The document discusses several theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the International Fisher Effect (IFE). It also covers the administration of foreign exchange, including authorized persons under the Foreign Exchange Management Act (FEMA) in India.
The document discusses several theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the International Fisher Effect (IFE). It also covers the administration of foreign exchange, including authorized persons under the Foreign Exchange Management Act (FEMA) in India.
The document discusses several theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the International Fisher Effect (IFE). It also covers the administration of foreign exchange, including authorized persons under the Foreign Exchange Management Act (FEMA) in India.
The document discusses several theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the International Fisher Effect (IFE). It also covers the administration of foreign exchange, including authorized persons under the Foreign Exchange Management Act (FEMA) in India.
One popular macroeconomic analysis metric to compare economic productivity and standards of living between countries is purchasing power parity (PPP). PPP is an economic theory that compares different countries’ currencies through a “basket of goods” approach, not to be confused with the Paycheck Protection Program created by the CARES .It is an economic theory that allows for the comparison of the purchasing power of various world currencies to one another. It is the theoretical exchange rate at which you can buy the same amount of goods and services with another currency.
According to this concept, two currencies are in equilibrium—known as the currencies being at par— when a basket of goods is priced the same in both countries, taking into account the exchange rates.
The purchasing power parity calculation tells you how much things would cost if all countries used the same currency. In other words, it is the rate at which one currency would need to be exchanged to have the same purchasing power as another currency.1 Purchasing power parity is based on an economic theory that states the prices of goods and services should equalize among countries over time.
The World Bank computes PPP for each country in the world. It provides a map that shows the PPP ratio compared to the United States.
How Does Purchase Power Parity Work?
An economist will use the PPP to compare the economic output of different nations against one another. It might be used to determine which country has the world’s largest economy. Using PPP exchange rates in addition to a country’s gross domestic product (GDP) may help to provide a more detailed picture of a country’s economic health.
The theoretical value is also helpful to traders in foreign currency and investors holding foreign stocks or bonds as it helps to predict fluctuations in international currency and indicate weakness.
The International Fisher Effect (IFE)
It states that the difference between the nominal interest rates in two countries is directly proportional to the changes in the exchange rate of their currencies at any given time. Irving Fisher, a U.S. economist, developed the theory.
The International Fisher Effect is based on current and future nominal interest rates, and it is used to predict spot and future currency movements. The IFE is in contrast to other methods that use pure inflation to try to predict and understand movements in the exchange rate. It basically shows you the changes in the exchange rates of two currencies correlate with the difference in nominal interest rates between the two countries. The term is by the name of its inventor, namely Irving Fisher, an American economist.
This hypothesis is important for predicting the movement of the spot currency and future spot prices. Long story short, when the domestic nominal interest rate is higher than its rate in the trading partner, we expect the domestic currency exchange rate to depreciate against the partner country’s currency.
International Fisher effect principle
Fisher emphasized that interest rates provide a strong indication of the performance of a country’s currency. In looking at the relationship between the difference in nominal interest rates and changes in exchange rates, he takes several assumptions:
• Capital freely flows between countries
• Real interest rates are the equal between countries in the world • Difference in nominal interest rates between countries equals expected inflation (expected inflation) • Capital markets are internationally integrated • No currency controls Understanding the International Fisher Effect (IFE)
The IFE is based on the analysis of interest rates associated with present and future risk-free investments, such as Treasuries, and is used to help predict currency movements. This is in contrast to other methods that solely use inflation rates in the prediction of exchange rate shifts, instead functioning as a combined view relating inflation and interest rates to a currency’s appreciation or depreciation.The theory stems from the concept that real interest rates are independent of other monetary variables, such as changes in a nation’s monetary policy, and provide a better indication of the health of a particular currency within a global market. The IFE provides for the assumption that countries with lower interest rates will likely also experience lower levels of inflation, which can result in increases in the real value of the associated currency when compared to other nations. By contrast, nations with higher interest rates will experience depreciation in the value of their currency
Interest Rate Parity (IRP)
The interest rate parity (IRP) is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country.
The theory suggests that suggests a strong relationship between interest rates and the movement of currency values. In fact, you can predict what a future exchange rate will be simply by looking at the difference in interest rates in two countries.
As with many other theories, the equation can be rearranged to solve for any single component of the equation to draw different inferences. If IRP holds true, then you should not be able to create a profit simply by borrowing money, exchanging it into a foreign currency, and exchanging it back to your home currency at a later date.
This,the IRP theory postulates a relationship between the exchange rate and interest rates of two countries
According to the theory, the forward exchange rate should be equal to the spot exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country
If IRP does not hold true, then there is the potential to profitably employ an arbitrage strategy. Interest rate parity is the fundamental equation that governs the relationship between interest rates and currency exchange rates.
The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of their interest rates.
Parity is used by forex traders to find arbitrage opportunities.
Interest rate parity is the fundamental equation that governs the relationship between interest rates and currency exchange rates.
The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of their interest rates.
Parity is used by forex traders to find arbitrage opportunities.
Understanding Interest Rate Parity (IRP)
Interest rate parity (IRP) plays an essential role in foreign exchange markets by connecting interest rates, spot exchange rates, and foreign exchange rates.IRP is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of IRP is that hedged returns from investing in different currencies should be the same, regardless of their interest rates.
IRP is the concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and sale of an asset to profit from a difference in the price). Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate.
Adminstration of foreign exchange
Authorised Person
When it comes to foreign exchange, the Reserve Bank of India cannot carry forward all transactions on its own. This is why the RBI delegates its powers to what it refers to as “Authorised Personnel” or any authorised person under FEMA. This personnel has the jurisdiction to deal with foreign securities and foreign exchanges. This brings us to FEMA. What is it?
FEMA has divided the authorised persons into four categories. Each category captures one segment of those who are authorised persons under FEMA. They are as follows:
1. Category I: Authorised Person Under FEMA
Category I includes entities like State Banks, Commercial Banks, Co-op and Urban Co-op Banks. From time to time, they are permitted to follow RBI issued directions for all their capital account and current account transactions.
2. Category II: Authorised Person Under FEMA
Category II is inclusive of Coop Banks, Regional Rural Banks, and Upgraded FFMCs among other such entities. These entities are permitted certain non-trade related transactions from their current accounts. When it comes to FFMCs though, all activities are permitted. These include the following:
– Remittances of tour operators.
– Business or private visits abroad.
– Participation in specialized training, global conferences, and international events.
– Remittance of international exam fees such as the TOEFL, GRE, and more.
– Any medical treatment that needs to be carried out abroad due to lack of availability of treatments and technology nationally.
– Overseas education.
– Any overseas employment or job applications.
– Emigration overseas, as well as the consultancy fees for emigrating.
– Any fees or payments for registering one’s documents.
– Fees for one’s international visa.
– Fees for any international organizations.
3. Category III: Authorised Person Under FEMA
Entities such as some selective financial institutions and others are included in Category III of authorised persons under FEMA. All transactions that are incidental to foreign exchange are permitted to these entities by the Reserve Bank of India.
4. Category IV: Authorised Person Under FEMA
The final category of authorised persons under FEMA includes entities like Full-fledged money changers. These include urban cooperative banks, the department of post, and other full-fledged money changers. When it comes to permissible activities under Category IV, as per RBIs regulations such entities can purchase foreign exchange securities for business visits abroad or private purposes.
How to become an Authorised Person Under FEMA?
Authorised persons have the jurisdiction from the Reserve Bank to deal in foreign exchange of the country. To become an authorised person, you have to submit the necessary application along with all the relevant documents to the Reserve Bank of India. If you are approved as an authorised person, keep in mind that you do not have a free hand in foreign exchange. You will be required to furnish any documents of your transactions to the RBI depending upon the Category of authorised personnel you fall under and as and when they request these documents.
Authorised dealers are the institutions that have the license from the RBI to sell and buy foreign currencies. Most of the authorised dealers are banks.
As per the Foreign Exchange Management Act, 1999, the Reserve Bank, on an application, may authorise any person to be known as an authorised person, to deal in foreign exchange as an Authorised Dealer. Different categories of Authorised Dealers
There are three types of authorised dealers, depending upon the type of institutions. These three types are classified under there categories.
Category I
Category II
Category III
Who is a Category I Authorised Dealer?
Category I Authorised Dealers are select banks who can carry out all permissible current and capital account transactions as per directions issued from time to time. There are 106 authorised dealers of Category -I as per the RBI regulations.
Who is a Category II AD?
Category II are select entities to carry out specified non-trade related current account transactions, all the activities permitted to Full Fledged Money Changers and any other activity as decided by the Reserve Bank
Who is a Category III AD?
Category III Ads are select financial and other institutions (as Authorised Dealers Category-III) to carry out specific foreign exchange transactions incidental to their business / activities.
Who is Full-Fledged Money Changer?
Another category, outside the Authorised Dealers, who can deal in a lesser way in foreign exchange dealing are the Full Fledged Money Changers. They have less functionalities vis a vis Ads.
FFMCs are select registered companies as Full-Fledged Money Changers (FFMC) to undertake purchase of foreign exchange and sale of foreign exchange for specified purposes viz. private and business travel abroad.
Authorised Money Changers/ AMCs are entities who are authorised by the Reserve Bank of India as per Section 10 of the Foreign Exchange Management Act of 1999. Accordingly, an AMC may either be a Restricted Money Changer (RMC) or a Full Fledged Money Changer (FFMC). As defined by the Act, an Authorised Person essentially means an authorised dealer, money changer, off-shore banking unit or any other individual for the time being authorised under sub-section (1) of Section 10 to involve in foreign securities or foreign exchange. A license is required by FFMCs to purchase foreign exchange from residents and non-residents visiting India and to sell foreign exchange for specifically approved purposes.
Authorised Money Changers are the authorised dealers, money changers, off-shore banking units or any such persons who have the authority to deal in foreign exchange or foreign securities under Section 10(1) of the Foreign Exchange Management Act.
An entity wishing to operate as a money changer in India must obtain the Authorised Money Changer License, or commonly known as Full-Fledged Money Changer License (FFMC License). The FFMC license can be obtained by filing an application with the Reserve Bank of India. The RBI is the regulatory authority that issues the guidelines as to how money changers work; the activities permitted and their compliance obligations.
The particulars relating to registration, renewal, cancellation, etc. of the FFMC license are provided under FEMA- the Foreign Exchange Management Act, 1999.
Account.
Type # 1. Nostro Account:
In Latin, ‘Nostro’ means “our account with you”. Nostro account is the account maintained by an Indian bank with an overseas/foreign bank. For example, PNB may maintain an account with Citibank, New York. The account would be in the host country’s currency, i.e., in US dollar. All foreign exchange transactions are routed through Nostro accounts by Indian Bank.
Type # 2. Vostro Account:
In Latin, ‘Vostro’ means “your account with us”. A foreign bank, say Citibank, New-York, may open Rupee account with State Bank of India. The account would be maintained in home currency where account is opened, i.e., Indian Rupees. Type # 3. Loro Account:
‘Loro account’ word stands for ‘Their account with you’, in Latin. Say, State Bank of India is maintaining an account with Citibank, New York. When Syndicate Bank of India likes to refer this account during the course of correspondence with Citibank, it would refer to it as ‘Loro Account’.
Cash Position:
Banks maintain accounts with counterparty banks always in foreign currency (Nostro Account). Banks may have many such accounts in different currencies depending on foreign exchange requirements. It is also possible that the bank may have more than one account even for a same currency.
Balances available in the Nostro accounts reflect the cash position of the bank. The proper utilization of balance in Nostro accounts can be done through delivery under forward contracts, inward or outward telex transfer. It is also known as Fund position.
Currency Position:
It deals with daily sale or purchase of foreign currency, results into excess, less or equal. In that case, it is named as overbought (more purchase), Oversold (more sales) or Square (purchase matches sales) position respectively. Open position needs to be covered suitably considering amalgamation of transactions for protecting the exposure risks.
