THE FOREIGN EXCHANGE

Meaning
FE rate refers to the rate at which the currency of one country is bought and sold in terms of another country. Foreign currencies are bought and sold in the foreign exchange market .the price of one currency in terms of another is called the exchange rate. Foreign exchange includes 1) all those institutions which foreign payments 2) all those methods and mechanisms which are made use of for making international payments 3) the rate at which the currency one country is converted into the currency of another country.

Foreign exchange market

Central Bank

Commercial Bank

Exporters ,importers ,tourists ,investors and immigrants

 The foreign exchange market refers to the buyers and sellers involved in sale and purchase of foreign currencies . FE market is thus the market in which currencies of different countries are bought and sold. This market is constituted of the central bank , brokers ,commercial banks , exporters and importers ,investors ,tourists and immigrants.

 Exporters and importers ,investors ,tourists and immigrants- they are the actual users of the FE. Those who need foreign currency approach commercial banks to buy the currency. Commercial banks make the 2nd and most important organ of the foreign exchange market. They buy foreign currency from the brokers and sells to the buyers. Foreign exchange Brokers make the 3rd layer of the market. Brokers as a link between the central bank and the commercial banks . They themselves do not buy or sell the foreign currency they only strike the deal between the buyers and sellers on a commission basis. Central Banks of different countries are the apex body in the organsiation of the foreign exchange market. They work as the custodians of the foreign exchange of the country. They have the power to control and regulate the foreign exchange market .

Functions of Foreign exchange Market

Transfers funds form one country to another where they needed in the settlement of payments. It provides short term credit to the importers and thereby , facilitates the smooth flow of goods and services from one country The spot and forward markets work in such a way it helps often in stabilizing the foreign exchange rate.

 The FE market is classified on the basis of the nature of transactions in 2 categories Spot market Forward market Spot Market the spot market refers to that segment of foreign exchange market in which sale and purchase transactions are settled within 2 days of the deal Forward Market refers to FE deals for sale and purchase of foreign currency at some future date normally after 90 days of the deal.

Determination of Foreign exchange rate

The exchange rate is the price of one currency in terms of another or the rate of exchange is the rate at which one currency is exchanged for another. Since rate of exchange is a price it is determined by the market forces ( demand and supply ). The demand for foreign currency arises from those traders who have to make payments for imported goods to the foreign exporters. The supply of foreign exchange comes from those people who have exported their goods and services to foreign countries or who have imported capital from abroad. The price or exchange rate is determined by the demand for and supply of that currency.

D D E x c h a n g e r a t e S

P 48
P 45

D2
S D1 10 13

Dollars demanded

 The demand curve for FE is derived from the demand for goods and services. There is an inverse relationship between exchange rate and demand for foreign exchange as shown by the DD1. Infact a lower exchange rate implies lower prices of foreign goods and services and vice versa. The lower the exchange rate ,the higher the demand for foreign goods and greater the demand for foreign exchange. Supply of FE is the usual supply curve sloping upward to the right as shown by SS.

 Let us suppose a 2 country ( india and USA) and 2 currency ( rupee and dollar) model. The demand and supply curve intersect at point P where demand and supply of dollars are equal. At this point exchange arte is determined at $1=Rs.45,the demand for and supply of dollars being equal at $ 10 million. This exchange rate clears the foreign exchange market. It is therefore an equilibrium rate of exchange. In case India's demand for dollar increase given the exchange arte demand curve will shift upwards to DD2, other things remaining constant. The exchange rate will then rise to $1= 48. this implies depreciation of rupees and appreciation of dollar.