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 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.

 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.
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.

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 (FECs), Options
(Derivatives

of

exchange

Guarantees,

Commercial

rates),

International

money

transfers,

Customer

Foreign

Currency

accounts,

Documentary Credit and Collections,

Market Players
Players in the Indian market include (a) ADs, mostly banks who are
authorised to deal in foreign exchange, (b) foreign exchange brokers who
act as intermediaries, and (c) customers individuals, corporates, who
need foreign exchange for their transactions. Though customers are major
players in the foreign exchange market, for all practical purposes they
depend upon ADs and brokers. In the spot foreign exchange market,
foreign exchange transactions were earlier dominated by brokers.
Nevertheless, the situation has changed with the evolving market
conditions, as now the transactions are dominated by ADs. Brokers
continue to dominate the derivatives market.

The main players in foreign exchange market are as follows:

1. Customers:
The customers who are engaged in foreign trade participate in foreign
exchange market by availing of the services of banks. Exporters require
converting the dollars in to rupee and importers require converting rupee
in to the dollars, as they have to pay in dollars for the goods/services they
have imported.
2. Commercial Bank:
They are most active players in the forex market. Commercial bank
dealings with international transaction offer services for conversion of
one currency in to another. They have wide network of branches.
Typically banks buy foreign exchange from exporters and sells foreign
exchange to the importers of goods. As every time the foreign exchange
bought or oversold position. The balance amount is sold or bought from
the market.
3. Central Bank:
In all countries Central bank have been charged with the responsibility of
maintaining the external value of the domestic currency. Generally this is
achieved by the intervention of the bank.
4. Exchange Brokers:
Forex brokers play very important role in the foreign exchange market.
However the extent to which services of foreign brokers are utilized
depends on the tradition and practice prevailing at a particular forex
market center. In India as per FEDAI guideline the Ads are free to deal
directly among themselves without going through brokers. The brokers
are not among to allowed to deal in their own account allover the world
and also in India.

5. Overseas Forex Market:

Today the daily global turnover is estimated to be more than US $ 1.5
trillion a day. The international trade however constitutes hardly 5 to 7 %
of this total turnover. The rest of trading in world forex market is
constituted of financial transaction and speculation. As we know that the
forex market is 24-hour market, the day begins with Tokyo and thereafter
Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris,
London, New York, Sydney, and back to Tokyo.
6. Speculators:
The speculators are the major players in the forex market. Bank dealing
are the major speculators in the forex market with a view to make profit
on account of favorable movement in exchange rate, take position i.e. if
they feel that rate of particular currency is likely to go up in short term.
They buy that currency and sell it as soon as they are able to make quick
profit.
Corporations particularly multinational corporation and transnational
corporation having business operation beyond their national frontiers and
on account of their cash flows being large and in multi currencies get in
to foreign exchange exposures. With a view to make advantage of
exchange rate movement in their favor they either delay covering
exposures or do not cover until cash flow materialize.
Individual like share dealing also undertake the activity of buying and
selling of foreign exchange for booking short term profits. They also buy
foreign currency stocks, bonds and other assets without covering the
foreign exchange exposure risk. This also results in speculations.

EXCHANGE RATE SYSTEM

Countries of the world have been exchanging goods and services amongst
themselves. This has been going on from time immemorial. The world
has come a long way from the days of barter trade. With the invention of
money the figures and problems of barter trade have disappeared. The
barter trade has given way ton exchanged of goods and services for
currencies instead of goods and services. The rupee was historically
linked with pound sterling. India was a founder member of the IMF.
During the existence of the fixed exchange rate system, the intervention
currency of the Reserve Bank of India (RBI) was the British pound, the
RBI ensured maintenance of the exchange rate by selling and buying
pound against rupees at fixed rates. The inter bank rate therefore ruled the
RBI band. During the fixed exchange rate era, there was only one major
change in the parity of the rupee- devaluation in June 1966. Different
countries have adopted different exchange rate system at different time.
The following are some of the exchange rate system followed by various
countries.
The Gold Standard
Many countries have adopted gold standard as their monetary system
during the last two decades of the 19he century. This system was in vogue
till the outbreak of World War 1. Under this system the parties of
currencies were fixed in term of gold. There were two main types of gold
standard:
1) Gold specie standard
Gold was recognized as means of international settlement for receipts and
payments amongst countries. Gold coins were an accepted mode of
payment and medium of exchange in domestic market also. A country

10

was stated to be on gold standard if the following condition were

satisfied:
Monetary authority, generally the central bank of the country,
guaranteed to buy and sell gold in unrestricted amounts at the fixed
price.
Melting gold including gold coins, and putting it to different uses
was freely allowed.
Import and export of gold was freely allowed.
The total money supply in the country was determined by the quantum of
gold available for monetary purpose.
2) Gold Bullion Standard:
Under this system, the money in circulation was either partly of entirely
paper and gold served as reserve asset for the money supply. However,
paper money could be exchanged for gold at any time. The exchange rate
varied depending upon the gold content of currencies. This was also
known as Mint Parity Theory of exchange rates. The gold bullion
standard prevailed from about 1870 until 1914, and intermittently
thereafter until 1944. World War I brought an end to the gold standard.
Bretton Woods System
During the world wars, economies of almost all the countries suffered. In
order to correct the balance of payments disequilibrium, many countries
devalued their currencies. Consequently, the international trade suffered a
deathblow. In 1944, following World War II, the United States and most
of its allies ratified the Bretton Woods Agreement, which set up an
adjustable parity exchange-rate system under which exchange rates were
fixed (Pegged) within narrow intervention limits (pegs) by the United
States and foreign central banks buying and selling foreign currencies.
This agreement, fostered by a new spirit of international cooperation, was
in response to financial chaos that had reigned before and during the war.
In addition to setting up fixed exchange parities (par values) of currencies

11

in relationship to gold, the agreement established the International

Monetary Fund (IMF) to act as the custodian of the system. Under this
system there were uncontrollable capital flows, which lead to major
countries suspending their obligation to intervene in the market and the
Bretton Wood System, with its fixed parities, was effectively buried.
Thus, the world economy has been living through an era of floating
exchange rates since the early 1970.
Floating Rate System
In a truly floating exchange rate regime, the relative prices of currencies
are decided entirely by the market forces of demand and supply. There is
no attempt by the authorities to influence exchange rate. Where
government interferes directly or through various monetary and fiscal
measures in determining the exchange rate, it is known as managed of
dirty float. PURCHASING POWER PARITY (PPP) Professor Gustav
Cassel, a Swedish economist, introduced this system. The theory, to put
in simple terms states that currencies are valued for what they can buy
and the currencies have no intrinsic value attached to it. Therefore, under
this theory the exchange rate was to be determined and the sole criterion
being the purchasing power of the countries. As per this theory if there
were no trade controls, then the balance of payments equilibrium would
always be maintained. Thus if 150 INR buy a fountain pen and the same
fountain pen can be bought for USD 2, it can be inferred that since 2 USD
or 150 INR can buy the same fountain pen, therefore USD 2 = INR
150.For example India has a higher rate of inflation as compared to
country US then goods produced in India would become costlier as
compared to goods produced in US. This would induce imports in India
and also the goods produced in India being costlier would lose in
international competition to goods produced in US. This decrease in
exports of India as compared to exports from US would lead to demand
for the currency of US and excess supply of currency of India. This in
turn, cause currency of India to depreciate in comparison of currency of
US that is having relatively more exports

12

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, Indias foreign exchange rating was
downgraded because of political instability and consequently, the external

13

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 countrys competitiveness and weakens its

14

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
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

15

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--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.
Governments 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 governments 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

16

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 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

17

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 countrys
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 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

18

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

19

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.

20

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.

21

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 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 importantlythat exchange rates are influenced only by relative
inflation rates.

22

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 validitysignificantly different rates of inflation
should certainly affect exchange rates. PPP is useful in assessing longterm 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.

23

 The Balance of Payments and the Internal- External Balance

Approach
PPP concentrates on one part of the balance of paymentstradable 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 todays world, it is generally agreed that it is essential to look at
the entire balance of paymentsboth current and capital account
transactionsin assessing foreign exchange flows and their role in the
determination of exchange rates.
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 nations 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 ratethat is, the higher

24

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 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.

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.

25

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 postwar 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 instability1. 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.

26

The main arguments in favour of fixed exchange rates areFirstly,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 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.

27

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.
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,

28

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 brettonwoods system.
The debate on fixed v/s flexible exchange rate is inconclusive . infact,
both systems have their own merits and demerits.

29

CONCLUSION
Derivative use for hedging is only to increase due to the increased global
linkages and volatile exchange rates. Firms need to look at instituting a
sound risk management system and also need to formulate their hedging
strategy that suits their specific firm characteristics and exposures.
In India, regulation has been steadily eased and turnover and liquidity in
the foreign currency derivative markets has increased, although the use is
mainly in shorter maturity contracts of one year or less. Forward and
option contracts are the more popular instruments. Regulators had
initially only allowed certain banks to deal in this market however now
corporates can also write option contracts. There are many variants of
these derivatives which investment banks across the world specialize in,
and as the awareness and demand for these variants increases, RBI would
have to revise regulations.
For now, Indian companies are actively hedging their foreign exchanges
risks with forwards, currency and interest rate swaps and different types
of options such as call, put, cross currency and range-barrier options. The
high use of forward contracts by Indian firms also highlights the absence
of a rupee futures exchange in India.

30

BIBLIOGRAPHY

Books Managerial Economics by D.N. Dwivedi.

Managerial Economics by Chaturvedi.
Macroeconomics by R.K.Misra
Macroeconomics by M.L. Seth

Sites
www.forex.com
www.moneyinvestment.com

31