FM 404: INTERNATIONAL FINANCIAL MANAGEMENT

Objective: to enlighten the students with the Concepts and Practical applications of International Financial Management.

Unit I : International Monetary and Financial System: Evolution; Breton Woods Conference and Other Exchange Rate Regimes; European Monetary System, South East Asia Crisis and Current Trends.

Unit II : Foreign Exchange Risk: Transaction Exposure; Accounting Exposure and Operating Exposure Management of Exposures Internal Techniques, Management of Risk in Foreign Exchange Markets: Forex Derivatives Swaps, futures and Options and Forward Contracts (Cases).

Unit III : Features of Different International Markets: Euro Loans, CPs, Floating Rate Instruments, Loan Syndication, Euro Deposits, International Bonds, Euro Bonds and Process of Issue of GDRs and ADRs.

Unit IV : Foreign Investment Decisions : Corporate Strategy and Foreign Direct Investment; Multinational Capital Budgeting; International Acquisition and Valuation, Adjusting for Risk in Foreign Investment.

Unit V : International Accounting and Reporting; Foreign Currency Transactions, Multinational Transfer Pricing and Performance Measurement; Consolidated Financial Reporting.

1.Explain Breton woods Conference ?

BRETTON WOODS AND THE INTERNATIONAL MONETARY FUND

(IMF), 1944-1973

a) Of paramount importance to the representatives at the 1944 meeting in Bretton Woods was the prevention of another breakdown of the international financial order, such as the one, which followed the peace after the First World War. From 1918 until well into the 1920s the world had witnessed a rise in protectionism on a grand scale to protect jobs for those returning the war, competitive devaluations designed for the same effect, and massive hyperinflation as the inability to raise conventional taxes led to use of the hidden tax of inflation: inflation shifts buying power from the holders of money, whose holdings buy less to the issuers of money, the central banks.

b) A system was required that would keep countries from changing exchange rates to obtain a trading advantages and to limit inflationary policy. This meant that some sort of control on rate changes was needed, as well as a reserve base for deficit countries.

c) The reserves were to be provided via an institution created for the purpose. The International Monetary Fund (IMF) was established to collect and allocate reserves in order to implement the Articles of Agreement signed in Bretton Woods.

d) The Articles of Agreement required IMF member countries (of which there were 178 as of March 1994) to:

1. Promote international monetary cooperation

2. Facilitate the growth of trade

3. Establish a system of multilateral payments

4. Create a reserve base

e) The reserves were contributed by the member countries according to a quota system (since then many times revised) base on the national income and importance of trade in different countries. Of the original contribution, 25 percent was in gold- the so-called gold tranche position- and the remaining 75 percent was in the countrys own currency.

f) A country was allowed to borrow up to its gold-tranche contribution without IMF approval and to borrow an additional 100 percent of its total contribution in four steps, each with additional stringent conditions established by the IMF.

g) These conditions were designed to ensure that corrective macroeconomic policy actions would be taken. The lending facilities have been expanded over the years. Standby arrangements were introduced in 1952, enabling a country to have funds appropriated ahead of the need so that currencies would be less open to attack during the IMFs deliberation of whether help would be made available. Other extensions of the IMFs lending ability took the form of:

i). The Compensating Financing Facility, introduced in 1963 to help countries with temporarily inadequate foreign exchange reserves as a result of events such as crop failures.

ii). The Extended Fund Facility of 1974, providing loans for countries with structural difficulties that take longer to correct.

iii) The Trust Fund from the 1976 Kingston Agreement to allow the sale of goods, which was no longer to have a formal role in the international. financial system. The proceeds of gold sales are used for special development loans.

iv). The Supplementary Financing Facility, also known as the Witteveen Facility after the then managing director of the IMF. This gives standby credits and replaced the 1974-1976 Oil Facility, which was established to help countries with temporary difficulties resulting from oil price increases..

v) The Buffer Stock Facility, which grants loans to enable countries to purchase crucial inventories.

2. Explain other Exchange Rate Regimes ?

EXCHANGE RATE REGIME 1973-85

1) In the wake of the collapse of the Bretton Woods exchange rate system,

2) the IMF appointed the Committee of Twenty that suggested for various options for exchange rate arrangement. Those suggestions were approved at Jamaica during February 1976 and were formally incorporated into the text of the Second Amendment to the Articles of Agreement that came into force from April 1978.

3)The options were broadly:

1. Floating-independence and managed

2. Pegging of currency

3. Crawling peg

4. Target-zone arrangement

A) Floating Rate System: In a floating-rate system, it is the market forces that determine the exchange rate between two currencies. The advocates of the floating-rate system put forth two major arguments

.i) One is that the exchange rate varies automatically according to the changes in the macro-economic variables. As a result, there does not appear any gap between the real exchange rate and the nominal exchange rate.

ii)The country does not need any adjustment that is often required in a fixed-rate regime and so it does not have to bear the cost of adjustment (Friedman, 1953). The other is that this system possesses insulation properties meaning that the currency remains isolated of the shocks emanating from other countries.

iii)It also means that the government can adopt an independent economic policy without impinging upon the external sector performance (Friedman, 1953).

B) Floating rate system may be independent or managed. Theoretically speaking, the system of managed floating involves intervention by the monetary authorities of the country for the purpose of exchange rate stabilization.

i)The process of intervention interferes with market forces and so it is known as dirty floating as against independent floating which is known as clean floating. However, in practice, intervention is global phenomenon. Keeping this fact in mind, the IMF is of the view that while the purpose of intervention in case of independent floating system is to moderate the rate of change, and to prevent undue fluctuation, in exchange rate; the purpose in managed floating system is to establish a level for the exchange rate. Intervention is direct as well indirect.

ii)When the monetary authorities stabilize exchange rate through changing interest rates, it is indirect intervention. On the other hand, in case of direct intervention, the monetary authorities purchase and sell foreign currency in the domestic market.

iii)When they sell foreign currency, its supply increases. The domestic currency appreciates against the foreign currency.

iv)When they purchase foreign currency, its demand increases. The domestic currency tends to depreciate vis--vis the foreign currency.

v)The IMF permits such intervention. If intervention is adopted for preventing long-term changes in exchange rate away from equilibrium, it is known as learning-against-the-wind intervention.

vi)Intervention helps move up or move down the value of domestic currency also through the expectations channel. When the monetary authorities begin supporting the foreign currency, speculators begin buying it forward in the expectation that it will appreciate. Its demand rises and in turn its value appreciates vis--vis domestic currency. Intervention may be stabilizing or destabilizing.

vii)Stabilizing intervention helps move the exchange rate towards equilibrium despite intervention. The former causes gains of foreign exchange, while the latter causes loss of foreign exchange.

3. Explian international Monetory Fund ?

a) One of the most important players in the current international financial

system, the IMF was created to administer a code of fair exchange practices and

provide compensatory financial assistance to member countries with balance of

payments difficulties.

b) The role of the IMF was clearly spelled out in its articles of agreement:

1. To provide international monetary cooperation through a permanent institution that provides the machinery for consultation and collaboration on international monetary problems.

2. To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy.

3. To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.

4. To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions that hamper the growth of world trade.

5. To give confidence to members by making the Funds resources available to them under adequate safeguards, thus providing them with the opportunity to correct maladjustments in the balances of payments without resorting to measures destructive of national or international balances of payments of members.

c)When a member entered the IMF, it was obliged to submit a par value of its currency in gold or in US dollars. Once that value was established it could only vary by 1 percent either way and any changes required the permission of the IMF.

d) All transactions with other members were then exercised at that rate. The resources of the IMF came from the subscriptions for member countries.

e) Subscriptions were determined on the basis of the members relative

economic size, 25 percent of the quota was to be paid in gold and the rest in themembers domestic currency.

f)The size of the quota was important because it determined the members voting power and the amount it could borrow. In practice, members could borrow up to the first 25 percent of their quota, which was called the gold tranche beyond the gold tranche, the IMF imposed

conditions

g)Although the goals and ground rules for membership are still the same, the IMF has changed considerably since its creation. Its capital has been increased several times. The gold tranche has become the first credit tranche and other upper credit tranches have been added. In 1969 it created the first SDRs.

h)The IMF has evolved with the perceived problems of the times. In 1963 it introduced the Compensating Financing Facility to help countries with temporarily inadequate foreign exchange reserves resulting from events such as crop failure.

IMF Exchange regime

1. Exchange Agreements with No Separate Legal Tender (39): The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union which the same legal tender is shared by the members of the union.

2. Currency Board Arrangement (08):A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligations.

3. Other Conventional Fixed Peg Arrangement (44): The country pegs its currency (for mall or de facto) at a fixed rate to a major currency or a basket of currencies (a composite), where the exchange rate fluctuates within a narrow margin or at most + 1 percent around a central rate.

4. Pegged Exchange Rates within Horizontal Bonds (6): The value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than + 1 percent around a central rate.

5. Crawling Pegs (4): The currency is adjusted periodically in small amounts at a fixed, pre announced rate or in response to changes in selective quantitative indicators.

6. Exchange Rates within Crawling Pegs (5): The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced rate or in response to change in selective quantitative indicators.

7. Managed Floating with No Pre-Announced Path for the Exchange Rate (33): The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying or pre-committing to a pre-announced path for the exchange rate.

8. Independent Floating (47): The exchange rate is market-determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.

4. Explian European Monetary System ?

1.1979 all ten EU members participated in the European Monetary system (EMS). Eight in a formal system of mutually fixed Exchange rates setting exchange rates relative to each other, and float jointly against the dollar: Exchange rate mechanism (ERM).. [UK and Greece not included.

2.UK joined in 1990 The bilateral exchange rates allowed to fluctuate within bands of an assigned par value with each of the other currencies. Called margins. Each currency has a central parity in terms of ECUs - European currency units, basket of member currencies, of all members of EMS. Use central parities to determine what bilateral central rates are.

3. Initially each bilateral rate was only allowed to deviate from this by 2.25% above or below, with a couple of exceptions. Initially capital controls limited the ability of private citizens to trade in foreign currencies: relaxed in 1987 1978 to 1982 strong convergence of critical economic indicators between the main countries of Europe success of EMS. 1987-1992 no changes in parities.

4. Crisis in EMS German Dominance Germany dominance: reputation for low inflation Other countries wanted to import Germanys reputation for low inflation used DM as main reserve currency, , monetary policy mimic Germany like Bretton Woods system, with Germany at centre . Domestic problems German domestic interests ahead of international role. Economic shock caused by German Unification:

5.July 1992 East Germans traded f East German currency for DMas rush to buy the modern consumer goods consumption Also fiscal expenditures on East Germany as: 1) unemployment in East: demanded same wages as in west, without modern equipment or training so less productive.

6.Enterprises could not produce goods of competitive quality or price bankruptcy and need to pay for training and support of the unemployed 2) Need to rebuild infrastructure in East - roads, etc, and to clean up the polluted environment. huge demand and in inflationary pressure.

7.Government fear economy overheating and generating inflation main German economic fear tight monetary policy to lower inflation r interest rates demand for deutch marks Results in Currency Crisis To stay within bands relative to the DM rest of EMS had to implement tight monetary policy and interest rates output levels unemployment speculation Pressure on the Lira devalue in September 11 1992 speculators made profit: EMS could indeed be cracked.

8. September 16, Black Wednesday Continued pressure for Lira to be devalued more and pressure on UK, costly draining of reserves. Ended up taking Lira and Pound out of the EMS system and allowed currencies to float.

9. France also attacked, but managed to hang on Many other currencies had to be devalued: Spanish peseta, Irish punt, Portuguese Escuda.

10. Before the European monetary system it was difficult to carry out trade with inter European countries as each countries had their own currencies and accepted that for trade, so because of this the importer country had to get its currency converted to that of the exporter country to clear of the payment of trade.

11. This lead to a huge friction in the trade because the countries used to lose a huge amount of their currency in currency exchange due to fluctuating values along with the premium to be paid to custodian banks for conversion.

12.With the formation of European monetary system the conversion became simple a European currency unit was used as a reference for exchange rates and its rates were pegged with that currency unit and was allowed to fluctuate in a range. This eased the movement of trade among the European countries.

13.But still there was no single currency that can act as an anchor for trade so along with the currencies European monetary system and the stronger economies tried to dominate the European monetary system so to keep the interests of other countries ,the committee of EMS with time decided to align the monetary system of the European countries and let there be only a single monetary system of all these countries which may regulate the currencies. So this led to the pioneer of European Monetary Union (EMU) and European Central Bank in 1999 which led to the generation of a unified European currency known as Euro.

14. Hence, this concludes the definition of European Monetary System (EMS) along with its overview.

5. Discuss South East Asian Crisis ?

1)The 'Asian financial crisis' which started in currency markets in South East Asia, then spread to other markets, undermined first confidence, then faith in the certainty of continued high growth in the region - the so-called East Asian Miracle.

2)The ensuing economic downturn has raised questions about the foundations of that growth, the soundness of the region's financial sectors, the role of government in directing investment and lending, even the appropriateness of 'Asian values' in the context of free market orthodoxy.

3) It has also presented the region's economies with a number of inter-related challenges: implementing the financial sector reforms needed to attract foreign capital back into the region; establishing governance practices which will improve transparency and accountability; and developing growth strategies which are both sustainable and inclusive.

4)Most witnesses agreed that the economic problems of the region will result in

significant contractionary pain for the ASEAN economies in the immediate term, but that in

the longer term, their strong macro-economic fundamentals - high savings and investment

rates, low levels of public debt, competitive factor markets - should ensure a return to high growth.

5) The regional economic downturn in turn will affect Australia's trade performance

and domestic growth; however estimates of the likely extent of the economic dislocation

varied considerably.

6)Where commentators were predicting that the crisis would reduce Australia's GDP growth by around half a per cent in 1998 six months ago, many now see the growth rate as likely to be slowed by 1 to 1.5 per cent.

7) In terms of Australia's export markets in ASEAN, the hardest hit are likely to be building and construction, tourism, transport, primary commodities such as livestock and cotton, elaborately transformed manufactures, precious metals and some capital intensive goods (such as marine vessels). Domestic markets are also likely to be affected by the increased competitiveness of ASEAN imports, particularly manufactures, resulting from the recent significant devaluations of regional currencies.

8)Prior to July 1997, the exchange rates for most of the convertible ASEAN currencies were loosely tied to the US dollar. The Thai baht, although tied to a basket of currency, was effectively pegged to the US dollar (the primary weight in the currency basket) at an exchange rate ranging around 25 baht. Like the baht, the Philippine peso was allowed to move in a fairly narrow range around the US dollar at a rate between 25 and 27 pesos to the US dollar.

9) The Indonesian rupiah was subject to managed, gradual devaluation against the US dollar, in effect a moving peg, which drifted toward the 2,500 mark through the first part of 1997.

10) The Malaysian ringgit was allowed to fluctuate more than the other three currencies, but still maintained a rough band of around 2.5 ringgit to the dollar.

11)The Singapore dollar, in contrast to the other ASEAN currencies, has long been floated against the US dollar, while the currencies of the newer ASEAN members (with the exception of Myanmar) remain non-convertible

12)Dramatic devaluations to the region's currencies and the general loss of investor confidence in the Asian economies in turn triggered a sharp decline in share prices in a number of ASEAN stock markets.

13) It should be noted that in the case of Thailand, Malaysia and the Philippines, these declines had actually begun months earlier. For example, in the first half of 1997 Thai and Malaysian stock prices on average fell by 12 per cent, while the Philippines market lost close to 15 per cent.

14)Whether this earlier decline was a part of a larger pattern of increasing investor nervousness in the region or a cyclical response (for example an adjustment in maco-economic policy such as an increase in official interest rates) is not clear.

15)Following the devaluation of the Thai baht in July, stock prices in the region fell dramatically. Thai and Philippine stock markets each suffered 30 per cent reduction in average equity prices, with greater falls in Indonesia (32 per cent) and Malaysia (38 per cent). Attempts by central banks to hold exchange rate pegs with the US dollar resulted in relatively sharp increases in interest rates, which encouraged investment funds to flow into other types assets (for example loan capital) or out of the region completely.

16) In turn, the fall in exchange rates, coupled with the still high interest rates, increased the rate of business insolvencies in the region, further undermining confidence in share markets and asset prices

17) The impact of currency devaluation and falls in equity prices on financial sectors in almost all of the ASEAN economies through the latter part of 1997 has been severe. Banks and financial institutions throughout the region became exposed to increasingly high levels of bad debt.

18) This is because many customers used stocks as collateral or borrowed abroad at artificially low exchange rates, only to default when both the foreign exchange and stock markets declined.

19)By December 1997, some 58 financial institutions in Thailand had been closed, with remaining firms requiring an estimated US$13.9 billion in bailout funds from authorities (equivalent to approximately 10 per cent of Thai GDP) to remain solvent.In Indonesia sixteen banks have been closed and deposits in remaining banks have shrunk dramatically.

20) Financial markets in Malaysia and the Philippines have also been affected

21)Currency and stock market devaluations in South East Asian economies prompted

international (and local) investors to look more critically at other markets in the region.

22)Many of the conditions present in South East Asia - over-investment in certain sectors, high and growing current account deficits, and increasing financial sector exposure to bad debt - were present in the region's other tiger, South Korea.

23) Consequently, by early October 1997, speculative pressure on foreign exchange markets had lead to a significant devaluation of the Korean Won, despite its relatively low real effective exchange rate against the US dollar, and large falls in stock market capitalisation.

24) Falling exchange rates in turn exposed the huge short-term foreign debt held by many large conglomerates (Chaebol), estimated at around US$100 billion. By the end of 1997, eight of Korea's fifty largest companies had declared bankruptcy or were technically insolvent.

25)Attempts to explain the causes of the regional crisis, and in particular the severity and extent of financial collapse, have tended to concentrate on a number of trigger factors, for example: pegged exchange rates which had become over-valued; high interest rate differentials between domestic and offshore capital markets; and growing inflation and current account deficits which inevitably began to sap investor confidence.

26)However, they have also identified a number of underlying causes, related to critical weaknesses in financial systems throughout the region which have been exposed by rapid, uneven liberalisation, and the increasing mobility (and hence volatility) of international capital.

27. While the regional crisis has been far more severe than earlier predicted, the

prospects for a return to robust growth in the region would appear to be strong. As a number of commentators have pointed out, the fundamental features of Asia's solid growth in the recent past have not changed:

28. [T]he hard work, entrepreneurship, high savings, low levels of taxation, family values and flexible labour markets that helped the region grow at 7-8 per cent a year for over a decade are still in place. So too the highways, factories and office towers these countries built at Break neck pace.

Unit - II

1. What is Foreign Exchange Risk ?

Foreign exchange risk is the risk that a businesss financial performance or position will be affected by fluctuations in the exchange rates between currencies. The risk is most acute for businesses that deal in more than one currency (for example, they export to another country and the customer pays in its own currency). However, other businesses are indirectly exposed to foreign exchange risk if, for example, their business relies on imported products and services. Foreign exchange risk should be managed where fluctuations in exchange rates impact on the businesss profitability. In a business where the core operations are other than financial services, the risk should be managed in such a way that the focus of the business is on providing the core goods or services without exposing the business to financial risks.

2. What are the source of Foreign Exchange Risk ?

Foreign exchange risk for a business can arise from a number of sources, including:

where the business imports or exports

where other costs, such as capital expenditure, are denominated in foreign currency

where revenue from exports is received in foreign currency

where other income, such as royalties, interest, dividends etc, is received in foreign currency

where the businesss loans are denominated (and therefore payable) in foreign currency

where the business has offshore assets such as operations or subsidiaries that are valued in a foreign currency, or foreign currency deposits

3. What are the Impact of Foreign Exchange Risk ?

I. A falling domestic exchange rate can have the following effects:

it can increase costs for importers, thus potentially reducing their profitability. This can lead to decreased dividends, which in turn can lead to a fall in the market value of the business

domestically produced products can become more competitive against imported products

it can increase the cost of capital expenditure where such expenditure requires, for example, importation of capital equipment

the cost of servicing foreign currency debt increases

exporters may become more competitive in terms of costs, potentially increasing their market share and profitability

the business could become a more attractive investment proposition for foreign investors

for the business, the cost of investing overseas could increase

II. A rising domestic exchange rate can have the following effects:

exports can be less competitive, thus reducing the profitability of exporters. This can lead to decreased dividends, which in turn can lead to a fall in the market value of the business

it can decrease the value of investment in foreign subsidiaries and monetary assets (when translating the value of such assets into the domestic currency)

foreign currency income from investments, such as foreign currency dividends, when translated into the domestic currency may decrease

the cost of foreign inputs may decrease, thus giving importers a competitive advantage over domestic producers

the value of foreign currency liabilities will fall. Hence the cost of servicing these liabilities decreases

the cost of capital expenditure will decrease if it is for the importation of capital equipment, for example

the business potentially becomes a less attractive investment proposition for foreign investors

the cost of investing overseas may decrease

4. How to Measure Foreign Exchange Risk ? or Methods of Foreign Exchange risk ?.

1. Register of foreign currency exposures A very simple method is to maintain a register of exposures and their associated foreign exchange hedges. Basically the details of each hedge are recorded against its relevant exposure. This type of approach may also assist with compliance with accounting standards (for hedging), such as Financial Instruments: Recognition and Measurement.

2. Table of projected foreign currency cashfflows Where the business both pays and receives foreign currency, it will be necessary to measure the net surplus or deficit for each currency. This can be done by projecting foreign currency cash flows. This not only indicates whether the business has a surplus or is short of a particular currency, but also the timing of currency flows.

3. Sensitivity analysis A further extension of the previous measure is to undertake sensitivity analysis to measure the potential impact on the business of an adverse movement in exchange rates. This may be done by choosing arbitrary movements in exchange rates or by basing exchange rate movements on past history. For example, the business may wish to know how much it will gain or lose for a given change in exchange rates. Where commodities are involved, businesses sometimes develop a matrix showing the combined result of currency and commodity price movements.

4. Value at risk Some businesses, particularly financial institutions, use a probability approach when undertaking sensitivity analysis. This is known as value at risk. While it is useful to know the potential impact of a given change in exchange rates (say a USD one cent movement) the question will arise: how often does this happen? Accordingly, we can do a sensitivity analysis using past price history and apply it to the current position. Then, given the businesss current position, and based on exchange rates observed over the last two years, it can be 99 per cent confident that it will not lose more than a certain amount, given a certain movement in exchange rates. In effect, the business has used actual rate history to model the potential impact of exchange rate movements on its foreign currency exposures.

5. What is Transaction Exposure, Types and how it is Managed ?.

Transaction exposure measures changes in the value of financial obligations incurred before a change in exchange rates but to be settled after the change.

Definition:TheTransaction Exposureis a kind of foreign exchange risk involved in the international trade wherein the cross-currency transactions (multiple currencies) are involved. In other words, a risk faced by the company that while dealing in the international trade, the currency exchange rates may change before making the final settlement, is termed as a transaction exposure.

If the Indian exporter has the receivable of $5,00,00, due five months hence, but in the meanwhile the dollar depreciates relative to the rupee, then the exporter will suffer the cash loss. But however, in the case of a payable of the same amount, the exporter gains if the dollar depreciates relative to the rupee.

Thus, once the cross-currency contract has been agreed upon by the firms located in two different countries for the specific amount of goods and money, the contract value may change with the fluctuations in the foreign exchange rates. This risk of change in the exchange rates is called the transaction exposure.

The greater the time gap between the agreement and the final settlement, the higher is the risk associated with the change in the foreign exchange rates. However, the companies could save themselves against the transaction exposure through hedging techniques.

Transaction Exposure: Types of Exposure

1. Purchasing or selling on credit when prices are stated in a foreign currency.

2. Borrowing or lending funds when repayment is to be made in a foreign currency.

3. Being a party to an unperformed foreign exchange forward contract.

4. Acquiring assets or incurring liabilities denominated in a foreign currency

Example

A U.S. firm sells merchandise on open account to a Belgian buyer for 1,800,000, payment to be made in 60 days. Current exchange rate is $1.1200/. Seller expects to receive 1,800,000$1.1200/ = $2,016,000. Transaction exposure: If the euro weakens, the seller will receive less than $2,016,000. If the euro appreciates, the seller will receive more than $2,016,000.

Dayton, a U.S.-based manufacturer of gas turbine equipment, has just concluded negotiations for the sale of a turbine generator to a British firm for the sum of 1,000,000. The sale is concluded in March but payment will be made three months later, in June

Assumptions Spot exchange rate: $1.7640/. Three-month forward rate: $1.7540/. Daytons cost of capital: 12%. U.K. three-month borrowing (lending) rate: 10% (8%) per annum. U.S. three-month borrowing (lending) rate: 8% (6%) per annum.

Assumptions June put option: 1,000,000; $1.75 strike price; 1.5% premium. June put option: 1,000,000; $1.71 strike price; 1.0% premium. Daytons forecast of the spot rate in June: $1.76/. Daytons minimum acceptable exchange rate: $1.7000/.

6. What is Accounting Exposure and Managing it ?.

Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries financial statements, usually stated in foreign currency, into the parents reporting currency when preparing the consolidated financial statements. Restating financial statements may lead to changes in the parents net worth or net income.

"Accounting exposure": Risk management.1.The potential impact on an entity's accounts of a particular policy or transaction. For example the effect on group accounts in applying accounting policies relating to the translation of assets and liabilities denominated in currencies other than the group's functional currency.2.Potential secondary adverse effects resulting from accounting exposure (as defined above).For example the potential breach of a borrowings covenant.

Accounting Exposure

Theriskthatacompanymaysufferareductioninvaluebecauseachangeinexchange ratesreducesthevalueofitsaccountsorassetsdenominatedinforeigncurrencies.Thatis,ifaparticularcurrencyinwhichacompanyhassomeassetsdenominateddecreasesinvalue,thevalueofthoseassetsalsodecreaseswithrespecttothecompany's maincurrency.

Translation exposure is measured at the time of translating foreign financial statements for reporting purposes and indicates or exposes the possibility that the foreign currency denominated financial statement elements can change and give rise to further translation gains or losses, depending on the movement that takes place in the currencies concerned after the reporting date. Such translation gains and losses may well reverse in future accounting periods but do not, in themselves, represent realized cash flows unless, and until, the assets and liabilities are settled or liquidated in whole or in part. This type of exposure does not, therefore, require management action unless there are particular covenants, e.g., regarding gearing profiles in a loan agreement, that may be breached by the translated domestic currency position, or if management believes that translation gains or losses will materially affect the value of the business. International

Accounting Standards set out best practice.

A firm which has subsidiaries and assets in another country is subject to translation exposure. Translation exposure results as a consequence of the fact that a parent company must consolidate all of the operations of its subsidiaries into its own financial statements. Since a foreign subsidiarys assets are carried on its books in a foreign currency, it is necessary to convert the foreign values into domestic currency for combining with the parents assets. Fluctuating exchange rates, results in gains and losses occurring during the translation process. Since this type of exposure is related to balance sheet assets and liabilities, it is often referred to as accounting exposure. The primary issue related to the translation of foreign asset values has to do with

whether the proper exchange rate to use is the current rate of exchange or the historic rate

of exchange that existed at the time that an asset was acquired. In order to see the possible

gains and losses that can occur, lets consider the following:

A U.S. company has a Mexican subsidiary that buys an asset for 12 million pesos

in 20x1 when the exchange rate is 12 pesos per USD. Over the following year, inflation in

Mexico is 50% while in the U.S. it is 0%. Of course, if purchasing power parity holds, then

the exchange rate in one year should be 18 pesos per dollar.

If we use historical cost accounting, the asset will have a value of 12 million pesos on

the Mexican subsidiarys books. Translating this at the current exchange rate of 18 pesos/

USD yields a US dollar value of

USD 666,667

18 pesos/USD

12,000,000 pesos = =

If we translate the historical cost of 12 million pesos at the historical exchange rate

at the time of acquisition of 12 pesos/USD we get a US dollar value of

USD1,000,000

12 pesos/USD

12,000,000 pesos = =

Thus, the correct value would be to use the historical exchange rate when the books

are kept on an historical cost basis.

On the other hand, Mexico is a country that utilizes an inflation-adjusted (or current)

accounting system where assets are indexed for inflation. Thus, the Mexican subsidiary would carry the asset on the books at 18 million pesos (12 million pesos * (1+50%) = 18

million pesos). Translating this using the current exchange rate of 18 pesos/USD yields

USD1,000,000

18 pesos/USD

18,000,000 pesos = =

If the historical exchange rate were used, we would obtain the following value:

USD1,500,000

12 pesos/USD

18,000,000 pesos = =

For the proper translation of value, we should either use the historic exchange

rate with historical cost accounting or the current exchange rate with current accounting

practices. For a foreign currency that has depreciated, we get the following general results

(an appreciating currency would yield the opposite results)

In any event, translation exposure is not a real gain or loss in terms of making or losing money. The value of the asset is the value of the asset. The gain or loss results simply from translating from one currency to another. In that sense, one should not really worry about translation exposure (except to the extent that there is a perceived gain or loss from unsophisticated users of the financial statements).

This is also referred to as conversion exposure or cash flow exposure. It concerns the

actual cash flows involved in setting transactions denominated in a foreign currency. These

could include, for example:

Sales receipts

Payments for goods and services

Receipt and/or payment of dividends

Servicing loan arrangements as regards interest and capital

Measurement of Translation Exposure

Translation exposure measures the effect of an exchange rate change on published

financial statements of a firm.

Assets & liabilities that are translated at the current exchange rate are considered

to be exposed (uncovered) as the balance sheet will be affected by fluctuations in

currency values over time.

Assets & liabilities that are translated at a historical exchange rate will be regarded as

not exposed as they will not be affected by exchange rate fluctuations.

So, the difference between exposed assets & exposed liabilities is called translation

exposure.

Translation Exposure = Exposed Assets- Exposed Liabilities

(Change in the Exchange Rate)

STEPS for Measuring Translation Exposure are:

1. Determine functional currency.

2. Translate using temporal method recording gains/losses in the income statement as

realized

3. Translate using current method recording gains/losses in the balance sheet & as realized

4. Consolidate into parent company financial statements.

7. What is meant By Operating Exposure ?

Operating Exposure

Operating exposure is known as economic exposure. The extent to which the value

of the firm changes when the exchange rate changes (value is measured as the present value

of expected future cash flows)

Suppose

PV = present value of the firm

PV = change in present value of the firm

S = change in exchange rate

If PV/S 0, then the firm is exposed to currency risk (i.e., operating exposure)

Operating exposure arises because currency fluctuations can alter a firms future

revenues and costs (i.e., its operating cash flows).

Managing Operating Exposure

Long-term; Techniques involve:

Marketing Management

A. Market Selection

To examine which markets to sell products (strong currency market vs. Weak currency market). Sell in multiple markets to take advantage of economies of scale and diversification of exchange rate risk. (Example: Mexican peso devalued in December 1994. The sale of Goodyear tires

of Mexican plant plunged more than 20% (i.e., a drop of 3,500 tires per day) in Mexico.

The plant changed its sale strategy quickly and exported tires to U.S., South America, and

Europe.)

B. Pricing Strategy

Emphasize on market share or profit margin. Exporters will benefit from a weak home currency and can either increase price or increase market share.

C. Product Strategy

New products, product line decisions, and product innovation (through R&D), VW sold very inexpensive vehicles in the early 1970s, but the appreciation of the DM caused VW to keep lowering prices to maintain market share. VW lost over $300 million in 1974. VW altered their strategy to sell more expensive cars with higher quality. Successful R&D allows for cost cutting, enhanced productivity, and product differentiation

Production Management

A. Product Sourcing: purchase components overseas (outsource components)

B. Plant Location: shift production to lower cost sites. Increase production in a country with a weaker currency, and decrease production in a country with a stronger currency (e.g., Honda built North American factories in response to strong yen, but later Honda imported the cars from Japan because of a weak yen).

C. Increase Productivity: close inefficient plants, high automation

Financial Hedging

It involves the use of currency swaps, currency futures, currency forwards, and currency options.

Proactive Management

Six of the most commonly employed proactive policies are

Matching currency cash flows

Risk-sharing agreements

Back-to-back loans

Currency swaps

Leads and lags (pay early and pay late)

Re invoicing centers

Matching Currency Cash Flows

One way to offset an anticipated continuous exposure to a particular currency is to

acquire debt denominated in that currency

This policy results in a continuous receipt of payment and a continuous outflow in

the same currency

This can sometimes occur through the conduct of regular operations and is referred

to as a natural hedge

Risk-Sharing Agreements

Risk-sharing is a contractual arrangement in which the buyer and seller agree to

share or split currency movement impacts on payments

Parallel Loan

A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when

two firms in different countries arrange to borrow each others currency for a specific period of time

The operation is conducted outside the FOREX markets, although spot rates may be

used to decide the equivalent amount

This swap creates a covered hedge against exchange loss, since each company, on itsown books, borrows the same currency it repays

Currency Swaps

Currency swaps resemble back-to-back loans except that it does not appear on a

firms balance sheet.

In a currency swap, a dealer and a firm agree to exchange an equivalent amount of

two different currencies for a specified period of time

Currency swaps can be negotiated for a wide range of maturities

A typical currency swap requires two firms to borrow funds in the markets and

currencies in which they are best known or get the best rates

Leads and Lags: Re-Timing the Transfer of Funds

Firms can reduce both operating and transaction exposure by accelerating or

decelerating the timing of payments that must be made or received in foreign currencies

To lead is to pay early

To lag is to pay late

Leading and lagging can be done between related firms (intracompany) or with independent firms (intercompany)

Leading and lagging between related firms is more feasible because they presumably

share a common set of goals for the consolidated group

In the case of financing cash flows with foreign subsidiaries, there is an additional

motivation for early or late payments to position funds for liquidity reasons

For example, a subsidiary which is allowed to lag payments to the parent company is

in reality borrowing from the parent company

Leading or lagging between independent firms requires the time preference of one

firm to be imposed to the detriment of the other firm

For example, Trident Europe may wish to lead in collecting its Brazilian accounts

receivable (A/R) that are denominated in real because it expects the real to drop in value compared with the euro

Re-Invoicing Centers

A re-invoicing center is a separate corporate subsidiary that serves as a type of

middle-man between the parent or related unit in one location and all foreign

subsidiaries in a geographic region

For example, the U.S. manufacturing unit of Trident Corporation invoices the firms

re-invoicing center located within the corporate HQ in Los Angeles in U.S. dollars

However, the physical goods are shipped directly to Trident Brazil

The re-invoicing center in turn re-sells to Trident Brazil in Brazilian real

Consequently, all operating units deal only in their own currency, and all transaction

exposure lies with the re-invoicing center

8.What is Value at risk?.

Practitioners 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.

9. What are foreign Exchange Markets & Functions of foreign exchange Market ?.

Meaning:

Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and the central bank.

Functions of Foreign Exchange Market:

1.Transfer Function:

It transfers purchasing power between the countries involved in the transaction. This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.

2.Credit Function:

It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are generally used for international payments. Credit is required for this period in order to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.

3.Hedging Function:

When exporters and importers enter into an agreement to sell and buy goods on some future date at the current prices and exchange rate, it is called hedging. The purpose of hedging is to avoid losses that might be caused due to exchange rate variations in the future

10. What kinds of foreign exchange market are there ?.

Kinds of Foreign Exchange Markets:

Foreign exchange markets are classified on the basis of whether the foreign exchange transactions are spot or forward accordingly, there are two kinds of foreign exchange markets:

(i) Spot Market,

(ii) Forward Market.

(i) Spot Market:

Spot market refers to the market in which the receipts and payments are made immediately. Generally, a time of two business days is permitted to settle the transaction. Spot market is of daily nature and deals only in spot transactions of foreign exchange (not in future transactions). The rate of exchange, which prevails in the spot market, is termed as spot exchange rate or current rate of exchange.

The term spot transaction is a bit misleading. In fact, spot transaction should mean a transaction, which is carried out on the spot (i.e., immediately). However, a two day margin is allowed as it takes two days for payments made through cheques to be cleared.

(ii) Forward Market:

Forward market refers to the market in which sale and purchase of foreign currency is settled on a specified future date at a rate agreed upon today. The exchange rate quoted in forward transactions is known as the forward exchange rate. Generally, most of the international transactions are signed on one date and completed on a later date. Forward exchange rate becomes useful for both the parties involved in the transaction.

Forward Contract is made for two reasons:

(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);

(b) To make profit (through speculation)

11.Who are the participants in the Foreign exchange market ?.

The participants in the foreign exchange market comprise;

(i) Corporates

(ii) Commercial banks

(iii) Exchange brokers

(iv) Central banks

Corporates

The business houses, international investors, and multinational corporations may operate in the market to meet their genuine trade or investment requirements. They may also buy or sell currencies with a view to speculate or trade in currencies to the extent permitted by the exchange control regulations. They operate by placing orders with the commercial banks. The deals between banks and their clients form the retail segment of foreign exchange market.

In India the foreign Exchange Management (Possession and Retention of Foreign Currency) Regulations, 2000 permits retention, by resident, of foreign currency up to USD 2,000. Foreign Currency Management (Realisation, Repatriation and Surrender of Foreign Exchange) Regulations, 2000 requires a resident in India who receives foreign exchange to surrender it to an authorized dealer:

(a) Within seven days of receipt in case of receipt by way of remuneration, settlement of lawful obligations, income on assets held abroad, inheritance, settlement or gift: and

(b) Within ninety days in all other cases.

Any person who acquires foreign exchange but could not use it for the purpose or for any other permitted purpose is required to surrender the unutilized foreign exchange to authorized dealers within sixty days from the date of acquisition. In case the foreign exchange was acquired for travel abroad, the unspent foreign exchange should be surrendered within ninety days from the date of return to India when the foreign exchange is in the form of foreign currency notes and coins and within 180 days in case of travellers cheques. Similarly, if a resident required foreign exchange for an approved purpose, he should obtain from and authorized dealer.

Commercial Banks

Commercial Banks are the major players in the market. They buy and sell currencies for their clients. They may also operate on their own. When a bank enters a market to correct excess or sale or purchase position in a foreign currency arising from its various deals with its customers, it is said to do a cover operation. Such transactions constitute hardly 5% of the total transactions done by a large bank. A major portion of the volume is accounted buy trading in currencies indulged by

the bank to gain from exchange movements. For transactions involving large volumes, banks may deal directly among themselves. For smaller transactions, the intermediation of foreign exchange brokers may be sought.

Exchange Brokers

Exchange brokers facilitate deal between banks. In the absence of exchange brokers,

banks have to contact each other for quotes. If there are 150 banks at a centre, for obtaining

the best quote for a single currency, a dealer may have to contact 149 banks. Exchange

brokers ensure that the most favorable quotation is obtained and at low cost in terms of

time and money.

The bank may leave with the broker the limit up to which and the rate at which it

wishes to buy or sell the foreign currency concerned. From the intends from other banks,

the broker will be able to match the requirements of both. The names of the counter parities

are revealed to the banks only when the deal is acceptable to them. Till then anonymity is

maintained. Exchange brokers tend to specialize in certain exotic currencies, but they also

handle all major currencies.

In India, banks may deal directly or through recognized exchange brokers. Accredited exchange brokers are permitted to contract exchange business on behalf of authorized dealers in foreign exchange only upon the understanding that they will conform to the rates, rules and conditions laid down by the FEDAI. All contracts must bear the clause subject to the Rules and Regulations of the Foreign Exchanges Dealers Association of India.

Central Bank

Central Bank may intervene in the market to influence the exchange rate and change it from that would result only from private supplies and demands. The central bank may transact in the market on its own for the above purpose. Or, it may do so on behalf of the government when it buys or sell bonds and settles other transactions which may involve foreign exchange payments and receipts.

In India, authorized dealers have recourse to Reserve Bank to sell/buy US dollars to the extent the latter is prepared to transact in the currency at the given point of time. Reserve Bank will not ordinarily buy/sell any other currency from/to authorized dealers. The contract can be entered into on any working day of the dealing room of Reserve Bank.

No transaction is entered into on Saturdays. The value date for spot as well as forward

delivery should be in conformity with the national and international practice in this regard.

Reserve Bank of India does not enter into the market in the ordinary course, where

the exchages rates are moving in a detrimental way due to speculative forces, the Reserve

Bank may intervene in the market either directly or through the State Bank of India

12..How the foreign exchange settlements are done ?

Settlement of Transactions

Foreign exchange markets make extensive use of the latest developments in telecommunications for transmitting as well settling foreign exchange transaction, Banks use the exclusive network SWIFT to communicate messages and settle the transactions at electronic clearing houses such as CHIPS at New York.

SWIFT

SWIFT is a acronym for Society for Worldwide Interbank Financial Telecommunications, a co operative society owned by about 250 banks in Europe and North America and registered as a co operative society in Brussels, Belgium. It is a communications network for international financial market transactions linking effectively more than 25,000 financial institutions throughout the world who have been allotted bank identified codes. The messages are transmitted from country to country via central interconnected operating centers located in Brussels, Amsterdam and Culpeper, Virginia. The member countries are connected to the centre through regional processors in each country. The local banks in each country reach the regional processors through the national net works.

The SWIFY System enables the member banks to transact among themselves quickly

(i) International payments

(ii) Statements

(iii) Other messages connected with international banking.

Transmission of messages takes place within seconds, and therefore this method is economical as well as time saving. Selected banks in India have become members of SWIFT. The regional processing centre is situated at Mumbai. The SWIFT provides following advantages for the local banking community:

1. Provides a reliable (time tested) method of sending and receiving messages from a

vast number of banks in a large number of locations around the world.

2. Reliability and accuracy is further enhanced by the built in authentication facilities, which has only to be exchanged with each counterparty before they can be activated or further communications.

3. Message relay is instantaneous enabling the counterparty to respond immediately, if not prevented by time differences.

4. Access is available t a vast number of banks global for launching new cross border initiatives.

5. Since communication in SWIFT is to be done using structure formats for various types of banking transactions, the matter to be conveyed will be very clear and there will not be any ambiguity of any sort for the received to revert for clarifications. This is mainly because the formats are used all ove3r the world on a standardized basis for conducting all types of banking transactions. This makes the responses and execution very efficient at the receiving banks end thereby contributing immensely to quality service being provided to the customers of both banks (sending and receiving).

6. Usage of SWIFT structure formats for message transmission to counterparties will

entail the generation of local banks internal records using at least minimum level

of automation. This will accelerate the local banks internal automation activities,

since the maximum utilization of SWIFT a significant internal automation level is

required.

CHIPS

CHIPS stands for Clearing House Interbank Payment System. It is an electronic payment system owned by 12 private commercial banks constituting the New York Clearing House Association. A CHIP began its operations in 1971 and has grown to be the worlds largest payment system. Foreign exchange and Euro dollar transactions are settled through CHIPS. It provides the mechanism for settlement every day of payment and receipts of numerous dollar transactions among member banks at New York, without the need for physical exchange of cheques/funds for each such transaction.

The functioning of CHIPS arrangement is explained below with a hypothetical transaction: Bank of India, maintaining a dollar account with Amex Bank, New York, sells USD 1 million to Canara Bank, maintaining dollar account with Citibank.

1. Bank of India intimate Amex Bank debuts the account of Bank through SWIFT to debit its account and transfer USD 1 million to Citibank for credit of current account of Canara Bank.

2. Amex Bank debits the account of Bank of India with USD 1 million and sends the equivalent of electronic cheques to CHIPS for crediting the account of Citibank. The transfer is effected the same day.

3. Numerous such transactions are reported to CHIPS by member banks and transfer effected at CHIPS. By about 4.30 p.m, eastern time, the net position of each member is arrived at and funds made available at Fedwire for use by the bank concerned by 6.00 p.m. eastern time.

4. Citibank which receives the credit intimates Canara Bank through SWIFT. It may be noted that settlement of transactions in the New York foreign exchange market takes place in two stages, First clearance at CHIPS and arriving at the net position for each bank. Second, transfer of fedfunds for the net position. The real balances are held by banks only with Federal Reserve Banks (Fedfunds) and the transaction is complete only when Fedfunds are transferred. CHIPS help in expediting the reconciliation and reducing the number of entries that pass through Fedwire.

CHAPS

CHAPS is an arrangement similar to CHIPS that exists in London. CHAPS stands for Clearing House Automated Payment System.

Fedwire

The transactions at New York foreign exchange market ultimately get settled through Fedwire. It is a communication network that links the computers of about 7000 banks to the computers of federal Reserve Banks. The fedwire funds transfer system, operate by the Federal Reserve Bank, are used primarily for domestic payments, bank to bank and third party transfers such as interbank overnight funds sales and purchases and settlement transactions. Corporate to corporate payments can also be made, but they should be effected through banks. Fed guarantees settlement on all payments sent to receivers even if the sender fails.

13How the Interbank transactions happen in foreign exchange market ?.

The exchange rates quoted by banks to their customer are based on the rates prevalent

in the interbank market. The big banks in the market are known as market makers, as they

are willing to buy or sell foreign currencies at the rates quoted by them up to any extent.

Depending buy or sell foreign currencies at the rates quoted by them up to any

extent. Depending upon its resources, a bank may be a market maker in one or few major

currencies. When a banker approaches the market maker, it would not reveal its intention

to buy or sell the currency. This is done in order to get a fair price from the market maker.

Two Way Quotations

Typically, the quotation in the interbank market is a two way quotation. It means

the rate quoted by the market maker will indicate two prices. One at which it is willing to

buy the foreign currency, and the other at which it is willing to sell the foreign currency.

For example, a Mumbai bank may quote its rate for US dollar as under

USD 1 = ` 48.1525/1650

More often, the rate would be quoted as 1525/1650 since the players in the market

are expected to know the big number i.e., ` 48. In the given quotation, one rate is `

48.1525 per dollar and the other rate is ` 48.1650. per dollar.

Direct Quotation

It will be obvious that the quoting bank will be willing to buy dollars at ` 48.1525

and sell dollars $ at ` 48.1650. If one dollar bought and sold, the bank makes a gross profit

of ` 0.0125. In a foreign exchange quotation, the foreign currency is the commodity that is

being bought and sold.

The exchange quotation which gives the price for the foreign currency in terms of

the domestic currency is known as direct quotation. In a direct quotation, the quoting bank

will apply the rule: Buy low; Sell high.

Indirect Quotation

There is another way of quoting in the foreign exchange market. The Mumbai bank

quotes the rate for dollar as:

` 100 = USD 2.0762/0767

This type of quotation which gives the quantity of foreign currency per unit of

domestic currency is known as indirect quotation. In this case, the quoting bank will

receive USD 2.0767 per ` 100 while buying dollars and give away USD 2.0762 per ` 100

while selling dollars. In other world, he will apply the rule: Buy high: Sell low.

The buying rate is also known as the bid rate and selling rate as the offer rate. The

difference between these rates is the gross profit for the bank and is known as the Spread.

Spot and Forward Transactions

The transactions in the interbank market may place for settlement

(a) On the same day; or

(b) Two days later; or

(c) Some day late; say after a month

Where the agreement to buy and sell is agreed upon and executed on the same date,

the transaction is known as cash or ready transaction. It is also known as value today.

The transaction where the exchange of currencies takes place two days after the

date of the contact is known as the spot transaction. For instance, if the contract is made

on Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the

delivery will take place on the next day, i.e., Thursday. Rupee payment is also made on the

same day the foreign currency is received.

The transaction in which the exchange of currencies takes places at a specified

future date, subsequent to the spot date, is known as a forward transaction. The forward

transaction can be for delivery one month or two months or three months etc. A forward

contract for delivery one month means the exchange of currencies will take place after one

month from the date of contract. A forward contract for delivery two months means the

exchange of currencies will take place after two months and so on.

Forward Margin/Swap points

Forward rate may be the same as the spot rate for the currency. Then it is said to

be at par with the spot rate. But this rarely happens. More often the forward rate for a

currency may be costlier or chapter tan its spot rate. The rate for a currency may be costlier

or cheaper than nits spot rate.

The difference between the forward rate and the spot rate is known as the forward

margin or swap points. The forward margin may be either at premium or at discount. If

the forward margin is at premium, the foreign correct will be costlier under forward rate

than under the spot rate. If the forward margin is at discount, the foreign currency will be

cheaper for forward delivery then for spot delivery.

Under direct quotation, premium is added to spot rate to arrive at the forward rate.

This is done for both purchase and sale transactions. Discount is deducted from the spot

rate to arrive at the forward rate.

Interpretation of Interbank quotations

The market quotation for a currency consists of the spot rate and the forward

margin. The outright forward rate has to be calculated by loading the forward margin into

the spot rate. For instance, US dollar is quoted as under in the interbank market on 25th

January as under:

Spot USD 1 = ` 48.4000/4200

Spot/February 2000/2100

Spot/March 3500/3600

The following points should be noted in interpreting the above quotation;

1. The first statement is the spot rate for dollars. The quoting bank buying rate is `

48.4000 and selling rate is ` 48.4200.

2. The second and third statements are forward margins for forward delivery during

the months of February. Spot/March respectively. Spot/February rate is valid for

delivery end February. Spot/March rate is valid for delivery end March.

3. The margin is expressed in points, i.e., 0.0001 of the currency. Therefore the forward

margin for February is 20 paise and 21 paise.

4. The first rate in the spot quotation is for buying and second for selling the foreign

currency. Correspondingly, in the forward margin, the first rate relates to buying

and the second to selling. Taking Spot/February as an example, the margin of 20

paise is for purchase and 21 paise is for sale of foreign currency.

5. Where the forward margin for a month is given in ascending order as in the quotation

above, it indicates that the forward currency is at premium. The outright forward

rates arrived at by adding the forward margin to the spot rates.

14. What are all the factors Determine Spot Rates ?.

Factors Determining Spot Exchange Rates

Balance of Payments

Balance of Payments represents the demand for and supply of foreign exchange

which ultimately determine the value of the currency. Exports, both visible and invisible,

represent the supply side for foreign exchange. Imports, visible and invisible, create

demand for foreign exchange. Put differently, export from the country creates demand for

the currency of the country in the foreign exchange market. The exporters would offer to

the market the foreign currencies they have acquired and demand in exchange the local

currency. Conversely, imports into the country will increase the supply of the currency of

the country in the foreign exchange market.

When the balance of payments of a country is continuously at deficit, it implies that

the demand for the currency of the country is lesser than its supply. Therefore, its value in

the market declines. If the balance of payments is surplus continuously it shows that the

demand for the currency in the exchange market is higher than its supply therefore the

currency gains in value.

Inflation

Inflation in the country would increase the domestic prices of the commodities.

With increase in prices exports may dwindle because the price may not be competitive.

With the decrease in exports the demand for the currency would also decline; this in turn

would result in the decline of external value of the currency. It may be noted that unit is

the relative rate of inflation in the two countries that cause changes in exchange rates. If,

for instance, both India and the USA experience 10% inflation, the exchange rate between

rupee and dollar will remain the same. If inflation in India is 15% and in the USA it is 10%,

the increase in prices would be higher in India than it is in the USA. Therefore, the rupee

will depreciate in value relative to US dollar.

Empirical studies have shown that inflation has a definite influence on the exchange

rates in the long run. The trend of exchange rates between two currencies has tended to

hover around the basic rate discounted for the inflation factor. The actual rates have varied

from the trend only by a small margin which is acceptable. However, this is true only where

no drastic change in the economy of the country is. New resources found may upset the

trend. Also, in the short run, the rates fluctuate widely from the trend set by the inflation

rate. These fluctuations are accounted for by causes other than inflation.

Interest Rate

The interest rate has a great influence on the short term movement of capital. When

the interest rate at a centre rises, it attracts short term funds from other centers. This would

increase the demand for the currency at the centre and hence its value. Rising of interest

rate may be adopted by a country due to tight money conditions or as a deliberate attempt

to attract foreign investment. Whatever be the intention, the effect of an increase in interest

rate is to strengthen the currency of the country through larger inflow of investment and

reduction in the outflow of investments by the residents of the country.

Money Supply

An increase in money supply in the country will affect the exchange rate through

causing inflation in the country. It can also affect the exchange rate directly.

An increase in money supply in the country relative to its demand will lead to large

scale spending on foreign goods and purchase of foreign investments. Thus the supply

of the currency in the foreign exchange markets is increased and its value declines. The

downward pressure on the external value of the currency then increases the cost of imports

and so adds to inflation.

The effect of money supply on exchange rate directly is more immediate than its

effect through inflation. While in the long run inflation seems to correlate exchange rate

variations in a better way, in the short run exchange rates move more in sympathy with

changes in money supply.

One explanation of how changes in money supply vary the exchange rate is this; the

total money supply in the country represents the value of total commodities and services in

the country. Based on this the outside world determines the external value of the currency.

If the money supply is doubles, the currency will be valued at half the previous value so as

to keep the external value of the total money stock of the country constant.

Another explanation offered is that the excess money supply flows out of the country

and directly exerts a pressure on the exchange rate. The excess money created, the extent

they are in excess of the domestic demand for money, will flow out of the country. This will

increase the supply of the currency and pull down its exchange rate.

National Income

An increase in national income reflects increase in the income of the residents of

the country. This increase in the income increases the demand for goods in the country.

If there is underutilized production capacity in the country, this will lead to increase in

production. There is a chance for growth in exports too. But more often it takes time for

the production to adjust to the increased income. Where the production does not increase

in sympathy with income rise, it leads to increased imports and increased supply of the

currency of the country in the foreign exchange market. The result is similar to that of

inflation, viz., and decline in the value of the currency. Thus an increase in national income

will lead to an increase in investment or in consumption, and accordingly, its effect on the

exchange rate will change. Here again it is the relative increase in national incomes of the

countries concerned that is to be considered and not the absolute increase.

Resource Discoveries

When the country is able to discover key resources, its currency gains in value. A

good example can be the have played by oil in exchange rates. When the supply of oil from

major suppliers, such as Middles East, became insecure, the demand fro the currencies

of countries self sufficient in oil arose. Previous oil crisis favoured USA, Canada, UK and

Norway and adversely affected the currencies of oil importing countries like Japan and

Germany.

Similarly, discovery oil by some countries helped their currencies to gain in value.

The discovery of North Sea oil by Britain helped pound sterling to rise to over USD 2.40

from USD 1.60 in a couple of years. Canadian dollar also benefited from discoveries of oil

and gas off the Canadian East Coast and the Arctic.

Capital Movements

Capital movements there are many factors that influence movement of capital from

one country to another. Short term movement of capital may be influenced buy the offer of

higher interest in a country. If interest rate in a country rises due to increase in bank rate or

otherwise, there will be a flow of short term funds into the country and the exchange rate

of the currency will rise. Reverse will happen in case of fall in interest rates.

Bright investment climate and political stability may encourage portfolio investments

in the country. This leads to higher demand for the currency and upward trend in its rate.

Poor economic outlook may mean repatriation of the investments leading to decreased

demand and lower exchange value for the currency of the country.

Movement of capital is also caused by external borrowing and assistance. Large

scale external borrowing will increase the supply of foreign exchange in the market. This

will have a favorable effect on the exchange rate of the currency of the country. When

repatriation of principal and interest starts the rate may be adversely affected.

Political Factors

Political factors Political stability induced confidence in the investors and

encourages capital inflow into the country. This has the effect of strengthening the

currency of the country. On the other hand, where the political situation in the country is

unstable, it makes the investors withdraw their investments. The outflow of capital from

the country would weaken the currency. Any news about change in the government or

political leadership or about the policies of the government would also have the effect of

temporarily throwing out of gear the smooth functioning of exchange rate mechanism.

15. How transactions Conducted in Foreign Exchange Market ?

A very brief account of certain important types of transactions conducted in the

foreign exchange market is given below

1. Spot and

2. Forward Exchanges

Spot Market

The term spot exchange refers to the class of foreign exchange transaction which

requires the immediate delivery or exchange of currencies on the spot. In practice the

settlement takes place within two days in most markets. The rate of exchange effective

for the spot transaction is known as the spot rate and the market for such transactions is

known as the spot market.

Forward Market

The forward transactions is an agreement between two parties, requiring the

delivery at some specified future date of a specified amount of foreign currency by one of

the parties, against payment in domestic currency be the other party, at the price agreed

upon in the contract.

The rate of exchange applicable to the forward contract is called the forward

exchange rate and the market for forward transactions is known as the forward market.

The foreign exchange regulations of various countries generally regulate the forward

exchange transactions with a view to curbing speculation in the foreign exchanges market.

In India, for example, commercial banks are permitted to offer forward cover only with

respect to genuine export and import transactions.

Forward exchange facilities, obviously, are of immense help to exporters and

importers as they can cover the risks arising out of exchange rate fluctuations be entering

into an appropriate forward exchange contract.

With reference to its relationship with spot rate, the forward rate may be at par,

discount or premium.

If the forward exchange rate quoted is exact equivalent to the spot rate at the time

of making the contract the forward exchange rate is said to be at par.

The forward rate for a currency, say the dollar, is said to be at premium with respect

to the spot rate when one dollar buys more units of another currency, say rupee, in the

forward than in the spot rate on a per annum basis.

The forward rate for a currency, say the dollar, is said to be at discount with respect

to the spot rate when one dollar buys fewer rupees in the forward than in the spot market.

The discount is also usually expressed as a percentage deviation from the spot rate on a per

annum basis.

The forward exchange rate is determined mostly be the demand for and supply of

forward exchange. Naturally when the demand for forward exchange exceeds its supply,

the forward rate will be quoted at a premium and conversely, when the supply of forward

exchange exceeds the demand for it, the rate will be quoted at discount. When the supply

is equivalent to the demand for forward exchange, the forward rate will tend to be at par.

Futures

While a focus contract is similar to a forward contract, there are several differences

between them. While a forward contract is tailor made for the client be his international

bank, a future contract has standardized features the contract size and maturity dates are

standardized.

Futures cab traded only on an organized exchange and they are traded competitively.

Margins are not required in respect of a forward contract but margins are required of all

participants in the futures market an initial margin must be deposited into a collateral

account to establish a futures position.

Options

While the forward or futures contract protects the purchaser of the contract fro m

the adverse exchange rate movements, it eliminates the possibility of gaining a windfall

profit from favorable exchange rate movement.

An option is a contract or financial instrument that gives holder the right, but not

the obligation, to sell or buy a given quantity of an asset as a specified price at a specified

future date. An option to buy the underlying asset is known as a call option and an option

to sell the underlying asset is known as a put option. Buying or selling the underlying asset

via the option is known as exercising the option. The stated price paid (or received) is

known as the exercise or striking price. The buyer of an option is known as the long and

the seller of an option is known as the writer of the option, or the short. The price for the

option is known as premium.

Types of Options

With reference to their exercise characteristics, there are two types of options,

American and European. A European option cab is exercised only at the maturity or

expiration date of the contract, whereas an American option can be exercised at any time

during the contract.

Swap Operation

Commercial banks who conduct forward exchange business may resort to a swap

operation to adjust their fund position. The term swap means simultaneous sale of spot

currency for the forward purchase of the same currency or the purchase of spot for the

forward sale of the same currency. The spot is swapped against forward. Operations

consisting of a simultaneous sale or purchase of spot currency accompanies by a purchase

or sale, respectively of the same currency for forward delivery are technically known as

swaps or double deals as the spot currency is swapped against forward.

Arbitrage

Arbitrage is the simultaneous buying and selling of foreign currencies with intention

of making profits from the difference between the exchange rate prevailing at the same time

in different markets

Forward Contract

Forward contracts are typical OTC derivatives. As the name itself suggests, forward

are transactions involving delivery of an asset or a financial instrument at a future date.

One of the first modern to arrive contracts as forward contracts ere known was agreed at

Chicago Boar of Trade in March 1851 for maize corn to be delivered in June of that year.

Characteristics of Forward Contracts

The main characteristics of forward contracts are given below;

They are OTC contracts

Both the buyer and seller are committed to the contract. In other words, they have

to take deliver and deliver respectively, the underlying asset on which the forward

contract was entered into. As such, they do not have the discretion as regards

completion of the contract.

Forwards are price fixing in nature. Both the buyer and seller of a forward contract

are fixed to the price decided upfront.

Due to the above two reasons, the pay off profiles of the borrower and seller, in a

forward contract, are linear to the price of the underlying.

The presence of credit risk in forward contracts makes parties wary of each other.

Consequently forward contracts are entered into between parties who have good

credit standing. Hence forward contracts are not available to the common man.

Determining Forward Prices

In principle, the forward price for an asset would be equal to the spot or the case

price at the time of the transaction and the cost of carry. The cost of carry includes all the

costs to be incurred for carrying the asset forward in time. Depending upon the type of asset

or commodity, the cost of carry takes into account the payments and receipts for storage,

transport costs, interest payments, dividend receipts, capital appreciation etc. Thus

Forward price = Spot or the Cash Price + Cost of Carry

Merchant Rate

The foreign exchange dealing of a bank with its customer is known as merchant

business and the exchange rate at which the transaction takes place is the merchant rate.

The merchant business in which the contract with the customer to buy or sell foreign

exchange is agreed to and executed on the same day is known as ready transaction or cash

transaction. As in the case of interbank transactions a value next day contract is deliverable

on the next business day and a spot contract is deliverable on the second succeeding

business day following the date of the contract. Most of the transactions with customers

are on ready basis. In practice, the term ready and spot are used synonymously to refer

to transactions concluded and executed on the same day.

Foreign Exchange Transactions

Foreign exchange dealing is a business in which foreign currency is the commodity.

It was seen earlier that foreign currency is not a legal tender. The US dollar cannot be used

for settlement of debts in India; nevertheless, it has value. The value of US dollar is like the

value of any other commodity. Therefore, the foreign currency can be considered as the

commodity in foreign exchange dealings.

Purchase and Sale transactions

Any trading has two aspects (i) Purchase (ii) sale. A trader has to purchase goods

from his suppliers which he sells to his customers. Likewise the bank (which is authorized

to deal in foreign exchange) purchases as well as sells its commodity the foreign currency.

Two points need be constantly kept in mind while talking of a foreign exchange transaction:

1. The transaction is always talked of from the banks point of view

2. The item referred to is the foreign currency.

Therefore when we say a purchase we implied that

(i) The bank has purchased

(ii) It has purchased foreign currency

Similarly, when we sale a sale, we imply that

(i) The bank has sold

(ii) It has sold foreign currency.

In a purchase transaction the bank acquired foreign currency and parts with home currency.

In a sale transaction the bank parts with foreign currency and acquires home currency.

Exchange Quotations

We have seen that exchange rates can be quoted in either of the two ways;

(a) Direct quotation

(b) Indirect quotation.

The quotation in which exchange rate is expressed as the price per unit of foreign

currency in terms of the home currency is k known as Home currency quotation or Direct

quotation. It may be noted that under direct quotation the number of units of foreign

currency is kept constant and any ch