Lecture 14 – Foreign Exchange Market

What Are Foreign Exchange Rates?How Is the Foreign Exchange Rate

Determined?

Exchange rate

• Rupee devaluation may up banks non-interest income (The Nation August 04, 2009)

• “the depreciation of rupee will have positive impact for exploration and production, IPPs, textile whereas it will have neutral to positive impact on banks, cement and fertilizer and negative on chemical sector”

• Rupee depreciated more than 38% from the start of 2008 till today

• Rupee’s devaluation: Senate shows concern; Govt to control price hike [Wed, May 14, 2008]

A foreign exchange market

• A foreign exchange market is market where funds are converted from one currency to another

• A foreign exchange rate is the price of one currency in terms of another

Why are foreign exchange important

• Exchange rates affect the relative price of domestic and foreign goods.

• Had imported a laptop for $500 dollars in 2007, it would have cost you Rs.60000 (60x500)

• If you import it now assuming that the price of the laptop has not changed, it would cost you Rs.41500 because the exchange rate of rupee has depreciated to Rs.83 a dolloar

• When a country’s currency appreciates, – the country’s goods abroad become more expensive – and foreign goods in that country become cheaper

• Conversely, when a country’s currency depreciates, – its goods abroad become cheaper and foreign goods

in that country– become more expensive.

Why are foreign exchange important

• Appreciation of a currency:– can make it harder for domestic manufacturers to

sell their goods abroad– and can increase competition at home from

foreign goods,

How Is the Foreign Exchange Rate Determined?

How Does the Foreign Exchange Market 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, simply

go foreign exchange company, an individual in informal market, or a bank that specializes in currency business

• When you want to convert large amount of rupees into other currencies, open an account with bank or an exchange company, the bank or the company will trade to buy the required currency for you

How Is the Foreign Exchange Rate Determined?

• To understand exchange rate determination, the concept of “law of one price” is helpful

• Law of one price states that if two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same

Example of one price

• Suppose a 40 k.g bale of Pakistani-cotton is available for Rs. 3000 whereas similar bale of Chines-cotton is available for CNY.6000

• For one price to maintain, one CNY should be equal to 0.5 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 excess supply of pakistani-cotton

• This excess supply can only be sold if exchange rate is brought back to 2 CNY to a rupee

• One of the most prominent theories of how exchange rates are determined is the theory of purchasing power parity (PPP).

• It states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries.

• PPP suggests that if one country’s price level rises relative to another’s, its currency should depreciate

How Is the Foreign Exchange Rate Determined?

Purchasing power parity

• Pak-cotton = Rs.3000• Chin-cott = CYN6000• Parity; rupee = 2CYN• If Pakistani cotton price increase by 10%, i.e

Rs. 3300, new exchange price should be• 6000/3300 = 1.8181 which is 10% less than

the original price

Factors affecting exchange rates

• Anything that increases the demand for domestic goods relative to foreign goods tends to appreciate the domestic currency

• The reason is domestic goods will continue to sell well even 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 the

domestic currency because domestic goods will continue to sell well only if the value of the domestic currency is lower.

Factors affecting exchange rates

• There are mainly five factors that influence exchange rates. They are:– Domestic prices– Trade barriers– Import demand– Export demand– productivity

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