MEANING OF FOREX

Foreign exchange, or forex, is the conversion of one country's currency into another. In a free economy, a
country's currency is valued according to the laws of supply and demand. In other words, a currency's
value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of
currencies. A country's currency value may also be set by the country's government.

However, many countries float their currencies freely against those of other countries, which keeps
them in constant fluctuation.

Factors Affecting Currency Value

The value of any particular currency is determined by market forces based on trade, investment, tourism,
and geopolitical risk. Every time a tourist visits a country, for example, they must pay for goods and
services using the currency of the host country. Therefore, a tourist must exchange the currency of their
home country for the local currency. Currency exchange of this kind is one of the demand factors for a
particular currency.

Key Takeaways

 Foreign exchange, also known as forex, is the conversion of one country's currency into another.

 The value of any particular currency is determined by market forces related to trade, investment,
tourism, and geopolitical risk.

 Foreign exchange is handled globally between banks and all transactions fall under the auspice of
the Bank for International Settlements (BIS).1

Another important factor of demand occurs when a foreign company seeks to do business with another
in a specific country. Usually, the foreign company will have to pay in the local company's currency. At
other times, it may be desirable for an investor from one country to invest in another, and that
investment would have to be made in the local currency as well. All of these requirements produce a
need for foreign exchange and contribute to the vast size of foreign exchange markets.

Foreign exchange is handled globally between banks and all transactions fall under the auspice of
the Bank for International Settlements (BIS).1

How Inflation Affects Foreign Exchange Rates

Inflation can have a major effect on the value of a country's currency and its foreign exchange rates with
other currencies. While it is just one factor among many, inflation is more likely to have a significant
negative effect on a currency's value and foreign exchange rate. A low rate of inflation does not
guarantee a favourable exchange rate, but an extremely high inflation rate is very likely to have a
negative impact.
 CURRENCY
APPRECIATION
Currency appreciation is an increase in the value of one currency in relation to another currency.
Currencies appreciate against each other for a variety of reasons, including government policy, interest
rates, trade balances, and business cycles.

Currency appreciation, however, is different from the increase in value for securities. Currencies are
traded in pairs. Thus, a currency appreciates when the value of one goes up in comparison to the other.
This is unlike a stock whose appreciation in price is based on the market’s assessment of its intrinsic
value. Typically, a forex trader trades a currency pair in the hopes of currency appreciation of the base
currency against the counter currency.

Appreciation is directly linked to demand. If the value appreciates (or goes up), demand for the currency
also rises. In contrast, if a currency depreciates, it loses value against the currency against which it is
being traded.

CURRENCY
DEPRECIATION
Currency depreciation refers to the exchange value of a country’s currency compared to other currencies
in a floating rate system. Currency depreciation rate is determined based on trade imports and exports
for a particular country. Demand for foreign products results in more bring-in, resulting in foreign
currency investment and domestic currency depreciation.

Currency depreciation and its impacts greatly depend upon the situation and current condition of the
country’s economy. For example, during a recession, devaluation can bring economic growth by
impacting industrial output due to competitiveness, and the opposite impact may be in the case of rapid
development. On the other hand, if there is depreciation, the economy may experience a slowdown due
to increased inflation.

TYPES OF FOREIGN
EXCHANGE RESERVES
Types of Exchange Rate Systems

There are three types of exchange rate systems that are in effect in the foreign exchange market and
these are as follows:

1. Fixed exchange rate System or Pegged exchange rate system: The pegged exchange rate or the fixed
exchange rate system is referred to as the system where the weaker currency of the two currencies in
question is pegged or tied to the stronger currency.

Fixed exchange rate is determined by the government of the country or central bank and is not
dependent on market forces.

To maintain the stability in the currency rate, there is purchasing of foreign exchange by the central bank
or government when the rate of foreign currency increases and selling foreign currency when the rates
fall.

This process is known as pegging and that’s why the fixed exchange rate system is also referred to as the
pegged exchange rate system.

Advantages of Fixed Exchange Rate System

Following is some of the advantages of fixed exchange rate system

1. It ensures stability in foreign exchange that encourages foreign trade.

2. There is a stability in the value of currency which protects it from market fluctuations.

3. It promotes foreign investment for the country.

4. It helps in maintaining stable inflation rates in an economy.

Disadvantages of Fixed Exchange Rate System

Following is some of the disadvantages of the fixed exchange rate system

1. There is a constant need for maintaining foreign reserves in order to stabilise the economy.

2. The government may lack the flexibility that is required to bounce back in case an economic shock
engulfs the economy.

2. Flexible Exchange Rate System: Flexible exchange rate system is also known as the floating exchange
rate system as it is dependent on the market forces of supply and demand. There is no intervention of
the central banks or the government in the floating exchange rate system.

Advantages of Floating Exchange Rate System

Following are the advantages of the floating exchange rate system

1. There is no need to maintain foreign reserves in this exchange system.

2. Any deficiencies or surplus in Balance of Payment is automatically corrected in this system.

Disadvantages of Floating Exchange Rate System

Following are some of the disadvantages of the floating exchange rate system

1. It encourages speculation that may lead to fluctuations in the exchange rate of currencies in the
market.
2. If the fluctuations in exchange rates are too much it can cause issues with movement of capital
between countries and also impact foreign trade.

3. It will discourage any type of international trade and foreign investment.

3. Managed floating exchange rate system: Managed floating exchange rate system is the combination
of the fixed (managed) and floating exchange rate systems. Under this system the central banks intervene
or participate in the purchase or selling of the foreign currencies.

DEMAND FOR FOREIGN