What is Exchange Rate?
The concept of exchange rate of currencies may be explained as the value of a currency in terms of another currency. The rupee exchange rate is determined by market forces. The exchange rates of currencies are extremely important in the modern day economic scenario as they help one in assessing the economic stability of a country. All economists and analysts that if the Reserve Bank did not purchase all surplus dollars, the rupee rate against the dollar would appreciate quite substantially and that it is the RBI's action, which determine key exchange rates.

How It Works: -
There are two situations through which this exchange rate can effectively be understood from Indian perspective we can easily cope up with the understanding of the Exchange Rate by taking the below the two situations. They are mentioned below.

General Perspective: -
Suppose the supply of dollar increases (excess injection of the dollar term money in the Indian Economy) relative to its demand. This excess growth in the money supply will cause inflation in India and that would lead to devaluate the Indian Currency i.e. in Rs. Term and as the evidence proves this fact that inflation had gone to 14.12% and the Rs. Value in dollar terms had gone from 1$=38 or 40 Rs. To Currently 1$=45Rs. Approximately and On the contrary if we take the reverse of it then before 2007 or the Sub-Prime issue was not yet encountered at that point of time or in the year 2006-07 the inflation rate was quite lower compared to the current one and at that time the dollar was appreciated at that period.

Importer’s Perspective: -
When the Importers imports any goods, services and assets in that case if the Rs. Had been depreciated then Importers won’t be benefited because previously they were paying 1$=40 Rs. For a particular product by now due to depreciation it has came to 1$=45 Rs. Then the Importer has to pay 5 Rs. Extra for those imported products or services. On the contrary if the Rs. Value has been appreciated then in that case the Importers would be benefited by this appreciation.

Exporter’s Perspective: -
Whenever any company exporting the goods and services form India to other countries then in that case if the Rs. Value has been depreciated then the Exporter would be benefitted because previously they would be receiving 1$=40 Rs. But due to depreciation they would be receiving 1$=45 Rs. So they would have a clear cut profit because of the depreciation of the Rs. Term and on the contrary if the Rs. Value had been appreciated then the Importers won’t be benefited.

Note: - But the Company which is indulged in both Importing and Exporting the goods and services then in that case they won’t be affected that much as individually Importers and Exporters are affected due to this imbalance in the Exchange Rate and Interest Rate.

Exchange rates determinants: an overview: -
Forex market is the largest financial market in terms of size. This is so irrespective of the fact that it is fully over the counter market. By far the largest market for currencies is the interbank market, which trades spot and forward contracts. The market can be termed as efficient with enough breadth, depth and resilience.

Basic theories underlying the exchange rates Equibrium
Law of One Price:
In competitive markets free of transportation costs barriers to trade, identical products sold in different countries must sell at the same price when the prices are expressed in terms of their same currency.

Purchasing power parity:
As inflation forces prices higher in one country but not another country, the exchange rate will change to reflect the change in relative purchasing power of the two currencies.

Interest rate effects:
If capital is allowed to flow freely, the exchange rates stabilize at a point where equality of interest is established.

The Fisher Effect:
The nominal interest rate (r) in a country is determined by the real interest rate R and the inflation rate i as follows:

(1 + r) = (1 + R)(1 + i)

International Fisher Effect: the spot rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.

S1 - S2
----------- x 100 = i2 – i1
S2
Where: S1 = spot rate using indirect quotes at beginning of the period;
S2 = spot rate using indirect quotes at the end of the period;
i = respective nominal interest rates for country 1 and 2.

Though the above principles attempt to explain the movement of exchange rates, the assumptions behind these two theories [free flow of capital] are seldom seen and thus these theories can’t be applied directly. The dual forces of demand and supply determine exchange rates. Various factors affect these, which in turn affect the exchange rates:

Arbitrage Opportunity: -

As above theories says that there shouldn’t be any mismatch between the Interest rate and Exchange Rate between the two countries but as we all know that most or majority of the country had adopted the “Free-Float” and “Managed Float” and it’s totally dependent on the market forces so the Arbitrageurs, Speculators, Investors and Financial Institutions have the Arbitrage Opportunity i.e. the rate differential they will fetch profit between the two countries Markets. So these Players buy dollars here and sell abroad because the Rs. Value is depreciated at large so in that case the investors have the opportunity to fetch return out of both the market.

PLAYERS BUY DOLLARS HERE, SELL ABROAD

Cos, banks cash in on Re slide

Exploit Difference In Re-$ Rate Between Home & Offshore Markets

Sugata Ghosh MUMBAI

THE recent attack on the Korean won and its ripples across currency markets in Asia have turned out to be a money-making opportunity for players with an overseas presence. Multinational banks operating in India, large corporate and diamond houses have cashed in on the difference that has surfaced in the dollar-rupee exchange rate between the Mumbai currency market and the unregulated, unofficial, offshore markets in Singapore, Dubai and London.

The difference (which reflects the arbitrage opportunity) was as much as 40 paisa to Re 1 last week. It’s the outcome of hedge funds and foreign portfolio managers taking big bets that the rupee will slip further against the US currency. Such bets, which primarily boil down to these players shorting the Indian currency, have made the rupee weaker in the offshore market than what it is in India. In other words, the dollar has become stronger (against the rupee) in the offshore market than what is quoted here.

So, corporate and institutions, which have the wherewithal and flexibility, have profited by buying the dollar in India and selling it in the offshore market — better known as the non-deliverable forward (NDF) market.
As the name suggests, all deals in the NDF market are forward deals settled in dollars; it’s not a spot market since the rupee, a nonconvertible currency, cannot be ‘delivered’ in the offshore market. Thus, deals are settled in cash, and on maturity of the forward contract, the difference between the forward rate and the RBI reference rate prevailing on the date of maturity is either paid or received in dollar by the party concerned. (The RBI reference rate is based on noon rates of a few active banks in Mumbai).

For instance, the one-month forward dollar was 45.83 in India against 45.96 on the NDF market. Senior treasury officials said that many have taken advantage of this difference — buying forward in India and selling forward abroad to lock in a gain of 13 paisa. A few days ago, the difference was 40 paisa in the one-month forward, but around a rupee in far-month contracts. “Volumes have shot up, and banks are charging less margin for NDF trades. It’s a billion-dollar market which believes that rupee will drop faster than the official exchange rate,” said the treasurer of a private bank. Just like stock or currency futures, a corporate or fund taking an NDF position has to pay a margin to a bank. Having undertaken such trades for years, many Indian corporate enjoy credit lines with banks abroad for NDF trades.

According to a senior official with a foreign bank, the difference may shrink on Monday since the dollar has weakened, but could widen subsequently. “The dip in the Korean won has turned other currencies volatile. Large funds will use the NDF market to take positions in currencies they think will weaken against dollar. Forward deals of two to three years are also happening on NDF,” he said. Like the rupee, there is an active NDF market in the Taiwan dollar, Philippine peso and Korean won. Indeed, the NDF market has turned so active in recent times that the Korean central bank had to intervene.

NDF market may dilute RBI’s intervention

HOWEVER, most monetary authorities, including RBI, don’t attach much significance to the NDF market. “But it would be difficult for the central bank to ignore it. RBI might disagree, but if the NDF volumes continue to grow then its currency market intervention will have a less impact,” said an official of a state-owned bank.

Typically, when RBI sells dollar in the spot market, it sucks out rupee. To manage liquidity, it then does buy sell swap — buying in the spot market to release some of the rupee that was mopped up and simultaneously selling in the forward market.

However, if there are active buyers in the forward market to take advantage of the NDF arbitrage, such forward selling by RBI would be partly offset by these players who are buying in the local forward market. Such arbitrage possibility will exist as long as NDF market is there.

Such market thrives because hedge funds and FIIs, which don’t have adequate facility to hedge rupee exposure, look for other ways to do it. While the usual difference between NDF and the home market is 5-15% paisa, it can widen suddenly, as it has now, on the back of development in the international currency market.