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Foreign Exchange

A foreign exchange means the conversion of a local currency of a country into


another a currency of another country. In a free market economy, the value of a
currency if determined by the factors of demand and supply, in other words the
value of a currency can be fixed in accordance with the currency of another country
like the GBP or the Euro, or even to a basket of currencies. A countrys currency may
also be pegged by the government of that particular country. However, most
countries float their currencies freely against the currencies of other countries,
which constantly keeps them in fluctuations.
The need for foreign exchange arises due to trade, investments & tourism. For
example a tourist from USA who visits India would require the local currency of India
to purchase goods or services in the country, therefore, he would have to get it
exchanged. Another example could be that of a company who wants to do business
with a company in another country. The foreign company would have to pay the
local company in the local currency of the country. Similarly an investor who desires
to invest in another company would have to pay in the local currency. These
requirements create the need for foreign exchange

Foreign Exchange Market


In general a market is a place where there are buyers and sellers of particular goods
and services, similarly a foreign exchange market is a place where currencies of
different countries are bought and sold. The major participants of the foreign
exchange market are:
1. Central banks
2. Brokers
3. Commercial banks
4. Exporter, Importer, Tourist, Investors, Immigrants.

Central Banks
The central bank is an important participant in the organization of the exchange
market. They work as the custodian of the foreign exchange of the country. The
central bank plays an important role in the foreign exchange market. Its main
function is to prevent the aggressive fluctuations in the foreign exchange market. It
does this by selling the currency when it is overvalued and buying it when it is
undervalued.

Broker
The brokers act as a link between the central bank and the commercial bank and
also between the actual buyers and commercial banks. A major source of market
information comes from the brokers. The brokers do not buy the currency for
themselves but instead strike a deal between the buyer and seller on a commission
basis.

Commercial Banks
The second most important organ in the foreign exchange market are the
commercial banks. The Commercial Bank are the market makers as they quote on a
daily basis for buying and selling foreign exchange. The Commercial Banks buy the
foreign currency from the brokers and sell it to the buyers.

Exporters, Importers, Tourists, Investors, Immigrants.


They are the actual buyers of the foreign currency. They buy foreign currencies from
the commercial banks as and when their need arise

Market Players in Foreign Exchange

Source: http://old.fxstreet.com/education/forex-basics/the-six-forces-of-forex/2006-06-

29.html

Determination of Foreign Exchange Rates


The relative level of economic health of a country can be determined by the foreign
exchange rate of that country. It is one of the means of economic stability which is
why it is analyzed. For example if a father wants to send some foreign currency to
his son in the US who has gone there for his further studies he may have to keep a
constant eye on the fluctuation on the currency. The foreign exchange rates may
keep fluctuating due to the market forces of demand and supply of currencies from
a country to another. Therefore, it is important to understand as to what causes the
fluctuations in the exchange rates when one is sending or receiving funds
internationally.

Factors influencing variations or fluctuations in exchange rates


1. Inflation Rates: Fluctuations or variations in the currency exchange rates
is due to the changes in the market inflation. A country with low inflation rate
will have an appreciation in the value of its currency and country with a high
inflation rate will see a decline in the value of its currency. The prices of
goods and services tend to increase at a slower pace the inflation rate of the
country is low.
2. Interest Rates: the foreign exchange rates, inflation and interest rates are
correlated. Higher interest rates attract foreign investments as it gives higher
rates to the lenders attracting foreign capital which in turn increases the
demand and value of the home currency.
3. Countrys Current Account / Balance of Payments: Current account
of a country is the total exports and imports of the country. If the imports are
greater than that of the exports it is known as a current account deficit but if
the exports are more than that of the imports it is known as a current account
surplus. The fluctuations of currency i.e. the appreciation or devaluation is
dependent on status of the current account of a country. If the current
account shows a surplus it means that it has an inflow of foreign currency but
if the current account shows a deficit it means that the country has to pay
and there is an outflow of currency. Therefore, the balance of payments also
plays a major role in the fluctuation of a currency.
4. Government Debt: government debt also known as national debt is
owned by the central government. National debt truly has an impact on the
Foreign exchange rates. *For example Spain recently accepted a 100 billion
loan for its banking sector from the European Commission. This adds about
10.0% to Spains national debt, because the loan must be guaranteed by the
Spanish state. Theoretically this should be fine, because Spain is a $1 trillion
economy, and so can handle a large loan without difficulty. The problem
though is that Spain is in the midst of a depression, with Gross National
Product expected to shrink over the next three years. Spain therefore has no
credible plan for paying back this loan. It could default, which would cause
immense problems for the Eurozone because, again, Spains economy is so
big. That in turn has had an adverse impact on the value of the euro. Hence,
in this way, national debt has a direct impact on the foreign exchange rates.
*(http://www.purefx.co.uk/help-centre/daily-market-commentary/view/how-
does-national-debt-affect-the-foreign-exchange-rate)
5. Terms of Trade: the terms of trade is the ratio of the export prices to the
import prices. if the prices of the exports increases than the prices of the
imports, the terms of trade also improves and increases the demand for the
countrys currency and its value resulting in the appreciation of the
exchange rate.
6. Political Stability & Performance: The political stability and the economic
performance of a country affects the strength of the currency. A country with
less political risk attracts more foreign investors which increases foreign
capital leading to an appreciation in the domestic currency.
7. Recession: The interest rates of a country falls when a country experiences
recession which decreases the chances of acquiring the foreign capital. This
results in the weakening of the currency in comparison to other countries
which further results in lowering of the exchange rate.

Foreign exchange risk


A bank also holds assets and liabilities in foreign currencies which impacts its
earnings and capital due to the fluctuations in the exchange rate, this is known as
foreign exchange risk the exchange rates cannot be predicted for the future period,
it may either rise or fall regardless of the estimations and predictions. These
uncertain variations which are undesired and unanticipated possess a threat to the
banks earnings as well as its capital.

Types of Foreign exchange Risk


1. Transactional Exposure
2. Economic Exposure
3. Translational Exposure
4. Operational Exposure

Transactional Exposure
Transaction exposure is a kind of risk where cross currency transactions are involved
(international Trade) where multiple currencies come in from various countries. In
other words if a company id dealing with another foreign company where it would
have to make a payment in foreign denomination and the exchange rates fluctuates
before the final settlement then this known as Transactional Exposure.
For example if an Indian company is doing business with a US based company and it
has a receivable of USD 5000 due in five months time but at the same the the
dollar depreciates relative to the Indian rupee the the Indian company will face a
cash loss but on the other hand if it had to payable to the US company then the
Indian company would have made a gain due to the depreciation of the US dollar.
Thus a cross currency contract between the two firms located in different countries
agree for a specific amount of money and goods. However the contract value may
change due to fluctuations in the foreign exchange rate. This risk of change in the
exchange rate is called Transaction Exposure. The time gap associated between the
agreement and the final settlement determines the risk in the foreign exchange
rates. Greater the time gap higher the risk. However companies use hedging
techniques to save themselves from transactional exposure.

Operating exposure
The extent to which a companys future cash flows are affected due to the changes
in the price and most importantly due to the changes in the exchange rate is known
as the operating exposure. In other words an operating exposure is the risk that the
companys revenue is affected due to inflation rate and change in the exchange
rates.
Like transactional exposure, operating exposure also involves the actual or potential
gain or loss, but the transactional exposure deals with particular transactions of the
company while operating exposure deals with the macro level exposure where not
only the company involved gets affected but the whole industry observes change
along with the change in the inflation rate and exchange rates thus the entire
economy is exposed to foreign exchange risk with the operating exposure.
Operating Exposure is difficult to identify as the cash flows largely depend upon the
companys input and the prices of its output which gets altered significantly with
the change in the foreign exchange rates. Operating exposure relates to unseen
challenges from the competitors, entry barriers etc which are subjective in nature
and are interpreted differentially by different experts. Thus, competitive position of
the company is influenced substantially by operating exposure.

Translation Exposure
Translation exposure is also known as accounting exposure. It is the risk arising due
the translation of assets held in foreign currency or abroad changes due to the
movement in the foreign exchange rates. The translation exposure is concerned
with recorded profits and the balance sheet values and does not affect the overall
value of the company. Since the losses or gains due to the translation of financial
items has no significant impact on the stock prices of the company

Foreign Exchange Risk in Commercial Banks


Commercial Banks actively deal in foreign currencies, they hold foreign
denominated currencies and are therefore continuously exposed to foreign
exchange risk. The foreign exchange risk in a commercial bank mainly arises from
its trade and non-trade services.
The commercial bank is exposed to foreign exchange risk only to the extent to
which it has not hedged or covered its position. The foreign exchange risk of a
commercial bank lies where there is uncertainty that the future rates will affect the
value of financial instruments and not where the future exchange rate is predefined
by the bank using different instruments and tools.