In the past posts in the series on international trade we covered important topics like balance of payment and in the last post we saw the basics of currency exchange rate like base and price currencies, direct and indirect quotes and spot and forward rates. Today lets move our discussion forward to more advanced concepts like the nominal and real exchange rates and forward premium and discount.
Nominal and real currency exchange rates
Nominal currency exchange rates tell us how much of one currency can be bought against another currency. Nominal exchange rate has nothing to do with the purchasing power of the currency. It is just the market determined exchange rate based on the demand and supply of currencies in a free floating exchange rate regime. If the demand for a currency increases it appreciates in value and the exchange rate decreases. Conversely, if the demand for a currency falls it depreciates in value and the exchange rate increases. For example, if the current USD – INR rate is 68 INR/USD and if the Rupee appreciates in value against the Dollar then the exchange rate would be 67 INR/USD. That means now more Dollars can be purchased with less Rupees. Conversely if the Rupee depreciates in value to 69 INR/USD, more Rupees would be required to purchase a Dollar.
In a country where the exchange rates with foreign currencies are fixed, appreciation in domestic currency is called revaluation and depreciation is called devaluation.
Real currency exchange rates on the other hand are the nominal exchange rates adjusted for purchasing power. Real exchange rate is the nominal exchange rate between two countries multiplied by the price indices of goods and services in the two countries as given by the indices of inflation. It tells us how much of each currency is required to buy the same amount of goods and services in the two countries. For example if the rupee-dollar real exchange rate is 50 INR / USD, it means that 1$ can buy exactly the same quantity of goods and services in India as Rs.50 can buy in the US.
Real currency exchange rates can be higher or lower than the nominal currency exchange rates. For example, if the price level in the U.S. is higher than that in India then the rupee – dollar real exchange rate will be higher than the nominal exchange rate. Let’s say if the nominal exchange rate is 68 INR/USD, then 1 USD can buy more goods in India than Rs. 68 can buy in the US. You would require more Rupees to buy the same quantity of goods in the US, let’s say Rs.75. Therefore the real exchange rate becomes 75 INR/USD.
Forward discount and Forward premium
Forward currency exchange rate is said to be at a premium to the spot exchange rate when the forward rate is higher than the spot rate for a currency. Conversely it is said to be at a discount when then forward exchange rate is lower than the spot rate. For example, if the 30 day INR/USD is 69 INR/USD and the spot rate is 68 INR/USD, then the dollar is expected to appreciate going forward. So the Dollar is at a forward premium and the INR is at a forward discount.
Premiums and discounts are based on the market expectations. If the market expects the Dollar to appreciate in value in 30 days the 30 day forward rate for the Dollar will be at a premium.
The forward premium or discount is calculated as,
Forward / spot – 1
A negative forward premium is a discount.
Current forward exchange rates are always expected to be equal to future spot rates. The difference between the forward rate and spot rate is approximately equal to the difference between the interest rates in the two countries. If they are not, there is opportunity for arbitrage profit.
Arbitrage can be earned as follows;
If the interest rates in country B are higher than the interest rates in country A the currency of country B will appreciate in the spot market as more and more people will sell currency A and buy currency B to invest in country B at higher interest rates. Going forward when the investments mature, people will sell currency B and convert back to currency A. Therefore the currency B will be a forward discount and currency A will be at a forward premium. If the difference between the spot exchange rate and the forward exchange rate for currency A and B is equal to the difference in the interest rates in the two countries then there is it is a zero sum gain. If not there is a riskless profit.
A trader can therefore borrow in country A and convert currency A into currency B, invest currency B at the interest rates prevailing in country B and convert it back to currency A at maturity and earn a riskless profit by earning more than the cost of borrowing currency A.
The no- arbitrage relationship is referred to as interest rate parity and is given as ,
Forward / spot = (1+ interest rate domestic) / (1 + interest rate foreign)
In reality there is always an arbitrage opportunity available or else no one would trade in the foreign exchange market.
Currency exchange rates regimes
Currency exchange rates regimes for countries can be broadly classified into two categories, for countries that do not issue their own currency and countries that issue their own currency.
Countries that do not issue their own currency
A country can use the currency of another country. In such a case the country cannot have its own monetary policy as it does not issue the currency.
A country can be part of a monetary union where many countries use a common currency. For example, the European Union and the Euro. The individual countries in the European Union cannot formulate their own monetary policy however they can all participate in deciding the monetary policy of the ECB.
Countries that issue their own currency
Currency board arrangement
Under this regime the currency exchange rate between two currencies is fixed at a specific rate. For example Hong Kong issues Hong Kong Dollars only against fully backed holdings in US Dollars.
A country pegs its currency allowing ±1% margin to another currency or a basket of currencies of its major trading partners. The margin affords the central banks more flexibility than the formal dollarization regime in managing the monetary policy. You can read all about monetary policy here;
The monetary authorities can use indirect intervention like changes in interest rate policy to manage this currency arrangement.
In a passive crawling peg the currency exchange rate is periodically adjusted for factors like inflation. In an active crawling peg the adjustments are more frequent.
Crawling exchange rate bands
The permissible band within which the currency exchange rates can move is increased over time. This regime can be used as a transition regime to move from fixed peg to floating rate regime.
Managed floating exchange rates
In such a regime the currency exchange rates are allowed to float but are managed with direct or indirect intervention by the monetary authorities who try to influence the exchange rates in response to specific indicators like balance of payments, inflation rates. The exchange rate does not have a specific target or path under this regime.
Freely floating exchange rates
The currency exchange rates under this regime are purely market determined and intervention by the authorities are only to slow down the rate of change to avoid fluctuations in the foreign exchange market.
That’s all for today….thanks for reading and don’t forget to share………in the next post we will cover the effects of exchange rates on international trade among many other things…don’t miss it…
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