A PROJECT ON

Study of Indian Financial System and Financial Market

Compare the market stock exchange of AUSTRALIA and INDIA

MASTER OF BUSINESS ADMINISTRATION

SUBMITTED BY:-

Kashmir Singh (Roll no. 200600010)

Simarjeet Kaur (Roll no. 200600022)

Under the guidance of

Dr. Rozy Rani

UNIVERSITY BUSINESS SCHOOL

MAHARAJA RANJIT SINGH PUNJAB TECHNICAL UNIVERSITY
Mandi Dabwali Road, Bathinda- 15100,
Punjab (India)
Batch no. 2020-2022
 DECLARATION

We are Kashmir Singh and Simarjeet Kaur the undersigned hereby declare that the project work titled
“Study of Indian financial system and financial market Compare the market stock exchange of USA and
INDIA,” submitted in the partial fulfillment of the degree of Master of Business Administration, under the
guidance of Dr. Rozy Rani, is my original work and has not been submitted elsewhere for the reward of
any other degree, diploma, fellowship, or any other similar title.

NAME

Kashmir Singh and Simarjeet Kaur

Acknowledgement
Before we begin my documentation, we must think all the people behind the successful completion of our
project.

We are grateful to my teacher. We know that we are here and that we are able to write all of this for a
reason. A special thanks to my faculty guide Dr. Rozy Rani for helping me at every step to complete our
project. We will do our best. We hope we are doing the work you have planned to our to do.

Last but not the least thanks to all those people who contributed their helps directly or indirectly by helping
us finishes project, thank you very much.

NAME

Kashmir Singh and Simarjeet Kaur

FOREIGN EXCHANGE MARKET

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-
counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for
every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined
prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit
market.[1]

The main participants in this market are the larger international banks. Financial centers around the world
function as anchors of trading between a wide range of multiple types of buyers and sellers around the
clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange
market does not set a currency's absolute value but rather determines its relative value by setting the market
price of one currency if paid for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.

The foreign exchange market works through financial institutions and operates on several levels. Behind
the scenes, banks turn to a smaller number of financial firms known as "dealers", who are involved in large
quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes
market is sometimes called the "interbank market" (although a few insurance companies and other kinds of
financial firms are involved). Trades between foreign exchange dealers can be very large, involving
hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has
little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion.
For example, it permits a business in the United States to import goods from European Union member
states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It
also supports direct speculation and evaluation relative to the value of currencies and the carry
trade speculation, based on the differential interest rate between two currencies.[2]

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with
some quantity of another currency.

The modern foreign exchange market began forming during the 1970s. This followed three decades of
government restrictions on foreign exchange transactions under the Bretton Woods system of monetary
management, which set out the rules for commercial and financial relations among the world's major
industrial states after World War II. Countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed per the Bretton Woods system.

The foreign exchange market is unique because of the following characteristics:

 its huge trading volume, representing the largest asset class in the world leading to high liquidity;
 its geographical dispersion;
 its continuous operation: 24 hours a day except for weekends, i.e., trading from 22:00 GMT on Sunday
(Sydney) until 22:00 GMT Friday (New York);
 the variety of factors that affect exchange rates;
 the low margins of relative profit compared with other markets of fixed income; and
 the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition,
notwithstanding currency intervention by central banks.

According to the Bank for International Settlements, the preliminary global results from the 2019 Triennial
Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in
foreign exchange markets averaged $6.6 trillion per day in April 2019. This is up from $5.1 trillion in April
2016. Measured by value, foreign exchange swaps were traded more than any other instrument in April
2019, at $3.2 trillion per day, followed by spot trading at $2 trillion.[3]

The $6.6 trillion break-down is as follows:

 $2 trillion in spot transactions
 $1 trillion in outright forwards
 $3.2 trillion in foreign exchange swaps
 $108 billion currency swaps
 $294 billion in options and other products

Foreign Exchange

Exchange-rate flexibility
Foreign exchange
Dollarization
Exchange rates
Fixed exchange rate

Currency band Floating exchange rate

Exchange rate Linked exchange rate

Exchange rate regime Managed float regime

Dual exchange rate

Markets

Foreign exchange market

Futures exchange

Retail foreign exchange trading

Assets

Currency

Currency future

Currency forward

Non-deliverable forward

Foreign exchange swap

Currency swap

Foreign exchange option

The foreign exchange market is the market in which foreign currency—such as the yen or euro or pound—
is traded for domestic currency—for example, the U.S. dollar. This “market” is not in a centralized
location; instead, it is a decentralized network that is nevertheless highly integrated via
modern information and telecommunications technology.

Role of Foreign Exchange Market in India

The foreign exchange market is a financial institution that facilitates the exchange of one country’s
currency for that of another. Foreign exchange markets are the oldest and most traditional financial
marketplaces. It is a worldwide over-the-counter (OTC) marketplace that decides currency exchange rates
all around the world. Banks, dealers, commercial companies, investment management firms, and
hedge funds make up the foreign exchange markets. In all major financial centers, all major currencies
are exchanged. The currency market is open five days a week, 24 hours a day. In the forex market, currency
trading entails the simultaneous buying and selling of two currencies. In this method, the value of one
currency (base currency) is determined by comparing it to another currency (counter currency). The foreign
exchange rate is the price at which one currency may be exchanged for another currency. The forex market
has no physical address. It is an electronically linked network. In a simple definition, the exchange rate is
the value at which one currency is exchanged for another or the worth of one currency in terms of another
economic zone or currency.
In financial centers, the foreign exchange market is just a subset of the money market. It is a location where
foreign currencies are purchased and traded. A foreign exchange market is made up of buyers and sellers of
foreign currency claims, as well as middlemen. In the foreign exchange market, there are many different
types of traders. Banks are the most significant among them. Banks that deal in foreign exchange have
branches in several countries with significant balances. The services of such institutions commonly referred
to as “Exchange Banks,” are available all over the world through their branches and correspondents. These
financial institutions discount and sell foreign bills of exchange, issue bank draughts, conduct telegraphic
transfers and other credit transactions, and discount and collect payments based on such papers.

The Main Functions of Foreign Exchange Market:

1. The function of Transfer:
The primary purpose of the foreign exchange market is to make it easier to convert one currency into
another or to make buying power transfers between nations. A number of credit instruments, such as
telegraphic transfers, bank draughts, and foreign bills, are used to transmit purchasing power. The foreign
exchange market performs the transfer function by making international payments by clearing debts in
both directions at the same time, similar to domestic clearings.  
For example, if an Indian exporter imports products from the United States and the payment is to be paid
in dollars, FOREX will simplify the conversion of the rupee to the dollar. Credit instruments such as
bank draughts, foreign exchange bills, and telephone transfers are used to carry out the transfer function.

2. The function of Credit:

Another important role of the foreign exchange market is to facilitate international trade by providing
credit, both domestic and international. When foreign bills of exchange are used in overseas payments,
a credit of around three months is necessary before they mature. The FOREX provides importers with
short-term loans in order to promote the flow of goods and services between countries. The importer can
fund international imports with his own credit.
3. Hedging Function:
Hedging foreign exchange risks is a third function of the foreign exchange market. Hedging is the
process of avoiding foreign currency risk. When the exchange rate, or the price of one currency in terms
of another currency, changes in a free exchange market, the party involved may earn or lose money. If
there are large amounts of net claims or net liabilities that must be satisfied in foreign currency, a person
or a company takes on a significant exchange risk. 

As a whole, exchange risk should be avoided or minimized. For this, the exchange market offers forward
contracts in exchange as a means of hedging potential or present claims or liabilities. A three-month
forward contract is a contract to purchase or sell foreign exchange against another currency at a price
agreed upon today for a defined period in the future. At the moment of the deal, no money is exchanged.
However, the contract allows you to ignore any potential changes in the currency rate. As a result of the
presence of a forward market, an exchange position can be hedged.

Some of the benefits of the Foreign Exchange Market:

 Flexibility: The forex market offers traders a great deal of freedom. This is due to the fact that
the quantity of money that may be traded is unlimited. Moreover, market regulation is essentially
non-existent.
 Transparency: The Forex market is enormous in size and spans many time zones. Despite this,
information about the Forex market is freely available. Additionally, neither government nor the
central bank has the authority to corner the market or set prices for an extended period of
time. Because of the temporal lag in transferring information, some entities may get short-term
benefits. The magnitude of the Forex market makes it fair and efficient!
  Options Trading: Traders can choose from a wide range of trading alternatives on the forex markets.
Traders have lots of different currency pairs to select from. Investors can also choose between spot
trading and signing a long-term contract. As a consequence, the Forex market has a remedy for any
budgetary and investor’s risk appetite.

The Money and Foreign Exchange Markets Are Key Components of the Financial System

Money markets are the financial markets where short-term financial assets are bought and sold. By
definition, the financial assets, such as stocks and bonds, that are traded in these markets will mature in one
year or less. Over a billion dollars in transactions take place in these markets on a daily basis. Financial
institutions, corporations, governments, and the U.S. Treasury are active in the money markets as they
adjust their short-term portfolios.

Foreign exchange markets facilitate the trade of one foreign currency for another. Most exchanges are
made in bank deposits and involve U.S. dollars. Over a trillion dollars in foreign exchange trades take place
every day; foreign exchange dealers handle most transactions. Businesses, financial institutions,
governments, investors, and individuals use the foreign exchange markets to adjust their currency holdings.

Domestic Money Markets

Money markets provide an important mechanism in an economy for transferring short-term funds from
lenders to borrowers.1 For corporations, governments, and financial institutions with temporary excess
funds, these markets provide an efficient means to lend to other corporations, governments, and individuals
who have a temporary need for funds. Money markets, therefore, represent the short-term spectrum of the
financial markets, where securities that mature in a year or less are traded.

Key money market characteristics:2

 "Generally characterized by a high degree of safety of principal."

 Most markets are informal "telephone" markets with low transaction costs.
 Assets are typically issued in large denominations, often $1 million or more.
 Most money market instruments are liquid, which means that they can be quickly converted into cash assets
without a sizeable loss.

Each day billions of dollars are traded in the money markets. Several important money market instruments
are listed below:3
 U.S. Treasury bills
 Short-term Federal agency securities
 Commercial paper
 Federal funds
 Net Eurodollar borrowings by domestic banks from their own foreign branches
 Large-denomination certificates of deposit ($100,000 or more)

Money Market Interest Rates

Forces influencing interest rates in the money markets are varied and may reflect supply and demand
conditions in different money market instruments. There are also broader forces that affect interest rates in
all money and capital markets. Rose notes that Treasury bills, with no default risk and an active secondary
market, usually yield the lowest rate in the money market and those other instruments appear to move with
Treasury bill rates. Goodfriend and Whelpley, however, point out that the current and expected interest
rates on federal funds are "… the basic rates to which all other money market rates are anchored." That
relationship reflects the use of the federal funds rate by the Federal Reserve in implementing monetary
policy.4

Foreign Exchange Markets Play an Important Role

The foreign exchange markets play a critical role in facilitating cross-border trade, investment, and
financial transactions. These markets allow firms making transactions in foreign currencies to convert the
currencies or deposits they have into the currencies or deposits they want. Most transactions are handled by
foreign exchange dealers; on a typical day they handle over a trillion dollars in foreign currency exchanges
involving U.S. dollars alone. The importance of foreign exchange markets has grown with increased global
economic activity, trade, and investment, and with technology that makes real-time exchange of
information and trading possible.

Factors Driving Exchange Rate Movements

A number of factors may influence foreign exchange rates, including the following cited by Rose (1994):

 Balance-of-payments position. A country experiencing a trade deficit usually faces downward pressure on
its foreign exchange rate.
 Speculation over future currency values. Speculators buy or sell currencies when they see profitable
opportunities.
 Domestic economic and political conditions. Deteriorating economic conditions and inflation typically
have an adverse effect on foreign exchange rates.
 Central bank intervention. Central banks may buy or sell currencies to influence the value of their currency.
 INTRODUCTION OF AUSTRALIA

Australia is a country in Oceania bordering the Indian Ocean and the Southern Pacific Ocean. Australia is
comprised of mainland Australia, the island of Tasmania, and several small islands in the Indian and
Pacific Oceans. The terrain is mostly low plateau with deserts. The government system is a federal
parliamentary democracy and a commonwealth realm. The chief of state is the queen and the head of
government is the prime minister. Australia has a mixed economic system in which the economy includes a
variety of private freedom, combined with centralized economic planning and government regulation.
Australia is a member of Asian Pacific Economic Cooperation (APEC) and the Trans-Pacific Partnership
(TPP).

The Australian mainland extends from west to east for nearly 2,500 miles (4,000 km) and from Cape York
Peninsula in the northeast to Wilsons Promontory in the southeast for nearly 2,000 miles (3,200 km). To
the south, Australian jurisdiction extends a further 310 miles (500 km) to the southern extremity of the
island of Tasmania, and in the north it extends to the southern shores of Papua New Guinea. Australia is
separated from Indonesia to the northwest by the Timor and Arafura seas, from Papua New Guinea to the
northeast by the Coral Sea and the Torres Strait, from the Coral Sea Islands Territory by the Great Barrier
Reef, from New Zealand to the southeast by the Tasman Sea, and from Antarctica in the far south by
the Indian Ocean.

Demonym
Noun: Australian(s)
Adjective: Australian
Capital City
Canberra (+10 GMT)
Currency
Australian dollar (AUD)
Languages
English 72.7%, Mandarin 2.5%, Arabic 1.4%, Cantonese 1.2%, Vietnamese 1.2%, Italian 1.2%,
Greek 1%, other 14.8%, unspecified 6.5% (2016 est.)

Ethnic Groups
English 25.9%, Australian 25.4%, Irish 7.5%, Scottish 6.4%, Italian 3.3%, German 3.2%, Chinese
3.1%, Indian 1.4%, Greek 1.4%, Dutch 1.2%, other 15.8% (includes Australian aboriginal .5%),
unspecified 5.4% (2011 est.)

Calling Code
61
Voltage
230/240
Religions
Protestant 23.1% (Anglican 13.3%, Uniting Church 3.7%, Presbyterian and Reformed 2.3%, Baptist
1.5%, Pentecostal 1.1%, Lutheran .7%, other Protestant .5%), Roman Catholic 22.6%, other
Christian 4.2%, Muslim 2.6%, Buddhist 2.4%, Orthodox 2.3% (Eastern Orthodox 2.1%, Oriental
Orthodox .2%), Hindu 1.9%, other 1.3%, none 30.1%, unspecified 9.6% (2016 est.)

Importance of the Australian Dollar

The central bank in Australia is called the Reserve Bank of Australia. As the 5th most traded currency in
the world, the Australian dollar is also referred to as buck, dough, or the Aussie. The Australian Dollar is
known as a commodity currency due to its substantial raw material exports. As a result, the AUD is
affected by China and other Asian import markets. Due to its relatively high interest rates, the Australian
Dollar is often used in carry trades with the Japanese Yen. A carry trade is a strategy in which a currency
with low interest rate is sold in order to buy a currency with a higher interest rate.
Early Currency in Australia
When New South Wales was first established in 1788 the English Pound was the official currency,
although Spanish Dollars were used quite regularly. In 1813, to try to discourage the illegal use of Spanish
Dollars, the centers of the coins were cut out; they became known as 'holey dollars' and the cores were
called 'dumps'; this was Australia's first form of coinage.
From the Pound Sterling to the Australian Dollar
In 1825, the government imposed the Sterling standard and British coins began to be minted in Australia.
These silver and bronze coins continued to be used until 1910, when a new national currency, the
Australian Pound, was introduced. The Australian Pound was fixed in value to the Pound Sterling and, as a
result, used a gold standard. Three years later, the first series of Australian notes were issued. In February
of 1966, the Australian Dollar (AUD) was introduced under a decimalized system; dollars and cents
replacing the pounds, shillings, and pence. In 1988, banknotes were converted to polymer, a technology
originally developed in Australia to help prevent counterfeiting.
Australian Dollar Stats

Name Australian Dollar

Symbol $

Minor unit 1/100 = Cent

Minor unit symbol c

Central bank rate 0.10%

Inflation 2.00%

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Australian Dollar Profile

Nicknames Buck, Dough

Coins Freq used: 5c, 10c, 20c, 50c, $1, $2

Bank notes Freq used: $5, $10, $20, $50, $100

Central
bank Reserve Bank of Australia

Australia, Christmas Island, Cocos (Keeling) Islands,

Norfolk Island, Ashmore and Cartier Islands, Australian
Antarctic Territory, Coral Sea Islands, Heard Island,
Users McDonald Islands, Kiribati, Nauru

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Live Currency Rates

Currency Rate Change

EUR / USD 1.13231 ▼

GBP / EUR 1.18228 ▼

USD / JPY 114.380 ▼

GBP / USD 1.33870 ▼

USD / CHF 0.920506 ▲

USD / CAD 1.28127 ▼

Currency Rate Change

EUR / JPY 129.514 ▼

AUD / USD 0.722498 ▼

Central Bank Rates

Currency Interest Rate

JPY -0.10%

CHF -0.75%

EUR 0.00%

USD 0.25%

CAD 0.25%

AUD 0.10%

NZD 0.50%

GBP 0.10%
 INTRODUCTION OF INDIA

India, officially the Republic of India, is a country in South Asia. It is the seventh-largest country by area,
the second-most populous country, and the most populous democracy in the world. Bounded by the Indian
Ocean on the south, the Arabian Sea  on the southwest, and the Bay of Bengal on the southeast, it shares
land borders with  Pakistan to the west; China, Nepal, and Bhutan to the north; and Bangladesh  and
Myanmar  to the east. In the Indian Ocean, India is in the vicinity of Sri Lanka and the Maldives;
its Andaman and Nicobar Islands share a maritime border with  Thailand,  Myanmar  and Indonesia.

Modern humans arrived on the Indian subcontinent from Africa no later than 55,000 years ago. Their long
occupation, initially in varying forms of isolation as hunter-gatherers, has made the region highly diverse,
second only to Africa in human genetic diversity. Settled life emerged on the subcontinent in the western
margins of the Indus river basin 9,000 years ago, evolving gradually into the Indus Valley Civilization of
the third millennium BCE. By 1200 BCE, an  archaic form of Sanskrit, an Indo-European language, had 
diffused into India from the northwest, unfolding as the language of the Rig-Veda, and recording the
dawning of Hinduism in India. The Dravidian languages of India were supplanted in the northern and
western regions. By 400  BCE, stratification  and  exclusion  by caste had emerged within Hinduism, and
Buddhism  and  Jainism had arisen, proclaiming social orders  unlinked to heredity. Early political
consolidations gave rise to the loose-knit Maurya  and Gupta Empires based in the Ganges Basin. Their
collective era  was suffused with wide-ranging creativity, but also marked by the declining status of
women, and the incorporation of  un touch ability into an organized system of belief. In South India,
the Middle kingdoms exported Dravidian-languages scripts and religious cultures to the kingdoms
of Southeast Asia.

In the early medieval era, Christianity, Islam, Judaism, and Zoroastrianism put down roots on India's

southern and western coasts. Muslim armies from Central Asia intermittently overran India's northern
plains, eventually establishing the Delhi Sultanate, and drawing northern India into the
cosmopolitan networks of medieval Islam. In the 15th century, the Vijayanagara Empire created a long-
lasting composite Hindu culture in south India. In the  Punjab,  Sikhism emerged, rejecting in stitution
alised religion. The Mughal Empire, in 1526, ushered in two centuries of relative peace, leaving a legacy of
luminous architecture. Gradually expanding rule of the British East India Company followed, turning India
into a colonial economy, but also consolidating its sovereignty. British Crown rule began in 1858. The
rights promised to Indians were granted slowly, but  technological changes were introduced, and ideas of
education, modernity and the public life took root. A pioneering and influential nationalist movement
emerged, which was noted for nonviolent resistance and became the major factor in ending British rule. In
1947 the British Indian Empire was partitioned into two independent dominions, a Hindu-
majority Dominion of India and a Muslim-majority Dominion of Pakistan, amid large-scale loss of life and
an unprecedented migration.

India has been a federal republic since 1950, governed in a democratic parliamentary system. It is

a pluralistic, multilingual and multi-ethnic society. India's population grew from 361 million in 1951 to
1.211 billion in 2011. During the same time, its nominal per capita income increased from US$64 annually
to US$1,498, and its literacy rate from 16.6% to 74%. From being a comparatively destitute country in
1951, India has become a  fast-growing major economy and a hub for information technology services,
with an expanding middle class. It has a space programme which includes several planned or
completed extraterrestrial missions. Indian movies, music, and spiritual teachings play an increasing role in
global culture. India has substantially reduced its rate of poverty, though at the cost of increasing economic
inequality. India is a nuclear-weapon state, which ranks high in military expenditure. It has disputes over
Kashmir with its neighbours, Pakistan and China, unresolved since the mid-20th century. Among the socio-
economic challenges India faces are  gender inequality, child malnutrition, and rising levels of air
pollution. India's land is mega diverse, with four  biodiversity hotspots. Its forest cover comprises 21.7% of
its area. India's wildlife, which has traditionally been viewed with tolerance in India's culture, is supported
among these forests, and elsewhere, in protected habitats.

DOW FUTURES

-0.05%

-19.00

35,362.00

S&P FUTURES

-0.11%

-5.25

4,635.50

NASDAQ FUTURES

-0.20%
-31.75

15,948.25

GOLD

-0.13%

1,786.53

OIL (WTI)

+0.34%

71.36

BTC/USD

+0.75%

The central bank in India is called the Reserve Bank of India. The INR is a managed float, allowing the
market to determine the exchange rate. As such, intervention is used only to maintain low volatility in
exchange rates.

Early Coinage of India

India was one of the first issuers of coins, circa 6th Century BC, with the first documented coins being
called 'punch-marked' coins because of the way they were manufactured. India's coinage designs frequently
changed over the next few centuries as various empires rose and fell. By the 12th century a new currency
referred to as Tanka was introduced. During the Mughal period, a unified monetary system was established
and the silver Rupayya or Rupee was introduced. The states of pre-colonial India minted their coins with a
similar design to the silver Rupee with variations depending on their region of origin.
Currency in British India
In 1825, British India adopted a silver standard system based on the Rupee and was used until the late 20th
century. Although India was a colony of Britain, it never adopted the Pound Sterling. In 1866, financial
establishments collapsed and control of paper money was shifted to the British government, with the
presidency banks being dismantled a year later. That same year, the Victoria Portrait series of notes was
issued in honor of Queen Victoria, and remained in use for approximately 50 years.
The Modern Day Indian Rupee
After gaining its independence in 1947 and becoming a republic in 1950, India's modern Rupee (INR) was
changed back to the design of the signature coin. The Indian Rupee was adopted as the country's sole
currency, and the use of other domestic coinage was removed from circulation. India adopted a
decimalization system in 1957.
In 2016, the Rs 500 and Rs 1,000 ceased to be legal tender in India. The removal of the denominations is an attempt
to stop corruption and illegal cash holdings. In November of the same year, the Reserve Bank of India began issuing
₹ 2000 denomination banknotes in the Mahatma Gandhi (New) Series.

Indian Rupee Stats

Name Indian Rupee

Symbol ₹

Minor unit 1/100 = paisa

Minor unit symbol p

Inflation 3.60%

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Indian Rupee Profile

Nicknames Taaka, Rupayya, Rūbāi, Athanni (for 50 Paise coins)

Coins Freq used: ₹1, ₹2, ₹5, ₹10, p50

 Freq used: ₹5, ₹10, ₹20, ₹50, ₹100, ₹500, ₹2000, ₹200
Bank notes Rarely used: ₹1, ₹2

Central bank Reserve Bank of India

Users India, Bhutan, Nepal

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Live Currency Rates

Currency Rate Change

EUR / USD 1.13228 ▼

GBP / EUR 1.18231 ▼

USD / JPY 114.380 ▼

GBP / USD 1.33870 ▼

USD / CHF 0.920511 ▲

USD / CAD 1.28127 ▼

EUR / JPY 129.510 ▼

 Currency Rate Change

AUD / USD 0.722499 ▼

Central Bank Rates

Currency Interest Rate

JPY -0.10%

CHF -0.75%

EUR 0.00%

USD 0.25%

CAD 0.25%

AUD 0.10%

NZD 0.50%

GBP 0.10%

The rupee has been losing value (or depreciating or weakening) against the dollar over the past few
months.

 The exchange rate of rupee is one of the markers to compare Indian economy’s competitiveness vis-a-vis
other economies (also amid Covid-19 outbreak).
 Another measure for comparison is looking at the growth rates of Gross Domestic Product (GDP) and
Gross Value Added (GVA).

 High-frequency data like sales of automobiles etc. can also be used as a proxy to compare economies.

Key Points

 Exchange Rate

o The price of one currency in terms of the other is known as the exchange rate.

o A currency’s exchange rate vis-a-vis another currency reflects the relative demand among the holders of
the two currencies.

o For e.g. If the US dollar is stronger than the rupee (implying value of dollar is higher with respect to
rupee), then it shows that the demand for dollars (by those holding rupee) is more than the demand for
rupees (by those holding dollars).

o This demand in turn depends on the relative demand for the goods and services of the two countries.

 Index for Exchange Rate

o Since a country interacts with many countries, it wants to see the movement of the domestic currency
relative to all other currencies in a single number rather than by looking at bilateral rates.

o That is, it would want an index for the exchange rate against other currencies, just as it uses a price
index (CPI or WPI) to show how the prices of goods in general have changed.

o The Reserve Bank of India tabulates the rupee’s Nominal Effective Exchange Rate (NEER) in relation
to the currencies of 36 trading partner countries.

 This is a weighted index — that is, countries with which India trades more are given a greater
weight in the index.

 A decrease in this index denotes depreciation in rupee’s value whereas an increase reflects

appreciation.

o There is one more measure that is even better at capturing the actual change. This is called the Real
Effective Exchange Rate (REER) and is essentially an improvement over the NEER because it
also takes into account the domestic inflation in the various economies.
 o The REER is the weighted average of NEER adjusted by the ratio of domestic prices to foreign
price.

 Impact of Inflation on Exchange Rate

o Many factors affect the exchange rate between any two currencies ranging from the interest rates to
political stability (less of either results in a weaker currency). Inflation is one of the most important
factors.

o Illustration: Imagine that the Rupee-Dollar exchange rate was exactly 1 in the first year. This means that
with Rs 100, one could buy something that was priced at $100 in the US. But suppose the Indian inflation
is 20% and the US inflation is zero. Then, in the second year, an Indian would need Rs 120 to buy the
same item priced at $100, and the rupee’s exchange rate would depreciate (reduce in value) to 1.20.

 Comparison between NEER and REER

 As the chart shows, in NEER terms, the rupee has depreciated to its lowest level since November 2018. The
rupee has been steadily losing value — showing the Indian economy’s reducing competitiveness— since
July 2019.

 In REER terms also, the rupee has depreciated in March and fallen to its lowest level since September 2019.

 The difference between trends of NEER and REER was due to India’s domestic retail inflation being lower
relative to the other 36 countries. As domestic inflation started rising, the REER, too, started depreciating
like the NEER.
ding
Becker C and M Davies (2002), ‘Developments in the Trade-Weighted Index’, RBA Bulletin October, pp 1–6.

Edwards K, D Fabbro, M Knezevic and M Plumb (2008), ‘ An Augmented Trade-weighted Index of the
Australian Dollar’, RBA Bulletin, February.

Ellis L (2001), ‘Measuring the Real Exchange Rate: Pitfalls and Practicalities’, RBA Research Discussion
Paper 2001-04.

Weights for the TWI

2. Why Does Australia have a Floating Exchange Rate?

Exchange rate policy in Australia shifted through several regimes before the Australian dollar was eventually
floated in 1983 (Graph 3). From 1931, Australia's currency was pegged to the UK pound, before it was changed
to a peg against the US dollar in 1971. For much of this period – from 1944 to the early 1970s – Australia's
exchange rate peg operated as part of a global system of pegged exchange rates, known as the Bretton Woods
system. When the Bretton Woods system broke down in the early 1970s, the major advanced economies floated
their exchange rates. However, Australia did not follow suit, in part reflecting the fact that, at that time,
Australia's financial sector was relatively underdeveloped.

The Australian dollar did, however, become progressively more flexible from around the mid 1970s. In 1974, a
decision was made to peg the Australian dollar against the TWI and in 1976 this peg was changed from a ‘hard’
peg to a crawling peg. The crawling peg involved regular adjustments to the level of the exchange rate, in
contrast to the occasional discrete revaluations and devaluations that had occurred under the previous regimes.

Graph 3

The Australian dollar eventually floated in 1983, for a number of reasons. First, the fixed exchange rate regime
made it difficult to control the money supply. Like many other countries at that time, Australia targeted growth
in the money supply, under a policy known as ‘monetary targeting’. However, under the fixed and crawling peg
arrangements, the Reserve Bank was required to meet all requests to exchange foreign currency for Australian
dollars, or vice versa, at the prevailing exchange rate. This meant that the supply of Australian dollars (and
therefore the domestic money supply) was affected by changes in the demand for purchases and sales of
Australian dollars, which could arise from Australia's international trade and capital flows. While the Reserve
Bank could seek to offset these effects (through a process called sterilisation), in practice, this was often
difficult to achieve. This ultimately meant that prior to the float there was significant volatility in domestic
monetary conditions (Graph 4).

Graph 4

Floating the exchange rate addressed this problem. It meant that one of the final prerequisites for effective
domestic monetary policy had been achieved (the other, namely that the government fully finance any budget
deficit in the market at market interest rates, had been achieved in the early 1980s when the Australian
Government adopted a tender system for issuing bonds). While the ability to gain greater control of domestic
monetary conditions was well understood at the time as one of the key benefits of floating the exchange rate, the
decision to float in late 1983 occurred largely as a result of speculative pressure on the exchange rate. That is, in
the lead-up to the float, there were very large capital inflows coming into Australia from speculators betting on
an appreciation of the Australian dollar. This was not sustainable and the government had the choice of either
tightening capital controls or floating the exchange rate. The latter was chosen as the more desirable course of
action.

Consistent with obtaining better control over domestic monetary conditions, the choice of exchange rate regime
can also influence the way in which economies cope with external shocks. Take for example, a sharp rise in the
terms of trade (the ratio of export prices to import prices), as experienced in Australia's recent mining boom.
The combination of a flexible exchange rate and independent monetary policy led to a high exchange rate and
high interest rates relative to the rest of the world during that period, both of which played an important role in
preserving overall macroeconomic stability. This is in contrast to previous resources booms, which typically
ended with an episode of significant inflation.

In summary, the floating exchange rate regime that has been in place since 1983 is widely accepted as having
been beneficial for Australia. The floating exchange rate has provided a buffer against external shocks –
particularly shifts in the terms of trade – allowing the economy to absorb them without generating the large
inflationary or deflationary pressures that tended to result under the previous fixed exchange rate regimes.
While discretionary changes were made to the value of the Australian dollar under previous regimes in response
to developing pressures, it was extremely difficult to calibrate the adjustments to provide an effective buffer
against the shocks. The shift to a floating exchange rate has therefore contributed to a reduction in output
volatility over the past two decades or so. Importantly, it has also enabled the Reserve Bank to set monetary
policy that is best suited to domestic conditions (rather than needing to meet a certain target level for the
exchange rate).
Related Reading
Atkin T, M Caputo, T Robinson and H Wang (2014), ‘Macroeconomic Consequences of Terms of Trade
Episodes, Past and Present’, RBA Research Discussion Paper No 2014-01.

Ballantyne A, J Hambur, I Roberts and M Wright (2014), ‘Financial Reform in Australia and China’, RBA
Research Discussion Paper 2014-10.

Debelle G and M Plumb (2006), ‘The Evolution of Exchange Rate Policy and Capital Controls in
Australia’, Asian Economic Papers, 5(2), pp 7–29.

Lowe P (2012), ‘The Changing Structure of the Australian Economy and Monetary Policy’, Address to the
Australian Industry Group 12th Annual Economic Forum, Sydney, 7 March.

Stevens G (2013), ‘The Australian Dollar: Thirty Years of Floating’, Address to the Australian Business
Economists’ Annual Dinner, Sydney, 21 November.

3. What Determines the Behaviour of the Exchange Rate?

One important determinant of a country's trade-weighted exchange rate over the long run is whether it has a
higher or lower inflation rate than its trading partners. The theory of purchasing power parity (PPP) suggests
that the exchange rate between two countries will adjust to ensure that purchasing power is equalised in both
countries. If a country's inflation rate is persistently higher than that of its trading partners, its trade-weighted
exchange rate will tend to depreciate to prevent a progressive loss of competitiveness over time. Graph 5
demonstrates this by showing the relationship between the nominal Australian dollar TWI and the ratio of the
Australian consumer price index (CPI) to the average price level of Australia's trading partners. From the mid
1970s through to the end of the 1980s, prices in Australia rose more quickly than prices overseas. The TWI
depreciated over the same period, but a large part of this was doing no more than offsetting the cumulatively
higher inflation Australia was experiencing. In other words, much of what appears to have been a potential gain
in competitiveness due to the lower exchange rate was offset by Australia's relatively poor performance on
inflation.

Graph 5

Estimates of real exchange rates adjust for this difference in inflation rates. Between the mid 1970s and the end
of the 1980s, when Australia's CPI was rising faster than that of its trading partners, the nominal TWI
depreciated by about 50 per cent, whereas the real TWI depreciated by 30 per cent. While still subject to
considerable fluctuations, movements in real exchange rates provide a better guide to changes in
competitiveness than movements in nominal exchange rates. A pure purchasing power parity theory is limited to
the extent that it does not capture structural factors affecting the economy, which have arguably been important
in Australia's case over the past decade or so. In recognition of this, one extension of the pure purchasing power
parity theory is the Balassa-Samuelson model, which predicts that countries which experience relatively rapid
productivity growth in their tradable sectors will experience real exchange rate appreciation (and vice versa).
While cross-country productivity differentials may have explained part of Australia's real exchange rate
depreciation in the mid to late 1980s, they are less able to explain the appreciation of the Australian dollar over
the period from the mid 2000s through to the peak of the mining boom.

Historically, one of the strongest influences on the Australian dollar has been the terms of trade. For example, a
rise in the terms of trade as a result of an increase in the prices of commodities (which are an important
component of Australia's exports) provides an expansionary impulse to the economy through an increase in
income. The increased demand for inputs from the export sector also creates inflationary pressure. An
appreciation of the exchange rate, together with higher domestic interest rates, will counteract these influences
to some extent, thereby contributing to overall macroeconomic stability.

However, the strength of the relationship between the Australian dollar and the terms of trade has varied over
time (Graph 6). In the first 15 years of the floating exchange rate, the relationship was on average one-for-one,
but it has since weakened. This weakening has implications for the robustness of models that seek to estimate a
‘fair value’ for the Australian dollar (discussed below). Nevertheless, changes in the terms of trade still play a
dominant role in explaining changes in Australia's real exchange rate.

Graph 6

Factors that affect capital transactions are a third major influence on the exchange rate, although their
importance has tended to vary over time. There are a range of factors which affect relative rates of return on
Australian dollar assets including monetary policy settings, expectations about future economic growth and
inflation, the relative risk premium associated with investing in Australian dollar assets, and more broadly,
investors' appetite for taking on risk. Anecdotally, there have been a number of periods since the float when
relative rates of return were seen as being a major influence. One such episode occurred in the late 1980s, when
Australian real interest rates were much higher than those overseas and the exchange rate rose sharply. The
second was in the late 1990s, when Australian real interest rates fell below those in the US and the exchange
rate depreciated. The third was in the first half of the 2000s, when Australian real interest rates were again
notably higher than those in the major economies, as the major economies experienced a downturn and
monetary policy was eased in these countries. In the decade following the global financial crisis, relatively high
real interest rates in Australia compared with in the major advanced economies were likely to have influenced
the Australian dollar. Although this effect may have waned in recent years, particularly as differences in interest
rates between Australia and the major advanced economies declined.

Historically, Australian interest rates have generally been higher than those in the major economies, in part
because Australian dollar assets have tended to embody a higher risk premium. Changes in the size of the
relative risk premium can influence the relative demand for Australian dollar assets and therefore also have a
direct effect on the exchange rate. For example, the relative risk premium declined during the European debt
crisis, which saw foreign demand for highly rated Australian government debt increase. This was reflected in
strong capital inflows to the Australian public sector in 2010 and 2011, which are likely to have provided some
support to the Australian dollar (though these inflows were somewhat offset by outflows from the private sector
over this period, Graph 7).

Graph 7

Empirical models of the exchange rate

While it is widely accepted that attempts to forecast exchange rates are fraught with difficulty, even attempts to
model historical movements in exchange rates have met with mixed success. However, compared with some
other currencies, efforts to model the Australian dollar exchange rate in the post-float era have been relatively
successful in explaining medium-term movements in the currency. Two key determinants of the Australian
dollar are the terms of trade and differences in interest rates between Australian and other major advanced
economies.

While it is possible to identify some key determinants of the exchange rate, it is important to note that their
impact can vary over time. In particular, while the terms of trade have displayed a strong correlation with the
exchange rate in the post-float era, there have been periods where this relationship has not been as strong (as
discussed above). This relationship was particularly weak in the late 1990s and early 2000s, when Australia's
terms of trade was rising but the nominal and real exchange rates both declined substantially. Some part of this
decline reflected the substantial appreciation in the US dollar at the time, which was in turn attributable to
investors shifting their portfolios towards investment in ‘new economy’ technology assets and away from the
so-called ‘old economy’ assets prevalent in Australia. However, the relationship strengthened again during the
mining boom, and a notable feature of the period after the mining boom when the Australian dollar depreciated
was a decline in the terms of trade.

Differences in interest rates between Australia and other major advanced economies have also helped explain
movements in the Australian dollar exchange rate. The extraordinary monetary policy measures undertaken by
major advanced economies following the global financial crisis are likely to have supported the Australian
dollar. These policies depressed returns on low-risk assets, such as government debt, encouraging investors to
search for higher yields, and demand for Australian assets increased. At times, the stock of foreign liabilities,
the current account balance or economic growth differentials have been found to have an influence. In part, the
changing influence of some of these variables reflects the varying focus of financial market participants.

Related Reading
Battellino R (2010), ‘Mining Booms and the Australian Economy’, Address to The Sydney Institute, Sydney, 23
February.

Beechey M, N Bharucha, A Cagliarini, D Gruen and C Thompson (2000), ‘A Small Model of the Australian
Macroeconomy’, RBA Research Discussion Paper RDP2000-05.

Blundell-Wignall A, J Fahrer and A Heath (1993), ‘The Exchange Rate, International Trade and the Balance of
Payments’, in A Blundell-Wignall (ed), Major Influences on the Australian Dollar Exchange Rate, Proceedings
of a Conference, Reserve Bank of Australia, Sydney, pp 30–78.

Chapman B, J Jaaskela and E Smith (2018) ‘A Forward-looking Model of the Australian Dollar’, RBA Bulletin,
December.

Chen Y and K Rogoff (2003), ‘Commodity currencies’, Journal of International Economics, vol. 60(1), pp 133–
160.

Clifton K and M Plumb (2007), ‘Intraday Currency Market Volatility and Turnover’, RBA Bulletin, December.

Cockerell L, J Hambur, C Potter, P Smith and M Wright (2015), ‘Modelling the Australian Dollar’, RBA
Research Discussion Paper RDP2015-12.

D'Arcy P and E Poole (2010), ‘ Interpreting Market Responses to Economic Data’, RBA Bulletin, September.

Edwards K and M Plumb (2009), ‘US Economic Data and the Australian Dollar’, RBA Bulletin, July.

Gruen D (2001), ‘Some Possible Long-term Trends in the Australian Dollar’, RBA Bulletin December, pp 30–
41.
Gruen D and J Wilkinson (1991), ‘Australia's Real Exchange Rate – Is it Explained by the Terms of Trade or by
Real Interest Differentials?’, RBA Research Discussion Paper RDP9108.

Jääskelä, J and P Smith (2011), ‘Terms of Trade Shocks: What are They and What Do They Do?’, RBA
Research Discussion Paper RDP2011-05.

Kearns J and P Manners (2005), ‘The Impact of Monetary Policy on the Exchange Rate: A Study Using
Intraday Data’, RBA Research Discussion Paper RDP2005-02.

Meese R and K Rogoff (1983), ‘Empirical Exchange Rate Models of the Seventies: do they fit out of
sample?’, Journal of International Economics, 14(1/2), pp 3–24.

Reserve Bank of Australia (2005), ‘ Commodity Prices and the Terms of Trade’, RBA Bulletin, April, pp 1–7.

Stone A, T Wheatley and L Wilkinson (2005), ‘A Small Model of the Australian Macroeconomy: An Update’,
RBA Research Discussion Paper RDP2005-11.

4. The Exchange Rate and Monetary Policy

The exchange rate plays an important part in considerations of monetary policy in all countries. However, the
exchange rate has not served as a target or an instrument of monetary policy in Australia since the 1980s –
instead, it is best viewed as part of the transmission mechanism for monetary policy. More generally, the
exchange rate serves to buffer the economy from external shocks, such that monetary policy can be directed
towards achieving domestic price stability and growth.

Since the early 1990s, Australian monetary policy has been conducted under an inflation targeting framework.
Under inflation targeting, monetary policy no longer targets any particular level of the exchange rate. Various
measures suggest that exchange rate volatility has been higher in the post-float period (Graph 4, above).
However, exchange rate flexibility, together with a number of other economic reforms – including in product
and labour markets as well as reforms to the policy frameworks for both fiscal and monetary policy – has likely
contributed to a decline in output volatility over this period. In particular, exchange rate fluctuations have
played a particularly important role in smoothing the influence of terms of trade shocks. Similar findings have
been made for other commodity producing countries.

Both through counterbalancing the influence of external shocks, and more directly, through its influence on
domestic incomes and therefore demand, the exchange rate has been an important influence on inflation. Under
the previous fixed exchange rate regimes, the Australian economy ‘imported’ inflation from the country (or
countries) to which the exchange rate was pegged. However, the floating of the exchange rate meant that
changes in world prices no longer had a direct effect on domestic prices: not only did it break the mechanical
link between domestic and foreign prices, but it meant that the Reserve Bank was now able to implement
independent monetary policy. Instead, under the floating exchange rate regime, movements in the exchange rate
have a direct influence on inflation through changes in the price of tradable goods and services – a process
commonly referred to as ‘exchange rate pass-through’. The extent of this influence has changed since the float,
and since the introduction of inflation targeting. In particular, exchange rate pass-through has become more
protracted in aggregate, but is faster and larger for manufactured goods, which are often imported. The observed
slowdown in aggregate exchange rate pass-through is not unique to Australia, having been also found in the
United Kingdom and the United States, among others.

Related Reading
Atkin T and G La Cava (2018), ‘The Transmission of Monetary Policy: How Does It Work?’, RBA Bulletin,
September.

Chung E, M Kohler and C Lewis (2011), ‘ The Exchange Rate and Consumer Prices’, RBA Bulletin September
Quarter, pp 9–16.

Grenville S (1997), ‘Monetary Policy and Inflation Targeting’, in P Lowe (ed), ‘ The Evolution of Monetary
Policy: From Money Targets to Inflation Targets’, Proceedings of a Conference, Reserve Bank of Australia,
Sydney, pp 125–158.

Gruen D and G Stevens (2000), ‘The Australian Economy in the 1990s’, in D Gruen and S Shrestha (ed),
‘Australian Macroeconomic Performance and Policies in the 1990s’, Proceedings of a Conference, Reserve
Bank of Australia, Sydney, pp 1–72.

Heath A, I Roberts and T Bulman (2004), ‘The Future of Inflation Targeting’, in C Kent and S Guttmann (eds),
‘Inflation in Australia: Measurement and Modelling’, Proceedings of a Conference, Reserve Bank of Australia,
Sydney, pp 167–207.

Manalo J, D Perera and D Rees (2014), ‘Exchange Rate Movements and the Australian Economy’, RBA
Research Discussion Paper RDP2014-11.

Simon J (2001), ‘The Decline in Australian Output Volatility’ RBA Research Discussion Paper RDP2001-01.

5. The Foreign Exchange Market

Foreign exchange turnover in Australia is currently around A$160 billion a day. According to the most recent
global survey of foreign exchange markets (conducted by the Bank for International Settlements in April 2019)
the Australian market is the eighth largest in the world, although the two largest – the United Kingdom and the
United States – are much larger than the remainder. About half of the turnover in the Australian foreign
exchange market is against the Australian dollar (Graph 8). The remaining half is largely made up of trade in
major currencies against the US dollar, although trade in less traditional currencies has continued to expand.

Graph 8

Between 2000 and 2007, turnover in the Australian and global markets grew rapidly, supported by increased
cross-border investment and trade flows. Following the onset of the global financial crisis, foreign exchange
turnover fell in both Australia and in other major markets, driven initially by a decline in foreign exchange (FX)
swaps turnover, which was in turn related to reduced cross-border investment activity (FX swaps are
transactions in which parties agree to exchange two currencies on a specific date and to reverse the exchange at
a later date, and are commonly used to hedge foreign exchange exposures arising from cross-border claims,
Graph 9). Subsequently, the collapse in international trade in late 2008 also saw turnover in the spot market fall
sharply. While between 2009 and early 2011, foreign exchange turnover in the Australian market recovered in
line with global markets, it dipped again in late 2011 amid heightened market uncertainty related to the
European sovereign debt crisis. More recently, foreign exchange turnover in Australia has remained relatively
stable.

Graph 9

In addition to the traditional market segment (comprising turnover in spot foreign exchange, outright forward
contracts and foreign exchange swaps), other ‘non-traditional’ foreign exchange derivatives such as options and
currency swaps are also traded in the Australian market. The Australian market processes around A$5 billion of
transactions in these non-traditional products every day, covering a wide variety of products, ranging from very
simple to more complex designs. Foreign exchange derivatives, including both traditional and non-traditional
products, are an important tool for many Australian companies with foreign currency exposures, because they
can be used to provide protection against adverse exchange rate movements.

As well as trading in Australia, there is considerable turnover of the Australian dollar in other markets. Global
trade in the Australian dollar averaged around US$450 billion per day in April 2019 (the date of the most recent
global survey), making it the fifth most traded currency in the world, and the AUD/USD the fourth most traded
currency pair (Graph 10). The size of the market indicates that the exchange rate is being determined in a liquid,
active and competitive marketplace.

Graph 10

Related Reading
Cassidy N, K Clifton, M Plumb and B Robertson (2008), ‘The Australian Foreign Exchange and Derivatives
Markets’, RBA Bulletin, January.

Garner M, A Nitschke and D Xu (2016), ‘Developments in Foreign Exchange and OTC Derivatives Markets’,
RBA Bulletin, December.

Guo J, D Ranasinghe and Z Zhang (2019), ‘Developments in Foreign Exchange and Over-the-counter
Derivatives Markets’, RBA Bulletin, December.

Heath A and J Whitelaw (2011), ‘Electronic Trading and the Australian Foreign Exchange Market’,
RBA Bulletin, June.

Nightingale S, C Ossolinski and A Zurawski (2010), ‘Activity in Global Foreign Exchange Markets’,
RBA Bulletin, December.

6. Why Does the Reserve Bank Intervene in the Foreign

Exchange Market?
The Bank's approach to foreign exchange market intervention has evolved over the past 30 years as the
Australian foreign exchange market has matured. In particular, intervention has become less frequent, as
awareness of the benefits of a freely floating exchange rate has grown. These benefits rely in part upon market
participants and end-users being able to effectively manage their exchange rate risk, a process requiring access
to well-developed foreign exchange markets.

In the period immediately following the float, the market was at an early stage of development and the exchange
rate was relatively volatile as a result. As market participants were not always well-equipped to cope with this
volatility, the Bank sought to mitigate some of this volatility to lessen its effect on the economy. This period has
previously been described as the ‘testing and smoothing’ phase of intervention.
But even before the end of the 1980s, the foreign exchange market had developed significantly, and the need to
moderate day-to-day volatility was much diminished. Accordingly, the focus of intervention evolved towards
responding to episodes where the exchange rate was judged to have ‘overshot’ the level implied by economic
fundamentals and/or when speculative forces appeared to have been dominating the market. This shift resulted
in less frequent, but typically larger, transactions than those undertaken in the 1980s (Graph 11).

Graph 11

As the foreign exchange market became increasingly sophisticated and market participants became better
equipped to manage volatility, particularly through hedging, the threshold for what constituted an
‘overshooting’ in the exchange rate became much higher: a moderate misalignment was no longer considered
sufficient to justify intervention.

More recently, intervention has been in response to episodes that could be characterised by evidence of
significant market disorder – that is, instances where market functioning has been impaired to such a degree that
it was clear that the observed volatility was excessive – although the Bank continues to retain the discretion to
intervene to address gross misalignment of the exchange rate. In particular, on certain days during August 2007
and October/November 2008, the Reserve Bank identified trading conditions that had become extremely
disorderly, with liquidity deteriorating rapidly in the spot market even though there did not appear to be any new
public information, resulting in sharp price movements between trades. Accordingly, on each of these
occasions, the Reserve Bank's interventions were designed to improve liquidity in the market and thereby limit
disruptive price adjustments.

Related Reading
Becker C and M Sinclair (2004), ‘Profitability of Reserve Bank Foreign Exchange Operations: Twenty Years
After The Float’, RBA Research Discussion Paper RDP2004-06.

Newman V, C Potter and M Wright (2011), ‘ Foreign Exchange Market Intervention’, RBA Bulletin, December.

Stevens G (2013), ‘The Australian Dollar: Thirty Years of Floating’, Address to the Australian Business
Economists’ Annual Dinner, Sydney, 21 November.

7. How Does the Reserve Bank Intervene in the Foreign

Exchange Market?
When the Reserve Bank intervenes in the foreign exchange market, it creates demand or supply for the
Australian dollar by buying or selling Australian dollars against another currency. The Reserve Bank almost
always conducts its intervention against the US dollar, owing to the fact that liquidity and turnover are greatest
in the Australian dollar/US dollar currency pair. The Reserve Bank has the capacity to deal in foreign exchange
markets around the world and in all time zones. The Reserve Bank's foreign exchange intervention transactions
to date have been executed almost exclusively in the spot market. If the Reserve Bank chooses to neutralise any
resulting effects on domestic liquidity conditions, foreign exchange intervention transactions can be ‘sterilised’
through offsetting transactions in the domestic money market or, as has been typically the case, through the use
of foreign exchange swaps.

In large part, the approach taken by the Bank will depend on the precise objective of the intervention and, in
particular, the type of signal the Bank wishes to send to the market. By using its discretion in deciding when to
transact, the size of the transaction and how the transaction will be conducted, the Reserve Bank is potentially
able to elicit different responses from the foreign exchange market. Generally speaking, transactions that are
relatively large in size and signalled clearly are expected to have the largest effect on market conditions, with
these effects further amplified if trading conditions are relatively illiquid. This is in stark contrast to the routine
foreign exchange transactions undertaken by the RBA on behalf of the Government, where the express intention
is to have a minimal influence on the exchange rate.

Historically, the Reserve Bank has generally chosen to intervene by transacting in the foreign exchange market
in its own name, in order to inform participants of its presence in the market. This ‘announcement effect’ can
itself have a significant impact on the exchange rate, as it conveys information to the market about the Reserve
Bank's views on the exchange rate from a policy perspective. The intervention transactions are typically
executed through the electronic broker market, or through direct deals with banks. Intervention in the broker
market could involve the Reserve Bank placing a ‘bid’ or ‘offer’ (which means the market needs to move to that
precise level before a deal is struck) but, if it wishes to send a stronger signal, the Reserve Bank would transact
immediately in the market, either ‘giving the bid’ or ‘paying the offer’ of the broker. Direct deals with banks are
similar, whereby the Reserve Bank would request a ‘two-way’ quote for a fixed amount and either ‘give the
bank's bid’ or ‘pay the bank's offer’. The effects of direct transactions with banks are realised over two stages.
First, after receiving a direct quote request from the Reserve Bank, banks will adjust their quotes as
compensation for holding the currency the Reserve Bank is trying to sell and for bearing the potential risk that
the Reserve Bank is simultaneously dealing with other banks (who would also be adjusting their quotes). For
example, if the Reserve Bank wants to sell US dollars and purchase Australian dollars, banks will increase their
Australian dollar offer quotes. Second, after banks have traded with the Reserve Bank, this can trigger
additional price adjustments among market makers in the spot foreign exchange market.
 Related Reading
Becker C and M Sinclair (2004), ‘Profitability of Reserve Bank Foreign Exchange Operations: Twenty Years
After The Float’, RBA Research Discussion Paper RDP2004-06.

Newman V, C Potter and M Wright (2011), ‘ Foreign Exchange Market Intervention’, RBA Bulletin, December.

8. Has Intervention Been Effective?

It is inherently difficult to quantify the effect of intervention transactions on the exchange rate for at least three
key reasons:

i. Interventions usually take place when the exchange rate is moving in the opposite direction to the expected
effect of the intervention and it is virtually impossible to know what would have happened to the exchange rate
in the absence of the intervention.

ii. It may not always be appropriate to measure the success or failure of interventions using a simple metric such as
the daily exchange rate movement, nor may it be feasible to develop alternatives.

iii. Data which accurately identify the magnitude of genuine intervention transactions have been scarce, with
researchers often resorting to the use of imperfect proxies.

These difficulties have led to the development of a number of different methods of attempting to evaluate the
effectiveness of intervention, three of which have been employed by Reserve Bank staff in recent years to
evaluate the effectiveness of Reserve Bank intervention.

The first (Kearns and Rigobon, 2003), used the change in the Reserve Bank's intervention policy in the early
1990s (when the Bank ceased to make very small interventions) to identify the contemporaneous relationship
between intervention and the exchange rate. This study supported the description of Reserve Bank intervention
as ‘leaning against the wind’ – that is, acting to slow or correct excessive trends in the exchange rate.
Intervention was found to have a significant effect on the exchange rate, particularly on the day of intervention.

The second (Becker and Sinclair, 2004 and Andrew and Broadbent, 1994) used the ‘profits test’ to evaluate the
effectiveness of intervention, as advocated by Friedman (1953). The application of the profits test relies on the
central bank acting as a stabilising long-term speculator. If the objective of the central bank is to limit
fluctuations in the exchange rate, this will tend to involve the purchase of the local currency (sale of foreign
currency) when the exchange rate is relatively low, and the sale of the local currency (purchase of foreign
currency) when the exchange rate is high. If the central bank is successful in ‘buying low’ and ‘selling high’, its
intervention should yield a profit. It follows from this that if a central bank has been profitable in its
intervention, it must have bought low and sold high, therefore contributing to the stabilisation of the exchange
rate. These studies both found that the Reserve Bank's intervention activities have been profitable, and therefore,
stabilising.

The third study (Newman, Potter and Wright, 2011) presented the results of time series econometrics using a
unique dataset that specifically addressed problem (iii) above. Notwithstanding the improved dataset, the results
of this paper mainly demonstrated the difficulties in drawing strong conclusions about the effectiveness of
interventions from time series analysis, owing to some inherent limitations – in particular, problems (i) and (ii)
above. Nevertheless, this study does find some weak evidence that the Reserve Bank's interventions have been
effective.

Related Reading
Andrew R, and J Broadbent (1994), ‘Reserve Bank operations in the foreign exchange market: effectiveness and
profitability’, RBA Research Discussion Paper No 9406.

Becker C and M Sinclair (2004), ‘Profitability of Reserve Bank Foreign Exchange Operations: Twenty Years
After The Float’, RBA Research Discussion Paper RDP2004-06.

Friedman M (1953), ‘The case for flexible exchange rates’, Essays on Positive Economics, University of
Chicago Press, Chicago, pp 157–203.

Kearns J and R Rigobon (2003), ‘Identifying the Efficacy of Central Bank Interventions: Evidence from
Australia’, RBA Research Discussion Paper RDP2003-04.

Newman V, C Potter and M Wright (2011), ‘Foreign Exchange Market Intervention’, RBA Bulletin, December.

CONCLUSION
There are various dealers in the foreign currency markets, with banks being the most dominant. Foreign
exchange is facilitated by Exchange Banks, which have branches in a variety of nations. The foreign
exchange market is a worldwide market where different countries’ currencies are exchanged. It is
decentralized in the sense that it is not under the jurisdiction of a single authority, such as an international
agency or a government. Governments (typically through their central banks) and commercial banks are
the main players in this market. The act of transferring one currency into another is known as foreign
exchange. The exchange rate is the rate agreed upon by the two parties in the transaction, which might
fluctuate substantially, resulting in foreign currency risk.