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Exchange Rate and Exchange Controls - Vignesh Selvaraj, UAFA 1135.

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What is a Currency ?
A currency is nothing other than a common commodity just as other goods, which is commonly accepted my other members in an economy domestically, in exchange of a commodity.

Why it is commonly accepted ?


It is commonly made accepted by means of the guarantee provided by the government and other monetary authorities to the people of the country or economy.

What is a Foreign Exchange ?


Foreign exchange for an economy is the currency used in any other economy as the mean commodity for exchange.

What is an Exchange Rate ?


An Exchange rate is the exchange value of a foreign exchange in an economy. It may be defined as units of domestic currency available for or to be given for, selling or buying a foreign exchange.

How Demand for and Supply of Foreign Exchange arises ?


Exports and Imports Investment in and from Foreign Countries

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Apart from this, each commercial bank will generally have a account in a foreign bank called Nastro account. This is the major source of supply of foreign exchange into the For-Ex market.

How Payments are made to Foreign Countries?


There are three modes of payment which can be made to make a foreign payment. They are: Bill of Exchange: When an exporter makes a bills of exchange and sends to the importer for acceptance and receives payment form the bank either discounting before maturity or at maturity of the bill, the transfer is made by Foreign Bills. Bankers Draft : This mode of payment is similar to payment by Demand Draft. Here an Importer deposits his own national currency and obtains a Bankers Draft quoted in terms of the Exporters Currency, and sends it to the exporter. Telegraphic Transfer : In this Method, the importer deposits his national currency in the exchange bank and sends the information to the exporter so that he could receive payment without any lag on delivery of Bill or Draft.

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How Rate of Exchange is determined? (System of determination)


Being a currency is nothing other than a commonly accepted commodity, Foreign Exchange is also deemed to be commodity. Just how equilibrium rate is determined by the market forces viz. Demand and Supply for the commodity, Exchange Rate is also determined by the demand and supply of particular currency. BUT, in-case of under-developed countries, the frequent inflow and outflow of investments may cause a heavy fluctuation which makes economy unstable, Government uses a system of pegging in-order to control fluctuations. Some mid-range countries like india follow a mixture of both mechanism known as Exchange-Rate Band control.

What is a Foreign Exchange Market?


Being a Foreign Exchange is a commodity, there require a market to facilitate liquidity, exchange for domestic currency, determination of Exchange rate. An individual who wants such commodity in retail cannot trade in For-Ex market due to inconvenience as well as regulations. The participants of For-Ex markets are: Companies Financial Institutions including Commercial banks Exchange Brokers Central Banks Individual Importers and Exporters

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The Foreign exchange market is a two-segmented market. One segment deals with Inter-bank market which is between commercial banks and financial institutions governed by RBI, the other segment is market between the banks and the ultimate buyer or seller of foreign exchange who deals in retail.

How an Inter-bank market functions ?


Each individual participant in the inter-bank market will never prescribe their intention, whether to buy or sell the For-Ex from the market. They instead announce the Quoted rate at which they are ready to buy the For-Ex and the rate at which they are ready to sell the For-Ex.

How Quotations are made in Inter-Bank Market ? There are ways of making market quotations. They are Direct Quotations - where the domestic currency units are kept variable for a fixed unit of For-Ex. Indirect Quotations - where the domestic currency units are kept fixed and the respective units of For-Ex is variable.

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Various types of Exchange-rates : Inter-bank rate : The rate which prevails in the interbank market at which the participants can buy or sell For-Ex. This is the base rate for quoting the Spot rate and Forward rates.

Spot rate : The rate at which individual Importers or Exporters can buy or sell For-Ex from the participants of Inter-bank Market Immediately on the day or within a week or on the same-month.

Forward rate : The rate quoted by the Banks for buying or selling off For-Ex at a future date which will be more than a month. Generally a agreement is made between bank and buyer or seller of For-Ex at Forward rate to avoid loss by means of fluctuations.

Inter-bank buying Rate - Exchange margin = Spot Buying Rate Inter-bank Selling rate + Exchange margin = Spot Selling Rate Spot Buying Rate +/- Forward Premium/Discount = Forward Buying Rate Spot Selling Rate +/- Forward Premium/Discount = Forward Selling Rate Buying and selling rates are quoted with a slight difference and selling rate will be quoted higher than the buying rate to earn profit from the transactions in-order to cover-up the administration costs.
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The Exchange margin is mainly profit oriented that the portion is enjoyed by the bank by buying or selling to the customer instead of trading in inter-bank market. Forward Premium or Discount is based on trends of prices of the For-Ex in the ForEx Market and estimation on changes in prices of For-ex.

Determination of Forward Margin (Premium or Discount):


Rate of Interest : The rate of Interest prevailing in the Home Country and the Foreign Country plays the vital role in determining the Forward Margin of the For-Ex. The loss of Interest which the bank would have gained instead of using the fund for buying For-Ex for delivering customer at future date is balanced by their Forward Premium. If any gain they would earn they may give a Forward Discount. Demand and Supply trends : When the existing demand of the For-Ex is higher and the trends seems to have the same demand exceeding the supply, Forward margins are charged at a premium, if the supply trends to exceed the demand the Forward margin is charged with discount. Speculations : Since, Forward rate is based on Spot rate, the forward margin is also affected by means of speculations prevailing on spot rate of the For-Ex. Exchange Regulations : Any Interventions of Regulatory Authorities like Central Bank would affect the Forward margin quoted.
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Quotation of Exchange Rate in inter-bank market : 1 USD = 62.2030 / 2330 INR

Base or Equilibrium Rate.

Inter-Bank Buying Rate

Inter- Bank Selling Rate

Determination of Base Rate or Equilibrium Rate : The Base rate may or may not be the Equilibrium rate of the For-ex, due to the Exchange control and interventions of RBI. As the Equilibrium rate fluctuates based on the demand and supply, and the economy may not be healthy if the fluctuation is more, RBI generally in-order to avoid fluctuations at large scale, uses a system of controlling called Pegging System. But, Countries which are neither developed nor underdeveloped, has to follow the mixed system of both FIXED-Rate (pegging) and FLOATING-Rate (free equilibrium) called Exchange-Rate Band, which allows RBI to intervene in critical situations and let the rate to move according to market in usual circumstances.

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The Exchange-Band defines Central bank at which rate it has to buy For-ex at higher rates by itself in order to get more For-ex reserves and when to sell For-ex at cheaper rate to reduce over-valuation or scarcity of For-ex in economy. The RBI sells for-ex if the rate tends to move beyond the maximum determined rate at the maximum rate to bring back in control, if the For-ex rate declines beyond the minimum rate, it buys For-ex at the minimum rate to grab it back to exchange band. Thus the rate of exchange is kept between the borders of price-levels.

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Exchange Control:
There are many ways to introduce exchange control in an economy. These are usually classified into two groups: (i) Direct Exchange Control and (ii) Indirect Exchange Control.

Direct Methods of Exchange Control: In direct exchange control, certain measures are adopted which effectuate immediate direct restriction on foreign exchange from all sides - its quantum, use and allocation. In general, direct exchange control includes measures like: (i) Intervention; (ii) Exchange restrictions; (iii) Exchange clearing agreements; (iv) Payment agreements; and (v) Gold policy.

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