Exchange rates International transaction in cash requires two distinct purchases Purchase of foreign currency Purchase of good/service with the FC Term foreign exchange is used to denote foreign currency Foreign exchange market exists to cater to the demand for foreign currency/currencies

Foreign Exchange Market Organisational setting within which individuals, governments and banks buy and sell foreign currencies Only a small fraction of daily transactions in foreign exchange involve trading of currency Most foreign exchange transactions involve transfer of bank deposits

Definition of foreign exchange Deposits, credits and balances payable in foreign currency Drafts, travellers’ cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency Drafts, travellers’ cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency The above definition is as per FEMA (1999)

Exchange rate (1) Denotes the price or the ratio or the value at which one currency is exchanged for another Exchange rate is very dynamic The foreign exchange market is round- the-clock market due to different time zones Major participants- central banks, commercial banks, forex brokers, corporations, individuals

Factors affecting exchange rate Major banks that act as market-makers always give two-way quotes; gives depth and volume to the market Fundamental reasons Technical reasons Speculation

Fundamental reasons Balance of payments->surplus- >appreciation Growth rate of the economy-> higher growth->depreciation of currency Fiscal policy-> financing of fiscal deficit influences exchange rate Monetary policy->loose monetary policy- > depreciation of exchange rate

Technical reasons Freedom or restrictions on capital movements can affect exchange rates to a large extent Among other factors there are: Huge trade surpluses of oil exporting countries Capital moving from low-yielding currencies to high yielding currencies (interest differential)

Types of exchange rate (1) Ready/cash- Settlement of funds on the same day (date of the deal). Tom- Settlement of funds takes place on the next working day of the date of the deal Spot- Settlement of funds takes place on the second working day following the date of the deal

Types of exchange rate (2) Forward- Delivery takes place on any day after the date of the deal In the forex market all rates that are quoted are generally spot rates When delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicable Forward rate = Spot rate + Premium (- discount)

Forward rate If the forward value of a currency is higher than the spot value the currency is said to be at a premium If the above is reversed the currency is said to be at a discount The forward premium/discount is based on interest rate differentials of the two currencies involved Direct and indirect quotes of exchange rate- direct quote, local currency is variable

Slide Copyright © 2003 Pearson Education, Inc. Exchange rates are important because they enable us to translate different counties’ prices into comparable terms. Exchange rates are determined in the same way as other asset prices. The general goal of this chapter is to show: How exchange rates are determined The role of exchange rates in international trade

Slide Copyright © 2003 Pearson Education, Inc. Exchange Rates and International Transactions An exchange rate can be quoted in two ways: Direct The price of the foreign currency in terms of dollars Indirect The price of dollars in terms of the foreign currency

Slide Copyright © 2003 Pearson Education, Inc. Exchange Rates and International Transactions Table 13-1: Exchange Rate Quotations

Slide Copyright © 2003 Pearson Education, Inc. Domestic and Foreign Prices If we know the exchange rate between two countries’ currencies, we can compute the price of one country’s exports in terms of the other country’s money. Example: The dollar price of a £50 sweater with a dollar exchange rate of $1.50 per pound is (1.50 $/£) x (£50) = $75. Exchange Rates and International Transactions

Slide Copyright © 2003 Pearson Education, Inc. The Foreign Exchange Market Exchange rates are determined in the foreign exchange market. The market in which international currency trades take place The Actors The major participants in the foreign exchange market are: Commercial banks International corporations Nonbank financial institutions Central banks

Slide Copyright © 2003 Pearson Education, Inc. Exchange rates play a role in spending decisions because they enable us to translate different countries’ prices into comparable terms. A depreciation (appreciation) of a country’s currency against foreign currencies makes its exports cheaper (more expensive) and its imports more expensive (cheaper). Exchange rates are determined in the foreign exchange market.

Slide Copyright © 2003 Pearson Education, Inc. Summary An important category of foreign exchange trading is forward trading. The exchange rate is most appropriately thought of as being an asset price itself. The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes.

Slide Copyright © 2003 Pearson Education, Inc. Equilibrium in the foreign exchange market requires interest parity. For given interest rates and a given expectation of the future exchange rate, the interest parity condition tells us the current equilibrium exchange rate. A rise in dollar (euro) interest rates causes the dollar to appreciate (depreciate) against the euro. Today’s exchange rate is altered by changes in its expected future level.