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Research Methods in Management



Factors effecting Foreign Exchange rates in India

Submitted to

DR. R. Venkateswarlu


Submitted by

K. Hari Krishna -1226210115

Prathik - 1226210101
(International Banking and Finance)

We bestow the privilege of expressing our gratitude towards those who have helped us in
successfully completing this report. Despite our endeavor, we would like to thank our
esteemed guide,
Dr. R.VENKATESWARLU, GSIB, GITAM UNIVERSITY, for his continuous guidance
and stupendous support for the completion of our project in time.

We hereby declare that this report entitled “Factors affecting the Foreign Exchange rates in

India” have been prepared by us in partial fulfillment of the requirement for the award of

degree of MBA-IBF. (2010 – 2012 batch)

We also declare to the best of our knowledge that this project is a result of our own and that

has not been submitted to any other university or institution for award of any degree or


Declared by
K. Hari Krishna -1226210115
A. Prathik - 1226210101
Objectives of the study:

The objective of the study is to determine the factors effecting Foreign exchange rates in
India. In this project we study how those factors effecting foreign exchanges rates and among
those factors, which factor is influencing the most.
General Introduction on the industry
Foreign exchange rate:

Foreign exchange, or Forex, is the conversion of one country's currency into that of
another. In a free economy, a country's currency is valued according to factors of supply and
demand. In other words, a currency's value can be pegged to another country's currency, such
as the U.S. dollar, or even to a basket of currencies. A country's currency value also may be
fixed by the country's government. However, most countries float their currencies freely
against those of other countries, which keep them in constant fluctuation.

The value of any particular currency is determined by market forces based on trade,
investment, tourism, and geo-political risk. Every time a tourist visits a country, for example,
he or she must pay for goods and services using the currency of the host country. Therefore, a
tourist must exchange the currency of his or her home country for the local currency.
Currency exchange of this kind is one of the demand factors for a particular currency.
Another important factor of demand occurs when a foreign company seeks to do business
with a company in a specific country. Usually, the foreign company will have to pay the local
company in their local currency. At other times, it may be desirable for an investor from one
country to invest in another, and that investment would have to be made in the local currency
as well. All of these requirements produce a need for foreign exchange and are the reasons
why foreign exchange markets are so large.

Foreign exchange is handled globally between banks and all transactions fall under the
auspice of the Bank of International Settlements.

Aside from factors such as interest rates and inflation, the exchange rate is one of the most
important determinants of a country's relative level of economic health. Exchange rates play a
vital role in a country's level of trade, which is critical to most every free market economy in
the world. For this reason, exchange rates are among the most watched analyzed and
governmentally manipulated economic measures. But exchange rates matter on a smaller
scale as well: they impact the real return of an investor's portfolio. Here we look at some of
the major forces behind exchange rate movements.
Before we look at these forces, we should sketch out how exchange rate movements affect a
nation's trading relationships with other nations. A higher currency makes a
country's exports more expensive and imports cheaper in foreign markets; a lower currency
makes a country's exports cheaper and its imports more expensive in foreign markets. A
higher exchange rate can be expected to lower the country's balance of trade, while a lower
exchange rate would increase it.

Determinants of Exchange Rates:

Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.

Differentials in Inflation:
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of
the twentieth century, the countries with low inflation included Japan, Germany and
Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries
with higher inflation typically see depreciation in their currency in relation to the currencies
of their trading partners. This is also usually accompanied by higher interest rates.

Differentials in Interest Rates:

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing
interest rates impact inflation and currency values. Higher interest rates offer lenders in an
economy a higher return relative to other countries. Therefore, higher interest rates attract
foreign capital and cause the exchange rate to rise. The impact of higher interest rates is
mitigated, however, if inflation in the country is much higher than in others, or if additional
factors serve to drive the currency down. The opposite relationship exists for decreasing
interest rates - that is, lower interest rates tend to decrease exchange rates.
Current-Account Deficits:
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services, interest and
dividends. A deficit in the current account shows the country is spending more on foreign
trade than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives through
sales of exports, and it supplies more of its own currency than foreigners demand for its
products. The excess demand for foreign currency lowers the country's exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests.

Public Debt:
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with
large public deficits and debts are less attractive to foreign investors. The reason is a large
debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately
paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not
able to service its deficit through domestic means (selling domestic bonds, increasing the
money supply), then it must increase the supply of securities for sale to foreigners, thereby
lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe
the country risks defaulting on its obligations. Foreigners will be less willing to own
securities denominated in that currency if the risk of default is great. For this reason, the
country's debt rating

Terms of Trade:
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a greater rate
than that of its imports, its terms of trade have favorably improved. Increasing terms of trade
shows greater demand for the country's exports. This, in turn, results in rising revenues from
exports, which provides increased demand for the country's currency (and an increase in the
currency's value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners

Political Stability and Economic Performance:

Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment
funds away from other countries perceived to have more political and economic risk. Political
turmoil, for example, can cause a loss of confidence in a currency and a movement of capital
to the currencies of more stable countries.

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

Exchange rates between currencies can be either controlled as in the case of India
prior to the reforms or left to the market to decide, as is the case now in India. In the
case of controlled exchange rates, it is quite obvious that the government would fix
them, so the question really boils down to what is the process by which markets
determine rates. The process is really not different in its essentials from the way any
market functions. The supply and demand for different goods determine what their
prices are. In this case, substitute currencies for goods. Let’s take the case of one
foreign currency to understand
how this market works. Thus, the dollar-rupee exchange rate will depend on how the
demand-supply balance moves. When the demand for dollars in India rises and
supply does not rise correspondingly, each dollar will cost more rupees to buy.

Supply of dollars:
The supply of dollars comes from several sources. One obvious source is Indian
exporters of goods and services who sell their wares in the international market for
dollars. Another important source is Indian immigrant workers abroad who repatriate
money to their kin at home. The third major source is investments by foreign
individuals, companies or institutions in India. This could be in the form of foreign
direct investment where they are using the money to create some assets in India or to
buy into the equity of an existing company. It could also be in the form of portfolio
investments where dollars are being brought in to
buy assets in the stock markets, for instance, with the purpose of selling these assets
when they appreciate in value to book a profit. While all these forms contribute to
the supply of dollars, it should be obvious that the last of them portfolio investment
is a relatively uncertain source, since it necessarily implies an exit of dollars at some
point. That explains why such flows of capital from abroad are often described as hot
flows, since they can move out very rapidly. Foreign tourists visiting India would
also contribute to the inflow of dollars.
Factors determine the demand for dollars:
Just as exporters earn dollars, importers spend them. Imports are thus the most
important source of demand for dollars. Another major source of demand is
individuals or companies repatriating incomes or profits to their home countries.
This would include portfolio investors as well as Indian branches of multinationals
sending back some of their profits to the parent company as dividends. A third
source would be Indians investing abroad, whether as firms or as individuals.
Besides this, of course, the forex you buy when you travel abroad is also adding to
the demand for dollars. As you can see, the factors that contribute to the demand for
dollars are mirror images of those that add to their supply.

Rapid increase in the value of the dollar recently:

As should be clear by now, this is because the demand for dollars is surging when its
supply is not. A couple of factors have been particularly crucial in this.
First, the trade deficit the gap between the value of our imports and that of our
exports has been widening, meaning exporters are earning a smaller proportion of the
dollars that importers need. The high prices of crude oil have been a large, but not
the only, factor. Second, foreign institutional investors (FIIs) who had been pumping
billions of dollars every year into a booming Indian stock exchange have this year
been equally desperately pulling out their money thanks to the financial crisis facing
them in their home market.

Role of expectations:
As in any market, expectations and the consequent speculation play a significant
role. For instance, when there is an expectation that the dollar will rise against the
rupee, exporters tend to hold back their earnings for a while in the hope of getting a
higher rate when they ultimately bring their dollars in.
This, of course, skews the supply-demand equation even further confirming their
initial expectations and thus setting off a vicious cycle. Similarly, importers who
expect to pay more for their dollars tomorrow will try and buy up as much as they
can today, adding to the current demand and making the dollar rise
even more. Currency traders in such a situation would also try to benefit by betting
on what the future price of the dollar would be.
RBI role
With hundreds of billions of dollars in its reserves, the RBI would seem to have the
ability to be a major factor in how the dollar moves. If, for instance, it were to dump
a huge amount of dollars in the market, it could dramatically add to the supply and
hence reduce the price. There are at least two major reasons why central banks are
reluctant to do this. First, they do not like to interfere too much with market
valuation of currencies, though they do try and contain excessive volatility. Second,
every time the RBI sells dollars, it buys up rupees, thus sucking some liquidity out of
the system. Given the current liquidity crunch, that is obviously not something it
would be very keen to do

Reason for rupee depreciating:

The answer is less simple than it might seem. Exporters clearly gain when there is
depreciation, since they can price their goods cheaper in dollars and yet earn the
same amount of rupees, making them more competitive internationally. However,
importers lose because their costs go up and since they are likely to pass this on to
consumers it means costs in the economy rise. In theory, as import costs rise,
imports should fall and with exports rising the trade gap should close thereby
correcting the demand-supply mismatch in dollars and leading to the rupee
appreciating again. In practice, this often does not happen. One reason is that not all
imports may be price elastic that is, some imports might not be reduced despite
higher costs. The same may be true in exports, where some exports may not gain
since their demand is not price elastic. Also, other factors including speculation may
more than offset any reduction in the trade deficit

Multiple Regressions:-

Regression Analysis is a powerful and flexible procedure for analysis associative

relationships between a metric dependent variable and two or more
independent variables. It can be used in the following ways:
1. Determine whether the independent variable explain a significant variable in the
dependent variable: whether a relationship exists.
2. Determine how much of the variation in the dependent variable can be explained
by the independent variable: strength of the relationship
3. Determine the structure or form of the relationship the mathematical equation
relating the independent and dependent variables
4. Predict the value of the dependent variable
5. Cannot for other independent variable when evaluating the contribution of a
specific variable or set of variables

Although the independent variable may explain the variation in the dependent variable, this
does not necessarily imply causation. The use of the terms dependent do criterion variables,
and independent or predictor variables, in regression analysis arises from the mathematical
relationship between the variables. These terms do not imply that the criterion variable is
dependent on the independent variable in a casual sense. Regression analysis is concerned
with the nature and degree of association between variable and does not imply or assume any
Computational Approach

The general computational problem that needs to be solved in multiple regression analysis is
to fit a straight line to a number of points.

In the simplest case - one dependent and one independent variable - you can visualize this in
a scatter plot

The Regression Equation

A line in a two dimensional or two-variable space is defined by the equation Y=a+b*X; in

full text: the Y variable can be expressed in terms of a constant (a) and a slope (b) times the X
variable. The constant is also referred to as the intercept, and the slope as the regression
coefficient or B coefficient.

Unique Prediction and Partial Correlation

Note that in this equation, the regression coefficients (or B coefficients) represent the
independent contributions of each independent variable to the prediction of the dependent
variable. Another way to express this fact is to say that, for example, variable X 1 is correlated
with the Y variable, after controlling for all other independent variables. This type of
correlation is also referred to as a partial correlation

Predicted and Residual Scores

The regression line expresses the best prediction of the dependent variable (Y), given the
independent variables (X). However, nature is rarely (if ever) perfectly predictable, and
usually there is substantial variation of the observed points around the fitted regression line.
The deviation of a particular point from the regression line (its predicted value) is called the
residual value.
Interpreting the Correlation Coefficient R

Customarily, the degree to which two or more predictors (independent or X variables) are
related to the dependent (Y) variable is expressed in the correlation coefficient R, which is the
square root of R-square. In multiple regression, R can assume values between 0 and 1. To
interpret the direction of the relationship between variables, look at the signs (plus or minus)
of the regression or B coefficients. If a B coefficient is positive, then the relationship of this
variable with the dependent variable is positive if the B coefficient is negative then the
relationship is negative. Of course, if the B coefficient is equal to 0 then there is no
relationship between the variables.

Assumptions, Limitations, Practical Considerations

Assumption of Linearity

First of all, as is evident in the name multiple linear regression, it is assumed that the
relationship between variables is linear. In practice this assumption can virtually never be
confirmed; fortunately, multiple regression procedures are not greatly affected by minor
deviations from this assumption. However, as a rule it is prudent to always look at bivariate
scatter plot of the variables of interest. If curvature in the relationships is evident, you may
consider either transforming the variables, or explicitly allowing for nonlinear component.

Normality Assumption

It is assumed in multiple regression that the residuals (predicted minus observed values) are
distributed normally (i.e., follow the normal distribution). Again, even though most tests
(specifically the F-test) are quite robust with regard to violations of this assumption, it is
always a good idea, before drawing final conclusions, to review the distributions of the major
variables of interest. You can produce histograms for the residuals as well as normal
probability plots, in order to inspect the distribution of the residual values.

The major conceptual limitation of all regression techniques is that you can only ascertain
relationships, but never be sure about underlying causal mechanism.

Statistics Associates with Multiple Regressions

Adjusted R- Square: - coefficient of multiple determinations is adjusted for the number of

independent variable and the sample size to account for diminishing returns. After the first
few variables, the additional independent variable does not make much contribution.

Coefficient of Multiple determination:- The strength of association in multiple regression is

the measured by the square of the multiple correlation coefficient, R- Square, which is also
called the coefficient of multiple determination.

F test: - The F test is used to test the null hypothesis that the coefficient of multiple
determinations is the population, R-Square is zero. This is equivalent to testing the null
hypothesis Ho: Y = β1=β2=β3= βk = 0. The test statistics has an F distribution with k and (n-
k-10 degree of freedom

Partial F test:- The significance of a partial regression coefficient, β1, of Xi may be tested
using an incremental F statistic. The incremental F statistic is based on the increment in the
explained sum of squares resulting from the addition of the independent variable Xi to the
regression equation after all the other independent variable have been included.

Partial Regression coefficient: - The partial regression coefficient, b1, denote the change in
the predictable value, Y, per unit change in Xa when the other independent variables, X2 to
Xk are held constant.
Data: we have taken depend variable as Foreign Exchange rates
And independent variables is inflation, exports, imports, foreign reserves, interest rates.

End of
Forex Imports
Foreign reserves Exports of
Exchange Inflation in USD of goods Interest
rates CPI MILLION goods% in % Rates
1975-76 8.4058 -4 2172 20.57 10.27 12.50
1976-77 9.0017 -13.8 3747 19.05 -1.61 12.50
1977-78 8.7625 10.6 5824 10.5 15.65 12.50
1978-79 8.2133 -2.2 7268 7.29 34.9 12.50
1979-80 8.1467 9.1 7361 14.67 26.96 12.50
1980-81 7.8800 14.2 6823 8.03 35.09 13.50
1981-82 8.6926 12.4 4390 2.98 -2.11 13.50
1982-83 9.4924 5.2 4896 9.12 3.12 13.50
1983-84 10.1379 11.3 5649 3.91 0.65 13.50
1984-85 11.3683 0.2 5952 2.03 -5.19 13.50
1985-86 12.3640 4.8 6520 -5.96 10.05 13.50
1986-87 12.6053 4.8 6574 10.06 2.52 13.50
1987-88 12.9552 10 6223 21.43 11.75 13.50
1988-89 13.9147 12.6 4802 12.76 19.21 16.00
1989-90 16.2238 5.4 3962 18.92 3.36 16.00
1990-91 17.4992 7.6 5834 8.98 14.35 16.00
1991-92 22.6890 19.3 9220 -1.14 -24.54 19.00
1992-93 25.9206 12.3 9832 3.3 15.44 17.00
1993-94 31.4439 3.5 19254 20.21 9.96 14.00
1994-95 31.3742 11.9 25186 18.39 34.28 15.00
1995-96 32.4198 10.7 21687 20.32 21.63 16.50
1996-97 35.4280 9.1 26423 5.64 12.09 14.75
1997-98 36.3195 3.4 29367 4.53 4.57 14
1998-99 41.2665 11 32490 -3.87 -7.12 14.5
1999-00 43.0552 4.4 38036 9.46 16.49 14.5
2000-01 44.9401 -0.3 42281 21.07 4.57 15
2001-02 47.1857 1.1 54106 -1.65 -2.82 15.5
2002-03 48.5993 3.2 76100 20.29 14.55 15
2003-04 46.5818 3.9 112959 23.27 24.1 16
2004-05 45.3165 2.6 141514 28.54 48.63 15.5

We have taken foreign exchange rates in relation t the US dollar and for better results we
have taken 30 years data
The Importance of Residual Analysis

Even though most assumptions of multiple regressions cannot be tested explicitly, gross
violations can be detected and should be dealt with appropriately. In particular outliers (i.e.,
extreme cases) can seriously bias the results by "pulling" or "pushing" the regression line in a
particular direction there by leading to biased regression coefficients. Often, excluding just a
single extreme case can yield a completely different set of results.

Model Summary

Std. Error of the

Model R R Square Adjusted R Square Estimate
1 .981a .963 .954 2.1359351

A. Predictors: (Constant), Lending Rates, Exports of goods%, Forex reserves, Inflation

b. Independent Variable: Foreign exchange rate

R - R is the square root of R-Squared and is the correlation between the observed and
predicted values of dependent variable.

R-Square - This is the proportion of variance in the dependent variable (Foreign

exchange rate) which can be explained by the independent variables (Lending Rates,
Exports of goods%, Forex reserves and inflation.

This is an overall measure of the strength of association and does not reflect the
extent to which any particular independent variable is associated with the dependent
Adjusted R-square - This is an adjustment of the R-squared that penalizes the
addition of extraneous predictors to the model. Adjusted R-squared is computed using
the formula 1 - ((1 - Rsq) ((N - 1) /( N - k - 1)) where k is the number of predictors.

Std. Error of the Estimate - This is also referred to as the root mean squared error.
It is the standard deviation of the error term and the square root of the Mean Square
for the Residuals in the ANOVA table.

Sum of
Model Squares df Mean Square F Sig.
1 Regression 2111.837 4 527.959 115.724 .000a
Residual 82.120 18 4.562
Total 2193.957 22

a. Predictors: Lending Rates, Exports of goods%, Forex reserves and inflation rate

Regression, Residual, Total - Looking at the breakdown of variance in the outcome

variable, these are the categories we will examine: Regression, Residual, and Total. The Total
variance is partitioned into the variance which can be explained by the independent variables
(Model) and the variance which is not explained by the independent variables (Error).

Sum of Squares - These are the Sum of Squares associated with the three sources of
variance, Total, Model and Residual. The Total variance is partitioned into the variance
which can be explained by the independent variables (Regression) and the variance which is
not explained by the independent variables (Residual).

DF - These are the degrees of freedom associated with the sources of variance. The total
variance has N-1 degrees of freedom. The Regression degrees of freedom correspond to the
number of coefficients estimated minus 1. Including the intercept, there are 4 coefficients, so
the model has 4-1=3 degrees of freedom. The Error degrees of freedom are the DF total
minus the DF model, 22-18 =4.
Mean Square - These are the Mean Squares, the Sum of Squares divided by their respective

F and Sig. - This is the F-statistic the p-value associated with it. The F-statistic is the Mean
Square (Regression) divided by the Mean Square (Residual): 527.959/ 4.562 = 115.724 is
the p-value is compared to some alpha level in testing the null hypothesis that all of the model
coefficients are 0.

Unstandardized Standardized
Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) -27.481 4.414 -6.226 .000
V3 -.188 .081 -.133 -2.334 .031
Forex reserves in USD
.001 .000 .833 17.616 .000
Exports of goods% .053 .061 .041 .863 .400
Lending Rates 2.453 .327 .422 7.490 .000

A. Dependent Variable: Foreign Exchange rates

This column shows the predictor variables (Predictors: Lending Rates, Exports of goods%,
Forex reserves and inflation rate ). The first variable (constant) represents the constant, also
referred as the Y intercept, the height of the regression line when it crosses the Y axis. In
other words, this is the predicted value of factors when all other variables are 0.
B - These are the values for the regression equation for predicting the dependent variable
from the independent variable. The regression equation is presented in many different ways,
for example:


Y predicted = b0 + b1*x1 + b2*x2 + b3*x3

The column of estimates provides the values for b0, b1, b2, b3 and b4 for this equation.

That would be Foreign exchange rate = -27.481 -.188 (CPI) +.001 (Forex reserves) + .053
(Export of goods) + 2.453 (interest rates)
Inflation rate (CPI) - The coefficient for Inflation rate is - .188 so for every unit decrease
in raw material cost is a -.188 unit increase in Foreign Exchange rate is predicted, holding
all other variables constant.

Foreign Exchange Reserves - For every unit increase in Foreign Exchange Reserves we
expect a .001 unit increase in Foreign Exchange rate the holding all other variables constant.

Export of goods - The coefficient for natural gas is .053 So for every unit increase in
Export of goods, we expect an approximately .053 point increase in the Foreign exchange rate
, holding all other variables constant..

Interest rates - For every unit increase in Interest rates we expect a 2.53 unit increase in
Foreign Exchange rate the holding all other variables constant.

Std. Error - These are the standard errors associated with the coefficients


show calculation and data

Variables Entered/Removedb
Variables Variables
Model Entered Removed Method
1 Lending
Exports of
Forex . Enter
reserves in
a. All requested variables entered.
b. Dependent Variable: Foreign Exchange rates

Model Summary
Std. Error of the
Model R R Square Adjusted R Square Estimate
1 .981 .963 .954 2.1359351
a. Predictors: (Constant), Lending Rates, Exports of goods%, Forex reserves

Sum of Mean
Model Squares df Square F Sig.
1 Regression 2111.837 4 527.959 115.724 .000a
Residual 82.120 18 4.562
Total 2193.957 22
a. Predictors: (Constant), Lending Rates, Exports of goods%, Forex
reserves in USD MILLION, V3
b. Dependent Variable: Foreign Exchange rates
Unstandardized Standardized
Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) -27.481 4.414 -6.226 .000
V3 -.188 .081 -.133 -2.334 .031
Forex reserves in USD
.001 .000 .833 17.616 .000
Exports of goods% .053 .061 .041 .863 .400
Lending Rates 2.453 .327 .422 7.490 .000
a. Dependent Variable: Foreign Exchange rates