Modern Exchange Rate Theory and a Sandwich Made of Dollar Bills

Rs.66.49/$, Rs.66.82/$, Rs.66.03/$, Rs.67.01/$.. Have you ever looked at the financial page of a newspaper and wondered how the value of the Rupee moves everyday? There’s a famous theory in International Finance that states that currency values are random. That is to say, their movements do not have a logic and hence, cannot be predicted.

But the general understanding otherwise is that currency rates go up and down due to two basic factors in Economics that you might have already heard of: Supply and Demand.

main-qimg-4b3dd0b900395089191edbc4aa0960c5
(Source: Investopedia)

Before knowing how currencies move, there has to be a basic understanding of how Supply, Demand and by extension, Price are related. Supply is inversely related to Demand and Demand is directly related to Price (This also means that Supply is inversely related to Price). This is Economics. But this is the boring kind of explanation.

We can understand this phenomenon with a more interesting example. Assume that you need to have sandwich for breakfast everyday. There’s no other option. Now, would you give Rs.1000 to get that sandwich? That sound crazy, right? But what if there were only 10 sandwiches in your entire locality? Would you pay the Rs.1000, considering there are handful of other people who also want them? What if there was only 10 sandwiches in the entire country? Would you then pay Rs.5000, Rs.10000? You have to. Because you need the sandwich and the supply is low. So you are willing to pay a higher price to get it.

Now flip it around. Imagine that every other shop in your locality and millions of shops in the country sell sandwiches. Would you still pay Rs.1000? Rs.100? If a shop is selling it at Rs.50 or below, you’d probably get it from there. Why do you do this? Because the supply is humongous. If you feel that one shop has priced the sandwich higher, you can go to the next one. You have several options. You are only willing to pay the least possible price or at least a price that is comparatively very low for a good sandwich.

The same is the case with currencies, because a currency is nothing but another commodity, albeit with very different properties. In this case, the foreign currency is the sandwich.

main-qimg-4905fe55d8736b8c122f23576df3adfe-c-1

Let us say that the current price of the Dollar-Sandwich is Rs.67.14. Whenever more people in India demand for more Dollar-Sandwiches, the price will move to Rs.67.14, Rs.67.85, Rs.68.21 and so on, upwards. When this happens, we say that the Indian Rupee is depreciating against the Dollar (Or that the Dollar is appreciating against the Indian Rupee). When the demand for Dollar-Sandwiches fall, the the price of one Dollar-Sandwich moves from Rs.67.14 to Rs.66.98, Rs.66.02 and so on below. When this happens, we say that the Indian Rupee is appreciating against the Dollar (or that the Dollar is depreciating against the Indian Rupee).

That’s all there is to it.

This article is written by Dinesh Sairam (PGDM, XIME-B, Batch 21)

Investment Gyaan from the Oracle of Omaha

Warren Buffet, also called “The Oracle of Omaha” is known world-wide for being super-rich. But more than his ascent to a luxurious life, his simple and sometimes whimsical gyaan on investment is what’s most sought after by aspiring investors. Here, we will see 10 of his time-tested investment wisdom and what they mean.

 

20150226155143-warren-buffett
(Source: Entrepreneur)

 

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

 

The stock market is made up of people who want to sell stocks and those who want to buy stocks. Whatever price the buyer agrees to pay for a stock becomes the stock’s price. What Mr. Buffet is trying to say here is that, even if the market shut down for 10 years, provided you are holding the stocks of a very good company, it would still be profitable when the market re-opens, that is to say, people would be willing to pay a bomb for the share you bought at a considerably low price.

 

“Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”

 

One very good long-term investment is better than several mediocre short-term investments.

 

“Price is what you pay. Value is what you get.”

 

This quote summarize the entire ‘value investing’ strategy of Mr. Buffet. The price that you pay to pick up a stock is the money you are willing to commit in order to obtain all the future cash flows of the business to the extent of your stake in it. Make sure that this additional ‘value’, or the returns in excess of your expectations, provided by the company is well worth the money you are committing to the business.

 

“Be fearful when others are greedy. Be greedy only when others are fearful.”

 

When people buy stocks just because everyone else is buying, the stock becomes overvalued and becomes a bad investment. On the flip side, panic selling of a stock opens up opportunities for the long-term investor to purchase good companies at a cheaper price, therefore increasing their returns. Look forward for these opportunities.

 

“Risk comes from not knowing what you’re doing.”

 

More than anything else, Mr. Buffet emphasizes on investing in businesses that the investor understands. Legend has it that once Bill Gates approached Buffet to convince him to invest in Microsoft, which had some operational issues at that time. Buffet politely declined, stating that he has no knowledge of computers. Imagine telling “no” to business of the richest man in the world! But as an iron rule, a good investor should only invest in businesses he knows in-and-out.

 

“It’s only when the tide goes out that you learn who has been swimming naked.”

 

When everyone is spending in the economy and every business seems to be doing well, it is hard to differentiate a good business from the bad. Only during times of crisis, you can figure out which businesses close shop and which survive. A good businesses always survives.

 

“Do not save what is left after spending. Instead, spend what is left after saving.”

 

The saving habit is the crucial difference between a good investor and a bad investor. You may create mountains of wealth, but if you do not have the habit of saving, there’s a good chance that the wealth will be eroded eventually.

 

“Forecasts tell you a great deal about the forecaster; they tell you nothing about the future.”

 

In investment, the ‘fundamentals’ (Qualitative factors) of a company have a much higher weightage in determining its value than the ‘technicals’ (Quantitative factors). In fact, good fundamentals automatically lead to good technicals.

 

“I try to buy stocks in businesses that are so wonderful that an idiot can run them because sooner or later, one will.”

 

Invest in a business because you believe in the core-competency of the business and you believe that they can maintain it for a long, long time. Don’t invest in the business because the current CEO is an inspirational person. The CEO can be and will be replaced. The core competency stays with the business.

 

“What we learn from history is that people don’t learn from history.”

 

Change is the order of the day. History may repeat itself, but it definitely does not repeat itself in the same manner. Reading the past information of a business is important, but the winning trick is in understanding what the past information means for the future of the business.

 

Albert Einstein once said “Everything should be as simple as possible, but no simpler.” How fitting it is to Warren Buffet’s case!

 

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)