ECHANGE RATE MECHANISM

In a foreign exchange market where different currencies are bought and sold, it is
essential to know the ratio between different currencies, how many units of one currency well
equal one unit of another currency. The ratio between two currencies is known as an exchange
rate. The various exchange rates are regularly quoted in newspapers and periodicals.

Major currencies in the world:

USD, EURO, YEN, GBP, CAN$, SWISS FRANC, AUS$

There are two methods for quoting exchange rates.

1. Direct quote
2. Indirect quote

Direct quote:
A direct quote gives the home currency price of a certain amount of foreign currency
usually one or 100units. If India quotes the exchange rate between the rupee and the us dollar
in a direct way the quotation will be written as Rs.35/US$. Direct quote places domestic
currency on the numerator of the quote.

Indirect Quote:
In the indirect quoting the value of one unit of home currency is presented in terms of
foreign currency. If India adopts indirect quotation, the banks in India will quote the exchange
rate as us$ 0.2857/Re. indirect quote domestic currency placed in denominator.

Buying and selling rates:

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Normally, two rates are published one being the buying rate and the other the selling
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rate. The buying rate is also known as the bid rate. The selling rate is known as the ask rate or
offer rate. Bid rate always given first, followed by the ask rate quote.

Buying quote of a currency denotes the rate at which banks buy it. Selling quote at
which banks sell it. The banks need to make profit in these transactions, the selling quote is
higher than the buying the rate. The difference between these two quotes forms the banks
profit and is known as the spread.

Spread = (Ask price-Bid price)/ Ask price *100

Anjan Kumar MBA International Financial Management

Forward market quotation:
The quotes for the forward market are also published in the newspapers and periodicals. The
quoting rates may be expressed as outright quotes, or as swap quotes. The outright quote for the US
dollar in terms of the rupee can be written for different periods of forward contract as follows.

Spot one month three month

Rs.40.00-40.30 Rs. 39.80-40.20 Rs. 39.60-40.10

The swap quote on the other hand expresses only the difference between the spot
quote and the forward quote. It can be written as follows.

Spot one month three month

Rs.40.00-30 Rs. (20)-(10) Rs. (40)-(20)

Forward premium and discount:

The forward rates have longer maturity, the spread too gets wider. This is because of
uncertainty in the future that increases with lengthening of maturity. The changes in forward
rates may be upward or downwards. Such movements arise between spot and forward rates.
This is known as the swap or forward rate differential.

If the forward rate is lower than the spot rate, it well is a case of forward discount.

If the forward rate is higher than the spot rate it would be known as forward premium.
Forward premium or discount is expressed as an annualized percentage deviation from the spot
rate. It is computed as follows.

Forward Premium (Discount) = (n-day forward rate – spot rate)/spot rate * 360/n
2

Cross rates:
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The value of currency in terms of another one is not known directly. In such cases one
currency is sold for a common currency and again the common currency is exchanged for the
desired currency. This is known as cross rate trading and the rate established between the two
currencies is known as the cross rate.

Anjan Kumar MBA International Financial Management

Spot cross rate:
The selling rate of the Canadian dollar in Indian can be worked out by selling the rupee
for the US dollar at Rs.35.20/US$ and then buying Canadian dollar with the US dollar at C$
0.76/US$ .

Rs.35.20/US $ 1* US$ 1/C$0.76=Rs.46.32/C$

Forward Cross Rate:

The selling rate of one currency is divided by the buying rate of another currency and vice
versa. One month forward rate in case of the two currencies is Rs.34.50-34.80/US$ and C$ 0.79-
0.83/US$. The forward rate of the Canadian dollar in terms of the rupee can be found as:

Rs. 34.80/C$ 0.79 = Rs.44.05/C$

Rs. 34.50/C$0.83=Rs. 41.57

By combining the two we get Rs. 41.57-44.05/C$

NOMINAL, REAL AND EFFECTIVE EXCHANGE RATE:

Nominal exchange rates are also called bilateral exchange rates. It represents the ratio
between the values of two currencies at a particular point of time. Real exchange rates other
hand is the price adjusted nominal exchange rate. The relationship between nominal exchange
rate, e and the real exchange rate, er can be written in the form.

Er = eP/P*
Where p and p* are domestic and foreign price indices.

It is possible that the Indian rupee tends to depreciate against US dollar but it
appreciates against Japanese Yen. It is also possible that rupee depreciates vis-à-vis different
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currencies at different rates. so it is essential to develop an index or a summary measure of

how rupee fares, on an average, in the foreign exchange market. Such an index is called an
effective exchange rate. Effective exchange rate is the measure of the average value of a
currency relative to two or more currencies normally shown in the form of indices.

Anjan Kumar MBA International Financial Management

DETERMINATION OF EXCHANGE RATE IN THE SPOT MARKET
The exchange rate between two currencies in a floating rate regime is determined by
the interplay of demand and supply forces. The exchange rate between say the rupee and the
US dollar depends upon the demand for the US dollar and its availability or supply in the Indian
foreign exchange rate. The demand for foreign currency comes from individuals and firms who
have to make payments in foreign currency mostly on account of import of goods and services
and purchase of securities. The supply of foreign exchange results from the receipt of foreign
currencies normally on account of export or sale of financial securities to foreign entities.

Rs. /US $
S

S’
42

40

D’
D

Q1 Q2 Q3
Demand for and Supply of US $

FACTORS INFLUENCING EXCHANGE RATE:

 Flow of funds on the current and capital accounts

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 Impact of inflation
 Interest rate

DETERMINATION OF EXCHANGE RATE IN THE FORWARD MARKET

Forward exchange rate is normally not equal to the spot rate. The size of forward premium or
discount depends mainly on the current expectation of future events. The determination of
exchange rate in a forward market finds an important place in the theory of interest rate parity
(IRP). Covered interest rate Arbitrage, Uncovered interest rate arbitrage.

Anjan Kumar MBA International Financial Management