Foreign Exchange Rate

What is Foreign Exchange Rate?

A medium of exchange for goods and services is called

currency. It is money issued by governments and
accepted for payment in the country. It comes in the
form of coins and paper.
 Every nation has a currency that is widely accepted
within its boundaries. For example, the Indian rupee
(₹) in India, the Pound (£) in England, and the Dollar
($) in the United States of America.
Need
For facilitating cross country trade, the currency of one
country is converted into the currency of another
country and the rate at which one currency is
exchanged for another is called the Foreign Exchange
Rate or Foreign Rate of Exchange.
 In simple words, it is the price paid in domestic
currency for buying a unit in foreign currency. For
example, If 82.67 rupees are to be paid to get one dollar
then the exchange rate in that case is:
 $ 1 : ₹ 82.67
…
The exchange rate can be expressed as the ratio of
exchange between the currencies of other countries. It
is the price of one currency in terms of another
currency.
The exchange rate is also known as the External
Value of Domestic Currency. It is the rate at which
the imports and exports of a country are valued at a
given point of time.
Foreign Exchange

Foreign Exchange refers to the currencies of countries

other than the domestic currency of a given country.

It is the aggregation of the Foreign currencies held by

the country’s government, and Securities and bonds
issued by foreign companies and governments.
 There are two ways to interpret the Foreign
Exchange Rate:

It is the number of units of domestic currency that are

required to purchase a unit in the domestic currency.
As discussed above, $1 = ₹82.67. Thus an Indian
resident needs ₹82.67 to buy a unit of $(dollar).

Similarly, it means the foreign currency required to buy

a unit of the domestic currency. If we take the above
example, then the price of a rupee is i.e., ₹1 = 0.120$.
Thus a foreign resident needs 0.120$ to buy a unit of ₹
(rupee).
Currency Depreciation and
Currency Appreciation
Currency Depreciation
It refers to the decrease in the value of the domestic
currency (₹) in terms of one or more foreign
currencies (like $). It makes domestic currency less
valuable, and more is required to buy a unit of
currency. For example, if the price of $1 rises from ₹83
to ₹87, then it can be said that there is a depreciation
of the Indian currency.
The main factors:
 easy monetary policy
 excessive inflation.
political instability.
For example, Due to the war between Russia and Ukraine
investors fear investing in the country because of
instability in the economy. Besides, if the country imports
large amounts of products, then there will be a trade
imbalance, which will lead to currency depreciation.
 Effects of Currency Depreciation on Exports

Currency depreciation means a fall in the price of

domestic currency (₹) in comparison to foreign currencies
($).
For example, earlier people can get goods worth ₹60
from a unit of the dollar, but now they can get goods
worth ₹64 from 1$. It means that more goods can be
purchased from India in rupees with the same amount of
dollar. Thus it leads to an increase in exports from India to
the USA, as exports become cheaper.
Currency Appreciation
It refers to an increase in the value of a domestic currency
(₹) in terms of one or more foreign currencies (like $). It
makes the domestic currency more valuable, and less of it
is required to buy a unit of currency.
For example, if the price of $1 falls from ₹64 to ₹ 60, then
it can be said that there is appreciation of Indian currency.
The main factors contributing to currency appreciation are
interest rates and inflation.
Effects of Currency Appreciation on Imports

Currency appreciation means a rise in the price of domestic

currency (₹) in comparison to foreign currencies ($).
Earlier, for example, an Indian resident needs ₹64 to buy a unit
of dollar, but now he needs ₹60 to buy the same. It means that
more goods can be purchased from the USA with the same
amount of rupees in dollars. Thus, it leads to an increase in
imports from the USA to India as American goods become
cheaper.
Different countries have different methods of determining their
currency’s exchange rate. It can be a Fixed exchange rate,
Floating exchange rate or Managed Floating exchange rate.
Types of Foreign Exchange Rates

Fixed Exchange Rate

Under this system, the exchange rate for the currency is fixed
by the government. Thus the government is responsible to
maintain the stability of the exchange rate. Each country
maintains the value of its currency in terms of some ‘external
standard’ like gold, silver, another precious metal, or another
country’s currency.
The main purpose of a fixed exchange rate is to maintain
stability in the country’s foreign trade and capital flows.
The central bank or government purchases foreign exchange
when the rate of foreign currency rises and sells foreign
exchange when the rates fall to maintain the stability of the
exchange rate.
…
Thus government has to maintain large reserves of foreign
currencies to maintain a fixed exchange rate.
When the value of one currency(domestic) is tied to
another currency, then this process is known
as pegging, and that’s why the fixed exchange rate system
is also referred to as the Pegged Exchange Rate System.
When the value of one currency(domestic) is fixed in
terms of another currency or in terms of gold, then it is
called the Parity Value of currency.
Methods of Fixed Exchange Rate in Earlier Times

Methods of Fixed Exchange Rate in Earlier Times

1. Gold Standard System (1870-1914): As per this system,
gold was taken as the common unit of parity between the
currencies of different countries. Each country defines the value
of its currency in terms of gold. Accordingly, the value of one
currency is fixed in terms of another country’s currency after
considering the gold value of each currency.
For example,
1£(UK Pound)= 5g of gold
1$(US Dollar)= 2g of gold
hen the exchange rate would be £1(UK Pound) = $2.5(US
Dollar)
 ….
2. Bretton Woods System (1944-1971): The gold standard system was
replaced by the Bretton Woods System. This system was adopted to have
clarity in the system. Even in the fixed exchange rate, it allowed some
adjustments thus it is called the ‘adjusted peg system of exchange rate’.
Under this system:
 Countries were required to fix their currency against the US Dollar($).
 US Dollar was assigned gold value at a fixed price.
 The value of one currency say £(UK Pound) was pegged in terms of the
US Dollar($), which ultimately implies the value of the currency in gold.
 Gold was considered an ultimate unit of parity.
 International Monetary Fund (IMF) worked as a central institution in
controlling this system.
 This is the system that was abandoned and replaced by the Flexible
Exchange rate in 1977.
Flexible Exchange Rate System
 Under this system, the exchange rate for the currency is fixed by the forces of
demand and supply of different currencies in the foreign exchange market. This
system is also called the Floating Rate of Exchange or Free Exchange Rate. It
is so because it is determined by the free play of supply and demand forces in the
international money market.
 Under the Flexible Exchange Rate system, there is no intervention by the
government.
 It is called flexible because the rate changes with the change in the market forces.
 The exchange rate is determined through interactions of banks, firms, and other
institutions that want to buy and sell foreign exchange in the foreign exchange
market.
 The rate at which the demand for foreign currency is equal to its supply is called
the Par Rate of Exchange, Normal Rate, or Equilibrium Rate of Foreign
Exchange.
 Managed Floating Exchange Rate
It is the combination of the fixed rate system (the managed part) and
the flexible rate system (the floating part), thus it is also called
a Hybrid System. It refers to the system in which the foreign
exchange rate is determined by the market forces and the central
bank stabilizes the exchange rate in case of appreciation or
depreciation of the domestic currency.
Under this system, the central bank acts as a bulk buyer or seller of
foreign exchange to control the fluctuation in the exchange rate. The
central bank sells foreign exchange when the exchange rate is high to
bring it down and vice versa. It is done for the protection of the
interest of importers and exporters.
For this purpose, the central bank maintains the reserves of foreign
exchange so that the exchange rate stays within a targeted value.
 Importance of Exchange Rate

The exchange rate is a key financial variable that affects

decisions made by foreign exchange investors, exporters,
importers, bankers, businesses, financial institutions,
policymakers and tourists in the developed as well as developing
world.
 Exchange rate fluctuations affect the value of international
investment portfolios, competitiveness of exports and imports,
value of international reserves, currency value of debt payments,
and the cost to tourists in terms of the value of their currency.
 Movements in exchange rates thus have important implications
for the economy’s business cycle, trade and capital flows and are
therefore crucial for understanding financial developments and
changes in economic policy.
Exchange Rates and Exchange Rate
Policy in India: A Review
India’s exchange rate policy has evolved over time in line with
the gradual opening up of the economy as part of the broader
strategy of macroeconomic reforms and liberalization since the
early 1990s.
In the post independence period, India’s exchange rate policy has
seen a shift from a par value system to a basket-peg and further
to a managed float exchange rate system.
With the breakdown of the Bretton Woods System in 1971, the
rupee was linked with pound sterling. In order to overcome the
weaknesses associated with a single currency peg and to ensure
stability of the exchange rate, the rupee, with effect from
September 1975, was pegged to a basket of currencies till the
early 1990s.
The Liberalised Exchange Rate Management System
(LERMS) was put in place in March 1992.
The dual exchange rate system was replaced by a unified
exchange rate system in March 1993.
The experience with a market determined exchange rate
system in India since 1993 is generally described as
‘satisfactory’ as orderliness prevailed in the Indian market
during most of the period.
Episodes of volatility were effectively managed through
timely monetary and administrative measures.
 An important aspect of the policy response in India to the
various episodes of volatility has been market intervention
combined with monetary and administrative measures to
meet the threats to financial stability.

 As India progresses towards full capital account

convertibility and gets more and more integrated with the
rest of the world, managing periods of volatility is bound to
pose greater challenges in view of the impossible trinity of
independent monetary policy, open capital account and
exchange rate management.
 Preserving stability in the market would require more
flexibility, adaptability and innovations with regard to the
strategy for liquidity management as well as exchange rate
management.
 Mechanism
Exchange rates respond quickly to all sorts of events –
both tangible and psychological. The movement of
exchange rates is the result of the combined effect of a
number of factors that are constantly at play.
Economic factors, also called fundamentals, are better
guides to how a currency moves in the long run. Short-
term changes are affected by a multitude of factors that
need to be examined carefully.
 Exchange Rate Determinants
The factors determining exchange rates can be classified into two categories:

1. PRIMARY DETERMINANTS
2. SECONDARY DETERMINANTS

Demand and supply

Domestic Economic Policies

 Interest rate differentials

 Expectations and other psychological factors
 Political Events
 Central Bank Intervention
 Primary Determinants

I. DEMAND & SUPPLY

II. DOMESTIC ECONOMIC POLICIES
DEMAND & SUPPLY
It is the supply and demand for each particular currency, that
impacts foreign exchange rate. As the exchange rate
increases, the demand for the currencies decreases. Similarly,
if the supply of a country's currency increases, the value of
that currency will decrease in relation to other currencies and
more money is needed in order to purchase foreign
currencies.
The reason for this is that if the demand increases but the
supply stays constant, the price will obviously goes up
because more the supply-demand ratio drives up the price. In
contrast, if the supply goes up but the demand stays the same
(or goes down) then the value of that currency will fall.
The supply of foreign exchange to a banking system
comes from the following:
Export of goods and services;
Inflow of foreign capital through foreign direct
investment and portfolio investment; profits, interest,
Dividend and other incomes earned and repatriated to the
country by investors abroad;
 Money spent by foreign travellers; expenditure incurred
by those involved in foreign diplomatic missions and
other international organizations in India; foreign bilateral
and multilateral aid, foreign grants and gifts;
Repayment of loans and interest payments by foreigners.
FDI and Portfolio Investment
Foreign direct investment (FDI) is an ownership stake in a
foreign company or project made by an investor,
company, or government from another country.
A portfolio investment is ownership of a stock, bond, or
other financial asset with the expectation that it will earn a
return or grow in value over time, or both. It entails
passive or hands-off ownership of assets, it entails
strategic investment and tactical decisions on investment.
The demand for foreign exchange comes from the
following:
 The import of goods and services;
 Outflow of capital through foreign direct investment and
portfolio investment;
 Profits, interest, dividend and other incomes earned by
foreigners/corporate bodies and repatriated to their country;
 Indian travellers going abroad for education, medical
treatment; pleasure; expenditure incurred by embassies
abroad;
 Bilateral loans/aids granted to other countries; subscription
payment to international organizations;
 Grants and gifts to other friendly countries; repayment of
foreign loans and interest payment; etc.
All these transactions can be classified into
three classes which are as follows:

Purchases and sales for trading purposes

Speculative deals by professional dealers
Protective movements by substantial holders

*Multinational corporations have certain protective

movements in place for their funds to avoid losses. In
general, if a country has an import surplus, the exchange
rate is likely to depreciate; and in case of export surplus, it
is likely to go up.
Examples of Factors Affecting Imports and Exports

Change in the country’s resource endowments, for

instance, the discovery of North Sea oil in the UK and
natural gas in the Netherlands pushed up the value of
the British pound and the Netherlands guilder.
Change in comparative advantage shift in the demand
from the US to Japanese automobiles in the USA and
elsewhere pushed up the value of yen.
Rise in labour cost and loss of competitiveness of a
country’s export may erode the value of its currency.
The demand for a currency can be increased by
making it cheaper.
The speculation involves a conscious assumption of risks.

Speculators take a definite view about currency movements and

take an open position. They buy or sell currencies according to
their estimates of what the future exchange rate is likely to be
from those who want to buy or sell currencies to hedge or to
eliminate the speculative element in their transactions.
For example, if the bulls expect the dollar to go up, they
purchase dollars forward at current prices to sell later at higher
rates. If bears expect the dollar to go down, they sell forward at
current rates to purchase later at a lower price. Accounts are
usually settled by payment of differences.
A person can choose to behave like a hedger in some cases and
like a speculator for some currencies. Thus, there is no
watertight compartment between hedgers and speculators.
Speculators
 Speculators are people who analyze and forecast futures price
movement, trading contracts with the hope of making a profit.
Speculators put their money at risk and must be prepared to accept
outright losses in the futures market.
 Speculators earn a profit when they offset futures contracts to their
benefit. To do this, a speculator buys contracts then sells them back
at a higher (contract) price than that at which they purchased
them. Conversely, they sell contracts and buy them back at a lower
(contract) price than they sold them. In either case, if successful, a
profit is made.
 Scalpers
 Day traders
 Position traders
…
 The significance of speculation is that speculators create
pressures in the market and may ultimately affect the spot
rate as well. Speculative transactions are not permitted in
India.
An UNCTAD study shows that the removal of restrictions
on financial capital movements and increased financial
mobility, have led to the decoupling of currency markets
from trade, production and investment, and to the
predominance of the speculative component of the market
in the determination of exchange rates.
The spot rate is the price quoted for immediate settlement
on an interest rate, commodity, a security, or a currency.
The spot rate, also referred to as the current market price
of an asset available for immediate delivery at the moment
of the quote. This value is in turn based on how much
buyers are willing to pay and how much sellers are willing
to accept, which usually depends on a blend of factors
including current market value and expected future market
value.
The spot rate reflects real-time market supply and demand
for an asset available for immediate delivery.
The spot rates for particular currency pairs, commodities,
and other securities are used to determine futures prices
and are correlated with them.
Hedgers
 A hedge can be defined as protection against financial losses in the
future. There are so many financial products that help hedge against any
kind of financial loss.
 For example, a fund can hedge against inflation, which will reduce the
value of the cash holdings, by buying commodities such as gold. Since
gold is considered a natural hedge against inflation.
 So, basically, a hedge is a protection tool and the person who uses these
tools are called a hedge. Insurance can also be said to be a type of hedge.
If you think that a currency, say Euro, would lose its value against the
Dollar, so you would buy the dollar and sell Euros. This is the way you
have hedged yourself against any losses that may arise due to a decrease
in the value of the Euro in the future relative to the U.S. Dollar.
 In ancient times, the tools were simple, like buying gold or land which is
an effective hedge against inflation.
Domestic Economic Policies
Policies affecting the internal purchasing power of the
currency concerned or, in other words, the relative inflation
rates, also affect exchange rates.
A country with a rate of inflation higher than other countries
may witness a decline in the value of its currency relative to
other currencies, and vice versa. It is based on the purchasing
power parity theory (PPP).
The PPP theory maintains that exchange rates will tend
towards the point at which their international purchasing
power is equal. Since inflation erodes a currency’s purchasing
power, the difference between the inflation rates in two
countries will determine how far one currency erodes in terms
of the other, i.e., how exchange rates move
What is the right way to measure inflation in two countries?
 Price indices, either of consumer prices or wholesale prices, may not be
a good measure as they cover items that are not internationally traded.
 There is yet another aspect that affects exchange rates—the increasing
importance of capital flows between various countries. As a result,
exchange rates are affected not just by the movements of goods.
 PPP as a determinant of exchange rates has proved inadequate in
explaining exchange rate movements in the short term. Partly, this is
because it ignores the importance of transport, insurance and other
costs in assessing the relative costs of goods.
*A study of 10 countries for the period 1953–77 showed that
countries with higher inflation rates such as the UK and Italy had
depreciating currencies whereas those with lower inflation rates
such as West Germany and Switzerland had their currencies rising
in value.
Secondary Determinants

I. INTEREST RATE DIFFRENTIALS

II. EXPECTATIONS AND OTHER PSYCHOLOGICAL
FACTORS
III. POLITICAL EVENTS
IV. CENTRAL BANK INTERVENTION
Interest rate differentials
 Foreign exchange markets and exchange rates are quite sensitive to movements
in interest rates.

 The growing interest in international investment.

 The elimination or constraints on the mobility of capital to a large extent.

 Most investors would like to move their funds from a country having lower
interest rates to a country having higher interest rates. Such funds are usually
termed as ‘hot money.
 If the interest rate in the UK is higher than the interest rate in the USA, investors
would find it more profitable to invest funds in the UK and would purchase
pounds and sell dollars in the spot market, leading to an upward movement in
pound sterling. In fact, the United Kingdom very often uses interest rates as a
weapon to push up the ‘pound’.
…
However, if the rise in the interest rate is due to people expecting a
higher inflation rate or bigger budget deficits, there is reason to
doubt the strength of the currency as it would not lead to higher
investment.
The role of interest rate differences, thus also depends upon what it
is caused by. For example, in the early 1980s, interest rates in the
UK were pushed way up to reduce demand.
But that led to an exceptionally strong appreciation of sterling, and
thus, marked a deterioration in the competitiveness of the UK
industry. Similarly, a steady increase of German interest rates
between 1988 and 1990 led to a substantial inflow of capital and a
rise in the DM(Deutsche Mark). Now it is Euro.
 EXPECTATIONS AND OTHER PSYCHOLOGICAL FACTORS

The expectations of corporate finance managers, foreign

exchange traders and potential speculators do have a profound
influence on the exchange rates. These expectations again depend
on various factors like the country’s economic policy and
economic development, including balance of payments, the
discovery of new resources, political stability, movements of
capital and so on.
The behaviour of the major participants in the foreign exchange
market may make the exchange rate move differently from that
determined by economic fundamentals because of their ‘instinct’.
Arbitrage and speculative transactions also cause movements in
exchange rates, albeit in opposite directions.
 Role of Expectations
Current exchange rate, buyers and sellers exert an offsetting
influence and the exchange rate remains reasonably stable.
But something may happen to change the expectations, such
as a change in the government policy and the import policy or
a civil disturbance like the Kargil conflict.
Once the balance of expectations is upset, everybody tries to
adjust their position by bidding or offering the affected
currency. As more of them expect the currency to rise,
commercial purchases of that currency speed up and sales are
delayed.
…
As more expect the currency to fall, purchases are delayed and
sales speed up. The dynamics of the subsequent changes in the
interest rate depend upon market reactions to the factor that
stimulate the initial rate movement and the speed and sharpness
of the rate change.
If the sentiment about the future exchange rate is predominantly
bearish, it will have its impact on the spot exchange rate as
well, leading to its depreciation. If the sentiment about the
future exchange rate is bullish, the spot rate is likely to go up.
*If for some reason or the other, trading becomes one-sided,
central banks may intervene to provide the counterweight
that may not be forthcoming from the market itself.
Political Events
 Events such as a change in the government can have a dramatic
impact on the exchange rate even before any change in the
government policies actually takes place. This occurs on the
assumption that changes will be made because of previous
experience with the particular party, or because of certain stated
intentions in their pre-election platform.
 Political stability induces confidence in the investors and encourages
capital inflow into the country. This has the positive effect of
strengthening the currency of the country.
 The resultant outflow of capital from the country weakens the
currency. News of political disturbance in different parts of the
world often causes the US dollar to appreciate as investors buy
dollars, seeking a safe haven for the money in the world’s largest
economy.
 Central Bank Intervention
The foreign exchange market is of great importance to central
bankers because of the impact that exchange rates have on a
country’s balance of payments and its competitive position in
world markets. Hence, very often, central banks find it
necessary to intervene or influence market conditions or
exchange rate movements.

It is through the timing and visibility of their operations that the
monetary authorities provide indirect information about official
attitudes towards current exchange market conditions although
market participants may interpret them in different ways while
taking their own decisions whether to buy or sell a currency.
International Capital Flows

Factors affecting DFI

Changes in restrictions
Privatization
Potential economic growth
Tax rates
 Exchange rates
Structure of the Indian Foreign Exchange Market and
Turnover
 The foreign exchange market in India today is equipped
with several derivative instruments.
 These derivative instruments have been cautiously
introduced as part of the reforms in a phased manner, both
for product diversity and more importantly as a risk
management tool. Recognising the relatively nascent stage
of the foreign exchange market then with the lack of
capabilities to handle massive speculation, the ‘underlying
exposure’ criteria had been imposed as a prerequisite.
 Trading volumes in the Indian foreign exchange market has grown
significantly over the last few years. The daily average turnover has seen
almost a ten-fold rise during the 10 year period from 1997-98 to 2007-08
from US $ 5 billion to US $ 48 billion. The pickup has been particularly
sharp from 2003-04 onwards since when there was a massive surge in
capital inflows. It is noteworthy that the increase in foreign exchange
market turnover in India between April 2004 and April 2007 was the
highest amongst the 54 countries covered in the latest Triennial Central
Bank Survey of Foreign Exchange and Derivatives.

 Bank for International Settlements (BIS) survey, daily average turnover in

India jumped almost 5-fold from US $ 7 billion in April 2004 to US $ 34
billion in April 2007; global turnover over the same period rose by only 66
per cent from US $ 2.4 trillion to US $ 4.0 trillion.

 With the increasing integration of the Indian economy with the rest of the
world, the efficiency in the foreign exchange market has improved.
Capital Flows and Exchange Rates: The Indian
Experience
In the recent period, external sector developments in India have
been marked by strong capital flows, which had led to an
appreciating tendency in the exchange rate of the Indian rupee
up to January 2008.
The movement of the Indian rupee is largely influenced by the
capital flow movements rather than traditional determinants like
trade flows. Though capital flows are generally seen to be
beneficial to an economy, a large surge in flows over a short
span of time in excess of the domestic absorptive capacity can,
however, be a source of stress to the economy giving rise to
upward pressures on the exchange rate, overheating of the
economy, and possible asset price bubbles.