These arrangements are being listed below.There are many intermediate arrangements for determination of exchange values.
Domestic currency pegged to one foreign currency
Under this arrangement, the exchange rate of one currency is pegged to a dominant foreign currency, usually the U.S. dollar. For example the Argentine peso was till recently pegged to the US dollar in the ratio 1:1, due to the economic depression that started in the year 1999.
Managed Float
Central bank of a country decides the exchange rate in this system. The rates are revised from time to time depending on forex reserves, developments in parallel exchange markets, the real effective exchange rate etc.
Independent Float
In this system market forces determine the exchange rate. Most of the developed countries follow this system of exchange rate.
A currency pegged to a basket of currencies
The currency of a country may be pegged to a basket of currencies. The basket is generally formed by the currencies of major trading parties to make the pegged currency more stable than if a single currency peg is used. Trade, services and major capital flows may be used as currency weights while calculating the basket. The Indian Rupee is linked to a basket of currencies.
Flexibility limited in terms of a single currency
In this system, the value of the currency is maintained within certain margins of the peg. Some Middle Eastern countries follow this system and maintain their currency within a limit of the per against the U.S. dollar.
Pegged to some indicators
Under this arrangement, the currencies adjust more or less automatically to changes in the selected indicators. A common indicator is the real effective exchange rate (REER) that reflects inflation adjusted changes in the currency against major trading parties.
This category also includes cases where the exchange rate is adjusted according to a pre-announced schedule.
These are Spot Exchange Rates and Forward Exchange Rates.Currencies in the foreign exchange market may be transacted for immediately delivery or for a postponed delivery and consequently, there are two types of rates in the market.
Saturday, December 13, 2008
EXCHANGE RATE QUOTE
The foreign exchange transaction (i.e, for the sale and purchase of foreign currencies) takes place in foreign exchange market, which provides a mechanism for transfer of purchasing power from one currency to another. This market is not a physical entity like the Mumbai Stock Exchange or a trading center; rather it is network of telephones among banks, foreign exchange dealers and brokers etc.Every firm and individual operating in international environment is concerned with foreign exchange i.e, the exchange of foreign currency into domestic currency and vice-a-versa. Generally, the firm's foreign operations earn income denominated in some foreign currency, however, the shareholders expect payment in domestic currency and therefore, the firm must convert the foreign currency into domestic currency.
For example, a trader in Delhi may buy foreign exchange, say U.S. $, from a bank in Mumbai for making payment to a U.S. supplier against the purchases made. The bank in Mumbai, in turn may purchase the U.S. $ from a New York bank, which in turn may purchase from some other bank in New York itself or at some other center and so on. As the foreign exchange market provides transactions in a continuous manner for a large number and volume of sales and purchases, this market is an efficient one. Minute differences in exchange rates at different center may get eliminated without time lag.
In the foreign exchange market, the price of any currency may be quoted in terms of several currencies. It is important to realize that every price or exchange rate is relative. For example, if U.S. $ is worth Rs. 44, then it also implies that Re. 1 is worth $ 1/44. All foreign exchange rates in this way are related to each other in a reciprocal way. In other words, the value of $/Re. is just the reciprocal of the value of Re./$.
There are two major ways of offering exchange rate quotes. There are called the direct quote and indirect quote. These quotes are given after the exchange value has been established according to the practice being followed by a country. If the country follows a fixed rate of parity between its currency and a foreign currency, then the changes in parity value of that currency shall determine changes in the value of the domestic currency vis-a-vis other foreign currencies. These performances of the domestic economy is not reflected in the valuation of its currency. This is one extreme side of absolute rigidity in fixation of exchange data. The other extreme is allowing the exchange value of the national currency to float independently according to market forces without any intervention from the Central Bank. In between these two extremes, there are many intermediate arrangements for determination of exchange values...Quotations in the foreign exchange market are generally made in terms of local currency or the domestic currency in terms of per unit of a foreign currency. For example, the exchange rates of Re. in India may be quoted in terms of $, say Re./$ = Rs.44/$. It means that one $ is worth Rs.44. A change in price of one currency implies, therefore, a change in price of the other currency that appears in the quote. For example, if the price of Re. against the $ moves from Rs.44/$ to Rs.43.5/$, one can say that Re. has appreciated relative to $ by Re. 0.50. This is the same as saying that $ has depreciated relative to the Re.
For example, a trader in Delhi may buy foreign exchange, say U.S. $, from a bank in Mumbai for making payment to a U.S. supplier against the purchases made. The bank in Mumbai, in turn may purchase the U.S. $ from a New York bank, which in turn may purchase from some other bank in New York itself or at some other center and so on. As the foreign exchange market provides transactions in a continuous manner for a large number and volume of sales and purchases, this market is an efficient one. Minute differences in exchange rates at different center may get eliminated without time lag.
In the foreign exchange market, the price of any currency may be quoted in terms of several currencies. It is important to realize that every price or exchange rate is relative. For example, if U.S. $ is worth Rs. 44, then it also implies that Re. 1 is worth $ 1/44. All foreign exchange rates in this way are related to each other in a reciprocal way. In other words, the value of $/Re. is just the reciprocal of the value of Re./$.
There are two major ways of offering exchange rate quotes. There are called the direct quote and indirect quote. These quotes are given after the exchange value has been established according to the practice being followed by a country. If the country follows a fixed rate of parity between its currency and a foreign currency, then the changes in parity value of that currency shall determine changes in the value of the domestic currency vis-a-vis other foreign currencies. These performances of the domestic economy is not reflected in the valuation of its currency. This is one extreme side of absolute rigidity in fixation of exchange data. The other extreme is allowing the exchange value of the national currency to float independently according to market forces without any intervention from the Central Bank. In between these two extremes, there are many intermediate arrangements for determination of exchange values...Quotations in the foreign exchange market are generally made in terms of local currency or the domestic currency in terms of per unit of a foreign currency. For example, the exchange rates of Re. in India may be quoted in terms of $, say Re./$ = Rs.44/$. It means that one $ is worth Rs.44. A change in price of one currency implies, therefore, a change in price of the other currency that appears in the quote. For example, if the price of Re. against the $ moves from Rs.44/$ to Rs.43.5/$, one can say that Re. has appreciated relative to $ by Re. 0.50. This is the same as saying that $ has depreciated relative to the Re.
VARIABLES AFFECTING EXCHANGE
The expected difference in inflation rates between two countries equals, in equilibrium, the expected movement in spot rates. The forward rate for a given period, say 6 months, should equal the spot rate 6 months hence. The difference between the forward rate and the present spot represents the interest element for the period of the forward rate. In reality, the future spot rate would usually be higher or lower than the forward rate.Interest rate, inflation rates, forward margins, exchange rates and expectation across nations are inter-related as shown in the diagram below.Interest rate, inflation rates, forward margins, exchange rates and expectation across nations are inter-related as shown in the diagram below.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
SPOT EXCHANGE RATE
In the spot exchange market, the quote may be denoted as direct or indirect. A direct quote indicates the number of units of the domestic currency required to buy one unit of foreign currency. That is, in Mumbai, the typical exchange rate quote indicates the number of Re. needed to buy one unit of a foreign currency e.g., Re. Per $ or Re. per Euro etc. The quotes in the spot market in New York are given in the terms of U.S. dollar and in Tokyo, the rates are given in the terms of Yen.A spot exchange rate is a rate at which currencies are being traded for delivery on the same day. For example, and Indian Importer may need U.S. $ to pay for the shipment that has just arrived. He will have to purchase the $ in the market to make payment for the import. The rate at which he will buy the $ in the market is known as the spot exchange rate. He will make the payments in terms of Rs. and gets in turn the U.S. $ which will be paid to the foreign exporter. The spot exchange rate therefore, for a currency is the current rate at which once currency can be immediately converted into another currency. For example, a spot rate of $0.6912/Euro indicates that one Euro can be converted into $0.6912 in the market place at present. In most of the cases, the spot exchange rates are set by the demand and supply forces in the foreign exchange market.
An indirect quote indicates the number of units of foreign currency that can be exchanged for one unit of the domestic currency. For example, in New York, the rates may be given as £ per $ or Euro per $ etc. As already stated, that the foreign exchange rates are relative to each other, the direct quote and indirect quote are related to each other in an inverse relationship i.e., an indirect quote is the inverse of a direct quote. So,
Indirect Quote = 1 / Direct Quote
In this case, the quote for $/Euro may be obtained as the inverse of Euro/$ i.e., 1/1.037 = 0.9643. So, he will require $0.9643 x 1,000 = $964.32 to pay for the German firm.In International transactions, both the direct quote and indirect quote are used. For example, if the direct quote of Euro in U.S. is Euro/$ = Euro 1.037 and American importer has to pay Euro 1,000 to a German Firm, then how many $ will be required by the American importer?
An indirect quote indicates the number of units of foreign currency that can be exchanged for one unit of the domestic currency. For example, in New York, the rates may be given as £ per $ or Euro per $ etc. As already stated, that the foreign exchange rates are relative to each other, the direct quote and indirect quote are related to each other in an inverse relationship i.e., an indirect quote is the inverse of a direct quote. So,
Indirect Quote = 1 / Direct Quote
In this case, the quote for $/Euro may be obtained as the inverse of Euro/$ i.e., 1/1.037 = 0.9643. So, he will require $0.9643 x 1,000 = $964.32 to pay for the German firm.In International transactions, both the direct quote and indirect quote are used. For example, if the direct quote of Euro in U.S. is Euro/$ = Euro 1.037 and American importer has to pay Euro 1,000 to a German Firm, then how many $ will be required by the American importer?
CURRENCY CROSS RATE
The exchange rate between two currencies calculated on the basis of the rate of these two currencies in terms of a third currency is known as a cross rate.The cross rate for a currency is the exchange rate based on the exchange rate of two other currencies. For example, an American trader gives the following quotations in New York: $0.99/Euro and $1.80/£, then the cross rates Euro/£ or £/Euro may be ascertained as follows:
Euro/£ = ( Euro / $ ) x ( $ / £)
= (1 / 0.99) x 1.80
= Euro 1.818 / £
Similarly, £ / Euro = ( £ / $ ) x ( $ / Euro )
= (1 / 1.80) x 0.99
= £ 0.555 / Euro
The forward rate for a currency may be higher of lower than the spot rate. Forward rate may be higher than the spot rate if the market participants expect the currency to apprecuate vis-a-vis the other currency, say USD. The currency, in such case is called trading at a forward premium. If the forward rate is lower than the spot rate, the participants expect the currency to depreciate vis-a-vis the USD. The currency in this case is said to be 'trading at forward discount'.The forward rate is a price quotation to deliver the currency in future. The exchange rate is determined at the time of concluding the contract, but payment and delivery are not required till maturity. Foreign exchange dealers and banks give the forward rate quotations for delivery in future according to the requirements if their clients. Generally, the forward quotations are given for delivery in 30 days, 90 days, and 180 days. But, the quotations may be given up to 2 years. Sometimes, forward contracts with maturities exceeding two years are also arranged by the dealers to meet specific requirements of their clients. Quotations are normally given for major currencies, but dealers also provide forward quotations for other currencies on the specific request of their clients.
Euro/£ = ( Euro / $ ) x ( $ / £)
= (1 / 0.99) x 1.80
= Euro 1.818 / £
Similarly, £ / Euro = ( £ / $ ) x ( $ / Euro )
= (1 / 1.80) x 0.99
= £ 0.555 / Euro
The forward rate for a currency may be higher of lower than the spot rate. Forward rate may be higher than the spot rate if the market participants expect the currency to apprecuate vis-a-vis the other currency, say USD. The currency, in such case is called trading at a forward premium. If the forward rate is lower than the spot rate, the participants expect the currency to depreciate vis-a-vis the USD. The currency in this case is said to be 'trading at forward discount'.The forward rate is a price quotation to deliver the currency in future. The exchange rate is determined at the time of concluding the contract, but payment and delivery are not required till maturity. Foreign exchange dealers and banks give the forward rate quotations for delivery in future according to the requirements if their clients. Generally, the forward quotations are given for delivery in 30 days, 90 days, and 180 days. But, the quotations may be given up to 2 years. Sometimes, forward contracts with maturities exceeding two years are also arranged by the dealers to meet specific requirements of their clients. Quotations are normally given for major currencies, but dealers also provide forward quotations for other currencies on the specific request of their clients.
SPOT RATES TYPES
Generally, in the spot exchange market, two types if spot rates may be quoted.
* Ask Price
* Bid Price
Bid Price:
Bid Price is the rate at which the dealer is ready to buy the foreign currency in exchange for the domestic currency. So, the bid price is the rate which the dealer is ready to pay in domestic currency in exchange for the foreign currency and therefore, it is the buying rate. The dealer sells the foreign currency for more than what they are ready to pay for buying it. Normally, the direct ask price is greater than the direct bid price and the difference between the two is known as the ask-bid spread.
Ask Price:
The Ask price is the rate at which the foreign exchange dealer ‘asks’ its customers to pay in local currency in the local exchange of the foreign currency. In other words, ask price is the selling rate or the offer rate and refers to the rate at which the foreign currency can be purchased from the dealer.
In case, when there is a large volume of transactions and the trading is continuous in any currency, the spread is small and may range between 0.1% to 0.5%. The spread is much higher for infrequently traded currencies.
The ask-bid spread depends upon the breadth and depth of the market for that currency and the volatility of the currency. This spread compensates the dealer for holding the risky foreign currency and for providing the service of converting currencies. The bid spread is usually stated as a percentage cost of transacting in the foreign exchange market and may be computed as follows:
For example, if the ask price of $/£ is $1.6646 and the bid price is $1.6629, then the % spread may be ascertain as follows:
% Spread = ((1.6646 – 1.6629)/ 1.6646) x 100 = 0.1%
% Spread = ((Ask Price – Bid Price) / Ask Price) x 100
* Ask Price
* Bid Price
Bid Price:
Bid Price is the rate at which the dealer is ready to buy the foreign currency in exchange for the domestic currency. So, the bid price is the rate which the dealer is ready to pay in domestic currency in exchange for the foreign currency and therefore, it is the buying rate. The dealer sells the foreign currency for more than what they are ready to pay for buying it. Normally, the direct ask price is greater than the direct bid price and the difference between the two is known as the ask-bid spread.
Ask Price:
The Ask price is the rate at which the foreign exchange dealer ‘asks’ its customers to pay in local currency in the local exchange of the foreign currency. In other words, ask price is the selling rate or the offer rate and refers to the rate at which the foreign currency can be purchased from the dealer.
In case, when there is a large volume of transactions and the trading is continuous in any currency, the spread is small and may range between 0.1% to 0.5%. The spread is much higher for infrequently traded currencies.
The ask-bid spread depends upon the breadth and depth of the market for that currency and the volatility of the currency. This spread compensates the dealer for holding the risky foreign currency and for providing the service of converting currencies. The bid spread is usually stated as a percentage cost of transacting in the foreign exchange market and may be computed as follows:
For example, if the ask price of $/£ is $1.6646 and the bid price is $1.6629, then the % spread may be ascertain as follows:
% Spread = ((1.6646 – 1.6629)/ 1.6646) x 100 = 0.1%
% Spread = ((Ask Price – Bid Price) / Ask Price) x 100
Spot And Forward Rates
Moreover, the relationship between spot and forward rates may be affected by the efficiency of the financial and exchange markets in two countries. Controls, restrictions and other interventions which can affect adjustments in exchange, and interest and inflation rates differential also influences the spot and forward rates.The collective judgment of the participants in the exchange market influences the appreciation or depreciation in the future spot price of a currency against other currencies. The forward premium or discount is also affected by the interest rate differential between two countries, differences in the rates of inflation between them, and the degree to which inflation rate differential is translated into interest rate differential in the expected time horizon.
Theoretically, in the efficient market and absence of intervention of control in the exchange or financial markets, the forward rate is an accurate predictor of the future spot rate. These requirements are, generally, satisfied if the following three conditions are found.It should, however, be noted that even if these conditions are satisfied, the future spot rate might not be identical to the forward rate. Random differences between the two rates may be found.
1. Interest rate parity:
According to interest rate parity principle, the forward premium (or discount) on currency of a country vis-a-vis the currency of another country will be exactly offset by the interest rate between the countries. The currency of the country with lower interest rate is quoted at a forward premium and vice-versa.
2. Purchasing Power Parity (PPP):
According to the PPP Principle, the currency of a country will depreciate vis-a-vis the currency of another country on the basis of differential in the rates of inflation between them. The rate of depreciation in the currency of the country would roughly be equal to the excess inflation rate in the country over the other country.
3. International Fisher Effect:
The interest rate differential between two countries, according to the Fisher effect, will reflect differences in the inflation rates in them. The high interest country will experience higher inflation rate.
Theoretically, in the efficient market and absence of intervention of control in the exchange or financial markets, the forward rate is an accurate predictor of the future spot rate. These requirements are, generally, satisfied if the following three conditions are found.It should, however, be noted that even if these conditions are satisfied, the future spot rate might not be identical to the forward rate. Random differences between the two rates may be found.
1. Interest rate parity:
According to interest rate parity principle, the forward premium (or discount) on currency of a country vis-a-vis the currency of another country will be exactly offset by the interest rate between the countries. The currency of the country with lower interest rate is quoted at a forward premium and vice-versa.
2. Purchasing Power Parity (PPP):
According to the PPP Principle, the currency of a country will depreciate vis-a-vis the currency of another country on the basis of differential in the rates of inflation between them. The rate of depreciation in the currency of the country would roughly be equal to the excess inflation rate in the country over the other country.
3. International Fisher Effect:
The interest rate differential between two countries, according to the Fisher effect, will reflect differences in the inflation rates in them. The high interest country will experience higher inflation rate.
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