The term ‘rate of exchange‘ expresses the price of one currency in terms of another. Thus, it indicates the exchange ratio between the currencies of two countries. Suppose for example, one Indian Rupee is equal to 13 USA Cents. This implies that in the exchange market, one Indian Rupee will fetch 13 Cents. Just as the price of a commodity is determined by its demand and supply conditions, the price of a foreign currency (i.e., the rate of an exchange) is also determined on the basis of demand and supply of the currency. In fact, the rate of exchange of a currency will keep on changing in the foreign exchange market, due to changes in demand and supply conditions of the currency. In this section we shall study about exchange rate varies under different monetary standards. Rate of Exchange Under the Gold Standard: Under the Gold Standard the monetary authorities Continue reading
International Finance
International finance is the branch of economics that studies the dynamics of foreign exchange,foreign direct investment and how these affect international trade. Also studies the international projects, international investment and the international capital flow .International Finance can be broadly defined, as the study of the financial decisions taken by a multinational corporation in the area of international business i.e. global corporate finance. International finance draws much of its background from the preliminary studies in the topics of corporate finance such as capital budgeting, portfolio theory and cost of capital but now viewed in the international dimension.
Methods of Exchange Control
Exchange control is one of the important means of achieving certain national objectives like an improvement in the balance of payments position, restriction of inessential imports and conspicuous consumption, facilitation of import of priority items, control of outflow of capital and maintenance of the external value of the currency. Under the exchange control, the whole foreign exchange resources of the nation, including those currently occurring to it, are usually brought directly under the control of the exchange control authority (the Central Bank, treasury or a specially constituted agency). Dealings and transactions in foreign exchange are regulated by the exchange control authority. Exporters have to surrender the foreign exchange earnings in exchange for home currency and the permission of the exchange control authority have to be obtained for making payments in foreign exchange. It is generally necessary to implement the overall regulations with a host of detailed provisions designed to eliminate Continue reading
Futures Contract
Future contracts allow the price risk to be separated from the reliability risk by removing the former from the set of factors giving rise to opportunism. The governance structure supplied by the exchange authority effectively eliminates reliability risk from future trading. The seller of futures contracts incurs a liability not to the buyer, but to the clearing house, and likewise the buyer acquires an asset from the clearing house. The clearing house in effect guarantees all transactions. In addition, the exchange rules, especially regarding its members’ contract, severely limit their ability to behave opportunistically. Organized exchanges greatly reduce default and reliability risk from future contracts. This is achieved by transferring transactions over price risks from a personal to an impersonal market through standard form futures contracts traded in self-regulated market price. Future contracts are standard form contracts with only one negotiable term: price. The standardization of future contracts has significant Continue reading
Attributes of Ideal Currency and a Sound Currency System
Attributes of the Ideal Currency: If the ideal currency existed in today‘s world, it would possess three attributes: Fixed value. The value of the currency would be fixed in relationship to other major currencies so that trades and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future. Convertibility. Complete freedom of monetary flows would be allowed, so that traders and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks. Independent monetary policy. Domestic monetary and interest rate policies would be set by each individual country so as to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment. Unfortunately, these three attributes usually cannot be achieved at the same time. For example, countries whose Continue reading
Types of Letters of Credit
A Letter of Credit (L/C) or documentary credit is an undertaking issued by a bank, on behalf of the buyer (the importer), to the seller (exporter), to pay for the goods and services, provided that the seller presents documents, which comply with the terms and conditions of the letter of credit. Letters of credit are classified in to various categories on the basis of their nature which are used depending on the needs of the importer/opener. Revocable Letter of Credit: A revocable L/C is one that can be amended or cancelled at anytime by the issuing bank without the notice or reference to the beneficiary, consequently, revocable credit does not constitute a legally binding undertaking between the banks and the beneficiary as it can be modified or cancelled at any time without notice to the Beneficiary. Irrevocable Letter of Credit: An irrevocable L/C constitutes a definite undertaking of the issuing Continue reading
Interest Rate Parity (IRP) Theory of Exchange Rate
When Purchasing Power Parity (PPP) Theory applies to product markets, Interest Rate Parity (IRP) condition applies to financial markets. Interest Rate Parity (IRP) theory postulates that the forward rate differential in the exchange rate of two currencies would equal the interest rate differential between the two countries. Thus it holds that the forward premium or discount for one currency relative to another should be equal to the ratio of nominal interest rate on securities of equal risk (and duration) denominated in two currencies. For example, where the interest rate in India and US are respectively 10% and 6% and the dollar-rupees spot exchange rate is Rs.42.50/US $. The 90 day forward exchange rate would be calculated as per IRP as follows: = 42.50 (1+0.10/4)/(1+0.06/4) = Rs.42.9250 And hence, the forward rate differential [forward premium (p)] will be; (42.9250 — 42.50)/42.50 = 1% And the interest rate differential will be; Continue reading