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FOREIGN EXCHANGE Meaning, Problems and Importance

In todays world economy, the existence of separate monetary unites under different monetary system poses a great problem, in the settlement of international transactions. Each party will like to get the payments in the currency of his own country. This complex situation makes the conversion of different world currencies compulsory. Foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another. International trade and money and capital movements resulting from financial transactions are the basis of foreign dealings. Clearly the day that sees the arrival of a single world currency will also witness the disappearance of foreign exchange business.


The term Foreign Exchange is used in three different senses:

In the sense of foreign currency or foreign bills Some economists use the term Foreign Exchange in a narrow sense. According to them, foreign exchange refers to sale and purchases of foreign currencies like US $(dollar) British Pound or Sterling and Japanese Yen. exchange refers the rate of exchange or the rate at which the currency of one country is converted into the currency of another country. In other words, the external value of domestic currency is the rate of exchange.

ii. In the sense of Rate of Exchange According to this sense, foreign

iii. In the sense of an Entire System of International Money Changing

According to this wider sense, the term Foreign Exchange refers to that entire operational system by which the countries clear off their international obligations. It is a science and art of international money changing. It includes: a. All those institutions which facilitate international payments. b. All methods and instruments used for making international payment.

c. The rate at which the currency of one country is converted into the currency of another country. In order to explain the term foreign exchange in more elaborate manner, we take the help of some definitions given by well-known economists and others. DEFINITIONS S.E.Thomas, Foreign Exchange is that branch of science of economics in which we seek to determine the principles on which the peoples of the world settle their debts one to the other. Hartley Withers, Foreign Exchange is a mechanism by which international indebtedness is settled between one country and another. It is an art and science of international money changing. Encyclopaedia Britannica. The Foreign Exchange is a system by which commercial nations discharge their debts to each other. Paul Einzig, Foreign Exchange (in singular) as a system or process of converting one national currency into another and transferring money from one country to another. Foreign Exchanges (in plural) as the mean of payment in which currencies are converted, international transfers are made, also the activity of transacting business in such means. FERA/ FEMA defines the term Foreign Exchange means foreign currency and includes1. All deposits, credits and balances payable in any foreign currency and any drafts, traveler cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency. 2. Any instrument payable at the option of the drawer or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other. Thus, foreign exchange includes foreign currencies, balances kept abroad and instruments payable in foreign currency with the help of which countries of the world clear off their international obligations.


In world economy, we know that every country has its own monetary system and separate monetary unit. For making international payment, the currency of one country has to be converted into the currency of another country. The problem of foreign exchange was not so complicated under the gold standard as it is today under the managed and regulated paper currency standard. The reason was that under gold standard, the payments were executed in terms of gold but it is not possible under present system. Due to this problem and in order to make international payment, the study of foreign exchange has become highly significant.
1. Existence of Different Currencies With Different Values In

todays world economy, each country is having its own monetary system and monetary units and all the currencies of the world have different values. No currency has been accepted as an international currency for making international payments.
2. Disequilibrium in Demand and Supply of Currencies All the

currencies of the world are not equally demanded. They have imbalances in their demand and supply. Some currencies have more demand in comparison to the supply and vice versa. Some currencies having more demand in international market are called Hard or Dear currency while the currencies having more supply in comparison to their demand are called Soft Currencies. This situation also presents grave problem.
3. Lack of Stability in Exchange rates The foreign exchange rates

also fluctuates frequently due to several reasons. Due to lack of stability in their rates also there are many problems.
4. Problem of the methods of International Payments- There are

several methods which are being used in making international payments. There is no generally accepted means and there are several problems in accepting payments in soft currency. Due to these problems, the international payments become more complicated.
5. Problem of Transfer of Payments- There are several problems in

transferring payments because of so many hurdles and barriers imposed nu the countries under exchange control.
6. Problems of Determination of Rate of Exchange- How to

determine the rate of exchange for one countrys currency with the

other currency of another country? There is no unanimity on this problem.

7. Problems of Restrictions imposed by Countries- Many measures

of control restrictions are being imposed by almost all the countries of the world and create several types of problems. IMPORTANCE OF FOREIGN EXCHANGES In todays world economy, despite several problems of foreign exchange the volume of international economic and monetary transactions has tremendously increased and all countries of the world have been so integrated with each other that not a single country of the world could claim to be a self reliant economy. Its increasing importance can be explained as under:
1. For solving the Problems- For solving problems of foreign exchange

enumerated above, the study of foreign had become vitally important.

2. Vital Role in International Trade- The foreign exchange plays a

vital role in making international trade possible. Through the help of foreign exchange, a country can import essential goods, raw materials, machinery and other capital goods etc and export its surplus goods and earn foreign exchange.
3. Trade in Services With the help of foreign exchange, a country

could render services in different fields like travels, transportation, communication, banking insurance and other can get services from other parts of the world.
4. Transfer of Technology- Foreign exchange also facilitates easy

transfer of technology from one country to another.

5. Global Capital Movement- Capital is flowing throughout the world

and it is due to foreign exchange.

6. International Remittance and Payments- from various parties like

businessmen, tourists, NRIs and others huge amount is remitted and all these transactions have become possible with the help of foreign exchange.
7. It Facilitates Convertibility of All Currencies- Convertibility of

currencies of the world has become easier under foreign exchange.

8. Development of a Separate Branch in Economics Science- Due

to increasing importance, the foreign exchange has been developed as a distinct and important branch of economics science which deals in settling international obligations.
9. To Know the Complex Mechanism of International Payment- The

foreign exchange has become more essential in the present complex and complicates system of international payment. So, in order to study that mechanism it has gained much significance.
10. Developed as a Powerful Market- Foreign exchange market has

become the most powerful market among all international markets. The average daily foreign exchange dealings have exceeded $1 trillion which is very high in comparison to the volume of transactions in other international financial markets like security and capital market, Gold and Bullion markets. The growth of foreign exchange market had outpaced the output of goods and services in the world.


Foreign Exchange Rate refers to the rate at which the currency of one country can be converted into the currency of another country. The rate of exchange, this, indicated the exchange ratio between the currencies of two countries, for example, if one US $ Dollar is equal to forty Indian Rupees. What this implies that one US $ can fetch forty rupees in the exchange market. Dealings in foreign exchange markets are carried out at specified rate or price of a unit of one currency in terms of another currency. It could be regarded as an external value of domestic currency in terms of other foreign currencies. Simply the rate is parity between two currencies. The rate at which one currency buys exchanges for another currency is known as foreign exchange rate. The rate of exchange is expressed in foreign exchange market in two ways:

1. Expressing the rate in terms of domestic currency. By taking the one unit of foreign currency we take the value of domestic currency. For example, one US dollar is equal to forty Indian rupees. This is also called as direct rate. Direct method: US $ 1 = Rs. 40.00 2. Expressing the rate of exchange in terms of foreign currency or indirect rate method In this method, the home currency unit is kept constant and foreign currency unit is varied. The rate is stated to be quoted in the indirect method. Indirect method: Rs. 100 = US $ 2.50 DEFINITIONS Some important definitions given by prominent economists are given as under: Crowther- It (rate of exchange) measures the number of unites of one currency which exchanges in foreign exchange market for one unit of another. Haynes- Exchange rate is the price of currency stated in terms of another currency. R.S. Sayers-The prices of currencies in terms of each other are called foreign exchange rates. S.E. Thomas- The price of one currency unit in terms of another currency at any particular time is called the rate of exchange between two currencies. P.T. Ellsworth-An exchange rate is frequency defined as the price in domestic currency of a unit of foreign currency. It might equally well be defined as the price in a foreign currency of a unit of domestic currency. Norman Crump-The rate of exchange between two currencies is the amount of one currency which in foreign exchange market will exchange for given amount of the other. In a nutshell, foreign exchange trade can be defined as an exchange ratio of two currencies. TYPES OF FOREIGN EXCHANGE RATES

These are several types of foreign exchange rates. The important types are as follows:
1. Normal Rate and Actual Rate- Normal or true rate or par of

exchange rate is determined by forces that are of different nature from those influencing the actual rate. Normal rate may be fixed through exchange control while the actual rate or the current rate or market rate is determined by the market forced of demand and supply of foreign exchange. This actual rate fluctuate from day to day due to changes in demand and supply but these changes take place around the rate which is called normal rate. The actual rate may be above or below the normal rate. For example, if the normal rate of Re and $ is 40:1 the actual rate may be 42:1 or 38:1.
2. Spot Rate and Forward Rate- The spot rate refers to that rate of

exchange at which the delivery of foreign exchange is made to the buyer by the seller at the spot or delivery of currency bought or sold, is immediate. Forward rates at those quoted for forward or future delivery of currency, the rate of exchange is fixed at the time of deal but actual delivery is effected at contacted future date at this rate. The forward rate is quoted either at a premium or at a discount over the spot rate. This rate is calculated by making an allowance of premium or discount or in other words, forward margin is adjusted.

Single Rate and Multiple Rates- In general circumstances, there is only one single rate for all purposes. But in certain special circumstances, a country may adopt more than one, two, or three rates with another currency. This is known as the Multiple Exchange Rate system. For example, the government of a country adopts one rate for export and another for imports. the quotation in the foreign exchange market, the rate could be direct and indirect. Under direct rate, the foreign currency unit is kept constant and the home currency is varied, the rate is said to be quoted in direct method. While in indirect method of quotation, the home currency unit is kept constant and foreign currency unit id varied, the rate is called indirect for example: Direct Rate US $ 1 + Rs. 40 / Indirect Rate Rs. 100 = $2.50

4. Direct Rate and Indirect Rate- From the point of view of expressing

5. Buying Rate and Selling Rate-As the foreign market is very

lucrative and competitive market, the parties engaged in this business, naturally and to earn maximum profit. The dealers will quote the rates of foreign currencies in two ways. They will give low rate when they will buy foreign currencies in two ways. They will give low rate when they will buy foreign currency and change high rates in case of sale of foreign exchange. These buying and selling rates are quoted on the basis of T.T., M.T. or bills.
6. Favorable Rate and Unfavorable Rate- The rate of exchange can

either be favorable or unfavorable to a country. If the external value of the domestic currency increases in terms of the foreign currency, there will be favorable rate and vice-versa.
7. Official and Unofficial Exchange Rates- When the International

trade and other transactions are carried on the basis of pre-determined and authorized rates, these rates are called official rates and if the transactions are executed on the basis of other rates, they are called unauthorized and unofficial rates. These rates are also termed as Black Market rates.
8. Fixed and Flexible Exchange Rates: The fixed rates of exchange

refer to maintenance of external value of the currency at a predetermined level that is fixed by the country. Whenever the rate differs from this level, it is corrected through official intervention. After the collapse of gold standard, IMP was instituted under article IV of IMP fixed exchange rates system was adopted and member countries adopted this system and agreed not to change these rates except in consultation with the fund. This system was abolished in 1978 with the amendment in the article of IMF, still the fixed rates continue in many countries in the form of pegging their currencies to a major currency. The world economy now has been living in an era of flexible or floating exchange rates. Currencies outside their home countries have lost the character of money and have become more like commodities. The flexible free or floating rates refer to the system where the exchange rates are determined by the conditions of market forces viz the demand and supply of foreign exchange in the market. The rates are free to fluctuate according to the changes in demand and supply forces with no restrictions on buying and selling of foreign currencies in the exchange market.