Exchange Rate Determination:

International Monetary System: An Overview

International monetary system is defined as a set of procedures, mechanisms,

processes, institutions to establish that rate at which exchange rate is
determined in respect to other currency.
The whole story of monetary and financial system revolves around 'Exchange
Rate' i.e. the rate at which currency is exchanged among different countries
for settlement of payments arising from trading of goods and services.

To have an understanding of historical perspectives of international monetary

system, firstly one must have a knowledge of exchange rate regimes. Various
exchange rate regimes found from 1880 to till date at the international level
are described briefly as follows:
1 Monetary System Before First World War: (Era of Gold Standard) The
exchange rate between pair of two currencies was determined by respective
exchange rates against 'Gold' which was called 'Mint Parity'.
E.g.1 pound = .005 ounce of gold, 1$ = .00125 ounce of gold. Then 1pound = 4$. This is the
mint parity between dollar & pound. Thus if the dollar pound exchange rate for some reason
takes the value of $3.50 per pound, any one will acquire a pound by spending $3.50,
convert the pound into 0.005 ounce of gold in U.K., ship the gold back to the U.S. & then
convert the gold into $4.00 realizing a profit of 0.50$. Thus, large demand will drive the
price of pound down. If the exchange rate is fixed at $4.50 per pound, arbitrage in the
reverse direction will flow.
2 The Bretton Woods Era :
In Bretton Woods modified form of Gold Exchange Standard was set up with
the following characteristics :
• One US dollar conversion rate was fixed by the USA as 35 dollar per
ounce of Gold
• Other members agreed to fix the parities of their currencies vis-à vis dollar
with respect to permissible central parity with one per cent (± 1%)
fluctuation on either side.
• In case of Fundamental Disequilibrium, changes upto 10% in either
direction could be made.
 Rs/$ D2 S
D1

12.12 Upper Support

12.00 Parity

11.88 S Lower Support

D2
D1
QUANTITY OF DOLLARS

7 Dr. Amitabh Joshi

LIMITATIONS OR TRIFFIN PARADOX

This system depend on the dollar performing its role as the key currency. Countries other
than the US had to accumulate dollar balances as the dollar was the means of international
payments. This means that the US had to run BOP deficit so that other countries could build
up a stock of claims on the US. When the US deficit started mounting, there was a crisis of
confidence. Soon it was obvious that the US did not possess enough gold to honour its
convertibility commitment if all holders of dollar assets decided to demand gold.
3 Floating Exchange Rate System: the relative prices of currencies are determined purely
by forces of demand & supply.

The system in which there are no officially declared parities but there is official intervention
is called as Dirty Float.
Limited Flexibility System:
a. Crawling Peg: parity change in a month cannot be more than 1/12th of the yearly ceiling.

b. Wider Bands: more flexibility is introduced by permitting wider bands of variation around
the central parity.

c. Mixed System: for current & capital a/c separate exchange rates.
What Is Purchasing Power Parity (PPP)
One popular macroeconomic analysis metric to compare economic
productivity and standards of living between countries is purchasing power
parity (PPP). PPP is an economic theory that compares different countries'
currencies through a "basket of goods" approach.

Purchasing power is the power of money expressed by the number of goods or

services that one unit can buy.

According to this concept, two currencies are in equilibrium—known as the

currencies being at par—when a basket of goods is priced the same in both
countries, taking into account the exchange rates.
 USA USD/CHF Switzerland
1/1/1999 A basket cost $ 100 2.00 Same basket cost CHF
200
31/12/99 Basket cost $ 108 1.9074 The basket costs CHF
206
Calculating Purchasing Power Parity
The relative version of PPP is calculated with the following formula:
S=P1/ ​P2​​

where:
S= Exchange rate of currency 1 to currency 2
P1​= Cost of good X in currency 1
P2​= Cost of good X in currency 2
Pairing Purchasing Power Parity With Gross Domestic Product
• Gross domestic product (GDP) refers to the total monetary value of the
goods and services produced within one country.

• Nominal GDP calculates the monetary value in current, absolute terms.

• Real GDP adjusts the nominal gross domestic product for inflation.

However, some accounting goes even further, adjusting GDP for the PPP
value. This adjustment attempts to convert nominal GDP into a number more
easily comparable between countries with different currencies.
To better understand how GDP paired with purchase power parity works,
suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an
identical shirt in Germany.
To make an apples-to-apples comparison, we must first convert the €8.00 into
U.S. dollars. If the exchange rate was such that the shirt in Germany costs
$15.00, ( 1$= 1.875 €)
the PPP would, therefore, be 15/10, or 1.5.

In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to
obtain the same shirt in Germany buying it with the euro.
Drawbacks of Purchasing Power Parity
1 Transport Costs Goods that are unavailable locally must be imported,
resulting in transport costs. These costs include not only fuel but import duties
as well. Imported goods will consequently sell at a relatively higher price than
do identical locally sourced goods.

2 Tax Differences Government sales taxes such as the value-added

tax (VAT) can spike prices in one country, relative to another.
 3 Government Intervention Tariffs can dramatically augment the price
of imported goods, where the same products in other countries will be
comparatively cheaper.

4 Non-Traded Services include such items as insurance, utility costs,

and labor costs. Therefore, those expenses are unlikely to be at parity
internationally.
5 Market Competition Goods might be deliberately priced higher in a
country. In some cases, higher prices are because a company may have
a competitive advantage over other sellers. The company may have a
monopoly or be part of a cartel of companies that manipulate prices, keeping
them artificially high.
Relative Purchasing Power Parity (RPPP)

• It is an expansion of the traditional purchasing power parity (PPP) theory

to include changes in inflation over time.
• Purchasing power is the power of money expressed by the number of
goods or services that one unit can buy, and which can be reduced by
inflation.
• RPPP suggests that countries with higher rates of inflation will have a
devalued currency.
• According to relative purchasing power parity (RPPP), the difference
between the two countries’ rates of inflation and the cost of commodities
will drive changes in the exchange rate between the two countries.
The relative version of PPP is calculated with the following formula:
S=k(P1/ P2)

USA USD/CHF Switzerland

1/1/2000 A basket cost $ 100 1.6660 Same basket cost CHF 200

31/12/2000 Basket cost $ 108 1.5889 The basket costs CHF 206
 USA USD/CHF Switzerland

1/1/2000 A basket cost $ 100 1.6660 Same basket cost CHF 200 (=120.05$)

31/12/2000 Basket cost $ 108 1.5889 The basket costs CHF 206 (=$129.65)
With k = 1.20. price level in Switzerland is 20% higher than what is required by absolute PPP
but it is so in both periods

In the above example, the US and the Swiss inflation rates are respectively 8% & 3%. The
percentage appreciation of the Swiss franc is 4.63% (1.666-1.5889)/1.666. Thus result is
known as relative PPP. In other words, it says that the proportionate (or %) change in
exchange rate between 2 currencies A& B between two points of time equals the difference
in the inflation rates in the two countries over the same time interval.
Example of Relative Purchasing Power Parity
Suppose that over the next year, inflation causes average prices for goods in
the U.S. to increase by 3%. In the same period, prices for products in Mexico
increased by 6%. We can say that Mexico has had higher inflation than the
U.S. since prices there have risen faster by three points.

According to the concept of relative purchase power parity, that three-point

difference will drive a three-point change in the exchange rate between the
U.S. and Mexico. So we can expect the Mexican peso to depreciate at the rate
of 3% per year, or that the U.S. dollar should appreciate at the rate of 3% per
year.
Nominal Exchange Rates versus Real Exchange Rates
The nominal exchange rate is the rate at which currency can be exchanged. If
the nominal exchange rate between the dollar and the lira is 1600, then one
dollar will purchase 1600 lira.

Exchange rates are always represented in terms of the amount of foreign

currency that can be purchased for one unit of domestic currency. Thus, we
determine the nominal exchange rate by identifying the amount of foreign
currency that can be purchased for one unit of domestic currency.
While the nominal exchange rate tells how much foreign currency can be
exchanged for a unit of domestic currency,

the real exchange rate tells how much the goods and services in the domestic
country can be exchanged for the goods and services in a foreign country.

The real exchange rate is represented by the following equation: real exchange
rate = (nominal exchange rate X domestic price) / (foreign price).
Let's say that we want to determine the real exchange rate for grapes between
the US and Italy. We know that the nominal exchange rate between these
countries is 1600 lira per dollar. We also know that the price of grapes in Italy
is 3000 lira and the price of grapes in the US is $6. Remember that we are
attempting to compare equivalent types of grapes in this example.

In this case, we begin with the equation for the real exchange rate of real
exchange rate = (nominal exchange rate X domestic price) / (foreign price).
Substituting in the numbers from above gives real exchange rate = (1600 X
$6) / 3000 lira = 3.2 basket of Italian grapes per basket of American grapes.
By using both the nominal exchange rate and the real exchange rate, we can
deduce important information about the relative cost of living in two
countries.

While a high nominal exchange rate may create the false impression that a
unit of domestic currency will be able to purchase many foreign goods, in
reality, only a high real exchange rate justifies this assumption.
Arbitrage is of two types:-

1)Arbitrage with transaction cost

2)Arbitrage without transaction cost

Arbitrage without transaction cost is again divided into 2 parts:

a)Covered Interest Arbitrage
b) One Way Arbitrage
Covered Interest Arbitrage

Covered interest arbitrage is a strategy in which an investor uses a forward

contract to hedge against exchange rate risk.

Covered interest rate arbitrage is the practice of using favorable interest rate
differentials to invest in a higher-yielding currency, and hedging the exchange
risk through a forward currency contract.
LIBOR RATES DIFFER FROM CURRENCIES TO CURRENCIES

Euro USD 6 month LIBOR= 3.75 % p.a.

Euro GBP 6 month LIBOR = 5.8 %p.a.
Euro YEN 6 month LIBOR = 0.60 %p.a.

Spot exchange rate GBP/USD = 1.8410

6 month forward exchange rate GBP/USD = 1.8107

Spot exchange rate USD/JPY = 106.19

6 month forward exchange rate USD/JPY = 104.75
a) 100 USD is put in GBP deposit, maturity value of deposit sold forward. At the end of 6
months the depositor will get:
1*5.8%*6/12
USD[(100/1.8410)(1+0.0290)(1.8107)]=USD(101.21)

b) 100 USD is put in JPY deposit, maturity value of deposit sold forward. At the end of 6
months the depositor will get:

USD[(100*106.19)(1+0.0030)/(104.75)]=USD(101.68)

Thus, despite the higher interest rate on GBP, the depositor would have been better off
putting money in JPY deposit.
When all depositors attempt such transactions, the market rates would change. , in
equilibrium, the effective returns on all currencies would be equalized.

Thus, the difference in interest rates between currencies in the euro market reflect the
market’s expectations regarding exchange rate movements as captured in the spot- forward
differentials. On a covered basis all currencies should yield equal returns.

The difference in Interest rates between currencies in the euro market and the spot-forward
margins are inter- related through covered interest arbitrage.
Suppose a Euro dollar deposit gives the interest rate of 10% for 90 days. It
will give

$(1+.1(90/360)).

S= the GBP/USD spot rate

Fn=the GBP/USD forward rate for “n” yr maturity, n=1/12, 1/6, 1/4
iGBP= annualized interest rate on Euro Sterling deposits of maturity n yrs
iUSD=annualized interest rate on Euro dollar n yr deposits.

If the investor puts 1 GBP in a n year Euro sterling at maturity its

value is given by GBP[1+niGBP] ------ Eq.1. where
I = interest rate.
If the investor selects to invest in Euro dollar and eliminate exchange risk, he
must do the following:
a)Convert Sterling into dollar spot

b)Invest in Euro dollar deposit

c)Sell the dollar proceed of the deposits forward for sterling

GBP[S(1+niUSD)/Fn] ---- Eq.2

Here S(1+niUSD) is the maturity value of the dollar deposit in dollar, which
sold forward at Fn dollars per GBP yields the maturity value in Sterling.
Suppose if they are unequal [1+niGBP] > S(1+niUSD)/Fn then British investors
would find it profitable to invest in Euro Sterling.

Arbitrage will work & everyone will buy dollar & sell it to Sterling. Thus in
an efficient market covered investment in either currency would give the
same return. There are no risk less arbitrage profit to held.

1+niB = Fn(A/B)
1+niA S(A/B)

1+niUSD/1+niGBP = Fn(GBP/USD)/S(GBP/USD)
ONE WAY ARBITRAGE

Covered interest arbitrage involves activity in 4 market i.e. forward market,

spot market, (Euro dollar deposit market, Euro sterling Market) two deposit
market. Under one way arbitrage one of the market is avoided.
For E.g..
(USD/CHF)S = 1.6450, 6 MF = 1.6580. Euro $ 6m interest = 4.50%p.a.
Euro CHF 6m interest = 6.50% p.a.

A Swiss firm need one million $ to settle an import bill.

1)It can acquire this in a spot market at a cost of 1.645 million frank or
2) alternatively it can borrow 1 million $ in Euro Dollar market for 6 month
and set aside enough CHF on deposit to buy the dollar loan 6 MF.
It has to repay $1,000,000(1+.045/2) = $1.0225 million.

To acquire this amount in forward market it will need CHF1.0225 million x

1.6580 = 1.69530 million CHF.

To have this amount ready 6 month later it must deposit now CHF1.69530m
= P(1+.065/2)
=1.69530/1.0325 = P =1641941.9 CHF

Spot Price = 1.645 x 10,00,000 = 16,45,000 CHF.

16,45,000CHF - 1641937 CHF = 3000 CHF.

Fn(B/A)(1+niB)/(1+niA)≥S(B/A)
Arbitrage With Transaction Cost
Transaction cost like telephone calls etc.
1.Covered Interest Arbitrage with T.C.
2.One way with transaction cost

For any pair of currencies X and Y

Spot (Y/X)bid: S(1-ts)
Spot (Y/X)ask: S(1+ts)
Suppose Spot GBP/USD = 1.4750/ 1.4758

Smid= 1.4754
Ts= .0002711

Then, S can be regarded as the mid rate and the spread 2tsS as the transaction
cost.
Spread= 2tsS= .0008 or ts= .0002711
The spot bid rate will be denoted Sb and the spot ask rate Sa

Forward (Y/X)bid: F (1-tf)

Forward (Y/X)ask: F (1+tf)
F is the mid rate and 2tfF is the transaction cost in forward market.
Eurodeposit Markets: Bid rates are the rates banks will pay on deposits and
ask rates are rates they would charge on loan

The bid rate for EuroX deposit ixb =ix(1-tx)

The ask rate for EuroX deposit ixa =ix(1+tx)

The bid rate for EuroY deposit iyb =iy(1-ty)

The ask rate for EuroY deposit iya =iy(1+ty)

Covered Interest Arbitrage with transaction cost:
GBP/ USD spot: 1.5625/ 35
Euro Dollar Deposits: 8.25- 8.5
Euro Pound Deposit: 125/8 – 13

Consider first transaction:

Borrow sterling at 13% pa, convert spot to dollar, invest dollar and sell the maturing dollar
deposit forward. Each sterling borrowed will give $1.5625 in the spot market. This is
deposited at the rate of 8.25% pa. the maturity value of the deposit is:
1.5625*1.0825= 1.6914$
This is sold forward at forward ask rate of F
The sterling inflow would be £ ( 1.6914/ F). The repayment of the sterling loan would require
£1.13. if there is no riskless profit we must have

(1.6914/F) =1.13
F= 1.6914/1.13= 1.4968

Second Transaction:
Now consider the reverse arbitrage
Borrow Dollar at 8.5% pa, convert spot to sterling at $1.5635 per pound., invest sterling at
12.625 pa and sell the sterling deposit forward . One dollar sold spot would get us (1/1.5635)
sterling. This amount will be deposited at interest rate12.625% will grow to
(1/1.5635)*1.12625 sterling a year.
Second Transaction:
Now consider the reverse arbitrage
Borrow Dollar at 8.5% pa, convert spot to sterling at $1.5635 per pound., invest sterling at
12.625 pa and sell the sterling deposit forward . One dollar sold spot would get us (1/1.5635)
sterling. This amount will be deposited at interest rate12.625% will grow to
(1/1.5635)*1.12625 sterling a year.
This would be sold forward at the forward bid rate F to fetch
F(1/1.5635)(1.12625) dollar a year.
The repayment of dollar loan would require $1.0850. to prevent riskless profit, we must have:
F[(1/1.5635)(1.12625)]= 1.0850
F= 1.0850*1.5635/1.12625= 1.5062

Finally Fb< Fa

Fn= 1.4968/ 1.5062

One way arbitrage with transaction cost:
The following rate are available in the market:
USD/ CHF s= 1.6010/20
3 month forward: 1.5710/ 25
CHF 3 month deposit rates 4- 4.25
Euro USD 3 mf rate: 121/8 -123/8

1) Borrow 1 CHF to make a covered investment in 3 month Euro $. At the end of 3 months,
you must repay:
CHF(1+(.25*.0425)= 1.0106CHF

Covered investment in Euro$ yields, after conversion back to CHF ( convert CHF to dollar
and back to CHF)
CHF [(1.0/1.6020)[1+(.025)(.12125)]1.5710]=
CHF 1.0104
There is no profit
2) Borrow $1 to make covered investment in CHF
You have to repay
$[1+.025*.012375]
= $1.0309
Covered CHF investment yields, after conversion back to USD ( convert 1$ to CHF at spot,
deposit for 4% and convert it at forward rate to get back dollar) :
$[(1.6010)[1+.25*.04]]/1.5725
$ 1.0283
Thus there is no riskless profit to be had by way of interest arbitrage.
Cash-and-Carry-Arbitrage

Cash-and-carry-arbitrage is a market-neutral strategy combining the purchase

of a long position in an asset such as a stock or commodity, and the sale
(short) of a position in a futures contract on that same underlying asset. It
seeks to exploit pricing inefficiencies for the asset in the cash (or spot) market
and futures market, in order to make riskless profits. The futures contract must
be theoretically expensive relative to the underlying asset or the arbitrage will
not be profitable.
In a cash-and-carry-arbitrage, the arbitrageur would typically seek to "carry"
the asset until the expiration date of the futures contract, at which point it
would be delivered against the futures contract. Therefore, this strategy is only
viable if the cash inflow from the short futures position exceeds
the acquisition cost and carrying costs on the long asset position.

Cash-and-carry arbitrage positions are not 100% without risk as there is still
risk the carrying costs can increase, such as a brokerage raising
its margin rates. However, the risk of any market movement, which is the
major component in any regular long or short trade, is mitigated by the fact
that once the trade is set in motion the only event is the delivery of the asset
against the futures contract. There is no need to access either one in the open
market at expiration.
Physical assets such as barrels of oil or tons of grain require storage and
insurance, but stock indexes, such as the S&P 500 Index, likely require only
financing costs, such as margin. Therefore, arbitrage may be more profitable,
all else held constant, in these non-physical markets. However, because the
barriers to participate in arbitrage are much lower, they allow more players to
attempt such a trade. The result is more efficient pricing between spot and
futures markets and lower spreads between the two. Lower spreads mean
lower opportunities to profit.
Example of Cash-and-Carry Arbitrage
Consider the following example of cash-and-carry-arbitrage. Assume an asset
currently trades at $100, while the one-month futures contract is priced at
$104. In addition, monthly carrying costs such as storage, insurance, and
financing costs for this asset amount to $3.
In this case, the arbitrageur would buy the asset (or open a long position in it)
at $100 and simultaneously sell the one-month futures contract (i.e. initiate a
short position in it) at $104. The trader would then hold or carry the asset until
the expiration date of the futures contract and deliver the asset against the
contract, thereby ensuring an arbitrage or riskless profit of $1
Main Factors Affecting the Forward Rate Mechanism

1 FCNR Deposits and the Forward Rate:

Under the Foreign Currency Non-residents (FCNR-B) deposit scheme, banks
can swap foreign currency deposits for rupees in the market. (Under an earlier
FCNR-A scheme, now discontinued, such swaps were done with RBI, at level
rates). Swap is a kind of transaction which banks enters, to hedge their
position of foreign exchange.
They are always in a position in foreign exchange market viz. over-bought or
over-sold. The banker who is in over-bought position will need to provide
home currency on the exchange date.
Thus, he will need to arrange for requisite home currency to get foreign
currency. To hedge his position to the variations in the foreign exchange
market, he will also need to sell foreign currencies; else he will have lots of
foreign currency but no home currency to pay for it.
So when he sells foreign currency he hedges his position through availability
of home currency and can maintain his profits through the continuous changes
happening in foreign exchange market.
Bank also faces the same type of problems, with respect to interest amount
receivables and payables with respect to foreign currency. If the interest
amount is not hedged in the forward market, strictly speaking, it should be
included in the “gap” limit referred to above.
A bank would swap FCNR deposits for rupees in the manner indicated, only if
the overall cost of generating the rupee resources is economic, i.e., when the
forward margin is less than the interest differentials between foreign
currencies and rupees. Thus, the deposited banks are also a source of demand
in the forward market.
2 Forward Margin:
The forward margin depends on the perceptions of the buyers and
sellers of currencies in the Indian market. The forward margin is called a
premium on the currency whose forward rate is costlier than the spot rate and
a discount where the forward rate is cheaper. It is expressed in the same
currency as the spot rate and the general practice is to quote it as a discount or
premium on that i.e., reported currency.
3 Delivery Options:
Delivery option refers to the option for choosing the value date within an
agreed period. In the interbank market, the option period may be limited to the
extent of a calendar month, and can be further broken down based on the need
of the party, by considering the actual date of need.
One feature of the Indian market is that the delivery of a claim for foreign
currency receivable is considered as delivery of the foreign currency although
the currency may be receivable after some time.
For example, if a bank buys from an exporter a dollar bill of exchange drawn
on the buyer abroad, the exchange transaction, namely the purchase of dollars,
is completed when the bill itself is purchased. It will be readily seen that the
bank would actually get the dollars only when the buyer abroad will pay the
bill in accordance with its tenor of maturity.

When the agreed value date for the transaction is in mid of the month, then the
accepted standard rule for rate quotations for option contracts is the worse rate
among the beginning and end of the option period, and is use by bank to quote
to the customer.
It means that if a foreign currency is at a premium in the forward market, then
the rate applicable to the beginning of the option period will be quoted and
used by bank for purchase of the foreign currency from the trader or
merchant. But, if the bank has to sell the foreign currency the rate applicable
at the end of the period will be applicable. This is done with a specific reason
to gain to be earned by banker.

4 Card Rates for Customer Transactions

Banks in India have either a central interbank trading office for foreign
exchange operations (the FX Treasury), or at best can have offices in two or
three major centers. The customer transactions are undertaken at a large
number of branches. The practice therefore is to calculate the so-called “card
rates” for customer transactions in the FX treasury in the morning, based on
the ruling rates in the domestic and international markets.
The card rates are then communicated to the operating branches by telephone
or fax or e-mail etc. The card rates are used for undertaking customer
transactions for amounts not exceeding a stipulated limit. Generally, the card
rates are for relatively small value transactions, and are difficult to change
intra-day.
Card rate includes the maximum permissible margins. For large value
transactions, i.e., beyond the stipulated limits, the branches are expected to
telephone the FX treasury and get applicable rate. In general, these would be
more competitive, and based on the ruling interbank rates.
5 Interbank Forward Quotations:
These quotations are in paisa per dollar or any other foreign currency and
apply to end of the month deliveries. The interbank market is not active
beyond 12 months. The interbank forward quotations are quotes used and
applied for transactions between two banks to ensure to remove the mismatch
of maturities in their forward transactions.

6 Cash: Spot and Call Rates:

The cash spot margin in the interbank market is generally governed by the call
market in Indian rupees. This is because arbitrage is possible between
borrowings in the call market at a particular rate, and sells cash or buy spot
dollar swap in the exchange market. Banks would use the cheaper market;
hence, there is a strong correlation between the cash: spot margin and the call
rate.