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Financial Markets Products and Institutions

Atharva Institute of Management Studies


Learning Objectives

Atharva Institute of Management StudiesUnderstand the concept of Exchange Rate

Understanding the factors determining the demand and supply of foreign exchange

Understand the theories of exchange rate determination

Understanding the concept of equilibrium exchange rate


Understanding the Concept of Foreign Exchange and Exchange Rate

Atharva Institute of Management StudiesAs we all know, each country has its own currency or its domestic measure of value.

The USA has dollar, India has rupee etc

When countries exchange goods or services they earn or have to pay the other countries.

Exporting earns the currency of other countries and importing requires payment in the other countrys currency.

Foreign exchange refers to the receipts or payments in terms of other countries currencies.

The residents in a country have their own domestic currency, which is not legal tender in the other countries. Hence, it is necessary to convert the currency of one country into that of the other country

The rate at which one unit of a countrys currency is converted in to that of another is known as the exchange rate.


Understanding the Concept of Foreign Exchange and Exchange Rate

Atharva Institute of Management StudiesAlternatively, it is the price of foreign exchange per unit of domestic currency.

When one unit of domestic currency purchases more units of the foreign currency, we say the exchange rate appreciated: US$ 1= Rs.48 becomes, US$ 1= Rs. 46 [alternatively Rs1= US$ 0.02083 becomes Rs.1 = US$0.02173]. Conversely, if the domestic currency purchases lesser units of foreign currency, the exchange rate depreciates: say, US$ 1 becomes Rs.52 [Rs 1= US$ 0.20833 and Rs. 1 = US$ 0.017857].


Understanding the Concept of Foreign Exchange and Exchange

Atharva Institute of Management StudiesSpot Rate and Forward Rate:

Sport rate refers to the exchange rate between two currencies that will prevail in the market for a day or two. In other words, it is the rate for today and tomorrow. This rate is used for settling the transactions in the market.

Forward rate is the rate of exchange that will come into effect at a future date. The forward rate is contracted today to settle a transaction that will take place sometime in future.


Determination of the Exchange Rate

Atharva Institute of Management StudiesSince exchange rate is the price of foreign exchange, it is determined by the demand for and supply of foreign exchange. The following are the various sources of demand and supply of foreign exchange

Demand for Foreign Exchange A country would demand foreign exchange for the following sources Merchandise Imports: A country requires foreign exchange to pay for its imports. These are a major source of demand for foreign exchange.

Import of Services (invisible imports): A country requires foreign exchange in order to pay for the transport, insurance and banking services that the residents obtained from other countries. Debt servicing and amortization are also important sources of demand for foreign exchange.

Export of Capital: When residents, institutions and government invest abroad, they will demand foreign exchange.



Atharva Institute of Management StudiesSupply for Foreign Exchange

A country obtains foreign exchange from the following sources:

Merchandise Exports: When country exports its produce to other countries, it will obtain foreign exchange.

Exports of Invisibles: Countries obtain foreign exchange when they provide transport, insurance and banking services to other countries. Remittances, interest received on previous loans to other countries are also an important source of supply of foreign exchange.

Imports of Capital: These are borrowings and transfer of reserves from one country to another.




The market exchange rate is determined by the interaction between the demand and supply of foreign exchange. The following diagram explains the determination of the exchange rate.


Purchasing Power Parity Theory

Atharva Institute of Management StudiesOne of the most important concepts in international trade is the purchasing power parity. Before 1914, the value of each currency was expressed in terms of the gold it could buy. For example, if we required Rs 5,000 to buy one gram of gold and $ 17.5 to buy the same gold, the exchange rate was given as Rs 5,000 = US $ 17.5 or the purchasing power. Following the First World War, the gold standard was given up and inconvertible paper currencies were introduced. In order to arrive at the equilibrium exchange rate under this system, in 1922, Gustav Cassel of Sweden proposed a new theory. This theory is known as the purchasing power parity theory. It attempts at arriving the value of a currency in terms of the goods it commands. Thus, the prices of traded goods in two countries are compared for the equilibrium exchange rate between the two.



Atharva Institute of Management Studies The Absolute Version: In this version, the price of a particular traded commodity is compared to arrive at the exchange rate. For example, if an automobile costs Rs 10,00,000 in the India and $ 125,000 in the US, the equilibrium exchange rate would be Rs 1,000 = $125. This version is based on the assumptions that there are no barriers to trade, no transport cost, perfect competition in both the countries and there are no capital movements. As can be seen easily, this version can give us more than one exchange rate. If we consider another commodity, say textiles, the prices might have been Rs 1,500 and $325. So obviously, the problem would be which rate should be considered as the equilibrium exchange rate.



Atharva Institute of Management StudiesThe Relative Version:In order to answer this question, Cassel introduced the relative version. This version is based on the following assumptions:There is free trade between the two countries. There is full employment in both the countries. Only the prices of traded goods are considered. Non-traded goods do not influence the purchasing power. There are no international capital flows. There is perfect competition in both the countries.There is no transport cost between the two countries.



Atharva Institute of Management StudiesGiven the above assumptions, Cassel shows that the movement in the purchasing power parity equilibrium exchange rate can be shown as:

Let 1 = US$ 1.758 in 2000; the base year is 2000; UKs price index of traded goods is 228 and that of US is 248 in 2010; then, the new exchange rate based on the purchasing power parity between the pound and dollar would be:

1.758 x (248/228) = 1.9122 implying that the dollar would depreciate by 8.77 percent or the pound would appreciate by 8.77 percent. Therefore, a country with a higher increase in the price level would lose its purchasing power.1.9122-1.758 = 0.1542 0.1542/1.758 x 100 = 8.77%



Atharva Institute of Management StudiesCriticism- There has been extensive research on the purchasing power parity since it is necessary to understand the changes in a countrys price competitiveness. This has led to a number of observations on the determination of the value of a currency. Following are some of the important observations in this direction. It is difficult to choose an appropriate base year for the comparison of the changes in the price levels in the two countries.The assumption that there is full employment in both the countries is not realistic. In the absence of full employment, an increase in money supply does cause the output to increase.Exchange controls also influence the purchasing power. An over-valued currency cannot give us a true picture of purchasing power.It is important to note that the purchasing power parity theory, despite its many limitations is a popular tool of policy analysis.


Foreign Exchange Market in India

Atharva Institute of Management StudiesForeign Exchange Market (FEM) refers to the market that deals with national monetary units or claimed that are exchanged for the foreign monetary units. It is not a physical place, but a network of commercial banks, foreign exchange brokers and dealers that bring the buyers and sellers together. It helps in transfer of purchasing power denominated in one currency to another. The transactions in this market are liquid, large and frequent, as the exchange rates of major currencies tend to change 20 times in a minute. Some transactions run into U.S. $ 200 million to $ 500 million. In 2005, the average daily turnover in the global FEM is estimated at U.S.$ 3.6 trillion. The importance of FEM in India can be understood by looking at a few statistics relating to Indias trade.

In India, foreign exchange refers to: a) all deposits, credits, balances payable in any foreign currency, drafts, travellers cheques, letters of credit, and bills of exchange; b) any instrument payable in Indian currency or in foreign currency or partly in both. The following chart shows the structure of the FEM.


Foreign Exchange Market in India

Atharva Institute of Management StudiesIn India, RBI allows two types of foreign exchange dealers. Restricted Money Changers or Retailers are, firms, hotels, shops and other organisations, which are allowed to purchase foreign exchange. Full fledged Money Changers are allowed to both buy and sell foreign exchange.

Inter-bank FEM comprises of the Head offices and Regional Offices of major commercial banks, along with the IDBI, IFCI, ICICI, 84 of these, are known as authorised dealers (ADs). They are allowed to conduct all foreign exchange transaction of the public and are directly supervised by the RBI. They transfer bank deposits from sellers to buyers accounts. There is no physical transfer of currency and all transfers are book-keeping entries. The inter-bank market does not charge any commission for their services. There are 40 exchange brokers, who form part of the indirect market, charging a commission for their services. These brokers match purchases and sales orders of different currencies in the market. These 124 entities together are known as Foreign Exchange Dealers Association of India (FEADI) and operate under the supervision of the RBI. Inter-bank transactions in the FEM are settled through a clearinghouse, where the banks deposit funds. In September 1995, RBI introduced a clearing system in India, which is still in nascent stage.


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