This document discusses factors that influence foreign exchange rates, including both short-term and long-term determinants. It also covers theories of exchange rate determination such as purchasing power parity and interest rate parity. Finally, it provides background on Bangladesh's history with exchange rates, transitioning from pegged rates to a floating rate system in the early 2000s.

1. Balance of Payments and Foreign
Exchange
International Business
Lecture 2b

2. Factors of International Business
• Production of Goods and Services
• Routes, Roads and Transportation System
• Technological Development
• Development of Monetary and Exchange
System
• Advertising world wide

3. • Today we want to talk about national
monetary system before we discuss
international monetary system
• And influence and determination of Exchange
Rate

4. Exchange System

5. Foreign Exchange Rate
Foreign exchange rates (the price of one
country’s currency in terms of another’s) are
important because they affect the price of
domestically produced goods sold abroad and
the cost of foreign goods bought domestically.

6. Factors Affecting Exchange Rate –Long
Run
• The theory of purchasing power parity
suggests that long-run changes in the
exchange rate between two countries’
currencies are determined by changes in the
relative price levels in the two countries.
• Other factors that affect exchange rates in the
long run are tariffs and quotas, import
demand, export demand, and productivity.

7. Determinants of Exchange Rate –
Short Run
3. In the short run, exchange rates are determined by
changes in the relative expected return on domestic
assets, which cause the demand curve to shift.
Any factor that changes the relative expected return on
domestic assets will lead to changes in the exchange
rate.
Such factors include changes in the interest rates
on domestic and foreign assets as well as changes in
any of the factors that affect the long-run exchange
rate and hence the expected future exchange rate.

8. Determinants of Exchange Rate
4. The asset market approach to exchange rate
determination can explain both the volatility of
exchange rates and the rise of the dollar in the 1980–
1984 period and its subsequent fall.
5. Forecasts of foreign exchange rates are very valuable
to managers of financial institutions because
these rates influence decisions about which assets
denominated in foreign currencies the institutions
should hold and what kinds of trades should be made
by their traders in the foreign exchange market.

9. Absolute Purchasing Power Parity
In short, exchange rate between two countries is
equal to the ratio of price levels of them. This is
absolute Purchasing Power Parity (PPP) theory, which
may be denoted by,

10. Relative Purchasing Power Parity
• The absolute PPP was ultimately revised to
relative PPP theory, which asserts that
percentage change in exchange rate between
two countries is equal to the difference of
percentage changes in their price level,

11. • %Δe = %ΔPd -%ΔPf
• Or,
• When π is inflation rate
• %Δe = π d - πf
• Note that inflation is the percentage changes in prices

12. Fisher Effect
• Fisher Effect, named after Irving Fisher, states
that nominal interest rates in each country are
equal to the required real rate of return plus
compensation for expected inflation.
• i = r + π
• i$ = r$ + π$ , i¥ = r¥ + π¥
•
• i= nominal interest rate, r = real interest rate
and π is the expected inflation

13. • International Fisher Effect or Fisher-Open
states that the spot exchange rate should
change in an amount equal to but in opposite
direction of the difference in interest rates
between two countries.
i$-i¥ = r$ + π$ - r¥ - π¥ = π$ - π¥ =
100x (S t-1 - S t)/ S t .... (approx.)

14. Bangladesh History of FE Rate
• Immediately before Independence Pakistani Rupee was pegged
with Pound Sterling. Up to December 31, 1971 £1=Rs. 13.33
• From January 1, 1972 £1 = Tk. 18.98. Pegged to a single currency,
namely Pound Sterling.
• May, 1975£1 = Tk.30
• Since 1976 Re-fixed 18 occasions during 26 April 1976- 13 August
1979
• August 1979 Pegged to multiple currencies, i.e., Trade Weighted
Basket Method, 4 Currencies: £, $, DM, ¥. £ being intervention
currency
• 11 January 1983 Trade Weighted Basket Method with 6 currencies,
Intervention currency US $.
• July 1989Trade Weighted Basket Method with 10 currencies
• 1990 Single Rate, Trade Weighted Basket, daily monitoring through
calculation of REER to maintain purchasing power parity.

15. • From 1971 to 1990 multiple exchange rates were allowed (Export benefits
like, Export Bonus Scheme, XPL, XPB, Home Remittance Scheme etc.)
• 1983 a pegged to a basket policy: through monitoring REER, calculated on
the basis of a basket containing currencies of 10/15 countries.
• Up to 31 December 1991, a Secondary Exchange Market existed
• The SEM rate and the Official rates have been unified from 1 January,
1992.
• Since 17 July, 1993, first step towards currency convertibility was taken.
• Convertibility on current transactions was adopted in July 1993.
• Forex rates were used to be calculated everyday on the basis of previous
day’s REER of the 15 currencies, dollar being the intervention currency.
Convertibility on capital accounts is not under consideration.
• Bangladesh Taka was floated since May 2003 without any trouble.

16. What’s in the Balance-of-Payments
• Three sub-accounts: Current Account, Capital
and Financial Account, Net errors and
omissions
Transactions Within the Current Account
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© Mojmir Mrak
Accounts?
Page 16
 Merchandise
Trade
 Services
 Income receipts:
 Income derived from ownership of
assets, such as dividends on
holdings of stock and interest on
 Transfers securities

17. Transactions Within the Capital and
• Classification of transactions according to the
5th Edition of the Balance of Payments
Manual (characteristics of transactions)
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© Mojmir Mrak
Financial Account
Page 17
 Capital Account:
 Capital transfers
 Transfer of title to fixed assets, debt forgiveness, etc.
 Financial Account:
 Direct Investment:
 At least a ten percentage share of the foreign investor in the capital
of the economic subject the foreign investor invested in

18. Transactions Within the Capital and
 Financial Account(continued):
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© Mojmir Mrak
Financial Account
Page 18
 Portfolio investment:
 Less than ten percent share of the foreign investor
 Other investment:
 Trade credits and all other types of long-term and short-term
borrowing abroad (except securities), including IMF credits and bank
credits
 International monetary reserves:
 Foreign assets under the control of the central bank
 Monetary gold
 SDR assets
 Reserve position of the country in the IMF

19.  Complete recording of transactions is impossible
 Errors and omissions reflect the statistical discrepancy of recording
the BOP transactions:
 Difference between recorded credit statements and recorded debit
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© Mojmir Mrak
Errors and Omissions
Page 19
statements
 Reasons for errors and omissions:
 Incomplete recording of transactions between residents and non-residents
 Tax evasion
 Time discrepancy between the occurrence of the transaction and its
settlement
 Unregistered international merchandise trade
 Incomplete data about the “escape of capital” and about the financial
transactions in offshore centers

20. 5. What Are Balance-of-Payments
• Sum of the BOP statements is always zero :
– Autonomous transactions:
• Goals unrelated to the balance of payments
– Accommodating (compensatory) transactions:
• Finance the difference between autonomous credits and
autonomous debits in BOP
– Autonomous credits > autonomous debits: surplus
International Finance
© Mojmir Mrak
Surpluses and Deficits?
Page 20
Which
transactions
are
autonomous?
Merchandise trade balance
Current account balance
Basic balance
Overall balance

21. BOP of Bangladesh FY 02 FY 03 FY 04 FY 05
Bangladesh BOP
Trade Balance -1768 -2207 -2319 -3297
Exports, fob (including EPZ) 1/ 5929 6492 7521 8573
Imports, cif (including EPZ) 2/ -7697 -8699 -9840 -11870
Services (net) -499 -688 874 -870
Income (net) -319 -195 -374 -641
Current transfers 2826 3418 3743 4290
Current Account Balance 240 328 176 -518
Capital account (net) 410 392 196 163
Capital transfers 410 392 196 163
Financial account 71 302 78 744
Direct investment 65 92 385 540
Portfolio investment -6 2 6 0
Other investment 12 208 -313 204
Errors and omissions -356 -123 -279 -228
OVERALL BALANCE 365 899 171 161
Reserve Assets -365 -899 -171 -161

22. CONVENTIONS IN
FOREIGN
EXCHANGE
MARKET

23. (1)Quoting Wall Street Journal
Argentina (Peso) 0.9900 1.0100
Country Buying Selling
Bid Ask (Offer)
(2) Digits Four after decimal
(3)Three letters
Exchange Name US Dollar USD
Bangladeshi Tk. BDT
Indian Rs. INR
Pakistani Rs. PKR

24. (4) Quotation System Price /Direct
Quotation
Indirect Quotation
In Dhaka
Price/Direct Quotation:
1 USD = BDT 60.0000
Indirect Quotation:
1 BDT= USD 0.0167 or 0.0166

25. 5. Notation
e /$ =Taka per USD
eY /$ =Yen per USD
6. Spread
Ask - Bid
Sell - Buy
7. Points (PiP)
1 USD = IRS 57.3005 Ask
= IRS 57.3000 Bid
___________
0.0005 5 points

26. 8. Cross Rate
Bid Ask
Spot NPR/USD 49.4000 49.5000
INR/USD 31.3500 31.4500
Cross INR/NPS 31.3500/49.5000 31.45/49.4000
= 0.6333 = 0.6366
Cross NPS/INR 49.4000/31.4500 49.5000/31.35
=1.5707 = 1.5789
(Others Bid divided by own Ask; Others Ask divided
by own Bid)

27. 9. Value date/Delivery date
• Bank Note  Travelers Demand
 Spread is high
 Value date : Immediate
Spot Market  Spot Rate
 Value date 1 or 2 days
 Spread very low
•  Largest Market
•  Open 24 hours
•  2/3 months transaction is equal to NYSE’s
one day

28. Forward Market
• (Contacted today for the exchange of currencies at a specified date
in the future)
 1, 2, 3, 4, 6, 9, 12 months
 Value date + 1/2 days
 No forecasting
 No Speculation
 Ensure supply of currency later
• Forward Premium Forward Rate  Spot Rate
• Forward Discount Forward Rate  Spot Rate
• Forward Flat Forward Rate = Spot Rate