Foreign Exchange

What is an Exchange Rate?

An exchange rate is the rate at which one currency will be exchanged for another. Or, exchange rate is the
value of one nation's Currency versus the currency of another nation or economic zone. For example,
how many U.S. dollars does it take to buy one euro?

Types of Exchange Rate

1. Fixed Exchange rate

A fixed exchange rate, also known as the pegged exchange rate, is “pegged” or linked to
another currency or asset (often gold) to derive its value. Such an exchange rate
mechanism ensures the stability of the exchange rates by linking it to a stable currency
itself. Also, a fixed currency system is relatively well protected against the rapid
fluctuations in inflation. Some countries following a fixed rate system include Denmark,
Hong Kong, Bahamas & Saudi Arabia.

Advantage: A country with a fixed exchange rate system is attractive to foreign investors who
are lured to invest in that country due to the stability it offers.

Disadvantage: The government of a country following such a system has to maintain a huge
amount of foreign exchange or gold reserves to maintain its value. This system thus proves to
be an expensive one.

2. Flexible exchange rate

Flexible or Floating exchange rate systems are ones whereby the rate of a currency is
determined by the market forces of demand and supply. Unlike the fixed exchange rate, they
do not derive their value from any underlying. Some economists argue that a floating system is
more preferable since it absorbs the shocks of a global crisis and automatically adjusts to arrive
at an equilibrium.

The central bank of the country may interfere in economically extreme situations such as the
recession or boom to stabilize the currency. They may buy or sell an amount of the currency to
prevent the rates from going haywire. This phenomenon is known as the managed float.

Advantage: The rates under this system are determined by a self-sufficient mechanism.
Therefore, the dependence on government or international monetary organizations is
minimum. Also, the determination of rate by the market forces of demand and supply promote
efficiency and robustness of operations.

Disadvantage: Floating rate systems are prone to greater volatility since they are determined
by the market forces. The increased volatility increases the risk quotient in such markets
consequently making it a relatively expensive place for the foreign investors.

3. FORWARD RATE

A forward rate is a one that is determined as per the terms of a forward contract. It stipulates
the purchase or sale of a foreign currency at a predetermined rate at some date in the future. A
forward contract is generally entered into by exporters and importers who are exposed to
Forex fluctuations. The forward rate is quoted at a premium or discount to the spot price.

Advantage: A forward contract freezes the rate of exchange for both the parties and thus
eliminates the element of uncertainty. Therefore, it provides a complete hedge against all
unruly movements in the market.

Disadvantage: A forward contract is not backed by any exchange. Therefore, the possibility of
default is quite high. Also freezing the rates may prove to be a loss-making decision in some
situations. For example, a long forward in a bearish market or a short forward in a bullish
market are instances of the forward backfiring.

4. SPOT RATE
The spot rate is the current exchange rate for any currency. It is the rate at which your currency
shall be converted if you decided to execute a foreign transaction “right now”. They represent
the day-to-day exchange rate and vary by a few base points every day.

Advantage: Trading at a spot rate does not require deep mathematical or statistical analysis. It
is what it is. It is a straightforward rate without any ambiguity.

Disadvantage: Spot rates can be a misleading indicator in times of economic crisis,

unreasonable demand or supply patterns or temporary transitional phases in an economy.

4. DUAL EXCHANGE RATE

In this type of system, the currency rate is maintained separately by two values-one rates
applicable for the foreign transactions and another for the domestic transactions. Such systems
are normally adopted by countries who are transitioning from one system to another. This
ensures a smooth changeover without causing much disruption to the economy.

Advantage: Countries enforcing a dual exchange rate can enforce separate rates for capital and
current account transactions. Therefore, a significant amount of control is with the government
whereby it can influence revenues from capital or current sources depending upon the need of
the hour. It also becomes easier to regulate international trade and at the same time protect
the domestic markets.

Disadvantage: A dual exchange rate system may cause mis-fixing of the exchange rate and
consequent misallocation of resources in various industries. Because of these several economic
anomalies such as black markets, arbitrage opportunities and inflation may emerge.
Determine the Rate of Foreign Exchange

Four steps to determine the rate of foreign exchange are:

(a) Demand for foreign exchange (currency)

(b) Supply of foreign exchange

(c) Determination of exchange rate

(d) Change in Exchange Rate

In a system of flexible exchange rate, the exchange rate of a currency (like price of a good) is
freely determined by forces of market demand and supply of foreign exchange.

Let us assume that there are two countries—India and USA—and the exchange rate of their
currencies, viz., rupee and dollar are to be determined. Presently there is floating or flexible
exchange regime in both India and USA. Therefore, the value of currency of each country in
terms of the other currency depends upon the demand for and supply of their currencies.

(a) Demand for foreign exchange (currency):

Demand for foreign exchange is caused (i) to purchase abroad goods and services by domestic
residents, (ii) to purchase assets abroad, (iii) to send gifts abroad, (iv) to invest directly in shops,
factories abroad, (v) to undertake foreign tours, (vi) to make payment of international trade,
etc. The demand for dollars varies inversely with rupee price of dollar, i.e., higher the price, the
lower is the demand. The demand curve in Fig. 10.1 is downward sloping because there is
inverse relationship between foreign exchange rate and its demand.

(b) Supply of foreign exchange:

Supply of foreign exchange caused-

(i) when foreigners purchase home country’s (say, India’s) goods and services through our
exports

(ii) when foreigners make direct investment in bonds and equity shares of home country

(iii) when speculation causes inflow of foreign exchange

(iv) when foreign tourists come to home country

The supply curve is upward sloping (vide Fig. 10.1) because there is direct relationship between
foreign exchange rate and its supply.

(c) Determination of exchange rate:

This is determined at a point where demand for and supply of foreign exchange are equal.
Graphically, intersection of demand and supply curves determines the equilibrium exchange
rate of foreign currency. At any particular time, the rate of foreign exchange must be such at
which quantity demanded of foreign currency is equal to quantity supplied of that currency. It is
proved with the help of the following diagram. The price on the vertical axis is stated in terms
of domestic currency (i.e., how many rupees for one US dollar).

The horizontal axis measures quantity demanded or supplied of foreign exchange (i.e., dollars).
In this figure, demand curve is downward sloping which shows that less foreign exchange is
demanded when exchange rate increases (i.e., inverse relationship). The reason is that rise in
the price of foreign exchange (dollar) increases the rupee cost of foreign goods which makes
them more expensive. The result is fall in imports and demand for foreign exchange.

The supply curve is upward sloping which implies that supply of foreign exchange increases as
the exchange rate increases (i.e., direct relationship). Home country’s goods (here Indian
goods) become cheaper to foreigners because rupee is depreciating in value.
As a result, demand for Indian goods increases. Thus, our exports should increase as the
exchange rate increases. This will bring greater supply of foreign exchange. Hence, the supply of
foreign exchange increases as the exchange rate increases which proves the slope of supply
curve.

In the Fig. 10.1, demand curve and supply curve of dollars intersect each other at point E which
implies that at exchange rate of OR (QE), quantity demanded and supplied are equal (both
being equal to OQ). Hence, equilibrium exchange rate is OR and equilibrium quantity is OQ.

(d) Change in Exchange Rate:

Suppose, exchange rate is 1 dollar = Rs 50. An increase in India’s demand for US dollars, supply
remaining the same, will cause the demand curve DD shift to D’D’. The resulting intersection
will be at a higher exchange rate, i.e., exchange rate (price of dollar in terms of rupees) will rise
from OR to OR, (say, 1 dollar = 52 rupees). It shows depreciation of Indian currency (rupees)
because more rupees (say, 52 instead of 50) are required to buy 1 US dollar. Thus, depreciation
of currency means a fall in the price of home currency.

Likewise, an increase in supply of US dollar will cause supply curve SS shift to S’S’ and as a result
exchange rate will fall from OR to OR2. It indicates appreciation of Indian currency (rupees)
because cost of US dollar in terms of rupees has now fallen, say, 1 dollar = Rs 48, i.e., less
rupees are required to buy 1 US dollar or now Rs 48 instead of Rs 50 can buy 1 dollar. Thus,
appreciation of currency means ‘a rise in the price of home currency’.