Foreign Exchange

Foreign Exchange
I. Exchange Rate Foreign Exchange market is a mechanism or an institutional arrangement for buying & selling foreign exchange. According to Kindleberger, The foreign exchange market is a place here foreign moneys are bought and sold.! The forex "arket consists of a number of banks, brokers & dealers in foreign exchange. #n short it is called as Forex "arket. The o$erall super$ision & monitoring of such market is done by the %entral &ank of a country. The fundamental feature of forex market is transfer of the purchasing po er from one currency to another for hich t o components are needed' ( )i* #nstitutions like banks, brokers, acceptance houses & %entral &ank of country. )ii* #nstruments like &ills of Exchange, &ank +rafts, Telegraphic Transfers & ,-%. The Forex market of any country performs the follo ing functions' ( ).* Transfer Functions: #t facilitates the con$ersion of one currency into another i.e. payments bet een exporters and importers. )/* Credit Functions: The Forex market pro$ides credit to both to national & international. This is because the international payments get delayed due to credit terms i.e. 01 days to 21 days etc3 The exporter in such cases gets the bills discounted ith the bank. )4* Hedging Function: The Forex market pro$ided hedging facilities. 5edging refers to buying or selling spot or for ard foreign exchange that is necessary to a$oid the risk of fluctuations in forex price. Foreign exchange is the mechanism through, hich payments are affected bet een nations ha$ing different currency systems. Exchange rate is the rate at hich one currency gets exchanged ith another currency. For example . American +ollar is exchanged for #ndian 6upees 78, then the rate of exchange bet een the dollar and rupee is 9. : 6s. 78.11 The rate of exchange is a price of one currency in terms of some other currency, i.e. the $alue of one dollar in terms of rupees or the $alue of one rupee in terms of dollar.
Lecture Notes Prof. Rahul Shah !": # $%& %'(') *+*(,

Foreign Exchange

-eter.ination of the Exchange Rate:

The rate of exchange is akin to price of a commodity. Thus ;ust like the price of a commodity is determined by the demand and supply forces, the foreign exchange rate is also determined by the interaction of market forces of demand and supply. The e<uilibrium rate of exchange is the rate at hich the supply and demand are e<ual. The ine<uality bet een the supply and demand ould force the price up ards or do n ards and this mo$ement ould stop at the e<uilibrium price. The e<uilibrium rate of exchange is sho n ith the help of the follo ing diagram'

.* Factors influencing de.and for foreign exchange'

The demand ould come in the form of =>+ to pay for import of goods and ser$ices, #ndian in$estors ho ant to incest in => bonds, e<uity shares, +emand from indi$iduals ho ant to tra$el and study in =>, +emand from corporate intending to in$est in =>, =nilateral payments like donations, gifts creating a demand for dollars.

(" Factors influencing su//l0 of foreign exchange:

+emand from => citi?ens through import of #ndian @oods and ser$ices, American tra$elers and tourists in #ndia, #nflo of capital from => companies, 6emittances from =>A into #ndia.

Lecture Notes Prof. Rahul Shah !": # $%& %'(') *+*(,

Foreign Exchange

'" 1ther Factors

Ane of the key indicators of the strength of a country is seen in its foreign exchange rate. The continues drop or fall in exchange rate or the resultant decrease in the purchasing po er is a bad symptom for any country. Therefore, one of the important ob;ecti$e before the monetary authorities is to maintain exchange rate stability. The exchange rate is influenced by $arious factors such as' ( A* Foreign Exchange 6eser$es. &* @+B. %* #nflation. +* +ebt &urden. E* Trade +eficits and &AB Bosition. F* >tability of the country. @* @o$ernment Bolicies.

INTERN2TI1N2L P23!ENT S3STE! 4 -IFFERRENT !1-ES 1F P23!ENTS: #

&" 1/en 2ccount 4 Sales on 1/en 2ccount: #f the exporter has implicit faith in the integrity and business morality of the buyer this is the simplest method of selling goods. #n this case, the seller sends the shipping documents direct to the foreign buyer and re<uest in the co$ering letter that the in$oice $alue be remitted to him. This is kno n as CApen AccountD, by hich is meant that the exporter debits the importer account in his books ith the in$oice $alue of each exporter deal. (" 5ill or -raft: The debtor has many courses open to him for making the remittance. 5e may remit by buying up bills of exchange on the creditorDs country arising from the countryD exports and sending those to the seller ho ill present them to the dra ee and collect the proceeds.

Lecture Notes Prof. Rahul Shah !": # $%& %'(') *+*(,

Foreign Exchange

2r6itrage:
Arbitrage means buying in one market and simultaneously selling it in the same market or other markets. The items in$ol$ed in arbitrage may be foreign exchange, stock, bonds and other commodities. Thus, arbitrage is done to take ad$antage of price differentials in t o markets. The arbitrage acti$ity in$ol$es buying in a lo priced market and selling the same goods in a high priced market and thereby earning the profit through price differentials. Brofits through arbitrage ould be impossible if the prices of the currencies, commodities or securities traded in ere ad;usted to exact parties. Ehen permitted by exchange restricted and regulations, successful arbitrage transactions in foreign exchange consist of buying in the eak market )going long* and simultaneously selling )technically going short* in the strong market. For e.g. suppose the sterling is selling Fe Gork at 9/.428 but is a$ailable are 9/.421 in ,ondon. The Arbitrage ould be affected by selling sterling in FG H /.428 and ha$ing a ,ondon &ank or foreign exchange firm sell dollars in ,ondon for /.421 to obtain the sterling needed for deli$ery in Fe Gork. The gross profit )91.18 per pound sterling* ould be significant on a substantial transaction.

S7IFT:
The acronym >E#FT stands for >ociety for Eorld ide #nterbank Financial Telecommunication. >E#FT allo s member financial institution orld ide to electronically exchange information amongst each other. >er$ices offered by >E#FT are cost effecti$e, reliable and secure. "essages are transmitted globally high speed communication channels on standardi?ed message formats for many international baking operations. >E#FT as e$ol$ed in "ay .2I4 here /42 ma;or international banks from .8 countries formed >E#FT cooperati$e society ith its head<uarters in &russels, &elgium. ,i$e operati$e commenced ith effect from 2th "ay .2II. >E#FT pro$ides connection to approximately /8111 users spread o$er J7 countries all o$er the globe. The users include banks, financial institutions, dealers in securities, brokers, clearing houses, depositors etc., >E#FT enables the members to transact amount themsel$es <uickly.
Lecture Notes Prof. Rahul Shah !": # $%& %'(') *+*(,

Foreign Exchange

Net8or9: >E#FT computers are linked by a high speed global

communications net ork. >ecurity features are in(built ensuring pre$enting of unauthori?ed transmission or fraudulent transmissions. 5enefits of S7IFT: #t pro$ides a <uick, reliable and cheap medium for communication of financial messages. The message security is better compared to other means of message transmission

F1REI:N C;RRENC3 E<P1S;RES

Foreign currency exposures and the attendant risks arise hene$er a business has an income or expenditure or an asset or liability in a currency other than the balance sheet currency. The $olatility of the exchange rates and the exchange rate mo$ements destabili?e the cash flo s of a business significantly. >uch destabili?ation of cash flo s hich affects the profitability of a business is the risk from foreign currency exposures. T0/es of Ex/osures: .* Transaction Exposure /* Translation Exposure 4* Economic Exposure .* Transaction Ex/osures: These exposures are the most common. For e.g. A company is exporting to =>A orth =>+ .11111 and the rate pre$ailing on the date of the contract is 74.81. #n this case, of on the date of the date of payment, the rate mo$es abo$e 74.81 say to 70.11, it ill result in creating a loss say to the tune of /.81 per dollar. The risk is an ad$erse mo$ement of the exchange rate from the time the transaction as undertaken till the time. /* Translational Ex/osures: Translation exposures arise from the need to CtranslateD foreign currency assets or liabilities into the home currency for the purpose of finali?ing the accounts for any gi$en period. For e.g. %onsider that a company has borro ed dollars to finance the import of capital goods orth =>+ .1111 H 6s. 74 per dollar. The entry as booked at this rate. The depreciation on the asset ould be pro$ided accordingly assuming that the forex rate has not changed. 5o e$er if at the time of finali?ation of the accounts, the exchange rate mo$es to say 6s. 7J per +ollar, it ould in$ol$e translational loss of 6s. 81111-(. '" Econo.ic Ex/osures: Transaction & Translation are accounting concepts & affects the bottom lines of the companies directly. Ehereas, an economic exposure is a managerial concept. Economic Exposure to an exchange rate is risk that change in the rate that affects the companies competiti$e position in the market and hence indirectly affects the bottom line.
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Foreign Exchange

RIS=S IN F1RE:N E<CH2N:E 5;SINESS > !E2S;RES T1 !ITI:2TE S;CH RIS=S:

Foreign exchange &usiness had become the profit centers of banks throughout the orld. There is a drift from the traditional lending business due to intense competition, lo ering spread, increase in bad loans, etc., Thus, earning from non fund based and off balance sheet items has been the call of the day for the banks. 5o e$er, through the foreign exchange business looks attracti$e it is not ithout risks. The foreign exchange market is a /7 hours market al ays remain open due to time difference and the forex transactions take place. The $arious risks peculiar to forex operation in a foreign exchange trading are summari?ed belo ' ).* Apen Bosition 6isk. )/* "ismatched "aturity 6isk. )4* %redit 6isk. )7* >o$ereign 6isk.

&" 1/en Position Ris9:

Exchange %ontrol guidelines in #ndia re<uires banks to maintain at the close of e$ery orking day a s<uare position in currencies. &ut in practice, absolute s<uare positions are impossible to maintain. Therefore, some open position either o$erbought or o$ersold is una$oidable in the $ery nature of foreign exchange operation. Also, it may happen that the dealer may be excepting the dollar to eaken during the day might s<uare the deal later, 5ence the bank makes profit out such open position hich is a deliberate attempt. 5o e$er, such unco$ered positions may result into a loss for the banks. To circum$ent such losses, banks adopt the follo ing measures as a part of risk management' )a* ,imits on #ntra day open position in each currency. )b* ,imits on o$ernight open position in each currency. )c* A limit on aggregate open position for all currencies taken
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Foreign Exchange

together. )d* A Turno$er limit on total daily transaction $olume for all %urrencies.

(" !is.atch !aturit0 Ris9s:

This can be illustrated by ay of an example. >uppose a customer has booked a for ard contract for =>+ 8111 maturing .4th >eptember /118. The banks ould ideally again go for #nterbank for ard borro ing for =>+ 8111 maturing .4-12-/118.5o e$er, it is possible that no seller - counter party might be a$ailable. This is mismatch maturity risk. The bank has a problem of first finding out the seller ho ill agrees to sell the re<uired forex at the re<uired rate on the agreed rate. #n the abo$e case, if the co$er date a$ailable is /8-2-18, the bank here ill run the risk of o$erdra ing its account abroad for ./ days. #f the rate of o$erdraft is costlier than the rate payable to customer the bank incurs a loss. Alternati$ely, the bank may undertake a s ap K buy for deli$ery .4 >eptember and sell for deli$ery /8-2-18. #f s ap rates mo$e against the bank it ould incur a loss. "easures to "itigate such risks' )a* A monthly gap limit for each currency. )b* A cumulati$e gap limit for each currency. )c* Accumulati$e gap limit for all currencies taken together.

'" Credit Ris9s' %redit 6isks are also $ery important in foreign
exchange business. These can arise hen a counter party, hether a customer or a bank, fails to meet his at the going rate. #f the rates ha$e mo$ed against the banks, a loss can result. !easures to !itigate Credit Ris9: )a* Brudential Exposure ,imit for customers. )b* Fixing of %ounter Barty - bank exposure ,imit and re$ie ing the same at regular internals.

Lecture Notes Prof. Rahul Shah !": # $%& %'(') *+*(,

Foreign Exchange

)" So?ereign Ris9s:

This is the political side of the credit risk. These risks can arise should country suddenly suspend or impose a moratorium on foreign payments because of balance of payments or other problems. The risk arises hen banks deal ith other banks in other countries.

E<CH2N:E R2TE !ECH2NIS! 2PPR12CHES 2N- !1-ELS:

THERI1ES@

An exchange rate is the relati$e price of one currency in terms of another. The exchange rate is the external $alue of a currency and influences trade and capital flo s across national boundaries, relati$e profitability of $arious industries, real ages of orkers and allocation of recourses ithin and across countries. The exchange rate thus tell us the purchasing po er of a countryDs currency. =nlike, any other prices exchange rate is also influenced by the interaction bet een the supply and demand forces. The supply of foreign exchange comes from experts and the demand from imports.

Theories in Foreign Exchange:

&"Purchasing Po8er Parit0 Theor0 PPP": The BBB as enunciated by > edish economist, @usta$ %assel in .2J.. According to this theory, the price le$els )and the changes in these price le$els* in different countries determine the exchange rates of countries currencies. The basic tenet of this principle is that exchange rates bet een $arious currencies reflect their purchasing po er. The la of one price pre$ails in the market. Therefore, this la is also kno n as ,AE Af Ane Brice. #n e<uilibrium conditions, the price of the commodity has to be the same across the orld. #f it ere not so, the arbitrageurs ould dri$e the price to ards e<uality by buying in the cheaper market and selling in the dearer market.

Lecture Notes Prof. Rahul Shah !": # $%& %'(') *+*(,

Foreign Exchange

For e.g. if in #ndia the cost of iron ore ere 9411-ton and in the => it ere 9481-ton, arbitrageurs ould buy the commodity in #ndia and sell in =>. This in turn ould increase the price in #ndia and reduce the price in =>. This process ill continue till the e<uality bet een the prices is restored. Brice e<uilibrium is possible only imperfect market condition.

2ssu./tions of the Theor0:

)&" Free !o?e.ent of :oods' The theory assumes that there is no restriction on the mo$ement of goods bet een the countries. )(" No Trans/ortation Costs: The la ill hold true only if it is assumed that there are no transport costs. This is becauseL the presence of transport cost ould negate the difference in prices and the mo$ement of goods. '" No Tariffs: The imposition or presence of tariffs ould distort the la and hence it is assumed that there are no tariffs imposed. 26solute Aersion of PPP: As per BBB, the price of currencies determine the exchange rate. According to this ,a , the domestic currency price of commodities in $arious countries hen con$erted into a common currency at the ruling spot exchange rate, is the same throughout the orld. Thus, the price of a commodity in country A can be calculated by con$erting its price in country &Ds currencies.

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Foreign Exchange

Criticis.s of PPP: The criticisms emerge from the assumptions. The la does not hold true in the short term, especially so in the case of goods ha$ing inelastic demand. Another problem is the construction of prices indices. "o$ement in prices are measured by price indexes. These indices used in different countries are based on different baskets of commodities ith the proportions of the commodities on the basis of usage and preferences of the residents. Further, the base year of these indexes are different t. hence indexes become inappropriate to $erify the absolute BBB.

Exchange Rate Forecasting !odels:

)&" 2sset !ar9et !odel' According to this method, the e<uilibrium exchange rate is that rate at hich the market as a hole is illing to hold the gi$en stocks of assets denominated in different countries. ("!onetar0 2//roach: The theory predicts that an increase in real @FB of a country causes its currency to appreciate. #n relation to / countries the country ha$ing a higher @FB ill see its currency appreciate $is(M($is other country hose @FB is lo er. An increase in real money demand appreciates the currency. An increase in nominal interest rates causes the currency to depreciate. An increase in the money supply cause the currency to depreciate.

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Foreign Exchange

-IRECT R2TES
.. Foreign exchange rates hich represent a relationship bet een fixed number of units of foreign currency ith $ariable number of units of domestic currency are called +#6E%T 6ATE>. An example of a direct rate in #ndia ould be, . =>+ #F6 77.I/81. +irect rate ere introduces in #ndia effecti$e from /nd August, .224. Ehen trading in foreign currency ith the use of direct rates, e follo the principle C&uy lo K >ell 5ighD. +irect rates are generally expressed in #ndia to the base of # unit of foreign currency except Napanese Gen hose relationship is expressed to the base of .11 units. #n =>A, direct rates are called C6ates on American termsD. An example of a rate on American terms ould be, . @B :=>+ ..20I8

IN-IRECT R2TES
Foreign exchange rates hich represent a relationship bet een fixed number of units of domestic currency ith a $ariable number of units of foreign currency are called #F+#6E%T 6ATE>. An example of an indirect rate in #ndia ould be, .11 #F6 : =>+ /./148. #ndirect rates ere used in #ndia from .2I. up(to /nd August, .224. Ehen trading in foreign currency using indirect rates, e follo the principle C&uy high K >ell lo D. #ndirect rates in #ndia ere generally expressed to the base of .11 #F6.

/.

4.

7.

8.

0. I.

#n =>A, indirect rates are called C6ates on European termsD. An example of a rate on European terms ould be, . =>+ : %5F ..4081

Lecture Notes Prof. Rahul Shah !": # $%& %'(') *+*(,

Foreign Exchange

J.

#n the case of direct rates, the base currency is al ays a foreign currency hereas $ariable currency is al ays the domestic currency.

#n the case of indirect rates, the base currency is al ays domestic currency hereas $ariable currency is al ays a foreign currency.

Co./arison 6et8een different le?els of 2-R:

P2RTIC;L2RS Trading Pattern LEAEL & LEAEL ( Anly on AT% ,isting allo ed market on >tock exchanges in =>A. Registration 8ith A+6Ds are &oth A+6Ds and SEC. registered but underlying underlying shares are shares are not registered. registered. 2dherence to Anly nominal Bartial :22P nor.s fulfillment. compliances -isclosure nor.s ,imited >tringent Ca/ital raising Fo public issue. Bublic issue Anly pri$ate ithout fresh placement capital. LEAEL ' ,isting allo ed on >tock exchanges in =>A. &oth A+6Ds and underlying shares are registered Full compliances Oery stringent Bublic issue ith fresh capital

-istinguish 6et8een :-R and 2-R:

N1. :L152L -EP1SIT1R3 RECEIPT .. %an be denominated in any freely con$ertible currency. /. %an be issued to in$estors in one or more markets simultaneously. 4. +epository bank can be any international in$estment bank. 7. #ssue does not re<uire foreign regulatory clearances. 8. 2!ERIC2N -EP1SIT1R3 RECEIPT %an be denominated only in => +ollars. %an be issued only to in$estors resident in the =>. +epository bank needs to be located in the =>. #ssue re<uire appro$al from the >ecurities and Exchange %ommission )>E%* of the => There is no sub(classification in They are sub(classified in terms of this instrument. the le$el of clearance of the >E%.
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Foreign Exchange

0.

@+6Ds are normally co(related #n many cases A+6Ds are co( to e<uity shares of the issuing related to e<uity shares of the company expressed in hole company expressed as a fraction. numbers.

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