Declaration

We hereby declare that this assignment entitled Foreign Exchange Market is written and submitted by us under the kind guidance of Mrs. Gargi Bandho adhyay. !he content of the ro"ect is based on secondary data collection. !his assignment is not co ied from any source or other ro"ect submitted for the similar ur ose.

ACKNOWLEDGEMENT
!his assignment would ha$e been im ossible without a host of hel ing hands "oining to make the load lighter. !he work now com leted bears testimony to their kind su during it%s formation. We would like to be grateful to our faculty& Mrs Gargi Bandho adhyay& for her guidance and encouraging su ort. 'lso& to the library at 'mity Business school for ro$iding us with the books which were the source of information of our ro"ect. ort we a$ailed

Contents Topic
#. Foreign exchange market) 'n introduction (. Foreign exchange instruments. +. Factors influencing Exchange rates *. -etermination of Exchange .ates ,. Foreign Exchange Forecasting in ractice 1. 2fficial 'ctions to influence Exchange .ates 3. Flexible $4s Fixed Exchange rates 5.Bibliogra hy

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# * , #/ #0 (+ (1 (0

The Foreign Exchange Market An intro!"ction

+

What is #oreign exchange rate or exchange rate$ 'n exchange rate is sim ly the rice of one currency in terms of another. !he rocess by which that rice is determined de ends on the articular exchange rate mechanism ado ted. 6n a floating rate system& the exchange rate is determined directly by market forces& and is liable to fluctuate continually& as dictated by changing market conditions. 6n a 7fixed7& or managed rate system& the authorities attem t to regulate the exchange rate at some le$el that they consider a ro riate. 8uch a system often seems a ealing to those who are troubled by the uncertainties of the resent& highly $olatile& floating rate en$ironment. But the choice of exchange rate regime in$ol$es considerations that extend beyond the stability or otherwise of currency rices. !his will become clearer after an examination of some fundamentals of the foreign exchange market.

Econo%ics o# the Foreign Exchange Market 6n a floating exchange rate regime the rice of the dollar& like any other market9determined rice& de ends on the rele$ant forces of su ly and demand. But what are the rele$ant forces of su ly and demand in the foreign exchange market: !o try to answer this ;uestion& let us consider& for illustration& the factors that determine the relationshi between the 'ustralian dollar and the <a anese yen. !he <a anese re;uire dollars to ay for their im orts of goods and ser$ices from 'ustralia and to fund any in$estment they may wish to undertake in this country. 'ssume that they obtain these dollars on the foreign exchange market by su su lying =selling> yen in return. 8o the <a anese demand for dollars =mirrored by the ly of yen> is determined by the ex orts to <a an and our ca ital inflow from that country.

2n the other side of the market& the 'ustralian demand for yen is determined by our need to ay for im orts from <a an& and for any ca ital in$estment that we undertake there. We buy those yen by su country. lying 'ustralian dollars in return. !hus the su ly of dollars =mirrored by the demand for yen> is determined by our im orts from <a an and our ca ital outflow to that

6n summary& then& the demand for 'ustralian dollars reflects the beha$ior of our ex orts and ca ital inflow& while the su ly of dollars reflects the beha$ior of our im orts and ca ital outflow. 6n other words& transactions on the foreign exchange market echo the international trade and financial transactions that are summari?ed in the balance of ayments. Within the balance of ayments& the relationshi between our ex orts and im orts of goods and ser$ices is ca tured by the balance of current account& while the relationshi between ca ital inflow and ca ital outflow is ca tured by the balance of ca ital account. !he acti$ities of international currency s eculators affect the exchange rate directly through their im act on ca ital flows. !he distinguishing characteristic of a floating exchange rate system is that the rice of a currency ad"usts automatically to whate$er le$el is re;uired to e;uate the su transactions and the su ly of and demand for that currency& thereby clearing the market. !he logic of the relationshi between our international ly and demand for currencies im lies that this market9clearing& or 7e;uilibrium7& rice also roduces automatic e;uilibrium in the balance of ayments. !hat is& the balance of current account =whether ositi$e& negati$e& or ?ero> must be recisely offset by the balance =negati$e& ositi$e& or ?ero> of the ca ital account. @nder floating exchange rates these outcomes are achie$ed automatically without the need for go$ernment inter$ention. By contrast& under fixed exchange rates balance of ayments e;uilibrium is not the normal condition. !hese characteristics of the floating exchange rate mechanism ha$e im ortant im lications both for the nature of our relationshi with the global en$ironment& and for the olicy o tions a$ailable to the authorities in managing the economy. Aet us now consider some of these.

&nternational Trans%ission o# Econo%ic 'ta(ilit) ' flexible exchange rate acts as a kind of shock absorber that hel s to insulate us against o$erseas disturbances. !his is because the relationshi between our international transactions and ,

the foreign exchange market runs in both directions. Aet us su

ose& for exam le& that recession

in the <a anese economy leads to a decline in the demand for 'ustralian ex orts. 6n itself& this will tend to reduce economic acti$ity in 'ustralia. But this tendency will be offset by an associated de reciation of the dollar& which will induce an ex ansion of ex orts& a contraction of im orts& and erha s an increase in net ca ital inflow& all of which will hel to cushion the 'ustralian economy against recession. 'n analogous mechanism would o erate to reduce the im act of an initial decline in <a anese in$estment in 'ustralia. Both cases illustrate the role of exchange rate flexibility in insulating our economy to some degree against international economic instability. By the same reasoning& floating exchange rates also hel to diminish the international transmission of our own domestic economic instability. Characteristics o# the Foreign Exchange Market !he Forex market does not exist hysically& it is a framework where artici ants are connected by com uters& tele hones and telex =8W6F!> and o erates in most financial centres globally. Because the Forex market is so highly integrated globally& it can o erate (* hours a day B when one ma"or market is closed& another ma"or market is o en to facilitate trade occurring (* hours a day mo$ing from one ma"or market to another. Most exchanges of currency are made through bank de osits i.e. transferred electronically from one account to another. !he $olume of foreign exchange transactions worldwide is assumed to be a roximately @8- ( trillion er day. !he a$erage daily turno$er in the 8outh 'frican market is .## billion er day and 8tandard Bank is the recognised leader in the domestic foreign exchange market& handling more than +/C of 8outh 'frica7s foreign exchange $olume. !he Forex market is an o$er9the9 counter market i.e. trading in financial instruments that are not listed or a$ailable on an officially recognised exchange =such as the <8E B <ohannesburg 8tock Exchange>& but traded in direct negotiation between buyers and sellers. !rading takes lace tele honically or electronically.

Wh) !o *e %ake "se o# the Foreign Exchange Market$

!rading in a domestic market is substantially different from doing business in an offshore market. 6n the com lex world of international trade& merchants face a number of risks that need to be managed in order to ensure the success of their cross B border transactions. 6n order to rotect themsel$es& these cor orations a ly hedging techni;ues using $arious foreign exchange instruments and roducts in order to negate the im acts of exchange rate fluctuations. 8uccessful com anies em loy effecti$e risk management techni;ues when making business decisions& and e$aluate commercial risk in an ex licit and logical manner in order to offset financial loss occasioned by the $olatility in exchange rates =currency risk>. Who are the Foreign Exchange Market Participants$ Dommercial Banks artici ate in the market by offering to buy and sell foreign exchange on behalf of their retail or wholesale customers as a art of their financial ser$ice. !hey also trade in foreign exchange as an intermediary and market maker. =' market maker ;uotes a buy and sell rice on a currency or financial instrument ho ing to make a rofit on the s read i.e. the difference between the buying and the selling rice>. 2ther financial 6nstitutions& such as Brokers =6nstitutional 6n$estors& 6nsurance com anies& Eension& Mutual and Fedge Fund Managers> need to manage $arious ortfolios on behalf of their clients& and thus artici ate in the foreign exchange market. !hey rely on the rates ;uoted by the market makers to market artici ants and charge commission or a brokerage fee for ser$ices rendered. Dor orations buy and sell foreign exchange generally to facilitate trade& or as a result of a trade done and also to hedge currency ex osures that exist due to a articular trade conducted. !hese cor orations generally consist of ex orters and im orters. Dentral Banks can sometimes inter$ene in the foreign exchange market in order to im lement monetary olicies.

Foreign Exchange &nstr"%ents

3

' number of foreign exchange instruments ha$e been designed for effecti$e hedging as well as enhancement of returns. !he following instruments and roducts are most common to the Foreign Exchange Market to facilitate international trade and will be co$ered in future Forex Bulletins) 8 ot transactions& Forward !ransactions =FED%s>& 2 tions =-eri$ati$es of exchange rates>& 6nternational money transfers& Guarantees& Dommercial Dustomer Foreign Durrency accounts& -ocumentary Dredit and Dollections&

Factors in#l"encing exchange rates

Foreign exchange rates are extremely $olatile and it is incumbent on those in$ol$ed with foreign exchange 9 either as a urchaser& seller& s eculator or institution 9 to know what causes rates to mo$e. 'ctually& there are a $ariety of factors 9 market sentiment& the state of the economy& go$ernment olicy& demand and su ly and a host of others.

!he more im ortant factors that influence exchange rates are discussed below) Strength of the Economy :!he strength of the economy affects the demand and su ly of

foreign currency. 6f an economy is growing fast and is strong it will attract foreign currency thereby strengthening its own. 2n the other hand& weaknesses result in an outflow of foreign exchange. 6f a country is a net ex orter =as were <a an and Germany>& the inflow of foreign currency far outstri s the outflow of their own currency. !he result is usually a strengthening in its $alue. Political and Psychological Factors: Eolitical or sychological factors are belie$ed to ha$e an influence on exchange rates. Many currencies ha$e a tradition of beha$ing in a articular way such as 8wiss francs which are known as a refuge or safe ha$en currency while the dollar mo$es =either u or down> whene$er there is a olitical crisis anywhere in the world. Exchange rates can also fluctuate if there is a change in go$ernment. 8ome time back& 6ndia%s foreign exchange rating was downgraded because of olitical instability and conse;uently& the external $alue of the ru ee fell. Wars and other external factors also affect the exchange rate. For exam le& when Bill 5

Dlinton was im eached& the @8 dollar weakened. -uring the 6ndo9Eak war the ru ee weakened. 'fter the #000 cou in Eakistan =2ctober4Go$ember #000>& the Eakistani ru ee weakened. Economic Expectations )Exchange rates mo$e on economic ex ectations. 'fter the #000 budget in 6ndia there was an ex ectation that the ru ee would fall by 3C to 0C. 8ince such ex ectations affect the external $alue of the ru ee& all economic data 9 the balance of ayments& ex ort growth& inflation rates and the likes 9 are analysed and its likely effect on exchange rates is examined. 6f the economic downturn is not as bad as antici ated the rate can e$en a reciate. !he mo$ement really de ends on the market sentiment 9 the mood of the market 9 and how much the market has reacted or discounted the antici ated4ex ected information. Inflation Rates : 6t is widely held that exchange rates mo$e in the direction re;uired to com ensate for relati$e inflation rates. For instance& if a currency is already o$er$alued& i.e. stronger than what is warranted by relati$e inflation rates& de reciation sufficient enough to correct that osition can be ex ected and $ice $ersa. 6t is necessary to note that an exchange rate is a relati$e rice and hence the market weighs all the relati$e factors in relati$e terms =in relation to the counter art countries>. !he underlying reasoning behind this con$iction is that a relati$ely high rate of inflation reduces a country%s com etiti$eness and weakens its ability to sell in international markets. !his situation& in turn& will weaken the domestic currency by reducing the demand or ex ected demand for it and increasing the demand or ex ected demand for the foreign currency =increase in the su of foreign currency>. Capital Movements : Da ital mo$ements are one of the most im ortant reasons for changes in exchange rates. Da ital mo$ements of foreign currency are usually more than connected with international trade. !his occurs due to a $ariety of reasons 9 both ositi$e and negati$e. When 6ndia began its economic liberalisation and in$ited Foreign 6nstitutional 6n$estors =F66s> to urchase e;uity shares in 6ndian com anies& billions of @8 dollars came into the country strengthening the currency. 6n #001 and #003& F66s took se$eral billion @8 dollars out of the country weakening the currency. !hese were ca ital outflows. 2ne of the reasons o ularly belie$ed for the ru ee not de reciating in the manner other 8outh9east 'sian currencies did in #003905 was because the ru ee was not con$ertible on the ca ital account. 0 ly of domestic currency and decrease in the su ly

 Speculation ) 8 eculation in a currency raises or lowers the exchange rate. For instance& the foreign exchange market in Henya is $ery shallow. 6f a s eculator enters and buys @8 I# million& it will raise the $alue of the @8 dollar significantly. 6f a few others do so too& the rice of the @8 dollar will rise e$en further against the Henya shilling. !he most famous s eculator in foreign currency is Mr George 8oros who made o$er a billion ounds sterling in Euro e =by correctly redicting the de$aluation of the ound> and then is belie$ed to ha$e triggered the free fall of the currencies of 8outh9east 'sia. . Balance of Payments ) 's mentioned earlier& a net inflow of foreign currency tends to strengthen the home currency $is9J9$is other currencies. !his is because the su ly of the foreign currency will be in excess of demand. ' good way of ascertaining this would be to check the balance of ayments. 6f the balance of ayments is ositi$e and foreign exchange reser$es are increasing& the home currency will become stronger. overnment!s Monetary and Fiscal Policies : Go$ernments& through their monetary and fiscal olicies affect international trade& the trade balance and the su 6ncreasing the su ly and demand for a currency. ly of money raises rices and makes im orts attracti$e. Fiscal sur luses will

slow economic growth and this will reduce demand for im orts and encourage ex orts. !he effecti$eness of the olicy de ends on the rice and income elasticities of demand for the articular goods. Figh rice elasticity of demand means the $olume of a good is sensiti$e to a change in rice. Monetary and fiscal olicy su su ort the currency through a reduction in inflation. ly direct ly and they are !hese also affect exchange rate through the ca ital account. Get ca ital inflows su ort for the exchange rate. Dentral go$ernments control monetary su

ex ected to ensure that the go$ernment%s monetary olicy is followed. !o this extent they could increase or decrease money su restricted and cut money su ly. For exam le& the .eser$e Bank of 6ndia& to curb inflation& ly. 6n Henya& the central bank in order to attract foreign money into

the country is offering $ery high rates on its treasury bills. 6n order to maintain exchange rates at a certain rice the central bank will also inter$ene either by buying foreign currency =when there is an excess in the su ly of foreign exchange> and selling foreign currency =when demand for ly>. !his is known as Kcentral bank inter$ention%. 6t must be noted foreign exchange exceeds su

that the ob"ecti$e of monetary olicy is to maintain stability and economic growth and central

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banks are ex ected to 9 by increasing4decreasing money su by o en market o erations 9 maintain stability.

ly& raising4lowering interest rates or

Exchange Rate Policy and Intervention) Exchange rates are also influenced& in no small measure& by ex ectation of change in regulations relating to exchange markets and official inter$ention. 2fficial inter$ention can smoothen an otherwise disorderly market. 's ex lained before& inter$ention is the buying or selling of foreign currency to increase or decrease its su ly. Dentral banks often inter$ene to maintain stability. 6t has also been ex erienced that if the authorities attem t to half9heartedly counter the market sentiments through inter$ention in the market& ultimately more stee and sudden exchange rate swings can occur. Interest Rates : 'n im ortant factor for mo$ement in exchange rates in recent years is interest rates& i.e. interest differential between ma"or currencies. 6n this res ect the growing integration of financial markets of ma"or countries& the re$olution in telecommunication facilities& the growth of s ecialised asset managing agencies& the deregulation of financial markets by ma"or countries& the emergence of foreign trading as $olatility. Henya intrinsically has a $ery weak economy but the rates offered within the country ha$e always been $ery high. !o illustrate this oint the treasury bill rate in 8e tember #005 was as high as (+C. Figh interest rates attract s eculati$e ca ital mo$es so the announcements made by the Federal .eser$e on interest rates are usually eagerly awaited 9 an increase in the same will cause an inflow of foreign currency and the strengthening of the @8 dollar. "ariffs and #uotas ) !ariffs and ;uotas exist to rotect a country%s foreign exchange by reducing demand. !ill before liberalisation& 6ndia followed a olicy of tariffs and restrictions on im orts. Lery few items were ermitted to be freely im orted. 'dditionally& high customs duties were im osed to discourage im orts and to rotect the domestic industry. !ariffs and ;uotas are not o ular internationally as they tend to close markets. When 6ndia lifted its barriers& se$eral industries such as the mini steel and the scra metal industries colla sed =im orted scra became chea er than the domestic one>. Muotas are not restricted to de$elo ing countries. !he @nited ## rofit centres er se and the tremendous sco e for bandwagon and s;uaring effects on the rates& etc. ha$e accelerated the otential for exchange rate

8tates im oses ;uotas on readymade garments and <a an has se$ere ;uotas on non9<a anese goods. Exchange Control ) !he ur ose of exchange control is to manage the su ly and demand balance of the home currency by the go$ernment using direct controls basically to rotect it. Durrency control is the restriction of using or a$ailing of foreign currency at home4abroad. 6n 6ndia& u to liberali?ation in the nineties there was $ery se$ere exchange control. 'ccess to foreign currency was tightly controlled and the same was released only for ermitted ur oses. !his was because 6ndian ex orts had not taken off and there were still large im orts. !here are se$eral countries that maintain their rates at artificial le$els such as Bangladesh. 6ndia is now fully& con$ertible on the current account but not as yet on the ca ital account. !his& to an extent& ossibly sa$ed 6ndia when the run on currencies took lace in 'sia in #003. 6f the 6ndian ru ee was fully con$ertible and there were no exchange control restrictions& the ru ee would ha$e been o en for s eculation. !here would ha$e been large outflows at a time of concern resulting in a snowballing lunge in its $alue. 's long as the ar $alue system re$ailed& the rates could not go beyond the u er and lower

inter$ention oints. !he only real ;uestion under the fixed rate system was whether the balance of ayments and foreign exchange reser$es had deteriorated to such an extent that de$aluation was imminent or ossible. Dountries with strong balance of ayments and reser$e ositions were hardly called u on to re$alue their currencies. Fence& a watch had to be ke t only on deficit countries. Fowe$er& under generali?ed floating regime& exchange rates are influenced by a multitude of economic& financial& olitical and sychological factors. But the relati$e significance of any of these factors can $ary from time to time making it difficult to redict recisely how any single factor will influence the rates and by how much.

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Deter%ination o# Exchange +ates

6n sim le terms& it is the interaction of su ly and demand factors for two currencies in the ly and

market that determines the rate at which they trade. But what factors influence the many thousands of decisions made each day to buy or sell a currency: Fow do changes in su year: !his com lex issue has been extensi$ely studied in economic literature and widely discussed among in$estors& officials& academicians& traders& and others. 8till& there are no definiti$e answers. Liews on exchange rate determination differ and ha$e changed o$er time. Go single a roach ro$ides a satisfactory ex lanation of exchange rate mo$ements& articularly short9 and medium9term mo$ements& since the ad$ent of wides read floating in the early #03/s. !hree as ects of exchange rate determination are discussed below. First& there is a brief descri tion of some of the broad a roaches to exchange rate determination. 8econd& there are some comments on the roblems of exchange rate forecasting in ractice. !hird& central bank inter$ention and its effects on exchange rates are discussed. 8ome a roaches to exchange rate determination) "he Purchasing Po$er Parity %pproach Eurchasing Eower Earity =EEE> theory holds that in the long run& exchange rates will ad"ust to e;uali?e the relati$e urchasing ower of currencies. !his conce t follows from the law of one rice& which holds that in com etiti$e markets& identical goods will sell for identical rices when $alued in the same currency. !he law of one rice relates to an indi$idual roduct. ' generali?ation of that law is the absolute $ersion of EEE& the ro osition that exchange rates will e;uate nations% o$erall rice le$els. More commonly used than absolute EEE is the conce t of relati$e EEE& which focuses on #+ demand conditions ex lain the ath of an exchange rate o$er the course of a day& a month& or a

changes in rices and exchange rates& rather than on absolute rice le$els. .elati$e EEE holds that there will be a change in exchange rates ro ortional to the change in the ratio of the two nations% rice le$els& assuming no changes in structural relationshi s. !hus& if the @.8. rice le$el rose #/ ercent and the <a anese rice le$el rose , ercent& the @.8. dollar would de reciate , ercent& offsetting the higher @.8. inflation and lea$ing the relati$e urchasing ower of the two currencies unchanged. EEE is based in art on some unrealistic assum tions) that goods are identicalN that all goods are tradableN that there are no trans ortation costs& information ga s& taxes& tariffs& or restrictions of tradeN and Oim licitly and im ortantlyOthat exchange rates are influenced only by relati$e inflation rates. But contrary to the im licit EEE assum tion& exchange rates also can change for reasons other than differences in inflation rates. .eal exchange rates can and do change significantly o$er time& because of such things as ma"or shifts in roducti$ity growth& ad$ances in technology& shifts in factor su lies& changes in market structure& commodity shocks& shortages& and booms.

6n addition& the relati$e $ersion of EEE suffers from measurement roblems)What is a good starting oint& or base eriod: Which is the a ro riate rice index: Fow should we account for new roducts& or changes in tastes and technology: EEE is intuiti$ely lausible and a matter of common sense& and it undoubtedly has some $alidity Osignificantly different rates of inflation should certainly affect exchange rates. EEE is useful in assessing long9term exchange rate trends and can ro$ide $aluable information about long9run e;uilibrium. But it has not met with much success in redicting exchange rate mo$ements o$er short9 and medium9term hori?ons for widely traded currencies. 6n the short term& EEE seems to a ly best to situations where a country is ex eriencing $ery high& or e$en hy erinflation& in which large and continuous rice rises o$erwhelm other factors. "he Balance of Payments and the Internal& External Balance %pproach

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EEE concentrates on one art of the balance of aymentsOtradable goods and ser$icesO and ostulates that exchange rate changes are determined by international differences in rices& or changes in rices& of tradable items. 2ther a roaches ha$e focused on the balance of ayments on current account& or on the balance of ayments on current account lus long9term ca ital& as a guide in the determination of the a ro riate exchange rate. But in today%s world& it is generally agreed that it is essential to look at the entire balance of aymentsOboth current and ca ital account transactionsOin assessing foreign exchange flows and their role in the determination of exchange rates. <ohn Williamson and others ha$e de$elo ed the conce t of the fundamental e;uilibrium exchange rate& or FEE.& en$isaged as the e;uilibrium exchange rate that would reconcile a nation%s internal and external balance. 6n that system& each country would commit itself to a macroeconomic strategy designed to lead& in the medium term& to internal balanceOdefined as unem loyment at the natural rate and minimal inflationOand to external balanceOdefined as achie$ing the targeted current account balance. Each country would be committed to holding its exchange rate within a band or target ?one around the FEE.& or the le$el needed to reconcile internal and external balance during the inter$ening ad"ustment eriod. !he conce t of FEE.& as an e;uilibrium exchange rate to reconcile internal and external balance& is a useful one. But there are ractical roblems in calculating FEE.s.!here is no uni;ue answer to what constitutes the FEE.N de ending on the articular assum tions& models& and econometric methods used& different analysts could come to ;uite different results. !he authors recogni?e this difficulty& and acknowledge that some allowance should be made by way of a target band around the FEE..Williamson has suggested that FEE. calculations could not realistically "ustify exchange rate bands narrower than lus or minus #/ ercent.

#,

!he 6MF& while generally agreeing that it is not ossible to identify recise e;uilibrium$alues for exchange rates and that oint estimates of notional e;uilibrium rates should generally be a$oided& does use a macroeconomic balance methodology to under in its internal 6MF multilateral sur$eillance. !his mehodology& which is used for assessing the a ro riatenessof current account ositions and exchange rates for ma"or industrial countries& is described in Box ##9#.3 "he Monetary %pproach !he monetary a roach to exchange rate determination is based on the ro osition that exchange rates are established through the rocess of balancing the total su for& the national money in each nation. !he remise is that the su ly of& and the total demand ly of money can be controlled

by the nation%s monetary authorities& and that the demand for money has a stable and redictable linkage to a few key $ariables& including an in$erse relationshi to the interest rateOthat is& the higher the interest rate& the smaller the demand for money. 6n its sim lest form& the monetary a roach assumes that) rices and wages are com letely flexible in both the short and long run& so that EEE holds continuously& that ca ital is fully mobile across national borders& and that domestic and foreign assets are erfect substitutes. 8tarting from e;uilibrium in the money and #1

foreign exchange markets& if the @.8. money su <a anese money su

ly increased& say& (/

ercent& while the

ly remained stable& the @.8. rice le$el& in time& would rise (/ ercent and

the dollar would de reciate (/ ercent in terms of the yen. 6n this sim lified $ersion& the monetary a roach combines the EEE theory with the ;uantity theory of moneyOincreases or decreases in the money su ly lead to ro ortionate increases or rice decreases in the rice le$el o$er time& without any ermanent effects on out ut or interest rates. More so histicated $ersions relax some of the restricti$e assum tionsOfor exam le& role of national monetary olicies. Em irical tests of the monetary a roachO sim le or so histicatedOha$e failed to ro$ide an ade;uate ex lanation of exchange rate mo$ements during the floating rate eriod. !he a roach offers only a artial $iew of the forces influencing exchange ratesOit assumes away the role of nonmonetary assets such as bonds& and it takes no ex licit account of su ly and demand conditions in goods and ser$ices markets. -es ite its limitations& the monetary a roach offers $ery useful insights. 6t highlights the im ortance of monetary olicy in influencing exchange rates& and correctly warns that excessi$e monetary ex ansion leads to currency de reciation. !he monetary a roach also ro$ides a basis for ex laining exchange rate o$ershootingOa situation often obser$ed in exchange markets in which a olicy mo$e can lead to an initial exchange rate mo$e that exceeds the e$entual change im lied by the new long9term situation. 6n the context of monetary a roach models that incor orate short9term stickiness in rices& exchange rate o$ershooting can occur because rices of financial assetsOinterest and exchange ratesOres ond more ;uickly to olicy mo$es than does the rice le$el of goods and ser$ices. !hus& for exam le& a money su ly increase =or decrease> in the @nited 8tates can lead to a flexibility and EEE may be assumed not to hold in the short runObut maintain the focus on the

greater tem orary dollar de reciation =a reciation> as domestic interest rates decline =rise> tem orarily before the ad"ustment of the rice le$el to the new long9run e;uilibrium is com leted and interest rates return to their original le$els.

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"he Portfolio Balance %pproach

!he ortfolio balance a roach takes a shorter9term $iew of exchange rates and broadens the focus from the demand and su su ly conditions for money to take account of the demand and ly conditions for other financial assets as well. @nlike the monetary a roach& the ortfolio

balance a roach assumes that domestic and foreign bonds are not erfect substitutes. 'ccording to the ortfolio balance theory in its sim lest form& firms and indi$iduals balance their ortfolios among domestic money& domestic bonds& and foreign currency bonds& and they modify their ortfolios as conditions change. 6t is the rocess of e;uilibrating the total demand for& and su of& financial assets in each country that determines the exchange rate. Each indi$idual and firm chooses a ortfolio to suit its needs& based on a $ariety of ly

considerationsOthe holder%s wealth and tastes& the le$el of domestic and foreign interest rates& ex ectations of future inflation& interest rates& and so on. 'ny significant change in the underlying factors will cause the holder to ad"ust his ortfolio and seek a new e;uilibrium. !hese actions to balance ortfolios will influence exchange rates. 'ccordingly& a nation with a sudden increase in money su ly would immediately urchase both domestic and foreign bonds& resulting in a decline in both countries% interest rates& and& to the extent of the shift to foreign bonds& a de reciation in the nation%s home currency. 2$er time& the de reciation in the home currency would lead to growth in the nation%s ex orts and a decline in its im orts& and thus& to an im ro$ed trade balance and re$ersal of art of the original de reciation. 's yet& there is no unified theory of exchange rate determination based on the ortfolio balance a roach that has ro$ed reliable in forecasting. 6n fact& results of em irical tests of the ortfolio balance a roach do not com are fa$orably with those from sim ler models. !hese results reflect both conce tual roblems and the lack of ade;uate data on the si?e and currency

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com osition of ri$ate sector ortfolios.

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Ge$ertheless& the ortfolio balance a roach offers a useful framework for studying exchange rate determination. With its focus on a broad menu of assets& this a roach ro$ides richer insights than the monetary a roach into the forces influencing exchange rates. 6t also enables foreign exchange rates to be seen like asset rices in other markets& such as the stock market or bond market& where rates are influenced& not only by current conditions& but to a great extent by market ex ectations of future e$ents. 's with other financial assets& exchange rates change continuously as the market recei$es new information about current conditions and information that affects ex ectations of the future. !he random character of these asset rice mo$ements does not rule out rational ricing. 6ndeed& it is ersuasi$ely argued that this is the result to be ex ected in a well functioning financial market. But in such an en$ironment& exchange rate changes can be large and $ery difficult to redict& as market artici ants try to "udge the ex ected real rates of return on their domestic assets in com arison with alternati$es in other currencies. ,o* Goo! Are the -ario"s Approaches$ !he a roaches noted abo$e are some of the most general and most familiar ones& but there are many others& focusing on differentials in real interest rates& on fiscal olicies& and on other elements.

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!he research on this to ic has been of great $alue in enhancing our understanding of long9run exchange rate trends and the issues in$ol$ed in estimating e;uilibrium rates. 6t has hel ed us understand $arious as ects of exchange rate beha$ior and articular exchange rate e isodes. Pet none of the a$ailable em irical models has ro$ed ade;uate for making reliable redictions of the course of exchange rates o$er a eriod of time. .esearch thus far has not been able to find stable and significant relationshi s between exchange rates and any economic fundamentals ca able of consistently redicting or ex laining short9term rate mo$ements.

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Foreign exchange #orecasting in practice

Most of the a roaches to exchange rate determination tell only art of the storyOlike the se$eral blindfolded men touching different arts of the ele hant%s bodyOand other& more com rehensi$e ex lanations cannot& in ractice& be used for recise forecasting. We do not yet ha$e a way of bringing together all of the factors that hel determine the exchange rate in a single com rehensi$e a roach that will ro$ide reliable short9 to medium9term redictions. !he exchange rate is a er$asi$e and com lex mechanism& influencing and being influenced by many different forces& with the effects and the relati$e im ortance of the different influences continuously changing as conditions change. !o the extent that trade flows are a force in the market& com etiti$eness is ob$iously im ortant to the exchange rate& and the many factors affecting com etiti$eness must be considered.!o the extent that the money market is a factor& the focus should be on short9term interest rates& and on monetary olicy and other factors influencing those shortterm interest rates. !o the extent that ortfolio ca ital flows matter& the focus should be broadened to include bond market conditions and long9term interest rates. Earticularly at times of great international tension& all other factors affecting the dollar exchange rate may be o$erwhelmed by considerations of safe ha$en. 6ndeed& countless forces influence the exchange rate& and they are sub"ect to continuous and un redictable changes o$er time& by a market that is broad and heterogenous in terms of the artici ants& their interests& and their time frames. With conditions always changing& the im act of articular e$ents and the res onse to articular olicy actions can $ary greatly with the circumstances at the time. Figher interest rates might strengthen a currency or weaken it& by a small amount or by a lotOmuch de ends on why the interest rates went u & whether a mo$e was antici ated& what subse;uent mo$es are ex ected& and the im lications for other financial markets& decisions& or go$ernment olicy mo$es. 8imilarly& the results of exchange rate changes are not always redictable) 6m orters might ex ect to ay more if their domestic currency de reciates& but not if foreign roducers are (+

 ricing to market in order to establish a beachhead or maintain a market share& or if the im orters or ex orters had antici ated the rate mo$e and had acted in ad$ance to themsel$es from it. Gonetheless& those artici ating in the market must make their forecasts& im licitly and rotect

ex licitly& day after day& all of the time. E$ery iece of information that becomes a$ailable can be the basis for an ad"ustment of each artici ant%s $iew oint& or ex ectationsOin other words& a forecast& informal or otherwise. When the screen flashes with an unex ected announcement that& say& Germany has reduced interest rates by a ;uarter of one ercent& that is not "ust news& it is the basis for countless assessments of the significance of that e$ent& and countless forecasts of its im act in number of basis oints. !hose who forecast foreign exchange rates often are di$ided into those who use technical analysis& and those who rely on analysis of fundamentals& such as G-E& in$estment& sa$ing& roducti$ity& inflation& balance of ayments osition& and the like. !echnical analysis assumes certain short9term and longer9term information has been absorbed into the atterns in exchange rate iece of

mo$ements. 6t differs from the random walk hiloso hyOthe belief that all resently a$ailable resent exchange rate and that& the next information as well as the direction of the next rate mo$e is random& with a ,/ ercent chance the rate will rise& and ,/ ercent chance it will decline.

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Gearly all traders acknowledge their use of technical analysis and charts. 'ccording to sur$eys& a ma"ority say they em loy technical analysis to a greater extent than fundamental analysis& and

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that they regard it as more useful than fundamental analysisOa contrast to twenty years ago when most said they relied many more hea$ily on fundamental analysis. Eerha s traders use technical analysis in art because& at least su erficially& it seems sim ler& or because the data are more current and timely. Eerha s they use it because traders often ha$e a $ery short9term time frame and are interested in $ery short9term mo$es. !hey might agree that fundamentals determine the course of rices in the long run& but they may not regard that as rele$ant to their immediate task& articularly since many fundamental data become a$ailable only with long lags and are often sub"ect to ma"or re$isions. Eerha s traders think technical analysis will be effecti$e in art because they know many other market artici ants are relying on it. 8till& s otting trends is of real im ortance to tradersOa trend is a friend is a comment often heardOand technical analysis can add some disci line and so histication to the rocess of disco$ering and following a trend. !echnical analysis may add more ob"ecti$ity to making the difficult decision on when to gi$e u on a ositionOenabling one to see that a trend has changed or run its course& and it is now time for reconsideration. Most market artici ants robably use a combination of both fundamental and technical analysis& with the em hasis on each shifting as conditions changeOthat is& they form a general $iew about whether a articular currency is o$er$alued or under$alued in a structural or longer9term sense& and within that longer9term framework& assess the order flow and all current economic forecasts& news e$ents& olitical de$elo ments& statistical releases& rumors& and changes in sentiment& while also carefully studying the charts and technical analysis.

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O##icial actions to in#l"ence exchange rates

's in some other ma"or industrial nations with floating exchange rate regimes&in the @nited 8tates there is considerable sco e for the lay of market forces in determining the dollar exchange rate.But also& as in other countries&@.8. authorities do take ste s at times to influence the exchange rate& $ia olicy measures and direct inter$ention in the foreign exchange market to buy or sell foreign currencies.'s noted abo$e& in reser$es is offset by monetary olicy action. Go one ;uestions that monetary olicy measures can influence the exchange rate by affecting the relati$e attracti$eness of a currency and ex ectations of its ros ects& although it is difficult to find a stable and significant relationshi that would yield a redictable& recise res onse. But the ;uestion of the effecti$eness of sterili?ed inter$ention& which has been extensi$ely studied and debated& is much more contro$ersial. 8ome economists contend that sterili?ed inter$ention can ha$e& at best& a modest and tem orary effect. 2thers say it can ha$e a more significant effect by changing ex ectations about olicy and hel ing to guide the market. 8till others belie$e that the effect de ends on the articular market conditions and the inter$ention strategy of each situation. Gi$en the resent si?e of @.8. monetary aggregates& balance of ayments flows& and the le$els of acti$ity in the foreign exchange market and other financial markets& it is widely acce ted that any effects of sterili?ed inter$ention are likely to be through indirect channels rather than through direct im act on these large aggregates. Em irical tests of sterili?ed inter$ention ha$e focused on two main channels through which such inter$ention might indirectly influence the exchange rate) the ortfolio balance channel and the ex ectations& or signaling& channel.. !he ortfolio balance channel ostulates that the exchange rate is determined by the balance of su ly and demand for a$ailable stocks of financial assets held by the ri$ate sector. 6t holds that sterili?ed inter$ention will alter the currency com osition of assets a$ailable to the global ri$ate sector& and that if dollar and foreign currency9denominated assets are $iewed by in$estors as im erfect substitutes& sterili?ed inter$ention will cause mo$ements in the exchange rate to ree;uilibrate su ly and demand for dollar assets. !he si?e of this ortfolio balance effect would (3 ractice& all foreign exchange market inter$ention of the @.8. authorities is routinely sterili?edOthat is& the initial effect on @.8. bank

de end on the degree of substitutability between assets denominated in different currencies and on the si?e of the inter$ention o eration. !he ex ectations& or signaling& channel holds that sterili?ed inter$ention may cause ri$ate agents to change their ex ectations of the future ath of the exchange rate. !hus& inter$ention could signal information about the future course of monetary or other economic olicies& signal information about& or analysis of& economic fundamentals or market trends& or influence ex ectations by affecting technical conditions such as bubbles and bandwagons. ' considerable number of studies ha$e found no ;uantitati$ely im ortant effects of sterili?ed inter$ention through the ortfolio balance channel. 8ome studies ha$e found ex ectations or signaling effects of $arying degrees of significance. 2thers conclude that the effecti$eness de ends $ery much on market conditions and inter$ention strategy. !here are serious data and econometric roblems in studying this ;uestion. !o assess success& the researcher needs to know the ob"ecti$e of the inter$ention and other s ecific detailsOwas the aim to ameliorate a trend& sto a trend& re$erse a trend& show a resence& calm a market& discourage s eculation& or buy a little time: !he researcher also needs to know the counterfactual Owhat would ha$e ha ened if the inter$ention had not taken lace. 'lso& research on this issue must be laced in the broader context of research on exchange rate determination& which noted abo$e& indicates that it has not been ossible to find stable and significant relationshi s between exchange rates and any economic fundamentals. 's a ractical matter& it is difficult to make swee ing assessments about the success or failure of official inter$ention o erations. 8ome inter$ention o erations ha$e successful& while others ha$e been dismal failures. !he success or failure of inter$ention is not so much a matter of statistical robability as it is a matter of how it is used and whether conditions are a ro riate. 6s the ob"ecti$e reasonable: -oes the market look technically res onsi$e: 6s inter$ention antici ated: Will an o eration look credible: What is the likely effect on ex ectations: ro$en resoundingly

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6n #05+& the Working Grou

on Foreign Exchange Market 6nter$ention established at the

Lersailles summit of the Grou of 8e$en warned against ex ecting too much from official inter$ention& but concluded that such inter$ention can be a useful and effecti$e tool in influencing exchange rates in the short run& es ecially when such o erations are consistent with fundamental economic olicies. @n;uestionably& inter$ention o erations are more likely to succeed when there is a consistency with fundamental economic olicies& but it may not always be ossible to know whether that consistency exists. 'lthough attitudes differ& monetary authorities in all of the ma"or countries inter$ene in the foreign exchange markets at times when they consider it useful or a ro riate& and they are likely to continue to do so. !he current attitude toward foreign exchange market inter$ention is summari?ed in the following excer t from the <une #001 re ort of the finance ministers of the Grou of 8e$en nations)

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Flexi(le ./s #ixe! exchange rates

Exchange rates stability has always been the ob"ecti$e of monetary olicy of almost all countries. Exce t during the eriod of great de ression and world war66 & the exchange rate ha$e been almost stable.during the ost9 war 66 eriod & the 6MF had brought a new hase of exchange rate stability. Most go$ernments ha$e maintained ad"ustable fixed exchange rates till #03+. But the 6MF system failed to ro$ide an ade;uate solution to three ma"or roblems causing exchange instability9 #. Ero$iding sufficient reser$es to mitigate the short term fluctuations in the balance of ayments while maintaining the fixed exchange arte system. (. Eroblems of long term ad"ustments in the balance of ayments. +. Erices generated by s eculati$e transactions. For these reasons the currencies of many countries & es ecially the reser$e currency were sub"ect to fre;uent de$aluation in the early #03/&s. this raised doubts about the ossibility of the Brettenwood&s system&and also about the $iability of the fixed exchange rate system. !he breakdown of Brettonwood system generated a debate on whether fixed or flexible exchange rate should be used.Q !he main arguments in fa$our of fixed exchange rates are9 Firstly&Fixed exchange rate ro$ides stability in the foreign exchange market and certainty about the future course of the exchange rate and it eliminates risks caused by uncertainty due to fluctuations in the exchange rates. !he stability of exchange rate encourages international trade.on the contrary& flexible exchange rate system causes uncertainty and might also often lead to $iolent fluctuations in international trade. 's a result foreign trade oriented economies become sub"ect to se$ere economic fluctuations& if im ort elasticities are less than ex ort elasticities. Secondly & the fixed exchange rate system creates conditions for smooth flow of international ca ital sim ly because it ensures a certain return on the foreign in$estment. While in the case of +/

flexible exchange rate& ca ital flows are constrained because of uncertainity about ex ected rate of return. Thirdly, the fixed rate eliminates the ossibility of s eculation& whereby it remo$es the dangers of s eculati$e acti$ities in the foreign exchange market. 2n the contrary flexible exchange rates encourage s eculation. Fourthly , the fixed exchange rate system reduces the ossibility of com etiti$e de reciation of currencies as it ha ened during #0+/s. also& de$iations from fixed rate are easily ad"ustable. Fifthly& a case is also made in fa$our of fixed exchange rate on the basis of existence of currency areas. !he flexible exchange rate is said to be unsuitable between the nations which constitute a currency area& since it leads to a chaotic situation and hence ham ers trade between them. !he main arguments in fa$our of flexible exchange rates ) Firstly, flexible exchange rate system ro$ides larger degree of autonomy in res ect of domestic economic olicies as it is not obligatory for the coutries to tune their domestic olicies to fixed foreign exchange rate. Secondly& flexible exchange rate is self ad"usting and therefore it does not de$ol$e on the go$ernment to maintain an ade;uate foreign exchange reser$e. Thirdly, the flexible exchange rate& which is determined by market forces& has a theory behind it and has the ;uality of redictability. Fourthly& flexible exchange rates ser$e as a barometer of the actual urchasing ower and strength of a currency in the foreign exchange market. 6t ser$es as a useful arameter in the formulation of the domestic economic olicies.

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Fifthly, economists ha$e also argued that the most serious charge against fluctuating exchange rate i.e. unceratinty is not tenable because s eculators themsel$es create conditions for exchange rate stability. 'lso& the degree of uncertainity associated with flexible exchange rate could not be much greater then what the world has ex erienced with ad"ustable fixed exchange rate under the brettonwood%s system. !he debate on fixed $4s flexible exchange rate is inconclusi$e . infact& both systems ha$e their own merits and demerits.

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0i(liograph)
Books 9 Managerial Economics by -.G. -wi$edi. Managerial Economics by Dhatur$edi. Macroeconomics by ..H.Misra Macroeconomics by M.A. 8eth 8ites B www.forex.com www.moneyin$estment.com

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