Foreign Exchange Market demystified

Foreign exchange market is one of the largest structures bypassing the equity market in the world. An estimate of $3.2 trillion of turnover, on average, takes place in the currency OTC market, which is truly a 24 by 7 market.

The OTC market is also known as the “spot”, “cash”, or “off-exchange” forex market. (A spot transaction refers to an exchange of currencies at the prevailing market rate.) Similarly, the forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid.

Devaluation, in common modern usage, specifically implies an official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. In contrast, depreciation is used for the unofficial decrease in the exchange rate in a floating exchange rate system. 

The basic principle of depreciation (and its opposite - appreciation) is that country’s currency decreases in value relative to the foreign currencies (e.g. 1USD = 46INR now IUSD = 50INR). This make’s the country’s currency more competitive, as the price of country’s goods/services when exchanged for the foreign currency will be cheaper i.e. it will increase exports. In case of currency appreciation, the country’s currency will be less competitive, as it will take less currency to purchase a foreign currency. Consequently, it will lead to larger import of foreign goods in the country and less exports.   



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