Scenario of Exchange Rates in India

India is following the direct rate in Forex markets, i.e. foreign currency is fixed and home currency is varying. When we go to a shop and ask for the price of a product he tells us only one rate for the product, because the trader is only selling the product to consumers. He is not buying from consumers. Whatever rate the seller tells is implied as his selling price for the product. Even though the consumer is buying a product, what he pays to the trader is the selling price of the trader. Foreign Exchange market is different from this market in the sense that the authorized dealer buys as well as sells the foreign currency. Banks and financial institutes authorized by RBI to sell the foreign currency are called as Authorized Dealers. When you ask the rate of a foreign currency from an authorized dealer, he quotes two- way rates. It means that he quotes the rate for buying as well as selling the foreign currency.

Example US$ 1=Rs.45.2200,45.2300

In this rate, the authorized dealer will buy US$ at the rate of US$ 1=45.2200 and he will sell the US$ at the rate of US$ 1=Rs.45.2300. The difference between the buying and selling price is his profit margin. Here, the dealer will make a profit of Rs.0.0100 by buying and selling one US dollar. Even though, the word “Buying rate” and “Selling rate” is not mentioned in the quotations, it is implied that the lesser rate is the buying rate and that the higher rate is the selling rate.

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Exchange Rate Determination Models

Determination of the exchange rate is as simple as the determination of price of any commodity or product or service. Only thing, here the commodity itself is one currency, so price of one currency in terms of another is required. But the caveat is determination of price of any commodity/product/service is not that simple. The determinants of the exchange rate are too many to consider. Yet certain macro variables would capture the same.

Flow models and asset models are used in exchange rate determination. These are explained below:

1. Flow Model

The flow model of exchange rate determination simply is based on demand and supply of Forex. Demand for foreign exchange takes place whenever a country imports goods and services, people of a country undertake visits to other countries, citizens of a country remit money abroad and whatever purpose, business units set up foreign subsidiaries and so on. In all these cases the nation concerned buys relevant and required foreign exchange, in exchange of its own currency, or draws from foreign exchange reserves built. So the demand side includes importers, citizens undertaking outward travel, remittances against foreign services obtained, outward foreign debt servicing, export of capital for overseas investment, buying of Forex by monetary authority as an intervention strategy, etc.

On the other hand, when a country exports goods and services to another country, when people of other countries visit the country, when citizens of the country settled abroad remit money homewards, when foreign citizens, firms and institutions invest in the country and when the country or its business community raises funds from abroad, the country’s currency is brought by others, giving foreign exchange, in exchange, inflow of foreign exchange takes place.… Read the rest

Interest Rate Parity (IRP) Theory of Exchange Rate

When Purchasing Power Parity (PPP) Theory applies to product markets, Interest Rate Parity (IRP) condition applies to financial markets. Interest Rate Parity (IRP) theory postulates that the forward rate differential in the exchange rate of two currencies would equal the interest rate differential between the two countries. Thus it holds that the forward premium or discount for one currency relative to another should be equal to the ratio of nominal interest rate on securities of equal risk (and duration) denominated in two currencies.

For example, where the interest rate in India and US are respectively 10% and 6% and the dollar-rupees spot exchange rate is Rs.42.50/US $. The 90 day forward exchange rate would be calculated as per IRP as follows:

= 42.50  (1+0.10/4)/(1+0.06/4)

= Rs.42.9250

And hence, the forward rate differential [forward premium (p)] will be;

(42.9250 – 42.50)/42.50 = 1%

And the interest rate differential will be;

(1+0.10/4) /(1+0.06/4)  – 1   = p

 i.e., 1.01 – 1 = p

Therefore, p = 0.01 or 1%

Thus, If there is no parity between the forward rate differential and interest rate differential, opportunities for arbitrage will arise. Arbitrageurs will move funds from one country to another for taking advantage of disparity. But in an efficient market, with free flow of capital and negligent transaction cost, continuous arbitration process will soon restore parity between the forward rate differential and interest rate differential which is called as covered interest arbitration.

Let us take another example where the interest rate in India and the USA are 12% and 4% respectively, the dollar-rupee exchange rates are: Spot = Rs.42.50/$.1 and Forward (90) = Rs.43.00/$.1.… Read the rest

International Fisher Effect

According to the Relative Version of Purchasing Power Parity Theory (PPP) one of the factors leading to change in exchange rate between currencies is inflation in the respective countries. As long as the inflation rate in the two countries remains equal, the exchange rate between the currencies would not be affected. When a difference or deviation arises in the inflation levels of the two countries, the exchange rate would be adjusted to reflect the inflation rate differential between the countries.

The International Fisher Effect (IFE) theory is an important concept in the fields of economics and finance that links interest rates, inflation and exchange rates. Similar to the Purchasing Power Parity (PPP) theory, IFE attributes changes in exchange rate to interest rate differentials, rather than inflation rate differentials among countries. Nominal interest rates would automatically reflect differences in inflation by a purchasing power parity or no-arbitrage system. The two theories are closely related because of high correlation between interest and inflation rates. The IFE theory suggests that currency of any country with a relatively higher interest rate will depreciate because high nominal interest rates reflect expected inflation.

International Fisher Effect, which was first proposed by Irving Fisher, suggests that there is a positive correlation between nominal interest rates and expected inflation. This hypothesis also implies that the real interest rate is constant and independent of monetary measures. He states that Nominal interest rate comprises of Real interest rate plus expected rate of inflation. So the nominal interest rate will get adjusted when the inflation rate is expected to change.… Read the rest

Forward Foreign Exchange Contracts

Forward exchange is a device to protect traders against risk arising out of fluctuations in exchange rates. A trader, who has to make or receive payment in foreign currency at the end of a given period, may find at the time of payment or receipt that the foreign currency has appreciated or depreciated. If the currency moves down or gets depreciated the trader will be at a loss as he will get lesser units of home currency for a given amount of foreign currency, which he was holding. Similarly, an importer, who was contracted to make payment of a given amount in dollar at the end of a given period, may find that at the time of payment, the rupee dollar rate is higher. He would then have to pay more in rupees than what it would have been at the time when the contract was made.

To protect traders against such risks of appreciation and getting lesser amount of home currency, there is a device in foreign exchange market of booking forward exchange contracts. The emergence of forward exchange contracts has been due to the exchange rate fluctuations and possible losses that the traders might have to suffer in their foreign exchange business. The forward exchange transaction is an umbrella which gives protection to the dealers against the adverse movement of exchange rates. The forward exchange market in fact came into existence when the exchange rates were highly unstable following the abandonment of the gold standard by most of the countries at the end of first and Second World Wars.… Read the rest

History of Exchange Rate Mechanism in India

India was a founder member of the International Monetary Fund (IMF). It followed the fixed parity system till the early 1970s as a result which the value of the rupee in terms of gold was originally fixed as the equivalent of 0.268601 gram of fine gold. In view of India’s long economic and political relations with England and membership of the sterling area from September 1939 to June 1972, the rupee was pegged to the pound sterling. The exchange rate was thus remained unchanged but the gold content of the rupee fell to 0.186621 gram. Again, with the devaluation of the Indian rupee in June 1996 the gold content fell further to 0.118489 gram. The following year, the pound was also devalued. This devaluation did have an impact on the rupee pound link, but the rupee was kept stable in terms of the pound. The latter continued as an intervention currency.

In August 1971 when the system of fixed parity was under a cloud, the rupee was briefly pegged to the US dollar at Rs. 7.50/US $ and this continued till December 1971. The peg to the dollar was not very effective as the pound sterling remained to continue as the intervention currency. In December 1971, the rupee returned to the sterling peg at a parity of Rs. 18.9677/£ with of  course , a margin of ±2.2 percent.

After the Smithsonian arrangement had failed  and the pound had began to float, the rupee tended to depreciate. The Reserve Bank of India  then had to delink it from the pound sterling in September 1975 and link it with a basket of five currencies; but the pound sterling was retained as the intervention currency for fixing the external value of the rupee.… Read the rest