1. International Payment
Mechanism

2. International Payment Mechanism

Mechanism available for settlement of International Transactions

Through international payment domestic currency of one country is
converted into the currency of another country through foreign
exchange market.

Three major form of international money are
1) Gold
2) Foreign Reserve currencies
3) SDR – Special Drawing Rights

3. Instruments of External Payments
1. Foreign Bills of Exchange:
It is a customary form of making international payments.
A written request or an order form between two transacting parties.
2. Cheques and Bank Drafts
3. Telegraphic Transfers:
Transferred by cable or telax
4. Mail Transfer:

4. Foreign Exchange Market
Is a market in which currencies of different countries are bought & sold
by individuals, firms, banks & brokers
Central
Banks
Control & regulate to ensure it works in
orderly fashion. Lenders of last resort.
Prevents violent fluctuations in Ex rate
Brokers
Facilitators of foreign currency to Banks
Help in striking deals on a commission basis
They do not buy or sell themselves.
Commercial Banks
Providers of foreign currency to users
Quote daily buying & selling rates
Manage the demand & supply for a currency
Exporters, Importers,
Tourists, Investors, Immigrants
Actual users.
They are the buyers & sellers of foreign
currencies

5. Function of Foreign Exchange
Market?
FE market is a market in which foreign Exchange transactions take
place
1) Transfer of Purchasing Power:
Transfer funds from one country to another for facilitating
international trade and capital movement.
2) Provision of Credit:
Growth of Foreign Trade
3) Minimising Risk: - “ Hedging”

6. The FE Markets
It classified on the basis of nature of Transaction
FE Market
Spot Market
Forward Market

7. The Markets

Spot Markets

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When buyers & sellers of a currency settle their transaction within
2 days of the deal – it is called spot transaction
Spot sale & purchase – makes it spot market
And the rate – is spot rate
For all practical purposes – spot rate is the prevailing exchange
rate
Forward Markets



When buyers & sellers enter an agreement to buy & sell a foreign
currency after 90 days of the deal – it is called
forward transaction
Sale & purchase transaction after 90 days – makes it
forward market
And the settled rate – is forward rate

8. The Transactions
Hedging

Is settling the exchange rate in advance for a future transaction with
a view to avoiding loss that might arise due to exchange
depreciation in future

It is essentially covering risk arising out of exchange rate fluctuations

The exporter is assured of the value of his exports at the current
exchange rate

An importer secures his interest against possible increases in
cost of imports due to exchange rate fluctuations

9. The Transactions
Arbitrage

Is an act of simultaneous purchase & sale of different currencies in
two or more exchange markets

The objective is to make profit – taking advantage of exchange rate
differentials in various markets

It equates the foreign exchange rates in all major foreign exchange
markets
 It leads to transfer of foreign exchange from the markets where
rate is low to the markets where the rate is high

It works as a stabilising factor in foreign exchange markets
 As it equates demand for foreign exchange with its supply

10. The Transactions
Speculations

Is an act of buying & selling currency under uncertain conditions with
a view to make profits

Speculators
 Buy a currency when its weak and sell when its strong
 If they expect rate to decrease – they may sell forward at the
current rate and buy spot when they need currency for delivery
 And If they expect rate to increase – they may buy forward at the
current rate and then sell spot immediately.

It has both effects
 Stabilizing – if speculators buy when its cheap and sell when its
dear.
 Destabilizing – if they sell when rate is cheap expecting it decrease
more and buy if rates are rising expecting them rise further

11. What is Foreign Exchange Rate?
Price of one currency in terms of another currency.
It is rate at which one currency is exchanged for another

12. Determination of Exchange Rate
Exchange Rate is determined by demand
and supply of Foreign Exchange

13. The Equilibrium Exchange Rate
D
Excess Supply
R’ = 44
Exchange
Rate (Rs / $)
R = 42
S
E
R”= 40
Excess Demand
D
S
O
Q
Quantity of Dollars

14. Determination of Exchange Rate
Appreciation of a currency:
Is a increase in the value in terms of another foreign currency
For EX:
Rs 43 = $ 1
Rs 42 = $1


Strengthening / Appreciation of Indian Rupee
Depreciation of Dollar
Depreciation of a Currency:
Is a decrease in the value in terms of another foreign currency
For EX:
Rs 43 = $ 1
Rs 44 = $1


Weakening / Depreciation of Indian Rupee
Appreciation of Dollar
Devaluation: One time lowering of value of its currency in terms of foreign exchange
occasionally by a country
Revaluation: If the country raises the value of its currency in terms of foreign currency

15. Determination of Exchange Rate
Demand for Foreign Exchange ( US Dollar)

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When Dollar Depreciates / Rupee Appreciate

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

The Indian individuals, firms or Govt who import goods from the USA
Indians travellers and Students
Indians who want to invest in equity , shares and bonds of US
Indian firms who want to invest in physical assets in US
Import becomes cheaper
Demand (Import) increases
More demand of Dollar
When Dollar Appreciates / Rupee Depreciate



Import becomes expensive
Demand (Import) decreases
Less demand of dollar
Therefore lower price of dollar, greater quantity is demanded for imports
Higher price of dollar, smaller quantity is demanded for imports.

16. Determination of Exchange Rate
Supply of Foreign Exchange ( US Dollar )

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The Indian individuals, firms or Govt who export goods to USA
Foreign travellers to India
Americans who want to invest in equity, shares and bonds of India
American firms who want to invest in physical assets
Indians settled aboard send money home (Remittances)

When Dollar Appreciates / Rupee Depreciate
 Indian exports cheaper
 Increase in exports
 More supply of dollars

When Dollar Depreciates / Rupee Appreciate
 Indian goods become expensive
 Decrease in exports
 Less supply of dollar

17. Determination of Exchange Rate
Exchange Rate
Fixed
Flexible

18. Fixed Exchange Rate
When the Govt agrees to maintain the convertibility of the
currency.
The Govt acting through the central bank agrees to buy and
sell as much currency as it is needed.
Countries keep there currency at a fixed rate and change their
value only at infrequent intervals – when the economic situation
forces them to do so.

19. Maintaining Fixed Rates
- Demand For Rupee Increases
Demand increase
D1
D
That is demand for Indian
Goods & Services has risen
S
Exchange Rate (Re /$)
R’ = 0.026
R = 0.025
Rupee appreciates vs $
E
D1
To get it back to its original
rate Supply has to increase
D
RBI – prints more money &
Sells them in exchange for $
S
O
Q
Quantity of Rupees
Foreign Exchange Reserves
Increases

20. Maintaining Fixed Rates
- Demand For Rupee Decreases
Demand reduces
D
Exchange Rate (Re /$)
S
Rupee depreciates vs $
R = 0.025
E
To get it back to its original
rate Supply has to decrease
R”= 0.024
Less Demand
D
S
O
Q
Quantity of Rupees
RBI – buys Rupees
in exchange for $
Foreign Exchange Reserves
Reduces

21. Arguments for Fixed Exchange Rate

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It provides development and growth of Foreign Trade.
It provides stability in foreign exchange market and reduces risk
and uncertainty.
It prevents depreciation of currency for the countries (developing) which
faces persistent problem of deficit in BOP.
Smooth flow of International capital as investors are interested in a
country having stable currency.
Eliminates the possibility of speculations.
Necessary for the growth of international money and capital market
Encourages Globalisation or integration of the world economy

22. Demerits of Fixed Exchange Rate

Countries with persistent deficit / surplus in BOP have long term
disequilibrium.

Deficit in BOP cannot always be corrected by a regular drawing form the
foreign exchange and sale of gold.

Borrowing money from IMF could lead to devaluation

Which leads to inflation

Surplus in BOP could also lead to inflation

23. Flexible Exchange Rate

The rate of exchange is allowed to be freely determined by
interaction between demand and supply of foreign exchange
in the foreign exchange market.

Under this the first impact of BOP is on the Exchange Rate.

Surplus:
Excess demand for country’s currency and exchange rate will rise.

Deficit:
Excess supply of the country’s currency and exchange rate will fall.

24. Factors effecting Demand and
Supply

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Interest Rates
Rate of Inflation
Political or Military Unrest
Domestic Financial Market
Strong Domestic Economy
Business Environment
Stock Markets
Economic data
Balance of Trade
Government budget deficits/surpluses
Rumors

25. Maintaining Flexible Rates
- Increase in Supply
Increase USA Income
S
D
Exchange Rate (Re /$)
S’
Increase in Supply of $
Supply curve shift to S’S’
E
R
That is demand for Indian
Goods & Services has risen
E1
R’
Rupee appreciates vs $
D
S
O
S’
Dollar Depreciate
Q
Quantity of US Dollars
New Exchange Rate at E1

26. Maintaining Flexible Rates
- Increase in Demand
Increase in India Income
D’
S
D
Increase in Demand for
US Exports
Exchange Rate (Re /$)
E1
R’
Increase in Demand of $
Demand curve shift to D’D’
E
R
Rupee depreciates vs $
D’
D
S
Dollar appreciate
O
Q
Q1
Quantity of US Dollars
New Exchange Rate at E1

27. Arguments for Flexible Exchange
Rate



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It automatically deals with the BOP problem.
During Deficit: External value falls , discourages import and
encourages export.
It provides freedom in respect of domestic economic policies.
 It is not necessary for economies to depend upon exchange rate
for planning there domestic economic policy.
Its self adjusting and Govt intervention are not required.
You can predict the exchange rate
It gives a true picture of the strength of the currency in foreign exchange
market

28. Which system should a
country adopt?
It depends upon
 The characteristics of the economy
 Values and view of a political nature