Foreign Exchange refers to the

money of a foreign country, such as

foreign currency bank balances,
cheques and drafts.

 Foreign Exchange Rate refers to the

price of one currency expressed in
terms of another currency or gold.

Example: € 1= $ 1.30 (1 Euro buys

1.3 U.S. Dollar)
International Monetary System
(IMS)

It refers to the set of policies,

institutions, regulations and
mechanism that determine foreign
exchange rates.
 The Gold Standard Period
(1876-1913)
 In this period gold was used as a medium of
exchange and a store of value.

 Each country backed up its currency with gold,

and currencies were convertible into gold at
specified rate.

 Relative convertibility rates of the currencies

per ounce of gold determined the exchange
rate between the two countries.
 Example
 If price of gold in U.K. is £ 4.2474 per
ounce;

 If price of gold in U.S is $ 20.67 per ounce .

 The £ price of the $ or exchange rate could

be; R = $/£ = $20.67/4.2472 = $4.87;

 Exchange rate between £ and $ would be

£1 = 4.87 $. This is called mint parity.
 The Inter-war Years (1914-1944)
 With the outbreak of World War I, the
classical gold standard came to an end.

 Govt. financed massive military expenditure

by printing money.

 This led to sharp rise both in the supply of

money and market price. Consequently,
hyperinflation existed in Germany during
1919 to 1923.
 Resultantly , in 1919, U.S. $ returned to
the gold standard to achieve financial
stability.

 In 1930, following the great depression,

gold standard were abandoned and
countries attempted to peg their currency
with U.S. $.
 Contemporary Exchange Rate
Arrangements

 Fixed or Managed Exchange Rate

It refers to the rate at which country’s

currency (Indian Rupee )is fixed or pegged
to another currency (U.S dollar) or gold.
 The Bretton-Woods System
(1944-1973
 In July 1944, Each member country of IMF
agreed to maintain a fixed exchange rate for its
currency in terms of US dollar or gold.

 This was a gold-exchange standard. The U.S

was to maintain the price of gold fixed at $35
per ounce.
 Example
 If the Deutsche Mark was set equal to $35
/140DM. Exchange rate = 1DM = 0.25 dollar..

 US became the international currency by

1971, the foreign demand for the US dollar
was higher than supply.
U.S. Dollar appeared to be
overvalued (Appreciated).

 To promote exports, U.S. dollar

was devalued from $ 35 per
ounce gold to $ 38 per ounce gold
by Central Bank of USA.
 The Post Bretton-woods System
(1973-present)
 In 1973, fixed exchange rate system was
abandoned.

 This period is marked by floating exchange

rate system where in nation’s monetary
authority intervenes in foreign exchange
market to smooth out short-run fluctuation.
Floating and Flexible Exchange Rate

It refers to the rate at which country’s

exchange rate is determined on the basis of
market demand and supply of foreign
exchange without government
intervention.
 Foreign Exchange Market
Distinctive Features
 In this market different currencies are bought and
sold.
 The market does not denote a particular place
where currencies are transacted. Rather it is an
over-the-counter market.
It consists :
 Trading desks as major agencies (Banks) dealing in foreign
exchange market through out the world, which are connected
by telephones, telex and so on. These banks are known as
‘Exchange Banks’.

14
 Functions Of Foreign Exchange Market
 Transfer Function:
 The main function is to facilitate the conversion
of one currency into another to accomplish
transfers of purchasing power between two
countries through credit instruments such as
telegraphic transfers, bank drafts, and foreign
bills.
 Credit Function:
 Provide credit to promote foreign trade.

15
 Hedging Function:

 To hedge foreign exchange risks. In a free

exchange market when exchange rates
change there may be a gain or loss to the
party concerned.

 In this case risk can be avoided through

forward exchange rate in forward
market.
16
 Types of Exchange Rates
Spot Exchange Rate:

 When foreign exchange dealer converts one

currency into another currency and execute
deal immediately at existing or current
exchange rate.

 Spot rates are reported daily in the financial

pages of News Papers.
17
 Spots Exchange rates change continually, on day –
by -day basis.

 The value of currency is determined by the relative

difference in demand and supply of both the
currency.
 Example: if there is demand of US dollar and it is
in short supply than British Pound which is in
plentiful supply. The spot Ex. rate will change and
exchange rate of dollar will appreciate against
pound. As - Spot Ex. Rate - £ 1 = $ 1.50
By the end of the day - £ 1 = $ 1.48
(because of high demand of dollar)
 Example

 Suppose an Indian citizen buys goods

from America worth $ 100, payable in
3 months.

 If he will make payment at existing

rate (Spot exchange rate) at the time
of purchase i.e. Rs.47.50 = $ 1 then
he has to make payment of Rs.4750
 Case : Spot Exchange Rate
 A US company imports laptop from Japanese
company at the cost of ¥ 200,000.

 US Company has to make payment at the Spot

exchange rate of $1 = ¥ 120.
 At this rate, each computer cost the importer
$ 1,667 (200,000/120).
 The importer knows that he can sell the
computers in $ 2000 and yield gross profit of
$333 ($ 2000-1667) per computer.
 However, the importer will not have the funds to
pay the Japanese computer company until the
computers have been sold.
 All laptop could be sold out over the next 30 days.
 But importer has fear if $ depreciates and
exchange rate will change to $1 = ¥95 .
 In this case, importer will face loss because he has
to pay same amount ¥ 200,000 per computer but
in dollar terms more amount as $ 2,105 whereby
deal will convert into loss.
 To avoid this risk, US importer might enter into
Forward exchange.
 Forward Exchange Rates
 When two parties agree to exchange
currency and execute the deal at some
specific date in future at the same exchange
rate which was finalized at the time of deal .

 For major currencies, forward exchange rates

are quoted for 30 days, 90 days and 180 days
into the future.
 Example
 Suppose an Indian citizen buys goods
from America worth $ 100, payable in 3
months.
 In order to avoid risk of exchange rate,
he may enter into forward contact in the
forward exchange market to buy $ 100
three months’ forward at a rate agreed
now (Forward Rate).
 Forward rate agreed at a discount paise
and premium also.
 If spot rate is Rs.47.50/- = 1 $ forward
rate at discount of 50 paise would be
RS. 47/- = 1 $
 Forward rate at premium on 50 paise
would be Rs.48/- = 1 $.
 In this case, buyer avoid risk in the
sense that whatever may be the
fluctuations in exchange rate in the
future he knows what he will have to
pay for $ 100.
Case : Forward Exchange Rate
 In this case, the spot exchange rate ($ 1= ¥120) and
the 30 days forward rates ($1 = ¥110) differ because of
the foreign exchange market about future currency
movements.

 In this case , it bought 1 ¥ less than spot rate and

depreciates against the Yen in the next 30 days.

 It reflects, dollar is selling at discount on the 30 day

forward market because it is worth less than the spot
market.
 If the 30-days forward exchange rate were $1 = ¥130,
dollar 1 would buy 1 Yen more than in the case of
Spot exchange rate.

 In such case , dollar is selling at a premium on the 30-

days forward market.

 It reflects, the expectation of the appreciative dollar

against Yen over the next 30 days.

 Many firms routinely enter into forward exchange

contracts to hedge their foreign risk.
 Determination of Exchange Rate
The price of national currency in terms of another
currency is determined on the basis of interaction
of the forces of supply and demand.
$V S D • P is the equilibrium point
A
where DD and SS intersected
L a b each other
U P2
E
O P
F
P
R
U c d
P P1
E
E D S
S
Amount of Dollar supplied
and Demanded 27
 The country's import of goods and
services, investment in foreign countries
(outward investment of capital)
determine its demand for foreign
exchange.

 On the other hand, the supply of foreign

exchange depends on the country’s
exports.
 .
28
 In the figure, positive slope of demand
curve showing that the demand for
foreign exchange increases as the rate of
exchange (price of home currency)
increases, (Rs. 43 = 1 US $).

 India will buy US $ against Rupee to

make payment of imports whereby
supply of Rupee will increase.
 Which will decrease the price of Indian
rupee in terms of US $ and increase the
value of US $ . As Rs. 46 =1 US$

 Whereby, exports were cheaper and they

will increase.
 Resultantly, now supply of US $ will increase
because of higher exports but demand of
Indian Rupee will also increase because US $
to pay its import from India. Now price of
Indian rupee will go up.
 Factors affecting Foreign Exchange
Rate
 International Trade:
 Imports are higher
 Demand of foreign currency will
higher then value of foreign currency
will also higher
 Value of domestic currency will low
because of higher supply of Indian
Rupee.
 ER = Rs. 46 = 1US $
 Capital Investment:

 Inflow of capital through foreign investment will

witnessing an appreciation in domestic currency.
 As it demand rises.
 ER - 45 = 1 US $
 Outflow of capital would mean a depreciation of
domestic currency because of high supply of
domestic currency.
 ER - 46 = 1 US $
 Changes in Price
 Inflation and deflation affects the exchange
rate.

 If price in India go up , Indian goods will be

costlier in World market.

 Exports go down, the demand for rupee will

fall causing depreciation in exchange value.
 Speculation
 If speculator expects fall in the value of
currency declines e.g. Rs. Depreciates from
Rs. 45 = US 1 to Rs. 46 = US $1. The demand
of this currency will decline.

 If speculator expects rise in value of

currency , that currency will appreciate
(Rs. 45 = US $ 1) because of high demand.
 Strength of the Economy
 Economic fundamentals of economy are
strong as:

 High GDP, Low inflation rate, low fiscal

deficit, balance current account

 The exchange rates of its domestic

currency remain stable and strong.
 Determination of Exchange Rate
Purchasing Power Parity
 Purchasing power parity (PPP) is a theory
which states that exchange rates between
currencies are in equilibrium when their
purchasing power is the same in each of the
two countries.

 The basis for PPP is the “law of one price”

and non-existence of tariff and other trade
barriers.
 Example
 If the identical basket of goods cost ¥
1000 in Japan and $ 10 in United
States.
 PPP-based Exchange Rate of U.S.
dollar to Japanese Yen.

 ¥ 1000/ $ 10 = 1 US $ = 100 ¥
 The ratio of one country’s price of a basket
of goods and services to another country’s
price of identical basket of goods and
services should be exchange rate of two
countries.

 When a country's domestic price level is

increasing (i.e., a country experiences
inflation), that country's exchange rate
must depreciated in order to return to PPP.
 Hamburger Index
 The Economist magazine publishes a light-hearted
version of PPP: its “Big Mac Index" that compares
the price of a McDonald's burger around the world.
PPP = Px
PY

PPP = Hamburger prices in local currency

Hamburger prices in the US
 The Hamburger Index
Big Mac Price PPP Actual under (-
of the Exchange )/over
dollar Rate (+) valuation
against
dollar (%)
Local Currency In Dollar

US $3.57 3.57 --
China Yuan 12.5 1.83 3.50 6.83 -49

Denmark Dk 28.0 5.95 7.84 4.70 28

Hong Kong HK $4.90 1.71 3.73 7.80 -52

Singapore S$ 3.95 2.92 1.11 1.35 -18

Pakistan Rs. 140.00 1.97 39.22 70.90 -45

 Overvaluation /undervaluation of
Currency :

 {1- (Implied PPP of the US dollar)}

Actual dollar exchange rate
100
Example : [{ 1- (3.50/6.83)} *100]

Chinese Yuan undervalued by 49 %

 The Hamburger Index is presumably useful
because it is based on a well-known goods
whose final price, includes input costs of :

 Agricultural commodities (bread, lettuce,

cheese), labor (blue and white collar).

 Advertising, rent and real estate costs,

transportation, etc.