Notes on Foreign Exchange Rate and Foreign Exchange Market!
Foreign Exchange Rate:
The rate at which currency of one country can be exchanged for currency of another country is called the Rate of Foreign Exchange.
It is the price of a country’s currency m terms of another country’s currency. Put in another way, the rate of foreign exchange is the amount of domestic currency that must be paid to obtain one unit of foreign currency.
For instance, if 1 American dollar can be obtained (exchanged) for 50 Indian rupees, then foreign exchange rate is $1 = Rs 50. This (50 to J dollar) will be called foreign exchange rate between USA and India. In other words, 1 dollar can purchase 50 rupees of Indian money clearly; the rate of exchange of a currency simply expresses its external value or its external purchasing power.
Stability in exchange rate is one of the important factors which indicate economic stability of a country Earnings from exports and payments for imports are directly affected by the foreign exchange rate .Nominal vs. Real Exchange Rate.
Nominal exchange rate is price of foreign currency in terms of domestic currency. Real exchange rate is the relative price of foreign goods in terms of domestic goods. It is equal to the nominal exchange rate multiplied by foreign price level and divided by domestic price level.
Real Exchange Rate = Nominal exchange rate x Foreign price level /Domestic price level
Foreign Exchange Market:
The market in which national currencies of various countries are converted, exchanged or traded for one another is called foreign exchange market. It is not any physical place but is a network of communication system which connects the whole complex of institutions. It includes banks, specialised foreign exchange dealers, brokers and official government agencies through which the currency of one country can be exchanged (converted) for that of another country. Again, foreign exchange market is of two types—Spot market and Forward market.
Foreign exchange market performs three main functions, namely (i) transfer function, (ii) credit function and (iii) hedging function. Transfer function refers to transferring purchasing power between countries; credit function refers to providing credit channels for foreign trade and hedging function pertains to protecting against foreign exchange risks. Hedging is an activity which is designed to minimise risk of loss. When people want to operate in the foreign exchange market, it implies that they intend to buy or sell foreign exchange depending on their demand for or supply of foreign exchange.
For instance, when we (Indian residents) buy foreign goods, say, Japanese goods, it shows supply of rupees to foreign exchange market to be exchanged for yen because seller of Japanese goods will expect payment in yen only. Similarly, Indian exporters of their goods will expect to be paid in rupees for which foreigners will have to sell their currency in the exchange market to buy rupees in return. It shows demand for rupees in foreign exchange market. Transactions in foreign exchange market are reflected in the balance of payment account.