Foreign Exchange Rate

 Meaning of foreign exchange

 History
 Types of foreign exchange system
 Demand and supply for foreign exchange
 Determination of exchange rate
 Factors affecting movement of exchange rate
 Foreign exchange market
 Why foreign exchange market is unique?
 Participants of foreign exchange market
 Functions of foreign exchange market
 Types of foreign exchange market
 Depreciation of rupee
 Historical Indian rupee rate
 Why dollar
 Conclusion
 Bibliography
 Meaning of foreign exchange
Foreign exchange (Forex or FX) is the conversion of one country’s currency into
another. In a free economy, a country’s currency is valued according to the laws
of supply and demand. In other words, a currency’s value can be pegged to
another country’s currency, such as the U.S. dollar or even to a basket of
currencies.

For example, India’s currency is Indian Rupee and all other currencies are its
foreign exchange. Here are some currencies of different countries –

 US – Dollar
 Bangladesh – Taka
 Canada – Canadian Dollar
 Japan - Yen
 France – Euro
 History
Forex trading, which is the act of exchanging fiat currencies, is thought to be
centuries old – dating back to the Babylonian period. The barter system is the
oldest method of exchange and began in 6000BC, introduced by Mesopotamia
tribes. Under the barter system goods were exchanged for other goods.

Eventually, as early as 6th century BC, the first gold coins were produced, and they
acted as a currency because they had the critical characteristics like portability,
durability, divisibility, uniformity, limited supply and acceptability. Gold coins
became widely accepted as a medium of exchange, but they were impractical
because they were heavy.

In the 1800s countries adopted the gold standard. The gold standard guaranteed
that the government would redeem any amount of paper money for its value in
gold. This worked fine until World War I where European countries had to suspend
the gold standard to print more money to pay for the war. The foreign exchange
market was backed by the gold standard at this point and during the early 1900s.
Countries traded with each other because they could convert the currencies they
received into gold. The gold standard, however, could not hold up during the
world wars.
 Types of foreign exchange system
 Fixed exchange rate system
 Under fixed exchange system, each country maintains value of its currency
fixed in terms of gold, silver, other precious metal, another country’s
currency, etc.
 The basic purpose of adopting this system is to ensure stability in foreign
exchange.
 To achieve stability, government undertakes to buy foreign currency when
the exchange rate become weaker and sell foreign currency when the rate
gets stronger.

Advantages –

 Stability in exchange rate

 Prevent speculative activities
 Coordination of macroeconomic policies

Disadvantages –

 Does not encourage venture capital

 Possibility of under or over valuation of the currency
 Government has to maintain 100% gold reserves

Flexible exchange rate

 It refers to a system in which exchange rate between currencies of

different countries is determined by the market forces of demand and
supply.
 The value of currency is allowed to fluctuate freely according to change in
demand and supply of foreign exchange.
 There is no government intervention in foreign exchange market.

Advantages –
  It solves the problem of under or over valuation of currencies
 No need of government to hold 100% gold reserves
 It encourages venture capital

Disadvantages –

 It is unstable as the foreign exchange keeps fluctuating

 Discourages international trade and coordination of macro policies
becomes inconvenient

 Managed floating rate system –

 It refers to a system in which foreign exchange rate is determined by
market forces and central bank stabilizes the exchange rate in case of
appreciation or depreciation of domestic currency
 For this, central bank maintains reserve of the foreign exchange to ensure
that the exchange rate stays within the targeted value
 It is called a ‘hybrid’ system between fixed rate and flexible rate.
 Demand and Supply for foreign exchange
The foreign exchange rate is determined in the free foreign exchange markets by
the forces of ‘demand and supply for foreign exchange’. To make the demand and
supply functions to foreign exchange, like the conventional market demand and
supply functions, we define the rate of exchange as the price of one unit of the
foreign currency expressed in terms of the units of the home  currency.

Demand for foreign exchange

Foreign exchange is demanded for the following reasons –

 Import of goods and services

 Tourism
 Remittances by foreigners working in India
 Repayment of interest and loans
 Extension of loans to foreigners
 Investment

The relationship between the quantities of the foreign exchange demanded and
the rate of foreign exchange is inverse in such a way that a fall in the rates of
exchange is followed by a rise in its demand and vice-versa.

Supply for foreign exchange

Supply of foreign exchange depends in following factors –

 Export of goods and services

 Foreign tourists in India
 Remittances by Indian Working abroad
 Foreign Direct Investment by Multinational Companies
 Purchases of Shares by Foreign Investors
 Deposits by Non-resident Indians
The relationship between the quantities of foreign exchange supplied and rate of
foreign exchange is direct in such a way that a fall in the rates of exchange is
followed by a fall in its demand and vice-versa.
Determination of exchange rate

Flexible exchange rate is determined by the intervention of forces of demand and

supply.

The equilibrium exchange rate is determined where demand and supply are equal.
 Factors affecting changes in foreign exchange
1. Inflation rates – Changes in market inflation cause changes in currency
exchange rates. A country with a consistently lower inflation rate exhibits a
rising currency value while a country with higher inflation typically sees
depreciation in its currency and is usually accompanied by higher interest
rates.
2. Interest rates - Forex rates, interest rates, and inflation are all correlated.
Increases in interest rates cause a country's currency to appreciate because
higher interest rates provide higher rates to lenders, thereby attracting more
foreign capital, which causes a rise in exchange rates.
3. Country’s current account/balance of payments - A country's current account
reflects balance of trade and earnings on foreign investment. It consists of
total number of transactions including its exports, imports, debt, etc. A
deficit in current account due to spending more of its currency on importing
products than it is earning through sale of exports causes depreciation.
Balance of payments fluctuate exchange rate of its domestic currency.
4. Government debt - Government debt is public debt or national debt owned
by the central government. A country with government debt is less likely to
acquire foreign capital, leading to inflation. Foreign investors will sell their
bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate will
follow.
5. Political stability and performance - A country's political state and economic
performance can affect its currency strength. A country with less risk for
political turmoil is more attractive to foreign investors, as a result, drawing
investment away from other countries with more political and economic
stability. Increase in foreign capital, in turn, leads to an appreciation in the
value of its domestic currency. A country with sound financial and trade
policy does not give any room for uncertainty in value of its currency. But, a
country prone to political confusions may see depreciation in exchange rates.
6. Recession - When a country experiences a recession, its interest rates are
likely to fall, decreasing its chances to acquire foreign capital. As a result, its
currency weakens in comparison to that of other countries, therefore
lowering the exchange rate.
 7. Speculation - If a country's currency value is expected to rise, investors will
demand more of that currency in order to make a profit in the near future.
As a result, the value of the currency will rise due to the increase in demand.
With this increase in currency value, comes a rise in the exchange rate as
well.
 


 Foreign exchange market
Foreign exchange market – it is defined as the market in which foreign currencies
are bought and sold. It is a system where buyers and sellers of foreign currency
provide facilities in trading of foreign currencies. Foreign exchange market
constitutes brokers, banks, central banks, etc.

Why foreign exchange market is unique?

1. Its huge trading volume represent the largest assets class in the world leading
to high liquidity
2. Its geographical dispersion
3. Its continuous operation : 24 hours a day except weekends
4. The low margin relative profit compared with other market of fixed income
5. The use of leverage to enhance project and loss margin and with respect to
account size.
Participants of foreign exchange market –
1. Commercial bank – the major participants in the foreign exchange market are
large commercial banks who provide the core of market. As many as 100 to
200 banks across the globe actively make the market in the foreign exchange
2. Foreign exchange banks – foreign exchange brokers also operates in
international currency market, they act as agent who facilitate trading between
dealers. They actively and constantly monitor exchange rates offered by major
international banks.
3. Central bank – central banks plays an important role in foreign exchange
markets. They try to control the money supply, inflation and/or interest rates
for their currencies. They can use their substantial foreign exchange reserve to
stabilize market. There is also no convincing evidence that they actually make
profit from trading.
4. MNC – MNCs are the major non bank participants in the forward market as
they exchange cash flow associated with their multinational operations. MNCs
often contract to either pay or receive fixed amounts in foreign currencies at
future dates, so they are exposed to foreign currency risk.
5. Individual and small business – individual and small businesses also use foreign
exchange market to facilitate exchange market to facilitate execution of
commercial or investment transactions. The foreign needs of these players are
usually small and account for only a fraction of all foreign exchange
transactions.
Functions of foreign exchange market –
1. Transfer function – it transfers purchasing power between the countries
involved in the transaction. This function is performed through credit
installments like bills of exchange, bank drafts, and telephone transfers.
2. Credit function – it provides credit for foreign trade. Bills of exchange with
maturity period of three months are generally used for international payments.
Credit is required for their period in under the importer to take possession of
goods, sell them and obtain money to pay off the bill.
3. Hedging function – when exporter and importer enter into agreement to sell
and buy goods on some future dates at current prices and exchange rate is
called hedging. The purpose of hedging is to avoid losses that might be caused
due to exchange rate variations in future.
Types of foreign exchange market -
1. Spot market – it refers to a market where current transactions in foreign
exchange take place. The sale and purchase of foreign currency is affected at
the prevailing rate of exchange on the spot. The delivery of foreign exchange is
also affected instantaneously.
2. Forward market – it refers to the transactions – sale and purchase of foreign
exchange at some specified dates in the future usually after 90 days of deal.
 DEPRECIATION OF RUPEE
Introduction
Depreciation of Indian currency means loss of value of Rupee with respect to
one or more foreign reference, currencies, typically in a floating exchange rate
system.
For example, a month ago, 1USD = INR 72.5 which means for each $1 we need
to pay rs. 72.5 while in current day 1USD = INR 77.63 which means for each $1
we need to pay rs. 77.63.

Historical Indian Rupee rate

1USD TO 1USD TO
YEAR INR YEAR INR
1947 1 1985 12.37
1948 3.31 1986 12.61
1949 3.67 1987 12.96
1950 4.76 1988 13.92
1951 4.76 1989 16.23
1952 4.76 1990 17.5
1953 4.76 1991 22.74
1954 4.76 1992 25.92
1955 4.76 1993 30.49
1956 4.76 1994 31.37
1957 4.76 1995 32.43
1958 4.76 1996 35.43
1959 4.76 1997 36.31
1960 4.76 1998 41.26
1961 4.76 1999 43.06
1962 4.76 2000 44.94
1963 4.76 2001 47.19
1964 4.76 2002 48.61
1965 4.76 2003 46.58
1966 4.76 2004 45.32
1967 7.5 2005 44.1
1968 7.5 2006 45.31
1969 7.5 2007 41.35
1970 7.5 2008 43.51
1971 7.49 2009 48.41
1972 7.59 2010 45.73
1973 7.74 2011 46.67
1974 8.1 2012 53.44
1975 8.38 2013 56.57
1976 8.96 2014 62.33
1977 8.74 2015 62.97
1978 8.19 2016 67.28
1979 8.13 2017 68.02
1980 7.86 2018 68.49
1981 8.66 2019 70.65
1982 9.46 2020 74.13
1983 10.1 2021 73.93
1984 11.36 2022 77.62
 Why Dollar
Dollar is used to determine the value of currency. As of the end of 2020, the U.S.
had $2.04 trillion in circulation. As much as half that value is estimated to be in
circulation abroad. Many of these bills are in the former Soviet Union countries
and in Latin America. They are often used as hard currency in day-to-day
transactions.

In the foreign exchange market, the dollar rules. Around 90% of forex

trading involves the U.S. dollar. The dollar is just one of the world's 185 currencies
according to the International Standards Organization List, but most of these
currencies are only used inside their own countries.
 Reasons of depreciation
 Crude oil – the price of crude oil has always had a significant impact on the
value of the INR against the USD. When the price of crude oil rises, the INR
depreciates. In the same way, when crude price declines, the INR
appreciated because India imports around 80% of her crude oil and pays for
those imports in USD.
 Law of economics – as per the rudimentary law of economics if the demand
for USD in India exceeds its supply then it’s worth will go up and that of INR
will come down in that respect.
 Trade war between US and China – US and China have been involved in
heated up trade war as these countries are imposing imports tariffs on goods
from either of these countries. Both the nations have triggered a trade war
situation which is not adoptable for countries like India.
 US fed – since national economies share an intricate bond, the effects of US
Fed rate hikes are felt in the Indian market as well. A hike in fed rates
strengthens the US Dollar which in turn leads to depreciation of Indian
currency.
 Huge CAD – in December 2021, India’s Current Account Deficit rose to 2.7%
approximately $23 billion. An increase in CAD of India leads to increase in
demand of Dollars. An increase in demand of currency leads to its
appreciation. And if USD is appreciating against INR, it means INR is
depreciating.
 The LIRA connection – LIRA – the official Turkish currency has fallen 44%
against US Dollar in 2021. The Lira crisis has made the global market anxious
about its spillover effects. Developing country tends to be more exposed to
crises like these, making the situation a tricky one for India.
 Effects
NEGATIVE EFFECTS

1. Importer – importer will strongly feel the pinch of falling rupee as they will
be forced to pay more rupees on importing products. Buying imported stuff
will be a very costly affair.
2. Tourism – the depreciating rupee will surely be a dampener if you are
planning your holiday abroad. Your traveler charges as well as hotel charges
will escalate drastically, let alone shopping and other miscellaneous spending
activity.
3. Increase in fiscal burden – the central government fiscal burden might
increase as the hike in the price of imported crude oil and fertilizer might
warrant for a higher subsidy provision to be made for these commodities.
4. Higher inflation – higher inflation and uncertainty about future inflation
discourages investments and savings. As higher inflation raises uncertainty in
the economy, It also leads to lower equity values.
5. Fuel price – a weak rupee will increase the burden of oil marketing
companies (OMCs) and this will be surely be passed on to the consumers as
the companies are allowed to do so following deregulation of petrol and
partial deregulation of fuels.

POSITIVE EFFECTS
1. Exporter – a feeble rupee will bring delight the exporter as goods
exported abroad will fetch dollars which in return will translate into
more rupees.
2. Competition – a weak rupee will make India produce more competition
in global market which will be fruitful for India’s export.
3. Overseas Indian – depreciation of rupee is certainly good news for the
overseas Indians. Those working abroad can gain more on remitting
money to their homeland.
4. Tourism – travel and tourism is a sector which will be benefitted from
depreciation of rupee devaluates then it would become cheaper for
him.
 Impact of depreciation
1. Infrastructure – around 15% of the borrowings of Infrastructure Company
have been in dollar terms. Increased in price of construction equipment and
building material result in enhanced project execution cost. Increased cost of
output like steel and cement are also affecting infrastructure building. Fresh
investment in infrastructure could also get over period.
2. Agriculture –
 Sugar – India, the world second largest producer of the sweetener. A
softening rupee will be advantage for exporter from India.
 Wheat – India is world largest producer of wheat. Fall in rupee will lift
margins for Indian wheat exporter.
 Rice – India is the world largest and second biggest rice producer. Fall in
rupee will lift the margin for Indian rice exporter.
3. Real estate – real estate sector is second largest employment generator after
agriculture as demands of property declining is not only affect economy.

Increase in project cost and time frame followed by increased in price of

input, transportation, wages, etc. outsourced service in form of design
consultancy, architects.

Higher inflation rate and weak economic condition make unfavorable climate
for investors.

4. Foreign investment – as the rupee keeps on depreciating the foreign investor

lose a significant amount of money, due to this most of the investor fear
while investing in Indian market also many investor are pulling out there
money from Indian markets.
5. GDP – as the rupee keeps on devaluating the foreign investor will hesitate in
investing in India and it will hence decrease the GDP of India.
6. Banking Sector – If an Indian company defaults on its dollar debt and goes up
bankrupt then it will have a contagion effect on all the bank that have lent to
that company.
The other adverse effect is that the liability on NRE and foreign currency
deposit may increase because of depreciation in rupee.
7. Common man – there are so many commodities which are imported by many
companies to produce finished products for common man. All these will
become costlier, therefore fuel petrol, diesel aviation will become costlier for
common man. Transportation will be costlier so, inflation will go up and
common man need to sell out more money for running daily home.
 The rope – that can pull out INR
MEASURES OF RBI

1. Using index reserve – RBI can sell forex reserve and buy Indian Rupees
leading to demand for rupee. When RBI realizes that market value of
domestic currency is heavily depreciating, its restore its value by selling US
dollars in international market.
2. Hike in repo rate – a hike in repo rate acts as a disincentive for banks to
borrow from the central bank and is employed by RBI to central money
circulation and thus rise in inflation. A high repo rate can reduce money
supply in economy and thus help arrest price rise.
3. Cut in repo rate – when RBI cuts repo rate, bank needs to pay less interest on
their borrowings from RBI. Thus banks also charge less on their loans and it
thereby raises money circulation which leads to price rise and increase
economic activity.
4. Make investment attractive – RBI can take steps to increase supply of foreign
currency by expanding market participation to support rupee. RBI can
increase FII limit on investment in government and corporate debt
investment, it can invite long term FDI debt funds in infrastructure sector.

MEASURES BY GOVT

1. Easier external commercial borrowings (ECBs)

2. No hedging for infrastructure ECBs
3. Review of FPI 4 exposure limits
4. Encouraging capital inflows
5. Limiting imports and encouraging exports
6. Curbing speculative in currency
7. Improving the environment for FDI
8. Policy reforms such as GST, DTC. Etc
9. Creating infrastructure and promote inclusive growth
10. Reduce unnecessarily expenditure of government institutions
11. Proper implementation of monetary supply and fiscal police in our
country
12. To balance demand and supply
13. Government should observe restaurants in offering financial aid to
other countries

POWER OF COMMON MAN

1. Expenditure in form of dollars to be reduced

2. Expenditure on gold to be brought down
3. Higher investment in government bonds, treasury bills rather than gold
4. Enhancement of remittances from abroad and curtailment of remittances to
abroad
 Is the Indian only loser
A review of the values of 143 global currencies indicate that so far this year, more
than 80% have fallen in value. There have been outside declines in countries like
Venezuela, Iran, Vietnam, Indonesia, etc. The reasons for these declines would
appear to be the differing monetary policies of United States and most of rest of
world. The US is experiencing solid economic growth.

Following is the currency rates of countries against dollar (as of May 2022) –

 Venezuela Bolivar – 1 USD = 457795.47 VEF

 Iranian Rial - 1 USD = 42,300.00 IRR 
 Vietnamese Dong - 1 USD = 22,942.50 VND 
 Indonesian Rupiah - 1 USD = 14,526.30 IDR
 Sierra Leonean Leone - 1 USD = 12,700.00 SLL
 Laotian Kip - 1 USD = 12,760.00 LAK
 Uzbekistani Som - 1 USD = 11,160.00 UZS
 Guinean Franc - 1 USD = 8,800.00 GNF
 Paraguayan Guarani - 1 USD = 6,856.36 PYG
 Cambodian Riel - 1 USD = 4,063.00 KHR
 Conclusion
Today’s scenario presents that even after some steps taken by government, there
is not stabilization in value of rupee. However, INR is not the only currency that’s
depreciating. Except from United States, almost every country has shown a
depreciating pressure on their currency, both domestic and global conditions are
indicating that the downward pressure on rupee will remain in future. EBI has
responded with timely intervention by selling dollars intermittently. Thus, RBI
should continue its policy mixed up of controlled intervention in forex market and
administrative measure to curb volatility in rupee.
 Bibliography
Internet -

 www.wikipedia.com
 www.economictimes.com
 www.quora.com
