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m.com. Module5 Sem II

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    -. Pr"+ii"n ") cre,it intr(&ent an, cre,it#For the purpose of transferring credit credit instruments are used. These are in the formof telegraphic transfer foreign exchange bill drafts etc. 6nstruments with time period i.e.a bill of foreign exchange of *8 days can be discounted before the due date. uch apro!ision enables to obtain credit from the commercial banks or authorized agents.

    . C"+erage ri$:

    Exporter and importers may co!er the possible risk due to a future change in theexchange rate through forward exchange market.

    Thus Foreign Exchange 9arket plays !ery important role in

    ) Transfer funds through one currency of a country to another currency.-) 2ro!ision of short term credit to finance trade between countries through !arious

    credit instruments.,) :nd to facilitate a!oidance of foreign exchange risks or pro!ision of 4edging 3

    speculation facilities.

    Met!", ") )"reign pa-&ent:

    The Foreign Exchange 9arket performs its functions through !arious methods of Foreignpayments are made in the currency of the country to when the payments is to be madebut countries mostly prefer u.s. dollars. 2ayment is made through ;emand ;raftTelegraphic transfer mail Transfer $ankers che&ue $ills of Exchange tra!ellers che&ue.6nternational credit card or by international money orders.

    F"reign E#c!ange Tranacti"n:

    Following are the important transaction carried out in the Foreign Exchange 9arket.

    ./ Sp"t E#c!ange Mar$et:

    pot exchange is a type of foreign exchange transaction in which immediate deli!ery orexchange of currency on the spot takes place. The foreign exchange transaction in!ol!esthe payment and receipt of the foreign exchange within two business days after the daythe transaction is agreed.

    The exchange rate at which the transaction takes place is the spot rate. The spot exchangerate is determined by immediate market demand supply of foreign exchange.

    0/ F"r*ar, E#c!ange Mar$et:6n the forward exchange market the foreign exchange is bought and sold for deli!ery atfuture date at an agreed rate today. The rate at which the forward exchange contract isagreed upon is called the forward rate. The usual forward exchange contract is for month , months < months * months and year. :s compared the spot rate the forwardrate may be at par at discount or at premium.

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    At par:

    The foreign exchange rate is at par when it &uoted at a rate e&ual to the spot rate at thetime of making the contract.

    At pre&i(&:

    =hen one unit of a currency buys more units of another currency in the forward rate thanin the spot rate the former is at a premium. The premium is usually expressed as a

    percentage de!iation from the spot rate on a per annum basis.

    At ,ic"(nt:

    =hen the forward rate is lower than the spot rate the former is at discount. The discountis usually expressed as a percentage de!iation from the spot rate per annum.

    '/ FLEXI'LE EXCHANGE RATES

    Meaning: Flexible floating or fluctuating exchange rates are determined by marketforces. The monetary authority does not inter!ene for the purpose of influencing theexchange rate.

    1"r$ing ") )%e#i2%e e#c!ange rare:'nder flexible exchange rate system if there is anexcess supply of a currency the !alue of that currency in foreign exchange markets willfall. 6t will lead to depreciation of the exchange rate. %onse&uently e&uilibrium will berestored in the exchange market. >n the other hand shortage of a currency will lead toappreciation of exchange rate thereby leading to restoration of e&uilibrium in theexchange market. These market forces operate automatically without any inter!ention on

    the part of monetary authority. This is illustrated in the following diagram.

    ? ; : $

    E-

    E 2

    @ E 4 ; > A A- A A, A B

    3(antit- ") M"ne- S(pp%-

    ,

    Rate ofExchange

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    6n the abo!e diagram ;; and are the demand and supply cur!es of currency whichintersects at point 2 and the e&uilibrium exchange rate E is determined.

    uppose the exchange rate rises to E- the &uantity of currency ("s.) supplied. >A , ismore than &uantity demanded >A-. =hen currency is in excess supply the price ofcurrency in terms of other currency (say dollars) will depreciate now less currency (ay"s.) will be supplied and more will be demanded ultimately e&uilibrium will be reC

    established at the exchange rate E. >n the other hand if the exchange rate falls to E the&uantity of currency ("s.) demanded >Ais more than the &uantity supplied >A. =henthere is a shortage of currency ("s.) in the foreign exchange market the price of currency("s.) in terms of other currency (ay dollar) will appreciate the rise in the price ofcurrency will reduce the demand for them and increase their supply and this process willcontinue till e&uilibrium exchange rate E is reCestablished at point 2.

    POSITIE IMPACT 5A,+antage ") E#c!ange rate )%(ct(ati"n6 :

    . En(re 'a%ance ") Pa-&ent e7(i%i2ri(

    6n a flexible exchange rate especially in a floating exchange rate system the exchangerate automatically ad/usts the imbalance in the balance of payment through demand andsupply forces. : deficit in the balance of payments leads to depreciation of currencyresulting in an increase in exports and decrease in imports. : surplus on the other handresults in the appreciation of the currency which restricts the exports and encouragesimports.

    -. M"netar- A(t"n"&-#Flexible exchange rate system pro!ides monetary autonomy to the authorities. Eachcountry under this system is free to follow inflationary of deflationary policies. 6n other

    words independent monetary policy can be pursued by an indi!idual country rather thanlinking it with other countries as is the case under fixed exchange rate.

    ,. Pr"&"te Ec"n"&ic Sta2i%it-#:ccording to 9ilton Friedman the flexible exchange rate system is more conduci!e toeconomic stability. 6t is easier to allow exchange rate to appreciate or depreciate forexternal ad/ustment rather than initiati!e price changes (usually deflation). 6t is difficultto reduce the domestic price le!el as it is resistant to downward pressure.

    . In(%ate ,"&etic Ec"n"&-#

    ;omestic economy under the flexible exchange rate can operate independently to a greatextent. :n appreciation of the domestic currency would pre!ent the import of othercountries inflation. 'nder fixed exchange rate a country will en/oy surplus in the balanceof payments when the rest of the world has inflation but in turn will be sub/ected toinflation due to increase in money supply. The increase in money supply is due topegging operation or and con!ersion of foreign exchange into domestic currency.

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    D. Sta2i%i8e t!e Pri+ate Spec(%ati"n:peculators who buy at a low price and sell at a higher !alue narrow down in theprocess the gap between the two prices. Thus the speculati!e acti!ities mo!e theexchange rate towards its fundamental e&uilibrium !alue.

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    currencies. uch wrong /udgments lead to irrational speculation and destabilization ofthe exchange rate.

    D. P""r Internati"na% C";"perati"n# Flexible exchange rate does not bring in the coCoperation between the countries. ince each country allows the exchange rate to bedetermined in the market it is not binding on them establish coCordination with othercountries. Thus flexible exchange rate may not be suitable for open economies.

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    C CURRENC< CONERTI'ILIT2 gets corrected without the inter!ention of the go!ernment.

    >. Specia%i8e in t!e Pr",(cti"n ") G"", )"r *!ic! t!e- !a+e a C"&parati+eA,+antage: Each country will be able to engage in the production of goods inaccordancewith their comparati!e ad!antage and resource endowments. =hen there iscurrency con!ertibility market exchange rate truly reflects the purchasing power of theircurrencies which is based on the prices and costs of goods in different countries. 6n acompetiti!e en!ironment lower prices of goods which reflect the comparati!e ad!antagewill enable countries to increase exports. Thus currency con!ertibility will lead tospecialization and international trade on the basis of comparati!e ad!antage. This will bebeneficial for all countries in trade.

    ?/ Integrati"n ") 1"r%, Ec"n"&-: %urrency con!ertibility enables better integration of

    the world Keconomy. The easy a!ailability of foreign exchange helps in the growth oftrade and increased capital flows between countries. This will enable the growth of allcountries which is important in the context of globalization.

    Dia,+antage ") c(rrenc- c"n+erti2i%it-

    ./ In)%ati"n: %urrency con!ertibility can gi!e rise to problems of inflation in thedomestic economy. The market determined exchange rate is generally higher than theofficially fixed exchange rate. This leads to a rise in prices of essential imports which canresult in a situation of cost push inflation in an economy. 6f people monitoring is not

    done con!ertibility can result in the depreciation of the domestic currency. 'nduedepreciation of a currency can make people loose confidence in the currency itself. Thiscan ad!ersely affect the trade and capital flows of a country.

    0/ Spec(%ati"n: peculati!e acti!ities may increase under free con!ertibility making theexchange rates highly !olatile. peculation can lead to depreciation of currencies andflight of capital.

    =/ Ri$: 'nder capital account con!ertibility a country is gi!en the freedom to transactin financial assets with foreign countries without restrictions. uch an arrangement is to

    enable increased in!estment acti!ities. $ut there are risks attached to it. : !ery likelypossibility is that of capital flight at the first sign of an internal economic problem. TheshortCterm capital flights termed as Nhot moneyN transfers can destabilize an economyunless precautionary or counter measures are taken to achie!e stability.

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    C"n+erti2i%it- ") In,ian r(pee:

    Earlier the rupee was made partially con!ertible when dual exchange rate was introducedand n the

    other hand an open account would bring the weakness of the 6ndian financialsystem under a sharper focus. 6t would impose a tr"ng ,icip%ine upon thefinancial system.

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    Prec"n,iti"n )"r CAC:

    ) : strong balance of payment position.-) The strengthening of the financial system.,) Fiscal consolidation.) %onduct of an appropriate exchange rate policy.

    Prec"n,iti"n )"r CAC in In,ia:

    The committee stipulated preconditions in three important areas for the implementationof %:%. They are

    ) Fica% c"n"%i,ati"n # The ratio of centres gross fiscal deficit to gross domesticproduction to be reduced from a budgeted .DO in **+C*H to .O in **HC** andfurther to ,.D O in ***C-888 accompanied by a reduction in states deficit.

    -) Man,ate, in)%ati"n rate # The inflation for the three year period should be ana!erage of ,CD percent.

    ,) Strengt!ening ") Financia% S-te 6nterest rates should be fully deregulated in**+C*H. The a!erage effecti!e %"" should be reduced to HO in **+C*H

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    ,. $anks may supplement their domestic deposit base with borrowing from offCsharemarket. The !olatility in interest and exchange rates can be ,anger"( t" *ea$2an$.

    . Fluctuations in interest may affect the cost of borrowing for emerging markets andalter the relati!e attracti!eness of in!esting in these markets. "eal exchange rate!olatility may cause currency and maturity mismatches creating large losses forbank borrowers.

    D. ;ue to increased competition the margins for the banks may be reduced.

    D SIGNIFICANCE OF FOREIGN EXCHANGE RESERES

    Foreign exchange (Forex) reser!es is the result of a excess inflow of foreign currency orgold. ;omestic official holding of gold also adds up the forex. 'sually forex comprisesgold reser!e and foreign currency assets held by the %entral bank of a country and the

    credit balance of ;"s in the 69F.

    The central banks buy or sell the reser!e currency to stabilize the exchange rate. Thusforeign exchange reser!es are instrument to maintain or manage the exchange rate whileenabling orderly absorption of international capital flows. >fficial reser!es are mainlyheld for precautionary and transaction moti!es keeping in !iew the aggregate of nationalinterests to achie!e balance between demand for and supply of foreignK currencies forinter!ention and to preser!e confidence in the countryKs ability to carry out externaltransactions.

    6n a floating exchange rate system the central bank clears any excess demand orsupply of foreign exchange by purchasing or selling the foreign currency. Foreignexchange operations that are unsterilized will cause an expansion or contraction in theamount of domestic currency in circulation and hence directly affect monetary policy andinflation. 6n the e!ent of low foreign exchange reser!es to defend a weak currency aforeign exchange crisis will be the result leading to de!aluation. :n appreciated currency!alue can lead to an increase in domestic money supply resulting in inflation. This willreduceK the demand for goods leading to a reduction in reser!es.

    Deter&inant ") t!e ,e&an, )"r reer+e:

    : broad based approach to identify the potential determinants of reser!es was adopted byLane and $urke in -88. The following factors influenced the demand for money.

    . Trade openness and financial deepening are the most important !ariables.-. maller countries which are industrially de!eloping hold large reser!es compared tolarger countries since they face !olatile situations in the economy.

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    ,. %ountries hold reser!es to a!oid debt situations.

    :ccording to "$6 the following are the ob/ecti!es of maintaining reser!es.

    . To maintain confidence in monetary and exchange rate policies.-. To enhanceJ the capacity to inter!ene in foreign exchange markets.,. To limit the external !ulnerability by maintaining foreign currency li&uidity to absorb

    shocks during times of crisis including national disasters or emergencies.. To pro!ide confidence to the markets including credit rating agencies that externalobligations can always be met.D. To increase the comfort of the market participants by demonstrating the backing ofdomestic currency by external assets.

    Signi)icance ") F"reign E#c!ange Reer+e:

    6n a fixed exchange rate system a country holds forex in order to maintain the external!alue of its currency stable. 6n a floating exchange rate theoretically speaking an

    economy need not hold any forex as the system is self correcting. :s most of thecountries ha!e adopted a managed float a certain amount of foreign exchange reser!es isessential for the purpose of market inter!ention. The following points highlight theimportance of forex reser!e#

    .6 A(t"n"&- in p"%ic- &a$ing: :n economy can ha!e independentmonetary policy if it has enough forex. 6t also has confidence to a!oid widefluctuations in the foreign exchange rate.

    06 En!ancing t!e capacit-:Through under flexible exchange rate the market

    plays a ma/or role yet it is necessary to inter!ene in the market to maintain theexchange rate within a margin.

    =6 Li&iting e#terna% +(%nera2i%it-: 6n an open system the foreign capitalflows in and out freely. peculators usually tries to take ad!antages of market. :nyinstability may gi!e rise to take ad!antages of market. :ny instability may gi!e riseto serious repercussions. 4ence the inter!ention is necessary and it is possible onlywith sufficient forex a buffer against external !ulnerability.

    46 Pr"+i,ing c"n)i,ence: The knowledge and information of ha!ing enough

    forex with the go!ernment imparts a sense of confidence in the market.

    >6 Re,(cing +"%ati%it-: Foreign exchange market becomes less !olatile whenit is known that the monetary authorities are capable of disciplining market with thehelp forex at their disposal.

    ?6 Ri$ &anage&ent:"eser!es help the countries manage the internationalfinancial risks they face. They also infuse confidence in both the country and

    ,

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    currency. They buffer against unexpected changes in the cost of debt caused by anincrease in interest rate. : large reser!e helps in pre!enting shortCterm hot moneysituation.

    @6 T" Maintain Interna% an, E#terna% Sta2i%it-: : country with acomfortable foreign exchange reser!es find it Keasier to implement independentmonetary policy and any discrepancies in exchange rate can be easily corrected.

    T!e i8e ") )"reign e#c!ange reer+e: ize of reser!es# 4ow much forex should acountry hold depends on many factors. The important of them are i) size of the country -)%urrent account deficit ,) %apital account !ulnerability ) Pulnerability of exchange rateflexibility and D) opportunity cost.

    The size of the country !iewed form the population and @;2 angle demands additionalreser!e as both the !ariables increase. 6f the current and capital account are more opengreater the re&uirement of forex. Exchange rate flexibility also influences the re&uired

    reser!es to enable the go!ernment M %entral $ank of the country to inter!ene as and whenre&uired. 4olding a large amount of forex has an opportunity cost in terms of lostopportunity of using the forex in a profitable manner.

    The le!el of foreign exchange rate system followed by that country. 6n a fixed exchangerate system the monetary authority do re&uire more forex to maintain the desiredexchange rate. 6n a floating exchange rate system the exchange rate would ad/ust itselfaccording to the market forces. 4ence there is no need to absorb excess inflows in thereser!es.

    4igh demand for forex in some of the de!eloping countries arises out of politicalinstability high fiscal deficit resulting in unproducti!e in!estment and finally their affecton foreign exchange market.

    4ow much foreign exchange reser!e should a country maintain is nor a precisely settled&uestion. 9any economists suggest some ratio of gross reser!e to annual imports as acriterion to /udge the ade&uacy. "obert Triffin after studying the case of - leadingcountries during the period of *D8 to *D+ concluded that ,D percent of li&uidity orreser!e as a ratio of annual imports as ade&uate. "eser!es below this ratio according thim would compel the country in &uestion to adopt import restrictions.

    :ccording to another criterion the international li&uidity is ade&uate if it is sufficient tomeet cyclical fluctuations without imposing undesirable restrictions on world trade.

    6n recent years it is pointed out that a country must possess foreign exchange reser!e(Forex) e&ual to three months imports. "eser!es less than this would compel a country toimpose import restrictions. 6f a country cannot restrict its imports then it has to borrow

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    E/ FOREIGN EXCHANGE RISKS

    Intr",(cti"n an, Meaning:

    Foreign exchange risk is a financial risk caused due to an exposure to unanticipatedchanges in the exchange rate between two currencies. The risk arises when the !alue ofin!estments changes due to changes in currency exchange rate creates uncertainties.

    Foreign exchange risk affects businesses or production units that export or import. 6t canaffect in!estors making international in!estments. Exchange risks are the risks whicharise due to the inability to ad/ust prices and .costs to offset changes in the exchange rate.Fluctuations in the exchange rate cause uncertainty and entails risks for importers andexporters. The exporters and importers are not sure of the amount of foreign currency bypaying less in domestic currency

    T-pe ") )"reign e#c!ange ri$:

    Exchange of currency between countries often in!ol!es loss to either the buyer or theseller this is due to inherent risk of exchange rate fluctuations. The exchange rate ishighly !olatile. The main exchange risks encountered may be classified as economicrisk trading risk balanceCsheet risk exposure risk.

    ./ Ec"n"&ic Ri$ :

    Economic risk occurs as a result of changes in the real exchange rates. 6f competitionexists between two countries i.e. 6ndia and rilanka there will be inflation in 6ndia isdouble the rate of inflation in rilanka 6n real terms. :s a result of this 6ndian exporterswill be priced out of the international market by their ri!als in rilanka. 6n order to

    counter this the 6ndian exporter will be forced to lower his price thus narrowing his profitmargin. ometimes the exchange rate might change after the price has been &uoted. :neconomic risk pre!ents sales from taking place.

    -. Tra,ing Ri$ :"isks arises because of change in the !alue of the currency i.e. there may be either anappreciation or a depreciation. This risk is created because of the time lag between thepricing decision and the con!ersion of the sales proceeds into the currency in which thecosting is done. =hen the actual exchange rate differs from the estimated exchange ratethen the exporter will gain if the currency in which the sales are made appreciates.

    imilarly the importer will gain if the currency in which imports are made depreciatesand will lose if the currency in which imports are made appreciates.

    ,. 'a%ance !eet Ri$ :$alanceCsheet risks take place because all companies must prepare financial statements ina specified currency. 4owe!er it is not possible to make entries of the assets as well asliabilities in the currency of the reporting country. Therefore it is necessary to con!ertthese in the currency of the reporting country and as a result of changes in the exchange

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    rate there is likely to be either a loss or gain. ince the !alue of the exports and importsha!e to be con!erted or translated into the domestic currency they are referred to astranslation risks and because they are an accounting phenomenon they are often referredto as an accounting risk.

    . Tranacti"n Ri$:Transaction risk arise out of !arious types of transactions such as international trade

    borrowing and lending in foreign currencies and the local purchasing and sale acti!itiesof foreign subsidiaries that re&uire settlement in a foreign currency. Transaction riskexists whene!er it has contractual cash flows whose !alues are sub/ect to unanticipatedchanges in exchange rate due to a contract being denominated in a foreign currency. :sfirms negotiate contracts with set price and deli!ery dates in the face of a !olatile foreignexchange market with exchange rates constantly fluctuating the firms face a risk ofchanges in exchange rate between the foreign and the domestic currency.

    D. C"ntingent Ri$ # : firm has contingent risk when bidding for foreign pro/ects or negotiating other

    contracts or F;6.

    perating "isk refer to change in expected future cash flows (from future sale andproduction) due to an unexpected change in the exchange rates. 6t affects the firmKspresent !alue. 6t has a ma/or influence on the stock process for listed companies.

    +. E#p"(re ri$ :Exchange risk arises because of exogenous factors. ince these are factors that areoutside the firm cannot do anything to protect itself against such risks. There are a

    number of !ariables that determine the firmJs exposure to exchange or currency risk.These are#

    a) Pr",(ct &i#:6f undifferentiated products are sold the company exposesitself to foreign currency risk thus by introducing different products the firm canreduce its exchange risk.

    b) Pr",(ct age:This is linked to the product life cycle. :s the product matures thenumber of ri!als M imitators increase. This makes the commodity price sensiti!e.

    c) O*ner!ip tr(ct(re# 6f the firm has subsidiaries in a number of countries thecurrency risk is lower when the parent company manages the foreign exchangeportfolio.

    d) %urrency management and currency mix influences the extent to which acountry has to bear foreign currency risk. 6f the inflow of currency does notmatch the outflow then a currency risk arises.

    +

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    : foreign exchange risk arises not only from transactions in!ol!ing future payments andreceipts in a foreign currency (transactional exposure) but also from the need to !aluein!entories and assets held abroad in terms of the domestic currency for inclusion in thefirmJs consolidated balanceCsheet (transaction or accounting exposure) and in estimatingthe domestic currency !alue of the future probability of the firm (the economicexposure).

    Tec!ni7(e ") &anage&ent ") )"reign e#c!ange ri$:

    Foreign exchange risk is associated with ad!erse currency mo!ements that translate intolost profits and purchasing power. 2ri!ate indi!iduals and businesses can manage foreignCexchange risk with di!ersification currency deri!ati!es and currency swap techni&ues.

    . Di+eri)icati"n:;i!ersification is a currency risk management strategy that enables you to profit acrossmultiple economic scenarios. 6t is possible to assemble a foreign exchange portfolio ofse!eral currencies to di!ersify. For example a currency portfolio featuring '.. dollars

    and "ussian rubles could ser!e as a di!ersification play against commodity prices. 4ighcommodity prices typically translate into economic recession and inflation for the 'nitedtates. :t that point the '.. dollar weakens as foreigners begin to li&uidate :mericanassets. 9eanwhile your "ussian rubles will be appreciating in !alue because "ussia is aprimary exporter of oil and natural gas and benefits from high commodity prices.$eyond trading currencies large corporations di!ersify against currency risk byestablishing global businesses within se!eral different countries. For example %ocaC%olaKs international profits stabilize the firm when the :merican economy and dollar areweak. 6ndi!idual in!estors howe!er may lack the financial resources and expertise toestablish o!erseas businesses. maller in!estors may purchase shares of stock in

    multinational corporations such as %ocaC%ola or buy global mutual funds to protectthemsel!es against currency risks.

    -. Deri+ati+e:%urrency deri!ati!es are financial contracts that manage foreign exchange risk byestablishing predetermined exchange rates for set periods of time. %urrency deri!ati!esinclude futures options and forwards. %urrency futures and options contracts trade uponorganized financial exchanges such as the %hicago 9ercantile Exchange. 6n exchangefor premium payments options grant you the choice to accept foreign exchange ratesuntil the contract expires. Futures howe!er enforce the deli!ery of currencies at agreed

    upon !aluations at later dates. 9eanwhile forwards are customized agreements betweentwo parties that negotiate future exchange rates between themsel!es. %urrencyderi!ati!es function as foreign exchange risk management tools because they allowin!estors to lock in predetermined exchange rates for set periods of time.

    ,. C(rrenc- S*ap:

    H

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    %urrency swaps are agreements between separate parties to exchange payments indifferent currencies between themsel!es. 6nstead of simultaneously exchanging infinitecurrency payments swaps feature netting. 0etting calculates one payment where thewinning party recei!es one payment for the total difference between currency !alues thatoccurred during the contractKs duration. %urrency swaps may be combined with interestrate swaps where trading partners exchange fixed and ad/ustableCrate interest payments.

    o foreign exchange risk is like in any kind of domestic business risk but its scope is!ery !ast. 6t has a!ailable in !arious types as well as there are !arious factors affectingthe F>"EB risk like interest rate central bank actions etc. there are also !arioustechni&ues to manage foreign exchange risks like currency swaps di!ersion deri!ati!esetc.

    F/ GLO'AL LINKAGE OF FOREIGN EXCHANGE MARKETS

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    Intr",(cti"n:

    The foreign exchange market is a forum for exchange of global decentralized trading ofinternational currencies. The financial centers in !arious countries function as anchors oftrading between a wide range of different types of buyers and sellers round the clock. Theforeign exchange market assists international trade and in!estments by enabling currencycon!ersion. 6t also supports direct speculation in the !alue of currencies and carry tradespeculation based onK the interest rate differentials between two currencies.

    Uni7(e )eat(re: The foreign exchange market is uni&ue due to the followingcharacteristics#

    . Hig!%- %i7(i,:The trading !olume is huge representing the largest asset class in theworld and has high li&uidity. Foreign Exchange 9arket is the largest and most li&uidmarket in the world. The estimated turno!er is 7 .D trillion a day. 6t is e&ui!alent to morethan 7 -88 in foreign exchange market transactions e!ery business day of the year fore!ery man woman and child on earth. 6t has been estimated that the worldJs most acti!eexchange rates can change upto H888 times during a single day.

    -. Ge"grap!ica%%- ,ipere,: 6t is geographically dispersed. 6n a globalised economywhere the world is treated as global !illageG the foreign exchange centers are linkedinto a single united cohesi!e worldwide market. Foreign exchange trading takes placeamong the dealers in a large number of indi!idual financial centers but the trade takesplace in the same currencies. The access to different markets throughout the world beinga!ailable through the !ast amount of market information transmitted simultaneously andmost instantly the foreign exchange rate at any time tends to be !irtually identical in allthe financial centers.

    =/ T*ent-;F"(r H"(r Mar$et: Foreign Exchange markets operate - hours per day perday. 6t is said that the foreign exchange market follows the sun around the earth. Twentyfour hours market means that exchange rates can change at any time due to change inmarket conditions or other e!ents at anytime and any where. This demands alertness onthe part of dealers to the possibility of a change in exchange rate anywhere.

    4/ "%(&e ") tranacti"n: :ccording to the $ank of 6nternational ettlements as on:pril -88 the a!erage daily turno!er in global foreign exchange market was estimatedto be at 7 ,.*H trillion -8O growth o!er the 7 ,.- trillion daily !olume as on :pril -88+.

    >f the total transactions almost twoCthirds of the total represents transactions among thereporting dealers themsel!es with the remaining oneCthird accounted for by theirtransactions with financial wand nonCfinancial customers. :mong the !arious financialcenters around the world the largest amount of the foreign exchange trading takes placein the 'nited 5ingdom through the pound sterling is less widely traded than se!eralother currencies. The three largest markets are '5 ': and apan.

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    >/ Net*"r$ ") Dea%er: Foreign exchange dealers are geographically dispersed andlocated in numerous financial centers around the world. They are howe!er linked to andin close communication with each other through telephones computers and otherelectronic means. There are more than -888 dealer institutions whose foreign exchangeacti!ities are co!ered by the $ank for 6nternational ettlements of these -888 only 88C-88 are ma/or players.

    ?/ e!ic%e "r 'ae C(rrenc-: Transactions in international centres take place through amore widely traded currency. 9a/ority of the exchanges now take place through thedollar. uch currency is termed or called as in!estment currency reser!e currencytransaction currency in!oice currency or inter!ention currency. 9ore popularly known asPehicle or $ase currency. The use of IPehicleJ currency reduces the number of exchangerates that must be dealt with in a multilateral system. 6t is estimated that in a system of 8currencies with the help of !ehicle currency the market has to deal with only *exchanges rates as against D exchange rates in the absence of a Pehicle currency. :tpresent ;ollar and Euro are the leading Pehicle currencies.

    @/ S1IFT# The rapid impro!ement in communication and technology has enabled theforeign exchange dealers worldwide to link together through telephone telex and satellitecommunication network called the ociety for =orldwide 6nternational Financial%ommunication (=6FT). The communication system based in $russels $elgium linksbanks and brokers in e!ery financial centres.

    / G%"2a% %in$age an, !it"r- ") F"reign e#c!ange tranacti"n: 2rior to theinstitution of 69F the international monetary system was following the fixed exchangerate system based on international gold standard. 'nder the gold standard the !alue of thecurrency was kept e&ual to the !alue of a fixed weight of gold. >!er the years the gold

    standard took , forms.a) @old currency standard.b) @old bullion standard.c) @old exchange standard.

    / IMF an, g%"2a% %in$age:The 69F was instituted soon after the econd =orld =arwith the ob/ecti!e of facilitating smooth running of international trade and betterment ofall nations of the world. 6t was thought that a system of fixed exchange rate would benecessary for smooth functioning of international finance.

    For about two decades the system worked smoothly. lowly during the ne of the ma/or difficulties was that thegrowth of means of settlement of international debts did not keep pace with the increasein the !olume of international trade. :nother reason for the failure of the system was thehuge deficits in balance of payments in '..:. the dollar could not hold its !alue in theforeign exchange market

    .B/ E&ergence ") SDR:

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    The committee of -8 which had -8 2rincipal members both from de!eloped andde!eloping countriesCmade a number of far reaching recommendations on reforming the69F system. The ma/or recommendations relate to replace of gold in the 69F system andthe use of ;".

    ;" (pecial ;rawing "ights) also known as the paper gold are a form of internationalreser!es created by 69F to sol!e the problem of international li&uidity. They are not

    paper notes or currency. They are international units of account in which the officialaccounts of the 69F are kept. They are allocated to the 69F members in proportion totheir fund &uotas and are used to settle balance of payment deficits between them.

    ../ C!anne% ") g%"2a% %in$age# 69F conducted a study on the channels by whichincreased !olatility in foreign exchange can affect trade : crisis in. an economy istransmitted through three channels i.e tra,e c!anne% )inancia% c!anne% an, c"n)i,encec!anne%/:s a result economic phenomena in one country can easily spread to the othercountries. This has increased uncertainties. This also implies the need to ha!e strong

    macroeconomic fundamentals for countries and also a di!ersif6ed in!estment and tradeportfolio which can absorb shocks and remain resilient in ad!erse conditions also. .

    C"nc%(i"n: =ith greater interdependence across countries Cinternational linkages ha!ebecome imperati!e and stronger. From the late *8Ks real and financial linkages ha!ebecome more important and shocks are transmitted from especially large powerfuleconomies to the de!eloping or weaker countries. :ny type of economic disturbanceoriginating in one of the large countries can impact on the other countries and this will bereflected in theK &uantum of trade. @lobal disturbances can take a number of forms.

    The de!eloped countries ha!e experienced synchronized pattern of mo!ements in outputinflation interest rates etc. %ountries are interdependent on each other than e!er before.This increasing interdependence couldK be measured through the increase in trade flowsF;6 and financial flows and labour mo!ements between nations. The internationallinkages can enhance producti!ity and help to raise the income of nations thus impro!ingthe standard of li!ing. 6nternational linkages or technology transfers lead to increase inproducti!ity growth.

    :s per the 69F study exchange rate in principle can influence trade in many ways. "ealexchange rate ha!e a potentially strong impact on the incenti!e to allocate resources. i.e.

    labour and capital. "eal exchange rates are measures of real competiti!eness since theycapture the relati!e prices costs and producti!ity of one particular country !isCa..!is therest of the world.

    Thus it is clear that globally the foreign exchange markets are linked with each otherdue to globalization of trade and increased connecti!ity.

    G/ OPEN AND CLOSED: INTEREST PARIT< CONDITIONS

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    Intr",(cti"n:2eople hold wealth in !arious forms .like stocks bonds cash real estatediamonds etc. The ob/ecti!e of ac&uiring wealth or sa!ings is to transfer purchasingpower into the future. The desirability of an asset depends on its rate of return orpercentage increase in !alue it offers o!er some time period. To calculate the expectedrate of return o!er some time period one has to make the best forecast of the assetsK total!alue at the periodsK end. The percentage difference between that expected future !alue

    and the price one pays for the asset today e&uals the assets expected rate return o!er thetime period.The sa!ers are interested in the expected real rate of return. This is so since the ultimategoal of sa!ing is future consumption and only the real return measures the goods andser!ices a sa!er can buy in the future in return for gi!ing up some consumption today.

    Fi!er e))ect: 6t brings out the difference between nominal and the real interest rate.0ominal interest rate includes real re&uired rate of return and the inflation premiumwhich is the expected rate of inflation. S" rea% interet rate N"r&a% Interet ;In)%ati"n rate/ The in!estors look for the real interest rate differences while in!esting

    their funds. "eal interest rate differences will lead to the flow of capital to those countriesoffering higher real interest rates. :s a result ultimately the real interest rates willbecome e&ual across countries. 4ence indi!iduals prefer to hold assets offering thehighest expected real rate of return. The other consideration while selecting an asset arethe risk and li&uidity.

    Sit(ati"n ") Interet Parit-: To compare the returns on different deposits marketparticipants need - pieces of information. First they Nneed to know how the money !alueof the deposits will change. econdly they need to know how the exchange rate willchange so that they can translate rates of return measured in different currencies intocomparable terms. 6f the potential holders of foreign currency deposits !iew all assets ase&ually desirable it i a it(ati"n ") interet parit-/ T!i i a it(ati"n ") n" ar2itragec"n,iti"n/

    6nterest arbitrage refers to buying a foreign currency spot and selling it forward to takead!antage of the higher interest rate. 6nterest arbitrage is riskless because it is co!ered bya forward sale of the foreign currency. This is also called c"+ere, interet ar2itrage.There is co!ered interest parity when the interest differential is positi!e in fa!or of theforeign monitory centre and e&uals the forward discount on the foreign currency. 6n sucha situation no arbitrage will take place. $ut arbitrage opportunities will exist so long as

    the interest differential between the two monetary centres exceeds the premium ordiscount of the forward exchange rate.

    Interet rate an, ar2itrage:

    There is a relationship between interest rate and rate of inflation. :ccording to 6r!inFisher a countryJs nominal interest rate (i) is the sum of re&uired IrealJ rate of interest (r)

    -,

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    and the expected rate of inflation o!er the period for which the funds are to be lent (6) thiscan be stated as

    i r I

    6f the real rate of interest in a country is D percent and annual inflation is + percent thenominal interest rate will be - percent. The relationship is called Fi!er E))ectaccording to which a strong relationship seems to exist between inflation rates andinterest rates.

    6f the real interest rates between the countries differ then arbitrage takes place.

    There is a link between inflation and exchange rate and as the interest rates reflectexpectations about inflation if follows that there must also be a link between interest rateand exchange rate. uch a link is known as 6nternational Fisher Effect. 6t states that forany two countries the spot exchange rate should change in an e&ual amount but in theopposite direction to the difference in nominal interest rates between the two countries.

    6f 6ndiaJs nominal rate of interest is higher than ':Js with the expectation o higher rate

    of inflation the !alue of "upee against dollar should fall by that interest rate differentialin future

    Interet Parit- C"n,iti"n

    6t is a state under which in!estors will be indifferent to interest rates a!ailable on bankdeposits in two countries. The fact that this condition does not always hold allows forpotential opportunities to earn riskless profits from co!ered interest arbitrage. Twoassumptions which are central to interest rate parity are capital mobility and perfectsubstitutability of domestic and foreign assets. 6nterest rate parity conditions imply thatthe expected return on domestic assets will e&ual the exchange rate ad/usted expected

    return on foreign currency assets. 6n!estors cannot then earn arbitrage profits exchangingback to their domestic currency at maturity.N

    6nterest arbitrage may be unco!ered or co!ered.

    Unc"+ere, Ar2itrage: 6n this system arbitrageurs would take a risk to earn profit byin!esting in a high interest bearing risk free securities in a foreign market. 4is earningswould be according to his calculations if the currency of the foreign market where hein!ested does not depreciate. 6f the depreciations is e&ual to the difference in interest ratethe in!estor would not incur loss. 4owe!er if the depreciation is more than interest rate

    differential then the arbitrageur will incur loss.

    C"+ere, Ar2itrage: 6nternational in!estors would like to a!oid the foreign exchangerisk thus interest arbitrage is usually co!ered. For this purpose the in!estors purchaseforeign currency to in!est the same in a foreign currency which has higher rate ofinterest.

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    :t the same time the in!estor sells forward the amount of the foreign currency he isin!esting plus the interest in the in!ested amount for a period which will coincide withthe maturity of the in!estment. The co!ered interest arbitrage refers to the spot purchaseof the foreign currency to make the in!estment and offsetting simultaneous forward sale(swap) of the foreign currency to co!er the foreign exchange risk. 'nder this systemwhen the foreign in!estment matures (usually , months) the in!estor will get thedomestic currency e&ui!alent of the amount in!ested plus interest earned. 4owe!er the

    currency with higher rate of interest is usually at a forward discount the net return on thein!estment is roughly e&ual to the interest differential (higher interest) minus the forwarddiscount on foreign currency.

    The less earnings due to forward discount can be considered as the cost of insuranceagainst foreign exchange risk.:s co!ered interest arbitrage continues the difference in interest again diminishes andfinally the gain arising out of interest arbitrage completely disappears.

    Interet parit- ta$e 0 )"r& ; c"+ere, an, (nc"+ere,. Economists ha!e foundempirical e!idence that co!ered interest rate parity holds though# sub/ected to !ariousconditions like the !arious types of risks costs taxation etc. =hen unco!ered interestrate parity and the purchasing power parity hold together it leads to a situation of realinterest rate parity. This condition can be attained when there are no country risk premiaand zero change in the expected real exchange rate.

    This parity condition suggests that the real interest rates will e&ualize between countriesand capital mobility will result in capital flows that eliminate opportunities for arbitrage.

    C"+ere, Interet Ar2itrage Parit-: The difference in interest rates in monetary centresof different countries and the forward premium and discount which lead to a outflow orinflow of foreign currency may ultimately result in elimination of gain out of arbitrage.

    =hen funds mo!e abroad interest rate at home tends to rise and declines abroad. :s theforward dealings increase the forward rate also declined but the spot rate increases. :sthe spot transactions increase the spot rate goes up. The process leads to the point zeroindicating no gain from arbitrage. :t this point the inflow and outflow come to end. 6nreality according to ;ominik al!atore the process of flow in and out of monetary centrescomes to an end.

    6f capital is completely free to mo!e between the countries and the real and nominal rates

    of interest are also the same the exchange rate between the two currencies must also bethe same in the foreign exchange markets of the two countries.

    The arbitrage process would induce the transfer of capital and conse&uent changes in theinterest rate and finally e&uality of exchange rates. The arbitrage opportunity which arisesdue to difference in rate of interest brings the exchange rates in the two markets on par.

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    H/ EUROCURRENC

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    H. Dep"it ") (rp%( )(n, 2- OPEC C"(ntrie: :fter the oil price increase of*+, the >2E% countries began to deposit large amounts of dollars in Europeanbanks. The Eurocurrency market experienced phenomenal growth after *+,.

    C!aracteritic ") t!e E(r"c(rrenc- &ar$et:

    . Free ") g"+ern&ent reg(%ati"n:The Eurocurrency market is an important channel

    or mobilizing funds and de!eloping them on an international scale. The importantcentres are London 2aris 4ongkong and ingapore. 6t is generally outside thedirect control of any go!ernment regulation.

    -. S!"rt;ter& nat(re:The deposits and loans of Eurobanks are predominantly of ashortCterm nature. The maturity nature of some deposits is as short as one day andma/ority are under six months.

    ,. C%"e &at(rit- ") aet an, %ia2i%itie: There is a close matching of the maturitystructure of assets (loans) and liabilities (deposits). This is due to the fact that

    Eurobanks ha!e to be cautions about the sudden large withdrawals of shortCtermfunds by the depositors.

    . E(r"2an$ t!e&e%+e t!e (er ") E(r"c(rrencie: : large proportion ofEurocurrencies are used by the Eurobanks themsel!es. Those Eurobanks withsurplus funds loan to Eurobanks ha!ing lending possibilities but are short of funds.The other users of Eurocurrency market facilities are nonCEurobank financialinstitutions 9ultinational corporations international institutions like =orld $ankand go!ernments.

    D. 1!"%ea%e &ar$et:Eurocurrency market is a wholesale market in the sense thattheir size of transactions is !ery large.

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    -) The national monetary authorities lose effecti!e control o!er monetary policy sincedomestic residents can make their efforts less effecti!e by borrowing or lendingabroad. ince Eurocurrency market contributes to increasing the degree ofinternational mobility of capital it makes monetary policy less effecti!e.Eurocurrency market pro!ides opportunities for a!oiding many of the regulations thatthe monetary authorities try to enforce on domestic money markets.

    ,. ince the Eurocurrency market can be a source of international li&uidity it cancontribute to inflationary tendencies in the world economy.

    . The Eurocurrency market allows the central banks of deficit countries to borrow forbalance o payments purposes. This may make these countries to postpone the neededbalance of payments ad/ustment measures.

    ADANTAGES:

    ;espite these problems arising from the growth of Eurocurrency market it has gi!en rise

    to many ad!antages.

    ) 6t has helped to alle!iate considerably the international li&uidity problem.

    -) 6t has pro!ided credit to countries to finance the balance of payments deficits. 6n otherwords it has played an important role in recycling funds from surplus to deficitcountries.

    ,) 6t has helped to meet the shortCterm credit re&uirements of business corporations.

    ) 6t has pro!ided a market for profitable in!estment of funds by commercial banks.

    D) 6t has enabled the exporters and importers to obtain credit.

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    EURO'OND MARKETS

    Meaning:Eurobonds are longCterm debt securities that are sold outside the borrowerJscountry to raise longCterm capital in a currency other than the currency of the countrywhere the bonds are sold.

    :n example is gi!en by a ' corporation selling bonds in London denominated in eurosor ' dollars. 6n *H* the funds raised by Eurobonds amounted to 7,88 billion. 6n **+new issues of Eurobonds amounted to 7 +,D billion. The incenti!e for Eurobonds is thatthey generally represent a lower cost of borrowing longCterm funds than a!ailablealternati!ely.

    E(r"2"n, S D"&etic an, F"reign 2"n,: Eurobonds differ from most domesticbonds. Eurobonds are usually unsecured that is they do not re&uire collateral whiledomestic bonds are securedEurobonds are different from foreign bonds. Foreign bonds refer simply bonds sold in a

    foreign country but denominated in the currency of the country in which the bonds arebeing sold. :n example is a ' multinational corporation selling bonds are bonds sold ina foreign country and denominated in another currency.

    Nat(re ") E(r"2"n,: Eurobonds are attracti!e financing tools as they gi!e issuers Ktheflexibility to choose the country in which to offer their bond according to the countryJsregulatory constraints. They may also denominate their Eurobond in their preferredcurrency. Eurobond are. attracti!e to in!estors as they ha!e small par !alues and highli&uidity. o a Eurobond is an international bond thatK is denominated in a currency notnati!e to the country where it is issued. 6t can be categorized according to the country in

    which it is issued. London is one of the centers of the Eurobonds market. Eurobonds arenamed after the currency they are denominated in. For example Euroyen and Eurodollar.bonds are denominated in apanese ?en and :merican dollar respecti!ely. Eurobonds arebearer bonds and also free of withholding tax. The bank =ill pay the holder of thecoupon the interest premium. 'sually no official records .are kept. The leading centers ofthe eurobond market are London Frankfurt 0ew ?ork and Tokyo. The maturity period ofeurobonds is short upto fi!e years.

    Interet rate:Eurobonds may be with fixed interest rates or floating interest. rates. 6nfixed rate of interest bearing bonds the rate of interest remains the same throughout the

    duration of the bond. uch bonds ha!e higher interest rate risk. 6n floating interest basedEurobonds returns !ary as per the mo!ements in interest rate.The interest rates on Eurocredit are expressed as a markCup or spread o!er L6$>" (theLondon 6nterbank >ffer "ate) or E'">$>" (the $russelCset rate). This is the rate atwhich Eurobanks lend funds to one another. The spread !aries accordingK to thecreditworthiness of the borrower and range from O for the best or prime borrowers to-O for borrowers with weak credit ratings. The weaker banks can negotiate a lower

    ,8

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    spread by paying !arious fees up front. There are a management fees for the banks orbanks organizing the syndication a participation fee to all participating banks based onthe amount lent by each as well as a commitment fee on any undrawn portion of the loan.The rapid growth of these markets is taking us to a truly global banking system.

    Tranacti"n an, %ea,ing center: The leading centers in the Eurobond market are

    London Frankfurt 0ew ?ork and Tokyo. 6n -88 corporations banks and countriesraised about 7 ,D8 billion in Eurobonds. The sharp increase was made possible by theopening up of capital markets in these international debt securities by se!eral countriesincluding France @ermany and apan. The incenti!e to issue Eurobonds and Euronotes isthat they generally represent a lower cost of borrowing long term funds than a!ailablealternati!es. 6n -88 about HO of Eurobonds and Euronotes were denominated in '..dollars O were denominated in euros DO in pound sterling O in apanese ?en andsmaller percentages in other currencies.

    ome Eurobonds are denominated in more than one currency in order to gi!e the

    lender the choice of the currencies in which to be repaid thus pro!iding some exchangerate protection to the lender. : large issue of Eurobonds or Euronotes is usuallynegotiated by a group (called a syndicate) of banks so as to spread the credit risk amongnumerous banks in many countries. Eurobonds and Euronates usually ha!e floating rates.The interest rates charged are reCfixed usually e!ery three to six months in line with thechanges in market conditions. :fter an issue of Eurobonds and Euronotes is sold by thesyndicate a secondary market in the international note or bond emerges in which thein!estors can sell their holdings.

    EUROE3UIT< MARKETS

    : Euro e&uity issue according to 9ichael ". %zinkota and others is the simultaneous saleof a firmJs share in se!eral different countries with or without listing the shares onexchange in that country. The sale takes place through in!estment banks. >nce issuedmost euroCe&uities are listed at least on the computer screen &uoting system of theinternational tock Exchange (6E) in London.

    Euro market is an important financial market for raising finance through euro e&uitiesor Eurobonds. @lobal ;epository "eceipts (@;"s) are financial instruments for raising

    funds in more than one foreign market except in the domestic market of the issuingcompany. Euro e&uities are sold through @;"s in the international market. : @;" is afinancial instrument which represents one or more shares of an issuing firm or company.@;"s are issued in the following manner. : company which issues the shares depositsthem with a depository bank. The bank and brokers sell these .shares through @;"s. Thein!estors get the depository receipts. ince the in!estors ha!e rights to the receipts onlyand not the actual shares of the company they ha!e no !oting rights.

    ,

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    T!e )"%%"*ing tep are in+"%+e, in raiing )(n, t!r"(g! e(r";e7(it-/

    . The company wants to raise capital for expansion of capital base through euroCe&uities.

    -. The depository bank issues @;"s.. The local custodian appointed has to super!isethe issue and cancellation of @;"s.

    ,. The in!estment bankers form the syndicate of participating banks. They also workout all the technicalities in the issue of @;"s. The custodian will be in possessionof the underlying ordinary shares of the company and the @;"s are issued basedon these shares. The @;"s are sold or marketed through !arious channels.

    A c"&pan- can raie e7(it- capita% in t!e internati"na% &ar$et in t*" *a-

    . $y issuing shares in the EuroCmarket which are listed on the foreign stock

    exchange.

    -. Through the issue of :merican ;epository "eceipt (:;"s) European ;epository

    "eceipt (E;"s) or @lobal ;epository "eceipts (@;"s). . i

    T!e Fact"r Rep"ni2%e )"r t!e E#pani"n ") E(r";e7(it- Mar$et:The expansion of

    EuroCe&uity market has been facilitated by a 6 number K>f factors and inno!ations. They

    are#

    . 6nternational syndicates of banks act as lead managers and brokerage 6 firms that are

    capable of handling euroCissues within short period of time ha!e emerged.

    -. yndication and distribution fees for euroCe&uities are much lower compared to

    domestic issues.

    ,. The inno!ati!e approach to in!estment in foreign e&uities ha!e helped to 6

    o!ercome the stringent regulations in the '.. 6t enabled the 90%s to issue new

    instruments without costly registration and lengthy procedures. .. EuroCe&uity 62>s (6nitial 2ublic >ffer) allow as many in!estors as possible. This

    enables the newly opened public company to raise more capital.

    D. 6ssue of euroCe&uities enables companies to raise funds from !arious sources since

    they are sold on se!eral international markets..