Year: 2020

Overall account of BOP is always in equilibrium. This balance or equilibrium is only in accounting sense because deficit or surplus is restored with the help of capital account.

In fact, when we talk of disequilibrium, it refers to current account of balance of payment. If autonomous receipts are less than autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.

Causes of disequilibrium in BOP

There are several factors which cause disequilibrium in the BOP indicating either surplus or deficit.

Such causes for disequilibrium in BOP are listed below:

(i) Economic Factors

• Imbalance between exports and imports. (It is the main cause of disequilibrium in BOR)
• Large scale development expenditure which causes large imports
• High domestic prices which lead to imports
• Cyclical fluctuations (like recession or depression) in general business activity
• New sources of supply and new substitutes.

(ii) Political Factors

Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.

(iii) Social Factors

Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports

High population growth in poor countries adversely affects their BOP because it increases the needs of the countries for imports and decreases their capacity to export.

Other Causes of Disequilibrium in the Balance Payments

Cause 1. Cyclical Disequilibrium

Cyclical disequilibrium is caused by the fluctuations in the economic activity or what are known as trade cycles.

During the periods of prosperity, prices of goods fall and incomes of the people go down. These changes in incomes of the people and prices of goods affect exports and imports of goods and thereby influence the balance of payments.

“If prices rise in pros­perity and decline in depression, a country with a price elasticity for imports greater than unity will experience a tendency for a decline in the value of imports in prosperity, while those for which imports price elasticity is less than one will experience a tendency for increase. These tendencies may be overshadowed by the effects of income changes, of course. Conversely, as prices decline in depression, the elastic demand will bring about an increase in imports, the inelastic demand a decrease.”

Cause 2. Secular or Long-Run Disequilibrium

Secular (long-run) disequilibrium in balance of payments occur because of long-run and deep-seated changes in an economy as it develops from one stage of growth to another. The current account in the balance of payments follows a varying pattern from one stage to another. In the initial stages of development, domestic investment exceeds domestic savings and imports exceed exports. Disequilibrium arises due to lack of sufficient funds available to finance the import surplus, or the import surplus is not covered by available capital from abroad.

Then comes a stage of growth when domestic savings tend to exceed domestic investment and export outrun imports. Disequilibrium may result because the long-term capital outflow falls short of the surplus savings or because surplus savings exceed the amount of investment opportunities abroad. At a still later stage of growth domestic savings tend to equal domestic investment and long- term capital movements are , on balance, zero.

Thus we see that a secular disequilibrium will occur when either the long-term capital move­ments get out of adjustment with deep-seated factors affecting savings and investment, or planned savings and investment change without an offsetting change in the movement of long-term capital. If investment adjusted itself readily to the amount of domestic savings plus foreign capital there could be no tendency for secular disequilibrium.

The balance-of-payments position will be in equilibrium, if the international capital flow falls into line with the requirements of domestic investment minus domestic savings. There is a tendency to secular disequilibrium, because of domestic savings and domestic investment are independent of the foreign capital flow and are of different magnitudes.

There is a strong tendency for underdevel­oped countries to over-invest and/or under save. The underdeveloped countries are investing larger than their domestic savings and exports allow them because they are eager to accelerate the rate of economic growth. This tendency to over-invest causes a secular disequilibrium in the balance of payments.

Cause 3. Technological Disequilibrium

Technological disequilibrium in the balance of payments is caused by various technological changes. Technological changes involve inventions or innovations of new goods or new techniques of production. These technological changes affect the demand for goods and productive factors which in turn influence the various items in the balance of payments.

Each technological change implies a new comparative advantage to which a country adjusts to. The innovation leads to increased exports if it is a new good and export-biased innovation. The innova­tion may lead to decline in imports if it is import-biased. This will create a disequilibrium. A new equilibrium will require either increased imports or reduced exports.

Cause 4. Structural Disequilibrium

Let us see how the structural type of disequilibrium is caused. “Struc­tural disequilibrium at the goods level occurs, when a change in demand or supply of exports 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.”

Suppose demand in foreign countries for Indian handicrafts falls. The resources engaged in the production of these handicrafts must shift to some other line or the country must restrict imports, otherwise the country will experience a structural disequilibrium. A change in supply may also cause a structural disequilibrium. Suppose Indian jute crop falls because of the change in the shift in the crop-pattern, Indian jute exports will fall and a disequilibrium will be created.

Apart from goods, a loss of service income may also upset the balance-of-payments position on current account. Besides, the loss of income may arise because foreign investment has proved a failure or it has been confiscated or nationalised, e.g. nationalisation of Anglo-Iranian Company in Iran. A war also produces structural changes which may affect not only goods but also factors of production.

A deficit arising from a structural change can be filled by increased production or decreased expenditure, which in turn affect international transactions in increased exports or decreased imports. Actually, it is not so easy because the resources are relatively immobile and expenditure not readily compressible. Under such circumstances, more drastic steps are called for to correct a serious disequilibrium.

“Structural disequilibrium at the factor level results from factor prices which fail to reflect accurately factor endowments … i.e., when factor prices, out or line with factor endowments, distort the structure of production from the allocation of resources which appropriate factor prices would have indicated.” If, for instance, the price of labour is too high, it will be used more sparingly and the country will import highly capital-intensive equipment and machinery. This will lead to disequi­librium in the balance of payments on the one hand and unemployment of labour on the other.

Measures to correct disequilibrium in BOP

Sustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve of foreign exchange and gold.

Following remedial measures are recommended:

(i) Export promotion

Exports should be encouraged by granting various bounties to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs.

(ii) Import

Restrictions and Import Substitution are other measures of correcting disequilibrium.

(iii) Reducing inflation

Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore, government should check inflation and lower the prices in the country.

(iv) Exchange control

Government should control foreign exchange by ordering all exporters to surrender their foreign exchange to the central bank and then ration out among licensed importers.

(v) Devaluation of domestic currency

It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level.

(vi) Depreciation

Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)

The balance of payments is the record of all international trade and financial transactions made by a country’s residents.

The balance of payments has three components the current account, the financial account, and the capital account. Current accounts measure international trade, net income on investments, and direct payments. The financial account describes the change in international ownership of assets. The capital account includes any other financial transactions that don’t affect the nation’s economic output.

Balance of Payments

The Balance of Payments or Balance of Payments is a statement or record of all monetary and economic transactions made between a country and the rest of the world within a defined period (every quarter or year). These records include transactions made by individuals, companies and the government. Keeping a record of these transactions helps the country to monitor the flow of money and develop policies that would help in building a strong economy.

In a perfect scenario, the Balance of Payments (Balance of Payments) should be zero. That is, the money coming in and the money going out should balance out. But that doesn’t happen in most cases. A country’s Balance of Payments statement correctly indicates whether the country has a surplus or a deficit of funds. A Balance of Payments surplus indicates that a country’s exports are more than its imports. A Balance of Payments deficit, on the other hand, indicates that a country’s imports are more than exports. Both scenarios have short-term and long-term effects on the country’s economy.

Components of Balance of Payments

Now let’s understand the different components of the Balance of Payments. The Balance of Payments consists of three main components current account, capital account, and financial account. As mentioned earlier, the Balance of Payments should be zero. The current account must balance with the combined capital and financial accounts.

1. Current Account

The current account monitors the flow of funds from goods and services trade (import and export) between countries. Now this includes money received or spent on manufactured goods and raw materials. It also includes revenue from tourism, transportation receipts, revenue from specialized services (medicine, law, engineering), and royalties from patents and copyrights. In addition, the current account includes revenue from stocks.

2. Capital Account

The capital account monitors the flow of international capital transactions. These transactions include the purchase or disposal of non-financial assets (for example, land) and non-produced assets. The capital account also includes money received from debt-forgiveness and gift taxes. In addition, the capital account records the flow of the financial assets by migrants leaving or entering a country and the transfer, sale, or purchase of fixed assets.

3. Financial Account

The financial account monitors the flow of funds pertaining to investments in businesses, real estate, and stocks. It also includes government-owned assets such as gold and Special Drawing Rights (SDRs) held with the International Monetary Fund (IMF). In addition, it includes foreign investments and assets held abroad by nationals. Similarly, the financial account includes a record of the assets owned by foreign nationals.

Importance of Balance of Payments

The Balance of Payments statement provides a clear picture of the economic relations between different countries. It is an integral aspect of international financial management. Now that you have understood Balance of Payments and its components, let’s look at why it is important.

To begin with, the Balance of Payments statement provides information pertaining to the demand and supply of the country’s currency. The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries. Next, the country’s Balance of Payments determines its potential as a constructive economic partner. In addition, a country’s Balance of Payments indicates its position in international economic growth.

By studying its Balance of Payments statement and its components closely, a country would be able to identify trends that may be beneficial or harmful to the economy and take appropriate measures.

Purchasing Power Parity Theory

The theory aims to determine the adjustments needed to be made in the exchange rates of two currencies to make them at par with the purchasing power of each other. In other words, the expenditure on a similar commodity must be same in both currencies when accounted for exchange rate. The purchasing power of each currency is determined in the process.

Purchasing power parity is used worldwide to compare the income levels in different countries. PPP thus makes it easy to understand and interpret the data of each country.

Example: Let’s say that a pair of shoes costs Rs 2500 in India. Then it should cost $50 in America when the exchange rate is 50 between the dollar and the rupee.

Purchasing power parity theory is based on a market-basket approach to comparing the cost of living between two or more countries. The concept is simple in principle: Compare how much consumers pay for the same types of items in their own currency and use the comparative information to determine the relative costs of living for the economies in question.

For example, suppose a computer costs $1,000 in the United States, and the very same computer can be purchased for £900 in England. The exchange rate between these two currencies is easy to look up: In October 2019, 1 British pound was equivalent to $1.28 in U.S. currency.

In other words, the £900 computer would cost, in dollars, 900 x 1.28, or $1,152. In this (entirely hypothetical) example, a consumer in England is paying about 15 percent more than a consumer in the U.S. for the same item. If that is true across the board for other goods, then the cost of living in England, or its PPP, is 15 percent greater than in the U.S.

Purchasing Power Parity Theory in Practice

While the concept behind purchasing power parity may be straightforward, in practice, it’s difficult to come up with realistic comparisons. The key issue is the wide variability in products and services available in different countries. The computers sold in Britain and in the U.S., though similar, may not be exactly the same – and even if they are, they may not come bundled with the same software, subscriptions, technical assistance packages and so on.

Comparing housing costs from one country to another can also be challenging, especially when lifestyles may differ significantly. An apartment dweller in New York City has a very different living experience than, say, a reindeer herder in Lapland or a villager in rural Nigeria.

To get around these difficulties with PPP theory, international organizations like the United Nations and the World Bank have attempted to standardize market-basket comparisons, making whatever adjustments are needed to account for local differences.

Purchasing Power Parity Theory and GDP

National economies are compared using a metric known as the gross domestic product, or GDP. This measures the value of all the goods and services produced in a country during a year. The size of countries’ economies can be ranked by comparing the size of the GDP of each nation. But it’s not as simple as it sounds.

The key issue, once again, revolves around comparing currencies. The GDP of the United States is measured in dollars; Britain’s, in pounds; China’s in yuan; Japan’s in yen; Germany, France and other EU members’ in Euros; and so on. Before they can be compared, the GDPs need to be converted to a common unit of currency. In international circles, the conversion is usually expressed as dollars.

If the official exchange rates (say, between the U.S. dollar and the Chinese yuan) are used for the conversion, then the ranking of the top five economies in the world (in 2018-2019) looks like this:

• India
• United States
• China
• Japan
• Germany

However, if the PPP of each currency is used to determine conversion rates, as suggested by purchasing PPP theory, then the list takes on a different look:

• China
• United States
• India
• Japan
• Germany

These differences reflect differences in the cost of living in the countries, as indicated in the PPP market-basket calculations. China and India, generally have lower costs of living, so the money circulating in the economies of these countries goes farther, so to speak, than an equivalent amount of cash would go in the economies of the U.S., Germany and Japan.

Interest Rate Theories

Interest rate theories use the inflation rates in determining the exchange rates, unlike the price levels used under the PPP theory.

Fisher Effect theory

Establishing a relationship between the inflation and interest rates, the Fisher Effect (FE) theory states that the nominal interest rate ‘r’ in a country is determined by the real interest rate ‘R’ and the expected inflation rate ‘i’ as follows

(1 + Nominal interest rate) = (1 + Real interest rate)

(1 + Expected inflation rate)

(l + r) = (l + R)( 1 + i)

or r = R + i + Ri

Since, Ri is of negligible value, the preceding equation is generally approximated as

r = R + i

Nominal interest rate = Real interest rate + Expected inflation rate

Real interest rate is used to assess exchange rate movements as it includes interest and inflation rates, both of which affect exchange rates. Given all other parameters constant, there is a high co-relation between differentials in real interest rate and the exchange rate of a currency.

International Fisher Effect theory

The International Fisher Effect (IFE) combines the PPP and the FE to determine the impact of relative changes in nominal interest rates among countries on their foreign exchange values. According to the PPP theory, the exchange rates will move to offset changes in inflation rate differentials.

Thus, a rise in a country’s inflation rate relative to other countries will be associated with a fall in its currency’s exchange value. It would also be associated with a rise in the country’s interest rate relative to foreign interest rates. A combination of these two conditions is known as the IFE, which states that the exchange rate movements are caused by interest rate differentials.

If real interest rates are the same across the country, any difference in nominal interest rates could be attributed to differences in expected inflation. Foreign currencies with relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation.

The IFE explains that the interest rate differential between any two countries is an unbiased predictor of the future changes in the spot rate of exchange.

Other Determinants of Exchange Rates

In addition to inflation, real income, and interest rates, other market fundamentals that influence the exchange rates include bilateral trade relationships, customer tastes, investment profitability, product availability, productivity changes, and trade policies.

Foreign exchange rate is the price at which one currency can be converted into another. It represents the rate at which a firm may exchange one currency for another. Thus, the exchange rate is simply the amount of a nation’s currency that can be bought at a given time for a specified amount of the currency of another country.

The actual amount received in conversion or the effective exchange rate, usually differs from the stated rate because it takes into account all taxes, commissions and other costs that the public must pay to complete the transaction and actually receive the foreign funds.

Types of Foreign Exchange Rate

1. Fixed and Floating Rates

When Government of a country fixes the rate of exchange for its own currency, it is termed as ‘Fixed Exchange Rate’. This is also known as official rate of exchange. Fixed exchange rates are fixed by the respective Governments from time to time for the betterment of their economy.

In contrast exchange rates move, as in any other market place, depending on the demand and supply pressure and are further influenced by the market forces and economic conditions of the respective countries. Floating exchange rate may be free floating or a managed floating.

A currency is freely floating if there does not exist a system of fixed exchange rates and if the Central Bank of the country in question does not attempt to influence the value of the currency. However, in reality this kind of situation does not exist.

In most of the countries Governments attempt to influence movements of exchange rate either through direct intervention in the exchange market or through a mix of fiscal and monetary policies. Under such circumstances, floating is called as ‘managed’ or ‘dirty float’.

A number of countries use a pegged float as a system of exchange rates. The value of one currency is pegged to the value of another currency that itself floats. In a joint float, currencies in a particular group have a fixed exchange value in terms of each other, but the group of currencies floats in relation to other currencies outside the group.

The fixed exchange rate system has inbuilt ad-vantage of simplifying exchange transactions. It imbibes self-discipline for economic policies by participating countries. In India the exchange rate regime of rupee has evolved over a period of time moving in the direction of less exchange controls and current account accountability. The RBI manages the exchange rate of the rupee.

In recent few years the RBI has been very actively intervening in the market to hold the rupee-dollar rates within tight bounds while rupee rates in relation to other currencies fluctuate in correspondence with the fluctuation of this US dollar against them. In addition, the RBI took several measures to relax exchange control and liberalize foreign trade.

2. Spot and Forward Rates

Spot rates refer to those rates which are applicable on the day of transaction in which physical delivery is made within two working days after the date of transaction the spot exchange between two currencies should be the same across the various banks engaged in rendering foreign exchange services.

In case of large discrepancy customers or other banks would buy large amounts of a currency from whatever banks quoting relatively low price and sell the same immediately to a bank quoting a relatively high price. This will cause adjustments in the exchange rate quotations that would offset the existing discrepancy.

In Forward rates, exchange rates are fixed in advance for a transaction which matures at some specified future date. The exchange at the date in future will be at the price agreed upon now. Foreign exchange rates are function of forward demand and forward supply of various currencies.

A foreign currency is said to be at a forward premium if its future value exceeds its present value in terms of domestic currency and it is said to be at discount if the reverse is true. For example spot rate between rupees and dollar is S (Rs/$) = Rs. 45.50 and three months forward is F3 (Rs. /$) = Rs. 46.70/$; these rates signify that dollar is at a premium and rupee is at discount in the forward.

Forward exchange rates are quoted on most major currencies for different maturities. Standard maturities quoted by banks are of 1, 3, 6, 9 and 12 months. Maturities beyond one year are now becoming more common. Maturity extending to 5 and beyond 5 years is also possible for good bank customers.

Alternative Dispute Resolution (ADR) is the procedure for settling disputes without litigation, such as arbitration, mediation, or negotiation. ADR procedures are usually less costly and more expeditious. They are increasingly being utilized in disputes that would otherwise result in litigation, including high-profile labor disputes, divorce actions, and personal injury claims.

One of the primary reasons parties may prefer ADR proceedings is that, unlike adversarial litigation, ADR procedures are often collaborative and allow the parties to understand each other’s positions. ADR also allows the parties to come up with more creative solutions that a court may not be legally allowed to impose.

Common Forms of Alternative Dispute Resolution (ADR)

The most common forms of ADR for civil cases are conciliation, mediation, arbitration, neutral evaluation, settlement conferences and community dispute resolution programs.

1. Facilitation

Facilitation is the least formal of the ADR procedures. A neutral third-party works with both sides to reach a resolution of their dispute. Facilitation assumes that the parties want to reach a settlement. The negotiation is done through telephone contacts, written correspondence, or via e-mail. Facilitation is sometimes used by judges at settlement teleconferences exploring alternatives to taking the dispute to trial.

2. Mediation

Mediation is more formal but still leaves control of the outcome to the parties. An impartial mediator helps the parties try to reach a mutually acceptable resolution to the dispute. The parties control the substance of the discussions and any agreement reached. A typical session starts with each party telling their story. The mediator listens and helps them identify the issues in the dispute, offering options for resolution and assisting them in crafting a settlement.

Mediation can take many forms, depending on the needs of the parties, such as:

• Face to face: Parties directly communicate during the process,
• Shuttle: The mediator separates the parties and shuttles between each one with proposals for settlement,
• Facilitative: The mediator helps the parties directly communicate with each other, or
• Evaluative: The mediator makes an assessment of the merit of the parties’ claims during separate meetings and may propose terms of settlement.

When Should You Use Mediation?

Mediation should be considered when the parties have a relationship they want to preserve. So when family members, neighbors or business partners have a dispute, mediation may be the best ADR procedure to use. Mediation is also effective when emotions may get in the way of a solution. A mediator can help the parties communicate in a non-threatening and effective manner.

Mediation is available to the parties at any point in the litigation process including through the appeal.

3. Arbitration

Arbitration is the most formal of the ADR procedures and takes the decision making away from the parties. The arbitrator hears the arguments and evidence from each side and then decides the outcome of the dispute. Arbitration is less formal than a trial and the rules of evidence are usually relaxed. Each party can present proofs and arguments at the hearing. There isn’t, however, any facilitative discussion between the parties. Unlike other forms of ADR, the award is often supported by a reasoned opinion (though the parties can agree that no opinion will issue).

Arbitration can be “binding” or “non-binding.” Binding arbitration means the parties have waived their right to a trial, agree to accept the arbitrator’s decision as final and, usually, there is no right of appeal of the decision. If there is a binding arbitration clause in a contract, the matter must proceed to arbitration and there is no trial.

Non-binding arbitration means the parties can request a trial if they don’t accept the arbitrator’s decision. Some courts will impose costs and fines if the court decision is not more favorable than that awarded in arbitration. Non-binding arbitration is increasingly rare.

When Should You Use Arbitration?

Arbitration is good for cases where the parties want a third person to settle the dispute but want to avoid the cost of money and time that accompanies a court trial. It is also appropriate where the parties want a decision maker experienced in the subject of the dispute.

Other Types of Alternative Dispute Resolution (ADR)

Neutral Evaluation

Neutral Evaluation is a procedure where each party presents their case to a neutral party who gives an opinion on the strengths and weaknesses of each parties’ evidence and arguments and how the dispute should be settled. It is effective where the subject matter of the dispute requires an expert in the field. The evaluator’s opinion is often used to negotiate a settlement.

Neutral Evaluation is best for cases with technical issues that need an expert and where there aren’t significant emotional or personal barriers to reaching a settlement.

Settlement Conferences

Settlement Conferences may be voluntary or mandatory depending on the judge. The parties will meet with the judge or a referee to discuss a possible settlement of their dispute. The judge will not make a decision but will assist the parties in evaluating the strengths and weaknesses of their case.

Community Dispute Resolution Program

In Michigan there are Community Dispute Resolution Centers that are staffed with trained community volunteers who provide low-cost mediation as an alternative to costly court procedures. This type of mediation is tailored to handle a wide range of private and public conflicts such as landlord/tenant, business dissolutions, land use, public education or adult guardianships/conservatorships. Most of the cases are referred by the courts.

ADR is becoming more popular with courts across the country. The main reason parties prefer ADR proceedings is that, unlike adversarial litigation, ADR proceedings allow the parties to understand each person’s position and create a solution that works for them.

The foreign exchange market is the place where money denominated in one currency is bought and sold with money denominated in another currency. It provides the physical and institutional structure through which the currency of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed.

The primary purpose of this market is to permit transfer of purchasing power denominated in one currency to another. For example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells instruments to a Japanese Company for yen. The U.S. Company will like to receive payment in dollar, while the Japanese exporter will want yen.

It would be inconvenient for individual buyers and sellers of foreign exchange to seek out one another. So a foreign exchange market has developed to act as an intermediary. It is the largest financial market in the world with prices moving and currencies trading somewhere every hour of every business day.

Major world trading starts each morning in Sydney and Tokyo; moves West to Hong Kong and Singapore; passes on to Bahrain; shifts to the main European markets of Frankfurt, Zurich and London; Jumps the Atlantic to New York; goes west to Chicago, and ends in San Francisco and Los Angeles.

It is the largest financial market in the world having daily turnover of over 1600 billions dollar in 2001. Bulk of the trading is accounted for by a small number of currencies the U.S. dollar, Deutschemark (DM), Yen, Pound Sterling, Swiss Franc, and Canadian dollar.

Foreign exchange market is of two types, viz.; retail market and wholesale market, also termed as the inter-bank market. In retail market, travellers and tourists exchange one currency for another. The total turnover in this market is very small.

Wholesale market comprises of large commercial banks, foreign exchange brokers in the inter-bank market, commercial customers, primarily MNCs and Central banks which intervene in the market from time to time to smooth exchange rate fluctuations or to maintain target exchange rates.

Over 90% of the total volume of the transactions is represented by inter-bank transactions and the remaining 10% by transactions between banks and their non-bank customers. It is worth noting that central bank intervention involving buying or selling in the market is often indistinguishable from the foreign exchange dealings of commercial banks or of other participants.

The foreign exchange is similar to the over-the counter market in securities. It has no centralized physical market place (except for a few places in Europe and the futures market of the International Monetary Market of the Chicago Mercantile Exchange) and no fixed opening and closing time.

The trading in foreign exchange is done over the telephone, telexes, computer terminals and other electronic means of communication. The currencies and the extent of participation of each currency in this market depend on local regulations that vary from country to country.

It is interesting to note that bulk of the turnover in the international exchange market is represented by speculative transactions.

Foreign exchange market in India is relatively very small. The major players in that market are the RBI, banks and business enterprises. Indian foreign exchange market is controlled and regulated by the RBI. The RBI plays crucial role in settling the day-to-day rates.

Participants in Foreign Exchange Market

Participants in Foreign exchange market can be categorized into five major groups, viz.; commercial banks, Foreign exchange brokers, Central bank, MNCs and Individuals and Small businesses.

1. Commercial Banks

The major participants in the foreign exchange market are the 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. These banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that require foreign exchange.

These banks operate in the foreign exchange market at two levels. At the retail level, they deal with their customers-corporations, exporters and so forth. At the wholesale level, banks maintain an inert bank market in foreign exchange either directly or through specialized foreign exchange brokers.

The bulk of activity in the foreign exchange market is conducted in an inter-bank wholesale market-a network of large international banks and brokers. Whenever a bank buys a currency in the foreign currency market, it is simultaneously selling another currency.

A bank that has committed itself to buy a certain particular currency is said to have long position in that currency. A short-term position occurs when the bank is committed to selling amounts of that currency exceeding its commitments to purchase it.

2. Foreign Exchange Brokers

Foreign exchange brokers also operate in the international currency market. They act as agents who facilitate trading between dealers. Unlike the banks, brokers serve merely as matchmakers and do not put their own money at risk.

They actively and constantly monitor exchange rates offered by the major international banks through computerized systems such as Reuters and are able to find quickly an opposite party for a client without revealing the identity of either party until a transaction has been agreed upon. This is why inter-bank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.

3. Central banks

Another important player in the foreign market is Central bank of the various countries. Central banks frequently intervene in the market to maintain the exchange rates of their currencies within a desired range and to smooth fluctuations within that range. The level of the bank’s intervention will depend upon the exchange rate regime flowed by the given country’s Central bank.

4. MNCs

MNCs are the major non-bank participants in the forward market as they exchange cash flows 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. This is why they often hedge these future cash flows through the inter-bank forward exchange market.

5. Individuals and Small Businesses

Individuals and small businesses also use foreign 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. Even then they are very important participants in the market. Some of these participants use the market to hedge foreign exchange risk.

Segments of Foreign Exchange Market

There are two segments of foreign exchange market, viz., Spot Market and Forward Market.

1. Spot Market

In spot market currencies are exchanged immediately on the spot. This market is used when a firm wants to change one currency for another on the spot. The procedure is very simple. A banker can either handle the transaction for the firm or may have it handled by another bank.

Within minutes the firm knows exactly how many units of one currency are to be received or paid for a certain number of units of another currency.

For instance, a US firm wants to buy 4000 books from a British Publisher. The Publisher wants four thousand British Pounds for the books so that the American firm needs to change some of its dollars into pounds to pay for the books. If the British Pound is being exchanged, say, for US $ 1.70, then £ 4,000 equals $ 6800.

The US firm simply pays $ 6800 to its bank and the bank exchanges the dollars for 4000 £ to pay the British Publisher.

In the Spot market risks are always involved in any particular currency. Regardless of what currency a firm holds or expects to hold, the exchange rate may change and the firm may end up with a currency that declines in values if it is unlucky or not careful.

There are also risks that what the firm owes or will owe may be stated in a currency that becomes more valuable and, as such possibly harder to obtain and use to pay the obligation.

2. Forward Market

Forward market has come into existence to avoid uncertainties. In Forward market, a forward contract about which currencies are to be traded, when the exchange is to occur, how much of each currency is involved, and which side of the contract each party is entered into between the firms.

With this contract, a firm eliminates one uncertainty, the exchange rate risk of not knowing what it will receive or pay in future. However, it may be noted that any possible gains in exchange rate changes are also estimated and the contract may cost more than it turns out to be worth.

For example, suppose that the ninety-day forward price of the British pound is 2.000 (US$ 2.00 per £) or quoted £ 0.5000 per US $, and that the current spot price is US $ 1.650. If a firm enters into a forward contract at the forward exchange rate, it indicates a preference for this forward rate to the unknown rate that will be quoted ninety days from now in the spot market.

However, if the spot price of the pound increases by 100 per cent during the next 90 days, the pound would be US $ 3.3000 and the £ 5,00,000 could be converted into US $ 1,650,000 The forward market, therefore, can remove the uncertainty of not knowing how much the firm will receive or pay. But it creates one uncertainty-whether the firm might have been better off by waiting.

Functions of Foreign Exchange Market

Foreign exchange market plays a very significant role in business development of a country because of the fact that it performs several useful functions, as set out below:

1. Foreign exchange market transfers purchasing power across different countries, which results in enhancing the feasibility of international trade and overseas investment.
2. It acts as a central focus whereby prices are set for different currencies.
3. With the help of foreign exchange market investors can hedge or minimize the risk of loss due to adverse exchange rate changes.
4. Foreign exchange market allows traders to identify risk free opportunities and arbitrage these away.
5. It facilitates investment function of banks and corporate traders who are willing to expose their firms to currency risks.

Currency Appreciation

Currency appreciation is an increase in the value of currency comparing to another currency. There are number of reasons that contribute currency appreciation, including government policy, interest rates, trade balances and business cycles. Currency appreciation happens in a floating exchange rate system, so a currency appreciates when the value of one goes up compared to another. In other word, appreciation takes place when exchange rates change, allowing for the purchase of more units of a currency.

Currency Depreciation

Currency depreciation is an opposite of currency appreciation, it is a fall in the value of a currency in a floating exchange rate system. Currency depreciation can occur due to any number of reasons – economic fundamentals, interest rate differentials, political instability, risk aversion among investors and so on.

Easy monetary policy and high inflation are two of the leading causes of currency depreciation. In a low interest-rate environment, hundreds of billions of dollars chase the highest yield. Expected interest rate differentials can trigger a bout of currency depreciation. While higher inflation is combated with central banks increasing interest rates, too much inflation is seen as a threat to stability, hence the likelihood of currency depreciation.

Additionally, inflation can lead to higher input costs for export which makes a nation’s exports less competitive in global markets, which will widen the trade deficit and cause the currency to depreciate.

How, exactly, do we define currency appreciation and depreciation?

Appreciation and depreciation of the currency can be very simple to identify. For example, USD/JPY = 100. The first of the two currencies (USD) is the base currency and represents a single unit, or the number 1 in the case of a fraction such as 1/100. The second is the quoted currency and is represented by the rate as the amount of that currency needed to equal one unit of the base currency. The way this quote reads is: One U.S. dollar buys 100 units of Japanese yen.

For the purposes of currency appreciation, the rate directly corresponds to the base currency. For example, If the rate increases to 110, then one U.S. dollar now buys 110 units of Japanese yen and if the currency depreciate that means one U.S. dollar can only buy Japanese yen in the value of less than 100. Therefore, the currency depreciation and appreciation can have a part in contributing exports and imports.

How does a change in currency affects exports and imports?

Since the exchange rate has an effect on the trade surplus or deficit, a weaker domestic currency stimulates exports and makes imports more expensive. Conversely, a strong domestic currency hampers exports and makes imports cheaper.

The example to illustrate this concept is, for example, an electronic component priced at $10 in the U.S. that will be exported to India. Assume the exchange rate is 50 rupees to the U.S. dollar. Ignoring shipping and other transaction costs such as import duties for the moment, the $10 item would cost the Indian importer 500 rupees. Now, if the dollar strengthens against the Indian rupee to a level of 55, assuming that the U.S. exporter leaves the $10 price for the component unchanged, its price would increase to 550 rupees ($10 x 55) for the Indian importer. This may force the Indian importer to look for cheaper components from other locations. The 10% appreciation in the dollar versus the rupee has thus diminished the U.S. exporter’s competitiveness in the Indian market.

To conclude, when a country has stronger value of currency or appreciation, they can import more goods and services from another country (assuming that the currency of exporting country remains the same.) than what they used to. And in the opposite way, if depreciation occurs in a country,no matter what the reason is, the number of product that they used to buy will be lesser in the same amount of money.

The precise meanings of the terms “forward rate” and “spot rate” are somewhat different in different markets. But what they have in common is that they refer, for example, to the current price or bond yield the spot rate versus the price or yield for the same product or instrument at some point in the future the forward rate.

In commodities futures markets, a spot rate is the price for a commodity being traded immediately, or “on the spot”. A forward rate is the settlement price of a transaction that will not take place until a predetermined date; it is forward-looking.

The precise meanings of the terms “forward rate” and “spot rate” are somewhat different in different markets. But what they have in common is that they refer, for example, to the current price or bond yield the spot rate versus the price or yield for the same product or instrument at some point in the future the forward rate.

In commodities futures markets, a spot rate is the price for a commodity being traded immediately, or “on the spot”. A forward rate is the settlement price of a transaction that will not take place until a predetermined date; it is forward-looking.

The Spot and Forward Rates in Commodities Markets

A spot rate, or spot price, represents a contracted price for the purchase or sale of a commodity, security, or currency for immediate delivery and payment on the spot date, which is normally one or two business days after the trade date. The spot rate is the current price quoted for immediate settlement of the contract.

For example, if during the month of August a wholesale company wants immediate delivery of orange juice, it will pay the spot price to the seller and have orange juice delivered within two days.

On the other hand, if the company needs orange juice to be available in late December, but believes the commodity will be more expensive during the winter period due to lower supply, it wouldn’t want to make a spot purchase since the risk of spoilage is high. A forward contract would a better fit for the investment. Unlike a spot transaction, a forward contract, involves an agreement of terms on the current date with the delivery and payment at a specified future date.

Spot and Forward Rates in Bond and Currency Markets

The terms spot rate and forward rate are applied a little differently in bond and currency markets. In bond markets, the price of an instrument depends on its yield that is, the return on a bond buyer’s investment as a function of time. If an investor buys a bond that is nearer to maturity, the forward rate on the bond will be higher than the interest rate on its face.

For example, if an investor buys a $1,000, two-year bond with a 10% interest rate, but buys it when there is only one year left until maturity, the yield or forward rate will actually be 21%, because he will be returned $1,210 in one year.

In currency markets, the spot rate, as in most markets, refers to the immediate exchange rate. The forward rate, on the other hand, refers to the future exchange rate agreed upon in forward contracts. For example, if a Chinese electronics manufacturer has a large order to be shipped to America in one year, and expects the U.S. dollar to be much weaker by that time, it might be able to transact a currency forward to lock in a more favorable exchange rate.

Spot and Forward Exchange Rates

Broadly speaking, we may distinguish between two types of exchange rates prevailing in the foreign exchange market viz., spot rate of exchange and forward rate of exchange. Spot rate of exchange and forward rate of exchange in terms of domestic money payable refers to the price of foreign exchange in terms of domestic money payable for the immediate delivery of a particular foreign currency.

It is, thus, a day-to-day rate. On the other hand, forward rate of exchange refers to the price at which a transaction will be consummated at some specified time in the future. A forward exchange market functions side by side with a spot exchange market.

The transactions of forward exchange market are known as forward exchange transactions, which simply involve purchase or sale of a foreign currency for delivery at some time in the future; the rates at which these transactions are consummated are, therefore, called forward rates.

Forward exchange rate is determined at the time of sale but the payment is not made until the exchange is delivered by the seller. Forward rates are usually quoted on the basis of a discount or premium over or under the spot rate of exchange.

Currency Swap

A sport of a currency when combined with a forward repurchase in a single transaction is called ‘currency swap.’ The swap rate is the difference between the spot and forward exchange rates in the currency swap.

Usually, a forex market is dominated by the spot markets transactions swaps and forward transactions.

Arbitrage

Arbitrage is the act of simultaneously buying a currency in one market and selling in another to make a profit by taking advantage of price or exchange rate differences in the two markets. If the arbitrage operations are confined to two markets only, they will be known as “two-point” arbitrage. If they extend to three or more markets, they are known as “three-point” arbitrage or “multipoint” arbitrage.

The term bid and ask (also known as bid and offer) refers to a two-way price quotation that indicates the best potential price at which a security can be sold and bought at a given point in time. The bid price represents the maximum price that a buyer is willing to pay for a share of stock or other security. The ask price represents the minimum price that a seller is willing to take for that same security. A trade or transaction occurs after the buyer and seller agree on a price for the security which is no higher than the bid and no lower than the ask.

The difference between bid and ask prices, or the spread, is a key indicator of the liquidity of the asset. In general, the smaller the spread, the better the liquidity.

The Role of Bid Price and Ask Price in Liquidity

Typically, when there is a big difference between the bid price and the ask price of a security, it means there is not much trading going on. This is not a good thing when you are a seller, because it can leave you stuck with a stock you don’t want to own.

In contrast, the narrower the spread between the bid price and the ask price of a security, the easier it is to sell. This is a very good thing as a seller, because it means there is plenty of trade volume around the ask price. This, in turn, means less risk as an investor.

Think of it like this, as a kid, if you decided to open a lemonade stand in the middle of winter when the demand for lemonade is low and sell each cup for $5, if customers were only willing to pay $1, you would be experiencing a bid-ask spread of $4. Now, you could choose to sell your lemonade for a significantly lower price, and cut your losses. Or, you could choose to hold at your price, but you might end up waiting until July before somebody was willing to buy a cup at your ask price. This is an example of low liquidity.

Meanwhile, if you lowered your price to $1.01, because the difference between your ask price and the bid price of your customers was much smaller, you would have a much easier time selling your lemonade. In other words, you would be much more liquid.

The same applies to buying and selling securities. The closer the bid price and the ask price are to one another, the more liquid the security is.

3 Factors That Affect Bid Price And Ask Price

When it comes to the bid-ask spread, there are a number of factors that can affect how wide or narrow it is. In this next section, we will cover three of them.

1. Market Size

The larger the market size and trading volume that happens on a daily basis for a particular security, the narrower the bid-ask spread is likely to be. Which makes total sense if you think about it. I mean, if there are 1 million people wanting to buy a particular stock, it is much more likely that you will be able to sell it if you need to liquidate your shares.

On the other hand, if you are trying to sell a particular security, but there are only 100 people interested in buying it, you are much less likely to sell for a high price.

2. Volatility

In short, volatility widens the bid-ask spread. Why? Because if the price of a security jumps and falls wildy, or without any predictability, market-makers have a much harder time setting the ask price or the bid price. Remember, unpredictability is the opposite of liquidity. This lack of liquidity is reflected in the bid-ask spread.

3. Political/Economic Uncertainty

When people are uncertain about the political or economic climate, people tend to play it safe with their investments. In other words, sellers stop selling, and buyers stop buying. Or at least, sellers stop dropping their ask price, and buyers stop increasing their bid price.

Benefits of Bid-Ask Spread

The bid-ask spread works to the advantage of the market maker. Continuing with the above example, a market maker who is quoting a price of $10.50 / $10.55 for security A is indicating a willingness to buy A at $10.50 (the bid price) and sell it at $10.55 (the asked price). The spread represents the market maker’s profit.

Bid-ask spreads can vary widely, depending on the security and the market. Blue-chip companies that constitute the Dow Jones Industrial Average may have a bid-ask spread of only a few cents, while a small-cap stock that trades less than 10,000 shares a day may have a bid-ask spread of 50 cents or more.

The bid-ask spread can widen dramatically during periods of illiquidity or market turmoil, since traders will not be willing to pay a price beyond a certain threshold, and sellers may not be willing to accept prices below a certain level.

Exchange Rate

Exchange rate quotations can be quoted in two ways Direct quotation and indirect quotation. Direct quotation is when the one unit of foreign currency is expressed in terms of domestic currency. Similarly, the indirect quotation is when one unit of domestic currency us expressed in terms of foreign currency.

1. Direct Method

Under this method, the foreign exchange rate of a foreign currency is expressed as number of units of home currency (Local, domestic currency).

Under direct method, the number of units of foreign currency is kept constant (normally a unit, with exceptions, viz. Japanese Yen, in which Yen is taken as 100, if Yen is foreign currency) and any change in the exchange rate will be made by changing the value of local currency or home currency or domestic currency.

For example, US dollar 1.00 = Indian Rupees 46.86 (as on August 27th, 2010) would be a direct exchange rate for the US dollar in India, and US $ 1.00 = Japanese Yen 93.25 (as on March 31st, 2010) is a direct quote for Japan. The quotation of the exchange rate as found by Direct Method is known as “Direct Quotation” or “Direct Rate”.

Direct Quotation: Buy Low, Sell High

A trader, organization, business unit, banks, etc. are the various parties who contribute to the trade and commerce, through their manufacturing, trading in goods and/or providing of services. They do this kind of activities to earn profit. Though their prime motive might be different, but they need to make profit to sustain themselves.

In the same way, the banker buys the foreign currency at lower rate and sell at higher rate, which may result into margin, which help to cover his expenditures relating to the transaction, cost of storing the foreign currency, etc. and also a margin of profit. For having a practical idea, you may go to any of the Bank in your neighbourhood and inquire the rate of buying a foreign currency from them and of selling it.

You may see that there is some difference between them. In Layman’s words, the difference between the two rates is the profit of the banker; but in fact it is his margin, and he will earn profit after deducting all kinds of expenses relating to the transaction, or as per the method adopted by the bank.

For understanding this we can take an example, where a bank buys US $ from its customer for Rs. 44.94 (rate as on March 30th, 2010) and sell it to other customer at Rs. 45.14 (rate as on March 31st, 2010).

Thus under Direct method of Exchange rate the principle adopted by the bank is to buy at a lower price from customers and sell them at a higher price. This principle can be stated in the form of a maxim: ‘Buy Low, Sell High’.

2. Indirect Method

Under this method, the foreign exchange rate is quoted as number of units of foreign currency for a unit of local currency. Under the indirect method, the numbers of units of foreign currency are stated in exchange of a unit of local currency. Thus, in indirect method, the numbers of units of local currency are kept constant and the number of units of foreign currency changes.

Under indirect method, any change in the exchange rate is stated as a change in the number of units of foreign currency. For example, US dollar 2.2153 = Indian Rupees 100 (as on March 31st, 2010) would be the corresponding indirect quotation in India for the US dollar.

The method in which the foreign exchange rate is derived by keeping local or hone or domestic currency constant and the rate is expressed in number of units of foreign currency is known as Indirect Method.

It is also known as ‘Foreign Currency Quotation’ or ‘Indirect Quotation’ or simply ‘Currency Quotation’. Thus, under indirect method the change in exchange rate is shown by changing the number of units of foreign currency and keeping the home currency as constant.

Indirect Quotation: Buy High; Sell Low

Buy more quantity and sell less quantity of commodities or goods or services at same amount of currency. Hypothesize the statement with respect to the quantity that a trader purchases and sells instead of the variation in prices.

For a fixed amount of investment, trader would acquire more units of the commodity when he purchases and for the same amount he would part with lesser units of the commodity when he sells. Taking the orange vendor as an example, if for Rs.100 he gets 50 oranges from his supplier and for the same amount of Rs.100 he sells 40 oranges, he would make profit.

Applying the same principle as discussed above in foreign exchange management we can state that the banker may also earn buying more quantity and selling less quantity of foreign currency at same rate. In indirect method, it is the number of units of foreign currency which vary and home currency remains the same.

For example, for Rs.100, the bank may quote a selling rate of US dollar 2.3000 and buying rate of US dollar 2.3100. The difference between US dollar 2.3100 and US dollar 2.3000 is the bank’s margin of profit. The position is summed up in the maxim

In India, Direct Quotation was prevalent till 1966. After devaluation of rupee in 1966, following the practice in London exchange market, indirect quotation was adopted. Effective from 2nd August 1993, India has switched over to direct method of quotation. The change has been introduced in order to simplify and establish transparency in exchange rates in India.

Trading banks offer a two-way quotation. If, in London, where the exchange rates are quoted indirectly, the US dollar is quoted at $ 1.6290-98, it means that while the quoting bank is willing to sell $ 1.6290 per pound, it will buy dollars at $ 1.6298. It will be readily appreciated that the selling rate for one currency is the buying rate for the other. The indirect rate system also yields the somewhat odd maxim namely “buy high and sell low”.

The “buy high and sell low” maxim refers only to the nominal rates no trader will make a profit if he buys at a higher cost than the yield on selling. In the direct quotation, bank buys at a lower price, and sells at a higher price.

In indirect quotation, for a fixed unit of home currency buy high (acquired more units of foreign currency), and sell low (part with lesser units of foreign currency). Exchange rate has to be quoted in four decimal points. In direct quotation, for a fixed unit of foreign currency buy low (pay lesser units of home currency) and sell high (receive more units of home currency).