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What is a Currency ?
A currency is nothing other than a common commodity just as other goods, which is commonly accepted my other members in an economy domestically, in exchange of a commodity.
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Apart from this, each commercial bank will generally have a account in a foreign bank called Nastro account. This is the major source of supply of foreign exchange into the For-Ex market.
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The Foreign exchange market is a two-segmented market. One segment deals with Inter-bank market which is between commercial banks and financial institutions governed by RBI, the other segment is market between the banks and the ultimate buyer or seller of foreign exchange who deals in retail.
How Quotations are made in Inter-Bank Market ? There are ways of making market quotations. They are Direct Quotations - where the domestic currency units are kept variable for a fixed unit of For-Ex. Indirect Quotations - where the domestic currency units are kept fixed and the respective units of For-Ex is variable.
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Various types of Exchange-rates : Inter-bank rate : The rate which prevails in the interbank market at which the participants can buy or sell For-Ex. This is the base rate for quoting the Spot rate and Forward rates.
Spot rate : The rate at which individual Importers or Exporters can buy or sell For-Ex from the participants of Inter-bank Market Immediately on the day or within a week or on the same-month.
Forward rate : The rate quoted by the Banks for buying or selling off For-Ex at a future date which will be more than a month. Generally a agreement is made between bank and buyer or seller of For-Ex at Forward rate to avoid loss by means of fluctuations.
Inter-bank buying Rate - Exchange margin = Spot Buying Rate Inter-bank Selling rate + Exchange margin = Spot Selling Rate Spot Buying Rate +/- Forward Premium/Discount = Forward Buying Rate Spot Selling Rate +/- Forward Premium/Discount = Forward Selling Rate Buying and selling rates are quoted with a slight difference and selling rate will be quoted higher than the buying rate to earn profit from the transactions in-order to cover-up the administration costs.
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The Exchange margin is mainly profit oriented that the portion is enjoyed by the bank by buying or selling to the customer instead of trading in inter-bank market. Forward Premium or Discount is based on trends of prices of the For-Ex in the ForEx Market and estimation on changes in prices of For-ex.
Determination of Base Rate or Equilibrium Rate : The Base rate may or may not be the Equilibrium rate of the For-ex, due to the Exchange control and interventions of RBI. As the Equilibrium rate fluctuates based on the demand and supply, and the economy may not be healthy if the fluctuation is more, RBI generally in-order to avoid fluctuations at large scale, uses a system of controlling called Pegging System. But, Countries which are neither developed nor underdeveloped, has to follow the mixed system of both FIXED-Rate (pegging) and FLOATING-Rate (free equilibrium) called Exchange-Rate Band, which allows RBI to intervene in critical situations and let the rate to move according to market in usual circumstances.
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The Exchange-Band defines Central bank at which rate it has to buy For-ex at higher rates by itself in order to get more For-ex reserves and when to sell For-ex at cheaper rate to reduce over-valuation or scarcity of For-ex in economy. The RBI sells for-ex if the rate tends to move beyond the maximum determined rate at the maximum rate to bring back in control, if the For-ex rate declines beyond the minimum rate, it buys For-ex at the minimum rate to grab it back to exchange band. Thus the rate of exchange is kept between the borders of price-levels.
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Exchange Control:
There are many ways to introduce exchange control in an economy. These are usually classified into two groups: (i) Direct Exchange Control and (ii) Indirect Exchange Control.
Direct Methods of Exchange Control: In direct exchange control, certain measures are adopted which effectuate immediate direct restriction on foreign exchange from all sides - its quantum, use and allocation. In general, direct exchange control includes measures like: (i) Intervention; (ii) Exchange restrictions; (iii) Exchange clearing agreements; (iv) Payment agreements; and (v) Gold policy.
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