3. Write a note on exchange rate.

What are the positive and negative effects, India faced due to Fluctuations in its currency against U.S. dollar in the resent past. Answer : In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY, ) to theUnited States dollar (US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMTon Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as traveller's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash. An exchange rate is usually quoted in terms of the number of units of one currency that can be exchanged for one unit of another currency - e.g., in the form: 1.2290 EUR/USD. In this example, the US$ is referred to as the "quote currency" (price currency, payment currency) and the Euro is the "base currency" (unit currency, transaction 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. Accordingly, a conversion from EUR to AUD, EUR is the base currency, AUD is the term currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 Euro. Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective)[4] and are used by most countries. Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone. Using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPEUR : 1.4436 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.

Exchange rate regime Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid. If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, marketbased regimes. Still, some governments keep their currency within a narrow range. As a result currencies become over-valued or under-valued, causing trade deficits or surpluses.

Purchasing power of currency The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries (P,Pf), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set depending on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of the domestic country. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of

goods, purchasing power parity (PPP) would hold for the GDP deflators of the two countries, and the RER would be constant and equal to one.

Balance of payments model This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium. Like PPP, the balance of payments model focuses largely on trade-able goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model. The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government): 1. International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world. 2. Balance of payments model (see exchange rate): This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of

dollar during 1980s and most part of 1990s in face of soaring US current account deficit. 3. Asset market model (see exchange rate): views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days) algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology. These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.


Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).

Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.

Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.

Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.

Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.

Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector.

Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency. Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Flights to quality: Unsettling international events can lead to a "flight to quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.

Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

"Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

Exchange rate the rate at which a currency can be exchanged. It is the rate at which one currency is sold to buy another. Foreign exchange market Also known as Forex or FX. It is a market to trade currencies Indian foreign exchange rate system India FX rate system was on the fixed rate model till the 90s, when it was switched to floating rate model. Fixed FX rate is the rate fixed by the central bank against major world currencies like US dollar, Euro, GBP, etc. Like 1USD = Rs. 40. Floating FX rate is the rate determined by market forces based on demand and supply of a currency. If supply exceeds demand of a currency its value decreases, as is happening in the case of the US dollar against the rupee, since there is huge inflow of foreign capital into India in US dollar Why is the US dollar walking down? When it comes to the US being a consumer, it has one of the largest appetites in the world. To keep up its demand for consumption, its imports are huge when compared to exports. This created pressure since there were more payments in dollars than receipt of any other currency, which made the supply of the dollar greater for imports payment and less receipt of foreign currency from exports. This resulted in the depreciation of the dollars value, which again caused more outflow of dollar for import payments. This created a state of inflation and made consumables costlier to US. To control inflation US resorted to increase in interest rates to cool down pressure on demand side of consumption. This factor along with recession in all other sectors, particularly real estate, is causing the mighty US dollar to shake. Positive and negative impact of dollar fluctuations on the Indian economy Until the 70s and 80s India aimed at to be self-reliant by concentrating more on imports and allowing very little exports to cover import costs. However, this could not last long because the oil price rise in the 1970s and 80s created a big gap in Indias balance of payment. Balance of payment (BOP) of any country is the balance resulting from the flow of payments/receipts between an individual country and all other countries as a result of import/exports happening between an individual country, in our case India and rest of the world. This gap widened during Iraqs attempt to take over Kuwait. Thereafter, exports also contributed to FX reserve along with Foreign Direct Investment into the Indian economy and reduced the BOP gap Indian rupee appreciation against dollar impacted heavily to the following:

1. Exporters 2. Importers 3. Foreign investors Exports from India are of handicrafts, gems, jewelry, textiles, ready-made garments, industrial machinery, leather products, chemicals and related products. Since the 1990s, India is the worlds largest processor of diamonds. The mentioned export items contribute substantially to foreign receipts. During the periods when the dollar was moving high against the rupee, exporters stood to gain, when $1 = Rs. 48, was getting them Rs. 4800 for every $100. Since the beginning of the year 2007, rupee appreciated by about 10%. With its value of rupee Rs. 39.35 = $1 as on 16 Nov 2007, for every $100, exporters would get only Rs. 3935. This difference is towing away the profit margins of exporters and BPO service providers alike. Imports to India are of petroleum products, capital goods, chemicals, dyes, plastics, pharmaceuticals, iron and steel, uncut precious stones, fertilizers, pulp paper etc. With the same scenario as given for export, if we analyze an importer is paying Rs. 3935 now instead of Rs. 4800 paid during yester years for every $100. This gain on FX is likely to create savings in cost, which could be passed on to consumers, thereby contributing to control inflation Foreign investment into India is also contributing well to dollar depreciation against dollar. With the recent liberalized norms on foreign investment policy like Foreign investment of up to 51% equity limit in high priority industries; foreigners & NRIs are allowed to repatriate their profits and capital with exception for Indian nationals who were allowed to do so only under special circumstances; allowing free usage of export earnings to exporters, made foreign investment in India very attractive. It is this favorable atmosphere which made FX reserve surplus in US dollar and helped rupee to appreciate Conclusion : Appreciation and depreciation of rupee cannot certainly be taken as beneficial to the Indian economy in general. On one hand the rupee appreciation will affect exporters, BPOs, etc., on the other, rupee depreciation will affect importers. So now it depends on what the future has to reveal for, how effectively the central bank can balance the FX rates with little impact to the relative areas of FX usage. Can the Dollar remain king or not, is no longer a million dollar question, but a million Rupee question!