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Foreign Exchange Rates

Foreign exchange rate represents the price of one currency in terms of another currency. It can be expressed in two ways:

•    The units of domestic currency required to purchase a unit f foreign currency e.g., $ 1 = Rs. 50.

•    The units of foreign currency that can be purchased in exchange fore a unit of domestic currency, e.g., Re.1 = 2 cents.
Either way, it represents the purchasing power of domestic currency in terms of foreign currencies.
Foreign exchange rate so defined is also known as the nominal rate of exchange (NRE).

•    Effective Rate of Exchange (ERE). Whereas NRE is the purchasing power of domestic currency in terms of a foreign currency, ERE is the purchasing power of a currency in terms of a basket of currencies.

•    Real Exchange Rate (RER). National exchange relates tend to fluctuated with changes in domestic price level in either of the two countries. The rate of inflation in the two countries may not be the same, so that the relative price levels in the two countries undergo a change. PER is the NERE adjusted for eth inflation differential.

Fore example, suppose in January 2008, $ 1 = Rs. 40; further suppose between January 2008 and January 2009, the general price level in India has gone up by 6 per cent and that in the US it has gone up by 1 per cent. The inflation differential is 5 per cent. If the real exchange rate is to remain unchanged the nominal exchange rate must be

Rs. 40 + 5% of Rs. 40 = Rs. 42.00
At $ 1 = Rs. 42.00, the real exchange rate would be said to have undergone no change.

Had the nominal exchange rate moved to $ 1 Rs. 41.00, Indian rupee would be said to be overvalued. Similarly, if the nominal exchange rate moved to $ 1 = Rs. 43.00, Indian rupee would be said to be undervalued.

•    Real Effective Exchange Rate (REER). The nominal exchange rate adjusted for inflation differential with the countries in the currency basket is known as the real effective exchange rate.

•    Trade Weighted Exchange Rate (TWER). Since over time a currency can depreciate with respect to some currencies and appreciate against others, an effective exchange rate is calculated. This is a weighted average of the exchange rates between the domestic currency and the nation’s most important trade partners, with weights given by the relative importance of the nation’s trade with each of these trade partners.

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