BUSI 303
(Liberty University)
FOREIGN EXCHANGE MARKET
The concern of foreign exchange is, in the words of H.E. Evitt, "...that
segment of monetary technology which deals with the means and
methods by which rights to wealth in one country's currency are
converted into rights to wealth in terms of another country's currency"
(Evitt 1). As he further observes, it "includes the investigation of the
method by which the currency of one country is exchanged for that of
another, the causes which render such exchange necessary, the forms
which such exchange may take, and the ratios or equivalent values at
which such exchanges are effected" (Evitt 2).
There are different interpretations of the term foreign exchange, of which
the following two are most important and common:
1. Foreign exchange is the system or process of exchanging one
national currency into another, and of transferring money from one
country to another (Einzig 1).
2. Secondly, the term foreign exchange is used to refer to foreign
currencies, as exemplified by the Foreign Exchange Regulation Act,
1973 (FERA), which defines foreign exchange as foreign currency
and includes all deposits, credits, and balances payable in any
foreign currency and any drafts, traveler's cheques, letters of credit,
and bills of exchange, expressed or drawn in Indian currency but
payable in any foreign currency.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
1. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
2. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
3. Provision of Hedging Facilities: Another essential function of the
forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
1. Telegraphic Transfer: This method allows the transfer of funds
from a bank in one country to a bank in another part of the world by
cable or telex, making it the fastest way of transmitting funds.
2. Mail Transfer: International transfers of funds can be done by mail,
similar to transferring funds from one bank account to another
within the country.
3. Cheques and Bank Drafts: International payments can be made
through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
4. Foreign Bill of Exchange: A bill of exchange is an unconditional
order in writing, requiring one person to pay a certain sum to
another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
5. Documentary (or Compensation) Credit: This method involves
an importer opening a credit in favor of the exporter, at a bank in
the exporter's country, providing assurance of payment in exchange
for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
4. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
5. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
6. Provision of Hedging Facilities: Another essential function of the
forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
6. Telegraphic Transfer: This method allows the transfer of funds
from a bank in one country to a bank in another part of the world by
cable or telex, making it the fastest way of transmitting funds.
7. Mail Transfer: International transfers of funds can be done by mail,
similar to transferring funds from one bank account to another
within the country.
8. Cheques and Bank Drafts: International payments can be made
through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
9. Foreign Bill of Exchange: A bill of exchange is an unconditional
order in writing, requiring one person to pay a certain sum to
another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
10. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
7. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
8. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
9. Provision of Hedging Facilities: Another essential function of the
forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
11. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
12. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
13. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
14. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
15. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
10. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
11. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
12. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
16. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
17. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
18. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
19. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
20. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
13. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
14. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
15. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
21. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
22. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
23. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
24. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
25. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
16. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
17. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
18. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
26. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
27. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
28. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
29. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
30. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
31. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
32. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
33. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
34. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
35. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
36. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
37. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
38. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
39. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
40. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
41. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
42. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
43. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
44. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
45. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
46. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
47. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
48. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
49. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
50. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
51. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
52. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
53. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
54. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
55. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
19. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
20. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
21. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
56. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
57. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
58. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
59. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
60. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
22. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
23. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
24. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
61. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
62. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
63. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
64. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
65. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
66. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
67. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
68. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
69. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
70. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
71. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
72. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
73. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
74. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
75. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
76. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
77. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
78. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
79. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
80. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
81. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
82. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
83. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
84. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
85. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
86. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
87. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
88. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
89. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
90. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
25. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
26. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
27. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
91. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
92. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
93. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
94. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
95. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
28. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
29. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
30. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
96. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
97. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
98. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
99. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
100. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
101. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
102. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
103. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
104. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
105. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
106. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
107. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
108. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
109. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
110. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
111. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
112. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
113. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
114. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
115. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
116. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
117. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
118. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
119. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
120. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
121. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
122. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
123. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
124. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
125. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
31. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
32. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
33. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
126. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
127. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
128. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
129. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
130. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
34. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
35. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
36. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
131. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
132. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
133. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
134. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
135. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
136. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
137. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
138. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
139. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
140. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
141. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
142. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
143. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
144. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
145. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
146. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
147. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
148. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
149. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
150. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
151. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
152. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
153. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
154. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
155. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
156. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
157. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
158. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
159. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
160. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
37. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
38. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
39. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
161. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
162. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
163. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
164. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
165. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Features of the Foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national
currencies are bought and sold against one another. The forex market
performs three crucial functions:
40. Transfer of Buying Power: The primary function of a foreign
exchange market is the transfer of buying power from one country
to another and from one currency to another. The global clearing
function performed by forex markets plays a crucial role in
facilitating international trade and capital movements.
41. Provision of Credit: The credit function performed by forex
markets also plays a vital role in the growth of foreign trade, as
international trade depends to a great extent on credit facilities.
Exporters may obtain pre-shipment and post-shipment credit, and
credit facilities are available for importers. The Euro-dollar market
has emerged as a significant global credit market.
42. Provision of Hedging Facilities: Another essential function
of the forex market is to provide hedging facilities. Hedging refers to
covering export risks, and it provides a mechanism for exporters
and importers to protect themselves against losses arising from
fluctuations in exchange rates.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
166. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
167. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
168. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
169. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
170. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Determination of Exchange Rates
How are exchange rates between different currencies determined under
the paper currency standard? There are two main theories that aim to
explain the mechanism of exchange rates. These two theories are the
Purchasing Power Parity (PPP) theory and the Interest Rate Parity
(IRP) theory.
Purchasing Power Parity (PPP)
The PPP theory posits that in the long run, exchange rates between
currencies will adjust to equalize the purchasing power of different
currencies. In other words, a unit of currency should have the same
purchasing power regardless of the country in which it is used. The basic
idea is that over time, exchange rates should move in the direction that
equalizes the prices of an identical basket of goods and services in
different countries.
There are two versions of PPP: absolute PPP and relative PPP. Absolute PPP
states that the exchange rate between two currencies should equal the
ratio of the price levels in their respective countries. Relative PPP, on the
other hand, suggests that changes in exchange rates are proportional to
changes in price levels in different countries.
Interest Rate Parity (IRP)
The Interest Rate Parity theory links interest rates, inflation rates, and
exchange rates. According to IRP, the difference in interest rates between
two countries should be equal to the expected change in the exchange
rate over the same period. In other words, investors should earn the same
return regardless of whether they invest at home or abroad when
adjusting for differences in interest rates and expected changes in
exchange rates.
The two main forms of IRP are covered interest rate parity and uncovered
interest rate parity. Covered interest rate parity implies that forward
exchange rates should reflect interest rate differentials between two
countries, accounting for the cost of hedging. Uncovered interest rate
parity suggests that the expected change in the spot exchange rate
should equal the interest rate differential, and forward rates should be
unbiased predictors of future spot rates.
Exchange Rate Determination under the Paper Currency Standard
Under the paper currency standard, exchange rates are influenced by a
variety of factors, including economic indicators, interest rates, inflation
rates, political stability, and market speculation. Central banks and
monetary authorities also play a role in influencing exchange rates
through monetary policy decisions and interventions in the foreign
exchange market.
For instance, if a country's economy is growing rapidly and its interest
rates are high, it may attract foreign capital, leading to an appreciation of
its currency. Conversely, a country with economic challenges and lower
interest rates may experience a depreciation of its currency. Political
stability and economic policies also impact investor confidence and,
consequently, exchange rates.
Market speculation can result in short-term fluctuations in exchange rates.
Traders and investors analyze economic data, geopolitical events, and
other factors to anticipate currency movements and make informed
decisions. Additionally, central banks may intervene in the foreign
exchange market to stabilize their currencies or achieve specific economic
objectives.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
171. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
172. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
173. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
174. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
175. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
176. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
177. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
178. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
179. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
180. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
181. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
182. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
183. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
184. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
185. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
186. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
187. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
188. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
189. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
190. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Techniques of Affecting International Payments
There are five crucial techniques to effect international payments:
191. Telegraphic Transfer: This method allows the transfer of
funds from a bank in one country to a bank in another part of the
world by cable or telex, making it the fastest way of transmitting
funds.
192. Mail Transfer: International transfers of funds can be done
by mail, similar to transferring funds from one bank account to
another within the country.
193. Cheques and Bank Drafts: International payments can be
made through cheques and bank drafts, with the latter being more
commonly used. A bank draft is a cheque drawn on a bank rather
than a customer's own account, providing a secure means of
payment.
194. Foreign Bill of Exchange: A bill of exchange is an
unconditional order in writing, requiring one person to pay a certain
sum to another on demand or on a specific future date. There are
significant differences between inland and foreign bills, including the
calculation of due dates and the fact that foreign bills are usually
drawn in sets of three.
195. Documentary (or Compensation) Credit: This method
involves an importer opening a credit in favor of the exporter, at a
bank in the exporter's country, providing assurance of payment in
exchange for the bill of exchange and shipping documents.
Dealings on the Foreign Exchange Market
A brief account of certain important types of transactions conducted in the
foreign exchange market is given below:
Spot and Forward Exchanges
The term spot exchange refers to the category of foreign exchange
transaction that requires the immediate delivery or exchange of
currencies on the spot. In practice, the settlement takes place within two
days in most markets. The exchange rate effective for the spot transaction
is known as the spot rate, and the market for such transactions is referred
to as the spot market.
The forward transaction is an agreement between two parties, requiring
the delivery at some specific future date of a certain amount of foreign
currency by one party, against payment in domestic currency by the other
party, at the rate agreed upon in the contract. The exchange rate
applicable to the forward contract is known as the forward exchange rate,
and the market for forward transactions is known as the forward market.
The currency regulations of various countries generally regulate forward
exchange transactions to curtail speculation in the foreign exchange
market.
In India, for example, commercial banks are authorized to provide forward
cover only with respect to genuine export and import transactions.
Forward exchange facilities, evidently, are of considerable help to
exporters and importers as they can cover the risks arising out of
exchange rate fluctuations by entering into the appropriate forward
exchange contract.
Forward Exchange Rate
Concerning its relationship with the spot rate, the forward rate can be at
par, discount, or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to
the spot rate at the time of making the contract, the forward
exchange rate is said to be at par.
At Premium: The forward rate for a currency is said to be at a
premium concerning the spot rate when one unit of the currency
buys more units of another currency in the forward than in the spot
market. The premium is generally expressed as a percentage
deviation from the spot rate on a per annum basis.
At Discount: The forward rate for a currency is said to be at a
discount concerning the spot rate when one unit of the currency
buys fewer units in the forward than in the spot market. The
discount is also commonly expressed as a percentage deviation
from the spot rate on a per annum basis. The forward exchange rate
is determined primarily by the demand for and supply of forward
exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium
and, conversely, when the supply of forward exchange exceeds the
demand for it, the rate will be quoted at a discount. When the
supply is equal to the demand for forward exchange, the rate will
tend to be at par.
Futures
While a futures contract is similar to a forward contract, there are several
differences between them. While a forward contract is customized for the
buyer by his international bank, a futures contract has standardized
features—the contract period and maturity dates are standardized.
Futures can be traded only on an organized exchange and are traded
competitively. Margins are not required in respect of a forward contract,
but margins are required of all participants in the futures market—an
initial margin has to be deposited into a collateral account to establish a
futures position.
Options
While the forward or futures contract protects the buyer of the contract
from adverse exchange rate movements, it eliminates the possibility of
gaining a windfall benefit from favorable exchange rate movements. For
example, if an Indian exporter has a forward contract to sell his future
dollar receipts at $1 = Rs. 48, he is protected against the risk of a
depreciation of the dollar by the time he receives the payment (for
example, $1 = Rs. 46). However, the forward contract prevents him from
gaining the profit of possible appreciation of the dollar (say, $1 = Rs. 50).
Currency options are designed to address this issue.
An option is a contract or financial instrument that gives the holder the
right, but not the obligation, to sell or buy a given amount of an asset at a
specified price at a specific future date. An option to sell the underlying
asset is known as a call option, and an option to buy the underlying asset
is known as a put option. Buying or selling the underlying asset through
the option is to exercise the option. The agreed-upon price paid (or
received) is referred to as the exercise or striking price. The buyer of an
option is called the long, and the seller of an option is called the writer of
the option or the short. The price for the option is known as the premium.
In terms of their exercise characteristics, there are two types of options—
American and European. A European option can be exercised only at the
maturity or expiration date of the contract, whereas an American option
can be exercised at any time during the contract.
Swap Operation
Commercial banks that conduct forward exchange business may resort to
a swap operation to adjust their fund position. The term swap means
simultaneous sale of spot currency for the forward purchase of the same
currency or the purchase of spot for the forward sale of the same
currency. The spot is swapped against forward. Operations involving a
simultaneous sale or purchase of spot currency followed by a purchase or
sale, respectively, of the same currency for forward delivery, are
technically referred to as swaps or double deals, as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
the intention of making profits from the differences between the exchange
rate prevailing at the same time in different markets.
For example, assume that the rate of exchange in London is £1 = $2 while
in New York £1 = $2.10. This creates a situation where one can buy one
pound sterling in London for 2 dollars and earn a profit of $0.10 by selling
the pound sterling in New York for $2.10. This situation would, therefore,
lead to an increase in demand for sterling in London and, consequently,
an increase in the supply of sterling in New York. Such operations, i.e.,
arbitrage, could lead to equalizing the exchange rates in different markets
(in our example London and New York).
Arbitrage in foreign currencies is possible due to the ease and speed of
modern means of communication between business centers across the
world. Thus, an operator in New York might buy dollars in Amsterdam and
sell them a few minutes later in London. The effect of arbitrage, as has
already been referred to, is to iron out differences in the prices of
exchange of currencies in different centers, thereby creating, theoretically
speaking, a single-world market in currency.
Conclusion
In conclusion, the foreign exchange market is a complex and dynamic
system where currencies are bought and sold. Various instruments,
including spot and forward exchanges, futures, options, swaps, and
arbitrage, facilitate international trade and investment. Exchange rates
are determined by economic factors, interest rates, inflation, political
stability, and market speculation. The PPP and IRP theories provide
frameworks for understanding long-term and short-term movements in
exchange rates. In a globalized economy, exchange rates play a crucial
role in shaping international trade, investment, and financial flows.
Understanding the mechanisms and theories behind foreign exchange is
essential for participants in the global economy.
