Currency Exchange

Definition

An exchange rate is the price of one nation’s currency in terms of another currency, often termed as the reference currency.

For example, the rupee/dollar exchange rate is just the number of Rupees that one dollar will buy, if a dollar will buy 100 Rupees then the exchange rate could be expressed as Rs.100/$ and Rupees will be the reference currency.

Similarly, the dollar/Rupees exchange rate is the number of dollars one Rupee will buy; following the same example the exchange rate would be $0.01/Rs.

As per Foreign Exchange Act, (Section 2), 1947:
(a) "Foreign Currency" means any currency other than Indian currency
(b) "Foreign Exchange" includes any instrument drawn, accepted, made or issued under clause (8) of section 17 of the Banking Regulation Act, 1956, all deposits, credits and balance payable in any foreign currency and any drafts, traveler’s cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency.

Currency Quotation

The first currency quoted in a currency pair on forex BC/VC. It is also typically considered the domestic currency or accounting currency. For accounting purposes, a firm may use the base currency to represent all profits and losses. For example, if you were looking at the CAD/USD currency pair, the Canadian dollar would be the base currency and the U.S. dollar would be the Foreign/quote currency. The price represents how much of the quote currency is needed for you to get one unit of the base currency.

Direct Quote: A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other words, it involves quoting in fixed units of foreign currency against variable amounts of the domestic currency.

Example: In the U.S., a direct quote for the Canadian dollar would be US$0.85= C$1. Conversely, in Canada, a direct quote for the U.S. dollars would be C$1.17= US$1.

Indirect Quote: For example, in the U.S., an indirect quote for the Canadian dollar would be C$1.17 = US$1. Conversely, in Canada an indirect quote for the U.S. dollars would be US$0.85 = C$1.

Currency Appreciation and Depreciation:

When a currency becomes more valuable relative to another currency it is said to be appreciated. The price of the foreign exchange has fallen (for example, 1 USD buys Rs. 45 instead of Rs. 39 earlier).
When a currency becomes less valuable relative to another currency, it is said to be depreciated. The price of the foreign exchange has risen (for example 1 USD buys Rs. 39 instead of Rs. 45).

Participants in the Foreign Exchange Market

All Scheduled Commercial Banks (Authorized Dealers only)
Reserve Bank of India (RBI)
Corporate Treasuries
Public Sector/Government
Inter Bank Brokerage Houses
Resident Indians
Non Residents
Exchange Companies
Money Changers

Foreign Exchange Regimes

FIXED/PEGGED: A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to maintain their currency value constant against one another. In a fixed exchange-rate system, a country’s government decides the worth of its currency in terms of either a fixed weight of gold, a fixed amount of another currency or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payments imbalances.

How Does it Work

Under this system, the central bank first announces a ﬁxed exchange-rate for the currency and then agrees to buy and sell the domestic currency at this value. The market equilibrium exchange rate is the rate at which supply and demand will be equal that is, markets will clear. In a ﬂexible exchange rate system, this is the spot rate. In a ﬁxed exchange-rate system, the pre-announced rate may not coincide with the market equilibrium exchange rate. The foreign central banks maintain reserves of foreign currencies and gold which they can sell in order to intervene in the foreign exchange market to make up the excess demand or take up the excess supply.
The demand for foreign exchange is derived from the domestic demand for foreign goods, services and financial assets. The supply of foreign exchange is similarly derived from the foreign demand for goods, services and financial assets coming from the home country. Fixed exchange-rates are not permitted to fluctuate freely or respond to daily changes in demand and supply. The government fixes the exchange value of the currency. For example, the European Central Bank (ECB) may fix its exchange rate at €1 = $1 (assuming that the euro follows the fixed exchange-rate). This is the central value or par value of the euro. Upper and lower limits for the movement of the currency are imposed, beyond which variations in the exchange rate are not permitted. The "band" or "spread" in Fig.1 is €0.4 (from €1.2 to €0.8).

Scenario 1 - Excess demand for dollars: Fig. 2 describes the excess demand for dollars. This is a situation where domestic demand for foreign goods, services and financial assets exceeds the foreign demand for goods, services, and financial assets from the European Union. If the demand for dollar rises from DD to D'D', excess demand is created to the extent of cd. The ECB will sell cd dollars in exchange for euros to maintain the limit within the band. Under a floating exchange rate system, equilibrium would have been achieved at e.

When the ECB sells dollars in this manner, its official dollar reserves decline and domestic money supply shrinks. To prevent this, the ECB may purchase government bonds and thus, meet the shortfall in money supply. This is called sterilized intervention in the foreign exchange market. When the ECB starts running out of reserves, it may also devalue the euro in order to reduce the excess demand for dollars that is, narrow the gap between the equilibrium and ﬁxed rates.

Scenario 2 - Excess Supply for Dollars: Fig. 3 describes the excess supply of dollars. This is a situation where the foreign demand for goods, services and financial assets from the European Union exceeds the European demand for foreign goods, services and financial assets. If the supply of dollars rises from SS to S'S', excess supply is created to the extent of ab. The ECB will buy ab dollars in exchange for euros to maintain the limit within the band. Under a floating exchange rate system, equilibrium would again have been achieved at e. When the ECB buys dollars in this manner, its official dollar reserves increase and domestic money supply expands, which may lead to inflation. To prevent this, the ECB may sell government bonds and thus, counter the rise in money supply. When the ECB starts accumulating excess reserves, it may also revalue the euro in order to reduce the excess supply of dollars that is, narrow the gap between the equilibrium and ﬁxed rates. This is the opposite of devaluation.

2. COMPOSITE: Countries often have several important trading partners or are apprehensive of a particular currency being too volatile over an extended period of time. They can thus choose to peg their currency to a weighted average of several currencies (also known as a currency basket).

3. CRAWLING PEGS: In a crawling peg system a country fixes its exchange rate to another currency or basket of currencies. This fixed rate is changed from time to time at periodic intervals with a view to eliminating exchange rate volatility to some extent without imposing the constraint of a fixed rate. Crawling pegs are adjusted gradually, thus avoiding the need for interventions by the central bank (though it may still choose to do so in order to maintain the fixed rate in the event of excessive fluctuations).

4. FREE FLOATING: Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

Exchange Rate Determination:

It is determined by the equilibrating interaction of buyers and sellers of currencies in the FOREX market: demand and supply determine exchange rates.
Demand for a currency for making payments for foreign trade and capital flows.
Supply of a currency, during foreign trade:

Exchange Rate Equilibrium

An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.

Factors Affecting Exchange Rate:

1. Relative Inflation Rate:
U.S. Inflation: 1. The U.S. demand for Indian goods, and hence Rs
2. Indian desire for the U.S. goods, and hence the supply of Rs

2. Relative Interest Rate:
The U.S. Interest rates: 1. U.S. demand for Indian bank deposits, and hence demand for Rs
2. Indian desire for the U.S. bank deposits and hence the supply of Rs

3. Relative Income Levels:
The U.S. income level: 1. The U.S. demand for Indian goods, and hence Rs

No expected change for the supply of Rs

Political and Economic Risk: Investors prefer to hold lesser amounts of riskier assets thus, low risk currencies—those associated with more politically and economically stable nations—are more highly valued than high risk currencies.

Exchange-Rate Contd.

Theories of Exchange Rate

PPP theory (Purchasing Power Parity Theory):Given by Gustav Cassel. According to this theory, the price levels and the changes in the price levels in different countries determine the exchange rates of these country’s currencies. This theory is based on the principle that the exchange rates between various currencies reflect the purchasing power of these currencies. It is thus based on the law of One Price.

Assumptions of Law of One Price are:

There is no restriction on the movement of goods between countries.
There is no transportation cost involved.
There is no transaction cost involved in the buying and selling of goods.
There are no tariffs involved.

Example: US/French exchange rate: $1 = .78Eur A jacket selling for $50 in New York should retail for 39.24Eur in Paris (50x.78).
S=P1/P2
S=exchange rate Currency1/currency2
P1=cost of goods in currency 1
P2=cost of good in currency 2
According to this theory, the price of a commodity should remain the same across the world. If not then arbitrageurs would buy from cheaper market and sell them in dearer market till price would become same in both countries/markets.
Another way to explain this is that in equilibrium where domestic purchasing powers at the rate of exchange are equivalent. Therefore, the rate of exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two currencies. This point is called Purchasing Power Parity.

Reasons Why PPP is Not Perfect

PPP numbers can vary with the specific basket of goods used, making it a rough estimate.
Preferences and choices can vary from country to country. Goods then differ in their contribution to welfare.
International competitiveness is mainly affected by the exchange rate and not by PPP.
Differences in quality of goods are not sufficiently reflected in PPP.

Balance of Payments Theory: According to this theory, when there is free market situation, the exchange rates are determined by the market forces, such as demand for and supply of the foreign exchange. This theory is based on simple market mechanism in which the price of any commodity is determined.

Under this theory the external values cf domestic currency depends on the demand for and the supply of the currency. The Nation's overall Balance of Payments (BOP) can either be in surplus or in deficits. When the nation's BOP is in deficits, the exchange rate depreciates, and when BOP is in surplus, there will be healthy foreign exchange reserves, leading to the appreciation of the home currency. Under deficits in the BOP, residents of a country in question demands foreign currency, excessively leading to excess demand for foreign currency in terms of home currency. However, under surplus BOP situation there is an excess demand for home currency from foreigners than the actual supply of home currency. Due to this price of home currency in terms of concerned foreign currency rises; that is, exchange rate improves or appreciates. Thus according to this theory the exchange rate is basically determined by the demand for and the supply of foreign currency in concerned nations.

The BOP theory of exchange rate determination is more satisfaction is more satisfactory than the PPP theory of exchange rate determination. It is because BOP theory recognizes the significance of all items in the BOP rather than few items selected under the PPP theory. The BOP theory is like the general equilibrium theory, under which market forces determines the value of the commodity. According to this theory the BOP disequilibrium can be corrected by adjusting the exchange rate in direction that is, devaluation or revaluation. However, this theory has a drawback like it ignores the impact of exchange rate on the BOP.

Merits:

1. The balance of payments theory is consistent with the demand and supply analysis.
2. The theory is more realistic as it considers other variables which affect domestic price of foreign money.
3. The theory offers explanation of marginal adjustments in exchange rate by devaluation or revaluation.

Demerits

1. The theory assumes perfect competition between countries which is not realistic.
2. The theory assumes balance of payments as the cause and the rate o exchange as the effect. The fact, however, is that the rate of exchange has more influence on the balance of payments.
3. The theory assumes causal relationship between the exchange rate and the domestic price level. In fact there exists relationship between the two.
4. According to Haberler, the balance of payments, as assumed in the theory, is of fixed quantity. The fact is that the balance of: payments are influenced by the changes in the rates of exchange.

Conclusion: It has been observed that in the long run PPP theory holds correct and in the short run BOP theory stands correct.

Table of Contents