Foreign
Exchange
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TERMINOLOGIES
Foreign Exchange:
Any financial instrument that carries out payment
from one currency to another currency.
Currency: A system of money in general use in a
particular country.
For nearly 30 years following the world war-2nd,
world currencies were maintained at a fixed ratio
i.e. a system of fixed exchange rates, the system
broke down in 1973 and was replaced by a
mixture of fixed and floating exchange system.
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TERMINOLOGIES
Fixed Exchange Rate:
The government of the a country officially declares that its currency is
convertible into a fixed rate or amount of some other currency.
Floating Exchange Rate:
Under this system, the government possess no responsibility to declare
that its currency is convertible into a fix amount of some other
currency;
Foreign currency exchange rate:
The price of one country’s currency in terms of another country’s
currency.
• e.g. How many Japanese yen per U.S. dollar or how many dollars per
yen?
OR
• How many Afs per U.S. dollars or how many dollars per Af.
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Which currency is better for exchange?
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TERMINOLOGIES
Exchange control:
Control on the movement on capital in and out of a
country, some time impose when the country faces a
shortage of foreign currency.
Cross Rates:
Exchange rates quotations which do not include US dollar
as one of the two currencies quoted.
Currency Flows:
The movement of currency from nation to nation, which
in turn determine exchange rates.
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TERMINOLOGIES
Forward Rates
Contracts that provide for two parties to exchange currencies
on a future date at an agreed- upon exchange rate.
Forward contracts
Agreement between firms and banks which permits the firm
to either sell or buy a specific foreign currency at a future
date at a known price.
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TERMINOLOGIES
Dual pricing
Price-setting strategy in which the export price and
domestic price are differentiated.
Dumping
Selling goods overseas at a price lower than in the
exporter’s home market, or at a price below the cost of
production, or both.
Hedge
To make counterbalance sales or purchases in
international
markets
as
protection
against
adverse(unpleasent) movement in the exchange rates.
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TERMINOLOGIES
Spot Exchange Rate
Spot exchange rate are determined in the spot mkt. It is the number of
units of one country currency per unit of another country currency. Where
as both currencies are in form of bank deposits. Spot exchange rates are
determined by the supply and Demand for currencies being exchanged in
the global markets.
1. A commodities or securities market in which goods are sold for cash and
delivered immediately. Contracts bought and sold on these markets are
immediately
effective.
2. A futures transaction for which commodities can be reasonably
expected to be delivered in one month or less. Though these goods may
be bought and sold at spot prices
Triangular arbitrage
The exchange of one currency for a second currency, the second for a third,
and the third for the first in order to make profit.
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TERMINOLOGIES
Spread
The difference between the currencies open
market and bank rates as well as it’s the
difference between currencies Bank buy and
Bank sale rate.
Speculators
A group of brokers invest in foreign exchange in
the hope of gain but with the risk of loss.
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Meaning of foreign Exchange Rate
1. The foreign exchange rate or exchange rate is the rate at which
one currency is changed for another.
2. It is the price of one currency in terms of another currency.
• For example, if a person in US want to purchase a pound, a
number of dollars required to purchased a pound, $ 2.50=£1
• And UK it should be £0.40=$1
• So the exchange rate should be as follows
$ 2.50=£1 OR £0.40=$1
OR
$ 1= 52Afs
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Three types of Exchange Rates
• Spot
• Forward &
• Cross
SPOT: the rate quieted for current foreign currency
transaction.
FORWARD: the rated quoted for the delivery of foreign
currency at a free determine future date such as 90 days
from now.
CROSS: an exchange rate computed from two other rates,
such as the relation ship Swiss Frances and German
Marks
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Areas of Foreign Exchange
• For the purpose of international business,
there are three important areas of foreign
exchange that warrant consideration,
1. Foreign Exchange Markets
2. Participants in foreign exchange markets
3. Determination of exchange rates
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Theories of Foreign Exchange
1:The Mint Parity theory
2: The Purchasing Power Parity Theory
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The Mint Parity Theory
This theory is associated with the work of the
International Gold Standard.
Under this system, the currency in use was made of
gold or convertible into gold at a fix rate. The
value of currency unit was defined in terms of
certain weight of gold, that is, so many grains of
gold to dollar or the pound etc.
The rate at which the standard currency of a
country was convertible into gold was called the
Mint Price of gold.
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Explanation of the Theory
If the official British price of gold was £ 6 per
once and the US price of gold $36 per once,
they were the mint price of gold in respective
countries.
The exchange rate between $ and £ would be
fixed at $36/£6= 6
Thus under the gold standard, the normal rate
of exchange was equal to the ration mint price
P= $/ £
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Assumption of the Theory
1. The price of gold is fixed by a country in
terms of its currency
2. It buys and sells gold in any amount at that
price.
3. Its supply of money consists of gold or paper
currency which is backed by gold.
4. There is movement of gold between
countries
5. Capital is moveable within countries.
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Criticisms on Mint Parity Theory
1. The international gold standard does not
exist now ever since after 1930
2. The theory is based on the free buying and
selling of gold, while Govt. do not allow such
sales or purchases
3. The theory is fails to explain the
determination of exchange rates
4. it is based on flexibility of internal prices but
Modern Govt.s follow independent domestic
price policy.
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Purchasing Power Parity (PPP)
The relationship between the exchange rate and the
price level in different countries.
The price of £ in the foreign currency = Foreign
Country price level/UK price level
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The Purchasing Power Parity Theory (PPP)
The PPP theory was developed by Gustav Cassel
in 1920 to determine the exchange rate
between countries on inconvertible paper
countries.
This theory states that, the rate of exchange
between two countries is determined by their
relative price levels.
PPP have two versions:
1. The absolute &
2. The relative
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PPP Theory
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Cont’d
The absolute version states that the exchange rates
between two countries should be equal to the ratio
of the prices index in the two countries. The formula
is,
R AB = PA /PB
where RAB is the exchange rate between two countries
A and B and P refers to the price index.
This version is not use because it ignore the
transportation cost and other factors.
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The Second Version ( Relative)
This theory can be explain with the help of an
example.
Suppose India and England are on inconvertible
paper standard and by spending Rs.60, the
bundle of goods can be purchased in India as
can be bought by spending £ 1 in England.
Thus, according to PPP, the rate of exchange
will be Rs. 60= £ 1
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Explanation
If the price levels in the two countries remain the same but
the exchange rate moves to ,
Rs.50= £ 1. this means Rs. Is overvalue. This will encourage
imports & discourage exports by India, as a result, the
demand for £ will be increase and Rs. Fall.
This process will ultimate Restore the normal exchange rate
Rs.60= £ 1
In other hand if the Rs.70= £ 1 it is the example of under
devalue. In this case exports are encourage and imports are
discourage.
The demand for Rupee will rise and that for £ will fall. This
process will ultimate Restore the normal exchange rate
Rs.60= £ 1.
Normally the following Formula is used for calculation
R=
Domestic Price of a Foreign Currency x Domestic Price Index
Foreign price Index
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Explanation-II
• The exchange rate would be a proper reflection
of the purchasing power in each country if the
relative values bought the same amount of goods
in each country.
• E.g. If the price of a pint of Stella in the UK was
£3.00 and in Europe €4.50, the exchange rate
between the two countries should be £1 = €1.50
• If any lower than this value, the £ would be
undervalued and if any higher, the £ would be
overvalued.
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End of Chapter
ANY QUESTION ?
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Thank You
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