Module: 5 Determination Exchange rate and Trading Strategies in Derivative Exchange

market

5.1 Measuring exchange rate movements

5.2 Exchange rate equilibrium

5.3 Factors influencing exchange rates

5.4 Nominal, Real and Effective exchange rates

5.5 Cross Rates

5.6 Exchange Rate Systems: Fixed, Floating, Managed Float and Pegged

Reference:

Model Questions:

5.1 Measuring exchange rate movements

Exchange rate movements are measured by comparing the value of one currency to another.
Exchange rates are constantly changing and can be measured using the spot rate, forward rate,
standard deviation, and trade-weighted index.

They measure how much of one currency it takes to purchase a unit of another. Exchange rates
are ultimately determined in global foreign exchange markets by the supply and demand of
currencies. Economic factors like inflation, interest rates, and geopolitical events influence
these market forces.

Measuring exchange rate movements

 Spot rate: The current market value of an exchange rate

 Forward rate: The expected value of an exchange rate in the future
 Standard deviation: A measure of exchange rate fluctuation
 Trade-weighted index (TWI): A weighted average of exchange rates for groups of
currencies

Factors that affect exchange rates

 Supply and demand: The value of a currency is determined by the supply and demand
for that currency

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  Economic factors: Inflation, interest rates, GDP growth, stock market performance, and
government debt
 Geopolitical events: Events that can affect the supply and demand for a currency

Exchange rate systems

Exchange rates can be fixed or floating. In a fixed exchange rate system, the value of a currency
is pegged to another currency. In a floating exchange rate system, the market determines the
value of a currency.

Exchange rate forecasting

Exchange rate forecasting involves analysing trends in exchange rates to predict how one
currency will perform relative to another.

5.2 Exchange rate equilibrium

The equilibrium exchange rate is the long-term exchange rate that equals the purchasing power
parity (PPP) of a currency in a world where all goods are traded and where markets are fully

The foreign exchange market is like any other market insofar as something is being bought and
sold. However, the foreign exchange market is unique in two ways:

 A currency is being bought and sold, rather than a good or service

 The currency being bought and sold is being bought with a different currency.

When thinking about the meaning of equilibrium it quickly becomes apparent that it is a
difficult concept to pin down. This is clearly illustrated by the discussion in Milgate (1998)
which charts the development of the concept of equilibrium within economics. The debate over
what constitutes equilibrium has ranged over issues as diverse as its existence, uniqueness,
optimality, determination, evolution over time and indeed whether it is even valid to talk about
disequilibrium. All of these points are important, as is the question of whether the concept of
equilibrium can be separated from the models which are used to measure it. Clearly, in theory,
this is desirable, but in practice it may be much harder. As most models tend to have an
equilibrium associated with them, then one question is how do you distinguish between these
different equilibria? The work of von Neumann and Morgenstern (1944) would suggest that
the solution to all models must enjoy equal analytical status. What is important therefore is
their significance, which is determined by whether they are “similar to reality in those respects
which are essential in the investigation in hand” [von Neumann and Morgenstern (1944).

Equilibrium therefore means different things to different people and this is no less true in the
context of exchange rates than it is for any other field in economics. This section therefore aims
to discuss how different concepts of equilibrium can be useful for understanding the exchange
rate literature. In particular we emphasise how the time scale under consideration will affect

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the concept of equilibrium, as it will influence the questions of interest and hence the
significance of a given equilibrium.

We do not claim to have provided a new theory of equilibrium. Instead we are trying to apply
some of the existing insights in the context of exchange rates.

The equilibrium exchange rate refers to the exchange rate at which the demand for and
supply of a currency are balanced. There are different types of equilibrium exchange rates
based on various economic models and perspectives. Here are the key types:

1. Purchasing Power Parity (PPP) Equilibrium Exchange Rate

 Based on the Law of One Price, which states that identical goods should cost the same
in different countries when expressed in a common currency.
 Relative PPP: Exchange rate changes are linked to inflation differentials between two
countries.

2. Interest Rate Parity (IRP) Equilibrium Exchange Rate

 Determined by the relationship between interest rates and forward exchange rates.
 If domestic interest rates are higher than foreign rates, the domestic currency should
depreciate over time to maintain parity.

3. Fundamental Equilibrium Exchange Rate (FEER)

 Represents the exchange rate at which the economy is in both internal equilibrium
(full employment and stable inflation) and external equilibrium (sustainable current
account balance).
 Used in policy analysis for long-term exchange rate assessment.

4. Behavioural Equilibrium Exchange Rate (BEER)

 Considers various macroeconomic fundamentals like productivity, interest rate

differentials, and trade balance to determine the equilibrium rate.
 More dynamic than FEER and considers short- to medium-term fluctuations.

5. Natural Real Exchange Rate (NATREX)

 A long-term equilibrium exchange rate model considering capital flows, productivity

growth, and trade balances.
 Reflects equilibrium based on macroeconomic fundamentals without speculative
influences.

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6. Monetary Equilibrium Exchange Rate

 Based on the monetary approach to exchange rates, linking money supply and
demand to exchange rate movements.
 If money supply increases relative to demand, the domestic currency depreciates.

7. Real Effective Exchange Rate (REER) Equilibrium

 Measures the value of a currency relative to a basket of trading partner currencies,

adjusted for inflation.
 A REER above equilibrium suggests overvaluation, while below equilibrium suggests
undervaluation.

5.3 Factors influencing exchange rates

1. Economic Factors

A. Inflation Rates

 Currencies of countries with low inflation tend to appreciate, while those with high
inflation depreciate.
 Example: If India's inflation is higher than the U.S., the Indian Rupee (INR) may
depreciate against the U.S. Dollar (USD).

B. Interest Rates

 Higher interest rates attract foreign capital, leading to currency appreciation.

 Central bank policies (e.g., Federal Reserve rate hikes) significantly impact exchange
rates.

C. Balance of Payments (Trade Balance)

 A trade surplus (exports > imports) leads to currency appreciation.

 A trade deficit (imports > exports) puts downward pressure on the currency.

D. Economic Growth & GDP

 Strong GDP growth attracts foreign investment, leading to currency appreciation.

 Weak economic growth can result in depreciation.

2. Political & Policy Factors

E. Government Debt & Fiscal Policy

 High national debt can weaken investor confidence and lead to currency depreciation.
 A sound fiscal policy strengthens the currency.

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F. Political Stability & Economic Policies

 Countries with stable governments attract foreign investment, strengthening their

currency.
 Political uncertainty can lead to capital flight and currency depreciation.

3. Market & Speculative Factors

G. Speculation & Investor Sentiment

 If investors expect a currency to appreciate, demand for it increases, causing it to rise

in value.
 Speculators can cause short-term fluctuations based on market news and trends.

H. Capital Flows & Foreign Investment

 Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) impact
currency demand.
 Higher FDI inflows strengthen the domestic currency.

4. External & Global Factors

I. Global Events & Crises

 Wars, pandemics, and financial crises can cause exchange rate volatility.
 Safe-haven currencies (e.g., USD, Swiss Franc) appreciate during crises.

J. Terms of Trade (TOT)

 If export prices rise relative to import prices, the currency appreciates.

 A decline in TOT weakens the currency.

Interest Rates and Exchange Rates

Interest rates play a pivotal role in shaping a country's exchange rate. The relationship between
interest rates and exchange rates is primarily driven by the flow of capital between countries
seeking the best return on investments. Here's how it works:

1. Attraction of Foreign Capital

 Higher Interest Rates: When a country offers higher interest rates compared to others,
it becomes an attractive destination for foreign investors looking for better returns on
their investments. This influx of foreign capital increases the demand for the country's
currency, leading to its appreciation.
o Example: If India raises its interest rates while the U.S. maintains lower rates,
investors might convert their USD into INR to take advantage of the higher
returns in India, causing the INR to appreciate against the USD.

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  Lower Interest Rates: Conversely, if a country lowers its interest rates, it may lead to
capital outflows as investors seek better returns elsewhere. This increased supply of the
country's currency in the foreign exchange market can lead to depreciation.
o Example: If the European Central Bank reduces interest rates, investors might
move their funds to countries with higher rates, leading to a depreciation of the
Euro.

2. Inflation and Interest Rates

Interest rates are often adjusted to control inflation. The interplay between inflation and interest
rates can further influence exchange rates:

 Controlling Inflation: Central banks may increase interest rates to curb high inflation.
While this can attract foreign investment and strengthen the currency, it's essential to
balance, as excessively high rates can stifle economic growth.
 Stimulating Growth: Lowering interest rates can stimulate borrowing and spending,
potentially boosting economic growth. However, if not managed carefully, this can lead
to higher inflation and a weaker currency.

3. Speculative Movements

Traders and investors often speculate on future interest rate movements:

 Anticipation of Rate Changes: If the market anticipates that a country's central bank
will raise interest rates, the currency might appreciate in advance due to expected higher
returns.
 Uncertainty and Volatility: Unexpected changes in interest rates can lead to increased
volatility in exchange rates as markets adjust to new information.

5.4 Nominal, Real and Effective exchange rates

In the derivatives market, understanding Nominal, Real, and Effective Exchange Rates is
crucial for effective risk management and strategic decision-making. Here's an in-depth look
at these concepts and their relevance in derivatives trading:

1. Nominal Exchange Rate

The Nominal Exchange Rate is the rate at which one currency can be exchanged for another in
the open market. It reflects the current market price without adjusting for inflation or
purchasing power differences.

 Relevance in Derivatives:
o Pricing: Derivatives such as futures and options on currencies are priced based
on the nominal exchange rate.

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 o Settlement: The payoff from currency derivatives depends on the nominal
exchange rate at the time of contract maturity.

2. Real Exchange Rate

The Real Exchange Rate adjusts the nominal rate by accounting for price level differences
between countries, reflecting the true purchasing power of one currency relative to another.

 Formula: Real Exchange Rate (RER) = (Nominal Exchange Rate × Domestic Price
Level) / Foreign Price Level
 Relevance in Derivatives:
o Hedging: Investors and firms use derivatives to hedge against changes in the
real exchange rate, which can affect competitiveness and profitability.
o Investment Decisions: Understanding RER helps in making informed decisions
about cross-border investments and in assessing the real return on foreign assets.

3. Effective Exchange Rates

Effective Exchange Rates measure a currency's value relative to a basket of other currencies,
providing a comprehensive view of its overall strength. There are two main types:

A. Nominal Effective Exchange Rate (NEER)

The Nominal Effective Exchange Rate (NEER) is a weighted average of a country's currency
against a basket of other major currencies, without adjusting for inflation.

 Relevance in Derivatives:
o Portfolio Management: Traders use NEER to assess the overall strength of a
currency and to make decisions about currency diversification in their
portfolios.
o Risk Assessment: A declining NEER may signal potential risks, prompting the
use of derivatives to hedge against currency depreciation.

B. Real Effective Exchange Rate (REER)

The Real Effective Exchange Rate (REER) adjusts the NEER for inflation differentials,
reflecting the real purchasing power and competitiveness of a currency.

 Relevance in Derivatives:
o Competitiveness Analysis: A rising REER indicates that a country's goods are
becoming more expensive relative to its trading partners, which can influence
decisions on hedging export revenues.
o Strategic Planning: Businesses use REER to plan for long-term investments and
to assess the potential impact of currency movements on future cash flows.

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 Application in Derivatives Instruments

 Currency Futures and Options: These derivatives allow traders to lock in exchange rates
or to speculate on future movements, using nominal rates as the basis for contracts.
 Non-Deliverable Forwards (NDFs): Used in markets where currencies are not freely
tradable, NDFs are settled in a convertible currency, with the settlement amount based
on the difference between the agreed-upon rate and the actual nominal exchange rate at
maturity. For instance, the Indian Rupee's NDF market has seen significant growth,
with volumes reaching record highs due to arbitrage opportunities and market
sentiment.
 Quanto Derivatives: These are exotic options where the underlying asset is
denominated in one currency, but the payoff is in another, protecting investors from
exchange rate fluctuations. For example, a U.S. investor might invest in a Japanese
stock index (denominated in Yen) but receive returns in USD, with the exchange rate
risk hedged.

5.5 Cross Rates

Cross rates are exchange rates between two currencies that are calculated using a third
currency. They are used in the derivatives market for international transactions, investments,
and risk management.
How are cross rates calculated?
 Cross rates are calculated by dividing the exchange rate of one currency by the exchange rate
of a common currency, and then multiplying that result by the exchange rate of the second
currency.
 For example, the cross rate between EUR/GBP is calculated by dividing EUR/USD by
GBP/USD.

When are cross rates used?

 Cross rates are used when the currencies being exchanged are not commonly traded directly
against each other.
 They are useful for international trade and travel, where one currency needs to be converted to
another without using the native currency.
Examples of cross rates GBP-JPY, CAD-BRL, and EUR-JPY.
A cross rate is a foreign currency exchange transaction between two currencies that are both
valued against a third currency. The U.S. dollar (USD) is the currency that's usually used in
foreign currency exchange markets to establish the values of the pair being exchanged.

As the base currency, the U.S. dollar always has a value of one. Some USD pairs are
reciprocal and the dollar is not the base currency.

Two transactions are involved when a cross-currency pair is traded. The trader first trades one
currency for its equivalent in U.S. dollars. The U.S. dollars are then exchanged for another
currency.

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The Major Currency Pair
Foreign exchange (forex) traders use the term cross rate to refer to price quotes between
currencies in which neither is the U.S. dollar.1

Most transactions on the forex are in major currency pairs. If one of the currencies being
swapped is the U.S. dollar, it would mean that one U.S. dollar is equal to 1.28 Canadian dollars
if you see on a financial news site that USD/CAD is quoted at 1.28.

An exchange rate between the euro and the Japanese yen is considered to be a commonly
quoted cross rate because it doesn't include the U.S. dollar. But in the pure sense of the
definition, it's considered a cross rate if it's referenced by a speaker or writer who isn't in Japan
or one of the countries that use the euro as its official currency.
The pure definition of a cross rate requires that it be referenced in a place where neither
currency is used but the term is primarily used to reference a trade or quote that doesn't include
the U.S. dollar.

Examples of Major Cross Rates

Any two currencies can be quoted against each other but the most actively traded cross-
currency pairs are the euro versus the British pound, or EUR/GBP, and the euro versus the
Japanese yen, or EUR/JPY. These two pairs are the only cross-rate currency pairs that appear
in the top 10 most traded currency pairs.

5.6 Exchange Rate Systems: Fixed, Floating, Managed Float and Pegged

Exchange rate systems define how a country manages its currency in relation to foreign
currencies and the foreign exchange market. The primary systems include Fixed, Floating,
Managed Float, and Pegged exchange rate regimes. Here's a detailed explanation of each:

1. Fixed Exchange Rate System

In a Fixed Exchange Rate System, a country's currency value is tied or pegged to another
major currency, a basket of currencies, or a commodity like gold. The central bank maintains
this fixed rate by intervening in the foreign exchange market, buying or selling its currency to
offset supply and demand fluctuations.

 Advantages:
o Stability: Provides certainty in international prices, fostering trade and
investment.
o Inflation Control: By pegging to a low-inflation currency, a country can import
price stability.
 Disadvantages:
o Loss of Monetary Autonomy: The country cannot freely adjust its monetary
policy to respond to domestic economic conditions.

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 o Risk of Currency Crises: Maintaining a fixed rate can be challenging if the
pegged value doesn't reflect the market equilibrium, potentially leading to
speculative attacks.

Example: The Bretton Woods System (1944-1971) established fixed exchange rates where
currencies were pegged to the U.S. dollar, which was convertible to gold.

2. Floating Exchange Rate System

A Floating Exchange Rate System allows a currency's value to fluctuate according to the
foreign exchange market. Supply and demand dynamics determine the exchange rate without
direct governmental or central bank intervention.

 Advantages:
o Monetary Policy Independence: Governments can implement policies tailored
to domestic economic conditions.
o Automatic Adjustment: Exchange rates adjust to economic variables, helping
to correct trade imbalances.
 Disadvantages:
o Volatility: Exchange rates can be highly volatile, creating uncertainty for
international trade and investment.
o Speculative Attacks: Currencies can be subject to speculative pressures,
leading to abrupt devaluations or appreciations.

Example: Major currencies like the U.S. Dollar, Euro, and Japanese Yen operate under
floating exchange rate regimes.

3. Managed Float (Dirty Float) Exchange Rate System

In a Managed Float or Dirty Float system, a currency primarily floats in the open market, but
the central bank may intervene occasionally to stabilize or steer the currency's value. This
intervention aims to prevent excessive volatility or to achieve specific economic objectives.

 Advantages:
o Flexibility: Allows the currency to respond to market forces while enabling
intervention to prevent extreme fluctuations.
o Policy Tool: Central banks can influence the exchange rate to support economic
goals, such as controlling inflation or boosting exports.
 Disadvantages:
o Uncertainty: Market participants may be unsure about the extent and timing of
interventions.
o Resource Intensive: Frequent interventions can deplete foreign exchange
reserves.

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Example: India operates a managed float system, where the Reserve Bank of India intervenes
to curb excessive volatility in the Indian Rupee's exchange rate.

4. Pegged Exchange Rate System

A Pegged Exchange Rate System is similar to a fixed system, where a country's currency is
anchored to another major currency or a basket of currencies. However, unlike a strict fixed
system, the peg may allow for slight fluctuations within a specified band.

 Advantages:
o Exchange Rate Stability: Provides predictability for traders and investors
dealing with the pegged currencies.
o Inflation Anchoring: Helps stabilize domestic inflation rates by tying the
currency to a stable foreign currency.
 Disadvantages:
o Limited Monetary Policy Flexibility: Domestic interest rates must align with
those of the anchor currency, potentially conflicting with local economic needs.
o Adjustment Challenges: Maintaining the peg can be difficult during economic
shocks or when the anchor currency experiences volatility.

Example: Saudi Arabia pegs its currency, the Saudi Riyal, to the U.S. Dollar, maintaining a
fixed exchange rate to stabilize its oil revenues, which are dollar-denominated.

Understanding these exchange rate systems is vital for policymakers, businesses, and investors,
as each system has distinct implications for economic stability, trade, and monetary policy.

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Reference

1. [Link]

Terminal questions:

Section-A 5 Marks

1. Enumerate the different exchange rate systems.

2. Explain the factors influence exchange rate movements.
3. Explain the way the managed float exchange rate system operate.
4. Describe the difference between real and nominal exchange rates.
5. Outline the process of determining exchange rate equilibrium.

Section-B 9 Marks

1. Demonstrate: Show how inflation rates in two countries can affect their real exchange
rate.
2. Explain the concept of effective exchange rates to assess a country's trade
competitiveness.

Section-C 12 Marks

1. Describe the differences between fixed and floating exchange rate systems in terms of
economic stability.

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Model Questions

Section-A (5x5=25)

1. Identify the different types of commodities traded in the market.

2. Construct the payoff profiles for futures contracts in a bullish and bearish market.
3. Differentiate between financial and commodity derivatives.
4. Define the term Premium/Discount in the context of commodity derivatives.
5. Explain the factors influence exchange rate movements.

Section-B (2x9=18)

1. Examine the factors affecting the fair value of a futures contract.

2. Explain the different types of derivatives.
3. Differentiate between physical and cash settlement in the clearing process.

Section-C (1X12=12)

1. Describe the differences between fixed and floating exchange rate

systems in terms of economic stability.

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