Education

How are currency exchange rates determined ?

S. Murlidharan | Updated on February 20, 2011 Published on February 13, 2011

BL14FOREX.1   -  The Hindu



Shishir Kumar Naik, Kolkata

Exchange rates are to some extent determined by market forces only in respect of floating currencies. All currencies are not floating. Indian rupee and Chinese yuan are not, for example, whereas British pound, euro, US dollar and Japanese yen are. When a currency is not floating, its exchange rate is often fixed by authorities. For example, the yuan is pegged to the dollarAs for floating currencies , there are a number of explanations as to how the markets find the exchange rate.

Purchasing Power Parity (PPP) theory says a currency is only as strong as its purchasing power. Interest parity theory says the country offering higher rate of interest should be able to attract funds from the other and thus its currency should be stronger. All these are oversimplified theories and the truth is there are several factors at work that influence the exchange rate. The US dollar for example has been commanding a premium disproportionate to its economy's fundamentals thanks to its first mover advantage and the TINA (there is no other alternative) factor.

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Published on February 13, 2011
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