Essay on Foreign Exchange: Top 7 Essays | International Banking

Essay Contents:

Foreign exchange is the name given to:

(i) Either foreign currency, or to

(ii) The means by which debts between foreign countries are settled.

Money is essentially bank debts, therefore, it cannot physically move from one country to another, but debts in one country must be exchanged for debts in another.

The process of making international payments is therefore one of exchanging the ownership of bank balances- an Englishman making a payment to India must obtain a bank balance in Rupees and give in exchange his bank balance in Sterling.

The proceeds of Indian exports give merchants and banks in this country foreign currency which they use in payment for imports.

Essay # 2. Definition of Foreign Exchange:

Foreign Exchange Management Act (FEMA), 1999, (Section 2) defines foreign exchange as:

“Foreign Exchange means foreign currency, and includes:

(i) All deposits, credits and balances payable in foreign currency, and any drafts, traveller’s cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency and payable in any foreign currency,

(ii) Any instrument payable at the option of the drawee or holder, thereof or any other party thereto, either in Indian currency or in foreign currency, or partly in one and partly in the other.”

Thus, broadly speaking, foreign exchange is all claims payable abroad, whether consisting funds held in foreign currency with banks abroad or bills, checks payable abroad.

In other sense, a foreign exchange transaction is a contract to exchange funds in one currency for funds in another currency at an agreed rate and arranged basis. Exchange rates thus denote the price or the ratio or the value at which one currency is exchanged for another currency.

The number of units of one currency, which exchange for a given number of units of another currency, is the exchange rate of the currency. For example, 1 US dollar is equal to Rs 48.10, or 1 Euro is equal to 1.47 US dollar.

The exchange rate is a dynamic rate, which varies from day-to-day, minute-to-minute and second to second, and in practice a few times per second, depending upon a variety of factors. We shall learn more about the forex markets and other aspects as we go ahead.

Essay # 3. Characteristics of Foreign Exchange:

Thus the characteristics of foreign exchange market can be listed as under:

i. A 24-hour market

ii. An over the counter market

iii. A global market with no barriers/no specific location

iv. A market that supports large capital and trade flows

v. Highly liquid markets

vi. High fluctuations in currency rates (every 4 seconds)

vii. Settlements affected by time zone factor

viii. Markets affected by governmental policies and controls.

Essay # 4. Foreign Exchange Markets:

Foreign exchange markets comprise a large spectrum of market participants, which include individuals, business entities, commercial and investment banks, central banks, cross border investors, arbitrageurs and speculators across the globe, who buy or sell currencies for their needs.

It is a communication system-based market, with no boundaries, and operates round the clock, within a country or between countries. It is not bound by any four-walled marketplace, which is a common feature for commodity markets, say vegetable market, or fish market. It is a profit centre with simultaneous potential for losses.

Forex markets are dynamic markets and work round-the-clock, in different time zones, in which various countries are located. Geographically, forex markets extend from Tokyo and Sydney in the east, through Hong Kong, Singapore, Bahrain, London and New York in the west.

If we view the markets as per GMT, when the London and other European markets start the day it is almost lunch time for the Indian markets, and when the Indian markets are about to close, the New York market is about to begin its day.

Further, while the New York market operates for some-time alongside the London and European markets, the markets in the east: Tokyo, Hong Kong and Singapore are ready to start, before New York closes. The Indian and Middle East markets are ready to start the day, before close of Singapore and Hong Kong markets.

The world currency market is a very large market, with a large number of participants.

Major participants of forex markets are:

i. Central Banks:

Managing their reserves and using currency markets to smoothen out the value of their home currency.

ii. Commercial Banks:

Offering exchange of currencies to their retail clients and hedging and investing their own assets and liabilities, as also on behalf of their clients, and also speculating on the movements in the markets.

iii. Investment Funds/Banks:

Moving funds from one country to another using exchange markets as a vehicle for investments as also hedging their investments in various countries/currencies.

iv. Forex Brokers:

Acting as middleman, between other participants, and at times taking positions on their books.

v. Corporations:

Moving funds between different countries and currencies for investment or trade transactions or even speculation in currency markets.

vi. Individual:

Ordinary or high net worth individuals using markets for their investment, trade, personal, and travel and tourism needs.

As given here, the participants not only use the forex markets for trade or travel purposes, but also for investments, hedging and speculative, thus generating large volumes for the market.

It may be surprising to note that the global forex market handles total turnover of approx. US dollar 3.20 trillion (USD 3200 billion) per day, while the daily world trade turnover is approx. 2.00 % of this forex turnover.

This means that around 98% of the global forex trading relates to investments, or speculative trading. The Indian forex markets too, trade over USD 30 billion per day, which is again a good multiple of the India’s average daily export/import trade turnover, mostly because of regulatory exchange control regime and restrictive flow of foreign currency.

The forex markets are highly dynamic, that on an average the exchange rates of major currencies (say GBP/USD) fluctuate every four seconds, which effectively means it registers 21,600 changes in a day (15 × 60 × 24). Now that means that you look aside for a second and when you turn back for the rate, the same could have moved either way.

Forex markets usually operate from ‘Monday to Friday’ globally, except for the Middle East or other Islamic countries which function on Saturday and Sunday with restrictions, to cater to the local needs, but are closed on Friday.

The bulk of the forex markets are OTC (over the counter), meaning that the trades are concluded through telephone or other electronic systems (dealing systems of various news agencies, banks, brokers or Internet-based solutions).

Banks in London quite commonly deal with banks in Paris, Frankfurt, Mumbai and New York and even in Tokyo or Singapore, which are totally in a different time zone. Large dealing rooms of global banks or Corporates, operate round the clock, to be with all major markets across the globe.

A few traders are provided dealing platforms in their homes, to enable them to trade in any time zone. Now with the internet accessibility on the mobile, the markets can be accessed any time any place. Major Banks, which act as market makers offer two-way quotes, (buy and sell), and leave upon the caller to either buy or sell as per his needs. This generates greater market depth and volumes.

Essay # 5. Mechanism of Foreign Exchange:

Debts between two countries may be settled with the help of following mechanisms:

(i) Bills of exchange,

(ii) Cheques or drafts,

(iii) Telegraphic transfer (T.T.),

(iv) Mail transfers (M.T.).

A bill of exchange is an order drawn by a person upon a bank or another person, asking the latter to make certain payments to a third party. The exporters sell these to their banks, who get them collected in the foreign countries and credit to their accounts.

For speedier payments telegraphic transfers (T.T.) are used: the Indian bank wires to the foreign bank with which it has an account to transfer the deposit at once to the account of a specified person. Mail transfers (M.T.) are similar to telegraphic transfers, except that they are sent by post. Both M.T.’s and T.T.’s are safer than drafts or cheques since there is no danger from loss.

Essay # 6. Factors Determining Exchange Rates:

A. Fundamental Reasons:

These include all those causes or events, which affect the basic economic and monetary policies of the concerned government. The causes normally affect the long-term exchange rates, while in the short- run, many of these are found ineffective.

In a long run, exchange rates of all currencies are linked to fundamentals, as given under:

i. Balance of Payment:

Generally a surplus leads to a stronger currency, while a deficit weakens a currency.

ii. Economic Growth Rate:

A high growth leads to a rise in imports and a fall in the value of currency, and vice versa.

iii. Fiscal Policy:

An expansionary policy, e.g., lower taxes can lead to a higher economic growth.

iv. Monetary Policy:

The way, a central bank attempts to influence and control interest and money supply can impact the value of currency of their country.

v. Interest Rates:

High domestic interest rates tend to attract overseas capital, thus the currency appreciates in the short term. In the longer term, however, high interest rates slow the economy down, thus weakening the currency.

vi. Political Issues:

Political stability is likely to lead the economic stability, and hence a steady currency, while political instability would have the opposite effect.

B. Technical Reasons:

Government controls can lead to an unrealistic value of a currency, resulting in violent exchange rates. Freedom or restriction on capital movement can affect exchange rates to a larger extent. This is a recent phenomenon, as seen in Indonesia, Korea, etc.

Huge surpluses generated in the petroleum exporting countries, (due to the sudden spurt in petroleum prices), which could not be utilised in these countries, had to be invested overseas. This creates huge movement of capital overseas and resultant appreciation of the relative currency.

Capital tends to move from lower yielding to higher yielding currencies, and results, is movement in exchange rates.

C. Speculation:

Speculative forces can have a major effect on exchange rates. In an expectation, that a currency will be devalued, the speculator will short sell the currency for buying it back cheaper at a later date. This very act can lead to vast movements in the market, as the expectation for devaluation grows and extends to other market participants.

Speculative deals provide depth and liquidity to the market and at times, act as a cushion too, if the views do not lead to a contagious effect.

Essay # 7. Control of Foreign Exchange:

Foreign exchange control is the child of economic difficulty born out of depression or war. The second World War brought about a great deal of exchange control in more or less all countries. In depression many countries found they could not meet all their overseas debts, e.g., interest payments, on account of a big drop in the value of their exports, so in order to prevent heavy sales of their currency from depreciating it, they blocked the bank balances due to foreigners and merely refused to allow them to be offered in exchange from foreign currency.

The problem of excess demand for foreign currency was solved by cutting off the demand at source; the foreigners were left with their funds in the debtor country in which they had to spend their money themselves, since they were not allowed to exchange it for their own currencies.

Exchange control coupled with the power to control imports is thus an alternative to a very heavy depreciation of the exchange value of a currency. Exchange control enables a country to control its foreign trade.

All exporters are obliged to sell the foreign currency they receive, to the authorised Government Bank, where it is resold to the importers of such goods as the state desires to import. State authorises imports only upto the amount of foreign exchange available from exports.

In India, the leading currencies can only be dealt in through the Reserve Bank which adjusts the proceeds of exports and imports in order of preference, the rate of exchange being determined by the Bank.

The aim of exchange control is to keep exchange rates stable. The rate of exchange may be either higher or lower than the equilibrium rate of a free market. A country pegging the rate at a low level-that is under-valuing its currency-may do so to stimulate its export trade.

New Zealand followed such a policy after 1933. A policy of over-valuation might be pursued in order to bolster up confidence in the currency at home, or to cheapen imports during time of war or preparation for war. Thus the German mark was over-valued in 1931.