INTER-RELATIONSHIP OF VARIABLES AFFECTING EXCHANGE RATES

Interest rate, inflation rates, forward margins, exchange rates and expectation across nations are inter-related as shown in the diagram below.

The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.

The expected difference in inflation rates between two countries equals, in equilibrium, the expected movement in spot rates. The forward rate for a given period, say 6 months, should equal the spot rate 6 months hence. The difference between the forward rate and the present spot represents the interest element for the period of the forward rate. In reality, the future spot rate would usually be higher or lower than the forward rate.

Exchange rate movements overtime are influenced by various factors not only those mentioned above but also by market imperfections arising out of official intervention in markets, exchange control restrictions, custom barriers, etc.

EXCHANGE RATE QUOTES

Every firm and individual operating in international environment is concerned with foreign exchange i.e, the exchange of foreign currency into domestic currency and vice-a-versa. Generally, the firm's foreign operations earn income denominated in some foreign currency, however, the shareholders expect payment in domestic currency and therefore, the firm must convert the foreign currency into domestic currency.

The foreign exchange transaction (i.e, for the sale and purchase of foreign currencies) takes place in foreign exchange market, which provides a mechanism for transfer of purchasing power from one currency to another. This market is not a physical entity like the Mumbai Stock Exchange or a trading center; rather it is network of telephones among banks, foreign exchange dealers and brokers etc.

For example, a trader in Delhi may buy foreign exchange, say U.S. $, from a bank in Mumbai for making payment to a U.S. supplier against the purchases made. The bank in Mumbai, in turn may purchase the U.S. $ from a New York bank, which in turn may purchase from some other bank in New York itself or at some other center and so on. As the foreign exchange market provides transactions in a continuous manner for a large number and volume of sales and purchases, this market is an efficient one. Minute differences in exchange rates at different center may get eliminated without time lag.

In the foreign exchange market, the price of any currency may be quoted in terms of several currencies. It is important to realize that every price or exchange rate is relative. For example, if U.S. $ is worth Rs. 44, then it also implies that Re. 1 is worth $ 1/44. All foreign exchange rates in this way are related to each other in a reciprocal way. In other words, the value of $/Re. is just the reciprocal of the value of Re./$.

Quotations in the foreign exchange market are generally made in terms of local currency or the domestic currency in terms of per unit of a foreign currency. For example, the exchange rates of Re. in India may be quoted in terms of $, say Re./$ = Rs.44/$. It means that one $ is worth Rs.44. A change in price of one currency implies, therefore, a change in price of the other currency that appears in the quote. For example, if the price of Re. against the $ moves from Rs.44/$ to Rs.43.5/$, one can say that Re. has appreciated relative to $ by Re. 0.50. This is the same as saying that $ has depreciated relative to the Re.

There are two major ways of offering exchange rate quotes. There are called the direct quote and indirect quote. These quotes are given after the exchange value has been established according to the practice being followed by a country. If the country follows a fixed rate of parity between its currency and a foreign currency, then the changes in parity value of that currency shall determine changes in the value of the domestic currency vis-a-vis other foreign currencies. These performances of the domestic economy is not reflected in the valuation of its currency. This is one extreme side of absolute rigidity in fixation of exchange data. The other extreme is allowing the exchange value of the national currency to float independently according to market forces without any intervention from the Central Bank. In between these two extremes, there are many intermediate arrangements for determination of exchange values...