What is Foreign Exchange Market?

The foreign exchange market is the marketplace in which participants are able to sell, purchase, exchange and
theorize on currencies. Foreign exchange markets are made up of investment management firms, banks, central
banks, hedge funds, commercial companies and investors and retail FOREX brokers.
The major participants in the foreign exchange market are commercial banks, FOREX brokers and other
legitimized dealers and monetary authorities. It is important to note that although participants themselves may
have their own trading centers, the market itself is worldwide. There is a close and continuous contact between
the trading centers and the participants deal in more than one market.
Demand for Foreign Exchange
People demand foreign exchange because, they want to buy commodities and services from other nations; they
want to send presents abroad and they want to buy financial assets of a particular nation.
Supply of Foreign Exchange
Foreign currency flows into the host nation due to the following reasons:
 Exports by a nation lead to the buy its domestic commodities and services by the foreigners send
presents or make transfers
 The assets of a host nation are bought by the foreigners
What is Foreign Exchange Rate?
Forex rate or foreign exchange rate is the cost price of one currency in terms of another currency. The
currencies from the other nations are linked and associated which enables the comparison of international costs
and prices.
Foreign Exchange Market: Meaning, Functions and Kinds
Meaning:
Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and sellers
include individuals, firms, foreign exchange brokers, commercial banks and the central bank.
Like any other market, foreign exchange market is a system, not a place. The transactions in this market are not
confined to only one or few foreign currencies. In fact, there are a large number of foreign currencies which are
traded, converted and exchanged in the foreign exchange market.
Functions of Foreign Exchange Market:
Foreign exchange market performs the following three functions:
1. 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.
2. 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.
3. 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 (ii) Forward Market

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
(b) risk of loss due to adverse changes in the exchange rate (through hedging);
(b) To make profit (through speculation).

Foreign Exchange Rate Determination in India and Types of Exchange Rate

Foreign Exchange Rate Determination: Foreign Exchange Rate is the amount of domestic currency that must
be paid in order to get a unit of foreign currency. According to Purchasing Power Parity theory, the foreign
exchange rate is determined by the relative purchasing powers of the two currencies.
Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in India, then the exchange rate between
India and the USA will be (100/20=5), 1 $ = 5 Re.
Forces Behind Exchange Rate Determination
Foreign Exchange is a price of one country currency in relation to other country currency, which like the price
of any other commodity is determined by the demand and supply factors. The demand and supply of the foreign
exchange rate come from the residents of the respective countries.
Demand for Foreign Exchange (Foreign Money goes out) Supply of Foreign Exchange (Foreign Money Comes in)

Foreign Currency is needed to carry out transactions in The source of foreign currency available to the
foreign countries or for the purchase of foreign goods domestic country are foreigners purchasing our goods
and services (IMPORTS). and services (Exports).
Foreign currency is needed to invest in foreign country Foreigners investing in Indian Stock markets, Assets,
assets/shares/bonds etc. Bonds etc. (FPIs and FDIs)
Foreign currency is needed to make transfer payments.
Transfer payments. Example: Indian working in the
Example: Indian Parents sending Money to his/her
USA, sending money to his/her old aged parents.
son/daughter studying in the USA.
Indians holding money in overseas Banks Foreigners holding assets in Indian Banks.

Indians Travelling abroad for Tourism Purpose. Foreigners travelling to India.

 The DD curve represents the demand for foreign exchange by India. The SS curve represents the supply of
foreign exchange to India.
 The point where both DD and SS curves intersect is the point of equilibrium. At this point demand for foreign
exchange is exactly equal to the supply of foreign exchange.
 At equilibrium point E0, the exchange rate is 1 $ equal to 5 Re.
 In normal day to day functioning of markets, the exchange rate may fluctuate. If at any point in time, the
exchange rate is at E1, then the demand for foreign exchange falls short of supply of foreign exchange, as a
result at this point Indians are demanding less foreign currency due to which Re will appreciate vis-à-vis foreign
currency. The appreciation mainly occurs due to a favourable balance of payment situation (Surplus).
 By the same token at point E2, demand for foreign exchange is greater than the supply of foreign exchange, at
this point Indians are demanding excess foreign exchange than what the foreigners are willing to supply, as a
result, at E2 Re will depreciate vis-à-vis foreign currency. The depreciation mainly occurs due to the
unfavourable balance of payments situation (Deficits).
Types of Exchange Rate Regimes
 Fixed Exchange Rate versus Floating Exchange Rate
Fixed Exchange Rate Floating Exchange Rate
Under this system, there is complete government Under this system, the market is allowed to determine
intervention in the foreign exchange markets. the value of exchange rate freely.
The government or central bank determines the
The exchange rate is determined by the forces of
official exchange rate by linking exchange rate to the
demand and supply.
price of gold or major currencies like US dollar.
If due to any reason, the exchange rate fluctuates, If due to any reason exchange rate fluctuates, the
government intervenes and make sure that government never intervenes and allows the market to
equilibrium pre-determined level is maintained. function and determine the true value of exchange rate.

The only merit of fixed exchange rate system is that

it assures the stability of exchange rate. It prevents
both currency appreciation and depreciation.
The many disadvantages of such a system are: It puts
a heavy burden on governments to maintain
exchange rate. This especially happens during the
time of deficits, as the governments need to infuse a
lot of money to maintain exchange rate.
The foreign investors avoid investing in such
countries as they fear to lose their investments
because they believe that exchange rate does not
reflect the true value of the economy.
The only demerit of floating exchange rate system is
that exchange rate fluctuates a lot on day to day basis.
The advantages of such a system are: the exchange
rate is determined in well-functioning foreign
exchange markets with no government interference.
The exchange rate reflects the true value of the
domestic currency which helps in establishing the trust
among foreign investor.
A country can easily access funds/ loans from IMF and
other international institutions if the exchange rate is
market determined.

Managed Floating Exchange rate

Manage Floating exchange rate lies in between of the two extremes of fixed and floating exchange rate. Under
such a system, the exchange is allowed to move freely and determined by the forces of the market (Demand and
Supply). But when a difficult situation arises, the central banks of the country can intervene to stabilise the
exchange rate.
There are mainly three sub categories under managed floating exchange rate:
1. Adjusted Peg System: In this system, a country should try to hold on to a fixed exchange rate system for as
long as it can, i.e. until the country’s foreign exchange reserves got exhausted. Once the country’s foreign
exchange reserves got exhausted, the country should undergo devaluation of currency and move to another
equilibrium exchange rate.
2. Crawling Peg System: In this system, a country keeps on adjusting its exchange rate to new demand and
supply conditions. The system requires that instead of devaluing currency at the time of crisis, a country
should follow regular checks at the exchange rate and when require must undertake small devaluations.
3. Clean Floating: In the clean float system, the exchange rate is determined by market forces of demand and
supply. The exchange rate appreciates or depreciates as per market forces and with no government
intervention. It is identical to floating exchange rate.
4. Dirty Floating: In the dirty float system, the exchange rate is to a very large extent is determined by the
market forces of demand and supply (so far identical to clean floating), but occasionally the central banks of
the countries intervene in foreign exchange markets to smoothen or remove excessive fluctuations from the
foreign exchange markets.

Note for Students

The Bretton Woods system of exchange rate which was in operation from 1944 till 1971, was one of relative
fixed exchange rate as opposed to rigid fixed exchange rate. As a matter of fact, rigid fixed exchange rate as
defined above, is never been used in history. Even under the system of Gold Standard 1870-1941, the exchange
was relatively fixed and not rigidly fixed.

Exchange Rate Management in India

Over the last six decades since independence the exchange rate system in India has transited from fixed
exchange rate regime where the Indian Rupee was pegged to the UK Pound to a basket of currencies during the
1970s and 1980s and eventually to the present form of market determined exchange rate regime since 1993.
 Par Value System (1974-1971): After Independence Indian followed the ‘Par Value System’ whereby the
rupee’s external par value was fixed with gold and UK pound sterling. This system was followed up to
1966 when the rupee was devalued by 36 percent.
 Pegged Regime (1971-1992): India pegged its currency to the US dollar (1971-1991) and to pound (1971-
75). Following the breakdown of Breton Woods system, the value of pound collapsed, and India witnessed
misalignment of the rupee. To overcome the pressure of devaluation India pegged its currency to a basket
of currencies. During this period, the exchange rate was officially determined by the RBI within a nominal
band of +/- 5 percent of the weighted average of a basket of currencies of India’s major trading partners.
 The period since 1991: The transition to market-based exchange rate was in response to the BOP crisis of
1991. As a first step towards transition, India introduces partial convertibility of rupee in 1992-93 under
LERMS.
 Liberalised Exchange Rate Management System (LERMS): The LERMS involved partial convertibility
of rupee. Under this system, India followed a dual exchange rate policy, where 40 percent of the exchange
rate were to be converted at the official exchange rate and the remaining 60 percent were to be converted at
the market-based exchange rate. The exchange rate converted at the official rate were to be used for
essential imports like crude, oil, fertilizers, life savings drugs etc. All other imports should be financed at
the market-based exchange rate.
 Market-Based Exchange rate Regime (1993- till present): The LERMS was a transitional mechanism to
provide stability during the crisis period. Once the stability is achieved, India transited from LERMS to a
full flash market exchange rate system. As a result, since 1993, exchange rate fluctuations are marker
determined. In the 1994 budget, 60:40 ratio was removed, and 100 percent conversion at market-based rate
was allowed for all goods and capital movements.
Foreign Exchange Rate:
The rate at which currency of one country can be exchanged for currency of another country is called the Rate
of Foreign Exchange.
It is the price of a country’s currency m terms of another country’s currency. Put in another way, the rate of
foreign exchange is the amount of domestic currency that must be paid to obtain one unit of foreign currency.

For instance, if 1 American dollar can be obtained (exchanged) for 50 Indian rupees, then foreign exchange rate
is $1 = Rs 50. This (50 to J dollar) will be called foreign exchange rate between USA and India. In other words,
1 dollar can purchase 50 rupees of Indian money clearly; the rate of exchange of a currency simply expresses its
external value or its external purchasing power.
Stability in exchange rate is one of the important factors which indicate economic stability of a country
Earnings from exports and payments for imports are directly affected by the foreign exchange rate .Nominal vs.
Real Exchange Rate.
Nominal exchange rate is price of foreign currency in terms of domestic currency. Real exchange rate is the
relative price of foreign goods in terms of domestic goods. It is equal to the nominal exchange rate multiplied
by foreign price level and divided by domestic price level.
Symbolically:
Real Exchange Rate = Nominal exchange rate x Foreign price level /Domestic price level
Foreign Exchange Market:
The market in which national currencies of various countries are converted, exchanged or traded for one another
is called foreign exchange market. It is not any physical place but is a network of communication system which
connects the whole complex of institutions. It includes banks, specialised foreign exchange dealers, brokers and
official government agencies through which the currency of one country can be exchanged (converted) for that
of another country. Again, foreign exchange market is of two types—Spot market and Forward market.
Functions:
Foreign exchange market performs three main functions, namely (i) transfer function, (ii) credit function and
(iii) hedging function. Transfer function refers to transferring purchasing power between countries; credit
function refers to providing credit channels for foreign trade and hedging function pertains to protecting against
foreign exchange risks. Hedging is an activity which is designed to minimise risk of loss. When people want to
operate in the foreign exchange market, it implies that they intend to buy or sell foreign exchange depending on
their demand for or supply of foreign exchange.

For instance, when we (Indian residents) buy foreign goods, say, Japanese goods, it shows supply of rupees to
foreign exchange market to be exchanged for yen because seller of Japanese goods will expect payment in yen
only. Similarly, Indian exporters of their goods will expect to be paid in rupees for which foreigners will have to
sell their currency in the exchange market to buy rupees in return. It shows demand for rupees in foreign
exchange market. Transactions in foreign exchange market are reflected in the balance of payment account.

Four ways to determine the rate of foreign exchange are:

(a) Demand for foreign exchange (currency) (b) Supply of foreign exchange (c) Determination of exchange rate
(d) Change in Exchange Rate!
In a system of flexible exchange rate, the exchange rate of a currency (like price of a good) is freely determined
by forces of market demand and supply of foreign exchange.

Expressed graphically the Intersection of demand and the supply curves determines the equilibrium exchange
rate and equilibrium quantity of foreign currency. This is called equilibrium in foreign exchange market).
Let us assume that there are two countries—India and USA—and the exchange rate of their currencies, viz.,
rupee and dollar are to be determined. Presently there is floating or flexible exchange regime in both India and
USA. Therefore, the value of currency of each country in terms of the other currency depends upon the demand
for and supply of their currencies.
(a) Demand for foreign exchange (currency):
Demand for foreign exchange is caused (i) to purchase abroad goods and services by domestic residents, (ii) to
purchase assets abroad, (iii) to send gifts abroad, (iv) to invest directly in shops, factories abroad, (v) to
undertake foreign tours, (vi) to make payment of international trade, etc. The demand for dollars varies
inversely with rupee price of dollar, i.e., higher the price, the lower is the demand. The demand curve in Fig.
10.1 is downward sloping because there is inverse relationship between foreign exchange rate and its demand.
(b) Supply of foreign exchange:
Supply of foreign exchange conies
(i) when foreigners purchase home country’s (say, India’s) goods and services through our exports
(ii) when foreigners make direct investment in bonds and equity shares of home country
(iii) when speculation causes inflow of foreign exchange
(iv) when foreign tourists come to home country
The supply curve is upward sloping (vide Fig. 10.1) because there is direct relationship between foreign
exchange rate and its supply.
(c) Determination of exchange rate:
This is determined at a point where demand for and supply of foreign exchange are equal. Graphically,
intersection of demand and supply curves determines the equilibrium exchange rate of foreign currency. At any
particular time, the rate of foreign exchange must be such at which quantity demanded of foreign currency is
equal to quantity supplied of that currency. It is proved with the help of the following diagram. The price on the
vertical axis is stated in terms of domestic currency (i.e., how many rupees for one US dollar).
The horizontal axis measures quantity demanded or supplied of foreign exchange (i.e., dollars). In this figure,
demand curve is downward sloping which shows that less foreign exchange is demanded when exchange rate
increases (i.e., inverse relationship). The reason is that rise in the price of foreign exchange (dollar) increases
the rupee cost of foreign goods which makes them more expensive. The result is fall in imports and demand for
foreign exchange.
The supply curve is upward sloping which implies that supply of foreign exchange increases as the exchange
rate increases (i.e., direct relationship). Home country’s goods (here Indian goods) become cheaper to
foreigners because rupee is depreciating in value.
As a result, demand for Indian goods increases. Thus, our exports should increase as the exchange rate
increases. This will bring greater supply of foreign exchange. Hence, the supply of foreign exchange increases
as the exchange rate increases which proves the slope of supply curve.
In the Fig. 10.1, demand curve and supply curve of dollars intersect each other at point E which implies that at
exchange rate of OR (QE), quantity demanded and supplied are equal (both being equal to OQ). Hence,
equilibrium exchange rate is OR and equilibrium quantity is OQ.
(d) Change in Exchange Rate:
Suppose, exchange rate is 1 dollar = Rs 50. An increase in India’s demand for US dollars, supply remaining the
same, will cause the demand curve DD shift to D’D’. The resulting intersection will be at a higher exchange
rate, i.e., exchange rate (price of dollar in terms of rupees) will rise from OR to OR, (say, 1 dollar = 52 rupees).
It shows depreciation of Indian currency (rupees) because more rupees (say, 52 instead of 50) are required to
buy 1 US dollar. Thus, depreciation of currency means a fall in the price of home currency.
Likewise, an increase in supply of US dollar will cause supply curve SS shift to S’S’ and as a result exchange
rate will fall from OR to OR2. It indicates appreciation of Indian currency (rupees) because cost of US dollar in
terms of rupees has now fallen, say, 1 dollar = Rs 48, i.e., less rupees are required to buy 1 US dollar or now Rs
48 instead of Rs 50 can buy 1 dollar. Thus, appreciation of currency means ‘a rise in the price of home
currency’.

Foreign Exchange Rate: Meaning and Exchange Rate Determination

1. Meaning:
If a Kashmiri shawlmaker sells his goods to a buyer in Kanyakumari, he will receive in terms of Indian rupee.
This suggests that domestic trade is conducted in terms of domestic currency. But if the Indian shawl- maker
decides to go abroad, he must exchange Indian rupee into franc or dollar or pound or euro.
To facilitate this exchange form, banking institutions appear. Indian shawlmaker will then go to a bank for
foreign currencies. The bank will then quote the day’s exchange rate—the rate at which Indian rupee will be
exchanged for foreign currencies. Thus, foreign currencies are required in the conduct of international trade.
In a foreign exchange market comprising commercial banks, foreign exchange brokers and authorised dealers
and the monetary authority (i.e., the RBI), one currency is converted into another currency.
A (foreign) exchange rate is the rate at which one currency is exchanged for another. Thus, an exchange rate
can be regarded as the price of one currency in terms of another. An exchange rate is a ratio between two
monies. If 5 UK pounds or 5 US dollars buy Indian goods worth Rs. 400 and Rs. 250 then pound- rupee or
dollar-rupee exchange rate becomes Rs. 80 = £1 or Rs. 50 = $1, respectively. Exchange rate is usually quoted in
terms of rupees per unit of foreign currencies. Thus, an exchange rate indicates external purchasing power of
money.
A fall in the external purchasing power or external value of rupee (i.e., a fall in exchange rate, say from Rs. 80 =
£1 to Rs. 90 = £1) amounts to depreciation of the Indian rupee. Consequently, an appreciation of the Indian
rupee occurs when there occurs an increase in the exchange rate from the existing level to Rs. 78 = £1.
In other words, external value of the rupee rises. This indicates strengthening of the Indian rupee. Conversely,
the weakening of the Indian rupee occurs if external value of rupee in terms of pound falls. Remember that each
currency has a rate of exchange with every other currency.
Not all exchange rates but about 150 currencies are quoted, since no significant foreign exchange market exists
for all currencies. That is why exchange rate of these national currencies are quoted usually in terms of US
dollars and euros.
2. Exchange Rate Determination:
Now two pertinent questions that usually arise in the foreign exchange market are to be answered now. Firstly,
how is equilibrium exchange rate determined and, secondly, why exchange rate moves up and down?
There are two methods of foreign exchange rate determination. One method falls under the classical gold
standard mechanism and another method falls under the classical paper currency system. Today, gold standard
mechanism does not operate since no standard monetary unit is now exchanged for gold.
All countries now have paper currencies not convertible to gold. Under inconvertible paper currency system,
there are two methods of exchange rate determination. The first is known as the purchasing power parity theory
and the second is known as the demand-supply theory or balance of payments theory. Since today there is no
believer of purchasing power parity theory, we consider only demand-supply approach to foreign exchange rate
determination.
1. Demand-Supply Approach of Foreign Exchange, Or BOP Theory of Foreign Exchange:
Since the foreign exchange rate is a price, economists apply supply-demand conditions of price theory in the
foreign exchange market. A simple explanation is that the rate of foreign exchange equals its supply. For sim-
plicity, we assume that there are two countries: India and the USA. Let the domestic currency be rupee. US
dollar stands for foreign exchange and the value of rupee in terms of dollar (or conversely value of dollar in
terms of rupee) stands for foreign exchange rate. Now the value of one currency in terms of another currency
depends upon demand for and supply of foreign exchange.
(i) Demand for foreign exchange:
When Indian people and business firms want to make payments to the US nationals for buying US goods and
services or to make gifts to the US citizens or to buy assets there, the demand for foreign exchange (here dollar)
is generated. In other words, Indians demand or buy dollars by paying rupee in the foreign exchange market.
A country releases its foreign currency for buying imports. Thus, what appears in the debit side of the BOP
account is the sources of demand for foreign exchange. The larger the volume of imports the greater is the
demand for foreign exchange.
The demand curve for foreign exchange is negative sloping. A fall in the price of foreign exchange or a fall in
the price of dollar in terms of rupee (i.e., dollar depreciates) means that foreign goods are now more cheaper.
Thus, an Indian could buy more American goods at a low price. Consequently, imports from the USA would
increase resulting in an increase in the demand for foreign exchange, i.e., dollar. Conversely, if the price of
foreign exchange or price of dollar rises (i.e., dollar appreciates) then foreign goods will be expensive leading to
a fall in import demand and, hence, fall in the demand for foreign exchange.
Since price of foreign exchange and demand for foreign exchange move in opposite direction, the importing
country’s demand curve for foreign exchange is downward sloping from left to right.
In Fig. 5.4, DD1 is the demand curve for foreign exchange. In this figure, we measure exchange rate expressed
in terms of domestic currency that costs 1 unit of foreign currency (i.e., dollar per rupee) on the vertical axis.
This makes demand curve for foreign exchange negative sloping.
If exchange rate is expressed in terms of foreign currency that could be purchased with 1 unit of domestic
currency (i.e., dollar per rupee), the demand curve would then exhibit positive slope. Here we have chosen the
former one.
(b) Supply of foreign exchange:
In a similar fashion, we can determine supply of foreign exchange. Supply of foreign currency comes from its
receipts for its exports. If the foreign nationals and firms intend to purchase Indian goods or buy Indian assets or
give grants to the Government of India, the supply of foreign exchange is generated.
In other words, what the Indian exports (both goods and invisibles) to the rest of the world is the source of
foreign exchange. To be more specific, all the transactions that appear on the credit side of the BOP account are
the sources of supply of foreign exchange.
A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to foreigners in terms of
dollars. This will induce India to export more. Foreigners will also find that investment is now more profitable.
Thus, a high price or exchange rate ensures larger supply of foreign exchange. Conversely, a low exchange rate
causes exchange rate to fall. Thus, the supply curve of foreign exchange, SS1, is positive sloping.
Now we can bring both demand and supply curves together to determine foreign exchange rate. The equilibrium
exchange rate is determined at that point where demand for foreign exchange equals supply of foreign ex-
change. In Fig. 5.4, DD1 and SS1 curves intersect at point E. The foreign exchange rate thus determined is OP.
At this rate, quantities of foreign exchange demanded (OM) equals quantity supplied (OM). The market is
cleared and there is no incentive on the part of the players to change the rate determined.

Suppose that at the rate OP, Rs. 50 = $1, demand for foreign exchange is matched by the supply of foreign
exchange. If the current exchange rate OP1 exceeds the equilibrium rate of exchange (OP) there occurs an
excess supply of dollar by the amount ‘ab’. Now the bank and other institutions dealing with foreign
exchange—wishing to make money by exchanging currency—would lower the exchange rate to reduce excess
supply.
Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand for foreign exchange by
the amount ‘cd’ arises if the exchange rate falls below OP, i.e., OP2. Thus, banks would experience a shortage
of dollars to meet the demand. Rate of foreign exchange will rise till demand equals supply.
The exchange rate that we have determined is called a floating or flexible exchange rate. (Under this exchange
rate system, the government does not intervene in the foreign exchange market.) A floating exchange rate, by
definition, results in an equilibrium rate of exchange that will move up and down according to a change in
demand and supply forces. The process by which currencies float up and down following a change in demand
or change in supply forces is, thus, illustrated in Fig. 5.5.

Let us assume that national income rises. This results in an increase in the demand for imports of goods and
services and, hence, demand for dollar rises. This results in a shift in the demand curve from DD1 to DD2.
Consequently, exchange rate rises as from OP1 to OP2 determined by the intersection of new demand curve and
supply curve. Note that dollar appreciates from Rs. 50 = $1 to Rs. 53 = $1, while rupee depreciates from $1 =
Rs. 50 to $1 = Rs. 53.
Similarly, if supply curve shifts from SS1 to SS2, as shown in Fig. 5.6, new exchange rate thus determined
would be OP2. If Indian goods are exported more, following an increase in national income of the USA, the sup-
ply curve would then shift rightward. Consequently, dollar depreciates and rupee appreciates. New exchange
rate is settled at that point where the new supply curve (SS2) intersects the demand curve at E2.
This is the balance of payments theory of exchange rate determination. Wherever government does not
intervene in the market, a floating or a flexible exchange rate prevails. Such system may not necessarily be ideal
since frequent changes in demand and supply forces cause frequent as well as violent changes in exchange rate.
Consequently, an air of uncertainty in trade and business would prevail.
Such uncertainty may be damaging for the smooth flow of trade. To prevent this situation, government
intervenes in the foreign exchange rate. It may keep the exchange rate fixed. This exchange rate is called a fixed
exchange rate system where both demand and supply forces are manipulated or calibrated by the central bank in
such a way that the exchange rate is kept pegged at the old level.
Often managed exchange rate is suggested. Under this system, exchange rate, as usual, is determined by
demand for and supply of foreign exchange. But the central bank intervenes in the foreign exchange market
when the situation demands to stabilise or influence the rate of foreign exchange. If rupee depreciates in terms
of dollar, the RBI would then sell dollars and buy rupee in order to reduce the downward pressure in the
exchange rate.

Spot and Forward Exchange Rates and Real Exchange Rate | International Trade
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Spot and Forward Exchange Rates and Real Exchange Rate!
Transactions in the exchange market are carried out at what are termed as exchange rates.
The rate at which the currencies of two nations are exchanged for each other is called the rate of exchange. For
example, if 1 U.S. dollar is exchanged for Rs. 10 then foreign exchange rate is 1 U.S. $ = Rs. 10.
In other words, the rate of exchange is nothing but the value or price of a country’s currency expressed in terms
of a foreign currency.
In the foreign exchange market, however, at any one point of time, there hardly exists a unique rate of
exchange. Rather there is a variety of exchange rates according to the credit instruments employed for the
transfer function.
Thus, there is a T.T. or cable rate, also called the spot rate, a sight rate in the case of foreign currency bills, a
usance rate or long rate which may be one month’s rate or 3 months’ rate and also a forward exchange rate for
future contracts. There is, thus, a cluster of rates in the exchange market and not one rate between any two
currencies.
1. Spot and Forward Exchange Rates:
Broadly speaking, we may distinguish between two types of exchange rates prevailing in the foreign exchange
market viz., spot rate of exchange and forward rate of exchange. Spot rate of exchange and forward rate of
exchange in terms of domestic money payable refers to the price of foreign exchange in terms of domestic
money payable for the immediate delivery of a particular foreign currency.
It is, thus, a day-to-day rate. On the other hand, forward rate of exchange refers to the price at which a
transaction will be consummated at some specified time in the future. A forward exchange market functions
side by side with a spot exchange market.
The transactions of forward exchange market are known as forward exchange transactions, which simply
involve purchase or sale of a foreign currency for delivery at some time in the future; the rates at which these
transactions are consummated are, therefore, called forward rates.
Forward exchange rate is determined at the time of sale but the payment is not made until the exchange is
delivered by the seller. Forward rates are usually quoted on the basis of a discount or premium over or under the
spot rate of exchange.
Currency Swap:
A sport of a currency when combined with a forward repurchase — in a single transaction is called ‘currency
swap.’ The swap rate is the difference between the spot and forward exchange rates in the currency swap.
Usually, a forex market is dominated by the spot markets transactions swaps and forward transactions.
Arbitrage:
Arbitrage is the act of simultaneously buying a currency in one market and selling in another to make a profit by
taking advantage of price or exchange rate differences in the two markets. If the arbitrage operations are
confined to two markets only, they will be known as “two-point” arbitrage. If they extend to three or more
markets, they are known as “three-point” arbitrage or “multipoint” arbitrage.
2. Real Exchange Rate:
The real exchange rate is the nominal exchange rate adjusted for the relative price levels variation. It
may be measured as:
RER1 = NER1 (Pb1: O/Pa1: O)
Where,
RER = Real exchange rate (between the currencies of countries A and B).
NER = Nominal index for country B.
Pb = Price index for country A.
1 stands for current date
0 stands for base date
A higher degree of inflation rate in home country implies a lower real exchange rate and vice versa. When the
real exchange rate declines, it means a decrease in international competitiveness of the country.
Variability in inflation rates leads to changes in real exchange rates

Cross rates
Cross rates are the relation of two currencies against each other, based on the rate of each of them against a third
currency. For example, the Bank of England sells or purchases euros for yen. To calculate the cross rate of
the EURJPY, the bank will use the dollar quotes for the two pairs, EURUSD and USDJPY. As such,
the Ask and Bid quotes of EURJPY will be calculated as follows: Bid EURJPY = Bid EURUSD x Bid
USDJAPY; Ask EURJPY = Ask EURUSD x Ask USDJPY
Let’s say that if there is an upward trend on the EURCAD currency pair, this means that the price of EUR
against that of USD is growing at a faster rate than the cost of CAD against USD. It’s worth noting that cross
rates are not the primary indicators, although by using them we can quite accurately define the speed at which
quotes of key currency instruments change. It’s also worth remembering that cross rates often come under
speculative pressure due to the small volumes at which they are traded. Changes in the rates are impacted not
only by the economies of said currencies in the cross rate, but also by global fundamental news and the US
economy. Therefore only experienced traders tend to be effective when trading cross rates.
Definition of 'Arbitrage'

Definition: Arbitrage is the process of simultaneous buying and selling of an asset from different platforms,
exchanges or locations to cash in on the price difference (usually small in percentage terms). While getting into
an arbitrage trade, the quantity of the underlying asset bought and sold should be the same. Only the price
difference is captured as the net pay-off from the trade. The pay-off should be large enough to cover the costs
involved in executing the trades (i.e. transaction costs). Else, it won’t make sense for the trader to initiate the
trade in the first place.

Description: Suppose an asset, gold, is quoted at Rs 27,000 per 10 gm in the Delhi bullion market and at Rs
27,500 in the Mumbai bullion market. A trader may buy 10 gm of gold in Delhi and sell it in Mumbai, making a
profit of Rs 500 (Rs 27,500 - Rs 27,000). However, this trade will be profitable only if the cost of transactions is
less than Rs 500 per 10 gm of gold.

In the above example, assuming that the total transaction cost, of executing the trades and physical delivery of
gold, is Rs 200 for 10gm, then the net profit for the trader would reduce to Rs 300.
If the price difference between the two bullion markets reduces to Rs 200 (or less than that) per 10gm of gold,
then the arbitrage opportunity between the two markets shall cease to exist, as the transaction costs shall be
equal to, or more than, the price difference between the two markets.

In real life, arbitrage opportunities (if any) exist only for brief periods since most of the arbitrage trading has
been taken over by algorithm-based trading in matured markets. These algorithms are quick to spot and capture
arbitrage opportunity, making it easy for human traders to keep track