FOREIGN EXCHANGE MARKET AND FOREIGN EXCHANGE RATE

CALCULATION IN NIGERIA
PRESENTED BY

S/N Name Registration No.

1 AKPAMA OKPA UKET
2 NJIDEKA IFY NONYELUM AGU
3 LATEEF A. KASHIMAWO
4 IGBANOR MICHAEL ABU
5 RABO ISHAKU BALEWA
6 DAKON POKYES JOSIAH
7 NDAM LOHSEL SAMUEL
8 MARTHE ANAM
9 KAATYO VICTOR DEWER
10 TELEMO THELMA OWOLABI
11 GLORY NKIRE
12 OJEGWO, DEBORAH G.
13 DAMFA MARFE
14 MODU KUR ALI
NSU/ADM/MBA/BUS/469/15/16
NSU/ADM/MBA/BUS/594/15/16
NSU/ADM/MBA/BUS/267/15/16
NSU/ADM/MBA/BUS/222/15/16
NSU/ADM/MBA/BUS/499/15/16
NSU/ADM/MBA/BUS/252/15/16
NSU/ADM/MBA/BUS/315/15/16
NSU/ADM/MBA/BUS/602/15/16
NSU/ADM/MBA/BUS/254/15/16
NSU/ADM/MBA/BUS/509/15/17
NSU/ADM/MBA/BUS/321/15/16
NSU/ADM/MBA/BUS/359/15/16
NSU/ADM/MBA/BUS/151/15/16
NSU/ADM/MBA/BUS/287/15/16

MBA 2 INTERNATIONAL FINANCE (MBA841)

DEPARTMENT OF BUSINESS ADMINISTRATION
FACULTY OF ADMINISTRATION
NASARAWA STATE UNIVERSITY, KEFFI,
KEFFI, NASARAWA STATE.
JUNE 2017

1.0 INTRODUCTION
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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. The forex market is considered the largest financial market in the
world. (Investopedia)

The foreign exchange market – also called forex, FX, or currency market – trades currencies.
Aside from providing a floor for the buying, selling, exchanging and speculation of
currencies, the forex market also enables currency conversion for international trade and
investments.

It enables the use of convertible currencies, such as British pound sterling, US Dollars and
European euro, to facilitate payment for international transactions and businesses. It is the
market that facilitates the exchange of domestic currency (Naira) for these foreign currencies
and the rate at which currencies are traded is called exchange rate.

The foreign exchange market has no physical presence except in a few instances.
Transactions are consummated through telephone conversations between foreign exchange
dealers or the treasurers of big companies.

2.0 CHARACTERISTICS OF THE FOREIGN EXCHANGE MARKET

The forex market has unique characteristics and properties that make it an attractive market
for investors who want to optimize their profits. Some of the main characteristics are:

i. Foreign exchange market is the only market which is open 24 hours a day, except for
weekends unlike equity or commodities market which are open only for few hours.

ii. It is the most liquid market as it trades over $5 trillion per day. The closest market is
the futures market (a contract to buy specific quantities of a commodity or financial
instrument at a specified price with delivery set at a specified time in the future) which
has a volume of $437Billion per day.

iii. Foreign Exchange Market is present in every country and therefore geographically it
is located everywhere in the world, which makes them quite unique

iv. Foreign exchange market is the most difficult market to trade in as the exchange rates
of countries are affected by so many factors like interest rates, liquidity, geo political
factor, etc.

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 v. Foreign exchange market is considered a big player market, because it is mostly the
big banks and government who are the players in the market.

3.0 FOREIGN EXCHANGE MARKETS IN NIGERIA

3.1 PARTICIPANTS IN FOREIGN EXCHANGE MARKET

The major participants in the foreign exchange market in Nigeria are the Deposit Money
Banks (DMBs), the public sector, the Bureaux-de-Change (BDCs) retail customers, and
the CBN. The DMBs constitute the most important institutions involved in the operations
of the foreign exchange market. They buy and sell foreign on behalf of their customers
and hold foreign exchange deposits with correspondent banks abroad for the purpose of
meeting the foreign exchange needs of their customers. The BDCs are foreign exchange
dealers who engage in over-the-counter (OTC) transactions to meet the needs of small-
scale users of foreign exchange. The CBN is a major supplier of foreign exchange in the
market, but it also participates in the buying and selling of foreign exchange (forex)
through the two-way quote system.

3.2 OBJECTIVES OF MANAGING THE FOREIGN EXCHANGE MARKET

The objectives of managing the foreign exchange market are to:

- preserve the external value of the domestic currency and maintain healthy
balance of payments.

- conserve external reserve position;

- reduce to the barest minimum the premium between the official rate and the
parallel market and/or BDCs market rate;

- ensure stability of the Naira exchange rate;

- restructure and diversify the productive base;

- achieve fiscal and BOP viability in the medium term;

- promote non-inflationary growth, etc

3.3 HISTORICAL BACKGROUND

Different mechanisms of managing the foreign exchange market in Nigeria had been
deployed from 1957 to date. During the 1957 to 1986 period, the fixed exchange rate
regime was operated, and it was mostly characterized with overvaluation of exchange
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rate. A major policy reversal took effect in September 1986 when that regime was
abolished and replaced with a flexible exchange rate mechanism under a dual foreign
exchange market - the first and second tier foreign exchange markets.

The first and second tier foreign exchange markets were subsequently merged into a
single market in 1987. By 1992, the official exchange rate was pegged at N21.996 per
US dollar. There was a policy review in 1995 to adopt guided deregulation, under
which Bureaux-De-Change(BDCs) were allowed to buy and sell foreign exchange
while the Autonomous Market for Foreign Exchange Market (AFEM) was also
reintroduced.

In order to further liberalize the foreign exchange market, deepen the inter-bank
market and stabilize the exchange rate, the Inter-bank Foreign Exchange Market
(IFEM) was re-introduced in 1999. The CBN introduced the Retail Dutch Auction
System (rDAS) to replace the IFEM in 2002, under which banks bided on behalf of
their customers. The Wholesale Dutch Auction System (wDAS) was introduced on
February 20, 2006, to consolidate the gains of retail Dutch Auction System (rDAS)
and further liberalize the foreign exchange market. It is an inter-bank forex market for
both spot and forward foreign currency transactions. Under wDAS, banks bided on
their own accounts and exchange rate stabilized around N27.7 per dollar during the
period. Subsequently, there was a persistent appreciation of the nominal exchange
rate, as the rate appreciated by 2.0, 2.3 and 5.8 percent in 2006, 2007 and 2008,
respectively.

Following reports that Nigeria was the largest importer of US Dollar due largely to
importation of cash by DMBs, the CBN suspended the wDAS and reintroduced the
rDAS with effect from 2nd October, 2013.

The fall in oil price which resulted from the glut in the global oil market led to a low
accretion to the external reserves. This development constrained the supply of forex to
the market. This led to deprecation in the exchange rate and widened the spread
between the interbank market rate and the parallel market rate. As a result, the bank
shut the rDAS on 18th February, 2015 and moved all eligible transactions to the
interbank forex market.

In order to sustain the stability of the forex market, ensure its efficient utilization and
derive optimum benefits from goods and services imported into the country, the
importers of the under-listed items were excluded from accessing the Nigerian foreign
exchange market on 23rd June, 2015, to encourage local production of the items. Such
importers are allowed to use their own funds to import the affected items.

1. Rice

2. Cement

3. Margarine
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4. Palm kernel/palm oil products/vegetable oils

5. Meat and processed meat products

6. Vegetables and processed vegetable products

7. Poultry – chicken, eggs, turkey

8. Private airplanes/jets

9. Indian incense

10. Tinned fish in sauce (Geisha)/Sardines

11. Cold rolled steel sheets

12. Galvanized steel sheets

13. Roofing sheets

14. Wheel barrows

15. Head pans

16. Metal boxes and containers

17. Enamelware

18. Steel drums

19. Steel pipes

20. Wire rods (deformed and not deformed)

21. Iron rods and reinforcing bars

22. Wire mesh

23. Steel nails

24. Security and razor wire

25. Wood particle boards and panels

26. Wood fiber boards and panels

27. Plywood boards and panels

28. Wooden doors

29. Furniture

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 30. Toothpick

31. Glass and glassware

32. Kitchen utensils

33. Tableware

34. Tiles – vitrifies and ceramic

35. Textiles

36. Woven fabrics

37. Clothes

38. Plastic and rubber products, cellophane wrappers

39. Soap and cosmetics

40. Tomatoes/tomato pastes

41. Euro bond/foreign currency bond/shares purchases

3.4 RECENT DEVELOPMENTS IN THE FOREIGN EXCHANGE MARKET

In order to enhance the efficiency and facilitate a liquid and transparent Foreign
Exchange (FX) market, the CBN in June 2016 revised the Guidelines on operation of
the Nigerian Inter-Bank FX market towards the liberalization of the market. The
Guidelines indicated that the “CBN shall operate a single market structure through the
autonomous/inter-bank market i.e. the Inter-Bank Foreign Exchange Market with the
CBN participating in the FX market through interventions (i.e. CBN Interventions)
directly in the inter-bank market or through dynamic “Secondary Market Intervention
Mechanisms”.

The CBN would offer additional risk management products to promote the global
competitiveness of the market and support the inter-bank FX market to further deepen
the FX market, boost its liquidity and promote financial security in the market.

Additionally, to further improve the dynamics of the market, the CBN introduced FX
Primary Dealers (FXPDs). These are registered Authorized Dealers designated to deal
with the CBN on large trade sizes on a two-way quote basis. They shall buy and sell
FX among themselves on a two-way quote basis via the FMDQ Thomson Reuters FX
Trading Systems or any other system approved by the CBN.

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3.5 FEATURES OF RDAS

i. Banks bid on behalf of their customers.

ii. Funds purchased must be utilized by the customer within five (5) business days.
Otherwise, they must be returned to the CBN.

iii. Results were announced one day after the auction.

iv. Funds purchased were for the customers for whom they were bought. Such funds
were not to be sold in the inter-bank market or to another customer by the dealing
bank.

v. Dealing banks could not sell funds purchased to CBN.

vi. Dealing banks were debited with Naira on the delivery date (T+2).

vii. Customers determined their buying rates and requested their bankers to buy from
CBN on their behalf at those rates.

viii. Bid schedule submitted by dealing banks bore many details: amount, customer’s
name, address, RC No./Passport No; Form ‘M’ or Form ‘A’ No.

3.6 FEATURES OF WDAS

i. Banks bid on their own account and sell to their customers.

ii. Rules were silent on the return of funds to the CBN and the DMBs (Deposit Money
Banks) were under no compulsion to do so.

iii. Results are announced same day; latest by 12 noon.

iv. Funds purchased could be sold inter-bank or to any customer by the dealing bank.

v. Dealing banks could sell funds purchased to CBN.

vi. Dealing banks were debited with Naira on the bid day. Their accounts were to be
funded two days prior to the bidding date.

vii. Dealing banks quoted two-way and displayed conspicuously their buying and selling
rates in their banking halls.

viii. Bid schedules were simplified. Dealing banks were required to provide just the name
of the bank, its code, the amount and the bid rate.

3.7 STRUCTURE OF THE FOREIGN EXCHANGE MARKET IN NIGERIA

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The Nigerian forex market is made up of the spot market and the forward market. In a
spot market transaction, delivery and payment of forex purchased take place
instantaneously or on a t+2 basis, while delivery under a forward contract may have a
tenor of 1, 2 or 3 months. Forward transactions occur at the official segment of the
market.

a. OFFICIAL WINDOW

The major player in the official forex market is the CBN which supplies the highest
volume of forex in the market. The Bank also intervenes in the market to moderate
volatility and influence the direction of exchange rates. The official window operates
either the rDAS which enable the sale of forex to end-users, or wDAS which allows
the authorized dealers to buy forex on their own account.

b. INTER-BANK SEGMENT

The inter-bank segment comprises the CBN, authorized DMBs, private oil companies
such as Shell, Mobil, Total, Nigerian National Petroleum Corporation (NNPC) as well
as Nigerian Ports Authority. Some of these participants deal in forex through their
operations thus influence the pressure in the official market. For instance, if volume
traded in the inter-bank market is high, the demand pressure in the official market is
eased and vice versa.

c. BUREAUX-DE-CHANGE SEGMENT

The BDCs are operated by DMBs, private money market operators such as Travelex
and corporates/individuals. They buy and sell forex to small end-users.

d. FOREX FORWARD CONTRACT SEGMENT

The forward forex window allows formal agreements between two parties, in which
the terms of agreement clearly stipulate the quantity of currency to be exchanged,
where and when the currency will be delivered, and at an agreed exchange rate. The
forward price for individual currency is what parties to the contract agreed or
contracted to pay now in order to buy the currency in a specific future date. In a
forward market, the price of each currency is determined immediately (i.e. at the
transaction date), but the payment and delivery are not carried out until maturity. The
maturity date is also called ‘value date’. The rates at which currencies are traded in
the forward segment of foreign exchange market is called ‘forward rate’. The forward
transaction only accounts for a small proportion of total foreign exchange transactions
globally.

e. FOREX FUTURES

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 Foreign exchange futures market is an organized market or exchange where currency
futures contracts are traded. A currency future contract is a standardized agreement
between two parties to fix today the price to buy or sell a specific currency at a future
date. The standardized features make the contract tradable up to its maturity date at
the futures market or exchange. This makes the futures contract more liquid than the
forward contract, although the two have similar features. Some of the differences
between forward and futures contracts are that futures contracts are mostly exchange-
listed while forward contracts are not. Forward contracts can be tailored to fit a
buyer’s specific requirements and are held up to maturity, while futures contracts are
standardized which make them tradable on commodity exchanges and can be closed
before the maturity date.

f. FOREX SWAPS

This is a contract between two parties to exchange one currency for another currency
at a set exchange rate and date (start date) and to re-exchange the two currencies at an
agreed rate at a specified future date (end date). The exchange rates are agreed upon at
the time the swap is initiated. In this way, any exposure to exchange rate variations
during the period of the forex swap is removed. Thus, a foreign exchange swap is a
concurrent buying and selling transaction with two settlement dates and rates (swap
rates). The exchange rate for each of the transaction is usually different and this
difference is called ‘swap points’.

g. FOREX OPTIONS

This is a contract in which two parties agree to buy or sell a specific currency at a
stated exchange rate, on or before a specific date. Under this arrangement, the buyer
has the right but not obligated to execute the option, while the seller is obligated to
comply once the buyer exercises the option since he has already been compensated
through the price or premium of the option. There are two types of options: call and
put options. The difference between the two is the kind of right the buyer has. While
the call option gives the buyer the right to buy, the put option gives the seller the right
to sell an agreed currency at a specific exchange rate, at a specific date.

3.8 CHALLENGES OF FOREX MANAGEMENT IN NIGERIA

Some of the challenges facing the forex market in Nigeria are:

i. The inconvertibility of the Naira

ii. Instability of forex flows;

iii. Lack of trust among dealers (e.g. DMBs): need for market discipline, playing
the game by the rules and effective supervision by the regulatory authorities.

iv. Dwindling reserve position.

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 v. Developments in the international oil market

vi. Capital account liberalization

vii. CBN role in the forex Market - the frequency of the Bank in the market, the
volume of forex supplied and its sustainability.

4.0 FOREIGN EXCHANGE RATE

This is the equivalent of the foreign currency that is obtainable from a unit of the
domestic currency. Exchange rates allow you to determine how much of one currency
you can exchange for another. For example, the dollar exchange rate indicates how
much a dollar is worth in relation to a foreign currency, and vice versa. The rate is
determined by market forces in the forex market. It is the bid rate quoted and agreed
by forex dealers (buyers and sellers) of forex in the market. The bids could be offered
through direct quote or indirect quote.

Direct Quote: This is the number of units of a domestic currency that exchanges for
one unit of a foreign currency. Since the advent of SAP in 1986 Nigeria adopted
direct quote of exchange. It is a common thing in the banking halls to see a quote
stated as follows N314.25/US$. This means that N314.25 is being offered to buy
1US$.

Indirect Quote: An indirect quote is the amount of a foreign currency that can be
exchanged for one unit of the domestic currency. An indirect quote between US$ and
Nigerian Naira will be stated as US$0.003/N1.

Factors affecting fluctuations in Exchange Rates

i. The supply and demand for the foreign currency

ii. The supply and demand for the local currency
iii. Global inflation rates and its effect on the domestic rate of inflation
iv. Economic performance: Local economic conditions including production of
goods for export and local interest rate, gross domestic product and balance of
payment
v. The political environment in and out of the country.
vi. International confidence in the Naira reflecting international confidence in
domestic economic management policies
vii. Interest rate
viii. Speculative activity
ix. Volume and Terms of trade
x. Current account deficits
xi. Public and foreign debt positions

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 A variety of exchange rates exist in the foreign exchange market at any particular time
depending on the market segment (inter-bank, spot, forward, BDCs, etc.) and credit
instruments used in the transfer function. The major types of exchange rates are as
follows:

4.1 SPOT RATE:

Spot rate of exchange is the rate at which foreign exchange is bought and sold in the spot
market. It is also known as cable rate or telegraphic transfer rate because at this rate cable
or telegraphic sale and purchase of foreign exchange can be arranged immediately. Spot
rate is the day-to-day rate of exchange. The spot rate is quoted differently for buyers and
sellers. For example, $ 1 = NGN 314.25 for buyers and $ 1 = NGN313.75 for seller. This
difference is due to transport costs, insurance charges, dealer's commission, etc. These
costs are borne by the buyers.

For most currencies, only a spot rate is quoted. Spot exchange is foreign exchange for
immediate delivery that is used for international payments (for imports and investment).
The daily quotations are for bank (cable) transfers. While transactions between these
banks are instantaneous, these funds become available for use by customers 1-2 working
days after the purchase. Transactions agreed on Monday will result in payments on
Wednesday. Those agreed on Thursday will be available on Monday. Canadian/US dollar
business is cleared in one day (because Toronto and New York are in the same time
zone). Some New York banks maintain 2 shifts (one arriving at the office at 3 am when
London and Frankfurt are open). Large New York banks also have branches in Tokyo,
Frankfurt, and London. Thus, they are in contact with all financial centres 24 hours.
When a Foreign exchange dealer or broker quotes a price on the telephone, he can be held
to it for only a few seconds (It used to be up to 1 minute). Dealers may quote different
prices to different customers. Prices change throughout the day.

4.2 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.

a. What is a forward premium?

A forward premium occurs when dealing with foreign exchange (FX); it is a situation

where the forward exchange rate, with respect to the domestic currency, is trading at a
higher exchange rate than it is currently.

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b. What is a forward discount?

A forward discount means the market expects the domestic currency to depreciate against
another currency, but that is not to say that will happen. Although the
forward expectation's theory of exchange rates states this is the case, the theory does not
always hold.

c. What is a currency forward?

An FX forward contract is an agreement to purchase or sell a set amount of a foreign

currency at a specified price for settlement at a predetermined time in the future.
“Closed” forward contracts must be settled at an exact date that is the future exchange
rate and date on which they will make a foreign exchange transaction.

d. Calculation of Forward Discount/Premium Rate

Forward exchange rates are often quoted at a discount or premium to the spot exchange
rate. Mathematically, this can be determined using the formula below:

(FR-SR/SR)(12months/No. of months forward)*100

Where FR is the Forward Rate

SR is the Spot Rate

Illustration 1

Given the following quotes

Spot Rate SFr/$ = 1.3598
3 months Forward Rate SFr/$ = 1.3471

Question

1) Is the Dollar trading at a discount or premium?

2) What is the annualised forward premium or discount?

Solution

1) The Dollar quotes at a discount while the Swiss Franc quotes at a premium.

2) Annualised forward premium/discount

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Where SR = 1.3598
FR = 1.3471
Number of months forward = 3 months

Annualised forward premium/discount –AFP/AFD

AFD/PR = (FR-SR/SR)(12months/No. of months forward)*100

= {(1.3471-1.3598)/1.3598}{12/3}*100
= {-0.0127/1.3598}{4}*100
= {-0.00934*4)*100
= -.03736*100
= -3.73%

This implies that the Dollar trades at discount of 3.73% whereas the Swiss Franc trades at
a premium of 3.73%.

4.3 CROSS RATE:

The American Dollar is the number one currency in the world. Consequently, each
country has her currency quoted (for exchange conversion) in Dollars. If there are two
countries without direct conversion ratio between them, a conversion can still be carried
out by using the relationship between two foreign currencies expressed in terms of a third
currency (the US$).

Illustration:

Given an exchange rate of N126/$ and Cede140/$, what is the exchange rate quoted for
Cedes/N?

N/$ = 126 or $/N = 1/126

Cedes/$ =140 or $/Cedes =1/140

Cedes/N = Cedes/$ * $/N

= 140/1 * 1/126

= 140/126

= 1.1111

4.4 FIXED RATE:

Fixed or pegged exchange rate refers to the system in which the rate of exchange of a
currency is fixed or pegged to the value of gold or another currency.

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4.5 FLEXIBLE RATE:

Flexible or floating exchange rate refers to the system in which the rate of exchange 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.

4.6 MULTIPLE RATES:

Multiple rates refer to a system in which a country adopts more than one rate of exchange
for its currency. Different exchange rates are fixed for importers, exporters, and for
different countries.

4.7 TWO-TIER RATE:

Two-tier exchange rate system is a form of multiple exchange rate system in which a
country maintains two rates, a higher rate for commercial transactions and a lower rate for
capital transactions. Some countries, such as Venezuela, employ different rates
depending on the entities involved in the exchange. These currency systems often have a
two-tier setup with floating rates for trades conducted by private commercial entities and
fixed rates for exchanges involving “essential” or governmental bodies, including
importers and exporters. Rates for vital entities also are often higher to encourage these
kinds of transactions.

4.8 TYPES OF FOREIGN EXCHANGE RATES SYSTEM

Some of the major types of foreign exchange rate systems are as follows: 1. Fixed
Exchange Rate System 2. Flexible Exchange Rate System 3. Managed Floating Rate
System.

a. Fixed Exchange Rate System (or Pegged Exchange Rate System).:

Fixed exchange rate system refers to a system in which exchange rate for a currency is
fixed by the government. 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.

1. The basic purpose of adopting this system is to ensure stability in foreign trade and
capital movements.

2. To achieve stability, Central Bank undertakes to buy foreign currency when the
exchange rate becomes weaker and sell foreign currency when the rate of exchange gets
stronger.

3. For this, Central Bank has to maintain large reserves of foreign currencies to maintain
the exchange rate at the level fixed by it.

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 4. Under this system, each country keeps value of its currency fixed in terms of some
‘External Standard’.

5. This external standard can be gold, silver, other precious metal, another country’s
currency or even some internationally agreed unit of account.

6. When the value of domestic currency is tied to the value of another currency, it is
known as ‘Pegging’.

Advantages of fixed exchange rates

 Certainty - with a fixed exchange rate, firms will always know the exchange rate and
this makes trade and investment less risky.
 Absence of speculation - with a fixed exchange rate, there will be no speculation if
people believe that the rate will stay fixed with no revaluation or devaluation.

 Constraint on government policy - if the exchange rate is fixed, then the government
may be unable to pursue extreme or irresponsible macro-economic policies as these
would cause a run on the foreign exchange reserves and this would be unsustainable
in the medium-term.

Disadvantages of fixed exchange rates

 The economy may be unable to respond to shocks - a fixed exchange rate means that
there may be no mechanism for the government to respond rapidly to balance of
payments crises.
 Problems with reserves - fixed exchange rate systems require large foreign exchange
reserves and there can be international liquidity problems as a result.

 Speculation - if foreign exchange markets believe that there may be a revaluation or

devaluation, then there may be a run of speculation. Fighting this may cost the
government significantly in terms of their foreign exchange reserves.

 Deflation - if countries with balance of payments deficits deflate their economies to

try to correct the deficits, this will reduce the surpluses of other countries as well as
deflating their own economies to restore their surpluses. This may give the system a
deflationary bias.

 Policy conflicts - the fixed exchange rate may not be compatible with other economic
targets for growth, inflation and unemployment and this may cause conflicts of
policies. This is especially true if the exchange rate is fixed at a level that is either too
high or too low.

b. FLEXIBLE EXCHANGE RATE SYSTEM (OR FLOATING EXCHANGE

RATE SYSTEM)

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 Flexible exchange rate system refers to a system in which exchange rate is determined
by forces of demand and supply of different currencies in the foreign exchange
market.

1. The value of currency is allowed to fluctuate freely according to changes in

demand and supply of foreign exchange.

2. There is no official (Government) intervention in the foreign exchange market.

3. Flexible exchange rate is also known as ‘Floating Exchange Rate’.

4. The exchange rate is determined by the market, i.e. through interactions of

thousands of banks, firms and other institutions seeking to buy and sell currency for
purposes of making transactions in foreign exchange.

Advantages of floating exchange rates

 Protection from external shocks - if the exchange rate is free to float, then it
can change in response to external shocks like oil price rises. This should
reduce the negative impact of any external shocks.
 Lack of policy constraints - the government is free with a floating exchange
rate system to pursue the policies they feel are appropriate for the domestic
economy without worrying about them conflicting with their external policy.

 Correction of balance of payments deficits - a floating exchange rate can

depreciate to compensate for a balance of payments deficit. This will help
restore the competitiveness of exports. There is a link to Figure 1 below which
illustrates the operation of the automatic adjustment mechanism under a
floating exchange rate system.

Disadvantages of floating exchange rates

 Instability - floating exchange rates can be prone to large fluctuations in value
and this can cause uncertainty for firms. Investment and trade may be
adversely affected.
 No constraints on domestic policy - governments may be free to pursue
inappropriate domestic policies (e.g. excessively expansionary policies) as the
exchange rate will not act as a constraint.

 Speculation - the existence of speculation can lead to exchange rate changes

that are unrelated to the underlying pattern of trade. This will also cause
instability and uncertainty for firms and consumers.

Fixed Exchange Rate System Vs Flexible Exchange Rate System:

Basis Fixed Exchange Rate Flexible Exchange Rate

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 Determination ofIt is officially fixed in terms of gold orIt is determined by forces of
Exchange Rate: any other currency by government. demand and supply of foreign
exchange

Government Control:There is complete government controlThere is no government

as only government has the power tointervention and it fluctuates
change it. freely according to market
conditions.

Stability in ExchangeThe exchange rate generally remainsThe exchange rate keeps on

Rate: stable and only a small variation is changing.
possible.

c. MANAGED FLOATING RATE SYSTEM:

Traditionally, International monetary economists focused their attention on the

framework of either fixed or flexible exchange rate system. With the end of the
Bretton Woods’s system, many countries adopted the Managed Floating Exchange
Rate system. It is also known as ‘Dirty Floating’.

It refers to a system in which foreign exchange rate is determined by market forces

and central bank influences the exchange rate through intervention in the foreign
exchange market.

1. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.

2. In this system, central bank intervenes in the foreign exchange market to restrict the
fluctuations in the exchange rate within certain limits. The aim is to keep exchange
rate close to desired target values.

3. For this, central bank maintains reserves of foreign exchange to ensure that the
exchange rate stays within the targeted value.
5.0 THEORY OF FOREIGN EXCHANGE DETERMINATION

5.1 PURCHASING POWER PARITY

 
Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are
in equilibrium when their purchasing power is the same in each of the two countries. This means
that the exchange rate between two countries should equal the ratio of the two countries' price level
of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a
country experiences inflation), that country's exchange rate must be depreciated in order to return to
PPP.

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The basis for PPP is the "law of one price". In the absence of transportation and other transaction
costs, competitive markets will equalize the price of an identical good in two countries when the
prices are expressed in the same currency. For example, a particular TV set that sells for 750
Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the
exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver
was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this
process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian
goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to
them. This process continues until the goods have again the same price. There are three caveats
with this law of one price.
(1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be
significant.
(2) There must be competitive markets for the goods and services in both countries.
(3) The law of one price only applies to tradable goods; immobile goods such as houses, and many
services that are local, are of course not traded between countries.

Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP;

Absolute PPP was described in the previous paragraph; it refers to the equalization of price levels
across countries. Put formally, the exchange rate between Canada and the United States
ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United
States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3
CAD per 1 USD. If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies
that the CAD will appreciate (get stronger) against the USD, and the USD will in turn depreciate
(get weaker) against the CAD.

Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states
that the rate of appreciation of a currency is equal to the difference in inflation rates between the
foreign and the home country. For example, if Canada has an inflation rate of 1% and the US has
an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year.
This proposition holds well empirically especially when the inflation differences are large.
  
PPP does not determine exchange rate in the short term. Exchange rate movements in the short
term are news-driven. Announcements about interest rate changes, changes in perception of the
growth path of economies and the likes are all factors that drive exchange rates in the short run.
PPP, by comparison, describes the long run behaviour of exchange rates. The economic forces
behind PPP will eventually equalize the purchasing power of currencies. This can take many years.
A time horizon of 4-10 years would be typical.
 
The simplest way to calculate purchasing power parity between two countries is to compare the
price of a "standard" good that is in fact identical across countries. Every year The
Economist magazine publishes a light-hearted version of PPP: it’s "Hamburger Index" that
compares the price of a McDonald's hamburger around the world. More sophisticated versions of
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PPP look at a large number of goods and services. One of the key problems is that people in
different countries consume very different set of goods and services, making it difficult to compare
the purchasing power between countries.

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REFERENCES:

1. Wilfred J. Ethier: Modern International Economics, 3rd edition. W. W. Norton &

Comp., New York/London: 1995.Chapter 18, section 2 on "Price Linkages" contains
an excellent non-technical overview of PPP
2. Kenneth Rogoff: The Purchasing Power Parity Puzzle, Journal of Economic
Literature, 34(2), June 1996, pages 647-668
3. Chief Oye Akinsulire: Financial Management, 5th edition
4. I.B.B. Shettima: Wholesale Dutch Auction System And Exchange Rate Management
in Nigeria, Trade & Exchange Department, Central Bank of Nigeria, 2007

5. Z. A. Okorocha: Exchange Rate Management And The Retail Dutch Auction System,
2009

6. Central Bank of Nigeria, CBN Briefs 2012 – 2013 Edition

7. Central Bank of Nigeria, CBN Briefs 2014 – 2015 Edition

8. Central Bank of Nigeria, Central Banking in Nigeria 1958 to 2008

9. Central Bank of Nigeria: Revised Guidelines for the Operation of The Nigerian Inter-
Bank Foreign Exchange Market issued, June 2016
10. Central Bank of Nigeria: Education in Economics Series 4: Foreign Exchange Rate,
2016

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SUGGESTED QUESTIONS

1) Write short notes on the following:

a. Spot market

b. Forward market

c. Parallel market

d. Inter-bank market

2a) What are the factors that influence the foreign exchange rate in Nigeria?

b) What in your opinion informed Nigeria’s decision to ban the sourcing of forex from
the official foreign exchange market segment for importation of 41 items in 2015?

3a. If the ninety day ¥ / $ forward exchange rate is 109.50 and the spot rate
is ¥ / $ = 109.38.

i. Which currency is trading at a discount and at a premium?

ii. Would the Dollar currency be considered as a strong currency relative to yen and why?
iii. What is the premium on currency?
iv. What is the annualized forward premium or discount?

b) Why would you pick flexible exchange rate system over fixed exchange rate system?

c) Write short notes on the following:

i. Fixed exchange rate

ii. Floating exchange rate

iii. Managed floating exchange rate

SUGGESTED SOLUTIONS

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