Exchange Rate

Determination

T.J. Joseph

1
 Introduction
 International business transactions involve more than
one currencies
 195 countries and 178 different currencies in the
world (CIA World Factbook)
 The relative values of these currencies keep changing,
creating uncertainty about the returns from IB
 A major risk in international business arise from non-
predictability of future exchange rates
 Managing foreign exchange risk is a major task in
international business management
2
 Introduction
 What is exchange rate?

 How the foreign exchange market works?

 What are the forces that determine the exchange rate?

 How to predict future changes in exchange rates?

 What are the implications of exchange rate changes on

international business?

3
 Definitions
 Foreign Exchange: refers to the money of a foreign
country, such as foreign currency balances, banknotes,
checks and drafts
 A (Foreign) Exchange Rate: is the relative price of one
currency expressed in terms of another currency
It is the rate at which one currency is converted into
another currency (` 45/$1)
 Foreign exchange market is a market for converting the
currency of one country into that of another country

4
 Definitions
 Fixed/Managed Foreign Exchange Rate System: Govt. of
the country regulates the rate at which the local
currency is exchanged for other currencies or gold
 Pegged Exchange Rate System: A country’s currency is
tied or fixed to another country’s currency (par value)
 Floating/ flexible Exchange Rate System: The value of
one currency with respect to other currencies are
decided by the demand and supply of those currencies
The govt. does not interfere in the valuation of its
currency
5
 Definitions
 Nominal Exchange Rate: The price of domestic currency
in relation to another currency. (` 45/$1)
 Real Exchange Rate: The exchange rate after deducting an
inflation factor. [(` 45/$1)*(price indexforeign) /(price indexdomestic) ]
The nominal exchange rate times the foreign price level
divided by the domestic price level
 Effective Exchange Rate (EER): The weighted average of
the price of one country’s currency in relation to other
foreign currencies
Weight: Trade share in total trade
 Definitions

Exchange Rate System

Fixed or Managed
Devaluation of a currency refers to a drop in
the foreign exchange value of a currency
that is pegged to another currency or gold
Revaluation is the opposite of devaluation

Depreciation means a drop in the foreign

Floating Exchange
exchange value of a floating currency

Rate System
Appreciation means a gain in the exchange
value of a floating currency
It is the opposite of depreciation
 Exchange Rate
RBI Reference Rate  on 30/08/2011
INR / 1 USD                    : 46.0190
INR / 1 Euro                   : 66.6958
INR / 100 Jap. YEN       : 59.9800
INR / 1 Pound Sterling  : 75.4251
 Depreciation and appreciation – for floating exchange
rate system
 Devaluation and revaluation – for fixed exchange rate
system
 Foreign Exchange Market
 The market where currencies are bought and sold against
each other
 A network of banks, brokers, and foreign exchange
dealers connected by electronic communications systems
 Daily turnover in the market: Around $3.8 trillion

 Important trading centers: London, New York, Tokyo, and

Singapore
 Most traded currencies: U.S. dollar, euro, and British
pound
 Foreign Exchange Market
Main Functions:
 To convert one currency in to
another
 To provide insurance against
foreign exchange risks
 Currency speculation to profit
from differences/changes in
exchange rates
 Foreign Exchange Market
The Need:
 Existence of a number of
currencies and transactions to
settle international payments
 In international transactions at
least one foreign currency is
involved
Ex: Difficult for a British tourist to
get tea & snacks using pound in a
roadside shop in Calcutta
 Foreign Exchange Market
Geographical Extent
 The foreign exchange market spans the globe

 Major trading starts each morning in Sydney and Tokyo,

moves to Hong Kong, Singapore, Bahrain, European
markets, New York, Chicago and ends in Los Angeles
 It is a market that never sleeps
 It is a market that never sleeps….!
Geographically, the markets span all the time zones from New
Zealand to the West coast of the United States
3.00 p.m. in Tokyo 2.00 p.m. in Hong Kong.
3.00 p.m. in Hong Kong 1.00 p.m. in Singapore.
3.00 p.m. in Singapore 12.00 noon in Bahrain.
3.00 p.m. in Bahrain Noon in Frankfurt and Zurich
and 1.00 a.m. in London.
3.00 p.m. in London 10.00 a.m. in New York.
New York 3.00 p.m. Noon in Los Angeles.
3.00 p.m. in Los Angeles 9.00 a.m. of the next day in
Sydney.
 Foreign Exchange Market
Currency Codes for Major Currencies:
USD : US Dollar AUD : Australian Dollar
CAD : Canadian Dollar JPY : Japanese Yen
GBP : British Pound IEP : Irish Pound (punt)
INR : Indian Rupee SAR : Saudi Riyal
EUR : Euro SEK : Swedish Kroner
DKK : Danish Kroner CHF : Swiss Franc
Some European Currencies which have become history:
DEM : Deutschemark FRF : French Franc
ITL : Italian Lira ESP : Spanish Peseta
BEF : Belgian Franc
 Types of Transactions
Spot Exchange Rate
 The rate at which a foreign exchange dealer converts one
currency into another currency on a particular day/time
 The rate can be quoted in two ways:
 The amount of domestic currency (say, rupee) required to
buy one foreign currency (say, US dollar) – (eg: ` 45/$1)
 The amount of foreign currency (say, dollar) required to
buy one domestic currency (say, rupee) (eg: $0.2222/`1)
 Spot Transactions are transactions which are settled after
two business days from the date of contract
 Types of Transactions
Forward Exchange Rate:
 Forward Exchange Contract: is one where the parties of
transaction agree to buy or sell a currency at a
predetermined future date at a particular exchange rate
 Exchange rate governing such future transactions are
referred to as forward exchange rates
In the forex market, forward contracts are usually for 1,
2, 3, 6, 9 or 12 months (or 30 days, 60 days, …etc..)

The date of settlement is referred to as the value date

 Forward Quotes
 Forward exchange contracts are used to cover against
possible movements in the future exchange rate that
will make your transaction unprofitable
 Ex: A U.S. company imports laptops from Japan knows that in 30
days it has to pay the Japanese supplier JPY 2,00,000 per laptop
when the shipment arrives
Current JPY/USD rate is JPY 120/1 USD (i.e., USD 1667 =
2,00,000/120 per laptop)
The importer expect to sell the laptop at USD 2000 each
Suppose the next 30 days the dollar unexpectedly depreciates
against the Yen, say, to JPY 95/1 USD
What happens?
 Forward Quotes
Forward Discount and Premium
 A currency is at forward premium against another
currency if the forward rate is higher than the spot rate
Ex: Spot rate: $1 = `45; 30-days forward rate: $1 = `48, then we
say dollar is selling at a premium in 30-days forward market
 A currency is at a forward discount if the forward rate is
cheaper than the spot rate
Ex: Spot rate: $1 = `45; 30-days forward rate: $1 = `43, then we
say dollar is selling at a discount in 30-days forward market
 Swap Quotes
 Currency Swap: is the simultaneous purchase and sale of a
given amount of foreign exchange for two different value
(settlement) dates
 A swap is a combination of two transactions: A spot plus a
forward or two forwards.
 Example: Apple computers both buys components from and
sells finished laptops to Japan
Today’s spot rate is JPY 120/1 USD and the 90-day forward rate
is JPY 110/1 USD
In a swap, amount of one currency kept same in the spot and
the forward leg. Buy JPY 120m spot, sell JPY 120m forward.
Amount of USD will be different.
 Exchange Rate Determination
 In a floating exchange rate system, exchange rate is
determined by the demand and supply of one currency
relative to the demand and supply of another currency
Ex: Consider INR/USD exchange rate and suppose, USDdd >
USDss and INRdd < INRss , then USD will appreciate and INR will
depreciate
 Different models of exchange rates differ in the emphasis
they put on the different components of demand for and
supply of a currency
 Importance: If we know how exchange rates are determined
it would be easy to forecast exchange rate movements
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 Exchange Rate Determination

D S E: Equilibrium Exchange
Rate
Exchange
Rate
Re/$ E

S D

No. of Dollars

Equilibrium exchange rate is the exchange rate that equates the demand for
and supply of currency
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 Exchange Rate Determination
We can identify the major forces that drive the demand
and supply of foreign exchange by observing the items in
the Balance of Payment (BoP) Account
Demand for currency A arises from the Debit side of BoP
1. Rest of the World purchasing goods and services from A,
making payments in A’s currency
2. Making unilateral transfers to residents of A
3. ROW wishing to hold financial assets denominated in
currency A
4. ROW wishing to make direct investments in A
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 Exchange Rate Determination
Supply of currency A arises from the Credit side of BoP
1. Residents of country A wishing to buy goods and
services from ROW
2. Make unilateral transfers to ROW

3. Residents of country A wishing to make direct and

portfolio investments abroad

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 Factors Affecting Exchange Rate
 Some of the factors that influence currency supply and
demand are:
 Inflation Rates
 Interest Rates
 Economic Growth
 Expectations about these factors also exert a
powerful influence on exchange rates

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 Relative Inflation Rates
Consider Re/$ exchange rate
 Suppose supply of rupee increases relative to its demand,
(due to growth in money supply)
 Causes inflation in India - Indian prices will rise relative to
prices of goods and services in the US
 US will buy less Indian products, leading to a decline in
dollar supplied (leftward shift in dollar supply curve)
 Indians will go for more US products, causing increase in
demand for dollars (shown by D’)

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 Inflation and Exchange Rate
D’ S‘

D S

Exchange
Rate e1
Re./$ e0

Q0 Q1 No. of Dollars
 Inflation and Exchange Rate
 A higher rate of inflation in India than in US will
simultaneously increase US exports to India and reduce
Indian exports to US
 Leading to a depreciation of rupee relative to the dollar,
or equivalently, an appreciation of dollar relative to the
rupee
 Theoretical explanations about the relationship between
inflation and exchange rate is given by the Purchasing
Power Parity Theorem

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 Purchasing Power Parity (PPP)
Absolute Purchasing Power Parity (PPP)
• Law of one price: Price of a specified bundle of goods and
services, denominated in a given currency is same
everywhere
Ex: Suppose Re/$ exchange rate is $1= `45, then according to
law of one price a laptop costing $1000 in U.S. should cost
`45,000 in India
Assumptions:
 No transportation cost and no barriers to trade
 Perfect competition with a homogeneous product
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 Purchasing Power Parity (PPP)
Purchasing Power Parity: A dollar is worth 45 rupees
because what costs $1 in US costs Rs.45 in India

St = Pt / P*t
St = exchange rate expressed as number of units of home
currency per unit of foreign currency
Pt = the price index in the home country

Pt* = the price index in the foreign country

(both price indices with reference to a common base year)

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 Purchasing Power Parity (PPP)
Relative Purchasing Power Parity
 Percent change in exchange rate equals inflation differential
% Change in (Rupee/Dollar Exchange Rate)
= Inflation Rate in India – Inflation Rate in US

Ŝ =π A - π B
If during a year inflation in US is 5% while inflation in India
is 8%, dollar will appreciate against the rupee by 3%.

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 Purchasing Power Parity (PPP)
Is the theory empirically valid?
 The Absolute PPP theory (law of one price) found not
valid empirically
 Reasons: transport costs, non-homogeneous goods, non-
traded goods, trade barriers like tariffs & quotas, non-
homogeneous tastes, quality differences etc.
 However, the relative PPP theory seems to predict
exchange rate changes for countries with high rate of
inflation (eg: Zimbabwe)
 Empirical studies shows that PPP theory provides more
accurate predictions in the long run than short-run
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 Interest Rates and inflation Rates
 Theoretically interest rates reflects expectations about
likely future inflation rates
 If inflation is expected to be high, then interest rates will
be high because investors want compensation for the
decline in the value of their money
 The relationship was first formalized by Irvin Fisher,
therefore, referred as Fisher Effect

32
 The Fisher Effect
 States that a country’s ‘nominal’ interest rate (i) is a
combination of the ‘real’ interest rate (r) and the
expected rate of inflation (e)
i = r +e
The nominal interest rate is equal to the real interest rate
plus the expected inflation rate
Ex: If the real interest rate in a country is 4% and expected
annual inflation rate is 8%, then the nominal interest rate will
be 12%

33
 International Fisher Effect
 We have seen the link between inflation and exchange
rate in the PPP theory
 Fisher effect shows the link between interest rates and
expected inflation
 Therefore, there must be a link between interest rates
and exchange rates – known as International Fisher
Effect (IFE)
 IFE states that an expected change in the current exchange
rate between any two currencies is approximately equivalent
to the difference between the two countries' nominal interest
rates for that time
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 Interest Rates and Exchange Rates
Interest Rate Parity Theorem
 The Interest Rate Parity Theorem says that among
convertible currencies spot-forward exchange rate
margin equals interest rate differential
e= -
Ŝ i A i B
Where, Ŝe denote the expected proportionate change in the
exchange rate and iA and iB denote nominal interest rates in
country A and B

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 Implications for Mangers

Foreign Exchange Exposure - Types

 Transaction exposure
 Translation exposure
 Economic exposure
 Transaction Exposure
 Measures the sensitivity of cash transactions to
unanticipated changes in exchange rate
 Can arise when currency has to be converted
 in order to make or receive payment for imports and
exports
 to repay a loan or make an interest payment
 currency has to be converted to make a dividend
payment
 to convert the assets or liabilities when they are
liquidated
 Translation Exposure
 Also known as accounting exposure/ Balance Sheet
Exposure
 Arises as a result of the process of consolidation of
foreign currency items into group financial statements
denominated in the currency of the parent company.
 No direct effect on cash flows

 They are “paper” gains and losses, but still important

Translation Exposure - Illustration
A U.S. firm has a subsidiary in Mexico. Mexican peso
depreciates against dollar, reducing the dollar value
of the Mexican subsidiary's equity. In turn, this
would reduce the total dollar value of the firm in its
consolidated balance sheet. This could increase the
firm’s cost of borrowing and potentially limit its
access to capital market.
 Economic Exposure
 The sensitivity of future cash flows and profits of a firm
to unanticipated exchange rate changes
 This is the long-run effect of changes in exchange rates
on future prices, sales, and costs
 Also known as Operating Exposure

 If some inputs are imported, material costs will increase with

a depreciation of home currency
 Labour costs may increase due to change in the costs of living

 Exchanges rate changes usually accompanied by differences in

inflation
 International
Monetary System
 Introduction

International monetary system refers to the set of

policies, institutions, practices, regulations, and
mechanisms that determine foreign exchange rates
 Exchange Rate Regimes

 Main exchange rate regimes are three:

 Fixed exchange rate system
 Flexible/Floating exchange rate system
 Managed float exchange rate system

Note: (IMF classifies all exchange rate regimes into eight specific
categories span from rigidly fixed to independently floating)
 Fixed exchange rate system
The central bank/government fixes the price of the
domestic currency in relation to the foreign currency and
agrees to maintain the value at that level
Advantages:
 Economic Stability:
No uncertainty about the exchange rate which provides
businesses with sure basis for planning and pricing,
especially for the conduct of trade
 Inherently anti-inflationary - Imposes monetary policy
discipline (no excessive borrowings and spending)
 Fixed exchange rate system
Disadvantages:
 Rigidity
in the economy because of restrictive
monetary and fiscal policies
 Difficulty
in pursuing policies to alleviate internal
economic problems such as high unemployment and
slow eco. growth
 Requirement of adequate foreign exchange reserves
 Difficulty
in adapting to structural changes in the
economy and trade relations
 Flexible Exchange Rate System
Exchange rate is determined on the basis of demand for
and supply of foreign exchange in the market (eg: US,
UK, Switzerland, etc)
Advantages:
 It reflects the true value of the exchange rate if the
markets are perfect
 No scope for speculation
 The central bank can follow independent monetary
policy
 Flexible Exchange Rate System
Disadvantages:
 If markets are not perfect, exchange rates may not
reflect the true value
 Then, it may show high volatility, and thus affect
business planning
 Though exchange rate movements does not affect
monetary policy, monetary policy affects exchange
rates
 Managed Float System
A compromise between a fixed exchange rate system and a
flexible exchange rate system
 The central bank allows the exchange rate to be market
determine, but intervenes from time to time to orderly
conditions in the market
Eg: Argentina, Pakistan, etc.
Advantages:
 The fluctuations in the exchange rates are smoothened
and brings stability in ER
 Reduce speculative attack on ER
 Managed Float System

Disadvantages:
 Uncertainty is not completely eliminated
 The macroeconomic implications of Central Bank
intervention
 Uncertainty about Central Bank’s tactics
Balance of Payments
(BoP) Account
 The Balance of Payments (BoP)
 BoP is a systematic record of all economic transactions
between the residents of a country and the residents of
the rest of the world, carried out in a specific period of
time, usually a year.
 It is a classified statement of all the receipts of residents
of a country from foreigners and payments by residents
to foreigners
 The Balance of Payments (BoP)
 BoP is a double book entry
That is, every transaction is entered twice, once as a credit
item and once as a debit item
 The general rule:
 If a transaction earns foreign exchange for the nation, it
is a credit and recorded as a plus item
 If the transaction involves spending foreign exchange, it
is a debit and recorded as a negative item
 E.g.: Exports are credit and imports are debits
 Components of BoP

BoP Account is usually divided into two major

account headings:

A. Current Account
B. Capital Account
A. Current Account: includes
(1) merchandise trade account
 exports and imports (Physical/visible goods)
(2) Invisibles
 (a) services

 Travel and tourism (visits of tourists)

 Transportation
 Financial & other services including insurance
 Govt. not included elsewhere (embassies, consulates)
 Miscellaneous (includes software exports)
 (b) investment income (dividends, interests, profits…)

 (c) transfer payments

 Official and private (foreign aid, gifts, remittances,..)

(B) Capital Account- includes all transactions of financial
nature (financial assets)
1. Foreign investment
 Direct investment – capital buying physical assets
 Portfolio investment – capital buying financial assets
2. Loans
 Bilateral or multilateral loans received/paid by the government
 Commercial borrowings/repayments of private sector
3. Banking capital
 Changes in the foreign assets and liabilities of commercial banks
authorized to deal in foreign exchange
 NRI investments
4. Rupee debt service by way of obligation to repay foreign
loan/interests in rupees
5. Other capital, mostly the delayed receipts on exports
 (C) Errors and Omissions
 Discrepancies may crop up between debits and credits because
of data lags (timing) and other estimation problems
 A negative value indicates that receipts are overstated or
payments are understated or both, and vice versa
(D) Monetary Movements (Reserve Account)
 Record of India’s transactions with IMF
 India’s foreign currency reserves, basically consists of RBI
holdings of gold and foreign currency assets
 Drawings from IMF (a kind of borrowing) and from foreign
exchange reserves are credit items
 Payments made to IMF or additions to existing reserves are
debit items
 INDIA: Balance of Payment Accounts, 2009-10 (US$million)
Item Credit Debit Net
I. Trade Account 182163 299491 -117328
II. Invisible Account 161245 82328 78917
Services 93791 59586 34205
Transfer Payments 54432 2318 52114
Investment Income 13021 20425 -7404
III. Current Account (I + II) 343408 381819 -38411
IV. Capital Account 344001 290399 53602
Foreign Investments 198089 145964 52125
Loans 73204 60982 12222
Banking Capital 61499 59415 2084
Rupee Debt Service 0 97 -97
Other Capital 11209 23941 -12732
V. Errors and Omissions 0 1746 -1746
VI. Overall Balance (III + IV) 687407 673966 13441
VII Monetary Movements 0 13441 -13441
Increase in Reserves 0 13441 -13441
 Balance in the BoP Statement
 What does the manager make out of the balance of
payment statements?

 Key to understand the factors determining the exchange

rate

 Higher the share of exports in a country’s GDP, faster will

be economic growth in response to foreign demand