Financial Market

Assignment # 3

Submitted to: Prof. Tariq Zia

Submitted by:

Sibgha Butt (01), Zaha Mehboob (06),

Nimra Shahid (08), Atika Maqbool(31)

M.Com -7B

04-06-2018
 Effect of foreign exchange on Pakistan Economy

 Foreign exchange:
Foreign exchange is the exchange of one currency for another or the conversion
of one currency into another currency. Foreign exchange also refers to the global market
where currencies are traded virtually around the clock.

 Foreign exchange market:

The foreign exchange market is a global online network where traders buy and
sell currencies. It has no physical location and operates 24 hours a day, seven days a week. It
sets the exchange rates for currencies with floating rates.
This global market has two tiers. The first is the Interbank Market. It's where the biggest
banks exchange currencies with each other. Even though it only has a few members, the
trades are enormous.
As a result, it dictates currency values.
The second tier is the over-the-counter market. That's where companies and individuals
trade. The OTC has become very popular since there are now many companies that offer
online trading platforms.

 Characteristics of foreign exchange market:

The foreign exchange market is unique because of the following characteristics:

 Its huge trading volume, representing the largest asset class in the world leading to
high liquidity
 Its geographical dispersion
 Its continuous operation the variety of factors that affect exchange rates
 The low margins of relative profit compared with other markets of fixed income
 The use of leverage to enhance profit and loss margins and with respect to account
size
 Types of foreign exchange market

Spot Market:
A spot market is the immediate delivery market, representing that segment of the foreign
exchange market wherein the transactions (sale and purchase) of currency are settled within
two days of the deal. That is, when the seller and buyer close their deal for currency within
two days of the deal, is called as Spot Transaction.
Thus, a spot market constitutes the spot sale and purchase of foreign exchange. The rate at
which the transaction is settled is called a Spot Exchange Rate. It is the prevailing exchange
rate in the market.

Forward Market:
The forward exchange market refers to the transactions – sale and purchase of foreign
exchange at some specified date in the future, usually after 90 days of the deal. That is, when
the buyer and seller enter into a contract for the sale and purchase of foreign currency after
90 days of the deal at a fixed exchange rate agreed upon now, is called a Forward
Transaction.
Thus, the forward market constitutes the forward transactions in foreign exchange. The
exchange rate at which the buyers or sellers settle the transactions in the forward market is
called a Forward Exchange Rate.

Thus, the spot and forward markets are the important kinds of foreign exchange market that
often helps in stabilizing the foreign exchange rate.
 Effect of foreign exchange
A currency’s level has a direct impact on the following aspects of the economy:

 Merchandise trade:
This refers to a nation’s international trade, or its exports and imports. In general terms, a weaker
currency will stimulate exports and make imports more expensive, thereby decreasing a nation’s trade
deficit (or increasing surplus) over time.

 Economic growth:
The basic formula for an economy’s GDP is C + I + G + (X – M) where:

C = Consumption or consumer spending, the biggest component of an economy

I = Capital investment by businesses and households

G = Government spending

(X – M) = Exports minus imports, or net exports

From this equation, it is clear that the higher the value of net exports, the higher a nation’s GDP. As
discussed earlier, net exports have an inverse correlation with the strength of the domestic currency.

 Capital Flows:
Foreign capital will tend to flow into countries that have strong governments, dynamic economies
and stable currencies. A nation needs to have a relatively stable currency to attract investment capital
from foreign investors. Otherwise, the prospect of exchange losses inflicted by currency depreciation
may deter overseas investors.

Capital flows can be classified into two main types – foreign direct investment (FDI), in which
foreign investors take stakes in existing companies or build new facilities overseas; and foreign
portfolio investment, where foreign investors buy, sell and trade overseas securities. FDI is a critical
source of funding for growing economies such as China and India.

 Inflation:
A devalued currency can result in “imported” inflation for countries that are substantial importers.
A sudden decline of 20% in the domestic currency may result in imported products costing 25% more
since, a 20% decline means a 25% increase to get back to the original price point.