Foreign exchange management

1:
FOREIGN
EXCHANGE
MANAGEMENT
KARISHMA SIROHI
IMS KUK

KARISHMA SIROHI
KARISHMA SIROHIkishusirohi@gmail.com Page2

KARISHMA SIROHI
UNIT 1
FOREIGN EXCHANGE
Every nation has its own currency and a single currency is not acceptable in all the countries.
When the trading is done at international level, a mechanism is needed to make proper
arrangement for the settlements of commitments of both the parties. As rupees are not an
international means of exchange so foreign exchange market or mechanism is needed to deal
with currencies of other nations, in order to make the international business transactions
dynamic.
Meaning of Foreign Exchange
Foreign Exchange refers to foreign currencies possessed by a country for making payments to
other countries. It may be defined as exchange of money or credit in one country for money or
credit in another. It covers methods of payment, rules and regulations of payment and the
institutions facilitating such payments. Foreign exchange is the activity/process by which
currency of one country gets converted into the currency of other country.
Definition
According to FERA 1973, now FEMA 1999,
"Foreign Exchange means foreign currency and includes:
(a) (i) All deposits, credits and balances payable in any foreign currency.
(ii) The drafts, traveler's cheques, letters of credits and bills of exchange expressed or
drawn in Indian currency but payable in any foreign currency.
(b) All instruments payable at the option of the drawee or the holders thereof or any other
party there to either in Indian currency or in foreign currency partly in one and partly in
other.
This is clear from the above definition that the foreign exchange market is the market where
foreign currencies are bought and sold. In other words foreign exchange market is a system
facilitating mechanism through which one country's currencies can be exchanged for the
currencies of another country.
Foreign exchange market
A foreign exchange market refers to buying foreign currencies with domestic currencies and
selling foreign currencies for domestic currencies. Thus it is a market in which the claims to
foreign moneys are bought and sold for domestic currency. Exporters sell foreign currencies for
domestic currencies and importers buy foreign currencies with domestic currencies.

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The genesis Foreign Exchange (FE) market can be traced to the need for foreign currencies
arising from:
 International Trade.
 Foreign Investment.
 Lending to and borrowing from foreigners
In order to maintain the equilibrium in the FE market, the monetary authority concerned country
normally intervenes/steps in to bring out the desired balance by:
 Variation in the exchange rate
 Changes in official reserve
 Both
Every firm operating in international environment faces problems with foreign exchange i.e., the
exchange of foreign currency into domestic and vice-versa. Generally firm's foreign operations
earn income denominated in some foreign currency, however shareholder expect payment in
domestic currency and therefore the firm must convert foreign currency into domestic currency.
Foreign exchange market doesn’t denote the physical place. It is informal over the counter
market and electronically linked network of big banks, foreign broker or dealer, whose function
is to bring buyers and sellers together. The trading in foreign exchange market is usually done 24
hours a day by telephone, display monetary, telex and fax machines and satellite called SWIFT
(Society for World Wide Interbank Financial Telecommunication), system. Each participatory
bank separate foreign exchange trading room and mostly transaction based on verbal
communication because the documentation is done later on.
Although the foreign exchange market is global, the market features in each country are
influenced by the local regulatory framework. Therefore, foreign exchange market is the means
by which payments are made across national boundaries, jurisdictions and currencies, it is also
the market in which one currency is exchanged for other and hence sets the price for the currency
it terms of the another.
Definition
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".
Foreign Exchange transactions result in inflow & outflow of foreign exchange.

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Features of Foreign Exchange Market
Following are the features of the foreign exchange market:
1. Global market: Foreign exchange market is a
global market. It means foreign exchange buyer
and seller world wide exist. It is the largest
market in the world.
2. Over the counter market: The market does
not denote a particular place where currencies
are transacted. Rather it is an over the counter
market. It consists of trading desks at major
agencies dealing in foreign exchange
throughout the world, which are connected by
telephones, telex and
3. Around the clock market: Foreign exchange
market is a round the clock market meaning
that the transactions can take place any time
within 24 hours of the day. The markets are
situated throughout the different time zones of
the globe in such a way that one market is
closing the other is beginning its operations.
4. Currency traded: in this market only currency are traded.
5. Dynamic: it is dynamic because of continuous trading.
6. Normative: in this market principles of economics are applied.
7. No geographical boundaries: It is virtual network of big banks through latest
technologies.
8. Variety of participants: ranging from individual customer to central monetary authority
of the country.
9. By and large unregulated market: because it is regulated by demand and supply only.
10. Most liquid market: transactions are made speedily.
11. System: Foreign exchange market is a system. It is a system of private banks, financial
banks, foreign exchange dealers and central bank through which individual, business and
government trade foreign exchange.
12. Informal arrangement: among the banks and brokers.
13. Wholesale and retail segment: the wholesale segment of the market, where the dealing
take place among the banks. The retail segment refers to the dealings take place between
banks and their customers.
14. Major trading centers: Tokyo, Singapore, New York etc. are major trading centers.
15. Largest market: it is largest and biggest financial market in the world.
16. Major currencies: US $, Japanese Yen, Deutche Mark, Swiss Franc.
FEATURES
1. Global Market
2. Over the Counter Market
3. Around the clock market
4. Currencies traded
5. Dynamic
6. Normative
7. No geographical boundaries
8. Variety of participants
9. By and large unregulated market
10. Most liquid market
11. System
12. Informal arrangements
13. Wholesale and retail segment
14. Major trading centers
15. Largest market

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17. Indian Forex market is very small as compared to global. Turnover of $5-10 bn/day.
18. The retail segment is situated at a large number of places. They can be considered not as
foreign exchange markets, but as the countries of such market.
19. The leading foreign exchange market is in India is Mumbai, Kolkata, Chennai, Delhi.
20. The policy of RBI has been to decentralize exchange operations and develop broader
based exchange markets.
21. As a result of the effort of RBI Cochin, Bangalore, Ahmadabad, Goa has emerged as new
exchange centers in India.
Functions of Foreign exchange market
The Foreign Exchange Market performs the following functions:
1. Transfer Of Purchasing Power
The basic function of the foreign exchange market is to facilitate the conversion of one
currency into another i.e. payment between exporters and importers. eg. Indian rupee is
converted into U.S. dollar and vice-versa. In performing the transfer function variety of
credit instruments are used such as telegraphic transfers, bank drafts and foreign bills.
Telegraphic transfer is the quickest method of transferring the purchasing power.
2. Credit Function
The foreign exchange market also provides credit to both national and international, to
promote foreign trade. It is necessary as sometimes, the international payments get
delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is required. eg. Mr.
A can get his bill discounted with a foreign exchange bank in New York and this bank
will transfer the bill to its correspondent in India for collection of money from Mr. B after
the stipulated time.
3. Hedging Function
A third function of foreign exchange market is to hedge foreign exchange risks. By
hedging, we mean covering of a foreign exchange risk arising out of the changes in
exchange rates. Under this function the
foreign exchange market tries to protect the
interest of the persons dealing in the market
from any unforeseen changes in exchange
rate. The exchange rates under free market
can go up and down, this can either bring
gains or losses to concerned parties.
Hedging guards the interest of both
exporters as well as importers, against any
changes in exchange rate. Hedging can be
done either by means of a spot exchange
market or a forward exchange market involving a forward contract.
FUNCTIONS
Transfer of
purchasing
power
Provision
of Credit
Minimizing
FE risk

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PARTICIPANTS
Central
Banks
Speculators
Arbitrageur
Business
Firm
General
Public
Authorised
Dealers
Financial
Institutions
Exchange
Brokers
Hedgers
Category (A) 100
•-Royal Bank of London
-Abu Dhabi Bank
-Axis Bank
Category (B) 110
•-Channai
-Cochin
-Kolkata
-New Delhi
-Patna
Category (C) 09
•-IDBI
RXIM
ICICI
AD'S
Participants in Foreign Exchange Market
The main participants in foreign exchange markets are
1. Authorized Dealers: are those persons who
have license from the RBI to deal in foreign
exchange. There are 84 authorized banks.
Public has to conduct the foreign
transaction through AD’s. AD’s
formed an organization called FEDAI
(Foreign Exchange Dealers
Association of India).
Following are the categories of the
AD’s:
2. Financial Institutions: such as IDBI, ICICI, IFCI etc. They are Authorized dealers also.
3. Exchange Brokers: who are specialists in matching supply and demands of banks and
who work for a commission. They facilitate deals between banks. In the absence of a
broker, banks have to contract each other for quests.
4. Central banks: like RBI in India, intervene in order to maintain or to influence the
exchange rate of their currency within a certain range and also to execute the orders of
govt. The currencies traded by RBI on its own behalf or on the behalf of the govt.
5. Hedgers: are interested in reducing transferring the risk. Hedging is done to make the
outcome more certain, but it does not necessarily, improve the outcome.
6. Speculators: wish to take risk and advantage of position in the market. They buy and sell
the currency when they expect movement in the exchange rate in particular direction.
They bet for the price up or down. They are market makers.

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FEM Structure
RETAIL
Full Fledged
Money
Changers
(P&S)
Restricted
Money Changer
(P)
WHOLESALE
Interbank
(Direct and
Indirect)
Spot Forward Derivative
Central Bank
7. Arbitrageurs: They take advantages of exchange rate differential arbitrage involves
locking in a riskless profits by entering simultaneously into transactions into two or more
markets. Arbitrageurs buy currency at lower rate from one market and sell at higher rate
in another market, the varying rate are the source of their income.
8. Business firm/corporate: The business houses, international investors, MNC’s may
operate in the market to meet their genuine trade or investment requirements.
9. Commercial Banks: They buy and sell currencies for their clients.
Structure of Foreign Exchange Market
This diagram shows the structure:
1. Retail Foreign exchange market:
It refers to the dealings take place between the banks and their customers or the brokers
and their customers.
(a) Full fledged money changers: can undertake both purchase and sale transaction
with the public.
(b) Restricted money changers: can only purchase foreign currency from the
foreign tourists.
2. Wholesale Foreign exchange market:
It refers to the market where the dealings take place among the banks.

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(a) Interbank: major banks trade in currencies held in different currency dominated
bank currency, i.e. these transfer bank deposits from seller’s to buyer’s accounts.
In this market only the head office and regional office of the major commercial
banks is the market maker. Through correspondent relationships with banks in
other countries, major banks have ready access to foreign currencies.
 Direct: banks quote buying and selling directly to each other and all
participating banks are market maker. It is also known as decentralized
open-bid, double auction market.
 Indirect: In this broker is involved for the dealings.
In this market transactions are settled by clearing houses.
i. Spot Market: refers to the class of foreign exchange transactions which
requires the immediate delivery or exchange of currencies on the spot. The
exchange rate in this market is known as the spot rate (e).
ii. Forward Market: is an agreement between two parties, requiring the
delivery at some specified future date of a specified amount of foreign
currency by one of the parties, against payments in domestic currency be
the other party, at the price agreed upon in the contract.
iii. Derivatives:are the contracts between the parties in which the value of
underlying widely held and easily marketable security is derived between
the parties. The underlying assets can be agricultural and other physical
commodities, currencies, short term and long term financial instruments,
intangible things like price index.
(b) Central Bank: Both political and economic considerations move governments to
intervene in the forex market. Government intervention may be designed either to
stabilize an exchange rate or to move it to a new level.
Foreign Exchange Quotation
Quotation is amount of a currency necessary to buy or sell a unit of another currency. The
various exchange rate are regularly quoted in newspapers and periodicals.
The foreign exchange quote published daily in the financial papers for major currencies.
Foreign exchange rates are quoted either for immediate delivery (spot rate) or for delivery on a
future date (forward rate). In practice, delivery in spot market is made two days later. (t+2)
The method and types of quoting are explained in the diagram---

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FE Quatations
Quoting
Types
Two Way
Quotes
Spot
Cross
Rate
Quoting
Method
Direct
Buy at low Sell at high
Indirect
1. Quoting Types:These are as follows:
a) Two Way Quote: A forex dealer usually quotes a two way price for a given
currencies. Banks are the dealer in this. The price at which the dealer is buying
(Bid Price) and the price in which dealer is selling (Offer Price or Ask Price) of
the currency. When the bid quote is lower than the ask quote, the bank is buying
and selling the currency in the denominator of the quote. When the bid quote is
higher than the ask quote, the bank is buying and selling the currency in the
numerator of the quote.
It is standard practice to divide the amount of the spread by the ask price, that is,
Percentage spread = 100
Ask
Bid-Ask

b) Spot:The FE rates are quoted either for immediate deliveries i.e., spot rate or
future date. In practice delivery in spot market is made generally 2 days later
considering t+2 formulas.
c) Cross Rate (Chain Rule): It is price of any foreign currency other than the home
currency. Most tables of exchange rate quotations express currencies relative to
the dollar, but in some instances, a firm will be concerned about the exchange rate
between two non-dollar currencies. For example, if a Canadian firm needs
Mexican pesos to buy Mexican goods, it wants to know the Mexican peso value

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CONVERTIBLE
CURRENCIES
FULLY
CONVERTIBLE
PARTLY
CONVERTIBLE
NON
CONVERTIBLE
relative to the Canadian dollar. The type of rate desired here is known as a cross
exchange rate, because it reflects the amount of one foreign currency per unit of
another foreign currency. Cross exchange rates can be easily determined with the
use of foreign exchange quotations.
2. Quoting Methods: These are two methods for determining quotes in the FEM-
a) Direct Quote: A direct quotes gives the home currency price of a certain quantity
of foreign currency, usually one unit. In other worlds price of one unit of foreign
currency quoted in terms of home country's currency is known as direct quote. If
India quotes the exchange ratebetween the rupee and US dollar directly, the
quotation will be written as
(Buy at low and Sell at high)
Rs. 45/ US $.
b) Indirect Quotes: In case of indirect quoting, the value of one unit of home
currency is presented in term of foreign currency. In other worlds price of one
unit of home currency quoted in terms of foreign currency is known as indirect
quote. If India adopts indirect quote, the banks in India will quote the exchange
rate as
(Buy at high and Sell at low)
US $ 0.022/ Rs.
Currency Convertibility
It refers to the convertibility of the domestic currency to the foreign (International) currency. The
rate at which the currency is converted is known as exchange rate. Convertible currency means
those currencies which are convertible freely without the permission of the administration.
 The report on Fuller Capital Account Convertibility (FCAC) defines convertibility as, the
freedom to convert local financial assets into foreign financial assets and vice versa.
 Convertible currencies are defined as currencies that are readily bought, sold, and
converted without the need for permission from a Central Bank or government entity.
Types of Convertible Currencies:
1. Fully convertible currencies: those
currencies where there is no restrictions for
the convertibility.
2. Partly convertible currencies: those
currencies where there is restrictions and
control over the convertibility.

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3. Non convertible currencies: are those currencies which are not converted into the any
other currency.
Pre conditions for currency convertibility:
§ Appropriate exchange rate system.
§ Adequate level of international liquidity.
§ Sound macro-economic policies, including the elimination of any monetary overhang.
§ An environment in which the agent have the both, the incentive and the ability to
respond to market price.
Convertibility of Rupee
Rupee convertibility is the system to convert any amount of rupee into the currency of any other
country.Rupee convertibility means the system where any amount of rupee can be converted into
any other currency without any question asked about the purpose for which the foreign exchange
is to be used.The need to convert domestic currency into foreign currency or to convert foreign
currency into domestic currency arises for two reasons:
1. Current Account Convertibility: Current AC refers to the payments and transfers for
current international transactions. Current transactions means to purchase foreign goods
and services without any restrictions.
Current account convertibility refers to freedom in respect of payments and transfers
for current international transactions. In other words, if Indians are allowed to buy only
foreign goods and services but restrictions remain on the purchase of assets abroad, it is
only current account convertibility. As of now, convertibility of the rupee into foreign
currencies is almost wholly free for current account i.e. in case of transactions such as
trade, travel and tourism, education abroad etc.The Government of India introduced a
system of Partial Rupee Convertibility (PCR) (Current Account Convertibility) on
February 29,1992 as part of the Fiscal Budget for 1992-93. PCR is designed to provide a
powerful boost to export as well as to achieve as efficient import substitution. It is
designed to reduce the scope for bureaucratic controls, which contribute to delays and
inefficiency. Government liberalized the flow of foreign exchange to include items like
amount of foreign currency that can be procured for purpose like travel abroad, studying
abroad, engaging the service of foreign consultants etc. What it means that people are
allowed to have access to foreign currency for buying a whole range of consumables
products and services. These relaxations coincided with the liberalization on the industry
and commerce front which is why we have Honda City cars, Mars chocolate and Bacardi
in India.

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§ Components:
 Goods-
* General merchandise.
* Goods for processing
* Goods for repair. Etc.
 Services-
* Travel
* Medical
* Education
* Business services
* Personal, cultural services.
* Govt. services
* Computer and information services etc….
 Income-
* Compensation to employees
* Investment (short term) etc.
 Current transfers-
* Govt. loans etc.
2. Capital Account Convertibility: Capital account is made up of both the short term and
long term capital transactions. CAC means the freedom to convert the domestic financial
asset to the foreign financial assets.The concept of Capital Account Convertibility was
coined by RBI and CAC is now almost synonymous with the SS Tarapore
Committee.capital account is made up of both the short-term and long-term capital
transactions. The Capital Transaction may be Capital outflow or capital inflow. Capital
account convertibility (CAC) or a floating exchange rate means the freedom to convert
local financial assets into foreign financial assets and vice versa at market determined
rates of exchange. This means that capital account convertibility allows anyone to freely
move from local currency into foreign currency and back.convertibility on the capital
account is usually introduced after a certain period of introducing the Current account
convertibility. The most important effect of introducing the capital account convertibility
is that it encourages the inflow of the foreign capital, because under certain conditions,
the foreign investors are enabled to repatriate their investments, wherever they want. But
the risk is that it may accelerate the flight of the capital from the country if things are
unfavorable. For example, an Indian can sell property here and take the Capital outside.
This is why, it is generally introduced after experimenting with the convertibility on
current account. CAC refers to the removal of restraints on international flows on a
country's capital account, enabling full currency convertibility and opening of the
financial system

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UNIT 2
EXCHANGE RATE
Exchange rate is the rate at which one currency can be exchanged for another. Transactions in
exchange market are carried out at what are termed as exchange rates. In other words, exchange
rate is the price of one country’s currency in terms of other country’s currency. Alternatively
exchange rate is the rate at which the currencies are transacted or traded i.e. called exchange rate
or rate of exchange. In foreign exchange market two types of exchange rate operations take
place. They are spot exchange rate and forward exchange rate.
1. Spot Exchange Rate:When foreign exchange is bought and sold for immediate delivery,
it is called spot exchange. It refers to a day or two in which two currencies are involved.
The basic principle of spot exchange rate is that it can be analyzed like any other price
with the help of demand and supply forces. The exchange rate of dollar is determined by
intersection of demand for and supply of dollars in foreign exchange. The Remand for
dollar is derived from country’s demand for imports which are paid in dollars and supply
is derived from country’s exports which are sold in dollars. The exchange rate
determined by market forces would change as these forces change in market. The
primary price makers buy (Bid) or sell (ask) the currencies in the market and the rates
continuously change in a free market depending on demand and supply. The primary
dealer (bank) quotes two-way rates i.e., buy and sell rate.
(Bid) Buy Rate 1 US $ = ` 45.50
(Ask) Sell Rate 1 US $ = ` 45.75
The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The difference of
Rs.0.25 is the profit margin of dealer.
2. Forward Exchange Rate: Here foreign exchange is bought or sold for future delivery
i.e., for the period of 30, 60 or 90 days: There are transactions for 180 and 360 days also.
Thus, forward market deals in contract for future delivery. The price for such
transactions is fixed at the time of contract; it is called a forward rate. Forward exchange
rate differs from spot exchange rate as the former may either be at a premium or
discount. If the forward rate is above the present spot rate, the foreign exchange rate is
said to be at a premium. If the forward rate is below the present spot rate, the foreign
exchange rate is said to be at a discount. Thus foreign exchange rate may be at forward
premium or at forward discount.
For E.g. an Indian importer may enter into an agreement to purchase US $ 10,000 sixty
days from today at 1 US $ = Rs. 48. No amount is paid at the time of agreement, except
for usual security margin money of about 10% of the total amount. 60 days form today,

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the importer will get 10,000 US $ in exchange for Rs. 4,80,000 irrespective of the Spot
exchange rate prevailing on that date.
Exchange Rate Determination Theories:
It is influenced by many factors relative to the reference countries whose currencies are involved.
Different advocates have presented different opinion or approaches/theories determination of
exchange rate between currencies from time to time.
1. Mint Par Theory
2. Purchasing Power Parity Theory
3. Balance of Payment Theory
4. Portfolio Theory
1. Mint Par Theory:
Concept:
The rate of exchange between the gold standard countries is determined on a weight to
weight basis of the gold countries of their currencies. In other words, the exchange rate is
determined by the gold equivalents of the currencies involved.
The mint par is an expression of the ratio of weights of gold's used for the coinage of the
currencies.
Explanation: This theory is associated with the working of the international gold
standard. Under this system, the currency in use was made of gold or was convertible into
gold at a fixed rate. The value of the currency unit was defined in terms of certain weight
of gold, that is, so many grains of gold to the rupee, the dollar, the pound, etc. The central
bank of the country was always ready to buy and sell gold at the specified price. The rate
at which the standard money of the country was convertible into gold was called the mint
price of gold.
Example: If the gold content of Indian rupee is 5 grains of standard purity and the US$ is
40 grains of standard purity, the rate of exchange will be determined as
Rupee 1 = 5 grains
$1 = 40 grains
$1 = 8 rupee (49/5)
Rupee 1 = 0.0125 $ (5/40)
2. Purchasing Power Parity Theory:
Concept:
This theory holds that the rate of exchange between two currencies depends upon their
relative purchasing power in the countries concern.
Theory propounded by Dr. Gustav Cassel (1918)
There are two versions of Purchasing Power Parity theory:
a) Absolute Version of the PPP theory.
b) Relative Version of the PPP theory.

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a) Absolute Version of the PPP theory: The PPP theory suggests that at any point
of time, the rate of exchange between two currencies is determined by their
purchasing power. If e is the exchange rate and PA and PB are the purchasing
power of the currencies in the two countries, A and B, the equation can be written
as
e = PA/PB
Example: if one bag of sugar cost rupee 500 in India and $ 50 in USA, the rate of
exchange between these two currencies will be-
$50 = Rs 500
$1 = Rs 10
Limitations: However this version of the theory holds good, if the same
commodities are included in the same proportion in the domestic market basket
and the world market basket. Since it is normally not so, the theory faces a serious
limitation. Moreover, it does not cover non-traded goods and services, where the
transactions cost is significant.
b) Relative Version of the PPP theory: In view of the above limitation, another
version of this theory has evolved, which is known as the relative version of the
PPP theory. The relative version of PPP theory states that the exchange rate
between the currencies of the two countries should be a constant multiple of the
general price indices prevailing in two countries. In other words, percentage
change in the exchange rates should equal the percentage change in the ratio of
price indices in the two countries.
Example: The price index in India and the USA for a particular year was 100 and
at that time rate of exchange was US$ 1 = Rs 8. Subsequently the price index in
India increased to 150 points which means purchasing power of the Rs as reduced
to that extent. In this case the new rate of exchange between Rs and $ will be—
$ 1 = Rs 8×150/100 = 12 Rs.
If there is simultaneous increase in USA also up to 200 points in this case the
combined effect will be---
$1 = Rs 8 × 150/100×100/200 = Rs 6
This theory states that inflation rate affects the exchange rate between the
countries.
Inflation Home Currency Value Exchange Value
Conclusion:
Merits: PPP theory holds good if:
§ Changes in the economy originate from the monetary sector.
§ There is no structural change in the economy, such as changes in tariff and
in technology.

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Demerits: PPP theory does not hold good in following situations:
§ The assumptions of this theory do no necessarily hold good in real
life.
§ There are other factors such as interest rates, governmental
interference and soon that influence the exchange rate.
3. Balance of Payment Theory:
Concept:
This theory states that the rate of exchange is determined by the demand and supply for
the currency in foreign exchange market.
BOP approach states that an increase in domestic price level over the foreign price level
makes foreign goods cheaper.
Explanation:
There will be two conditions:
§ When BoP is at deficits- It indicates that the supply of foreign exchange is less
than demands.
§ When BOP is at surplus- It indicates that the supply of foreign exchange is more
than demands.
It indicates that the supply of foreign exchange is in excuse of its demands. Therefore, in
relation to domestic currency will fall alternatively the price of home currency will rise.
This theory is also called demand and supply of foreign exchange theory.
Merits:
§ It is an improvement of other theories as it consider factor influencing BOP.
§ This theory also suggest that unfavorable BOP position can be corrected by
marginal adjustment in the exchange rates i.e. the devaluation or evaluation.
4. Portfolio Theory:
Concept:
This theory argues that exchange rate is determined by the portfolio decision of all
investors. Exchange rate between freely traded currencies are influenced more by capital
flows than by trade flows. The theory emphasized that risk factors and current account
imbalance may have an important rate to play in exchange rate development. It says that
interest rate reduction affects investments, output and prices and that will ultimate affect
rate of exchange or exchange rate.

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Exchange Rate System
There are two types of exchange rate system:
1. Fixed exchange rate system: Fixed exchange rates refer to the system under the gold
standard where the rate of exchange tends to stabilize around the mint par value. Any
large variation of the rate of exchange from the mint par value would entail flow of gold
into or from the country. This would have the effect of bringing the exchange rate back to
the mint par value. In the present day situation where gold standard no longer exists,
fixed rates of exchange refer to maintenance of external value of the currency at a
predetermined level. Whenever the exchange rate differs from this level it is corrected
through official intervention. There may be two situations:
a) When exports greater than imports: If the exports of the country exceed
imports, the demand for the local currency in the exchange market will This will
raise the value of the currency to the market.
b) When imports greater than exports: If the country is facing balance of
payments deficits due to higher imports, it would have the effect of increase in
supply of local currency in the foreign and the central bank may have to intervene
by buying local currency at higher price.
Under fixed rates, the compulsion to devalue the currency may be postponed or avoided by
mopping up additional reserves. One such way is exchange of currency reserves between the
central banks of countries.
a) When demand of foreign currency is greater than supply ( Demand > Supply):
When demand of foreign currency is more than supply, then central bank maintains the
exchange rate by increasing the foreign currency in market. In this way supply of foreign
currency will increases and there will be equality between demand & supply.
Excess Demand Sale of foreign Currency by Central Bank.
Results: In case of demand more than supply price of foreign currency in terms of
domestic currency would be costly. Thus Central Bank supply foreign currency in
market.
Q1Q Y
D
D1S
S1
Rs/ US$

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b) When Supply of foreign currency is greater than Demand ( Supply > Demand):
When Supply of foreign currency is more than demand, then central bank maintains the
exchange rate by purchase of foreign currency or creates the demand of foreign currency
in market through. In this way supply of foreign currency will decrease and there will be
equality between demand & Supply
Excess supply Purchase of foreign currency by central bank.
Results: In case of supply more than demand price of foreign currency in terms of
domestic currency would be cheaper. Central bank maintains the foreign currency in
market through.
Conclusion:
Demand >Supply ------------- Sale of foreign currency.
Supply > Demand ------------ purchase of foreign currency.
Merits:
§ Avoid forex risk to some extent.
Demerits:
§ Long run/term foreign capital may not be attracted.
§ Due to LPG most of the economic prefer flexible ERS.
§ It increase the chances of deficit BOT.
§ Long term planning may be failure because adjustments are not made timely.
2. Flexible Exchange Rate System:
It is also called free/floating and unregulated exchange rate system. Under this system the
exchange rate is determined by the equality of market demand for and supply of
currencies generated on trade, investment hedging, arbitrageurs and speculative accounts.
Simply the exchange rate is determined by the market forces. The exchange rate are free
to fluctuate according to the changes in demand and supply forces with no restrictions on
buying and selling of foreign currencies in the foreign exchange market. Under the
Q1Q Y
D
D1S
S1
Rs/ US$

KARISHMA SIROHI
system if the supply of forex is greater than the demand, the exchange rate is determined
that lower rate and vice-versa.
In a floating-rate system, it is the market forces that determine the exchange rate between two
currencies. In floating exchange Rate system the central bank does not control demand or supply
of foreign currency. Thus the central bank has to show or provide order line in the movement of
exchange rate. There are two situations:
a) Crawling Peg: In this situation central
bank fix the upper limit & lower limit
of exchange rate. The exchange rate
will lie between these two limits.
 Upper Limit
 Lower Limit
This can be explained with diagram:
b) Over shooting peg : Under this
condition exchange rate can over the
upper limit and below the lower
c) Hybrid Exchange Rate System: It is a combination of fixed and flexible
exchange rate, this system changes par values of currency by small amount at
frequent specified intervals. Unlike the earlier uniform system under either the
gold standard or Breton Woods, today's exchange rate system fits into no tidy
mold. Without anyone's having planned it, the world has moved to a hybrid
exchange rate system. The major features are as follows:
S1
D2
D1
S2
S1
D2
S2
D1
Q Q1 Q2
O
E
E1
Y
X
Demand for and Supply of US$
Rs/US$

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§ A few countries allow their currencies to float freely, as the United States
has for some periods in the last two decades. In this approach country
allows markets to determine its currency's value and it rarely intervenes.
§ Some major countries have managed but flexible exchange rates. Today
this group includes Canada, Japan, and more recently Britain. Under this
system a country will buy or sell its currency to reduce the day-to-day
volatility of currency fluctuations.
§ Many countries particularly small ones change their currencies to a
major currency or to a basket of currencies. Some countries join together
in a currency bloc in order to stabilize exchange rates among themselves
while allowing their currencies to move flexibly relative to those of the
rest of the world.
§ In addition almost all countries tend to intervene either when markets
become disorderly or when exchange rates seem far out of line with the
fundamentals that is with exchange rates that are appropriate for existing
price levels and trade flows
Merits:
§ Promotion of international trade.
§ Promotion of international investment.
§ Facilities of long range planning.
§ Development of currency areas.
§ Simple to operate.
§ Less expenditure.
Demerits:
§ Market mechanism may fail to bring about appropriate exchange rate.
§ It may increase exchange risk, bread uncertainty impede international trade and capital
movement.
§ A reduction in exchange rate may lead to vicious circle of inflation.
§ Increase in speculation.

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Which is better??????
Neither of the system in there extreme form is not good. Both have their merits and demerits and
considering these there is a need for managed or administered flexible exchange rate system. The
system prevalent under IMF in many countries is a managed float in which exchange rates of
major currencies are floating but subject to exchange control regulations to keep the exchange
rate movement within limits. The system needs large forex reserves in order to manage the
exchange rate.
In India we have LERMS (Liberalized Exchange Rate Management System) and amended
LERMS for the determination of exchange rate in our country.
Factors affecting Exchange Rate:
The most important factor influencing the exchange rate is:
1. Balance of Payments: Balance of Payments position of a country is a definite indicator
of the demand and supply of foreign exchange. There are two situations:-
(i) If a country is having a favorable balance of payments position it implies that
there is more supply of foreign exchange and therefore foreign currencies will
tend to be cheaper.
(ii) If balance of payments position is unfavorable, it indicates that there is more
demand for foreign exchange and this will result in price of foreign currency.
2. Strength of the Economy : The relative strength of the economy also has an effect on
the demand and supply of foreign currencies. If an economy is growing at a faster rate it
is generally expected to have a better performance on balance of trade.
3. Fiscal Policy:The fiscal policy followed by government has an impact on the economy of
the country which in turn affects the exchange rates. If the government follows an
expansionary policy by having low interest rates, it will fuel the engine of economic
growth and as discussed earlier, it will lead to better trade performance.
4. Monetary Policy: The monetary policy is a very effective toll for controlling money
supply, and is used particularly for keeping a tab on the inflationary pressures in the
economy. The main objective of the monetary policy of any economy is to maintain the
money supply in the economy at a level which will ensure price stability, full
employment and growth in the economy.
5. Interest Rate: High interest rates make the speculative capital move between countries
and this affects the exchange rate. If interest rates of domestic currency are raised this
will result in more demand for domestic currency and more supply of the foreign
currency thus, making the latter cheaper.
6. Political Factors:If a change is expected in the government on account of elections ,the
exchange rates may be affected. However, whether the currency of the country concerned

KARISHMA SIROHI
will become stronger or weaker will depend upon expected policies to be pursued by the
new govt. which is likely to take over.
7. Exchange Control: Exchange control is generally aimed at disallowing free movement
of capital flows and it therefore affects the exchange rates. Sometimes countries exercise
control through exchange rate mechanism by keeping the price of their currency at an
artificial level.
8. Central Bank Intervention:Buying or selling of foreign currency in the market by the
central bank with a view to increase the supply or demand, thereby affecting the
exchange rate is known as 'Intervention'. If a central bank is of the opinion that local
currency. It will increase the demand for foreign currency and the rates of foreign
currency.
9. Speculation: In the foreign exchange market dealers taking speculative positions is
common. If a few big speculative operators are buying a particular currency in a big way
others may follow suit and that currency may strength in the short run. This is popularly
known as the 'Bandwagon affect' and this affects exchange rates.
10. Tariff and Non-tariff Barriers: Imports are restricted through tariff and Non-tariff
barriers. Tariff means duty levied by the government on imports. When assessed on a per
unit basis, tariff is known as specific duty. But when assessed as a percentage of the value
of the imported commodity, tariff is called ad valorem duty. When both types of tariff are
charged on the same product, it is known as compound duty. Apart from tariff, import is
restricted through non tariff barrier.
11. Peace and security in particular industry.
12. Productivity of an economy: Increasing productivity in an economy should positively
influence the value of its currency. Its effects are more prominent if the increase is in the
traded sector
LERMS (LIBERALISED EXCHANGE RATE MANAGEMENT SYSTEM)
In view of the continuing pace of liberalization policy, the Liberalized Exchange Rate
Management System (LERMS) has assumed a special significance in the arena of international
financial management. The rupee has already been made fully convertible on current account.
The main objective of the Government is to move the rupee finally into the era of full
convertibility to boost exports.
Liberalized Exchange Rate Management System", (LERMS for short), introduced with effect
from 1.3.1992.
Under the LERMS, Exporters of goods and services and those who are recipients of remittances
from abroad could sell the bulk of their foreign exchange receipts at market determined rates.
Similarly, those who need to import goods and services or undertake travel abroad could buy
foreign exchange to meet such needs, at market determined rates from the authorized dealers,
subject to their transactions being eligible under the liberalized exchange control system. By this

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scheme, partial convertibility of the rupee was introduced. 40% of the foreign exchange received
on current account receipts, whether through export of goods or services alone needed to be
converted at the official rate, while take remaining 60% was convertible at market determined
rates.The imports of materials other than petroleum, oil products, fertilizers, defence and life
saving drugs and equipment always had to be effected against market determined rates. All
receipts of foreign exchange were required to be surrendered to authorized dealers as was the
practice hitherto.The rate of exchange for the transactions was to be the free market rate quoted
by authorized dealers except for 40% of the proceeds which would be based on the official rate
fixed by the Reserve Bank of India. The authorized dealers were required to surrender 40% of
their purchases of foreign exchange to the RBI at official rate. The remaining 60% could be
retained by them for sale in free market for all permissible transactions. The Exporters were also
given a choice to retain a maximum of 15% of the export earnings in foreign exchange itself,
which could be utilized by them for their own personal needs.
Basic features of LERMS can be stated as follows:
§ The exchange rate of the rupee will be determined purely on the basis of market forces of
demand and supply. It may, therefore, also could be described as “market determination
exchange rate system”.
§ All receipts whether on current or capital account and of the balance of payments and
whether on government or private account will be converted entirely at the market rate of
exchange.
§ NRIs will be permitted to maintain the Residents Foreign Currency Account (RFCA) to
which the entire foreign exchange brought in by them will be credited. Moreover, those
Indians who get receipts from abroad now can have the benefit of getting the entire
foreign currency credit to them at the market rate.
§ Exporters and the recipients of inward remittances are required to surrender the foreign
currency received by them to the authorized dealers in foreign currency. However, they
are allowed to maintain 15% of the receipts, in foreign currency account with an
authorized dealer.
§ There is no obligation on the authorize dealers to sell any portion of their foreign
currency receipts directly to the Reserve Bank as was the case so far. They can sell the
receipts in the Indian Market to other authorized dealers for any permissible transactions.
§ Foreign currency remittances abroad are subject to the exchange control regulations, of
course, it does not mean that the Reserve Bank of India's permission would be required in
every case.

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§ The intervention currency of the Reserve Bank continues to be US Dollar. It may at its
discretion buy and sell US dollars from/to various authorized dealers.
Modified Liberalized Exchange Rate Management System (Modified LERMS)
The process of liberalization continued further and it was decided to make the Rupee fully
floating with effect from March 1, 1993. The new arrangement is called Modified Liberalized
Exchange Rate Management System or Modified LERMS.
Salient features are as under:
§ Effective March 1, 1993, all foreign exchange transactions, receipts and payments, both
under current and capital accounts of balance of payments are being put through by
authorized dealers at market determined exchange rates.
§ Authorized dealers are free to retain the entire foreign exchange surrendered to them for
being sold for permissible transactions and are not required to surrender to the Reserve
Bank any portion of such receipts.
§ Foreign exchange receipts are to be surrendered to the authorized dealers except in cases
where the residents have been permitted by RBI to retain them either with the banks in
India or abroad.
§ Reserve Bank of India, under Section 40 of RBI Act, 1934, was obliged to buy and sell
foreign exchange to the authorized dealers.
§ Reserve Bank is now required to sell any authorized person at its offices/branches US
Dollars for meeting foreign exchange payments at its exchange rates based on the market
rate only for such purposes as are approved by the Central Government.
Advantages of the New System :
§ The system seeks to ensure equilibrium between demand and supply with respect to a
fairly large subset of external transactions.
§ It has facilitated removal of several trade restrictions and granted relaxation in exchange
control (under current account transactions).
§ It is a step towards full convertibility of current account transactions in order to achieve
the full benefits of integrating the Indian economy with the world economic system.
§ The incentives to exporters will be higher and more particularly to those whose exports
are not highly import intensive. Exporters of agricultural products will find exports
attractive.

KARISHMA SIROHI
§ A large number of expatriates, who are hitherto denied any advantages on their
remittances to India in line with the earnings of the exporters, are now eligible for market
rate for the full amount of remittances being in the nature of capital inflows.
§ This system, coupled with the exchange control relaxation in certain areas, and the
abolition of travel tax is expected to make the havala route less tempting.
§ In this context it needs to be remembered that smaller the gap between the average rate
received by the exporters and other earners of foreign exchange and the market rate, the
lesser will be the temptation to continue using illegal channels for remittances.
§ In the fiscal area, customs revenue is likely to be higher, other things being the same, to
the extent the valuation of imports would be based on the market exchange rate. It is,
however, necessary to ensure that the tariff rates together with higher input values do not
result in a sharp increase in import costs.
Derivatives:
Derivatives are the contracts between the parties in which the value of underlying widely held
and easily marketable security is derived between the parties. The underlying assets can be
agricultural and other physical commodities, currencies, short term and long term financial
instruments, intangible things like price index.
Currency Forward Contracts:
Forward contracts are customized contracts between two parties for purchase or sale of the
currency of foreign at a specified price of specified quantity to be delivered at a specified date in
the future.
The parties who have entered to the contract negotiate on quantity, price and period of the
contract.
In the forward market, on the contrary, contracts are made to buy and sell currencies for a future
delivery, say, after a fortnight, one month, two months, and and so on. The rate of exchange for
the transaction is agreed upon on the very day the deal is finalized. In other words, no party can
back out of the deal even if changes in the future spot rate are not in his/her favour. The
exchange rate for delivery and payment at specified future dates are called forward exchange
rates and is denoted by F (.). The major participants in forward market can be categorized:-
§ Arbitrageurs
§ Hedgers
§ Speculators

KARISHMA SIROHI
The maturity period of a forward contract is normally one month, two months, three months, and
and so on. But sometimes it is not for the whole month and represents a fraction of a month. A
forward contract with a maturity period of 35 days is an example. Naturally, in this case, the
value date falls on a date between two whole months. Such a contract is known as broken-date
contract.
Forward rates may also contain a premium or discount.
§ If the forward rate exceeds the existing spot rate, it contains a premium.
§ If the forward rate is less than the existing spot rate, it contains a discount.
Forward contracts can be fixed or option forwards.
In a fixed contract the performance date is pre-fixed whereas performance can be on any day
during the period of the contract for option forwards.
Features:
§ It is customized and can be used by any person or institution
§ Price exposure can be hedged upto 100 %
§ No margins are payable
§ No initial cost
§ One to one negotiation leads to tremendous flexibility
§ Forward exchange rate is at par when
Forward rate=Spot rate
§ Add premium when forward rate is greater than spot rate.
§ At discount when forward rate is less than spot rate.
§ Forward contracts can be of two types: fixed, range
Limitations:
§ No performance guarantee and his counter party or default risk.
§ Search for suitable counter party is difficult.
§ High penalty cost.
§ Absence of exchange intermediation.
For example:
Situation 1:There is a party A, who is importer. He import the goods from USA worth US$
1000 for 100 units. He have to make payment of US$ 1000 after 2 months of the dealing. Now

KARISHMA SIROHI
the party A needs US$1000 after 2 months and in the present time spot rate in the market is Rs.
60 = US$ 1. And he want to hedge the forex risk.
Situation 2: there is another party B who is seller of currency have the US$ 5000 and he is
willing to sell.
Party A
Importer US$ 1000/100 units.
Payment after 2 months
E= US$1=Rs.60
Expectation of exchange rate= Rs.65/US$1
Party B
Seller of currency
Have currency US$ 5000
E= US$1=Rs.60
Expectation of exchange rate= 63 incre.
58 decre.
In the absence of forward contract
Party A will contact to Party B after 2 months and make deal whatever the rate prevail in the
market.
Exchange rate may be 63, 58, 60
In the presence of forward contract
Party A contact to the party B and negotiate on three things, exchange rate, time of purchase,
quantity of the currency. After negotiation they decide that party A will buy US$ 1000 at the rate
of Rs. 63/US$ after 2 months.
Through this the party hedges the forex risk.
After 2 months
‘e’=FWR
‘e’>FWR
‘e’<FWR

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UNIT 3
CURRENCY FUTURE
A Foreign exchange derivative is a financial derivative where the underlying is a particular
currency and/or its exchange rate these instruments are used either for currency speculation and
arbitrage or for hedging foreign exchange risk.
• Forex/Currency Forwards
• Forex /Currency Swaps
• Forex/Currency Futures
• Forex/Currency Options
NSE was the first exchange to have received an in-principle approval from SEBI for setting up
currency derivative segment.
The exchange lunched its currency futures trading platform on 29thAugust, 2008.
Currency futures on USD-INR were introduced for trading and subsequently the Indian rupee
was allowed to trade against other currencies such as euro, pound sterling and the Japanese yen.
Currency Options was introduced on October 29, 2010.
Currency Futures
It is a standardized contract between the parties through recognized futures exchange to buy or
sell currency of standardized quantity for specified price on a specified future date.
Futures are exchange-traded contracts to sell or buy financial instruments or physical
commodities for a future delivery at an agreed price. There is an agreement to buy or sell a
specified quantity of financial instrument commodity in a designated future month at a price
agreed upon by the buyer and seller.To make trading possible, BSE specifies certain
standardized features of the contract.A currency future, also known as FX future, is a futures
contract to exchange one currency for another at a specified date in the future at a price
(exchange rate) that is fixed on the purchase date. On NSE the price of a future contract is in
terms of INR per unit of other currency e.g. US Dollars.Currency future contracts allow investors
to hedge against foreign exchange risk. Currency Derivatives are available on four currency pairs
viz. US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY).
Currency options are currently available on US Dollars.
A currency futures contract is different from a forward contract. The size of a future contract is
standardized, involving fixed amount of different currencies. The date of delivery is also fixed,

KARISHMA SIROHI
trader contact to his agent
agent contact to the commission broker
commission broker confirm the trade with
agent
the agent inform the trader about the
dealing price, time etc.
final settlement on maturity date
whereas in a forward contract, neither the size of the contract nor the delivery date is fixed. In a
future contract, the buyer and the seller agree on:
§ A future delivery date
§ The price to be paid on that future date
§ The quantity of the currency.
Process of Future Contract: When a trader has to enter a currency futures contract, he informs
his agent who in turn informs the commission broker at the stock exchange. The commission
broker executes the
deal for a
commission/fee. After
the deal is executed,
the commission broker
confirms the trade
with the agent of the
trader. The agent
informs the principal
about the transaction
and the future price.
The final settlement is
made on
maturity.Currency
futures market refers
to organized foreign exchange market where a fixed amount of a currency is exchanged on a
fixed maturity date.
Features of future contracts:
1. Size and maturity of the contract
2. Use of pits (pit is a place where the currencies are traded)
3. Transactions through a clearing house (clearing house is a part of the system with which
traders strike the deal)Clearing house involvement… National Securities Clearing
Corporation Ltd. (NSCCL) at NSE and Indian Clearing Corporation Limited (ICCL)
4. Margin money (represents traders deposit with the clearing house for the adjustment of
gain/loss)Initial, Maintenance and Variation
5. Marking to the market (involves daily comparison of spot rate with yesterday’s rate up to
the maturity for the assessment of loss/gain)
6. Standardized Contract….. Quality, quantity, price, time period, daily price limits etc.
7. Through recognized futures exchanges.. Derivatives segment of NSE/BSE
8. Trading by member… exchange brokers

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9. Provide liquidity and reduction to counter party risk
10. Better price discovery
11. Regulation by … Acts, SEBI, FCRA etc.
Standardized items in future contracts:
• Quantity of the underlying asset
• The date and month of delivery
• The units of price quotation and minimum change in price
• Location of settlement
Participants in future market:
• Hedgers
• Speculators
• Arbitrageurs
Currency forward vs currency future:
Basis Currency Forwards Currency Futures
Contract Customised Standardized
Regulation By and Large self regulated Exchange/C.H. etc.
Operation Traded directly On exchange
Credit/counterparty risk Exists for parties Exists for C.H.
Liquidity Poor High
Price discovery and Party difficult Better
Marking to Market Not applied Done settlement
Margins Not kept Required by parties

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Currency options:
In finance, an option is a derivative financial instrument that specifies a contract between two
parties for a future transaction on an asset at a reference price. The buyer of the option gains the
right, but not the obligation, to engage in that transaction, while the seller incurs the
corresponding obligation to fulfill the transaction. The price of an option derives from the
difference between the reference price and the value of the underlying asset (commonly a stock,
a bond, a currency or a futures contract) plus a premium based on the time remaining until the
expiration of the option.
Currency Options Market refersto market for the exchange of currency where the option buyer
enjoys the privilege of not exercising the option if the rate is not favorable.It is an agreement
whereby the writer (seller/exchange) of the options contract gives the right (but not the
obligation) to the buyer of the options contract, to buy or sell specified amount of currency at a
strike price on/before the specified date. The buyer of the options contract pays premium to the
seller, which is non-refundable.
Features of the Options contract:
§ Parties –Option Buyer and seller
§ Main two types- Call (Right to buy) and Put (Right to sell)
§ Premium- paid by buyer at the time of entering the contract.
§ Strike Price- on which currencies are agreed to be exchanged or predetermined price.
§ Maturity/expiration date
§ Execution –American (exercise of right on any date), European (only on maturity date)
§ Exchange traded and OTC-traded.
Important terminologies:
 Option Holder :is the one who buys an option, which can be a call, or a put option. He
enjoys the right to buy or sell the underlying asset at a specified price on or before
specified time.His upside potential is unlimited while losses are limited to the premium
paid by him to the option writer.
 Option seller/ writer :is the one who is obligated to buy (in case of put option) or to sell
(in case of call option), the underlying asset in case the buyer of the option decides to
exercise his option. His profits are limited to the premium received from the buyer while
his downside is unlimited.

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 Option Premium : Premium is the price paid by the buyer to the seller to acquire the
right to buy or sell.
 Strike Price or Exercise Price : The strike or exercise price of an option is the specified/
predetermined price of the underlying asset at which the same can be bought or sold if the
option buyer exercises his right to buy/ sell on or before the expiration day.
 Expiration date : The date on which the option expires is known as the Expiration Date.
On the Expiration date, either the option is exercised or it expires worthless.
 Exercise Date : The date on which the option is actually exercised is called the Exercise
Date.In case of European Options, the exercise date is same as the expiration date while
in case of American Options, the options contract may be exercised any day between the
purchase of the contract and its expiration date (see European/ American Option). In
India, options on "SENSEX®" are European style, whereas options on individual are
stocks American style.
Types of Currency Options Market:The options market is of three types:-
1. Listed Currency options market: Listed currency options market is found as a part of
stock exchanges. The size and the maturity of the contract are normally fixed. The option
buyer or the seller makes the deal with the help of a broker.Exchange-traded options are
a class of exchange-traded derivatives. Exchange traded options have standardized
contracts, and are settled through a clearing house with fulfillment guaranteed by the
credit of the exchange. Since the contracts are standardized, accurate pricing models are
often available. Exchange-traded options include:
 stock options,
 commodity options,
 bond options and other interest rate options
 stock market index options or, simply, index options and
 options on futures contracts
2. Over the Counter Option Market: In case of the over-the-counter market, options deals
are finalised with the banks. The size of contract is normally bigger and the banks
repackage the size of the contract according to the clients needs.Over-the-counter
options (OTC options, also called "dealer options") are traded between two private
parties, and are not listed on an exchange. The terms of an OTC option are unrestricted
and may be individually tailored to meet any business need. In general, at least one of the
counterparties to an OTC option is a well-capitalized institution. Option types commonly
traded over the counter include:
 interest rate options
 currency cross rate options, and
 options on swaps

KARISHMA SIROHI
3. Currency Future Option Market: In the currency futures options market, the options
are marked to market, as in the case of a futures contract.
Types of options Contracts:Broadlly speaking, there are two types of options:
1. A call option gives the holder (buyer/ one who is long call), the right to buy specified
quantity of the underlying asset at the strike price on or before expiration date in case of
American option. The seller (one who is short call) however, has the obligation to sell the
underlying asset if the buyer of the call option decides to exercise his option to buy.
2. A Put option gives the holder (buyer/ one who is long Put), the right to sell specified
quantity of the underlying asset at the strike price on or before an expiry date in case of
American option. The seller of the put option (one who is short Put) however, has the
obligation to buy the underlying asset at the strike price if the buyer decides to exercise
his option to sell.
Execution of option contract:
 In case of call option: buying will be done from exchange on or before maturity.
 In case of put option: selling will be made to the exchange on or before the maturity
date.
Call option Put option
In the money Strike price < e Strike price >e
At the money Strike price =e Strike price = e
Out of the money Strike price > e Strike price < e
§ In the money: when it is profitable for the parties to exercise their rights or to complete
the contract.
§ At the money: when it is neither profitable nor in loss to exercise their rights.
§ Out of the money: when it is not profitable for the parties to exercise their rights.
Future vs options contracts:
Future contracts Option contract
 Both the buyer and seller are obligated
to buy/sell the underlying asset.
 Futures Contracts have symmetric risk
profile for both the buyer as well as the
seller.
 Futures contracts prices are affected
mainly by the prices of the underlying
asset.
 buyer enjoys the right & not the
obligation, to buy or sell the underlying
asset.
 options have asymmetric risk profile.
 The prices of options are however;
affected by prices of the underlying
asset, time remaining for expiry of the
contract, interest rate & volatility of the
underlying asset.

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SWAPS:
Currency Swap: A currency swap is different from the interest -rate swap insofar as it (currency
swap) involves two different currencies. This is the reason that the two currencies are exchanged
in the beginning and again at maturity they are re-exchanged. The exchange of currencies is
necessitated by the fact that one counter-party is able to borrow a particular currency at a lower
interest rate than the other counter-party.
A swap is an agreement to exchange cashflows at specified future times according to certain
specified rules. A swap can also be described as a custom tailored product in which two
counterparties agree to exchange a stream of cash flows over an agreed period of time. The
agreed amount which determines the cash flow may be exchanged upfront or may not be so
exchanged. When it is not exchanged it is referred to as Notional principle.
Example: Suppose firm A can borrow the euro at a fixed rate of 8.0 per cent or the US dollar at
a floating rate of one-year LIBOR. Firm B can borrow euro the at a fixed rate of 9.2 per cent and
can borrow the US follar at one year LIBOR. If firm B needs the fixed rate euro, it will approach
the swap dealer, provided that firm A needs the floating rate US dollar. The swap deal will be
conducted in different stages, as follows:
Stage1: In the first stage, firm A borrows euro at 8.0 per cent interest rate. Firm B borrows US
dollars at LIBOR.
Stage 2: The two firms exchange the borrowed currencies with the help of the swap dealer. After
the exchange firm A will possess US dollars. Firm B will posses euros.
Stage 1 and 2 of Currency Swap:
EURO DEBT MARKET
DOLLAR DEBT MARKET
FIRM A SWAP DEALER FIRM B
PRINCIPAL
PRINCIPAL

KARISHMA SIROHI
Stage 3: Interest payment will flow. Firm A will pay LIBOR on the US dollar that will reach the
US dollar market first, through, the swap dealer and then through Firm B. Similarly, firm B will
pay a fixed rate interest that will flow to the fixed rate through the swap dealer and through firm
A. Firm B will pay a fixed rate of interest to the swap dealer, which will be more than 8.o per
cent but less than 9.20 per cent. It will be, say, 8.60 per cent. The swap dealer will take its own
commission and shall pay to firm A in this case only, say, 8.40 per cent.
Stage 3 :
8%
EURO DEBT MARKET
DOLLAR DEBT MARKET LIBOR
Stage 4 :The two principals are again exchanged between the two counter-parties. Firm A gets
back euro and repays them to the lender. Firm B gets back US dollars and repays it to the lender.
Stage 4:
PRINCIPAL EURO DEBT MARKET
DOLLAR DEBT MARKET PRINCIPAL

KARISHMA SIROHI
Features of SWAPS:
§ Exchange of interest payments on some agreed-upon notional amount.
§ No exchange of principal amount
§ Converts the interest rate on an asset or liability from:
 fixed to floating
 floating to fixed
 floating to floating
§ A swap is a powerful tool which allows the user to align risk characteristics of assets and
liabilities
§ A swap transaction, is a custom-tailored bilateral agreement
§ two counter-parties agree to exchange specified cash flows at periodic intervals over a
pre-determined life of the swap on a notional amount
§ Features of currency SWAP:
§ A contract between two counterparties.
§ Commitment to an exchange of cashflows over an agreed period
§ One counterparty pays a fixed or floating rate on a principal amount, denominated in one
currency
§ The other counterparty pays a fixed or floating rate on a (different) principal amount,
denominated in another currency
§ At the end of the period, the corresponding principal amounts are exchanged at a pre-
determined FX rate (usually spot FX rate)
§ Exchange Of Principal Takes Place At The Beginning & End Whereas Interest Payments
Takes Place During The Life Of The Swap.
§ Banks Act As Intermediaries To Eliminate Counterparty Risk. Product Available In
India
§ The swap value is sensitive to Forex rates

KARISHMA SIROHI
Currency
Exposure
Accounting
Exposure
Transaction
Exposure
Translation
Exposure
Economic/
Operating
Exposure
Contingent
Exposure
Competitive
/Strategic
Exposure
UNIT 4
FOREIGN EXCHANGE EXPOSURE
Introduction:
Foreign exchange risk is the risk that the value of an asset or liability will change because of a
change in exchange rates. Because these international obligations span time, foreign exchange
risk can arise.
Forex Risk- is the possibility of loss to any individual/business concern due to unanticipated
changes in exchange rate.
Forex Exposure- is the extent to which transactions, assets and liabilities of an enterprise are
denominated in currencies other than reporting currency of the enterprise itself. The reporting
currency is generally the home currency of parent company. The exposure arises because the
enterprise denominates transactions in a foreign currency or it operates in a foreign market.
The exposure is measured by the value of assets and liabilities or transactions denominated to
foreign currency.
When one talk about foreign exchange exposure, it may be noted that such exposure occurs
because of unanticipated change in the exchange rate.
Suppose the spot rate is Rs. 40/US$ and the one month forward rate is Rs. 40.30/US$. This
means that the market has already anticipated a depreciation in the value of the rupee vis-à-vis
the USDollar by Rs.0.30. if the value of the rupee depreciates to 40.30 per dollar, there would be
no foreign exchange exposure inasmuch as this depreciation is anticipated by the market, but if
the rupee value depreciates to 40.50 foreign exchange exposure would be said to exist because it
is beyond expectation.
Exposure is the extent to which you face foreign exchange risk.
Types of forex exposure:
The diagram shows the two types of forex exposure:
1. Accounting exposure
§ Transaction exposure
§ Translation exposure
2. Economic exposure
§ Contingent exposure
§ Competitive
exposure

KARISHMA SIROHI
1. Accounting exposure: Accounting exposure is the exchange rate exposure that results
when consolidated financial statements are prepared in a single currency.
Accounting exposure can be divided into two parts:
§ Transaction exposure: When business is conducted at international level,
receipts and payments are also made in foreign currency. The unanticipated
changes in exchange rate between two currencies leads to forex exposure. The un-
anticipation due to transaction of currencies, in the form of receivables and
payables is referred to transaction exposure. T.E. arises because a receivable or
payable is denominated in a foreign currency. T.E. is concerned with how
changes in exchange rate affect the home currency value of foreign currency
denominated cash flows relating to transactions which have already been entered
into. Also called cash flow exposure. Since the gain/loss arises on converting the
foreign currency into domestic currency, so it is also called conversion exposure.
Transaction exposure involves changes in the present cash flows, on account of:
i. Export and import of commodities on open account:- There are two
situations:
 If a firm has to make payments for imports in a foreign currency
and the foreign currency appreciates, the firm will have to incure
loss in term of its own currency.
 Similarly, if an exporter has to receive foreign currency for its
export and the foreign currency depreciates, the exporter will have
to face loss in terms of its own currency.
ii. Borrowing and lending in a foreign currency:- The borrower of a
foreign currency is put to loss if that particular foreign currency
appreciates.
iii. Intra-firm flows:- Again, changes in exchange rate laters the value of the
intra firm cash flow.
Situations which gives rise to Transaction Exposure:
Conversion of currency at the time of ----
§ Import payables or export receivables denominated in a foreign
currency.
§ Repayment of loan or interest payment and vice-versa.
§ Making dividend or royalty payment and vice-versa.
In every case foreign currency value of the item is fixed, the uncertainty
pertains to home currency value.
T.E. usually has short time horizons and operating cash flows are affected.

KARISHMA SIROHI
Management of Transaction Exposure:
1. External strategies/ Techniques: They include the
forward market hedge, money market hedge, future
market hedge, and the options market hedge.
 Forward Market Hedge:- In the forward
market hedge, the exporter sells forward, and
the importer buys forward, the foreign
currency in which the trade is invoiced.
For Example:- Suppose an Indian exporter
signs a contract for leather export to USA for
US$ 1000. The export proceeds are to be
received within three months. The exporter
fears a drop in the value of the US dollar,
which may diminish the export earnings. To
avoid diminution, the exporter goes for a
three-month forward contract and sells US$
1000 forward. The spot as well as the forward
rate is Rs. 40/US$. If the dollar depreciates to
Rs. 39 after three months, the export earnings
in the absence of any forward contract would
have dminished to Rs. 39000. But since the exporter has already sold forward a
similar amount of dollars, the loss occurred due to depreciation of the dollar will
be met through the forward contract Selling the dollars on maturity would fetch
him Rs. 40000which will be equal to the original export value.
 Future Market Hedge:- Hedging in a future market is similar. The only
difference is of the procedure, with a view to the varying characteristics of the
future market.
 Option Market Hedge:- For hedging in the currency options market, the
importer buys a call option or sells a put option or performs both the functions at
the same time. The exporter buys a put option and sells a call option or performs
both the functions at the same time. The exporter buys a put option and sells a call
option or performs both the functions simultaneously.
 Money Market hedge:- Money market hedge is just taking a money market
position to cover future payables or receivables position.
 An importer, who is to cover future payables, firstly, borrows local
currency; secondly converts the borrowed local currency into the currency
of payables; and finally, invests the converted amount for a period
matching with the payments to be made for imports.
Mgt of T.E.
External
strategies/tech.
Forward
contract
Future Contract
OptionContract
MoneyMarket
Hedge
Internal
strategies/tech.
Exposure
Netting
Currency
Invoicing
FCA's
Leadingand
Lagging

KARISHMA SIROHI
 On the contrary, an exporter hedging receivables, firstly , borrows the
currency in which the receivables are denominated; secondly, converts the
borrowed currency into local currency and finally invests the converted
amount for a maturity coinciding with the receipt of export proceeds.
2. Internal strategies/ Techniques: it includes techniques such as:
 Exposure netting: It involves offsetting exposures in one currency with
exposures in another currency, where exchange rates are expected to move in
such a way that losses (gains) in the first exposed position should be offset by
gains (losses) from the second currency exposure.
Receivables>Payables=Net Receivables
Receivables<Payables=Net Payables
If a company has both receivables and payables in a foreign currency it need not
hedge its receivables and payables separately, but do so only for net position.
R=5000/-, P=4000/-, N=1000/- of exposure will be considered.
In exposure netting, the entire exposure portfolio matters rather than gain (loss)
on any individual monetary unit (currency). The gain in receivables is offset by
loss in payables and vice versa.
In case of multi-currency transactions, the currencies can be grouped into two-
(i) those whose value is likely to appreciate,
(ii) those whose value is likely to depreciate.
The exposure due to receivables in a currency which is likely to appreciate may
be offset by payables in another currency which also likely to appreciate.
Alternatively, netting can be done by having near equal amount of receivables in
two currencies- one likely to appreciate and other likely to depreciate. Netting
assumes importance in the context of cash management in an MNC with a
number of subsidiaries and extensive intra-company transactions.
 Currency Invoicing: The exchange risk can be avoided or transferred by one
party to another, if the transactions are denominated in local (home) currency.
This invoicing depends upon the relative bargaining power of parties because in
this case other party may suffer. To strike a balance, the transactions may be
invoiced partly in home currency and partly in foreign currency or full amount in
any third (stable) currency which is accepted to both. Also called Third country’s
currency denomination, Partial H.C. denomination or H.C. denomination.
 Foreign currency accounts: Exchange risk can be minimised if an account is
maintained abroad, in the currency of trade, through which all transactions can be
routed. Opening of accounts expressed in foreign currency with authorized
dealers in India by non-residents/residents require general or special permission
of Reserve Bank. Non-resident individuals/entities are permitted to maintain
foreign currency accounts/deposits in India under special schemes. Reserve Bank

KARISHMA SIROHI
has also granted general permission for opening of foreign currency accounts in
India to residents/returning Indians under different schemes.
Dual advantage for the trader-
Since exports can be paid for imports, the exposure remains for only the net
balance. In general conditions, the bank may apply buying rate for exports and
selling rate for imports with spread bw the rates towards margin. Thus, the loss of
exchange in converting from foreign currency into home currency is avoided.
 Leading and lagging: Leads the payment (pay before any change/ preponement)
When foreign currency is expected to be depreciated– the exporter would like to
receive payments earlier than the normal date.When the foreign currency is
expected to be appreciated– the importer would like to pay before normal date.
Lag the payment (pay after any change/ postponement)
Expectation of appreciation in foreign currency--exporter would delay the
receivables. Expectation of foreign currency depreciation– importer will delay the
payments.
§ Translation exposure: Also called accounting/balance sheet exposure
An MNC may wish to translate the financial statement of its subsidiaries/ affiliates in its
home currency (Parent’s financial statements) in order to compare financial results.
Generally, the investors and regulatory bodies wish to know the real financial position of
an enterprise as a whole.
Translation exposure arises when a parent MNC is required to consolidate a foreign
subsidiary’s financial statements with the parent’s own statements, after translating the
subsidiary statements from its functional currency into parents’ home currency with the
changed exchange rate. Actual conversion of currencies does not take place because the
translation of assets, liabilities, profit/loss is done notionally.
The translation can be done at different rates-
 Historic rate- the exchange rate on the date the assets were purchased or liability
was aroused.
 Current rate- the rate prevailing on the date of preparation of balance sheet.
 Average rate- the avg. rate prevailed throughout the year.
Assets and liabilities are not liquidated, so no direct effect on the cash flows.
The difference bw exposed assets and exposed liabilities is called Translation Exposure.
If EA>EL=positive/long/asset TE
If EA<EL=negative/short/liability TE
The translation gain/loss is shown as separate component of shareholder’s equity in
Balance-sheet. This G/L does not affect the current earnings but surely future earnings.

KARISHMA SIROHI
Translation G/L is measure by the diff bw the value of Assets/Liabilities at the historic
rate and current rate.
T.G/L= A&L at current rate-A&L at historic rate.
Measurement and management of Translation Exposure:
1. Measurement methods: it includes:
§ Current/ non current methods: under this method, current assets and current
liabilities of the subsidiary are translated at current rate or the post-change rate. The
fixed assets and long term liabilities are translated at the historical or pre-change rate
or at a rate at which they were acquired. In fact, this approach is based on traditional
accounting that makes a clear-cut distinction between current and long term items.
The magnitude of the exposure is measured by the difference between current assets
and current liabilities, that is, the subsidiary’s working capital. The critics of this
approach opine that the long term debt which is also exposed to exchange rate change
is ignored by this method. As far as the income statement items are concerned, they
are translated at the average rate of exchange-the average of the pre-change and the
post-change rates. However, there are few income statement items which by virtue of
being closely ralated to the non current and long term liabilities are translated at the
pre-change rate.
§ Monetary/non monetary method: under this method, the assets and liabilities are
classified as monetary and non monetary. Items that represent a claim to receive, or
an obligation to pay, a fixed amount of foreign currency such as cash, accounts
receivable, accounts payable, etc. come under the monetary group, while the physical
assets and liabilities such as fixed assets, inventory and long term investment are
• Measurement Methods
•Current/ non-current
•Monetary/ non-monetary
•Temporal
•Current Rate
• Management Methods
•Balance-sheet Hedging
•Exposure Netting
•Leading and Lagging
•Forward contract
•Transfer Pricing
•Swaps
Translation
Exposure

KARISHMA SIROHI
treated as non monetary items are translated at historical rate. The translation
exposure under this method is measured by the net monetary assets or by the
difference between the monetary assets and the monetary liabilities. As far as the
income statement items are concerned, they are translated at average rate and those
closely related to non monetary assets and liabilities are translated at historical rate.
§ Current rate method: this method is also known as closing rate method. In this
method all items of the income statement and the balance sheet are translated at
current rate or the post-change rate. This method is preferred in case of those host
countries where the local currency accounts are periodically adjusted for inflation.
The translation exposure in this case is simply the net worth of the as stated in local
currency. The merit of this method is that the relative proportion of individual balance
sheet accounts remains the same and the process of translation does not distort the
various balance sheet ratios. But the demerit is that the fixed assets are also translated
at current rate and that goes against the principles of accounting.
§ Temporal method: the temporal method uses historical rate for the items that are
stated at historical cost. For example, fixed assets are translated at historical rate but
items that are stated at replacement cost, realizable value, market value are translated
at current rate. This is done in order to preserve the value of assets and liabilities as
shown in the original financial statement.
Summary of translation methods
Exchange rate Current rate
method
Current/non
current
methods
Monetary/non
monetary
method
Temporal
method
Current rate All items Current assets
and current
liabilities
All liabilities and
current assets
except inventory
All liabilities and
all current assets
if inventory
shown at market
price
Historical rate All items Fixed assets and
long term
liabilities
Inventory and
fixed assets
Fixed assets and
inventory if not
shown at market
price
Average rate All items Income
statement items
except those
related to fixed
assets
Income
statement items
except those
related to fixed
assets
Income statement
items except
those related to
fixed assets

KARISHMA SIROHI
2. Management methods: it includes:
§ Balance sheet hedging: It means to bring about a balance bw the EA and EL, so
that net exp becomes zero.
In case of ATE= EA>EL
The exp can be made zero by increasing the liability amount in the functional
currency (foreign currency) of subsidiary unit without making any change in
asset.
In case of LTE= EA<EL
By increasing the amount of assets in subsidiary books.
§ Leading and Lagging-
§ ATE= EA>EL
Delay in payment of liabilities=EL (Lags)
Expediting(Hasten) the realisation of assets= EA (Leads)
§ Transfer Pricing-
The price at which goods, assets and liabilities are transferred from parent
company to subsidiary or branch or vice versa.
ATE= EA>EL
Transfer price of assets can be shown lesser than actual, thus, decrease in amount
of assets and net will be zero.
3. Economic exposure: Economic exposure measures the risk that the value of a security or
a firm will decline due to an unexpected change in relative foreign exchange rates
-Would reduce the value of the security or firm
-The most important type of exposure for security investors
MNCs generally not only export/import finished products, but raw materials also. So,
whenever there is a change in exchange rate, it will have direct or indirect impact on the
cost of product, price of product, sale of product, revenues of firm and overall financial
position of the firm and overall financial position of the firm or operations of the firm.
So, any unexpected change in exchange rate affecting operations of the firm is called
operating exposure. Operating exposure arises when unexpected exchange rate changes
make an impact (directly/ indirectly) over the future cash flows/operating cash flows of
the co.
§ Contingent- Impact of unanticipated exchange rate changes over the firm’s
revenues, operating costs and operating net flows in the coming future.
§ Competitive/Strategic- Impact of unanticipated exchange rate change over the
competitiveness of the firm.
It may be due to a) increase in costs, b) inability to service the market in normal way.

KARISHMA SIROHI
Features of economic exposure/ operating exposure:
• Generally a medium/long run aspect
• Total impact of a real exchange rate change on firm’s sales, costs and revenues depends
upon the response of consumers, suppliers, competitors and Govt.
• Macro-economic shock
• Exchange rate change affects both future and current cash flows.
• Measurement of EOE is very difficult as it s an impact of various economic factors, like-
D&S, Inflation rate, extent of competition etc.
Management of economic exposure:
Management of
EOE
Marketing I/ S
-Market Selection
-Product Strategy
-Pricing Strategy
-Promotional Strategy
Production I/S
-Product Sourcing
-Input Mix
-Plant Location
-Raising Productivity
Finance I/S
-Balance sheet Hedging
-Leading and Lagging
-Parallel Loans
-Currency Invoicing
Strategic I/S
-Diversification of operating
Base strategy
-Diversification of Firm’s
financing Strategy

KARISHMA SIROHI
UNIT 5
International monetary system:
What is International Monetary System:
This term denotes the institutions under which payments are made for transactions that cross
national boundaries. In particular, the international monetary system determines how foreign
exchange rates are set and how governments can effect exchange rates (Samuelson and
Nordhaus, 2005, p.609).
The international monetary system refers to the institutional arrangements that countries adopt
to govern exchange rates. The rules and procedures for exchanging national currencies are
collectively known as the international monetary system. This system doesn't have a physical
presence, like the Federal Reserve System, nor is it as codified as the Social Security system.
They provide means of payment acceptable between buyers and sellers of different nationality,
including deferred payment. It addresses to solve the problems relating to international trade.
 Liquidity
 Adjustment
 Stability
 Adjustment : a good system must be able to adjust imbalances in balance of payments
quickly and at a relatively lower cost;
 Stability and Confidence: the system must be able to keep exchange rates relatively fixed
and people must have confidence in the stability of the system;
 Liquidity: the system must be able to provide enough reserve assets for a nation to
correct its balance of payments deficits without making the nation run into deflation or
inflation.
Meaning:
International monetary systems are sets of internationally agreed rules, conventions and
supporting institutions, that facilitate international trade, cross border investment and generally
there allocation of capital between nation states.
International monetary system refers to the system prevailing in world foreign exchange markets
through which international trade and capital movement are financed and exchange rates are
determined.

KARISHMA SIROHI
Central banks, international financial institutions, commercial banks and various types of money
market funds — along with open markets for currency and, depending on institutional structure,
government bonds — are all part of the international monetary system.
The International Monetary System is part of the institutional framework that binds national
economies, such a system permits producers to specialize in those goods for which they have a
comparative advantage, and serves to seek profitable investment opportunities on a global basis.
International monetary system is defined as a set of procedures, mechanism, processes, and
institutions to establish that rate at which exchange rate is determined in respect to other
currency. To understand the complex procedure of international trading practice, it is pertinent to
have a look at the historical perspective of the financial and monetary system.
Features
§ Flow of international trade and investment according to comparative advantage.
§ Stability in foreign exchange and should be stable.
§ Promoting Balance of Payments adjustments to prevent disruptions associated with
temporary or chronic imbalances.
§ Providing countries with sufficient liquidity to finance temporary balance of payments
deficits.
§ Should at least try to avoid adding further uncertainty.
§ Allowing member countries to pursue independent monetary and fiscal policies.
Importance of IMS
The importance of the international monetary system was well described by economist - Robert
Solomon:-
§ Like the traffic lights in a city, the international monetary system is taken for granted
until it begins to malfunction and to disrupt people’s lives. …
§ A well functioning monetary system will facilitate international trade and investment
and smooth adaptation to change.
§ A monetary system that functions poorly may not only discourage the development of
trade and investment among nations but subject their economies to disruptive shocks
when necessary adjustments to change are prevented or delayed.
(Robert Solomon, The International Monetary System, 1945 – 1981: An Insider’s View
(Harper & Row, New York 1982), pp. 1,7.)

KARISHMA SIROHI
Stages in IMS
1. Classical Gold Standard:
Historically, the most important
fixed-exchange-rate system was the
gold standard, which was used off
and on from 1717 until 1933
(Samuelson and Nordhaus, 2005,
p.610). In this system, each
country defined the value of its
currency in terms of a fixed amount
of gold, thereby establishing fixed
exchange rates among the countries
on the gold standard. The United
States adopted the gold standard in
1879 and defined the US$ as 23.22 fine grains of gold. With 480 fine grains per troy
ounce, it took $20.67 to equal one ounce of gold (Levich, 2001, p. 26). Similarly, the
British pound was defined as £1 = 113 grains of fine gold. So it took £4.2474 to equal
one ounce of gold. The exchange rate was determined at $4.86656/£ based on the gold
contents of the currencies. Exchange rates were fixed for all countries on the gold
standard. The exchange rates (also called “part values” or “parities”) for different
currencies were determined by the gold content of their monetary units.
Rules of this system:
§ Each country defined the value of its currency in terms of gold.
§ Exchange rate between any two currencies was calculated as X currency per ounce of
gold/ Y currency per ounce of gold.
§ These exchange rates were set by arbitrage depending on the transportation costs of
gold.
§ Central banks are restricted in not being able to issue more currency than gold
reserves.
Advantages:
§ Monetary Discipline - because central banks throughout the world were obliged to fix
the money price of gold. They could not allow their money suppliers to grow more
rapidly than real money demand, since such rapid monetary growth eventually raises the
money prices of all goods and services, including gold.
§ Symmetric monetary adjustment refers to the fact that no country in the system
occupied a privileged position by being relieved of the commitment to intervene (or to
Classical Gold
standard
(1860-1914)
Interwar
Period(1918-
1939)
Bretton
Woods
System
(1944-1971)

KARISHMA SIROHI
defend the value of its currency). Countries shared equally in the cost or burden (relative
prices changes, unemployment or recession) of balance of payments adjustment.
Argument in favor of this system:
§ Price Stability:- By trying the money supply to the supply of gold, central banks are
unable to expand the money supply.
§ Facilitates BOP adjustment automatically:- The basic idea is that a country that runs a
current account deficit needs to export money (gold) to the countries that run a surplus.
The surplus of gold reduces the deficit country’s money supply and increases the surplus
country’s money supply.
Argument against this system:
§ The growth of output and the growth of gold supplies needs to be closely linked. For
example, if the supply of gold increased faster than the supply of goods; there would be
inflationary pressure. Conversely, if output increased faster than supplies of gold; there
would be deflationary pressure.
§ Volatility in the supply of gold can cause adverse shocks to the economy, rapid changes
in the supply of gold would cause rapid changes in the supply of money and may cause
wild fluctuations in prices that could prove quite disruptive
§ In practice monetary authorities may not be forced to strictly tie their hands in limiting
the creation of money.
§ Countries with respectable monetary policy makers cannot use monetary policy to fight
domestic issues like unemployment.
2. Interwar period (1918-1939)
The years between the world wars have been described as a period of de-globalization, as
both international trade and capital flows shrank compared to the period before World
War I. During World War I countries had abandoned the gold standard and, except for
the United States. The onset of the World Wars saw the end of the gold standard as
countries, other than the U.S., stopped making their currencies convertible and started
printing money to pay for war related expenses. After the war, with high rates of
inflation and a large stock of outstanding money, a return to the old gold standard was
only possible through a deep recession inducing monetary contraction as practiced by the
British after WW I. The focus shifted from external cooperation to internal reconstruction
and events like the Great Depression further illustrated the breakdown of the international

Foreign exchange management

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