3rd Module

Foreign Exchange
Foreign exchange is the trading of one currency for another currency in the foreign
exchange market at a specific rate. The specific rate is known as the foreign exchange rate.
Foreign Exchange Management Act (FEMA) defines. “foreign exchange as foreign currency
and includes all deposits, credits and balance payable in any foreign currency and any drafts,
travelers cheque, letters of credit and bill of exchange drawn by banks, institutions or
persons outside India but payable in Indian currency”
Foreign Exchange Market
Foreign exchange market is market where the currencies of different countries are bought
and sold. The buyers and sellers include central bank, commercial banks, foreign exchange
brokers, business firms, exporters, importers and individuals. Like any other market, foreign
exchange market is a system, not a particular place.
Structure of Foreign Exchange Market

Central banks are the apex body as they hold the top position in the foreign exchange
market. They have the power to control and regulate the domestic foreign exchange market
to ensure that it works in an orderly manner. One of their main functions is to prevent by
direct intervention, if necessary, the violent fluctuations in the exchange rate.
Foreign exchange brokers hold the second most important place in the foreign exchange
market. Brokers work as a link between the central bank and the commercial banks and
between the banks. They are the major source of market information. Their main function is
to facilitate foreign exchange transactions between the actual buyers and the banks, the
sellers.
Commercial banks make the third important organ of the foreign exchange market. Banks
dealing in foreign exchange play the role of market makers-they quote the daily exchange
rates for buying and selling a foreign currency. They work also as the clearing house. They
clear the market by buying the foreign currency from the brokers and selling it to the
buyers.
At the bottom of the foreign exchange market are the actual buyers and sellers of the
foreign currencies-exporters, importers, tourists, investors and immigrants. They are the
actual users of the foreign exchange.
Foreign exchange market is the biggest market in the world economy. Unlike other markets,
the foreign exchange market centers work 24 hours a day and seven days a week. Foreign
bills of exchange, telegraphic transfer, bank draft, letter of credit, etc. are the important
foreign exchange instruments used in the foreign exchange market to carry out its functions.
Functions of Foreign Exchange Market

 Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion of one
currency into another currency that is to accomplish transfers of purchasing power
between two countries. This transfer of purchasing power is functioned through a
variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills.

 Credit Function:
Another function of the foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Bills of exchange, with maturity period of three
months, are generally used for international payments. Credit is required for this period
in order to enable the importer to take possession of goods, sell them and obtain money
to pay off the bill.

 Hedging Function
Hedging means the avoidance or covering of a foreign exchange risk. In a free exchange
market when exchange rate, i. e., the price of one currency in terms of another currency,
change, there may be a gain or loss to the party concerned. These foreign exchange risks
can be avoided or covered by hedging through forward contract. This usually involves an
agreement today to buy or sell a certain amount of foreign exchange at some future
date (usually three months hence) at a rate agreed upon today. No money passes at the
time of the contract.
Kinds of foreign exchange market

 Spot Market
Spot market refers to that segment of the foreign exchange market in which the sale and
purchase of foreign currency are settled within two days of the deal. The rate at which
foreign currency is bought and sold in the spot market is called spot exchange rate or
current rate of exchange. Spot market is of daily nature and deals only in spot transactions
of foreign exchange (not in future transactions).

 Forward Market
The Forward exchange market refers to the market in which sale and purchase of foreign
currency is settled on a specified future date at a rate agreed upon today. When buyers
and sellers enter an agreement to buy and sell a foreign currency after 90 days of the
deal, it is called forward transaction. The exchange rate quoted in forward transactions is
known as the forward exchange rate. Generally, most of the international transactions
are signed on one date and completed on a later date. Forward exchange rate becomes
useful for both the parties involved in the transaction. Forward Contract is made for two
reasons: To minimize the risk of loss due to adverse changes in the exchange rate and to
make profit.
The nature of foreign exchange market

 Hedging
Hedging is a method of covering risk arising from a change in the exchange rate. It
means settling the exchange rate by agreement 90 days in advance for forward
transactions with a view to avoiding the loss due to exchange rate fluctuations. The
contract between exporters and importers to buy and sell goods at some future date
takes place at current prices and the current exchange rate. The forward exchange
market provides an opportunity to cover the risk arising out of exchange rate fluctuation
and to avoid the resulting loss in foreign trade.

 Arbitrage
It is an act of simultaneous purchase and sale of different foreign currencies in different
exchange markets. The objective of arbitraging is to make profit by taking the advantage
of different exchange rates in different exchange markets.

 Speculation
Speculative transactions in foreign exchange transactions are opposite of hedging. In
hedging, the buyers and sellers try to avoid risk, if any, due to fluctuation in the
exchange rate, whereas speculation in foreign exchange is a deliberate attempt under
the condition of risk to make profits from the fluctuation in exchange rates. The
speculative sale and purchase of foreign currency is based on the speculators'
expectations about the future exchange rates. The two kinds of speculative dealers in
 the foreign exchange market are bears and bulls. The bears of the foreign exchange
market expect the exchange rate between any two currencies to decline in the near
future and hence they sell their currency holding to avoid loss. On the other hand, the
bulls of the market expect exchange rate to increase, and hence they buy the foreign
currency with a view to selling it when exchange rate increases in future. If the
speculator correctly predicts the market, he or she makes a profit. Otherwise, the
speculator incurs a loss. Speculation usually occurs in the forward exchange market.

 Currency Swap
Buying and selling of spot currency by commercial bank is known as currency swap. It is
also called double deals. It means sale of spot currency by commercial bank in order to
forward purchase of same currency or purchase of spot currency by commercial banks.
Exchange rate
The exchange rate is the rate at which currency of a country can be exchanged for another
country currency. In simple, price paid to unit of foreign currencies in terms of home
currencies. It expresses in two ways, ratio of one unit of foreign currency to certain number
of home currencies and on other hand ratio of certain number of home currency to one unit
of foreign currency.
Exchange rate is usually quoted in terms of rupees per unit of foreign currencies. Thus, an
exchange rate indicates external purchasing power of a money. A fall in the external
purchasing power or external value of rupee from Rs.80 = $ 1 (dollar) to Rs.90 = $ 1 amounts
to depreciation of the Indian rupee as we now need more rupees to purchase each dollar.
On the other hand, a rise in the external purchasing power or external value of rupee from
Rs.90 = $ 1 to Rs.80 =$ 1 amounts to appreciation of Indian rupee as we need less rupees to
purchase each dollar as compare to earlier.

Determination of exchange rates

In a free market, the exchange rate is determined by the demand for and the supply of
foreign exchange.
The demand for foreign exchange
The demand for foreign exchange is a derived demand. Demand arise due to demand for
foreign goods and services, suppose India import goods and services from U.S then India will
pay to U.S by foreign currency (in Dollar), So India will demanded US currency by indirectly,
such type of demand is called derived demand.
Exchange rate of dollar with rupees decreases means Indian currency (rupees) will stronger,
so there is more imports in our nation. When we encourage more imports from US then it
will lead to more demand for dollar in foreign exchange market.
Exchange rate of dollar with rupees increases means Indian currency will weaker, so there is
more exports in our nation. When India will encourage more exports to US then it will lead
to less demand for dollar in foreign exchange market.
So there is negative relationship between demand for dollar and rate of foreign exchange
(price of dollar in terms of rupees). Since rate of foreign exchange and demand for dollar
move in opposite directions. It was shown in below figure.

The supply of foreign exchange

The supply of foreign exchange rate is dependent upon the supply of goods and services by
the home country to the foreign country. Exchange rate value of dollar with rupee lower
means Indian currency will stronger, so there was lower in export to U.S because India will
encourage to more imports then exports so it will lead to less supply of dollar in foreign
exchange markets.
On the other hand exchange rate value of dollar with rupee increase means Indian currency
will weaker, so there was more exports to U.S because India will encourage to more exports
then imports so it will lead to more supply of dollar in foreign exchange markets.
Hence there is positive relationship between exchange rate (price of dollar in terms of
rupees) and supply of dollar. Since rate of foreign exchange and supply of dollar move same
direction. It was shown in below figure.
Equilibrium Exchange Rates
Given the demand and supply functions of foreign exchange, the equilibrium rate of
exchange is determined by the equality between demand for and supply of foreign
exchange. In the figure, DD1 and SS1 curves intersect at point E. The foreign exchange rate
thus determined is OP. On the point P2 there was showing excess demand over supply for
foreign exchange dollar. On the point P1 there was showing excess supply over demand for
foreign exchange dollar.
Demand and supply are not the only factors affecting exchange rate. Other factors affecting
exchange rate determination are:

 Balance of payment
 Inflation
 Interest rates
 Money supply
 Political Factors
 Technical Factors

Theories of foreign exchange

1. Mint Parity Theory
The mint parity theory was one of the earliest theories of foreign exchange. This theory was
applicable for those countries which had the same metallic standard (gold or silver). Under
the gold standard, countries had their standard currency unit either of gold or it was freely
convertible into gold of a given purity. Under gold standard, the value of currency unit was
defined in terms of weight of gold of a specified purity contained in it. The price at which
the standard currency unit of the country was convertible into gold was called as the mint
price. Suppose the official price of gold in Britain was £ 20 per ounce and in the United
States it was 80 per ounce, these were the mint prices of gold in the two countries. The rate
of exchange between these two currencies would be determined as £ 20 = $ 80 or £ 1 = $ 4.
This rate of exchange determined on weight-to- weight basis of the metallic contents of
currencies of the two countries was called mint par of exchange or the mint parity. So the
mint par values of the two currencies determined the basic rate of exchange between them.
Under the gold standard, the balance of payments adjustments were made through the free
international flows of gold. The export and import of gold involved costs of packing, freight,
insurance, interest etc. Consequently, the actual rate of exchange between two currencies
could vary above and below the mint parity by the extent of cost of gold export. To explain
this, let us assume that the U.S. has a BOP deficit with Britain. It is adjusted through the
export of gold to Britain. The mint parity between pound and dollar is £ 1 = $ 4. The cost of
exporting gold including freight, insurance, packing, interest etc. of gold worth $ 4 is 0.04
dollar. So the U.S. importers have to pay 4.04 dollars (4+.04) for each pound. No U.S.
importer will pay more than 4.04 dollars for one British. Therefore, the exchange rate
between dollar and pound at the maximum can be £ 1 = $ 4.04. This exchange rate signifies
U.S. gold export point or upper specie point. Similarly, the exchange rate of pound could not
fall below $ 3.96 dollars, in case the United States had a BOP surplus resulting in flow of gold
from Britain to that country. This rate of exchange (£ 1 = $ 3.96) is the U.S. gold import point
or lower specie point. The upper and lower specie points prescribe the limits within which
the fluctuation can take place in the market rate of exchange.
The determination of the rate of exchange, according to mint parity theory, can be
explained with the help of the following figure;

The amount of foreign exchange is measured along the X axis and exchange rate is
measured along the Y axis. DD1 and SS1 are the demand and supply curves of foreign
exchange. The equilibrium market rate of exchange between dollar and pound sterling is
determined by the intersection of demand and supply curves at E. The equilibrium rate of
exchange is OR at which the quantity of foreign exchange demanded and supplied OQ. The
horizontal line drawn at M denotes mint parity. The horizontal lines drawn at U denote the
gold export point or upper specie point and L denote the gold import point or lower specie
point.
Criticism

 International gold standard does not exist after the great depression of 1930’s
 Most of the countries at present are having inconvertible paper currencies. In such a
system, the mint parity theory cannot at all determine the rate of exchange.
 The theory emphasis the free international gold movements. The modern
governments do not permit the free buying and selling of gold internationally.
2. The Purchasing Power Parity Theory (PPP Theory)
The purchasing power parity theory was developed by Swedish economist Gustav Cassel.
The theory enunciates the determination of the rate of exchange between two inconvertible
paper currencies. This theory states that the equilibrium rate of exchange is determined by
the equality of the purchasing power of two inconvertible paper currencies. It implies that
the rate of exchange between two inconvertible paper currencies is determined by the
internal price levels in two countries.
There are two versions of the purchasing power parity theory:
 (i) The Absolute Version and
(ii) The Relative Version.

a) The Absolute Version:

According to absolute version, the rate of exchange should normally reflect the relation
between the internal purchasing power of the different national currency units. Or the rate
of exchange equals the ratio of outlay required to buy a particular set of goods at home as
compared with what it would buy in a foreign country. The exchange rate under this version
of the PPP theory is given as,
ER = PA/PB
Where
ER = Exchange Rate
PA = price level in country A
PB = price level in country B
It may be illustrated with an example. Suppose a basket of goods can be bought in India for
Rs.800 and in the U.S.at an outlay of 20 dollars. In that sense, the exchange rate between
the Indian rupee (INR) and the U.S. dollar will be determined as follows.

ER = PA / PB = Rs.800/ $20
$I = Rs.40
The absolute version of the purchasing power parity theory has certain shortcomings. In
fact, the purchasing power is measured in relative terms. Moreover, there are differences in
the kinds and qualities of products in the two countries, differences in the pattern of
demand, technology, transport costs, tariff structures, tax policies, extent of state
intervention and control and several other factors. These differences prohibit the
measurement of exchange rate in two or more currencies in strict absolute terms.
b) The Relative Version:
The relative version of purchasing power parity theory is a modified version of its absolute
version. While the absolute version assumes price level to remain constant, in reality, price
levels do not remain constant. The relative PPP theory gives a measure of the change in the
exchange rate under the condition of changes in relative prices. The relative PPP theory
states that the relative change in the exchange rate over time is proportional to the change
in the relative price level over a period of time. In other words, the relative changes in the
price levels in two countries between some base period and current period have vital
bearing upon the exchange rates of currencies in the two periods. According to this version,
the equilibrium rate of exchange in the current period (R1) is determined by the equilibrium
rate of exchange in the base period (R0) and the ratio of price indices of current and base
period in one country to the ratio of price indices of current and base periods in the other
country. The formula for relative PPP theory is given as,
ER1 = (PB1/PB0 ÷ PA1/PA0) ER0
Where,
ER1 = Equilibrium exchange rate in current year
ER0 = Equilibrium exchange rate in base year
PB1 = Price index of country B in current year
PB0 = Price index of country B in base year
PA1 = Price index of country A in current year
PA0 = Price index of country A in base year
For eg: To illustrate, it is supposed that the original or base period rate of exchange between
rupee and dollar was $ 1 = Rs.64 The price index in India (country B) in the current period (P
B1 ) is 180 and the price index in the U.S.A. (country A) in the current period (PA1) is 160.
The price indices of two countries in the base period were 100 (PA0 and PB0)
So, the equilibrium exchange rate in current year ER1 =
ER1 = (PB1/PB0 ÷ PA1/PA0) ER0
ER0 = 64
PB1 = 180
PA1 = 160
PA0 = 100
PBO = 100
ER1 = (180/100 ÷ 160/100) 64
= (1.8/1.6) 64
= 64 X 1.125
= 72
It shows that rupee has depreciated while dollar has appreciated between the two periods.
If the price level in India (B) has risen between the two periods at a relatively lesser rate
than in the U.S.A., the exchange rate of rupee with dollar will appreciate. The dollar on the
opposite will show some depreciation.
 It is, of course, true that the purchasing power parity between the two currencies is
determined by the quotient of their respective purchasing power. This parity is modified by
the cost of transportation including freights, insurance and other charges. These costs lay
down the limits within which the rate of exchange will fluctuate. The upper limit is called as
the commodity export point where as the lower limit is termed as the commodity import
point. These two limits are vary with varying price level. This is shown in the below diagram

Criticism

 Tariff and subsidies changes purchasing power, so it was not reflected in this theory
 Equilibrium exchange rate depend upon the reciprocal demand for foreign
exchanges. This was excluded in the relative purchasing power parity.
 Difficulty to compare the general price level

3. Balance of Payment Theory

This theory was also called the Demand and Supply or General Equilibrium theory of
exchange rate. According to this theory, the rate of exchange of one country with other
country is determined by the balance of payment position of a country.
When there is BOP deficit, there was imports greater than exports, that is demand for
foreign exchange greater than supply for foreign exchange. So, there will be need to BOP
equilibrium by home currency depreciate or foreign currency appreciate for reduce imports.
In other hand, when there is BOP surplus, there exist exports greater than imports, that is
demand for foreign exchange less than supply for foreign exchange. So, there will be need to
BOP equilibrium by home currency appreciate or foreign currency depreciate for reduce
exports. The determination of equilibrium rate of exchange can be shown in the below
figure,
Here figure X axis shows the demand and supply for foreign exchange and Y axis shows the
Rate of Exchange. DD is the demand curve that is inverse relationship between exchange
rate, SS is the supply curve that is positive relationship between exchange rates.
Equilibrium exchange rate is at OR0 when demand and supply intersect. When there is OR1
exchange rate there exist supply for foreign exchange greater than demand for foreign
exchange. So, excess supply of foreign exchange lower the value of foreign currency in
related to home currency that is lead to reduction exports and raise the imports. So, BOP
surplus turns to BOP equilibrium.
When there is OR2 exchange rate there exist BOP deficit, that is demand for foreign
exchange greater than the supply for foreign exchange. Excess demand for foreign currency
will tend to exchange value of foreign currency appreciate, so lead to increase the exports
and reduction the imports. So BOP deficit move to equilibrium attained in OR0.
Criticism

1. The theory assume perfect competition, so this theory is unrealistic

2. This theory of exchange rate is just a truism. Because the BOP of a country is necessarily be in a
state of balance.

3. The theory neglect the role of the price level influencing the BOP of a country.
4. This theory neglect the basic value of currency used in the exchange system.
 Exchange rate system (Foreign exchange rate policy)
There are two broad types or systems of exchange rate known as fixed exchange rate and
flexible exchange rate.
I. Fixed Exchange rate system
It was also called Pegged exchange rate system. Under fixed exchange rate policies all
exchange rate transactions take place at an exchange rate that is determined by
government or monetary authority of a country. If the exchange rate diverges from the
equilibrium due to some reasons then the monetary authority interfaces and correct the
equilibrium. Under a fixed exchange rate system, devaluation and revaluation are official
changes in the value of country’s currency relative to other currencies.
Argument for /Advantages of the Fixed Exchange Rate System:

1. Promote international trade

In this system, the exporters know in advance that what they will receive and importers
know how much they will pay. So it eliminates all the possibilities of risk and uncertainty
and Promote smooth flow of international trade.
2. It creates condition for the smooth flow of foreign capital

Fixed exchange rates ensure a certain return on foreign investment. Fluctuations in

exchange rates affect the investment and the growth rate of the economy.

3. Fixed exchange rates reduce uncertainty:

This system ensures a high degree of certainty in international business, and thereby
economic stability in individual economies as well as the global economy. It is more
conducive to the expansion of world trade as it prevents risk and uncertainty in transactions.

4. Promote Economic Integration

Due to stability in exchange rate, the system can pave the way for greater degree of
economic integration among the country.
5. Ensure Long term Capital Investment

In this exchange rate system, Investors can plan long term investment and large scale capital
inflows facilitates higher rate of economic growth.

6. Ensure Price Discipline

7. No adverse effects of Speculation

8. It contributes to the better co-ordination and implementation of macroeconomic

policies across different countries of the world.
 9. Fixed exchange rate ensures that major economic disturbances in the member
countries do not occur.

Argument Against / Disadvantages of the Fixed Exchange Rate System:

1. Sacrifice of Objectives

A serious defect in this system of exchange rates is that the authorities become concerned
primarily with the maintenance of exchange rate at some official level. It often results in the
sacrifice of the objectives of price stability and full employment.

2 International Transmission of Economic Variations:

The fixed or stable exchange rates can be responsible for transmitting the economic
disturbances in one country to another. Suppose there are deflationary conditions in one
country, It will export its low-price goods to other countries. The industries of foreign
countries, faced with competition from cheap goods, will be forced to lower their prices and
vice versa.
3 Heavy Burden upon the Authorities:

If a country is under continuous pressure on account of the BOP deficit, the government or
monetary authority may not be in a position to mobilise sufficient international liquid
resource for undertaking the pegging operations. In the event of failure to mobilise reserves
of foreign currencies, the home currency has to be devalued.

4. No Solution of BOP Problem:

The policy of fixed exchange rates cannot help in resolving the problem of BOP deficit. It
simply suppresses it through the government intervention. The forces underlying the BOP
disequilibrium remain to be tackled through monetary, fiscal and other policies
5. High degree of Exchange Controls:

The policy of fixed or stable exchange rates requires quite complicated exchange control
mechanism. This can result in misallocation of economic resources, bureaucratic
II. Flexible Exchange Rate System (Fluctuating or Floating Exchange rate)
Under a flexible exchange rate system, exchange rate determined by market forces of
demand and supply. The government or monetary authority does not interfere with the
working of exchange rate. Under a flexible exchange rate, if there is an excess supply of
currency the value of that currency decreases this is called depreciation. On the other hand,
shortage of currency will lead to an appreciation of currency in foreign markets.
Arguments for Flexible Exchange Rates: (Advantage)

1. Simple Mechanism:

The system of flexible exchange rates operates in an easy, quick and efficient manner in
clearing the foreign exchange market. It ensures an automatic adjustment between the
forces of demand and supply without involving any intervention of the monetary or fiscal
authorities in the foreign exchange market.
2. Continuous Adjustments:

Under a system of flexible exchange rates, there are smooth and continuous adjustments in
the foreign exchange market through appropriate changes in the rates of exchange.
3. No Need of Accommodating Gold or Capital Movements:

Unlike the fixed, exchange system where the achievement of BOP equilibrium requires the
accommodating gold or capital movements, there is no such necessity under flexible
exchange rates. The automatic exchange rate adjustments ensure the maintenance of BOP
equilibrium even without the accommodating transactions.
4. No Necessity of Adjustments through Price and Income Changes:

The flexible exchange system can ensure the automatic BOP adjustment through the simple
mechanism of freely flexible exchange rates rather than price and income variations.
5. Removal of the Problem of International Liquidity:

In a system of flexible exchange rates, a deficit country is simply to allow its currency to
depreciate and adjust the BOP equilibrium. On the other hand, the pegging of exchange rate
payment to BOP deficit required large inflows of foreign currencies. There is no problem s of
liquidity under flexible exchange rates.
6. Economical:

The flexible exchange system is very economical. There is no idle holding of international
currency reserves that is so essential under the system of fixed exchange rates. The
countries having flexible exchange system can make an optimum use of their entire
available exchange reserves.
7. Beneficial for International Trade:

In the case of a flexible exchange system because exchange rates are likely to remain at the
natural level due to continuous market adjustments, it can ensure sustained expansion of
trade and steady growth of the economy.

8. No Need of International Institutional Arrangements:

The flexible exchange system can dispense with complex international institutional
arrangements for borrowing and lending of short term fund for maintaining exchange rate
and Balance of payment equilibrium.
Arguments against Flexible Exchange Rates: (Dis-advantage)

1. Possibility of Disequilibrium:

In case of flexible exchange system, it is believed that the free working of the market forces
results in the establishment of rate of exchange that corresponds with the BOP equilibrium.

2. Indirect Government Intervention

The flexible exchange system presumes that the government does not interfere in the
foreign exchange market. The government may not directly interfere through pegging or
exchange controls and regulations. But there can still be indirect government intervention
through the impact of monetary and fiscal policies
3. Not Practical:

It is advocated in this system that the exchange rate should be allowed to be determined by
the free working of demand and supply forces in the market. All the governments in the
present day world exercise controls upon the prices of goods, services, capital and all other
assets in varying degrees. Such a system of exchange rates is, therefore, not consistent with
the actual realities of practical life.

4. Exchange Risks and Uncertainty:

The flexible exchange system causes frequent variations in the rates of exchange which
create exchange risks, breed uncertainty and be a barrier for the international trade and
capital movements.
5. Destabilizing Speculation:

A very strong objection against the flexible exchange system is that continuous variations in
exchange rate greatly stimulate the activities of speculators in the foreign exchange market
and which is highly destabilizing. That means, it tends to widen the fluctuation in exchange
rate.
6. Not Suited to the Less Developed Countries:

The flexible exchange system may efficiently bring about BOP adjustment in advanced
countries. But it is suitable to less developed countries In case of the latter, the necessity of
maintaining a rate of investment higher than that of savings and difficulty in reducing
imports, while the capacity to export is limited, there are persistent BOP deficits.
 Basis Fixed Exchange Rate Flexible Exchange Rate

Meaning A fixed exchange rate is a A flexible exchange rate is a

rate which is maintained rate which is determined
and controlled by the by the market forces.
central government.
Determined by A fixed exchange rate is A flexible exchange rate is
determined by an apex determined by the demand
bank or a monetary and supply forces.
authority or government.
How it affects currency A fixed exchange rate has a A flexible exchange rate
devaluation and can depreciate and
revaluation in a currency. appreciate the value of
currency.
Hedging There is no hedging risk if Hedging is used to reduce
the country is using fixed the currency risks in the
exchange rate. flexible exchange rate.

Devaluation and Depreciation

Devaluation includes a reduction in the value of domestic currency in terms of foreign
currencies by the government or monetary authority under a fixed exchange rate system.
Depreciation refers to the decrease in the value of domestic currency in terms of foreign
currencies due to the market fluctuations under a flexible exchange rate system.
Revaluation and Appreciation
Revaluation is rise in the value of domestic currency in terms of foreign currencies by the
government or monetary authority under a fixed exchange rate system.
Appreciation refers to the increase in the value of domestic currencies in terms of foreign
currencies due to the market fluctuations under a flexible exchange rate system.

Exchange Rate Regimes in India

Over the last seven decades since independence the exchange rate system in India has
transited from fixed exchange rate regime where the Indian Rupee was pegged to the UK
Pound to a basket of currencies during the 1970s and 1980s and eventually to the present
form of market determined exchange rate regime since 1993. The evolution of exchange
management is discussed below:
Par Value System (1947-1971): Since Independence, India followed a fixed exchange rate
system under the Bretton Woods System formed in 1944. Under this system, the gold
exchange standard was introduced. The United States was to maintain the price of gold
fixed at 35 dollars per ounce and was supposed to exchange dollars for gold at that price
without restrictions or limitations. Other nations were required to fix the price of their
currencies directly in terms of dollars and indirectly in terms of gold. This par value system
of exchange rate was followed till 1971 till the breakdown of the Bretton Woods system,
after which most of the countries adopted floating systems.
Pegged Regime (1971-1992): With the breaking down of the Bretton Woods system in 1971,
India moved towards the pegged exchange rate system. India pegged its currency to the US
dollar (from August 1971 to December 1991) and to the pound sterling (from December
1971 to September 1975). The Indian Rupee was linked to U.K. Pound Sterling. This pegging
of currency to another country's currency results in a fixed exchange rate system which
helps to maintain stability among the trading partners. However, it increases the imbalances
between the countries. With this, the pegged exchange rate system ended and India moved
towards a market determined exchange rate system.
Market-Based Exchange rate Regime (1993- till present)
There was a two-step devaluation of Rupee in 1991 by the RBI which ended the pegged
exchange rate system and marked the beginning of the market determined exchange rate
system. The Liberalized Exchange Rate Management System (LERMS) was introduced to
ease the transition from one system to another. It begins from March 1, 1992. Under this
system, rupee was made partially convertible. This partial convertibility of rupee is known as
the dual exchange rate system. Where 40% of the exchange rate was to be converted at the
official exchange rate and the remaining 60% were to be converted at the market based
exchange rate.
Managed Floating Exchange rate
A managed floating exchange rate is a type of exchange rate regime where a country's
currency value is primarily determined by market forces (supply and demand) but with
active intervention from the central bank to stabilize the currency or achieve economic
goals. It is also called as dirty floating. It combines the features of both floating and fixed
exchange rate systems.

Nominal Exchange Rate and Real Exchange Rate

Nominal Exchange Rate: It refers to the price of foreign currency in terms of domestic
currency. It shows the number of units of domestic currency one must give up to get a unit
of foreign currency.
Real Exchange Rate: It refers to the relative price of foreign goods in terms of domestic
goods. In order to make a purchase, one should ideally consider the real exchange rates.
Real exchange rate accounts for inflation and international competitiveness and will
compare the price of the two good.