Q. 1: Explain the Structure of Balance of Payments. Write note on India s Balance of !rade.

OR

"ns. "# S!R$%!$RE O& B"'"(%E O& P")*E(!S:+ !he Balance of Payment ,BOP# of a country is a systematic account of all economic transactions -et.een a country and the rest of the .orld/ underta0en durin1 a specific period of time. BOP is the difference -et.een all receipts from forei1n countries and all payments to forei1n countries. If the receipts exceed payments/ then a country is said to ha2e fa2oura-le BOP/ and 2ice 2ersa. "ccordin1 to %harles 3indle Ber1er 4!he BOP of a country is a systematic recordin1 of all economic transactions -et.een residents of that country and the rest of the .orld durin1 a 1i2en period of time4. !he Balance of payments record is maintained in a standard dou-le + entry -oo0 + 0eepin1 method. International transactions enter into record as credit or de-it. !he payments recei2ed from forei1n countries enter as credit and payments made to other countries as de-it. !he follo.in1 ta-le sho.s the elements of BOP. B"'"(%E O& P")*E(!S "%%O$(! Receipts ,%redits# 1. Export of 1oods. Payments ,5e-its# Imports of 1oods. !rade "ccount Balance 6. 7. Export of ser2ices. Interest/ profit and di2idends recei2ed. 4. $nilateral receipts. Import of ser2ices. Interest/ profit and di2idends paid. $nilateral payments.

%urrent "ccount Balance ,1 to 8# 5. &orei1n in2estments. 6. Short term -orro.in1s. 7. *edium and lon1 term -orro.in1. In2estments a-road. Short term lendin1. *edium and lon1 term lendin1. %apital "ccount Balance ,9 to :# 8. Errors and omissions. 9. %han1e in reser2es. ,;# !otal Reciepts !otal payments. Errors and omissions. %han1e in reser2e ,+# < !otal Payments

1.

!rade Balance :+

!rade -alance is the difference -et.een export and import of 1oods/ usually referred as 2isi-le or tan1i-le items. If the exports are more than imports/ there .ill -e trade surplus and if imports are more than exports/ there .ill -e trade deficit. 5e2elopin1 countries ha2e most of the time suffered a deficit in their -alance of payments. !he trade -alance forms a part of current account. In 6==>+=?/ trade deficit of India .as 11>.@ $S A -illion. 6. %urrent "ccount Balance :+ It is the difference -et.een the receipts and payments on account of current account .hich includes trade -alance. !he current account includes export of ser2ices/ interest/ profits/ di2idends and unilateral receipts from a-road and the import of ser2ices/ profits/ interest/ di2idends and unilateral payments a-road. !here can -e either surplus or deficit in current account. When de-its are more than credits or .hen payments are more than receipts deficit ta0es place. %urrent account surplus .ill ta0e place .hen credits are more and de-its are less. %urrent account -alance is 2ery si1nificant. It sho.s a countryBs earnin1 and payments in forei1n exchan1e. " surplus -alance stren1thens the countryBs international financial position. It could -e used for de2elopment of the country. " deficit is a pro-lem for any country -ut it creates a serious situation for de2elopin1 countries. In 6==?+1= India s current account deficit .as 7>.8 $S A -illion. 7. %apital "ccount Balance :+ It is the difference -et.een receipts and payments on account of capital account. !he transactions under this title in2ol2es inflo.s and outflo.s relatin1 to in2estments/ short term -orro.in1sI lendin1/ and medium term to lon1 term -orro.in1s C lendin1. !here can -e surplus or deficit in capital account. When credits are more than de-its surplus .ill ta0e place and .hen de-its are more than credits deficit .ill ta0e place. In 6==?+1=. India s capital account surplus .as 91.> $S A -illion. 8. Errors and Omissions :+ !he dou-le entry -oo0 + 0eepin1 principle states that for e2ery credit/ there is a correspondin1 de-it and therefore/ there should -e a -alance in BOP as .ell. In reality BOP may not -alance/ due to errors and omissions. Errors may -e due to statistical discrepancies ,differences# and omissions may -e due to certain transactions may not 1et recorded. &or E1./ remittance -y an Indian .or0in1 a-road to India may not 1et recorded etc. If the current and capital account sho.s a surplus of 6=/=== A/ then the BOP should sho. an increase of 6=/=== A. But/ if the statement sho.s an increase of 66/=== A/ then there is an error or omission of 6/=== A on credit side. 9. &orei1n Exchan1e Reser2es :+ !he -alance of forei1n exchan1e reser2e is the com-ined effect of current and capital account -alances. !he reser2es .ill increase .hen:+ a# !he surplus capital account is much more than the deficit in current account. -# !he surplus in current account is much more than deficit in capital account. c# Both the current account and capital account sho.s a surplus.

In 6==?+1= India s forei1n exchan1e reser2es increased -y 17.8 $S A -illion. Q.6. Write note on India s Balance of !rade "(S. ". I(5I" S B"'"(%E O& !R"5E:+ Balance of trade is the difference -et.een exports and imports. India s Balance of trade is mostly in deficit. !his is due to lo. share off Exports in .orld mar0et. Imports are hi1h due to petroleum/ oil and lu-ricant products. INDIAS BALANCE OF TRADE (US $ Billion) DDDDDDDDDDDDDDDD I Year 1990-91 00!-0" 009-10 E#$or%& I)$or%& Tra-e Balan.e 1'(" *(9 -9(! '"( 11'(9 - ++(* 1' ( +00(, -11'(!

India s export performance is poor. "t present/ India s share off .orld export trade is 1E. !he share of exports of other de2elopin1 countries is much more than India. B. RE"SO(S &OR POOR PER&OR*"(%E O& I(5I" S EFPOR! !R"5E !here are Se2eral reasons for India s Poor performance. Some off them are: I. 1. Export + Related Pro-lems :+ Gi1h Prices :+

"s compared to other "sian %ountries the price of Indian 1oods is hi1h. Prices are hi1h due to documentation formalities/ hi1h transaction costs H also to ma0e hi1her profits. 6. Poor + Quality :+ *any Indian exporters do not 1i2e much importance to Iuality control/ so their products are of poor Iuality. 5ue to lo. Iuality many times Indian 1oods are reJected H sent -ac0 to India -y forei1n -uyers. 7. Poor (e1otiation S0ills :+ Indian exporters lac0 (e1otiation S0ills due to poor trainin1 in *ar0etin1. !hey fail to %on2ince H induce the forei1n -uyers to place orders. 8. InadeIuate Promotion :+ &or Export *ar0etin1/ Promotion is important. *any Indian Exporters do not 1i2e much importance to promotion. " 1ood no. of Indian exporters are not professional in ad2ertisin1 H Sales promotion. !hey do not ta0e part in trade fairs H exhi-itions. 9. Poor follo.+up of sales :+ Indian exporters are ineffecti2e in pro2idin1 after+sale+ser2ice. !hey do not -other to find out the reactions of -uyers after sale. !his results in poor performance of India s export trade. II. Keneral %auses Kood 5omestic *ar0et

1.

6.

Sellers find a ready mar0et for their 1oods .ithin the country/ so they do not ta0e patns to 1et orders from o2erseas mar0ets. (um-er of formalities !here are num-er of documentation H other formalities due to .hich the some rnar0eters do not enter the export field. So there is a need to simplify formalities. Pro-lem of !radin1 Blocs !radin1 -locs reduce trade -arriers on mem-er nations/ -ut they impose trade -arriers on non+mem-ers. "s India is not a mem-er of some po.erful tradin1 -locs/ it has to face some pro-lems. (e1ati2e "ttitude Some of the o2erseas -uyers ha2e a ne1ati2e attitude to.ards Indian 1oods. !hey feel that Indian 1oods are inferior 1oods. !hus there is a need to correct this attitude. Poor Infrastructure Indian infrastructure is poor. Indian exporters find it difficult to 1et orders H also to deli2er them at time. Q. 7 : What are the !ypes of BOP

7.

8.

9.

5iseIuili-riumL OR Write note on Types of Disequilibrium in Balance of Payments. "ns. ". EQ$I'IBRI$* "(5 5ISEQ$I'IBRI$* I( BOP :+ Balance of payments is the difference -et.een the receipts from and payments to forei1ners -y residents of a country. In accountin1 sense -alance of payments/ must al.ays -alance. 5e-its must -e eIual to credits. So/ there .ill -e eIuili-rium in -alance of payments. Sym-olically/ B !"P Where : + B < Balance of Payments ! < Receipts from &orei1ners P < Payments made to &orei1ners When B < Mero/ there is said to -e eIuili-rium in -alance of payments. When B is positi2e there is fa2oura-le -alance of paymentsN When H. B is ne1ati2e there is unfa2oura-le or ad2erse -alance of payments.B When there is a surplus or a deficit in -alance of payments there is said : to -e diseIuili-rium in -alance of payments. !hus diseIuili-rium refers to im-alance in -alance of payments. B. 1. T#P$% &' D(%$)*(+(B!(*, (- B&P !he follo.in1 are the main types of diseIuili-rium in the -alance of payments:+

%tructural Dise.uilibrium /"

Structural diseIuili-rium is caused -y structural chan1es in the economy affectin1 demand and supply relations in commodity and factor mar0ets. Some of the structural diseIuili-rium are as follo.s :+ a. " shift in demand due to chan1es in tastes/ fashions/ income etc. .ould decrease or increase the demand for imported 1oods there-y causin1 a diseIuili-rium in BOP. -. If forei1n demand for a countryBs products declines due to ne. and cheaper su-stitutes a-road/ then the countryBs exports .ill decline causin1 a deficit. c. %han1es in the rate of international capital mo2ements may also cause structural diseIuili-rium. d. If supply is affected due to crop failure/ shorta1e of ra.+materials/ stri0es/ political insta-ility etc./ then there .ould -e deficit in BOP. e. " .ar or natural calamities also result in structural chan1es .hich may affect not only 1oods -ut also factors of production causin1 diseIuili-rium in BOP. f. Institutional chan1es that ta0e place .ithin and outside the country may result in BOP diseIuili-rium. &or E1. if a tradin1 -loc0 imposes additional import duties on products imported in mem-er countries of the -loc0/ then the exports of exportin1 country .ould -e restricted or reduced. !his may .orsen the BOP position of exportin1 country. 1yclical Disequilibrium :+ Economic acti2ities are su-Ject to -usiness cycles/ .hich normally ha2e four phases Boom or Prosperity/ Recession/ 5epression and Reco2ery. 5urin1 -oom period/ imports may increase considera-ly due to increase in demand for imported 1oods. 5urin1 recession and depression/ imports may -e reduced due to fall in demand on account of reduced income. 5urin1 recession exports may increase due to fall in prices. 5urin1 -oom period/ a country may face deficit in BOP on account of increased imports. %yclical diseIuili-rium in BOP may occur -ecause a. !rade cycles follo. different paths and patterns in different countries. -. Income elasticities of demand for imports in different countries are not identical. 2. c. Price elasticities of demand for imports differ in different countries. %3ort " !un Disequilibrium :+ !his diseIuili-rium occurs for a short period of one or t.o years. Such BOP diseIuili-rium is temporary in nature. Short + run diseIuili-rium arises due to unexpected contin1encies li0e failure of rains or fa2oura-le monsoons/ stri0es/ industrial peace or unrest etc. Imports may increase exports or exports may increase imports in a year due to these reasons and causes a temporary diseIuili-rium exists. International -orro.in1 or lendin1 for a short + period .ould cause short + run diseIuili-rium in -alance of payments of a country. Short term diseIuili-rium can -e corrected throu1h short + term -orro.in1s. If short + run diseIuili-rium occurs repeatedly it may pa2e .ay for lon1 + run diseIuili-rium.

0.

4.

+on. " !un ( %ecular Disequilibrium :+ 'on1 run or fundamental diseIuili-rium refers to a persistent deficit or a surplus in the -alance of payments of a country. It is also 0no.n as secular diseIuili-rium. !he causes of lon1 + term diseIuili-rium are a. %ontinuous increase in demand for imports due to increasin1 population. -. %onstant price chan1es + mostly inflation .hich affects exports on continuous -asis. c. 5ecline in demand for exports due to technolo1ical impro2ements in importin1 countries/ and as such the importin1 countries depend less on imports. !he lon1 run diseIuili-rium can -e corrected -y ma0in1 constant efforts to increase exports and to reduce imports.

5.

,onetary Dise.uilibrium *onetary diseIuili-rium ta0es place on account of inflation or deflation. 5ue to inflation/ prices of products in domestic mar0et rises/ .hich ma0es exports expensi2e. Such a situation may affect BOP eIuili-rium. Inflation also results in increase in money income .ith people/ .hich in turn may increase demand for imported 1oods. "s a result imports may turn BOP position in diseIuili-rium. $4c3an.e !ate 'luctuations /" " hi1h de1ree of fluctuation in exchan1e rate may affect the BOP position. &or E1. if Indian Rupee 1ets appreciated a1ainst dollar/ then Indian exporters .ill recei2e lo.er amounts of forei1n exchan1e/ .hereas/ there .ill -e more outflo. of forei1n exchan1e on account of hi1her imports. Such a situation .ill ad2ersely affect BOP position. But/ if domestic currency depreciates a1ainst forei1n currency/ then the BOP position may ha2e positi2e impact. ). 4 / W3at are t3e main causes of B&P Disequilibrium5 &! Discuss t3e causes of 6isequilibrium in Balance of Payments5 7,.118 "ns. ". %"$SES O& 5ISEQ$I'IBRI$* I( BOP "ny diseIuili-rium in the -alance of payment is the result of im-alance -et.een receipts and payments for imports and exports. (ormally/ the term diseIuili-rium is interpreted from a ne1ati2e an1le and therefore/ it implies deficit in BOP. !he diseIuili-rium in BOP is caused due to 2arious factors. Some of them are (. (mport " !elate6 1auses !he rise in imports has -een the most important factor responsi-le for lar1e BOP deficits. !he causes of rapid expansion of imports are :+ Population Kro.th Population Kro.th may increase the demand for imported 1oods such as food items and non food items/ to meet their 1ro.in1 needs. !hus/ increase in imports may lead to BOP diseIuili-rium. 5e2elopment Pro1ramme

6.

1.

6.

7.

Increase in de2elopment pro1rammes -y de2elopin1 countries may reIuire import of capital 1oods/ ra. materials and technolo1y. "s de2elopment is a continuous process/ imports of these items continue for a lon1 time landin1 the de2elopin1 countries in BOP deficit. Imports Of Essential Items %ountries .hich do not ha2e enou1h supply of essential items li0e %rude oil or %apital eIuipments are reIuired to import them. "1ain due to natural calamities 1o2ernment may resort to hea2y imports/ .hich ad2ersely affect the BOP position. Reduction Of Import 5uties When import duties are reduced/ imports -ecomes cheaper as such imports increases. !his increases the deficit in BOP position. Inflation Inflation in domestic mar0ets may increase the demand for imported 1oods/ pro2ided the imported 1oods are a2aila-le at lo.er prices than in domestic mar0ets. 5emonstration Effect "n increase in income coupled .ith a.areness of hi1her li2in1 standard of forei1ners/ induce people at home to imitate the forei1ners. !hus/ .hen people -ecome 2ictims of demonstration effect/ their propensity to import increases. II. Export Related %auses :+ E2en thou1h export earnin1s ha2e increased -ut they ha2e not -een sufficient enou1h to meet the risin1 imports. Exports may reduce .ithout a correspondin1 decline in imports. &ollo.in1 are the causes for decrease in exports 1. (ncrease (n Population :+ Koods .hich .ere earlier exported may -e consumed -y risin1 population. !his reduces the export earnin1s of the country leadin1 to BOP diseIuili-rium. 0. (nflation /" When there is inflation in domestic mar0et/ prices of export 1oods increases. !his reduces the demand of export 1oods .hich in turn results in trade deficit. 2. 9ppreciation &f 1urrency :+ "ppreciation of domestic currency a1ainst forei1n currencies results in lo.er forei1n exchan1e to exporters. !his demoti2ates the exporters. 4. Disco:ery &f %ubstitutes /" With technolo1ical de2elopment ne. su-stitutes ha2e come up. 'i0e plastic for ru--er/ synthetic fi-re for cotton etc. !his may reduce the demand for ra. material reIuirement. 5. Tec3nolo.ical De:elopment :+ !echnolo1ical 5e2elopment in importin1 countries may reduce their imports. !his can -e possi-le .hen they start manufacturin1 1oods .hich they .ere exportin1 earlier. !his .ill ha2e an ad2erse effect on exportin1 countries. 6. Protectionist Tra6e Policy /" Protectionist trade policy of importin1 country .ould encoura1e domestic producers -y 1i2in1 them incenti2es/ .hereas/ the imports .ould -e discoura1ed -y imposin1 hi1h duties. !his .ill affect exports. III. Other %auses :+ 1. 'li.3t of 1apital

8.

9.

@.

5ue to speculati2e reasons/ countries may lose forei1n exchan1e or 1old stoc0s. In2estors may also .ithdra. their in2estments/ .hich in turn puts pressure on forei1n exchan1e reser2es. 0. ;lobalisation Klo-alisation and the rules of W!O ha2e -rou1ht a li-eral and open en2ironment in 1lo-al trade. It has positi2e as .ell as ne1ati2e effects on imports/ exports and in2estments. Poor countries are una-le to cope up .ith this ne. en2ironment. $ltimately they -ecome loser and their BOP is ad2ersely affected. 2. 1yclical Transmission International trade is also affected -y Business cycles. Recession or depression in one or more de2eloped countries may affect the rest of the .orld. !he ne1ati2e effects of trade cycle ,lo. income/ lo. demand/ etc.# are transmitted from one country to another. &or e1. !he current financial crisis in $.S.". is affectin1 the rest of the .orld. 4. %tructural 96<ustments *any countries in recent years are under1oin1 structural chan1es. !heir economies are -ein1 li-eralised. "s a result/ in2estment/ income and other 2aria-les are chan1in1 resultin1 in chan1es in exports and imports. 5. Political factors !he existence of political insta-ility may result in disruptin1 the producti2e apparatus of the country causin1 a decline in exports and increase in imports. 'i0e.ise/ payment of .ar expenses may also serious affect diseIuili-rium in the country s BOP. !hus political factors may also produce serious diseIuili-rium in the country s BOPs. Q. 9 : Explain the different measures to correct diseIuili-rium in BOP. Examine the measures ta0en -y 1o2ernment to o2ercome crisis. OR What are the measures to -e underta0en to correct BOP diseIuili-rium. "ns. ". *E"S$RES !O %ORRE%! 5ISEQ$I'IBRI$* I( BOP :+ "ny diseIuili-rium ,deficit or surplus# in -alance of payments is -ad for normal internal economic operations and international economic relations. " deficit is more harmful for a country s economic 1ro.th/ thus it must -e corrected sooner than later. !he measures to correct diseIuili-rium can -e -roadly di2ided into four 1roups ,$9%*!$% OR BOP

the

,onetary Policy

'iscal Policy

$4c3an.e !ate Policy

-on"monetary Policy

I. 18

*onetary *easures :+ ,onetary Policy :+ !he monetary policy is concerned .ith money supply and credit in the economy. !he %entral Ban0 may expand or contract the money supply in the economy throu1h appropriate measures .hich .ill affect the prices. 9. (nflation :+ If in the country there is inflation/ the %entral Ban0 throu1h its monetary policy .ill ma0e an attempt to reduce inflation. !he %entral Ban0 .ill adopt ti1ht monetary policy. *oney supply .ill -e controlled -y increase in Ban0 Rate/ %ash Reser2e Ratio/ Statutory Ratio etc. !he monetary policy measures may reduce money supply/ and encoura1e people to sa2e more/ .hich .ould reduce inflation. If inflation is reduced/ the prices of domestic mar0et .ill decrease and also that of export 1oods. In forei1n mar0ets there .ill -e more demand for export 1oods/ .hich .ould correct BOP diseIuili-rium. B. Deflation /" 5urin1 deflation the %entral Ban0 of the country may adopt easy monetary policy. It .ill try to increase money supply and credit in the economy/ .hich .ould increase in2estment. *ore in2estment leads to more production. Surplus can -e exported/ .hich in turn may impro2e BOP position. &iscal Policy &iscal policy is 1o2ernmentBs policy on income and expenditure. Ko2ernment incurs de2elopment and non + de2elopment expenditure/. It 1ets income throu1h taxation and non + tax sources. 5ependin1 upon the situation 1o2ernments expenditure may -e increased or decreased. a# (nflation 5urin1 inflation the 1o2ernment may adopt easy fiscal policy. !he tax rates for corporate sector may -e reduced/ .hich .ould encoura1e more production and distri-ution includin1 exports. Increased exports .ill -rin1 more forei1n exchan1e there -y ma0in1 the BOP position fa2oura-le. -# Deflation 5urin1 deflation the 1o2ernment .ould adopt restricti2e fiscal policy.It may impose additional taxes on consumers or may introduce tax sa2in1 schemes. !his may reduce the consumption of citiOens/ .hich in turn may ena-le more export surplus. !o restrict imports the 1o2ernment may also impose additional tariffs or customs duties .hich may impro2e the BOP position. $4c3an.e !ate Policy &orei1n exchan1e rate in the mar0et may directly or indirectly -e influenced -y the Ko2ernment. a# De:aluation When forei1n exchan1e pro-lem is faced -y the country/ the 1o2ernment tries to reduce imports and .increase exports. !his is done throu1h de2aluation of domestic currency. $nder de2aluation/ the+ 1o2ernment ma0es a deli-erate effort to reduce the 2alue of home country. If

08

28

de2aluation is carried out/ then the exports .ill -ecome cheaper and imports costlier. !his is turn .ill help to reduce imports and increase exports.
-#

Depreciation

5epreciation li0e de2aluation lo.ers the 2alue of domestic currency or increases the 2alue of forei1n currency. 5epreciation of a countryBs currency ta0es place in free or competiti2e forei1n exchan1e mar0et due to mar0et forces. 5epreciation and de2aluation ha2e the same effect on exchan1e rate. If there is hi1h demand for forei1n currency than its supply/ it .ill appreciate and 2ice 2ersa. Go.e2er/ in se2eral countries the system of mana1ed flexi-ility is follo.ed. If there is more demand for forei1n exchan1e/ the central -an0 .ill release the forei1n currency in the mar0et from its reser2es so as to reduce the appreciation of forei1n currency. If there is less demand for forei1n exchan1e/ it .ill purchase the forei1n currency from mar0et so as to reduce the depreciation of forei1n country and appreciation of domestic currency. 5ue to de2aluation and depreciation of domestic currency/ the exports -ecome cheaper and imports -ecome expensi2e. !his helps to increase exports. (8 -on",onetary = ;eneral ,easures / " deficit country alon1 .ith monetary measures may adopt the follo.in1 non+monetary

measures too/ .hich .ill either restrict imports or promote exports. 1# !ariffs :+ !ariffs refer to duties on imports to restrict imports. !ariff is a fiscal de2ice .hich may -e used to correct an ad2erse -alance of payments. !he imposition of import duties .ill raise the prices of imports. !his .ill lead to a reduction in demand for imports there-y impro2in1 the -alance of payments position. 6# Quotas :+ $nder Quota System/ the 1o2ernment may fix and permit the maximum Iuantity or 2alue of a commodity to -e imported durin1 a 1i2en period. By restrictin1 imports throu1h Iuota system/ the deficit is reduced and the -alance of payments position is impro2ed. 7# Export Promotion :+ !he 1o2ernment may introduce a num-er of export promotion measures to encoura1e exporters to export more so as to earn 2alua-le forei1n exchan1e/ .hich in turn .ould impro2e BOP Situation. Some of the incenti2es are Su-sidies/ !ax %oncessions/ Krants/ Octroi refund/ Excise exemption/ 5uty 5ra.-ac0/ *ar0etin1 facilities etc. 8# Import Su-stitution Ko2ernments/ especially/ that of the de2elopin1 countries may encoura1e import su-stitution so as to restrict imports and sa2e 2alua-le forei1n exchan1e. !he 1o2ernment may encoura1e domestic producers to produce 1oods .hich .ere earlier imported. !he domestic producers may -e 1i2en se2eral incenti2es such as !ax holiday/ %ash Su-sidy/ "ssistance in Research H 5e2elopment/ Pro2idin1 technical assistance/ Pro2idin1 Scarce inputs etc. 9. 1&-1+*%(&- /"

&rom the a-o2e measures it is clear that more exports .ith import su-stitution -ased on economic stren1th of the country are the real effecti2e solutions to correct the diseIuili-rium in the -alance of payments.

17 " D$T$!,(-9T(&- &' $>1?9-;$ !9T$

Q. 1 : What is exchan1e rateL Go. is it determinedL "ns. "# EF%G"(KE R"!E Exchan1e rate refers to the rate at .hich a country s currencies are exchan1ed for currencies of other country. In other .ords it is the price of one currency in terms of another currency. &or E1. If the 2alue of 1 $S dollar in Indian rupees is 89 then the exchan1e rate is 1 $S A < P 89. !hus forei1n exchan1e rate indicates the external 2alue of a country s currency. It also sho.s the purchasin1 po.er of a country s currency in terms of currency of another country. O2erall .e can say that the rate of exchan1e is nothin1 -ut the 2alue or price of a country s currency expressed in terms of a forei1n currency. 5E!ER*I("!IO( O& EF%G"(KE R"!E !he rate of exchan1e -ein1 a price of national currency in terms of another/ is determined in forei1n exchan1e mar0et in accordance .ith 1eneral principle of the theory of 2alue i.e./ -y the interaction of forces of demand and supply. !hus the rate of exchan1e in the forei1n exchan1e mar0et .ill -e determined -y interaction -et.een demand for forei1n exchan1e and supply of forei1n exchan1e. 1. 5emand &or &orei1n Exchan1e &orei1n exchan1e is reIuired -y citiOens or Ko2ernment to ma0e payments a-road. !his results in demand for forei1n exchan1e. !hese payments are recorded in payment side of BOP. !he demand for forei1n currency arises due to the follo.in1 payments 9. Import Of Koods %onsumer as .ell as capital 1oods are imported from other countries. &orei1n exchan1e is demanded -y people .ho import these 1oods. Gi1her the 2alue of Imports/ hi1her is the demand for forei1n currency. (mport of ser:ices Ser2ices rendered -y other countries .hich include -an0in1/ insurance/ transport/ communication/ educational ser2ices/ etc. are reIuired to -e paid in forei1n exchan1e. 5i2idend. Interest "nd Profits In India/ many forei1n firms ha2e in2ested in 2arious sectors/ .hich results in outflo. of forei1n exchan1e on account of di2idend and profits. On other hand Ko2ernment and Indian firms ha2e also -orro.ed from forei1n countries/ .hich results in payment of Interest. $nilateral Payments 5onations/ 1ifts etc. are Bone sided payments .ithout correspondin1 returns. Such payments create demand for forei1n exchan1e. Export Of %apital Repayment of de-t/ purchase of assets in forei1n countries etc. all reIuire forei1n exchan1e. "ll the a-o2e cate1ories of payments a-road result in a11re1ate demand for forei1n exchan1e. !he total demand for forei1n currency is in2ersely related to forei1n exchan1e B.

B. 1.

D. $.

rate. "t a hi1her exchan1e rate/ the demand for forei1n currency may -e lo.. 'et us explain .ith dia1ram:

!he demand cur2e li0e an ordinary demand cur2e is slopin1 do.n.ards from left to ri1ht. "t the rate OR per unit of forei1n currency/ OQ amount is demanded. *ore is demanded at a lo.er price. 6. Supply Of &orei1n Exchan1e Supply of forei1n exchan1e in a country comes from receipts of its exports. !he receipts of forei1n currency are recorded in the receipt side of BOP. !he main sources of supply are: 9. Exports Of Koods !his constitutes a maJor source of supply of forei1n exchan1e. Both siOe and price of exports depends on demand of elasticity for 1oods. In India/ the manufactured items occupy the top position in exports. B. Exports Of Ser2ices In recent years this source is 1ainin1 importance. Expert Ser2ices in 2arious fields/ tourists comin1 from other countries/ transport/ communication/ insurance etc. are important ser2ices .hich earn and supply forei1n exchan1e. %. 5i2idend/ Interest "nd profits Indian firms ha2e in2ested in 2arious sectors in forei1n countries. !hus there is inflo. of forei1n exchan1e on account of di2idend and profits. Indian institutions also ha2e lent money a-road/ .hich results in reciept of interest. 5. $nilateral Receipts Payments recei2ed in form of remittance from domestics .or0in1 a-road/ donations etc. form a part of forei1n exchan1e supply. E. Import Of %apital

&orei1n in2estment + direct and portfolio + repayment of de-ts -y forei1ners/ all increase the supply of forei1n exchan1e. "ll the a-o2e cate1ories of receipts from a-road result in a11re1ate supply of forei1n exchan1e. !he total supply/ li0e the supply of any other commodity/ is directly related to price i.e. the forei1n exchan1e rate. "t a hi1her exchan1e rate/ the supply of forei1n currency may -e hi1h. 'et us explain .ith dia1ram

) (in US $)

7.

!he a-o2e dia1ram sho.s that the supply cur2e for forei1n exchan1e slopes up.ards from left to ri1ht .hich sho.s direct relationship -et.een exchan1e rate and demand for forei1n currency. !here is hi1her supply of forei1n currency at hi1her exchan1e rate. 5etermination Of Exchan1e Rate I 5etermination Of EIuili-rium Exchan1e Rate !he forei1n exchan1e rate is determined -y demand for and supply of forei1n exchan1e. !he rate esta-lished at a point .here demand and supply are eIual is called eIuili-rium rate of exchan1e. In other .ords an eIuili-rium rate of exchan1e is one Where there is neither a surplus nor a deficit in -alance of payments of a country. "ny chan1e in demand and supply .ill result in a chan1e in exchan1e rate.

In the a-o2e fi1ure/ the eIuili-rium rate is at E/ .here demand and supply cur2es intersect. OR is eIuili-rium exchan1e rate .hen demand for the exchan1e is eIual to its supply. OR/ and OR6are not eIuili-rium exchan1e rates. "t OR1/ 5 Q S ,i.e. Rr* Q R/(#/ and at OR6/ S Q 5 ,i.e. R6! Q R6P#. "t R/ and R6 exchan1e rates there .ill -e pressure on the pre2ailin1 rate to mo2e to.ards the eIuili-rium exchan1e rate i.e. to.ards point E. !hus exchan1e rate/ li0e any+other price is determined -y demand and supply forces in the forei1n exchan1e mar0et. "ny chan1e in demand and supply .ill result in chan1e in exchan1e rate.

<
Q. 7 : Explain the Purchasin1 Po.er Parity !heory. Write a note on PPP !heory. OR "ns. "# P$R%G"SI(K POWER P"RI!) ,PPP# !GEOR) !he %redit of Purchasin1 Po.er Parity ,PPP# !heory 1oes to S.edish economist Kusta2 %assel. "ccordin1 to this theory/ the exchan1e rate -et.een t.o countries is determined -y their purchasin1 po.er in terms of 1oods and ser2ices. !he PPP !heory is presented in t.o 2ersions the "-solute Rersion and the Relati2e Rersion. 1. "-solute Rersion Of PPP !he a-solute 2ersion of the PPP theory the exchan1e rates -et.een t.o currencies of t.o different countries is decided -y their purchasin1 po.er. In other .ords/ the rate of exchan1e .ill -e determined at the point .here the internal purchasin1 po.ers of the t.o currencies -ecome eIual. Kusta2 %assel said that the purchasin1 po.er of t.o different currencies is to -e compared only in terms of a -as0et of 1oods H ser2ices rather than a sin1le commodity. &or e1. a particular -as0et of 1oods cost P. 8/=== in India and A 1== in $.S.". !hat means the exchan1e rate .ould -e .P 8= < A 1. &ormula
!ate of $4c3an.e

<
(nternal Purc3asin. Po@er in (n6ia (nternal Purc3asin. Po@er in *.%.
! P P=

Sym-olically/

Where :+ R < Rate of exchan1e of domestic currency in relation to forei1n currency. P < Prices of certain 1oods in domestic currency Po< Prices of same 1oods in forei1n currency. "ccordin1 to a-solute PPP/ a rise in domestic price le2el in relation to forei1n price le2el .ill lead to proportional depreciation of domestic currency a1ainst forei1n currency. &or E1. If the price of -as0et of 1oods in India increases to P. 8/69=/ .hile the price of -as0et in $S" remains same/ then the ne. exchan1e rate .ill -e R < 869= < 86.9 P 1== In the a-o2e case/ the Indian P depreciates H $S A appreciates. 6. Relati2e Rersion Of PPP !he relati2e 2ersion of PPP !heory states that the exchan1e rate .ill adJust -y the amount of inflation differential -et.een the t.o countries. "ccordin1 to P.R. 3ru1man H *.O-stfeld/ S!he relati2e PPP states that the percenta1e chan1e in the exchan1e rate -et.een t.o currencies o2er any period eIuals the difference -et.een the percenta1e chan1es in national price le2els. Gere some past exchan1e rate is ta0en as -ase rate. 'ormula/" !1 < (e. EIuili-rium exchan1e rate !A < EIuili-rium rate in -ase period. P1 < (e. price Index in domestic country. P0 < (e. price Index in forei1n country. &or E1 !he price index in India increases from 1== to 7== H in $S" it increased from 1== to 6==.!he -ase rate is 8=. !hen the ne. exchan1e rate .ill -e

R < 8= x 7== < @= < ,Rs @=<1$S A#. 6== Q+8. %ritically e2aluate the Purchasin1 Po.er Parity !heory. Explain the limitations of PPP !heory. "ns. "# %RI!I%"' ER"'$"!IO( I 'I*I!"!IO(S O& PPP !GEOR) !he Purchasin1 Po.er Parity theory has follo.in1 dra.-ac0s 1. I1nores Ko2ernment Inter2ention !he PPP theory does not consider Ko2ernment or %entral Ban0 inter2ention in exchan1e rate determination. If domestic currency depreciates or appreciates too much/ the central -an0 inter2enes as it can ha2e ad2erse effects on economy. (ormally/ under mana1ed float/ the central -an0 inter2enes in exchan1e rate. 6. I1nores Quality Of Koods PPP i1nores Iuality of 1oods .hile determinin1 prices. Quality of 1oods in t.o different countries may -e different. !his pre2ents the eIualisation of prices thus it is difficult to arri2e at eIuili-rium exchan1e rate. 7. I1nores Specialisation PPP theory i1nores specialisation effect in international trade. %ountries specialise in those items in .hich they enJoy superior cost ad2anta1e and accordin1ly produce such items. But PPP theory considers relati2e purchasin1 po.er of currencies for a similar -as0et of 1oods and ser2ices. 8. I1nores !he Effect Of %han1e In Exchan1e Rate On Price 'e2el PPP theory assumes that chan1es in price le2els lead to chan1es in exchan1e rates and it does not consider the effect of chan1es in exchan1e rate on price le2el. Such an assumption is unrealistic/ as depreciation of domestic currency ma0es imports expensi2e/ there-y increasin1 price of items. 9. &aulty "ssumptions PPP theory is -ased on faulty assumptions such as lac0 of transport cost/ lac0 of trade -arriers such as custom duties and Iuotas etc. In reality international trade in2ol2es hi1her transportation cost and is also affected -y trade -arriers. @. 5oes (ot %onsider Speculation In &orei1n Exchan1e *ar0et (o.+a+days there is lot of speculation in forei1n exchan1e mar0et/ .hich affects the exchan1e rate. PPP theory does not consider speculation in forei1n exchan1e mar0et. :. 'imited "pplication !o 'ar1e %ountries &or lar1e countries li0e India/ %hina/ $.S." etc. the application of this theory is limited. !he PPP theory may ha2e applica-ility to small countries .here a lar1e part of national income comes form international trade. OR

>.

(e1lects %apital !ransfers PPP theory ta0es into account only trade in merchandise. It excludes trade in ser2ices/ capital transfers and unilateral transfers. "ll such items create demand for and supply of forei1n exchan1e. By excludin1 such factors/ the theory has limited rele2ance. !oo *uch Emphasis On Purchasin1 Po.er PPP theory places too much emphasis on purchasin1 po.er as a determinin1 factor of rate of exchan1e. It i1nores factors such as reciprocal demand of tradin1 countries .hich can influence the rate of exchan1e e2en .ith no chan1e in price le2els. B. 1&-1+*%(&-/" !hou1h PPP theory is su-Ject to 2arious limitations/ yet it has rele2ance in lon1+ term. ?.

1?9PT$!"18 " '&!$(;- $>1?9-;$ ,9!B$T

).1 / Define 'orei.n $4c3an.e an6 $4plain t3e 'unctions of 'orei.n $4c3an.e ,arCet. 7,.0A118 9ns. 98 '&!$(;- $>1?9-;$ &orei1n Exchan1e refers to forei1n currencies possessed -y a country for ma0in1 payments to other countries. It may -e defined as exchan1e of money or credit in one country for money or credit in another. It co2ers methods of payment/ rules and re1ulations of payment and the institutions facilitatin1 such payments. 9. '&!$(;- $>1?9-;$ ,9!B$T " forei1n exchan1e mar0et refers to -uyin1 forei1n currencies .ith domestic currencies and sellin1 forei1n currencies for domestic currencies. !hus it is a mar0et in .hich the claims to forei1n moneys are -ou1ht and sold for domestic currency. Exporters sell forei1n currencies for domestic currencies and importers -uy forei1n currencies .ith domestic currencies. "ccordin1 to Ells.orth/ 4" &orei1n Exchan1e *ar0et comprises of all those institutions and indi2iduals .ho -uy and sell forei1n exchan1e .hich may -e defined as forei1n money or any liIuid claim on forei1n money4. &orei1n Exchan1e transactions result in inflo. H outflo. of forei1n exchan1e. B. '*-1T(&-% &' '&!$(;- $>1?9-;$ ,9!B$T &orei1n exchan1e is also referred to as forex mar0et. Participants are importers/ exporters/ tourists and in2estors/ traders and speculators/ commercial -an0s/ -ro0ers and central -an0s. &orei1n -ill of exchan1e/ tele1raphic transfer/ -an0 draft/ letter of credit etc. are the important forei1n exchan1e instruments used in forei1n exchan1e mar0et to carry out its functions.

!he &orei1n Exchan1e *ar0et performs the follo.in1 functions. 1. Transfer &f Purc3asin. Po@er ( 1learin. 'unction !he -asic function of the forei1n exchan1e mar0et is to facilitate the con2ersion of one currency into another i.e. payment -et.een exporters and importers. &or e1. Indian rupee is con2erted into $.S. dollar and 2ice+2ersa. In performin1 the transfer function 2ariety of credit instruments are used such as tele1raphic transfers/ -an0 drafts and forei1n -ills. !ele1raphic transfer is the Iuic0est method of transferrin1 the purchasin1 po.er. 0. %redit &unction !he forei1n exchan1e mar0et also pro2ides credit to -oth national and international/ to promote forei1n trade. It is necessary as sometimes/ the international payments 1et delayed for @= days or ?= days. O-2iously/ .hen forei1n -ills of exchan1e are used in international payments/ a credit for a-out 7 months/ till their maturity/ is reIuired. &or e1. *r. " can 1et his -ill discounted .ith a forei1n exchan1e -an0 in (e. )or0 and this -an0 .ill transfer the -ill to its correspondent in India for collection of money from *r. B after the stipulated time. 2. Ged1in1 &unction " third function of forei1n exchan1e mar0et is to hed1e forei1n exchan1e ris0s. By hed1in1/ .e mean co2erin1 of a forei1n exchan1e ris0 arisin1 out of the chan1es in exchan1e rates. $nder this function the forei1n exchan1e mar0et tries to protect the interest of the persons dealin1 in the mar0et from any unforseen chan1es in exchan1e rate. !he exchan1e rates under free mar0et can 1o up and do.n/ this can either -rin1 1ains or losses to concerned parties. Ged1in1 1uards the interest of -oth exporters as .ell as importers/ a1ainst any chan1es in exchan1e rate. Ged1in1 can -e done either -y means of a spot exchan1e mar0et or a for.ard exchan1e mar0et in2ol2in1 a for.ard contract. ). 0 / $4plain t3e 6ealers or participants in forei.n e4c3an.e marCet. 7,.0A118 "ns. "# P"R!I%IP"(!S I 5E"'ERS I( &OREIK( EF%G"(KE *"R3E! &orei1n exchan1e mar0et needs dealers to facilitate forei1n exchan1e transactions. Bul0 of forei1n exchan1e transaction are dealt -y %ommercial -an0s H financial institutions. RBI has also allo.ed pri2ate authorised dealers to deal .ith forei1n exchan1e transactions i.e -uyin1 H sellin1 forei1n currency. !he main participants in forei1n exchan1e mar0ets are 1. !etail 1lients Retail %lients deal throu1h commercial -an0s and authorised a1ents. !hey comprise people/ international in2estors/ multinational corporations and others .ho need forei1n exchan1e.

0.

1ommercial BanCs %ommercial -an0s carry out -uy and sell orders from their retail clients and of their

o.n account. !hey deal .ith other commercial -an0s and also throu1h forei1n exchan1e -ro0ers. 2. 'orei.n $4c3an.e BroCers Each forei1n exchan1e mar0et centre has some authorised -ro0ers. Bro0ers act as intermediaries -et.een -uyers and sellers/ mainly -an0s. %ommercial -an0s prefer -ro0ers. 4. 1entral BanCs $nder floatin1 exchan1e rate central -an0 does not interfere in exchan1e mar0et. Since 1?:7/ most of the central -an0s inter2ened to -uy and sell their currencies to influence the rate at .hich currencies are traded. &rom the a-o2e sources demand and supply 1enerate .hich in turn helps to determine the forei1n exchan1e rate. B. !)PES O& &OREIK( EF%G"(KE *"R3E! &orei1n Exchan1e *ar0et is of t.o types retail and .holesale mar0et. 1. !etail ,arCet !he retail mar0et is a secondary price ma0er. Gere tra2ellers/ tourists and people .ho are in need of forei1n exchan1e for permitted small transactions/ exchan1e one currency for another. W3olesale ,arCet !he .holesale mar0et is also called inter-an0 mar0et. !he siOe of transactions in this mar0et is 2ery lar1e. 5ealers are hi1hly professionals and are primary price ma0ers. !he main participants are %ommercial -an0s/ Business corporations and %entral -an0s. *ultinational -an0s are mainly responsi-le for determinin1 exchan1e rate.
0.

2. a8

&t3er Participants BroCers Bro0ers ha2e more information and -etter 0no.led1e of mar0et. !hey pro2ide information to -an0s a-out the prices at .hich there are -uyers and sellers of a pair of currencies. !hey act as middlemen -et.een the price ma0ers. b8 Price TaCers Price ta0ers are those .ho -uy forei1n exchan1e .hich they reIuire and sell .hat they earn at the price determined -y primary price ma0ers.

c8
i. ii.

(n6ian 'orei.n $4c3an.e ,arCet It is made up of three tiers Gere dealin1s ta0e place -et.een RBI and "uthorised dealers ,"5s# ,mainly commercial -an0s#. Gere dealin1s ta0e place -et.een "5s

iii.

Gere "5s deal .ith their corporate customers. Q. 7 : 5efine I Explain I Write note on spot and for.ard exchan1e rates. "ns. "# EF%G"(KE R"!E !ransactions in exchan1e mar0et are carried out at .hat are termed as exchan1e rates. In forei1n exchan1e mar0et t.o types of exchan1e rate operations ta0e place. !hey are spot exchan1e rate and for.ard exchan1e rate. 1# Spot Exchan1e Rate :+ When forei1n exchan1e is -ou1ht and sold for immediate deli2ery/ it is called spot exchan1e. It refers to a day or t.o in .hich t.o currencies are in2ol2ed. !he -asic principle of spot exchan1e rate is that it can -e analysed li0e any other price .ith the help of demand and supply forces. !he exchan1e rate of dollar is determined -y intersection of demand for and supply of dollars in forei1n exchan1e. !he Remand for dollar is deri2ed from country s demand for imports .hich are paid in dollars and supply is deri2ed from country s exports .hich are sold in dollars. !he exchan1e rate determined -y mar0et forces .ould chan1e as these forces chan1e in mar0et. !he primary price ma0ers -uy ,Bid# or sell ,as0# the currencies in the mar0et and the rates continuously chan1e in a free mar0et dependin1 on demand and supply. !he primary dealer ,-an0# Iuotes t.o+.ay rates i.e./ -uy and sell rate. ,Bid# Buy Rate 1 $S A < P 89.9= ,"s0# Sell Rate 1 $S A < P 89.:9 !he -an0 is ready to -uy 1 $S A at Rs. 89.9= and sell at Rs. 89/:9. !he difference of Rs.=.69 is the profit mar1in of dealer. 08 'or@ar6 $4c3an.e !ate Gere forei1n exchan1e is -ou1ht or sold for future deli2ery i.e./ for the period of 7=/ @= or ?= days: !here are transactions for 1>= and 7@= days also. !hus/ for.ard mar0et deals in contract for future deli2ery. !he price for such transactions is fixed at the time of contract/ it is called a for.ard rate. &or.ard exchan1e rate differs from spot exchan1e rate as the former may either -e at a premium or discount. If the for.ard rate is a-o2e the present spot rate/ the forei1n exchan1e rate is said to -e at a premium. If the for.ard rate is -elo. the present spot rate/ the forei1n exchan1e rate is said to -e at a discount. !hus forei1n exchan1e rate may -e at for.ard premium or at for.ard discount. &or E1. an Indian importer may enter into an a1reement to purchase $S A 1=/=== sixty days from today at 1 $S A < Rs. 8>. (o amount is paid at the time of a1reement/ except for usual security mar1in money of a-out 1=E of the total amount. @= days form today/ the importer .ill 1et 1=/=== $S A in exchan1e for Rs. 8/>=/=== irrespecti2e of the Spot exchan1e rate pre2ailin1 on that date. a8 'actors (nfluencin. 'or@ar6 $4c3an.e !ate

i8 ii8 iii8 i:8 :8 :i8

Interest rates. 5e1ree of speculation in forei1n exchan1e mar0et. Inflation rate. &orei1n in2estor s confidence in domestic country. Economic situation in the country. Political situation in the country.

:ii8 Balance of payments position etc. b8 -ee6 'or 'or@ar6 $4c3an.e !ate 1ontracts !o o2ercome the possi-le ris0 of loss due to fluctuations in exchan1e rate/ exporters/ importers and in2estors in other countries may enter in for.ard exchan1e rate contracts. In floatin1 or flexi-le exchan1e rate system the possi-ility of .ide fluctuation in exchan1e is more. !hus/ -oth exporters and importers safe1uard their position throu1h a for.ard arran1ement. By enterin1 into such an arran1ement -oth parties minimiOe their loss. ). 8 : Write note on 9rbitra.e. Write note on (nterest rate an6 9rbitra.e. "ns. ". "RBI!R"KE "r-itra1e is the act of simultaneously -uyin1 a currency in one mar0et and sellin1 it in another to ma0e a profit -y ta0in1 ad2anta1e of exchan1e rate differences in t.o mar0ets. If the ar-itra1es are confined to t.o mar0ets only it is said St.o+pointT ar-itra1e. If they extend to three or more mar0ets they are 0no.n as Sthree+pointT or Smulti+pointT ar-itra1e. !hose .ho deal .ith ar-itra1e are called ar-itra1eurs. " Spot sale of a currency .hen com-ined .ith a for.ard repurchase in a sin1le transaction is called S%urrency S.ap4. !he S.ap rate is the difference -et.een spot and for.ard exchan1e rates in currency s.ap. "r-itra1e opportunities may exist in a forei1n exchan1e mar0et.. Suppose the rate of exchan1e is 1 $S A < P. 9= in $S mar0et and 1 $S A < P. 99 in Indian *ar0ets/ then an ar-itra1eur can -uy dollars in $S mar0et and sell it in Indian mar0et and 1et a profit of P. 9 per dollar.. In today s modern .ell connected and ad2anced mar0ets/ ar-itra1eurs ,.hich are mainly -an0s# can spot it Iuic0ly and exploit the opportunity. Such opportunities 2anish o2er a period of time and eIuili-rium is a1ain maintained. &or E1. Ban0 " Ban0 B P C A < 9=.9= C 9=.99 P C A < 9=.8= C 9=.89 OR

!he a-o2e rates are 2ery close. !he ar-itra1eur may ta0e ad2anta1e and he can purchase A 1/==/=== from Ban0 B at P. 9=.89 C a dollar and sell to it to Ban0 " at P. 9=.9=/ thus

ma0in1 a profit of =.=9. !he total profit .ould -e ,1/==/=== x =.=9# < P. 9/===. !he profit is earned .ithout any ris0 and -loc0in1 of capital. B. 9!B(T!9;$.9-D (-T$!$%T !9T$ Interest ar-itra1e refers to differences in interest rates in domestic mar0et and in o2erseas mar0ets. If interest rates are hi1her in o2erseas mar0et than in domestic mar0et/ an in2estor may in2est in o2erseas mar0et to ta0e the ad2anta1e of interest differential. Interest ar-itra1e may -e co2ered and unco2ered. 18 *nco:ere6 9rbitra.e In this system/ ar-itra1eurs .ould ta0e a ris0 to earn profit -y in2estin1 in a hi1h interest -earin1 ris0 free securities in a forei1n mar0et. Gis earnin1s .ould -e accordin1 to his calculations if the currency of forei1n mar0et .here he in2ested does not depreciate. If depreciation is eIual to the difference in interest rate/ the in2estor .ould not incur loss. Go.e2er/ if depreciation is more than interest rate/ then the ar-itra1eur .ill incur loss. &or E1. In (e. )or0 interest rate on @ month !reasury Bill is @E and in Spain it is >E. "n $S in2estor may con2ert $S dollars in E$RO and in2est in Spain/ there-y ta0in1 an ad2anta1e of ;6E interest rate. (o. .hen -ill matures/ $S in2estor .ill con2ert E$RO into dollars. Go.e2er/ -y that time E$RO may ha2e depreciated the $S in2estor .ill 1et less dollars per E$RO. If E$RO depreciates -y 1E/ $S in2estor .ill 1ain only ;1E ,;6 U 1E#. If E$RO depreciates -y 6E or more/ $S in2estor .ill not 1ain anythin1 or incur loss. If E$RO appreciates/ $S in2estor .ill 1ain/ ;6E and interest rate differential 08 1o:ere6 9rbitra.e International in2estors .ould li0e to a2oid the forei1n exchan1e ris0/ thus interest ar-itra1e is usually co2ered. !he in2estor con2erts the domestic currency for forei1n currency at the current spot rate for the purpose of in2estment. "t the same time/ in2estor sells for.ard the amount of forei1n currency .hich he is in2estin1 plus the interest that he .ill earn so as to coincide .ith maturity of forei1n in2estment. !he co2ered interest ar-itra1e refers to spot purchase of forei1n currency to ma0e in2estment and offsettin1 simultaneous for.ard sale of forei1n currency to co2er forei1n exchan1e ris0. When treasury -ills mature/ the in2estor .ill 1et the domestic currency eIui2alent of forei1n in2estment plus interest .ithout a forei1n exchan1e ris0.