FOREIGN EXCHANGE

MANAGEMENT
…tools of international exchange 

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Introduction
 This chapter examines exchange rate
theories or how exchange rates are
determined in the real world.
 The exchange rate is one of the most
important, if not the most important,
variable in all of international finance and
the exchange rate theories discussed here
provide the background for all the topics
examined in international finance.
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Contd….
 We will see that exchange rates are determined by the interaction of
many forces, some of a long run in nature while others of a short-
run nature.
 We will examine international trade and price changes in the trading
nations as determinants of exchange rate changes in the long run.
 Then we will focus on the importance of capital markets and
international capital flows, which seek to explain the short-run
volatility of exchange rates and their tendency to overshoot their
long-run equilibrium path or level.
 While both traditional or long-run and short-run forces are clearly
important, we do not yet have a unified or comprehensive theory of
exchange rate determination, as evidenced by the fact that we are
unable to accurately forecast exchange rate, especially in the short
run.
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Overview of Exchange Rate Determination

 To sum up, when the exchange rates

are free to fluctuate, the exchange rate
is determined at the intersection of the
market demand and supply curves of
foreign exchange.
 But saying concretely, exchange rates
are affected by many important forces.
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Contd…
1. Relative rates of economic growth
If the India grows more rapidly than the rest of the

world, its demand for imports will increase more

rapidly. By itself, this should increase the demand
for foreign currency and lead to depreciation of the
dollar.

2. Relative rates of inflation

If India inflation is greater than the rate of inflation

in the rest of the world, the dollar will decrease in

value.
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Contd…
3. Changes in interest rates
If India interest rates fall relative to interest

rates in the rest of the world, the demand for

India interest bearing assets will fall. By itself,
this will lead to a fall in international demand
for the rupee and a depreciation of the rupee.

4. Expectations
If it is expected that the rupee will fall in

value, people will move out of rupee holdings.

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Contd…

Figure: Forces affecting the dollar/euro exchange rate

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Purchasing Power Parity Theory

Purchasing Power Parity Theory:- There are two versions of Purchasing
Power Parity theory :-
Absolute Version of the PPP theory.

Relative Version of the PPP theory.

(1) Absolute Version of the PPP theory:- The PPP theory suggests that at any
point of time, the rate of exchange between two currencies is determined by
their purchasing power.
For example: If e is the exchange rate and PA and PB are the purchasing power
of the currencies in the two countries, A and B, the equation can be written as
PA
e = -------
PB
In fact, this theory is based on the theory of one price in which the domestic
price of any commodity equals its foreign price quotes in the same currency.
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Absolute Version of the PPP theory

To explain it, if the exchange rate is Rs.2/US$, the price of a particular
commodity must be US$50 in the United state of America if it is Rs.100 in
India.
In other words:
US$ price of a commodity X Price of US$ = Rupee price of the commodity
If inflation in one country causes a temporary deviation from the equilibrium,

arbitrageurs will begin operating, as a result of which equilibrium will be

restored through changes in the exchange rate.

For Example:- Suppose, the price of the commodity soars up in India to Rs.
125, the arbitrageurs will buy that commodity in the United States of America
and sell it in India earning a profit of RS. 25. This will go on till the exchange
rates moves to Rs. 2.5/US$ and the profit potential of arbitrage is eliminated.
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Relative Version of the PPP theory

(2) Relative Version of the PPP theory:- In view of the above limitation, another version of this
theory has evolved, which is known as the relative version of the PPP theory.
The relative version of PPP theory states that the exchange rate between the currencies of the two
countries should be a constant multiple of the general price indices prevailing in two countries. In other
words, percentage change in the exchange rates should equal the percentage change in the ratio of
price indices in the two countries.
To put it in the form of an equation, where IA and IB are the rates of inflation in country A and country
B, e0 is the A' currency value for one unit of B's currency at the beginning of the period and et is the
spot exchange rate in period t,
then
et (1+ IA)t
----- = ---------------
e0 (1+ IB )t
e0 = A' currency value for one unit of B's currency at the beginning of the period.
et = Spot exchange rate in period t
IA = Rate of Inflation in A country
IB = Rate of Inflation in B Country.
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Relative Version of the PPP theory

For Example:- If India has an inflation rate of 5 per cent
and the United State of America has a 3 per cent rate of
inflation and if the initial exchange rate is Rs. 40/US$, the
value of the rupee in a two year period will be:-

(1.05)2
et= 40 X --------------
(1.03)2
= Rs. 41.57/US$
This theory suggests that a country with a high rate of

inflation should devlauate its currency relative to the

currency of the countries with lower rates of inflation.
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Contd….
Conclusion:-
Merits:- PPP theory holds good if:
Changes in the economy originate from the monetary

sector.
There is no structural changes in the economy, such as

changes in tariff and in technology.

Demerits:- PPP theory does not hold good in following

situations:-
The assumptions of this theory do no necessarily hold

good in real life.

are other factors such as interest rates, governmental

interference and so on that influence the exchange rate.

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Monetary Approach of Exchange Rate

Monetary Approach:- Monetary Approach is divided into two sections:-
Monetary Approach of Flexible Price Version.

Monetary Approach of Sticky-price Version.

1. Monetary Approach of Flexible Price Version:- The monetary

approach of the flexible price version emphasizes the role of demand for
money and the supply of money in determination of the exchange rate.
The exchange rate between two currencies, accordingly to this approach,
is ratio of the value of two currencies determined on the basis of the two
countries money supply and money demand positions. There are three
situations:-
(i) Any increase in money supply raises the domestic price level and the

resultant increase in price level lowers the value of the domestic currency.
It can also be explained with the help of following equation:
Increase in Money Supply Higher Price Level
Depreciation of domestic currency.
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Contd…..
(ii) If the increase in money supply is lower than the increase in real
domestic output, the excess of real domestic output over the money
supply causes excess demand for money balances and leads to a
lowering of domestic prices, which causes an improvement in the value
of domestic currency.
Money Supply being less than real domestic output excess
demand for money balances lower domestic prices
Appreciation of domestic currency.

(iii) Monetary theory explains that a rise in domestic interest rate lowers
the demand for money in the domestic economy relative to its supply
and thereby causes depreciation in the value of domestic currency.
Rise in interest rate lower demand for money
domestic currency depreciates.
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Contd…
2. Monetary Approach of Sticky-Price Version:- The sticky price
version makes a more detailed study of interest rate differential. The
argument in favour of this approach is that an increase in money supply
(through changes in the real interest rate differential) leads to depreciation
in the value of domestic currency.

Assumptions:-
The monetary approach of the sticky price version rests on a couple of
assumptions.
Money Supply is Endogenous:- The money supply in a country is

endogenous, meaning that it is positively related to the market interest rate.

PPP Theory applies in long run:- The second assumption is that the

PPP theory applies in the long run and so the expected inflation
differential changes have a role to play in the determination of the
exchange rate.
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Contd….

The sticky price theory can be explained in two sections:-

(A)Study of Interest Rate Differential:- The sticky price

version makes a detailed study of interest rate differential.

The interest rate differential has three components:-

(i) One denotes that when the interest rate rises, the money
balances held by the public come to the money market in
lure of high interest rate. Money supply increases leading
to currency depreciation.

Increase in Money Supply Depreciation of

domestic currency.
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Contd…..
(ii) Second denotes that if interest rate rises, financial
institutions increase the funds to be supplied to the money
market. Money supply increases and the value of domestic
currency depreciates.
Rise in Interest Rate Increase in money
supply (lonable funds) Depreciation of domestic
currency.

(iii) The third is that a rise in interest rate stimulates the capital
inflow into the country that, like the balance of payments
approach, causes appreciation in the value of domestic currency.
Rise in interest rate Greater Inflow of Capital
Appreciation of domestic currency
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Contd…..
(B) Study of Inflation Rate Differential:- The sticky price
version specially mentions the expected inflation rate
differential. A rise in inflation rate compared to that in the
foreign country leads to depreciation in the value of
domestic currency. This is because a rise in inflation rate
decreases the real interest rate and discourages the capital
inflow.
Increase in Money Supply Price rise
Lower real interest rate
Lower inflow of capital depreciation
of domestic currency.
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Portfolio Balance Approach

Introduction:-
The portfolio balance approach suggests that it is not only

the monetary factor but also the holding of financial assets

such as domestic and foreign bonds that influences the
exchange rate.
If foreign bonds and domestic bonds turn out to be perfect

substitutes and if the conditions of interest arbitrage hold

good, the portfolio balance approach will not be different
from the monetary approach.
But since these conditions do not hold good in real life, the

portfolio balance approach maintains a distinction from the

monetary approach.
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Contd…
This approach suggests that the exchange rate is determined
by the interaction of following factors:-
(i) Real Income
(ii) Interest Rates
(iii) Risk
(iv) Price Level
(v) Wealth
If a changes takes place in these variables, the investor re-

establishes a desired balance in its portfolio. The re-

establishment of the portfolio balance needs some adjustments
which, in turn, influence the demand for foreign assets. Any
such change influences the exchange rate. For Example:-
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Contd…
1. A rise in real domestic income leads to a greater
demand for foreign bonds. Demand for foreign
currency will rise, in turn, depreciating the
domestic currency.

Domestic Income/Wealth Increase Greater

demand for foreign financial assets
depreciation of domestic currency.
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Contd…
2. Again, the legal, political, and economic conditions in a foreign
country may be different from those at home. If foreign bonds turn
out to be more risky on these grounds, the demand for foreign
currency will decrease, in turn, appreciating the value of domestic
currency. Similarly, rising inflation in a foreign country makes
foreign bonds risky. The demand for foreign currency will drop and
the domestic currency will appreciate.

Foreign financial assets being more risky demand

for them decreases Appreciation of domestic
currency.

When the exchange rate changes, the above mentioned variables

change, which cause a shift in the desired balance in the investment
portfolio. Thus two -way forces continue to act until equilibrium is
reached, But the equilibrium is only short lived.
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Major Factors Influencing the Exchange Rate

Factors Influencing Exchange Rate:- The most important factor influencing
the exchange rate are:-

1. Balance of Payments:- Balance of Payments position of a country is a

definite indicator of the demand and supply of foreign exchange. There are two
situations:-
If a country is having a favourable balance of payments position it implies

that there is more supply of foreign exchange and therefore foreign currencies
will tend to be cheaper.
If balance of payments position is unfavourable, it indicates that there is more

demand for foreign exchange and this will result in the price of foreign
currency.

2. Strength of the Economy :- The relative strength of the economy also has
an effect on the demand and supply of foreign currencies. If an economy is
growing at a faster rate it is generally expected to have a better performance on
balance of trade.
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Contd…
3. Fiscal Policy:- The fiscal policy followed by government has an
impact on the economy of the country which in turn affects the
exchange rates. If the government follows an expansionary policy by
having low interest rates, it will fuel the engine of economic growth and
as discussed earlier, it will lead to better trade performance.

4. Monetary Policy:- The monetary policy is a very effective toll for

controlling money supply, and is used particularly for keeping a tab on
the inflationary pressures in the economy. The main objective of the
monetary policy of any economy is to maintain the money supply in the
economy at a level which will ensure price stability, full employment
and growth in the economy. If the money supply in the economy is
more it will lead to inflation and the central bank will raise interest
rates, sell government securities through open market operations, raise
cash reserve requirement and viceversa.
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Contd…
5. Interest Rate:- High interest rates make the speculative
capital move between countries and this affects the exchange
rate. If interest rates of domestic currency are raised this will
result in more demand for domestic currency and more supply of
the foreign currency, thus making the latter cheaper.

6. Political Factors:- If a change is expected in the government

on account of elections, the exchange rates may be affected.
However, whether the currency of the country concerned will
become stronger or weaker will depend upon expected policies
to be pursued by the new government which is likely to take
over. War also affects the exchange rates of the currencies of the
country involved. Some times it affects the currencies of other
countries also.
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Contd…
7. Exchange Control:- Exchange control is generally aimed at
disallowing free movement of capital flows and it therefore
affects the exchange rates. Sometimes countries exercise control
through exchange rate mechanism by keeping the price of their
currency at an artificial level.

8. Central Bank Intervention:- Buying or selling of foreign

currency in the market by the central bank with a view to
increase the supply or demand, thereby affecting the exchange
rate is known as 'Intervention'. If a central bank is of the opinion
that local currency is becoming stronger thereby affecting the
exports, it will buy foreign currency and sell local currency. It
will increase the demand for foreign currency and the rates of
foreign currency.
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Contd…
9. Speculation:- In the foreign exchange market dealers taking
speculative positions is common. If a few big speculative operators
are buying a particular currency in a big way others may follow suit
and that currency may strength in the short run. This is popularly
known as the 'Bandwagon affect' and this affects exchange rates.

10. Tariff and Non-tariff Barriers:- Imports are restricted through

tariff and Non-tariff barriers . Tariff means duty levied by the
government on imports. When assessed on a per unit basis, tariff is
known as specific duty. But when assessed as a percentage of the
value of the imported commodity, tariff is called ad valorem duty.
When both types of tariff are charged on the same product, it is
known as compound duty. Apart from tariff, import is restricted
through non-tariff barriers.
Exchange rate
overshooting
&
J-Curve effect

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Introduction
Exchange rate overshooting:
The tendency of exchange rates to
immediately depreciate or appreciate by more
than required for long-run equilibrium, and
then partially reversing their movement as
they move toward their long-run equilibrium
levels.
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Exchange Rate Overshooting

 The exchange rate is said to overshoot when its
immediate response to a change is greater than its long
run response.
 We assume that changes in the money supply have immediate
effects on interest rates and exchange rates.
 We assume that people change their expectations about
inflation immediately after a change in the money supply.
 Overshooting helps explain why exchange rates are so
volatile.
 Overshooting occurs in the model because prices do not
adjust quickly, but expectations about prices do.
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Exchange Rate Volatility

Changes in price
levels are less
volatile, suggesting
that price levels
change slowly.

Exchange rates are

influenced by
interest rates and
expectations, which
may change rapidly,
making exchange
rates volatile.
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Overshooting Exchange Rate Model

 Money demand (L) is positively
related to income Y and negatively to
interest rate i:

 In the short run, as money supply

increases, income and price level are
constant. Consequently, interest rates
must fall to equate money demand and
money supply.
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Overshooting XR Model (cont.)

 The drop in interest rate will have a direct
effect on the exchange rate via the interest
rate parity relation:

 With the increase in money supply in

country A, prices will be expected to rise.
This higher future price will imply a higher
long run exchange rate to achieve PPP:
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Overshooting XR (cont.)
 The spot exchange rate will increase
above the long run equilibrium
exchange rate due to a need to
maintain interest parity. Over time, as
prices increase, the interest rate rises,
and the exchange rate converges to its
new equilibrium level.
 Refer to Figure 18.2
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THE J-CURVE
 Investors should expect a greater return from
private equity than from public equity
investments due to illiquidity and a long-term
commitment.
 In contrast to public equity, private equity
investments initially have negative returns and
accumulated negative net cash flows for a
relatively long time period, which investors have
to bear in mind when setting up a new
programmed or approving new investments.
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Contd…
 Due to the characteristics of the return and cash flow
profile, this pattern is called the J-Curve, which
illustrates the tendency of private equity funds to
deliver negative returns and cash flows in the early
years and investment gains and positive cash flows
later in the investment fund’s life as the portfolio
companies mature and are gradually exited.

 Plotting the fall and then rise of net exports over time
in response to a fall in the real exchange rate produces
a graph that might resemble the letter J, hence the J
Curve
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Contd…

The J Curve Effect is the term used to

describe the impact of currency
devaluation on a country’s balance of
trade.
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THE J - CURVE
39

Net Trade balance

change Currency improves
in trade depreciation
balance

0 TIME

Trade balance
initially deteriorates
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J-Curve Hypothesis

 Devaluation of a currency deteriorates the

trade balance condition in the short run
because imports can not decrease and export
cannot increase immediately.

 However over time adjustments will take

place so that exports increase and imports
can decrease
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The J Curve

 Suppose that oil is the foreign good, If the price of

foreign oil rises, the real exchange rate falls. Even
though we import fewer barrels of oil, the real value
of that oil (in terms of domestic output units) can
rise.

 This leads to the paradoxical result that net exports

can (initially) fall when exports become relatively
cheaper After a time, when the home country can
better substitute for the more expensive foreign
good, net exports are more likely to rise.
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