UNIT-4 EXCHANGE RATES

UNIT-IV
EXCHANGE
RATES

Introduction:
Measuring exchange rate movements, factors influencing exchange rates. Government influence
on exchange rates, exchange rate systems. Managing Foreign exchange Risk. International
arbitrage and interest rate parity.
Relationship between inflation, interest rates and exchange rates, purchasing power parity,
international Fisher effect, Fisher effect, interest rate parity, expectations theory.

Measuring Exchange rate movements

Gold standard
With the failure of gold standard during First World War, a much refined form of exchange
regime was initiated in 1925 in which US and England could hold gold reserve and other nations
could hold both gold and dollars/sterling as reserves. In 1931, England took its foot back which
resulted in abolition of this regime.
Also to maintain trade competitiveness, the countries started devaluing their currencies in order
to increase exports and demotivate imports. This practice led to great depression which was a
threat to war ravaged world after the Second World War. Allied nations held a conference in
New Hampshire, the outcome of which gave birth to two new institutions namely the
International Monetary Fund (IMF) and the World Bank, (WB) and the system was known as
Bretton Woods System which prevailed during (1946-1971) (Bretton Woods, the place in New
Hampshire, where more than 40 nations met to hold a conference).

The Bretton Woods Era (1946 to1971)

To streamline and revamp the war ravaged world economy & monetary system, allied powers
held a conference in 'Bretton Woods', which gave birth to two super institutions - IMF and the
WB. 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 one dollar = 35 ounce of Gold

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• 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 crossing
the limits, the authorities were free hand to intervene to bring back the exchange rate within
limits.

Purchasing Power parity

According to the Purchasing Power Parity theory, the exchange rate is nothing but the ratio of
prices between two countries. Since A has had a relatively greater rise in prices, A‘s currency
depreciates, will fall, and a new exchange rate will get established.
The monetary theory states that there is a direct connection between relative changes in money
supply in two countries and the exchange rate between both countries, provided there are no
transportation costs in moving goods between both countries.

Floating rate system

A floating exchange rate occurs when governments allow the exchange rate to be determined by
market forces and there is no attempt to influence the exchange rate. A floating exchange rate
contrasts with a fixed exchange rate. A situation where the government try to keep the exchange
rate within a certain target against other currencies.

Factors influencing Exchange rates

Foreign Exchange rate (For Ex rate) is one of the most important means through which a
country‘s relative level of economic health is determined. A country's foreign exchange rate
provides a window to its economic stability, which is why it is constantly watched and analyzed.
While sending or receiving money from overseas, there‘s a need to keep a keen eye on the
currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency may be converted into
another." It may fluctuate daily with the changing market forces of supply and demand of
currencies from one country to another. For these reasons; when sending or receiving money
internationally, it is important to understand what determines exchange rates.
i) Inflation Rates

Changes in market inflation cause changes in currency exchange rates. A country with a lower
inflation rate than another‘s will see an appreciation in the value of its currency. The prices of

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goods and services increase at a slower rate where the inflation is low. A country with a
consistently lower inflation rate exhibits a rising currency value while a country with higher
inflation typically sees depreciation in its currency and is usually accompanied by higher interest
rates
ii) Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates,
and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate
because higher interest rates provide higher rates to lenders, thereby attracting more foreign
capital, which causes a rise in exchange rates
iii) Country’s Current Account / Balance of Payments
A country‘s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its
domestic currency.
iv) Government Debt
Government debt is public debt or national debt owned by the central government. A country
with government debt is less likely to acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate will follow.
v) Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export
prices to import prices. A country's terms of trade improves if its exports prices raise at a greater
rate than its imports prices. This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in an appreciation of
exchange rate.
vi) Political Stability &Performance

A country's political state and economic performance can affect its currency strength. A country
with less risk for political turmoil is more attractive to foreign investors, as a result, drawing
investment away from other countries with more political and economic stability. Increase in

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foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country
with sound financial and trade policy does not give any room for uncertainty in value of its
currency. But, a country prone to political confusions may see depreciation in exchange rates.
vii) Recession

When a country experiences a recession, its interest rates are likely to fall, decreasing its chances
to acquire foreign capital. As a result, its currency weakens in comparison to that of other
countries, therefore lowering the exchange rate.
viii) Speculation

If a country's currency value is expected to rise, investors will demand more of that currency in
order to make a profit in the near future. As a result, the value of the currency will rise due to the
increase in demand. With this increase in currency value comes a rise in the exchange rate as
well. All of these factors determine the foreign exchange rate fluctuations. If you send or receive
money frequently, being up-to-date on these factors will help you better evaluate the optimal
time for international money transfer. To avoid any potential falls in currency exchange rates, opt
for a locked-in exchange rate service, which will guarantee that your currency is exchanged at
the same rate despite any factors that influence an unfavorable fluctuation.

Government influence on exchange rates

The Foreign Exchange Regulation Act (FERA), 1973 was replaced by the market friendly
Foreign Exchange Management Act (FEMA), 1999. The Reserve Bank delegated powers to
authorized dealers (ADs) to release foreign exchange for a variety of purposes. In pursuance of
the Sodhani Committee‘s recommendations, the Clearing Corporation of India Limited (CCIL)
was set up in 2001. To further the participatory process in a more holistic manner by taking into
account all segments of the financial markets, the ambit of the Technical Advisory Committee
(TAC) on Money and Securities Markets set up by the Reserve Bank in 1999 was expanded in
2004 to include foreign exchange markets and the Committee was rechristened as TAC on
Money, Government Securities and Foreign Exchange Markets. Increase in Instruments in the
Foreign Exchange Market. The rupee-foreign currency swap market was allowed.
Additional hedging instruments such as foreign currency-rupee options, cross-currency options,
interest rate swaps (IRS) and currency swaps, caps/ collars and forward rate agreements (FRAs)
were introduced. Liberalization Measures

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Authorized dealers were permitted to initiate trading positions, borrow and invest in overseas
market, subject to certain specifications and ratification by respective banks‘Boards. Banks were
also permitted to (i) fix net overnight position limits and gap limits (with the Reserve Bank
formally approving the limits); (ii) determine the interest rates (subject to a ceiling) and maturity
period of FCNR(B) deposits with exemption of inter-bank borrowings from statutory
preemptions; and (iii) use derivative products for asset liability management.
Participants in the foreign exchange market, including exporters, Indians investing abroad, and
FIIs were permitted to avail forward cover and enter into swap transactions without any limit,
subject to genuine underlying exposure. FIIs and NRIs were permitted to trade in exchange
traded derivative contracts, subject to certain conditions.
The Reserve Bank has been taking initiatives in putting in public domain all data relating to
foreign exchange market transactions and operations. The Reserve Bank disseminates:
(a) daily reference rate which is an indicative rate for market observers through its website,

(b) data on exchange rates of rupee against some major currencies and foreign exchange reserves on
a weekly basis in the Weekly Statistical Supplement (WSS),and
(c) Data on purchases and sales of foreign currency by the Reserve Bank in its Monthly Bulletin.
The Reserve Bank has already achieved full disclosure of information pertaining to international
reserves and foreign currency liquidity position under the Special Data Dissemination Standards
(SDDS) of the IMF.

Types of Exchange Rate Systems

There are three broad exchange rate systems
 currency board,
 fixed exchange rate and
 floating rate exchange rate.
A fourth can be added when a country does not have its own currency and merely adopts
another country‘s currency.
The fixed exchange rate has three variants and the floating exchange rate has two variants. This
consists of
(i) Rigid peg with a horizontal band, (ii) crawling peg and (iii) crawling band.

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Variants of a Fixed Exchange Rate System

Rigid Peg with a Horizontal Band
It is an exchange rate system under which the exchange rate fluctuation is maintained by the
central bank within a range that may be specified (Iceland) or not specified (Croatia). The
specified band may be one- sided (+7% in Vietnam), a narrow range (+ 2.25% in Denmark) or a
broad range (+ 77.5% in Libya).
Crawling Peg
The par value of the domestic currency is set with reference to a selected foreign currency (or
precious metal or currency basket) and is reset at intervals, according to pre-set criteria such as
change in inflation rate. The central bank decides the new par value based on the average
exchange rate over the previous few weeks or months in the foreign exchange market. The
biggest advantage of the crawling peg is its responsiveness to the market value of the domestic
currency.
Crawling Band
The domestic currency is on a crawling peg which is maintained within a range (band).
Floating Exchange Rate
This consists of
(i) Managed float and (ii) free float.
When a country has its own currency as legal tender, it can choose between the three broad types
of exchange rate systems. Within the fixed exchange rate, a country can choose a rigid peg or a
crawling peg. Again within each peg, it can choose to have a horizontal band within which its
exchange rate would be permitted to fluctuate. Within the floating exchange rate system, a
country can choose a free float or a managed float. The main source of the exchange rate system
followed by any country is the IMF‘s Annual Report on exchange rate arrangements. Many
countries declare that they follow a particular exchange rate system, but may follow another
system inpractice:
i. Exchange Arrangements with No Separate Legal Tender

A few countries (such as Micronesia and San Marino) select another country‘s currency as legal
tender. This is called Dollarization, since the selected foreign currency is usually the US dollar.

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ii. Currency Board

The central bank of the country promises to convert domestic currency (on demand and at any
point in time) for a predetermined number of units of a specific foreign currency. In order to
fulfill this promise, the central bank has to hold foreign exchange reserves in the selected foreign
currency. Usually a government decides to adopt a currency board when the holders of domestic
currency lose confidence in it is as a medium of exchange, triggered by rampant inflation,
unbridled government debt (resulting in fiscal deficits) and recession.
The first currency board was set up in Mauritius in 1849. Hong Kong has had a currency board
since 1983 when its currency was linked to the US dollar. Argentina chose the currency board in
1991 and Bosnia in 1997. Argentina‘s currency board promised to convert each peso into one US
dollar. The Central Bank held only 66% of the peso as dollar reserves, when it should have held
100% (given the 1:1 peso/dollar currency board arrangement). In 2001, Argentina defaulted in
repayment of its external debt and confidence in the Argentine peso plunged. There was a run on
the banking system, and the government abandoned the currency board.
Variants of a Floating Exchange Rate System
i) Managed Float

A floating exchange rate (or exchange rate) is the opposite of the fixed exchange rate. Market
forces determine the value of the domestic currency against a selected foreign currency. A
managed float (or dirty float) is a floating exchange rate in which the monetary authorities
influence the exchange rate (through direct or indirect intervention without specifying the target
exchange rate. India is on a managed float.
ii) Free Float or Clean Float

Here, the exchange rate is purely determined by market forces (demand and supply of the
currency).
Flexible Exchange Rate System-Advantages
1. It permits quicker adjustments in the exchange rate to changes in macro-economic factors such
as changes in inflation rate, growth rate, and interest rates.
2. There is less likelihood of currency overvaluation. So the country‘s growth prospects are
brighter.
Disadvantages

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1. Exchange rate risk is high due to greater volatility in the short- and long-term. This makes
exchange rate forecasting extremely important as well as extremely difficult.
2. There is a tendency for capital inflows through foreign portfolio investment, or ‗hot money‘.

3. Imports and overseas debt repayment are adversely affected by depreciation of domestic
currency.
Determination of Floating Exchange Rates
There are four theories that explain how floating exchange rates are set. The first theory (the
demand and supply theory) is called a flow theory because it studies how the demand for and
supply of a domestic currency over a period of time results in a particular level for the exchange
rate. The other three theories (the monetary theory, the asset price theory, and the portfolio
balance theory) are called stock theories, since they study the amount of currency available at a
certain time-the stock of currency-and peoples ‘willingness to hold the currency. They are also
called modern theories of exchange rate determination.
Fixed Exchange Rate
It is also called the pegged exchange rate. The par value of the domestic currency is set with
reference to a selected foreign currency (or precious metal or currency basket). The exchange
rate fluctuates with a range (usually +1% of the par value).
The domestic currency‘s par value is fixed by the monetary authorities against any of the following:

a. A precious metal (gold in the gold standard)

b. A single currency, which can be an artificial currency (such as the SDR), or an existing currency
(such as the US dollar or the pound sterling). When a single currency is chosen, in some cases
colonial legacy determines the choice-most former French colonies chose the French franc, while
former British colonies tended to choose the pound sterling. Sometimes, a fixed exchange rate is
adapted to arrest the steep fall in value of the domestic currency. In September 1998, the
Malaysian monetary authorities announced a rigid peg of 3.8 ringgit/USD after the Ringgit
plunged by 60% against the US dollar.
c. A currency basket as in the case of the Indian rupee in 1975; the Indian rupee was de-linked from
the pound and linked to a basket of currencies. The central bank may keep the currencies in the
basket a secret, or make the currency In 2005, China pegged its Yuan to a currency basket whose
composition and weights are undisclosed.

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Fixed Exchange Rate System-Advantages

1. There is stability in exchange rate and exchange rate risk is nil.

2. Capital inflows through foreign direct investment are higher because there is no exchange rate
volatility. FDI is a ‗desirable ‘capital inflow due to its stable and long- term nature.
3. Inflation rates tend to be lower and therefore real interest rates (nominal interest rates adjusted
for inflation) are higher.
Disadvantages:
1. The exchange rate does not reflect macro-economic changes. The entire foreign exchange
entering and leaving the country has to be converted at the fixed exchange rate.
2. Punitive action for contravening rules.

In a fixed exchange rate regime, the entire institutional infrastructure is geared towards
identifying evasion of foreign exchange controls and imposing penal punishments. A fixed
exchange rate creates a flourishing parallel market for foreign exchange in which the ‗true‘value
of the domestic currency is determined by market forces. This is because the par value of the
domestic currency is very often at variance with what the exchange rate would be if left to the
vagaries of supply and demand.
Very often countries fix a separate par value for exports and a separate one for imports. This is
done to boost its exports and deter imports. This merely increase the draconian system needed to
monitor foreign currency inflows and outflows.
The problems with a fixed exchange rate are described below
1. The possibility of overvaluation of the domestic currency is quite high. Suppose the rupee is on a
fixed exchange rate of Rs. 40/$ instead of Rs. 43/$ when left to market forces. So, instead of 1$
being able to buy Rs. 43 worth of goods, it can buy only Rs. 40 worth of goods). This would hurt
the competitiveness of India‘s exports and therefore hamper its growth prospects.
2. When the country on a fixed exchange rate is seen consistently to have trade surpluses, it
generates a lot of ill will, and a perception that the trade surpluses are the result of currency
manipulation of keeping the exchange rate artificially high (or low as the case may be). Consider
the hypothetical example below. If the Chinese Yuan should have an exchange rate of Yuan
5.60/$ but is instead kept at Yuan 7.00/$, Chinese exports have extremely competitive prices in
world markets, and China has a trade surplus.

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De Facto and De Jure Exchange Rate Systems

A de facto exchange rate is the one that a country actually follows. A de jure exchange rate
system is the one that the country claims to follow. Both systems need not always be the same.
China‘s de facto system was the fixed rate but it insisted that its de jure system was a managed
float. The IMF conducts surveys of exchange rate systems around the world. The surveys take
into account both the de facto and de jure systems for each country.

Fixed versus Floating Exchange Rate

To know which exchange rate system is the best, the objectives of the monetary authorities in a
country have to be studies.
There are three possible objectives:
i. Maintain stable exchange rates

ii. Allow mobility of capital

iii. Have control over monetary policy.

With a floating exchange rate, the last two objectives can be attained but there will be exchange
rate volatility. With a fixed exchange rate, the first two objectives can be attained but there will
be no control over the monetary policy. In other words, irrespective of whether the fixed rate or
the floating exchange rate is selected, only two of the three objectives can be attained. Thus, the
three objectives are called the impossible trinity. In practice, countries can and do fine-tune their
exchange rate systems, and need not choose either extreme.
Differences between Flexible and Fixed Exchange Rate System
Some countries (Canada, USA) consistently follow a particular exchange rate while others
(Argentina, Russia) shift from one exchange rate to another. Canada has followed a flexible
exchange rate since 1971, Hong Kong has had a currency board since 1983 and Argentina moved
from a flexible exchange rate to a currency board in 1991. India moved from a fixed exchange
rate to a partially floating rate in 1993 and a full float in 1994.
There has been a gradual shift from fixed exchange rate (and its variants) to flexible exchange
rate. While a majority of developing countries had a fixed exchange rate in 1975, less than half
had a fixed exchange rate 20 years later. Economists advocate a fixed exchange rate when an
economy is affected by shifts in the demand for money that can affect price levels.

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They advocate a flexible exchange rate when an economy is affected by changes in demand for
products. A country that makes a successful transition from a fixed to a floating rate has a deep
foreign exchange market, a well thought out policy of intervention by the central bank, and
effective mechanisms to manage exchange rate risks.
The pegged exchange rate was popular in the early 1990s among countries that were making the
transition to becoming market economies. Countries moved away from the hard peg towards the
crawling peg. The efficacy of a particular exchange rate system is a function of each country‘s
unique economic circumstances, stage of development, strength of the financial system, and the
degree of autonomy enjoyed by its monetary authority. No single exchange rate system has been
an unqualified success across countries in terms of improvement in growth rates or financial
stability.
The fixed exchange rate did not accelerate growth rates in countries that adopted it, nor did it
protect them from currency crises. The same is true of the floating exchange rate. On the other
hand, the central banks of many developing countries fear the impact a floating exchange rate
would have through a sharp appreciation or depreciation of their currency on their exports and
imports, as well as their capacity to repay overseas debt.

Exchange Rate Systems in Selected Emerging Markets(1980-2010)

The Brazilian real-The crawling peg was replaced by a floating exchange rate in 1990.

The Hong Kong dollar-It is on a currency board.

The Indonesian rupiah-The managed float was replaced by a floating exchange rate in 1997.
The Malaysian ringitt-The currency peg to a currency basket was replaced by a fixed exchange
rate in 1998.
The Philippine peso-It is on a floating exchange rate.
The Singapore dollar-The currency peg to a currency basket was replaced by a fixed exchange
rate in 1985.
The Thai baht-It is on a managed float.
Theory Supply and Demand:
This theory states that the exchange rate is the intersection of the supply of domestic currency
(shown as the supply curve) and its demand (shown as the demand curve). The supply of

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domestic currency is determined by imports and the demand is determined by exports.

Monetary Theory:
This theory links money supply and prices to the exchange rate. An increase in money supply
leads to an increase in prices (inflation). According to the monetary theory, the exchange rate is
the ratio of prices in two countries, so an increase in price causes the exchange rate to be reset.
Consider two countries A and
B. When the money supply in each country rises, the prices in each country rise. If the growth of
money supply in A is greater than the growth of money supply in B, then A experiences a higher
inflation rate than B.
According to the Purchasing Power Parity theory, the exchange rate is nothing but the ratio of
prices between two countries. Since A has had a relatively greater rise in prices, A‘s currency
depreciates, will fall, and a new exchange rate will get established.
The monetary theory states that there is a direct connection between relative changes in money
supply in two countries and the exchange rate between both countries, provided there are no
transportation costs in moving goods between both countries.
Asset Price Theory:
The theory states that currency is an asset just as real estate or securities or gold. The desire to
hold a particular type of asset is driven by the perception of the asset‘s future value. If the value
is likely to rise, people will want to buy the asset now and sell it at a higher price so as to make a
profit. Conversely, if they think the asset‘s value will drop, all those holding the asset now will
start selling the asset fearing a greater decline in price in the near future. Therefore, the asset‘s
current attractiveness is a function of what the market believes its value is going to be in future.
In other words, future expectations decide current buy/sell decisions.
This is true even for currency. If the market believes that the domestic currency is going to rise in
value, everyone will start buying it. If the current exchange rate is Rs. 43/$, and the expectation
is that the rupee will appreciate over the next six months. Participants will start purchasing the
rupee and this will drive up demand. Because demand rises, the rupee will appreciate against the
dollar, and the exchange rate will settle at Rs. 42/$.
If on the other hand, the market expects the rupee to depreciate, there will be selling pressure and
the rupee will depreciate, probably settling at Rs. 44/$. At any point in time, the current

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exchange rate contains market expectations of the future value of the domestic currency.
Portfolio Balance Theory:
The portfolio balance theory connects money supply, supply and demand for domestic securities,
demand for foreign securities, and the exchange rate.

Its assumptions are:

i. Investors can hold only two types of assets—currency and bonds (domestic bonds issued in
domestic currency and foreign bonds issued in foreign currency).
ii. Investors in two countries have identical asset preferences.

iii. When the wealth of investors in either country increases, they would prefer to hold more of
the asset that they already hold in excess.
Investors in two countries prefer to hold more of bonds in the country where wealth (value of the
portfolio) is higher when translated into domestic currency. This is called the preferred habitat
version of the portfolio balance theory. Changes in money supply affect wealth which in turn,
has an impact on the exchange rate. Open market operations bring about changes in money
supply.
When a central bank conducts open market operations by buying domestic currency-
denominated government bonds, money supply increases and the domestic currency declines in
value (depreciates) against the selected foreign currency and the exchange rate changes. When
the central bank buys government bonds their supply decreases. But since the domestic currency
has depreciated, the domestic currency value of foreign currency-denominated bonds rises. This
makes investors prefer foreign bonds to domestic bonds, and the demand for domestic bonds
decreases.

exchange risk
Foreign exchange risk refers to the losses that an international financial transaction may incur
due to currency fluctuations. Also known as currency risk, FX risk and exchange-rate risk, it
describes the possibility that an investment‘s value may decrease due to changes in the relative
value of the involved currencies. Investors may experience jurisdiction risk in the form of foreign
exchange risk.
Understanding Foreign Exchange Risk
Foreign exchange risk arises when a company engages in financial transactions denominated in a
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currency other than the currency where that company is based. Any appreciation / depreciation
of the base currency or the depreciation / appreciation of the denominated currency will affect
the cash flows emanating from that transaction. Foreign exchange risk can also affect investors,
who trade in international markets, and businesses engaged in the import / export of products or
services to multiple countries.
The proceeds of a closed trade, whether its a profit or loss, will be denominated in the foreign
currency and will need to be converted back to the investor's base currency. Fluctuations in the
exchange rate could adversely affect this conversion resulting in a lower than expected amount.
An import/export business exposes itself to foreign exchange risk by having account
payables and receivables affected by currency exchange rates. This risk originates when a
contract between two parties specifies exact prices for goods or services, as well as delivery
dates. If a currency‘s value fluctuates between when the contract is signed and the delivery date,
it could cause a loss for one of the parties.

Types Of Foreign Exchange Risk

There are three types of foreign exchange risk:
Transaction risk: This is the risk that a company faces when it's buying a product from a
company located in another country. The price of the product will be denominated in the selling
company's currency. If the selling company's currency were to appreciate versus the buying
company's currency then the company doing the buying will have to make a larger payment in its
base currency to meet the contracted price.

Translation risk: A parent company owning a subsidiary in another country could face losses
when the subsidiary's financial statements, which will be denominated in that country's currency,
have to be translated back to the parent company's currency.
Economic risk: Also called forecast risk, refers to when a company‘s market value is
continuously impacted by an unavoidable exposure to currency fluctuations.
Companies that are subject to FX risk can implement hedging strategies to mitigate that risk.
This usually involves forward contracts, options, and other exotic financial products and, if done
properly, can protect the company from unwanted foreign exchange moves.

Capital risk management-Different types

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Sometimes referred to as investment risk, capital market risk is a term that refers to one of the
risks associated with investing. Capital markets such as the stock, bond, foreign currency and
derivatives markets are considered risky because of the constantly changing prices of the
securities that are traded. In other words, security prices are volatile. Securities prices are not
influenced just by their fundamentals, but also by broader market influences such as economic
news, political developments, currency movements, or even ―black-swan‖ unexpected events
such as a massive earthquake, tsunami or general market panic. While debatable, some consider
price volatility to be a proxy for risk. The risk of financial loss associated with either choosing to
or being forced to sell a security when prices have declined is what is meant by capital market
risk.
Types of Capital risk
i. Market risk
Market risk is the possibility of an investor experiencing losses due to factors that affect the
overall performance of the financial markets in which he or she is involved. Market risk, also
called "systematic risk," cannot be eliminated through diversification, though it can be hedged
against in other ways.
ii. Industry risk
Industry Risk refers to the impact that the state's industrial policy can have on the
performance of a specific industry.
iii. Regulatory Risk
Regulatory risk is the risk that a change in regulations or legislation will affect a security,
company, or industry. Companies must abide by regulations set by governing bodies that oversee
their industry. Therefore, any change in regulations can cause a rippling effect across an industry.
Regulations can increase costs of operations, introduce legal and administrative hurdles, and
sometimes even restrict a company from doing business.
iv. Business Risk
Business risk can be defined as uncertainties or unexpected events, which are beyond control. In
simple words, we can say business risk means a chance of incurring losses or less profit than
expected. These factors cannot be controlled by the businessmen and these can result in a decline
in profit or can also lead to a loss.

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Business risk is the possibilities a company will have lower than anticipated profits or experience
a loss rather than taking a profit. Business risk is influenced by numerous factors, including sales
volume, per- unit price, input costs, competition, and the overall economic climate and
government regulations.
v. Interest rate risk

Interest rate risk is the danger that the value of a bond or other fixed-income investment will
suffer as the result of a change in interest rates. Investors can reduce interest rate risk by buying
bonds that mature at different dates. They also may allay the risk by hedging fixed-income
investments with interest rate swaps and other instruments.
A long-term bond generally offers a maturity risk premium in the form of a higher built-in rate of
return to compensate for the added risk of interest rate changes overtime.
vi. Liquidity Risk
Liquidity risk is the risk that a company or bank may be unable to meet short term financial
demands. This usually occurs due to the inability to convert a security or hard asset to cash
without a loss of capital and/or income in the process
vii. Product Risk
Product risk is the risk that you may not actually be able to deliver the product to market
within the resources (time, money) that you have available to you. And if you do deliver the
product, the risk is also in that the product may not work exactly as well as hoped or promised
or envisioned.
Types of product market risks are:
1. Credit/Default risk

2. Basis risk

3. Settlement risk

4. Currency risk

5. Foreign exchange risk

6. Commodity risk

i. Credit/Default risk
A credit risk is the risk of default on a debt that may arise from a borrower failing to make
required payments. In the first resort, the risk is that of the lender and includes lost principal and
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interest, disruption to cash flows, and increased collection costs. The loss may be complete or
partial.
Default risk can be gauged using standard measurement tools, including FICO scores for
consumer credit, and credit ratings for corporate and government debt issues. Credit ratings for
debt issues are provided by nationally recognized statistical rating organizations (NRSROs),
such as Standard & Poor's (S&P), Moody's, and Fitch Ratings.
Default risk can change as a result of broader economic changes or changes in a company's
financial situation. Economic recession can impact the revenues and earnings of many
companies, influencing their ability to make interest payments on debt and, ultimately, repay the
debt itself. Companies may face factors such as increased competition and lower pricing power,
resulting in a similar financial impact. Entities need to generate sufficient net income and cash
flow to mitigate default risk.
ii. Basis risk
Basis risk is the financial risk that offsetting investments in a hedging strategy will not
experience price changes in entirely opposite directions from each other.
iii. Settlement risk
Settlement risk-also often called delivery risk - is the risk that one party will fail to deliver the
terms of a contract with another party at the time of settlement. Settlement risk can also be the
risk associated with default, along with any timing differences in a settlement between the two
parties. Default risk can also be associated with principal risk.
iv. Currency risk

Currency Risk, sometimes referred to as exchange rate risk, is the possibility that currency
depreciation will negatively affect the value of one's assets, investments, and their related interest
and dividend payment streams, especially those securities denominated in foreign currency.
v. Foreign exchange risk
Foreign exchange risk refers to the losses that an international financial transaction may
incur due to currency fluctuations. Foreign exchange risk can also affect investors, who trade
in international markets, and businesses engaged in the import / export of products or services to
multiple countries. They are classified into three types:
 Transaction risks

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 Translation risks
 Economic risks
vi. Commodity risk
Commodity risk refers to the uncertainties of future market values and of the size of the future
income, caused by the fluctuation in the prices of commodities. These commodities may be
grains, metals, gas, electricity etc.
Commodity price risk to buyers stems from unexpected increases in commodity prices, which
can reduce a buyer's profit margin and make budgeting difficult. For example, automobile
manufacturers face commodity price risk because they use commodities like steel and rubber to
produce cars.
In the first half of 2016, steel prices jumped 36%, while natural rubber prices rebounded by 25%
after declining for more than three years. This led many Wall Street financial analysts to
conclude that auto manufacturers and auto parts makers could see a negative impact on their
profit margins.

International arbitrage and interest rate parity

Arbitrage can be defined as capitalizing on a discrepancy in quoted prices. The funds invested
are not tied up and no risk is involved. In response to the imbalance in demand and supply
resulting from arbitrage activity, prices will realign very quickly, such that no further risk-free
profits can be made.

Lavational arbitrage is the process of buying a currency at the location where it is priced cheap
and immediately selling it at another location where it is priced higher. Lavational arbitrage is
possible when a bank‘s buying price (bid) is higher than another bank‘s selling price (ask) for the
same currency.

Triangular Arbitrage in which currency transactions are conducted in the spot market to capitalize
on a discrepancy in the cross exchange rate between two currencies. This is possible, if quoted
cross exchange rate differs from the appropriate cross exchange rate.
When the exchange rates of the currencies are not in equilibrium, triangular arbitrage will force
them back into equilibrium.
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Covered Interest Arbitrage is the process of capitalizing on the interest rate differential between
two countries, while covering for exchange rate risk. Covered interest arbitrage tends to force a
relationship between forward rate premiums and interest rate differentials.
As many investors capitalize on covered interest arbitrage, there is upward pressure on the spot
rate and downward pressure on the 90-day forward rate. Once the forward rate has a discount
from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage will
no longer be feasible.

Interest Rate Parity (IRP)

Sometimes market forces cause the forward rate to differ from the spot rate by an amount that is
sufficient to offset the interest rate differential between the two currencies. Then, covered
interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest
rate parity (IRP).

When IRP exists, it does not mean that both local and foreign investors will earn the same
returns. What it means is that investors cannot use covered interest arbitrage to achieve higher
returns than those achievable in their respective home countries.

Relation between inflation, interest rates and exchange rates

While exchange rates can be subject to myriad factors in intraday trading-from market
sentiment, breaking economic news, and cross-border trade and investment flows -inflation and
interest rate policy are often important indicators for exchange rate trends-they can help traders
gain an idea of what is likely to be a profitable trade for foreign exchange positions taken over
longer periods.
Inflation is commonly thought of as the pace at which prices increase in a given economy and
determines the "worth" of money in relation to goods and services offered. If more money is
perceived to be circulating at a given time, suppliers of goods and services typically react by
adjusting their prices upward, meaning less can be purchased with a given unit of currency.
Conversely, if the offer of money by consumers appears to be scarce, suppliers often react by
lowering prices to attract buyers, meaning inflation will decelerate and money in that economy
will gain relative value.

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Measures of Inflation
Inflation is normally measured by governments using groups of price levels for goods in varying
sectors known as price indices. These include measures such as a producer price index (PPI),
which measures wholesale inflation, and a consumer price index (CPI), which measures inflation
for consumers. Governments and central banks frequently use these indices to help determine
their economic measures through instruments such as inflation-targeting strategies.
Inflation in the economies of currencies being traded is an important factor to consider because it
affects the relative value of those currencies internationally and because it can determine future
policy adjustments by governments and central banks.
Interest Rates
Through use of monetary policy, national central banks attempt to adjust their base interest rates
and available banking money reserves to control the rate of lending by banks within their
economies. The theory is that when there is more, or cheaper, money perceived to be available in
the economy through bank loans and other types of credit, consumers and businesses will spend
more, sellers of goods and services will adjust prices upward, and inflation can accelerate.
Conversely, when there is less, or more expensive, money available, consumers and businesses
will restrict their spending, prices will fall, and inflation will decelerate. Thus, if central banks
want to curb inflation, they will raise interest rates; and if they want to induce spending and
economic activity, they will lower interest rates.
Interest Rate Parity
While directly related to inflation control policy, interest rates are also considered to have their
own particular relevance for foreign exchange trading because of what is known as interest rate
parity. This theory posits that the real interest rates (interest rates less inflation) across borders
tend to move toward equilibrium and those currencies in economies with higher interest rates
tend to weaken over time.
However, where capital is allowed to move freely across borders, investors will seek to put their
money in countries where they can get the highest returns. Thus, if one country has a higher
interest rate than another, money will tend to flow to the country with the higher interest rate,
causing that country's weaker currency to once again appreciate over time. When the currency
has risen to an equilibrium price level

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Where its cost is no longer offset by gains from its higher interest rate, it reaches interest rate
parity and further investment flows from abroad come to a halt.
Currency traders, then, hope to predict future exchange rate movements by paying
attention to the relative levels of inflation in the countries of their target currency pairs in
addition to where each country is in its monetary policy cycle, and the size and pace of
currency flows moving into and out of each country.

Purchasing Power Parity Theory

Under the theory of Purchasing Power Parity, the change in the exchange rate between
two countries' currencies is determined by the change in their relative price levels locally
that are affected by inflation. It is generally agreed that this theory mostly holds true over
the long run, but economists have found that it can suffer distortions over the short term
because of trade and investment barriers, local taxation, and other factors.
As a result of this relationship, one can expect the currencies of countries with higher
inflation rates to weaken over time versus their peers, whereas currencies of countries
with lower inflation rates tend to strengthen. In economies with weak production of local
goods and services, the depreciation of the local currency can at times even be
accelerated by the "pass-through effect" of importing foreign goods with relatively higher
prices.
When a country‘s inflation rate rises relative to that of another country, decreased exports
and increased imports depress the high-inflation country‘s currency because of worsening
trade and current account balances. Purchasing Power Parity (PPP) theory attempts to
quantify this inflation-exchange rate relationship.
Interpretations of PPP
 The absolute form of PPP is an extension of the law of one price. It suggests that
the prices of the same products in different countries should be equal when
measured in a common currency.
 The relative form of PPP accounts for market distortions like transportation costs,
labor costs, tariffs, taxes, and quotas. It states that the rate of price changes should
be similar.
Rationale behind PPP Theory

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Suppose U.S. inflation > U.K. inflation.

U.S. imports from U.K.
U.S. exports to U.K., and U.S. current account
Downward pressure (depreciation) is placed on the $. This shift in consumption and the
$‘s depreciation will continue until
in the U.S.: price U.K.goods ≥price
U.S.goods and in the U.K.: price
U.S.goods ≤ price
U.K.goodsDerivation of PPP
Assume that PPP holds. Over time, as inflation occurs exchange rates adjusts to maintain
PPP: Ph1 → Ph0 (1 + Ih)
Where Ph1=home country‘s price
index, year-1 end Ih =home country‘s
inflation rate for the year
Pf1→ Pf0 (1 + If )(1 + ef
) where Pf = foreign
country‘s priceindex
If = foreign country‘s
inflation rate ef = foreign
currency‘s % in value
If PPP holds Ph1 = Pf1 and Ph0 (1 + Ih ) = Pf0 (1 + If ) (1 + ef )

Solving for ef = (1 + Ih ) / (1 + If ) -1
Ih> If ef> 0 i.e. foreign currency
appreciates Ih< If ef< 0 i.e. foreign
currencydepreciates Example:
Suppose IU.S. = 9% and IU.K. = 5%.
Then e £ ={ (1 + 0.09 ) / (1+0.05)}– 1 = 3.81%
When the inflation differential is small, the PPP relationship can be simplified as ef Ih – If
Graphic Analysis of Purchasing Power Parity

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Testing the
PPP Theory
Conceptual
Test
Plot actual inflation differentials and spot exchange rate changes for two or more
countries on a graph. If the points deviate significantly from the PPP line over time,
then PPP does not hold.
Statistical Test
Apply regression analysis to historical exchange rates and
inflation differentials: ef = a0 + a1 [ (1+ Ih)/(1+ If) – 1 ] +
Then apply t-tests to the regression coefficients (Test for a 0 = 0 and a 1 = 1.) .If any
coefficient differs significantly from what was expected, PPP does not hold.
Empirical studies indicate that the relationship between inflation differentials and
exchange rates is not perfect even in the long run. However, the use of inflation
differentials to forecast long-run movements in exchange rates is supported. A limitation
in the tests is that the choice of the base period will affect the result.
PPP does not occur consistently due to confounding effects, a lack of substitutes for
some traded goods. Exchange rates are also affected by differences in inflation, interest
rates, income levels, government controls and expectations of future rates.

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PPPcanbetestedbyassessinga―real‖exchangerateovertime (e.g., crawlingpegs).Thereal

exchange rate is the actual exchange rate adjusted for inflationary effects in the two
countries of concern. If the real exchange rate follows a random walk, it cannot be
viewed as being a constant in the long run. Then PPP does not hold.

International Fisher Effect(IFE)

According to the Fisher Effect, nominal risk-free interest rates contain a real rate of return
and anticipated inflation in = ir + inflation
If all investors require the same real return on assets of similar risk and maturity, then
differentials in interest rates may be due to differentials in expected inflation.
The International Fisher Effect (IFE) theory suggests that currencies with higher
interest rates will depreciate because the higher nominal rates reflect higher expected
inflation.
Hence, investors hoping to capitalize on a higher foreign interest rate should earn a return
no higher than what they would have earned domestically
According to the IFE, E (rf ), the expected effective return on a foreign money market
investment, should equal rh , the effective return on a domestic investment.
rf = (1 + if )(1 + ef ) – 1
if = interest rate in the foreign country ef = % change in the foreign
currency‘s value rh = ih = interest rate in the home country
Setting rf = rh : (1 + if )(1 + ef ) –
1 = ih Solving for ef : e f =] (1 + i
h ) / 1 (1 + i f )]-1
ih > i f ef> 0 i.e. foreign currency
appreciate ih< if ef< 0 i.e. foreign
currency depreciates
Example: Suppose iU.S. = 11% and iU.K. = 12%. Then eU.K. = [(1 + .11)/ (1 + .12 ) ] – 1
= –(.89)% .
This will make rf = rh
When the interest rate differential is small, the IFE relationship can be simplified as ef ih-if
If the British rate on 6-month deposits were 2% above the U.S. interest rate, the £ should

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depreciate by approximately 2% over 6 months. Then U.S. investors would earn about
the same return on British deposits as they would on U.S. deposits.

If actual interest rates and exchange rate changes are plotted over time on a graph, we can
see whether the points are evenly scattered on both sides of the IFE line. Empirical
studies indicate that the IFE theory holds during some time frames. However, there is
also evidence that it does not hold consistently
To test the IFE statistically, apply regression analysis to historical exchange rates and
nominal interest rate differentials: ef = a0 + a1 [ (1+ ih)/(1+ if) – 1 ] + .

Then apply t-tests to the regression coefficients. (Test for a0 = 0 and a1 = 1.). IFE does not
hold if any coefficient differs significantly from what was expected.
Since the IFE is based on PPP, it will not hold when PPP does not hold. • In particular, if
there are factors other than inflation that affect exchange rates, exchange rates may not
adjust in accordance with the inflation differential.

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Comparison of the IRP, PPP, and IFE Theories

Expectations theory
Expectations theory attempts to predict what short-term interest rates will be in the future
based on current long-term interest rates. The theory suggests that an investor earns the
same amount of interest by investing in two consecutive one-year bond investments
versus investing in one two-year bond today. The theory is also known as the "unbiased
expectations theory."
Understanding Expectations Theory
The expectations theory aims to help investors make decisions based upon a forecast of
future interest rates. The theory uses long-term rates, typically from government bonds, to
forecast the rate for short- term bonds. In theory, long-term rates can be used to indicate

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where rates of short-term bonds will trade in the future.

Example of Calculating Expectations Theory

In this example, the investor is earning an equivalent return to the Let's say that the
present bond market provides investors with a two-year bond that pays an interest rate of
20% while a one-year bond pays an interest rate of 18%. The expectations theory can be
used to forecast the interest rate of a future one-year bond.
The first step of the calculation is to add one to the two-year bond‘s interest rate.
The result is 1.2. The next step is to square the result or (1.2 * 1.2 = 1.44).
Divide the result by the current one-year interest rate and add one or ((1.44 / 1.18) +1 =
1.22).
To calculate the forecast one-year bond interest rate for the following year, subtract one
from the result or (1.22 -1 = 0.22 or 22%). present interest rate of a two-year bond. If the
investor chooses to invest in a one-year bond at 18% the bond yield for the following
year‘s bond would need to increase to 22% for this investment to be advantageous.

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