Economic Analysis assignment

Foreign exchange marketSubmitted to : Mrs. Gargi Bandhopadhyay

Submitted by:

Student’s name Roll no.Garima Sharma 108H21Nidhi Upadhyay 108H25Kanika Bhatia 108H26

Paras Suri 108H39Ishaan Saxena 108H43Gurneet Singh 108H55Shivangi Joshi 108H58

[MBA class of 2010]

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Declaration

We hereby declare that this assignment entitled “Foreign Exchange Market” is written and

submitted by us under the kind guidance of Mrs. Gargi Bandhopadhyay.

The content of the project is based on secondary data collection. This assignment is not copied

from any source or other project submitted for the similar purpose.

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ACKNOWLEDGEMENT

This assignment would have been impossible without a host of helping hands joining to make

the load lighter. The work now completed bears testimony to their kind support we availed

during it’s formation.

We would like to be grateful to our faculty, Mrs Gargi Bandhopadhyay, for her guidance and

encouraging support. Also, to the library at Amity Business school for providing us with the

books which were the source of information of our project.

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Contents

Topic Page no.

1. Foreign exchange market: An introduction 1

2. Foreign exchange instruments. 4

3. Factors influencing Exchange rates 5

4. Determination of Exchange Rates 10

5. Foreign Exchange Forecasting in practice 19

6. Official Actions to influence Exchange Rates 23

7. Flexible v/s Fixed Exchange rates 26

8.Bibliography 29

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The Foreign Exchange Market: An introduction

What is foreign exchange rate or exchange rate?

An exchange rate is simply the price of one currency in terms of another. The process by which

that price is determined depends on the particular exchange rate mechanism adopted. In a

floating rate system, the exchange rate is determined directly by market forces, and is liable to

fluctuate continually, as dictated by changing market conditions. In a 'fixed', or managed rate

system, the authorities attempt to regulate the exchange rate at some level that they consider

appropriate. Such a system often seems appealing to those who are troubled by the uncertainties

of the present, highly volatile, floating rate environment.

But the choice of exchange rate regime involves considerations that extend beyond the stability

or otherwise of currency prices. This will become clearer after an examination of some

fundamentals of the foreign exchange market.

Economics of the Foreign Exchange Market

In a floating exchange rate regime the price of the dollar, like any other market-determined price,

depends on the relevant forces of supply and demand. But what are the relevant forces of supply

and demand in the foreign exchange market?

To try to answer this question, let us consider, for illustration, the factors that determine the

relationship between the Australian dollar and the Japanese yen. The Japanese require dollars to

pay for their imports of goods and services from Australia and to fund any investment they may

wish to undertake in this country. Assume that they obtain these dollars on the foreign exchange

market by supplying (selling) yen in return. So the Japanese demand for dollars (mirrored by the

supply of yen) is determined by the exports to Japan and our capital inflow from that country.

On the other side of the market, the Australian demand for yen is determined by our need to pay

for imports from Japan, and for any capital investment that we undertake there. We buy those

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yen by supplying Australian dollars in return. Thus the supply of dollars (mirrored by the

demand for yen) is determined by our imports from Japan and our capital outflow to that

country.

In summary, then, the demand for Australian dollars reflects the behavior of our exports and

capital inflow, while the supply of dollars reflects the behavior of our imports and capital

outflow. In other words, transactions on the foreign exchange market echo the international trade

and financial transactions that are summarized in the balance of payments. Within the balance of

payments, the relationship between our exports and imports of goods and services is captured by

the balance of current account, while the relationship between capital inflow and capital outflow

is captured by the balance of capital account. The activities of international currency speculators

affect the exchange rate directly through their impact on capital flows.

The distinguishing characteristic of a floating exchange rate system is that the price of a currency

adjusts automatically to whatever level is required to equate the supply of and demand for that

currency, thereby clearing the market. The logic of the relationship between our international

transactions and the supply and demand for currencies implies that this market-clearing, or

'equilibrium', price also produces automatic equilibrium in the balance of payments. That is, the

balance of current account (whether positive, negative, or zero) must be precisely offset by the

balance (negative, positive, or zero) of the capital account. Under floating exchange rates these

outcomes are achieved automatically without the need for government intervention. By contrast,

under fixed exchange rates balance of payments equilibrium is not the normal condition.

These characteristics of the floating exchange rate mechanism have important implications both

for the nature of our relationship with the global environment, and for the policy options

available to the authorities in managing the economy. Let us now consider some of these.

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International Transmission of Economic Stability

A flexible exchange rate acts as a kind of shock absorber that helps to insulate us against

overseas disturbances. This is because the relationship between our international transactions and

the foreign exchange market runs in both directions. Let us suppose, for example, that recession

in the Japanese economy leads to a decline in the demand for Australian exports. In itself, this

will tend to reduce economic activity in Australia. But this tendency will be offset by an

associated depreciation of the dollar, which will induce an expansion of exports, a contraction of

imports, and perhaps an increase in net capital inflow, all of which will help to cushion the

Australian economy against recession. An analogous mechanism would operate to reduce the

impact of an initial decline in Japanese investment in Australia. Both cases illustrate the role of

exchange rate flexibility in insulating our economy to some degree against international

economic instability. By the same reasoning, floating exchange rates also help to diminish the

international transmission of our own domestic economic instability.

Characteristics of the Foreign Exchange Market

The Forex market does not exist physically, it is a framework where participants are connected

by computers, telephones and telex (SWIFT) and operates in most financial centres globally.

Because the Forex market is so highly integrated globally, it can operate 24 hours a day – when

one major market is closed, another major market is open to facilitate trade occurring 24 hours a

day moving from one major market to another. Most exchanges of currency are made through

bank deposits i.e. transferred electronically from one account to another.

The volume of foreign exchange transactions worldwide is assumed to be approximately USD 2

trillion per day. The average daily turnover in the South African market is R11 billion per day

and Standard Bank is the recognised leader in the domestic foreign exchange market, handling

more than 30% of South Africa's foreign exchange volume. The Forex market is an over-the-

counter market i.e. trading in financial instruments that are not listed or available on an officially

recognised exchange (such as the JSE – Johannesburg Stock Exchange), but traded in direct

negotiation between buyers and sellers. Trading takes place telephonically or electronically.

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Why do we make use of the Foreign Exchange Market?

Trading in a domestic market is substantially different from doing business in an offshore

market. In the complex world of international trade, merchants face a number of risks that need

to be managed in order to ensure the success of their cross – border transactions. In order to

protect themselves, these corporations apply hedging techniques using various foreign exchange

instruments and products in order to negate the impacts of exchange rate fluctuations. Successful

companies employ effective risk management techniques when making business decisions, and

evaluate commercial risk in an explicit and logical manner in order to offset financial loss

occasioned by the volatility in exchange rates (currency risk).

Who are the Foreign Exchange Market Participants?

Commercial Banks participate in the market by offering to buy and sell foreign exchange on

behalf of their retail or wholesale customers as a part of their financial service. They also trade in

foreign exchange as an intermediary and market maker. (A market maker quotes a buy and sell

price on a currency or financial instrument hoping to make a profit on the spread i.e. the

difference between the buying and the selling price). Other financial Institutions, such as Brokers

(Institutional Investors, Insurance companies, Pension, Mutual and Hedge Fund Managers) need

to manage various portfolios on behalf of their clients, and thus participate in the foreign

exchange market. They rely on the rates quoted by the market makers to market participants and

charge commission or a brokerage fee for services rendered. Corporations buy and sell foreign

exchange generally to facilitate trade, or as a result of a trade done and also to hedge currency

exposures that exist due to a particular trade conducted. These corporations generally consist of

exporters and importers. Central Banks can sometimes intervene in the foreign exchange market

in order to implement monetary policies.

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Foreign Exchange Instruments

A number of foreign exchange instruments have been designed for effective hedging as well as

enhancement of returns. The following instruments and products are most common to the

Foreign Exchange Market to facilitate international trade and will be covered in future Forex

Bulletins: Spot transactions, Forward Transactions (FEC’s), Options (Derivatives of exchange

rates), International money transfers, Guarantees, Commercial Customer Foreign Currency

accounts, Documentary Credit and Collections,

Factors influencing exchange rates

Foreign exchange rates are extremely volatile and it is incumbent on those involved with foreign

exchange - either as a purchaser, seller, speculator or institution - to know what causes rates to

move.

Actually, there are a variety of factors - market sentiment, the state of the economy, government

policy, demand and supply and a host of others.

The more important factors that influence exchange rates are discussed below:

Strength of the Economy :The strength of the economy affects the demand and supply of

foreign currency. If an economy is growing fast and is strong it will attract foreign currency

thereby strengthening its own. On the other hand, weaknesses result in an outflow of foreign

exchange. If a country is a net exporter (as were Japan and Germany), the inflow of foreign

currency far outstrips the outflow of their own currency. The result is usually a strengthening in

its value.

Political and Psychological Factors: Political or psychological factors are believed to have an

influence on exchange rates. Many currencies have a tradition of behaving in a particular way

such as Swiss francs which are known as a refuge or safe haven currency while the dollar moves

(either up or down) whenever there is a political crisis anywhere in the world. Exchange rates

can also fluctuate if there is a change in government. Some time back, India’s foreign exchange

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rating was downgraded because of political instability and consequently, the external value of the

rupee fell. Wars and other external factors also affect the exchange rate. For example, when Bill

Clinton was impeached, the US dollar weakened. During the Indo-Pak war the rupee weakened.

After the 1999 coup in Pakistan (October/November 1999), the Pakistani rupee weakened.

Economic Expectations :Exchange rates move on economic expectations. After the 1999 budget

in India there was an expectation that the rupee would fall by 7% to 9%. 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 analysed and its likely effect on exchange rates is

examined. If the economic downturn is not as bad as anticipated the rate can even appreciate.

The movement really depends on the “market sentiment” - the mood of the market - and how

much the market has reacted or discounted the anticipated/expected information.

Inflation Rates : It is widely held that exchange rates move in the direction required to

compensate for relative inflation rates. For instance, if a currency is already overvalued, i.e.

stronger than what is warranted by relative inflation rates, depreciation sufficient enough to

correct that position can be expected and vice versa. It is necessary to note that an exchange rate

is a relative price and hence the market weighs all the relative factors in relative terms (in

relation to the counterpart countries). The underlying reasoning behind this conviction is that a

relatively high rate of inflation reduces a country’s competitiveness and weakens its ability to

sell in international markets. This situation, in turn, will weaken the domestic currency by

reducing the demand or expected demand for it and increasing the demand or expected demand

for the foreign currency (increase in the supply of domestic currency and decrease in the supply

of foreign currency).

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

international trade. This occurs due to a variety of reasons - both positive and negative. When

India began its economic liberalisation and invited Foreign Institutional Investors (FIIs) to

purchase equity shares in Indian companies, billions of US dollars came into the country

strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the

country weakening the currency. These were capital outflows. One of the reasons popularly

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believed for the rupee not depreciating in the manner other South-east Asian currencies did in

1997-98 was because the rupee was not convertible on the “capital account”.

Speculation : Speculation in a currency raises or lowers the exchange rate. For instance, the

foreign exchange market in Kenya is very shallow. If a speculator enters and buys US $1 million,

it will raise the value of the US dollar significantly. If a few others do so too, the price of the US

dollar will rise even further against the Kenya shilling. The most famous speculator in foreign

currency is Mr George Soros who made over a billion pounds sterling in Europe (by correctly

predicting the devaluation of the pound) and then is believed to have triggered the free fall of the

currencies of South-east Asia.

. 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 be in 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.

Government’s Monetary and Fiscal Policies : Governments, through their monetary and fiscal

policies affect international trade, the trade balance and the supply and demand for a currency.

Increasing the supply of money raises prices and makes imports attractive. Fiscal surpluses will

slow economic growth and this will reduce demand for imports and encourage exports. The

effectiveness of the policy depends on the price and income elasticities of demand for the

particular goods. High price elasticity of demand means the volume of a good is sensitive to a

change in price. Monetary and fiscal policy support the currency through a reduction in inflation.

These also affect exchange rate through the capital account. Net capital inflows supply direct

support for the exchange rate. Central governments control monetary supply and they are

expected to ensure that the government’s monetary policy is followed. To this extent they could

increase or decrease money supply. For example, the Reserve Bank of India, to curb inflation,

restricted and cut money supply. In Kenya, the central bank in order to attract foreign money into

the country is offering very high rates on its treasury bills. In order to maintain exchange rates at

a certain price the central bank will also intervene either by buying foreign currency (when there

is an excess in the supply of foreign exchange) and selling foreign currency (when demand for

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foreign exchange exceeds supply). This is known as ‘central bank intervention’. It must be noted

that the objective of monetary policy is to maintain stability and economic growth and central

banks are expected to - by increasing/decreasing money supply, raising/lowering interest rates or

by open market operations - maintain stability.

Exchange Rate Policy and Intervention: Exchange rates are also influenced, in no small

measure, by expectation of change in regulations relating to exchange markets and official

intervention. Official intervention can smoothen an otherwise disorderly market. As explained

before, intervention is the buying or selling of foreign currency to increase or decrease its supply.

Central banks often intervene to maintain stability. It has also been experienced that if the

authorities attempt to half-heartedly counter the market sentiments through intervention in the

market, ultimately more steep and sudden exchange rate swings can occur.

Interest Rates : An important factor for movement in exchange rates in recent years is interest

rates, i.e. interest differential between major currencies. In this respect the growing integration of

financial markets of major countries, the revolution in telecommunication facilities, the growth

of specialised asset managing agencies, the deregulation of financial markets by major countries,

the emergence of foreign trading as profit centres per se and the tremendous scope for

bandwagon and squaring effects on the rates, etc. have accelerated the potential for exchange rate

volatility.

Kenya intrinsically has a very weak economy but the rates offered within the country have

always been very high. To illustrate this point the treasury bill rate in September 1998 was as

high as 23%. High interest rates attract speculative capital moves so the announcements made by

the Federal Reserve on interest rates are usually eagerly awaited - an increase in the same will

cause an inflow of foreign currency and the strengthening of the US dollar.

Tariffs and Quotas : Tariffs and quotas exist to protect a country’s foreign exchange by reducing

demand. Till before liberalisation, India followed a policy of tariffs and restrictions on imports.

Very few items were permitted to be freely imported. Additionally, high customs duties were

imposed to discourage imports and to protect the domestic industry. Tariffs and quotas are not

popular internationally as they tend to close markets. When India lifted its barriers, several

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industries such as the mini steel and the scrap metal industries collapsed (imported scrap became

cheaper than the domestic one). Quotas are not restricted to developing countries. The United

States imposes quotas on readymade garments and Japan has severe quotas on non-Japanese

goods.

Exchange Control : The purpose of exchange control is to manage the supply and demand

balance of the home currency by the government using direct controls basically to protect it.

Currency control is the restriction of using or availing of foreign currency at home/abroad.

In India, up to liberalization in the nineties there was very severe exchange control. Access to

foreign currency was tightly controlled and the same was released only for permitted purposes.

This was because Indian exports had not taken off and there were still large imports. There are

several countries that maintain their rates at artificial levels such as Bangladesh.

India is now fully, convertible on the current account but not as yet on the capital account. This,

to an extent, possibly saved India when the run on currencies took place in Asia in 1997. If the

Indian rupee was fully convertible and there were no exchange control restrictions, the rupee

would have been open for speculation. There would have been large outflows at a time of

concern resulting in a snowballing plunge in its value.

As long as the par value system prevailed, the rates could not go beyond the upper and lower

intervention points. The only real question under the fixed rate system was whether the balance

of payments and foreign exchange reserves had deteriorated to such an extent that devaluation

was imminent or possible. Countries with strong balance of payments and reserve positions were

hardly called upon to revalue their currencies. Hence, a watch had to be kept only on deficit

countries. However, under generalized floating regime, exchange rates are influenced by a

multitude of economic, financial, political and psychological factors. But the relative

significance of any of these factors can vary from time to time making it difficult to predict

precisely how any single factor will influence the rates and by how much.

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Determination of Exchange Rates

In simple terms, it is the interaction of supply and demand factors for two currencies in the

market that determines the rate at which they trade. But what factors influence the many

thousands of decisions made each day to buy or sell a currency? How do changes in supply and

demand conditions explain the path of an exchange rate over the course of a day, a month, or a

year?

This complex issue has been extensively studied in economic literature and widely discussed

among investors, officials, academicians, traders, and others. Still, there are no definitive

answers. Views on exchange rate determination differ and have changed over time. No single

approach provides a satisfactory explanation of exchange rate movements, particularly short- and

medium-term movements, since the advent of widespread floating in the early 1970s.

Three aspects of exchange rate determination are discussed below. First, there is a brief

description of some of the broad approaches to exchange rate determination. Second, there are

some comments on the problems of exchange rate forecasting in practice. Third, central bank

intervention and its effects on exchange rates are discussed.

Some approaches to exchange rate determination:

The Purchasing Power Parity Approach

Purchasing Power Parity (PPP) theory holds that in the long run, exchange rates will adjust to

equalize the relative purchasing power of currencies. This concept follows from the law of one

price, which holds that in competitive markets, identical goods will sell for identical prices when

valued in the same currency.

The law of one price relates to an individual product. A generalization of that law is the absolute

version of PPP, the proposition that exchange rates will equate nations’ overall price levels.

More commonly used than absolute PPP is the concept of relative PPP, which focuses on

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changes in prices and exchange rates, rather than on absolute price levels. Relative PPP holds

that there will be a change in exchange rates proportional to the change in the ratio of the two

nations’ price levels, assuming no changes in structural relationships. Thus, if the U.S. price

level rose 10 percent and the Japanese price level rose 5 percent, the U.S. dollar would

depreciate 5 percent, offsetting the higher U.S. inflation and leaving the relative purchasing

power of the two currencies unchanged.

PPP is based in part on some unrealistic assumptions: that goods are identical; that all goods are

tradable; that there are no transportation costs, information gaps, taxes, tariffs, or restrictions of

trade; and —implicitly and importantly—that exchange rates are influenced only by relative

inflation rates.

But contrary to the implicit PPP assumption, exchange rates also can change for reasons other

than differences in inflation rates. Real exchange rates can and do change significantly over time,

because of such things as major shifts in productivity growth, advances in technology, shifts in

factor supplies, changes in market structure, commodity shocks, shortages, and booms.

In addition, the relative version of PPP suffers from measurement problems:What is a good

starting point, or base period? Which is the appropriate price index? How should we account for

new products, or changes in tastes and technology?

PPP is intuitively plausible and a matter of common sense, and it undoubtedly has some validity

—significantly different rates of inflation should certainly affect exchange rates. PPP is useful in

assessing long-term exchange rate trends and can provide valuable information about long-run

equilibrium. But it has not met with much success in predicting exchange rate movements over

short- and medium-term horizons for widely traded currencies. In the short term, PPP seems to

apply best to situations where a country is experiencing very high, or even hyperinflation, in

which large and continuous price rises overwhelm other factors.

The Balance of Payments and the Internal- External Balance Approach

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PPP concentrates on one part of the balance of payments—tradable goods and services— and

postulates that exchange rate changes are determined by international differences in prices, or

changes in prices, of tradable items.

Other approaches have focused on the balance of payments on current account, or on the balance

of payments on current account plus long-term capital, as a guide in the determination of the

appropriate exchange rate.

But in today’s world, it is generally agreed that it is essential to look at the entire balance of

payments—both current and capital account transactions—in assessing foreign exchange flows

and their role in the determination of exchange rates.

John Williamson and others have developed the concept of the “fundamental equilibrium

exchange rate,” or FEER, envisaged as the equilibrium exchange rate that would reconcile a

nation’s internal and external balance. In that system, each country would commit itself to a

macroeconomic strategy designed to lead, in the medium term, to “internal balance”—defined as

unemployment at the natural rate and minimal inflation—and to “external balance”—defined as

achieving the targeted current account balance. Each country would be committed to holding its

exchange rate within a band or target zone around the FEER, or the level needed to reconcile

internal and external balance during the intervening adjustment period.

The concept of FEER, as an equilibrium exchange rate to reconcile internal and external balance,

is a useful one. But there are practical problems in calculating FEERs.There is no unique answer

to what constitutes the FEER; depending on the particular assumptions, models, and econometric

methods used, different analysts could come to quite different results. The authors recognize this

difficulty, and acknowledge that some allowance should be made by way of a target band around

the FEER.Williamson has suggested that FEER calculations could not realistically justify

exchange rate bands narrower than plus or minus 10 percent.

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The IMF, while generally agreeing that it is not possible to identify precise “equilibrium”values

for exchange rates and that point estimates of notional equilibrium rates should generally be

avoided, does use a macroeconomic balance methodology to underpin its internal IMF

multilateral surveillance. This mehodology, which is used for assessing the “appropriateness”of

current account positions and exchange rates for major industrial countries, is described in Box

11-1.7

The Monetary Approach

The monetary approach to exchange rate determination is based on the proposition that exchange

rates are established through the process of balancing the total supply of, and the total demand

for, the national money in each nation. The premise is that the supply of money can be controlled

by the nation’s monetary authorities, and that the demand for money has a stable and predictable

linkage to a few key variables, including an inverse relationship to the interest rate—that is, the

higher the interest rate, the smaller the demand for money. In its simplest form, the monetary

approach assumes that: prices and wages are completely flexible in both the short and long run,

so that PPP holds continuously, that capital is fully mobile across national borders, and that

domestic and foreign assets are perfect substitutes. Starting from equilibrium in the money and

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foreign exchange markets, if the U.S. money supply increased, say, 20 percent, while the

Japanese money supply remained stable, the U.S. price level, in time, would rise 20 percent and

the dollar would depreciate 20 percent in terms of the yen.

In this simplified version, the monetary approach combines the PPP theory with the quantity

theory of money—increases or decreases in the money supply lead to proportionate increases or

decreases in the price level over time, without any permanent effects on output or interest rates.

More sophisticated versions relax some of the restrictive assumptions—for example, price

flexibility and PPP may be assumed not to hold in the short run—but maintain the focus on the

role of national monetary policies.

Empirical tests of the monetary approach— simple or sophisticated—have failed to provide an

adequate explanation of exchange rate movements during the floating rate period. The approach

offers only a partial view of the forces influencing exchange rates—it assumes away the role of

nonmonetary assets such as bonds, and it takes no explicit account of supply and demand

conditions in goods and services markets. Despite its limitations, the monetary approach offers

very useful insights. It highlights the importance of monetary policy in influencing exchange

rates, and correctly warns that excessive monetary expansion leads to currency depreciation.

The monetary approach also provides a basis for explaining exchange rate overshooting—a

situation often observed in exchange markets in which a policy move can lead to an initial

exchange rate move that exceeds the eventual change implied by the new long-term situation. In

the context of monetary approach models that incorporate short-term stickiness in prices,

exchange rate overshooting can occur because prices of financial assets—interest and exchange

rates—respond more quickly to policy moves than does the price level of goods and services.

Thus, for example, a money supply increase (or decrease) in the United States can lead to a

greater temporary dollar depreciation (appreciation) as domestic interest rates decline (rise)

temporarily before the adjustment of the price level to the new long-run equilibrium is completed

and interest rates return to their original levels.

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The Portfolio Balance Approach

The portfolio balance approach takes a shorter-term view of exchange rates and broadens the

focus from the demand and supply conditions for money to take account of the demand and

supply conditions for other financial assets as well. Unlike the monetary approach, the portfolio

balance approach assumes that domestic and foreign bonds are not perfect substitutes. According

to the portfolio balance theory in its simplest form, firms and individuals balance their portfolios

among domestic money, domestic bonds, and foreign currency bonds, and they modify their

portfolios as conditions change. It is the process of equilibrating the total demand for, and supply

of, financial assets in each country that determines the exchange rate.

Each individual and firm chooses a portfolio to suit its needs, based on a variety of

considerations—the holder’s wealth and tastes, the level of domestic and foreign interest rates,

expectations of future inflation, interest rates, and so on. Any significant change in the

underlying factors will cause the holder to adjust his portfolio and seek a new equilibrium.

These actions to balance portfolios will influence exchange rates. Accordingly, a nation with a

sudden increase in money supply would immediately purchase both domestic and foreign bonds,

resulting in a decline in both countries’ interest rates, and, to the extent of the shift to foreign

bonds, a depreciation in the nation’s home currency. Over time, the depreciation in the home

currency would lead to growth in the nation’s exports and a decline in its imports, and thus, to an

improved trade balance and reversal of part of the original depreciation.

As yet, there is no unified theory of exchange rate determination based on the portfolio balance

approach that has proved reliable in forecasting. In fact, results of empirical tests of the portfolio

balance approach do not compare favorably with those from simpler models. These results

reflect both conceptual problems and the lack of adequate data on the size and currency

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composition of private sector portfolios.

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Nevertheless, the portfolio balance approach offers a useful framework for studying exchange

rate determination. With its focus on a broad menu of assets, this approach provides richer

insights than the monetary approach into the forces influencing exchange rates. It also enables

foreign exchange rates to be seen like asset prices in other markets, such as the stock market or

bond market, where rates are influenced, not only by current conditions, but to a great extent by

market expectations of future events. As with other financial assets, exchange rates change

continuously as the market receives new information about current conditions and information

that affects expectations of the future. The random character of these asset price movements

does not rule out rational pricing. Indeed, it is persuasively argued that this is the result to be

expected in a well functioning financial market. But in such an environment, exchange rate

changes can be large and very difficult to predict, as market participants try to judge the expected

real rates of return on their domestic assets in comparison with alternatives in other currencies.

How Good Are the Various Approaches?

The approaches noted above are some of the most general and most familiar ones, but there are

many others, focusing on differentials in real interest rates, on fiscal policies, and on other

elements.

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The research on this topic has been of great value in enhancing our understanding of long-run

exchange rate trends and the issues involved in estimating “equilibrium” rates. It has helped us

understand various aspects of exchange rate behavior and particular exchange rate episodes.

Yet none of the available empirical models has proved adequate for making reliable predictions

of the course of exchange rates over a period of time. Research thus far has not been able to find

stable and significant relationships between exchange rates and any economic fundamentals

capable of consistently predicting or explaining short-term rate movements.

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Foreign exchange forecasting in practice

Most of the approaches to exchange rate determination tell only part of the story—like the

several blindfolded men touching different parts of the elephant’s body—and other, more

comprehensive explanations cannot, in practice, be used for precise forecasting. We do not yet

have a way of bringing together all of the factors that help determine the exchange rate in a

single comprehensive approach that will provide reliable short- to medium-term predictions.

The exchange rate is a pervasive and complex mechanism, influencing and being influenced by

many different forces, with the effects and the relative importance of the different influences

continuously changing as conditions change. To the extent that trade flows are a force in the

market, competitiveness is obviously important to the exchange rate, and the many factors

affecting competitiveness must be considered.To the extent that the money market is a factor, the

focus should be on short-term interest rates, and on monetary policy and other factors

influencing those shortterm interest rates. To the extent that portfolio capital flows matter, the

focus should be broadened to include bond market conditions and long-term interest rates.

Particularly at times of great international tension, all other factors affecting the dollar exchange

rate may be overwhelmed by considerations of “safe haven.”

Indeed, countless forces influence the exchange rate, and they are subject to continuous and

unpredictable changes over time, by a market that is broad and heterogenous in terms of the

participants, their interests, and their time frames.

With conditions always changing, the impact of particular events and the response to particular

policy actions can vary greatly with the circumstances at the time. Higher interest rates might

strengthen a currency or weaken it, by a small amount or by a lot—much depends on why the

interest rates went up, whether a move was anticipated, what subsequent moves are expected,

and the implications for other financial markets, decisions, or government policy moves.

Similarly, the results of exchange rate changes are not always predictable: Importers might

expect to pay more if their domestic currency depreciates, but not if foreign producers are

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“pricing to market” in order to establish a beachhead or maintain a market share, or if the

importers or exporters had anticipated the rate move and had acted in advance to protect

themselves from it.

Nonetheless, those participating in the market must make their forecasts, implicitly and

explicitly, day after day, all of the time. Every piece of information that becomes available can

be the basis for an adjustment of each participant’s viewpoint, or expectations—in other words, a

forecast, informal or otherwise. When the screen flashes with an unexpected announcement that,

say, Germany has reduced interest rates by a quarter of one percent, that is not just news, it is the

basis for countless assessments of the significance of that event, and countless forecasts of its

impact in number of basis points.

Those who forecast foreign exchange rates often are divided into those who use “technical”

analysis, and those who rely on analysis of “fundamentals,” such as GDP, investment, saving,

productivity, inflation, balance of payments position, and the like.

Technical analysis assumes certain short-term and longer-term patterns in exchange rate

movements. It differs from the “random walk” philosophy—the belief that all presently available

information has been absorbed into the present exchange rate and that, the next piece of

information as well as the direction of the next rate move is random, with a 50 percent chance

the rate will rise, and 50 percent chance it will decline.

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Nearly all traders acknowledge their use of technical analysis and charts. According to surveys, a

majority say they employ technical analysis to a greater extent than “fundamental” analysis, and

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that they regard it as more useful than fundamental analysis—a contrast to twenty years ago

when most said they relied many more heavily on fundamental analysis.

Perhaps traders use technical analysis in part because, at least superficially, it seems simpler, or

because the data are more current and timely. Perhaps they use it because traders often have a

very short-term time frame and are interested in very short-term moves. They might agree that

“fundamentals” determine the course of prices in the long run, but they may not regard that as

relevant to their immediate task, particularly since many “fundamental” data become available

only with long lags and are often subject to major revisions. Perhaps traders think technical

analysis will be effective in part because they know many other market participants are relying

on it. Still, spotting trends is of real importance to traders—“a trend is a friend” is a comment

often heard—and technical analysis can add some discipline and sophistication to the process of

discovering and following a trend.

Technical analysis may add more objectivity to making the difficult decision on when to give up

on a position—enabling one to see that a trend has changed or run its course, and it is now time

for reconsideration.

Most market participants probably use a combination of both fundamental and technical analysis,

with the emphasis on each shifting as conditions change—that is, they form a general view about

whether a particular currency is overvalued or undervalued in a structural or longer-term sense,

and within that longer-term framework, assess the order flow and all current economic forecasts,

news events, political developments, statistical releases, rumors, and changes in sentiment, while

also carefully studying the charts and technical analysis.

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Official actions to influence exchange rates

As in some other major industrial nations with floating exchange rate regimes,in the United

States there is considerable scope for the play of market forces in determining the dollar

exchange rate.But also, as in other countries,U.S. authorities do take steps at times to influence

the exchange rate, via policy measures and direct intervention in the foreign exchange market to

buy or sell foreign currencies.As noted above, in practice, all foreign exchange market

intervention of the U.S. authorities is routinely sterilized—that is, the initial effect on U.S. bank

reserves is offset by monetary policy action.

No one questions that monetary policy measures can influence the exchange rate by affecting the

relative attractiveness of a currency and expectations of its prospects, although it is difficult to

find a stable and significant relationship that would yield a predictable, precise response. But the

question of the effectiveness of sterilized intervention, which has been extensively studied and

debated, is much more controversial. Some economists contend that sterilized intervention can

have, at best, a modest and temporary effect. Others say it can have a more significant effect by

changing expectations about policy and helping to guide the market. Still others believe that the

effect depends on the particular market conditions and the intervention strategy of each situation.

Given the present size of U.S. monetary aggregates, balance of payments flows, and the levels of

activity in the foreign exchange market and other financial markets, it is widely accepted that any

effects of sterilized intervention are likely to be through indirect channels rather than through

direct impact on these large aggregates. Empirical tests of sterilized intervention have focused on

two main channels through which such intervention might indirectly influence the exchange rate:

the portfolio balance channel and the expectations, or signaling, channel..

The portfolio balance channel postulates that the exchange rate is determined by the balance of

supply and demand for available stocks of financial assets held by the private sector. It holds that

sterilized intervention will alter the currency composition of assets available to the global private

sector, and that if dollar and foreign currency-denominated assets are viewed by investors as

imperfect substitutes, sterilized intervention will cause movements in the exchange rate to

reequilibrate supply and demand for dollar assets. The size of this portfolio balance effect would

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depend on the degree of substitutability between assets denominated in different currencies and

on the size of the intervention operation.

The expectations, or signaling, channel holds that sterilized intervention may cause private

agents to change their expectations of the future path of the exchange rate. Thus, intervention

could signal information about the future course of monetary or other economic policies, signal

information about, or analysis of, economic fundamentals or market trends, or influence

expectations by affecting technical conditions such as bubbles and bandwagons.

A considerable number of studies have found no quantitatively important effects of sterilized

intervention through the portfolio balance channel. Some studies have found expectations or

signaling effects of varying degrees of significance. Others conclude that the effectiveness

depends very much on market conditions and intervention strategy.

There are serious data and econometric problems in studying this question. To assess success, the

researcher needs to know the objective of the intervention and other specific details—was the

aim to ameliorate a trend, stop a trend, reverse a trend, show a presence, calm a market,

discourage speculation, or buy a little time? The researcher also needs to know the counterfactual

—what would have happened if the intervention had not taken place. Also, research on this issue

must be placed in the broader context of research on exchange rate determination, which noted

above, indicates that it has not been possible to find stable and significant relationships between

exchange rates and any economic fundamentals.

As a practical matter, it is difficult to make sweeping assessments about the success or failure of

official intervention operations. Some intervention operations have proven resoundingly

successful, while others have been dismal failures.

The success or failure of intervention is not so much a matter of statistical probability as it is a

matter of how it is used and whether conditions are appropriate. Is the objective reasonable?

Does the market look technically responsive? Is intervention anticipated? Will an operation look

credible? What is the likely effect on expectations?

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In 1983, the Working Group on Foreign Exchange Market Intervention established at the

Versailles summit of the Group of Seven warned against expecting too much from official

intervention, but concluded that such intervention can be a useful and effective tool in

influencing exchange rates in the short run, especially when such operations are consistent with

fundamental economic policies.

Unquestionably, intervention operations are more likely to succeed when there is a consistency

with fundamental economic policies, but it may not always be possible to know whether that

consistency exists.

Although attitudes differ, monetary authorities in all of the major countries intervene in the

foreign exchange markets at times when they consider it useful or appropriate, and they are

likely to continue to do so. The current attitude toward foreign exchange market intervention is

summarized in the following excerpt from the June 1996 report of the finance ministers of the

Group of Seven nations:

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Flexible v/s fixed exchange rates

Exchange rates stability has always been the objective of monetary policy of almost all countries.

Except during the period of great depression and world warII , the exchange rate have been

almost stable.during the post- war II period , the IMF had brought a new phase of exchange rate

stability.

Most governments have maintained adjustable fixed exchange rates till 1973. But the IMF

system failed to provide an adequate solution to three major problems causing exchange

instability-

1. Providing sufficient reserves to mitigate the short term fluctuations in the balance of payments

while maintaining the fixed exchange arte system.

2. Problems of long term adjustments in the balance of payments.

3. Prices generated by speculative transactions.

For these reasons the currencies of many countries , especially the reserve currency were subject

to frequent devaluation in the early 1970,s. this raised doubts about the possibility of the

Brettenwood,s system,and also about the viability of the fixed exchange rate system. The

breakdown of Brettonwood system generated a debate on whether fixed or flexible exchange rate

should be used.\

The main arguments in favour of fixed exchange rates are-

Firstly,Fixed exchange rate provides stability in the foreign exchange market and certainty about

the future course of the exchange rate and it eliminates risks caused by uncertainty due to

fluctuations in the exchange rates. The stability of exchange rate encourages international

trade.on the contrary, flexible exchange rate system causes uncertainty and might also often lead

to violent fluctuations in international trade. As a result foreign trade oriented economies become

subject to severe economic fluctuations, if import elasticities are less than export elasticities.

Secondly , 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

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flexible exchange rate, capital flows are constrained because of uncertainity about expected rate

of return.

Thirdly, the fixed rate eliminates the possibility of speculation, whereby it removes the dangers

of speculative activities in the foreign exchange market. On the contrary flexible exchange rates

encourage speculation.

Fourthly , the fixed exchange rate system reduces the possibility of competitive depreciation of

currencies as it happened during 1930s. also, deviations from fixed rate are easily adjustable.

Fifthly, a case is also made in favour of fixed exchange rate on the basis of existence of currency

areas. The flexible exchange rate is said to be unsuitable between the nations which constitute a

currency area, since it leads to a chaotic situation and hence hampers trade between them.

The main arguments in favour of flexible exchange rates :

Firstly, flexible exchange rate system provides larger degree of autonomy in respect of domestic

economic policies as it is not obligatory for the coutries to tune their domestic policies to fixed

foreign exchange rate.

Secondly, flexible exchange rate is self adjusting and therefore it does not devolve on the

government to maintain an adequate foreign exchange reserve.

Thirdly, the flexible exchange rate, which is determined by market forces, has a theory behind it

and has the quality of predictability.

Fourthly, 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.

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Fifthly, economists have also argued that the most serious charge against fluctuating exchange

rate i.e. unceratinty is not tenable because speculators themselves create conditions for exchange

rate stability. Also, the degree of uncertainity associated with flexible exchange rate could not be

much greater then what the world has experienced with adjustable fixed exchange rate under the

brettonwood’s system.

The debate on fixed v/s flexible exchange rate is inconclusive . infact, both systems have their

own merits and demerits.

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Bibliography

Books -1. Managerial Economics by D.N. Dwivedi.2. Managerial Economics by Chaturvedi.3. Macroeconomics by R.K.Misra4. Macroeconomics by M.L. Seth

Sites –www.forex.comwww.moneyinvestment.com

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