EXCHANGE RATE THEORIES

23

exchange rate variations and to predict their future course. Several theories have been propounded to this effect. These theories, by and large, use factors such as inflation, interest rates and balance of payment deficit. The two important theories are:

3 EXCHANGE RATE THEORIES
3.1 Introduction

(1) Purchasing Power Parity (PPP), and (2) Interest Rate Parity (IRP). 3.2 Purchasing Power Parity (PPP) Theory

It is necessary to know long-term future exchange rates in order to take strategic decisions concerning investment and management of foreign subsidiaries. These predictions of future rates will be .~itten in the strategic plan of the group as whole, compnsmg the parent as well as the different subsidiaries: Besides long-term future rates, it is equally important to estimate exchange rate in medium term, that is, over a period of one year, because cash flows of subsidiaries consist of domestic as well as foreign currencies. Short-term prediction on the other hand, is necessary for managing exchange exposure on day-to-day basis. . Gene:ally graphs and charts are used for short-term prediction while fundamentals are used for predicting medium and long term rates. Fundamentals consist of factors like interest rates, inflation, economic growth, and money supply. It is reasonable to assume that these factors will have some impact on e~c~ange rate. The effect of each of them may not always be distinctly clear, yet the fact is that each of the fundamental factors has an influence on the evolution of exchange rates. From the above, the significance of prediction of future exchange rate is apparent. Theorists have been trying to explain

Purchasing Power Parity theory is based on the premise that the same product cannot have different prices in two different markets at any given point of time. This theory assumes restriction free movements of goods and absence of incidental costs such as transportation. According to this theory, if a product costs Rs 100 in India and $ 2.5 in USA, then one US dollar has to be equal to Rs 40. That is, a sum of Rs 100 has the same purchasing power as the sum of $ 2.5. This theory was first enunciated by Gustav Cassel, a Swedish economist. He said that the purchasing power of a currency is determined by the amount of goods and services that can be purchased with one unit of that currency. If there are more than one currency, the exchange rates between them should be such that they provide the same purchasing power to different currencies. In case the existing rate is such that purchasing power parity does not exist, it is a situation of disequilibrium. It is expected that the exchange rate among different currencies conforms eventually to purchasing power parity. Now, let us consider two countries, A and B. The rate of inflation are rA and rB respectively in the two countries. Let us assume further that rA is higher than rB• Since inflation rate is lower in country B, its goods will be relatively cheaper compared to those of country A. As a result the imports of country A from country B will increase, since the prices of foreign goods tend to be lower for country A. Similarly, exports from country A will decrease since the prices of its goods appear to be higher to foreigners. This situation will not persist for long.

24

FOREIGN EXCHANGE

MARKETS

EXCHANGE RATE THEORIES

25

As a consequence, the currency of country A will depreciate 'with respect to the currency of country B and a new exchange rate will be established. Let us say that at pet· od 1, the price of a basket of goods in country A is PIAwhile at in country B is PIB and SI units of currency A are equal t one unit of currency B. The relation between the currencies of the two countries at the period 1 is given by equation 3.1. PIA = SI
X

or PIA PIB =S ( 1
X

2

+ rB) 1 + rA

or SI = S2 X C1 1

+ +

r ) B rA

PIB

(3.1 )

At period 2, the prices of the same basket of goods are P2Aand P2Bin the two countries respectively. The equations 3.2 and 3.3 relate the prices and inflation rates. I P2A= PIA (I and P2B= PIB (I

S2 = SI x

( 1

+ rA ) 1 + rB

(3.5)

+ rA)

(3.2)

+ rB)

(3.3)

The equation 3.5 is the fundamental equation of the PPP. Thus, if the rate of inflation in country A is lower than that in country B, the exchange rate of period 2, S2' will reflect appreciation of the currency of country A with respect to the currency.of country B. From equation 3.5, one can work out the rate of appreciation or depreciation as follows: S2 - SI (d) = --SI
)

The exchange rate and price at the period 2 are linked as shown by equation 3.4. P2A= S2 P2B Substituting get values of prices from equations
(3.4)

Rate of appreciation 3.2 and 3.3, we

or depreciation

1

PIA (I

+ rA) = S2 X PIB (1 + rB)
Or

SI ( --

+ rA
+
rB

-1

1

-....
l-l-trA ~

_I

\

SI
1. The rate of inflation of a country is normally calculated from the price indices: For example, price indices are PI and P2 at the beginning of year 1 and year 2 respectively, then inflation rate (r) over the period year 1 - year 2 is given by equation as given below:

rA

-

rB
r
B

d

=

1

+

(3.6a)

r

= ---

P2 - PI x 100 per cent PI

If we consider rBto be much smaller than 1, then d",,(rA-rB)
(3.6b)

1 ~ ~~~ 3. As per Fisher. the response of indi viduals to changes in value of real and monetary assets i expected to be strong and the prediction of exchange rates b the PPP theory may turn out to be realistic. ~ + rA + ra ) = = 1 Rs 42 x ( 1 + 0. Some of the major factors in this regard are: (i) Trade restrictions. The PPP theory is ideal for predicting exchange rates i specific situations such as high rate of inflation or monetar disturbances. For example. the nominal rate of interest is related to real rate of interest and inflation by the equation: (I where in ir r + in) = (I + i. (ii) Government restrictions on exchange rates. Example 3.8155/US and d = 1 ( 1 + 0. there are a nurnbe of factors which prevent it from predicting exchange rate i practice. If a currency is an instrument of pa ment for other countries..7) = = nominal rate of interest real rate of interest rate of inflation.s:pt ~etween period 1 and period 2. i. Example 3. it is important to establis whether price indices should be based on only thos commodities that are traded internationally or on a commodities. S2 _ ( 1 1 . the real future worth of a monetary asset should be the same irrespective of the currency in which it is invested.levels.SI Here S I == Rs 42/US $ rA == 5 per cent rB == 3 per cent Then.1 illus trates the application of PPP theory.) (I + r) (3. The PPP takes into account only the movement of goo and not that of capital. as is the case with the US dollar.5. (iii) Continuation of long-term flows despite the disequi librium between purchasing power parity and exchang rates. EXCHANGE RATE THEORIES . the exchange rate may evolve in a manner independent of pri level of the country concerned.05 ) . ( ~"1-/~)~ ~ 27 ! <.3 Theory of Interest Ra.02 or 2 per cent Thus. . . at period 2.1: The exchange rate between Rupee and US dolla is Rs 42.03 = 0. USA. In operational terms.03 $ Rs 42. . the exchange rate is Rs 42.e. In these specific situations. we wnte S2 . it is concerne only with the current account segment of Balance of Paymen and not the total BOP. Though this theory is conceptually sound.6b states that rate of appreciation or deprecia tion is simply the difference between the rates of inflation i the two countries.8155/US $ and Rupee has undergone a depreciation of 2 per c. (iv) lack of definition of the relevant rate of inflation an price .26 FOREIGN EXCHANGE MARKETS The equation 3.05 ) + 0.00/$ at period I and respective rates of inflation i India and USA are 5 per cent and 3 per cent respectively. Wha is the likely exchange rate at period 2 and the rate of deprecia tion or appreciation? Solution: Applying the PPP equation.1 + 0.te Parity (IRP) The basic premise of this theory is that in an open economic system.

11 implies that the currencies that undergo higher inflation will have higher nominal rates of interest than those which have lower inflation.8) (3. We can further derive a relationship between interest rate and variation in exchange rate (d). or 1 + inA ---I + rA --- ~\.( 1 + inB) in country B and the two sums obtained should be equal.I .I (3. (inA rA ) = (inB - or (3. Since all financial contracts are denominated in terms of nominal rates. as long as there is no restriction on movement of capital. That is. 1 + rB S2 = SI --I Equation 3. then one can write: (I (I + inA) = (I + irA) (1 + rA) (3. The nominal rates of interests are inA and inBrespectively.10) I + inA u f. the values of rA and rB has been presumed to be very small in comparison to 1. real interest rates in two different countries should tend to be equal because of arbitrage process.10 can be modified as follows: 1 + inA I _ + inB I = I + inB I + rA - + rB rB) . In other words. in the state of equilibrium.14 can be 52 = 5."~ ~>t (3.t -(.14 expresses the interest rate parity relationship. If Fisher effect is applied to two countnes. the real rate should be adjusted to take into account th~ anticipated inflation.13) If the exchange rate at period 2 be S2' then one unit of currency of B is equal to SI (I + i . For a period other than one year (say 0 days) equation modified as follows: J +i . The investor places either SI units of currency in country A or one unit of currency in country B.11 ) Equation 3. A and B. [ l+i nB 360 0 360 1 x~- .14) 1 + inB (\~l".• x-M 3. Equ~tion .11. the exchange nB rate! at period 2 is ~\ ( \ ~L <\11) _ \ I+ inA) According to Fisher. That is. While writing equation 3.3. (3.28 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 29 The market rate of interest is the nominal rate.12) d= . The real rate· of interest or real rate of return corresponds to increase of purchasing power. The other stipulation of Fisher is that an investor should 2. then he obtains 51 (I + inA) in country A or 1..d (3.9) + inB) = (I + irB) (1 + rB) obtain the same real rate of return whether he places his funds in the currency of country A or that of B. in the state of equilibrium. Let the current exchange rate between the currencies of countries A and B be such that 5 units of the currency of A is equal to one unit of the curI rency of B.

. rate after 3 months will be exchange x or (3. that is.1 X ~ = (i nA . there would be a global demand of funds against a global supply and thus a rate of interest will result from equilibrium of demand and supply. Monetary policy. Yet. Inflation rate. Evolution of GDP. it seems that the major part of variations of nominal interest rates can be attributed to the anticipated difference of inflation rates.2: The current exchange rate between US dollar and Euro is $ 1. d x ~ + 006 l. dollar. It is so because exchange rates are influenced. It is found that the countries that have higher rate of inflation have higher nominal interest rates. Thus.15) [1 1 + is X + iEu X ~ - 1 12 (1 + = 1. Budgetary and fiscal deficit. On the contrary. An analysis of how these factors affect exchange rate is called fundamental analysis. What is the exchange rate expected to be after 3 months? S2 = $ 1. in a very complex way. when markets are segmented. collectively known as fundamentals.0973 If we consider inB to be much smaller than 1. If the capital markets were integrated.30 or FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 31 Solution: Applying interest rate parity relationship. But these two theories do not capture exchange rate changes in totality.1 0lIS>< 3] 1. Some of these factors include: (i) (ii) (iii) (iv) (v) (vi) Balance of payments.0125 = 1. Long-term as well as short-term interest rates.4 x l. Example 3. PPP and IRP are able to quantitatively link future exchange rate with inflation rate and interest rate respectively. Three-month interest rates in USA and Euro-zone are 5 per cent and 6 per cent respectively. by many economic factors.0973/Euro Euro has depreciated marginally vis-a-vis Fundamental Analysis As we have seen. demand and supply are determined at the level of each country as a function of its specific conditions and hence theory of interest parity is not fully verified.l/Euro.015 The theory of Interest Rate Parity and Fisher effect have been tested.i nB ) (3. it is not easy to test the hypothesis of equality of real interest rates.16) or As is expected. 3. Integration of capital markets brings in some degree of homogeneity of interest rates. The differences that exist between real interest rates may be either due to exchange risk or political risk. then variation can be shown to be equal to the differential of interest rate in the two countries.

governments have different ways of acting in short term on the equilibrium of BOP.16. Therefore. employment mar. (ii) price controls. There are always 'erro~s and 0r:'issior s' whose amount is significantly high in certain countnes. balance of services and invisibles. It identifies repetitive situation and it is the extrapolation of these tendencies which enables prediction of future rates. the prices of currencies on the market. The tendencies of rates of the past serve to anticipate the evolution of rates in short term. ematical equations linking future exchange rate with each one of these factors. If. variations of exchange rates are not random but are linked in some way to past variations. The external trade and capital movements influence the supply and demand of foreign exchange and consequently. a country with a surplus of BOP. Here. r ) ~Inlmum rate of the day (or of the week) and (c) closing hate Indicated by a small horizontal line.l\~wing: (a) maximum rate of the day (or of the week). by borrowing from or lending to international institutions in foreign currency. However. currencies of the countries suffering from a deficit of current account have a tendency to depreciate. For example. These include measures relating to (i) monetary and fiscal policies. mathematical models can be developed and verified on empirical data to see which factors have had more significant influence on exchange rates than others aver a given period of time. 3. Besides. capital investment. Technical analysis is generally used for short-term. N is given by the equation 3.17) Similarly. 3. (iii) exchange control. use of the capacity of production. This adjustment of exchange rate through BOP. technical analysis does not seek to determine the explanatory factors. As per technical analysts. it is not easy to develop precise math. balance of payments comprise trade balance. The current and capital accounts are balanced by variations of official reserves. Forward contracts are not included in the accounts of BOP. Other factors enumerated can be discussed in qualitative terms. We have already seen how inflation and interest rates are linked to exchange rates. Generally. and balance of capital in short term as well as long term. but rather a~tempts to understand the evolution of exchange rates from historical series. It presupposes the stability of the behaviour of the operators. over a certain period. Most of these factors are inter-dependent in a rather com. In any case. when the foreign currency reserves of a country fall below the value of three months' imports. N = . the currency of that country is considered vulnerable. is not always verifiable for different reasons. all the capital flows are not registered in the BOP account. wholesalorders. Theoretically. such as industrial production. .5 Technical Analysis: Graphical Method for Predicting Exchange Rates Technical analysis makes use of graphs and charts. Some thinkers consider that the BOP is a good indicator of the pressure that a currency may be subject to. Secondly.1. retail sales. Firstly. If a country's reserves are represented by R and annual imports plus debt service obligations by I. bar charts indicate for each period (be fo. a country buys more than what it sells overseas.5. all things being equal. and housing market. and (iv) quantitative and tariff barriers on imports.1 Bar Charts of Ex~hange Rates ~ shown in the Figure 3. then N should be greater than 3 months if the currency is not to enter a dangerous zone. the probability of depreciation of its currency vis-avis others increases. Bar charts give a first and idea of the exchange rate volatility. such as orders for durable goods.x 12 I R (3. Unlike fundamental analysis. other factors will influence the exchange rates. and (ix) Indicators pf supply.32 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 33 (vii) Borrowing by household sector. however. ket and capital market. (viii) Indicators of demand. plex manner. should have a strong currency.

4 are charts of tendency. 3.3 and 3. the time coordinate is not important. By joining high points.5. Instead.2 Line of Resistance In this chart. there is likely to be a change in the market behaviour. 10 paise .4 An Ascending Tunnel When exchange rates differ substantially from these lines. for example. A rate crossing the upper line (or line of resistance) gives a signal for buying.34 Rs/$ FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 35 Rs41 Rs 40 Rs 39 Rs 38 4---~--'---'----.2 Principal Tendencies Principal tendencies can be determined by drawing a line that joins high points or low points.---r---r--~--~--~_~Days 2 3 4 5 6 7 ~--------------------------~------------~T~ FIG. 3. 3. 3. ! ~ ca ~ ------------------------------------------~·T~ FIG. One defines a minimum variation. Inversely.3 L-__ Point and Figure Chart ~------------------------------------~T~ FIG.---.5. The line obtained by joining low points is called the line of support.1 Bar Chart of Exchange Rates 3. Figures 3.2. 3. one obtains the line of resistance. a rate crossing the lower line (or line of suppqrt) gives a signal for selling. The two lines joining low and high points may form a tunnel which indicates that markets are either strongly ascendent or descendent. 3.3 Line of Support 8 9 10 FIG.

5 Point and' FiguTeChart a figure. 3. the declining tendency has set in.4 Some ObserPed Figures . another cross is marked over the previous one in the same column. almost of the same level. circles are marked. each below the previous one in the same column. the column is changed and a circle is marked at the new level attained. Figure 3. forming right shoulder.6 depicts heads and shoulders. rates move towards high in the form of left shoulder and then a high point is reached.ndicating that a tendency of climb is going to set m. On the other hand. The highest points of each column of crosses indicate the 'high' points.7(a) and 3.36 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORlE~. 3. there is a decrease in the rate. the lowest points of each column of circles indicate the 'low' points.6 Heads and Shoulder-s (b) Wor M Forms: As· shown in Figures 3. often followed by a decrease.5 plots crosses and circles. 3.10 rupee).7(a) 'w' Form Time . 3. FIG. FIgure 3. referred to as neck line. Likewise. o x o x o x o o x o o FIG. figures that are observed in practice are ~ t (a) Heads and Shoulders: It is a symmetrical formation with two low peaks (shoulders) enclosing one high peak (head). For as long as the rate decreases. a cross (x) is marked. Once the neck line is crossed downward. the volumes are high when left shoulder is being formed. If the rate continues to go up. Volumes are lower for the head and still lower for the right shoulder. The figure W indicates three peaks. 37 (or 0. In a market. 0:: !II CI) C) C !II x 0 0 0 0 0 0 x 0 0 0 0 o x s: W ~ x o x 0 x o x 0 x o x o o x x x x x x x 0 0 0 0 x x x x 0 0 0 x x 0 x x x x x x 0 0 0 x x x x 0 0 0 0 x x x x x 0 0 0 0 0 x x x x x ~------------------------------~--~-----. The base of the shoulders and head can be ~ s --------------------------------~----~. When the rate increases at least by this mini.Time FIG. like head.! Some of the important now shown. on the other hand. If.5. mum amount. Normally. x o ~. M indicates a form with two peaks and one trough. There are also inverted heads and shoul~ers i. approximately similar to W or M is also observed.7(b).

~Time a:: s 10 Q) 01 C Q) a:: 1ii Q) 01 C (e) Flag: As shown in Figure 3. I0.0 days.8 (c) Symmetrical Triangle Moving averages are used to follow the average tendency of markets.- Time FIG. Moving averages permit an extrapolation of the evolutIon of tendency over long-term.7(b) 'M' Form LFlG.5 Moving Averages W s: o x 10 1.38 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 39 (d) Diamond: This form looks like a diamond. 3. as shown in Figure 3. descending triangle 0: symmetrical triangle as shown in the Figure 3.10 l!l ~----------------~Time Flag (b) Descending Flag (a) Ascending a:: 10 Q) 01 C 3.3.8 (a) Ascending Time Triangle s: o x LU 10 Triangle (b) Descending ~----------------~Time FIG.8.5. there are flag forms as well. These are generally calculated for duration of 10 and 3. s: o x LU 10 s: o x LU 10 Q) a:: L- 1ii Q) 01 C ~----------------~Time FIG.9 Diamond Form (c) Triangles: There may occur different forms of tenden cies such as ascending triangle. A signal of purchase is given when the curve of the exchange rate crosses upwards the curve .3.3.9. 3. fl s: o x LU l!l Q) 01 C 10 L-------------------------------------------~T~ FlG. Flags may be of climbing tendency as well as of descending tendency.

irne needed for research on fundamentals. Forward rates may be considered as unbiased predictors of Future spot rates. Various theories combined together explain the relationship between different exchange rates. That is to say. If currency markets are efficient. Inflation rate. should reflect the difference of anticipated inflation. The exponents of the theory of efficient markets say that there is no correlation between past and present.40 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 41 of moving averages. it is the interest differential and technical analysis that provide better :esults. however. and exchange rates follow an uncertain path.6 Conclusion change market use a whole lot of information from sources e~ch as newspapers. though. results of elections and market psychology. The formation of exchange rates in real life. it would not be possible to predict future rates. Prime Ministers. Likewise. should be equal to the difference of interest rates. If this was true. the theory of Purchasing Power Parity is almost verified. is influenced by numerous other factors such as declaration of Presidents. the signal of sale is given when the curve of exchange rate crosses downwards the curve of moving averages. Finance ministers. journals. The operators on . Anticipated difference of inflation reflects the difference of anticipated future rates. 3. in turn. as there exists a strong relationship between Spot rate. specially for the countries whose currency is not used for international reserves. ~adiO'television. In the final analysis. The difference between Forward and Spot rate. On the other hand. an efficient market is the one where exchange rates adjust themselves rapidly to the arrival of new information and integrate it with all the past information. The importance of graphical or technical analysis lies 1~ Carrying out the analysis rapidly and economising on the t. Reuters and Telerate screens. etc. the prediction of future exchange rates is more of an art than a science. In the long term. Interest rate and Forward rate. premium or discount. A financial market is said to be efficient if the price of financial assets reflects all available information at any given moment. In short term. which. a market is said to be inefficient if current exchange rates do not reflect all the available information.

provided there is no holiday between Monday and Wednesday As a matter of fact. Thus. The Spot market is the one in which the exchange of currencies takes place within 48 hours. encashment of travellers' cheques and transfers through banking channels. The rest are meant for covering the orders of the clients of banks. round the clock.2 Magnitude of Spot Market Accord· rn Ing to a Bank of International Settlements (BIS) estiate. The last category accounts for the majority of transactions. the daily volume of spot exchange transactions is about . certain length of time is necessary for completing the orders of ~ayrnent and accounting operations due to time differences etween different time zones across the globe. This market functions continuously.1 Introduction Spot transactions in the foreign exchange market are increasing in volume.4 SPOT EXCHANGE MARKET 4. a spot transaction effected on Monday will be settled by Wednesday. which are essentially enterprises. These transactions are primarily in forms of buying/ selling of currency notes. 4. It is estimated that about 90 per cent of spot transactions are carried out exclusively for banks.

Arbitrageurs and Speculators Dealers are basically involved in buying currencies when they are low and selling them when they are high. The banks are intermediaries between seekers and suppliers of currency. In a free and open market. they may deal with corp orates and central banks. at the Paris exchange market. Dollar (75 per cent of the total). they operate on these markets to make a profit through speculation and the process of arbitrage. they virtually handle all major currencies. accessible only to dealer banks. Amongst the recent changes observed on the exchange markets.3 Participants on the Spot Market 4. While London market trades a large number of currencies. London market is the first market of the world not only in . The spread is wide in these transactions. For example. Banks are able to avoid undesirable positions with the help of brokers. and (3) Central banks. they act as speculators.and sell dear. speculators expose themselves to risk. Dealers' operations are wholesale and majority of their transactions are interbank in nature although. A large portion of foreign exchange transactions is conducted through brokers. 4.not very large in number. by and large. Besides. 4. by and large.01 per cent of the transaction amount. However.terms of the volume but also in terms of diversity of currencies traded.46 FOREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKeT 47 50 per cent of the total transactions of exchange markets. They are .2· Dealers. bid and ask prices. it is noted that there is a relative decline in operations involving dollar while there is an increase in the operations involving Deutschmark. leading to large variation in their holdings of foreign currencies exposing them to exchange risk. Payment of commission is split between trading parties. When they assume the risk deliberately. they charge higher commissions. They are constantly in liaison with banks and in search of counterparties. banks prefer to keep their exposure low and not get intO unduly large speculations. Yen. arbitrageurs and speculators. deregulation of markets has accelerated the process of international transactions. Their remuneration is in the form of brokerage. the New York market trades. Arbitrageurs make gains by discovering price discrepancies that allow them to buy cheap . Wholesale transactions account for 90 per cent of the total value of foreign exchange deals. In interbank trade. Brokers exist because they lower the dealers' costs. They are not authorized to take a position on the market. there are about 20 brokers. Exchange brokers specialize in playing the role of intermediaries between different banks. Pound Sterling and Swiss Franc only. (2) Dealers. Dealers at the retail level cater to needs of customers wishing to buy or sell foreign exchange. Also. Deutschmark. brokers charge a small commission of around 0. brokers.3.1 Commercial Banks Commercial banks intervene in the spot market through their foreign exchange dealers either for their own account or for their clients. They have low transaction costs as well as thin spreads which reflect their long experience in exchange risk management as well as the intense competition among banks. They simultaneously quote. peculation gives rise to financial transactions that develop Major participants on the spot exchange market are: (1) Commercial banks. once in a while. S Unlike arbitrageurs. indicating their willingness to buy and sell foreign currencies at quoted rates. reduce their risks and provide anonymity. Their operations are risk-free. Brokers. While they tend to specialize in certain currencies. the scope for currency arbitrage tends to be low and it is. In illiquid currency dealings.3. Big commercial banks serve as marketmakers. Their job is to find a buyer and a seller for the same amount for the given currencies. The purchases and sales of large commercial banks seldom match. . The role of banks is to enable their clients to change one currency into another.

4. When an enterprise or client wants to buy a currency from the bank. when they accept either a net asset or a net liability in foreign currency. If we say forty-two rUPee s are needed to buy one dollar. if dollar is quoted as Rs 42.3004-3120. it means that the bank is ready to buy dollar at Rs 42. The reverse operation may be done to stop rupee from appreciation. the buying rate is lower than selling rate. are for the Interbank market involving trade among dealers.buying (bid rate) and another for selling (ask or offered rate) for a currency.3120.3004-42. Unlike the markets of other commodities. For example. . There is always one rate for . Each quotation. this is a unique feature of exchange markets. as we see quoted in the newspapers. It is these four digits that vary the most during the day. The direct quote or European type ta~es the value of the foreign currency as one unit. it is an example of direct . 4. For example. Selling rate is the rate at which it is ready to sell a currency. central bank may release (sell) a certain amount of foreign currency. Dealers do not quote the entire figure. Central Banks Central banks intervene in the market to reduce fluctuations of the domestic currency and to ensure an exchange rate compatible with the requirements of the national economy. They may quote. TABLE4.3. for example. Speculators are classified as bulls and bears. It should be noted that when the bank sells dollars against rupees.1 Currency Currency Quotations given by a Bank Buying rate Selling rate Rupee/US dollar Rupee/DM 42. naturally. He buys the currency either Spot or Forward today in the belief that he can sell it at a higher price in the future. These rates may be direct or European. Often. He sells either Spot or Forward today in the hope of buying it back at a cheaper rate in the future. Their objective is not to make profit out of these interventions but to influence the value of national currency in the interest of country's economic well being.2025 42. Here.3004 22. The bank is a market-maker. The difference between the two constitutes the profit made by the bank. A bear expects a particular currency to become cheaper in the future. 3004-3120 for dollar. Banks or corp orates . it buys at the selling rate of the bank. In India Pnce is q~ote d as so many rupees per urut of foreign currency. Likewise.48 FCREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKET 49 when an individual's expectations differ from the expectations of the market.4 Quotations on Spot Exchange Market bank is ready to buy a currency. are indulging in speculation. A bull expects a currency to become more expensive in the future. Table 4.3120.' It i S a dIrect quote or European quote. Bulls take a long position in the particular currency.2080 The exchange rate is the price of one currency expressed in another currency. As is clear from the rates in the table. one can say that it buys rupees against dollars. An open position denominated in foreign currency constitutes speculation.1 gives typical quotations. The prices. only two or four digits are written after the dash indicating a fractional amount by which the selling rate is different from buying rate. Bears take a short position on a particular currency. In order to separate buying and selling rates.3.. involves two currencies. the operators understand because of their experience that a quote of 30043120 means Rs 42. a small dash or an oblique line is drawn between the two. if rupee shows signs of depreciating. The bid rate is the rate at which the quoting .3120 22.3004 and ready to sell dollar at Rs 42. Speculators transact in foreign exchange primarily because of an anticipated but uncertain gain as a result of an exchange rate change. when the enterprise wants to sell a currency to the bank. The banks buy at a rate lower than that at which they sell a currency. it sells at the buying rate of the bank. This increased supply of foreign currency will halt the depreciation of rupee.

50 FOREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKET 51 quote. These rates are not the ones used for enterprises or clients. Rs 22 per DM and Rs 7 per French franc. Examples of direct quotes in India are Rs 42 per dollar.02363-0. These quotations relate to transactions which have taken place on the interbank markets and are of the order of millions of dollars. for both buying and selling.67 per DM and $ 0.0274 per cent 42. which in turn are influenced by the size and frequency of transactions.3004 x 100 or 0. Similarly. It may be noted that spreads charged from . It is important to note that selling rate is always higher than buying rate.Buying rate x 100 Buying rate (4. the spread has a tendency to diminish and vice versa. Width of spread depends on transaction costs and risks. etc. currencies with greater volatility have higher spread and vice-versa. They create the market by quoting bid and ask prices. For example. The Wall Street Journal gives quotations for selling rates on the interbank market for a minimum sum of 1 million dollars at 3 p. change on the day. if the quotation for dollar is Rs 42. The rates for the latter will be close to the ones quoted for interbank transactions. CUstomersare bigger than interbank spreads. Financial newspapers daily publish the rates of different currencies as quoted at a certain point of time during the day. an importer needs to buy $ 1 :Il~~n to pay to his American supplier. The average amount of transactions on spot market is about 5 million dollars or equivalent in other currencies. the importer indicates his account to tl . In the interbank market. Size affects the transaction costs per unit of currency traded while freque~cy ?r turnover rate affects both costs and risks by spreadmg fixed costs of currency trading. in the UK. The importer calls IS bank and asks for a rate of US dollar. Similarly.3120 can be transformed into indirect quote as $ 1/(42. After receiving e rate from the bank. indicates closing mid-point (middle of buying and selling rate). This is indirect or American type of quote. Spreads are very narrow between leading currencies because of the large volume of transactions. bid-offer spread and the day's high and low mid-point. a rupee-dollar direct quote of Rs 42. mainly.300413120. financial Times.02364). The variation from interbank rates will depend on the magnitude of the transaction entered into by the enterprise.m. For example.1 ) For example. Banks do not charge commission on their currency transactiO~S but rather profit from the spread between buying and s~llmg rates. Currencies with greater volatility and higher trade have larger spreads. . the examples of direct quote in USA are $ 1.2 gives a typical quotation. etc. the spread is given by = -------- 42.to be carried out.. The spread varies depending on market conditions and the currency concerned.3120 . Table 4. The spread is generally expressed in percentage by the equation: Spread = Selling rate .42.6 per pound.2 per French franc. for example. the quote would be one unit of pound sterling equal to seventy rupees. It would be interesting to know how a typical spot operation IS.3004-42.3004 Currencies which are least quoted have wider spread than others.3004) (or $ 0. When market is highly liquid. The difference between buying and selling rate is called spread. In UK. There are a few countries which follow the system of indirect quote or American quote. . Traders in the major banks that deal in two-way prices. This way of quoting is prevalent. Spreads may also widen during financial and econo rruc uncertainty. $ 0. Ireland and South Africa.3120)-1/(42. One can easily transform a direct quote into an indirect quote and vice versa. for example. spreads depend upon the depth of a m~rket of a particular currency as well as its volatility. are called market-makers.

3600 36.85 . it is given by the equation: Change in percentage = x 100 percent (4.5213 7.0010 +0.1710 5.5818 1.0035 13.3070 6680.4687 9. the change is calculated to be 42.1108 121.52 FOREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKET 53 TABLE 4.3) Rate (N .630 1.5494 1.1323 -0.0695 1162.1261 7.1) (Peso) (R$) (C$) (New Peso) ($) 0.4693 1.1374 7.8000 1.3001 38.3402 1.3500 -0.arI~.42.00 4.7920 1.8905 313.2800 -0.74930 -------------------------------------------------0.0012 +0.8000 1.6992 6. 4.00 4.7040 6.8050 1.9190 7.4500 +0.2 A Typical Sample of Quotations of Currencies (against US dollar) in Financial Newspapers June 24 Closing mid-point Change on day Day's mid High Low Europe Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Norway Portugal Spain Sweden Switzerland UK Euro SDR America Argentina Brazil Canada Mexico USA Philippines Saudi Arabia Singapore South Africa South Korea Taiwan Thailand (Peso) (SR) (S$) (R) (Won) (T$) (Bt) 37.1300 7.3623 1.1862 5.7504 1.5417 1.8706 1.420 160.Rate (N .822 8.3997 1.8615 Ch.0038 +0.0370 13.0000 +0.85.00 4.1) .5163 7.3370 6780.5 Evolution of Spot Rates How does one calculate the change in spot rate from one quotation to the next? In case of direct quotation.6000 the bank and asks it to debit his account in rupees in Delhi and credit the account of the American supplier in dollars in America.450 161.8001 1.0450 0.3275 6755.2757 38. the dollar rate has changed from Rs 42.1225 122.5460 +0.0064 -1.1270 2. if the quotation is in indirect form.3137 1871.3286 1.7364 6.5812 1.3161 1878.4725 9.9909 2.7200 37.0216 -0.0213 -0.7583 43.5741 1.7018 6.0307 Source: Financial Times.0133 1.530 8.2) Rate N .0675 +40.Rate N Rate N .3466 39.50 to Rs 42.05 39.630 1.1) Rate (N . the percentage nge IS given by equation: Change in percentage = x 100 per cent (4.5223 7.3800 36.9999 1.0210 -0.0039 +0.000 +0.5443 1.300 3.7469 6.7507 1.52 38.0020 +0.50 32.4539 1. A majority of exchange operations takes place through transfer from one account in one bank to another account in another bank.50 42. 37.0237 1157.9500 3.2090 5.0050 -0.0500 (Sch) (BFr) (DKr) (FM) (FFr) (DM) (Dr) (1£) (L) (LFr) (FI) (NKr) (Es) (Pta) (SKI) (SFr) (£) (Eu) 13.777 160.3750 36.4550 0.0195 -0.7573 43.imil.4450 For example.08 38.8970 314.50 x 100 per cent or 0.0413 -5.8890 194.7200 +0.8073 193.8500 193.8550 3.7578 43.00 32.0029 +0.0044 -6.0630 1157.4730 9. 25 June 1999.1323 -0.6500 +0.0073 -0.9999 1.7506 1.7600 3.8870 312.0452 -0.380 8.1 176 122.8060 1.0219 -0.0346 0.9999 1.3091 1868.1270 7.50 32.650 3.9190 2.909per cent Pacific/Middle East/Africa Australia Hong Kong India Indonesia Israel Japan Malaysia New Zealand (A$) (HK$) (Rs) (Rupiah) (Shk) (¥) (M$) (NZ$) 1.0030 -0.6580 -0.9909 7.0500 -0.8641 -0.245 3.7670 6.750 1.

.• C'llrlC"1Q\ 00 oOQ\r--o •...0 lrl•.......• r--Q\lrl 'D CO •.0.• C'lQ\oOQ\ •..85 so the decrease in the rupee is ~~g.o<'i •..• C"1C'lO"\CO r--O co •.....c0\.. if the rates of inflation of the countries concerned compensate the variation.-40....~~g8~~ C"1<'i\Ci<'io<'ioo<'i<'i C'lC'lr--~r--~cor--C'l ~ 00 co co CV) r-. The knowledge and analysis of real exchange rates and their evolutions is important for the political economy of a country.85 or 0.50 to 1/42. C"1C'lQ\ C'lOC'l lrlQ\lrl "".. <'i"".....• r-C'loo •. a variation of real exchange rate has an important impact on competitive positions.ce""l.c.....i...• COO'D Q\C'l~ .• 00 Q\ 0"\ C'l00 r-.• C'looOOCOO~ 00000""..s-s) x 100 1 "".c \ Nominal exchange rates may appreciate or depreciate but that does not reflect upon the competitiveness of the country in the international markets...c....""r--: <'ir--:r--:v-i O •..02574 lrlCO'DQ\r--r-C'l~O~C"1CV) x 100 per cent or 0. 4..........02574 0. On the other hand.. In contrast..• cor-.... it is said that the rate is over valued.....• ~ ....j ~COC"1O"\C'looOOCO 0 I lrl 00 C"1 (ds-o .. I C'lr-......89 per cent .......02597 ...c~C'f"). For that purpose.... ...o<'ioooooo 0 42...6 Cross Rates We will take an example to explain the concept of cross rates· cxi<'ir--:.. the above rate has passed from 1/42..c 0\.54 FOREIGN EXCHANGE MARKETS OOO"\COC'lO"\O"\C'lCO~"'" C'l'DO"\ •..• 0"\ C'l .• or--~ 'Dcoo •... a decrease in the real exchange rate represents a decrease in purchasing power. the real exchange rate needs to be calculated by taking a particular year as base year...... The real exchange rate is the rate obtained by taking into account the change in prices (or the rate of inflation) in \the two countries during the period under consideration. 0 0 r-. An increase in the real exchange rate represents an increase in purchasing power.o .c •..otM~C'J~. If a currency has appreciated in nominal terms more than what is justified by the inflation rates of the two countries.• r--r--C'lor--oo~ r-...ooooo"".•.• C'lC'lC'lr--C'lr-- For example.0 CV)COO~lrlQ\COQ\ IlrlC"1coo~r--lrlC"1 ~S~gg~~~ 00000000 00 C'l •....• Q\ 8'D 'D~ lrl~o"\lrlC'l •.. A variation of nominal rates does not automatically alter the competitive positions of enterprises..

4 and 4.2057 . importer buys US $ (or bank sells US $) at the rate of Rs 42.3363 ) --x OM 1 Rs 6. can dollars and sell those Canadian dollars to the imp rter against rupees.0004 ( 1. In general.5020/5100 Sobttion: Applying the equations (4. the buying rate would be obtained as Rs 31.2057 is = 42.3004-3120 Finally.4) (4.xIDnple 4.sk 28.60 = FFr 3. That~e ns that the bank is going to buy Canadian dollars against eri. Likewise.3333-63 RupeeNS $: 42. It is basically a derived rate.60 FFr FFr 22 DM 6. His operation involves buying of Canadian dollars against rupees. 7348/Can $ OM: Rs22 That is.2: From the following rates.4) and (4. in which one currency is common. rate can be defined as a rate between a third pair of currencies.5) Let us sayan Indian importer is to settle his bill in Canadian dollars. the equations 4.1000/3650 1.5020) So.43.3333 per US $. the Re/DM relationship 27. Cross rate will give the relationship It is clear from the data that bid and ask rates are between FFr and Rupee/Can $ = = Rs 31.3333/DM Eumple 4.56 FOREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKET 57 (4.3120 per US $ and then buys Can $ at the buying rate of Can $ 1. the importer will get the Canadian dollars at the following rate: 42. So cross. Suppose the rates are Can $NS $: 1.8808 = = $)bid x (US $/DM)bid x 1/( 1.1: Following rates are given: Rs 221DM and Rs 6.60 ~_- FFr 22 = --- DM 6.51 00) Table 4.8808-28.e!Us $: OMlUS$: 42.sk and (B/A)ask= (NB)bid f. What is FFr/DM rate? StOtion: equal.3 contains cross rates between different pairs of currencies.sk (ReNS $)'Sk x (US $/DM).7348/Can $ is a cross rate as it has been derived from the rates already given as Rupee/l.sk = (B/A)askx (NC)ask Here (B/A)bid = (NB).5).60/FFr.IS $ and Can $/ US $.3650 x 1/( 1. In order to give him a Can $IRe rate.5 can be used to find the cross rates between two currencies Band C. the banks should call for US $/Can $ and US $/Re quotes. by using the rates of two pairs. we get (Re/DM)bid = (ReNS = 42. So Rupee 31. if the ratef between A and B and between A and C are given: (ReJDM).3333 (B/C)bid = (B/A)bid X (NC)bid (B/C).1000 = 27. find out Re/DM relationship: R.3120 1.041 Can $ or 42.

. Example 4. Solution: An arbitrageur who has Rs 10. s. and (2) Triangular arbitrage.3.1 Geographical Arbitrage Geographical arbitrage consists of buying a currency where it is the cheapest. rium is disturbed constantly. the gain would be substantial and without risk.7650) .7600 I 4.000 In inter-bank operations.4 Illustrates the triangular arbitrage. It is to.at there will be no geographical arbitrage gain possible If there IS an overlap between the rates quoted at two di~ferent dealers.7610/$ and sell the same dollars at the Bank B at a rate of Rs 42.7530-7610 Bank B: Rs 42.7600-7700 42.7. if the sum involved was in couple of million of rupees.58 4. Though the gain made on Rs 10.9200 6. he will make a gain of Rs 10.00. this equilib. lishment of equilibrium on the exchange markets.Rs 10. 0. On the Spot exchange market.7700 Since there is an overlap between the rates of dealers A and B respectively. When differences exist between the SPOt rates of two banks.7530-7610 Dealer B: Rs 42.7610 42.7610 or Rs 93. as new demands and new offers come on the market. two types of arbitrages are possible: (1) Geographical arbitrage. Example 4. in the process. However. be ~oted th.00.7.2 Triangular Arbitrage Tri~ngular arbitrage occurs when three currencies are involved.7530 42.1080 Dealer A Dealer B Dealer C Are there any arbitrage gains possible? .00. the arbitrageurs may proceed to make arbitrage gains without any risk.000 42. 4. Examp Ie 4. In order to make an arbitrage gain.6700 8.00. no arbitrage gain is possible.7650/$· 42. Arbitrage enables the re-estab. thIS can be realised when there is distortion between cross rates of cur rencres. .4: Following rates are quoted dealers: £IUS FFr/£: FFr/US by three different s.3 explains how geographical arbitrage gain is made. unlike in the example 4. That is why it is important to give 'good' quotations. the dealers indicate a buying rate and a selling rate without knowing whether the counterparty wants to buy or sell currencies. Example 4.7 FOREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKET 59 Equilibrium on Spot Markets ThUS. For example. and selling it where it is the dearest so as to make a profit from the difference in the rates. consider the following two quotatIons: Dealer A: Rs 42.50 x (42.3: Two banks are quoting the following US dollar rates: Bank A: Rs 42.000 is apparently small.7650-7730 Find out the arbitrage possibilities. the selling rate of one bank needs to be lower than the buying rate of the other bank.000 (let us suppose) will huy dollars from the Bank A at a rate of Rs 42.

60 FOREIGN EXCHANGE MARKETS Solution: Cross rate between French franc and US dollar is 0.202. Some of the Significant features of ForWard contracts are given in Table 5. the Forward exchange market is not located at any specific place.10.1.10. The rest of the transactions are done for different clients or enterprises. This market fixes the rates at which currencies will be exchanged on a future date.67). S. The Forward market primarily deals in currencies that are frequently used and are in demand in the international trade. There is little or almost no Forward market for the currencies of developing countries. with the difference that the period . 4. But its rate of growth is less than that of derivative products. as we have not taken into account the transaction costs here.34 (6. ForWard rates are quoted with reference to Spot rates as they are always traded at a premium or discount vis-a-vis Spot rate in the inter-bank market. The banks selling or buying currencies forward constitute the Forward market. Deutschmark. The major part of Spot transactions are done between different dealers.6700 x 8. The bid-ask spread increases with the forward time horizon. to obtain $ 1.000 x 6.800 (1.1080/US $.8 Conclusion 5 FORWARD EXCHANGE MARKET S. the real gain will be less. it does not remain in existence for long.l Introduction The Spot exchange market is very important. Like the Spot exchange market. The markets are rarely in equilibrium. Once art equilibrium is established through arbitrage process. The following steps have to be taken: (i) Start with US $ 1.00.475. Italian lira. Pound Sterling. Belgian franc. Of course.202 (68. Canadian dollar and Japanese yen. The arbitrageurs try to make gains through geographical as well as triangular arbitrage. to get £ 68475. there is a possibility of arbitrage gain.92) (Hi) Further convert these Pound sterling into US dollar. such as US dollar. Since there is a difference between the two FFr/$ rates.800/8. there is a net gain of US $ 2. Swiss franc.2 Importance of Forward Markets The Forward market can be divided into two parts-Outright Porward and Swap market.97641US $.00.000 and acquire with these dollars a sumofFFr 6. French franc.02. These arbitrages lead to the re-establishment of the equilibrium on currency markets. Compare this with the given rate of FFr 6. Dutch Guilder.1080) (ii) Convert these French francs into Pound sterling. The Outright Forward market resembles the Spot market.9200 or FFr 5. The arbitrage operations on the market continue to take place as long as there are significant differences between quoted and cross rates. Thus.3410. New demands and offers create new conditions for arbitrage.

0500 Selling rate 6. The rates are locked in for the entire period of contract up to maturity. either to cover the orders of their clients or to place their own cash in different currencies. Dealers' commission Major participants in the Forward market are banks. banks may quote different maturity spans.1 Significant Features of Forward Contract exchange rates.62 FOREIGN EXCHANGE MARKETS FORWARD EXCHANGE MARKET 63 of delivery is much greater than 48 hours in the Forward market. Usually. Quotations Buying rate Spot One-month forward 3-month forward 6-month forward 6. For example. two months. A major part of its operations is for clients or enterprises who decide to cover against exchange risks emanating from trade operations.2 Re/FFr Quotations Features 1. including several of developing countries as well. by and large. three months. The Forward Swap market comes second in importance to the Spot market and it is growing very fast. That is. S. exchange brokers and hedgers.0125 6. Arbitrageurs look for a profit without risk. As regards brokers.3 Quotations on Forward Markets Forward rates are quoted for different maturities such as one month. and a dealer. the maturity dates are closer to month-ends. domestic currency is likely to depreciate). A majority (more than 90 per cent) of contracts are settled by delivery. to cater to the market/client needs. The currency swap consists of two separate operations of borrowing and of lending. if the Forward rate is lower than Spot rate.0200 6.0335 6. the foreign CUrrency is said to be at Forward premium with respect to the domestic currency (in operational terms. US dollar occupies an important place on the Swap market. Currencies Description A private contract between a customer with flexible terms. Kind of contract 2. It is involved in 95 per cent of transactions. Cashflows occur only at the time of maturity/delivery. Prices are quoted by dealers with bid-ask spreads. Forward contracts are available in all major currencies of the world. On the other hand. Hedgers are the enterprises or the financial institutions who want to cover themselves against the exchange risk. speculators. a Swap deal involves borrowing a sum in one currency for short duration and lending an equivalent amount in another currency for the same duration.0080 6. six months and one year. The 3. by operating on the interest rate differences and If the Forward rate is higher than the Spot rate. Risk 6. . The quotations may be given either in outright manner or through Swap points. arbitrageurs. Table 5. the foreign currency is said to be at Forward discount with respect to domestic currency (likely to appreciate).0250 6. Cashflows 4. Apart from the standardised pattern of maturity periods. self-regulated. Outright rates indicate complete figures for buying and selling. Commercial banks operate on this market through their dealers.0025 6.0590 Spread 55 points 75 points 85 points 90 points 5. This kind of rates are quoted to the clients of banks. Forward market is. their job involves match making between seekers and suppliers of currencies on the Spot market.2 contains Re/FFr quotations in the outright form. Commission is inbuilt in the bid-ask spread. Speculators take risk in the hope of making a gain in case their anticipation regarding the movement of rates turns out to be correct. TABLE 5. A loss can occur in case of default on either side. TABLE 5.

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