# Foreign Exchange Rate: Explained

`Mukunda Tripathee`

### Foreign Exchange Rate

Foreign exchange rate is a rate in which the amount of the domestic currency is required to obtain one unit of foreign currency. For example- if Rs. 116.96 is required to purchase one unit of US dollar, foreign exchange rate for one US dollar is Rs. 116.96

Foreign exchange rate is determined by the central bank of a country and the changes can be made by the central bank only.

Foreign exchange rate is quoted in bid and ask price format. BID price is buying rate at which buyer is willing to buy and ASK price is selling rate at which seller is willing to sell foreign currency. If \$1 equal to Rs. 116.96/117.56 , which means Rs. 116.96 is buying rate and Rs. 117.56 is selling rate.

The difference between BID and ASK is called ‘spread’ rate, i.e. ask price minus bid price. Here Rs 117.56 minus 116.96 equal to Re. 0.6 is spread rate.

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### Foreign Exchange Rate Quotation

Foreign exchange rate quotation can be quoted into two ways- Direct quotation and Indirect quotation.

A direct quote is a foreign exchange rate quote in which foreign currency’s unit is fixed against variable amount of the local currency. In this quote system foreign exchange rate is fixed, such as 1 dollar, 1 Japanese Yen, 1 EUR whereas local currency is variable such as Rs. 116.96.

Direct quote in Nepal, Rs. 116.96 equal to \$1, dollar 1 is fixed and Rs. 116.96 is variable and can be changed at any point of time.

An indirect quote is just opposite of direct quote, in which domestic currency rate/unit is fixed against the variable amount/unit of the foreign currency.

Indirect quote is expressed like GBP 1 equals to USD 1.30 (GBP is domestic), US\$1 equals to C\$1.2300 (USD is domestic).

### Determination of Foreign Exchange Rate

Basically, foreign currency is required to perform international trade between the countries for the serving the merchandised goods and services, for the movement of natural person for different purposes across the border, and for accounting purposes in recording the capital transfer and capital investment cross the border.

Foreign exchange rate is determined in foreign exchange market through the interaction of demand and supply of foreign currency. If the demand of currency is high, foreign exchange rate will increase. And, if the demand of foreign currency is low, naturally foreign currency rate will decrease.

### Method of Foreign Exchange Rate Determination

Foreign exchange rate can be determined through fixed exchange rate, flexible exchange rate, and managed floating system.

Fixed exchange rate is determined by monetary authority of the nation against the market mechanism i.e. supply and demand of currency and is revised by the same way as and when needed.

Flexible exchange rate is determined by market mechanism and structure i.e. demand and supply of currency. Foreign exchange rate is arrived at a point where the demand for foreign exchange equals its supply.

Under managed floating system, foreign exchange rate is determined by monetary authority with the consideration of demand and supply of foreign currency. Both method, fixed foreign exchange and flexible exchange rate system is considered for to determine foreign exchange rate.

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### Demand For Foreign Exchange/Currency

Foreign exchange rate depends on demand and supply foreign currency. Basically, demand of foreign currency depends on the import of merchandise good and services, volume of transfer-both current and capital, payment of foreign loan installment by government and corporate house, maintenance of regular expenses for diplomatic offices and missions, and so on. Volume of imports and exports of merchandise good and services is largely dependent on foreign exchange rate.

Increasing foreign exchange rate means devaluation of domestic currency. If so, the value of foreign goods and services will increase which results payment in more domestic currency/ money for to import goods and services. Marks in inflations and demand of goods and services will decrease in domestic market. In the same line, demand of foreign currency will constrict because of high foreign exchange rate.

### Supply Of Foreign Exchange/Currency

Supply of merchandise good and services, income from services provided to foreigner, remittances and other transfer, receipts from donors as a foreign assistance, expenses done by diplomatic and missions, and so on are the major sources for supply of foreign currency. Volume of merchandise goods and services and foreign services depend on foreign exchange rate.

With the increment of foreign exchange rate, the domestic currency will devaluate. As a result, exporter will be benefited because exporter will gain from the devaluation of domestic currency through the exchange of foreign currency in the new exchange rate.

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### Theories of Rate of Exchange

Mint Par Parity, Purchasing Power Parity and Balance of Payments theory are major theories to determine the foreign exchange rate.

#### Mint Par Parity Theory

According to S.E. Thomas, “the mint par is an expression of the ratio between the statutory bullion equivalents of the standard monetary units of two countries on the same metallic standard”. This theory explains the determination of foreign exchange rate between the countries that are on the same metallic standard.

A nation is said to be fully on the gold standard if the government of that country- expresses the rate of exchange based on monetary unit in terms of gold, gold shall have to bought and sold voluminously at officially fixed price, and nation permits inflow and outflow of gold.

As per monetary system of the concerned countries under this theory, the exchange rate is determined by different ways:

##### When the both countries are on the same metallic standard:

When both countries are on metallic standard, the exchange rate of both countries base on the ratio of the bullion equivalents of the standard monetary units of two countries on the same metallic standard.

For illustration, both the USA and UK standard was gold as of late 1920s. The value of one unit of pound and dollar was equivalent to 113.0016 and 23.22000 grains of gold respectively. Thus, the exchange rate of pound and dollar was determined on the basis of the mint parity theory.

Here,

Exchange rate of 1 pound equals to 4.866 dollar i.e. (113.0016/23.22000=4.866). Similarly, exchange rate of 1 dollar is equals to 0.205 pond i.e. (23.22000/113.0016=0.205)

##### When two countries adopt different metallic standards, say a country adopts gold standard and another one adopts silver standard:

Here, let’s suppose, one of the country is adopting gold standard and other country is adopting sliver standard. To find out the exchange rate under mint par parity theory, quantity of find gold and silver contained in the standard coin of the country adopting the gold standard and silver standard of concern country shall have to be found out. After that, find out the gold value of the silver coin or vice versa.

Till 1898 the Indian Rupee contained 165 grains of fine silvers which was equivalent to 7.53344 grains of fine gold. Whereas, American Doller was equivalent to 23.2200 grains of gold. Therefore, the exchange rate between the American Dollar and Indian Rupee was 1 Dollar equals to 3.082 i.e. (23.2200/7.53344=3.082) and 1 Indian Rupee equals to 0.324 Doller i.e. 7.53344/23.2200=0.324)

##### When a country is on a metallic standard and another country is on inconvertible paper currency standard:

Under this theory, the foreign exchange rate is determined by the quantity of the gold that is can be purchased by the currencies of individual countries. The government shall declare the gold value of the currency of a nation. Inconvertible paper currency which is adopting the gold value of the country, may change time to time according to the situation in the market.

##### When both the countries are on inconvertible paper currency standard:

If both countries adopt inconvertible paper currency standard, the rate of exchange between two countries is determined by the demand and supply of foreign exchange/currency. Paper currencies have no link with metal like gold and silver.

The purchasing power parity theory (PPP) was first propounded by Wheatlay in 1802. Later, this theory is brought back and properly developed by Swedish Economist Gustav Cassel in the year 1918. Each and every countries have currencies, having purchasing power in its own country. Thus, for the different purpose of nation, domestic currency has be exchanged with foreign currency. When the domestic currency is exchanged for the foreign currency, which means the exchange of domestic purchasing power for the foreign purchasing power. The foreign exchange rate is determined by relative purchasing power of between two currencies. Purchasing power parity theory has two version.

##### Absolute Purchasing Power Parity Theory

Suppose, cost of a particular goods in Nepal is Rs. 500 and cost of same goods in America is \$8. Then, the purchasing power of \$8 equals to the purchasing power of Rs. 500. The exchange rate can be expressed as \$1 equals to Rs. 62.5 (500/8), likely Re 1 equals to 0.016 (1/62.5)

Symbolically, R= Pa/Pb (R= Exchange rate of country A’s currency in terms of country B’s currency, Pa= the general price level in country A and Pb= the general price level in country B)

In absolute purchasing power parity theory, the rate of exchange is the ratio of internal purchasing power of the foreign currency and the internal purchasing power of the domestic currency.

##### Relative Purchasing Power Parity Theory

The theory suggest that the change in the exchange rate over the period of time should be proportional to the relative change in the price level in the two nations over the same period time.

Now, suppose that, between America and Nepal the exchange rate in the base year was \$1 equals to Rs. 70 and the price index at the base year is 0 both in Nepal and America. In the current year the price index in Nepal climbed up by 3 times to 300 in the current year while the price level went up by 50% in USA to 150 compared to the base year, then equilibrium dollar exchange rate in terms of Nepalese rupee (R1) will be 140, Rs. 140 is the new parity between the currency.

#### Balance Of Payments Or Modern Theory Of Exchange

Let’s illustrate by example, suppose current exchange rate between the Nepal and the America is \$1= 72 Nepalese rupee. As per the result of imports and exports of merchandise goods and services, there is surplus in Nepal’s Balance of payments. Which means that the supply of dollars in Nepal is greater than demand. As a result, exchange rate fall. Suppose that new rate of exchange is \$1 equals to 71 Rupees. At this exchange rate, Nepalese export to the America will be costlier and American imports to Nepal will be cheaper. This means that, more dollar will be required to import merchandise goods from the America.

The country’s balance of payment will face a deficit leading to depreciation in the external value of that currency versus foreign currencies if the demand for the foreign exchange is greater than its supply.

Again, let’s suppose that the initial rate of exchange between the Nepal and the America is \$1 equals to 72 Nepalese Rupees. If balance of payment is seemed deficit, means demand of dollar is greater in Nepal then its supply. As a result, exchange rate rises. Suppose that new exchange rate is \$1 equals to 73 Rupees. At this exchange rate, Nepalese exports to America will be cheaper and American imports to Nepal will be dearer.

(Mr. Mukunda Tripathee is a Banker.)

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