v sharan chapter 4

8/10/2019 v sharan chapter 4

1/17

Inte77U1 ional Financial Management

SUGGESTED FURTHER READING

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

Methuen.

- -

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!

5

~

oJv JvV\J

E J

-

g

bjectives

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. n 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

th

interest rate parity theory in _his _context.

t

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

~ h n g 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

75


2/17

'

76 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'

process.

EXCHANGE RATE QUOTATIONS

In a f o r e i ~ e x c h ~ n g e 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

~ ~ ~ ~ s i i ~ 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:

opposite.

rate

as US $

0 0 2 8 5 7 ~

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 t he 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

market to another.

Continental

European dealers

normally

the direct quot,

while the indirect quote is used in London. Both methods are in use in the US

olution

US

$

45 = US

$

0 0 2 2 2 ~

If indirect quote is US

direct quote?

olution

1IUS $ 0.025 :

-

. .

40mS

.

Chapter 4

Exchange Rate Mechanism :77

uying arid Selling ates

ormally, two rates

are

published-one being

the

buying rate and

the

other

the

Uing rate. The buying rate is also known as the id 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 q u ~ t e . If

the

.rupee-US dollar rate is

4 0 . ~ 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 < m ~ s . b u y ; t ; s e l l i n g

rchase a foreign currency from the customer. Suppose, in India, a qu ote

at

. which

, h h U d

h b .

1

b h

banks sell

It

tomer exc an ges t e

oar

for

the

rupee, t e

ank

wil

uy

t e

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.

r 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 (4.1)

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, i f the

r

position of that

foreign

currency

is comfortable, the

spread will be

lower.

;IU ;


3/17

(4.2)

.

.

. .

.' . . 30

X.

-

45)= 0.12. 45 x

360

45 + OA5/or

x=

45 45

Chapter

4

Exchange Rate Mechanism

ross

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

c u r r e n C i ~ s i s

at,

the same

time, it quotes

Canadian $

0.76-0.78IUS

$

but does

not

f o u ~ d o u t t h r o u g h

. 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.

I f

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:

F.

d

. (d' t) n-day forward rate spot rate 360

orwar

preIDlum Iscoun = t t x

po ra e n

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

39.80 - 40.00 360 0 06 6 fi d d'

' 4 0 . 0 0 x W = -. or per cent orwar Iscount.

:;

,.

~ . ( 4 0 , 5 0 ~ x ) / 4 0 . 5 0 = 0 : 0 1 2 B ' ~

. .

.. ..... 40.50 ,;,0.0123 x 40,50

40.50'- 0:50 =

X .

x ' ;

40:00

TT.Buy

.

Bill,Buy 'T l 'Sell

BillSell

T C B u y ~ CCY,Buy

Forward Premium

and

Discount

Sql[JtitJn

A u s h - a n ; ; D o r i ~

. 50.6300 . 50.5300'

5};3500

51:4500 50.1800

' ~ ~ ~ g ~ ~ ; j ~ ~ ; ~ ~ ~ 6 : ~ ~ 6 <

, ~ ~ : ~ i ~ ~ : : ~ ~ ~ 1 d ~ i + : i ~ ~ i h b d ' : ~ ~ : ~ ~ 6 d ; ~ t ~ : d d

S o ~ r C ~

: T h e . E i ; o n ~ - ' i c 7 ' i m e s , .

:Nov, 12,2Clll:

EXCII:ANGE RATE

QUOTATION:Tl:J.e

Value

o f D i f f e r ~ t C U r r e n c i e s in Ter:ms'ofINR

Forward, rate

In the

above quotes, it

is

found that

the

longer

the maturity, the diffElreniiaI

h

. h h . h fi d t A . h I represents t e

greater IS t e c ange m t e orwar ra es. gam, WIt onger d i f f ~ r e n c E J Q f

maturity, the spread

too gets wider. This is because o f u n c e r t a i n t Y f c i i W a : r d a h d s ~ o t

in the future that

increases

with lengthening of maturity.

The

; r ~ e S ? i l J i g e d I : l Y

change in forward rates' may be upwards or downwards. With s p o t r ~ t e s ~ o w n in

h d

b t d fi d .

terms of

suc movements,

Ispanty

anses etween spo an orwar rates. annualised

This is known

as the swap

or

forward rate differential.

percentage,

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:

Spot

One

month

Three

months

40.00-40.30 39.80-40.20 39.60-40.10 .

The

swap quote, on

the other hand,

expresses only

the

difference between

the

spot

quote

and

the forward quote. I t can be

written

as follows:

Spot

One month Three

months

40;00-30

(20)-(10)

(40)-(20)

It may be noted'that decimals are

not written

in swap quotes.

Forward Market Quotation

International inancial Management

~ : : ~ : f i B j


4/17

NOMINAL REAL AND

EFFECTIVE

EXCHANGE RATES

Chapter

4 Exchange Rate Mechanism

and P

are

domestic and foreign price indices. f 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.

(4.3)

orward cross rate

n 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 r a t e 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

41.57

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

44.87-46.32/C$

The selling

rate

of the Canadian dollar in India can be worked out by selliI{

for the US dollar 35.201US $ and then buying Canadian dollars w t

US dollar at C$ 0.76IUS $. This means

35.20IUS 1 x US $ 1/C$ 0.76

46.32/C$

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

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. Th e real exchange rate, on the other hand,

l ~ a l ~ x 9 h i : 1 I 1 g i i i a t e

is the price-adjusted nominal exchange

rate. The

relationship

t w ~ n

: t h - e : r r i f l a t i o ~ ~

nominal exchlillge rate,

e and the real

exchange

rate, e

r

can

be

written

~ j U s t e d n o m i r i ~ r

in

the form: .

~ ~ h ~ Q I l ~ : r ? t e : e

r

eP/P


5/17

~ . . . l .

I T.n.

l;)

''':.J .

Chapter 4 Exchange Rate Mechanism

S

D D

I ' >Szt

Q,Q2Q3

Demand for and supply of US $

MIN TION OF EXCH NGE

R TE

IN

THE

SPOT M RKET

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

a c c o ~ n t

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

:es.

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 dolla r moves upward to

the

right with a

n 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 $.

Bu ti

export

rises as

a

result

of decline

in the value

of

the rupee and

International Financial Management

,

T h i t ~ ~ t ~ g i ~ d : 3 4 p ~ ~ i a . ~ ~ . ~ r i d ~ l i ; ~ b i g g e s t t ; ~ d ~ p a i t f 1 e r ~ ~ h 8 . ~ i r i g i ~ s p e c t ; i ~ ~ r

4 0 , j ) e r F ~ n t ; .35per'cjiin.tancI25

per cenf

o

its: trade. respectively.

A S S U m . ~ , I

2 0 0 0 ' : ' O ~ l i S t h e q a s : e ~ : r ~ a r ; . w h E m

the

e x c h ~ i i g e i a t ~ s w e r e 45.68/US:

4 ) 1 ~ / * u r o a p . d ~ 0

J fY

en. These ratescb.angeq o er tJie , . y ~ a r s ~ n d ,.il

2 0 0 4 : - ( ) 5 , t h e Y ~ e r e a s : ~ . 4 3 . 9 1 / U S $, ~ 5 2 6 7 E ~ r 6 ancl 0 . 4 0 ~ f X e n ;

Fino o u t t h ~

e f f e e t i y e e x t h a n ~ e r a t e i n d e x

dtiring 2004-05. ' ' , . .' .

Effective

Exchange Rates

e 9 t V e i l ~ c h a Q Q e r t is possible

that

the Indiap. rupee tends to depreciate against US cC

i . ~ } ~ ; : t h e : : e ; i . ; ; L

but

it appreciates against

Japanese

Yen. t is also possible that

~ ~ 4 r e : : p t , : t h , ~ ; : ' \ : : depreciates vis-a.-vis different cu rrencies

at

different rates. So it is ess

~ r ~ ~ 7 y ~ w e l < ~ f < to develop

an

index or a summary measure of how rupee fares, 0

~ ~ r r e n ( : y Jeatl\(e:, . . .

. t ~ o p r n : l ~ . r e . < . . average, m the foreIgn exchange market. Such an mdex IS calle

, \ e t i s . u r r e : d ~ l ~ s , , : L

effective exchange rate In other words, effective exchange

rate

r ~ ~ I I Y ~ I ? W t \ i p i ; 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

f 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

w a s ~ 40/US $

and ~ 5 0 1 Y e n

100;

in

2001,

the

exch .

rate

changed to

44/US

$ and 60IYen

100. f 1998 is

the

base,

the

exchange r'

index in 2001 will be 110 for the US dollar

and

120 for Yen.

f the effective exchange rate index for 1998 is

EER

1998

= [(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

period. '

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.


6/17

Intematioru U Financial Managemenr

the supply of

the

dollar

increases

to S , the exchange

rate will a g a i n ~ ~ j )

'{ 40lUS . Quite evidently,

the

frequent shifts

in

the demand

and

supply o n d i t i ~

cause

the

exchange rate to also

adjust

frequently to a new equilibrium.

F CTORS INFLUENCING EXCH NGE R TE

Flow

of Funds

on the

Current

and Capital ccounts

A country with current account deficit experiences a depreciation of its c u r r e ~ ~

I t 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

s u p p l y : ~

foreign exchange

with

the result that

the

country x p e r i e n c ~ s

an

appreciation o f ; ~ ~

currency. An apposite example of current account deficit country is

the

USA w l : i { ; ~

trade deficit was one of

the

important

causes

for

depreciation

in dollar during t

post-2002 years. On

the

other hand,

the

currency of

Japan and

Switzerland

p p r e c i a : t ~

in

view of surplus

current

accoUnt. However,

the

current account alone is

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 a n d : ~

the same

time,

smaller

appreciation

in their

currency.

In

fact,

this

paradox is

th

result o fcarry trade

that

explains why trade

flows

are

dwarfed

by capital

flowsl?

account of interest

rate

differential. '

Impact of Inflation

I t is normally the inflation

rate

differential between

the

two countri

E:'I Ptheorysh?ws

that influences the exchange

rate

between

the

two currencies. The influeIl'

exchange

rate .

determiiledby ihe'

of inflation rate finds a nice explanation in

the

Purchasing Power Pan

p'urchasingpower

(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. I f e

is

the exchange rate

and

P

A

and

P

B

"

the purchasing

power

of two

currencies,

A and B the equation can be written'

e

= PAIP

B

Prior

to 1914,

the purchasing

power

of

a

unit of

a currency

was

reckoni

Theo,ry,

of one

p r i ~ e x p l ~ i r i s how,

in terms

of gold. The principle applies even today, but now it is reckoni

i f ) ~ ~ s t i ? g r i c ~ ,

o f

in

terms of tradable commodities. As a corollary, a country experienci'

a , p r q ~ ' ~ ~ ~ . f 0 ~ ~ s ' , , ' . '

higher inflation will experience a corresponding depreciation of its curren',

while a country with a lower inflation

rate

will experience an appreciati

in the vahle

of

its

currency.

In

fact,

this

theory is

based

on

the

theory

a i n - ~ . f ~ ~ ~ ; ~ ~ ~ y .

.'

- ;: ,,, ',:, , :,:

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,

Chapter 4


, $ 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

~ t i g h

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 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

:upee.

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. I f

t

is not, PPP theory will

'hold good

despite

the law of one price hold ing good. Moreover, this theory does

':cover the non-traded goods and services where transaction cost is significant.


7/17

I n ~ 7 l a t i o f t a l

inancial 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 s t a t ~ 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. t 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

)tl(l

+

IB)t

wb.ere I

and I

B

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 e

t

is

the

spot exchange rate

in

period t.

For

example, inflation rate

in

India is 5

per

cent and that in USA 3 p.er ce

and if the initial exchange rate is 40lUS $, the value of the rupee in a two-ye

period will be '

e

=

40(1.05/1.03)2

or

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

e x c h a n g ~

:-ates which results in lowering of export competitiveness and in turn, the t r a 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 l o w ~ ;

inflation rates. Again,.it is the real exchange rate, and not the' nomi nal excharile:

rate,

that

has

a bearing on the performance

of

the economy.

Chapter 4


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

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

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

n 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 ofdomestic 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

r

oad

in lure ofhigher 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 ofinterest is cancelled

by the loss on account

of

inflation. In fact, since

it

was

Irving

Fisher who


8/17

Chapter 4 Exchange Rate Me2hanism

ined ffect of Interest Rate and Inflation

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

is also

Fisher s

open proposition,

known as the International Fisher Effect

or

lised version of

the Fisher

effect.

t is

a combination of

the

conditions

of

the

eory and

Fisher s

closed propositio?: t may. be recalled :he1ilterl;iati

eory

suggests

that

exchange

rate IS determmed

by

the m f l a t l O n l : . ~ e 8 t :

fferentials, while

the

latter

states

that

the nominal interest

r a t e t 6 a i ; i n t ~ r 1 3 s ~ f l : t e ,

er in

a

country with higher

inflation

rate.

Combining

these

two

di flerehliaiis

'tions, the International Fisher effect states

that

the interest

r a t e ~ f f t h 1 3 i ; : j l f t i o n rate

tial shall equal

the

inflation

rate differential.

t can

be

written as

I

eren

3;

(

l+r

A

)

I+IA)

( = 48)

1

+ rB

1

+ I

B

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.

f

the exchange

rate in the beginning

of

the year is

401

the

value of

the rupee will f all vis-a.-vis the

US

dollar at the end of the period

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).

e 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.

Intemational Financial Management

where

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

pe r 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.

88

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 ~ ~ ri::

covers the

~ x p e c t e d inflation

and the required real interest

iriflation rate.

MathematIcally, It can

be expressed

as

1 +

r

= 1 + a) 1 + I


9/17

4.11)

{1

+

rA -1}

+8

F 1 +rB

F = 40 {1.1

0

_

I}

+ 40

4 1.07

F

=

40.281US

$

means

that the

higher

interest rate in India

will

push

down

the

forward

.the rupee from 40 to 40.28 a dollar. .

,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

x (n-day F - 8 18

=

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

Chapter 4 Exchange Rate Mechanism

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,

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. .

GtfANGE RATE

DETERMINATION

IN FORWARD MARKET

l b ~ 0 6 / l 6 6 X 4 3 9 L ,=:. 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 r t i i p ~

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

selling

it

forward. The other speculators follow

the

lead. Ultimately, the c u r r e ~

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..

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 beappl ied :

e/eo = 1 + rINd1 + rUSA

Basing on the above equation, we have

41.94/40 =

l + rIND)/1.04

or 1 + r IND = 1.09

. or rIND = 0.09 or

9%

. ,f,f

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.

(4.10)


10/17

r ~

::;:r::'

92 International Financial Management

., : 1

~ , ~ ~

: ~ ~ { ~ t t ~ n ~ . ~ ~ ~ f l ~ ~ ~ \ .

Applying

the interest

r a t e p a r i t Y } ~ 9 i - ~ r i , l , " . .

. .

3-mo"t!>

f O < W > r ~ f I ~ ; ~ ? ~ \ 0 3 ? ; \ { ; ~ ~ f i '

Covered Interest rbitrage

f he forward rate differentialisnot equal to

the

interest rate differential,cove'

interest arbitrage willbegin and it willcontinuetill the two differentialsbeco

, ' . ' approximatelyequal.In other words,apositive

interest rate

differen

Covered

Interest,.

.

ff:

b '

l'

d

fi

d d'

tAt t'

arbitrage involves n

a

c ~ u n t r y

0:

set

y

annua

Ise 0:r:war ISCOun.

~ e g a r,,:e

me

borrowing

and

rate dlfferentlalls

offsetbyan annualised forwardpremIUm.Fmally,

IElndipgintv;O, twodifferentialswillbe equal.Infact, this is the point where the forw

m ~ I k e t s a n d

als!?

'

rate

is determined.

,bUYing,

spot and",.

ellingfoiwardthe To

the

process ofcovered

mterest

arbItrage,.suppose,

r e ~ p e c t i v e

spot rate

IS

40/US $

and

the three-month forward rate IS

40.28

currencies .so

as" $involvingaforwarddifferentialof2.8per cent.The interest rate i

,

t Q a d ~ ~ n parity ,

per

cent

in India and

12

per

cent in

the

USA involving

interest

con

Itlons.' .I =al f 37 S' h

d'=

. 1 t

Wllerenti 0 5. per cent. mce t e two iHerent las are no eq'

':.,

covered interest

arbitrage will

begin.

The

successive

steps

shall

be

as follow

Borrowingin

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-dayforward

at

40.28/$

Mter

three

months, liquidating

the

40,000 investment which would

~ , 4 1 , 8 0 0 , .

Selling

41,800 for

US dollars

at the rate

of

40.28/US

$ t

US $1,038 "OJ

Repayingloan in the USAwhich amounts toUS$ 1,030

Reapingprofit: US$ 1,038 ...:. 1,030

=

US

$

8.

So long as

inequality

continuesbetween the forward rate differential a

interest rate differential,

arbitrageurs

willprofitand the processof arbitrage

on.

But with this

process,

the

differentialwillbewiped

out

for

the

following

re

1.

Borrowing in the USAwill raise the

interest

rate there.

2. Investing in

India would

increase

the

invested

fundsand

thereby

low

interest rate there.

3.

Buyingrupees

at

spot rate will increase spot rate of

the

rupee.

4. Sellingrup'ees forward willdepress

the

forward rate of

the

rupee.

,

The

first

twoactions

narrow

the

interest

rate differential,while3and 4 w i d ~

forward

rate

differential.

CI,apter4

d

but

the

amount

of

profito'J:fof covered I l t e r e - ; ~ a r b l t r ~ g ; ~ i ~ l i i i ~ ~ ~ ~ , ~ ' l

. ia

and the

USAisrespectively9

per

cent and 4.50

per

cent and the,6

7

IIl.

a rd"

and

spot exchange rates are respectively 45.00 $and

4 5 . 2 6 :

,

.C

'

. . .

1

. < : , : , . , ~ ; : / : I ' : ' ( S; ~ ' ; ' . , , : ' ~ ' , t : : ' : , : ~ > . ' , : :: h : : , ; \ , '

iit n ' i i , ':";:?:

; ~ i l l

becoverediilterest arbitrage insofar as the n t ~ r e s t J , f t , e ~ I l ~ : f ~ ~ : ~ ~ ,

,differentialsare not equal. . ' " ' " " "" ' " :U,t , ,h" , i

'0, start with, borrowing $ 1,000iIi

the

USA, converting

i t < i n t ( ) I i l l i > ~ e , J g : t

00 and investing

the

rupee, for six months will fetch, 4 7 , 0 ? i 5 , P ~ l l i ~ g

,025

forward

willfetch$1,045,

Mter.

repaying

dollar

0 a n ~ 1 0 n g i r , i . t ~ ) M ~ r ~ ~ t

,1;022.50,

the

arbitrageur profits $ 1,045- 1,022.50,= $,22:50. ", '" . , ." , '

However, the real life experience shows that the two

differentials-interest

eand forwardrate-are equal onlyapproximatelyand not precisely.It is because

interest

rate

parity theoremassumes ,no transaction cost,notax rate differences

politicalstability.But the

assumptions

do

not hold

in real life.

First ofall, there isalways

transaction

costinvolved

in

sellinga

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

sactioncost,whichisinvolvedalso

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 differentialtodeviate from the

ctedone.

ast but not least,

if

there

is political

unrest

in

the

country

where

the

funds

,invested, the costof investment will be greater and this will influence the

,est rate differential. '

overed

Interest

rbitrage

Uncovered interest

n

one talks about

interest

arbitrage, it wouldbeworthwhiletonote

arbit


11/17

iii


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.

I

~ ~ ~ f ~ ; t ~ r ~ ~ i 1 f ~ ~ f ~ ~ 1

e ~ c h a ~ ~ e { a t e ; g t : p r : ~ s e n

a r p i t ~ ~ g ~ ? r ~ ' ~ r ~ ' : t ~ l l i ~ ~ ~ j ~

N ~ e i ~ i n y ~ s t ~ e I l t . z n a t U I ' ~ ~ i r

~ ~ ; 1 ~ i l t ~ t ' 1 h : ~ ~ : ~ ~ i ~ ~ ~ ~ 6 ?

' ~ O ~ @ r 'f ;; . i i . ~ ; ; < : . . ,.. .

I n ~ y f e S t . r aty

d i f f E r e n t i a l = : ; i ~ . : ? ? / l ; : q 5 . \ # ' 1 7 : I q ~ ~ . ( 5 : P E r : c ~ J : i t

~ u t ~ r e .

s p ~ ~ / ~ a t e ~ i f , f e r e ~ i a l . ' 7 . { ~ ~ : 2 0 i ~ 4 ? . 3

'

.........

'

...

~ ~ i ~ W j ~ l ' l l ' i t i l i

ar i ty , ; ;

.


12/17

Chapter 4 E x c h a ~ g e

Rate Mechanism

lance

of Payments Approach

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. I t 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

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

theory..

.Monetary Approach

The flexible-price version of the monetary approach emphasises the role ofdemand.

: and supply ofmoney 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 ofthe 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.

S: 5F

EXCH NGE

RATE

BEHAVIOUR

[ e ~ p r e s e n t 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 asset s

and

foreign financial assets. Perfect substitutability

betw

the two led to the

monetary

approach, while the lack ofperfect 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

. '.'

.'

. ". . . < { ~

." ~ a l a n c e

paYIlJ,ents. theory:. .... . '. . . .

. i

+ ~ t , H i g h e r i n f l a i i o : n r a t e

differential athoIile

greater

import and

l o w ~ ~ 1

...... export . ~ g r e a t e r demand

fofforeign

c u r r e n c y ~ depreciation

of

o m e s t i F ~

Cc

.

currencY. " ..............'

.

" . '

< ' ..... ~ ~ I

:h.;:Z::Greaterrealincomeat

o I i l e ~

greater import

depreCiation

of domesti C\

i;;..cUn:e:ncy.

'.." ... . . ......... ......... . . . . . . . . ; ....

'. ,"\j

~ 3 G r e a t e r i n t e r e s t rate at home ;7. inflow of foreign capital -7 greater supply;'

.o{f6.reigIl6lrI:ency -7 .appreciation of domestic currency:

i ~ i

. ~ . M o n e t a r y A p p r o a c h - - : F l e x i b l e

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

< .mo n ey

balances

-7

lower domestic prices

~

appreciation of domestic currency.'

ke

iIi interest

i ate

lower "demand' for money -7 domestic currency

. ~ : . l v t 6 ~ f ~ c i : ; ; 6 ~ C h ~ t i C k Y Price Version:' : . . .'

..

' .. . . .

~ J ' ' J r i d - e a s e

irl

m,oneysupplY;7 .depreciation of domestic Currency.

> . : 2 > I n c r e ~ e i n

money supply

,-+

r i c ~ rise

-7

lowerrealinterestrate lower

" " .fuflowof capital -7 . d e p r e c i a t i o n o f d o m ~ s t i c cUrrency. .

i ' ~ ] 3 ~ ' : R i # ' i I : l i r i t e r e s f ; a t e 4 i r e a t e r i r i n o w o f ~ a i ? i t a l - - . n i p p r e c i a t i o n o f

domestic

cUijeIlcy.:, . .....

....

. ' ;

..

>

. j ' 4 : R i ~ e , i n : i n t e r e s t : r a t ~ . ~ i I l c r e a s e in money stippl

y

(IoaIiable funds) ~

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

...

>

...

. . . . . .

" ".

C . ) . ? * e ~ t i S i ~ s ~ I l e { o / ~ i + t h i ~ s r e a . s e ' 7 ' p r e a t e r

deInand

f o r f ~ r e i g n

fmancial

: ~ s ~ t s ; ; ~ ' 1 ~ p ' r ~ ~ i ~ ~ i ? ~ ~ r . d o W e ~ t i s s v r i e ~ S Y :

i: ' ,

i ..

. ,

~ ? l ' ~ ~ ~ l 1 : ; f i I , a . l c i ~ J . a . ~ s ~ t 1 i ' p e i : : l g I I W r ~rtsky demand

f()r

.them decreases

~ ; a : p p r e C i a t l o n . o f d ~ m : e s t i c . : . s u I T e .ncY

.. , . ..

.

.

::\\;, ;:.,,,;

:

, . - - """ -< """"" ' ~ \ : : ' . ' ,

. .: ,

,

; '


13/17

'. '9&:' [ntemarional Financial Management

Thestickypriceversion bas proved that gradual adjustment of

goocis

prices

followingamonetary shockimparts a"dynamicadjustment path tothe.exchange

rate. The

real

exchangerate

alters

in

the short

run but

returns

to

the

originalleve.l

in the long run on.accountofPPP deviations. .

Thesticky-priceversionmakes amoredetailedstudy of

interest rate

differential.

Theinterest

rate

differential

has three

components.Onedenotes that when interest

rate rises, the moneybalancesheld by the public come tothe moneymarket lured'

by the high interest.Theincrease in moneysupply leads tocurrencydepreciation.

The

other

denotes

that if

interest

rate

rises, financial

institutions

release more

funds intothe moneymarket asaresult,thevalue of domesticcurrencydepreciates.

The third isthat arise in interest rate stimulates the capital flowi nto the country

that, similarlyas

in

the balance ofpayments approach,causesappreciationin the

value of domesticcurrency.

stickypriceversionis based on at least three assumptions.The first is

the

perfectcapitalmobilitywhichmeans that the interest

rate

parity conditionsprevail.

Thesecond is the slow price adjustment. The

third

is

the

element of certainty.

whichmean.sthat the traders areaware ofthe factwhenshockswillbehitting the

market and howtorespondto them.

Portfolio

Balance pproach

Theportfoliobalanceapproach(McKinnon,

1969)

suggests

that

not only

the

monetary.

factor

but

also

the

holdingoffinancialassets,

such as

domestic

and

foreignbonds

influences

the

exchangerate. If foreignbondsand domesticbondsturn out tobe.

perfectsubstitutes

and ifthe

conditionsof interest arbit rage holdgood, the portfolio

balanceapproachwillnot bedifferentfrom

the

monetary approach.

But

since these

conditionsdo not hold good

in

real life,

the

portfoliobalanceapproachmaintains

.a distinctionfrom the

monetary

approach.

The'portfoliobalance approachis based ontwofinancial assets: money

and

bondsofboth the domesticcountry

and

the foreigncountry. There is norestriction

on the allocation ofwealth amongdomestic money, domestic bonds

and

foreign

bonds.Thus, for accountingpurposes,

Wealth

=

domestic money domesticbonds foreignbonds

The exchangerate establishes

an

e-quilibriumor a balance in investor'sportfolio

whichincludesall these three formsofwealth. f there is any changein the three

formsofportfolioonaccount ofchangein real income,interest-rate, risk and price

level,

the

investorre-establishesadesiredbalance

in its

portfolio.Thisre-establishment

needssome adjustments which, in

turn,

influencethe demand forforeignass ets.

Anysuch changeinfluencesthe exchangerate. For example, a'rise in real domestic

inCome or a rise in interest rate abroad leadsto a greater demand for foreign

bonds.Anyrise of demand for foreign currencywillresult in depreciationof the

domesticcurrency.Again,the legal,politicaland economicconditions in aforeign'

countrymay bedifferentfromthose

at

home.

f

foreignbonds turn outtobemore

risky on these grounds,j;he demand for foreign currency will decrease, in turn

appreciatingthe value ofthe domesticcurrency.Similarly,arisinginflationin the

foreigncountrywouldmake foreignbondsriskyand the demand forforeigncurrency,

willdropand sodomesticcurrencywillappreciate.When the exchangerate changes,.

Chapter4 Exchange J ,ate Mechanism

'. he abovementionedvariablesalsochangeleadingtoashift in the desired balance

the

investmentportfolio.

Thus

the two-wayinteractioncontinues

until

equilibrium

reached.The equilibriumis,however,shor t - l ived . .'

...............

,.....,

Again,whena country'swealth increases,holdingofforeignassets

V l J e a l l t ~ ; 7 t t f h ~ 9 t : . i i

i

. d d

dec

. h' h exp all)S . at,

.....

'. ,'

Iso Increases, an eman Lor !oreIgncurrency goes up w IC causes i n c ~ e a s ~ i i i t i W ~ ~ l t h

epreciationin the valueofdomesticcurrency.

In

this context,the possibility

e ~ ~ ~ : f ~ ~ f I a n i i

;f substitution effectcannot becompletelynegated;becauseit o u t w e i g h s f 8 q W ~ i i ~ n ~ s ~ 7 t s

.e impact of wealth effect. The portfolio balance approach is more d a n 9 i ~ h ~ ~ t ~ b Y ~ 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

valueof twocurrencies. It is

quoted in newspapers eIther in a director in an indirect'way. The quote

showsbuying .:md sellingrates. The differencebetweenthe two, k n o ~ as

spread forms the banks' income.The quotealsoshows the spot quote and

the forwardquote.The differencebetween

the

twoiseither forwardpremium

orforward discount. The cross rate between twocurrencies is established

through a common currency. .

In

a floating-rate.regime,

rate

ofexchailge IS determined by the forces of

supplyand demand.With higher demand for, orlowersupply of aforeign

currency, its value appreciates vis-a.-vis the domesticcurrency.

Variousdifferentfactorsinfluencethe demand

and

supply forces,

important

among

them

being

the

inflationrate

and

interest rate differentials.The

PPP

theory suggests

that

the higher

the

inflation

rate,

theloweris the

value

of

currency.Again,the real interest rate

tends

toequalise,but

it is

the differing

inflationrate that createsnominalinterest rate differential.Ahigher interest

.rate encouragesinflowofcapital and the value ofdomesticcurrencyrises.

The monetary authorities try to stabilise the

value

of currency through

intervention in the foreign'exchange'market.

In aforward market, the rate of exchangeis determined

by

the

interest

rate

differentialthat findsaplacein

the

Interest Rate Parity theory.

This

theory

tells

us

that

the interest

rate differentialequalsthe forwardrate differential.

f

these

two differentials

are

not equal, coveredinte:restarbitrage begins

and equalises

the

two.

In

caseofuncoveredinterest arbitrage,the arbitrageur

takes intoaccount, the expected future spot rate and not the forwardrate.

Thesedifferentvariablesasdiscussedaboveform

the

basisfor

the

explanation

ofdifferenttheories that essentially concernexchangerate determination.

The balance

of payments

approach links

exchange rate

behaviour

with

the

changes in capital

and current

account of

the

balance.ofpaYments.The

monetary theory

lays

emphasis upon

the

demand

for, and supplyof money

as afactorinfluencing

the

exchangerate. However,the sticky-price

version

of

the monetary approachgivesamoredetailedexplanationofinterest

rate

differential.TheportfoliobalanceapproachinCludesalso the holdingo.nancial

assets-domestic

and

foreign bonds-that influencesthe e x h n g ~

rate.


14/17

IntemaricnaI Financial Management

C SE

STUDY

INTRODUCTION OF M N GED FLO TING EXCH NGE

R TE REGIME IN

.'

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 r a t ~

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 m a f ~

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

e x c h r ~ e

rate at times could not completely be ruled

o u t ; ~ \

Trend in the Exchange

Rate. :

' .%

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.

TABLE CS4 1

Annual Average Value of Rupee vis-a.-vis

US

Dollar

Exchange Ra

FY

IUS Average) FY

IUS

Average) FY IUS Avera

1993-94

31.37

1999-00

43.33

2005-06

44.26

1994-95

31.4

2000-01 45.68

2006-07

45.25

1995-96

33.45

2001-02

47.69 2007-08 40.24

1996-97 35.5 2002-03

48.4

2008-09 45.99

1997-98

37.17

2003-04

45.95

2009-1b

47.42

1996-99

42.07

2004-05

44.93 2010-11 45.52

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 dai ly. 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

Chapter 4

xchange Rate Mechanism

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

t u r b u l ~ n c e 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 signi ficant 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

< : : ~ ~ : : : : t r .


15/17


Chapter 4 xchange Mechanism

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:

D high inflation rate

(ii) lowering of

inflation

rate

(iii)

constant

inflation

rate

.(d) Nominal interest rate is the product

of:

D

real interest rate and rate

of inflation

(ii)

real interest rate and

exchange rate

(iii)

none of these

e) 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

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

rate?

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?

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?

3.9

2.7

2.9

. 3.8

1.4

0.5

0.4

0.7

0.8

0.6

0.7

RBI Intervention as

o

Turnove

n

Foreign Exchange Market

2,356

7,154

15,712

30,478

20,847

8,143

26,824

78,203

-3,492

-2,635

1,690

Net Purchase-Sale)

ale

25,846

15,668

14,927

24,940

10,551

7,096

1,493

61,485

6,645

760

28,202

22,822

30,639

55,418

31,398

15,239

26,824

79,696

26,563

4,010

2,450

Purchase

T BLE CS4.2

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

(US $ million

Year

2000-01

2001-02

2002-03

2003-04

2004--05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

..

QUESTIONS

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?

Sources:

1.

RBI Annual Report,

various

issues.

2. RBI Bulletin,

various issues.

Objective Type

Questions

.1. State whether

true

(T)

or

false (F):

(a) Domestic

currency

is on the numerator in case

of direct

quote.

(b)

Bid

rate

and buying rate

are synonyms.

D

(c) Ask

rate/offer

rate

and

selling rate carry the same meaning. D

(d)

Forward differential

is

greater in

case

of shorter maturity. D

(e) Cross rate

is

found

out through

a common: currency.

D

RevI W

QUESTIONS

.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.


16/17

International Financial Management.

umerical Problems

1. f

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)

Documents

v sharan chapter 4