Unit 3.1 Exchange+Rate V1+

BBA F&A Year) (3 rd
International Financial Management

COC642B – SEMESTER 6
International Financial Management COC642B – BBA F&A Jan to May 2023

Exchange Rate
The supply of and demand for foreign exchange in the domestic foreign exchange market
determine the external value of the domestic currency, or in other words, a country’s
exchange rate.
The demand and supply side in the foreign exchange market can be for:
➢ Purchase goods and services from another country

➢ For unilateral transfers such as gifts, awards, grants, donations or endowments
➢ To make investment income payments abroad
➢ To purchase financial assets, stocks or bonds abroad
➢ To open a foreign bank account
➢ To acquire direct ownership of real capital, and
➢ For speculation and hedging activities related to risk-taking or risk avoidance activity
Exchange Rate
INR against major currencies in 2022
USD EUR GBP AUD CAD SGD Chart Title
Jan 74.45 84.32 100.93 53.45 58.96 55.12
100.00
Feb 74.96 85.01 101.44 53.63 58.88 55.64
Mar 76.22 83.92 100.41 56.21 60.23 56.10

90.00
Apr 76.19 82.51 98.72 56.16 60.36 55.82
May 77.30 81.69 96.22 54.49 60.14 55.91

80.00
Jun 78.02 82.50 96.19 54.87 60.90 56.37
Jul 79.52 81.13 95.50 54.55 61.49 57.01 70.00
Aug 79.57 80.54 95.31 55.34 61.60 57.49
Sep 80.14 79.49 90.87 53.69 60.31 56.77 60.00
Oct 82.29 80.90 92.84 52.33 59.99 57.76

50.00
Nov 81.61 83.28 95.77 53.87 60.83 58.85 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Dec 82.40 87.22 100.29 55.62 60.62 60.91 USD EUR GBP AUD CAD SGD

Changes in Exchange Rate
Currency Depreciation:- When the value of one currency increases compared to other
currency or basket of currencies
Under a floating rate system, if for any

reason, the demand curve for foreign
currency shifts to the right representing
increased demand for foreign currency,
and supply curve remains unchanged,
then the exchange value of foreign
currency rises and the domestic
currency depreciates in value

Changes in Exchange Rate
Currency Appreciation:- When the value of one currency increases compared to other
currency or basket of currencies
An increase in the supply of foreign

exchange shifts the supply curve to the
right to S1 $ and as a consequence, the
exchange rate declines to e1. It means,
that lesser units of domestic currency
(here Indian Rupees) are required to buy
one unit of foreign currency(dollar), and
that the domestic currency (the Rupee)
has appreciated.
Change in Exchange rate
Depreciation is a decrease in a currency's value (relative to other major currency benchmarks) due to
market forces of demand and supply under a floating exchange rate and not due to any government or
central bank policy actions.
Devaluation is a deliberate downward adjustment in the value of a country's currency relative to another
country’s currency or group of currencies or standard. Generally, happens for Fixed Rate currencies.
Appreciation, on the other hand, is an increase in a currency's value (relative to other major currencies)
due to market forces of demand and supply under a floating exchange rate and not due to any
government or central bank policy interventions.
Revaluation is the opposite of devaluation and the term refers to a discrete official increase of the
otherwise fixed par value of a nation’s currency.

Causes of Exchange rate fluctuation
➢ Increase in domestic price (inflation)
➢ A rise in real income of the country (excess import or export)
➢ Rate of interest in domestic economy as compared to other
countries
➢ Inflow and outflow of short term and long term capital
➢ Speculative purchase of foreign currency
➢ Structural changes in the economy
➢ Occasional changes due to political instability

Purchasing Power Parity (PPP)
➢ The basic idea of PPP was advanced by David Ricardo in the
19th century. It was popularized by a Swedish economist Gustav
Cassel.
➢ When the law of one price is applied internationally to a
standard commodity basket, we obtain the theory of PPP.
➢ Law of One Price explains how domestic price of a product
equates its foreign price quoted in the same currency.
➢ PPP tells us the about the impact of inflation on exchange rates.

Purchasing power is the amount of goods and services that you
can buy with a specific currency
The law of one price is that one good in one currency should have
the same price of an identical good in another country when
converting into different currencies. Therefore the purchasing
power of two countries should be same for the identical product.


Absolute Purchasing Parity
The absolute version of the PPP theory is based on the following assumptions:
• There are no transportation costs.
• There are no tariffs on imports and subsidies on exports.
• There is free trade between nations.

Relative Purchasing Parity
➢ Relative PPP states that the percentage change in the
exchange rate over any period equals the difference
between the percentage changes in national price levels.
➢ In other words, exchange rates should change to offset
differences in inflation rates.
➢ If U.S. inflation is 5% & in U.K. it is 8%, the pound should
depreciate by 3%.


Projected inflation rates for the U.S. and Euro for the next twelve months are 10%
and 4%, respectively. If the current exchange rate is $ 1.20/EUR, what should the
future spot rate be at the end of next twelve months?
1 Eur = 1.2 USD
(1 + 10%)
E1 = X 1.20 = 1.27
(1 + 4%)

Inflation in India is 5%, inflation in the US is 3%. Currently the exchange rate is
Rs40/$. Calculate the exchange rate within two years of span by using PPP principle.
1 USD = 40 INR
(1 + 5%)^2
E1 = X 40 = 41.57
(1 + 3%)^ 2

Purchasing Power Parity
Absolute PPP – To identify Spot Relative PPP – To identify future
price price
Pd
ER or SR =
Pf
ER or SR Exchange Rate - Spot

Pd Price Index Domestic
Pf Price Index Foreign

Illustrations
Example 1:
A Laptop Bag is priced at $ 105.00 at New York. The same bag is priced at Rs.4,250 in
Mumbai.
(a) Determine Exchange Rate in Mumbai.
(b) If, over the next one year, price of the bag increases by 7% in Mumbai and by 4% in
New
York, determine the price of the bag at Mumbai and-New York?
(c) Determine the exchange rate after one year
(d) Determine the appreciation or depreciation in $ and Rs. in one year from now.

Illustrations
Example 2:
Average price of consumer goods is priced at $ 1200.00 at New York. The same bag
is priced at GBP 800 in London.
(a) Determine Exchange Rate in New York.
If, over the next one year, price of the bag increases by 5 % in London and by 7% in
New York
(b) Determine the exchange rate after one year
(c) Determine the appreciation or depreciation in GBP and USD. in one year from
now.

Illustrations
Example 3:
Average price of consumer goods is priced at $ 1200.00 at New York. The same bag
is priced at GBP 800 in London.
(a) Determine Exchange Rate in New York.
If, over the next one year, price of the bag increases by 5 % in London and by 7% in
New York
(b) Determine the exchange rate after two years
(c) Determine the appreciation or depreciation in GBP and USD. in two years from
now.

Illustrations
Example 4:
The spot rate is Rs.36.00/$. Inflation rates in India and USA are
expected to be 8% and 3% respectively.
What is the expected rate of depreciation or appreciation and for which
currency?

Illustrations
Example 5:
Spot rate DM 1.50/$

1 Year forward rate DM 1.64/$
The inflation rate in Germany is 4%. Calculate the inflation rate in
the USA assuming that
Purchasing Power Parity holds goods even in the short run. [Ans:
1.32%]

Illustrations
Example 6:
Spot rate DM 1.50/$

3-month forward rate DM 1.51/$
The inflation rate in Germany is 4%. Calculate the inflation rate in
the USA assuming that
Purchasing Power Parity holds goods even in the short run. [Ans:
1.32%]

Real Exchange rate
➢ Inflation adjusted exchange rate is known as real exchange
rate.
➢ It measures the degree of deviation from PPP over a period
of time, assuming PPP held at the beginning of the period.
➢ It is a measure of exchange rate between two countries
adjusted for relative purchasing power of the currencies
with reference to a given time period.

Real Exchange Rate / PPP Exchange Rate
At the end of January 2007 the INR to USD was 44.01 while it was 35.90 at the end of January 1997. CPI, at the end of Jan
2007, in India is 171 while in the US CPI is 128 for the same period. Calculate real exchange rate.
REAL EXCHANGE RATE BASED ON PPP - Rate in 2007
Jan 2007 Jan 1997 Inflation Jan 2007 Jan 1997 Inflation
INR INR INR INR
1 USD = 44.01 35.9 1 USD = 44.01 35.9
CPI India 171 100 1.71 CPI India 171 100 1.71
CPI US 128 100 1.28 CPI US 128 100 1.28
If in 2007 INR worth 44.01/USD, what is it worth in If in 1997, 1 USD worth 35.90 INR then based on CPI
INR USD INR
(44.01 / 1.71) = 25.74 (35.90 X 1.71 / 1.28) 47.96
(1/1.28) = 0.781
Real exchange rate in Jan 1997 32.94 PPP rate of INR on Jan 2007 47.96
(25.74 / 0.781)
Deviation from PPP 9% Deviation from PPP 9%
(35.9-32.94) / 32.94 (47.96 - 44.01)/44.01)

Purchasing power parity
➢ As it is clear now, exchange rate changes may indicate nothing more
than the reality that countries have different inflation rates
(outcome of PPP). Hence, changes in nominal exchange rates may
not be significant to evaluate the true effects of currency changes on
a firm.
➢ Real exchange rate is the nominal exchange rate adjusted for

changes in relative purchasing power of each currency since some
base period.

Relative purchasing power parity
Applications of Relative PPP:
➢ Forecasting future spot exchange rates.
➢ Calculating appreciation in “real” exchange rates. This will provide a

measure of how expensive a country’s goods have become (relative
to another country’s).

Deviations from PPP
➢ Shipping costs, as well as tariffs and quotas can lead to deviations
from PPP.
➢ Cost of Land and other factors of production may vary in different
countries.
➢ transportation costs and restrictions
➢ departures from free competition
➢ differently constructed price indices
➢ relative price changes
➢ Non-traded goods and services

Interest Rate Parity
➢ Uses nominal interest rates to analyze the relationship between spot
rate and a corresponding forward exchange rate.
➢ Any rise in domestic interest rates lowers demand for money and
the lower demand for money in relation to the supply of money
causes depreciation in the value of domestic currency.
➢ If nominal interest rates are higher in country A than country B, the
forward rate for country B’s currency should be at a premium
sufficient to prevent arbitrage.

1+rd
F = X S
1+rf
F = Forward spot rate

S = Spot rate
r = Rate
d = domestic
f = foreign

Interest Rate in India = 12%
Interest Rate in USA = 7%
Exchange Rate @ borrowing = 1 USD = 64 INR

USD 1,00,000 X 64 = Rs 64 Lakhs in Hand @ 5% Rs 3,20,000
FR as per formula is 66.99 RS per USD

Rate of interest in Switzerland is 2% and in US is 7%, if the same condition prevail for one more year
calculate the exchange rate after one year. The spot rate is 1SF = $3.02.
1+rd
F = X S
1+rf
F = (1+7%) X 3.02
(1+2%)
F = 3.17

The rate of return in the US is 10% annually. Rate of return in Japan is 7%. 1 Yen = $0.0038.
Calculate 90 days forward rate of Japanese Yen in relation to US dollar.
Calculate the currency premium or discount.
1+rd
F = X S
1+rf
F = (1+10%*3/12) X 0.00380
(1+7% * 3/12)
F = 0.003828
Premium/ F-S/S 0.74%

Discount
Example 1:
The US Dollar is selling in India at Rs. 45.50. If the interest rate for a 6 month
borrowing in India is 8% p.a. and the corresponding rate in USA is 2%,
(i) What is the expected/fair 6 month forward rate for US Dollar in India; and
(ii) What is the rate of forward premium or discount on $?
(iii)What is the rate of forward premium or discount on Rs.?
(iv)Do you expect US Dollar to be at a premium or at discount in the Indian forward

market;
(v) If actual FR of 6 months is $ 1 = Rs.47, Actual Prem/Dis on $;

Example 2:
The US Dollar is selling in India at Rs. 55.50. If the interest rate for a 6 month
borrowing in India is 10% per annum and the corresponding rate in USA is 4%,
(i) What is the expected 6 month forward rate for US Dollar in India; and
(ii) What is the rate of forward premium or discount on $?
(iii) If actual FR of 6 months is $ 1 = Rs.58, Actual Prem/Dis on $;

Example 3
The spot Danish Krone rate is $ 0.15986 and the three month forward rate is $
0.1590. The three month treasury bill rate in the United States is 6.25% p.a. and in
Denmark 7.50% p.a.
(i) Calculate forward premium or discount on Danish Krone
(ii) Are the forward rates and interest rate in equilibrium?
(iii)Work out the forward rate if the forward rate or interest rate are in equilibrium.

Shoe Company sells to a wholesaler in Germany. The purchase price of a shipment is
50,000 deutsche marks with term of 90 days. Upon payment, Shoe Company will
convert the DM to dollars. The present spot rate for DM per dollar is 1.71, whereas the
90-day forward rate is 1.70. You are required to calculate and explain
(i) If Shoe Company were to hedge its foreign exchange risk, what would it do? What
transactions are necessary?
(ii) Is the deutsche mark at a forward premium or at a forward discount?
(iii) What is the implied differential in interest rates between the two countries? (Use
IRPT
assumption)

Spot $ 1 = DM 1.71
FR of 90 days $ 1 = DM 1.70
(i) To hedge foreign exchange risk, shoe co can take forward contract, by selling DM
50,000 in forward Market @ $ 1 =
DM 1.70
$ receivable by taking forward contract = DM50,000/1.70 = $29411.76
$ receivable under Spot Rate = DM50,000/1.71 = $29239.77
Benefit by forward Contract = 29411.76 – 29239.77 = $171.99
(ii)
Prem/ Dis on $ (LHC) = (FRActual - SR)*100/SR = (1.70 – 1.71)*100/1.71 = -
0.5848%
$ is at discount and DM is at premium
(iii) Interest rate differential is just another name of premium or discount of one
currency in relation to another currency.
IF IRPT exists
Discount on $ under IRPT = Actual Discount on $ = 0.5848%
Hence Interest rate differential = Discount on $ under IRPT = 0.5848%

The following table shows interest rates for the US
dollar and French francs. The spot exchange rate is 7.05 francs per dollar. Complete the
missing
entries:
3 Months 6 Months For 1 year
Dollar interest rate (Annually compounded) 11.5% 12.25% ?
Franc interest rate (Annually compounded) 19.5% ? 20%
Forward francs per dollar ? ? 7.52
Forward discount on FF per cent per year ? -6.3% ?

SR 1 $ = FF 7.05 [$ is LHC and FF is RHC]
(i) For 3 months
Interest Rate ($) = 11.5% p.a.
PIR of 3 months ($) = 2.875%
Interest Rate (FF) = 19.5% p.a.
PIR of 3 months (FF) = 4.875%
Assuming IRPT Exists
FR under IRPT (FF/$) = (1 + PIRFF)*SR/(1 + PIR$) = (1 + 0.04875)*7.05/(1 + 0.02875) = FF 7.187
(a) FR of 3 months under IRPT $ 1 = FF 7.187
(b) Discount on FF (RHC) = (SR - FRIRPT)*100/FRIRPT = (7.05 – 7.187)*100/7.187 = - 1.906%
Discount p.a. on FF = 1.906*4 = 7.624%
(ii) For 6 months
Interest Rate ($) = 12.25% p.a.
PIR of 6 months ($) = 6.125%
Discount on FF = 6.3% p.a.
Discount on FF for 6 months = 3.15%
Discount on FF (RHC) is given, hence
FR of 6 months = SR/(1-Dis on FF) = 7.05/(1-0.0315) = 7.279
(a) FR of 6 months $ 1 = FF 7.279
Assuming IRPT Exists
FR/SR = [1 + PIRFF]/[1 + PIR$]
7.279/7.05 = [1 + PIRFF]/[1.06125]
1 + PIRFF = 7.279*1.06125/7.05 = 1.095
PIR on FF = 0.095 = 9.5%
(b) Interest rate on FF p.a. = 9.5%*2 = 19%

(iii) For 1 year
Interest Rate (FF) = 20% p.a.
FR of 1 year $ 1 = FF 7.52
(a) Discount on FF (RHC) = (SR – FRGiven)*100/FRGiven = (7.05 – 7.52)*100/7.52 = - 6.25%
Discount p.a. on FF = 6.25%
(b) Assuming IRPT Exists
FR/SR = [1 + IRFF]/[1 + IR$]
7.52/7.05 = [1.20]/ [1 + IR$]
1 + IR$ = 1.20*7.05/7.52 = 1.125
IR$ = = 0.125 = 12.5% p.a.
Particulars 3 Months 6 Months 1 Year
IR$ p.a. 11.% 12.% 12 .%
IR$ p.a. 19.% 19% 20%
Forward Francs per Dollar 7.187 7.279 7.52
Forward Discount on Franc (Percent per Year) (7.624%) (6.3%) 6.25%

Fishers effect
International Financial Management COC642B – BBA F&A

Jan to May 2023
Fishers effect
➢ Fisher Effect explains that nominal interest rate is the amalgam of real interest
rate and inflation rate.
➢ An increase (decrease) in the expected rate of inflation will cause a
proportionate increase (decrease) in the interest rate in the country.
➢ It states that the expected nominal interest rate is made up of
➢ A real required rate of return ‘a’
➢ An inflation premium equal to the expected amount of inflation ‘i’.
India USA
N Nominal Rate 10% 4%
I Inflation Rate 7% 1%
R = N-I Real Rate 3% 3%

Jan to May 2023
Fishers effect
India USA
N Nominal Rate 10% 4%
I Inflation Rate 7% 1%
R = N-I Real Rate 3% 3%

Jan to May 2023

Unit 3.1 Exchange+Rate V1+

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BBA F&A Year) (3 rd

International Financial Management

International Financial Management COC642B – BBA F&A Jan to May 2023

➢ Purchase goods and services from another country

Mar 76.22 83.92 100.41 56.21 60.23 56.10

May 77.30 81.69 96.22 54.49 60.14 55.91

Jul 79.52 81.13 95.50 54.55 61.49 57.01 70.00

Aug 79.57 80.54 95.31 55.34 61.60 57.49

Sep 80.14 79.49 90.87 53.69 60.31 56.77 60.00

Oct 82.29 80.90 92.84 52.33 59.99 57.76

International Financial Management COC642B – BBA F&A Jan to May 2023

Under a floating rate system, if for any

International Financial Management COC642B – BBA F&A Jan to May 2023

An increase in the supply of foreign

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

1 Eur = 1.2 USD

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

ER or SR Exchange Rate - Spot

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

Spot rate DM 1.50/$

International Financial Management COC642B – BBA F&A Jan to May 2023

Spot rate DM 1.50/$

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

➢ Real exchange rate is the nominal exchange rate adjusted for

International Financial Management COC642B – BBA F&A Jan to May 2023

➢ Forecasting future spot exchange rates.

➢ Calculating appreciation in “real” exchange rates. This will provide a

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

F = Forward spot rate

International Financial Management COC642B – BBA F&A Jan to May 2023

Exchange Rate @ borrowing = 1 USD = 64 INR

FR as per formula is 66.99 RS per USD

International Financial Management COC642B – BBA F&A Jan to May 2023

International Financial Management COC642B – BBA F&A Jan to May 2023

Premium/ F-S/S 0.74%

(ii) What is the rate of forward premium or discount on $?

(iii)What is the rate of forward premium or discount on Rs.?

(iv)Do you expect US Dollar to be at a premium or at discount in the Indian forward

(v) If actual FR of 6 months is $ 1 = Rs.47, Actual Prem/Dis on $;

International Financial Management COC642B – BBA F&A Jan to May 2023

(ii) What is the rate of forward premium or discount on $?

(iii) If actual FR of 6 months is $ 1 = Rs.58, Actual Prem/Dis on $;

International Financial Management COC642B – BBA F&A Jan to May 2023

(i) Calculate forward premium or discount on Danish Krone

(ii) Are the forward rates and interest rate in equilibrium?

International Financial Management COC642B – BBA F&A Jan to May 2023