International financial system

2.1. INTRODUCTION
The global financial system is the worldwide framework of legal agreements, institutions, and
both formal and informal economic actors that together facilitate international flows of financial capital
for purposes of investment and trade financing.The role of financial markets play a vital role in the
economy by bringing the buyers and sellers together. Market prices, which results from this interacting,
promote the economic efficiency. The producers and consumers thus create a demand and supply in the
market helps in the flow of trade commodity. When markets function smoothly, market participants can
improve their welfare by trading: endowments or assets that fail to promote one owner’s objectives can
be treated for other goods or assets with more desirable characteristics.
Market prices, which result from this interaction, promote economic efficiency by providing
signals to both producers and consumers about the size of the demand or supply of the traded
commodity. When markets function smoothly, market participants can improve their welfare by
trading.
2.1.1. Role of Financial Market
Financial markets facilitate trade between buyers and sellers of financial assets. Smoothly
functioning financial markets allow traders to exchange one set of financial characteristics for another
in the same way that efficient commodity markets permit the exchange of goods that embody different
productive and consumption possibilities.Financial markets allow individuals and institutions to trade
loanable funds. Traders can select the set of financial asset characteristics that best meet their objectives.
In complete markets investors and borrowers can complete multiple transactions to obtain some
preferred combination of characteristics. In a sense they can custom design their own financial
instruments by combining available instruments.
In domestic financial markets two basic asset characteristics are traded. The first is investment
maturity. Borrowers exchange a promise to return cash in future for investable funds received in the
present. The future might be two days or twenty years hence, and a borrower can often combine
borrowing and lending transactions to achieve a particular maturity not directly available in the market
place.The other basic characteristic is the expectation of asset risk and return. Borrowers can choose
to increase the risk attached to their commitment by making the future payment contingent on some
economic outcome. For example, a borrower who issues equity is selling some of the risk attached to
the underlying investment project because the lender's return in dividends and capital gains will depend
on the success of the project.
In forward or futures markets the risk is isolated and traded separately from the underlying asset or
commodity. For example, an investor can use futures contracts to insure the expected return on an
asset.In combination, these two characteristics, risk/return and maturity, can be used to smooth the flow
of funds available for investment as well as funds that repress returns on investment. Financial markets
should supply signals (interest rates! capital costs, or rates of return) so that investors and borrowers
efficiently allocate funds to the end uses of capital consumption and investment.Well-functioning and
complete markets increase welfare by promoting allocative efficiency. Available funds are utilized
effectively. In addition, both the overall supply of and demand for lendable funds increase as borrowers
and lenders create the combination of maturity and risk characteristics that are most appropriate to their
particular circumstances.

2.1.2. Market Participants

The markets are the channels through which funds flow from one market participant to another.
There are three types of market participants:
a. ultimate borrowers
b. ultimate lenders
c. financial intermediaries.
Investors attempt to accumulate wealth, to alter or smooth their pattern of consumption, or to change
the risks attached to their consumption or portfolios of assets. Borrowers transact to gain investable
funds, to consume or to alter the risks attached to their liabilities. Financial intermediaries earn a return
by packaging financial assets for borrowers or lenders-increasing the variety of securities directly
available in the market. They can also act as brokers by arranging deals between borrowers and
lenders.In recent years government agencies and institutions have become increasingly active as
intermediaries in domestic financial systems. However, their stated goals are not regulatory, but the
redistribution of wealth or income. These agencies can borrow directly in the capital market and lend
to qualified beneficiaries at reduced rates; they can also provide an indirect subsidy by guaranteeing the
beneficiaries debt. Beneficiaries include groups or individuals whose objectives are considered socially
desirable, but insupportable at free-market costs of capital. For obvious reasons this method of income
redistribution has become an extremely popular policy tool in many countries; in consequence, the
relative presence in the capital markets of government agencies and institutions has increased
enormously.Private and public institutions can facilitate the growth and strength of the financial system.
Government agencies such as the SEBI perform both regulatory and market development functions.
Rules that insure the smooth functioning of the markets are developed and enforced. In addition these
agencies can develop markets for new types of securities.

2.1.3. The International Financial System- Unique Elements

In many countries domestic financial markets are inadequate. Borrowers and investors in countries
with inefficient or incomplete capital markets are often forced to use foreign markets to meet financial
needs. Borrowers and lenders from countries with fully developed financial systems can also choose to
transact in foreign markets; they can act from any of several possible motives. One of the most important
motive is the financial support of direct foreign investment. Many investors find that foreign operations
can be financed by foreign debt at a lower cost or with lower risk. Portfolio considerations also
encourage investors to lend abroad in pursuit of more attractive combinations of risk, return, maturity,
and liquidity. Finally, funds can flow between different capital markets in response to speculative
expectations or to equate the supplies and demands for loanable funds.

One unique element of this decision to finance or invest abroad is that foreign financial contracts
are denominated in a foreign currency. As a consequence, the market for the exchange of currencies,
the forex market, is a basic and unique element of the international financial system. A second
characteristic that differentiates international from domestic transactions is that some market
participants are operating outside their national boundaries. In summary, the international financial
system is distinguished by two elements. First, some parties might be transacting in currencies that are
foreign to them. Second, participants are financing or investing outside their national boundaries.. The
domestic financial systems—markets and participants—are subsets of the international system. In the
past the domestic financial markets were thought to be segregated or independent of each other.
Whatever the past reality of capital market independence, domestic markets are now generally
integrated into the world financial system.
1. Foreign Exchange Market.
2. Euro currency Market.
3. Euro Bond Market.
4. Futures Market.
Details of elements are given below.
1. Foreign Exchange Market.
Foreign exchange market is the market in which participants are able to buy, sell, exchange and
speculate on currencies. Foreign exchange markets are made up of banks, commercial
companies, central banks, investment management firms, hedge funds, and retail forex brokers and
investors. The forex market is considered the largest financial market in the world. Several functions
done by FOREX Maket. Functions are given below.

a. Transfer Function:
It transfers purchasing power between the countries involved in the transaction. This function is
performed through credit instruments like bills of foreign exchange, bank drafts and telephonic
transfers.
b. Credit Function:

It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are
generally used for international payments. Credit is required for this period in order to enable the
importer to take possession of goods, sell them and obtain money to pay off the bill.

c. Hedging Function:
When exporters and importers enter into an agreement to sell and buy goods on some future date at the
current prices and exchange rate, it is called hedging. The purpose of hedging is to avoid losses that
might be caused due to exchange rate variations in the future.

Kinds of Foreign Exchange Markets:

Foreign exchange markets are classified on the basis of whether the foreign exchange transactions

are spot or forward accordingly, there are two kinds of foreign exchange markets:

(i) Spot Market:

Spot market refers to the market in which the receipts and payments are made immediately. Generally,

a time of two business days is permitted to settle the transaction. Spot market is of daily nature and

deals only in spot transactions of foreign exchange (not in future transactions). The rate of exchange,

which prevails in the spot market, is termed as spot exchange rate or current rate of exchange.The term

‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a transaction, which is carried

out ‘on the spot’ (i.e., immediately). However, a two day margin is allowed as it takes two days for

payments made through cheques to be cleared.

(ii) Forward Market:

Forward market refers to the market in which sale and purchase of foreign currency is settled on a

specified future date at a rate agreed upon today. The exchange rate quoted in forward transactions is

known as the forward exchange rate. Generally, most of the international transactions are signed on one

date and completed on a later date. Forward exchange rate becomes useful for both the parties involved

in the transaction.
Forward Contract is made for two reasons:

(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);(b) To

make profit (through speculation).

2.Euro Currency Market

The eurocurrency market is the money market in which currency held in banks outside of the
country where it is legal tender is borrowed and lent by banks. The eurocurrency market is utilized by
banks, multinational corporations, mutual funds and hedge funds that wish to circumvent regulatory
requirements, tax laws and interest rate caps often present in domestic banking, particularly in the
United States. The term eurocurrency has nothing to do with the euro currency or Europe, and the
market functions in many financial centers around the world. The eurocurrency market originated in
the aftermath of World War II when the Marshall Plan to rebuild Europe sent a flood of dollars overseas.
The market developed first in London as banks needed a market for dollar deposits outside the United
States. Dollars held outside the United States are referred to as eurodollars, even if they are held in
Asian markets such as Singapore or Caribbean markets such as Grand Cayman.The eurocurrency
market has expanded to include other currencies such as the yen and the British pound whenever they
trade outside of their home market. However, the eurodollar market remains the largest.

3. Euro Bond Market

A Eurobond is an international bond that is denominated in a currency not native to the country where
it is issued. Also called external bond; "external bonds which, strictly, are neither Eurobonds nor
foreign bonds would also include: foreign currency denominated domestic bond”. The Eurobond
market is made up of investors, banks, borrowers, and trading agents that buy, sell, and transfer
Eurobonds. Eurobonds are a special kind of bond issued by European governments and companies, but
often denominated in non-European currencies such as dollars and yen. They are also issued by
international bodies such as the World Bank. The creation of the unified European currency, the euro,
has stimulated strong interest in euro-denominated bonds as well; however, some observers warn that
new European Union tax harmonization policies may lessen the bonds' appeal.

Eurobonds are unique and complex instruments of relatively recent origin. They debuted in 1963, but
didn't gain international significance until the early 1980s. Since then, they have become a large and
active component of international finance. Similar to foreign bonds, but with important differences,
Eurobonds became popular with issuers and investors because they could offer certain tax shelters
and anonymity to their buyers. They could also offer borrowers favorable interest
rates and international exchange rates. There is an active bond market for companies and financial
institutions to borrow in currencies outside of their domestic market. The first such bond was by the
Italian company Autostrade in 1963. It borrowed $15 million for 15 years in a deal arranged in London
and listed on the Luxembourg stock exchange. In 2014, Apple was able to borrow $3.5 billion.

4. Futures Currency Market

A currency future, also known as an FX future or a foreign exchange future, is a futures contract
to exchange one currency for another at a specified date in the future at a price (exchange rate) that is
fixed on the purchase date urrency futures are a transferable futures contract that specifies the price at
which a currency can be bought or sold at a future date. Currency futures contracts are legally binding
and counterparties that are still holding the contracts on the expiration date must trade the currency pair
at a specified price on the specified delivery date. Currency future contracts allow investors
to hedge against foreign exchange risk. currency futures contracts are marked-to-market daily,
investors can exit their obligation to buy or sell the currency prior to the contract's delivery date. This
is done by closing out the position. The prices of currency futures are determined when the contract is
signed, just as it is in the forex market, only and the currency pair is exchanged on the delivery date,
which is usually some time in the distant future. However, most participants in the futures
markets are speculators who usually close out their positions before the date of settlement, so most
contracts do not tend to last until the date of delivery.
For example, assume hypothetical company XYZ, which is based in the United States, is heavily
exposed to foreign exchange risk and wishes to hedge against its projected receipt of 125 million euros
in September. In August, company XYZ could sell futures contracts on the euro for delivery in
September, which have a contract specification of 125,000 euros. Therefore, company XYZ would need
to sell 1,000 futures contracts on the euro to hedge its projected receipt. Consequently, if the euro
depreciates against the U.S. dollar, the company's projected receipt is protected. However, the company
forfeits any benefits that would occur if the euro appreciates.
The unique elements of the international system are shown at the centre section on the diagram in
Exhibit-1
 Exhibit -1

THE INTERNATIONAL FINANCIAL SYSTEM

Domestic Financial system International financial system Domestic Financial system

Country A Unique Elements Country B

MARKETS
MARKETS
Foreign exchange
Money market
MARKETS market
Bond Market
Money market Eurocurrency market
Equity market
Bond Market Eurobond market
Equity market Forward and futures
market
For foreign exchange

PARTICIPANT PARTICIPANT
Individual Individual
Corporations PARTICIPANTS Corporations
governments Domestic participants from governments
Financial country A Domestic Financial
intermediaries participants from country B intermediaries
brokers International public brokers
financial or welfare
organizations

The international financial system is similar to the domestic systems because it embodies all of the
elements of the domestic financial systems. As in domestic financial markets, risk, in this case
international risk or the risk of variation in the rates at which currencies can be exchanged, can be
isolated from other elements of the financial transaction. This risk can be traded directly in forward or
future markets for foreign exchange, or indirectly through other markets. An additional similarity is the
presence of financial intermediaries and public agencies. Many domestic financial intermediaries
transact directly with foreigner and the financial sectors of most countries are heavily international by
virtue of the extensive branch networks of major financial institutions. While international
organizations do not generally perform a regulatory function, several other institution actively
redistribute wealth from developed to developing countries. Such institution include the International
Monetary Fund and the World Bank.
 International
Financial
Markets Domestic
Domestic Borrowers
Borrowers Corporation
Corporation Consumers
Consumers Government
Intermediaries
Government
Intermediaries Intermediaries
And Brokers And Brokers
Foreign exchange Market
Spot foreign exchange
Forward foreign exchange Domestic
Domestic Financial Foreign currency futures Financial
Markets Markets
Brokers
Intermediaries and
brokers Intermediaries
and brokers
Domestic Domestic
Investors Investors
Pension Funds Pension Funds
Financial Financial
institutions institutions
Individuals Individuals
Corporation Corporation
Governments Governments
International Monetary system fulfills two major roles. First, it serves to integrate the separate
domestic systems. As a result the international financial tern has grown to accommodate large and
more numerous domestic financial sytems. Second, it acts as a system in its own fight by supporting
financial transactions that are superanational. Increasing numbers of borrowers and investors prefer to
cerate outside of domestic financial markets or are located in countries where financial markets are
limited or nonexistent.

The foreign exchange market is the channel by which the first function is accomplished; it
links domestic financial systems. (The linkage is diagrammed ). In this market, borrowers and lenders
can literally change the currency denomination of securities. For example, a Japanese investor can
purchase a bond in the U.S. domestic market after exchanging yen for U.S. dollars in the foreign
exchange market. The principal and interest payments, made in U.S. dollars, can be exchanged for yen
at the time of payment. The risk that the exchange rate will vary in the interim can be hedged in the
market for forward foreign exchange. In essence, the foreign exchange market opens the domestic
financial markets to foreign investors and borrowers because it allows them to move funds from one
currency to another and to hedge against the risks of exchange rate changes. The financial opportunities
for investors and borrowers in both countries increase when foreign markets can be tapped as well as
domestic markets. Investors
Country B
Investors
Country
Country A

Foreign Securities market Foreign

Exchange Domestic Securities Exchange
Market External securities Market

Borrowers Borrowers
Country A Country B

The superanational aspects of the international system are relatively recent. (This characteristic is
shown diagrammatically). The markets rely on the activities of banks, securities dealers, brokers, and
underwriters who are increasingly international; they have tended to specialise in international markets
as the demand for these services has grown. The markets in which they operate are external markets—
free of any nationality. These are the Euromarkets, which are defined as markets where financial
instruments are denominated in currencies different from the currency of the country where the market
is located. For example, dollar deposits that are accepted by the London branch of Citibank are
Eurodollars. Euro-Swiss Franc bonds might be issued and placed in Frankfurt.Some investors also
believe that external markets offer reduced risk of expropriation. The reasoning is that governments
might not have the authority to impose capital controls on funds deposited in a foreign country. While
this might not be true for foreign branches of domestic banks, foreign banks that accept deposits in a
foreign currency are almost certainly immune from such control.

Transactions in external markets can be linked to foreign exchange transactions. A U.S. borrower
can transform the proceeds of a Euro-Deutsche mark issue into dollars via the foreign exchange market.
On the other hand, many participants in the system have no need to transfer funds between currencies.
Truly, international corporations, banks, international and national institutions, and wealthy individuals
enjoy a great deal of flexibility in their choice of currency denomination. For example, governments of
oil-exporting companies might complete all transactions in U.S. dollars—from the sale of oil to the
payment for imported goods and services. Most economists believe that the international markets have
grown along with these international borrowers and lenders.
2.2. Foreign Exchange Markets in India - History
Indian forex market since independence can be grouped in three distinct phases. Traditionally Indian
forex market has been a highly regulated one. Till about 1992-93, government exercised absolute
control on the exchange rate, export-import policy, FDI ( Foreign Direct Investment) policy.
1947 to1977:
During 1947 to 1971, India exchange rate system followed the par value system. RBI fixed rupee’s
external par value at 4.15 grains of fine gold. 15.432grains of gold is equivalent to 1 gram of gold. RBI
allowed the par value to fluctuate within the permitted margin of ±1 percent. With the breakdown of
the Bretton Woods System in 1971 and the floatation of major currencies, the rupee was linked with
Pound-Sterling. Since Pound-Sterling was fixed in terms of US dollar under the Smithsonian
Agreement of 1971, the rupee also remained stable against dollar.
1978-1992:
During this period, exchange rate of the rupee was officially determined in terms of a weighted basket
of currencies of India’s major trading partners. During this period, RBI set the rate by daily announcing
the buying and selling rates to authorized dealers. In other words, RBI instructed authorized dealers to
buy and sell foreign currency at the rate given by the RBI on daily basis. Hence exchange rate fluctuated
but within a certain range. RBI managed the exchange rate in such a manner so that it primarily
facilitates imports to India.
1992 onwards:
1992 marked a watershed in India’s economic condition. During this period, it was felt that India needs
to have an integrated policy combining various aspects of trade, industry, foreign investment, exchange
rate, public finance and the financial sector to create a market-oriented environment. Many policy
changes were brought in covering different aspects of import-export, FDI, Foreign Portfolio Investment
2.3. Current Account Convertibility
One important policy changes pertinent to India’s forex exchange system was brought in --
rupees was made convertible in current account. This paved to the path of foreign exchange
payments/receipts to be converted at market-determined exchange rate. However, it is worthwhile to
mention here that changes brought in by government of India to make the exchange rate market oriented
have not happened in one big bang. This process has been gradual. Convertibility in current account
means that individuals and companies have the freedom to buy or sell foreign currency on specific
activities like foreign travel, medical expenses, college fees, as well as for payment/receipt related to
export-import, interest payment/receipt, investment in foreign securities, business expenses etc. An
related concept to this is the “convertibility in capital account”. Convertibility in capital account
indicates that Indian people and business houses can freely convert rupee to any other currency to any
extent and can invest in foreign assets like shares, real estate in foreign countries. Most importantly
Indian banks can accept deposit in any currency.
2.4. Exchange Rate Systems in the world
There are three broad categories of exchange rate systems. In one system, exchange rates are set
purely by private market forces with no government involvement. Values change constantly as the
demand for and supply of currencies fluctuate. In another system, currency values are allowed to
change, but governments participate in currency markets in an effort to influence those values. Finally,
governments may seek to fix the values of their currencies, either through participation in the market
or through regulatory policy.

1. Fixed Exchange Rates

In a fixed exchange rate system, the exchange rate between two currencies is set by government policy.
There are several mechanisms through which fixed exchange rates may be maintained. Whatever the
system for maintaining these rates, however, all fixed exchange rate systems share some important
features.

A Commodity Standard

In a commodity standard system, countries fix the value of their respective currencies relative to a
certain commodity or group of commodities. With each currency’s value fixed in terms of the
commodity, currencies are fixed relative to one another.

For centuries, the values of many currencies were fixed relative to gold. Suppose, for example,
that the price of gold were fixed at $20 per ounce in the United States. This would mean that the
government of the United States was committed to exchanging 1 ounce of gold to anyone who handed
over $20. (That was the case in the United States—and $20 was roughly the price—up to 1933.) Now
suppose that the exchange rate between the British pound and gold was £5 per ounce of gold. With £5
and $20 both trading for 1 ounce of gold, £1 would exchange for $4. No one would pay more than $4
for £1, because $4 could always be exchanged for 1/5 ounce of gold, and that gold could be exchanged
for £1. And no one would sell £1 for less than $4, because the owner of £1 could always exchange it
for 1/5 ounce of gold, which could be exchanged for $4. In practice, actual currency values could vary
slightly from the levels implied by their commodity values because of the costs involved in exchanging
currencies for gold, but these variations are slight.
 Under the gold standard, the quantity of money was regulated by the quantity of gold in a
country. If, for example, the United States guaranteed to exchange dollars for gold at the rate of $20 per
ounce, it could not issue more money than it could back up with the gold it owned.The gold standard
was a self-regulating system. Suppose that at the fixed exchange rate implied by the gold standard, the
supply of a country’s currency exceeded the demand. That would imply that spending flowing out of
the country exceeded spending flowing in. As residents supplied their currency to make foreign
purchases, foreigners acquiring that currency could redeem it for gold, since countries guaranteed to
exchange gold for their currencies at a fixed rate. Gold would thus flow out of the country running a
deficit. Given an obligation to exchange the country’s currency for gold, a reduction in a country’s gold
holdings would force it to reduce its money supply. That would reduce aggregate demand in the country,
lowering income and the price level. But both of those events would increase net exports in the country,
eliminating the deficit in the balance of payments. Balance would be achieved, but at the cost of a
recession. A country with a surplus in its balance of payments would experience an inflow of gold. That
would boost its money supply and increase aggregate demand. That, in turn, would generate higher
prices and higher real GDP. Those events would reduce net exports and correct the surplus in the
balance of payments, but again at the cost of changes in the domestic economy.Because of this tendency
for imbalances in a country’s balance of payments to be corrected only through changes in the entire
economy, nations began abandoning the gold standard in the 1930s. That was the period of the Great
Depression, during which world trade virtually was ground to a halt. World War II made the shipment
of goods an extremely risky proposition, so trade remained minimal during the war. As the war was
coming to an end, representatives of the United States and its allies met in 1944 at Bretton Woods, New
Hampshire, to fashion a new mechanism through which international trade could be financed after the
war. The system was to be one of fixed exchange rates, but with much less emphasis on gold as a
backing for the system.

In recent years, a number of countries have set up currency board arrangements, which are a
kind of commodity standard, fixed exchange rate system in which there is explicit legislative
commitment to exchange domestic currency for a specified foreign currency at a fixed rate and a
currency board to ensure fulfillment of the legal obligations this arrangement entails. In its simplest
form, this type of arrangement implies that domestic currency can be issued only when the currency
board has an equivalent amount of the foreign currency to which the domestic currency is pegged. With
a currency board arrangement, the country’s ability to conduct independent monetary policy is severely
limited. It can create reserves only when the currency board has an excess of foreign currency. If the
currency board is short of foreign currency, it must cut back on reserves.

Argentina established a currency board in 1991 and fixed its currency to the U.S. dollar. For an
economy plagued in the 1980s with falling real GDP and rising inflation, the currency board served to
restore confidence in the government’s commitment to stabilization policies and to a restoration of
economic growth. The currency board seemed to work well for Argentina for most of the 1990s, as
inflation subsided and growth of real GDP picked up.The drawbacks of a currency board are essentially
the same as those associated with the gold standard. Faced with a decrease in consumption, investment,
and net exports in 1999, Argentina could not use monetary and fiscal policies to try to shift its aggregate
demand curve to the right. It abandoned the system in 2002. he Bretton Woods Agreement called for
each currency’s value to be fixed relative to other currencies. The mechanism for maintaining these
rates, however, was to be intervention by governments and central banks in the currency market.

Now suppose that the British choose to purchase more U.S. goods and services. The supply

curve for pounds increases, and the equilibrium exchange rate for the pound (in terms of dollars)

falls to, say, $3. Under the terms of the Bretton Woods Agreement, Britain and the United States

would be required to intervene in the market to bring the exchange rate back to the rate fixed in

the agreement, $4. If the adjustment were to be made by the British central bank, the Bank of

England, it would have to purchase pounds. It would do so by exchanging dollars it had previously

acquired in other transactions for pounds. As it sold dollars, it would take in checks written in pounds.
When a central bank sells an asset, the checks that come into the central bank reduce the money supply
and bank reserves in that country. In order to bring its exchange rate back to the agreed-to level, Britain
would have to carry out a contractionary monetary policy.

Alternatively, the Fed could intervene. It could purchase pounds, writing checks in dollars. But
when a central bank purchases assets, it adds reserves to the system and increases the money supply.
The United States would thus be forced to carry out an expansionary monetary policy.Domestic
disturbances created by efforts to maintain fixed exchange rates brought about the demise of the Bretton
Woods system. Japan and West Germany gave up the effort to maintain the fixed values of their
currencies in the spring of 1971 and announced they were withdrawing from the Bretton Woods system.
President Richard Nixon pulled the United States out of the system in August of that year, and the
system collapsed. An attempt to revive fixed exchange rates in 1973 collapsed almost immediately, and
the world has operated largely on a managed float ever since.Under the Bretton Woods system, the
United States had redeemed dollars held by other governments for gold; President Nixon terminated
that policy as he withdrew the United States from the Bretton Woods system. The dollar is no longer
backed by gold.Fixed exchange rate systems offer the advantage of predictable currency values—when
they are working. But for fixed exchange rates to work, the countries participating in them must
maintain domestic economic conditions that will keep equilibrium currency values close to the fixed
rates. Sovereign nations must be willing to coordinate their monetary and fiscal policies. Achieving that
kind of coordination among independent countries can be a difficult task. When exchange rates are
fixed but fiscal and monetary policies are not coordinated, equilibrium exchange rates can move away
from their fixed levels.

Case on Thailand Baht

Thailand’s experience with the baht illustrates the potential difficulty with attempts to

maintain a fixed exchange rate. Thailand’s central bank had held the exchange rate between the

dollar and the baht steady, at a price for the baht of $0.04. Several factors, including weakness in

the Japanese economy, reduced the demand for Thai exports and thus reduced the demand for the

baht. Thailand’s central bank, committed to maintaining the price of the baht at $0.04, bought

baht to increase the demand. Central banks buy their own currency using their reserves of foreign

currencies. It was seen that when a central bank sells bonds, the money supply falls. When it sells

foreign currency, the result is no different. Sales of foreign currency by Thailand’s central bank in

order to purchase the baht thus reduced Thailand’s money supply and reduced the bank’s holdings

of foreign currencies. As currency traders began to suspect that the bank might give up its effort to

hold the baht’s value, they sold baht, shifting the supply curve to the right. That forced the central

bank to buy even more baht—selling even more foreign currency—until it finally gave up the effort

and allowed the baht to become a free-floating currency. By the end of 1997, the baht had lost

nearly half its value relative to the dollar.

Advantages of Fixed Exchange rate system
• Commitment to a single fixed exchange rate encourages international trade by making prices of goods
involved in trade more predictable.
• Fixed exchange rate is a part of a more general argument for national economic policies conducive
to international economic integration.
• Since uncertainty and risk of exchange rates volatility is rare in case of fixed exchange rate, hence it
promote long-term capital flows.
• Since there is no fear of currencies fluctuations, fixed exchange rate creates confidence in the strength
of the domestic currency and there is no fear of adverse effect of speculation on the exchange rate.
• Fixed exchange rate serve as an anchor and imposes a discipline on monetary authorities to follow
responsible financial policies within countries. Any inflationary monetary expenditure creates balance
of payments deficit and thus reserves loss and hence monetary authorities generally do not practice an
independent monetary policies.

Disadnantages of Fixed Exchange Rate System

•Fixed exchange rate may achieve exchange rate stability but at the expense of domestic economic
stability.
• Monetary authorities lose the independence of monetary policy formulation to maintain exchange rate
stability. Any instability in exchange rate needs to be corrected by buying/selling of foreign exchange
reserves or by controlling the domestic money supply. In this context, monetary authorities sacrifice
the objectives of monetary policy to protect the fixed exchange rate.
• To protect the fixed exchange rate, country needs to have significant foreign exchange reserves and
this imposes heavy burden on the monetary authorities for managing foreign exchange reserves.

2. Free-Floating Systems

A free-floating system has the advantage of being self-regulating. There is no need for
government intervention if the exchange rate is left to the market. Market forces also restrain large
swings in demand or supply. Suppose, for example, that a dramatic shift in world preferences led to a
sharply increased demand for goods and services produced in Canada. This would increase the demand
for Canadian dollars, raise Canada’s exchange rate, and make Canadian goods and services more
expensive for foreigners to buy. Some of the impact of the swing in foreign demand would thus be
absorbed in a rising exchange rate. In effect, a free-floating exchange rate acts as a buffer to insulate an
economy from the impact of international events.
 In a free-floating exchange rate system, governments and central banks do not participate in the
market for foreign exchange. The relationship between governments and central banks on the one hand
and currency markets on the other is much the same as the typical relationship between these institutions
and stock markets. Governments may regulate stock markets to prevent fraud, but stock values
themselves are left to float in the market. The U.S. government, for example, does not intervene in the
stock market to influence stock prices. The concept of a completely free-floating exchange rate system
is a theoretical one. In practice, all governments or central banks intervene in currency markets in an
effort to influence exchange rates. Some countries, such as the United States, intervene to only a small
degree, so that the notion of a free-floating exchange rate system comes close to what actually exists in
the United States.

The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts
between buyers and sellers in different countries must not only reckon with possible changes in prices
and other factors during the lives of those contracts, they must also consider the possibility of exchange
rate changes. An agreement by a U.S. distributor to purchase a certain quantity of Canadian lumber
each year, for example, will be affected by the possibility that the exchange rate between the Canadian
dollar and the U.S. dollar will change while the contract is in effect. Fluctuating exchange rates make
international transactions riskier and thus increase the cost of doing business with other countries.

Advantages of Free Floating System

• Floating exchange rates gives the government / monetary authorities’ flexibility in determining interest
rates. This is because interest rates do not have to be set to keep the value of the exchange rate within
pre-determined bands.
• Balance of Payments on current account disequilibrium can automatically be restored to equilibrium
floating exchange rate regime and the scarcity or surplus of any currency is eliminated under floating
exchange rate regime.

Disadvanges of Free Floating System

• Market forces may fail to determine the appropriate exchange rate and hence floating exchange rate
regime may not provide the desired results and may also lead to misallocation of resources.
• It is impossible to have an exchange rate system without official intervention. Government may not
intervene, however domestic monetary policy and fiscal policy would definitely influence the exchange
rate.
• A wildly fluctuating exchange rate at the mercy of national and international currency speculators.
Volatile exchange rate introduces considerable uncertainty in export and import prices and consequently
to economic development.

3. Managed Float Systems

Governments and central banks often seek to increase or decrease their exchange rates by
buying or selling their own currencies. Exchange rates are still free to float, but governments try to
influence their values. Government or central bank participation in a floating exchange rate system is
called a managed float.Countries that have a floating exchange rate system intervene from time to time
in the currency market in an effort to raise or lower the price of their own currency. Typically, the
purpose of such intervention is to prevent sudden large swings in the value of a nation’s currency. Such
intervention is likely to have only a small impact, if any, on exchange rates. Roughly $1.5 trillion worth
of currencies changes hands every day in the world market; it is difficult for any one agency—even an
agency the size of the U.S. government or the Fed—to force significant changes in exchange rates.

Still, governments or central banks can sometimes influence their exchange rates. Suppose the
price of a country’s currency is rising very rapidly. The country’s government or central bank might
seek to hold off further increases in order to prevent a major reduction in net exports. An announcement
that a further increase in its exchange rate is unacceptable, followed by sales of that country’s currency
by the central bank in order to bring its exchange rate down, can sometimes convince other participants
in the currency market that the exchange rate will not rise further. That change in expectations could
reduce demand for and increase supply of the currency, thus achieving the goal of holding the exchange
rate down.

2.5. History of International Monetary System

The gold standard or gold exchange standard of fixed exchange rates prevailed from about 1870 to
1914, before which many countries followed bimetallism. The period between the two world wars was
transitory, with the Bretton Wood system emerging as the new fixed exchange rate regime in the
aftermath of World War II. It was formed with an intent to rebuild war-ravaged nations after World
War II through a series of currency stabilization programs and infrastructure loans. The early 1970s
saw the breakdown of the system and its replacement by a mixture of fluctuating and fixed exchange
rates.

i. Gold standard

The earliest establishment of a gold standard was in the United Kingdom in 1821 followed by Australia
in 1852 and Canada in 1853. Under this system, the external value of all currencies was denominated
in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price.
Each central bank maintained gold reserves as their official reserve asset. For example, during the
“classical” gold standard period (1879–1914), the U.S. dollar was defined as 0.048 troy oz. of pure
gold.

ii. Bretton Woods system

Following the Second World War, the Bretton Woods system (1944–1973) replaced gold with the U.S.
dollar as the official reserve asset. The regime intended to combine binding legal obligations with
multilateral decision-making through the International Monetary Fund (IMF). The rules of this system
were set forth in the articles of agreement of the IMF and the International Bank for Reconstruction and
Development. The system was a monetary order intended to govern currency relations among sovereign
states, with the 44 member countries required to establish a parity of their national currencies in terms
of the U.S. dollar and to maintain exchange rates within 1% of parity (a "band") by intervening in
their foreign exchange markets (that is, buying or selling foreign money). The U.S. dollar was the only
currency strong enough to meet the rising demands for international currency transactions, and so the
United States agreed both to link the dollar to gold at the rate of $35 per ounce of gold and to convert
dollars into gold at that price.

Due to concerns about America's rapidly deteriorating payments situation and massive flight of liquid
capital from the U.S., President Richard Nixon suspended the convertibility of the dollar into gold on 15
August 1971. In December 1971, the Smithsonian Agreement paved the way for the increase in the
value of the dollar price of gold from US$35.50 to US$38 an ounce. Speculation against the dollar in
March 1973 led to the birth of the independent float, thus effectively terminating the Bretton Woods
system.

iii. Current monetary regimes

Since March 1973, the floating exchange rate has been followed and formally recognized by the
Jamaica accord of 1978. Countries still need international reserves in order to intervene in foreign
exchange markets to balance short-run fluctuations in exchange rate. The prevailing exchange rate
regime is in fact often considered as a revival of the Bretton Woods policies, namely Bretton Woods II.
2.6. Functions of IMF(International Monetary Fund)
IMF, its three primary functionswere: to oversee the fixed exchange rate arrangements
between countries, thus helping national governments manage their exchange rates and allowing these
governments to prioritise economic growth, and to provide short-term capital to aid the balance of
payments.

The origin of the IMF goes back to the days of international chaos of the 1930s. During the Second
World War, plans for the construction of an international institution for the establishment of monetary
order were taken up. At the Bretton Woods Conference held in July 1944, delegates from 44 non-
communist countries negotiated an agreement on the structure and operation of the international
monetary system.The Articles of Agreement of the IMF provided the basis of the international monetary
system. The IMF commenced financial operations on 1 March 1947, though it came into official
existence on 27 December 1945, when 29 countries signed its Articles of Agreement (its charter). Today
(May 2012), the IMF has near-global membership of 188 member countries. Virtually, the entire world
belongs to the IMF. India is one of the founder- members of the Fund.

Objectives of IMF are given below

These are:

I. To promote international monetary cooperation through a permanent institution which provides the
machinery for consolation and collaboration on international monetary problems.

II. To facilitate the expansion and balanced growth of international trade, and to contribute thereby to
the promotion and maintenance of high levels of employment and real income and to the development
of the productive resources of all members as primary objective of economic policy.

III. To promote exchange stability, to maintain orderly exchange arrangements among members, and to
avoid competitive exchange depreciation.

IV. To assist in the establishment of a multilateral system of payments in respect of current transactions
between members and in the elimination of foreign exchange restrictions which hamper the growth of
world trade.

V. To give confidence to members by making the general resources of the Fund temporarily available
to them under adequate safeguards, thus providing them with the opportunity to correct maladjustments
in their balance of payments, without resorting to measures destructive of national or international
prosperity.
VI. In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of members.

To promote international cooperation; to facilitate the expansion and balanced growth of

international trade; to promote exchange stability; to assist in the establishment of a multilateral system
of payments; to make its general resources available to its members experiencing balance of payments
difficulties under adequate safeguards; and to shorten the duration and lessen the degree of
disequilibrium in the international balance of payments of members.

Functions of IMF

The principal function of the IMF is to supervise the international monetary system. Several
functions are derived from this. These are: granting of credit to member countries in the midst of
temporary balance of payments deficits, surveillance over the monetary and exchange rate policy of
member countries, issuing policy recommendations. It is to be noted that all these functions of the IMF
may be combined into three.

These are: regulatory, financial, and consultative functions:

i. Regulatory Function:

The Fund functions as the guardian of a code of rules set by its (AOA— Articles of Agreement).

ii. Financial Function:

It functions as an agency of providing resources to meet short term and medium term BOP
disequilibrium faced by the member countries.

iii. Consultative Function:

It functions as a centre for international cooperation and a source of counsel and technical assistance to
its members.

The main function of the IMF is to provide temporary financial support to its members so that
‘fundamental’ BOP disequilibrium can be corrected. However, such granting of credit is subject to strict
conditionality. The conditionality is a direct consequence of the IMF’s surveillance function over the
exchange rate policies or adjustment process of members.The main conditionality clause is the intro-
duction of structural reforms. Low income countries drew attraction of the IMF in the early years of
1980s when many of them faced terrible BOP difficulties and severe debt repayment problems. Against
this backdrop, the Fund took up ‘stabilisation programme’ as well as ‘structural adjustment
programme’. Stabilisation programme is a demand management issue, while structural programme
concentrates on supply management. The IMF insists member countries to implement these
programmes to tackle macroeconomic instability.

Its main elements are:

(i) Application of the principles of market economy;

(ii) Opening up of the economy by removing all barriers of trade; and

(iii) Prevention of deflation.

The Fund provides financial assistance. It includes credits and loans to member countries with
balance of payments problems to support policies of adjustment and reform. It makes its financial
resources available to member countries through a variety of financial facilities.It also provides
concessional assistance under its poverty reduction and growth facility and debt relief initiatives. It
provides fund to combat money- laundering and terrorism in view of the attack on the World Trade
Centre of the USA on 11 September 2001.

In addition, technical assistance is also given by the Fund. Technical assistance consists of
expertise and support provided by the IMF to its members in several broad areas : the design and
implementation of fiscal and monetary policy; institution-building, the handling and accounting of
transactions with the IMF; the collection and retirement of statistical data and training of
officials.Maintenance of stable exchange rate is another important function of the IMF. It prohibits
multiple exchange rates.mIt is to be remembered that unlike the World Bank, the IMF is not a
development agency. Instead of providing development aid, it provides financial support to tide over
BOP difficulties to its members.

Organisation and Management of the IMF:

Like many international organisations, the IMF is run by a Board of Governors, an Executive Board
and an international staff. Every member country delegates a representative (usually heads of central
banks or ministers of finance) to the Board of Governors—the top link of the chain of command. It
meets once a year and takes decision on fundamental matters such as electing new members or changing
quotas. The Executive Board is entrusted to the management of day-to-day policy decisions. The Board
comprises 24 executive directors who supervise the implementation of policies set by the member
governments through the Board of Governors.The IMF is headed by the Managing Director who is
elected by the Executive Board for a 5 year term of office.

Financial Structure of the IMF:

The capital or the resources of the Fund come from two sources:
(i) Subscription or quota of the member nations, and

(ii) Borrowings.

Each member country is required to subscribe an amount equivalent to its quota. It is the quota on which
payment obligations, credit facilities, and voting right of members are determined. As soon as a country
joins the Fund, it is assigned a quota which is expressed in Special Drawing Rights (SDRs). At the time
of formation of the IMF, the quota of each member was made up of 25 p.c. in gold or 10 p.c. of its net
official holdings of gold and US dollars (whichever was less). Now this has been revised. The capital
subscriptions or quota is now made up of 25 p.c. of its quota in SDRs or widely accepted currencies
(such as the US dollar, euro, the yen or the pound sterling) instead of gold and 75 p.c. in country’s own
currency. The size of the Fund equals the sum of the subscriptions of members. Total quotas at the end-
August 2008 were SDR 217.4 billion (about $341 billion).The Fund is authorised to borrow in special
circumstances if its own resources prove to be insufficient. It sells gold to member countries to replenish
currency holdings. It is entitled to borrow even from international capital market. Though the Articles
of Agreement permit the Fund to borrow from the private capital market, till today no such use has been
made by the IMF.

Special Drawing Rights (SDRs):

The Special Drawing Rights (SDRs) as an international reserve asset or reserve money in the
international monetary system was established in 1969 with the objective of alleviating the problem of
international liquidity. The IMF has two accounts of operation—the General Account and the Special
Drawing Account.The former account uses national currencies to conduct all business of the fund, while
the second account is transacted by the SDRs. The SDR is defined as a composite of five currencies—
the Dollar, Mark, Franc, Yen and Pound. The SDRs are allocated to the member countries in proportion
to their quota subscriptions. Only the IMF members can participate in SDR facility. SDRs being
costless, often called paper gold, is just a book entry in the Special Drawing Account of the IMF.
Whenever such paper gold is allocated, it gets a credit entry in the name of the participating countries
in the said account. It is to be noted that SDRs, once allocated to a member, are owned by it and operated
by it to overcome BOP deficits. Since its inception, there have been only four allocation to SDRs—the
first in 1970, and the last in 2008-09—mainly to the developing countries.

Instruments of IMF Lending and Loan Conditionality:

The IMF Articles of Agreement clearly state that the resources of the Fund are to be used to
give temporary assistance to members in financing BOP deficit on current account. Of course, the
financial assistance provided by the Fund is loan. The following technique is employed: If a country
calls on the Fund it buys foreign currencies from the IMF in return for the equivalent in the domestic
currency.This, in legal and technical terms, is called a ‘drawing’ on the Fund. The technique, therefore,
suggests that the IMF does not lend, but sells the required currency to the members on certain terms.
This unique financial structure of the Fund clearly suggests that the Fund’s resources cannot be lent for
long time. It is meant to cover short run gaps in BOP.

The IMF’s unique financial structure does not allow any member to enjoy financial assistance
over a long time period. The total amount that a country is entitled to draw is determined by the amount
of its quota. A member is entitled to draw an amount not exceeding 25 p.c. of its quota. The first 25 p.c.
called the ‘gold tranche’ (‘tranche’ a French Word meaning slice) or ‘reserve tranche’ can easily be
drawn by countries with BOP problems. This 25 p.c. of the quota is the members’ owned reserves and
therefore no conditions are attached to such drawings. This may be called ‘ordinary, drawing rights;
even the Fund cannot deny its use. However, no interest for the first credit tranche is required to be paid
though such drawings are subject to repayment within 3-5 years period.The ‘credit tranche’ of 100 p.c.
each equalling 25 p.c. of a member’s quota are also available subject to the IMF approval and hence,
‘conditional’.Originally, it was possible to borrow equal to 125 p.c. of one’s quota. At present,
borrowing limit has been raised to 450 p.c. of one’s quota which must be redeemed within five years.

Borrowing methods used by the Fund are:

(i) Stand-by Arrangements:

This method of borrowing has become the most normal form of assistance by the Fund. Under this form
of borrowing, a member state obtains the assurance of the Fund that, usually over 12-18 months,
requests for drawings of foreign exchange (i.e., to meet short- term BOP problems) up to a certain
amount will be allowed if the country concerned wishes.

However, the stand-by arrangements can be extended up to 3 years while repayments are required to be
made within 3-5 years of each drawing. The term “stand-by” here means that, subject to conditionality,
a member has a right to draw the money made available, if needed. In most cases, the member does, in
fact, draw.

(ii) Extended Fund Facility (EFF):

Stand-by arrangements to stabilise a member’s BOP run usually for a period of 12-18 months.
Developing countries suffer from chronic BOP problems which could not be remedied in the short run.
Such protracted BOP difficulties experienced by the LDCs were the result of structural imbalances in
production and trade. It then necessitated an adjustment programme and redemption scheme of longer
duration.
In the 1970s, the Fund recognised this idea and built up the EFF in 1974. The EFF is designed to provide
assistance to members to meet their BOP deficits for longer period (3-4 years) and in amounts larger in
relation to their quotas. Repayment provisions of EFF cover a period of 4-10 years. However, conditions
for granting loans are very stringent. Drawings on this account since 2000 stand at over 50 billion dollar
in SDRs.

(iii) Compensatory Financing Facility (CFF):

Apart from the ordinary drawing rights, there are some ‘special finances’ windows to assist the
developing countries to tide over BOP difficulties. CFF, introduced in 1963, is one such special drawing
provision. Its name was changed to Compensatory and Contingency Financing Facility (CCFF) in 1980,
but the ‘contingency’ was dropped in 2000. Under it, members were allowed to draw up to 25 p.c. of
its quota when CFF was introduced.

It can now draw up to 45 p.c. Since the mid- 1990s, this has been the least-used facility.

(iv) Structural Adjustment Facility (SAF) and the Enhanced SAF (ESAF):

In 1986 a new facility—the SAF—was introduced for the benefit of low income countries. It was
increasingly realised that the so-called stringent and inflexible credit arrangements were too inadequate
to cope with the growing debt problems of the poorest members of the Fund. In view of this, SAF was
introduced which stood quite apart from the monetary character of the Fund.

Under it, credit facilities for economic reform programmes are available at a low interest rate of 0.5 p.
c compared to 6 p.c. for most Fund facilities. Loans are for 10 years with a grace period of five and a
half years. LDCs facing protracted BOP problems can get assistance under SAF provided they agree to
undertake medium-term structural adjustment programmes to foster economic growth and improve
BOP conditions. An extended version of SAF—ESAF—was introduced in 1987. The ESAF has been
replaced by a new facility, called Poverty Reduction and Growth Facility in 1999.

What emerges from the structural adjustment facility is that the IMF’s loan is now available to member
countries in support of policy programmes. It now insists on the supply side policy ‘as a condition’ for
assistance, in addition to loans meant for short-term BOP difficulties.

(v) Poverty Reduction and Growth Facility (PRGF):

The PRGF that replaced the ESAF in November 1999 provides concessional lending to help the poorest
member countries with the aim of making poverty reduction and economic growth —the central
objectives of policy programmes. Under this facility, low-income member countries are eligible to
borrow up to 140 p.c. of its quota for a 3-year period. Rate of interest that is charged is only 0.5 p. c and
repayment period covers 5 1/2-10 years, after disbursement of such facility. However, financial
assistance under this facility is, of course, ‘conditional’.

(vi) Supplemental Reserve Facility (SRF):

This instrument provides additional short-term financing to member countries facing exceptional BOP
difficulties because of a sudden and disruptive loss of market confidence reflected in capital outflows
of countries concerned. Consequent upon the eruption of East Asian financial crisis, the SRF was
introduced in 1997.Till date (March, 2012), the top three largest borrowing nations are Greece, Portugal
and Ireland from the IMF.

Strings of Conditionality:

It is to be remembered here that the IMF lending is conditional. Further, the IMF lending is temporary
ranging from 1 year to 3 years. Repayment period varies from country to country and from one facility
to another. Repayment under PRGF for low income countries is 10 years with a 5 1/2 year grace period
on principal payments. The IMF may be viewed as both a financing and an adjustment-oriented
international institution for the benefit of its members. The distinguishing features of the Fund loans
are their cost and certain macroeconomic policy conditions. These conditionality requirements range
from rather general commitments to cooperate with the IMF in setting policies to formulating a specific,
quantified plan for monetary, trade, and fiscal policies.

The IMF practice of tying loans to conditions reflects the dominant influence of the capitalist world.
The strings of conditionality’s as well as the policy of sanctions that came to the fore in the early 1960s
made this international organisation the most controversial institution. This is because of the fact that
the conditions set by the Fund cannot constitute a standard solution for deficit countries to the Fund’s
finances. By attaching conditions to credit facilities, the Fund has assumed the role of a ‘neo-colonist’.
Some say that the IMF has been acting as ‘a rubber stamp for the desires of the US administration’.The
conditionality is always intended to restore internal and external balance and price stability. While
formulating specific performance criteria (often referred to as ‘conditional loans’ that is, ‘at the point
of a gun’), the Fund prepares ‘stabilisation’ programme and ‘adjustment’ programme which member
states will be required to adopt to tackle macroeconomic instability.

The programme design involves monetary and fiscal policy measures so that structural adjustment (i.e.,
reforms aimed at changing the structure of both production and consumption) takes place. Stabilisation
is generally regarded as a precondition of structural adjustment policies’.Thus, stabilisation and
structural programmes not only includes monetary and fiscal policies but also exchange rate policy (i.e.,
devaluation), liberalisation or deregulation, privatisation, reforming institutions to carry governments’
new role, freeing markets to determine prices, reforming the labour sector. Almost all stabilisation
programmes intend to curb effective demand.
Working of the IMF:

There are two phases in the working of the IMF over the last 65 years. The first phase covers the period
late 1940s (i.e., 1947) to 1971. This phase is popularly known as the ‘Bretton Woods System’. The IMF
system or the Bretton Woods System provides for exchange rate stability in the short run but allowed
for the possibility of exchange rate adjustment when a country experienced ‘fundamental’
disequilibrium in its BOP accounts. Thus, the pegged exchange rate was adjusted in accordance with
the IMF. Hence the name ‘adjustable peg system’.As the system was the source of some major
problems, it was abandoned in 1971 and more flexibility was introduced in the monetary system. In
other words, the demise of the Bretton Woods System made room for the floating exchange rate regime,
requiring changes in the role of the IMF. After prolonged negotiations (1973-78), the IMF started its
second-leg journey in 1978.

The decade of the 1970s saw massive borrowing by the developing countries. It rose to $600 billion by
1982. Meanwhile, the rise in interest rates in the USA from 1979 and the appreciation of dollar caused
tremendous difficulties to the developing countries in servicing their debts. On the other hand, the
switch to the floating exchange rate system coincided with the deteriorating economic conditions in the
industrialised countries.Debt crisis that emerged in many developing countries had a dramatic effect.
Mexico a Latin American country announced its failure to honour debt obligations. The IMF now
played a crucial role to put the international financial system in order. It came in for mobilisation of
additional financial resources so as to reduce the debt burden. As a result of this and other related
measures, many countries regained access to the international banks and creditors and the severity of
the debt problem moderated considerably in Latin America in the early 1990s.

With the breakup of the Soviet Union in 1989, a new category of countries, especially the erstwhile
communist countries, joined the IMF. The IMF now came forward to assist countries undergoing
transition from a centrally planned economy to a market-oriented economy. Privatisation is indeed a
crucial element of the transition process. That is why the IMF is providing financial assistance and
technical support for the development of sound economic management and the privatisation of state
enterprises.In 1997, the East Asian financial crisis began when the currencies of the ‘Asian tiger’
economies (South Korea, Singapore, Hong Kong, Taiwan) plummeted, and the stock market crashed.
Rescue packages were launched by the IMF under strong authority conditions.

Achievements:

From this balance sheet of the working of the IMF, we are now in a position to evaluate its performance
over the last 65 years or so. First, we state the achievements of the Fund.The IMF acts both as a
financing and an adjustment-oriented international institution for the benefit of its members It has been
providing financial assistance to the deficit countries to meet their temporary disequilibrium in BOP.
The Fund aims at promoting exchange rate stability. In its early phase, the Fund made arrangements of
avoidance of competitive exchange depreciation. It has made an attempt to solve the problem of
international liquidity. To create international liquidity. Special Drawing Rights (SDRs)—an artificial
currency—were created in 1969 as foreign exchange reserves to benefit the developing countries in
particular. SDR allocations are made to member countries to finance the BOP deficits. It is an institution
through which consultation in monetary affairs takes place in an on-going way. It acts as a forum for
discussions of the economic, fiscal and financial policies of member countries, keeping the BOP
problems in mind. Previously, the poorest developing countries did not receive adequate treatment from
the Fund. But from 1980s onwards—when the debt crisis broke out in poor countries—the Fund decided
to divert its financial resources to these countries.

In 1980s, centrally planned economies were not hitherto members of the Fund. With the collapse of the
Soviet Union in 1989, ex-communist countries became members of the Fund and the Fund is providing
assistance to these countries so as to instill, the principles of market economy. It has decided to finance
resources to combat terrorism and money-laundering.Finally, the IMF has assisted its members in the
formulation of appropriate monetary, fiscal, and trade policies.

Failures:

Despite these achievements, its failures are glaring. In other words, its success is, on the whole, limited.
There are some serious charges against this institution that cannot escape attention.

These are:

The Fund provides short-term finance to its members to tackle BOP disequilibrium. For this purpose, it
adopted an adjustable peg system in the first phase of its life. But it failed to establish a stable exchange
rate. Its role in controlling the competitive exchange depreciation policies adopted by the members was
subject to serious scrutiny, although it was created to avoid devaluation as a BOP measure as much as
possible.Truly speaking, the IMF is incapable of taking independent policy decisions. It complies with
the ‘order’ of the superpowers. Further, it has minimal influence over the policy decisions of the major
industrial powers. In these cases, its mandate to exercise ‘firm surveillance’ over some influential
members or superpowers is virtually meaningless—it has no influence over the US deficits or European
interest rates.

Secondly, the Fund imposes conditions on the poor countries while sanctioning loans. Now, it is
ignoring its central concern—exchange rate management and the BOP problems. It is now championing
the issue of ‘market principle’. It suggests poor developing countries to cut expenditure-borrowing-
subsidy, raise prices of state enterprises, privatisation of state-owned enterprises, etc. If such
measures—most popularly known as structural adjustment programmes—are adopted only then the
IMF credit would follow. It is said that the third world debt crisis is due to the Fund policies and
working.

Thirdly, the Fund has failed to eliminate foreign exchange restrictions imposed by its members that
hamper the growth of trade.

In view of these, the developing countries are blaming the IMF for their economic malaise. It is said
that the IMF has outlived its mission and the time has come for it to go into oblivion. Sixty- five years
is long enough!

Role of IMF in Economic Development of LDCs:

Being a central institution of international monetary system, the IMF works for global prosperity by
promoting a balanced expansion of world trade. The IMF not only operates as a BOP adjustment
institution but also a BOP financing institution.The IMF system provides for exchange rate stability in
the short run but allows for exchange rate adjustment if a country faces ‘fundamental’ disequilibrium
in its BOP accounts. Hence the name ‘adjustable peg system’ that lasted till 1971 since its birth. Till
the mid-60s of the 20th century, some progress had been achieved in the direction of international
cooperation and compliance with the Fund’s Articles of Agreement. Continuous drop in its gold
reserves and chronic BOP deficits resulting in a crisis of confidence of dollar forced the USA to abandon
the convertibility of dollars into gold in 1971. This is called breakdown of the Bretton Woods System
that seriously raised questions about the role of the IMF in the provisioning of international finance.
Floating exchange rate system thus introduced caused severe hardships to the LDCs. Meanwhile, many
LDCs faced serious BOP deficits because of a world recession, the first oil shock in the form of
ricocheting fuel prices, and a falling exports of LDCs.

Earlier, that is before 1971, the bulk of the Fund’s resources was used to maintain the value of currencies
of the developed world. The Fund had been also marginalised by the actions of the G-7 and regional
trading blocks. However, with the change in the exchange rate system, the role of the IMF also
underwent a change. It shifted its focus of attention to the developing countries in the late 1970s. In the
1980s, it became more generous in providing resources to the countries in difficulty. Since then, both
the IMF and the World Bank have been helping ex-communist countries to build a market economy,
though the IMF was created primarily as an institution for the promotion of international monetary
stability. The founding fathers of the Fund expected that it would poke its nose in the affairs of the
LDCs and, lately, of the former communist countries. Today, the Fund is being labelled as an ‘anti-
developmental’ institution, as far as structural adjustment lending is concerned. The IMF now serves
the needs of global finance instead of the needs of global stability. The use of conditionality and the
direct ‘surveillance’ on macroeconomic policy by the Fund is suggestive of increasing involvement in
the LDCs’ development process.
Drawings from the EFF, SRF, PRGF, etc., are available if the member countries agree to a stabilisation
programme. The IMF focuses mainly on a country’s macroeconomic stability as well as structural
adjustment programme that influences its macroeconomic performance. Conditionality’s are attached
when member countries opt for drawings from the above noted sources of the Fund. Structural
adjustment programmes (that includes not only stabilisation programmes associated with monetary and
fiscal policy measures, but also trade liberalisation, privatisation, globalisation, freeing markets to
determine prices, reforming institutions, to carry government’s new role, and so on) are said to be
preconditions for securing Bank-Fund loans. Its adverse impacts on the LDCs are varied and numerous.

First, SAP was justified as necessary to the LDC world as it would enable them to repay their debt to
banks of advanced countries. By the late 1980s, more than 70 LDCs had to swallow the SAP medicine.
But its impact on growth of these countries was negative. As many as 77 p.c. of countries saw the most
significant decline in their per capita incomes. In Latin America, during the 1960s and 1970s, income
grew by 75 p.c. when these economies were relatively closed, but during the 1980s, income grew by 61
p.c. only. Average incomes in sub-Saharan Africa actually contracted. Latest research data (2006) for
98 countries during 1970-2000 revealed a negative impact of the IMF programmes on the per capita
income growth of 1.7 p.c. p.a. Another study (1991) of 40 countries showed negligible growth in GDP,
marginal increase in export growth and the BOP situation and a decline in investment. The IMF aims
at tackling BOP disequilibrium but does little to learn the root causes of such disequilibrium.

Secondly, the costs of adjusting to greater openness of the LDC economy are shouldered mainly by the
poor. The Fund recommends privatisation so as to offset government failure. It is said that the
government-run enterprises are inefficient. Bureaucracies are corrupt. Thus by ‘freeing the markets’,
competitive efficiency could be improved. But the costs of such adjustment programmes are expensive.
Indeed, globalisation has triggered both poverty and inequality. Today’s world see the “billionaires of
capitalists” and the exponential growth of poverty-stricken, malnourished people.In compliance with
the IMF demand, in Argentina during 1976-87, employment in public administration was down by 11.5
p.c. and in State enterprises by 18.9 p.c. In India, during the stabilisation period 1991-99, growth rates
in employment in the organised sector declined form 1.44 p.c. to 0.84 p.c. and further to -0.31 p.c.
during 1994-2006. The inevitable consequence of this is the rise in the number of unemployed and poor
people. “In the eyes of some, the acronym IMF stands for (I)inflation, (M)isery and
(F)amine!” (A.P Thirlwall). Again, the IMF introduced economic shock therapy measures in command
economies. All these comprised the introduction of capitalism in Russia and other former Soviet-bloc
countries and hence a shift from the state-led development to market-led development.

Thirdly, Joseph Stiglitz has accused the IMF of promoting an agenda of ‘market fundamentalism’
thereby injuring the country’s social fabric. The Fund emphasises fiscal discipline—cuts in government
expenditures and subsidies—so as to pursue a free market economy philosophy. But because of cuts in
government expenditures and various subsidies on basic necessities and a rise in the price of public
services, vulnerable people bore the major brunt. Following cuts in subsidies on food products, milk
prices in Chile went up by 400 p.c., bread by 367 p.c., potatoes by 850 p.c. and carrot by 1.589 p.c. in
1975—the average rate of inflation there was 340 p.c. Many LDCs saw their indicators of standard of
living—infant mortality, life expectancy, adult literacy, primary school enrolment, per capita calorie
supply, etc. — falling to an unimaginable proportion. The Fund is unresponsive to “adjustment with
a human face”. Fourthly, structural adjustment conditionality is often criticised for the third world debt
crisis. Borrowing-dependent third world countries in the 1970s and 1980s went for private commercial
bank loans—thereby causing accumulation of external debt and ballooning of debt service payments.
Faced with this crisis, many of the LDC countries approached the IMF for borrowing to avert the risk
of default.

2.7. FUNCTIONS OF WORLD BANK

The International Bank for Reconstruction and Development (IBRD), commonly referred to as the
World Bank, is an international financial institution whose purposes include assisting the development
of its member nation’s territories, promoting and supplementing private foreign investment and
promoting long-range balance growth in international trade.The World Bank was established in
December 1945 at the United Nations Monetary and Financial Conference in Bretton Woods, New
Hampshire. It opened for business in June 1946 and helped in the reconstruction of nations devastated
by World War II. Since 1960s the World Bank has shifted its focus from the advanced industrialized
nations to developing third-world countries.

Organization and Structure:

The organization of the bank consists of the Board of Governors, the Board of Executive
Directors and the Advisory Committee, the Loan Committee and the president and other staff members.
All the powers of the bank are vested in the Board of Governors which is the supreme policy making
body of the bank.The board consists of one Governor and one Alternative Governor appointed for five
years by each member country. Each Governor has the voting power which is related to the financial
contribution of the Government which he represents.The Board of Executive Directors consists of 21
members, 6 of them are appointed by the six largest shareholders, namely the USA, the UK, West
Germany, France, Japan and India. The rest of the 15 members are elected by the remaining countries.

ach Executive Director holds voting power in proportion to the shares held by his Government. The

board of Executive Directors meets regularly once a month to carry on the routine working of the

bank.The president of the bank is pointed by the Board of Executive Directors. He is the Chief Executive

of the Bank and he is responsible for the conduct of the day-to-day business of the bank. The Advisory
committees appointed by the Board of Directors. It consists of 7 members who are expects in different

branches of banking. There is also another body known as the Loan Committee. This committee is

consulted by the bank before any loan is extended to a member country.

Capital Resources of World Bank:

The initial authorized capital of the World Bank was $ 10,000 million, which was divided in 1 lakh

shares of $ 1 lakh each. The authorized capital of the Bank has been increased from time to time with

the approval of member countries. On June 30, 1996, the authorized capital of the Bank was $ 188

billion out of which $ 180.6 billion (96% of total authorized capital) was issued to member countries in

the form of shares.

Member countries repay the share amount to the World Bank in the following ways:
1. 2% of allotted share are repaid in gold, US dollar or Special Drawing Rights (SDR).

2. Every member country is free to repay 18% of its capital share in its own currency.

3. The remaining 80% share deposited by the member country only on demand by the World Bank.

Objectives:
The following objectives are assigned by the World Bank:
1. To provide long-run capital to member countries for economic reconstruction and development.

2. To induce long-run capital investment for assuring Balance of Payments (BoP) equilibrium and
balanced development of international trade.

3. To provide guarantee for loans granted to small and large units and other projects of member
countries.

4. To ensure the implementation of development projects so as to bring about a smooth transference

from a war-time to peace economy.

5. To promote capital investment in member countries by the following ways;

6. To provide guarantee on private loans or capital investment.

7. If private capital is not available even after providing guarantee, then IBRD provides loans for

productive activities on considerate conditions.

Functions:

World Bank is playing main role of providing loans for development works to member countries,

especially to underdeveloped countries. The World Bank provides long-term loans for various

development projects of 5 to 20 years duration.

The main functions can be explained with the help of the following points:

1. World Bank provides various technical services to the member countries. For this purpose, the Bank

has established “The Economic Development Institute” and a Staff College in Washington.

2. Bank can grant loans to a member country up to 20% of its share in the paid-up capital.

3. The quantities of loans, interest rate and terms and conditions are determined by the Bank itself.

4. Generally, Bank grants loans for a particular project duly submitted to the Bank by the member

country.

5. The debtor nation has to repay either in reserve currencies or in the currency in which the loan was

sanctioned.

6. Bank also provides loan to private investors belonging to member countries on its own guarantee,

but for this loan private investors have to seek prior permission from those counties where this amount

will be collected

7. Granting reconstruction loans to war devastated countries.

8. Granting developmental loans to underdeveloped countries.

9. Providing loans to governments for agriculture, irrigation, power, transport, water supply, educations,
health, etc

10. Providing loans to private concerns for specified projects.

11. Promoting foreign investment by guaranteeing loans provided by other organisations.

12. Providing technical, economic and monetary advice to member countries for specific projects

13. Encouraging industrial development of underdeveloped countries by promoting economic reforms.

2.8. Impact of Regional Economic Integration

The term 'economic integration' is specifically mean to refer to either regional economic integration
or international economic integration. Whereas international economic integration is synonymous with
globalisation, regional economic integration limits economic integration to a particular region. So,
“Regional economic integration is an agreement among countries in a geographic region to reduce and
ultimately remove tariff and non-tariff barriers to the free flow of goods or services and factors of
production among each others”. In theory, regional economic integration benefits all members. Over
the last 20 years, the number of regional trade agreements has been on the rise. It can be also refers as
any type of arrangement in which countries agree to coordinate their trade, fiscal, and/or monetary
policies are referred to as economic integration. Obviously, there are five different levels of integration
as follows.

i. Free Trade Area: A free trade area occurs when a group of countries agree to eliminate tariffs
between themselves, but maintain their own external tariff on imports from the rest of the world. The
North American Free Trade Area is an example of a FTA. When the NAFTA is fully implemented,
tariffs of automobile imports between the US and Mexico will be zero. However, Mexico may continue
to set a different tariff than the US on auto imports from non-NAFTAcountries.
ii. Customs Union: A customs union occurs when a group of countries agree to eliminate tariffs
between themselves and set a common external tariff on imports from the rest of the world. Andean
Community, CARICOM is example of custom union. Andean Community Includes Bolivia, Colombia,
Ecuador, Peru and Venezuela.
iii. Common Market: A common market establishes free trade in goods and services sets common
external tariffs among members and also allows for the free mobility of capital and labor across
countries. EU is one of example of common market.
iv. Economic Union: An economic union typically will maintain free trade in goods and services, set
common external tariffs among members, allow the free mobility of capital and labor, and will also
relegate some fiscal spending responsibilities to a supra-national agency. E.g. EMU (Economic and
Monetary Union)
v. Political Union: Independent states are combined into a single union, this requires that a central
political apparatus coordinate economic, social, and foreign policy for member states. The EU is headed
toward at least partial political union, and the US is an example of even closer political union Regional
Economic Integration plays a major importance role in global trade.
 It enhances trade among member through the elimination of customs barriers, and to quickly and
substantially improves the allocation of resources and general dynamism, by fostering greater
competition among the participating countries and by providing more incentives for the introduction of
new and rapidly changing technologies and production methods. It helps to accelerate national
investments and foreign direct investments in order to acquire international competitiveness in the face
of increasing globalization. Regional Economic Integration stimulates economic growth in countries
and provides additional gains from free trade beyond international agreements such as GATT and
WTO. Economic interdependence creates incentives for political cooperation and reduces potential for
violent confrontation. Together, the countries have the economic clout to enhance trade with other
countries or trading blocs.

Importance of regional economic integration is as follows:-

1.Since a regional common market obviously provides a much larger market than that offered by the
domestic market of a single country, economies of scale, both internal and external, become possible
with the widened size of the market.
2. Secondly, the large market so created would permit a high degree of sophistication and specialization
of products conducive to furtherance of modern industrial development. Moreover, the possibility of
specialization for regional trade would encourage the flow of investment into industries which have a
comparative cost advantage, so that gains from international trade would rise.
3.Apart from an increase in the volume of total trade as a result of such an integration, a favorable
change in the cost and price structure may also be effected along with, the desirable change in the
structure and composition of foreign trade. 4.Furthermore, this may facilitate the realization of the
optimum allocation of resources, and thus, lead toan increase in efficiency in production.
5. Above all, the increased possibilities of competition in a regional common market would ensure that
all benefits accruing to the producers from the existence of a large market would be passed on to the
consumer.
6. In fine, thus, there can be an increase in the general welfare due to better production and enhanced
consumption, and a rise in real income generated by the overall growth and development.
In short, thus, it has been conceived that, as a factor in the development of the less developed
countries, a regional common market is economically far superior to the relatively small national
market sheltered behind a protectionist tariff wall.

2.9. Global Integration of Ecocnomic Systems

Economic integration is an economic arrangement between different regions, marked by the

reduction or elimination of trade barriers and the coordination of monetary and fiscal policies. There
are economic as well as political reasons why nations pursue economic integration. The economic
rationale for the increase of trade between member states of economic unions that it is meant to lead to
higher productivity. This is one of the reasons for the global scale development of economic integration,
a phenomenon now realized in continental economic blocs such as ASEAN, NAFTA, SACN,
the European Union, and the Eurasian Economic Community; and proposed for intercontinental
economic blocks, such as the Comprehensive Economic Partnership for East Asia and the Transatlantic
Free Trade Area.

Comparative advantage refers to the ability of a person or a country to produce a particular

good or service at a lower marginal and opportunity cost over another. Comparative advantage was first
described by David Ricardo who explained it in his 1817 book On the Principles of Political Economy
and Taxation in an example involving England and Portugal.[3] In Portugal it is possible to produce
both wine and cloth with less labour than it would take to produce the same quantities in England.
However the relative costs of producing those two goods are different in the two countries. In England
it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy
to produce. Therefore, while it is cheaper to produce cloth in Portugal than England, it is cheaper still
for Portugal to produce excess wine, and trade that for English cloth. Conversely England benefits from
this trade because its cost for producing cloth has not changed but it can now get wine at a lower price,
closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in the
good where it has comparative advantage, and trading that good for the other.

Economies of scale refers to the cost advantages that an enterprise obtains due to expansion.
There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased.
Economies of scale is a long run concept and refers to reductions in unit cost as the size of a facility
and the usage levels of other inputs increase.[4] Economies of scale is also a justification for economic
integration, since some economies of scale may require a larger market than is possible within a
particular country — for example, it would not be efficient for Liechtenstein to have its own car maker,
if they would only sell to their local market. A lone car maker may be profitable, however, if they export
cars to global markets in addition to selling to the local market.Besides these economic reasons, the
primary reasons why economic integration has been pursued in practise are largely political.
The Zollverein or German Customs Union of 1867 paved the way for partial German unification under
Prussian leadership in 1871. "Imperial free trade" was (unsuccessfully) proposed in the late 19th century
to strengthen the loosening ties within British Empire. The European Economic Community was
created to integrate France and Germany's economies to the point that they would find it impossible to
go to war with each other.

Integration of financial markets has resulted in the demise of financing along the predominantly
national lines. The concept of the "family doctor" has been replaced. In days gone by, if companies
needed money they went, as it were, to the "family banker". Nowadays not just one bank approaches
companies regularly; instead many banks from different countries complete at corporate level for
favours. This competition between financial intermediaries resulted from liberalisation and
globalisation of financial markets. This trend has increased competition on a global scale and led to
concentration of the parties in the financial markets.The liberalisation of international capital account
transactions in most major countries over the past decade or so has given rise to the rapid development
of an integrated international capital market. This development has enhanced capital mobility and
substitutability between domestic and foreign bonds. Euro and domestic interest rates have converged
for most major currencies. Furthermore, there appears to be a tendency for real interest rate differentials
between countries, averaged over periods of several years, to be smaller, although with considerable
volatility of these differentials over shorter time periods (especially at the short and medium term part
of the spectrum). Increased international capital transactions have also strengthened the interaction
between real interest rates and real exchange rates with important long and short-term implications.

The internationalisation of financial markets exert important effects on the efficiency of macro-
economic policy. If domestic real interest rates are affected more by the development of the world real
interest rate than in the past, the efficacy of monetary policy in influencing domestic private investment
might be reduced. On the other hand, monetary policy may have stronger effects on exports (exchange
rate crowding out) and prices via the exchange rate. The impact of fiscal policy on real output might
also change; the more closely linked are financial markets, the stronger are the exchange rate crowding
out effects and the weaker are the interest rate crowding out effects, i.e., the stronger the link between
fiscal policy changed and current account imbalances together with corresponding capital flows. Since
all these changes tend to strengthen the effect of macro-economic policy instruments on the exchange
rate and the current balance, better international co-ordination of macro policies is indispensable for
stable exchange rates and for the sustainable international configuration of balance of payments.

International integration of financial markets also has implications for international allocation of
capital. Provided there are no other distortions, how do the tendency towards convergence effect
financially open countries? How does internationalisation of financial markets effect the efficacy of
macro-economic policy instrument. To what extent does the increased integration of financial markets
improve the international allocation of capital? What are the effects of domestic tax incentives for
investment when capital is highly mobile?. During the past twenty-five years or so, increasing capital
market integration has strengthened convergence between domestic and Euro market interest rates.;
Internationalisation of capital markets has produced convergence of real returns on financial assets
across countries through various mechanisms. An important mechanism for the real interest rate
convergence is a long-run tendency of exchange rates to fluctuate around purchasing power parity
(PPP). Of course, exchange rates diverse some PPP levels and, correspondingly, expected changes in
exchange rates can differ from expected inflation differentials. If such changes in real exchange rates
take place, current account positions will be affected, with corresponding effect on net capital flows.
Such capital flows will tend to reduce real interest rate differentials though subtracting savings from
surplus of real interest rates though international capital movements would improve the allocation of
resources and raise the level of welfare. However, the corporate and personal tax system of each country
penetrates wedges specific to that country between market real interest rates and the real after tax cost
of capital for corporate investments. Since tax systems are usually not indexed to prices, these tax
wedges depend not only on tax parameters but also on the rate of inflation. It may be pointed that the
countries with tax incentives for investment and/or with high inflation tend to have wide tax wedges.
Therefore, even if market real-interest rates are equalized across countries, real costs of capital would
differ significantly among them penetrating a distorted allocation of capital. If resource allocation is
to be improved on a world-wide basis, international financial integration may call for international
harmonisation of those aspects of tax systems that relate to investment and savings.

Market participants
The main reason for the existence of the market are the market participants. The flow of funds move
within and outside these participants in the financial market. There are mainly three types of market
participants. They are
 Ultimate borrowers
 Ultimate lenders
 Financial intermediaries
Investors attempt to accumulate wealth, to alter or smooth their pattern of consumption, or to change
the risks attached to their consumption or portfolios of assets. Borrowers transacts to gain investable
funds, to consume or to alter the risks attached to their liabilities. Financial intermediaries earn a return
by packaging financial assets for borrowers or lender-increasing the variety of securities directly
available in the markets. They can also act as brokers by arranging deals between borrowers and lenders.
There are several agencies and institutions acting as intermediaries in domestic financial systems. Even
though their stated goals are not regulatory, their redistribution of wealth and income are. They borrow
directly from capital market and lend to qualified beneficiaries with reduced rate: they also provide an
indirect subsidy by guaranteeing the beneficiaries debt. Beneficiaries include groups or individuals
whose objectives are considered socially desirable, but insupportable at free-market costs of capital. So
this methods of income distribution has become an extremely popular policy tool in many countries; in
consequence, the relative presence in the capital markets of government agencies and institutions has
increased enormously. The financial system in India is controlled and supervised by SEBI. Public and
private institutions facilitate the growth and development of the financial system.
2.10. Exchange Rate issues in Developing Countries
The 1997-98 Asian crisis, with its offshoots in Eastern Europe and South America, revealed
how little we still know about workable exchange rate policies for developing countries. in every
country that abandoned a peg and floated (Brazil, Russia, Ecuador, Thailand, again Indonesia and
Korea), the exchange rate overshot massively and a period of currency turmoil followed djustable or
crawling pegs were in place. Every country that experienced serious difficulties recently: Brazil,
Ecuador, Indonesia, Korea, Russia, Thailand related to exchange rate problems.

2.10.1. ISSUES INVOLVED IN INDIAN RUPEE DEPRECIATION AND VOLATILE

There are two issues involved here - depreciation and volatility. As far as depreciation is concerned,
the facts are well known. India has always had current account deficit which has increased significantly
during the past few years in view of strong petroleum prices, increased gold imports coupled with strong
gold prices and deceleration in the growth of exports on the back of faltering or even falling growth in
most of the developing/developed countries which also happen to be the major trading partners. On the
other hand, autonomous capital flows also seem to have slowed down because of several factors
including global risk aversion, slowdown of investment in the Indian economy and several structural
issues including inadequate infrastructure. In such a situation Rupee exhibiting a depreciating bias is no
surprise. A depreciating currency is often seen to act as an instrument for correction of imbalances in
the BoP. However, a sharp depreciation within a short period of time has a destabilising impact
inasmuch as it provokes panic reaction amongst market participants which apart from leading to sub-
optimal economic decision making further accentuates the price process. While the policy response to
structural as well as exogenous factors that lead to mismatch between inflows and outflows and
consequent depreciation (or appreciation) of the currency take time to yield results, Reserve Bank has
a mandate to maintain orderliness in the foreign exchange market.

In forex markets, volatility essentially means unpredictability. Unpredictability not only of the extent
of change over any given time period but also the direction of change. It affects all as the decisions are
to be taken today that will fructify at a future point in time. Because all financial prices are inherently
forward looking in the sense that they incorporate the participants' future view, it is no wonder that
volatility is their most important attribute. It is further complicated by the fact that usually future view
is informed by past experience. It may be interesting to recall that in 2007-08 when Rupee was at 39
levels, informed participants were forecasting 35-36 levels by the end of 2008 and very recently, during
end-June this year, when Rupee reached 57, market was looking at 58-60 or even 60-65 as inevitable.
It is to be emphasised that when economic agents take decision based on such a view of the future, it
certainly does not bode well either for them or for the economy as a whole. This raises a related issue.
If we accept that market makers/analysts who often are in a position to influence the market sentiment
tend to be either euphoric or despondent, what is the accountability if their forecasts turn out to be
widely wrong but meanwhile some participants in the market do get taken in by these forecasts and
their decisions then turn out to be sub-optimal or inappropriate?
Thus, it needs to be recognised that increased volatility in the financial markets has become a way
of life- a kind of new normal-and it has to be accepted as such. Capital account liberalisation during last
few decades and enormous increase in the scale and variety of cross border financial transactions has
increased the magnitude of exchange rate movements, particularly in the emerging market economies.
Of course, volatility may be moderate for some stretch of time - recall that in 2006 people were seeking
explanations for low volatility in the forex market - and heightened at other times, as now. The question
is: What should be the response to volatility? For ease of exposition, may be discussed the issue in the
context of two sets of market participants. The real sector agents - exporters, importers, foreign currency
borrowers and so on and the banks or authorised dealer

2.11. Foreign Exchange Contracts

Forex market players can trade foreign exchange in differing maturities and using different types of
instruments i.e, cash, tom, spot, forward, futures, swaps and options market.
Forex rates can be quoted as spot or, forward contracts. When buyers and sellers agree to trade at the
current exchange rate for immediate delivery, it is known as spot transaction or cash transaction. It can
“ at that instance” can go upto maximum of two days.
i. Ready or cash- The transaction to be settled on the same day
ii. Tom- The delivery of foreign exchange to be made on the day next (tomorrow) to the date of
transaction.
iii. Spot- Delivery of foreign exchange would take place on the 2nd working day from the trade date.
iv. Forward rate- In a forward contract both parties enter into a contract on a given day and lock in a
fixed rate on specific future date. In such types of contract, the terms of the purchase (buy or sell) are
agreed up front (trade execution date) but actual exchange take place on a date in the future (maturity
date). On the maturity date, both parties exchange the prenegotiated rate. For example, an Indian
company which is likely to earn foreign currency i.e, Euro on account of an export order after one
month, may enter into a contract today ( trade execution date) to sell Euro and receive Indian Rupees
after 1 month ( maturity date). The rate is fixed on the trade date and the rate is be known as Fwd- 1
month rate. Suppose on trade date, the Indian exporter agrees to sell EURO 1000 and receive INR
72450. On the maturity date, he delivers EURO 1000 and receives INR 72450. Such types of forward
contracts are known as outright forward contracts (OFTs).
v. Futures- A exchange traded forward contract is known as futures contract. Forward contracts are
tailor made depending on the requirement of the contract buyers or sellers. However being exchange
traded, futures contracts are standardized – contract size, maturity period etc. Being exchange traded,
futures contract can be squared off easily which may not be possible in case of forward contract. In case
of futures contract, the clearing house associated with exchange takes the counterparty risk – risk that
the loss making party does not deliver during the maturity period.

vi. SWAP- Currency swap works like this: An Indian company, XYZ Co. took an ECB (External
Commercial Borrowing) loan of USD 250mn for 6 years at a fixed interest rate of 5.5%. After two
years, remaining time to maturity is 4 years. XYZ Co. wants to shift this USD obligation and wants to
pay the interest and principal in INR. The Indian company fears that INR to depreciate – hence
increasing its INR expenditure to service the foreign currency denominated interest as well as principal.
It approaches different banks for swapping its USD obligations. BBK bank agrees to be the counterparty
for this swap at an 8.5% per annum. Once both parties agree, the following swap payment happens
between XYZ Co. and BBK Bank.
vii. Options- Companies buy and sell call and put options to hedge their foreign times exchange
exposure as well as at times indulge in speculative activities. Options on foreign currency are offered
by banks as OTC product or can be bought and sold in exchanges.
In a call option, the option buyer (long call position holder) has the right to buy the underlying currency
at the maturity at the exercise price. For example, an importer wanting to hedge the USD risk, enters
into long call option for 20,000 USD at INR 44.45/USD with contract maturing after 15 days from
today. The counterparty to the importer takes a short call option. On T+15 day, the spot rate is INR
43.80/USD. Whether the importer will exercise his option to buy USD from the counterparty or not? In
this case, the option will not be exercised as the importer is better off buying the USD from spot market
than from the short call position holder. The importer will exercise call option, when the spot price is
higher than INR 44.45/USD—when INR depreciates.

In a put option, the option buyer (long put position holder) has the right to sell the underlying currency
at the maturity at the exercise price. For example, an exporter wanting to hedge the USD risk, enters
into long put option for 18950 USD at INR 44.45/USD with contract maturing after 15 days from today.
The counterparty to the exporter takes a short put option. On T+15 day, the spot rate is INR 43.80/USD.
Whether the exporter will exercise his option to sell USD to the counterparty or not? In this case, the
option will be exercised as the exporter can sell USD at INR44.45 per USD due to the option contract.
Without the option, the exporter would have sold USD at INR 43.80/USD. The exporter will exercise
his put option, when the spot price is lesser than INR 44.45/USD—when INR appreciates.

2.12. Types of Foreign Exchange Quotations

Forex quotations can be expressed as “Direct/Indirect”, “American/European”, “Base and

Variable/term/Quote currency

Direct /Indirect Quotation

 A direct quote is the home currency price of one unit of foreign currency. An indirect quote is
foreign currency price of one unit of domestic currency. A forex quotation becomes direct/indirect
quotations depending on who is using this quote. For example, INR 48.45/USD is a direct quotation for
resident Indian while it is indirect quotation for American. Similarly, USD0.020673/ INR is a direct
quotation for American person while it is an indirect quotation for Indian. INR 70.25/Pound is direct
quotation for a resident Indian while Pound 0.01423/INR is an indirect quotation.

European/American Terms

In the interbank market, USD is the most traded currency pair. In other words, for majority
trades one leg of the currency is USD. Banks & professional dealers normally quote in one of the two
ways i.e, a) foreign currency price per one USD, also known as “European Terms” b) USD price per
unit of foreign currency also known as “American Terms”.

Base/Variable currency
Each forex quotation has a “base” currency and a “variable/quote/term” currency. Any exchange rate
quotation shows how many units of variable/quote/term currency for unit of base currency. For example
a forex exchange dealer is quoting USD/HKD as 7.7756. In his case, USD is the base currency while
HKD 7.7756 variable/quote/term currency.

Bid/Ask rate
Buyers and sellers give their buying and selling rate. Hence at a given point of time, there are two rates
available.These two rates are known as “bid” and “ask” rates. However in a forex market buyers and
sellers can be individual entities (exporters or importers) as well as a single entity buying and selling a
currency simultaneously. The difference between these two rates is known as bid-ask spread.

Suppose State Bank of India (SBI), a dealer in forex, is quoting bid-ask EURO/INR of 76.5025 to
76.5048 for spot transaction at 11.15am on 29th August 20XX.
Spot Rate by SBI Bid Ask
Euro/INR 76.5025 76.5048
In this quotation, Euro is the base currency while INR is variable/term/quote currency. Bid-ask price is
always expressed in terms of base currency. The bid rate indicates that, SBI is willing to buy 1 Euro
from the counterparty and pay INR 76.5025. The ask rate indicates that SBI is willing to sell (or give)
1 Euro to counterparty and accept (or receive) INR 76.5048. In other words, for every Euro SBI buys
and sells, it makes a profit of INR 0.0013. Bid rate is always lesser than ask rate. At times bid-ask spread
is quoted in percentage terms. A banks/forex dealer’s spread is calculated as follows:
bid ask spread = .(ASK- BID)/ASK *100
Cross Rate
Many currency pairs are not directly quoted i.e dealers do not offer a rate for these currency pairs. For
example, an Indian importer is importing oil from Azerbaijan. The company from Azerbaijan wants
that Indian exporter must make the payment in local currency i.e. Azerbaijanian Manat (AZN). As no
bank or dealer is offering INR/AZN quote, the Indian company has to use a via-media currency to
convert the INT to AZN to make payment. The exchange calculated in this round about manner is
known as cross rates. Besides offering spot quotations, banks also quote spot rates for buying/selling or
exchanging TC (Travelers Cheques) and TT (Telegraphic transfers).
USD/CAD USD/AUD CAD/AUD
BID ASK BID ASK BID ASK
1.1641 1.1646 1.2948 1.2956

• Bank buys 1USD and pays (sells) 1.1641 CAD

• Bank sells 1 USD and receives (buys)1.1646 CAD
• Bank buys 1 USD and pays (sells) 1.2948 AUD
• Bank sells 1 USD and receives(buys) 1.2956 AUD
To get the bid rate for CADAUD (CAD as base currency and AUD as quote currency), the bank must
sell AUD and buy CAD. This is achieved in two steps ie. the bank must sell AUD and buy USD and
simultaneously sell USD and buy CAD.
This indicates that 1.1646 CAD = 1.2948 AUD. In other words, 1 CAD = 1.1118 AUD
To get the ask rate for CADAUD, the bank must sell CAD and buy AUD. This is achieved in two
steps ie. the bank must sell CAD buy USD and simultaneously sell USD and buy AUD.
This means that 1.1641 CAD = 1.2956 AUD. In other words, 1 CAD = 1.1129 AUD.
Appreciation and Depreciation
A currency appreciates against another currency when its value rises in terms of the other currency. In
a currency pair, when the value of one currency rises, obviously the value of other currency pair
declines. For example on January 1 2010, the spot rate was INR 48.25/USD. Suppose, on February 1
2010, the spot rate is INR 46.75/USD. During the one month period, as the value of INR has risen in
comparison to USD. In other words, INR has appreciated or USD has depreciated. In a simpler way,
the concept can be understood as follows: On 1 January 2010, 1 USD is equivalent to INR 48.25. Just
after a month on 1 February 2010, 1 USD is equivalent to INR 46.75. This clearly shows that USD
value has gone down compared to INR.
Reasons for Appreciation/ Depreciation
Though many factors influence the domestic exchange rate, in this section, some important factors
affecting the exchange rate are listed.
• Difference in national inflation rates: The currency of a country experiencing higher inflation will
depreciate and vice versa.
• Changes in the real interest rates: Currency of a country with higher real interest rate will appreciate.
• Investment climate: A country with better investment climate will attract investment thus leading to
appreciation of the currency.
• Political uncertainty: a country with greater degree of political uncertainty will exhibit higher
depreciation.

2.13. Exchange Rate Forecast

Exchange Rate Forecasts are derived by the computation of value of vis-à-vis other foreign currencies
for a definite time period. There are numerous theories to predict exchange rates, but all of them have
their own limitations.
The two most commonly used methods for forecasting exchange rates are:
Fundamental Approach: This is a forecasting technique that utilizes elementary data related to a
country, such as GDP, inflation rates, productivity, balance of trade, and unemployment rate. The
principle is that the ‘true worth’ of a currency will eventually be realized at some point of time. This
approach is suitable for longterm investments.
Technical Approach: In this approach, the investor sentiment determines the changes in the
exchange rate. It makes predictions by making a chart of the patterns. In addition, positioning surveys,
moving-average trend-seeking trade rules, and Forex dealers’ customer-flow data are used in this
approach.

Exchange Rate Forecast Model

Some important exchange rate forecast models are discussed below.

i. Purchasing Power Parity Model
The purchasing power parity (PPP) forecasting approach is based on the Law of One Price. It states that
same goods in different countries should have identical prices. For example, this law argues that a chalk
in Australia will have the same price as a chalk of equal dimensions in the U.S. (considering the
exchange rate and excluding transaction and shipping costs). That is, there will be no arbitrage
opportunity to buy cheap in one country and sell at a profit in another. Depending on the principle, the
PPP approach predicts that the exchange rate will adjust by offsetting the price changes occurring due
to inflation. For example, say the prices in the U.S. are predicted to go up by 4% over the next year and
the prices in Australia are going to rise by only 2%. Then, the inflation differential between America
and Australia is: 4% – 2% = 2% According to this assumption, the prices in the U.S. will rise faster in
relation to prices in Australia. Therefore, the PPP approach would predict that the U.S. dollar will
depreciate by about 2% to balance the prices in these two countries. So, in case the exchange rate was
90 cents U.S. per one Australian dollar, the PPP would forecast an exchange rate of: (1 + 0.02) × (US
$0.90 per AUS $1) = US $0.918 per AUS $1 So, it would now take 91.8 cents U.S. to buy one Australian
dollar.
ii. Relative Economic Strength Model
The relative economic strength model determines the direction of exchange rates by taking into
consideration the strength of economic growth in different countries. The idea behind this approach is
that a strong economic growth will attract more investments from foreign investors. To purchase these
investments in a particular country, the investor will buy the country's currency – increasing the demand
and price (appreciation) of the currency of that particular country. Another factor bringing investors to
a country is its interest rates. High interest rates will attract more investors, and the demand for that
currency will increase, which would let the currency to appreciate. Conversely, low interest rates will
do the opposite and investors will shy away from investment in a particular country. The investors may
even borrow that country's lowpriced currency to fund other investments. This was the case when the
Japanese yen interest rates were extremely low. This is commonly called carry-trade strategy. The
relative economic strength approach does not exactly forecast the future exchange rate like the PPP
approach. It just tells whether a currency is going to appreciate or depreciate.

iii. Econometric Model

It is a method that is used to forecast exchange rates by gathering all relevant factors that may affect a
certain currency. It connects all these factors to forecast the exchange rate. The factors are normally
from economic theory, but any variable can be added to it if required. For example, say, a forecaster for
a Canadian company has researched factors he thinks would affect the USD/CAD exchange rate. From
his research and analysis, he found that the most influential factors are: the interest rate differential
(INT), the GDP growth rate differences (GDP), and the income growth rate (IGR) differences. The
econometric model he comes up with is: USD/CAD (1 year) = z + a(INT) + b(GDP) + c(IGR) Now,
using this model, the variables mentioned, i.e., INT, GDP, and IGR can be used to generate a forecast.
The coefficients used (a, b, and c) will affect the exchange rate and will determine its direction (positive
or negative)
iv. Time Series Model
The time series model is completely technical and does not include any economic theory. The popular
time series approach is known as the autoregressive moving average (ARMA) process. The rationale is
that the past behavior and price patterns can affect the future price behavior and patterns. The data used
in this approach is just the time series of data to use the selected parameters to create a workable model.
To conclude, forecasting the exchange rate is an ardent task and that is why many companies and
investors just tend to hedge the currency risk. Still, some people believe in forecasting exchange rates
and try to find the factors that affect currency-rate movements. For them, the approaches mentioned
above are a good point to start with.
2.14. Bid- Ask Spread
Buyers and sellers give their buying and selling rate. Hence at a given point of time, there
are two rates available.These two rates are known as “bid” and “ask” rates. Bid-ask rates are given by
forex dealers who are willing to buy and sell forex at these rates. It is to be noted here that in a traditional
market, the buyers and sellers are normally separate entities. For example, buyers and sellers of steel
would be different. A buyer is an user of the steel while seller is the producer of the steel. However in
a forex market buyers and sellers can be individual entities (exporters or importers) as well as a single
entity buying and selling a currency simultaneously. The difference between these two rates is known
as bid-ask spread.
Suppose State Bank of India (SBI), a dealer in forex, is quoting bid-ask EURO/INR of 76.5025 to
76.5048 for spot transaction at 11.15am on 29th August 20XX.

Bid-Ask rates
Spot Rate by SBI Bid- Ask (Euro/INR ) 76.5025 - 76.5048

In this quotation, Euro is the base currency while INR is variable/term/quote currency. Bid-ask price is
always expressed in terms of base currency. The bid rate indicates that, SBI is willing to buy 1 Euro
from the counterparty and pay INR 76.5025. The ask rate indicates that SBI is willing to sell (or give)
1 Euro to counterparty and accept (or receive) INR 76.5048. In other words, for every Euro SBI buys
and sells, it makes a profit of INR 0.0013. Bid rate is always lesser than ask rate. While buying a
currency, the traders pay a higher amount compared to selling the same amount of the currency. The
bid-ask spread is what the bank/foreign exchange dealer profits. Bid-ask spread represent the profit
potential for the forex dealer while it the transaction cost for the company intending to buy/sell forex.
Of course, the spread must cover other costs such as phone bills, internet charges, employees’ salary
and bookkeeping charges etc. To summarize, a trader need to first identify the base currency in a
currency quotations. Then focus on the bid-ask rate to determine the price he would pay/receive for any
forex transaction.
At times bid-ask spread is quoted in percentage terms. A banks/forex dealer’s spread is calculated as
follows: 100* bid bidask spread (ASK−BID)/ BID *100 .
As per the RBI document “The normal spot market quote has a spread of 0.25 paisa to 1 paise while
swap quotes are available at 1 to 2 paise spread. A closer look at the bid-ask spread in the rupeeUS
dollar spot market reveals that during the initial phase of market development (i.e., till the mid 1990s),
the spread was high and volatile due to thin market with unidirectional behavior of market participants
In the later period, with relatively deep and liquid markets, bid-ask spread has sharply declined and has
remained low and stable, reflecting efficiency gains”.
Bid- Ask Spread adjustment

Forex dealers or banks from time to time expand or squeeze the bid-ask spread to manage the inventory
position in a given currency. Normally forex dealers or banks make these quotes for a currency pair or
some currency pairs. They are ready to buy and sell currencies at the quoted rate. For example, if a
dealer is quoting 1.62536-1.63576 for GBP/USD, then the bank is willing to buy 1 GBP and pay
USD1.62536 and willing to sell 1 GBP and receive USD1.62576. If a bank has more USD than it wants
to hold, then the bank offers a higher bid price. For example the bank may quote USD1.63540 as bid
price (instead of 1.62536). This means that the bank is willing to buy 1 Euro and give USD1.62540
compared to USD 1.62536. This would encourage many traders to sell Euro to the bank and in return
receive higher USD. To reduce USD inventory, the bank may also increase the offer price. Instead of
1.62576, the bank may offer, 1.62579. This means that the bank requires the traders to pay USD 1.62579
instead of earlier payment of USD1.62576. This would dissuade the traders to sell USD to this bank.
Hence, depending on their inventory position, foreign exchange dealers/banks may narrow or widen the
spread. However, they are not absolutely free to quote any rate. Willy-nilly they have to maintain parity
with other dealers for the same currency pair. Too much of difference in quotes among banks/dealers
will lead to arbitrage profit i.e, thus forcing the rates to remain range bound.
The bid-ask spread is also affected by large number of other factors.
These are
• Liquidity/trading volume in the market
• Size of the transaction
• Number of players, time of the day etc
• Currency rate volatility.

Standard of Forex Quotation

Many a times, news paper states that USDINR rate in 47.28 or 46.35 i.e, the rate is expressed upto two
decimal point. Banks quote forex rate the upto two decimal point mostly for retail trades. However, all
interbank forex quotations are expressed up to 4 decimal point. As, in the forex market, the volume of
a single transaction can run up to corers of rupees, variation in few point can be very significant. For
example, an Indian company wants to sell USD 1 crore to buy INR. One bank is giving rate of 47.6130
while another one is giving a rate of 47.6120. The Indian company would receive INR 1000 less if it
goes for the second rate compared to the first rate.
Pip and forex quotation
PiP is the acronym for "price interest point". A pip is the smallest unit by a currency quotations can
change. For example, let us assume that on a given day, a bank quotes spot USDINR quote is INR
48.75. The minimum value this rate can change is either INR 48.74 or INR 48.76. In other words, for
USD/INR quote, the pip value is 0.01. Pip in foreign currency quotation is similar to the tick size in
share quotations. The difference between bid-ask spread is also quoted in pip terms. For example Spot
EURUSD is quoted at a bid price of 1.0213 and an ask price of 1.0219. The difference is USD 0.0006
equal to 6 “pips”.
Forward Quotation
Besides these spot rates, banks/forex exchange dealers also offer quotations for forward contracts. In a
forward contract, the bank/forex dealer and counterparty agree to buy/sell foreign currency at a future
date at rate fixed today.
USDINR Bid Rate Ask Rate Bid-ask spread
Spot 47.0725 47.0745 INR 0.0020/USD

1 week 47.0750 47.0775 INR 0.0025/USD

2 weeks 47.0795 47.0835 INR 0.0040/USD
1 month 47.0840 47.0890 INR 0.0055/USD
2 months 47.0900 47.0965 INR 0.0065/USD

For the spot trade, bid rate indicates that the bank is willing to buy 1 USD from the counterparty and
pay Rs.47.0725. Ask rate indicates that the bank is willing to sell 1USD to the counterparty and receive
Rs.47.0745. Like the spot rate, banks/forex dealers, give bid-ask spread for different maturities of
forward contracts. As discussed earlier, in forward contract, both parties agrees on a forward trade at
day 0, but actual settlement happens after the maturity of the contract.
Forward quotations on point basis
forex dealers normally quote forward rates in points. In terms of points, these quotations are known as
“cash rates” or “swap rates” or “basis points”. The cash/swap rates are nothing but the difference
between the forward rate and the spot rate. The spot rate is expressed in outright form and the forward
rates are point form. In earlier days when most of the forex transactions were undertaken through
telephone, to reduce the effort to quote full figure forex quotes, operators started quoting in point form.
As there is a higher probability of the dealer making a mistake in quoting in outright form, quotations
based point form evolved and gained popularity.
Transaction Bid Rate (points) Ask Rate(points)
Spot 47.0725 47.0745

1 week 25 30
2 weeks 70 90
1 month 115 145
2 months 175 220
It indicates that the spot bid is 47.0725 and spot ask is 47.0745. From the details given in Table, only
the last digits in the bid rate gets replaced to arrive the ask rate. Quotations given below are known as
“outright” quotations i.e, quotations expressed in full form.
Outright Calculation
The cash/swap rates are either added or subtracted from the spot rates to get the forward rates in
“outright” form. Now the question is when these points are to be added and when to be subtracted?
There is a thumb rule to decide when points are added or deleted.
If “Bid in points” > “Ask in points” Points are subtracted from the spot
If “Bid in points” < “ask in points” Points are added to the spot
The above thumb rule, is also know as “High-Low” or “Low-High” rule.
High-Low Rule: If the bid points are higher (than the ask points), the spot rate has to be made lower
(by subtracting bid-ask points from spot bid-ask rates) to find the forward rate.
Low-High Rule: If the bid points are lower (than the ask points), the spot rate has to be made high ( by
adding bid-ask points to spot bid-ask rates) to arrive at the forward bidask rates.
Transaction Bid Rate Ask Rate
Spot 47.0725 47.0745

1 week 47.0750 47.0775

2 weeks 47.0795 47.0835
1 month 47.0840 47.0890
2 months 47.0900 47.0965

Above table shows the outright rates calculated based on low- high rule.
Transaction Bid Rate (points) Ask Rate (points)
Spot 47.0725 47.0745

1 week 35 30
2 weeks 40 33
1 month 60 45
2 months 75 55

As the “bid in points” > “ask in points”, these points are subtracted from the spot rate to arrive at the
forward rates. When these points are subtracted, the outright quotations will be same as the details given
in Table. The outright quotations will be

Transaction Bid Rate Ask Rate

Spot 47.0725 47.0745

1 week 47.0690 47.0710

 2 weeks 47.0685 47.0712
1 month 47.0665 47.0700
2 months 47.0650 47.0690

Forex dealers normally quote rates in outright form to retail customers and in point form for other kinds
of customers. In fact, forex dealers may either be quoting bid rate or ask rate as a retail trader may be
interested either buy or sell foreign currency but not both at a given point of time.
1 Can $ = 0.8592 US $.
• 1 Euro = 1.3958 US$.
• From these two rates, the cross rate for Can $/Euro can be calculated.
Implied Cross Rates
1 Euro = 1.3958 US$
1US $= 1/.8592 Can$= 1.16387 Can $= 1.6245Can$.
Can$1.6245/Euro is known as the implied cross rate.

Arbitrage
Suppose there is a significant difference between the implied cross rate and the actual rate. This will
lead to arbitrage profit. Let us take a numerical example, to understand how triangular arbitrage
happens. Three different banks are quoting spot rates for three currency pairs given below.
Bank of Japan quotes : St = 100 JPY/USD
Bank of America quotes: St = 1.60 USD/GBP
Bank of England quotes St = 140 JPY/GBP
If we consider the first two quotes, then JPY/GBP quote should be at 160 JPY/GBP. However bank of
England quotes 140 JPY/GBP. It indicates that Bank of England is undervaluing GBP.
The triangular arbitrage happens:
• Borrow 100 USD
• Convert it to 10000 JPY at Bank of Japan.
• Convert 10,000 JPY to GBP at Bank of England. Receive 71.428 GBP.
• Convert 71.428 GBP to USD at Bank of America. Receive 114.285 USD.
• Profit of 14.285 USD before adjusting for USD borrowing cost.

Bid/Ask rates offered by three banks

Transaction Bid Rate Ask Rate
Bank A (GBP/USD) 1.60 1.61

Bank B (MYR/USD) 0.2 0.202

Bank C (GBP/MYR) 8.10 8.20
The triangular arbitrage happens in three steps:
• Sell USD 1.61 and Receive 1 GBP at Bank A ask rate
• Sell 1 GBP and Receive 8.10 MYR at Bank C bid rate
• Sell 8.10 MYR and receive $ 1.62 at Bank B bid rate.
Interest rate arbitrage
Forex traders regular make arbitrage profit though interest rate differential in two countries. This is
known as “interest rate arbitrage”.
Example: Spot rate £1 = €1.6140. Interest rate for coming 12 months is 5.5% for Pound Sterling and
3.75% for Euro. Suppose a bank quotes a 3 month forward rate as £1 = €1.5970. Now let us see whether
there exist an arbitrage opportunity or not. For example, a trader borrows £100,000 for 3 months. He
has to pay £101,375 after 3- months. He converts £100,000 to € at the spot rate. He receives €161400.
Invests €161400 at 3.75% interest rate for 3 months. He earns € 162913. He converts euro proceeding
to Pound sterling at the 3 month forward rate of £1 = €1.5970. He earns £102,012. He returns
£101,375and makes a arbitrage profit of £636. This profit opportunity will entice many traders to
borrow Pound Sterling, sell Pound sterling to buy Euro, invest in Euro and sell Euro forward to buy
Pound Sterling. This will ensure that the arbitrage opportunity vanishes quickly. In fact, with spot bid
£1 = €1.6140, interest rate for coming 12 months is 5.5% for Pound Sterling and 3.75% for Euro, the
3month forward rate should have been £1 = €1.6070 and not £1 = €1.5970.
Illustrations
1. Calculate Outright rates/ Forward rates from the given information

Cuurency Pair Spot 1 Month 3 Month 6 Month

FFR/USD 5.2321/2345 24/21 40/35 20/28

Solution
Maturity Bid Price Ask Price
Spot Rate FFR 5.2321/USD FFR 5.2340/ USD
1 Month FFR 5.2297/USD FFR 5.2324/USD
3 Month FFR 5.2281/USD FFR 4.2310/USD
6 Month FFR 5.2341/USD FFR5.2373/USD

In the case of 1 month and 3 month contract USD is at discount. So points are substracted from spot
rate to get outright rate. In case of 6 month contract, USD is at premium. So points are added to get
outright rates.

2. Convert the following rates into outright rates

 Currency Pair Spot 1 Month 3 Month 6 Month
RS/POUND 35.6800/25 30/35 35/45 40/50
RS/DOLLAR 55.2000/45 50/40 60/45 65/52

Solution:
Maturity Bid Price Ask Price
(RS/POUND)
Spot Rate 35.6800 35.6825
1 Month 35.6830 35.6860
3 Month 35.6835 35.6870
6 Month 35.6840 35.6875
.
In case of 1,3 and 6 month contract, RS is at premium. So points are added to get outright rates.

Maturity Bid Price Ask Price

(RS/POUND)
Spot Rate 55.2000 55.2045
1 Month 55.1950 55.2005
3 Month 55.1940 55.2000
6 Month 55.1935 55.1993

In case of 1,3 and 6 month contract, RS is at discount. So points are substracted to get outright rates.
3. Given the following data.
Exchange rate : Rs35.0000 per US $ (Spot)
Rs 35.9010 per US $ (6 month forward)
6 month interest rate
RS 12%
$ 7%
Work out the arbitrage gain?
USD is quoting at premium in foraward contract.
So Premium= (35.9010- Rs35.0000) / 35.9000 *(12/6) *100 = 5.02%
Interest rate differential=12-7=5%
If the interest rate differential is greater than premium or discount , Place the money in the currency
has higher rate of interest(RS money market). If the interest rate differential is smaller than premium
or discount , Place the money in the currency has lower rate of interest(US Dollar money market). So
place money in US dollars.
Steps
1. Borrow 1000 RS at 12% for 6 months.
2. Convert this sum to obtain the spot rate (1000/35.0000) = USD 28.5714.
3.Place the dollars at 7% interest for 6 months to receive (28.5714.*(7*6/12*1/100+1)= 29.5713 Dollar
4. Sell USD at 6 month forward rate at 35.9010 (29.5713*35.9010)= 1061.63 rs
5. Refund the rupee debt (1000*1+12*6/12*1/100)= 1060 rs
6. Profit= 1061.63- 1060= 1.63 rs
4. Identify the arbitrage opportunity
Trader A (Paris)- FFR 5.5012/USD
Trader B(New York) – USD 0.1817/FFR
Sol: A combosite buys 10000 USD from from trader A by paying FFR 55012. Then he sells these USD
to trader B and recives FFR 55036 (1/.1817= 5.5036 FFR).In this process, he gain FFR 24 (55036-
55012).

5. Identify the Triangular Arbitrage

Trader A
$ 0.60-SF
$ 0.51- DM
Trader B
$ 0.60-SF
$ 0.52- DM
Sol: Since three currencies are involved in this, we find cross rates between SF and DM. SF 0.85/DM
(.51/.60) at the trader A and SF .867/DM (.52/.60) at the trader B.So the situation is given below.
Trader A
$ 0.60-SF
$ 0.51- DM
SF 0.85/DM
Trader B
$ 0.60-SF
$ 0.52- DM
SF .867/DM
*DM against USD is quoted at Trader B. So buy DM from trader A and sell them to trader B.
*A similar possibility of arbitrage gain exists between SF and DM. Buy DM against SF from Trader A
and sell them to trader B.
6. Are there any arbitrage opportunity available from the data given below
RS 55.500= £1 in London
RS 35.625= $ 1 in Delhi
$1.5820= £1 in New York.
Sol: Triangular currency arbitrage opportunity is available
i. Use 1000 $ to buy rupees in Delhi. Arbitrager will get 35625.
ii. Sell Rs 35625 in London to get £ 641.89(35625/55.5)
iii. Sell £ 641.89 in New York to get $1015.47(641.89*1.5820)
iv. net profit is $15.47 (1015.47-1000)

7.Arbitrage in Forward Market

Arbitrage operates on the differential of interest rate and the premium or discount on the exchange rates.
The rule is that if the interest rate differential is greater than premium or discount , Place the money in
the currency has higher rate of interest.

Exchange rate : Can$ 1.317 per US $ (Spot)

Can $ 1.2950 per US $ (6 month forward)
6 month interest rate
US $ 10%
CAN$ 6%
Work out the arbitrage gain?
Here US$ is at discount on 6 month forward contract. The rate of annualized discount is
Discount=(forward rate-spot rate)/spot rate}*12/n*100
{(1.2950-1.317)/1.317}*12/6*100= 3.34%
Differential in interest rate= 10-6=4%
if the interest rate differential is greater than premium or discount , Place the money in the currency
has higher rate of interest(US Dollar money market)

Following steps are involved

1. Borrow CAN$ 1000 at 6% pa for 6 months.
2. Transform thi sum into USD at spot rate to obtain USD 759.3(1000/1.317)
3. Place these USD at 10% for 6 months in the money market to obtain USD 797.23
( 759.3*(1+.01*6/12)
4.Sell USD 797.23in the forward market to yield at the end of 6 months Canadian $1032.4
(797.23*1.295)
5. At the end of 6 months, refund the debt taken in Canadian dollars plus interest
(1000*(1+.06*6/12)=1030can $. Net gain= 1032.4 can$- 1030 can$= 2.4 can$