NOTES

: Foreign exchange transactions are of two types

a)    Spot exchange rate transaction

Spot exchange rate is the current exchange rate of two currencies it is determined by market forces, i.e. demand for and supply of foreign exchange, it is the rate at which immediate delivery of foreign exchange has to be made. In case of large transactions, there is a two day time lag between the spot sale / purchase and actual delivery of foreign exchange. The two day margin is allowed for payments clearance for instance, the spot exchange rate is$ and Indian rupee in India is determined by demand for and supply of dollars in India.

b)   Forward exchange rate transactions

Forward exchange rate is the outcome of forward transactions in foreign currency. Forward transaction involves an agreement entered into at current day to purchase or sell certain amount of foreign exchange at certain rate on a specified future date. The forward exchange contract have varying maturity period of thirty days to 180 days and even up to 360 days. The exchange rate quoted in forwards exchange contract is known as forward exchange rate.

c)    Arbitrage:

Arbitrage refers to process of buying & selling foreign exchange in two difference between two markets. The persons involve in doing arbitrage are called as arbitrageurs. Arbitrageurs will purchase foreign currency from low price market and sell it immediately in high price market in order to earn profits. For e.g.:- Price of $ in USA market is $1=Rs..50 and the price in Indian market is $1=Rs..55 then arbitrageurs will purchase $ from USA & sell in India. Thereby making profit of Rs..5 per dollar.

Arbitrageur is an important economic activity which is useful to equalize the rate of exchange in all the countries of the world. In our example, arbitrageur will purchase dollars from USA as such the demand for dollars in USA will increase and thereby force the rate of exchange to increase whereas the arbitrageur will sell the dollars in Indian market which will use increase it supply in India. Thereby forcing the rate of exchange in India to fall.

d)   Hedging

Hedging is done by importers and exporters in order to cover risk which may arise on account of fluctuations in the rate of exchange. Hedging is mainly done through financial institutions by payment of requisite fees.

For e.g. An Indian importer Mr. I purchases one machinery from an exporter of USA Mr. A worth 50,000 $. Mr. I has been provided credit period of 6 months for payment of the amount due.

The current spot rate is $1=Rs..50 i.e. Mr. I will have to make payment of Rs..25,00,000 at current spot rate. However Mr. I anticipates depreciation in the value of rupee and therefore after 6 months, he may have to pay more than Rs..50 per $. Therefore, he may enter into hedging contract to buy $ from financial institutions at one $=Rs..55. As such, he will have to make payment of Rs..27,50,000 after 6 months.

Now if in period of 6 months if the exchange rate further depreciate and becomes Rs..60 per $. The importer stands to gain or need not suffer further losses. However, if in time being the exchange rate appreciates, the importer stands at loss.

e)    Managed Flexibility:-

Prior to 1970s, the economies of the world used to follow fixed exchange rate. However, 1971 onward this economies adopted flexible exchange rate where they allowed market forces i.e. Demand for and Supply of foreign currency to determine the rate of exchange i.e. under flexible exchange rate the central bank will not interfere in determination of rate of exchange. However, the flexible exchange rate suffered from the drawback that if demand exceeds supply there was drawback that if demand exceeds supply there was appreciation of foreign currency and depreciation of domestic currency and vice-versa. Thus, with an objective to overcome the drawbacks of flexible exchange rate, the world economies adopted Managed Flexible Exchange Rate (MFER). Under MFER, the central bank of country will interfere to bring stability in the rate of exchange. This is done by the central government by buying and selling foreign currency into domestic market so as to bring the balance between demand for and supply of foreign currency.

      The central bank of country holds the huge stock of foreign currency and it manages as well as controlled the foreign exchange rate by manipulating demand and supply of foreign currency.

      For e.g. If demand for foreign currency say USA $ is very high in India. In this case, the dollar win appreciate and the rupee will depreciate. Such depreciation of India rupee will adversely influence the imports in domestic economy and also foreign investors will loose confidence in domestic market as they do not except better returns. These problems have arised on account of higher demand for foreign currency. As such in this case, the central bank will release the dollar from foreign exchange reserve which will bring foreign exchange rate stability.

      Suppose if demand of foreign exchange is less than supply. Then the situation will lead to appreciation of rupee and depreciation of dollar. Such situation is adversely influencing the exporter in the domestic economy. Thus, in this case, central bank will interfere and purchase dollars from the market so as to bring exchange rate stability.