EXCHANGE RATE

In finance, an exchange rate (also known as a foreign-exchange rate, forex

rate, FX rate or Agio) between two currencies is the rate at which one
currency will be exchanged for another. It is also regarded as the value of one
countrys currency in terms of another currency. For example, an interbank
exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$)
means that 91 will be exchanged for each US$1 or that US$1 will be
exchanged for each 91. Exchange rates are determined in the foreign
exchange market, which is open to a wide range of different types of buyers
and sellers where currency trading is continuous: 24 hours a day except
weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday.
The spot exchange rate refers to the current exchange rate. The forward
exchange rate refers to an exchange rate that is quoted and traded today but for
delivery and payment on a specific future date. In the retail currency exchange
market, a different buying rate and selling rate will be quoted by money
dealers. Most trades are to or from the local currency. The buying rate is the
rate at which money dealers will buy foreign currency, and the selling rate is
the rate at which they will sell the currency. The quoted rates will incorporate
an allowance for a dealer's margin (or profit) in trading, or else the margin
may be recovered in the form of a "commission" or in some other way.
Different rates may also be quoted for cash (usually notes only), a
documentary form (such as traveler's cheques) or electronically (such as a
credit card purchase). The higher rate on documentary transactions has been
justified to compensate for the additional time and cost of clearing the
document, while the cash is available for resale immediately. Some dealers on
the other hand prefer documentary transactions because of the security
concerns with cash.

RETAIL EXCHANGE MARKET

People may need to exchange currencies in a number of situations. For
example, people intending to travel to another country may buy foreign
currency in a bank in their home country, where they may buy foreign
currency cash, traveler's cheques or a travel-card. From a local money changer
they can only buy foreign cash. At the destination, the traveler can buy local
currency at the airport, either from a dealer or through an ATM. They can also
buy local currency at their hotel, a local money changer, through an ATM, or
at a bank branch. When they purchase goods in a store and they do not have
local currency, they can use a credit card, which will convert to the purchaser's
home currency at its prevailing exchange rate. If they have traveler's cheques
or a travel card in the local currency, no currency exchange is necessary. Then,
if a traveler has any foreign currency left over on their return home, they may
want to sell it, which they may do at their local bank or money changer. The
exchange rate as well as fees and charges can vary significantly on each of
these transactions, and the exchange rate can vary from one day to the next.
There are variations in the quoted buying and selling rates for a currency
between foreign exchange dealers and forms of exchange, and these variations
can be significant.

QUOTATION
A currency pair is the quotation of the relative value of a currency unit against
the unit of another currency in the foreign exchange market. The quotation
EUR/USD 1.3533 means that 1 Euro is able to buy 1.3533 US dollar. In other
words, this is the price of a unit of Euro in US dollar. Here, EUR is called the
"Fixed currency", while USD is called the "Variable currency".

There is a market convention that determines which is the fixed currency and
which is the variable currency. In most parts of the world, the order is: EUR
GBP AUD NZD USD others.

FLUCTUATIONS IN EXCHANGE RATE

A market-based exchange rate will change whenever the values of either of the
two component currencies change. A currency will tend to become more
valuable whenever demand for it is greater than the available supply. It will
become less valuable whenever demand is less than available supply (this does
not mean people no longer want money, it just means they prefer holding their
wealth in some other form, possibly another currency).
Increased demand for a currency can be due to either an increased transaction
demand for money or an increased speculative demand for money. The
transaction demand is highly correlated to a country's level of business
activity, gross domestic product (GDP), and employment levels. The more
people that are unemployed, the less the public as a whole will spend on goods
and services. Central banks typically have little difficulty adjusting the
available money supply to accommodate changes in the demand for money
due to business transactions.
Speculative demand is much harder for central banks to accommodate, which
they influence by adjusting interest rates. A speculator may buy a currency if
the return (that is the interest rate) is high enough. In general, the higher a
country's interest rates, the greater will be the demand for that currency. It has
been arguedthat such speculation can undermine real economic growth, in
particular since large currency speculators may deliberately create downward
pressure on a currency by shorting in order to force that central bank to buy
their own currency to keep it stable. (When that happens, the speculator can
buy the currency back after it depreciates, close out their position, and thereby
take a profit.)

For carrier companies shipping goods from one nation to another, exchange
rates can often impact them severely. Therefore, most carriers have a CAF
(Currency Adjustment Factor) charge to account for these fluctuations.

PURCHASING POWER OF CURRENCY

The real exchange rate (RER) is the purchasing power of a currency relative to
another at current exchange rates and prices. It is the ratio of the number of
units of a given country's currency necessary to buy a market basket of goods
in the other country, after acquiring the other country's currency in the foreign
exchange market, to the number of units of the given country's currency that
would be necessary to buy that market basket directly in the given country.
There are different kind of measurement for RER.
Thus the real exchange rate is the exchange rate times the relative prices of a
market basket of goods in the two countries. For example, the purchasing
power of the US dollar relative to that of the euro is the dollar price of a euro
(dollars per euro) times the euro price of one unit of the market basket
(euros/goods unit) divided by the dollar price of the market basket (dollars per
goods unit), and hence is dimensionless. This is the exchange rate (expressed
as dollars per euro) times the relative price of the two currencies in terms of
their ability to purchase units of the market basket (euros per goods unit
divided by dollars per goods unit). If all goods were freely tradable, and
foreign and domestic residents purchased identical baskets of goods,
purchasing power parity (PPP) would hold for the exchange rate and GDP
deflators (price levels) of the two countries, and the real exchange rate would
always equal 1.
The rate of change of this real exchange rate over time equals the rate of
appreciation of the euro (the positive or negative percentage rate of change of
the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the
inflation rate of the dollar.

MANIPULATION OF EXCHANGE RATES

A country may gain an advantage in international trade if it controls the
market for its currency to keep its value low, typically by the national central
bank engaging in open market operations. The People's Republic of China has
been acting this way over a long period of time.
Other nations, including Iceland, Japan, Brazil, and so on also devalue their
currencies in the hopes of reducing the cost of exports and thus bolstering their
economies. A lower exchange rate lowers the price of a country's goods for
consumers in other countries, but raises the price of imported goods and
services, for consumers in the low value currency country.
In general, a country that exports goods and services will prefer a lower value
on their currencies, while a country that imports goods and services will prefer
a higher value on their currencies.

FACTORS INFLUENCING EXCHANGE RATES

Aside from factors such as interest rates and inflation, the exchange rate is one
of the most important determinants of a country's relative level of economic
health. Exchange rates play a vital role in a country's level of trade, which is
critical to most every free market economy in the world. For this reason,
exchange rates are among the most watched, analyzed and governmentally
manipulated economic measures. But exchange rates matter on a smaller scale
as well: they impact the real return of an investor's portfolio. Following are
some of the major forces behind exchange rate movements
Before we look at these forces, we should sketch out how exchange rate
movements affect a nation's trading relationships with other nations. A higher
currency makes a country's exports more expensive and imports cheaper in
foreign markets; a lower currency makes a country's exports cheaper and its
imports more expensive in foreign markets. A higher exchange rate can be

expected to lower the country's balance of trade, while a lower exchange rate
would increase it.
Determinants of Exchange Rates-

Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative,
and are expressed as a comparison of the currencies of two countries. The
following are some of the principal determinants of the exchange rate between
two countries. Note that these factors are in no particular order; like many
aspects of economics, the relative importance of these factors is subject to
much debate.

1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate
exhibits a rising currency value, as its purchasing power increases
relative to other currencies. During the last half of the twentieth
century, the countries with low inflation included Japan, Germany and
Switzerland, while the U.S. and Canada achieved low inflation only
later. Those countries with higher inflation typically see depreciation in
their currency in relation to the currencies of their trading partners.
This is also usually accompanied by higher interest rates.

2. Differentials

in

Interest

Rates

Interest rates, inflation and exchange rates are all highly correlated.
By manipulating interest rates, central banks exert influence over
both inflation and exchange rates, and changing interest rates
impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries.
Therefore, higher interest rates attract foreign capital and cause the

exchange rate to rise. The impact of higher interest rates is

mitigated, however, if inflation in the country is much higher than
in others, or if additional factors serve to drive the currency down.
The opposite relationship exists for decreasing interest rates - that
is, lower interest rates tend to decrease exchange rates.

3. Current-Account

Deficits

Thecurrent account is the balance of trade between a country and

its trading partners, reflecting all payments between countries for
goods, services, interest and dividends. A deficit in the current
account shows the country is spending more on foreign trade than
it is earning, and that it is borrowing capital from foreign sources to
make up the deficit. In other words, the country requires more
foreign currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand for its
products. The excess demand for foreign currency lowers the
country's exchange rate until domestic goods and services are
cheap enough for foreigners, and foreign assets are too expensive
to generate sales for domestic interests.

4. Public

Debt

Countries will engage in large-scale deficit financing to pay for

public sector projects and governmental funding. While such
activity stimulates the domestic economy, nations with large public
deficits and debts are less attractive to foreign investors. The
reason? A large debt encourages inflation, and if inflation is high,
the debt will be serviced and ultimately paid off with cheaper real
dollars in the future.
In the worst case scenario, a government may print money
to pay part of a large debt, but increasing the money supply
inevitably causes inflation. Moreover, if a government is not able

to service its deficit through domestic means (selling domestic

bonds, increasing the money supply), then it must increase the
supply of securities for sale to foreigners, thereby lowering their
prices. Finally, a large debt may prove worrisome to foreigners if
they believe the country risks defaulting on its obligations.
Foreigners will be less willing to own securities denominated in
that currency if the risk of default is great. For this reason, the
country's debt rating (as determined by Moody's or Standard &
Poor's, for example) is a crucial determinant of its exchange rate.

5.

Terms

of

Trade

A ratio comparing export prices to import prices, the terms of trade

is related to current accounts and the balance of payments. If the
price of a country's exports rises by a greater rate than that of its
imports, its terms of trade have favorably improved. Increasing
terms of trade shows greater demand for the country's exports.
This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an
increase in the currency's value). If the price of exports rises by a
smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.

6. Political

Stability

and

Economic

Performance

Foreign investors inevitably seek out stable countries with strong

economic performance in which to invest their capital. A country
with such positive attributes will draw investment funds away from
other countries perceived to have more political and economic risk.
Political turmoil, for example, can cause a loss of confidence in a
currency and a movement of capital to the currencies of more
stable countries.

The exchange rate of the currency in which a portfolio holds the bulk of its
investments determines that portfolio's real return. A declining exchange rate
obviously decreases the purchasing power of income and capital gains derived
from any returns. Moreover, the exchange rate influences other income factors
such as interest rates, inflation and even capital gains from domestic securities.
While exchange rates are determined by numerous complex factors that often
leave even the most experienced economists flummoxed, investors should still
have some understanding of how currency values and exchange rates play an
important role in the rate of return on their investments.

In the present era of increasing globalization and heightened currency

volatility, changes in exchange rates have a substantial influence on
companies operations and profitability. Exchange rate volatility affects not
just multinationals and large corporations, but small and medium-sized
enterprises as well, even those who only operate in their home country. While
understanding and managing exchange rate risk is a subject of obvious
importance to business owners, investors should be familiar with it as well
because of the huge impact it can have on their investments.
Economic or Operating Exposure
Companies are exposed to three types of risk caused by currency volatility:

Transaction exposure This arises from the effect that exchange rate
fluctuations have on a companys obligations to make or receive
payments denominated in foreign currency in future. This type of
exposure is short-term to medium-term in nature.

Translation exposure This exposure arises from the effect of currency

fluctuations on a companys consolidated financial statements,
particularly when it has foreign subsidiaries. This type of exposure is
medium-term to long-term.

Economic (or operating) exposure This is lesser known than the

previous two, but is a significant risk nevertheless. It is caused by the
effect of unexpected currency fluctuations on a companys future cash
flows and market value, and is long-term in nature. The impact can be
substantial, as unanticipated exchange rate changes can greatly affect a
companys competitive position, even if it does not operate or sell
overseas. For example, a U.S. furniture manufacturer who only sells
locally still has to contend with imports from Asia and Europe, which
may get cheaper and thus more competitive if the dollar strengthens
markedly.

Note that economic exposure deals with unexpected changes in exchange rates
- which by definition are impossible to predict - since a companys
management base their budgets and forecasts on certain exchange rate
assumptions, which represents their expected change in currency rates. In
addition, while transaction and translation exposure can be accurately
estimated and therefore hedged, economic exposure is difficult to quantify
precisely and as a result is challenging to hedge.

EXCHANGE RISK MANAGEMENTIt is quite common that the exchange rates fluctuate quite often. The
fluctuations are mostly in favour of hard currencies and the advanced
countries. The risk is more in case of developing countries. Therefore, the
business organisations dealing in international business, particularly MNCs
should take into consideration the risks of exchange rate fluctuations while
carrying out business or while investing in foreign markets.
The business managers have to manage exchange risk insuring the various
business operations and getting the benefits from the institutions like Export
Credit and Guarantee Corporation. They can make forward transactions in

order to avoid or insure the risk in exchange fluctuations. Several types of

transactions are carried out in a foreign exchange market. Forward transaction
is one of the significant transactions, where a specified amount of one
currency is exchanged for a specified amount of another currency of a future
value date. In such a transaction, only the delivery and payment take place at a
future date, the exchange rates being determined at the time of agreement. The
exchange rate quoted in such a transaction is called a forward rate. Forward
exchange rates are normally quoted for value dates of one, two, three, six and
twelve months.
When the payment made for forward delivery is more than the spot delivery of
a foreign currency, the forward contract is said to be at premium, on the other
hand, when the payment for forward delivery is less then the payment for the
spot delivery of a foreign currency, the forward contract is said to be a
discount. When the forward and the spot rates are equal, the forward currency
rate is said to be flat. It is likely that the forward rate would be higher or lower
than the current spot rate on account of interest rate differential, the discount
or premium affects the cost of hedging.

FOREIGN EXCHANGE RISK MANAGEMENT

The foreign exchange is the money in one country for money or credit or
goods or services in another country. The importing country pays to the
exporting country in return of goods or services either in its domestic currency
or hard currency. This currency which facilitates the payment to complete the
business transaction is called foreign exchange. Foreign exchange includes
foreign currency, foreign cheques or foreign drafts. These currencies are
bought and sold in foreign exchange markets. The components of foreign
exchange market include the buyers, the sellers and the intermediaries.
Foreign exchange market is not restricted to any place or country. It is the
market for currencies of various countries anywhere in the globe. In recent
times, foreign exchange is traded through online (internet). The market
intermediaries of foreign exchange include banks, brokers, acceptance houses

and Central bank of the country. Certain banks are authorised to deal in
foreign exchange. These banks discount and sell foreign bills of exchange,
issue bank drafts, travellers cheques etc. Every business transaction in
international business involves foreign exchange because every country has its
own currency.