Foreign Exchange rates

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EXCHANGE RATE

Foreign exchange rate, forex rate or fx rate The price of one currency in terms of another currency (say Euros per dollar or rupees per dollar)is called the exchange rate. It is regarded as the value of one country‟s currency in terms of another country‟s currency.
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Types Of Exchange Rate Trading Systems:

An exchange rate can operate under the following types of exchange rate systems; • Floating exchange rate • Managed floating exchange rate • Fixed exchange rate • Semi fixed exchange rate • Spot exchange rate • Forward exchange rate
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Floating Exchange Rate:
• A country‟s exchange rate for its currency supply & demand for that particular currency relative to others.

• Changes freely • Determined by trading in forex market
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Managed Floating Exchange Rate:
• If currency value moves in one direction at rapid and sustained rate central bank intervene by buying and selling its own currency reserves in foreign exchange market in order to: • Stabilize local currency & • Resist undesirable fluctuations

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Advantages of Floating Exchange rate:
• Fluctuation in exchange rate provide automatic adjustments with large BOP. • Key advantage govt./monetary authority are flexible enough in determining interest rates as they do not need to be used to influence the exchange rate.

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Fixed Exchange Rate:
• Pegged exchange rate. • Govt. or central bank ties the official exchange rate to another country‟s currency. • Purpose: Maintain country‟s currency value within a very narrow band.

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Semi Fixed Exchange Rate:
• Currency can move within a permitted range, but exchange rate is dominant target of economic policymaking. • Interest rates are set to meet the target exchange rate.

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Advantages of Fixed Exchange Rate:
• Greater certainty to importers and exporters. • Also helps govt. maintain low inflation, which in long run should keep interest rates down and stimulate increased trade and investments. • Less speculative activity- though this depends on whether the foreign dealers regard given exchange rate as appropriate and credible.

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Spot Exchange Rate:
• Exchange rate for spot transactions. • Involves immediate (2 days) exchange of bank deposits.

Forward Exchange Rate:
• Exchange rate for forward transactions. • Involves exchange of bank deposits at some specified date in future.

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Foreign Exchange Market:
• It is a place in which participants are able to buy, sell, exchange and speculate on currencies. • Exchange rates are determined. • It is one of the largest financial market in the world made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail Forex brokers and investors.
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• Forex market is not dominated by single market but it is combination of global network of computers and brokers around the world. • Central banks use their massive buying and selling capabilities to alter the exchnage rates through their open market activities. • Forex brokers also act as market makers, and may post bid and ask prices for currency pair that differs from the most competitive bid in the market.

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Importance of Exchange Rates:
• Banks and businesses need to buy currencies because of following reasons: • Settlement of payment against exports. • For making investment in any attractive and profitable opportunity. • For saving purpose. • Settlement of payments against imports.

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Exchange Control:
• Govt. control imposed to ban or restrict the amount of foreign currency or local currency that is allowed to be traded or purchased by the resident or non-residents respectively. • Common exchange controls include: • Banning the use of foreign currency. • Restricting the amount of currency that can be exchanged (imported or exported) within the country. • Banning locals from possessing foreign currency.

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• Restricting currency exchange to govt.approved exchangers. • Fixed exchange rate. • Countries with forex exchange controls are also known as “Article 14 countries” after provisions in IMF agreement allowing exchange control for transitional economies. • It allows greater degree of economic stability by limiting the amount of exchange rate volatility due to currency inflows/outflows.

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Determination of Exchange Rates:
• Like wise the price of goods or assets in free market, exchange rates are determined by interaction of supply and demand.

Law of One Price:
• The starting point for understanding how exchange rates are determined. “In a competitive market, if two goods are identical, then they should sell for the same price.”
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Purchasing Power Parity:
• The most prominent theory. • It states that: “Exchange rates between two countries will adjust to reflect changes in the price level of two the countries.” • It is simply an application of law of one price to national price levels rather than to individual prices.

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Factors That Effects Exchange Rates:
• • • • • Relative price levels Tariffs & quotas Preferences for domestic v/s foreign goods Productivity Increased demand for domestic goods appreciate domestic currency whereas • Increased demand for foreign goods depreciates the domestic currency.
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Relative price levels:
“In the long run, a rise in a country's price level (relative to the foreign price level) causes its currency to depreciate, and a fall in the country's relative price level causes its currency to appreciate.” Mathematical representation: Domestic goods price level demand for foreign goods

Foreign currency will be appreciated and domestic currency will be depreciated.
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Tariffs & Quotas:
• Tariffs means taxes imposed on the imported goods • Quotas refer to the restriction on the quantity of foreign goods that can be imported • They are considered as barriers to free trade. “Tariffs & quotas cause a country’s currency to appreciate in the long run.” Mathematical representation:

Tariffs & Quotas

Imports

Demand for domestic goods
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Domestic currency will be appreciated in long run.

Preferences For Domestic v/s Foreign Goods:
• “Increased demand for a country's exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to depreciate.” Mathematical representation: Exports of a country demand of goods in foreign countries Domestic currency will be appreciated.
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Productivity:
• “In long run, as a country becomes more productive relative to other countries, its currency appreciates.” Mathematical representation: Productivity domestic demand for goods prices domestic goods Domestic currency will be appreciated.

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Factors That Effects Exchange Rates In ShortRun:
• • • • • • • Domestic interest rates Foreign interest rates Expected domestic price level Expected tariffs & quotas Expected import demand Expected exports demand Expected production
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Domestic Interest Rates:
• “In short run, the rise in a country interest rate relative to foreign interest rate will increase the demand for domestic currency as expected return on domestic currency must increase relative to foreign currency and hence its currency appreciates.” Mathematical representation: Interest rate domestic currency demand
Domestic currency will be appreciated.
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Foreign Interest Rates:
• “In short run, when the interest rates offered on foreign currency rises, holding every thing constant, the expected return on these deposits must also increase, increasing the demand for foreign currency that causes foreign currency to appreciate and domestic currency to depreciate.” Mathematical representation: Foreign Foreign currency interest rate demand Domestic currency will be depreciated.

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Expected Domestic Price Level:
• “When continuous increase in the aggregate price level of goods is expected, holding everything else constant, the demand for domestic currency will increase that causes depreciation of domestic currency.” Mathematical representation: Expected price Expected demand level of goods of foreign goods Demand for domestic currency decreases that will depreciate its value.

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Expected Tariffs & Quotas:
• “An increase in expected tariff and quotas imposed by the government will appreciate the domestic currency as imports will be limited in that scenario and domestic goods will have more demand among customers giving boost to domestic industry so that demand for domestic currency increases.” Mathematical representation: Expected demand for tariffs & quotas domestic goods Domestic currency will be appreciated.

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Expected Import Demand:
• “When a country’s expected demand for imports increases, keeping all other things constant, the domestic currency depreciates as the country will need to have more foreign currency for the settlement of payment against goods imported, causing appreciation in the foreign currency.” Mathematical representation: Expected Expected demand Imports demand for domestic goods Domestic currency will depreciate.

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Expected Exports Demand:
• “Whenever the expected exports of any country increases, its currency will be appreciated as the goods produced by the country will have more demand all over the demanding countries.” Mathematical representation: Expected Expected demand exports demand for domestic goods Domestic currency will be appreciated.
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Expected Production:
• “In short run, increase in production is expected by a country, it will have more goods not only to satisfy the domestic needs of its country but also for the export purpose that will cause appreciation in domestic currency.” Mathematical representation: Expected expected domestic Production export level goods demand Domestic currency will be appreciated.
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What is Foreign Remittance?
• Foreign remittance can be defined as „the purchase and sale of freely convertible foreign currencies as admissible under Exchange Control Regulations of the country‟. • A looser translation is the sending of money home while working in a foreign country. • The current figure of foreign remittances in Pakistan is estimated to reach 15 arab 18 crore from overseas Pakistanis to their families in Pakistan.

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Types of Foreign Remittances:
• Foreign outward remittance. • Foreign inward remittance.

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Foreign outward remittance:
• The sending country, where the wage earner is located. The sender uses a bank or foreign exchange company to send money to foreign country. Many of the receiving banks have established remittance relationships with currency houses and banks in other countries to better facilitate the flow of remittances into the country.

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Foreign Inward Remittance:
• The receiving country, where the beneficiary resides. The bank receives the money that has been sent from the sending person in the country in which the money has been earned.

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