Chapter 1:What is Exchange Rate?The price of a nations currency in terms of another currency. An exchange rate thus has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. In an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency. An exchange rate that does not have the domestic currency as one of the two currency components is known as a cross currency, or cross rate.Also known as a currency quotation, the foreign exchange rate or forex rate.An exchange rate has a base currency and a counter currency. In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency.Most exchange rates use the US dollar as the base currency and other currencies as the counter currency. However, there are a few exceptions to this rule, such as the euro and Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar.Exchange rates for most major currencies are generally expressed to four places after the decimal, except for currency quotations involving the Japanese yen, which are quoted to two places after the decimal.Lets consider some examples of exchange rates to enhance understanding of these concepts.US$1 = C$1.1050. Here the base currency is the US dollar and the counter currency is the Canadian dollar. In Canada, this exchange rate would comprise a direct quotation of the Canadian dollar. This is easy to understand intuitively, since prices of goods and services in Canada are expressed in Canadian dollars; therefore the price of a US dollar in Canadian dollars is an example of a direct quotation for a Canadian resident.C$1 = US$ 0.9050 = 90.50 US cents. Here, since the base currency is the Canadian dollar and the counter currency is the US dollar, this would be an indirect quotation of the Canadian dollar in Canada.If US$1 = JPY 105, and US$1 = C$1.1050, it follows that C$1.1050 = JPY 105, or C$1 = JPY 95.02. For an investor based in Europe, the Canadian dollar to yen exchange rate constitutes a cross currency rate, since neither currency is the domestic currency. Exchange rates can be floating or fixed. While floating exchange rates in which currency rates are determined by market force are the norm for most major nations, some nations prefer to fix or peg their domestic currencies to a widely accepted currency like the US dollar.Exchange rates can also be categorized as the spot rate which is the current rate or a forward rate, which is the spot rate adjusted for interest rate differentials.How are international exchange rates set?

International currency exchange rates display how much one unit of a currency can be exchanged for another currency. Currency exchange rates can be floating, in which case they change continually based on a multitude of factors, or they can be pegged (or fixed) to another currency, in which case they still float, but they move in tandem with the currency to which they are pegged.Knowing the value of your home currency in relation to different foreign currencies helps investors to analyze investments priced in foreign dollars. For example, for a U.S. investor, knowing the dollar to euro exchange rate is valuable when selecting European investments. A declining U.S. dollar could increase the value of foreign investments, just as an increasing U.S. dollar value could hurt the value of your foreign investments.Factors That Influence Exchange RatesFloating rates are determined by the market forces of supply and demand. How much demand there is in relation to supply of a currency will determine that currency's value in relation to another currency. For example, if the demand for U.S. dollars by Europeans increases, the supply-demand relationship will cause an increase in price of the U.S. dollar in relation to the euro. There are countless geopolitical and economic announcements that affect the exchange rates between two countries, but a few of the most popular include: interest rate decisions, unemployment rates, inflation reports, gross domestic product numbers and manufacturing information.Some countries may decide to use a pegged exchange rate that is set and maintained artificially by the government. This rate will not fluctuate intraday, and may be reset on particular dates known as revaluation dates. Governments of emerging market countries often do this to create stability in the value of their currencies. In order to keep the pegged foreign exchange rate stable, the government of the country must hold large reserves of the currency to which its currency is pegged in order to control changes in supply and demand.How To Calculate An Exchange Rate?

Anexchange rateis how much it costs to exchange one currency for another. Exchange rates fluctuate constantly throughout the week as currencies are actively traded. This pushes the price up and down, similar to other assets such as gold or stocks. The market price of a currency--how many U.S. dollars it takes to buy a Canadian dollar for example--is different than the rate you will receive from your bank when you exchange currency. Here's how exchange rates work, and how to figure out if you are getting a good deal. (For the more advanced investor, you might want to check out Investopedia's article,"Currency Exchange: Floating Rate vs. Fixed Rate"or "What economic indicators are most used when forecasting an exchange rate?")Finding Market Exchange RatesTraders and institutions buy and sell currencies 24 hours a day during the week. For a trade to occur, one currency must be exchanged for another. To buy British Pounds (GBP), another currency must be used to buy it. Whatever currency is used will create a currency pair. If U.S. dollars (USD) are used to buy GBP, the exchange rate is for the GBP/USD pair. Live rates for several major currency are available on the InvestopediaForexpage.Reading an Exchange RateIf the USD/CAD exchange rate is 1.0950, that means it costs 1.0950 Canadian dollars for 1 U.S. dollar. The first currency listed (USD) always stands for one unit of that currency; the exchange rate shows how much fo the second currency (CAD) is needed to purchase that one unit of the first (USD).This rate tells you how much it costs to buy one U.S. dollar using Canadian dollars. To find out how much it costs to buy one Canadian dollar using U.S. dollars use the following formula: 1/exchange rate.In this case, 1 / 1.0950 = 0.9132. It costs 0.9132 U.S. dollars to buy one Canadian dollar. This price would be reflected by the CAD/USD pair; notice the position of the currencies has switched.Yahoo! Financeprovides live market rates for all currency pairs. If looking for a very obscure currency, click the "Add Currency" button and type in the two currencies being used to get an exchange rate. Find charts, with live market rates, for most currency pairs onFreeStockCharts.com.Conversion SpreadsWhen you go to the bank to covert currencies, you most likely won't get the market price that traders get. The bank or currency exchange house will markup the price so they make a profit, as will credit cards and payment services providers such as PayPal when a currency conversion occurs.If the USD/CAD price is 1.0950, the market is saying it costs 1.0950 Canadian dollars to buy 1 U.S. dollar. At the bank though, it may cost 1.12 Canadian dollars. The difference between the market exchange rate and the exchange rate they charge is their profit. To calculate the percentage discrepancy, take the difference between the two exchange rates, and divide it by the market exchange rate: 1.12 - 1.0950 = 0.025/1.0950 = 0.023. Multiply by 100 to get the percentage markup: 0.023 x 100 = 2.23%.A markup will also be present if converting U.S. dollars to Canadian dollars. If the CAD/USD exchange rate is 0.9132 (see section above), then the bank may charge 0.9382. They are charging you more U.S. dollars than the market rate. 0.9382 - 0.9132 = 0.025/0.9132 = 0.027 x 100 = 2.7% markup.Banks and currency exchanges compensate themselves for this service. The bank gives you cash, whereas traders in the market do not deal in cash. In order to get cash, wire fees and processing or withdrawal fees would be applied to a forex account in case the investor needs the money physically. For most people looking for currency conversion, getting cash instantly and without fees, but paying a markup, is a worthwhile compromise.Shop around for an exchange rate that is closer to the market exchange rate; it can save you money. Some banks have have ATM network alliances worldwide, offering customers a more favorable exchange rate when they withdraw funds from allied banks.Calculate Your RequirementsNeed a foreign currency? Use exchange rates to determine how much foreign currency you want, and how much of your local currency you'll need to buy it.If heading to Europe you'll need euros (EUR), and will need to check the EUR/USD exchange rate at your bank. The market rate may be 1.3330, but an exchange might charge you 1.35 or more.Assume you have $1000 USD to buy Euros with. Divide $1000 by 1.3330 to get 740.74 euros. That is how many Euros you get for your $1000. Since Euros are more expensive, we know we have to divide, so that we end up with fewer units of EUR than units of USD.Now assume you want 1500 euros, and want to know what it costs in USD. Multiply 1500 by 1.35 to get 2025 USD. Since we know Euros are more expensive, one euro will more than one US dollar, that is why we multiply in this case.The Bottom LineExchange rates always apply to the cost of one currency relative to another. The order in which the pair are listed (USD/CAD versus CAD/USD) matters. Remember the first currency is always equal to one unit and the second currency is how much of that second currency it takes to buy one unit of the first currency. From there you can calculate your conversion requirements. Banks will markup the price of currencies to compensate themselves for the service. Shopping around may save you some money as some companies will have a smaller markup, relative to the market exchange rate, than others.

Main Types of Foreign Exchange Rates

Some of the major types of foreign exchange rates are as follows: 1. Fixed Exchange Rate System 2. Flexible Exchange Rate System 3. Managed Floating Rate System.1. Fixed Exchange Rate System (or Pegged Exchange Rate System).2. Flexible Exchange Rate System (or Floating Exchange Rate System).3. Managed Floating Rate System.

1. Fixed Exchange Rate System:

Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by the government.1. The basic purpose of adopting this system is to ensure stability in foreign trade and capital movements.2. To achieve stability, government undertakes to buy foreign currency when the exchange rate becomes weaker and sell foreign currency when the rate of exchange gets stronger.3. For this, government has to maintain large reserves of foreign currencies to maintain the exchange rate at the level fixed by it.4. Under this system, each country keeps value of its currency fixed in terms of some External Standard.5. This external standard can be gold, silver, other precious metal, another countrys currency or even some internationally agreed unit of account.6. When value of domestic currency is tied to the value of another currency, it is known as Pegging.7. When value of a currency is fixed in terms of some other currency or in terms of gold, it is known as Parity value of currency.Advantages of Fixed Exchange RatesThe main arguments advanced in favor of the system of fixed or stable exchange rates are as follows:1. Promotes International Trade:Fixed or stable exchange rates ensure certainty about the foreign payments and inspire confidence among the importers and exporters. This helps to promote international trade.2. Necessary for Small Nations:Fixed exchange rates are even more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously affect the process of economic growth in these economies.3. Promotes International Investment:Fixed exchange rates promote international investments. If the exchange rates are fluctuating, the lenders and investors will not be prepared to lend for long-term investments.4. Removes Speculation:Fixed exchange rates eliminate the speculative activities in the international transactions. There is no possibility of panic flight of capital from one country to another in the system of fixed exchange rates.5. Necessary for Small Nations:Fixed exchange rates arc even more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously disturb the process of economic growth of these economies.6. Necessary for Developing Countries:Fixed exchanges rates are necessary and desirable for the developing countries for carrying out planned development efforts. Fluctuating rates disturb the smooth process of economic development and restrict the inflow of foreign capital.7. Suitable for Currency Area:A fixed or stable exchange rate system is most suitable to a world of currency areas, such as the sterling area. If the exchange rates of the countries in the common currency area are flexible, the fluctuations in the leading country, like England (whose currency dominates), will also disturb the exchange rates of the whole area.8. Economic Stabilization:Fixed foreign exchange rate ensures internal economic stabilization and checks unwarranted changes in the prices within the economy. In a system of flexible exchange rates, the liquidity preference is high because the businessmen will like to enjoy wind fall gains from the fluctuating exchange rates. This tends to Increase price and hoarding activities in country.9. Not Permanently Fixed:Under the fixed exchange rate system, the exchange rate does not remain fixed or is permanently frozen. Rather the rate is changed at the appropriate time to correct the fundamental disequilibrium in the balance of payments.10.Other Arguments:Besides, the fixed exchange rate system is also beneficial on account of the following reasons.(i) It ensures orderly growth of world's money and capital markets and regularises the international capital movements.(ii) It ensures smooth functioning of the international monetary system. That is why, IMF has adopted pegged or fixed exchange rate system.(iii) It encourages multilateral trade through regional cooperation of different countries.(iv) In modern times when economic transactions and relations among nations have become too vast and complex, it is more useful to follow a fixed exchange rate system.Disadvantages of Fixed Exchange RatesThe system of fixed exchange rates has been criticized on the following grounds:1. Outmoded System:Fixed exchange rate system worked successfully under the favorable conditions of gold standard during 19th century when(a) The countries permitted the balance of payments to influence the domestic economic policy;(b) There was coordination of monetary policies of the trading countries;(c) The central banks primarily aimed at maintaining the external value of the currency in their respective countries; and(d) The prices were more flexible. Since all these conditions are absent today, the smooth functioning of the fixed exchange rate system is not possible.2. Discourage Foreign Investment:Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system discourages long-term foreign investment which is considered available under the really fixed exchange rate system.3. Monetary Dependence:Under the fixed exchange rate system, a country is deprived of its monetary independence. It requires a country to pursue a policy of monetary expansion or contraction in order to maintain stability in its rate of exchange.4. Cost-Price Relationship not Reflected:The fixed exchange rate system does not reflect the true cost-price relationship between the currencies of the countries. No two countries follow the same economic policies. Therefore the cost-price relationship between them go on changing. If the exchange rate is to reflect the changing cost-price relationship between the countries, it must be flexible.5. Not a Genuinely Fixed System:The system of fixed exchange rates provides neither the expectation of permanently stable rates as found in the gold standard system, nor the continuous and sensitive adjustment of a freely fluctuating exchange rate.6. Difficulties of IMF System:The system of fixed or pegged exchange rates, as followed by the International Monetary Fund (IMF), is in reality a system of managed flexibility.It involves certain difficulties, such as deciding as to(a) when to change the external value of the currency,(b) what should be acceptable criteria for devaluation; and(c) how much devaluation is needed to reestablish equilibrium in the balance of payments of the devaluing country.Devaluation and Revaluation:Devaluation refers to reduction in the value of domestic currency by the government. On the other hand, Revaluation refers to increase in the value of domestic currency by the government.DevaluationVs. Depreciation:BasisDevaluationDepreciation

Meaning:Devaluation refers to reduction in price of domestic currency in terms of all foreign currencies under fixed exchange rate regime.Depreciation refers to fall in market price of domestic currency in terms of a foreign currency under flexible exchange rate regime.

Occurrence:It takes place due to Government.It takes place due to market forces of demand and supply.

Exchange Rate System:It takes place under fixed exchange rate system.It takes place under flexible exchange rate system.

2. Flexible Exchange Rate System:

Flexible exchange rate system refers to a system in which exchange rate is determined by forces of demand and supply of different currencies in the foreign exchange market.1. The value of currency is allowed to fluctuate freely according to changes in demand and supply of foreign exchange.2. There is no official (Government) intervention in the foreign exchange market.3. Flexible exchange rate is also known as Floating Exchange Rate.4. The exchange rate is determined by the market, i.e. through interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of making transactions in foreign exchange.Advantage of Flexible Exchange RatesFlexible exchange rate system is claimed to have the following advantages:1. Independent Monetary Policy:Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of a country is not limited or affected by the economic conditions of other countries.2. Shock Absorber:A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad.3. Promotes Economic Development:The flexible exchange rate system promotes economic development and helps to achieve full employment in the country. The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national objectives.4. Solutions to Balance of Payment Problems:The system of flexible exchange rates automatically removes the disequilibrium in the balance of payments. When, there is deficit in the balance of payments, the external value of a country's currency falls. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment.5. Promotes International Trade:The system of flexible exchange rates does not permit exchange control and promotes free trade. Restrictions on international trade are removed and there is free movement of capital and money between countries.6. Increase in International Liquidity:The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically solved. In fact, the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit.7. Market Forces at Work:Under the flexible exchange rate system, the foreign exchange rates are determined by the market forces of demand and supply. Market is cleared off automatically through changes in exchange rates and the possibility of scarcity or surplus of any currency does not exist.8. International Trade not Promoted by Fixed Rates:The argument that fixed exchange rates promotes international trade is not supported by historical facts of inter-war or post-war period. On the other hand under the flexible exchange rate system, the trend of the rate of exchange is generally assessed through the forward market, and the traders are protected from financial losses arising from fluctuating exchange rates. This helps in promoting international trade.9. International Investment not Promoted by Fixed Rates:The argument that long-term international investments are encouraged under fixed exchange rate system is not valid. Both the lenders and borrowers cannot expect the exchange rate to remain stable over a very long-period.10. Fixed Rates not Necessary for currency Area:This stable exchange rates are not necessary for any system of currency areas. The sterling block functioned smoothly during the thirties in spite of the fluctuating rates of the member countries.11. Speculation not Prevented by Fixed Rates:The main weakness of the stable exchange rate system is that in spite of the strict exchange control, currency speculation is encouraged. This destroys the stability in the exchange value of the home currency and makes devaluation of the currency inevitable. For instance, the pound had to be devalued in 1949 mainly because of such speculation.Disadvantage of Flexible Exchange RatesThe following are the main drawbacks of the system of flexible exchange rates :1. Low Elasticities:The elasticities in the international markets are too low for exchange rate, variations to operate successfully in bringing about automatic equilibrating adjustments. When import and export elasticities are very low, the exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further.2. Unstable conditions:Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long-term foreign investments arc greatly reduced because of higher risks involved.3. Adverse Effect on Economic Structure:The system of flexible exchange rates has serious repercussion on the economic structure of the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the economy of the country.4. UnnecessaryCapital Movements:The system of fluctuating exchange rates leads to unnecessary international capital movements. By encouraging speculative activities, such a system causes large-scale capital outflows and inflows, thus, seriously disturbing the economy of the country.5. DepressionEffects of Capital Movements:Speculative capital movements caused by fluctuating exchange rates may lead to the problem of extremely high liquidity preference. In a situation of high liquidity preference, people tend to hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the economy.6. Inflationary Effect:Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external value of the currency.7. Factor Immobility:The immobility of various factors of production deprives the flexible exchange rate system of its advantages arising from the adoption of monetary and other policies for maintaining internal stability. Such policies produce desirable effects on production and employment only when supply of factors of production is elastic.8. Failure of Flexible Rate System:Experience of the flexible exchange rate system adopted between the two world wars has shown that it was a flop.Fixed Exchange Rate System Vs Flexible Exchange Rate System:BasisFixed Exchange RateFlexible Exchange Rate

Determination of Exchange Rate:It is officially fixed in terms of gold or any other currency by government.It is determined by forces of demand and supply of foreign exchange.

Government Control:There is complete government control as only government has the power to change it.There is no government intervention and it fluctuates freely according to market conditions.

Stability in Exchange Rate:The exchange rate generally remains stable and only a small variation is possibleThe exchange rate keeps on changing

3. Managed Floating Rate System:

Traditionally, International monetary economists focused their attention on the framework of either Fixed or a Flexible exchange rate system. With the end of Bretton Woodss system, many countries have adopted the method of Managed Floating Exchange Rates.It refers to a system in which foreign exchange rate is determined by market forces and central bank influences the exchange rate through intervention in the foreign exchange market.1. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.2. In this system, central bank intervenes in the foreign exchange market to restrict the fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close to desired target values.3. For this, central bank maintains reserves of foreign exchange to ensure that the exchange rate stays within the targeted value.4. It is also known as Dirty Floating.4.SEMI-FIXED EXCHANGE RATES Exchange rate is given a specific target Currency can move between permitted bands of fluctuation Exchange rate is dominant target of economic policy-making (interest rates are set to meet the target) Bank of England may have to intervene to maintain the value of the currency within the set targets Re-valuations possible but seen as last resort October 1990 - September 1992 during period of ERM membership5.FULLY-FIXED EXCHANGE RATES Commitment to a single fixed exchange rate No permitted fluctuations from the central rate Achieves exchange rate stability but perhaps at the expense of domestic economic stability Bretton-Woods System 1944-1972 where currencies were tied to the US dollar Gold Standard in the inter-war years - currencies linked with gold Countries joining EMU in 1999 have fixed their exchange rates until the year 2002What is the difference between a fixed and a floating exchange rate? A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly. A fixed exchange rate regime reduces the transaction costs implied by exchange rate uncertainty, which might discourage international trade and investment, and provides a credible anchor for low-inflationary monetary policy. On the other hand, autonomous monetary policy is lost in this regime, since the central bank must keep intervening in the foreign exchange market to maintain the exchange rate at the officially set level. Autonomous monetary policy is thus a big advantage of a floating exchange rate. If the domestic economy slips into recession, it is autonomous monetary policy that enables the central bank to boost demand, thus 'smoothing" the business cycle, i.e. reducing the impact of economic shocks on domestic output and employment. Both types of exchange rate regime have their pros and cons, and the choice of the right regime may differ for different countries depending on their particular conditions. In practice there is a range of exchange rate regimes lying between these two extreme variants, thus providing a certain compromise between stability and flexibility. The exchange rate in the Czech Republic was pegged to a basket of currencies until early 1996, then the peg was effectively eliminated through a substantial widening of the fluctuation band, and now the Czech economy operates in the so-called managed floating regime, i.e. the exchange rate is floating, but the central bank may turn to interventions should there be any extreme fluctuations.

Conclusion The paper has presented an overview of different exchange rate regimes. Recent research has disputed the conventional wisdom of clear demarcation between fixed and floating exchange rate regimes. Taking into account historical perspectives, the paper examines different arguments for and against choosing one or the other regime. It discusses the Mundell-Fleming Model as well as the concepts of Optimal Currency Area and nominal anchor. While the former introduced trilemma in which a country has an option of choosing only two of the three possible outcomes (open capital markets, monetary independence or pegged exchange rate), the latter aims to maximise economic efficiency by sharing a single currency in the entire region. It also differentiates between the developed and emerging economies and analyses why the latter should be careful in blindly following a course successfully pursued by a developed country. The paper classifies and discusses de jure and de facto exchange rate regimes and reviews literature to provide empirical evidence on their economic performance. We conclude on the basis of our review that there is no uniform algorithm for classifying different regimes in distinct categories. As a whole, hard pegs are associated with low inflation though floating may not always lead to higher inflation. We go on to identify factors that determine which exchange rate regime is the best, depending on the unique characteristics of each country. A country with a long history of monetary instability will be better served by hard peg. As for the emerging economies, the case for making intermediate arrangements before switching to floating exchange rate seems strong. The last section of the paper analyses the case of pegging UAE Dirham with US dollar that has proved a liability due to its recent depreciation. There is a public policy debate on the pros and cons of continuing with the existing fixed exchange regime, with arguments from both sides of the political-economic divide. Those in favour argue on the basis of three factors: small economy, openness and nominal domestic shocks resulting from large monetary expansion. While those who oppose this stance mention four factors: large external imbalance, capital mobility, external nominal shocks, and real 3/30/2010 24 domestic and external shocks. Adding to this is the dimension of what is the objective of policy makers: correcting external balance or low inflation. The analysis that follows in this section takes into accounts the current status of UAE economy, its existing strengths and weaknesses, the countrys role and influence in the international economic arena as well as its future economic plans and prospects. On the basis of discussion, we conclude that UAE should persist with its current fixed exchange rate decision.

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