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Episode 3.
The idea of Foreign Exchange
Exchange – the dictionary gives the following meaning

(n.) The thing given or received in return; esp., a publication exchanged for another.
(n.) To part with for a substitute; to lay aside, quit, or resign (something being received in
place of the thing parted with); as, to exchange a palace for cell.
(n.) To part with give, or transfer to another in consideration of something received as an
equivalent; -- usually followed by for before the thing received.
(v. i.) To be changed or received in exchange for; to pass in exchange; as, dollar exchanges
for ten dimes.

The above definitions lay the foundation for not only business in general (as I feel business
in every part is an exchange be it exchange of goods, knowledge, service or money or
whatever) and all the more particularly for the forthcoming pages of this book.

So what is Exchange rate? It is nothing but the price of X currency with respect to Y
currency. That is if you go to the local shop and he is selling Dollars, then the exchange rate
is nothing but how many rupees (the author is Indian!!!) you would have to give to get one
dollar.

For example if you get one dollar for Rs 46.10 then the exchange rate is give as
INR46.10/$ (i.e 46.10 Rupees for every dollar) – here the Rupee is the reference
currency. Vice versa $ 1÷46.10/INR would denote that the dollar is the Reference
currency.

Thus the idea of Forex (the more commonly term used for Foreign Currency Exchange,
though mostly people use Foreign Exchange) stems from the fact that a currency can be
treated like any other commodity you generally buy in the market and for buying it you just
need to pay the price denominated in the other currency you can offer.

Forex Market (FX Market): There is no one supermarket or shop where you buy or sell
currencies it is more of a virtual place which is defined by different activities and physical

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actions taking place across the world. When you give dollars in return for Yuan’s at Beijing
airport, or you pay your supplier in INR for imports from India, or you go to the bank and
encash a dollar denominated travellers cheque, or you buy a product from London thru e-
bay and pay through your Indian credit card, or your company signs a contract to supply
products to Tokyo at a future date in exchange for payment in Yens you are being a part of
the so called Forex Market.

The Forex market is the biggest market in the world. Latest estimates put the volume of
transactions in the market each day at approx $3.8 Trillion dollars (1 trillion = 1000
billion, 1 billion= …..). It is a market that works 24 hours a day, 7 days a week and 365
days a year or 366 if leap year!!!

From the previous two paragraphs we also realise that the participants in the forex market
can be listed as below:
Banks and financial institutions: these are probably the biggest participants as they buy
and sell for their own use as well as on behalf of their customers.

Million, Billion, Trillion...

Number of zeros U.S. & scientific community India Other countries
3 thousand Thousand thousand
6 million Ten lakhs million
9 billion 100 crores 1000 million (1 milliard)
12 trillion 100000 Crores billion
15 quadrillion 1000 billion
18 quintillion trillion
21 sextillion 1000 trillion
24 septillion quadrillion
27 octillion 1000 quadrillion
30 nonillion quintillion
33 decillion 1000 quintillion
36 undecillion sextillion
39 duodecillion 1000 sextillion
42 tredecillion septillion
45 quattuordecillion 1000 septillion
48 quindecillion octillion
51 sexdecillion 1000 octillion
54 septendecillion nonillion
57 octodecillion 1000 nonillion
60 novemdecillion decillion
63 vigintillion 1000 decillion
66 - 120 undecillion - vigintillion
303 centillion

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Brokers: these are the intermediaries who help the market run similar to the brokers in
the stock markets or even commodity markets. They are in the market for making profits as
stand alone businessmen or on behalf of others which could include banks or Corporates or
individuals too.

Customers: Companies and individuals require Forex for business, for travel or for even
making profits by arbitrage or using futures etc. They are in the market more for needs.
And probably are the main driving forces of the market by creating demand.

Central Banks: The main bank of each nation is called the central bank. It is usually the
authority on all money related policies in a country. In India its called the Reserve Bank Of
India, In the United states its called as the Federal Reserve. The Central banks are
participants in the Forex markets in two ways. One is creating reserves of foreign currency
and two to influence the value of their own currency (a process called intervention which
will be discussed later in the book- page number- )

From the above discussions we can understand that the participants are in the market for
one of the following reasons:
• To earn short-term profits
• Protecting themselves against fluctuations
• Getting forex required for buying goods and services.

Based on the type of transactions the Forex Mkt is called by the below names:

Spot market: This is the market where the currencies are traded immediately or for
delivery in a short span. Hence the rate in the spot market is called the Spot rate. That is if
today you go to the shop to buy dollars this is the price for dollars.

Forward market: This is the market where the trade is finalised today in form of a contract
and the actual transaction could take place somewhere in the future. This could range from
30 days to over a year too. This is called as the Forward rate. That is if you tell the
shopkeeper you will buy dollars after 180 days what will be the rate on that day.

♥The origin of the $ sign.

The origin of the "$" sign has been variously accounted for. Perhaps the most widely accepted explanation is that it
is the result of the evolution of the Mexican or Spanish "P's" for pesos, or piastres, or pieces of eight. This theory,
derived from a study of old manuscripts, explains that the "S," gradually came to be written over the "P,"
developing a close equivalent to the "$" mark. It was widely used before the adoption of the United States dollar in
1785.

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Understanding Forex rates a little better

Suppose you travel to New York to buy a book worth $100

Current Exchange rate Effect You pay
INR 47 to $1 100*47= INR 4700
INR 46 to $1 Rupee becomes strong 100*46=INR 4600
INR 48 to $1 Rupee becomes weak 100*48=INR 4800

Thus we can understand that:

If rupee is strong:
• Indians can buy more of foreign goods for cheaper (better for imports)
• Foreigners can buy less of Indian goods for same amount of their currency (bad for
exports as Indian goods become costly)
If rupee is weak:
• Indians can buy less of foreign goods for same amount (bad for imports)
• Foreigners can buy more of Indian goods for same amount of their currency (good
for exports as Indian goods become cheap)

Economics of Forex
Economics has taught us that almost what all economists talk about is related to supply and
demand. (Paul Krugman today got the Nobel Prize-will I get one soon??? For telling that
economists are good guys) Anyways thus those same laws should be applicable to
currencies because we have been treating it as a commodity.

Supply and demand of currencies: The demand for Indian rupees will be based on the
demand for Indian products or INR denominated financial instruments. There will be a time
when the supply and demand will equalise to some extent. The exchange price at the
particular point is called the equilibrium exchange rate. For most of our discussion we
will have to be bothered about this rate.

We need to note here that the supply will in a large way be dictated by the central bank
which will try to manage the money supply to keep in tune with the government’s monetary
policies and economic goals.
Price of a currency will rise if demand is more than supply
Price of a currency will drop if demand is lesser than supply.

Ha ha ha ha : The market is weird. Every time one guy sells, another one buys, and they both think they're smart.

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Also this has a very distinct relationship to inflation:

Too much money supply->Inflation->value of money declines->prices rise

Too little money supply->low economic growth->inflation decreases->prices decrease

Now arises the question as to why does the supply and demand change. Or what
are the factors that affect the exchange rate?

In bullet points – Practical and Psychological reasons are galore, some are:
• Business cycles
• Balance of payments – basically inter country trade
• Political developments
• New tax laws
• Stock market news
• Inflationary expectations
• International pattern
• Government and Central bank policies

On a more technical plane the factors affecting Equilibrium Exchange rate are:

Relative Inflation rates: the relative inflation rates between two countries will
work in such a way as to bring the exchange rates to equilibrium.
Suppose, Supply of Rupees > Demand for Rupees
This will Increase inflation in India
Therefore Prices of Indian products will rise w.r.t global products
This in turn will Reduce Indian exports
Leading Reduction in supply of foreign currency
Also Indian will start preferring imports due to high local prices
Thus Demand for foreign currency will increase
Implied that Indian rupees will depreciate compared to foreign currencies

This is being seen live in today’s India (Oct-2008) where inflation has risen to
over 12% as against 6% at the start of the year and simultaneously the rupee has
depreciated against the dollar from INR 38/$ to INR 47/$.

Ha ha ha ha: The market may be bad, but I slept like a baby last night. I woke up every hour and cried.

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Relative Interest rates:

If Interest rate in India rises as compared to other countries (ceteris paribus)
Then, foreigners will try to buy Rupee denominated instruments
Thus, Rupee value will appreciate as demand for rupee will increase!!!

Relative Economic Growth:

Higher economic growth will lead to more foreigners investing in India. Demand for local
assets will increase, thus creating a demand for local currency, and thus Rupee will
appreciate.

Other factors include the Political and Economic factors. Investors will always flock to
countries which have lower risk in terms of stability of government and other factors

Joke time

A Japanese guy is at Los Angeles International Airport,

waiting for his flight back home to Japan. While he's
waiting, he goes to the currency exchange counter to change
his remaining dollars.

He counts his money at the counter. "Wait a minute," he says

to the clerk, "When I came here I got more dollars for my
yen. What's going on here?"

"Fluctuations." says the clerk.

The Japanese man stiffens. "Well! Fluck you Americans, too!"

Internal Glossary
Soft Currency: Currencies which do not have much of a demand. Mostly of less developed
countries as no one is actually bothered about them. (Srilanka, Kenya etc)
Hard Currency: Currencies which are high in demand. Mostly of well developed countries (UK,
USA, etc) and economically growing countries (India, China etc)
Spread: Difference between rate at which people are ready to buy and sell a currency
PIPS: The smallest price change that a given exchange rate can make. Since most major
currency pairs are priced to four decimal places, the smallest change is that of the last decimal

point - for most pairs this is the equivalent of 1/100th of one percent, or one basis point.

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Exchange rate Change:

A little earlier we were talking about the Rupee weakening or the Rupee strengthening. But
in real economic terms or so called MBA terms the right words would be Appreciation and
Depreciation. But it makes a lot more sense if we can attach some number to the same.

This is expressed in terms of %( percentages)

New dollar value of rupee - Old dollar value of rupee

Change in Value of Rupee w.r.t dollar
(appreciation if "+", depreciation if "-" =
Old dollar value of rupee

Alternatively Dollar as compared to Rupee will be as follows

New Rupee value of dollar - Old rupee value of dollar
Change in Value of Dollar w.r.t Rupee
(appreciation if "+", depreciation if "-" =
Old rupee value of dollar

To put it into real life terms:

On 26 April 2008 the Exchange rate for Rupee/$ was 39.90991

On 13 Oct 2008 the Exchange rate is 48.96226

How has the Rupee value behaved?

From the latest formula

% change of dollar w.r.t Rupee = (48.96226 – 39.90991) ÷39.90991 = 22.68 i.e
the dollar has appreciated against the rupee by 22.68 %

Or using the previous formula

% change of Rupee w.r.t Dollar = (1/48.96226-1/39.90991)÷1/39.90991 = -
18.48% i.e. the Rupee has Depreciated by 18.48% against the Dollar.

Since the denominator is different in both cases hence the Depreciation

(appreciation) of currency X against currency Y will never be equal to Appreciation
(Depreciation) of Y against X

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