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ional Financial Management


Eichengreen, B. Ed. (1986) , The Gold Standard in Theory and History, New

IMP, International Financial Statistics, Washington, D.C., Annual No., latest.

Scammel, W.M. (1975), International Monetary Policy: Bretton Woods and:
New York: Wiley.


Tew, B. (1995), Evolution of International Monetary System,- New York: Wi!

V 5 ~ oJv(JvV\J I~ E-J


g Objectives
a floating-rate regime, exchange rate -is determined by market forces. The present chapter
us discusses the process of its determination, although in the beginning, it acquaints the
aders with the basics of how exchange rates are quoted. In particular, the chapter attempts:
"To explain how exchange rates are quoted in spot and forward markets.
To explain the distinction between nominal, real and effective exchange rates.
-To present how demand and supply forces determine the exchange rate in spot market.
To show how SOme macroeconomic variables, such as inflation rate and interest rate influence
the exchange rate.
:Tq show how the interest rate differential influence the forward exchange rate and to evaluate
the interest rate parity theory in _this _context.
to show how covered/uncovered interest arbitrage takes place when interest rate differential

is not equal to f9rward rate differential.

To examine different theories of the exchange rate behaviour.

3, we discussed different forms of the exchange rate regime ranging

ie gold standard to the adjustable peg under the Bretton Woods system

the independent and managed floating and target-zone arrangement in

ades. Since major currencies dominating t4e international financial and

~hange market today are on float, their value is subject to variations
gupon changes in macroeconomic variables and market forces. The present
iscusses the determination of exchange rate that is of utmost significance



lntemarianal Financial Management

for a floating-rate, regime and especiaUy for those who deal in foreign exchange.
However, in the beginning, let us understand' the fundamentals of exchange rate
quotation, so that we may bette:rliriderstarid the exchange rate determination'

In a forei~ exch~nge market where different currencies are bought and sold, it is
'essential to know the ratio between different currencies; or how many units of one
currency will equal one unit pf another currericy. The ratio between two currencies
is known as an exchange rate. The various exchange rates are regularly quoted in
ne";'spapers and periodicals.

Direct and Indirect Quote

The methods for quoting exchange rates are both direct and indirect. A direct quat,
gives the home-currency price of a certain amount of foreign currency, usually
, 'lone or 100 units. If India quotes the exchange rate between the rupee
~~~~sii~o~u~;:~~~ and the US dollar in a direct way, the quotation will be written as
on the numerator of ~ 35IUS $. On the other hand, in case of indirect quoting, the value of 0
the .quote. Indirect unit of home currency is presented in terms of foreign currency. If Indi
quote, is just the adopts indirect quotation, the banks in India will quote the exchang:
rate as US $ 0.02857~.
If the quotation is published in a third country to which neither of the tw
, currencies belongs, the usual practice is to put the stronger currency on the numerato:,
For example, if the US dollar-Indian rupee rate is published in London, it will bE
quoted as US $ 0.02857R'. In practice, the method of quotation varies from on~'
market to another. Continental European dealers normally ~se the direct quot,
while the indirect quote is used in London. Both methods are in use in the US


US $ 1~ 45 = US $ 0.0222~.,

If indirect quote is US
direct quote?

Chapter 4 Exchange Rate Mechanism



uying arid Selling Rates

ormally, two rates are published-one being the buying rate and the other the
Uing rate. The buying rate is also known as the bid rate. The selling rate is
own as the ask rate or offer rate.. The bid rate is always given first,
Howed by the ask rate qu~te. If the .rupee-US dollar rate is ~ 40.~0- ~~r!~~c~u~~n~:e~
.301US $, then the former IS the bUYing rate and the latter the sellmg the rate at which
teo In other words, the buying rate is the rate at which the banks b<;t;selling
rchase a foreign currency from the customer. Suppose, in India, a qu'ote "at . which
,stomer exch anges t h e U Soar
d 11 for the rupee, t h e b ank wil
. 1 b uy t h e banks sell It.
dollar at the buying rate, which is at ~ 40.00 a dollar. The selling rate, on the
er hand, is the rate at which the banks sell foreign currency to their customers.
example, a bank in India selling one US dollar to a customer, will charge the
ing rate, that is ~ 40.30 per US dollar. Since the banks need to make a profit
hese transactions, the selling quote is higher than the buying rate. The difference
een these two quotes forms the banks' profit 'and is known as the spread., In

above example, the spread is ~ 0.30 per US dollar. The bid-ask spread is often

,ed in percentage terms that can be computed as follows:


Spread: (Ask price - Bid price)/Ask price x 100


s in the above example,

Spread: (40.30 - 40.00)/40.30 x 100 = 0.744%
e size of spread in respect of a currency depends upon many factors, like its
gth, the type of transaction, and its supply and demand. position with the
acting bank. The spread is smaller in a widely traded currency because it is
for the banks to transact iD. such a 'currency. In a scarcely traded currency,
janks have to face some difficulty, and hence the spread is large. Again; for
".duals and firms, the spread is bigger than for banks. An individual and a
"uy a foreign currency at a higher rate and sell at a rate lower than that
,in the newspapers, although in big transactions, they get some relief. Similarly,
bank is temporarily short of a foreign currency, the spread will be larger
)l1arly if the demand for that foreign currency is high. On the contrary, if the
r position of that foreign currency is comfortable, the spread will be lower.



~ 1IUS
- . ,. $ 0.025 : ~ 40mS $.

~::~:fiBj ~'.


International Financial Management

Sql[JtitJn .

~.(40,50 ~x)/40.50= 0:012B'~

.'. . ..... 40.50 .~;


,;,0.0123 x 40,50

0:50 = X

.. '.

x';" 40:00.

Exchange Rate, Mechanism

If the forward rate is lower than the spot rate, it will be a case of forward
discount. On the contrary, if the forward rate is higher than the spot rate, it would
'be known as forward premium. Forward premium or discount is expressed as an
annualised percentage deviation from the spot rate. It is computed as follows:

n-day forward rate spot rate 360

x -n
F.orward preIDlum Iscoun =
spo t ra t e


where n is the length of forward contract expressed in number of days.

Applying the above example of a one-month forward quotation, we get

Forward Market Quotation

The quotes for the forward market are also published in the newspapers and'
periodicals. The quoting rates may be expressed as outright quotes, or as swap'
quotes. The outright quote for the US dollar in terms of the rupee can be written
for different periods of forward contract as follows:
One month
Three months
~ 40.00-40.30
~ 39.80-40.20
~ 39.60-40.10 .

- 40.00 x W
360 = -0. 06 or 6 per cent fiorwar d d'Iscount.

The swap quote, on the other hand, expresses only the difference between the spot
quote and the forward quote. It can be written as follows:
One month
Three months
~ 40;00-30
~ (20)-(10)
~ (40)-(20)
It may be noted'that decimals are not written in swap quotes.

EXCII:ANGE RATE QUOTATION:Tl:J.e Value ofDiffer~tCUrrenciesin Ter:ms'ofINR


:; ,.

TT.Buy . Bill,Buy



TCBuy~. CCY,Buy


. 50.6300 . 50.5300' " 5};3500" 51:4500

50.1800 '<49.8800
51.8000 -';52.1000"
79.2500. , 79.1000,80;6700.' ,80.8200,'78.5500 '78:,2500:. ,81.3700' ,81.6700,
Qiu:iadi3J,.Dollar.... 48.9600
49.58()0 '49.68()0 '48.5100.. 48.210~ '50.0300 "50.3300,
DaniSh Krone.
9;08.00 .' 9.03009,3000. .9.:350~. . 8.9300
,8.8~00,9:~500:.: 9.5000 '
.', 67.8000
67,6~~069:0200 .69.1700:
66.8000' 69,1200' 70.0200
Hong Kong Dollar
6.5600 . 6:6100
. 6.7600
J~pimeSe Yen ('10()) 64:1100 . 63.9600" 65;3300 . 65.4800
63.4100'.63.1100 .66.0300' 66.3300
New Zeiland Dollar' 38.7500 "38.6.700' 39j"700
39.4500. 3'8:600038.1500
S;:':'i:apore'DoIlM .
39:3400:. 38A900' 38.640039:4100
<7:4200 '7.3700. 7.6400
7.6900, .. 7.2700.7:2200,
7.7900 .,'7'.8400

. .
(X. - 45)= 0.12. ~ 45 x 360




&~b~~~~': '0: > :.~~:~g~~:;.j.~~:;:~~.. ~6:~~6< ,~~:~i~~::~~~1%d~i+:i~~ihbd . ,: ':~~:~~6d";~t~:dd

So~rC~: :The.Ei;on~-"'ic7'imes,. :Nov, 12,2Clll:

Forward Premium and Discount

Forward, rate
In the above quotes, it is found that the longer the maturity, the diffElreniiaI h
' WIt
. h Ionger represents
. t h e ch ange m
. t h e fiorwar d ra t es. A
greater IS
maturity, the spread too gets wider. This is because ofuncertaintYfciiW'a:rdahds~ot
in the future that increases with lengthening of maturity. The ;r~!eS?ilJigedI:lY '.
change in forward rates' may be upwards or downwards. With spot.r~tes~own in

such movements, d
anses b etween spo t an d fiorwar d rates.
This is known as the swap or forward rate differential.

45 + OA5/or x= 45,45

Cross Rates
Sometimes the value of a currency in terms of another one is not known directly.
In such cases, one currency is sold for a common currency; and again, the common
currency. is exchanged for the .desired currency. This is kn0:w n . as cross Cross exchange
rate tradmg and the rate estabhshed between the two currenCIes IS known rate'.betyieen two
as the cross rate. Suppose, a newspaper quotes ~ 35.00-35.20IUS $; and currenCi~sis
at, the same time, it quotes Canadian $ 0.76-0.78IUS $ but does not fou~doutthrough
their value. In a
quote the exchange rate between the rupee and the CanadIan dollar. common currency.
Thus the rate of exchange between the rupee and the Canadian dollar ....,-,----'---"-
will be found through the common currency, the US dollar. The technique is similar
for both spot and forward c.ross rates.

Chapter 4 Exchange Rate Mechanism

The selling rate of the Canadian dollar

in India can be worked out by selliI{

~pee for the US dollar ~t ~ 35.201US $ and then buying Canadian dollars wit
US dollar at C$ 0.76IUS $. This means

35.20IUS$ 1 x US $ 1/C$ 0.76 =


The buying rate of the Canadian dollar in India can be found through buy
the Indian rupee for the US dollar at ~ 35.001US $ and selling the Canadian do
for US dollar at C$ 0.78IUS $. This means that

35.001US $ 1 x US $ 1/C$ 0.78 = ~ 44.87/C$

Combining the two, we get



Forward cross rate

In this case too, the selling rate of one currency is divided by the buying rate
another currency and vice versa. Suppose, one month forward rate in case of t
two currencies is ~ 34.50-34.80IUS $ and C$ 0.79-0.83fUS $. The forward rate'E~'
the Canadian dollar in terms of the rupee can be found as

34.80/C$0.79 = ~ 44.05/C$ ,

34.50/C$ 0.83 =


Combining the two, we get ~ 41.57-44.05/C$.


Nominal and Real Exchange Rates
The exchange rates mentioned in the preceding section are the nominal exchange
rates/bilateral exchange rates. They represent the ratio between the value of two
currencies at a particular' point of time. The real exchange rate, on the other hand,
l~al~x9hi:1I1gii'iate is the price-adjusted nominal exchange rate. The relationship betw~en
,:'th-e,,:rriflatio~~ nominal exchlillge rate, e and the real exchange rate, e r can be written
,~jUsted)nomiri~r in the form:
e r = eP/P*

and P* are domestic and foreign price indices. If the price index in India
,USA rises from 100 in 1998 to 120 and 110, respectively in 2001 and if
inal exchange rate between the two currencies between the two dates
'at ~ 40lUS $, the real exchange rate will move to:
40.00 x 120/110 = ~ 43.64!US $
floating-rate regime, as discussed in Chapter 3, the nominal exchange rate
'automatically with a change in the price level. But in a fixed-rate regime,
not happen so because the rate is administered. As a result, there arises
between the nominal exchange rate and the real exchange rate.


International Financial Management

Chapter 4 Exchange Rate Mechanism

Effective Exchange Rates

!e9t!Veil~chaQQer It is possible that the Indiap. rupee tends to depreciate against US cC
i.~}~;:the::e;i.;,;L but it appreciates against Japanese Yen. It is also possible that
!~~4re::pt,:th,~;:'\:: depreciates vis-a.-vis different currencies at different rates. So it is ess
to develop'
an index
~~rren(:y Jeatl\(e:,
.or a summary measure of how rupee
' . ,0<.". average, m the foreIgn exchange market. Such an mdex IS calle
,\e"tis.urre:d~l~s,,:L effective exchange rate .. In other words, effective exchange rate i~
r~~IIY~I1?Wt\ipi; measure of the average value of a currency relative to two or more "
m .of,anlfldelk currencies. The relationship between an effective exchange rate an
nominal exchange rate is similar to that between the general price index an
price of an individual commodity.
For the construction of an effective exchange rate index, the first step 1
select the currency for the basket, for it is not feasible to include all the curre
of the world. Only those currencies are included that matter significantly in
country's trade. The second step is to find out the weight of different currencie
the basket. This is because different currencies do not carry the same importa
If India' largest trading partner is USA, the US dollar should be assigned
largest weight. Suppose India has trade link with only two countries, viz. USA
Japan. India's exports to USA and Japan value, respectively, $ 6,000 and $ 4,
and its imports from these two countries. value, respectively, $ 7,000 and $ 3,
The weight for these two countries will be:
USA = (6,000 + 7,000)/[(6,000 + 7,000) + (4,000 + 3,000)] = 0.65
Japan = (4,000 + 3,000)/[(4,000 + 3,000) + (6,000 + 7,000)] = 0.35
The third step in this process is to find out the exchange rate index. Supp
in 1998, the exchange rate was~ 40/US $ and ~501Yen 100; in 2001, the exch .
rate changed to ~ 44/US $ and ~ 60IYen 100. If 1998 is the base, the exchange r'
index in 2001 will be 110 for the US dollar and 120 for Yen.
If the effective exchange rate index for 1998 is
EER1998 = [(0.65 x 100) + (0.35 x 100)] = 100, .
Then the effective exchange rate index for 2001 will be
EER2001 = [(0.65 x 110) + (0.35 x 120)] = 113.5
This means the rupee depreciated on an average by 13.5 per cent duringt
So far we have discussed the nominal effective exchange rate. Sometimes t'
real effective exchange rate is also shown. In the calculation of real effective exchan
rate, the same process is applied with the exception that the real exchange rate
taken into account. In other words, the real effective exchange rate is based on re
bilateral exchange rates, while the nominal effective exchange rate is based'
nominal bilateral exchange rates.




hange rate -between two currencies in a floating-rate regime is determined
'interplay of demand and supply forces. The' exchange rate between, say, the
. and the US dollar depends upon the demand for the US dollar and its
:bility or supply in the Indian foreign exchange market. The demand for
currency comes from individuals and firms who have to make payments in
~ currency mostly on acco~nt of import of goods and services and purchase
urities. The supply of foreign exchange results from the receipt of foreign
icy normally on account of export or sale of financial securities to foreign
11 Figure 4.1, the exchange rate designated by the price of the US dollar
[gn currency) in terms of the rupee, is shown on the vertical axis, and the
)ly of, and demand for" the US dollar is shown on the horizontal axis. The
"a.nd curve sJopes downward to the right because the higher the value of the
p.ollar, the costlier are the Indian imports and the importers curtail the demand
.ports and consequently the demand for foreign currency falls. Similarly, a
er value of the US dollar makes Indian export cheaper and thereby stimulates
Iemand for export. The supply oftheUS dollar increases in the form of export
lingS and the supply curve of the US dollar moves upward to the right with a
in its value. The equilibrium exchange rate is reached where the supply curve
._ects the demand curve at Ql' This rate as shown in the figure is ~ 40lUS $.
f demand for import rises owing to some factors at home, the demand for the
ollar will rise to D' and intersect the supply at Q2, the exchange rate will then
A2/US $. Butif export rises as a result of decline in the value of the rupee and


~~ I '

40,j)erF~nt; .35per'cjiin.tancI25 per cenf ofits: trade. respectively. ASSUm.~,I

2000':'O~liS theqas:e~:r~ar;.whEm the exch~iigeiat~swere.'~' 45.68/US:
~'. 4)1~/*uroap.d~0 .4J4fYen. These '. ratescb.angeq o"er tJie ,.y~ars~nd ,.il

2004:-()5,theY~ereas:~.43.91/US $, .~.52.671E~r6 ancl ~ 0.40~fXen; Fino

effeetiyeexthan~erateindexdtiring 2004-05.
' . . , . .'





Demand for and supply of US $


A 1


.......... I"T.n.

l;) ... f..n. no."f..n.,...TV\;"I"\.."f.;"......

Chapter 4 Exchange Rate Mechanism

Intematioru:U Financial Managemenr

the supply of the dollar increases to S', the exchange rate will again'~~j)'
'{ 40lUS $. Quite evidently, the frequent shifts in the demand and supply conditi~
cause the exchange rate to also adjust frequently to a new equilibrium.


Flow of Funds on the Current and Capital Accounts
A country with current account deficit experiences a depreciation of its curre~~'
It is because there is demand for foreign currency to make payment for impof,fS1
On the contrary, a current account surplus country possesses, a large supply':~
foreign exchange with the result that the country experienc~s an appreciation of;~~
currency. An apposite example of current account deficit country is the USA wl:i{;~
trade deficit was one of the important causes for depreciation in dollar during
post-2002 years. On the other hand, the currency of Japan and Switzerland apprecia:t~
in view of surplus current accoUnt. However, the current account alone is n~
responsible for this state of affairs. Capital account flows help change the situatior
Larger inflow on the capital account leads to an appreciation of the curreny. .
Indian case is an apposite example. Rupee appreciated in 2007 because of I
inflow of foreign investment and depreciated when FIls' net disinvestment
large during 2008. There are countries, such as Australia, Britain, Iceland
New Zealand that experienced greater appreciation in their currency in the
half of 2008 even after having large deficits on their current account relativehiit
Japan and Switzerland that witnessed surpluses on their current account and,:~
the same time, smaller appreciation in their currency. In fact, this paradox is thJ
result ofcarry trade that explains why trade flows are dwarfed by capital flowsl?
account of interest rate differential.


Impact of Inflation
It is normally the inflation rate differential between the two countri
that influences the exchange rate between the two currencies. The influeIl'
determiiledby ihe' of inflation rate finds a nice explanation in the Purchasing Power Pan
(PPP) theory (Cassel, 1921; Officer, 1976). This theory suggests that'
of the ,iwo ';;
'any,given time, the rate of exchange between two currencies is determiri
currencies. '
by their purchasing perwer. If e is the exchange rate and PA and PB "
the purchasing power of two currencies, A and B, the equation can be written'

exchange rate . "


Prior to 1914, the purchasing power of a unit of a currency was reckoni

Theo,ry, of one,
pri8~expl~iris how, in terms of gold. The principle applies even today, but now it is reckoni
if()~~'sti?gric~, of' in terms of tradable commodities. As a corollary, a country experienci'
a,prq~'~~~.!%f0~~s',,'.' higher inflation will experience a corresponding depreciation of its curren',
while a country with a lower inflation rate will experience an appreciati
sain-~.f~~~;~~~y. .' in the vahle of its currency. In fact, this theory is based on the theory'
",::," -.;",,::, ;":',' ,,', "',:, , :,:
one price in which domestic price of any good equals its foreign pri,.
quoted in the same currency. For instance, if the exchange rate is ~ 2/US $, tb
price of a particular commodity, ifitis ~ 100 in India, must be US $ 50 in the US
In other words,


, $ price of a commodity x price of US $ = Re. price of the commodity (4.5)

iflation in one country causes, a temporary deviation from the equilibrium,

ftrageurs will begin operating and, as a result, equilibrium will be restored

~tigh changes in the exchange rate. Suppose the price of a commodity soars in

ia to ~ 125, the arbitrageurs will buy that commodity in the USA and sell it in

:a to earn a profit of~ 25. This will go on till the exchange rate moves to ~ 2.51

$ and the profit potential of arbitrage is eliminated.

The exchange rate adjustment as a sequel to inflation may be further explained.

s if the Indian commodity turns costlier, its export will fall. At the same time, ,

import price being cheaper, its import from' the USA will expand. Higher
'rt will raise the demand for the US dollar in turn raising its value vis-a.-vis
owever, this version of the theory, which is known as the absolute version,
s good if the same commodities are included in the same proportion in the
iestic 'market basket and the world market basket. If it is not, PPP theory will
'hold good despite the law of one price holding good. Moreover, this theory does
':cover the non-traded goods and services where transaction cost is significant.


Financial Management

In view of the above limitation, another version of this theory has evolv
which is known as the relative version of the PPP theory. The relative version stat~k
that a change in exchange rate that would retain the original level of relative pr"
of tradable to non-tradable goods in the economy, would establish an equilibri
exchange rate. It further states that the exchange rate between currencies of a
, two countries should be a constant multiple of the general price indices prevaili
iz: them. In other words, percentage change in exchange rate should equal t
percentage change in the ratio of price indices in the two countries. To put it
an equation,
e!eo = (1 + I A )tl(l + IB)t
wb.ere IA and IB are the rates of inflation in country A and country B, eo is the val
of A's currency in terms of one unit of B's currency in the beginning of the peri
and et is the spot exchange rate in period t.
For example, inflation rate in India is 5 per cent and that in USA 3 ce
and if the initial exchange rate is ~ 40lUS $, the value of the rupee in a two-ye
period will be
e2 = 40(1.05/1.03)2
~ 41.571US $

Such an inflation-adjusted rate is known as the real exchange rate. This mea,
that if the real exchange rate is constant, currency gains or losses from nomi"
exchange rate changes will be offset by the difference in relative rates of inflati
Sometimes when a government sticks to a particular exchange rate without carin,gj
for prevailing inflation, a gap emerges between the real and the nominal exchang~
:-ates which results in lowering of export competitiveness and in turn, the tra'q.~,
deficit. This is why, this theory suggests that a country with high rate of inflati4'
should devalue its currency relative to the currency of the countries with low~;
inflation rates. Again,.it is the real exchange rate, and not the' nominal excharile:
rate, that has a bearing on the performance of the economy.

Chapter 4 Exchange Rate Mechanism

The theory holds good only if:

Changes in the economy originate from the monetary sector,
Relative price structure remains stable in different sectors; since changes in
the relative prices of various goods and, services may lead to differently
constructed indices to deviate from each other, and
There is no structural change in the economy, such as changes in tariff, in
technology, and in autonomous capital flow.
Again, if the difference of inflation rate between the two countries is small, its
ect on competItiveness may be offset by other factors, such as balance of payments
formance" development in real income, and interest-rate differential, etc. As a
ult, comparison of inflation rates may not explain changes in exchange rates.
A number of studies have tested empirically the two versions of the PPP theory.
e absolute version has been tested by Isard (1977) and McKinnon (1979). Both
them find violation of the theory in the short run, but in the long run, they find
e theory holding good to some extent. As regards the relative version, the studies
lide till the early 1980s found normally relationship existing between rate of
.flation and exchange rate, especially in the long run (Aliber and Stickney, 1975;
ornbusch, 1976; Mussa, 1982). But subsequent studies find clear-cut violation of
e theory also in the long run (Adler and Lehmann, 1983; Edison, 1985). Taylor
~88) finds very little evidence forPPP to hold good. In a review of 14 cases,
'icDonald (1988) finds that in 10 cases, the theory is not applicable even in the
ig run, but in four cases it holds good.
Primarily, there are tlu:ee factors why the PPP theory does not hold good in
~l life. Firstly, the assumptions of this theory do not hold good in real life.
'ondly, extraneous factors such as interest rates, governmental interference, etc.
uence the exchange rate. In the early 1990s, for instance, some of the European
ntries experienced higher inflation rates than the USA, but their currencies did
;'depreciate against the dollar because their high interest rates attracted capital
In the USA. Thirdly, when no domestic substitute to an import is available, the
,terial is imported even after the prices go higher in the exporting countries.

erts differ on how changes in interest rate influence the exchange rate. The
,ible price version of the monetary theory explains that any rise in domestic
est rate lowers the demand for money, and the lower demand for money in
.ion to the supply of money causes depreciation in the value of domestic currency.
sticky price version of the monetary theory has a different explanation which
at a rise in interest rate increases the supply of loanable funds which leads
eater supply of money and a depreciation in domestic currency. At the same
e, however, it shares the views with the balance of payments approach where'
ligher interest rate at home than in a foreign' country attracts, capital from
oad in lure of higher return and the inflow of foreign currency results in increase
'Lhe supply of foreign currency and raises the value of domestic currency.,
However, suggests Fisher, this proposition cannot be thought of in isolation of
,ation, inasmuch as inflation negates the return on capital to be received. If the
;rest rate is 10 per cent and the rate of inflation is 10 per cent, the real return
:apital would be zero. This is because the gain in the form of interest is cancelled
by the loss on account of inflation. In fact, since it was Irving Fisher who


Chapter 4 Exchange Rate Me2hanism'


Intemational Financial Management

decomposed nominal interest into two parts-the real interest rate and the exp
fisher Effect
rate of inflation, the relationship between these two elements is
explains that
as the Fisher Effect.
nominal interest
The Fisher effect states that whenever an investor thinks 0
rate is the'
investment, he is interested in a particular nominal interest rate
~'::~s~~a~~ 7ri::
covers bot~ the ~xpected inflation and the required real interest
iriflation rate.
MathematIcally, It can be expressed as
1 + r = (1 + a)(1 + I)
r = nominal interest rate,
a =real interest rate, and
I = expected rate of inflation.
Suppose the required real interest rate is 4 per cent and the expected ra
inflation is 10 per cent, the required nominal interest rate will be:
1.04 x 1.10 - 1 = 14.4%
Suppose, the interest rate in the USA is 4 per cent and the inflation rate in
is 10 per cent higher than in the USA. A US investor,will be tempted to inv
India only when the nominal interest in India is more than 14.4 per cent.

ing volume of capital in India will push down the interest rate. The capital
'11 continue till the real interest rate in the two countries becomes equal.
eanS that the process of arbitrage helps equate the real interest rate across
ies, and since the real interest rate is equal in different countries, the country
igher nominal interest rate must be facing a higher rate of inflation.
,r this type of arbitrage, however, it is necessary that the capital market be
neous throughout the world so that the investors do not differentiate between
mestic capital market and the foreign capital markets. In real life, such
eneo us capital market is not found in view of government restrictions and
economic policies in different countries. As a result, interest rates vary
countries. Mishkin (1984) confirms this view and finds that investors have a
liking for the domestic capital market in order to insulate themselves from
'exchange risk; and so, there will be no arbitrage even if real interest rate on
securities is higher. Again, the Fisher effect holds good normally in case of
aturity government securities and very seldom in other cases (Abdullah, 1986).
empirical tests present different results. Gibson (1970, 1972)
'ma and Schwert (1977) find the result in 'favour of the Fisher effect; while
dies of Mishkin (1984) and Cumby and Obstfeld (1984) do not support it.

ined Effect of Interest Rate and Inflation

is also Fisher's open proposition, known as the International Fisher Effect or
lised version of the Fisher effect. It is a combination of the conditions of the
eory and Fisher's closed propositio?: It may. be recalled ~hat :he1ilterl;iati
eory suggests that exchange rate IS determmed by the mflatlOnl:'.~e8t:,
fferentials, while the latter states that the nominal interest rate't6ai;int~r13s~(fl:te,
er in a country with higher inflation rate. Combining these two di,flerehliaiis eq~al
'tions, the International Fisher effect states that the interest rate~ffth13i;:jlftion rate
tial shall equal the inflation rate differential. It can be written as I eren 13;

A)= (I+IA)


e rationale behind this proposition is that an investor likes to hold assets

inated in currencies expected to depreciate only when the interest rate on
ssets is high enough to compensate the loss on account of depreciating
ge rate. As a corollary, an investor holds assets denominated in currencies
,ed to appreciate even at a lower rate of inte'rest because the expected capital
n account of exchange rate appreciation will make up the loss on yield on
nt of low interest.
e equality between interest rate differential and inflation rate differential
explained with the help of the following example. Suppose, India is expecting
;; cent inflation rate during the next one year as compared to 3 per cent
on rate in the USA. If the exchange rate in the beginning of the year is ~ 401
the value of the rupee will fall vis-a.-vis the US dollar at the end of the period
~ 40(1.08/1.03) = ~ 41.94!US

se further that at the beginning of the period, interest rate in India is 7 per
s against 4 per cent in the USA. At the end of the period, interest rate in

International Financial Management

Chapter 4 Exchange Rate Mechanism

India will rise to an extent that will equate approximately the inflationra
differential. In order to find out the change in interest rate, the following equati6'"
may be a p p l i e d : ' ' ' ' ' '
e/eo = 1 + rINd1 + rUSA
Basing on the above equation, we have
41.94/40 = (l + rIND)/1.04

. or


rIND =


rIND = 0.09 or 9%

If the rate of interest in India rises to 9 per cent, the interest rate different'
between the two countries will be: 1.0911.04 or 4.81 per cent which will
approximately equal to the inflation rate differential which is 1.08/1.03
4.85 per cent.


ard exchange rate is normally not equal to the spot rate. The size of forward
'um or discount depends mainly on the current expectation of future events.
expectations determine the trend of the future spot rate towards appreciation
'epreciation and thereby determine the forward rate that is equal to, or close
he future spot rate. Suppose, the dollar is expected to depreciate, then holders
Dllars will start selling forward. These actions will help depress the forward
'of the dollar. On the contrary, when the dollar is expected to appreciate, the
rs will buy it forward and the forward rate will improve.
'he determination of exchange rate in a forward market finds an important
in the theory ofInterest Rate Parity (IRP). It is, therefore, relevant to explain
,heory and how it helps in exchange rate determination in a forward market
lOW the arbitrageurs behave when the forward rate differential is not equal
~. interest rate differential.

,st Rate Parity Theory

RP theory states that equilibrium is achieved when the forward
ifferential is approximately equal to the interest rate differential.
er words, forward rate differs from the spot rate by an amount that
ents the interest rate differential. In this process; the currency of
try with lower interest rate should be at a forward premium in
in to the currency of a country with higher interest rate.
,uating forward rate differential as per Eq. (4.2) with interest rate [rate., .,.;,:
,ntial as shown in Eq. (4.8), we find that
A x (n-day F - 8)18


,=:'. ~ 45.18IUS $. '

Intervention by Monetary Authorities

When the market forces do not influence the exchange rate in the country's fav,
then its monetary authorities in'iJervene in the foreign exchange. market throt...,.
buying and selling offoreign currency and influence the exchange rate. The mecha .,'>,
of intervention has been explained in Chapter 3 and readers are advised to'
to that portion of the discussion.

Participants' Psyche and Bandwagon Effect

Yet the other factor influencing the exchange rate is the psychology ofthe particip~
in the foreign exchange market. When a speculator being dominant in the forei.
exchange market expects a drop in the value of a particular currency, he be~
selling it forward. The other speculators follow the lead. Ultimately, the curre~'
depreciates even if the inflation and interest rates are in a position to push up
value of the currency. In fact, this factor played a crucial role in the depreciati,i
of British pound in 1992 and of rupee during the closing months of 1997..

= (l

+ rA)/(1 + rB) - 1


ination of Forward Exchange Rate

'-basis ofthe IRP theory, the forward exchange rate can easily be determined.
s simply to find out the value offorward rate (F) in Eq. (4.10). The equation
.' re-written as

_ ...

.F A

{1 + -1} + 8

1 +rB


Ie interest rates in India and the USA are respectively 10 per cent and 7 per
'he spot rate is ~ 40lUS $. The 90-day forward rate can be calculated thus,
F = 40 {1.1 0 _ I} + 40
4 1.07


40.281US $

means that the higher interest rate in India will push down the forward
.the rupee from 40 to 40.28 a dollar.





CI,apter 4


International Financial Management



d but the amount of profito'J:f ofcovered iIltere-;~ arbltr~g;~"i~liii~~~~,~!'l

. ia and the USA is respectively 9 per cent and 4.50 per cent and the, 67IIl.'
a"rd" and spot exchange rates are respectively ~ 45.00 $1.and ~45.26$':


Applying the interest

. 3-mo"t!>






i i t , n ' 'ii,':";:?:
; ~ill be covered iilterest arbitrage insofar as the int~restJ,"ft,e~Il~:f~~:~~,

rateparitY}~9i-~ri,l, " ..


,differentials are not equal.

. '
" ' " " ""'":U,t,,h"!,i
'0, start with, borrowing $ 1,000 iIi the USA, converting it<int()Iilli>~e,Jg:t"
00 and investing the rupee, for six months will fetch, ~ 4'7,0?i5",P~lli~g
,025 forward will fetch $ 1,045, Mter. repaying dollar 10an~10ngir,i.t~)M~r~~t
,1;022.50, the arbitrageur profits $ 1,045 - 1,022.50, = $ ,22:50. ", '". ,.",'

Covered Interest Arbitrage




If the forward rate differential is not equal to the interest rate differential, cove'
interest arbitrage will begin and it will continue till the two differentials beco
approximately equal. In other words, a positive interest rate differen
t "r,,:e m t' e
arbitrage involves In a c~untry'.1~ 0:ff:set b'
y annual'Ised fi0:r:ward d'ISCOun.
borrowing and
rate dlfferentlalls offset by an annualised forward premIUm. Fmally,
two differentials will be equal. In fact, this is the point where the forw
m~Iketsand als!? ',' rate is determined.
spot and" ,
To e~lam
the process of covered .
mterest '
arbItrage,. suppose,
spot rate IS ~ 40/US $ and the three-month forward rate IS ~ 40.28
currencies .so as" $ involving a forward differential of 2.8 per cent. The interest rate i
tQad~~n parity ,
per cent in India and 12 per cent in the USA involving interest
. 1s are no t eq'
, Itlons.'
Wllerenti 0f 5. 37 per cent. S'mce t h e two d'=
covered interest arbitrage will begin. The successive steps shall be as follow
Borrowing in the USA, say, US $ 1,000 at 12 per cent interest
Converting the US dollar into the rupee at spot rate to get ~ 40,000/
Investing ~ 40,000 in India at 18 per cent interest
Selling the rupee 90-day forward at ~ 40.28/$
Mter three months, liquidating the ~ 40,000 investment which would
Selling ~ 41,800 for US dollars at the rate of ~ 40.28/US $ t
US $1,038
Repaying loan in the USA which amounts to US $ 1,030

Reaping profit: US $ 1,038 ...:. 1,030 = US $ 8.

So long as inequality continues between the forward rate differential a
interest rate differential, arbitrageurs will profit and the process of arbitrage
on. But with this process, the differential will be wiped out for the following re
1. Borrowing in the USA will raise the interest rate there.
2. Investing in India would increase the invested funds and thereby low
interest rate there.
3. Buying rupees at spot rate will increase spot rate of the rupee.
4. Selling rup'ees forward will depress the forward rate of the rupee. '

The first two actions narrow the interest rate differential, while 3 and 4 wid~
forward rate differential.

However, the real life experience shows that the two differentials-interest
e and forward rate-are equal only approximately and not precisely. It is because
interest rate parity theorem assumes ,no transaction cost, no tax rate differences
political stability. But the assumptions do not hold in real life.
First of all, there is always transaction cost involved in selling a currency spot
buying it forward. The transaction cost, which is manifest in the bid-ask
ad, forces forward rate differential to deviate from the expected one: The
saction cost, which is involved also in borrowing and investing, influences the
tive interest rate and thereby the interest rate differential.
Secondly, there is disparity in the tax rate on interest income in different
tries. Such a disparity allows the interest rate differential to deviate from the
cted one.
ast but not least, if there is political unrest in the country where the funds
,invested, the cost of investment will be greater and this will influence the
, est rate differential.

overed Interest Arbitrage

'n one talks about interest arbitrage, it would be worthwhile to note

interest arbitrage may not be only covered, it may also be uncovered.
'ver, in an uncovered interest arbitrage, the arbitrageur does not
advantage of the forward market and does not go for any forward

ct for reaping profit. Rather the decision behind profit-making depends

:the expectation about the future spot rate, inasmuch as the interest
ifferential between two countries leads to, changes in future spot

Uncovered interest
arbit<agedoes not
involve forward ,. '
rnark~f , '

transactions as
~iffeire.niial,leads ".
to <::hangesin

interest-rate differential is equal to changes in the future spot rate, uncovered

st parity will exist. This can be represented in the form of an equation:
(1 + R A )/(1 + R B ) = (8 e+l



8 e+l i~ the expected future spot rate, and R A and R B are the interest rates
ntrY,A and Country B.
long as equality is not reached, the arbitrageurs will go for uncovered interest
ge and reap profits. Suppose the interest rate on the Indian treasury bill is
cent and that on the UK treasury bill is 4.0 per cent and so the interest
ifferential is 2.88' per cent. If the investor expects a depreciation of

International Financial Management

Chapter 4

4.0 per cent in the future spot rate of Indian rupee helshe will invest in the UK
treasury bill because a fixed amount of British pound will fetch greater amount of
Indian rupee at a future date. This will go on till the two differentials are equal.'
This is uncovered interest arbitrage.



Exchange Rate Mechcmism

Even the covered interest arbitrage does hardly help achieve interest rate
parity. The reasons are:
(a) There is transaction cost involved in the arbitrage process which the
IRP theory does not take Into account.
(b) Control on capital account transactions is found in many countries that
hinders a smooth arbitrage process.'






'"f"";; '.' ii.,~,;;<:..,

.. ,..


In~yfeSt.r aty.. diffE!rential=:;i~.:??/l;:q5.\#'1"7:Iq~~.(5:PE!r:c~J:it

~ut~re . sp~~/~ate~if,fere~ial.'7.{~~:20i~4?.3 . .' ......... ' ...






+/'f;i)'; . (

c;,,, " ' ; . '

Evaluating IRP Theorem

Does the IRP theory hold good in real life or do the arbitrageurs respond to the
interest rate differential? The study of Marston (1976) shows that the IRP theorem
held good with greater accuracy in the Euro-currency market in view of the complete
freedom from controls and restrictions. Similar findings emerge from the work 0
Giddy and Duffey (1975). However, there are studies that identify deviation from
the theorem (Officer and Willet, 1970; Aliber, 1973; Frenkel and Levich, 1975).
.The reasons for derivations are:
(i) Since different rates prevail on bank deposits, loans, treasury bills, etc.,
short-term interest rate c~nnot be specific and the chosen rate can hardly,
be the definitive rate of the formula.
(ii) The marginal interest rate applicable to borrowers and lenders differs;,,'
from the average interest rate because interest rate changes with successive;!
amount of borrowing.
(iii) The investment in foreign assets is more risky than t4at in domestic assets.;j
If greater diversification is applied to foreign investment in order to lower;f
the risk element, the law of diminishing returns may apply; and as i'\
result, the arbitrageurs may not respond to the interest rate differential as:
envisaged by the IRP theorem.
(iv) There are also cases when interest rate parity is distllrbed owing to theJ
play ofextraordinary forces leading to speculation. It is basically the market"
expectation of future spot rates that influences the forward rate. If marke~~
expectations are strong enough, they can push forward rates beyond the';
point which interest rate parity would . d i c t a t e . '

The IRP theorem explains the forward rate differential in terms of interest rate
differential between two countries and emphasises the role of arbitrageurs who
help equalise the two differentials and help determine the no-profit forward exchange
rate. The proponents of the modern theory feel that it is not only the role of the
arbitrageurs but of all participants in the foreign exchange market, such as
e traders and hedgers and speculators, that influences the forward exchange
teo If they are taken into account, the forward exchange rate may differ from the
o-profit forward exchange rate as explained by the IRP theorem (Grubel, 1966;
toll, 1968).
The proponents of this theory explain the role of all the different participants.
e can present a simple illustration here. Suppose, the forward rate of the British
ound in relation to the US dollar. is expected to be higher than the no-profit
orward rate, then the arbitrageurs will be selling the British pound forward for
:he US dollar. In the reverse case, they will buy the pound forward for US dollars.
e larger the difference between the two rates, the greater will be the size of
,rward purc;hase or sale by the arbitrageurs.
The arbitrageurs are risk-averse, but the traders are fully risk-averse. They
over their transaction exposure either through forward market hedge or money
arket hedge or through both. So when the forward rate of the British pound is
ing to appreciate, the British exporter will sell the dollar forward if the export
II is invoiced in US dollars.
'. Speculators, however, are risk-takers. They have their own perception of exchange
te changes. If they expect that the future spot rate of the British pound in
lation to the US dollar will be higher than the forward rate, they purchase the
lund forward. On the maturity, they buy pounds and with the pound, they purchase
~llars at the future spot rate thus making a profit. On the contrary, when future
lot rate of the pound is expected to be lower than the forward rate, they will sell
le pound forward. On the maturity, they sell the pound at the forward rate, get
'''\e US dollaJ;., convert the US dollar into pounds "at the future spot rate and make
profit. The greater the expected difference between the two rates, the larger will
. the size of their forward purchase and sale. Thus, the activities of different
rticipants will force the forward rate of exchange with different intensity. The
Uilibrium rate will be established where different forces will come to eqUIlibrium.
:other words, the equilibrium forward rate is represented by a weighted average
:the no-profit forward rate of exchange and the expected future spot rate.



Chapter 4 Excha~ge Rate Mechanism



section refers to a few major postulates that explain exchange r'

behaviour and the ways in which Some important macroeconomic variables mflue.
the exchange rate movement. These different theories are compartmentalised i
the balance-of-payments approach and the asset-market model. The latter is ag
compartmentalised into two approaches on the basis of substitutability b,etw
domestic financial assets and foreign financial assets. Perfect substitutability betw
the two led to the monetary approach, while the lack of perfect substitution has I
to the portfolio balance approach. The monetary approach, which is an outgrow'
of PPP theory and the quantity theory of money, has two versions: one being t
flexible-price version and the other being the sticky-price version.

. '.'


. Exchange Rate Theories

". ". '. .



~alance ~f paYIlJ,ents. theory:. .... . '. .

+'~'t,Higherinflaiio:nratedifferential athoIile ~ greater import and low~~1
...... export .~greater demand fofforeign currency'~ depreciation of domestiF~
Cc .currencY. "
..............'.." .. '
:h.;:Z::Greaterrealincomeat hoIile~ greater import ~. depreCiation of domesti'C\




'.." .... ." ... . . . .........

. .' ......;
~'3.Greaterinterest rate at home ;7. inflow of foreign capital -7 greater supply;'
.o{f6.reigIl6lrI:ency '-7 .appreciation of domestic currency:
.~.MonetaryApproach--':'Flexible PriceVersion: ..... . '., '.'
. .. ' .. ' . , i
'. "1.' Increas.e ininoney supply '-7 higher price level --+ depreciation of domestic',
!?; "; cuiJ:eticy. ' . ' ......... .
. '.' '.
'.. '
.,'':2,.:i\1oney!'upply being less than real domestic output. --+excess. demand. for;
Rke balances '-7 lower domestic prices appreciation of domestic currency.'
iIi interest i'ate
lower "demand' for money -7' domestic currency


.~:.lvt6~f~ci:;;6~Ch~tiCkYPrice Version:' : .

. .' .. '

.. .

~"J''Jrid-ease irl m,oneysupplY;7 .depreciation of domestic Currency.

>.:"2'>Incre~ein money supply ,-+ Pric~ rise ''-7 'lowerrealinterestrate ~ lower

" "..fuflowof capital '-7 . depreciationof'dom~stic cUrrency. '.'

i'~]3~':Ri#'iI:liriteresf;ate4ireater irinowof~ai?ital--.nippreciationof
. ..... .... . ' ; . . '
" ".


money stipply (IoaIiable funds)

::~~~~!~4~~f~~~~;';S~~'Y . .

> ... . .....



forf~reign fmancial

:~s~ts;;~'1~p'r~~i~~i?~~r.doWe~tissvrie~SY":i:. ' ,
r tsky '.~' . demand f()r .them decreases
~;a:ppreCiatlon.ofd~m:estic.':.suITe.ncY.. ,
. .. .'
' i .. '

::\\;, ';:.,,',;" :' . ,:,I.:..!i;,.'::.'-'-""",:,-:<""""",,

'~\::""'. ' , .,.,.,'.", .:" ,.::, , ;::: '. ~

t us begin with the balance of payments approach (Allen and Kennen, 1978) that
ggests that an increase in domestic price level over the foreign price level makes
,reign goods cheaper. It lowers export earnings and boosts the import bill. Lower
port reduces the supply of foreign exchange, and at the same time, greater
port increases the demand for foreign exchange and domestic currency depreciates
s a result. Similarly, growth in real national income causes larger imports if
arginal propensity to import is positive. Larger import will cause greater demand
r foreign currency and thereby depreciation in the value of domestic currency.
Increase in domestic interest rate, on the contrary, causes greater capital inflow
at increases the supply of foreign exchange and thereby causes appreciation in
.~he value of domestic currency. The first two factors influence the current account,
hile the third factor influences the capital account.
However, the empirical study of Pearce (1983) shows that none of the above
mentioned variables was very significant in the case of exchange rate between the
Canadian dollar and the US dollar. On this ground; he has suggested for an alternative

' .....



lance of Payments Approach


.Monetary Approach
The flexible-price version of the monetary approach emphasises the role of demand.
: and supply of money in determining the exchange rate (Frenkel, 1976). The exchange
rate between two currencies, according to this approach, is the ratio of their values
determined on the basis of the money supply and money demand positions of the
two countries. The demand for money--'--either in domestic economy or in a foreign
economy-is positively related with prices and real output and negatively related
with the rate of interest. Any increase in money supply raises the domestic price
level (based on the quantity theory of money) and the resultant increase in price
level lowers the value of the domestic currency. But if the increase in money supply
is lower than the increase in real domestic output, the excess of real domestic
output over the money supply causes excess demand for money balances and leads
to a lowering of domestic prices which causes an improvement in the value of
domestic currency. This explanation thus runs contrary to the balance of payment
approach where increase in real output causes depreciation in the value of domestic
currency through greater imports. Again, the monetary approach is different from
the balance of payments approach in the sense that the former explains that a rise
in domestic interest rate lowers the demand for money in the domestic economy
relative to its supply and thereby causes depreciation in the value of domestic
currency, However, the critics of this theory argue that since the purchasing power
parity theory is not applicable in the short run, this theory does not hold good in
such cases.
Dornbusch (1976), the proponent of the sticky price version, feels that the
simple assumption of the flexible price version that the PPP holds continuously
and the real exchange rate never changes is unrealistic. In the real life, real
exchange rate has changed at least in the short run, although the variability of
nominal exchange rate has been greater. He assumes further that the pace of
adjustment of asset prices is faster than the pace of adjustment of goods prices.
Thus, when the goods prices are sticky, it is necessary for the asset prices to move
more than in the flexible price case for attaining a temporary equilibrium.

Chapter 4 Exchange J!,ate Mechanism.


[ntemarional Financial Management

The sticky price version bas proved that gradual adjustment of goocis prices
following a monetary shock imparts a "dynamic adjustment path" to the. exchange
rate. The real exchange rate alters in the short run but returns to the originalleve.l
in the long run on. account of PPP deviations.
The sticky-price version makes a more detailed study of interest rate differential.
The interest rate differential has three components. One denotes that when interest
rate rises, the money balances held by the public come to the money market lured'
by the high interest. The increase in money supply leads to currency depreciation.
The other denotes that if interest rate rises, financial institutions release more
funds into the money market as a result,thevalue of domestic currency depreciates.
The third isthat a rise in interest rate stimulates the capital flow into the country
that, similarly as in the balance of payments approach, causes appreciation 'in the
value of domestic currency.
Th~ sticky price version is based on at least three assumptions. The first is the
perfect capital mobility which means that the interest rate parity conditions prevail.
The second is the slow price adjustment. The third is the element of certainty.
which mean.s that the traders are aware ofthe fact when shocks will be hitting the
market and how to respond to them.

Portfolio Balance Approach

The portfolio balance approach (McKinnon, 1969) suggests that not only the monetary .
factor but also the holding of financial assets, such as domestic and foreign bonds
influences the exchange rate. If foreign bonds and domestic bonds turn out to be .
perfect substitutes and ifthe conditions of interest arbitrage hold good, the portfolio
balance approach will not be different from the monetary approach. But since these
conditions do not hold good in real life, the portfolio balance approach maintains
. a distinction from the monetary approach.
The' portfolio balance approach is based on two financial assets: money and
bonds of both the domestic country and the foreign country. There is no restriction
on the allocation of wealth among domestic money, domestic bonds and foreign
bonds. Thus, for accounting purposes,
Wealth = domestic money + domestic bonds + foreign bonds
The exchange rate establishes an e-quilibrium or a balance in investor's portfolio
which includes all these three forms of wealth. If there is any change in the three
forms of portfolio on account of change in real income, interest-rate, risk and price
level, the investor re-establishes a desired balance in its portfolio. This re-establishment
needs some adjustments which, in turn, influence the demand for foreign assets.
Any such change influences the exchange rate. For example, a'rise in real domestic
inCome or a rise in interest rate abroad leads to a greater demand for foreign
bonds. Any rise of demand for foreign currency will result in depreciation of the
domestic currency. Again, the legal, political and economic conditions in a foreign'
country may be different from those at home. If foreign bonds turn out to be more
risky on these grounds, j;he demand for foreign currency will decrease, in turn
appreciating the value of the domestic currency. Similarly, a rising inflation in the
foreign country would make foreign bonds risky and the demand for foreign currency,
will drop and so domestic currency will appreciate. When the exchange rate changes, .

'. he above mentioned variables also change leading to a shift in the desired balance
the investment portfolio. Thus the two-way interaction continues until equilibrium
reached. The equilibrium is, however, s h o r t - l i v e d . ' .' ...............,..... ,
Again, when a country's wealth increases, holding of foreign assets VlJeallt~;7ttfh,~9t!:.ii. i
d d
h' h
exp all)S ". at, .....'.",'
Iso Increases, an
eman Lor !oreIgn currency goes up w IC causes inc~eas~iiiti'W~~lth'
epreciation in the value of domestic currency. In this context, the possibility )e~~~:f9~~fI)an9i)i
;f substitution effect cannot be completely negated; because it outweighsf8qW~ii~n~,s~'7ts,
. e impact .of wealth effect.
. . The portfolio balance approach is more dan9i.~h'~~t~bY~O.
eprsCia IOn. In

omprehenslVe but as BISIgnano and Hoover (1982) find, data do notdom'estii::cyrrency.

pport the hypothesis of this approach.



. . ....

Exchange rate denotes the ratio between the value of two currencies. It is
quoted in newspapers eIther in a direct or in an indirect'way. The quote
shows buying .:md selling rates. The difference between the two, kno~ as
spread forms the banks' income. The quote also shows the spot quote and
the forward quote. The difference between the two is either forward premium
or forward discount. The cross rate between two currencies is established
through a common currency.
In a floating-rate. regime, rate of exchailge IS determined by the forces of
supply and demand. With higher demand for, or lower supply of, a foreign
currency, its value appreciates vis-a.-vis the domestic currency.
Various different factors influence the demand and supply forces, important
among them being the inflation rate and interest rate differentials. The PPP
theory suggests that the higher the inflation rate, thelower is the value of
currency. Again, the real interest rate tends to equalise, but it is the differing
inflation rate that creates nominal interest rate differential. A higher interest
. rate encourages inflow of capital and the value of domestic currency rises.
The monetary authorities try to stabilise the value of currency through
intervention in the foreign' exchange' market.
In a forward market, the rate of exchange is determined by the interest rate
differential that finds a place in the Interest Rate Parity theory. This theory
tells us that the interest rate differential equals the forward rate differential.
If these two differentials are not equal, covered inte:rest arbitrage begins
and equalises the two. In case of uncovered interest arbitrage, the arbitrageur
takes into account, the expected future spot rate and not the forward rate.
These different variables as discussed above form the basis for the explanation
of different theories that essentially concern exchange rate determination.
The balance of payments approach links exchange rate behaviour with the
changes in capital and current account of the balance. of paYments. The
monetary theory lays emphasis upon the demand for, and supply of, money
as a factor influencing the exchange rate. However, the sticky-price version
of the monetary approach gives a more detailed explanation of interest rate
differential. The portfolio balance approach inCludes also the holding o.nancial
assets-domestic and foreign bonds-that influences the exchang~ rate.

IntemaricnaI Financial Management

Chapter 4 Exchange Rate Mechanism





The. High Level Committee on Balance of Payments, commonly known as the Rangaraja
Committee (1992), suggested a dual exchange rate system or a mix of official and market rat~
at least for a year before finally stepping into a managed floating exchange rate system in Mare:
1993. The managed float inVOlves essentially RBI's intervention in the foreign exchange maf~
either directly through the purchase and sale of US dollars or indirectly through making chang'lS1
in the repo rate and the resultant size of liquidity in the monetary and financial system. It is-fdft
that the new system of exchange rate along with reforms in trade and investment policies helpl'
boost up trade and investment (Sharan and Mukherji, 2001), but the oscillations in exchar\~e
rate at times could not completely be ruled out.;~\:
Trend in the Exchange R a t e . , ! :


As regards the movements in the exchange rate, Table CS4.1 shows that the annual averagj
v.alue of rupee vis-a.-vis US dollar tended to depreciate all along from 31.37}{i)'
FY 1993-94 to 48.40 in FY 2002-03, although then appreciated moving in the range of 44:2'
and 45.95 dUring FYs 2003-07. In FY 2007-08, rupee appreciated at a rapid pace making
average of 40.24 a dollar. But again, the rupee depreciated during the following two finan'
years, although there was some' appreciation in FY 2010-11.

Annual Average Value of Rupee vis-a.-vis US Dollar



,IUS $ (Average)


,IUS $ (Average)







$ Exchange Ra
,IUS $ (Avera


Sources: 1. RBI, Annual Report, various issues.

2. RBI, Reserve Bank of India Bulletin, various issues.

For the appreciation of rupee during FY 2007-08, it was primarily the inflow of large amo
of foreign direct investment and foreign portfolio investment that helped increase the supplY.,
dollars i.n the foreign exchange marKet. When the foreign institutional investors began makil
disinvestment in the wake of the sub-prime crisis, the rupee tended to depreciate fast duringtl
first half of FY 2008-09. By October 2008, rupee fell to 50.29 a dollar. Thus, it is primarily t.
demand and supply forces that help determine the exchange' rate.
Probing still deeper, it is found that the standard deviation of daily. spot rate remai
confined to a level of 0.04-0.1 till FY 2001-02. In fact, the exchange rate oscillations to s
a low degree led some of the experts to analogise the managed floating regime in India
a fixed exchange rate regime for all practical purposes (Baig, 2001; Patnaik, 2003). Ra
Mohan (rbLorg) has also presented the coefficient of variation of daily spot rate beginning f
March 1995 to March 2007 and is of the view that instability in the daily spot rate was cc;mfi
between 0.1 Cind 0.3 except for March 1995, March 1996 and March 2004 when it was, respecti
2.5, 1.8 and 1.1.

Managed float, by its very nature, could not avoid exchange rate risk and the result..
forward trading to hedge the risk. Forward rates are expected rates in the future. The Iiterat
on the issue whether or not the forward rate is an unbiased indicator of future spot rate is

hlhCigen,1975; Edwards, 1982; Hansen and Hodrick, 1983). Again, there are many studies
how that the widening/narrowing of interest rate differential has influenced the forward
ang e rate of Indian rupee (Chakrabarti, 2006; Patnaik, et aI., 2003; Sharma and Mitra,
). Their discussion is not explained here; nevertheless, it can be said that the average
unt on forward rate of rupee-both 3-month and 6-month-was about 4.0 per cent per
m between late 1997 and mid-2004. To be more precise, it was 3.7 per cent for 3-month
ard and 3.8 per' cent for 6-month forward (Chakrabarti, 2006). From June 2004 onward,
ard premium was evident that was as high as 3.0 per cent by August 2004 but then it tended
ecline to less than 2.0 per cent by June 2005 and further to less than 1.0 per cent by
ber 2005. At the close of FY 2005-06, it ascended again to over 3.0 per cent but then
11k to less than one per cent by July 2006. (RBI, 2006). During FY 2006-07, the forward
ia increased reflecting growing interest rate differential in view of increased domestic interest
. In March 2007, one-month, three-month and six-month premia were, respectively,
per cent, 5.14 per cent and 4.40 per cent. In fact, it was because of the changes in the
ro-economic variables that the spot rates and the forward rates tended to oscillate. In
2007-08,because of continuous off-loading of forward position by the exporters, the
month, three-month and six-month premia tended to decline and reached, respectively,
per cent, 2.75 per cent and 2.50 per cent.
ring Stability in the Exchange Rate
issue of financial stability attained significance in the late 1990s in view of keeping at bay
spill-over effects of the turbul~nce in the South-East Asian financial markets and also the
ening of the financial crisis in Russia. The RBI announced a set of policy measures in June
. These measures emphasised on the RBI's role of meeting mismatches between the
nd and supply of foreign currency through market intervention, allowing the foreign institutional
tors (Fils) to manage their exchange rate exposure through undertaking foreign exchange
r on their incremental investment, advising traders .and banks to monitor their foreign currency
tion and allowing domestic financial institutions to buy back their debt from international
cial market. Foreign Exchange Management Act (FEMA) replacing the Foreign Exchange
lation Act (FERA) came into force from Jane 1, 2000. It aimed at promoting an orderly
pment and maintenance of the foreign exchange. market in India. The Act provides transparent
s relating to the RBI's approval for acquiring and holding of foreign exchange and the limits
hich foreign exchange is admissible to current / capital account transactions from the
point of full current account convertibility and growing convertibility on capital account.
In fact, it is the very macro-economic policy, especially the monetary measures and the
inistrative measures that have helped ensure stability in the foreign exchange market through
ncing the supply of, and demand for, the foreign currency. For example, when normal
al inflows .faltered, the State Bank of India raised US $ 4.2 billion through the issue of
rgent India Bonds during August 1998 and another US $ 5.5 billion through the issue of
Millennium Deposits during October-November 2000. However, the RBI's role in the form
arket intervention has been the most significant one. It has already been mentioned how
intervenes in the foreign exchange market, but it needs some more details about the extent
tervention .. Looking at the figures in the recent past in Table CS4.2, it is evident that the
aunt of the purchase of foreign currency ranged between US $ 15,239 million and
$ 55,418 million annually during FYs 2000-06. Similarly, the sale of foreign currency varied
een US $ 7,096 million and US $ 24,940 million during this period. The FY 2006-07 was
ular in the sense that the RBI bought US dollars, and never sold them. The quantum. of
hase was $ 26.824 billions that helped check at least to some extent the rupee from
reciating. As a ratio of turnover in the foreign exchange market, the size of intervention
led between 3.9 per cent and 0.4 per cent. All this shows that the RBI has taken pains to
lid mismatches between demand and supply of foreign currency in the market and thereby
ring in stability in the exchange rate. Unnikrishnan and Mohan (2003) probe deeper into this
e and find that beginning from January 1996 to March 2002, the RBI adopted a "leaning



Chapter 4 Exchange

International Financial Management

.against the wind" approach which is evident from a negative correlation between the exchange
rate and net dollar purchases. It thereby stressed more on checking volatility in the foreig
exchange market rather than simply checking appreciation/depreciation of the currency.
In FY 2007-08, the purchases of dollars were far larger than the sales in view of the fact
that the rupee had appreciated. But when the rupee depreciated during the following two financial
years, the sale of dollars turned larger. In FY 2010-11, the table turned and the purchase oi
dollars was greater since the rupee had tended to appreciate.

RBI's Purchase and Sale of Foreign Currency During 2000s

(US $





Net (Purchase-Sale)

RBI Intervention as % of Turnove

in Foreign Exchange Market





. 3.8


Sources: 1. RBI, Annual Report, various issues.

2. RBI, Bulletin, various issues.


1. What do you mean by managed floating exchange rate regime? Why was it adopte
in India?
2. Comment on the trend of the exchange rate of rupee during the managed floatin
. regime.
3.. How was fluctuation in tile rupee/dollar exchange rate controlled?


Objective-Type Questions
. 1. State whether true (T) or false (F):


Domestic currency is on the numerator in case of direct quote.

Bid rate and buying rate are synonyms. D
Ask rate/offer rate and selling rate carry the same meaning. D
Forward differential is greater in case of shorter maturity. D
Cross rate is found out through a common: currency. D



2. Choose. the right answer:

(a) Demand for foreign currency is influenced primarily by:
(i) size of export
(ii) size of import
(iii) none of these .
(b) Supply of foreign currency is influenced by:
(i) size of export
(ii) size of import
(iii) none of these
(c) Domestic currency tends to depreciate owing to:
CD high inflation rate
(ii) lowering of inflation rate
(iii) constant inflation rate
. (d) Nominal interest rate is the product of:
CD real interest rate and rate of inflation
(ii) real interest rate and exchange rate
(iii) none of these

Covered interest arbitrage takes place when:

(i) forward rate differential is equal to interest rate differential
(ii) forward rate differential is not equal to interest rate differential
(iii) none of these

hort-Answer Questions
Distinguish between:
(a) direct and indirect quote of exchange rate
(b) buying and selling rate
(c) outright forward quote and swap quote
How do you compute the forward rate differential?
What is bid-ask spread? How is it computed?
What is cross rate? How is it computed?

g-Answer Questions
1. Explain the PPP theory. Is it applicable to both short term and long term?
2. What do you mean by Fisher effect? Is it true that interest rate differential
equals inflation rate differential?
Explain. the IRP theory. Is it sufficient to explain the forward exchange
"The spot exchange rate in: a floating-rate reginie is determined by the
supply and demand forces." Explain.
Examine different theories of exchange rate determination.
Explain covered interest arbitrage with suitable example.. Is it different
from uncovered interest arbitrage?

International Financial Management.

Chapter 4 Exchange Rate Mechanism

Numerical Problems

'Aliber, RZ. and C.P. Stickney (1975), Accounting Measures of Foreign Exchange
Exposure: The long and short of it, The Accounting Review, L, 4-57.

1. If direct quote is: ~ 50iUS $, how can this exchange rate

under indirect quote?

2. Consider the following bid-ask prices: ~ 40.00-40.50IUS $. Find out;

(a) the bid-ask price for rupee and (b) the bid-ask spread.
3. Find the cross. rate for Mex. PesolEuro, if: Euro 4.25-4.28IUS $ and Mex~
Peso 65.2Q-65.30IUS $ . 1 ;

4. Explain on the basis. of the following data: whether

(a) absolute version of PPP theory holds good
(b) law of one price holds good














Exchange rate


US $ Price / Unit


~, Price/Unit;~


40lUS $

5. The exchange rate between rupee and US $ is '{ 40lUS $ at the en.l
of Period 1. The rate of inflation in India and the USA is 6 per cent
3 per cent, respectively." What is the likely exchange rate at the end 0"
Period 2?




6. If the nominal rate of interest is 15 per cent and the rate of inflation is
per cent, what would be the real interest rate?
7. Calculate the forward differential if the spot rate is '{ 40lUS $ and t
3-month forward rate is 40.501US $.
8. Calculate the 3-month forward rate, if the spot rate is ~ 46IUS $; thi
interest rate in India and the USA is, respectively, 6 per cent and 3 p
9. The spot exchange rate between Indian rupee and US dollar in 1995 w
~ 30lUS $ when the price index in both the countries was 100. By 200
rupee depreciated to 45IUS dollar and at the same time, the price ind,
moved up during this pe"tiod in India and USA to 110 and 125, respectivel
.Find out the extent 'of change in nominal and real exchange rates.

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International Financial Management

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