Exchnage rate determination

Exchnage rate determination

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  EXCHANGE RATE DETERMINATION Dr. MohamedKutty Kakkakunnan Associate Professor P G Dept. of Commerce N A M College Kallikkandy Kannur – Kerala - India
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  EXCHANGE RATE  Whatis a market?  What is market mechanism?  In a foreign exchange market foreign currencies are bought and sold  Transaction involves in two currencies  One currency = how many foreign currency?  Relationship is expressed in the form of ratios or rates  The ratio or rate at which one currency is bought and sold for another currency – foreign exchange rate  It is the price of one currency in terms of another  It specifies the number of units of a given currency that can be purchased with one unit of other currency
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  Quotations in ForeignExchange Market  Two currencies - one in term of other  Home currency – foreign currency  Expression of one currency in terms of other This expression can be made in two ways • Direct quotation and • Indirect quotations  Direct Quotation : Local currencies are expressed in terms of one unit of foreign currency.  Direct rate is the rate at which the number of units of home currency can be bought or sold at per unit of foreign currency  Eg: INR 68 = $ 1 This shows that Rs. 68 is required to get one dollar (home currency varies but foreign currency is fixed)
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  Indirect quote /rate - the number of units of foreign currency that can be bought or sold per unit of local currency In case of indirect quote the exchange rate is given in terms of units (variable) of foreign currency as equivalent to a fixed number of home currency Eg: $. 0.147 = INR 1 Direct quote expresses per unit of foreign currency in term of home currency and indirect quote expresses per unit of local currency in terms of foreign currency
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  Two-way Quotes (Buyingand Selling Rates)  Different players in foreign exchange market – dealers, brokers etc  A dealer buys and sells foreign currencies at his own risk  Usually quote two prices for the same currency  One for buying and Another for selling  Buying rate is the rate at which he buys the foreign currency and is known as bid rate  Selling rate is the rate at which he sells the same foreign currency and is known as ask rate  The difference between these rates represent his profit and is know as spread  Spread is the margin or profit of a dealer in foreign exchange market  Percentage of spread is
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  Determination of ExchangeRates • Price mechanism • Market forces • Equilibrium price • Equilibrium exchange rate is the at which the demand for and supply of foreign currency are equal • “that rate which over a certain period of time keeps the balance of payments in equilibrium”- Regnar Nurkse
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  Demand for ForeignCurrency • Arises from individuals and firms who have to make payments to foreigners in foreign currencies (import of goods and services and for purchases of securities) Factors affecting demand 1. Price of goods and services in domestic and foreign countries 2. Import of goods and services 3. Investments made in foreign countries 4. Other payments based on bilateral agreements, charity etc
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  Supply of ForeignExchange Export of goods and services, and other receipts in the form of investment, donations, charities and payments based on bilateral agreements Factors 1. Export of goods and services 2. Investments 3. Receipts by way of bilateral agreements 4. Donations, charities etc 5. Remittances made by NRIs etc
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  D D S S Excess demand Excess supply Equilibrium point P1 P P2 A B E
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  Factors Influencing ExchangeRate 1. Relative inflation rates Due to inflation in one country, the goods become dearer at the same time price level of the other country remains the same. This results in import of goods from other country resulting in the increase of the demand for the currency of the importing country.
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  2. Relative InterestRates Difference in interest rates result in the demand and supply of foreign currency How? Investment for earning interest Citizens of countries where interest rate is low will invest in countries where there is high interest – increasing demand for the currency of the investing country Increased supply of foreign currency in the investing country will result in decline of the exchange rate of foreign currency
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  3. Relative IncomeLevels Increase in the income level of one country will result in increased consumption and more import ultimately resulting in the increased demand for foreign currency 4. Govt. controls and regulations 5. Market expectations Future expectations about possible increase or decrease in exchange rates 6. Speculation 7. Changes in bank rates
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  8. Political conditions 9.Stock exchange activities like sale and purchase of securities etc. 10. Banking operations (purchase and sale of foreign exchanges and securities) 11. Credit policy of banks – liberal credit policy helps speculators to purchase and old foreign currencies 12. National budgetary influences : Deficit, balanced and surplus budget – deficit budget require more resources and lead to exchange rate decline