Determination of Exchange Rates

Introduction- Exchange Rate

 Exchange rates are important because they enable us
to translate different counties’ prices into comparable
terms.
 Exchange rates are determined in the same way as
other asset prices.
 Defined as the number of units of one currency that
must be given to acquire one unit of another currency.
 It is the price paid in the home currency to purchase a
certain quantity of funds in the currency of another
country.
 Exchange Rates
 An exchange rate can be quoted in two ways:
• Direct
– Gives the home currency price of one unit of the
foreign currency (also called the American terms) Eg.
INR 81/USD

• Indirect
– Gives the number of units of foreign currency for one
unit of home currency (also called an European terms)
Eg. USD 0.0123/INR
Exchange Rates
Exchange Rate Quotations
 Exchange Rates
 Cross Rate of Exchange
• Sometimes the value of a currency in terms of
another one is not known directly. In such cases,
one currency is sold for a common currency and
the common currency is exchange 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.
 Exchange Rates
• Two types of changes occur in exchange rates:
– Depreciation of home country’s currency
– A rise in the home currency prices of a foreign
currency
– It makes home goods cheaper for foreigners and
foreign goods more expensive for domestic residents.
– Appreciation of home country’s currency
– A fall in the home price of a foreign currency
– It makes home goods more expensive for foreigners
and foreign goods cheaper for domestic residents.
 Exchange Rates
 Buying and Selling Rates

- Buying rate (also known as bid rate) is the rate at

which the banks purchase a foreign currency from the
customers.

- Selling rate (also known as ask rate / offer rate) is

the rate at which the banks sell foreign currency to
their customers
 Exchange Rates
 Since bank needs to make a profit in these
transactions, so
Selling rate > Buying rate

 The difference between the two quote forms the

bank’s profit which is known as ‘Spread’
 Exchange Rates
 Two rates are published
If Rupee – US$ rate is
INR 40.00 – 40.30 / USD

Here INR 40.00 is the bid rate of USD

and INR 40.30 is the ask rate of USD
 Exchange Rates
 Bid –Ask Spread is often stated in %
Spread = (Ask price – Bid price) / Ask price x 100
= ( 40.30 – 40.00) / 40.30 X 100
= 0.744 %
 Exchange Rates
 Factors affecting the size of spread in respect of a
currency
- Its strength
- type of transaction
- Its supply and demand position with the
transacting bank
 Spot Rate / Forward Rate
Forward market includes both spot and forward rates

 Spot rate is the rate paid for delivery within two

business days after the day the transaction takes place.

 The forward rate is the rate quoted for delivery of

foreign currency at some future date. The exchange rate
is established at the time of contract though payment
and delivery is not required until maturity.

The various exchange rates are regularly quoted in

newspapers and periodicals
 Forward Market Quotation
Expressed as – Outright quote
– Swap quotes

 Outright quotes for US dollar in terms of rupee for

different periods of forward contract is expressed as

Spot INR 80.00 – 80.30

One month INR 79.80 – 80.40
Three months INR 79.60 – 80.50
 Forward Market Quotation
 Swap quote expresses the difference between the spot
quote and the forward quote
Spot INR 80.00 - 30
One month INR (20) – 10
Three months INR (40) – 20

It may be noted that decimals are not written in swap

quotes
Swap or Forward Rate Differential
 The change in forward rates may be upward or
downward. With such movements, disparity arises
between spot and forward rates. This is known as the
swap or forward rate differential.

 If the forward rate is lower than spot rate, it is a case

of forward discount.

 If the rate is higher than the spot rate, it is a case of

forward premium.
Forward Premium and Discount
 Forward premium and discount is expressed as an
annualized percentage deviation from the spot rate. It is
expressed as

Forward premium (discount)

=(n-day forward rate - spot rate)/spot rate x 360/n x 100
= (39.80 – 40.00)/ 40.00 X 360/ 30
= -0.06 or 6% forward discount

(where n is the length of forward contract expressed in

days.)
 Cross Rate
 Sometimes the value of a currency in terms of another one
is not known directly.

 In such cases, one currency is sold for

a common currency
and again 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.
 Spot Cross Rate
 Spot Cross Rate Eg. INR35.00 – 35.20 / USD
CAD 0.76 – 0.78 / USD

Selling rate of CAD in India can be worked out by

selling INR for USD at INR 35.20 / USD and then
buying CAD with the USD at CAD 0.76 / USD. This
means
INR 35.20 / USD 1 X USD 1 / CAD 0.76
= 35.20/1 X 1/ 0.76
=INR 46.32 / CAD
 Spot Cross Rate
 Buying rate of CAD in India can be worked out by
buying the rupee for the USD at

Rs 35.00 / USD and then selling CAD with the USD at

CAD 0.78 / USD. This means

INR 35.00 / USD1 X US $ 1 / CAD 0.78

= 35.00/1 X 1/ 0.78
=INR 44.87 / CAD

Combining the two, we get

INR 44.87 – 46.32 / CAD
 Forward Cross Rate
 Eg. One month forward rate in two currencies is
Rs. 34.50 – 34.80 / US $
Canadian $ 0.79 – 0.83 / US $
Forward rate of Can $ in terms of the rupee can be
found as
Rs. 34.80 / Can $ 0.79 = Rs. 44.05 / Can $
Rs. 34.50 / Can $ 0.83 = Rs. 41.57
Combining the two, we get Rs. 41.57 – 44.05 / Can $
 Nominal & Real Exchange Rate
 The nominal exchange rate (e) is the ratio between the
value of two currencies at a particular point of time.
 The real exchange rate (er) is the price adjusted
nominal exchanged rate.

The relationship between the two can be expressed as

er = eP/P*
where P is domestic price indices
P* is the foreign price indices
Nominal & Real Exchange Rate
 If the price index in India and USA rises from 100 to 120
in the year 2010 and 110 respectively in 2016 and

 If the nominal exchange rate between the two currencies

between the two dates remains at Rs. 40/US$

 The real exchange rate er = 40.00 x 120 / 110

= Rs. 43.64 / US$
Nominal & Real Exchange Rate
 In a floating rate regime, the nominal exchange rate
moves automatically with a change in the price level.

 In a fixed rate regime, it does not happen as the rate is

administered. As a result there arises a gap between
the nominal exchange rate and the real exchange rate.
 Effective Exchange Rate (EER)
 It is possible that the Indian rupee tends to depreciate
against different currencies but it appreciate against some
other 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 FX
market.

 Effective Exchange Rate is the measure of the average

value of a currency relative to two or more other currencies.
 Construction of EER
 Step 1: Select the currency of basket. Only those
currencies are included that matters significantly in the
country’s trade.
 Step 2: Find out the weight of different currencies in the
basket because different currencies do not carry the same
importance. If India’s largest trading partner is USA, the
US$ should be assigned the largest weight.
Weight = (EUSA + M USA)/ (Et + Mt)
 Step 3: Find out the exchange rate index.
 Step 4: Find out Effective Exchange Rate (EER)
 Example of EER
USA Japan Exchange 2010 2014
Rate
USA Rs. Rs.44/
India’s $ 6000 $ 4000 40 /US$ US$
export to
Japan Rs. Rs.
India’s $ 7000 $ 3000 50/Yen 60/Yen
import 100 100
from If 2010 is the base year, the
Weight of 0.65 0.35 Exchange rate index in 2014
will be (44/40)*100= 110 for
USA and (60/50)*100=120 for
Japan
 Example of EER
n
EER = Σ ( Ri index ) weight
i=R

where Ri is the exchange rate with the ith partner

EER2010= (0.65 x 100) + (0.35 x 100) = 100

EER2014= (0.65 x 110) + (0.35 x 120) = 113.5

This means that the rupee depreciated on an average

by 13.5% during this period.
Exchange Rate in the Spot Market
Rs. / US $ S

S'
62

60

D'
D

Q1 Q2 Q3

Demand for and Supply of US $

Factors Influencing Exchange Rate
 Impact of Inflation – The inflation rate differential
between the two countries influences the exchange
rate between the two currencies. The influence of
inflation rate finds a nice explanation in PPP Theory.

 Impact of Interest Rate

 Impact of Inflation
 Purchasing Power Parity (PPP) theory suggests that at
any given time, the rate of exchange between the two
currencies is determined by their purchasing power.

 It can be expressed as
e = PA / P B

where e is the exchange rate and

PA & PB are the purchasing power of two currencies
Purchasing Power Parity (PPP)
theory
The Purchasing Power Parity theory has been
presented in two versions
 Absolute version
 Relative version
 Absolute version of PPP Theory
A country with higher inflation will experience a
corresponding depreciation of its currency, while a
country with a lower inflation rate will experience an
appreciation in the value of its currency.

 If inflation in one country causes a temporary deviation

from the equilibrium, arbitrageurs will begin operating
and as a result equilibrium will be restored through
changes in the exchange rate.
Relative version of PPP Theory
 The exchange rate between currencies of any two
countries is a constant multiple of the general price
indices prevailing in them.

 In other words, % change in the exchange rate is equal to

the % change in the ratio of the price indices in the two
countries
It can be expressed as et/eo = (1+IA)t / (1+ IB)t
Relative version of PPP Theory
 et/eo = (1+IA)t / (1+ IB)t
where
et is the spot exchange rate in period t
eo is the value of A’s currency in terms of one
unit of B’s currency in the beginning of the
period
IA&IBare the rates of inflation in country A and
country B
Relative version of PPP Theory
What is the value of rupee in two years period if
Inflation rate in India is 5% and that in USA is 3%
and if the initial exchange rate is Rs. 40/US $

et/eo = (1+IA)t / (1+ IB)t

et = 40 (1.05)2 / (1.03)2 = Rs. 41.57 / US$
 Impact of Interest Rate (IR)
Experts differ on how interest rate influence the exchange rate.
 Rise in domestic IR lowers the demand for money and the
lower demand for money in relation to the supply of money
causes depreciation in the value of domestic currency.
 Rise in IR increases the supply of loan able fund which leads
to greater supply of money and a depreciation in domestic
currency.
 Higher IR at home than in foreign currency attracts capital
from abroad in lure of higher return and in flow of foreign
currency results in increase in the supply of foreign currency
and raises the value of domestic currency.
 Impact of Interest Rate (IR)

According to Irving Fisher

 interest rate and Inflation cannot be isolated

 If both IR and inflation rate is 10%, the real return

on capital would be zero because the gain in the
form of interest is cancelled out by the loss on
account of inflation.
 Impact of Interest Rate (IR)
 Irving Fisher has decomposed nominal interest rate into
the real interest rate and the rate of inflation.

 The relationship between the two elements is known as

Fisher Effect.

 The Fisher effect states that whenever an investor thinks

of an investment, he is interested in a particular nominal
IR which covers both the expected inflation and the
required real interest rate.
 Impact of Interest Rate (IR)
 It can be expressed as
1+ r = (1+a) (1+I)
where r = nominal interest rate
a = real interest rate
I = Expected rate of inflation
 Nominal Interest Rate
 Eg.: If the required real interest rate is 4% and the
expected rate of inflation is 10%, the required
nominal interest rate ( r ) will be
1.04 x 1.10 -1 = 14.4%

 If the real interest rate in USA is 4% and the inflation

rate in India is 10% higher than in USA, A US
investor will be investing in India only when the
nominal interest rate in India is more than 14.4%.
 Real Interest Rate
 An investor invests in a foreign country if the real
interest rate differential is in his favour.

 If real interest rate is 5% in India and 4% in the USA,

arbitrage begins in the form of international capital flow
from the USA to India that ultimately equals the real
interest rate across countries.

 The declining volume of capital in the USA will raise

the interest rate while the increasing volume of capital
in India will push down the interest rate.
 Real Interest Rate
 The capital flow will continue till the real interest rate
in the two countries become equal.
 Since the real interest rate is equal in different
countries, the country with higher nominal interest
rate much be facing a higher rate of inflation.
 Real Interest Rate
In real life, such homogeneous capital market is not
found in view of government restrictions and vary
economic policies in different countries.
Combined Effect of Interest Rate & Inflation

 The International Fisher effect states that the interest

rate differential is equal to the inflation rate
differential.
 It can be expressed as
(1 + rA) / (1 + rB) = (1 + IA) / (1 + IB)
Combined Effect of Interest Rate & Inflation

 Eg. India is expecting 8% inflation rate during the

next one year as compared to 3% inflation rate in the
USA. If the ex rate in the beginning of the year is Rs.
40/US $, the value of the rupee will fall vis-à-vis the
US $ at the end of the period to

= Rs. 40(1.08/1.03) = Rs. 41.94 / US$

Combined Effect of Interest Rate & Inflation
 Further that at the beginning of the period, the interest
rate in India is 7% as against 4% in the USA.

 At the end of the period, the interest rate in India will rise
to an extent that will equate approximately the inflation
rate differential.

 To find out the change in the interest rate, the following

eqn may be applied
et/eo = (1+rIND)t / (1+ rUSA)t
Combined Effect of Interest Rate & Inflation
et/eo = (1+rIND)t / (1+ rUSA)t
=> 41.94 /40 = (1 + rIND) / 1.04
=> 1 + rIND = 1.09
=> rIND = 0.09 or 9%

 If the rate of interest in India rises to 9%, the interest

differential between the two countries will be (1.09/1.04)
or 4.81% which will be approximately equal to the
inflation rate differential which is (1.08/ 1.03) or 4.85%.
Exchange Rate in the Forward Market
 Forward rate is not equal to the spot rate.

 The size of forward premium or discount depends

mainly on the current expectation of future events which
determine the trend of the future spot rate towards
appreciation or depreciation.

 If the $ is expected to appreciate, the holders will buy it

forward and the forward rate will improve and if the $ is
expected to depreciate, then the holders will sell it
forward and such action will depress the forward.
Exchange Rate in the Forward Market
 Interest Rate Parity (IRP) theory states that equilibrium
is achieved when the forward rate differential is
approximately equal to the interest rate differential.

 Forward rate can be determined as

F = S/A { (1 + rA) / (1 + rB) -1} + S
Exchange Rate in the Forward Market
 If the interest rate in India and the USA are
respectively 10% and 7%. The spot rate is Rs. 40/US$.
The 90days forward rate will be

F = S/A { (1 + IA) / (1 + IB) -1} + S

= 40/ 4 { (1.10) / (1.07) -1} + 40
= Rs. 40.28 / US$

i.e. the higher interest rate in India will push down the
forward value of the rupee
 Currency Arbitrage in the Spot Market
 Refers to the purchase of a currency by speculators in the
monetary centre where it is cheaper for immediate resale
in the monetary centre where it is more expensive so as to
make a profit.

 The process of arbitrage helps in keeping the exchange

rate between any two currencies the same in different
monetary centers i.e. the process influencing the demand
for and supply of the particular currency in the two
markets ultimately leads to removal of inconsistency in
the value of currencies in two market.
Currency Arbitrage in the Spot Market
 When two currencies and two markets are involved
where the particular currency is bought or sold, it is
known as two-point arbitrage.

 When three currencies and three markets are involved

where the particular currency is bought or sold, it is
known as three-point arbitrage or triangular arbitrage.
Speculation in the Spot Market
 Occurs when the speculator anticipates a change in the
value of a currency especially an appreciation in the
value of foreign currency.

 Eg. Exchange rate is Rs. 40/ US$ and speculator

anticipates this rate to be Rs. 41/US$ within 3 months.
Speculation in the Spot Market
 Speculator will
• Buy US$ 1000 for Rs. 40,000
• Hold this amount for 3 months
• When the target ex rate is reached he will sell US$
1000 at Rs. 41/US$ and earn Rs.41,000
• The difference of Rs. 1000 is the profit
Speculation in the Forward Market
 Suppose a speculator sells US $ 1,000 3-month
forward at the rate of Rs. 40.50/US$. If on maturity,
the US$ depreciates to Rs. 40, the speculator will get
Rs. 40,500 under the forward contact.

 At the same time, he will exchange Rs. 40,500 at the

then future spot rate of Rs. 40/US$ and get US$
1,012.50.
Speculation in the Forward Market
 The activities of selling and buying the US$ will be
simultaneous.

 Thus without making any investment, the speculator

will make a profit of US $ 12.50 through the forward
market deal.