TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 16

Key Topics
Foreign Exchange Market : Demand-Supply Framework
Determinants in Forex Market
Spot and Forward Market
Foreign Exchange Risks
Theories: PPP and IRP

Foreign Exchange Market

It is the market in which individuals, firms, and banks buy and sell
foreign currencies or foreign exchange.
Demand for foreign currencies
-Import/expenditures abroad/investment abroad
Supply of foreign currencies
-Export/earnings from tourism/receipt of foreign investments

Key participants
1. Immediate users and suppliers of foreign currenciesimporters/exporters/ tourists/investors
2. Commercial bank
3. Foreign exchange brokers-interbank / wholesale market
4. The nations central bank-lender of last resort

Demand-Supply framework for ER determination

INR/$
Supply of $

INR 65 /$

Demand for $
$ Reserve

Show graphically the effect of the following

conditions on ER between India and USA
1. Indian Families prefer US electronic products
2. If inflation rate in India is relatively higher than of US
3. If Indian Banks offer higher interest rates on term deposits than US Banks

What determines the Exchange Rate?

Determinants in Forex Market

Taste and Preferences for foreign goods and domestic goods.
Relative interest rates among trading countries
Relative inflation rates among trading countries
Market Speculation

Two Types of Forex Markets

1.

2.

Spot Market:
- immediate transaction
- recorded by 2nd business day
Forward Market:
- transactions take place at a
- specified future date and at a specified rate

Foreign Exchange Risks

Foreign exchange risks arise due to

1. Changes in tastes for domestic and foreign products in the nation and
abroad
2. Different growth and inflation rates in different nations
3. Changes in relative rates of interest
4. Changing expectations

Theories of Exchange Rate Determination

The law of one price

The law of one price states
Identical products sold in different countries must sell for one price if their
price is expressed in one currency
Assumptions:
Competitive markets
No transportation costs; no trade barriers

The law of one price..

Goods Market

Asset Market

Purchasing Power Parity (PPP)

Theory

Interest Rate Parity (IRP) Theory

Purchasing Power Parity (PPP) Theory

The PPP theory states that price of identical goods
and services should be equal at home and abroad.
Absolute Version:
= .
Relative Version:

Interest Rate Parity (IRP) Theory

States that arbitrage under perfect mobility of funds will ensure
equality of return on currencies.
i.e, r = r* +
Where r =domestic interest rate
r* = foreign interest rate
= expected depreciation of domestic currency

IRP Contd..
For an investor from India, there are two comparable investment options:
returns from risk less Indian bonds of 1 year maturity = (1+r)
returns from risk less Foreign bond of 1 year maturity=(1+r*)
But he invests todays ER , that is , E.
He gets turn after a year, that is,
For the investor to be indifferent between the two options,
r = r* +( - E)/E
If INR depreciates, > E and the second term is positive( forward premium)
If INR appreciates, < E and the second term is negative (forward discount)

IRP Contd..
Summary:
Interest Rate Parity states:
Higher interest rates on a currency offset by forward discounts.
Lower interest rates are offset by forward premiums.