FOREIGN EXCHANGE RATES

K K JINDAL

Foreign Exchange Rate

Number of units of one currency which may be bought or sold for one unit of another currency. Foreign currency may be viewed as an asset, a store of value having purchasing power.

FOREX MARKET
Overseas Market London, New York, Tokyo, Frankfurt
BI B2 B3 B4 B5 B6 B7 Bn Buy from ADs

RBI
IB Market
Mumbai, Delhi, Kolkata, Chennai AD1 AD2 AD3 AD4 AD5

Monitors FEX Market

ADn

AD
REMITTERS MERCHANT BENEFECIARIES IMPORTERS EXPORTERS

Forex Transactions [in $ bn] [2007-08]

Cash T+1 Spot Fwd TOTAL 315 408 1585 730 3038 233 316 885 343 1777

Spot Trade Foreign banks Public sector banks

57.08% 28.42%

Theories of Exchange rate determination

Efficient Exchange rate market Market equilibrium Purchase power parity The Fisher effect The international Fisher effect Interest rate parity The forward rate and future spot rate

Efficient Exchange Markets

Efficient exchange markets exist when exchange rates reflect all available information and adjust quickly to new information The concept of efficient exchange markets depends on three hypotheses:
Market prices such as product prices, interest rates, spot rates, and forward rates should reflect the markets consensus estimate of the future spot rate. Investors should not earn unusually large profits in forward speculation. Because exchange-rate forecasts based on market prices are accurate, publicly available forecasts of the future spot rate do not lead to unusual profits in forward speculation. It is impossible for any market analyst to beat the market consistently.

There are many indications that support the efficient market assumption for international money and exchange markets.

Market Equilibrium
There is an inverse relationship between exchange rate and quantity demanded, which explains why the demand curve for foreign exchange is downward sloping.
As the foreign exchange rate falls, the corresponding quantity of the foreign exchange demanded rises. As the exchange rate increases, the corresponding quantity demanded falls.

Changes in the demand for foreign exchange over time cause demand and supply schedules to shift upward or downward.

The Theory of Purchasing Power Parity

The PPP theory in its simplest form holds that the exchange rate must change in terms of a single currency so as to equate the prices of goods in two countries. The absolute version of the PPP theory maintains that the equilibrium exchange rate between domestic and foreign currencies equals the ratio between domestic and foreign prices. The relative version of the PPP doctrine indicates that in the ling run, exchange rates reflect the relative purchasing power of currencies. Appraisal of the PPP theory

The Theory of Purchasing Power Parity

Appraisal of the PPP theory
The PPP theory has some weaknesses: It assumes that goods are identical across countries and are readily transported for arbitrage purposes. It is not possible to compare a similar basket of goods for all countries, and as such we must rely on price indices, which are not always truly reflective of goods traded between countries. Many other factors influence exchange rates besides relative prices.

Despite of some weaknesses, the PPP theory is quite useful and seems to be valid over the long run.

The Fisher Effect

The Fisher Effect assumes that the nominal interest rate in each country consists of a real interest rate and an expected rate of inflation. It says that nominal interest rates are higher when people expect higher rates of inflation and are lower when people expect lower rates of inflation. The Fisher Effect asserts that real interest rates reequalized across countries through arbitrage. Appraisal of the Fisher Effect
The hypothesis of the Fisher Effect, based on long-term securities, suffers from an increased financial risk inherent in fluctuations of a bond market value prior to maturity. However, the Fisher Effect, based on long-term maturities, has worked fairly well in recent years.

The International Fisher Effect

The International Fisher Effect states that the future spot rate should move in an equal amount but in a difference in interest rates between two countries. A future spot rate of a currency with a higher interest rate would depreciate in the long run; a future spot rate of a currency with a lower interest rate would appreciate in the long run. The International Fisher Effect holds that the interest differential between two countries should be an unbiased predictor of the future change in the spot rate. Short-Run Behavior
Currencies of countries with higher interest rates than the United States tend to appreciate in value against the dollar. By the same token, currencies of countries with lower interest rates than the United States tend to depreciate in value against the dollar.

The Theory of Interest-Rate Parity

According to the interest parity theory, the spread between a forward rate and a spot rate should be equal but opposite in sign to the difference in interest rates between two countries. The interest rate parity theory holds that the difference between a forward rate and a spot rate equals the difference between a domestic interest rate and a foreign interest rate.

The Forward Rate and the Future Spot Rate

If speculators think that a forward rate is higher than their prediction of a future spot rate, they will sell the foreign currency forward.
This speculative transaction will bid down the forward rate until it equals the expected future spot rate.

By the same token, if spe4culators think that a forward rate is lower than the expected future spot rate, they will buy a foreign currency forward.
This speculative transaction will bid up the forward rate until it reaches the expected future spot rate.

Determination Theories
The forward rate is the best possible forecaster of the future spot rate. The text develops a graphical framework which emphasizes the links that exist among spot exchange rates, forward rates, interest rates, and inflation rates.

EXCHANGE RATE

DIRECT QUOTE

INDIRECT QUOTE

Number of domestic currency units needed to buy/sell one unit of foreign currency

Number of domestic currency units needed to buy/sell one unit of domestic currency

EXCHANGE RATE PREDICTIONS

Aspects of Market Behaviour No single factor provides are liable basis Relative influence of each factor varies from time to time Exchange rate responds quickly to changes in some of the variables (INTT rate changes)

Govt. intervention policy forecasting of govt. / central bank intervention

Existence of international speculators moving funds from one centre to another Day to day influences can move exchange rate substantially
Most of the future developments are foreseen by the market operations causing anticipatory adjustments in the market rates Development cast their shadows forward : the market discounts expected changes and after occurrence, currency rate may not more in the same directions

EXCHANGE RATES
1. Base Rate

The base rate selected by ADs should be in line with the ongoing market rate
it may be cover rate for large value orders

2. Exchange Margin
a) TT buying b) Bill buying c) TT selling Margin are negotiable 0.025% to 0.80% 0.125% to 0.150% 0.125% to 2.00%

3. Spread
TT (Selling) TT (Buying) TT (Buying) + TT (Selling)

2
US $ Pound Others 1% (not to exceed) 2% No limits

4. Round Off
To the nearest paise in case of card rates

TT SELLING RATE
Outward Remittance in Foreign Currency (TT, MT, PO, DD) Cancellation of purchase Bill purchased earlier is returned unpaid Transferred to collection Earlier inward remittance (returned to the remitting banks) A forward purchase contract cancelled Import documents received directly by the importer

Generally, if the remittance is clean remittance i.e. no documents to be handled by the bank, the TT selling rate is applied.

BILL SELLING RATE

Remittance of proceeds of Import Bills retired by importers (bill received directly by Banks) Even if proceeds of import bills are to be remitted in FC by way of TT, MT. PO. DD. Rate to be applied is bill selling rate.

IILUSTRATIVE TRANSACTIONS
TT BUYING RATES (a) Clean inward remittance (TT, MT, DD for which cover has already been credited to Ads NOSTRO A/c abroad. (b) Conversion of proceeds of instruments sent on collection basis (c) Cancellation of outward TT, MT, DO. PO. Etc. (d) Cancellation of forward sale contract Generally, if the NOSTRO account has been credited, the TT Buying rate is applied BILLS BUYING RATES

Purchase / Discounting / Negotiations of export bills

FC TCS AND CURRENCY NOTES

TC BUYING RATES Take one month forward market buying rate Deduct a commission of a max of 1% Round off to 5 paise

TC SELLING RATES
Take clean TT selling rate Add a margin of 0.5% (Optional) Add commission of 1% (Optional) Round off to 5 paise

CURRENCY NOTES

PURCHASE RATE

SELLING RATE

TC Buying Rate less 0.5%

TC Selling Rate Plus plus 0.5%

PERSONAL CHEQUES / IMO / PO PAYABLE ABROAD

TT buying rate deduct exchange margin 0.15%

Interest to be recovered separately to 15 days from customer at domestic commercial Rate or Interest

VALUE DATE
Is a date on which the exchange of currencies actually takes place CASH / READY SAME DAY It is the rate when exchange of currencies take place on the date of deal TOM When exchange of currencies takes place on the next working day SPOT When the exchange of currencies takes place on the second working day after the date of deal

FORWARD RATE

When the exchange of currencies takes place after period of spot date
Premium Discount : : When currency is costlier in future When currency is cheaper in future

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