The mechanism through which payments are effected between two countries having different currency systems is called foreign exchange. Foreign exchange thus, may be defined as the exchange of money or credit in one country for money or credit in another.

The process of foreign exchange is similar to that of the clearing and collection of cheques required for resettlement of internal claims, except that in external dealings we have an additional process of converting one currency into another.

In fact, foreign exchange is a collective term that embraces all kinds of negotiable claims expressed in foreign money – as seen by the domestic buyer or seller. In simple words, and rather in a restricted sense, by foreign exchange we mean foreign currencies. However, in a broad sense, the term refers to the system of external or international payments. It covers methods of payment, rules and regulations of payment and the institutions facilitating such payments.

Instruments of External Payments:


External payments utilise a variety of specialised instruments. Important among these are foreign bills of exchange, bank drafts and telegraphic transfers, bank letters of credit and travellers’ cheques.

Foreign Bills of Exchange:

A foreign bill of exchange is a customary form of making international payments. It is a written request or an order from the drawer to the drawer to pay a certain sum of money either to himself or to the payee as ordered by the drawer on demand or some time hence.

A foreign bill of exchange is generally used with the added formality of a letter of credit. Its working is very simple. The creditors (exporters) of one country draw bills on their debtors (importers) in other countries and have them duly accepted by them.


These bills they sell to the debtors of their own country who desire to send money abroad. The debtors (importers) send these bills to their creditors in other countries who collect them from the debtors of their own country (who had originally accepted the bills). The following illustration will clarify the point.

Suppose trader A in Mumbai imports machinery from trader B in New York and that another businessman C in New York owes the same amount of money to merchant D in Mumbai, for tea imported by him. In this case, B, the American creditor, will draw a bill for the amount due to him, which A, the Indian debtor will have to accept. B has therefore, the right to money in India in the form of a bill drawn.

This right he can sell to C, the American debtor, who has to pay money in India, C will send this bill to D his creditor, who through his bank will collect the money from A. However, the mechanism of the bills of exchange makes it necessary that, every payment in external exchange in one direction is matched by an equal payment in the other.

Bank Drafts and Telegraphic Transfers:


A bank draft is an order of a bank to its branch or another bank to pay the bearer on demand a specified amount out of its deposit account. The debtor in an international transaction can get suet bank draft from his bank and send it to his creditor who will collect the sum from the branch or b of his own country.

A telegraphic transfer is a telegraphic order by a bank to its correspondent bank abroad pay a certain sum to a certain person on account out of its deposit account. It is a quicker mode o payment.

Letter of Credit: A letter of credit is an instrument authorising a person to draw a bill or cheque for special sum on the issuing bank at a stipulated time. The letter of credit makes exporter willing to ship the goods to the importer, for the liability for payment is assumed by the b issuing the letter of credit. Such letters of credit are also issued to travellers going abroad.

The le authorises the traveller to draw cheques for the amount on a branch or correspondent of the b abroad. Likewise, travellers’ cheques are also issued by the bank which can be cashed at a bran or correspondent of the bank in a foreign country.


In addition to these means, international payments may also be concluded by the use of gold home currency, personal cheques and international money orders.