Foreign Exchange Rate:- In International finance an exchange rate b/w 2 currencies is the rate at which one currency will

be exchanged for another. It is also regarded as the value of one countrys currency in terms of another countrys. It is also known as foreign exchange rate / Forex rate/FX rate. For example: - An interbank exchange rate of 91 Japanese yen (91 JPY, ) to the united state dollar (USD, $), means 91 will be exchanged for each us$ 1 or that US$1 will be exchanged for 91. Spot exchange rate:- it refers to the current exchange rate. Forward exchange rate:- it refers to the exchange rate quoted or traded today but for delivery or payment on a specific future date. Determination of Foreign Exchange Rate:The interaction of supply and demand factor of 2 currencies in the market that determines the rate at which they are traded. 3 aspects of exchange rate determination are discussed below. First, there is a brief description of some broad approaches of exchange rate determination. Second there is comment on problems of foreign exchange rate determination. Third, central bank intervention and its effect on foreign exchange rate. 1. Purchasing power parity (PPP):- Why a dollar worth Rs.40/CHF 1.30/ 130.00 etc at a same period of time? Perhaps the simple answer is one can think is that these exchange rates reflects the relative purchasing power of the currencies, i.e the basket of goods can be purchased with USD($) will cost Swiss franc 1.35 in Switzerland, Rs40 in India, 1.35 in Japan. The theory of PPP traced to David Ricardo but the Credit goes to Swedish economist Cassel. The PPP theory is stated in 2 versions (a) The stronger absolute Purchase Power Parity and, (b) The diluted relative Purchase Power Parity (a) Absolute Purchasing Power Parity:Symbolically, .. e = Pd/Pf .. e = foreign exchange rate for the foreign currency in terms of domestic currency Pd = price in domestic currency Pf =price in foreign currency --- Consider the hypothetical data below about the cost of a specific basket of goods and services:USA Exchange rate Switzerland USD/CHF 1-1-07 The basket cost 1.3000 Same basket cost $100 CHF 130 1-1-08 The basket cost 1.2875 Same basket cost $105 CHF =105*1.2875= 135.19

1-1-2007 S0 (USD/CHF ) = 1.30 =Ps(0)/Pus(0)=130/100 On 1-1-2008 S1(USD/CHF) = 1.2875 = Ps(1)/Pus(1)= 135.19/105 Hence, Ps (0) and Pus(0) denotes the price in Switzerland and US respectively, as on 1 jan 2007. Ps (1) and Pus(1) are the price of same basket as on 1 jan 2008 and S0 and S1 are the spot price on those 2 dates. Now let S^ denote the proportionate change in exchange rate between 2 dates. S1 = S0 (1+S^) In the above example S1=1.2875, S0= 1.35 thus 1+S^= 1.2875/1.35 =0.9904 Thus Pie(s) and pie(us) are the proportionate change in price or more familiarly known as inflation rates in Switzerland and US respectively. Then, Ps (1) = Ps(0)(1 + pie(s)) Pus (1) = Pus (0) (1 + pie (us)) In the example (1 + pie(us)) = 105/100=1.05 (1 + pie(s))=135.19/130= 1.309 Now recall that S0 =Ps(0)/Pus(0) and S0 =Ps(0)/Pus(0) Consequently (1+S^)= (1 + pie(s)) / (1 + pie(us)) (1 + pie(s))= 1.309 (1 + pie(us))=1.05 (1+S^)= 0.9904 (1 + pie(s)) / (1 + pie(us)) = 1.309/1.05= 0.9904 This is an absolute purchasing power parity viz the relation St = Pt / Pt*

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