What is Exchange rate determination? full concept

EXCHANGE RATE DETERMINATION

FOREIGN EXCHANGE: Each country has its own currency which is called as home currency. Our home currency is Rupee (INR). The home currency of US is US Dollar (USD). All currencies other than the home currency are called foreign currency. They are also called foreign exchange as they have to be converted or exchanged into home currency and vice versa.

Exchange Rate:  It is the ratio of exchange between 2 currencies. It is also called foreign exchange quotation. There are 2 methods of quoting the exchange rate.

-        Direct method: It tells the number of units of home currency required to buy one unit of foreign currency. Ex – 1 USD = Rs 45.5125.

-        Indirect method: It tells the number of units of foreign currency that can be bought with 1 unit of home currency. Ex – Rs 1 = 0.22USD or Rs 100 = 22USD.

BID AND OFFER RATE: Foreign exchange dealers usually quote 2 rates, one for buying and the other for selling. The buying rate is called bid rate while the selling rate sis called offer or ask rate. The offer rate would be higher than the bid rate. The difference between the bid and the offer rate is called bid –offer spread and is a source of profit for the dealers. 

SPOT MARKET AND FORWARD MARKET

-        In the spot market, deals are arranged for immediate delivery of foreign exchange. The settlement takes place on the second working day after the transaction. The rate at which these transactions occur is called the spot rate.

-        In the forward market, the purchase and sale of a foreign currency is arranged today at an agreed exchange rate, buy delivery is scheduled to take place sometime later. The rate at which these transactions happen is called the forward rate.

CROSS RATE: The exchange rate between 2 currencies depends upon the demand and supply of each of them. Exchange rate is available for currencies that are frequently transacted. However, the exchange rate may not be available for currencies which have only a limited transaction. In such cases, the home currency can be converted into a common currency like USD or Euro and the common currency can then be converted into desired currency. This is called cross rate trading where there is a three way transaction involving 3 currencies i.e. the home currency, common currency and desired currency. The exchange rate established through such a three way transaction is called cross rate. Ex – Suppose INR – Canadian dollar exchange rate is not available. So, it can be done through a common currency USD. The following rates are available:

1 USD = Rs 40 (bid rate), Rs 40.30 (ask rate)

1 USD = Can $ 0.76 (Bid rate), 0.78 (ask rate)

To buy Can $ we need to buy USD at Rs 40 and then sell this USD at Can $ 0.76 (which is Rs 40.30). So to get 0.76 Can $ we have to pay Rs 40.30. So for 1 Can $ we pay Rs 53.03. This is the cross rate.

 

MOVEMENTS IN EXCHNAGE RATE

1.      CURRENCY APPRECIATION AND DEPRECIATION: Happens in case of floating exchange rate regime. When the home currency price of a foreign currency increases or moves up then there is appreciation in the value of foreign currency and the foreign currency is said to be appreciating in comparison to home currency. Ex – If the Exchange rate of INR / USD was 1 USD = Rs 45.5125 and later is becomes 1 USD = Rs 47, it means that USD is now more expensive and hence has appreciated.  

When the home currency price of a foreign currency decreases or moves down then there is depreciation in the value of foreign currency and the foreign currency is said to depreciate with respect to home currency. Ex – If the Exchange rate of INR / USD was 1 USD = Rs 45.5125 and later is becomes 1 USD = Rs 43, it means that USD is now less expensive and hence has depreciated.  

2.      CURRENCY DEVALUATION AND REVALUATION: Happens in case of fixed exchange rate regime. Devaluation of a currency is a deliberate lowering of an official exchange rate of a country and setting a new fixed rate with respect to a reference of foreign currency such as the USD. It should not be confused with depreciation which is the decrease in the currency value as compared to other major currency benchmarks due to market forces. The process of devaluation tends to render the foreign currency more expensive than the local currency. For instance, a country whose 10 units of its currency is equivalent to one dollar may decide to devalue its currency by fixing 20 units to be equal to one dollar. By doing so, the home country would be half as expensive a

 

               Revaluation is a significant rise in a county’s official exchange rates in relation to a foreign currency. The process of revaluation can only be done by the central bank of the revaluing country. For instance, if a countries currency trades at 10 units to 1 US dollar, to revalue it, the said country can change to using 5 units of its currency to be equivalent to 1 dollar in order to make it twice expensive compared to the dollar.

Difference between Devaluation and depreciation:

Base	Devaluation of currency	Depreciation of currency
Meaning	Devaluation means to lower the value of country's currency as compared to the another country’s value	The meaning of depreciation of the currency is the same as the meaning of devaluation of the currency.
Circumstances	It is done by government authority.	It is done by the force of demand and supply in the international market.
Rate	It is done by using fixed exchange rate.	It is done by using floating exchange rate
Effect on economy	It just for short term.	It affects the economy for a longer term
Changes	There is no fixed time for it but it doesn’t occur in regularly.	It occurs on a daily basis.

 

FACTORS AFFECTING EXCHNAGE RATE MOVEMENTS

1.                Inflation Rates: Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates

 

2.                Interest Rates: Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates

 

3.                Country’s Current Account / Balance of Payments: A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.

 

4.                Government Debt: Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

 

5.                Terms of Trade: Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value. This results in an appreciation of exchange rate.

 

6.                Political Stability & Performance: A country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

 

7.                Recession: When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

 

8.                Speculation: If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as well.

 

 

 

CONCEPT OF INTERNATIONAL ARBITRAGE

Arbitrage refers to the simultaneous purchase and sale of commodities or financial instruments in various markets to profit from unequal prices without risk.  Arbitrars take benefit from price differential in different markets. They purchase from a market where the price is low and simultaneously sell in a market where the price is high thereby making riskless profit. 

The term international arbitrage refers to the practice of simultaneously buying and selling a foreign security on two different exchanges. The international arbitrage is of three types:

Local arbitrage: It is possible when a banks buying price (bid price) is higher than another banks selling price (ask price) for the same currency.  Example:

Bank A: INR/USD: 1 USD = Rs 40 (bid rate), Rs 40.30 (ask rate)

Bank B: INR/USD: 1 USD = Rs 42 (bid rate), Rs 41 (ask rate)

They buy from bank A at Rs 40.30 and sell to bank B at Rs 42.

Triangular arbitrage: A triangular arbitrage opportunity is a trading strategy that exploits the arbitrage opportunities that exist among three currencies in a foreign currency exchange.

The arbitrage is executed through the consecutive exchange of one currency to another when there are discrepancies in the quoted prices for the given currencies.

A triangular arbitrage opportunity occurs when the exchange rate of a currency does not match the cross-exchange rate. The price discrepancies generally arise from situations when one market is overvalued while another is undervalued. The nature of foreign currency exchange markets limits the price discrepancies between different currencies to a few cents or even to a fraction of a cent. Therefore, the transactions in a triangular arbitrage opportunity involve trading large amounts of money.

Example: suppose you have $1 million and you are provided with the following exchange rates: EUR/USD = 0.8631, EUR/GBP = 1.4600 and USD/GBP = 1.6939.

With these exchange rates there is an arbitrage opportunity:

1.      Sell dollars for euros: $1 million x 0.8631 = €863,100

2.      Sell euros for pounds: €863,100/1.4600 = £591,164.40

3.      Sell pounds for dollars: £591,164.40 x 1.6939 = $1,001,373

4.      Subtract the initial investment from the final amount: $1,001,373 - $1,000,000 = $1,373

From these transactions, you would receive an arbitrage profit of $1,373 (assuming no transaction costs or taxes).

COVERED INTEREST RATE ARBITRAGE: It is the process of capitalising on the interest rate differential between 2 countries while covering the exchange rate risk by using a forward contact. It is called covered arbitrage as 2 objectives are fulfilled: Covering against risk and arbitrage opportunity. Steps:  Exchanging domestic currency for foreign currency at the current spot exchange rate. Investing the foreign currency at the foreign interest rate. Simultaneously, the arbitrageur negotiates a forward contract to sell the amount of the future value of the foreign investment at a delivery date consistent with the foreign investment's maturity date, to receive domestic currency in exchange for the foreign-currency funds.

Example: An investor has $5,000,000 USD. The interest rate is U.S is 3.4%, while the euro deposit rate is 4.6%. The current spot exchange rate is 1.2730 $/€ and the six-month forward exchange rate is 1.3000 $/€. Investing $5,000,000 USD domestically at 3.4% for six months ignoring compounding, will result in a future value of $5,085,000 USD. However, exchanging $5,000,000 dollars for euros today (3927730 euros) , investing those euros at 4.6% for six months ignoring compounding (4108405 euros), and exchanging the future value of euros for dollars at the forward exchange rate (on the delivery date negotiated in the forward contract), will result in $5,223,488 USD, implying that investing abroad using covered interest arbitrage is the superior alternative.

THEORIES OF EXCHANGE RATE

The following theories explain the different aspects of exchange rate behaviour:

1. PURCHASING POWER PARITY THEORY:  According to this theory, the exchange rate between any two currencies is determined by their purchasing power. The purchasing power of a currency is equivalent to the amount of goods and services that can be purchased with one unit of that currency. According to this theory, it is fair and equitable that the exchange rate between any two currencies is determined such that the same purchasing power is considered for both currencies. Assumptions of the theory:

-          Law of one price.

-          No arbitrars are present.

-          Unrestricted movement of goods and other financial assets

For Example: If a commodity costs Rs 90 in India and USD 2 in USA, then the initial exchange rate would be 2 USD = 90 INR or 1 USD = 45 INR. If the price changes in any of the countries then the exchange rate would move accordingly to accommodate any such change.

 There are 2 versions of the purchasing power theory:

 

-          Absolute PPP theory: It states that the exchange rate between the currencies of 2 countries would be equal to the ration of price levels of the two countries as measured by their consumer price index i.e. Current exchange rate = price level in home country/price level in foreign country. This model will work only if the same commodities are included in the same proportion while calculating price level in both countries.

 

-          Relative PPP theory: It explains why the exchange rate between 2 currencies fluctuates in the long run. According to this theory, one of the responsible factors is the inflation rate. The change in the exchange rate would be equal to the inflation rate differential in both countries. As long as the inflation in both the countries remains the same, the exchange rate will not be affected. As the inflation rate changes, the same gets reflected in the exchange rate. Formula: Expected exchange rate at time t = Current exchange rate { (1+ expected domestic inflation)^t / (1+ expected foreign inflation rate )^t}

Problems of PPP theory

-          The assumptions on which this theory is based may are not true.

-          Other factors like interest rate, BOP etc may also have an impact on the exchange rate.

-          It ignores capital flow between countries.

 

2. FISHER EFFECT THEORY

This theory deals with the varying interest rates in different countries. The theory states that assuming that there is an international mobility of funds or facility for free flow of funds across nations; the interest rate in different countries will be the same. Or else, arbitrage in the form of international capital flows will begin and continue till the parity is established between the interest rates across countries. For example: if the interest rate in Indian and USA is 6% and 4 % respectively; then arbitrage will happen. Capital will begin to flow from USA and India as the higher rate of interest is in India. This will reduce the volume of capital in USA and hence increase the interest rate. In India, the volume of capital will increase and hence the interest rate would decline. Hence, through arbitrage the interest rate would become same. 

But in real world, we see that the interest rate is different among different countries. This was explained by a scientist named Fisher. He made a distinction between 2 types of interest rates: nominal and real. The real interest rate is the rate which the investor expects after allowing for inflation.  A nominal interest rate refers to the interest rate before taking inflation into account.

According to fisher equation,

Nominal interest rate = Real interest rate + expected inflation

So, according to fisher the difference in the interest rate among countries arises due to the difference in the rate of inflation among the countries. Difference in interest rates among the countries = difference in inflation rates among them.

 

3.      INTERNATIONAL FISHER EFFECT THEORY

According to the purchasing power theory, the exchange rate between countries changes as per the change in the price level (inflation rates). So, Difference in exchange rate = difference in inflation rate.

According to fisher theory, Difference in interest rates among the countries = difference in inflation rates among them.

From above two statements,

Difference in exchange rate = difference in the interest rate among countries. This is called the international fisher effect theory. According to this theory, the exchange rate between countries will move in an equal but opposite direction to the difference in the interest rates between the countries. 

 

4.      INTEREST RATE PARITY THEORY

This theory states that the interest rate difference between two countries is equal to the percentage difference between the forward and the spot rate. The forward rate may be at premium (higher) or at discount (Lesser) than the spot rate. 

Explanation: Suppose an investor has some USD.

Option A: Invest the USD in India at a risk free rate for a specified period of time. Then convert the proceeds from the investment and convert to USD.

Option B: Invest USD in the US market for the same time period.

Result of parity: In absence of arbitrage, the return in both the cases would be the same.

According to the IRP relationship, the amount that you have exchanged at the spot rate, invested in the foreign interest rate and then exchanged at the future date should be equal to simply investing in the home currency interest rate for the same period of time. The idea behind the IRP theory is that if currencies are in equilibrium, then you should not be able to profit from just exchanging money.

So, in equilibrium the return on currency will be equal and the interest rate parity can be written as:

F/S = (1+ Rhome)/ (1+Rforeign).

 

So, According to the theory, the forward exchange rate should be equal to the spot exchange
rate times the interest rate of the home country, divided by the interest rate of the foreign
country

Where,

F = forward exchange rate for a specific future period

S = spot rate

R_foreign = nominal interest rate with maturity equal to that of foreign exchange rate in foreign currency.

R_home = nominal interest rate with maturity equal to that of foreign exchange rate in foreign currency.

 

VIOLATION OF IRP

In case the IRP does not hold, then there will be covered international arbitrage.

Why is Interest Rate Parity (IRP) Important?

Interest rate parity is an important concept. If the interest rate parity relationship does not hold true, then you could make a riskless profit. The situation where IRP does not hold would allow for the use of an arbitrage strategy. For example, let us look at the scenario where the forward exchange rate is not in equilibrium with the spot exchange rate.

If the actual forward exchange rate is higher than the IRP forward exchange rate, then you could make an arbitrage profit. To do this, you would borrow money, exchange it at the spot rate, invest at the foreign interest rate and lock in the forward contract. At maturity of the forward contract, you would exchange the money back into your home currency and pay back the money you borrowed. If the forward price you locked in was higher than the IRP equilibrium forward price, then you would have more than the amount you must pay back. You have essentially made riskless money with nothing but borrowed funds.

Interest rate parity is also important in understanding exchange rate determination. Based on the IRP equation, we can see how changing the interest rate can affect what we would expect the spot rate to be at a later date. For example, by holding the foreign country interest rate steady and increasing the home country’s interest rate, we would expect the home country currency to appreciate in relation to the foreign currency. This would affect the expected exchange rate.