Foreign Exchange Rate The foreign exchange rate or exchange rate is the rate at which one currency is exchanged for another. It is

the price of one currency in terms of another currency. The exchange rate is determined in the

foreign exchange market on the basis of demand for and supply of foreign currencies.

The Foreign exchange market It is a market where foreign exchange is bought and

sold. It performs three functionsa. Transaction b. credit c. hedging

Key players

Central bank

Brokers

Commercial banks

Exporters, importers, tourists investors and immigrants

Kinds of foreign exchange market

• Spot market Selling and buying of foreign currency on the spot is spot market. Settlement is done within two days.

• Forward market When buyers and sellers enter an agreement to buy and sell a foreign currency after 90 days of deal, it is called forward transactions.

Some concepts• Hedging Importers and exporters enter into an

agreement to sell and buy goods at some future date at current prices it is called hedging. The purpose of hedging is to avoid the risk arising from fluctuations in the exchange rate.

• Arbitrage foreign currencies are purchased in market where the prices are less and sold in the market where the prices are high. It serves as an equalizer and stabilizer of exchange rates in major exchange markets.

• Speculation speculators expectations about rise and fall in prices of foreign exchange rates. Bears expect the prices will fall. Bulls expect it will rise. who gains depends on how correct are their expectations .

Determination of Exchange rate

• The exchange rate in a free market is determined by the demand for and the supply of foreign exchange. The equilibrium exchange rate is the rate at which the demand for foreign exchange equals to supply of foreign exchange. Ragner Nurkse “ that rate which over a certain period of time, keeps the balance of payments in equilibrium”.

Determination of Exchange rate

• Demand for foreign exchange is derived from demand for foreign goods, services and securities. And from speculators and monetary authorities. There is inverse relationship between the demand for foreign exchange and the exchange rate.

• Supply curve supply of foreign currencies is from exports of goods, services and capital movement.

Equilibrium exchange rate

D S R” A B R E R’ G H

O Q Demand for supply of foreign exchange

Theories of exchange rate• Mint Parity theory• Purchasing power parity theory• Balance of Payments theory Purchasing Power Parity theory Theory was developed by Gustav Cassel in 1920

to determine the exchange rate between countries on inconvertible paper currencies. It is determined by their prices.

Theories of exchange rate• Mint Parity theory• Purchasing power parity theory• Balance of Payments theory Purchasing Power Parity theory Theory was developed by Gustav Cassel in 1920

to determine the exchange rate between countries on inconvertible paper currencies. It is determined by their prices.

there

Purchasing Power Parity theory

• The absolute rate of exchange is determined in terms of absolute prices. A basket of goods and services can be bought in India for

• Rs. 1000 and in the US for $5 .Then the exchange rate between the two currencies will be determined

• $20 = Rs. 1000• $1 = Rs. 50• Based on the assumption 1. no transport cost 2. no

tariffs 3. no subsidies.

Purchasing Power Parity theory• Relative version • R1 = R0* P1

A / P0A / P1

B / P0B

Drawbacks1. Defects in calculating price level2. Comparison of general price level a difficult proble3. Not applicable to capital account4. Difficult to find Base year5. Structural changes in factors6. No free trade7. Neglect of elasticities8. One sided9. Static theory•

Fixed Exchange rates• Fixed or pegged exchange rates all exchange transactions take place at an

exchange rate that is determined by the monetary authority. It is fixed by legislation or intervention.

• Case for fixed exchange rate• 1. based on common currency• Encourage long term capital flows.• No fear of currency fluctuations• No adverse effect of speculation • Disciplinary • Best for small countries.• Less inflationary• Certainty• Suitable for common currency areas.• Promotes money and capital markets• Multilateral trade• International monetary co operation.

• Case against• 1. Heavy burden• 2. misallocation of resources• Complex system• Not always possible.• Bop disequilibrium persists• Dependence on international institutions.•

Flexible exchange rate

• Case for flexible exchange rate• Simple operation• Smoother adjustments• Autonomy of economic policies• Disequilibrium in the Bop • No need of foreign exchange• Removes problem of international liquidity• Effective monetary policy• Economical

• Case against flexible exchange rates• 1. mal allocation of resources• 2. official intervention• No justification• Exchange risks and uncertainity• Encouragement to inflation

Different systems of exchange rate

• Independent floating 35 countries including USA,UK ,Japan, South Korea and Brazil follow the system of independent floating of their currency.