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Project Title

Exchange Rate Mechanism


Submitted To: Prof. TMC Vardrajan
Made By:
Roll No
Dalvi Aftab
26
Dhenkar Daniyal
27
Sajan Mujahid
32
Shaikh Hussain
35
Surve Sakib
38

Exchange Rate

What is Exchange Rate?


Exchange Rate is a rate at which one currency can
be exchanged into another currency. In other words
it is value one currency in terms of other.
say:

US $ 1 = Rs.45.18
This rate is the conversion rate of every US $ 1 to
Rs. 45.18

Example..

History
In 1821-1914Most of the World's currencies were redeemable into
gold. (i.e. you could "cash in" your paper notes for predefined weights
of gold coin).
Britain was the first to officially adopt this system in 1821 and was
followed by other key countries during 1870s.
The result was a global economy connected by the common use of
gold as money.

Contd
By 1970, the existing exchange rate system was already under threat. The
Nixon-led US government suspended the convertibility of the national
currency into gold. The supply of the US dollar had exceeded its demand.
In 1971, the Smithsonian Agreement was signed. For the first time in
exchange rate history, the market forces of supply and demand began to
determine the exchange rate.

Exchange Rate Mechanism


Major currencies dominating the international financial and foreign
exchange market today are on float.
Their value is subject to variation depending upon changes in
macroeconomic variable and market forces
Determination of exchange rate is of utmost importance for floating
rate regime and for those who deal in foreign exchange.

Buying Rate
It is also known as bid rate.
It is the rate at which banks buy a foreign currency from the
customer.
E.g.. In India a customer exchanges the USD for the rupees, the
bank will buy the USD at a buying rate of market.
The bid rate is always given first followed by the selling rate
quote.

Selling Rate
It is the rate at which banks sell foreign currency to their
customer.
E.g.. A bank in India, selling 1USD to a customer, will charge
the selling rate according to market price
For making profit, in these transaction the selling rate is higher
than the buying rate.

Forward Rate
Rate agreed for settlement on an agreed date in the future
All rates are derived from Spot rates
Forward rate is the spot rate adjusted for the premium / discount
Forward Rate = Spot Rate + / - premium or discount

Cross Rates
The rate established between the two currencies is known as cross
Sometimes the value of currency in terms of another one is not
known directly.
In such case one currency is sold for a common currency and then
the common currency is exchanged for the desired currency.
The rate of exchange between the rupee and the Canadian dollar will
be found through the common currency, the US dollar.

Market Quotation
Spot Exchange Rate: The rate today for exchanging one currency for
another at immediate delivery.
Forward Exchange Rate: The rate today for exchanging one currency
for another at a specific Future Date

Factor Determining Exchange Rate


Fundamental Reasons:
- Balance of Payment surplus leads to stronger currency.
- Economic Growth Rates High/Low growth rate.
- Fiscal / Monetary Policy- deficit financing leads to depreciation
of currency.
- Interest Rates currency with higher interest will appreciate in
the short term.
- Political Issues Political stability leads to stable rates

Contd
Technical Reasons
- Government Control can lead to unrealistic value.
- Free flow of Capital from lower interest rate to higher
interest rates.

Speculation higher the speculation higher the volatility in


rates

Exchange Rate Categories


Flexible Exchange Rate Systems
Fixed Exchange-rate System

Flexible Exchange Rate Systems


The value of the currency is determined by the market, ex. by the
interactions of thousands of banks, firms and other institutions seeking to
buy and sell currency for purposes of transactions clearing, hedging,
arbitrage and speculation.
So higher demand for a currency, all else equal, would lead to an
appreciation of the currency. Lower demand, all else equal, would lead
to a depreciation of the currency
Most OECD countries have flexible exchange rate systems: the U.S.,
Canada, Australia, Britain, and the European Monetary Union.

Advantages of flexible exchange rate


Theoretical elimination of trade imbalances
No need for reserves
More freedom over domestic policy

Disadvantages of a flexible exchange rate


Speculation
Uncertainty

Fixed Exchange-rate System


A system whereby the exchange rates of the member countries were fixed
against the U.S. dollar, with the dollar in turn worth a fixed amount of gold.
Governments try to keep the value of their currencies constant against one
another.
The central bank of a country remains committed at all times to buy and
sell its currency at a fixed price.
The central bank provides foreign currency needed to finance payments
imbalances.

Advantages of a fixed exchange rate


Stability
Discipline
Avoid speculation

Disadvantages of a fixed exchange rate


The loss of monetary policy
The need for a large pool of reserves
Problems of un-competitiveness

Factors that influence the Exchange Rate


Market Expectations
Political Events
Relative Inflation Rates
Relative Interest Rates
Relative Income Levels

Market Expectations

Expectations about future exchange rate changes on the basis of


current and future political and economic conditions
1960s Strong $

Between 1960s and 1970s: weak $

Strong $ in 1999 2001

Strong Dollar today 2014

Political Events

Fall of Berlin Wall and unification of East and West Germany

Rumors about resignation of Mikhail Gorbachov

Tiannanmon Square

Persian Gulf War

Relative Inflation

High inflation relative to a foreign country, decline in value of


currencyWhy?

Low inflation relative to a foreign country, increase in value of


currencyWhy?

Relative Interest Rates

High interest rates in home country relative to a foreign country may


cause domestic currency to appreciate.

Relative Income Levels

Increase in domestic income relative to foreign income may lead to


a decline in the value of domestic currency.

Exchange Rate Determination

An interaction of factors

Is it possible for a country with high real returns to have a low


currency value?

Is it possible for a country with low real returns to have a high


currency value?