Lecture 14 – Foreign ExchangeMarket
What Are Foreign Exchange Rates?
How Is the Foreign Exchange RateDetermined?
Exchange rate
•Rupee devaluation may up banks non-interest income (The Nation August 04, 2009)
•“the depreciation of rupee will have positive impact forexploration and production, IPPs, textile whereas it will haveneutral to positive impact on banks, cement and fertilizer andnegative on chemical sector”
•Rupee depreciated more than 38% from the start of 2008 tilltoday
•Rupee’s devaluation: Senate shows concern; Govt to controlprice hike [Wed, May 14, 2008]
A foreign exchange market
•A foreign exchange market is market wherefunds are converted from one currency toanother
•A foreign exchange rate is the price of onecurrency in terms of another
Why are foreign exchangeimportant
•Exchange rates affect the relative price ofdomestic and foreign goods.
•Had imported a laptop for $500 dollars in2007, it would have cost you Rs.60000(60x500)
•If you import it now assuming that the price ofthe laptop has not changed, it would cost youRs.41500 because the exchange rate of rupeehas depreciated to Rs.83 a dolloar
•When a country’s currency appreciates,
–the country’s goods abroad become moreexpensive
–and foreign goods in that country become cheaper
•Conversely, when a country’s currencydepreciates,
–its goods abroad become cheaper and foreigngoods in that country
–become more expensive.
Why are foreign exchangeimportant
•Appreciation of a currency:
– can make it harder for domestic manufacturers tosell their goods abroad
–and can increase competition at home fromforeign goods,
How Is the Foreign Exchange RateDetermined?
How Does the Foreign ExchangeMarket Work?
•Foreign exchange market is not a centralized market
•It works like an over-the-counter market
•When you want to convert rupee into dollars, simplygo foreign exchange company, an individual ininformal market, or a bank that specializes incurrency business
•When you want to convert large amount of rupeesinto other currencies, open an account with bank oran exchange company, the bank or the company willtrade to buy the required currency for you
How Is the Foreign Exchange RateDetermined?
•To understand exchange rate determination,the concept of “law of one price” is helpful
•Law of one price states that if two countriesproduce an identical good, and transportationcosts and trade barriers are very low, the priceof the good should be the same
Example of one price
•Suppose a 40 k.g bale of Pakistani-cotton is available forRs. 3000 whereas similar bale of Chines-cotton isavailable for CNY.6000
•For one price to maintain, one CNY should be equal to0.5 rupees or one rupee should be equal to 2 CNY
•If the exchange rate of CNY to one rupee jumps to 4,chines-cotton will sale for Rs.1500 per k.g in Pakistan.
•No one will buy Pakistani-cotton which will create excesssupply of pakistani-cotton
•This excess supply can only be sold if exchange rate isbrought back to 2 CNY to a rupee
•One of the most prominent theories of howexchange rates are determined is the theoryof purchasing power parity (PPP).
•It states that exchange rates between any twocurrencies will adjust to reflect changes in theprice levels of the two countries.
•PPP suggests that if one country’s price levelrises relative to another’s, its currency shoulddepreciate
How Is the Foreign Exchange RateDetermined?
Purchasing power parity
•Pak-cotton = Rs.3000
•Chin-cott = CYN6000
•Parity; rupee = 2CYN
•If Pakistani cotton price increase by 10%, i.eRs. 3300, new exchange price should be
•6000/3300 = 1.8181 which is 10% less thanthe original price
Factors affecting exchange rates
•Anything that increases the demand for domestic goodsrelative to foreign goods tends to appreciate thedomestic currency
•The reason is domestic goods will continue to sell welleven when the value of the domestic currency is higher.
•Similarly, anything that increases the demand for foreign
•goods relative to domestic goods tends to depreciate thedomestic currency because domestic goods will continueto sell well only if the value of the domestic currency islower.
Factors affecting exchange rates
•There are mainly five factors that influenceexchange rates. They are:
–Domestic prices
–Trade barriers
–Import demand
–Export demand
–productivity
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