- Anubhav Kandpal – 04- Shabbir Pittalwala – 42- Udit Singh Yadav – 50- Vibhash Joshi - 53

Foreign Exchange Rate

Index What is foreign exchange rate What is the foreign exchange market Nominal & Real exchange rates[NER] Real effective exchange rate[REER] What are the different ways to determine the exchange rate of a currency Floating [flexible] exchange rate system Demand & Supply of a foreign currencyo Equilibrium exchange rate Free market Changes in exchange rate in a free market Purchasing power parity Inflation Interest rates Fixed and flexible exchange rate system Managed float system in India Devaluation of the Indian rupee Currency convertibility Advantages and problems.

What is foreign exchangeWhat is a currency? -it is the mode of exchange used in an economyWhat is foreign exchange rate -it is the name given to any foreign currency; Eg:- US dollars and the British Pound are foreign

exchange for India.What is foreign exchange market -the market in which the currencies of various countries

are exchanged, traded or converted is called the foreign exchange market. It is seen as a network of communication system connecting institutions including banks, specialized foreign exchange dealers and govt. agencies.

DETERMINATION OF BASE CURRENCY

There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others. Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.

Important exchange rate concepts

Nominal exchange rate[NER] the no. of units of a domestic currency needed to purchase 1 unit of

a foreign currency. Eg:- the exchange rate of rupees per dollar is the NER, {Rs 40 can buy $1}

Nominal effective exchange rate[NEER] it is the weighted average of nominal exchange rates where the

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

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

NEER=(NERUS X WUS)+(NERUK X WUK)NEER-nominal effective exchange rateNERUS/ NERUK- nominal exchange rate of the US and UK respectivelyWUS / WUK- trade shares of the US and UK respectively

Real exchange rate - it is the relative price of 2 countries after adjusting for the price

levels within the countries.Eg:-the real exchange rate of rupee and the US dollar is defined as the

rupee price of a basket of goods in India relative to a dollar price of the same basket of goods in the USA.

RER= NER [PUS/ PIn]RER- real exchange rate NER- nominal exchange ratePUS and PIN - price level in USA and price level in India respectively.

Real effective exchange rate -it is the weighted average of all real exchange rates with all its trade

partners, the shares of different countries in its total trade are used as weights

Appreciation of a currency (floating exchange rate system):- - it is the increase in the value of one currency in terms of

the other. Eg. US $ decreases from 45.5 to 44 to a dollar, this is when the Indian rupee is said to be appreciated.

This indicates the strengthening of the Indian rupee.Depreciation of a currency (floating exchange rate system):- - it is when the decrease in the value of one currency in

terms of the other. Eg. US $ increases from 45.5 to 46 to a dollar, this is when the Indian rupee depreciates

[note that when the Indian rupee appreciates the US $ depreciates, and when the Indian rupee Depreciates the US $ appreciates]

Revaluation of a foreign currency(fixed rate system):-

- this is the same as appreciation of a currency, except that the govt. increases the value of its currency.

Devaluation of a foreign currency(fixed rate system):-

- this is same as depreciation of a currency, except that the govt. decreases the value of its currency.

like India did in 1966 and 1991.

Fixed and Flexible Exchange RatesThe fixed exchange rate system was carried

out in the earlier 90s. Under this, currencies of different countries were tied to gold.Thus, the exchange rate of different countries got automatically fixed.

The flexible exchange rate system is one in which the value of currency of one country is expressed in terms of that of the other.

Determination of exchange rate[demand and supply]

At present in both India and USA there is floating exchange regime. Therefore the value of currency of each country in terms of the other depends upon the demand and supply of their currency

We shall take a case between the $ and the Indian Rupee

Indians sell Rupees for US $People holding US $ will sell dollars in exchange

for Rupees.It is the demand and supply of foreign exchange

that will determine the rate between the tow.

s

Price of dollar[rupees as per dollar]

Quantity of dollars

sD

D

Excess Supply

Excess Demand

R’

R”

R

Rs 46

Rs 45.5

Rs 44

E

Q

Y

O X

Now to understand the shape of the demand curve:- When there is a fall in the price of a $ in terms of

rupees, that is, when $ depreciates, fewer rupees that before would be required to buy a $ now.

This implies, that goods worth in $s are now cheaper in terms of Indian rupees.

This implies to an increased demand of USA made goods in India.

This implies to an increased demand for dollars-which will again increase the price of the dollar

In the end this means, that lower the price of a $, greater is the quantity of dollars demanded for imports. and higher the price of a dollar, smaller the quantity of imports from the USA by the indians.

This causes the demand curve to slope downwards.

Reasons for demand of the US $[foreign currency]

Indian individuals or firms that import goods from the USA into India, need US $s

Indians traveling or living in the USA would need $s to meet their demand

Indians that invest in shares and bonds of companies in the USA would require $s

Indians that directly invest in houses, shops ect. In the USA would need $s

Now to understand the shape of the supply curve:- According to the current exchange rate between US$s

and Indian rupees;Rs100 worth of Indian goods would be relatively cheaper in terms of dollars.[Rs48=$1]

This will increase demand for Indian goods in the USA, and boost exports of from India to USA at a higher price of the dollar and thus ensure more supply of $s in the foreign exchange markets.

This implies that increased supply of $s will reduce its value in terms of rupees.

This implies that the Indian goods will now be more expensive in terms of $s

This will reduce the demand for Indian goods, and hence reduce the supply of $s in the foreign exchange market.

This shows, that when the rate of exchange is high, the supply increases, and visa versa.

Reasons for supply of US $s:-When USA exports goods and charges

revenue in $s.Citizens of USA that invest $s in India.Those who make loans to Indians.American tourists that spend $s in India.Indians living in the USA send $s to their

relatives in India [remittances]

The equilibrium exchange rate

In the fig we see, equilibrium price of $ in terms of rupees is Rs.45.5 at which demand and

sup-ply curve intersect.• At Rs46[higher price of $] qty supplied exceeds qty demanded.• Excess supply will reduce the exchange rate of $ and the price will fall back to Rs45.5.• When the rate of $ in terms of

rupees is Rs44, there will be excess demand

• This will increase the price again to Rs45.5.

R’

R

R”

Excess Supply

Excess Demand

D

D

s

s

Rs 46

Rs 45.5

Rs 44

E

O

Y

Q X

Price of dollar[rupees as per dollar]

Quantity of dollars

Free marketThere are factors other than the rater of a currency in terms of

another currency that affects the demand and supply of the currency

This hence affects the equilibrium exchange rate.Eg. If there is an increase in the income in the US economy, due to

conditions of BOOM.This will increase imports into the US including goods from IndiaThis implies that there will be an increase in the supply of $s in the

foreign exchange market.This will cause a rightward shift in the supply curve, and hence

affect the equilibrium price.This also shows that the value of the $ will depreciate and the

value of the rupee will appreciate. Before we study the shift in the curve, we shall take a look at the factors that affect the exchange rate in a free market.

Reasons for the Changes in exchange rate in the free marketPurchase power parity[relative price levels]:- To understand this, we must first assume that there are no

restrictions in trade between countries, and transport cost is nil.Then the exchange rate between 2 countries will show the difference

between the price levels in the 2 countries. The exchange rate can now be fixed, by the proportionate

difference between the price levels prevailing in the country. For instance, a TV costs much higher in India that in the US. This will pay businessmen to buy TVs from the US and sell it in India This will decrease the supply of TVs in the US, and increase it in

India Hence the price of the same TV will now be high in the US and low

in India. This process will continue till the price of the TV is same in both the

countries

This concludes, that price levels in different countries affects the exchange rate of the currency

It must be noted that, it is only in the long run that with no trade restrictions, that this may be possible.

Rate of inflation and exchange rate High rate of inflation in a country will

affect the exchange rate of that country.Suppose, India has a relatively high rate

of inflation that USA. This means that the cost of production

in India is higher than USAThis prompts the Indian consumer to

import more goods from USAThis results in an increased demand for

US$s

This will cause the demand curve of US$ to shift to the right as shown in the fig.

At the same time, if there is a high price level in USA, the Indian goods will be more expensive to the Americans.

The demand for imports into the US will reduce.Hence the supply of US $ will increase, causing

the supply curve to shift towards the right.

RATE

R’

R

46.5

45.5

S’

S’

D’

D’

S

S D

D

Y

OQ X

Effect of a higher rate of inflation on the exchange rate of a country

Y

R

R’

O Q Q’ X

45.5

44.5

D

D

S

S

S’

S’

E

E’

RATE

Amount of dollars Amount of dollars

Effect of relatively higher rate of interest in india on the exchange rate

INTEREST RATES & EXCHANGE RATEThe interest rate in a country relative to

interest rate of other countries with which it trades its goods is an important factor affecting foreign exchange rate.

This means that businessmen of the home country will invest in a the bonds of a foreign country if the latter’s interest rates are lower.

As a result, there will be a flight of capital from the foreign country or Capital Inflows into the home country.

Fixed and Flexible Exchange RatesThe fixed exchange rate system was carried

out in the earlier 90s. Under this, currencies of different countries were tied to gold.Thus, the exchange rate of different countries got automatically fixed.

The flexible exchange rate system is one in which the value of currency of one country is expressed in terms of that of the other.

Devaluation of the Indian rupeeIntroductionLarge reserves of foreign exchange helps in smooth

flow of international trade. If a nation depletes its foreign currency reserves and

finds that its own currency is not accepted abroad, the only option left to the country is to borrow from abroad.

It will have to replay the loan in its own currency or in any other hard currency

If the nation is not credit worthy, it will not get any loans, and there will be no way to pay off imports.

This results in a financial crisis accompanied by devaluation and capital flight.

To avert a financial crisis, a nation will maintain a stable exchange rate to lessen exchange rate risk and increase international confidence and to safeguard its foreign currency reserves.

if the market for a nation’s currency is too weak to justify the given exchange rate, that nation will be forced to devalue its currency.

That is, the price the market is willing to pay for the currency is less than the price dictated by the government.

The 1966 DevaluationAs a developing economy, it is to be expected that India would

import more than it exports India has had consistent balance of payments deficits since

the 1950s.1966, inflation had caused Indian prices to become much

higher than world prices at the pre-devaluation exchange rateGovernment of India had a budget deficit problem and could

not borrow money from abroadAs a result, the government issued bonds to the RBI, which

increased the money supply. In the long run, there is a strong link between increases in money supply and inflation and the data presented

Despite of budget deficits and high rate of inflation, Through restrictions on currency trading and convertibility as well as export subsidisation and quantitative restrictions [QR]on imports, India was able to maintain its unjustified exchange rate while experiencing inflation until 1966 when it faced a severe shortage of foreign reserves.

Source: Data on M1 and M2 are from the source given above and the average rates are computed by the authors,inflation data is from http://indiagovt.nic.in/es2001-02/chapt2002/chap51.pdf

Time Period

Inflation M1 Growth

M2Growth

1961-1965 5.8% 7.72% 8.14%

1966-1970 6.7% 9.05% 11.50%

In the period of 1950 through 1966, foreign aid was never greater than the total trade deficit of India except for 1958. But this helped to postpone the rupee’s final reckoning until 1966.

In 1966 India was told it had to liberalise its restrictions on trade before foreign aid would again materialise.

India did as said. When India still did not receive foreign aid, the government backed off its commitment to liberalisation.

India was in a state of war with Pakistan in late 1965. The US and other countries friendly towards Pakistan, withdrew foreign aid to India, which further necessitated devaluation.

Defence spending in 1965/1966 was 24.06% of total expenditure, the highest it has been in the period from 1965 to 1989

The second factor is the drought of 1965/1966. The sharp rise in prices in this period, which led to devaluation, is often blamed on the drought, but in 1964/1965 there was a record harvest and still, prices rose by 10%

The government used the method of QRs with varying levels of severity until the Import-Export Policy of 1985-1988.

Devaluation of the Indian rupee caused the prices in India to fall.

This increased the exports from India in the short run.

This in turn, balanced the BOP-balance of payments {Exports – imports}

The 1991 Devaluation1991 is often cited as the year of economic reform in

Indiathe Import-Export Policy of 1985-1988 replaced import

quotas with tariffs.Chaos in the gulf regions caused the prices of oil to

rise at the international levelIndian economy was a developing economy, and

hence there was a high demand for oilTo meet this demand, India again increased its

exports.This disrupted the balance of payments.

ZIMBABWEAN ECONOMYThe economy of Zimbabwe is collapsing from

economic mismanagement, resulting in 94% unemployment and hyperinflation.

The economy poorly transitioned in recent years, deteriorating from one of Africa's strongest economies to the world's worst. Inflation has surpassed that of all other nations at over 80 sextillion(1021)%[1] (although it is impossible to calculate an accurate value), with the next highest in Ethiopia at 41%[4].

It currently has the lowest GDP real growth rate in an independent country and 3rd in total (behind Palestinian territories.)

Hence, due to corruption or ‘rent seeking’ , Zimbabwe has reached the 22nd highest place in hyperinflation.

The currency of Zimbabwe is presently at a shocking low value.

Its internal as well as external debts are intensively heavy and it’s quite difficult to get out of the situation without help from other countries such as US and South Africa.

CURRENCY CONVERTIBILITYBy convertibility of a currency, we mean that the

currency of a country can be freely converted into foreign exchange at market determined rate of exchange, ie. the rate determined by demand & supply.

Here, there are authorized dealers foreign exchange such as banks, which constitute Foreign Exchange market. The exporters who receive of other currencies can go to these dealers and get their convertibility.

Importers who require foreign exchange, can go to these dealers and get their home currency converted into foreign exchange.

CONVERTIBILITY OF INDIAN RUPEEAs a part of the new economic reforms initiated

in 1991, Rupee was made partly convertible under the ‘LERM’ scheme in which 60% of all receipts on current a/c could be converted freely into rupees at market determined exchange rate quoted by authorized dealers.

The other 40% exchange receipts on current a/c was meant for meeting government needs.

Thus, partial convertibility of rupee on current a/c was adopted so that essential imports could be made available at lower exchange rate to ensure that their prices do not rise much.

FEMAThe Foreign Exchange Regulation Act of 1973 (FERA) in India

was replaced on 1 June, 2000 by the Foreign Exchange Management Act (FEMA), which was passed in the winter session of Parliament in 1999.

FEMA, which has replaced FERA, had become the need of the hour since FERA had become incompatible with the pro-liberalisation policies of the Government of India. FEMA has brought a new management regime of Foreign Exchange consistent with the emerging frame work of the World Trade Organisation(WTO).

Country 1 INR in INR American Dollar    0.0207748   48.1353 Australian Dollar    0.0239238   41.7994 British Pound    0.0127192   78.6215 Canadian Dollar    0.0222539   44.9359  Chinese Yuan    0.141848   7.04982 Euro    0.0141277   70.7829 Hong Kong Dollar    0.161008   6.21089 Japanese Yen    1.89551   0.527562 Mexican Peso    0.275411   3.63093 Nepalese Rupee    1.598   0.625784  New Zealand Dollar    0.0292557   34.1814 Pakistan Rupee    1.72437   0.579922 Singapore Dollar    0.0293899   34.0253  South African Rand    0.154729   6.4629 Sri Lanka Rupee    2.38455   0.419366  Thai Baht    0.700212   1.42814 

What is currency futures A transferable futures contract that specifies

the price at which a specified currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk.

History of Currency futures Currency futures were first created at the

Chicago Mercantile Exchange (CME) in 1972 International Monetary Market (IMM) launched

trading in seven currency futures on May 16, 1972.

Currency futures in IndiaCurrency futures trading was started in Mumbai

August 29, 2008. With over 300 trading members including 11

banks registered in this segment, the first day saw a very lively counter, with nearly 70,000 contracts being traded.

The first trade on the NSE was by East India Securities Ltd

Amongst the banks, HDFC Bank carried out the first trade. The largest trade was by Standard Chartered Bank constituting 15,000 contracts. Banks contributed 40 percent of the total gross volume.

Fundamentals of Indian currency futures

Currency futures can be traded between Indian rupees and US dollar (US$ -- INR)

The trading of Indian currency futures can be done between 9 am to 5 pm

The minimum size of currency futures is US$ 1000 periodically the value of the contract can be changed by RBI and SEBI

The currency future can have maximum validity of 12 months

The currency futures contract can be settled in cash

Trade exchanges for currency futures There are 3 trade exchange that trades in

currency futures 1. National Stock Exchange (NSE)

2. Bombay Stock Exchange (BSE)

3. Multi-Commodity Exchange (MCX)

Importance of currency futuresAccording to market analysts, introduction

of currency futures in the Indian market will give companies greater flexibility in hedging their underlying currency exposure and will bring in more liquidity into the market as currency future or forex derivative contract will enable a person, a bank or an institution to buy or sell a particular currency against the other on a specified future date, and at a price specified in the contract.

RISK IN EXCHANGE RATE MOVEMENTThe floating regime that we have around the world

today brings about volatility and uncertainty and creates risk for all market participants. For example, when a Australian wine merchant puts in an order to buy 1,000 cases of French wine, the merchant may agree to pay in Euros, say 100 Euros per case, when the vintage is ready for shipment in two years. However, over the next two years, the value of the Australian Dollar could drop from 0.68 EUR/AUD to 1.0 EUR/AUD which raises the price of each case from 68 Australian Dollars to 100 Australian Dollars. Thus, pricing the wine in Euros exposes the Australian wine merchant to a currency exchange-rate risk.

BibliographyEconomic timesForeign exchange rate – Debjani Mitra Sarkar WikipediaMacroeconomics by HL Ahuja