Exchange Rates and Spot Rates in Foreign Exchange

Exchange Rate Definitions

• An exchange rate is the rate at which one country's currency can be traded for another country's currency.
• The spot rate is the exchange or interest rate currently offered on a particular currency or security for immediate delivery.
• The forward rate is an exchange rate set now for currencies to be exchanged at a future date.

Exchange Rate Determination Theories

Purchasing Power Parity (PPP)

• PPP states that the exchange rate between two currencies is the same in equilibrium when the purchasing power of currency is the same in each country.
• PPP uses inflation rates to predict future movements in exchange rates.
• PPP emphasizes that indistinguishable goods should sell at the same price when converted into the same currency.
• As local currency prices change with inflation, the exchange rates should change to keep the relative price the same.

Interest Rate Parity

• The current exchange rate (spot rate) and the forward rate may differ, and the difference reflects the interest rate.
• Forward rate can be calculated using the formula: Forward Rate = Spot Rate x (1 + Interest Rate).

Balance of Payments Approach

• The balance of payments approach argues that the equilibrium exchange rate is found when currency flows match up vis-à-vis current and financial account activities.
• This framework has wide appeal as BOP transaction data is readily available and widely reported.

Monetary Approach

• The monetary approach states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks.

Asset Market Approach

• The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets.
• Shifts in the supply and demand for financial assets alter exchange rates.
• Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.

Currency Market Intervention

Why Intervene?

• To fight inflation (strong currency)
• To fight slow economic growth (weak currency)

Currency Market Intervention Methods

Direct Intervention

• The active buying and selling of the domestic currency against foreign currencies.
• If the goal is to increase the value, then the central bank buys its own currency.
• If the goal is to decrease the value, then the central bank sells its own currency.

Coordinated Intervention

• Several central banks agree on a strategy to increase or decrease a currency value.

Indirect Intervention

• The alteration of economic or financial fundamentals thought to be drivers of capital to flow in and out of specific currencies.
• Increase real rates to strengthen a currency.
• Decrease real rates to weaken a currency.

Capital Controls

• Restrictions of access to foreign currency by the government by limiting the exchange of domestic currency for foreign currency.