Foreign Exchange market & international Parity Relations
Foreign Exchange market &
international parity relations.
FOREIGN EXCHANGE MARKET
The Foreign Exchange Market is the framework of
individuals, firms, banks and brokers who buy and sell
Foreign exchange markets tend to be located in national financial
centers near the local financial markets.
There are main three types of transactions undertaken in these
foreign exchange markets:
1. Spot Transactions Currencies or bank deposits are exchanged
immediately (two day settlement period).Spot rate is the price
quote at which you can buy immediately.
2. Forward deals
Currencies or bank deposits are
exchanged at a set date in the future.
Investors sign a contract for a given
quantity of currency and exchange
rate. At future date, actual exchange
takes place at rate known as forward
PLAYERS IN THE FOREIGN
Foreign Exchange- money denominated in the
currency of another nation or group of nations.
1. Deposits, credits, and balances payable in any foreign
2. Drafts, travellers cheques, letters of credits or bills of
exchange, expressed or drawn in Indian currency but
payable in any foreign currency and Vice Versa.
FOREIGN EXCHANGE RATE
-The price of a currency
An exchange rate is the rate at which one currency
can be exchanged for another.
In other words, it is the value of another country's
currency compared to that of your own.
Theoretically, identical assets should sell at the same
price in different countries, because the exchange
rate must maintain the inherent value of one
currency against the other
TYPES OF CURRENCY
Hard currency:- It is usually fully convertible and
strong or relatively stable in value in comparison with
Exotic currency:- It is currency of a developing country
and is often unstable, weak and unpredictable.
There are five main players in this global arena...
The United States (USD)
The European Union (EURO)
Great Britain (GBP)
Exchange Rate Quotations
An exchange rate quotation is given by stating the number of
units of "term currency" or "price currency" that can be
bought in terms of 1 unit currency (also called
Quotations can be of two types:-
1. Direct quotation (1 foreign currency = x home currency)
2. Indirect quotation (1 home currency = x foreign currency )
Role of Central Banks
The central Banks controls the policies that effects
the value of currencies.
It involves buying and selling of home currency and
foreign currencies with a view of ensuring that
exchange rates move in line with established
targets of governments.
Arbitrage is the practice of taking
advantage of a state of imbalance
between two or more markets. A person
who engages in arbitrage is called an
arbitrageur. The arbitrageur exploits the
imbalance that is present in the market
by making a couple of matching deals in
different markets, with the profit being
the difference between the market
Example of an Arbitrage
Suppose that an iPhone is selling for $800 in the US and
for £500 in the UK. For simplicity sake, let us assume
that the current exchange rate is £1 = $2. A simple
conversion will tell us that an iPhone is worth more in
the UK, since £500 = $1,000, which is more than $800.
With the presence of such mispricing, an investor can
seek to take advantage of such a situation by adopting
the following strategy:
1) Buy an iPhone in the US for $800.
2) Sell it in the UK for £500.
3) Convert £500 into $1,000.
This simple strategy will help yield an arbitrage profit of
$1,000 - $800 = $200 per iPhone. Therefore, if one were
to follow this strategy for 500 iPhones, the profit would
be a whopping 500 x $200 = $100,000.
Triangular arbitrage is in similar to the iPhone
example given above
exploiting the mispricing that exists in the market.
But what exactly is triangular arbitrage? Basically,
triangular arbitrage is the act of exploiting an
arbitrage opportunity resulting from a pricing
discrepancy among three differentcurrencies
in theforeign exchange market. A typical triangular
arbitrage strategy involves three trades:
1) Exchanging the initial currency for a second
2) Trading second currency for a third
3) and the third currency for the initial.
Nominal exchange Rate
When we say that $1=Rs. 40 we are
talking about nominal exchange rate.
This is the rate at which you can
Now that we understand what is
“Nominal” exchange rate, let’s
understand what “Real” exchange
rate is all about…
To understand this let’s consider an
Let’s say the nominal exchange rates
between the currencies of US & India are in
the ratio of 1:40.
This means that $1 = Rs. 40.
Now let’s say the cost of a McDonald’s
Burger in the US is $1 .
This means that for a US resident earning
in US dollars, the cost of the Burger in
India should be Rs. 40.
Now suppose the rate of inflation in
India is 10% while the rate of
inflation in US is 0%. Due to this, the
cost of the Burger in India would
actually be equal to Rs (40x1.1) =
Rs. 44. Therefore, although the US
resident can buy Rs. 40 for $1, he
cannot purchase the Burger for $1 in
Real Exchange rate
By the same token, the Burger becomes more
expensive for an Indian resident too even
though the nominal exchange rate does not
change. This is because, although $1 is still
equal to Rs 40, an Indian resident needs Rs. 44
to purchase the same Burger. Thus this
exchange rate, which is in the ratio of 1:44,
gets impacted by inflation from the perspective
of purchase of products. This is known as the
“Real Exchange Rate”.
Economic theories of exchange
Exchange rates are determined by the
demand and supply of one currency
relative to the demand and supply of
another Price and exchange rates:
Law of One Price
Purchasing Power Parity (PPP)
Money supply and price inflation
Interest rates and exchange rates
Investor psychology and “Bandwagon”
Law of one price
In competitive markets free of
transportation costs and trade barriers,
identical products sold in different
countries must sell for the same price
when their price is expressed in terms of
the same currency
Example: US/French exchange rate: $1
= .78Eur A jacket selling for $50 in New
York should retail for 39.24Eur in Paris
Purchasing Power Parity
It claims that a change in relative inflation between two
countries must cause a change in exchange rates in order
to keep the prices of goods in two countries fairly similar.
If the domestic inflation rate is lower than that in the
foreign country, the domestic currency should be stronger
than that of the foreign country.
To understand the interrelationship between
interest rates and exchange rates, two key finance
theories are used:
1. The Fisher Effect: The nominal interest rate r in a
country is determined by the real interest rate R
and the inflation rate i as follows:
(1+r) = (1+R)(1+i)
2. International Fisher Effect (IFE): The IFE
implies that the currency of the country with the
lower interest rate will strengthen in the future.
For any two countries the spot exchange rate
should change in an equal amount but in the
opposite direction to the difference in nominal
interest rates between the two countries
Money supply and inflation
PPP theory predicts that changes in
relative prices will result in a change in
a. A country with high inflation should
expect its currency to depreciate against
the currency of a country with a lower
b. Inflation occurs when the money
supply increases faster than output
Investor psychology and
Evidence suggests that neither PPP
nor the International Fisher Effect are
good at explaining short term
movements in exchange rates
Explanation may be investor
psychology and the bandwagon effect
a. Studies suggest they play a major
role in short term movements
b. Hard to predict
Other Factors In Exchange Rate
Technical Factors like release of Economic
Statistics, seasonal demand for a currency etc.
Social factors like terrorist attacks, scandals and a
swelling budget deficit