Module - 3 : Exchange rate determination and forecasting – Setting the equilibrium spot exchange rate – theories of exchange rate determination – exchange rate forecasting.

2. Module - 3:
Exchange rate determination and forecasting – Setting
the equilibrium spot exchange rate, – theories of
exchange rate determination – exchange rate
forecasting.

3. In finance, an exchange rate (also known as a foreign-
exchange rate, forex rate, ER, FX rate or Agio) between two
currencies is the rate at which one currency will be
exchanged for another. It is also regarded as the value of one
country's currency in relation to another currency.
“Conversion rate of one currency into another. This rate
depends on the local demand for foreign currencies and their
local supply, country's trade balance, strength of its economy,
and other such factors.”
MEANING & DEFINITION OF EXCHANGE RATE

4. KEY FACTORS INFLUENCING THE EXCHANGE RATE

5. Foreign Exchange rate (ForEx rate) is one of the most
important means through which a country’s relative level of
economic health is determined. A country's foreign exchange
rate provides a window to its economic stability, which is why
it is constantly watched and analyzed. If you are thinking of
sending or receiving money from overseas, you need to keep a
keen eye on the currency exchange rates.
The exchange rate is defined as "the rate at which one
country's currency may be converted into another." It may
fluctuate daily with the changing market forces of supply and
demand of currencies from one country to another. For these
reasons; when sending or receiving money internationally, it is
important to understand what determines exchange rates.

6. 1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A
country with a lower inflation rate than another's will see an appreciation
in the value of its currency. The prices of goods and services increase at a
slower rate where the inflation is low. A country with a consistently
lower inflation rate exhibits a rising currency value while a country with
higher inflation typically sees depreciation in its currency and is usually
accompanied by higher interest rates.
2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate.
Forex rates, interest rates, and inflation are all correlated. Increases in
interest rates cause a country's currency to appreciate because higher
interest rates provide higher rates to lenders, thereby attracting more
foreign capital, which causes a rise in exchange rates.

7. 3. Country’s Current Account / Balance of Payments
A country’s current account reflects balance of trade and earnings on
foreign investment. It consists of total number of transactions including
its exports, imports, debt, etc. A deficit in current account due to
spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments
fluctuates exchange rate of its domestic currency.
4. Government Debt / Public Debt
Government debt is public debt or national debt owned by the central
government. A country with government debt is less likely to acquire
foreign capital, leading to inflation. Foreign investors will sell their
bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate
will follow.

8. 5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade
is the ratio of export prices to import prices. A country's terms of trade
improves if its exports prices rise at a greater rate than its imports prices.
This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in
an appreciation of exchange rate.
6. Political Stability & Performance
A country's political state and economic performance can affect its
currency strength. A country with less risk for political turmoil is more
attractive to foreign investors, as a result, drawing investment away from
other countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of its
domestic currency. A country with sound financial and trade policy does
not give any room for uncertainty in value of its currency. But, a country
prone to political confusions may see a depreciation in exchange rates.

9. 7. Recession: When a country experiences a recession, its interest rates
are likely to fall, decreasing its chances to acquire foreign capital. As a
result, its currency weakens in comparison to that of other countries,
therefore lowering the exchange rate.
8. Speculation: If a country's currency value is expected to rise,
investors will demand more of that currency in order to make a profit in
the near future. As a result, the value of the currency will rise due to the
increase in demand. With this increase in currency value comes a rise in
the exchange rate as well.
9. RBI Intervention: When there is too much volatility in the rupee-
dollar rates, the RBI prevents rates going out of control to protect the
domestic economy.
The RBI does this by buying dollars when the rupee appreciates too
much and by selling dollars when the rupee depreciates way too much.
The same was recently felt on June 12, 2013 when the rupee recovered
sharply from Rs. 58.95/$ level

10. Conclusion:
All of these factors determine the foreign exchange rate fluctuations. If
you send or receive money frequently, being up-to-date on these factors
will help you better evaluate the optimal time for international money
transfer. To avoid any potential falls in currency exchange rates, opt for a
locked-in exchange rate service, which will guarantee that your currency
is exchanged at the same rate despite any factors that influence an
unfavorable fluctuation.
10. Market sentiments: During turbulent markets, investors usually
prefer to park their money in safe havens such as US treasuries, Swiss
Franc, gold in order to avoid losses to their portfolios. So this flight to
safety would lead to foreign investors redeeming their investments from
India and would naturally increase the demand for dollar vis-à-vis the
Indian rupees. Remember the rupee/dollar rates during 2007 and 2008?
Even today we are seeing a lot of FIIs redeeming their investments from
emerging markets like India and are investing into US treasuries which
are currently quoting at higher yields. This has lead to Indian rupee
depreciating to Rs. 60/$.

11. EXCHANGE RATE DETERMINATION IN INDIA
In a system of flexible exchange rate, the exchange rate of a
currency (like price of a good) is freely determined by forces of
market demand and supply of foreign exchange.
Expressed graphically the Intersection of demand and the supply
curves determines the equilibrium exchange rate and equilibrium
quantity of foreign currency. This is called equilibrium in foreign
exchange market.
Let us assume that there are two countries—India and USA—and
the exchange rate of their currencies, viz., rupee and dollar are to
be determined. Presently there is floating or flexible exchange
regime in both India and USA. Therefore, the value of currency of
each country in terms of the other currency depends upon the
demand for and supply of their currencies.

12. (a) Demand for foreign exchange (currency):
Demand for foreign exchange is caused (i) to purchase abroad goods and
services by domestic residents, (ii) to purchase assets abroad, (iii) to send
gifts abroad, (iv) to invest directly in shops, factories abroad, (v) to
undertake foreign tours, (vi) to make payment of international trade, etc.
The demand for dollars varies inversely with rupee price of dollar, i.e.,
higher the price, the lower is the demand. The demand curve in Fig. 10.1
is downward sloping because there is inverse relationship between
foreign exchange rate and its demand.
(b) Supply of foreign exchange:
Supply of foreign exchange conies
(i) when foreigners purchase home country’s (say, India’s) goods and
services through our exports
(ii) when foreigners make direct investment in bonds and equity shares
of home country
(iii) when speculation causes inflow of foreign exchange
(iv) when foreign tourists come to home country

13. (c) Determination of exchange rate:
This is determined at a point where demand for and supply of foreign
exchange are equal. Graphically, intersection of demand and supply
curves determines the equilibrium exchange rate of foreign currency. At
any particular time, the rate of foreign exchange must be such at which
quantity demanded of foreign currency is equal to quantity supplied of
that currency. It is proved with the help of the following diagram. The
price on the vertical axis is stated in terms of domestic currency (i.e.,
how many rupees for one US dollar).
The horizontal axis measures quantity demanded or supplied of foreign
exchange (i.e., dollars). In this figure, demand curve is downward
sloping which shows that less foreign exchange is demanded when
exchange rate increases (i.e., inverse relationship). The reason is that rise
in the price of foreign exchange (dollar) increases the rupee cost of
foreign goods which makes them more expensive. The result is fall in
imports and demand for foreign exchange.

14. The supply curve is upward sloping which implies that supply of
foreign exchange increases as the exchange rate increases (i.e., direct
relationship). Home country’s goods (here Indian goods) become
cheaper to foreigners because rupee is depreciating in value.
As a result, demand for Indian goods increases. Thus, our exports
should increase as the exchange rate increases. This will bring greater
supply of foreign exchange. Hence, the supply of foreign exchange
increases as the exchange rate increases which proves the slope of
supply curve.
In the Fig. 10.1, demand curve and supply curve of dollars intersect
each other at point E which implies that at exchange rate of OR (QE),
quantity demanded and supplied are equal (both being equal to OQ).
Hence, equilibrium exchange rate is OR and equilibrium quantity is
OQ.

15. (d) Change in Exchange Rate:
Suppose, exchange rate is 1 dollar = Rs 50. An increase in India’s
demand for US dollars, supply remaining the same, will cause the
demand curve DD shift to D’D’. The resulting intersection will be at a
higher exchange rate, i.e., exchange rate (price of dollar in terms of
rupees) will rise from OR to OR, (say, 1 dollar = 52 rupees). It shows
depreciation of Indian currency (rupees) because more rupees (say, 52
instead of 50) are required to buy 1 US dollar. Thus, depreciation of
currency means a fall in the price of home currency.
Likewise, an increase in supply of US dollar will cause supply curve SS
shift to S’S’ and as a result exchange rate will fall from OR to OR2. It
indicates appreciation of Indian currency (rupees) because cost of US
dollar in terms of rupees has now fallen, say, 1 dollar = Rs 48, i.e., less
rupees are required to buy 1 US dollar or now Rs 48 instead of Rs 50 can
buy 1 dollar. Thus, appreciation of currency means ‘a rise in the price of
home currency’.

16. Note:
Appreciation = increase in value
of exchange rate
Depreciation / devaluation =
decrease in value of exchange
rate.

17. EXCHANGE RATE FORECASTING
– The Economic Times
How are exchange rates determined?
Exchange rates between currencies can be either controlled as in the case
of India prior to the reforms or left to the market to decide, as is the case
now in India.
In the case of controlled exchange rates, it is quite obvious that the
government would fix them, so the question really boils down to what is
the process by which markets determine rates.
The increase in dollar value is due
to the widening gap in trade
deficit, high oil prices and FIIs
pulling out money.

18. The process is really not different in its essentials from the way any
market functions. The supply and demand for different goods
determine what their prices are. In this case, substitute currencies for
goods. Lets take the case of one foreign currency to understand how
this market works.
Thus, the dollar-rupee exchange rate will depend on how the demand-
supply balance moves. When the demand for dollars in India rises and
supply does not rise correspondingly, each dollar will cost more
rupees to buy.
The supply of dollars comes from several sources. One obvious
source is Indian exporters of goods and services who sell their wares
in the international market for dollars. Another important source is
Indian immigrant workers abroad who repatriate money to their kin at
home.

19. The third major source is investments by foreign individuals,
companies or institutions in India. This could be in the form of
foreign direct investment where they are using the money to create
some assets in India or to buy into the equity of an existing company.
It could also be in the form of portfolio investments where dollars are
being brought in to buy assets in the stock markets, for instance, with
the purpose of selling these assets when they appreciate in value to
book a profit. While all these forms contribute to the supply of
dollars, it should be obvious that the last of them portfolio investment
is a relatively uncertain source, since it necessarily implies an exit of
dollars at some point.
That explains why such flows of capital from abroad are often
described as hot flows, since they can move out very rapidly. Foreign
tourists visiting India would also contribute to the inflow of dollars.

20. Just as exporters earn dollars, importers spend them. Imports
are thus the most important source of demand for dollars.
Another major source of demand is individuals or companies
repatriating incomes or profits to their home countries.
This would include portfolio investors as well as Indian
branches of multinationals sending back some of their profits
to the parent company as dividends.
A third source would be Indians investing abroad, whether as
firms or as individuals. Besides this, of course, the forex you
buy when you travel abroad is also adding to the demand for
dollars.
As you can see, the factors that contribute to the demand for
dollars are mirror images of those that add to their supply.

21. What can the RBI do about it?
With hundreds of billions of dollars in its reserves, the RBI would
seem to have the ability to be a major factor in how the dollar
moves.
If, for instance, it were to dump a huge amount of dollars in the
market, it could dramatically add to the supply and hence reduce
the price. There are at least two major reasons why central banks
are reluctant to do this.
First, they do not like to interfere too much with market valuation
of currencies, though they do try and contain excessive volatility.
Second, every time the RBI sells dollars, it buys up rupees, thus
sucking some liquidity out of the system. Given the current
liquidity crunch, that is obviously not something it would be very
keen to do.

22. EXCHANGE RATE FORECASTING
Where - the rates are determined
independently by market
supply/demand variations, so there
is no monopoly of a country,
institution or bank that can decide
the rates. In some countries with
fixed rate (like China), the rate is
determined by the central bank
according to its related currency
(the USD in the example with
China).
How - The exchange rates of the
currency pairs always fluctuate
because of more reasons.

23. The first one is because of the supply/demand law as to the goods
from the market. Imagine that a company has produced 1 million
mobile phones and there are 4 million people ready to buy them. The
demand for such mobile phones is too high, so it is obvious that the
price will increase to a point when only 1 million will be able to pay
for it. In another situation, imagine that the company produces the
same million of mobile phones, but there are only 200 000 people
wanting to buy such a product. In the last case the offer is too high, so
the price will be reduced so that more people will want to buy it and
the company doesn't waste its resources and energy.
Keeping these examples in mind, you can also apply them in the
Forex. Some of the currencies are more attractive because of the
economic situation at a given moment in a given country. For
example, if the US economy today shows some positive statistics, the
US dollar will become more valuable, and the pairs where it is the
base currency (USD/YYY) will go up, while the pairs where it is the
quote currency (YYY/USD) will go down.

24. The second reason why the currency pairs do fluctuate is because
of the Purchasing Power Parity. In simple words, if the price is
fluctuating, it will also influence the currency pair. The meaning
of this factor is as follows: under equal circumstances, the change
in the ratio of currency exchange rates between two countries is
proportional to the ratio between the prices of domestic and
overseas prices. For example, consider the fact that 1 EUR = 1
USD: if the X product in the USA is 1 dollar, in Europe it should
be 1 euro. If tomorrow our X product in the USA gets more
expensive, to 1.50 dollars, while in Europe it remains the same,
then it means the value of the dollar decreases and the exchange
rate will be 1.50 dollars for 1 euro.

26. WHY THE SUPPLY/DEMAND CHANGES?
1. Economic state - this is the most significant economic factor, which
depends on the following sub-factors: the growth rate of the economy,
changes in the tax system, unemployment and employment, economic
condition and the level of stability of the country as a whole.
2. The relative interest rates - The change in relative interest rates is a
prerequisite for a change in investors' confidence in the currency. This
may entail changes in the growth of confidence in a particular
currency.
3. The demand and supply of capital, influencing the exchange rates.
4. Political changes - any instability in the country could significantly
shake the price level, not only within the country but also around the
world.
5. The market sentiment.
6. Natural factors. This includes any natural disasters and other
natural phenomena, which have a significant impact on the global
economy.

27. SETTING THE EQUILIBRIUM SPOT EXCHANGE RATE
Foreign exchange markets are among the largest markets in the world
with an annual trading volume in excess of $160 trillion. It is an over-
the-counter market, with no central trading location and no set hours of
trading. Prices and other terms of trade are determined by computerized
negotiation. There are three markets for foreign exchange:
•Spot market - deals with currency for immediate delivery (within one
or two business days)
•Forward market - involves the future (one, three or six months from
today) delivery of foreign currency
•Currency futures and options market - deals in contract to hedge
against future changes in foreign exchange rates.

29. THEORIES OF EXCHANGE RATE DETERMINATION –
EXCHANGE RATE FORECASTING.
The main economic theories found in the foreign exchange
deal with parity conditions. A parity condition is an economic
explanation of the price at which two currencies should be
exchanged, based on factors such as inflation and interest
rates. The economic theories suggest that when the parity
condition does not hold, an arbitrage opportunity exists for
market participants. However, arbitrage opportunities, as in
many other markets, are quickly discovered and eliminated
before even giving the individual investor an opportunity to
capitalize on them. Other theories are based on economic
factors such as trade, capital flows and the way a country runs
its operations.

30. Purchasing Power Parity: Purchasing Power Parity (PPP) is the economic
theory that price levels between two countries should be equivalent to one
another after exchange-rate adjustment. The basis of this theory is the law of
one price, where the cost of an identical good should be the same around the
world. Based on the theory, if there is a large difference in price between two
countries for the same product after exchange rate adjustment, an arbitrage
opportunity is created, because the product can be obtained from the country
that sells it for the lowest price. The relative version of PPP is as follows:
Where 'e' represents the rate of change in the exchange rate and 'π1' and
'π2'represent the rates of inflation for country 1 and country 2, respectively.
For example, if the inflation rate for country XYZ is 10% and the inflation for
country ABC is 5%, then ABC's currency should appreciate 4.76% against that
of XYZ.

31. Interest Rate Parity: The concept of Interest Rate Parity
(IRP) is similar to PPP, in that it suggests that for there to be
no arbitrage opportunities, two assets in two different
countries should have similar interest rates, as long as the risk
for each is the same. The basis for this parity is also the law of
one price, in that the purchase of one investment asset in one
country should yield the same return as the exact same asset in
another country; otherwise exchange rates would have to
adjust to make up for the difference.
Where 'F' represents the forward exchange rate; 'S' represents
the spot exchange rate; 'i1' represents the interest rate in
country 1; and 'i2' represents the interest rate in country 2.

32. International Fisher Effect: The International Fisher Effect
(IFE) theory suggests that the exchange rate between two
countries should change by an amount similar to the difference
between their nominal interest rates. If the nominal rate in one
country is lower than another, the currency of the country with
the lower nominal rate should appreciate against the higher
rate country by the same amount.
Where 'e' represents the rate of change in the exchange rate
and 'i1' and 'i2'represent the rates of inflation for country 1 and
country 2, respectively.

33. Balance of Payments Theory: A country's balance of payments is
comprised of two segments - the current account and the capital account
- which measure the inflows and outflows of goods and capital for a
country. The balance of payments theory looks at the current account,
which is the account dealing with trade of tangible goods, to get an idea
of exchange-rate directions.
If a country is running a large current account surplus or deficit, it is a
sign that a country's exchange rate is out of equilibrium. To bring the
current account back into equilibrium, the exchange rate will need to
adjust over time. If a country is running a large deficit (more imports
than exports), the domestic currency will depreciate. On the other hand, a
surplus would lead to currency appreciation.
Where BCA represents the current account balance; BKA represents the
capital account balance; and BRA represents the reserves account
balance.

34. Real Interest Rate Differentiation Model: The Real Interest Rate
Differential Model simply suggests that countries with higher real
interest rates will see their currencies appreciate against countries with
lower interest rates. The reason for this is that investors around the world
will move their money to countries with higher real rates to earn higher
returns, which bids up the price of the higher real rate currency.
Asset Market Model: The Asset Market Model looks at the inflow of
money into a country by foreign investors for the purpose of purchasing
assets such as stocks, bonds and other financial instruments. If a country
is seeing large inflows by foreign investors, the price of its currency is
expected to increase, as the domestic currency needs to be purchased by
these foreign investors. This theory considers the capital account of the
balance of trade compared to the current account in the prior theory. This
model has gained more acceptance as the capital accounts of countries
are starting to greatly outpace the current account as international money
flow increases.

35. Monetary Model: The Monetary Model focuses on a country's
monetary policy to help determine the exchange rate. A country's
monetary policy deals with the money supply of that country, which is
determined by both the interest rate set by central banks and the amount
of money printed by the treasury. Countries that adopt a monetary policy
that rapidly grows its monetary supply will see inflationary pressure due
to the increased amount of money in circulation. This leads to a
devaluation of the currency.
These economic theories, which are based on assumptions and perfect
situations, help to illustrate the basic fundamentals of currencies and how
they are impacted by economic factors. However, the fact that there are
so many conflicting theories indicates the difficulty in any one of them
being 100% accurate in predicting currency fluctuations. Their
importance will likely vary by the different market environment, but it is
still important to know the fundamental basis behind each of the theories.

36. Economic Data: Economic theories may move currencies in the
long term, but on a shorter-term, day-to-day or week-to-week basis,
economic data has a more significant impact. It is often said the
biggest companies in the world are actually countries and that their
currency is essentially shares in that country. Economic data, such
as the latest gross domestic product (GDP) numbers, are often
considered to be like a company's latest earnings data. In the same
way that financial news and current events can affect a company's
stock price, news and information about a country can have a major
impact on the direction of that country's currency. Changes in
interest rates, inflation, unemployment, consumer confidence, GDP,
political stability etc. can all lead to extremely large gains/losses
depending on the nature of the announcement and the current state
of the country.