Foreign Exhange Rate

DEFINITION

• In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio) between two currencies is the rate at which one currency will be exchanged for another

• It is  the minimum number of units of one countries currency required to purchase one unit of the other countries currency.

Why do we need it?

• To pay the country from which the goods are imported.• Different countries have different currencies with 

different values.• Example: America - Dollar, Japan - Yen

                    China – Yuan, Yaman – Rial, etc• Currency of one country is not acceptable in another.

Different Currencies

FOREIGN EXCHANGE MARKET

• Also called “FOREX” market.• It is the place were foreign moneys are bought and sold.• It involves the buying of one currency and  selling of 

another currency simultaneously.• Exchange rates are determined here.• No geographical boundaries.

STRUCTURE OF FOREIGN EXCHANGE MARKET

FUNCTIONS OF FOREIGN EXCHANGE MARKET

• To transfer funds from one country to another

• To provide short term credit to importers

• To stabilize foreign exchange rate

TYPES OF MARKET

• Two types of market:•Spot Market•Forward Market

SPOT MARKET

• Transaction time of 2 days• Spot Transaction• Spot Exchange Rate

FORWARD MARKET

• Transaction time of more than 90 days• Forward Transaction• Forward Exchange Rate

FACTORS AFFECTING THE EXCHANGE RATE• Differentials in Inflation• Differentials in interest rates• Current account deficits• Public Debt• Terms of trade• Political stability and Economic Performance

Differentials in Inflation

• Lower inflation exhibits rising currency value• Purchasing power increases

Differentials in Interest Rates

• Interest rates, inflation and exchange rates co-related• Higher interest rates means higher exchange rate

Current Account Deficits

• Balance of trade• Country spends more on foreign trade than its earning• Excess foreign currency demands decreases exchange

rate

Public Debt

• Countries with large public deficits and debts are less attractive to foreign investors

• If governments prints money, it causes inflation and decrease in exchange rate

Terms of Trade

• More exports than imports means improved terms of trade

Political Stability and Economic Performance

• Foreign investors seeks countries with strong economy• Political turmoil can be dangerous

Theories of exchange rate determination

• Meaning:

Theories which determine the prices of forex rate considering inflation, interest rate, and elasticity of price etc..

Methods:

a) Short run theory

b) Long run theory

Short Run Theory

• This theories are based more on current information or immediate performance of economic variables.

• This theories try to take into account the short run factor which may be eliminated in the long run.

Long Run Theory

•This are the theories which predominately take into account the fundamental changes of economy. •Here fundamental changes refers to the change which are going to change the economic performance of the economy Purchasing power for all times to come.

Types of theory:

Purchasing power parity.•1) Absolute purchasing power parity.•2) Relative purchasing power parity.

Interest Rate parity•1) Covered Interest Rate parity•2) UnCovered Interest Rate parity

Purchasing Power Parity TheoryFounder –Swedish economist Gustav Cassel in 1918.•Meaning : According to this theory ,the price levels and the changes in these price levels in different countries determine the exchanges rates of these countries currencies.

•The basic principle of this theory is that the exchange rates between various currencies reflect the purchasing power of these currencies .This theory is based law of one price.

Absolute form of PPP Theory

•If the law of one price were to hold good for each and every commodity then the theory is termed as Absolute form of PPP Theory.•This theory describes the link between the spot exchange rate and price levels at a particular point of time

Relative form of PPP

• This theory describes the link between the changes in spot exchange rate and in the price levels over a period of time.

• According to this theory ,changes in spot rates over a period of time reflect the changes in the price level over the same period in the concerned economies.

• This theory relaxes three assumptions of PPP ie Absences of transportation cost ,transaction costs and tarriffs.

Interest Rate Parity Theory• Definition :

The process that ensures that the annualized forward premium or discount equals the interest rate differential on equivalent securities in two currencies.

It represents an equilibrium state under which investers will be indifferent to interest rates available on bank deposits in 2 countries

• International Fisher effect• Expected Rate of change = Interest rate of the exchange rate

differential• Interest Rate = Real Interest Expected Differential Rate +

inflation rate

Interest Rate parity•1) Covered Interest Rate parity•2) UnCovered Interest Rate parity

PERSISTANT DECLINE IN RUPEE

• Imports becoming costlier• Imports extensive country• Drives away foreign investors

Factors affecting the fluctuation in exchange rate of Indian Rupee

• Using FOREX reserve• Interest Rate

• Balance Of Trade

• Foreign Debt

CONCLUSION

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