Foreign Exchange Market According to Kindleberger, the foreign exchange market is a place where foreign money are bought

and sold. Foreign exchange market is an institutional arrangement for buying and selling of foreign currencies. Exporter sells the foreign currencies while the importers buy them. Purpose of Foreign Exchange Market The usefulness and main purposes of foreign exchange Markets are as follows:1. The Foreign exchange Market `Forex` is useful in assisting international business organizations in the matters related to international trade and investment. 2. The foreign exchange market allows business to convert one currency to another foreign currency. For example, it permits a U.S. business to import European goods and pay Euros, even though the businesss income is in U.s. dollars 3. Third, a firm may want to invest in a different country from that in which it currently holds underused funds. 4. Fourth, a firm may want to speculate on exchange rate movements, and earn profits on the changes it expects. If it expects a foreign currency to appreciate relative to its domestic currency, it will convert its domestic funds into the foreign currency. Alternately stated, its domestic currency to depreciate relative to the foreign currency. An example similar to the one in the book can help illustrate how money can be made on exchange rate speculation. The management focus on George Soros shows how one fund has benefited from currency speculation. 5. Exchange rates change on a daily basis. The price at any given time is called the spot rate, and is the rate for currency exchanges at that particular time. One can obtain the current exchange rates from a newspaper or online. 6. The fact that exchange rates can change on a daily basis depending upon the relative supply and demand for different currencies increases the risks for firms entering into contracts where they must be paid or pay in a foreign currency at some time in the future. In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods System. Exchange Rate In finance, the exchange rate (also known as the foreign exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of another. It is the value of a foreign nations currency in terms of the home nations currency. Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk. When an investor decides to cash out, or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many repercussions on an economy: Affects the prices of imported goods. Affects the overall level of price and wage inflation Influences tourism patterns

Will influence consumers buying decisions and investors long-term commitments. Exchange Rate Determination Methods

MINT PAR PARITY THEORY OF EXCHANGE RATE OR DETERMINATION OF RATE OF EXCHANGE UNDER GOLD STANDARD what is mint parity theory?

Mint parity theory explains the determination of exchange rate between the two countries which are on gold standard. In a country which is on gold standard, the currency is either made of gold or is convertible into gold at a fixed rate. There are also no restrictions on the export or import of gold. Determination of Exchange Rate

The rate of exchange between the gold standard countries is determined on a weight to weight basis of the gold contents of their currencies. In other words, the exchange rate is determined by the, gold equivalents of the currencies involved. In the words of Thomas, The mint par is an expression of the ratio of weights of gold used for the coinage of the currencies. For examples, before World War-ll (1926-1931) England and American currencies were on gold standard. The mint par between these two countries was pound one of England=4.86 dollars of America. The rate of exchange showed that one pound of England contained as much fine gold as 4.866 dollars contained in America. The ratio of weights of metal 1$4.866 was called the mint parity. The mint par between England and France was oe 1=25.24 Francs at that time.

The mint par was a fixed rate. It remained constant so long as the monetary laws of the country remained unchanged. The current or the market rate of exchange, however, fluctuated from time to time due to changes in the balance of payments of the respective countries. The variations in the exchange rate remained within the well defined limits called gold points or specie points The gold points refer to the limits within which the market rate of exchange between two gold standard countries fluctuates from the mint parity equilibrium. The upper gold point indicates the upper limit and the lower gold point indicates the lower limit.

Calculations of gold points The gold points are determined by the costs of transporting gold (such as shipping, packing, insurance charges, etc.) from one country to another. The upper gold point (upper specie point) is

obtained by adding the cost 6f shipping gold to the mint parity rate of exchange. The lower gold point (lower specie point) is arrived at by deducting the cost of shipping gold from .the mint parity rate of exchange. For example, the mint parity rate of exchange between England and America is 1=$4.866. The shipping cost of gold from America to England worth 4.866 dollars of gold is .02 cent. In that case the upper gold point = 1=$4.866 + .02=$4.886. The lower gold point = 1$4.866 .02= $4.846.

Gold export point and gold import point. The upper gold point is also called gold export point. It is the rate of exchange above which the gold will be exported. The lower gold point is also called the gold import point. It is the rate of exchange below which gold will be imported. Under the gold standard, the exchange rate between the two currencies cannot vary above the upper gold point and below the lower gold point as is illustrated in the figure 7.2:-

In the figure 7.2, the demand curve DD and supply curve DD intersect each other at point R. OR is the exchange rate between the dollar and the pound. It may here be noted that the exchange rate need not be at the mint parity. It can be any where between the upper and lower gold points depending on the shape of demand and supply curves. An American importer would not pay mare than $4.886 to obtain one pound of England. It is because he can purchase $4.866 worth of gold from the US Treasury and ship it to England at a cost of .02 cent per pound. The exchange rate, therefore, cannot rise beyond the gold export point OU. The supply curve of pounds becomes perfectly elastic at the US gold export point. Similarly, the rate of exchange cannot fall between $4846 to a pound. The exchange rate of $4846 to a pound is the US gold import point. In case of lower rate, the Americans would prefer to use the pounds to import gold from England. The Americans demand curve for pounds becomes perfectly elastic at the gold import point OL.

The Mint Par Parity Theory has been discarded since the gold standard broke down in 1931. As no country is now on the gold standard, therefore, the mint parity theory has, now, an academic interest only.

Interest Rate Parity (IRP) Theory

Interest Rate Parity (IPR) theory is used to analyze the relationship between at the spot rate and a corresponding forward (future) rate of currencies. The IPR theory states interest rate differentials between two different currencies will be reflected in the premium or discount for the forward exchange rate on the foreign currency if there is no arbitrage - the activity of buying shares or currency in one financial market and selling it at a profit in another. The theory further states size of the forward premium or discount on a foreign currency should be equal to the interest rate differentials between the countries in comparison.

Interest Rate Parity Flowchart For our illustration purpose consider investing 1000 for 1 year. We'll consider two investment cases viz:

Case I: Domestic Investment

In the U.S.A., consider the spot exchange rate of $1.2245/ 1. So we can exchange our 1000 @ $1.2245 = $1224.50 Now we can invest $1224.50 @ 3.0% for 1 year which yields $1261.79 at the end of the year.
Case II: Foreign Investment

Likewise we can invest 1000 in a foreign European market, say at the rate of 5.0% for 1 year. But we buy forward 1 year to lock in the future exchange rate at $1.20025/ 1 since we need to convert our 1000 back to the domestic currency, i.e. the U.S. Dollar. So 1000 @ of 5.0% for 1 year = 1051.27 Then we can convert 1051.27 @ $1.20025 = $1261.79 Thus, in the absence of arbitrage, the Return on Investment (RoI) is same regardless of our choice of investment method.