Conceptual Understanding of Rates of Exchange

1. Rates of Exchange
Radhakishan V
Karthik S
Jaichander
Yasser Farook

2. DEFINITION
• The rate at which one currency buys or exchanges for another
currency is known as the rate of exchange.
• The rate of exchange expresses the external purchasing power of
the currency.
• The rate of exchange is a price – the price of one currency in terms
of the other.
1 USD = 43.3 Rupees

3. TERMINOLOGIES
1 SPOT / FORWARD Exchange Rate
2 FIXED / FLEXIBLE / FLOATING Exchange Rate
3 MULTIPLE Exchange Rates
4 TWO TIER Exchange Rate System
SPOT: Currencies are bought and sold according to the current price.
FORWARD: They deal in contracts that represent claims to a certain
currency type, a specific price per unit and a future date for settlement.
FIXED: Currency's value is matched to another measure of value
FLEXIBLE: Keeping the rate fixed over short periods
FLOATING: Currency unit of a country is free to fluctuate
If a country adopts more than one rate of exchange for its currency, it
is said to follow a system of multiple exchange rates.
It may have one rate for exports and another for imports
A form of multiple exchange rates under which the Government
maintains two rates – a higher rate for commercial transactions and a
lower rate for capital transactions.

4. THE FOREIGN EXCHANGE MARKET
• The Foreign Exchange Market consists of a number of banks,
brokers and dealers engaged in buying and selling foreign exchange
and also the central bank of the country and Treasury authorities.
• It is a worldwide decentralized financial market for the trading of
currencies.
BASIC FUNCTIONS

5. DETERMINING THE RATE OF EXCHANGE
• The rate of exchange is determined by demand and supply forces -
demand and supply of one currency as against the supply and demand
of another currency.
Method 1: Under The Gold Standard – The Mint Par
If two countries are on gold standard and if their currencies are expressed
in terms of weight of gold.
For example, if rupee being equal to 0.1 gram of gold and the dollar is
equal to 1 gram of gold, then the rate of exchange between these two
currencies will be:
$1 = 1 gram/0.1 gram = Rs.10 (or) Re.1 = 0.1 gram/1 gram = 10 cents,
where $1 = 100 cents.
Advantages: Self stabilizing, less debt, no inflation

6. The actual exchange rate in the foreign exchange market at any
particular time will slightly be different from the mint par of exchange.
• Bank commission
• Transport & shipping charges
Thus, Re.1 = 9 cents to 11 cents
The lower rate is for the Indians and the higher rate is for the
Americans.
Gold Points
• The maximum and minimum rates are also known as gold points.
• Any rate above or below the specie points will lead to movement of
gold between countries.

7. Method 2: Under free Paper Currencies – Purchasing Power Parity (PPP)
The previous method depends only on gold reserve and not on general
productivity.
The value of a currency will depend upon the price level in that country.
If the level of prices rose, the purchasing power of the currency would fall
and hence its value in terms of foreign currency would also fall.
For example, if a bale of cotton is sold for Rs.1000 in India and if the same
bale is sold for $100 in the US, the rate of exchange (ignoring transport
costs) will be:
$100 = Rs.1000 (or) $1 = Rs.10

8. Extended PPP Theory
The previous method of comparison is through the medium of one
commodity which is traded in both countries.
In the case of all internationally traded goods, prices will tend to be the
same in all countries.
It is necessary to take the prices of all goods and services which money
helps to purchase.
Thus comparison must be made with the help of general index numbers.
The extended PPP equalizes the purchasing power of different currencies
in their home countries for a given Basket of Goods.
More goods and services imply more productivity.

9. Year Indian IN American IN Exchange Rate
1980 100 100 $1 = Rs 10
1991 250 150 ?
The price quotient is found out by comparing the price changes in the two
countries.
When we want to know the exchange rate for India, the price quotient will be
the American price index over Indian price index.
The reverse will hold well, when we want to find out the exchange rate for
America.
$1 = (250/150) * Rs.10 = Rs.16.67 (or) Re.1 = (150/250) * 10 cents = 6 cents,
where $1 = 100 cents.

10. Criticisms of PPP
• No direct link between purchasing power and rate of exchange.
Tariff , capital movements, etc
• Difficulty in comparing price indices.
Wholesale, cost of living, agricultural, etc. which one?
• Index number problems.
Different types of goods enter into the calculation of index
numbers.
• Ignores Foreign Trade Restrictions
Import duties – exchange value of currency will rise even though its
internal price remains constant.
• Ignores speculative, political and psychological factors.

11. • Ignores dynamic factors
Technological advancement may affect demand, supply and the rate
of exchange even when relative prices remain unchanged.
• Change in the exchange rate as the cause
• This theory implies that the changes in exchange rate exercise no
influence over the price level which is wrong.
• Suppose $1 = Rs10 has changed to $1 = Rs 0.10, due to capital
movement from America to India.
• Indian currency has become costlier to Americans.
• Exports from India reduces.
• Decline in demand for Indian goods.
• Price in India decreases.
• American goods become cheaper
• Demand for American goods increases, in turn pushing up prices of
foreign goods.
• Thus national price levels may follow rather than precede the
movements of exchange rates.

12. WHY DOES RATE OF EXCHANGE FLUCTUATE
1 Course of international trade
If India’s demand for American goods is greater than
vice versa, there is a greater demand for dollar.
2 Monetary Policy
High inflation in India will reduce demand for Indian
goods from abroad. Also Indians, would prefer foreign goods.
3 Capital movements
Suppose a large amount of capital is shifted from
America to India. Demand for rupee increases.
4 Speculative activities

13. FORWARD EXCHANGE MARKET
• Forward transactions consist of contracts to exchange one currency
for another at a future date, but at a rate determined now
• PREMIUM: If the demand for foreign currency, in the forward
exchange market, is in excess of its supply
• DISCOUNT: When the demand for foreign currency in the foreign
exchange market is less than its supply

14. FIXED AND FLEXIBLE EXCHANGE RATES

15. THANK YOU