Forex market, types of exchange rates, exchange rate theories, BOP

1. Foreign Exchange and Balance of
Payments

2. Definition of Foreign Exchange
• According to Hartly Wethers, “Foreign
exchange is the art and science of
international monetary exchange”.

3. Importance of Foreign Exchange
• For availing services such as education,
tourism, healthcare, insurance, banking,
hospitality etc
• For import purposes
• Transfer of purchasing power
• Transfer of funds

4. Foreign Exchange Regulation Act
• Legislation passed by the Indian paliament in
1973, and came into force from January 1, 1974
• Consisted of 81 sections
• Emphasized strict exchange control
• Control everything that was specified, relating to
foreign exchange
• Law violators were treated as criminal offenders
• Aimed at minimizing dealings in foreign exchange
and foreign securities

5. Objectives of FERA
• To regulate certain payments
• To regulate dealings in foreign exchange and
securities
• To regulate transactions, indirectly affecting
foreign exchange
• To regulate import and export of the currency
• To conserve precious foreign exchange
• To promote economic development of the
country

6. Foreign Exchange Management Act
(FEMA)
• Introduced as a replacement of FERA in 1999
• Contains 49 sections
• Violation of FEMA is a civil offence
• More concerned with management than
regulation or control
• Regulatory mechanism that enables the RBI
and Central government to pass regulations
and rules relating to foreign exchange in tune
with the Foreign Trade Policy of India

7. Objectives of FEMA
• Promoting orderly development and
maintenance of Foreign exchange market in
India
• Facilitate external trades and payments
• Consolidate and amend the law relating to
foreign exchange
• To remove imbalance of payments
• Regulation of employment business and
investments of non-residents

10. Foreign Exchange Market
• According to Ellsworth, “A foreign Exchange
market comprises of all those institutions and
individuals who buy and sell foreign exchange
which may be defined as foreign money or any
liquid claim on foreign money”.

11. Functions of Foreign exchange Market
• Transfer Function
• Credit Function
• Hedging Function

12. Quoting a currency
• Direct quote (USD/INR)
Rs. 73.39/$
• Indirect quote (INR/USD)
1/73.39 = $0.014/Rs

13. Bid, Ask and Spread

14. Forex Market Intermediaries
• Commercial Banks
• Investment Banks
• Foreign exchange brokers
• Governments and Central Banks
• Consumers and Travellers
• Businesses
• Investors and Speculators

15. Purpose of the intermediaries
• Payment settlements
• Hedging
• Speculation
• Intermediation
• Intervention
• Arbitration
For example £1 = Rs.95.08, $1 = 73.61, £1 =
$1.29

16. American Depository Receipts(ADRs)
• A negotiable certificate issued by a U.S. bank
representing a specified number of share in a
foreign stock that is traded on a U.S.
exchange.
• ADRs are listed on the NYSE, AMEX or
NASDAQ as well as OTC

17. Features
• Denominated in US Dollars
• Dividend also payable in US Dollars
• Listed on American stock exchange
• A single ADR can represent more than one
share in a foreign company
• Holder of ADR can get it converted into shares
• Have no right to vote in a company

18. Types of ADRs

20. Disadvantages
• Limited Selection
• Exchange rate fluctuation
• Strict action by SEC for any violation
• Liquidity

22. Global Depository Receipts(GDRs)
• global equivalent of the original American
depositary receipts (ADR)
• Negotiable instrument which is denominated in
some freely convertible currency
• enable a company, the issuer, to access investors
in capital markets outside of its home country
• it may be converted into number of shares
• it is listed and traded in the stock exchange
• Unsecured securities

23. • The domestic company enters into an agreement
with the overseas depository bank for the purpose of
issue of GDR.
• The overseas depository bank then enters into a
custodian agreement with the domestic custodian of
such company.
• The domestic custodian holds the equity shares of
the company.
• On the instruction of domestic custodian, the
overseas depository bank issues shares to foreign
investors.
• The whole process is carried out under strict
guidelines.

26. Indian Depository Receipts(IDRs)
• Standard Chartered Bank created history in
the Indian Capital Market by becoming the
first foreign company to come up with an IDR
issue.
• Terminated on June 15,2020

27. Foreign Exchange Rate
• According to P G Apte, “An exchange rate is
the relative price of one currency in terms of
another”.

28. Types of Foreign Exchange rates
• Spot Rate
• Forward Rate
• Fixed Exchange Rate
• Floating Exchange Rate
• Direct exchange rate
• Indirect exchange rate
• Buying and selling rate(Bid and Ask)

29. Factors affecting foreign exchange rate
• Monetary Policy
• Political Situation
• Balance of Payments
• Interest Rates
• Market Sentiments
• Speculation
• Inflation
• Government Debt
• Economic growth/recession
• Terms of trade

30. Theories relating to exchange rate
determination

31. Purchasing Power Parity(PPP) Theory
• Absolute PPP
Suppose 10 units of commodity X, 12 units of
commodity Y and 15 units of commodity Z can
be bought through spending Rs. 1500 and the
same quantities of X, Y and Z commodities can
be bought in the United States at an outlay of
25 dollars. It signifies that the purchasing
power of 25 dollars is equivalent to that of Rs.
1500 in their respective countries.

32. • The exchange rate between them can be
expressed as:

34. Relative PPP
In the above expression, R1 is the rate of exchange
in the current period and R0 is the rate of exchange
in the base period or the original rate of exchange.
PB1 and PB0 are the price indices in country B in the
current and base periods respectively. PA1 and
PA0 are the price indices in the current and base
periods respectively in the country A.

35. It shows that rupee has depreciated while dollar has
appreciated between the two periods.
If the price level in India (B) has risen between the two
periods at a relatively lesser rate than in the U.S.A., the
exchange rate of rupee with dollar will appreciate. The
dollar on the opposite will show some depreciation.

36. Thus rupee has appreciated while the dollar has
depreciated between the two time periods.

38. Assumptions
• There are no transportation costs
• There are no trade barriers
• Perfect information
• Goods and services are perfectly
interchangeable

39. Criticisms
• Transportation costs
• Trade restriction
• Perfect information
• Effect of nontraded costs
• It ignores many real determinants
• The theory overlooks the influence of demand
and supply factors in foreign exchange

40. • The theory holds good in the long run
• The theory involves a practical difficulty of
measuring the true purchasing power of a
currency
• The theory neglects capital transactions in
international economic relations
• The theory applies to a stationary world

41. Balance of Payments Theory
• A deficit in the balance of payments of a country
signifies a situation in which the demand for
foreign exchange (currency) exceeds the supply of
it at a given rate of exchange.
• The demand pressure results in an appreciation
in the exchange value of foreign currency. As a
consequence, the exchange rate of home
currency to the foreign currency undergoes
depreciation.

42. • A balance of payments surplus signifies an
excess of the supply of foreign currency over
the demand for it. In such a situation, there is
a depreciation of foreign currency but an
appreciation of the currency of the home
country.
• The equilibrium rate of exchange is
determined, when there is neither a BOP
deficit nor a surplus. In other words, the
equilibrium rate of exchange corresponds with
the BOP equilibrium of a country.

44. Criticism
• It assumes perfect competition and non-intervention
of the government in the foreign exchange market.
• The theory does not explain what determines the
internal value of a currency
• It unrealistically assumes the balance of payments to
be at a fixed quantity.
• According to the theory, there is no causal connection
between the rate of exchange and the internal price
level.
• The theory is indeterminate at a time. It states that the
balance of payments determine the rate of exchange.
However, the balance of payments itself is a function of
the rate of exchange. Thus, there is a tautology, so
what determines what, is not clear

45. Monetary Approach
• the demand for money depends upon the
level of real income, the general price level
and the rate of interest.
• The demand for money is the direct function
of the real income and the level of prices.
• On the other hand, it is an inverse function of
the rate of interest.
• this approach depends upon the PPP theory

46. • For instance, if the Reserve Bank of India
increases the supply of money by 20 percent,
it may cause a 20 percent rise in price level
and 20 percent depreciation of rupee relative
to, say dollar, over the long period. The rate of
interest, given the demand for money, is
however likely to fall.

47. • Md1 = MS1
• Md2 = MS2
• The subscripts 1 and 2 denote the two countries.
• MS1 = K1P1Y1
• Md2 = K2P2Y2
• Here K1 and K2 are the desired rates of nominal
money balances to nominal national income in two
countries. P1 and P2 are the price levels in two
countries and Y1 and Y2 are the real national
incomes or outputs in the two countries.

48. If K2 and Y2 in the U.S.A. and K1 and Y1 in India remain
unchanged, R will remain unchanged so long as MS1 and
Ms2 remain constant. The changes in R is directly
proportional to change in MS1and inversely proportional to
changes in MS2.

49. • Start with the domestic central bank suddenly increase
the money supply by a substantial amount, with all
other domestic and foreign variables kept unchanged.
The quantity theory of money implies that the rise of
money supply without increase in real output will
drives up the domestic price level, which means
inflation also. The increase in domestic price level will
induce domestic people to buy more foreign products
and cause the exchange rate to depreciate. This is the
same equilibrating mechanism described in PPP.
• If the foreign central bank increase money supply, the
foreign currency would depreciate as by our previous
analysis. Then, in turn, the domestic currency would
appreciate relatively.

50. Portfolio Balance Approach
• the domestic and foreign financial assets such as
bonds to be imperfect substitutes.
• the exchange rate is determined in the process of
equilibrating or balancing the demand for and
supply of financial assets out of which money is
only one form of asset.
• Assumes perfect capital mobility without capital
controls and similar barriers to investment
• home country wealth W = M + B + SF
where M - domestic money, B - domestic bonds
SF - value of foreign bonds F

51. • To start with, this approach postulates that an increase
in the supply of money by the home country causes an
immediate fall in the rate of interest. It leads to a shift
in the asset portfolio from domestic bonds to home
currency and foreign bonds. The substitution of foreign
bonds for domestic bonds results in an immediate
depreciation of home currency. This depreciation, over
time, causes an expansion in exports and reduction in
imports.
• It leads to the appearance of a trade surplus and
consequent appreciation of home currency, which
offsets part of the original depreciation. Thus the
portfolio balance approach explains also exchange
over-shooting. This explanation, in contrast to the
monetary approach, brings in trade explicitly into the
adjustment process in the long run.

52. Criticisms
• It ignores real income as a determinant
• Does not deal with trade flows
• Assigns no role to expectations
• Does not integrate financial and commodity
markets in the short run and long run

53. Interest Rate Parity
• the differential between the interest rates of two
countries remains equal to the differential calculated
by using the forward exchange rate and the spot
exchange rate techniques
• According to this theory, there will be no arbitrage in
interest rate differentials between two different
currencies and the differential will be reflected in the
discount or premium for the forward exchange rate on
the foreign exchange.
• The theory also stresses on the fact that the size of the
forward premium or discount on a foreign currency is
equal to the difference between the spot and forward
interest rates of the countries in comparison.

54. Assumptions
• The purchasing power parity (PPP) does not hold
• The exchange rate is expected unchanged
• Only three (3) assets are available for investment
for each household: money, domestic bonds, and
foreign bonds
• Bonds are not perfect substitutes
• Assumes perfect capital mobility without capital
controls and similar barriers to investment

56. • Covered Interest Rate Parity (CIRP) According
to Covered Interest Rate theory, the exchange
rate forward premiums (discounts) nullify the
interest rate differentials between two
sovereigns. In other words, covered interest
rate theory says that the difference between
interest rates in two countries is nullified by
the spot/forward currency premiums so that
the investors could not earn an arbitrage
profit.

57. • Uncovered Interest Rate Parity (UIP)
Uncovered Interest Rate theory says that the
expected appreciation (or depreciation) of a
particular currency is nullified by lower (or
higher) interest. This method is known as
uncovered, as the risk of exchange rate
fluctuation is imminent in such transactions.

58. • The current spot rate is Rs. 43/USD. The
nominal interest rates in India and the USA are
11.67% and 5% respectively; the one-year
Rs/$ forward rate is Rs. 45.2500/$. An investor
with a one- year holding period can borrow
Rs. 43,000, or $ 1,000. Is covered interest
arbitrage possible?

59. The investor would act as follows:
• Borrow $1,000 for 1 year at 5% p.a. Amount repayable
= $1,000 (1.05) = $1,050
• Convert dollars borrowed at spot rate into rupees =
$1,000 x Rs. 43 = Rs. 43,000
• Invest in rupee-denominated securities for one year.
Amount receivable = Rs. 43,000(1.1167) = Rs.
48,018.10
• Sell rupee proceeds receivable forward at FX/Y. He will
receive – Rs. 48,018.10 ÷ Rs. 45-2500 = $1,061.17
At the end of the year:
• Receive rupee investment plus interest, Rs. 48,018.10
• Honour the forward contract. Give Rs. 48,018.10 and
get $1,061.17
• Repay the dollar loan plus interest ($1,050). The profit
= $1,061.17 – $1,050 = $11.70.

60. Balance of Payments

61. Definition
• According to Sloman and John “Balance of
Payment is an accounting record of all
monetary transactions between a country and
the rest of the world”

62. A country has to deal with other
countries in respect of the following
• Visible items
which include all types of physical goods
exported and imported.
• Invisible items
which include all those services whose export
and import are not visible. e.g. transport services,
medical services etc.
• Capital transfers
which are concerned with capital receipts and
capital payment.

63. Features
• It is a systematic record of all economic
transactions between one country and the rest of
the world.
• It includes all transactions, visible as well as
invisible.
• It relates to a period of time. Generally, it is an
annual statement.
• It adopts a double-entry book-keeping system. It
has two sides: credit side and debit side. Receipts
are recorded on the credit side and payments on
the debit side.

64. Balance of Trade
• The difference between a country's imports
and its exports. Balance of trade is the largest
component of a country's balance of
payments.
• When exports are greater than imports than
the BOT is favourable and if imports are
greater than exports then it is unfavourable

66. Importance of Balance Of Payments
• BOP records all the transactions that create
demand for and supply of a currency.
• Judge economic and financial status of a country
in the short-term
• BOP may confirm trend in economy’s
international trade and exchange rate of the
currency. This may also indicate change or
reversal in the trend.
• This may indicate policy shift of the monetary
authority (RBI) of the country.

67. The General Rule in BOP Accounting
• If a transaction earns foreign currency for the
nation, it is a credit and is recorded as a plus
item.
• If a transaction involves spending of foreign
currency it is a debit and is recorded as a negative
item.
• Debit items include imports, foreign aid, domestic
spending abroad and domestic investments
abroad.
• Credit items include exports, foreign spending in
the domestic economy and foreign investments
in the domestic economy.

68. The various components of a BOP
statement
• Current Account
• Capital Account
• Reserve Account
• Errors & Omissions

69. Current Account
• Merchandise exports & imports
 Exports = credit entry ( i.e. claims on
foreigners)
 Imports = debit entry (i.e.claims on home
country)
• Invisibles include:
 non factor services exports and imports:
travel, transportation, insurance,
communication, construction, financial,
software, news agency, royalties,
management and business services

70. Interest, Profits and Dividends
If received = credit entry
If paid = debit entry
Unilateral Transfer Account
One-sided transactions
Include private remittances, gifts, govt grants,
pension payments, disaster relief, etc.
If received = credit;
If paid = debit

71. Capital Account
• Foreign Investments
 Foreign Direct Investments
 Foreign Portfolio Investments
• Short term borrowings
• Medium and Long term borrowings

72. Errors & Omissions
• The entries under this head relate mainly to
leads and lags in reporting of transactions
• It is of a balancing entry and is needed to
offset the overstated or understated
components.

73. Official reserves Account
• Official reserves represent the holdings by the
Government (or official agencies) of the means of
payment that are generally accepted for the
settlement of international claims.
• The changes in Official Reserves are necessary to
account for the deficit or surplus in the balance of
payments
• It includes SDRs, gold, Foreign exchange reserve
and borrowings from IMF
• If deficit = credit entry
If Surplus = Debit entry

76. • Balance of Payment is at equilibrium when
Receipts are equal to the payments
• Types of Equilibrium in BOP
 Static Equilibrium
 Dynamic Equilibrium
• Balance of Payment is at Disequilibrium when
Receipts are not equal to the payments
• Deficit(Reciepts<Payments)
Surplus(Reciepts>Payments)

77. Types of Disequilibrium
• Structural Disequilibrium
• Cyclical Disequilibrium
• Short-run Disequilibrium
• Long-run Disequilibrium
• Monetary Disequilibrium

78. Structural Disequilibrium
• Two types namely, Structural Disequilibrium at
Goods level and Structural Disequilibrium at
Factors level
• Structural disequilibrium at the goods level
occurs when a change in demand or supply of
exports or imports alters a previously existing
equilibrium or when a change occurs in the basic
circumstances under which income is earned or
spent abroad, in both cases without the requisite
parallel changes elsewhere in the economy.

79. • Structural disequilibrium at the factor level
results from factors which fail to reflect
accurately factor endowments i.e., when
factor prices, out of line with factor
endowments, distort the structure of
production from the allocation of resources
which appropriate factor prices would have
indicated.

80. Some of the important causes of structural
disequilibrium are as follows :-
• If the foreign demand for a country's products
decline due to the discovery of cheaper
substitutes abroad, then the country's export
will decline causing a deficit.
• If the supply position of a country is affected
due factors like crop failure, shortage of raw-
materials, strikes, political instability, etc, then
there would be the deficit in the balance of
payments.

81. • Changes in the rate of international capital
movements may also cause structural
disequilibrium.
• A war also results in structural changes which
may affect not only goods but also factor of
production causing a disequilibrium in balance
of payments.
• A shift in demand due to the changes in
tastes, fashions, income, etc, would increase
or decrease the demand for imported goods
causing a disequilibrium in the balance of
payments.

82. Cyclical Disequilibrium
• Occurs because of two reasons
• Trade Cycles follow different paths and
patterns in different countries
• Income and Price elasticity of demand for
imports differs in different countries

83. • It is possible that different phases of trade cycles
like depression, prosperity, boom, recession, etc,
may disturb terms of trade and cause
disequilibrium in balance of payments.
• For instance, during boom period, imports may
increase considerably due to increase in demand
for imported goods. During recession and
depression, imports may be reduced due to fall in
demand on account of reduced income.
• During boom period, a country may face deficit in
its BoP position on account increase in imports.
However, during recession its export may
increase, and as such BoP position may show
surplus.

84. • When prices rise in prosperity, a country with
more elastic demand for imports will
experience a decline in the value of imports,
thus leading to a surplus in the balance of
payments. Conversely, as prices decline in
depression, more elastic demand will increase
imports and cause a deficit in the balance of
payments.

85. Short run Disequilibrium
• Disequilibrium caused on a temporary basis
for a short period, say one year is called short
run disequilibrium
• does not pose a serious threat
• caused due to international borrowing and
lending
• Arises due to contingencies like failure of
rains, favourable monsoons, strikes, industrial
peace or unrest

86. Long run or Secular Disequilibrium
• The IMF terms such disequilibrium as
"Fundamental Disequilibrium“
• refers to a persistent deficit or a surplus in the
balance of payments also known as secular
disequilibrium
• Permanent changes in the conditions of
demand and supply of exports and imports
cause fundamental disequilibrium

87. • A developing country in its initial stages may
import large amount of capital & hence its
imports would exceeds exports.
• Deep rooted dynamic changes like capital
formation, innovations, technological
advancements, growth of population etc. also
contribute to fundamental disequilibrium
• When there is a continuous increase in the stock
of gold and foreign exchange reserves there is a
persistent surplus & vise-versa
• When there is a series of short-run disequilibrium
in a country's balance of payments, ultimately it
would lead to fundamental disequilibrium

88. Monetary Disequilibrium
• takes place on account of inflation or deflation
• Due to inflation, the prices of the products in
the domestic market rises, and therefore,
export items will become expensive
• Inflation also results in to increase in money
income with the people, which in turn may
increase demand for imported goods
• As a result imports increases in comparison to
exports

89. • Due to deflation, the prices of the products in
the domestic market falls, and therefore,
export items will become cheap and less
expensive
• Deflation also results in decrease in money
income with the people, which in turn may
decrease demand for imported goods
• As a result exports increases in comparison to
imports

90. Causes of Disequilibrium in BOP
• Import related causes
 Population growth
 Development programs
 Imports of Essential Items
 Reduction of import duties
 Inflation
 Demonstration effect

91. • Export Related Causes
 Increase in population
 Inflation
 Appreciation of currency
 Discovery of substitutes
 Technological developments
 Protectionist trade policy

92. • Other Causes
 Flight of Capital
 Globalization
 Cyclical Transmission
 Structural adjustments
 Political factors

93. Measures to correct Disequilibrium
• Monetary measures
 Monetary policy
o Inflation:- Control money supply by
increase in CRR, SLR, Bank rate etc
o Deflation:- Increase money supply by
increase in CRR, SLR, Bank rate etc
 Fiscal policy
o Inflation:- Easy policy like reduced
corporate taxes
o Deflation:- Restrictive policy like
additional taxes

94.  Exchange rate policy
o Depreciation
o Devaluation
• Non- Monetary/General Measures
 Tariffs
 Quotas
 Export promotion
 Import substitution