Introduction

Globally, operations in the foreign exchange market started in a major way after the breakdown
of the Bretton Woods system in 1971, which also marked the beginning of floating exchange rate
regimes in several countries. Over the years, the foreign exchange market has emerged as the
largest market in the world. The decade of the 1990s witnessed a perceptible policy shift in many
emerging markets towards reorientation of their financial markets in terms of new products and
instruments, development of institutional and market infrastructure and realignment of regulatory
structure consistent with the liberalised operational framework. The changing contours were
mirrored in a rapid expansion of foreign exchange market in terms of participants, transaction
volumes, decline in transaction costs and more efficient mechanisms of risk transfer.
The origin of the foreign exchange market in India could be traced to the year 1978 when banks
in India were permitted to undertake intra-day trade in foreign exchange. However, it was in the
1990s that the Indian foreign exchange market witnessed far reaching changes along with the
shifts in the currency regime in India. The exchange rate of the rupee, that was pegged earlier
was floated partially in March 1992 and fully in March 1993 following the recommendations of
the Report of the High Level Committee on Balance of Payments (Chairman: Dr.C. Rangarajan).
The unification of the exchange rate was instrumental in developing a market-determined
exchange rate of the rupee and an important step in
the progress towards current account convertibility, which was achieved in August 1994.

The evolution of Indias foreign exchange market may be viewed in line with the shifts in Indias
exchange rate policies over the last few decades from a par value system to a basket-peg and
further to a managed float exchange rate system. During the period from 1947 to 1971, India
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followed the par value system of exchange rate. Initially the rupees external par value was fixed
at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the
permitted margin of 1 per cent using pound sterling as the intervention currency. Since the
sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates of
rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable. The
devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction
of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. The
exchange rate of the rupee remained unchanged between 1966 and 1971.

Exchange Rate Theories

The Asset Approach
The monetary approach to the BOP incorporates international financial flows to the model. The
monetary approach views any BOP disequilibrium as a monetary disequilibrium, which is
manifested through the capital account. Under fixed exchange rates, the intuition of the monetary
approach to the BOP is very simple: if the central bank is supplying more money than what
domestic residents demand, the excess supply will be eliminated through capital outflows. Given
the excess supply of money, domestic prices increase. Foreign goods become relatively cheaper.
Since the exchange rates are fixed, the excess money supply leaves the country as capital
outflows until domestic prices get to the level of the rest of the world. At that point, equilibrium
is achieved again. On the other hand, when there is an excess money demand in the domestic
country, the country will receive an inflow of capital. That is, under fixed exchange rates,
international capital flows adjust monetary disequilibria. Under flexible exchange rates, the
adjustment mechanism is different. Recall that the KA includes financial transactions associated
with international trade as well as flows associated with portfolio shifts involving the purchase of

foreign stocks, bank deposits, and bonds. The KA is assumed to depend on the interest rate
differential. Since investors only care about returns denominated in their home currency, the KA
also depends on S. Thus, Modern exchange rate models emphasize financial-asset markets.
Rather than the traditional view of exchange rates adjusting to equilibrate international trade in
goods, the exchange rate is viewed as adjusting to equilibrate international trade in financial
assets. Because goods prices adjust slowly relative to financial asset prices and financial assets
are traded continuously each business day, the shift in emphasis from goods markets to asset
markets has important implications. Exchange rates will change every day or even every minute
as supplies of and demands for financial assets of different nations change. An implication of the
asset approach is that exchange rates should be much more variable than goods prices. This
seems to be an empirical fact. Table 18.1 lists the standard deviations of percentage changes in
prices and exchange rates for two countries. In the 1990s period covered in the table, we
observe that spot rates for the countries were much more volatile than prices. Comparing the
prices with the exchange rates, we find that the volatility of exchange rates averaged anywhere
from 4 to 12 times the volatility of prices. Such figures are consistent with the fact that exchange
rates respond to changing conditions in financial-asset markets and are not simply reacting to
changes in international goods trade. Exchange rate models emphasizing financial-asset markets
typically assume perfect capital mobility. In other words, capital flows freely between nations
as there are no significant transactions costs or capital controls to serve as barriers to investment.
Balance of Payments (BOP) Approach
Under the BOP approach, the domestic price of a foreign currency is determined just like the
price of any commodity, i.e., by the intersection of the market demand and supply curves for that
foreign currency. The BOP approach models the demand and supply for foreign exchange as

determined by the flows of currency created by international transactions. According to the BOP
theory of exchange rates, the supply and demand for a currency arise from the flows related to
the BOP, that is, trade in goods and services, portfolio investment, and direct investment.
Equilibrium exchange rates are determined when the BOP is in equilibrium. Exchange rates will
move in response to a BOP imbalance and, therefore, will restore the equilibrium to the BOP. We
should note that PPP implicitly incorporated, through trade, demand and supply factors in the
determination of exchange rates. For example, under PPP, if prices abroad are lower than at
home, then domestic demand for foreign goods will increase and then the foreign currency will
appreciate.
The BOP tracks all financial flows crossing the borders of a country during a given period. For
example, an import creates a negative financial inflow (positive financial outflow) for the
country, whereas an export creates a positive financial inflow (negative financial outflow). The
convention is to treat all financial inflows as a credit to the balance of payments. A BOP is not an
income statement or a balance sheet but rather a cash balance of the country relative to the rest of
the world. As long as the country is not bankrupt, the balance of all financial flows must be
equilibrated, like any cash balance. In other words, the final balance must be zero.
The Monetary Approach
The BOP analysis becomes more complex when the capital account is taken into consideration.
When the official reserve account (OR) is small, the KA provides the other side of the CA. That
is, KA = -CA.
A CA surplus equals a KA deficit. For example, in 1979, Kuwait was earning much more on its
oil exports than it was spending on imports. Since it was earning more than it was spending, it
was accumulating foreign IOUs, or financial assets, in the form of bank deposits in New York

and other financial centers. By looking at the KA, we can see that when the CA is in a deficit,
then the country is either accumulating debt or else running down its current stock of foreign
assets. If the CA is in surplus, then the country is either repaying debt or building up its stock of
foreign assets. The monetary approach to the BOP incorporates international financial flows to
the model. The monetary approach views any BOP disequilibrium as a monetary disequilibrium,
which is manifested through the capital account. Under fixed exchange rates, the intuition of the
monetary approach to the BOP is very simple: if the central bank is supplying more money than
what domestic residents demand, the excess supply will be eliminated through capital outflows.
Given the excess supply of money, domestic prices increase. Foreign goods become relatively
cheaper. Since the exchange rates are fixed, the excess money supply leaves the country as
capital outflows until domestic prices get to the level of the rest of the world. At that point,
equilibrium is achieved again. On the other hand, when there is an excess money demand in the
domestic country, the country will receive an inflow of capital. That is, under fixed exchange
rates, international capital flows adjust monetary disequilibria. Under flexible exchange rates, the
adjustment mechanism is different. Recall that the KA includes financial transactions associated
with international trade as well as flows associated with portfolio shifts involving the purchase of
foreign stocks, bank deposits, and bonds. The KA is assumed to depend on the interest rate
differential. Since investors only care about returns denominated in their home currency, the KA
also depends on S.
Determination of Exchange rate in the Spot Market
The exchange rate between two currencies in a floating rate regime is determined by the
interplay of demand and supply forces. The exchange rate between say the rupee and the US
dollar depends upon the demand for the US dollar and its availability or supply in the Indian

foreign exchange rate. The demand for foreign currency comes from individuals and firms who
have to make payments in foreign currency mostly on account of import of goods and services
and purchase of securities. The supply of foreign exchange results from the receipt of foreign
currencies normally on account of export or sale of financial securities to foreign entities.
Rs. /US $
S
S
42
40

Q1

Q2

Q3

DETERMINATION OF EXCHANGE RATE IN THE FORWARD MARKET

Forward exchange rate is normally not equal to the spot rate. The size of forward premium or
discount depends mainly on the current expectation of future events. The determination of
exchange rate in a forward market finds an important place in the theory of interest rate parity
(IRP). Covered interest rate Arbitrage, Uncovered interest rate arbitrage.
Covered Interest Arbitrage
Returns on covered interest rate arbitrage tend to be small, especially in markets that are
competitive or with relatively low levels of information asymmetry. While the percentage gains
are small they are large when volume is taken into consideration. A four cent gain for $100 isn't
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much but looks much better when millions of dollars are involved. The drawback to this type of
strategy is the complexity associated with making simultaneous transactions across different
currencies. A strategy in which an investor uses a forward contract to hedge against exchange
rate risk. Covered interest rate arbitrageis the practice of using favorable interest rate differentials
to invest in a higher-yielding currency, and hedging the exchange risk through a forward
currency contract. Covered interest arbitrage is only possible if the cost of hedging the exchange
risk is less than the additional return generated by investing in a higher-yielding currency. Such
arbitrage opportunities are uncommon, since market participants will rush in to exploit an
arbitrage opportunity if one exists, and the resultant demand will quickly redress the imbalance.
An investor undertaking this strategy is making simultaneous spot and forward market
transactions, with an overall goal of obtaining riskless profit through the combination of currency
pairs. Covered interest arbitrage is not without its risks, which include differing tax treatment in
various jurisdictions, foreign exchange or capital controls, transaction costs and bid-ask spreads.
Note that forward exchange rates are based on interest rate differentials between two currencies.
As a simple example, assume currency X and currency Y are trading at parity in the spot market
(i.e. X = Y), while the one-year interest rate for X is 2% and that for Y is 4%. The one-year
forward rate for this currency pair is therefore X = 1.0196 Y (without getting into the exact math,
the forward rate is calculated as [spot rate] times [1.04 / 1.02]).
The difference between the forward rate and spot rate is known as swap points, which in this
case amounts to 196 (1.0196 1.0000). In general, a currency with a lower interest rate will
trade at a forward premium to a currency with a higher interest rate. As can be seen in the above
example, X and Y are trading at parity in the spot market, but in the one-year forward market,
each unit of X fetches 1.0196 Y.
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A savvy investor could therefore exploit this arbitrage opportunity as follows Borrow 500,000 of currency X @ 2% per annum, which means that the total loan repayment
obligation after a year would be 510,000 X. Convert the 500,000 X into Y (because it offers a
higher one-year interest rate) at the spot rate of 1.00. Lock in the 4% rate on the deposit amount
of 500,000 Y, and simultaneously enter into a forward contract that converts the full maturity
amount of the deposit (which works out to 520,000 Y) into currency X at the one-year forward
rate of X = 1.0125 Y. After one year, settle the forward contract at the contracted rate of 1.0125,
which would give the investor 513,580 X. Repay the loan amount of 510,000 X and pocket the
difference of 3,580 X.
Effect of arbitrage
If there were no impediments, such as transaction costs, to covered interest arbitrage, then any
opportunity, however minuscule, to profit from it would immediately be exploited by many
financial market participants, and the resulting pressure on domestic and forward interest rates
and the forward exchange rate premium would cause one or more of these to change virtually
instantaneously to eliminate the opportunity. In fact, the anticipation of such arbitrage leading to
such market changes would cause these three variables to align to prevent any arbitrage
opportunities from even arising in the first place: incipient arbitrage can have the same effect, but
sooner, as actual arbitrage. Thus any evidence of empirical deviations from covered interest
parity would have to be explained on the grounds of some friction in the financial markets.

Uncovered interest arbitrage

Uncovered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on

the interest rate differential between two countries. Unlike covered interest arbitrage, uncovered
interest arbitrage involves no hedging of foreign exchange risk with the use of forward contracts
or any other contract. The strategy involves risk, as an investor exposed to exchange rate
fluctuations is speculating that exchange rates will remain favorable enough for arbitrage to be
profitable. The opportunity to earn profits arises from the reality that the uncovered interest rate
parity condition does not constantly holdthat is, the interest rate on investments in one
country's currency does not always equal the interest rate on foreign-currency investments plus
the rate of appreciation that is expected for the foreign currency relative to the domestic
currency. When a discrepancy between these occurs, investors who are willing to take on risk
will not be indifferent between the two possible locations of investment, and will invest in
whichever currency is expected to offer a higher rate of return including currency exchange gains
or losses (perhaps adjusted for a risk premium).
Mechanics of uncovered interest arbitrage
An arbitrageur executes an uncovered interest arbitrage strategy by exchanging domestic
currency for foreign currency at the current spot exchange rate, then investing the foreign
currency at the foreign interest rate, and at the end of the investment term using the spot foreign
exchange market to convert back to the original currency. The risk arises from the fact that the
future spot exchange rate for the currencies is not known with certainty when the strategy is
chosen.
For example, consider that an investor with $5,000,000 USD is considering whether to invest
abroad using an uncovered interest arbitrage strategy or to invest domestically. The dollar deposit
interest rate is 3.4% in the United States, while the euro deposit rate is 4.6% in the euro area. The
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current spot exchange rate is 1.2730 $/. For simplicity, the example ignores compounding
interest. Investing $5,000,000 USD domestically at 3.4% for six months ignoring compounding,
will result in a future value of $5,170,000 USD. However, exchanging $5,000,000 dollars for
Euros today, investing those Euros at 4.6% for six months ignoring compounding, and
exchanging the future value of Euros for dollars at the future spot exchange rate (which for this
example is 1.2820 $/), will result in $5,266,976 USD, implying that investing abroad using
uncovered interest arbitrage is the superior alternative if the future spot exchange rate turns out
to be favorable.

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Bibliography

Journals

Forward And Spot Exchange Rates, Eugene F. Fama, Journal Of Monet.. Economics 14
The Monetary Approach to Exchange Rates, IAN WILSON, The Journal of Business
Inquiry 2009.

Internet

Wikipedia
Investopedia

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