Description
covers Fixed and Flexible. It also covers structures, functions and types(spot, forward) of exchange market. Other topics covered are arbitrage, fluctuation etc.
• Foreign Exchange refers to the rate at which the currency of one country is bought and sold in terms of currency of another country
NOW……….
• The question arises here is „why does the need for buying and selling of foreign currency arise??
• In foreign trade, goods and services are traded across national boundaries but the currency of one country is not acceptable in another country
• The price of one currency in terms of another is called the Exchange Rate
• There are two different conditions under which the rate of exchange will determined
i. When foreign Exchange market works freely ii. When foreign Exchange market is controlled and regulated
T
•
The foreign Exchange market transfers funds (foreign currency) from one country to another where they are needed in the settlement of payments It provides short-term credit to the importers and, thereby, facilitates the smooth flow of goods and services from one country to another
•
•
The spot and forward market work in such way that it helps often in stabilizing the foreign Exchange rate
TYPES OF FOREIGN EXCHANGE MARKET
• Spot Market
– Transactions settled within 2 days
• Forward Market
– Agreement to transact after 90days of deal
NATURE OF TRANSACTIONS IN FOREIGN EXCHANGE MARKET
• Hedging
– Settle exchange rate in advance – Covers risk of exchange rate fluctuation
• Arbitrage
– Act of simultaneous purchase and sale of different currency in two or more exchange markets – Works as stabilizing factor in foreign exchange markets.
• Speculation
– Buying and selling currency under uncertain condition to make profit – “Buy forward and Sell on the spot” & “Sell Forward and Buy on the spot”
EXCHANGE RATE REGIME
• The exchange-rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market. • Closely related to monetary policy and the two are generally dependent on many of the same factors.
TYPES OF EXCHANGE RATE
• • • • Floating/ Fluctuating exchange rate Fixed exchange rate Pegged Float Dollarization
FLOATING/ FLUCTUATING EXCHANGE RATE
• Currency's value is allowed to fluctuate according to
the foreign exchange rate.
• Belize(Located on the north eastern coast of Central America) is an example of floating exchange rate. • Mundell-Fleming Model( fixed exchange rate, free capital movement, and an independent monetary policy )
• Fear of Floating
FIXED EXCHANGE RATE
• Value of currencies kept constant • Worth of its currency in terms of either a fixed weight of gold,
a fixed amount of other currency or a “basket of other
currencies” • The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payment imbalances.
TYPES OF FIXED EXCHANGE RATE
• The Gold Standard • Price Specie Flow Mechanism • Reserve Currency Standard • Gold Exchange Standard
PEGGED FLOAT
• Crawling Bands: the rate is allowed to fluctuate in a
band around a central value, which is adjusted periodically
• Crawling pegs: the rate itself is fixed, and adjusted as above. • Pegged with horizontal bands:The currency is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.
DOLLARIZATION
• Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the
national currency.
FACTORS DETERMINING ECONOMIC VALUE OF CURRENCY
• Import and export
– Payment in dollars
– For example:• 1$=1Rs
– But current 1$ = 50Rs – Finally govt. will have no “$”
• Military force
– Saudi Arabia – Kuwait – Libya – Iraq
• Resources available in country
– Iron, steel, petrol, advance-technology
– unique production capability
– Japan (TV, quality-goods )
• Debt on country
– Payment of interest and loan in dollars
– India was 0 debt country till independence
– 1$=1Rs in 1947
– 1$=50Rs 2012
DETERMINATION OF ER IN
• FREE MARKET
• REGULATED MARKET
FREE MARKET
Demand for FX
Demand for foreign goods, services & securities
Supply of FX
Supply of foreign goods, services & securities
Speculators willing to build their FX reserves
Speculators willing to get rid of their FX reserves
FREE MARKET
Exchange Rate (Rs. Per $) D D P’ P 45 D2 S’
ROUGH WORK
1$= Rs.48 S W 1$=Rs.45 W S
ER US
48
S
D1
India’s demand for $ Supply increases Prices of foreign goods Rs.
Demand of foreign goods
Demand for foreign exchange
India
Demand $
10 13 $ demanded per time unit (million)
FREE MARKET
• Rise in domestic prices
Increases demand for FX Fall in exports
Rise in ER
Demand curve shifts upwards Supply curve shifts leftward
• ROI (domestic) > ROI (foreign)
Capital inflow increases Capital outflow decreases
Fall in ER
Increased supply for FX
FREE MARKET
• Rise in real income (domestic)
Increase in imports
Rise in ER
Increased demand for FX
• Rise in real income (abroad)
Increase in exports
Fall in ER
Increased supply for FX
REGULATED MARKET
• ER is fixed by the Central Bank • Flexibility, if any, usually 10%
• Currency?s par value
• Central Bank undertakes the buy & sell of FX in the FX market • Any change in ER is made by the Central Bank • Devaluation • Revaluation
REGULATED MARKET
D’ S’ Exchange Rate (Rs. Per $)
D
D’’ P’
T F B
P
D’
D R
S O M N
D’’ Q
$ demanded per time unit (million)
FACTORS AFFECTING FOREIGN EXCHANGE VALUE
INTERNATIONAL TRADE
• If a country?s imports are higher, the demand for foreign currency in this country will be high. Higher demand for foreign currency means high value of foreign currency and low value of the domestic currency. • This is a typical case for underdeveloped countries which rely on imports for development needs. The current account balance (deficit or surplus) thus reflects the strength and weakness of the domestic currency.
CAPITAL MOVEMENTS
• International investments in the form of Foreign direct investment (FDI) and Foreign institutional investments (FII) have become the most important factors affecting the exchange rate in today?s open world economy. • Countries which attract large capital inflows through foreign investments, will witness an appreciation in its domestic currency as its demand rises. Outflow of capital would mean a depreciation of domestic currency.
CHANGE IN PRICES
• Domestic inflation or deflation affects the exchange rate by affecting the demand and supply of domestic currency in the foreign exchange market. • For example, if prices in India go up, making Indian goods costlier, the demand for Indian goods will go down. When exports go down, the demand for rupee will fall, causing depreciation in its exchange value.
SPECULATIONS
• Uncertainties are always there in the financial market. • If the speculators expect a fall in the value of a currency in the near future, they will sell that currency and start buying the other currency that they expect to appreciate. The selling of the former currency will thus increase its supply in the foreign exchange market and bring down its value. The other currency appreciates as its demand increases.
STRENGTH OF THE ECONOMY
• If the economic fundamentals of a country are strong, the exchange rate of its domestic currency remains stable and strong • Fiscal balance, international current account balance, international liabilities, foreign exchange reserves, resilience to international trade fluctuations, GDP, inflation rate all are indicators of a country?s economic strength.
GOVERNMENT POLICIES
• In countries where there is fixed or managed float, the central bank becomes an important player in the foreign exchange market. • The bank influences the value of the currency by its market operations like buying and selling of bills and currencies. • The bank rate also influences the exchange rate by influencing investments and thereby the demand and supply of the domestic currency.
STOCK EXCHANGE OPERATIONS
• Stock exchange operations in foreign securities, debentures, stocks and shares, influence the demand and supply of related currencies, thus influencing their exchange rate.
POLITICAL FACTORS
• Political scenario of the country ultimately decides the strength of the country. • An economy with a strong, positive image will obviously have a strong domestic currency. This is the reason why speculations rise considerably during the parliament elections, with various predictions of the future government and its policies.
FACTS
• George Soros is known as "The Man Who Broke the Bank of England" because of his US$1 billion in investment profits during the 1992 Black Wednesday UK currency crisis.
Black Wednesday
•
refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after they were unable to keep it above its agreed lower limit.
FIXED vs FLEXIBLE EXCHANGE RATE
ARGUMENTS IN FAVOUR OF FIXED EXCHANGE RATES
• The stability of exchange rate encourages international trade.
On the contrary, flexible exchange rate system causes uncertainty. • The fixed exchange rate system creates conditions for smooth flow of international capital simply because it ensures a certain
return on the foreign investment. While in the case of flexible
exchange rate, capital flows are constrained because of uncertainty about expected rate of return.
• It removes the dangers of speculative activities in the foreign exchange market. On the contrary flexible exchange rates encourage speculation. • The fixed exchange rate system reduces the possibility of competitive depreciation of currencies.
• Fixed exchange rates can exert a strong discipline on domestic firms and employees to keep their costs under control in order to remain competitive in international markets. This helps the
government maintain low inflation - which in the long run
should bring interest rates down and stimulate increased trade and investment.
ARGUMENTS IN FAVOUR OF FLEXIBLE EXCHANGE RATES
• Flexible exchange rate is self adjusting and therefore it does not devolve on the government to maintain an adequate foreign exchange reserve. • Flexible exchange rates serve as a barometer of the actual
purchasing power and strength of a currency in the foreign
exchange market. It serves as a useful parameter in the formulation of the domestic economic policies.
• Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. If an economy has a large deficit, there is a net outflow of currency from the country. This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the
home markets goes up (making imports appear more
expensive).
• Key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be
set to keep the value of the exchange rate within predetermined bands.
doc_677125575.pptx
covers Fixed and Flexible. It also covers structures, functions and types(spot, forward) of exchange market. Other topics covered are arbitrage, fluctuation etc.
• Foreign Exchange refers to the rate at which the currency of one country is bought and sold in terms of currency of another country
NOW……….
• The question arises here is „why does the need for buying and selling of foreign currency arise??
• In foreign trade, goods and services are traded across national boundaries but the currency of one country is not acceptable in another country
• The price of one currency in terms of another is called the Exchange Rate
• There are two different conditions under which the rate of exchange will determined
i. When foreign Exchange market works freely ii. When foreign Exchange market is controlled and regulated
T
•
The foreign Exchange market transfers funds (foreign currency) from one country to another where they are needed in the settlement of payments It provides short-term credit to the importers and, thereby, facilitates the smooth flow of goods and services from one country to another
•
•
The spot and forward market work in such way that it helps often in stabilizing the foreign Exchange rate
TYPES OF FOREIGN EXCHANGE MARKET
• Spot Market
– Transactions settled within 2 days
• Forward Market
– Agreement to transact after 90days of deal
NATURE OF TRANSACTIONS IN FOREIGN EXCHANGE MARKET
• Hedging
– Settle exchange rate in advance – Covers risk of exchange rate fluctuation
• Arbitrage
– Act of simultaneous purchase and sale of different currency in two or more exchange markets – Works as stabilizing factor in foreign exchange markets.
• Speculation
– Buying and selling currency under uncertain condition to make profit – “Buy forward and Sell on the spot” & “Sell Forward and Buy on the spot”
EXCHANGE RATE REGIME
• The exchange-rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market. • Closely related to monetary policy and the two are generally dependent on many of the same factors.
TYPES OF EXCHANGE RATE
• • • • Floating/ Fluctuating exchange rate Fixed exchange rate Pegged Float Dollarization
FLOATING/ FLUCTUATING EXCHANGE RATE
• Currency's value is allowed to fluctuate according to
the foreign exchange rate.
• Belize(Located on the north eastern coast of Central America) is an example of floating exchange rate. • Mundell-Fleming Model( fixed exchange rate, free capital movement, and an independent monetary policy )
• Fear of Floating
FIXED EXCHANGE RATE
• Value of currencies kept constant • Worth of its currency in terms of either a fixed weight of gold,
a fixed amount of other currency or a “basket of other
currencies” • The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payment imbalances.
TYPES OF FIXED EXCHANGE RATE
• The Gold Standard • Price Specie Flow Mechanism • Reserve Currency Standard • Gold Exchange Standard
PEGGED FLOAT
• Crawling Bands: the rate is allowed to fluctuate in a
band around a central value, which is adjusted periodically
• Crawling pegs: the rate itself is fixed, and adjusted as above. • Pegged with horizontal bands:The currency is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.
DOLLARIZATION
• Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the
national currency.
FACTORS DETERMINING ECONOMIC VALUE OF CURRENCY
• Import and export
– Payment in dollars
– For example:• 1$=1Rs
– But current 1$ = 50Rs – Finally govt. will have no “$”
• Military force
– Saudi Arabia – Kuwait – Libya – Iraq
• Resources available in country
– Iron, steel, petrol, advance-technology
– unique production capability
– Japan (TV, quality-goods )
• Debt on country
– Payment of interest and loan in dollars
– India was 0 debt country till independence
– 1$=1Rs in 1947
– 1$=50Rs 2012
DETERMINATION OF ER IN
• FREE MARKET
• REGULATED MARKET
FREE MARKET
Demand for FX
Demand for foreign goods, services & securities
Supply of FX
Supply of foreign goods, services & securities
Speculators willing to build their FX reserves
Speculators willing to get rid of their FX reserves
FREE MARKET
Exchange Rate (Rs. Per $) D D P’ P 45 D2 S’
ROUGH WORK
1$= Rs.48 S W 1$=Rs.45 W S
ER US
48
S
D1
India’s demand for $ Supply increases Prices of foreign goods Rs.
Demand of foreign goods
Demand for foreign exchange
India
Demand $
10 13 $ demanded per time unit (million)
FREE MARKET
• Rise in domestic prices
Increases demand for FX Fall in exports
Rise in ER
Demand curve shifts upwards Supply curve shifts leftward
• ROI (domestic) > ROI (foreign)
Capital inflow increases Capital outflow decreases
Fall in ER
Increased supply for FX
FREE MARKET
• Rise in real income (domestic)
Increase in imports
Rise in ER
Increased demand for FX
• Rise in real income (abroad)
Increase in exports
Fall in ER
Increased supply for FX
REGULATED MARKET
• ER is fixed by the Central Bank • Flexibility, if any, usually 10%
• Currency?s par value
• Central Bank undertakes the buy & sell of FX in the FX market • Any change in ER is made by the Central Bank • Devaluation • Revaluation
REGULATED MARKET
D’ S’ Exchange Rate (Rs. Per $)
D
D’’ P’
T F B
P
D’
D R
S O M N
D’’ Q
$ demanded per time unit (million)
FACTORS AFFECTING FOREIGN EXCHANGE VALUE
INTERNATIONAL TRADE
• If a country?s imports are higher, the demand for foreign currency in this country will be high. Higher demand for foreign currency means high value of foreign currency and low value of the domestic currency. • This is a typical case for underdeveloped countries which rely on imports for development needs. The current account balance (deficit or surplus) thus reflects the strength and weakness of the domestic currency.
CAPITAL MOVEMENTS
• International investments in the form of Foreign direct investment (FDI) and Foreign institutional investments (FII) have become the most important factors affecting the exchange rate in today?s open world economy. • Countries which attract large capital inflows through foreign investments, will witness an appreciation in its domestic currency as its demand rises. Outflow of capital would mean a depreciation of domestic currency.
CHANGE IN PRICES
• Domestic inflation or deflation affects the exchange rate by affecting the demand and supply of domestic currency in the foreign exchange market. • For example, if prices in India go up, making Indian goods costlier, the demand for Indian goods will go down. When exports go down, the demand for rupee will fall, causing depreciation in its exchange value.
SPECULATIONS
• Uncertainties are always there in the financial market. • If the speculators expect a fall in the value of a currency in the near future, they will sell that currency and start buying the other currency that they expect to appreciate. The selling of the former currency will thus increase its supply in the foreign exchange market and bring down its value. The other currency appreciates as its demand increases.
STRENGTH OF THE ECONOMY
• If the economic fundamentals of a country are strong, the exchange rate of its domestic currency remains stable and strong • Fiscal balance, international current account balance, international liabilities, foreign exchange reserves, resilience to international trade fluctuations, GDP, inflation rate all are indicators of a country?s economic strength.
GOVERNMENT POLICIES
• In countries where there is fixed or managed float, the central bank becomes an important player in the foreign exchange market. • The bank influences the value of the currency by its market operations like buying and selling of bills and currencies. • The bank rate also influences the exchange rate by influencing investments and thereby the demand and supply of the domestic currency.
STOCK EXCHANGE OPERATIONS
• Stock exchange operations in foreign securities, debentures, stocks and shares, influence the demand and supply of related currencies, thus influencing their exchange rate.
POLITICAL FACTORS
• Political scenario of the country ultimately decides the strength of the country. • An economy with a strong, positive image will obviously have a strong domestic currency. This is the reason why speculations rise considerably during the parliament elections, with various predictions of the future government and its policies.
FACTS
• George Soros is known as "The Man Who Broke the Bank of England" because of his US$1 billion in investment profits during the 1992 Black Wednesday UK currency crisis.
Black Wednesday
•
refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after they were unable to keep it above its agreed lower limit.
FIXED vs FLEXIBLE EXCHANGE RATE
ARGUMENTS IN FAVOUR OF FIXED EXCHANGE RATES
• The stability of exchange rate encourages international trade.
On the contrary, flexible exchange rate system causes uncertainty. • The fixed exchange rate system creates conditions for smooth flow of international capital simply because it ensures a certain
return on the foreign investment. While in the case of flexible
exchange rate, capital flows are constrained because of uncertainty about expected rate of return.
• It removes the dangers of speculative activities in the foreign exchange market. On the contrary flexible exchange rates encourage speculation. • The fixed exchange rate system reduces the possibility of competitive depreciation of currencies.
• Fixed exchange rates can exert a strong discipline on domestic firms and employees to keep their costs under control in order to remain competitive in international markets. This helps the
government maintain low inflation - which in the long run
should bring interest rates down and stimulate increased trade and investment.
ARGUMENTS IN FAVOUR OF FLEXIBLE EXCHANGE RATES
• Flexible exchange rate is self adjusting and therefore it does not devolve on the government to maintain an adequate foreign exchange reserve. • Flexible exchange rates serve as a barometer of the actual
purchasing power and strength of a currency in the foreign
exchange market. It serves as a useful parameter in the formulation of the domestic economic policies.
• Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. If an economy has a large deficit, there is a net outflow of currency from the country. This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the
home markets goes up (making imports appear more
expensive).
• Key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be
set to keep the value of the exchange rate within predetermined bands.
doc_677125575.pptx