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Foreign Exchange Market

It’s a market where participants buy, sell, exchange and speculate on currencies. Its constituents are banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors. The market determines the foreign exchange rate and enables currency conversion for international trade and investments.

Structure of a Foreign Exchange Market

Central Bank

As depicted in this diagram, the central bank of any country is at the top slot. It is the custodian of foreign exchange of that country and works as the lender of last resort. In the case of India, the central bank is RBI which regulates and control the foreign exchange market to ensure that it works properly. RBI prevents aggressive fluctuations in the market by its own measures.


The foreign exchange brokers link the commercial bank with central banks as well as with actual buyers. They don’t buy and sell the currency themselves, rather they strike deals between parties on a commission basis.

Commercial Banks

These are the market makers as they quote the foreign exchange rates of buying and selling the currencies. They also function as clearinghouses where different foreign exchange deals are settled.

Actual Buyers & Sellers

Actual buyers & sellers are actually in a need to buy/sell their foreign currencies. They can be exporters, importers, tourist, investors, and immigrants who approach commercial banks through brokers to deal in foreign currencies.

Foreign Exchange Control

It’s a method of state intervention in the export-import so as to correct the adverse balance of payment. Ways using which the foreign exchange can be controlled are:

  1. Banning the use of foreign currency
  2. Banning locals to possess foreign currency
  3. Restricting currency exchange to be done only at government-approved exchangers
  4. Fix exchange rates
  5. Restricting the amount of currency being imported/exported

Objectives of Foreign Exchange Control

  1. One of the primary purposes of exchange control is to sustain the balance of payment equilibrium. It’s done by limiting imports thereby reducing the usage of foreign exchange. Devaluation of currency is also done to encourage exporters to export more and consequently get more foreign currency.
  2. To protect the domestic trade and industries from foreign competition, the government sometimes induces the industries to produce and export more thereby restricting imports.
  3. The government maintains a fund, commonly known as Exchange Equalization Fund to peg the rate of exchange if the rate of a particular currency vis-a-vis its domestic currency shoots up. If the rate of that particular currency goes up and the government wants to control it, it starts selling that currency in the open market thereby increasing its supply and making the rate of that currency fall.
  4. If the domestic capital starts migrating to other countries, the government may use exchange control to check its exports thereby avoiding the flight of capital.
  5. The government may be selective in allowing international trade with some countries by releasing its currency and vice versa with other countries. This way it adopts the policy of differentiation.

Types of Foreign Exchange Control

Mild System

Here the government intervenes and maintains the rate of exchange at a particular level by keeping a fund (such as Exchange Equalization Fund) in foreign currencies. If the exchange rate of a foreign currency shoots up way too high, it starts selling the foreign currency using that fund and keeps it under control.

Full Fledged System

Here the central bank keeps all the details of exports and other transactions and accordingly allocate the foreign exchange to different buyers. The government is the sole dealer in foreign exchange in this system.

Compensating Agreement

When two countries get engaged in a barter system skipping currency movement altogether, it’s called a compensating agreement. The goods exchanges are of the same value and therefore no currency is required.

Clearing Agreement

Here two or more countries come to a mutual understanding to buy/sell goods/services to each other at agreed exchange rates (against payments made by buyers in their own currency). The balance of outstanding claims are settled between the central banks at the end of stipulated periods.

Payments Arrangement

Here two countries enter into an agreement where citizens of a country are forced to purchase goods/services imported from another country and vice versa.

Kinds of Exchange Rates

Fixed Exchange Rate System

In this system, the exchange rates for different currencies are set up by the government who does this by buying/selling a foreign currency as per different requirements. It stabilizes foreign trade and capital movement. The government keeps the value of its currency fixed in terms of some external standard which can be gold, silver, any other currency or any other internationally agreed unit of account.

When the value of a domestic currency is tied to the value of another currency, it is known as pegging. On the other hand, when the value of a currency is fixed in terms of gold/other currency, it is known as parity value of currency. Devaluation and Revaluation refer to decrease and increase in the value of the domestic currency respectively by the government.

Flexible Exchange Rate System

Here the exchange rate is determined by the forces of demand & supply of different currencies in the foreign exchange market and there isn’t any governmental intervention. It’s also known as floating exchange rate.

Managed Floating Rate System

It’s a mix of fixed and flexible exchange rate system. Here the central bank of a country intervenes in the foreign exchange market to restrict the fluctuations within certain limits. The aim is to keep the exchange rate attuned to the targeted value. This system is also known as Dirty Floating.

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1 Comment

  1. sushma kanna Reply

    thanks a lot for providing with detailed notes with respect to syllabus on the security market. I have searched a lot for Sebi grade A notes. your website helped me a lot.

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