Exchange mechanism

Exchange mechanism

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  ECHANGE RATEMECHANISM In aforeign exchange market where different currencies are bought and sold, it is essential to know the ratio between different currencies, how many units of one currency well equal one unit of another currency.The ratio between two currencies is known as an exchange rate. The various exchange rates are regularly quoted in newspapers and periodicals. Major currencies in the world: USD, EURO, YEN, GBP, CAN$, SWISS FRANC, AUS $ There are two methods for quoting exchange rates. 1.Direct quote 2.Indirect quote Direct quote: A direct quote gives the home currency price of a certain amount of foreign currency usually one or 100units. If India quotes the exchange rate between the rupee and the us dollar in a direct way the quotation will be written as Rs.35/US$. Direct quote places domestic currency on the numerator of the quote. Indirect Quote: In the indirect quoting the value of one unit of home currency is presented in terms of foreign currency. If India adopts indirect quotation, the banks in India will quote the exchange n rate as us$ 0.2857/Re. indirect quote domestic currency placed in denominator. Buying and selling rates: Normally, two rates are published one being the buying rate and the other the selling rate. The buying rate is also known as the bid rate. The selling rate is known as the ask rate or offer rate. Bid rate always given first, followed by the ask rate quote. Buying quote of a currency denotes the rate at which banks buy it. Selling quote at which banks sell it. The banks need to make profit in these transactions, the selling quote is higher than the buying the rate. The difference between these two quotes forms the bank profit and is known as the spread. Spread = (Ask price-Bid price)/Ask price*100 Forward market quotation: The quotes for the forward market are also published in the newspapers and periodicals. The quoting rates may be expressed as outright quotes, or as swap quotes. The outright quote for the US dollar in terms of the rupee can be written for different periods of forward contract as follows. Spot one month three monthRs.40.00-40.30 Rs. 39.80-40.20 Rs. 39.60-40.10 The swap quote on the other hand expresses only the difference between the spot quote and the forward quote. It can be written as follows. Spot one month three monthRs.40.00-30 Rs. (20)-(10) Rs. (40)-(20) Forward premium and discount: The forward rates have longer maturity, the spread too gets wider. This is because of uncertainty in the future that increases with lengthening of maturity. The changes in forward rates may be upward ordownwards. Such movements arise between spot and forward rates. This is known as the swap or forward rate differential. If the forward rate is lower than the spot rate, it well is a case of forward discount. If the forward rate is higher than the spot rate it would be known as forward premium. Forward premium or discount is expressed as an annualized percentage deviation
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  from the spotrate. It is computed as follows. Forward Premium (Discount) = (n-day forward rate spot rate)/spot rate * 360/n Cross rates: The value of currency in terms of another one is not known directly. In such cases one currency is sold for a common currency and again the common currency is exchanged for the desired currency. This is known as cross rate trading and the rate established between the two currencies is known as the cross rate. Spot cross rate: The selling rate of the Canadian dollar in Indian can be worked out by selling the rupee for the US dollar at Rs.35.20/US $ and then buying Canadian dollar with the US dollar at C$0.76/US$ .Rs.35.20/US$1*US$ 1/C$0.76=Rs.46.32/C$ Forward Cross Rate: The selling rate of one currency is divided by the buying rate of another currency and vice versa. One month forward rate in case of the two currencies is Rs.34.50-34.80/US$ and C$ 0.79-0.83/ US$. The forward rate of the Canadian dollar in terms of the rupee can be found as: Rs. 34.80/C$ 0.79 = Rs.44.05/C$Rs. 34.50/C$0.83=Rs. 41.57 By combining the two we get Rs. 41.57-44.05/C$ NOMINAL, REAL AND EFFECTIVE EXCHANGE RATE: Nominal exchange rates are also called bilateral exchange rates. It represents the ratio between the values of two currencies at a particular point of time. Real exchange rates other hand is the price adjusted nominal exchange rate. The relationship between nominal exchange rate, e and the real exchange rate, er can be written in the form. Er = eP/P*W here p and p* are domestic and foreign price indices. It is possible that the Indian rupee tends to depreciate against US dollar but it appreciates against Japanese Yen. It is also possible that rupee depreciates vis-à-vis different currencies at different rates. so it is essential to develop an index or a summary measure of how rupee fares, on an average, in the foreign exchange market. Such an index is called an effective exchange rate. Effective exchange rate is the measure of the average value of a currency relative to two or more currencies normally shown in the form of indices. DETERMINATION OF EXCHANGE RATE IN THE SPOT MARKET The exchange rate between two currencies in a floating rate regime is determined by the interplay of demand and supply forces. The exchange rate between say the rupee and the US dollar depends upon the demand for the US dollar and its availability or supply in the Indian foreign exchange rate. The demand for foreign currency comes from individuals and firms who have to make payments in foreign currency mostly on account of import of goods and services and purchase of securities. The supply of foreign exchange results from the receipt of foreign currencies normally on account of export or sale of financial securities to foreign entities.
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  Main Factors forDetermining Spot Exchange Rates | Foreign Exchange Some factors which affect the exchange rates are as follows:- 1. Balance of Payments 2. Inflation 3. Interest Rates 4. Money Supply 5. National Income 6. Resource Discoveries 7. Capital Movements 8. Political Factors 9. Psychological Factors and Speculation. Factor # 1. Balance of Payments: Balance of payments is a statement which shows the total demand and supply of a foreign currency which helps in determining the value of the currency. Various exports (whether of goods or services) and the imports, affect the balance of payment continuously. Factor # 2. Inflation: Inflationrate meanstherate at which the costof living of peopleofa country is increasing. Putting it in different words, the inflation rate depicts the rates at which the cost of various goods and services under its scope are increasing. The case where they are reducing it is known as deflation. The relative changes in the inflation rates of different countries results into different value of the local or domestic currency.This results into different exchange rates. Suppose, in India inflation is at 10%, and in USA is at 3%, then the prices of goods and services would be higher in India, in comparison to USA. Thus, the rupee is a weaker currency in comparison to US $. Thus, the value of rupee will depreciate in relation to USA. Thus, the inflation rate across the countries of the globe influences the exchange rates. Factor # 3. Interest Rates: The interest rates on various deposits and on loans are different across the countries of the globe. This is due to the economics concept of demand and supply. If the capital is available in abundance in a country, then the rate offered on deposits will be low. And if the requirement of capital is more than its supply, the rates of which loans will be given will be high. Now if the capital is scarcely available then the rate of the deposits will be higher, so as to attract more deposits. And if the requirement of capital is less than its supply, then the rates on which loans will be given will be low, to encourage people to take more loans. Now due to change in interest rates among different countries, and supply and demand of capital differs from a country to another in the globe, they exists some difference in their value. Thus, the money, which is in a country where supply is low, the interest rates offered, will be more. Thus, its currency will value more than the countries where the capital supply is more. Factor # 4. Money Supply: The total money quantum available in a country during a period is known as money supply. The money supply shows the total money available in an economy during a period, which helps in determining the rates of interest, inflation, etc. Increase in money supply, is normally taken as increase in spare money in the country. The money supply increase with increase in domestic production and service capacity of the country. This results into increase in spending on foreign goods and purchase of foreign investments. Because with increase in money supply, the interest rate decreases; thus the investors are tempted to invest in other countries where interest rates are higher. This results into excess supply of money getting transferred to other countries. Due to this the value of currency
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  reduces in foreignmarket, and results into increase in value of imports. This in turn results into increase in inflation rate. Factor # 5. National Income: National income shows the total income of the residents of an economy. The increase in national income results into increase in supply of money and in turn results into increase in production or creation of production capacities. The increase in production results into increase in exports, directly or indirectly. The increase in incomes of the residents of economy results into increase in imports. This in turn results into dilution of the domestic currency of the country in the foreign exchange market. Thus, in turn increase in inflation will also affect exchange rate Factor # 6. Resource Discoveries: When a country discovers resources, and starts exporting them, it results into their strong position in exchange market. A good example can be of the oil, which plays a significant role in foreign exchange market through its export and import in the International market, through International Trade Thus, when the supply of oil, in raw or finished form from its major suppliers, such as Middle East, becomes insecure, the demand of the currencies of this countries increase. Previous oil crisis favoured USA, Canada, UK and Norway and adversely affected the currencies of oil-importing countries like Japan and Germany. Similarly, discovery of oil by some countries helped their currencies to gain in value. The discovery of North Sea oil by Britain helped pound-sterling to rise in foreign exchange market. Canadian dollar also benefited from discoveries of oil and gas off the Canadian East Coast and the Arctic. Factor # 7. Capital Movements: Short-term movement of capital from one country to another is normally influenced by the interest rates in a country. As seen in the discussion of interest rates, the country with higher rate of interest will get more capital supply in comparison to the countries providing lower rate of interest. If interest rate in a country rises due to change in various key indicators of economy and policies of the country, there will be a flow of short-term funds into that country and the exchange rate of the currency will increase in the foreign exchange market. Reverse will happen in case of fall in interest rates. If there is increase in the interest rate of the country and other factors remains constant, the foreign investment in that country will see an upward trend, thus leading it to a strong position in the foreign exchange market. Reverse will happen in a country where there is decrease in the interest rate, and the upward trend will not be as high as said above, if the other factors don’t remain constant. The external borrowing and assistance in various ways will result into a favourable effect on the exchange rate of the country. But, when the repatriation of principal with interest is done or started the exchange rate will move in opposite direction. Factor # 8. Political Factors: The look out of government towards the foreign market and international trade and commerce define their policies. A steady government of a country provides more time to investors of different countries to decide their strategies and take steps of investing.
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  The turbulence ingovernment of a country will affect the investors of different countries, and might reduce the overall foreign investment in the country. Thus, the policy of a country decides the ratio and proportion of the foreign investment in the country. The policy of the government depends on the economic situation in an economy. For Example, if a country is moving with deficit in balance of payments and lower inflation rate (some rate of inflation is required in a country to sustain itself), the government will take measures to increase the exports, decreasing the imports, calling for foreign capital and in – built capital creation, etc. The pattern which government decides to follow will result into creation of that kind of policies, thus will provide an idea to foreign investors, that what a government of a country is planning and how the economy of a country is proceeding. Government will initiate various steps in like intervening in the market, if there is wide variation between the market rates from predetermined rate. Factor # 9. Psychological Factors and Speculation: The perception and speculative motives in the mind of an individual player or firm will play a significant role in the movement of prices of the foreign currency. Many a times, the market maker in the market can influence the rate, to move differently from that determined by long-term economic forces, by buying or selling a particular foreign currency or group of freeing currency on large scale and conversion to take place immediately from one currency to another. A large-scale purchase or sale of foreign exchange by speculators with expectation of fall or rise in exchange rates in addition to change in the interest rates or taking the support of capital account convertibility, accelerates the fall or rise in the foreign exchange conversion rate. The speculator may purchase heavily a foreign currency by expecting a rise in price (known as bull player) or sell heavily by assuming future fall in prices (known as bear). The speculator may also rake the form of leads (pre or early) and lags (post or delay) in delivery of foreign currency, with an intention to gain benefits of the price movements. The exchange rates are influenced by numerous factors. Some are interrelated while some are independent. Factors together decide the trend. DETERMINATION OF EXCHANGE RATE IN THE FORWARD MARKET Forward exchange rate is normally not equal to the spot rate. The size of forward premium ordiscount depends mainly on the current expectation of future events. The determination of exchange rate in a forward market finds an important place in the theory of interest rate parity (IRP). Covered interest rate Arbitrage,Uncovered interest rate arbitrage. Main Factors Affecting the Forward Rate Mechanism Factor # 1. FCNR Deposits and the Forward Rate: Under the Foreign Currency Non-residents (FCNR-B) deposit scheme, banks can swap foreign currency deposits for rupees in the market. (Under an earlier FCNR-A scheme, now
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  discontinued, such swapswere done with RBI, at level rates). Swap is a kind of transaction which banks enters, to hedge their position of foreign exchange. They are always in a position in foreign exchange market viz. over-bought or over-sold. The banker who is in over-bought position will need to provide home currency on the exchange date. Thus, he will need to arrange for requisite home currency to get foreign currency. To hedge his position to the variations in the foreign exchange market, he will also need to sell foreign currencies; else he will have lots of foreign currency but no home currency to pay for it. So when he sells foreign currency he hedges his position through availability of home currency and can maintain his profits through the continuous changes happening in foreign exchange market. Bank also faces the same type of problems, with respect to interest amount receivables and payables with respect to foreign currency. If the interest amount is not hedged in the forward market, strictly speaking, it should be included in the “gap” limit referred to above. A bank would swap FCNR deposits for rupees in the manner indicated, only if the overall cost of generating the rupee resources is economic, i.e., when the forward margin is less than the interest differentials between foreign currencies and rupees. Thus, the deposited banks are also a source of demand in the forward market. Factor # 2. Forward Margin: The forward margin depends on the perceptions of the buyers and sellers of currencies in the Indian market. The forward margin is called a premium on the currency whose forward rate is costlier than the spot rate and a discount where the forward rate is cheaper. It is expressed in the same currency as the spot rate and the general practice is to quote it as a discount or premium on that i.e., reported currency. Factor # 3. Delivery Options: Delivery option refers to the option for choosing the value date within an agreed period. In the interbank market, the option period may be limited to the extent of a calendar month, and can be further broken down based on the need of the party, by considering the actual date of need. One feature of the Indian market is that the delivery of a claim for foreign currency receivable is considered as delivery of the foreign currency although the currency may be receivable after some time. For example, if a bank buys from an exporter a dollar bill of exchange drawn on the buyer abroad, the exchange transaction, namely the purchase of dollars, is completed when the bill itself is purchased. It will be readily seen that the bank would actually get the dollars only when the buyer abroad will pay the bill in accordance with its tenor of maturity. When the agreed value date for the transaction is in mid of the month, then the accepted standard rule for rate quotations for option contracts is the worse rate among the beginning and end of the option period, and is use by bank to quote to the customer.
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  It means thatif a foreign currency is at a premium in the forward market, then the rate applicable to the beginning of the option period will be quoted and used by bank for purchase of the foreign currency from the trader or merchant. But, if the bank has to sell the foreign currency the rate applicable at the end of the period will be applicable. This is done with a specific reason to gain to be earned by banker. If the foreign currency is at a discount the worse rate rule will be to load the highest discount in the purchase rate, and the lowest in the sale rate. In brief, for option forwards, The basic principle for quoting a forward rate to the customer is the same as for spot rates, to ascertain the wholesale market rate and add a load of margin. If the interbank spot rate is Rs.42.53/56 and the one month discount on the rupee (i.e. premium on the dollar) is 5/6 ps, the wholesale market rates for one month forward dollars are Rs.42.58/62. The one month option forward customer rates, assuming a margin of 10 p, will be selling, or offering, dollars (to importers, etc.) at Rs.42.72, and buying, or bidding for dollars (from exporters, etc.) at Rs.42.48. The one month fixed date delivery rates will be Rs.42.48/42.72. Factor # 4. Card Rates for Customer Transactions: Banks in India have either a central interbank trading office for foreign exchange operations (the FX Treasury), or at best can have offices in two or three major centers. The customer transactions are undertaken at a large number of branches. The practice therefore is to calculate the so-called “card rates” for customer transactions in the FX treasury in the morning, based on the ruling rates in the domestic and international markets. The card rates are then communicated to the operating branches by telephone or fax or e-mail etc. The card rates are used for undertaking customer transactions for amounts not exceeding a stipulated limit. Generally, the card rates are for relatively small value transactions, and are difficult to change intra-day. Card rate includes the maximum permissible margins. For large value transactions, i.e., beyond the stipulated limits, the branches are expected to telephone the FX treasury and get applicable rate. In general, these would be more competitive, and based on the ruling interbank rates. Factor # 5. Interbank Forward Quotations: These quotations are in paisa per dollar or any other foreign currency and apply to end of the month deliveries. The interbank market is not active beyond 12 months. The interbank forward quotations are quotes used and applied for transactions between two banks to ensure to remove the mismatch of maturities in their forward transactions. Factor # 6. Cash: Spot and Call Rates: The cash spot margin in the interbank market is generally governed by the call market in Indian rupees. This is because arbitrage is possible between borrowings in the call market at a particular rate, and sells cash or buy spot dollar swap in the exchange market. Banks would use the cheaper market; hence, there is a strong correlation between the cash: spot margin and the call rate.