Foreign Money Exchange – How Exchanges Work and Who Governs the Rates

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Foreign Money Exchange - How Exchanges Work and Who Governs the Rates

A coherent understanding of the Foreign Money Exchange is crucial while travelling abroad for any purpose from exploring to studying. This information is not only useful to people travelling abroad but for traders and investors of foreign currency as well. Foreign exchange rate or Forex rate is the rate at which one currency is exchanged for another. It is the value of one country’s currency in comparison to another currency. The exchange rate keeps fluctuating and depends on a number of factors. Among these, the forces of demand and supply plays a major role. This blog explores what foreign exchange rate is, how foeign exchange markets work, who governs the rate and what all factors influence the foreign exchange rate.

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What is Foreign Exchange Rate?

YouTube: Bank of England

Foreign exchange rate is the trading of one currency for another. It is the rate at which one currency is exchanged for another. For example, the exchange rate helps determine how much INR will be equal to 1 US Dollar. Exchange rates can either be fixed- as determined by the Central Bank of a country or floating- fluctuating due to forces of demand and supply or a combination of both. Foreign exchange transactions take place through the foreign exchange market.

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Foreign Exchange Market

Foreign exchange market is the place where all transactions related to forex take place. You can exchange one currency for another in a forex market. It is made up of banks, brokers, institutions, and individual traders. There is no centralised marketplace. There is no physical location where trading occurs. Instead, a network of buyers and sellers conducts all currency transactions electronically over the counter (OTC) directly between themselves. Due to the absence of a central location, you can trade in forex 24 hours a day for 5 and a half days a week across major financial centres around the world. The market remains active at any time of the day, leading to fluctuation in exchange rates. 

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Types of Forex Markets

Here are the different types of Forex markets:

Spot Market

Spot market is where exchange of currency takes place at their trading price. Forces of demand and supply, and various other factors like current interest rates, economic performance, ongoing political situations, and perception of the future performance of one currency against another determines the price. In a spot market, the exchange at the agreed upon rate takes place at the exact point the deal is settled, i.e., on the spot or within a short period of time.

Forward Market

In a forward market, two parties agree to buy or sell a fixed amount of currency at a predetermined price on a specific date in the over-the-counter (OTC) markets.

Future Market

In a future market, two parties agree to buy or sell a fixed amount of currency at a predetermined price on a specific date on currency exchanges. A futures contract is legally binding. Both future and forward market deals in contract listing the price and amount of currency and the specified settlement date. These markets don’t deal in actual currencies unlike the spot market.

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How Exchanges Work?

An exchange occurs when one currency is exchanged for another. For example, when INR is used to purchase another currency like USD. As such for a trade where INR is used to buy USD would be denoted by the currency pair USD/INR. If the USD/INR pair is 76, this means that 76 Indian Rupees can buy 1 US Dollar. Whatever currency is used, it creates a currency pair. The first currency in the pair is equal to one unit and the second is currency used to buy the first one. Since the value of currencies is not equal, it is helpful to know the value of domestic currency in relation to foreign currencies. It helps investors/tourists/students to understand anything priced in any foreign currency. 

After calculating the foreign currency you require, you can convert your domestic currency into foreign currency through banks, currency exchanges or brokers. However, they will markup the market price of the exchange  in order to make a profit for themselves. Even when you make a transaction through your credit card, in a currency other than the domestic currency, you will be charged higher for the conversion than the market price.

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Who Governs the Exchange Rate

The exchange rate at which the trade occurs can be either floating, fluctuating or a combination of both. Each country is free to decide which exchange rate system is to be followed and what limits and controls need to be imposed by the government. Let’s understand the different exchange rate systems through which the forex rate is determined:

Fixed Exchange Rate System/Pegged Exchange Rate System

In a fixed exchange rate system, the domestic currency is pegged to a major world currency (such as the U.S. dollar, euro, or yen). The rate is determined by the country’s central bank or government and not by the forces of demand and supply. In order to maintain the fixed rate, the government/central bank buys or sells its foreign exchange reserves. 

Floating/Flexible Exchange Rate System

In a floating exchange rate system, the exchange rate is determined in the open market through the forces of demand and supply. Higher the demand, higher would be the price of the currency in relation to another currency. For example, if the demand for Euro increases in India, then the price of Euro in relation to INR will increase. Various other factors also influence the demand and supply in the market, resulting in change in exchange rate.

Managed Floating Exchange Rate System

Managed floating exchange rate system is a combination of fixed and floating exchange rate system. In this the government/central bank lets the market forces decide the exchange rate, but at the same time the government/central bank can intervene in cases of market uncertainty to maintain the exchange rate.

Factors Affecting the Foreign Exchange Rate

The Foreign exchange market deals in currencies from all over the world which makes the determination of the exchange rate difficult. The primary factor that drives the price of the exchange rate is the forces of demand and supply in the market. The other factors that could influence the exchange rate are as follows:

Inflation 

Inflation is the indicator of a currency’s purchasing power as compared to other currencies. For example, the cost of an apple might be 1 unit in one currency and 100 units in another currency due to inflation. Change in a country’s inflation rate causes a change in the currency exchange rate. A country with a consistently lower inflation rate has a strong currency as its purchasing power is more as compared to other currencies. A country with higher inflation rate experiences a depreciation in their currency value and is usually accompanied by a higher interest rate.

Interest Rate

There is a close inter-relation between Interest rate, inflation and exchange rate. In an economy, higher interest rates offer lenders a higher return which attracts foreign capital and raises the exchange rate. However, if interest rates are high for a long time, the inflation rate may increase which would lead to depreciation of the currency.

Current Account Deficit

Current account balance is the balance of trade between a country and its trading partners. Ut shows the payments made between the countries lik imports, exports, interests and dividends. If the current account of a country shows a deficit, it means that the country is spending more of its currency on importing products than it is earning through exports  which causes depreciation of currency.

Government Debt

Countries pay for large public projects and budgets through large scale debt financing. Countries with large public deficits and debts encourage inflation and become less attractive to foreign investors. This results in devaluation of currency.

Balance of Trade

Balance of trade/Terms of trade is the difference between a country’s imports and exports. A positive BOT means exports are higher than imports and a negative BOT means imports are higher. With a positive BOT, a country’s foreign exchange reserve grows due to more net exports leading to rise in value of the country’s currency.

Political Stability 

A politically stable country attracts foreign investors which leads to a rise in the value of the country’s currency. A country with political uncertainty will lead to devaluation of its currency.

Economic Performance

A country with high economic performance attracts foreign investors. This leads to low inflation rate and a rise in the value of the country’s currency. A country with poor economic performance will lead to devaluation of its currency. Inflation rates, interest rates, balance of trade, etc. are used to measure economic performance.

Speculation 

The speculation of traders affects the value of currency. For example, a currency may be devalued before an election. Inversely, if the demand of a currency is expected to rise in the near future, it will lead to increase in its value.

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