EXCHANGE RATE

DETERMINATION
 FOREIGN EXCHANGE
• Popularly referred to as "FOREX"
• The conversion of one country's currency into
that of another.
• It is the minimum number of units of one
countries currency required to purchase one
unit of the other countries currency.
• What is 'Forex - FX'
• Forex (FX) is the market in which currencies
 are traded. The forex market is the largest,
most liquid market in the world with an
average traded value that exceeds $1.9 trillion
per day and includes all of the currencies in
the world.
 BREAKING DOWN 'Forex - FX'
• There is no central marketplace for currency
exchange; trade is conducted over the counter. The
forex market is open 24 hours a day, five days a
week and currencies are traded worldwide among
the major financial centers of London, New York,
Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris
and Sydney.

The forex is the largest market in the world in terms

of the total cash value traded, and any person, firm
or country may participate in this market.
 WHY IT NEEDED???.....
• Different countries have different currencies with
different values….
Example: India - Rupees
America -Dollar
China - Yuan
• When trade takes place…..
the persons of these countries have to
convert their currencies to other countries
currencies to make payments
• For this purpose the concept of foreign
exchange come into operation.
• Under mechanism of international payments,
the currency of a country is converted in to
the currency of another country through
FOREIGN EXCHANGE MARKET.
• The effect of globalization and international
trade
• Increased import and export
FOREIGN EXCHANGE MARKET
• Also called “FOREX” market.
• It is the place were foreign moneys were
bought and sold.
• It involves the buying of one currency and
selling of another currency simultaneously.
• Exchange rates are determined here….
• Has no geographical boundaries…..
 TYPES OF FOREX TRANSACTIONS
• 1. SPOT RATE
• 2. FORWARD RATE
 E.R OF US vis-à-vis Japan
CATEGORIES USD YEN
1.US Tourist love Japan S ↑ DEP. D ↑ APP.

2. US Govt. goes for a tax S ↑ DEP. D ↑ APP.

cut
3. Higher Inflation in Japan D ↑ APP. S ↑ DEP.
4. Higher interest rates in S ↑ DEP. D ↑ APP.
Japan
5. Low interest rates in US D ↓ DEP. S ↓ APP.
6. US experiences a S ↓ APP. D ↓ APP.
recessionary gap
 FOREIGN EXCHANGE RATE
• It is the rate at which one currency will be
exchanged for another in foreign exchange.
• It is also regarded as the value of one
country’s currency in terms of another
currency.
There are three basic types;
Fixed rate
Floating rate
Managed rate
 FIXED EXCHANGE RATE
• It is the system of following a fixed rate for
converting currencies.
• In this system, the government (or the central
bank acting on its behalf) intervenes in the
currency market in order to keep the
exchange rate close to a fixed target.
• It does not allow major fluctuations from the
central rate.
 Advantages
 It provide the stability of exchange rate.
 Fixed rates provide greater certainty for
exporters and importers.

Disadvantages
 Too rigid to take care of major upheavals.
 Need large reserves to defend the fixed
exchange rate.
 May cause destabilizing speculations; most
currency crisis took place under a fixed
exchange system.
 FLOATING/FLEXIBLE
EXCHANGE RATE
• Under the flexible exchange rate system, the
rate of exchange is allowed to vary to suit the
economic policies of the government.
• Flexible exchange rates are exchange rates,
which fluctuate according to market forces.
• The value of the currency is determined solely
by the forces of demand and supply in the
exchange market.(self correcting mechanism)
 Advantages

 Automatic adjustment for countries with a

large balance of payments deficit.
 Flexibility in determining interest rates
 Allow countries to maintain independent
economic policies.
 Permit a smooth adjustment to external
shocks.
 Don't need to maintain large international
reserves.
Disadvantages
 Flexible exchange rates are highly unstable so
that flows of foreign trade and investment
may be discouraged.
 They are inherently inflationary.
 MANAGED EXCHANGE RATE
• Managed exchange rate systems permit the
government to place some influence on an
exchange rate that would otherwise be freely
floating.
• Managed means the exchange rate system
has attributes of both systems.
• Through such official interventions it is
possible to manage both fixed and floating
exchange rates.
 Simple Mechanism of Demand &
Supply
• As stated earlier exchange rate is determined
by its the forces of supply and demand.
• Therefore, if for some reason people increase
their demand for a specific currency, then the
price will rise provided that the supply
remains stable.
• On the contrary, if the supply is increased the
price will decline and it is provided that the
demand remains stable.
CASE
INTEREST RATE
 Purchasing Power Parity Theory (PPP Theory)

• Most widely accepted theory

“According to PPP theory, when exchange rates
are of a fluctuating nature, the rate of exchange
between two currencies in the long run will be
fixed by their respective purchasing powers in
their own nations.”

• i.e the price of a good that is charged in one

country should be equal to the one charged for
the same good in another country, being
exchanged at the current rate.
• This rule is also known as the law of one price.
• It is an economic theory that estimates the
amount of adjustment needed on the
exchange rate between countries in order for
the exchange to be equivalent to each
currency's purchasing power.
CASE
 The Balance of Payment Theory
• The balance of payments approach is another method
that explains what the factors are that determine the
supply and demand curves of a country’s currency.
• As it is known from macroeconomics, the balance of
payments is a method of recording all the international
monetary transactions of a country during a specific
period of time.
• The transactions recorded are divided into four
categories: the current account transactions, the
capital account transactions, financial account and the
central bank transaction.
 CURRENT ACCOUNT

export and import of goods &services

CAPITAL ACCOUNT

Capital transfers
FINANCIAL TRANSFERS

Foreign direct investment

Portfolio investment
RESERVEBANK TRANSACTIONS
• According to the theory, a deficit in the balance of
payments leads to fall or depreciation in the rate of
exchange, while a surplus in the balance of payments
strengthens the foreign exchange reserves, causing an
appreciation in the price of home currency in terms of
foreign currency. A deficit balance of payments of a
country implies that demand for foreign exchange is
exceeding its supply.
• As a result, the price of foreign money in terms of
domestic currency must rise, i.e., the exchange rate of
domestic currency must fall. On the other hand, a
surplus in the balance of payments of the country
implies a greater demand for home currency in a
foreign country than the available supply. As a result,
the price of home currency in terms of foreign money
rises, i.e., the rate of exchange improves.
 DETERMINANTS OF FOREIGN
EXCHANGE RATE
1. Interest Rate
Whenever there is an increase interest rates in domestic
market there will be increase investment funds causing a
decrease in demand for foreign currency and an increase in
supply of foreign currency.
2. Inflation Rate
when inflation increases there will be less demand for
local goods (decreased supply of foreign currency) and more
demand for foreign goods (increased demand for foreign
currency).
3. Government budget deficit or surplus
The market usually react negatively to widening
govt. budget deficits and positively to narrowing
budget deficits. This will result in change in the
value of countries currency.
4. Political conditions
Internal, regional and international political
conditions and events can have a profound effect
on currency market