EXCHANGE RATES

Meaning of Exchange Rates

Exchange rates refer to the valuation of one currency in relation to another currency.
Essentially, it represents the worth of a country's currency when compared to the currency of
another nation. Mohamed Ibrahim Justice Ganawah defines exchange rates as the
comparison of the value of one nation's currency against another nation's currency. For
instance, it reflects the number of Sierra Leone Leones (Le) required obtaining one United
States dollar ($1).

Beyond factors like interest rates and inflation, the currency exchange rate stands out as a
crucial determinant of a country's relative economic well-being. It plays a pivotal role in
shaping the economic landscape by influencing international trade, investment, and overall
economic stability
An exchange rate is critical in the determination of a country's level of trade. Exchange rate is
a political tool and as a result it is among the most watched, analyzed variable in an economy.

Main Factors that Influence Exchange Rates

There are several factors that determine exchange rates. We are only going to look at the key
factors that influences exchange rate between two nations.

 Inflation Factor: It must be noted that a country with a lower inflation rate
consistently exhibits a rising currency value, as its purchasing power increases
relative to other currencies. The opposite occurs for countries with higher inflation.
With a consistent higher inflation rate, the domestic currency will depreciate against
its trading partners. This is also usually accompanied by higher interest rates.

 Interest Rates Level: There are highly positive or negative correlations that exist
between Interest rates, infla-tion, and exchange rates. When the Central bank
manipulates the interest rates, it influences both inflation and exchange rates.
When a country increases its interest rates or its domestic interest rate is higher than
the foreign interest rate, it will cause capital in-flow, thereby increasing the demand
for domestic currency, allowing the currency to appreciate and the foreign currency

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 depreciate. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates leads to the depreciation of the domestic currency.

 Current Account Deficits: The current account is the balance of trade between a
country and its trading partners reflecting all payments between countries for goods,
services, interest, and dividends. A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that it is borrowing capital from
foreign sources to make up the deficit. In other words, the country requires more
foreign currency than it receives through sales of exports, and it supplies more of its
own currency than foreigners demand for its products, The excess demand for foreign
currency lowers the country's exchange rate until domestic goods and services are
cheap enough for foreigners, and foreign assets are too expensive to generate sales for
domestic interests.

 Public Debt: Countries will engage in large-scale deficit financing to pay for public
sector projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to foreign
investors. The reason? A large debt encourages inflation, and if inflation is high, the
debt will be serviced and ultimately paid off with cheaper real dollars in the future
In the worst-case scenario, a government may print money to pay part of a large debt,
but increasing the money supply inevitably caus-es inflation. Moreover, if a
goverament is not able to service its deficit through domestic means (selling domestic
bonds, increasing the money supply), then it must increase the supply of securities for
sale to foreigners, thereby lowering their prices. Finally, a large debt may prove
worrisome to foreigners if they believe the country risks defaulting on its obligations.

 Terms of Trade: A ratio comparing export prices to import prices, the terms of trade
is related to current accounts and the balance of payments. If the price of a country's
exports rises by a greater rate than that of its imports, its terms of trade have favorably
improved. Increasing terms of trade shows' greater demand for the country's exports.
This, in turn, results in rising revenues from exports, which provides increased
demand for the country's currency (and an increase in the currency's value). If the

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 price of exports rises by a smaller rate than that of its imports, the currency's value
will decrease in relation to its trading partners.

 Strong Economic Performance: Foreign investors inevitably seek out stable

countries with strong economic performance in which to invest their capital. Country
with such positive attributes will draw investment funds away from other countries
perceived to have more political and economic risk. Political turmoil, for example,
can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.

Classification of Exchange Rates

In the foreign exchange market, an exchange rate is classified based on different perspective.
The major classifications of exchange rates are as follows:

Based on the Bank Foreign Exchange Trading

 Selling Rate- This is also known as the foreign exchange selling price. It is the rate
the bank used to sell foreign currency to customers.

 Buying Rate- it is also known as the purchase price. It is the rate the bank used to buy
foreign currency from customers.

 Middle Rate- It is the average of the bid price and ask price.

Based on the Time of Delivery After Foreign Exchange Transactions.

 Spot Rate - It is the rate at which foreign exchange is made available on the spot. It is
also known as cable rate or telegraphic transfer rate because at this rate cable or
telegraphic sale and purchase of foreign exchange can be day rate of exchange
arranged immediately. Spot rate is the day-to-day exchange rate.
 Forward Rate - This is the rate at which the future contract for foreign currency is
made. The forward exchange rate is settled now but the actual sale and purchase of
foreign exchange occurs in future. The forward rate is quoted at a premium or
discount over the spot rate.

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Based on the Level of Foreign Exchange Controls

 Official Rate - It is the rate of exchange announced by a country's foreign exchange

ad-ministration.
 Market Rate - It refers to the real exchange rate for trading foreign exchange in the
free market. It fluctuates with changes in the conditions of demand and supply of
foreign ex-change.

Based on Whether Inflation is Included Nominal Exchange Rate - The number of units of
the domestic currency that are needed to purchase a unit of a given foreign currency. It is the
exchange rate that does not take inflation into consideration. For example, if the value of the
Dollars (s) in terms of the Leones (Le) is 1.5, this means that the nominal exchange rate
between the Dollar and the Leone is 1.5. We need to give 1.5 to buy one dollar.

It's called nominal, because it takes into account only the numerical value of the currencies. It
doesn't take into account the purchasing power of the currencies.
There is no special formula for the nominal exchange rate; it's just a number without
additional mathematical operations.
Nominal Exchange Rate = E= Number of Units of C that can purchase a unit of C*
Where:
C: Domestic Currency
C*: Foreign Currency

Real Exchange Rate - It measures the price of foreign goods relative to the price of domestic
goods. Mathematically, the real exchange rate is the ratio of a foreign price level and the
domestic price level, multiplied by the nominal exchange rate.
Formally:
R = (E. P*)/P
Where:
R: real exchange rate
E: nominal exchange rate
P*: foreign price level
P: domestic price level

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Price of a basket of Foreign
Goods, expressed in local currency: E.p local currency: P
Price of a basket of Local Goods, expressed in local currency: P

Major Systems of Exchange Rate Exchange Rate

System is basically looking at the degree of control exercised by the government or by the
forces of demand and supply in determining the exchange rate at a particular time in the
economy. There are three main exchange rate systems. These are:
1. Fixed Exchange Rates System
2. Purely or Freely Floating Exchange Rates System
3. Managed Exchange Rates System.

Fixed Exchange Rates System: Fixed exchange rate system is also known as the Pegged
exchange rate system. This is a system wherein the exchange rate is either held constant or
allowed to fluctuate only within refers to a system in which exchange rate for a currency is
fixed by the government. The basic purpose of adopting this system is to ensure stability in
foreign trade and capital movements. To achieve stability, government undertakes to buy
foreign currency when the exchange rate becomes weaker and sell foreign currency when the
rate of exchange gets stronger.

Merits of Fixed Exchange Rates

 Promotes International Trade: pixed or stable exchange rates ensure®cer-tainty
about the foreign payments and inspire confidence among the importers and
exporters. This helps to promote international trade.

 Promotes International Investment: This system promotes international invest-

ments. If the exchange rates are fluctuating, the lenders and investors will not be
prepared to lend for long-term investments.

 Removes Speculation: Fixed exchange rates eliminate the speculative activities in

the international transac-tions. There is no possibility of panic flight of capital from
one country to another in the system of fixed exchange rates.

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  Necessary for Developing Countries: Fixed exchanges rates are necessary and
desirable for the developing countries for carrying out planned development efforts.
Fluctuating rates disturb the smooth process of economic development and restrict the
inflow of foreign capital.

 Economic Stabilization: Fixed foreign exchange rate ensures internal economic

stabilization and checks unwarranted changes in the prices within the economy-in a
system of flexible exchange rates, the liquidity preference is high because the
businessmen will like to enjoy wind fall gains from the fluctuating exchange rates.
This tends to Increase price and hoarding activities in country.

Demerits of Fixed Exchange Rates

 Old Fashion System: This system was very successful in the 19th century when
nations used gold standard but now not functional in our modern economy.

 Discourage Foreign Investment: Fixed exchange rates are not permanently fixed or
rigid. Therefore, such a system discourages long-term foreign investment which is
considered available under the really fixed exchange rate system.

 Monetary Dependence: Under the fixed exchange rate system, a country is deprived
of its monetary independence. It requires a country to pursue a policy of monetary
expansion or contraction in order to maintain stability in its rate of exchange.

 Cost-Price Relationship not reflected: The fixed exchange rate system does not
reflect the true cost-price relationship between the currencies of the countries. No two
countries follow the same economic policies. Therefore, the cost-price relationships
between them go on changing. If the exchange rate is to reflect the changing cost-
price relationship between the countries, it must be flexible.

 Not a Genuinely Fixed System: The system of fixed exchange rates provides neither
the expectation of permanently stable rates as found in the gold standard system, or
the continuous and sensitive adjustment of a freely fluctuating exchange rate.

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Purely Floating Exchange Rates System:
This is also known as freely or clean floating exchange rate system. This is an exchange rate
system in which exchange rate is determined by forces of demand and supply of different
currencies in the foreign exchange market. Here the value of currency is allowed to fluctuate
freely according to changes in demand and supply of foreign exchange. There is no official
(Government) intervention in the foreign exchange market.

Merits of Purely Floating Exchange Rates

 Independent Monetary Policy: Here, a country is free to adopt an independent
policy to conduct properly the domestic economic affairs. The monetary policy of a
country is not limited or affected by the economics conditions of other countries.

 Promotes Economic Development: The flexible exchange rate system promotes

economic development and helps to achieve full employment in the country. The
exchange rates can be changed in accordance with the requirements of the monetary
policy of the country to achieve the planned national objectives.

 Solutions to Balance of Payment Problems: This system automatically removes the

disequilibrium in the balance of payments. When, there is deficit in the balance of
payments, the external value of a country's currency falls. As a result, exports are
encouraged, and imports are discouraged thereby, establishing equilibrium in the
balance of payment.

 Promotes International Trade: this system does not permit exchange control and
promotes free trade. Restrictions on international trade are removed and there is free
movement of capital and money between countries.

 Increase in International Liquidity: The system totally and automatically eliminates

the need for official foreign exchange reserves, if the individual governments do not
employ stabilization funds to influence the rate. Thus, the problem of international
liquidity is automatically solved. In fact, the present shortage of international liquidity
is due to pegging the exchange rates and the intervention of the IMF authorities to
prevent fluctuations in the rates beyond a narrow limit.

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  Market Forces at Work: Here, the foreign exchange rates are determined by the
market forces of demand and supply. Market is cleared off automatically through
changes in exchange rates and the possibility of scarcity or surplus of any currency
does not exist.

Demerits of Flexible Exchange Rates

 Unstable conditions: This system creates conditions of instability and uncertainty
which, in turn, tend to reduce the volume of international trade and foreign
investment. Long-term foreign investments arc greatly reduced because of higher
risks involved.

 Adverse Effect on Economic Structure: There is a serious repercussion on the

economic structure of the economy. Fluctuating exchange rates cause changes in the
price of imported and exported goods which, in turn, destabilize the economy of the
country.

 Unnecessary Capital Movements: The system of fluctuating exchange rates leads to

unnecessary international capital movements. By encouraging speculative activities,
such a system causes large-scale capital outflows and inflows, thus, seriously
disturbing the economy of the country.

 Depression Effects of Capital Movements: Speculative capital movements caused

by fluctuating ex-change rates may lead to the problem of extremely high liquidity
preference. In a situation of high liquidity preference, people tend to hoard currency,
interest rates rise, investment falls and there is large-scale unemployment in the
economy.

 Inflationary Effect: There is a greater possibility of inflationary effect of exchange

depreciation on domestic price level of a country. Inflationary rise in prices leads to
further depreciation of the external value of the currency.

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Managed Floating Rate System
This system is also known as the dirty floating exchange rate. This is a system in which
foreign exchange rate is determined by market forces and central bank influences the
exchange rate through intervention in the foreign exchange market. It is the combination of a
fixed exchange rate and a flexible exchange rate system.
In this system, central bank intervenes in the foreign exchange market to restrict the
fluctuations in the exchange rate within certain lim-its. The aim is to keep exchange rate close
to desired target values.

Merits of Managed Floating Rate System

The greatest advantage is that the adjustments needed to achieve external equilibrium impact
only indirectly on the domestic economy

 Monetary policy tends to be stronger: Demerits of Managed Floating Rate System

Different governments try to set their exchange rates at levels that are inconsistent
with each other.
 Devaluation versus Depreciation and Revaluation versus Appreciation:
Devaluation refers to reduction in the value of domestic currency by the government
under a fixed exchange rate system. While, Depreciation refers to fall in market price
of domestic currency in terms of a foreign currency under flexible exchange rate
system. Revaluation refers to increase in the value of domestic currency by the
government. Whiles, Appreciation refers to a rise in market price of domestic
currency in terms of a foreign currency under flexible exchange rate system.

Some Theories of Exchange Rate

There are several theories of exchange rates in economics literature. But for the purpose of
this text I would look at two fundamental theories. These theories serve the basic purpose of
the beginning of exchange rate concept.

The following are the key fundamental theories of exchange rates.

 Purchasing Power Parity Model
 Balance of Payment Model

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Purchasing Power Parity Model: This is also known as the Law of One Price.
This theory was propounded by Cassel in1918. It is basically saying that if some factors are
held constant the necessary adjustments should create the platform for the prices of the goods
in the two nations under consideration to the same.

Assumptions Underlying Purchasing Power Parity Model

 PPP assumes that there are no transportation costs. This means goods and services
could be moved from one country to another at no cost.

 PPP assumes that there are no barriers: This simply means there are no trade
limitations such as taxes.

 PPP assumes there is perfect information: This implies all participants in the market
have perfect information about the prices of goods and services in any economy. With
such condition been met, we can say the markets are in equilibrium, and when such
happens in the system then there will be not arbitrage opportunity.

 PPP assumes that goods and services are perfectly substitutable. This simply means
there is an identical basket of goods and services in both countries.

Calculation the Purchasing Power Parity

Basically, the price parity between two countries is formulated as
E=PD/PF
Where:
 e = The PPP equilibrium exchange rate value
 Pd = Domestic price level of a commodity
 Pf = Foreign price level of a commodity

Example:

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Assuming the consumer price index in Sierra Leone is Le2,0 N, and identical basket in
Nigeria is priced at N2, 750.
Calculate the exchange rate between the Leone and Naira under the Purchasing Power Parity
as a direct quote and as an indirect quote.
Solution
e=pd/pf
Where:
 e = The PPP equilibrium exchange rate value
 Pd = Domestic price level in Sierra Leone
 Pf = Foreign price level Nigeria

Direct Quote
2,750/ 2650
Leone/Naira = e=
= 1.0377
Indirect Quote
2650
2750
Naira/ Leone = e= = 0.963
Criticism of the PPP Model
The following are the criticisms levied on the PPP model:

 Trade Barrier - it is an unrealistic assumption in modern day trade for nations not to
charge duties or tariffs. With the levying of import or export tariffs, duties etc. will
increase the price in the importing nation.

 Perfect Information- market participants do not always get price information

perfectly and immediately which leads to price discrepancies and cannot be
eliminated by the arbitrage process.

 Transportation Costs- in the real-world situation transportation cost do exist and has
a great impact on the price charge. For in-stance, the price of a mobile phone in the

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 exporting nation say Japan will be cheaper than the price in the importing nation say
Sierra Leone.

 Purchasing Power Parity Model analysis may not hold for services and other non-
tradable goods in the economy.

Balance of Payment Model

For proper understanding of this model it is important to know the meaning of balance of
payment. It is a general account that includes all payments and receipts of the residents of a
nation in their transactions with residents of foreign nations.

According to the Balance of Payments model, changes in a country's national income affect
the country's current account. Consequently, the exchange rate is adjusting in a new level in
order to achieve new balance of payments equilibrium.

The total annual payments and receipts of each country must be equal. Any difference leads
to a deficit or a surplus in the balance of payments.

Balance of Payments Deficit is said to occur when the nation's total annual Payments is
greater than the nation's total annual receipts.

Balance of Payments Surplus is said to occur when the nation's total annual Revenue is
greater than the nation's total annual payments. The balance of payments account contains
two sub-accounts: the current and the capital accounts.
The current account includes exports and imports of goods and services as well as unilateral
transfers. The capital account includes payments of debts and claims (no matter the time
period).

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Foreign currency risk and its management
It is referred to as the possibility of losing money due to unfavorable movement in the
exchange rates.
It is also referred to as the losses that an international financial transaction may incur due to
currency fluctuations. Increasingly, many businesses have dealings in foreign currencies and,
unless exchange rates are fixed with respect to one another, this introduces risk.
There are three main types of currency risk as detailed below.

 Transaction risk: This is also known as short-run exposure. This type of risk arises
when a company or firm enters into short-term contractual cash flows of importing or
exporting. If the exchange rate moves between agreeing the contract in a foreign
currency and paying or receiving the cash, the amount of home currency paid or
received will alter, making those future cash flows uncertain, For example, in May
2020 a Sierra Leonean company say JusGan Ltd agrees to sell an export to Nigeria for
N2, 000,000, payable in Four months. The exchange rate at the date of the contract is
N/Le25 so the company is expecting to receive 2,000,000/25 = Le80, 000. If,
however, the N weakened over the four months to become worth only N/Le30, then
the amount received would be worth only Le66, 666. Also, if the N strengthens over
the four months to become N/Le20, then the amount received would be worth only Le
100,000.

 Economic Risk: This is also known as long term exposure. It is the change in the
competitive strength of imports and exports. For example, if a company is exporting
let's say from Sierra Leone to Nigeria and the naira weakens from say N/ Le 10 to
N/Le15 any exports from Sierra Leone will be more expensive when priced in nai-ra.
Also, goods imported from Nigeria will be cheaper in Leone than they had been, as a
result those goods will be more competitive in the Sierra Leone market.
It is important to note that a business or firm can experience economic risk even if it
has no explicit dealings with foreign nations. If competing imports could become
cheaper you are suffering risk arising from currency rate movements.

 Translation Risk: This type of risk occurs with multinational companies. For
instance, if the subsidiary is in a foreign country whose currency weakens, the

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 subsidiary's assets will be less valuable in the consolidated accounts. Usually, this
effect is of little real importance to the holding company because it does not affect its
day-to-day cash flows. However, it would be important if the holding company
wanted to sell the subsidiary and remit the proceeds. It also becomes important if the
subsidiary pays dividends. However, the term 'translation risk' is usually reserved for
consolidation effects.

Some Methods of Hedging Exchange Rate Risk

Exchange risk can create a lot of disturbances for businesses at both domestic and
international levels. Here we are going to look at four ways of mitigating transaction risks.

Invoice: Arrange for the contract and the invoice to be in your own currency. This will shift
all exchange risk from you onto the other party. Of course, who bears the risk will be a matter
of negotiation, along with price and other payment terms. If you are very keen to get a sale to
a foreign customer you might have to invoice in their currency.

Netting: Let assume JusGan limited owes Mam G. limited a Ghanaian company 5,000,000
cedis, and another Ghanaian company say J& Investment Company owes a subsidiary of
JusCan limited 5,200,000 cedis then by netting off group currency flows your net exposure is
only for 200,000 cedis. This will really only work effectively when there are many sales and
purchases in the foreign currency. It would not be feasible if the transactions were separated
by many months. Bilateral netting is where two companies in the same group cooperate as
explained above; multilateral netting is where many companies in the group liaise with the
group's treasury department to achieve netting where possible.

Matching: If you have a sales transaction with one foreign customer, and then a purchase
transaction with another (but both parties operate with the same foreign currency) then this
can be efficiently dealt with by opening a foreign currency bank account. For example:
1 May: should receive N5m from a Nigerian customer
15 May: must pay N4.5m to a Nigerian supplier.
Deposit the N5m in a Nigerian bank account and simply pay the supplier from that. That
leaves only NO.5m of exposure to currency fluctuations. Usually, for matching to work well,
either specific matches are spotted (as above) or there have to be many import and export

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transactions to give opportunities for matching. Matching would not be feasible if you
received N5m in May, but didn't have to pay N4.5m until the following March. There aren't
many businesses that can simply keep money in a foreign currency bank account for months
on end.

Leading and lagging: Let's imagine you are planning to go to USA and you believe that the
US dollars will strengthen against your own currency say the Leone. It might be wise for you
to change your spending money into dollars now. That would be leading' because you are
changing your money in advance of when you really need to.
Of course, the dollar might weaken and then you'll want to kick yourself, but remember:
managing transaction risk is not about maximizing your income or minimizing your
expenditure, it is about knowing for certain what the transaction will cost in your own
currency. Let's say, however, that you believe that the dollar is going to weaken. Then you
would not change your money until the last possible moment. That would be lagging',
delaying the transaction. Note, however, that this does not reduce your risk. The dollar could
suddenly strengthen and your holiday would turn out to be unexpectedly expensive.
Lagging does not reduce risk because you still do not know your costs. Lagging is simply
taking a gamble that your hunch about the weakening dollar is correct.

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