International Financial Manageme

nt

seminar

Submitted To. Submitted By

Deepthi miss. Aiswarya S Dev
Dept.of Commerce. M Com, S3
EXCHANGE RATE MECHANISM
&
EXCHANGE RATE THEORIES
 Exchange Rate
Exchange rate is the rate at which on
e currency is exchanged for another.

eg: INR 71.48=$1

EXCHANGE RATE MECHANISM (ERM)

• Device used to manage or control a countries cu

rrency exchange rate relative to other currenci
es.
• Eg: European Exchange Rate Mechanism

• Objective of ERM
• Keep exchange rate stable
• minimize currency rate volatility
 Types of ERM

• Floating ERM: Exchange rate is determined by forces o

f demand and supply
• Allow currencies to trade without intervention by Govt.

• Fixed ERM: It involves any measure necessary to keep r

ates set at particular value.

• Managed ERM: Falls somewhere between these two ca

tegories.
 EXCHANGE RATE THEORIES

•Mint Parity Theory

•Purchasing Power Parity Theory(PPP )

•Balance of Payment Theory

 Mint Parity Theory
• The earliest theory of foreign exchange
• Applicable for those countries having same metallic s
tandard ( gold standard)
• Exchange rate is determined on the basis of mint pari
ty of one currency relative to another.
• Mint parity of currency refers to weight of gold of a s
pecified purity contained init.
• Suppose currency A contains 10 gram of gold and cur
rencyvB contains 5 grams of gold,,then rate of exchan
ge or mint rate is 1A=2B
Conti........
Criticism
•None of the countries in the world follow gold or me
tallic standard
•Most of the countries today are on paper standard
•Free buying and selling of gold internationally not pe
rmitted.
 PPP THEORY
• PPP Theory was proposed byDavid Ricardo, 19 the cen
tury, but popularized by Gustav Cassel in 1920's
• According to this theory exchange rate of a commodit
y is determined on the basis of pp of the currency.
• The Theory considers foreign exchange as a commodit
y.
• Thus, to determine the exchange rate, pp of 2 currenci
es can be considered.
Conti.....
Assumptions
•Exist perfect market condition
•Absence of transportation cost
•Free trade
•No barriers or control
•No country is strong enough to influence exchange r
ate
•This theory is based on "Law of One Price"
• BoP Theory \ Demand and supply Theor
y
• Foreign exchange rate is determined by market forces su
ch as demand and supply
• The forces of demand and supply are determined by vari
ous items in BoP of a country
• The demand for foreign exchange arises from the debit it
ems in the BoP and the supply of foreign exchange arises
from the credit items.
Conti......
Criticism
• It assumes perfect competition and non-intervention of gov
t. in Forex market. This is not realistic
• It doesn't explain what determine the internal value of a cur
rency
• As per this theory there is no connection between rate of ex
change and internal price level; but there should be some c
onnections
• There is a tautority of whether BoP determines the rate of
exchange or viceversa
Thank you ............