Unit 4

MBA/BBA/B.com /PGDBM/UGC Net

By
Dr. Anand Vyas
 Foreign Exchange Determination Systems:
• Foreign Exchange Rate is the amount of domestic currency that must be paid in order to get a
unit of foreign currency. According to Purchasing Power Parity theory, the foreign exchange
rate is determined by the relative purchasing powers of the two currencies.22-Sept-2017
• Now two pertinent questions that usually arise in the foreign exchange market are to be
answered now. First, how is the equilibrium exchange rate determined, and secondly, why
does exchange rate move up and down?
• There are two methods of foreign exchange rate determination. One method falls under the
classical gold standard mechanism and another method falls under the classical paper
currency system. Today, gold standard mechanism does not operate since no standard
monetary unit is now exchanged for gold. All countries now have paper currencies not
convertible to gold.
• A (foreign) exchange rate is the rate at which one currency is exchanged for another. Thus, an
exchange rate can be regarded as the price of one currency in terms of another. An exchange
rate is a ratio between two monies. If 5 UK pounds or 5 US dollars buy Indian goods worth Rs.
400 and Rs. 250 then pound-rupee or dollar-rupee exchange rate becomes Rs. 80 = £1 or Rs.
50 = $1, respectively. Exchange rate is usually quoted in terms of rupees per unit of foreign
currencies. Thus, an exchange rate indicates external purchasing power of money.
 Basic Concepts Relating to Foreign Exchange,
• Exchange Rate

• Direct & Indirect Quotes

• A quote is a way of expressing one currency in certain units of the other
currency. So 1 USD = Rs. 64 would mean 1 unit of USD is equivalent to 64
units of Indian Rupee. The quotes can be given in two ways – direct and
indirect. Under direct method, local currency or the home currency is
variable. For instance, the quote we mentioned above is a direct quote
as we can get the value of home currency against USD directly. Direct
quote is also known as Home currency.
• In indirect quote, the foreign currency is variable while home currency is
fixed. For instance, Rs. 128 = 2 USD is an indirect quote. Generally direct
quotes are used across the globe with few notable exceptions
• Cross Rate Mechanism
• Sometimes, in a particular market, we might not get a quote between two
currencies and we need to exchange them. In such a case we make use of
cross rate mechanism. Under this, we make use of a currency having
quotes with both of the above currencies. The most common example is
that of USD. So we will obtain direct quotes involving USD for both the
currencies and by simply crossing them out using plain mathematics, we
can get the desired quote.
• Spot Rate
• Most of the forex transactions are not necessarily settled on the same day.
They may be settled in future also. So, depending on the settlement time,
the exchange also varies. Generally, the settlement of forex transactions
takes place on the second working day. The rate then applied is called Spot
rate. Even though the word ‘spot’ indicates a quick settlement, the actual
transaction is completed only on the second working day.
• Forward Rate
• If settlement of funds takes place after second working day i.e. spot date, then the
rate applied is called forward rate. This rate is derived from the spot rate.
• Ready/Cash
• When the settlement takes place on the same day of the deal, it is called Ready or
Cash.
• Tom
• If settlement takes place on next working day of the deal, it is referred to as Tom.
• Premium & Discount
• If the forward rate is more than spot rate of a currency, then that currency is said
to be at premium. On the other hand, if the forward rate is less than spot rate, the
currency is said to be at discount. This relationship can be expressed as
Forward Rate = Spot rate +Premium ( or – discount)
• Bid & Offered rate
• They are nothing but buying & selling rates of currencies. So a bid rate refers to the rate at which a
financial institution is ready to buy currency while offer rate is the rate at which it is ready to sell
currency.
• Authorized Dealers
• The authorized dealers are the entities who are authorized to deal in foreign exchange. They are
basically financial institutions who have been allowed to undertake transactions pertaining to forex
by RBI. There was a change in the definition of the authorized dealers in the year 2005. As per new
definition, these entities are called Authorized Persons. Moreover, they have been divided into
three different categories.
• Authorised Person: Category I refer to financial institutions that are authorized to handle all types
of forex transactions.
• Authorised Person: Category II refers to entities who can deal with buying/selling of foreign
currency, remittances, travelers cheques etc.
• Authorised Person: Category III refers to entities who are authorized for purchasing of foreign
currency and traveler’s cheques only.
 Various types of Exchange Rate Regimes,
• There are three broad exchange rate systems—currency board,
fixed exchange rate and floating rate exchange rate. A fourth can be
added when a country does not have its own currency and merely
adopts another country’s currency. The fixed exchange rate has
three variants and the floating exchange rate has two variants.
• In reality, there are only two types of exchange rate regimes, which
are possible viz. the fixed regime and the floating regime.
However, these two systems have several variations within them.
Each of these systems is commonly associated with the degree of
liberalization of the underlying economy.
• This consists of – (i) managed float and (ii) free float.
 Factors Affecting Exchange Rates,
• 1. Inflation Rates
• 2. Interest Rates
• 3. Country’s Current Account / Balance of
Payments
• 4. Government Debt
• 5. Political Stability & Performance
• 6. Recession
 Brief History of Indian Rupee
Year What Happened
1540-45 Sher Shah Suri issued a Silver coin which was in use during the Mughal period, Maratha era and British India.
The earliest paper rupees were issued by Bank of Hindostan (1770– 1832), General Bank of Bengal and Bihar
1770-1832
(1773–75), and Bengal Bank (1784–91).
1 Apr 1935 Reserve Bank of India is set up.
Jan 1938 Reserve Bank issues first note of Rs 5
Feb-Jun
RBI issues Rs 10, Rs 100, Rs 1,000 and Rs 10,000 notes.
1938
Rs 1 note reintroduced. Rs 1 was first introduced on 30 Nov 1917, followed by Rs 2 and 8 annas, and was
Aug 1940
discontinued on 1 Jan 1926.
Mar 1943 Rs 2 note introduced
1950 RBI issues first post-Independence coins in 1 pice, 1.2, one and two annas, 1.4, 1.2 and Rs 1 denominations.
1953 Hindi language features prominently on the new notes, and plural of rupaya was decided to be rupiye
1954 High denomination notes of Rs 1,000, Rs 5,000, and Rs 10,000 reintroduced.
1957 Rupee is decimalised and divided into 100 naye paise.
1957-67 Aluminium coins of denomination of one, two-, three-, five- and ten-paise are introduced.
1967 Note sizes reduce due to the lean period of the early Sixties.
New notes issued with symbols of science & tech (Aryabhatta on Rs 2 note), progress (oil rig on Rs 1 and
1980
farm mechanisation on Rs 5) and Indian art forms on Rs 20 and Rs 10 notes (Konark wheel, peacock).
Oct 1987 Rs 500 note introduced due to the growing economy and fall in purchasing power

1988 Stainless steel coins of 10, 25 and 50 paise introduced.

1992 Rs 1 and Rs 5 coins in stainless steel introduced
The Mahatma Gandhi series of notes issued, starting with Rs 10 and Rs 500 notes. This series
1996 has replaced all notes of the Lion capital series. A changed watermark, windowed security
thread, latent image and intaglio features for the visually handicapped were the new features.
2005-8 New 50 paise, Rs 1, Rs 2 and Rs 5 stainless steel coins introduced.
2009 The printing of Rs 5 notes (which had stopped earlier) resumed.

July 2010 New symbol ‘₹’ is officially adopted

25 paise coin and all paise coins below it demonetised. New series of 50 paise coins and Rs 1,
2011
Rs 2, Rs 5 and Rs 10 notes with the new rupee symbol introduced.
New ‘₹’ sign is incorporated in notes of the Mahatma Gandhi series in denominations of Rs 10,
2012
Rs 20, Rs 50, Rs 100, Rs 500 and Rs 1,000
Nov 2016 Rs 500 and Rs 1,000 notes discontinued and new Rs 500 and Rs 2,000 notes introduced.
History of Indian Rupee—Demonetisation
Demonetisation is when currency notes and coins are withdrawn. The reasons given in the past were to curb and control black money
or to introduce new notes.

Time
What Happened
Period.

12 Aug Rs 500, Rs 1,000 and Rs 10,000 notes were demonetised to control black
1946 money.

1954 High denomination notes of Rs 1,000, Rs 5,000, and Rs 10,000 reintroduced.

16 Jan Denominations higher than Rs 100 demonetised again to control the menace
1978 of black money.

1987 & While Rs 500 note was issued in 1987, the Rs 1,000 note was reintroduced in
2000 the year 2000

1995 Rs 1 and Rs 2 notes were removed from circulation.

2011 25 paise and all paise coins below this denomination were withdrawn.
Nov 2016 Rs 500 and 1000 notes were withdrawn.