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Ans 1
The following are the important functions of a foreign
exchange market:
1. To transfer finance, purchasing power from one nation to another.
Such transfer is affected through foreign bills or remittances made
through telegraphic transfer. (Transfer Function).
2. To provide credit for international trade. (Credit Function).
3. To make provision for hedging facilities, i.e., to facilitate buying and
selling spot or forward foreign exchange. (Hedging Function).
1. Transfer Function:
The basic function of the foreign exchange market is to facilitate the
conversion of one currency into another, i.e., to accomplish transfers
of purchasing power between two countries. This transfer of
purchasing power is effected through a variety of credit instruments,
such as telegraphic transfers, bank draft and foreign bills.
In performing the transfer function, the foreign exchange market
carries out payments internationally by clearing debts in both
directions simultaneously, analogous to domestic clearings.
2. Credit Function:
Ans 2
Risks associated with international projects- financial, political, others
1. Financial risk
In general, international projects are prone to greater financial risk as a bulk of finance
is in the form of debt. The major factors affecting financial risk are degree of
indebtedness, the terms and conditions of repayment of debt and currency used.
Some projects will have expenses and revenues that involve several currencies. As a
result the exchange rate risk is very high.
Projects maybe financed with floating rates. In view of the volatility observed on the
rates like LIBOR, the interest rate risk is also significant. Therefore it is necessary to
plan the coverage of all these risks.
2. Foreign Exchange Risk
As corporations expand their international activities, they begin to acquire foreign assets
and foreign liabilities. As exchange rates change, the values of these foreign assets and
liabilities change accordingly. For a corporation, exchange rate risk is the sensitivity of
the value of the corporation when the exchange rates change. Obviously, the change in
the corporation value is related to the net change in the values of the foreign assets and
foreign liabilities. (E.g. foreign direct investment, foreign exchange loss, sales and
income from foreign sources.)
3. Economic Risk
Economic risk is risk created by changes in the economy. Typically, it is related to
technological changes, the actions of competitors, shifts in consumer preferences, etc.
Ideally, a pure domestic firm is affected only by domestic economic conditions the
domestic economic risk. However, in todays integrated world economy, the concept of a
pure domestic firm has less practical relevance. Many firms that appear strictly pure
domestic confront foreign economic risk indirectly. (E.g.: local restaurant/dept store, real
estate agent)
4. Political Risk
Political risk is risk created by political changes or instability in a country. These factors
include, but are not limited to, nationalization, confiscation, price controls, foreign
Ans 3
Hedging
that the main position fails to mature in the way that the investor
foresaw, the counterposition with reduce his losses, either partially
or in full, depending on the nature of the hedge.
Advantages
The main advantage of this investment approach is to help reduce the risks and losses of the investor.
Hedging is a good strategy when dealing with foreign investment opportunities. The price of currencies
are volatile, however, hedging currencies can provide investors with more leverage when they put
money in the very risky Forex market.
Moreover, investors who do not have the time to monitor and check their investments can also benefit
from hedging. There are many hedging tools that can effectively lock profits for investors. The gains
from hedging are often realized in long term gains.
Also, since the objective of hedging currencies is to minimize losses, it can also allow traders to survive
economic downturns, or bearish market periods. If you are a successful hedger, you will be protected
against inflation, interest rate changes, commodity price volatility and currency exchange rate
fluctuations.
Ans 4