INTERNATIONAL FINANCE

ASSIGNMENT NO: 2 Topic: Factors Affecting Exchange Rate

Submitted by, Deepthi R. MBA (IB) Semester 3 Roll no: 20

INTRODUCTION: Every country has its own currency that has its own individual value. Whether you are an active trader in the foreign exchange market, planning your vacation abroad or shopping an exotic product online, understanding of exchange rate is essential. The value of currency across the world differs as the Kuwaiti dinar varies from the US dollar. The fact that a countrys financial healthiness is judged by its exchange rate, makes evident its significance. Other than factors like interest rate and inflation, exchange rate is deemed to play a pivotal role in the countrys trade activities with it being one of the most valued factors. The exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. A country with a stronger currency will lose as its exports will be more expensive and imports will be cheaper in the foreign market. On the contrary, a country with a weaker currency will benefit from as imports will be expensive and exports cheaper. A higher exchange rate is expected to lower the countrys balance of trade, while a lower exchange rate would increase it. The foreign exchange market ascertains this rate based on varied crucial factors. Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Exchange rates are relative, and are expressed as a comparison of the currencies of two countries. EXCHANGE RATE: Based on the value of a currency viz. others, a countrys purchasing potential is decided, followed by an understanding of the variance between the demand and supply. In simple words, the exchange rate is the rate at which one countrys currency may be converted into another. A country with a stronger currency will lose as its exports will be more expensive and imports will be cheaper in the foreign market. On the contrary, a

country with a weaker currency will benefit from as imports will be expensive and exports cheaper. The FX market ascertains this rate based on varied crucial factors including interest rates, inflation, rate of trade, etc. Exchange rates are determined by supply and demand. A country's exchange rate is typically affected by the supply and demand for that country's currency in international exchange markets. It is known as a floating exchange rate since it floats according to supply and demand. For example, if there was greater demand for American goods then there would tend to be an appreciation (increase in value) of the dollar. If markets were worried about the future of the US economy, they would tend to sell dollars, leading to a fall in the value of the dollar. Note:

Appreciation = increase in value of exchange rate Depreciation / devaluation = decrease in value of exchange rate.

FACTORS INFLUENCING EXCHANGE RATE Like any price, the exchange rate deviates from the cost basis - the purchasing power of currencies under the influence of supply and demand of currency. The ratio of the supply and demand depends on several factors. It reflects connections with other economic categories - cost, price, money, interest, balance of payments, etc. There is a complex of interweaving and nomination of decisive factors. Among them are the following.
1.THE RATE OF INFLATION:

The ratio of currency in their purchasing power (purchasing power parity) serves as a kind of axis of the exchange rate reflecting the law of value. That's why the rate of inflation has an impact on the exchange rate. All other things being equal, the inflation rate in the country has inversely proportional impact on the value of national currency, i.e. an increase in inflation in the country leads to a reduction in the national currency, and vice versa. Inflationary depreciation of money in the country reduces the purchasing power and a tendency to a drop in their currency's exchange rate against currencies of countries where the rate of inflation is lower. Alignment of the exchange rate

and adjustment to purchasing power parity are occurred within two years. This is because the daily quotation of exchange rates is not corrected on the basis of their purchasing power, and there are other factors of forming of exchange rates.
2.BALANCE OF PAYMENTS

Balance of payments directly affects the value of the exchange rate. Thus, the active balance of payments improves the national currency as the demand from foreign debtors increases. The passive balance of payments leads to a tendency to a decrease in the national currency's exchange rate as domestic debtors try to sell everything using a foreign currency to repay their external obligations. The size of the impact of balance of payments on the exchange rate is determined by the degree of openness of the economy. Thus, the higher the share of exports in gross national product (the higher the openness of the economy), the higher the elasticity of the exchange rate. In addition, the exchange rate affects economic policy of the state in components of the balance of payments: current account and capital account. For example, the effect of changes in tariffs, import restrictions, trade quotas, export subsidies has an impact on the trade balance. When the positive balance of trade is on the advance there is an increase in the demand for the currency of the country that raises its rate, and in case of negative balance the reverse process occurs. Movement of short-term and longterm capital depends on the level of domestic interest rates, restrictions or encourage of import and export of capital. Changes in the balance of capital have an impact on the currency, which is similar to the trade balance by its mark (plus or minus). However, there is a negative influence of excessive short-term capital inflows into the country on the rate of its currency because it can increase the excess money supply, which, in turn, may lead to higher prices and the depreciation of the currency.
3.INTEREST RATES

The influence of this factor on the exchange rate is explained by two main factors. First, changes in interest rates in a country affect, all else being equal, international capital flows, especially short-term ones. In principle, an increase in the interest rate stimulates the inflow of foreign capital and its cutting promotes the reduction of outflow of capital, including national. That is why in a country with higher interest rates capital comes into, the demand for its currency increases, and it becomes expensive. The movement of capital, especially speculative "hot" money, increases instability of the balance of

payments. Secondly, interest rates affect the operation of foreign exchange markets and money markets. When executing transactions, banks take into account the difference in interest rates on national and global capital markets with a view of deriving of profit. They prefer to get cheaper loans in foreign money markets, where rates are lower, and place foreign currency on the domestic credit market, if its interest rates are higher. On the other hand, the nominal increase in interest rates in the country reduces the demand for domestic currency as receipt of credits becomes expensive for business. In case of taking out a loan, an entrepreneur increases the cost of their product that, in turn, leads to higher prices for goods inside the country. This relatively devalues the national currency against a foreign one.
4. MONETARY POLICY

The ratio of market and state regulation of the exchange rate affects its dynamics. The formation of the exchange rate on foreign exchange markets through the mechanism of demand and supply of currency is usually accompanied by sharp fluctuations in exchange relations. Real exchange rate forms in the market which is an indicator of the economy, money, finance, credit and confidence in a certain currency. State regulation of the exchange rate is aimed at its raising or lowering on the basis of the purposes of monetary and economic policy.
5. SENTIMENT:

The way, market perceives our economy as an investment destination, is essential. If it confides in our policies and believes that we are on the right track, paving way for an unprecedented growth, it will express its interest by investing with the expectation of receiving lucrative returns. Hence, sentiment of the market tends to be a major determinant of a countrys exchange rate. ie, Investor confidence impacts currency exchange rates. If investors are confident that a country's economy will be strong, they will be more likely to buy that country's assets, pushing up the value of that country's currency. If investors are not confident that a country's economy will be strong, they will be less likely to buy that country's assets, pushing down the value of that country's currency.
6. EMPLOYMENT OUTLOOK

Employment levels have an immediate impact on economic growth. As unemployment increases, consumer spending falls because jobless workers have

less money to spend on non-essentials. Those still employed worry for the future and also tend to reduce spending and save more of their income. An increase in unemployment signals a slowdown in the economy and possible devaluation of a country's currency because of declining confidence and lower demand. If demand continues to decline, the currency supply builds and further exchange rate depreciation is likely. One of the most anticipated employment reports is the U.S. Non-Farm Payroll (NFP), a reliable indicator of U.S. employment issued the first Friday of every month.
7. ECONOMIC GROWTH EXPECTATIONS

To meet the needs of a growing population, an economy must expand. However, if growth occurs too rapidly, price increases will outpace wage advances so that even if workers earn more on average, their actual buying power decreases. Most countries target economic growth at a rate of about 2% per year. With higher growth comes higher inflation, and in this situation central banks typically raise interest rates to increase the cost of borrowing in an attempt to slow spending within the economy. A change in interest rates may signal a change in currency rates. Deflation is the opposite of inflation; it occurs during times of recession and is a sign of economic stagnation. Central banks often lower interest rates to boost consumer spending in hopes of reversing this trend.
8.CENTRAL BANK ACTIONS

With interest rates in several major economies already very low (and set to stay that way for the time being), central bank and government officials are now resorting to other, less commonly used measures to directly intervene in the market and influence economic growth. For example, quantitative easing is being used to increase the money supply within an economy. It involves the purchase of government bonds and other assets from financial institutions to provide the banking system with additional liquidity. Quantitative easing is considered a last resort when the more typical response lowering interest rates fail to boost the economy. It comes with some risk; increasing the supply of a currency could result in a devaluation of the currency.

9.SPECULATION

Speculation by major market operators is another crucial factor that influences exchange rates. In the forex market, the proportion of transactions that are directly related to international trade activities is relatively low. Most of the transactions are actually speculative tradings which cause currency movement and influence exchange rates. When the market predicts that a certain currency will rise in value, it may spark a buying frenzy that pushes the currency up and fulfill the prediction. Conversely, if the market expects a drop in value of a certain currency, people will start selling it away and the currency will depreciate. For example, after World War II, the United States enjoyed a period of political stability, well-managed economy, low inflation rate and an average annual economic growth of about 5% in the early 1960s. At that time, all the other countries in the world were willing to use US Dollar as the mode of payment to safeguard their wealth. This causes a continuous rise in value of the US Dollar. However, from the end of 1960s to early 1970s, the Vietnam War, Watergate scandal, serious inflation, increased tax burden, trade deficit and declining economic growth caused the US Dollar to plunge in value.
10.CURRENT ACCOUNT DEFICITS

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
11.GOVERNMENT POLICIES AND MEASURES:

A country prone to political turmoil and continuous clashes will deter the investors confidence lowering the value of the currency. However, a country with sound financial and trade policies without giving room for uncertainties will witness a positive influence on the value of a currency directly and

indirectly, as it will influence every aspect of trade including tariffs, exports and imports, etc.
12.PUBLIC DEBT

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate. Whenever our Government fails to match expenses with equivalent revenue, there is a shortage of funds. To finance this, the Government at times opts to borrow money from institutions such as the World Bank and the IMF. This debt, accrued interests, and the payments made, also lead to currency fluctuations.
13.TERMS OF TRADE

A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favourably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

14.POLITICAL STABILITY AND ECONOMIC PERFORMANCE

Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.
15.RBI INTERVENTION

When there is too much volatility in the rupee-dollar rates, the RBI prevents the rates from going out of control to protect the domestic economy. The RBI does this by buying dollars when rupee appreciates too much and by selling dollars when the rupee depreciates significantly.
16.CHANGE IN COMPETITIVENESS

If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound. This is similar factor to low inflation.
17.RELATIVE STRENGTH OF OTHER CURRENCIES

In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets were worried about all the other major economies US and EU. Therefore, despite low interest rates and low growth in Japan, the Yen kept appreciating.

18.ACTIVITIES OF FOREIGN EXCHANGE MARKETS AND SPECULATIVE

TRANSACTIONS

If the rate of a currency tends to decline firms and banks sell it for a more stable currency and it worsens the position of weakened currency. Currency markets react quickly to changes in the economy and politics, fluctuations in exchange ratios. In doing so, they increase opportunities of currency speculations and spontaneous movement of "hot" money. 19.THE DEGREE OF CONFIDENCE IN THE NATIONAL AND WORLD
CURRENCY MARKETS

It depends on the economy and political situation in the country as well as the factors indicated above which affect the exchange rate. Dealers take into account not only the rate of economic growth, inflation, the purchasing power of currencies, the balance of demand and supply of currency, but the prospects of their dynamics. Sometimes, even the expectation of the publication of official data on the trade balance and the balance of payments or election results affects the ratio of supply and demand and currency rate. Sometimes, in the currency market there is a change of priorities in favor of political news, rumors of resignations of ministers, etc. 20.NATIONAL INCOME However, in general, the factors which lead to changes in the national income have a great impact on the exchange rate. Thus, an increase in the supply of products enhances the exchange rate, while increases in domestic demand reduce its rate. In the long run, a higher national income means higher value of the currency of the country. 21.MARKET FACTORS These factors can significantly change the value of currency at short intervals.Thus, the overall expectations for future economic growth, changes in fiscal and foreign trade deficits directly affect the exchange rate. In addition, the foreign exchange market participants' expectations have a significant impact on the value of the exchange rate. Seasonal peaks and downs of business activity in the country have a significant impact on the rate of national currency.

CONCLUSION Conversion of currencies is possible because of the existence of the exchange rate theory, enabling people to trade, and transfer funds between two countries. It also represents a countrys performance and its stance globally as an investment destination. Strong Exchange rate directly mirrors a countrys backdrop: balanced payments, less debts, increased number of trades and a good demand for its currency, which as a result encourages more investment from the FIIs, and strengthen its standing globally. This will hence instigate growth, development, and global competitiveness of a country, representing a cycle. Not only the global investors or the traders in the stock market, exchange rate influences everybody. Whether you are travelling abroad for a financial trip or vacationing with your family, exchange rate matters. It is necessary to understand exchange rate when buying the revered exported watch, online. A greater understanding of this term will enable you to save more as you will know when to go in for your desires. Businesses can also observe a huge impact on their balance sheet by taking the right decision with respect to imports and exports and also about foreign currency borrowings. An informed decision would enable competitive pricing which will help gain market share for exports and better pricing with respect to imports.

BIBLIOGRAPHY Kirt .C. Butler: Multinational Finance , Second Edition www.nber.org International Financial Management- P G Apte fxtrade.oanda.com/learn/top-factors-that-affect-exchange-rates