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Unit 3: Foreign Exchange Market and Exchange Rates

invoiced only in a single Currency, the parties mutually agree on a Currency beforehand. The Notes
Currency agreed could also be any convenient third country Currency such as the US dollar. For,
if an Indian exporter sells machinery to a UK importer, the exporter could invoice in pound,
rupees or any other convenient Currency like the US dollar.

Notes The transfer of funds function is performed through T.T, M.T, Draft, Bill of exchange,
Letters of Credit, etc. The bill of exchange is the most important and effective method of
transferring purchasing power between two parties located in different countries.

Another important function of Foreign Exchange Market is to minimize Foreign Exchange Risk.
The Foreign Exchange Market performs the Hedging function covering the risks on foreign
exchange transactions. These are the risks of unexpected changes in Foreign Exchange Rates.

3.1.3 Participants in the Foreign Exchange Market

Why do individuals, firms and banks want to exchange one national Currency for another? The
demand for foreign currencies arises when tourists visit another country and need to exchange
their national Currency for the Currency of the country they are visiting, when a domestic firm
wants to import from other nations, when an individual wants to invest abroad and so on. On
the other hand, a nation’s supply of foreign currencies arises from foreign tourist expenditures
in the nation, from export earnings, from receiving foreign investments, and so on. For example,
suppose a US firm exporting to the UK is paid in pounds sterling (the UK Currency). The US
exporter will exchange the pounds for dollars at a commercial bank. The commercial bank will
then sell these pounds for dollars to a US resident who is going to visit the UK or to a United
States firm that wants to import from the UK and pay in pounds, or to a US investor who wants
to invest in the UK and needs the pounds to make the investment.

Thus, a nation’s commercial banks operate as clearing houses for the foreign exchange demanded
and supplied in the course of foreign transactions by the nation’s residents. In the absence of this
function, a US importer needing UK pounds, for instance, would have to locate a US exporter
with pounds to sell. This would be very time consuming and inefficient and would essentially
revert to barter trade. Those US commercial banks that find themselves with an over-supply of
pounds will sell these excess pounds (through intermediary foreign exchange brokers) to
commercial banks that happen to be short of pounds in satisfying their customers’ demand for
pounds. In the final analysis, then, a nation pays for its tourist expenditures abroad, its imports,
its investments abroad and so on with its foreign exchange earnings from tourism, exports and
the receipt of foreign investments.
If the nation’s total demand for foreign exchange in the course of its foreign transactions exceeds
its total foreign exchange earnings, the rate at which currencies exchange for one another will
have to change to equilibrate the total quantities demanded and supplied. If such an adjustment
in the exchange rates were not allowed, the nation’s commercial banks would have to borrow
from the nation’s central bank. The nation’s central bank would then act as the “lender of last
resort” and draw down its foreign exchange reserves. On the other hand, if the nation generated
an excess supply of foreign exchange in the course of its business transactions with other nations
(and if adjustment in exchange rates were not allowed), this excess supply would be exchanged
for the national Currency at the nation’s central bank, thus, increasing the nation’s foreign
Currency reserves.
Thus, four levels of transactors or participants can be identified in foreign exchange markets. At
the first level are tourists, importers, exporters, investors, and so on. These are the immediate

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