Foreign Exchange

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What is Foreign Exchange?

The foreign exchange is defined in different ways, e.g.

  • Webster Dictionary as “transferring of funds to settle accounts with firms or residents in a foreign currency.”
  • Encyclopedia Britannica: as the system by which commercial nations discharge their debts to each other and
  • H.E. Evitt : “the means and methods by which rights to wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of currency of another country are known as foreign exchange.

The term foreign exchange is used whenever there is a transaction involving a currency of another country.

Factors that Influence Exchange Rate Fluctuations:

The exchange rate in any country are influenced by a variety of factors; some of the major factors that influence movements, both short term and long term are as under:

Supply and Demand

The currency treated as a commodity, its price (exchange rate) is affected by supply and demand. If there are more imports and more outward remittances i.e. more demand for foreign exchange, the rate will tend to move upward. Conversely if there are more exports and hence the rate will fall.

Balance of Trade and Balance of Payment

The periodical result of balance of trade influence the exchange rate. A favorable balance of trade means there are surplus foreign exchange funds whereas an unfavorable balance of trade would mean lesser supply of foreign exchange/or more demand of foreign exchange. Trade creates demand both for spot dollars and also in future, i.e. when Usance Bills become due for payment. Similarly if balance of payment is reported as favorable it means foreign exchange is available whereas if it is reported as unfavorable it would mean dearth of foreign exchange.

Leads and Lags

Whenever there is apprehension that the value of local currency will fall in terms of foreign currency, importers requiring to pay will try to make immediate payment taking advantage of lower rate i.e. lead in making payment and on the other hand, people(exporters) will like to delay receiving payments i.e. lag so that they would get higher rate of exchange after the local currency’s rate is increased against foreign currency.

Central Bank Intervention 

The Central bank in any country would watch movement of its currency and through invention i.e. either building or selling in the market or by taking other measures can influence the market rates.

Speculative Activities

Rumors of devaluation; revaluation affect market and speculators would immediately enter the market for making quick capital gains. They either will buy/sell spot/forward thus affecting both spot and forward market.

Hot Money

Money brought into country for making quick gains and then taking out is called hot money. Sudden inflow / outflow of money affect the exchange rates.

Interest Rate Differential

e.g. higher rate of interest on US Dollars attracts investors to convert their funds into that particular currency leading to rise in spot rate of US Dollars and more Dollars would be in demand. Prudent investors will book forward cover to cover the contract period and convert the Dollars back to local currency on maturity which in turn would affect the forward rate of the local currency.


Countries with lesser inflation rate and rising foreign exchange reserves usually have strong exchange rate whereas the countries which have smaller foreign exchange reserves, and more inflation etc. have less confidence of investors and thus influence the exchange rate.

Political and Economic Events

Sudden departure of a government create political vacuum and similarly statements political leaders influence the exchange rate. The releasing of economic data e.g. if it brings good news, it will improve the rate and bad news it will have adverse affect on the rate.

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