Exchange Rates and Interest Rates in Pakistan Analysis

Exchange Rates and Interest Rates in Pakistan Analysis Abstract This paper endeavors the relationship and the positive effect between exchange rates and interest rates in Pakistan by utilizing the foreign exchange market and current scenario of increasing interest rates because of increasing exchange rates to represent the economic position of Pakistan. The data by the researcher is all on daily basis for the above variables from the period of September 2001 to May 2008 for exchange rates, while for interest rates (6 month KIBOR) from the period of September 2001 to May 2008. The researcher implement regression model to test the effect of exchange rates progression on interest rates. So in this result, there is the issue of auto correlation exists and it shows the serial correlation between these variables. The issue should be resolved by taking time and KIBOR lag values as the dumm dependent variables. The study concludes on this way that there is the negative relationship between exchange rates and interest rates (KIBOR) in Pakistan and there i s the impact of time and KIBOR on KIBOR.. It identifies that when exchange rates increases, there is decreasing in interest rates (KIBOR). This results and relationship is consistent as predicted by Meese and Rogoff (1988). INTRODUCTION Every country has its own financial markets and it is the back bone of a countrys economy. The financial markets is divided in parts like foreign exchange market, stock market, money market, bond market etc. In this study, the researcher is focuses on the foreign exchange market, which is commonly known as Forex. It is the largest and most prolific part of financial market and defining the balancing of countrys economy, because every particular day, there are approximately one trillion amount of foreign exchange takes place in the countries around the world. The actual mechanism of the foreign exchange, that it is work as the main driving force for an any countys economy in the world. Therefore, any country in the world should challenge their currency in the global economic markets. In the exchange markets for all the countries, home country currencies trade with other foreign country currencies. The foreign exchange market system is needed for every developed and under developed cou ntry; this system known as currency in exchange determination. For the determination of the value of a currencys exchange rate, there are two main types of system is used, one is floating exchange rates system and the other is fixed exchange rates system. The intervention of government officials authorities in the foreign exchange market is to influence the exchange rate fluctuation as a worldwide phenomenon. The authorities intervene maintaining the objective to orderly market conditions that ultimately help to achieve the overall macroeconomic goals. However, the exchange rate has playing an important role in terms of the flexibility in macroeconomic framework to deal with changes in the external terms of trade, but the monetary policy also aims the national objectives of economic diversification and to support export competitiveness. The ineffective monetary policy under fixed exchange rates as compared to flexible exchange rates, but fiscal policy under both fixed and flexible exchange rates remains weaker of achieving the level of output. (R.A. Mundell, 1968). The level of currency risk changes, it has no negligible impact on the rates of change of exchange rates and on relatives rates of interest between currencies. (Clas Whilborg, 1982). The risk premium of the currency is the important factor relative to floating exchange rate system, but movements in the exchange rate are dominated by the non speculative activity and it has the adverse effect on world economy. (John bilson, 1985). The true statement that in many cases the sign of the estimated exchange rate-interest rate differential relationship is consistent with the possible predominance of financial market disturbance (R. Meese K. Rogoff, 1988). The consequences changes in the nominal interest rate reflect changes in the tightness of monetary policy. T he higher the interest rate in the country attracts the capital inflow, which causes the domestic currency appreciates, so this gets the relationship could be negative between the exchange rate and nominal interest rate differentials. (J.A. Frankel, 1979). The assets are dominated and exchange risks interest reflects the interest rate parity when different currencies affect political risk and thats why assets are issued in different currencies. Thus the interest differentials to the political risk of future capital control must be distinguished due to the effective tax that controls the place in interest earnings. (M.P. Dooley P. Isard, 1980). The concept of political risk is that the probability authority of the state will be interposed between investors in one country and investment opportunities in other countries that is the probability that controls the imposed on capital flows. (R.Z. Aliber, 1973). If price levels and exchange rate are significantly volatile and cannot be cos tly hedged, are adversely affected in the real value of the domestic currency. There is some evidence that exchange rate fluctuations are a priced factor in cross sections of stock return converted into a common currency. (W. Bailey P. Chung, 1995). In the perfect mobility the exchange rate movements and an adjustment of goods market is relative to asset market and consistent expectations. The extends that output responds to a monetary expansion in the short run, this acts as an effect on exchange depreciation which lead to an increase in interest rates. (Rudiger Dornbusch, 1976). The foreign exchange gain or loss is made in the course of covering; consider being capital assets, so this gain or loss treated on capital account. This shows the highly sensitive interest dynamics with exchange rates. (M.D. Levi, 1977). The variability of industrial production output will be higher in the regime of fixed exchange rates instead of regime of flexible exchange rates. (Flood Hodrick, 1986) . The effect of consumption goods purchases by the government is not the private utility, but per capita real government expenditure are the composite of individual consumption of goods. So notice that the demand of money its depends on consumption of goods rather than income and that is the important distinction of closed economies.(Obstfeld Rogoff, 1995). The fixed and floating exchange rates depend on higher welfare yield and on the nature of sticky prices, so the risk would be shared and there are some opportunities to aware. The evidence, which should give opportunities about price setting and risk sharing are not refined and not to make the definite conclusions for the optimal regime of the exchange rate of that country. There are three types of ways which gives stickiness in prices, the prices which would set by the firms in their own currencies, the firms would set the prices for consumers currencies, or firms would set the prices in the currencies of producers. (Charles En gel, 2001). When the exchange rates changes, it may cause to appear the changes in relative prices and make to generate additional uncertainty for equilibrium in markets. However, there is also defining that the changes in terms of trade would play the larger role of changes in the exchange rates which affect the variability of exchange rates. (A.C. Stockman, 1980). This study explores to investigate the determinants of exchange rates in developing country such as Pakistan. The framework of this study is concern to be conceptual and theoretical and is to set up the ground of unidirectional causality from exchange rates to economy. In principal, it determines the exchange rates relationship with interest rates so it will spurs the determinants in Pakistan with related to the economy. This view implies that the choice of an exchange rates regime be a relatively simple, if countries were faced to intervene regularly in the foreign exchange market to stabilize, therefore the monetary authorities intervene with the objective of maintaining orderly market conditions, which ultimately help to achieve the overall macroeconomic goals. The discretionary nature of the existing monetary policy in Pakistan is inflation, and it is targeting to hit on the Pakistani economy by focusing attention on the monetary policy. So the government of Pakistan is to make t heir monetary policy more transparent for achieving their explicit goal, and decreasing the inflation. Therefore, it is increasing the publics understanding of the central banks strategy to deliver the target, so the State Bank of Pakistan will help to provide an anchor for inflation expectations in the economy. The State Bank of Pakistan (SBP) has accorded a high priority to achieving a low rate of inflation, and the monetary policy also aims to support the objectives of the national country of Pakistan to meet their diversified economy and competitiveness in the export from other countries of the world. This study will also helpful to the SBP to developed their awareness of the relationship of exchange rates with KIBOR, so SBP may observed the controversy of their ups and downs fluctuations so it may controlled significantly. The bank treasury department should get the help because, they have continuously meet the exchange rates and make transactions of the countrys currency with others country currencies, so it should make them identify that if exchange rates increases or decreases it should not make effect on interest rates but their should be some inverse effect in nature. This effect should create controversy in the country economy so the central bank should make some authorized decisi on to controlled the exchange rates and interest rates The thesis is structures as follows. Chapter II provides literature review. Chapter III defines the outline of variables, their sample size, data sources and its formatting and the model. Chapter IV explains our findings and results. Finally Chapter V reports conclusion Chapter II Literature Review: This study relates to examine the relationship and effect between exchange rates with interest rates. Numbers of studies have done by the researchers, Robert A. Mundell, (1961), Bela Balassa (1964), Robert Z. Aliber, (1973), Rudiger Dornbusch, (1976), Richard A. Meese Kenneth Rogoff (1982), H.M.S Gerlach (1988), to investigate the determinants of exchange rates have applied in the world exchange rates market and help for different countries in their market development and economic growth. Researchers attempted to exemplify whether, how and to what extent the determinants of exchange rates market can contribute to the process of economic growth. Purchasing Power Parity Theory: The purchasing power parity theory doctrine means different things to different people. It has two versions of this theory that can be called the absolute and the relative interpretation. The first version of purchasing power theory calculated as a ratio of consumer goods prices for any country would tend to the equilibrium rates of exchange. In the second version of relative interpretation the rate of exchange rate would be determined between two countries and quoted with general levels of prices of two countries. It amend the international trade theory which would be the part of PPP, in which introducing the non-traded goods (services), but the advantage is greater in regards of traded goods than non-traded goods, because of the assumptions of marginal rates of transformation. The relationship between purchasing power parity and exchange rates provides the international comparison of national incomes and living standards (Bela Balassa, 1964). (Lawrence H. Officer, 1976) is the rese archer which gave another review of this purchasing power parity theory. It has define two applications in economics, the first application use of the conversion factor to transfer the data in one national way to another. The use of PPP is mainly the body of (index number theory) and applications of GDP that have improved over the years and path breaking studies in the area continue to appear. The second application of PPP has not the widespread acceptance, which has remained the unsophisticated applications. A.C. Stockman, (1980), develops the model of determination of exchange rates and prices of goods. The changes in prices of goods due to supply and demand would affect the changes in exchange rates with deviations of purchasing power parity. The changes in exchange rates have failed to resemble the changes in prices of goods, because exchange rates more volatile than prices levels and inflation rates. The research proposes the equilibrium of exchange rates behavior and different international goods that would have been traded. This relationship cannot be exploited by the government, because the greater the changes in terms of trade the larger the changes in exchange rates variability. The deviations from PPP persist that variation of exchange rates more than ratios of price indexes. The results found the two interpretation of the relationship between exchange rates and terms of trade. In the first, the causes that affect the changes in exchange rates would also affect the change in te rms of trade because prices of goods do not adjust to clear the markets. This interpretation would also found in the research of Dornbusch (1976), and Isard (1977), they formally differentiates the system with respect to exchange rates and allow prices to change but not the changing in asset stocks. The another interpretation presented the elasticity approach of the foreign exchange market and the relation between the trade and exchange rates. Real supply and demand shocks affect prices and the derived demand of exchange rates. The affect of such a shift has the advantage to raise the value of currency in terms of foreign currencies relative PPP. These changes in demand for foreign exchange would result the supply and demand shocks and that should affect the equilibrium of exchange rates. In second interpretation the expected rate of change of exchange rates revealed on the forward foreign exchange market. This should be related the anticipated change in the terms of trade and the i nflation differentials. A persuasive argument about the level of exchange rates is only associated with not causes of the relative prices changes. Clas Wihlborg, (1982), examined the relation of interest rates, exchange rate and currency risks in this research. It identifies the test which empirically impact of currency on interest rates and exchange rates. In this research there are three different ways in which the importance of currency risks for interest rate and exchange rate determination. First different risk characteristics of assets denominated in different currencies. Second changes in the level of risks that affect the elastic ties of substitutes among different assets and the monetary policy. Third changes in the level of risks on alternative assets which have a direct impact on rates of return. This research used the three specifications of the dependent variable to test the theory, firstly the rates of return is adjusted for the expected rate of changes in the exchange rates, second difference between nominal rates of interest and third rate of change of deviation from the exchange rate. The results presented here that substantiate the changes in the level of currency risk have a non-negligible impact on the rates of change of exchange rates and on relatives rates of interest between currencies. The risks explain the small share of variation in these variables. Another results indicate that the nominal interest rate seem to adjust in fiscal policies and savings behavior but not affect real rates of interest. But changes in relative risks level would affect relative rates on interest these changes still be important for the substitutability between assets of different currency denominations. Richard Meese Kenneth Rogoff, (1983), analysis the out of sample forecasting accuracy on various models. It estimated the horizons of the dollar with different country currencies, like Dutch mark, Japanese yen, and Britain pound that traded to weight the dollar exchange rates. Its also studied the flexible exchange rates with the monetary models of sticky price, so the model of sticky price, which incorporates the current account. The first model is structural models in which it requires to generate the forecasts of exchange rates and explanatory variables. It contains the explanatory power, but its predicted badly because the explanatory variables are difficult to predict. The second is the univariate times series model in which identify a variety of prefiltering techniques involve differencing, de-seasonalizing and removing time trends. The relative performance of these techniques is of interest in itself. The third model use is the random walk model; it should also link with this univariate time series model. It uses as the predictor of the current spot rate with the entire future spot rate, and it requires no estimation. In this research the performance of estimated univariate time series models or candidate structural model is so worse. From a methodological stand point the view that the out of sample model fit is an important criterion when evaluating exchange rate, but the estimation of out of sample is failure with time series models, that are well approximated the major country exchange rates. John Bilson, (1985), gives the empirical findings about macro economic and flexible exchange rate of the U.S dollar related to PPP theory. From the perspective of this research in which sluggish price adjustment in the commodity markets resulted in increased variability in exchange rates. For the demonstration of result it is important because the instability of floating exchange rate could be due to the inherent differences between commodity and foreign exchange markets. The determination of the expected future rate is impossible, because it is more difficult to reject the forward parity condition. The major part of the forward parity is the variation in the premium is due to the forecast. The object of this research is to determine that if the forward parity failed is the cause of instability in the same way that the failure of purchasing power parity. The findings develop that currency risk premium is the important factor relative to floating rate system, and movement in the excha nge rate are dominated by the non speculative activity and it has the adverse effect on world economy. Roger D. Huang, (1987), evaluate that the expected change in the exchange rate of two countries equals the expected differentials in their inflation rats over the same holding period. It makes the empirical evidence link with PPP theory and obtained that the changes in expected nominal exchange rate is appear to deviate inflation rate systematically. It relates the PPP based on the constraint that, in efficient market the net return to speculators engaging in speculation on goods in the foreign country. The purpose of this research is to know the equality restriction between expected nominal exchange rate and expected inflation rate differentials. The investigation should have the result that the evidence is inconsistent with the current floating exchange rates over the major industrialized countries. Since the test perform meaningful in conjunction with market efficiency and simply indicate the failure expectations. John Doukas Abdul Rahman, (1987), conducted the unit root test for the presence of evidence from the foreign exchange futures market, and gets the representation of foreign exchange currency future prices. The research describes the procedure from the foreign exchange future markets on five different currencies with varying maturity. It was found that presence in the series may cause the OLS estimates and its true value leading to errors, for small sample sizes the model has smaller forecast error. The process generate the log of currencies future rates by random walk, and it is consistent with other model of asset price determination that they imply the mean and dispersion of returns that don not change over short time period. But in general if follow the random walk; it is line with (Meese Singletons) findings from the spot and forward exchange market. H.J. Edison, (1987), addresses that whether PPP is valid in the long run movements in exchange rates, though it is failed in the short run. However number of studies was conduct for the behavior of exchange rates, Alder Lehmann (1983), Frankel (1986), developed more statistical techniques to examine the validity of exchange rates in the long run. Both of these have provided the evidence that PPP does not hold the exchange rates behavior in the long run. This research also incorporates the error correction mechanism and discusses the empirical results which generally show the result of failure of exchange rate support by PPP in the long run. In general, the result indicates the force which exists in the economy for driving the exchange rates towards the PPP equilibrium. The main conclusion from this research is the PPP relationship does not represents the exchange rates n the long run holding, so that the PPP permanent deviations cannot ruled out. This shows the reinforcement of PPP theory that was tested the fixed rate counterpart and the equalization of prices across countries, and it supports an interpretation of the PPP doctrine. This proportionality between the exchange rates and price level emerges in the long run. Richard Meese Kenneth Rogoff, (1988), examined the relationship between real exchange rates and real interest rate differentials from different countries. It based on the joint hypothesis that the prices of the domestic currency are sticky and the disturbances of monetary policy are predominant, which would found the little evidence of a stable relationship between interest rates and exchange rates. It is true that in many cases the sign of the estimated exchange rate and interest rate differential relationship is consistent with the possible predominance of financial market disturbances, but the relationship is not stable enough to be statistically significant. In Quasi reduced form real exchange rate models, examined the real versions of alternative rational expectations monetary models of exchange rate determination. In the nominal rate models, the exchange rate depends on fundamentals such as relative national money supplies, real incomes, short-term interest rates, expected inf lation differentials, and cumulated trade balances. The rationale view for this approach is that the nominal exchange rates poor performance is primarily attributable to money demand disturbances, so it can define the close relationship between there real interest differentials and real exchange rates, because, in the class of monetary models considered here, unanticipated money demand disturbances affect both variables proportionately. Feinberg Seth Kaplan, (1992), evaluate and interacts the real exchange rates index expectations is developed and used to explore the role of determination on domestic producer prices. The fact that time path of the exchange rate will directly affect the input costs, and the price of substitutes strongly. To examine the links between both actual and anticipated movements in the dollar and relative domestic producer prices, it chooses to analyze price responses to real exchange rate changes. The effect is dependent on the nature of substitutability between imports and domestic goods. The major finding is that the period of appreciation and depreciation over the past 10 years to inhibit the pass through in to domestic prices. In depreciation the market share to enjoy the continued good times kept prices other than expected. Warren Bailey Peter Chung, (1995), considers the study that the impact of fluctuations on exchange rates and political risk is on the risks premium and is reflected the individual equity returns. It suggests the factors which is common for emerging market equity, currency and debt markets, and make empirical implications to evaluate corporate and portfolio management. If price levels and exchange rate are significantly volatile and cannot be costly hedged, are adversely affected in the real value of the domestic currency. Some evidence that exchange rate fluctuations are a priced factor in cross sections of stock return converted into a common currency. The purpose of this research is to explore the impact of fluctuations on exchange rates and political risk which is consider on stock process of individual companies from the same country. The extent of measurement is that, which exposure factors explain cross sections of returns on individual securities and industry portfolios. The result suggests that the exchange rates and political risks could be significant in equity markets. The result also suggests that the risk premium can be time varying and not be detected by assuming constantly. This research shows the results that it did not find the evidence of the equity market premiums for the currency and political risk. It complements the importance to attach the exchange rates and political risk in the international finance. J.R. Lothian M.P. Taylor, (1996), examines the real exchange rate behavior, and explains the variations in sample of stationary univariate equations in real exchange rates. It investigates the additional insight in the exchange rates behavior that can be gained by considering the floating rate from the perspective of the data. These issues can be best understood on the subject of real exchange rates stability between the currencies of the major industrialized countries. Some of the pre-float studies support the fairly stable exchange rates in the long run. Subsequently, Dornbusch (1976), Frenkel (1981), gave largely as the result of studies published, and reject the hypothesis of random walk behavior of real exchange rates. The PPP shows the empirical movements in real exchange rates were highly persistent and effective; although the PPP is reject the hypothesis of non-stationary behavior of real exchange rates in the long run. The result of this research shows that the longest span of two countries exchange rates are significantly mean reverting. The first model result indicates the 80 percent of the variation in the exchange rates of the history data of two countries. By using of another model, the results explaining the performance of remarkably well in the floating, so that they produce better forecasts of the actual exchange rates. In line with recent studies, it fined that this process of mean reverting is quit slow, with estimated adjustment of data. In the long run the PPP equilibrium is remaining a useful empirical approximation. The deviations of the PPP that observe are consistent with the existence of slowly mean reverting influences, which may be real or monetary regimes. Theory of Optimum Currency Areas: The theory of optimum currency areas, which is usually presented the other name called flexible exchange rate system, but it is proponents as a device of depreciation that take the place of unemployment when the balance of payment is deficit and appreciation when it replace inflation when it is surplus. The problem can be exposed and more revealing by defining a currency area within when exchange rates are fixed. To this three answer can be given; first certain parts of the world are going processes of economic integration, so new experience can be made and at what constitutes the optimum currency area can give the meaning of these experiments. Second those countries that have flexible exchange rates are likely to face problems with the theory of optimum currency areas, so it does not coincide the optimum currency areas with the national currency. Third the idea that illustrates the functions of currencies which have been treated in economic literature, and sometimes neglected in the problems of economic policy. In the currency area, different currency countries including national country currencies interact pace of employment in deficit, because there is the willingness to inflation by the surplus countries. The argument for flexible exchange rate system is based on national currencies, and is valid about mobility of factor, so if it is high in the country and low in the foreign countries, the flexible exchange rates system on home country currencies might work effectively. The concept of optimum currency area has practically applicable only in those areas, where the state has the political organization in the country. The factor mobility is most considered is more relative rather than absolute concept, with both industrial and geographical. It likely to change the alterations with time over time in conditions, where the conditions of political and economic stability. Money is the convenience that restricts the optimum number of currencies, so in terms of this argument the optimum currency area which is composed in number of countries. (Robert A. Mundell, 1961). In another review the author defines the stabilization of capital mobility policy under the exchange rates which is fixed and flexible in the currencies markets; it concerns the theoretical and practical approach of the increased mobility of capital. The assumption is that the interest rate differentials from the level of abroad cannot maintain by the country, if there is the degree of mobility. The securities system are perfect substitutes, because different currencies are involved can be taken in the perfect mobilization, and there exchange rates expected to persist indefinitely, but the forward and spot exchange rate are identical. It identify the monetary and fiscal policy, in which monetary policy assumed the open market purchase of securities while fiscal policy is to form of increase in government spending and financed by an increased in public debt. Its effect the floatin g exchange rate result when monetary policy does not intervene in the exchange market, but it intervene the fixed exchange rates, when the buying and selling of international reserves at the rate of fixed price. The results of this research analyze that, the fixed exchange rates is become a device for the monetary policy and for the levels of reserve, whereas the flexible exchange rates becomes a device for the fiscal policy and for the balance of trade, but policies are unaffected to the level of output and employment. The fixed exchange rates in the perfect mobility will lead to the breakdown as the absence of gold sterilization. The gold sterilization is frustrated the capital outflows and offsetting monetary changes through the exchange rates equalization. The conclude remarks is that, the fixed exchange rates as compared to flexible exchange rates is ineffective under monetary policy, but in fiscal policy both the exchange rates either fixed or flexible are remains weaker for a chieving the level of output. The flexible exchange rates under fiscal policy to play some role in employment policy that can be expected, while monetary policy can have influence on output under fixed exchange rates. In this possibility existing, it wills lesser extent in the future. (R.A. Mundell, 1968). J.H. Makin, (1978), analysis the way to deal the risks involved in foreign exchange currency positions but exchange rates are uncertain. It incorporates the exchange rate changes with the changes in the determination of overall hedging strategy. The purpose is to survey the literature rather to examine the logic on hedge no hedge strategy and to suggest the viewing problem of exchange risk. It identifies the exchange risk diversification in two groups. First diversification investigates the exchange risk with the investor point of view selecting the locations of firms in different countries which denominated in different currencies. The second considers exchange risk with the firm manager point of view to decrease the impact of exchange rate fluctuations. The study concentrates the exchange risk and not overall corporate risk, so the analysis of co Exchange Rates and Interest Rates in Pakistan Analysis Exchange Rates and Interest Rates in Pakistan Analysis Abstract This paper endeavors the relationship and the positive effect between exchange rates and interest rates in Pakistan by utilizing the foreign exchange market and current scenario of increasing interest rates because of increasing exchange rates to represent the economic position of Pakistan. The data by the researcher is all on daily basis for the above variables from the period of September 2001 to May 2008 for exchange rates, while for interest rates (6 month KIBOR) from the period of September 2001 to May 2008. The researcher implement regression model to test the effect of exchange rates progression on interest rates. So in this result, there is the issue of auto correlation exists and it shows the serial correlation between these variables. The issue should be resolved by taking time and KIBOR lag values as the dumm dependent variables. The study concludes on this way that there is the negative relationship between exchange rates and interest rates (KIBOR) in Pakistan and there i s the impact of time and KIBOR on KIBOR.. It identifies that when exchange rates increases, there is decreasing in interest rates (KIBOR). This results and relationship is consistent as predicted by Meese and Rogoff (1988). INTRODUCTION Every country has its own financial markets and it is the back bone of a countrys economy. The financial markets is divided in parts like foreign exchange market, stock market, money market, bond market etc. In this study, the researcher is focuses on the foreign exchange market, which is commonly known as Forex. It is the largest and most prolific part of financial market and defining the balancing of countrys economy, because every particular day, there are approximately one trillion amount of foreign exchange takes place in the countries around the world. The actual mechanism of the foreign exchange, that it is work as the main driving force for an any countys economy in the world. Therefore, any country in the world should challenge their currency in the global economic markets. In the exchange markets for all the countries, home country currencies trade with other foreign country currencies. The foreign exchange market system is needed for every developed and under developed cou ntry; this system known as currency in exchange determination. For the determination of the value of a currencys exchange rate, there are two main types of system is used, one is floating exchange rates system and the other is fixed exchange rates system. The intervention of government officials authorities in the foreign exchange market is to influence the exchange rate fluctuation as a worldwide phenomenon. The authorities intervene maintaining the objective to orderly market conditions that ultimately help to achieve the overall macroeconomic goals. However, the exchange rate has playing an important role in terms of the flexibility in macroeconomic framework to deal with changes in the external terms of trade, but the monetary policy also aims the national objectives of economic diversification and to support export competitiveness. The ineffective monetary policy under fixed exchange rates as compared to flexible exchange rates, but fiscal policy under both fixed and flexible exchange rates remains weaker of achieving the level of output. (R.A. Mundell, 1968). The level of currency risk changes, it has no negligible impact on the rates of change of exchange rates and on relatives rates of interest between currencies. (Clas Whilborg, 1982). The risk premium of the currency is the important factor relative to floating exchange rate system, but movements in the exchange rate are dominated by the non speculative activity and it has the adverse effect on world economy. (John bilson, 1985). The true statement that in many cases the sign of the estimated exchange rate-interest rate differential relationship is consistent with the possible predominance of financial market disturbance (R. Meese K. Rogoff, 1988). The consequences changes in the nominal interest rate reflect changes in the tightness of monetary policy. T he higher the interest rate in the country attracts the capital inflow, which causes the domestic currency appreciates, so this gets the relationship could be negative between the exchange rate and nominal interest rate differentials. (J.A. Frankel, 1979). The assets are dominated and exchange risks interest reflects the interest rate parity when different currencies affect political risk and thats why assets are issued in different currencies. Thus the interest differentials to the political risk of future capital control must be distinguished due to the effective tax that controls the place in interest earnings. (M.P. Dooley P. Isard, 1980). The concept of political risk is that the probability authority of the state will be interposed between investors in one country and investment opportunities in other countries that is the probability that controls the imposed on capital flows. (R.Z. Aliber, 1973). If price levels and exchange rate are significantly volatile and cannot be cos tly hedged, are adversely affected in the real value of the domestic currency. There is some evidence that exchange rate fluctuations are a priced factor in cross sections of stock return converted into a common currency. (W. Bailey P. Chung, 1995). In the perfect mobility the exchange rate movements and an adjustment of goods market is relative to asset market and consistent expectations. The extends that output responds to a monetary expansion in the short run, this acts as an effect on exchange depreciation which lead to an increase in interest rates. (Rudiger Dornbusch, 1976). The foreign exchange gain or loss is made in the course of covering; consider being capital assets, so this gain or loss treated on capital account. This shows the highly sensitive interest dynamics with exchange rates. (M.D. Levi, 1977). The variability of industrial production output will be higher in the regime of fixed exchange rates instead of regime of flexible exchange rates. (Flood Hodrick, 1986) . The effect of consumption goods purchases by the government is not the private utility, but per capita real government expenditure are the composite of individual consumption of goods. So notice that the demand of money its depends on consumption of goods rather than income and that is the important distinction of closed economies.(Obstfeld Rogoff, 1995). The fixed and floating exchange rates depend on higher welfare yield and on the nature of sticky prices, so the risk would be shared and there are some opportunities to aware. The evidence, which should give opportunities about price setting and risk sharing are not refined and not to make the definite conclusions for the optimal regime of the exchange rate of that country. There are three types of ways which gives stickiness in prices, the prices which would set by the firms in their own currencies, the firms would set the prices for consumers currencies, or firms would set the prices in the currencies of producers. (Charles En gel, 2001). When the exchange rates changes, it may cause to appear the changes in relative prices and make to generate additional uncertainty for equilibrium in markets. However, there is also defining that the changes in terms of trade would play the larger role of changes in the exchange rates which affect the variability of exchange rates. (A.C. Stockman, 1980). This study explores to investigate the determinants of exchange rates in developing country such as Pakistan. The framework of this study is concern to be conceptual and theoretical and is to set up the ground of unidirectional causality from exchange rates to economy. In principal, it determines the exchange rates relationship with interest rates so it will spurs the determinants in Pakistan with related to the economy. This view implies that the choice of an exchange rates regime be a relatively simple, if countries were faced to intervene regularly in the foreign exchange market to stabilize, therefore the monetary authorities intervene with the objective of maintaining orderly market conditions, which ultimately help to achieve the overall macroeconomic goals. The discretionary nature of the existing monetary policy in Pakistan is inflation, and it is targeting to hit on the Pakistani economy by focusing attention on the monetary policy. So the government of Pakistan is to make t heir monetary policy more transparent for achieving their explicit goal, and decreasing the inflation. Therefore, it is increasing the publics understanding of the central banks strategy to deliver the target, so the State Bank of Pakistan will help to provide an anchor for inflation expectations in the economy. The State Bank of Pakistan (SBP) has accorded a high priority to achieving a low rate of inflation, and the monetary policy also aims to support the objectives of the national country of Pakistan to meet their diversified economy and competitiveness in the export from other countries of the world. This study will also helpful to the SBP to developed their awareness of the relationship of exchange rates with KIBOR, so SBP may observed the controversy of their ups and downs fluctuations so it may controlled significantly. The bank treasury department should get the help because, they have continuously meet the exchange rates and make transactions of the countrys currency with others country currencies, so it should make them identify that if exchange rates increases or decreases it should not make effect on interest rates but their should be some inverse effect in nature. This effect should create controversy in the country economy so the central bank should make some authorized decisi on to controlled the exchange rates and interest rates The thesis is structures as follows. Chapter II provides literature review. Chapter III defines the outline of variables, their sample size, data sources and its formatting and the model. Chapter IV explains our findings and results. Finally Chapter V reports conclusion Chapter II Literature Review: This study relates to examine the relationship and effect between exchange rates with interest rates. Numbers of studies have done by the researchers, Robert A. Mundell, (1961), Bela Balassa (1964), Robert Z. Aliber, (1973), Rudiger Dornbusch, (1976), Richard A. Meese Kenneth Rogoff (1982), H.M.S Gerlach (1988), to investigate the determinants of exchange rates have applied in the world exchange rates market and help for different countries in their market development and economic growth. Researchers attempted to exemplify whether, how and to what extent the determinants of exchange rates market can contribute to the process of economic growth. Purchasing Power Parity Theory: The purchasing power parity theory doctrine means different things to different people. It has two versions of this theory that can be called the absolute and the relative interpretation. The first version of purchasing power theory calculated as a ratio of consumer goods prices for any country would tend to the equilibrium rates of exchange. In the second version of relative interpretation the rate of exchange rate would be determined between two countries and quoted with general levels of prices of two countries. It amend the international trade theory which would be the part of PPP, in which introducing the non-traded goods (services), but the advantage is greater in regards of traded goods than non-traded goods, because of the assumptions of marginal rates of transformation. The relationship between purchasing power parity and exchange rates provides the international comparison of national incomes and living standards (Bela Balassa, 1964). (Lawrence H. Officer, 1976) is the rese archer which gave another review of this purchasing power parity theory. It has define two applications in economics, the first application use of the conversion factor to transfer the data in one national way to another. The use of PPP is mainly the body of (index number theory) and applications of GDP that have improved over the years and path breaking studies in the area continue to appear. The second application of PPP has not the widespread acceptance, which has remained the unsophisticated applications. A.C. Stockman, (1980), develops the model of determination of exchange rates and prices of goods. The changes in prices of goods due to supply and demand would affect the changes in exchange rates with deviations of purchasing power parity. The changes in exchange rates have failed to resemble the changes in prices of goods, because exchange rates more volatile than prices levels and inflation rates. The research proposes the equilibrium of exchange rates behavior and different international goods that would have been traded. This relationship cannot be exploited by the government, because the greater the changes in terms of trade the larger the changes in exchange rates variability. The deviations from PPP persist that variation of exchange rates more than ratios of price indexes. The results found the two interpretation of the relationship between exchange rates and terms of trade. In the first, the causes that affect the changes in exchange rates would also affect the change in te rms of trade because prices of goods do not adjust to clear the markets. This interpretation would also found in the research of Dornbusch (1976), and Isard (1977), they formally differentiates the system with respect to exchange rates and allow prices to change but not the changing in asset stocks. The another interpretation presented the elasticity approach of the foreign exchange market and the relation between the trade and exchange rates. Real supply and demand shocks affect prices and the derived demand of exchange rates. The affect of such a shift has the advantage to raise the value of currency in terms of foreign currencies relative PPP. These changes in demand for foreign exchange would result the supply and demand shocks and that should affect the equilibrium of exchange rates. In second interpretation the expected rate of change of exchange rates revealed on the forward foreign exchange market. This should be related the anticipated change in the terms of trade and the i nflation differentials. A persuasive argument about the level of exchange rates is only associated with not causes of the relative prices changes. Clas Wihlborg, (1982), examined the relation of interest rates, exchange rate and currency risks in this research. It identifies the test which empirically impact of currency on interest rates and exchange rates. In this research there are three different ways in which the importance of currency risks for interest rate and exchange rate determination. First different risk characteristics of assets denominated in different currencies. Second changes in the level of risks that affect the elastic ties of substitutes among different assets and the monetary policy. Third changes in the level of risks on alternative assets which have a direct impact on rates of return. This research used the three specifications of the dependent variable to test the theory, firstly the rates of return is adjusted for the expected rate of changes in the exchange rates, second difference between nominal rates of interest and third rate of change of deviation from the exchange rate. The results presented here that substantiate the changes in the level of currency risk have a non-negligible impact on the rates of change of exchange rates and on relatives rates of interest between currencies. The risks explain the small share of variation in these variables. Another results indicate that the nominal interest rate seem to adjust in fiscal policies and savings behavior but not affect real rates of interest. But changes in relative risks level would affect relative rates on interest these changes still be important for the substitutability between assets of different currency denominations. Richard Meese Kenneth Rogoff, (1983), analysis the out of sample forecasting accuracy on various models. It estimated the horizons of the dollar with different country currencies, like Dutch mark, Japanese yen, and Britain pound that traded to weight the dollar exchange rates. Its also studied the flexible exchange rates with the monetary models of sticky price, so the model of sticky price, which incorporates the current account. The first model is structural models in which it requires to generate the forecasts of exchange rates and explanatory variables. It contains the explanatory power, but its predicted badly because the explanatory variables are difficult to predict. The second is the univariate times series model in which identify a variety of prefiltering techniques involve differencing, de-seasonalizing and removing time trends. The relative performance of these techniques is of interest in itself. The third model use is the random walk model; it should also link with this univariate time series model. It uses as the predictor of the current spot rate with the entire future spot rate, and it requires no estimation. In this research the performance of estimated univariate time series models or candidate structural model is so worse. From a methodological stand point the view that the out of sample model fit is an important criterion when evaluating exchange rate, but the estimation of out of sample is failure with time series models, that are well approximated the major country exchange rates. John Bilson, (1985), gives the empirical findings about macro economic and flexible exchange rate of the U.S dollar related to PPP theory. From the perspective of this research in which sluggish price adjustment in the commodity markets resulted in increased variability in exchange rates. For the demonstration of result it is important because the instability of floating exchange rate could be due to the inherent differences between commodity and foreign exchange markets. The determination of the expected future rate is impossible, because it is more difficult to reject the forward parity condition. The major part of the forward parity is the variation in the premium is due to the forecast. The object of this research is to determine that if the forward parity failed is the cause of instability in the same way that the failure of purchasing power parity. The findings develop that currency risk premium is the important factor relative to floating rate system, and movement in the excha nge rate are dominated by the non speculative activity and it has the adverse effect on world economy. Roger D. Huang, (1987), evaluate that the expected change in the exchange rate of two countries equals the expected differentials in their inflation rats over the same holding period. It makes the empirical evidence link with PPP theory and obtained that the changes in expected nominal exchange rate is appear to deviate inflation rate systematically. It relates the PPP based on the constraint that, in efficient market the net return to speculators engaging in speculation on goods in the foreign country. The purpose of this research is to know the equality restriction between expected nominal exchange rate and expected inflation rate differentials. The investigation should have the result that the evidence is inconsistent with the current floating exchange rates over the major industrialized countries. Since the test perform meaningful in conjunction with market efficiency and simply indicate the failure expectations. John Doukas Abdul Rahman, (1987), conducted the unit root test for the presence of evidence from the foreign exchange futures market, and gets the representation of foreign exchange currency future prices. The research describes the procedure from the foreign exchange future markets on five different currencies with varying maturity. It was found that presence in the series may cause the OLS estimates and its true value leading to errors, for small sample sizes the model has smaller forecast error. The process generate the log of currencies future rates by random walk, and it is consistent with other model of asset price determination that they imply the mean and dispersion of returns that don not change over short time period. But in general if follow the random walk; it is line with (Meese Singletons) findings from the spot and forward exchange market. H.J. Edison, (1987), addresses that whether PPP is valid in the long run movements in exchange rates, though it is failed in the short run. However number of studies was conduct for the behavior of exchange rates, Alder Lehmann (1983), Frankel (1986), developed more statistical techniques to examine the validity of exchange rates in the long run. Both of these have provided the evidence that PPP does not hold the exchange rates behavior in the long run. This research also incorporates the error correction mechanism and discusses the empirical results which generally show the result of failure of exchange rate support by PPP in the long run. In general, the result indicates the force which exists in the economy for driving the exchange rates towards the PPP equilibrium. The main conclusion from this research is the PPP relationship does not represents the exchange rates n the long run holding, so that the PPP permanent deviations cannot ruled out. This shows the reinforcement of PPP theory that was tested the fixed rate counterpart and the equalization of prices across countries, and it supports an interpretation of the PPP doctrine. This proportionality between the exchange rates and price level emerges in the long run. Richard Meese Kenneth Rogoff, (1988), examined the relationship between real exchange rates and real interest rate differentials from different countries. It based on the joint hypothesis that the prices of the domestic currency are sticky and the disturbances of monetary policy are predominant, which would found the little evidence of a stable relationship between interest rates and exchange rates. It is true that in many cases the sign of the estimated exchange rate and interest rate differential relationship is consistent with the possible predominance of financial market disturbances, but the relationship is not stable enough to be statistically significant. In Quasi reduced form real exchange rate models, examined the real versions of alternative rational expectations monetary models of exchange rate determination. In the nominal rate models, the exchange rate depends on fundamentals such as relative national money supplies, real incomes, short-term interest rates, expected inf lation differentials, and cumulated trade balances. The rationale view for this approach is that the nominal exchange rates poor performance is primarily attributable to money demand disturbances, so it can define the close relationship between there real interest differentials and real exchange rates, because, in the class of monetary models considered here, unanticipated money demand disturbances affect both variables proportionately. Feinberg Seth Kaplan, (1992), evaluate and interacts the real exchange rates index expectations is developed and used to explore the role of determination on domestic producer prices. The fact that time path of the exchange rate will directly affect the input costs, and the price of substitutes strongly. To examine the links between both actual and anticipated movements in the dollar and relative domestic producer prices, it chooses to analyze price responses to real exchange rate changes. The effect is dependent on the nature of substitutability between imports and domestic goods. The major finding is that the period of appreciation and depreciation over the past 10 years to inhibit the pass through in to domestic prices. In depreciation the market share to enjoy the continued good times kept prices other than expected. Warren Bailey Peter Chung, (1995), considers the study that the impact of fluctuations on exchange rates and political risk is on the risks premium and is reflected the individual equity returns. It suggests the factors which is common for emerging market equity, currency and debt markets, and make empirical implications to evaluate corporate and portfolio management. If price levels and exchange rate are significantly volatile and cannot be costly hedged, are adversely affected in the real value of the domestic currency. Some evidence that exchange rate fluctuations are a priced factor in cross sections of stock return converted into a common currency. The purpose of this research is to explore the impact of fluctuations on exchange rates and political risk which is consider on stock process of individual companies from the same country. The extent of measurement is that, which exposure factors explain cross sections of returns on individual securities and industry portfolios. The result suggests that the exchange rates and political risks could be significant in equity markets. The result also suggests that the risk premium can be time varying and not be detected by assuming constantly. This research shows the results that it did not find the evidence of the equity market premiums for the currency and political risk. It complements the importance to attach the exchange rates and political risk in the international finance. J.R. Lothian M.P. Taylor, (1996), examines the real exchange rate behavior, and explains the variations in sample of stationary univariate equations in real exchange rates. It investigates the additional insight in the exchange rates behavior that can be gained by considering the floating rate from the perspective of the data. These issues can be best understood on the subject of real exchange rates stability between the currencies of the major industrialized countries. Some of the pre-float studies support the fairly stable exchange rates in the long run. Subsequently, Dornbusch (1976), Frenkel (1981), gave largely as the result of studies published, and reject the hypothesis of random walk behavior of real exchange rates. The PPP shows the empirical movements in real exchange rates were highly persistent and effective; although the PPP is reject the hypothesis of non-stationary behavior of real exchange rates in the long run. The result of this research shows that the longest span of two countries exchange rates are significantly mean reverting. The first model result indicates the 80 percent of the variation in the exchange rates of the history data of two countries. By using of another model, the results explaining the performance of remarkably well in the floating, so that they produce better forecasts of the actual exchange rates. In line with recent studies, it fined that this process of mean reverting is quit slow, with estimated adjustment of data. In the long run the PPP equilibrium is remaining a useful empirical approximation. The deviations of the PPP that observe are consistent with the existence of slowly mean reverting influences, which may be real or monetary regimes. Theory of Optimum Currency Areas: The theory of optimum currency areas, which is usually presented the other name called flexible exchange rate system, but it is proponents as a device of depreciation that take the place of unemployment when the balance of payment is deficit and appreciation when it replace inflation when it is surplus. The problem can be exposed and more revealing by defining a currency area within when exchange rates are fixed. To this three answer can be given; first certain parts of the world are going processes of economic integration, so new experience can be made and at what constitutes the optimum currency area can give the meaning of these experiments. Second those countries that have flexible exchange rates are likely to face problems with the theory of optimum currency areas, so it does not coincide the optimum currency areas with the national currency. Third the idea that illustrates the functions of currencies which have been treated in economic literature, and sometimes neglected in the problems of economic policy. In the currency area, different currency countries including national country currencies interact pace of employment in deficit, because there is the willingness to inflation by the surplus countries. The argument for flexible exchange rate system is based on national currencies, and is valid about mobility of factor, so if it is high in the country and low in the foreign countries, the flexible exchange rates system on home country currencies might work effectively. The concept of optimum currency area has practically applicable only in those areas, where the state has the political organization in the country. The factor mobility is most considered is more relative rather than absolute concept, with both industrial and geographical. It likely to change the alterations with time over time in conditions, where the conditions of political and economic stability. Money is the convenience that restricts the optimum number of currencies, so in terms of this argument the optimum currency area which is composed in number of countries. (Robert A. Mundell, 1961). In another review the author defines the stabilization of capital mobility policy under the exchange rates which is fixed and flexible in the currencies markets; it concerns the theoretical and practical approach of the increased mobility of capital. The assumption is that the interest rate differentials from the level of abroad cannot maintain by the country, if there is the degree of mobility. The securities system are perfect substitutes, because different currencies are involved can be taken in the perfect mobilization, and there exchange rates expected to persist indefinitely, but the forward and spot exchange rate are identical. It identify the monetary and fiscal policy, in which monetary policy assumed the open market purchase of securities while fiscal policy is to form of increase in government spending and financed by an increased in public debt. Its effect the floatin g exchange rate result when monetary policy does not intervene in the exchange market, but it intervene the fixed exchange rates, when the buying and selling of international reserves at the rate of fixed price. The results of this research analyze that, the fixed exchange rates is become a device for the monetary policy and for the levels of reserve, whereas the flexible exchange rates becomes a device for the fiscal policy and for the balance of trade, but policies are unaffected to the level of output and employment. The fixed exchange rates in the perfect mobility will lead to the breakdown as the absence of gold sterilization. The gold sterilization is frustrated the capital outflows and offsetting monetary changes through the exchange rates equalization. The conclude remarks is that, the fixed exchange rates as compared to flexible exchange rates is ineffective under monetary policy, but in fiscal policy both the exchange rates either fixed or flexible are remains weaker for a chieving the level of output. The flexible exchange rates under fiscal policy to play some role in employment policy that can be expected, while monetary policy can have influence on output under fixed exchange rates. In this possibility existing, it wills lesser extent in the future. (R.A. Mundell, 1968). J.H. Makin, (1978), analysis the way to deal the risks involved in foreign exchange currency positions but exchange rates are uncertain. It incorporates the exchange rate changes with the changes in the determination of overall hedging strategy. The purpose is to survey the literature rather to examine the logic on hedge no hedge strategy and to suggest the viewing problem of exchange risk. It identifies the exchange risk diversification in two groups. First diversification investigates the exchange risk with the investor point of view selecting the locations of firms in different countries which denominated in different currencies. The second considers exchange risk with the firm manager point of view to decrease the impact of exchange rate fluctuations. The study concentrates the exchange risk and not overall corporate risk, so the analysis of co