A PROJECT REPORT
ON
STUDY ON FOREIGN EXCHANGE RISK
In the subject of Economics of Global Trade & Finance
SUBMITTED TO
UNIVERSITY OF MUMBAI
FOR SEMESTER II OF M.COM. ( )
BY
Name of the Student Nikilesh PillaiRoll No.
UNDER THE GUIDANCE OF
Prof.
YEAR 2012 2013
CERTIFICATE
This is to certify that the project entitled STUDY ON FOREIGN
EXCHANGE RISK. Submitted by Ms. Yogita Nath Gosavi Roll No. 217
Student of M.Com (Part-I) Banking & Finance (University of
Mumbai) Semester II examination has not been submitted for any
other examination and does not form a part of any other course
undergone by the candidate. It is further certified that she has
completed all required phases of the project. This project is
original to the best of our knowledge and has been accepted for
Internal Assessment.
Internal Examiner External Examiner
Co - Ordinator Principal
College seal
DECLARATION
Miss. YOGITA NATH GOSAVI the student of FIRST year of MCOM Part
1 (Banking and Finance) Semester 2 (2012-2013) hereby declares that
I have completed the project on STUDY ON FOREIGN EXCHANGE RISK. The
information submitted is true and original to the best of my
knowledge.
Signature of Student
ACKNOWLEDGEMENT
I wish express my sincere acknowledgement to our principal Dr.
M. R. Nair and all other who were directly or indirectly associated
with the project. In the completion for this project, support and
help of many is acknowledged.I would like to express my sincere
appreciation to Prof P.S. IYER for her guidance, patience, Inness
and wisdom with this research project, as well as all other
important aspect of this project.Additional acknowledgements go to
the Librarian for providing me with all the required reference
books for the project.Lastly, I would like to express my sincerest
appreciation towards my parents, sister and all of my extended
friends for their everlasting support and encouragement.
Signature of Student
METHODOLOGY
PRIMARY DATA:
I collected my project informations from Books. And I also
collected from my friends.
SECONDRY DATA:
I have collected my project information from internet. The
websites from were I have got the information is google.com,
Wikipedia, and from Investopedia website.
OBJECTIVES
To study the Functions of FOREIGN EXCHANGE in detail.
To find out new changes in the FOREIGN EXCHANGE RISK.
How it is benefited to the FOREIGN EXCHANGE MARKET.
To understand the FOREIGN EXCHANGE Environment.
To understand the Role of FOREIGN EXCHANGE RISK.
To see the future of FOREIGN EXCHANGE .
TABLE OF CONTENTSSR NOTOPICSPAGE NO
1INTRODUTION
2DEFINITION
3FOREIGN EXCHANGE MARKET
4NEEDS OF FOREIGN EXCHANGE
5THE ROLE OF CURRENCY AND FOREIGN EXCHANGE MARKETS
6EXCHANGE RATE
7METHODS OF EXCHANGE CONTROL
8FUNCTIONS OF FOREIGN EXCHANGE MARKETS
9FOREIGN EXCHANGE RISK MANAGEMENT
10FOREIGN EXCHANGE MANAGEMENT ACT
11DETERMINANTS OF EXCHANGE RATES
12MEASUREMENT
13CONCLUSION
INTRODUCTION OF FOREIGN - EXCHANGE RISKThis risk usually affects
businesses that export and/or import, but it can also affect
investors making international investments.For example, if money
must be converted to another currency to make a certain investment,
then any changes in the currency exchange ratewill cause that
investment's valueto either decrease or increase when the
investment is sold and converted back into the original
currency.
Definition of Foreign-Exchange Risk
The risk of an investment's value changing due to changes in
currency exchange rates. The risk that an investor will have to
close out a long or short position inaforeign currency at a lossdue
to an adverse movement in exchange rates. Also known as "currency
risk" or "exchange-rate risk"
FOREIGN EXCHANGE MARKETThe foreign exchange market (forex, FX,
or currency market) is a form of exchange for the global
decentralized trading of international currencies. Financial
centers around the world function as anchors of trading between a
wide range of different types of buyers and sellers around the
clock, with the exception of weekends. EBS and Reuters' dealing
3000 are two main interbank FX trading platforms. The foreign
exchange market determines the relative values of different
currencies.
The foreign exchange market assists international trade and
investment by enabling currency conversion. For example, it permits
a business in the United States to import goods from the European
Union member states especially Eurozone members and pay Euros, even
though its income is in United States dollars. It also supports
direct speculation in the value of currencies, and the carry trade,
speculation based on the interest rate differential between two
currencies. In a typical foreign exchange transaction, a party
purchases some quantity of one currency by paying some quantity of
another currency. The modern foreign exchange market began forming
during the 1970s after three decades of government restrictions on
foreign exchange transactions (the Bretton Woods system of monetary
management established the rules for commercial and financial
relations among the world's major industrial states after World War
II), when countries gradually switched to floating exchange rates
from the previous exchange rate regime, which remained fixed as per
the BrettonHYPERLINK
"http://en.wikipedia.org/wiki/Bretton_Woods_system" Woods
system.The foreign exchange market is unique because of the
following characteristics:its huge trading volume representing the
largest asset class in the world leading to high liquidity; its
geographical dispersion; its continuous operation: 24 hours a day
except weekends, i.e., trading from 20:15 GMT on Sunday until 22:00
GMT Friday; the variety of factors that affect exchange rates; the
low margins of relative profit compared with other markets of fixed
income; and the use of leverage to enhance profit and loss margins
and with respect to account size. As such, it has been referred to
as the market closest to the ideal of perfect competition,
notwithstanding currency intervention by central banks. According
to the Bank for International Settlements, as of April 2010,
average daily turnover in global foreign exchange markets is
estimated at $3.98 trillion, a growth of approximately 20% over the
$3.21 trillion daily volume as of April 2007. Some firms
specializing on foreign exchange market had put the average daily
turnover in excess of US$4 trillion. The $3.98 trillion break-down
is as follows: $1.490 trillion in spot transactions $475 billion in
outright forwards $1.765 trillion in foreign exchange swaps $43
billion currency swaps $207 billion in options and other
products
NEED OF FOREIGN EXCHANGE
There was a time in human civilization that money, whether in
coins or in paper, didn't exist. When you needed something, you
would have to give up one of your possessions for another's. For
example, if a farmer sees a travelling merchant visiting their
community to sell some precious and delicate china porcelains, he
would have to exchange a portion of his rice for the merchant's
china. Such an agreement is called barter where one thing is
exchanged for another that was believed to be of the same value. Of
course, this hardly ever happens now as barter, except maybe for
e-bay, as it could become a very complicated process in the
large-scale. Money has become an effective tool to make businesses
and ultimately, our daily lives, easy and simple. When you need a
commodity or service, all you need to do is to have the right
amount of money in order to have that thing you desire.Because of
globalization and with more countries opening up to the world, it
is inevitable that we become more involved with each other. The
young Koreans have found it important to see and travel the world
with a certain fondness for the beaches in the Southeast Asia. The
Americans travel all the time to France and Italy to see the latest
fashion and the great landmarks. The Africans are selling their
nicely-crafted home designs to the Europeans. All of these are
indicative as to how we are all connected, one way or another.
However, when you travel, you cannot bring your nation's money
alone and expect to live on a foreign land. This is where foreign
exchange becomes important to you.Each nation is represented by its
own national currency. The US has the American dollar while the
Japanese has the yen, just to name a few. When an American travels
to Japan, he would need to exchange his dollars to yen in order to
buy things in that country. This is called foreign exchange. In
order for him to have a benchmark as to how many yen his dollars
could buy, he would need to now the current exchange rate in local
banks or money exchange. If it says 1 dollar = 101 yen, it means
that his dollar is highly valued and could already buy 101 yen. If
the exchange rate the following day changes and becomes 1 dollar =
100 yen, his dollar had depreciated against the yen and now could
buy one yen less than the other day. A depreciation and
appreciation of a currency indicates the strength of that
particular currency and is always in reference to another
currency.Multiple countries are also doing business with each other
and this is another situation where foreign exchange becomes
important. When a Filipino exporter exports his mangoes to the US,
he does not get paid in pesos but in dollar equivalent. Foreign
exchange is an exchange of two national currencies, in this case,
the peso and the dollar.So now we have seen how foreign exchange
works and how we are affected by it one way or another. It is not
as complicated as how it looks like in the business papers. All you
need to do is to have a clear grasp on how the exchange of money
happens and you would do just fine.
THE ROLE OF CURRENCY AND FOREIGN EXCHANGE MARKETS
The role of currency is only as a tool or a means of exchanging
goods. Its value is derived from the faith people have in the
currency. For any currency to have a value, people must be able to
accept it as a means which they will part or exchange other items
for it. In itself, currency has no value. It is only how we
perceive currency that gives it value.In todays world, currency is
bought and sold in the international currency market or foreign
exchange market for those not in the financial sector. National
currencies are valued independently due to the nations central
banking system which is independent from one another. However each
currency in todays market, from the strongest to the weakest are
all dependent and interconnected with each other for purposes of
value and stability. The trading between national currencies is
important in the overall value of a single countrys currency. How
active the foreign exchange market also tells the story of what the
financial community thinks of the global economy at that time. The
foreign exchange is often the barometer for influences on the world
economy as it is often the first market to react whenever there is
a dip or boom in the global economy.The foreign currency market is
also always open. For instance, when the currency markets open in
Europe, its counterpart in Asia will be winding down to a close. As
the European market closes, the American market opens and so on and
so forth. This trading cycle continues throughout the day making it
the most active market in the world. People are always conscious of
money. Whether they are keeping track of these markets to find some
money saving tips, it is something that remains at the forefront of
many peoples minds.The players who are big in foreign exchange
market are banks, large commercial entities hedge fund, investment
firms and central banks of the nations. Hedge funds and central
banks are the two biggest influences on the foreign exchange
market. Although not all central banks do it, but some central
banks do trade in the foreign exchange market. They do this for a
multitude of reasons. Among the reasons include synchronizing the
countrys interest rates in line with the other countries and to
stabilize the currency of the country so that the import and export
of goods can be completed in an orderly manner. Some central banks
also use the foreign exchange market to control fiscal issues like
inflation.On the other hand, hedge funds represent the purely
commercial side of the foreign exchange market. Hedge funds trade
in the market with the sole purpose of taking advantage of
anomalies and market huge profits sometimes even at the expense of
destabilizing a nations currency.
EXCHANGE RATE
An exchange rate is the rate at which one currency can be
exchanged for another. In other words, it is the value of another
country's currency compared to that of your own. If you are
traveling to another country, you need to "buy" the local currency.
Just like the price of any asset, the exchange rate is the price at
which you can buy that currency. If you are traveling to Egypt, for
example, and the exchange rate for U.S. dollars is 1:5.5 Egyptian
pounds, this means that for every U.S. dollar, you can buy five and
a half Egyptian pounds. Theoretically, identical assets should sell
at the same price in different countries, because the exchange rate
must maintain the inherent value of one currency against the
other.
FIXED EXCHANGE RATES
There are two ways the price of a currency can be determined
against another. A fixed, or pegged, rate is a rate the government
(central bank) sets and maintains as the official exchange rate. A
set price will be determined against a major world currency
(usually the U.S. dollar, but also other major currencies such as
the euro, the yen or a basket of currencies). In order to maintain
the local exchange rate, the central bank buys and sells its own
currency on the foreign exchange market in return for the currency
to which it is pegged. If, for example, it is determined that the
value of a single unit of local currency is equal to US$3, the
central bank will have to ensure that it can supply the market with
those dollars. In order to maintain the rate, the central bank must
keep a high level of foreign reserves. This is a reserved amount of
foreign currency held by the central bank that it can use to
release (or absorb) extra funds into (or out of) the market. This
ensures an appropriate money supply, appropriate fluctuations in
the market (inflation/deflation) and ultimately, the exchange rate.
The central bank can also adjust the official exchange rate when
necessary.
FLOATING EXCHANGE RATES
Unlike the fixed rate, a floating exchange rate is determined by
the private market through supply and demand. A floating rate is
often termed "self-correcting," as any differences in supply and
demand will automatically be corrected in the market. Look at this
simplified model: if demand for a currency is low, its value will
decrease, thus making imported goods more expensive and stimulating
demand for local goods and services. This in turn will generate
more jobs, causing an auto-correction in the market. A floating
exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed
regime, market pressures can also influence changes in the exchange
rate. Sometimes, when a local currency reflects its true value
against its pegged currency, a "black market (which is more
reflective of actual supply and demand) may develop. A central bank
will often then be forced to revalue or devalue the official rate
so that the rate is in line with the unofficial one, thereby
halting the activity of the black market.
METHODS OF EXCHANGE CONTROL
The various methods of exchange control may broadly be
classified into two types, direct and indirect. Direct methods of
exchange control include those devices which are adopted by
governments to have an effective control over the exchange rate,
while indirect methods are designed to regulate international
movements of goods.There are many ways to introduce exchange
control in an economy. These are usually classified into two
groups:(i) Direct Exchange Control and(ii) Indirect Exchange
Control.Direct Methods of Exchange Control: In direct exchange
control, certain measures are adopted which effectuate immediate
direct restriction on foreign exchange from all sides - its
quantum, use and allocation.In general, direct exchange control
includes measures like:(i) Intervention;(ii) Exchange
restrictions;(iii) Exchange clearing agreements;(iv) Payment
agreements; and(v) Gold policy.Intervention: It refers to the
government's intervention or interference in the free working of
the exchange market with a view to overvalue or undervalue the
country's currency in terms of foreign money.The government or its
agency - the central bank - can intervene in the free market by
resorting to buying and selling the home currency against foreign
currency in the foreign exchange market to support or depress the
exchange rate of its currency.Pegging Operations: Government
intervention in the foreign exchange market takes the from of of
the currency of the country to a chosen ratepegging down or pegging
up of exchange. Since undervaluation or overvaluation is not the
equilibrium rate, it has to be pegged. Thus, pegging means keeping
a fixed exchange value of a currency; however, intervention may be
practised by a government without resorting to pegging as
such.Pegging operations take the form of buying and selling of the
local currency by the central bank of a country in exchange for the
foreign currency in the foreign exchange market, in order to
maintain an exchange rate whether, it is overvalued or undervalued.
Pegging up means pegging down pegging may be holding fixed
overvaluation, i.e., to maintain the exchange rate at a higher
level. Pegging down means holding fixed undervaluation, i.e., to
maintain the exchange rate at a lower (depressed) level. In the
case of pegging up, the central bank shall have to keep itself
ready to buy unlimited amount of local currency in exchange for
foreign currencies at a fixed rate, because overvaluation tends to
increase the demand for foreign currencies by creating import
surplus.In the case of pegging down, the central bank or central
agency shall have to keep itself ready to sell any amount to local
currency by creating export surplus. Similarly, pegging up involves
holding of sufficient amount of foreign currencies while pegging
down involves holding of sufficient amount of local currency by the
central bank. It goes without saying that pegging up, is more
difficult to maintain as it requires huge amounts of foreign
currencies which is difficult to obtain. As such pegging up can be
adopted only as a temporary expedient.It should be noted that
intervention by a government in the foreign exchange market has the
effect of neutralising the forces of demand and supply of foreign
exchange. However, it is generally assumed that government
intervention or pegging up and pegging down operations should be
used as temporary expedients to remove fluctuations in the exchange
rate.Exchange Restrictions: Exchange restrictions refer to the
policy or measures adopted by a government which restrict or
compulsory reduce the flow of home currency in the foreign exchange
market. Exchange restrictions may be of three types:(i) The
government may centralise all trading in foreign exchange with
itself or a central authority, usually the central bank; (ii) the
government may prevent the exchange of local currency against
foreign currencies without its permission; (iii) the government may
order all foreign exchange transactions to be made through its
agency.Exchange restrictions may take various forms, the most
common of them being: (1) Blocked accounts, (2) Multiple exchange
rates.Blocked Accounts: Under the condition of severe financial
crisis, a debtor country may adopt the scheme of blocking the
accounts of its creditors. In 1931, Germany, for instance, had done
so in order to have exchange restrictions.Blocked accounts refer to
bank deposits, securities and other assets held by foreigners in a
country which denies them conversion of these into their home
currency. Blocked accounts, thus, cannot be converted into the
creditor country's currency. Under the blocked accounts scheme, all
those who have to make payments to any foreign country will have to
make them not to the foreign creditor directly but to the central
bank of the country which will keep the amount in the name of the
foreign creditor. This amount will not be available to the
foreigners in their own currency, but can be used by them for
purchase in the controlling country.Blocked accounts system has two
drawbacks: (i) It reduces international trade to a minimum, and
(ii) it leads to black-marketing in foreign exchange.Multiple
Exchange Rates: In the early thirties, Germany had initiated the
device of multiple rates, as a weapon to improve her balance of
payments position. Under this system, different exchange rates are
set for different classes and categories of exports and imports.
Generally a low rate, i.e., low prices of foreign money in terms of
domestic currency, is confined to imports of necessary items having
an inelastic demand, while a high penalty rate is fixed for the
imports of luxury items. In short, the multiple exchange rates
system implies official price discriminatory policy in foreign
exchange transactions.By simply fixing a high exchange rate for a
commodity, the government can check its imports (when its
elasticity of demand for import is greater than unity). Similarly,
its imports can be encouraged by fixing a low exchange
rate.Likewise, the export of a commodity can be encouraged by
setting a high rate of exchange. Thus, the device of multiple
exchange rates can be effectively used by the government for making
short-term adjustments in the balance of payments, without
resorting to quantitative restrictions and licensing. Indeed,
multiple exchange rates amount to discriminatory export taxation
and varying rates of tariffs on imports.In other words, the system
of multiple exchange rates in essence is a form of discriminatory
partial devaluation, because instead of devaluing the currency for
the whole of foreign trade, under this system, the currency is
devalued for imports and exports of goods with an elasticity
greater than unity and appreciating the currency for goods with an
elasticity less than unity. It is thus more effective in bringing
about the desired effect on the level of trade and thereby, improve
the balance of payments.Thus, the main merit of the system of
multiple exchange rates is that it allows more effective control of
the balance of payments. Secondly, it also contains disguised
subsidies and tariffs, which may encourage or discourage trade in
certain goods and affect the level of foreign trade.Apparently,
buying foreign exchange at a rate above the equilibrium rate
amounts to subsidisation of exports, while selling foreign exchange
at a rate above the equilibirum rate amounts to a tariff on
imports.Another merit of the system is that it enables the
government to yield revenue by buying foreign exchange at low
prices in domestic money from exporters and then selling it at
higher prices to importers.However, the system has the following
drawbacks:Instead of correcting the balance of payments, it
adversely affects the growth of international trade and the
maximisation of world output and welfare.(ii) It puts too much
arbitrary powers into the hands of the government to influence
foreign trade.(iii) It creates undue complexities in calculation,
due to different exchange rates for different imports and exports
which may be changed from time to time, resulting in uncertainty in
foreign trade.(iv) The system has a formidable administrative
problem of effective control. Utmost vigilance has to be maintained
against the undervaluation of export invoices and overvaluation of
import invoices and care should be taken to see that exporters do
not sell their proceeds of foreign exchange in the black-market and
importers do make specific and proper use of the allotted foreign
exchange. Further, the system is also likely to breed corruption.We
may thus, conclude with Ellsworth that exchange control by the
system of multiple exchange rates is only a partial solution to
devaluation, and introduces uncertainties and distortions of its
own.Exchange Clearing Agreements: European countries had adopted
this form of exchange control in the Thirties. It was a system for
the direct bilateral bartering of goods on a national scale. Under
this device, two countries engaged in trade pay to their respective
central banks the amounts payable to their respective foreign
creditors.These central banks then use the money in offsetting the
corresponding claims after fixing the value of the currencies by
mutual agreement. And, importers have to deposit their payment with
the central bank can use such money to pay the domestic
exporters.This economises exchange needs for trade. Therefore,
exchange clearing device is helpful to a country which has little
or no foreign exchange reserves and which is more interested in
selling than buying. However, this system is essentially one of
offsetting each other's payments, and the basic assumption is that
countries entering into such an agreement should try to equalise
their imports and exports so that, there will be no necessity for
either making or receiving payments from the other countries.
Following are the drawbacks of exchange clearing agreements:(i)
There is a possibility of exploitation of an economically weaker
country by a stronger country.(ii) The exchange clearing agreements
involve bilateral transactions in foreign trade, which cause a
diversion of normal trade pattern and endanger the promotion of
world trade.(iii) This device also reduces the volume of
international trade. Besides, it attempts to do away with the
foreign exchange market.(iv) The scheme requires that all payments
have to be centralised.Payment Agreements: To overcome the
difficulties of the problems of waiting and centralisation of
payments observed in clearing agreements, the device is formed as
payment agreements. Under this scheme, a creditor is paid as soon
as informants.Under this scheme, a creditor is paid as soon as
information is received by the central bank of the debtor country
from the creditor country's central bank that its debtor has
discharged his obligation and vice versa. By designing the
arrangement for mutual credit facilities, thus, possibilities of
delay are ruled out. Payment Agreements have the advantage that
direct relation between exporters and importers are
maintained.However, payment agreements suffer from two defects:(i)
The agreement accounts could only be debited or credited for
licensed payments.(ii) The balances in the accounts could only be
used for payment from one partner to another.Gold Policy: Through a
suitable gold policy, the country can bring the desired exchange
control. For this, the country may resort to the manipulation of
the buying and selling prices of gold which affect the exchange
rate of the country's currency. In 1936, for instance, the U.K.,
France and U.S.A. signed the Tripartite Agreement in this regard
for fixing a suitable purchase and sale price of gold.Indirect
Methods of Exchange Control : Apart from the direct methods, there
are several indirect methods also regulating the rates of exchange.
Important ones are briefly discussed below.Changes in Interest
Rates: Changes in interest rate tend to influence indirectly the
foreign exchange rate. A rise in the interest rate of a country
attracts liquid capital and banking funds of foreigners. It will
tend to keep their funds in their own country. All this tends to
increase the demand for local currency and consequently the
exchange rate move in its favour. It goes without saying that, a
lowering of the rate of interest will have the opposite
effect.Tariffs Duties and Import Quotas: The most important
indirect method is the use of tariffs and import quotas and other
such quantitative restrictions on the volume of foreign trade.
Import duty reduces imports and with it rise the value of home
currency relative to foreign currency. Similarly, export duty
restricts exports; as a result, the value of home currency falls
relative to foreign currencies. In short, when import duties and
quotas are imposed, the rate of exchange tends to go up in favour
of the controlling country.
Export Bounties: Export bounties of subsidies increase exports.
As such the external value of the currency of the subsidy-giving
country rises.It should be noted that import duties and export
bounties are treated as indirect instruments of exchange control
only if they are imposed with the object of conserving the foreign
exchange. Otherwise, the fundamental aim of import duty is merely
to check imports and that of export bounty is to encourage
exports.In fine, interest rates, import duty or export subsidy,
each has its limitations. For instance, import duty cannot go so
far as to completely restrict imports. There is also the fear of
retaliation in regard to tariff policy. Similarly, the volume of
subsidy depends upon the support of public fund. Likewise,
manipulation of exchange rate through changes in interest rate may
not be always effective. Moreover, rates of interest cannot be
raised to any limit without engendering depression.Concluding
Remarks: There are various forms in which the exchange control
system may be devised. Each form has its own merits and demerits
and each one serves a specific purpose. Therefore, the whole
economic situation of foreign trade of a country must be carefully
viewed while resorting to exchange control and more than one
methods must be combined together.In so far as the correction of
disequilibirum is concerned, it should be noted that exchange
control does not basically solve the problem, it only prevents the
situation from becoming worse.Moreover, exchange control is always
an inhibiting factor to an expanding world trade. With its adoption
the gains from international trade are reduced and channels of
trade are distorted. It also checks the flow of international
investments which are very essential for the planned development of
world's economic resources. In normal peace times, therefore, it
has hardly anything to commend. That is why; International Monetary
Fund also has mentioned the removal of exchange controls as one of
its major objectives.
FUNCTIONS OF FOREIGN EXCHANGE MARKETS
To detail the functions of the foreign exchange market (FOREX),
we need an understanding of what a foreign currency exchange market
is, what it does, why we need it, and the benefits it has on
monetary systems of all participating countries. Starting with a
simple explanation given by Ball, McCulloch, Frantz, Geringer, and
Minor (2006 p.166), FOREX "is a place where monies can be bought,
sold, or borrowed". FOREX locations are in various countries and
cities, but the major FOREX locations are in London, New York,
Tokyo, and Singapore (Ball et al., 2006).As previously stated the
FOREX provides a place for nations to purchase, borrow, or sell
their own currency to members of other nations. So what does the
FOREX do? FOREX provides the resources for countries to make
payments and transfer funds across borders, and provides purchasing
power from one currency to another (Cross, 1998). Cross explains
that these provisions make valuations of currency available to
determine one of the greatest functions of the FOREX, the exchange
rate.The exchange rate, as determined by Cross (1998), is "a price
determined by the number of units of one nation's currency that
must be surrendered in order to acquire one unit of another
nation's currency". Cross continues to explain that the exchange
rate between two currencies is dependent upon official or private
participants to buy and sell its currency to maintain an authorized
pegged rate. The exchange rates in FOREX are set then by the market
and not by governments (Ball et al., 2006), thus referred to as the
floating currency exchange rate. Other approaches to determining
the exchange rate like the purchasing power parity (PPP) theory
which states that exchange rates in the long run will adjust to
equalize the purchasing power of differing currencies (Ball et al.,
2006). Therefore, products in competitive markets will sell for
identical prices when valued in the same currency (Cross, 1998).
The PPP relies on a portion of another approach in determining
exchange rates, balance of payments (BOP). BOP approach relies on
assessing foreign exchange flows and evaluating balance of payments
on current and capital accounts (Cross, 1998). Even with these
determinations, the biggest player in defining the exchange rates
rely on supply and demand of American goods and
currency.International business relies directly on the
functionality of the FOREX. In addition to international business,
citizens traveling to foreign nations have to a standard in which
they can pay for foreign goods and services. FOREX make these
situations possible. As we know, every nation has its own currency
and monetary system. The FOREX makes it possible for U.S. citizens
to travel to foreign nations and by goods and services in forms
acceptable to foreigners (Cross, 1998). Whether the business in the
foreign country accepts the dollar at a determined exchange rate or
the U.S. citizen exchanges their dollars at a bank for a foreign
currency, business transactions can be made. The same can be said
for foreign businesses investing in American owned companies or
vice versa, cross boarder purchases and investments are able to be
made.The international use of currency creates many benefits to
issuing countries. First, it obtains profit from minting coins,
because the noninterest-bearing claims on it are expressed in its
own currency and is able to do this by unexpectedly inflating its
currency (Tavlas, 1998). Second, as Tavlas states, as the
international use of a currency expands, loans, investments, and
purchases of goods and services will increasingly be executed
through the financial institutions of the issuing country". Thus,
we can say that another function of FOREX is the participation in
the growth of developing nations; helping to eliminate poverty and
internationalize their goods and services.
FIXED EXCHANGE - RATE SYSTEM
A fixed exchange-rate system (also known as pegged exchange rate
system) is a currency system in which governments try to maintain
their currency value constant against one another.[1] In a fixed
exchange-rate system, a countrys government decides the worth of
its currency in terms of either a fixed weight of gold, a fixed
amount of another currency or a basket of other currencies. The
central bank of a country remains committed at all times to buy and
sell its currency at a fixed price. The central bank provides
foreign currency needed to finance payments imbalances.
Types Of Fixed Exchange Rate Systems
The gold standardUnder the gold standard, a countrys government
declares that it will exchange its currency for a certain weight in
gold. In a pure gold standard, a countrys government declares that
it will freely exchange currency for actual gold at the designated
exchange rate. This "rule of exchange allows anyone to go the
central bank and exchange coins or currency for with pure gold or
vice versa. The gold standard works on the assumption that there
are no restrictions on capital movements or export of gold by
private citizens across countries.Because the central bank must
always be prepared to give out gold in exchange for coin and
currency upon demand, it must maintain gold reserves. Thus, this
system ensures that the exchange rate between currencies remains
fixed. For example, under this standard, a 1 gold coin in the
United Kingdom contained 113.0016 grains of pure gold, while a $1
gold coin in the United States contained 23.22 grains. The mint
parity or the exchange rate was thus: R = $/ = 113.0016/23.22 =
4.87.[6] The main argument in favour of the gold standard is that
it ties the world price level to the world supply of gold, thus
preventing ination unless there is a gold discovery (a gold rush,
for example). Price specie flow mechanismThe automatic adjustment
mechanism under the gold standard is the price specie flow
mechanism, which operates so as to correct any balance of payments
disequilibria and adjust to shocks or changes. This mechanism was
originally introduced by Richard HYPERLINK
"http://en.wikipedia.org/wiki/Richard_Cantillon"Cantillon and later
discussed by David Hume in 1752 to refute the mercantilist
doctrines and emphasize that nations could not continuously
accumulate gold by exporting more than their imports.The
assumptions of this mechanism are: Prices are exible All
transactions take place in gold There is a xed supply of gold in
the world Gold coins are minted at a xed parity in each country
There are no banks and no capital ows Adjustment under a gold
standard involves the flow of gold between countries resulting in
equalization of prices satisfying purchasing power parity, and/or
equalization of rates of return on assets satisfying interest rate
parity at the current fixed exchange rate. Under the gold standard,
each country's money supply consisted of either gold or paper
currency backed by gold. Money supply would hence fall in the
deficit nation and rise in the surplus nation. Consequently,
internal prices would fall in the deficit nation and rise in the
surplus nation, making the exports of the deficit nation more
competitive than those of the surplus nations. The deficit nation's
exports would be encouraged and the imports would be discouraged
till the deficit in the balance of payments was eliminated. Reserve
currency standardIn a reserve currency system, the currency of
another country performs the functions that gold has in a gold
standard. A country fixes its own currency value to a unit of
another countrys currency, generally a currency that is prominently
used in international transactions or is the currency of a major
trading partner. For example, suppose India decided to fix its
currency to the dollar at the exchange rate E/$ = 45.0. To maintain
this fixed exchange rate, the Reserve Bank of India would need to
hold dollars on reserve and stand ready to exchange rupees for
dollars (or dollars for rupees) on demand at the specified exchange
rate. In the gold standard the central bank held gold to exchange
for its own currency; with a reserve currency standard it must hold
a stock of the reserve currency.Currency board arrangements are the
most widespread means of fixed exchange rates. Under this, a nation
rigidly pegs its currency to a foreign currency, Special drawing
rights (SDR) or a basket of currencies. The central bank's role in
the country's monetary policy is therefore minimal. CBAs have been
operational in many nations like Hong Kong (since 1983); Argentina
(1991 to 2001); Estonia (1992 to 2010); Lithuania (since 1994);
Bosnia and Herzegovina (since 1997); Bulgaria (since 1997); Bermuda
(since 1972); Denmark (since 1945); Brunei (since 1967) [12]
Gold exchange standard
The fixed exchange rate system set up after World War II was a
gold-exchange standard, as was the system that prevailed between
1920 and the early 1930s.[13] A gold exchange standard is a mixture
of a reserve currency standard and a gold standard. Its
characteristics are as follows:All non-reserve countries agree to
fix their exchange rates to the chosen reserve at some announced
rate and hold a stock of reserve currency assets. The reserve
currency country fixes its currency value to a fixed weight in gold
and agrees to exchange on demand its own currency for gold with
other central banks within the system, upon demand. Unlike the gold
standard, the central bank of the reserve country does not exchange
gold for currency with the general public, only with other central
banks. Hybrid exchange rate systemsThe current state of foreign
exchange markets does not allow for the rigid system of fixed
exchange rates. At the same time, freely floating exchange rates
expose a country to volatility in exchange rates. Hybrid exchange
rate systems have evolved in order to combine the characteristics
features of fixed and flexible exchange rate systems. They allow
fluctuation of the exchange rates without completely exposing the
currency to the flexibility of a free float.
Basket-of-currenciesCountries often have several important trading
partners or are apprehensive of a particular currency being too
volatile over an extended period of time. They can thus choose to
peg their currency to a weighted average of several currencies
(also known as a currency basket) . For example, a composite
currency may be created consisting of hundred rupees, 100 Japanese
yen and one U.S. dollar the country creating this composite would
then need to maintain reserves in one or more of these currencies
to satisfy excess demand or supply of its currency in the foreign
exchange market.A popular and widely used composite currency is the
SDR, which is a composite currency created by the International
Monetary Fund (IMF), consisting of a fixed quantity of U.S.
dollars, euros, Japanese yen, and British pounds.
Crawling pegsIn a crawling peg system a country fixes its
exchange rate to another currency or basket of currencies. This
fixed rate is changed from time to time at periodic intervals with
a view to eliminating exchange rate volatility to some extent
without imposing the constraint of a fixed rate. Crawling pegs are
adjusted gradually, thus avoiding the need for interventions by the
central bank (though it may still choose to do so in order to
maintain the fixed rate in the event of excessive fluctuations).
Pegged within a bandA currency is said to be pegged within a band
when the central bank specifies a central exchange rate with
reference to a single currency, a cooperative arrangement, or a
currency composite. It also specifies a percentage allowable
deviation on both sides of this central rate. Depending on the band
width, the central bank has discretion in carrying out its monetary
policy. The band itself may be a crawling one, which implies that
the central rate is adjusted periodically. Bands may be
symmetrically maintained around a crawling central parity (with the
band moving in the same direction as this parity does).
Alternatively, the band may be allowed to widen gradually without
any pre-announced central rate. Currency boardsA currency board
(also known as 'linked exchange rate system")effectively replaces
the central bank through a legislation to fix the currency to that
of another country. The domestic currency remains perpetually
exchangeable for the reserve currency at the fixed exchange rate.
As the anchor currency is now the basis for movements of the
domestic currency, the interest rates and inflation in the domestic
economy would be greatly influenced by those of the foreign economy
to which the domestic currency is tied. The currency board needs to
ensure the maintenance of adequate reserves of the anchor currency.
It is a step away from officially adopting the anchor currency
(termed as dollarization or euroization).
Dollarization/euroizationThis is the most extreme and rigid manner
of fixing exchange rates as it entails adopting the currency of
another country in place of its own. The most prominent example is
the eurozone, where 17 seventeen European Union (EU) member states
have adopted the euro () as their common currency. Their exchange
rates are effectively fixed to each other. There are similar
examples of countries adopting the U.S. dollar as their domestic
currency- British Virgin Islands, Caribbean Netherlands, East
Timor, Ecuador, El Salvador, Marshall Islands, Federated States of
Micronesia, Palau, Panama, Turks and Caicos Islands.
Advantages
A fixed exchange rate may minimize instabilities in real
economic activity[14] Central banks can acquire credibility by
fixing their country's currency to that of a more disciplined
nation On a microeconomic level, a country with poorly developed or
illiquid money markets may fix their exchange rates to provide its
residents with a synthetic money market with the liquidity of the
markets of the country that provides the vehicle currency A fixed
exchange rate reduces volatility and fluctuations in relative
prices It eliminates exchange rate risk by reducing the associated
uncertainty It imposes discipline on the monetary authority
International trade and investment ows between countries are
facilitated Speculation in the currency markets is likely to be
less destabilizing under a fixed exchange rate system than it is in
a flexible one, since it does not amplify fluctuations resulting
from business cycles Fixed exchange rates impose a price discipline
on nations with higher inflation rates than the rest of the world,
as such a nation is likely to face persistent deficits in its
balance of payments and loss of reserves [6]
Disadvantages
The need for a fixed exchange rate regime is challenged by the
emergence of sophisticated derivatives and financial tools in
recent years, which allow rms to hedge exchange rate HYPERLINK
"http://en.wikipedia.org/wiki/Currency_risk"uctuations The
announced exchange rate may not coincide with the market
equilibrium exchange rate, thus leading to excess demand or excess
supply The central bank needs to hold stocks of both foreign and
domestic currencies at all times in order to adjust and maintain
exchange rates and absorb the excess demand or supply Fixed
exchange rate does not allow for automatic correction of imbalances
in the nation's balance of payments since the currency cannot
appreciate/depreciate as dictated by the market It fails to
identify the degree of comparative advantage or disadvantage of the
nation and may lead to inefficient allocation of resources
throughout the world There exists the possibility of policy delays
and mistakes in achieving external balance The cost of government
intervention is imposed upon the foreign exchange market
FOREIGN EXCHANGE RATE RISK
When you conduct business overseas, you will have to convert
currencies involved at some prevailing exchange rate. The price of
one country's currency in terms of another country is called the
exchange rate. When the currency of one country depreciates (drops
in value), there will be a corresponding appreciation of value in
another country's currency. Depreciation occurs when it takes more
currency to purchase the currency of another country. Appreciation
is just the opposite; the currency is able to purchase more units
of the other country's currency. Since most currencies are valued
according to the marketplace, there are constant changes to
exchange rates. This gives rise to exchange rate risk. There are
several ways to reduce exchange rate risk. Two popular approaches
are hedging and netting. Hedging is where you buy or sell a forward
exchange contract to cover liabilities or receivables that are
denominated in a foreign currency. Forward exchange contracts
offset the gains or losses associated with foreign receivables or
payables. A very popular form of hedging is the Interest Rate Swap.
Interest rate swaps are arrangements whereby two companies located
in different countries agree to exchange or swap debt-servicing
obligations. This swap helps each company avoid the risks of
changes in the foreign currency exchange rates. Due to the
popularity of interest rate swaps, most major international banks
offer interest rate swaps for organizations concerned about foreign
exchange rate risks when making interest payments. The costs
charged by banks for interest rate swaps is relatively low. Another
solution to foreign exchange rate risk is the use of netting.
Netting is the practice of maintaining an equal level of foreign
receivables against foreign payables. The net position is zero and
thus exchange rate risk is avoided. If you expect the currency to
depreciate in value, than you should hold a net liability position
since it will take fewer units of currency to pay the foreign
currency debt. If you expect the currency to appreciate in value,
then you would want to have a net receivable position to take
advantage of the increased purchasing power of the foreign
currency. There are other vehicles for dealing with exchange rate
risk, such as option hedges and other types of derivatives.
However, the costs and risks associated with these types of
arrangements can be much higher than a simple approach such as the
interest rate swap. If you have exchange rate exposure, then take a
look at simple hedges and netting as ways of avoiding foreign
exchange rate risk.When companies conduct business across borders,
they must deal in foreign currencies. Companies must exchange
foreign currencies for home currencies when dealing with
receivables, and vice versa for payables. This is done at the
current exchange rate between the two countries. Foreign exchange
risk is the risk that the exchange rate will change unfavorably
before the currency is exchanged.FOREIGN EXCHANGE RISK
MANAGEMENT
Your business is open to risks from movements in competitors'
prices, raw material prices, competitors' cost of capital, foreign
exchange rates and interest rates, all of which need to be
(ideally) managed. This section addresses the task of managing
exposure to Foreign Exchange movements. These Risk Management
Guidelines are primarily an enunciation of some good and prudent
practices in exposure management. They have to be understood, and
slowly internalized and customized so that they yield positive
benefits to the company over time. It is imperative and advisable
for the Apex Management to both be aware of these practices and
approve them as a policy. Once that is done, it becomes easier for
the Exposure Managers to get along efficiently with their task.
FOREIGN EXCHANGE MANAGEMENT ACT
The Foreign Exchange Management Act (FEMA) was passed in the
winter session of Parliament in 1999 replacing Foreign Exchange
Regulation Act. This act seeks to make offenses related to foreign
exchange civil offenses. It extends to the whole of India. , which
replaced Foreign Exchange Regulation Act (FERA), had become the
need of the hour since FERA had become incompatible with the
pro-liberalisation policies of the Government of India. has brought
a new management regime of Foreign Exchange consistent with the
emerging framework of the World Trade HYPERLINK
"http://en.wikipedia.org/wiki/World_Trade_Organisation"Organisation
(WTO). It is another matter that the enactment of FEMA also brought
with it the Prevention of Money Laundering Act 2002, which came
into effect from 1 July 2005.Unlike other laws where everything is
permitted unless specifically prohibited, under this act everything
was prohibited unless specifically permitted. Hence the tenor and
tone of the Act was very drastic. It required imprisonment even for
minor offences. Under FERA a person was presumed guilty unless he
proved himself innocent, whereas under other laws a person is
presumed innocent unless he is proven guilty.MAIN FEATURES
Activities such as payments made to any person outside India or
receipts from them, along with the deals in foreign exchange and
foreign security is restricted. It is FEMA that gives the central
government the power to impose the restrictions.
Restrictions are imposed on people living in India who carry out
transactions in foreign exchange, foreign security or who own or
hold immovable property abroad.
Without general or specific permission of the Reserve Bank of
India, FEMA restricts the transactions involving foreign exchange
or foreign security and payments from outside the country to India
the transactions should be made only through an authorised
person.
Deals in foreign exchange under the current account by an
authorised person can be restricted by the Central Government,
based on public interest.
Although selling or drawing of foreign exchange is done through
an authorised person, the RBI is empowered by this Act to subject
the capital account transactions to a number of restrictions.
People living in India will be permitted to carry out transactions
in foreign exchange, foreign security or to own or hold immovable
property abroad if the currency, security or property was owned or
acquired when he/she was living outside India, or when it was
inherited to him/her by someone living outside India.
Exporters are needed to furnish their export details to RBI. To
ensure that the transactions are carried out properly, RBI may ask
the exporters to comply to its necessary requirements.
DETERMINANTS OF EXCHANGE RATES
The following theories explain the fluctuations in exchange
rates in a floating exchange rate regime (In a fixed exchange rate
regime, rates are decided by its government)
International parity conditions: Relative Purchasing Power
Parity, interest rate parity, Domestic Fisher effect, International
Fisher effect. Though to some extent the above theories provide
logical explanation for the fluctuations in exchange rates, yet
these theories falter as they are based on challengeable
assumptions [e.g., free flow of goods, services and capital] which
seldom hold true in the real world.
Balance of payments model (see exchange rate): This model,
however, focuses largely on tradable goods and services, ignoring
the increasing role of global capital flows. It failed to provide
any explanation for continuous appreciation of dollar during 1980s
and most part of 1990s in face of soaring US current account
deficit.
Asset market model (see exchange rate): views currencies as an
important asset class for constructing investment portfolios.
Assets prices are influenced mostly by people's willingness to hold
the existing quantities of assets, which in turn depends on their
expectations on the future worth of these assets. The asset market
model of exchange rate determination states that the exchange rate
between two currencies represents the price that just balances the
relative supplies of, and demand for, assets denominated in those
currencies.
None of the models developed so far succeed to explain exchange
rates and volatility in the longer time frames. For shorter time
frames (less than a few days) algorithms can be devised to predict
prices. It is understood from the above models that many
macroeconomic factors affect the exchange rates and in the end
currency prices are a result of dual forces of demand and supply.
The world's currency markets can be viewed as a huge melting pot:
in a large and ever-changing mix of current events, supply and
demand factors are constantly shifting, and the price of one
currency in relation to another shifts accordingly. No other market
encompasses (and distills) as much of what is going on in the world
at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value,
are not influenced by any single element, but rather by several.
These elements generally fall into three categories: economic
factors, political conditions and market psychology.
FINANCIAL INSTRUMENTS
SPOTA spot transaction is a two-day delivery transaction (except
in the case of trades between the US Dollar, Canadian Dollar,
Turkish Lira, EURO and Russian Ruble, which settle the next
business day), as opposed to the futures contracts, which are
usually three months. This trade represents a direct exchange
between two currencies, has the shortest time frame, involves cash
rather than a contract; and interest is not included in the
agreed-upon transaction.FORWARDOne way to deal with the foreign
exchange risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed
upon future date. A buyer and seller agree on an exchange rate for
any date in the future, and the transaction occurs on that date,
regardless of what the market rates are then. The duration of the
trade can be one day, a few days, months or years. Usually the date
is decided by both parties. Then the forward contract is negotiated
and agreed upon by both parties.SWAPThe most common type of forward
transaction is the swap. In a swap, two parties exchange currencies
for a certain length of time and agree to reverse the transaction
at a later date. These are not standardized contracts and are not
traded through an exchange. A deposit is often required in order to
hold the position open until the transaction is
completed.FUTUREFutures are standardized forward contracts and are
usually traded on an exchange created for this purpose. The average
contract length is roughly 3 months. Futures contracts are usually
inclusive of any interest amounts.OPTIONA foreign exchange option
(commonly shortened to just FX option) is a derivative where the
owner has the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed
exchange rate on a specified date. The options market is the
deepest, largest and most liquid market for options of any kind in
the world.MEASUREMENTIf foreign exchange markets are efficient such
that purchasing power parity, interest rate parity, and the
international Fisher effect hold true, a firm or investor needn't
protect against foreign exchange risk due to an indifference toward
international investment decisions. A deviation from one or more of
the three international parity conditions generally needs to occur
for an exposure to foreign exchange risk. Financial risk is most
commonly measured in terms of the variance or standard deviation of
a variable such as percentage returns or rates of change. In
foreign exchange, a relevant factor would be the rate of change of
the spot exchange rate between currencies. Variance represents
exchange rate risk by the spread of exchange rates, whereas
standard deviation represents exchange rate risk by the amount
exchange rates deviate, on average, from the mean exchange rate in
a probability distribution. A higher standard deviation would
signal a greater currency risk. Economists have criticized the
accuracy of standard deviation as a risk indicator for its uniform
treatment of deviations, be they positive or negative, and for
automatically squaring deviation values. Alternatives such as
average absolute deviation and semivariance have been advanced for
measuring financial risk. Value at RiskPractitioners have advanced
and regulators have accepted a financial risk management technique
called value at risk (VAR), which examines the tail end of a
distribution of returns for changes in exchange rates to highlight
the outcomes with the worst returns. Banks in Europe have been
authorized by the Bank for International Settlements to employ VAR
models of their own design in establishing capital requirements for
given levels of market risk. Using the VAR model helps risk
managers determine the amount that could be lost on an investment
portfolio over a certain period of time with a given probability of
changes in exchange rates.
CONCLUSION
Derivative use for hedging is only to increase due to the
increased global linkages andvolatile exchange rates. Firms need to
look at instituting a sound risk managementsystem and also need to
formulate their hedging strategy that suits their specific
firmcharacteristics and exposures.In India, regulation has been
steadily eased and turnover and liquidity in the foreigncurrency
derivative markets has increased, although the use is mainly in
shortermaturity contracts of one year or less. Forward and option
contracts are the morepopular instruments. Regulators had initially
only allowed certain banks to deal in thismarket however now
corporates can also write option contracts. There are manyvariants
of these derivatives which investment banks across the world
specialize in,and as the awareness and demand for these variants
increases, RBI would have torevise regulations. For now, Indian
companies are actively hedging their foreign exchanges risks with
forwards, currency and interest rate swaps and different types of
options such as call,put, cross currency and range-barrier options.
The high use of forward contracts byIndian firms also highlights
the absence of a rupee futures exchange in India.However, the Dubai
Gold and Commodities Exchange in June, 2007 introducedRupee- Dollar
futures that could be traded on its exchanges and had provided
anotherroute for firms to hedge on a transparent basis. There are
fears that RBIs ability tocontrol the partially convertible
currency will be subdued by this introduction but thisissue is
beyond the scope of this study. The partial convertibility of the
Rupee will bedifficult to control if many exchanges offer such
instruments and that will be factor toconsider for the RBI.