Foreign Exchange: History, Characteristics, and Processes

Posted on Oct 28, 2024 in Economy

What is Foreign Exchange?

Foreign exchange (forex, FX, or currency market) is the global decentralized market for exchanging national currencies. It facilitates commerce, trading, and tourism, encompassing buying, selling, and exchanging currencies at current or determined prices. This continuous, nonstop market differs from financial markets where currencies are borrowed and lent.

History of Forex

While currency conversion for financial gain has existed since the advent of currencies, the modern forex market emerged after the 1971 Bretton Woods agreement, which allowed major currencies to float freely against each other. Varying currency values created the need for foreign exchange services and trading.

Characteristics of Forex

Market Transparency: Currency fluctuations are easily monitored through account tracking and real-time portfolios, without brokers.

Dollar Dominance: The USD, paired with most currencies, is the most traded globally.

Dynamic Market: Currency values change constantly, 24/7, making forex highly active.

International Dealer Network: Global dealer institutions facilitate exchange and trading.

Over-the-Counter (OTC) Market: Forex is largely unregulated, with banks trading via telex and telephone.

High Liquidity: Currency is the most traded financial instrument, ensuring high market liquidity.

24-Hour Operation: Forex operates continuously, enabling trading at any time.

Liberalized Exchange Rate Management System (LERMS)

LERMS is a flexible, market-driven approach to exchange rate management. Unlike fixed systems, LERMS allows currency values to fluctuate based on supply and demand. Central banks intervene to maintain stability and prevent excessive volatility.

Repatriation and Non-Repatriation

Repatriation

Repatriation converts India-based earnings (interest, dividends) into foreign currency and transfers them back to the investor’s home country. Example: An NRI in the USA investing in Indian stocks can convert dividend rupees to USD and transfer them to their US bank account.

Repatriation Steps:

  1. Currency Conversion (e.g., INR to GBP for a UK-based NRI).
  2. Transfer to the NRI’s foreign bank account.

Non-Repatriation

Non-repatriable funds remain in India and are only usable within the country. Example: Funds in an NRI’s Non-Resident Ordinary (NRO) account are non-repatriable.

Implications of Non-Repatriation:

  • Limited fund usage (within India only).
  • Potential tax implications.

Documents Required for Foreign Exchange

  • Proof of Identity: Passport, Aadhaar card, PAN card
  • Proof of Address: Bank statement, utility bill
  • Proof of Purpose: Admission letter (for study abroad)
  • Bank Details: Sending bank account information
  • Invoice/Bill: For business transactions
  • Confirmed Ticket: For travel within 60 days
  • A2 Form: As required
  • CA Certificate: For large amounts or specific cases
  • Beneficiary’s Passport Copy: As required

Export Finance

Export finance is financial assistance from banks and other institutions to businesses for shipping products internationally.

Institutions Offering Export Finance

  1. EXIM Bank
  2. ECGC (Export Credit Guarantee Corporation of India)
  3. Development banks (IDBI, SIDBI, ICICI)
  4. Export Credit Agency (ECA)
  5. National Small Industries Corporation (NSIC)
  6. Commercial banks
  7. State Finance Corporations

Incoterms, CIF, and FOB

Incoterms (International Commercial Terms) define buyer and seller responsibilities in international trade. CIF (Cost, Insurance, and Freight) applies to ocean shipments, with the seller covering costs, insurance, and freight. FOB (Free on Board) indicates the point of responsibility transfer from seller to buyer.

Covered Interest Rate Parity

Covered interest rate parity is a no-arbitrage condition used to determine forward exchange rates. It allows investors to hedge against exchange rate fluctuations.

Methods of International Trade Settlement

  1. Cash in Advance
  2. Open Account
  3. On Consignment
  4. Draft/Documentary Collection
  5. Letter of Credit

Cash in Advance

  • Payment before shipment (wire transfer or check).
  • Risk-free for the exporter, risky for the buyer.

Open Account

  • Payment after shipment (e.g., 14, 30, or 60 days).
  • Common method, often used by large companies.
  • Risky for the seller unless a strong relationship exists.

On Consignment

  • Payment after resale by the consignee (importer).
  • Very risky for the seller, with limited control.

Draft/Documentary Collection

  • Used when cash in advance or open account is unsuitable.
  • Seller ships goods and draws a draft/bill of exchange on the buyer through a bank.
  • Documents required before title transfer.

Letter of Credit (LC)

  • Bank guarantee of payment upon shipment and document presentation.
  • Various types: Revocable, Irrevocable, Deferred Payment, Revolving, Transferable, Sight, Usance, Standby.