Amity Business School

Amity Business School

International Financial and Forex Management

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EXCHANGE RATE DETERMINATION

➢ The exchange rate between two currencies in a floating rate regime is

determined by the interplay of demand & supply forces.

➢ The demand for foreign currency comes from individuals & firms who
have to make payments in foreign currency mostly on account of imports of
goods & services and purchase of securities.

➢ The supply of foreign exchange results from the receipts of foreign

currency normally on account of exports or sale of financial securities.
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Factors Determining the Spot Exchange Rate

The rate of exchange in the market is the outcome of the combined effect of a
Multiple of factors constantly at play. The Economic factors are better guides in the long run.

Some of the important factors that affects the exchange rate are as follows:
➢ Balance of Payment
➢ Inflation Rate
➢ Interest Rate
➢ Money Supply
➢ National Income
➢ Resource Discoveries
➢ Capital Moments
➢ Political Factors
➢ Psychological Factors & Speculation
 Theories on Exchange Rate Determination Amity Business School

PURCHASE POWER PARITY THEORY

This theory holds that the exchange rate
between two currencies is determined by the Purchasing power parity (PPP) is a theory
relative purchasing power as reflected in the which states that exchange rates between
price levels expressed in domestic currencies currencies are in equilibrium when their
purchasing power is the same in each of the
in the two countries concerned. two countries
Changes in the exchange rates are
explained by relative changes in the
purchasing power of the currencies caused
by inflation in the respective countries

This means that the exchange rate between

two countries should equal the ratio of the
two countries' price level of a fixed basket of
goods and services. When a country's
domestic price level is increasing (i.e., a
country experiences inflation), that country's
exchange rate must depreciated
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PURCHASE POWER PARITY THEORY

This theory is enunciated by prof. Gustav Cassel. According to him ,the Rate of
Exchange between two countries on inconvertible paper currency standard is
determined by the purchasing power parity of there currency.

Therefore the theory suggests that at any given time, the rate of exchange
between two currencies is determined by there purchasing power

i.e. if e is the exchange rate and Pa & Pb are the purchasing power of two
currencies, a & b then as an equation it can be

e = Pa/Pb
A country experiencing high rate of inflation will experience a corresponding
depreciation of its currency, while a country with low inflation rate will
experience an appreciation in the value of its currency.
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Absolute Version of PPP

The absolute version is based on the Law of one price. This law states that under
Free Market conditions with the absence of transportation costs, tariffs and other
frictions of Free trade, the price for identical goods should be the same at any
market
when measured in a common currency.

The law of one price relates to a single product, PPP theory does not confine to a
Single products. Instead of single commodity, we consider a basket comprising
a variety of products.

Symbolically PPP absolute version can be stated as

e = Pd
pf
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If inflation of one country causes a temporary deviation from the equilibrium ,

arbitrageurs will begin operating and as a result, equilibrium will be restored

through changes in exchange rate.

Thus if the Indian commodity turns costlier ,its export will fall. At the same time
the import price being cheaper ,its import from the foreign will expand. Higher
imports will raise the demand for foreign currency in turn raising its value vis-à-
vis the rupee.

This version of PPP theory is the Absolute version , it hold good only when the
same commodities are included in the domestic market basket &world market
basket.
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RELATIVE VERSION OF PPP THEORY

The Relative version states that the exchange rate between currencies of any two
countries should be a constant multiple of the general price indices prevailing in
them

Therefore it indicate that percentage change in exchange rate should be equal to the
percentage change in the ratio of price indices in the two countries. e.g. if the current
exchange rate is ₹ 62.91/US$ and the rate of inflation is 7% in India & 4% in USA
then the exchange rate will be

(1+.07)/(1+.04)* 62.91 = ₹ 64.72

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Therefore the purchasing power parity is never constant but keeps on changing

according to the change in the price level of the two countries.

In short period the rate of exchange between the two countries can be either
more or less than the purchasing power parity. But in the long period the rate of
exchange between the two countries is determined by the purchasing power
parity.

WHY PPP THEORY DOES NOT HOLD?

1. The rate of exchange is also influenced by some more factor i.e. interest rate,
governmental interference etc.

2. When no domestic substitute to an import is available the material is imported even

after the price is going high.
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Q. If Exchange Rate at the end of the 2018-2019 is ₹65.22/$ and if

the rate of inflation in India is 8% and inflation in USA is 5% during the
year 2019-2020. Calculate
i. Exchange rate at the end of 2019-2020
ii. Inflation rate differential

Real & Nominal Exchange Rate

Q. The administered exchange rate in India was ₹7.91/$ during 1981-90.

The price Index in India and the USA is rose by 67% and 26% respectively.
Calculate whether there was any change in real exchange rate during the
period.
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The spot exchange rate between Indian Rupee and US dollar in 1995 was
₹30/$ when the price index in both the countries were 100. By 2000 Rupee
was devalued to ₹45/$ and at the same time the price index has moved up
during the period. In India it was 110 and in US it was 125. Find out the
extent of change in nominal and real exchange rate.
 INTEREST RATE PARITY Amity Business School

Experts have different views on how changes in interest rate influence

exchange rate.

The flexible price version of Monetary Theory:

Any rise in domestic interest rate lower the demand for money in relation
to the supply of money causing depreciation in the value of domestic
currency.

The Sticky Price version of Monetary Theory:

A rise in interest rate increases the supply of loan able fund which lead to
greater supply of money and depreciation of in domestic currency.
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The sticky BOP version: The higher rate of interest at home than in foreign country
attracts capital from abroad in lure of higher returns and in flow of foreign
currency results in increase of the supply of foreign currency, raises the value of
domestic currency

Fishers Approach: He suggested that any preposition cannot be thought in isolation of

inflation, as inflation negates the returns on capital to be received. The gain in
form of interest may be cancelled out by the loss on account of inflation.

So according to Irving Fisher nominal interest is decomposed into two parts:

1. The Real Interest Rate

2. The Expected Rate of Inflation.

The relationship between the two is known as Fisher Effect

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Therefore the investor is always interested in the nominal rate of interest that
covers both the expected inflation and required real interest rate. It can be
mathematically expressed as: r = (1+a)(1+i) -1

r nominal interest rate; a real interest rate; i expected rate of inflation

Suppose required real rate of interest is 8% and inflation is 10% in India then the
nominal rate of interest will be

r = (1+.04)(1+.10) -1

r =18.8%

Therefore US investor will be tempted to invest in India only when the nominal interest
in India is more than 18.8%
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Concept check Calculation

a. If the Real Interest rate is 5% and the inflation rate is 7% what would
be the nominal interest rate

b. Calculate the Interest rate if nominal interest rate is 10% and inflation
rate is 4%.

c. Calculate the rate of inflation if nominal and real rates are 15% and
5% respectively
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Combine effect of inflation & interest rate:

The combine effect is given the name of International Fisher Effect or generalized
version of the Fisher Effect.

The International Fisher Effect states that the interest rate differential is equal to
the inflation rate differential i.e. ( 1+rA/1+rB) = (1+IA/1+IB)

The rationale behind this preposition is that an investor likes to hold assets
denominated in currencies expected to depreciate only when the interest rate on
those assets is high enough to compensate the loss on account of depreciating
exchange rate. As corollary, an investor holds assets denominated in currencies
expected to appreciate even at a lower rate of interest because the expected capital
gain on account of exchange rate appreciation will make up the loss on yield on
account of low interest rate
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If the rate of inflation in India and the US is 7 percent and

4 percent respectively and if the interest rate in the USA is
6 percent, calculate the interest rate in India.

If Interest rate in India is 9.06 percent and 6 percent in

USA and the exchange rate prevailing ₹68.92/$, calculate
the expected exchange rate next year.
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Exchange Rate determination in Forward Market

Interest Rate Parity theory helps in determining the forward Exchange rate.

IRP suggests that forward rate differentials is approximately equal to the interest rate
differential

Therefore IRP theory states that equilibrium s achieved when the forward rate
differential is approximately equal to the interest rate differential

In simple, forward rate differs from spot rate by an amount that

represents the interest rate differential.
Q. Calculate 90 days forward rate when interest rate in India & the US are 10 percent
& 7 percent respectively. The spot rate is Rs.60/US$.
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Calculate 6-month forward rate if the spot rate is ₹68/$ and the interest
rate in India is 6% and interest rate in US is 3%.
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Forecasting Exchange Rates

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Forecasting of exchange rate is used for several purposes such as

hedging of risk, earning assessment, investment decision and
financing decision
Techniques of Forecasting
➢ Technical Forecasting Technique

➢ Fundamental Forecasting Technique

➢ Market Based

➢ Mixed Forecasting
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Technical Forecasting
➢ Technical forecasting is based on the movement of
historical rates. Therefore historical rates are used to
estimating the future rates.

➢ The technical forecasting technique is used for short

term forecasting and the coverage is normally not very
wide.
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Tools used in Technical forecasting

➢ Classical Charting techniques embracing line chart,
bar chart, candlestick chart, point and figure charts

➢ Statistical techniques includes moving average system-

both simple and weighted moving average techniques
are used.

➢ Mathematical techniques used are regression analysis

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Fundamental forecasting
Fundamental forecasting is based on fundamental
relationship between economic variables and exchange
rate. This technique of forecasting is based on the macro
economic variables and not on the historical data.
Examines economic relationships and financial data
to arrive at a forecast.
• Short term horizons: Asset Choice Model
• Long term horizons: Parity Models
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Asset Choice:
(Foreign exchange is viewed as financial asset)
Examines why one currency might be preferred over others. Variables
include:
➢ Relative interest rates (current and anticipated)
➢ Political/country risk
➢ Carry trade strategies
The carry trade is a strategy in which traders borrow a currency that has a low
interest rate and use the funds to buy a different currency that is paying a higher
interest rate. The traders' goal in this strategy is to earn not only the interest rate
differential between the two currencies, but to also look for the currency they
purchased to appreciate.

Essentially, trying to identify why the demand for a

currency will change.
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Fundamental Analysis: Long Term

Parity Models

➢Through these models one attempts to calculate an

“equilibrium” exchange rate in the future.

➢Analysis built on “long standing” economic

theories of exchange rate determination.

a. Purchasing Power Parity Model

b. International Fisher Effect

 Purchasing Power Parity Amity Business School

➢ One of the oldest exchange rate models.

➢ Assumes that exchange rates will change to offset relative

prices levels between countries.

❖Countries with relatively high rates of inflation will show

currency depreciation

❖Countries with relatively low rates of inflation will

experience currency appreciation

➢ In equilibrium, the amount of depreciation (or appreciation)

will be equal to the inflation differential.
 International Fisher Effect Amity Business School

➢ Assume that exchange rates will change in direct proportion to

relative differences in long term interest rates.
❖Assumes that long term interest rates capture the market’s
expectation for inflation.
❖Countries with relatively high rates of long term interest
rates (i.e., high inflation) will show currency depreciation.
❖Countries with relatively low rates of long term interest
rates (i.e., low inflation) will show currency appreciation.
➢ In equilibrium, the amount of depreciation (or appreciation)
will be equal to the long term interest rate differential.
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Market Based Forecasting

Market based forecasting is based on the expected trend in the market.

In this technique, the estimation of future rates depends on the spot and
forward rates prevailing in the market and on the expectations about the future.

Mixed Forecasting
Market based forecasting is a weighted average of technical, fundamental and
market based forecasting technique.

Under this technique each technique is assigned a particular weight, the total
weight being 1. The result of each technique is multiplied by the assigned
weight and then are summed up to reach the final forecast.