ASSIGNMENT I

BASIS OF EXCHANGE RATES

K.ARUN KUMAR
MBA-IBM

BASIS OF FOREIGN EXCHANGE RATES

EXCHANGE RATES:
An exchange rate is the rate at which one nations currency is expressed in terms
of other foreign currency.
Exchange rates are impacted by international in a free market system that helps
to maintain a balance of trade and balance of capital.
Importance:
Ex-rates are important for any country as they determine the level of exports and
imports. If domestic currency appreciates with regard to foreign currency goods
imported will be cheaper in the domestic market and we can see a attractiveness
towards foreign goods by customers.
Exchange rates are important because it allows for the conversion of one
countrys currency in to that of another which would facilitate international trade for
purchasing of goods and services.
Exchange rates are determined in the same way as other assets.
Determinants of level of ex-rates:
A wide range of factors interact to determine the exchange rate level:
i)
ii)
iii)
iv)
v)
vi)

The government
Market forces for supply & demand
Interest rates
Inflation
Balance of trade
Consumers expectations

Of the above mentioned factors only two are in the level of focusing :

1) The government
2) Market forces for supply & demand

Ex-rates and international transactions:

An exchange rate can be quoted in two ways:
a)Direct :
The price of the local currency expressed in terms of foreign currency.
b)Indirect :
The price of the foreign currency expressed in terms of local currency.
There are two types of changes in exchange rates:
1.) Depreciation of home countrys currency:
It is the situation where there is rise in home countrys prices for foreign currency. It
makes home goods cheaper for foreigners and foreign goods more expensive for
domestic residents.
2.) Appreciation of home countrys currency:
It is fall in the home price of a foreign currency. It makes home goods more expensive
for foreigners and foreign goods cheaper for domestic residents.

Ex-rates and relative prices:

Demand for exports and imports are influenced by the concerned relative prices.
a) On appreciation of countrys currency:
Raises the relative price of its exports and lowers the relative price of the imports.
b) On depreciation of countrys currency:
Lowers the relative price of the exports and raises the relative price of the
imports.

Foreign exchange market:

Exchange rates are determined in foreign exchange market. It is the market in
which international currency trading takes place.
The major players in the foreign exchange market are:

Commercial banks

International corporations

Nonbank financial institutions

Central banks

Interbank trading:
It refers to the foreign currency trading among banks. It accounts for the most of
the activity in the foreign exchange market.
Characteristics of the market:

It is a worldwide market whose volume is enormous and it has become so

enlarged in the recent years.

In major foreign exchange trading centers (London, New York, Tokyo, Frankfurt,
and Singapore) new technologies such as internet links are used.

The integration among financial centers implies that there can be no significant
arbitrage.
-

The process of buying a currency cheap and selling it for profit by taking
advantage of the place and time.

Vehicle currency:
It represents the currency that is widely used to denominate international contracts
made by parties who do not reside in the country that issues the vehicle currency.
Example: in 2001 around 90% of the transactions between banks involved
exchanges of foreign currencies for U.S dollars.
Spot exchange rate:
It is the rate at which a foreign exchange dealer converts one currency into
another currency on a particular day. Exchange rates governing such on the
spot trades are referred to as spot exchange rates.
Spot exchange rates are reported daily in the financial pages of the newspapers. It
can also found on the net. This spot rate change continually, often on a day-by-day
basis. The value of the currency is determined by the interaction between the
demand and supply of that currency relative to the demand and supply of other
currencies. For example if lots of people want U.S dollars and dollars in short
supply and few people want British pounds and pounds are in plentiful supply, the
spot exchange rate for converting dollars into pounds will change. The dollar is
likely to appreciate against the pound.

Forward exchange rates:

A forward exchange occurs when two parties agree to exchange currency and
execute the deal at some specific date in the future. Exchange rates governing
such future transactions are referred to as forward exchange rates.
For most major currencies, forward exchange rates are quoted for 30 days, 90
days, and 180 days in to the future. In some cases it is possible to get forward
exchange rates for several years in to the future.
Forward and spot exchange rates, though not necessarily equal, do move closely
together.
Foreign exchange swaps:
In swap, two counter parties agree to a contractual arrangement where in they
agree to exchange cash flows at periodic intervals.
There are two types of interest rate swaps:
o Single currency interest swap
o Cross currency interest swap
Futures and options:
Futures contract
The buyer buys a promise that a specified amount of foreign currency will be
delivered on a specified date in the future.
Future option:
The owner has the right to buy or sell a specified amount of foreign currency at
as specified price at any time up to a specified expiration date.