmen in the international market.
7) Minimizing risks : The foreign exchange market helps the importer and exporter in the foreign
trade to minimize their risks of trade. This is being done through the provision of ‘Hedging’ facilities.
This enables traders to transact business in the international market with a view to earning a normal
business profit without exposure to an expected change in anticipated profit. This is because exchange
rates suddenly change.
8) 24 Hours Market : The markets are situated throughout the different time zones of the globe in
such a way that when one market is closing the other is beginning its operations. Thus at any point of time
one market or the other is open. Therefore, it is stated that foreign exchange market is functioning
throughout 24 hours of the day.
9) Currencies Traded : In most markets, US dollar is the vehicle currency i.e. this currency is used
to denominate international transactions.

7 factors affecting exchange rates

Here’s the deal – these rates can be affected by a whole lot of factors, and no, we’re not
talking about mystical forces or ancient spells (although that would make it way more
interesting). We’ll cover the basics in a way that even your grandma could understand!

1. Interest and inflation rates

Inflation is the rate at which the cost of goods and services rises over time. Interest rates
indicate the amount charged by banks for borrowing money. These two are linked by the fact
that people tend to borrow and spend more when the interest rates are low, which results in
an increase in costs. These rates are direct indicators of the current and future economic
performance of a country and can influence the decisions of forex investors and traders
throughout the globe. An increase in interest rate is usually followed by a rise in the value of
the local currency.

This happens usually because the economy is growing too fast and central banks are trying to
slow inflation.

2. Current account deficits

The current account is the balance of trade between a country and its trading partners. It
describes the difference in value between the goods and services traded with other countries.
If a country buys more than it sells then the balance of trade is a deficit. It directly affects the
exchange rate since a country will need more foreign capital, thus diminishing the demand
for local currency. This excess supply of local currency drives down its value against foreign
currency.
3. Government debt
This is the total national or public debt owed by the central government. A country with a
large amount of government debt is less likely to attract foreign investment and acquire
foreign capital, leading to inflation. It may also happen that existing foreign investors will
sell their bonds in the open market if they foresee an increase in government debts. This will
result in an oversupply of the local currency, thus diminishing its value.

4. Terms of trade
Terms of trade are the ratio of the export prices of a country to its import prices. When the
export prices of a country rise at a greater rate than its import prices, its terms of trade
improves. This in turn results in higher revenue, higher demand for the country’s currency,
and an increase in the value of the currency. This cumulatively results in appreciation of the
exchange rate of the currency.

5. Economic performance
One of the many factors that affect the economic performance of a country is its political
stability. A country, which has a stable political environment, attracts more foreign
investment and vice versa. An increase in foreign capital results in appreciation in the value
of its domestic currency. Such stability also directly affects the financial and trade policy,
thus eliminating any uncertainty in the value of its currency.

6. Recession
During a recession, a country’s interest rates are likely to fall, thus decreasing its chances to
acquire foreign capital. This in turn weakens the currency of the country in question,
weakening the exchange rate.

7. Speculation
Investors demand more of a country’s currency when its value is expected to rise to make a
profit in the near future. As a result, the value of the currency rises due to its increased
demand. Which in turn results in a rise in the exchange rate as well.

With so many factors involved, exchange rates are subject to fluctuations and that can be
pretty distressing for people who transfer money overseas frequently. Though watching the
rates of a currency corridor can give you a fair idea of the best time to make transfers, it’s
best to stay updated about the real-time exchange rates.
Types of Foreign Exchange Markets
There are three main forex markets: the spot forex market, the forward forex market,
and the futures forex market.

Spot Forex Market: The spot market is the immediate exchange of currencies at the
current exchange. On the spot. This makes up a large portion of the total forex market
and involves buyers and sellers from across the entire spectrum of the financial
sector, as well as those individuals exchanging currencies.

Forward Forex Market: The forward market involves an agreement between the
buyer and seller to exchange currencies at an agreed-upon price at a set date in the
future. No exchange of actual currencies takes place, just the value. The forward
market is often used for hedging.

Futures Forex Market: The futures market is similar to the forward market, in that
there is an agreed price at an agreed date. The primary difference is that the futures
market is regulated and happens on an exchange.5 This removes the risk found in
other markets. Futures are also used for hedging.

Advantages and Disadvantages of the Foreign Exchange Market

Advantages

 There are fewer rules than in other markets, which means investors aren’t held
to the strict standards or regulations found in other markets.
 There are no clearinghouses and no central bodies that oversee the forex
market.
 Most investors won’t have to pay the traditional fees or commissions that they
would on another market.
 Because the market is open 24 hours a day, you can trade at any time of day,
which means there’s no cutoff time to be able to participate in the market (except if
you’re heading into the weekend).
 Finally, if you’re worried about risk and reward, you can get in and out
whenever you want, and you can buy as much currency as you can afford based on
your account balance and your broker’s rules for leverage.

Disadvantages

 Though the market being unregulated brings advantages, it also creates risks,
as there is no significant oversight that can ensure risk-free transactions.
 Leverage can help magnify profits but can also lead to high losses. As there
are no set limits on leverage, investors stand to lose a tremendous amount of money
if their trades move in the wrong direction.
 Unlike stocks that can also provide returns through dividends and bonds
through interest payments, FX transactions solely rely on appreciation, meaning they
have less residual returns than some other assets.
 Lack of transparency in the FX market can harm a trader as they do not have
full control over how their trades are filled, may not get the best price, and may have
a limited view of information, such as quotes.

LERMS (Liberalized Exchange Rate Management System) was a new

exchange rate management system. The Reserve Bank of India (RBI)
purchased 40 percent of the proceeds of exports and inward remittances
at the official exchange rate for official use under this scheme. Following
the recommendations of the C. Rangarajan Committee, the Liberalized
Exchange Rate Management System (LERMS) with the dual exchange
rate was implemented. It came into effect on March 1, 1993. The UPSC IAS
Exam includes LERMS (Liberalized Exchange Rate Management System) as
an important topic in the Indian Economy Syllabus.

The following are the basic characteristics of LERMS:

 The rupee's exchange rate will be set entirely by market forces of

demand and supply.
 As a result, it might also be referred to as a "market determination
exchange rate system."
 All receipts, whether on the current or capital account, and whether on
the government or private account, will be exchanged totally at the market
rate of exchange.
 NRIs will be able to open a Residents Foreign Currency Account
(RFCA), which will be credited with all of the foreign currency they bring in.
 Furthermore, Indians who get receipts from abroad now have the option
of receiving the complete foreign currency credit at market rates.
 Authorized dealers are no longer required to sell any percentage of
their foreign currency receipts directly to the Reserve Bank, as was formerly
the case. They can sell the receipts in the Indian Market to other approved
dealers or for any transaction that is legal.
 Foreign currency remittances outside of India are subject to exchange
control restrictions. This does not mean that authorization from the Reserve
Bank of India is required in every circumstance.
 The Reserve Bank's intervention currency remains the US dollar. It
may buy and sell US dollars from and to various approved dealers at its
discretion.

Modified LERMS
Modified Liberalized Exchange Rate Management System

 The process of liberalization progressed, and on March 1, 1993, it was

agreed to make the Rupee fully floating.
 Modified Liberalized Exchange Rate Management System, or Modified
LERMS, is the name of the new system.
 All foreign exchange transactions, receipts, and payments, both in the
current and capital accounts of the balance of payments, are routed through
authorized dealers at market-determined exchange rates as of March 1, 1993.
 Authorized dealers are free to keep all foreign exchange surrendered to
them for sale in permitted transactions and are not obligated to transfer any
share of such revenues to the Reserve Bank.
 Foreign exchange receipts must be returned to authorized
dealers unless the residents have been granted permission by the RBI to keep
them with banks in India or overseas.
 The Reserve Bank of India was required to buy and sell foreign
exchange to approved dealers under Section 40 of the RBI Act, 1934.
 The Reserve Bank is now required to sell US Dollars to any
authorized individual at its offices/branches for fulfilling foreign
exchange payments at market prices only for purposes permitted by the
Central Government.

Advantages
Advantages of New System

 With respect to a wide subset of external transactions, the system tries

to keep demand and supply equilibrium.
 It has permitted the lifting of various trade restrictions as well as
exchange control liberalization (under current account transactions).
 It is a step toward full convertibility of current account transactions,
which will allow India to receive the full benefits of economic integration
with the rest of the globe.
 Exporters will receive greater incentives, particularly those whose
exports are not heavily dependent on imports. Exports will be appealing to
agricultural product exporters.

Conclusion
Conclusion
Because of the rapid speed of policy liberalization, the Liberalized Exchange
Rate Management System (LERMS) has taken on a new significance in the
world of international finance. On the current account, the rupee has already
been made fully convertible. The government's major goal is to get the rupee
closer to complete convertibility in order to stimulate exports.