It BMS International Finance half theory part.

1. International Finance

2. Module No V
(Balance of Payment)
 It is a systematic record of all economic
transactions between the „residents 'of a given
country and the residents of other countries-rest
of the world-carried out in a specific period of
time, usually a year.

3. Components of BOP
Item/Year 2009-10
Credit Debit Net
A. Current account
1. Merchandise 182163 299491 -117328
2. Invisibles (a+b+c) 161245 82328 78917
a) Services 93791 59586 34205
i) Travel 11859 9342 2517
ii)Transportation 11147 11934 -787
iii) Insurance 1600 1286 314
iv) G.n.i.e. 440 526 -86
v) Miscellaneous 68744 36499 32245
of which: Software services 49705 1469 48236
Business services 11645 18626 -6981
Financial services 3736 4736 -1000
Communication services 1229 1389 -160
b) Transfers 54432 2318 52114
i) Official 532 473 59
ii) Private 53900 1845 52055
c) Income 13021 20425 -7404
i) Investment income 12107 18720 -6613
ii) Compensation of employees 914 1705 -791
Total Current account (1+2) 343408 381819 -38411

4. A) Current account
It captures the effect of trade link between the economy
and rest of the world.
1) Merchandise Trade :It includes exports and Imports.
2) Invisibles
Gnie: Government not included elsewhere: It relates to
receipt and payments on government account not
included elsewhere as well as receipts and payment on
account of maintenance of embassies and diplomatic
missions and offices of international institutions such as
UNO,WHO,etc.
Credits includes allocation made for the embassy
expenditure in India out of rupee proceeds of sales in
India of US surplus agricultural commodities

5. A) Current account
 Transfers: It represent all receipts and payments
without a quid pro quo. They include items like aid
and grants received from /extended to foreign
governments, migrants‟ transfer, repatriation of
savings, remittances of family maintenance
Contribution and donations to religious organizations
and charitable institutions etc.
 Investment Income: Remittances, receipts, and
payments on account of profits, dividends, interest
and discounts including interest charges and
commitment charges on foreign loans including those
on purchase from the IMF

6. A) Current account
 Compensation of Employees: It covers wages,
salaries and other benefits, in cash or in kind, and
include those of border, seasonal and other
nonresidents workers(e.g. local staff of
embassies)

7. Item/Year 2009-10
Credit Debit Net
B. Capital account
1. Foreign investment (a+b) 198089 145964 52125
a) Foreign direct investment (i+ii) 37920 18191 19729
i) In India 37182 5500 31682
Equity 27149 4242 22907
Reinvested earnings 8080 0 8080
Other Capital 1953 1258 695
ii) Abroad 738 12691 -11953
Equity 738 8057 -7319
Reinvested earnings 0 1084 -1084
Other capital 0 3550 -3550
b) Portfolio investment 160169 127773 32396
i) In India 159897 127521 32376
of which: Flls 156570 127521 29049
GDRs/ADRs 3328 0 3328
ii) Abroad 272 252 20
2. Loans (a+b+c) 73204 60982 12222
a) External assistance 4965 2917 2048
i) By India 52 420 -368
ii) To India 4913 2497 2416
b) Commercial borrowings (MT & LT) 14674 12152 2522
i) By India 974 1505 -531
ii) To India 13700 10647 3053
c) Short term to India 53565 45913 7652
i) Suppliers' Credit >180 days & Buyers' Credit 48571 43914 4657
ii) Suppliers' credit up to 180 days 4994 1999 2995

8. Item/Year 2009-10
Credit Debit Net
3. Banking capital (a+b) 61499 59415 2084
a) Commercial Banks 60893 58966 1927
i) Assets 17097 15259 1838
ii) Liabilities 43796 43707 89
of which: Non-resident deposits 41356 38432 2924
b) Others 606 449 157
4. Rupee debt service 0 97 -97
5. Other capital 11209 23941 -12732
Total capital account (1 to 5) 344001 290399 53602
C. Errors & omissions 0 1746 -1746
D. Overall balance (A+B+C) 687407 673966 13441
E. Monetary movements (i+ii) 0 13441 -13441
i) I.M.F.
ii) Foreign exchange reserves (Increase-/ 0 13441 -13441

9.  Banking capital: It is the changes in assets and
liabilities of commercial banks,
 This includes government banks, private banks, co-
operative banks.
 Assets are held by foreign branches of Indian banks.
 Liabilities are deposit balances held by foreign banks
in India.
 So increase in asset is debit and increase in
liabilities is credit.
 Decrease in asset is credit and decrease in liabilities
is debit.

10.  Rupee Debt Service is the payment under
rupee/rouble agreement with Russia.It is defined
as the cost of meeting interest payments and
regular contractual repayments of principal of a
loan along with administration charges in rupees
by India
 Errors and omissions: It indicates the value of
discrepancies. Recording of transaction in the
BOP statement is made according to the
principle of double entry book system, certain
discrepancies in estimating and timing may result
in a situation where debits are not exactly equal
to credits. Receipts are either overstated or

11. Monetary movements:
a) India‟s transaction s with the IMF
b) RBI‟s foreign currency reserves
c) Drawings(essentially type of borrowing) from
the IMF or drawing down of reserves credit
items whereas repayments made to IMF or
addition made to existing reserves are debit
items.
d) It measures the effect of transactions on
current and capital account on the official
reserves of the country

12.  IMF account: It contains purchase (credits) and re-
purchases (debits) from IMF.
 SDR are a reserve account created by IMF and
allocated from time to time to member countries.
 It can be used to settle international payments
between monetary authorities of two different
countries.
 An allocation is a credit and retirement is the debit.
 Foreign exchange reserves are in the form of
balances with the foreign central banks and
investment in foreign government securities.

13.  Changes in official reserves
 Official gold reserves (Monetary gold)
 Official foreign exchange holdings ( For e.g.
Reserves)
 Reserve position in IMF and (IMF Quotas)

14. Overall Balance
 Balance on current account
i) Balance of Trade: Difference between value
of exports and imports.
ii) Balance of payment: Balance of trade +
Invisibles.
 Balance on Capital account: It is the net
inflows and outflows on capital transactions.
 It is more of private capital account becoz it
excludes movement in official reserves.

15. BASIC BALANCE AND OVERALL
BALANCE
 Basic Balance: This is the total of balance on
current and long term items in capital account
 It is overall balance less short–term capital
movements
 Overall balance: It is total of balance on
current account and balance on capital
account.
 It is also called as official settlements balance
since it must be financed by official reserves
or by other non-reserve transactions that are
substituted for reserve transaction

16. Balance of payment always
balances
 In accounting sense ,a BOP account always
balances, because it is prepared on the principle of
double entry of book-keeping.
 The total of the credit and debit entries must be
equal to each other
 Balance in current A/C + Balance in capital A/C +
Change in Movements = Zero
 The change in Monetary Movements reflects the
overall BOP position.

17.  Increase in foreign exchange reserves indicates
BOP Surplus
 Decrease in foreign exchange reserves indicates
BOP deficit.
 No change indicates
 (Surplus/Deficit in Current A/C = Surplus/Deficit in
Capital A/C)

18.  However , actual recording of entries can rarely
be complete and accurate.
 Some transaction are bound to be left out (for
e.g. illegal transactions like smuggling and
havala do not appear in official records )
 Some discrepancies is bound to persist in the
totals of credit and debit entries.
 These discrepancies are more likely to arise in
the short run, particularly because actual deals,
shipment of goods, and the payments do not
take place simultaneously.
 For this reason the balancing item E & O is
inserted.

19. Concept of Autonomous and
Accommodating
 Autonomous flows: This takes place in the
ordinary course of foreign trade. These are
“transaction above the line”.
 Accommodating flows (induced): These flows
takes place to equalize the BOP. These are
transactions above the line.

20. Credits Amt (Rs) Debits Amt (Rs)
Current A/C Current A/C
Autonomous 800 Autonomous 930
Transactions Transactions
Export of 550 Imports of 500
goods goods
Export of 150 Imports of 280
services services
Unrequited Unrequited
receipts payments
Gifts 75 Gifts 20
Indemnity 25 Remittances 60
Capital A/C Capital A/C
Accommodatin Accommodatin
g transaction g transaction
Borrowings 200 Loans 70

21. CAUSES OF DISEQUILIBRIUM IN
BOP
 Change in foreign Demand:
 Inflationary or deflationary pressure: Inflation will
increases the imports as the goods become
relatively cheaper and vice-versa, making it
favorable or unfavorable
 Development expenditure:
 Increase in cost structure of export sector:
Higher wages, higher prices of raw materials, or
higher rate of inflation.

22.  Decrease in supply: Agir.production falls due to the failure
in monsoon, IND. Prod. Falls due to labour strike, shortage
of raw materials.
 Appreciation of exchange rate:
 Increased debt Burden: Increase in capital inflows lead to
debt servicing like interest.
 Demonstration Effect:
 Population Pressure:
 Political factors: political turmoil and instability majorly in
African, Gulf countries, Afghanistan etc.

23. MEASURES TO CORRECT THE
DISEQUILIBRIUM IN BOP
 Depreciation: Under flexible exchange rate
,changes in exchange rate will automatically
adjust the BOP.
 Devaluation: It is used under the fixed exchange
rate system, it means fall in the value of home
currency. It is used to wipe out the deficit. If the
elasticity is high then definitely the devaluation
will work.
 Import control: By Imposing quotas and tariff.

24. MEASURES TO CORRECT THE
DISEQUILIBRIUM IN BOP
 Export promotion: Reducing export duties ,
subsidies for exports, provision of market
information, arranging exhibition, providing
finance ,raw material at relatively less cost
 Exchange control: Buying and selling the
foreign exchange through central Bank to restrict
the foreign exchange.
 Production of Import substitutes:
 Monetary Policy: Tight monetary policy can be
used to reduce expenditure to reduce deficit and
vice-versa.

25. Foreign Exchange rate
 The foreign exchange rate is the rate at which the
currency of a country is exchanged against the
currency of another country.

26. Factors affecting Foreign
Exchange Rates
 GDP: It is the primary indicator of the strength of the economic
activity. The growth in GDP positively influences the foreign
exchange prices of the currency and vice-versa.
 Trade Balance: A positive BOT (appreciation in the domestic
currencies) and vice-versa.
 Inflation: It reduces the purchasing power of the currency which will
lead to depreciation of the exchange rate.
 Employment levels: It reflect the development and stability in the
economy. Increase in empt increases the consumption and savings
which leads to increase in investment and leads to the appreciation
of the domestic currency.
 Interest rate differential:
 Exchange rate policy:
 Political factors: These events may be anticipated or unforeseen.
Some of the political developments are election, public
announcements by central bank or government officials, military
takeovers, political instability etc can affect the exchange rate.
 View of Speculators:

27. Concepts of Foreign exchange
transactions
 FIAT Currencies:
 Currency that a government has declared to be legal
tender, despite the fact that it has no intrinsic value
and is not backed by reserves.
 Historically, most currencies were based on physical
commodities such as gold or silver, but fiat money is
based solely on faith.
 The term derives from the Latin fiat, meaning "let it be
done" or "it shall be [money]", as such money is
established by government decree. Where fiat money
is used as currency, the term fiat currency is used.

28.  Foreign Currency:
 It is defined as, the legal tender applicable in a
country outside the domestic area.
 Foreign Exchange means foreign currency and
includes-
 Deposits, credits and balances payable in any
foreign currency.
 Drafts, travellers cheque, letters of credit or bills
of exchange expressed in Indian currency but
payable in foreign currency and
 Drafts, travellers cheque, letters of credit or bills
of exchange drawn by banks outside India but
payable in Indian currency.

29.  Nostro Account – It is the overseas account which is held
by the domestic bank in the foreign bank or with the own
foreign branch of the bank. For example the account held
by state bank of India with bank of America in New York is
a Nostro account of the state bank of India. It is “our
account with you”.
 Vostro Account – It is the account which is held by a
foreign bank with a local bank, so if bank of America
maintains an account with state bank of India it will be a
vostro account for state bank of India. It is “your account
with us”
 From the above one can see that the account which is
Nostro for one bank is Vostro for another so when SBI
opens a Nostro account with Bank of America, it is a
Vostro account for them and vice versa.

30.  LORO Account:
 An account held by a domestic bank in itself on behalf of
a foreign bank.
 The latter in turn would view this account as
a Nostro account.
 A Loro is our account of their money, held by you.
 Loro account is a record of an account held by a second
bank on behalf of a third party;
 i.e, my record of their account with you.
 In practice this is rarely used, the main exception being
complex syndicated financing.
 Their account with them.
 Ex.: Just like State bank Of India maintaining an
account with foreign correspondent say BTC, New
York, Canara Bank may also maintain a Nostro
Account with them. When SBI advises BTC New York
for transfer of funds to Canara Bank Account with
them, Canara Bank Account is titled as Loro Account
"i.e. their account with you".

31.  Correspondent banks are used by domestic banks in
order to service transactions originating in foreign
countries, and act as a domestic bank's agent abroad.
 This is done because the domestic bank may have limited
access to foreign financial markets, and cannot service its
client accounts without opening up a branch in another
country.
 Maintaining the foreign currency a/c and receiving and
making payments on behalf of the counterparty (principal)
bank.
 Providing temporary overdrafts as and when necessary.
 Providing credit reports on companies located in the
country of the correspondent bank.
 Assisting the principal bank in all agency functions such as
presenting of documents, advising of LC , confirmation of
LC etc.

32. Foreign Exchange Market
a) The foreign exchange market provides the physical
and institutional structure through which the money
of one country is exchanged for that of another
country, the rate of exchange between currencies is
determined, and foreign exchange transactions are
physically completed .
b) A foreign exchange transaction is an agreement
between a buyer and seller that a fixed amount of
one currency will be delivered for some other
currency at a specified rate.
c) Foreign exchange means the money of a foreign

33. FUNCTIONS
 Transfer function: It helps the transfer the
purchasing power between the countries. It
utilizes the instrument like bills of exchange, bank
drafts, telegraphic transfers, etc.
 Credit functions: normally with maturity of 12
months.
 Hedging function: It is undertaken to avoid a risk
with a change in exchange rate.

34. FUNCTIONS
 Speculating function: It is function which
speculator undertakes and it is risky.
 Arbitrage function: It refers to the process by
which an individual purchases foreign exchange
in a low price market for a sale in a high price
market for the purpose of making profit. It is the
riskless profit.

35. FOREIGN EXCHANGE
DEALERS
 Market Participants: Investment Bankers deals
in inter bank Market.
 Commercial Bank: These are major players in
the market who buy and sell the currencies.
 Exchange Brokers: This facilitates deals
between the banks.
 Central Bank
 Investment Management Firms: An investment
management firm with an international portfolio
buys and sells the currencies

36. FOREIGN EXCHANGE DEALERS
 Hedge Funds
 Commercial companies: Often trades in the small
amount
 Traders and Investors
 Money Changers: Are authorized by the RBI
Restricted Money changers can only buy while others
can buy as well as sell the currencies. for e.g. some
hotels, firms have given the licenses by the RBI.
 Retail clients

37. Gold Standard
 This is the oldest system.
 This was in operation till
first world war.
 It is based on value of
gold
 There are three kinds of
gold standard that have
been adopted since 1700.
 The Gold specie
 Gold Exchange
 Gold bullion Standard

38. Gold Specie
 In this system actual gold coins or coins
with content of gold were in circulation
 The unit of currency is linked with the
gold coins
 Gold along with silver coins were also
in use
 There were fix conversion ratio such as
5 silver coins = 1 gold coins
 Gold were used for trading of goods of
services.
 Value of gold coin is same as the gold
contents.
 Gold should be freely exported and
imported.
 The supply of gold determine the
liquidity and consequently its value.
 Some used only gold for conversion

39. Bimetallism: Before 1875
 A “double standard” in the sense that both gold and
silver were used as money.
 Some countries were on the gold standard, some on
the silver standard, some on both.
 Both gold and silver were used as international means
of payment and the exchange rates among currencies
were determined by either their gold or silver contents.
 Gresham’s Law implied that it would be the least
valuable metal that would tend to circulate.
2-39

40. Gold Specie
 Eastern roman empire made
use of gold coin called Byzant.
 US dollar was minted as gold
and silver coin till 1862 and
continued along with paper
notes till 1933.
 The four main basic unit was
the cent, the dime, and an
eagle
 Dime is 10 cents, a dollar is 10
dime, and an eagle is 10
dollars.
 The international gold standard
was established by Britain in
1821, using the Gold
Sovereign as their unit.
 By 1871 Germany established

41. Gold Specie
 The net trade imbalance between two countries
would get settled through transfer of gold
reserves.
 This would result in reduced in money supply and
commodity prices in the deficit country and
increased money supply and inflation in the
surplus country.
 This would make commodities more attractive in
the deficit country leading to a reversal in the
trade imbalance and help to achieve equilibrium
of trade.
 This in-built mechanism for balancing trade in the
Gold Standard was called „Price Specie

42.  Gold Points was a term which referred to the rates of
foreign exchange likely to cause movements of gold
between countries adhering to the gold standard.
 Application
 In accordance with the law of supply and demand, the
concept determined that the fluctuating limits of
currency fixed the cost of money between the place
where the bill was drawn and that in where it was
payable. In the exchanges rates between gold-
standard countries, these limits were known as the
gold points, for the reason that, if the price of foreign
bills rose above the upper limits determined by the
exchange rate, countries would find it cheaper to
export gold than to export bills for the purpose of
settling international accounts. Conversely, if the
exchange rate fell below the lower limit of the
determined rate, countries would find it cheaper to
import gold than to sell bills to foreign creditors.

43. Gold bullion Standard
 Gold Bullion Standard
 The reconstructed fixed exchange rate regime differed
from the pre-war standard into two aspects.
 Gold coin no longer circulated as a currency and the inter-
convertability of bank notes with gold coins were
substituted by much more heavier minimum weight of gold
bars.
 In gold Bullion standard, monetary authorities hold stock of
Gold. Currency in circulation is a paper currency note. (or
silver coin or low value metal coin).
 On these paper notes there is written promise that if you
demand , on submission of this note, they would give you
specified quantity of gold. Hence the paper currency is
pegged with the gold and is unconditionally converted in to
gold, on demand.
 The gold per note was fixed by the issuing authority (gold
to bullion ratio).

44.  The USA introduced Gold Bullion paper currency
notes in 1862 and they existed along with actual
gold eagle coin dollars.
 Dollar coin or note was equivalent to 1.50 g
(23.22 grains) of gold.

45. Mechanism of Exchange of Two currencies
(Mint par of Exchange or Par value System)
 The mechanism of establishing exchange rates between
currencies under the gold Standard was the Mint Par of
Exchange.
 The exchange rate between two currencies was
represented by the ratio of the official gold prices for the
two currencies.
 Example
 If 1 ounce of gold in USA = USD 400
 And 1 ounce of gold in Germany = DEM 600
 „then 1 USD = = DEM 1.5000
 Exchange rate established in this manner were called
CENTRAL EXCHANGE RATES‟ or “MINT PARITIES.
 It is basically gold that was getting exchange, either
actually or through promises.
 Hence in bullion standard, if one currency is worth

46.  In Gold exchange standard system, currency is
exchanged for another currency at a specified
ratio, as promised by the monetary authority.
 Another currency with which it is pegged is called
as reserve currency.
 Reserve currency (Dollar and Pound) were in
turn, convertible to real gold as these were in glld
bullion standard.

47. The gold exchange standard (1870-1914)
 Towards the end of the 19th century, some of the
remaining silver standard countries began to peg their
silver coin units to the gold standards of the United
Kingdom or the USA.
 In 1898, British India pegged the silver rupee to the
pound sterling at a fixed rate of 1s 4d, while in 1906,
the Straits Settlements adopted a gold exchange
standard against the pound sterling with the silver
Straits dollar being fixed at 2s 4d.
 At the turn of the century, the Philippines pegged the
silver Peso/dollar to the US dollar at 50 cents.
 A similar pegging at 50 cents occurred at around the
same time with the silver Peso of Mexico and the
silver Yen of Japan.
 When Siam adopted a gold exchange standard in
1908, this left only China and Hong Kong on the silver
standard.

48. Classical Gold Standard:
1875-1914
 Highly stable exchange rates under the classical gold
standard provided an environment that was conducive
to international trade and investment.
 Misalignment of exchange rates and international
imbalances of payment were automatically corrected
by the price-specie-flow mechanism.

49. Classical Gold Standard:
1875-1914
 There are shortcomings:
 The supply of newly minted gold is so restricted that the
growth of world trade and investment can be hampered
for the lack of sufficient monetary reserves.
 Even if the world returned to a gold standard, any
national government could abandon the standard.

50. Advantages
 Long-term price stability has been described as the great
virtue of the gold standard. Under the gold standard, high
levels of inflation are rare, and hyperinflation is impossible
as the money supply can only grow at the rate that the
gold supply increases.
 Economy-wide price increases caused by ever-increasing
amounts of currency chasing a constant supply of goods
are rare, as gold supply for monetary use is limited by the
available gold that can be minted into coin.
 High levels of inflation under a gold standard are usually
seen only when warfare destroys a large part of the
economy, reducing the production of goods, or when a
major new source of gold becomes available.
 In the U.S. one of those periods of warfare was the Civil
War, which destroyed the economy of the South, while the
California Gold Rush made large amounts of gold available
for minting.

51.  The gold standard limits the power of governments to
inflate prices through excessive issuance of paper
currency.
 It provides fixed international exchange rates between
those countries that have adopted it, and thus
reduces uncertainty in international trade.
 Historically, imbalances between price levels in
different countries would be partly or wholly offset by
an automatic balance-of-payment adjustment
mechanism called the "price specie flow mechanism.“
 The gold standard makes chronic deficit spending by
governments more difficult, as it prevents
governments from inflating away the real value of
their debts.
 A central bank cannot be an unlimited buyer of last
resort of government debt. A central bank could not
create unlimited quantities of money at will, as there is

52. Disadvantages
 Deflation rewards savers and punishes debtors. Real debt burdens
therefore rise, causing borrowers to cut spending to service their debts
or to default.
 Lenders become wealthier, but may choose to save some of their
additional wealth rather than spending it all. The overall amount of
expenditure is therefore likely to fall.
 Deflation also prevents a central bank of its ability to stimulate
spending. However in practice it has always been possible for
governments to control deflation by leaving the gold standard or by
artificial expenditure.
 The total amount of gold that has ever been mined has been estimated
at around 142,000 metric tons. Assuming a gold price of US$1,000 per
ounce, or $32,500 per kilogram, the total value of all the gold ever mined
would be around $4.5 trillion.
 This is less than the value of circulating money in the U.S. alone, where
more than $8.3 trillion is in circulation or in deposit (M2). Therefore, a
return to the gold standard, if also combined with a mandated end to
fractional reserve banking, would result in a significant increase in the
current value of gold, which may limit its use in current applications.
 For example, instead of using the ratio of $1,000 per ounce, the ratio
can be defined as $2,000 per ounce effectively raising the value of gold
to $9 trillion. However, this is specifically a disadvantage of return to

53.  Many economists believe that economic recessions can be
largely mitigated by increasing money supply during economic
downturns.
 Following a gold standard would mean that the amount of money
would be determined by the supply of gold, and hence monetary
policy could no longer be used to stabilize the economy in times
of economic recession.
 Such reason is often employed to partially blame the gold
standard for the Great Depression, citing that the Federal
Reserve couldn't expand credit enough to offset the deflationary
forces at work in the market. Opponents of this viewpoint have
argued that gold stocks were available to the Federal Reserve for
credit expansion in the early 1930s, but Fed operatives failed to
utilize them.
 Monetary policy would essentially be determined by the rate of
gold production. Fluctuations in the amount of gold that is mined
could cause inflation if there is an increase, or deflation if there is
a decrease. Some hold the view that this contributed to the
severity and length of the Great
 Depression as the gold standard forced the central banks to keep
monetary policy too tight, creating deflation.[29][38] Milton
Friedman however argued that the main cause of the severity of
the Great Depression in the United States was the Federal
Reserve, and not the gold standard, as they willfully kept
monetary policy tighter than was required by the gold standard.

54.  Although the gold standard gives long-term price stability, it does
in the short term bring high price volatility. In the United States
from 1879 to 1913, the coefficient of variation of the annual
change in price levels was 17.0, whereas from 1943 to 1990 it was
only 0.88.
 It has been argued by among others Anna Schwartz that this kind
of instability in short-term price levels can lead to financial
instability as lenders and borrowers become uncertain about the
value of debt.
 Some have contended that the gold standard may be susceptible
to speculative attacks when a government's financial position
appears weak, although others contend that this very threat
discourages governments' engaging in risky policy (see Moral
Hazard).
 For example, some believe the United States was forced to raise
its interest rates in the middle of the Great Depression to defend
the credibility of its currency after unusually easy credit policies
in the 1920s.
 This disadvantage however is shared by all fixed exchange rate
regimes and not just limited to gold money. All fixed currencies
that appear weak are subject to speculative attack.
 If a country wanted to devalue its currency, it would generally
produce sharper changes than the smooth declines seen in fiat
currencies, depending on the method of devaluation.

55. SPOT AND FORWARD EXCHANGE
RATE
 Spot Rate: it is the single outright transaction
involving the exchange of two currencies at a
rate agreed on the date of the contract for value
of delivery within two business days.
For e.g. If AD quotes
Rs 43.46-48/US$ This is the two way quotes of
the spot rate.
 Trade date: The day the deal is struck
 Value date or settlement date: the day the
exchange of currencies takes place is the value
date.

56. THREE DIFFERENT SETTLEMENT
MATURITIES
 Ready Transactions or a cash transaction:
Exchange of currency takes on the day itself.
 Value TOM: Exchange of currency takes on the
next business day.
 Spot Transaction: Exchange of currency takes
on the second business day.

57. BID and ASK Quotation
 Interbank quotations are given as a bid and ask
(also referred to as offer).
 A bid is the price (i.e., exchange rate) in one
currency at which a dealer will buy another
currency.
 An ask is the price (i.e., exchange rate) at which
a dealer will sell the other currency.
 Dealers bid (buy) at one price and ask (sell) at a
slightly higher price, making their profit from the
spread between the buying and selling prices.

58. BID and ASK Quotation
 Bid and ask quotations in the foreign exchange
markets are superficially complicated by the fact
that the bid for one currency is also the offer for
the opposite currency.
 A trader seeking to buy dollars with Swiss francs
is simultaneously offering to sell Swiss francs for
dollars.
 Assume a bank makes the quotations for the
Japanese yen.
 The spot quotations on the first line indicate that
the bank‟s foreign exchange trader will buy
dollars (i.e., sell Japanese yen) at the bid price of
¥118.27 per dollar.
 The trader will sell dollars (i.e., buy Japanese

59. Direct quote and Indirect quote
 A direct quote is a home currency price of a unit
of foreign currency. An example, using Mexico
and the United States (home country) is:
$0.1050/Peso.
 An indirect quote is a foreign currency price of a
unit of home currency. An example, using Japan
and China (home country) is: ¥14.75/Rmb.

60. European terms and American terms
 Most foreign currencies in the world are stated in
terms of the number of units of foreign currency
needed to buy one dollar. For example, the exchange
rate between U.S. dollars and Swiss franc is normally
stated
 SF1.6000/$, read as “1.6000 Swiss francs per dollar.”
 This method, called European terms, expresses the
rate as the foreign currency price of one U.S. dollar.
An alternative method is called American terms. The
same exchange rate above expressed in American
terms is $0.6250/SF, read as “0.6250 dollars per
Swiss franc.”
 Under American terms, foreign exchange rates are
stated as the U.S. dollar price of one unit of foreign
currency.

61.  Reciprocals. Convert the following indirect
quotes to direct quotes and direct quotes to
indirect quotes:
a. Euro: €1.02/$ (indirect quote); 1/1.02 = $0.98/i
(direct)
b. Russia: Rub 30/$ (indirect quote); 1/30 =
$0.0333/Rub (direct)
c. Canada: $0.63/C$ (direct quote); 1/0.63 =
C$1.5873/$ (indirect)
d. Denmark: $0.1300/DKr (direct quote); 1/0.1300 =
DKr7.6923/$ (indirect)

62. FORWARD TRANSACTION
 It is also known as forward outright rate. The
forward is the transaction involving the exchange
of two currencies at a rate agreed on the date of
the contract for a value or delivery at the same
time in future (more than two days).

63. FORWARD TRANSACTION
 Transaction shows the forward
a) Suppose the trade date is April 1
b) Value date is calculated one month after the
spot date (i.e. April ) ,therefore the value is may
3. If May 3 is holiday then May 4.

64. OUTLINE
 Defining Exchange Rate
 Measuring Exchange Rate Movements
 Appreciation/Depreciation of a currency
 Exchange Rate Equilibrium
 Factors that influence Exchange Rate
Movements

65. MEANING OF EXCHANGE RATE AND
MEASURING CHANGES IN EXCHANGE
RATES
 Value of one currency in units of another
currency
 A decline in a currency‟s value is referred to as
depreciation and an increase in currency‟s value
is called appreciation.
 If currency A can buy you more units of foreign
currency, currency A has appreciated and foreign
currency depreciated
 If currency A can buy you less units of foreign
currency, currency A has depreciated and foreign
currency appreciated

66. APPRECIATION/DEPRECIATIO
N
 Percentage change in value US $
- Old value of rupees per $
New Value of rupees per unit of $
--------------------------------------------------------- X 100
Old value of rupees per $
 Percentage change in value of Rupees
- Old value of $ per unit of Rupees
New Value of $ per units of Rupees
--------------------------------------------------------------
X 100
Old value of $ per unit of Rupees

67. EXCHANGE RATE
EQUILIBRIUM
 Forces of Demand and Supply
 Demand for foreign currency negatively related to
the price of foreign currency
 Supply of foreign currency positively related to
the price of foreign currency
 Forces of demand and supply together determine
the exchange rate

68. DEMAND FOR ($)
Price in ($)
Exchange rate Demand for ($)
50 100
40 200
30 300
20 400
10 500

69. DEMAND FOR ($)
60
50
40
Price of ($) EXchange rate
30
20
10
0
0 100 200 300 400 500 600
Demand for ($)

70. SUPPLY OF ($)
Price in ($)
Exchange rate Supply of ($)
50 500
40 400
30 300
20 200
10 100

71. SUPPLY OF ($)
Price in ($) Exchange rate
60
50
40
Price in ($)
30
20
10
0
0 100 200 300 400 500 600
Supply of ($)

72. EQUILIBRIUM EXCHANGE
RATE
Price in ($)
Exchange rate Demand for ($) Supply of ($)
50 100 500
40 200 400
30 300 300
20 400 200
10 500 100

73. EQUILIBRIUM EXCHANGE
RATE
D
S
Excess
Supply
$1=30
Excess
S
Demand
D
300 Units of Foreign
Currency($)