Foreign Exchange Rate

- Anubhav Kandpal – 04
- Shabbir Pittalwala – 42
- Udit Singh Yadav – 50
- Vibhash Joshi - 53
Index
 What is foreign exchange rate
 What is the foreign exchange market
ü Nominal & Real exchange rates[NER]
ü Real effective exchange rate[REER]
 What are the different ways to determine the exchange rate of a currency
ü Floating [flexible] exchange rate system
v Demand & Supply of a foreign currency
o Equilibrium exchange rate
Ø Free market
Ø Changes in exchange rate in a free market
§ Purchasing power parity
§ Inflation
§ Interest rates
ü Fixed and flexible exchange rate system
ü Managed float system in India
 Devaluation of the Indian rupee
 Currency convertibility
 Advantages and problems.



What is foreign exchange
What is a currency?
 -it is the mode of exchange used in an economy
What is foreign exchange rate
 -it is the name given to any foreign currency;
 Eg:- US dollars and the British Pound are foreign exchange
for India.
What is foreign exchange market
 -the market in which the currencies of various countries are
exchanged, traded or converted is called the foreign exchange
market. It is seen as a network of communication system
connecting institutions including banks, specialized foreign
exchange dealers and govt. agencies.



DETERMINATION OF BASE CURRENCY
 There is a market convention that determines which is the base currency
and which is the term currency. In most parts of the world, the order is:
EUR – GBP – AUD – NZD – USD – others. Thus if you are doing a
conversion from EUR into AUD, EUR is the base currency, AUD is the
term currency and the exchange rate tells you how many Australian
dollars you would pay or receive for 1 euro. Cyprus and Malta which
were quoted as the base to the USD and others were recently removed
from this list when they joined the euro. In some areas of Europe and in
the non-professional market in the UK, EUR and GBP are reversed so
that GBP is quoted as the base currency to the euro. In order to
determine which is the base currency where both currencies are not
listed (i.e. both are "other"), market convention is to use the base
currency which gives an exchange rate greater than 1.000. This avoids
rounding issues and exchange rates being quoted to more than 4 decimal
places. There are some exceptions to this rule e.g. the Japanese often
quote their currency as the base to other currencies.
Important exchange rate concepts
 Nominal exchange rate[NER]
 the no. of units of a domestic currency needed to purchase 1 unit of a foreign
currency. Eg:- the exchange rate of rupees per dollar is the NER, {Rs 40 can
buy $1}
 Nominal effective exchange rate[NEER]
 it is the weighted average of nominal exchange rates where the weights used

are the shares of trading partners in the foreign trade of a country.

Eg:-the USA accounts to 60% of total trade with India, and the UK 40 %; then

the
 NEER=(NERUS X WUS)+(NERUK X WUK)
NEER-nominal effective exchange rate

NERUS/ NERUK- nominal exchange rate of the US and UK respectively

WUS / WUK- trade shares of the US and UK respectively


 Real exchange rate
 - it is the relative price of 2 countries after adjusting for the price levels within
the countries.
Eg:-the real exchange rate of rupee and the US dollar is defined as the rupee

price of a basket of goods in India relative to a dollar price of the same basket
of goods in the USA.
 RER= NER [PUS/ PIn]
RER- real exchange rate

NER- nominal exchange rate

PUS and PIN - price level in USA and price level in India respectively.


 Real effective exchange rate

 -it is the weighted average of all real exchange rates with all its trade partners,
the shares of different countries in its total trade are used as weights

Appreciation of a currency (floating exchange rate system):-
 - it is the increase in the value of one currency in terms of the
other. Eg. US $ decreases from 45.5 to 44 to a dollar, this is
when the Indian rupee is said to be appreciated.
This indicates the strengthening of the Indian rupee.

Depreciation of a currency (floating exchange rate system):-

 - it is when the decrease in the value of one currency in terms of

the other. Eg. US $ increases from 45.5 to 46 to a dollar, this is

when the Indian rupee depreciates
[note that when the Indian rupee appreciates the US $ depreciates,

and when the Indian rupee Depreciates the US $ appreciates]

Revaluation of a foreign currency(fixed rate system):-
- this is the same as appreciation of a currency, except that
the govt. increases the value of its currency.
Devaluation of a foreign currency(fixed rate system):-
- this is same as depreciation of a currency, except that the

govt. decreases the value of its currency.

like India did in 1966 and 1991.


Fixed and Flexible
Exchange Rates
The fixed exchange rate system was carried out in the
earlier 90s. Under this, currencies of different countries
were tied to gold.
Thus, the exchange rate of different countries got
automatically fixed.

The flexible exchange rate system is one in which the value
of currency of one country is expressed in terms of that of
the other.
Determination of exchange
rate[demand and supply]

At present in both India and USA there is floating exchange

regime. Therefore the value of currency of each country in
terms of the other depends upon the demand and supply of
their currency
We shall take a case between the $ and the Indian Rupee
Ø Indians sell Rupees for US $
Ø People holding US $ will sell dollars in exchange for
Rupees.
Ø It is the demand and supply of foreign exchange that will
determine the rate between the tow.
Ø
 Y
D s
Excess
Supply

Rs 46

R’


Price

R
Rs
E
45.5
of
dolla


Rs 44
r R”
[rupee

s as
per
dolla
 sExcess Demand D
r ]

O Q X
Quantity of dollars
Now to understand the shape of the demand curve:-
Ø When there is a fall in the price of a $ in terms of rupees, that is, when
$ depreciates, fewer rupees that before would be required to buy a $
now.
Ø This implies, that goods worth in $s are now cheaper in terms of
Indian rupees.
Ø This implies to an increased demand of USA made goods in India.
Ø This implies to an increased demand for dollars-which will again
increase the price of the dollar
Ø In the end this means, that lower the price of a $, greater is the quantity
of dollars demanded for imports. and higher the price of a dollar,
smaller the quantity of imports from the USA by the indians.
Ø This causes the demand curve to slope downwards.
Reasons for demand of the US $[foreign currency]
Ø Indian individuals or firms that import goods from the USA
into India, need US $s
Ø Indians traveling or living in the USA would need $s to
meet their demand
Ø Indians that invest in shares and bonds of companies in the
USA would require $s
Ø Indians that directly invest in houses, shops ect. In the USA
would need $s
Ø
 Now to understand the shape of the supply curve:-
Ø According to the current exchange rate between US$s and Indian
rupees;Rs100 worth of Indian goods would be relatively cheaper in
terms of dollars.[Rs48=$1]
Ø This will increase demand for Indian goods in the USA, and boost exports
of from India to USA at a higher price of the dollar and thus ensure
more supply of $s in the foreign exchange markets.
Ø This implies that increased supply of $s will reduce its value in terms of
rupees.
Ø This implies that the Indian goods will now be more expensive in terms
of $s
Ø This will reduce the demand for Indian goods, and hence reduce the
supply of $s in the foreign exchange market.
Ø This shows, that when the rate of exchange is high, the supply increases,
and visa versa.
Reasons for supply of US $s:-
Ø When USA exports goods and charges revenue in $s.
Ø Citizens of USA that invest $s in India.
Ø Those who make loans to Indians.
Ø American tourists that spend $s in India.
Ø Indians living in the USA send $s to their relatives in India
[remittances]

The equilibrium exchange
rate
In the fig we see, equilibrium
Y
price of $ in terms of rupees is Excess Supply s
Rs.45.5 at which demand and sup- D
ply curve intersect.
R’ Rs 46
Price
 At Rs46[higher price of $] qty of
supplied exceeds qty demanded. dolla Rs 45.5
r R E
 Excess supply will reduce the [rupe
exchange rate of $ and the price es as Rs 44
will fall back to Rs45.5.
perR”
dolla
 When the rate of $ in terms of r] Excess Demand
rupees is Rs44, there will be
excess demand s
D
 This will increase the price again O X
to Rs45.5. Q

Quantity of dollars


Free market
There are factors other than the rater of a currency in terms of another
currency that affects the demand and supply of the currency
This hence affects the equilibrium exchange rate.
Eg. If there is an increase in the income in the US economy, due to
conditions of BOOM.
This will increase imports into the US including goods from India
This implies that there will be an increase in the supply of $s in the
foreign exchange market.
This will cause a rightward shift in the supply curve, and hence affect
the equilibrium price.
This also shows that the value of the $ will depreciate and the value of
the rupee will appreciate. Before we study the shift in the curve, we
shall take a look at the factors that affect the exchange rate in a free
market.


Reasons for the Changes in
exchange rate in the free
market
 Purchase power parity[relative price levels]:-
 To understand this, we must first assume that there are no restrictions in trade
between countries, and transport cost is nil.
Then the exchange rate between 2 countries will show the difference between

the price levels in the 2 countries.

Ø The exchange rate can now be fixed, by the proportionate difference between
the price levels prevailing in the country.
Ø For instance, a TV costs much higher in India that in the US.
Ø This will pay businessmen to buy TVs from the US and sell it in India
Ø This will decrease the supply of TVs in the US, and increase it in India
Ø Hence the price of the same TV will now be high in the US and low in India.
Ø This process will continue till the price of the TV is same in both the
countries
Ø This concludes, that price levels in different
countries affects the exchange rate of the
currency
Ø It must be noted that, it is only in the long
run that with no trade restrictions, that this
may be possible.
Rate of inflation and exchange rate
Ø High rate of inflation in a country
will affect the exchange rate of
that country.
Ø Suppose, India has a relatively high
rate of inflation that USA.
Ø This means that the cost of production
in India is higher than USA
Ø This prompts the Indian consumer to
import more goods from USA
Ø This results in an increased demand
for US$s

Ø This will cause the demand curve of US$ to shift to the right
as shown in the fig.
Ø At the same time, if there is a high price level in USA, the
Indian goods will be more expensive to the Americans.
Ø The demand for imports into the US will reduce.
Ø Hence the supply of US $ will increase, causing the supply
curve to shift towards the right.
 Y Y S
D
D’ S’ S’

R
A R 45.5 E
R 46.5 S T
A R’ 44.5
D E R’ E’
T
E
45.
R 5 D’ S D
S’
S’

S D

O O
Q X
Amount of dollars Q QAmount
’ of dollars
X

Effect of a higher rate of Effect of relatively higher rate of

inflation on the exchange rate of interest in india on the exchange
a country rate
INTEREST RATES & EXCHANGE
RATE
The interest rate in a country relative to interest rate of
other countries with which it trades its goods is an
important factor affecting foreign exchange rate.
This means that businessmen of the home country will
invest in a the bonds of a foreign country if the
latter’s interest rates are lower.
As a result, there will be a flight of capital from the
foreign country or Capital Inflows into the home
country.
Fixed and Flexible
Exchange Rates
The fixed exchange rate system was carried out in the
earlier 90s. Under this, currencies of different countries
were tied to gold.
Thus, the exchange rate of different countries got
automatically fixed.

The flexible exchange rate system is one in which the value
of currency of one country is expressed in terms of that of
the other.
Devaluation of the Indian
rupee
Introduction
Ø Large reserves of foreign exchange helps in smooth flow of
international trade.
Ø If a nation depletes its foreign currency reserves and finds that
its own currency is not accepted abroad, the only option left to
the country is to borrow from abroad.
Ø It will have to replay the loan in its own currency or in any other
hard currency
Ø If the nation is not credit worthy, it will not get any loans, and
there will be no way to pay off imports.
Ø This results in a financial crisis accompanied by devaluation and
capital flight.
Ø

Ø To avert a financial crisis, a nation will maintain a stable
exchange rate to lessen exchange rate risk and increase
international confidence and to safeguard its foreign
currency reserves.
Ø if the market for a nation’s currency is too weak to justify
the given exchange rate, that nation will be forced to
devalue its currency.
Ø That is, the price the market is willing to pay for the
currency is less than the price dictated by the
government.


Ø
The 1966 Devaluation
Ø As a developing economy, it is to be expected that India would
import more than it exports
Ø India has had consistent balance of payments deficits since the
1950s.
Ø 1966, inflation had caused Indian prices to become much higher
than world prices at the pre-devaluation exchange rate
Ø Government of India had a budget deficit problem and could not
borrow money from abroad
Ø As a result, the government issued bonds to the RBI, which
increased the money supply. In the long run, there is a strong
link between increases in money supply and inflation and the
data presented
Despite of budget deficits and high rate of
inflation, Through restrictions on currency
trading and convertibility as well as export
subsidisation and quantitative restrictions [QR]on
imports, India was able to maintain its
unjustified exchange rate while experiencing
inflation until 1966 when it faced a severe
shortage of foreign reserves.
Time Period Inflation M1 Growth M2

Growth

1961-1965 5.8% 7.72% 8.14%
 1966-1970 6.7% 9.05% 11.50%


Source: Data on M1 and M2 are from the source given above

and the average rates are computed by the authors,inflation

data is from http://indiagovt.nic.in/es2001-
02/chapt2002/chap51.pdf
Ø In the period of 1950 through 1966, foreign aid was never
greater than the total trade deficit of India except for 1958.
But this helped to postpone the rupee’s final reckoning until
1966.
Ø In 1966 India was told it had to liberalise its restrictions on trade
before foreign aid would again materialise.
Ø India did as said. When India still did not receive foreign aid, the
government backed off its commitment to liberalisation.
Ø India was in a state of war with Pakistan in late 1965. The US
and other countries friendly towards Pakistan, withdrew
foreign aid to India, which further necessitated devaluation.
Ø Defence spending in 1965/1966 was 24.06% of total
expenditure, the highest it has been in the period from
1965 to 1989
Ø The second factor is the drought of 1965/1966. The sharp
rise in prices in this period, which led to devaluation, is
often blamed on the drought, but in 1964/1965 there was
a record harvest and still, prices rose by 10%
Ø The government used the method of QRs with varying
levels of severity until the Import-Export Policy of 1985-
1988.
Ø Devaluation of the Indian rupee caused the prices in India
to fall.
Ø This increased the exports from India in the short run.
Ø This in turn, balanced the BOP-balance of payments
{Exports – imports}
The 1991 Devaluation
Ø 1991 is often cited as the year of economic reform in India
Ø the Import-Export Policy of 1985-1988 replaced import
quotas with tariffs.
Ø Chaos in the gulf regions caused the prices of oil to rise at
the international level
Ø Indian economy was a developing economy, and hence
there was a high demand for oil
Ø To meet this demand, India again increased its exports.
Ø This disrupted the balance of payments.
 ZIMBABWEAN ECONOMY
The economy of Zimbabwe is collapsing from economic
mismanagement, resulting in 94% unemployment and
hyperinflation.
The economy poorly transitioned in recent years, deteriorating
from one of Africa's strongest economies to the world's worst.
Inflation has surpassed that of all other nations at over 80
sextillion(1021 )%[1] (although it is impossible to calculate an
accurate value), with the next highest in Ethiopia at 41%[4] .
It currently has the lowest GDP real growth rate in an
independent country and 3rd in total (behind Palestinian
territories.)
Hence, due to corruption or ‘rent seeking’ ,
Zimbabwe has reached the 22nd highest place
in hyperinflation.
The currency of Zimbabwe is presently at a
shocking low value.
Its internal as well as external debts are
intensively heavy and it’s quite difficult to get
out of the situation without help from other
countries such as US and South Africa.
CURRENCY CONVERTIBILITY
By convertibility of a currency, we mean that the currency
of a country can be freely converted into foreign
exchange at market determined rate of exchange, ie. the
rate determined by demand & supply.
Here, there are authorized dealers foreign exchange such as
banks, which constitute Foreign Exchange market. The
exporters who receive of other currencies can go to these
dealers and get their convertibility.
Importers who require foreign exchange, can go to these
dealers and get their home currency converted into
foreign exchange.
CONVERTIBILITY OF INDIAN
RUPEE
As a part of the new economic reforms initiated in 1991,
Rupee was made partly convertible under the ‘LERM’
scheme in which 60% of all receipts on current a/c could
be converted freely into rupees at market determined
exchange rate quoted by authorized dealers.
The other 40% exchange receipts on current a/c was meant
for meeting government needs.
Thus, partial convertibility of rupee on current a/c was
adopted so that essential imports could be made available
at lower exchange rate to ensure that their prices do not
rise much.
 FEMA
 The Foreign Exchange Regulation Act of 1973 (FERA) in India was replaced
on 1 June, 2000 by the Foreign Exchange Management Act (FEMA),
which was passed in the winter session of Parliament in 1999.

 FEMA, which has replaced FERA, had become the need of the hour since
FERA had become incompatible with the pro-liberalisation policies of the
Government of India. FEMA has brought a new management regime of
Foreign Exchange consistent with the emerging frame work of the World
Trade Organisation(WTO).


 Country 1 INR in INR
 American Dollar    0.0207748   48.1353
 Australian Dollar    0.0239238   41.7994
 British Pound    0.0127192   78.6215
 Canadian Dollar    0.0222539   44.9359 
 Chinese Yuan    0.141848   7.04982
 Euro    0.0141277   70.7829
 Hong Kong Dollar    0.161008   6.21089
 Japanese Yen    1.89551   0.527562
 Mexican Peso    0.275411   3.63093
 Nepalese Rupee    1.598   0.625784 
 New Zealand Dollar    0.0292557   34.1814
 Pakistan Rupee    1.72437   0.579922
 Singapore Dollar    0.0293899   34.0253 
 South African Rand    0.154729   6.4629
 Sri Lanka Rupee    2.38455   0.419366 
 Thai Baht    0.700212   1.42814 
What is currency futures
A transferable futures contract that specifies the price at
which a specified currency can be bought or sold at a
future date. Currency future contracts allow investors to
hedge against foreign exchange risk.
History of Currency
futures
Currency futures were first created at the
Chicago Mercantile Exchange (CME) in 1972
International Monetary Market (IMM) launched trading in
seven currency futures on May 16, 1972.
Currency futures in
India
Currency futures trading was started in Mumbai August 29,
2008.
With over 300 trading members including 11 banks registered in
this segment, the first day saw a very lively counter, with
nearly 70,000 contracts being traded.
The first trade on the NSE was by East India Securities Ltd
Amongst the banks, HDFC Bank carried out the first trade. The
largest trade was by Standard Chartered Bank constituting
15,000 contracts. Banks contributed 40 percent of the total
gross volume.
Fundamentals of Indian
currency futures

Currency futures can be traded between Indian rupees

and US dollar (US$ -- INR)
The trading of Indian currency futures can be done
between 9 am to 5 pm
The minimum size of currency futures is US$ 1000
periodically the value of the contract can be changed
by RBI and SEBI
The currency future can have maximum validity of 12
months
The currency futures contract can be settled in cash
Trade exchanges for
currency futures
There are 3 trade exchange that trades in currency futures
1.National Stock Exchange (NSE)
2.
3.Bombay Stock Exchange (BSE)
4.
5.Multi-Commodity Exchange (MCX)
6.
Importance of currency
futures
According to market analysts, introduction of currency
futures in the Indian market will give companies
greater flexibility in hedging their underlying
currency exposure and will bring in more liquidity
into the market as currency future or forex derivative
contract will enable a person, a bank or an institution
to buy or sell a particular currency against the other
on a specified future date, and at a price specified in
the contract.
RISK IN EXCHANGE RATE
MOVEMENT
The floating regime that we have around the world today
brings about volatility and uncertainty and creates risk for
all market participants. For example, when a Australian
wine merchant puts in an order to buy 1,000 cases of
French wine, the merchant may agree to pay in Euros, say
100 Euros per case, when the vintage is ready for
shipment in two years. However, over the next two years,
the value of the Australian Dollar could drop from 0.68
EUR/AUD to 1.0 EUR/AUD which raises the price of
each case from 68 Australian Dollars to 100 Australian
Dollars. Thus, pricing the wine in Euros exposes the
Australian wine merchant to a currency exchange-rate
risk.
 Bibliography
Economic times
Foreign exchange rate – Debjani Mitra Sarkar
Wikipedia
Macroeconomics by HL Ahuja
