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Exchange Rate Mechanism
by Nagaraj S R, Banking Consultant & Trainer

Exchange Rate Mechanism

The Foreign Exchange Market (Forex Market – often called) is a virtual market wherein various currencies are traded. A Currency is a kind of money and a medium of exchange. There are 180 currencies recognised as Legal Tender and many of these currencies are traded in the market against each other. 

What is the Forex Market?

The Foreign Currency Market is very huge in its size and is decentralised. A 40% increase in daily forex trading volume was noted over the last decade. Daily turnover in the global foreign exchange market has hit $6.6 trillion. In 2019, the global foreign exchange (forex) market saw an average daily turnover of approximately 5.1 trillion U.S. dollars. The US Dollar remains the dominant currency in forex trading being on the one side of the currency trade.  There is no central physical marketplace for currency trading. The market operates on both Over-the-Counter (OTC) and Exchange Traded. In a broader sense, currencies can be traded on both the platforms, though there may be few country-wise restrictions. In these markets, there are various market participants viz., Government & Central Banks, Financial Institutions, Brokers, Commercial Banks, Currency Traders/Speculators etc. Foreign Exchange Market is not only the largest in the world, but also the most liquid – a major differentiation from other markets. The advantage of the market operating on a virtual mode and decentralised mode, the participants have the option of choosing a dealer from many numbers of dealers. 

The Foreign Exchange Market is unique because of the following characteristics:

  • Its huge trading volume with high liquidity
  • the geographical spread
  • the continuous operations except for weekends
  • the factors which determines the rates
  • the factors that influence the margins
  • the local regulations

Let’s first understand few basics of Foreign Exchange Market.

All trades in Foreign Exchange Market involve, on one side buying one currency and on the other side, selling another currency. 

In financial terms, Exchange Rate is the rate at which one currency is exchanged for another.

Few Foreign Exchange Market Terminology:

Base Currency & Quote  Currency:

In the Forex Market, each currency is quoted against another currency. For eg. USD/INR, here the price of USD is quoted in terms of INR. The first currency in the currency pair i.e. USD is called ‘Base Currency’ and the second currency is called ‘Quote or Term Currency’. The currency pair shows how much of Quote or Term Currency is to be paid to purchase a unit of Base Currency. 

Types of Quotes:

The quotes for each currency pair, is quoted in two ways:

Direct Quote

The Currencies are quoted in two different ways in the Forex Market. One is Direct Quote and another is Indirect Quote. Let’s understand the difference between these two quotes. 

Direct Quote is one, when the Base Currency is stated in a fixed number of units and the price for the base currency is quoted in terms of Counter Currency, which is fluctuating. In other words, the counter currency keeps fluctuating whereas the Base Currency is in fixed units. A Direct quotation is also known as “Price quotation”, since it expresses the variable amount of home currency required to buy a fixed unit of foreign currency. In a Direct Quote, the foreign currency is base currency, while the home currency is counter currency.

For eg.  USD/INR = 76.70/76.75

The above quote is a direct quote, wherein, to buy one unit of USD, INR76.75 must be paid and to sell one unit of USD, INR76.70 will be received by the person. In other words, Market’s buy rate for USD (Base Currency) against INR is 76.70 and sell rate for USD (Base Currency) against INR is 76.75. One must understand the rates from his/her point of view, whether he/she is buying or selling. If you are buying USD from the Market, then the rate for you is INR76.75, because the market is selling at this rate. If you are selling USD to the Market, then the rate for you is INR76.70, because the market is buying USD at this rate. Many currencies are quoted in direct method.

Indirect Quote:

Indirect Quote is exactly the opposite of direct quote. The term indirect quote is a currency quotation in the foreign exchange market that expresses the variable amount of foreign currency required to buy or sell a fixed unit of the home currency. An indirect quote is also known as “Quantity quote”, since it expresses the amount of foreign currency required to buy or sell fixed units of home currency. In other words, the domestic currency is the base currency in an indirect quote, while the foreign currency is the counter currency. 

Understanding Currency Quotes

As the USD is the dominant currency in the global forex markets, many currencies are quoted against USD as the Base currency and the home currency (other currency) being the counter currency. A Direct quotation is easy to understand and interpret. For eg. If the INR is quoted against USD – USD/INR 76.70/76.75 – It is easy to understand that the market is buying USD at 76.70 and selling at 76.75. The concept, here, is ‘Buy Low and Sell High’. 

All over the world, the following four currencies are quoted in indirect methods:-

Britain Pounds (GBP)


Readers may remember them with the acronym ‘PANE’ – Pounds, AUD, NZD & EUR

Euro (EUR)

Australian Dollar (AUD)

New Zealand Dollar (NZD)

 

For eg. GBP is quoted as – GBP/USD = 1.3000/1.3200

In the direct quote, a lower quote means, the home currency (base currency) is appreciating or becoming stronger and vice versa. Continuing with the above USD/INR quote, let’s say the quote now is USD/INR = 76.50/76.55, which means that the INR is becoming stronger against USD. For buying USD, earlier a buyer would have paid INR76.75 while at the present quote, he/she pays INR76.55. INR has appreciated by Ps.0.20.

In an indirect quote, it is exactly opposite, A lower quote means, the home currency is depreciating or weakening. 

Cross Currency

 

What about cross-currency rates, which express the price of one currency in terms of a currency other than the US dollar? A trader or investors should first ascertain which type of quotation is being used – direct or indirect – to price the cross-rate accurately.

For example, if the Japanese yen is quoted at US$1 = JPY 100, and US$1 = C$1.2700, what is the price of yen in Canadian dollars (both direct and indirect quotations)?

In Canada, the indirect quotation would be: C$1 = US$0.7874 x 100 (yen per USD) = 78.74 yen. The direct quotation would be: JPY 1 = C$1.2700/100 = C$ 0.012.

Exchange Rate Types

Floating and Fixed Exchange Rate

Exchange rates do not remain constant. They can be floating or fixed. The exchange rate is floating when the currency rate is determined by market conditions. Most countries use a floating exchange rate. On the other hand, some countries prefer to fix their domestic currency against a dominant currency, such as the USD.

Who Determines the Exchange Rate?

Each nation has its own internal exchange rate determination policies. Few follow Fixed Exchange Rate and others Floating Exchange Rate. 

In a Fixed Exchange Rate Regime, the government will fix the exchange rate, mostly against the US Dollar which is a dominant currency in the world. A fixed exchange rate is when a country ties the value of its currency to some other widely-used commodity or currency. The dollar is used for most transactions in international trade. Today, most fixed exchange rates are pegged to the U.S. dollar. Countries also fix their currencies to that of their most frequent trading partners.

Brief History and Definition

In the past, currencies were fixed to an ounce of gold. In the 1944 Bretton Woods Agreement, countries agreed to peg all currencies to the U.S. dollar. The United States agreed to redeem all dollars for gold. In 1971, President Nixon took the dollar off, of the gold standard to end the recession. Nixon's action ended the 100-year history of the gold standard. Still, many countries kept their currencies pegged to the dollar, because the dollar is the world's reserve currency.

A fixed exchange rate tells you that you can always exchange your money in one currency for the same amount of another currency. It allows you to determine how much of one currency you can trade for another. For example, if you go to Saudi Arabia, you always know a dollar will buy you 3.75 Saudi riyals, since the dollar's exchange rate in riyals is fixed. Saudi Arabia did that because its primary export, oil, is priced in U.S. dollars. All oil contracts and most commodities contracts around the world are written and executed in dollars.

Advantages:

A fixed exchange rate provides currency, a stability. Investors always know what the currency is worth. That makes the country's businesses attractive to foreign direct investors. They don't have to protect themselves from wild swings in the currency's value. They are hedging their currency risk.

A country can avoid inflation if it fixes its currency to a popular one like the U.S. dollar or euro. It benefits from the strength of that country's economy. As the United States or European Union grows, its currency does as well. Without that fixed exchange rate, the smaller country's currency will slide. As a result, the imports from the large economy become more expensive. 

For example, the U.S. dollar's value is 3.75 Saudi riyals. If the dollar strengthens 20% against the euro, the value of the riyal, which is fixed to the dollar, has also risen 20% against the euro. To purchase French pastries, the Saudis pay less than they did before the dollar strengthened. For this reason, the Saudis didn't need to limit supply as oil prices fell to $50 a barrel in 2014. The value of money is what it purchases for you. If most of your country's imports are to a single country, then a fixed exchange rate in that currency will stabilize prices.

One country that is loosening its fixed exchange rate is China. It ties the value of its currency, the yuan, to a basket of currencies that includes the dollar. In August 2015, it allowed the fixed rate to vary according to the prior day's closing rate. It keeps the yuan in a tight 2% trading range around that value. 

China has to manually adjust the exchange rate of the yuan to the dollar. This is advantageous to China, but not for the U.S. That's why the U.S. government has pressured the Chinese government to let the yuan rise in value. That action would effectively make U.S. exports cheaper in China, while Chinese exports would be more expensive in the U.S. In other words, it's an attempt by the U.S. to lower its trade deficit with China.

Disadvantages

A fixed exchange rate can be expensive to maintain. A country must have enough foreign exchange reserves to manage its currency's value. 

A fixed exchange rate can make a country's currency a target for speculators. They can short the currency, artificially driving its value down. That forces the country's central bank to convert its foreign exchange, so it can prop up its currency's value. If it doesn't have enough foreign currency on hand, it will have to raise interest rates. That will cause a recession.

That happened to the British pound in 1992. The pound was pegged to Germany's mark, but Britain had higher inflation than Germany, and the already-high interest rates in the UK left its central bank with little wiggle room to adjust for inflation differences. George Soros kept shorting the pound until the U.K. central bank gave in and allowed the pound to float. In 2015, it happened when Switzerland had to release the Swiss franc from its fix to the euro, which had plummeted in value.

There are several ways countries maintain a fixed exchange rate. The purest form is when its currency is pegged to a set value against a single currency. Alternatively, many countries fix a set value to a basket of currencies, instead of just one currency. Other countries peg it to either a single currency or to a basket of currencies, but then allow it to fluctuate within a range of the pegged currency. Here are examples of each type.

In a floating rate regime, the following theories are adopted by the nations.

  1. International Parity Conditions: The nations use Purchasing Power Party (Inflation based), Interest Rate Parity, Fisher Effect etc. But these theories have become redundant in the present scenario as they are based on challengeable assumptions, which seldom hold true in the real world.
  2. Balance of Payment Method: This method, focuses on tradeable goods & services

The purchasing power parity stated that the exchange rate between two countries is always determined by the price level between those two countries. The major thing that affects the purchasing power parity is the change in the price level (INFLATION). It affects the purchasing power of the currencies in such a way that the change is reflected in the exchange rate. This concept is based on the law of one price

The “LAW OF ONE PRICE” states that when there is a perfect market condition; which means that there are no tariffs, free flow of goods, no transportation and transaction cost etc… then the price of the commodity has to be the same across the world.

Example:
Price commodity X is Rs. 1000 in India
If Rs./$ is 45; then 1000/45$ is the price of X in the US

None of the above methods developed over a period have succeeded in scientific determination of exchange rates between currencies. It is understood, many macroeconomic factors, including the dual market forces viz., demand & supply determine the rates. The two market determinants – supply & demand depends on various factors:-

Economic Factors:

A Nation’s Economic Policies composed of Govt. Fiscal policy & Central Bank’s Monetary policy are one of the factors which influences the exchange rates. The market’s react to the Government's Budget deficit position and it impacts the value of the country’s currency in the forex market.

The Trade flow between countries illustrates demand for goods and services, which in turn indicates demand for a country’s currency to settle trade payments. The Trade deficit and Trade surplus reflect the competitiveness and/or dependability of the economy and in turn, its currency value. For eg. Huge Trade deficit indicates imports exceeding the exports and a huge demand for foreign currency for trade settlements, putting pressure on the nation’s home currency.

In addition to the above, a nation’s inflation & domestic price levels also influence the price movement in the forex market. This is because inflation erodes purchasing power theory.

 

Political Conditions:

A nation’s political situation & political stability including the economic policies influence exchange rates. Any kind of geo-political differences and their effects may influence the exchange rates adversely.

 

Market Psychology & Sentiments:

A major factor which influences the forex market is Market participants psychology and view/sentiments. The saying ‘Buy the rumour, Sell the Facts’ applies in the Forex market also. The tendency of the price of an underlying either goes up or falls due to the impact of a happening or future action before it occurs and, when the anticipated event happens or comes to an end, the price moves exactly the opposite direction. This psychology of the market influences the price movement.

 

Forex Market Conventions:

All of us have visited the vegetable market and are many times surprised how the whole market discovers the rate. The prices are almost similar. This is an understanding in the market that nobody will sell below a specified rate. This is unwritten and orally agreed upon. This is a Market Convention. If any players try to cheat the market with a lower rate, he/she is thrown out of the market. The Forex Market also has few Market Conventions. Let’s understand them.

Two Way quote: Every market maker quotes a two-way quote – ‘Bid and Ask. ‘Bid’ is the rate at which he/she is ready to buy the underlying currency and ‘Ask’ is the rate at which he/she is ready to sell the underlying currency. For eg. USD/INR quote = 75.60/75.65 means the person quoting, is ready to buy the USD against INR at 75.60 and sell USD against INR at 75.65.

Before a quote is made, the persons seeking the quote, need not disclose the transaction interest nor the person quoting the rate ask for it. And the person receiving the quote has three options – Can buy at the Selling rate of the Dealer or Can Sell at the Buying rate of the Dealer or do no transaction.

But the dealer may have to take the hit either on bid or ask side if exercised by the other person.

Forex Market Operation:

The Forex Market operates at two levels – Wholesale Transactions & Retail or Merchant Transactions. The Wholesale market is between the market participants with pre-defined market lots without disclosure of any transaction interest or to cover their currency positions or for speculative positions. Whereas the Retail or Merchant Transactions are the deals between a Bank and its customer. The Merchant or Customer Transactions are different from the Wholesale Deals. The customer must disclose the transaction interest, transaction details, submit prescribed documents etc as per Bank’s internal policy & FEMA guidelines.

In respect of Merchant Transactions, banks either Buy or Sell Currency from/to customers at their buy or sell rates. These positions created by the Banks are covered in the Interbank Market through Cover Operations. 

As mentioned earlier, the Forex Market is a virtual market and is a 24 hour market. It is said that “Sun never sets on the Currency Market”. 

Exchange Margin:

Every Dealer will load transaction margin on each buy/sell transaction. This is called Exchange Margin. In India, FEDAI – An Association of Banks dealing in Foreign Exchange, recommends no margins/charges and is left to the discretion of each Bank. Each Bank has its own, internally designed policy on margin matrix depending on the Length of Relationship, Customer Business Volume, Complexity of the Transaction, Volatility in the Market, Ticket Size & Wallet Share etc. Usually Banks will have different levels of margins for different segments & customer class.

Forex Market & Concept of Value Date:

In the Forex Market, the Deal & the Settlement happens on different dates. As per the Market Convention, all the Inter-Bank or Wholesale deals are settled on spot basis. Let’s now understand the forex market settlement on different time scales. The settlement date is technically referred to as ‘VALUE DATE’ on which the funds move from buyer to seller & vice versa.

Concept of Value Date:

When a Deal, if settled on the deal date itself, is called a ‘Cash Transaction’. The deal settlement, a day after the deal date is called a ‘Tom Transaction’ and the deal settled on the T+2 days is called ‘Spot Transaction’. All the deals settled after the spot date are termed as ‘Forward Deals’.

As per the Market Convention, all the deals are to be settled on spot basis, the basic reason behind is due to the Different Time Zones, involvement of different currencies and movement of funds between different players. For eg. A Mumbai Dealer deals in USD/INR with another dealer in Chennai. Depending on the nature of the deal, Mumbai or Chennai Dealer will be able to move the INR funds as the banks are open for business, where the USD settlement may take 1-2 days because the settlement has to happen with US (Nostro) Bank Account of the dealers and the deal may be dependent on delivery of another deal.

Understanding the Market Practice, all the deals are to be settled on spot basis. But in practice, it may not be practical. The buyers & sellers of currency may need the funds either prior to the spot date or after the spot date. This brings us to the concept of ‘compensation for early settlement or late settlement’ – which is referred to as Premium or Discount in the forex market.

If the deals are settled against the Market convention, the party at loss should be compensated, which is referred to as Premium or Discount. The Discount or Premium depends on various factors viz., Time Period, Interest Rates, Funds Outlay etc.

Conclusion:

The Forex Market is non-physical and dynamic. The price of each currency against other currencies depends on various factors and the market discovers the rate depending on the strongest factor which will influence the exchange rate. On a few occasions, regulator will also influence the exchange rate by entering purchase or sale deals to bring in the equilibrium in the market. 



About Author : Mr Nagaraj Susurla RamasubbaRao held various assignments in SBI in India and at foreign offices. He also occupied the  position of Director, SBI’s Regional Training Institute.