Exchange Rate Mechanism (ERM) Exchange Rate and Types

1. Exchange Rate Mechanism (ERM)
&
Exchange Rate and Types
Prepared by:
Mr. Mohammed Jasir PV
Asst. Professor
MIIMS, Puthanangadi
Contact: 9605 69 32 66

2. Topics
• Exchange Rate Mechanism (ERM)
• Exchange Rate and Types

3. Exchange Rate Mechanism (ERM)
• It is part of monetary policy and used by central banks
• ERM is a device used to manage a country's currency exchange rate
relative to other currencies
• It can be employed if a country utilizes either a fixed exchange rate or
one with floating exchange rate that is bounded around its peg (known as
an adjustable peg or crawling peg)

4. The Basics of the Exchange Rate Mechanism (ERM)
• An exchange rate mechanism is not a new concept
• Most new currencies started as a fixed exchange mechanism that tracked
gold or a widely traded commodity
• It is loosely based on fixed exchange rate margins, whereby exchange rates
fluctuate within certain margins
• An upper and lower bound interval allows a currency to experience some
variability without sacrificing liquidity or drawing additional economic risks
• The concept of currency exchange rate mechanisms is also referred to as a
semi-pegged currency system

5. Real World Example of the European ERM
• Most notable ERM in Europe in the late 1970s
• The European Economic Community introduced the ERM in 1979
• As a part of the European Monetary System
• To reduce exchange rate variability (1 currency)
• To avoid any problems with price discovery
• The ERM came in 1992 when Britain (withdrew from the treaty)
• British pound deviating by more than 6%

6. Real World Example of the European ERM
• The most notable exchange rate mechanism happened in Europe during the late
1970s.
• The European Economic Community introduced the ERM in 1979, as part of
the European Monetary System, to reduce exchange rate variability and achieve
stability before member countries moved to a single currency.
• It was designed to normalize exchange rates between countries before they
were integrated in order to avoid any problems with price discovery.
• The exchange rate mechanisms came to a head in 1992 when Britain, a member
of the European ERM, withdrew from the treaty.
• The British government initially entered the agreement to prevent the British
pound and other member currencies from deviating by more than 6%

7. What is an 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
• Eg- US $ 1 = Rs. 75.48

8. Types of Exchange Rates
1. Fixed Exchange Rate
2. Floating/Flexible Exchange Rate
3. Managed Float

9. 1. Fixed Exchange Rate

10. 1. Fixed Exchange Rate
• Hard Peg / Rigid Peg
• This is where a Government maintains a given exchange rate over a
period of time
• This could be for a few months or even years
• In order to maintain the exchange rate at the stated level
government uses fiscal and monetary policies to control aggregate
demand

11. Merits of Fixed Exchange Rate
• Exchange Rate Stability
• Promotes Capital Movements
• Prevents Capital Outflow
• Prevents Speculation in Foreign Exchange Market
• Promotes economic integration of the world
• Promotes growth of internal money and capital markets

12. Demerits of fixed exchange rate
• Discourage Foreign Investment
• Monetary Dependence
• Cost-Price Relationship not Reflected
• Conflict with other objectives
• Less Flexibility
• Join at the Wrong Rate
• Current Account Imbalances

13. 2. Floating exchange rate

14. 2. Floating exchange rate
• A floating exchange rate is where the rate of exchange is determined
purely by the demand and supply of that currency on the foreign
exchange market

15. 3. Managed Float

16. 3. Managed Float
• This is where the currency is broadly managed by the forces of
demand and supply
• But the government takes action to influence the rate of change in
the exchange rate

17. Spot and Forward Exchange Rate
• Spot Exchange Rate Transactions
• The Spot Market

18. Spot Exchange Rate
• A spot exchange rate is the price to exchange one currency for another
for immediate delivery
• It represent the prices buyers pay in one currency to purchase a second
currency
• The spot exchange rate is the price paid to sell one currency for another
for delivery on the earliest possible value date for most spot
transactions is two business days after the transaction date
• Spot date is : T+2 days, where ‘T’ refers to the trading day
• Usually, spot transactions in the interbank market involve large
transactions
• 43% of total Forex Transactions

19. Spot Exchange Rate
• Definition:
– The spot exchange rate is the amount one currency will trade for
another today
– In other words, it’s the price a person would have to pay in one
currency to buy another currency today
– You could also think of it as today’s rate that one currency can be
traded with another

20. What Does Spot Exchange Rate Mean?
• It’s the way foreign exchange rates are expressed as the foreign currency
per unit of the domestic currency or vice versa, enabling investors to
equate the price of a good or a service in a common currency
• Usually, spot transactions in the interbank market involve large
transactions, whose bank settlement takes place on the second following
business day
• Spot transactions account for 43% of the total foreign exchange
transactions

21. • Thus, the foreign exchange spot market is prone to fluctuations and high volatility,
especially in the short-term.
• As speculators often create noise around a currency, they affect the exchange rate.
• In cases that the foreign exchange spot market fluctuates sharply, the government
sometimes intervenes to adjust interest rates or to make transactions in the
domestic currency, so their country isn’t put in a trading disadvantage with other
countries. Sometimes this is referred to as currency manipulation.

22. • The spot rate is the price at which a currency, security, or commodity can be
acquired. Spot rates are settlement prices of spot contracts.
• A spot contract is a contract of buying or selling stocks on the spot date.
• Spot date is : T+2 days, where ‘T’ refers to the trading day.
• So, if a spot contract is executed at a price today, it would be delivered to
the investor two business days after the trade date. And the price at which
the contact got executed would be considered as the spot rate.

23. • Example
• A U.S. multinational imports textile from Bangladesh and Pakistan. The company is
required to pay 5 billion Bangladeshi Taka to the company from Bangladesh and 11
billion Pakistani Rupee to the company from Pakistan, today. Jonathan, who works
in the accounting department, uses today’s exchange rate to convert the
Bangladeshi Taka and the Pakistani Rupee in US dollars.
• 1 Bangladeshi Taka = 0.013 US Dollar, therefore 5 billion Bangladeshi Taka =
5,000,000 x 0.013 = $65,000
• 1 Pakistani Rupee = 0.0095 US Dollar, therefore 11 billion Pakistani Rupee =
11,000,000 x 0.0095 = $104,500
• Therefore, the U.S. multinational has to sell $65,000 to pay its supplier from
Bangladesh and $104,500 to pay its supplier from Pakistan.

24. Spot Market
• The spot market is where financial instruments, such as commodities,
currencies and securities, are traded for immediate delivery
• Delivery is the exchange of cash for the financial instrument
• A futures contract, on the other hand, is based on the delivery of the
underlying asset at a future date

25. Spot Exchange Rate Transactions
• For most spot foreign exchange transactions, the settlement date is two business
days after the transaction date
• The most common exception to the rule is the U.S. dollar vs. the Canadian dollar,
which settles on the next business day
• Weekends and holidays mean that two business days is often far more than two
calendar days, especially during the Christmas and Easter holiday season

26. Forward Exchange Rate /Forward rate / Forward Price
• A forward rate is a rate applicable to a financial transaction that will take place
in the future
• It is the exchange rate at which a bank agrees to exchange one currency for
another at a future date when it enters into a forward contract with an investor
• Multinational corporations, banks, and other financial institutions enter into
forward contracts to take advantage of the forward rate for hedging purposes

27. Forward Exchange Rate
• Forward rates are based on the spot rate, adjusted for the cost of carry and
refer to the rate that will be used to deliver a currency, bond or commodity at
some future time.
• It may also refer to the rate fixed for a future financial obligation, such as the
interest rate on a loan payment.

28. Thank You