Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 1998

Foreign Exchange Rate SystemPresented byBharatKavita & Amit Introduction

Currencies are traded inforeign exchange marketsand the volume of money bought and sold is huge! Daily foreign exchange market turnover averaged $4 trillion in 2010, 20% higher than in 2007.An exchange rate is the price of one currency in terms of another in other words, the purchasing power of one currency against another.Exchange rates are an important instrument of monetary policy.

Exchange ratePurpose of Forex Market The foreign exchange market is the mechanism by which currencies are valued relative to one another, and exchanged.

1. CURRENCY CONVERSION:- companies, investores and government wants to exchange 1 currency into another . A companies primary purpose for need to convert currencies is to pay or receive money for goods or services . 2. CURRENCY HEDGING :- One of the biggest challenges in foreign exchange is increasing or decreasing rates of risk in greater amount or directions than anticipated . Currency hedging refers to the technique of protecting against the potential losses that result from adverse changes in exchange rate .3. CURRENCY ARBITRAGE:Currency arbitrage involves buying and selling currency pairs from different brokers to take advantage of this disparity.For example, two different banks (Bank A and Bank B) offer quotes for the US/EUR currency pair. Bank A sets the rate at 3/2 dollars per euro, and Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the trader would take one euro, convert that into dollars with Bank A and then back into euros with Bank B. The end result is that the trader who started with one euro now has 9/8 euro. The trader has made a 1/8 euro profit if trading fees are not taken into account.

4. CURRENCY SPECULATION:Currency speculation exists whenever someone buys a foreign currency, not because she needs to pay for an import or is investing in a foreign business, but because she hopes to sell the currency at a higher rate in the future (in technical language the currency "appreciates"). This is nothing more than the old rule of buying low and selling highonly with foreign money

Some currency speculation is necessary to facilitate international trade. Take, for example, a car manufacturer in Germany which exports cars to the United States. As the U.S. importer of German cars is paying her bill in U.S. dollars, the German exporter receives U.S. currency.

DETERMINATION OF EXCHANGE RATE:-

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

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

3. Current Account Deficits:Thecurrent account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. Adeficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products.4. Interest Rates :Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates,central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.

There are several ways to quotes currency, but lets keep it simple . In general, when we quotes currencies, we are indicating how much of one currency it take to buy another currency . These quotes requires to components : the base currency and the quoted currency. the base currency is the currency that is to be purchased with the another currency, and it is noted in the denominator.EXCHANGE RATE QUOTES:-DEFINITION OF 'DIRECT QUOTE' A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other words, it involves quoting in fixed units of foreign currency against variable amounts of the domestic currency. For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1. Conversely, in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.

DEFINITION OF 'INDIRECT QUOTE' A currency quotation in the foreign exchange markets that expresses the amount of foreign currency required to buy or sell one unit of the domestic currency. An indirect quote is also known as a quantity quotation, since it expresses the quantity of foreign currency required to buy units of the domestic currency. In other words, the domestic currency is the base currency in an indirect quote, while the foreign currency is the counter currency. An indirect quote is the opposite or reciprocal of a direct quote, also known as a price quotation, since it expresses the price of one unit of a foreign currency in terms of the domestic currency. Consider the example of the Canadian dollar (C$), which we assume is trading at 1.0400 to the US dollar.In Canada, the indirect form of this quote would be C$1 = US$0.9615 (i.e. 1/1.0400).

DIRECT CURRENCY QUOTE AND INDIRECT CURRENCY QUOTEDEFINITION OF 'SPOT RATE' The price quoted for immediate settlement on a commodity, a security or a currency. The spot rate, also called spot price, is based on the value of an asset at the moment of the quote. This value is in turn based on how much buyers are willing to pay and how much sellers are willing to accept, which depends on factors such as current market value and expected future market value. As a result, spot rates change frequently and sometimes dramatically.

DEFINITION OF 'FORWARD RATE' A rate applicable to a financial transaction that will take place in the future. Forward rates are based on the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time. It may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan payment.

1. SWAPS: A swap is a derivative in which two parties agree to exchange a set ofcash flow(or leg) for another set. A notional principal amount is used to calculate eachcash flow; these are rarely exchanged by the parties. A swap is usually used to hedge a risk, such as aninterest-rate risk, or to speculate on aprice change. It may also be used to access anunderlying asset in order to earn a profit or loss from any change in price while avoiding posting the notional amount in cash or collateral.

2. OPTION: An option is afinancial instrumentthat gives the holder the right to engage in a future transaction on an underlying security or futures contract. The holder is under no obligation to exercise this right. There are two main types of option. Acall optiongives the holder the right to purchase a specified quantity of a security at a fixed price (thestrike price) on or before the specifiedexpiration date. Aput optiongives the holder the right to sell. If the holder chooses to exercise the option, the party who sold, or wrote, the option is obliged to fulfill the terms of the contract.

Swaps, Options, and Futures:3. Futures: Futures are traded on afutures exchangeand represent an obligation to buy or sell a specified underlying instrument on a specified date (thedelivery dateor final settlement date) in the future at a specified price (the futures price). The settlement price is the price of theunderlying asseton thedelivery date. Both parties to afutures contractare legally bound to fulfill the contract on the delivery date. If the holder of a futures position wishes to exit their obligation before thedelivery date, they must offset it either by selling along positionor buying back ashort position. Such an action effectively closes the futures position and itscontractual obligations.

1. PURCHASING POWER PARITY(PPP):- The theory of the purchasing power parity is the oldest and most extensively accepted theory of all exchange rate determination theories . PPP theory is based on concept of law of one price that is the price if commodity shall be the same in two markets. If were not true, arbiterageurs would buy in cheaper market and sell in expensive market to make risk less gain. 2. BALANCE OF PAYMENT APPROACH:- the balance of payment approach is the second most utilized theoretical approach in exchange rate determination . The basic approach argues that the equilibrium exchange rate is found when currency flows match up current and financial activities .

EXCHANGE RATE THEORIES:3. ASSET MARKET APPROACH:- Asset market approach argues that exchange rate are determined by the supply and demand for a wide variety of financial assets the asset market approach assumes that whether foreigners are willing to hold claims in monetary from depends on extensive set of investment consideration or drivers: 1. Relative real interest rate 2. Prospects for economic growth 3. capital market liquidity 4. countries economic and social infrastructure 5. Political safety 6. corporate governance practices 7. speculation4. INTEREST RATE PARITY (IRPT):- IRP theory states that exchange rate between currencies is directly affected by their interest rate . Interest rate parity is one of the most important fundamental economic relation relating differential interest rate and forward exchange rate between a pair of currency. 5. INTERNATIONAL FISHER EFFECT:- international fishers effect postulates that the estimated change in the current exchange rate between any two currencies is directly proportionals to the difference between the two countries nominal interest rate at a particular time. The international fishers effect relates the nominal interest rates between two countries and the movement of exchange rate between the currencies of two countries . According to prof. fisher , there are two type of interest rate :

Real interest rate: real interest rate depends upon productivity of capital.Nominal interest rate : nominal interest rate is also called as money interest rate , also referred as out-of-pocket interest rate Prof. fishers stated the relationship between the two interest rate as follows : (1+r) (1+i)=(1+n)where, r= real interest rate , i= inflation rate , n= nominal interest rate.Thank you