Usually, buyers of foreign exchange react to changes in the rate of exchange, but in different degrees. This phenomenon is described as elasticity of demand. It may be defined as the ratio percentage change in the amount of foreign exchange demanded to the percentage change in the rate of exchange. The slope and shape of a demand curve is determined by its degree of elasticity, If demand is elastic (e > 1) the demand curve will be flatter. It will be steeper when demand is inelastic (e < 1).
Similarly, sellers of foreign exchange react to the changes in exchange rate. The elasticity supply of foreign exchange measures the responsiveness of sellers to changes in the rate of exchange The elasticity of supply of foreign exchange may be defined as the ratio of percentage change in ‘ quantity of foreign exchange supplied to the percentage change in the rate of exchange.
The slow and shape of a supply function is determined by its degree of elasticity. A steeper supply cir implies inelastic supply indicating that the amount offered is not very much affected by a movement in the rate of exchange. A flatter supply curve, on the other hand, suggests elastic supply indicate’ that the amount offered is greatly affected by a movement in the rate of exchange.
Other things being equal, when there is an increase in the demand for foreign exchange causing a shift in the demand curve, it will lead to a fall in the rate of exchange and vice very Similarly, an increase in supply of foreign exchange will lead to a rise in the rate of exchange ^ external value of home currency in terms of foreign currency rises) and vice versa. However, extent of change in exchange rate as a result of change in demand or supply position depends on nature and degree of their respective elasticity’s.
Spot and Forward Exchange Rates:
Broadly speaking, we may distinguish between two types of exchange rates prevailing in foreign exchange market, viz., spot rate of exchange refers to the price of foreign exchange terms of domestic money payable for the immediate delivery of a particular foreign currency.
It thus, a day-to-day rate. On the other hand, forward rate of exchange refers to the price at which transaction will be consummated at some specified time in the future. A forward exchange mar functions side by side with a spot exchange market.
The transactions of forward exchange mar are known as forward exchange transactions which simply involve purchase or sale of a fore’ currency for delivery at some time in the future; the rates at which these transactions are consume: are, therefore, called forward rates. Forward exchange rate is determined at the time of sale but payment is not made until the exchange is delivered by the seller. Forward rates are usually quo on the basis of a discount or premium over or under the spot rate of exchange; thus, forward rates may be expressed as a percentage deviation from the sport rates. ] To illustrate the point suppose an Indian citizen buys goods from America worth $100, payable in 3 months.
The ‘spot rate’ (i.e., rate prevailing at the time of purchase) is Rs. 37.50 = $1. In order to avoid exchange risk, he may enter into a forward contract in the forward exchange market to buy $ 100 three months’ forward at a rate agreed on now – the forward rate.
If the rate agreed on is 50 paise at a discount then the buyer shall have to pay at the rate of Rs. 37 = $1. If the rate is fixed at 50 paise at a premium then he shall have to pay at the rate of Rs. 38 = $1. In this way, in the forward rate system, a buyer avoids risk in the sense that whatever, may be the fluctuations in exchange rate in the future, he knows now what he will have to pay for $ 100.
Thus, forward exchange rates enable exporters and importers of goods to know the prices of their goods which they are about to export or import. Thus, in general, the process of covering exchange risks in the forward market is simply a way of eliminating uncertainties of spot rate fluctuations from time to time.
However, the forward exchange rate is quite sensitive to speculative influences and to changes in sentiment with respect to different currencies. Moreover, forward rates are not independent of spot rates of exchange and they are inter-related indirectly through interest rates prevailing in the two countries.
Thus, forward exchange theory holds that under normal conditions, the forward discount or premium on one currency in terms of another is directly related to the difference interest rates prevailing in the two countries.
That means usually the forward rate is determined by the relative rates of interest in the countries concerned. If the rate of interest is lower abroad relative to the rate of interest at home, the forward rate will be at a premium compared with the spot rate by an amount equal to the difference in the rates of interest plus commission.
This is because the dealer (usually the bank) borrows at home at a rate higher than the rate at which he invests the foreign funds abroad; he makes out a deficit that goes to his client in competitive market, plus his own charges – commission. Conversely, if the rate of interest abroad is higher, then the forward rate may be quoted at discount by an amount equal to the difference in the rates of interest, less dealer’s commission.
The other factors which determine the forward rate are:
1. The confidence in the future of a currency. If the future of a foreign currency is unstable the dealer may quote at a premium on the spot rate.
2. The chance of “marrying.” If the chance of canceling the purchases and sales of a foreign currency is high the dealer may quote at a discount on the spot rate, for it reduces the exchange risks.
In short, the spot rate is the exchange rate meant for immediate delivery of currencies exchanged, whereas, the forward rate is the exchange rate quoted for future delivery of currencies exchange. Forward exchange rate depends on future expectations and uncertainties. It may be higher than or lower than the spot rate as per premium or discount percentage.
Exchange Rate Quotes
1. Direct: USD 1 =RM 3.80
2. Indirect: 1 RM = USD 38 cents
1 =RM 3.7894
The last decimal place is called point: 4 points or 4 pips. In foreign markets, there are always two way quotations: 4. rate for buying
5. y rate for selling
e.g., a bank quota USD 1 = RM 3.8005 – RM 3.8035 means it would buy USD 1 at 3.8005 and sell at RM 3.8035
6. Forward rate = spot rate + premium
7. Indirect rate premium is added to both buying and selling rate.
i. premium – when currency is costlier in future (forward) comparing to spot.
ii. indirect rate premium is always deducted from both buying/selling rate.
8. Discount: when currency is cheaper in future (forward) as compared to spot
Indirect rate discount is deducted
Indirect rate discount is added
9. It is the base currency for which the premium/discount is always mentioned.
10. Base currency is the currency which is being bought and sold. The other currency is incidental.
11. Example : Spot: USD + DEM 1.8235 – 1.8245 Forwards: Spot/1 month 17/18 Spot/2 month 35/37 Spot/3 month 53/56 Spot/6 month 99/100 Calculate forward buying and selling DEM.
If one has to buy 1£ against USD
Spot £1 = USD 1.6291
1 month discount forward-0.0015/USD 1.6276
if one sells
Spot £ 1 = USD 1.6284
I month discount forward – 0.0017/USD1.6267
Market quote: 1 month forward £ 1 = US 1.6267 – 1.6276
Arbitrage is the act of simultaneously buying a currency in one market and selling it in another to make a profit by taking advantage of price or exchange rate differences in the two markets. If the arbitrage operations are confined to two markets only, they will be known as “two point” arbitrage. If they extend to three or more markets they are known as “three point” or “multi point” arbitrage.
Let us now examine a hypothetical illustration to grasp the two-point arbitrage operation. Suppose the official exchange rate between dollar and rupee is 1$= Rs.35. If, however, due to increasing demand for $ in the Mumbai foreign exchange market, the market rate of exchange is 1 $ = Rs.37, while in the New York market it is 1 $ = Rs. 35. In view of the clear-cut difference of exchange rat in the two different markets, the arbitrager gets an opportunity to make profit by purchasing dollar Rs. 35 in New York and selling it at Rs. 37 in Mumbai.
Under such arbitrage operations, however the effect would be that the rate of exchange in New York will rise on account of increased demand from arbitragers’ act of buying dollars and it will decline in the Mumbai market due to increased supply of dollars.
The process will halt when the market exchange rates in both the markets are equal, and if there be any discrepancy, it may be due to the extent of cost difference. Similarly, there can be a three-point of triangular arbitrage when three currencies are involved in switching funds. Here, the cross rate and the market rate are compared to make profit through arbitrage. Cross is the rate of exchange between two currencies worked out from the external values of the two currencies against a third currency. Whereas, market rate is the exchange rate that actually exists between two currencies.
Suppose $-£ rate is 2, $-DM rate is I and £-DM rate is 0.45. If we convert $ 200 to $ 100, then convert £ 100 to DM 222.22. Again, convert DM 222.22 into $ 222.22 and make $ 22.22 profit, it is not so easy in practice. Our illustration is based on the assumption that exchange rates are given. in reality, exchange rates under the floating system change very rapidly, so the disparities between market rates and cross rates do not last due to quick flows of funds in the forex markets.