Some Other Important Concepts of Exchange Rates
In forex markets, we are mainly concerned with nominal exchange rates. However, for analysis purposes it is not sufficient to consider the nominal exchange rates alone.
There are other concepts of exchange rates which are being used through out the literature on exchange rate by economists. The most important concepts of exchange rates that economists use are:
1.Real Exchange Rate(RER)
2.Nominal Effective Exchange Rate(NEER)
3.Real Effective Exchange Rate(REER)
4.Equilibrium Real Exchange Rate (ERER)
5.Natural Real Effective Exchange Rate (NATREX)
Real Exchange Rate (RER)- This concept adjusts
nominal exchange rate for relative prices in the economies of the currencies involved. This exchange rate is given as:
Real Exchange Rate = S(Rs./S) (PS /pRs)
S(Rs./$) = Spot Nominal Exchange Rate, pS = For-
eign Price level and pRs = domestic price level.
Thus, we know that when nominal exchange rate is multiplied by relative price levels of the two countries, we get real exchange rate. This exchange rate actually refers to the change in the real purchasing power of a currency relative to its past purchasing power in relation to a foreign currency.
Nominal Effective Exchange Rate (NEER)- The ba-
sic critique of export promotion policies through incentives or import substitution is that, such a regime provides incentive to inefficiencies to the production systems. Since the system is inefficient therefore it is not possible for the producers to enter the international markets. To make these companies enter the international markets, incentives to exports are provided. When we add this per unit incentive to
the nominal exchange rate we get Nominal Effective Exchange
This concept is being used by economists. This is known as nominal effective exchange rate as opposed to nominal exchange rate and the real exchange rate. For example, the official exchange rate is Rs. 25/$ and
each dollar earned gets 10% subsidy from the state in one
shape or the other, then the effective exchange rate is: Nominal exchange rate + per unit subsidy, i.e., Rs. 25 + 10% of Rs.
25 = Rs. 25+ Rs. 2.5 = Rs. 27.5 In this way the nominal effective exchange rate is calculated.
Real Effective Exchange Rate (REER)- The Real Ef-
fective Exchange Rate is again a relative price adjusted ef-
fective exchange rate. When Nominal Effective Exchange
Rate is adjusted for relative prices, the Real Effective Ex-
change Rate is obtained. This is defined as:
REER = NEER (P
Where again pl
= Foreign Price level and
= domestic price level.
Equilibrium Real Exchange Rate- It is that relative
price of tradable goods to non-tradable goods that for given sustainable equilibrium values of other relevant variables such as taxes, international prices and technology, results in the simultaneous attainment of internal and external equilibrium. Internal equilibrium means that the market for nontradable (the goods which are not internationally traded) goods clears. External equilibrium, on the other hand is attained when current account is balanced. According to Edwards, this equilibrium exchange rate is determined by real and fundamental factory.
NATREX- It is the acronym for Natural Real Ex-
change, referring to a medium fun inter cyclical equilibrium real exchange rate, determined by real and fundamental factors. Importantly, the NATREX is a moving equilibrium real exchange rate, responding to continual changes in exogenous and endogenous real fundamentals.
Indian Forex-Market, its Structure
and Exchange Rate Fixation
In India the quotes appear in all the newspapers.
These rates pertain to a bank (the source is always given with the quotes). The banks quote a spectrum of rates because it works as agent of its customers as well.
when a customer reaches a bank with a cheque or sight draft or time draft, the banks quote for all types of transactions with immediate payments or for transactions involving some service (time drafts). In this section we shall be discussing these quotes. This section also deals with the issue of fixing different types of exchange rates, where agency function of the banks are involved.
Structure of Exchange Rates In Indian Forex Market -In Indian forex market not all the currencies are bought or sold. For the currencies which are not frequently traded in Indian forex market, the banks use London or New York or Singapore Markets. From these rates, the cross rates are calculated and the rates are quoted keeping in view the comparative business environment prevailing in these markets.
In fact, authorised dealers (ADs) face, two types of transactions: (i) Clean instruments (known telegraphic transfers (TT), and (ii) Payment against collection (BC, i.e.,bill for collection) of documents. In the second category of trans actions, the ADs have to provide more services therefore the two rates have to be different. While fixing the exchange rate for a transaction ADs must consider three aspects:
1.Is the transaction clean or documentary?
2.Is the bill under consideration a sight or time draft or a usance bill?
3.Does the AD have to fork out funds in rupees or in
foreign exchange or the reimbursement would be more or less immediate?
After considering these aspects, ADs quote the rates for the following types of instruments:
1.TT Clean Buying Rate
2.TT Documentary Buying Rate
3.On Demand (OD) Bills Buying Rate
5.Tel Quel Rate
6.D/A Bill buying rate
TT dean buying rate- is the best rate that a customer can get. It is quoted for transactions of which the reimbursement is more or less immediate. This rate also applies to remittances by mail transfers and bank drafts provided the required conditions are met.
TT Documental of buying rate- will be lower than IT clean, because in this case certain documents are to be collected, therefore handling changes are involved. On Demand Bill Buying Rate – is used for sight draft or demand bills that are negotiated or purchased by authorised dealers. For discounting usance bills, long exchange rates are required. Since different usance bills have different usance period therefore various long term exchange rates were required.
Thus there are several long rates. These quotations are used for usance bills that are discounted by ADs. The applicable rate depends on the usance period.
In all the cases; the usance period will have run for some time before the bill is presented to an authorised dealer for discounting. In such cases, the Tel Quel Rates are quoted. These rates cover the unbroken period of usance.
D/A stands for documents against acceptance and all the D/A rates are long rates. Tel Quel Rates and the D/A rates depend on the transit time involved. Transit time is the time between the payment made to the document holder and the reimbursement of the document from the issuing agency. A traveller cheque is paid at sight, but it takes time to realise these cheques from the issuing bank. Similarly exports bills also involve transit time.
FEDAI has prescribed transit periods and interest
factors. These are taken into account and loaded onto the exchange rates. The main loading factors are:
2.Expenses on postage,
5.Commission to the exchange brokers or to correspondent banks,
6.Exchange rate fluctuations, and
TT-Bill Rate for Immediate Payment- IT Bill Rate is
a sight draft (a draft to be paid on seeing) or a bill to be paid immediately, the buying and selling rates for such payments are fixed as follows:
Illustration Suppose the interbank rate between
rupees and dollars is S(Rs. /S) = 35.50 and the exchange margin is 0.12%, then
TT-Buying Rate = Basic Rat
TT-Selling Rate = Basic Rat
TT Buying Rate is: -33.50-33.
T Selling Rate is: -33.50+33
= 33.50 (1 +
or The rules of rounding-off the exchange rates are fixed by Foreign Exchange Dealers Association of India (FEDAI).
Bill Rate When the Bill IS to be Sent for Collection-
If some delay is involved in payments such as in the case of time draft (the draft to be paid after specified time) or bill for collection another margin for the lag in payment to the bank is added in the form of interest payment. This charge is called transit time charges.
Foreign Exchange Dealers Association of
India(FEDAI) fixes the exchange margins, transit time and rules for charging interest. These involve discounting for immediate payment. If some service is required the service charges are also to be added or subtracted to the basic rate. For example, banker’s drafts issued by other banks or personal cheques then in that case the clearance is involved,ie., the bills are to be sent for collection overseas; so in this case the Bill buying and selling rates are fixed as follows: = Basic rate (T) Forward Discount (Premi
Bill Buying rate the higher (lower) month – Exchange Ma Or Bill selling rate: Since it is the issuing of the bill to the importer only, therefore it only involves a service, i.e..
issuing and service the collection of bills therefore its rate is formed as per TT-selling rate plus a margin for the service rendered.
Bill Selling Rate = TT Selling Rate + Serv
The margins are regulated by FEDAI.
Forward Buying and Selling of Bills- The buying
and selling in the forward are set as follows:
Forward Buying rate= Spot rate Forward Discount
(Premium) for transit time period plus usance period plus forward period rounded off to the higher (lower) month Exchange Margin.
Here spot rate is the spot bill buying rate.
Forward selling rate = Interbank spot selling
rate Forward discount (premium) for forward period + Exchange Margin
Bill Selling rate
rate + Exchange Margin for selling a Bill
= Forward TT Selling
Note: In the case of forward buying, the forward
period, usance period and the transit period are to be added together.
Thus for 60 days bill bought 2 months forward, with transit period of 15 days, the total comes to 60+60+ 15 = 135
days. If the currency is at a discount the bank will charge the discount for 150 days and if the currency is at a premium the bank will pay premium for four months.
Adjustment of Transactions in India- In India, the
official rate is determined by the RBI on the basis of the multi-currency basket. The official buying and selling rates are announced. The foreign Exchange Dealers Association (FEDAI) announces indicative free market rate on every business day. The RBI has the discretion to enter the market so as to stabilize the exchange rate. Every authorised dealer has to maintain, at the close of the day a square or near square position in each foreign currency, except for the limits of open positions prescribed for each currency or total currency value. The authorised dealers have now much wider powers of releasing foreign exchange for business travel abroad, medical treatment, the remittance of agency commissions and legal expenses. The bank’s payment, in those countries where the bank does not have their branch, are done through a correspondent bank account called nostro account. It-literally means our account with you. The opposite of this is the vostro account.
The Structure of Foreign
Exchange Market in India
The exchange market in India has three segments. The first segment consist of transaction between the Reserve Bank of India (RBI) and the Authorised Dealers(ADS).
The authorised dealers are usually the commercial banks.The second segments is the interbank market in which the banks deal among themselves. The third segment is the retail segment in which the ADS deal with their corporate clients and other retail customers. In the retail segment money changers also operate. These are licensed dealers in the currency market to cater to the needs of retail customers. In the interbank market the quotes appear in swap points. There are currency brokers also who match the buyers and sellers.These brokers work on commission basis.