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FOREIGN EXCHANGE RATE THEORIES

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  1. FOREIGN EXCHANGE RATE THEORIES Four theories Purchasing Power Parity Interest Rate Parity Fisher condition for capital market equilibrium Expectations theory of forward rates

  2. 0 The Determinants of Foreign Exchange Rates Parity Conditions 1. Relative inflation rates 2. Relative interest rates 3. Forward exchange rates 4. Interest rate parity Spot Exchange Rate Is there a sound and secure banking system in-place to support currency trading activities? Is there a well-developed and liquid money and capital market in that currency? Asset Approach 1. Relative real interest rates 2. Prospects for economic growth 3. Supply & demand for assets 4. Outlook for political stability 5. Speculation & liquidity 6. Political risks & controls Balance of Payments 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves

  3. INTERNATIONAL PARITY RELATIONSHIP • To reduce the effect of disparities caused by- • Arbitrage , speculation etc • This economic behaviour- ‘law of one price’ • Four theories come into practice

  4. Exchange rate determination theories • 1.Interest rate parity: • Relationship between interest rates and • Exchange rates of two countries

  5. Exchange rate of two countries will be affected by their interest rate differential • Currency of a high interest rate country will be at a forward discount- • Relative to the currency of a low interest rate country

  6. Exchange rate(forward& spot) differential will be equal to the interest rate differential between two countries • Interest differential=exchange rate(F&S)differential • 1+rf = f F/D 1+rd s F/D

  7. rf = Interest rate of country F • rd= Interest rate of country D • sF/D = Spot exchange rate of country F&D • fF/d= Forward rate between country F&D • Note : High interest rate:-Forward discount Low interest rate :- Forward premium

  8. Concept:- • Interest rate parity works fairly well -internal markets • There is no restriction from one country to other • Euro currency market are the international capital market –minimum restrictions and control • Here the market forces determine interest rates

  9. 0 • 2. Theory of Purchasing Power Parity: • The oldest, and most widely accepted theory • Concept: • Exchange rate between the currencies of two countries equals the ratio between the prices of goods in these countries

  10. Purchasing power states – • The exchange rate between the currencies of two countries will adjust • Purpose: • To reflect changes in the inflation rates of the two countries • Inflation rate differential= current spot & expected spot rate differential

  11. 1+iF = E(SF/D) 1+iD sF/D • iD= Rate of inflation in country D • iF= Rate of inflation in country F • sF/D= Spot exchange rate between country F&D • E(SF/D)=Expected spot rate between country F&D in future

  12. 3. Expectation theory of forward rates: • Expected future spot rate depends on the expectations of the FOREX market participants • Concept: • When the forward rate is higher than the market participants prediction-

  13. Participants will tend to sell the foreign currency forward • Cause a fall in the forward rate • Until it equals the expected future spot rate

  14. Forward rate& the current rate differential must be equal to the expected spot rate & the current spot rate differential • F&C spot rate differential=Expected & Current spot rate differential

  15. fF/D = E(Sf/d) sF/D s F/D • E( Sf /D)=Expected future spot exchange rate for a unit of foreign currency per unit of domestic currency • f F/D =forward rate between countries F&D

  16. 4.International Fisher Effect: • Nominal interest rate comprises of a real interest rate and an expected rate of inflation • Nominal interest rate adjust when the inflation rate is expected to change • Concept:

  17. Nominal interest rate will be higher :–When a higher inflation rate is expected • It will be lower when a lower inflation rate is expected • 1+nominal interest rate=(1+real interest rate)(1+inflation rate) • 1+rn =(1+rr)(1+i)

  18. rn= rr+i+rri • rn= Nominal rate of interest • rr= Real rate of interest • i= Inflation rate

  19. International Fischer Effect – • Nominal interest rate differential must equal to the expected inflation rate differential in two countries • Nominal interest rate differential=expected inflation rate differential

  20. 1+rf = E(1+if) 1+rn E(1+if)

  21. EXCHANGE RATE MECHANISM • There is a price for any purchase or sale of a currency • Such a price in the exchange market is called the exchange rate • Definition: • The no.of units of one currency that will be exchanged for a unit of another currency

  22. Exchange rate of any currency can be expressed in two ways • 1.In terms of foreign currency units against a given unit of domestic currency • Eg Rs.45=$1 • 2.In terms of the no.of domestic currency units against a given unit of foreign currency • Eg:$1=Rs.45

  23. Exchange rate depends on the supply and demand for a currency • Supply and demand depends on : • Arbitrage and interest rate speculation, • Currency speculation and • Short-term capital flows

  24. GUSTAV’s THEORY • Prof. Gustav Cassel-purchasing power parity theory • Exchange rates are determined by what each unit of a currency can buy in terms of real goods and services in its own country • Rate of exchange is the amount of currency which would buy the equivalent basket of goods and services in both countries

  25. There should be comparison between currencies at two periods of time • One year as the basis of comparison • But no absolute comparison between two currencies are possible

  26. It is assume that the base year prices in both the countries are at equilibrium • Exchange ratio at that time represents ratio of their purchasing powers

  27. E.g.. If base period exchange rate is 1:1 a doubling of prices in the domestic economy of B with A’S price remaining constant. • These lead to a new exchange rate of 1:2 • This ratio would set the bounds or limits to day –to-day fluctuations in the exchange rates

  28. Spot and forward rates • Importer is paying on receipts of documents • He can buy dollars spot and • The bank sells him spot dollars • If importer agrees to pay at a later date • His demand arise only at a later date • These dollars are called forward dollars • The market is a forward market

  29. Existence of forward market provides cover- • Or hedge against fluctuations in the spot exchange rates • This exchange risk falls on the bank who are buying or selling dollars forward • Banks can pass the risk to central bank • Forward purchase or sale of currencies include interest rate fluctuations

  30. Forward currency may be quoted at premium or at discount • E.g.: premium(higher than the spot expressed in foreign currency per domestic unit quoted) • 2003 Rs. 100=$2.7555, if interest rates abroad are higher than at home

  31. Speculation • Speculation and hedging are taking place in free market • It take advantage of interest rate and exchange rate differentials • Speculation on a limited scale is healthy • It should be on both sides of purchase and sale • NOTE: Not possible in India where banks are allowed only to keep a minimum balance of cash

  32. Arbitrage • Exchange rate of currencies are same in all the centers • For eg. • If dollar rate per sterling is different in New York and Frankfurt • Then funds would flow in either direction to take advantage of the rate differential

  33. Slight differentials might be still there due to : • Carrying costs of moving funds from one place to another • Operations in terms of movement of funds from one centre to another • Known as arbitrage operations • Arbitrage can be three point or multi point • E.g.. moving funds from dollar to franc , franc to sterling, sterling to dollar

  34. TYPES OF EXCHANGE RATE • 1.Floating Vs. Fixed rates • Traditional floating systems are: • Single float, joint float , managed float etc • Fixed rates come into existence after the break down of Breton woods system in August 1971 • Floating rate is the rate which is freely allowed to fluctuate • According to the supply and demand situation

  35. If no intervention by central bank it is known as free float • Some degree of intervention exists which lead to a managed float • Managed float can be either single or joint • When various currencies were floating with varying degree of intervention- within a band of 2.25% on either side are single float

  36. The European Common Market countries are under a joint float with in a narrow band called ‘snake in the tunnel’ • ECM-west Germany, France , Belgium, Netherlands, Luxemburg and Ireland, Denmark and Sweden • Indian rupee is kept stable still 1991

  37. Then rupee devalued and Limited Exchange Management System (LERMS) • FERA was diluted • Banks are allowed greater freedom of lending • Deposit and lending rates are freed • Now FERA is changed to FEMA in 2000

  38. Quotations • Now quotations are called ‘direct quotes’ • Principle the banker follows is to give two way quotes-based on • ‘give less and take more’ • The spread between the buying and selling rates is the banks profit • Spread depends on the cable cost , brokerage cost and administrative cost

  39. E.g.; if the quotation is$1=Rs.45.750-45.780 • First is the purchase price • Second is the selling price • Principle is ‘buy low sell high’

  40. Method of quotation • 1. Direct method: • Gives no . of currency units of domestic country to one unit of foreign currency • 2.Indirect method: • Gives no . of foreign currency units for one unit of domestic currency

  41. E.g. indirect method: • For Rs.100= • US-2.99 • UK-1.21 • EURO-1.76 • Pakistan-136.1 • Malaysia-8.7 • China-18.97

  42. Direct method • As on June 30,2005 • 1 USD=Rs.43.5150 • 1UKsterling=Rs.79.6988 • 1Euro=Rs.52.6425 • 1ooYen=Rs.39.5200 • SOURCE : Official quote of RBI

  43. Exchange rate calculation • Spot TT buying rate

  44. 0 Exchange Rate Determination: Theorietical approach • The balance of payments approach is the most utilized theoretical approach in exchange rate determination: • demand and supply of a currency reflected in current and financial accounts determines the exchange rate. • This framework has wide appeal as balance of payment transaction data is readily available and widely reported. • This theory does not take into account stocks of money or financial assets.

  45. 0 Exchange Rate Determination: Theories • The monetary approach states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. • Changes in money stocks affect the inflation rate, which in turn affects the exchange rates through the PPP effect. • Other financial assets, such as bonds are not considered relevant for exchange rate determination, as both domestic and foreign bonds are viewed as perfect substitutes.

  46. 0 Exchange Rate Determination: Theories • The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets. • Changes in monetary and fiscal policy alter expected returns and relative risks of financial assets, which in turn alter exchange rates. Mundell-Fleming proposed this view.

  47. 0 Exchange Rate Determination: Theories • The forecasting inadequacies of fundamental theories has led to the growth and popularity of technical analysis, the belief that the study of past price behavior provides insights into future price movements. • The primary assumption is that any market driven price (i.e. exchange rates) follows trends.

  48. 0 The Asset Market Approach to Forecasting • The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations: • Relative real interest rates • Prospects for economic growth • Capital market liquidity • A country’s economic and social infrastructure • Political safety • Corporate governance practices • Contagion (spread of a crisis within a region) • Speculation

  49. 0 The Asset Market Approach to Forecasting: • Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. • The experience of the U.S. is the case in point. U.S. dollar strengthened despite growing current account deficits during the 1981-85, 1990 and 2000. Foreign capitals flowed into U.S. due to • rising stock and real estimate prices, • low inflation and relatively high real returns, • low political risk

  50. However, the 9/11 attack caused a negative assessment of long-term prospect for growth and profitability, and political risk in the U.S. • Loss of confidence in the U.S. economy led to a large outflow of foreign capital and subsequently depreciation of U.S. dollar by 18% between Jan-July 2002.