B EXCHANGE RATE MANAGEMENT

- Dr. Toufic Ahmad Choudhury

1. Exchange Rate is the rate at which at one national currency is exchanged for
another national currency.

2. Two types of exchange Rate systems:

Fixed and Floating/Flexible.

3. Variants of Fixed Exchange Rate System: In this case, the exchange rate is
determined by a central monetary authority. Variants of Fixed Exchange Rates
are:
● Currency Board: under which the value of local currency is irrevocably fixed
with one strong foreign currency and money supply of the country depends
solely on the reserve of that foreign currency.
● Replacement of Local Currency by some strong foreign
Currency/Dollarization (if replaced by Dollar)
● Currency / Monetary Union: a number of countries will form some
union/make an agreement for using only one currency among themselves.
Example - Euro (€).
● Pegging: under which the value of local currency is pegged or tagged with
one foreign currency (single currency pegging) or more than one foreign
currencies (basket/multiple currency pegging.

4. Variants of Floating Exchange Rate Systems: under which exchange rate will
be determined by the market forces of demand and supply.
● Independent Floating: if the rate is completely depended on demand and
supply
● Managed /Dirty Floating: within broader framework of floating, if there is
interference by the government / central bank, time to time.

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5. Advantages / Disadvantages of Fixed and Floating Rate Systems: Under
fixed, the users are not subjected to fluctuations in exchange rates and therefore,
they can plan their future activities comfortably. However, this is not possible
under floating exchange rate system.

Under floating / flexible system, any sort of BOP problem can be corrected by
exchange rate appreciation or depreciation. However, under fixed system, BOP
problems are addressed through using monetary and fiscal policies.

Finally, the proponents of floating system say that they can also enjoy the
benefits of fixed system (less or no fluctuation in exchange rate) through
adopting some hedging techniques like forward booking, future or option
contracts.

6. Factors Affecting Exchange Rate Movements: Exchange rate movements are

captured by Appreciation (gain in value) or Depreciation (loss in value). The
same gain or loss in value in case of fixed exchange rate system are reflected by
Revaluation and Devaluation respectively. However, under floating exchange
rate system, the movements in exchange rates are influenced by:
● Relative Inflation rates
● Relative Interest rate
● Relative Income levels
● Government controls
● Expectations

7. Evolution of Exchange Rate System in Bangladesh: Started with Single

Currency Pegging in 1972, firstly pegged with Pound Sterling and then shifted to
Dollar Pegging in mid-1970’s; moved to basket currency pegging in mid-1980’s;
and finally moved to floating exchange rate system in May, 2003. Bangladesh
adoption of floating exchange rate system may better be classified as Managed /
Dirty Floating.

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8. Exchange Rate quotations:
Direct: If the ER is expressed in variable units of domestic currency for a fixed
unit(s) of foreign currency. It is also called Pence Rate.

Indirect: If the ER is expressed in variable units of foreign currency per fixed

unit of the domestic currency. It is also called currency rate.

9. Buying and Selling Rates:

Usually an ER quotation has both buying (bid) and selling (ask) rates. The
maxim for finding out buying and selling rates in a quotation system is as
follows:

Buy Low, Sell High.

Difference between buying (bid) and selling (ask) rates is known as Dealing
Spread / Margin or Bid - Ask spread.

10. Spot Rate :

It is an ER for "on the spot" transaction.

11. Cross Rate :

It is a rate to be found out from two given ERs.

12. Calculating Cross Rates:

a) If both currencies involved in the cross transaction are quoted in the same
form (direct or indirect), divide the spot rate of one currency by the spot rate of
the other currency.

Example: If $ / Tk. : 72.50

$/ : .90

Then, / Tk. : 72.50 /.90 = Tk. 80.55

b) If one currency is quoted in one form and the other currency is quoted in
another form, multiply the spot rates.

Example: £/$ : 1.5620

$ / Tk. : 72.50

then, £ / Tk. : 1.5620 ⋅ 72.50 = Tk. 113.25

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13. Forward Rate:
It is an ER for the transaction to be happened at some future date, but agreement
for the transaction is to be done today. Forward rate is quoted either at premium
(+) or at discount (-) over spot rate. In case of direct quotation, premium will be
added to and discount will be subtracted from spot rate. The reverse is true for
indirect quotation. The formula for calculating forward rate:

F = S(1+P) ; F = Forward Rate

S = Spot Rate

P = Premium/Discount

1 + ih
P= - 1; ih = interest rate in home country
1 + if
if = interest rate in foreign country.