FOREIGN EXCHANGE RATE MANAGEMENT

8/13/2019 FOREIGN EXCHANGE RATE MANAGEMENT

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FOREIGN EXCHANGERATE MANAGEMENT



The main objective of India's exchange rate policy is to ensure

that economic fundamentals are reflected in the external value of

the rupee.

The three dominant views that shaped exchange rate policy inIndia since 1997 were:-

(a) exchange rates should be flexible and not fixed or pegged;

(b) countries should be able to intervene or manage exchange

rates;(c) reserves should at least be sufficient to take care of

fluctuations in capital flows and “liquidity at risk”.



•

Subject to the above predominant objective, the conduct of exchangerate policy is guided by three major purposes as follow :-

• First, to reduce excess volatility in exchange rates, while ensuring that

the market correction of overvalued or undervalued exchange rate is

orderly and calibrated.

• Second, to help maintain an adequate level of foreign exchange

reserves.

• Third, to help eliminate market constraints with a view to the

development of a healthy foreign exchange market.



• FEMA ACT 1999 Defines Foreign Exchange as “Foreign Exchangemeans & includes as follow”:-

• a) All deposits, credits and balances payable in foreign currency, and

any drafts, traveler's cheques, letters of credit and bills of exchange,expressed or drawn in Indian currency and payable in any foreigncurrency.

• b) Any instrument payable at the option of the drawee or holder,

thereof or any other party thereto, either in Indian currency or inforeign currency, or partly in one and partly in the other”.



Method – II

Rs. 10 = 5 Oranges

Rs. 10 = 4 Apples

Method – I

One Orange = Rs 2

One Apple = Rs 2.50

Price under both the methods is the same though expressed

differently.

Method - I

DIRECT(FC fixed)USD 1 = Rs 54.36

Pound1 = Rs.82.59

EUR 1 = Rs 71.12

Method - II

INDIRECT( HC fixed)

Rs 100 = USD 1.83

Rs 100 = GBP 0.83

Rs 100 = EUR 0.71



BENEFICIARIES

Governments, banks, businesses,

traders, individual investors and

vacationers all participate in the forex

market. Governments use the forexmarket to ensure competitive trade.

Banks use the forex market to invest.

Businesses use the forex market to

protect themselves against exchange

rate risk. Traders and individual

investors try to profit in the forex

market. Vacationers use the forex

market to convert their currencies.



FACTORS

INFLUENCING

FOREIGNEXCHANGE

RATE.



• Strength of the Economy :The strength of the economy affects the

demand and supply of foreign currency.

• Political and Psychological Factors: Political or psychologicalfactors are believed to have an influence on exchange rates.

• Economic Expectations :Exchange rates move on economic

expectations. Since such expectations affect the external value of the

rupee, all economic data – the balance of payments, export growth,inflation rates and the likes – are analyzed and its likely effect on

exchange rates is examined.

• Capital Movements : Capital movements are one of the most

important reasons for changes in exchange rates. Capital movementsof foreign currency are usually more than connected with international

trade. This occurs due to a variety of reasons – both positive and

negative.



• Capital Movements : Capital movements are one of the most

important reasons for changes in exchange rates. Capital movements

of foreign currency are usually more than connected with internationaltrade. This occurs due to a variety of reasons – both positive and

negative.

• Interest Rates : An important factor for movement in exchange rates

in recent years is interest rates, i.e. interest differential between majorcurrencies.

• Inflation Rates : It is widely held that exchange rates move in the

direction required to compensate for relative inflation rates.

• Tariffs and Quotas : Tariffs and quotas exist to protect a country’s foreign exchange by reducing demand. Till before liberalization, India

followed a policy of tariffs and restrictions on imports. Very few

items were permitted to be freely imported.



• Balance of Payments : As mentioned earlier, a net inflow of foreign

currency tends to strengthen the home currency vis-à-vis other

currencies. This is because the supply of the foreign currency will bein excess of demand. A good way of ascertaining this would be to

check the balance of payments. If the balance of payments is positive

and foreign exchange reserves are increasing, the home currency will

become stronger.



HEDGING STRATEGY

Hedging is a transaction designed to limit what is called exchange raterisk. A business or individual is exposed to exchange rate risk when

they conduct business in a country that uses a different currency.



•

A fixed exchange-rate system (also known as peggedexchange rate system) is a currency system in which

governments try to maintain their currency value constant

against one another.

• The fixed exchange rate system was carried out in the earlier 90s.

Under this, currencies of different countries were tied to gold. Thus,

the exchange rate of different countries got automatically fixed.

• The flexible exchange rate system is one in which the value of

currency of one country is expressed in terms of that of the other.



DEFINITION OF 'CURRENCY PEG'

• A country or government's exchange-rate policy of pegging the

central bank's rate of exchange to another country's currency.

Currency has sometimes also been pegged to the price of gold.

• Also known as a "fixed exchange rate" or "peggedexchange rate."



THE PEGGED EXCHANGE RATE

• A pegged, or fixed system, is one in which the exchange rate is set

and artificially maintained by the government. The rate will be pegged

to some other country's dollar, usually the U.S. dollar. The rate will

not fluctuate from day to day

• Countries that have immature, potentially unstable economies usually

use a pegged system. Developing nations can use this system to

prevent out-of control-inflation. The system can backfire, however, if

the real world market value of the currency is not reflected by the

pegged rate. In that case, a black market may spring up, where thecurrency will be traded at its market value, disregarding the

government's peg.



CURRENCY BASKET

• A portfolio of several currencies with different weightings. Forexample, one may construct a currency basket with 40% euros, 35%

U.S. dollars, and 25% British pounds; the percentages determine the

basket's value.

• Using a currency basket is a common way to peg a currency withoutoverexposing it to the fluctuations of a single currency. For example,

Kuwait shifted the peg of the Kuwaiti dinar to a currency basket from

the U.S. dollar in 2007 because the dollar was weak at the time,

resulting in high inflation.



• At present in both India and USA, there is floating exchange regime.

Therefore the value of currency of each country in terms of the other

depends upon the demand and supply of their currency.

• We shall take a case between the $ and the Indian Rupee:

Indians sell Rupees for US $;

People holding US $ will sell dollars in exchange for Rupees;

It is the demand and supply of foreign exchange that will determinethe rate between the two.



s

Priceofdollar[rupee s as

perdollar(assu med)]

Quantity of dollars

sExcessSupply

Excess Demand

R’

R”

R

Rs 46

Rs

45.5

Rs 44

E

Q

Y

O X



SHAPE OF THE DEMAND CURVE When there is a fall in the price of a $ in terms of rupees, that is when

$ depreciates, fewer rupees than before would be required to buy a $now.

This implies, that goods worth in $s are now cheaper in terms of

Indian rupees and also an increased demand of USA made goods in

India. This implies to an increased demand for dollars which will again

increase the price of the dollar.

In the end this means that lower the price of a $, greater is the quantity

of goods demanded for imports and higher the price of a dollar,smaller the quantity of imports demanded from the USA by the

Indians.

This causes the demand curve to slope downwards.



REASONS FOR DEMAND OF THE US $

[FOREIGN CURRENCY]

Indian individuals or firms that import goods from USA to India, need

US $s;

Indians traveling or living in USA would need $s to meet their

demand;

Indians that invest in shares and bonds of companies in USA would

require $s;

Indians that directly invest in houses, shops, etc. in the USA would

need $s.



SHAPE OF THE SUPPLY CURVE

According to the current exchange rate between US $s and Indianrupees; Indian goods of worth Rs100 would be relatively cheaper in

terms of dollars.[Suppose Rs48=$1]

This will increase demand for Indian goods in the USA, and boost

exports from India to USA at a higher price of the dollar and thusensure more supply of $s in the foreign exchange market.

This implies that increased supply of $s will reduce its value in terms

of rupees and it also implies that the Indian goods will now be more

expensive in terms of $s.

This will reduce the demand for Indian goods, and hence reduce the

supply of $s in the foreign exchange market.

This shows, that when the rate of exchange is high, the supply

increases, and vice versa.



REASONS FOR SUPPLY OF US $S

When USA exports goods and charges revenue in $s.

Citizens of USA who invest $s in India.

Those who make loans to Indians.

American tourists who spend $s in India. Indians living in the USA send $s to their relatives in India

[remittances].



THE EQUILIBRIUM EXCHANGE RATE

• If equilibrium price of $ in termsof rupees is Rs.45.5 at which

demand and supply curve

intersect. At Rs46 [higher price

of $] qty supplied exceeds qty

demanded. Excess supply will

reduce the exchange rate of $ and

the price will fall back to Rs45.5.

When the rate of $ in terms of

rupees is Rs44, there will beexcess demand. This will

increase the price again to

Rs45.5.

R’

R

R”

Excess Supply

Excess Demand

D

D

s

s

Rs 46

Rs 45.5

Rs 44

E

O

Y

Q X

Pri

ce

of

dol lar

[ru

pe

es

as

perdol

lar]

Quantity of dollars



• There are factors other than the rater of a currency in terms of anothercurrency that affects the demand and supply of the currency.

• This hence affects the equilibrium exchange rate.

• For e.g. if there is an increase in the income of the US economy, due

to conditions of BOOM.• This will increase imports in the US including goods from India.

• This implies that there will be an increase in the supply of $s in the

foreign exchange market.

• This will cause a rightward shift in the supply curve, and hence affectthe equilibrium price.

• This also shows that the value of the $ will depreciate and the value of

the rupee will appreciate.



• Purchase power parity[relative price levels]:-

To understand this, we must first assume that there are no restrictions

in trade between countries, and transport cost is nil.

Then the exchange rate between two countries will show thedifference between the price levels in the two countries.

The exchange rate can now be fixed, by the proportionate difference

between the price levels prevailing in the country.

For instance, a TV costs much higher in India that in the US. This will pay businessmen to buy TVs from the US and sell it in

India.



CONTINUED..

This will decrease the supply of TVs in the US, and increase it inIndia.

Hence the price of the same TV will now be high in the US and low in

India.

This process will continue till the price of the TV is same in both thecountries.

This concludes, that price levels in different countries affects the

exchange rate of the currency.

It must be noted that, it is only in the long run that with no traderestrictions, that this may be possible.



RATE OF INFLATION AND EXCHANGE

RATE

High rate of inflation in a country will affect the exchange rate of that

country.

Suppose, India has a relatively high rate of inflation that USA.

This means that the cost of production in India is higher than USA. This prompts the Indian consumer to import more goods from USA.

This results in an increased demand for US $s.



• The interest rate in a country relative to interest rate of other countries

with which it trades its goods is an important factor affecting foreign

exchange rate.

• This means that businessmen of the home country will invest in a the

bonds of a foreign country if the latter’s interest rates are lower.

• As a result, there will be a flight of capital from the foreign country

or Capital Inflows into the home country.



• By convertibility of a currency, we mean that the currency of a

country can be freely converted into currency of foreign country at

market determined rate of exchange, ie. the rate determined by

demand & supply.

• Here, there are authorized dealers of foreign exchange such as banks,which constitute Foreign Exchange market. The exporters who receive

other currencies can go to these dealers and get their convertibility.

• Importers who require foreign exchange, can go to these dealers and

get their home currency converted into foreign currency.



TYPES OF CONVERTIBILITY

• Current Account Convertibility

Currency convertibility means “the freedom to convert one currency into

other internationally accepted currencies, wherein the exporters and

importers where allowed a free conversion of rupee. But still none was

allowed to purchase any assets abroad.• Capital Account Convertibility

Capital Account Convertibility means that one currency can now be

freely convertible into any foreign currencies for acquisition of assets

like shares, properties and assets abroad. Further, the banks can acceptdeposits in any currency.



Daily foreign exchange market turnover in billions of US dollars



0

0.005

0.01

0.015

0.02

0.025

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

INR / EUR

INR / EUR

0

0.005

0.01

0.015

0.02

0.025

0.03

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

INR / USD

INR / USD



A Spot transaction in the interbank market is the purchase of foreign

exchange, with delivery and payment between banks to take place,

normally.

The date of settlement is referred to as the value date.

A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for twodifferent value dates.

Both purchase and sale are conducted with the same counterparty.



An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of onecurrency for a specified amount of another currency.

The exchange rate is established at the time of the agreement, but

payment and delivery are not required until maturity. Forward exchange rates are usually quoted for value dates of one,

two, three, six and twelve months.



The foreign exchange market consists of two tiers:

– the interbank or wholesale market (multiples of $1M US orequivalent in transaction size), and

– the client or retail market (specific, smaller amounts).

Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms,central banks and foreign exchange brokers.



UNDERSTANDING THE FOREX QUOTES

• Working at any forex quote you note is that all currencies arequoted in pairs such as

EUR/USD (Euro US dollar pair or)

USD/JPY (US dollar yen pair)

GBP/USD

USD/CHF

AUD/USD

USD/CAD NZD/USD



A foreign exchange rate is the price of one currency

expressed in terms of another currency.

A foreign exchange quotation (or quote) is a

statement of willingness to buy or sell at an

announced rate.



Foreign currency dealers provide two quotes:Bid Price: Price at which the dealer is willing to buy foreign

currency from you.

Ask Price: Price at which the dealer is willing to sell foreign

currency to you.

It is always the case that the Ask Price > Bid Price. The difference is the

Bid-Ask spread.



Banks act as market makers and realise their profits from the spread:

Bid-Ask Spread = (Ask-Bid)/Ask

Consider the quote example,

%38.1100

4484.1

4482.14484.1

%

spread



Many currency pairs are inactively traded, so their exchange rate is

determined through their relationship to a widely traded thirdcurrency.

For example, an Australian importer needs Danish currency to

pay for purchases in Copenhagen.

The Australian dollar (symbol A$) is not widely quoted against

the Danish kroner (symbol DKr).

However, both currencies are quoted against the U.S. dollar.

Assume the following quotes:Australian dollar A$1.5431/US$

Danish kroner DKr7.0575/US$



The Australian importer can buy one U.S. dollar for A$1.5431 andwith that dollar buy DKr7.0575. The cross-rate calculation would be:

A$/DKr 0.2186

US$DKr7.0575/

S$A$1.5431/U

dollar .kroner/U.SDanish

dollar .dollar/U.SAustralian



The Australian dollar be quoted atA$1.8445/US$ on Aug 19, 2012, while onMarch 2, 2012 it was quoted at A$1.335/US$.

Thus, the appreciation/depreciation of the US$, relative to theA$ from t-1 to t is:

11,

1

A$1.335/$ $1.844527.6%

$1.8445

t t

t t

t

S S A /$ R

S A /$

Thus, the U.S.$ has depreciated

relative to the A$ by 27.6%



• A transferable futures contract that specifies the price at which a

specified currency can be bought or sold at a future date. Currency

future contracts allow investors to hedge against foreign exchange

risk.



• Currency futures trading was started in Mumbai August 29, 2008.

• With over 300 trading members including 11 banks registered in thissegment, the first day saw a very lively counter, with nearly 70,000contracts being traded.

• The first trade on the NSE was by East India Securities Ltd• Amongst the banks, HDFC Bank carried out the first trade. Thelargest trade was by Standard Chartered Bank constituting 15,000contracts. Banks contributed 40 percent of the total gross volume.



• Currency futures can be traded between Indian rupees and US dollar(US$ -- INR)

• The trading of Indian currency futures can be done between 9 am to 5 pm

• The minimum size of currency futures is US$ 1000 periodically thevalue of the contract can be changed by RBI and SEBI

• The currency future can have maximum validity of 12 months

• The currency futures contract can be settled in cash



• There are 3 trade exchange that tradesin currency futures

1. National Stock Exchange (NSE)

2. Bombay Stock Exchange (BSE)

3. Multi-Commodity Exchange (MCX)



• According to market analysts, introduction of currency futures in theIndian market will give companies greater flexibility in hedging theirunderlying currency exposure and will bring in more liquidity into the

market as currency future or forex derivative contract will enable a person, a bank or an institution to buy or sell a particular currencyagainst the other on a specified future date, and at a price specified inthe contract.



EXCHANGE RATE MANAGEMENT IN

INDIA • India was under fixed exchange rate regime till March 1992. The

exchange rate of the Rupee was determined and adjusted by the

Central Bank (Reserve Bank of India). The Rupee was adjusted to a

basket of currencies, comprising of currencies of important trade

partners of India like US, Britain, Japan etc.

• Through the system of fixed/pegged exchange rate and exchange

controls, the governments objective was to attain exchange rate

stability to encourage traders and discourage speculators.



LIBERALIZED EXCHANGE RATE

MANAGEMENT (POST 1991)

• In March 1992, following the policies of liberalization and structural

adjustment program, the Rupee was made partially convertible on the

current account .

• When the Rupee began depreciating sharply at the end of 1995, theRBI intervened by selling the foreign exchange in the market to check

further fall of the Rupee.



CURRENT SCENARIO

• India went ahead with full convertibility of Rupee on the current

account, but rightly adopted a very cautious, phased out approach

towards Capital account convertibility. The country was in no way

economically strong enough for Capital account convertibility.

• A strong economy would mean an appreciation of the Rupee. At the

same time RBI has raised policy rates to check inflationary pressure.This would encourage more portfolio investment, leading to

appreciation of the rupee.

• The RBI has thus stepped in to check the rupee from appreciating,

following a managed float; allowing the exchange rate to bedetermined by market forces, while also intervening when required by

buying and selling foreign exchange, to protect the economy from the

dangers of volatile foreign capital and sudden depletion of reserves.



THANK YOU

FOREIGN EXCHANGE RATE MANAGEMENT

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