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which will have to be managed by the genuine traders and investors in foreign countries and dealers in foreign exchange and banks. 2. 6. 3. Hot money flows as between countries and currencies will take place to take advantage of short term economic and political factors or disturbances or fears of such developments leading to changes in currency rates and interest rates. 4. Present international monetary system under IMF imposes the burden of adjustments on the deficit countries to change their exchange rates rather than on the surplus countries. 4. TYPES OF RISK IN GENERAL:1. Similarly. 3. Risk of credit worthiness Risk of credit control Risk of economic and political policy. The fluctuating rates result in uncertainty and risk. 5. Freely fluctuating exchange rates across countries do sometimes lead to erratic movements of rates on either side. Exchange rates volatility emerges out of erratic fund flows as between countries short –term flow of funds in either direction and inflows of funds followed by immediate reversals etc. if funds are transmitted from one country to country to another the amounts to be sent or to be received will not be certain.Exchange risk simply means that the rate at which a currency is exchanged for another currency may be uncertain and volatile and the amount that an exporter receives in domestic currency or an importer has to pay in terms of domestic currency will be unpredictable and uncertain . 2. Speculative attacks on currencies in anticipation of exchange rate changes and interest rate changes through short term flow of funds due to rumors “news” and expectations. unless counter veiled by central bank of the country to offset such excesses. 8. Limited powers of IMF to discipline the surplus countries also lead to partial adjustment or lack of adjustment as between currencies of countries with the result that currency rate may fluctuate. 5. 6. FACTORS AFFECTING EXCHANGE RATES:1. Risk of interest rate changes Risk of market changes Risk of uncertainty in exchange rates Risk of war and epidemics Risk of changes in cross currency . if exchange rates are not fixed. 7.

If the government does not stand willing to buy and sell at the mint parity price. the workings of the internal economy were subservient to balance in the external economy Gold Standard How it worked? If 1 unit of currency A is worth 0. Exchange rate= 1 currency B=2 currency . 1879-1913 With stable exchange rates and a common monetary policy. dollars. then the price will fluctuate with changes in the supply and demand for money once gold. 1918-1939 World War I ended the gold standard.Real rates of interest also tended toward equality across a broad range of countries. The International Gold Standard. The Interval Period. Thus. countries desired to establish an international monetary system based on mutual cooperation and freely convertible currencies. each nation specified the gold content of its currency. New Hampshire in 1944. Europe had experienced rapid inflation during war and afterward and it was not possible to restore the gold standard. Each currency is defined in terms of its gold value.Exchange Rate Theories Background of International Monetary System • International monetary system has been in existence since late nineteenth century. all currencies are linked together in a system of fixed exchange rate. The exchange rate of $4. then 1 unit of currency B is worth twice as much as A. United Stated experienced little inflation during the war and thus returned to a gold standard The Gold Exchange Standard: 1944-1970 After World War II.87/£ is known as mint parity’s the cost of shipping gold from New York to London was approximately . whereas 1 unit of currency B is worth 0.10 ounce of gold. currencies are valued in terms of gold equivalent. It was during this period that the gold standard began.S. prices of tradable commodities were much equalized across countries.The result of this conference is to tie all currencies together The gold standard Under the gold standard. On the other hand. known as mint parity price. An ounce of gold was worth $20. Led to an international conference at Breton Woods. The Gold Standard: 1880-1914 • Under gold standard.76 in terms of U.2 o Maintaining gold standard requires a commitment from participating countries to buy and sell gold to anyone in the world at the fixed price.

The U. Dollar was being devalued by about 8%. Introduction .$4. If a trade imbalance exists. Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. If a trade imbalance exists. The system in operation can be best described as managed float. the actual exchange rate would always lie between $4. Although we described the system since 1973 as floating system. Adjustment under the gold standard Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. Change in dollar value in terms of gold from $35 to $38.S. the increase in gold supplies in the trade surplus country increases its money supply and raises its price level. exchange rate is determined by free market forces of demand and supply. Floating Exchange Rates: Since 1973 In this system. $1 was defined as being equal to 1/35 ounce of gold. gold will flow from the country with a trade deficit to the country with a trade surplus. but it may also be a conduit for the transfer of macroeconomic shocks from one nation to another. The Transition Years: 1971-1973 In 1971 international monetary conference was held in Washington to realign foreign-exchange values of the major currencies. Bretton Woods Agreement The Breton Woods agreement required that each country fix the value of its currency in terms of gold.$4. International Monetary Arrangements in Theory and Practice The international financial system can promote the gains from international trade and the economic integration of regions. The International Monetary Fund (IMF) was created to monitor the operation of the system. Nations belonging to the system were committed to maintaining the parity value. Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. The fall in gold supplies in the trade deficit country reduces its money supply and pushes its price level lower. currencies of countries with balance-of-payment surplus revalued upward In 1972 Britain allowed pound to float according demand and supply conditions By 1973 major currencies were all floating.84/£ is the gold import point. dollar was the key currency in the system. gold will flow from the country with a trade deficit to the country with a trade surplus. it has never been fully determined by free market forces.90/£ is the gold export point.3 cents.90/£. The concept of the price-specie-flow mechanism was initially introduced in 1752 by David Hume.84/£ and$4.

portfolio decisions of FIIs can generate significant volatility in the rupee exchange rate.An exchange rate is the relative price of one currency in terms of another . Exchange Rate Theories • • • • Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates Interest Rate Parity .During the Breton Woods era exchange rate was treated as an exogenous variable.It influences allocation of resources within and across countries . the cost incurred when forecasts turn out to be wrong How much does the forecast contribute to better decision making given that the firm has its own sources of information and is able to generate its own forecasts. attention once again shifted to determinants of exchange rates themselves. The RBI policy in 2000: No fixed target for exchange rate nominal or real. Basics of exchange rate economics to be able to evaluate forecasts given by “experts. Behavior of the spot rate in India is largely governed by trade related flows since the capital account continues to be strictly controlled .Exchange controls may prohibit portfolio shifts between currencies and interfere with realization of UIP. The exchange rate system in India has had a chequered history . The use to which the forecast is put . With the advent of floating rates in 1973.e.Determinants of exchange rate movements in India are difficult to assess during the period of managed float. Composite Forecasts – A combination of different forecasts.In the very short run. Exchange Rate Forecasting Exchange rate forecasts are an important input into a number of corporate financial decisions Forecasting methodologies can be divided into two broad categories. Structural economic models of exchange rate determination such as the PPP or the monetarist model “Pure forecasting models" that includes time series methods and "technical analysis" Recent developments in modeling and predicting financial time series have applied mathematical tools like Chaos Theory and Neural Networks.The Corporation’s "loss function" i. Any forecast paid for must do considerably better than forward rate in predicting direction and magnitude of movement. The forward rate is always available as a forecast free of charge. they could have differing views about future exchange rate movements Transaction costs and liquidity needs would force people to hold some of their wealth in the currency of their operating habitat even though the expected return on a foreign currency is higher . Some Fundamental Relationships Investors are risk averse and therefore would not be guided only by expected returns Even if all investors are risk neutral. RBI acts to moderate excessive fluctuations and prevent panics.

All financial contracts are stated in nominal terms. we can safely assume that IRP holds. Since we don’t typically observe persistent arbitrage conditions. Shipping costs. The real rate of interest is the net increase in the wealth that people expect to achieve when they save and invest their current income. If IRP did not hold. PPP probably doesn’t hold precisely in the real world for a variety of reasons. Forecasting exchange rates It states that exchange adjusted price of identical trade able goods and assets must be within the cost of equality worldwide. then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. on the other hand. is a highly standardized commodity that is actively traded across borders. Film. Assumptions:- .• • • • • • Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity IRP is an arbitrage condition. PPP-determined exchange rates still provide a valuable benchmark. • Purchasing Power Parity • • • • • • Purchasing Power Parity and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Evidence on PPP. as well as tariffs and quotas can lead to deviations from PPP. the real rates of interest must be adjusted to reflect inflation. • • The Fishers Effect It states that currencies with high rate of inflation should bear higher rates of interest than currencies with lower rates of inflation. Haircuts cost 10 times as much in the developed world as in the developing world.

to reduce excess volatility in exchange rates. have to be subservient to overall macroeconomic targets. Subject to this predominant objective. trade and other restrictions often exist. while ensuring that the market correction of overvalued or undervalued exchange rate is orderly and calibrated. the conduct of exchange rate policy is guided by three major purposes. First. 2. To hold a rational market there should be no barriers of trade. distorting prices. The goods have to be homogeneous. shipping and other transactions costs can turn out to be much different from the initial conditions. The main objective of India's exchange rate policy is to ensure that economic fundamentals are reflected in the external value of the rupee. 3. goods cannot be transferred across countries simultaneously. Recently. Exchange rate policy will form part of the overall macroeconomic policy and will. There are no transaction cost involving buying a commodity in one market and selling it on another. Developing exchange markets is another important consideration in exchange rate management. Reasons for Exchange Rates            Trade movements Capital inflow Granting of loans Banking operations Speculations Protection Inflation Financial policy Bank rate Peace on security Political condition Risk in Foreign Trade and Finance     Credit risk of customer Country risk Currency risk Market risk Exchange Rate Management in India  In the real world. several measures were initiated to further integrate the Indian fore market with the global financial system. therefore.1.    . expectations cannot be easily subjected to definitive formulae.