About Foreign Exchange

What Is Foreign Exchange?
‘Foreign exchange’ refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his ownnation’s currency for money denominated in anothernation’s currency acquires foreign exchange.

This holds true whether the amountof the transaction is equal to a few rupees or to billions of rupees; whether the person involvedis a tourist cashing a traveller’s cheque in a restaurant abroad or an investor exchanging hundreds of millions of rupees for the acquisition of a foreign company; and whether the form of moneybeing acquired is foreign currency notes, foreign currency-denominated bank deposits, or other short-term claims denominated in foreign currency.

A foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian rupee (INR) is, broadly speaking, ‘foreign exchange’. Foreign exchange can be cash, funds available on credit cards and debit cards, traveller’s cheques, bank deposits, or other short-term claims. It is still ‘foreign exchange’ if it is a short-term negotiable financial claim denominated in a currency other than INR.

Why Do You Need Foreign Exchange?
Almost every nation has its own national currency or monetary unit—its rupee, its dollar, its peso—used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for foreign exchange transactions—exchanges of one currency for another.

Role of the Exchange Rate
The exchange rate is a price—the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency. There are scores of “exchange rates” for INR and other currencies, say the US dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the euro or the International Monetary Fund’s Special Drawing Rights (SDRs). There are also various ‘trade-weighted’ or ‘effective’ rates designed to show a currency’s movements against an average of various other currencies (for example, the US dollar index, which is a weighted index against world’s major currencies like euro, pound sterling, yen, and the Canadian dollar). Quite apart from the spot rates, there are additional exchange rates for other delivery dates in the forward markets.

A market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a key participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range. But in countries like the United States, which follows a complete free floating regime, the authorities do not intervene in the foreign exchange market on a continuous basis to influence the exchange rate. The market participation is made up of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling US dollars at that particular time.

The participants in the foreign exchange market are thus a heterogeneous group. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whatever is the constitution of participants, and whether their motive is investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market price at that instant. Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain business. At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much else. The role of the foreign exchange market in the determination of that price is critically important.