Chapter 8 Foreign Exchange and International Financial Markets

Chapter 8: Foreign Exchange and International Financial Markets 8 -1

Chapter Objectives § Meaning of Foreign Exchange and foreign exchange market. § Who are the players in the market? § Types of currencies § Foreign exchange instruments § Exchange rate regime/system. 8 -2

Foreign Exchange A commodity that consists of currencies issued by countries other than one’s own 8 -3

Foreign Exchange Market Foreign exchange market comprises buyers and sellers of currencies issued by foreign countries. It consists of actual customers of foreign currencies. An Exchange rate is the price of a currency. It is the number of units of one currency that buys one unit of another currency. 8 -4

Participants of foreign exchange market § Commercial customers: Commercial customers engage in foreign exchange transactions as part of their normal commercial activities such as exporting and importing of goods and services, making foreign investments, paying and receiving dividends etc. § Speculators: They deliberately assume exchange rate risks by acquiring positions in a currency, hoping that they can correctly predict changes in the currency’s market value. Foreign exchange speculation can be very lucrative if one guesses correctly, but it is also very risky. 8 -5

Participants of foreign exchange market § Arbitrageurs: They attempt to exploit small differences in the price of a currency between markets. They seek to obtain riskless profits by simultaneously buying the currency in the lower priced market and selling it in the higher priced market. 8 -6

Types of Currencies § Convertible or Hard Currencies: The currencies that are freely tradable are called convertible or hard currencies. These include- US dollar, Euro, Pound etc. § Inconvertible or Soft Currencies: A situation where one currency cannot be exchanged for another currency because of domestic laws or foreign exchange regulations or the unwillingness of foreigners to hold them are called inconvertible currencies or soft currencies. 8 -7

Instruments of foreign exchange market § Traditional Instruments – Spot Transactions – Forward Transactions. 8 -8

Instruments of foreign exchange market § Spot Transactions: A transaction in the foreign exchange market which is being delivered into market within two days. § When two parties agree to exchange currency and execute the deal immediately (within two days) the transaction is referred to as spot transaction. § Forward Transactions: A forward transaction occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. 8 -9

Exchange Rate Regime/ System § There are two types of exchange rate system: – Fixed exchange rate system – Floating exchange rate system § Fixed exchange rate system( Pegging system): It is an international monetary system in which each government promises to maintain the price of its currency in terms of other currencies. Here, the value of the currency is fixed by the central bank. 8 -10

Exchange Rate Regime/ System § Floating exchange rate system: When exchange rate is determined by the demand supply (market forces) of foreign currencies, it is called floating or flexible exchange rate system. § Managed floating: In floating exchange rate system, although the price of a currency is to be set by the interaction of market forces, sometimes the government intervenes the exchange rate through buying and selling foreign currencies. 8 -11

Exchange rate changes or movements 1. 2. 8 -12 Devaluation or depreciation of currency: Devaluation is the decrease in the value of one currency against another. Such decrease is known as devaluation in the fixed exchange rate system while it is called depreciation in the floating exchange rate system. Revaluation or appreciation of currency: Revaluation is the opposite of the previous term. That means, revaluation or appreciation is the increase in the value of one currency against another. Such increase is known as revaluation.