Introduction:

Meaning of International Finance:

International finance means management of finance in an international business environment,

it implies, doing of trade and making money through the exchange of foreign currency. It is
the application of financial strategy that takes into account the differences and complexities
involved in cross- b o r d e r transactions. International financial activities help organizations
to connect with international dealings with overseas business partners- customers,
suppliers, lenders etc.

Foreign exchange (forex):

It 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. However, many countries
float their currencies freely against those of other countries, which keeps them in constant
fluctuation.

Foreign Exchange and Markets:

Foreign exchange market (forex, or FX, market), institution for the exchange of one
country's currency with that of another country. A foreign exchange market is a 24-hour
over-the-counter (OTC) and dealers' market, meaning that transactions are completed
between twoparticipants via telecommunications technology. GDP.
Importance of foreign exchange market

The foreign exchange markets play a critical role in facilitating cross- border trade,
investment, and financial transactions. These markets allow firms making
transactions in foreign currencies to convert the currencies or deposits they have
into the currencies or deposits they want.

Define Foreign Exchange Market

The foreign exchange market is over a counter (OTC) global marketplace that determines the
exchange rate for currencies around the world. This foreign exchange market is also known as
Forex, FX, or even the currency market. The participants engaged in this market are able to
buy, sell, exchange, and speculate on the currencies.

These foreign exchange markets consist of banks, forex dealers, commercial companies,
central banks, investment management firms, hedge funds, retail forex dealers, and investors.
In our prevailing section, we will widen our discussion on the ‘Foreign Exchange Market’.

Types of Foreign Exchange Market

The Foreign Exchange Market has its own varieties. We will know about the types of these
markets in the section below:
The Major Foreign Exchange Markets −
Spot Markets
Forward Markets
Future Markets
Option Markets
Swaps Markets

Spot Market
In this market, the quickest transaction of currency occurs. This foreign exchange market
provides immediate payment to the buyers and the sellers as per the current exchange rate. The
spot market accounts for almost one-third of all the currency exchange, and trades which
usually take one or two days to settle the transactions.
Forward Market
In the forward market, there are two parties which can be either two companies, two
individuals, or government nodal agencies. In this type of market, there is an agreement to do
a trade at some future date, at a defined price and quantity.
Future Markets
The future markets come with solutions to a number of problems that are being encountered in
the forward markets. Future markets work on similar lines and basic philosophy as the forward
markets.
Option Market
An option is a contract that allows (but is not as such required) an investor to buy or sell an
instrument that is underlying like a security, ETF, or even index at a determined price over a
definite period of time. Buying and selling ‘options’ are done in this type of market.
Swap Market
A swap is a type of derivative contract through which two parties exchange the cash flows or
the liabilities from two different financial instruments. Most swaps involve these cash flows
based on a principal amount.

Functions of Foreign Exchange Market:

The various functions of the Foreign Exchange Market are as follows:

Transfer Function: The basic and the most obvious function of the foreign exchange market
is to transfer the funds or the foreign currencies from one country to another for settling their
payments. The market basically converts one’s currency to another.
Credit Function: The FOREX provides short-term credit to the importers in order to facilitate
the smooth flow of goods and services from various countries. The importer can use his own
credit to finance foreign purchases.
Hedging Function: The third function of a foreign exchange market is to hedge the foreign
exchange risks. The parties in the foreign exchange are often afraid of fluctuations in the
exchange rates, which means the price of one currency in terms of another currency. This might
result in a gain or loss to the party concerned.

Features of Foreign Exchange Market:

This kind of exchange market does have characteristics of its own, which need to be identified.
The features of the Foreign Exchange Market are as follows:
High Liquidity
The foreign exchange market is the most easily liquefiable financial market in the whole world.
This involves the trading of various currencies worldwide. The traders in this market are free
to buy or sell the currencies anytime as per their own choice.
Market Transparency
There is much clarity in this market. The traders in the foreign exchange market have full access
to all market data and information. This will help to monitor different countries’ currency price
fluctuations through the real-time portfolio.
Dynamic Market
The foreign exchange market is a dynamic market structure. In these markets, the currency
values change every second and hour.
Operates 24 Hours
The Foreign exchange markets function 24 hours a day. This provides the traders the possibility
to trade at any time.

Elements of foreign exchange market

The foreign exchange market is a decentralized market where currencies are traded, and its
main elements are:

1. Currency exchange rate: The exchange rate is the price of one currency in terms of
another currency. It is the price at which currencies can be bought and sold in the
foreign exchange market.
2. Participants: The participants in the foreign exchange market include banks,
corporations, central banks, hedge funds, and individual investors. They trade in
currencies for various purposes, including hedging against currency risk, speculating
on exchange rate movements, and facilitating international trade.

The participants in a foreign exchange market are as follows:

Central Bank: The central bank takes care of the exchange rate of the currency of their
respective country to ensure that the fluctuations happen within the desired limit and this
participant keeps control over the money supply in the market.
Commercial Banks: Commercial banks are the channel of forex transactions, which facilitates
international trade and exchange to its customers. Commercial banks also provide foreign
investments.
Traditional Users: The traditional users consist of foreign tourists, the companies who carry
out business operations across the globe.
Traders and Speculators: The traders and the speculators are the opportunity seekers who
look forward to making a profit through trading on short-term market trends.
Brokers: Brokers are considered to be the financial experts who act as a sure intermediary
between the dealers and the investors by providing the best quotations.

3. Instruments: The instruments traded in the foreign exchange market include spot
transactions, forward transactions, options, and futures contracts. These instruments
allow participants to manage their currency risk and take advantage of exchange rate
movements.
4. Market structure: The foreign exchange market is a decentralized market, with no
central exchange. Transactions are conducted electronically through a network of
banks, brokers, and other financial institutions.
5. Regulatory framework: The foreign exchange market is subject to various regulations
and guidelines set by governments and central banks. These regulations aim to ensure
the stability and transparency of the market and prevent fraudulent activities.
6. Economic factors: Economic factors such as interest rates, inflation, and political events
can influence exchange rates and the behavior of market participants. Participants
analyze and interpret these factors to make informed trading decisions.

Advantages of Foreign Exchange Market

The whole world economy is relying upon this foreign exchange market for obvious
advantageous reasons. Let us check what are the advantages gained in the foreign exchange
market-
1. There are very few restrictive rules, this allows the investors to invest in this market
freely.
2. There are no central bodies or clearinghouses that head the Foreign Exchange Market.
 Hence, the intervention of the third party is less.
3. Many investors are not required to pay any commissions while entering the Foreign
Exchange Market.
4. As the market is open 24 hours, the investors can trade here without any time-bound.
5. The market allows easy entry and exit to the investors if they feel unstable.

Evolution of exchange rate system

The exchange rate system has evolved over time, with several distinct regimes:

1. Fixed exchange rate system: This system fixes the exchange rate of a currency to a
certain value, usually to the US dollar or gold. The Bretton Woods system, which was
in place from 1944 to 1971, is an example of a fixed exchange rate system.
2. Floating exchange rate system: This system allows the exchange rate to be determined
by market forces, with supply and demand determining the exchange rate. Most major
currencies now use a floating exchange rate system.
3. Managed float exchange rate system: In this system, the central bank of a country
intervenes in the foreign exchange market to influence the exchange rate, but still
allows market forces to play a role in determining the exchange rate.
4. Pegged exchange rate system: This system is similar to a fixed exchange rate system,
but with some flexibility. The exchange rate of a currency is fixed to a certain value,
but the central bank can adjust the exchange rate under certain circumstances.
5. Dual or multiple exchange rate system: In this system, there are multiple exchange rates
for a currency, which can create incentives for arbitrage and can lead to distortions in
the economy. This system has been used in some developing countries to manage
foreign exchange transactions.

International Monetary System

The international monetary system refers to the framework of rules, institutions, and
procedures that govern the exchange of currencies and the flow of capital across national
borders. The system plays a crucial role in facilitating international trade and investment.

The international monetary system has evolved over time, with several distinct phases:

1. The gold standard: Under the gold standard, currencies were fixed to a certain weight
of gold. This system was in place from the mid-19th century until the outbreak of World
War I.
2. The interwar period: In the aftermath of World War I, the gold standard was restored,
but with several modifications. However, the system proved to be unstable, and most
countries abandoned it during the Great Depression.
3. The Bretton Woods system: In 1944, the Bretton Woods system was established, which
fixed the value of the US dollar to gold and other currencies were pegged to the US
dollar. This system was in place until 1971 when the US ended convertibility of the
dollar into gold.
 4. The floating exchange rate system: Since 1971, most countries have adopted a floating
exchange rate system, which allows the exchange rate to be determined by market
forces.
5. The recent period: In recent years, there has been increased discussion about the need
for reform of the international monetary system, including the role of the US dollar as
the dominant international reserve currency and the governance of international
financial institutions such as the International Monetary Fund.

Gold Standard in exchange rate system

The gold standard was a monetary system in which the value of a country's currency was fixed
to a certain weight of gold. Under this system, a country's central bank would exchange its
currency for gold at a fixed price, and the country's money supply was tied to the amount of
gold it held. The gold standard was in place in many countries from the mid-19th century until
the outbreak of World War I.

Advocates of the gold standard argue that it provided stability and discipline to monetary
policy, as it limited the ability of central banks to create inflation by printing more money.
However, critics argue that the gold standard was inflexible and could lead to deflationary
pressures during periods of economic growth, as the money supply was tied to the supply of
gold rather than the needs of the economy.

The gold standard was abandoned during World War I, as countries needed to finance their war efforts
and could not do so under the constraints of the gold standard. It was briefly restored in the interwar
period, but most countries abandoned it during the Great Depression. Since then, the gold standard has
not been used as a basis for the exchange rate system of any major economy.

Types of exchange rate

A medium of exchange for goods and services is called currency. In a nutshell, it is money
issued by governments and accepted for payment in the country. It comes in the form of coins
and paper. Every nation has a currency that is widely accepted within its boundaries. For
example, the Indian rupee (₹) in India, the Pound (£) in England, and the Dollar ($) in the
United States of America.

However, a country’s currency cannot be used in another country; For example, the Indian
rupee (₹) can not be directly acceptable in the USA. In today’s world, countries have economic
relations with each other. Thus, there is an increase in interdependence among the countries.
Therefore, in the case of international payments, it has to be first converted into the other
country’s currency after this, it can be used in economic transactions. If an Indian resident
wants to visit the USA, then he/she has to pay in Dollars ($) to stay there, or if an Indian resident
wants to purchase a certain thing from abroad, then he/she has to pay in their respective
currency to purchase that thing.

Thus, for this purpose, the currency of one country is converted into the currency of another
country and the rate at which one currency is exchanged for another is called the Foreign
Exchange Rate or Foreign Rate of Exchange. In simple words, it is the price paid in domestic
currency for buying a unit in foreign currency. For example, If 60 rupees are to be paid to get
one dollar, then the exchange rate, in that case, is $ 1 = ₹ 60.
Types of Foreign Exchange Rates

The three types of exchange rates are:

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1. Fixed Exchange Rate

Under this system, the exchange rate for the currency is fixed by the government. Thus, the
government is responsible to maintain the stability of the exchange rate. Each country
maintains the value of its currency in terms of some ‘external standard’ like gold, silver, another
precious metal, or another country’s currency.

 The main purpose of a fixed exchange rate is to maintain stability in the country’s foreign trade
and capital flows.
 The central bank or government purchases foreign exchange when the rate of foreign currency
rises and sells foreign exchange when the rates fall to maintain the stability of the exchange
rate.
 Thus, government has to maintain large reserves of foreign currencies to maintain a fixed
exchange rate.
 When the value of one currency(domestic) is tied to another currency then this process is known
as pegging and that’s why the fixed exchange rate system is also referred to as the Pegged
Exchange Rate System.
 When the value of one currency(domestic) is fixed in terms of another currency or in terms of
gold, then it is called the Parity Value of currency.

Methods of Fixed Exchange Rate in Earlier Times

1. Gold Standard System (1870-1914): As per this system, gold was taken as the common
unit of parity between the currencies of different countries. Each country defines the value of
its currency in terms of gold. Accordingly, the value of one currency is fixed in terms of another
country’s currency after considering the gold value of each currency.

For example,

1£(UK Pound)= 5g of gold

1$(US Dollar)= 2g of gold

then the exchange rate would be £1(UK Pound) = $2.5(US Dollar)

2. Bretton Woods System (1944-1971): The gold standard system was replaced by the Bretton
Woods System. This system was adopted to have clarity in the system. Even in the fixed
exchange rate, it allowed some adjustments, thus it is called the ‘adjusted peg system of
exchange rate’. Under this system:

 Countries were required to fix their currency against the US Dollar($).

 US Dollar was assigned gold value at a fixed price.
 The value of one currency say £(UK Pound) was pegged in terms of the US Dollar($), which
ultimately implies the value of the currency in gold.
 Gold was considered an ultimate unit of parity.
 International Monetary Fund (IMF) worked as a central institution in controlling this system.
This is the system that was abandoned and replaced by the Flexible Exchange rate in 1977.

Devaluation and Revaluation

Devaluation includes a reduction in the value of the domestic currency in terms of foreign
currencies by the government. Under a fixed exchange rate system, the government undertakes
devaluation when the exchange rate is increased.

Revaluation refers to an increase in the value of the domestic currency by the government.

Devaluation is different from Depreciation in the following ways:

Basis Devaluation Depreciation
Devaluation includes reduction in the Depreciation refers to the decrease in
value of domestic currency in terms the value of domestic currency in terms
Meaning of of
foreign currencies by the government foreign currencies by the government
under a fixed exchange rate system. under a flexible exchange rate system.
Exchange Rate
Fixed exchange rate system. Flexible exchange rate system.
System
It occurs due to market forces of
Occurrence It occurs due to the government. demand
and supply.
Merits of Fixed Exchange Rate System:

1. It ensures stability in the exchange rate. Thus it helps in promoting foreign trade.
2. It helps the government to control inflation in the economy.
3. It stops speculating in the foreign exchange market.
4. It promotes capital movements in the domestic country as there are no uncertainties about
foreign rates.
5. It helps in preventing capital outflow.

Demerits of Fixed Exchange Rate System:

1. It requires high reserves of gold. Thus it hinders the movement of capital or foreign exchange.
2. It may result in the undervaluation or overvaluation of the currency.
3. It discourages the objective of having free markets.
4. The country which follows this system may find it difficult to tackle depression or recession.

Fixed Exchange Rate has been discontinued because of many demerits of the system by all
leading economies, including India.

2. Flexible Exchange Rate System

Under this system, the exchange rate for the currency is fixed by the forces of demand and
supply of different currencies in the foreign exchange market. This system is also called the
Floating Rate of Exchange or Free Exchange Rate. It is so because it is determined by the
free play of supply and demand forces in the international money market.

 Under the Flexible Exchange Rate system, there is no intervention by the government.
 It is called flexible because the rate changes with the change in the market forces.
  The exchange rate is determined through interactions of banks, firms, and other institutions that
want to buy and sell foreign exchange in the foreign exchange market.
 The rate at which the demand for foreign currency is equal to its supply is called the Par Rate
of Exchange, Normal Rate, or Equilibrium Rate of Foreign Exchange.

Merits of Flexible Exchange Rate System

1. With the flexible exchange rate system, there is no need for the government to hold any reserve.
2. It eliminates the problem of overvaluation or undervaluation of the currency.
3. It encourages venture capital in the form of foreign exchange.
4. It also enhances efficiency in the allocation of resources.

Demerits of the Flexible Exchange Rate System

1. It encourages speculation in the economy.

2. There is no stability in the economy as the exchange rate keeps on fluctuating as per demand
and supply.
3. Under this, coordination of macro policies becomes inconvenient.
4. There is uncertainty in the economy that discourages international trade.

3. Managed Floating Exchange Rate

It is the combination of the fixed rate system (the managed part) and the flexible rate system
(the floating part), thus, it is also called a Hybrid System. It refers to the system in which the
foreign exchange rate is determined by the market forces and the central bank stabilizes the
exchange rate in case of appreciation or depreciation of the domestic currency.

 Under this system, the central bank acts as a bulk buyer or seller of foreign exchange to control
the fluctuation in the exchange rate. The central bank sells foreign exchange when the exchange
rate is high to bring it down and vice versa. It is done for the protection of the interest of
importers and exporters.
 For this purpose, the central bank maintains the reserves of foreign exchange so that the
exchange rate stays within a targeted value.
 If a country manipulates the exchange rate by not following the rules and regulations, then it is
known as Dirty Floating.
 However, the central bank follows the necessary rules and regulations to influence the exchange
rate.

Example of Managed Floating Exchange Rate

Suppose, India has adopted Managed Floating System and the Reserve Bank of India (Central
Bank) wants to keep the exchange rate $1 = ₹60. And, let’s assume that the Reserve Bank of
India is ready to tolerate small fluctuations, like from 59.75 to 60.25; i.e., .25.
If the value remains within the above limit, then there is no intervention. But if due to excess
demand for the Indian rupee the value of the rupee starts declining below 59.75/$. Then, in that
case, RBI will start increasing the supply of rupees by selling the rupees for dollars and
acquiring holding of dollars.
Similarly, due to the excess supply of the Indian rupee, if the value of the rupee starts increasing
above 60.25/$. Then, in that case, RBI will start increasing the demand for Indian rupees by
exchanging the dollars for rupees and running down its holding of dollars.
Hence, in this way, the Reserve Bank of India maintains the exchange rate.
Other types of Exchange Rate System

Over the time period, because of the different changes in the global economic events, the
exchange rate systems have evolved. Besides, fixed, flexible, and managed floating exchange
rate systems, the other types of exchange rate systems are:

1. Adjustable Peg System: An exchange rate system in which the member countries fix the
exchange rate of their currencies against one specific currency is known as Adjustable Peg
System. This exchange rate is fixed for a specific time period. However, in some cases, the
currency can be repegged even before the expiry of the fixed time period. The currency can be
repegged at a lower rate; i.e., devaluation, or at a higher rate; i.e., revaluation of currency.
2. Wider Band System: An exchange rate system in which the member country can change its
currency’s exchange value within a range of 10 percent is known as Wider Band System. It
means that the country is allowed to devalue or revalue its currency by 10 percent to facilitate
the adjustments in the Balance of Payments. For example, if a country has a surplus in its
Balance of Payments account, then its currency can be appreciated by maximum of 10% from
its parity value to correct the disequilibrium.
3. Crawling Peg System: An exchange rate system which lies between the dirty floating system
and adjustable peg system is known as Crawling Peg System. In this system, a country can
specify the parity value for its currency and permits a small variation around that parity value.
This rate of parity is adjusted regularly based on the requirements of the International Reserve
of the country and changes in its money supply and prices.
 Case Study

One recent case study on foreign exchange involves the Swiss National Bank's (SNB)
decision to remove the cap on the Swiss franc's exchange rate with the euro in January 2015.
The SNB had set a minimum exchange rate of 1.20 Swiss francs to the euro in 2011, to
prevent the Swiss franc from appreciating too much against the euro, which would have
made Swiss exports more expensive and hurt the country's economy.

However, in early 2015, the European Central Bank (ECB) announced a new program of
quantitative easing, which would increase the supply of euros and potentially weaken its
value. As a result, the SNB decided to remove the exchange rate cap, allowing the franc to
appreciate freely.

The removal of the cap caused an immediate and significant appreciation of the Swiss franc,
which rose by around 30% against the euro and other major currencies. This had a major
impact on Swiss businesses and the economy, as Swiss exports became more expensive and
less competitive on the global market. Many Swiss companies had to cut jobs and reduce
production to cope with the sudden appreciation of the currency.

Question:

Highlight the importance of understanding the complex interaction between two economies.

The SNB's decision to remove the exchange rate cap was controversial, and some criticized
it as a rash and poorly thought-out move. However, others argued that the SNB had little
choice but to remove the cap in the face of the ECB's quantitative easing program, which
posed a serious threat to the stability of the Swiss franc-euro exchange rate. The case
highlights the importance of understanding the complex interactions between different
economies and central banks in the global foreign exchange market, and the potential
impact of policy decisions on businesses and the wider economy.

Challenges faced by foreign exchange market in India

Some of the challenges faced by the foreign exchange market in India include:

1. Regulatory restrictions: The foreign exchange market in India is subject to various

regulations, including restrictions on capital account transactions, which can limit the
flexibility of the market.
2. Volatility: The foreign exchange market in India can be volatile due to factors such as
changes in global commodity prices, geopolitical events, and fluctuations in global
capital flows.
3. Lack of depth: The foreign exchange market in India is not as deep as those in other
major economies, which can result in lower liquidity and wider bid-ask spreads.
 4. Limited participation: The foreign exchange market in India is dominated by a few
large players, with limited participation by smaller players, which can affect market
dynamics.
5. Exchange rate management: The Reserve Bank of India manages the exchange rate of
the Indian rupee, which can lead to interventions in the market that can affect market
outcomes.

Causes of Fluctuations in Exchange Rates

Market rates (or day-to-day rates) of exchange are, however, subject to fluctuations in response
to the supply of and demand for international money transfers.

In fact, there are various factors which affect or influence the demand for and supply of foreign
currency (or mutual demand for each other’s currencies) which are ultimately responsible for
the short-term fluctuations in the exchange rate.

Important among these are:

1. Trade Movements:

Any change in imports or exports will certainly cause a change in the rate of exchange. If
imports exceed exports, the demand for foreign currency rises; hence the rate of exchange
moves against the country. Conversely, if exports exceed imports, the demand for domestic
currency rises and the rate of exchange moves in favour of the country.

2. Capital Movements:

International capital movements from one country for short periods to avail of the high rate of
interest prevailing abroad or for long periods for the purpose of making long-term investment
abroad. Any export or import of capital from one country to another will bring about a change
in the rate of exchange.

3. Stock Exchange Operations:

These include granting of loans, payment of interest on foreign loans, repatriation of foreign
capital, purchase and sale of foreign securities e c., which influence demand for foreign funds
and through it the exchange rates.

For instance, when a loan is given by the home country to a foreign nation, the demand for
foreign money increases and the rate of exchange tends to move unfavourably for the home
country. But, when foreigners repay their loan, the demand for home currency exceeds its
supply and the rate of exchange becomes favourable.

4. Speculative Transactions:

These include transactions ranging from anticipation of seasonal movements in exchange rates
to the extreme one, viz., flight of capital. In periods of political uncertainty, there is heavy
speculation in foreign money. There is a scramble for purchasing certain currencies and some
currencies are unloaded. Thus, speculative activities bring about wide fluctuations in exchange
rates.
5. Banking Operations:

Banks are the major dealers in foreign exchange. They sell drafts, transfer funds, issue letters
of credit, accept foreign bills of exchange, take up arbitrage, etc. These operations influence
the demand for and supply of foreign exchange, and hence the exchange rates.

6. Monetary Policy:

An expansionist monetary policy has generally an inflationary impact, while a constructionist

policy tends to have a deflationary inflation. Inflation and deflation bring about a change in the
internal value of money. This reflects in a similar change in the external value of money.
Inflation means a rise in the domestic price level, fall in the internal purchasing power of
money, and hence a fall in the exchange rate.

7. Political Conditions:

Political stability of a country can help very much to maintain a high exchange rate for its
currency; for it attracts foreign capital which causes the foreign exchange rate to move in its
favour. Political instability, on the other hand, causes a panic flight of capital from the country
hence the home currency depreciates in the eyes of foreigners and consequently, its exchange
value falls.

STABILITY OF EXCHANGE RATES

A stable currency is one that can successfully hold its unit of account or purchasing
power over some time. At a basic level, a currency is stable when the international
currency exchange rates do not fluctuate too much as against the Consumer Price Index
(CPI).
Exchange rates express the value of one country's currency in relation to the value of
another country's currency. The rates play an important part in economics, affecting the
balance of trade between nations and influencing investment strategies. A higher-valued
currency makes a country's imports less expensive and its exports more expensive in
foreign markets. A lower-valued currency makes a country's imports more expensive
and its exports less expensive in foreign markets. A higher exchange rate can be
expected to worsen a country's balance of trade, while a lower exchange rate can be
expected to improve it.

Determinants of Stability in Exchange Rates:

1. Differentials in Inflation:
Typically, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half
of the 20th century, the countries with low inflation included Japan, Germany, and
Switzerland, while the U.S. and Canada achieved low inflation only later. 1 Those
countries with higher inflation typically see depreciation in their currency about the
currencies of their trading partners. This is also usually accompanied by higher interest
rates.
2. Differentials in Interest Rates:
Interest rates, inflation, and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The impact of
higher interest rates is mitigated, however, if inflation in the country is much higher
than in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates – that is, lower interest rates tend to
decrease exchange rates.
3. Current Account Deficits:
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest, and dividends.
A deficit in the current account shows the country is spending more on foreign trade
than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives
through sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt:
Countries will engage in large-scale deficit financing to pay for public sector projects
and governmental funding. While such activity stimulates the domestic economy,
nations with large public deficits and debts are less attractive to foreign investors. The
reason being, a large debt encourages inflation, and if inflation is high, the debt will be
serviced and ultimately paid off with cheaper real dollars in the future. In the worst-
case scenario, a government may print money to pay part of a large debt, but increasing
the money supply inevitably causes inflation. Moreover, if a government is not able to
service its deficit through domestic means (selling domestic bonds, increasing the
money supply), then it must increase the supply of securities for sale to foreigners,
thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners
if they believe the country risks defaulting on its obligations. Foreigners will be less
willing to own securities denominated in that currency if the risk of default is great. For
this reason, the country's debt rating (as determined by Moody's or Standard & Poor's,
for example) is a crucial determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a
greater rate than that of its imports, its terms of trade have favourably improved.
Increasing terms of trade shows' greater demand for the country's exports. This, in turn,
results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports rises
by a smaller rate than that of its imports, the currency's value will decrease in relation
to its trading partners.
6. Strong Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes will
draw investment funds away from other countries perceived to have more political and
economic risk. Political turmoil, for example, can cause a loss of confidence in a
currency and a movement of capital to the currencies of more stable countries.
7. The Bottom Line
The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases
the purchasing power of income and capital gains derived from any returns. Moreover,
the exchange rate influences other income factors such as interest rates, inflation and
even capital gains from domestic securities. While exchange rates are determined by
numerous complex factors that often leave even the most experienced economists
flummoxed, investors should still have some understanding of how currency values and
exchange rates play an important role in the rate of return on their investments.

Determination of Exchange rate

Exchange rates are determined by the forces of supply and demand in the foreign exchange
market. Essentially, exchange rates reflect the value of one currency in terms of another
currency. When the demand for a currency increases relative to its supply, its exchange rate
tends to appreciate or increase, while a decrease in demand relative to supply tends to cause its
exchange rate to depreciate or decrease.

Factors that can influence the demand and supply of a currency in the foreign exchange market
include:

1. Interest rates: Generally, higher interest rates tend to attract foreign investors seeking
higher returns, thereby increasing demand for a currency, and vice versa.
2. Inflation: Higher inflation tends to decrease the value of a currency, as it erodes the
purchasing power of that currency.
3. Economic performance: Strong economic performance tends to increase demand for a
currency, while weak economic performance tends to decrease demand.
4. Political stability: A stable political environment tends to increase demand for a
currency, while political instability can decrease demand.
5. International trade: A country with a high volume of exports relative to imports tends
to have a higher demand for its currency, as foreign buyers need to purchase that
currency to pay for the goods.
6. Speculation: Speculators can also influence exchange rates by buying or selling
currencies based on anticipated changes in demand and supply.

Central banks and governments can also influence exchange rates through policies such as
monetary policy, fiscal policy, and foreign exchange interventions. For example, a central bank
may use monetary policy tools such as interest rate adjustments or quantitative easing to
influence the value of its currency. Governments may also use policies such as trade restrictions
or currency controls to influence the demand and supply of their currencies.

There are numerous methods of calculating the exchange rate of currencies. Some popular
methods are -

 Floating Exchange Rate

 Fixed Exchange Rate
 Flexible Exchange Rate.
Floating Exchange Rate

An exchange rate that is not fixed is called a flexible exchange rate. The flexible exchange rate
fluctuates from one value to another. The market determines whether the exchange rate moves
or not. The term "floating currency" is used to indicate any currency subject to a floating
regime.

For example, the US dollar is an example of a floating exchange currency.

Floating rates are notable and are very popular among economists. The believers in a free
market are of the mindset that markets should determine the currency value. The USD values
usually decline when crude oil prices rise, for example. So, the crude oil prices and USD
currency value are inversely related. Therefore, the USD value fluctuates freely because oil
prices fluctuate daily.

Economists are of the point of view that markets generally correct themselves frequently. Most
major economies are generally dependent on floating exchanges because of little government
intervention. These countries are popularly known as 'First World Countries'.

Flexible Exchange Rate

The flexible exchange rate is called pegged exchange rate system because of government
intervention. The value of a currency is maintained either to certain currencies’ values–either
collectively or individually–or to the reserves of gold and foreign currencies available in the
given country.

Fixed Exchange Rate

China is probably the most famous example of fixed exchange regimes. A fixed-rate regime
also used to exist under the former Soviet Union. It must be noted that the flexible exchange
rate is not solely determined by market forces. If the foreign exchange market fluctuates
widely, the central banks will have to sell or buy currency reserves.

Speculation

Money is an asset for every nation. Therefore, citizens of one country may hold reserves of
foreign exchange from another country as an asset. Therefore, Indians will be more interested
in the value of the USD if they think that the value of their own currency will fluctuate in the
near future. When people hold foreign exchange to get a benefit from the changing values, the
currency values are affected by it.

Interest rates

The difference in interest rates of different countries also plays a major role in the determination
of the value of exchange rates. In order to get more returns, banks, MNCs, and affluent
investors invest money around the globe. This also affects the exchange rates to a large extent
for a country.

Exchange Rates in the Long Run

To make long-term predictions of the exchange rate, purchasing power parity or PPP can be
used in an exchange rate structure that is flexible. According to theory, if a business does not
have any frontier to cross such as quotas (quantitative controls on imports), and taxation (tariffs
on business), then exchange rates will gradually adjust so that the same products cost the same
price regardless of location.

Therefore, whether one is transferring it into rupees in India, yen in Japan, or dollars in the US,
the value of the currency must be the same in terms of exchange rates.

Pegged Floating Exchange Rates

There are three hybrid domains in this system. Governments and Central Banks are capable of
controlling foreign exchange rates by intervening in the markets. However, the rates are mostly
determined by existing market forces.

Crawling Bands

In such a regime, the central bank allows fluctuations in a currency exchange rate until a
specific range that is usually set in advance is reached. The authorities intervene in the system
once the range is breached. These ranges are generally determined by monetary and economic
policies.

For example, let's say that the government of a hypothetical country has set a crawling band
for its currency, the "Hypothetical dollar" (HYD), against the US dollar (USD). The crawling
band is set with an upper and lower limit for the exchange rate, say HYD 1.00 = USD 0.75 at
the lower end of the band and HYD 1.00 = USD 0.85 at the upper end of the band.

If the exchange rate moves towards the upper end of the band, meaning that the HYD is getting
stronger against the USD, the central bank will sell its HYD reserves and buy USD in the
foreign exchange market. This increases the supply of HYD in the market, which tends to
weaken the HYD and push the exchange rate back down towards the lower end of the band.
On the other hand, if the exchange rate moves towards the lower end of the band, the central
bank will buy HYD and sell USD to reduce the supply of HYD in the market, strengthening
the currency and pushing the exchange rate back up towards the upper end of the band.

By using a crawling band system, the central bank can manage the exchange rate to some extent
while still allowing for some flexibility in the market. This can help promote stability in the
currency and reduce volatility in the foreign exchange market.

Crawling Pegs

In this system, the Central Bank of a country allows its currency exchange rate to appreciate or
depreciate gradually on international markets. The currency will float if there are any market
uncertainties. However, the authorities will interfere if appreciations or depreciations are
swiftly followed by one another. Such instances have already happened in Vietnam, Argentina,
and Costa Rica.
For example, let's say that the government of a hypothetical country has set a crawling peg for
its currency, the "Hypothetical dollar" (HYD), against the US dollar (USD), with a crawl rate
of 1% per month. If the initial exchange rate is HYD 1.00 = USD 0.75, then after one month
the new exchange rate would be HYD 1.01 = USD 0.7575. After another month, the new
exchange rate would be HYD 1.0201 = USD 0.7651, and so on.

The crawling peg system allows for some flexibility in the exchange rate over time, which can
help reduce the need for large adjustments to the exchange rate all at once. This can be useful
in managing external imbalances and reducing the impact of sudden changes in the exchange
rate on the economy.

However, a crawling peg system also requires careful management by the central bank to
ensure that the exchange rate remains within a sustainable range. If the crawl rate is set too
high, it can lead to excessive appreciation of the currency and hurt the competitiveness of the
country's exports. On the other hand, if the crawl rate is set too low, it can lead to excessive
depreciation of the currency and inflationary pressures in the economy.

Horizontally Pegged Bands

It resembles the crawling bands to some extent. In such a case, the Central Bank allows the
currencies to fluctuate increasingly freely until the exchange rate does not go above 1% of the
gross value of the currency.

For example, let's say that the government of a hypothetical country has set a horizontally
pegged band for its currency, the "Hypothetical dollar" (HYD), against the US dollar (USD).
The band is set with an upper and lower limit for the exchange rate, say HYD 1.00 = USD 0.75
at the lower end of the band and HYD 1.00 = USD 0.85 at the upper end of the band.

If the exchange rate moves towards the upper end of the band, the central bank will intervene
by selling its HYD reserves and buying USD in the foreign exchange market to bring the
exchange rate back down within the band. On the other hand, if the exchange rate moves
towards the lower end of the band, the central bank will intervene by buying HYD and selling
USD to bring the exchange rate back up within the band.

The horizontally pegged band system provides a fixed exchange rate within a certain range,
which can be useful for promoting trade and investment between countries with different
currencies. However, the system can also be vulnerable to external shocks and may require
significant intervention by the central bank to maintain the exchange rate within the band.

Moreover, maintaining a fixed exchange rate band can limit the flexibility of the country's
monetary policy, as the central bank may need to adjust interest rates and other policy tools to
keep the exchange rate within the band. In addition, a fixed exchange rate can make it difficult
for a country to adjust to changes in global economic conditions, such as changes in trade
patterns, shifts in capital flows, and fluctuations in commodity prices.

Theories of Exchange rate Determination

1. Mint Parity theory

Mint Parity Theory, also known as the Specie-Flow Mechanism, is a theory of exchange rate
determination that was developed in the 19th century. According to this theory, the exchange
rate between two currencies is determined by the relative supply and demand for gold, which
was the dominant international currency at the time.

The theory is based on the assumption that there are fixed exchange rates between countries
and that gold is used as a medium of exchange in international trade. If one country experiences
an inflow of gold, its money supply increases, leading to inflation and a decrease in the value
of its currency. This makes its exports more competitive and increases demand for its goods,
leading to a decrease in the country's gold reserves.

On the other hand, if a country experiences an outflow of gold, its money supply decreases,
leading to deflation and an increase in the value of its currency. This makes its imports more
competitive and decreases demand for its goods, leading to an increase in the country's gold
reserves.

The Mint Parity Theory suggests that over time, these changes in the supply and demand for
gold will lead to a re-alignment of exchange rates between countries, as the value of each
currency adjusts to reflect the relative supply and demand for gold. However, this theory has
largely been discredited as a result of the breakdown of the gold standard and the adoption of
flexible exchange rates.

The price at which the standard currency unit of the country was convertible into gold
was called as the mint price. Suppose the official price of gold in Britain was £ 20 per
ounce and in the United States it was $ 80 per ounce, these were the mint prices of gold
in the two countries. The rate of exchange between these two currencies would be
determined as £ 20 = $ 80 or £ 1 = $ 4.

2. The Purchasing Power Parity Theory:

The idea originated with the School of Salamanca in the 16th century, and was developed
in its modern form by Gustav Cassel in 1916, in The Present Situation of the Foreign
Trade. Purchasing power parity (PPP) is a theory which states that exchange rates
between currencies are in equilibrium when their purchasing power is the same in each
of the two countries. One popular macroeconomic analysis metric to compare economic
productivity and standards of living between countries is purchasing power parity
(PPP). PPP is an economic theory that compares different countries' currencies through
a "basket of goods" approach.

Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that
compares different countries' currencies through a "basket of goods" approach.
• Purchasing power parity (PPP) allows for economists to compare economic
productivity and standards of living between countries.
• Some countries adjust their gross domestic product (GDP) figures to reflect PPP.
Drawbacks of Purchasing Power Parity
Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s
(MCD) Big Mac hamburger across many countries. Their study results in the famed
"Big Mac Index". In "Burgernomics"—a prominent 2003 paper that explores the Big
Mac Index and PPP— authors Michael R. Pakko and Patricia S. Pollard cited the
following factors to explain why the purchasing power parity theory is not a good
reflection of reality.
Transport Costs
Goods that are unavailable locally must be imported, resulting in transport costs. These
costs include not only fuel but import duties as well. Imported goods will consequently
sell at a relatively higher price than do identical locally sourced goods.
Tax Differences
Government GST can spike prices in one country, relative to another.
Government Intervention
Tariffs can dramatically augment the price of imported goods, where the same products
in other countries will be comparatively cheaper.

3. The Balance of Payment Theory

It is the foundation of what is known in modern economic studies as the quantity theory
of money, the neutrality of money and the consideration of interest rates not as a
monetary phenomenon, but a real one. Adam Smith built on this foundation. There are
three components of balance of payment viz;

Current Account
The current account is used to monitor the inflow and outflow of goods and services
between countries. This account covers all the receipts and payments made with respect
to raw materials and manufactured goods.
Capital Account
All capital transactions between the countries are monitored through the capital account.
Capital transactions include the purchase and sale of assets (non-financial) like land and
properties. The capital account also includes the flow of taxes, purchase and sale of
fixed assets etc by migrants moving out/into a different country. The deficit or surplus
in the current account is managed through the finance from the capital account and vice
versa. There are 3 major elements of a capital account:
Financial Account
The flow of funds from and to foreign countries through various investments in real
estates, business ventures, foreign direct investments etc is monitored through the
financial account. This account measures the changes in the foreign ownership of
domestic assets and domestic ownership of foreign assets. On analyzing these changes,
it can be understood if the country is selling or acquiring more assets (like gold, stocks,
equity etc).
• The Balance of Payments Theory: The balance of payments theory of exchange rate
holds that the price of foreign money in terms of domestic money is determined by
the free forces of demand and supply in the foreign exchange market. It follows
that the external value of a country's currency will depend upon the demand for and
supply of the currency.

4. Interest rate parity (IRP): It is a theory according to which the interest rate
differential between two countries is equal to the differential between the
forward exchange rate and the spot exchange rate.

For example, if the interest rate in Country A is 3% and the interest rate in Country B is
5%, then according to interest rate parity, the expected exchange rate between the
currencies of Country A and Country B should change in a way that compensates for the
difference in interest rates. If the expected exchange rate does not change in this way,
then there is an opportunity for investors to profit from the difference in interest rates by
borrowing in the low-interest-rate country and investing in the high-interest-rate country.

Interest rate parity is an important concept in international finance and can help explain
the behavior of exchange rates and the flows of capital between countries. However, in
practice, there are many factors that can affect exchange rates and interest rates, making
interest rate parity a useful but not perfect tool for understanding international financial
markets.