The Impact Of Currency Conversions

By Glenn CurtisAAA | 

The currency price of one country gets stronger and/or weaker against another country's currency on a daily basis, but what exactly does that mean for those who don't trade in the  forex market? Currency exchange rates affect travel, exports, imports and the economy. In this article, we'll discuss the nature of currency exchange and its effect on people and the economy.

Before delving into the topic in more detail, we must first establish a constant; for demonstration purposes we will be talking about the relationship between the euro and the U.S. dollar. More specifically, we will be talking about what happens to the U.S. economy and to the economies of Europe if the euro trades markedly higher against the U.S. dollar. The assumption we will be making is that US$1 will purchase 0.7 euros.

The Impact on TravelersIf US$1 buys 0.7 euros, U.S. citizens will be more reluctant to travel across the pond. That's because everything from food to souvenirs would be more expensive - about 43% more expensive than if the two currencies were trading at parity. This is an illustration of the effect of the purchasing power parity (PPP) theory.

However, under these conditions European travelers would be much more apt to visit the United States for both business and pleasure. American businesses and governments (via taxes) in the areas that European tourists visit will prosper - even if just for a season.

The Impact on Corporations and EquitiesThe impact that this scenario would have on corporations (particularly large multi-nationals) is a little more complex because these businesses often conduct transactions in a number of different currencies and tend to obtain their raw materials from a wide variety of sources. That said, U.S.-based companies that generate the majority of their revenue in the U.S. (but that source their raw materials from Europe) would likely see their margins take a hit on higher costs.

Similar pain would be felt by U.S. companies that must pay their employees in euros. By definition, these decreased margins would likely have an adverse impact on overall corporate profits, and therefore on equity valuations in the domestic market. In other words, stock prices may drop due to these lower earnings and forecasts for future profit potential.

On the flipside, U.S. companies that have a hefty overseas presence and draw in a significant amount of revenue in euros (as opposed to dollars), but pay their employees and other expenses in U.S. dollars could actually fare quite well.

European companies that generate the lion's share of their revenue in euros, but also source their materials or employees from the United States as part of their business, would likely see margin expansion as their costs and currency decrease. By definition, this could lead to higher corporate

profits and equity valuations in some overseas stock markets. However, European companies that garner a significant amount of their revenue from the United States and must pay their expenses in euros are likely to suffer.

The Impact on Foreign InvestmentUnder these assumptions, it is likely that Europeans (both individuals and corporations) would expand their investment in the United States. They would also be better suited to make acquisitions of U.S.-based businesses and/or real estate. In fact, this has happened at several points in the past. For example, when the Japanese yen traded at record highs against the dollar back in the 1980s, Japanese firms made significant purchases of real estate - including the world-renowned Rockefeller Center.

Conversely, U.S. corporations would be less apt to acquire a European company or European real estate under US$1 for 0.70 euros scenario.

How Can You Protect Yourself from Currency Moves?When planning a trip, check the most up-to-date currency conversion before you book your vacations so you can plan your choice of locations appropriately. (There are many ways of finding out local currency rates, including looking in the business section of your local newspaper, checking with a travel agency or searching the internet.) Incidentally, one of the best tips for travelers making purchases overseas is to use a credit card. The reason behind that is that credit card companies tend to negotiate the best rates and the most favorable conversions because they do such a high volume of transactions. These companies take out all the guess work for you, paving the way for smoother (and probably less expensive) transactions.

For small and large business owners operating in the U.S. that source some of their raw materials from Europe, one of the best moves can be to stock certain supplies if the price of the euro starts to climb rapidly against the dollar. Conversely, if the euro starts falling against the dollar, it may make sense to keep inventory at a minimum in the hope that the euro will decline enough for the company to save on its purchased goods.

The Bottom LineOver time, currency values can vary quite dramatically. However, individuals, investors and business owners can take steps to mitigate risks and take advantage of such currency movements.

The price of a nation’s currency in terms of another currency. An exchange rate thus has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. In an indirect quotation, the price of a unit of domestic currency is

expressed in terms of the foreign currency. An exchange rate that does not have the domestic currency as one of the two currency components is known as a cross currency, or cross rate.

Also known as a currency quotation, the foreign exchange rate or forex rate.

The process of converting one form of currency into another country's usable currency. Based on current exchange rates, a person may receive less or more value after the currency is converted. This can be determined by looking at the current exchange rate for the country's currency.

Read more: http://www.investorwords.com/8563/currency_conversion.html#ixzz3SMFHaHMl

Currency Exchange Rates Explained

As the world’s largest retail provider of foreign currency, we know that exchanging currency can, at times, be confusing.

Dealing with money can be complicated at the best of times, but in the rush to get away, or while you are abroad, changing your travel money can be tricky.

This is especially true as there are a number of unfamiliar terms and phrases connected with the foreign currency exchange process.

As the world’s foreign-exchange specialist, we are helping consumers to make things as simple as possible by developing this guide to currency exchange rates.

We have designed this guide to:

cut through the confusion;

make sure you get the best value for your travel money; and

make changing your money one less thing to worry about the next time you head abroad.

About Currency Exchange Rates

Here is a guide to what to look out for.

Sell rate – this is the rate at which we sell foreign currency in exchange for local currency. For example, if you were heading to Canada, you would exchange your currency for Canadian dollars at the sell rate. 

Buy rate – this is the rate at which we buy foreign currency back from travellers to exchange into local currency. For example, if you were returning from America, we would exchange your dollars back into euros at the buy rate. 

Holiday money rate or tourist rate – another term for a sell rate. 

Spot rate – This is known more formally as the ‘interbank’ rate. It is the rate banks or large financial institutions charge each other when trading significant amounts of foreign currency. In the business, this is sometimes referred to as a ‘spot rate’. It is not the tourist rate and you cannot buy currency at this rate, as you are buying relatively small amounts of foreign currency. In everyday life it is the same as the difference between wholesale and retail prices. The rates shown in financial newspapers and in broadcast media are usually the interbank rates. 

Spread – This is the difference between the buy and sell rates offered by a foreign-exchange provider such as us. 

Cross rate – This is the rate we give to customers who want to exchange currencies that do not involve the local currency. For example, if you want to exchange Australian dollars into US dollars. 

Commission – This is a common fee that foreign-exchange providers charge for exchanging one currency to another.

Now that you’re all clued up on the terms and phrases surrounding exchange rates, why not head over to our currency exchange rates page and reserve your foreign currency online today.

How Currency Works

Currency seems like a very simple idea. It's only money, after all, and that's just what we use to buy the things we want and need. We get paid by our employers, and we use that money to pay the bills, buy our food, and purchase goods and services. We might put some in a savings account at the bank or invest it in stocks or real estate, but for the most part, currency seems like a fairly straightforward concept.

In fact, the development of currency has shaped human civilization. Currency has stopped wars, and it has started many more. Cities and nations as we know them would not exist without it. It is difficult to overstate the importance of currency in modern life.

"We invented money and we use it, yet we cannot...understand its laws or control its actions. It has a life of its own." - Lionel Trilling, literary critic

Like most other rates in economics, the exchange rate is essentially a price and can be analyzed in the same way we would a price. Take a typical supermarket price, say lemons are selling at the price of 3 for a dollar or 33 cents each. Then we can think of the dollar-to-lemon exchange rate as being 3 lemons because if we give up one dollar, we can get three lemons in return. Similarly, the lemon-to-dollar exchange rate is 1/3 of a dollar or 33 cents, because if you sell a lemon, you will get 33 cents in return. So when we speak of an X-to-Y exchange rate of Z, this means that if we give up 1 unit of X, we get Z units of Y in return. If we want to know the Y-to-X exchange rate, we calculate it using the simple exchange rate formula:

Y-to-X exchange rate = 1 / X-to-Y exchange rate

Of course, the exchange rates we read in the paper or hear on radio or TV are not prices for X and Y or for oranges and lemons. Instead they're relative prices for different currencies, but they work in the same fashion. On February 26, 2003 the U.S.-to-Japan exchange rate was 117 yen, so this means that you can purchase 117 Japanese yen in exchange for 1 U.S. dollar. To figure out how many U.S. dollars you can get for 1 Japanese yen, we can just use the formula:

Japan-to-U.S. exchange rate = 1 / U.S.-to-Japan exchange rate

Japan-to-U.S. exchange rate = 1 / 117 = .00854

So this tells us that one Japanese yen is worth .00854 U.S. dollars, which is less than a penny.

Similarly if the Canadian dollar is worth .67 U.S. dollars, we have a Canada-to-U.S exchange rate of .67. If we want to know how many Canadian dollars we can buy with 1 U.S. dollar, we use the formula:

U.S.-to-Canada exchange rate = 1/Canada-to-U.S. Exchange rate

U.S.-to-Canada exchange rate = 1/0.67 = 1.4925

So one U.S. dollar can get us $1.49 in Canadian funds.

Exchange rates-supply

Basic econonomic theory teaches us that if the supply of a good increases, and nothing else changes, the price of that good will decrease. If the supply of a country's currency increases, we should see that it takes more of that currency to purchase a different currency than it did before. Suppose there was a big jump in the supply of the Canadian dollar. We would expect to see the Canadian dollar become less valuable relative to other currencies. So the Canadian-to-U.S. Exchange rate should decrease, from 67 cents down to, say, 50 cents. Each Canadian dollar would give us less American dollars than it did before. Similarly, the U.S.-to-Canadian exchange

rate would increase from $1.49 to $2.00, so each U.S. dollar would give us more Canadian dollars than it did before, as a Canadian dollar is less valuable than it used to be.

Why would the supply of a currency increase?

Currencies are traded on the foreign exchange market, and the supply of a currency on that market will change over time. There are a few different organizations whose actions will cause a rise in the supply of the foreign exchange market:

1. Export Companies

Suppose a South African farm sells the cashews it produces to a large Japanese firm. It is likely that the contract will be negotiated in Japanese yen, so the farm will receive its revenue in a currency with limited use outside of Japan. Since the company needs to pay it's employees in the local currency, namely the South African rand, the company would sell its yen on a foreign exchange market and buy rands. The supply of Japanese yen on the foreign exchange market will increase, and the supply of South African rands will decrease. This will cause the rand to appreciate in value (become more valuable) relative to other currencies and the yen to depreciate.

2. Foreign Investors

A German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. However most of their cash reserves are held in euros. The company will be forced to go to the foreign exchange market, sell some of its euros, and buy Canadian dollars. The supply of euros on the foreign exchange market goes up, and the supply of Canadian dollars goes down. This will cause Canadian dollars to appreciate and euros to depreciate.

Foreign investment does not have to be in tangible goods such as land. If German investors buy Canadian stocks, such as stocks listed on the Toronto Stock Exchange or purchase Canadian dollar bonds, we will have the same situation as above.

3. Speculators

Like the stock market, there are investors who try to make a fortune (or at least a living) by buying and selling currencies. Suppose a currency investor thinks that the Mexican peso will depreciate in the future, so it will be less valuable than other currencies than it is now. In that case, she is likely to sell her pesos on the foreign exchange market and buy a different currency instead, such as the South Korean won. The supply of pesos goes up and the supply of won goes down. This causes pesos to depreciate, and won to appreciate.

Note the self-fulfilling nature of the beliefs investors hold. If investors feel that a currency will depreciate in the future, they will try to sell it today. Since the currency is being sold by investors, the supply of it will go up, and the price of it will decrease. The investor thought that

the currency would depreciate, she acted on that belief and sold her currency, and the act of selling caused the depreciation to take place. Self-fulfilling prophecies such as this one are quite common in economics.

4. Central Bankers

The central bank of the United States is the Federal Reserve, more commonly known as "The Fed". One of the responsibilities of the Fed is to control the supply, or the amount, of currency in a country. The most obvious way to increase the supply of money is to simply print more currency, though there are much more sophisticated ways of changing the money supply. If the Fed prints more 10 and 20 dollar bills, the money supply will increase. When the government increases the money supply, it is likely some of this new money will make its way to the foreign exchange market, so the supply of U.S. dollars will increase there as well.

A central bank will often directly increase the supply of money on the foreign exchange markets. Central banks like the Fed keep a supply of most (if not all) currencies in reserve and will often use them to influence the exchange rate. If the Fed decides that the U.S. dollar has appreciated in value too much relative to the Japanese yen, it will sell some of the U.S. dollars it has in reserve and buy Japanese yen. This will increase the supply of dollars on the foreign exchange market, and decrease the supply of yen, causing a depreciation in the value of the dollar relative to the yen. Of course, the Fed cannot do this as much as it would like, because it may end up running out of some currencies. As well, the Japanese central bank (named the Bank of Japan) could decide that the Fed is manipulating the price of the yen too much and the Bank of Japan could counteract the Fed by selling yen and by buying dollars.

These are the organizations who will increase the supply of currency on the exchange market. Now we'll investigate the demand side of foreign exchange markets.

Why would the demand for a currency increase?

Not surprisingly pretty much the same organizations who caused supply changes will cause demand changes. They are as follows:

1. Import Companies

A British retailer specializing in Chinese merchandise will often have to pay for that merchandise in Chinese yuan. So if the popularity of Chinese goods goes up in other countries the demand for Chinese yuan will go up as retailers purchase yuan to make purchases from Chinese wholesalers and manufacturers.

2. Foreign Investors

As before a German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. So the demand for Canadian dollars will rise.

3. Speculators

If an investor feels that the price of Mexican pesos will rise in the future, she will demand more pesos today. This increased demand leads to an increased price for pesos.

4. Central Bankers

A central bank might decide that its holdings of a particular currency are too low, so they decide to buy that currency on the open market. They might also want to have the exchange rate for their currency decline relative to another currency. So they put their currency on the open market and use it to buy another currency. So Central Banks can play a role in the demand for currency.

Supply and demand are often thought of as being two sides of the same coin. Here we see that this is the case, as in every transaction there is a buyer and a seller, or in other words, a demander and a supplier.

Now we know what agents can cause price changes and for what reasons. We can use our knowledge to analyze what happens in the "real world". An interesting case is the Canadian-to-American exchange rate. Due to the geographical proximity and economic intergration of the two countries the Canadian-to-American exchange rate is often examined. The sharp decline in the value of the Canadian dollar relative to the American one is widely discussed in the news, so we'll discuss it now.

Factor 1: Commodity prices.

Moreso than any other industrialized country, Canada's economy relies heavily on the export of raw materials such as lumber, natural gas, and agricultural products. The Bank of Canada has developed a Commodity Price Index, which tracks changes in the prices of commodities which Canada exports. The breakdown of the elements in the Commodity Price Index is roughly:

Category Percentage

Energy 34.9

Food 18.8

Metals 14.4

Minerals 2.3

Forest Products 29.6

Commodities such as these represent almost 40 percent of Canadian exports. As shown in the following chart, the Commodity Price Index fell sharply several times between 1990 and 2002, particularly during the Asian crisis of 1997-1998:

Note that I divided the Commodity Price Index (CPI) by 100, so I could show both the CPI and the exchange rate on the same chart.

It would appear that both the exchange rate and the Commodity Price Index suffered similar declines during 1997 and 1998. I calculated the correlation coefficient between the exchange rate and the (unscaled) Commodity Price Index between January 1997 and December 1998. The correlation coefficient between the two was a whopping 0.94, indicating a particularly strong positive relationship between the two. We cannot infer from this that the drop in the Commodity Price Index necessarily caused a drop in the exchange rate, but we can say that the two changed in the same direction most months during this period. This strong relationship did not occur before or after this period. The correlation coefficient for 1990-1996 was -0.31, and for 1999-2002 was 0.29.

Now consider why this relationship might occur. After a reduction in lumber prices, an American construction company now needs less Canadian dollars to purchases its Canadian lumber. The reduction in lumber prices will likely cause the company to increase its purchases, but their total expenditures will likely be lower than they were before. Because of this American construction companies will need to buy less Canadian dollars on the foreign exchange market to get the lumber they need. The demand for Canadian dollars will decrease, and the price of the Canadian dollar relative to all currencies including the U.S. one will go down. We would expect that all else being equal, a reduction in commodity prices will occur at the same time as a reduction in the exchange rate. This appears to have happened during the Asian crisis of 1997-1998 and possibly since then as well.

This reduction in commodity prices represents only a partial explanation for the decline in the Canadian dollar.

Factor 2: Interest Rates

During the early 1990s, the Bank of Canada (BoC), Canada's central bank, embarked on a policy to lower interest rates, particularly interest rates on government bonds. The BoC succeeded and Canadian interest rates dropped much faster than American rates. The Canadian prime rate of interest was around 14% during 1990 while the American prime rate was around 10%. We usually compare interest rates by basis points, where 100 basis points a difference of 1%, say between 5% and 6% or between 17% and 18%. So here we have a 400 point difference in rates.

By 1997 the Canadian prime rate of interest was 375 points lower than the American one. The following chart shows the difference between the Canadian rate and the American one:

Changes in interest rates can have a drastic effect on exchange rates. Investors interested in purchasing a security that pays interest, such as a bond, will buy the bond that gives them the highest interest rate, all else being equal. Since Canadian bonds had a lower interest rate than American bonds, investors were more interested in purchasing American bonds, and less interested

in Canadian ones. In order to purchase American bonds, they would need to buy American dollars on the foreign exchange market, causing a reduction in the supply of U.S. dollars and a rise in their value relative to other currencies such as the Canadian one. If Canadians are buying U.S. bonds, they'll be selling Canadian dollars and buying American ones, so we'll see an increase in the supply of Canadian dollars and a decline in their value.

We should then expect to see periods where the exchange rate and the interest rate move in the same direction. Visually it would be helpful to plot them both on the same set of axes. To do this I had to perform a scaling operation on the interest rate gap. By taking the gap, dividing it by 50 then adding 0.7 to this figure, I was able to plot both on the same chart:

The exchange rate is the blue line which starts higher and the interest rate gap is the purple line which starts lower. Note how both decline until 1997. The correlation coefficient for the interest rate gap and the exchange rate from January 1990 to December 1996 is 0.73; the two were highly positively related during this period. However during the Asian crisis of

1997-1998 the two went in opposing directions and the correlation coefficient was -0.91. Changes in the interest rates gap have not gone in the same direction as changes in the exchange rate since 1998 as the correlation coefficient is -0.75. It would appear that if we're looking for reasons why the Canadian dollar may have been weak since 1998, we'll have to look elsewhere for an answer.

Case Study: Canada - International Factors]

Factor 3: International Factors and Speculation

During 1997 and 1998, the economies of most Asian countries went into steep decline which became known as the Asian Crisis. The Asian crisis had a far greater impact on Canada than it did on the United States. Exports take up a much smaller portion of the U.S. economy than they do of the Canadian economy. So the American dollar is much more insulated to international events than the Canadian dollar. Canada also exports a large amount of construction materials to

Asian countries, so when the economies of these countries went into severe decline, new construction became non-existent so raw materials were no longer demanded. This drop in the demand for commodities caused a decline in the price of the Canadian dollar relative to other non-Asian currencies.

Understandably most investors are somewhat risk-averse, so they will avoid unnecessary risk. Investors during times of international turmoil prefer to invest in large countries that are more insulated from turmoil in other counries. The United States is a haven for investors trying to avoid this type of uncertainty, whereas smaller open economies like Canada are not. So not surprisingly the Canadian dollar declined during the Asian crisis.

This still doesn't explain why the Canadian dollar declined from 1998 to 2002. Unfortunately I can't provide any solid evidence of why this happened, but here are three possibilities.

1. The Bush Election win:The Republicans are seen as a party which will create an environment positive for investors. It is conceivable that many international investors moved their money from Canada to the United States when the White House went from Democratic to Republican control.

2. International Uncertainty:As mentioned before investors will flock to a country like the United States during time of unrest. Investors have been worried that a global recession might occur during the beginning of this decade. Terrorist threats and military actions in Afghanistan and Iraq may have caused investors to put their money into large countries like the United States.

3. The Beliefs of Currency Speculators:Many currency speculators felt that the Canadian dollar would continue to decline in the future. Many investors did not want to be part of a sinking ship, so they sold their holdings of Canadian dollars, further reducing the price. If investors feel that the Canadian dollar will improve in the near future, they will jump back on the bandwagon by buying Canadian dollars and the value of the Canadian dollar will rise. It appears this is what has been happening in the beginning of 2003.

Currency impact of a rate cut

A rate cut can trigger some depreciation in the value of the currency, making it more difficult for companies to import. Exporters, of course, stand to gainfluctuations are among the biggest downsides of an open economy. The value of a currency can change on a minute-by-minute basis. One of the main advantages of an open economy is the greater opportunity for trade and trade involves continuously pricing and comparing goods. Currency value changes make this a difficult task.

India is not an open economy but it has gradually edged closer and closer to being open. Somewhat over 40 per cent of India's GDP   involves trade in the form of either exports or imports. In almost every manufacturing sector, domestically produced goods have to compete with their foreign equivalents. This has some interesting consequences.

There are some segments where the domestic manufacturer has a large competitive advantage. For example, cement manufacturers are unlikely to be challenged by imports. There are other areas where the overseas manufacturers have large advantages -for example, almost all electronic components are imported from South East Asia.

But there are a large number of segments where domestic and imported items are roughly competitive with each other. Changes in customs duties can afford protection to the domestic manufacturer (or remove protection). Having an edge in the marketing and distribution network can also give an advantage. And swings in currency rates can also change the competitiveness.

Every change in domestic interest rates usually leads to a change in the currency rates as well. The direct impact of lower (or higher) policy rates on the domestic economy is well understood and usually discussed at great length when the RBI cuts (or raises) policy rates. However, if a change in policy rates leads to a change in currency rates, there is another important impact and that is not discussed in such detail.

There are several models that try to value currencies in terms of interest rate parities. At its broadest, currency rates should reflect long-term interest yields. Say, for example, that the dollar-rupee rate is 60 and the one-year dollar treasury bill is at a yield of 2.4 per cent while the equivalent rupee yield is at 8.5 per cent. A year down the line, $1.024 will be worth Rs 65.1 because those are the respective returns and it is possible to convert one currency to another without much trouble. Hence, the one-year forward rate should reflect this interest rate differential.

The complications arise because of differences in inflation rates and, hence, differences in real interest rates, differences in relative ease of conversion, short-term demands for one currency or another, etc. The currency market reflects the consensus opinion about such factors.

Other things being more or less discounted, a rate cut in one currency can trigger some depreciationin the value of that currency. This is actually an interesting situation that could affect India at the moment. A policy rate cut may make it easier for Indian corporations to raise money domestically. It might also stimulate consumer demand for goods and services. But if it also leads to rupee depreciation it will make it more difficult for corporations to import and it will make it more difficult to repay outstanding overseas

demand. Of course, depreciation will make Indian exports more competitive.

Conversely a rate hike may have positive effects if it triggers currency appreciation. Importers have an easier time and corporation with external debt obligations find it easier to meet commitments. The RBI has to take these effects into account since Indian corporations do have significant overseas debt. The central bank presumably has some sort of stress test model where it assesses the likely effect on the rupee and on overseas debt everytime there is a change in policy rates.

The stock market probably ignores this effect entirely in the short run. The impact of a rate cut is almost always seen to be broadly positive. In fact, there may be negative effects if there are a large number of corporations with external debt. The RBI has chosen not to touch rates in this policy review. The next time it does change policy rates, bear the currency effect in mind.

How exchange rate changes impact Indian manufacturing firms –

After falling to its lifetime low of 68.85 against the dollar in August last year, the Rupee has now appreciated to breach the 60-per-dollar mark. This column explores the impact of currency movements on the performance of Indian manufacturing firms. It finds that in the short run, real exchange rate movements have a significant impact on firm performance through changes in import costs, rather than changes in export competitiveness. 

With Rupee close to the 60-per-dollar mark, firms and policymakers in India are trying to find ways of dealing with the economic consequences of a fluctuating currency. This has brought back the focus on attempts to measure the impact of currency movements on economic performance. Theoretically, exchange rate movements can affect economic performance through a number of channels, such as cost of imported inputs, competitiveness of exports, and changes in the value of firms’ foreign assets and liabilities. For example, when the value of the Rupee falls vis-à-vis other currencies, the cost of imported inputs such as energy increases, causing a reduction in the profit margins and prompting firms to cut down on production. On the other

hand, decline in the value of Rupee makes Indian exports cheaper and hence more competitive in the global market, which makes higher production more attractive for exporting firms. Of the channels mentioned above, which one is dominant is a question of empirical investigation.

A brief background of India’s exchange rate policies

India presents a unique case for studying the impact of exchange rate movements. Prior to the Balance of Payments crisis in 1991, Indian Rupee was pegged to a basket of currencies dominated by the US Dollar. The external payment crisis of 1991 forced the Reserve Bank of India (RBI) to implement a set of market-oriented financial sector reforms, and a paradigm shift from fixed1 to market-based exchange rate regime2 in March 1993. Institution of Current Account convertibility3 in August 1994, gradual liberalisation of the Capital Account4 along with other trade and financial liberalisation measures meant a rise in total turnover in the foreign exchange market by more than 150% (from $73.2 bn in 1996 to $130 bn in 2002-2003, and further to $1,100 bn in 2011-2012). A direct outcome of these changes has been a rise in the volatility of Indian Rupee.

Against this backdrop, RBI’s exchange rate management policy has aimed at maintaining orderly conditions in the foreign exchange market by eliminating lumpy demand and supply and preventing speculative attacks, without setting a specific exchange rate target. Towards this end, RBI has used a combination of tools including sales and purchase of currency in both the spot and the forward5 segments of the foreign exchange market, adjustment of domestic liquidity through the use of Bank Rate6, Cash Reserve Ratio (CRR)7, Repo rate8 etc., and monetary sterilisation9 through specialised instruments. An interesting feature of RBI’s intervention during this period has been asymmetry during episodes of appreciation and depreciation. RBI has been intervening actively in the foreign exchange market during episodes of Rupee appreciation by purchasing foreign exchange, while following a hands-off approach during episodes of Rupee depreciation. Underlying this asymmetry has been the notion that an appreciated Rupee would hurt exporters through a loss in cost competitiveness and by corollary, adversely affect India’s growth performance. However, empirical evidence on the impact of exchange rate on the performance of Indian firms is non-existent. 

Exchange rate movements and performance of firms

In a recent paper, I seek to understand the relationship between real exchange rate 10 movements and firm-level performance (Dhasmana 2013). The primary source of data used in the analysis is the Prowess database compiled by the Centre for Monitoring Indian Economy (CMIE). My

sample includes data on 250 manufacturing firms covering 13 broad manufacturing sectors, over 2000-2012. 

The usual real exchange rate indices computed by RBI are not effective in capturing changes in industry competitiveness induced by movements in bilateral exchange rates11. To address this issue, I construct industry-specific indices of real exchange rates using annual data on key trading partners’ trade share in each industry and bilateral exchange rates12. Results from the data analysis confirm that in line with the theoretical predictions, firms with a higher share of imported inputs tend to benefit significantly from a real exchange rate appreciation on account of lower input costs. However, the impact of real appreciation operating through decreased export competitiveness is not significant in the short-run. 

Market power and real exchange rates

An important determinant of a firm’s response to exchange rate movements is the degree of market power. Firms in industries with higher share of output held by a few firms (higher market concentration) are likely to experience a smaller impact of exchange rate movement on their output growth – this is because producers in such industries are better able to absorb shocks to their overall profitability on account of exchange rate changes owing to their greater market power. I try to test this hypothesis. Once again the import cost channel appears significant - for a given share of imported inputs in total costs and a constant path of currency depreciation, higher market concentration is associated with a smaller reduction in output and sales. Export competitiveness channel continues to remain insignificant even after accounting for differences in market power13. One can safely conclude, therefore, that real depreciation affects firm level-output growth through higher import costs in the short run.

Policy implications

For policymakers trying to assess the impact of exchange rate movements on the real economy, these results provide various important insights. Firstly, the short-run impact of a real depreciation on firm’s output growth is likely to be negative since it is the import cost channel that dominates in the short run. Further, the impact is asymmetric, with real depreciation having a stronger impact as compared to real appreciation. This indicates the need for an effective reserve management policy that allows monetary authorities to meet the challenges posed by sudden episodes of sharp Rupee depreciation, as happened recently. It also implies that the call for the RBI to ‘assist’ with the revival of economic growth in the presence of uncertainties in the

domestic and external policy environment is likely to be counterproductive if it leads to a downward pressure on the domestic currency. 

At the same time, maintaining a competitive real exchange rate is imperative for boosting intermediate and long-term economic growth and maintaining the external balance. Thus, using scarce foreign exchange reserves to prevent currency depreciation in the face of sustained downward pressure on the currency due to growing fiscal deficit and/ or massive capital outflows would be problematic, apart from being unsustainable.

On the whole, for countries relying on volatile foreign capital inflows to finance their consumption and investment needs, a careful reserve management policy along with a sound fiscal policy are necessary to balance the multiple objectives of stable growth and external sector balance in the long run.

Notes

1. A fixed exchange-rate system, also known as a pegged exchange rate system, is a currency system in which governments try to maintain their currency value constant against one another. Under this system, a country’s government decides the worth of its currency in terms of either a fixed weight of gold, a fixed amount of another currency or a basket of other currencies.

2. Under a market-based exchange rate regime, the exchange rate is allowed to fluctuate according to demand/ supply of the currency in the foreign exchange market. This is known as floating exchange rate.  

3. Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa. Current account convertibility refers to freedom with respect to Current Account transactions. The Current Account records the trade of goods and services of an economy with other countries of the world. 

4. The Capital Account gives a summary of the capital expenditure and income for a country. It comprises private and public investment flows such as foreign direct investments (FDI), portfolio investments etc.

5. In a forward transaction, a buyer and seller of foreign exchange agree on an exchange rate for any date in the future, and the transaction occurs on that date at the agreed rate, regardless of what the market rates are then. In contrast, a spot transaction is a direct

exchange between two currencies, and cash delivery needs to takes place within two working days.

6. Bank Rate is the rate at which RBI lends to commercial banks through its Discount Window.

7. Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves with the RBI.

8. Repo rate is the rate at which the RBI provides money to commercial banks through its short-term Repo Window in the event of a temporary shortfall of funds, under the Liquidity Adjustment Facility.

9. Monetary sterilisation is the process by which monetary authorities ensure that foreign exchange interventions do not affect the money supply in the domestic economy. For example, if due to a Balance of Payments (exports minus imports) surplus, the domestic currency is appreciating – The Central Bank can use domestic currency to purchase foreign currency-denominated assets. As a result, more of the domestic currency will be in circulation, its supply will increase and appreciation of the currency would be countered. 

10. Nominal exchange rate is the price of one currency in terms of number of units of some other currency. It is 'nominal' because it measures only the numerical exchange value, and does not say anything about other aspects such as the purchasing power of that currency. To incorporate the purchasing power and competitiveness aspects, real exchange rates are used. The real exchange rates are nominal exchange rates multiplied by the price indices of the two countries.

11. Aggregate Real Exchange Rate Indices using total trade shares of different trading partners do not take into account the fact that the share of each trading partner varies by industry.

12. Data source: UN Comtrade Database and International Monetary Fund’s (IMF) International Financial Statistics.

13. To deepen our analysis further we incorporate the impact of overvaluation of real exchange rate and firm-level characteristics (for example, share of foreign currency borrowing in total borrowing, ratio of net-fixed assets to total assets etc.) – the results remain unchanged. 

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How exchange rate fluctuations affect companies

Most investors will be familiar with the concept of currency exposure, with constantly changing exchange rates affecting the cost of investing in international stocks. These same issues also affect companies that operate internationally. So what effect do currency fluctuations have on company profits, and what are they doing to insulate themselves? In this extract from the Modern Wealth Management blog, we take a look at this issue.

International firms vs international currency

Companies with overseas branches, or those that trade internationally, are at the mercy of global currency fluctuations. As is the case with private investments, changes in conversion rates can wipe out profits or increase gains.

When a firm has shareholders to report to, and the figures can run into millions, then it can have a serious impact on profits and losses. The rapidly changing currency landscape can have the potential to make businesses reluctant to set firm figures in contracts months before a deal takes place. If a US-based firm makes EUR 10 million, they can end up with much more or less than they thought depending on the movement of the EUR/USD exchange rate. For example, in June 2011 it would have been worth $14.4 million, but in June 2012 it would have been worth $2 million less.

These issues also exist when discussing contracts with international clients. Although something may seem like a good deal when it is first written down, it can turn bad a few months later when the contract is fulfilled.

A study by SunGard Data Systems polled 275 US businesses of various sizes. It found that 59 per cent of those surveyed had seen a loss or gain of more than five per cent as a result of currency fluctuations in the previous year.

"The majority of corporations are in the business of doing business, producing and manufacturing, not hedging currencies," said Paul Bramwell, a senior vice president of Treasury solutions at the AvantGard unit of SunGard. "A lot of companies were caught unawares by volatility."

He explained that looking at where the exposure lies instead of waiting for quarterly results to discover the impact of fluctuations was a better approach, although he conceded that this is a stance more and more firms are taking.

The impact on real businesses

Therefore, organisations have to evaluate the risks of doing business on an international level. But it doesn't always work in their favour. For instance, McDonald's saw sales in Europe increase in 2011, but the yearly profits were actually down as a result of a weakening euro. Indeed, some experts think investors should be cautious this year too given that the US dollar has strengthened so much recently and is expected to continue doing so. As McDonald's generate nearly three quarters of its profits overseas, this could be an issue if they have not hedged.

Another recent example of this happened at eBay, with CFO Bob Swan admitting that currency fluctuations will hit the bottom line by around three points in 2012. Ralph Lauren reported that although currency changes have gone in its favour so far in 2012, it expects a turnaround in fortunes in 2013.

"Foreign currency effects are estimated to negatively impact net revenue growth by approximately 200-300 basis points in the first quarter," the company stated.

What can firms do?

As with private investors, business essentially have four options to counteract their currency exposure.

The simplest approach is just to monitor the changes, and this can be the best option if companies do not think that they are at a particularly high risk from exchange rate fluctuations.

Another option is to lock into an exchange rate for a fixed period of time by setting up a forward contract. If the exposure estimates are correct, this can be a beneficial approach. Some businesses will also purchase currency in advance if they know that they will be making big purchases and are concerned about volatility.

A third option is to hedge against this exposure via derivatives. Although this may be the most complicated option, it can be effective in limiting exposure to volatility. It can also give a clearer picture of how a company's overseas operations are really performing.

Finally, firms can choose to manage their currency exposure through business practices. Having a truly international company can help with this as, theoretically, losses made when one currency

falls will be recovered when another rises. Where contracts are concerned businesses can also set up clauses that reduce this exposure. In many cases this comes in the form of an agreement to protect the client and the company should exchange rate movements exceed the agreed-upon level. Some businesses also agree on setting all contracts in their core currency, protecting them from any exposure as they will always be paid the same relative amount.

Dealing with currency exposure is all about managing risk, as fluctuations are by their very nature unpredictable. However, while private investors only have their own savings to worry about if they fail to manage this risk appropriately, businesses face angry shareholders and a drop in share value - as well as a drop in profits.

Factors which influence the exchange rate

Exchange rates are determined by supply and demand. For example, if there was greater demand for American goods then there would tend to be an appreciation (increase in value) of the dollar. If markets were worried about the future of the US economy, they would tend to sell dollars, leading to a fall in the value of the dollar.

Note:

Appreciation = increase in value of exchange rate

Depreciation / devaluation = decrease in value of exchange rate.

Main Factors that Influence Exchange Rates

1. Inflation

If inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also foreign goods will be less competitive and so UK citizens will buy less imports.Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency.

2. Interest Rates

If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK. You will get a better rate of return from saving in UK banks, Therefore demand for Sterling will rise.  This is known as “hot money flows” and is an important short run factor in determining the value of a currency. Higher interest rates cause anappreciation.

3. Speculation

If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the

exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.

4. Change in Competitiveness

If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound. This is similar factor to low inflation.

5. Relative strength of other currencies.

In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets were worried about all the other major economies – US and EU. Therefore, despite low interest rates and low growth in Japan, the Yen kept appreciating.

6. Balance of Payments

A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial / capital account then this is OK. But a country who struggles to attract enough capital inflows to finance a current account deficit, will see a depreciation in the currency. (For example current account deficit in US of 7% of GDP was one reason for depreciation of dollar in 2006-07)

7. Government Debt.

Under some circumstances, the value of government debt can influence the exchange rate. If markets fear a government may default on its debt, then investors will sell their bonds causing a fall in the value of the exchange rate. For example, Iceland debt problems in 2008, caused a rapid fall in the value of the Icelandic currency.

For example, if markets feared the US would default on its debt, foreign investors would sell their holdings of US bonds. This would cause a fall in the value of the dollar. See: US dollar and debt

8. Government Intervention

Some governments attempt to influence the value of their currency. For example, China has sought to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan.

see also: Chinese Currency | Swiss Franc pegged against Euro

9. Economic growth / recession

A recession may cause a depreciation in the exchange rate because during a recession interest rates usually fall. However, there is no hard and fast rule. It depends on several factors. See: Impact of recession on currency.

Example Fall in Value of Sterling 2007 – Jan 2009

  

During this period, the value of Sterling fell over 20%. This was due to:

Restoring UK’s lost competitiveness. UK had large current account deficit in 2007

Bank of England cut interest rates to 0.5% in 2008.

Recession hit UK economy hard. Markets expected interest rates in UK to stay low for a considerable time.

Bank of England pursued quantitative easing (increasing money supply). This raised prospect of future inflation, making UK bonds less attractive.

Sterling Effective Exchange Rate

The Risks of Currency Value Fluctuation

From political turmoil to a natural disaster, there are plenty of factors that cause a currency's value to rise and fall. When a business engages in international business transactions — such as importing, exporting and paying foreign employees — swings in currency value can have a significant impact on the bottom line.

Market fluctuations can impact everything from purchasing power to operating costs, making it difficult for businesses to predict profits and losses. If exchange rates take an unfavorable turn, an international business may end up paying more or receiving less from its partners and overseas customers.

Here are three approaches that can help business owners plan for swings in currency value.

The yen continued to soar, and as it did, it became harder for Japanese exporters to compete with the prices offered by exporters in other countries.

1. Acknowledge that Unpredictability Is Predictable

It’s crucial that business owners take steps to understand where a country’s currency stands. But it’s just as important to acknowledge that foreign currency values can change on a dime. Take, for example, the 2011 natural disasters that impacted Japan.

Immediately after the 8.9-magnitude earthquake and 13-foot tsunami hit Japan’s Eastern coast on March 11, 2011, the Japanese yen began to slide. But within a few days, the currency value strengthened as Japanese business owners and citizens created a high demand for the currency by purchasing medical supplies and other essential items.[1]

The Japanese government began pumping money into the economy to guard against an overly strong yen. Yet the yen continued to soar, and as it did, it became harder for Japanese exporters to compete with the prices offered by exporters in other countries. Adding to the problem, when customers made international payments in their native currencies, Japanese exporters ended up with less money after currency conversion.[1]

Currency Converter

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$ USD - United States Dollar

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common        remaining                                                                                                                                                                                                                                                                             

2. Consider Currency Risk at the Outset

“A lot of business owners think of an exotic spot to do business, and they just move there and start a business,” says Dmitry Dragilev, a Boston native and designer of the Currency Exchange Fee Calculator app.

Dragilev says it’s important for business owners to consider the economic climate and fluctuations in the exchange market before setting up shop in another country. While many economic and political turns can’t be predicted, understanding the variables can help business owners steer clear of markets on the verge of instability.

3. Minimize Risk

There are a few things small business owners can do to help minimize fluctuation risks in the market. For example, business owners can employ strategies such as crafting contract terms that ensure payment will be submitted in their domestic currency. And when businesses make international payments, they may consider locking in a fixed rate on their currency exchanges by using forward contracts.

SIGNIFICANCE

The exchange rate expresses the national currency's quotation in respect to foreign ones. For example, if one US dollar is worth 10 000 Japanese Yen, then the exchange rate of dollar is 10 000 Yen. If something costs 30 000 Yen, it automatically costs 3 US dollars as a matter of accountancy. Going on with fictious numbers, a Japan GDPof 8 million Yen would then be worth 800 Dollars.

Thus, the exchange rate is a conversion factor, a multiplier or a ratio, depending on the direction of conversion.

In a slightly different perspective, the exchange rate is a price. If the exchange rate can freely move, the exchange rate may turn out to be the fastest moving price in the economy, bringing together all the foreign goods with it.

Types of exchange rate

$ CAD - Canadian Dollar

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It is customary to distinguish nominal exchange rates from real exchange rates. Nominal exchange rates are established on currency financial markets called "forex markets", which are similar to stock exchange markets. Rates are usually established in continuous quotation, with newspaper reporting daily quotation (as average or finishing quotation in the trade day on a specific market). Central bank may also fix the nominal exchange rate.

Real exchange rates are nominal rate corrected somehow by inflation measures. For instance, if a country A has an inflation rate of 10%, country B an inflation of 5%, and no changes in the nominal exchange rate took place, then country A has now a currency whose real value is 10%-5%=5% higher than before [1]. In fact, higher prices mean an appreciation of the real exchange rate, other things equal.

Another classification of exchange rates is based on the number of currencies taken into account. Bilateralexchange rates clearly relate to two countries' currencies. They are usually the results of matching of demand and supply on financial markets or in banking transaction. In this latter case, the central bank acts usually as one of the sides of the relationship.

Other bilateral exchange rates may be simply computed from triangular relationships: if the exchange rate dollar/yen is 10 000 and the dollar/Angolan kwanza is 100 000 then, as a matter of computation, one yen is worth 10 kwanza. No direct yen/kwanza transaction needs to take place. If, instead,a financial market exists for yen to be exchanged with kwanza, the expectation is that actions by speculators (arbitrage among markets) will bring the parity of 10 kwanza per yen as an effect.

Multilateral exchange rates are computed in order to judge the general dynamics of a country's currency toward the rest of the world. One takes a basket of different currencies, select a (more or less) meaningful set of relative weights, then computes the "effective" exchange rate of that country's currency.

For instance, having a basket made up of 40% US dollars and 60% German marks, a currency that suffered from a value loss of 10% in respect to dollar and 40% to mark will be said having faced an "effective" loss of 10%x0.6 + 40%x0.4 = 22%.

Some countries impose the existence of more than one exchange rate, depending on the type and the subjects of the transaction. Multiple exchange rates then exist, usually referring to commercial vs. public transactions or consumption and investment imports. This situation requires always some degree of capital controls.

In many countries, beside the official exchange rate, the black market offers foreign currency at another, usually much higher, rate.

Exchange rate regimes

When the exchange rate can freely move, assuming any value that private demand and supply jointly establish, "freely floating exchange rate" will be the name of currency institutional regime. Equivalently, it is called "flexible" exchange rate as well.

If the central bank timely and significantly intervenes on the currency market, a "managed floating exchange rate regime" takes place. The central bank intervention can have an explicit target, for example in term of a band of currency acceptable values.

In "freely" and "managed" floating regimes, a loss in currency value is conventionally called a "depreciation", whereas an increase of currency's international value will be called "appreciation". If the dollar rise from 10 000 yen to 12 000 yen, then it has shown an appreciation of 20%. Symmetrically, the yen has undergone an 8.3% depreciation.

But central banks can also declare a fixed exchange rate, offering to supply or buy any quantity of domestic or foreign currencies at that rate. In this case, one talks of a "fixed exchange rate".

Under this regime, a loss of value, usually forced by market or a purposeful policy action, is called a "devaluation", whereas an increase of international value is a "revaluation".

The most stabile fixed exchange regimes are backed by an international agreement on respective currency values, often with a formal obligation of loans among central banks in case of necessity.

A "currency crisis" is a rupture of fixed exchange rates with an unwilling devaluation or even the end of that regime in favour of a floating exchange rate. It can dominate the attention of the public, policymakers and entrepreneurs, both in advance and after. For instance, people expecting a crisis can borrow inside the country, convert in a foreign currency, lend that money (e.g. by purchasing bonds). When the crisis comes, they sell the bonds, convert to the national currency, pay back their loans, are gain a hefty profit.

An extreme national engagement to fixed exchange rates is the transformation of the central bank in a mere "currency board" with no autonomous influence on monetary stock. The bank will automatically print or lendmoney depending on corresponding foreign currency reserves. Thus, exports, imports and capital inflows (e.g. FDI) will largely determine the monetary policy.

Monetary unions phase out the national currencies in favour of one (new or existing). Some further countries can target to join the union and put in place economic and financial policies to that aim, especially if there are explicit conditions for entering into that monetary area. Exiting a monetary union can provoke with large devaluation of the new national currency. Depending on trade elasticities, on foreign debt of the country, on how the exit is managed and on the overall institutional conditions, this can lead to massive internal poverty or a large export led-growth.

Determinants of the nominal exchange 

Fixed exchange rates are chosen by central banks and they may turn out to be more or less accepted by financial markets.

Changes in floating rates or pressures on fixed rates will derive, as for other financial assets, from three broad categories of determinants:

i) variables on the "real" side of the economy; ii) monetary and financial variables determined in cross-linked markets; iii) past and expected values of the same financial market with its autonomous dynamics.

Let's see them separately for the case of the exchange rate.

Real variables

1. Exports, imports and their difference (the trade balance) influence the demand of currency aimed at real transactions.

A rising trade surplus will increase the demand for country's currency by foreigners, so that there should be a pressure for appreciation. A trade deficit should weaken the currency.

Were exports and imports largely determined by price competitiveness and were the exchange rate very reacting to trade unbalances, then any deficit would imply depreciation, followed by booming exports and falling imports. Thus, the initial deficit would be quickly reversed. Net trade balance would almost always be zero.

This is hardly the case in contemporary world economy. Trade unbalances are quite persistent, as you can verify with these real world data. Additionally, not so seldom, exchange rates go in the opposite direction than one would infer from trade balance only.

2. An even more radical form of real determination of exchange rate is offered by the "one price law", according to which any good has the same price worldwide, after taken into account nominal exchange rates. If a hamburger costs 3 US dollars in the United States and 30 000 yen in Japan, then the exchange rate must be 10 000 yen per dollar. The forex market  would passively adjust to permit the functioning of the "one price law".

But in order to equalise the price of several goods, more than one exchange rate may turn out to be "necessary". Moreover the "one price law" seems to suffer from too many exceptions to be accepted as the fundamental determinant of exchange rates.

Large, persistent and systematic violations of Purchasing Power Parity are connected to price-to-market decisions of firms in this paper of September 2007.

Monetary and financial variables in cross-linked markets

1. Interest rates on Treasury bonds should influence the decision of foreigners to purchase currency in order to buy them. In this case, higher interest rates attract capital from abroad and the currency should appreciate. Decisive would be the difference between domestic and foreign interest rates, thus a reduction in interest rates abroad would have the same effects.

Similarly other fixed-interest financial instruments could be objects of the same dynamics. Accordingly, an increase of domestic interest rates by the central bank is usually considered a way to "defend" the currency.

Nonetheless, it may happen that foreigners rather buy shares instead of Treasury bonds. If this were the strongest component of currency demand, then an increase of interest rate may even provoke the opposite results, since an increase of interest rate quite often depresses the stock market, favouring a tide of share sales by foreigners.

In the same "reversed" direction foreign direct investments would work: arestrictive monetary policy usually depresses the growth perspective of the economy. If FDI are mainly attracted by sales perspectives and they constitute a large component of capital flows, then FDI inflow might stop and the currency weaken.

Needless to say, those conditions are quite restrictive and not so usually met.

A matter of discussion would be whether the relevant interest rate is the nominal or the real one (which, in contrast with the former, keeps into account inflation). Usually foreign investors do not purchase bread, clothes, and the other items included in the bundle used to compute price level and its dynamics:   they do not buy anything real in the target economy. So nominal rates are more likely to be taken into account.

As a temporary conclusion, interest rates should have an important impact on exchange rate but one has to be careful to check additional conditions.

2. Inflation rate is often considered as a determinant of the exchange rate as well. A high inflation should be accompanied by depreciation. The more so if other countries enjoy lower inflation rates, since it should be the difference between domestic and foreign inflation rates to determine the direction and the scale of exchange rate movements.

All this would be implied by a weak version of "one price law" stating that price dynamics of a good are the same worldwide, after taking into account nominal exchange rates. Thus, here not absolute level but just thepercentage differences in price are requested to be equalised .

If an hamburger costs in Japan 5% more than a year ago, while in USA it costs 8% more, then the dollar should have been depreciated this year by about 8-5=3%.

But in order to equalise the price dynamics of different goods, more than one exchange rate change may turn out to be "necessary".

In reference to the overall price level of the economy, if exchange rates would move exactly counterbalancing inflation dynamics, then real exchange rates should be constant. On the contrary, this is not true as a strict universal rule.

Still, even if this weak version of the "law" does not always hold, high inflation usually give rise todepreciation, whose exact dimension need not match the inflation itself or its difference with foreign inflation rates.

3. The  balance of payments  can highlight pressures for devaluation or revaluation, reflected in large and systematic trend of foreign currency reserves at the central bank. In particular, large inflows, due for instance to a rise in the world price of main export items, tend to raise the exchange rate. Conversely, a collapse in the trust of government to manage the economic conditions might provoke a flight of capital, the exhaustion of foreign currency reserves and force devaluation / depreciation.

Autonomous dynamics on the forex market

Past and expected values of the exchange rate itself may impact on current values of it. The activities of forex specialists and investors may turn out to be extremely relevant to the determination of market exchange rate also thanks to their complex interaction with central banks. Sophisticated financial instruments like futures on exchange rates may play an important role. Imitation and positive feedbacks give rise to herd behaviour and financial fashions.

Fears and confidence in a currency are heterogeneosly distributed across agents, with special events (as unexpected news) realigning them and generating large movement in the exchange rate.

For a full-text free book on artificial forex market based on empirical field research see here.

Impact on other variables

Levels and fluctuations in the exchange rate exert a powerful impact on exports, imports and the trade balance. A high and rising exchange rate tends to depress exports, to boost import and to deteriorate the trade balance, as far as these variables respond to price stimuli. Consumers find foreign goods cheaper so the consumptioncomposition will change. Similarly, firms will reduce their costs by purchasing intermediate goods abroad.

In extreme cases, local firms producing for the domestic market might go bankrupt. If the reason of appreciation was a soaring world price of main exports (e.g. energy carriers, like oil for many oil producing countries), the composition of the industrial texture would be starkly simplified and concentrated to those exports. This is at odds and works in the opposite direction of the diversification of the economy that is often the stated goal of public strategies in countries depending on too few productions (high export concentration).

A devaluation or depreciation should work in the opposite direction, improving the trade balance thanks to soaring exports and falling imports.

If, however, imports have an elasticity to price less than 1, their values in local currency will grow instead of falling. Moreover, if the state, the citizens and / or the enterprises have a debt denominated in a foreign currency, their principal and the interests to be paid soar because of the devaluation. They usually squeeze other expenditures and launch a recessionary impulse throughout the economy.

Previous investors in real estate and other assets would be hurt by devaluation, so the perspective of such a dynamics makes investors cautious and might sink FDI.

External debt denominated in foreign currency can, if large enough, provide considerable effects on the positive or negative impact of fluctuation. A devaluation with a large external debt provokes a larger outflows of interest payments (expressed in local currency), possibly squeezing the economy and the public budget, with recessionary effects.

Hosting different industries, regions usually exhibit a differentiated degree of international openness: exchange rate fluctuations will have an uneven impact on them. Similarly, the number of job places and the working conditions may be influenced by the degree of international competition and exchange rates levels.

Exchange rate influences also the external purchasing power of residents abroad, for example in term of purchasing real estate and other assets (e.g. firm equity as a foreign direct investment), so by different channels, also the balance of payments.

Exchange rate devaluation (or depreciation) gives rise to inflationary pressures: imported good become more expensive both to the direct consumer and to domestic producer using them for further processing. In reaction to inflation (actual and feared), the central bank can rise the interest rates, thus sending a recessionary impulse.

Currency crisis have a sweeping impact on income distribution. The few rich able to borrow (because they have collateral and the banks trust them) will get richer and the people purchasing imported goods facing inflation and reduction of real incomes.

Symmetrically, the central bank may use a fixed exchange rate as a nominal anchor for the economy to keep inflation under control, compelling domestic producer to face tougher competition as soon as they decide to increase prices or accept to pay higher wages.

For a small economy, joining a monetary union makes the exchange rate to fluctuate according to fundamentals and market pressures referring to a much larger area, erratically going in directions that are (or are not) coherent with positive macroeconomic developments.

For statistics purposes, international comparisons of current values converted to a common currency are "distorted" by wide exchange rate fluctuations.

Long-term trends

Some geographical monetary areas have enjoyed long periods of stable exchange rate, with moments of consensual realignment after divergence in inflation rates. Many countries strive to keep their currency at a fixed level toward the dollar, the Euro (earlier the German mark) or a basket with multiple currencies.

Still, most currency progressively devaluate, especially those issued by periphery countries. The US dollar has extremely wide fluctuations with years of "weak" and "strong" dollar.

Business cycle behaviour

Too many elements are at work for the exchange rate to exhibit a clearly-defined business cycle behaviour. To the extent that the exchange rate is determined by the trade balance, the exchange rate is counter-cyclical as the latter. At peaks, the trade deficit would depress the exchange rate, forcing it to depreciate.

If it is rather the interest rate that turns out to the main driver of the exchange rate, a possible pro-cyclicity of the interest rate would imply a pro-cyclical exchange rate.

In this scenario, recovery and boom are accompanied by rising interest rates and exchange rates. At peaks, we would see very strong currency. Together with domestic demand pressures, this would be the source of a high trade deficit.

If autonomous dynamics in the forex market are the main determinants of the exchange rate, then intense micro-fluctuations and long term tides would ride the exchange rate, possibly with central bank significant interventions.

ConclusionThe exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.