Demonisation of Foreign Exchange Markets

With the Rupee fluctuating from mid 30s to early 50s against the US dollar in period of just 1 year, the foreign exchange market, more than any other market has been cast in a villain’s role. Even heads of states have been known to visit invective upon the market. This kind of animosity may come from the fact that few heads of state study economics. Pursing no education seems to be a better preparation for a career in politics. Even very few chief executives have attained a fundamental understanding of the functioning of prices in modern economics. Prices, including exchange rates, are the agents that distribute scarce resources among competing demands. Prices do their work, without any one being conscious of their activity, much like the human body’s central autonomous system that controls its functioning.

Finance ministers and central bankers are supposed to know more about economics than heads of state do. Yet they too have an adversarial relationship with foreign exchange market because exchange rates have a habit of making them look silly; the currency market has made a monkey out of many a finance minister. In popular thinking, the whole foreign exchange market derives its existence from business centred on speculation. What is missed out in this rush to diagnose the foreign exchange markets is an important, if not crucial distinction about volatility.

In normal functioning markets, prices move up and down in more or less continuous manner. While a normal market can be trending up or down, it can even experience large fluctuations from time to time and there will be specialised agents willing to deal in derivatives contract. The importance of this is that derivatives are the principal tool that investors use to hedge foreign exchange risks. Among these are forward foreign exchange contracts and options on foreign exchange. Hence one can make an important generalisation that investors are not put off by the possibility that national currency will weaken over time – if that is their view, they can hedge, so long as there are dealers offering such instruments at a reasonable prices .Where this breaks down is in case of exchange rate that is capable of sharp discontinuous movements as has been witnessed in India recently owing to partially fixed exchange rate regime when Rupee started appreciating. Thus dollar rate crash seems inevitable in near future