INTERNATIONAL

BUSINESS
ASSIGNMENT

BY:

NEETIKA JALAN

08D1678

BBA “B”
 INTRODUCTION – FORGEIN EXCHANGE MARKET

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.[2]

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.

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 of leverage to enhance profit margins with respect to account size
 FUNCTIONS OF FORGEIN EXCHANGE MARKET

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

Other functions :

• 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 worth more 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 purchase and sale of a given amount of currency at
two different dates and values.
 DETERMINATION OF FORGEIN EXCHANGE RATE

Exchange rates respond directly to all sorts of events, both tangible and psychological—
• Business cycles;
• Balance of payment statistics;
• Political developments;
• New tax laws;
• Stock market news;
• Inflationary expectations;
• International investment patterns;
• And government and central bank policies among others.
•

At the heart of this complex market are the same forces of demand and supply that determine the
prices of goods and services in any free market. If at any given rate, the demand for a currency is
greater than its supply, its price will rise. If supply exceeds demand, the price will fall.

The supply of a nation’s currency is influenced by that nation’s monetary authority, (usually its
central bank), consistent with the amount of spending taking place in the economy. Government
and central banks closely monitor economic activity to keep money supply at a level appropriate
to achieve their economic goals.

Too much money è inflation è value of money declines è prices rise

Too little money è sluggish economic growth è rising unemployment

Monetary authorities must decide whether economic conditions call for a larger or smaller
increase in the money supply.

Sources for currency demand on the FX market:

 • The currency of a growing economy with relative price stability and a wide variety of
competitive goods and services will be more in demand than that of a country in political
turmoil, with high inflation and few marketable exports.
• Money will flow to wherever it can get the highest return with the least risk. If a nation’s
financial instruments, such as stocks and bonds, offer relatively high rates of return at
relatively low risk, foreigners will demand its currency to invest in them.
• FX traders speculate within the market about how different events will move the
exchange rates. For example:
o News of political instability in other countries drives up demand for U.S. dollars
as investors are looking for a "safe haven" for their money.
o A country’s interest rates rise and its currency appreciates as foreign investors
seek higher returns than they can get in their own countries.
o Developing nations undertaking successful economic reforms may experience
currency appreciation as foreign investors seek new opportunities.

THEORIES :

Basic economic theory tells us that money is like any other commodity and its exchange rate
(price) should be determined by the demand and supply of one currency relative to the demand
and supply of another.

Exchange rates are complex but we do know that the two most general predictors of a country's
exchange rate are:

• its inflation rate ( PURCHASING POWER PARITY ) and

• Its interest rate( FISHER EFFECT ).

Purchasing power parity (PPP) is the key theory which explains the relationship between
currencies. PPP begins with the notion of the law of one price, which states that in competitive
markets free of transportation costs and tariffs, identical products sold in different countries must
sell for the same price when that price is expressed in terms of the same currency.

Now, according to PPP theory, if Japanese inflation was 3% and Australian inflation 6%, we
would expect the value of the dollar to fall by the difference in their inflation rates. That means
the dollar would be worth fewer yen than previously and the yen would be worth more dollars.

The anticipated future exchange rate would equal:

where:

e is the exchange rate quoted in terms of the number of units of

Australian currency for one unit of Japanese currency
i is the rate of inflation
a represents Australia
j represents Japan
o represents the base period
t represents the time period

Let's assume that the consumer price index (CPI) in Australia went from 100 to 106 and the CPI
in Japan went from 100 to 103 at a time when the exchange rate was 80 yen to the dollar or
$A0.0125 per yen. After the rise in the CPI:

= $A0.0129 per yen or 78 yen per dollar.

Thus the yen yields more dollars and the dollar is worth fewer yen when inflation is higher in
Australia than in Japan.

PPP theory is useful in the long-term and for predicting exchange rates in countries with high
inflation rates. It is less useful in the short-term because of a variety of market imperfections.
These include:

• Assuming away transportation costs and tariffs (law of one price) when in practice both
of these factors create price differentials between countries.
• The tendency of governments to intervene in the foreign exchange market to influence the
value of their currencies.
• Currencies are rarely related accurately to a two-country world. When several currencies
are involved, it is difficult to use prices to determine an equilibrium rate.
• Exchange rates are basically concerned with traded goods whereas inflation relates to all
goods, whether traded or not.
Having looked at the effect of inflation on exchange rates, let's see now the effect of interest rates
on exchange rates. To do this, we must first relate interest rates to inflation. We do this through
the Fisher Effect, which says that the nominal interest rate i in a country is determined by the real
interest rate r and the inflation rate I .

The bridge from interest rates to exchange rates can be explained by the International Fisher
Effect ( IFE ). The IFE implies that for any two countries the currency of the country with the
lower interest rate will strengthen in the future. Put another way, the IFE states that for any two
countries, the spot exchange rate will change by an equal amount but in opposite directions to the
difference in nominal interest rates between the two countries.

Assume Australia’s interest rate is 8% and Japan 's interest rate is 4%. Australia 's inflation rate is
4% higher than Japan 's, so we would expect the dollar to depreciate by 4% against the yen.
Remember from the Fisher Effect that nominal interest rates are higher in Australia than in Japan
because inflation is also higher. Thus, if inflation is lower in Japan than in Australia , the dollar is
expected to be weaker as well. This follows from the notion that if there is relatively high
inflation in Australia, the A$ will be regarded as less valuable than the yen; thus the relative
demand for yen will rise, putting pressure on and then reducing its supply; that in turn will mean
an increase in the value of the yen in terms of Australian dollars.

As with PPP theory, the IFE suggests a relationship between interest rate differentials and
changes in exchange rates in the long run. However, the IFE is not a good predictor of short-term
changes in exchange rates.

Therefore,

• the Fisher Effect tells us about the link between interest rates and the inflation rate
• The International Fisher Effect tells us about the link between interest rates and exchange
rates.
 FIXED AND FLEXIBLE EXCHANGE RATE

FIXED EXCHANGE RATE:

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange 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. In addition, according to the Mundell-Fleming model, with
perfect capital mobility, a fixed exchange rate prevents a government from using domestic
monetary policy in order to achieve macroeconomic stability.

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.

FLEXIBLE EXCHANE RATE:

A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein
a currency's value is allowed to fluctuate according to the foreign exchange market. A currency
that uses a floating exchange rate is known as a floating currency. It is not possible for a
developing country to maintain the stability in the rate of exchange for its currency in the
exchange market.

There are economists who think that, in most circumstances, floating exchange rates are
preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a
country to dampen the impact of shocks and foreign business cycles, and to preempt the
possibility of having a balance of payments crisis. However, in certain situations, fixed exchange
rates may be preferable for their greater stability and certainty. This may not necessarily be true,
considering the results of countries that attempt to keep the prices of their currency "strong" or
"high" relative to others, such as the UK or the Southeast Asia countries before the Asian
currency crisis. The debate of making a choice between fixed and floating exchange rate regimes
is set forth by the Mundell-Fleming model, which argues that an economy cannot simultaneously
maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It
can choose any two for control, and leave third to the market forces.

In cases of extreme appreciation or depreciation, a central bank will normally intervene to

stabilize the currency. Thus, the exchange rate regimes of floating currencies may more
technically be known as a managed float. A central bank might, for instance, allow a currency
price to float freely between an upper and lower bound, a price "ceiling" and "floor".
Management by the central bank may take the form of buying or selling large lots in order to
provide price support or resistance, or, in the case of some national currencies, there may be legal
penalties for trading outside these bounds.
 MEASURES TO CORRECT FORGEIN EXCHANGE DISEQUILIBRIUM

Balance of Payments Disequilibrium

The balance of payments of a country is said to be in equilibrium when the demand for foreign
exchange is exactly equivalent to the supply of it. The balance of payments is in disequilibrium
when there is either a surplus or a deficit in the balance of payments. When there is a deficit in
the balance of payments, the demand for foreign exchange exceeds the demand for it.

A number of factors may cause disequilibrium in the balance of payments. These various causes
may be broadly categorized into:
(i) Economic factors;
(ii) Political factors; and
(iii) Sociological factors.

Economic Factors

A number of economic factors may cause disequilibrium in the balance of payments.

These are:
• Development Disequilibrium
Large-scale development expenditures usually increase the purchasing power, aggregate
demand and prices, resulting in substantially large imports. The development
disequilibrium is common in developing countries,
because the above factors, and large-scale capital goods imports needed for carrying out
the various development programmes, give rise to a deficit in the balance of payments.
• Capital Disequilibrium
Cyclical fluctuations in general business activity are one of the prominent reasons for the
balance of payments disequilibrium. As Lawrance W. Towle points out, depression
always brings about a drastic shrinkage in world trade, while prosperity stimulates it. A
country enjoying a boom all by itself ordinarily experiences more rapid growth in its
imports than its exports, while the opposite is true of other countries. But production in
the other countries will be activated as a result of the increased exports to the boom
country.
• Secular Disequilibrium
Sometimes, the balance of payments disequilibrium persists for a long time because of
certain secular trends in the economy. For instance, in a developed country, the
disposable income is generally very high and, therefore, the aggregate demand, too, is
very high. At the same time, production costs are very high because of the higher wages.
This naturally results in higher prices. These two factors ± high aggregate demand and
higher domestic prices may result in the imports being much higher than the exports.
 • Structural Disequilibrium
Structural changes in the economy may also cause balance of payments disequilibrium. Such
structural changes include the development of alternative sources of supply, the development
of better substitutes, the exhaustion of productive resources, the changes in transport routes
and costs, etc.

Political Factors

Certain political factors may also produce balance of payments disequilibrium. For instance, a
country plagued with political instability may experience large capital outflows, inadequacy of
domestic investment and production, etc. These factors may, sometimes, cause disequilibrium in
the balance of payments.
Further, factors like war, changes in world trade routes, etc., may also produce balance of
payments difficulties.

Social Factors

Certain social factors influence the balance of payments. For instance, changes in tastes,
preferences, fashions, etc. may affect imports and exports and thereby affect the balance of
payments.
 Correction of Disequilibrium

A country may not be bothered about a surplus in the balance of payments; but every country
Strives to remove, or at least to reduce, a balance of payments deficit. A number of measures are
available for correcting the balance of payments disequilibrium. These various measures fall into
measures.
Important measures for correcting the disequilibrium caused by a deficit in the balance of
payments are:

Automatic Corrections

The balance of payment disequilibrium may be automatically corrected under the Paper
Currency Standard. The theory of automatic correction is that if the market forces of demand and
supply are allowed to have free play, the equilibrium will automatically be restored in the course
of time. For example, assume that there is a deficit in the balance of payments. When there is a
deficit, the demand for foreign exchange exceeds its supply, and these results in an increase in the
exchange rate and a fall in the external value of the domestic currency. This makes the exports of
the country cheaper and its imports dearer than before. Consequently, the increase in exports and
the fall in imports will restore the balance of payments equilibrium.

Deliberate Measures

This measure is widely employed today. The various deliberate measures may be broadly
grouped into;

(a) Monetary measures

(b) Trade measures; and
(c) Miscellaneous.

The important monetary measures are outlined below;

• Monetary contraction;
• the level of aggregate domestic demand,
• the domestic price level and
• the demand for imports and exports may be influenced by a contraction or expansion in
money supply and correct the balance of payments disequilibrium.

Monetary contraction

The measure required is a contraction in money supply. A contraction in money supply is likely
to reduce the purchasing power and thereby the aggregate demand. It is also likely to bring about
a fall domestic prices. The fall in the domestic aggregate demand and domestic prices reduces for
imports. The fall in the domestic aggregate demand and domestic prices reduces the demand for
imports. The fall in domestic prices is likely to increase exports. Thus, the fall in imports and the
rise in exports would help correct the disequilibrium.

Devaluation: Devaluation means a reduction in the official rate at which one currency is
exchanged for another currency. A country with a fundamental disequilibrium in the balance of
payments may devalue its currency in order to stimulate its exports and discourage imports to
correct the disequilibrium. The success of devaluation, however, depends on a number of factors,
such as the price elasticity of demand for exports and imports.

Exchange Control: Exchange control is a popular method employed to influence the balance of
Payments position of a country. Under exchange control, the government or central bank
assumes complete control of the foreign exchange reserves and earnings of the country. The
recipients of foreign exchange such as exporters are required to surrender foreign exchange to the
government/central bank in exchange for domestic currency. By the virtue of its control over the
use of foreign exchange, the government can control the imports.

Trade Measures

Trade measures include:

• export promotion measures and
• Measures to reduce imports.

Export Promotion

Exports may be encouraged by reducing or abolishing export duties, providing an export

subsidy, and encouraging export production and export marketing by offering monetary, fiscal,
physical and institutional incentives and facilities.

Import Control: Imports may be controlled by imposing or enhancing import duties, restricting
imports through import quotas and licensing, and even by prohibiting altogether the import of
certain inessential items

Miscellaneous Measures

Apart from the measures mentioned above, there are a number of other measures that can help
make the Balance of Payments position more favorable, such as obtaining foreign loans,
encouraging foreign investment in the home country, development of tourism to attract foreign
tourists, providing incentives to enhance inward remittances, developing import substituting
industries, etc
 CONCLUSION

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.

Therefore, the foreign exchange market is the the world's largest financial market, and it is
critical for global commerce. Private citizens and business entities enter foreign exchange
markets to make international payments and explore investment opportunities.
The foreign exchange market does not refer to one centrally organized financial exchange.
Instead, it refers to a vast network of participants that trade currencies with the help of
information technology. The Federal Reserve Bank of New York indicates that $1.2 trillion
worth of foreign exchange transactions are executed daily.
Foreign exchange rates shift with the supply and demand dynamics of a particular currency.
Low money supplies along with high demand for the currency support high exchange rates.
Treasury officials sell government securities to the public for cash to reduce the money supply
available in circulation.
Meanwhile, economic growth and stability improve currency demand. Currency transactions are
executed either at spot rates or forward rates. Spot transactions trade currencies at current
exchange rates. Forward negotiations are agreements to exchange currencies at set rates at a later
date. Consumers may exploit high exchange rates to buy relatively cheap overseas goods and
investments. Alternatively, businesses benefit from weak domestic exchange rates that add value
to overseas profits when they are converted back into the home currency.
 BIBLIOGRAPHY

WEBSITES:

• en.wikipedia.org/wiki/Foreign_exchange_market
• www.fxstreet.com
• rbidocs.rbi.org.in/rdocs/Publications/PDFs/77577.pdf
• www.investopedia.com › Dictionary
• www.sitpro.org.uk/trade/forex.pdf
BIBLIOGRAPHY