(UNIT-1)

Que:-1 Define foreign exchange market. Explain nature and structure of

foreign exchange market. Who are various players| participants in foreign
exchange rate?
Ans:- INTRODUCTION:

The foreign exchange market is the market in which participants are able to buy, sell,
exchange and speculate on currencies. Foreign exchange markets are made up of banks,
commercial companies, central banks, investment management firms, hedge funds, and
retail forex brokers and investors

 Meaning of foreign exchange market

Foreign exchange market is the market in which foreign currencies are bought and sold. The
buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks
and the central bank.

Like any other market, foreign exchange market is a system, not a place. The transactions in
this market are not confined to only one or few foreign currencies. In fact, there are a large
number of foreign currencies which are traded, converted and exchanged in the foreign
exchange market.
 NATURE OF FOREIGN EXCHANGE MARKET-

Foreign exchange market is a market where exchange rates are determined. The nature of
market can be explained in terms of its location, size, hours of operation, efficiency and
composition of currencies ma

 Location – foreign exchange market is described as an OTC (over the counter)

market as there is no physical place where the participants meet the executes the
deals. It is more an informal arrangement among the banks and brokers operating in
the financial centre purchasing and selling currencies, connected to each other by
telecommunication like telax, telephone and a satellite communication network,
SWIFT. The term foreign exchange is used to refer to the wholesale segment to the
market, where the dealing take place among banks.
 Size of market-
Foreign exchange market is the largest financial market in the world. The business in
foreign exchange market has shown a steady increase as a consequence of increase
in the volume of foreign trade of the country, improvement in the communications
system and greater access to the international exchange market. There are different
currencies that are actively traded in the foreign exchange markets such as US
dollars, pounds-sterling, euro, Japanese yen etc.
  24-Hour market- Major markets are situated in Sydney, Tokyo, Hong Kong,
Singapore, Paris, Brussels, Amsterdam, London, New York etc. thus at any point of
time one market or the other is open. Therefore it is stated that foreign market is
functioning throughout 24 hours of the day.
 Efficiency-

The Participants keeps knowledge of current happenings by access to such services like
Dow Jones Telerate and Reuter. Any significant development in any market is almost
instantaneously received by the other market situated at a far off place and thus has global
impact. This makes foreign exchange market very efficient as if functioning under one roof.

 STRUCTURE OF FOREX MARKET

Foreign exchange market

Retail
wholesale

Bank and money changers Interbank bank account Central bank

currencies, bank note or deposits
cheques

Direct Indirect

Spot Market Forward (outright

&swaps) Derivatives (future,
option etc.)

Merchandise Non-merchandise
Foreign exchange market
 Retail market
Retail foreign exchange trading is a small segment of the larger foreign exchange market
where individuals speculate on the exchange rate between different currencies. This
segment has developed with the advent of dedicated electronic trading platforms and the
internet which have allowed individuals to access the global currency markets
(1) Bank and money changers currencies, bank note cheques
The main participants in this market are the larger international banks. Financial centers
around the world function as anchors of trading between a wide range of multiple types of
buyers and sellers around the clock, with the exception of weekends. The foreign exchange
market does not determine the relative values of different currencies, but sets the current
market price of the value of one currency as demanded against another.
In a typical foreign exchange transaction, a party purchases some quantity of one currency
by paying with some quantity of another currency
 Wholesale market
The interbank market is an important segment of the foreign exchange market. It is a
wholesale market through which most currency transactions are channeled. It is mainly
used for trading among bankers.
(1) Interbank bank account or deposits
The interbank market is the financial system of trading currencies among banks and
financial institutions, excluding retail investors and smaller trading parties. While some
interbank trading is done by banks on behalf of large customers, most interbank trading is
proprietary, meaning that it takes place on behalf of the banks' own accounts.
 Direct under this, a given number of units of local currency per unit of
foreign currency is quoted. They are designated as direct\certain rates
because the rupee cost of single foreign currency unit can be obtained
directly.
 Indirect
 under this, a given number of units of foreign currency per unit of
local currency is quoted.
Central bank
A central bank, reserve bank, or monetary authority is an institution that
manages a state's currency, money supply, and interest rates. Central
banks also usually oversee the commercial banking system of their
respective countries. In contrast to a commercial bank, a central bank
 possesses a monopoly on increasing the monetary base in the state, and
usually also prints the national currency
 Part of direct market
 Spot Market:
Spot market refers to the market in which the receipts and payments are made
immediately. Generally, a time of two business days is permitted to settle the transaction.
Spot market is of daily nature and deals only in spot transactions of foreign exchange (not in
future transactions). The rate of exchange, which prevails in the spot market, is termed as
spot exchange rate or current rate of exchange.

The term ‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a
transaction, which is carried out ‘on the spot’ (i.e., immediately). However, a two day
margin is allowed as it takes two days for payments made through cheques to be cleared.

 Forward Market:

Forward market refers to the market in which sale and purchase of foreign currency is
settled on a specified future date at a rate agreed upon today. The exchange rate quoted in
forward transactions is known as the forward exchange rate. Generally, most of the
international transactions are signed on one date and completed on a later date. Forward
exchange rate becomes useful for both the parties involved in the transaction.

 Forward Contract is made for two reasons:

(a) To minimize the risk of loss due to adverse changes in the exchange rate (through
hedging);

(b) To make profit (through speculation).

 Derivatives

A foreign exchange derivative is a financial derivative whose payoff depends on the foreign
exchange rate (s) of two (or more) currencies. These instruments are commonly used for
currency speculation and arbitrage or for hedging foreign exchange risk. Specific foreign
exchange derivatives, and related concepts include.

 Merchandise

Merchandising is the promotion of goods and/or services that are available for retail sale.
Merchandising includes the determination of quantities, setting prices for goods and
services, creating display designs, developing marketing stra

 Non- merchandise
Non-merchandise transactions are transactions involving a service product or other item
that does not have a regular SKU or UPC code and is therefore not considered general
merchandise. Some examples of non-merchandise items are gift certificates, charges for
clothing alterations, equipment or movie rental fees, and postage stamps. Non-merchandise
transactions can also be set up as accounting entries for transactions such as paid ins and
paid outs.
 participants in foreign exchange market

Foreign exchange market needs dealers to facilitate foreign exchange

transactions. Bulk of foreign exchange transaction are dealt by Commercial banks & financial
institutions. RBI has also allowed private authorised dealers to deal with foreign exchange
transactions i.e buying & selling foreign currency. The main participants in foreign exchange
markets are

(1) Exporter
To sends goods or services acrossnational borders for the purpose of selling and
realizing foreign exchange are also called exporter.

(2) Importer
Importer is a person which good or services brought into one country from another.

(3) Remittance
A remittance is a transfer of money by a foreign worker to an individual in his or her
home country .Money sent home by migrants competes with international aid as
one of the largest financial inflows inflows to developing countries.

(4) Retail market

Retail Clients deal through commercial banks and authorised agents. They
comprise people, international investors, multinational corporations and others
who need foreign exchange.
(5) Commercial Bank
Commercial banks carry out buy and sell orders from their retail clients and of their own
account. They deal with other commercial banks and also through foreign exchange brokers.

(6). Foreign Exchange Brokers

Each foreign exchange market centre has some authorised brokers. Brokers act as
intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers.

.  7. Consumers and Travelers

  Consumers may purchase goods in a foreign country or via the internet with their
credit card.

 The amount consumers pay in the foreign currency will be converted to their home
currency on their credit card statement.

 Travelers must go to a bank or currency exchange bureau to convert one currency

(their "home" currency) into another (the "destination" currency) when using cash to
pay for goods and services in a foreign country.

 Travelers need to be aware of exchange rates to ensure they receive a fair deal

8. Businesses

 Businesses often need to convert currencies when they conduct trade outside their
home country.

 Large companies need to convert huge amounts of currency; a multinational

company such as General Electric (GE) for instance, converts tens of billions of
dollars each year.

9. Investors and Speculators

 Investors and speculators require currency exchange whenever they deal in any
foreign investment, be it equities, bonds, bank deposits, or real estate.

 Investors and speculators also trade currencies in an attempt to benefit from

movements in the currency exchange markets.

10. Governments and Central Banks

 Governments and central banks trade currencies to improve economic conditions or

to intervene in an attempt to adjust economic or financial imbalances.

 Because they are non-profit, governments and central banks do not trade with the
intention of earning a profit, but because they tend to trade on a long-term basis, it
is not unusual for some trades to earn revenue.

Ques2 Define exchange rate. Explain various ways of quoting the exchange
rate?
ANS:
Exchange Rate(meaning):-

The price of a nation’s currency in terms of another currency. An exchange rate thus has
two components:

a>Domestic currency

b>Foreign currency

Both currencies can be quoted either directly or indirectly.

 In a direct quotation, the price of a unit of foreign cuurency is expressed in terms of

the domestic currency.
 In an indirect quotation, the price of a unit of domestic currency is expressed in
terms of foreign currency.

An exchange rate that does not have the domestic currency as one of the two currency
components is known as a cross currency/cross rate.

Rate at which one currency may be converted into another. The exchange rate is used when
simply converting one currency to another (such as for the purposes of travel to another
country), or for engaging in speculation or trading in the foreign exchange market. There are
a wide variety of factors which influence the exchange rate, such as interest rates,inflation,
and the state of politics and the economy in each country also called rate of
exchange or foreign exchange rate or currency exchange rate.

Features of Exchange Rate:-

1. Exchange Rate always fluctuates Due to Stronger or Weaker of Currency.

2. Exchange rate always are affected from balance of payment and trade, interest rate
(inflation rate), economic growth and fiscal and monetary policies and political issues

3.  Exchange rate is two types, one is buying exchange rate and other is selling exchange
rate

Types of Quotations in Foreign Exchange:

There are mainly two type of quotation of foreign exchange:-
1. Direct Quote(meaning):
 Under this method, the quote is expressed in terms of domestic currency. This
means that the rate expresses a currency price in terms of one unit of the foreign
currency and x units of home currency.
 If we live in austrailia we can convert the indirect quote AUD/USD 0.8168, into a
direct quote of approx. USD/AUD 1.2243. This is achieved by dividing one by the
indirect quote and adding one.
Another important thing you need to know about foreign rates is the base currency
or the commodity currency.The base currency are those whose price is given in the
exchange rate.
The next thing we need to know about foreign currency transactions are bid and ask
price. You may have noticed in the above picture that the AUD/USD has a bid price
and ask price.

Spot rates- A spot exchange rate is the price to exchange one currencyfor another for
immediate delivery. The spot rates represent the prices buyers pay in one currency to
purchase a second currency.
Spot exchange quotations:
a. Direct quote and indirect quote.
b. Direct quote is a home currency price per unit of a foreign currency, such as Rs. 50=
US$ 1.
c. Indirect quote is a foreign currency price per unit of a home currency, such as Rs. 1=
US$ 0.02.
d. Cross rate is an exchange rate between two non- home currencies, such as Mex$6.40
per pound for a US resident.
e. Bid Ask Rate :- these rate are always quoted as atwo way price- bid price and ask bid
price.
f. Bid price is the price at which bank is willing to buy foreign currency.
g. Ask price is the price at which bank is willing to sale foreign currency.
h. This difference between two rates is termed as Spread.
i. Spread in direct quote= (ask price- bid price)/ask price.

B. Forward spot rates- forward spot rate refers to the rate that will be used to deliver a
currency, bond or commodity at some future time.
FORWARD EXCHANGE QUOTATION
1. Forward premium or discount.
a. Quote in points:
One point is equal to 0.01 percent or $0.0001.
Forward quote in point = forward rate – spot rate.

b. Premium or = n – day discount forward rate – spot rate x 360

 Spot rate n

2. Forward exchange tranactions are used to eliminate possible exchange losses on

foreign- currency denominated obligations.

3. Speculating in the forward market:-

Speculators buy a foreign currency forward today, will hold it for some time, and will
resell it at a higher spot rate.

2. Indirect Quote (meaning):-

This method is the opposite of the direct quotation method. Under this method, the
quote is expressed in terms of foreign currency. Therefore this rate assumes one unit of
foreign currency. It then expresses how many units of domestic currency are required to
obtain a single unit of a foreign currency. Sometimes this quote is also expressed in
terms of 100 units of foreign currency. This method is often referred to as the quantity
quotation method.
Since this method is quoted in terms of foreign currency, the quoted rate has a
direct correlation with the domestic rate. If the quote goes up, so does the value of
the domestic currency and vice versa.

 Usage: The usage of indirect currency quotation is extremely rare. It is only in the

Commonwealth countries like United Kingdom and Australia that the indirect
quotation method is used as a result of convention.

3. Cross rates- a cross rate is the currency exchange rates between two currencies,
both of which are not the official currencies of the country in which the exchange
rate quote is given.

Cross rate is an exchange rate between two non- home currencies, such as Mex$6.40
per pound for a US resident.

QUES: 3 Short notes on:

1. PREMIUM AND DISCOUNT RATE IN EXCHANGE MARKET

The concept of Discount and Premium arises in foreign exchange transactions with respect
to Forward and Spot rates. Forward exchange rate is the rate of exchange applicable for
delivery of foreign exchange at a future specified date; example: Forward exchange contract
for 3 months or 90 days. Spot rate is the rate of exchange of the day on which the
transaction takes place and of the days the transaction is executed. Forward exchange rates
can be at a premium or at a discount. To find out if the forward exchange rate is at a
premium or at a discount, we have to compare the Spot rate and Forward rate.

 A foreign currency is said to be at a premium when its forward rate is higher than the
spot rate.
 A foreign currency is said to be at a discount when its spot rate is higher than the
forward rate.

It can be expressed as follows: 

Forward Rate > Spot Rate, then forward rate of foreign currency is at a Premium. 

Spot Rate > Forward Rate, then forward rate of foreign currency is at a Discount.

Calculation of Forward rate Premium or Discount in annualized percentages:

Premium = Forward rate-Spot rate x 360 x 100

Spot rate n

Discount = Spot rate-Forward rate x 360 x 100

Spot rate n

Where: N = number of days for which forward contract has been made.

2. SPREAD

Before we understand what a spread is we should first of all understand that in the foreign
exchange market prices are represented as currency pairs or exchange rate quotation where
the relative value of one currency unit is denominated in the units of another currency. An
exchange rate, applied to a customer willing to purchase a quote currency is called BID. It is
the highest price that a currency pair will be bought. And a price of quote currency selling is
called ASK. It’s the lowest price that a currency pair will be offered for sale. BID is always
lower than ASK. The difference between ASK and BID is called spread. When the authorized
seller buy and sell, then they occurred difference, is called spread.

SPREAD = Ask price-Bid price

 Bid price

TYPES OF SPREADS:

Following types of spreads are used in Foreign exchange Trading.

Fixed spread – Difference between ASK and BID is kept constant and do not depend on
market conditions. Fixed spreads are set by dealing companies for automatically traded
accounts.

Fixed spread with an extension – certain part of a spread is predetermined and another part
may be adjusted by a dealer according to market.

Variable spread – Fluctuates in correlation with market conditions. Generally variable

spread is low during times of market inactivity (approximately 1-2 pips), but during volatile
market can actually widen to as much as 40-50 pips. This type of spread is closer to real
market but brings higher uncertainty to trade and makes creation of effective strategy more
difficult.

WHAT INFLUENCES THE SPREAD IN FOREX TRADING?

There are several factors that influence the size of the bid-offer spread.

 The most important is currency liquidity. Popular currency pairs are traded with
lowest spreads while rare pairs raise dozen pips spread.
 Next factor is amount of a deal. Middle size spot deals are executed on quotations
with standard tight spreads; extreme deals – both too small and too big – are quoted
with broader spreads due to risks involved.
 On volatile market bid-offer spreads are wider than during quiet market conditions.
 Status of a customer also impact spread as large scale traders or premium clients
enjoy personal discounts.
 Nowadays, Forex market characterizes high competition and as brokers are trying to
stay closer to customers, spreads tends to be fixed on lowest possible level.
 Maximum performance can only be achieved when maximum quantity of market
conditions is taken into account.

Successful trading strategy is based on effective evaluation of market indicators and specific
financial conditions of a deal. The best tools here are complex analysis, forecasting,
risk/return analysis, transaction cost evaluation. Because spreads are subject to change,
spread management strategy should also be flexible enough to adjust to market movement.

3. DIRECT AND INDIRECT RATE

Direct Rate:

It refers to the number of units of domestic currency which is required to buy one unit of
foreign currency. A direct currency rate, also known as a “price rate”, is one that expresses
the price of a unit of foreign currency in terms of the domestic currency. So if direct rate for
rupee/$ is 45/1 then it implies that for buying 1 dollar you have to pay 45 rupees.

Indirect Rate:

It refers to the number of units of foreign currency required to buy 1 unit of domestic
currency. An indirect currency rate, also known as a “volume rate”, is the reciprocal of
a direct rate, and expresses the amount of foreign currency per unit of domestic currency.
So if indirect rate for $/rupee is .25$ then it implies that for buying 1 rupee one has to pay .
25$. Indirect rate is an inverse of direct rate so if one knows direct rate one can easily
calculate indirect rate for a currency.

The difference between indirect and direct exchange rates is that an indirect exchange rate
is the number of foreign currency units that may be obtained for one local currency unit and
a direct exchange rate is the number of local currency units needed to acquire one foreign
currency unit. The direct exchange rate has the local currency units in the numerator (the
U.S. dollar for the direct exchange rate for the U.S. dollar).

4. DIFFERENCE BETWEEN SPOT AND FORWARD RATE

Spot Rate:

In finance, a spot contract, spot transaction, or simply "spot," is a contract of buying or

selling a commodity, security, or currency for settlement (payment and delivery) on the spot
date, which is normally two business days after the trade date. The settlement price (or
rate) is called a "spot price" or "spot rate”.

Spot exchange rates are the rates that are applicable for purchase and sale of foreign
exchange on spot delivery basis or immediate delivery basis. Although, the term spot
denotes immediate happening and closing of transaction, practically it takes two business
days for a spot exchange transaction to get settled. So, we can say that the Spot rate is the
rate of exchange of the day on which the transaction has occurred and of the days the
execution of the transaction is taking place.

The spot rate is quoted differently for buyers and sellers. For example, $ 1 = Rs 15.50 for
buyers and $ 1 = Rs 15.30 for the seller. This difference is due to the transport charges,
insurance charges, dealer's commission, etc. These costs are to be born by the buyers.

Forward Rate:

Forward rate of exchange is the rate at which the future contract for foreign currency is
made. The forward exchange rate is settled now but the actual sale and purchase of foreign
exchange occurs in future. The forward rate is quoted at a premium or discount over the
spot rate. Forward exchange rates, in contrast, are the rates that are applicable for the
delivery of foreign exchange at a certain specified future date. Depending on the item being
traded, spot prices can indicate market expectations of future price movements. In other
words, spot rates can be used to calculate forward rates. In theory, the difference in spot
and forward prices should be equal to the finance charges, plus any earnings due to the
holder of the security, according to the cost of carry model.

For example, a foreign exchange contract may specify that the payment has to be settled
after 3 months, or it may be a 90-day maturity contract. When a contract is agreed upon,
the dealer of the foreign exchange settles the payment due after the 90-day period at the
agreed forward exchange rate. This settlement will be at the initially agreed rate, called
forward exchange rate, and will not be affected by the spot exchange rates prevailing at the
time of settlement at maturity. This is a way by which uncertainty and risk could be avoided
in dealing with foreign exchange transactions.

5. DIFFERENCE BETWEEN BID AND ASK PRICE

A two-way price quotation that indicates the best price at which a security can be sold and
bought at a given point in time.

Bid price:

A bid is the exchange rate in one currency at which a dealer will buy another currency.
The bid price represents the maximum price that a buyer or buyers are willing to pay for a
security. ". In other words, the bid price is the price that the dealer is willing to pay or “bid”
for a currency.

Ask price:

An ask is the exchange rate at which a dealer will sell the other currency. The ask price
represents the minimum price that a seller or sellers are willing to receive for the security. A
trade or transaction occurs when the buyer and seller agree on a price for the security. In
other words, the “ask” price is the price that the dealer wants for a currency.

The bid-ask price is simply the difference between the price at which a dealer will buy a
currency and the price at which the dealer will sell a currency. The difference between the
bid and asked prices, or the spread, is a key indicator of the liquidity of the asset - generally
speaking, the smaller the spread, the better the liquidity.

Dealers buy at the bid price and sell at the ask price, profiting from the spread between the
bid and ask prices: bid < ask. Bid and ask quotations are complicated by the fact that the bid
for one currency is the ask for another currency.
The spread between bid and ask prices exist for two reasons:

1. Transaction costs and dealers as financial intermediaries

2. Profits

6. DIFFERENCE BETWEEN OFFICIAL AND MARKET PRICE

Official price:
The official price as set by a government. Official rate is that rate which is fixed by the central bank
of any country. An official exchange rate may be expressed with relation to a commodity
such as gold, but currencies are usually pegged to other currencies. Depending on how well 
a government manages its currency, the official exchange rate may or may not reflect the
currency’s true value.
Official exchange rate refers to the system in which the rate of exchange of a currency is
fixed or pegged in terms of gold or another currency. And if deviations are occurred, then
central bank controlled (like RBI in India).

Market price:

The market price is the current price at which an asset or service can be bought or sold.
Economic theory contends that the market price converges at a point where the forces of
supply and demand meet. Shocks to either the supply side and/or demand side can cause
the market price for a good or service to be re-evaluated.

Market rate is determined by the forces of demand and supply in the foreign exchange
market.
It is free to fluctuate according to the changes in the demand and supply of foreign
currency.

How a Market Price Is Derived :

The interaction between dealers and traders is what manipulates the market price. For
example, assume the market price for XYZ stock is $50/51. There are eight traders wanting
to buy XYZ stock; this represents demand. Five buy 100 shares at $50, three at $49 and one
at $48. These orders are listed on the bid. There are also eight traders wanting to sell XYZ
stock; this represents supply. Five sell 100 shares at $51, three at $52 and one at $53. These
orders are listed on the offer. At this point, supply and demand are balanced, and traders do
not want to cross the spread to execute their trade. Say a new trader comes in and wants to
buy 800 shares at the market price, which is the shock. This trader has to buy at the offer:
500 shares at $51, and 300 at $52. Now the spread widens and the market price is $50/53.
Dealers immediately take action to close the spread. Since there are more buyers, the
spread is closed by the bid adjusting upward. The end result is a new market price of
$52/53. This interaction is constantly taking place in both directions.

Q4. Explain relationship between real, nominal effective exchange rate?

Ans:

Exchange rate :

In finance, an exchange rate also knows as a foreign-exchange rate, forex rate, FX rate or
Agio between two currencies is the rate at which one currency will be exchanged for
other. It is also regarded as the value of one country’s currency in terms of another
currency.

Nominal exchange rate:

Nominal exchange rate is the price of one currency in terms of number of units of some
other currency. This is determined by fiat in a fixed rate regime and by demand and supply
for the two currencies in the foreign exchange rate market in a floating rate regime.

It is 'nominal' because it measures only the numerical exchange value, and does not say
anything about other aspects such as the purchasing power of that currency. In a floating
rate regime, an increase in the value of the domestic currency against other currencies is
called an appreciation, while a decrease in value is called depreciation. In contrast, an
increase in the exchange rate in a fixed rate regime is called a revaluation (for an increase)
and a decrease in the exchange value of the domestic currency is referred to as a
devaluation.

Real exchange rate:

To incorporate the purchasing power and competitiveness aspect and, therefore, make the
measure more meaningful, real exchange rates are used. The real exchange rates are
nothing but the nominal exchange rates multiplied by the price indices of the two countries.
This means the market price level of goods and services, given by indices of inflation. For
example, if both the US and India manufacture the same (or highly comparable)
pharmaceutical drug, and Indian drug prices are lower than US prices, then the exchange
rate in terms of drugs is favourable to India. This can be generalized to all the goods
manufactured by the two economies that compete in the export market. If the real rupee-
dollar exchange rate based on export-competing goods depreciates, then Indian exports
enjoy an enhanced pricing advantage over US goods. The converse is true for a real
appreciation

Effective exchange rate:

The effective exchange rate is the exchange rate of a monetary zone, measured as the
weighted sum of the exchange rates with trading partners and competitors.
The nominal effective exchange rate is measured with the nominal parts (therefore without
taking account of the differences in purchasing power between the two currencies), while
the real effective exchange rate includes price indices and their trends.
Example: The nominal effective exchange rate of the euro for France is a weighted mean
(with the weighting being specific to France) of the exchange rates of the euro against the
currencies of the competing countries in a given zone (OECD, for example). The weighting of
the exchange rate in relation to a country in the zone includes the market share of France in
this country and the market shares of this country and of France in each of the third-party
markets. The real effective exchange rate of the euro for France includes the exchange rate
but also the ratio of France's export prices to those of competing countries in the zone
under consideration.
A rise in the nominal (resp. real) effective exchange rate corresponds to a deterioration in
exchange (resp. price) competitiveness.

Real effective exchange rate (REER):

The real effective exchange rate (REER) is the weighted average of a country's currency
relative to an index or basket of other major currencies, adjusted for the effects of inflation.
The weights are determined by comparing the relative trade balance of a country's currency
against each country within the index. This exchange rate is used to determine an individual
country's currency value relative to the other major currencies in the index, such as the U.S.
dollar, Japanese yen and the euro.

BREAKING DOWN 'Real Effective Exchange Rate - REER';

The REER is used to measure the value of a specific currency in relation to an average group
of major currencies. The REER takes into account any changes in relative prices and shows
what can actually be purchased with a currency. This means that the REER is normally trade-
weighted.

The REER is derived by taking a country's nominal effective exchange rate (NEER) and
adjusting it to include price indices and other trends. The REER, then, is essentially a
country's NEER after removing price inflation or labor cost inflation. The REER represents
the value that an individual consumer pays for an imported good at the consumer level. This
rate includes any tariffs and transaction costs associated with importing the good.

A country's REER can also be derived by taking the average of the bilateral real exchange
rates (RER) between itself and its trading partners and then weight it using the trade
allocation of each partner. Regardless of the way in which REER is calculated, it is an average
and considered in equilibrium when it is overvalued in relation to one trading partner and
undervalued in relation to a second partner.

Benefits of Analyzing and Using the REER;

A country's REER is an important measure when assessing its trade capabilities and current
import/export situation. The REER can be used to measure the equilibrium value of a
country's currency, identify the underlying factors of a country's trade flow, look at any
changes in international price or cost competition, and allocate incentives between tradable
and non-tradable sectors.

A country can positively affect its REER through rapid productivity growth. When this
happens, the country realizes lower costs and can reduce prices, thus making the REER more
advantageous for the country.

Understanding a country's REER is extremely important when conducting economic analysis

and policymaking. Therefore, the World Bank, the Eurostat, the Bank for International
Settlements (BIS) and others all publish various REER indicators. These world institutions
combine to provide the public with REER analysis on 113 countries around the globe

'Nominal Effective Exchange Rate - NEER':

The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at
which one country's currency exchanges for a basket of multiple foreign currencies. In
economics, the NEER is an indicator of a country's international competitiveness in terms of
the foreign exchange (forex) market. Forex traders sometimes refer to the NEER as the
trade-weighted currency index.

BREAKING DOWN 'Nominal Effective Exchange Rate - NEER':

The NEER may be adjusted to compensate for the inflation rate of the home country relative
to the inflation rate of its trading partners. The resulting figure is the real effective exchange
rate (REER).

Unlike the relationships in a nominal exchange rate, NEER is not determined for each
currency separately. Instead, one individual number, typically an index, expresses how a
domestic currency’s value compares against multiple foreign currencies at once.

If a domestic currency increases against a basket of other currencies inside a floating

exchange rate regime, NEER is said to appreciate. If the domestic currency falls against the
basket, the NEER depreciates.

Uses of NEER:

The NEER only describes relative value; it cannot definitively show whether a currency is
strong or gaining strength in real terms. It only describes whether a currency is weak or
strong, or weakening or strengthening, compared to foreign currencies. As with all exchange
rates, the NEER can help identify which currencies store value more or less effectively.
Exchange rates influence where international actors buy or sell goods.
NEER is used in economic studies and for policy analysis about international trade. It is also
used by forex traders who engage in currency arbitrage. The Federal Reserve calculates
three different NEER indices for the United States: the broad index, the major currencies
index and the other important trading partners (OITP) index.

The Basket of Foreign Currencies:

Every NEER compares one individual currency against a basket of foreign currencies. This
basket is chosen on the basis of the domestic country's most important trading partners, as
well other major currencies.

The world's major currencies are the U.S. dollar, the euro, the British pound sterling, the
Japanese yen, the Australian dollar, the Swiss franc, the South African rand and the
Canadian dollar.

The value of foreign currencies in a basket are weighted according to the value of trade with
the domestic country. This could be export or import value, the total value of exports and
imports combined, or some other measure. The weights often relate to the assets and
liabilities between different countries.

A higher NEER coefficient (above 1) means that the home country's currency is usually
worth more than an imported currency, and a lower coefficient (below 1) means that the
home currency is usually worth less than the imported currency.

There is no international standard for selecting a basket of currencies. The Organization for
Economic Co-operation and Development (OECD) basket is different than the one for the
International Monetary Fund (IMF), the Federal Reserve or Bank of Japan. However, many
different institutions rely on the International Financial Statistics (IFS) published by the IMF.

RELATIONSHIP BETWEEN NEER AND REER:

The Nominal Effective Exchange Rate (NEER) captures the overall variation in the value of a
country's currency against the currencies of all trading partners. It measures the changes in
overall nominal value of a currency. In contrast, the Real Effective Exchange Rate (REER)
measures changes in real value of a currency by incorporating the price levels in its
construction. Thus, it is the REER which reflects changes in external competitiveness of a
country. However, it is the nominal exchange rate which is used as a policy tool to improve a
country's trade balance as the central bank manipulates it. There are two channels through
which nominal depreciation could lead to an improvement in the trade balance. One is by
making a country's exports cheaper in terms of foreign currencies, leading to an increase in
exports. The other channel is by making a country's imports expensive in terms of her
domestic currency leading to a decline in imports. However, it also has its negative effects as
expensive imports usually do contribute to domestic inflation which over time spreads into
the export sector and this may wipe out the favorable effects that nominal depreciation
could have on the exports. Therefore, to investigate the impact of exchange rate
adjustment, one has to take account of the price change as well, both domestic and foreign.
Thus, nominal depreciation could lead to improvement in trade balance only if it leads to
real depreciation. The present study investigates whether nominal exchange rate
depreciation eventually leads to depreciation in real exchange rate in the short run as well
in the long run. To achieve this objective, we perform cointegration analysis through the
Autoregressive Distributed Lag (ARDL) bounds test which has an edge over the conventional
cointegration tests such as Engle-Granger, Johansen, Johansen and Juselius, etc

Ques5: Explain various exchange rate regimes in international market with

example?
An exchange rate regime is the way an authority manage its currency in relation to other
currencies and the foreign exchange market. It is closely related to monetary policy and the
two are generally dependent on many of the same factors. the basic type are a floating
exchange rate, where the market dictates movements in the exchange rate; a pegged float,
where a central bank keeps the rate ,which ties the currency to another currency , mostly
more widespread currencies such as the Indian rupees or euro or a basket of currencies.

Features

1. Show financial condition of country:

It is show the financial condition of the particular country

2. Show the condition of money market:

It is define and express the condition of the money market that which type of trend come in
market.

3. Show the condition about economy:

In country, which type of cycle come in economic like inflation and deflation. It is very
closely express the condition.

4. Control on the exchange rate:

It is help in control on the exchange rate for good economy of our country.

Advantages

1 Easy to analyses the market condition

2 It can control the condition

Flexible oriented regimes:

Those rate which is flexible not fixed. flexible oriented regimes mean those rate which is
flexible or changed. Most exchange rates are determined by the foreign exchange market,
known as foreign exchange. For this reason, exchange rates vary on a moment-by-moment
basis, depending on what foreign exchange traders think the currency is worth. This
depends on a lot of factors, including central bank interest rates, the country's debt levels,
and the strength of its economy. Most countries allow their currencies to be determined by
the foreign exchange market. This is known as a flexible exchange rate.
Advantages:
1. Exchange rate risk: The main disadvantage of flexible exchange rates is their
volatility. In the post–Bretton Woods era, one of the characteristics of flexible
exchange rate is their excess volatility.
2. Potential for too much use of expansionary monetary policy.
3. Questionable stabilizing effects: Previously, automatic stabilizing was mentioned as
an advantage of the flexible exchange rate system. Exchange rates change in the
appropriate direction when the country’s inflation rate, output, and current account
balance change. Especially in terms of current account imbalances.

4. Flexible exchange rates as automatic stabilizers.

Features
• Automatic correction of payments imbalances

• Governments have policy independence can choose any domestic inflation rate

1. Free float:
This extreme kind of regime has been rarely seen in the world economy. In this regime,
government has no effects on the currency market. The market agents determine the
rate. This regime provides elasticity. Monetary policy is very efficient. There is no need
to keep large amount of reserve .the change in rate adsorb all of the internal and
external shocks.
A free floating exchange rate increases foreign exchange volatility. There are economists
who think that this could cause serious problems, especially in emerging economies.
These economies have a financial sector with one or more of following conditions:

 high liability
 financial fragility
 strong balance sheet effects
Example: some country name where exist free float are:
Inflation-targeting framework
  Australia (AUD)
  Canada (CAD)
  Chile (CLP)
  Japan (JPY)
  Mexico (MXN)
  Norway (NOK)
  Poland (PLN)
  Sweden (SEK)
  United Kingdom (GBP)

2 Managed float regime 

Mainly the free market determine the rate, but central bank is ready to intervene to the
market without anchored .in other words, there is no determined rate but policy maker may
intervene according to the economic conditions. Intervention are generally indirect. Relative
to free float, volatility of exchange rate is rates is less than that of free float.
Example: some country where exist managed float regime are:
Rupees as exchange rate:
India
US dollar as exchange rate
  Cambodia (KHR)
  Liberia (LRD)

Features
1. Not risky
2. Easily managed
3. Not Speedily increase or decrease
3 Floating within band:

Floating within band means exchange rate fluctuate with some specify rate which is decide
by reserve bank of India but some time or few time take fixed or same rate. It means the
international financial environment in which exchange rate increase or decrease but
changed with in growth.

Example: In starting 1rs = 65 then after some time 10rs=65 then this second term continue
with some period then come fluctuation.

Features:

 Not suddenly change in exchange rate

 Good impact on economics compare than free floating
 Rate is decide by reserve bank of India.
4 Sliding Band

Sliding band means firstly band decide that what is rate fixe for exchange rate with in
between some rate but after sometime, this band has changed with the growth.

Example: like 10 -15 is the band rate , exchange rate is used within rate as like 23 or 23 .after
some time the rate changed with increase or growth rate like as 17 or 18.

Advantages:

 It is increase growth of economy.

 It is increase value of money.

2 ) FIXED ORIENTED REGIMES:

Those rate which is fixed not flexible. This type of rate is more risky. it is not good for
economic. One country that has traditionally had a fixed exchange rate is China. It pegs its
currency, the Yuan, to a fixed value against the dollar. As of June 7, 2016, one dollar was
worth 6.57 Chinese Yuan. The dollar has weakened against the Yuan since February 7, 2003,
when a dollar could be exchanged for 8.28 Yuan.
Feature

• Exchange-rate stability promotes globalization – more trade and investment.

• Fixing value of currency to the currency of a low inflation country forces govt to keep
prices in line.

Advantages:
1. Avoid Currency Fluctuations.
2. Stability encourages investment.
3. Keep inflation Low.
 4. A rapid appreciation in the exchange rate will badly effect manufacturing firms

Export, this may also cause a worsening of the current account.

5. Joining a fixed exchange rate may cause inflationary expectations to be lower.

Disadvantage of Fixed Exchange Rates:

1. Conflict with other objectives. To maintain a fixed level of the exchange rate may
conflict with other macroeconomic objectives.

2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil

importer may face a balance of payments deficit if oil price increases, but in a fixed
exchange rate there is little chance to devalue.

3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate is
too high, it will make exports uncompetitive. If it is too low, it could cause inflation.

4. Current Account Imbalances. Fixed exchange rates can lead to current account
imbalances. For example, an overvalued exchange rate could cause a current account
deficit.

1. Fixed but adjusted exchange rate:

Nominal exchange rate is fixed but central bank is not restricted by strict rules . Sometime it
may intervene to the market. This regime provide macroeconomic discipline, because
expectation of risk decreases especially exchange rate risk in foreign trade. Devaluation
chance causes elascity in the economy. On other hand, if the devaluation rate is too high,
that will cause uncertainity. uncertainity increase the inflation expectation.
features
• Requires heavy govt involvement.

• BOP deficits are much more troublesome than BOP surpluses

Example: BOP surplus – indian central bank simply sells rupees-which it can print freely--
and exchanges them for foreign exchange (U.S. dollars) – This alleviates the shortage of
rupees in the FOREX market, causing the rupees’s value to depreciate back to the promised
rate.

2 Full Dollarization:

Country uses another country’s currency. That means its monetary policy is dependent on
the other country . the credibility level is at maximum .some of the latin American countries
implemented this regime. On the contrary , system does not have elasticity . external shocks
can only be absorbed by unemployment and recession.

A foreign currency acts as legal tender. Monetary policy is delegated to the anchor country.

Example: Ecuador and El Salvador in Latin American countries implemented this regime.

Benefits:

Dollarization reduces the time-inconsistency problem (subject to the perceived probability

of a re-introduction of domestic money) and real exchange rate volatility).

Drawbacks:

Under dollarization external shocks cannot be buffered by exchange rate movements,

imposing costs if business cycles are asynchronous; while seignorage revenues decline.

3 Currency Boards

This is a fixed exchange rate regime with strict regulations. Monetary authority can issue the
currency if only it has more foreign currency. That is, the more foreign currency a country
has the more national currency it can issue. That means central bank is no more the last
land of resort. Credibility of system is at maximum level because all the economic agents
can foresee exchange rates in the future. However, system is not elastic. If the country has a
relatively small economy, external shocks can only be absorbed by unemployment and
recession.

A fixed exchange rate regime (mostly enshrined in law) is complemented by a minimum

backing requirement for domestic money in foreign currency.

Example: some country name where currency board regulate are:

US dollar as exchange rate:

  Antigua and Barbuda (XCD)
  Djibouti (DJF)
  Dominica (XCD)
  Grenada (XCD)
  Hong Kong (HKD)
  Saint Kitts and Nevis (XCD)
  Saint Lucia (XCD)
  Saint Vincent and the Grenadines (XCD)
Euro as exchange rate:
  Bosnia and Herzegovina (BAM)
  Bulgaria (BGN)
Other currency as exchange rate:
  Brunei (BND)
Benefits:

The time-inconsistency problem is reduced (subject to the perceived probability that the
regime is abandoned) and real exchange rate volatility is diminished.

Drawback:

External shocks cannot be buffered by exchange rate movements, imposing costs if business
cycles are asynchronous. The scope for lender of last resort activity is restricted to excess
reserve holdings and fiscal mechanisms. Requires high reserve holdings.

4 Crawling Peg:

Crawling peg means change exist with minor base. It means change in exchange rate with
minor rate like10 is rate if changes come then rate will be 10.2. Nominal exchange rate is
adjusted periodically according to some economic indicators. The band is very narrow.
Market expectation are corrected according to this system. Credibility of policies is higher.

Example:

US dollar as exchange rate

Country name:  Nicaragua (NIO)
Composite exchange rate

Country name:  Botswana (BWP)

Feature:

A rule-based system for altering the par value, typically at a predetermined rate or as a
function of inflation differentials.

Benefits:

An attempt to combine flexibility and stability. Often used by (initially) high inflation
countries pegging to low inflation countries in an attempt to avoid trend real appreciation.

5 Crawling Band:

It refers to those band which is decided by a fixed rate like 10-15 and rate is change with this
rate .it means rate fluctuate with slowly- slowly. Not change suddenly like firstly take 10
then take 10.5.

Example: firstly Decide 10 to 15 is exchange rate then in starting take 10 then if changes
come in rate then take 10.5.
Some country name where crawling band follow are:

US dollar as exchange rate

  Honduras (HNL)
  Jamaica (JMD)
Euro as exchange rate
  Croatia (HRK)

Benefits:

Provides a limited role for exchange rate movements to counteract external shocks and
partial expectations anchor, retains exchange rate uncertainty and thus motivates
development of exchange rate risk management tools.

Drawbacks:

On the margin, a band is subject to speculative attacks. Does not by itself place hard
constraints on monetary and fiscal policy, and thus provides only partial solution against the
time inconsistency problem. The credibility effect depends on accompanying institutional.

(UNIT-2)

Q1. Define exchange rate? What are various factors/ determinants affecting
exchange rates?
Ans1. The exchange rate is defined as "the rate at which one country's currency may be
converted into another." It may fluctuate daily with the changing market forces of supply
and demand of currencies from one country to another. For these reasons; when sending or
receiving money internationally, it is important to understand what determines exchange
rates.

An exchange rate (also known as a foreign-exchange rate, forex rate , 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 country’s currency in terms of another currency. For example,
an interbank exchange rate of 119 Japanese yen (JPY, ¥) to the United States dollar (US$)
means that ¥119 will be exchanged for each US$1 or that US$1 will be exchanged for each
¥119. In this case it is said that the price of a dollar in terms of yen is ¥119, or equivalently
that the price of a yen in terms of dollars is $1/119.

Exchange rates are determined in the foreign exchange market which is open to a wide
range of different types of buyers and sellers, and where currency trading is continuous: 24
hours a day except weekends. 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.

Factors affecting exchange rates-

Foreign Exchange rate (Forex rate) is one of the most important means through which a
country’s relative level of economic health is determined. A country's foreign exchange rate
provides a window to its economic stability, which is why it is constantly watched and
analyzed. If you are thinking of sending or receiving money from overseas, you need to keep
a keen eye on the currency exchange rates.

There are different factors affecting exchange rates. These are-

psychological
factors

political economic
factors factors

factors
speculation
affecting forces of
demand and
exchange supply
rates

balance of
recession
payment

terms of trsde
1. Forces of demand and supply- Exchange rate is established as a result of equilibrium
forces of demand and supply of any currency. Transactions in the foreign exchange market
can be expressed in terms of supply and demand of national currencies. Whenever there is
any rise in domestic price, there will be decline in exports and exports earnings. On the
other hand, import will increase. The demand of foreign exchange will lead to depreciation
of currency.

2. Political factors- Political stability induces confidence in the investors and encourages
capital inflow into the country. This has the effect of strengthening the currency of the
country. On the other hand, where the political situation in the country is unstable, it makes
the investors withdraw their investment. The outflow of capital from the country would
weaken the currency. Any news about change in the government or political leadership or
about the policies of the government would also have the effect of temporarily throwing out
of gear the smooth functioning of exchange rate mechanism.

3. Psychological factors- In the short run, the exchange rate is affected mostly by the views
of the participants in the market about the likely changes in the interest rates. Whenever
there is a discrepancy between the previously held expectation of a given factors and actual
outcome of it, exchange rates will usually be affected. For example: if the market expects
the balance of payment of india to be of the order of Rs.2.0 billion surplus, but when the
actual figures are announced, it is Rs. 1.3 billion, it will immediately have an effect of
depressing the price of rupee temporarily.

4. Economic factors- Economic factors such as hedging activities , interest rates, inflationary
pressures, trade imbalances, and euro market activities have a great impact on exchange
rate. Four way equivalence model explains the relationship of exchange rate with different
economic variables such as interest rate and inflation rates.

 Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a
lower inflation rate than another's will see an appreciation in the value of its currency. The
prices of goods and services increase at a slower rate where the inflation is low. A country
with a consistently lower inflation rate exhibits a rising currency value while a country with
higher inflation typically sees depreciation in its currency and is usually accompanied by
higher interest rates.
  Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest
rates, and inflation are all correlated. Increases in interest rates cause a country's currency
to appreciate because higher interest rates provide higher rates to lenders, thereby
attracting more foreign capital, which causes a rise in exchange rates

5. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is
earning through sale of exports causes depreciation. Balance of payments fluctuates
exchange rate of its domestic currency.

6. Government Debt

Government debt is public debt or national debt owned by the central government. A
country with government debt is less likely to acquire foreign capital, leading to inflation.
Foreign investors will sell their bonds in the open market if the market predicts government
debt within a certain country. As a result, a decrease in the value of its exchange rate will
follow.

7. Terms of Trade

Related to current accounts and balance of payments, the terms of trade is the ratio of
export prices to import prices. A country's terms of trade improves if its exports prices rise
at a greater rate than its imports prices. This results in higher revenue, which causes a
higher demand for the country's currency and an increase in its currency's value. This results
in an appreciation of exchange rate.

8. Change in competitiveness
If British goods become more attractive and competitive this will also cause the value of the
exchange rate to rise. For example, if the UK has long-term improvements in labour market
relations and higher productivity, good will become more internationally competitive and in
long-run cause an appreciation in the Pound. This is a similar factor to low inflation.

9. Recession

When a country experiences a recession, its interest rates are likely to fall, decreasing its
chances to acquire foreign capital. As a result, its currency weakens in comparison to that of
other countries, therefore lowering the exchange rate.

10. Speculation

If a country's currency value is expected to rise, investors will demand more of that currency
in order to make a profit in the near future. As a result, the value of the currency will rise
due to the increase in demand. With this increase in currency value comes a rise in the
exchange rate as well.

Conclusion:

All of these factors determine the foreign exchange rate fluctuations. If you send or receive
money frequently, being up-to-date on these factors will help you better evaluate the
optimal time for international money transfer. To avoid any potential falls in currency
exchange rates, opt for a locked-in exchange rate service, which will guarantee that your
currency is exchanged at the same rate despite any factors that influence an unfavorable
fluctuation

Ques.2 Explain four ways equivalence model of exchange rate determination?

Four ways equivalence mode means a model that proposes a number of related
conceptual linkage between differences in interest rate, spot and forward rate, expected
inflation rates and expected change in spot foreign exchange rates.

1. Interest Rate Party :-

At interest rate parity the forward exchange rate should make the foreign currencies
exactly equal. Interest parity line indicates that interest rate differential is equal top the
 difference in the forward and spot rates. This equilibrium is being established by action of
arbitrageurs, hedgers and speculators. It is based on international mobility of money. It is
possible only in case of free markets as currency markets. A lower interest rate currency
will be at premium for future delivery as compare to spot rate. Whereas a higher interest
rate currency will be at a discount.

Forward rates bring equilibrium in interest rates. If such equilibrium does not exist,
arbitrage process will work arbitrageur will borrow currency in one centre, convert it to
the other, invest there and sell the proceeds forward. Exploitation of such opportunities
creates movements in spot and forward exchange rates and also in interest rates. Such
movements will bring equilibrium in currency and interest rate market.

iA - iB = F O - SO

1 + iA So

2. EXPECTATION THEORY:-

As per expectation theory, difference between spot and forward rate will be equal to
expected changes in spot rate. When there are changes of a currency to depreciate in
future. It will be quoted at discount. Whereas when there are changes of a currency to
appreciate in future, it will quote at premium. If a trader takes the view that the forward
rate is lower than the expected future spot price, there is an incentive to buy forward.
The buying pressure on the forward raises the price, until the forward price equals the
market consensus view on the expected spot price.

FO - SO = S 1 - SO

SO SO

As a result:-

Forward premium/Discount =Expected change in exchange rate

3. International Fisher effect:-

International Fisher effect states that interest rate differential will exist only if the change
rate is expected to change in such a way that the advantage of the higher interest rate is
offset by the loss on the foreign exchange transactions. Finally, the forward rate is unbiased
estimate of the expected future spot exchange rate. It suggest that locking in the forward
exchange rate offers the same expected returns as remaining exposed to the ups and downs
of the currency- on average, it can be expected to as much above as below the forward rate.
In long run, it seems that a firm operating under such conditions will not experience net
exchange losses or gains. It shows that whenever there is difference between interest rate
of deposits of two currencies it will result in equivalent change in future exchange rate
between those currencies. Rational spot rate of exchange. Their buying and selling activities
would bring currency interest rate differential into line with expected change in exchange
rate. As a result:-

Expected change in exchange rate= currency interest rate differential.

4. Fisher effect:-

It shows that whenever there are differences in expected inflation rates. It

will bring equivalent change in interest rates of deposits of those currencies. Normal
currency interest rate in a country reflects anticipated real return adjusted for local inflation
expectations.

As a result:- Currency interest rate differential=difference in expected inflation rates.

5. Purchasing power parity:-

It shows that changes in the future spot rate may be estimated with
the help of expected inflation differentials. Whenever there is
difference in inflation between two currencies, it will result in
equivalent change in future exchange rate to compensate that
difference.

As a result:-

Difference in inflation rate=Difference expected spot rate.

QUES: 3 Explain overshooting and sticky price theory of exchange rate

volatility/fluctuations?
ANSWER:
EXCHANGE RATE:
The price of a nation’s currency in terms of another currency. An exchange rate thus has
two components, the domestic currency and a foreign currency, and can be quoted either
directly or indirectly. In a direct quotation, the price of a unit of foreign currency is
expressed in terms of the domestic currency. In an indirect quotation, the price of a unit of
domestic currency is expressed in terms of the foreign currency. An exchange rate that does
not have the domestic currency as one of the two currency components is known as a cross
currency, or cross rate.

STICKY PRICE THEORY AND OVERSHOOTING MODEL OF EXCHANGE RATE :

The overshooting model, or the exchange rate overshooting hypothesis, first developed by

economist Rudi Dornbusch, is a theoretical explanation for high levels of exchange
rate volatility. The key features of the model include the assumptions that goods' prices are
sticky, or slow to change, in the short run, but the prices of currencies are flexible,
that arbitrage in asset markets holds, via the uncovered interest parity equation, and that
expectations of exchange rate changes are "consistent": that is, rational. The most
important insight of the model is that adjustment lags in some parts of the economy can
induce compensating volatility in others; specifically, when an exogenous variable changes,
the short-term effect on the exchange rate can be greater than the long-run effect, so in the
short term, the exchange rate overshoots its new equilibrium long-term value.
Dornbusch developed this model back when many economists held the view that ideal
markets should reach equilibrium and stay there. Volatility in a market, from this
perspective, could only be a consequence of imperfect or asymmetric information or
adjustment obstacles in that market. Rejecting this view, Dornbusch argued that volatility is
in fact a far more fundamental property than that.
According to the model, when a change in monetary policy occurs (e.g., an unanticipated
permanent increase in the money supply), the market will adjust to a new equilibrium
between prices and quantities. Initially, because of the "stickiness" of prices of goods, the
new short run equilibrium level will first be achieved through shifts in financial market
prices. Then, gradually, as prices of goods "unstick" and shift to the new equilibrium,
the foreign exchange market continuously reprices, approaching its new long-term
equilibrium level. Only after this process has run its course will a new long-run equilibrium
be attained in the domestic money market, the currency exchange market, and the goods
market.
As a result, the foreign exchange market will initially overreact to a monetary change,
achieving a new short run equilibrium. Over time, goods prices will eventually respond,
allowing the foreign exchange market to dissipate its overreaction, and the economy to
reach the new long run equilibrium in all markets.

Outline of the model

 Assumption Aggregate demand is determined by the standard open economy IS-LM
1: mechanism

That is to say, the position of the Investment Saving (IS) curve is determined by the volume
of injections into the flow of income and by the competitiveness of Home country output
measured by the real exchange rate.
The first assumption is essentially saying that the IS curve (demand for goods) position is in
some way dependent on the real effective exchange rate Q.
That is, [IS = C + I + G +N x (Q)]. In this case, net exports is dependent on Q (as Q goes up,
foreign countries' goods are relatively more expensive, and home countries' goods are
cheaper, therefore there are higher net exports).

Assumption Financial Markets are able to adjust to shocks instantaneously, and

2: investors are risk neutral.

If financial markets can adjust instantaneously and investors are risk neutral, it can be said
the uncovered interest rate parity (UIP) holds at all times. That is, the equation r = r* +
Δse holds at all times (explanation of this formula is below).
It is clear, then, that an expected depreciation/appreciation offsets any current difference in
the exchange rate. If r > r*, the exchange rate (domestic price of one unit of foreign
currency) is expected to increase. That is, the domestic currency depreciates relative to the
foreign currency.

Assumption In the short run, goods prices are 'sticky'. That is, aggregate supply is
3: horizontal in the short run, though it is positively sloped in the long run.

In the long run, the exchange rate will equal the long run equilibrium exchange rate.
OVERSHOOTING AND STICKY PRICE THEORY
Short run disequilibrium (sticky price theory)
The exchange rate will be moving towards the long run equilibrium exchange rate, whilst
being in a position that implies that it was initially overshot. From the assumptions above, it
is possible to derive the following situation. This demonstrated the overshooting and
subsequent readjustment. In the graph on the top left, So is the initial long run equilibrium,
S1 is the long run equilibrium after the injection of extra money and S2 is where the
exchange rate initially jumps to (thus overshooting). When this overshoot takes place, it
begins to move back to the new long run equilibrium S1.

Short run sticky price theory/overshooting

1. Stickiness of price of goods in commodity market.

2. Any change in monetary policy will result immediate response in financial market as in
goods market prices are sticky in short run.

Example:

 Increase in money supply will result in increase rate interest and depreciation of
home currency and exchange rate will increase (overshoot their long run
equilibrium).
 Since prices are sticky, products will become more competitive in international
market and foreign buyers will demand our products more.
 As a result exports will increase.
 On other side, imported products will be expensive due to increased exchange rates.
So, imports will reduce.
 Finally net exports will rise drastically.

OR

Presently ri in home country > ri in foreign countries, then

(1) Increase money supply, LM curve will shift to right side significantly and huge decline in
rate of interest.

(2) Increase flow of foreign currency & increase net exports as a result of currency
depreciation. (International competitiveness - Very significantly).

(3) Expected appreciation in home currency in future, UIP result in expected decline in ER to
mitigate impact of reduced rate of interest. As a result, NEER overdepreciates.

Long run equilibrium (overshooting)

This reveals that given a rise in money stock pushes up the long run values of both in equally
proportional measures, the real exchange rate (q) must remain at the same value as it was
before the market shock. Therefore, the properties of the model at the beginning are
preserved in long run equilibrium, the original equilibrium was stable.

Long run

1. Prices in goods market will increase as a result of increased demand (both at domestic &
international level).

2. LM Curve shifts left side back at initial equilibrium level where r ih = rif.

So, rate of interest increases back, Currency appreciates and reaches at long run equilibrium
level.

Q4: What is J curve?

J Curve

The J-curve effect is seen in economics when a country’s trade balance initially worsens
following a devaluation or depreciation of its currency. The higher exchange rate first
corresponds to more costly imports and less valuable exports, leading to a bigger initial
deficit or a smaller surplus.

In economics, the ‘J Curve’ refer to the trend of a country’s trade balance following a
devaluation under a certain set of assumptions. A devalued currency means imports are
more expensive and on the assumption that the volume of imports and exports change
little immediately, this causes a depreciation of the current account . After some time,
though, the volume of exports may start to rise becoz of their lower more competitive
prices to foreign buyers, and domestic consumers may buy fewer of the costlier imports.

Eventually, if this happened , the trade balance may improve on what it was before the
devaluation. If there is a currency revaluation or appreciation the same reasoning leads
to an inverted J-curve.

 In the short run, demand for the more expensive imports (and demand for exports,
which are cheaper to foreign buyers using foreign currencies) remain price inelastic.
This is due to time lags in the consumer's search for acceptable, cheaper alternatives
(which might not exist).
 Over the longer term a depreciation in the exchange rate can have the desired effect
of improving the current account balance. Domestic consumers might switch their
expenditure to domestic products and away from expensive imported goods and
services, assuming equivalent domestic alternatives exist. Equally, many foreign
consumers may switch to purchasing the products being exported into their country,
 which are now cheaper in the foreign currency, instead of their own domestically
produced goods and services.

J-Curve Model

Features

 A country’s trade balance is defined as the difference between the amount it exports
and the amount it imports.
 When the value of imports exceeds that of exports, the trade balance is said to be in
a deficit position. One policy to improve a deficit situation is devaluation; that is,
lowering the value of one currency in terms of another currency.
 By devaluing its currency, a country makes its exports cheaper in terms of foreign
currency and its imports more expensive in terms of domestic currency, leading to
an increase in export volume and a decrease in import volume.
 The expansion in exports and retardation of imports are expected to improve the
trade deficit. However, for several reasons, after devaluation the trade balance often
worsens before improving. Since this pattern of movement of the trade balance over
time subsequent to devaluation resembles the letter J, economists have termed it
the J-Curve phenomenon.
 Several factors contribute to the J-Curve effect.
 First
• At the time of devaluation, commodities in transit are priced at the old exchange
rate. If the trade balance had been deteriorating before devaluation, it will
continue to deteriorate after devaluation. Only after the passage of some time
when new prices begin to prevail at the new exchange rate will the trade balance
improve.
• Second
• At the time of devaluation a country could experience a rapid increase in its
economic activity, leading to economic growth. Since a growing economy
consumes more of not only domestically produced goods but also of imported
goods, its imports could rise substantially. The increase in imports may offset any
 favorable effects of devaluation, resulting in a short-run deterioration of the
trade balance.
• Finally,
• Devaluation is expected to increase the volume of exports and reduce the
volume of imports. However, the adjustment of export and import volumes to a
change in the exchange rate may occur with some time delay or adjustment lags.
For example, there may be lags in delivery time, lags in replacing inventories, and
lags in adjusting the production process.

Immediately following the depreciation or devaluation of the currency, the volume of

import and export may remain largely unchanged due in part to pre-existing trade
contracts that have to be honoured. Moreover, in the short run, demand for the more
expensive imports remain price inelastic. This is due to time lags in the consumer’s
search for acceptable, cheaper alternatives. Over the longer term a depreciation in the
exchange rate can have the desired effect of improving the current account balance.
Domestic consumers might their expenditure to domestic products and away from
expensive imported goods and services, assuming equivalent domestic alternatives exist.
Equally, many foreign consumers may switch to purchasing the products being exported
into their country, which are now cheaper in the foreign currency, instead of their own
domestically produced goods and services.

What is the 'J-Curve Effect'

The J-curve effect is a type of diagram where the curve falls at the outset and eventually
rises to a point higher than the starting point, suggesting the letter J. While a J-curve can
apply to data in a variety of fields, such as medicine and political science, the J-curve effect
is most notable in both economics and private equity funds; after a certain policy or
investment is made, an initial loss is followed by a significant gain.
BREAKING DOWN 'J-Curve Effect'
A J-curve demonstration is a representation of any value that initially falls before recovering
and ultimately rising; it shifts in investment values and the impacts of policy changes on
applicable economic metrics. The theory focuses on the premise that an internal rate of
return initially drops until a level of stability is established that allows a particular business
or investment to enter into a profitable state.
J-Curves in Economics
An example of the J-curve effect is seen in economics when a country's trade balance
initially worsens following a devaluation or depreciation of its currency. The higher
exchange rate first corresponds to more costly imports and less valuable exports, leading to
a bigger initial deficit or a smaller surplus.
Due to the competitive, relatively low-priced exports, the affected country's exports of the
goods in question start to increase as outside demand for the lower-priced option increases.
Local consumers also purchase less of the more expensive imports and focus on local goods
as the exchange rate makes certain locally produced items more affordable than the
imported counterpart. The trade balance eventually improves to better levels compared to
before devaluation.
In cases where a country’s currency appreciates, a reverse J-curve may occur. This is based
on the country’s associated exports becoming more expensive for importing countries than
experienced previously. If other countries are able to offer the good at a more affordable
rate, the country with a higher currency value may see demand drop in the export arena.
Additionally, local consumers may favour imported versions of goods if they are available at
a lower cost.
BENEFIT

 J Curve as a short-run deterioration of the trade balance and a longrun

improvement.
 It is in line with more recent advances in econometric modeling such as error-
correction and coin tegration techniques.
 The error correction specification of any model tests the short-run dynamics while
coin tegration tests the Generated For evaluation only.
 provide strong support for the phenomenon.
Summary of J curve
As a result balance of trade over a long period of time will result in substantial depreciation
of currency or devaluation of currency of that country. It will result in higher exchange rates
which will make imports costly and less value will be received for exports. It will create
deficit balance of trade temporarily. But them reaction in goods market will start and
demand for imported goods will fall whereas demand for domestic goods will increase in
that country. Foreign buyers will increase demand for products due to competitive in
international market and as a result exports will increase. It will result in upward movement
in trade balance of country resulting in J curve.