IB-Unit-3 BBA BVIMR 2022 Syllabus_watermark.pdf
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International Business BBA 4 as per Syllabus CBCS 2022 of Bharati Vidyapeeth (Deemed to be University)
IB-Unit-3 BBA BVIMR 2022 Syllabus_watermark.pdf
- 1. Slides Prepared by: Dr. Mahtab Alam INTERNATIONAL BUSINESS Dr. MAHTAB ALAM Assistant Professor Management Department
- 2. Slides Prepared by: Dr. Mahtab Alam UNIT -III Unit Sub Unit Unit III Foreign Exchange Market Types of Exchange Rate –Real and Nominal exchange Rate, Fixed vs. Flexible. Exchange Rate, Managing Float, Factors affecting Foreign Exchange Rate.
- 3. Slides Prepared by: Dr. Mahtab Alam Meaning of Exchange Rate An exchange rate is a rate at which one currency will be exchanged for another currency Exchange rate affects trade and the movement of money between countries
- 5. Slides Prepared by: Dr. Mahtab Alam Important Nations & their Currencies
- 6. Slides Prepared by: Dr. Mahtab Alam Foreign Exchange Foreign exchange refers to exchanging one country’s currency for another at prevailing exchange rates. The foreign exchange market, commonly referred to as the Forex or FX is the global marketplace for exchanging national currencies Currencies trade against each other as exchange rate pairs. For example, EUR/USD is a currency pair for trading the euro against the U.S. dollar and INR/USD, etc.
- 8. Slides Prepared by: Dr. Mahtab Alam Foreign Exchange Market The foreign exchange market is a system that establishes an international network allowing the buyers and sellers to carry out trade or exchange of currencies of different countries. Forex Market also known as the FX market or Currency Market. The Foreign Exchange Market is the biggest and the most liquid financial market in the whole world. Trading in OTC FX markets reached $7.5 trillion per day in April 2022
- 9. Slides Prepared by: Dr. Mahtab Alam Features of Foreign Exchange Market 1. 24-Hour Trading: The Forex market operates 24 hours a day, five days a week, with trading sessions in different time zones (Asia, Europe, and North America), allowing continuous trading across the globe. 2. OTC (Over the Counter) Market: Unlike stock exchanges, Forex trading does not occur on a centralized exchange. Instead, it operates through a global network of banks, brokers, financial institutions, and individual traders. 3. High Liquidity: The Forex market is the largest financial market in the world, with a daily trading volume exceeding $6 trillion (Highest in April 2022 with $7.51 trillion per day), offering high liquidity and ease of entering and exiting trades. 4. Currency Pairs: Currencies are traded in pairs (e.g., EUR/USD, GBP/JPY). The first currency is called the base currency, and the second one is the quote currency. The price reflects how much of the quote currency is needed to purchase one unit of the base currency. 5. Leverage: The leverage available in FX markets is one of the highest that traders and investors can find anywhere. Leverage is a loan given to an investor by their broker. With this loan, investors can increase their trade size and earn huge profits. Losses are also there and in leverage manner.
- 10. Slides Prepared by: Dr. Mahtab Alam 6. Market Participants: Participants include central banks, commercial banks, hedge funds, investment firms, corporations, and individual retail traders. These participants engage in Forex trading for purposes such as speculation, hedging, and currency exchange. 7. Market Volatility: Forex prices can be highly volatile due to economic events, geopolitical factors, interest rate changes, and other global news that can affect currency values. 8. Different Trading Instruments: Besides the standard spot market, the Forex market also offers futures, options, and forward contracts, providing different ways to speculate and hedge on currency movements. 9. Dollar is Extensively Traded: The U.S. Dollar (USD) is extensively traded in the Forex market, making it the most dominant global currency. It is involved in over 80% of all Forex transactions due to its role as the world’s primary demanded currency due to its use for global commodities like oil and gold, reinforcing its demand in international markets. 10.Low/Nil Commissions: Generally low commission charged which vary between 0.006% to 0.014%. Per round exchange. Many Forex brokers do not charge commissions, instead making money through the bid- ask spread (the difference between the buying and selling prices). Features of Foreign Exchange Market
- 11. Slides Prepared by: Dr. Mahtab Alam Source of Demand of Foreign Exchange The demand (or outflow) of foreign exchange comes from the people who need it to make payments in foreign currencies. It is demanded by the domestic residents for the following reasons: ❑ International Trade (Imports & Exports): When India imports goods and services, foreign exchange is demanded to make the payment for imports of goods and services vice versa for exports. ❑ Tourism: Foreign exchange is demanded to meet expenditures incurred in foreign tours. ❑ Unilateral Transfers Sent Abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries. ❑ Purchase of Assets in Foreign Countries: It is demanded to make payment for the purchase of assets, like land, shares, bonds, etc. in foreign countries. ❑ Repayment of loans to Foreigners: As and when we have to pay interest and repay the loans to foreign lenders, we require foreign exchange. ❑ Speculation: Demand for foreign exchange arises when people want to make gains from the appreciation of currency. ❑ Government & Central Bank Reserves: Central banks demand foreign currencies to maintain forex reserves and stabilize exchange rates.
- 12. Slides Prepared by: Dr. Mahtab Alam Participants in Forex Market
- 13. Slides Prepared by: Dr. Mahtab Alam Advantages of Forex Market
- 14. Slides Prepared by: Dr. Mahtab Alam 1. High Leverage: A forex investor can avail the facility of leverage or loan of up to 20 or 30 times of his/her capacity, for trading in the forex market. 2. International Trade: Every country has its currency and therefore, to facilitate trade activities between two countries, the forex market is essential. 3. Trading Option: The speculators or traders, the foreign exchange market is just like other financial markets where they can make money on short- term fluctuations in the currencies. 4. Flexibility: Forex market is a 24 Hour market, and there is no minimum or maximum limit of the exchange amount. It provides the flexibility of investment or exchange to the traders. 5. Hedging Risk: The forex market provides for hedging the risk of loss on currency fluctuations while carrying global business operations and trading in foreign currency. 6. Low Transaction Costs: Since brokers are not very much entertained in the forex market, the transaction cost (called as ‘spread’) charged by the dealers is reasonably low if compared to other financial markets. 7. Inflation Control: To maintain the economic stability in the country and control situations like inflation, the central bank maintains a forex reserve which consists of currencies of different countries around the world.
- 15. Slides Prepared by: Dr. Mahtab Alam Disadvantages of Forex Market 1. Leverage Risks: Leverage refers to loan in other terms. Forex market initiates the leverage of up to 20 to 30 times the investment capacity of the traders or speculators, which may even lead the loss of the entire amount of the investor. 2. Counterparty Risks: The forex is highly unregulated with no central authority for currency exchange or trading risk mitigation. Thus, it may encounter the risk of non-fulfilment of the obligations by any of the parties involved in such a contract. 3. Operational Risks: Since forex is a twenty-four hours market, it is difficult to manage its operations by humans. As a result, the traders and MNCs rely on the algorithms, and trading desks spread, respectively, to safeguard their investment in their absence. 4. Market Volatility: The Forex market can be highly volatile, especially during major economic announcements or geopolitical events. Sudden price swings can result in unexpected losses. 5. Potential for Fraud: The decentralized nature of the Forex market means that traders must be cautious when choosing brokers. Unregulated brokers or scams can expose traders to risks of fraud and loss of capital. 6. Complexity: Forex trading requires a deep understanding of market factors like interest rates, economic indicators, and global events, making it complex for beginners to navigate effectively
- 16. Slides Prepared by: Dr. Mahtab Alam Functions of foreign exchange market A foreign exchange market is the largest global financial market which performs some crucial functions. The primary functions of a forex market are as follows: 1. Transfer Function: The forex market majorly functions to exchange the currency of one country into that of another, to facilitate international trade activities. 2. Credit Function: Providing the credit facility at the time of making overseas payments through a foreign bill of exchange (Bill of exchange that is drawn in one country and is payable in another country) to its maturity or execution, is another significant function of the forex market
- 17. Slides Prepared by: Dr. Mahtab Alam 3. Hedging Function: The globally trading business entities can hedge the risk of currency fluctuations by forward contract. Here, the goods are to be delivered on a pre- determined future date and at a mutually agreed price. 4. Capital flow: The FX market supports the flow of capital between countries, which can help economies grow 5. Speculation and Profit Making: Traders and investors speculate on currency movements in order to profit from price changes. 6. Economic Stability by Central Bank Intervention: Central banks participate in the Forex market to influence the exchange rate of their currencies. Through buying or selling their currency, central banks aim to stabilize the currency value and control inflation, interest rates, or economic growth.
- 18. Slides Prepared by: Dr. Mahtab Alam Exchange Rate Formula What is the formula for calculating exchange rates? Exchange Rate = Base Currency Quote Currency For example, if you exchange 100 U.S. Dollars for 80 Euros, the exchange rate would be 1.25 Base Currency 100 USD Quote Currency 80 Euros Exchange Rate = 100/80 = 1.25
- 19. Slides Prepared by: Dr. Mahtab Alam Exchange Rate Calculation (Direct Quotation) 1. Direct Quote (Price of 1 Unit of Foreign Currency in Home Currency) Exchange Rate =Home Currency/Foreign Currency Indian Exchange Rate of INR/USD = 1/86.94 =0.015 (0.12 round off up to 2 decimal) Exchange rates represent the value of one currency relative to another. The formula depends on perspective of Country. The below mentioned example is from Indian Perspective. Data as on 18 Feb 2025
- 20. Slides Prepared by: Dr. Mahtab Alam Exchange Rate Calculation (Indirect Quotation) 2. Indirect Quote (Price of 1 Unit of Home Currency in Foreign Currency) Exchange Rate =Foreign Currency/Home Currency Indian Exchange Rate of INR/USD = 86.96/1 =1 Data as on 18 February 2025
- 21. Slides Prepared by: Dr. Mahtab Alam Exchange Rate Calculation (Cross Exchange Rate) 3. Cross Exchange Rate (Between Two Currencies Using a Common Third Currency): A cross exchange rate is the exchange rate between two currencies that are both quoted against a common third currency (usually the USD).
- 22. Slides Prepared by: Dr. Mahtab Alam ForexTrading in India Forex trading is partially restricted in India. It is not completely banned, but it is highly regulated by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) to prevent currency speculation and financial risks. ✅ Allowed: • Trading in currency pairs involving INR is allowed on recognized exchanges like NSE, BSE, and MCX-SX. 1. Permitted pairs: USD/INR, EUR/INR, GBP/INR, JPY/INR • Cross-currency pairs (EUR/USD, GBP/USD, and USD/JPY) were introduced in 2015 for trading on Indian exchanges. • Only SEBI-regulated brokers are allowed for legal forex trading in India. 🚫 Restricted/Banned: • Trading forex in the international market through foreign brokers is illegal for Indian residents under the Foreign Exchange Management Act (FEMA). • Leveraged forex trading on overseas platforms (such as using platforms like Binance, OctaFX, or Forex.com) is strictly prohibited.
- 23. Slides Prepared by: Dr. Mahtab Alam How to Start ForexTrading in India ✅ Step 1: Open a ForexTrading Account ❑ Choose a SEBI-registered forex broker like Zerodha, Angel Broking, ICICI Direct, Kotak Securities etc. ❑ Open a Demat &Trading Account linked to a bank account. ❑ Submit KYC Documents (PAN,Aadhar, Bank Proof). ✅ Step 2: Learn & Choose aTrading Platform ❑ Most brokers provide software platforms like MetaTrader 4 (MT4), MetaTrader 5 (MT5) etc. for charting, analysis, and automated trading. ✅ Step 3: FundYourTrading Account ❑ Deposit funds only in INR (Forex deposits in foreign currency are not allowed). ✅ Step 4: Choose a Currency Pair & StartTrading ❑ Buy or sell based on market analysis (Technical & Fundamental). ❑ Only trade on regulated Indian exchanges NSE, BSE, MSE (Metropolitan Stock Exchange of India). ✅ Step 5: Risk Management & Exit Strategy ❑ Use stop-loss orders to manage risk. ❑ Withdraw funds in INR only to a bank account.
- 24. Slides Prepared by: Dr. Mahtab Alam Types of Foreign Exchange Market 1. Spot Forex Market (Cash Market) : The spot market is the immediate exchange of currencies at the current exchange rate (Spot Price) on the spot. This makes up a large portion of the total forex market. Example: A company in India needs USD to import goods. They buy USD/INR at the current rate from a bank or forex dealer. 2. Forward Forex Market: The forward market involves an agreement between the buyer and seller to exchange currencies at an agreed-upon price at a set date in the future. Forward Contract is made for two reasons: To minimize the risk of loss due to adverse changes in the exchange rate (through hedging); To make a profit (through speculation). Example: An Indian exporter expects USD/INR to drop in 3 months, so they enter a forward contract with the counter party buyer to trade at today’s price after 3 months, locking in the exchange rate and avoiding future losses due to currency fluctuation.
- 25. Slides Prepared by: Dr. Mahtab Alam 3. Future & Option Forex Market : The Futures & Options (F&O) Market in forex trading consists of Futures Contracts, which are standardized agreements to buy/sell currency at a fixed price on a set date through regulated exchange such as NSE, BSE & MSE etc. a) Future Market: The futures market is similar to the forward market, in that there is an agreed price at an agreed date. It is traded in regulated exchange such as NSE through F&O (Futures & Options) segment of a Demat account. ➢A currency futures contract is legally binding, meaning that counterparties holding the contract until its expiration date must settle it at the agreed price. ➢The buyer is obligated to purchase, and the seller is obligated to deliver the specified currency on the settlement date. Example: An Indian trader expects USD/INR to rise from ₹83 to ₹85 in the next two months. They buy a USD/INR futures contract at ₹83. If USD/INR increases to ₹85 before expiry, they sell the contract for a profit of ₹2 per USD. However, if the exchange rate drops to ₹81, they incur a loss of ₹2 per USD.
- 26. Slides Prepared by: Dr. Mahtab Alam b) Options Market: The Options Market consists of standardized contracts that give investors the right, but not the obligation, to buy or sell an underlying currency at a predetermined price before a specific expiry date. In an options contract: ➢ In this, the buyer will have right but no obligation to buy or execute the contract. ➢ The buyer in an options contract is pay a premium. The premium payment allows the buyer of the option the chance not to purchase the asset on a future date if it tends to become unattractive. ➢ If the options contract holder opts not to buy the asset, the premium paid is the amount he is supposed to lose. Types of Currency Option Contracts are: ❖Call Option: Gives the right (but not obligation) to buy a specific currency at a fixed price (strike price) before expiry. ❖Put Option: Gives the right (but not obligation) to sell a specific currency at a fixed price before expiry.
- 27. Slides Prepared by: Dr. Mahtab Alam Example: An Indian importer expects the USD/INR exchange rate to rise from ₹83 to ₹85 in the next two months. To hedge against this risk, they buy a USD/INR call option at a strike price of ₹83 by paying a premium of ₹1 per USD. Possible Outcomes: ✅ If USD/INR rises to ₹85 (Favorable Outcome) The importer exercises the call option and buys USD at ₹83 instead of ₹85. Profit: ₹2 per USD (₹85 - ₹83) minus the ₹1 premium = ₹1 net profit per USD. ❌ If USD/INR falls to ₹81 (Unfavorable Outcome) The importer does not exercise the option because buying at ₹83 is more expensive than the market price of ₹81. Loss: Limited to the premium paid (₹1 per USD), as the option is not exercised.
- 28. Slides Prepared by: Dr. Mahtab Alam Arbitrage: Arbitrage refers to the simultaneous buying and selling of foreign currencies to profit from differences in exchange rates across different markets at the same time. It relies on traders' ability to capitalize on price discrepancies of currency pairs across multiple exchanges as these differences are short-lived, often lasting only a few seconds or minutes before the market corrects itself. To execute arbitrage efficiently, arbitrage traders (arbitrageurs) use advanced trading algorithms and sophisticated software to quickly detect and exploit these.
- 29. Slides Prepared by: Dr. Mahtab Alam Currency Swap: A currency swap is a financial derivative that involves the exchange of Loans (principal and interest payments) in different currencies between two parties for a predetermined period. ❑ It is commonly used by businesses, investors, and governments for International Business. ❑ It is done to hedge against exchange rate fluctuations, reduce borrowing costs, or gain access to foreign capital. ❑ The parties are essentially loaning each other money and will repay the amounts at a specified date. ❑ Banks facilitate currency swaps by acting as intermediaries, matching counterparties, structuring agreements, managing risk, and providing liquidity to ensure smooth cross-border transactions. Example: Union Bank
- 30. Slides Prepared by: Dr. Mahtab Alam The given example illustrates a currency swap between an Indian company (XYZ Ltd.) and a U.S.A company (ABC Inc.) facilitated by a Swaps Bank to reduce borrowing costs. ▪ ABC Inc. (USA) needs ₹7 crore in India but faces a high borrowing cost of 14% in India being a foreign Borrower (Indian Borrower can take at 12%). ▪ XYZ Ltd. (India) needs $1 million in USA also faces high borrowing cost of 8% in USA being a foreign Borrower (USA Borrower can take at 6%). ▪ Here ABC Inc. (USA) has taken loan of $1 million at 6% in USA (Domestic Borrower) from Lender 1 and Paid 0.25% to Swap Bank(Service Charge) and given that amount to XYZ Ltd. (India) in USA for conduct of their business on their behalf through Swap Bank ▪ Here XVZ Inc. (India) has taken loan of 7 Crore at 12% in India (Domestic Borrower) from Lender 2 and Paid 0.25% to Swap Bank(Service Charge) and given that amount to ABC Ltd. (USA) in India for conduct of their business on their behalf through Swap Bank. ▪ Swap Bank Plays a role to find the counterparties with the same amount and nation of interest and earn 0.25% from Both Parties.Swap Bank develop an agreement for both the parties to deal with pre-agreed exchange rate ($1 = ₹70) avoiding exchange rate risks and reducing borrowing costs. https://www.youtube.com/watch?v=uxF7m08cgJk
- 31. Slides Prepared by: Dr. Mahtab Alam Factor’s affecting foreign exchange market 1. Economic Indicators : Economic indicators such as inflation rates, interest rates, GDP growth, and unemployment play a vital role in the Forex market. Lower inflation and higher interest rates generally strengthen a country's currency, while strong GDP growth and low unemployment often reflect a robust economy, boosting the currency's value. 2. Political Stability and Economic Performance : Political events, government policies, and political instability can have significant effects on currency values. Countries with stable governments and low debt levels usually see stronger currencies, while political uncertainty and high debt may lead to depreciation due to reduced investor confidence. 3. Central Bank Policies and Interventions : Central banks use monetary policies (such as interest rate adjustments) and currency interventions to manage economic growth and control inflation. Interest rate hikes typically strengthen the currency, while rate cuts or interventions to manage volatility can weaken it. 4. Geopolitical Events : Geopolitical events like wars, conflicts, or economic crises create uncertainty in the market. In such situations, investors often flock to safe-haven currencies (e.g., USD, JPY), leading to a depreciation of currencies from regions affected by instability.
- 32. Slides Prepared by: Dr. Mahtab Alam Factor’s affecting foreign exchange market 5. Market Sentiment and Speculation : Traders' risk appetite and market sentiment drive speculation in the Forex market. Positive sentiment and confidence in an economy tend to strengthen a currency, while negative sentiment and global uncertainty can lead to sell-offs and currency depreciation. 6. Trade Balance and Current Account : Countries with a trade surplus tend to see their currency appreciate as foreign buyers demand their goods and currency. In contrast, a trade deficit (importing more than exporting) often weakens the currency due to increased demand for foreign currencies to pay for imports. 7. Natural Disasters and Environmental Factors : Natural disasters or environmental crises can severely disrupt a country's economy, affecting production and trade. Such events often lead to a weaker currency as economic activities slow down and investor confidence drops. 8. Commodity Prices : Countries dependent on commodity exports, such as oil, gold, or natural gas, often see their currencies fluctuate with the price of those commodities. A rise in commodity prices usually strengthens the currency of these exporting nations due to higher demand for their goods.
- 33. Slides Prepared by: Dr. Mahtab Alam Methods of Determining Exchange Rate/ Types of Exchange Rates System There are three types of exchange rate systems that are in effect in the foreign exchange market, and these are as follows:
- 34. Slides Prepared by: Dr. Mahtab Alam Fixed Exchange Rate: In this system where a country's currency value is pegged to another currency, a basket of currencies, or a commodity like gold. The central bank actively intervenes in the forex market to maintain the fixed rate. The government controls fluctuations by buying or selling foreign reserves to keep the exchange rate fixed at 40. Features 1.Stable Currency Value: The exchange rate is set and maintained by the government or central bank. 2.Central Bank Intervention: The central bank buys or sells foreign currency to maintain the fixed rate. 3.Low Exchange Rate Volatility: Reduces uncertainty in international trade and investment. 4.Foreign Reserves Requirement: Requires large foreign currency reserves to defend the fixed rate. 5.Pegged to a Standard: Often pegged to a strong currency (e.g., USD) or a commodity like gold. Over the period of time, governments may make several changes to the system due to economic, political, or global financial factors. When Govt. increases currency price, it is called Revaluation and when Govt. decreases currency price, it is called Devaluation.
- 35. Slides Prepared by: Dr. Mahtab Alam Fixed Exchange Rate System Advantages 1.Stability in Trade & Investment: Businesses and investors feel safe as they don’t have to worry about currency fluctuations. 2.Prevents Speculation: Since the exchange rate is fixed, there is less risk of sudden currency devaluation due to market speculation. 3.Controls Inflation: By fixing the currency, the government can prevent excessive inflation caused by currency depreciation. 4.Encourages Foreign Investment: Stability attracts foreign investors who prefer predictable exchange rates. 5.Promotes Economic Discipline: Governments must manage their economy wisely to maintain the fixed rate, avoiding excessive money printing. Disadvantages 1.Requires Large Forex Reserves: The central bank must hold a lot of foreign currency reserves to maintain the fixed rate. 2.No Automatic Adjustment: Unlike floating rates, fixed rates don’t adjust automatically to economic changes, causing imbalances. 3.Risk of Black Markets: If the official rate is unrealistic, people may trade currency illegally at different rates. 4.Difficulty in Crisis Management: In case of economic shocks, the government has limited flexibility to adjust the currency value. 5.Expensive to Maintain: Constant intervention (buying/selling foreign currency) can be costly for a country.
- 36. Slides Prepared by: Dr. Mahtab Alam Example-Floating Exchange Rate •Australia - AU dollar (AUD) •Canada - CA dollar (CAD) •Japan - JP yen (JPY) Flexible Exchange Rate System: In this system is where the currency’s value is determined by market forces of supply and demand without direct government intervention. It fluctuates based on trade, inflation, interest rates, and economic conditions. Features •Market-Driven – Exchange rates fluctuate based on demand and supply. •No Government Intervention – Central banks do not fix or control currency values. •Volatility – Rates can change frequently due to economic and political factors. •Self-Correcting Mechanism – Trade deficits or surpluses adjust automatically. •Influenced by Global Events – Wars, recessions, and investor sentiment impact exchange rates.
- 37. Slides Prepared by: Dr. Mahtab Alam The diagram above for floating exchange rates shows that the value of the US Dollar ($) is at e1 where Supply (S) = Demand (D) for USD. At that exchange rate (e1), the equilibrium quantity of US Dollars is Q1. It is important to note that on the Y axis the value of $ is expressed in terms of how many Euros you can buy with $1
- 38. Slides Prepared by: Dr. Mahtab Alam Flexible/floating exchange rate System (Appreciation) 80 90 80 90 USD= Currency Appreciation INR= Currency Depreciation
- 39. Slides Prepared by: Dr. Mahtab Alam Flexible/floating exchange rate System (Depreciation) 70 80 70 80 USD= Currency Depreciation INR= Currency Appreciation
- 40. Slides Prepared by: Dr. Mahtab Alam Floating Exchange Rate System Advantages & Disadvantages ✅ Advantages: 1.Automatic Adjustment: The market naturally corrects currency imbalances. 2.No Need for Forex Reserves: Governments don’t need large reserves to maintain rates. 3.Monetary Policy Independence: Central banks can focus on domestic economic policies. 4.Encourages Foreign Investment: Investors can benefit from market-driven rates. 5.Reflects Economic Strength: Currency value shows the true health of an economy. ❌ Disadvantages: 1.High Volatility: Rapid currency fluctuations can create uncertainty in trade and investment. 2.Speculation Risks: Traders may manipulate or bet on currency changes, destabilizing economies. 3.Inflation Impact: If the currency weakens, import prices rise, leading to inflation. 4.Uncertainty in Trade: Exporters and importers face unpredictable costs. 5.Can Worsen Economic Crises: A weak currency during a crisis can make economic recovery harder.
- 41. Slides Prepared by: Dr. Mahtab Alam Example Managed Exchange Rate India, Mexico,Thailand,Turkey, Sweden, Israel, and Brazil. Managed Floating Exchange Rate System: It is a system where a currency's value is primarily determined by market forces (supply & demand) but with occasional government or central bank intervention to stabilize extreme fluctuations. This system provides flexibility while preventing excessive volatility.
- 42. Slides Prepared by: Dr. Mahtab Alam Features 1.Market-Driven with Government Intervention: Currency value is determined by demand-supply but adjusted when needed. 2.Prevents Excessive Volatility: Central banks intervene to avoid extreme currency fluctuations. 3.No Fixed Pegging – Unlike a fixed system, the rate is not tied to another currency. 4.Flexibility in Economic Policies: Governments can adjust policies based on economic conditions. 5.Used by Many Countries: Most modern economies, like India, use this system for balance between control and flexibility.
- 43. Slides Prepared by: Dr. Mahtab Alam Managed Floating Exchange Rate System Advantages & Disadvantages ✅ Advantages 1.Balance Between Stability & Flexibility: Allows exchange rate adjustments while avoiding extreme fluctuations. 2.Prevents Currency Crises: Government intervention can stop rapid currency depreciation. 3.Encourages Investment & Trade: Stability attracts investors while maintaining market-driven value. 4.Less Forex Reserve Requirement: Unlike fixed rates, countries don’t need massive reserves for defense. 5.Better Inflation Control: Helps regulate inflation through interest rate adjustments. ❌ Disadvantages 1.Government Manipulation Risk: Frequent interventions may lead to economic distortions. 2.Still Subject to Speculation: Though managed, speculative attacks can still impact the currency. 3.Uncertainty in Policy Making: Frequent interventions may confuse investors and businesses. 4.Costly Interventions: Requires central banks to spend reserves in case of major fluctuations. 5.May Not Fully Reflect Market Conditions: Artificial adjustments can create long-term imbalances.
- 44. Slides Prepared by: Dr. Mahtab Alam Difference Between Fixed, Flexible and Floating Exchange Rate Basis Fixed Exchange Rate Flexible Exchange Rate Managed Exchange Rate Definition The government or central bank fixes the exchange rate of the currency against another currency or a basket of currencies. The exchange rate is determined by market forces of supply and demand without direct government intervention. A hybrid system where the exchange rate is primarily determined by market forces, but the central bank intervenes occasionally to stabilize fluctuations. Government Intervention High intervention by central bank or government to maintain a fixed rate. No intervention; the rate is determined by market demand and supply. Occasional intervention to prevent excessive fluctuations. Stability Highly stable as the rate remains fixed. Volatile as it fluctuates with market forces. Moderately stable due to occasional intervention. Exchange Rate Determination Determined by the government or central bank. Determined by market demand and supply of currencies. Determined by market forces but influenced by central bank interventions. Changes When currency price increases, it is called Revaluation and when price decreases, it is called Devaluation. When the currency price increases, it is called appreciation, and when the price decreases, it is called depreciation. When the currency price increases due to central bank intervention, it is called "Managed Appreciation.“ and When the currency price decreases due to central bank intervention, it is called "Managed Depreciation." Speculation Risk Low, as the rate is fixed. High, as speculation can cause large fluctuations. Moderate, as interventions help curb excessive speculation. Economic Impact Provides certainty for international trade but may cause trade imbalances. Encourages adjustments in trade balance but may create instability. Balances stability and flexibility, allowing some adjustments while avoiding extreme volatility. Examples Bahrain, Hong Kong, Saudi Arabia (pegged to USD) USA, Canada, Japan India, China , Sweden, Israel etc.
- 45. Slides Prepared by: Dr. Mahtab Alam Difference Between Nominal Exchange Rate and Real Exchange Rate
- 46. Slides Prepared by: Dr. Mahtab Alam Real Exchange Rate The real exchange rate (RER) is a related concept to Purchasing Power Parity (PPP) & Inflation. It calculates, for example, how much quantity of Goods in country A is equal to the Same Goods in country B. The Real Exchange Rate (RER) shows the true value of one currency compared to another by adjusting for price differences (inflation) between countries. It helps measure how much goods and services in one country cost relative to another. ❑ Higher RER (More than 1) means foreign goods are more expensive than domestic ❑ Lower RER (Less than 1) means foreign goods are more Cheaper than domestic
- 47. Slides Prepared by: Dr. Mahtab Alam A simple example will better clarify this concept. Suppose you are American and planning a trip, and you have to choose between Europe and the U.S.A and Purchasing Parity on Hotel Room Prices is to be adjusted with nominal exchange rate • Nominal Exchange Rate = 1 USD = 0.75 EUR • Price of a hotel room in the U.S.A = 180 USD • Price of a hotel room in Europe = 80 EUR Formula Real Exchange Rate (RER) RER < 1, this indicates that European hotels are cheaper than U.S. hotels.
- 48. Slides Prepared by: Dr. Mahtab Alam No, in Real Exchange Rate (RER) calculations, we don’t need to compute a new exchange rate for every individual item. Instead, the RER is typically calculated using price indices (like the Consumer Price Index, CPI represents an average price level across multiple goods and services.) rather than single product prices. Do we need to calculate every time Real Exchange Rate (RER) for every new item?
- 49. Slides Prepared by: Dr. Mahtab Alam Basis Nominal Exchange Rate Real Exchange Rate Definition Shows how much of one currency is needed to buy another currency. Shows how much of a country’s goods and services can be bought with foreign currency. Formula Effect of Inflation Does not consider inflation. Adjusts for inflation to reflect true purchasing power. Purpose Used for currency conversion and foreign exchange transactions. Used to compare the actual purchasing power of currencies and assess competitiveness. Stability More volatile as it changes frequently with market demand and supply. More stable as it reflects long-term price level changes. Example If 1 USD = 80 INR, this is the nominal exchange rate. If inflation in India is higher than in the U.S., the real exchange rate may indicate that 1 USD should be worth more than 80 INR. Difference Between Nominal Exchange Rate and Real Exchange Rate
- 50. Slides Prepared by: Dr. Mahtab Alam Exchange Rate System in India 1. Fixed exchange rate system a Gold Standard (1870-1914) ❑ The Gold Standard was a fixed exchange rate system used between 1870 and 1914, where currencies were directly linked to a specific amount of gold. This meant that each country’s currency had a fixed value in terms of gold, and exchange rates were determined on the basis of quantity of gold offered for their currency. ❑Example of Gold Pegging ❖1 Great British Pound (GBP) = 25 ounces of gold. ❖1 U.S. Dollar (USD) = 5 ounces of gold. ❖Exchange Rate (GBP/USD) = 25/5 =5 (Means 1 GBP=5 USD) ❑ This system collapsed during the First World War (WW1) because the nation’s currency printing capacity was limited by their gold reserve, but their governments were more eager to print more money to finance the war (soldiers’ salaries, rifles, ammunition, etc.)
- 51. Slides Prepared by: Dr. Mahtab Alam 2. Fixed exchange rate system a Bretton Woods System (1946-1971) ❑ The Bretton Woods System was a fixed exchange rate system established in 1944 and implemented from 1946 to 1971. It aimed to create a stable international monetary system after World War II by pegging currencies to the U.S. Dollar (USD), which was in turn backed by gold. ❑ U.S. Dollar as the Anchor: All countries fixed their currencies to the U.S. Dollar at a set exchange rate. ❖Example: 1 British Pound (GBP) = 2.8 USD, 360 JapaneseYen (JPY)= 1 USD 4.76 Indian Rupee (INR)= 1 USD ❑ Gold Convertibility: – The U.S. promised to exchange 1 USD for 35 ounces of gold, meaning the USD was as good as gold for central banks. ❑ Robert Triffin (American Economist) warned that the Bretton Woods System would collapse because gold is limited, and its price would rise. People could buy gold at $35 per ounce from the U.S., sell it at a higher price in the open market, and make a profit, draining U.S. gold reserves. ❑ 1971 Nixon Shock – U.S. President Richard Nixon ended the gold convertibility of USD, due to US Gold reserve drainage and also wanted freedom to print more dollars to finance the Cold War and arms race against the USSR leading to the collapse of the system. ❑ Thus, USA shifted to “Floating Exchange System”. Eventually, most of the nations also shifted in that either floating / managed-floating system.
- 52. Slides Prepared by: Dr. Mahtab Alam 3. Pegged Regime (1971-1991) A currency peg is when a country fixes its currency’s value to another currency or a group of currencies to maintain stability in exchange rates. ❑ After the Bretton Woods system collapsed, the British pound lost value, affecting India’s currency. ❑ To prevent excessive fluctuations and devaluation, India pegged the rupee to a basket of currencies (currencies of key trading partners). ❖Initially (1971-1975):The rupee was pegged to the British pound. ❖Later (1975 onwards): It was linked to a basket of 14 currencies (USD, GBP, JPY, etc.) later reduced to 5 key currencies. Hypothetical Values Example of Pegged against 5 Currencies
- 53. Slides Prepared by: Dr. Mahtab Alam 4. Dual exchange rate policy 1991-1993 (LERMS) ❑ In 1991, India introduced the Liberalized Exchange Rate Management System (LERMS), which allowed partial convertibility of the rupee. This meant India used two exchange rates instead of one. ❖40% of foreign exchange earnings had to be converted at the official exchange rate (set by the government). ❖60% of foreign exchange earnings had to be converted at the market-based exchange rate (determined by supply and demand).
- 54. Slides Prepared by: Dr. Mahtab Alam 5. Market-Based Exchange rate Regime (1993- 1994) In the 1994 budget, 60:40 ratio was removed, and 100 percent conversion at a market-based rate was allowed for all goods and capital movements. 6. Managed Floating rate regime (1994 – till present) Indian exchange rate is based on market forces i.e., Demand and supply but RBI intervenes in the market in case of high volatility to stabilize the currency.
- 55. Slides Prepared by: Dr. Mahtab Alam Factors Determining Foreign Exchange Rate 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 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. Low Inflation rate (Home Currency will be stronger than trading Partner) High Inflation rate (Home Currency will be Weaker than trading Partner) Balance of Payments A deficit in the BOP due to spending more of its currency on importing products than it is earning through the sale of exports causes depreciation. The balance of payments fluctuates the exchange rate of its domestic currency. Exports>Imports (Home Currency will be Stronger than trading Partner) Imports>Exports (Home Currency will be Weaker than trading Partner)
- 56. Slides Prepared by: Dr. Mahtab Alam Government 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. Less Govt. Debts (Home Currency will be stronger than trading Partner) More Govt. Debts (Home Currency will be Weaker than trading Partner) Govt. Policies &Terms of Trade A trade deficit also can cause exchange rates to change. A country's terms of trade improve if its export prices rise at a greater rate than its import 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 the exchange rate. Liberal for GlobalTrade (Home Currency will be stronger than trading Partner) Rigid for GlobalTrade (Home Currency will be Weaker than trading Partner)
- 57. Slides Prepared by: Dr. Mahtab Alam 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. Political Stability & Good Performance (Home Currency will be stronger than trading Partner) Political Instability & Bad Performance (Home Currency will be Weaker than trading Partner) Interest Rate 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. High-Interest Rates (Home Currency will be stronger than trading Partner) Low-Interest Rates (Home Currency will be Weaker than trading Partner)
- 58. Slides Prepared by: Dr. Mahtab Alam Boom/Recession During a recession, a country’s interest rates are likely to fall, thus decreasing its chances to acquire foreign capital.This in turn weakens the currency of the country in question, therefore weakening the exchange rate. Boom (Home Currency will be stronger than trading Partner) Recession (Home Currency will be Weaker than trading Partner)