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Exchange rate
Introduction
Currencies are traded inforeign exchange

marketsand the volume of money bought and sold

is huge! Daily foreign exchange market turnover
averaged $4 trillion in 2010, 20% higher than in
2007.
An exchange rate is the price of one currency in
terms of another in other words, the purchasing
power of one currency against another.
Exchange rates are an important instrument of
monetary policy.

 Purpose of Forex Market

The foreign exchange market is the mechanism by which currencies
are valued relative to one another, and exchanged.

1. CURRENCY CONVERSION:companies, investores and government wants to exchange 1

currency into another . A companies primary purpose for need to
convert currencies is to pay or receive money for goods or services .

2. CURRENCY HEDGING :One of the biggest challenges in foreign exchange is increasing or

decreasing rates of risk in greater amount or directions than anticipated
. Currency hedging refers to the technique of protecting against the
potential losses that result from adverse changes in exchange rate .

3. CURRENCY ARBITRAGE:
Currency arbitrage involves buying and selling currency pairs from

different brokers to take advantage of this disparity.

For example, two different banks (Bank A and Bank B) offer quotes for the
US/EUR currency pair. Bank A sets the rate at 3/2 dollars per euro, and
Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the
trader would take one euro, convert that into dollars with Bank A and then
back into euros with Bank B. The end result is that the trader who started
with one euro now has 9/8 euro. The trader has made a 1/8 euro profit if
trading fees are not taken into account.

4. CURRENCY SPECULATION:
Currency speculation exists whenever someone buys a foreign currency,

not because she needs to pay for an import or is investing in a foreign

business, but because she hopes to sell the currency at a higher rate in
the future (in technical language the currency "appreciates"). This is
nothing more than the old rule of buying low and selling highonly with
foreign money
Some currency speculation is necessary to facilitate international trade.

Take, for example, a car manufacturer in Germany which exports cars to

the United States. As the U.S. importer of German cars is paying her bill in
U.S. dollars, the German exporter receives U.S. currency.

DETERMINATION OF EXCHANGE

RATE:-

1.Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the
trading relationship between two countries. Remember, exchange
rates are relative, and are expressed as a comparison of
thecurrenciesof two countries. The following are some of the
principal determinants of the exchange rate between two countries.
Note that these factors are in no particular order; like many aspects
ofeconomics, the relative importance of these factors is subject to
much debate.

2.Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate
exhibits a rising currency value, as its purchasing power increases
relative to other currencies. During the last half of the twentieth
century, the countries with low inflation included Japan, Germany and
Switzerland, while the U.S. and Canada achieved low inflation only
later. Those countries with higher inflation typically see depreciation
in their currency in relation to the currencies of their trading partners.
This is also usually accompanied by higher interest rates.

3. Current Account Deficits:

Thecurrent account is the balance of trade between a country
and its trading partners, reflecting all payments between
countries for goods, services, interest and dividends. Adeficit in
the current account shows the country is spending more on
foreign trade than it is earning, and that it is borrowing capital
from foreign sources to make up the deficit. In other words, the
country requires more foreign currency than it receives through
sales of exports, and it supplies more of its own currency than
foreigners demand for its products.

4. Interest Rates :
Interest rates, inflation and exchange rates are all highly
correlated. By manipulating interest rates,central banks exert
influence over both inflation and exchange rates, and changing
interest rates impact inflation and currency values. Higher
interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates
attract foreign capital and cause the exchange rate to rise.

EXCHANGE RATE QUOTES: There are several ways to quotes currency, but lets keep it simple .

In general, when we quotes currencies, we are indicating how

much of one currency it take to buy another currency . These
quotes requires to components : the base currency and the quoted
currency.
the base currency is the currency that is to be purchased with
the another currency, and it is noted in the denominator.

DIRECT CURRENCY QUOTE AND

INDIRECT CURRENCY QUOTE
DEFINITION OF 'DIRECT QUOTE'

A foreign exchange rate quoted as the domestic currency per unit of the foreign
currency. In other words, it involves quoting in fixed units of foreign currency against
variable amounts of the domestic currency.
For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 =
C$1. Conversely, in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.
DEFINITION OF 'INDIRECT QUOTE'

A currency quotation in the foreign exchange markets that expresses the amount of
foreign currency required to buy or sell one unit of the domestic currency. An indirect
quote is also known as a quantity quotation, since it expresses the quantity of
foreign currency required to buy units of the domestic currency. In other words, the
domestic currency is the base currency in an indirect quote, while the foreign
currency is the counter currency. An indirect quote is the opposite or reciprocal of a
direct quote, also known as a price quotation, since it expresses the price of one
unit of a foreign currency in terms of the domestic currency.

Consider the example of the Canadian dollar (C$), which we assume is

trading at 1.0400 to the US dollar.In Canada, the indirect form of this quote would
be C$1 = US$0.9615 (i.e. 1/1.0400).

 DEFINITION OF 'SPOT RATE'

The price quoted for immediate settlement on a commodity,

a security or a currency. The spot rate, also called spot
price, is based on the value of an asset at the moment of
the quote. This value is in turn based on how much buyers
are willing to pay and how much sellers are willing to
accept, which depends on factors such as current market
value and expected future market value. As a result, spot
rates change frequently and sometimes dramatically.

 DEFINITION OF 'FORWARD RATE'

A rate applicable to a financial transaction that will take

place in the future. Forward rates are based on the spot
rate, adjusted for the cost of carry and refer to the rate that
will be used to deliver a currency, bond or commodity at
some future time. It may also refer to the rate fixed for a
future financial obligation, such as the interest rate on a
loan payment.

Swaps, Options, and Futures:

Definition

1. SWAPS: A swap is a derivative in which two parties agree to exchange a set

ofcash flow(or leg) for another set. A notional principal amount is used to calculate
eachcash flow; these are rarely exchanged by the parties. A swap is usually used
to hedge a risk, such as aninterest-rate risk, or to speculate on aprice change. It
may also be used to access anunderlying asset in order to earn a profit or loss from
any change in price while avoiding posting the notional amount in cash or
collateral.
2. OPTION: An option is afinancial instrumentthat gives the holder the right to
engage in a future transaction on an underlying security or futures contract. The
holder is under no obligation to exercise this right. There are two main types of
option. Acall optiongives the holder the right to purchase a specified quantity of a
security at a fixed price (thestrike price) on or before the specifiedexpiration date.
Aput optiongives the holder the right to sell. If the holder chooses to exercise the
option, the party who sold, or wrote, the option is obliged to fulfill the terms of the
contract.

3. Futures: Futures are traded on afutures

exchangeand represent an obligation to buy or sell a
specified underlying instrument on a specified date
(thedelivery dateor final settlement date) in the future
at a specified price (the futures price). The settlement
price is the price of theunderlying asseton
thedelivery date. Both parties to afutures contractare
legally bound to fulfill the contract on thedelivery date.
If the holder of a futures position wishes to exit their
obligation before thedelivery date, they must offset it
either by selling along positionor buying back ashort
position. Such an action effectively closes the futures
position and itscontractual obligations.

EXCHANGE RATE THEORIES:

1. PURCHASING POWER PARITY(PPP):The theory of the purchasing power parity is the oldest and
most extensively accepted theory of all exchange rate
determination theories .
PPP theory is based on concept of law of one price that is
the price if commodity shall be the same in two markets. If were
not true, arbiterageurs would buy in cheaper market and sell in
expensive market to make risk less gain.

2.

BALANCE OF PAYMENT APPROACH:-

the balance of payment approach is the second most utilized

theoretical approach in exchange rate determination . The basic
approach argues that the equilibrium exchange rate is found when
currency flows match up current and financial activities .

3. ASSET MARKET APPROACH:Asset market approach argues that exchange rate are determined
by the supply and demand for a wide variety of financial assets
the asset market approach assumes that whether foreigners are
willing to hold claims in monetary from depends on extensive set of
investment consideration or drivers:
1. Relative real interest rate
2. Prospects for economic growth
3. capital market liquidity
4. countries economic and social infrastructure
5. Political safety
6. corporate governance practices
7. speculation

4. INTEREST RATE PARITY (IRPT):IRP theory states that exchange rate between currencies
is directly affected by their interest rate . Interest rate parity is one
of the most important fundamental economic relation relating
differential interest rate and forward exchange rate between a pair
of currency.

5. INTERNATIONAL FISHER EFFECT:international fishers effect postulates that the estimated

change in the current exchange rate between any two currencies is
directly proportionals to the difference between the two countries
nominal interest rate at a particular time.
The international fishers effect relates the nominal interest
rates between two countries and the movement of exchange rate
between the currencies of two countries . According to prof. fisher ,
there are two type of interest rate :

1. Real interest rate: real interest rate

depends upon productivity of capital.

2. Nominal interest rate : nominal interest
rate is also called as money interest rate ,
also referred as out-of-pocket interest rate
Prof. fishers stated the relationship between
the two interest rate as follows : (1+r)
(1+i)=(1+n)where, r= real interest rate , i=
inflation rate , n= nominal interest rate.

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