Foreign Currency Exchange Rate Mechanism


April 2015                                                                                     Ajit Kumar (Wisdom IAS, New Delhi)
The exchange rate—the price of one nation's currency in terms of another nation's—is a central concept in international finance. Virtually any nation's currency can be converted into the currency of any other nation, because of exchange rates and the foreign exchange market.
Foreign Exchange Markets
The current currency exchange rate mechanism has evolved over thousands of years of the world community trying with various mechanism of facilitating the trade of goods and services. Initially, the trading of goods and services was by barter system where in goods were exchanged for each other. For example, a farmer would exchange wheat grown on his farmland with cotton with another farmer. Such system had its difficulties primarily because of non-divisibility of certain goods, cost in transporting such goods for trading and difficulty in valuing of services. For example, how does a dairy farmer exchange his cattle for few liters of edible oil or one kilogram of salt? The farmer has no way to divide the cattle! Similarly, suppose wheat is grown in one part of a country and sugar is grown in another part of the country, the farmer has to travel long distances every time he has to exchange wheat for sugar. Therefore the need to have a common medium of exchange resulted in the innovation of money. People tried various commodities as the medium of exchange ranging from food items to metals. Gradually metals became more prominent medium of exchange because of their ease of transportation, divisibility, certainty of quality and universal acceptance. People started using metal coins as medium of exchange. Amongst metals, gold and silver coins were most prominent and finally gold coins became the standard means of exchange. The process of evolution of medium of exchange further progressed into development of paper currency. People would deposit gold/ silver coins with bank and get a paper promising that value of that paper at any point of time would be equal to certain number of gold coins. This system of book entry of coins against paper was the start of paper currency. With time, countries started trading across borders as they realized that everything cannot be produced in each country or cost of production of certain goods is cheaper in certain countries than others. The growth in international trade resulted in evolution of foreign exchange (FX) i.e., value of one currency of one country versus value of currency of other country. Each country has its own “brand” alongside its flag. When money is branded it is called “currency”. Whenever there is a cross-border trade, there is need to exchange one brand of money for another, and this exchange of two currencies is called “foreign exchange” or simply “forex” (FX).
The smooth functioning of international trade required a universally accepted foreign currency to settle the internal trade and a way to balance the trade imbalances amongst countries. This led to the question of determining relative value of two currencies? Different systems were tried in past to arrive at relative value of two currencies. The documented history suggests that sometime in 1870 countries agreed to value their currencies against value of currency of other country using gold as the benchmark for valuation. As per this process, central banks issue paper currency and hold equivalent amount of gold in their reserve. The value of each currency against another currency was derived from gold exchange rate. For example, if one unit of gold is valued at Indian Rupees (INR) 10,000 and US dollar (USD) 500 than the exchange rate of INR versus USD would be 1 USD = INR 20. This mechanism of valuing currency was called as gold standard. With further growth in international trade, changing political situations (world wars, civil wars, etc) and situations of deficit/ surplus on trade account forced countries to shift from gold standard to floating exchange rates. In the floating exchange regime, central bank’s intervention was a popular tool to manage the value of currency to maintain the trade competitiveness of the country. Central bank would either buy or sell the local currency depending on the desired direction and value of local currency. During 1944-1971, countries adopted a system called Bretton Woods System. This system was a blend of gold standard system and floating rate system. As part of the system, all currencies were pegged to USD at a fixed rate and USD value was pegged to gold. The US guaranteed to other central banks that they can convert their currency into USD at any time and USD value will be pegged to value of gold. Countries also agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity with US dollar. With adoption of this system, USD became the dominant currency of the world. Finally Bretton Woods system was suspended and countries adopted system of free floating or managed float method of valuing the currency. Developed countries gradually moved to a market determined exchange rate and developing countries adopted either a system of pegged currency or a system of managed rate. In pegged system, the value of currency is pegged to another currency or a basket of currencies. The benefit of pegged currency is that it creates an environment of stability for foreign investors as they know the value of their investment in the country at any point of time would be fixed. Although in long run it is difficult to maintain the peg and ultimately the central bank may change the value of peg or move to a managed float or free float. In managed float, countries have controls on flow of capital and central bank intervention is a common tool to contain sharp volatility and direction of currency movement.
Major currency pairs
The most traded currency pairs in the world are called the Majors. The list includes following currencies: Euro (EUR), US Dollar (USD), Japanese Yen (JPY), Pound Sterling (GBP), Australian Dollar (AUD), Canadian Dollar (CAD), and the Swiss Franc (CHF). These currencies follow free floating method of valuation. Amongst these currencies the most active currency pairs are: EURUSD, USDJPY, GBPUSD, AUDUSD, CADUSD and USDCHF.
Currency Price Fluctuation
Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the other currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency. Whenever the base currency buys more of the quotation currency, the base currency has strengthened / appreciated and the quotation currency has weakened / depreciated. For example, if USDINR has moved from 44.00 to 44.25, the USD has appreciated and the INR has depreciated. Similarly to say that USD looks strong over next few months would mean that USDINR pair may move towards 45.00 from the current levels of 44.00.
There are multiple factors impacting the value of the currency at any given point of time. Some of the factors are of the local country while others could be from global markets. For example, the value if INR against USD is a function of factors local to India like gross domestic product (GDP) growth rate, balance of payment situation, deficit situation, inflation, interest rate scenario, policies related to inflow and outflow of foreign capital. It is also a function of factors like prices of crude oil, value of USD against other currency pairs and geopolitical situation. All the factors are at work all the time and therefore some factors may act towards strengthening of currency and others may act towards weakening. It becomes important to identify the dominating factors at any point of time as those factors would decide the direction of currency movement. For example, economic factors in India might be very good indicating continued inflow of foreign capital and hence appreciation of INR. However, in global markets USD is strengthening against other currency pairs (on account of multiple factors). In this situation local factors are acting towards strengthening and global factors towards weakening of INR. One needs to assess which factors are more dominating at a point of time and accordingly take decision on likelihood of appreciation or depreciation of INR. In the very short term, demand supply mismatch would also have bearing on the direction of currency’s movement. The extent of impact of demand supply mismatch is very high on days when market is illiquid or on currency pairs with thin trading volumes. For USDINR, demand supply factors have considerable impact on the currency movement. For example, on some day INR may appreciate on account of large USD inflow (ECB conversion/ large FDI/ or any other reason) despite the trend of weakness driven by economic factors. Once the USD inflow is absorbed by the market, INR may again depreciate. Therefore it is important to keep track of such demand supply related news.
To assess the impact of economic factors on the currency market, it is important to understand the key economic concepts, key data releases, their interpretation and impact on market. The analytical tools of foreign-exchange market are the same as that of stock market: fundamental analysis and technical analysis. The underlying assumption of use of technical analysis in FX is same as that of stock market: price is assumed to have captured all news and available information and the charts are the objects of analysis. However, with respect to fundamental analysis, unlike companies countries do not have a balance sheet; do not have earnings report etc. Therefore how can fundamental analysis be conducted on a currency? Since fundamental analysis is all about looking at the intrinsic value of an investment, its application in FX means analysis of the economic conditions of the country that may affect the value of its currency. Since currency market is a globalised market and the value of currency is always determined against another currency, therefore fundamental analysis in FX market also means analysis of economic conditions in other major countries of the world. Just like stock market has key indicators like price/ earning multiple, revenue growth, profit growth etc to analyse a basket of stocks or a particular stock, FX market also has key indicators used by analysts in assessing the value of a currency pair. These indicator are released at scheduled times, providing the market with an indication of whether a nation's economy has improved or declined. The effects of these indicators are comparable to how indicators affect stock prices. Additionally, just like the stock market, any deviation in the reading of the key economic indicator from the expected number can cause large price and volume movements in currency market also. The interpretation of changing values of economic indicators on currency value could be difficult. It cannot be said with certainty that an indicator showing healthy economic health of the country would mean strengthening of the currency of that country. The exact impact would be a function of relative health of other economies, global risk appetite among investors and market expectation. For example, during global financial crisis of 2008 and 2009, USD strengthened against all major currencies like EUR, GBP and JPY. This was despite US running record high fiscal deficit and its economy not doing well. Some of the important economic factors that have direct impact on currency markets are inflation, balance of payment position of the country, trade deficit, fiscal deficit, GDP growth, policies pertaining to capital flows and interest rate scenario.
Price discovery 
Indian currency market is increasingly getting aligned to international markets. The opening levels of OTC market are primarily dependent on the development in international markets since closing of domestic market on the previous day. The value of impact of overnight development on the opening level of currency is quite subjective and would vary from one participant to other and therefore the OTC market is generally not very liquid in the first few minutes of its opening. Gradually, market discovers an equilibrium price at which market clears buy and sell orders. This process of discovering an equilibrium price is called as price discovery. The above is true for transactions where merchants execute the transaction on the interbank prices. However, for small value transactions, banks give a standard price called as card rate for whole day. For large volume transactions, the bid/ask difference could be higher than that for small value transactions. The exact bid/ask difference for a particular deal size could vary from bank to bank.

RBI reference rate
RBI reference rate is the rate published daily by RBI for spot rate for various currency pairs. The rates are arrived at by averaging the mean of the bid / offer rates polled from a few select banks during a random five minute window between 1145 AM and 1215 PM and the daily press on RBI reference rate is be issued every week-day (excluding Saturdays) at around 12.30 PM. The contributing banks are selected on the basis of their standing, market-share in the domestic foreign exchange market and representative character. The Reserve Bank periodically reviews the procedure for selecting the banks and the methodology of polling so as to ensure that the reference rate is a true reflection of the market activity. There is an increasing trend of large value FX transaction being done at RBI reference rate even on OTC market. The reference rate is a transparent price which is publicly available from an authentic source.







Sunday, 05th Apr 2015, 06:24:16 PM

Add Your Comment:
Post Comment