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Project TitleExchange Rate MechanismSubmitted To: Prof. TMC VardrajanMade By:Roll NoDalvi Aftab26Dhenkar Daniyal27Sajan Mujahid32Shaikh Hussain35Surve Sakib38

Exchange Rate

What is Exchange Rate?Exchange Rate is a rate at which one currency can be exchanged into another currency. In other words it is value one currency in terms of other.say:US $ 1 = Rs.45.18This rate is the conversion rate of every US $ 1 to Rs. 45.18

Example..History

In 1821-1914Most of the World's currencies were redeemable into gold. (i.e. you could "cash in" your paper notes for predefined weights of gold coin).

Britain was the first to officially adopt this system in 1821 and was followed by other key countries during 1870s.

The result was a global economy connected by the common use of gold as money.

ContdBy 1970, the existingexchangerate systemwas already under threat. The Nixon-led US government suspended the convertibility of the national currency into gold. The supply of the US dollar had exceeded its demand.

In 1971, the Smithsonian Agreement was signed. For the first time in exchange rate history, the market forces of supply and demand began to determine the exchange rate.

Exchange Rate MechanismMajor currencies dominating the international financial and foreign exchange market today are on float.

Their value is subject to variation depending upon changes in macroeconomic variable and market forces

Determination of exchange rate is of utmost importance for floating rate regime and for those who deal in foreign exchange.

Buying RateIt is also known as bid rate.

It is the rate at which banks buy a foreign currency from the customer.

E.g.. In India a customer exchanges the USD for the rupees, the bank will buy the USD at a buying rate of market.

The bid rate is always given first followed by the selling rate quote.8Selling RateIt is the rate at which banks sell foreign currency to their customer.

E.g.. A bank in India, selling 1USD to a customer, will charge the selling rate according to market price

For making profit, in these transaction the selling rate is higher than the buying rate.Forward RateRate agreed for settlement on an agreed date in the future

All rates are derived from Spot rates

Forward rate is the spot rate adjusted for the premium / discount

Forward Rate = Spot Rate + / - premium or discount

Cross RatesThe rate established between the two currencies is known as cross

Sometimes the value of currency in terms of another one is not known directly.

In such case one currency is sold for a common currency and then the common currency is exchanged for the desired currency.

The rate of exchange between the rupee and the Canadian dollar will be found through the common currency, the US dollar.

Market QuotationSpot Exchange Rate: The rate today for exchanging one currency for another at immediate delivery.

Forward Exchange Rate: The rate today for exchanging one currency for another at a specific Future DateFactor Determining Exchange RateFundamental Reasons:

- Balance of Payment surplus leads to stronger currency.

- Economic Growth Rates High/Low growth rate.

- Fiscal / Monetary Policy- deficit financing leads to depreciation of currency.

- Interest Rates currency with higher interest will appreciate in the short term.

- Political Issues Political stability leads to stable rates

ContdTechnical Reasons

- Government Control can lead to unrealistic value.

- Free flow of Capital from lower interest rate to higher interest rates.

Speculation higher the speculation higher the volatility in rates

Exchange Rate CategoriesFlexible Exchange Rate Systems

Fixed Exchange-rate System

Flexible Exchange Rate Systems

The value of the currency is determined by the market, ex. by the interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of transactions clearing, hedging, arbitrage and speculation.

So higher demand for a currency, all else equal, would lead to an appreciation of the currency. Lower demand, all else equal, would lead to a depreciation of the currency

Most OECD countries have flexible exchange rate systems: the U.S., Canada, Australia, Britain, and the European Monetary Union.

Advantages of flexible exchange rate

Theoretical elimination of trade imbalances

No need for reserves

More freedom over domestic policyDisadvantages of a flexible exchange rateSpeculation

Uncertainty

Fixed Exchange-rate System

A system whereby the exchange rates of the member countries were fixed against the U.S. dollar, with the dollar in turn worth a fixed amount of gold.

Governments try to keep the value of their currencies constant against one another.

Thecentral bankof 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 financepayments imbalances.

Advantages of a fixed exchange rate Stability

Discipline

Avoid speculationDisadvantages of a fixed exchange rate The loss of monetary policy

The need for a large pool of reserves

Problems of un-competitiveness

Factors that influence the Exchange RateMarket Expectations

Political Events

Relative Inflation Rates

Relative Interest Rates

Relative Income Levels

Market ExpectationsExpectations about future exchange rate changes on the basis of current and future political and economic conditions 1960s Strong $

Between 1960s and 1970s: weak $

Strong $ in 1999 2001

Strong Dollar today 2014

Political EventsFall of Berlin Wall and unification of East and West Germany

Rumors about resignation of Mikhail Gorbachov

Tiannanmon Square

Persian Gulf War

Relative InflationHigh inflation relative to a foreign country, decline in value of currencyWhy?

Low inflation relative to a foreign country, increase in value of currencyWhy?Relative Interest RatesHigh interest rates in home country relative to a foreign country may cause domestic currency to appreciate.Relative Income LevelsIncrease in domestic income relative to foreign income may lead to a decline in the value of domestic currency.Exchange Rate DeterminationAn interaction of factors

Is it possible for a country with high real returns to have a low currency value?

Is it possible for a country with low real returns to have a high currency value?