Foreign exchange market

Multiple currencies, Euromarkets, differential taxation and barriers to financial flows are the distinguishing features of international finance. Of these the multiple currency factor, and the attendant issue of exchange rates, has received considerable attention in recent years.

An exchange rate represents the relationship between two currencies. Presently, the system of direct quotes is used in India in which the exchange rates are quoted as number of rupees per unit (or per 100 units in some cases) of foreign currency.

In the foreign exchange market a spot rate refers it the rate applicable to transactions in which settlement (i.e. delivery) is two business days after the date of transactions.

Forward transaction is also possible in which the rate is fixed today but settlement is at some specified date in the future. Such rates are called forward rates.

Forward rates will in general be different from spot rates. With the direct system of quotations, the foreign currency is said to be at forward premium (discount) when the forward rate is greater than (smaller than) the spot rate.

The foreign exchange market is the largest financial market in the world. It is primarily an over the counter market.

The major sources available to an Indian firm for raising foreign currency finance are: foreign currency term loans from financial institutions, exports credit schemes, external commercial borrowings, euro issues and foreign domestic issues.

Financial institutions provide foreign currency term loans for certain purposes. The periodical liability for interest and principal remains in the currency/currencies of the loan/s and is translated into rupees at the prevailing rate of exchange.

Export credit agencies have been established by the governments of major industrialized countries. Two kinds of export credit are provided: buyer’s credit and supplier’s credit.

Subject to certain terms and conditions, the Government of India permits firms to resort to external commercial borrowing.

Many Indian companies are raising funds by way of Euro issues and foreign domestic issues the two principal mechanisms used by Indian companies are the Depository Receipts mechanism and Euro convertible issues. The former represents in direct equity investment while the latter is debt with an option to convert it into equity.

Commercial banks and EXIM Bank provide export finance and Export Credit Guarantee Corporation provides insurance to exports.

In comparison with domestic trade, international trade presents special problems. In order to cope with these problems, international trade relies considerably on three major documents/instruments: trade draft, bill of lading and letter of credit.

There are three broad types of foreign exchange exposure: translation exposure, and economic exposure.

The two most commonly used devices for managing foreign exchange exposure in India are forward market contracts and financial swaps (interest rate swaps and currency swaps).

Demand and supply of a particular currency are the most important factors affecting its exchange rate. In general, if a country has an import surplus, its exchange rate is likely to depreciate; in case of export surplus, the rate is likely to go up. There are three classes of transactions on the foreign exchange market; purchases and sales for trading purposes speculative deals by professional dealers and protective movements by substantial holders. Professional dealers are willing to buy or sell currencies according to their estimate of that the future exchange rate is likely to be from those who want to sell or buy to hedge their position or eliminate the speculative elements in their transactions. There are protective movements of funds by multinational corporations to avoid losses. Domestic economic policies affecting the internal purchasing power of the currency concerned or, in other words, the relative inflation rates also affect the exchange rates. A country with a higher rate of inflation than other countries may witness a decline in the value of its currency relative to other currencies and vice versa.