The Impact Of Currency Conversions

By Glenn CurtisAAA |
The currency price of one country gets stronger and/or weaker against another country's currency
on a daily basis, but what exactly does that mean for those who don't trade in the forex market?
Currency exchange rates affect travel, exports, imports and the economy. In this article, we'll
discuss the nature of currency exchange and its effect on people and the economy.
Before delving into the topic in more detail, we must first establish a constant; for demonstration
purposes we will be talking about the relationship between the euro and the U.S. dollar. More
specifically, we will be talking about what happens to the U.S. economy and to the economies
of Europe if the euro trades markedly higher against the U.S. dollar. The assumption we will be
making is that US$1 will purchase 0.7 euros.
The
Impact
on
Travelers
If US$1 buys 0.7 euros, U.S. citizens will be more reluctant to travel across the pond. That's
because everything from food to souvenirs would be more expensive - about 43% more
expensive than if the two currencies were trading at parity. This is an illustration of the effect of
the purchasing power parity (PPP) theory.
However, under these conditions European travelers would be much more apt to visit the United
States for both business and pleasure. American businesses and governments (via taxes) in the
areas that European tourists visit will prosper - even if just for a season.
The
Impact
on
Corporations
and
Equities
The impact that this scenario would have on corporations (particularly large multi-nationals) is a
little more complex because these businesses often conduct transactions in a number of different
currencies and tend to obtain their raw materials from a wide variety of sources. That said, U.S.based companies that generate the majority of their revenue in the U.S. (but that source their raw
materials from Europe) would likely see their margins take a hit on higher costs.
Similar pain would be felt by U.S. companies that must pay their employees in euros. By
definition, these decreased margins would likely have an adverse impact on overall corporate
profits, and therefore on equity valuations in the domestic market. In other words, stock prices
may drop due to these lower earnings and forecasts for future profit potential.
On the flipside, U.S. companies that have a hefty overseas presence and draw in a significant
amount of revenue in euros (as opposed to dollars), but pay their employees and other expenses
in U.S. dollars could actually fare quite well.
European companies that generate the lion's share of their revenue in euros, but also source their
materials or employees from the United States as part of their business, would likely see margin
expansion as their costs and currency decrease. By definition, this could lead to higher corporate

profits and equity valuations in some overseas stock markets. However, European companies
that garner a significant amount of their revenue from the United States and must pay their
expenses in euros are likely to suffer.
The
Impact
on
Foreign
Investment
Under these assumptions, it is likely that Europeans (both individuals and corporations) would
expand their investment in the United States. They would also be better suited to make
acquisitions of U.S.-based businesses and/or real estate. In fact, this has happened at several
points in the past. For example, when the Japanese yen traded at record highs against the dollar
back in the 1980s, Japanese firms made significant purchases of real estate - including the worldrenowned Rockefeller Center.
Conversely, U.S. corporations would be less apt to acquire a European company or European
real estate under US$1 for 0.70 euros scenario.
How
Can
You
Protect
Yourself
from
Currency
Moves?
When planning a trip, check the most up-to-date currency conversion before you book your
vacations so you can plan your choice of locations appropriately. (There are many ways of
finding out local currency rates, including looking in the business section of your local
newspaper, checking with a travel agency or searching the internet.) Incidentally, one of the
best tips for travelers making purchases overseas is to use a credit card. The reason behind that is
that credit card companies tend to negotiate the best rates and the most favorable conversions
because they do such a high volume of transactions. These companies take out all the guess work
for you, paving the way for smoother (and probably less expensive) transactions.
For small and large business owners operating in the U.S. that source some of their raw materials
from Europe, one of the best moves can be to stock certain supplies if the price of the euro starts
to climb rapidly against the dollar. Conversely, if the euro starts falling against the dollar, it may
make sense to keep inventory at a minimum in the hope that the euro will decline enough for the
company to save on its purchased goods.
The
Bottom
Line
Over time, currency values can vary quite dramatically. However, individuals, investors and
business owners can take steps to mitigate risks and take advantage of such currency movements.

The price of a nations currency in terms of another currency. An exchange rate thus has two
components, the domestic currency and a foreign currency, and can be quoted either directly or
indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of
the domestic currency. In an indirect quotation, the price of a unit of domestic currency is

expressed in terms of the foreign currency. An exchange rate that does not have the domestic
currency as one of the two currency components is known as a cross currency, or cross rate.
Also known as a currency quotation, the foreign exchange rate or forex rate.
The process of converting one form of currency into another country's usable currency. Based on
current exchange rates, a person may receive less or more value after the currency is converted.
This can be determined by looking at the current exchange rate for the country's currency.
Read more: http://www.investorwords.com/8563/currency_conversion.html#ixzz3SMFHaHMl

Currency Exchange Rates Explained

As the worlds largest retail provider of foreign currency, we know that exchanging currency can,
at times, be confusing.
Dealing with money can be complicated at the best of times, but in the rush to get away, or while
you are abroad, changing your travel money can be tricky.
This is especially true as there are a number of unfamiliar terms and phrases connected with the
foreign currency exchange process.
As the worlds foreign-exchange specialist, we are helping consumers to make things as simple
as possible by developing this guide to currency exchange rates.
We have designed this guide to:

cut through the confusion;

make sure you get the best value for your travel money; and

make changing your money one less thing to worry about the next time you head abroad.

About Currency Exchange Rates

Here is a guide to what to look out for.
Sell rate this is the rate at which we sell foreign currency in exchange for local currency. For
example, if you were heading to Canada, you would exchange your currency for Canadian
dollars
at
the
sell
rate.
Buy rate this is the rate at which we buy foreign currency back from travellers to exchange
into local currency. For example, if you were returning from America, we would exchange your
dollars
back
into
euros
at
the
buy
rate.

Holiday

money

rate

or

tourist

rate

another

term

for

sell

rate.

Spot rate This is known more formally as the interbank rate. It is the rate banks or large
financial institutions charge each other when trading significant amounts of foreign currency. In
the business, this is sometimes referred to as a spot rate. It is not the tourist rate and you cannot
buy currency at this rate, as you are buying relatively small amounts of foreign currency. In
everyday life it is the same as the difference between wholesale and retail prices. The rates
shown in financial newspapers and in broadcast media are usually the interbank rates.
Spread This is the difference between the buy and sell rates offered by a foreign-exchange
provider
such
as
us.
Cross rate This is the rate we give to customers who want to exchange currencies that do not
involve the local currency. For example, if you want to exchange Australian dollars into US
dollars.
Commission This is a common fee that foreign-exchange providers charge for exchanging one
currency to another.
Now that youre all clued up on the terms and phrases surrounding exchange rates, why not head
over to our currency exchange rates page and reserve your foreign currency online today.
How Currency Works
Currency seems like a very simple idea. It's only money, after all, and that's just what we use to
buy the things we want and need. We get paid by our employers, and we use that money to pay
the bills, buy our food, and purchase goods and services. We might put some in a savings
account at the bank or invest it in stocks or real estate, but for the most part, currency seems like
a fairly straightforward concept.
In fact, the development of currency has shaped human civilization. Currency has stopped wars,
and it has started many more. Cities and nations as we know them would not exist without it. It is
difficult to overstate the importance of currency in modern life.
"We invented money and we use it, yet we cannot...understand its laws or control its actions. It
has a life of its own." - Lionel Trilling, literary critic

Like most other rates in economics, the exchange rate is essentially a price and can be analyzed
in the same way we would a price. Take a typical supermarket price, say lemons are selling at the
price of 3 for a dollar or 33 cents each. Then we can think of the dollar-to-lemon exchange rate
as being 3 lemons because if we give up one dollar, we can get three lemons in return. Similarly,
the lemon-to-dollar exchange rate is 1/3 of a dollar or 33 cents, because if you sell a lemon, you
will get 33 cents in return. So when we speak of an X-to-Y exchange rate of Z, this means that if
we give up 1 unit of X, we get Z units of Y in return. If we want to know the Y-to-X exchange
rate, we calculate it using the simple exchange rate formula:
Y-to-X exchange rate = 1 / X-to-Y exchange rate
Of course, the exchange rates we read in the paper or hear on radio or TV are not prices for X
and Y or for oranges and lemons. Instead they're relative prices for different currencies, but they
work in the same fashion. On February 26, 2003 the U.S.-to-Japan exchange rate was 117 yen, so
this means that you can purchase 117 Japanese yen in exchange for 1 U.S. dollar. To figure out
how many U.S. dollars you can get for 1 Japanese yen, we can just use the formula:
Japan-to-U.S. exchange rate = 1 / U.S.-to-Japan exchange rate
Japan-to-U.S. exchange rate = 1 / 117 = .00854
So this tells us that one Japanese yen is worth .00854 U.S. dollars, which is less than a penny.
Similarly if the Canadian dollar is worth .67 U.S. dollars, we have a Canada-to-U.S exchange
rate of .67. If we want to know how many Canadian dollars we can buy with 1 U.S. dollar, we
use the formula:
U.S.-to-Canada exchange rate = 1/Canada-to-U.S. Exchange rate
U.S.-to-Canada exchange rate = 1/0.67 = 1.4925
So one U.S. dollar can get us $1.49 in Canadian funds.
Exchange rates-supply
Basic econonomic theory teaches us that if the supply of a good increases, and nothing else
changes, the price of that good will decrease. If the supply of a country's currency increases, we
should see that it takes more of that currency to purchase a different currency than it did before.
Suppose there was a big jump in the supply of the Canadian dollar. We would expect to see the
Canadian dollar become less valuable relative to other currencies. So the Canadian-to-U.S.
Exchange rate should decrease, from 67 cents down to, say, 50 cents. Each Canadian dollar
would give us less American dollars than it did before. Similarly, the U.S.-to-Canadian exchange

rate would increase from $1.49 to $2.00, so each U.S. dollar would give us more Canadian
dollars than it did before, as a Canadian dollar is less valuable than it used to be.
Why would the supply of a currency increase?
Currencies are traded on the foreign exchange market, and the supply of a currency on that
market will change over time. There are a few different organizations whose actions will cause a
rise in the supply of the foreign exchange market:
1. Export Companies
Suppose a South African farm sells the cashews it produces to a large Japanese firm. It is likely
that the contract will be negotiated in Japanese yen, so the farm will receive its revenue in a
currency with limited use outside of Japan. Since the company needs to pay it's employees in the
local currency, namely the South African rand, the company would sell its yen on a foreign
exchange market and buy rands. The supply of Japanese yen on the foreign exchange market will
increase, and the supply of South African rands will decrease. This will cause the rand to
appreciate in value (become more valuable) relative to other currencies and the yen to depreciate.
2. Foreign Investors
A German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To
purchase the land, hire construction workers, etc., the firm will need Canadian dollars. However
most of their cash reserves are held in euros. The company will be forced to go to the foreign
exchange market, sell some of its euros, and buy Canadian dollars. The supply of euros on the
foreign exchange market goes up, and the supply of Canadian dollars goes down. This will cause
Canadian dollars to appreciate and euros to depreciate.
Foreign investment does not have to be in tangible goods such as land. If German investors buy
Canadian stocks, such as stocks listed on the Toronto Stock Exchange or purchase Canadian
dollar bonds, we will have the same situation as above.
3. Speculators
Like the stock market, there are investors who try to make a fortune (or at least a living) by
buying and selling currencies. Suppose a currency investor thinks that the Mexican peso will
depreciate in the future, so it will be less valuable than other currencies than it is now. In that
case, she is likely to sell her pesos on the foreign exchange market and buy a different currency
instead, such as the South Korean won. The supply of pesos goes up and the supply of won goes
down. This causes pesos to depreciate, and won to appreciate.
Note the self-fulfilling nature of the beliefs investors hold. If investors feel that a currency will
depreciate in the future, they will try to sell it today. Since the currency is being sold by
investors, the supply of it will go up, and the price of it will decrease. The investor thought that

the currency would depreciate, she acted on that belief and sold her currency, and the act of
selling caused the depreciation to take place. Self-fulfilling prophecies such as this one are quite
common in economics.
4. Central Bankers
The central bank of the United States is the Federal Reserve, more commonly known as "The
Fed". One of the responsibilities of the Fed is to control the supply, or the amount, of currency in
a country. The most obvious way to increase the supply of money is to simply print more
currency, though there are much more sophisticated ways of changing the money supply. If the
Fed prints more 10 and 20 dollar bills, the money supply will increase. When the government
increases the money supply, it is likely some of this new money will make its way to the foreign
exchange market, so the supply of U.S. dollars will increase there as well.
A central bank will often directly increase the supply of money on the foreign exchange markets.
Central banks like the Fed keep a supply of most (if not all) currencies in reserve and will often
use them to influence the exchange rate. If the Fed decides that the U.S. dollar has appreciated in
value too much relative to the Japanese yen, it will sell some of the U.S. dollars it has in reserve
and buy Japanese yen. This will increase the supply of dollars on the foreign exchange market,
and decrease the supply of yen, causing a depreciation in the value of the dollar relative to the
yen. Of course, the Fed cannot do this as much as it would like, because it may end up running
out of some currencies. As well, the Japanese central bank (named the Bank of Japan) could
decide that the Fed is manipulating the price of the yen too much and the Bank of Japan could
counteract the Fed by selling yen and by buying dollars.
These are the organizations who will increase the supply of currency on the exchange market.
Now we'll investigate the demand side of foreign exchange markets.

Why would the demand for a currency increase?

Not surprisingly pretty much the same organizations who caused supply changes will cause
demand changes. They are as follows:
1. Import Companies
A British retailer specializing in Chinese merchandise will often have to pay for that merchandise
in Chinese yuan. So if the popularity of Chinese goods goes up in other countries the demand for
Chinese yuan will go up as retailers purchase yuan to make purchases from Chinese wholesalers
and manufacturers.
2. Foreign Investors

As before a German automobile manufacturer wants to build a new plant in Windsor, ON,
Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian
dollars. So the demand for Canadian dollars will rise.
3. Speculators
If an investor feels that the price of Mexican pesos will rise in the future, she will demand more
pesos today. This increased demand leads to an increased price for pesos.
4. Central Bankers
A central bank might decide that its holdings of a particular currency are too low, so they decide
to buy that currency on the open market. They might also want to have the exchange rate for
their currency decline relative to another currency. So they put their currency on the open market
and use it to buy another currency. So Central Banks can play a role in the demand for currency.
Supply and demand are often thought of as being two sides of the same coin. Here we see that
this is the case, as in every transaction there is a buyer and a seller, or in other words, a demander
and a supplier.
Now we know what agents can cause price changes and for what reasons. We can use our
knowledge to analyze what happens in the "real world". An interesting case is the Canadian-toAmerican exchange rate. Due to the geographical proximity and economic intergration of the
two countries the Canadian-to-American exchange rate is often examined. The sharp decline in
the value of the Canadian dollar relative to the American one is widely discussed in the news, so
we'll discuss it now.
Factor 1: Commodity prices.
Moreso than any other industrialized country, Canada's economy relies heavily on the export of
raw materials such as lumber, natural gas, and agricultural products. The Bank of Canada has
developed a Commodity Price Index, which tracks changes in the prices of commodities which
Canada exports. The breakdown of the elements in the Commodity Price Index is roughly:
Category

Percentage

Energy

34.9

Food

18.8

Metals

14.4

Minerals

2.3

Forest Products

29.6

Commodities such as these represent almost 40 percent of Canadian exports. As shown in the
following chart, the Commodity Price Index fell sharply several times between 1990 and 2002,
particularly during the Asian crisis of 1997-1998:

Note that I divided the

Commodity Price Index
(CPI) by 100, so I could
show both the CPI and the
exchange rate on the same
chart.
It would appear that both
the exchange rate and the
Commodity Price Index
suffered similar declines
during 1997 and 1998. I
calculated
the correlation coefficient
between the exchange rate
and
the
(unscaled)
Commodity Price Index between January 1997 and December 1998. The correlation coefficient
between the two was a whopping 0.94, indicating a particularly strong positive relationship
between the two. We cannot infer from this that the drop in the Commodity Price Index
necessarily caused a drop in the exchange rate, but we can say that the two changed in the same
direction most months during this period. This strong relationship did not occur before or after
this period. The correlation coefficient for 1990-1996 was -0.31, and for 1999-2002 was 0.29.
Now consider why this relationship might occur. After a reduction in lumber prices, an American
construction company now needs less Canadian dollars to purchases its Canadian lumber. The
reduction in lumber prices will likely cause the company to increase its purchases, but their total
expenditures will likely be lower than they were before. Because of this American construction
companies will need to buy less Canadian dollars on the foreign exchange market to get the
lumber they need. The demand for Canadian dollars will decrease, and the price of the Canadian
dollar relative to all currencies including the U.S. one will go down. We would expect that all
else being equal, a reduction in commodity prices will occur at the same time as a reduction in

the exchange rate. This appears to have happened during the Asian crisis of 1997-1998 and
possibly since then as well.
This reduction in commodity prices represents only a partial explanation for the decline in the
Canadian dollar.
Factor 2: Interest Rates
During the early 1990s, the Bank of Canada (BoC), Canada's central bank, embarked on a policy
to lower interest rates, particularly interest rates on government bonds. The BoC succeeded and
Canadian interest rates dropped much faster than American rates. The Canadian prime rate of
interest was around 14% during 1990 while the American prime rate was around 10%. We
usually compare interest rates by basis points, where 100 basis points a difference of 1%, say
between 5% and 6% or between 17% and 18%. So here we have a 400 point difference in rates.
By 1997 the Canadian prime rate of interest was 375 points lower than the American one. The
following chart shows the difference between the Canadian rate and the American one:

Changes in interest rates

can have a drastic effect on
exchange rates. Investors
interested in purchasing a
security that pays interest,
such as a bond, will buy
the bond that gives them
the highest interest rate, all
else being equal. Since
Canadian bonds had a
lower interest rate than
American bonds, investors
were more interested in
purchasing
American
bonds, and less interested
in Canadian ones. In order
to purchase American bonds, they would need to buy American dollars on the foreign exchange
market, causing a reduction in the supply of U.S. dollars and a rise in their value relative to other
currencies such as the Canadian one. If Canadians are buying U.S. bonds, they'll be selling
Canadian dollars and buying American ones, so we'll see an increase in the supply of Canadian
dollars and a decline in their value.

We should then expect to see periods where the exchange rate and the interest rate move in the
same direction. Visually it would be helpful to plot them both on the same set of axes. To do this
I had to perform a scaling operation on the interest rate gap. By taking the gap, dividing it by 50
then adding 0.7 to this figure, I was able to plot both on the same chart:

The exchange rate is the

blue line which starts
higher and the interest rate
gap is the purple line
which starts lower. Note
how both decline until
1997. The correlation
coefficient for the interest
rate gap and the exchange
rate from January 1990 to
December 1996 is 0.73;
the two were highly
positively related during
this
period.
However
during the Asian crisis of
1997-1998 the two went in
opposing directions and the correlation coefficient was -0.91. Changes in the interest rates gap
have not gone in the same direction as changes in the exchange rate since 1998 as the correlation
coefficient is -0.75. It would appear that if we're looking for reasons why the Canadian dollar
may have been weak since 1998, we'll have to look elsewhere for an answer.
Case Study: Canada - International Factors]

Factor 3: International Factors and Speculation

During 1997 and 1998, the economies of most Asian countries went into steep decline which
became known as the Asian Crisis. The Asian crisis had a far greater impact on Canada than it
did on the United States. Exports take up a much smaller portion of the U.S. economy than they
do of the Canadian economy. So the American dollar is much more insulated to international
events than the Canadian dollar. Canada also exports a large amount of construction materials to
Asian countries, so when the economies of these countries went into severe decline, new
construction became non-existent so raw materials were no longer demanded. This drop in the
demand for commodities caused a decline in the price of the Canadian dollar relative to other
non-Asian currencies.
Understandably most investors are somewhat risk-averse, so they will avoid unnecessary risk.
Investors during times of international turmoil prefer to invest in large countries that are more
insulated from turmoil in other counries. The United States is a haven for investors trying to
avoid this type of uncertainty, whereas smaller open economies like Canada are not. So not
surprisingly the Canadian dollar declined during the Asian crisis.
This still doesn't explain why the Canadian dollar declined from 1998 to 2002. Unfortunately I
can't provide any solid evidence of why this happened, but here are three possibilities.
1. The
Bush
Election
win:
The Republicans are seen as a party which will create an environment positive for
investors. It is conceivable that many international investors moved their money from
Canada to the United States when the White House went from Democratic to Republican
control.
2. International
Uncertainty:
As mentioned before investors will flock to a country like the United States during time
of unrest. Investors have been worried that a global recession might occur during the
beginning of this decade. Terrorist threats and military actions in Afghanistan and Iraq
may have caused investors to put their money into large countries like the United States.
3. The
Beliefs
of
Currency
Speculators:
Many currency speculators felt that the Canadian dollar would continue to decline in the
future. Many investors did not want to be part of a sinking ship, so they sold their
holdings of Canadian dollars, further reducing the price. If investors feel that the
Canadian dollar will improve in the near future, they will jump back on the bandwagon
by buying Canadian dollars and the value of the Canadian dollar will rise. It appears this
is what has been happening in the beginning of 2003.
Currency impact of a rate cut
A rate cut can trigger some depreciation in the value of the currency, making it more
difficult for companies to import. Exporters, of course, stand to gainfluctuations are among

the biggest downsides of an open economy. The value of a currency can change on a
minute-by-minute basis. One of the main advantages of an open economy is the greater
opportunity for trade and trade involves continuously pricing and comparing goods.
Currency
value
changes
make
this
a
difficult
task.
India is not an open economy but it has gradually edged closer and closer to being open.
Somewhat over 40 per cent of India's GDP involves trade in the form of either exports or
imports. In almost every manufacturing sector, domestically produced goods have to
compete with their foreign equivalents. This has some interesting consequences.
There are some segments where the domestic manufacturer has a large competitive
advantage. For example, cement manufacturers are unlikely to be challenged by imports.
There are other areas where the overseas manufacturers have large advantages -for
example, almost all electronic components are imported from South East Asia.
But there are a large number of segments where domestic and imported items are roughly
competitive with each other. Changes in customs duties can afford protection to the
domestic manufacturer (or remove protection). Having an edge in the marketing and
distribution network can also give an advantage. And swings in currency rates can also
change
the
competitiveness.
Every change in domestic interest rates usually leads to a change in the currency rates as
well. The direct impact of lower (or higher) policy rates on the domestic economy is well
understood and usually discussed at great length when the RBI cuts (or raises) policy rates.
However, if a change in policy rates leads to a change in currency rates, there is another
important
impact
and
that
is
not
discussed
in
such
detail.
There are several models that try to value currencies in terms of interest rate parities. At its
broadest, currency rates should reflect long-term interest yields. Say, for example, that the
dollar-rupee rate is 60 and the one-year dollar treasury bill is at a yield of 2.4 per cent while
the equivalent rupee yield is at 8.5 per cent. A year down the line, $1.024 will be worth Rs
65.1 because those are the respective returns and it is possible to convert one currency to
another without much trouble. Hence, the one-year forward rate should reflect this interest
rate
differential.
The complications arise because of differences in inflation rates and, hence, differences in
real interest rates, differences in relative ease of conversion, short-term demands for one
currency or another, etc. The currency market reflects the consensus opinion about such
factors.
Other things being more or less discounted, a rate cut in one currency can trigger

some depreciationin the value of that currency. This is actually an interesting situation that
could affect India at the moment. A policy rate cut may make it easier for Indian
corporations to raise money domestically. It might also stimulate consumer demand for
goods and services. But if it also leads to rupee depreciation it will make it more difficult
for corporations to import and it will make it more difficult to repay outstanding overseas
demand. Of course, depreciation will make Indian exports more competitive.
Conversely a rate hike may have positive effects if it triggers currency appreciation.
Importers have an easier time and corporation with external debt obligations find it easier
to meet commitments. The RBI has to take these effects into account since Indian
corporations do have significant overseas debt. The central bank presumably has some sort
of stress test model where it assesses the likely effect on the rupee and on overseas debt
everytime
there
is
a
change
in
policy
rates.
The stock market probably ignores this effect entirely in the short run. The impact of a rate
cut is almost always seen to be broadly positive. In fact, there may be negative effects if
there are a large number of corporations with external debt. The RBI has chosen not to
touch rates in this policy review. The next time it does change policy rates, bear the
currency effect in mind.

How exchange rate changes impact Indian manufacturing firms

After falling to its lifetime low of 68.85 against the dollar in August last year, the Rupee has now
appreciated to breach the 60-per-dollar mark. This column explores the impact of currency
movements on the performance of Indian manufacturing firms. It finds that in the short run, real
exchange rate movements have a significant impact on firm performance through changes in
import
costs,
rather
than
changes
in
export
competitiveness.
With Rupee close to the 60-per-dollar mark, firms and policymakers in India are trying to find
ways of dealing with the economic consequences of a fluctuating currency. This has brought
back the focus on attempts to measure the impact of currency movements on economic

performance. Theoretically, exchange rate movements can affect economic performance through
a number of channels, such as cost of imported inputs, competitiveness of exports, and changes
in the value of firms foreign assets and liabilities. For example, when the value of the Rupee
falls vis--vis other currencies, the cost of imported inputs such as energy increases, causing a
reduction in the profit margins and prompting firms to cut down on production. On the other
hand, decline in the value of Rupee makes Indian exports cheaper and hence more competitive in
the global market, which makes higher production more attractive for exporting firms. Of the
channels mentioned above, which one is dominant is a question of empirical investigation.

A brief background of Indias exchange rate policies

India presents a unique case for studying the impact of exchange rate movements. Prior to the
Balance of Payments crisis in 1991, Indian Rupee was pegged to a basket of currencies
dominated by the US Dollar. The external payment crisis of 1991 forced the Reserve Bank of
India (RBI) to implement a set of market-oriented financial sector reforms, and a paradigm shift
from fixed1 to market-based exchange rate regime2 in March 1993. Institution of Current
Account convertibility3 in August 1994, gradual liberalisation of the Capital Account4 along with
other trade and financial liberalisation measures meant a rise in total turnover in the foreign
exchange market by more than 150% (from $73.2 bn in 1996 to $130 bn in 2002-2003, and
further to $1,100 bn in 2011-2012). A direct outcome of these changes has been a rise in the
volatility of Indian Rupee.

Against this backdrop, RBIs exchange rate management policy has aimed at maintaining orderly
conditions in the foreign exchange market by eliminating lumpy demand and supply and
preventing speculative attacks, without setting a specific exchange rate target. Towards this end,
RBI has used a combination of tools including sales and purchase of currency in both the spot
and the forward5 segments of the foreign exchange market, adjustment of domestic liquidity
through the use of Bank Rate 6, Cash Reserve Ratio (CRR)7, Repo rate8 etc., and monetary
sterilisation9 through specialised instruments. An interesting feature of RBIs intervention during
this period has been asymmetry during episodes of appreciation and depreciation. RBI has been
intervening actively in the foreign exchange market during episodes of Rupee appreciation by
purchasing foreign exchange, while following a hands-off approach during episodes of Rupee
depreciation. Underlying this asymmetry has been the notion that an appreciated Rupee would
hurt exporters through a loss in cost competitiveness and by corollary, adversely affect Indias
growth performance. However, empirical evidence on the impact of exchange rate on the
performance of Indian firms is non-existent.

Exchange rate movements and performance of firms

In a recent paper, I seek to understand the relationship between real exchange rate 10 movements
and firm-level performance (Dhasmana 2013). The primary source of data used in the analysis is
the Prowess database compiled by the Centre for Monitoring Indian Economy (CMIE). My
sample includes data on 250 manufacturing firms covering 13 broad manufacturing sectors, over
2000-2012.

The usual real exchange rate indices computed by RBI are not effective in capturing changes in
industry competitiveness induced by movements in bilateral exchange rates 11. To address this
issue, I construct industry-specific indices of real exchange rates using annual data on key
trading partners trade share in each industry and bilateral exchange rates 12. Results from the data
analysis confirm that in line with the theoretical predictions, firms with a higher share of
imported inputs tend to benefit significantly from a real exchange rate appreciation on account of
lower input costs. However, the impact of real appreciation operating through decreased export
competitiveness is not significant in the short-run.

Market power and real exchange rates

An important determinant of a firms response to exchange rate movements is the degree of
market power. Firms in industries with higher share of output held by a few firms (higher market
concentration) are likely to experience a smaller impact of exchange rate movement on their
output growth this is because producers in such industries are better able to absorb shocks to
their overall profitability on account of exchange rate changes owing to their greater market
power. I try to test this hypothesis. Once again the import cost channel appears significant - for a
given share of imported inputs in total costs and a constant path of currency depreciation, higher
market concentration is associated with a smaller reduction in output and sales. Export
competitiveness channel continues to remain insignificant even after accounting for differences
in market power13. One can safely conclude, therefore, that real depreciation affects firm leveloutput growth through higher import costs in the short run.

Policy implications
For policymakers trying to assess the impact of exchange rate movements on the real economy,
these results provide various important insights. Firstly, the short-run impact of a real
depreciation on firms output growth is likely to be negative since it is the import cost channel
that dominates in the short run. Further, the impact is asymmetric, with real depreciation having
a stronger impact as compared to real appreciation. This indicates the need for an effective

reserve management policy that allows monetary authorities to meet the challenges posed by
sudden episodes of sharp Rupee depreciation, as happened recently. It also implies that the call
for the RBI to assist with the revival of economic growth in the presence of uncertainties in the
domestic and external policy environment is likely to be counterproductive if it leads to a
downward pressure on the domestic currency.

At the same time, maintaining a competitive real exchange rate is imperative for boosting
intermediate and long-term economic growth and maintaining the external balance. Thus, using
scarce foreign exchange reserves to prevent currency depreciation in the face of sustained
downward pressure on the currency due to growing fiscal deficit and/ or massive capital outflows
would be problematic, apart from being unsustainable.

On the whole, for countries relying on volatile foreign capital inflows to finance their
consumption and investment needs, a careful reserve management policy along with a sound
fiscal policy are necessary to balance the multiple objectives of stable growth and external sector
balance in the long run.

Notes
1. A fixed exchange-rate system, also known as a pegged exchange rate system, is a
currency system in which governments try to maintain their currency value constant
against one another. Under this system, a countrys government decides the worth of its
currency in terms of either a fixed weight of gold, a fixed amount of another currency or
a basket of other currencies.
2. Under a market-based exchange rate regime, the exchange rate is allowed to fluctuate
according to demand/ supply of the currency in the foreign exchange market. This is
known as floating exchange rate.
3. Currency convertibility refers to the freedom to convert the domestic currency into other
internationally accepted currencies and vice versa. Current account convertibility refers
to freedom with respect to Current Account transactions. The Current Account records the
trade of goods and services of an economy with other countries of the world.
4. The Capital Account gives a summary of the capital expenditure and income for a
country. It comprises private and public investment flows such as foreign direct
investments (FDI), portfolio investments etc.

5. In a forward transaction, a buyer and seller of foreign exchange agree on an exchange

rate for any date in the future, and the transaction occurs on that date at the agreed rate,
regardless of what the market rates are then. In contrast, a spot transaction is a direct
exchange between two currencies, and cash delivery needs to takes place within two
working days.
6. Bank Rate is the rate at which RBI lends to commercial banks through its Discount
Window.
7. Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of
customers, which commercial banks have to hold as reserves with the RBI.
8. Repo rate is the rate at which the RBI provides money to commercial banks through its
short-term Repo Window in the event of a temporary shortfall of funds, under the
Liquidity Adjustment Facility.
9. Monetary sterilisation is the process by which monetary authorities ensure that foreign
exchange interventions do not affect the money supply in the domestic economy. For
example, if due to a Balance of Payments (exports minus imports) surplus, the domestic
currency is appreciating The Central Bank can use domestic currency to purchase
foreign currency-denominated assets. As a result, more of the domestic currency will be
in circulation, its supply will increase and appreciation of the currency would be
countered.
10. Nominal exchange rate is the price of one currency in terms of number of units of some
other currency. It is 'nominal' because it measures only the numerical exchange value, and
does not say anything about other aspects such as the purchasing power of that currency.
To incorporate the purchasing power and competitiveness aspects, real exchange rates are
used. The real exchange rates are nominal exchange rates multiplied by the price indices
of the two countries.
11. Aggregate Real Exchange Rate Indices using total trade shares of different trading
partners do not take into account the fact that the share of each trading partner varies by
industry.
12. Data source: UN Comtrade Database and International Monetary Funds (IMF)
International Financial Statistics.
13. To deepen our analysis further we incorporate the impact of overvaluation of real
exchange rate and firm-level characteristics (for example, share of foreign currency
borrowing in total borrowing, ratio of net-fixed assets to total assets etc.) the results
remain unchanged.
- See more at: http://ideasforindia.in/article.aspx?article_id=273#sthash.ig2Ho3Dt.dpuf

How exchange rate fluctuations affect companies

Most investors will be familiar with the concept of currency exposure, with constantly changing
exchange rates affecting the cost of investing in international stocks. These same issues also
affect companies that operate internationally. So what effect do currency fluctuations have on
company profits, and what are they doing to insulate themselves? In this extract from the Modern
Wealth Management blog, we take a look at this issue.
International firms vs international currency
Companies with overseas branches, or those that trade internationally, are at the mercy of global
currency fluctuations. As is the case with private investments, changes in conversion rates can
wipe out profits or increase gains.
When a firm has shareholders to report to, and the figures can run into millions, then it can have
a serious impact on profits and losses. The rapidly changing currency landscape can have the
potential to make businesses reluctant to set firm figures in contracts months before a deal takes
place. If a US-based firm makes EUR 10 million, they can end up with much more or less than
they thought depending on the movement of the EUR/USD exchange rate. For example, in June
2011 it would have been worth $14.4 million, but in June 2012 it would have been worth $2
million less.
These issues also exist when discussing contracts with international clients. Although something
may seem like a good deal when it is first written down, it can turn bad a few months later when
the contract is fulfilled.
A study by SunGard Data Systems polled 275 US businesses of various sizes. It found that 59
per cent of those surveyed had seen a loss or gain of more than five per cent as a result of
currency fluctuations in the previous year.

"The majority of corporations are in the business of doing business, producing and
manufacturing, not hedging currencies," said Paul Bramwell, a senior vice president of Treasury
solutions at the AvantGard unit of SunGard. "A lot of companies were caught unawares by
volatility."
He explained that looking at where the exposure lies instead of waiting for quarterly results to
discover the impact of fluctuations was a better approach, although he conceded that this is a
stance more and more firms are taking.
The impact on real businesses
Therefore, organisations have to evaluate the risks of doing business on an international level.
But it doesn't always work in their favour. For instance, McDonald's saw sales in Europe increase
in 2011, but the yearly profits were actually down as a result of a weakening euro. Indeed, some
experts think investors should be cautious this year too given that the US dollar has strengthened
so much recently and is expected to continue doing so. As McDonald's generate nearly three
quarters of its profits overseas, this could be an issue if they have not hedged.
Another recent example of this happened at eBay, with CFO Bob Swan admitting that currency
fluctuations will hit the bottom line by around three points in 2012. Ralph Lauren reported that
although currency changes have gone in its favour so far in 2012, it expects a turnaround in
fortunes in 2013.
"Foreign currency effects are estimated to negatively impact net revenue growth by
approximately 200-300 basis points in the first quarter," the company stated.
What can firms do?
As with private investors, business essentially have four options to counteract their currency
exposure.
The simplest approach is just to monitor the changes, and this can be the best option if
companies do not think that they are at a particularly high risk from exchange rate fluctuations.
Another option is to lock into an exchange rate for a fixed period of time by setting up a forward
contract. If the exposure estimates are correct, this can be a beneficial approach. Some
businesses will also purchase currency in advance if they know that they will be making big
purchases and are concerned about volatility.
A third option is to hedge against this exposure via derivatives. Although this may be the most
complicated option, it can be effective in limiting exposure to volatility. It can also give a clearer
picture of how a company's overseas operations are really performing.
Finally, firms can choose to manage their currency exposure through business practices. Having
a truly international company can help with this as, theoretically, losses made when one currency

falls will be recovered when another rises. Where contracts are concerned businesses can also set
up clauses that reduce this exposure. In many cases this comes in the form of an agreement to
protect the client and the company should exchange rate movements exceed the agreed-upon
level. Some businesses also agree on setting all contracts in their core currency, protecting them
from any exposure as they will always be paid the same relative amount.
Dealing with currency exposure is all about managing risk, as fluctuations are by their very
nature unpredictable. However, while private investors only have their own savings to worry
about if they fail to manage this risk appropriately, businesses face angry shareholders and a drop
in share value - as well as a drop in profits.
Factors which influence the exchange rate
Exchange rates are determined by supply and demand. For example, if there was greater demand
for American goods then there would tend to be an appreciation (increase in value) of the dollar.
If markets were worried about the future of the US economy, they would tend to sell dollars,
leading to a fall in the value of the dollar.
Note:

Appreciation = increase in value of exchange rate

Depreciation / devaluation = decrease in value of exchange rate.

Main Factors that Influence Exchange Rates

1. Inflation
If inflation in the UK is relatively lower than elsewhere, then UK exports will become more
competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also
foreign goods will be less competitive and so UK citizens will buy less imports.
Therefore countries with lower inflation rates tend to see an appreciation in the value of their
currency.
2. Interest Rates
If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in
the UK. You will get a better rate of return from saving in UK banks, Therefore demand for
Sterling will rise. This is known as hot money flows and is an important short run factor in
determining the value of a currency. Higher interest rates cause anappreciation.
3. Speculation
If speculators believe the sterling will rise in the future, they will demand more now to be able to
make a profit. This increase in demand will cause the value to rise. Therefore movements in the

exchange rate do not always reflect economic fundamentals, but are often driven by the
sentiments of the financial markets. For example, if markets see news which makes an interest
rate increase more likely, the value of the pound will probably rise in anticipation.
4. Change in Competitiveness
If British goods become more attractive and competitive this will also cause the value of the
Exchange Rate to rise. This is important for determining the long run value of the Pound. This is
similar factor to low inflation.
5. Relative strength of other currencies.
In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets were
worried about all the other major economies US and EU. Therefore, despite low interest rates
and low growth in Japan, the Yen kept appreciating.
6. Balance of Payments
A deficit on the current account means that the value of imports (of goods and services) is greater
than the value of exports. If this is financed by a surplus on the financial / capital account then
this is OK. But a country who struggles to attract enough capital inflows to finance a current
account deficit, will see a depreciation in the currency. (For example current account deficit in
US of 7% of GDP was one reason for depreciation of dollar in 2006-07)
7. Government Debt.
Under some circumstances, the value of government debt can influence the exchange rate. If
markets fear a government may default on its debt, then investors will sell their bonds causing a
fall in the value of the exchange rate. For example, Iceland debt problems in 2008, caused a rapid
fall in the value of the Icelandic currency.
For example, if markets feared the US would default on its debt, foreign investors would sell
their holdings of US bonds. This would cause a fall in the value of the dollar. See: US dollar and
debt
8. Government Intervention
Some governments attempt to influence the value of their currency. For example, China has
sought to keep its currency undervalued to make Chinese exports more competitive. They can do
this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan.

see also: Chinese Currency | Swiss Franc pegged against Euro

9. Economic growth / recession

A recession may cause a depreciation in the exchange rate because during a recession interest
rates usually fall. However, there is no hard and fast rule. It depends on several factors.
See: Impact of recession on currency.
Example Fall in Value of Sterling 2007 Jan 2009

During this period, the value of Sterling fell over 20%. This was due to:

Restoring UKs lost competitiveness. UK had large current account deficit in 2007

Bank of England cut interest rates to 0.5% in 2008.

Recession hit UK economy hard. Markets expected interest rates in UK to stay low for a
considerable time.

Bank of England pursued quantitative easing (increasing money supply). This raised
prospect of future inflation, making UK bonds less attractive.

Sterling Effective Exchange Rate

The Risks of Currency Value Fluctuation

From political turmoil to a natural disaster, there are plenty of factors that cause a currency's
value to rise and fall. When a business engages in international business transactions such as
importing, exporting and paying foreign employees swings in currency value can have a
significant impact on the bottom line.

Market fluctuations can impact everything from purchasing power to operating costs, making it
difficult for businesses to predict profits and losses. If exchange rates take an unfavorable turn,
an international business may end up paying more or receiving less from its partners and
overseas customers.
Here are three approaches that can help business owners plan for swings in currency value.
The yen continued to soar, and as it did, it became harder for Japanese exporters to compete with
the prices offered by exporters in other countries.
1. Acknowledge that Unpredictability Is Predictable
Its crucial that business owners take steps to understand where a countrys currency stands. But
its just as important to acknowledge that foreign currency values can change on a dime. Take,
for example, the 2011 natural disasters that impacted Japan.
Immediately after the 8.9-magnitude earthquake and 13-foot tsunami hit Japans Eastern coast on
March 11, 2011, the Japanese yen began to slide. But within a few days, the currency value
strengthened as Japanese business owners and citizens created a high demand for the currency by
purchasing medical supplies and other essential items.[1]
The Japanese government began pumping money into the economy to guard against an overly
strong yen. Yet the yen continued to soar, and as it did, it became harder for Japanese exporters
to compete with the prices offered by exporters in other countries. Adding to the problem, when
customers made international payments in their native currencies, Japanese exporters ended up
with less money after currency conversion.[1]
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2. Consider Currency Risk at the Outset

A lot of business owners think of an exotic spot to do business, and they just move there and
start a business, says Dmitry Dragilev, a Boston native and designer of the Currency Exchange
Fee Calculator app.
Dragilev says its important for business owners to consider the economic climate and
fluctuations in the exchange market before setting up shop in another country. While many
economic and political turns cant be predicted, understanding the variables can help business
owners steer clear of markets on the verge of instability.
3. Minimize Risk
There are a few things small business owners can do to help minimize fluctuation risks in the
market. For example, business owners can employ strategies such as crafting contract terms that
ensure payment will be submitted in their domestic currency. And when businesses make
international payments, they may consider locking in a fixed rate on their currency exchanges by
using forward contracts.
SIGNIFICANCE
The exchange rate expresses the national currency's quotation in respect to foreign ones. For
example, if one US dollar is worth 10 000 Japanese Yen, then the exchange rate of dollar is 10
000 Yen. If something costs 30 000 Yen, it automatically costs 3 US dollars as a matter of
accountancy. Going on with fictious numbers, a Japan GDPof 8 million Yen would then be worth
800 Dollars.

Thus, the exchange rate is a conversion factor, a multiplier or a ratio, depending on the direction
of conversion.
In a slightly different perspective, the exchange rate is a price. If the exchange rate can freely
move, the exchange rate may turn out to be the fastest moving price in the economy, bringing
together all the foreign goods with it.
Types of exchange rate
It
is
customary
to
distinguish nominal exchange
rates
from real exchange
rates. Nominal exchange rates are established on currency financial markets called
"forex markets", which are similar to stock exchange markets. Rates are usually established in
continuous quotation, with newspaper reporting daily quotation (as average or finishing
quotation in the trade day on a specific market). Central bank may also fix the nominal exchange
rate.
Real exchange rates are nominal rate corrected somehow by inflation measures. For instance,
if a country A has an inflation rate of 10%, country B an inflation of 5%, and no changes in the
nominal exchange rate took place, then country A has now a currency whose real value is 10%5%=5% higher than before [1]. In fact, higher prices mean an appreciation of the real exchange
rate, other things equal.
Another classification of exchange rates is based on the number of currencies taken into
account. Bilateralexchange rates clearly relate to two countries' currencies. They are usually the
results of matching of demand and supply on financial markets or in banking transaction. In
this latter case, the central bank acts usually as one of the sides of the relationship.
Other bilateral exchange rates may be simply computed from triangular relationships: if the
exchange rate dollar/yen is 10 000 and the dollar/Angolan kwanza is 100 000 then, as a matter of
computation, one yen is worth 10 kwanza. No direct yen/kwanza transaction needs to take place.
If, instead,a financial market exists for yen to be exchanged with kwanza, the expectation is that
actions by speculators (arbitrage among markets) will bring the parity of 10 kwanza per yen as
an effect.
Multilateral exchange rates are computed in order to judge the general dynamics of a country's
currency toward the rest of the world. One takes a basket of different currencies, select a (more
or less) meaningful set of relative weights, then computes the "effective" exchange rate of that
country's currency.
For instance, having a basket made up of 40% US dollars and 60% German marks, a currency
that suffered from a value loss of 10% in respect to dollar and 40% to mark will be said having
faced an "effective" loss of 10%x0.6 + 40%x0.4 = 22%.

Some countries impose the existence of more than one exchange rate, depending on the type
and the subjects of the transaction. Multiple exchange rates then exist, usually referring to
commercial vs. public transactions or consumption and investment imports. This situation
requires always some degree of capital controls.
In many countries, beside the official exchange rate, the black market offers foreign currency at
another, usually much higher, rate.
Exchange rate regimes
When the exchange rate can freely move, assuming any value that private demand and supply
jointly establish, "freely floating exchange rate" will be the name of currency institutional
regime. Equivalently, it is called "flexible" exchange rate as well.
If the central bank timely and significantly intervenes on the currency market, a
"managed floating exchange rate regime" takes place. The central bank intervention can have an
explicit target, for example in term of a band of currency acceptable values.
In "freely" and "managed" floating regimes, a loss in currency value is conventionally called a
"depreciation", whereas an increase of currency's international value will be called
"appreciation". If the dollar rise from 10 000 yen to 12 000 yen, then it has shown an
appreciation of 20%. Symmetrically, the yen has undergone an 8.3% depreciation.
But central banks can also declare a fixed exchange rate, offering to supply or buy any
quantity of domestic or foreign currencies at that rate. In this case, one talks of a "fixed
exchange rate".
Under this regime, a loss of value, usually forced by market or a purposeful policy action, is
called a "devaluation", whereas an increase of international value is a "revaluation".
The most stabile fixed exchange regimes are backed by an international agreement on
respective currency values, often with a formal obligation of loans among central banks in case
of necessity.
A "currency crisis" is a rupture of fixed exchange rates with an unwilling devaluation or even
the end of that regime in favour of a floating exchange rate. It can dominate the attention of the
public, policymakers and entrepreneurs, both in advance and after. For instance, people
expecting a crisis can borrow inside the country, convert in a foreign currency, lend that money
(e.g. by purchasing bonds). When the crisis comes, they sell the bonds, convert to the national
currency, pay back their loans, are gain a hefty profit.
An extreme national engagement to fixed exchange rates is the transformation of the central bank
in a mere "currency board" with no autonomous influence on monetary stock. The bank will

automatically print or lendmoney depending on corresponding foreign currency reserves.

Thus, exports, imports and capital inflows (e.g. FDI) will largely determine the monetary policy.
Monetary unions phase out the national currencies in favour of one (new or existing). Some
further countries can target to join the union and put in place economic and financial policies to
that aim, especially if there are explicit conditions for entering into that monetary area. Exiting a
monetary union can provoke with large devaluation of the new national currency. Depending on
trade elasticities, on foreign debt of the country, on how the exit is managed and on the overall
institutional conditions, this can lead to massive internal poverty or a large export led-growth.
Determinants of the nominal exchange
Fixed exchange rates are chosen by central banks and they may turn out to be more or less
accepted by financial markets.
Changes in floating rates or pressures on fixed rates will derive, as for other financial assets,
from three broad categories of determinants:
i)
variables
on
the
"real"
side
of
the
economy;
ii) monetary
and
financial variables
determined
in
cross-linked
markets;
iii) past and expected values of the same financial market with its autonomous dynamics.
Let's see them separately for the case of the exchange rate.
Real variables
1. Exports, imports and their difference (the trade balance) influence the demand of currency
aimed at real transactions.
A rising trade surplus will increase the demand for country's currency by foreigners, so that there
should be a pressure for appreciation. A trade deficit should weaken the currency.
Were exports and imports largely determined by price competitiveness and were the exchange
rate very reacting to trade unbalances, then any deficit would imply depreciation, followed by
booming exports and falling imports. Thus, the initial deficit would be quickly reversed. Net
trade balance would almost always be zero.
This is hardly the case in contemporary world economy. Trade unbalances are quite persistent,
as you can verify with these real world data. Additionally, not so seldom, exchange rates go in
the opposite direction than one would infer from trade balance only.
2. An even more radical form of real determination of exchange rate is offered by the "one price
law", according to which any good has the same price worldwide, after taken into account
nominal exchange rates. If a hamburger costs 3 US dollars in the United States and 30 000 yen in

Japan, then the exchange rate must be 10 000 yen per dollar. The forex market would passively
adjust to permit the functioning of the "one price law".
But in order to equalise the price of several goods, more than one exchange rate may turn out to
be "necessary". Moreover the "one price law" seems to suffer from too many exceptions to be
accepted as the fundamental determinant of exchange rates.
Large, persistent and systematic violations of Purchasing Power Parity are connected to price-tomarket decisions of firms in this paper of September 2007.
Monetary and financial variables in cross-linked markets
1. Interest rates on Treasury bonds should influence the decision of foreigners to purchase
currency in order to buy them. In this case, higher interest rates attract capital from abroad and
the currency should appreciate. Decisive would be the difference between domestic and foreign
interest rates, thus a reduction in interest rates abroad would have the same effects.
Similarly other fixed-interest financial instruments could be objects of the same dynamics.
Accordingly, an increase of domestic interest rates by the central bank is usually considered a
way to "defend" the currency.
Nonetheless, it may happen that foreigners rather buy shares instead of Treasury bonds. If this
were the strongest component of currency demand, then an increase of interest rate may even
provoke the opposite results, since an increase of interest rate quite often depresses the stock
market, favouring a tide of share sales by foreigners.
In the same "reversed" direction foreign direct investments would work: arestrictive monetary
policy usually depresses the growth perspective of the economy. If FDI are mainly attracted by
sales perspectives and they constitute a large component of capital flows, then FDI inflow might
stop and the currency weaken.
Needless to say, those conditions are quite restrictive and not so usually met.
A matter of discussion would be whether the relevant interest rate is the nominal or the real one
(which, in contrast with the former, keeps into account inflation). Usually foreign investors do
not purchase bread, clothes, and the other items included in the bundle used to compute price
level and its dynamics: they do not buy anything real in the target economy. So nominal rates are
more likely to be taken into account.
As a temporary conclusion, interest rates should have an important impact on exchange rate but
one has to be careful to check additional conditions.
2. Inflation rate is often considered as a determinant of the exchange rate as well. A high
inflation should be accompanied by depreciation. The more so if other countries enjoy lower

inflation rates, since it should be the difference between domestic and foreign inflation rates to
determine the direction and the scale of exchange rate movements.
All this would be implied by a weak version of "one price law" stating that price dynamics of a
good are the same worldwide, after taking into account nominal exchange rates. Thus, here not
absolute level but just thepercentage differences in price are requested to be equalised .
If an hamburger costs in Japan 5% more than a year ago, while in USA it costs 8% more, then
the dollar should have been depreciated this year by about 8-5=3%.
But in order to equalise the price dynamics of different goods, more than one exchange rate
change may turn out to be "necessary".
In reference to the overall price level of the economy, if exchange rates would move exactly
counterbalancing inflation dynamics, then real exchange rates should be constant. On the
contrary, this is not true as a strict universal rule.
Still, even if this weak version of the "law" does not always hold, high inflation usually give rise
todepreciation, whose exact dimension need not match the inflation itself or its difference with
foreign inflation rates.
3. The balance of payments can highlight pressures for devaluation or revaluation, reflected in
large and systematic trend of foreign currency reserves at the central bank. In particular, large
inflows, due for instance to a rise in the world price of main export items, tend to raise the
exchange rate. Conversely, a collapse in the trust of government to manage the economic
conditions might provoke a flight of capital, the exhaustion of foreign currency reserves and
force devaluation / depreciation.
Autonomous dynamics on the forex market
Past and expected values of the exchange rate itself may impact on current values of it. The
activities of forex specialists and investors may turn out to be extremely relevant to the
determination of market exchange rate also thanks to their complex interaction with central
banks. Sophisticated financial instruments like futures on exchange rates may play an important
role. Imitation and positive feedbacks give rise to herd behaviour and financial fashions.
Fears and confidence in a currency are heterogeneosly distributed across agents, with special
events (as unexpected news) realigning them and generating large movement in the exchange
rate.
For a full-text free book on artificial forex market based on empirical field research see here.
Impact on other variables

Levels and fluctuations in the exchange rate exert a powerful impact on exports, imports and
the trade balance. A high and rising exchange rate tends to depress exports, to boost import and
to deteriorate the trade balance, as far as these variables respond to price
stimuli. Consumers find foreign goods cheaper so the consumptioncomposition will change.
Similarly, firms will reduce their costs by purchasing intermediate goods abroad.
In extreme cases, local firms producing for the domestic market might go bankrupt. If the reason
of appreciation was a soaring world price of main exports (e.g. energy carriers, like oil for many
oil producing countries), the composition of the industrial texture would be starkly simplified
and concentrated to those exports. This is at odds and works in the opposite direction of
the diversification of the economy that is often the stated goal of public strategies in countries
depending on too few productions (high export concentration).
A devaluation or depreciation should work in the opposite direction, improving the trade
balance thanks to soaring exports and falling imports.
If, however, imports have an elasticity to price less than 1, their values in local currency will
grow instead of falling. Moreover, if the state, the citizens and / or the enterprises have a debt
denominated in a foreign currency, their principal and the interests to be paid soar because of the
devaluation. They usually squeeze other expenditures and launch a recessionary impulse
throughout the economy.
Previous investors in real estate and other assets would be hurt by devaluation, so the perspective
of such a dynamics makes investors cautious and might sink FDI.
External debt denominated in foreign currency can, if large enough, provide considerable effects
on the positive or negative impact of fluctuation. A devaluation with a large external debt
provokes a larger outflows of interest payments (expressed in local currency), possibly squeezing
the economy and the public budget, with recessionary effects.
Hosting different industries, regions usually exhibit a differentiated degree of international
openness: exchange rate fluctuations will have an uneven impact on them. Similarly, the number
of job places and the working conditions may be influenced by the degree of international
competition and exchange rates levels.
Exchange rate influences also the external purchasing power of residents abroad, for example
in term of purchasing real estate and other assets (e.g. firm equity as a foreign direct investment),
so by different channels, also the balance of payments.
Exchange rate devaluation (or depreciation) gives rise to inflationary pressures: imported good
become more expensive both to the direct consumer and to domestic producer using them for
further processing. In reaction to inflation (actual and feared), the central bank can rise the
interest rates, thus sending a recessionary impulse.

Currency crisis have a sweeping impact on income distribution. The few rich able to borrow
(because they have collateral and the banks trust them) will get richer and the people purchasing
imported goods facing inflation and reduction of real incomes.
Symmetrically, the central bank may use a fixed exchange rate as a nominal anchor for the
economy to keep inflation under control, compelling domestic producer to face tougher
competition as soon as they decide to increase prices or accept to pay higher wages.
For a small economy, joining a monetary union makes the exchange rate to fluctuate according to
fundamentals and market pressures referring to a much larger area, erratically going in directions
that are (or are not) coherent with positive macroeconomic developments.
For statistics purposes, international comparisons of current values converted to a common
currency are "distorted" by wide exchange rate fluctuations.
Long-term trends
Some geographical monetary areas have enjoyed long periods of stable exchange rate, with
moments of consensual realignment after divergence in inflation rates. Many countries strive to
keep their currency at a fixed level toward the dollar, the Euro (earlier the German mark) or a
basket with multiple currencies.
Still, most currency progressively devaluate, especially those issued by periphery countries. The
US dollar has extremely wide fluctuations with years of "weak" and "strong" dollar.
Business cycle behaviour
Too many elements are at work for the exchange rate to exhibit a clearly-defined business cycle
behaviour. To the extent that the exchange rate is determined by the trade balance, the exchange
rate is counter-cyclical as the latter. At peaks, the trade deficit would depress the exchange rate,
forcing it to depreciate.
If it is rather the interest rate that turns out to the main driver of the exchange rate, a possible
pro-cyclicity of the interest rate would imply a pro-cyclical exchange rate.
In this scenario, recovery and boom are accompanied by rising interest rates and exchange rates.
At peaks, we would see very strong currency. Together with domestic demand pressures, this
would be the source of a high trade deficit.
If autonomous dynamics in the forex market are the main determinants of the exchange rate,
then intense micro-fluctuations and long term tides would ride the exchange rate, possibly
with central bank significant interventions.

Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the exchange
rate influences other income factors such as interest rates, inflation and even capital gains from
domestic securities. While exchange rates are determined by numerous complex factors that
often leave even the most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rates play an important role in the rate of
return on their investments.