Exchange Rate

Presented By : MMS - B

Sumit Dadhich (73)

Tanmay Shringarpure (107)
Nikesh Shah (103)
Girdhar Adhikari (63)
Vinit Rokde (99)
 Agenda
 Foreign Exchange,  Indian Rupee Case Study
Market,  RBI Role

Characteristics  Currency Convertibility

 Functions of Forex  Interest Rate Parity
 Main Players In Forex  Chinese Renminbi 
 Instruments of Forex
 FX Rate
 FX Rate Regimes
 Determination of FX Rate
 Factors Affecting FX Rate
 Effects of FX Rate
Foreign Exchange
Currency of one country gets converted into currency of
other country.

Refers to all Deposits, Credits, Balances payable in

foreign currency.

Eg. US dollars and British Pound are Foreign

Exchange for India.
Foreign exchange market
 Market in which currencies of various countries
are exchanged, traded or converted. Includes
banks, foreign exchange dealers and govt.
agencies.

 Also Known as Forex/ FX/ currency market

FX Characteristics
 Currency Pair Transactions
 Huge trading volume, high liquidity
 Geographical dispersion
 24 hours a day except weekends, i.e. trading from

20:15 GMT on Sunday until 22:00 GMT Friday

 Low margins
 Leverage to enhance profit margins with respect to

account size.
 The Biggest Financial Market In The World
 Difficult to manipulate due to size
Daily Volume Comparison
Functions of Forex
 Converting Currencies

• Revenue From Exports, foreign profits

• Suppliers
• Speculation
 Exchange rate movement

 Reducing risk
Main Players
In Forex
Forex Instruments

 Spots
 2 days delivery transaction

 Forwards
 Contracted currencies
Forex Instruments contd.
 Options
 Call and Put

 Future
 Marking to market

 Swap
 Spot and Forward
Foreign Exchange Rate /Forex rate /FX rate

 How much one currency is worth in terms of the

other.

 Nominal Exchange Rate NER

 Nominal Effective Exchange Rate NEER

It is the weighted average of nominal exchange
rates where the weights used are the shares of
trading partners in the foreign trade of a country.
FX Rate Cont.
Eg. - USA accounts to 60% of total trade with India
and UK is 40 %.

NEER = (NERUS X WUS) + (NERUK X WUK)

NEER - nominal effective exchange rate
NERUS/ NERUK - nominal exchange rate of the
US and UK respectively
WUS / WUK - Trade shares of the US and UK
respectively
 FX Rate Cont.
 Real exchange rate
Relative price of 2 countries after adjusting for price
levels within countries.

Eg - Rupee price of a basket of goods in India relative to

dollar price of same basket of goods in USA.
RER= NER [PUS/ PIN]
RER- real exchange rate
PUS and PIN - price level in USA, India respectively.

 Real effective exchange rate

 Adjusted for effects of inflation.
FX Rate Conventions
 Base Currency - Unit currency, Transaction currency
 Quote Currency - Term Currency, Price currency,
Payment currency

USD/INR = 45.1202
Base Currency - USD
Quote Currency – INR

Bid Price – Buyers Price

Ask Price – Sellers Price
Bid/Ask Spread – Profit Margin of trader
FX Rate Conventions Cont.

 EUR – GBP – AUD – NZD – USD – others.

 When both are “others”

 Exception Like Japanese YEN

 FX Rate Table
Currency  1 INR in INR
American Dollar 0.022063 45.3248
Australian Dollar 0.0217664 45.9424
Brazilian Real 0.0366376 27.2944
British Pound 0.013712 72.9288
As of Canadian Dollar 0.0216221 46.249
27-Feb-2011 Chinese Yuan 0.145109 6.89139
Danish Krone 0.119522 8.36666
Euro 0.0160318 62.376
Hong Kong Dollar 0.171946 5.81578
Israeli New Shekel 0.0804107 12.4362
Japanese Yen 1.8039 0.554354
Kuwaiti Dinar 0.006139 162.892
Pakistan Rupee 1.89009 0.529074
Foreign Exchange Rate Regimes
 Float / Flexible - eg. INR, USD
• Independent floating system and Managed
floating system
• Automatic Correction
• Currency is not tied to foreign currency
• Prone to Speculation and Uncertainity

 Fixed - eg. Chinese Renminbi

• Creates stable atmosphere for foreign investment
• Prone to Currency Crisis / Balance of Payments

Crisis.
Determination of FX Rate
Method 1 : The Purchasing Power Parity Approach
  Long run
 The law of one price
 Focuses on changes in prices

p = p* / e
Where,
p = domestic prices [say INR = 45]
p* = foreign prices [say USD = 1]
e = exchange rate [say INR/USD = 0.0222]

Assumptions: goods are identical, no transportation

costs
 The Monetary Approach - Demand and Supply

P – Price of INR/USD Q – Quantity of INR

D – Demand of INR S – Supply of INR
The Balance of Payments Approach

 PPP concentrates on one part of the balance of

payments—tradable goods and services.

 Other approaches have focused on the balance of

payments on current account.

  It is essential to look at the entire balance of

payments both current and capital account
transactions in assessing foreign exchange flows and
their role in the determination of exchange rates.
Factors Affecting FX Rates

 Government policies

 Inflation rates

 Interest rates

 Current-Account Deficits
Factors Affecting FX Rates Cont.

 Current events and Political Stability

 Public Debt

 Speculation
Effects of FX Rate Fluctuations

 On economy

 On foreign investors

 On industry/companies – import/exports
FX Rate Appreciation
FX Rate Depriciation
Effects of FX Rate Fluctuations Cont.
Indian Rupee Case Study
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

44.9 47.2 48.7 46.7 45.3 44.1 45.3 41.4 43.8 49.1 46.2 45.7

USD/INR Exchange Rate

50

48

46

44

42

40

38

36
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

USD/INR Exchange Rate

 Indian Rupee Case Study Cont.
 Appreciation/Depreciation of Rupee (2007)

 Appreciation of 2007:

o 9.8% appreciation against

the US dollar.

o Appreciation in currency
of 8.35% - 2nd Highest
among EM.
FII Capital Inflow

Year FII ‘s in $ Billion

2003 6.59
2004 8.52
2005 10.7
2006 7.99
2007* 17.33
Indian Rupee Appreciation
Reasons for Appreciation
 FDI

 Foreign portfolio inflows (FII’s)

ECB (External commercial borrowings) :

 US $ 729 million with growth of 88.9%

 Investment and remittances

 NRI investment – US $ 3.9 Billion
 Remittances - $19.6 Billion with 15% Y-O-Y
increase
Effects of INR Appreciation
 Importers and Exporters :
 Effects of INR Appreciation contd
INDIAN IT INDUSTRY

Large IT players

For every 1% appreciation in rupee

Operating profit margins fell by

40-50 basis points

Large scale M& A opportunity overseas

BPO and relatively smaller players

Effects of INR Appreciation Cont.

 Textile And Apparel Industry

 Failed to reach the set

target of $ 25 bn .

 Textile Exports declined

by 0.1% .

 2.72 direct jobs and 3.2 Lakhs

Indirect jobs lost .
INR Depreciation In 2008
Indian Rupee Depreciation in 2008

Reasons:
 Flight of foreign funds from

the Indian market

 Slowdown in the capital inflows

 Higher global crude oil prices

$135 per barrel

 Recovery of US dollar
RBI Role in Forex
Key role in FOREX :

 Regulating transactions and facilitating

development of foreign exchange market.

 Ensuring smooth conduct and orderly conditions

in domestic foreign exchange market.

 Managing foreign currency assets and gold

reserves of the country.
 RBI Role Cont.
 RBI carries out market Interventions by

Sterilized Foreign Exchange Interventions    

To cause a change in the exchange rate

+
Leaving the money supply and interest rates
unaffected.
 Currency Convertibility
Refers to ease with which domestic currency can be
traded for foreign currency

Recall Balance of Payment : Current vs. Capital A/c

Exports / imports of goods, services,
financial transfers and financial capital BOP
Surplus
Current account  = nation's net income
vs.
Capital account  = net change in national
ownership of assets. Deficit
Rebalancing by changing the
Current account convertibility

 Consumed in current period - No future claims

 Foreign goods and services and Incomes

 Sum of the balance of trade, net factor income

 No Funds linked to acquisition/disposal of fixed

assets

 INR Fully convertible on current account

Capital account convertibility
 Ownership of foreign assets

 Cautious approach towards full float of INR

Rate per
 Herd Behavior USD Jun-97 Jul-98 Change

Thai baht 24.5 41 40.20%

 1997-98 Asian financial crisis Indonesian
rupiah 2,380 14,150 83.20%
Philippine
peso 26.3 42 37.40%
Malaysian
ringgit
2.5 4.1 39.00%
South Korea
Won 850 1,290 34.10%
Capital account convertibility
Cont.
Pros of Capital Account Convertibility

 Diversified investment portfolio – Reduce Risk

 NRI Diaspora

 Easy and cheaper capital

 Reduce the size of the black economy

 Induces competition – eg. Liberisation

Capital account convertibility Cont.

Cons of Capital Account Convertibility

 Export of domestic savings

 Herd Behaviour

 Unequal playing field

 International finance capital - Hot Money

Risk Free Cash
Interest Rate Parity
 Basic idea of covered interest arbitrage (CIA)

 Make money riskless.

Eg.
 12-month interest rate in US and US is 5% and

8% per annum respectively.

 Current spot exchange rate is 1.5 $/£
 Forward exchange rate (maturity 12 months in

future) is 1.5 $/£.

Interest Rate Parity Cont.
Example - Covered interest rate (CIA) arbitrage

1. Borrow $1 from the US bank at 5% interest rate.

2. Convert $ into £ at current spot rate of 1.5$/£

giving 0.67£

3. Invest the 0.67£ in the UK for the 12 month period

4. Purchase a forward contract on the 1.5$/£

Interest Rate Parity Cont.
At the end of 12-months

1. 0.67£ becomes 0.67£(1 + 8%) = 0.72£

2. Convert the 0.72£ back to $ at 1.5$/£  $1.08

3. Pay off borrowed $1 and 5% interest, i.e $1.05

4. arbitrage profit = $1.08 − $1.05 = $0.03 or 3 cents /

dollar.

Arbitrage Opportunities vanish very quickly

Chinese Renminbi RMB ( ¥ )
Chinese Renminbi RMB
 Renminbi pegged to USD : 2.46 yuan per USD

 Reached 1.50 yuan per USD in 1980.

 Transition to a free market in 1980

 Increased its participation in foreign trade

 Renminbi devalued to benefit Chinese industry.

 Current exchange rate far lower than real Renminbi

value
Chinese Renminbi RMB Cont.

RMB/USD
Chinese Renminbi RMB Cont.
 FOREX Rate management By china

 Pressure to let yuan strengthen to stem a trade deficit against the

China

 Gradual Shift to managed, floating exchange-rate

 How China Has Dug up a Hole For Itself by Float Policy

 Selling Currency In Forex market to not let currency appreciate thus

acquiring Highest Foreign Exchange reserves in World

 Massive Foreign Exchange Reserves Vs. Currency appreciation –

Depletion of reserves

 Economist predict 1% Increase in Yuan will lead to corresponding

decrease up to 10% in Chinese exports
Q&A