Exchange rate theories

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Exchange rate theories

  1. 1. EXCHANGE RATE THEORIES TRADITIONAL APPROACH ( ALSO CALLED THE TRADE OR ELASTICITIES APPROACH) : •BASED ON FLOW OF GOODS & SERVICES. •ASSUMES AN EQUILIBRIUM EXCHANGE RATE WHERE THE IMPORTS BALANCES THE EXPORTS OF THE COUNTRY. •IF AT ANY POINT OF TIME THE IMPORTS EXCEEDS THE EXPORTS (TRADE DEFICIT) THEN THE EXCHANGE RATE WILL FALL, WHICH IN OTHER WORDS MEANS – THE DOMESTIC CURRENCY WILL DEPRECIATE.
  2. 2. EXCHANGE RATE THEORIES IN SUCH A SITUATION, THE COUNTRIES EXPORTS WILL BE CHEAPER TO FOREIGNERS AND IMPORTS WILL BE COSTLIER FOR RESIDENTS. THE RESULT IS THAT THE NATIONS EXPORTS TEND TO RISE AND THE IMPORTS TEND TO FALL TILL THE BALANCE IN RESTORED. THE SPEED OF THE ADJUSTMENT WILL DEPEND UPON THE DEGREE OF RESPONSIVENESS OF THE TRADE TOWARDS CHANGES IN PRICE.
  3. 3. EXCHANGE RATE THEORIES ASSUMING A FULL EMPLOYMENT PHASE IN THE NATION, IT IS ADVISED THAT THE DOMESTIC RESOURCES OF THE NATION BE SHIFTED TOWARDS PRODUCTION OF EXPORT ORIENTED GOODS AND SERVICES.
  4. 4. EXCHANGE RATE THEORIES PURCHASING POWER PARITY : ONE OF THE MOST CONTROVERSIAL THEORIES. BASED ON INFLATION EXCHANGE RATE RELATIONSHIP. IN ITS ABSOLUTE FORM IT IS ALSO CALLED “LAW OF ONE PRICE”.
  5. 5. EXCHANGE RATE THEORIES THIS THEORY SUGGESTS THAT THE PRICE OF SIMILAR PRODUCTS OF TWO DIFFERENT COUNTRIES SHOULD BE EQUAL, IF THEY ARE MEASURED IN A COMMON CURRENCY. IF, THERE EXISTS ANY DIFFERENCE THEN THE DEMAND SHOULD SHIFT FROM ONE COUNTRY TO ANOTHER IN SUCH A WAY THAT THE PRICES WILL HAVE TO CONVERGE.
  6. 6. EXAMPLE SUPPOSE, A PRODUCT OF THE SAME QUALITY AND SIZE IS PRODUCED BOTH BY INDIA AND CHINA. AS PER THE THEORY, IF MEASURED IN A COMMON CURRENCY THE PRICE OF THE PRODUCT IN INDIA WILL BE EQUAL TO THAT IN CHINA. IF THE PRICE, IN CHINA, IS LOWER THAN THAT IN INDIA, THEN DEMAND FOR THE PRODUCT WILL INCREASE IN CHINA AND DECREASE IN INDIA.
  7. 7. EXAMPLE DECREASE IN DEMAND, WILL ULTIMATELY LEAD TO DECREASE IN PRICE IN INDIA TILL THEY EQUATE EACH OTHER. REALISTICALLY, THIS THEORY IN ITS ABSOLUTE FORM DOES NOT ACTUALLY HAPPEN BECAUSE OF MARKET IMPERFECTIONS BROUGHT ABOUT BY DIFFERENT LEVELS OF TECHNOLOGY, COST OF PRODUCTION, TAXATION SCHEMES, TRANSPORTATION COSTS ETC.
  8. 8. RELATIVE FORM OF PPP IT IS AN ALTERNATE VERSION OF PPP AND IT DOES ACCOUNT FOR THE IMPERFECTIONS THAT MAY EXIST IN THE MARKET. THIS FORM OF THE THEORY, ACKNOWLEDGES THE FACT THAT PRICES OF SIMILAR PRODUCTS OF DIFFERENT COUNTRIES WILL NOT NECESSARILY BE THE SAME, EVEN IF MEASURED IN A COMMON CURRENCY.
  9. 9. RELATIVE FORM OF PPP HOWEVER, IT STATES THAT THE RATE OF CHANGE IN THE PRICES OF SIMILAR PRODUCTS IN DIFFERENT COUNTRIES WILL BE SOMEWHAT SIMILAR, WHEN MEASURED IN A COMMON CURRENCY. HERE, THE ASSUMPTION IS THAT THE TRANSPORTATION COSTS AND OTHER TRADE BARRIERS REMAINS CONSTANT.
  10. 10. RELATIVE FORM OF PPP ASSUME THAT THE TWO COUNTRIES HAVE ZERO INFLATION AND THE CURRENT INTER COUNTRY TRADE OR THE EXCHANGE RATE BETWEEN THE TWO COUNTRIES IS IN EQUILIBRIUM. WITH THE PASSAGE OF TIME BOTH THE COUNTRIES WILL EXPERIENCE SOME INFLATION AND THE EXCHANGE RATE OR TRADE BETWEEN THE TWO COUNTRIES WILL AUTOMATICALLY ADJUST ITSELF IN SUCH A MANNER SO THAT THE DIFFERENCE IN THE RATE OF INFLATION WILL BE OFFSET. IN SUCH A SITUATION THE PRICES OF THE PRODUCTS IN THE TWO COUNTRIES WILL APPEAR SIMILAR TO ITS CITIZENS.
  11. 11. RELATIVE FORM OF PPP THIS WILL MEAN THAT THE CONSUMERS WILL NOTE VERY LITTLE DIFFERENCE IN THEIR PURCHASING POWER WHEN COMAPARED BETWEEN THE TWO COUNTRIES. CONCLUSION OF THE RELATIVE FORM OF PPP IS THAT THE CHANGE IN THE EXCHANGE RATES IS EQUAL TO THE DIFFERNCE IN INFLATION RATES WHICH ALMOST NEUTRALISES THE EFFECT OF EACH OTHER.
  12. 12. WHY PPP DOES NOT HOLD GOOD ? EXCHANGE RATES ARE ALSO AFFECTED BY FACTORS OTHER THAN THE INFLATION DIFFERENTIAL. THEY MAY BE INCOME LEVEL, GOVT.CONTROLS OR INTEREST RATE. ASSUME THE INFLATION RATE IN INDIA TO BE 5% ABOVE TO THAT OF JAPAN. BASED ON THIS INFORMATION THE PPP WOULD SUGGEST THAT THE INR SHOULD DEPRECIATE BY 5% AGAINST THE JAPANESE YEN.
  13. 13. WHY PPP DOES NOT HOLD GOOD ? NOW IF THE INDIAN GOVT. HAS IMPOSED RESTRICTIONS ON IMPORTS FROM JAPAN THEN THE INDIAN CONSUMERS AND FIRMS WILL NOT BE ABLE TO ADJUST THEIR SPENDING IN REACTION TO THE INFLATION DIFFERENTIAL. THEREFORE, THE EXCHANGE RATE WILL NOT ADJUST ITSELF IN REACTION TO DIFFERENCE IN INFLATION RATES.
  14. 14. WHY PPP DOES NOT HOLD GOOD ? IN THE EARLY 90’S MANY EUROPEAN COUNTRIES HAD HIGHER INFLATION THAN THE U.S., YET THE CURRENCIES OF THESE COUNTRIES DID NOT DEPRECIATE AGSINT THE DOLLAR. THIS WAS BECAUSE OF THE FACT THAT VERY HIGH INTEREST RATES IN THESE COUNTRIES ATTRACTED LARGE CAPITAL FLOWS FROM THE U.S. INVESTORS THUS DEFYING THE THEORY OF PPP.
  15. 15. WHY PPP DOES NOT HOLD GOOD ? IN THE SAME PERIOD HONGKONG, SINGAPORE AND SOUTH KOREA HAD QUIET HIGHER INFLATION RATES THAN THE U.S. BUT THEIR CURRENCIES DID NOT DEPRECIATE AGAINST THE DOLLAR BECAUSE OF THE GOVERNMENTAL POLICY OF THE U.S. TO CAPITALISE IN THE VIRGIN MARKETS OF THESE PLACES. VERY EARLY STAGES OF THE ACC – THIS WAS ONE OF THE REASONS FOR FIXED ADOPTING FIXED EXCHANGE RATE SYSTEM.
  16. 16. WHY PPP DOES NOT HOLD GOOD ? THE PPP SUGGESTS THAT AS SOON AS THE PRICES BECOME RELATIVELY HIGHER IN ONE COUNTRY, THE OTHER COUNTRY WILL DISCONTINUE IMPORTING FROM THAT COUNTRY AND WILL SHIFT TO DOMESTIC RESOURCES. HERE, IT SHOULD BE POINTED OUT THAT IT IS NOT NECESSARY THAT THERE WILL BE DOMESTIC RESOURCES AVAILABLE IN QUALITY AND QUANTITY.
  17. 17. WHY PPP DOES NOT HOLD GOOD ? HOWEVER, IT SHOULD BE UNDERSTOOD THAT IN A LONG RUN OF OBSERVATIONS, IT HAS BEEN FOUND THAT THE EXCHANGE RATES HAVE BEEN AFFECTED BY MANY MORE FACTORS AND AT DIFFERENT INTENSITY LEVELS. THESE AFFECTING FACTORS HAVE ACTUALLY OFFSET THE IMPACT OF EACH OTHER IN THE LONG RUN. THUS, IT IS CONCLUDED THAT THE CONTROVERSIES OF THE PPP THEORY HAVE ALWAYS STOOD THEIR GROUND IN THE SHORT RUN . IN OTHER WORDS THE PPP DOES HOLD GOOD IN THE LONG RUN.
  18. 18. CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 - 89 COUNTRY INFLATION RATIO TO USA CHANGE IN VALUE OF CURRENCY AUSTRALIA 4.4 1.6 1.8 AUSTRIA 2.1 0.8 0.7 CANADA 3.2 1.1 1.2 FRANCE 3.3 1.2 1.4
  19. 19. CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 - 89 COUNTRY INFLATION RATIO TO USA CHANGE IN VALUE OF CURRENCY GERMANY 1.7 0.6 0.7 GREECE 14.4 5.1 5.3 ITALY 4.9 1.8 2.4 JAPAN 2.2 0.8 0.5
  20. 20. CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 – 89 COUNTRY INFLATION RATIO TO USA CHANGE IN VALUE OF CURRENCY KOREA 5.8 2.1 1.7 SWEDEN 3.7 1.3 1.5 SWITZERLAND 1.7 0.6 0.5 UK 4.9 1.8 1.5
  21. 21. CHANGE IN INFLATION AND CURRENCY VALUE VIZ THE USA 1973 – 89 COUNTRY INFLATION RATIO TO USA CHANGE IN VALUE OF CURRENCY TURKEY 278 99.3 151.6
  22. 22. INTEREST RATE PARITY(IRP) THIS THEORY PROVIDES A LINKAGE BETWEEN THE FOREIGN EXCHANGE MARKET AND THE INTERNATIONAL MONEY MARKETS. CONCLUDING OBSERVATION OF THE THEORY THE DIFFERENCE IN THE NATIONAL INTEREST RATES ON SECURITIES WITH SIMILAR RISK & MATURITY SHOULD BE EQUAL TO, BUT OPPOSITE IN SIGN, TO THE FORWARD DISCOUNT OR PREMIUM FOR A FOREIGN CURRENCY.
  23. 23. EXAMPLE OF (IRP) Assume that an investor has $1000. Now, if the investor chooses to invest in a dollar money market instrument, he would earn the dollar based rate of interest. He may however, choose to invest in a Swiss Franc money market instrument, which would naturally be of the same risk profile and same maturity period and thus earn returns as per the Francs based rate of interest.
  24. 24. EXAMPLE OF (IRP) To do this he would be required to exchange the Dollars for Francs at the spot rate of exchange, then invest the Francs in a Franc money market instrument. Next, if he wants to avoid any risk of change in the exchange rate, he would enter into a forward transaction to sell the Francs ( period being the period of the investment). At the end of the Forward transaction period he would convert the resulting proceed back to Dollars.
  25. 25. EXAMPLE OF (IRP) Assume that the returns he would have got, if he had directly invested in a Dollar based money market instrument is $ 200, thereby making the amount to be $1200. The final outcome of investment he actually made in Franc based money market (finally converted in to Dollars) is also $1200(assume).
  26. 26. EXAMPLE OF (IRP) In such a situation, it seems that the return in terms of Dollars are equal between the two alternative money market investments. Here, the Spot & Forward rates are said to be at Interest rate parity. The transaction is called “Covered” as because the exchange rate for converting the Francs back to Dollars are locked by the forward transaction.
  27. 27. EXAMPLE OF (IRP) Therefore, if the result of the two alternatives is equal, it will be found that the difference in the interest rates of the two separate money markets is actually offset by the difference in the Spot and Forward exchange rates.IRP EXAMPLE.xlsx
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