Exchange Rate

Recently updated on April 13th, 2023 at 05:57 pm

Foreign exchange rate is the price at which one currency can be converted into another. It represents the rate at which a firm may exchange one currency for another. Thus, the exchange rate is simply the amount of a nation’s currency that can be bought at a given time for a specified amount of the currency of another country.

The actual amount received in conversion or the effective exchange rate, usually differs from the stated rate because it takes into account all taxes, commissions and other costs that the public must pay to complete the transaction and actually receive the foreign funds.

Types of Foreign Exchange Rate

  1. Fixed and Floating Rates

When Government of a country fixes the rate of exchange for its own currency, it is termed as ‘Fixed Exchange Rate’. This is also known as official rate of exchange. Fixed exchange rates are fixed by the respective Governments from time to time for the betterment of their economy.

In contrast exchange rates move, as in any other market place, depending on the demand and supply pressure and are further influenced by the market forces and economic conditions of the respective countries. Floating exchange rate may be free floating or a managed floating.

A currency is freely floating if there does not exist a system of fixed exchange rates and if the Central Bank of the country in question does not attempt to influence the value of the currency. However, in reality this kind of situation does not exist.

In most of the countries Governments attempt to influence movements of exchange rate either through direct intervention in the exchange market or through a mix of fiscal and monetary policies. Under such circumstances, floating is called as ‘managed’ or ‘dirty float’.

A number of countries use a pegged float as a system of exchange rates. The value of one currency is pegged to the value of another currency that itself floats. In a joint float, currencies in a particular group have a fixed exchange value in terms of each other, but the group of currencies floats in relation to other currencies outside the group.

The fixed exchange rate system has inbuilt ad-vantage of simplifying exchange transactions. It imbibes self-discipline for economic policies by participating countries. In India the exchange rate regime of rupee has evolved over a period of time moving in the direction of less exchange controls and current account accountability. The RBI manages the exchange rate of the rupee.

In recent few years the RBI has been very actively intervening in the market to hold the rupee-dollar rates within tight bounds while rupee rates in relation to other currencies fluctuate in correspondence with the fluctuation of this US dollar against them. In addition, the RBI took several measures to relax exchange control and liberalize foreign trade.

  1. Spot and Forward Rates

Spot rates refer to those rates which are applicable on the day of transaction in which physical delivery is made within two working days after the date of transaction the spot exchange between two currencies should be the same across the various banks engaged in rendering foreign exchange services.

In case of large discrepancy customers or other banks would buy large amounts of a currency from whatever banks quoting relatively low price and sell the same immediately to a bank quoting a relatively high price. This will cause adjustments in the exchange rate quotations that would offset the existing discrepancy.

In Forward rates, exchange rates are fixed in advance for a transaction which matures at some specified future date. The exchange at the date in future will be at the price agreed upon now. Foreign exchange rates are function of forward demand and forward supply of various currencies.

A foreign currency is said to be at a forward premium if its future value exceeds its present value in terms of domestic currency and it is said to be at discount if the reverse is true. For example spot rate between rupees and dollar is S (Rs/$) = Rs. 45.50 and three months forward is F3 (Rs. /$) = Rs. 46.70/$; these rates signify that dollar is at a premium and rupee is at discount in the forward.

Forward exchange rates are quoted on most major currencies for different maturities. Standard maturities quoted by banks are of 1, 3, 6, 9 and 12 months. Maturities beyond one year are now becoming more common. Maturity extending to 5 and beyond 5 years is also possible for good bank customers.

Functions of Foreign Exchange Market

  1. Transfer Function: Foreign exchange market transfers purchasing power between the countries involved in the transaction.

This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.

  1. Credit Function: Foreign exchange market provides credit for foreign trade.

Bills of exchange, with maturity period of three months, are generally used for international payments.

Thus, credit is required for this period to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.

  1. Hedging Functions: Hedging in an important function of foreign exchange market.

When exporter and importers enter into an agreement to sell and buy gods on some future date at the current prices and exchange rate, it is called hedging.

Fixed exchange rate system:

The system in which the foreign exchange rate is officially fixed by the government/monetary authority and not determined by markets forces.

Under fixed exchange rate system: Each country keeps the value of its currency fixed in terms of some external standard.

This external standard can be gold, silver, other precious metal, another country’s currency, or even some internationally agreed unit of account.

In earlier times, exchange rates of all major countries were fixed according to the Gold Standard.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating (flexible) exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.

Merits:

(i) It ensures stability in exchange rate which encourages foreign trade.

(ii) It contributes to the coordination of macro policies of countries in an interdependent world economy.

(iii) Fixed exchange rates prevents capital outflow.

(iv) It prevents speculation in foreign exchange market.

(v) Fixed exchange rates are more conductive to expansion of world trade because it prevents risk and uncertainty in transactions.

Demerits:

(i) There is a fear of devaluation in situation of excess demand.

Central Bank uses its reserves to maintain fixed exchange rate.

But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency.

If speculators believe the exchange rate cannot be held for log, they buy foreign exchange in massive amount causing deficit in BOP. This may lead to larger devaluation.

This is the main flaw of fixed exchange rate system.

(ii) Benefits of free markets are deprived.

(iii) There is always possibility of undervaluation or overvaluation.

Disadvantages of Fixed Exchange Rate

Developing economies commonly use a fixed rate structure to curb inflation and provide a stable system. A secure environment enables importers, exporters, and investors to plan without having to worry about currency movements.

A fixed-rate structure, however, limits the ability of a central bank to change interest rates as required for boosting economic growth. Often, a fixed rate system prevents market fluctuations when a currency is over or undervalued. Effective management of a fixed-rate system also needs a large pool of reserves, when it is under pressure, to support the currency.

An unsustainable official exchange rate can also trigger a parallel, unofficial, or dual exchange rate to grow. A large gap between official and unofficial rates will draw hard currency away from the central bank, which can result in shortages of forex and periodic devaluations. These can be more detrimental for an economy than the daily adjustment of a floating currency regime.

Flexible (fixating) Exchange Rate:

Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market. There is no official (govt.) Intervention. Here the value of a currency is left completely free to be determined by market forces of demand and supply of foreign exchange.

In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency’s value is allowed to fluctuate in response to foreign exchange market events. A currency that uses a floating exchange rate is known as a floating currency, in contrast to a fixed currency, the value of which is instead specified in terms of material goods, another currency, or a set of currencies (the idea of the last being to reduce currency fluctuations).

In the modern world, most of the world’s currencies are floating, and include the most widely traded currencies: the United States dollar, the euro, the Swiss franc, the Indian rupee, the pound sterling, the Japanese yen, and the Australian dollar. However, even with floating currencies, central banks often participate in markets to attempt to influence the value of floating exchange rates. The Canadian dollar most closely resembles a pure floating currency because the Canadian national bank has not interfered with its price since it officially stopped doing so during 1998. The US dollar is a close second, with very little change of its foreign reserves. By contrast, Japan and the UK intervene to a greater extent, and India has medium-range intervention by its national bank, the Reserve Bank of India

Merits:

(i) Deficit or surplus in BOP is automatically corrected.

(ii) There is no need for government to hold any foreign reserve.

(iii) It helps in optimum resource allocation.

(iv) It frees the government from problem of balance of payment.

(v) Flexible exchange rate increases the efficiency in the economy by achieving best allocation of resources.

Demerits:

(i) It encourages speculation leading to fluctuation in exchange rate.

(ii) Wide fluctuations in exchange rate can hamper foreign trade and capital movement between countries.

(iii) It generates inflationary pressure when prices of imports go up due to depreciation of the  currency caused by deficit in BOP.

(iv) It discourages investment and international trade.

Determination of Exchange Rate (Flexible Exchange Rate System)

Rate of exchange is determined by the interaction of then force of demand and supply.

let us understand the various sources of demand and supply of foreign exchange.

Demand for Foreign Exchange Demand (outflow) for foreign exchange arises due to the following reasons

  1. Import of Goods and Services: foreign exchange is demanded to make the payment for imports of goods and services.
  2. Tourism: When Indian tourists go abroad, they need to have foreign currency with them to meet their expenditure abroad. So, foreign exchange is needed to undertake foreign tour.
  1. Unilateral Transfers sent abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.
  2. Purchase of Assets in Foreign Countries: Foreign exchange in needed to make payment for the purchase of assets (like land, building, share, bonds etc.) in foreign countries.
  3. Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of the currency.

Computation and Treatment of exchange rate Differences

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.

The exchange rate is defined as the rate on the basis of which two countries involved in trade exchange marketable items or commodities. It is basically the cost of exchanging one currency for another currency.

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.

Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveler’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveler’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.

Therefore, the exchange rate can be calculated as per the below-mentioned relationship:

Exchange Rate = Money in Foreign Currency / Money in Domestic Currency

Additionally, it can also be determined as per the below-mentioned relationship:

Exchange Rate = Money in After Exchange / Money Before Exchange

The equation for the exchange rate can be calculated by using the following steps:

  • First, determine the amount that is to be transferred or exchanged from domestic currency to foreign currency.
  • Next, the individual can access foreign exchange markets through trading platforms or through financial institutions to determine the available exchange rates prevalent between the two nations.
  • Next, multiply the exchange rate with the domestic currency to arrive at the foreign currency.

Model

Purchasing Power Parity

Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England

If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.

The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.

Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.

Asset Market Model

Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Accounting Treatment of Exchange Difference Approach # 1. Single Transaction Approach:

Single transaction approach is based on the premise that any transaction and its settlement is a single event. So if any exchange difference is there that may be charged to cost of goods purchased or to an export sale.

Accounting Treatment of Exchange Difference Approach # 2. Double Transaction Approach:

In contrast to single transaction approach, Dual transaction approach considers exchange element separately, hence emphasizes on accounting treatment of both separately. In other words, purchase or sale is recorded in the books of accounts at the exchange rate prevailing at the date of transaction and adjustments are not made for any change in exchange rates. These changes in exchange rates on different dates are treated as expenses and charged to loss on foreign exchange account.

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