Introduction to Exchange Rate Mechanism: Spot- Forward Rate, Exchange Arithmetic. -- Deriving the Actual Exchange Rate: Forwards, Swaps, Futures and Options. Guarantees in Trade: Performance, Bid Bond etc.

1. Forex Management
Module 4

2. Module IV - Syllabus
Introduction to Exchange Rate Mechanism : Spot- Forward Rate,
Exchange Arithmetic. - Deriving the Actual Exchange Rate:
Forwards, Swaps, Futures and Options. Guarantees in Trade:
Performance, Bid Bond etc.

3. Exchange Rate Mechanism (ERM)
• An exchange rate mechanism (ERM) is a device used to manage
a country's currency exchange rate relative to other currencies.
It is part of an economy's monetary policy and is put to use by
central banks.
• Such a mechanism can be employed if a country utilizes either
a fixed exchange rate or one with floating exchange rate that is
bounded around its peg (known as an adjustable peg or
crawling peg).

4. The Basics of the Exchange Rate Mechanism (ERM)
• An exchange rate mechanism is not a new concept.
• Most new currencies started as a fixed exchange mechanism that
tracked gold or a widely traded commodity.
• It is loosely based on fixed exchange rate margins, whereby
exchange rates fluctuate within certain margins.
• An upper and lower bound interval allows a currency to
experience some variability without sacrificing liquidity or drawing
additional economic risks.
• The concept of currency exchange rate mechanisms is also
referred to as a semi-pegged currency system.

5. What is an Exchange Rate ?
• Exchange Rate is a rate at which one currency can be exchanged
into another currency.
• In other words it is value one currency in terms of other.
say:
US $ 1 = Rs. 69.48

6. Types of Exchange Rates
1. Fixed Exchange Rate
2. Floating/Flexible Exchange Rate
3. Managed Float

7. 1. Fixed Exchange Rate
• This is where a Government maintains a given exchange
rate over a period of time.
• This could be for a few months or even years.
• In order to maintain the exchange rate at the stated level
government uses fiscal and monetary policies to control
aggregate demand.

8. 2. Floating exchange rate
• A floating exchange rate is where the rate of
exchange is determined purely by the demand and
supply of that currency on the foreign exchange
market.

9. 3. Managed Float
• This is where the currency is broadly managed by
the forces of demand and supply but the
government takes action to influence the rate of
change in the exchange rate.

10. Spot Exchange Rate
• A spot exchange rate is the price to exchange one currency for another
for immediate delivery.
• The spot rates represent the prices buyers pay in one currency to
purchase a second currency.
• Although the spot exchange rate is for delivery on the earliest value
date, the standard settlement date for most spot transactions is two
business days after the transaction date.
• The spot exchange rate is the price paid to sell one currency for another
for delivery on the earliest possible value date

11. Spot Exchange Rate
• Definition:
– The spot exchange rate is the amount one currency will trade for
another today.
– In other words, it’s the price a person would have to pay in one
currency to buy another currency today.
– You could also think of it as today’s rate that one currency can be traded
with another.

12. Spot Market
• The foreign exchange spot market can be very volatile; in the
short term, rates are often driven by rumor, speculation and
technical trading.
• In the long term, rates are generally driven by a combination of
economic growth and interest rate differentials.
• Central banks sometimes intervene to smooth the market,
either by buying or selling the local currency or by adjusting
interest rates

13. Forward Exchange Rate
• The forward exchange rate (also referred to as forward rate or
forward price) is the exchange rate at which a bank agrees to
exchange one currency for another at a future date when it enters
into a forward contract with an investor.
• Multinational corporations, banks, and other financial institutions
enter into forward contracts to take advantage of the forward rate
for hedging purposes.

14. Forward Exchange Rate
• A forward rate is a rate applicable to a financial transaction that will
take place in the future.
• Forward rates are based on the spot rate, adjusted for the cost of
carry and refer to the rate that will be used to deliver a currency,
bond or commodity at some future time.
• It may also refer to the rate fixed for a future financial obligation,
such as the interest rate on a loan payment.

15. Foreign Exchange Quotations & Rates
• American quotations and the European quotations
• Direct quotes
• Indirect quotes
• Cross rates
• TT buying rate
• Bill buying rate
• Forward margin
• Exchange margin
• Bill selling rate

16. American quotations and the European quotations:-
– The European quotations are quotes given as
“number of units of a currency per us dollar.“
• Example : JPY I25.65/ USD, INR 69.57/ USD.
– The American quotations are quotes given as
“number of US dollars per unit of a currency”.
• Example : USD 0.8775 / EUR, USD 0.014 / INR etc.

17. • Direct quotes : in a country, direct quotes are those that give units
of the home currency per unit of a foreign currency,
– For example :
• INR 69.75/USD is a direct quote in India
• USD 0.6385/CHF is a direct quote in USA
• Indirect quotes : stated as number of units of a foreign currency
per unit of home currency.
– USD 0.04132/INR is a indirect quote in India
– JPY 0.243/USD is an indirect quote in America

18. • Cross rates : Given the exchange rates of two countries, the
exchange rate for a third country can also be found out.
• USD 0.02339/ GBP , USD 0.02536 / INR.
• TT buying rate : The banks quote a variety of exchange rates.
• One of them is the TT buying rate (TT stands for telegraphic
transfer).
• TT rates are applicable for clean inward or outward remittances
where the banks undertake only the job of money transfer and do
not have to perform any other function, such as handling
documents.

19. • Bill buying rate : Exporters frequently draw bills of exchange on their
foreign customers. Then they sell these bills to an authorized dealer in
foreign currency. The authorised dealer buys the bill and then collects
the payment from the importer.
• Exchange margin : The banks have to transmit or transit the cheques or
bills it has received, in which, considerable amount of time and some
money is spent. In order to recover this along with profit the bank or ad
charges exchange margin.

20. • Bill selling rate : When an importer requests the bank to make
payment to a foreign supplier, against a bill drawn on an importer,
the bank has to handle documents related to the transaction.
• For this, the bank loads another margin on the base rate to arrive at
the bill selling rate.
• Hence bill selling rate = base rate + exchange margin.

21. Deriving The Actual Exchange Rate Forwards
Swaps Futures And Options

22. Derivatives - (Meaning)
• Derivatives: derivatives are instruments which include
– Security derived from a debt instrument share, loan, risk instrument or contract
for differences of any other form of security and ,
– a contract that derives its value from the price/index of prices of underlying
securities. Derivatives (Definition)
• A financial instrument whose characteristics and value depend upon the
characteristics and value of an underlier, typi- cally a commodity, bond,
equity or currency,

23. Derivatives (Definition)
• A financial instrument whose characteristics and value depend
upon the characteristics and value of an underlier, typically a
commodity, bond, equity or currency.
• Examples of derivatives include futures and options.
• Advanced investors sometimes purchase or sell derivatives to
manage the risk associated with the underlying security, to
protect against fluctuations in value, or to profit from periods
of inactivity or decline.
• These techniques can be quite complicated and quite risky.

24. Advantages of Derivative Market
• Diversion of speculative instinct form the cash market to the
derivatives.
• Increased hedge for investors in cash market.
• Reduced risk of holding underlying assets.
• Lower transactions costs.
• Enhance price discovery process.
• Increase liquidity for investors and growth of savings flowing
into these markets.
• It increase the volume of transactions.

25. Types Of Derivatives
There are two types of derivatives
1. Financial derivatives
– Financial Derivatives the underlying instruments is stock,
bond, foreign exchange.
2. Commodity Derivatives
– Commodity derivatives the underlying instruments are a
commodity which may be sugar, cotton, copper, gold, silver.

26. Financial Derivatives further divided into 2 types
1. Basic 2. Complex.
Basics Four Parts: Basics Four Parts:
– Forward -- Swap
– Future -- Exotics
– Option
– Warrents & Convertibles.

27. Forward contract
• A forward is a contract in which one party commits to buy and the
other party commits to sell a specified quantity of an agreed upon
asset for a pre-determined price at a specific date in the future.
• It is a customised contract, in the sense that the terms of the
contract are agreed upon by the individual parties.
• A bilateral contract
• Hence, it is traded OTC.
• Generally closing with delivery of base asset
• Not need any initial payment when signing the contract

28. • A forward contract is an agreement to buy or sell an
asset on a specified date for a specified price.
• One of the parties to the contract assumes a long
position and agrees to buy the underlying asset on a
certain specified future date, for a certain specified price

30. Over The Counter(OTC) Trading
• In general, the reason for which a stock is traded over-the-counter is
usually because the company is small, making it unable to meet
exchange listing requirements.
• Also known as "unlisted stock", these securities are traded by
broker-dealers who negotiate directly with one another over
computer networks and by phone.
• OTC stocks are generally unlisted stocks which trade on the Over the
Counter Bulletin Board (OTCBB)

31. Risks in Forward Contracts
• Credit Risk
– Does the other party have the means to pay?
• Operational Risk
– Will the other party make delivery?
– Will the other party accept delivery?
• Liquidity Risk
– Incase either party wants to opt out of the contract, how to find
another counter party?

32. Terminology
• Long position – Buyer
• Short position – seller
• Spot price – Price of the asset in the spot market.(market price)
• Delivery/forward price – Price of the asset at the delivery date.

33. The salient features of forward contracts
• They are bilateral contracts and hence, exposed to
counterparty risk.
• Each contract is customer designed, and hence is unique in
terms of contract size, expiration date and the asset type and
quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by
delivery of the asset and If party wishes to reverse the
contract

34. Limitations of Forward contract
• Forward markets are afflicted by several problems:
– Lack of centralization of trading,
– Liquidity and Counterparty risk.
• The basic problem in the first two is that they have too
much flexibility and generality.
• Counterparty risk arises from the possibility of default by
any one party to the transaction. When one of the two
sides to the transaction declares bankruptcy, the other
suffers

35. FUTURE CONTRACT
• A future is a standardised forward contract.
• It is traded on an organised exchange.
• Future contract is an agreement between two parties to buy or sell
an asset at a certain time in the future, at a certain price.
• But unlike forward contract, futures contract are standardized and
stock ex-changed traded.
• Futures contracts are special types of forward contracts in the sense
that the former are standardised exchange-traded contracts.
• The counter party to a futures is a clearing house on the appropriate
futures exchange
• Settled by cash or cash equivalents rather than physical assets

36. The standardized items in a futures contract are:
• Quantity of the underlying,
• Quality of the underlying,
• The date/month of delivery,
• The units of price quotation and minimum price change and
• Location of settlement.

37. Closing a Futures Position
• Most futures contracts are not held till expiry, but closed
before that.
• If held till expiry, they are generally settled by delivery. (2-3%)
• By closing a futures contract before expiry, the net difference
is settled between traders, without physical delivery of the
underlying.

39. Terminology
• Contract size – The amount of the asset that has to be delivered
under one contract. All futures are sold in multiples of lots which is
decided by the exchange board.
– Eg. If the lot size of Tata steel is 500 shares, then one futures contract is
necessarily 500 shares.
• Contract cycle – The period for which a contract trades.
– The futures on the NSE have one (near) month, two (next) months, three (far)
months expiry cycles.

40. Terminology
• Expiry date – usually last Thursday of every month or
previous day if Thursday is public holiday.
• Strike price – The agreed price of the deal is called the
strike price.
• Cost of carry – Difference between strike price and current
price.

41. Margins
• A margin is an amount of a money that must be deposited
with the clearing house by both buyers and sellers in a
margin account in order to open a futures contract.
• It ensures performance of the terms of the contract.
• Its aim is to minimise the risk of default by either
counterparty.

42. Marking to Market
• This is the practice of periodically adjusting the margin account
by adding or subtracting funds based on changes in market
value to reflect the investor’s gain or loss.
• This leads to changes in margin amounts daily.
• This ensures that there are o defaults by the parties.

43. Margins
• Initial Margin - Deposit that a trader must make before trading any
futures. Usually, 10% of the contract size.
• Maintenance Margin - When margin reaches a minimum
maintenance level, the trader is required to bring the margin back
to its initial level. The maintenance margin is generally about 75%
of the initial margin.
• Variation Margin - Additional margin required to bring an account
up to the required level.
• Margin call – If amt in the margin A/C falls below the maintenance
level, a margin call is made to fill the gap.

44. Difference between Forward and Futures
Forward Future
Trade in OTC Only Ex-changes or through CH
Standardised Contract, hence more liquid Customized contract, hence liquid
NO Margin payment required Required margin payment
Settlement by the end of the period Follows daily settlement
Markets are not transparent Markets are transparent
No Marked to market daily Marked to market daily
No prior delivery Closed prior to delivery
No Profits or losses realised daily Profits or losses realised daily

45. What are Options?
• Contracts that give the holder the option to buy/sell specified quantity
of the underlying assets at a particular price on or before a specified
time period.
• The word “option” means that the holder has the right but not the
obligation to buy/sell underlying assets.
• An option is the right, but not the obligation to buy or sell something on
a specified date at a specified price.
• In the securities market, an option is a contract between two parties to
buy or sell specified number of shares at a later date for an agreed price.

46. Features of Options
• A fixed maturity date on which they expire. (Expiry date)
• The price at which the option is exercised is called the exercise price
or strike price.
• The person who writes the option and is the seller is referred as the
“option writer”, and who holds the option and is the buyer is called
“option holder”.
• The premium is the price paid for the option by the buyer to the
seller.
• A clearing house is interposed between the writer and the buyer
which guarantees performance of the contract.

47. Types of Options
• There are three parties involved in the option trading,
– 1. The option seller or writer is a person who grants someone else
the option to buy or sell. He receives premium on its price,
– 2. The option buyer pays a price to the option writer to induce him
to write the option.
– 3. The securities broker acts as an agent to find the option buyer
and the seller, and receives a commission or fee for it.

48. • An option to buy anything is known as a CALL while an
option to sell a thing is called a PUT.
• Options trade in an organized market but, large percentage
of it is traded over the counter (i.e. privately).
• This is just an option. That means it is a right and not an
obligation.
• Strike price: Price specified in the options contract is known
as the strike price or exercise price.

49. Types of Options
Options are of two types – call and put.
• Call option give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price
on or before a particular date by paying a premium.
• Put Option: Give the buyer the right, but not obligation to
sell a given quantity of the underlying asset at a given price
on or before a particular date by paying a premium.

50. Types of Options (cont.)
The other two types are
• European style options and American style options.
– European style options can be exercised only on the maturity
date of the option, also known as the expiry date.
– American style options can be exercised at any time before and
on the expiry date.

51. Right to buy 100
Reliance share at price
of Rs. 300 / Share after
one month.
Current price 250
Demo - Call Option
Premium Rs. 25/ share
Amount to buy Call option = 2500
Suppose after a month, Mkt price is
Rs.400, Then the option is exercised.
Means the shares are brought.
Net gain= 40000 – 30000 – 2500 = 7500
Suppose after a month, Mkt price is
Rs.200, Then the option is not
exercised.
Net Loss = Premium = 2500

54. Right to sell 100
Reliance share at price
of Rs. 300 / Share after
one month.
Current price 250
Demo – Put Option
Premium Rs. 25/ share
Amount to buy Call option = 2500
Suppose after a month, Mkt price is
Rs.200, Then the option is exercised.
Means the shares are sold.
Net gain= 30000 – 20000 – 2500 = 7500
Suppose after a month, Mkt price is
Rs.400, Then the option is not exercised.
Net Loss = Premium Amt= 2500

57. Options Terminology
• Underlying : Specific security or asset.
• Option premium : Price paid.
• Strike price : Pre-decided price.
• Expiration date : Date on which option expires.
• Exercise date : Option is exercised.
• Option holder : One who buys option.
• Option writer : One who sells option.

58. Contd.
• Open interest: Total numbers of option contracts that
have not yet been expired.
• Option class: All listed options of a type on a particular
instrument.
• Option series: A series that consists of all the options of a
given class with the same expiry date and strike price.
• Put-call ratio: The ratio of puts to the calls traded in the
market.

59. What are SWAPS?
• In a swap, two counter parties agree to enter into a
contractual agreement wherein they agree to exchange
cash flows at periodic intervals
• Most swaps are traded “Over The Counter”.
• Some are also traded on futures exchange market.

60. • An agreement between two parties to exchange one set of
cash flows for another. In essence it is a portfolio of forward
contracts.
• While a forward contract involves one exchange at a
specific future date, a swap contract entitles multiple
exchanges over a period of time

61. – Swaps are private agreements between two parties to exchange
cash flows in the future according to a prearranged formula.
– They can be regarded as portfolios of forward contracts
There are 2 main types of swaps:
– Plain vanilla fixed for floating swaps
or simply interest rate swaps.
– Fixed for fixed currency swaps
or simply currency swaps

62. What is an Interest Rate Swap?
• A company agrees to pay a pre-determined fixed interest
rate on a notional principal for a fixed number of years.
• In return, it receives interest at a floating rate on the same
notional principal for the same period of time.
• The principal is not exchanged. Hence, it is called a
notional amount.

63. Floating Interest Rate
• LIBOR – London Interbank Offered Rate
• It is the average interest rate estimated by leading banks in
London.
• It is the primary benchmark for short term interest rates around
the world.
• Similarly, we have MIBOR i.e. Mumbai Interbank Offered Rate.
• It is calculated by the NSE as a weighted average of lending rates
of a group of banks.

65. Using a Swap to Transform a Liability
• Firm A has transformed a fixed rate liability into a floater.
– A is borrowing at LIBOR – 1%
– A savings of 1%
• Firm B has transformed a floating rate liability into a fixed
rate liability.
– B is borrowing at 9.5%
– A savings of 0.5%.
• Swaps Bank Profits = 8.5%-8% = 0.5%

66. What is a Currency Swap?
• It is a swap that includes exchange of principal and interest rates in
one currency for the same in another currency.
• It is considered to be a foreign exchange transaction.
• It is not required by law to be shown in the balance sheets.
• The principal may be exchanged either at the beginning or at the
end of the tenure.
• However, if it is exchanged at the end of the life of the swap, the
principal value may be very different.
• It is generally used to hedge against exchange rate fluctuations.

67. Direct Currency Swap Example
• Firm A is an American company and wants to borrow €40,000
for 3 years.
• Firm B is a French company and wants to borrow $60,000 for 3
years.
• Suppose the current exchange rate is €1 = $1.50.

69. Comparative Advantage
• Firm A has a comparative advantage in borrowing Dollars.
• Firm B has a comparative advantage in borrowing Euros.
• This comparative advantage helps in reducing borrowing
cost and hedging against exchange rate fluctuations.

70. Guarantees in trade

71. Guarantees in trade
• Letter of credit
• Bank guarantee
• Performance bond (guarantee)
• Bid or Tender Bonds
• Advance Payment Bonds
• Warranty or maintenance bonds
• Guarantees

72. Guarantees in trade
• Trade finance signifies financing for trade, and it
concerns both domestic and interactional trade
transactions.
• A trade transaction requires a seller of goods and
services as well as a buyer.
• Various intermediaries such as banks and financial
institutions can facilitate these transactions by
financing the trade

73. Letter of credit
• It is an undertaking/promise given by a Bank/- Financial
Institute on behalf of the Buyer/Importer to the Seller/-
Exporter, that, if the Seller/Exporter presents the complying
documents to the Buyer's designated Bank/Financial Institute as
specified by the Buyer/Importer in the Purchase Agreement
then the Buyer's Bank/Financial Institute will make payment to
the Seller/Exporter.

74. Bank guarantee
• It is an undertaking/promise given by a Bank on behalf of the
Applicant and in favour of the Beneficiary.
• Whereas, the Bank has agreed and undertakes that, if the Applicant
failed to fulfill his obligations either Financial or Performance as per
the Agreement made between the Applicant and the Beneficiary,
then the Guarantor Bank on behalf of the Applicant will make
payment of the guarantee amount to the Beneficiary upon receipt of
a demand or claim from the Beneficiary.

75. Performance bond (guarantee)
• A bond or guarantee which has been issued as security for one
party's performance: if that party (the principal) fails to
perform the beneficiary under the bond/guarantee may
obtain payment.
• A performance bond may be of either the demand or
conditional variety, which means that the beneficiary may or
may not be required to prove default by the principal in order
to obtain payment.

76. Bid or Tender Bonds
• A Tender or Bid Bond is usually for between 2% and 5% of the
contract value, and the aim is to guarantee that the contract
will be taken up if it is awarded.
• In the event that the contract is not taken up, then there will be
a resultant penalty for the value of the Bond.
• The Tender Bond usually commits both the Seller and its Bank
to joining in a Performance Bond if the contract is granted.

77. Advance Payment Bonds
• This will provide protection to the Buyer when an advance or
progress payment is made to the Seller prior to completion of the
contract.
• The Bonds undertake that the Seller will refund any advance
payments that have been made to the Buyer in the event that the
product is unsatisfactory.
• This is typical in large construction matters where a contractor will
purchase high-value equipment, plant or materials specifically for
the project.
• The bond will protect in the event of failure to fulfill its contractual
obligations @.g. due to insolvency.

78. Warranty or maintenance bonds
• These provide a financial guarantee to cover the satisfactory
performance of equipment supplied during a specified maintenance
or warranty period.
• The undertaking is by a bond issuer to pay the buyer an amount of
money if a company's warranty obligations for products that are
provided are not met and the amount will often be as a stated
percentage of the export contract value.
• A warranty bond may be conditional or unconditional.
• If conditional, it may be a condition of the contract that a warranty
bond is purchased before a buyer makes the final payment.

79. Guarantees
• A guarantee is issued by a bank on the instruction of a client
and is used as an insurance policy, to be used when one fails to
fulfil a contractual commitment.
• A financial institution issuing a Letter of Credit will carry out
underwriting duties to ensure the credit quality of the party
looking for the Letter of Credit before contacting the bank of
the party that requests the Letter of Credit. Letters of Credit
are usually open for a year.

80. Exchange Rate Theories

81. • The important factors affecting exchange rates
are:
–Rate of inflation
–Interest rates and
–Balance of payments

82. Theory of Purchasing Power Parity(PPP)
• PPP theory measures the purchasing power of one currency
against another after taking into account their exchange
rate ‘taking into account their exchange rate’, simply means
that you measure the strength on $ 1 with that of Rs. 50
and not with Rs. 1{ assuming the exchange rate is $ 1 = Rs.
50)

83. • Developed by Gustav Cassel ( Swedish economist — 1918)
• The theory states that in ideally efficient markets, identical
goods should have one price
• The concept is founded on the law of one price; the idea that in
the absence of transaction costs, identical goods will have the
same price in different markets
• However, if it doesn't happen, then we say that purchase parity
does not exist between the two currencies

84. • If this happens:
• “American consumers’ demand for Indian Rupees would
increase which will cause the Indian Rupee to become more
expensive
• “The demand for cricket bats sold in the US would decrease,
and hence its prices would tend to decrease
• “The increase in demand for cricket bats in India would make
them more expensive

85. Monetary Model
• It focuses on a country’s monetary policy to help determine the
exchange rate.
• A country’s monetary policy deals with the money supply of that
country, which is determined by both the interest rate set by central
banks and the amount of money printed by the treasury.
• Countries that adopt a monetary policy that rapidly grows its
monetary supply will see inflationary pressure due to the increased
amount of money in circulation, This leads to a devaluation of the
currency.

86. Interest Rate Parity Theory
• This theory states that premium or discount of one currency
against another should reflect the interest differential between
the two currencies
• The currency of the country with a lower interest should be at a
forward premium in terms of the currency of the country with
a higher rate
• In an efficient market with no transaction costs, the interest
differential should be (approximately) equal to the forward
differential

87. Covered interest rate parity
• Interest parity ensures that the return on a hedged ( or
covered) foreign investment will just equal the domestic
interest rate on investments of identical risk
• Which means the covered interest differential — the difference
between the domestic interest rate and the hedged foreign
rate is zero

88. Covered interest rate parity- Example
–Investment of $ 10,00,000 for 90 days
–New ‘York { Dollar) Interest Rate : 8% p.a.
–Frankfurt ( Euro) Interest Rate : 6% p.a.
–Investment in dollar will yield : $ 10,20,000

89. International Fisher Effect
• The International Fisher Effect (IFE) theory suggests that the
exchange rate between two countries should change by an
amount similar to the difference between their nominal
interest rates, If the nominal rate in one country is lower than
another, the currency of the country with the lower nominal
rate should appreciate against the higher rate country by the
same amount.

90. • The formula for IFE is as follows:
• Where
– ‘e' represents the rate of change in the exchange rate
– 'i1’ and ‘i2'represent the rates of inflation for country 1 and country 2,
respectively

91. Balance of Payments Theory
• A country's balance of payments is comprised of two segments
- the current account and the capital account - which measure
the inflows and outflows of goods and capital for a country.
• The balance of payments theory looks at the current account,
which is the account dealing with trade of tangible goods, to
get an idea of exchange rate directions.

92. • If a country is running a large current account surplus or deficit,
it is a sign that a country's exchange rate is out of equilibrium.
• To bring the current account back into equilibrium, the
exchange rate will need to adjust over time.
• If a country is running a large deficit (more imports than
exports), the domestic currency will depreciate. On the other
hand, a surplus would lead to currency appreciation.

93. Real Interest Rate Differentiation Model
• The Real Interest Rate Differential Model simply suggests that countries
with higher real interest rates will see their currencies appreciate against
countries with lower interest rates.
• The reason for this is that investors around the world will move their
money to countries with higher real rates to earn higher returns, which
bids up the price of the higher real rate currency.

94. Asset Market Model
• The Asset Market Model looks at the inflow of money into a country by
foreign investors for the purpose of purchasing assets such as stocks,
bonds and other financial instruments. If a country is seeing large
inflows by foreign investors, the price of its currency is expected to
increase, as the domestic currency needs to be purchased by these
foreign investors.
• This theory considers the capital account of the balance of trade
compared to the current account in the prior theory. This model has
gained more acceptance as the capital accounts of countries are starting
to greatly outpace the current account as international money flow
increases