UNIT I

FOREIGN EXCHANGE MANAGEMENT

Q. What are the Sources of demand for and supply of foreign Exchange? Also
Explain the Process of Determination of Exchange Rate.
Ans. Meaning of Foreign Exchange: Foreign Exchange is the system or process of
converting one national currency into another and of transferring the ownership of money
from one country to another country.
Meaning of Exchange Rate: Exchange rate is the rate at which one currency can be
exchanged for another.
Sources of Demand for Foreign Exchange :- The demand for foreign currency comes
from individuals and firms who have to make payments to foreigners in foreign currency. The
various sources are:-
(i) Import Companies
(ii) Foreign Investors
(iii) Speculators
(iv) Lending to Foreigners.
Relation between Exchange Rate and Demand for Foreign Exchange: There is an
inverse relation between exchange rate and demand for foreign exchange. It states that
when exchange rate increases, demand for foreign exchange decreases and when
exchange rate decreases, demand for foreign exchange increases. There may be two
situations:-
(i) When Exchange Rate Increases:- When exchange rate increases, the imports
becomes costlier and the importers curtail the demand for imports. Consequently, the
demand for foreign currency falls.
(ii) When Exchange Rate Decreases:- When exchange rate decreases, the imports
becomes cheaper and the importers increase the demand for imports. Consequently,
the demand for foreign currency increases.
This relation can be shown with the help of Diagram. Suppose a person wants to change
Rupees into U.S. Dollar.
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INTERNATIONAL FINANCIAL MANAGEMENT
Explanation:- In this figure Demand for US $ is shown on Horizontal axis i.e. OX-axis and
the exchange rate designated by the price of the US dollar(foreign currency) in terms of the
rupee is shown on Vertical axis i.e. OY-axis. DD is the Demand curve for US$. DD curve
represents that when exchange rate increases from OE to OE1, then demand for US$
decreases from OQ to OQ1. DD curve slopes downward to the right. It shows a negative
relation between exchange rate and demand for foreign currency.
Shifting of Demand Curve:- There are two possibilities:-
(i) When demand increases:- When demand for foreign currency increases then
demand curve will move to the right. It can be explained with the help of following
diagram:-
Y
D
E1
Exchange
Rate
E
O
Q1 Q
X
Demand for US $
D
Y
D
D1
Exchange
Rate
D
D1
O
Demand for US $
X
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(ii) When demand Decreases:- When demand for foreign currency decreases then
demand curve will move to the left. It can be explained with the help of following
diagram:-
Sources of Supply of Foreign Exchange:- The supply of foreign results from the receipt
of foreign currency. There are various sources:-
i) Exports Companies
ii) Foreign Investors
iii) Speculators
iv) Borrowings from Foreigners.
Relation between Supply of Foreign Exchange and Exchange Rate: There is a positive
relation between exchange rate and supply of foreign exchange. It states that when
exchange rate increases, supply of foreign exchange will also increases and when
exchange rate decreases, supply of foreign exchange will also decreases. There may be
two situations:-
i) When Exchange Rate Increases:- When exchange rate increases, the
exports earnings will also increase. Consequently, the supply of foreign
currency increases.
ii) When Exchange Rate Decreases:- When exchange rate decreases, the
exports earnings will also decrease. Consequently, the supply of foreign
currency decrease.
This relation can be shown with the help of Diagram.
Y
D1
D
Exchange
Rate
D1
D
O
Demand for US $
X
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Explanation:- In this figure Supply of US $ is shown on Horizontal axis i.e. OX-axis and the
exchange rate designated by the price of the US dollar(foreign currency) in terms of the
rupee is shown on Vertical axis i.e. OY-axis. SS is the Supply curve of US$. SS curve
represents that when exchange rate increases from OE to OE1, then supply of US$ will also
increases from OQ to OQ1. SS curve slopes upward to the right. It shows a positive relation
between exchange rate and supply of foreign currency.
Shifting of Supply Curve:- There are two possibilities:-
(i) When Supply Increases:- When supply of foreign currency increases then supply
curve will move to downward . It can be explained with the help of following diagram:-
(ii) When Supply Decreases:- When supply of foreign currency decreases then supply
curve will move to upward. It can be explained with the help of following diagram:-
Y
S
E1
Exchange
Rate
E
S
Q Q1
Y
Supply of US $
Y
S
Exchange
Rate
S1
O
Supply for US $
X
S1
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Process of Determination of Exchange Rate:-
It is the interplay of demand and supply forces that determines the exchange rate between
two currencies. The exchange rate between, say, the rupee and the US dollar depends upon
the demand for the US dollar and supply of US dollar in the Indian foreign exchange market.
The process of determination of rate of exchange can be explained with the help of following
diagram:-
Y
S1
E1
Rs/US$
E
S
Q Q1 O X Q2
Demand for and supply of US$
S
S1
D
D
D1
D1
Y
S1
Exchange
Rate
S
O
Supply for US $
X
S
S1
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Explanation: In this figure the exchange rate designated by the price of the US dollar
(foreign currency) in terms of the rupee is shown on the OY-axis and the supply of and
demand for the US dollar is shown on the OX-axis. The demand curve slopes downward to
the right. The supply curve slopes upward to the right. The equilibrium exchange rate arrives
where the demand curve intersects the supply curve. In this figure demand curve DD
intersect supply curve SS at point M and so exchange rate is determined OE. If the demand
for import rises owing to some factors at home, the demand for the US dollar will rise to D1D1
and intersect to supply at point N. The exchange rate will be OE1. But if the export rises as a
sequel to decline in the value of rupee and supply of dollar increases to S1S1, the exchange
rate will again be OE. Quite evidently, frequent shifts in demand and supply conditions cause
the exchange rate to adjust frequently to a new equilibrium.
Q. Explain the Balance of Payment in detail.
Ans. Balance of payments: Balance of payments is a statement listing receipts and
payments in the international transactions of a country. In other words, it records the inflow
and the outflow of foreign exchange. The system of recording is based on the concept of
double entry book keeping, where the credit side shows the receipts of foreign exchange
from abroad and the debit side shows payments in foreign exchange to foreign residents.
Disequilibrium does occur, but not form accounting point of view because debit and credit
balances equal each other if the various entries are properly made.
Again receipts and payments are compartmentalized into two heads:
(1) Current Account: The current account records the receipts and payments of foreign
exchange in the following ways. They are:
Current Account Receipts Current Account Payments
Export of Goods Imports of Goods
Invisibles: Invisibles:
Services Services
Unilateral transfers Unilateral transfers
Investment Income Investment Income
Non-monetary movement of gold Non-monetary movement of gold
The explanations are:
(i) Export and Imports of Goods: Export of goods effects the inflow of foreign
exchange into the country while import of goods causes outflow of foreign
exchange from the country. The difference between the two is known as the
balance of trade.
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If export exceeds import, balance of trade is in surplus.
Excess of import over export means deficit balance of trade.
(ii) Exports of Invisibles: Trade in services embraces receipts and payments on
account of travel and tourism, financial charges concerning banking, insurance,
transportation and so on. Investment income includes interest, dividend and
other such receipts and payments.
(iii) Non-monetary movement of gold: There is another item in the current
account, known as non-monetary movement of gold. It may be noted that there
are two types of sale and purchase of gold. One is termed as monetary sale and
purchase that influences the international monetary reserves. The other is non-
monetary sale and purchase of gold. This is for industrial purposes and is shown
in the current account.
(2) Capital Account: Similarly capital account transactions take place in the following
ways:
Capital Account Receipts Capital Account Payments
Long term inflow of funds Long term outflow of funds
Short term inflow of funds Short term outflow of funds
The flow on capital account is long-term as well as short-term. The difference between
the two is that the former involves maturity over one year, while the short-term flows
are affected for one year or less.
(i) The credit side records the official and private borrowing from abroad net of
repayments, direct and portfolio investment and short-term investments into the
country.
(ii) The debit side includes disinvestment of capital, country's investment abroad,
loans given to foreign government or a foreign party and the bank balances held
abroad
Balance of Payments
Balance of Trade = Export of goods-Imports of goods
Balance of Current Account = Balance of Trade + Net Earnings on Invisibles
Balance of Capital Account = Foreign exchange inflow - Foreign exchange
outflow, on account of foreign investment, foreign loans, banking transactions,
and other capital flows
Overall balance of payments = Balance of current account + Balance of capital
account

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Definition of Balance of Payment
According to Kindleberger
"The balance of payment of a country is a systematic record of all economic
transactions between its resi
Features of Balance of Payments:
(1) Systematic Records: It is a systematic record of receipts and payments of a country
with other countries.
(2) Fixed Period of time: It is a statement of account pertaining to a given period of time,
usually one year.
(3) Comprehensiveness: It includes all the three items, i.e.,
Visible
Invisible
Capital Transfers
(4) Double Entry System: Receipts and payments are recorded on the basis of double
entry system.
(5) Adjustment of Differences: Whenever there is difference in actual total receipts and
payments, need is felt for necessary adjustment.
(6) All items-Government and Non-Government: Balance of payments includes
receipts and payments of all items government and non-government.
Q. What are the different approaches for adjustment of Balance of Payments?
Ans. Different Approaches to Adjustment:
(A) The Classical View: Classical economists were aware of the balance of payments
disequilibrium, but they were of the view that it was self adjusting. Their view, which
was based on the price-specie-flow mechanism, stated that an increase in money
supply raises domestic prices, where by exports become uncompetitive and export
earnings drop. Foreign goods become cheaper, and imports rise, causing the current
account balance to go into deficit in the sequel. Precious metal leaves the country in
order to finance imports. As a result, the quantity of money lessens, that lowers the
price level. Lower prices in the economy lead to greater export and trade balances
reaches equilibrium once again.
(B) Elasticity Approach: After the collapse of the gold standard, the classical view could
not remain tenable. The adjustment in the balance of payments disequilibrium was
thought of in terms of changes in the fixed exchange rate, that is through devaluation
or upward revaluation. But its success was dependent upon the elasticity of demand
for export and import. Marshall and Lerner explained this phenomenon through the
"elasticity" approach.
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The elasticity approach is based on partial equilibrium analysis where everything is
held constant, except for the effects of exchange rate changes on export or import.
There are some other assumptions:-
(i) The elasticity of supply of output is infinite so that the price of export in home
currency does not rise as demand increases.
(ii) Elasticity approach ignores the monetary affects of variation in exchange rates.
Based on these assumptions, devaluation helps improve the current balance only if:
Em + Ex > 1
Em = Price Elasticity of demand for import.
Ex = Price Elasticity of demand for export.
If the elasticity of demand is greater than unitary, the import bill will contract and export
earnings will increase. Trade deficit will be removed. When the devaluation of currency
leads to a fall in export earnings in the initial stage and then a rise in export earnings, making
the earning curve look like the alphabet, J it is called J-curve effect.
J-curve can be explained with the help of following diagram:-
Explanation: - In this figure time is shown on OX- axis and Balance of trade is shown on OY-
axis. Trade balance moves deeper into the deficit zone immediately after devaluation. But
then it gradually improves and crosses into surplus zone. The curve resembles the alphabet,
J and so, it is known as the J-curve Effect.
Currency
Depreciation
Trade balance eventually improves
Trade balance initially deteriorates
+ -
- -
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Criticism:- The weakness of the elasticity approach is that it is a partial equilibrium analysis
and does not consider the supply and cost changes as a result of devaluation as well as the
income and the expenditure effects of exchange rate changes. In this context, it may be
mentioned that it was Stern (1973) who incorporated the concept of supply elasticity in the
elasticity approach. According to him, devaluation could improve balance of payments only
when:
Where X = Exports
M = Imports.
EDx = Elasticity of demand for exports
ESx = Elasticity of supply for exports
EDm = Elasticity of demand for imports
ESm= Elasticity of supply for imports.
(C) Keynesian Approach: The Keynesian view takes into consideration primarily the
income effect that was ignored under the elasticity approach. Here the readers are
acquainted with three different views that are based on the Keynesian approach.
(1) Absorption Approach: The absorption approach explains the relationship
between domestic output and trade balance and conceives of adjustment in a
different way. Sidney A. Alexander treats balance of trade as a residual given by
the difference between what the economy produces and what it takes for
domestic use or what it absorbs. He begins with the contention that the total
output is equal to the sum of consumption, investment, government spending
and net export. In the form of an equation,
Y = C + I + G + (X-M)
Y = Total output C = Consumption
I = Investment G = Government spending
X-M = Net export
Substituting C+I+G by absorption, A, it can be rewritten as:
Y = A + X-M
Y-A= X-M
This means that the amount by which total output exceeds total spending or
absorption is represented by net export, which means a surplus balance of trade. This
also means that if A>Y, deficit balance of trade will occur. This is because excess
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absorption in the absence of desired output will cause imports. Thus, in order to bring
equilibrium to the balance of trade, the government has to increase output or income.
Increase in income without corresponding and equal increase in absorption will lead to
improvement in balance of trade. This is called the expenditure switching policy.
(2) Mundell's View: Mundell also incorporates interest rate and capital account in
the ambit of discussion. In his view it is not only government spending but also
interest rate that influences income as well as balance of payments. While larger
government spending increases income, an increase in income leads to rise in
import. With a positive marginal propensity to import, any rise in income as a
sequel to increase in government spending will lead to greater imports and
worsen the current account. However, changes in interest rate influence both
the capital account and the current account. A higher interest rate will lead to
improvement in current account through lowering of income. At the same time, a
higher interest rate will improve the capital account by attracting foreign
investment flow.
(3) New Cambridge School Approach: This is a special case of absorption
approach. It takes into account savings, investment, taxes and government
spending and their impact on the trade account. In the form of an equation, it can
be written as:
S+T+M = G+X+I
OR (S-I) + (T-G) + (M-X) = 0
OR (X-M) =(S-I) + (T-G)
The theory assumes that (S-I) and (T-G) are determined independently of each other
and of the trade gap. (S-I) in normally fixed as the private sector has a fixed net level of
saving. And so the balance of payments deficit or surplus is dependent upon (t-G) and
the constant (S-I). In other words, with constant (S-I) , it is only the manipulation of (T-
G) that is necessary and a sufficient tool for balance of payments adjustment.
(D) Monetary Approach: Monetarists believe that the balance of payments
disequilibrium is a monetary and not a structural phenomenon. To explain the
phenomenon, it is assumed that
(1) Demand for money depends upon the domestic price level and real income. The
relationship among these three variables does not change significantly over
time. In form of an equation, it can be written as:
L = kPY
Here,
L = Demand for money
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P = Domestic Price Level
Y = Real Income
(2) Money supply depends upon domestic credit and international reserves held
and money multiplier. It can be written as
M = (R+D)m
Here,
M = Money Supply
R = International Reserves
D = Domestic credit
m = Money multiplier
(3) Domestic price level depends on the foreign price level, and the domestic
currency price of foreign current, we can write it as
P = EP*
Here,
P = Domestic Price Level
P* = Foreign Price Level
E = Domestic currency price of foreign currency.
(4) Demand for money equals the supply of money because there is held an
equilibrium in the money market, which is
L = M
The process of adjustment varies among the types of exchange rate regime the country has
opted for .
(i) Fixed Exchange Rate Regime : In a fixed exchange rate regime or in gold standard,
if the demand for money, that is the amount of money people wish to hold, is
greater than the supply of money, the excess demand would be met through the
inflow of money from abroad.
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On the contrary, with the supply of money being in excess of the demand for it,
the excess supply is eliminated through the outflow of money to other countries.
The inflow and outflow influence the balance of payments.
(ii) Floating Exchange Rate Regime : However, in a floating rate regime, the demand for
money is adjusted to the supply of money via changes in the exchange rate. Especially
in a situation when the central bank makes no market intervention, the international
reserves component of the monetary base remains unchanged. The balance of
payments remains in equilibrium with neither surplus nor deficit. The spot exchange
rate is determined by the quantity of money supplied and the quantity of money
demanded.
When the central bank increases domestic credit through open market operations, the
supply of money is greater than the demand for it. Households increase their imports
and with increased demand for imports, the domestic currency will depreciate and it
will continue depreciating until the supply of money equals the demand fore money.
Conversely, with decrease in domestic credit, the households reduce their import.
Domestic currency will appreciate and it will continue appreciating until supply of
money equals demand for money.
Q. Write a short note on following:-
(A) Nominal Exchange Rate
(B) Real Exchange Rate
(C) Effective Exchange Rate
Ans:-
(A) Nominal Exchange Rate :- The nominal exchange rate is the price in domestic
currency of one unit of a foreign currency. In other words, the value of a country's currency in
relation to other currencies without adjustment for the rate of inflation.
The nominal exchange rate is defined as the number of units of the domestic currency that
can purchase a unit of a given foreign currency. There are two situations:-
(ii) A decrease in this variable is termed nominal appreciation of the currency.
(iii) An increase in this variable is termed nominal depreciation of the currency.
Thus we can say that nominal exchange rate tell us the purchasing power of our own
currency in exchange for a foreign currency. It does not reflect changes in prive levels in the
two nations.
(B) Real Exchange Rate:- The real exchange rate is defined as the ratio of the domestic
price level and the price level abroad, where the latter is converted into domestic
currency units via the current nominal exchange rate.

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Formally,
Pd
Q = ----------
Pf
where
Q = Real Exchange Rate
Pd = Domestic price level
Pf =Foreign Price Level
This rate tells us how many times more goods and services can be purchased abroad
(after conversion into a foreign currency) than in the domestic market for a given amount. In
practice, changes of the real exchange rate rather than its absolute level are important. An
increase in the real exchange rate Q is termed appreciation of the real exchange rate, a
decrease is termed depreciation. In contrast to the nominal exchange rate, the real
exchange rate is always 'floating", since even in the regime of a fixed nominal exchange rate
, Q can move via price-level changes.
The real exchange rate adjusts the nominal exchange rate for changes in nation's
price levels and thereby measurers the purchasing power of domestic goods and services in
exchange for foreign goods and services.
Equation of Real Exchange Rate:-
et (1+ IA)t
---- = --------------
e0 (1+ IB )t
e0 = A' currency value for one unit of B's currency at the beginning of the period.
et = Real exchange rate in period t
IA = Rate of Inflation in A country
IB = Rate of Inflation in B Country.
For Example:- If India has an inflation rate of 5 per cent and the United State of America has
a 3 per cent rate of inflation and if the initial exchange rate is Rs. 40/US$, the value of the
rupee in a two year period will be:-
(1.05)2
et = 40 X ---------------
(1.03)2
= Rs. 41.57/US$
Such an inflation-adjusted rate is known as the real exchange rate.
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(C) Effective Rate of Exchange :- The weighted average of a country's currency relative
to an index or basket of other major currencies adjusted for the effects of inflation. The
weights are determined by comparing the relative trade balances, in terms of one
country's currency, with each other country within the index.
This exchange rate is used to determine an individual country's currency value relative
to the other major currencies in the index, as adjusted for the effects of inflation. All
currencies within the said index are the major currencies being traded today: U.S.
dollar, Japanese yen, euro, etc.
This is also the value that an individual consumer will pay for an imported good at the
consumer level. This price will include any tariffs and transactions costs associated
with importing the good
Nominal Effective Exchange Rate:- The unadjusted weighted average value of a
country's currency relative to all major currencies being traded within an index or pool
of currencies. The weights are determined by the importance a home country places
on all other currencies traded within the pool, as measured by the balance of trade.
Real Effective Exchange Rate:- The weighted average of a country's currency
relative to an index or basket of other major currencies adjusted for the effects of
inflation. The weights are determined by comparing the relative trade balances, in
terms of one country's currency, with each other country within the index.
Q. Explain Purchasing Power Parity (PPP) Theory.
Ans. Purchasing Power Parity Theory:- There are two versions of Purchasing Power
Parity theory :-
(1) Absolute Version of the PPP theory.
(2) Relative Version of the PPP theory.
(1) Absolute Version of the PPP theory:- The PPP theory suggests that at any point of
time, the rate of exchange between two currencies is determined by their purchasing
power.
If e is the exchange rate and PA and PB are the purchasing power of the currencies in
the two countries, A and B, the equation can be written as
PA
e = -------
PB
In fact, this theory is based on the theory of one price in which the domestic price of any
commodity equals its foreign price quotes in the same currency. To explain it, if the
exchange rate is Rs.2/US$, the price of a particular commodity must be US$50 in the
United state of America if it is Rs. 100 in India. In other words
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US$ price of a commodity X Price of US$ = Rupee price of the commodity
If inflation in one country causes a temporary deviation from the equilibrium,
arbitrageurs will begin operating, as a result of which equilibrium will be restored
through changes in the exchange rate.
For Example:- Suppose, the price of the commodity soars up in India to Rs. 125, the
arbitrageurs will buy that commodity in the United States of America and sell it in India
earning a profit of RS. 25. This will go on till the exchange rates moves to Rs. 2.5/US$
and the profit potential of arbitrage is eliminated.
The exchange rate adjustment resulting from inflation may be explained further. If the
Indian commodity turns costlier, its export will fall. At the same time, its import from the
United States of America will expand as the import gets cheaper. Higher import will
raise the demand for the US dollar raising, in turn, its value vis--vis rupee.
Limitation of Absolute Version:- However this version of the theory holds good, if
the same commodities are included in the same proportion in the domestic market
basket and the world market basket. Since it is normally not so, the theory faces a
serious limitation. Moreover, it does not cover non-traded goods and services, where
the transactions cost is significant.
(2) Relative Version of the PPP theory:- In view of the above limitation, another version
of this theory has evolved, which is known as the relative version of the PPP theory.
The relative version of PPP theory states that the exchange rate between the
currencies of the tow countries should be a constant multiple of the general price
indices prevailing in two countries. In other words, percentage change in the
exchange rates should equal the percentage change in the ratio of price indices in the
two countries. To put it in the form of an equation, where I A and IB are the rates of
inflation in country A and country B, e0 is the A' currency value for one unit of B's
currency at the beginning of the period and et is the spot exchange rate in period t,
then
et (1+ IA)t
----- = ---------------
e0 (1+ IB )t
e0 = A' currency value for one unit of B's currency at the beginning of the period.
et = Spot exchange rate in period t
IA = Rate of Inflation in A country
IB = Rate of Inflation in B Country.
For Example:- If India has an inflation rate of 5 per cent and the United State of America has
a 3 per cent rate of inflation and if the initial exchange rate is Rs. 40/US$, the value of the
rupee in a two year period will be:-
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(1.05)2
et= 40 X --------------
(1.03)2
= Rs. 41.57/US$
This theory suggests that a country with a high rate of inflation should devlauate its currency
relative to the currency of the countries with lower rates of inflation.
Conclusion:-
Merits:- PPP theory holds good if:
(1) Changes in the economy orginate from the monetary sector.
(2) There is no structural changes in the economy, such as changes in tariff and in
technology.
Demerits:- PPP theory does not hold good in following situations:-
(1) The assumptions of this theory do no necessarily hold good in real life.
(2) There are other factors such as interest rates, governmental interference and so
on that influence the exchange rate.
Q. Explain Monetary Approach of Exchange Rate.
Ans. Monetary Approach:- Moneatry Approach is divided into two sections:-
(1) Monetary Approach of Flexible Price Version.
(2) Monetary Approach of Sticky-price Version.
1. Monetary Approach of Flexible Price Version:- The monetary approach of the
flexible price version emphasises the role of demand for money and the supply of
money in determination of the exchange rate. The exchange rate between two
currencies, accordingly to this approach, is ratio of the value of two currencies
determined on the basis of the two countries money supply and money demand
positions. There are three situations:-
(i) Any increase in money supply raises the domestic price level and the resultant
increase in price level lowers the value of the domestic currency. It can also be
explained with the help of following equation:
Increase in Money Supply Higher Price Level
Depreciation of domestic currency.
(ii) If the increase in money supply is lower than theincrease in real domestic
output, the excess of real domestic output over the money supply causes
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excess demand for money balances and leads to a lowering of domestic prices,
which causes an improvement in the value of domestic currency.
Money Supply being less than real domestic output excess
demand for money balances lower domestic prices
Appreciation of domestic currency.
(iii) Monetary theory explains that a rise in domestic interest rate lowers the demand
for money in the domestic economy relative to its supply and thereby causes
depreciation in the value of domestic currency.
Rise in interest rate lower demand for money
domestic currency depreciates.
Criticism:- However, critics of this theory argue that this theory does not hold good in
the short run.
(2) Monetary Approach of Sticky-Price Version:- The sticky price version makes a
more detailed study of interest rate differential. The argument in favour of this
approach is that an increase in money supply (through changes in the real interest rate
differential) leads to depreciation in the value of domestic currency.
Assumptions:-
The monetary approach of the sticky price version rests on a couple of assumptions.
Money Supply is Endogenous:- The money supply in a country is
endogenous, meaning that it is positively related to the market interest rate.
PPP Theory applies in long run:- The second assumption is that the PPP
theory applies in the long run and so the expected inflation differential changes
have a role to play in the determination of the exchange rate.
Explanation:- The sticky price theory can be explained in two sections:-
(A) Study of Interest Rate Differential:- The sticky price version makes a detailed
study of interest rate differential. The interest rate differential has three
components:-
(i) One denotes that when the interest rate rises, the money balances held by
the public come to the money market in lure of high interest rate. Money
supply increases leading to currency depreciation.
Increase in Money Supply Depreciation of domestic currency.
(ii) Second denotes that if interest rate rises, financial institutions increase
the funds to be supplied to the money market. Money supply increases
and the value of domestic currency depreciates.
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Rise in Interest Rate Increase in money supply (loanable funds)
Depreciation of domestic currency.
(iii) The third is that a rise in interest rate stimulates the capital inflow into the
country that, like the balance of payments approach, causes appreciation
in the value of domestic currency.
Rise in Interest Rate Greater inflow of capital
Appreciation of domestic currency.
(B) Study of Inflation Rate Differential:- The sticky price version specially mentions the
expected inflation rate differential. A rise in inflation rate compared to that in the foreign
country leads to depreciation in the value of domestic currency. This is because a rise
in inflation rate decreases the real interest rate and discourages the capital inflow.
Increase in Money Supply Price rise Lower real interest rate
Lower inflow of capital depreciation of domestic currency.
Q. Explain the Portfolio Balance Approach.
Ans. Introduction:- The portfolio balance approach suggests that it is not only the
monetary factor but also the holding of financial assets such as domestic and foreign bonds
that influences the exchange rate. If foreign bonds and domestic bonds turn out to be perfect
substitutes and if the conditions of interest arbitrage hold good, the portfolio balance
approach will not be different from the monetary approach. But since these conditions do not
hold good in real life, the portfolio balance approach maintains a distinction from the
monetary approach.
This approach suggests that the exchange rate is determined by the interaction of following
factors:-
(i) Real Income
(ii) Interest Rates
(iii) Risk
(iv) Price Level
(v) Wealth
If a changes takes place in these variables, the investor re-establishes a desired balance in
its portfolio. The re-establishment of the portfolio balance needs some adjustments which, in
turn, influence the demand for foreign assets. Any such change influences the exchange
rate. For Example:-
(1) A rise in real domestic income leads to a greater demand for foreign bonds. Demand
for foreign currency will rise, in turn, depreciating the domestic currency.
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Domestic Income /Wealth Increase Greater demand for foreign
financial assets depreciation of domestic currency.
(2) Again, the legal, political, and economic conditions in a foreign country may be
different from those at home. If foreign bonds turn out to be more risky on these
grounds, the demand for foreign currency will decrease, in turn, appreciating the value
of domestic currency. Similarly, rising inflation in a foreign country makes foreign
bonds risky. The demand for foreign currency will drop and the domestic currency will
appreciate.
Foreign financial assets being more risky demand for them
decreases Appreciation of domestic currency.
When the exchange rate changes, the above mentioned variables change, which
cause a shift in the desired balance in the investment portfolio. Thus two -way forces
continue to act until equilibrium is reached, But the equilibrium is only short lived.
Note: - It may be asserted that although real income, interest rate, risk and price level have
an important role to play in exchange rate determination, the significance of wealth effect is
quite large. When a country's wealth increases, holding of foreign assets increases.
Demand for foreign currency goes up, which causes depreciation in the value of domestic
currency.
Q. Write a short note on following:
(A) Fixed Exchange Rate System
(B) Flexible Exchange Rate System
Ans. Fixed Exchange Rate System:- Fixed exchange rates refer to the system under the
gold standard where the rate of exchange tends to stabilize around the mint par value. Any
large variation of the rate of exchange from the mint par value would entail flow of gold into or
from the country. This would have the effect of bringing the exchange rate back to the mint
par value.
In the present day situation where gold standard no longer exists, fixed rates of exchange
refer to maintenance of external value of the currency at a predetermined level. Whenever
the exchange rate differs from this level it is corrected through official intervention. There
may be two situations:
1. When exports greater than imports: If the exports of the country exceed imports,
the demand for the local currency in the exchange market will This will raise the value
of the currency to the market. Where the increase in value is beyond the support point
and central bank of the country intervenes in the market to sell local currency and thus
the foreign exchange reserves of the country increase. The sale of local currency in
the market leads to increase in money supply in the country causing inflation.
Revaluation may be resorted to allow for more imports and contain inflation.
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2. When imports greater than exports: If the country is facing balance of payments
deficits due to higher imports, it would have the effect of increase in supply of local
currency in the foreign and the central bank may have to intervene by buying local
currency at a higher price. In the process, the foreign reserves of the country are
depicted because the foreign currencies are exchanges in the market for buying local
currency. To make up for the deficit, the country may be compelled to devalue the
currency. The large scale buying of local currency will reduce the domestic money
supply and may help fight inflation.
Under fixed rates, the compulsion to devalue the currency may be postponed or avoided by
mopping up additional reserves. One such way is exchange of currency reserves between
the central banks of countries.
1. When demand of foreign currency is greater than supply ( Demand > Supply)
When demand of foreign currency is more than supply, then central bank maintains
the exchange rate by increasing the foreign currency in market. In this way supply of
foreign currency will increases and there will be equality between demand & supply.
Excess Demand Sale of foreign Currency by Central Bank.
Results: In case of demand more than supply price of foreign currency in terms of domestic
currency would be costly. Thus Central Bank supply foreign currency in market.
2. When Supply of foreign currency is greater than Demand ( Supply > Demand)
When Supply of foreign currency is more than demand, then central bank maintains
the exchange rate by purchase of foreign currency or creates the demand of foreign
currency in market through. In this way supply of foreign currency will decrease and
there will be equality between demand & Supply.
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Excess supply Purchase of foreign currency by central bank .
Results : In case of supply more than demand price of foreign currency in terms of
domestic currency would be cheaper. Central bank maintains the Foreign currency in
market through.
Conclusion :
Demand > Supply ------------- Sale of foreign currency.
Supply > Demand ------------- purchase of foreign currency.
Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to
automatically adjust the balance of trade. When a trade deficit occurs, there will be
increased demand for the foreign (rather than domestic) currency which will push up the
price of the foreign currency in terms of the domestic currency. That in turn makes the price
of foreign goods less attractive to the domestic market and thus pushes down the trade
deficit. Under fixed exchange rates, this automatic re-balancing does not occur.
(B) Floating Exchange Rate System: A floating exchange rate or fluctuating exchange
rate is a type of exchange rate regime wherein a currency's value is allowed to
fluctuate according to the foreign exchange market. A currency that uses a floating
exchange rate is known as a floating currency. It is not possible for a developing
country to maintain the stability in the rate of exchange for its currency in the exchange
market. Thus the central bank has to show or provide order line in the movement of
exchange rate. There are two situations:
1. Crawling Peg: In this situation central bank fix the upper limit & lower limit of
exchange rate. The exchange rate will lie between these two limits.
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Upper Limit
Lower Limit
This can be explained with diagram:
2. Over shooting peg : Under this condition exchange rate can over the upper
limit and below the lower
(C) Hybrid Exchange Rate System : It is a combination of fixed and flexible exchange
rate, this system hanges par values of currency by small amount at frequent specified
intervals.
Unlike the earlier uniform system under either the gold standard or Breton Woods,
today's exchange rate system fits into no tidy mold. Without anyone's is having
planned it, the world has moved to a hybrid exchange rate system. The major features
are as follows:
1. A few countries allow their currencies to float freely, as the United States has for
some periods in the last two decades. In this approach country allows markets to
determine its currency's value and it rarely intervenes.
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2. Some major countries have managed but flexible exchange rates. Today this
group includes Canada, Japan, and more recently Britain. Under this system a
country will buy or sell its currency to reduce the day-to-day volatility of currency
fluctuations.
3. Many countries particularly small ones change their currencies to a major
currency or to a basket of currencies.
4. Some countries join together in a currency bloc in order to stabilize exchange
rates among themselves while allowing their currencies to move flexibly relative
to those of the rest of the world.
5. In addition almost all countries tend to intervene either when markets become
disorderly or when exchange rates seem far out of line with the fundamentals
that is with exchange rates that are appropriate for existing price levels and
trade flows
Q. Explain the Competitive Mint Par Theory.
Ans. Mint parity theory explains the determination of exchange rate between the two
countries which are a gold standard. In a country which is on gold standard, the currency is
either made of gold or is convertible into gold at a fixed rate. There are also no restrictions on
the export or import of gold.
The rate of exchange between the gold standard countries is determined on a weight to
weight basis of the gold countries of their currencies. In other words, the exchange rate is
determined by the gold equivalents of the currencies involved. The mint par is an expression
of the ratio of weights of gold's used for the coinage of the currencies. For examples before
World War 1 England and American were on gold standard. The mint par between these two
countries was pound, one of England+4.866 dollars of America. The rate of exchange
showed that one pound of England contained as much fine gold as 4.866 dollars contained
in America. The ratio of weights of metal1 pound= $4.866 was called the mint parity.
The mint par was a fixed rate. It remained so long as the monetary laws of the country remain
unchanged. The current or the market rate of exchange, however, fluctuated from time to
time due to changes in the balance of payments of the respective countries.
This theory is associated with the working of the international gold standard. Under this
system, the currency in use was made of gold or was convertible into gold at a fixed rate. The
value of the currency unit was defined in terms of certain weight of gold, that is, so many
grains of gold to the rupee, the dollar, the pound, etc. The central bank of the country was
always ready to buy and sell gold at the specified price. The rate at which the standard
money of the country was convertible into gold was called the mint price of gold. If the official
British price of gold was 6 per ounce and of the US price of gold $ 36 per ounce, they were
the mint price of gold in the respective countries. The exchange rate between the dollar and
the pound would be fixed at $ 36/ 6 = $ 6. This rate was called the mint parity or mint par of
exchange because it was based on the mint price of gold. Thus under the gold standard, the
normal or basic rate of exchange was equal to the ratio of their mint par values (R=$/).
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But the actual rate of exchange could vary above and below the mint parity by the cost
of shipping gold between the two countries. To illustrate this, suppose the US has a deficit in
its balance of payments with Britain. The difference between the value of imports and
exports will have to be paid in gold by US importers because the demand for pounds
exceeds the supply of pounds. But the transshipment of gold involves transportation cost
and other handling charges, insurance, etc. Suppose the shipping cost of gold from the US
to Britain in 3 cents. So the US importers will have to spend $ 6.03 ($ 6 + .03c) for getting 1.
This could be the exchange rate which is the US gold export point or upper specie point.
The exchange rate under the gold standard is determined by the forces of demand and
supply between the gold points and is prevented from moving outside the gold points by
shipment of gold
Figure shows the determination of the exchange rate under the gold standard. The
exchange rate OR is set up at point E where the demand and supply curves DD? and SS'
intersect. The exchange rate need not be at the mint parity. It can be anywhere between the
gold points depending on the shape of the
Demand and supply curves. The mini parity is simply meant to define the us gold export point
($6.03) and the us gold import point ($5.97)where the us beauty is prepared to sell
any amount of gold at the price of $36 per ounce, no American would pay more than $6.03
per pound, because he can get any quantity of pounds at the price by exporting gold. That is
why ,the us supply curve of pounds becomes perfectly elastic or horizontal at the us gold
export point. This is shown by horizontal portion S' of the SS' supply curve. Similarly, as the
US treasury is prepared to buy any quantity of gold at $36 per ounce, no American would sell
pounds less than $ 5.97 because he can sell any quantity of pounds at that price by gold
imports .Thus the US demand curve for pounds becomes perfectly elastic at the US gold
import point. This is shown by horizontal portion D' of the demand curve DD'.
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Gold export point
S'
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Gold import point
S
Quantity of foreign exchange Pounds
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The mint parity theory has long been discarded ever since the gold standard broke down.
No country is on the gold standard. There are neither free movements of gold nor gold
parities. So this theory has only an academic interest.
Q. Write a short note on Overvalued and Undervalued Currencies.
Ans. Overvalued currency: Currency whose value is artificially higher than its market
value because of governmental support. A currency whose quoted or traded rate is above
what the market believes to be its correct level, given its country's balance of payments
position and other relevant factors. Traders and speculators would be reluctant to buy a
currency they believed to be overvalued as that suggests it should fall. If the domestic
currency is considered overvalued, exporters would delay bringing in foreign-currency
payments, while importers would benefit from advancing payments.
Leads and lags: In international trade, the gaps between shipment and payment. These
gaps can be exaggerated as importers and exporters try to advance or delay their payments
or receipts according to how they expect exchange rates to move. If devaluation of the
domestic currency is forecast, importers with a foreign-currency obligation will hurry to pay
(if they wait, they will need more local currency to pay the bill) - they 'lead' their payments.
Exporters, on the other hand, would benefit in that situation by delaying converting foreign
currency receipts into the local currency - they 'lag'. Before the virtual abolition of exchange
controls in Australia in December 1983, leads and lags could not be exploited extensively
because, for example, exporters had to convert foreign receipts into $A within 30 days.
Leads and lags are also used in a variety of economic models; for example, investment this
year might be determined by last year's profits. Economists talk of the policy lag: in this
context the inside lag is the time taken to implement a policy change once the need for it is
recognised, and the outside lag is the time taken for the change to affect the economy once
implemented.
Undervalued currency: A currency which is quoted or traded below what is perceived as its
true market value, given its country's balance of payments position, economy, interest rates
and so on. An undervalued currency will be in demand as traders and speculators believe it
will rise and therefore will buy it to make a profit; enough of such buying and expectations
become self-fulfilling as demand pushes the currency higher. Exporters' and importers'
views on currencies would influence how they manage cash flows. An exporter would bring
foreign-exchange receipts into the country if the domestic currency were considered
undervalued and therefore likely to rise; an importer would delay payments in the hope that
the undervalued domestic currency would rise, thereby reducing the cost of imports.
Q. Explain the Evolution of International Monetary System.
Ans. International Monetary System: International monetary system is defined as a set of
procedures, mechanism, processes, and institutions to establish that rate at which
exchange rate is determined in respect to other currency. To understand the complex
procedure of international trading practice, it is pertinent to have a look at the historical
perspective of the financial and monetary system.
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The whole story of monetary and financial system revolves around exchange rate i.e. the
rate at which currency is exchanged among different countries for settlement of payments
arising from trading of goods and services. To have an understanding of historical
perspectives of international monetary system, firstly one must have a knowledge of
exchange rate regimes. Various exchange rate regimes from 1880 to till date at the
international level are described as follows:
(A) Monetary System before First World War (1880-1914 Era of Gold Standard): The
oldest system of exchange rate was known as "Gold Species Standard" in which
actual currency contained a fixed content of gold. The other version called "Gold
Bullion Standard", where the basis of money remained fixed gold but the authorities
were ready to convert, at a fixed rate, the paper currency issued by them into paper
currency of another country which is operating in Gold. The exchange rate between
pair of two currencies was determined by respective exchange rates against 'Gold'
which was called 'Mint Parity'. The main rules were followed with respect to this
conversion:
The authorities must fix some once-for-all conversion rate of paper money
issued by them into gold.
There must be free flow of Gold between countries on Gold Standard.
The money supply should be tied with the amount of Gold reserves kept by
authorities.
The gold standard was very rigid and during great depression it vanished completely.
(B) The Gold Exchange Standard (1925-1931) : With the failure of gold standard during
first world war, a much refined form of exchange regime was initiated in 1925 in which
US and England could hold gold reserve and other nations could hold both gold and
dollars as reserves. In 1931, England took its foot back which resulted in abolition of
this regime.
(C) The Gold Exchange Standard ( 1925-1931) : With the failure of gold standard during
first world war, a much refined form of exchange regime was initiated in 1925 in which
US and England could hold gold reserve and other nations could hold both gold and
dollars as reserves. In 1931, England took its foot back which resulted in abolition of
this regime.
(D) The Bretton Woods Era (1946 to 1971) : To streamline and revamp the war ravaged
world economy & monetary system allied powers held a conference in 'Bretton
Woods', which gave birth to two super institutions:
(i) International Monetary Fund (IMF)
(ii) World Bank (WB)
In Bretton Woods modified form of Gold Exchange Standard was set up with the
following characteristics:
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(i) One US dollar conversion rate was fixed by the USA as one dollar = 35 ounce of
Gold.
(ii) Other member agreed to fix the parities of their currencies vis--vis dollar with
respect to permissible central parity with one per cent fluctuation on either side.
In case of crossing the limits, the authorities were free hand to intervene to bring
back the exchange rate within limits.
Mechanism of Bretton Woods: The mechanism of Bretton Woods can be understood with
the help of the following illustration and diagram:
Suppose there is a supply curve SS and demand curve DD for dollars. On OY-axis price of
dollar with respect of rupees are shown. Suppose Indian residents start demanding
American goods & services. Naturally demand of US Dollar will rise. And suppose US
residents develop an interest in buying goods and services from India, it will increase supply
of dollars from America.
Assume a parity rate of exchange is Rs. 10.00 per dollar. The +1% limits are therefore Rs.
10.10 (Upper Support) and Rs. 9.90 (Lower Support).
As long as the demand and supply curve intersect within the permissible rant; Indian
authorities will not intervene.
Suppose demand curve shifts towards right due to a shift in preference of Indian towards
buying American goods and the market determined exchange rate would fall outside the
band, in this situation, Indian authorities will intervene and buy rupees and supply dollars to
bring back the demand curve within permissible band. The vice-versa can also happen.
D1
D
S
Rs./$
10.10
Upper Support
Parity
10.00
9.90
Lower Support
Quantity of Dollars
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During Bretton Woods regime American dollar became international money while other
countries needed to hold dollar reserves. US could buy goods and services from her own
money. The confidence of countries in US dollars started shaking in 1960s with
chronological events which were political and economic and on August 15, 1971 American
abandoned their commitment to convert dollars into gold at fixed price of $35 per ounce, the
currencies went on float rather than fixed. Though "Smithsonian Agreement".
(E) Current Scenario of Exchange Rate Regime: At present IMF categories different
exchange rate mechanism as follows:
(i) Currency Board Agreement: In this regime, there is a legislative commitment
to exchange domestic currency against a specified at a fixed rate. As of 1999,
eight members had adopted this regime.
(ii) Conventional Fixed peg arrangement: This regime is equivalent to Bretton
Woods in the sense that a country pegs its currency to another or to a basket of
currencies with a band variation not exceeding + 1% around the central parity.
Upto 1999, thirty countries had pegged their currencies to a single currency
while fourteen countries to a basket of currencies.
(iii) Pegged Exchange Rates within Horizontal Bands: In this regime, the
variation around a central parity is permitted within a wider band, it is a middle
way between a fixed peg and floating peg. Upto 1999, eight countries had this
regime.
(iv) Crawling Peg: Here also a currency is pegged to another currency or a basket
of currencies but the peg is adjusted periodically which may be pre-announced
or discretion based or well specified criterion. Sixty countries had this type of
regime in 1999.
(v) Crawling Bands: The currency is maintained within a certain margin around a
central parity which crawls in response to certain indicators. Upto 1999, nine
countries enjoyed this regime.
(vi) Managed Float: In this regime, central bank interferes in the foreign exchange
market by buying and selling foreign currencies against home currencies
without any commitment. Twenty five countries have this regime as in 1999.
(vii) Independent floating: Here exchange rate is determined by market forces and
central bank only act as a catalyst to prevent excessive supply of foreign
exchange and not to drive it to a particular level. Including India, in 1999, forty
eight countries had this regime.
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UNIT II
FOREIGN EXCHANGE MANAGEMENT
Q. What are the major factors influencing the Exchange Rate?
Ans. Factors Influencing Exchange Rate:- The most important factor influencing the
exchange rate are:-
1. Balance of Payments:- Balance of Payments position of a country is a definite
indicator of the demand and supply of foreign exchange. There are two situations:-
(i) If a country is having a favourable balance of payments position it implies that
there is more supply of foreign exchange and therefore foreign currencies will
tend to be cheaper.
(ii) If balance of payments position is unfavourable, it indicates that there is more
demand for foreign exchange and this will result in the price of foreign currency.
2. Strength of the Economy :- The relative strength of the economy also has an effect
on the demand and supply of foreign currencies. If an economy is growing at a faster
rate it is generally expected to have a better performance on balance of trade.
3. Fiscal Policy:- The fiscal policy followed by government has an impact on the
economy of the country which in turn affects the exchange rates. If the government
follows an expansionary policy by having low interest rates, it will fuel the engine of
economic growth and as discussed earlier, it will lead to better trade performance.
4. Monetary Policy:- The monetary policy is a very effective toll for controlling money
supply, and is used particularly for keeping a tab on the inflationary pressures in the
economy. The main objective of the monetary policy of any economy is to maintain the
money supply in the economy at a level which will ensure price stability, full
employment and growth in the economy. If the money supply in the economy is more it
will lead to inflation and the central bank will raise interest rates, sell government
securities through open market operations, raise cash reserve requirement and vice-
versa.
It will be clear from the above discussion that monetary policy influences interest rates,
inflation, employment etc. and consequently affects the exchange rates.
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5. Interest Rate:- High interest rates make the speculative capital move between
countries and this affects the exchange rate. If interest rates of domestic currency are
raised this will result in more demand for domestic currency and more supply of the
foreign currency, thus making the latter cheaper.
6. Political Factors:- If a change is expected in the government on account of elections ,
the exchange rates may be affected. However, whether the currency of the country
concerned will become stronger or weaker will depend upon expected policies to be
pursued by the new government which is likely to take over. War also affects the
exchange rates of the currencies of the country involved. Some times it affects the
currencies of other countries also.
7. Exchange Control:- Exchange control is generally aimed at disallowing free
movement of capital flows and it therefore affects the exchange rates. Sometimes
countries exercise control through exchange rate mechanism by keeping the price of
their currency at an artificial level.
8. Central Bank Intervention:- Buying or selling of foreign currency in the market by the
central bank with a view to increase the supply or demand, thereby affecting the
exchange rate is known as 'Intervention'. If a central bank is of the opinion that local
currency is becoming stronger thereby affecting the exports, it will buy foreign
currency and sell local currency. It will increase the demand for foreign currency and
the rates of foreign currency.
The central banks all over the world also play a crucial role in maintaining an orderly
foreign exchange market. Thus at the time of violent fluctuations in the exchange rates
the central banks intervene in the market.
9. Speculation:- In the foreign exchange market dealers taking speculative positions is
common. If a few big speculative operators are buying a particular currency in a big
way others may follow suit and that currency may strength in the short run. This is
popularly known as the 'Bandwagon affect' and this affects exchange rates.
10. Tariff and Non-tariff Barriers:- Imports are restricted through tariff and Non-tariff
barriers . Tariff means duty levied by the government on imports. When assessed on a
per unit basis, tariff is known as specific duty. But when assessed as a percentage of
the value of the imported commodity, tariff is called ad valorem duty. When both types
of tariff are charged on the same product, it is known as compound duty. Apart from
tariff, import is restricted through non-tariff barriers.
Q. Explain Central Bank Interventions for Exchange Rate Stability.
Ans. Central Bank Intervention:- Buying or selling of foreign currency in the market by the
central bank with a view to increase the supply or demand, thereby affecting the exchange
rate is known as 'Intervention'. If a central bank is of the opinion that local currency is
becoming stronger thereby affecting the exports, it will buy foreign currency and sell local
currency. It will increase the demand for foreign currency and the rates of foreign currency.
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The central banks all over the world also play a crucial role in maintaining an orderly foreign
exchange market. Thus at the time of violent fluctuations in the exchange rates the central
banks intervene in the market.
CENTRAL BANK INTERVENTION FOR EXCHANGE RATE STAIBILITY
Central bank has been charged with the responsibility of maintaining external value of the
currency of the country and also maintains a stable exchange rate.
TWO FUNCTIONAL ASPECTS OF CENTRAL BANK
CONTROL ON FLOATING/ FIXED
DEMAND/ SUPPLY EXCHANGE RATE
OF FOREIGN CURRENCY
(A) Central Bank Intervention with Fixed Exchange Rates:
In a fixed exchange rate system most of the transactions of one currency for another will take
place in the private market between individuals, businesses and international banks.
However, by fixing the exchange rate the government would have declared illegal any
transactions that do not occur at the announced rate. However, it is very unlikely that the
announced fixed exchange rate will at all times equalize private demand for foreign currency
with private supply. In a floating exchange rate system, the exchange rate adjusts to
maintain the supply and demand balance. In a fixed exchange rate system it becomes the
responsibility of the central bank to maintain this balance.
The central bank can intervene in the private FOREX market whenever needed by acting as
a buyer and seller of currency of last resort. To see how this works, consider the following
example.
E$
E$
D
Q1 Q2 Q
D
S
S'
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Suppose the US establishes a fixed exchange rate to the British pound at the rate ?$/. In
the adjoining figure we depict an initial private market FOREX equilibrium in which the
supply of pounds (S) equals demand (D) at the fixed exchange rate ?$/. But suppose, for
some unspecified reason, the demand for pounds on the private FOREX rises one day to
D'. At the fixed exchange rate, ?$/, private market demand for pounds is now Q2 whereas
supply of pounds is Q1. This means there is excess demand for pounds in exchange for US
dollars on the private FOREX.
To maintain a credible fixed exchange rate, the US central bank would immediately satisfy
the excess demand by supplying additional pounds to the FOREX market. That is, they sell
pounds and buy dollars on the private FOREX. This would cause a shift of the pound supply
curve from S to S'. In this way the equilibrium exchange rate is automatically maintained
at the fixed level.
Alternatively, consider the next diagram in which again the supply of pounds (S) equals
demand (D) at the fixed exchange rate ?$/. Now suppose, for some unspecified reason,
the demand for pounds on the private FOREX falls one day to D'. At the fixed exchange
rate, ?$/, private market demand for pounds is now Q2 whereas supply of pounds is Q1.
This means there is excess supply of pounds in exchange for US dollars on the private
FOREX.
In this case, an excess supply of pounds also means an excess demand for dollars in
exchange for pounds. The US central bank can satisfy the extra dollar demand by entering
the FOREX and selling dollars in exchange for pounds. This means they are supplying more
dollars and demanding more pounds. This would cause a shift of the pound demand curve
from D'back to D. Since this intervention occurs immediately, the equilibrium exchange
rate is automatically and always maintained at the fixed level.
E$
E$
D
Q1 Q2 Q
D
S'
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(B) Floating Exchange Rate System:-
In a floating-rate system, it is the market forces that determine the exchange rate between
two currencies. In floating exchange Rate system the central bank does not control demand
or supply of foreign currency. Thus the central bank has to show or provide order line in the
movement of exchange rate. There are two situations:
a) Crawling Peg: In this situation central bank fix the upper limit & lower limit of
exchange rate. The exchange rate will lie between these two limits.
Upper Limit
Lower Limit
This can be explained with diagram:

b) Over shooting peg : Under this condition exchange rate can over the upper
limit and below the lower
Q. Explain DORNBUSCH Sticky-Price theory of Exchange Rate Volatility.
Ans. DORNBUSCH Sticky-Price theory:- The sticky price version makes a more detailed
study of interest rate differential. The argument in favour of this approach is that an increase
in money supply (through changes in the real interest rate differential) leads to depreciation
in the value of domestic currency.
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Assumptions:-
The monetary approach of the sticky price version rests on a couple of assumptions.
(i) Money Supply is Endogenous:- The money supply in a country is endogenous,
meaning that it is positively related to the market interest rate.
(ii) PPP Theory applies in long run:- The second assumption is that the PPP theory
applies in the long run and so the expected inflation differential changes have a role to
play in the determination of the exchange rate.
Explanation:- The sticky price theory can be explained in two sections:-
(A) Study of Interest Rate Differential:-The sticky price version makes a detailed study
of interest rate differential. The interest rate differential has three components:-
(2) One denotes that when the interest rate rises, the money balances held by the public
come to the money market in lure of high interest rate. Money supply increases
leading to currency depreciation.
Increase in Money Supply Depreciation of domestic currency.
(3) Second denotes that if interest rate rises, financial institutions increase the funds to be
supplied to the money market. Money supply increases and the value of domestic
currency depreciates.
Rise in Interest Rate Increase in money supply (loanable funds)
Depreciation of domestic currency.
(4) The third is that a rise in interest rate stimulates the capital inflow into the country that,
like the balance of payments approach, causes appreciation in the value of domestic
currency.
Rise in Interest Rate Greater inflow of capital
Appreciation of domestic currency.
(B) Study of Inflation Rate Differential:- The sticky price version specially mentions the
expected inflation rate differential. A rise in inflation rate compared to that in the foreign
country leads to depreciation in the value of domestic currency. This is because a rise
in inflation rate decreases the real interest rate and discourages the capital inflow.
Increase in Money Supply Price rise Lower real interest
rate Lower inflow of capital depreciation of domestic
currency.
Q. Explain J-Curve Effect OR Effect of Devaluation on Trade Balance.
Ans. J-Curve Effect:- In economic terms, balance of payments equilibrium occurs when
surplus or deficit is eliminated from the balance of payments. However, normally, in real life,
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Currency Depreciation
Trade balance eventually improves
Trade balance initially deteriorates
such equilibrium is not found. Rather it is the disequilibrium in the balance of payments that
is a normal phenomenon.
There are external economic variables influencing the balance of payments and giving rise
to disequilibrium. But domestic economic variables are more important for causing
disequilibrium.
The adjustment in the balance of payments disequilibrium was thought of in terms of
changes in the fixed exchange rate, that is through devaluation or upward revaluation. But
its success dependent upon the elasticity of demand for export and import. Marshall and
Lerner explained this phenomenon through the 'elasticity' approach.
Elasticity Approach:- The elasticity approach is based on partial equilibrium analysis
where everything is held constant, except for the effects of exchange rate changes on export
or import. There are some other assumptions:-
(i) The elasticity of supply of output is infinite so that the price of export in home currency
does not rise as demand increases.
(ii) Elasticity approach ignores the monetary affects of variation in exchange rates.
Based on these assumptions, devaluation helps improve the current balance only if:
Em + Ex > 1
Em = Price Elasticity of demand for import.
Ex = Price Elasticity of demand for export.
If the elasticity of demand is greater than unitary, the import bill will contract and export
earnings will increase. Trade deficit will be removed. When the devaluation of
currency leads to a fall in export earnings in the initial stage and then a rise in export
earnings, making the earning curve look like the alphabet, J it is called J-curve effect.
J-curve can be explained with the help of following diagram:-
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Explanation: -
In this figure time is shown on OX- axis and Balance of trade is shown on OY-axis. Trade
balance moves deeper into the deficit zone immediately after devaluation. But then it
gradually improves and crosses into surplus zone. The curve resembles the alphabet, J and
so, it is known as the J-curve Effect.
Criticism:- The weakness of the elasticity approach is that it is a partial equilibrium analysis
and does not consider the supply and cost changes as a result of devaluation as well as the
income and the expenditure effects of exchange rate changes. In this context, it may be
mentioned that it was Stern (1973) who incorporated the concept of supply elasticity in the
elasticity approach. According to him, devaluation could improve balance of payments only
when:
Where X = Exports M = Imports.
EDx = Elasticity of demand for exports
ESx = Elasticity of supply for exports
EDm = Elasticity of demand for imports
ESm= Elasticity of supply for imports.
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UNIT III
FOREIGN EXCHANGE MANAGEMENT
Q. Define Foreign Exchange Market. Explain its Nature.
Ans. Foreign Exchange Market:- The foreign exchange market is the market where the
currency of one country is exchanged for that of another country and where the rate of
exchange is determined. The genesis Foreign Exchange (FE) market can be traced to the
need for foreign currencies arising from:
International Trade.
Foreign Investment.
Lending to and borrowing from foreigners.
In order to maintain the equilibrium in the FE market, the monetary authority of the
concerned country normally intervenes/steps in to bring out the desired balance by:
Variation in the exchange rate
Changes in official reserves
Both.
Every firm operating in international environment faces problems with foreign exchange i.e.,
the exchange of foreign currency into domestic and vice-versa. Generally firm's foreign
operations earn income denominated in some foreign currency, however shareholders
expect payment in domestic currency and therefore the firm must convert foreign currency
into domestic currency.
Definition of Foreign Exchange Market:-
According to Foreign Exchange Regulation Act
"Foreign Exchange means foreign currency and includes:
(a) (i) All deposits, credits and balances payable in any foreign currency.
(ii) The drafts, traveler's cheques, letters of credits and bills of exchange expressed
or drawn in Indian currency but payable in any foreign currency.
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(b) All instruments payable at the option of the drawee or the holders thereof or any other
party there to either in Indian currency or in foreign currency partly in one and partly in
other.
This is clear from the above definition that the foreign exchange market is the market where
foreign currencies are bought and sold. In other words foreign exchange market is a system
facilitating mechanism through which one country's currencies can be exchanged for the
currencies of another country.
Nature or Features of Foreign Exchange Market:-
1. Global Market:- Foreign exchange market is a global market. It means foreign
exchange buyer and seller world wide exist. It is the largest market in the world.
2. Over the Counter Market:- In has already been mentioned that different currencies
are bought and sold in the foreign exchange market. The market does not denote a
particular place where currencies are transacted. Rather it is an over the counter
market. It consists of trading desks at major agencies dealing in foreign exchange
throughout the world, which are connected by telephones, telex and so on.
3. Around the Clock Market:- Foreign exchange market is a round the clock market
meaning that the transactions can take place any time within 24 hours of the day. The
markets are situated throughout the different time zones of the globe in such a way
that one market is closing the other is beginning its operations. Thus at any point of
time one market or the other is open..
4. Currencies Traded:- In the foreign exchange market one country's currencies can be
exchanged for the currencies of another country. In this market only currencies are
traded.
5. 1-2% transactions are for actual trade, rest for speculation:- In foreign exchange
market only 1-2% transaction are for actual trade and most of the transaction is related
to speculation.
6. System:- Foreign exchange market is a system. It is a system of private banks,
financial banks, foreign exchange dealers and central bank through which individual,
business and government trade foreign exchange.
7. No physical transfer of money:- In foreign exchange market, most markets have an
electronic system for transfer of funds, which save time and energy.
8. Exist in the network of information system:- It is more informal arrangement
among the banks and brokers operating in a financial centre purchasing and selling
currencies, connected to each other by Tele-communication like telex, telephone etc.
9. Banks are involved in 95% cases:- Most of the transactions in foreign exchange
market is done with the help of commercial banks.
10. Foreign exchange market facilitates trade and investment.
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11. A party can never be a demander of one currency without being simultaneously a
supplier of another.
Functions of Foreign Exchange Market:-
1. Transfer of Purchasing Power:- Transfer of purchasing power is necessary
international trade and capital transactions normally parties living in countries with
different national currencies. Each party usually wants to deal in its own currency, but
the trade or capital transactions can be invoiced in one single currency. The foreign
market provides the mechanism for carrying out these purchasing power transfers.
2. Provision of Credit:- Because the movement of goods between countries takes time,
inventory in transit must be financed.
3. Minimizing Foreign Exchange Risk:- Each may prefer to earn a normal business
profit without exposure to an unexpected change in anticipated profit because
exchange rates suddenly changes. The foreign exchange market provides "hedging"
facilities for transferring foreign exchange risk to someone else.
Q. Who are the Participants in the Foreign Exchange Market? Also Explain the
Structure of Foreign Exchange Markets.
Ans. Foreign Exchange Market:- The foreign exchange market is the market where the
currency of one country is exchanged for that of another country and where the rate of
exchange is determined.
Major Participants of Foreign Exchange Market:- Foreign exchange market is a world wide
market and is made up of:
1. Retail Clients :- Retail clients made up of:
Tourists:- Individuals are normally tourists who exchange their currencies.
They also migrants sending a part of their income to their family members living
in their home country.
Firms:- Firms that participate are generally importers or exporters. Exporters
prefer to get the payments in their own currency. Importers need foreign
exchange for making payments for the import.
International Investors
Multinational Corporations
Any other who need foreign exchange.
2. Commercial Banks Or Local Banks:- When firms and individual approach the local
branch of a bank, the local branch, in turn, approaches the foreign exchange
department in its regional office or head office. The later deals in foreign exchange with
other banks on behalf of the customers. Thus, there are two tiers in the foreign
exchange market.
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(i) One tier involves the transactions between the ultimate customers and the
banks.
(ii) The other tier consists of transactions between tow banks. The purpose of inter-
bank transactions is not only to meet the foreign exchange demand of the
ultimate customers, but also to reap gains out of movement in foreign exchange
rates. In some cases, inter-bank dealings take place directly, without any help
from intermediaries, but generally banks operate through foreign exchange
brokers.
3. Central Banks:- These banks have been charged with the responsibility of
maintaining external value of the currency of the country. Two functional aspects done
by Central Bank:
TWO FUNCTIONAL ASPECTS OF CENTRAL BANK:

Control on Demand/ Fixed/Floating Exchange Rate
Supply of Foreign currency
4. Speculators:- Speculators who buy or sell currencies when they expect movement in
the exchange rate in a particular direction. The movement of exchange rate in the
desired direction gives them profit.
5. Arbitrageurs: - Arbitrageurs who exchange currencies because of varying rates of
exchange in different markets. The varying rates are the source of their profit. They
buy a particular currency at a cheaper rate in one market and sell it at a higher rate in
the other. This process is known as currency arbitrage.
6. Hedgers:- Non-banking entities, such as traders, that use the foreign exchange
market for the purpose of hedging their foreign exchange exposure on account of
changes in the exchange rate. They are known as hedgers.
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Structure of Foreign Exchange Markets:
Q. Define Spot and Forward Markets.
Ans. Introduction: The foreign exchange market is classified either as a spot market or as
a forward market. It is the timing of the actual delivery of foreign exchange that differentiates
between spot market and forward market transactions. The spot and forward markets are:-
(1) Spot Market:- In the spot market ,currencies are traded for immediate delivery at the
rate existing on the day of transaction. For making book-keeping entries, delivery
takes two working days after the transaction is complete. If a particular market is
closed on Saturday and Sunday and of transaction takes place on Thursday, delivery
of currency shall taken place on Monday. Monday, in this case, is known as the value
date or settlement date. Some times there are short-date contracts where tome zones
permit the delivery of the currency even earlier. If the currency is delivered the same
day, it is known as the value-same-day contract. If it is done next day, the contract is
known as the value next-day contract.
RETAIL CLIENTS
LOCAL BANK
FOREIGN
EXCHANGE
BROKER
MAJOR BANKS
INTER BANK
FOREIGN
EXCHANGE
BROKER
LOCAL BANK
RETAIL CLIENTS
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The exchange rate for immediate delivery is called spot exchange rate and is denoted
by S (.)
For Example :- S(Rs./$) = Rs. 36.10/$
Forward Market:- In the forward market, on the contrary, contracts are made to but
and sell currencies for a future delivery, say, after a fortnight, one month, two months,
and so on. The rate of exchange for the transaction is agreed upon on the very day the
deal is finalized. In other words, no party can back out of the deal even if changes in the
future spot rate are not in his/her favour. The exchange rate for delivery and payment
at specified future dates are called forward exchange rates and is denoted by F (.). The
major participants in forward market can be categorized:-
Arbitrageurs
Hedgers
Speculators
The maturity period of a forward contract is normally one month, two months, three
months, and so on. But sometimes it is not for the whole month and represents a
fraction of a month. A forward contract with a maturity period of 35 days is an example.
Naturally, in this case, the value date falls on a date between two whole months. Such
a contract is known as broken-date contract.
Example of Spot And Forward Market:- Suppose a currency is purchased on the 1st of
August; if it is a spot transaction, the currency will be delivered on the 3rd of August, but if it is
a one-month forward contract, the value date will fall on the 3rd of September. If the value
falls on a holiday, the subsequent date will be the value date. If the value date does not exist
in the calendar, such as the 29th February (if it is not a leap year), the value date will fall on
the 28th of February.
Q. Write a short note on Forward Premium
Ans. Forward Rates:-The quotes for the forward market are also publish in the
newspapers. There are two ways of quoting forward rates:-
(i) Outright Quote:- The outright quote for the US dollar in terms of the rupee can be
written for different periods of forward contract, as follows
Spot One month Three months
(ii) Swap Quote:- The swap quote, on the other hand, expresses only the difference
between spot quote and forward quote. Decimals are not written in swap quotes.
Forward Premium:- If the forward rate is higher than the spot rate, it would be known
as the forward premium. Forward premium is expressed as an annualized percentage
deviation from the spot rate. It is computed as follows:-
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FORWARD RATE - SPOT RATE 360
FORWARD PREMIUM (DISCOUNT) = X
SPOT RATE N
40-39.80 360
Forward Premium =--------------- X ------------ = .0603 Or 6.03 %
39.80 30
Q. What are the methods of Quoting Exchange Rates?
Ans. Meaning of Quotation:- Quotation is amount of a currency necessary to buy or sell a
unit of another currency. There are various methods of quoting exchange rates:-
(B) Direct and Indirect Quotes
(C) Bid and Ask Rates
(D) American and European Terms Quotes.
(E) Forward Rates
(F) Cross Rates
(B) Direct and Indirect Quotes:- Exchange rates are quoted either directly or indirectly:
(i) Direct Quote:- A direct quotes gives the home currency price of a certain
quantity of foreign currency, usually one unit. In other worlds price of one unit of
foreign currency quoted in terms of home country's currency is known as direct
quote. If India quotes the exchange rate between the rupee and US dollar
directly, the quotation will be written as
Rs. 45/US$.
(ii) Indirect Quotes:- In case of indirect quoting, the value of one unit of home
currency is presented in term of foreign currency. In other worlds price of one
unit of home currency quoted in terms of foreign currency is known as indirect
quote. If India adopts indirect quote, the banks in India will quote the exchange
rate as
US$0.022/Re.
(C) Bid and Ask Rates OR Buying and Selling Rates:- In interbank market, banks
quote two way price:-
Bid-Price:- The rate at which the bank is willing to buy the currency from you is
bid price.
BID = Bank Buy
Ask-Price :- The rate at which the bank is willing to sell the currency to you is the
ask price.
ASK= Bank Sell
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Bid-Ask Spread:- When a bank quotes for a currency it simultaneously offers another
currency in lieu, i.e. if it buy dollars for rupees, it is simultaneously offering rupees for
dollars. The bid-ask spread is the spread between bid and ask rates for a currency. In
other words, Ask and Bid differential is called the spread.
SPREAD = ASK PRICE - BID PRICE
Differential charged in percentage terms is known as margin Or Cost of Transaction Or
Percent Spread which is computed as follows:-
COST OF TRANSACTION
OR ASK PRICE BID PRICE
PERCENT SPREAD =
OR ASK PRICE
(D) American and European Terms Quotes:-
(i) European Terms Quote:- European terms quote is the price of one US dollar in
terms of a foreign currency.
For Example:- Rs. 45/US$.
(ii) American Term Quote:- American terms quote is just the reverse; the price of
one unit of foreign currency in terms of dollars.
For Example:- US$0.022/Re.
(E) Forward Rates:-The quotes for the forward market are also publish in the
newspapers. There are two ways of quoting forward rates:-
(i) Outright Quote:- The outright quote for the US dollar in terms of the rupee can
be written for different periods of forward contract, as follows
Spot One month Three months
(ii) Swap Quote:- The swap quote, on the other hand, expresses only the
difference between spot quote and forward quote. Decimals are not written in
swap quotes.
If the forward rate is lower than the spot rate, it will be a case of forward discount.
On the contrary, if the forward rate is higher than the spot rate, it would be known
as the forward premium. Forward premium or discount is expressed as an
annualized percentage deviation from the spot rate. It is computed as follows:-
FORWARD RATE - SPOT RATE 360
FORWARD PREMIUM (DISCOUNT) = X
SPOT RATE N
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N = Length of the forward contract expressed in number of days.
(F) Cross Rates:- Sometimes the value of currency in terms of another is not known
directly. In such case, one currency is sold for a common currency; and again the
common currency is exchanged for the desired currency. This is known as cross rate.
Q. Write a note on bid-ask spreads.
Ans. In interbank market, banks quote two way price:-
(1) Bid-Price:- The rate at which the bank is willing to buy the currency from you is bid
price.
BID = Bank Buy
(2) Ask-Price :- The rate at which the bank is willing to sell the currency to you is the ask
price.
ASK= Bank Sell
Bid-Ask Spread:- When a bank quotes for a currency it simultaneously offers another
currency in lieu, i.e. if it buy dollars for rupees, it is simultaneously offering rupees for dollars.
The bid-ask spread is the spread between bid and ask rates for a currency. In other words,
Ask and Bid differential is called the spread.
SPREAD = ASK PRICE - BID PRICE
Differential charged in percentage terms is known as margin Or Cost of Transaction Or
Percent Spread which is computed as follows:-
COST OF TRANSACTION
OR ASK PRICE BID PRICE
PERCENT SPREAD =
OR ASK PRICE
MARGIN
Determinants of Spread:-
(1) Frequency of Trade: - There is an inverse relation between frequency of trade and
spread.
If frequency of trade is more ------ Less Spread.
If frequency of trade is less--------- More Spread.
(2) Volume of Currency: - There is also an inverse relation between volume of currency
and spread.
If Volume of Currency is more ------ Less Spread.
If Volume of Currency is less--------- More Spread.
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(3) Nature of Organization for Quotes:- There is a less spread if the organization is
bank and more spread if the organization is money changer.
If Bank ------ Less Spread.
If Money Changer --------- More Spread.
(4) Stability in Market:- If there is a stability in the market there will be less spread and if
market is instable then there will be more spread.
If More Stability ------ Less Spread.
If Less Stability--------- More Spread.
Q. Write a short note on following:
(C) Relation between Exchange Rate and Inflation Rate.
(D) Relation between Exchange Rate and Interest Rate
Ans.
(A) Relation Between Exchange Rate and Inflation Rate:- It is normally the inflation
rate differential between two countries that influences the exchange rate between
their currencies. The influence of inflation rate finds a suitable explanation in the
Purchasing Power Parity (PPP) theory. The theory suggests that at any point of time,
the rate of exchange between two currencies is determined by their purchasing power.
If e is the exchange rate and PA and PB are the purchasing power of the currencies in
the two countries, A and B, the equation can be written as
PA
e = -----------
PB
In fact, this theory is based on the theory of one price in which the domestic price of any
commodity equals its foreign price quotes in the same currency. To explain it, if the exchange
rate is Rs.2/US$, the price of a particular commodity must be US$50 in the United state of
America if it is Rs. 100 in India. In other words
US$ price of a commodity X Price of US$ = Rupee price of the commodity
If inflation in one country causes a temporary deviation from the equilibrium, arbitrageurs will
begin operating, as a result of which equilibrium will be restored through changes in the
exchange rate.
For Example:- Suppose, the price of the commodity soars up in India to Rs. 125, the
arbitrageurs will buy that commodity in the United States of America and sell it in India
earning a profit of RS. 25. This will go on till the exchange rates moves to Rs. 2.5/US$ and
the profit potential of arbitrage is eliminated.
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(B) Relation Between Exchange Rate and Interest Rate:- Experts differ on how
changes in interest rate influence the exchange rate. There are different opinions:-
(1) According to Flexible Price Version:- The flexible price version of monetary
theory explains that any rise in domestic interest rate lowers the demand for
money. Lower demand for money in relation to the supply of money causes
depreciation in the value of domestic currency.
(2) According to Sticky Price Version:- The sticky price version of monetary
theory has a different explanation. According to this version a rise in interest rate
increases the supply of loanable funds, which means a greater supply of money
and depreciation in domestic currency.
(3) According to Balance of Payments Approach:- According to Balance of
Payments approach where a higher interest rate at home, than in a foreign
country, attracts capital from abroad in anticipation of higher return. The inflow of
foreign currency will increase the supply of foreign currency and raise the value
of the domestic currency.
(4) Fisher Effect:- The Fisher effect states that whenever an investor thinks of an
investment, he is interested in a particular nominal interest rate, which covers
both the expected inflation and the required real interest rate. In the form of an
equation, it can be shown as:
1 + r = (1+a) (1+I)
Where r = Nominal Interest Rate
a = Real Interest Rate
I = Expected Rate of Inflation
Example:-
Suppose the required real interest rate is 4 per cent and the expected rate of inflation is 10
per cent, the required nominal interest rate will be:
1 + r = (1+.04) ( 1+ .10)
1+r = 1.04 X 1.10
r = 1.04 X 1.10 -1
r = 14.4%
Q. Explain Interest Rate Parity (IRP) Theorem.
Ans. Introduction:- The determination of exchange rate in a forward market finds an
important place in the theory of Interest Rate Parity. The IRP theory states that equilibrium is
achieved when the forward rate differential is approximately equal to the interest rate
differential. In other words, the forward rate differs from the spot rat by an amount that
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represents the interest rate differential. In this process, the currency of a country with a lower
interest rate should be at a forward premium in relation to the currency of a country with a
higher interest rate. More specially, in an efficient market with no transaction costs, the
interest differential should be equal to the forward differential. Equating forward rate
differential with interest rate differential, we find:
Equation of Interest Rate Parity:
Forward Rate - Spot Rate 360 1 + ra
------------------------------------- X --------- = ----------- - 1
Spot Rate n 1 + rb
On the basis of IRP theory, the forward exchange rate can easily be determined. One has
simply to find out the value of the forward rate (F) in following equation:
Spot rate 1 + ra
F = ------------ ------------ -1 + Spot rate
360/n 1 + rb
For Example:-
Suppose Interest rate in India and the United State of America is, respectively, 10 per cent
and 7 percent. The spot rate is Rs. 40/US $. The 90-day forward rate can be calculated as
follows:
40 1+.10
F = ----------- ---------------- - 1 + 40
360/90 1 + .07
F = Rs. 40.28 / US $
This means that a higher interest arte in India will push down the forward value of the rupee
from 40 a dollar to 40.28 a dollar.
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Graphic Presentation of Interest Rate Parity Theory:-
Explanation:- In this figure Point C indicates a situation of disequilibrium. Here, the interest
differential is 2% whereas the forward premium on the foreign currency 3%. The transfer of
funds abroad with exchange risks covered will yield an additional 1% annually. At point D,
the forward premium remains 3%, nut the interest differential increases to 4%. Now it
becomes profitable to reverse the flow of funds. It indicates that if the interest differential in
favor of the foreign country is 2%, then the currency of that country must be selling at a 2%
forward discount for equilibrium to exist.
Q. Define International Fisher Effect.
Ans. International Fisher Effect:- International Fisher Effect is a combination of the
conditions of the PPP theory and Fisher's closed proposition. International Fisher Effect
includes:-
Arbitrage inflow to
home country
D
Interest differential In
favour of home country (%)
Arbitrage outflow
from home country
-5 -4 -3 -2 -1 1 2 3 4 5
Forward Premium (+)
Or discount (-) on
Foreign currency (%) Parity Line
5
4
3
2
1
-1
-2
-3
-4
-5
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(1) PPP Theory:- PPP theory suggests that exchange rate is determined by the inflation
rate differential. Exchange rate is calculated by following Equation:-
et (1+ IA)t
------- = --------------
e0 (1+ IB )t
e0 = A' currency value for one unit of B's currency at the beginning of the period.
et = Spot exchange rate in period t
IA = Rate of Inflation in A country
IB = Rate of Inflation in B Country.
(2) Fisher Effect:- The relationship between nominal interest rate and the expected rate
of inflation is known as Fisher Effect. The Fisher effect states that whenever an
investor thinks of an investment, he is interested in a particular nominal interest rate,
which covers both the expected inflation and the required real interest rate.
In fact, it was Irving Fisher who decomposed nominal interest into two parts -
(i) Real Interest Rate
(ii) Expected Rate of Inflation.
In the form of an equation, it can be shown as:
1 + r = (1+a) (1+I)
Where
r = Nominal Interest Rate
a = Real Interest Rate
I = Expected Rate of Inflation
Example:-
Suppose the required real interest rate is 4 per cent and the expected rate of inflation is
10 per cent, the required nominal interest rate will be:
1 + r = (1+.04) ( 1+ .10)
1+r = 1.04 X 1.10
r = 1.04 X 1.10 -1
r = 14.4%
If the interest rate is 10 per cent and the rate of inflation is 10 per cent, the real return on
capital would be zero. This is because the gain in the form of interest compensates the loss
on account of inflation.
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Since the real interest rate is equal in different countries, a country with higher nominal
interest rate must be facing a higher rate of inflation.
Exchange Rate is calculated by the following equation:-
et (1+ rA)t
------- = ----------------
e0 (1+ rB )t
International Fisher Effect states that interest rate differential shall equal the inflation rate
differential. In the form of an equation, it can be written as:-
International Fisher Effect Equation:-
1 + rA 1+ IA
------------ = -------------
1 + rB 1 + IB
The rational behind this proposition is that:
(i) An investor likes to hold assets denominated in currencies expected to depreciate
only when the interest rate on those assets is high enough to compensate the loss on
account of depreciating exchange rate.
(ii) On the other hand, an investor holds assets denominated in currencies expected to
appreciate even at lower rate of interest because the expected capital gain on account
of exchange rate appreciation will make up the loss on yield on account of low interest.
Example:-
Suppose, if India is expected 8 per cent inflation rate during next one year as compared to 3
per cent inflation rate in the United states of America. If the exchange rate in the beginning of
the year is Rs. 40/US $, the value of rupee will fall vis--vis the US dollar at the end of the
period to:
First Method:-
et (1+ IA)t
------- = -----------------
e0 (1+ IB )t
1.08
et = 40 X ------------- = Rs. 41.94/US $
1.03
Suppose that in the beginning of the period, interest rate in India is 7 per cent as against 4 per
cent in the USA. At the end of the period, interest rate in India will rise to an extend that will
approximately equate the inflation rate differential. In order to find out changes in interest
rate, the following equation may be applied
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et 1 + rIND
------ = -------------------
e0 1 + rUSA
Based on the above Equation:-
41.94 1 + rIND
------------ = -------------- = 1 + rIND = 1.09
40 1.04
rIND = 1.09-1 = .09 = 9 %
If the interest rate in India rises to 9 per cent, then
Interest Rate Differential = 1.09/1.04 = 4.81 per cent
Inflation rate Differential = 1.08/1.03= 4.85 per cent
Interest rate differential approximately is equal to inflation rate differential.
Second Method:-
Interest Rate Differential = Inflation Rate differential
(1+ IA)t (1+ rA)t
--------------- = ------------------
(1+ IB )t (1+ rB ) t
1 + .08 1+ r
---------- = -----------------
1+.03 1+.04
1.08 X 1.04
---------------- = 1+r
1.03
1.09 = 1+r
.09=r
OR r = 9%
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UNIT IV
FOREIGN EXCHANGE MANAGEMENT
Q. Write a short note on Currency Future Market.
Ans. Currency Future:- Besides spot and forward markets, currencies are also traded in
the market for currency futures and the market for currency options. The market for currency
futures came into being in 1972 in the United States. Presently, it is found at many important
financial centres.
A currency futures contract is different from a forward contract. The size of a future contract
is standardised, involving fixed amount of different currencies. The date of delivery is also
fixed, whereas in a forward contract, neither the size of the contract nor the delivery date is
fixed.
In a future contract, the buyer and the seller agree on:
A future delivery date
The price to be paid on that future date
The quantity of the currency.
Process of Future Contract:- When a trader has to enter a currency futures contract, he
informs his agent who in turn informs the commission broker at the stock exchange. The
commission broker executes the deal for a commission/fee. After the deal is executed, the
commission broker confirms the trade with the agent of the trader. The agent informs the
prinicipal about the transaction and the future price. The final settlement is made on maturity.
Currency futures market refers to organised foreign exchange market where a fixed amount
of a currency is exchanged on a fixed maturity date.
Q. Define Currency Options Market. Also explain Options Terminology.
Ans. Currency Options Market:-Currency Options Market refers to market for the
exchange of currency where the option buyer enjoys the privilege of not excercising the
option if the rate is not favourable.
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Features of Currency Options Market:-
(i) A currency options contract is similar as a forward contract or a future contract in the
sense that the buyer of currency options posseses the right to but or sell foreign
currency after the lapse of a specified period at a rate determined on the day the
contract is made.
(ii) The currency options contract has a distinctive feature that is not found in a forward or
a futures contract. It is that the buyer of a currency options has the freedom to excercie
the options if the agreed upon rate turns in his favour. It if is not, he can let the options
expire.
Types of Currency Options Market:- The options market is of three types:-
(i) Listed Currency options market:- Listed currency options market is found as a part
of stock exchanges. The size and the maturity of the contract are normally fixed. The
option buyer or the seller makes the deal with the help of a broker.
(ii) Over the Counter Option Market:- In case of the over-the-counter market, options
deals are finalised with the banks. The size of contract is normally bigger and the
banks repackage the size of the contract according to the clients needs.
(iii) Currency Future Option Market:- In the currency futres options market, the options
are marked to market, as in the case of a futures contract.
Types of options Contracts:- Broadlly speaking, there are two types of options:-
(i) Call Option:- In a call option, the buyer of the option agrees to but the underlying
currency.
(ii) Put Option:- In a put option contract, the buyer of the options agrees to sell the
underlying currency.
Options Terminilogy:- For a clear understanding of the currency options, readers must be
acquainted with a few terms that are used in this context. They are as follows:-
(i) Option Buyer:- Option buyer is a person or a firm who holds the right to buy options.
If the option buyer agrees to buy an underlying currency, he is the buyer of a call
options.
If he agrees to sell an underlying currency, he is known as the buyer of a put
option. The option buyer is also known as the option holder.
(ii) Option Seller:- Option seller is that party that is obliged to perform if the option is
exercised. The option seller is also known as the option writer.
(iii) Excercise Price:- excercise price is the price at which options are excercised. It is
also known as the strike price.
(iv) At the Money:- At the money is the situation when the strike price is equal to the spot
price on the maturity date.
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(v) Premium:- Premium is the value or price of the option that the option-buyer pays to
the option seller at the time of siging of the contract. So it is also known as the option
value or the option price. It is nor returned even when the option is not exercised. The
amount of premium is the sum of the options intrinsic value and the time value. Intrinsic
value denotes the extent to which an option would currently be profitable to exercise.
Q. Explain Interest Rate Swap with an example.
Ans. Interest Rate Swap:- Interest rate swap involves the exchange of interest payments.
It usually occurs when a person or a firm needs fixed rate funds but is only able to get floating
rate funds. It finds another party who needs any floating rate loan but is able to get fixed rate
funds. The two, known as counter parties, exchange the interest payments and the loans
according to their own choice. It is the swap dealer, usually a bank, that brings together the
two counter-parties for the swap.
Essential conditions for interest-rate swap are:-
(i) The amount of loan is identical in the two cases.
(ii) The periodic payment of interest takes place in the same currency.
(iii) At the same time, there must be coincidence between the two parties-one getting
cheaper fixed rate funds and the other getting cheaper floating rate funds.
For Example: Suppose Firm A needs fixed rate funds, which is available to him at the rate of
10.50 per cent to be computed half yearly, but it has access to cheaper floating rate funds
available to it at LIBOR+0.3 per cent.
Firm B needs floating rate funds, available to it at 6-month LIBOR flat, but has access to
cheaper fixed rate funds available to it a the rate of 9.50 per cent to be computed half yearly.
Both the principals are identical in size and maturity and are in the same currency.
The interest rate swap will take place in the following stages:
Stage 1 : If firm A has access to the floating rate loan market, it will borrow from the floating
rate loan market. Similarly, Firm B having access to the fixed rate loan market, will borrow a
fixed rate loan.
Stage 1 of Interest Rate Swap:
FIXED RATE LOAN MARKET
PRINCIPAL
PRINCIPAL
FLOATING RATE LOAN MARKET
FIRM A FIRM B
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Stage 2: Both the counterparties approach a swap dealer. Since Firm A needs a fixed rate
loan, swap delaer asks firm A to pay fixed rate interest to it as if it has borrowed fixed rate
loan. The fixed rate of interest payable through the swap dealer is higher than what firm B
has to pay to the lender in the fixed rate loan market but lower than what firm A has to pay to
thelender if it had borrowed from the fixed rate loan market. It is, say, 9.75 per cent. In
exchange , the swap dealer pays firm A the interest at 6-month LIBOR. Firm A pays
LIBOR+o.3 percent to the lender on its floating rate borrowing.
On the other hand, the swap delaer asks firm B to pay 6 month LIBOR as if it has borrowed a
floating rate loan. In exchange, the swap dealer pays firm B fixed rate interest, which is
higher than what Firm B has to pay to the ultimate lender. This is the interest rate that the
swap dealer has received from firm A minus its swap commission. It is ,say, 9.65 per cent.
Here firm B gets interest from the swap dealer at 9.65 per cent and pays interest to the fixed
rate lender at 9.50 per cent.
Stage 2 of Interest Rate Swap:

Firm A is attracted to the swap deal as it uses the loan according to its own choice and also
because the fie\xed rate of interest payable by it is lower thsn what it had to pay in case it
borrowed firm the fixed rate loan market. Firm B is attracted to the swap deal not only
becasuse it is using the loan according to iuts own choice but also becuase the swap delaer
gives an interest rate that is higher than what it has to pay to the ultimate lender. The swap
delaer is attracted to the swap deal becuase it earns from such a deal.
Stage 3: At maturity, the two firms repay the loan. Firm A repays the floating rate loan and
Firm B repays fixed rate loan.
FIXED RATE
LOAN MARKET
LIBOR + 0.3%
FLOATING RATE
LOAN MARKET
9.50%
FIRM A
SWAP
DEALER
FIRM B
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FIRM A FIRM B
FIXED RATE
LOAN MARKET
PRINCIPAL
FLOATING RATE
LOAN MARKET
PRINCIPAL
Stage 3 of Interest Rate Swap:
Gain to Swap Dealer:
Interest Rate Received 9.75%
Interest Rate Paid 9.65%
Net Gain 0.10%
Q. Explain Currency Swap with an example.
Ans. Currecny Swap: A currecny swap is different from the interedt -rate swap insofar as it
(currency swap) involves two different currencies. This is the reason that the two currencies
are exchanged in the beginning and again at maturity they are re-exchanged. The exchange
of currencies is necessitated by the fact that one counter-party is able to borrow a particular
currency at a lower interest rate than the other counter-party.
Example: Suppose firm A can borrow the euro at a fixed rate of 8.0 per cent or the US dollar
at a floating rate of one-year LIBOR. Firm B can borrow euro the at a fixed rate of 9.2 per cent
and can borrow the US follar at one year LIBOR. If firm B needs the fixed rate euro, it will
approach the swap dealer, provided that firm A needs the floating rate US dollar. The swap
deal will be conducted in different stages, as follows:
Stage1: In the first stage, firm A borrows euqo at 8.0 per cent interest rate. Firm B borrows
US dollars at LIBOR.
Stage 2: The two firms exchange the borrowed currencies with the help of the swap dealer.
After the exchange firm A will possess US dollars. Firm B will posses euros.
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Stage 1 and 2 of Currency Swap:


Stage 3: Interest payment will flow. Firm A will pay LIBOR on the US dollar that will reach the
US dollar market first, through, the swap dealer and then through Firm B. Similarly, firm B will
pay a fixed rate interest that will flow to the fixed rate through the swap dealer and through
firm A. Firm B will pay a fixed rate of interest to the swap dealer, which will be more than 8.o
per cent but less than 9.20 per cent. It will be, say, 8.60 per cent. The swap dealer will take its
own commission and shall pay to firm A in this case only, say, 8.40 per cent.
Stage 3 :

FIRM A
SWAP
DEALER
FIRM B
PRINCIPAL
EURO DEBT MARKET
DOLLAR DEBT MARKET
PRINCIPAL
FIRM A
SWAP
DEALER
FIRM B
EURO DEBT MARKET
DOLLAR DEBT MARKET
8%
LIBOR
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FIRM A
SWAP
DEALER
FIRM B
PRINCIPAL
EURO DEBT MARKET
DOLLAR DEBT MARKET
PRINCIPAL
Stage 4 : The two principals are again exchanged between the two counter-parties. Firm A
gets back euro and repays them to the lender. Firm B gets back US dollars and repays it to
the lender.
Stage 4:
Q. Describe the different forms of exchange rate exposure. How do they differ
among themselves?
Ans. Foreign Exchange Exposure:- The gain or loss arising on account of unanticipated
exchage rate changes is known as foreign exchange exposure.
Classification of Foreign Exchange Exposure:- Foreign exchange exposure is classified
as :
1. Translation Exposure
2. Transaction Exposure
3. Real Operating Exposure
1. Translation Exposure:- Translation exposure, which is also known as accounting
exposure, does not involve cash flow. Translation exposure refers to exchange rate
risk arising out of the translation of the functional currency into the reporting currency.
It emerges on account of consolidation of the financial statements of different
units of a multinational firm for the purpose of ascertaining overall profitability
and evaluation of the comparative performance of different subsidiaries. When
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the currency of any of the host countries changes its value, its translated value in
domestic currency of the parent company (home-country currency) changes
and the picture of the consolidated statement changes. The extent of this
change represents the magnitude of translation exposure.
If is the fact that if the subsidiary maintains its account in the reporting
currency(domestic currency of the parent company), as it is sometimes done by
the extended departments of a firm abroad, translation exposure does not
emerge.
But since the subsidiaries normally maintain their accounts in a functional
currency, which is normally the currency of the host country, there is every
possibility of the translation exposure emerging in subsequent exchange rate
changes
The larger the fluctuation in the value of host country currency, the greater the
size of accounting exposure.
2. Transaction Exposure:- Transaction exposure involves changes in the present cash
flows, on account of:
(i) Export and import of commodities on open account:- There are two
situations:
If a firm has to make payments for imports in a foreign currency and the
foreign currency appreciates, the firm will have to incure loss in term of its
own currency.
Similarly, if an exporter has to receive foreign currency for its export and
the foreign currency depreciates, the exporter will have to face loss in
terms of its own currency.
(ii) Borrowing and lending in a foreign currency:- The borrower of a foreign
currency is put to loss if that particular foreign currency appreciates.
(iii) Intra-firm flows:- Again, changes in exchange rate laters the value of the intra-
firm cash flow.
3. Real Operating Exposure:- Real operating exposure arises when changes in
exchange rate, together with rate of inflation, alters the amount and risk element of a
company's future revenue and cost stream. The extent of the change in the present
value of future cash flows denotes the real operating exposure.
The word Real:- The word real denotes the concept of real exchange rate,
which means nominal exchange rate adjusted for inflation.
The word Operating:- The word operating is used because it considers the
operating cash flow, a change which causes change in the value of the firm.
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The measurement of rela operating exposure is not very easy, insofar as the measurement
of inflation rate differential in the years to come is not easy, especially when the countries are
experiencing a highly volatile rate of inflation. However, if the inflation rate differential is
forecasted correctly, real operating exposure can be estimated.
Q. What are the techniques of Exposure Management?
Ans. Techniques of Exposure Management:- The various techniques of exposure
management are:-
(1) Techniques of Translation Exposure Management:- There is one view that there
is no need for hedging translation exposure as it does not affect the cash flow. But
firms try to hedge it in view of its potential impact on the reported consolidated
earnings. The commonly used technique with respect to hedging of translation
exposure is known as the balance sheet hedge.
Balance Sheet Hedge:- Since translation exposure arises out of mismatch
between the size of assets and the size of liabilities resulting from the
conversion of figures in the functional currency to those in the reporting currency
using different methods of conversion, balance sheet hedge eliminates such
mismatches.
(i) If the liabilities are lower than the assets, fresh borrowings are made.
(ii) If the liabilities exceed assets, fresh investments are made to eliminate the
mismatch.
It may be noted that borrowings are made in weaker currencies and investment
is made in stronger currencies.
(2) Techniques of Transaction Exposure Management:- The techniques for heding
transaction exposure are :
Heading transaction Exposure
Contractual Hedges Natural Headges
(i) Forward market hedge (i) Leads and lags
(ii) Future market hedge (ii) Cross-hedging
(iii) Options market hedge (iii) Currency Diversification
(iv) Money market hedge (iv) Risk sharing
(v) Matching of cash flows
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(A) Contractual Hedge:- They include the forward market hedge, money market hedge,
future market hedge, and the options market hedge.
(i) Forward Market Hedge:- In the forward market hedge, the exporter sells
forward, and the importer buys forward, the foreign currency in which the trade is
invoiced.
For Example:- Suppose an Indian exporter signs a contract for leather export to
USA for US$ 1000. The export proceeds are to be received within three months.
The exporter fears a drop in the value of the US dollar, which may diminish the
export earnings. To avoid diminution, the exporter goes for a three-month
forward contract and sells US$ 1000 forward. The spot as well as the forward
rate is Rs. 40/US$. If the dollar depreciates to Rs. 39 after three months, the
export earnings in the absence of any forward contract would have dminished to
Rs. 39000. But since the exporter has already sold forward a similar amount of
dollars, the loss occurred due to depreciation of the dollar will be met through the
forward contract. Selling the dollars on maturity would fetch him Rs. 40000
which will be equal to the original export value.
(ii) Future Market Hedge:- Hedging in a future market is similar. The only
difference is of the procedure, with a view to the varying characteristics of the
future market.
(iii) Option Market Hedge:- For hedging in the currency options market, the
importer buys a call option or sells a put option or performs both the fuctions at
the same time. The exporter buys a put option and sells a call option or performs
both the functions simultaneously.
(iv) Money Market hedge:- Money market hedge is just taking a money market
position to cover future payables or receivables position.
An importer, who is to cover future payables, firstly, borrows local
currency; secondly converts the borrowed local currency into the currency
of payables; and finally, invests the converted amount for a period
matching with the payments to be made for imports.
On the contrary, an exporter hedging receivables, firstly , borrows the
currency in which the receivables are denominated; secondly, converts
the borrowed currency into local currency and finally invests the converted
amount for a maturity coinciding with the receipt of export proceeds.
(B) Natural Hedge: Firms go for natural hedges because contractual hedge provides only
temporary protection against exchange rate movement and some times the market for
contractual hedge is not well developed. Some important natural hedge are:
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(i) Leads and Lags:-
Leads: Lead means accelerating or advancing the timing of receipt or
payment of the foreign currency. Suppose a firm is located in a weak
currency country and it has to pay debt denominated in hard currency.
There is every possibility of the hard currency appreciating against the
weak currency. In such a situation, the debtor firm will like to lead the
payments.
Lags:- Lag is just the reverse, which means decelerating or postponing
the timing of receipt or payment of foreign currency. Suppose a firm is
located in hard currency country has to pay debt denominated in weak
currency, it sould like to lag the payment. In both the cases, the purpose is
to lower the debt burden.
(ii) Cross-hedging:- It is adopted when the desired currency cannot be hedged. In
this case, the firm has to identify a foreign currency that can be hedged, the
volatility of which is highly correlated with that of the desired currency.
(iii) Currency Diversification: If transactions are diversified over a number of
currencies and if there is negative correlation in the change of their values, the
exchange rate risk is automatically minimised. The greater the diversification,
the lesser the risk.
(iv) Risk Sharing: Risk sharing is a contractual arrangement through which the
buyer and the seller agree to share the exposure. Both parties normally agree to
such a proposal if their business relationship is a long term one.
(v) Matching of Cash Flows: Under this mechanism, a firm matches its foreign
currency inflow with the outflow in that currency not only in respect of size but
also in respect of timing. But, for this purpose, it is necessary that the firm has
both inflows and outflows in the same currency.
(3) Tehniques of Real Operating Exposure:
(i) Financial Strategy
(ii) Marketing Strategy
(iii) Production Strategy.
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