Exchange Rate

Introduction

The transactions in the exchange market are carried out at what are termed exchange rates. It is the price of foreign money. Thus, exchange rate may be defined as the price paid in the homes currency for a unit of foreign currency. Or more simply, rate of exchange is the prices of one national currency in terms of another. It can be quoted in two ways :

1. One unit of foreign money units of the domestic currency; or

2. A certain number of units of foreign currency to one unit of domestic
money.

For instance: I. U.S. dollar =Rs.30, or Re. 1 = U.S. 3.33 cents. It is obvious that the reversibility in the mode of quoting exchange rate does not alter the basic value of one currency in terms of another.

Exchange Rate System

Fixed Exchange Rates:

Countries following the fixed exchange rate (also known as stable exchange rate and pegged exchange rate) system agree to keep their currencies at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so.

Under the gold standard, the values of currencies were fixed in terms of gold. Until the breakdown of the Bretton Woods System in the early 1970, each member country of the IMF defined the value of its currency in terms of gold or the US dollar and agreed to maintain (to peg) the market value of its currency within ± 1 per cent of the defined (par)value. Following, the breakdown of the Bretton Woods System, some countries took to managed floating of their currencies while a number of countries still embraced the fixed exchange rate system.

Arguments for the Stable Exchange Rate System

A number of arguments have been put forward for the against each system. The important argument supporting the stable exchange rate system.

(i) Exchange rate stability is necessary for orderly development and growth of foreign trade. If exchange rate stability is not assured, exporters will be uncertain about the amount they will receive and importers will be uncertain about the amount they will have to pay. Such uncertainties and the associated risks adversely affect foreign
trade. A great advantage of the fixed exchange rate system is that it eliminates the possibilities of such uncertainties and risks.

(ii) Especially the developing countries, which have a persistant balance of payment deficits, should necessarily adopt the stable exchange rate system to prevent continuous depreciation of the external value of their currencies.

(iii) Exchange rate stability is necessary to attract foreign capital investment as foreigners will not be interested to invest in a country with an unstable currency. Thus, exchange rate stability is necessary to augment resources and foster economic growth.

(iv) Unstable exchange rates may encourage the flight of capital. Exchange rate stability is necessary to prevent its outflow.

(v) A stable exchange rate system eliminates speculation in the foreign exchange market.

(vi) A stable exchange rate system is a necessary condition for the successful functioning of regional groupings and arrangements among nations.

Must see:- Foreign-exchange-market

Flexible Exchange rates 

Under the flexible exchange rate system, exchange rates are freely determined in an open market primarily by private dealings, and they like other market princes, vary from day-to-day. Under the flexible exchange rate system, the first impact of any tendency toward a surplus or deficit in the balance of payments is on the exchange rate. A surplus in the balance of payments will create an excess demand for the country's currency and the exchange rate will tend to rise. 

On the other hand, a deficit in the balance of payments will give rise to an excess supply of the country's currency and the exchange rate will, hence, tend to fall. 

Automatic variations in the exchange rates, in accordance with the variations in the balance of payments position, tend to automatically restore the balance of payments equilibrium. A surplus in the balance of payments increases the exchange rate. This makes foreign goods cheaper in terms of domestic currency and domestic goods more expensive in terms of the foreign currency. This, in turn, encourages, imports and discourages exports, resulting in the restoration of the balance of payments equilibrium. On the other hand if there is a payments deficit, the exchange rate falls and this makes domestic goods cheaper in terms of the foreign currency and foreign goods more expensive in terms of the domestic currency. This encourages exports, discourages imports and thus helps to establish the balance of payments equilibrium. 

A number of economists, however, point out that certain serious problems are associated with the system of flexible exchange rates. 

1. Flexible exchange rates present a situation of instability, creating uncertainty and confusion. Friedman disputes this view and argues that a flexible exchange rate need not be an unstable exchange rate need not be an ustable exchange rate. If it is it is primarily because there is underlying instability in the economic conditions governing international trade. And a rigid exchange rate may, while itself remaining nominally stable, perpetuate and accentuate other elements of instability in the economy. 

2. The system of flexible exchange rates, with its associated uncertainties, makes it impossible for exporters and importers to be certain about the price they will have to pay or receive for foreign exchange. This will have a dampening effect on foreign trade. Under flexible exchange rates, there will be widespread speculation which will speculation a destabilishing effect. Against this, it is argued that normally has a stabilishing influence on exchange rates.

Spot and Forward Exchange Rates 

Spot rate of exchange refers to the price of foreign exchange in terms of domestic money payable for the immediate delivery of a particular foreign currency. It is, thus a day-to-day rate. On the other hand, forward rate of exchange refers to the price at which a transaction will be consummated at some specified time in the future. A forward exchange market functions side by side with a spot exchange market. The transactions of forward exchange market are known as forward exchange transactions which simply involve purchase or sale of a foreign currency for delivery at some time in the future; the rates at which these transaction are, therefore, called forward rates. Forward exchange rate is determined at the time of sale but the payment is not made until the 

exchange is delivered by the seller. Forward rates are usually quoted on the basis of a discount or premium over or under the spot rate of exchange; thus forward rates may be expressed as a percentage deviation from the sport rates. To illustrate the point suppose an Indian citizen buys goods from America worth $100, payable in 3 months. The 'spot rate' (i.e. rate prevailing at the time of purchase) is Rs.37.50 = $1. In order to avoid exchange risk, he may enter into a forward contract in the forward exchange market to buy $100 three months'forward at a rate agreed on now – the forward rate. If the rate agreed on is 50 paise at a discount then the buyer shall have to pay at the rate of Rs.37=$1. If the rate is fixed at 50 paise at a premium then he shall have to pay whatever, may be the fluctuations in exchange rate in the future, he knows now what he will have to pay for $100. Thus, forward exchange rates enable exporters and importers of goods to know the prices of their goods which they are about to export or import. Thus, in general, the process of covering exchange risks in the forward market is simply a way of eliminating uncertainties of spot rate fluctuations from time to time.

Foreign Exchange Risks, Hedging, and 

Speculation

Foreign Exchange Risks 

 Through time, a nation's demand and supply curves for foreign exchange shift, causing the spot (and the forward) rate to vary frequently. A nation's demand and supply curves for foreign exchange shift over time as a result of changes in tastes for domestic and foreign products in the nation and abroad, different growth and inflation rates in different nations, changes in relatives rates of interest, changing expectations, and so on.

Hedging 

The fact that exchange rates can change makes people take different views of foreign currencies. Some people do not want to have to gamble on what exchange rates will hold in the future and want to keep their assets in their home currency alone. Others, thinking they have a good idea of what will happen to exchange rates, would be quite willing to gamble by holding a "foreign" currency, one different from the currency in which they will ultimately buy consumer goods and services. These two attitudes have been personified into the concepts of hedgers and speculators, as though individual persons were always one or the other, even though the same person can choose to behave like a hedger in some cases and like a speculator in others. 

Hedging against an asset, here a currency, is the act of making sure that you have neither a net asset nor a net liability position in that asset.

Speculation 

Speculation is the opposite of hedging. Whereas a hedger seeks to cover a foreign exchange risk, a speculator accepts and even seeks out a foreign exchange risk, or an open position, in the hope of making a profit. If the speculator correctly anticipates future changes in spot rates, he or she makes a profit; otherwise, he or she incurs loss. As in the case of hedging, speculation can take place in the spot, forward futures, or options markets – usually in the forward marker. We begin by examining speculation in the spot market. If a speculator believes that the spot rate of a particular foreign currency will rise he or she can purchase the currency now and hold it on deposit in the bank for resale later. If the speculator is correct and the spot rate does indeed rise, he or she earns a profit on each unit of the foreign currency equal to the spread between the previous lower spot rate at which he or she purchased' the foreign currency and the higher subsequent spot rate at which he or she resells it. If the speculator is wrong and the spot rate falls instead, he or she incurs a loss because the foreign currency must be resold at a price lower than the purchase price.

Speculation can be stabilizing or destabilizing. Stabilizing speculation refers to the purchase of a foreign currency when the domestic price of the foreign currency (i.e., the exchange rate) falls or is low, in the expectation that it will soon rise, thus leading to a profit. Or it refers to the sale of the foreign currency when the exchange rate rises or is high, in the expectation that it will soon fall. Stabilizing speculation moderates fluctuations in exchange rates over time and performs a useful function.On the other hand, destabilizing speculation refers to the sale of a foreign currency when the exchange rate-falls or is low, in the expectation that it will fall even lower in the future, or the purchase of a foreign currency when the exchange rate is rising or is high, in the expectation that it will rise even higher in the future. Destabilizing speculation thus magnifies exchange rate fluctuations over time and can prove very disruptive to the international flow of trade and investment.