Thursday, July 2, 2009

Rupee Vs US Dollar: How the Exchange Rate is Determined and Its Impact

All of us have seen 20% increase in the value of dollar against rupee within a year and it is fluctuating these days within a small range. Someone has asked in the comments section about what determines the exchange rate and how it is fixed and I would like to provide some of my thoughts in relation to that.

What determines US Dollar exchange rate?

There is nothing extravagant to tell you about this as the rate is determined by market forces just like how the price of goods and commodities is fixed. The value of any currency is based on the demand for it. If the people buy more of a particular currency, value of that currency increases vice versa. The same thing holds true in case of US Dollar Vs INR as well. There are few other factors that play a role in determining the exchange rate particularly when you leave the currency value to the market forces and I will list them below.

Growth of the Economy
Inflation
Strength of the Economy including Export and Import
Employment / Unemployment
Government
Public Debt
Interest Rates
Sometimes speculation and fear.

Again all these factors either increase or decrease the demand for US Dollar or any other currency. If all the factors mentioned above are favorable, people across the world get confident about the stability of a particular country and investment climate, which in turn creates the demand for the currency.

Example: Rupee appreciated significantly in 2006 – 2007 and the first seven factors I have mentioned above were the reasons for the Rupee appreciation since India had stable government with favorable economic climate. USA and other multi-national companies started investing in India and they bought more Indian Rupees and the demand for rupee increased which in turn appreciated the rupee value.




What if a country does not have all these?

People will not have confidence in that country and the demand for the currency will come to a halt and then we will see a list of failed nations. Example: Zimbabwe. You might have read in news that a loaf of bread in Zimbabwe cost 1 million Zimbabwean dollar which means nobody values that currency in essence.

But what about the eighth factor speculation and fear? That’s what made the US Dollar appreciate 20% versus most of the international currencies in 2008 – 2009.

US Dollar Appreciation

To recap, I have mentioned that Demand for the currency increases the value of that particular currency. So, what made the people to demand for more US Dollar? That’s where speculation and fear came into play and I list out few points that were responsible for recent US Dollar appreciation.

1. During tough economic times, people get scared and they start moving all their foreign currency assets to more stable currency like US Dollar.

2. US Based Mutual Funds, Hedge Funds and stock investors played a huge role as well. US Funds invested huge amount of money in India during 2003 – 2007 period, but the funds saw a huge redemption pressure due to the fear of retail investors in US. People invested in mutual funds and hedge funds panicked and started redeeming the units and the Funds were in a huge liquidity crisis. So, they started dumping the Indian stocks and converted all the currency in to US Dollar which created so much demand in a quick time which in turn increased the value of dollar.

3. International currency traders and speculators wanted to take advantage of the rising value and they started buying more and more US Dollar.


Market Forces Vs Central Bank

While most of the countries let the market forces (Demand and Supply) to determine the currency value, some countries like China had fixed currency value for a long time before easing control over it though with a limited scope. Main reason for that was to have a stable balance of payment. Even RBI can regulate the exchange rate to an extent by adjusting the foreign exchange reserves.

Impact of Exchange Rates:

Exchange rates impact in many ways starting from reduced sales for companies to more buying power for individuals. I will explain this with couple of examples.

Exports and Imports get affected

Strong dollar reduces the export value of US Companies and likewise strong rupee reduces the export value of Indian companies. This is what happened in 2007 – 2008 with Indian companies particularly in IT and Textile sector. Example: Tirupur is the Textile Capital of India and let’s take a company called ABC Textiles which makes inners. Assume ABC had agreed to supply 10 inners to Macy’s in US @ $100 per piece in 2004 when the Rupee value against the dollar was 46. ABC would have earned Rs.46000 in 2004 by supplying 10 inners. But suddenly the Rupee value increased and in 2007 Rupee value was 40 against a US Dollar (You are able to buy 1 dollar by giving Rs.40 instead of Rs.46). ABC would now earn just Rs.40000 for supplying the same 10 inners and it gets affected by reduced revenues.

Strong currency makes the imports cheaper. Take another example where KS Oils imports 10 litre’s of oil from US Company US Oils @ $10 per litre in 2004 when the exchange rate was Rs. 46 Vs US Dollar, which means KS Oils imported 10 litre’s of oil by paying Rs.4600 (100 * 46). In 2007 rupee value has increased and the same 10 litre of oil now costs KS Oils only Rs.4000. So, exchange rates have its effect on imports and exports.

Buying Power

Assume a traveler from India visited US in 2004 with Rs. 46000. He could have bought goods worth $1000 in 2004. But assume the same traveler visited US again in 2007 with the same Rs.46000. In 2007 he could have bought goods worth $1150. Of course there could have been either increase or decrease in prices of individual items based on inflation or deflation. But the essence is, exchange rates affect buying power as well.

I have also uploaded a presentation on rupee appreciation and it would be useful if you want to know more. Readers can access the file at the following link to have additional understanding.

http://issuu.com/kumaran1978/docs/rupee_appreciation

Impact of Exchange Rate on Stocks

As I said above strong currency will reduce the sales and it will have an impact on company earnings particularly when company operates across many geographics. Example: When rupee value appreciated in 2007 - 2008, all the Indian IT, Pharma and Textile exporters faced huge foreign exchange loses and it reduced the earnings and thus the share price. Now, the rupee value against dollar has decreased and all these companies enjoy more earnings due to better foreign exchange rate. Hope I provided a detailed account of exchange rate determination and its impact and look forward to your comments.


Kumaran Seenivasan
www.stockanalysisonline.com

33 comments:

Sunil N. Karande July 4, 2009 at 1:56 AM  

Dear Sir,

Thanks a lot for the valuable information...sir you are genius...

rameshwar July 5, 2009 at 2:06 AM  

As i am engineer & i was just wondering how the currency value is going up and down ,After going through this brief statements, i was able to understand the mystery behind it.

thanks for it
best regards
ramehwar sharma

RK July 7, 2009 at 5:33 PM  

Sir,the article was highly informative.Could you please write about Green Shoe Option in case of share issue?

Yogesh S July 11, 2009 at 2:41 AM  

hello, i am S/W engineer though i have few knowledge about the Rupee exchang by reading some other articles earlier in 2007 and 2008.i would say that the examples that you have provided here were so simple and easy to understand (than any other articles i cam across). Carry on with this good work. Hope to get more intersting articles from you :-)

Madan Kumar July 11, 2009 at 10:05 AM  

Dear Mr.Kumaran,

I believe there are a lot of silent followers of your blogs, one of them being myself. Your posts are so simple and amazing. Your sense of sharing knowledge with others is definitely appreciable. I would say "Summa Asathureenga". I being a newbie in stock market (in fact, in investment world itself - I completed my college last year only) get to know the basics well. Please continue posting such valuable information.

Thanks,
Madan Kumar Rajan

Kumaran July 12, 2009 at 9:22 AM  

Guys,

Thanks for all your comments.

Kumaran.

Ajay July 13, 2009 at 12:30 PM  

You are sharing some fantastic articles. I am learning quite a log from your blog, thanks for sharing.

I know reasonably well about how to analyze individual companies. Just as info, following is my own article, may be useful for other blog readers:
http://finance-knol.blogspot.com/2008/10/how-to-perform-stock-research-using.html

However, I struggle to take sectorial view. I will request for one article which can suggest how to evaluate sector as a whole.

Robin William August 6, 2010 at 7:00 AM  

Always rely on your skills rather than trusting blindly on systems. Systems are made for assistance of trader. But a smart trader always calculates his profits by his own and later on confirm with the system. http://www.onlineforexfuturestrading.com/

danieal August 9, 2010 at 3:25 AM  

dear experties frens?

does change in nifty and sensex cause the change in the value of rupee ?

please give me an idea about it

thanks

vikas September 23, 2010 at 7:22 AM  

dear sir thanks

your article is very simple and demostrative .continue with your occupation

Penny Stocks January 14, 2011 at 12:55 AM  

Good post.....Valuable information for all.I will recommend my friends to read this for sure…

vijay February 5, 2011 at 10:32 AM  

Dear sir
I am a 21years old guy,studing in TYBFM(Bachelors in Financial Markets.
As per my knowledge,what i have been thought,currency rates are determined by calculating LIBID - LIBOR quotations.
The British Banker Association has designated 12 major Euro banks to contribute their quotations for all the 10 eligible currencies and the 16 standard maturities through the BBA at 11am London time on every trading day.
Effectively 160 quotations (10 currencies x 16 maturities )are received from each contributor.In each case the two highest and the two lowest quotations r ignored ant the average of the remaining 8 becomes the LIBID - LIBOR quotations for the given currency.
These quotations r valid only for transactions valid on that day.It represents the market on that day.
Thats what i was aware about.I would be keen to know more about calculations of currencies.Please sir if u can explain me much more about currencies,i would be glad to know about it.It will definitely add to my knowledge...
Thank you sir..
- Vijay Nagpal.

Anonymous,  November 27, 2011 at 4:25 AM  

thanks for explaning in brief.. it helps a lot for engineering graduate to understand the market

Anonymous,  December 14, 2011 at 12:42 PM  

Great Article.The flow of matter is awesome.

Anonymous,  December 25, 2011 at 7:38 AM  

Hi,

Thanks for the nice article. i have one question in my mind.

Now, since the value of rupee has gone down (1$~53Rs) so should we conclude that this is because of the less availability of the dollar in market and excess availability of rupee is more?
(if yes, then why can't Indian govt. reduce the production of Indian Rupee)

or should we conclude that foreign market have purposely reduced Indian rupee value so that people bring out their $ out of their banks a/c(by providing more Indian rupee in return 1$=53Rs)?

shailesh c. shah January 4, 2012 at 12:30 PM  

U can interpret the same in other manner.."The demand of Dollar is very high... so every1 wants to buy the dollar... & sale away the Indian rupee... & there are no the takers for the depreciating INR...
because of high demand of dollar.. the value is going high....

Vijay Sarabu January 11, 2012 at 12:44 PM  

Thank you for valuable information
-Dr. S. Vija Kumar

Nishad,  February 14, 2012 at 6:15 AM  

Dear All,
I have a query...

Can you please explain how our currency is depreciate against dollar.Sometimes it goes up and down, I know there is a various factor by which it gets up and down.

But the thing is that who set it say 1 $ = 50 INR.

Is there any independent body who set the 1 currency of country to another? or we only calculate this on the basis of various factors of economy of one's country?

Please help me out to explain this.

I am waiting for your valuable reply.

Thanks

Nishad

raipuneet83 May 4, 2012 at 9:46 AM  

Sir,

I want to know how much currency can India Produced in an year.
Regards
Puneet Rai

Rahul Gupta May 9, 2012 at 5:36 AM  

Sir,
I am a student of Narsee Monjee College, Mumbai and am pursuing CA couse..
When I read anything about foreign exchange reserve or market in our CPT books it is very difficult to digest those terms..
i have been hunting for a detailed explanation as per HSC level since a year..
By far this was the best and most easy to understand detailed explanation..
Thankyou..keep up the good work !!

apurba sen May 21, 2012 at 11:07 AM  

Respected Mr.Kumaran
I am a newcomer to this site. I have been really enriched by going through your article. Would you please explain the same once again
in the context of recent fall of price of INR ?
Awaiting your valued comments.
Regards,
Apurba Sen.

Anonymous,  May 24, 2012 at 3:39 AM  

Thanks for the info! It was really helpful to understand for a person who has very little idea of economics.

Sisir kumar Biswal,  May 24, 2012 at 5:00 AM  

Sir,
I am a student of CA Final and I gone through the article, It very easy written & understandable. It made many things clear in my mind about the increase and decrease of INR against Dollar.

Thank You

Anonymous,  June 23, 2012 at 12:59 PM  

Nice article I understood all about exchange rates
Diminishing value of rupee and how it is effecting
India Somebody said the value of one dollar
Will be Rs 60 Will this happen

bhakti June 25, 2012 at 2:05 AM  

It was really helpful to understand the rupee

Aslam AP,  July 5, 2012 at 1:22 PM  

dear sir,
you are really genius... thanks for your valuable information

chandru524 July 7, 2012 at 9:13 AM  

sir, the explanation was simply superb.... By reading this even a kid can get a good knowledge about the concept.....

chandru524 July 7, 2012 at 9:14 AM  

sir, the explanation was simply superb.... By reading this page even a kid can easily get the idea about the concept....

soumitra September 22, 2012 at 3:11 PM  

What an explantion !! I'm really surprised how easily Mr.Kumaran made me understand the value of currency,share price etc.

I salute you SIR.

Soumitra Thakur
Malda, W.B.

Anonymous,  October 8, 2012 at 3:12 AM  

great article

Forex market October 8, 2012 at 7:10 AM  

Your post is really good providing good information.. I liked it and enjoyed reading it. Keep sharing such important posts.

vish December 24, 2012 at 3:26 AM  

very thanks for the information which has been framed in a neat and easily understandabel manner., thanks a lot

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