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INTERNATIONAL FINANCE ASSIGNMENT

SUBMITTED BY, ANOOPA NARAYANAN S3 MBA (IB) ROLL NO.4 16/08/2011

INTRODUCTION

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 91Japanese yen (JPY, ) to the United 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 GMT on Sunday until 22:00 GMT Friday. The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business' income is in US dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies. All forex trading involves the exchange of one currency with another. At any one time, the actual exchange rate is determined by the supply and demand of the corresponding currencies. Keep in mind that the demand of a certain currency is directly linked to the supply of another. Likewise, when you supply a certain currency, it would mean that you have the demand for another currency. There are 2 exchange rates - spot exchange rate and forward exchange rate .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. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it.

FACTORS INFLUENCING EXCHANGE RATES

Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Economic factors 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).

Monetary Policy When a central bank believes that intervention in the forex market is effective and the results would be consistent with the governments monetary policy; it will participate in forex trading and influence the exchange rates. A central bank generally participates by buying or selling the domestic currency so as to stabilize it at a level that it deems realistic and ideal. Judgment on the possible impact of governments monetary policy and prediction on future policy by other market players will affect the exchange rates as well.

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. 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. 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 causes inflation. Moreover, if a government 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. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

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. Trade balance also has an effect on a country's currency. If world prices for what a country exports rise in comparison with the cost of that country's imports, that country will be earning more for its exports than it pays for its imports. The more demand there will be for that country's currency, the better the deal becomes. If investors are confident that the US economy will be strong, they will be more likely to buy American assets, pushing up the dollar's value. If investors are not so confident that the economy will be strong, they will be less likely to buy the country's assets, pushing the dollar's value down.

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 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.

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. As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange ratesWhen a countrys key interest rate rises higher or falls lower than that of another country, the currency of the nation with lower interest rate will be sold and the other currency will be bought so as to achieve higher returns. Given this increase in demand for the currency with higher interest rate, the value of that currency will rise against other currencies. Let us use an example to illustrate how interest rates affect exchange rates. Assume there are two countries, A and B. Both countries do not exercise foreign exchange control and capital funds can flow freely between them. As part of its monetary policy, Country A raises its interest rate by 1% while the interest rate of Country B remains unchanged. There is a huge volume of liquid capital in the market that flows freely between these two countries, seeking out the best possible interest rate. With all other conditions remaining unchanged, as Country As key interest rate rises, a large portion of the liquid capital will flow into Country A. When the liquid capital flows out from Country B to Country A, a large amount of Country Bs currency will be sold in exchange for Country As currency. In this way, the demand for Country As currency will increase, strengthening i t against Country Bs currency. In fact, in todays globalized market, this scenario applies to the whole world. Over the years, the market trend has been shifting towards free capital mobility and elimination of foreign exchange restrictions. This enables liquid capitals (also known as hot money) to flow freely in the international market. A point to note though is that such capital will only be moved to a region or country with higher interest rate if their investors believe that the change in exchange rate will not nullify the returns gained with higher interest rate. If interest rates are higher in, say, the US than in other countries, then investors will choose to invest in the us, increasing demand for the dollar, provided that the expected rate of inflation is not higher in the us than among other trading partners. If interest rates are lower in the US than in other countries, investors will choose not to invest in the US, decreasing demand for the dollar. If the US

inflation rate is higher, investors are less likely to prefer the useven with higher interest rates because of the expectation that the value of the dollar will be eroded by 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 .

Political conditions 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. Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A 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. Growing global tension will result in instability in the forex market. Irregular inflow or outflow of currencies may result in significant fluctuations in exchange rates. The stability of a foreign currency is closely related to the political situation of that place. In general, the more stable the country is, the more stable its currency will be. We will illustrate how political factors influence exchange rates with some actual examples. At the end of 1987, the US Dollar was suffering from continuous depreciation. In order to stabilize the US Dollar, the G7 Finance Ministers and central bank governors released a joint statement on 23 December 1987 announcing plans for a large-scale intervention in the forex market. On 4 January 1988, the group started to dump Japanese Yen and Deutsche Mark in huge volumes while buying US Dollars. This resulted in a rebound of the US Dollar and maintained its exchange rate at a stable level. For our second example, if you have been observing the Euro, you would have noticed that for three consecutive months during the Kosovo War, the Euro fell by about 10% against the US Dollar. One of

the

reasons

was

the

downward

pressure

on

the

Euro

caused

by the

Kosovo

War.

Market psychology Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Market Judgment The forex market does not always follow a logical pattern of change. Exchange rates are also influenced by intangible factors such as emotions, judgments as well as analysis and comprehension of political and economic events. Market operators must be able to interpret reports and data such as balance of payments, inflation indicators and economic growth rates accurately. In reality, before these reports and data become available to the public, the market would have already made its own predictions and judgments, and these will be reflected in the prices. In the event that the actual reports and data deviate too much from the predictions and judgments of the market, huge fluctuations in exchange rates will occur. Accurate interpretation of reports and data alone is not adequate, a good forex trader must also be able to determine market reactions before the information becomes publicly available.

Speculation Speculation by major market operators is another crucial factor that influences exchange rates. In the forex market, the proportion of transactions that are directly related to international trade activities is relatively low. Most of the transactions are actually speculative trading which cause currency movement and influence exchange rates. When the market predicts that a certain currency will rise in value, it may spark a buying frenzy that pushes the currency up and fulfill the prediction. Conversely, if the market expects a drop in value of a certain currency, people will start selling it away and the currency will depreciate. For example, after World War II, the United States enjoyed a period of political stability, well-managed economy, low inflation rate and an average annual economic growth of about 5% in the early 1960s. At that time, all the other countries in the world were willing to use US Dollar as the mode of payment to safeguard their wealth. This causes a continuous rise in value of the US Dollar. However, from the end of 1960s to early 1970s, the Vietnam War, Watergate scandal, serious inflation, increased tax burden, trade deficit and declining economic growth caused the US Dollar to plunge in value

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 it 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.

Conclusion

The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.

References 1. Wikipedia,2009, Exchange rate, http://en.wikipedia.org/wiki/Exchange_rate downloaded on 15/09/2011 2. Top 5 Factors Affecting Exchange Rates, 2008, http://www.investopedia.com/articles/basics/04/050704.asp#ixzz1Xf5I9GBp downloaded on 15/09/2011

3. 6 Factors That Influence Exchange Rates ,2009, http://www.economywatch.com/exchange-rate/ downloaded on 16/09/2011 4. Factors influencing a country's exchange rate,2008, http://www.lavenant.com/free reports/Factors%20influencing%20a%20countrys%20exchange%20rate.pdf downloaded on 16/09/2011